Interest Rates and Monetary Policy

1. Interest Rates and Monetary Policy

2. Interest Rates • Price paid for the use of money • Many different interest rates • Speak as if only one interest rate • Determined by money supply and money demand LO1

3. Monetary Policy Monetary policy is the manipulation of the money supply by changing bank’s excess reserves. LO1

4. Central Banks LO2

5. Definitions • Total (Actual) Reserves: Amount of money a bank holds (has available). Total Reserves = Required Reserves + Excess Reserves • Required Reserves: Fraction of Total (Actual) Reserves a bank must keep (can’t be loaned). • Reserve Ratio: Percentage of demand deposits bank must maintain for required reserves. LO1

6. Definitions • Excess Reserves: Amount of actual reserves the bank has to loan. Excess Reserves = Total Reserves – Required Reserves • Monetary Multiplier (m) = 1/Reserve Ratio LO1

7. Tools of Monetary Policy • Open Market Operations • The Reserve Ratio • The Discount Rate • Interest on Reserves LO2

8. Tools of Monetary Policy • Open Market Operations • Buying and selling of government securities (or bonds) by the Fed • Most important tool to change the money supply LO2

9. Tools of Monetary Policy To increase Sm, Fed can buy securities from bank or public. Example: Fed buys $1,000 security from commercial bank and the reserve ratio is 20%. LO2

10. Tools of Monetary Policy • Fed pays for securities by increasing bank’s actual reserves by $1,000. • Since bank doesn’t have to maintain required reserves for money from Fed, excess reserves increase by $1,000. LO2

11. Open Market Operations • Money creating potential of single bank is equivalent to its excess reserves (amount it can loan). • Bank’s money creating potential increased by $1,000. LO2

12. Open Market Operations • Monetary Multiplier (m) = 1/Reserve Ratio m = 1/.2 = 5 Change in Sm = m x change in excess reserves. • Money supply increases by $5,000 (5 x 1,000)due to monetary multiplier. LO2

13. Open Market Operations Example #2: • Fed buys $1,000 security from public, reserve ratio is 20% • Fed pays with $1,000 check, • money supply is directly increased by $1,000. LO2

14. Open Market Operations • Check is deposited and bank’s actual reserves rise by $1,000. • Required reserves increase by $200. (.2 x $1,000) • Bank’s excess reserves rise by $800. ($1000 - $200) • Bank’s lending ability increases by $800. LO2

15. Open Market Operations • Banking system’s money creating potential increases by $4,000 (5 x $800). • Money supply increases by $5,000 $4,000 + $1,000 (initial check). LO2

16. Tools of Monetary Policy The Reserve Ratio Percentage of demand deposits bank must maintain for required reserves. LO2

17. Tools of Monetary Policy • The Reserve Ratio • Changes the money multiplier • Reduce Reserve Ratio to increase money supply • Increase Reserve Ratio to reduce money supply LO2

18. Tools of Monetary Policy The Discount Rate LO2

19. Tools of Monetary Policy • The Discount Rate – Lender of Last Resort • Interest rate on loans from Fed to banks • Lower Discount Rate to increase money supply • Increase Discount Rate to reduce money supply LO2

20. Tools of Monetary Policy Interest on Reserves LO2

21. Tools of Monetary Policy • Interest on Reserves • Increase interest rate on reserves • Banks will leave more reserves with Fed • Decrease money supply • Decrease interest rate on reserves • Banks will leave fewer reserves with Fed • Increase money supply LO2

22. Tools of Monetary Policy • Reserve Ratio changes bank’s profitability • Discount Rate is a passive tool until financial crisis • Interest on Reserves is too new LO2

23. Fed Regulates Money Supply • Reduce Money Supply • Increase Reserve Requirement • Sell Government Bonds • Increase Discount Rate Slow Down • Increase Money Supply • Reduce Reserve Requirement • Buy Government Bonds • Decrease Discount Rate Expand

24. The Federal Funds Rate • Member banks borrow money from the Fed and pass it on to their customers – Prime Rate • Fed also sets the rate that banks charge each other – Federal Funds Rate

25. The Federal Funds Rate • Rate charged by banks on overnight loans made from temporary excess funds • Targeted by the Federal Reserve when changing the money supply • Prime interest rate is charged on loans to most credit-worthy customers • Prime interest rate is directly related to the Federal funds rate. LO3

26. Monetary Policy LO3

27. Monetary Policy • Expansionary Monetary Policy • Economy faces a recession • Increase money supply, interest rates fall • Lower target for federal funds rate • Fed buys securities from banks and public • Lower reserve ratio • Lower discount rate • Decrease interest on reserves LO3

28. Monetary Policy • Restrictive Monetary Policy • Periods of rising inflation • Decreases money supply, interest rates rise • Increase target Federal funds rate • Fed sells securities to banks and public • Raise reserve ratio • Raise discount rate • Increase interest on reserves LO3

29. Taylor Rule • Rule of thumb for tracking actual monetary policy • Fed has 2% target inflation rate • Target FFR varies as inflation and real GDP vary • Three basic rules when setting target for Federal Funds Rate: LO3

30. Taylor Rule • If real GDP = potential GDP and inflation is 2% then target federal funds rate is 4% • For each 1% increase of real GDP above potential GDP, the Fed should raise the real Federal Funds Rate by ½% • For each 1% increase in the inflation rate above the 2% target rate, the Fed should raise the Federal Funds Rate by ½% LO3

31. Expansionary Monetary Policy Problem: Unemployment and Recession CAUSE-EFFECT CHAIN Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises LO5

32. Restrictive Monetary Policy Problem: Inflation CAUSE-EFFECT CHAIN Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines LO5

33. Monetary Policy: Evaluation and Issues LO5

34. Evaluation and Issues • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy more subtle than fiscal policy LO5

35. Recent U.S. Monetary Policy • Highly active in recent decades • Quick and innovative actions during recent financial crisis and severe recession • Critics contend Fed contributed to crisis by keeping Federal funds rate too low for too long LO5

36. After the Great Recession • Slow recovery, especially with employment • Zero Interest Rate Policy (ZIRP) • Short-term rates near/at zero • FFR = (zero – 0.25%) • Zero-Lower-Bound Problem • Economy didn’t expand, interest rates already at zero • Cannot have negative interest rates LO5

37. After the Great Recession • Quantitative Easing (QE, Mar 2009) • Not intended to decrease interest rates • Meant to increase reserves in bank system • Purchased $1.75T • Forward Commitment (QE2, Nov 2010) • Fed preannounced purchase amount and for how long • $600B @ $75B/month for 8 months • Maturity Extension Program (Operation Twist) • Fed announced: buy $677B long-term gov’t bonds while selling equivalent amount of short-term gov’t bonds • Spur investment and consumption with lower long-term rates • QE3 (Sep 2012) • Open-ended policy commitment LO5

38. Worries about ZIRP, QE, and Twist • Government spending crowded out private spending • Large budget deficits by the Federal government would lead to huge interest costs • Low interest rates punish savers, pension plans, and retirement funds LO6

39. Problems and Complications • Lags – Fiscal vs. Monetary • Fiscal: Recognition, Administrative, Operational • Monetary: Recognition and Operational • Cyclical Asymmetry and the Liquidity Trap LO5