Download Interest Rate

Federal Funds Rate
Banks lend
more when
the interest
rate
increases
io Supply
increases
when the Fed
injects
reserves
Supply: banks, Fed
Banks increase
lending as interest
rates rise because
it is more
profitable
The Fed
manipulates the
amount of reserves
in the system.
Money
Wealth can be held in two
forms
Wealth
Assets that
earn a
return (bonds)
Assets that do
not earn a
return
(cash/Deposits)
The Demand for Money
Tells us “how much of our wealth
we want to hold as cash/Deposits
banks”
The Interest Rate
Represents the Cost of holding
cash balances…
what you give up…
The Demand for Money
Interest Rate
i0
The lower the
amount of desired
cash
(deposits)/reserves
Md0
The higher the i,
the higher the
opportunity cost
of holding cash/
reserves
The Demand for Money
Interest Rate
i1
The larger the
amount of desired
cash
(Deposits)/reserves.
Md1
As the i falls,
the opportunity
cost of holding
cash/reserves
decreases
The Federal Funds Rate
Federal Funds Rate
Supply: banks + Fed
As interest rate
rises bank’s
quantity
demanded drops
io
Demand: Public
Money
The Federal Funds Rate
Federal funds Rate
io
Deposits/
Demand for
reserves
increase with
more
transactions
Deposits/
Demand for
reserves
increase when
prices increase
Banks need
more reserves
when
Deposits
Supply=
excess
reservesincrease
+ Fed
changes
Demand = Banks in
need of reserves
Money
The
higherDetermines
prices
What
How Much Money
and Income, the
we
Want
to
hold
as
Deposits?
higher the need for
We need to hold more
cash
Prices
+
The higher the
interest rate, the lower
Real
Income
+
the demand
for cash
Interest rate
-
cash for more expensive
transactions
We buy more things: we
need more cash for more
transactions.
The higher the interest
rate the less money we
want to hold as cash
Shifts in the Demand for
Money
Increase in prices or Incomes
(GDP): shift demand to the
right
Decrease in prices or
incomes (GDP): shift the
demand to the left
When Prices Increase
More expensive
transactions require
larger cash holdings
Thedemand
demand
The
forbank
money
for
shifts to shifts
the
reserves
toright
the right
At each i we
hold more
cash than
before
i0
i1
Md0
Md1
When Real Income Increases
We engage in
MORE transactions
which require larger
i =5%
cash holdings.
The demand
for bank
reserves
shifts to the
right
i =3%
500
bill.
700 800
bill.
900
The Federal Reserve Bank
‘Controls’ the Supply of Money
Federal
i Funds Rate
Open Market
Operations.
Changes in the
Discount Rate
io
Changes in the
required reserve ratio.
Ms
Supply
Demand
Quantity Bank Reserves
The amount of money in circulation is
managed by the fed
$
The Public ‘controls’ the
Demand for money
When prices increase i
the demand for money
increases
When incomes
increase the demand
for money increases.
Ms
Md
$
Monetary Policy
The Fed determines the “desired level” for the
interest rate
The Fed adjusts the Money Supply until the
rate hits the target.





Via Open Market Operations.
Via changes in required reserves.
Via changes in discount rate.
Via changes in margin requirements.
Via moral suasion.
Relationship Between Bond
Prices and the Interest Rate
Peter
purchased this
bond
A month later a
new bond “A”
Is issued into
the market
Bond P
Price:$100
Interest Rate: 5%
Interest: $5
Bond A
Price:$100
Interest Rate: 8%
Interest: $8
Which Bond would you buy?
Peter’s?
Bond P
Price:$100
Interest Rate: 5%
Interest: $5
The new bond “A”?
Bond A
Price:$100
Interest Rate: 8%
Interest: $8
Clearly A is better than P: same price but
higher interest
What price should Peter ask for to
convince you to purchase his
bond rather than A?
A Price that would make
Peter’s bond more attractive
A price so low, that the interest
you earn on Peter’s bond is
higher than 8%
The lower
the price, the
higher the
interest rate
Peter’s Bond
If you pay $100
for Peter’s
Bond
You receive $105
at maturity
Interest Rate = (105 – 100)/100 = 5%
If you pay $90
for Peter’s
Bond
You receive $105
at maturity
Interest Rate = (105 – 90)/ 90 = 16.7%
What price will give us exactly
8% for Peter’s bond?
If you pay $X
for Peter’s
Bond
You receive $105
at maturity
Interest Rate = (105 – X)/ X
8% = (105 – X)/ X
0.08 X = 105 - X
0.08 X + X = 105
X(0.08 + 1) = 105
X(1.08) = 105
X = $97.22
If Peter needs to sell his bond
It must sell it for LESS than
$97.22 to make
i >8%
Since he paid $100 for it, he must
sell at a loss….
When
interest
rates rise,
bond bond
prices drop
What does this mean?
When interest rates rise: when new bonds
come into the market with higher interest
rates…I can still sell old bonds for cash, but I
will lose money in the transaction.
