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Interest Rates and Monetary Policy

Interest Rates and Monetary Policy. Chapter 10. Outline. Interest Rates Tools of Monetary Policy Monetary Policy, Real GDP, and the Price Level Monetary Policy in Action. Monetary Policy.

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Interest Rates and Monetary Policy

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  1. Interest Rates andMonetary Policy Chapter 10

  2. Outline • Interest Rates • Tools of Monetary Policy • Monetary Policy, Real GDP, and the Price Level • Monetary Policy in Action

  3. Monetary Policy Monetary policy consists of deliberate changes in the money supply (M) to influence interest rates and thus the total level of spending (AD) in the economy. The goal is to achieve and maintain price-level stability, full employment, and economic growth. 8/14/2014 3

  4. Interest Rates • The demand for money • Transactions demand, Dt • Asset demand, Da • Total money demand, Dm • The supply of money • The equilibrium interest rate

  5. U.S. interest rates 8/14/2014 5

  6. The demand for money Transactions demandDt Asset demand Da Total money demandDm • Dt: the demand for • money as a medium • of exchange, for purchasing G&S. • Da: the demand formoney held as a • store of value, in the form of financial • assets such as bonds, • stocks, etc. • Dm: the horizontalsum of Dt and Da. • Dm shifts when • either Dt or Da shifts. • Dt varies directly • with nominal GDP(Ym). • Dt = Ym / velocity • The amount of • money demanded as • an asset varies • inversely with the • rate of interest (the • opportunity cost of • holding money as an • asset) • Velocity of money:the average number • of times a dollar is • spent per year. 8/14/2014 6

  7. The money market Total money demandDm = Dt + Da Total money supplySm Money marketequilibrium • Dm: the horizontalsum of Dt and Da. • Dm shifts when • either Dt or Da shifts. • Sm: the stock of money determined bythe money authorities • and financial institutions • where the amount • of money demanded • equals the amount of • money supplied. • where total demandfor money curve cuts • the money supply • curve. • Qe: equilibriumamount of money- ie: equilibrium realinterest rate 8/14/2014 7

  8. The money market Transactions demandDt Asset demand Da Total money demandDm = Dt + Da i(%) i(%) i(%) Sm 10% E ie 5% Dm 200 200 300 100 Amount of money demanded ($ billions) 8/14/2014 8

  9. Tools of Monetary Policy • Open-market operations • Buying securities • Selling securities • The reserve ratio • Raising the rr • Lowering the rr • The discount rate • Term auction facility

  10. Tools of Monetary Policy Open-marketoperations (OMOs) Reserve ratio(rr) Discount rate (dr)Federal funds rate (ffr) Term auctionfacility OMOs: buying &selling of government bonds in the bonds market rr(%): the legallyrequiredpercentage of reserves for every $1 of a bank’s or thrift’s checkable deposits dr (%): theinterest rate the Fed charge onthe loans they make to commercial banks and thrifts A monetary toolused by the Fed to expand reserves through auctioning off loans (reserves) anonymously to commercial banks ffr (%): theinterest ratebanks and thriftscharge oneanother on overnight loans made out of their excess reserves 8/14/2014 10

  11. Tools of Monetary Policy Moneysupply Open-marketoperations (OMOs) Reserve ratio(rr) Discount rate (dr)Federal funds rate (ffr) Term auctionfacility Toincrease Buy securities Lower rr Lower dr/ffr Auction more reserves Todecrease Sell securities Raise rr Raise dr/ffr Auction fewerreserves MoneySupply MoneySupply Increase Decrease 8/14/2014 11

  12. Relative importance Open-marketoperations (OMOs) Reserve ratio(rr) Discount rate (dr)Federal funds rate (ffr) Term auctionfacility Most important Potentially powerful,rarely used Passive Most recent, to replace dr/ffr 8/14/2014 12

  13. Easy and tight money Easy money policy (expansionary monetary policy) Tight money policy(contractionary / restrictivemonetary policy) Used in a recession Used in an expansion Increase M to increase AD Decrease M to decrease AD To increase Q & employment, thus reducing unemployment To reduce spending & reduce inflation

  14. Monetary Policy, Real GDP, and the Price Level • Cause-effect chain • Market for money • Investment • Equilibrium GDP • Effect of an easy money policy • Effect of a tight money policy

