INTEREST RATE AND MONETARY POLICY Pertemuan 11 Matakuliah: J0594-Teori Ekonomi Tahun: 2009

Bina Nusantara University 3 Interest Rates Defined as the Price Paid for the Use of Money Demand for Money Transactions Demand, D 1 Asset Demand, D 2 Total Money Demand, D m … Graphically

Bina Nusantara University 4 Interest Rates Rate of Interest, I percent Amount of Money Demanded (Billions of Dollars) Amount of Money Demanded (Billions of Dollars) Amount of Money Demanded and Supplied (Billions of Dollars) = + (a) Transactions Demand for Money, D t (b) Asset Demand for Money, D a (c) Total Demand for Money, D m And Supply DtDt DmDm SmSm 5 DaDa Demand for Money and the Money Market

Bina Nusantara University 5 Interest Rates Equilibrium Interest Rate Interest Rates and Bond Prices –Bond Prices Fall When Interest Rates Rise –Bond Prices Rise When Interest Rates Fall –Inverse Relationship Between Interest Rates and Bond Prices

Bina Nusantara University 6 Tools of Monetary Policy Open Market Operations –Buying Securities From Commercial Banks From the Public –Selling Securities To Commercial Banks To the Public When the Fed Sells Securities, Commercial Bank Reserves are Reduced

Bina Nusantara University 7 Tools of Monetary Policy New Reserves $1000 $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) Fed Buys $1,000 Bond from a Commercial Bank $1000 Excess Reserves

Bina Nusantara University 8 Tools of Monetary Policy Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) Fed Buys $1,000 Bond from the Public $200 Required Reserves $800 Excess Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending

Bina Nusantara University 9 Tools of Monetary Policy The Reserve Ratio –Raising the Reserve Ratio –Lowering the Reserve Ratio The Discount Rate –Borrowing from the Fed by Banks Increases Reserves and Enhances Lending Ability Relative Importance of Each

Bina Nusantara University 10 Monetary Policy Amount of Investment, I (Billions of Dollars) Price Level Real Domestic Product, GDP (Billions of Dollars) Q1Q1 QfQf Q3Q3 $125$150$175 $25 P2P2 P3P3 S m1 S m2 S m3 DmDm ID AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (a) The Market For Money (b) Investment Demand (c) Equilibrium Real GDP and the Price Level AS Rate of Interest, i (Percent) Amount of Money Demanded and Supplied (Billions of Dollars) $15$20$25 Monetary Policy and Equilibrium GDP

Bina Nusantara University 11 Monetary Policy Cause-Effect Chain Market for Money Investment Equilibrium GDP Effects of an Expansionary Monetary Policy Effects of a Restrictive Monetary Policy

Bina Nusantara University 12 Monetary Policy Expansionary Monetary Policy Problem: Unemployment and Recession Fed Buys Bonds, Lowers Reserve Ratio, or Lowers the Discount Rate Excess Reserves Increase Federal Funds Rate Falls Money Supply Rises Interest Rate Falls Investment Spending Increases Aggregate Demand Increases Real GDP Rises CAUSE-EFFECT CHAIN

Bina Nusantara University 13 Monetary Policy Restrictive Monetary Policy Problem: Inflation Fed Sells Bonds, Increases Reserve Ratio, or Increases the Discount Rate Excess Reserves Decrease Federal Funds Rate Rises Money Supply Falls Interest Rate Rises Investment Spending Decreases Aggregate Demand Decreases Inflation Declines CAUSE-EFFECT CHAIN