Sources of Interest-Rate Fluctuations: Nominal Interest Rates Money and Banking Money and Banking Mr. Vaughan Updated: 2/18/09.

Sources Sources of of

Interest-Rate Fluctuations:Interest-Rate Fluctuations:

Nominal Interest RatesNominal Interest Rates

Money and BankingMoney and BankingMr. VaughanMr. Vaughan

Updated: 2/18/09

After this lecture, you will be able to:

• Explain how changes in expected inflation affect nominal interest rates in long run.

• Describe how monetary growth affects inflation in long run.

• Trace effects of monetary policy on nominal interest rate in short run and long run.

Learning Objectives:Learning Objectives: Part II – Nominal Interest RatePart II – Nominal Interest Rate

2Total Slides: 34

Recall: • Borrowers and lenders care about real interest rate.• But, financial markets set most interest rates in

nominal terms. • So, borrowers and lenders must guess about inflation

rate.

Real Interest Rate Real Interest Rate ++ Expected Inflation Expected InflationNominal Interest RateNominal Interest Rate

Fisher EquationFisher Equation

3Total Slides: 34

Expected Actual

Real Interest Rate 3% ?

Inflation 0% 3%

Nominal Interest Rate ? 3%

Debtors Win/Creditors Lose!

Guessing Wrong Is Costly!Guessing Wrong Is Costly!

4Total Slides: 34

Expected Actual

Real Interest Rate 3% ?

Inflation 3% 0%

Nominal Interest Rate ? 6%

Creditors WinCreditors Win/Debtors Lose!/Debtors Lose!

Guessing Wrong Is Costly!Guessing Wrong Is Costly!

5Total Slides: 34

To avoid losses, debtors and creditors: use all useful information. learn rapidly from mistakes. react quickly to changes in expected inflation.

Implications: “Rational” Expectations = Random forecast errorsChanges in inflation expectations move bond

demand/supply and nominal interest rate rapidly.

Expectations and Nominal RatesExpectations and Nominal Rates

6Total Slides: 34

Quantity of Bonds ($)

NominalInterest Rate

Bond Supply1

Bond Demand1

ia

Qa

Increase in expected inflation reduces expected return on bonds and, thus,

bond demand. a

Bond Demand2

ib

Qb

b

Fisher EquationFisher EquationIn PicturesIn Pictures

7Total Slides: 34

Quantity of Bonds ($)

NominalInterest Rate

Bond Supply1

Bond Demand1

ib

Qb

Increase in expected inflation reduces real cost

of borrowing and, thus, increases bond supply.

b

Bond Supply2

ic

Qc

c

Fisher EquationFisher EquationIn PicturesIn Pictures

8Total Slides: 34

Q*

Bond Supply2

ic

Quantity of Bonds ($)

NominalInterest Rate

Bond Supply1

Bond Demand1

ia

Absent distortions, nominal interest rate will

rise by increase in expected inflation.

expected inflation

a

Bond Demand2

c

Fisher EquationFisher EquationIn PicturesIn Pictures

9Total Slides: 34

NoteNote:: Inflation trends explainInflation trends explain• Rising rates before early 1980s• Falling rates since 1980s• Rate volatility since 1950s

Fisher Equation:Fisher Equation:EvidenceEvidence

10Total Slides: 34

……But what causes (changes in) inflation? But what causes (changes in) inflation?

“Inflation is always and everywhere a monetary phenomenon.”

Milton FriedmanHis Point? In short run, many factors can boost general level of prices Only sustained growth in money supply can produce sustained

rise in prices.

First things first: What is “money?”

11Total Slides: 34

Money in U.S. EconomyMoney in U.S. Economy

Money Supply: Total quantity (dollar volume) of assets providing medium-of-exchange services Currency: Paper bills & coins in public hands. Checkable Deposits: Bank balances depositors can

access on demand by writing check (demand deposits, NOWs)

Traveler’s Checks

This functional definition is M1 (narrow money).

