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Interest Rates and Monetary Policy

Chapter 16

McGraw-Hill/Irwin

This chapter starts by introducing the transactions and asset demand for money and explaining how the interaction of the demand and supply of money determine the interest rates in the market. Banks’ balance sheets are used to explain how open market operations is effective in changing the money supply. We will learn about tools other than open market operations that the Fed might use to manipulate the money supply and the reasons that these tools are chosen, or not chosen. We will then evaluate expansionary and restrictive monetary policy, conditions under which these policies should be used, and how they impact interest rates, investment, and aggregate demand. We close with a discussion of issues related to monetary policy and current monetary policy.

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

Understanding interest rates is a key economic concept. For example, imagine a gentleman who was beginning a new career working for an investment firm. He did not have a business background, but he was a salesman. One evening as he was discussing his new career with an economist friend, he told his friend that the reason his firm could offer investors a much higher return than the banks was because his firm had been around for over 100 years and, therefore, was considered “safer” than a bank and did not have to purchase insurance to safeguard depositors’ funds like banks did. The economist stopped him and had to explain to him that actually it was the opposite: His firm had to pay a higher interest rate to investors to compensate the investors for their increased risk with his firm because their investments were not insured.

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

People hold money for many different reasons. One reason is that it is convenient to have money available to purchase necessary goods and services. This is referred to as the transactions demand, or Dt. The larger the value of all goods and services exchanged in the economy, the larger the amount of money that will be needed to handle all of the transactions.

The second reason for holding money is the asset demand or Da. People like to hold some of their financial assets as money because money is the most liquid of all financial assets. If an emergency arises where you need funds in a hurry, you will have access to those funds quickly.

The disadvantage to holding money as an asset is that it is a non-productive asset. If you bury a pile of money in the backyard, when you dig it up ten years later, it will be the same amount that you buried, and ten years later the purchasing power of the money has probably declined.

The amount of money demanded as an asset is inversely related to the interest rates, meaning as interest rates go up, the demand for money as an asset goes down and vice versa.

Demand for Money

Rate of interest, i percent

7.5

2.5

Amount of money

demanded

(billions of dollars)

Amount of money

demanded

(billions of dollars)

Amount of money

demanded and supplied

(billions of dollars)

(a)

Transactions

demand for

money, Dt

(b)

Asset

demand for

money, Da

(c)

Total

demand for

money, Dm

and supply

LO1

100

150

200

100

150

200

100

150

200

250

300

The total demand for money is the sum of the transactions demand for money plus the asset demand for money. The transactions demand for money is assumed to be vertical as it depends on GDP rather than the interest rate. The asset demand for money is inversely related to the interest rate, meaning as interest rates go up, the amount of money demanded goes down. When we introduce the supply of money into the graphs, we find an equilibrium point for money.

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

Just like in other resource markets, there is an equilibrium interest rate that will cause the supply of money available to equal the demand for money. This rate can be thought of as the market-determined price that borrowers must pay for using someone else’s money over some period of time.

Assets

Securities

Loans to commercial banks

Liabilities

Reserves of commercial banks

Treasury deposits

Federal Reserve Notes outstanding

LO2

Federal Reserve Balance Sheet

Just like any other organization, the Federal Reserve Bank’s balance sheet reports the assets and liabilities of the organization as of that point in time. The Fed’s balance sheet helps us to consider how the Fed conducts monetary policy.

April 10, 2013 (in Millions)

Source: Federal Reserve Statistical Release, H.4.1, April 10, 2013, www.federalreserve.gov

Securities

Loans to Commercial

Banks

All Other Assets

Total

Reserves of Commercial

Banks

Treasury Deposits

Federal Reserve Notes

(Outstanding)

All Other Liabilities and

Net Worth

Total

$957,619

439

271,355

$3,229,413

$ 1,851,361

52,478

1,137,087

188,487

$3,229,413

LO2

Federal Reserve Balance Sheet

Assets Liabilities and Net Worth

LO2

The two main assets of the Federal Reserve Banks are securities and loans to commercial banks. The securities are government bonds that have been purchased by the Federal Reserve Bank to increase the supply of money in the economy. Loans to commercial banks also help the banks to increase their reserves. The liabilities of the Federal Reserve Banks have three noteworthy items. The reserves of commercial banks represent the required reserves that banks must hold to ensure their stability. These reserves are also listed as assets on the banks’ books. The Treasury Deposits represent the amount of money the U.S. government has on deposit with the Fed. The government uses this money to pay its obligations. The Federal Reserve Notes Outstanding represents the supply of paper money currently circulating outside of the Federal Reserve Banks. Over the past couple of years, the balance sheet of the Fed has increased dramatically as the Fed has taken various actions to help the economy recover from the recession.

