16
Interest Chapter Rates and
Monetary Policy
McGrawHill/Irwin
Copyright2009byTheMcGrawHillCompanies,Inc.Allrightsreserved.
Chapter Objectives
The equilibrium interest rate and
the market for money
Monetary policy
How the Fed controls the Federal
funds rate
How monetary policy affects GDP
and the price level
Effectiveness of monetary policy
and its shortcomings
16-2
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
16-3
Demand for Money
Why hold money?
Transactions demand, D1
Determined by nominal GDP
Independent of the interest rate
Asset demand, D2
Money as a store of value
Varies inversely with the interest
rate
Total money demand, D
16-4
Rate of interest, i percent
Demand for Money
(a)
Transactions
demand for
money, Dt
(c)
Total
demand for
money, Dm
and supply
(b)
Asset
demand for
money, Da
10
Sm
7.5
=
5
+
5
2.5
0
Dt
50
100
Da
150
200
Amount of money
demanded
(billions of dollars)
50
100
150
200
Amount of money
demanded
(billions of dollars)
Dm
50
100
150
200
250
300
Amount of money
demanded and supplied
(billions of dollars)
16-5
Interest Rates
Equilibrium interest rate
Changes with shifts in money
supply and money demand
Interest rates and bond prices
Inversely related
Bond pays fixed annual interest
payment
Lower bond price will raise the
interest rate
16-6
Federal Reserve Balance Sheet
Assets
Securities
Loans to commercial banks
Liabilities
Reserves of commercial banks
Treasury deposits
Federal Reserve Notes outstanding
16-7
Federal Reserve Balance Sheet
February 14, 2008 (in Millions)
Assets
Liabilities and Net Worth
Securities
Loans to Commercial
Banks
All Other Assets
Total
$713,369
60,039
111,689
$885,097
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, February 14, 2008
$ 11,312
4,979
778,937
89,869
$885,097
16-8
Central Banks
Selected Nations
Australia:
Canada:
Euro Zone:
Japan:
Mexico:
Russia
Sweden:
United Kingdom:
United States:
Reserve Bank of Australia (RBA)
Bank of Canada
European Central Bank (ECB)
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)
16-9
Tools of Monetary Policy
Open market operations
Buying and selling of government
securities (or bonds)
Commercial banks and the general
public
Used to influence the money supply
When the Fed sells securities,
commercial bank reserves are
reduced
16-10
Open Market Operations
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)
16-11
Open Market Operations
Fed buys $1,000 bond from the public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
16-12
Tools of Monetary Policy
The reserve ratio
Changes the money multiplier
The discount rate
The Fed as lender of last resort
Short term loans
Term auction facility
Introduced December 2007
Banks bid for the right to borrow
reserves
16-13
Tools of Monetary Policy
Open market operations most
important
Reserve ratio last changed Discount 1992
rate was a passive tool
Term auction facility is new
Guaranteed amount lent by the Fed
Anonymous
16-14
The Federal Funds Rate
Rate charged by banks on
overnight loans
Targeted by the Federal Reserve
FOMC conducts open market
operations to achieve the target
Demand curve for Federal funds
Supply curve for Federal funds
16-15
The Federal Funds Rate
Federal Funds Rate, Percent
Using Open Market Operations
4.5
Sf3
4.0
Sf1
3.5
Sf2
Df
Qf3
Qf1
Qf2
Quantity of Reserves
16-16
Monetary Policy
Expansionary monetary policy
Economy faces a recession
Lower target for federal funds rate
Fed buys securities
Expanded money supply
Downward pressure on other
interest rates
Contractionary monetary policy
16-17
Taylor Rule
Rule of thumb for tracking actual
monetary policy
Fed has 2% target inflation rate
If real GDP = potential GDP and
inflation is 2% then target federal
funds rate is 4%
Target varies as inflation and real
GDP vary
16-18
Monetary Policy
Affect on real GDP and price level
Cause-effect chain
Market for money
Investment and the interest rate
Investment and aggregate demand
Real GDP and prices
Expansionary monetary policy
Restrictive monetary policy
16-19
(a)
The market
for money
Sm1
Sm2
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Sm3
AS
P3
10
Pr i c e L e v e l
Rate of Interest, i (Percent)
Monetary Policy and GDP
8
P2
Dm
6
0
AD3
I=$25
AD2
I=$20
AD1
I=$15
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
ID
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
16-20
Expansionary Monetary Policy
Problem: unemployment and recession
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
F E ES UAC
-
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
16-21
Restrictive Monetary Policy
Problem: inflation
Fed sells bonds, increases reserve ratio, increases
the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
F E ES UAC
-
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
16-22
Monetary Policy
Advantages over fiscal policy
Speed and flexibility
Isolation from political pressure
Recent U.S. monetary policy
Problems and complications
Recognition lag
Operational lag
Cyclical asymmetry
16-23
The Big Picture
Input
Resources
With Prices
Productivity
Sources
LegalInstitutional
Environment
Consumption
(Ca)
Aggregate
Supply
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
16-24
The Mortgage Debt Crisis
Home mortgage default 2007
Banks write off bad loans
Reserves reduced
Fed as lender of last resort
Term auction facility
Fed lowered federal funds rate
Mortgage backed securities as a new
innovation
Bad incentives
16-25
Key Terms
monetary policy
interest
transactions demand
asset demand
total demand for
money
open-market
operations
reserve ratio
discount rate
term auction facility
Federal funds rate
expansionary
monetary policy
prime interest rate
restrictive monetary
policy
Taylor rule
cyclical asymmetry
mortgage debt crisis
16-26
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Financial Economics
16-27