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Topic 4: Monetary Policy Interest rates and investment Banking system Federal Reserve 1 Fiscal Policy v Monetary Policy Fiscal Policy– Conducted by legislative and executive branches of government Government spending and taxes to stimulate or slow down the economy Monetary Policy— Conducted by the Central Bank or Federal Reserve Aimed at influencing the amount of investment, often through influence over interest rates 2 Government Borrowing The government borrows money all the time. Where does it borrow money from? Issues government securities (e.g., “bonds”), which are promises to replay a loan in the future at a fixed rate of return Sells the securities in the bond market, just like any other large borrower. If you buy a bond from the Treasury, the US Government is borrowing money from you. 3 US Treasury Bonds US federal bonds (T-Bills) are guaranteed by the US government They are considered a very safe financial asset Safer than the stock market Safer than the bonds issued by other borrowers Safer than personal investments Essentially a 0% chance of default Prices are determined in the competitive market 4 Interest Rates In the market for money (supply and demand) the interest rate is the market price. We will use the term “interest rate” to refer to the price of T-bills (US Government Securities). There is a very strong correlation between the T-bill interest rate and the interest rates associated with other financial assets, loans, and bank deposits in the economy. 5 Interest Rates Suppose interest rate i = 5%. Buy a new 1-year bond for $1000. At the end of 1 year, the bond pays you: $1000(1+i) = $1000 (1.05) = $1050 Buy a new 3-year bond for $1000, with interest compounded annually. At the end of 3 years, the bond pays you: $1000(1.05)3 = $1158 6 Interest Rates On Jan 1, 2008 the 3-year T-bill rate was 5%. On that day, Sam bought a 3-year T-bill for $1000. At the end of 2010, that bond will payout $1158. If Sam sold her T-bill in the bond market on Jan 1, 2010 (1 year before maturity), how much could she get for it? Depends on the CURRENT interest rate (not the original rate) If the 1-year T-bill rate was 5% on Jan 1, 2010, then the “present value” of $1158 in one year is: $1158 / (1+i) = $1158 / (1.05) = $1103 If the 1-year T-bill rate was 10% on Jan 1, 2010, then the “present value” of $1158 in one year is: $1052 If the 1-year T-bill rate was 2% on Jan 1, 2010, then the “present value” of $1158 in one year is : $1135 7 Some Equations Future Value (i.e., value at maturity) of bond that costs $PV today, when there is a per-period interest rate of i, and maturity in t periods Future Value = PV (1+i)t Present Value (i.e., value at purchase) of bond that will be worth $FV at maturity, when there is a per-period interest rate of i, and maturity in t periods Present Value = FV (1 i) t 8 Interest Rates If the T-Bill Rate is really high, then would you ever put money in anything else? The T-Bill Rate (e.g., the interest rate) determines what other financial assets are reasonable choices for banks and firms. 9 Financial Assets: “Investment” Other expenditures Plant and Equipment Put in the bank Residential Construction Hold cash Inventories Stock market Bonds and securities 10 Interest Rates Suppose interest rate i = 5%. Buy a 1-year $1000 bond. At the end of the year, the bond pays out $1000 x 1.05 = $1050 Interest rates in the economy help determine the amount of “Investment” or “I”. Remember “investment” or “I” includes plant & equipment, housing, and inventories (NOT stocks and bonds) A higher interest rate “i” makes buying bonds more attractive relative to investing in I. So, as i goes up, I goes down. 11 How i influences I -- Example 12 Firm Project Cost Expected Return Gomer’s Filling Station Tow truck 190 10% Pay at the pump 150 8% Hydraulic Lift 50 4% Inventory speculation 35 2% How i influences I See In Class Exercise #1 13 How to influence i? The interest rate determines the amount of investment in the economy. The interest rate is determined in the market place (supply and demand). It is not set by the government or the central bank. But, the central bank can influence i through its ability to control money supply in the economy. 