Monetary Policy

1. Monetary Policy Chapter 13

2. The Supply of Reserves Banks lend more when the fed funds rate increases Federal Funds Rate Supply: banks Banks increase lending as interest rates rise because it is more profitable io A movement up (down) along the supply of funds resulting from higher (lower)interest rates Money

3. Banks lend more when the fed funds rate increases A movement up along the supply of funds resulting from higher rates Federal Funds Rate Supply: banks, Fed Banks increase lending as interest rate rises because it is more profitable Supply increases when the Fed injects reserves io The Fed manipulates the amount of reserves in the system. A rightward (left) shift in the supply of funds resulting from Fed pumping more (less) reserves into the system Money

4. The Demand for Reserves Federal Funds Rate Supply: banks + Fed As fed funds rate rises bank’s want to borrow less reserves io A movement up (down) along the demand for funds resulting from higher (lower)interest rates Demand: Public Money

5. Banks need more reserves when Deposits increase Demand for Reserves Federal funds Rate Supply= excess reserves + Fed changes io Demand: Banks + Public Money

6. The higher prices and Income, the higher the need for cash/deposits What Determines How Much Money public wants to hold as Deposits? We need more cash/deposits for more expensive transactions Prices + The higher the interest rate, the lower the demand for cash/deposits We need more cash/deposits for more transactions. Real Income + The higher the interest rate the less money we want to hold as cash/deposits Interest rate -

7. Deposits • Larger when we engage in more transactions • Real GDP is used as an indicator of the number of transactions (Q) • Larger when transactions are more expensive: • Price Index is used as indicator of the average price per transaction (P) Demand for Reserves depends on size of Deposits: R = r*D Size of Deposits depend on dollar value of transactions: P*Q Demand for Reserves depends on dollar value of transactions: P*Q

8. Deposits/ Demand for reserves increase when GDP increases Deposits/ Demand for reserves increase with more transactions Banks need more reserves when Deposits increase Shifts in Demand for Reserves Federal funds Rate Supply= excess reserves + Fed changes Deposits/ Demand for reserves increasewhen prices increase io A rightward (left) shift in the demand for funds resulting from increase (decrease) in GDP or Prices Demand = Banks in need of reserves Money

9. Monetary Policy • The Fed determines the “desired level” for the interest rate • The Fed adjusts the Money Supply until the rate hits the target. • Via Open Market Operations. • Via changes in required reserves. • Via changes in discount rate. • Via changes in margin requirements. • Via moral suasion.

10. The Demand for Money Interest Rate The higher the i, the higher the opportunity cost of holding cash i0 The less cash we wish to hold. Amount of cash WE wish to hold. Md0

11. The Demand for Money Interest Rate As the i falls, the opportunity cost of holding cash decreases We can afford to hold more cash. i1 Amount of cash WE wish to hold. Md1

12. What is the shape of the Demand for Money? The Demand for Money slopes downward and to the right. Why does it have this shape? Because as the interest rate increases, the opportunity cost of holding cash increases. Because as the interest rate decreases, the opportunity cost of holding cash decreases.

13. The Demand for Money Interest Rate • Tells us the quantity demanded of money at each interest rate or • The interest rate that would induce the public to hold a given amount of cash. i0 i1 Md0 Md1

14. Movements Along the Demand for Money • Represent a change (increase or decrease) in the demand for money • Are ONLY caused by changes in the interest rate. i i0 Increase in Md i1 Md0 Md1

15. What Determines How Much Money we Want to hold as cash? The higher prices and Income, the higher the need for cash We need to hold more cash for more expensive transactions Prices + The higher the interest rate, the lower the demand for cash We buy more things: we need more cash for more transactions. Real Income + Interest rate The higher the interest rate the less money we want to hold as cash -

16. Shifts in the Demand for Money i • Represent changes in the demand for money • Caused by FACTORS different from the interest rate. i0 i1 Md0 Md1 Income Prices

17. When Prices Increase At each iwe hold more cash than before • More expensive transactions require larger cash holdings i0 The demand for money shifts to the right i1 Md0 Md1

18. When Real Income Increases • We engage in MORE transactions which require larger cash holdings. i=5% The demand for money shifts to the right i=3% 700 bill. 900 500 bill. 800

19. i Ms $ The Federal Reserve Bank Controls the Supply of Money • Open Market Operations. • Changes in the Discount Rate • Changes in the required reserve ratio. 700 bill The amount of money in circulation is fixed by the fed

20. Relationship Between Bond Prices and the Interest Rate Bond P Price:$100 Interest Rate: 5% Interest: $5 Peter purchased this bond Bond A Price:$100 Interest Rate: 8% Interest: $8 A month later a new bond “A” is issued into the market

21. Which Bond would you buy? The new bond “A”? Peter’s? Bond P Price:$100 Interest Rate: 5% Interest: $5 Bond A Price:$100 Interest Rate: 8% Interest: $8 Clearly A is better than P: same price but higher interest

22. A Price that would make Peter’s bond more attractive The new bond “A” Peter’s Bond P Price:$100 Interest Rate: 5% Interest: $5 Bond A Price:$100 Interest Rate: 8% Interest: $8 What price should Peter ask for to convince you to purchase his bond rather than A? A price so low, that the interest you earn on Peter’s bond is higher than 8%

