Chapter 33 - Interest Rates and Monetary Policy

CHAPTER THIRTY-THREE INTEREST RATES AND MONETARY POLICY

CHAPTER OVERVIEW
The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around seven major topics: (1) interest rate determination; ( ) the balance sheet of the !ederal "eserve #an$s; (%) the tools of monetary policy; (&) !ederal "eserve targeting of the !ederal funds rate; (') the cause(effect chain of monetary policy; ()) an evaluation of the advantages and disadvantages of monetary policy; and (*) a brief+ but important+ synopsis of mainstream theory and policies. The purpose of the concluding sections is to summarize all the macro theory developed so far and fit the pieces together as an integrated ,hole for students. This was Chapter 14 in the 17th edition. There is a new discussion about the Term uction !acility that the !ederal Reser"e introduced in #ecember $%%7 durin& the Mort&a&e #ebt Crisis.

INSTRUCTIONAL OBJECTIVES
'ter completin& this chapter( students should be able to) 1. $. 3. 4. /. 0. 7. 3. 4. 1%. 11. 1$. 13. 14. 1/. 10. 17. Identi'y the &oals o' monetary policy. Identi'y two types o' demand 'or money and the main determinant o' each. #escribe the relationship between *#P and the interest rate and each type o' money demand. +,plain what is meant by e-uilibrium in the money mar.et and the e-uilibrium rate o' interest. +,plain the relationship between bond prices and the money mar.et 1ist the principal assets and liabilities o' the !ederal Reser"e 2an.s. +,plain how each o' the three tools o' monetary policy may be used by the !ed to e,pand and to contract the money supply. +,plain the relati"e importance o' the monetary policy tools. #escribe how the !ed tar&ets the !ederal 'unds rate as part o' its monetary policy actions. #escribe e,pansionary and restricti"e monetary policies( and e,plain why and how they are used. +,plain the Taylor rule and describe how it relates to current !ed policy. +,plain the cause-e''ect chain between monetary policy and chan&es in e-uilibrium *#P. #emonstrate &raphically the money mar.et and how a chan&e in the money supply will a''ect the interest rate. 5how the e''ects o' interest rate chan&es on in"estment spendin&. #escribe the impact o' chan&es in in"estment on a&&re&ate demand and e-uilibrium *#P. Contrast the e''ects o' an e,pansionary monetary policy with the e''ects o' a restricti"e monetary policy. 1ist two stren&ths and three shortcomin&s o' monetary policy.

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Chapter 33 - Interest Rates and Monetary Policy

13. 14. $%.

#escribe the ar&uments 'or and a&ainst 6in'lation tar&etin&7 "ersus a more discretionary 6art'ul mana&ement7 approach to monetary policy. 5ummari8e the connections between #- 5( the price le"el( real output( and stabili8ation 9'iscal and monetary: policy. #e'ine and identi'y terms and concepts at the end o' the chapter.

LECTURE NOTES
I. Introduction to Monetary Policy . Learning objectives ; In this chapter students will learn) 1. <ow the e-uilibrium interest rate is determined in the mar.et 'or money. $. The &oals and tools o' monetary policy. 3. bout the !ederal 'unds rate and how the !ed controls it. 4. The mechanisms by which monetary policy a''ects *#P and the price le"el. /. The e''ecti"eness o' monetary policy and its shortcomin&s. 2. Reemphasi8e Chapter 31=s points) The !ed=s 2oard o' *o"ernors 'ormulates policy( and twel"e !ederal Reser"e 2an.s implement policy. C. The 'undamental ob>ecti"e o' monetary policy is to aid the economy in achie"in& 'ull-employment output with stable prices. 1. To do this( the !ed chan&es the nation=s money supply. $. To chan&e money supply( the !ed manipulates si8e o' e,cess reser"es held by ban.s. #. Monetary policy has a "ery power'ul impact on the economy( and the Chairman o' the !ed=s 2oard o' *o"ernors( 2en 2ernan.e currently( is sometimes called the second most power'ul person in the ?.5. II. The Demand for Money: Two Com onents . Transactions demand( #t( is money .ept 'or purchases and will "ary directly with *#P 9@ey *raph 33.1a:. 2. sset demand( #a( is money .ept as a store o' "alue 'or later use. sset demand "aries in"ersely with the interest rate( since that is the price o' holdin& idle money 9@ey *raph 33.1b:.

