Interest Rates and Monetary Policy

1. “I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said.” Alan Greenspan Former Fed Chairman 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 Bond Market • The Mechanisms by Which Monetary Policy Affects GDP and the Price Level

3. Interest Rates • Interest = Price Paid for the Use of Money • Two Main Types of Demand for Money (Reasons to hold money) • Transactions Demand, Dt • Asset Demand, Da

4. Interest Rates • Two Types of Demand for Money • Transactions Demand, Dt • Demand for money as a medium of exchange. • People hold money to pay for goods and services. • Assume the transactions demand for money is independent of the interest rate.

5. Interest Rates • Two Types of Demand for Money • Asset Demand, Da • Demand for money as a store of value. • People hold some of their financial assets as money because it is most liquid asset. • Disadvantage – money, when not earning interest, loses value when prices increase. • Interest rate is considered the opportunity cost of holding money (ex, if a bond pays 6% interest, holding money instead of the bond costs 6% of foregone income). • So, the asset demand for money varies inversely with interest rates.

6. 50 50 100 100 150 150 200 200 50 100 150 200 250 300 Equilibrium interest rate, where Qty DM = Qty SM 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)

7. 50 100 150 200 250 300 Interest Rates Demand for Money and the Money Market Total Demand for Money, Dm And Supply What happens to the equilibrium interest rate when money supply increases? Decreases? 10 7.5 5 2.5 0 Sm Rate of Interest, I percent Dm Amount of Money Demanded and Supplied (Billions of Dollars)

8. $50 • $1000 = .05 = 5% interest yield Interest Rates Interest Rates and Bond Prices • Interest rates and bond prices move in opposite directions! Explanation: Bonds are bought and sold in bond market, so price is set by supply and demand. Suppose a bond sells for $1000, and pays 5% interest, or $50/year: Now suppose the interest rate increases to 7.5% (what could have caused that?), so brand new bonds will pay 7.5%, or $75 for a $1000 bond, but this old bond will still only pay $50 (the annual dollar amount, or coupon payment, is constant for life of bond).

9. $50 • $1000 • $50 • $667 = .05 = 5% interest yield = .075 = 7.5% interest yield Interest Rates Interest Rates and Bond Prices Nobody will be willing to pay $1000 to earn $50/year when they can pay $1000 for a new bond and earn $75/year. Question: So to sell the older 5% bond, what do you have to do? Answer: Cut the price to a dollar amount that will yield $50 at 7.5% interest rate:

10. $50 • $2000 = .025 = 2.5% interest yield Interest Rates Interest Rates and Bond Prices Conversely, if the interest rate falls to 2.5%, buyers will be willing to pay MORE than $1000 to earn $50/year: SO, anything that affects bond prices will also affect interest rates (in opposite direction).

11. Three Tools of Monetary Policy • Open Market Operations • Buying and Selling government bonds (aka securities) • Reserve Requirement • Raising or lowering reserve requirement changes amount of reserves banks are required to hold. • Discount Rate • Discount rate = interest rate paid by banks for borrowing money from the Fed.

12. Tools of Monetary Policy • Open Market Operations (conducted by FOMC) Buying Bonds (aka securities) • Impact on Money Supply • When the Fed buys bonds, money is transferred from the Fed, increasing bank reserves. • Banks can then increase loans, creating money. • Money supply increases. • Impact on Interest Rates • Increased money supply puts downward pressure on interest rates. • In bond market, increased demand for bonds increases bond prices, so interest rates fall. Selling Bonds (aka securities) VICE-VERSA (money supply down, interest rates up)

13. Tools of Monetary Policy 2. Reserve Requirement Increasing Reserve Requirement • Impact on Money Supply • Increasing reserve requirement decreases money multiplier. • Banks cannot loan as much, money supply contracts. • Impact on Interest Rates • Decreased money supply puts upward pressure on interest rates. Decreasing Reserve Requirement VICE-VERSA (money supply up, interest rates down)

14. Tools of Monetary Policy 3. Discount Rate Increasing Discount Rate • Impact on Money Supply • Increasing discount rate makes banks borrow less. • Banks have less money to loan, money supply contracts. • Impact on Interest Rates • Decreased money supply puts upward pressure on interest rates. Decreasing Discount Rate VICE-VERSA (money supply up, interest rates down)

15. Tools of Monetary Policy Expansionary Policy(fix recessionary gap) • Buy bonds • Cut reserve requirement • Cut discount rate Impact: • Increased money supply • Lower interest rates • Increased C and I • Increased real GDP • Increased aggregate demand (shift to right)

16. Tools of Monetary Policy Contractionary Policy(fix inflationary gap) • Sell bonds • Raise reserve requirement • Raise discount rate Impact: • Decreased money supply • Higher interest rates • Decreased C and I • Decreased GDP • Decreased aggregate demand (shift to left)

17. Targeting the Federal Funds Rate Federal Funds Rate • Interest rate banks charge each other for overnight loans to cover reserve shortfalls. • This is the rate targeted by the FOMC. Other rates change with it.

18. 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 P2 Dm AD2 ID AD1 $125 $150 $175 $15 $20 $25 Q1 Qf Q3

19. Expansionary Monetary Policy Problem: Unemployment and Recession 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

20. Contractionary Monetary Policy Problem: Inflation 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

21. Monetary Policy • Problems and Complications • Recognition Lag • Administrative Lag • Operational Lag

22. monetary policy transaction demand asset demand total demand for money reserve requirement discount rate Federal funds rate expansionary monetary policy Key Terms