Interest Rates & Monetary Policy

As with Fiscal Policy, the goal of Monetary Policy is to achieve and maintain price-level stability, full employment, and economic growth.

The Fed’s primary influence on the economy in normal economic times is through its ability to change the money supply (M1 and M2) and therefore affect interest rates. Interest is the price paid for the use of money.

Demand For Money 1.Transactions Demand (Dt)- People hold money because it is convenient for purchasing goods and services. Households must have enough money on hand to buy groceries and pay mortgage and utility bills. Businesses need money available to pay for labor, materials, power, and other inputs.

Transactions demand varies directly with nominal GDP and is shown as a vertical line at $100 billion in the graph below. If nominal GDP is $300 and we assume that each dollar is spent on average 3 times a year, which is called velocity, then we would need $100 to take that output off the market.

Nominal Ir Qty. of money Transactions demand (Dt) Dt 100

2. Asset Demand (Da)- The second reason for holding money derives from money’s function as a store of value. People may hold their financial assets in many forms, including stocks, bonds, or money.

The reason people want to hold money as an asset is because it is the most liquid of all financial assets. The disadvantage of holding money as an asset is that it earns no or very little interest.

Knowing these advantages and disadvantages, the public must decide how much of its financial assets to hold as money, rather than other assets such as bonds.

A household or business incurs an opportunity cost when it holds money; in both cases, interest income is forgone or sacrificed. The amount of money demanded as an asset therefore varies inversely with the rate of interest.

When the interest rate rises the public reacts by reducing its holdings of money. When the interest rate falls the cost of being liquid declines so the public wants to hold more money as an asset.

Nominal Ir Qty. of Money Da Asset Demand (Da)

3. Total Money demand (Dm)- We find the total demand for money by horizontally adding the asset demand to the transaction demand. The resulting down-sloping line represents the total demand for money.

Nominal Ir Qty. of Money Dm 100 Total Demand for Money (Dm) Dt + Da = Dm

Equilibrium Interest Rate We can combine the demand for money with the supply of money to determine the equilibrium rate of interest. The vertical line, Sm represents the money supply. It is a vertical line because the monetary authorities, (Fed) has provided the economy with some particular stock of money.

The intersection of the supply and demand for money sets the equilibrium interest rate (i). Changes in the demand for money, the supply of money, or both can change the equilibrium interest rate.

An increase in the supply of money will lower the equilibrium interest rate; a decrease in the supply of money will raise the equilibrium interest rate.

Nominal Ir Qty. of Money Dm Sm Ir Q Equilibrium Interest Rate E

Interest Rates & Bond Prices Bonds are a fixed maturity investment that pays a fixed dividend each period. The investor will then get back their original investment unless he company goes out of business.

Key point: Bond prices and interest rates are inversely related.

Ex. If you buy a $1000 bond that pays 5% interest, you would receive a $50 dividend quarterly. If the (Sm) decreases people will need to sell bonds to get more cash. When they sell bonds the price of bonds falls and the interest yield goes up. Competition in the marketplace will cause interest rates to go up.

Now the same bond sells for say $800 so $50 ÷ $800 = 6.25%

Ex. If the (Sm) increases people now are holding too much money as an asset so they convert their money to bonds increasing the demand. As a result bond prices now increase and the interest yield falls. If the bond price increases to $2000, now $50 ÷ $2000 = 2.5%

Loanable Funds Market A second way of looking at interest rates is called the loanable funds market which focuses on the private market for borrowing.

(S) comes from households and businesses who have extra income they want to save and lend out. People will be willing to supply more funds when interest rates are high rather than low.

(D) comes from households and businesses that wish to borrow funds. They will be more willing to borrow when interest rates are low rather than high. The real interest rate is shown on the vertical axis rather than the nominal rate.

Real Ir Qty of loanable funds S D Ir Q

Monetary Policy- consists of the expansion or contraction of the money supply (Sm) in order to influence the cost and availability of credit which is the interest rate. The fed does this with 4 tools.

1)Open Market Operations: This is the buying and selling of securities or bonds and represents the Fed’s most important tool. Buying securities from banks or the public increases bank reserves and allows them to extend loans to borrowers which increases the money supply.

