Topic 4: Monetary Policy Interest rates and investment Banking system Federal Reserve 1

Fiscal Policy v Monetary Policy 2 Fiscal Policy– Conducted by legislative and executive branches of government Government spending and taxes to stimulate or slow down the economy Monetary Policy— Conducted by the Central Bank or Federal Reserve Aimed at influencing the amount of investment, often through influence over interest rates

Government Borrowing 3 The government borrows money all the time. Where does it borrow money from? Issues government securities (e.g., “bonds”), which are promises to replay a loan in the future at a fixed rate of return Sells the securities in the bond market, just like any other large borrower. If you buy a bond from the Treasury, the US Government is borrowing money from you.

US Treasury Bonds 4 US federal bonds (T-Bills) are guaranteed by the US government They are considered a very safe financial asset Safer than the stock market Safer than the bonds issued by other borrowers Safer than personal investments Essentially a 0% chance of default Prices are determined in the competitive market

Interest Rates 5 In the market for money (supply and demand) the interest rate is the market price. We will use the term “interest rate” to refer to the price of T-bills (US Government Securities). There is a very strong correlation between the T-bill interest rate and the interest rates associated with other financial assets, loans, and bank deposits in the economy.

Interest Rates 6 Suppose interest rate i = 5%. Buy a new 1-year bond for $1000. At the end of 1 year, the bond pays you: $1000(1+i) = $1000 (1.05) = $1050 Buy a new 3-year bond for $1000, with interest compounded annually. At the end of 3 years, the bond pays you: $1000(1.05) 3 = $1158

Interest Rates 7 On Jan 1, 2008 the 3-year T-bill rate was 5%. On that day, Sam bought a 3-year T-bill for $1000. At the end of 2010, that bond will payout $1158. If Sam sold her T-bill in the bond market on Jan 1, 2010 (1 year before maturity), how much could she get for it? Depends on the CURRENT interest rate (not the original rate) If the 1-year T-bill rate was 5% on Jan 1, 2010, then the “present value” of $1158 in one year is: $1158 / (1+i) = $1158 / (1.05) = $1103 If the 1-year T-bill rate was 10% on Jan 1, 2010, then the “present value” of $1158 in one year is: $1052 If the 1-year T-bill rate was 2% on Jan 1, 2010, then the “present value” of $1158 in one year is : $1135

Some Equations 8 Future Value (i.e., value at maturity) of bond that costs $PV today, when there is a per-period interest rate of i, and maturity in t periods Future Value = PV (1+i) t Present Value (i.e., value at purchase) of bond that will be worth $FV at maturity, when there is a per-period interest rate of i, and maturity in t periods Present Value =

Interest Rates 9 If the T-Bill Rate is really high, then would you ever put money in anything else? The T-Bill Rate (e.g., the interest rate) determines what other financial assets are reasonable choices for banks and firms.

Financial Assets: “Investment”Other expenditures 10 Plant and Equipment Residential Construction Inventories Put in the bank Hold cash Stock market Bonds and securities

Interest Rates 11 Suppose interest rate i = 5%. Buy a 1-year $1000 bond. At the end of the year, the bond pays out $1000 x 1.05 = $1050 Interest rates in the economy help determine the amount of “Investment” or “I”. Remember “investment” or “I” includes plant & equipment, housing, and inventories (NOT stocks and bonds) A higher interest rate “i” makes buying bonds more attractive relative to investing in I. So, as i goes up, I goes down.

How i influences I -- Example 12 FirmProjectCostExpected Return Gomer’s Filling Station Tow truck19010% Pay at the pump1508% Hydraulic Lift504% Inventory speculation352%

How i influences I 13 See In Class Exercise #1

How to influence i? 14 The interest rate determines the amount of investment in the economy. The interest rate is determined in the market place (supply and demand). It is not set by the government or the central bank. But, the central bank can influence i through its ability to control money supply in the economy.

