Download Interest Rate

Monetary Policy
Chapter 13
The Supply of Reserves
Banks lend more
when the fed funds
rate increases
Federal Funds Rate
io
Supply: banks
Banks increase
lending as interest
rates rise because
it is more
profitable
A movement up (down)
along the supply of funds
resulting from higher (lower)
interest rates
Money
A movement up along the
supply of funds resulting
from higher rates
Banks lend more
when the fed funds
rate increases
Federal Funds Rate
Supply: banks, Fed
Banks increase
lending as interest
rate rises because
it is more
profitable
io Supply
increases
when the Fed
injects
reserves
The Fed
manipulates the
amount of reserves
in the system.
Money
A rightward (left) shift in the
supply of funds resulting
from Fed pumping more
(less) reserves into the
system
Federal Funds Rate
The Demand for
Reserves
Supply: banks + Fed
io
A movement up (down)
along the demand for funds
resulting from higher (lower)
Money
interest rates
As fed funds
rate rises bank’s
want to borrow
less reserves
Demand: Public
Demand for Reserves
Banks need
more reserves
when
Deposits
Supply=
excess
reservesincrease
+ Fed
Federal funds Rate
changes
io
Demand: Banks +
Public
Money
The
higherDetermines
prices
What
How Much Money
and Income, the
public
wants
to
hold
as
Deposits?
higher the need for
We need more
cash/deposits
Prices
+
The higher the
interest rate, the lower
Real
Income
the demand
for +
cash/deposits
Interest rate
-
cash/deposits for more
expensive transactions
We need more
cash/deposits for more
transactions.
The higher the interest
rate the less money we
want to hold as
cash/deposits
Deposits
Larger when we engage in more
transactions

Real GDP is used as an indicator of the
number of transactions (Q)
Larger when transactions are more
expensive:

Price Index is used as indicator of the
average price per transaction (P)
Demand for
Reserves depends
on size of Deposits:
R = r*D
Size of Deposits
depend on dollar
value of
transactions: P*Q
Demand for
Reserves depends
on dollar value of
transactions: P*Q
Shifts in Demand
for
Reserves
Deposits/
Banks need
Deposits/
Federal funds Rate
io
Demand for
more reserves
Demand for
reserves
when
Deposits
Supply=
excess
reserves
+ Fed
increase with reservesincrease
increase when
changes
more
Deposits/ GDP increases
transactions
Demand for
reserves
increase when
prices increase
A rightward (left) shift in the
demand for funds resulting
from increase (decrease) in
GDP or Prices
Money
Demand = Banks in
need of reserves
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.
The Demand for Money
Interest Rate
i0
Md0
The higher the
i, the higher the
opportunity
cost of holding
cash
The less cash
we wish to
Amount of
hold.
cash WE
wish to hold.
The Demand for Money
Interest Rate
i1
We can afford
to hold more
cash.
Md1
As the i falls,
the opportunity
cost of holding
cash
decreases
Amount of
cash WE
wish to hold.
What
The Demand
is the shape
for Money
of the Demand
slopes
downward
for and
Money?
to the right.
Because
Because as
as the
the interest
interest rate
rate
Why doesthe
it have
this shape?
increases,
opportunity
decreases, the opportunitycost
costofof
holding cash increases.
decreases.
The Demand for Money
Interest
Tells us the
quantity
i0
demanded of
money at each
interest rate or
The interest rate
that would induce
the public to hold i 1
a given amount of
cash.
Rate
Md0
Md1
Movements Along the
Demand for Money
Represent a change
(increase or
i
decrease) in the
demand for money
Are ONLY caused
by changes in the
interest rate.
i
0
i1
Md0
Md1
What Determines How Much
Money
we
Want
to
hold
as
cash?
The higher prices
and Income, the
higher the need
Prices
+for
cash
We need to hold more
cash for more expensive
transactions
The higher the
interest rate, the
Real
Income
+
lower the demand
for cash
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
Interest
rate
-
Shifts in the Demand for
Money
i
Represent
changes in the
demand for
money
Caused by
FACTORS
different from the
interest rate.
Prices
Income
i0
i1
Md0
Md1
When Prices Increase
More expensive
transactions require
larger cash holdings
The
demand for
money
shifts to
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 i
money
shifts to
the right
=3%
500
bill.
700 800
bill.
900
The Federal Reserve Bank
Controls the Supply of Money
Open Market
Operations.
Changes in the
Discount Rate
Changes in the
required reserve
ratio.
i
Ms
700 bill
$
The amount of money in circulation is fixed by the
fed
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?
Peter’s
Bond P
Price:$100
Interest Rate: 5%
Interest: $5
A Price that would
make Peter’s bond
more attractive
The new bond “A”
Bond A
Price:$100
Interest Rate: 8%
Interest: $8
A price so low, that
the interest you
earn on Peter’s
bond is higher
than 8%
The lower
the price you
pay, the
higher the
Yourate
receive $105
interest
Peter’s Bond
If you pay $100
for Peter’s
Bond
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%
If you
payprice
$97.22
getexactly
exactly
What
will you’ll
give us
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%
When
interest
rates rise,
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
If you
payprice
$104.76
you’llusget
exactly
What
will give
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
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.
Inverse Relationship Between
Price of Bonds and Interest Rate
25%
Interest
11%
=
rate
Amount
you100
get at
maturity
-
Price you
paid
90 for
Bond
80
Price you
90
paid 80
for
The lower the price on theBond
bond, the higher
the interest rate.
Bond Market
Supply of bonds
P0
Demand for bonds
Bond Market: Fed Sells Bonds
i =25%
i =11%
Supply of bonds
Bond Price
falls: Interest
Rates
Increase
P0=90
P1=80
Demand for bonds
Market for Reserves: Fed Sells Bonds
Federal funds Rate
Supply= excess
reserves + Fed
changes
i1
io
Demand: Banks +
Public
Money
The Money Market: Fed Sells
M
M
Reserves, Loans,
Bonds
s
Money scarce:
The interest
rate rises
s
1
0
Deposits and the Ms
decrease
i
Amount
Amount
Amountof
of
ofMoney
Money
Moneythe
the
the
Public
Public
Public holds
holds
holds in
in
in deposit
deposit
deposit
accounts<=Amount
=Amount
Amount
accounts
accounts
the
the
the
public
wants
to
public
public
wants
wants
to
tohold
hold
hold
when
i=5%
0 =3%
when
when
ii00=3%
i =5%
0
i =3%
0
$
Ms1
Ms0
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
Federal Funds Rate
Ms
Supply
ffro
i
i0
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 increase/decrease
Event
Demand
for
Reserves
Increase in
Required Reserve
Ratio (r)
b
Decrease in
Required Reserve
Ratio (r)
b
Supply of
Reserves
Federal
Funds
Rate
Banks
Loans
Deposit
s
Md/Ms
Items 1in yellow box mean that Ms
these effects are not mentioned
in the textbook so you are not
responsible
for knowing these. Ms
2
Buy Bonds
b
3
Ms
Sell Bonds
b
4
Ms
Increase in
Discount Rate
b
5
Decrease in
Discount Rate
b
6
ExplanationsMs
by number in
the next slideMs
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.