Transcript Topic 4: Monetary Policy

Topic 4: Monetary Policy
Interest rates and investment
Banking system
Federal Reserve
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Fiscal Policy v Monetary Policy
 Fiscal Policy–
 Conducted by legislative and executive branches of government
 Government spending and taxes to stimulate or slow down the
economy
 Monetary Policy—
 Conducted by the Central Bank or Federal Reserve
 Aimed at influencing the amount of investment, often through
influence over interest rates
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Government Borrowing
 The government borrows money all the time.
 Where does it borrow money from?
 Issues government securities (e.g., “bonds”), which are promises
to replay a loan in the future at a fixed rate of return
 Sells the securities in the bond market, just like any other large
borrower.
 If you buy a bond from the Treasury, the US Government is
borrowing money from you.
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US Treasury Bonds
 US federal bonds (T-Bills) are guaranteed by the US
government
 They are considered a very safe financial asset
 Safer than the stock market
 Safer than the bonds issued by other borrowers
 Safer than personal investments
 Essentially a 0% chance of default
 Prices are determined in the competitive market
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Interest Rates
 In the market for money (supply and demand) the interest
rate is the market price.
 We will use the term “interest rate” to refer to the price of
T-bills (US Government Securities).
 There is a very strong correlation between the T-bill interest
rate and the interest rates associated with other financial assets,
loans, and bank deposits in the economy.
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Interest Rates
 Suppose interest rate i = 5%.
 Buy a new 1-year bond for $1000.
 At the end of 1 year, the bond pays you:
$1000(1+i) = $1000 (1.05) = $1050
 Buy a new 3-year bond for $1000, with interest compounded
annually.
 At the end of 3 years, the bond pays you:
$1000(1.05)3 = $1158
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Interest Rates
 On Jan 1, 2008 the 3-year T-bill rate was 5%. On that day, Sam bought a 3-year
T-bill for $1000. At the end of 2010, that bond will payout $1158.
 If Sam sold her T-bill in the bond market on Jan 1, 2010 (1 year before
maturity), how much could she get for it?
 Depends on the CURRENT interest rate (not the original rate)
 If the 1-year T-bill rate was 5% on Jan 1, 2010, then the “present value” of
$1158 in one year is:
$1158 / (1+i) = $1158 / (1.05) = $1103
 If the 1-year T-bill rate was 10% on Jan 1, 2010, then the “present value” of
$1158 in one year is: $1052
 If the 1-year T-bill rate was 2% on Jan 1, 2010, then the “present value” of
$1158 in one year is : $1135
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Some Equations
 Future Value (i.e., value at maturity) of bond that costs $PV
today, when there is a per-period interest rate of i, and
maturity in t periods
Future Value = PV (1+i)t
 Present Value (i.e., value at purchase) of bond that will be
worth $FV at maturity, when there is a per-period interest
rate of i, and maturity in t periods
Present Value = FV
(1 i) t
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
Interest Rates
 If the T-Bill Rate is really high, then would you ever put
money in anything else?
 The T-Bill Rate (e.g., the interest rate) determines what other
financial assets are reasonable choices for banks and firms.
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Financial Assets:
“Investment”
Other expenditures
 Plant and Equipment
 Put in the bank
 Residential Construction
 Hold cash
 Inventories
 Stock market
 Bonds and securities
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Interest Rates
 Suppose interest rate i = 5%. Buy a 1-year $1000 bond.
 At the end of the year, the bond pays out $1000 x 1.05 = $1050
 Interest rates in the economy help determine the amount of
“Investment” or “I”.
 Remember “investment” or “I” includes plant & equipment,
housing, and inventories (NOT stocks and bonds)
 A higher interest rate “i” makes buying bonds more attractive
relative to investing in I. So, as i goes up, I goes down.
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How i influences I -- Example
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Firm
Project
Cost
Expected Return
Gomer’s Filling
Station
Tow truck
190
10%
Pay at the pump
150
8%
Hydraulic Lift
50
4%
Inventory speculation
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2%
How i influences I
 See In Class Exercise #1
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How to influence i?
 The interest rate determines the amount of investment in the
economy.
 The interest rate is determined in the market place (supply
and demand). It is not set by the government or the central
bank.
 But, the central bank can influence i through its ability to
control money supply in the economy.
