Lecture Economics (18th edition): Chapter 33 - McConnell, Brue, Flynn''s

Chapter 33 - Interest rates and monetary policy. After reading this chapter, you should be able to: Discuss how the equilibrium interest rate is determined in the market for money, list and explain the goals and tools of monetary policy, describe the Federal funds rate and how the Fed directly influences it, identify the mechanisms by which monetary policy affects GDP and the price level, explain the effectiveness of monetary policy and its shortcomings.

Interest Rates and Monetary Policy

Chapter 33

Interest Rates

• Price paid for the use of money

• Many different interest rates

• Speak as if only one interest rate

• Determined by money supply and money demand

Demand for Money

• Why hold money?

–Determined by nominal GDP

–Independent of the interest rate

–Money as a store of value

–Varies inversely with the interest rate

Demand for Money

Amount of money demanded (billions of dollars)

Amount of money demanded and supplied (billions of dollars)

= +

(c)

Total demand for

Interest Rates

• Equilibrium interest rate

–Changes with shifts in money

supply and money demand

• Interest rates and bond prices

Federal Reserve Balance Sheet

Treasury Deposits Federal Reserve Notes (Outstanding)

All Other Liabilities and Net Worth

Total

February 14, 2008 (in Millions)

Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008

$713,369

60,039 111,689

$885,097

$ 11,312 4,979

778,937 89,869

$885,097

Federal Reserve Balance Sheet

United Kingdom:

United States:

Selected Nations

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

Open Market Operations

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

Open Market Operations

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

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

Tools of Monetary Policy

• Open market operations most

important

• Reserve ratio last changed 1992

• Discount rate was a passive tool

• Term auction facility is new

–Guaranteed amount lent by the Fed –Anonymous

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

The Federal Funds Rate

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

• Contractionary monetary policy

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 target federal funds rate is 4%

• Target varies as inflation and real GDP vary

Monetary Policy

• 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

Monetary Policy and GDP

Amount of investment (billions of dollars)

(b)

Investment demand

(c)

Equilibrium real GDP and the Price level

AS

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

Restrictive Monetary Policy

Monetary Policy

• Advantages over fiscal policy

–Speed and flexibility

–Isolation from political pressure

• Recent U.S monetary policy

• Problems and complications

–Recognition lag

–Operational lag

–Cyclical asymmetry

The Big Picture

Levels of Output, Employment, Income, and Prices

Aggregate Demand

Aggregate Supply

Government Spending (G)

The Mortgage Debt Crisis

• Home mortgage default 2007

• Banks write off bad loans

• Reserves reduced

• Fed as lender of last resort

• Term auction facility

• Fed lowered federal funds rate

• Mortgage backed securities as a new innovation

–Bad incentives

• term auction facility

• Federal funds rate

• expansionary monetary policy

• prime interest rate

• restrictive monetary policy

• Taylor rule

• cyclical asymmetry

• mortgage debt crisis

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Financial Economics