Download Interest Rate

The Demand for Money
At any given time, people demand a certain
amount of liquid assets (money) for two different
reasons:
1. Transaction Demand for Money- People hold
money for everyday transactions.
**Perfectly inelastic – QD is the same at all interest rates
2. Asset Demand for Money - People hold money
since it is less risky than other assets
**QD is inversely related to interest rates
What is the opportunity cost of hold keeping
money in your pocket or checking account?
The interest you could be earning from other
1
financial assets like stocks, bonds, and real estate
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The Demand for Money
1. What happens to the quantity demanded of
money when interest rates increase?
Quantity demanded falls because individuals
would prefer to have interest earning assets
instead
2. What happens to the quantity demanded when
interest rates decrease?
Quantity demanded increases. There is no
incentive to convert cash into interest earning
assets
There is a inverse relationship
between the interest rate and the
quantity of money demanded
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The Demand for Money
Inverse relationship between interest rates and
the quantity of money demanded
Nominal
Interest Rate
(ir)
20%
5%
2%
0
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MD
Quantity of Money
(billions of dollars)
3
The Demand for Money
What happens if price level increase?
Nominal
Interest Rate
(ir)
20%
Money Demand Shifters
1. Changes in price level
2. Changes in RGDP
5%
2%
0
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MD2
MD1
Quantity of Money
(billions of dollars)
4
The Supply for Money
The U.S. Money Supply is set by the Board of Governors
of the Federal Reserve System (FED)
What does the MS curve look like? Why?
Interest
Rate (ir)
MS1
The FED can change the money
supply.
This is called Monetary
Policy.
20%
5%
2%
MD1
200
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Quantity of Money
(billions of dollars)
5
Increasing the Money Supply
Interest
Rate (ir)
MS1 MS2
10%
5%
If the FED increases the
money supply, a temporary
surplus of money will
occur at 5% interest.
The surplus will cause the
interest rate to fall to 2%
2%
MD1
200
Increase
money supply
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250
How does this
affect AD?
Quantity of Money
(billions of dollars)
Decreases
interest rate
Increases
investment
Increases
AD 6
Decreasing the Money Supply
Interest
Rate (ir)
MS2 MS1
10%
5%
2%
If the FED decreases the
money supply, a temporary
shortage of money will occur
at 5% interest.
The shortage will cause the
interest rate to rise to 10%
How does this
affect
AD?
MD
1
150
Decrease
money supply
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200
Quantity of Money
(billions of dollars)
Increase
interest rate
Decrease
investment
Decrease
AD
7
2007B Practice FRQ
8
2007B Practice FRQ
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2007B Practice FRQ
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2007B Practice FRQ
HOW DOES THE FED
CHANGE THE MONEY
SUPPLY???
How the Government Stabilizes the Economy
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How the FED Stabilizes the Economy
These are the three main tools of
monetary policy.
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3 Shifters of
Money Supply
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TOOLS OF MONETARY POLICY
• Open Market Operations – WHAT IS IT?
• Buying and selling securities (mostly
treasury bonds)
• Used to influence the money supply
• The reserve ratio – WHAT IS IT?
• Changes the money multiplier AND
excess reserves
• The discount rate – WHAT IS IT?
• The Fed as lender of last resort
• Short term loans
33-16
Using Open Market Operations
• Open Market Operations is when the FED buys or
sells government bonds (securities).
• This is the most important and widely used
monetary policy
To increase the Money supply, the FED should
BUY
_________
government securities,
adding reserves to the banking system
To decrease the Money supply, the FED should
SELL
_________
government securities,
subtracting reserves from the banking system
How are you going to remember?
Buy-BIG- Buying bonds increases money supply
Sell-SMALL- Selling bonds decreases money supply
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Using The Reserve Requirement
1. If there is a recession, what should the FED do to
the reserve requirement? (Explain the steps.)
Decrease the Reserve Ratio
1. Banks hold less money and have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD up
2. If there is inflation, what should the FED do to the
reserve requirement? (Explain the steps.)
Increase the Reserve Ratio
1. Banks hold more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down
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Practice
Don’t forget the Monetary Multiplier!!!!
1. If the reserve requirement is 50% and the
FED sells $10 million of bonds, what will
Decrease
happen to the money supply? $20 million
(Multiplier = 2)
2. If the reserve requirement is 10% and the
FED buys $10 million bonds, what will
Increase
happen to the money supply? $100 million
(Multiplier = 10)
3. If the FED decreases the reserve requirement
from 50% to 20% what will happen to the
money multiplier? It will rise
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from 2 to 5
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Using The Discount Rate
The Discount Rate is the interest rate that the
FED charges commercial banks.
• If Bank of America needs $10 million to meet their reserve
requirement, they may need to borrow it from the U.S.
Treasury (which the FED controls) but they must pay it
back with interest.
• The lower the rate of interest, the more lending banks will
do, accepting the risk of potentially needing to use the
discount window
To increase the Money supply, the FED should
DECREASE
_________ the Discount Rate (Easy Money Policy).
To decrease the Money supply, the FED should
_________ the Discount Rate (Tight Money Policy).
INCREASE
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HOMEWORK
• Review pgs. 752-761
• Review Monetary Policy
Packet
2012 Exam
OTHER TOOLS OF MONETARY POLICY
Term auction facility – WHAT IS IT?
