Master of Business Administration

GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

Selecting Channel Approaches

The Fed’s primary influence on the economy in normal economic times is through its ability
to change the money supply (M1 and M2) and therefore affect interest rates. Most basically,
interest is the price paid for the use of money. It is also the price that borrowers need to pay
lenders for transferring purchasing power to the future.

To the extent they want to hold money as an asset, there is an asset demand for money.

The amount of money demanded as an asset therefore varies inversely with the rate of
interest (which is the opportunity cost of holding money as an asset).

The Equilibrium Interest Rate

Just as in a product market or a resource market, the intersection of demand and supply
determines the equilibrium price in the market for money.

Interest Rates and Bond Prices

Interest rates and bond prices are inversely related. When the interest rate increases, bond
prices fall; when the interest rate falls, bond prices rise.

The Consolidated Balance Sheet of the Federal Reserve Banks

The two main assets of the Federal Reserve Banks are securities and loans to commercial
banks. (Again, we will simplify by referring only to commercial banks, even though the analysis
also applies to thrifts—savings and loans, mutual savings banks, and credit unions.)

The Fed requires that the commercial banks hold reserves against their checkable deposits.

Tools of Monetary Policy

The Fed has four main tools of monetary control it can use to alter the reserves of
commercial banks:

• Open-market operations
• The reserve ratio
• The discount rate
• Interest on reserves

Open-Market Operations

The Fed’s open-market operations consist of bond market transactions in which the Fed
either buys or sells government bonds (U.S. securities) outright, or uses them as collateral
on loans of money.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

First, as with Federal Reserve purchases of securities directly from commercial banks, the
purchases of securities from the public increase the lending ability of the commercial banking
system.

In addition to bond purchases and sales, the Fed can also alter the supply of money through
collateralized loans known as repos and reverse repos.

The Reserve Ratio

The Fed also can manipulate the reserve ratio in order to influence the ability of commercial
banks to lend.

As a consequence, either banks lose excess reserves, diminishing their ability to create money
by lending, or they find their reserves deficient and are forced to contract checkable deposits
and therefore the money supply. In the example in Table 36.2, excess reserves are
transformed into required reserves, and the money-creating potential of our single bank is
reduced from $1,000 to zero (column 6). Moreover, the banking system’s money-creating
capacity declines from $5,000 to zero (column 7).

TABLE 36.2 The Effects of Changes in the Reserve Ratio on the Lending Ability of Commercial
Banks
(1) (2) (3) (4) (5) (6) (7)
Reserve Checkable Actual Required Excess Money- Money-
Ratio, % Deposits Reserves Reserves Reserves, Creating Creating
(3) – (4) Potential of Potential of
Single Bank, = Banking
(5) System
(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 −3,333

What if the Fed increases the reserve requirement to 30 percent? (See row 4.) The commercial
bank, to protect itself against the prospect of failing to meet this requirement, would be
forced to lower its checkable deposits and at the same time increase its reserves. To reduce
its checkable deposits, the bank could let outstanding loans mature and be repaid without
extending new credit. To increase reserves, the bank might sell some of its bonds, adding the
proceeds to its reserves.

Lowering the reserve ratio transforms required reserves into excess reserves and enhances
the ability of banks to create new money by lending.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

The Discount Rate

Just as commercial banks charge interest on the loans they make to their clients, so too
Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest
rate they charge is called the discount rate.

Interest on Reserves

The Fed’s newfound ability to pay interest on excess reserves provided the Fed with a fourth
policy tool by which itPage 727 can implement monetary policy and either increase or
decrease the amount of monetary stimulus in the economy.

All four of the Fed’s instruments of monetary control are useful in particular economic
circumstances, but open-market operations are clearly the most important of the four tools
over the course of the business cycle.

Targeting the Federal Funds Rate

The Federal Reserve focuses monetary policy on the federal funds rate, which is the short-
term interest rate that the Fed can most directly influence. Recall that the Federal Reserve
requires banks (and thrifts) to deposit in their regional Federal Reserve Bank a certain
percentage of their checkable deposits as reserves.

By contrast, banks with excess reserves could obtain a positive interest rate by making
overnight loans to banks that had reserve deficiencies. The transactions took place in the
federal funds market and an equilibrium interest rate—the federal funds rate—was
determined by the demand and supply for reserves.

The trading desk at the New York Fed would then undertake whatever open-market
operations were necessary to achieve and maintain the target rate.

This massive increase in excess reserves meant that there were hardly ever any instances
where a bank needed to borrow excess reserves overnight in the federal funds market. That
lack of demand coupled with the massive increase in the supply of excess reserves had two
significant effects:

• The federal funds rate (the equilibrium price of borrowing money in the federal funds
market) plunged to nearly zero due to high supply coupled with low demand.
• The number of bank-to-bank transactions in the federal funds market collapsed
because there were hardly any instances in which a bank found itself deficient in
reserves.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

Expansionary Monetary Policy

Suppose that the economy faces a recession and rising unemployment. How will the Fed
respond? It will initiate expansionary monetary policy (or "easy money policy") to increase the
supply of credit in the economy and, hopefully, aggregate demand and real output, too.

