1. The Fed and The Interest Rates
Chapter 3
FIN 221

2. Fed Reserve Control of The Money supply
Measures of The Money supply

3. Monetary Base & Money Supply Changes
The CB changes the money supply by changing the monetary base (MB) through its monetary policy tools.
In case of Restrictive monetary policy:
OMO - sell securities, reduce bank reserves and the monetary base.
RR - increase reserve requirements, reduces excess reserves and the deposit expansion multiplier.
Discount rate -- increase the discount rate, reduce the money supply or its growth rate; increase interest rates.

4. The Fed’s Control Over Interest Rates
The central bank (Fed) funds rate is the interbank lending rate.
The interbank lending rate represent the primary cost of short-term loanable funds.
The Fed (CB) rate:
It measures the return on the most liquid of all financial assets.
It is closely related to monetary policy.
It directly measures the available reserves in the banking system which in turn influences commercial bank’s decision on making loans to consumers , businesses or other borrowers.

5. Market Equilibrium Interest Rate
Demand for the reserves by the depository institutions (Negative)
Supply of the reserves by the CB (Positive)
Equilibrium CB rate is when DRes = SRes
SRes
The CB Rate
Equilibrium Interest
DRes
Quantity of Reserves

6. Monetary Policy & The Fed Funds Rate
OMO and its impact on CB rate
Purchasing T – Treasury leads to increase reserves in the banking system then the supply curve shifts rightward. As a result, the market interest will decline.
Selling T – Treasury
The CB Rate
SRes1
SRes2
Quantity of reserves

7. Discount rate and its impact on CB rate
Increase discount rate means increase opportunity cost of holding reserves. So supply of reserves will decline, the supply curve will shift leftward, then the interest increases.
Decrease discount rate
SRes2
SRes1
The CB rate
DRes
Quantity of Reserves

8. RR and its impact on CB rate
Increase k (RRR) leads to increase RR, decrease ER i.e. the loans to the public, demand for reserves from the CB increases, demand curve shifts rightward, and interest increases.
2. Decrease k (RRR)
The CB rate
sRes
DRes2
DRes1
Quantity of Reserves

9. The Market Environment
The CB can influence the CB funds rate ONLY in the very short run
The CB does NOT have the power to set the CB funds rate in the long run

10. Importance of the Fed (CB) rate:
1- Monetary Theory (monetarist economists)
The money supply is the key variable that effect on economic activity.
2- Keynesian School
The interest rate is the key variable.
Example: in case of recession: CB will take a expansionary Monetary Policy, this will lead to decline in interest rate, this lead to increase components of AD and finally this leads to pushing the economy (Unless it is in a liquidity trap)
both schools about how CB should try to effect on real sector
What Is Liquidity Trap?

11. The CB’s Impact on Stock and Bond Markets
Increase in market interest rate leads to decrease in the value of fixed – income securities.
Raising discount rate or / and raising reserve requirements leads to a great fall in the stock market.

12. Objectives of Monetary Policy
Full Employment:
Definition
Frictional Unemployment
Structural Unemployment
Natural Rate of unemployment
Consequents of unemployment: economic and social results

13. 2. Economic Growth:
Definition
PPF and economic Growth
3. Stable Prices:
The relationship between Prices and purchasing power (money value)
Effects of unanticipated inflation

14. 4. Interest Rate Stability:
Definition
Interest rate fluctuations effects
5. Stability of financial System:
Fluctuation in financial system and efficiency
Instability in banking system
The role of CB
Example: 11 Sep., 2001

15. Possible Conflict Among Objectives
6. Stability of Foreign Exchange Market:
Definition
International Trade
Devaluation / overvaluation and the effects on X & M
Possible Conflict Among Objectives
Conflict between inflation & unemployment
Philips Curve

16. The Fed and The Economy OMO – Expansionary monetary policy
1- buying securities -- increase in banks’ reserves
2- the increase in reserves will lead to an increase in banks’ assets, banks’ investments and banks’ loans.
3- each of the Above has additional effects as follows:
The increase in banks’ assets will lead to an increase in money supply.
The increase in investments will increase securities’ prices and lead to decrease in interest rates.
The increase in loans will increase credit availability and lead to a decrease in interest rates.

17. The increase in money supply and decrease in interest rates will:
- Increase Investment expenditure ( I )
Increase consumption expenditure
(durable – houses) ( C )
- Increase government expenditure ( G)
Increase net exports (since exports increase and imports decrease ) ( NX)
Decrease foreign exchange rate.
i.e, expenditure on domestically produced goods will increase and the RGDP (= C+I+G+NX) will increase,
- also the price level will increase.

18. Business investment in real assets
Present values of future cash flows from real assets depend significantly on general level of interest rates:
Rates fall, PVFCF rises
Rates rise, PVFCF drops
Most capital expenditures are debt-financed; interest expense is thus material in profitability of most businesses.
Monetary policy thus always involves material incentives or disincentives for business investment.
The CB can manipulate incentives but not compel results.

19. Consumer spending for durable goods & housing
Much consumer spending is on credit, so it tends to vary directly with credit conditions:
Falling interest rates tend to encourage spending.
Rising interest rates tend to discourage spending.
Monetary policy can thus often affect aggregate demand to some extent.
The CB can encourage/discourage but not necessarily compel; Consumers don’t necessarily make financial decisions the way businesses do:

20. Interest rates affect exchange rates as follows:
Net exports
Interest rates affect exchange rates as follows:
Falling interest rates in a country tend to “weaken” its currency.
Rising interest rates in a country tend to “strengthen” its currency.
Exchange rates affect imports and exports
As domestic currency weakens—
Domestic demand for imports decreases as they become more expensive BUT
Foreign demand for exports increases as they become less expensive (cheaper).