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Interest Rates Presentation.ppt
- 1. A Citizen’s Guide toInterest Rates What most people don’t know about what really makes our economy go. (…… but should)
- 2. The Secret Lifeof Interest Rates • The most important thing that interest rates do is to act as signals for the market. • Signal to save or borrow and spend. • ir also serve to ration the available supply of money to those who are willing and able to use it most efficiently in the long run. • Act as an automatic stabilizer to inflation.
- 3. Rationale • Much ofthe internal doings of the U.S. (and World) economy have to do with monetary and fiscal policy decisions which affect interest rates. • Any understanding of Economics is incomplete without knowledge of how interest rates affect and are affected by every other component of the economy. • Savings and Investment in Capital are where the individual interfaces with these policies. • Most individuals understand interest rates imperfectly if at all.
- 4. Key Topics Regardingir • Identify models that should be used to demonstrate economic theories and discuss when to use which model. • Identify important concepts and how to apply them. • Discuss ir using appropriate vocabulary balancing jargon with concrete explanations in plain English.
- 5. Key Concepts • Whatare Interest Rates? • Real vs. Nominal • Money Supply and the Federal Reserve • Money Demand • Loanable Funds Market • Fiscal policy and its impact on interest rates • Crowding-Out Effect • Bond Market • Foreign Capital Injections and Leakages
- 6. The Relation BetweenCapital Investment and Interest Rates • Interest Rates DETERMINE the quantity of Capital Investment and Savings in the Economy. • Interest is the Opportunity Cost or “Price” paid for the use of money • Borrowers pay lenders for money to be used now, and repay later with interest • Savers earn interest because they are letting a lender use their money now • Lenders are financial intermediaries. • Interest rate is stated as a percentage
- 7. Real ir vs.Nominal ir • Appropriate abbreviations for Interest rate include “ir”, “i”, and “r” (always lower-case) • Nominal: loosely means “in name only” • Nominal ir discussed in terms of current price level • Real: loosely means “adjusted for inflation” • Real ir discussed in terms of actual purchasing power.
- 8. How Nominal andReal Relate • (Calculate) Nominal ir – Inflation Rate = Real ir • If Nominal ir goes up, Real ir doesn’t necessarily increase. • If Real ir goes up, Nominal ir will follow.
- 9. Graphic Models forir • Interest rates play a role in various graphic models, the key is to figure out if they are nominal or real ir. • The Money Market Model is used to discuss the supply of money as defined by the FED. (nominal ir) • The Loanable Funds Market is used to reflect the saving and borrowing habits of the private sector. (real ir)
- 10. Money Market Model •Used to target the Fed Funds Rate through monetary policy. • Nominal ir • Should be used in conjunction with AD/AS and Investment Demand models (Next Slide) Money Market Model Nominal ir ir ir1 MS MS1 MD QM QM1 Quantity of Money
- 11. Money Market Linkedto Demand for Capital Investment Expansionary Policy MS MS1 MD Nominal ir ir ir1 QM QM1 Quantity of Money Investment Demand I Nominal ir I I1 Quantity of Capital Investment
- 12. Investment Linked toAD/AS Investment in Capital Nom -inal ir I ir ir1 0 I I1 Quantity of Capital Investment Price level PL1 PL Y Y1 SRAS AD (C+I+G) AD1 (C+I1+G) Real Gross Domestic Product Expansionary Policy
- 13. Loanable Funds Market •The Demand Curve for LF represents private demand for Loanable Funds. • The Supply Curve for LF represents private savings. • LF model represents the real ir. (abbrev. “r”) • Supply of LF (savings) sets the Prime Lending Rate. • Government borrowing to cover deficit spending will move DLF to the right. • Changes in the savings habits of the private sector shift SLF Loanable Funds Market Real ir Quantity of Loanable Funds DLF SLF r QLF
- 14. Loanable Funds Theoryof Interest • The supply of loanable funds comes from savers who deposit money in banks. • Supply is positively-sloped because people need an incentive to delay current spending. • Demand is negatively-sloped since higher ir discourage borrowing and spending. • Government borrows money from this market when taxes don’t cover the bills.
- 15. Control of InterestRates • The majority of influence on interest rates comes from the private sector. • Rates react to changes in the individual desire of private citizens to consume or invest in capital. (or to save…) • Investment spending and the interest sensitive components of consumption spending are inversely related to interest rates. • The desire to save is positively related to ir.
