1. Interest Rates and Monetary Policy
Chapter 16
Interest Rates and Monetary Policy

2. 4 Goals of Monetary Policy 1) Price Stability 2) High Employment
-- Initiatives by Federal Reserve to influence the money supply and interest rates in pursuit of financial objectives
4 Goals of Monetary Policy
1) Price Stability
-- minimize amount of inflation (traditionally less than 4%)
2) High Employment
3) Economic Growth
4) Stability of Financial Markets and Institutions
Fed has 3 primary tools for conducting monetary policy
1) Open Market Operations – buying/selling of bonds
2) Discount Policy – adjusting discount rate
3) Altering Reserve Requirements

3. Demand for Money (MD)
-- demand for money by individuals and firms
-- Wealth comes in two forms:
a) money: means of payment but does not earn interest
b) bonds: not a means of payment but earns interest
-- Demand for money depends on 3 variables
1) Price Level
-- as price levels ↑, demand for money ↑
-- as goods become more expensive, it will
take more money to buy these goods

4. 2) Real GDP -- as real GDP ↑, demand for money ↑
-- increase in real GDP indicates that buying/selling of goods will increase, increasing the demand for money
3) Interest Rate
-- opportunity cost of holding money
-- as interest rates (r) ↑, quantity demanded of money ↓

5. Money Demand Curve (MD)
-- describes the relationship between interest rates and quantity of money demanded, with all other influences on money demand remaining constant
As interest rates ↑, quantity of money demanded ↓

6. Shifts in MD Curve
-- Changes in Real GDP or Price Levels
a) As real GDP ↑ or price levels ↑, MD ↑, shifting MD to the right

7. b) As real GDP ↓ or price levels ↓, MD ↓, shifting MD to the left

8. Supply of Money (MS)
-- Describes the relationship between quantity supplied of money and the interest rate
-- As we learned, the Fed can control the money supply through open market purchases or open market sales
-- Since the Fed has direct control over this variable, the MS curve is represented by a vertical line (not influenced by changes in the interest rate)

9. Shifts in Money Supply
-- Open market purchases (purchases of bonds) increases the money supply and causes MS to shift to the right.
-- Open market sales (sales of bonds) decreases the money supply and shifts MS to shift to the left
Equilibrium
-- point where MS and MD intersect
-- quantity of money being held (MS) = quantity of money wanting to be held (MD)

10. How Market Obtains Equilibrium
-- Bonds and money are the two assets people can choose as wealth
-- At Pt A, MD = $2 billion and MS = $6 billion. Since MS > MD, there is excess supply of money = $4 billion. Since people would want to hold less money than they’re currently holding, they would also like to hold more bonds (excess demand for bonds).
-- With excess supply money/excess demand for bonds, people will now try to convert money into bonds, so price of bonds ↑. As price bonds ↑, interest rates ↓ and we move down the curve toward pt E.
-- At Pt B, MD = $8 billion and MS = $6 billion. Since MD > MS, there is excess demand for money = $2 billion. Since people want to hold more money than they’re currently holding, they would also like to hold less bonds (excess supply for bonds).
-- With excess demand money/excess supply for bonds, people will now sell their bonds for money, so price of bonds ↓. As price bonds ↓, interest rates ↑ and we move up the curve toward pt E.

11. Manipulation of Interest Rate by Fed
-- Through open market purchases and sales of bonds, the
Fed can shift the Ms curve, thus influencing the interest
rate
-- Open market purchase
 Ms ↑
 Excess Supply for Money/Excess Demand for Bonds
 Price Bonds ↑
 Interest Rates ↓

12. -- Open market sale
 Ms ↓
 Excess Demand for Money/Excess Supply for Bonds
 Price Bonds ↓
 Interest Rates ↑

13. Other Ways to Control Money Supply
1) ∆ in Required Reserve Ratio (RR)
-- if RR ↑, money supply ↓
-- if RR ↓, money supply ↑
2) Discount Window Lending
-- commercial banks borrow money from the Federal Reserve
-- A decrease in the discount rate encourages borrowing from Fed which would increase borrowed reserves of the bank and ↑ money supply
-- An increase in the discount rate discourages borrowing from Fed which would decrease amount of borrowed reserves of the bank and cause a ↓ in money supply

14. How Interest Rates Affect the economy Federal Funds Rate
-- interest rate that commercial banks charge each other for short-term loans
-- most watched interest rate in the economy
-- changes in the Federal Funds Rate are decided by the FOMC
-- steers the direction of monetary policy
-- directed through open market operations
open market purchase  increase in money supply and decrease in Federal Funds Rate
open market sale  decrease in money supply and increase in Federal Funds Rate

15. -- Federal Funds Rate affects changes in other interest rates, causing them to move in the same direction (i.e. mortgage rates, interest rates on Gov’t bonds)
-- since interest rates all flow in the same direction, we can speak of changes in interest rates very generically.
-- In order to fight recessions, FOMC will announce a drop in the Federal Funds Rate
↓ r  ↑ C and IP  ↑ PAE (via multiplier) and ↑ Y
-- In order to fight inflation, FOMC will announce an increase in the Federal Funds Rate
↑ r  ↓C and IP  ↓ PAE (via multiplier) and ↓ Y