Introduced December 2007
Banks bid for the right to borrow
reserves
Only used a few times during the
height of the crisis
Interest on Reserves–
More on this later…
TOOLS OF MONETARY POLICY
• Which tool is most used?
• Open market operations most important
• Reserve ratio last changed 1992
• Limits for each tranche change yearly
• Discount rate was a passive tool
• Aggressive during credit crisis
• Term auction facility (2007-2010)
• Allowed the Fed to lend at a rate BELOW
the discount rate
• Guaranteed amount lent by the Fed
• Anonymous
33-27
THE FEDERAL FUNDS RATE
• Rate charged by banks on overnight
loans
• FED can’t directly control this… banks
decide
• Targeted by the Federal Reserve
• Most monetary policy revolves around
Federal Funds Rate
• FOMC conducts open market
operations to achieve the target
• What does the demand curve for
Federal Funds look like? Why?
• What does the supply curve for Federal
Funds look like? Why?
33-28
THE FEDERAL FUNDS RATE
Federal Funds Rate, Percent
Using Open Market Operations
4.5
Sf3
4.0
Sf1
3.5
Sf2
Df
Qf3
Qf1
Qf2
Quantity of Reserves
33-29
Federal Funds Rate
Explain the differences between 1979 and 2007
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PRIME INTEREST RATE
• Reference point used by banks
• Tied to Federal Funds Rate – about 3% difference
What is the Federal
Funds Rate right now?
TAYLOR RULE - BRIEFLY
• Rule of thumb for tracking actual monetary
policy
• Assumes Fed has 2% target inflation rate
• If real GDP = potential GDP and inflation is 2%
then target federal funds rate is a nominal 4%
(real=2%)
• Target varies as inflation and real GDP vary
• For every 1% increase above potential GDP
--or-- above inflation target, Fed should
increase real federal funds rate by ½%
33-34
READ PGS. 761-773
• Answer the following question in at
least 200 words:
• Based upon what you know and what
you’ve read, do you think the Federal
Reserve did a good job responding to
the financial crisis? What would you
have done differently and why?
• What risks are we currently facing due
to the FED’s actions?
PRE-PODCAST QUESTION
Why hasn’t the $4.5 Trillion created
by the FED since 2008 created rapid
hyperinflation?
POTENTIAL REASONS…
• International demand for the dollar
results in the extra cash being held
internationally, reducing it’s usage at
home
• Fear = Savings
• Banks are using the cash to speculate
instead of lending to “Main Street”
• But if lending does pick up we will run
the risk of high inflation, so what do we
do?
Wait, why would the FED ever
want to slow down the economy?
To fight inflation
The role of the Fed is to “take away the
punch bowl just as the party gets going”
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HOMEWORK:
•Podcast Comments due
Thursday
•Read pgs. 366-371and
complete Loanable
Funds and Crowding Out
packet
2014 AP® MACROECONOMICS FREE-RESPONSE QUESTIONS
2. The Federal Reserve can influence the supply of money.
(a) Assume that the Federal Reserve targets a lower federal funds
rate.
(i) What open market operation can the Federal Reserve
use to achieve the lower target?
(ii) Given your answer to part (a)(i), what will happen to
the price of government bonds?
(b) Using a correctly labeled graph of the money market, show
the effect of the open market operation from part (a)(i) on the
nominal interest rate.
(c) Assume that the Federal Reserve buys government bonds
from commercial banks. Based only on this transaction, will the
level of required reserves in the commercial banks increase,
decrease, or remain the same?
(d) Another monetary policy action involves changing the
discount rate. Define the discount rate.
EXPANSIONARY MONETARY POLICY
CAUSE-EFFECT CHAIN
Problem: unemployment and recession
Fed buys bonds, lowers reserve ratio, or 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
33-42
Interest
Rate (i)
Interest
Rate (i)
S&D of Money
SM SM1
10%
10%
5%
5%
2%
2%
DM
200
PL
250
QuantityM
AD/AS
PL1
PLe
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Qe
Q1
DI
Quantity of Investment
The FED increases the
money supply to
stimulate the economy…
AS
AD
Investment Demand
AD1
GDPR
1. Interest Rates Decreases
2. Investment Increases
3. AD, GDP and PL Increases
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RESTRICTIVE MONETARY POLICY
CAUSE-EFFECT CHAIN
Problem: inflation
Fed sells bonds, increases reserve ratio, or
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
33-44
Interest
Rate (i)
Interest
Rate (i)
S&D of Money
SM1 SM
10%
10%
5%
5%
2%
2%
DM
175
PL
200
QuantityM
AD/AS
PLe
AD
AD1
Qe
Quantity of Investment
1. Interest Rates increase
2. Investment decreases
3. AD, GDP and PL decrease
PL1
Q1
DI
The FED decreases the
money supply to slow
down the economy…
AS
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Investment Demand
GDPR
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MONETARY POLICY
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Problems and complications
• Recognition lag
• Operational lag
• Cyclical asymmetry
33-46