The Money Market and Interest Rate

1. The Money Market and Interest Rate • We studied how the Fed changes the money supply. • Through open market operations (purchase/sale of government bonds) • Why does the Fed want to change the money supply? • To influence the interest rate. • Today we want to talk about • How do changes in money supply affect the interest rate in the short run? • How do changes in interest rate affect the economy?

2. The Market for Money • To see the relationship between changes in money supply and interest rate, we need to study the money market • Demand for and Supply of Money • Demand for Money? • Or more precisely, the demand for cash holdings, given total wealth

3. An Individual’s Demand for Money • At any given moment, total amount of wealth we have is given • If we want to hold more wealth in form of money, we must hold less wealth in other forms • An individual’s quantity of money demanded • Amount of wealth individual chooses to hold as money • Rather than as other assets • Why do people want to hold some of their wealth in form of money? • Benefit: Money is a means of payments • Cost: Money pays either very little or no interest (unlike other assets) • Holding money comes with an opportunity cost • Interest you could have earned

4. An Individual’s Demand for Money • For simplicity, we assume that individuals can divide wealth between two assets • Money, which can be used as a means of payment but earns no interest • Bonds, which earn interest, but cannot be used as a means of payment • What determines how much money an individual will decide to hold? • Price level (higher prices; more money we need for purchases) • Real income (higher income; more spending; need more money) • Interest rate (higher interest rate; greater opportunity cost of holding money; hold less)

5. The Demand for Money by Businesses • Some money is held by businesses • Stores keep some currency in their cash registers • Firms generally keep funds in business checking accounts • They have only so much wealth, and they must decide how much of it to hold as money rather than other assets • They want to hold more money when real income or price level is higher • Less money when opportunity cost (interest rate) is higher

6. The Economy-Wide Demand For Money • Just as each person and each firm in economy has only so much wealth • There is a given amount of wealth in the economy as a whole at any given time • Total wealth must be held in one of two forms : Money or bonds • Economy-wide quantity of money demanded • Amount of total wealth all households and businesses choose to hold as money rather than as bonds • Demand for money depends on the same three variables that we discussed for individuals • A rise in the price level »» increased demand for money • A rise in real income (real GDP) »» increased demand for money • A rise in interest rate »» decreased demand for money

7. The Money Demand Curve • Figure 1 shows a money demand curve • Tells us total quantity of money demanded in economy at each interest rate • Curve is downward sloping • Keeping everything else constant (price level, GDP) • A drop in interest rate—which lowers the opportunity cost of holding money—will increase quantity of money demanded

8. Figure 1: The Money Demand Curve

9. Shifts in the Money Demand Curve • What happens when something other than interest rate changes quantity of money demanded? • Curve shifts • Increases (Decreases) in the price level or income shift the money demand curve out (in) • A change in interest rate moves us along money demand curve

10. Figure 2: A Shift in the Money Demand Curve

11. Figure 3: Shifts and Movements Along the Money Demand Curve—A Summary

12. The Supply of Money • We would like to draw a curve showing quantity of money supplied at each interest rate • Interest rate can rise or fall, but money supply remains constant until Fed decides to change it • So money supply curve is a vertical line • Suppose Fed, for whatever reason, were to change money supply • Would be a new vertical line • Showing a different quantity of money supplied at each interest rate

13. The Supply of Money • Open market purchases of bonds inject reserves into banking system • Shift money supply curve rightward by a multiple of reserve injection • Open market sales have the opposite effect • Withdraw reserves from system • Shift money supply curve leftward by a multiple of reserve ratio

14. s M 2 Interest s M 1 Rate E 6% J 3% 700 500 Money ($ Billions) Figure 4: The Supply of Money

15. Equilibrium in the Money Market • We are interested in how interest rate is determined in short-run • In short-run we look for the equilibrium interest rate in money market • Interest rate at which quantity of money demanded and quantity of money supplied are equal • Important to understand what equilibrium in money market actually means • Remember that money supply curve tells us quantity of money that actually exists in economy • Determined by Fed

16. Equilibrium in the Money Market • Money demand curve tells us how much money people want to hold at each interest rate • Equilibrium in money market occurs when quantity of money people are actually holding (quantity supplied) is equal to quantity of money they want to hold (quantity demanded) • How does interest rate will reach its equilibrium value in money market?