Federal Reserve 15 In the US, the central bank is called the Federal Reserve Controls money supply, which determines the price of money i, which determines investment

Banking System 16 Central Bank, aka Federal Reserve Controls the central money supply Fractional Reserve Banking System Where we keep our money Banks are allowed to lend out some fraction of our deposits as investments to others (“fractional reserve” is the fraction that they cannot lend out and must keep as reserves)

What is money? 17 Money is what money does: 1. Medium of exchange 2. Store of value 3. Unit of account Not the same as currency. Although currency is usually a form of money.

Evolution of Money Stage 1: No Money Q: Without money how do people engage in trade? A: Barter Problem: High transaction costs 2. Stage 2: Goods become treated as money E.g., tobacco in colonies, gold, silver, jewels Problems: Hard to carry Can be perishable Quality isn’t constant

Evolution of Money 19 Stage 3: Set up a central treasury for valued goods E.g., tobacco warehouse, where people can deposit their tobacco. The tobacco is rated, and the depositor is given a bank note stating rights to claim the tobacco. Now, bank note may be used as money. On gold standard, can take $1 bill to treasury and exchange for $1 worth of gold (case in US prior to 1971) Stage 4: Fiat money The government says that money can be used (e.g., “for all debts public and private”) If go to treasury, can trade in your $1 bill for another $1 bill

Philadelphia Goldsmith 20 Goldsmith in 1740 Philly Has a good safe to keep his gold Offers neighbors the chance to keep there gold in the safe On any given day some people take gold out, other people put gold in Observation: daily balance might go up and down slightly, but never falls below some level Good Idea: Lend out some of the money from the vault

Philadelphia Goldsmith Balance Sheet 21 AssetsLiabilities Reserves ($ in vault) $2000Demand Deposits $10,000 Loans $8,000 Total: $10,000

Bank Balance Sheet – same idea 22 AssetsLiabilities Reserves ($ in vault) $1000Demand Deposits $10,000 Loans $7000 Securities $2000 Total: $10,000

Reserve Ratio 23 Reserve Ratio = Reserves / Deposits Required Reserve Ratio (i.e., RRR) = The minimum reserve ratio as mandated by the Federal Reserve. If the RRR = 0.2, then a bank with $10,000 in deposits can lend out $8000. Required Reserves = RRR x Deposits Excess Reserves = Reserves – Required Reserves

Money Supply 24 Money Supply = Cash On Hand + Total Deposits The Fed influences money supply by buying or selling government securities (i.e., government bonds). Buy securities => put new money into the economy => increases the money supply Sell securities => take money out of the economy => decreases the money supply

Buying Securities 25 If the Fed buys $1000 in securities, it increases total money supply by MORE than $1000. Example: How the $1000 flows through the economy, with a RRR = 0.2 … Fed buys $1000 in securities from Sally, who puts the $ in bank Bank holds on to $200 and loans $800 to Fred to buy a car Fred buys the car from Sam who puts the $800 in her bank Sam’s bank keeps $160 in reserves and loans out $640 … In total, the money supply increases up to $5000

Changes to Money Supply 26 Initial injection of $Z into the money supply (i.e., purchase of $Z worth of bonds) changes the total money supply by up to Z * 1 / RRR Initial decrease of $Z in the money supply (i.e., sell $Z worth of bonds) changes the total money supply by up to - Z * 1 / RRR

Bank Balance Sheets – Summary Balance sheet is a table with one column listing “assets” and one listing “liabilities” For our purposes, liabilities include deposits, and assets include bank reserves, loans, and other investments (e.g., securities) Total Assets = Total Liabilities Total Reserves = (Req. Res. Ratio) x (Total Deposits) when banks don’t hold any excess reserves 27

In Class Exercise #2 28 See handout.

