Money and Interest Rates

1
Money and Interest Rates

• MBA 774
• Macroeconomics
• Class Notes Part 2

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What is Money?

• Medium of exchange
• Allows transactions not based on barter
• Avoids the need for a double coincidence of
  wants
• Unit of account
• Common measure of value for goods, services, and
  contracts
• Store of value
• Allows for transfer of wealth through time
• Most liquid of all assets

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Types of Money

• Pure Commodity
• Scarce commodity is agreed on as money
• For example gold, silver, cattle, cigarettes
• Commodity Standard
• Certificates representing claims on a commodity
  are issued and used instead of the commodity
  itself
• For example the US was once on a gold standard
• Fiat Money
• Money established by government decree
• Fiat money has no intrinsic value

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US Measures of Money

• Currency Bills and coins outside U.S. Treasury,
  Federal Reserve Banks and the vaults of
  depository institutions
• M1 Currency plus travelers checks, demand
  deposits, other checkable deposits
• M2 M1 plus savings deposits, small-denomination
  time deposits, retail money market mutual funds,
  and overnight repurchase agreements
• M3 M2 plus large-denomination time deposits,
  institutional money funds, and Eurodollars
  (discontinued in 2005)
• L M3 plus other liquid securities such as
  savings bonds and short-term Treasury securities

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US Money Supply Statistics
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The US Federal Reserve

• Federal Reserve System is the US central bank
• Foreign counterparts include the European Central
  Bank (ECB), The Bank of England, and the Bank of
  Japan
• Founded in 1913 by congress, to provide the
  nation with a safer, more flexible, and more
  stable monetary and financial system.
• Primary functions are
• Monetary policy
• Banking supervision and regulation
• Providing certain services (e.g., check clearing)

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The US Federal Reserve (2)

• The System is composed of 12 regional banks and
  a Board of Governors in Washington, DC
• Governors, the Chairman and Vice-Chairman are
  appointed by the President and confirmed by the
  Senate
• Monetary policy is overseen by the Federal Open
  Market Committee or FOMC which includes
• Board of Governors
• Fed Bank of NY President
• 4 other regional bank presidents on a rotating
  basis

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Monetary Policy (1)

• About every six weeks the FOMC meets to determine
  monetary policy for the US
• In practice, this means determining the target
  for the Federal Funds Rate
• an inter-bank overnight interest rate
• Fed decreases (increases) the Fed Funds rate by
  buying (selling) government securities which
  increases (decreases) the available money supply
• The Federal Reserve Bank of NY makes these
  purchases or sales on the open market--hence the
  name Federal Open Market Committee.

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Monetary Policy (2)
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The Feds Actions around 9/11
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Monetary Policy (3)

• The official objectives of US monetary policy
  are, economic growth in line with the economy's
  potential to expand, a high level of employment,
  stable prices (that is, stability in the
  purchasing power of the dollar), and moderate
  long-term interest rates.
• Conceptually, the Fed will raise (the real)
  interest rate if GDP is greater than Potential
  GDP and vice-versa

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Aside Real vs. Nominal Rates

• It is often said that the interest rate is the
  cost of money. Is this true?
• Ultimately, we use money to obtain consumption
  goods
• Think of the interest rate in terms of trading
  some real amount of consumption in one time
  period for some real amount of consumption in
  another time period
• Note however, borrowing and lending contracts are
  stated in nominal terms.

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Aside Real vs. Nominal Rates

• The real rate of interest (R) can be defined as
  approximately,
• Real Interest Rate
• Nominal Interest Rate - Anticipated Inflation
• In 2004, what was R in the
• the US?
• Japan?

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Monetary Policy (4)

• Potential GDP is the rate of economic activity
  that leads to stable prices and employment
• Intuitively it is the amount of output that is
  generated by utilizing all available resources at
  there highest sustainable level.
• Algebraically, we can think of it as
• PotGDP (aggregate hours available for work)
  x
• (average output per hour)

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Monetary Policy (5)

• Economists often discuss the Potential GDP Growth
  Rate which is approximately
• PotGDP Growth Labor Force Growth Rate
• Productivity Growth Rate
• We can calculate PotGDP Growth with this formula
  for the last 50 years

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Historical Potential GDP
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Better Estimates of PotGDP
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Monetary Policy and the GDP Gap
Note GDP Gap (Actual GDP - PotGDP) / PotGDP
Monetary Policy Regime Change
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NAIRU

• Another way of thinking about potential output is
  the equilibrium rate of unemployment or NAIRU
  (Non-accelerating Inflation Rate of Unemployment)
• NAIRU is the rate of unemployment below which
  there will be inflationary pressures
• The exact level of NAIRU is an issue of debate.
• Most economists believe it is somewhere between
  4 and 6 in the US and Japan. Probably higher
  in Europe (7-8).

