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## Inflation and Monetary Policy

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**General Lecture Topic**• Relax first Fisher Assumption “no inflation” • This means we now allow money to exist, not just real goods as in basic model. • We must now distinguish between nominal (money) and real interest rates • Monetary policy becomes possible**Specific Topics**• Nominal and real interest rates • Data sources • Implications for financial innovation • Monetary policy • How the Fed controls the money supply • How the money supply (monetary policy) enters the loanable funds model • Limits of monetary policy**Definitions**• Nominal interest rate • Interest rate in money terms • As reported in financial press etc. • Real interest rate • Interest rate in terms of purchasing power • Calculated by reducing nominal return by the amount of inflation**Backward looking vs. Forward looking interpretation**• This calculation can only be done after-the-fact. After inflation is known • The forward-looking approach – that relates nominal and real interest rates today is more interesting • Here expected inflation is used instead of realized inflation**Fisher Equation:relates real and nominal interest rates**(1+i) = (1+r)(1+α) Or, approximately i = r + α Where i = nominal interest rate r = real interest rate α = expected inflation**Logic of the relation**• A lender requires / a borrower will pay • Increased purchasing power in return for delaying consumption. This is the real interest rate, determined by the loanable funds model. • The nominal interest rate includes this and, since it is quoted in money terms, compensation for the expected loss in purchasing power of money (expected inflation)**Events that effect nominal rates**• Any factor that affects real rates [productive opportunities, tastes, endowments] • Any news that affects expected inflation [e.g. past inflation, policy, etc.]**Monetary policy affects nominal interest rates in two ways**If the money supply is increased • Nominal interest rates decrease because of the direct effect on real interest rates • Nominal interest rates increase • Because inflation and expected inflation increase • This is the inflationary expectations effect**What is the real rate now?**real = nominal – expected inflation Nominal interest rates • Current data • Historical data: (e.g. FRED: Federal Reserve Economic Data) 10 year treasury**Inflation Data**• FRED summary Inflation • Original source: Bureau of Labor Statistics www.bls.gov/cpi**For net result: history of real rate**(See text p. 61)**Alternative market information**TIPS: Treasury Inflation Protected Securities • At each coupon payment date, face value adjusts in proportion to realized inflation (lagged) • Thus the nominal amount of coupon and final principal payment offsets inflation (see text p. 72)**TIPS**• Thus TIPS coupon can be thought of as being quoted in real terms (what’s left after removing effect of inflation from the nominal payment received.) • The YTM calculated from the coupon is a real yield.**Historical TIPS Data**• 30 year bond ’98 to present • 10 year note 2000 to present**Current TIPS Data**• Wall Street Journal • Markets • Market Data**Financial Instruments based on inflation**• Government bonds • TIPs (or other index) • Foreign currency denominated • Private sector bonds • Indexed • Gold or commodity linked**Inflation instruments asfinancial innovation**Recall: ordinary loans as financial innovation • Innovation profitable if GFT created • GFT result from differences • For ordinary loans differences in productive opportunities, tastes, endowments**Do TIPS allow new GFT?**• What new choices do they offer investors? • Differential exposure to inflation • New GFT trade possible if investors differ in their desired exposure to inflation due to • differing opinions about amount of inflation • differing willingness to bear inflation risk**TIPS: Summary**• Potential source of data about the real rate of interest (or market expectations about inflation) • Does illustrate GFT from innovation but: • A public, not private, innovation • Timing (in an interval of relatively low and stable inflation) not typical**Money and the banking system**• Banks hold reserves as deposits at the Fed • In this sense the Fed is the bankers’ bank • Banks borrow and lend these Fed Funds • Banks must hold reserves in proportion to deposits • Bank deposits (checking accounts) are the most important form of money • The link between Fed Funds and bank deposits permits control of the money supply**Tools of monetary policy**• Open market operations: Buying or selling bonds • Rediscount rate: The rate at which the fed loans to banks • Reserve requirement: The proportion of deposits that must be held as reserves (non-interest bearing) with the Fed.**Open market operations**• The Fed buys (sells) bonds creating (extinguishing) reserves in payment • This is by far the most common tool of monetary policy • Note that creating reserves to pay for goods and services is fiscal, not monetary policy • We limit attention to pure monetary policy**How the money supply (monetary policy) enters the Fisher**Model**Basic idea**Changing money supply affects supply of loans (of loanable funds)**Preliminary observations**• Note: The Fisher Model works with real interest rates and real quantities • Nominal interest rates found by adding on expected inflation • It is also convenient to consider only demand and supply of loans to private borrowers (corporation)**Interpretation of curves**• Demand is demand for loans by firms (real borrowing as a function of real interest rate) • Supply is household supply of loans net of government borrowing. • Resulting quantity is private borrowing • It directly reflects demand for investment • Resulting interest rate applies to all**If Fed wants lower interest ratesit increases money supply**• Buys bonds, putting money in the accounts of households • Households relend these funds to firms • Supply (to private sector) shifts out • Interest rate falls • Private borrowing and investment increase**This is the direct effect or liquidity effect**• Monetary policy increases the (real) amount households have to lend to private sector • Thus supply curve of loans shifts out**Benefit of expansive policy**• Increased investment stimulates the economy • The direct effect dominates as long as Fed policies do not also produce inflation that modifies nominal interest rates and balances**Limitations of expansive policy**• New borrowing may stimulate a desire to invest beyond the capacity of the economy. • Increased demand for goods, with no room to increase output, leads to price increases. • Inflation, and the expectation of further inflation, results.**Expansive Monetary Policy**• Increases output and lowers real interest rates if the economy is operating below capacity • Creates inflation if the economy is at capacity**Restrictive Monetary policy**• Increases the real rate without inflation • Reduced money supply (bond sales) shifts supply to private sector to the left • Real interest rate increases • Desired borrowing decreases • Can move the economy more quickly out of the danger zone for inflation • Can choke the economy if applied when the economy is operating below capacity