14 Federal Reserve In the US, the central bank is called the Federal Reserve Controls money supply, which determines the price of money i, which determines investment 15 Banking System Central Bank, aka Federal Reserve Controls the central money supply Fractional Reserve Banking System Where we keep our money Banks are allowed to lend out some fraction of our deposits as investments to others (“fractional reserve” is the fraction that they cannot lend out and must keep as reserves) 16 What is money? Money is what money does: Medium of exchange 2. Store of value 3. Unit of account 1. Not the same as currency. Although currency is usually a form of money. 17 Evolution of Money Stage 1: No Money 1. Q: Without money how do people engage in trade? A: Barter Problem: High transaction costs Stage 2: Goods become treated as money 2. E.g., tobacco in colonies, gold, silver, jewels Problems: 18 Hard to carry Can be perishable Quality isn’t constant Evolution of Money Stage 3: Set up a central treasury for valued goods E.g., tobacco warehouse, where people can deposit their tobacco. The tobacco is rated, and the depositor is given a bank note stating rights to claim the tobacco. Now, bank note may be used as money. On gold standard, can take $1 bill to treasury and exchange for $1 worth of gold (case in US prior to 1971) Stage 4: Fiat money The government says that money can be used (e.g., “for all debts public and private”) If go to treasury, can trade in your $1 bill for another $1 bill 19 Philadelphia Goldsmith Goldsmith in 1740 Philly Has a good safe to keep his gold Offers neighbors the chance to keep there gold in the safe On any given day some people take gold out, other people put gold in Observation: daily balance might go up and down slightly, but never falls below some level Good Idea: Lend out some of the money from the vault 20 Philadelphia Goldsmith Balance Sheet Assets Liabilities Reserves ($ in vault) $2000 Demand Deposits $10,000 Loans $8,000 Total: $10,000 21 Total: $10,000 Bank Balance Sheet – same idea Assets Liabilities Reserves ($ in vault) $1000 Demand Deposits $10,000 Loans $7000 Securities $2000 Total: $10,000 22 Total: $10,000 Reserve Ratio Reserve Ratio = Reserves / Deposits Required Reserve Ratio (i.e., RRR) = The minimum reserve ratio as mandated by the Federal Reserve. If the RRR = 0.2, then a bank with $10,000 in deposits can lend out $8000. Required Reserves = RRR x Deposits Excess Reserves = Reserves – Required Reserves 23 Money Supply Money Supply = Cash On Hand + Total Deposits The Fed influences money supply by buying or selling government securities (i.e., government bonds). Buy securities => put new money into the economy => increases the money supply Sell securities => take money out of the economy => decreases the money supply 24 Buying Securities If the Fed buys $1000 in securities, it increases total money supply by MORE than $1000. Example: How the $1000 flows through the economy, with a RRR = 0.2 … Fed buys $1000 in securities from Sally, who puts the $ in bank Bank holds on to $200 and loans $800 to Fred to buy a car Fred buys the car from Sam who puts the $800 in her bank Sam’s bank keeps $160 in reserves and loans out $640 … In total, the money supply increases up to $5000 25 Changes to Money Supply Initial injection of $Z into the money supply (i.e., purchase of $Z worth of bonds) changes the total money supply by up to Z * 1 / RRR Initial decrease of $Z in the money supply (i.e., sell $Z worth of bonds) changes the total money supply by up to - Z * 1 / RRR 26 Bank Balance Sheets – Summary Balance sheet is a table with one column listing “assets” and one listing “liabilities” For our purposes, liabilities include deposits, and assets include bank reserves, loans, and other investments (e.g., securities) Total Assets = Total Liabilities Total Reserves = (Req. Res. Ratio) x (Total Deposits) when banks don’t hold any excess reserves 27 In Class Exercise #2 See handout. 28 Market for Money Vertical axis is the price of money, represented by the interest rate, i Horizontal axis is the quantity of money Firms, Individuals, etc. determine money demand The Federal Reserve (Fed) determines money supply 29 Money Demand Made up of three pieces: Transaction Demand – money on hand for transactions (money needed for purchases) Precautionary Demand – rainy day funds (money that might be needed for purchases) Speculative Demand – e.g., hold cash to buy bonds later if you expect bond rate will rise soon (money you are waiting until the right time to invest) Taken together => total demand (downward sloping) 30 Money Supply Typically, if banks have excess reserves, then they lend it out Money supply is vertical 31 Market for Money Supply and Demand together Shifts in Supply when the