Monetary Policy
Lesson 23


How are Interest Rates Determined?

1. Interest rate -

  • Borrowers - interest rate is a cost to borrow money
    • Consumers borrow money to buy houses, cars, appliances, etc.
    • Businesses borrow money to buy machines, equipment, and structures
    • Government borrows money when it has budget deficits
      • Government spending > taxes
  • Savers - interest rate is a benefit to savers

2. Interest rate differs

  • Maturity - when borrower makes last payment
  • Number of payments
  • Risk
  • However, interest rates tend to move together

Example 1: A saver deposits $1,000 into a savings account that earns 15% (Annual Percentage Rate (APR). At the end of the year:

  • Has $1,000 from the starting balance
  • Earns $150 (=$1,000 X 0.15) in interest
  • Ending balance is $1,150

Example 2: A company borrows $10,000 from a bank and agrees to pay the loan back plus $1,000 for interest.

  • The business pays 10% interest (=$1,000 / $10,000)

Example 3: A Treasury bill has a face value, but does not have a stated interest rate on it.

  • When the T-bill matures, the investor gets the face value.
  • An investor pays $9,000 for a $10,000 T-bill.
    • Investor earns $1,000 interest, or 10%
    • The market price of the bond is $9,000
  • If the investor pays $9,500 for the T-bill, he earns $500 in interest or 5%.
Blue arrow As market interest rates increase, market prices for bonds decrease, and vice versa.

3. Demand for money

  • Transaction demand - people need money to make transactions
    • Purchase groceries
    • Pay rent
    • Pay credit cards
  • Precautionary demand - deal with uncertainty
    • Medical emergency
    • Bail out a relative from jail, etc.
  • Store value - retain future purchasing value

4. Demand for money

  1. Demand for money is proportional to nominal GDP
    • A larger economy requires more money
  2. Interest rate is an opportunity costs
    • If people hold more money, they give up earning interest from a bank
    • At higher interest rates, people hold less money
    • Example
      • If savings rate is 1%, many people would not be concerned about earning interest
      • If savings rate is 15%, more people would deposit money into banks to earn interest.
  3. Technology - changes in technology affect people's demand for money
    • Widespread use of credit cards and debit cards reduced people's demand for money

Relationship is shown below

  • Real rate of interest is r
  • Quantity of money, M

The demand for money

5. Central bank supplies money (S)

  • Can make decisions independent of interest rate
  • Shown below

The supply for money

6. Equilibrium real interest rate is intersection of supply and demand

The supply and demand for money


The Fed's Balance Sheet

Federal Reserve has a balance sheet; the list is not comprehensive; refer to my course, Money & Banking, for a more extensive analysis

1. The Fed’s Assets:

  1. Securities
    • U.S. government securities, like Treasury bills, Treasury notes, and Treasury bonds
  2. Discount Loans - the Fed loans funds to banks, helping the bank overcome short-term financial problems.
    • The Fed controls the interest rate on these loans
    • The interest rate is called the discount rate.

2. The Fed’s Liabilities and Capital Accounts:

  1. Currency Outstanding:
    • Federal Reserve Notes - currency issued by the Fed, i.e. U.S. money.
  2. Deposits by Depository Institutions
    • Banks must hold required reserves in the form of vault cash and/or deposits at the Fed.
    • These deposits are assets to the depository institutions, but liabilities to the Fed.
  3. U.S. Treasury Deposits - checking account for U.S. government
    • The U.S. Treasury receives tax payments, collects fees,and sells U.S. government securities

Fed's Tools for Monetary Policy

1. Expansionary monetary policy

  • Federal Reserve increases the money supply
    • Bank reserves increase
    • Interest rates decrease (in short run)
      • Federal Funds rate is impacted first
    • Bond market prices increase
  • Below is market for money

The Fed increases the money supply

  • Expansionary monetary policy
    • An economy can grow faster
      • A lower real interest rate causes businesses to invest more, having a multiplier effect on economy
      • Causes U.S. dollar to depreciate, which boosts the export sector
      • Lower interest rates increase stock and bond prices, creating a wealth effect.
    • A larger money supply shifts the Aggregate Demand to the right
    • Society may have demand pulled inflation
    • Example - extremely low interest rates between 2000 and 2007 caused a real estate boom
      • U.S. economy was growing from the massive investment in houses
      • Property values were quickly climbing
      • Housing bubble "popped" in 2007, and property values are quickly falling.
      • Many people used Adjustable-Rate Mortgages
        • Mortgage interest rate changes with market interest rates.

