Chapters 30.1-30.2: Interest Rates and Monetary Policy

Interest Rates

• interest::
  • the price paid for the use of money
  • the price that borrowers need to pay lenders for transferring purchasing power to the future
  • the amount of money that must be paid for the use of $1 for 1 year

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The Demand for Money

Transactions Demand, Dt

• People hold money because it is convenient for purchasing goods and services.
• transactions demand for money::
  • The demand for money as a medium of exchange
• The level of nominal GDP is the main determinant of the amount of money demanded for transactions
• The ^^transactions demand for money varies directly with nominal GDP^^
• nominal GDP because households and firms will want more money for transactions if prices or real output increase
• transactions demand, Dt, is graphed as a vertical line
  • assume that the amount demanded depends exclusively on the level of nominal GDP and is independent of the interest rate

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Asset Demand, Da

• The second reason for holding money is money’s function as a store of value
  • people hold some financial assets as money because of its liquidity: it’s immediately usable for purchasing other assets now or in the future
  • Holding money presents no such risk of capital loss from changes in interest rates.
  • when the price of a bond falls, the bondholder will suffer a loss called a capital loss
• The disadvantage of holding money as an asset is that it earns little to no interest.
  • Checkable deposits pay no interest or lower interest rates than bonds.
  • Currency earns no interest at all.
  • A household or a business loses the opportunity to gain interest income when it holds money
• asset demand for money::
  • The amount of money people want to hold as a store of value
  • ^^varies inversely with the interest rate^^
  • graphed as a downsloping line
• When interest rates rise, people reduce the amount of money they hold as an asset and asset demand declines
• When interest rates fall, people increase the amount of money they hold as an asset and asset demand rises

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Total Money Demand, Dm

• total demand for money::
  • The sum of the transactions demand for money and the asset demand for money.
  • Results in a downsloping line
  • represents the total amount of money the public wants to hold, both for transactions and as an asset, at each possible interest rate.
• Recall that transactions demand for money depends on the nominal GDP
  • through transactions demand, ^^a change in nominal GDP will shift the total money demand curve^^
  • an increase in nominal GDP shifts total money demand to the right; a decrease in nominal GDP shifts total money demand to the left

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The Equilibrium Interest Rate

• In the above graph (c), the vertical line, Sm, represents the money supply.
  • it’s vertical because the monetary authorities and financial institutions provide the economy with some particular stock of money.
• At the equilibrium interest rate, the quantity of money demanded equals the quantity of money supplied
  • in graph c, the equilibrium interest rate is “ie” which falls at $200 billion demanded and supplied
  • Changes in the demand or supply for money or both can change the equilibrium interest rate, but we will focus on supply.
  • an increase in the supply of money will lower the equilibrium interest rate
  • a decrease in the supply of money will raise the equilibrium interest rate
• equilibrium interest rate can be thought of as the market-determined price that borrowers must pay for using someone else’s money over some period of time.

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Interest Rates and Bond Prices

• ^^Interest rates and bond prices are inversely related.^^
  • When the interest rate increases, bond prices fall
  • when the interest rate falls, bond prices rise
• bonds are bought and sold in financial markets
• the price of bonds is determined by bond demand and bond supply
• fixed annual interest paid by the bond / face value the bond is sold at = interest yield or rate
• ex.
  • a bond pays a fixed $50 annual interest payment and sells for a price of $1,000. The interest yield is 5% to the buyer of the bond.
  • ==$50 / $1000= 5%==
  • say the interest rate in the economy rises to 7.5% from 5%. Newly issued bonds will pay $75 per $1,000 lent.
  • $75 / $1000 = 7.5%
  • To compete with the new 7.5% bonds, the price of the first bond falls to $667.
    • ==$50 / $667 = 7.5%==
  • or instead, the interest falls to 2.5% from 5%. Newly issued bonds will pay $25 on $1,000 loaned.
  • $25 / $1000 = 2.5%
  • To keep the attractive $50 payment, the price of the first bond increases to $2000
    • ==$50 / $2000 = 2.5%==

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The Consolidated Balance Sheet of the Federal Reserve Banks

Fed’s Assets

• The two main assets of the Federal Reserve Banks are securities and loans to commercial banks.
• only commercial banks are mentioned for simplicity but analysis also applies to thrifts

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1. Securities

• the securities in the balance sheet are bonds that the Fed purchased
• The majority are Treasury bills (short-term securities), Treasury notes (mid-term securities), and Treasury bonds (long-term securities)
  • they’re issued by the U.S. government to finance past budget deficits so they’re part of US gov’s public debt
  • Fed buys them from commercial banks and the public through open-market operations
  • they’re an important source of interest income to the Federal Reserve Banks
  • but securities are mainly bought and sold to influence the size of commercial bank reserves and the ability of those banks to create money by lending
• also include mortgage backed securities purchased during and after the mortgaged debt crisis to bail out mortgage lenders

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2. Loans to Commercial Banks

• commercial banks occasionally borrow from Federal Reserve Banks
• They’re assets to the Fed and liabilities to the commercial banks
• commercial banks increase their reserves by borrowing from the Fed

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Fed’s Liabilities

1. Reserves of Commercial Banks

• The Fed pays interest on banks’ required reserves and on excess reserves they choose to hold at the Fed
  • reserves held at the Fed’s banks are assets to commercial banks
• Banks held a huge amount of excess reserves at the Fed during the severe recession of 2007–2009
  • they were concerned that loans to some private borrowers might not get paid back

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2. Treasury Deposits

• The U.S. Treasury keeps deposits in the Federal Reserve Banks and draws checks on them to pay its obligations.
  • these deposits are assets to the Treasury
• Treasury creates and replenishes these deposits by
  • depositing tax receipts
  • depositing money borrowed from the public
  • depositing money borrowed from commercial banks through the sale of bonds

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3. Federal Reserve Notes Outstanding

• the supply of paper money in the US consists of Federal Reserve Notes issued by the Federal Reserve Banks
• When this money is circulating outside the Federal Reserve Banks, they are claims against the Fed and therefore the Fed’s liabilities

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