Sources of Interest-Rate Fluctuations: Nominal Interest Rates

1. Sources of Interest-Rate Fluctuations: Nominal Interest Rates Money and Banking Mr. Vaughan

2. Learning Objectives:Part II – Nominal Interest Rate • After this lecture, you will be able to: • Explain how changes in expectedinflation affect nominalinterest rates in long run. • Describe how monetarygrowth affects inflation in long run. • Trace effects of monetarypolicy on nominal interest rate in short run and longrun.

3. Fisher Equation • Recall: • Borrowers and lenders care about real interest rate. • But, financial markets set most interest rates in nominal terms. • So, borrowers and lenders must guess about inflation rate. • Real Interest Rate + Expected Inflation • Nominal Interest Rate

4. Guessing Wrong Is Costly! Debtors Win/Creditors Lose!

5. Guessing Wrong Is Costly! Creditors Win/Debtors Lose!

6. Expectations and Nominal Rates • To avoid losses, debtors and creditors: • use alluseful information. • learn rapidly from mistakes. • react quickly to changes in expected inflation. Implications: • “Rational” Expectations = Random forecast errors • Changes in inflation expectations move bonddemand/supply and nominal interest rate rapidly.

7. Fisher EquationIn Pictures Bond Demand2 ib b Qb Nominal Interest Rate Bond Demand1 Increase in expected inflation reduces expected return on bonds and, thus, bond demand. ia a Bond Supply1 Quantity of Bonds ($) Qa

8. Fisher EquationIn Pictures ic c Bond Supply2 Qc Nominal Interest Rate Bond Demand1 Increase in expected inflation reduces real cost of borrowing and, thus, increases bond supply. ib b Bond Supply1 Quantity of Bonds ($) Qb

9. Fisher EquationIn Pictures Nominal Interest Rate Bond Demand2 Bond Demand1 ic Absent distortions, nominal interest rate will rise by increase in expected inflation. c  expected inflation ia a Bond Supply2 Bond Supply1 Quantity of Bonds ($) Q*

10. Fisher Equation:Evidence • Note: Inflation trends explain • Rising rates before early 1980s • Falling rates since 1980s • Rate volatility since 1950s

11. …But what causes (changes in) inflation? • “Inflation is always and everywhere a monetary phenomenon.” • Milton Friedman • His Point? • In short run, many factors can boost general level of prices • Only sustained growth in money supply can produce sustained rise in prices. First things first: What is “money?”

12. Money in U.S. Economy • Money Supply: Total quantity (dollar volume) of assets providing medium-of-exchange services • Currency: Paper bills & coins in public hands. • Checkable Deposits: Bank balances depositors can access on demand by writing check (demand deposits, NOWs) • Traveler’s Checks This functional definition is M1 (narrow money).

13. U.S. Money StockTwo Measures As of October 2008 (Seasonally Adjusted) $ Billions M2 = $7,878.9 billion $7,878.9 • Savings Deposits = $4,032.3 • Small Time Deposits = $1,314.0 • Money Market Mutual Funds = $1,059.6 • Total = $6,405.8 billion M1 = $1,473.1 billion $1,473.1 • Currency = $795.0 • Checkable Deposits = $672.4 • Traveler’s Checks = $5.8 Everything in M1 0 Note: - Currency only 10.1% of M2 - Checkable deposits only 8.5% of M2 M2 is “Broad” money – Better measure for policy, scientific purposes

14. How correlated are M’s?

15. Money and InflationQuantity Theory of Money • Quantity Theory starts with equation of exchange: M x v = P x y • M = Money Supply • v = Income Velocity of Money • Average number of times per period each dollar of money supply is spent on nominal GDP • P = GDP Deflator / 100(general price level) • y = Real GDP Note: • P x y = Nominal GDP • Equation is tautology (needs assumptions to become theory)

16. Quantity Theory of MoneyAssumptions • M= Exogenously determined (by government) • v= Not influenced by money (in short run relatively stable) • Determined by “real” factors such as payments technology/institutions, tastes, etc. • y =Not influenced by money (in short run) • Determined by “real” factors such as technology, factor endowments, societal commitment to markets/property rights, etc.

