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MODULE 31
MONETARY POLICY AND THE INTEREST RATE
You have heard it before but lets review it again.
1. The interest rate is the cost of borrowing money
Interest-Rate Effect
• When price level increases, lenders need
to charge higher interest rates to get a
REAL return on their loans.
• Higher interest rates discourage consumer
spending and business investment.
•WHY?
• An increase in prices leads to an increase in the
interest rate so you are less likely to take out loans
to improve your business.
2
The FED adjusts the money supply by changing
any one of the following:
1. Changing Reserve Requirements (Ratios)
2. Lending Money to Banks & Thrifts
•Discount Rate
3. Open Market Operations
•Buying and Selling Bonds
The FED is now chaired by Janet Yellen
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• 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
_________
government securities.
BUY
To decrease the Money supply, the FED should
SELL
_________
government securities.
How are you going to remember?
Buy-BIG- Buying bonds increases money supply
Sell-SMALL- Selling bonds decreases money supply
Buying Bonds= Bigger Bucks ( money supply)
Selling Bonds= Smaller Bucks ( money supply)
4
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When the Fed buys bonds, it adds to bank
reserves. This is called easy money,
expansionary monetary policy, or
quantitative easing.
◦ It is designed to increase excess reserves and
the money supply, and ultimately reduce
interest rates to stimulate the economy.

The opposite of an expansionary policy is
a tight money, restrictive, or
contractionary monetary policy.
◦ Tight money policies are designed to shrink
income and employment, usually in the
interest of fighting inflation. The Fed brings
about tight monetary policy by selling bonds,
thereby pulling reserves from the financial
system.
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Monetary authorities around the world have tried an
alternative to monetary rules by using the approach of
inflation targeting.
This sets targets for the inflation rate, usually around
2% per year. In January, 2012 the Fed adopted this
position as well.
If inflation exceeds the target, contractionary policy is
employed; if inflation falls below the target,
expansionary policy is used.
Forward looking policy- offers transparency since the
public knows the objective of an inflation targeting
central bank.
Central bank’s success can be judged and the bank is
accountable.
Monetary Policy and the Interest
Rate: Open Market Committee
• Sets the target federal funds rate every six
weeks- uses Open Market Operations to
achieve the goal.
The Federal Reserve Bank of
NY is charged with carrying this out.
Today, monetary authorities set a target
interest rate and then use open market
operations to adjust reserves and keep
the federal funds rate near this level.
 The Fed’s interest target is the level that
will keep the economy near potential
GDP and/or keep inflationary pressures in
check.
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Draw expansionary and
contractionary shift in loanable
funds market
Monetary Policy and Aggregate
Demand
• Review: fiscal policy can stabilize the economy
• Expansionary Monetary Policy:
• -expand the Money Supply= lower interest
rate=more investment spending=higher
rGDP=more consumer spending, etc
• Contractionary=opposite impact
Monetary Policy in Practice
• Remember, we try to fight recessions and
ensure price stability (aka low inflation).
• When real GDP is below potential
output=expansionary and vice versa
•  recall that the output gap= percentage
difference between real GDP and potential
output, + = exceeds Yp, and vice versa
Along came this gentleman…
Taylor rule for monetary policy
• Simple rule that takes into account concerns about
both the business cycle and inflation
• the federal funds rate takes into acct inflation rate
and output gap (in fact, we already follow this rule)
Federal funds rate=1 + (1.5 x inflation rate) + (0.5 x output gap)
Problem with the rule is that it has a “lag” and adjusts for past
inflation but not future inflation
Commitment
• The Fed does not commit to an inflation rate
but prefers about 2% (low, +); other central
banks do have inflation targets=set policy
(inflation target) to carry this out.
Difference?
• Inflation targeting looks forward,
monetary policy looks backward (future
inflation rates versus current)
• + infl. Targ= transparent and accountable
(can know the rate and see how close
they are)
• - too restrictive, not focused on stability
of financial system
FRQ 2010 Form B
2. The central bank of the country of Sewell sells bonds on
the open market.
 (a) Assume that banks in Sewell have no excess reserves.
What is the effect of the central bank’s action on the amount
of customer loans that banks in Sewell can make?
 (b) Using a correctly labeled graph of the money market,
show the effect of the central bank’s action on the nominal
interest rate in Sewell.
 (c) What is the effect of the central bank’s action on each of
the following in Sewell?
◦ (i) Price level
◦ (ii) Real interest rate. Explain.
 (d) Given your answer in part (c)(ii), how is the international
value of Sewell’s currency, the ono, affected?
 Explain.
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FRQ 2010 Form B- Ruberic
7 points (1 + 2 + 3 + 1)
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(a) 1 point: • One point is earned for stating that bank loans
will decrease.
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(b) 2 points:
• One point is earned for a correctly labeled graph of the money market.
• One point is earned for showing a leftward shift of the MS curve and an
increase in the nominal interest rate. (See graph on previous slide)
(c) 3 points:
• One point is earned for stating that the price level will fall.
• One point is earned for stating that the real interest rate will rise.
• One point is earned for the explanation that with an increase in the
nominal interest rate and a decrease in the price level, the real interest
rate increases.
(d) 1 point:
• One point is earned for stating that the ono will appreciate, because the
increase in the demand for Sewell’s financial assets causes an increase in
the demand for the ono.
Review: If the money supply
increases what happens in the
money market?
A.
B.
C.
D.
E.
The nominal interest rates rises
The nominal interest rates falls.
The nominal interest rate does not change
Transaction demand for money falls
Transaction demand for money rises
Which of the following is a predictable
advantage of expansionary monetary policy
in a recession?
A.
B.
C.
D.
Decreases aggregate demand so that the
price level falls.
Increases aggregate demand, which
increases real GDP, and increase
employment.
Increases unemployment, but low prices
negate this effect.
It boost the value of the dollar in foreign
currency markets.
Review again
If current federal funds rate is higher than
the target-the FED will increase the
money supply so the rate falls to the
target- Buy Bonds
 If the current federal funds rate is lower
than the target , the FED will decrease the
money supply so that the rate rises to the
target- Sell Bonds
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AP Exam Alert
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Remember that the Aggregate Demand
curve shifts in the same direction as the
Money Supply Curve.