Chapter 14: Interest Rates and Monetary Policy

How do ppl decide how much of their financial assets to hold as money?

Depends primarily on the interest rate. A HH or business incurs an opportunity cost when it holds money; in both cases, income interest is forgone or sacrificed. The amount of money demanded as an asset therefore varies inversely with the rate of interest. When i rises, being liquid and avoiding capital loss becomes more costly. The public reacts by reducing its holdings of money as an asset. When i falls, the cost of cost of being liquid and avoiding capital loss also declines. The public therefore increases the amount of financial assets that it wants to hold as money. Shown by a downward sloping line.

expansionary monetary policy (nickname?)

During a time when the economy faces recession and unemployment. It will initiate an expansionary monetary policy (or "easy money policy"). This policy will lower the interest rate to bolster borrowing and spending, which will increase aggregate demand and expand real output. The Fed's immediate step will be to announce a lower target for the Federal funds rate. To achieve that lower rate the Fed will use open-market operations to buy bonds from banks and the public. We know that the purchase of bonds increases the reserves in the banking system. Alternatively, the Fed could expand reserves by lowering the reserve requirement or lowering the discount rate to achieve the same result, but we have seen that the former is rarely used and the latter is not presently used for active monetary policy.

restrictive monetary policy (nickname?)

During periods of rising inflation. The Fed will undertake a restictive monetary policy (or "tight money policy"). This policy will increase the interest rate in order to reduce borrowing and spending, which will curtail the expansion of aggregate demand and hold down price level increases. The Fed's immediate step will be to announce a higher target for the Federal funds rate. Through open-market operations, the Fed will sell bonds to the banks and the public and the sale of those bonds will absorb reserves in the banking system. Alternatively, the Fed could absor reserves by raising the reserve requirement or raising the discount rate to achieve the same result, but we have seen that the former is rarely used and the latter is not presently used for active monetary policy.

What is the market for money?

Figure 14.5a shows the market for money, in which the demand curve for money and the supply surve for money are brought together. The figure shows 3 potential money supply curves (shown as a vertical line representing some fixed amount of money determined by the Fed). While monetary policy (specifically, the supply of money) helps determine the interest rate, the interest rate does not determine the location of the money supply curve. The equil. interest rate is the rate at which the amount of money demanded and the amount of money supplied are equal. (real, not the nominal, rate of interest rate is critical for investment decisions.)

How is equilibrium GDP affected by monetary policy?

Figure 14.5c shows the impact of our three real interest rates and corresponding level of investment spending and AD. Investment spending is one of the determinants of AD. Other things equal, the greater the investment spending, the farther to the right lies the AD curve. (this shows the equil. real output.)

Raising the reserve ratio

If the Fed raises the reserve ratio it would -increase the amount of required reserves banks must keep -as a consequence, either banks lose excess reserves, diminishing their ability to create money by lending, or they find their reserves deficient and are forced to contract checkable deposits and therefore the money supply. -To reduce its checkable deposits, the bank could let outstanding loans mature and be repaid without extending new credit. To increase its reserves, the banks might sell some of its bonds, adding the proceeds to its reserves. Both actions would reduce the supply of money.

Lowering the reserve ratio

If the fed lowers the reserve ratio -decrease the amount of required reserves banks must keep. -increase excess reserves. The single-banks lending ability would increase and the banking system's money-creating potential would expand.

How does the discount rate affect reserves?

In providing a loan, the Fed increases the reserves of the borrowing commercial bank. Since no required reserves need be kept against loans from Fed, all new reserves acquired by borrowing from the Fed are excess reserves. In short, borrowing from the Fed by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit. The Fed has the ability to set the discount rate. A lowering of the discount rate encourages commercial banks to obtain additional reserves by borrowing from the Fed. When commercial banks lend new reserves, the money supply increases. An increase in the discount rate has the opp. effect, so the Fed may decrease the discount rate when it wants to restrict the money supply.

What are interest rates?

