Topic 9 - Interest Rates and Monetary Policy PDF

Chapter 33 Interest Rates and Monetary Policy McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All  Chapter Objectives The equilibrium interest rate and the market for money Monetary policy How the Fed controls the Fe...

Chapter 33 Interest Rates and Monetary Policy McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All  Chapter Objectives The equilibrium interest rate and the market for money Monetary policy How the Fed controls the Federal funds rate How monetary policy affects GDP and the price level Effectiveness of monetary policy and its shortcomings 33-2  Interest Rates Price paid for the use of money Many different interest rates Speak as if only one interest rate Determined by money supply and money demand 33-3  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 interest rate Total money demand, Dm 33-4  Demand for Money (c) (a) (b) Total Transactions Asset demand for demand for demand for money, Dm money, Dt money, Da and supply Rate of interest, i percent 10 Sm 7.5 + =5 5 2.5 Dt Da Dm 0 50 100 150 200 50 100 150 200 50 100 150 200 250 300 Amount of money Amount of money Amount of money demanded demanded demanded and supplied (billions of dollars) (billions of dollars) (billions of dollars) 33-5  Interest Rates Equilibrium interest rate – Changes with shifts in money supply and money demand Interest rates and bond prices – Inversely related – Bond coupon- fixed annual interest payment – Lower interest will raise bond price, and vice versa. 33-6 Federal Reserve Balance Sheet Assets – Securities – Loans to commercial banks Liabilities – Reserves of commercial banks – Treasury deposits – Federal Reserve Notes outstanding 33-7 Federal Reserve Balance Sheet February 14, 2008 (in Millions) Assets Liabilities and Net Worth Securities $713,369 Reserves of Commercial Loans to Commercial Banks $ 11,312 Banks 60,039 Treasury Deposits 4,979 All Other Assets 111,689 Federal Reserve Notes (Outstanding) 778,937 All Other Liabilities and 89,869 Net Worth Total $885,097 Total $885,097 Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008 33-8  Central Banks Selected Nations Australia: Reserve Bank of Australia (RBA) Canada: Bank of Canada Euro Zone: European Central Bank (ECB) Japan: Bank of Japan (BOJ) Mexico: Banco de Mexico (Mex Bank) Russia Central Bank of Russia Sweden: Sveriges Riksbank United Kingdom: Bank of England United States: Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks) 33-9  Tools of Monetary Policy Open market operations – Buying and selling of government securities (or bonds) – Commercial banks and the general public – Used to influence the money supply When the Fed sells securities, commercial bank reserves are reduced 33-10  Open Market Operations Fed buys $1,000 bond from a commercial bank New Reserves $1000 $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) 33-11  Open Market Operations Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 $800 $200 Excess Required Reserves Reserves $1000 $4000 Initial Bank System Lending Checkable Deposit Total Increase in the Money Supply, ($5000) 33-12  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 borrow reserves 33-13  Tools of Monetary Policy Open market operations most important Reserve ratio last changed 1992 Discount rate was a passive tool Term auction facility is new – Guaranteed amount lent by the Fed – Anonymous 33-14  The Federal Funds Rate Rate charged by banks on overnight loans Targeted by the Federal Reserve FOMC conducts open market operations to achieve the target Demand curve for Federal funds Supply curve for Federal funds 33-15 The Federal Funds Rate Using Open Market Operations Federal Funds Rate, Percent 4.5 Sf3 4.0 Sf1 3.5 Sf2 Df Qf3 Qf1 Qf2 Quantity of Reserves 33-16  Monetary Policy Expansionary monetary policy – Economy faces a recession – Lower target for federal funds rate – Fed buys securities – Expanded money supply – Downward pressure on other interest rates Contractionary monetary policy 33-17  Taylor Rule Rule of thumb for tracking actual monetary policy Fed has 2% target inflation rate If real GDP = potential GDP and inflation is 2% then target federal funds rate is 4% Target varies as inflation and real GDP vary 33-18  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  Monetary Policy and GDP (c) (a) (b) Equilibrium real The market Investment GDP and the for money demand Price level Rate of Interest, i (Percent) Sm1 Sm2 Sm3 AS 10 P3 Price Level AD3 8 P2 I=$25 Dm AD2 6 ID I=$20 AD1 0 I=$15 $125 $150 $175 $15 $20 $25 Q1 Qf Q3 Amount of money Amount of investment Real GDP demanded and (billions of dollars) (billions of dollars) supplied (billions of dollars) 33-20 Expansionary Monetary Policy Problem: unemployment and recession Fed buys bonds, lowers reserve ratio, or lowers CAUSE-EFFECT CHAIN the discount rate Excess reserves increase- 2 results Supply of Federal funds increase and the rate falls Multiplied increase in money supply Market interest rate falls Investment spending increases Aggregate demand increases Real GDP rises 33-21  Restrictive Monetary Policy Problem: inflation Fed sells bonds, increases reserve ratio, or CAUSE-EFFECT CHAIN increases the discount rate Excess reserves decrease- 2 results Supply of Federal funds decline and the Multiplied decline in money supply Market Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines 33-22  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 asymmetry 33-23  The Big Picture Input Consumption Resources (Ca) With Prices Levels of Investment Aggregate Output, Aggregate (Ig) Employment, Supply Demand Productivity Income, and Prices Sources Net Export Spending (Xn) Legal- Institutional Environment Government Spending (G) 33-24  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 new innovation – Bad incentives 33-25