Interest Rates and Monetary Policy

Transcription

1 14 Interest Rates and Monetary Policy 14-1 Chapter Objectives How the equilibrium interest rate is determined in the market for money. The goals and tools of monetary policy. The federal funds rate and how the fed controls it. The mechanisms by which monetary policy affects GDP and the price level. Effectiveness of monetary policy and its shortcomings Interest Rates Defined as the Price Paid for the Use of Money. Demand for Money. Transactions Demand, D 1. Asset Demand, D 2. Total Money Demand, D m. Graphically

2 Interest Rates Demand for Money and the Money Market (a) Transactions Demand for Money, D t (b) Asset Demand for Money, D a (c) Total Demand for Money, D m And Supply Rate of Interest, I percent D t D a D m Amount of Money Amount of Money Amount of Money Demanded Demanded Demanded and Supplied (Billions of Dollars) (Billions of Dollars) (Billions of Dollars) = 5 S m 14-4 Interest Rates Equilibrium interest rate. Interest rates and bond prices. Bond prices fall when interest rates rise. Bond prices rise when interest rates fall. Inverse relationship between interest rates and bond prices Consolidated Balance Sheet Federal Reserve Banks Assets. Securities. Loans to Commercial Banks. Liabilities Reserves of Commercial Banks. Treasury Deposits. Federal Reserve Notes Outstanding

3 Consolidated Balance Sheet Federal Reserve Banks Consolidated Balance Sheet of the 12 Federal Reserve Banks March 29, 2006 (in Millions) Assets Liabilities and Net Worth Securities Loans to Commercial Banks All Other Assets Total $758,551 19,250 59,967 $837,768 Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes (Outstanding) All Other Liabilities and Net Worth Total $ 14,923 4, ,567 63,615 $837,768 Source: Federal Reserve Statistical Release, H.4.1, May 7, Consolidated Balance Sheet Federal Reserve Banks Global Perspective Central Banks, Selected Nations Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Reserve Bank of Australia (RBA) Bank of Canada Central Bank of Europe (CBE) Bank of Japan (BOJ) Banco de Mexico (Mex Bank) Central Bank of Russia Sveriges Riksbank Bank of England Federal Reserve System (the Fed ) (12 Regional Federal Reserve Banks) 14-8 Tools of Open market operations. Buying securities. From commercial banks. From the public. Selling securities. To commercial banks. To the public. When the fed sells securities, commercial bank reserves are reduced

4 Tools of Fed Buys $1,000 Bond from a Commercial Bank New Reserves $1000 $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) Tools of Fed Buys $1,000 Bond from the Public Check is Deposited New Reserves $1000 $800 Excess Reserves $200 Required Reserves $4000 Bank System Lending $1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) Tools of The reserve ratio. Raising the reserve ratio. Lowering the reserve ratio. The discount rate. Borrowing from the fed by banks increases reserves and enhances lending ability. Relative importance of each

5 Targeting the Federal Funds Rate Federal Funds Rate Defined. Expansionary (Easy Money). Prime Interest Rate. Restrictive (Tight Money). The Taylor Rule Targeting the Federal Funds Rate Using Open Market Operations To Set The Federal Funds Rate Federal Funds Rate, Percent D f S f3 S f1 S f Q f3 Q f1 Q f2 Quantity of Reserves Rate of Interest, i (Percent) and Equilibrium GDP (a) The Market For Money S m1 S m2 S m3 D m (b) Investment Demand $125 $150 $175 $15 $20 $25 ID Price Level P 3 P 2 (c) Equilibrium Real GDP and the Price Level Q 1 Q f Q 3 AS AD 3 I=$25 AD 2 I=$20 AD 1 I=$15 Amount of Money Demanded and Supplied (Billions of Dollars) Amount of Investment, I (Billions of Dollars) Real Domestic Product, GDP (Billions of Dollars)

6 Cause-Effect Chain. Market for Money. Investment. Equilibrium GDP. Effects of an Expansionary Monetary Policy. Effects of a Restrictive CAUSE-EFFECT CHAIN Expansionary Problem: Unemployment and Recession Fed Buys Bonds, Lowers Reserve Ratio, or Lowers the Discount Rate Excess Reserves Increase Federal Funds Rate Falls Money Supply Rises Interest Rate Falls Investment Spending Increases Aggregate Demand Increases Real GDP Rises CAUSE-EFFECT CHAIN Restrictive Problem: Inflation Fed Sells Bonds, Increases Reserve Ratio, or Increases the Discount Rate Excess Reserves Decrease Federal Funds Rate Rises Money Supply Falls Interest Rate Rises Investment Spending Decreases Aggregate Demand Decreases Inflation Declines 6

7 Evaluation and Issues. Speed and Flexibility. Isolation From Political Pressure. Recent U.S.. Problems and Complications. Recognition Lag. Administrative Lag. Operational Lag Cyclical Asymmetry. Artful Management or Inflation Targeting. The Big Picture AD-AS Theory of Price Level - Real Output and Stabilization Policy Input Resources With Prices Consumption (C d ) Productivity Sources Aggregate Supply Levels of Output, Employment, Income, and Prices Aggregate Demand Investment (I g ) Legal- Institutional Environment Net Export Spending (X n ) Government Spending (G)

8 Key Terms Monetary policy Transaction demand Asset demand Total demand for money Reserve ratio Discount rate Federal funds rate Expansionary monetary policy Taylor rule Cyclical asymmetry Inflation targeting Next Chapter Preview Extending The Analysis of Aggregate Supply Chapter