Market for Money 29 Vertical axis is the price of money, represented by the interest rate, i Horizontal axis is the quantity of money Firms, Individuals, etc. determine money demand The Federal Reserve (Fed) determines money supply

Money Demand 30 Made up of three pieces: Transaction Demand – money on hand for transactions (money needed for purchases) Precautionary Demand – rainy day funds (money that might be needed for purchases) Speculative Demand – e.g., hold cash to buy bonds later if you expect bond rate will rise soon (money you are waiting until the right time to invest) Taken together => total demand (downward sloping)

Money Supply 31 Typically, if banks have excess reserves, then they lend it out Money supply is vertical

Market for Money 32 Supply and Demand together Shifts in Supply when the Fed engages in open market operations or changes the required reserve ratio (RRR) Immediate shift Long-run shift

3 Primary Tools of Fed Open Market Operations – Buying and selling government securities (or other assets) 1. Changing the Required Reserve Ratio 1. Setting the Federal Funds Rate – interest rate at which banks can borrow at the Fed The Fed does not directly set the US T-bill rate. They announce a target, and achieve it through Open Market Operations.

Changing Investment through open market operations 34 Fed buys bonds, causing the money supply to increase Through the market for money, an increase in money supply causes the price of money (i.e., the interest rate, i) to decrease A decrease in the interest rate increases investment I, as investors become less likely to put their money in bonds and more likely to invest in capital improvement projects, etc. An increase in investment increases the equilibrium level of national income and output

Changing Investment through open market operations 35 Fed sells bonds, causing the money supply to decrease Through the market for money, a decrease in money supply causes the price of money (i.e., the interest rate, i) to increase An increase in the interest rate decreases investment I, as investors become more likely to put their money in bonds and less likely to invest in capital improvement projects, etc. A decrease in investment decreases the equilibrium level of national income and output

Changing Investment through changing the required reserve ratio 36 Fed decreases RRR Banks can loan out more of their deposits, which increases the money supply As money supply increases, the price of money (i.e., the interest rate i) decreases A decrease in the interest rate results in more investment Higher investment increases national income

Changing Investment through changing the required reserve ratio 37 Fed increases RRR Banks can loan out less of their deposits, which decreases the money supply As money supply decreases, the price of money (i.e., the interest rate i) increases An increase in the interest rate results in less investment Lower investment decreases national income

Changing Investment by changing the federal funds rate 38 Commercial banks are required to maintain sufficient reserves. If their reserves fall short of the RRR, then they must borrow funds at the end of the day to make up the difference. Fed increases federal funds rate, it becomes more costly for a bank to fall short of the RRR. Banks will keep a little extra reserves on hand to help ensure against falling short. This results in banks loaning out less of their deposits, which has a similar effect as a modest increase in the RRR. Decreases national income

Changing Investment by changing the federal funds rate 39 Fed decreases federal funds rate, it becomes less costly for a bank to fall short of the RRR. Actual reserves will tend to be closer to the required reserves. This results in banks loaning out more of their deposits, which has a similar effect as a modest decrease in the RRR. Increases national income

Some Links

Causal Arrows 41 Buy Bonds  + Δ MS  − Δ i  + Δ I  + Δ Y Sell Bonds  − Δ MS  + Δ i  − Δ I  − Δ Y −RRR  + Δ MS  − Δ i  + Δ I  + Δ Y +RRR  − Δ MS  + Δ i  − Δ I  − Δ Y

Causal Arrows – Second Order Effects 42 + Δ MS  − Δ i  + Δ I  + Δ Y  “Second order” effects: + Δ MD  + Δ i  … When income increases, money demand increases. This causes a “second order effect” Although the second order effect tends to decrease income (in this case), second order effects are less significant than the initial effect on income. Therefore, the overall change to income will still be positive. This slide is a technical point that you don’t need to know.

Can you answer this… 43 Buy Bonds  + Δ MS  − Δ i  + Δ I  + Δ Y (A) (B) (C) (D) (A) How does buying bonds increase the money supply? (B) How does an increase to the money supply decrease the interest rate? (C) How does a decrease to the interest rate increase investment? (D) How does increasing investment increase national income?

Types of Policy 44 “Expansionary” Policy Any policy that expands the economy Monetary Policy – Reducing the RRR, buying bonds Fiscal Policy – Increasing G, decreasing Tx “Contractionary” Policy Any policy that slows down or contracts the economy Monetary Policy – Increasing the RRR, selling bonds Fiscal Policy – Decreasing G, increasing Tx