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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

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the money market and interest rate
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?
the market for money
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
an individual s demand for money
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
an individual s demand for money4
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)
the demand for money by businesses
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
the economy wide demand for money
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
the money demand curve
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
shifts in the money demand curve
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
the supply of money
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
the supply of money13
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
figure 4 the supply of money

s

M

2

Interest

s

M

1

Rate

E

6%

J

3%

700

500

Money

($ Billions)

Figure 4: The Supply of Money
equilibrium in the money market
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
equilibrium in the money market16
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?
how the money market reaches equilibrium
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

an important detour bond prices and interest rates
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%
bond prices and interest rates
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
back to the money market
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
what happens when things change
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
how the fed changes the interest rate
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
how the fed changes the interest rate24
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
how do interest rate changes affect the economy
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
how the interest rate affects spending
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.)
how the interest rate affects spending28
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.
monetary policy and the economy
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
monetary policy in practice
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
maintaining an interest rate target
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.
maintaining an interest rate target34
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

changing the interest rate target
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
changing the interest rate target36
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

are there two theories of the interest rate
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
which interest rate
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
a new tool for monetary policy
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
unconventional monetary policy
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.
changing interest rate spreads
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?
unconventional policy to alter interest rate spreads
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
the zero lower bound
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
the fed s role in a financial crisis
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
conventional tools46
Conventional Tools
  • Lowering interest rates did not stimulate aggregate demand
  • Increasing credit spreads
    • Increased perception of risk
how the fed responded
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
the response of treasury
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
the exit strategy
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
the exit strategy50
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
controversies about the fed s role
Controversies about the Fed’s role
  • Fed’s expanded role in the economy
    • Trading safe government securities for risky assets
    • Taxpayers would bear the loss if the economy did not recover (which did not happen)
      • However, Fed was accused of rescuing a financial sector which took irresponsible risks and paid large bonuses and salaries
    • Some people want to expand the role of the Fed
      • To give them greater regulatory powers, prevent a repeat of the crisis
    • Others want to limit their power