Transcript Chapter 14
33 15 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 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 33-2 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 33-3 Rate of interest, i percent The Money Market (a) Transactions demand for money, Dt (b) Asset demand for money, Da 10 Sm 7.5 =5 + 5 2.5 Dt 0 50 100 Da 150 200 Amount of money demanded (billions of dollars) LO1 (c) Total demand for money, Dm and supply 50 100 150 200 Amount of money demanded (billions of dollars) Dm 50 100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) 33-4 Interest Rates • Equilibrium interest rate • Changes with shifts in money supply • LO1 and money demand Interest rates and bond prices • Inversely related • Bond pays fixed annual interest payment • Lower bond price will raise the interest rate 33-5 Federal Reserve Balance Sheet Assets Liabilities • Securities * Reserves of commercial banks * Loans to commercial banks * Treasury deposits * Federal Reserve Notes outstanding LO2 33-6 Federal Reserve Balance Sheet March 24, 2010 (in Millions) Assets Liabilities and Net Worth Securities Loans to Commercial Banks All Other Assets $2,017,955 Total $2,316,525 85,659 212,911 Reserves of Commercial $ 1,147,747 Banks 150,087 Treasury Deposits Federal Reserve Notes 893,035 (Outstanding) 125,656 All Other Liabilities and Net Worth $2,316,525 Total Note: The total amount of securities held by the Fed right now is about $4.2 trillion. Source: Federal Reserve Statistical Release, H.4.1, March 24, 2010, http://www.federalreserve.gov LO2 33-7 Tools of Monetary Policy • Open market operations • Buying government securities (or bonds) increases the money supply. • From commercial banks and the general public. • Either way the money supply can increase up to the amount of the purchase times the money multiplier. LO2 33-9 Tools of Monetary Policy • 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) LO2 33-10 Open Market Operations • 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) LO2 33-11 Open Market Operations • 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) LO2 33-12 Tools of Monetary Policy • Open market operations • Selling government securities (or bonds) decreases the money supply. • To commercial banks and the general public. • Either way the money supply can decrease up to the amount of the sale times the money multiplier. LO2 33-13 Tools of Monetary Policy • 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) LO2 33-14 Tools of Monetary Policy • The reserve ratio • Changes the money multiplier Requirement Liability Type Net transaction accounts $0 to $13.3 million % of liabilities 1 2 More than $13.3 million to $89.0 million More than $89.0 million Nonpersonal time deposits LO2 Effective date 0 1-23-14 3 1-23-14 10 1-23-14 0 12-27-90 33-15 3 The Reserve Ratio Effects of Changes in the Reserve Ratio (5) Excess (4) Reserves , Required Reserves (3) –(4) (6) MoneyCreating Potential of Single Bank, = (5) (7) MoneyCreating Potential of Banking System (1) Reser ve Ratio, % (2) Checka ble Deposit s (3) Actual Reserve s (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 LO2 33-16 Tools of Monetary Policy • The discount rate • The Fed is the “lender of last resort.” • Short term loans • Lower rate will encourage banks to borrow reserves (increases money supply.) • Higher rate will discourage banks from borrowing reserves (decreases money supply). • Mostly set now in response to other interest rates. LO2 33-17 Tools of Monetary Policy • Open market operations are the • • LO2 most important Reserve ratio last changed in 1992 Discount rate is a passive tool – the Fed mostly changes it to keep it in line with other short-term interest rates. 33-18 The Federal Funds Rate • Rate charged by banks on overnight • • • • LO3 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 33-19 The Federal Funds Rate Federal Funds Rate, Percent Using Open Market Operations 4.5 Sf 3 4.0 Sf 1 3.5 Sf 2 Df Qf3 Qf1 Qf2 Quantity of Reserves LO3 33-20 Monetary Policy • 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 LO3 33-21 Monetary Policy • Restrictive monetary policy • Periods of rising inflation • Increases Federal funds rate • Increases money supply • Increases other interest rates LO3 33-22 Monetary Policy 10 8 Prime interest rate Percent 6 4 Federal funds rate 2 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year 33-23 Taylor Rule • Rule of thumb for tracking actual • • • LO3 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 33-24 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 LO4 33-25 (a) The market for money Sm1 Sm2 Sm3 AS 10 P3 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) LO4 (c) Equilibrium real GDP and the Price level (b) Investment demand Price Level Rate of Interest, i (Percent) Monetary Policy and Equilibrium GDP $15 $20 $25 Amount of investment (billions of dollars) Q1 Qf Q3 Real GDP (billions of dollars) 33-26 Monetary Policy and Equilibrium GDP (d) Equilibrium real GDP and the Price level (c) Equilibrium real GDP and the Price level AS AS P3 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Q1 Qf Q3 Real GDP (billions of dollars) b a AD3 I=$25 AD4 I=$22.5 AD2 I=$20 AD1 I=$15 Price Level Price Level P3 LO4 c P2 Q1 Qf Q3 Real GDP (billions of dollars) 33-27 Expansionary Monetary Policy CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, lowers the discount rate. Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises LO4 33-28 Restrictive Monetary Policy CAUSE-EFFECT CHAIN Problem: Inflation Fed sells bonds, increases reserve ratio, increases the discount rate. Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines LO4 33-29 Evaluation and Issues • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy is more subtle than fiscal policy LO5 33-30 The Big Picture Input Resources With Prices Productivity Sources LegalInstitutional Environment Consumption (Ca) Aggregate Supply Levels of Output, Employment, Income, and Prices Aggregate Demand Investment (Ig) Net Export Spending (Xn) Government Spending (G) 33-33