1. 16 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rates and Monetary Policy

2. Definitions LO1 Total (Actual) Reserves: Amount of money a bank holds (has available). Total Reserves = Required Reserves + Excess Reserves Required Reserves: Fraction of actual reserves a bank must keep (can’t be loaned). Reserve Ratio: Percentage of demand deposits bank must maintain for required reserves.

3. Definitions Excess Reserves: Amount of actual reserves the bank has to loan. Excess Reserves = Total Reserves – Required Res. Monetary multiplier (m) = 1/Reserve Ratio LO1

4. 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 LO1

5. Central Banks LO2

6. Tools of Monetary Policy Monetary policy is the manipulation of the money supply by changing bank’s excess reserves. LO1

7. Tools of Monetary Policy Open market operations Buying and selling of government securities (or bonds) by the Fed Most important tool to change the money supply LO2

8. Tools of Monetary Policy To increase Sm, Fed can buy securities from bank or public. I.E. Fed buys $1,000 security from commercial bank, reserve ratio is 20%. LO2

9. Tools of Monetary Policy Fed pays for securities by increasing bank’s actual reserves by $1,000. Since bank doesn’t have to maintain required reserves for money from Fed, excess reserves increase by $1,000. LO2

10. Open Market Operations Money creating potential of single bank is equivalent to its excess reserves (amount it can loan). Bank’s money creating potential increased by $1,000. LO2

11. Open Market Operations Money supply increases by $5,000 (5 x 1,000)due to monetary multiplier. Change in Sm = m x change in excess reserves LO2

12. Open Market Operations Fed buys $1,000 security from public, reserve ratio is 20% Fed pays with $1,000 check – money supply is directly increased by $1,000. LO2

13. Open Market Operations Check is deposited and bank’s actual reserves rise by $1,000. Required reserves increase by $200. (.2 x $1,000) Bank’s excess reserves rise by $800. ($1000 - $200) Bank’s lending ability increases by $800. LO2

14. Open Market Operations Banking system’s money creating potential increases by $4,000 (5 x $800). Money supply increases by $5,000 $4,000 + $1,000 (initial check). LO2

15. Tools of Monetary Policy The reserve ratio Changes the money multiplier Reduce reserve ratio to increase money supply Increase reserve ratio to reduce money supply LO2

16. Tools of Monetary Policy The discount rate – Lender of Last Resort Interest rate on loans from Fed to banks Lower discount rate to increase money supply Increase discount rate to reduce money supply LO2

17. Tools of Monetary Policy Interest on reserves Increase interest rate on reserves Banks will leave more reserves with Fed Decrease money supply Decrease interest rate on reserves Banks will leave fewer reserves with Fed Increase money supply LO2

18. Tools of Monetary Policy Reserve ratio changes bank’s profitability Discount rate is a passive tool until financial crisis Interest on reserves is too new LO2

19. The Federal Funds Rate Rate charged by banks on overnight loans Targeted by the Federal Reserve when changing the money supply Prime interest rate is directly related to the Federal funds rate. Prime interest rate is charged on loans to most credit-worthy customers LO3

20. Monetary Policy LO3

21. Monetary Policy Expansionary monetary policy Economy faces a recession Increase money supply, interest rates fall Lower target for federal funds rate Fed buys securities Lower reserve ratio Lower discount rate Decrease interest on reserves LO3

22. Monetary Policy Restrictive monetary policy Periods of rising inflation Decreases money supply, interest rates rise Increase target Federal funds rate Fed sells securities Raise reserve ratio Raise discount rate Increase interest on reserves LO3

23. 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 LO3

24. Evaluation and Issues Advantages over fiscal policy Speed and flexibility Isolation from political pressure Monetary policy more subtle than fiscal policy LO5

25. Recent U.S. Monetary Policy Highly active in recent decades Quick and innovative actions during recent financial crisis and severe recession Critics contend Fed contributed to crisis by keeping Federal funds rate too low for too long LO5

26. After the Great Recession Slow recovery, especially with employment Zero interest rate policy (ZIRP) Short-term rates near/at zero Zero lower bound problem Economy didn’t expand, interest rates already at zero LO5

27. After the Great Recession Quantitative easing Not intended to decrease interest rates Meant to increase reserves in bank system Forward commitment Part of QE2 Fed announced purchase amount and for how long Operation twist Fed announced: buy $677bil long-term gov’t bonds while selling equivalent amount of short-term gov’t bonds Spur investment and consumption with lower long- term rates LO5

28. Problems and Complications Lags Recognition and operational Cyclical asymmetry Liquidity trap LO5