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Federal Reserve
 In the US, the central bank is called the Federal Reserve
 Controls money supply, which determines the price of
money i, which determines investment
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Banking System
 Central Bank, aka Federal Reserve
 Controls the central money supply
 Fractional Reserve Banking System
 Where we keep our money
 Banks are allowed to lend out some fraction of our deposits as
investments to others (“fractional reserve” is the fraction that
they cannot lend out and must keep as reserves)
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What is money?
 Money is what money does:
Medium of exchange
2. Store of value
3. Unit of account
1.
 Not the same as currency. Although currency is usually a
form of money.
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Evolution of Money
Stage 1: No Money
1.
Q: Without money how do people engage in trade?
A: Barter
Problem: High transaction costs
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Stage 2: Goods become treated as money
2.
E.g., tobacco in colonies, gold, silver, jewels
Problems:
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Hard to carry
Can be perishable
Quality isn’t constant
Evolution of Money
 Stage 3: Set up a central treasury for valued goods
 E.g., tobacco warehouse, where people can deposit their
tobacco. The tobacco is rated, and the depositor is given a bank
note stating rights to claim the tobacco.
 Now, bank note may be used as money.
 On gold standard, can take $1 bill to treasury and exchange for
$1 worth of gold (case in US prior to 1971)
 Stage 4: Fiat money
 The government says that money can be used (e.g., “for all debts
public and private”)
 If go to treasury, can trade in your $1 bill for another $1 bill
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Philadelphia Goldsmith
 Goldsmith in 1740 Philly
 Has a good safe to keep his gold
 Offers neighbors the chance to keep there gold in the safe
 On any given day some people take gold out, other people
put gold in
 Observation: daily balance might go up and down slightly,
but never falls below some level
 Good Idea: Lend out some of the money from the vault
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Philadelphia Goldsmith Balance Sheet
Assets
Liabilities
Reserves ($ in vault) $2000
Demand Deposits $10,000
Loans $8,000
Total: $10,000
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Total: $10,000
Bank Balance Sheet – same idea
Assets
Liabilities
Reserves ($ in vault) $1000
Demand Deposits $10,000
Loans $7000
Securities $2000
Total: $10,000
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Total: $10,000
Reserve Ratio
 Reserve Ratio = Reserves / Deposits
 Required Reserve Ratio (i.e., RRR) = The minimum reserve
ratio as mandated by the Federal Reserve.
 If the RRR = 0.2, then a bank with $10,000 in deposits can
lend out $8000.
 Required Reserves = RRR x Deposits
 Excess Reserves = Reserves – Required Reserves
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Money Supply
 Money Supply = Cash On Hand + Total Deposits
 The Fed influences money supply by buying or selling
government securities (i.e., government bonds).
 Buy securities => put new money into the economy =>
increases the money supply
 Sell securities => take money out of the economy =>
decreases the money supply
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Buying Securities
 If the Fed buys $1000 in securities, it increases total money
supply by MORE than $1000.
 Example: How the $1000 flows through the economy, with a
RRR = 0.2 …
 Fed buys $1000 in securities from Sally, who puts the $ in bank
 Bank holds on to $200 and loans $800 to Fred to buy a car
 Fred buys the car from Sam who puts the $800 in her bank
 Sam’s bank keeps $160 in reserves and loans out $640 …
 In total, the money supply increases up to $5000
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Changes to Money Supply
 Initial injection of $Z into the money supply (i.e., purchase of $Z
worth of bonds) changes the total money supply by up to
Z * 1 / RRR
 Initial decrease of $Z in the money supply (i.e., sell $Z worth of
bonds) changes the total money supply by up to
- Z * 1 / RRR
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Bank Balance Sheets – Summary
 Balance sheet is a table with one column listing “assets” and
one listing “liabilities”
 For our purposes, liabilities include deposits, and assets
include bank reserves, loans, and other investments (e.g.,
securities)
 Total Assets = Total Liabilities
 Total Reserves = (Req. Res. Ratio) x (Total Deposits)
 when banks don’t hold any excess reserves
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In Class Exercise #2
 See handout.
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Market for Money
 Vertical axis is the price of money, represented by the
interest rate, i
 Horizontal axis is the quantity of money
 Firms, Individuals, etc. determine money demand
 The Federal Reserve (Fed) determines money supply
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Money Demand
Made up of three pieces:
 Transaction Demand – money on hand for transactions
(money needed for purchases)
 Precautionary Demand – rainy day funds (money that might
be needed for purchases)
 Speculative Demand – e.g., hold cash to buy bonds later if
you expect bond rate will rise soon (money you are waiting
until the right time to invest)
 Taken together => total demand (downward sloping)
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Money Supply
 Typically, if banks have excess reserves, then they lend it out
 Money supply is vertical
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Market for Money
 Supply and Demand together
 Shifts in Supply when the Fed engages in open market
operations or changes the required reserve ratio (RRR)
 Immediate shift
 Long-run shift
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3 Primary Tools of Fed
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1.
