Econ789 chapter034

Interest Rates and Monetary Policy

Chapter 34

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34-2

Monetary Policy

• Monetary policy is the central bank’s attempt to control the quantity of money and interest rates to achieve its goals.

• Goals of the federal Reserve in the U.S. include• Price stability• Full employment• Economic growth

• A central bank can control money supply through banking system and interest rates in money market.

LO1

34-3

Money Market

• Market interest rate is determined through interaction of demand for money and supply of money in money market.

• Demand for money comes from households and firms.

• Supply of money comes from the Federal Reserve through the banking system.

LO1

34-4

Interest Rates

• Interest rate is an opportunity cost of holding money - the price paid for the use of money

• There are many different interest rates in economy• Short-term interest rate is determined in money

market.• Other interest rates follow the short-term

interest rate changes.

LO1

34-5

Demand for Money

• Two reasons for holding money• Transactions demand• Money as medium of exchange• Households and firms need money for making

payments – they need to carry cash or keep funds in checking accounts.

• Asset demand• Money as store of value• Households and firms keep money for later spending

purposeLO1

34-6

Transaction Demand for Money

• Transactions demand, Dt

• When households and firms want to spend more, then must hold more money.• Households’ income (real GDP)↑

⇒spending↑⇒ money demand↑• Independent of the interest rate

LO1

34-7

Asset Demand for Money

• Asset demand, Da

• Money is one of many alternatives of store of value• Other store of value (e.g. bonds) pays interest

rate. Interest rate is an opportunity cost of holding money rather than bonds.• Interest rate↑⇒demand for bonds↑

⇒demand for money↓ • Varies inversely with the interest rate

LO1

34-8

Demand for MoneyR

ate

of

inte

rest

, i p

erce

nt

10

7.5

5

2.5

0

50 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded


Amount of moneydemanded and supplied


=+

(a)Transactionsdemand formoney, Dt

(b)Asset

demand formoney, Da

(c)Total

demand formoney, Dmand supply

Dt Da Dm

LO1 33-8

34-9

Supply of Money

• Money supply is the total quantity of money in economy • M1 includes currencies and checkable deposits

• Money supply is determined by • the reserves injected by the Federal Reserve • the multiplier process in the banking system.

• Money supply curve is vertical at the actual quantity of money in economy.

LO1

34-10

Money Market Equil ibrium

Rat

e o

f in

tere

st, i

per

cen

t

10

7.5

5

2.5

0

50 100 150 200 250 300

Amount of moneydemanded and supplied


Dm

Sm

LO1 33-10

• The demand for money and supply of money determine the equilibrium in money market and the equilibrium interest rate.

Em

34-11

Equil ibrium Interest Rates

• Changes in money demand or money supply affect the equilibrium interest rate.

• The Federal Reserve controls the money supply. By changing money supply the Federal Reserve can control the equilibrium interest rate in money market.• However, the Federal Reserve cannot control both

money supply and interest rate. It must choose a combination of money supply and interest rate along the money demand curve.

LO1

34-12

Money Supply and Interest Rate

10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)

Amount of moneydemanded and

supplied(billions of dollars)

$125 $150 $175

Sm2 Sm1 Sm3

Dm

(a)The marketfor money

LO5

• A decreases in money supply

• An increases in money supply

increases the equilibrium interest rate.

decreases the equilibrium interest rate.

34-13

How to Control Money Supply

• The money supply is sum of currencies and checkable deposits.

• The Federal Reserve can issue new currencies or withdraw old currencies from circulation.

• The Federal Reserve can change the quantity of reserves in banking system, which affects the quantity of checkable deposits through the multiplier process.

• The Federal Reserve can affect the money multiplier, which affects the quantity of checkable deposits.

LO3

34-14

Tools of Monetary Policy

• Fed’s tools to control reserves• Open market operations

• Buying and selling of government securities

• Discount window operations• Discount loan: Fed’s loans to banks

• Discount rate: Interest rate on discount loan

• Fed’s tool to change multiplier

• Required reserve ratio

LO3

34-15

Open Market Operations

• Buying from and selling of government securities (or bonds) to commercial banks and the general public

• Most frequently used to influence the money supply• Fed sells securities to bank ⇒ bank reserves ↓

⇒ through money creation process loans and deposits↓⇒ Money supply ↓

• Fed buys securities to bank ⇒ bank reserves ↑ ⇒ through money creation process loans and deposits↑⇒ Money supply ↑

LO3

34-16

Tools of Monetary Policy

• Fed buys bonds from commercial banks

Assets Liabilities and Net Worth

Federal Reserve Banks

+ Securities + Reserves of Commercial Banks

(b) Reserves

Commercial Banks

-Securities (a)

+Reserves (b)

Assets Liabilities and Net Worth

(a) Securities

LO3

34-17

Open Market Operations

• Fed buys $1,000 bond from a commercial bank

New Reserves

$5000Bank System Lending

Total Increase in the Money Supply, ($5,000)

$1000Excess

Reserves

LO3

34-18

Discount Windows Operations

• The discount loans• Short term loans

• The Fed changes the discount rate to encourage or discourage banks to borrow from the Fed

• Passive monetary policy tool – it depends on bank’s decision on borrowing from the Fed

• Lender of last resort: if no other banks want to make a loan, the Fed stands to make the loan.

• Term auction facility• Introduced December 2007

• Banks bid for the right to borrow reserves

• Guaranteed amount lent by the FedLO3

34-19

Required Reserve Ratio

• The reserve ratio• Changes the money multiplier• Reserve ratio last changed in 1992

• Interest on reserves• Lower interest rate or even negative interest rate

will discourage banks to hold excess reserves

LO3

34-20

Federal Funds

• Federal Funds: Interbank overnight loans• Each bank must meet its reserve requirement every

day. Banks with short of reserves borrow funds from other banks with excess reserves.

