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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