Understanding Monetary Policy: Influence on Interest Rates

1. Chapter 16 Interest Rates and Monetary Policy

2. Monetary Policy -- Initiatives by Federal Reserve to influence the money supply and interest rates in pursuit of financial objectives 4 Goals of Monetary Policy 1) Price Stability -- minimize amount of inflation (traditionally less than 4%) 2) High Employment 3) Economic Growth 4) Stability of Financial Markets and Institutions Fed has 3 primary tools for conducting monetary policy 1) Open Market Operations – buying/selling of bonds 2) Discount Policy – adjusting discount rate 3) Altering Reserve Requirements

3. Demand for Money (MD) -- demand for money by individuals and firms -- Wealth comes in two forms: a) money: means of payment but does not earn interest b) bonds: not a means of payment but earns interest -- Demand for money depends on 3 variables 1) Price Level -- as price levels ↑, demand for money ↑ -- as goods become more expensive, it will take more money to buy these goods

4. 2) Real GDP -- as real GDP ↑, demand for money ↑ -- increase in real GDP indicates that buying/selling of goods will increase, increasing the demand for money 3) Interest Rate -- opportunity cost of holding money -- as interest rates (r) ↑, quantity demanded of money ↓

5. Money Demand Curve (MD) -- describes the relationship between interest rates and quantity of money demanded, with all other influences on money demand remaining constant As interest rates ↑, quantity of money demanded ↓

6. Shifts in MD Curve -- Changes in Real GDP or Price Levels a) As real GDP ↑ or price levels ↑, MD ↑, shifting MD to the right

7. b) As real GDP ↓ or price levels ↓, MD ↓, shifting MD to the left

8. Supply of Money (MS) -- Describes the relationship between quantity supplied of money and the interest rate -- As we learned, the Fed can control the money supply through open market purchases or open market sales -- Since the Fed has direct control over this variable, the MS curve is represented by a vertical line (not influenced by changes in the interest rate)

9. Shifts in Money Supply -- Open market purchases (purchases of bonds) increases the money supply and causes MS to shift to the right. -- Open market sales (sales of bonds) decreases the money supply and shifts MS to shift to the left Equilibrium -- point where MS and MD intersect -- quantity of money being held (MS) = quantity of money wanting to be held (MD)

10. How Market Obtains Equilibrium -- Bonds and money are the two assets people can choose as wealth -- At Pt A, MD = $2 billion and MS = $6 billion. Since MS > MD, there is excess supply of money = $4 billion. Since people would want to hold less money than they’re currently holding, they would also like to hold more bonds (excess demand for bonds). -- With excess supply money/excess demand for bonds, people will now try to convert money into bonds, so price of bonds ↑. As price bonds ↑, interest rates ↓ and we move down the curve toward pt E. -- At Pt B, MD = $8 billion and MS = $6 billion. Since MD > MS, there is excess demand for money = $2 billion. Since people want to hold more money than they’re currently holding, they would also like to hold less bonds (excess supply for bonds). -- With excess demand money/excess supply for bonds, people will now sell their bonds for money, so price of bonds ↓. As price bonds ↓, interest rates ↑ and we move up the curve toward pt E.

11. Manipulation of Interest Rate by Fed -- Through open market purchases and sales of bonds, the Fed can shift the Ms curve, thus influencing the interest rate -- Open market purchase  Ms ↑  Excess Supply for Money/Excess Demand for Bonds  Price Bonds ↑  Interest Rates ↓

12. -- Open market sale  Ms ↓  Excess Demand for Money/Excess Supply for Bonds  Price Bonds ↓  Interest Rates ↑

13. Other Ways to Control Money Supply 1) ∆ in Required Reserve Ratio (RR) -- if RR ↑, money supply ↓ -- if RR ↓, money supply ↑ 2) Discount Window Lending -- commercial banks borrow money from the Federal Reserve -- A decrease in the discount rate encourages borrowing from Fed which would increase borrowed reserves of the bank and ↑ money supply -- An increase in the discount rate discourages borrowing from Fed which would decrease amount of borrowed reserves of the bank and cause a ↓ in money supply

14. How Interest Rates Affect the economy Federal Funds Rate -- interest rate that commercial banks charge each other for short-term loans -- most watched interest rate in the economy -- changes in the Federal Funds Rate are decided by the FOMC -- steers the direction of monetary policy -- directed through open market operations open market purchase  increase in money supply and decrease in Federal Funds Rate open market sale  decrease in money supply and increase in Federal Funds Rate

15. -- Federal Funds Rate affects changes in other interest rates, causing them to move in the same direction (i.e. mortgage rates, interest rates on Gov’t bonds) -- since interest rates all flow in the same direction, we can speak of changes in interest rates very generically. -- In order to fight recessions, FOMC will announce a drop in the Federal Funds Rate ↓ r  ↑ C and IP  ↑ PAE (via multiplier) and ↑ Y -- In order to fight inflation, FOMC will announce an increase in the Federal Funds Rate ↑ r  ↓C and IP  ↓ PAE (via multiplier) and ↓ Y