Interest Rates and Monetary Policy Chapter 33

Demand for Money Asset Demand Transaction Demand The transactions demand (money used for purchases by households and businesses) varies directly with nominal GDP. GDP  Demand for Money P  Demand for Money Asset Demand People hold some money as a store of value. The asset demand for money varies inversely with the rate interest. When interest rates are high, other instruments (bonds) become more attractive as stores of wealth.

Money Market The Money Market graph determines the equilibrium rate of interest.

Monetary Policy Goal – The fundamental objective of monetary policy is to assist the economy in achieving a full employment, non-inflationary level of output. Monetary policy consists of altering the economy’s money supply to stabilize aggregate output, employment, and the price level. The Fed alters the nation’s money supply by manipulating the size of excess reserves held by commercial banks.

Tools of Monetary Policy 1. Open Market Operations – buying and selling government bonds by the Fed in the open market Buying Securities – commercial bank reserves increase From Banks – commercial banks hand securities over to the Fed in exchange for an increase in reserves From Individuals – Fed pays a check to individuals which are deposited in banks. Fed purchases of securities from banks lead to an equal increase in excess reserves whereas purchases from the public become deposits subject to the reserve requirement.

Selling Securities – reduces commercial bank reserves To commercial banks – banks pay the Fed for bonds out of their reserves To the public – individuals pay for bonds with checks drawn on commercial bank accounts Fed sales of securities to banks lead to equal decreases in excess reserves whereas a portion of sales to the public must be kept as required reserves.

2 . The Reserve Ratio Raising the reserve ratio increases the amount of required reserves banks must keep. Either banks lose excess reserves, diminishing their ability to create money by lending, or they find their reserves deficient and are forced to contract checkable deposits. Lowering the reserve ratio changes required reserves to excess reserves and enhances the ability of banks to create new money by lending. Reserve Ratio changes affect excess reserves and the size of the monetary multiplier 3. The Discount Rate – interest rate which the Fed charges to commercial banks and thrifts Commercial bank borrowing from the Fed increases the reserves of commercial banks, enhancing their ability to extend credit.

Easy vs. Tight Money Easy money actions increase the money supply. buy securities reduce the reserve ratio lower the discount rate Tight money actions reduce the money supply. sell securities increase the reserve ratio raise the discount rate Importance – Of the three tools of monetary policy, open market operations are the most important.

The Loanable Funds Market The demand for funds in the loanable funds market includes the following  Consumer borrowing Business borrowing – Investment --Government borrowing – financing deficits Foreign borrowing

Loanable Funds (cont.) The supply of loanable funds comes from the following sources. Private savings – household and business Federal Reserve – the money supply Foreign sector

Loanable Funds Graph