Interest is the price paid for the use of money. It is the price that borrowers need to pay lenders for transferring purchasing power to the future. Many different kind of interest rates but simply speak of "interest rate" unless stated otherwise.

How does the Fed target the Fed funds rate numerically?

It is demonstrated in Figure 14.3 where the Fed desires a 4 percent interest rate. The demand curve for Federal funds Df is downsloping bc lower interest rates give commercial banks a greater incentive to borrow Federal funds rather than reduce loans as a way to meet reserve requirements. The supply curve for Federal funds Sf1 is somewhat unusual. Specifically, it is horizantal at the targeted Federal funds rate, here 4 percent. The Fed will use open-market operations to provide whatever level of Federal funds the banks desire to hold at the targeted 4 percent interest rate. Note that at the 4 percent Federal funds rate, the quantity of Federal funds supplied (Qf1) equals the quantity of funds demanded (also Qf1).

Why is Sm a vertical line?

It is vertical bc monetary authorities provide the economy with a specific stock of money. Here it is $200 billion (or whatever amount).

What four things does monetary policy affect?

Monetary policy affeects the economy's levels of -investment -aggregate demand -real GDP -prices

Selling securities to commercial banks

(a) The Fed give up securities that commercial banks acquire. (b) the commercial banks pay for those securities by drawing checks against their deposits-- against their reserves-- in Federal reserve banks. The Fed collects those checks by reducing the commercial banks' reserves accordingly.

Selling securitites to the public

(a) The Fed sell government bonds to Gristly, which pays with a check drawn on the Wahoo bank. (b) The Fed clears this check against the Wahoo bank by reducing Wahoo's reserves. (c) The Wahoo bank returns the canceled check to Gristly, reducing Gristly's checkable deposit accordingly.

Why do ppl like to hold their financial assets in money?

-It is the most liquid of all finanical assets; immedietely usable for purchasing other assets when opportunites arise. -Also attractive to hold when the price of toher assets auch as bonds are expected to fall. There is no risk of capital loss in holding money. -Disadvantage is that it earns no or very little interest.

What are the liabilities of the Fed?

-Reserves of commercial banks -Treasury deposits -Federal Reserve Notes Outstanding

What are the assets of the Fed?

-Securities -Loans to commercial banks

Why does the public want ot hold some of its wealth as money?

-to make purchases with it -to hold it as an asset

What advantages does monetary policy have over fiscal policy?

1. Speed and flexibility 2. Isolation from political pressure

What do smaller reserves in the banking system result in?

1. The supply of Federal funds decreases, raising the Federal funds rate to the new targeted rate. We show this in Figure 14.3 as an upward shift of the hor. supply curve. The equil. Fed funds rate rises to 4.5%, and the equil. quantity of funds in this market falls to Qf3. 2. A multiple contraction of the nation's money supply occurs. Given the demand for money, the smaller money supply places an upward pressure on other interest rates. For example, the prime interest rate will rise.

What results occur with the greater reserves in the banking system?

1. The supply of Federal funds increases, lowering the Federal funds rate to the new targeted rate. (shown by downward shift to the hor. supply curve). The equil. Federal funds rate falls to 3.5%. The equil. quantity of reserves in the overnight market for reserves rises from Q1 to Q2. 2. A multiple expansion of the nation's money supply occurs. Given the demand for money, the larger money supply places a downward pressure on other interest rates.

What does chaning the reserve ratio do?

A change in the reserve ratio affects the money-creating ability of the banking system in 2 ways 1. It changes the amount of excess reserves. 2. It changes the size of the monetary multiplier.

How does the Fed use the Fed funds rate?

Although individual banks can lend excess reserves to one another, the Federal Reserve is the only supplier of Federal funds-- the currency used by banks as reserves. The Fed uses its status as a monopoly supplier of reserves to target the specific Federal funds rate that it deems appropriate for the economy. The FOMC meets regularly to choose a desired Federal funds rate. It then directs the Federal Reserve Bank of New York to undertake open-market operations to achieve and maintain the targeted rate.

