Interest Rates and Monetary Policy

Chapter 34

McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education. All rights reserved.

Interest Rates

• The price paid for the use of money• Many different interest rates• Speak as if only one interest rate• Determined by the money supply and money

demand

LO1LO1

Demand for Money

• Why hold money?• Transactions demand, Dt

• Determined by nominal GDP• Independent of the interest rate

• Asset demand, Da

• Money as a store of value• Varies inversely with the interest rate

• Total money demand, Dm

LO1LO1

Demand for MoneyR

ate

of

inte

rest

, i p

erce

nt

10

7.5

5

2.5

050 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded and supplied

(billions of dollars)

=+

(a)Transactionsdemand formoney, Dt

(b)Asset

demand formoney, Da

(c)Total

demand formoney, Dm

and supply

Dt Da Dm

Sm

5

LO1LO1

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

LO1LO1

• Assets• Securities• Loans to commercial banks

• Liabilities• Reserves of commercial banks• Treasury deposits• Federal Reserve Notes outstanding

LO2

Federal Reserve Balance Sheet

April 10, 2013 (in Millions)

Source: Federal Reserve Statistical Release, H.4.1, April 10, 2013, www.federalreserve.gov

SecuritiesLoans to Commercial BanksAll Other Assets

Total

Reserves of Commercial BanksTreasury DepositsFederal Reserve Notes (Outstanding)All Other Liabilities and Net WorthTotal

$957,619

439271,355

$3,229,413

$ 1,851,36152,478

1,137,087188,487

$3,229,413

LO2

Federal Reserve Balance Sheet

Assets Liabilities and Net Worth

LO2

Central Banks

LO2LO2

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

LO2LO3

Tools of Monetary Policy

• Fed buys bonds from commercial banks

Assets Liabilities and Net Worth

Federal Reserve Banks

+ Securities + Reserves of Commercial Banks

(b) Reserves

Commercial Banks

-Securities (a)

+Reserves (b)

Assets Liabilities and Net Worth

LO2

(a) Securities

LO3

Tools of Monetary Policy

• Fed sells bonds to commercial banks

Assets Liabilities and Net Worth

Federal Reserve Banks

- Securities - Reserves of Commercial Banks

Commercial Banks

+ Securities (a)

- Reserves (b)

Assets Liabilities and Net Worth

(a) Securities (b) Reserves

LO2LO3

Open Market Operations

• Fed buys $1,000 bond from a commercial bank

New Reserves

$5000Bank System Lending

Total Increase in the Money Supply, ($5,000)

$1000Excess

Reserves

LO2LO3

Open Market Operations

• Fed buys $1,000 bond from the publicCheck is Deposited

New Reserves$1000

Total Increase in the Money Supply, ($5000)

$200RequiredReserves

$800Excess

Reserves

$1000Initial

CheckableDeposit

$4000Bank System Lending

LO2LO3

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

LO2LO3

The Reserve Ratio

(1)

Reserve Ratio, %

(2)

Checkable Deposits

(3)

Actual Reserves

(4)

Required Reserves

(5)

Excess Reserves,

(3) –(4)

(6)

Money-Creating Potential of

Single Bank, = (5)

(7)

Money-Creating Potential of

Banking System

(1) 10 $20,000 $5000 $2000 $3000 $3000 $30,000

(2) 20 20,000 5000 4000 1000 1000 5000

(3) 25 20,000 5000 5000 0 0 0

(4) 30 20,000 5000 6000 -1000 -1000 -3333

Effects of Changes in the Reserve Ratio

LO2LO3

Tools of Monetary Policy

• Open market operations are the most important

• Reserve ratio last changed in 1992• Discount rate was a passive tool• Interest on reserves

LO2LO3

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

LO3

The Federal Funds Rate

Fed

eral

Fu

nd

s R

ate,

Per

cen

t

3.5

Quantity of Reserves

Df

Sf 3

4.0

4.5

Sf 1

Sf 2

Qf3 Qf1 Qf2

Using Open Market Operations

LO3

LO4

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

LO3LO4

Monetary Policy

• Restrictive monetary policy• Periods of rising inflation• Increases Federal funds rate• Increases money supply• Increases other interest rates

LO3LO4

Monetary Policy

LO4

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 targeted Federal funds rate is 4%• Target varies as inflation and real GDP vary

LO3LO4

Monetary Policy, Real GDP, Price Level

• 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

LO4LO5

Monetary Policy and Equilibrium GDP

10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)

Amount of moneydemanded and

supplied(billions of dollars)

Amount of investment (billions of dollars)

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3$125 $150 $175 $15 $20 $25

P2

P3

Sm1 Sm2 Sm3

Dm

IDAD1

I=$15

AD2

I=$20

AD3

I=$25

(a)The marketfor money

(b)Investment

demand

(c)Equilibrium real

GDP and thePrice level

AS

LO5

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3

P2

P3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(c)Equilibrium real

GDP and thePrice level

AS

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3

P2

P3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(d)Equilibrium real

GDP and thePrice level

AS

abc

AD4

I=$22.5

Monetary Policy and Equilibrium GDP

LO4LO5

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

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP rises

CA

US

E-E

FF

EC

T C

HA

IN

LO5

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

Interest rate rises

Investment spending decreases

Aggregate demand decreases

Inflation declines

CA

US

E-E

FF

EC

T C

HA

IN

LO5

Evaluation and Issues

• Advantages over fiscal policy• Speed and flexibility• Isolation from political pressure• Monetary policy is more subtle than fiscal

policy

LO6

Recent U.S. Monetary Policy

• Highly active in recent decades• Responded with quick and innovative actions

during the recent financial crisis and the severe recession

• Critics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long

LO6

After the Great Recession

• Slow recovery especially in terms of employment

• Zero interest rate policy• Zero lower bound problem• Quantitative easing• Forward commitment• Operation Twist

LO6

Problems and Complications

• Lags• Recognition and operational• Cyclical asymmetry• Liquidity trap

LO5LO6

The Big Picture

Levels ofOutput,

Employment,Income, and

Prices

AggregateDemand

AggregateSupply

InputResourcesWith Prices

ProductivitySources

Legal-InstitutionalEnvironment

Consumption(Ca)

Investment(Ig)

Net ExportSpending

(Xn)

GovernmentSpending

(G)LO6

Worries about ZIRP, QE, and Twist

• Government spending crowded out private spending

• Large budget deficits by the Federal government would lead to huge interest costs

• Low interest rates punish savers

LO6