2. Chapter Objectives
• The equilibrium interest rate and
the market for money
• Monetary policy
• How the Fed controls the Federal
funds rate
• How monetary policy affects GDP
and the price level
• Effectiveness of monetary policy
and its shortcomings
33-2
3. Interest Rates
• Price paid for the use of money
• Many different interest rates
• Speak as if only one interest rate
• Determined by money supply and
money demand
33-3
4. Demand for Money
• Why hold money?
• Transactions demand, D1
–Determined by nominal GDP
–Independent of the interest rate
• Asset demand, D2
–Money as a store of value
–Varies inversely with the interest
rate
• Total money demand, D 33-4
5. Demand for Money
Rateofinterest,ipercent
10
7.5
5
2.5
0
50 100 150 200 50 100 150 200 50 100 150 200 250 300
Amount of money
demanded
(billions of dollars)
Amount of money
demanded
(billions of dollars)
Amount of money
demanded and supplied
(billions of dollars)
=+
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
(c)
Total
demand for
money, Dm
and supply
Dt Da Dm
Sm
5
33-5
6. Interest Rates
• Equilibrium interest rate
–Changes with shifts in money
supply and money demand
• Interest rates and bond prices
–Inversely related
–Bond pays fixed annual interest
payment
–Lower bond price will raise the
interest rate
33-6
7. Federal Reserve Balance Sheet
• Assets
–Securities
–Loans to commercial banks
• Liabilities
–Reserves of commercial banks
–Treasury deposits
–Federal Reserve Notes outstanding
33-7
8. Securities
Loans to Commercial
Banks
All Other Assets
Total
Reserves of Commercial
Banks
Treasury Deposits
Federal Reserve Notes
(Outstanding)
All Other Liabilities and
Net Worth
Total
February 14, 2008 (in Millions)
Assets Liabilities and Net Worth
Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008
$713,369
60,039
111,689
$885,097
$ 11,312
4,979
778,937
89,869
$885,097
Federal Reserve Balance Sheet
33-8
9. Central Banks
Reserve Bank of Australia (RBA)
Bank of Canada
European Central Bank (ECB)
Bank of Japan (BOJ)
Banco de Mexico (Mex Bank)
Central Bank of Russia
Sveriges Riksbank
Bank of England
Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)
Australia:
Canada:
Euro Zone:
Japan:
Mexico:
Russia
Sweden:
United Kingdom:
United States:
Selected Nations
33-9
10. Tools of Monetary Policy
• Open market operations
–Buying and selling of government
securities (or bonds)
–Commercial banks and the general
public
–Used to influence the money supply
• When the Fed sells securities,
commercial bank reserves are
reduced
33-10
11. Open Market Operations
New Reserves
$1000
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
Fed buys $1,000 bond from a commercial
bank
$1000
Excess
Reserves
33-11
12. Open Market Operations
Check is Deposited
New Reserves
$1000
Total Increase in the Money Supply, ($5000)
Fed buys $1,000 bond from the public
$200
Required
Reserves
$800
Excess
Reserves
$1000
Initial
Checkable
Deposit
$4000
Bank System Lending
33-12
13. Tools of Monetary Policy
• The reserve ratio
–Changes the money multiplier
• The discount rate
–The Fed as lender of last resort
–Short term loans
• Term auction facility
–Introduced December 2007
–Banks bid for the right to borrow
reserves 33-13
14. Tools of Monetary Policy
• Open market operations most
important
• Reserve ratio last changed 1992
• Discount rate was a passive tool
• Term auction facility is new
–Guaranteed amount lent by the Fed
–Anonymous
33-14
15. The Federal Funds Rate
• Rate charged by banks on
overnight loans
• Targeted by the Federal Reserve
• FOMC conducts open market
operations to achieve the target
• Demand curve for Federal funds
• Supply curve for Federal funds
33-15
16. The Federal Funds Rate
FederalFundsRate,Percent
3.5
Quantity of Reserves
Df
Sf3
4.0
4.5
Sf1
Sf2
Qf3 Qf1 Qf2
Using Open Market Operations
33-16
17. Monetary Policy
• Expansionary monetary policy
–Economy faces a recession
–Lower target for federal funds rate
–Fed buys securities
–Expanded money supply
–Downward pressure on other
interest rates
• Contractionary monetary policy 33-17
18. Taylor Rule
• Rule of thumb for tracking actual
monetary policy
• Fed has 2% target inflation rate
• If real GDP = potential GDP and
inflation is 2% then target federal
funds rate is 4%
• Target varies as inflation and real
GDP vary 33-18
19. Monetary Policy
• Affect on real GDP and price level
• Cause-effect chain
–Market for money
–Investment and the interest rate
–Investment and aggregate demand
–Real GDP and prices
• Expansionary monetary policy
• Restrictive monetary policy 33-19
20. Monetary Policy and GDP
10
8
6
0
RateofInterest,i(Percent)
Amount of money
demanded and
supplied
(billions of dollars)
Amount of investment
(billions of dollars)
PriceLevel
Real GDP
(billions of dollars)
Q1 Qf Q3$125 $150 $175 $15 $20 $25
P2
P3
Sm1 Sm2 Sm3
Dm
ID
AD1
I=$15
AD2
I=$20
AD3
I=$25
(a)
The market
for money
(b)
Investment
demand
(c)
Equilibrium real
GDP and the
Price level
AS
33-20
21. Expansionary Monetary Policy
Problem: unemployment and recession
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
CAUSE-EF
33-21
23. Monetary Policy
• Advantages over fiscal policy
–Speed and flexibility
–Isolation from political pressure
• Recent U.S. monetary policy
• Problems and complications
–Recognition lag
–Operational lag
–Cyclical asymmetry
33-23
24. The Big Picture
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Aggregate
Supply
Input
Resources
With Prices
Productivity
Sources
Legal-
Institutional
Environment
Consumption
(Ca)
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
33-24
25. The Mortgage Debt Crisis
• Home mortgage default 2007
• Banks write off bad loans
• Reserves reduced
• Fed as lender of last resort
• Term auction facility
• Fed lowered federal funds rate
• Mortgage backed securities as a new
innovation
–Bad incentives 33-25
26. Key Terms
• monetary policy
• interest
• transactions demand
• asset demand
• total demand for
money
• open-market
operations
• reserve ratio
• discount rate
• term auction facility
• Federal funds rate
• expansionary
monetary policy
• prime interest rate
• restrictive monetary
policy
• Taylor rule
• cyclical asymmetry
• mortgage debt crisis
33-26