17. Figure 5: Money Market Equilibrium

18. How the Money Market Reaches Equilibrium • If people want to hold less money than they are currently holding, then, by definition • They must want to hold more in bonds than they are currently holding • An excess demand for bonds • When there is an excess supply of money in economy • There is also an excess demand for bonds • Can illustrate steps in our analysis so far as follows Conclude that, when interest rate is higher than its equilibrium value, price of bonds will rise

19. An Important Detour: Bond Prices and Interest Rates • A bond, in the simplest terms, is a promise to pay back borrowed funds at a certain date or dates in the future • When a large corporation or government wants to borrow money, it issues a new bond and sells it in the marketplace • Amount borrowed is equal to price of bond • The higher the price, the lower the interest rate • An example: Suppose a company sells you a bond for $100 today that promises to pay $110 in one year. • Interest Rate is (10/100)*100=10% • Now you sell this bond for $105. What is the interest rate for the buyer? • Its ((110-105)/105)*100=4.76% • Suppose she sells the bond for $108. • The interest rate is ((110-108)/108 )*100=1.85%

20. Bond Prices and Interest Rates • This general principle applies to all bonds • When the price of bonds rises, interest rate falls • When the price of bonds falls, interest rate rises • This will help us understand how equilibrium in the money market is reached. • Through changes in bond prices

21. Back to the Money Market • Complete sequence of events • Can also do the same analysis from the other direction • Would be an excess demand of money, and an excess supply of bonds • In this case, the following would happen

22. What Happens When Things Change? • Focus on two questions • What causes equilibrium interest rate to change? • What are consequences of a change in the interest rate? • Fed can change interest rate as a matter of policy, or • Interest rate can change on its own • As a by-product of other events

23. How the Fed Changes the Interest Rate • Changes in interest rate from day-to-day, or week-to-week, are often caused by Fed • Fed officials cannot just declare that interest rate should be lower • Fed must change the equilibrium interest rate in the money market • Does this by changing money supply • The process works like this • Fed can raise interest rate as well, through open market sales of bonds • Setting off the following sequence of events

24. How the Fed Changes the Interest Rate • If Fed increases money supply by open market purchases, the interest rate falls • If Fed decreases the money supply through open market sales, interest rates rise • By controlling money supply through purchases and sales of bonds • Fed can also control the interest rate

25. Figure 6: An Increase in the Money Supply

26. How Do Interest Rate Changes Affect the Economy? • If Fed increases money supply through open market purchases of bonds • Interest rate will fall • How is the macroeconomy affected? • A drop in the interest rate will boost several different types of spending in the economy

27. How the Interest Rate Affects Spending • Lower interest rate stimulates business spending on plant and equipment • The interest rate is one of the key costs of any investment project • Interest rate changes also affect investment by individuals • Housing investment • Consumer durables (cars, dishwashers etc.)

28. How the Interest Rate Affects Spending • Can summarize impact of money supply changes as follows • When Fed increases money supply, interest rate falls, and spending on three categories of goods increases • Plant and equipment • New housing • Consumer durables (especially automobiles) • Shifts the Aggregate Expenditure line UP • When Fed decreases money supply, interest rate rises, and these categories of spending fall • Shifts the Aggregate Expenditure line DOWN.

29. Monetary Policy and the Economy • Fed—through its control of money supply—has power to influence real GDP • When Fed controls or manipulates money supply in order to achieve any macroeconomic goal it is engaging in monetary policy • Open market sales by Fed have exactly the opposite effects • Equilibrium GDP would fall by a multiple of the initial decrease in spending

30. Figure 7(a): Monetary Policy andthe Economy

31. Figure 7(b): Monetary Policy andthe Economy

32. Monetary Policy in Practice • What is the “money market”? • The federal funds market. • Banks with excess reserves lend them out to other banks for short periods (a day) at an interest rate • The federal funds rate • This is the cost of funds to banks • Changes in the fed funds rate affects many other rates in the economy • Rates on automobile and consumer loans • Mortgages • By changing the money supply, the Fed can change this interest rate

33. Maintaining an Interest Rate Target • If the money demand curve shifts out • Increase interest rates • Reduce GDP • The Fed can counteract this • By increasing money supply • Maintaining interest rate at a target • To prevent fluctuations in money demand from affecting the economy, the Fed can adjust money supply to maintain the interest rate target • The Fed does this every day.