Open Market Operations – Buying and selling government
securities (or other assets)
1.
Changing the Required Reserve Ratio
1.
Setting the Federal Funds Rate – interest rate at which
banks can borrow at the Fed

The Fed does not directly set the US T-bill rate. They
announce a target, and achieve it through Open Market
Operations.
Changing Investment through open
market operations
 Fed buys bonds, causing the money supply to increase
 Through the market for money, an increase in money supply
causes the price of money (i.e., the interest rate, i) to
decrease
 A decrease in the interest rate increases investment I, as
investors become less likely to put their money in bonds and
more likely to invest in capital improvement projects, etc.
 An increase in investment increases the equilibrium level of
national income and output
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Changing Investment through open
market operations
 Fed sells bonds, causing the money supply to decrease
 Through the market for money, a decrease in money supply
causes the price of money (i.e., the interest rate, i) to
increase
 An increase in the interest rate decreases investment I, as
investors become more likely to put their money in bonds
and less likely to invest in capital improvement projects, etc.
 A decrease in investment decreases the equilibrium level of
national income and output
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Changing Investment through changing
the required reserve ratio
 Fed decreases RRR
 Banks can loan out more of their deposits, which increases
the money supply
 As money supply increases, the price of money (i.e., the
interest rate i) decreases
 A decrease in the interest rate results in more investment
 Higher investment increases national income
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Changing Investment through changing
the required reserve ratio
 Fed increases RRR
 Banks can loan out less of their deposits, which decreases the
money supply
 As money supply decreases, the price of money (i.e., the
interest rate i) increases
 An increase in the interest rate results in less investment
 Lower investment decreases national income
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Changing Investment by changing the
federal funds rate
 Commercial banks are required to maintain sufficient
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reserves. If their reserves fall short of the RRR, then they
must borrow funds at the end of the day to make up the
difference.
Fed increases federal funds rate, it becomes more costly for a
bank to fall short of the RRR.
Banks will keep a little extra reserves on hand to help ensure
against falling short.
This results in banks loaning out less of their deposits, which
has a similar effect as a modest increase in the RRR.
Decreases national income
Changing Investment by changing the
federal funds rate
 Fed decreases federal funds rate, it becomes less costly for a
bank to fall short of the RRR.
 Actual reserves will tend to be closer to the required
reserves.
 This results in banks loaning out more of their deposits,
which has a similar effect as a modest decrease in the RRR.
 Increases national income
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Some Links
http://www.bankrate.com/brm/news/fed/fedchart.asp
http://www.moneycafe.com/library/fedfundsratehistory.htm
http://www.moneycafe.com/library/1monthlibor.htm
http://www.moneycafe.com/library/cmt.htm
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Causal Arrows
 Buy Bonds  +ΔMS  −Δi  +ΔI  +ΔY
 Sell Bonds  −ΔMS  +Δi  −ΔI  −ΔY
 −RRR  +ΔMS  −Δi  +ΔI  +ΔY
 +RRR  −ΔMS  +Δi  −ΔI  −ΔY
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Causal Arrows – Second Order Effects
+ΔMS  −Δi  +ΔI  +ΔY

“Second order” effects: +ΔMD +Δi …
When income increases, money demand increases. This causes a
“second order effect”
Although the second order effect tends to decrease income (in
this case), second order effects are less significant than the
initial effect on income. Therefore, the overall change to
income will still be positive.
This slide is a technical point that you don’t need to know.
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Can you answer this…
Buy Bonds  +ΔMS  −Δi  +ΔI  +ΔY
(A)
(B)
(C)
(D)
(A)How does buying bonds increase the money supply?
(B)How does an increase to the money supply decrease the
interest rate?
(C)How does a decrease to the interest rate increase
investment?
(D)How does increasing investment increase national income?
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Types of Policy
 “Expansionary” Policy
 Any policy that expands the economy
 Monetary Policy – Reducing the RRR, buying bonds
 Fiscal Policy – Increasing G, decreasing Tx
 “Contractionary” Policy
 Any policy that slows down or contracts the economy
 Monetary Policy – Increasing the RRR, selling bonds
 Fiscal Policy – Decreasing G, increasing Tx
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