Chapter 15-Interest Rates and Monetary Policy

Monetary Policy

a set of actions to control a nation’s money supply and achieve economic goals. “Money” is like any other good, i.e., commodities.

There is a market for “money”

We demand “money” to use/spend it; the Fed supplies “money” according to economic conditions

Does “money” have a price?

Determined by the money supply and money demand

What is the price of “money”?

Using/ holding “money” has an opportunity cost, the price of “money” is the interest rate. Many different interest rates (the risk factor), speak as if only one interest rate

Interest Rates

Demand for Money: Why do we demand/ hold money?

Transactions demand, dt vs. Asset Demand, Da

Transactions demand, Dt

Dt- Determined by nominal GDP, independent of the interest rate. It depends on economic activity, i. e., nominal GDP, independent of the interest rate

Asset Demand, Da":

Money as a store of value, varies inversely with the interest rate.

Total demand for money, Dm

Dt+Da=Dm

Demand and Supply for money

Interest Rates: Equilibrium of the Money Market

Tools of Monetary Policy-How the Fed could shift/ change money supply? With “Tools”

Open-market operations and discount rates, term auction facility, interest on reserves, federal funds rate

Open-Market Operations

Buying and Selling of government securities(or bonds), to.from commercial banks and the general public

The discount rate

the rate the fed charges the banks over loans, the fed as lender of last resort, short-term loans

Term Auction Facility

Introduced in Dec 2007, banks bid for the right to borrow reserves

Interest on Reserves

Since 2008, the Fed pays interest on excess reserves to commercial banks

The Feds Dual Mandate: Congress ordered the Fed to pursue two objectives:

1. Full Employment in the labor force 2.Stable prices

Federal Funds Rate

Rate charged by banks on overnight loans, the Fed targets this rate by manipulating the supply of reserves that are offered in the market

Expansionary MP

It is implemented during a recession => the Fed increases Money Supply

Expansionary MP Effects: Cause-Effect Chain

Restrictive MP

Restrictive MP Effects

Cause-Effect Chain

Advantages of Monetary Policy over fiscal policy:

Speed and flexibility, Isolation from political pressure, Monetary policy is more subtle than fiscal policy

Problems and Complications of Monetary Policy

Recognition and operational, cyclical asymmetry, MP is more effective in dealing with inflation than helping with a recession, liquitity trap(even though the fed may create excess reserves, that does not mean the banks will loan the money out