16 Interest Rates and Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Definitions Total (Actual) Reserves: Amount of money a bank holds (has available) Total Reserves = Required Reserves Excess Reserves + Required Reserves: Fraction of actual reserves a bank must keep (can’t be loaned) Reserve Ratio: Percentage of demand deposits bank must maintain for required reserves LO1 Definitions Excess Reserves: Amount of actual reserves the bank has to loan Excess Reserves = Total Reserves – Required Res Monetary multiplier (m) = 1/Reserve Ratio LO1 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 LO1 Central Banks LO2 Tools of Monetary Policy Monetary policy is the manipulation of the money supply by changing bank’s excess reserves LO1 Tools of Monetary Policy Four tools of monetary policy 1.Open market operations 2.The required reserve ratio 3.The discount rate 4.Interest on reserves LO1 Tools of Monetary Policy • Open market operations • Buying and selling of government securities (or bonds) by the Fed • Most important tool to change the money supply LO2 Tools of Monetary Policy To increase Sm, Fed can buy securities from bank or public I.E Fed buys $1,000 security from commercial bank, reserve ratio is 20% LO2 Tools of Monetary Policy • Fed pays for securities by increasing bank’s actual reserves by $1,000 • Since bank doesn’t have to maintain required reserves for money from Fed, excess reserves increase by $1,000 LO2 Repos and Reverse Repos • Collateralized loans • Repo transaction – Fed loans money in exchange for government bonds used as collateral • Reverse Repo – Fed borrows money from financial institutions and uses government bonds as collateral LO2 Tools of Monetary Policy • The reserve ratio • Changes the money multiplier • Reduce reserve ratio to increase money supply • Increase reserve ratio to reduce money supply LO2 Tools of Monetary Policy • LO2 The discount rate – Lender of Last Resort • Interest rate on loans from Fed to banks • Lower discount rate to increase money supply • Increase discount rate to reduce money supply Tools of Monetary Policy • LO2 Interest on reserves – law changed 2008 • Increase interest rate on reserves • Banks will leave more reserves with Fed • Decrease money supply • Decrease interest rate on reserves • Banks will leave fewer reserves with Fed • Increase money supply Tools of Monetary Policy • Reserve ratio changes bank’s • • LO2 profitability Discount rate is a passive tool until financial crisis Interest on reserves is too new The Federal Funds Rate • Rate charged by banks on overnight • • • LO3 loans Targeted by the Federal Reserve when changing the money supply Prime interest rate is directly related to the Federal funds rate Prime interest rate is charged on loans to most credit-worthy customers Monetary Policy LO3 Monetary Policy • Expansionary monetary policy • Economy faces a recession • Increase money supply, interest rates fall • Lower target for federal funds rate • Fed buys securities • Lower reserve ratio • Lower discount rate • Decrease interest on reserves LO3 Expansionary Policy after Debt Crisis • Trillions of dollars in excess reserves • Zero lower bound problem • Economy didn’t expand, interest rates already at zero • Negative nominal interest rates • Deposits withdrawn from banking system • Less money for banks, decrease in money supply • Quantitative easing • No impact on interest rates • Increases excess reserves of banks LO5 Monetary Policy • Restrictive monetary policy • Periods of rising inflation • Decreases money supply, interest rates rise • Increase target Federal funds rate • Fed sells securities • Raise reserve ratio • Raise discount rate • Increase interest on reserves LO3 Restrictive Policy after Debt Crisis • In 2015, attempt to “normalize” interest rates • to 3% or higher Normalization process: • Raise interest on excess reserves (IOER) which could cause banks to increase their interest rates • Reverse repos with nonbanks to keep the federal funds rate higher than IOER • Hasn’t really used since there has been no reason for tight money LO5 Taylor Rule • Rule of thumb for tracking actual • • • LO3 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 Evaluation and Issues • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy more subtle than fiscal policy LO5 Recent U.S Monetary Policy • Highly active in recent decades • Quick and innovative actions • LO5 during recent financial crisis and severe recession Critics contend Fed contributed to crisis by keeping Federal funds rate too low for too long Problems and Complications • Lags • Recognition and operational • Cyclical asymmetry • Liquidity trap LO5