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15 interest rates and monetary policy new

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  • 1. Interest Rates andMonetary PolicyChapter 33McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
  • 2. Chapter Objectives• The equilibrium interest rate andthe market for money• Monetary policy• How the Fed controls the Federalfunds rate• How monetary policy affects GDPand the price level• Effectiveness of monetary policyand its shortcomings33-2
  • 3. Interest Rates• Price paid for the use of money• Many different interest rates• Speak as if only one interest rate• Determined by money supply andmoney demand33-3
  • 4. Demand for Money• Why hold money?• Transactions demand, D1–Determined by nominal GDP–Independent of the interest rate• Asset demand, D2–Money as a store of value–Varies inversely with the interestrate• Total money demand, D 33-4
  • 5. Demand for MoneyRateofinterest,ipercent107.552.5050 100 150 200 50 100 150 200 50 100 150 200 250 300Amount of moneydemanded(billions of dollars)Amount of moneydemanded(billions of dollars)Amount of moneydemanded and supplied(billions of dollars)=+(a)Transactionsdemand formoney, Dt(b)Assetdemand formoney, Da(c)Totaldemand formoney, Dmand supplyDt Da DmSm533-5
  • 6. Interest Rates• Equilibrium interest rate–Changes with shifts in moneysupply and money demand• Interest rates and bond prices–Inversely related–Bond pays fixed annual interestpayment–Lower bond price will raise theinterest rate33-6
  • 7. Federal Reserve Balance Sheet• Assets–Securities–Loans to commercial banks• Liabilities–Reserves of commercial banks–Treasury deposits–Federal Reserve Notes outstanding33-7
  • 8. SecuritiesLoans to CommercialBanksAll Other AssetsTotalReserves of CommercialBanksTreasury DepositsFederal Reserve Notes(Outstanding)All Other Liabilities andNet WorthTotalFebruary 14, 2008 (in Millions)Assets Liabilities and Net WorthSource: Federal Reserve Statistical Release, H.4.1, February 14, 2008$713,36960,039111,689$885,097$ 11,3124,979778,93789,869$885,097Federal Reserve Balance Sheet33-8
  • 9. Central BanksReserve Bank of Australia (RBA)Bank of CanadaEuropean Central Bank (ECB)Bank of Japan (BOJ)Banco de Mexico (Mex Bank)Central Bank of RussiaSveriges RiksbankBank of EnglandFederal Reserve System (the “Fed”)(12 Regional Federal Reserve Banks)Australia:Canada:Euro Zone:Japan:Mexico:RussiaSweden:United Kingdom:United States:Selected Nations33-9
  • 10. Tools of Monetary Policy• Open market operations–Buying and selling of governmentsecurities (or bonds)–Commercial banks and the generalpublic–Used to influence the money supply• When the Fed sells securities,commercial bank reserves arereduced33-10
  • 11. Open Market OperationsNew Reserves$1000$5000Bank System LendingTotal Increase in the Money Supply, ($5,000)Fed buys $1,000 bond from a commercialbank$1000ExcessReserves33-11
  • 12. Open Market OperationsCheck is DepositedNew Reserves$1000Total Increase in the Money Supply, ($5000)Fed buys $1,000 bond from the public$200RequiredReserves$800ExcessReserves$1000InitialCheckableDeposit$4000Bank System Lending33-12
  • 13. Tools of Monetary Policy• The reserve ratio–Changes the money multiplier• The discount rate–The Fed as lender of last resort–Short term loans• Term auction facility–Introduced December 2007–Banks bid for the right to borrowreserves 33-13
  • 14. Tools of Monetary Policy• Open market operations mostimportant• Reserve ratio last changed 1992• Discount rate was a passive tool• Term auction facility is new–Guaranteed amount lent by the Fed–Anonymous33-14
  • 15. The Federal Funds Rate• Rate charged by banks onovernight loans• Targeted by the Federal Reserve• FOMC conducts open marketoperations to achieve the target• Demand curve for Federal funds• Supply curve for Federal funds33-15
  • 16. The Federal Funds RateFederalFundsRate,Percent3.5Quantity of ReservesDfSf34.04.5Sf1Sf2Qf3 Qf1 Qf2Using Open Market Operations33-16
  • 17. Monetary Policy• Expansionary monetary policy–Economy faces a recession–Lower target for federal funds rate–Fed buys securities–Expanded money supply–Downward pressure on otherinterest rates• Contractionary monetary policy 33-17
  • 18. Taylor Rule• Rule of thumb for tracking actualmonetary policy• Fed has 2% target inflation rate• If real GDP = potential GDP andinflation is 2% then target federalfunds rate is 4%• Target varies as inflation and realGDP vary 33-18
  • 19. Monetary Policy• Affect 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 33-19
  • 20. Monetary Policy and GDP10860RateofInterest,i(Percent)Amount of moneydemanded andsupplied(billions of dollars)Amount of investment(billions of dollars)PriceLevelReal GDP(billions of dollars)Q1 Qf Q3$125 $150 $175 $15 $20 $25P2P3Sm1 Sm2 Sm3DmIDAD1I=$15AD2I=$20AD3I=$25(a)The marketfor money(b)Investmentdemand(c)Equilibrium realGDP and thePrice levelAS33-20
  • 21. Expansionary Monetary PolicyProblem: unemployment and recessionFed buys bonds, lowers reserve ratio, lowers thediscount rate, or increases reserve auctionsExcess reserves increaseFederal funds rate fallsMoney supply risesInterest rate fallsInvestment spending increasesAggregate demand increasesReal GDP risesCAUSE-EF33-21
  • 22. Restrictive Monetary PolicyProblem: inflationFed sells bonds, increases reserve ratio, increasesthe discount rate, or decreases reserve auctionsExcess reserves decreaseFederal funds rate risesMoney supply fallsInterest rate risesInvestment spending decreasesAggregate demand decreasesInflation declinesCAUSE-EF33-22
  • 23. Monetary Policy• Advantages over fiscal policy–Speed and flexibility–Isolation from political pressure• Recent U.S. monetary policy• Problems and complications–Recognition lag–Operational lag–Cyclical asymmetry33-23
  • 24. The Big PictureLevels ofOutput,Employment,Income, andPricesAggregateDemandAggregateSupplyInputResourcesWith PricesProductivitySourcesLegal-InstitutionalEnvironmentConsumption(Ca)Investment(Ig)Net ExportSpending(Xn)GovernmentSpending(G)33-24
  • 25. The Mortgage Debt Crisis• Home mortgage default 2007• Banks write off bad loans• Reserves reduced• Fed as lender of last resort• Term auction facility• Fed lowered federal funds rate• Mortgage backed securities as a newinnovation–Bad incentives 33-25
  • 26. Key Terms• monetary policy• interest• transactions demand• asset demand• total demand formoney• open-marketoperations• reserve ratio• discount rate• term auction facility• Federal funds rate• expansionarymonetary policy• prime interest rate• restrictive monetarypolicy• Taylor rule• cyclical asymmetry• mortgage debt crisis33-26
  • 27. Next Chapter Preview…Financial Economics33-27