17. Quantity Theory of MoneyAssumptions Reasonable?

18. Quantity Theory of MoneyImplications of Assumptions • Equation of Exchange (rate of change form): • Note: • If growth in velocity and real output are determined exogenously by real factors, then changes in prices (only endogenous variable) must be determined by changes in money supply. • Quantity Theory focuses on long run, not short run. %ΔM +%Δv = %ΔP +%Δy

19. Quantity Theory of MoneyU.S. Evidence NOTE: Money growth and inflation lower in period (2)!

20. Quantity Theory of MoneyCross-Country Evidence • Note: • Each point represents 30-year average annual money growth and 30-year average annual inflation • All points lie near/on 45-degree line. Source: McCandless and Weber, 1995

21. Proximate Cause of InflationExcessive Monetary Growth • Excessive Growth of Money Supply Faster than economy’s long-run real growth rate Excessive Spending on Goods and Services Long-Run Real Growth ≈ 3.3% Inflation

22. Money Growth and InflationU.S. Evidence VelocityGrowth: 0.1% Real GDP Growth: 3.3% Average Annual Rates United States 1959:Q1-2008:Q4 • Money Supply(M2) Growth: 7.0% Inflation:3.7%

23. Money and Nominal Rates Cross-Country Evidence Monetary growth => Inflation => Nominal Interest Rates Note: Each point represents average annual money growth and average annual inflation (circle/square represents average values for one country, 1961-1998). Source: Monnet and Weber, 2001

24. Money and Nominal RatesCross-Country Evidence Note: Each point represents average annual money growth and average annual inflation (circle/square represents average values for one country, 1961-1998). Source: Monnet and Weber, 2001

25. Money and Nominal Rates U.S. Evidence Monetary growth => Inflation => Nominal Interest Rates

26. Money and Nominal Rates Short Run Short-term effect on nominal interest rate is called liquidity effect. • Fed implements monetarypolicy by purchasing/selling Treasuries. • Transactions are called open-market operations. • Open-market purchases increase bank reserves and reducebond supply. • Open-market sales reduce bank reserves and increasebond supply.

27. Example:Fed in Action ia a ib b Bond Supply1 Bond Supply2 Qb Qa Nominal Interest Rate Bond Demand1 Suppose Fed buys Treasuries in open market. Bond supply will fall, and nominal interest rate will fall. Quantity of Bonds

28. Why ConductOpen-Market Operations? • Fed buys and sells Treasuries to stabilize economy. • Weakening economy: Fed buys Treasuries to lower interest rates and stimulate economy. • Overheating economy: Fed sells Treasuries to raise interest rates and slow economy.

29. Art of Central Banking • Balancing short-run goals of monetary policy (a stable, high-growth economy) with long-run goals (low inflation) is challenging. • High inflation and nominal interest rates of 1970swere due to excessive focuson short run.

30. Putting It All TogetherLinking the Long and Short Run • Does easy money lower nominal interest rate? • Short run: • Open-market purchases lower nominal interest rate. • Long run: • When economy perks up, nominal rate starts rising. • If monetary stimulus is excessive, inflation starts rising. • Bond demanders/suppliers adjust inflation expectations, further raising nominal rate.

31. Putting It All TogetherLinking the Long and Short Run Time path of actual nominal rates Initial rate Shortrun Longrun • Does easy money lower nominal interest rates? Nominal Interest Rate Time 0

32. You try it! Why were nominal rates lower in later period?

33. You try it! Money growth and inflation were lower!

34. Questions over Sources of Interest-Rate Fluctuations: Nominal Interest Rates? Money and Banking Mr. Vaughan