  15. The money market, investment demand,and the economy (original situation) The money market Investment demand i(%) i(%) Sm1 10 10 8 8 6 6 Dm Q($bil) I($bil) 125 150 175 15 20 25 The economy P With I = $20, the economy is at E1, where AD1 cuts AS. The price level is P1and real GDP is Qf. Originally, the equilibrium interestrate is 8% where Sm1 cuts Dm.The money supplyis $150 billion. i1 = 8%, M1 = $150 At the interest rate of 8%, investment spending equals $20 billion. i1 = 8%; I = $20 AS E1 P1 AD1 I = $20 8/14/2014 15 Real GDP ($bil) Qf

  16. Effects of an easy money policy The money market Investment demand i(%) i(%) Sm1 Sm2 10 10 8 8 6 6 Dm Q($bil) I($bil) 125 150 175 15 20 25 The economy P The new equilibrium interestrate is 6% where Sm2 cuts Dm.The money supplyis $175 billion. At the new lowinterest rate of 6%, investment spending increases to $25 billion.i2 = 6%; I = $25 Now suppose that the Fed implementsan easy money policy.Sm1 shifts to theright to Sm2. With higher I = $25, AD1 shifts to the rightto AD2. The economy is nowat E2, where AD2 cuts AS. The price level is P2and real GDP is Q2. Increases in moneysupply increase AD, output, employment, andthe price level.Unemployment falls and inflation rises. AS E2 P2 E1 AD2 I = $25 P1 AD1 I = $20 8/14/2014 16 Real GDP ($bil) Qf Q2

  17. Effects of a tight money policy The money market Investment demand i(%) i(%) Sm3 Sm1 10 10 8 8 6 6 Dm Q($bil) I($bil) 125 150 175 15 20 25 The economy P The new, higherequilibrium interestrate is 10% where Sm3 cuts Dm.The money supplyfalls to $125 billion. i3= 10%; M = $125 At the new highinterest rate of 10%, investment spending falls to $15.i3 = 10%, I = $15. With I = $15, AD1 shifts to the leftto AD3. The economy is at E3, where AD3 cuts AS. Decreases in moneysupply decrease AD, output, employment, and the price level.Inflation falls, butunemployment rises. The new price level is P3 and real GDP is Q3. Now suppose thatthe Fed implementsa tight money policy.Sm1 shift to the leftto Sm3. AS E1 P1 E3 AD1 I = $20 P3 AD3 I = $15 8/14/2014 17 Real GDP ($bil) Qf Q3

  18. Effect of monetary policy Easy money policy (expansionary monetary policy) Tight money policy(contractionary / restrictivemonetary policy) Problem to solve:unemployment (in recessions/stagflations) Problem to solve:inflation (in expansions) The Fed: (1) buys bonds, (2) lowers rr; (3) lowers dr; (4) auctions more reserves The Fed: (1) sells bonds, (2) raises rr; (3) raises dr; (4) auctions fewer reserves Excess reserves increase Excess reserves decrease Money supply increases Money supply decreases Interest rates fall Interest rates rise Investment spending (I) increases Investment spending (I) decreases Aggregate demand (AD) increases Aggregate demand (AD) decreases Real GDP rises; unemployment falls Inflation declines 8/14/2014 18

  19. Monetary Policy in Action The focus on federal funds rate Recent U.S. monetary policy Problems and complications The mortgage crisis: the Fed responds 8/14/2014 19

  20. Monetary Policy in Action • Monetary policy has become a dominant component of U.S. national stabilization policy. • It has two advantages over fiscal policy • Speed and flexibility • Isolation from political pressure

  21. The focus on federal funds rate (ffr) The Fed currently focuses monetary policy on altering federal funds rate as needed to stabilize the economy. ffr: the interest rate banks and thrifts charge one another on overnight loans made out of their excess reserves. The prime interest rate generally parallels the ffr. 8/14/2014 21

  22. The focus on federal funds rate (ffr) 8/14/2014 22

  23. Problems and complications Lags Monetary policy still faces a recognition lag and an operational lag (3-6 months). Cyclical symmetry Monetary policy may be highly effective in slowing expansion and controlling inflation.(It is like pulling on a string.) It is, however, not as effective in pushing the economy out of a severe recession. (It is like pushing on a string.) 8/14/2014 23

  24. Problems and complications Lags Monetary policy still faces a recognition lag and an operational lag (3-6 months). Cyclical symmetry Monetary policy may be highly effective in slowing expansion and controlling inflation.(It is like pulling on a string.) It is, however, not as effective in pushing the economy out of a severe recession. (It is like pushing on a string.) 8/14/2014 24

  25. See You! Take Care! 8/14/2014 25

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