Transcript Interest Rates - McGraw Hill Higher Education

Chapter 34
Interest Rates and
Monetary Policy
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Interest Rates
•
•
•
•
LO1
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
34-2
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
34-3
Demand for Money
Rate of interest, i percent
(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)
34-4
Interest Rates
• Equilibrium interest rate
• Changes with shifts in money supply and
money demand
• Interest rates and bond prices
• Inversely related
• Bond pays fixed annual interest payment
• Lower bond price will raise the interest rate
LO1
34-5
Federal Reserve Balance Sheet
• Assets
• Securities
• Loans to commercial banks
• Liabilities
• Reserves of commercial banks
• Treasury deposits
• Federal Reserve Notes outstanding
34-6
Federal Reserve Balance Sheet
April 10, 2013 (in Millions)
Assets
Securities
Loans to Commercial
Banks
All Other Assets
Total
Liabilities and Net Worth
$957,619
439
271,355
$3,229,413
Reserves of Commercial
$ 1,851,361
Banks
52,478
Treasury Deposits
Federal Reserve Notes
1,137,087
(Outstanding)
188,487
All Other Liabilities and
Net Worth
$3,229,413
Total
Source: Federal Reserve Statistical Release, H.4.1, April 10, 2013, www.federalreserve.gov
LO2
34-7
Central Banks
LO2
34-8
Tools of Monetary Policy
• Open market operations
• Buying and selling of government securities
(or bonds)
• Commercial banks and the general public
• Used to influence the money supply
• When the Fed sells securities, commercial
bank reserves are reduced
LO3
34-9
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)
LO3
34-10
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)
LO3
34-11
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)
LO3
34-12
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)
LO3
34-13
Tools of Monetary Policy
• The reserve ratio
• Changes the money multiplier
• The discount rate
• The Fed as lender of last resort
• Short term loans
• Term auction facility
• Introduced December 2007
• Banks bid for the right to borrow reserves
LO3
34-14
The Reserve Ratio
Effects of Changes in the Reserve Ratio
(6)
Money-Creating
Potential of
Single Bank, =
(5)
(7)
Money-Creating
Potential of
Banking System
(1)
Reserve
Ratio, %
(2)
Checkable
Deposits
(3)
Actual
Reserves
(4)
Required
Reserves
(5)
Excess
Reserves,
(3) –(4)
(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
LO3
34-15
Tools of Monetary Policy
• Open market operations are the most
important
• Reserve ratio last changed in 1992
• Discount rate was a passive tool
• Interest on reserves
LO3
34-16
The Federal Funds Rate
• Rate charged by banks on overnight
•
•
•
•
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
34-17
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
LO4
Qf1
LO3
Qf2
Quantity of Reserves
34-18
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
LO4
34-19
Monetary Policy
• Restrictive monetary policy
• Periods of rising inflation
• Increases Federal funds rate
• Increases money supply
• Increases other interest rates
LO4
34-20
Monetary Policy
LO4
34-21
Taylor Rule
• Rule of thumb for tracking actual 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
LO4
34-22
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
LO5
34-23
(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)
LO5
(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)
34-24
Monetary Policy and Equilibrium GDP
(d)
Equilibrium real
GDP and the
Price level
(c)
Equilibrium real
GDP and the
Price level
AS
AS
c
P3
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
a
AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15
Price Level
Price Level
P3
b
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
34-25
LO5
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
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
LO5
Real GDP rises
34-26
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
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
LO5
Inflation declines
34-27
Evaluation and Issues
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy is more subtle than fiscal
policy
LO6
34-28
Recent U.S. Monetary Policy
• Highly active in recent decades
• Responded with quick and innovative actions
during the recent financial crisis and the
severe recession
• Critics contend the Fed contributed to the
crisis by keeping the Federal funds rate too
low for too long
LO6
34-29
After the Great Recession
• Slow recovery especially in terms of
employment
• Zero interest rate policy
• Zero lower bound problem
• Quantitative easing
• Forward commitment
• Operation Twist
LO6
34-30
Problems and Complications
• Lags
• Recognition and operational
• Cyclical asymmetry
• Liquidity trap
LO6
34-31
The Big Picture
Input
Resources
With Prices
Productivity
Sources
LegalInstitutional
Environment
LO6
Consumption
(Ca)
Aggregate
Supply
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
34-32
Worries about ZIRP, QE, and Twist
• Government spending crowded out private
spending
• Large budget deficits by the Federal
government would lead to huge interest costs
• Low interest rates punish savers
LO6
34-33