18 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rates and Monetary Policy 18

18-2 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

18-3 Types of Interest Rates Type of Interest RateAnnual Percentage 20-year Treasury Bond rate (interest rate on federal government security used to finance the public debt) 4.05% 90-day Treasury Bill rate (interest rate on federal government security used to finance the public debt) 0.02 Prime interest rate (interest rate used as a reference point for a wide range of bank loans) year mortgage rate (fixed-interest rate on loans for houses) year automobile loan rate (interest rate for new autos by automobile finance companies) 4.05 Tax-exempt state and municipal bond rate (interest rate paid on a low-risk bond issued by a state or local government) 4.65 Federal funds rate (interest rate on overnight loans between banks) 0.08 Consumer credit card rate (interest rate charged for credit card purchases) LO1

18-4 Global Snapshot LO1 Short-Term Interest Rate, 2011

18-5 Demand for Money Why hold money? Transactions demand, D t Determined by nominal GDP Independent of the interest rate Asset demand, D a Money as a store of value Varies inversely with the interest rate Total money demand, D m LO1

18-6 Demand for Money 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 DaDa DmDm SmSm 5 LO1

18-7 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 rate LO1

18-8 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

18-9 Tools of Monetary Policy The reserve ratio Changes the money multiplier The discount rate The Fed as lender of last resort Short-term loans LO2

18-10 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$5,000$2,000$3,000 $30,000 (2) 20 20,000 5,000 4,000 1,000 5,000 (3) 2520,000 5, (4) 30 20,000 5,000 6,000-1,000 -3,333 LO2

18-11 Tools of Monetary Policy Open-market operations are the most important Reserve ratio last changed in 1992 Discount rate was a passive tool LO2

18-12 Monetary Policy Expansionary monetary policy Economy faces a recession Fed buys securities Lower the reserve ratio Lower the discount rate LO2

18-13 Monetary Policy Restrictive monetary policy Periods of rising inflation Sell securites Increase the reserve ratio Raise the discount rate LO2

18-14 Monetary Policy, Real GDP, Price Level Effect 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 LO3

18-15 Monetary Policy and Equilibrium GDP Rate of Interest, i (Percent) Amount of money demanded and supplied (billions of dollars) Amount of investment (billions of dollars) Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 $125$150$175$15$20$25 P2P2 P3P3 Sm1Sm1 Sm2Sm2 Sm3Sm3 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 LO3

18-16 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 LO3 CAUSE-EFFECT CHAIN

18-17 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 LO3

18-18 Monetary Policy in Action Advantages over fiscal policy Speed and flexibility Isolation from political pressure Monetary policy is more subtle than fiscal policy LO4

18-19 Federal Funds Rate Rate banks charge each other on overnight loans Easy for the Fed to target LO4

Percent Year Prime interest rate Federal funds rate Monetary Policy LO5

18-21 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

18-22 Problems and Complications Lags Recognition and operational Cyclical asymmetry Liquidity trap LO5

18-23 The Financial Crisis The Fed’s lender-of-last-resort activities Primary Dealer Credit Facility Term Securities Lending Facility Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility Commercial Paper Funding Facility LO5

18-24 The Financial Crisis Money Market Investor Funding Facility Term Asset-Backed Securities Loan Facility Interest Payments on Reserves LO5