Interest Rates & Monetary Policy

1. Interest Rates & Monetary Policy Chapter 16

2. Learning Targets: 16.1 I can determine the equilibrium interest rate in the market for money.

3. Interest Rates • Fed’s primary influence is on the money supply & interest rates • Interest- price paid for the use of money. • Price that borrowers need to pay lenders for transferring purchasing power to the future • There is a wide variety of US interest rates that vary by purpose, size, risk, maturity, & taxability

4. Demand for Money • Transactions demand • Asset demand • Total money demand

5. Transactions demand (Dt) • Demand for money as a medium of exchange • People hold money because it is convenient for buying goods & services • Level of nominal GDP is the main determinant of the amount of money demanded for transactions • Direct relationship between transaction demand for $ & nominal GDP (will shift the total money demand curve)

6. Asset demand (Da) • People hold their financial assets in many forms (i.e. stocks, bonds, or money) • Money is the most liquid of all assets & is immediately usable for buying other assets • Disadvantage of money – does not earn interest • Inverse relationship between amt. of money demand & rate of interest

7. Total Money Demand (Dm) • Sum of asset demand & transactions demand • Represents the total amount of money the public wants to hold, both for transactions and as an asset, at each possible interest rate

8. Equilibrium interest rate (Learning Target) • Intersection of supply & demand curve for money • Equilibrium “price” is the interest rate • Changes in demand or supply affect the interest rate • We are most interested in supply of money • Increase in supply…lowers int. rate • Decrease in supply…increase int. rate

9. Interest rates & bond prices • These are closely related (inverse relationship)

10. Learning Targets: 16.2 I can explain the goals and tools of monetary policy.

11. Consolidation Balance Sheet of Federal Reserve Banks • Assets • Two main assets of Federal Reserve Banks • Securities • Loans to Commercial Banks • Liabilities • Reserves of Commercial Banks • Treasury Deposits • Federal Reserve Notes Outstanding

12. Tools of Monetary Policy • Open-Market Operations • The Reserve Ratio • The Discount Rate • Term Auction Facility

13. Open-Market Operations • Consists of buying of government bonds from, or the selling of government bonds to, commercial banks & the general public • Most important instrument for influencing the money supply • U.S. government issued bonds to finance past budget deficits

14. Buying securities • From commercial banks • From the public In both cases, the reserves of commercial banks will increase but also increases checkable deposits when sellers (public) place Fed’s check into their personal checking acct. Increases lending ability of banks

15. Selling securities • To commercial banks • To the public In both cases, the reserves of commercial banks are reduced

16. Reserve Ratio • The Fed can manipulate the reserve ratio in order to influence the ability of commercial banks to lend • Raising the reserve ratio • Two consequences • Lowering the reserve ratio • Excess reserves would rise & enhances the ability of banks to create new money by lending

17. Effects of changes in reserve ratio on lending ability of commercial banks

18. Discount rate • When a commercial bank borrows, it gives the Federal Reserve Bank a promissory note (IOU) drawn against itself and secured by acceptable collateral • The Fed charges interest on loans they grant to commercial banks (discount rate) • Borrowing from the Fed increases the reserves of the commercial banks which enhances their ability to extend credit

19. Discount Rate (cont) • The Fed has the power to set the discount rate at which commercial banks borrow from them • From the commercial banks’ point of view, the discount rate is a cost of acquiring reserves

20. Relative importance • Of the three instruments of monetary control, buying & selling securities in the open market is the most important • It’s flexible (can occur daily) • Impact on reserves is prompt

21. 16.3 Learning Targets: I can explain the Federal funds rate and how the Fed controls it.

22. Targeting the Federal funds rate • Federal Funds rate • Rate of interest that banks charge one another on overnight loans made from temporary excess reserves • Some banks have excess reserves while others have deficiencies…they loan to each other to meet their reserve requirements

23. Term Auction Facility • Fourth Fed tool for altering bank reserves • Introduced in 12/07 in response to mortgage debt crisis • Fed holds two auctions per month at which banks bid for the right to borrow reserves for 28-day periods

24. Expansionary monetary policy • Easy money policy • Lower the interest rate to bolster borrowing & spending • This will increase AD & expand output

25. Prime interest rate • Benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses & individuals. • Higher than federal funds rate because prime rate involves longer, more risky loans than overnight loans between banks • They do closely track one another though

26. Restrictive monetary policy • Called “tight” money policy • Used during inflation. • Int rate goes up which will reduce borrowing and spending • Slows economy down and holds down price-level increases

27. Taylor rule • Assumes that the Fed has a 2 percent “target inflation rate” that it is willing to tolerate • FOMC follows three rules when setting its target for Federal Funds rate (pg. 320) • Fed has no official allegiance to Taylor rule • They change Fed Funds rate to any level it deems appropriate

28. 16.4 Learning Targets: I can explain the effectiveness of monetary policy as well as its shortcomings.

29. Monetary policy, real GDP, & the price level • Cause-effect chain • Market for money • Demand & supply curves for money are brought together • Money supply curves (vertical line representing some fixed amount of money determined by Fed) • Equilibrium interest rate – S & D curves intersect

30. Investment • Inverse relationship between interest rate & amount of investment spending (key graph p. 322) • Changes in interest rate mainly affect the investment component of total spending

31. Equilibrium GDP • Investment spending is one of the determinants of AD • The greater the investment spending, the farther to the right lies the AD curve

32. Effects of an expansionary Monetary Policy • Intended outcome will be an increase in excess reserves in the commercial banking system & a decline in the Federal Funds Rate • Banks earn profits by lending • Nation’s money supply will rise • Lowers interest rate, increases investment, aggregate demand, & equilbrium GDP

33. Effects of a Restrictive monetary policy • Inflation is a problem so restrictive monetary policy is used • Actions taken: • Sell government securities to banks & public • Increase the legal reserve ratio • Increase the discount rate • Decrease the amount of reserves auctioned off under term auction facility • Higher interest rate will discourage investment, lower AD, & restrain demand-pull inflation

34. Monetary Policy: Evaluation & Issues • Advantages over fiscal policy • Speed & flexibility • Can be quickly altered (securities can be bought & sold on a daily basis which affects the money supply & interest rates almost immediately) • Isolation from political pressure • Members of Fed BOG serve 14-year terms • Isolated from lobbying & political pressure

35. Recent U.S. Monetary Policy • In early 1990’s, Fed’s expansionary monetary policy helped economy recover from recession • To counter potential inflation during that strong expansion (1990’s), Fed reduced reserves in banking system to raise the interest rate

36. Problems & Complications • Lags • Monetary policy faces a recognition & operational lag • Cyclical asymmetry • Less reliable in pushing the economy from a severe recession