MONETARY POLICY

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MONETARY POLICY
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MONETARY POLICY

• The money supply can/does influence price levels
• Inflation occurs if the money supply increases,
  ceteris paribus.
• Deflation occurs if the money supply decreases,
  ceteris paribus.

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What if you stuff your money in a mattress?

• What does it cost you?
• Zero Inflation?
• 10 Inflation?
• Known as the opportunity cost of holding money!

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Interest

• The price you pay for using someone else's money
  (accounting cost or explicit cost)
• OR
• holding your own money as cash.
• (opportunity cost or implicit cost)

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Interest

• Nominal interest rates (market rates)
• Real interest rates
• A return net of inflation and risk premium
• Risk-Free interest rates
• Government treasury securities, no risk premium.

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Interest

• Nominal Interest Rate
• real interest rate
• compensation for inflation
• default risk premium

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Real Interest Rate

• The real interest rate is the price of money, net
  of inflation and risk, that people are willing to
  accept for deferring present consumption until
  some future time period
• 1000 Toman in your hand right now is worth more
  than the promise (without risk) of 1000 Toman in
  your hand a year from now.
• Even with 0 inflation.

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Real Interest Rate

• Example
• You can save money by ordering many items
  through the mail.
• Why do people drive to shahrvand?

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Real Interest Rate

• If 1 right now to you equals (has same value as)
  1.05 one year from now, guaranteed, with zero
  inflation,
• you have a real rate of interest of 5

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Nominal Interest Rate

• If inflation was expected to be 10 from now
  until one year from now, what market interest
  rate would you demand to have, to get your 5
  real rate of interest? Assume no risk.
• Answer 15.

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Nominal Interest Rate

• If you thought there was some risk that you might
  never see your 1000 Tomans,
• you would add a risk premium.

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Interest Rates on Govt. Securities

• Known as the "Risk-free Rate"
• Real rate E(inflation over life of security)

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Interest Rates on Govt. Securities

• When inflation , Risk-free interest rates
• AND
• Nominal interest rates

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Prime Rate

• real rate E(Inflation) small risk
• premium.
• Given to the most solid businesses and
  individuals!

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What Is the Risk Premium Charged by Banks for
Auto Loans?

• Tir 25, 1387
• Iran Treasury 3 yr. Note rate 3.41
• 36 mo. New Car, Nations Bank 7.93
• risk premium
  4.52
• WHY? Bankruptcies

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What Is the Risk Premium Charged by Banks for
Auto Loans?

• Tir. 3, 1388
• Iran Treasury 3 yr. Note rate 6.42
• 36 mo. New Car, Nations Bank 10.25
• risk premium
  3.83
• Why? Economy humming along rather nicely,
  unemployment down, less bankruptcies

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Recent Snapshot

• Tir 4, 1389
• Iran Treasury 3 yr. Note rate
  5.97
• 36 mo. New Car, Bank of America 11.70
• risk premium
  5.73

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MONETARY POLICY

• Government Reserve can or the money
• supply in order to change the level of
• output and prices (Monetary Policy).

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3 Tools to Change Money Supply

• Open-market operations (buying and selling
  treasury bonds, notes, and bills).
• Discount rate Interest rate banks are charged
  when they borrow from the Fed.
• Reserve requirement of deposits that must be
  held by a bank as vault cash or on account with
  the federal reserve.

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Open Market Operations

• When the Government Reserve sells more treasury
  securities than it buys
• Money Supply Decreases
• When the Government Reserve buys more treasury
  securities than it sells
• Money Supply Increases

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The Discount Rate

• The discount rate is adjusted to complement open
  market operations and to support the direction
  the Fed is taking in monetary policy.

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Reserve Requirement

• Commercial Banks, Savings Banks, Savings and
  Loans, Credit Unions, and Branches of Foreign
  Banks are subject to reserve requirements.
• Reserve requirement may range from 8 to 14
  percent of demand deposits and interest-bearing
  accounts offering unlimited checking privileges.

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Changing the Money Supply

• Increase Money Supply, c.p. Decrease
  interest rates (price of money) in S.R.
• BUT
• Increase Money Supply may cause inflation!
• Increase interest rates in L.R.
• Increase Money Supply too much
• Decrease value of money

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Changing the Money Supply

• THEREFORE
• Takes more Rials to buy same stuff
• Price of stuff Inflation!

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Changing the Money Supply

• Decrease Money Supply, c.p. Increase
  interest rates (price of money) in S.R.
• BUT
• Decrease Money Supply may cause deflation!
• Decrease interest rates in L.R.
• Decrease Money Supply too much
• Increase value of money

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Changing the Money Supply

• THEREFORE
• Takes less Rials to buy same stuff
• Price of stuff Deflation!

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Discretionary Income ( IDIS )

• (ID - Basic Housing bills, Basic Utility
  bills, Basic Food Bills, Basic transportation
  bills, Basic clothing, etc.)
• (Not payments on credit cards!)
• Money you have to spend or save at your
  discretion!

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Why has Stock Market Been Booming?

• People with money in banks, pulling it out
• and putting it in
• Stock Market for higher return!

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What affect do low interest rates have on retired
people?

• retirement income!
• Stock Market too risky!

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References

• N.c.State university-College of Agriculture and
  Life science Dr. herman_sampson