Interest Rates and Monetary Policy

1. 14 Interest Rates and Monetary Policy

2. Chapter Objectives • How the Equilibrium Interest Rate is Determined in the Market for Money • The Goals and Tools of Monetary Policy • The Federal Funds Rate and How the Fed Controls It • The Mechanisms by Which Monetary Policy Affects GDP and the Price Level • Effectiveness of Monetary Policy and its Shortcomings

3. O 14.1 W 14.1 Interest Rates • Defined as the Price Paid for the Use of Money • Demand for Money • Transactions Demand, D1 • Asset Demand, D2 • Total Money Demand, Dm …Graphically

4. Interest Rates • Fed’s primary influence is on money supply and interest rates • Interest – price paid for the use of money • Price that borrowers pay lenders for transferring purchasing power into the future • Amount of money that must be paid for the use of $1 for 1 year • Determined by S and D

5. The Demand for Money • 2 Reasons the public demands money: • 1. Transaction demand • 2. Asset demand

6. 1. Transaction Demand • The demand for money as a medium of exchange • People hold money b/c it is convenient for purchasing g/s • Level of nominal GDP main determinant of the amount of money demanded for transactions • Transaction demand curve is vertical line

7. 2. Asset Demand • The extent to which people want to hold money as an asset, or store of value • People hold financial assets as money b/c it is the most liquid asset • Amount of money demanded as an asset varies inversely with the rate of interest • Downward sloping curve

8. Total Money Demand • Find the total demand for money by horizontally adding the asset demand to the transactions demand • Resulting downward sloping line represents total amt of $$ the public wants to hold at each psb interest rate • Change in nominal GDP can shift this demand curve

9. 50 50 100 100 150 150 200 200 50 100 150 200 250 300 Interest Rates Demand for Money and the Money Market (a) Transactions Demand for Money, Dt (b) Asset Demand for Money, Da (c) Total Demand for Money, Dm And Supply 10 7.5 5 2.5 0 Sm = + Rate of Interest, I percent 5 Dt Da Dm Amount of Money Demanded (Billions of Dollars) Amount of Money Demanded (Billions of Dollars) Amount of Money Demanded and Supplied (Billions of Dollars)

10. W 14.2 G 14.1 Interest Rates • Equilibrium Interest Rate • Interest Rates and Bond Prices • Bond Prices Fall When Interest Rates Rise • Bond Prices Rise When Interest Rates Fall • Inverse Relationship Between Interest Rates and Bond Prices

11. The Equilibrium Interest Rate • Supply of money is a vertical line b/c monetary authorities have provided economy with a particular stock of money • Intersection of S and D curves est. equilibrium interest rate • Changes in S or D for money can affect the equilibrium interest rate, similar to Ch. 3 analysis

12. Interest Rates and Bond Prices • Closely related • When interest rate increase, bond prices fall • When the interest rate falls, bond prices rise • Inverse relationship b/w interest rate and bond prices

13. Consolidated Balance SheetFederal Reserve Banks • Assets • Securities • Loans to Commercial Banks • Liabilities • Reserves of Commercial Banks • Treasury Deposits • Federal Reserve Notes Outstanding

14. Consolidated Balance Sheet of Fed Reserve Banks • Fed’s balance sheet helps us understand how the Fed conducts monetary policy • Assets and liabilities of the Fed differ from those of commercial banks

15. Assets • 2 main assets: • 1. securities – gov bonds that have been purchased by Fed Reserve Banks (T-bills, T-notes, T-bonds) • 2. loans to commercial banks – commercial banks occasionally borrow from the Fed Reserve Banks • These loans are claims against commercial banks

16. Liabilities • 1. reserves of commercial banks • 2. treasury deposits – U.S. Treasury keeps deposits in the Fed Reserve Banks to draw checks on • 3. Federal Reserve Notes Outstanding – when money is circulating outside the Federal Reserve Banks, it constitutes claims against the assets of the Federal Reserve Banks

