1. Interest Rates and Monetary Policy Chapter 34 McGraw-Hill/IrwinCopyright © 2015 by McGraw-Hill Education. All rights reserved.

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

3. 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

4. Demand for Money Rate of interest, i percent 10 7.5 5 2.5 0 50100150200 50100150200 50100150200250300 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

5. 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

6. Assets Securities Loans to commercial banks Liabilities Reserves of commercial banks Treasury deposits Federal Reserve Notes outstanding LO2 Federal Reserve Balance Sheet

7. April 10, 2013 (in Millions) Source: Federal Reserve Statistical Release, H.4.1, April 10, 2013, www.federalreserve.gov Securities Loans to Commercial Banks All Other Assets Total Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes (Outstanding) All Other Liabilities and Net Worth Total $957,619 439 271,355 $3,229,413 $ 1,851,361 52,478 1,137,087 188,487 $3,229,413 LO2 Federal Reserve Balance Sheet Assets Liabilities and Net Worth LO2

8. Central Banks LO2

9. 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 LO3

10. Tools of Monetary Policy Fed buys bonds from commercial banks AssetsLiabilities and Net Worth Federal Reserve Banks + Securities+ Reserves of Commercial Banks (b) Reserves Commercial Banks -Securities (a) +Reserves (b) Assets Liabilities and Net Worth LO2 (a) Securities LO3

11. Tools of Monetary Policy Fed sells bonds to commercial banks AssetsLiabilities and Net Worth Federal Reserve Banks - Securities- Reserves of Commercial Banks Commercial Banks + Securities (a) - Reserves (b) Assets Liabilities and Net Worth (a) Securities (b) Reserves LO2 LO3

12. Open Market Operations Fed buys $1,000 bond from a commercial bank New Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) $1000 Excess Reserves LO2 LO3

13. Open Market Operations Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) $200 Required Reserves $800 Excess Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending LO2 LO3

14. Tools of Monetary Policy The reserve ratio Changes the money multiplier The discount rate The Fed as lender of last resort Short term loans Term auction facility Introduced December 2007 Banks bid for the right to borrow reserves LO2 LO3

15. 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$5000$2000$3000 $30,000 (2) 20 20,000 5000 4000 1000 5000 (3) 2520,000 5000 0 0 0 (4) 30 20,000 5000 6000-1000 -3333 Effects of Changes in the Reserve Ratio LO2 LO3

16. Tools of Monetary Policy Open market operations are the most important Reserve ratio last changed in 1992 Discount rate was a passive tool Interest on reserves LO2 LO3

17. The Federal Funds Rate Rate charged by banks on overnight loans Targeted by the Federal Reserve FOMC conducts open market operations to achieve the target Demand curve for Federal funds Supply curve for Federal funds LO3

18. The Federal Funds Rate Federal Funds Rate, Percent 3.5 Quantity of Reserves DfDf S f 3 4.0 4.5 S f 1 S f 2 Qf3Qf3 Qf1Qf1 Qf2Qf2 Using Open Market Operations LO3 LO4

19. Monetary Policy Expansionary monetary policy Economy faces a recession Lower target for Federal funds rate Fed buys securities Expanded money supply Downward pressure on other interest rates LO3 LO4

20. Monetary Policy Restrictive monetary policy Periods of rising inflation Increases Federal funds rate Increases money supply Increases other interest rates LO3 LO4

21. Monetary Policy LO4

22. Taylor Rule Rule of thumb for tracking actual monetary policy Fed has 2% target inflation rate If real GDP = potential GDP and inflation is 2%, then targeted Federal funds rate is 4% Target varies as inflation and real GDP vary LO3 LO4

23. Monetary Policy, Real GDP, Price Level Affect 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 LO4 LO5

24. Monetary Policy and Equilibrium GDP 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 LO5

25. Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 P2P2 P3P3 AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (c) Equilibrium real GDP and the Price level AS Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 P2P2 P3P3 AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (d) Equilibrium real GDP and the Price level AS a b c AD 4 I=$22.5 Monetary Policy and Equilibrium GDP LO4 LO5

26. Expansionary Monetary Policy 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 LO5

27. Restrictive Monetary Policy 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 LO5

28. Evaluation and Issues Advantages over fiscal policy Speed and flexibility Isolation from political pressure Monetary policy is more subtle than fiscal policy LO6

29. 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 LO6

30. After the Great Recession Slow recovery especially in terms of employment Zero interest rate policy Zero lower bound problem Quantitative easing Forward commitment Operation Twist LO6

31. Problems and Complications Lags Recognition and operational Cyclical asymmetry Liquidity trap LO5 LO6

32. The Big Picture Levels of Output, Employment, Income, and Prices Aggregate Demand Aggregate Supply Input Resources With Prices Productivity Sources Legal- Institutional Environment Consumption (C a ) Investment (I g ) Net Export Spending (X n ) Government Spending (G) LO6

33. Worries about ZIRP, QE, and Twist Government spending crowded out private spending Large budget deficits by the Federal government would lead to huge interest costs Low interest rates punish savers LO6