The Relationship Between Bond
Prices and the Interest Rate
Peter P is
Clearly
purchased this
better
than
bond
A: same
price but
A month later a
higher
new bond “A”
interest
Is issued into
the market
Bond P
Price:$100
Interest Rate: 10%
Interest: $10
Bond A
Price:$100
Interest Rate: 5%
Interest: $5
What price will give us exactly
5% for Peter’s bond?
If you pay $X
for Peter’s
Bond
You receive $110
at maturity
Interest Rate = (110 – X)/ X
5% = (110 – X)/ X
0.05 X = 110 - X
0.05 X + X = 110
X(0.05 + 1) = 110
X(1.05) = 110
X = $104.76
When
interest
rates fall,
bond prices
increase
If Peter needs to sell his bond
He can now sell it for MORE than
$100
Since he paid $100 for it, he will
make a profit ….
What does this mean?
When interest rates fall: when new bonds
come into the market with lower interest
rates…I can sell my bonds at a profit.
Bond Market
Supply of bonds
P0
Demand for bonds
Bond Market: Fed Sells Bonds
Bond Price
falls: Interest
Rates
Increase
Supply of bonds
P0
P1
Demand for bonds
Bond Market: Fed Buys Bonds
Supply of bonds
P1
P0
Bond Price
rises: Interest
Rates
Decrease
Demand for bonds
Monetary Policy
Changing the Money Supply in
order to affect Aggregate
Spending
The Effect of an Increase in
the Money Supply
The fed increases Ms by:
i
• Reducing the required
reserve ratio (r)
• Buying bonds in the Open
Market
• Reducing the Discount
Rate (d)
An increase in Ms is represented
as a rightward shift in the Money
Supply line
Ms 0
Ms 1
$
When the Fed Wants to
Reduce Unemployment
Use Expansionary Monetary Policy
Increase the Money Supply
Decrease the interest rate.
Increase demand for goods and
services
The Effect of a Decrease in
the Money Supply
The fed decreases Ms by:
• Increasing the required
reserve ratio (r)
• Selling bonds in the Open
Market
• Increasing the Discount
Rate (d)
A decrease in Ms is represented
as a leftward shift in the Money
Supply line
i
Ms 1
Ms 0
$
When the Fed Wants to
Reduce Inflation
Use Contractionary Monetary Policy
Decrease the Money Supply
Increase the interest rate.
Decrease Aggregate Demand
Ms
Federal Funds Rate
i
Supply
ffro
i
Md
Demand
$
Quantity Bank Reserves
Supply of bonds
P0
Demand for bonds
Questions to prepare for the test
Use a diagram to show the effect on reserves, the
money supply, the interest rate, the price of bonds
and Aggregate Demand for the following events.
Write a clear explanation of the process step by
step.
1.
The fed increases/decreases the required reserve
ratio
2.
The fed buys/sells bonds in the open market
3.
Fed increases/decreases the discount rate.
4.
Prices increase/decrease
5.
Incomes decrease/decrease
Event
Demand
for
Reserves
Supply of
Reserves
Federal
Funds
Rate
Banks
Loan
s
Deposits
Md/Ms
Increase in
Required Reserve
Ratio (r)
b
1
Ms
Decrease in
Required Reserve
Ratio (r)
b
2
Ms
Buy Bonds
b
3
Ms
Sell Bonds
b
4
Ms
Increase in
Discount Rate
b
5
Ms
Decrease in
Discount Rate
b
6
Ms
Increase in Prices
same
7
Md
Decrease in Prices
same
8
Md
Increase in Incomes
(GDP) An economic
Expansion
same
9
Md
Decrease in
Incomes (GDP)
Economic
Recession
same
10
Md
Interest
Rate
(i)
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
More banks in need of reserves, fewer banks with excess reserves, banks
try to beef up their reserves by making fewer loans thus decreasing
deposits and the money supply.
Fewer banks in need of reserves, more banks with excess reserves,
banks with excess reserves make more loans thus increasing deposits
and the money supply.
Fed injects more reserves: Fewer banks in need of reserves, more banks
with excess reserves, banks with excess reserves make more loans thus
increasing deposits and the money supply.
Fed erases reserves from the system: Fewer banks in need of reserves,
more banks with excess reserves, banks with excess reserves make more
loans thus increasing deposits and the money supply.
Banks borrow less from fed more from other banks (increase demand for
reserves); banks beef up their reserves (instead of using expensive fed
loans for emergencies) (decrease in supply): decrease loans, deposits
and money supply.
Banks borrow more from fed less from other banks (decrease demand for
reserves); banks decrease their excess reserves (instead of using their
own, they use cheap fed loans for emergencies) (increase in supply):
increase loans, deposits and money supply.
Increase in demand for reserves, increase in demand for money.
Decrease in demand for reserves, decrease in demand for money
Increase in demand for reserves, increase in demand for money.
Decrease in demand for reserves, decrease in demand for money.