Chapter 14

Chapter 14

Chapter 16 Interest Rates and Monetary Policy Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Interest Rates The price paid for the use of money Many different interest rates Speak as if only one interest rate Determined by the money supply and money demand LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-2 Demand for Money Why hold money? Transactions demand, Dt Determined by nominal GDP Independent of the interest rate Asset demand, Da Money as a store of value

Varies inversely with the interest rate Total money demand, Dm LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-3 Rate of interest, i percent Demand for Money Continued (a) Transactions demand for money, Dt 10 Sm 7.5 =5 +

5 2.5 Dt Da Dm 0 50 100 150 200 Amount of money demanded (billions of dollars) LO1

(b) Asset demand for money, Da (c) Total demand for money, Dm and supply 50 100 150 200 Amount of money demanded (billions of dollars) 50

100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-4 Interest Rates Continued Equilibrium interest rate Changes with shifts in money supply and money demand Interest rates and bond prices Inversely related Bond pays fixed annual interest payment

Lower bond price will raise the interest rate LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-5 Federal Reserve Balance Sheet Assets Securities Loans to commercial banks Liabilities Reserves of commercial banks Treasury deposits Federal Reserve Notes outstanding LO2 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-6 Federal Reserve Balance Sheet Example

April 6, 2016 (in Millions) Assets Liabilities and Net Worth Securities Loans to Commercial Banks All Other Assets $4,243,689 Total $4,484,069 37 240,343 Reserves of Commercial $2,467,091 Banks 263,537 Treasury Deposits 1,400,041

Federal Reserve Notes (Outstanding) 353,400 All Other Liabilities and Net Worth $4,484,069 Total Source: Federal Reserve Statistical Release, H.4.1, April 6,2016, www.federalreserve.gov LO2 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-7 Central Banks LO2 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-8 Four Tools of Monetary

Policy 1. 2. 3. 4. LO3 Open Market Operations The Reserve Ratio The Discount Rate Interest on Reserves Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-9 Tool #1: Open-Market Operations 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 LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-10 Open-Market Operations: Fed Buys Bonds from Commercial Banks Federal Reserve Banks Assets Liabilities and Net Worth + Securities + Reserves of Commercial Banks (a) Securities Assets

(b) Reserves Commercial Banks Liabilities and Net Worth - Securities (a) +Reserves (b) LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-11 Open Market Operations: Fed Buys Bonds from Commercial Banks Continued Fed buys $1,000 bond from a commercial bank New Reserves $1000 Excess Reserves $5000 Bank System Lending

Total Increase in the Money Supply, ($5,000) LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-12 Open Market Operations: Fed Buys Bonds from the Public Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 $800 Excess Reserves $4000 Bank System Lending $200 Required Reserves

$1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-13 Open Market Operations: Fed Sells Bonds to Commercial Banks Fed sells bonds to commercial banks Federal Reserve Banks Assets Liabilities and Net Worth - Securities - Reserves of Commercial Banks

(a) Securities Assets (b) Reserves Commercial Banks Liabilities and Net Worth + Securities (a) - Reserves (b) LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-14 Open Market Operations: Fed Sells Bonds to the Public Same effect as selling bonds to commercial banks LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-15 Repos and Reverse Repos Collateralized loans Repo transaction loan of money in exchange for government bonds used as collateral Reverse repo repo in reverse LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-16 Tool #2: 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 LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-17 The Reserve Ratio Continued Effects of Changes in the Reserve Ratio (6) Money-Creating Potential of Single Bank, = (5) (7) Money-Creating Potential of Banking System (1) Reserve Ratio, %

(2) Checkable Deposits (3) Actual Reserves (4) Required Reserves (5) Excess Reserves, (3) - (4) (1) 10 $20,000 $5000 $2000

$3000 $3000 $30,000 (2) 20 20,000 5000 4000 1000 1000 5000 (3) 25 20,000 5000

5000 0 0 0 (4) 30 20,000 5000 6000 -1000 -1000 -3333 LO3

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-18 Tool #3: The Discount Rate The discount rate The Fed as lender of last resort Short term loans LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-19 Tool #4: Interest on Reserves Law changed in 2008 Allows banks to pay interest on excess reserves Can encourage or discourage banks to keep reserves LO3

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-20 Tools of Monetary Policy Summary Open market operations are the most important Reserve ratio last changed in 1992 Discount rate was a passive tool Interest on reserves LO3 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-21 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 LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-22 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 LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-23 Restrictive Monetary Policy

Periods of rising inflation Increases Federal funds rate Decreases money supply Increases other interest rates LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-24 Prime Interest Rate and Monetary Policy Federal Funds Rate LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-25 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 targeted Federal funds rate is 4% Target varies as inflation and real GDP vary LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-26 Monetary Policy, Real GDP, Price Level 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 LO5

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-27 (a) The market for money Sm1 Sm2 Sm3 AS P3 10 8 Dm 6 0 AD3

I=$25 AD2 I=$20 AD1 I=$15 P2 $125 $150 $175 Amount of money demanded and supplied (billions of dollars) LO5 (c) Equilibrium real GDP and the Price level

(b) Investment demand Price Level Rate of Interest, i (Percent) Monetary Policy and Equilibrium GDP ID $15 $20 $25 Amount of investment (billions of dollars) Q1 Qf Q3

Real GDP (billions of dollars) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-28 Monetary Policy and Equilibrium GDP Continued (d) (c) Equilibrium real GDP and the Price level Equilibrium real GDP and the Price level AS AS

Q1 Qf Q3 Real GDP (billions of dollars) Price Level Price Level AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 LO5 c

P3 P3 b P2 Q1 Qf Q3 a AD3 I=$25 AD4 I=$22.5 AD2 I=$20 AD1 I=$15 Real GDP (billions of dollars)

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-29 Expansionary Monetary Policy Effects CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or lowers interest on reserves Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases LO5 Real GDP rises Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-30

Restrictive Monetary Policy Effects CAUSE-EFFECT CHAIN Problem: Inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or raises interest on reserves Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases LO5 Inflation declines Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-31 Evaluation and Issues Advantages over fiscal policy Speed and flexibility

Isolation from political pressure Monetary policy is more subtle than fiscal policy LO6 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-32 Recent U.S. Monetary Policy Highly active in recent decades Responded with quick and innovative actions during the recent financial crisis and the severe recession Critics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long LO6 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-33

After the Great Recession Slow recovery especially in terms of employment Zero interest rate policy Zero lower bound problem Quantitative easing Forward commitment Operation Twist LO6 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-34 Problems and Complications Lags Recognition and operational Cyclical asymmetry Liquidity trap LO6

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-35 The Big Picture Input Resources With Prices Productivity Sources LegalInstitutional Environment LO6 Consumption (Ca) Aggregate Supply Levels of Output,

Employment, Income, and Prices Aggregate Demand Investment (Ig) Net Export Spending (Xn) Government Spending (G) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16-36 Less than Zero European Central Bank set negative interest rates Idea is to make banks lend more

Existence of a negative lower bound 16-37 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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