17. Assets Liabilities and Net Worth $758,551 19,250 59,967 $837,768 $ 14,923 4,463 754,567 63,615 $837,768 Consolidated Balance SheetFederal Reserve Banks Consolidated Balance Sheet of the 12 Federal Reserve Banks March 29, 2006 (in Millions) Securities Loans to Commercial Banks All Other Assets Total Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes (Outstanding) All Other Liabilities and Net Worth Total Source: Federal Reserve Statistical Release, H.4.1, May 7, 2003

18. GLOBAL PERSPECTIVE Consolidated Balance SheetFederal Reserve Banks Central Banks, Selected Nations Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Reserve Bank of Australia (RBA) Bank of Canada Central Bank of Europe (CBE) Bank of Japan (BOJ) Banco de Mexico (Mex Bank) Central Bank of Russia Sveriges Riksbank Bank of England Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks)

19. O 14.2 W 14.3 Tools of Monetary Policy • Open Market Operations • Buying Securities • From Commercial Banks • From the Public • Selling Securities • To Commercial Banks • To the Public • When the Fed Sells Securities, Commercial Bank Reserves are Reduced

20. Tools of Monetary Policy • 1. open-market operations • 2. the reserve ratio • 3. the discount rate

21. Open-Market Operations • Bond markets are open to all buyers and sellers of corporate and gov bonds (securities) • Open-market operations consist of the Fed buying or selling government bonds to commercial banks and the public • Fed’s most important tool for influencing the money supply

22. Buying Securities • Fed can buy bonds from commercial banks or the public • Commercial banks – commercial banks give up part of their holdings of bonds to Fed Reserve banks, Fed Banks place newly created reserves in commercial banks (increasing lending ability of commercial banks)

23. From the public: • Individual gives up securities to the Fed and gets a check drawn by the Fed Banks on themselves • Money is deposited into individuals bank, commercial bank enjoys increase in its reserves

24. Selling securities • To commercial banks: • Fed Banks give up securities to commercial banks, commercial banks see reduction in their reserves • To the public: Fed sells bonds to individual, who pays with a check drawn on commercial bank, reduces checkable deposits of commercial bank

25. Tools of Monetary Policy Fed Buys $1,000 Bond from a Commercial Bank New Reserves $1000 $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000)

26. Tools of Monetary Policy Fed Buys $1,000 Bond from the Public Check is Deposited New Reserves $1000 $800 Excess Reserves $200 Required Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending Total Increase in the Money Supply, ($5000)

27. Tools of Monetary Policy • The Reserve Ratio • Raising the Reserve Ratio • Lowering the Reserve Ratio • The Discount Rate • Borrowing from the Fed by Banks Increases Reserves and Enhances Lending Ability • Relative Importance of Each

28. The Reserve Ratio • Fed can manipulate reserve ratio in order to influence the ability of commercial banks to lend • Raising the reserve ratio – leads to reduction in S of money • Lowering the reserve ratio – leads to increase on the money-creating ability of the banking system

29. The Discount Rate • Interest rate that the Fed charges on loans they grant to commercial banks • Lowering the discount rate encourages commercial banks to obtain additional reserves from the Fed banks – money supply increases, and vice versa

30. Relative Importance • Of the three instruments of monetary policy, open market operations in the most important • Flexible and has quick impact on bank reserves, work subtly and indirectly

31. W 14.4 Targeting the Federal Funds Rate • Federal Funds Rate Defined • Expansionary Monetary Policy (Easy Money) • Prime Interest Rate • Restrictive Monetary Policy (Tight Money) • The Taylor Rule

32. Targeting the Federal Funds Rate • Fed focuses monetary policy on the Federal funds rate – interest rate that banks charge one another on overnight loans made from temporary excess reserves • Federal Reserve is only supplier of Federal Funds • FOMC meets regularly to target the Fed funds rate that is appropriate for the economy, the undertakes open market operations to achieve and maintain the targeted rate

33. Supply curve for federal funds is horizontal line, Fed will provide whatever level of Federal funds the banks desire to hold at the targeted interest rate

34. Targeting the Federal Funds Rate Using Open Market Operations To Set The Federal Funds Rate 4.5 Sf3 4.0 Sf1 Federal Funds Rate, Percent 3.5 Sf2 Df Qf3 Qf1 Qf2 Quantity of Reserves