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Monetary Policy and NAIRU
Note U-NAIRU is actual unemployment minus NAIRU
and is sometimes called the employment gap.
Monetary Policy Regime Change
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Other Mechanisms for Monetary Policy

• The Fed also has two other ways of controlling
  monetary policy
• The discount rate
• Reserve requirements
• Reserve requirements (rr) directly affect the
  level of money via the money multiplier (1/rr)
• Example, if the reserve requirement is 20 of
  deposits then the money multiplier is 1/0.2 5

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Fractional Reserve Banking

• The Fed buys a 1,000 (market value) treasury
  bond from a bond dealer
• The dealer deposits the 1,000 proceeds into its
  bank, FirstBank
• Money supply increases by 1,000
• FirstBank only has to keep 200 as reserves and
  loans the 800 balance
• FirstBanks Balance Sheet
• Assets Liabilities
• Reserves 200 Deposits 1,000
• Loans 800

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Fractional Reserve Banking (2)

• Assume FirstBank made an 800 computer loan to a
  student. Money supply increases to 1,800
• The student buys a computer at BestBuy which
  deposits the 800 at its bank, SecondBank
• SecondBank also loans out all but 20
• SecondBank Balance Sheet
• Assets Liabilities
• Reserves 160 Deposits 800
• Loans 640
• Now money supply 1,000 800 640 2,440

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Fractional Reserve Banking (3)

• This practice of keeping 20 reserves and loaning
  out the rest continues indefinitely
• However, the ultimate increase in the money
  supply (DMS) is finite and equal to
• DMS DD / rr
• DMS 1,000 / 0.2
• DMS 5,000
• where DD is the original increase in money by
  the Fed
• Mathgeeks note, its a converging geometric
  sequence
• 1xx2x3... 1/(1-x) where x
  (1-rr)

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Fed Reserve Requirements

• Requirement
• Type of Deposit of
  Deposits Effective Date
• Net transaction accounts 0 million-8.5
  million 0 12/21/06 8.5 million-45.8
  million 3 12/21/06 More than 45.8
  million 10 12/21/06
• Nonpersonal time deposits 0 12/27/90
• Eurocurrency liabilities 0 12/27/90
• Required reserves must be held in the form of
  deposits with Federal Reserve Banks or vault
  cash. Nonmember institutions may maintain reserve
  balances with a Federal Reserve Bank indirectly,
  on a pass-through basis, with certain approved
  institutions. Under the Monetary Control Act of
  1980, depository institutions include commercial
  banks, savings banks, savings and loan
  associations, credit unions, agencies and
  branches of foreign banks, and Edge Act
  corporations.
• See also http//www.federalreserve.gov/monetarypo
  licy/0693lead.pdf

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Interest Rates

• There are lots of important USD interest rates
• Federal funds rate
• Discount rate
• Prime rate
• Commercial paper rate
• LIBOR and Eurodollar (similar for other
  currencies)
• T-bill, T-note, T-bond rate
• Swap rates
• Corporate bond rates
• Overnight repurchase rate or Repo rate
• Rates depend on credit risk, liquidity, and
  maturity

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Government Issues
Thru6/07
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Corporate Bonds
Thru6/07
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A Model of the Money Market

• More detail about what affects interest rates
• For now consider money to be M1
• Also we assume that the money supply is
  controlled by the central bank (e.g., the US
  Federal Reserve)
• Specifically, the central bank fixes the amount
  of money in the aggregate economy (MS) at a level
  it desires regardless of other factors

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Individual Money Demand

• Individuals demand for money is based on
• The expected (real) return on money
• Money (M1) pays little or no interest
• gt higher interest rates will lead to less demand
  for money
• The riskiness of the return
• The risk of holding money comes from variation in
  the price level. Why?
• Liquidity
• The primary value associated with money is
  derived from liquidity
• Since a primary use of money is as a medium of
  exchange, this implies an increase in the value
  of individual transactions increases the demand
  for money

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Aggregate Money Demand

• Aggregate money demand is the sum of demand for
  money by all households and firms in the economy
• In aggregate we can say the determinants of the
  aggregate demand for money are
• The interest rate
• The price level (think CPI)
• Real national income (or GNP or GDP)
• Because this determines the need for liquidity

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Aggregate Money Demand

• Define aggregate money demand as
• MD P L(R,Y) or
• MD / P L(R,Y)
• where,
• MD Aggregate money demand
• P Price level
• R Interest rate
• Y Real national income (or GNP or GDP)
• and,
• L decreases as R increases
• L increases as Y increases

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Aggregate Money Demand
Interest Rate (R)
Interest Rate (R)
Increase in Y
L(R,Y2)
L(R,Y)
L(R,Y1)
Aggregate Real Money (M/P)
Aggregate Real Money (M/P)
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Equilibrium in the Money Market

• In equilibrium, MS MD PL(R,Y)

Interest Rate (R)
Real Money Supply
2
R2
Aggregate Real Money Demand L(R,Y)
1
R1
3
R3
Aggregate Real Money (M/P)
Q2
Q3
MS/P
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Increase in Money Supply

• Suppose the money supply increases from M1/P to
  M2/P

Interest Rate (R)
Real Money Supply Increases
1
R1
Aggregate Real Money Demand L(R,Y)
2
R2
Aggregate Real Money (M/P)
M1/P
M2/P
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Increase in GDP

• Suppose real income (GDP) increases from Y1 to Y2

Interest Rate (R)
Real Money Supply
2
R2
1
1
R1
L(R,Y2)
L(R,Y1)
Aggregate Real Money (M/P)
Q1
MS/P