Interest Rates and Monetary Policy

Chapter 33

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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 shortcomings33-2

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

33-3

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, Dm33-4

Demand for MoneyR

ate

of

inte

rest

, i p

erce

nt

10

7.5

5

2.5

0 50 100 150 200 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, Dmand supply

Dt Da Dm

Sm

5

33-5

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 rate33-6

Federal Reserve Balance Sheet

• Assets–Securities–Loans to commercial banks

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

33-7

SecuritiesLoans to Commercial BanksAll Other Assets

Total

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

February 14, 2008 (in Millions)

Assets Liabilities and Net Worth

Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008

$713,369

60,039111,689

$885,097

$ 11,3124,979

778,93789,869

$885,097

Federal Reserve Balance Sheet

33-8

Central Banks

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)

Australia:

Canada:

Euro Zone:

Japan:

Mexico:

Russia

Sweden:

United Kingdom:

United States:

Selected Nations

33-9

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

33-10

Open Market Operations

New Reserves$1000

$5000Bank System Lending

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

Fed buys $1,000 bond from a commercial bank

$1000Excess

Reserves

33-11

Open Market Operations

Check is DepositedNew Reserves

$1000

Total Increase in the Money Supply, ($5000)

Fed buys $1,000 bond from the public

$200RequiredReserves

$800Excess

Reserves

$1000Initial

CheckableDeposit

$4000Bank System Lending

33-12

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 33-13

Tools of Monetary Policy

• Open market operations most important

• Reserve ratio last changed 1992

• Discount rate was a passive tool

• Term auction facility is new–Guaranteed amount lent by the Fed

–Anonymous 33-14

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 funds33-15

The Federal Funds Rate

Fed

eral

Fu

nd

s R

ate,

Per

cen

t

3.5

Quantity of Reserves

Df

Sf3

4.0

4.5

Sf1

Sf2

Qf3 Qf1 Qf2

Using Open Market Operations

33-16

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 policy33-17

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

33-18

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 33-19

Monetary Policy and 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

DmID

AD1I=$15

AD2I=$20

AD3I=$25

(a)The marketfor money

(b)Investment

demand

(c)Equilibrium real

GDP and thePrice level

AS

33-20

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

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP rises

CA

US

E-E

FF

EC

T C

HA

IN

33-21

Restrictive Monetary PolicyProblem: 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

33-22

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

33-23

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)

33-24

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

33-25

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

33-26

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Financial Economics

33-27