C. Total demand will e-ual -uantities o' money demanded 'or assets plus that 'or transactions 9@ey *raph 33.1c:. III. The !"uilibrium Interest #ate and $ond Prices .

%ey &ra h ''.(c illustrates the money mar)et. It combines demand with su ly of money.

2. I' the -uantity demanded e,ceeds the -uantity supplied( people sell assets li.e bonds to &et money. This causes bond supply to rise( bond prices to 'all( and a hi&her mar.et rate o' interest. C. I' the -uantity supplied e,ceeds the -uantity demanded( people reduce money holdin&s by buyin& other assets li.e bonds. 2ond prices rise( and lower mar.et rates o' interest result 9see e,ample in te,t:. I*. Consolidated $alance +heet of the ,ederal #eserve $an)s

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Chapter 33 - Interest Rates and Monetary Policy

. The assets column on the !ed=s balance sheet contains two ma>or items. 1. 5ecurities( which are 'ederal &o"ernment bonds purchased by !ed( and $. 1oans to commercial ban.s 9Aote) a&ain commercial ban.s term is used e"en thou&h the chapter analysis also applies to other thri't institutions.: 2. The liability side o' the balance sheet contains three ma>or items. 1. Reser"es o' ban.s held as deposits at !ederal Reser"e 2an.s( $. ?.5. Treasury deposits o' ta, receipts and borrowed 'unds( and 3. !ederal Reser"e Aotes outstandin&( our paper currency. *. -Tools.

of Monetary Policy

. Bpen-mar.et operations re'er to the !ed=s buyin& and sellin& o' &o"ernment bonds. 1. 2uyin& securities will increase ban. reser"es and the money supply 9see !i&ure 33.$: a. I' the !ed buys directly 'rom ban.s( then ban. reser"es &o up by the "alue o' the securities sold to the !ed. 5ee impact on balance sheets usin& te,t e,ample. b. I' the !ed buys 'rom the &eneral public( people recei"e chec.s 'rom the !ed and then deposit the chec.s at their ban.. 2an. customer deposits rise and there'ore ban. reser"es rise by the same amount. !ollow te,t e,ample to see the impact. i. 2an.s= lendin& ability rises with new e,cess reser"es. ii. Money supply rises directly with increased deposits by the public. c. Chen !ed buys bonds 'rom ban.ers( reser"es rise and e,cess reser"es rise by same amount since no chec.able deposit was created. d. Chen !ed buys 'rom public( some o' the new reser"es are re-uired reser"es 'or the new chec.able deposits. e. Conclusion) Chen the !ed buys securities( ban. reser"es will increase and the money supply potentially can rise by a multiple o' these reser"es. '. Aote) Chen the !ed sells securities( points a-e abo"e will be re"ersed. 2an. reser"es will &o down( and e"entually the money supply will &o down by a multiple o' the ban.s= decrease in reser"es. i. Chen !ed buys( it raises demand and price o' bonds( which in turn lowers e''ecti"e interest rate on bonds. The hi&her price and lower interest rates ma.e sellin& bonds to !ed attracti"e.

&. <ow the !ed attracts buyers or sellers)

ii. Chen !ed sells( the bond supply increases and bond prices 'all( which raises the e''ecti"e interest rate yield on bonds. The lower price and hi&her interest rates ma.e buyin& bonds 'rom !ed attracti"e. 2. The reser"e ratio is another 6tool7 o' monetary policy. It is the 'raction o' reser"es re-uired relati"e to their customer deposits. 1. Raisin& the reser"e ratio increases re-uired reser"es and shrin.s e,cess reser"es. ny loss o' e,cess reser"es shrin.s ban.s= lendin& ability and( there'ore( the potential money supply by a multiple amount o' the chan&e in e,cess reser"es.

