Chapter 33

Interest Rates and

Monetary Policy

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
• The equilibrium interest rate and
the market for money
• Monetary policy
• How the Fed controls the Federal
funds rate
• How monetary policy affects GDP
and the price level
• Effectiveness of monetary policy
and its shortcomings
33-2
 Interest Rates

• Price paid for the use of money

• Many different interest rates
• Speak as if only one interest rate
• Determined by money supply and
money demand

33-3
 Demand for Money
• Why hold money?
• Transactions demand, D1
–Determined by nominal GDP
–Independent of the interest rate
• Asset demand, D2
–Money as a store of value
–Varies inversely with the interest
rate
• Total money demand, Dm 33-4
 Demand for Money
(c)
(a) (b) Total
Transactions Asset demand for
demand for demand for money, Dm
money, Dt money, Da and supply
Rate of interest, i percent

10
Sm
7.5

5
+ =5
2.5

Dt Da Dm
0
50 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of money Amount of money Amount of money

demanded demanded demanded and supplied
(billions of dollars) (billions of dollars) (billions of dollars)

33-5
 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
33-6
Federal Reserve Balance Sheet
• Assets
–Securities
–Loans to commercial banks
• Liabilities
–Reserves of commercial banks
–Treasury deposits
–Federal Reserve Notes outstanding

33-7
Federal Reserve Balance Sheet
February 14, 2008 (in Millions)

Assets Liabilities and Net Worth

Securities $713,369 Reserves of Commercial
Loans to Commercial Banks $ 11,312
Banks 60,039 Treasury Deposits 4,979
All Other Assets 111,689 Federal Reserve Notes
(Outstanding) 778,937
All Other Liabilities and 89,869
Net Worth
Total $885,097 Total $885,097

Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008

33-8
 Central Banks

Selected Nations
Australia: Reserve Bank of Australia (RBA)
Canada: Bank of Canada
Euro Zone: European Central Bank (ECB)
Japan: Bank of Japan (BOJ)
Mexico: Banco de Mexico (Mex Bank)
Russia Central Bank of Russia
Sweden: Sveriges Riksbank
United Kingdom: Bank of England
United States: Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)

33-9
 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
33-10
 Open Market Operations
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)

33-11
 Open Market Operations
Fed buys $1,000 bond from the public
Check is Deposited
New Reserves
$1000

$800 $200
Excess Required
Reserves Reserves

$1000
$4000 Initial
Bank System Lending Checkable
Deposit

Total Increase in the Money Supply, ($5000)

33-12
 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 33-13
 Tools of Monetary Policy

• Open market operations most

important
• Reserve ratio last changed 1992
• Discount rate was a passive tool
• Term auction facility is new
–Guaranteed amount lent by the Fed
–Anonymous
33-14
 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
33-15
The Federal Funds Rate
Using Open Market Operations

Federal Funds Rate, Percent

4.5 Sf3

4.0 Sf1

3.5 Sf2

Df

Qf3 Qf1 Qf2

Quantity of Reserves
33-16
 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
• Contractionary monetary policy 33-17
 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 target federal
funds rate is 4%
• Target varies as inflation and real
GDP vary 33-18
 Monetary Policy
• 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 33-19
 Monetary Policy and GDP
(c)
(a) (b) Equilibrium real
The market Investment GDP and the
for money demand Price level
Rate of Interest, i (Percent)

Sm1 Sm2 Sm3 AS

10 P3

Price Level
AD3
8 P2 I=$25
Dm AD2
6 ID I=$20
AD1
0 I=$15
$125 $150 $175 $15 $20 $25 Q1 Qf Q3

Amount of money Amount of investment Real GDP

demanded and (billions of dollars) (billions of dollars)
supplied
(billions of dollars)

33-20
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
Real GDP rises
33-21
 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
Inflation declines
33-22
 Monetary Policy
• Advantages over fiscal policy
–Speed and flexibility
–Isolation from political pressure
• Recent U.S. monetary policy
• Problems and complications
–Recognition lag
–Operational lag
–Cyclical asymmetry
33-23
 The Big Picture
Input
Consumption
Resources (Ca)
With Prices

Levels of
Investment
Aggregate
Output,
Aggregate
(Ig)
Employment,
Supply Demand
Productivity Income, and
Prices
Sources
Net Export
Spending
(Xn)
Legal-
Institutional
Environment Government
Spending
(G)
33-24
 The Mortgage Debt Crisis
• Home mortgage default 2007
• Banks write off bad loans
• Reserves reduced
• Fed as lender of last resort
• Term auction facility
• Fed lowered federal funds rate
• Mortgage backed securities as a new
innovation
–Bad incentives
33-25
 Key Terms
• monetary policy • Federal funds rate
• interest • expansionary
• transactions demand monetary policy
• asset demand • prime interest rate
• total demand for • restrictive monetary
money policy
• open-market • Taylor rule
operations • cyclical asymmetry
• reserve ratio • mortgage debt crisis
• discount rate
• term auction facility
33-26
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Financial Economics

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