Transcript Chapter 16_20e

16
Interest Rates and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Definitions
Total (Actual) Reserves: Amount of money a bank
holds (has available).
Total Reserves = Required Reserves
+ Excess Reserves
Required Reserves: Fraction of actual reserves a
bank must keep (can’t be loaned).
Reserve Ratio: Percentage of demand deposits
bank must maintain for required reserves.
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Definitions
Excess Reserves: Amount of actual reserves the
bank has to loan.
Excess Reserves = Total Reserves –
Required Res.
Monetary multiplier (m) = 1/Reserve Ratio
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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
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Central Banks
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Tools of Monetary Policy
Monetary policy is the manipulation
of the money supply by changing
bank’s excess reserves.
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Tools of Monetary Policy
• Open market operations
• Buying and selling of government
securities (or bonds) by the Fed
• Most important tool to change the
money supply
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Tools of Monetary Policy
To increase Sm, Fed can buy securities
from bank or public.
I.E. Fed buys $1,000 security from
commercial bank, reserve ratio is
20%.
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Tools of Monetary Policy
• Fed pays for securities by increasing
bank’s actual reserves by $1,000.
• Since bank doesn’t have to maintain
required reserves for money from
Fed, excess reserves increase by
$1,000.
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Open Market Operations
• Money creating potential of single
bank is equivalent to its excess
reserves (amount it can loan).
• Bank’s money creating potential
increased by $1,000.
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Open Market Operations
• Money supply increases by $5,000
(5 x 1,000)due to monetary multiplier.
• Change in Sm = m x change in excess
reserves
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Open Market Operations
• Fed buys $1,000 security from public,
reserve ratio is 20%
• Fed pays with $1,000 check – money
supply is directly increased by $1,000.
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Open Market Operations
• Check is deposited and bank’s actual
reserves rise by $1,000.
• Required reserves increase by $200.
(.2 x $1,000)
• Bank’s excess reserves rise by $800.
($1000 - $200)
• Bank’s lending ability increases by
$800.
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Open Market Operations
• Banking system’s money creating
potential increases by $4,000 (5 x
$800).
• Money supply increases by $5,000
$4,000 + $1,000 (initial check).
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Tools of Monetary Policy
• The reserve ratio
• Changes the money multiplier
• Reduce reserve ratio to increase
money supply
• Increase reserve ratio to reduce
money supply
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Tools of Monetary Policy
• The discount rate – Lender of Last Resort
• Interest rate on loans from Fed to
banks
• Lower discount rate to increase money
supply
• Increase discount rate to reduce
money supply
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Tools of Monetary Policy
• Interest on reserves
• Increase interest rate on reserves
• Banks will leave more reserves with
Fed
• Decrease money supply
• Decrease interest rate on reserves
• Banks will leave fewer reserves with
Fed
• Increase money supply
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Tools of Monetary Policy
• Reserve ratio changes bank’s
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•
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profitability
Discount rate is a passive tool until
financial crisis
Interest on reserves is too new
The Federal Funds Rate
• Rate charged by banks on overnight
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•
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loans
Targeted by the Federal Reserve
when changing the money supply
Prime interest rate is directly related
to the Federal funds rate.
Prime interest rate is charged on
loans to most credit-worthy customers
Monetary Policy
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Monetary Policy
• Expansionary monetary policy
• Economy faces a recession
• Increase money supply, interest rates
fall
• Lower target for federal funds rate
• Fed buys securities
• Lower reserve ratio
• Lower discount rate
• Decrease interest on reserves
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Monetary Policy
• Restrictive monetary policy
• Periods of rising inflation
• Decreases money supply, interest rates
rise
• Increase target Federal funds rate
• Fed sells securities
• Raise reserve ratio
• Raise discount rate
• Increase interest on reserves
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Taylor Rule
• Rule of thumb for tracking actual
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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
Evaluation and Issues
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy more subtle than
fiscal policy
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Recent U.S. Monetary Policy
• Highly active in recent decades
• Quick and innovative actions during
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recent financial crisis and severe
recession
Critics contend Fed contributed to
crisis by keeping Federal funds rate
too low for too long
After the Great Recession
• Slow recovery, especially with
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employment
Zero interest rate policy (ZIRP)
• Short-term rates near/at zero
• Zero lower bound problem
• Economy didn’t expand, interest rates already
at zero
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After the Great Recession
• Quantitative easing
• Not intended to decrease interest rates
• Meant to increase reserves in bank system
• Forward commitment
• Part of QE2
• Fed announced purchase amount and for how long
• Operation twist
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Fed announced: buy $677bil long-term gov’t bonds
while selling equivalent amount of short-term gov’t
bonds
Spur investment and consumption with lower longterm rates
Problems and Complications
• Lags
• Recognition and operational
• Cyclical asymmetry
• Liquidity trap
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