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

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

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

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

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.

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%

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

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

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

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

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

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