What are "Federal Funds"?

Although individual banks can lend excess reserves to one another, the Federal Reserve is the only supplier of Federal funds-- the currency used by banks as reserves. The funds being lent and borrowed overnight are called "federal funds" bc they are reserves (funds) that are required by the Federal Reserve to meet reserve requirements.

How does the discount rate affect the Fed's balance sheet?

As a claim against the commercial bank, the borrowing bank's primissory note is an asset to the lending Federal Reserve Bank and appears on its balance sheet as "Loans to commercial banks." To the commercial bank the IOU is a liability, appearing as "Loans from the Federal Reserve Banks" on a commercial banks balance sheet.

What is the main determinant of the amount of money demanded for transactions?

The level of nominal GDP. The larger the total money value of all goods and services exchanged in the economy, the larger the amount of money needed to negotiate those transactions. (Transaction demand varies directly with nominal GDP).

Advantage of isolation of political pressure

Because the members of the Board of Governors are appointed and serve 14-yr terms, they are relatively isolated from lobbying and need not worry about retaining their popularity with voters. So the Board can engage in politically unpopular policies (higher interest rate) that may be necessary for the long-term health of the economy. Moreover, monetary policy is a subtler and more political conservative measure than fiscal policy. Changes in G and T have extensive political ramifications, but monetary policy works more subtly so it is more politically palatable.

What are open-market operations?

Bond markets are "open" to all buyers and sellers of corporate and government bonds (securities). The Fed is the largest single hodler of US government securities. The Fed's open-market operations consist of the buying of government bonds from, or the selling of governement bonds to, commercial banks and the general public. Open-market operations are the Fed's most important instrument for influencing the money supply.

What is the relative importance of the Fed's three tools?

Buying and sellling securities is the most important. This technique has the advantage of felxibility (gov't securities can be bought and sold daily in large or small amounts) and the impact on bank's reserves is prompt. It is also unquestionable. Changing the reserve requirement is less important, the Fed only uses it sparingly. Normally, it is easier to accomplish its goal usin gopne-market operations. Limited changes in hte reserve ratio probably happen bc they earn no interest and it has a substancial effect on bank's profits. The discount rate has become a passive, not active, tool of monetary policy. The Fed now sets the discount rate at 1 percentage point above the Fed's targeted rate of interest on the overnight loans that commercial banks make to other commercial banks that need the funds to meet the required reserve ratio. When the interest rate on overnight loans rises or falls, the discount rate automatically rises or falls along with it.

Asset of loans to commercial banks

Commercial banks occasionaly borrow from the Fed. The IOUs that commercial banks give these "bankers' banks" in return for loans are listed on the Fed balance sheet as "loans to commercial banks." They are assets to the Fed bc they are claims against the commercial banks. To commercial banks, these loans are liabilities in that they must be repaid. Through borrowing in this way, commercial banks can increase their reserves.

Advantage of speed and flexibility

Compared to fiscal policy, monetary policy can be quickly altered. Fiscal policy has timing lags but the Fed can buy and sell securities from day to day and thus affect the money supply and interest rates almost immediately.

cyclical asymmetry

Monetary policy may be highly effective in slowing expansions and controlling inflation but less reliable in pushing the economy from a severe recession. Economists say that monetary policy may suffer from cyclical asymmetry. If pursued vigorously, a restictive monetary policy could deplete commercial banking reserves to the point where banks would be forced to reduce the volume of loans. That would be a contraction of the money supply, higher interest rates, and reduced AD. The Fed can absorb reserves and achieve its goal. But it cannot be certain of achieving its goals when it adds reserves to the banking system. The Fed can create excess reserves, but it cannot guarentee that the banks will actually make the added loans and thus increase the supply of money. If commercial banks seek liquidity and are unwilling to lend, the efforts of the Fed will be of little avail. Similarly, businesses can frustrate the intentions of the Fed by not borrowing excess reserves. And the public may use money paid to them through Fed sales of US securities to pay of existing bank loans. Furthermore, a severe recession may so undermine business confidence that the ID curve shifts to the left and frustrates an expansionary monetary policy.

