macroeconomic mcgrowhill macro ch 16 19e use this one

16
Interest Rates and Monetary
Policy

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.


Chapter Objectives
• The equilibrium interest rate and
the market for money
• Monetary policy
• How the Fed controls the Federal
funds rate
• How monetary policy affects GDP
and the price level
• Effectiveness of monetary policy
and its shortcomings
33-2


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
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
0

Dt
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
•

LO1

and 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,
LO2

16-8


Central Banks

LO2

16-9


Tools of Monetary Policy

• 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

• 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

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 and frequently used
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
•
•
•
•
LO3

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
16-18


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

16-19


Monetary Policy

• Restrictive monetary policy
• Periods of rising inflation
• Increases Federal funds rate
• Increases money supply
• Increases other interest rates

LO3

16-20


Monetary Policy
10

8

Prime interest rate
Percent

6

4

2

Federal funds rate

0
1998

1999

2000

2001 2002

2003

2004

2005

2006

2007

2008

2009 2010

Year
16-21


Taylor Rule

• Rule of thumb for tracking actual
•
•
•

LO3

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
16-22


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

16-23


(a)
The market
for money
Sm1

Sm2

Sm3

AS
P3

10
8

Dm

6
0

AD3
I=$25
AD2
I=$20
AD1
I=$15

P2

$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

ID
$15

$20

$25

Amount of investment
(billions of dollars)

Q1

Qf Q3

Real GDP
(billions of dollars)

16-24

Monetary Policy and Equilibrium GDP
(AS-AD Model)
(d)
Equilibrium real
GDP and the
Price level

(c)
Equilibrium real
GDP and the
Price level

AS

AS
Price Level

AD3
I=$25
AD2
I=$20
AD1
I=$15

P2

Q1

Qf Q3

Real GDP
(billions of dollars)

b

Price Level

P3

P3

LO4

c

P2

Q1

Qf Q3

a

AD3
I=$25
AD4
I=$22.5
AD2
I=$20

AD1
I=$15

Real GDP
(billions of dollars)

16-25