35. Expansionary Monetary Policy • Easy money policy • Lower interest rate to increase borrowing and spending, increase AD and expand output • Fed will buy bonds through open market operations, lower the reserve requirement or lower the discount rate

36. Results: • Supply of Federal funds increases, lowering the Federal funds rate to new targeted rate • Multiple expansion of nation’s money supply occurs, downward pressure on other interest rates • Prime interest rate - the benchmark interest rate used by banks as a reference point for a wide variety of interest rates • Prime rate higher than Fed funds rate

37. Restrictive Monetary Policy • Aka tight money policy • Increase the interest rate in order to reduce borrowing and spending, Fed will sell bonds, or raise reserve requirement or discount rate

38. Results • Supply of Federal funds decreases, raising Federal funds rate to new targeted rate • Multiple contraction of nation’s money supply • Upward pressure on other interest rates, including prime rate

39. The Taylor Rule • Fed roughly follows the Taylor rule when targeting the Federal funds rate • The Taylor Rule – assumes a 2% rate of inflation and has 3 parts: • If real GDP rises by 1% above potential GDP, Fed should raise Fed funds rate by .5% • If inflation rises by 1% above 2%, Fed should raise rate by .5% • When real GDP = potential GDP, and inflation is 2%, Fed funds rate should remain at 4%

40. Rate of Interest, i (Percent) Price Level Amount of Money Demanded and Supplied (Billions of Dollars) Amount of Investment, I (Billions of Dollars) Real Domestic Product, GDP (Billions of Dollars) Monetary Policy Monetary Policy and Equilibrium GDP (a) The Market For Money (b) Investment Demand (c) Equilibrium Real GDP and the Price Level Sm1 Sm2 Sm3 AS 10 8 6 0 P3 AD3 I=$25 P2 AD2 I=$20 Dm ID AD1 I=$15 $125 $150 $175 $15 $20 $25 Q1 Qf Q3

41. G 14.2 Monetary Policy • Cause-Effect Chain • Market for Money • Investment • Equilibrium GDP • Effects of an Expansionary Monetary Policy • Effects of a Restrictive Monetary Policy

42. Monetary Policy, Real GDP, and Price Level • Cause-Effect Chain: See Figure 14.5 • Market for money: • Figure 14.5 a represents market for money, determines real rate of interest

43. Investment • Interest rates are carried rightward to the investment demand curve in 14.5 b, shows impact of changing interest rates on investment • Investment spending varies inversely with real interest rate

44. Equilibrium GDP • 14.5 c shows impact of real interest rates and corresponding levels of investment spending on aggregate demand

45. Effects of an Expansionary Monetary Policy • If economy is in recession, easy money policy may be used • Outcome will increase excess reserves and lower the Federal funds rate, increase in money supply, increase in investment spending, AD, and equilibrium real GDP rises

46. Effects of a Restrictive Monetary Policy • If AD is above economy’s full-employment level, Fed will institute a restrictive money policy to combat inflation • Bank reserves will decrease and Federal funds rate will rise, money supply will decline, investment spending decreases, AD decreases, and inflation declines

47. Monetary Policy Expansionary Monetary Policy Problem: Unemployment and Recession CAUSE-EFFECT CHAIN Fed Buys Bonds, Lowers Reserve Ratio, or Lowers the Discount Rate Excess Reserves Increase Federal Funds Rate Falls Money Supply Rises Interest Rate Falls Investment Spending Increases Aggregate Demand Increases Real GDP Rises

48. Monetary Policy Restrictive Monetary Policy Problem: Inflation CAUSE-EFFECT CHAIN Fed Sells Bonds, Increases Reserve Ratio, or Increases the Discount Rate Excess Reserves Decrease Federal Funds Rate Rises Money Supply Falls Interest Rate Rises Investment Spending Decreases Aggregate Demand Decreases Inflation Declines

49. Monetary Policy • Evaluation and Issues • Speed and Flexibility • Isolation From Political Pressure • Recent U.S. Monetary Policy • Problems and Complications • Recognition Lag • Administrative Lag • Operational Lag

50. Evaluation and Issues • Monetary policy has become dominant component of economic stabilization in U.S. • Speed and flexibility • Free from political pressure • Works more subtly than fiscal policy