• Federal funds rate: Interest rate on the federal funds

• The federal funds rate is determined by the demand and supply of the federal funds

• Demand and supply of the federal funds are affected by loans, deposits and reserves in banking system

34-21

The Federal Funds Rate

• The federal funds rate affects all other bank interest rates• Instead of trying to affect all interest rates in economy, the

Federal Reserve targets the federal funds rate which in turn sets other interest rates

• FOMC (Federal Open Market Committee) conducts open market operations to achieve the target• Open market operations directly affect the bank reserves

• Reserves ↑ ⇒ Supply of Federal funds ↑ & Demand for Federal funds ↓ ⇒ federal funds rate ↓• Reserves ↓ ⇒ Supply of Federal funds ↓ & Demand for

Federal funds ↑ ⇒ federal funds rate ↑

34-22

Monetary Policy

• Two types of Monetary Policy• Expansionary monetary policy: Used to “Expand”

the economy during a recession by “Expanding” money supply

• Contractionary (Restrictive) monetary policy: Used to “Contract” the economy during inflation by “contracting” money supply

LO4

34-23

Expansionary Monetary Policy

• When Economy is at below-full-employment equilibrium• Unemployment rate is higher than natural rate• Recessionary gap: Real GDP is below potential GDP

• To restore the full-employment equilibrium• Either AD or AS should increase• Real GDP increases• Unemployment rate decreases

LO4

34-24


• To restore the full-employment equilibrium ⇒ Fed lowers target for Federal funds rate⇒ Fed buys securities in Open market operation ⇒ Money supply increases⇒ Interest rate decreases⇒ Investment and consumption increase⇒ AE increases⇒ AD increases⇒ Real GDP increases

LO4

34-25


10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)



Amount of investment (billions of dollars)

Pri

ce

Le

vel

Real GDP(billions of dollars)

$180 $200$125 $150 $15 $20

100

90

Sm1 Sm2

IDAD1

I=$15

AD2

I=$20


(b)Investment

demand

(c)Equilibrium real

GDP and thePrice level

AS

LO5

Recessionary Gap

PGDP

Dm

Fed increases money supply

Investment increases

Aggregate demand increases

Interest rate decreases

Real GDP increases

34-26

Contractionary Monetary Policy

• When Economy is at above-full-employment equilibrium• Unemployment rate is lower than natural rate• Inflationary gap: Real GDP is above potential GDP• Price level is high & inflation is imminent

• To restore the full-employment equilibrium• Either AD or AS should decrease• Real GDP decreases• Price level decreases

LO4

34-27


• To restore the full-employment equilibrium ⇒ Fed raises target for Federal funds rate⇒ Fed sells securities in Open market operation ⇒ Money supply decreases⇒ Interest rate increases⇒ Investment and consumption decrease⇒ AE decreases⇒ AD decreases⇒ Real GDP decreases

LO4

34-28


10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)



Amount of investment (billions of dollars)

Pri

ce

Le

vel

Real GDP(billions of dollars)

$220$200$175$150 $25$20

100

110

Sm1Sm2

ID

AD1

I=$25AD2

I=$20


(b)Investment

demand

(c)Equilibrium real

GDP and thePrice level

AS

LO5

Inflationary Gap

PGDP

Dm

Fed decreases money supply

Investment decreases

Aggregate demand decreases

Interest rate increases

Real GDP decreases

34-29

Evaluation and Issues

• Advantages over fiscal policy• Speed and flexibility• Change the target federal funds rate

immediately • Change the money supply by any amount• Reverse the policy course easily if necessary

• Isolation from political pressure• Federal Reserve officers are appointed and

serve for a long term

LO6

34-30

Problems and Complications

• Lags: May not show effects in timely manner• Even though it can affect interest rate quickly, it takes time

to affect money supply and investment spending

• Passive: Fed cannot directly affect aggregate demand, but rely on banks’ and firms’ actions

• Cyclical asymmetry: Not effective during depression• When expected return on projects are low and risk is high,

low interest rate will not affect investment decision

• Liquidity trap: When interest rate is already low near zero, it cannot further lower the interest rate to stimulate investment.

LO5 33-30

34-31

Taylor Rule

• Due to lags, discretionary monetary policy may cause instability of economy

• Set a simple rule for monetary policy• Set a target inflation rate (2%)• Set a target real interest rate (2%)• At full employment, the Fed maintains the target

(nominal) federal funds rate (4% = 2% + 2%)• Raise the federal funds rate by ½% for every 1%

increase in real GDP over potential GDP• Raise the federal funds rate by ½% for every 1%

increase in inflation rateLO4

34-32

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

LO6

34-33

Long Run Effect of Monetary Policy

• Equation of Exchange: MV = PQ• M: Money supply

• V: Velocity of money – an average number of times per year a dollar is spent

• P: Price level

• Q: Quantity of goods & service produced (real GDP)

• PQ = nominal GDP

• V is assumed to be stable and changes slowly over time. It depends on payment system in economy.

LO5 33-33

34-34

Long Run Effect of Monetary Policy

• Equation of Exchange in growth rates

%∆M + %∆V = %∆P + %∆Q

• Two assumptions:•If velocity is constant, %∆V = 0.

•Real GDP (potential GDP) grows constant over time (e.g. %∆Q = 4%)

• Money supply growth rate directly relates to inflation rate•If money supply grows at 6%, the price level will increase by 2% (= 6% - 4%).

LO5 33-34

Econ789 chapter034

Economy & Finance