Chapter 16: Interest Rates and Monetary Policy

Interest Rates and Monetary PolicyMcGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Interest RatesThe price paid for the use of moneyMany different interest ratesSpeak as if only one interest rateDetermined by the money supply and money demandLO1Demand 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, DmLO1Demand 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, Dmand supplyDtDaDmSm5LO1AssetsSecuritiesLoans to commercial banksLiabilitiesReserves of commercial banksTreasury depositsFederal Reserve Notes outstandingLO2Federal Reserve Balance SheetTools 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 reducedLO2Tools of Monetary PolicyFed buys bonds from commercial banksAssetsLiabilities and Net WorthFederal Reserve Banks+ Securities+ Reserves of Commercial Banks(b) ReservesCommercial BanksSecurities (a)+Reserves (b)AssetsLiabilities and Net WorthLO2(a) SecuritiesTools of Monetary PolicyFed sells bonds to commercial banksAssetsLiabilities and Net WorthFederal Reserve Banks- Securities- Reserves of Commercial BanksCommercial Banks+ Securities (a)- Reserves (b)AssetsLiabilities and Net Worth(a) Securities(b) ReservesLO2Tools of Monetary PolicyThe reserve ratioChanges the money multiplierThe discount rateThe Fed as lender of last resortShort term loansTerm auction facilityIntroduced December 2007Banks bid for the right to borrow reservesLO2Tools of Monetary PolicyOpen market operations are the most importantReserve ratio last changed in 1992Discount rate was a passive toolTerm auction facility is newGuaranteed amount lent by the FedAnonymous LO2The Federal Funds RateRate charged by banks on overnight loansTargeted by the Federal ReserveFOMC conducts open market operations to achieve the targetDemand curve for Federal fundsSupply curve for Federal fundsLO3Monetary PolicyExpansionary monetary policyEconomy faces a recessionLower target for Federal funds rateFed buys securities Expanded money supplyDownward pressure on other interest ratesLO3Monetary PolicyRestrictive monetary policyPeriods of rising inflationIncreases Federal funds rateIncreases money supplyIncreases other interest ratesLO3Taylor RuleRule of thumb for tracking actual monetary policyFed has 2% target inflation rateIf real GDP = potential GDP and inflation is 2%, then targeted Federal funds rate is 4%Target varies as inflation and real GDP varyLO3Expansionary Monetary PolicyProblem: Unemployment and RecessionFed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctionsExcess reserves increaseFederal funds rate fallsMoney supply risesInterest rate fallsInvestment spending increasesAggregate demand increasesReal GDP risesLO4CAUSE-EFFECT CHAINRestrictive Monetary PolicyProblem: InflationFed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctionsExcess reserves decreaseFederal funds rate risesMoney supply fallsInterest rate risesInvestment spending decreasesAggregate demand decreasesInflation declinesCAUSE-EFFECT CHAINLO4Evaluation and IssuesAdvantages over fiscal policySpeed and flexibilityIsolation from political pressureMonetary policy is more subtle than fiscal policy LO5Problems and ComplicationsLagsRecognition and operationalCyclical asymmetryLiquidity trapLO5