Central Banks

LO2

This chart contains some examples of the central banks of other nations. Like the Federal Reserve System, these banks coordinate the monetary policies of their countries.

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

LO2

LO3

Open market operations are used by the Fed to increase or decrease the commercial bank reserves available which, in turn, will affect the amount of money available in the economy.

Tools of Monetary Policy

Fed buys bonds from commercial banks

Federal Reserve Banks

+ Securities

+ Reserves of Commercial Banks

(b) Reserves

Commercial Banks

Securities (a)

+Reserves (b)

Assets

Liabilities and Net Worth

LO2

(a) Securities

LO3

Assets

Liabilities and Net Worth

As part of their open-market operations, the Fed will buy or sell government bonds. If they purchase the bonds from commercial banks, the commercial banks are in effect transferring part of their holding of securities to the Fed, which creates new reserves for the banks in their accounts at the Fed. By increasing the commercial banks’ reserves, the Fed has increased their lending capacity.

Tools of Monetary Policy

Fed sells bonds to commercial banks

Federal Reserve Banks

- Securities

- Reserves of Commercial Banks

Commercial Banks

+ Securities (a)

- Reserves (b)

Assets

Liabilities and Net Worth

(a) Securities

(b) Reserves

LO2

LO3

Assets

Liabilities and Net Worth

If the Fed sells government bonds to commercial banks, the opposite effect occurs. The banks lose reserves, which will reduce their lending capacity.

Open Market Operations

Fed buys $1,000 bond from a commercial bank

LO2

LO3

New Reserves

$5000

Bank System Lending

Total Increase in the Money Supply, ($5,000)

$1000

Excess

Reserves

When the Fed buys government bonds from commercial banks, it increases the assets of the Fed and increases the reserves of the commercial banks. This will increase the lending ability of the commercial banks.

Open Market Operations

Fed buys $1,000 bond from the public

LO2

LO3

Check is Deposited

New Reserves

$1000

Total Increase in the Money Supply, ($5000)

$200

Required

Reserves

$800

Excess

Reserves

$1000

Initial

Checkable

Deposit

$4000

Bank System Lending

When the Fed buys government bonds from the public, the effect is much the same. The assets of the Fed increase, and as the public deposits the funds into a commercial bank, its reserves and lending ability will increase.

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

LO2

LO3

In addition to open market operations, the Fed has three other tools available. The Fed can change the reserve ratio, which will affect the ability of commercial banks to lend. If the reserve ratio is increased, the money multiplier will decrease and vice versa.

As the “lender of last resort,” the Fed makes short-term loans to banks to cover unexpected and immediate needs for additional funds. The rate that the Fed charges the banks is called the discount rate. In providing the loan, the Fed increases the reserves of the borrowing bank. Since there are no required reserves against loans from the Fed, all new reserves are considered excess reserves, and as such, they enhance the ability of the bank to lend. If the Fed raises the discount rate, it discourages banks from borrowing, and if it lowers the rate, it encourages banks to borrow.

The term auction facility is another way that the Fed can alter bank reserves. Twice a month, the Fed auctions off the right for banks to borrow reserves for 28- and 84-day periods. This tool allows the Fed to guarantee that the amount of reverses it wishes to lend will be borrowed and, therefore, will be available as excess reserves in the banking system to increase lending.

The Reserve Ratio

Effects of Changes in the Reserve Ratio

LO2

LO3

(1) Reserve Ratio, %	(2) Checkable Deposits	(3) Actual Reserves	(4) Required Reserves	(5) Excess Reserves, (3) –(4)	(6) Money-Creating Potential of Single Bank, = (5)	(7) Money-Creating Potential of Banking System
(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

This table shows that a change in the reserve ratio affects the money-creating ability of the banking system as a whole in two ways, (1) by changing the amount of excess reserves, and (2) changing the size of the monetary multiplier.

