Chapter 10 Interest Rates & Monetary Policy ECON 201 Chapter 10 Interest Rates & Monetary Policy

Monetary Policy A Central Bank’s changing of the money supply to influence interest rates & assist the economy in achieving price-level stability, full employment, & economic growth.

Interest rates & demand for $ Interest: the price paid for the use of money Transaction demand: the demand for money as a medium of exchange Asset demand: the demand for money to hold as an asset. Cost: when money is held, there is an opportunity cost to what is sacrificed concerning what you could have done with it.

Equilibrium, Interest rates & bond prices When you combine the demand for money and the supply of money, you find the equilibrium interest rate When interest rates increase, bond prices fall. When interest rates decrease, bond prices rise. What is a bond? – we would like to raise 5 mil $ and then pay for it later. Businesses will buy the bond, b/c bonds pay interest. Like loan. Bond is a set rate.

The Fed’s Assets Securities: government bonds that have been purchased by the Federal Reserve Banks. These have been issued by the gov’t to finance past budget deficits. Loans to Comm. Banks: sometimes banks borrow money, and they do so from the Fed

The Fed’s Liabilities Reserves of Comm. Banks: money that Comm. Banks are required to hold as reserves Treasury deposits: the U.S. Treasury keeps its deposits and its checking accounts with the Fed Federal Reserve Notes Outstanding: this is the paper money circulating in the economy

Tool #1 of Monetary Policy Open-Market Operations: This is where the Fed buys government bonds from, or sells government bonds to, commercial banks and the public Basically, when purchasing securities, the Fed transfers money to the commercial bank, who can then use that money to do things…like make more loans… which increases monetary activity!

Total Increase in the Money Supply, ($5,000) Example 1 Fed Buys $1,000 Bond from a Commercial Bank New Reserves $1000 $1000 Excess Reserves Assume all banks are loaned up initially, a federal Reserve purchase of a $1,000 bond from either a commercial bank or the public can increse the money supply by $5000 when the reserve ratio is 20%. In this diagram, the purchase of a $1,000 bond from a commercial bank creates $1,000 of excess reserves that support a $5,000 expansion of checkable deposits through loans. $5000 Bank System Lending Total Increase in the Money Supply, ($5,000)

Total Increase in the Money Supply, ($5000) Example 2 Fed Buys $1,000 Bond from the Public Check is Deposited New Reserves $1000 $800 Excess Reserves $200 Required Reserves The purchase of a $1,000 bond from the public creates a $1,000 checkable deposit but only $800 of excess reserves, because $200 of reserves is required to “back up” the $1,000 new checkable deposit. The commercial banks can therefore expand the money supply by only $4000 by making loans. This 44000 of checkable deposit money plus the new checkable deposit of $1000 equals $5000 of new money. $1000 Initial Checkable Deposit $4000 Bank System Lending Total Increase in the Money Supply, ($5000)

Tool #1 of Monetary Policy…cont. Basically, when the Fed sells securities, the required reserves of commercial banks are reduced IMPORTANT: when the Fed buys gov’t bonds, the demand for them goes up. Bond prices rise, and interest rates fall. IMPORTANT: when the Fed sells gov’t bonds, the supply increases, reducing prices, and interest rates rise

Tool #2 of Monetary Policy The Reserve Ratio: if the Fed increases the reserve ratio, then banks don’t have as much money on hand to use as they wish. And decreasing the reserve ratio gives banks more money to do whatever they want to with it.

Tool #3 of Monetary Policy The Discount Rate: Just like Comm. Banks charge you interest on loans, the loans that the Fed gives banks also charge interest. This is called the discount rate. This rate is different from the Fed Funds rate which is the rate charged on overnight loans between banks.

Tool #3 of Monetary Policy…cont. If the Fed lowers the Discount Rate, this encourages banks to borrow money and increase their reserves, which also encourages banks to lend more money, which increases the money supply. If the Fed increases the Discount Rate, then the opposite occurs.

Tool #4 of Monetary Policy Term Auction Facility Introduced in 2007 in response to mortgage debt crisis. Fed holds two auctions each month. Banks bid for the right to borrow reserves for 28 days. Lending guarantees that the amount of reserves the Fed wants to lend will be borrowed.

Targeting the Fed Funds rate The Fed Funds rate is the best one that the Fed can control. Banks use the Fed Funds rate because the Fed doesn’t pay interest to banks on the money that the banks are required to hold in reserves, so they loan it to other banks who need it temporarily.

