Monetary Theory and Demand for Money

Chapter 33: Interest Rates and Monetary Policy

• The chapter's objectives include: the equilibrium interest rate and the money market, monetary policy, how the Federal Reserve controls the federal funds rate, how monetary policy affects GDP and the price level, and the effectiveness and shortcomings of monetary policy.

Interest Rates

• Interest rates represent the price paid for borrowing money.
• Numerous interest rates exist, but the concept of a single rate is often used for simplification.
• Interest rates are determined by the supply and demand for money.

Demand for Money

• Individuals hold money due to transactions demands (D₁) and asset demands (D₂).
• Transactions demand is dependent on nominal GDP and independent of the interest rate.
• Asset demand (D₂) represents money as a store of value and is inversely related to the interest rate.
• Total money demand (Dm) combines both transactions and asset demand.

Demand for Money (Graph)

• Graph shows the demand for money (Dm) as the sum of transactions demand (D₁) and asset demand (D₂).
• Total Money demand is inversely related to the interest rate (i).
• Money supply (Sm) is also shown, demonstrating supply matches demand at a given rate (i).

Interest Rates

• The equilibrium interest rate changes with changes to money supply and money demand.
• Interest rates and bond prices are inversely related.
• Bond coupon payments are fixed annual interest payments to the bondholder.
• Lower interest rates increase bond prices and vice versa.

Federal Reserve Balance Sheet

• Assets include securities and loans to commercial banks.
• Liabilities include commercial bank reserves, treasury deposits, and outstanding Federal Reserve Notes.

Federal Reserve Balance Sheet (Example)

• A February 14, 2008 example is shown, outlining assets (securities, loans, etc.) and liabilities (reserves, treasury deposits, etc.) in millions of dollars.

Central Banks

• Specific central banks for various nations are listed. This includes Australia, Canada, Eurozone, Japan, Mexico, Russia, Sweden, UK, and the US. Each central bank is distinctly identified by description.

Tools of Monetary Policy

• Open market operations are a primary tool, involving the buying and selling of government securities (bonds) to influence the money supply.
• When the Fed sells securities, commercial bank reserves are reduced, and the opposite happens when the Fed buys bonds.
• Reserve ratio changes the money multiplier.
• The discount rate is the Fed's short-term lending rate to commercial banks.
• The term auction facility, introduced in 2007, enables banks to bid to borrow reserves.

Open Market Operations: Fed Buys $1000 Bond (Examples)

• One example depicts the process where the Fed buys a $1000 bond from a commercial bank, increasing reserves.
• Another example demonstrates the process of the Fed buying a $1000 bond from the public and increasing the supply of money in the same vein.

Tools of Monetary Policy (Additional)

• Open market operations are the most important tools of monetary policy.
• Reserve ratios were last changed in 1992.
• Discount rates have been passive in certain periods.
• Term auction facility is a newer tool.

The Federal Funds Rate

• The federal funds rate is the rate banks charge one another for overnight loans.
• The Federal Reserve targets this rate to control monetary conditions.
• The FOMC uses open market operations to achieve the target rate.

Monetary Policy

• Expansionary policy is used to counter economic downturns, such as recession.
• Actions involve lowered federal funds rate targets, Fed purchasing securities, and expanded money supply.
• Contractionary policy is used to counteract inflation.
• Actions include raising targets for the federal fund rate, Fed selling of securities, and a decreased money supply.

Taylor Rule

• A rule of thumb used by policymakers to monitor and set monetary policy.
• The rule considers inflation and Real GDP.
• Fed has a 2% target for inflation.
• When Real GDP=potential GDP and inflation is 2%, then the target Federal Funds rate is 4%.

Monetary Policy's Effect

• Monetary policy impacts real GDP and price levels through a chain reaction.
• Impacts begin with changes in the money market, leading to altered investment rates, aggregate demand, and eventually real GDP and prices.

Monetary Policy and GDP (Graph)

• Illustrates the impact of monetary policy on the market for money, interest rates, and investment demand, culminating in changes to real GDP and price levels, using graphical analysis.

Expansionary Monetary Policy (Cause-Effect Chain)

• The policy outlines the method employed when the economy is facing unemployment and recession.

Restrictive Monetary Policy (Cause-Effect Chain)

• Outlines steps undertaken to manage inflation. Actions include selling bonds, raising reserve ratio or discount rate to curb inflation.

Monetary Policy

• Explains benefits of Monetary Policy compared to fiscal policy, such as speed, flexibility and isolation from political pressure.
• Recent U.S. monetary policies and potential issues, like recognition lag, operational lag, and cyclical asymmetry, are pointed out.

The Big Picture

• A diagram illustrating the circular flow of economic activity, encompassing the relationships between input resources, productivity sources, aggregate supply, aggregate demand, consumption, investment, net spending, and government spending.

The Mortgage Debt Crisis (2007)

• A 2007 event showing how home mortgage defaults, bad loans, reduced reserves and the lowering of the federal funds rate by the Fed to stimulate the economy is a response.
• Also shows the effect of mortgage-backed securities.