1. Chapter 10 Interest Rates & Monetary Policy
ECON 201
Chapter 10
Interest Rates & Monetary Policy

2. Monetary Policy
A Central Bank’s changing of the money supply to influence interest rates & assist the economy in achieving price-level stability, full employment, & economic growth.

3. Interest rates & demand for $
Interest: the price paid for the use of money
Transaction demand: the demand for money as a medium of exchange
Asset demand: the demand for money to hold as an asset.
Cost: when money is held, there is an opportunity cost to what is sacrificed concerning what you could have done with it.

4. Equilibrium, Interest rates & bond prices
When you combine the demand for money and the supply of money, you find the equilibrium interest rate
When interest rates increase, bond prices fall.
When interest rates decrease, bond prices rise.
What is a bond? – we would like to raise 5 mil $ and then pay for it later. Businesses will buy the bond, b/c bonds pay interest. Like loan. Bond is a set rate.

5. The Fed’s Assets
Securities: government bonds that have been purchased by the Federal Reserve Banks. These have been issued by the gov’t to finance past budget deficits.
Loans to Comm. Banks: sometimes banks borrow money, and they do so from the Fed

6. The Fed’s Liabilities
Reserves of Comm. Banks: money that Comm. Banks are required to hold as reserves
Treasury deposits: the U.S. Treasury keeps its deposits and its checking accounts with the Fed
Federal Reserve Notes Outstanding: this is the paper money circulating in the economy

7. Tool #1 of Monetary Policy
Open-Market Operations: This is where the Fed buys government bonds from, or sells government bonds to, commercial banks and the public
Basically, when purchasing securities, the Fed transfers money to the commercial bank, who can then use that money to do things…like make more loans… which increases monetary activity!

8. Total Increase in the Money Supply, ($5,000)
Example 1
Fed Buys $1,000 Bond from a Commercial Bank
New Reserves
$1000
$1000
Excess
Reserves
Assume all banks are loaned up initially, a federal Reserve purchase of a $1,000 bond from either a commercial bank or the public can increse the money supply by $5000 when the reserve ratio is 20%. In this diagram, the purchase of a $1,000 bond from a commercial bank creates $1,000 of excess reserves that support a $5,000 expansion of checkable deposits through loans.
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)

9. Total Increase in the Money Supply, ($5000)
Example 2
Fed Buys $1,000 Bond from the Public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$200
Required
Reserves
The purchase of a $1,000 bond from the public creates a $1,000 checkable deposit but only $800 of excess reserves, because $200 of reserves is required to “back up” the $1,000 new checkable deposit. The commercial banks can therefore expand the money supply by only $4000 by making loans. This of checkable deposit money plus the new checkable deposit of $1000 equals $5000 of new money.
$1000
Initial
Checkable
Deposit
$4000
Bank System Lending
Total Increase in the Money Supply, ($5000)

10. Tool #1 of Monetary Policy…cont.
Basically, when the Fed sells securities, the required reserves of commercial banks are reduced
IMPORTANT: when the Fed buys gov’t bonds, the demand for them goes up. Bond prices rise, and interest rates fall.
IMPORTANT: when the Fed sells gov’t bonds, the supply increases, reducing prices, and interest rates rise

11. Tool #2 of Monetary Policy
The Reserve Ratio: if the Fed increases the reserve ratio, then banks don’t have as much money on hand to use as they wish. And decreasing the reserve ratio gives banks more money to do whatever they want to with it.

12. Tool #3 of Monetary Policy
The Discount Rate: Just like Comm. Banks charge you interest on loans, the loans that the Fed gives banks also charge interest. This is called the discount rate.
This rate is different from the Fed Funds rate which is the rate charged on overnight loans between banks.

13. Tool #3 of Monetary Policy…cont.
If the Fed lowers the Discount Rate, this encourages banks to borrow money and increase their reserves, which also encourages banks to lend more money, which increases the money supply.
If the Fed increases the Discount Rate, then the opposite occurs.

14. Tool #4 of Monetary Policy
Term Auction Facility
Introduced in 2007 in response to mortgage debt crisis.
Fed holds two auctions each month.
Banks bid for the right to borrow reserves for 28 days.
Lending guarantees that the amount of reserves the Fed wants to lend will be borrowed.

15. Targeting the Fed Funds rate
The Fed Funds rate is the best one that the Fed can control.
Banks use the Fed Funds rate because the Fed doesn’t pay interest to banks on the money that the banks are required to hold in reserves, so they loan it to other banks who need it temporarily.

16. Expansionary Policy
Often referred to as ‘easy money’ policy. It lowers interest rates to encourage borrowing and spending, which increases aggregate demand.
When banks’ reserves increase….
They loan more money
The money supply goes up
Prime interest rate: this is the rate banks base their loans on to you.