12Total Slides: 34

U.S. Money StockU.S. Money StockTwo MeasuresTwo Measures

As of October 2008 (Seasonally Adjusted)

Everything in M1

M1 = $1,473.1 billion

M2 = $7,878.9 billion

$ Billions

0

$1,473.1

$7,878.9

•Savings Deposits = $4,032.3

•Small Time Deposits = $1,314.0

•Money Market Mutual Funds = $1,059.6

Total = $6,405.8 billion

•Currency = $795.0•Checkable Deposits = $672.4 •Traveler’s Checks = $5.8

Note: - Currency only 10.1% of M2- Checkable deposits only 8.5% of M2

M2 is “Broad” money – Better measure for policy, scientific purposes13Total Slides: 34

How correlated are M’s?How correlated are M’s?

14Total Slides: 34

Money and InflationMoney and InflationQuantity Theory of MoneyQuantity Theory of Money

Quantity Theory Quantity Theory starts with equation of exchange:

M = Money Supply v = Income Velocity of Money

Average number of times per period each dollar of money supply is spent on nominal GDP

P = GDP Deflator / 100 (general price level)

y = Real GDPNote: P x y = Nominal GDP Equation is tautology (needs assumptions to become theory)

M x v = P x y

15Total Slides: 34

Quantity Theory of MoneyQuantity Theory of MoneyAssumptionsAssumptions

M = Exogenously determined (by government)

v = Not influenced by money (in short run relatively stable)

Determined by “real” factors such as payments technology/institutions, tastes, etc.

y = Not influenced by money (in short run) Determined by “real” factors such as technology, factor

endowments, societal commitment to markets/property rights, etc.

16Total Slides: 34

Quantity Theory of MoneyQuantity Theory of MoneyAssumptions Reasonable?Assumptions Reasonable?

17

Quantity Theory of MoneyQuantity Theory of MoneyImplications of AssumptionsImplications of Assumptions

Equation of Exchange (rate of change form):

Note: If growth in velocity and real output are determined exogenously

by real factors, then changes in prices (only endogenous variable) must be determined by changes in money supply.

Quantity Theory focuses on long run, not short run.

%ΔM + %Δv = %ΔP + %Δ y

18Total Slides: 34

Quantity Theory of MoneyQuantity Theory of MoneyU.S. EvidenceU.S. Evidence

PeriodMoney (M2)

Growth(Average)

Velocity Growth(Average)

Inflation Rate

(Average)

Real GDP Growth(Average)

(1) 1959:Q1 -

1983:Q4 8.4% 0.1% 4.8% 3.6%

(2) 1983:Q4 -

2008:Q45.5% 0.1% 2.5% 3.0%

Notes: All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures

Source: U.S. Department of Commerce, Board of Governors of Federal Reserve

NOTE: Money growth and inflation lower in period (2)!

19Total Slides: 34

Source: McCandless and Weber, 1995

Note:

1. Each point represents 30-year average annual money growth and 30-year average annual inflation

2. All points lie near/on 45-degree line.

Quantity Theory of MoneyQuantity Theory of MoneyCross-Country EvidenceCross-Country Evidence

20Total Slides: 34

Excessive Growth of Money Supply

Excessive Spending on Goods and Services

Inflation

Long-Run Real Growth ≈ 3.2%

Proximate Cause of InflationProximate Cause of InflationExcessive Monetary GrowthExcessive Monetary Growth

Faster than economy’s long-run real growth rate

21Total Slides: 34

Money Supply (M2) Growth: 7.0%

Inflation: 3.7%

Average Annual RatesUnited States

1959:Q1-2008:Q4

Real GDP Growth:

3.3%

VelocityGrowth:

0.1%

Money Growth and InflationMoney Growth and InflationU.S. EvidenceU.S. Evidence

22Total Slides: 34

Money and Nominal Rates Money and Nominal Rates Cross-Country EvidenceCross-Country Evidence

Monetary growth => Inflation => Nominal Interest Rates

Source: Monnet and Weber, 2001

Note:Each point represents average

annual money growth and average annual inflation (circle/square represents average values for one country, 1961-1998).