Selling bonds reduces reserves in the banking system which reduces the amount of loans given and therefore the money supply.

Easy Money Policy/ Recession Buy bonds→↑bank reserves→↑loans→↑Sm→↓Ir→ ↑C,I→↑AD→↑Real GDP, employment & Pl

Nominal Ir Qty. of money Dm Sm Ir Q Sm1 Ir1 Q1

r =i Investment Id Ir 10 Ir1 15

Price level Real GDP AD SRAS P1 Q1 AD1 P2 Q2

Q1 = 500 Q2 = 520 What is the multipier?

See if you can draw the same 3 graphs showing a tight money policy.

Tight Money Policy/Inflation Sell bonds→↓bank reserves→↓loans→↓Sm→↑Ir→ ↓C,I→↓AD→↓Real GDP, employment & Pl

2) The Reserve Requirement: The Fed can also influence the bank’s ability to lend through the reserve ratio. Lowering the reserve requirement transforms required reserves into excess reserves, while raising the reserve requirement transforms excess reserves into required reserves.

Reserve Checkable Actual Required Excess Single Banking Ratio Deposits Reserves Reserves Reserves Bank System 10% $20,000 $5000 $2000 $3000 $3000 $30,000 20% $20,000 $5000 $4000 $1000 $1000 $ % $20,000 $5000 $ % $20,000 $5000 $6000 −$1000 −$1000 −$3,333

Notice that at 30% the bank is not meeting the reserve requirement. It could call in some outstanding loans, sell some of its securities, borrow from the Fed, or from other banks.

Changing the reserve requirement does 2 things.  It affects the size of excess reserves.  It changes the size of the monetary multiplier.  Reserve requirements are changed infrequently.

3) Discount Rate: The Fed can loan money to banks if they are in need of it. The rate of interest that they are charged is called the discount rate. Banks take the additional reserves from borrowing and lend them out to other banks.

Remember this was the Fed’s original purpose as a lender of last resort. Lowering the discount rate encourages banks to borrow from the Fed, while raising the rate discourages banks from borrowing.

4) Term Auction Facility: This last tool was introduced most recently during the great recession of The Fed holds two auctions each month at which banks bid for the right to borrow reserves for a 28 or 84 day period.

Banks indicate how much they want to borrow and what interest rate they are willing to pay. Lending this way guarantees that the amount of reserves that the Fed wishes to lend will be borrowed.

Federal Funds Rate The fed focuses monetary policy on the interest rate it can directly influence: the federal funds rate. This is the rate that banks charge one another on overnight loans made from temporary excess reserves. As this rate changes so do other interest rates.

Prime Rate: is a benchmark rate used by banks as a reference point for a wide variety of interest rates charged on loans to businesses and individuals. The prime rate is higher because it involves longer, more risky loans than overnight loans between banks.

See fig 33.4, pg. 682 to see how the federal funds rate and prime rate track each other.

Easy Money Policy/Recession Buy bonds→↑excess reserves→↓federal funds rate→↑Sm→↓Ir→↑C,I→↑AD→ ↑real GDP, ↑employment, ↑price level ↓Reserve Requirement ↓Discount Rate

Tight Money Policy/Inflation Sell Bonds→↓excess reserves→↑federal funds rate→↓Sm→↑Ir→↓C,I→↓AD→ ↓real GDP, ↓employment, ↓price level ↑Reserve Requirement ↑Discount Rate

Strengths of Monetary Policy  Speed and flexibility  Isolation from political pressure

Problems & Complications  Time lags: Monetary policy still faces a recognition and operational lag, but avoids the administrative lag because policy is carried out by fewer people.

 Cyclical Asymmetry & Liquidity Trap: Monetary policy may be highly effective in slowing expansions and controlling inflation but much less reliable in pushing the economy from a recession.

Expansionary monetary policy suffers from a “you can lead a horse to water, but you can’t make it drink problem.” The liquidity trap basically says that adding more liquidity/ reserves to banks has little or no added positive effect on lending, borrowing, or investment.