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
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
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.
- 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
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