Given that situation, the Fed's approach to expansionary monetary policy involved lowering
the federal funds rate to boost borrowing and spending (and thereby increase aggregate
demand and expand real output).

The federal funds rate and the prime interest rate closely track one another, as is evident in
Figure 36.3.
FIGURE 36.3 The prime interest rate and the federal funds rate in the United States, 1998–2016. The
prime interest rate rises and falls with changes in the federal funds rate.

Source: Federal Reserve Statistical Release, Historical Data, H.15, www.federalreserve.gov.

To understand the second problem, suppose that interest rates were forced into negative
territory by the Fed. Many people would not want to leave their money in checking accounts
because doing so would mean that their balances would shrink over time (rather than grow
over time, as they do when interest rates are positive). Thus, any central bank that attempted
to impose negative nominal interest rates would see deposits withdrawn from banks. That
could be economically catastrophic because the withdrawals would imply that banks would
have less money to lend out to consumers and entrepreneurs.

Restrictive Monetary Policy after the Mortgage Debt Crisis

The Fed's normalization plan had two prongs. The first was to utilize the fact that starting in
2008 the Fed had begun paying interest on excess reserves (IOER) on any excess reserve
balances held by member banks. The IOER rate was set at 0.25 percent in 2008 and was
unchanged until the end of 2015, when it was raised to 0.50 percent.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

The Taylor Rule

The proper federal funds target rate (or target range) for a certain period is a matter of policy
discretion by the members of the FOMC. At each of their meetings, committee members
assess whether the current target for the federal funds rate remains appropriate for achieving
the twin goals of low inflation and full employment.

Monetary Policy, Real GDP, and the Price Level

Market for Money

The equilibrium interest rate is the rate at which the amount of money demanded and the
amount supplied are equal.

Investment

These 10, 8, and 6 percent real interest rates are carried rightward to the investment demand
curve in Figure 36.4b. This curve shows the inverse relationship between the interest rate—
the cost of borrowing to invest—and the amount of investment spending.
FIGURE 36.4 Monetary policy and equilibrium GDP. An expansionary monetary policy that shifts the
money supply curve rightward from Sm1 to Sm2 in (a) lowers the interest rate from 10 to 8 percent in (b).
As a result, investment spending increases from $15 billion to $20 billion, shifting the aggregate demand
curve rightward from AD1 to AD2 in (c) so that real output rises from the recessionary level of $880
billion to the full employment level Qf = $900 billion along the horizontal dashed line. In (d), the
economy at point a has an inflationary output gap of $10 billion because it is producing at $910 billion,
$10 billion above potential output. A restrictive monetary policy that shifts the money supply curve
leftward from Sm3 = $175 billion to just $162.5 billion in (a) will increase the interest rate from 6 percent
to 7 percent. Investment spending thus falls by $2.5 billion from $25 billion to $22.5 billion in (b). This
initial decline is multiplied by 4 by the multiplier process so that the aggregate demand curve shifts
leftward in (d) by $10 billion from AD3 to AD4, moving the economy along the horizontal dashed line to
equilibrium b. This returns the economy to full employment output and eliminates the inflationary
output gap.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

Equilibrium GDP

That is, investment spending is one of the determinants of aggregate demand.

This $20 billion of investment spending joins with consumption spending, net exports, and
government spending to yield aggregate demand curve AD2 in Figure 36.4c.

Effects of an Expansionary Monetary Policy

Recall that the inflationary ratchet effect discussed in Chapter 32 describes the fact that real-
world price levels tend to be downwardly inflexible. Thus, with our economy starting from the
initial equilibrium where AD2 intersects AS, the price level will be downwardly inflexible at P2
so that aggregate supply will be horizontal to the left of Qf. This means that if aggregate
demand decreases, the economy’s equilibrium will move leftward along the dashed horizontal
line shown in Figure 36.4c.

This results in a real output of $880 billion, $20 billion less than the economy’s full-
employment output level of $900 billion. The economy will be experiencing recession, a
negative GDP gap, and substantial unemployment. The Fed therefore should institute an
expansionary monetary policy.

To increase the money supply, the Fed will take some combination of the following actions:
(1) buy or initiate repos of government securities from banks and the public in the open
market, (2) lower the legal reserve ratio, (3) lower the discount rate, and (4) reduce the
interest rate that it pays on reserves. The intended outcome will be an increase in excess
reserves in the commercial banking system and a decline in the federal funds rate. Because
excess reserves are the basis on which commercial banks and thrifts can earn profit by lending
and thus creating checkable-deposit money, the nation’s money supply will rise. An increase
in the money supply will lower the interest rate, increasing investment, aggregate demand,
and equilibrium GDP.

