Transcript Monetary policy

Chapter 17: Interest Rates
and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
Monetary Policy and
Interest Rates
 The Fed conducts monetary policy by changing money
supply in order to influence interest rates.
 Even though there are many interest rates in the economy
that vary by purpose, size, risk, maturity, and taxability,
economists assume, for simplicity, a single interest rate.
 Interest rates are determined by the interaction of money
demand and money supply.
Monetary policy consists of a central bank’s changing of the money
supply to influence interest rates and assist the economy in achieving
price level stability, full employment, and economic growth.
LO: 17-1
17-2
Demand for Money
 People demand money for two main reasons: to make
purchases with it (medium of exchange) and to hold it as
an asset (store of value).
 The demand for money as a medium of exchange is called
the transactions demand for money (Dt).
 The amount of money people want to hold as a store of
value is called the asset demand for money (Da).
 The sum of the transactions demand and assets demand
for money equals the total demand for money (Dm).
Dm = Dt + Da
LO: 17-1
17-3
Demand for Money
 The main determinant of the amount of money
demanded for transactions is the level of nominal
GDP.
 The transactions demand for money is vertical.
 Holding money incurs an opportunity cost; therefore,
the amount of money demanded as an asset varies
inversely with the rate of interest, which is the
opportunity cost of holding money.
 The asset demand for money is negatively sloped.
LO: 17-1
17-4
Money Supply and Money
Market
 The money supply, Sm, is a vertical line because the
monetary authorities and financial institutions have
provided the economy with some particular stock of
money.
 The intersection of demand and supply in the money
market determines equilibrium price, or the real interest
rate (ic)—the inflation-adjusted price that is paid for the
use of money over some time period.
LO: 17-1
17-5
Equilibrium Interest Rate
Rate of interest, i percent
(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)
LO: 17-1
(c)
Total demand for
money, Dm
and supply
(b)
Asset
demand for
money, Da
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)
17-6
Goals and Tools of
Monetary Policy
 The goal of monetary policy is to achieve and maintain
price-level stability, full employment, and economic
growth.
 The three tools of monetary control are:
 Open-market operations: buying and selling of U.S.
government securities to change money supply.
 Changing the reserve ratio to influence the ability of the
commercial banks to lend. It is used very seldom.
 Discount rate: the interest rate the Federal Reserve Banks
charge on the loans they make to commercial banks and thrifts.
LO: 17-2
17-7
Open Market Operations
 Open market operations are the most important
instrument for influencing the money supply.
 Buying securities increases the reserves of
commercial banks.
 Excess reserves allow the banking system to expand the
money supply through loans.
 Selling securities reduces the reserves of
commercial banks.
 Lower reserves result in a multiple contraction of the
money supply.
LO: 17-2
17-8
Reserve Ratio
 If the Fed raises the reserve ratio, the amount of
required reserves that banks must keep increases.
 Banks will either lose excess reserves, diminishing their
ability to create money by lending, or reduce checkable
deposits, and therefore the money supply, due to deficient
reserves.
 If the Fed lowers the reserve ratio, the banks’
required reserves will decrease.
 Banks with more excess reserves are able to create new
money by lending.
LO: 17-2
17-9
Discount Rate
 Federal Reserve Banks make short-term loans to commercial
banks in their district.
 In providing loans, the Federal Reserve Bank increases the
reserves of the borrowing bank, enhancing its ability to extend
credit.
 From the commercial banks’ perspective, the discount rate is the
cost of acquiring reserves.
 Increasing the discount rate discourages commercial banks from
obtaining additional reserves through borrowing from the Federal
Reserve Banks.
 When the Fed raises the discount rate, it wants to restrict the
money supply.
LO: 17-2
17-10
Expansionary Monetary
Policy and GDP
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
LO: 17-3
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
17-11
Restrictive Monetary
Policy and GDP
CAUSE-EFFECT CHAIN
Problem: inflation
LO: 17-3
Fed sells bonds, increases reserve ratio, increases
the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
17-12
(a)
The market
for money
Sm1
Sm2
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Sm3
AS
10
P3
Price Level
Rate of Interest, i (Percent)
Monetary Policy and GDP in
AD-AS Model
8
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Dm
6
ID
0
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
LO: 17-3
17-13
Advantages of Monetary
Policy
 Monetary policy, a dominant component of U.S. national
stabilization policy, has two key advantages over fiscal policy:
 Speed and flexibility
 Isolation from political pressure
 Monetary policy can be quickly altered and is a subtler and
more politically neutral measure.
 For the conduct of monetary policy, the Fed focuses on the
Federal Funds Rate, interest rate banks and thrifts charge
one another on overnight loans made out of their excess
reserves.
 Other interest rates typically change in the same direction as the
Federal Funds rate.
LO: 17-4
17-14
Shortcomings of Monetary
Policy
 Monetary policy faces recognition lag and operational
lag.
 The Fed must be able to recognize and respond to changes in
economic activity.
 It takes time for monetary policy to work its way through to
aggregate demand.
 Monetary policy suffers from cyclical asymmetry.
 Cyclical asymmetry is the potential problem of monetary policy
successfully controlling inflation during the expansionary phase
of the business cycle but failing to expand spending and real
GDP during the recessionary phase of the cycle.
LO: 17-4
17-15