Transcript Chapter 14

16
Interest Rates and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. 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
LO1
16-3
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 = Dt + Da
LO1
16-4
Rate of interest, i percent
Demand for Money
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
10
Sm
7.5
=5
+
5
2.5
Dt
0
50
100
Da
150
200
Amount of money
demanded
(billions of dollars)
LO1
(c)
Total
demand for
money, Dm
and supply
50
100
150
200
Amount of money
demanded
(billions of dollars)
Dm
50
100
150
200
250
300
Amount of money
demanded and supplied
(billions of dollars)
16-5
Interest Rates
• Equilibrium interest rate
• Changes with shifts in money supply and
•
LO1
money demand
Interest rates and bond prices
• Inversely related
• Bond pays fixed annual interest payment
• Lower bond price will raise the interest
rate
16-6
Federal Reserve Balance Sheet
• Assets
• Securities
• Loans to commercial banks
• Liabilities
• Reserves of commercial banks
• Treasury deposits
• Federal Reserve Notes outstanding
LO2
16-7
Federal Reserve Balance Sheet
March 24, 2010 (in Millions)
Assets
Liabilities and Net Worth
Securities
Loans to Commercial
Banks
All Other Assets
$2,017,955
Total
$2,316,525
85,659
212,911
Reserves of Commercial
$ 1,147,747
Banks
150,087
Treasury Deposits
Federal Reserve Notes
893,035
(Outstanding)
125,656
All Other Liabilities and
Net Worth
$2,316,525
Total
Source: Federal Reserve Statistical Release, H.4.1, March 24, 2010, http://www.federalreserve.gov
LO2
16-8
Central Banks
LO2
16-9
Tools of Monetary Policy
• 1) Open market operations
• Buying and selling of government
•
LO2
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
16-10
Tools of Monetary Policy
• Fed buys bonds from commercial banks
Federal Reserve Banks
Assets
Liabilities and Net Worth
+ Securities
+ Reserves of Commercial
Banks
(a) Securities
Assets
(b) Reserves
Commercial Banks
Liabilities and Net Worth
-Securities (a)
+Reserves (b)
LO2
16-11
Tools of Monetary Policy
• Fed sells bonds to commercial banks
Federal Reserve Banks
Assets
Liabilities and Net Worth
- Securities
- Reserves of Commercial
Banks
(a) Securities
Assets
(b) Reserves
Commercial Banks
Liabilities and Net Worth
+ Securities (a)
- Reserves (b)
LO2
16-12
Open Market Operations
• Fed buys $1,000 bond from a
commercial bank
New Reserves
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
LO2
16-13
Open Market Operations
• Fed buys $1,000 bond from the
public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
LO2
16-14
Tools of Monetary Policy
• 2) The reserve ratio
• Changes the money multiplier
• 3) 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
16-15
The Reserve Ratio
Effects of Changes in the Reserve Ratio
LO2
(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
16-16
Tools of Monetary Policy
• Open market operations are the most
•
•
•
LO2
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
16-17
The Federal Funds Rate
• Rate charged by banks on overnight loans
• Targeted by the Federal Reserve
• Fed uses OMO to reach target
• FOMC conducts open market operations
•
•
LO3
to achieve the target
Demand curve for Federal funds
Supply curve for Federal funds
16-18
The Federal Funds Rate
Federal Funds Rate, Percent
Using Open Market Operations
4.5
Sf 3
4.0
Sf 1
3.5
Sf 2
Df
Qf3
Qf1
Qf2
Quantity of Reserves
LO3
16-19
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
16-20
Monetary Policy
• Restrictive monetary policy
• Periods of rising inflation
• Increases Federal funds rate
• Increases money supply
• Increases other interest rates
LO3
16-21
Monetary Policy
10
8
Prime interest rate
Percent
6
4
Federal funds rate
2
0
1998
1999
2000
2001 2002
2003
2004
2005
2006
2007
2008
2009 2010
Year
16-22
Taylor Rule
• Rule of thumb for tracking actual monetary
•
•
•
•
LO3
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
rT = 4% +½[(Y-Y0)/Y0]100% + ½(r-2%)
16-23
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
LO4
16-24
(a)
The market
for money
Sm1
Sm2
Sm3
AS
10
P3
8
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Dm
6
ID
0
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
LO4
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Price Level
Rate of Interest, i (Percent)
Monetary Policy and Equilibrium GDP
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
16-25
Monetary Policy and Equilibrium GDP
(d)
Equilibrium real
GDP and the
Price level
(c)
Equilibrium real
GDP and the
Price level
AS
AS
P3
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
b
a
AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15
Price Level
Price Level
P3
LO4
c
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
16-26
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
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
16-27
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
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
LO4
16-28
Evaluation and Issues
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy is more subtle than
fiscal policy
LO5
16-29
Recent U.S. Monetary Policy
• Highly active in recent decades
• Responded with quick and innovative
•
LO5
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
16-30
Problems and Complications
• Lags
• Recognition and operational
• Cyclical asymmetry
• Liquidity trap
LO5
16-31