﻿ Ken Szulczyk's Macroeconomics Lecture Notes - Monetary Policy HcWjnyVHiTd8hN_8STvJ2rWaXvhPz4wXYCNGvD4qDkU
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# Monetary PolicyLesson 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.
• 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%.
 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

5. Central bank supplies money (S)

• Can make decisions independent of interest rate
• Shown below

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

## 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

• 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.

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

• 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

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