Lecture Economics (18th edition): Chapter 33 - McConnell, Brue, Flynn''s

Chapter 33
Interest Rates and
Monetary Policy

McGraw­Hill/Irwin

        Copyright © 2009 by The McGraw­Hill 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
•
•
•
•

Price paid for the use of money
Many different interest rates
Speak as if only one interest rate

Determined by money supply and
money demand

33-3


Demand for Money
• Why hold money?
• Transactions demand, D1
– Determined by nominal GDP
– Independent of the interest rate

• Asset demand, D2
– Money as a store of value
– Varies inversely with the interest
rate

• Total money demand, D

33-4


Rate of interest, i percent

Demand for Money
(a)
Transactions
demand for
money, Dt

(c)
Total
demand for
money, Dm
and supply

(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)

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)
33-5


Interest Rates
• Equilibrium interest rate
– Changes with shifts in money
supply and money demand

• Interest rates and bond prices
– Inversely related
– Bond pays fixed annual interest
payment
– Lower bond price will raise the
interest rate
33-6


Federal Reserve Balance Sheet
• Assets
– Securities
– Loans to commercial banks

• Liabilities

– Reserves of commercial banks
– Treasury deposits
– Federal Reserve Notes outstanding
33-7


Federal Reserve Balance Sheet
February 14, 2008 (in Millions)

Assets
Securities
Loans to Commercial
Banks
All Other Assets

Total

Liabilities and Net Worth
$713,369
60,039
111,689

$885,097

Reserves of Commercial
Banks
Treasury Deposits
Federal Reserve Notes
(Outstanding)
All Other Liabilities and

Net Worth
Total

$ 11,312
4,979
778,937
89,869
$885,097

Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008
33-8


Central Banks
Selected Nations
Australia:
Canada:
Euro Zone:
Japan:
Mexico:
Russia
Sweden:
United Kingdom:
United States:

Reserve Bank of Australia (RBA)
Bank of Canada
European Central Bank (ECB)
Bank of Japan (BOJ)
Banco de Mexico (Mex Bank)

Central Bank of Russia
Sveriges Riksbank
Bank of England
Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)
33-9


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
33-10


Open Market Operations
Fed buys $1,000 bond from a commercial
bank
New Reserves
$1000

$1000
Excess

Reserves

$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
33-11


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)
33-12


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

33-13


Tools of Monetary Policy
• Open market operations most
important
• Reserve ratio last changed 1992
• Discount rate was a passive tool
• Term auction facility is new
– Guaranteed amount lent by the Fed
– Anonymous
33-14

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
33-15


The Federal Funds Rate
Federal Funds Rate, Percent

Using Open Market Operations
4.5

Sf3

4.0

Sf1

3.5

Sf2
Df
Qf3

Qf1

Qf2

Quantity of Reserves
33-16


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

• Contractionary monetary policy

33-17


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 target federal
funds rate is 4%
• Target varies as inflation and real

GDP vary

33-18


Monetary Policy
• 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

33-19


(a)
The market
for money
Sm1

Sm2

(c)
Equilibrium real
GDP and the
Price level

(b)
Investment
demand

Sm3

AS
P3

10

Price Level

Rate of Interest, i (Percent)

Monetary Policy and GDP

8

P2

Dm

6
0

AD3
I=$25
AD2

I=$20
AD1
I=$15

$125

$150

$175

Amount of money
demanded and
supplied
(billions of dollars)

ID
$15

$20

$25

Amount of investment
(billions of dollars)

Q1

Qf Q3

Real GDP

(billions of dollars)

33-20


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

F E- ES UAC

Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises

33-21


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

F E- ES UAC

Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines

33-22


Monetary Policy
• Advantages over fiscal policy
– Speed and flexibility
– Isolation from political pressure

• Recent U.S. monetary policy
• Problems and complications
– Recognition lag
– Operational lag
– Cyclical asymmetry
33-23


The Big Picture
Input
Resources
With Prices

Productivity

Sources

LegalInstitutional
Environment

Consumption
(Ca)

Aggregate
Supply

Levels of
Output,
Employment,
Income, and
Prices

Aggregate
Demand

Investment
(Ig)

Net Export
Spending
(Xn)
Government
Spending
(G)
33-24

The Mortgage Debt Crisis
•
•
•
•
•
•
•

Home mortgage default 2007
Banks write off bad loans
Reserves reduced
Fed as lender of last resort
Term auction facility
Fed lowered federal funds rate
Mortgage backed securities as a new
innovation
– Bad incentives

33-25