Chapter 15 - Interest rates and monetary policy. This chapter starts by introducing the transactions and asset demand for money and explaining how the interaction of the demand and supply of money determines the interest rates in the market. We will learn about tools other than open market operations that the Fed might use to manipulate the money supply and the reasons that these tools are chosen, or not chosen.
Chapter 15 Interest Rates and Monetary Policy McGrawHill/Irwin Copyright © 2013 by The McGrawHill Companies, Inc. All rights reserved Copyright © 2014 by The McGrawHill Companies, Inc. All rights reserved 11 Interest Rates • The price paid for the use of money • Many different interest rates • Speak as if only one interest rate • Determined by the money supply and money demand 152 Types of Interest Rates Type of Interest Rate Annual Percentage 20-year Treasury Bond rate (interest rate on federal government security used to finance the public debt) 4.05% 90-day Treasury Bill rate (interest rate on federal government security used to finance the public debt) 0.02 Prime interest rate (interest rate used as a reference point for a wide range of bank loans) 3.25 30-year mortgage rate (fixed-interest rate on loans for houses) 4.60 4-year automobile loan rate (interest rate for new autos by automobile finance companies) 4.05 Tax-exempt state and municipal bond rate (interest rate paid on a low-risk bond issued by a state or local government) 4.65 Federal funds rate (interest rate on overnight loans between banks) 0.08 Consumer credit card rate (interest rate charged for credit card purchases) 14.42 153 Global Snapshot Short-Term Interest Rate, 2011 154 Demand for Money • Why hold money? • Transactions demand, Dt • Determined by nominal GDP • Independent of the interest rate • Asset demand, Da • Money as a store of value • Varies inversely with the interest rate • Total money demand, Dm 155 Rate of interest, i percent Demand for Money (a) Transactions demand for money, Dt (c) Total demand for money, Dm, and supply (b) Asset demand for money, Da Sm 10 7.5 =5 + 2.5 Dt 50 100 150 Dm Da 200 Amount of money demanded (billions of dollars) 50 100 150 200 Amount of money demanded (billions of dollars) 50 100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) 156 Interest Rates • Equilibrium interest rate • Changes with shifts in money supply • and money demand Interest rates and bond prices • Inversely related • Bond pays fixed annual interest payment • Lower bond price will raise the interest rate 157 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 158 Tools of Monetary Policy • The reserve ratio • Changes the money multiplier • The discount rate • The Fed as lender of last resort • Short-term loans 159 The Reserve Ratio Effects of Changes in the Reserve Ratio (6) (7) MoneyMoneyCreating Creating Potential of Potential of Single Bank, Banking = (5) System (1) Reserv e Ratio, % (2) Checkabl e Deposits (3) Actual Reserves (4) Required Reserves (5) Excess Reserves, (3) –(4) (1) 10 $20,000 $5,000 $2,000 $3,000 $3,000 $30,000 (2) 20 20,000 5,000 4,000 1,000 1,000 5,000 (3) 25 20,000 5,000 5,000 0 (4) 30 20,000 5,000 6,000 -1,000 -1,000 -3,333 1510 Tools of Monetary Policy • Open-market operations are the most • • important Reserve ratio last changed in 1992 Discount rate was a passive tool 1511 Monetary Policy • Expansionary monetary policy • Economy faces a recession • Fed buys securities • Lower the reserve ratio • Lower the discount rate LO2 1512 Monetary Policy • Restrictive monetary policy • Periods of rising inflation • Sell securites • Increase the reserve ratio • Raise the discount rate 1513 Monetary Policy, Real GDP, Price Level • Effect 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 1514 (a) The market for money Sm1 Sm2 (b) Investment demand Equilibrium real GDP and the price level Sm3 AS P3 10 Price Level Rate of Interest, i (Percent) Monetary Policy and Equilibrium GDP (c) P2 Dm AD3 I=$25 AD2 I=$20 AD1 I=$15 $125 $150 $175 Amount of money demanded and supplied (billions of dollars) ID $15 $20 $25 Amount of investment (billions of dollars) Q1 Qf Q3 Real GDP (billions of dollars) 1515 Expansionary Monetary Policy Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, or lowers the discount rate Excess reserves increase Federal funds rate falls Money supply rises F E- ES UAC Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises 1516 Restrictive Monetary Policy Problem: Inflation Fed sells bonds, increases reserve ratio, or increases the discount rate Excess reserves decrease Federal funds rate rises Money supply falls F E- ES UAC Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines 1517 Monetary Policy in Action • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy is more subtle than fiscal policy 1518 Federal Funds Rate • Rate banks charge each other on • LO4 overnight loans Easy for the Fed to target 1519 Monetary Policy 10 Prime interest rate Percent Federal funds rate 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year 1520 Recent U.S. Monetary Policy • Highly active in recent decades • Responded with quick and innovative • actions during the recent financial crisis and the severe recession Critics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long 1521 Problems and Complications • Lags • Recognition and operational • Cyclical asymmetry • Liquidity trap 1522 The Financial Crisis • The Fed’s lender-of-last-resort activities • Primary Dealer Credit Facility • Term Securities Lending Facility • Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility • Commercial Paper Funding Facility 1523 The Financial Crisis • Money Market Investor Funding • • Facility Term Asset-Backed Securities Loan Facility Interest Payments on Reserves 1524 ... =5 + 2.5 Dt 50 100 150 Dm Da 200 Amount of money demanded (billions of dollars) 50 100 150 200 Amount of money demanded (billions of dollars) 50 100 150 200 250 300 Amount of money demanded and... 5,000 6,000 -1 ,000 -1 ,000 -3 ,333 15 10 Tools of Monetary Policy • Open-market operations are the most • • important Reserve ratio last changed in 1992 Discount rate was a passive tool 15 11 Monetary Policy... reduced 15 8 Tools of Monetary Policy • The reserve ratio • Changes the money multiplier • The discount rate • The Fed as lender of last resort • Short-term loans 15 9 The Reserve Ratio Effects of