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

LO2

LO3

The open market operations are the most important tool in the Fed’s arsenal. It gives the Fed great flexibility in controlling the money supply, and the impact on the money supply is swift. The other tools are typically only used in special circumstances. For example, the last change in the reserve ratio came in 1992 and was done more to shore up banks and thrifts in the aftermath of the 1990-1991 recession than to impact the money supply. In 2008, federal law was changed so that the Federal Reserve could for the first time pay banks interest on reserves. By changing the interest rate the Federal Reserve can encourage or discourage banks to keep reserves, thereby influencing the amount of lending banks do.

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

LO3

Instead of leaving excess reserves at the Federal Reserve Banks, which typically pay less interest than commercial banks, when banks have excess reserves, they will prefer to loan them to other banks that temporarily need the money to meet their own reserve requirements. The rate charged by the commercial bank on these overnight loans is referred to as the federal funds rate. It serves as the equilibrium rate for this market of bank reserves. The Federal Reserve targets this rate by manipulating the supply of reserves that are offered in the market. Typically this is done by buying or selling government bonds. The FOMC meets regularly to choose a desired federal funds rate and then directs the Federal Reserve Bank of New York to undertake the open market operations needed to achieve that rate.

The Federal Funds Rate

Federal Funds Rate, Percent

3.5

Quantity of Reserves

Sf 3

4.0

4.5

Sf 1

Sf 2

Qf3

Qf1

Qf2

Using Open Market Operations

LO3

LO4

In this example, we are assuming that the Fed desires a 4% interest rate. The demand curve is downward sloping because lower interest rates give banks greater incentives to borrow. The supply curve for Federal funds is horizontal at the desired rate because the Fed uses open market operations to manipulate the supply to keep it there.

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

LO4

During times of recession and unemployment, as in the past couple of years, the Fed will initiate expansionary monetary policy. The idea is to increase the supply of money in the economy in order to increase borrowing and spending. One of the problems with the recovery today is that while spending has increased some, borrowing is actually down. It seems ironic that when people save instead of borrow, it can actually be detrimental to the economy. If the Fed feels the economy is overheating or heading into a period of inflation, it will switch to restrictive monetary policy. This policy involves increasing the interest rate to reduce borrowing and spending, which should curtail the expansion of aggregate demand and keep prices down.

Monetary Policy

Restrictive monetary policy

Periods of rising inflation

Increases Federal funds rate

Increases money supply

Increases other interest rates

LO3

LO4

During times of rising inflation, the Fed will switch to a more restrictive monetary policy. In order to keep prices down, the Fed will increase the interest rate in order to reduce borrowing and spending, which will hopefully slow the expansion of aggregate demand that is driving up the price levels.

Monetary Policy

LO4

This figure illustrates the changes in the prime interest rate and the Federal funds rate in the United States between 1998-2013. The two rates move together.

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

LO3

LO4

The Taylor rule was developed by economist John Taylor and builds upon the theory that most economists have which is that central banks are willing to tolerate a small positive inflation rate if doing so helps the economy achieve its potential output. The Taylor Rule assumes that the Fed has a 2% target inflation rate and follows three basic rules when setting its target for the Federal funds rate: (1) When real GDP = potential GDP and inflation is at the target rate of 2%, the Federal funds rate should be 4%. (2) For each 1% increase of real GDP above potential GDP, the Fed should raise the real Federal funds rate by ½%. (3) For each 1% increase in the inflation rate above the 2% target rate, the Fed should raise the real Federal funds rate by ½%.

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

LO5

This next section will discuss how monetary policy affects the economy’s levels of investment, aggregate demand, real GDP, and prices.

Monetary Policy and Equilibrium GDP

$125

$150

$175

$15

$20

$25

Sm1

Sm2

Sm3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(a)

The market

for money

(b)

Investment

demand

(c)

Equilibrium real

GDP and the

Price level

LO5

Rate of Interest, i (Percent)

Amount of money

demanded and

supplied

(billions of dollars)

Amount of investment

(billions of dollars)

Price Level

Real GDP

(billions of dollars)

An expansionary monetary policy that shifts the money supply curve rightward in (a) lowers the interest rate from 10% to 8% which results in the investment spending in (b) to increase from $15 to $20 billion and causes aggregate demand to increase. This shifts the aggregate demand curve rightward from AD1 to AD2 in (c) so that real output rises to the full employment level Qf along the horizontal dashed line. Conversely, a restrictive monetary policy will cause the money supply curve to shift leftward, thereby increasing the interest rate, decreasing investment and aggregate demand.

