1. Sources of Interest-Rate Fluctuations: Nominal Interest Rates Money and Banking Money and Banking Mr. Vaughan Updated: 2/23/09

2. After this lecture, you will be able to: Explain how changes in expected inflation affect nominal interest rates in long run. Describe how monetary growth affects inflation in long run. Trace effects of monetary policy on nominal interest rate in short run and long run. Learning Objectives: Part II – Nominal Interest Rate 2 Total Slides: 34

3. Recall: Borrowers and lenders care about real interest rate. But, financial markets set most interest rates in nominal terms. So, borrowers and lenders must guess about inflation rate. Real Interest Rate + Expected Inflation Real Interest Rate + Expected Inflation Nominal Interest Rate Fisher Equation 3 Total Slides: 34

4. Debtors Win/Creditors Lose! Guessing Wrong Is Costly! 4 Total Slides: 34

5. Creditors Win/Debtors Lose! Guessing Wrong Is Costly! 5 Total Slides: 34

6. To avoid losses, debtors and creditors:  use all useful information.  learn rapidly from mistakes.  react quickly to changes in expected inflation. Implications:  “Rational” Expectations = Random forecast errors  Changes in inflation expectations move bond demand/supply and nominal interest rate rapidly. Expectations and Nominal Rates 6 Total Slides: 34

7. Quantity of Bonds ($) Nominal Interest Rate Bond Supply 1 Bond Demand 1 iaia QaQa Increase in expected inflation reduces expected return on bonds and, thus, bond demand. a Bond Demand 2 ibib QbQb b Fisher Equation In Pictures 7 Total Slides: 34

8. Quantity of Bonds ($) Nominal Interest Rate Bond Supply 1 Bond Demand 1 ibib QbQb Increase in expected inflation reduces real cost of borrowing and, thus, increases bond supply. b Bond Supply 2 icic QcQc c Fisher Equation In Pictures 8 Total Slides: 34

9. Q* Bond Supply 2 icic Quantity of Bonds ($) Nominal Interest Rate Bond Supply 1 Bond Demand 1 iaia Absent distortions, nominal interest rate will rise by increase in expected inflation.  expected inflation a Bond Demand 2 c Fisher Equation In Pictures 9 Total Slides: 34

10. Note:Inflation trends explain Rising rates before early 1980s Falling rates since 1980s Rate volatility since 1950s Fisher Equation: Evidence 10 Total Slides: 34

11. …But what causes (changes in) inflation? “Inflation is always and everywhere a monetary phenomenon.” Milton Friedman His Point?  In short run, many factors can boost general level of prices  Only sustained growth in money supply can produce sustained rise in prices. First things first: What is “money?” 11 Total Slides: 34

12. Money in U.S. Economy Money Supply: Total quantity (dollar volume) of assets providing medium-of-exchange services  Currency: Paper bills & coins in public hands.  Checkable Deposits: Bank balances depositors can access on demand by writing check (demand deposits, NOWs)  Traveler’s Checks This functional definition is M1 (narrow money). 12 Total Slides: 34

13. U.S. Money Stock Two Measures As of October 2008 (Seasonally Adjusted) Everything in M1 M1 = $1,473.1 billion M2 = $7,878.9 billion $ Billions 0 $1,473.1 $7,878.9 Savings Deposits = $4,032.3 Small Time Deposits = $1,314.0 Money Market Mutual Funds = $1,059.6 Total = $6,405.8 billion Currency = $795.0 Checkable Deposits = $672.4 Traveler’s Checks = $5.8 Note: - Currency only 10.1% of M2 - Checkable deposits only 8.5% of M2 M2 is “Broad” money – Better measure for policy, scientific purposes 13 Total Slides: 34

14. How correlated are M’s? 14 Total Slides: 34

15. Money and Inflation Quantity Theory of Money Quantity Theory Quantity Theory starts with equation of exchange: M = Money Supply v = Income Velocity of Money  Average number of times per period each dollar of money supply is spent on nominal GDP P= GDP Deflator / 100 (general price level) y = Real GDP Note:  P x y = Nominal GDP  Equation is tautology (needs assumptions to become theory) M x v = P x y 15 Total Slides: 34

16. Quantity Theory of Money Assumptions M=Exogenously determined (by government) v=Not influenced by money (in short run relatively stable)  Determined by “real” factors such as payments technology/institutions, tastes, etc. y=Not influenced by money (in short run)  Determined by “real” factors such as technology, factor endowments, societal commitment to markets/property rights, etc. 16 Total Slides: 34

