Presentation on theme: "THE FED AND INTEREST RATES. Notes in circulation Depository institution reserves The FED used its power over the monetary base to control the money."— Presentation transcript:
When the Fed wants to increase the money supply(using any of the three tools),initially the reserves increases creating excess reserves, that the banks can invest or lend. Additionally, the following things happen: new loans created increases borrower’s transactional balances. purchase of investment securities/assets increases seller’s transactional balances. This helps in financing the purchases of the DSUs of goods or services in real sector. Finally, this all contributes to economic growth. By expanding or contracting monetary base(increasing or decreasing the money supply), Fed - ◦ increases or decreases excess reserves, thus ◦ raising or lowering incentive to lend or invest, thus ◦ encouraging or discouraging expansion in real sector. 7
Market Equilibrium Interest Rate 1.Demand for the reserves by the depository institutions (downward sloped) 2.Supply of the reserves by the Fed (upward sloped) 3.Equilibrium FF rate is when D Res = S Res Quantity of Reserves The FF Rate D Res S Res Equilibrium Interest
Monetary Policy & The Fed Funds Rate OMO and its impact on FF rate 1.Purchasing Treasury securities leads to increase reserves in the banking system then the supply curve shifts rightward. As a result, the FF rate will decline. 2.Selling Treasury securities Quantity of reserves The FF Rate S Res 1 S Res 2
Discount rate and its impact on CB rate 1.Increase discount rate means increase opportunity cost of holding reserves. So supply of reserves will decline, the supply curve will shift leftward, then the FFR increases. 2.Decrease discount rate Quantity of Reserves The FF rate D Res S Res 2 S Res 1
RR and its impact on CB rate 1.Increase (RRR) leads to increase RR, decrease ER i.e. the loans to the public, demand for reserves from the FF increases, demand curve shifts rightward, and FFR increases. 2. Decrease (RRR) Quantity of Reserves The FF rate D Res 2 D Res 1 s Res
Two school of thought about what affects the level of economic activity: 1- Monetarist Economists Monetarists assume propensity to consume— rises as people perceive they have “more money” drops as people perceive they have “less money” The money supply is the key variable that effect on economic activity. adding reserves carefully should promote economic growth subtracting reserves carefully should slow the economy 2- Keynesian Economists John Maynard Keynes was influential British economist of 1930s. The interest rate is the key variable.
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.