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Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 19
Interest rates and
monetary transmission
©McGraw-Hill Companies, 2010
The central bank
• acts as banker to the commercial banks in
a country
• and is responsible for setting interest rates.
• In the UK, the Bank of England fulfils these
roles.
• Two key tasks:
– to issue coins and bank-notes
– to act as banker to the banking system
and the government
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The central bank and the
money supply
• Three ways in which the central bank MAY influence money
supply:
– Reserve requirements
• central bank sets a minimum ratio of cash reserves to
deposits that commercial banks must meet
– Discount rate
• the interest rate that the central bank charges when
the commercial banks want to borrow
• setting this at a penalty rate may encourage
commercial banks to hold more excess reserves
– Open market operations
• actions to alter the monetary base by buying or selling
financial securities in the open market
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The repo market
• A gilt repo is a sale and repurchase agreement.
– e.g. A bank sells you a bond with a simultaneous
agreement to buy it back at a specified price at
a specified future date.
– This uses the outstanding stock of long-term
assets as backing for new short-term loans.
• Used by central banks in carrying out open market
operations in order to alter cash in circulation
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Other functions of the Bank of
England
• Lender of last resort
– The bank stands ready to lend to banks and
other financial institutions when financial panic
threatens.
• Banker to the government
– The bank ensures that the government can
meet its payments when running a budget
deficit.
• Setting monetary policy to control inflation
– more of this later
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Prudential regulation
• It may also be the job of the central bank
to ‘police the financial system’. If not then
some other financial agency should do this.
• Capital adequacy ratios are one way of
doing this. A capital adequacy ratio is a
required minimum value of bank capital
relative to its outstanding loans and
investments.
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Prudential regulation (2)
• There should also be an element of selfregulation.
• If a bank makes large losses it may go
bankrupt. Typically, governments then
compensate depositors but not
shareholders.
• The knowledge that depositors are unlikely
to suffer helps prevent unjustified financial
panics.
• The knowledge that shareholders are likely
to suffer helps keep management on its
toes.
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Three things went wrong
leading up to 2008/9
1.
2.
3.
The magnitude of the initial shock was very large.
Banks had borrowed billions to speculate on
securitized products which subsequently proved
a very bad investment.
Capital adequacy regulations had been poorly
designed. What was adequate financial backing
by shareholders in good times turned out to be
grossly inadequate capital reserves in a big crisis.
Many banks had become ‘too big to fail’. This
became apparent when Lehman Brothers failed.
If the bank is large enough it causes massive
ripples through the financial system.
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Structural solutions to prevent a
future banking crisis?
• The separation of retail banking and investment
banking.
• Alternatively allow all banks to undertake all types
of transactions, but place an absolute limit on the
size of banks that are eligible for deposit
guarantees and fiscal bailouts.
• A third possibility is to rely on stronger prudential
supervision by regulatory agencies, particularly in
the enforcement of tougher capital adequacy
ratios.
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Competing financial centres
• But if some financial centres regulate more
than others, private business may tend to
migrate to the least intrusive location.
• London might have regulated earlier if it
had been less frightened of losing business
to Frankfurt and New York.
• This suggests that any real reforms may
have to be negotiated at the level of the
top 10 global countries, not merely a
country at a time.
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Money market equilibrium
Other things being equal,
the demand for real
money balances will be
lower when the
opportunity cost (the rate
of interest) is relatively
high.
r0
LL
L0
Real money holdings
The position of this
schedule depends
upon real income and
the price level.
When money supply is L0, money market
equilibrium occurs when the rate of interest is at
r0.
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Reaching money market
equilibrium
If the rate of interest is
set below the market
equilibrium – say at r1
r0
r1
– there is excess demand for
money (the distance AB).
A
L0
B
LL
Real money holdings
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This implies an excess
supply of bonds – which
reduces the price of
bonds and thus raises the
rate of interest until
equilibrium is reached.
Monetary control
Given the money demand schedule:
The central bank can ...
EITHER set the interest
rate at r0 and allow money
supply to adjust to L0
r0
LL
L0
Real money holdings
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OR set money supply at L0
and allow the market rate
of interest adjust to r0
BUT cannot set both
money supply and interest
rate independently.
Monetary control –
some provisos
• Monetary control cannot be precise unless the
authorities know the shape and position of
money demand and can easily manipulate the
money multiplier.
• Controlling money supply is especially
problematic,
– and the Bank of England has preferred to
work via interest rates.
– This involves fixing the interest rate and
accepting (i.e. supplying) the equilibrium level
of money.
©McGraw-Hill Companies, 2010
The economic crisis
We show again the
collapse of the ratio
of broad money to
bank reserves.
