ECO 103 Chp. 14

Portfolio allocation decision

Portfolio allocation decision

the decision about the forms in which to hold one’s wealth

• Ex. Lois could hold $5000 of his wealth in cash, $5000 in government bonds, $2000 in a checking account

• People generally prefer to hold assets that  they expect to pay a high returns nd do not carry too much risk

Demand for money

the amount of wealth an individual or firm choose to hold in the form of money

• Ex.if  Lois holds $5000 of his wealth in cash, $5000 in government bonds, $2000 in a checking account, his demand for money is $7000 (cash + checking account)

Nominal interest rate

The cost of holding money arises because, in order to hold an extra dollar of wealth in the form of money, a person must reduce by one dollar the amount of wealth held in the form of higher-yielding assets (like bonds or stocks)

• The opportunity cost of holding money is measured by the interest rate that could have been earned if the person has chosen to hold interest-bearing assets incstead of money

  • The higher the nominal itnerst rate, the higher the opportunity cost of holding money

Real income or output

An increase in aggregate real income or output (for example, by real GDP) raises the quantity of goods and services that people and businesses want to buy and sell

• When the economy enters a boom, people do more shopping- both individuals and businesses need to hold more money

Price level

The higher the prices of goods and services, the more dollars are needed to make a given set to transactions

• A higher price level is associated with a higher demand for money

Money demand curve

a curve that shows the relationship between aggregate quantity of money demanded M and the nominal interest rate i

• Slopes down

  • An increase in the general price level or in real GDP will shift the money demand curve to the right

  • A decrease in the general pruce level or in real output will shift the demand curve leftward

Federal funds rate

the interest rate that commercial banks charge each other for very short-term (usually overnight) loans

• Ex. a banks that has insufficient reserves to meet its legal reserve requirements might borrow reserves for a few days from a bank that has extra reserves

Real interest rate

=  nominal interest rate - rate of inflation

Money supply

= currency held by the public + (bank reserves / desired reserve-deposit ratio)

• Fore every $1 change (increase or decrease) in reserves, the money supply would change by $1/ (desired reserve-deposit ratio)

  • Ex. if the desired reserve-deposit ratio is 5%, then an increase in reserves by $1 would increase the money supply by $1/0.05 = $20

Ways the Fed changes bank reserves

1. Open-market operations

• In an open-market purchase , the Fed buys securities and effectively sells reserves

2. Discount window lending- the lending of reserves by the Federal Reserve to commercial banks

   1. Discount rate- the interest rate that the fed charges commercial banks that borrow reserves

      1. The Fed offers three discount window programs: primary credit, secondary credit, seasonal credit

3. Increase reserve-deposit ratio reduces the money supply

   1. Reserve requirements- set by the Fed, the minimum values of the ratio of bank reserves to bank deposits that commercial banks are allowed to maintain

      1. Changes in reserve requirements can affect the money supply

         1. Can force commercial banks to raise their reserve-deposit ratios

      2. Id banks kep all their deposits as reserves, the reserve-deposit ratio would be 100% and banks would not make any loans

      3. As banks lend out more deposits, the reserve-deposit ratio falls

      4. An increase in the reserve-deposit ratio reduces the money supply

Reserve-deposit ratio

= total bank reserves/total deposits

• As banks lend out more of their deposits, the reserve-deposit ratio falls

Excess Reserves

bank reserves that exceed the reserve requirements set by the central bank

• Reserves that the central bank makes available to commercial banks, but that do not add to the money supply because commercial banks do not use them for making additional loans

  • Because excess reserves don’t add to the money supply, they allow for the possibility that the money supply will not change in spite of the central bank increasing or decreasing the supply of reserves

Zero lower bound

a level, close to zero, below which the Fed cannot further reduce short-term interest rates

Quantitative easing

an expansionary monetary policy in which a central bank buys long-term financial assets thereby lowering the yield or return of those assets while increasing the money supply