The Aggregate Demand increases

2. Contractionary (Restrictive) monetary policy

  • Federal Reserve decreases the money supply
    • Bank reserves decrease
    • Interest rates increase (in short run)
      • Federal Funds rates increases
      • A real higher interest rate causes businesses to invest less
      • A lower investment causes economy to grow slower.
    • Bond market prices decrease
  • Below is market for money

The Fed decreases the money supply

  • Contractionary monetary policy
    • Slows the economy and to help lower inflation
      • Price level may not fall, because prices tend to be inflexible downward
    • A smaller money supply shifts the Aggregate Demand to the left

The Aggregate Demand decreases

3. Federal Reserve Tools

(i) Open Market Operations

  • Fed's most important tool
  • Very flexible
    • If Fed bought too many U.S. securities, it can turn around and sell them.
  • If Fed purchases U.S. government securities, bank reserves increase
    • Expansionary monetary policy
  • If Fed sells U.S. government securities, bank reserves decrease.
    • Contractionary monetary policy
  • Fed could buy any type of assets, but usually focuses on U.S. government securities
    • Fed buys U.S. securities from the private market
    • The Fed is independent of the U.S. Treasury
    • Buying directly from the U.S. Treasury could jeopardize the Fed's independence.
  • Example 1: Federal Reserve buys $50,000 in U.S. Treasury securities from U.S. bank, the T-accounts are below:
    • Bank reserves are a liability to the Fed
    • Money supply increases and interest rates decrease

U.S. Bank

Assets Liabilities + Net Worth
U.S. Treasury securities -$50,000    
Reserves at Fed +$50,000    

Federal Reserve

Assets Liabilities + Net Worth
U.S. Treasury securities +$50,000 Bank Reserves +$50,000
  • Example 2: Federal Reserve sells a ;$20,000 U.S. Treasury securities to U.S. bank, the T-accounts are below:
    • Money supply decreases and interest rates increase

U.S. Bank

Assets Liabilities + Net Worth
U.S. Treasury securities +$20,000    
Reserves at Fed -$20,000    

Federal Reserve

Assets Liabilities + Net Worth
U.S. Treasury securities -$20,000 Bank Reserves -$20,000

(ii) Discount Rate

  • The Fed can grant loans to financial institutions
  • The Fed sets the interest rate on the loan called the discount rate
    • A bank may have to put up collateral for the Fed loan.
  • If the Fed increases the discount rate, banks borrow less.
    • Contractionary monetary policy
  • If the Fed decreases the discount rate, banks borrow more.
    • Expansionary monetary policy
  • Benefits
    • The Fed is the “Lender of the last resort.”
    • If a bank has trouble with liquidity or needs reserves, the Fed is the last place to go.
    • The Fed extended credit to financial institutions during the stock market crash in 1987, preventing a recession.
  • Problems
    • A bank may try to profit from a Fed loan. A bank may borrow from the Fed at a low interest rate and grant loans for higher interest rates.
    • Borrowing from the Fed is a privilege and not a right!
    • European central banks charge a higher interest rate than the market rate, penalizing banks from borrowing from the central bank.
    • Not a good tool for monetary policy.
      • If Fed needs to increase money supply, it cannot force banks to take loans.
  • Example 3: Federal Reserve grants a $100,000 loan to U.S. Bank. The transaction is shown below:
    • Money supply increases and interest rates decrease

U.S. Bank

Assets Liabilities + Net Worth
Reserves at Fed +$100,000 Fed loan +$100,000

Federal Reserve

Assets Liabilities + Net Worth
Loan to U.S. Bank +$100,000 Bank Reserves +$100,000

(iii) Reserve Requirements - the ratio of reserves to deposits that banks must hold to satisfy depositors’ withdrawals.

  • Not a good tool for monetary policy
    • Small changes in the reserve requirements have a significant and disruptive impact on the banking system
      • i.e. the money multiplier
    • The Fed rarely changes the reserve
  • If the Fed raises the reserve requirements, banks have to hold more reserves.
    • Contractionary monetary policy
  • If the Fed lowers reserve requirement, banks have excess reserves and can grant more loans.
    • Expansionary monetary policy

Monetary Policy

1. Monetary policy - more flexible and faster than fiscal policy

  • Congress can take a long time before implementing a policy.
  • Federal Reserve Board for Fed meet regularly and can come up with decisions quickly.

2. Monetary policy suffers from the same lags as fiscal policy

  1. Recognition (or information) lag - takes time to collect data
    • Recession - two consecutive quarters of negative growth for real GDP
    • If government takes 3 months to collect data, then economy could already be in a recession
  2. Administrative lag - government requires time to make a decision
    • The Fed can make decisions much quicker than Congress and the President
  3. Impact lag - takes time for the monetary policy to impact the economy
    • Could be a from a six to twelve month delay for fiscal policy to impact economy

3. Monetary policy can become ineffective

  • During 1990s, Japan went into a recession for a decade
    • Business and consumers were so pessimistic, when the Japanese central bank lowered the interest rate, it had no impact on the economy.
  • Cyclical asymmetry - the belief the restrictive monetary policy is effective while expansionary monetary is not so effective
    • Low interest rates many not change behavior, but high interest rates do.

4. Central banks choose certain variables and use monetary policy to achieve targets for those variables.

  • Taylor Rule - Taylor developed rules for the Federal Reserve that stabilized the Federal Funds rate.
  • Inflation Target - central banks maintain a low inflation rate
    • Countries
      • Canada
      • New Zealand
      • Sweden
      • United Kingdom
Blue arrow Countries that have central banks independent from government have low inflation rates.


  • demand for money
  • transaction demand
  • precautionary demand
  • expansionary monetary policy
  • contractionary (restrictive) monetary policy
  • open market operations
  • discount rate
  • reserve requirements
  • recognition (information) lag
  • administrative lag
  • impact lag
  • cyclical asymmetry
  • inflation target