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In these notes that follow we will refer to short term interest rates. An important short term rate is the FED FUNDS rate. This is the rate banks charge each other when one bank lends to the other for a length of 1 day! Yes banks lend to each other and the length is 1 day. Other short term assets are 30, 60 or 90 day government treasury bills and the rate of interest paid is a short term rate.
Overview Monetary Policy is undertaken by the FED. The FED can use open market operations to change the money supply. The idea is for the interest rate to change. This will change the level of investment and hence the AD curve. Open market operations consist of FED purchases or sales of bonds (like we saw before). We want to spend a little time understanding the relationship between bond prices and the interest rate.
Present and future values Let’s first note that $1 today can grow into $1.10 at the end of the year if the interest rate is 10%. Thus 1.10 = 1(1+.1), or F = P(1+r). The future amount is the present amount times (1 + the interest rate). Bonds have a fixed future amount, F. If you hold a bond as of a certain date in the future you get paid a certain amount of money. The amount you pay for the bond today, P, determines the interest rate you earn, r.
Present and future values If you pay $1 for a bond that pays $1.10 next year you earn 10%. If you pay $0.90 for a bond that pays $1.10 next year you earn 22% So, bond prices and interest rates move in oppositedirections. On the previous screen I had the formula F = P(1+r). Rearranging terms we have r = (F/P) – 1. If F = $1.10 and P = $1, then r = (1.10/1) – 1 = .1 or 10% If F = $1.10 and P = $0.90, then r = (1.10/.9) – 1 = .22 or 22%. The point I want you to remember is that bond prices and interest rates move in opposite directions.
Now here is what happens when there is a FED purchase of securities from a bank like we saw before. 1) The FED purchase means the FED goes into the bond market reducing the supply of bonds banks (or people for that matter) can hold. This pushes the price of bonds up. 2) As bond prices go up, interest rates come down. 3) Banks can thus lend more at lower rates. 4) At the same time the supply of bonds is reduced, the money supply rises.
Money market focus On the previous screen we saw that a FED purchase reduces the supply of bonds or, equivalently, increases the supply of money. Here we will focus on the money market impact. There is an equivalent impact in the bond market. Let’s turn to the demand for money.
Money demand i In a graph we will see the demand for money look like this. This means the higher the interest rate, i, the lower the quantity of money demanded. On the following screens let’s see the economic rational for this graph. Md Qm
Money demand - transactions Remember money is currency and checkable deposits. A reason we hold money is to make transactions. Let’s imagine a person gets a paycheck once a month. Let’s also say when they get the paycheck they put all the funds into the bond market. This way they can earn interest on their wealth. Typically this means they can earn more than what they would if they put their funds into a checking account.
Money demand - transactions What happens when the individual wants to make a transaction? They would have to sell some bonds to get money because merchants want to be paid money. This could be a hassle - time consuming and maybe bad timing on the bonds. So, there is a trade-off involved here. If we want to earn interest we must put assets in the form of bonds. But when we want to make transactions we have to sell the bonds for money. There is a risk the bonds won’t yield much at that time and we could lose out. We are more willing to take the risk when the current rate of interest is high, and thus the quantity of money we demand would be low. When the rate of interest is low we do not take the risk and thus demand a greater quantity of money.
Money demand - precautionary People hold some money for emergencies – emergencies can be costly. But, they recognize when holding money they can NOT earn interest on things like bonds. Thus, the higher the interest rate (equivalent to low bond prices) the lower the quantity of money people demand because although the emergency is costly, it is even more costly to give up the interest.. Or, the lower the interest rate, the greater the quantity of money people will demand.
Money demand - asset Money is an asset. Two desirable features of money as an asset is its liquidity and lack of risk. Liquidity refers to an assets ability to be used in transactions. Money is the most liquid asset because it can be used in transactions right now. Real estate, for example, is less liquid than money because you have to find a buyer, get financing and other stuff that takes time. So real estate is not an asset that can be readily used in transactions. It has to be sold first. Money has no risk of losing its value as money. A dollar is always 100 pennies. Stocks, bonds and other stuff can lose value. The asset demand is inversely related to the interest rate just as is the precautionary demand.
Money demand So, the demand for money is a downward sloping graph when the amount of money is on the horizontal axis, and the interest rate is on the vertical axis. The demand curve can shift. We will focus on nominal GDP as the shifter. As nominal GDP rises folks demand more money to purchase the GDP (the money demand shifts to the right).
Interest rate determination r Ms Remember the money supply can be set by the FED through open market operations. The interest rate is determined where the Ms=Md in the economy. On the following few screens let’s see how the interest rate changes by FED action. r0 Md Qm
FED purchase r Ms1 Ms2 When the FED purchases securities in the open market banks find they have more reserves to lend and this means an increase in the money supply. The interest rate falls. r1 Md r2 Qm
FED sale - money supply fall The logic of a FED sale is similar, but in reverse, of a FED purchase.
Investment impact r Md Ms1 Ms2 r r1 r2 I I1 I2
FED purchase again On the previous screen you can see the money market and the investment function. You need to remember 1) The logic of the money market change - FED purchase of securities or bonds in the open market. 2) Why investment changes when the interest rate changes.
Expansionary Monetary Policy Recall Fiscal policy shifted AD by working on G and C (C, by changing T). Monetary Policy is going to work on AD through I. When Fed gets reserves in the banking system to grow the interest rate falls, increasing I and shifting AD to the right. The action is useful if the economy is in recession.
Contractionary Monetary Policy When Fed gets reserves in the banking system to shrink the interest rate rises, decreasing I and shifting AD to the left. The action is useful if the economy is in an inflationary period. Note, when AD shifts to the left the price level may not fall, but at least the rising price level is stabilized.
Problems of Monetary Policy Similar to fiscal policy, monetary policy may not always work as great as we see it can in theory because of recognition and operational lags (although it does not have administrative lag). Again, the point is it takes time to recognize the economy is in jeopardy and it takes time to put into place the policy to cure the ill.
