Topic 4: Monetary PolicyInterest rates and investmentBanking systemFederal Reserve

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Fiscal Policy v Monetary Policy

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Fiscal Policy– Conducted by legislative and executive

branches of governmentGovernment spending and taxes to stimulate

or slow down the economy

Monetary Policy—Conducted by the Central Bank or Federal

ReserveAimed at influencing the amount of

investment, often through influence over interest rates

Government Borrowing

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The government borrows money all the time.

Where does it borrow money from?Issues government securities (e.g., “bonds”),

which are promises to replay a loan in the future at a fixed rate of return

Sells the securities in the bond market, just like any other large borrower.

If you buy a bond from the Treasury, the US Government is borrowing money from you.

US Treasury Bonds

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US federal bonds (T-Bills) are guaranteed by the US government

They are considered a very safe financial assetSafer than the stock marketSafer than the bonds issued by other borrowersSafer than personal investmentsEssentially a 0% chance of default

Prices are determined in the competitive market

Interest Rates

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In the market for money (supply and demand) the interest rate is the market price.

We will use the term “interest rate” to refer to the price of T-bills (US Government Securities).There is a very strong correlation between the

T-bill interest rate and the interest rates associated with other financial assets, loans, and bank deposits in the economy.

Interest Rates

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Suppose interest rate i = 5%.

Buy a new 1-year bond for $1000.At the end of 1 year, the bond pays you:

$1000(1+i) = $1000 (1.05) = $1050

Buy a new 3-year bond for $1000, with interest compounded annually.At the end of 3 years, the bond pays you:

$1000(1.05)3 = $1158

Interest Rates

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On Jan 1, 2008 the 3-year T-bill rate was 5%. On that day, Sam bought a 3-year T-bill for $1000. At the end of 2010, that bond will payout $1158.

If Sam sold her T-bill in the bond market on Jan 1, 2010 (1 year before maturity), how much could she get for it?Depends on the CURRENT interest rate (not the original

rate)

If the 1-year T-bill rate was 5% on Jan 1, 2010, then the “present value” of $1158 in one year is:

$1158 / (1+i) = $1158 / (1.05) = $1103

If the 1-year T-bill rate was 10% on Jan 1, 2010, then the “present value” of $1158 in one year is: $1052

If the 1-year T-bill rate was 2% on Jan 1, 2010, then the “present value” of $1158 in one year is : $1135

Some Equations

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Future Value (i.e., value at maturity) of bond that costs $PV today, when there is a per-period interest rate of i, and maturity in t periods

Future Value = PV (1+i)t

Present Value (i.e., value at purchase) of bond that will be worth $FV at maturity, when there is a per-period interest rate of i, and maturity in t periods

Present Value =

€

FV

(1+ i)t

Interest Rates

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If the T-Bill Rate is really high, then would you ever put money in anything else?

The T-Bill Rate (e.g., the interest rate) determines what other financial assets are reasonable choices for banks and firms.

Financial Assets:

“Investment” Other expenditures

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Plant and Equipment

Residential Construction

Inventories

Put in the bankHold cashStock marketBonds and

securities

Interest Rates

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Suppose interest rate i = 5%. Buy a 1-year $1000 bond. At the end of the year, the bond pays out $1000 x

1.05 = $1050

Interest rates in the economy help determine the amount of “Investment” or “I”.Remember “investment” or “I” includes plant &

equipment, housing, and inventories (NOT stocks and bonds)

A higher interest rate “i” makes buying bonds more attractive relative to investing in I. So, as i goes up, I goes down.

How i influences I -- Example

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Firm Project Cost Expected Return

Gomer’s Filling Station

Tow truck 190 10%

Pay at the pump 150 8%

Hydraulic Lift 50 4%

Inventory speculation

35 2%

How i influences I

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See In Class Exercise #1

How to influence i?

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The interest rate determines the amount of investment in the economy.

The interest rate is determined in the market place (supply and demand). It is not set by the government or the central bank.

But, the central bank can influence i through its ability to control money supply in the economy.

