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Chapter 1

Determinants of Interest Rates

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Loanable Funds ApproachInterest rates

i

SupplyDemand

LoanablefundsDemand = Supply

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Business investment – the sum total of investment opportunities for all businesses in the economy. This is a list of investments from those with the highest returns to the lowest returns.

Consumer borrowing – sum total of consumer borrowing in the economy.

Government deficits.

The Demand for Funds

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ROR

$

Accept

Reject

.20

.15

.10

.05

Cost of funds

Project #1

Project #2

Project #3

Project #4

Capital Budgeting

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Individual savings. Most economists assume that as the interest rate increases consumers save larger dollar amounts. Thus, the supply curve is upward sloping.

Business savings. Retained earnings for all businesses.

Increases in the money supply.

Supply of Funds

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An Increase in the Money Supply

Interest rates

i1

Supply1Demand

Loanablefunds

Supply2

i2

Increase in money supply

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Increased Government Borrowing

Interest rates

i2

Demand1

Demand2

Loanablefunds

Supply

i1

Increase in government borrowing

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Total Income = Total Production

Income Per Capita = Production Per Capita

Income Production

Circular Flow for the Entire Economy

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The Federal Reserve is the central bank of the United States. It has two parts.

12 regional Federal Reserve Banks. The country is divided into 12 Federal Reserve regions, each of which has a Federal Reserve bank with branches in different parts of the district.

The Federal Reserve

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There is a board of seven governors of the Federal Reserve.

They are located in Washington D.C.Each governor is appointed to fill a 14

year term, which are staggered so that a new term becomes available every two years.

Board of Governors

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Each of the seven governors is appointed by the President of the United States with the consent of the United States Senate.

One of the governors is designated as chairman of the Federal Reserve Board and serves a four-year term as chairman, which begins in the fourth year of a Presidential term.

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The chairman has special influence for several reasons.He has the last word at meetings. He can act for the Federal Reserve in

emergencies.He is the spokesperson for the Federal

Reserve before the Congress and the public.He is chosen because of his strong

personality.

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Monetary policy is set by the Federal Open Market Committee, which has eight regularly scheduled meetings during the course of the year, approximately six weeks apart. Each meeting is attended by the 7 governors and the 12 presidents of the district Federal Reserve Banks. The meeting typically lasts 2 days.

The Federal Open Market Committee (FOMC)

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The result of these meetings is a policy directive on monetary policy. The directive sets bounds sets a target for the federal funds rate, and also may set bounds on the growth rate of the money supply.

Voting Rules: 7 governors, president of NY Fed and 4 other presidents on a rotating basis vote.

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In recent years, the directive has concentrated on the federal funds rate.

The federal funds rate is the rate at which banks borrow and lend funds to each other. These are funds that are on deposit at the Federal Reserve to meet reserve requirements. Banks with excess funds are lenders. Banks short of funds are borrowers.

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When the Federal Reserve wants to tighten monetary conditions, it increases the target federal funds rate (although the change is carried out by open market operations, discussed below).

All short-term interest rates tend to move together.

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Fractional Reserve Banking System and Federal Funds

Time

$

Lag

Average Deposits

Average Reserves

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Fed Funds vs. Fed Discount Rate

Time

Rates of Interest

Fed Discount Rate

Fed Funds

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The Federal Reserve is relatively independent from the rest of the government for several reasons.

Independence of the Federal Reserve

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InflationRate

Independent Not Independent

US

UK

Italy

Independence of the Central Bank and Inflation

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Low inflation. Why is inflation bad?a. Some people lose from inflation

because they are on fixed dollar incomes or hold money.

b. In the long run, high inflation tends to reduce economic growth and income of the population.

c. High inflation fosters political instability.

Goals of the Federal Reserve

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Full employment. The full employment act and equity are the main reasons for this.

Economic growth. Since output for the economy equals income for the economy, increasing output (economic growth) increases income.

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Open market operations. Buying (selling) bonds increases (reduces) the money supply and lowers (increases) interest rates.

Changing reserve requirements.Discount window.

a. Temporary loans.

b.Seasonal loans.

c. Distress loans.

Tools of the Federal Reserve

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Collect checks.Fed wire.

Other Functions of the Federal Reserve

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Inflation and Interest Rates

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Assumptions.Fisher examines the world from the

viewpoint of lenders only. One period horizon.No taxes.Complete certainty.

Irving Fisher’s Theory of Inflation and Interest Rates

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The letter “r” is the inflation free interest rate.

The letter “p” is inflation rate. The letter “i” is the nominal or

observed interest rate.Then Irving Fisher’s theory implies the

following.

Definitions

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.oductPrInflationfree-InflationalminNo

.rppri

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i = r + p + rpi = 0.05 + 0.10 + (0.05)(0.10) = 0.155.

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Time10

-$1

+r = 0.05

+1

+p = 0.10

+rp = 0.005

Principal

Now

Foregone consumption

Depreciation in principal

Depreciation in foregone consumption

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.PremiumRisk

InflationExpected

RateFree

Inflationi

h)p(Eri

The Case of Uncertainty

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i = 0.05 + 0.10 + 0.04 = 0.19 = 19%.

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Regression: [Nominal] = a + b[Recent infl.].

Relationship between the Nominal Interest Rate and Recent Inflation

Nominal InterestRate

Recent Inflation

a

b = slope

b = 1?0 < b < 1?

b > 1?