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Transcript
Chapter 34 Interest Rates and Monetary Policy Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Interest Rates • • • • LO1 The price paid for the use of money Many different interest rates Speak as if only one interest rate Determined by the money supply and money demand 34-2 Demand for Money • Why hold money? • Transactions demand, Dt • Determined by nominal GDP • Independent of the interest rate • Asset demand, Da • Money as a store of value • Varies inversely with the interest rate • Total money demand, Dm LO1 34-3 Demand for Money Rate of interest, i percent (a) Transactions demand for money, Dt (b) Asset demand for money, Da 10 Sm 7.5 =5 + 5 2.5 Dt 0 50 100 Da 150 200 Amount of money demanded (billions of dollars) LO1 (c) Total demand for money, Dm and supply 50 100 150 200 Amount of money demanded (billions of dollars) Dm 50 100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) 34-4 Interest Rates • Equilibrium interest rate • Changes with shifts in money supply and money demand • Interest rates and bond prices • Inversely related • Bond pays fixed annual interest payment • Lower bond price will raise the interest rate LO1 34-5 Federal Reserve Balance Sheet • Assets • Securities • Loans to commercial banks • Liabilities • Reserves of commercial banks • Treasury deposits • Federal Reserve Notes outstanding 34-6 Federal Reserve Balance Sheet April 10, 2013 (in Millions) Assets Securities Loans to Commercial Banks All Other Assets Total Liabilities and Net Worth $957,619 439 271,355 $3,229,413 Reserves of Commercial $ 1,851,361 Banks 52,478 Treasury Deposits Federal Reserve Notes 1,137,087 (Outstanding) 188,487 All Other Liabilities and Net Worth $3,229,413 Total Source: Federal Reserve Statistical Release, H.4.1, April 10, 2013, www.federalreserve.gov LO2 34-7 Central Banks LO2 34-8 Tools of Monetary Policy • Open market operations • Buying and selling of government securities (or bonds) • Commercial banks and the general public • Used to influence the money supply • When the Fed sells securities, commercial bank reserves are reduced LO3 34-9 Tools of Monetary Policy • Fed buys bonds from commercial banks Federal Reserve Banks Assets Liabilities and Net Worth + Securities + Reserves of Commercial Banks (a) Securities Assets (b) Reserves Commercial Banks Liabilities and Net Worth -Securities (a) +Reserves (b) LO3 34-10 Tools of Monetary Policy • Fed sells bonds to commercial banks Federal Reserve Banks Assets Liabilities and Net Worth - Securities - Reserves of Commercial Banks (a) Securities Assets (b) Reserves Commercial Banks Liabilities and Net Worth + Securities (a) - Reserves (b) LO3 34-11 Open Market Operations • Fed buys $1,000 bond from a commercial bank New Reserves $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) LO3 34-12 Open Market Operations • Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 $800 Excess Reserves $4000 Bank System Lending $200 Required Reserves $1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) LO3 34-13 Tools of Monetary Policy • The reserve ratio • Changes the money multiplier • The discount rate • The Fed as lender of last resort • Short term loans • Term auction facility • Introduced December 2007 • Banks bid for the right to borrow reserves LO3 34-14 The Reserve Ratio Effects of Changes in the Reserve Ratio (6) Money-Creating Potential of Single Bank, = (5) (7) Money-Creating Potential of Banking System (1) Reserve Ratio, % (2) Checkable Deposits (3) Actual Reserves (4) Required Reserves (5) Excess Reserves, (3) –(4) (1) 10 $20,000 $5000 $2000 $3000 $3000 $30,000 (2) 20 20,000 5000 4000 1000 1000 5000 (3) 25 20,000 5000 5000 0 0 0 (4) 30 20,000 5000 6000 -1000 -1000 -3333 LO3 34-15 Tools of Monetary Policy • Open market operations are the most important • Reserve ratio last changed in 1992 • Discount rate was a passive tool • Interest on reserves LO3 34-16 The Federal Funds Rate • Rate charged by banks on overnight • • • • loans Targeted by the Federal Reserve FOMC conducts open market operations to achieve the target Demand curve for Federal funds Supply curve for Federal funds 34-17 The Federal Funds Rate Federal Funds Rate, Percent Using Open Market Operations 4.5 Sf 3 4.0 Sf 1 3.5 Sf 2 Df Qf3 LO4 Qf1 LO3 Qf2 Quantity of Reserves 34-18 Monetary Policy • Expansionary monetary policy • Economy faces a recession • Lower target for Federal funds rate • Fed buys securities • Expanded money supply • Downward pressure on other interest rates LO4 34-19 Monetary Policy • Restrictive monetary policy • Periods of rising inflation • Increases Federal funds rate • Increases money supply • Increases other interest rates LO4 34-20 Monetary Policy LO4 34-21 Taylor Rule • Rule of thumb for tracking actual monetary policy • Fed has 2% target inflation rate • If real GDP = potential GDP and inflation is 2%, then targeted Federal funds rate is 4% • Target varies as inflation and real GDP vary LO4 34-22 Monetary Policy, Real GDP, Price Level • Affect on real GDP and price level • Cause-effect chain • Market for money • Investment and the interest rate • Investment and aggregate demand • Real GDP and prices • Expansionary monetary policy • Restrictive monetary policy LO5 34-23 (a) The market for money Sm1 Sm2 Sm3 AS 10 P3 8 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Dm 6 ID 0 $125 $150 $175 Amount of money demanded and supplied (billions of dollars) LO5 (c) Equilibrium real GDP and the Price level (b) Investment demand Price Level Rate of Interest, i (Percent) Monetary Policy and Equilibrium GDP $15 $20 $25 Amount of investment (billions of dollars) Q1 Qf Q3 Real GDP (billions of dollars) 34-24 Monetary Policy and Equilibrium GDP (d) Equilibrium real GDP and the Price level (c) Equilibrium real GDP and the Price level AS AS c P3 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Q1 Qf Q3 Real GDP (billions of dollars) a AD3 I=$25 AD4 I=$22.5 AD2 I=$20 AD1 I=$15 Price Level Price Level P3 b P2 Q1 Qf Q3 Real GDP (billions of dollars) 34-25 LO5 Expansionary Monetary Policy CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases LO5 Real GDP rises 34-26 Restrictive Monetary Policy CAUSE-EFFECT CHAIN Problem: Inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases LO5 Inflation declines 34-27 Evaluation and Issues • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy is more subtle than fiscal policy LO6 34-28 Recent U.S. Monetary Policy • Highly active in recent decades • Responded with quick and innovative actions during the recent financial crisis and the severe recession • Critics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long LO6 34-29 After the Great Recession • Slow recovery especially in terms of employment • Zero interest rate policy • Zero lower bound problem • Quantitative easing • Forward commitment • Operation Twist LO6 34-30 Problems and Complications • Lags • Recognition and operational • Cyclical asymmetry • Liquidity trap LO6 34-31 The Big Picture Input Resources With Prices Productivity Sources LegalInstitutional Environment LO6 Consumption (Ca) Aggregate Supply Levels of Output, Employment, Income, and Prices Aggregate Demand Investment (Ig) Net Export Spending (Xn) Government Spending (G) 34-32 Worries about ZIRP, QE, and Twist • Government spending crowded out private spending • Large budget deficits by the Federal government would lead to huge interest costs • Low interest rates punish savers LO6 34-33