Federal Reserve

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In the US, the central bank is called the Federal Reserve

Controls money supply, which determines the price of money i, which determines investment

Banking System

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Central Bank, aka Federal ReserveControls the central money supply

Fractional Reserve Banking SystemWhere we keep our moneyBanks are allowed to lend out some fraction

of our deposits as investments to others (“fractional reserve” is the fraction that they cannot lend out and must keep as reserves)

What is money?

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Money is what money does:1. Medium of exchange2. Store of value3. Unit of account

Not the same as currency. Although currency is usually a form of money.

Evolution of Money

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1. Stage 1: No Money Q: Without money how do people engage in

trade? A: Barter Problem: High transaction costs

2. Stage 2: Goods become treated as money E.g., tobacco in colonies, gold, silver, jewels Problems:

Hard to carry Can be perishable Quality isn’t constant

Evolution of Money

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Stage 3: Set up a central treasury for valued goodsE.g., tobacco warehouse, where people can deposit

their tobacco. The tobacco is rated, and the depositor is given a bank note stating rights to claim the tobacco.

Now, bank note may be used as money. On gold standard, can take $1 bill to treasury and

exchange for $1 worth of gold (case in US prior to 1971)

Stage 4: Fiat moneyThe government says that money can be used (e.g.,

“for all debts public and private”) If go to treasury, can trade in your $1 bill for another

$1 bill

Philadelphia Goldsmith

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Goldsmith in 1740 PhillyHas a good safe to keep his goldOffers neighbors the chance to keep there

gold in the safeOn any given day some people take gold

out, other people put gold inObservation: daily balance might go up and

down slightly, but never falls below some level

Good Idea: Lend out some of the money from the vault

Philadelphia Goldsmith Balance Sheet

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Assets Liabilities

Reserves ($ in vault) $2000 Demand Deposits $10,000

Loans $8,000

Total: $10,000 Total: $10,000

Bank Balance Sheet – same idea

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Assets Liabilities

Reserves ($ in vault) $1000 Demand Deposits $10,000

Loans $7000

Securities $2000

Total: $10,000 Total: $10,000

Reserve Ratio

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Reserve Ratio = Reserves / Deposits

Required Reserve Ratio (i.e., RRR) = The minimum reserve ratio as mandated by the Federal Reserve.If the RRR = 0.2, then a bank with $10,000 in

deposits can lend out $8000.

Required Reserves = RRR x DepositsExcess Reserves = Reserves – Required

Reserves

Money Supply

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Money Supply = Cash On Hand + Total Deposits

The Fed influences money supply by buying or selling government securities (i.e., government bonds).Buy securities => put new money into the

economy => increases the money supplySell securities => take money out of the

economy => decreases the money supply

Buying Securities

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If the Fed buys $1000 in securities, it increases total money supply by MORE than $1000.

Example: How the $1000 flows through the economy, with a RRR = 0.2 …Fed buys $1000 in securities from Sally, who puts the $

in bankBank holds on to $200 and loans $800 to Fred to buy a

carFred buys the car from Sam who puts the $800 in her

bankSam’s bank keeps $160 in reserves and loans out $640

…In total, the money supply increases up to $5000

Changes to Money Supply

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Initial injection of $Z into the money supply (i.e., purchase of $Z worth of bonds) changes the total money supply by up to

Z * 1 / RRR

Initial decrease of $Z in the money supply (i.e., sell $Z worth of bonds) changes the total money supply by up to

- Z * 1 / RRR

Bank Balance Sheets – SummaryBalance sheet is a table with one column

listing “assets” and one listing “liabilities”For our purposes, liabilities include deposits,

and assets include bank reserves, loans, and other investments (e.g., securities)

Total Assets = Total Liabilities

Total Reserves = (Req. Res. Ratio) x (Total Deposits)

when banks don’t hold any excess reserves

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In Class Exercise #2

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See handout.

