McConnellBrue Economics

1
14
I guess I should warn you, if I turn out to be
particularly clear, you've probably misunderstood
what I've said. Alan Greenspan
Former Fed Chairman
Interest Rates and Monetary Policy
2
Chapter Objectives

• How the Equilibrium Interest Rate is Determined
  in the Market for Money
• The Goals and Tools of Monetary Policy
• The Federal Funds Rate and How the Fed Controls
  It
• The Mechanisms by Which Monetary Policy Affects
  GDP and the Price Level

3
Interest Rates

• Interest Price Paid for the Use of Money
• Two Main Types of Demand for Money (Reasons to
  hold money)
• Transactions Demand, D1
• Asset Demand, D2

4
Interest Rates

• Two Types of Demand for Money
• Transactions Demand, D1
• Demand for money as a medium of exchange.
• People hold money to pay for goods and services.
• Assume the transactions demand for money is
  independent of the interest rate.
• Asset Demand, D2
• Demand for money as a store of value.
• People hold some of their financial assets as
  money because it is most liquid asset.
• Disadvantage money, when not earning interest,
  loses value when prices increase.
• Interest rate is considered the opportunity cost
  of holding money (ex, if a bond pays 6 interest,
  holding money instead of the bond costs 6 of
  foregone income).
• So, the asset demand for money varies inversely
  with interest rates.

5
Interest Rates
Demand for Money and the Money Market
(a) Transactions Demand for Money, Dt
(b) Asset Demand for Money, Da
(c) Total Demand for Money, Dm And Supply
10 7.5 5 2.5 0
Sm


Rate of Interest, I percent
5
Dt
Da
Dm
Amount of Money Demanded (Billions of Dollars)
Amount of Money Demanded (Billions of Dollars)
Amount of Money Demanded and Supplied (Billions
of Dollars)
6
Interest Rates
Demand for Money and the Money Market
Total Demand for Money, Dm And Supply
What happens to the equilibrium interest rate
when money supply increases? Decreases?
10 7.5 5 2.5 0
Sm
Rate of Interest, I percent
Dm
Amount of Money Demanded and Supplied (Billions
of Dollars)
7
Interest Rates

• Interest Rates and Bond Prices
• Interest rates and bond prices move in opposite
  directions!
• Explanation
• Bonds are bought and sold in bond market, so
  price is set by supply and demand. Suppose a
  bond sells for 1000, and pays 5 interest, or
  50/year

Now suppose the interest rate increases to 7.5
(what could have caused that?), so brand new
bonds will pay 7.5, or 75 for a 1000 bond, but
this old bond will still only pay 50 (the annual
dollar amount, or coupon payment, is constant for
life of bond). Nobody will be willing to pay
1000 to earn 50/year when they can pay 1000
for a new bond and earn 75/year. So to sell the
older 5 bond, what do you have to do?
8
Interest Rates

• Interest Rates and Bond Prices
• Interest rates and bond prices move in opposite
  directions!
• Explanation
• So to sell the older 5 bond, what do you have to
  do?
• Cut the price to a dollar amount that will yield
  50 at 7.5 interest rate

Conversely, if the interest rate falls to 2.5,
buyers will be willing to pay MORE than 1000 to
earn 50/year SO, anything that affects bond
prices will also affect interest rates (in
opposite direction).
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Three Tools of Monetary Policy

• Open Market Operations
• Buying and Selling government bonds (aka
  securities)
• Reserve Requirement
• Raising or lowering reserve requirement changes
  amount of reserves banks are required to hold.
• Discount Rate
• Discount rate interest rate paid by banks for
  borrowing money from the Fed.

10
Tools of Monetary Policy

• Open Market Operations (conducted by FOMC)
• Buying Bonds (aka securities)
• Impact on Money Supply
• When the Fed buys bonds, money is transferred
  from the Fed, increasing bank reserves.
• Banks can then increase loans, creating money.
• Money supply increases.
• Impact on Interest Rates
• Increased money supply puts downward pressure on
  interest rates.
• In bond market, increased demand for bonds
  increases bond prices, so interest rates fall.
• Selling Bonds (aka securities)
• VICE-VERSA (money supply down, interest rates
  up)

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Tools of Monetary Policy

• 2. Reserve Requirement
• Increasing Reserve Requirement
• Impact on Money Supply
• Increasing reserve requirement decreases money
  multiplier.
• Banks cannot loan as much, money supply
  contracts.
• Impact on Interest Rates
• Decreased money supply puts upward pressure on
  interest rates.
• Decreasing Reserve Requirement
• VICE-VERSA (money supply up, interest rates
  down)

12
Tools of Monetary Policy

• 3. Discount Rate
• Increasing Discount Rate
• Impact on Money Supply
• Increasing discount rate makes banks borrow less.
• Banks have less money to loan, money supply
  contracts.
• Impact on Interest Rates
• Decreased money supply puts upward pressure on
  interest rates.
• Decreasing Discount Rate
• VICE-VERSA (money supply up, interest rates
  down)

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Tools of Monetary Policy

• Expansionary Policy (fix recessionary gap)
• Buy bonds
• Cut reserve requirement
• Cut discount rate
• Impact
• Increased money supply
• Lower interest rates
• Increased C and I
• Increased real GDP
• Increased aggregate demand
• (shift to right)

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Tools of Monetary Policy

• Contractionary Policy (fix inflationary gap)
• Sell bonds
• Raise reserve requirement
• Raise discount rate
• Impact
• Decreased money supply
• HIgher interest rates
• Decreased C and I
• Decreased GDP
• Decreased aggregate demand
• (shift to left)

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Targeting the Federal Funds Rate

• Federal Funds Rate
• Interest rate banks charge each other for
  overnight loans to cover reserve shortfalls.
• This is the rate targeted by the FOMC. Other
  rates change with it.

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Monetary Policy
Monetary Policy and Equilibrium GDP
(a) The Market For Money
(b) Investment Demand
(c) Equilibrium Real GDP and the Price Level
Sm1
Sm2
Sm3
AS
10 8 6 0
P3
AD3 I25
P2
AD2 I20
Dm
ID
AD1 I15
Q1
Qf
Q3
125
150
175
15
20
25
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Monetary Policy
Expansionary Monetary Policy
Problem Unemployment and Recession
CAUSE-EFFECT CHAIN
Fed Buys Bonds, Lowers Reserve Ratio, or Lowers
the Discount Rate
Excess Reserves Increase
Federal Funds Rate Falls
Money Supply Rises
Interest Rate Falls
Investment Spending Increases
Aggregate Demand Increases
Real GDP Rises
18
Monetary Policy
Contractionary Monetary Policy
Problem Inflation
CAUSE-EFFECT CHAIN
Fed Sells Bonds, Increases Reserve Ratio, or
Increases the Discount Rate
Excess Reserves Decrease
Federal Funds Rate Rises
Money Supply Falls
Interest Rate Rises
Investment Spending Decreases
Aggregate Demand Decreases
Inflation Declines
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Monetary Policy

• Problems and Complications
• Recognition Lag
• Administrative Lag
• Operational Lag