Fed engages in open market operations or changes the required reserve ratio (RRR) Immediate shift Long-run shift 32 3 Primary Tools of Fed 33 1. Open Market Operations – Buying and selling government securities (or other assets) 1. Changing the Required Reserve Ratio 1. Setting the Federal Funds Rate – interest rate at which banks can borrow at the Fed The Fed does not directly set the US T-bill rate. They announce a target, and achieve it through Open Market Operations. Changing Investment through open market operations Fed buys bonds, causing the money supply to increase Through the market for money, an increase in money supply causes the price of money (i.e., the interest rate, i) to decrease A decrease in the interest rate increases investment I, as investors become less likely to put their money in bonds and more likely to invest in capital improvement projects, etc. An increase in investment increases the equilibrium level of national income and output 34 Changing Investment through open market operations Fed sells bonds, causing the money supply to decrease Through the market for money, a decrease in money supply causes the price of money (i.e., the interest rate, i) to increase An increase in the interest rate decreases investment I, as investors become more likely to put their money in bonds and less likely to invest in capital improvement projects, etc. A decrease in investment decreases the equilibrium level of national income and output 35 Changing Investment through changing the required reserve ratio Fed decreases RRR Banks can loan out more of their deposits, which increases the money supply As money supply increases, the price of money (i.e., the interest rate i) decreases A decrease in the interest rate results in more investment Higher investment increases national income 36 Changing Investment through changing the required reserve ratio Fed increases RRR Banks can loan out less of their deposits, which decreases the money supply As money supply decreases, the price of money (i.e., the interest rate i) increases An increase in the interest rate results in less investment Lower investment decreases national income 37 Changing Investment by changing the federal funds rate Commercial banks are required to maintain sufficient 38 reserves. If their reserves fall short of the RRR, then they must borrow funds at the end of the day to make up the difference. Fed increases federal funds rate, it becomes more costly for a bank to fall short of the RRR. Banks will keep a little extra reserves on hand to help ensure against falling short. This results in banks loaning out less of their deposits, which has a similar effect as a modest increase in the RRR. Decreases national income Changing Investment by changing the federal funds rate Fed decreases federal funds rate, it becomes less costly for a bank to fall short of the RRR. Actual reserves will tend to be closer to the required reserves. This results in banks loaning out more of their deposits, which has a similar effect as a modest decrease in the RRR. Increases national income 39 Some Links http://www.bankrate.com/brm/news/fed/fedchart.asp http://www.moneycafe.com/library/fedfundsratehistory.htm http://www.moneycafe.com/library/1monthlibor.htm http://www.moneycafe.com/library/cmt.htm 40 Causal Arrows Buy Bonds +ΔMS −Δi +ΔI +ΔY Sell Bonds −ΔMS +Δi −ΔI −ΔY −RRR +ΔMS −Δi +ΔI +ΔY +RRR −ΔMS +Δi −ΔI −ΔY 41 Causal Arrows – Second Order Effects +ΔMS −Δi +ΔI +ΔY “Second order” effects: +ΔMD +Δi … When income increases, money demand increases. This causes a “second order effect” Although the second order effect tends to decrease income (in this case), second order effects are less significant than the initial effect on income. Therefore, the overall change to income will still be positive. This slide is a technical point that you don’t need to know. 42 Can you answer this… Buy Bonds +ΔMS −Δi +ΔI +ΔY (A) (B) (C) (D) (A)How does buying bonds increase the money supply? (B)How does an increase to the money supply decrease the interest rate? (C)How does a decrease to the interest rate increase investment? (D)How does increasing investment increase national income? 43 Types of Policy “Expansionary” Policy Any policy that expands the economy Monetary Policy – Reducing the RRR, buying bonds Fiscal Policy – Increasing G, decreasing Tx “Contractionary” Policy Any policy that slows down or contracts the economy Monetary Policy – Increasing the RRR, selling bonds Fiscal Policy – Decreasing G, increasing Tx 44