Expansionary Policy Often referred to as ‘easy money’ policy. It lowers interest rates to encourage borrowing and spending, which increases aggregate demand. When banks’ reserves increase…. They loan more money The money supply goes up Prime interest rate: this is the rate banks base their loans on to you.

“Easy Money Policy” Fed will enact one of the following measures to try to increase money supply: The Fed will buy securities. The Fed may lower the reserve ratio, although this is rarely changed because of its powerful impact. The Fed could reduce the discount rate. Auction more reserves.

Restrictive Policy Often referred to as ‘tight money’ policy. It increases interest rates to discourage borrowing and spending, which curtails aggregate demand. When banks’ reserves decrease… The loan less money The money supply goes down

“Tight Money” Policy Fed will enact one of the following measures to try to decrease the money supply: The Fed will sell securities. The Fed may raise the reserve ratio, although this is rarely changed because of its powerful impact. The Fed could raise the discount rate. Auction fewer reserves.

Effects of Expansionary Policy To increase the money supply, the Fed will do some of the following things…. Buy gov’t securities from banks & the public Lower the reserve ratio requirement Lower the discount rate The intended outcome is to increase excess reserves in banks so they can loosen the money

Expansionary Monetary Policy and GDP Problem: unemployment and recession CAUSE-EFFECT CHAIN Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises How does expansionary monetary policy work? Suppose the economy falls into a recession and unemployment increases. The Fed buys bonds, lowers the reserve ratio, lowers the discount rate, or increases reserve auctions. As a result, excess reserves increase, the federal funds rate falls, and money supply rises, which makes all interest rates fall. With lower interest rates, investment spending increases, and so does aggregate demand, leading to an increase in GDP. Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises

Effects of Restrictive Policy To decrease the money supply, the Fed will do some of the following things… Sell gov’t securities to banks & the public Increase the reserve ratio requirement Increase the discount rate The intended outcome is to decrease excess reserves in banks so they can tighten the money

Restrictive Monetary Policy and GDP Problem: inflation CAUSE-EFFECT CHAIN Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Here is how restrictive monetary policy works. Suppose the economy is overheated and inflation is a problem. The Fed sells bonds, increases the reserve ratio, increases the discount rate, or decreases reserve auctions. As a result, excess reserves decrease, the federal funds rate rises, and money supply falls, which makes all interest rates rise. With higher interest rates, investment spending decreases, and so does aggregate demand, leading to a decline in inflation. Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines

The Taylor Rule The Fed shoots for (targets) a 2 % rate of inflation by…. If real GDP rises by 1% above potential GDP, the raise the Fed Funds rate by a ½ % If inflation rises by 1% above its target of 2%, the Fed Funds rate goes up by ½ % When real GDP is equal to potential GDP and inflation is equal to its target rate, the Fed Funds rate stays at 4%.

Policy affecting interest rates The impact of changing interest rates is mainly on investment Therefore, investment spending varies inversely with real interest rates The reason interest rates impact investment so much is because of the large cost and long-term nature of capital purchased (investment)

Monetary Policy and GDP in AD-AS Model Equilibrium, real GDP and the Price level (a) The market for money (b) Investment demand Rate of Interest, i (Percent) Amount of money demanded and supplied (billions of dollars) Sm1 Sm2 Sm3 Amount of investment (billions of dollars) Price Level Real GDP (billions of dollars) AS 10 8 6 P3 AD3 I=$25 P2 AD2 I=$20 Dm ID AD1 I=$15 We can use the AD-AS model to see this relationship between monetary policy and GDP. An easy money policy that shifts the money supply curve rightward from Sm1 to Sm2 lowers the interest rate from 10 to 8 percent. As a result, investment spending increases from $15 billion to $20 billion, shifting the aggregate demand curve rightward from AD1 to AD2, and real output rises from the recessionary level Q1 to the full-employment level Qf. A tight money policy that shifts the money supply curve leftward from Sm3 to Sm2 increases the interest rate from 6 to 8 percent. Investment spending thus falls from $25 billion to $20 billion, and the aggregate demand curve shifts leftward from AD3 to AD2, curtailing inflation. $125 $150 $175 $15 $20 $25 Q1 Qf Q3 LO: 10-3

Issues in Monetary policy Adjusting monetary policy is much quicker than fiscal policy The members of the Fed are isolated from lobbying and political pressure Adjusting monetary policy is more politically palatable than changing taxes or congressional spending

Problems It can take time for the Fed to recognize that a recession or inflation is happening If the Fed reduces reserves too much, it make cause banks to completely stop loaning If they reduce reserve requirements for banks, they can’t force the banks to make loans…so they may just hold onto the money instead (this is what is happening now)

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