1. 14
Interest Rates and Monetary Policy

2. Chapter Objectives
How the Equilibrium Interest Rate is Determined in the Market for Money
The Goals and Tools of Monetary Policy
The Federal Funds Rate and How the Fed Controls It
The Mechanisms by Which Monetary Policy Affects GDP and the Price Level
Effectiveness of Monetary Policy and its Shortcomings

3. Interest Rates …Graphically
Defined as the Price Paid for the Use of Money
Demand for Money
Transactions Demand, D1
Asset Demand, D2
Total Money Demand, Dm
…Graphically
O 14.1
W 14.1

4. Interest Rates Demand for Money and the Money Market + = (a)
Transactions
Demand for
Money, Dt
(b)
Asset
Demand for
Money, Da
(c)
Total
Demand for
Money, Dm
And Supply 10
7.5 5
2.5 Sm + =
Rate of Interest, I percent 5 Dt Da Dm 50
100
150
200 50
100
150
200 50
100
150
200
250
300
Amount of Money
Demanded
(Billions of Dollars)
Amount of Money
Demanded
(Billions of Dollars)
Amount of Money
Demanded and Supplied
(Billions of Dollars)

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
G 14.1
W 14.2

6. Consolidated Balance Sheet Federal Reserve Banks
Assets
Securities
Loans to Commercial Banks
Liabilities
Reserves of Commercial Banks
Treasury Deposits
Federal Reserve Notes Outstanding

7. Consolidated Balance Sheet Federal Reserve Banks
Consolidated Balance Sheet of
the 12 Federal Reserve Banks
March 29, 2006 (in Millions)
Assets
Liabilities and Net Worth
Securities
Loans to Commercial
Banks
All Other Assets
Total
$758,551
19,250
59,967
$837,768
Reserves of Commercial
Banks
Treasury Deposits
Federal Reserve Notes
(Outstanding)
All Other Liabilities and
Net Worth
Total
$ 14,923
4,463
754,567
63,615
$837,768
Source: Federal Reserve Statistical Release, H.4.1, May 7, 2003

8. Consolidated Balance Sheet Federal Reserve Banks
GLOBAL PERSPECTIVE
Central Banks, Selected Nations
Australia:
Canada:
Euro Zone:
Japan:
Mexico:
Russia
Sweden:
United Kingdom:
United States:
Reserve Bank of Australia (RBA)
Bank of Canada
Central Bank of Europe (CBE)
Bank of Japan (BOJ)
Banco de Mexico (Mex Bank)
Central Bank of Russia
Sveriges Riksbank
Bank of England
Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)

9. 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
O 14.2
W 14.3

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

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

12. 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

13. Targeting the Federal Funds Rate
Federal Funds Rate Defined
Expansionary Monetary Policy (Easy Money)
Prime Interest Rate
Restrictive Monetary Policy (Tight Money)
The Taylor Rule
W 14.4

14. Targeting the Federal Funds Rate
Using Open Market Operations
To Set The Federal Funds Rate
4.5
Sf3
4.0
Sf1
Federal Funds Rate, Percent
3.5
Sf2 Df
Qf3
Qf1
Qf2
Quantity of Reserves

15. Real Domestic Product, GDP
Monetary Policy
Monetary Policy and Equilibrium GDP
(a)
The Market
For Money
(b)
Investment
Demand
(c)
Equilibrium Real
GDP and the
Price Level
Rate of Interest, i (Percent)
Amount of Money
Demanded and Supplied
(Billions of Dollars)
Sm1
Sm2
Sm3
Amount of Investment, I
(Billions of Dollars)
Price Level
Real Domestic Product, GDP
(Billions of Dollars) AS 10 8 6 P3
AD3
I=$25 P2
AD2
I=$20 Dm ID
AD1
I=$15
$125
$150
$175
$15
$20
$25 Q1 Qf Q3

16. Monetary Policy Cause-Effect Chain Market for Money Investment
Equilibrium GDP
Effects of an Expansionary Monetary Policy
Effects of a Restrictive Monetary Policy
G 14.2

17. Monetary Policy Expansionary Monetary Policy
Problem: Unemployment and Recession
CAUSE-EFFECT CHAIN
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

18. Monetary Policy Restrictive Monetary Policy Problem: Inflation
CAUSE-EFFECT CHAIN
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

19. Monetary Policy Evaluation and Issues Recent U.S. Monetary Policy
Speed and Flexibility
Isolation From Political Pressure
Recent U.S. Monetary Policy
Problems and Complications
Recognition Lag
Administrative Lag
Operational Lag

20. Monetary Policy Cyclical Asymmetry
“Artful Management” or “Inflation Targeting”
“The Big Picture”

21. AD-AS Theory of Price Level - Real Output and Stabilization Policy
Input
Resources
With Prices
Consumption
(Cd)
Investment
(Ig)
Aggregate
Supply
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Productivity
Sources
Net Export
Spending
(Xn)
Legal-
Institutional
Environment
Government
Spending
(G)

22. For the Fed - Life is a Metaphor
Last
Word
The Fed as Mechanic
The Fed as Warrior
The Fed as the Fall Guy
The Fed as Cosmic Force
Really Concerned About Money

23. Key Terms monetary policy transaction demand asset demand
total demand for money
reserve ratio
discount rate
Federal funds rate
expansionary monetary policy
Taylor rule
cyclical asymmetry
inflation targeting

24. Extending The Analysis of Aggregate Supply Next Chapter Preview…