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Chapter 33 - Interest Rates and Monetary Policy

$. 1owerin& the reser"e ratio decreases the re-uired reser"es and e,pands e,cess reser"es. *ain in e,cess reser"es increases ban.s= lendin& ability and( there'ore( the potential money supply by a multiple amount o' the increase in e,cess reser"es. 3. Chan&in& the reser"e ratio has two e''ects. a. It a''ects the si8e o' e,cess reser"es. b. It chan&es the si8e o' the monetary multiplier. !or e,ample( i' ratio is raised 'rom 1% percent to $% percent( the multiplier 'alls 'rom 1% to /. 4. Chan&in& the reser"e ratio is "ery power'ul since it a''ects ban.s= lendin& ability immediately. It could create instability( so !ed rarely chan&es it. /. Table 33.$ pro"ides illustrations. C. The third 6tool7 is the discount rate( which is the interest rate that the !ed char&es to commercial ban.s that borrow 'rom the !ed. 1. $. n increase in the discount rate si&nals that borrowin& reser"es is more di''icult and will tend to shrin. e,cess reser"es. decrease in the discount rate si&nals that borrowin& reser"es will be easier and will tend to e,pand e,cess reser"es.

#. The 'ourth 6tool7 is the Term uction !acility 1. This tool was introduced in #ecember $%%7 in response to mort&a&e debt crisis. $. ?nder the term auction 'acility( the !ed holds two auctions each month. 3. 2an.s bid 'or the ri&ht to borrow reser"es 'or $3 days +. !or se"eral reasons( open-mar.et operations &i"e the !ed most control o' the 'our 6tools.7 1. Bpen-mar.et operations are most important. This decision is 'le,ible because securities can be bou&ht or sold -uic.ly and in &reat -uantities. Reser"es chan&e -uic.ly in response. $. The reser"e ratio is rarely chan&ed since this could destabili8e ban.=s lendin& and pro'it positions. 3. Chan&in& the discount rate has become a passi"e tool o' monetary policy. The !ed sets their tar&et 'or the !ederal 'unds rate( and then typically sets the discount rate at 1 percenta&e point abo"e that tar&et. lthou&h this rule is not at ri&id as it once was. The !ed set the discount rat /% basis points abo"e the !ed !unds Rate in u&ust o' $%%7. *I. Targeting the ,ederal ,unds #ate . The !ederal 'unds rate is the interest rate that ban.s char&e each other 'or o"erni&ht loans. 2. 2an.s lend to each other 'rom their e,cess reser"es( but because the !ed is the only supplier o' !ederal 'unds 9the currency used as reser"es:( it can set the !ederal 'unds rate and then use open-mar.et operations to ma.e sure that rate is achie"ed. 1. The !ed will increase the a"ailability o' reser"es i' it wants the !ederal 'unds rate to 'all 9or .eep it 'rom risin&:. $. Reser"es will be withdrawn i' the !ed wants to raise the !ederal 'unds rate 9or .eep it 'rom 'allin&:. C. The !ed may use an e,pansionary monetary policy i' the economy is e,periencin& a recession and risin& rates o' unemployment.

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Chapter 33 - Interest Rates and Monetary Policy