If reserves had
remained constant,
broad money would
have fallen to a sixth
of its previous level!
The complete drying
up of bank lending
transmitted a huge
shock to the real
economy.
©McGraw-Hill Companies, 2010
Quantitative easing
• House prices fell, industrial production fell and
increasing numbers of bankruptcies were
reported.
• To accomplish quantitative easing, the Bank
announced that it would buy ‘safe’ bonds from
private firms or government, in enormous amounts.
• This put narrow money into the system. Then
having circulated round the system a few times,
this ended up being held by banks as reserves at
the Bank of England.
©McGraw-Hill Companies, 2010
Quantitative easing (2)
• The reserves of UK banks rose sixfold between May
2008 and July 2009 as the Bank of England took
action.
• From May 2008 to July 2009, banks’ reserves increased
from £27bn to £152bn,
• whereas broad money increased from £1737bn to
£2001bn,
• so the £264bn increase in broad money was caused
not merely by the £125bn increase in bank reserves.
• As banks felt a little safer, they lent a little more,
thereby raising bank deposits.
©McGraw-Hill Companies, 2010
Targets and instruments of
monetary policy
• Monetary instrument
– the variable over which the central bank
exercises day to day control
– e.g. interest rate
• Intermediate target
– the key indicator, used as an input to frequent
decisions about how to set interest rates
• The financial revolution has reduced the reliability
of money supply as an indicator,
– and central banks increasingly use inflation
forecasts as the intermediate target.
©McGraw-Hill Companies, 2010
The transmission mechanism
• … is the channel through which
monetary policy affects output and
employment.
• In a closed economy, monetary
policy works through the impact of
interest rates on consumption and
investment demand.
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Consumption demand
• A simple version of the consumption
function is:
C = a + bYd
• monetary policy can affect
household wealth
– this is called a wealth effect
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Consumption demand the wealth effect
• The wealth effect occurs in two ways:
– directly, through an increase in the real
money supply (part of wealth is kept in
the form of money)
– indirectly, through the effect of interest
rates on share prices: as interest rates
fall, the price of bonds and shares rises
making stock holders feel wealthier
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Consumption demand -
consumer credit and durable goods
• Consumption is affected by two aspects of
consumer credit
– the quantity of credit: an increase in the
quantity of credit increases autonomous
consumption shifting the consumption function
up and vice versa
– the cost of credit: households will borrow less at
higher interest rates, thus reducing consumption
and vice versa
• These points are well illustrated by the UK housing
market.
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Consumption and the life-cycle
Actual
income
D
Income varies over
an individual's
lifetime.
Individuals try to smooth
their consumption, based
on expected lifetime (or
permanent) income.
BB
A
A
Permanent
income
0
Age
Saving (B) occurs
during middle age
Death
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and dissaving (A) in youth
and old age.
Consumption, wealth and the
life-cycle
Given the household’s initial
estimation of their wealth,
permanent income is OD.
Actual
income
B’
D’
D
0
A’
A
B
Permanent
income
Age
A’
A
Say the household consumes
its permanent income. Then
the two A’s (plus any interest)
would be offset by B.
Death
With higher wealth, permanent
income is revised upwards to
OD’ so that 2(A+A’) exceeds B’
This shortfall can be met from
the extra wealth.
Thus wealth and interest rates may influence consumption.
©McGraw-Hill Companies, 2010
Investment demand
• Investment spending includes:
– fixed capital
• Transport equipment
• Machinery & other equipment
• Dwellings
• Other buildings
• Intangibles
– working capital
• stocks (inventories)
• work in progress
• and is undertaken by private and public sectors
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The demand for fixed
investment
• Investment entails present sacrifice for
future gains
– firms incur costs in the short run
– but reap gains in the long run
• Expected returns must outweigh the
opportunity cost if a project is to be
undertaken.
• So, at relatively high interest rates, fewer
investment projects are viable.
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The investment demand
schedule
r0

The investment demand
schedule suggests that ceteris
paribus higher interest rates
reduce the volume of
investment projects and vice
versa.

II
I0
I1
II’
investment demand
Changes in the price of
capital goods and
expectations about profit
streams at given interest rates
shift the schedule up or down.
©McGraw-Hill Companies, 2010
The credit channel of monetary
policy
• Recent research emphasizes that interest rates are
not the only channel through which monetary
policy affects consumption and investment.
• The credit channel affects the value of collateral
for loans, and thus the supply of credit. There are
two ways this can happen:
– changes in goods prices alter the real value of
nominal assets
– policy induced changes in the interest rate alter
the market value of assets which may be used
as collateral
©McGraw-Hill Companies, 2010