10/7/20151 Interest Rates & Monetary Policy Chapter 16
Learning Targets: 16.1 I can determine the equilibrium interest rate in the market for money. 10/7/20152
3 Interest Rates Fed’s primary influence is on the money supply & interest rates Interest- price paid for the use of money. Price that borrowers need to pay lenders for transferring purchasing power to the future There is a wide variety of US interest rates that vary by purpose, size, risk, maturity, & taxability
10/7/20154 Demand for Money Transactions demand Asset demand Total money demand
10/7/20155 Transactions demand (D t ) Demand for money as a medium of exchange People hold money because it is convenient for buying goods & services Level of nominal GDP is the main determinant of the amount of money demanded for transactions Direct relationship between transaction demand for $ & nominal GDP (will shift the total money demand curve)
10/7/20156 Asset demand (D a ) People hold their financial assets in many forms (i.e. stocks, bonds, or money) Money is the most liquid of all assets & is immediately usable for buying other assets Disadvantage of money – does not earn interest Inverse relationship between amt. of money demand & rate of interest
10/7/20157 Total Money Demand (D m ) Sum of asset demand & transactions demand Represents the total amount of money the public wants to hold, both for transactions and as an asset, at each possible interest rate
10/7/20158 Equilibrium interest rate (Learning Target) Intersection of supply & demand curve for money Equilibrium “price” is the interest rate Changes in demand or supply affect the interest rate We are most interested in supply of money Increase in supply…lowers int. rate Decrease in supply…increase int. rate
10/7/20159 Interest rates & bond prices These are closely related (inverse relationship)
Learning Targets: 16.2 I can explain the goals and tools of monetary policy. 10/7/201510
10/7/ Consolidation Balance Sheet of Federal Reserve Banks Assets Two main assets of Federal Reserve Banks Securities Loans to Commercial Banks Liabilities Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes Outstanding
10/7/ Tools of Monetary Policy 1.Open-Market Operations 2.The Reserve Ratio 3.The Discount Rate 4.Term Auction Facility
10/7/ Open-Market Operations Consists of buying of government bonds from, or the selling of government bonds to, commercial banks & the general public Most important instrument for influencing the money supply U.S. government issued bonds to finance past budget deficits
10/7/ Buying securities From commercial banks From the public In both cases, the reserves of commercial banks will increase but also increases checkable deposits when sellers (public) place Fed’s check into their personal checking acct. Increases lending ability of banks
10/7/ Selling securities To commercial banks To the public In both cases, the reserves of commercial banks are reduced
10/7/ Reserve Ratio The Fed can manipulate the reserve ratio in order to influence the ability of commercial banks to lend Raising the reserve ratio Two consequences Lowering the reserve ratio Excess reserves would rise & enhances the ability of banks to create new money by lending
10/7/ Effects of changes in reserve ratio on lending ability of commercial banks Reserve Ratio Checkable Deposits Actual Reserves Required Reserves Excess Reserves Money- Creating Potential of Single Bank 10$20,000$ ““ ““ ““
10/7/ Discount rate When a commercial bank borrows, it gives the Federal Reserve Bank a promissory note (IOU) drawn against itself and secured by acceptable collateral The Fed charges interest on loans they grant to commercial banks (discount rate) Borrowing from the Fed increases the reserves of the commercial banks which enhances their ability to extend credit
10/7/ Discount Rate (cont) The Fed has the power to set the discount rate at which commercial banks borrow from them From the commercial banks’ point of view, the discount rate is a cost of acquiring reserves
10/7/ Relative importance Of the three instruments of monetary control, buying & selling securities in the open market is the most important It’s flexible (can occur daily) Impact on reserves is prompt
16.3 Learning Targets: I can explain the Federal funds rate and how the Fed controls it. 10/7/201521
10/7/ Targeting the Federal funds rate Federal Funds rate Rate of interest that banks charge one another on overnight loans made from temporary excess reserves Some banks have excess reserves while others have deficiencies…they loan to each other to meet their reserve requirements
10/7/ Term Auction Facility Fourth Fed tool for altering bank reserves Introduced in 12/07 in response to mortgage debt crisis Fed holds two auctions per month at which banks bid for the right to borrow reserves for 28-day periods
10/7/ Expansionary monetary policy Easy money policy Lower the interest rate to bolster borrowing & spending This will increase AD & expand output
10/7/ Prime interest rate Benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses & individuals. Higher than federal funds rate because prime rate involves longer, more risky loans than overnight loans between banks They do closely track one another though
10/7/ Restrictive monetary policy Called “tight” money policyCalled “tight” money policy Used during inflation.Used during inflation. Int rate goes up which will reduce borrowing and spendingInt rate goes up which will reduce borrowing and spending Slows economy down and holds down price- level increasesSlows economy down and holds down price- level increases
10/7/ Taylor rule Assumes that the Fed has a 2 percent “target inflation rate” that it is willing to tolerate FOMC follows three rules when setting its target for Federal Funds rate (pg. 320) Fed has no official allegiance to Taylor rule They change Fed Funds rate to any level it deems appropriate
16.4 Learning Targets: I can explain the effectiveness of monetary policy as well as its shortcomings. 10/7/201528
10/7/ Monetary policy, real GDP, & the price level Cause-effect chain Market for money Demand & supply curves for money are brought together Money supply curves (vertical line representing some fixed amount of money determined by Fed) Equilibrium interest rate – S & D curves intersect
10/7/ Investment Inverse relationship between interest rate & amount of investment spending (key graph p. 322) Changes in interest rate mainly affect the investment component of total spending
10/7/ Equilibrium GDP Investment spending is one of the determinants of AD The greater the investment spending, the farther to the right lies the AD curve
10/7/ Effects of an expansionary Monetary Policy Intended outcome will be an increase in excess reserves in the commercial banking system & a decline in the Federal Funds Rate Banks earn profits by lending Nation’s money supply will rise Lowers interest rate, increases investment, aggregate demand, & equilbrium GDP
10/7/ Effects of a Restrictive monetary policy Inflation is a problem so restrictive monetary policy is used Actions taken: Sell government securities to banks & public Increase the legal reserve ratio Increase the discount rate Decrease the amount of reserves auctioned off under term auction facility Higher interest rate will discourage investment, lower AD, & restrain demand-pull inflation
10/7/ Monetary Policy: Evaluation & Issues Advantages over fiscal policy 1.Speed & flexibility Can be quickly altered (securities can be bought & sold on a daily basis which affects the money supply & interest rates almost immediately) 2.Isolation from political pressure Members of Fed BOG serve 14-year terms Isolated from lobbying & political pressure
10/7/ Recent U.S. Monetary Policy In early 1990’s, Fed’s expansionary monetary policy helped economy recover from recession To counter potential inflation during that strong expansion (1990’s), Fed reduced reserves in banking system to raise the interest rate
10/7/ Problems & Complications Lags Monetary policy faces a recognition & operational lag Cyclical asymmetry Less reliable in pushing the economy from a severe recession