34. FF Market Aggregate Expenditure Maintaining an Interest Rate Target Interest Rate Real Aggregate Exp MS1 MS2 45 degree line 8% AE 5% 5% Md2 Md1 Money YFE Real GDP

35. Changing the Interest Rate Target • Suppose aggregate expenditure falls • GDP falls. We are in a recession • What should the Fed do? • Lower the interest rate target • To prevent changes in spending from influencing the economy, the Fed can change the target • Does this at FOMC meetings

36. FF Market Aggregate Expenditure Changing the Interest Rate Target Interest Rate Real Aggregate Exp MS1 MS2 45 degree line AE1 5% AE2 3% Md2 Md1 Money Y2 YFE Real GDP

37. Are There Two Theories of the Interest Rate? • In classical model, interest rate is determined in market for loanable funds • In this chapter you learned that interest rate is determined in money market • Where people make decisions about holding their wealth as money and bonds • Which theory is correct? • Both • Why don’t we use classical loanable funds model to determine the interest rate in short-run? • Because economy behaves differently in short-run than it does in long-run • In long run, we view interest rate as determined in market for loanable funds • Where household saving is lent to businesses and government • In short-run, we view interest rate as determined in the money market • Where wealth holders adjust their wealth between money and bonds, and Fed participates by controlling money supply • Changes in demand for money due to change in preferences for bonds or money are short lived • Can be ignored in the long run • Where interest rates are determined by demand and supply of loanable funds

38. Which Interest Rate? • Usually the Fed targets the “Fed Funds Rate” • Interest rate in the market where banks lend out their excess reserves short term • Usually for a day • This affect other interest rates as well • Fall in Fed funds rate implies banks will want to move out of that market and buy government bonds and/or corporate • Raising their price and lowering their rate

39. A New Tool for Monetary Policy • In 2008 the Fed introduced a new policy tool • Already used in Australia and Europe for some years • Paying interest on reserves held by banks at the Fed • By changing this rate, the Fed can establish a floor for interest rates • Since no bank will lend to another for less than this amount • Delinking the amount of reserves in the economy and the interest rate

40. Unconventional Monetary Policy • In normal times the Fed targets the Fed funds rate (or the interest rate on reserves) • Affects aggregate demand and GDP. • In the current recession, these proved inadequate for three reasons • The Financial Crisis • Changing interest rate spreads • Hitting the zero bound on interest rates • This called for “unconventional” monetary policy.

41. Changing Interest Rate Spreads • An interest rate spread is the difference between the Fed funds rate and other interest rates • On car loans, mortgages, corporate borrowing etc • Which are typically higher, since they are riskier • In normal times these rates move with the Fed funds rate • As their riskiness (or the spread) remains unchanged • If the perceived riskiness of these loans increases • Then the spread increases • Changes in the Fed Funds rate do not affect these rates • What can the Fed do?

42. Unconventional Policy to Alter Interest Rate Spreads • Other than government bonds, Fed can buy and sell other assets • Altering their rate of return. For example • If mortgage interest rates rise, Fed can buy mortgage backed securities • Driving up their prices, lowering the interest rates and lowering mortgage rates • Can intervene in any market where it wants to change the rate of return • Some downsides to this • Fed takes on the risk private sector cannot bear (and will ultimately be borne by the taxpayer • Can be a politically sensitive process

43. The Zero Lower Bound • The Fed lowers interest rate to stimulate aggregate expenditures • What if the interest rate reaches zero? • This is the nominal interest rate • Real Rate=Nominal Rate-Rate of Inflation • Fed can create inflation and lower the real rate • Danger that the inflation may be hard to control in the long run

44. The Fed’s role in a Financial Crisis • During a crisis, two safeguarding institutions • Lender of last resort (Fed) • Deposit insurers (FDIC) • In the current crisis, the Fed undertook unprecedented actions to stabilize the financial system

45. Conventional Tools

46. Conventional Tools • Lowering interest rates did not stimulate aggregate demand • Increasing credit spreads • Increased perception of risk

47. How the Fed Responded • Fed stepped up its role as lender of last resort • Allowed banks to borrow anonymously (without stigma) • Allowed security dealers to use mortgage backed securities as collateral for loans from Fed • If the securities increased in value, the dealers would gain • If they lost value, the Fed would bear the cost • Fed bought more than $1 trillion worth of mortgage backed securities directly

48. The Response of Treasury • The Fed assisted the Treasury to lend money to troubled financial institutions • Using their shares as collateral • Increase confidence of the market in lending to these institutions • All these actions prevented the collapse of the financial system

49. The Exit Strategy? • All the Fed’s rescue efforts had been to lend more money • Paid for by reserves. Huge increase in total reserves • After the crisis, the banks would lend these massive reserves out, causing the economy to overheat • Could be addressed by Fed reducing reserves (through open market sales) later. • But this is a very large amount, which could be destabilizing for the system if done rapidly

50. The Exit Strategy • Fed dealt with increase in reserves in two ways • Provided reserves to some institutions • But simultaneously conducted open market sales, mopping up the same quantity of reserves injected • Maintaining interest rates • In October 2008, Fed was allowed to pay interest on reserves • To set monetary policy independent of the amount of reserves in the system