AD1

I=$15

AD2

I=$20

AD3

I=$25

(c)

Equilibrium real

GDP and the

Price level

AD1

I=$15

AD2

I=$20

AD3

I=$25

(d)

Equilibrium real

GDP and the

Price level

AD4

I=$22.5

Monetary Policy and Equilibrium GDP

LO4

LO5

Price Level

Real GDP

(billions of dollars)

Price Level

Real GDP

(billions of dollars)

In (d), the economy at point a has an inflationary output gap because it is producing above potential output.

Expansionary Monetary Policy

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

Real GDP rises

CAUSE-EFFECT CHAIN

LO5

This chain illustrates the causes and effects of expansionary monetary policy. When faced with the problems of unemployment and recession, the Fed takes actions to increase the money supply, which should eventually lead to real GDP rising. Unfortunately, it is not an immediate reaction so the Fed may overshoot the mark, which can lead to inflation.

Restrictive Monetary Policy

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

Inflation declines

CAUSE-EFFECT CHAIN

LO5

In times of inflation, the Fed practices restrictive monetary policy and decreases the supply of money, which should lead to a decrease in the inflation rate. However, because prices tend to be inflexible, if the Fed is not careful, their actions can lead to a recession.

Evaluation and Issues

Advantages over fiscal policy

Speed and flexibility

Isolation from political pressure

Monetary policy is more subtle than fiscal policy

LO6

Compared to fiscal policy, which involved the government changing its taxing and spending policies, monetary policy has several advantages. It can quickly be changed to fit the current economic conditions, and because the members of the Fed’s Board of Governors served fixed terms and are appointed, not elected, they are not subject to the political pressures that Congress is under.

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

Given the fact that the recession was declared to have officially ended in June of 2009, many economists will continue to debate whether the Fed’s actions helped or hindered the recovery. Over the past decade, the Fed has acted quickly to attempt to stimulate the economy, even lowering the Federal funds rate to almost zero.

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

To help stimulate the economy after the Great Recession, the Fed implemented the zero interest rate policy, quantitative easing, Operation Twist and forward guidance. Under the zero interest policy, the Fed aimed to keep short-term interest rates near zero to stimulate the economy. When growth remained weak the Fed had to find a way to deal with the zero lower bound policy under which a central bank is constrained in its ability to stimulate the economy through lower interest rates since you cannot have a negative interest rate. Their next response was quantitative easing which is similar to open-market operations but is not intended to lower interest rates but rather stimulate increased lending. In the second round the Fed engaged in forward commitment, preannouncing exactly how much it was going to buy. This continued until the Maturity Extension Program, better known as Operation Twist, was introduced in September 2011. This program was designed to reduce long-term interest rates.

Problems and Complications

Lags

Recognition and operational

Cyclical asymmetry

Liquidity trap

LO5

LO6

The lags complicate monetary policy because although its impact is faster than fiscal policy, there is still a three to six month delay that can cause problems and end up with the Fed overshooting its targets. Economists also feel that monetary policy is more effective dealing with slowing expansions and controlling inflations than it is with helping the economy recover from a severe recession. Even though the Fed may create excess reserves during periods of recession, that does not mean the banks will loan the money out. This is why in the recent recessionary period, the U.S. turned more towards the use of fiscal policy to attempt to spend its way out of the recession. Which policies actually succeeded we will probably never figure out.

The Big Picture

Levels of

Output,

Employment,

Income, and

Prices

Aggregate

Demand

Aggregate

Supply

Input

Resources

With Prices

Productivity

Sources

Legal-

Institutional

Environment

Consumption

(Ca)

Investment

(Ig)

Net Export

Spending

(Xn)

Government

Spending

(G)

LO6

This figure illustrates the many concepts and principles discussed in the preceding chapters and how they relate to one another.

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

While most economists feel that the Fed’s aggressive use of ZIRP and QE were warranted by the severity of the recession, there are concerns about the long-run impact. The extremely low interest rate encourage Congress to overspend in efforts to stimulate the economy. Once interest recover, the Federal government will be faced with huge interest costs which will take away from other programs. The extremely low interest rates all punish savers who may have been living off the interest generated by their investments. Pension plans and retirement funds were also negatively impacted by the low rates leading to concerns about the long-term ability of those funds to meet their obligations.