Copyright© 2003 John Wiley and Sons, Inc. Power Point Slides for: Financial Institutions, Markets, and Money, 8 th Edition Authors: Kidwell, Blackwell, Peterson and Whidbee Prepared by: David R. Durst, The University of Akron

CHAPTER 3 THE FED AND INTEREST RATES

Copyright© 2003 John Wiley and Sons, Inc. Impacts of Federal Reserve Policy Expansionary monetary policy Open market operations -- purchase securities -- increase bank excess reserves and the monetary base. Reserve requirements -- reduce reserve requirements -- increase excess reserves and increase the deposit expansion multiplier. Discount rate -- reduce the rate -- reduce the cost of borrowing reserves. Expands the money supply; reduces interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Impacts of Federal Reserve Policy (concluded) Restrictive monetary policy Open market operations -- sell securities, reduce bank reserves and the monetary base. Reserve requirements -- increase reserve requirements, reduces excess reserves and the deposit expansion multiplier. Discount rate -- increase the discount rate and the cost of borrowing reserve deficiencies. Reduce the money supply or its growth rate; increase interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Effects of Federal Reserve Policy in the Financial System Changes in the Money Supply When the Fed either increases the monetary base or reduces reserve requirements, banks’ excess reserves increase. Excess reserves are loaned out or invested. Transaction deposits increase as loaned or invested funds are deposited. The money supply increases.

Copyright© 2003 John Wiley and Sons, Inc. Effects of Policy Changes Changes in Interest Rates Expansion of the monetary base or reductions in reserve requirements increase bank liquidity. Federal Funds rate declines. Price of other money market securities increase (rates decline) as banks invest their liquidity. Loan rates and other security rates decline with continued increases in bank liquidity. Monetary policy starts in the bank money market and spreads to other financial institutions and markets and to the real economy.

Copyright© 2003 John Wiley and Sons, Inc. Effects of Policy Changes Credit availability is increased with the expansion of bank liquidity and reduced interest rates. Wealth Effects -- reduced interest rates (increased security prices) increases the wealth of individuals. Increased wealth prompts increased spending. Increased spending has a current income, Y, impact and a multiplier effect in future income periods.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy Monetary policy affects spending Investment. Consumption. State and local government. Effects of Monetary Policy on Changes in Investment Investment demand, traditionally, has been sensitive to changes in interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy (continued) Housing investment -- both credit availability and mortgage rates have been impacted severely by monetary policy. Plant and equipment investment is related to expected rates of return relative to the cost of financing. Planned inventory investment is sensitive to the cost and availability of credit.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy (continued) Consumption expenditures are affected several ways: Increased or decreased holdings of money affect spending. Credit availability and interest rate levels affect the purchase of durable goods. Changes in wealth affect spending in the current period.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy (concluded) Foreign trade is affected by monetary policy. Increased interest rates increase the value of the dollar relative to the other currencies. Increased dollar exchange rates encourage imports; discourage exports. State and Local Government Expenditures Monetary policy affects capital project expenditures. Higher interest rates limit expenditures.

Copyright© 2003 John Wiley and Sons, Inc. Changes in the Discount Rate

Copyright© 2003 John Wiley and Sons, Inc. Change in Money Supply and Interest Rates and the Economy

Copyright© 2003 John Wiley and Sons, Inc. Long-Run Effects of Monetary Policy Expectations are affected by current, short- run monetary policy actions. High money growth to stimulate the economy may increase interest rates (interest rate effects). Market expects inflation from near-term policy action. Investors sell long-term bonds, prices fall, and interest rates increase.

Copyright© 2003 John Wiley and Sons, Inc. Long-Run Effects of Monetary Policy (concluded) Expected inflation may cause increased spending and borrowing and increased interest rates. Pay back lower value debts. Buy before the price goes up psychology. May move the economy to inflationary income levels. Cost increases (interest and labor) faster than price increases will cause reductions in investment spending.

Copyright© 2003 John Wiley and Sons, Inc. Practical Considerations in Monetary Policy Expectations may nullify intent of policy. Time lags in implementing monetary policy reduce its effectiveness. Political pressures influence Federal Reserve policy.