17. Quantity Theory of Money Assumptions Reasonable? 17

18. Quantity Theory of Money Implications of Assumptions Equation of Exchange (rate of change form): Note:  If growth in velocity and real output are determined exogenously by real factors, then changes in prices (only endogenous variable) must be determined by changes in money supply.  Quantity Theory focuses on long run, not short run. %Δ M + %Δ v = %Δ P + %Δ y 18 Total Slides: 34

19. Quantity Theory of Money U.S. Evidence Period Money (M2) Growth (Average) Velocity Growth (Average) Inflation Rate (Average) Real GDP Growth (Average) (1) 1959:Q1 - 1983:Q4 8.4%0.1%4.8%3.6% (2) 1983:Q4 - 2008:Q4 5.5%0.1%2.5%3.0% Notes: All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures Source: U.S. Department of Commerce, Board of Governors of Federal Reserve NOTE: Money growth and inflation lower in period (2)! 19 Total Slides: 34

20. Source: McCandless and Weber, 1995 Note: 1.Each point represents 30-year average annual money growth and 30-year average annual inflation 2.All points lie near/on 45-degree line. Quantity Theory of Money Cross-Country Evidence 20 Total Slides: 34

21. Excessive Growth of Money Supply Excessive Spending on Goods and Services Inflation Long-Run Real Growth ≈ 3.3% Proximate Cause of Inflation Excessive Monetary Growth Faster than economy’s long- run real growth rate 21 Total Slides: 34

22. Money Supply (M2) Growth: 7.0% Inflation: 3.7% Average Annual Rates United States 1959:Q1-2008:Q4 Real GDP Growth: 3.3% Velocity Growth: 0.1% Money Growth and Inflation U.S. Evidence 22 Total Slides: 34

23. Money and Nominal Rates Cross-Country Evidence Monetary growth => Inflation => Nominal Interest Rates Source: Monnet and Weber, 2001 Note: Each point represents average annual money growth and average annual inflation (circle/square represents average values for one country, 1961-1998). 23 Total Slides: 34

24. Source: Monnet and Weber, 2001 Note: Each point represents average annual money growth and average annual inflation (circle/square represents average values for one country, 1961- 1998). Money and Nominal Rates Cross-Country Evidence 24 Total Slides: 34

25. Money and Nominal Rates U.S. Evidence Monetary growth => Inflation => Nominal Interest Rates 25 Total Slides: 34

26. Fed implements monetary policy by purchasing/selling Treasuries. Transactions are called open-market operations. –Open-market purchases increase bank reserves and reduce bond supply. –Open-market sales reduce bank reserves and increase bond supply. Short-term effect on nominal interest rate is called liquidity effect. Money and Nominal Rates Short Run 26 Total Slides: 34

27. Bond Supply 1 a iaia QaQa Quantity of Bonds Nominal Interest Rate Bond Demand 1 Suppose Fed buys Treasuries in open market. Bond supply will fall, and nominal interest rate will fall. Bond Supply 2 ibib QbQb b Example: Fed in Action 27 Total Slides: 34

28. Fed buys and sells Treasuries to stabilize economy. Weakening economy: Fed buys Treasuries to lower interest rates and stimulate economy. Overheating economy: Fed sells Treasuries to raise interest rates and slow economy. Why Conduct Open-Market Operations? 28 Total Slides: 34

29. short-run goals long-run goalsBalancing short-run goals of monetary policy (a stable, high-growth economy) with long-run goals (low inflation) is challenging. 1970s excessive focus short runHigh inflation and nominal interest rates of 1970s were due to excessive focus on short run. Art of Central Banking 29 Total Slides: 34

30. Does easy money lower nominal interest rate? Short run:  Open-market purchases lower nominal interest rate. Long run:  When economy perks up, nominal rate starts rising.  If monetary stimulus is excessive, inflation starts rising.  Bond demanders/suppliers adjust inflation expectations, further raising nominal rate. Putting It All Together Linking the Long and Short Run 30 Total Slides: 34

31. Does easy money lower nominal interest rates? Time Nominal Interest Rate 0 Initial rate Long run Short run Time path of actual nominal rates Putting It All Together Linking the Long and Short Run 31 Total Slides: 34

32. Why were nominal rates lower in later period? Year Average 3-Month T-Bill Rate Year Average 3-Month T-Bill Rate 19787.2%19933.0% 197910.0%19944.3% 198011.5%19955.5% 198114.0%19965.0% 198210.7%19975.1% You try it! 32 Total Slides: 34

33. Money growth and inflation were lower! You try it! 33 Total Slides: 34

34. Sources of Interest-Rate Fluctuations: Nominal Interest Rates? Money and Banking Money and Banking Mr. Vaughan Questions Questionsover Total Slides: 34