1. Copyright 2008 The McGraw-Hill Companies 14-1 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 14 Interest Rates and Monetary Policy

2. Copyright 2008 The McGraw-Hill Companies 14-2 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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. Copyright 2008 The McGraw-Hill Companies 14-3 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Interest Rates Defined as the Price Paid for the Use of Money Demand for Money –Transactions Demand, D 1 –Asset Demand, D 2 –Total Money Demand, D m …Graphically O 14.1 W 14.1

4. Copyright 2008 The McGraw-Hill Companies 14-4 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Interest Rates Demand for Money and the Money Market 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

5. Copyright 2008 The McGraw-Hill Companies 14-5 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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 W 14.2 G 14.1

6. Copyright 2008 The McGraw-Hill Companies 14-6 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Consolidated Balance Sheet Federal Reserve Banks Assets –Securities –Loans to Commercial Banks Liabilities –Reserves of Commercial Banks –Treasury Deposits –Federal Reserve Notes Outstanding

7. Copyright 2008 The McGraw-Hill Companies 14-7 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Consolidated Balance Sheet Federal Reserve Banks 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 Consolidated Balance Sheet of the 12 Federal Reserve Banks March 29, 2006 (in Millions) AssetsLiabilities and Net Worth Source: Federal Reserve Statistical Release, H.4.1, May 7, 2003 $758,551 19,250 59,967 $837,768 $ 14,923 4,463 754,567 63,615 $837,768

8. Copyright 2008 The McGraw-Hill Companies 14-8 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Consolidated Balance Sheet Federal Reserve Banks 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) Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Central Banks, Selected Nations GLOBAL PERSPECTIVE

9. Copyright 2008 The McGraw-Hill Companies 14-9 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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. Copyright 2008 The McGraw-Hill Companies 14-10 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Tools of Monetary Policy New Reserves $1000 $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) Fed Buys $1,000 Bond from a Commercial Bank $1000 Excess Reserves

11. Copyright 2008 The McGraw-Hill Companies 14-11 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Tools of Monetary Policy Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) Fed Buys $1,000 Bond from the Public $200 Required Reserves $800 Excess Reserves $1000 Initial Checkable Deposit $4000 Bank System Lending

12. Copyright 2008 The McGraw-Hill Companies 14-12 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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. Copyright 2008 The McGraw-Hill Companies 14-13 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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. Copyright 2008 The McGraw-Hill Companies 14-14 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Targeting the Federal Funds Rate Federal Funds Rate, Percent 3.5 Quantity of Reserves DfDf S f3 4.0 4.5 S f1 S f2 Q f3 Q f1 Q f2 Using Open Market Operations To Set The Federal Funds Rate

15. Copyright 2008 The McGraw-Hill Companies 14-15 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Monetary Policy 10 8 6 0 Rate of Interest, i (Percent) Amount of Money Demanded and Supplied (Billions of Dollars) Amount of Investment, I (Billions of Dollars) Price Level Real Domestic Product, 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 Monetary Policy and Equilibrium GDP AS

16. Copyright 2008 The McGraw-Hill Companies 14-16 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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. Copyright 2008 The McGraw-Hill Companies 14-17 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Monetary Policy 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 CAUSE-EFFECT CHAIN

18. Copyright 2008 The McGraw-Hill Companies 14-18 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Monetary Policy 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

19. Copyright 2008 The McGraw-Hill Companies 14-19 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Monetary Policy Evaluation and Issues –Speed and Flexibility –Isolation From Political Pressure Recent U.S. Monetary Policy Problems and Complications –Recognition Lag –Administrative Lag –Operational Lag

20. Copyright 2008 The McGraw-Hill Companies 14-20 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Monetary Policy Cyclical Asymmetry “Artful Management” or “Inflation Targeting” “The Big Picture”

21. Copyright 2008 The McGraw-Hill Companies 14-21 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show AD-AS Theory of Price Level - Real Output and Stabilization Policy Levels of Output, Employment, Income, and Prices Aggregate Demand Aggregate Supply Input Resources With Prices Productivity Sources Legal- Institutional Environment Consumption (C d ) Investment (I g ) Net Export Spending (X n ) Government Spending (G)

22. Copyright 2008 The McGraw-Hill Companies 14-22 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show For the Fed - Life is a Metaphor The Fed as Mechanic The Fed as Warrior The Fed as the Fall Guy The Fed as Cosmic Force Really Concerned About Money Last Word

23. Copyright 2008 The McGraw-Hill Companies 14-23 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show 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. Copyright 2008 The McGraw-Hill Companies 14-24 Interest Rates Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Targeting the Federal Funds Rate Monetary Policy The Big Picture Last Word Key Terms End Show Next Chapter Preview… Extending The Analysis of Aggregate Supply