Interest Rates and Monetary Policy Chapter 34 McGraw-Hill/IrwinCopyright © 2015 by McGraw-Hill...
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Transcript of Interest Rates and Monetary Policy Chapter 34 McGraw-Hill/IrwinCopyright © 2015 by McGraw-Hill...
Interest Rates and Monetary Policy
Chapter 34
McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education. All rights reserved.
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
LO1LO1
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
LO1LO1
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
LO1LO1
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
LO1LO1
• Assets• Securities• Loans to commercial banks
• Liabilities• Reserves of commercial banks• Treasury deposits• Federal Reserve Notes outstanding
LO2
Federal Reserve Balance Sheet
April 10, 2013 (in Millions)
Source: Federal Reserve Statistical Release, H.4.1, April 10, 2013, www.federalreserve.gov
SecuritiesLoans to Commercial BanksAll Other Assets
Total
Reserves of Commercial BanksTreasury DepositsFederal Reserve Notes (Outstanding)All Other Liabilities and Net WorthTotal
$957,619
439271,355
$3,229,413
$ 1,851,36152,478
1,137,087188,487
$3,229,413
LO2
Federal Reserve Balance Sheet
Assets Liabilities and Net Worth
LO2
Central Banks
LO2LO2
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
LO2LO3
Tools of Monetary Policy
• Fed buys bonds from commercial banks
Assets Liabilities and Net Worth
Federal Reserve Banks
+ Securities + Reserves of Commercial Banks
(b) Reserves
Commercial Banks
-Securities (a)
+Reserves (b)
Assets Liabilities and Net Worth
LO2
(a) Securities
LO3
Tools of Monetary Policy
• Fed sells bonds to commercial banks
Assets Liabilities and Net Worth
Federal Reserve Banks
- Securities - Reserves of Commercial Banks
Commercial Banks
+ Securities (a)
- Reserves (b)
Assets Liabilities and Net Worth
(a) Securities (b) Reserves
LO2LO3
Open Market Operations
• Fed buys $1,000 bond from a commercial bank
New Reserves
$5000Bank System Lending
Total Increase in the Money Supply, ($5,000)
$1000Excess
Reserves
LO2LO3
Open Market Operations
• Fed buys $1,000 bond from the publicCheck is Deposited
New Reserves$1000
Total Increase in the Money Supply, ($5000)
$200RequiredReserves
$800Excess
Reserves
$1000Initial
CheckableDeposit
$4000Bank System Lending
LO2LO3
Tools of Monetary Policy
• The reserve ratio• Changes the money multiplier
• The discount rate• The Fed as lender of last resort• Short term loans
• Term auction facility• Introduced December 2007• Banks bid for the right to borrow reserves
LO2LO3
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 $5000 $2000 $3000 $3000 $30,000
(2) 20 20,000 5000 4000 1000 1000 5000
(3) 25 20,000 5000 5000 0 0 0
(4) 30 20,000 5000 6000 -1000 -1000 -3333
Effects of Changes in the Reserve Ratio
LO2LO3
Tools of Monetary Policy
• Open market operations are the most important
• Reserve ratio last changed in 1992• Discount rate was a passive tool• Interest on reserves
LO2LO3
The Federal Funds Rate
• Rate charged by banks on overnight loans
• Targeted by the Federal Reserve• FOMC conducts open market operations
to achieve the target• Demand curve for Federal funds• Supply curve for Federal funds
LO3
The Federal Funds Rate
Fed
eral
Fu
nd
s R
ate,
Per
cen
t
3.5
Quantity of Reserves
Df
Sf 3
4.0
4.5
Sf 1
Sf 2
Qf3 Qf1 Qf2
Using Open Market Operations
LO3
LO4
Monetary Policy
• Expansionary monetary policy• Economy faces a recession• Lower target for Federal funds rate• Fed buys securities • Expanded money supply• Downward pressure on other interest rates
LO3LO4
Monetary Policy
• Restrictive monetary policy• Periods of rising inflation• Increases Federal funds rate• Increases money supply• Increases other interest rates
LO3LO4
Monetary Policy
LO4
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 targeted Federal funds rate is 4%• Target varies as inflation and real GDP vary
LO3LO4
Monetary Policy, Real GDP, Price Level
• Affect 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
LO4LO5
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
LO5
Pri
ce
Le
ve
l
Real GDP(billions of dollars)
Q1 Qf Q3
P2
P3
AD1
I=$15
AD2
I=$20
AD3
I=$25
(c)Equilibrium real
GDP and thePrice level
AS
Pri
ce
Le
ve
l
Real GDP(billions of dollars)
Q1 Qf Q3
P2
P3
AD1
I=$15
AD2
I=$20
AD3
I=$25
(d)Equilibrium real
GDP and thePrice level
AS
abc
AD4
I=$22.5
Monetary Policy and Equilibrium GDP
LO4LO5
Expansionary Monetary Policy
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
CA
US
E-E
FF
EC
T C
HA
IN
LO5
Restrictive Monetary Policy
Problem: Inflation
Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions
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
LO5
Evaluation and Issues
• Advantages over fiscal policy• Speed and flexibility• Isolation from political pressure• Monetary policy is more subtle than fiscal
policy
LO6
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
LO6
After the Great Recession
• Slow recovery especially in terms of employment
• Zero interest rate policy• Zero lower bound problem• Quantitative easing• Forward commitment• Operation Twist
LO6
Problems and Complications
• Lags• Recognition and operational• Cyclical asymmetry• Liquidity trap
LO5LO6
The Big Picture
Levels ofOutput,
Employment,Income, and
Prices
AggregateDemand
AggregateSupply
InputResourcesWith Prices
ProductivitySources
Legal-InstitutionalEnvironment
Consumption(Ca)
Investment(Ig)
Net ExportSpending
(Xn)
GovernmentSpending
(G)LO6
Worries about ZIRP, QE, and Twist
• Government spending crowded out private spending
• Large budget deficits by the Federal government would lead to huge interest costs
• Low interest rates punish savers
LO6