23Total Slides: 34

Source: Monnet and Weber, 2001

Note:Each point represents average annual

money growth and average annual inflation (circle/square represents average values for one country, 1961-1998).

Money and Nominal RatesMoney and Nominal RatesCross-Country EvidenceCross-Country Evidence

24Total Slides: 34

Money and Nominal Rates Money and Nominal Rates U.S. EvidenceU.S. Evidence

Monetary growth => Inflation => Nominal Interest Rates

25Total Slides: 34

• Fed implements monetary policy by purchasing/selling Treasuries.

• Transactions are called open-market operations.

– Open-market purchases increase bank reserves and reduce bond supply.

– Open-market sales reduce bank reserves and increase bond

supply.

Short-term effect on nominal interest rate is called liquidity effect.

Money and Nominal Rates Money and Nominal Rates Short RunShort Run

26Total Slides: 34

Bond Supply1

aia

Qa Quantity of Bonds

NominalInterest Rate Bond Demand1

Suppose Fed buys Treasuries in open

market. Bond supply will fall, and nominal interest rate will fall.

Bond Supply2

ib

Qb

b

Example:Example:Fed in ActionFed in Action

27Total Slides: 34

Fed buys and sells Treasuries to stabilize economy. • Weakening economy: Fed buys Treasuries to lower

interest rates and stimulate economy.• Overheating economy: Fed sells Treasuries to raise

interest rates and slow economy.

Why ConductWhy ConductOpen-Market Operations?Open-Market Operations?

28Total Slides: 34

• Balancing short-run goalsshort-run goals of monetary policy (a stable, high-growth economy) with long-run goalslong-run goals (low inflation) is challenging.

• High inflation and nominal interest rates of 1970s1970s were due to excessive focusexcessive focus on short runshort run.

Art of Central BankingArt of Central Banking

29Total Slides: 34

Does easy money lower nominal interest rate?

Short runShort run: : Open-market purchases lower nominal interest rate.

Long runLong run::When economy perks up, nominal rate starts rising.If monetary stimulus is excessive, inflation starts rising.Bond demanders/suppliers adjust inflation expectations, further raising nominal rate.

Putting It All TogetherPutting It All TogetherLinking the Long and Short RunLinking the Long and Short Run

30Total Slides: 34

Does easy money lower nominal interest rates?

Time

Nominal Interest Rate

0

Initial rate

Longrun

Shortrun

Time path of actual nominal rates

Putting It All TogetherPutting It All TogetherLinking the Long and Short RunLinking the Long and Short Run

31Total Slides: 34

Why were nominal rates lower in later period?

YearAverage3-Month

T-Bill RateYear

Average3-Month

T-Bill Rate

1978 7.2% 1993 3.0%

1979 10.0% 1994 4.3%

1980 11.5% 1995 5.5%

1981 14.0% 1996 5.0%

1982 10.7% 1997 5.1%

You try it!You try it!

32Total Slides: 34

Money growth and inflation were lower!Money growth and inflation were lower!

Year

Prior Year's Money Growth

(M2)

Inflation Rate (CPI)

Average 3-Month

T-Bill Rate

Year

Prior Year's Money Growth

(M2)

Inflation Rate (CPI)

Average 3-Month

T-Bill Rate

1978 10.3% 7.6% 7.2% 1993 1.6% 3.0% 3.0%1979 7.5% 11.3% 10.0% 1994 1.5% 2.6% 4.3%1980 7.9% 13.5% 11.5% 1995 0.4% 2.8% 5.5%1981 8.6% 10.3% 14.0% 1996 4.1% 3.0% 5.0%1982 9.7% 6.2% 10.7% 1997 4.8% 2.3% 5.1%

Yearly Average (1978-82)

8.8% 9.8% 10.7%Yearly

Average (1978-82)

2.5% 2.7% 4.6%

You try it!You try it!

33Total Slides: 34

Sources Sources of of

Interest-Rate Fluctuations:Interest-Rate Fluctuations:

Nominal Interest Rates?Nominal Interest Rates?

Money and BankingMoney and BankingMr. VaughanMr. Vaughan

Questions Questions overover

Total Slides: 34