- 16. Definitions of Money •The Money Supply is broken down into three categories: M1: Cash, Currency, Checkable Deposits, NOW accounts, etc… M2: Savings (under $100,000), Short time deposits, CD’s, MMF’s, etc… M3: Deposits in excess of $100,000 and other long time deposits
- 17. The Demand forMoney • This is a uniquely Macroeconomic concept • At any given time, there is a finite quantity of money in circulation (M2 is Inelastic). • The transaction demand (M1) depends on GDP because incomes = expenditures.
- 18. Fiscal Policy • Mostexpansionary government spending programs are financed through borrowing. • Budget deficits will increase the demand for loanable funds and cause real ir to rise • Contractionary fiscal policy will cause budget surplus • Budget surplus will reduce the demand for money and reduce interest rates
- 19. Deficit Spending • Governmentdemands loanable funds to pay for deficit fiscal spending • By increasing the D for LF, the real ir increases. Loanable Funds Mkt. Qty. of Loanable Funds Real ir
- 20. Crowding Out • Theincreased real ir caused by deficit fiscal spending causes a decrease in private Investment spending and the interest-sensitive component of Consumption spending. • This lost investment and consumption is said to have been crowded out. • Crowding out is an effect, never a cause.
- 21. Crowding Out andAD/AS Deficit Fiscal Policy SLF (Private Savings) DLF (Private Demand) DLF1 (Private + Government) Real ir r1 r QLF QLF1 AD (C+I+G) AD1 (C+I+G1) AD2 (C+(I-I1)+G1) Price Level AD shifts to AD1 when G increases Then shifts back to AD2 as I falls due to the increase in interest rates. Pl1 Pl2 PL Y Y2 Y1 Quantity of Loanable Funds Real Gross Domestic Product SRAS
- 22. Barro-Ricardo Effect • TheBarro-Ricardo Effect is feedback caused by a Crowding Out effect. • Higher interest rates associated with Crowding Out cause individuals to save more of their incomes. • The rise in savings increases the supply of loanable funds, thereby reducing the real interest rate. • The B-R effect has a smaller impact and usually doesn’t fully negate a crowding out effect.
- 23. Monetary Policy • Moneyis Neutral: any changes of the money supply can stabilize the economy. • Any attempt to grow the economy will result in inflation. • At any moment, the money supply is fixed • The supply of money is controlled by the Federal Reserve (the FED), using three main techniques. • Discount Rate, Fed Funds Rate, & Required Reserve Ratio.
- 24. Expansionary and Contractionary Policy •Expansionary Policies are used to increase the money supply (ex. Decrease RRR, Discount or Fed Funds Rate) • Contractionary Policies are used to reduce the money supply (ex. Raise RRR, Discount or Fed Funds Rate) • Interest rates increase and decrease in an inverse relationship with changes in the money supply.
- 25. The Discount Rate •This is the interest rate that banks pay to borrow emergency cash from the FED • Also known as the “Overnight” rate. • Short term loans cover checkable deposits held by the banks and the FED. • These are determined at the district level but are adjusted with input from D.C. • The FED is the lender of last resort.
- 26. Required Reserves Ratio •Banks are required to retain some of their deposits on hand in the form of vault cash or on deposit at a federal reserve bank. • The quantity of reserve is determined as a percentage of checkable deposits. • That percentage is called the RRR or Required Reserve Ratio. • 1/RRR = Simple Deposit Expansion Multiplier • The multiplier determines the total growth of the money supply from checkable deposits.
- 27. Fed Funds Rate •AKA the “Immediate rate”, it is the ir that banks charge each other to borrow money • The supply of money relative to the demand for it determines the ir. • The FFR is not set at a particular %, but is “targeted” by changing the money supply through the purchase or sale of bonds on the open market. • Buying bonds from the public pumps money into the economy, selling bonds takes money out of the system.
- 28. The Bond Market •Bonds are loans made to the government by individuals and institutions with a guaranteed rate of return and a clearly defined time limit. • Bond Prices and ir are inversely related • Governments (state, federal, and local) use the sale of bonds to pay for deficit spending. • The FED buys and sells bonds to stabilize the economy after deficit spending. • Bond rates send signals to both domestic and international buyers.
- 29. Net Foreign Investment •High Interest rates in the U.S. encourage net foreign investment in U.S. Bonds. D for $ rises, exports down, and imports up. • Low Interest Rates in the U.S. discourage net foreign investment in U.S. Bonds. D for $ falls, exports up, and imports down. • Increased Net Investment in U.S. Bonds is called Capital Inflow (or “Injection”). • Decreased Net Investment in U.S. Bonds is called Capital Outflow (or “leakage”).