Transcript Chapter 16 - Joseph R Bartholomew

Chapter 16
Interest Rates and Monetary
Policy
Monetary Policy
-- Initiatives by Federal Reserve to influence the money
supply and interest rates in pursuit of financial
objectives
4 Goals of Monetary Policy
1) Price Stability
-- minimize amount of inflation (traditionally less than 4%)
2) High Employment
3) Economic Growth
4) Stability of Financial Markets and Institutions
Fed has 3 primary tools for conducting monetary policy
1) Open Market Operations – buying/selling of bonds
2) Discount Policy – adjusting discount rate
3) Altering Reserve Requirements
Demand for Money (MD)
-- demand for money by individuals and firms
-- Wealth comes in two forms:
a) money: means of payment but does not
earn interest
b) bonds: not a means of payment but earns
interest
-- Demand for money depends on 3 variables
1) Price Level
-- as price levels ↑, demand for money ↑
-- as goods become more expensive, it will
take more money to buy these goods
2) Real GDP
-- as real GDP ↑, demand for money ↑
-- increase in real GDP indicates that
buying/selling of goods will increase, increasing
the demand for money
3) Interest Rate
-- opportunity cost of holding money
-- as interest rates (r) ↑, quantity demanded of
money ↓
Money Demand Curve (MD)
-- describes the relationship between interest rates and
quantity of money demanded, with all other influences
on money demand remaining constant
Interest Rate (r)
8%
6%
4%
2%
MD
2
4
6
$ (billions)
8
As interest rates ↑, quantity of money demanded ↓
Shifts in MD Curve
-- Changes in Real GDP or Price Levels
a) As real GDP ↑ or price levels ↑, MD ↑, shifting MD to the
right
Interest Rate (r)
4%
2%
MD1
MD2
$ (billions)
6
8
b) As real GDP ↓ or price levels ↓, MD ↓, shifting MD to the
left
Interest Rate (r)
4%
2%
MD1
MD2
$ (billions)
6
8
Supply of Money (MS)
-- Describes the relationship between quantity supplied
of money and the interest rate
-- As we learned, the Fed can control the money supply
through open market purchases or open market sales
-- Since the Fed has direct control over this variable, the
MS curve is represented by a vertical line (not
influenced by changes in the interest rate)
Interest Rate (r)
MS
4%
2%
$ (billions)
6
8
Shifts in Money Supply
-- Open market purchases (purchases of bonds) increases the money
supply and causes MS to shift to the right.
-- Open market sales (sales of bonds) decreases the money supply and
shifts MS to shift to the left
Equilibrium
-- point where MS and MD intersect
-- quantity of money being held (MS) = quantity of money wanting to be
held (MD)
Interest Rate (r)
MS
A
8%
6%
E
4%
B
2%
MD
2
4
6
8
$ (billions)
How Market Obtains Equilibrium
-Bonds and money are the two assets people can choose as
wealth
-At Pt A, MD = $2 billion and MS = $6 billion. Since MS > MD, there
is excess supply of money = $4 billion. Since people would want
to hold less money than they’re currently holding, they would also
like to hold more bonds (excess demand for bonds).
-With excess supply money/excess demand for bonds, people will
now try to convert money into bonds, so price of bonds ↑. As
price bonds ↑, interest rates ↓ and we move down the curve
toward pt E.
--
--
At Pt B, MD = $8 billion and MS = $6 billion. Since MD > MS, there
is excess demand for money = $2 billion. Since people want to
hold more money than they’re currently holding, they would also
like to hold less bonds (excess supply for bonds).
With excess demand money/excess supply for bonds, people will
now sell their bonds for money, so price of bonds ↓. As price
bonds ↓, interest rates ↑ and we move up the curve toward pt E.
Manipulation of Interest Rate by Fed
-- Through open market purchases and sales of bonds, the
Fed can shift the Ms curve, thus influencing the interest
rate
-- Open market purchase
 Ms ↑
 Excess Supply for Money/Excess Demand for Bonds
 Price Bonds ↑
 Interest Rates ↓
M S1
Interest Rate (r)
M S2
8%
6%
A
4%
B
2%
MD
2
4
6
8
$ (billions)
-- Open market sale
 Ms ↓
 Excess Demand for Money/Excess Supply for Bonds
 Price Bonds ↓
 Interest Rates ↑
Interest Rate (r)
M S2
M S1
8%
B
6%
A
4%
MD
2%
$ (billions)
2
4
6
8
Other Ways to Control Money Supply
1) ∆ in Required Reserve Ratio (RR)
-- if RR ↑, money supply ↓
-- if RR ↓, money supply ↑
2) Discount Window Lending
-- commercial banks borrow money from the Federal
Reserve
-- A decrease in the discount rate encourages
borrowing from Fed which would increase borrowed
reserves of the bank and ↑ money supply
-- An increase in the discount rate discourages
borrowing from Fed which would decrease amount
of borrowed reserves of the bank and cause a ↓ in
money supply
How Interest Rates Affect the economy
Federal Funds Rate
-- interest rate that commercial banks charge each
other for short-term loans
-- most watched interest rate in the economy
-- changes in the Federal Funds Rate are decided
by the FOMC
-- steers the direction of monetary policy
-- directed through open market operations
 open market purchase  increase in money supply
and decrease in Federal Funds Rate
 open market sale  decrease in money supply and
increase in Federal Funds Rate
-- Federal Funds Rate affects changes in other
interest rates, causing them to move in the
same direction (i.e. mortgage rates, interest
rates on Gov’t bonds)
-- since interest rates all flow in the same direction,
we can speak of changes in interest rates very
generically.
-- In order to fight recessions, FOMC will announce
a drop in the Federal Funds Rate

↓ r  ↑ C and IP  ↑ PAE (via multiplier) and ↑ Y
-- In order to fight inflation, FOMC will announce
an increase in the Federal Funds Rate

↑ r  ↓C and IP  ↓ PAE (via multiplier) and ↓ Y