• Used by central banks to stimulate the economy by purchasing assets of longer maturity, thereby lowering longer-term interest rates

• By purchasing types of assets- such as debt related to mortgages- the Fed could help decrease interest rates in specific markets

Forward guidance

information that a central bank provides to the financial markets regarding its expected future monetary-policu path

• By guiding markets regarding the central bank’s future intentions, the central bank can influence long-term interest rates because these rates are affected by what market participants believe the central bank will do in the future

Policy reaction function

describes how the action a policy-maker takes depends on the state of the economy

• For the sake of simplicity, we consider a policy reaction function in which the real interest rate set by the Fed depends only on the rate of inflation

  • Because the Fed raises the real interest rate when inflation rises, in order to restrain spending, the Fed’s policy reaction is upward-sloping

• Contains information about the central bank’s long-run target for inflation and the aggressiveness with which it intends to pursue that target

Federal funds rate

the primary indicator of the stance of monetary policy in the use; the interst rate on overnight loans of reserves (federal funds) that banks trade among themselves

• Controlling the money supply and controlling the nominal interest rate are two sides of the same coin:

  • Any value of the money supply chosen by the Fed implies a specific setting for the nominal interest rate, and vice versa

Money supply

we will assume the Fed can fully control the amount of money by controlling the amount of bank reserves

Money demand

the amount of money economic agents desire to hold for transactionary purposes

Liquidity preference

the demand for money

• Recall that money is also a store of value, like stocks, bonds, or real estate— a type of financial asset

Demand for money

the amount of wealth held in the form of money

Demand for money depends on

1. Nominal interest rate (i)- the higher the interest rate, the lower the quantity of money demanded

2. Real income or output (Y)- the higher the level of income, the greater the quantity of money demanded

3. The price level (P)- the higher the price level, the greater the quantity of money demanded

Money demand curve

shows the relationship between the aggregate quantity of money demanded, and the nominal interest rate

• An increase in the nominal interest rate increases the opportunity cost of holding money, hence the negative slope

Shift in the money demand curve factors

1. An increase in output

2. Higher price levels

3. Technological advances

4. Financial advances

5. Foreign demand for dollars

Equilibrium

the intersection between the demand (money demand) and supply (money supply) curve

Current bond price

future value / 1 + nominal interest rate

Contractionary monetary policy

To decrease the money supply

1. The Fed sells bonds to the public

2. Supply of bonds increase

3. Price of bonds decrease

4. Interest rate increase

Expansionary monetary policy

To increase the money supply

1. The Fed buys bonds from the public

2. Supply of bonds decrease

3. Price of bodns increase

4. Interest rate decreases

Policy rate

monetary policy is announced in terms of interest rates

• The Fed announce a target for the Federal funds rate

• The Fed chooses to communicate its monetary policy in terms of the target nominal interst rate rather than target money supplu

  • Because the public is stupid and can’t understand money supply

Fed monetary policy tools

1. Open market operations- the Fed’s preferred method of monetary control which affects banking reserves

2. Discount rate- the interest rate the Fed charges on loans to banks

   1. To increase the money supply, the Fed could lower the discount rate, encouraging banks to borrow more reserves

3. Reserve requirements- Fed regulations impose a minimum reserve-deposit ratio

   1. To reduce the reserve-deposit ratio, the Fed could reduce reserve requirements

4. Interest on reserves- the Fed pays interest on bank reserve deposited with the Fed

   1. To reduce the reserve-deposit ratio, the Fed could pay a lower interest rate on reserves

Change in PAE

= (change in output) / (multiplier)

Policy reaction function

describes how the action a policymaker takes depends on the state of the economy

• Here, the policymaker’s action is the Fed’s choice of the real interest rate

• And the state of the economy is given by factors such as the output gap or the inflation rate

Taylor rule

a description of the Fed’s behavior in terms of a quantitative policy reaction function

• Real interest rate = 0.01 + 0.5 ((Y- Y*)/(Y*)) + (0.5 x inflation rate)