MODULE 31 MONETARY POLICY AND THE INTEREST RATE You have heard it before but lets review it again. 1. The interest rate is the cost of borrowing money

Interest-Rate Effect When price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment. WHY? An increase in prices leads to an increase in the interest rate so you are less likely to take out loans to improve your business.

The FED adjusts the money supply by changing any one of the following: 1. Changing Reserve Requirements (Ratios) 2. Lending Money to Banks & Thrifts Discount Rate 3. Open Market Operations Buying and Selling Bonds The FED is now chaired by Janet Yellen

How are you going to remember? Open Market Operations is when the FED buys or sells government bonds (securities). This is the most important and widely used monetary policy To increase the Money supply, the FED should _________ government securities. To decrease the Money supply, the FED should _________ government securities. BUY SELL How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply Buying Bonds= Bigger Bucks ( money supply) Selling Bonds= Smaller Bucks ( money supply)

When the Fed buys bonds, it adds to bank reserves When the Fed buys bonds, it adds to bank reserves. This is called easy money, expansionary monetary policy, or quantitative easing. It is designed to increase excess reserves and the money supply, and ultimately reduce interest rates to stimulate the economy.

The opposite of an expansionary policy is a tight money, restrictive, or contractionary monetary policy. Tight money policies are designed to shrink income and employment, usually in the interest of fighting inflation. The Fed brings about tight monetary policy by selling bonds, thereby pulling reserves from the financial system.

Monetary authorities around the world have tried an alternative to monetary rules by using the approach of inflation targeting. This sets targets for the inflation rate, usually around 2% per year. In January, 2012 the Fed adopted this position as well. If inflation exceeds the target, contractionary policy is employed; if inflation falls below the target, expansionary policy is used. Forward looking policy- offers transparency since the public knows the objective of an inflation targeting central bank. Central bank’s success can be judged and the bank is accountable.

Monetary Policy and the Interest Rate: Open Market Committee Sets the target federal funds rate every six weeks- uses Open Market Operations to achieve the goal. The Federal Reserve Bank of NY is charged with carrying this out.

Today, monetary authorities set a target interest rate and then use open market operations to adjust reserves and keep the federal funds rate near this level. The Fed’s interest target is the level that will keep the economy near potential GDP and/or keep inflationary pressures in check.

Draw expansionary and contractionary shift in loanable funds market

Monetary Policy and Aggregate Demand Review: fiscal policy can stabilize the economy Expansionary Monetary Policy: -expand the Money Supply= lower interest rate=more investment spending=higher rGDP=more consumer spending, etc Contractionary=opposite impact

Monetary Policy in Practice Remember, we try to fight recessions and ensure price stability (aka low inflation). When real GDP is below potential output=expansionary and vice versa  recall that the output gap= percentage difference between real GDP and potential output, + = exceeds Yp, and vice versa

Along came this gentleman…

Taylor rule for monetary policy Simple rule that takes into account concerns about both the business cycle and inflation the federal funds rate takes into acct inflation rate and output gap (in fact, we already follow this rule) Federal funds rate=1 + (1.5 x inflation rate) + (0.5 x output gap) Problem with the rule is that it has a “lag” and adjusts for past inflation but not future inflation

Commitment The Fed does not commit to an inflation rate but prefers about 2% (low, +); other central banks do have inflation targets=set policy (inflation target) to carry this out.

Difference? Inflation targeting looks forward, monetary policy looks backward (future inflation rates versus current) + infl. Targ= transparent and accountable (can know the rate and see how close they are) - too restrictive, not focused on stability of financial system

FRQ 2010 Form B 2. The central bank of the country of Sewell sells bonds on the open market. (a) Assume that banks in Sewell have no excess reserves. What is the effect of the central bank’s action on the amount of customer loans that banks in Sewell can make? (b) Using a correctly labeled graph of the money market, show the effect of the central bank’s action on the nominal interest rate in Sewell. (c) What is the effect of the central bank’s action on each of the following in Sewell? (i) Price level (ii) Real interest rate. Explain. (d) Given your answer in part (c)(ii), how is the international value of Sewell’s currency, the ono, affected? Explain.

FRQ 2010 Form B- Ruberic 7 points (1 + 2 + 3 + 1) (a) 1 point: • One point is earned for stating that bank loans will decrease.

(b) 2 points: • One point is earned for a correctly labeled graph of the money market. • One point is earned for showing a leftward shift of the MS curve and an increase in the nominal interest rate. (See graph on previous slide) (c) 3 points: • One point is earned for stating that the price level will fall. • One point is earned for stating that the real interest rate will rise. • One point is earned for the explanation that with an increase in the nominal interest rate and a decrease in the price level, the real interest rate increases. (d) 1 point: • One point is earned for stating that the ono will appreciate, because the increase in the demand for Sewell’s financial assets causes an increase in the demand for the ono.

Review: If the money supply increases what happens in the money market? The nominal interest rates rises The nominal interest rates falls. The nominal interest rate does not change Transaction demand for money falls Transaction demand for money rises

Which of the following is a predictable advantage of expansionary monetary policy in a recession? Decreases aggregate demand so that the price level falls. Increases aggregate demand, which increases real GDP, and increase employment. Increases unemployment, but low prices negate this effect. It boost the value of the dollar in foreign currency markets.

Review again If current federal funds rate is higher than the target-the FED will increase the money supply so the rate falls to the target- Buy Bonds If the current federal funds rate is lower than the target , the FED will decrease the money supply so that the rate rises to the target- Sell Bonds

AP Exam Alert Remember that the Aggregate Demand curve shifts in the same direction as the Money Supply Curve.