Interest Rates and Monetary Policy

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
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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
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Demand for Money
Rate of interest, i percent
10
7.5
5
2.5
0
Amount of money
demanded
(billions of dollars)
Amount of money
demanded
(billions of dollars)
Amount of money
demanded and supplied
(billions of dollars)
=
+
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
(c)
Total
demand for
money, Dm
and supply
Dt
Da
Dm
Sm
5
LO1
33-

Assets
Securities
Loans to commercial banks
Liabilities
Reserves of commercial banks
Treasury deposits
Federal Reserve Notes outstanding
LO2
Federal Reserve Balance Sheet
33-

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
33-

Tools of Monetary Policy
Fed buys bonds from commercial banks
Federal Reserve Banks
+ Securities
+ Reserves of Commercial Banks
(b) Reserves
Commercial Banks
Securities (a)
+Reserves (b)
Assets
Liabilities and Net Worth
LO2
(a) Securities
33-

Tools of Monetary Policy
Fed sells bonds to commercial banks
Federal Reserve Banks
- Securities
- Reserves of Commercial Banks
Commercial Banks
+ Securities (a)
- Reserves (b)
Assets
Liabilities and Net Worth
(a) Securities
(b) Reserves
LO2
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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
LO2
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Tools of Monetary Policy
Open market operations are the most important
Reserve ratio last changed in 1992
Discount rate was a passive tool
Term auction facility is new
Guaranteed amount lent by the Fed
Anonymous
LO2
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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
33-

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
LO3
33-

Monetary Policy
Restrictive monetary policy
Periods of rising inflation
Increases Federal funds rate
Increases money supply
Increases other interest rates
LO3
33-

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
LO3
33-

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
LO4
CAUSE-EFFECT CHAIN
33-

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
CAUSE-EFFECT CHAIN
LO4
33-

Evaluation and Issues
Advantages over fiscal policy
Speed and flexibility
Isolation from political pressure
Monetary policy is more subtle than fiscal policy
LO5
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