1. The !ed will initially announce a lower tar&et 'or the !ederal 'unds rate( then use openmar.et operations 9buyin& bonds in this case:. The !ed may also lower the reser"e ratio or the discount rate. $. Increasin& reser"es will &enerate two results) a. The supply o' !ederal 'unds will increase( lowerin& the !ederal 'unds rate. b. Throu&h the money multiplier process( a &reater e,pansion o' the money supply will occur. 95ee Chapter 31 'or a re'resher on that process: 3. +,pansionary monetary policy will put downward pressure on interest rates( includin& the prime interest rate ; the benchmar. interest rate used by ban.s to set many other interest rates. #. Restricti"e monetary policy is used to combat risin& in'lation. 1. The initial step is 'or the !ed to announce a hi&her tar&et 'or the !ederal 'unds rate( 'ollowed by the sellin& o' bonds to soa. up reser"es. Raisin& the reser"e ratio andDor discount rate is also an option. $. Reducin& reser"es will produce results opposite o' what we saw 'or an e,pansionary monetary policy. a. The reduced supply o' !ederal 'unds will raise the !ederal 'unds rate to the new tar&et. b. Multiple contraction o' the money supply( throu&h the money multiplier process 9Chapter 31:. 3. Restricti"e monetary policy results in hi&her interest rates( includin& the prime rate. !. C/0+ID!# T1I+ 2 The ,ed as a + onge I' reser"es in the ban.in& system are li.e a bowl o' water( the !ed can use open-mar.et operations as a spon&e that can chan&e the amount o' water 9reser"es: in the bowl. 1. I' there are too many reser"es( the !ed 6soa.s up7 the e,cess by sellin& bonds. $. I' the !ed wants more reser"es in the system( it 6s-uee8es the spon&e7 by buyin& bonds. !. The Taylor Rule ; 5tan'ord economist Eohn Taylor has proposed a rule 'or tar&etin& the !ederal 'unds rate. It assumes a tar&et in'lation rate o' $F and has three components) 1. I' real *#P rises by 1 percent abo"e potential( the !ederal 'unds rate should be raised by one-hal' a percenta&e point. $. I' in'lation rises by 1 percenta&e point abo"e its tar&et( the !ederal 'unds rate should be raised by one-hal' a percenta&e point. 3. Chen real *#P is at its potential and in'lation is at its tar&et( the !ederal 'unds rate should be at 4F 9implyin& a real interest rate o' $F:. 4. The rules wor. in re"erse as well( i' real *#P is below its potential and in'lation is below the $F tar&et. /. Chile the !ed has rou&hly 'ollowed the Taylor rule in recent years( it has also de"iated under certain circumstances 9e.&. the threat o' de'lation: *II. Monetary Policy3 #eal &DP3 and the Price Level: 1ow Policy 4ffects the !conomy . Cause-e''ect chain) 1. Money mar.et impact is shown in @ey *raph 33./. a. 5upply o' money is assumed to be set by the !ed.
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Chapter 33 - Interest Rates and Monetary Policy

b. Interaction o' supply and demand determines the mar.et rate o' interest( as seen in !i&ure 3./a. c. Interest rate determines amount o' in"estment businesses will be willin& to ma.e. In"estment demand is in"ersely related to interest rates( as seen in !i&ure 33./b. d. +''ect o' interest rate chan&es on le"el o' in"estment is &reat because interest cost o' lar&e( lon&-term in"estment is si8able part o' in"estment cost. e. s in"estment rises or 'alls( e-uilibrium *#P rises or 'alls by a multiple amount( as seen in !i&ure 33./c and 33./d.

$. +,pansionary monetary policy) The !ed ta.es steps to increase e,cess reser"es( which lowers the interest rate and increases in"estment which( in turn( increases a&&re&ate demand and real *#P. 95ee Column 1( Table 33.3: 3. Restricti"e monetary policy is the re"erse o' an e,pansionary monetary policy) +,cess reser"es 'all( which raises interest rate( which decreases in"estment( which( in turn( reduces a&&re&ate demand and in'lation. 95ee Column $( Table 33.3: *III. Monetary Policy: !valuation and Issues . 5tren&ths o' monetary policy) 1. It is speedier and more 'le,ible than 'iscal policy since the !ed can buy and sell securities daily. $. It is less political. !ed 2oard members are isolated 'rom political pressure( since they ser"e 14-year terms( and policy chan&es are more subtle and not noticed as much as 'iscal policy chan&es. It is easier to ma.e &ood( but unpopular decisions. 2. Recent monetary policy 1. +,pansionary monetary policy in the early 144%s helped produce reco"ery 'rom the 144%1441 recession and the e,pansion that lasted until $%%1. Ti&htenin& in 1444( 144/( 1447( 1444( and $%%%( helped ease in'lationary pressure durin& the e,pansion. $. To counter the recession that be&an in March $%%1( the !ed pursued an easy money policy that saw the prime interest rate 'all 'rom 4./ percent at the end o' $%%% to 4.$/ percent in #ecember $%%$. 3. The !ed has been praised 'or helpin& the ?.5. economy maintain simultaneously 'ull employment( price stability( and economic &rowth 'or o"er 'our years. They ha"e also recei"ed credit 'or swi't and stron& responses to the 5eptember 11( $%%1( terrorist attac.s( si&ni'icant declines in the stoc. mar.et( and the o"erall recessionary conditions. 4. In response to stron& economic &rowth in $%%4( the !ed be&an a series o' -uarterpercenta&e-point increases in the !ederal 'unds rate. Those increases ha"e continued well into $%%0. C. Problems and complications) 1. Reco&nition and operational la&s impair the !ed=s ability to -uic.ly reco&ni8e the need 'or policy chan&e and to a''ect that chan&e in a timely 'ashion. lthou&h policy chan&es can be implemented rapidly( there is a la& o' at least 3 to 0 months be'ore the chan&es will ha"e their 'ull impact. $. Cyclical asymmetry may e,ist) a restricti"e monetary policy wor.s e''ecti"ely to bra.e in'lation( but an e,pansionary monetary policy is not always as e''ecti"e in stimulatin& the economy 'rom recession. 6Gou can lead a horse to water( but you can=t ma.e it drin..7 3. C/0+ID!# T1I+ 2 Pushing on a +tring
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Chapter 33 - Interest Rates and Monetary Policy

