Interest Rates and Monetary Policy Chapter 33 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives The equilibrium interest rate and the market for money Monetary policy How the Fed controls the Federal funds rate How monetary policy affects GDP and the price level Effectiveness of monetary policy and its shortcomings 33-2

Interest Rates Price paid for the use of money Many different interest rates Speak as if only one interest rate Determined by money supply and money demand 33-3

Demand for Money Why hold money? Transactions demand, D 1 –Determined by nominal GDP –Independent of the interest rate Asset demand, D 2 –Money as a store of value –Varies inversely with the interest rate Total money demand, D m 33-4

Demand for Money Rate of interest, i percent Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded and supplied (billions of dollars) = + (a) Transactions demand for money, D t (b) Asset demand for money, D a (c) Total demand for money, D m and supply DtDt DaDa DmDm SmSm

Interest Rates Equilibrium interest rate –Changes with shifts in money supply and money demand Interest rates and bond prices –Inversely related –Bond pays fixed annual interest payment –Lower bond price will raise the interest rate 33-6

Federal Reserve Balance Sheet Assets –Securities –Loans to commercial banks Liabilities –Reserves of commercial banks –Treasury deposits –Federal Reserve Notes outstanding 33-7

Securities Loans to Commercial Banks All Other Assets Total Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes (Outstanding) All Other Liabilities and Net Worth Total February 14, 2008 (in Millions) AssetsLiabilities and Net Worth Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008 $713,369 60, ,689 $885,097 $ 11,312 4, ,937 89,869 $885,097 Federal Reserve Balance Sheet 33-8

Central Banks Reserve Bank of Australia (RBA) Bank of Canada European Central Bank (ECB) Bank of Japan (BOJ) Banco de Mexico (Mex Bank) Central Bank of Russia Sveriges Riksbank Bank of England Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks) Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Selected Nations 33-9

Tools of Monetary Policy Open market operations –Buying and selling of government securities (or bonds) –Commercial banks and the general public –Used to influence the money supply When the Fed sells securities, commercial bank reserves are reduced 33-10

Open Market Operations New Reserves $1000 $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) Fed buys $1,000 bond from a commercial bank $1000 Excess Reserves 33-11

Open Market Operations Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) Fed buys $1,000 bond from the public $200 Required Reserves $800 Excess Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending 33-12

Tools of Monetary Policy The reserve ratio –Changes the money multiplier The discount rate –The Fed as lender of last resort –Short term loans Term auction facility –Introduced December 2007 –Banks bid for the right to borrow reserves 33-13

Tools of Monetary Policy Open market operations most important Reserve ratio last changed 1992 Discount rate was a passive tool –Aggressive during credit crisis Term auction facility is new –Guaranteed amount lent by the Fed –Anonymous 33-14

The Federal Funds Rate Rate charged by banks on overnight loans Targeted by the Federal Reserve FOMC conducts open market operations to achieve the target Demand curve for Federal funds Supply curve for Federal funds 33-15

Monetary Policy Expansionary monetary policy –Economy faces a recession –Lower target for federal funds rate –Fed buys securities –Expanded money supply –Downward pressure on other interest rates Contractionary monetary policy 33-16

The Federal Funds Rate Federal Funds Rate, Percent 3.5 Quantity of Reserves DfDf Sf3Sf Sf1Sf1 Sf2Sf2 Qf3Qf3 Qf1Qf1 Qf2Qf2 Using Open Market Operations 33-17

Prime Interest Rate Reference point used by banks Tied to Federal Funds Rate

Prime Rate

Taylor Rule Rule of thumb for tracking actual monetary policy Fed has 2% target inflation rate If real GDP = potential GDP and inflation is 2% then target federal funds rate is 4% Target varies as inflation and real GDP vary 33-21

Monetary Policy Affect on real GDP and price level Cause-effect chain –Market for money –Investment and the interest rate –Investment and aggregate demand –Real GDP and prices Expansionary monetary policy Restrictive monetary policy 33-22

Monetary Policy and GDP Rate of Interest, i (Percent) Amount of money demanded and supplied (billions of dollars) Amount of investment (billions of dollars) Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 $125$150$175$15$20$25 P2P2 P3P3 S m1 S m2 S m3 DmDm ID AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (a) The market for money (b) Investment demand (c) Equilibrium real GDP and the Price level AS 33-23

Expansionary Monetary Policy Problem: unemployment and recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises CAUSE-EFFECT CHAIN 33-24

Restrictive Monetary Policy Problem: inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines CAUSE-EFFECT CHAIN 33-25

Monetary Policy Advantages over fiscal policy –Speed and flexibility –Isolation from political pressure Recent U.S. monetary policy Problems and complications –Recognition lag –Operational lag –Cyclical asymmetry 33-26

The Big Picture Levels of Output, Employment, Income, and Prices Aggregate Demand Aggregate Supply Input Resources With Prices Productivity Sources Legal- Institutional Environment Consumption (C a ) Investment (I g ) Net Export Spending (X n ) Government Spending (G) 33-27

The Mortgage Debt Crisis Home mortgage default 2007 Banks write off bad loans Reserves reduced Fed as lender of last resort Term auction facility Fed lowered federal funds rate Mortgage backed securities as a new innovation –Bad incentives 33-28

Key Terms monetary policy interest transactions demand asset demand total demand for money open-market operations reserve ratio discount rate term auction facility Federal funds rate expansionary monetary policy prime interest rate restrictive monetary policy Taylor rule cyclical asymmetry mortgage debt crisis 33-29

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