1 MONETARY POLICY Federal ReserveFederal Reserve (Central Bank) controls money supply.

2 MONETARY POLICY The money supply can/does influence price levels u Inflation occurs if the money supply increases, ceteris paribus. u Deflation occurs if the money supply decreases, ceteris paribus.

3 Dollar NOT backed by gold! 1)Up until 1935, citizens could redeem $ in a rate of $20.67 per ounce. 2)From 1935 to 1968, the US redeemed $ held by foreigners a rate of $35 an ounce.

4 Dollar NOT backed by gold! 3)From 1968 to 1971 there was only selective foreign redemption. 4)1971 "Gold Window" closed!

5 Dollar NOT backed by gold! u Dollar is only backed by "Faith," the fact most people "want it," and u not enough $ floating around out there such that everybody can have all they want!

6 What if you stuff your money in a mattress? What does it cost you? u Zero Inflation? u 10% Inflation? Known as the opportunity cost of holding money!

7 Interest The price you pay for using someone else's money (accounting cost or explicit cost) OR holding your own money as cash. (opportunity cost or implicit cost)

8 Interest u Nominal interest rates (market rates) u Real interest rates –A return net of inflation and risk premium u Risk-Free interest rates –Government treasury securities, no risk premium.

9 Interest Nominal Interest Rate = real interest rate + compensation for inflation + default risk premium

10 Real Interest Rate The real interest rate is the price of money, net of inflation and risk, that people are willing to accept for deferring present consumption until some future time period –$1 in your hand right now is worth more than the promise (without risk) of $1 in your hand a year from now. – Even with 0 inflation.

11 Real Interest Rate Example: u You can save money by ordering many items through the mail. u Why do people drive to Walmart?

12 Real Interest Rate u If $1 right now to you equals (has same value as) $1.05 one year from now, guaranteed, with zero inflation, u you have a real rate of interest of 5%

13 Nominal Interest Rate u If inflation was expected to be 10% from now until one year from now, what market interest rate would you demand to have, to get your 5% real rate of interest? Assume no risk. u Answer: 15%.

14 Nominal Interest Rate u If you thought there was some risk that you might never see your $1.00, u you would add a risk premium.

15 Interest Rates on Govt. Securities: Known as the "Risk-free Rate" = Real rate + E(inflation over life of security)

16 Interest Rates on Govt. Securities: When inflation, Risk-free interest rates AND Nominal interest rates

17 Prime Rate = real rate + E(Inflation) + small risk premium. u Given to the most solid businesses and individuals!

18 What Is the Risk Premium Charged by Banks for Auto Loans? August 25, 1993 US Treasury 3 yr. Note rate = 3.41% 36 mo. New Car, Nations Bank = 7.93% risk premium = 4.52% WHY? Bankruptcies

19 What Is the Risk Premium Charged by Banks for Auto Loans? Sept. 3, 1996 US Treasury 3 yr. Note rate = 6.42% 36 mo. New Car, Nations Bank = 10.25% risk premium = 3.83% Why? Economy humming along rather nicely, unemployment down, less bankruptcies

20 Recent Snapshot: u October 4, 2000 US Treasury 3 yr. Note rate = 5.97% 36 mo. New Car, Bank of America = 11.70% risk premium = 5.73%

21 More Recent Snap Shot u May 15, 2008 US Treasury 3 yr. Note rate = 2.78% 36 mo. New Car, Bank of America = 10.25% risk premium = 7.47%

22 MONETARY POLICY Federal Reserve can or the money supply in order to change the level of output and prices (Monetary Policy).

23 3 Tools to Change Money Supply: u Open-market operations (buying and selling treasury bonds, notes, and bills). u Discount rate: Interest rate banks are charged when they borrow from the Fed. u Reserve requirement: % of deposits that must be held by a bank as vault cash or on account with the federal reserve.

24 Open Market Operations u When the Federal Reserve sells more treasury securities than it buys: Money Supply Decreases u When the Federal Reserve buys more treasury securities than it sells: Money Supply Increases

25 The Discount Rate The discount rate is adjusted to complement open market operations and to support the direction the Fed is taking in monetary policy.

26 Reserve Requirement u Commercial Banks, Savings Banks, Savings and Loans, Credit Unions, and Branches of Foreign Banks are subject to reserve requirements. u Reserve requirement may range from 8 to 14 percent of demand deposits and interest-bearing accounts offering unlimited checking privileges.

27 Take A Look at the Following: u Implementation of Monetary Policy Please read Chapter 3: The Implementation of Monetary Policy. Feel free to read the entire publication if you wish.

28 Changing the Money Supply Increase Money Supply, c.p. Decrease interest rates (price of money) in S.R. BUT Increase Money Supply may cause inflation! Increase interest rates in L.R. Increase Money Supply too much Decrease value of money

29 Changing the Money Supply THEREFORE: u Takes more $ to buy same stuff u Price of stuff Inflation!

30 Changing the Money Supply Decrease Money Supply, c.p. Increase interest rates (price of money) in S.R. BUT Decrease Money Supply may cause deflation! Decrease interest rates in L.R. Decrease Money Supply too much Increase value of money

31 Changing the Money Supply THEREFORE: u Takes less $ to buy same stuff u Price of stuff Deflation!

32 Discretionary Income ( I DIS ) = (I D - Basic Housing bills, Basic Utility bills, Basic Food Bills, Basic transportation bills, Basic clothing, etc.) (Not payments on credit cards!) Money you have to spend or save at your discretion!

33 Ceteris Paribus: (Consumption - Production Model) Low unemp. P i LR ( I DIS ) (1) MS i SR C I V high unemp. P r i LR

34 Ceteris Paribus: (Consumption - Production Model) Low unemp. P i LR ( I DIS ) (1) MS i SR C I V high unemp. P r i LR However: The low interest rates of did not result in much `ed C!

35 WHY? (1) Consumer Debt Load maxed out! (2) Any I DIS from lower i rates being used to reduce current debt! (3) People with small debt, saving for fear of unemployment. (employment insecurity) (IBM, ATT, Apple, Airlines, Kodak everyday in paper, layoffs announced!)

36 Ceteris Paribus: (Consumption - Production Model) Low unemp. P r i LR ( I DIS ) (2) MS i SR C I V high unemp. P i

37 Ceteris Paribus: (Consumption - Production Model) Low unemp. P r i LR ( I DIS ) (2) MS i SR C I V high unemp. P i LR

38 Why has Stock Market Been Booming? People with money in banks, pulling it out and putting it in Stock Market for higher return!

39 What affect do low interest rates have on retired people? retirement income! u Stock Market too risky!