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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Graphs for Dt, Da, and Dm

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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

The Fed's balance sheet at a particular time

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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