Interest Rates

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Interest Rates
18
18
Interest Rates and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rates
• The price paid for the use of money
• Many different interest rates
• Speak as if only one interest rate
• Determined by the money supply and
money demand
LO1
18-2
Types of Interest Rates
Type of Interest Rate
Annual
Percentage
20-year Treasury Bond rate
(interest rate on federal government security used to finance the public debt)
4.05%
90-day Treasury Bill rate
(interest rate on federal government security used to finance the public debt)
0.02
Prime interest rate
(interest rate used as a reference point for a wide range of bank loans)
3.25
30-year mortgage rate
(fixed-interest rate on loans for houses)
4.60
4-year automobile loan rate
(interest rate for new autos by automobile finance companies)
4.05
Tax-exempt state and municipal bond rate
(interest rate paid on a low-risk bond issued by a state or local government)
4.65
Federal funds rate
(interest rate on overnight loans between banks)
0.08
Consumer credit card rate
(interest rate charged for credit card purchases)
14.42
LO1
18-3
Global Snapshot
Short-Term Interest Rate, 2011
0
1
2
3
4
5
6
Hungary
5.9
Australia
5.1
Poland
4.9
Mexico
4.6
Iceland
4.2
South Korea
3.6
New Zealand
2.8
Canada
1.6
United Kingdom
0.9
United States
Japan
LO1
7
0.8
0.3
18-4
Demand for Money
• Why hold money?
• Transactions demand, Dt
• Determined by nominal GDP
• Independent of the interest rate
• Asset demand, Da
• Money as a store of value
• Varies inversely with the interest rate
• Total money demand, Dm
LO1
18-5
Rate of interest, i percent
Demand for Money
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
10
Sm
7.5
=5
+
5
2.5
Dt
0
50
100
150
Dm
Da
200
Amount of money
demanded
(billions of dollars)
LO1
(c)
Total
demand for
money, Dm, and
supply
50
100
150
200
Amount of money
demanded
(billions of dollars)
50
100
150
200
250
300
Amount of money
demanded and supplied
(billions of dollars)
18-6
Interest Rates
• Equilibrium interest rate
• Changes with shifts in money supply
•
LO1
and money demand
Interest rates and bond prices
• Inversely related
• Bond pays fixed annual interest
payment
• Lower bond price will raise the
interest rate
18-7
Tools of Monetary Policy
• Open-market operations
• Buying and selling of government
•
LO2
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
18-8
Tools of Monetary Policy
• The reserve ratio
• Changes the money multiplier
• The discount rate
• The Fed as lender of last resort
• Short-term loans
LO2
18-9
The Reserve Ratio
Effects of Changes in the Reserve Ratio
(6)
MoneyCreating
Potential of
Single Bank, =
(5)
(7)
MoneyCreating
Potential of
Banking
System
(1)
Reserve
Ratio, %
(2)
Checkable
Deposits
(3)
Actual
Reserves
(4)
Required
Reserves
(5)
Excess
Reserves,
(3) –(4)
(1) 10
$20,000
$5,000
$2,000
$3,000
$3,000
$30,000
(2) 20
20,000
5,000
4,000
1,000
1,000
5,000
(3) 25
20,000
5,000
5,000
0
0
0
(4) 30
20,000
5,000
6,000
-1,000
-1,000
LO2
-3,333
18-10
Tools of Monetary Policy
• Open-market operations are the most
•
•
LO2
important
Reserve ratio last changed in 1992
Discount rate was a passive tool
18-11
Monetary Policy
• Expansionary monetary policy
• Economy faces a recession
• Fed buys securities
• Lower the reserve ratio
• Lower the discount rate
LO2
18-12
Monetary Policy
• Restrictive monetary policy
• Periods of rising inflation
• Sell securites
• Increase the reserve ratio
• Raise the discount rate
LO2
18-13
Monetary Policy, Real GDP, Price Level
• Effect 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
LO3
18-14
(a)
The market
for money
Sm1
Sm2
Sm3
AS
10
P3
8
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Dm
6
ID
0
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
LO3
(c)
Equilibrium real
GDP and the
price level
(b)
Investment
demand
Price Level
Rate of Interest, i (Percent)
Monetary Policy and Equilibrium GDP
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
18-15
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, or lowers
the discount rate
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
LO3
18-16
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed sells bonds, increases reserve ratio, or
increases the discount rate
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
LO3
18-17
Monetary Policy in Action
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy is more subtle
than fiscal policy
LO4
18-18
Federal Funds Rate
• Rate banks charge each other on
•
LO4
overnight loans
Easy for the Fed to target
18-19
Monetary Policy
10
8
Prime interest rate
Percent
6
4
Federal funds rate
2
0
1998
1999
2000
2001 2002
2003
2004
2005
2006
2007
2008
2009 2010
Year
LO5
18-20
Recent U.S. Monetary Policy
• Highly active in recent decades
• Responded with quick and innovative
•
LO5
actions during the recent financial
crisis and the severe recession
Critics contend the Fed contributed to
the crisis by keeping the Federal
funds rate too low for too long
18-21
Problems and Complications
• Lags
• Recognition and operational
• Cyclical asymmetry
• Liquidity trap
LO5
18-22
The Financial Crisis
• The Fed’s lender-of-last-resort
activities
• Primary Dealer Credit Facility
• Term Securities Lending Facility
• Asset-Backed Commercial Paper
Money Market Mutual Fund
Liquidity Facility
• Commercial Paper Funding Facility
LO5
18-23
The Financial Crisis
• Money Market Investor Funding
•
•
LO5
Facility
Term Asset-Backed Securities Loan
Facility
Interest Payments on Reserves
18-24

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