MONETARY POLICY

The money supply can/does influence price levels Inflation occurs if the money supply increases, ceteris paribus. Inflation occurs if the money supply increases, ceteris paribus. Deflation occurs if the money supply decreases, ceteris paribus. Deflation occurs if the money supply decreases, ceteris paribus.

What if you stuff your money in a mattress? What does it cost you? Zero Inflation? Zero Inflation? 10% Inflation? 10% Inflation? Known as the opportunity cost of holding money!

Interest The price you pay for using someone else's money (accounting cost or explicit cost) OR holding your own money as cash. (opportunity cost or implicit cost)

Interest Nominal interest rates (market rates) Nominal interest rates (market rates) Real interest rates Real interest rates A return net of inflation and risk premium A return net of inflation and risk premium Risk-Free interest rates Risk-Free interest rates Government treasury securities, no risk premium. Government treasury securities, no risk premium.

Interest Nominal Interest Rate = real interest rate + compensation for inflation + compensation for inflation + default risk premium + default risk premium

Real Interest Rate The real interest rate is the price of money, net of inflation and risk, that people are willing to accept for deferring present consumption until some future time period 1000 Toman in your hand right now is worth more than the promise (without risk) of 1000 Toman in your hand a year from now Toman in your hand right now is worth more than the promise (without risk) of 1000 Toman in your hand a year from now. Even with 0 inflation. Even with 0 inflation.

Real Interest Rate Example: You can save money by ordering many items through the mail. You can save money by ordering many items through the mail. Why do people drive to shahrvand? Why do people drive to shahrvand?

Real Interest Rate If $1 right now to you equals (has same value as) $1.05 one year from now, guaranteed, with zero inflation, If $1 right now to you equals (has same value as) $1.05 one year from now, guaranteed, with zero inflation, you have a real rate of interest of 5% you have a real rate of interest of 5%

Nominal Interest Rate If inflation was expected to be 10% from now until one year from now, what market interest rate would you demand to have, to get your 5% real rate of interest? Assume no risk. If inflation was expected to be 10% from now until one year from now, what market interest rate would you demand to have, to get your 5% real rate of interest? Assume no risk. Answer: 15%. Answer: 15%.

Nominal Interest Rate If you thought there was some risk that you might never see your 1000 Tomans, If you thought there was some risk that you might never see your 1000 Tomans, you would add a risk premium. you would add a risk premium.

Interest Rates on Govt. Securities: Known as the "Risk-free Rate" = Real rate + E(inflation over life of security)

Interest Rates on Govt. Securities: When inflation, Risk-free interest rates AND Nominal interest rates Nominal interest rates

Prime Rate = real rate + E(Inflation) + small risk = real rate + E(Inflation) + small risk premium. premium. Given to the most solid businesses and individuals! Given to the most solid businesses and individuals!

What Is the Risk Premium Charged by Banks for Auto Loans? Tir 25, 1387 Iran Treasury 3 yr. Note rate = 3.41% 36 mo. New Car, Nations Bank = 7.93% risk premium = 4.52% risk premium = 4.52% WHY? Bankruptcies

What Is the Risk Premium Charged by Banks for Auto Loans? Tir. 3, 1388 Iran Treasury 3 yr. Note rate = 6.42% 36 mo. New Car, Nations Bank = 10.25% risk premium = 3.83% risk premium = 3.83% Why? Economy humming along rather nicely, unemployment down, less bankruptcies

Recent Snapshot: Tir 4, 1389 Tir 4, 1389 Iran Treasury 3 yr. Note rate = 5.97% 36 mo. New Car, Bank of America = 11.70% risk premium = 5.73% risk premium = 5.73%

MONETARY POLICY Government Reserve can or the money supply in order to change the level of output and prices (Monetary Policy).

3 Tools to Change Money Supply: Open-market operations (buying and selling treasury bonds, notes, and bills). Open-market operations (buying and selling treasury bonds, notes, and bills). Discount rate: Interest rate banks are charged when they borrow from the Fed. Discount rate: Interest rate banks are charged when they borrow from the Fed. Reserve requirement: % of deposits that must be held by a bank as vault cash or on account with the federal reserve. Reserve requirement: % of deposits that must be held by a bank as vault cash or on account with the federal reserve.

Open Market Operations When the Government Reserve sells more treasury securities than it buys: When the Government Reserve sells more treasury securities than it buys: Money Supply Decreases When the Government Reserve buys more treasury securities than it sells: When the Government Reserve buys more treasury securities than it sells: Money Supply Increases

The Discount Rate The discount rate is adjusted to complement open market operations and to support the direction the Fed is taking in monetary policy.

Reserve Requirement Commercial Banks, Savings Banks, Savings and Loans, Credit Unions, and Branches of Foreign Banks are subject to reserve requirements. Commercial Banks, Savings Banks, Savings and Loans, Credit Unions, and Branches of Foreign Banks are subject to reserve requirements. Reserve requirement may range from 8 to 14 percent of demand deposits and interest-bearing accounts offering unlimited checking privileges. Reserve requirement may range from 8 to 14 percent of demand deposits and interest-bearing accounts offering unlimited checking privileges.

Changing the Money Supply Increase Money Supply, c.p. Decrease interest rates (price of money) in S.R. BUT Increase Money Supply may cause inflation! Increase interest rates in L.R. Increase interest rates in L.R. Increase Money Supply too much Decrease value of money

Changing the Money Supply THEREFORE: Takes more Rials to buy same stuff Takes more Rials to buy same stuff Price of stuff Inflation! Price of stuff Inflation!

Changing the Money Supply Decrease Money Supply, c.p. Increase interest rates (price of money) in S.R. BUT Decrease Money Supply may cause deflation! Decrease interest rates in L.R. Decrease interest rates in L.R. Decrease Money Supply too much Increase value of money

Changing the Money Supply THEREFORE: Takes less Rials to buy same stuff Takes less Rials to buy same stuff Price of stuff Deflation! Price of stuff Deflation!

Discretionary Income ( I DIS ) = (I D - Basic Housing bills, Basic Utility bills, Basic Food Bills, Basic transportation bills, Basic clothing, etc.) (Not payments on credit cards!) Money you have to spend or save at your discretion!

Why has Stock Market Been Booming? People with money in banks, pulling it out and putting it in Stock Market for higher return!

What affect do low interest rates have on retired people? retirement income! retirement income! Stock Market too risky! Stock Market too risky!

References: N.c.State university-College of Agriculture and Life science –Dr. herman_sampson N.c.State university-College of Agriculture and Life science –Dr. herman_sampson