What is the discount rate?

One of the functions of a central bank is to be a "lender of last resort." When a commercial bank borrows, it gives the fed a promissory note (IOU) drawn against itself and secured by acceptable collateral-- typically US goverment securities. Just as commercial banks charge interest on their loans, so do Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest rate they charge is called the discount rate.

Why do ppl buy and sell gov't securities with the Fed?

People buy and sell gov't securities bc of the inverse relationship between bond prices and i. When the Fed buys government bonds, the demand for them increases. Gov't bond prices rise, and their interest yields decline. The higher bond prices and their lower interest yields prompt banks, securities firms, and individual holders of gov't bonds to sell them to the Fed. When the Fed sells gov't bonds the additional supply of bonds lowers bonds prices and raises interest yields, making gov't bonds attractive purchases for banks and the public.

What is transaction demand (Dt)?

Ppl hold money bc it is convenient for purchasing goods and services. (HH must buy groceries, pay bills. Businesses msut pay for labor, materials, etc.) The demand for money as a medium of exchange is called transaction demand for money.

What do proponents say about inflation targeting?

Proponents of inflation targeting say that, along with increasing transparency and accountability, it would focus the Fed on what should be its main mission: controlling inflation and keeping deflation form occuring. They say an explicit commitment to price-level stability will create more certainty for households and firms about future product and input prices and create greater output stability. In the advocates view, setting and meeting an inflation target is the single best way for the Fed to achieve it important aubsidiary goals of full employment and strong economic growth.

What are the lags of Monetary policy?

Recall the three elapses of time (lags)- RAO - that hinder fiscal policy. Monetary policy faces a similar recognition lag and operational lag, but it avoids the administrative lag. Bc of monthly varitations in the economic activity and changes in the price level, the Fed may take a while to recognize that the economy is in recession or inflation (rec. lag). And once the Fed acts, it may take 3 to 6 months or more for interest-rate changes to have their full impacts on investment, AD, real GDP, and the price level (oper. lag).

Buying securities from the public

Suppose Gristly company has gov't bonds that it sells in the open market to the Fed. Transaction includes several elements... (a) Gristly gives up securities to the Fed and gets in payment a check drawn by the Fed on themselves. (b) Gristly promptly deposits the check in its account with the Wahoo bank. (c) The Wahoo bank sends this chack against the Fed for collection. As a result, the Wahoo bank enjoys an increase in its reserves. This increases the lending ability of the commercial banking system. Also, the supply of money is directly increased by the Fed's purchase of gov't bonds (aside from any expansion of the money supply that may occur from the increase in commercial banks reserves). This direct increase in the money supply has taken the form of an increased amount of checkable deposits in the economy as a result of Gristly's deposit.

Interest rate and bond prices

Talked about in fiscal policy. Make sure you know. (when i increases, bond prices fall. When i falls, bond prices rise.)

What are the tools of monetary policy?

The Fed can influence the money-creating abilities of the commercial banking system. The Fed has threee tools of monetary control it can use to alter the reserves of commercial banks. 1. Open-market operations 2. The Reserve ratio 3. The discount rate

What does the Fed do to the reserve ratio?

The Fed can manipulate the reserve ratio in order to influence the ability of commercial banks to lend.

Liability of reserves of commercial banks

The Fed requires that the commercial banks hold reserves against their checkable deposits. When held in the Fed, these reserves are listed as a liability on the Fed's balance sheet. They are assets on the books of the commercial banks, which still own them even though they a e deposited at the Fed.

What are the effects of expansionary monetary policy?

The Fed will do one of or a combination of the three tools for the intended outcome of an increase in excess reserves in the commercial banking system and a decline in the Fed funds rate. Bc excess reserves are the basis on which commercial banks and thrifts can earn profit by lending and thus creating checkable-deposit money, the nation's money supply will rise. An increase in the money supply will lower the interest rate, increasing investment, aggregate demand, and equil. GDP.