23. The lower the price you pay, the higher the interest rate Peter’s Bond If you pay $100 for Peter’s Bond You receive $105 at maturity Interest Rate = (105 – 100)/100 = 5% If you pay $90 for Peter’s Bond You receive $105 at maturity Interest Rate = (105 – 90)/ 90 = 16.7%

24. If you pay $97.22 you’ll get exactly What price will give us exactly 8% for Peter’s bond? If you pay $X for Peter’s Bond You receive $105 at maturity Interest Rate = (105 – X)/ X 8% = (105 – X)/ X 0.08 X = 105 - X 0.08 X + X = 105 X(0.08 + 1) = 105 X = $97.22 X(1.08) = 105

25. If Peter needs to sell his bond It must sell it for LESS than $97.22 to makei >8%

26. When interest rates rise, bond prices drop What does this mean? When interest rates rise: when new bonds come into the market with higher interest rates…I can still sell old bonds for cash, but I will lose money in the transaction.

27. The Relationship Between Bond Prices and the Interest Rate Bond P Price:$100 Interest Rate: 10% Interest: $10 Peter purchased this bond Clearly P is better than A: same price but higher interest Bond A Price:$100 Interest Rate: 5% Interest: $5 A month later a new bond “A” Is issued into the market

28. If you pay $104.76 you’ll get exactly What price will give us exactly 5% for Peter’s bond? If you pay $X for Peter’s Bond You receive $110 at maturity Interest Rate = (110 – X)/ X 5% =(110 – X)/ X 0.05 X = 110 - X 0.05 X + X = 110 X(0.05 + 1) = 110 X = $104.76 X(1.05) = 110

29. When interest rates fall, bond prices increase If Peter needs to sell his bond He can now sell it for MORE than $100

30. What does this mean? When interest rates fall: when new bonds come into the market with lower interest rates…I can sell my bonds at a profit.

31. Inverse Relationship Between Price of Bonds and Interest Rate Amount you get at maturity 100 Price you paid for Bond 90 25% 80 - 11% Interest rate = 90 Price you paid for Bond 80 The lower the price on the bond, the higher the interest rate.

32. Bond Market Supply of bonds P0 Demand for bonds

33. P1=80 Bond Market: Fed Sells Bonds Supply of bonds i =25% Bond Price falls: Interest Rates Increase i =11% P0=90 Demand for bonds

34. Market for Reserves: Fed Sells Bonds Federal funds Rate Supply= excess reserves + Fed changes i1 io Demand: Banks + Public Money

35. The Money Market: Fed Sells Bonds Ms0 Ms1 Reserves, Loans, Deposits and the Ms decrease Money scarce: The interest rate rises i Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when i0 =3% Amount of Money the Public holds in deposit accounts<Amount the public wants to hold when i0 =3% Amount of Money the Public holds in deposit accounts=Amount the public wants to hold when i0 =5% i0 =5% i0 =3% $ Ms1 Ms0

36. P1 Bond Market: Fed Buys Bonds Supply of bonds Bond Price rises: Interest Rates Decrease P0 Demand for bonds

37. Monetary Policy Changing the Money Supply in order to affect Aggregate Spending

38. The Effect of an Increase in the Money Supply • The fed increases Ms by: • Reducing the required reserve ratio (r) • Buying bonds in the Open Market • Reducing the Discount Rate (d) i Ms0 Ms1 An increase in Ms is represented as a rightward shift in the Money Supply line $

39. Use Expansionary Monetary Policy When the Fed Wants to Reduce Unemployment Increase the Money Supply Decrease the interest rate. Increase demand for goods and services

40. The Effect of a Decrease in the Money Supply • The fed decreases Ms by: • Increasing the required reserve ratio (r) • Selling bonds in the Open Market • Increasing the Discount Rate (d) i Ms1 Ms0 A decrease in Ms is represented as a leftward shift in the Money Supply line $

41. Use Contractionary Monetary Policy When the Fed Wants to Reduce Inflation Decrease the Money Supply Increase the interest rate. Decrease Aggregate Demand

42. Federal Funds Rate Ms Supply i ffro Md $ Demand Quantity Bank Reserves i0 Supply of bonds P0 Demand for bonds

43. Questions to prepare for the test Use a diagram to show the effect on reserves, the money supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step. • The fed increases/decreases the required reserve ratio • The fed buys/sells bonds in the open market • Fed increases/decreases the discount rate. • Prices increase/decrease • Incomes increase/decrease

44. Items in yellow box mean that these effects are not mentioned in the textbook so you are not responsible for knowing these. Explanations by number in the next slide

45. More banks in need of reserves, fewer banks with excess reserves, banks try to beef up their reserves by making fewer loans thus decreasing deposits and the money supply. Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply. Fed injects more reserves: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply. Fed erases reserves from the system: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply. Banks borrow less from fed more from other banks (increase demand for reserves); banks beef up their reserves (instead of using expensive fed loans for emergencies) (decrease in supply): decrease loans, deposits and money supply. Banks borrow more from fed less from other banks (decrease demand for reserves); banks decrease their excess reserves (instead of using their own, they use cheap fed loans for emergencies) (increase in supply): increase loans, deposits and money supply. Increase in demand for reserves, increase in demand for money. Decrease in demand for reserves, decrease in demand for money Increase in demand for reserves, increase in demand for money. Decrease in demand for reserves, decrease in demand for money.