Chapter 15: Interest Rates and Monetary Policy

Chapter 15Interest Rates and Monetary PolicyMcGraw-Hill/IrwinCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reservedInterest RatesThe price paid for the use of moneyMany different interest ratesSpeak as if only one interest rateDetermined by the money supply and money demand15-*Types of Interest RatesType of Interest RateAnnual Percentage20-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)0.02Prime interest rate(interest rate used as a reference point for a wide range of bank loans)3.2530-year mortgage rate(fixed-interest rate on loans for houses)4.604-year automobile loan rate(interest rate for new autos by automobile finance companies)4.05Tax-exempt state and municipal bond rate(interest rate paid on a low-risk bond issued by a state or local government)4.65Federal funds rate(interest rate on overnight loans between banks)0.08Consumer credit card rate(interest rate charged for credit card purchases)14.4215-*Global SnapshotShort-Term Interest Rate, 201115-*Demand for MoneyWhy hold money?Transactions demand, DtDetermined by nominal GDPIndependent of the interest rateAsset demand, DaMoney as a store of valueVaries inversely with the interest rateTotal money demand, Dm15-*Demand for MoneyRate of interest, i percent107.552.50501001502005010015020050100150200250300Amount of moneydemanded(billions of dollars)Amount of moneydemanded(billions of dollars)Amount of moneydemanded and supplied(billions of dollars)=+(a)Transactionsdemand formoney, Dt(b)Assetdemand formoney, Da(c)Totaldemand formoney, Dm, and supplyDtDaDmSm515-*Interest RatesEquilibrium interest rateChanges with shifts in money supply and money demandInterest rates and bond pricesInversely relatedBond pays fixed annual interest paymentLower bond price will raise the interest rate15-*Tools of Monetary PolicyOpen-market operationsBuying and selling of government securities (or bonds)Commercial banks and the general publicUsed to influence the money supplyWhen the Fed sells securities, commercial bank reserves are reduced15-*Tools of Monetary PolicyThe reserve ratioChanges the money multiplierThe discount rateThe Fed as lender of last resortShort-term loans15-*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) 2520,000 5,000 5,000 0 0 0(4) 30 20,000 5,000 6,000-1,000-1,000 -3,333Effects of Changes in the Reserve Ratio15-*Tools of Monetary PolicyOpen-market operations are the most importantReserve ratio last changed in 1992Discount rate was a passive tool15-*Monetary PolicyExpansionary monetary policyEconomy faces a recessionFed buys securities Lower the reserve ratioLower the discount rateLO215-*Monetary PolicyRestrictive monetary policyPeriods of rising inflationSell securitesIncrease the reserve ratioRaise the discount rate15-*Monetary Policy, Real GDP, Price LevelEffect on real GDP and price levelCause-effect chainMarket for moneyInvestment and the interest rateInvestment and aggregate demandReal GDP and pricesExpansionary monetary policy Restrictive monetary policy15-*Monetary Policy and Equilibrium GDP10860Rate of Interest, i (Percent)Amount of moneydemanded and supplied(billions of dollars)Amount of investment (billions of dollars)Price LevelReal GDP(billions of dollars)Q1QfQ3$125$150$175$15$20$25P2P3Sm1Sm2Sm3DmIDAD1I=$15AD2I=$20AD3I=$25(a)The marketfor money(b)Investmentdemand(c)Equilibrium realGDP and theprice levelAS15-*Expansionary Monetary PolicyProblem: Unemployment and RecessionFed buys bonds, lowers reserve ratio, or lowers the discount rateExcess reserves increaseFederal funds rate fallsMoney supply risesInterest rate fallsInvestment spending increasesAggregate demand increasesReal GDP risesCAUSE-EFFECT CHAIN15-*Restrictive Monetary PolicyProblem: InflationFed sells bonds, increases reserve ratio, or increases the discount rateExcess reserves decreaseFederal funds rate risesMoney supply fallsInterest rate risesInvestment spending decreasesAggregate demand decreasesInflation declinesCAUSE-EFFECT CHAIN15-*Monetary Policy in ActionAdvantages over fiscal policySpeed and flexibilityIsolation from political pressureMonetary policy is more subtle than fiscal policy 15-*Federal Funds RateRate banks charge each other on overnight loansEasy for the Fed to targetLO415-*1084620 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 PercentYearPrime interest rateFederal funds rateMonetary Policy15-*Recent U.S. Monetary PolicyHighly active in recent decadesResponded with quick and innovative actions during the recent financial crisis and the severe recessionCritics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long15-*Problems and ComplicationsLagsRecognition and operationalCyclical asymmetryLiquidity trap15-*The Financial CrisisThe Fed’s lender-of-last-resort activitiesPrimary Dealer Credit FacilityTerm Securities Lending FacilityAsset-Backed Commercial Paper Money Market Mutual Fund Liquidity FacilityCommercial Paper Funding Facility15-*The Financial CrisisMoney Market Investor Funding FacilityTerm Asset-Backed Securities Loan FacilityInterest Payments on Reserves15-*