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 + 2.5 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, http://www.federalreserve.gov 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 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 Prime interest rate Percent Federal funds rate 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 Dm 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 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 16-26 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 16-27 Evaluation and Issues • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy is more subtle than fiscal policy LO5 16-28 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 16-29 Problems and Complications • Lags • Recognition and operational • Cyclical asymmetry • Liquidity trap LO5 16-30 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) 16-31 Key Terms • • • • • • • • • monetary policy interest transactions demand asset demand total demand for money open-market operations reserve ratio discount rate term auction facility • Federal funds rate • expansionary monetary policy • prime interest rate • restrictive monetary policy • Taylor rule • cyclical asymmetry • mortgage debt crisis 33-32 ... 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 + 2.5 Dt 50 100 Da 150 200 Amount of money... 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... 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