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Transcript of 18 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved....
18
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rates and Monetary Policy
10
10-2
Interest Rates
• The price paid for the use of money
• Many different interest rates
• Speak as if only one interest rate
• Determined by the money supply and money demand
LO1
10-3
Types of Interest RatesType of Interest Rate Annual
Percentage
20-year Treasury Bond rate
(interest rate on federal government security used to finance the public debt)
4.05%
90-day Treasury Bill rate
(interest rate on federal government security used to finance the public debt)
0.02
Prime interest rate
(interest rate used as a reference point for a wide range of bank loans)
3.25
30-year mortgage rate
(fixed-interest rate on loans for houses)
4.60
4-year automobile loan rate
(interest rate for new autos by automobile finance companies)
4.05
Tax-exempt state and municipal bond rate
(interest rate paid on a low-risk bond issued by a state or local government)
4.65
Federal funds rate
(interest rate on overnight loans between banks)
0.08
Consumer credit card rate
(interest rate charged for credit card purchases)
14.42
LO1
10-4
Global Snapshot
LO1
Short-Term Interest Rate, 2011
10-5
Demand for Money
• Why hold money?
• Transactions demand, Dt
• Determined by nominal GDP
• Independent of the interest rate
• Asset demand, Da
• Money as a store of value
• Varies inversely with the interest rate
• Total money demand, Dm
LO1
10-6
Demand for MoneyR
ate
of
inte
rest
, i p
erce
nt
10
7.5
5
2.5
050 100 150 200 50 100 150 200 50 100 150 200 250 300
Amount of moneydemanded
(billions of dollars)
Amount of moneydemanded
(billions of dollars)
Amount of moneydemanded and supplied
(billions of dollars)
=+
(a)Transactionsdemand formoney, Dt
(b)Asset
demand formoney, Da
(c)Total
demand formoney, Dm, and
supply
Dt Da
Dm
Sm
5
LO1
10-7
Interest Rates
• Equilibrium interest rate
• Changes with shifts in money supply and money demand
• Interest rates and bond prices
• Inversely related
• Bond pays fixed annual interest payment
• Lower bond price will raise the interest rate
LO1
10-8
Tools of Monetary Policy
• Open-market operations
• Buying and selling of government securities (or bonds)
• Commercial banks and the general public
• Used to influence the money supply
• When the Fed sells securities, commercial bank reserves are reduced
LO2
10-9
Tools of Monetary Policy
• The reserve ratio
• Changes the money multiplier
• The discount rate
• The Fed as lender of last resort
• Short-term loans
LO2
10-10
The Reserve Ratio
Effects of Changes in the Reserve Ratio
(1)
Reserve Ratio, %
(2)
Checkable Deposits
(3)
Actual Reserves
(4)
Required Reserves
(5)
Excess Reserves,
(3) –(4)
(6)
Money-Creating
Potential of
Single Bank, = (5)
(7)
Money-Creating
Potential of Banking System
(1) 10 $20,000 $5,000 $2,000 $3,000 $3,000 $30,000
(2) 20 20,000 5,000 4,000 1,000 1,000 5,000
(3) 25 20,000 5,000 5,000 0 0 0
(4) 30 20,000 5,000 6,000 -1,000 -1,000 -3,333
LO2
10-11
Tools of Monetary Policy
• Open-market operations are the most important
• Reserve ratio last changed in 1992
• Discount rate was a passive tool
LO2
10-12
Monetary Policy
• Expansionary monetary policy
• Economy faces a recession
• Fed buys securities
• Lower the reserve ratio
• Lower the discount rate
LO2
10-13
Monetary Policy
• Restrictive monetary policy
• Periods of rising inflation
• Sell securites
• Increase the reserve ratio
• Raise the discount rate
LO2
10-14
Monetary Policy, Real GDP, Price Level
• Effect on real GDP and price level
• Cause-effect chain
• Market for money
• Investment and the interest rate
• Investment and aggregate demand
• Real GDP and prices
• Expansionary monetary policy
• Restrictive monetary policy
LO3
10-15
Monetary Policy and Equilibrium GDP
10
8
6
0
Rat
e o
f In
tere
st, i
(P
erce
nt)
Amount of moneydemanded and
supplied(billions of dollars)
Amount of investment (billions of dollars)
Pri
ce
Le
ve
l
Real GDP(billions of dollars)
Q1 Qf Q3$125 $150 $175 $15 $20 $25
P2
P3
Sm1 Sm2 Sm3
Dm
IDAD1
I=$15
AD2
I=$20
AD3
I=$25
(a)The marketfor money
(b)Investment
demand
(c)Equilibrium real
GDP and theprice level
AS
LO3
10-16
Expansionary Monetary Policy
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, or lowers the discount rate
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP risesLO3
CA
US
E-E
FF
EC
T C
HA
IN
10-17
Restrictive Monetary Policy
Problem: Inflation
Fed sells bonds, increases reserve ratio, or increases the discount rate
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
CA
US
E-E
FF
EC
T C
HA
IN
LO3
10-18
Monetary Policy in Action
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy is more subtle than fiscal policy
LO4
10-19
Federal Funds Rate
• Rate banks charge each other on overnight loans
• Easy for the Fed to target
LO4
10-20
10
8
4
6
2
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Per
cen
t
Year
Prime interest rate
Federal funds rate
Monetary Policy
LO5
10-21
Recent U.S. Monetary Policy
• Highly active in recent decades
• Responded with quick and innovative actions during the recent financial crisis and the severe recession
• Critics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long
LO5
10-22
Problems and Complications
• Lags
• Recognition and operational
• Cyclical asymmetry
• Liquidity trap
LO5
10-23
The Financial Crisis
• The Fed’s lender-of-last-resort activities
• Primary Dealer Credit Facility
• Term Securities Lending Facility
• Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
• Commercial Paper Funding Facility
LO5
10-24
The Financial Crisis
• Money Market Investor Funding Facility
• Term Asset-Backed Securities Loan Facility
• Interest Payments on Reserves
LO5