What are the effects of a restrictive monetary policy?

The Fed will do one of or a combination of the three tools. Banks then will discover that their reserves are below those required and that the Federal funds rate has increased. So they will need to reduce their checkable-deposits by refraining from issuing new loans as old loans are paid back. This will shrink the money supply and incrase the interest rate. The higher interest rate will discourage investment, lowering aggregate demand and restraining demand-pull inflation.

What is the consolidated balance sheet of the federal reserve bank?

The Fed's balance sheet helps us consider how the Fed conducts monetary policy. Some assets and liabilities differ than those of commercial banks.

What interest rate does the Fed focus on?

The Federal Reserve focuses monetary policy on the interest rate that it can best control: The Federal funds rate. This is the rate of interest that banks charge one another on overnight loans made from temporary excess reserves. An equilibrium interest rate-- the Federal funds rate-- arises in this market for bank reserves.

Liability of treasury deposits

The US treasury keeps deposits in the Fed and draws checks on them to pay obligations. To the treasury, these deposits are assets; to the Fed they are liabilities. The Treasury creates and replenishes these deposits by depositing tax reciepts and money borrowed from the public or from the commercial banks through the sale of bonds.

inflation targeting

The annual statement of a target range of inflation, for the economy over some period such as 2 years. The Fed would then undertake monetary policy to achieve that goal, explaining to the public how each monetary action fits within its overall strategy. If the Fed missed its target, it would need to explain what went wrong. So inflation targeting would increase the "transparency" of monetary policy and increase Fed accountability.

prime interest rate

The benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses and individuals. The prime interest rate is higher that the Federal funds rate bc the prime rate involves longer, more risky loans than overnight loans between banks. But they closely track one another.

How does the Fed buy securities?

The federal reserve banks can buy government bonds from commercial banks or from the public. In both cases, the reserves of the commercial banks will increase. When the banks lend out an amount equal to their excess reserves, the nation's money supply will rise.

What is the Taylor Rule?

The proper Fed funds rate for a certain period is a matter of policy discretion by the members of the FOMC. The FOMC does not adhere to a strict inflationary target or monetary policy rule. It targets the Federal funds rate at the level it thinks is appropriate for the underlying economic conditions. Nevertheless, the Fed appears to roughly follow a rule first established by economist John Taylor of Stanford. The Taylor rule assumes a 2 percent target rate of inflation and has three parts: 1. If real GDP rises by 1% above potential GDP, the Fed should raise the Fed funds rate by 1/2 a percentage point. 2. If inflation rises by 1 percentage point above its target of 2 percent, then the Fed should raise the Federal funds rate by 1/2 a percentage point. 3. When real Gdp is equal to potential GDP and inflation is equal to its target rate of 2%, the Fed funds rate should remain at about 4%, which would imply a real interest rate of 2%. (reversable for situations in which the real GDP falls below potential GDP and the rate of inflation falls below 2%.) (The Fed has shown a clear willingness to diverge from the Taylor rule under some circumstances.)

What is asset demand (Da)?

The second reason for holding money derives from money's function as a store of value. Ppl may hold their financial assets in many forms, including corporate stocks corportate or gov't bonds, or money. To the extent they want to hold money as an asset, there is an asset demand for money.

Asset of securities

The securities are gov't bonds that have been purchased by the Fed. They consist largely of treasury bills, notes, and bonds issued by the gov't to finance pat budget deficits. The Fed bought these securities from commercial banks and the public through open-market operations. Although they are an important source of interest income to the Fed, they are mainly bought and sold to influence the size of commercial bank reserves and therefore the ability of those banks to create money by lending.

Liability of federal reserve notes outstanding

The supply of paper money in the US consists of Federal Reserve Notes issued by the Fed. When this money is curculating ouside the Fed, it constitutes claims against the assets of teh Fed. The Fed thus treat these notes as a liability.

