1. McGraw-Hill/Irwin Chapter 17: Interest Rates and Monetary Policy Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

2. Monetary Policy and Interest Rates  The Fed conducts monetary policy by changing money supply in order to influence interest rates.  Even though there are many interest rates in the economy that vary by purpose, size, risk, maturity, and taxability, economists assume, for simplicity, a single interest rate.  Interest rates are determined by the interaction of money demand and money supply. LO: 17-1 Monetary policy consists of a central bank’s changing of the money supply to influence interest rates and assist the economy in achieving price level stability, full employment, and economic growth. 17-2

3. Demand for Money  People demand money for two main reasons: to make purchases with it (medium of exchange) and to hold it as an asset (store of value).  The demand for money as a medium of exchange is called the transactions demand for money (D t ).  The amount of money people want to hold as a store of value is called the asset demand for money (D a ).  The sum of the transactions demand and assets demand for money equals the total demand for money (D m ). D m = D t + D a LO: 17-1 17-3

4. Demand for Money  The main determinant of the amount of money demanded for transactions is the level of nominal GDP.  The transactions demand for money is vertical.  Holding money incurs an opportunity cost; therefore, the amount of money demanded as an asset varies inversely with the rate of interest, which is the opportunity cost of holding money.  The asset demand for money is negatively sloped. LO: 17-1 17-4

5. Money Supply and Money Market  The money supply, S m, is a vertical line because the monetary authorities and financial institutions have provided the economy with some particular stock of money.  The intersection of demand and supply in the money market determines equilibrium price, or the real interest rate (i c )—the inflation-adjusted price that is paid for the use of money over some time period. LO: 17-1 17-5

6. Equilibrium Interest Rate Rate of interest, i percent 10 7.5 5 2.5 0 501001502005010015020050100150200250300 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 LO: 17-1 17-6

7. Goals and Tools of Monetary Policy  The goal of monetary policy is to achieve and maintain price-level stability, full employment, and economic growth.  The three tools of monetary control are:  Open-market operations: buying and selling of U.S. government securities to change money supply.  Changing the reserve ratio to influence the ability of the commercial banks to lend. It is used very seldom.  Discount rate: the interest rate the Federal Reserve Banks charge on the loans they make to commercial banks and thrifts. LO: 17-2 17-7

8. Open Market Operations  Open market operations are the most important instrument for influencing the money supply.  Buying securities increases the reserves of commercial banks.  Excess reserves allow the banking system to expand the money supply through loans.  Selling securities reduces the reserves of commercial banks.  Lower reserves result in a multiple contraction of the money supply. LO: 17-2 17-8

9. Reserve Ratio  If the Fed raises the reserve ratio, the amount of required reserves that banks must keep increases.  Banks will either lose excess reserves, diminishing their ability to create money by lending, or reduce checkable deposits, and therefore the money supply, due to deficient reserves.  If the Fed lowers the reserve ratio, the banks’ required reserves will decrease.  Banks with more excess reserves are able to create new money by lending. LO: 17-2 17-9

10. Discount Rate  Federal Reserve Banks make short-term loans to commercial banks in their district.  In providing loans, the Federal Reserve Bank increases the reserves of the borrowing bank, enhancing its ability to extend credit.  From the commercial banks’ perspective, the discount rate is the cost of acquiring reserves.  Increasing the discount rate discourages commercial banks from obtaining additional reserves through borrowing from the Federal Reserve Banks.  When the Fed raises the discount rate, it wants to restrict the money supply. LO: 17-2 17-10

11. Expansionary Monetary Policy and GDP Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions 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 LO: 17-3 17-11

12. Restrictive Monetary Policy and GDP Problem: inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines CAUSE-EFFECT CHAIN LO: 17-3 17-12

13. Monetary Policy and GDP in AD-AS Model 10 8 6 0 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 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 LO: 17-3 17-13

14. Advantages of Monetary Policy  Monetary policy, a dominant component of U.S. national stabilization policy, has two key advantages over fiscal policy:  Speed and flexibility  Isolation from political pressure  Monetary policy can be quickly altered and is a subtler and more politically neutral measure.  For the conduct of monetary policy, the Fed focuses on the Federal Funds Rate, interest rate banks and thrifts charge one another on overnight loans made out of their excess reserves.  Other interest rates typically change in the same direction as the Federal Funds rate. LO: 17-4 17-14

15. Shortcomings of Monetary Policy  Monetary policy faces recognition lag and operational lag.  The Fed must be able to recognize and respond to changes in economic activity.  It takes time for monetary policy to work its way through to aggregate demand.  Monetary policy suffers from cyclical asymmetry.  Cyclical asymmetry is the potential problem of monetary policy successfully controlling inflation during the expansionary phase of the business cycle but failing to expand spending and real GDP during the recessionary phase of the cycle. LO: 17-4 17-15