Eapan=s ine''ecti"e e,pansionary monetary policy illustrates the potential inability o' monetary policy to brin& an economy out o' recession. Chile pullin& on a strin& 9restricti"e monetary policy: is li.ely to mo"e the attached ob>ect to its desired destination( pushin& on a strin& is not. 4. The impact on in"estment may be less than traditionally thou&ht. Eapan pro"ides a case e,ample. #espite interest rates o' 8ero( in"estment spendin& remained low durin& the recession. #. 6 rt'ul Mana&ement7 or 6In'lation Tar&etin&7H 1. The !ed under lan *reenspan mana&ed the money supply such that the ?.5. economy en>oyed price stability( hi&h le"els o' employment( and stron& economic &rowth. This leads some to ar&ue that the !ed should ta.e an acti"e policy role and attempt to pursue all o' those ob>ecti"es in settin& policy. $. 2en 2ernan.e replaced lan *reenspan in early $%%0. Many are wonderin& whether or not 2ernan.e has *reenspan=s intuition. 3. But o' concern that the !ed=s success under *reenspan may not be reproducible( some ar&ue 'or in'lation tar&etin&. This narrower policy ob>ecti"e( which has been success'ul in other industriali8ed economies( would ma.e monetary policy more predictable and 6transparent7 to those in the economy ma.in& decisions based on !ed action. 4. 5.eptics o' in'lation tar&etin& ar&ue that that approach is too narrow( and that successes o' other nations should be "iewed care'ully &i"en the relati"e lac. o' &lobal in'lationary pressure in recent years. I5. The $ig Picture 6%ey &ra h ''.78 +hows Many Interrelationshi s . !iscal and monetary policy are interrelated. The impact o' an increase in &o"ernment spendin& will depend on whether it is accommodated by monetary policy. !or e,ample( i' &o"ernment spendin& comes 'rom money borrowed 'rom the &eneral public( it may be o''set by a decline in pri"ate spendin&( but i' the &o"ernment borrows 'rom the !ed or i' the !ed increases the money supply( then the initial increase in &o"ernment spendin& may not be counteracted by a decline in pri"ate spendin&. 2. 5tudy @ey *raph 33.0 and you will see that the le"els o' output( employment( income( and prices all result 'rom the interaction o' a&&re&ate supply and a&&re&ate demand. In particular( note the items shown in red that constitute( or are stron&ly in'luenced by( public policy. C. Try Iuic. Iui8 33.0. 5. L4+T 9/#D: The Mortgage Debt Crisis . In $%%7 there was a ma>or wa"e o' de'aults on home mort&a&es( which threatened the health o' many 'inancial institutions. There is some debate o' whether this wa"e has crested yet. 2. stran&e thin& about the crisis was that be'ore it happened( ban.s had mista.enly belie"ed that an inno"ation .nown as the Jmort&a&e bac.ed security= had eliminated their e,posure to mort&a&e de'aults.

C. To deal with this crisis the !BMC lowered the tar&et rate 'or the !ed !unds Rate to $F by pril o' $%%3. #. Politicians and 'inancial re&ulators are now e,aminin& whether ti&hter lendin& rules would help o''set the Jpass-the-buc.= incenti"es created by mort&a&e bac.ed securities.

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