How does monetary policy affect investment?

These diff. interest rates are carried to the investment-demand curve in figure 14.5b. Shows the inverse relationship between the interest rate and the amount of investment spending. Changes in the interest rate mainly affect the investment component of total spending, although they also affect the spending on durable consumer goods that are purchased on store credit. The impact of changing interest rates on ovestment spending is great bc of the large cost and long-term nature of capital purchases. (Small change in interest rates could amount to thousands of dollars in large purchases). In brief, the impact of changing interest rates is mainly on investment (and, though that, on aggregate demand, output, employment, and the price level). Moreover, investment spending varies inversely with the real interest rate.

What do critics of inflation targeting say?

They say the overall success of the countries that have adopted the policy has come at a time in which inflationary pressures have been weak. The truer test will occur under more severe economic conditions. Critics of inflation targeting say that it assigns too narrow a role for the Fed. They do not want to limit the Fed's discretion to adjust the money supply and interest rates to smooth the business cycle, independent of meeting a specific inflation target. Ask themselves the question, why saddle the Fed with an explicit inflation target?

Graphing Dt

Transaction demand against the interest ratee For simplicity assume: -amount demanded depends exclusively on the level of GDP and is independent of the interest rate. This assumption allows us to graph transaction demand as a vertical line. This demand curve is positioned at $100 billion, on the assumption that each dollar held for transactions purposes is spent on an average of three times per year and the nominal GDP is $300 billion. Thus the public needs $100 billion to purchase that GDP.

artful management

Under the leadership of Alan Greenspan, the Fed and FOMC artfully managed themoney supply to avoid escalating inflation, on the one hand, and deep recession and deflation, on the other. The emphasis was on "risk management" and achieving a multiple set of objectives: primarily to maintain price stability but also to smooth the business cycle, maintain high levels of employment, and promote strong economic growth. Greenspan and the FOMC used their best judgement to determine appropriate changes in montary policy. But Greenspan retired in early 2006 and was replaced by Ben Bernanke as chairman. Does Bernanke-- or anyone-- have Greenspan's intuition? Some economists are concerned that this "artful" management" may have been unique to Greenspan and that someone less insightful may not be as successful. These economists, including Bernanke, say it might be beneficial to replace or combine the artful management of monetary policy with so-called inflation targeting

What is the equilibrium interest rate?

We can combine the demand for money with the supply of money to determine the equilibrium rate of interest. The vertical like Sm represents the supply of money The intersection of demand and supply determines the equilibrium price in the market for money. Here, the equilibrium price is the interest rate. Changes in the demand for money, the supply of money, or both, can change the equilibrium interest rate. Important generalization: an increase in the supply of money will lower the equilibrium interest rate; a decrease in the supply of money will raise the equilibrium interest rate.

What is the total money demand (Dm)?

We find the total money demand by horizatally adding the asset demand to the transactions demand. The resulting downward sloping line represents the total amount of money the public wants to hold, both for transactions and as an asset, at each possible interest rate. (recall, a change in nominal GDP with shift transaction demand and thus the whole curve of the total money demand curve. Increase in GDP, shift right. Decrease in GDP, shift left.)

How does the fed sell securities?

When the Fed sells gov't bonds, commercial banks' reserves are reduced. If all excess reserves are already lent out, this decline in commercial banks' reserves produces a decline in the nation's money supply.

Buying securities from commercial banks

When this happens... (a) the commercial banks give up part of their holdings of securities (the gov't bonds) to the Federal Reserve Banks. (b) The Fed, in paying for these securities, plave newly crated reserves in the accounts of the commercial banks at the Fed. The reserves of the commercial banks go up by the amount of the purchase of the securities. (These reserves are created "out of thin air.") Most important thing that happens is that when the Fed purchases securities from commercial banks, they increase the reserves in the banking system, which then increases the lending ability of the commercial banks.