17. “Easy Money Policy”
Fed will enact one of the following measures to try to increase money supply:
The Fed will buy securities.
The Fed may lower the reserve ratio, although this is rarely changed because of its powerful impact.
The Fed could reduce the discount rate.
Auction more reserves.

18. Restrictive Policy
Often referred to as ‘tight money’ policy. It increases interest rates to discourage borrowing and spending, which curtails aggregate demand.
When banks’ reserves decrease…
The loan less money
The money supply goes down

19. “Tight Money” Policy
Fed will enact one of the following measures to try to decrease the money supply:
The Fed will sell securities.
The Fed may raise the reserve ratio, although this is rarely changed because of its powerful impact.
The Fed could raise the discount rate.
Auction fewer reserves.

20. Effects of Expansionary Policy
To increase the money supply, the Fed will do some of the following things….
Buy gov’t securities from banks & the public
Lower the reserve ratio requirement
Lower the discount rate
The intended outcome is to increase excess reserves in banks so they can loosen the money

21. Expansionary Monetary Policy and GDP
Problem: unemployment and recession
CAUSE-EFFECT CHAIN
Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
How does expansionary monetary policy work? Suppose the economy falls into a recession and unemployment increases. The Fed buys bonds, lowers the reserve ratio, lowers the discount rate, or increases reserve auctions. As a result, excess reserves increase, the federal funds rate falls, and money supply rises, which makes all interest rates fall. With lower interest rates, investment spending increases, and so does aggregate demand, leading to an increase in GDP.
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises

22. Effects of Restrictive Policy
To decrease the money supply, the Fed will do some of the following things…
Sell gov’t securities to banks & the public
Increase the reserve ratio requirement
Increase the discount rate
The intended outcome is to decrease excess reserves in banks so they can tighten the money

23. Restrictive Monetary Policy and GDP
Problem: inflation
CAUSE-EFFECT CHAIN
Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Here is how restrictive monetary policy works. Suppose the economy is overheated and inflation is a problem. The Fed sells bonds, increases the reserve ratio, increases the discount rate, or decreases reserve auctions. As a result, excess reserves decrease, the federal funds rate rises, and money supply falls, which makes all interest rates rise. With higher interest rates, investment spending decreases, and so does aggregate demand, leading to a decline in inflation.
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines

24. The Taylor Rule
The Fed shoots for (targets) a 2 % rate of inflation by….
If real GDP rises by 1% above potential GDP, the raise the Fed Funds rate by a ½ %
If inflation rises by 1% above its target of 2%, the Fed Funds rate goes up by ½ %
When real GDP is equal to potential GDP and inflation is equal to its target rate, the Fed Funds rate stays at 4%.

25. Policy affecting interest rates
The impact of changing interest rates is mainly on investment
Therefore, investment spending varies inversely with real interest rates
The reason interest rates impact investment so much is because of the large cost and long-term nature of capital purchased (investment)

26. Monetary Policy and GDP in AD-AS Model
Equilibrium, real
GDP and the
Price level
(a)
The market
for money
(b)
Investment
demand
Rate of Interest, i (Percent)
Amount of money
demanded and
supplied
(billions of dollars)
Sm1
Sm2
Sm3
Amount of investment
(billions of dollars)
Price Level
Real GDP
(billions of dollars) AS 10 8 6 P3
AD3
I=$25 P2
AD2
I=$20 Dm ID
AD1
I=$15
We can use the AD-AS model to see this relationship between monetary policy and GDP. An easy money policy that shifts the money supply curve rightward from Sm1 to Sm2 lowers the interest rate from 10 to 8 percent. As a result, investment spending increases from $15 billion to $20 billion, shifting the aggregate demand curve rightward from AD1 to AD2, and real output rises from the recessionary level Q1 to the full-employment level Qf. A tight money policy that shifts the money supply curve leftward from Sm3 to Sm2 increases the interest rate from 6 to 8 percent. Investment spending thus falls from $25 billion to $20 billion, and the aggregate demand curve shifts leftward from AD3 to AD2, curtailing inflation.
$125
$150
$175
$15
$20
$25 Q1 Qf Q3
LO: 10-3

27. Issues in Monetary policy
Adjusting monetary policy is much quicker than fiscal policy
The members of the Fed are isolated from lobbying and political pressure
Adjusting monetary policy is more politically palatable than changing taxes or congressional spending

28. Problems
It can take time for the Fed to recognize that a recession or inflation is happening
If the Fed reduces reserves too much, it make cause banks to completely stop loaning
If they reduce reserve requirements for banks, they can’t force the banks to make loans…so they may just hold onto the money instead (this is what is happening now)

29. End