Market for Money

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Vertical axis is the price of money, represented by the interest rate, i

Horizontal axis is the quantity of money

Firms, Individuals, etc. determine money demand

The Federal Reserve (Fed) determines money supply

Money Demand

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Made up of three pieces:Transaction Demand – money on hand for

transactions (money needed for purchases)Precautionary Demand – rainy day funds (money

that might be needed for purchases)Speculative Demand – e.g., hold cash to buy

bonds later if you expect bond rate will rise soon (money you are waiting until the right time to invest)

Taken together => total demand (downward sloping)

Money Supply

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Typically, if banks have excess reserves, then they lend it out

Money supply is vertical

Market for Money

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Supply and Demand together

Shifts in Supply when the Fed engages in open market operations or changes the required reserve ratio (RRR)Immediate shiftLong-run shift

3 Primary Tools of Fed

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1. Open Market Operations – Buying and selling government securities (or other assets)

1. Changing the Required Reserve Ratio

1. Setting the Federal Funds Rate – interest rate at which banks can borrow at the Fed

The Fed does not directly set the US T-bill rate. They announce a target, and achieve it through Open Market Operations.

Changing Investment through open market operations

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Fed buys bonds, causing the money supply to increase

Through the market for money, an increase in money supply causes the price of money (i.e., the interest rate, i) to decrease

A decrease in the interest rate increases investment I, as investors become less likely to put their money in bonds and more likely to invest in capital improvement projects, etc.

An increase in investment increases the equilibrium level of national income and output

Changing Investment through open market operations

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Fed sells bonds, causing the money supply to decrease

Through the market for money, a decrease in money supply causes the price of money (i.e., the interest rate, i) to increase

An increase in the interest rate decreases investment I, as investors become more likely to put their money in bonds and less likely to invest in capital improvement projects, etc.

A decrease in investment decreases the equilibrium level of national income and output

Changing Investment through changing the required reserve ratio

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Fed decreases RRRBanks can loan out more of their deposits,

which increases the money supplyAs money supply increases, the price of

money (i.e., the interest rate i) decreasesA decrease in the interest rate results in

more investmentHigher investment increases national

income

Changing Investment through changing the required reserve ratio

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Fed increases RRRBanks can loan out less of their deposits,

which decreases the money supplyAs money supply decreases, the price of

money (i.e., the interest rate i) increasesAn increase in the interest rate results in

less investmentLower investment decreases national

income

Changing Investment by changing the federal funds rate

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Commercial banks are required to maintain sufficient reserves. If their reserves fall short of the RRR, then they must borrow funds at the end of the day to make up the difference.

Fed increases federal funds rate, it becomes more costly for a bank to fall short of the RRR.

Banks will keep a little extra reserves on hand to help ensure against falling short.

This results in banks loaning out less of their deposits, which has a similar effect as a modest increase in the RRR.

Decreases national income

Changing Investment by changing the federal funds rate

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Fed decreases federal funds rate, it becomes less costly for a bank to fall short of the RRR.

Actual reserves will tend to be closer to the required reserves.

This results in banks loaning out more of their deposits, which has a similar effect as a modest decrease in the RRR.

Increases national income

Some Linkshttp://www.bankrate.com/brm/news/fed/fedchart.asphttp://www.moneycafe.com/library/fedfundsratehistory.htmhttp://www.moneycafe.com/library/1monthlibor.htmhttp://www.moneycafe.com/library/cmt.htm

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Causal Arrows

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Buy Bonds +ΔMS −Δi +ΔI +ΔYSell Bonds −ΔMS +Δi −ΔI −ΔY

−RRR +ΔMS −Δi +ΔI +ΔY+RRR −ΔMS +Δi −ΔI −ΔY

Causal Arrows – Second Order Effects

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+ΔMS −Δi +ΔI +ΔY

“Second order” effects: +ΔMD +Δi …

When income increases, money demand increases. This causes a “second order effect”

Although the second order effect tends to decrease income (in this case), second order effects are less significant than the initial effect on income. Therefore, the overall change to income will still be positive.

This slide is a technical point that you don’t need to know.

Can you answer this…

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Buy Bonds +ΔMS −Δi +ΔI +ΔY (A) (B) (C)

(D)

(A)How does buying bonds increase the money supply?

(B)How does an increase to the money supply decrease the interest rate?

(C)How does a decrease to the interest rate increase investment?

(D)How does increasing investment increase national income?

Types of Policy

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“Expansionary” PolicyAny policy that expands the economyMonetary Policy – Reducing the RRR, buying

bondsFiscal Policy – Increasing G, decreasing Tx

“Contractionary” PolicyAny policy that slows down or contracts the

economyMonetary Policy – Increasing the RRR, selling

bondsFiscal Policy – Decreasing G, increasing Tx