33
Interest Rates and Monetary Policy
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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 33-2
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 33-3
Demand for MoneyR
ate
of
inte
rest
, i p
erce
nt
10
7.5
5
2.5
050 100 150 200 50 100 150 200 50 100 150 200 250 300
Amount of moneydemanded
(billions of dollars)
Amount of moneydemanded
(billions of dollars)
Amount of moneydemanded and supplied
(billions of dollars)
=+
(a)Transactionsdemand formoney, Dt
(b)Asset
demand formoney, Da
(c)Total
demand formoney, Dm
and supply
Dt Da Dm
Sm
5
LO1 33-4
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 rateLO1 33-5
• Assets•Securities• Loans to commercial banks
• Liabilities•Reserves of commercial banks•Treasury deposits•Federal Reserve Notes outstanding
LO2
Federal Reserve Balance Sheet
33-6
March 24, 2010 (in Millions)
Source: Federal Reserve Statistical Release, H.4.1, March 24, 2010, http://www.federalreserve.gov
SecuritiesLoans to Commercial BanksAll Other Assets
Total
Reserves of Commercial BanksTreasury DepositsFederal Reserve Notes (Outstanding)All Other Liabilities and Net WorthTotal
$2,017,955
85,659212,911
$2,316,525
$ 1,147,747150,087
893,035125,656
$2,316,525
LO2
Federal Reserve Balance Sheet
Assets Liabilities and Net Worth
33-7
Central Banks
LO2 33-8
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
LO2 33-9
Tools of Monetary Policy
• Fed buys bonds from commercial banks
Assets Liabilities and Net Worth
Federal Reserve Banks
+ Securities + Reserves of Commercial Banks
(b) Reserves
Commercial Banks
- Securities (a)
+Reserves (b)
Assets Liabilities and Net Worth
LO2
(a) Securities
33-10
Tools of Monetary Policy
• Fed sells bonds to commercial banks
Assets Liabilities and Net Worth
Federal Reserve Banks
- Securities - Reserves of Commercial Banks
Commercial Banks
+ Securities (a)
- Reserves (b)
Assets Liabilities and Net Worth
(a) Securities (b) Reserves
LO2 33-11
Open Market Operations
• Fed buys $1,000 bond from a commercial bank
New Reserves
$5000Bank System Lending
Total Increase in the Money Supply, ($5,000)
$1000Excess
Reserves
LO2 33-12
Open Market Operations
• Fed buys $1,000 bond from the public
Check is DepositedNew Reserves
$1000
Total Increase in the Money Supply, ($5000)
$200RequiredReserves
$800Excess
Reserves
$1000Initial
CheckableDeposit
$4000Bank System Lending
LO2 33-13
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
reservesLO2 33-14
The Reserve Ratio
Effects of Changes in 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 $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
LO2 33-15
Tools of Monetary Policy
• Open market operations are the most important
• Reserve ratio last changed in 1992• Discount rate was a passive tool• Term auction facility is new
•Guaranteed amount lent by the Fed•Anonymous
LO2 33-16
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
LO3 33-17
The Federal Funds Rate
Fed
eral
Fu
nd
s R
ate,
Per
cen
t
3.5
Quantity of Reserves
Df
Sf 3
4.0
4.5
Sf 1
Sf 2
Qf3 Qf1 Qf2
Using Open Market Operations
LO3 33-18
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 33-19
Monetary Policy
• Restrictive monetary policy•Periods of rising inflation• Increases Federal funds rate• Increases money supply• Increases other interest rates
LO3 33-20
10
8
4
6
2
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Per
cen
t
Year
Prime interest rate
Federal funds rate
Monetary Policy
33-21
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 targeted Federal funds rate is 4%
• Target varies as inflation and real GDP vary
LO3 33-22
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 33-23
Monetary Policy and Equilibrium GDP
10
8
6
0
Rat
e o
f In
tere
st, i
(P
erce
nt)
Amount of moneydemanded and
supplied(billions of dollars)
Amount of investment (billions of dollars)
Pri
ce
Le
ve
l
Real GDP(billions of dollars)
Q1 Qf Q3$125 $150 $175 $15 $20 $25
P2
P3
Sm1 Sm2 Sm3
Dm
IDAD1
I=$15
AD2
I=$20
AD3
I=$25
(a)The marketfor money
(b)Investment
demand
(c)Equilibrium real
GDP and thePrice level
AS
LO4 33-24
Pri
ce
Le
ve
l
Real GDP(billions of dollars)
Q1 Qf Q3
P2
P3
AD1
I=$15
AD2
I=$20
AD3
I=$25
(c)Equilibrium real
GDP and thePrice level
AS
Pri
ce
Le
ve
lReal GDP
(billions of dollars)
Q1 Qf Q3
P2
P3
AD1
I=$15
AD2
I=$20
AD3
I=$25
(d)Equilibrium real
GDP and thePrice level
AS
abc
AD4
I=$22.5
Monetary Policy and Equilibrium GDP
LO4 33-25
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
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP risesLO4
CA
US
E-E
FF
EC
T C
HA
IN
33-26
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
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
CA
US
E-E
FF
EC
T C
HA
IN
LO4 33-27
Evaluation and Issues
• Advantages over fiscal policy•Speed and flexibility• Isolation from political pressure•Monetary policy is more subtle
than fiscal policy
LO5 33-28
Recent U.S. Monetary Policy
• Highly active in recent decades• Responded with quick and innovative
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
LO5 33-29
Problems and Complications
• Lags•Recognition and operational•Cyclical asymmetry• Liquidity trap
LO5 33-30
The Big Picture
Levels ofOutput,
Employment,Income, and
Prices
AggregateDemand
AggregateSupply
InputResourcesWith Prices
ProductivitySources
Legal-InstitutionalEnvironment
Consumption(Ca)
Investment(Ig)
Net ExportSpending
(Xn)
GovernmentSpending
(G)
33-31