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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

TABLE 36.3 Monetary Policies for Recession and Inflation

(1) (2)
Expansionary Restrictive
Monetary Policy Monetary Policy
Problem: unemployment Problem: inflation
and recession
↓ ↓
Federal Reserve buys bonds, lowers reserve Federal Reserve sells bonds, increases
ratio, lowers the discount rate, reduces the reserve ratio, raises the discount rate,
interest rate on excess reserves, or initiates, increases the interest rate on excess
repos reserves, or initiates, reverse repos
↓ ↓
Excess reserves increase Excess reserves decrease
↓ ↓
Federal funds rate falls Federal funds rate rises
↓ ↓
Money supply rises Money supply falls
↓ ↓
Interest rate falls Interest rate rises
↓ ↓
Investment spending increases Investment spending decreases
↓ ↓
Aggregate demand increases Aggregate demand decreases
↓ ↓
Real GDP rises Inflation declines

Effects of a Restrictive Monetary Policy

To see how restrictive monetary policy works, first consider a situation in which the economy
moves from a full-employment equilibrium to operating at more than full employment so that
inflation is a problem and restrictive monetary policy would be appropriate. Assume that the
economy begins at the full-employment equilibrium where AD2 and AS intersect. At this
equilibrium, Qf = $900 billion and the price level is P2.

Next, assume that the money supply expands from $150 billion to $175 billion (Sm3) in Figure
36.4a. This results in an interest rate of 6 percent, investment spending of $25 billion rather
than $20 billion, and aggregate demand AD3. As the AD curve shifts to the right from AD2 to
AD3 in Figure 36.4d, the economy will move along the upsloping AS curve until it comes to an
equilibrium at point a, where AD3 intersects AS. At the new equilibrium, the price level has
risen to P3 and the equilibrium level of real GDP has risen to $910 billion, indicating an
inflationary GDP gap of $10 billion (= $910 billion − $900 billion). Aggregate demand AD3 is
excessive relative to the economy’s full-employment level of real output Qf = $900 billion. To
rein in spending, the Fed will institute a restrictive monetary policy.

The Federal Reserve Board will direct Federal Reserve Banks to undertake some combination
of the following actions: (1) sell or initiate reverse repos of government securities to banks
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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

and the public in the open market, (2) increase the legal reserve ratio, (3) increase the discount
rate, and (4) increase the interest rate that it pays on reserves. So they will need to reduce
their checkable deposits by refraining from issuing new loans as old loans are paid back. The
higher interest rate will discourage investment, lowering aggregate demand and restraining
demand-pull inflation.

Monetary Policy: Evaluation and Issues

Monetary policy has become the dominant component of U.S. national stabilization policy. It
has two key advantages over fiscal policy:

• Speed and flexibility.

• Isolation from political pressure.

In contrast, the Fed can buy or sell securities from day to day and thus affect the money supply
and interest rates almost immediately.

Moreover, monetary policy is a subtler and more politically neutral measure than fiscal policy.

Recent U.S. Monetary Policy

The mortgage default crisis (discussed in Chapter 34) began during the late summer of 2007
and posed a grave threat to the financial system and the economy. In response, the Fed took
several actions. In August it lowered the discount rate by half a percentage point. Then,
between September 2007 and April 2008, it lowered the target for the federal funds rate from
5.25 percent to 2 percent. And as discussed in Chapter 34, the Fed also took a series of
extraordinary actions to prevent the failure of key financial firms.

The Fed's solution was quantitative easing, or QE. Under QE, the Fed bought bonds solely with
the intention of increasing the quantity of reserves in the banking system.

Problems and Complications

Recall that fiscal policy is hindered by three delays, or lags—a recognition lag, an
administrative lag, and an operational lag.

Economists say that monetary policy may suffer from cyclical asymmetry.

The Fed can create excess reserves, but it cannot guarantee that the banks will actually make
additional loans and thus promote spending.

The “BIG” Picture

Study this diagram and you will see that the levels of output, employment, income, and prices
all result from the interaction of aggregate supply and aggregate demand. The items shown
in red relate to public policy.
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 Master of Business Administration
GSFM7223 Economics for Managers

Excerpts of Reading Assignment

LESSON 7, Chapter 36: Interest Rates and Monetary Policy

FIGURE 36.5 The AD-AS theory of the price level, real output, and stabilization policy. This figure
integrates the various components of macroeconomic theory and stabilization policy. Determinants
that either constitute public policy or are strongly influenced by public policy are shown in red.

End of Chapter excerpts. For wider reading coverage, please refer to the eBook provided in this course.

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