Chapter 15 - Interest Rates and Monetary Policy

Prime Interest Rate

The benchmark interest rate that banks use as a reference point for a wide range of loans to businesses and individuals.

Open-Market Operations

The buying and selling of U.S. government securities by the Federal Reserve Banks for purposes of carrying out monetary policy.

Monetary Policy

A central bank's changing of the money supply to influence interest rates and assist the economy in achieving price stability, full employment, and economic growth.

Repo

A repurchase agreement (or "repo") is a short-term money loan made by a lender to a borrower that is collateralized with bonds pledged by the borrower. The name repo refers to how the lender would view the transaction. The same transaction when viewed from the perspective of the borrower would be called a reverse repo.

Reverse Repo

A reverse repurchase agreement (or "reverse repo") is a short-term money loan that the borrower obtains by pledging bonds as collateral. The name reverse repo refers to how the borrower would view the transaction. The same transaction when viewed by the lender would be called a repo.

Liquidity Trap

A situation in a severe recession in which the Fed's injection of additional reserves into the banking system has little or no additional positive impact on lending, borrowing, investment, or aggregate demand.

Quantitative Easing (QE)

An open-market operation in which bonds are purchased by a central bank in order to increase the quantity of excess reserves held by commercial banks and thereby (hopefully) stimulate the economy by increasing the amount of lending undertaken by commercial banks; undertaken when interest rates are near zero and, consequently, does not allow the central bank to further stimulate the economy with lower interest rates due to the zero lower bound problem.

Tight Money Policy (Contractionary)

Federal Reserve System actions that contract, or restrict, the growth of the nation's money supply for the purpose of reducing or eliminating inflation. Sell or reverse repo securities By selling or borrowing government bonds in the open market, the Federal Reserve Banks can reduce commercial bank reserves. Increase the reserve ratio An increase in the reserve ratio will automatically strip commercial banks of their excess reserves and decrease the size of the monetary multiplier. Raise the discount rate A boost in the discount rate will discourage commercial banks from borrowing from Federal Reserve Banks in order to build up their reserves. Raise the interest rate on excess reserves Raising the interest rate that the Fed pays on excess reserves may encourage commercial banks to deposit their excess reserves with the Federal Reserve, rather than lend them to consumers and businesses.

easy money policy (expansionary)

Federal Reserve System actions to increase the money supply to lower interest rates and expand real GDP. buy or repo securites: By purchasing or loaning against securities in the open market, the Fed can increase commercial bank reserves. When the Fed's checks for the securities are cleared against it, or it issues loans collateralized by the securities, the commercial banks discover that they have more reserves. Lower the reserve ratio By lowering the reserve ratio, the Fed changes required reserves into excess reserves and increases the size of the monetary multiplier. Lower the discount rate By lowering the discount rate, the Fed may entice commercial banks to borrow more reserves from the Fed. Lower the interest rate on excess reserves By lowering the interest rate that the Fed pays on excess reserves, it may encourage commercial banks to lend their excess reserves, rather than keep them in Federal Reserve banks.

LO15.5

In response to the financial crisis of 2007-2009, the Fed pursued a number of expansionary monetary policies, including lowering the discount rate and Federal funds rate. In December 2008, it embarked on a zero interest rate policy (ZIRP) in an effort to stimulate economic recovery and growth. When lowering interest rates to nearly zero failed to have the desired stimulatory effect, the Fed implemented quantitative easing. Because of the severity of the financial crisis, including the possible failure of several major banks, the Federal Reserve provided lender-of-last-resort loans to financial institutions through a series of newly established Fed facilities. Most of these facilities closed in 2010 but could be reestablished in the event of another financial crisis. Monetary policy has two major limitations and potential problems: (a) Recognition and operation lags complicate the timing of monetary policy. (b) In a severe recession, the reluctance of banks to lend excess reserves and firms to borrow money to spend on capital goods may contribute to a liquidity trap that limits the effectiveness of an expansionary monetary policy. In 2015, the Fed began to take steps to raise interest rates back to historically normal levels. That has not yet been achieved, causing some to question what actions the Fed might take if the U.S. economy suffers another recession. Some central banks in Europe have adopted negative interest rates in an effort to stimulate borrowing, spending, and growth.

interest on excess reserves (IOER)

Interest rate paid by the Federal Reserve on bank excess reserves.

LO15.3

Monetary policy affects the economy through a complex cause-effect chain: (a) Policy decisions affect commercial bank reserves; (b) changes in reserves affect the money supply; (c) changes in the money supply alter the interest rate; (d) changes in the interest rate affect investment; (e) changes in investment affect aggregate demand; and (f) changes in aggregate demand affect the equilibrium real GDP and the price level.

LO15.4

The advantages of monetary policy include its flexibility and political acceptability. Recently, the Fed has targeted changes in the Federal funds rate as the immediate focus of its monetary policy. When it deems it necessary, the Fed uses open-market operations to change that rate, which is the interest rate banks charge one another on overnight loans of excess reserves. Interest rates in general, including the prime interest rate, rise and fall with the Federal funds rate. The prime interest rate is the benchmark rate that banks use as a reference rate for a wide range of interest rates on short-term loans to businesses and individuals.

Asset Demand

The amount of money people want to hold as a store of value; this amount varies inversely with the interest rate.

Transactions demand for money

The amount of money people want to hold for use as a medium of exchange (to make payments); varies directly with nominal GDP.

LO15.2

The goal of monetary policy is to help the economy achieve price stability, full employment, and economic growth. The four main instruments of monetary policy are (a) open-market operations, (b) the reserve ratio, (c) the discount rate, and (d) the interest rate on excess reserves. The Fed's most often used monetary policy tool is its open-market operations. The Fed injects reserves into the banking system (and reduces interest rates) by buying securities from commercial banks and the general public, or through repos, where the Fed loans money to banks that provide securities for collateral. The Fed withdraws reserves from the banking system (and increases interest rates) by selling securities to commercial banks and the general public, or through reverse repos, where the Fed borrows money from banks using securities as collateral.

Federal funds rate

The interest rate banks and other depository institutions charge one another on overnight loans made out of their excess reserves.

Discount Rate

The interest rate that the Federal Reserve Banks charge on the loans they make to commercial banks and thrift institutions.

Money Market

The market in which the demand for and the supply of money determine the interest rate (or the level of interest rates) in the economy.

cyclical asymmetry

The potential problem of monetary policy successfully controlling inflation during the expansionary phase of the business cycle but failing to expand spending and real GDP during the recessionary phase of the cycle.

Total Demand for Money

The sum of the transactions demand for money and the asset demand for money.

LO15.1

There is a set of interest rates that vary by loan purpose, size, risk, maturity, and taxability. Nevertheless, economists often speak of a single interest rate in order to simplify their analysis. The total demand for money consists of the transactions demand and asset demand for money. The amount of money demanded for transactions varies directly with the nominal GDP; the amount of money demanded as an asset varies inversely with the interest rate. The money market combines the total demand for money with the money supply to determine equilibrium interest rates.

reverse repo

the purchase of securities by one party with an agreement to sell them

Zero Interest rate policy (ZIRP)

A monetary policy in which a central bank sets nominal interest rates at or near zero percent per year in order to stimulate the economy.

repo

Arrangement where an institution sells a security with a commitment to buy it back at a later date at a specified higher price.