Chapter Five

Banking, Interest
Rates and
Monetary policy
 The Secret Life of Interest Rates

• The most important thing that interest rates

do is to act as signals for the market.
• Signal to save or borrow and spend.
• ir also serve to ration the available supply of
money to those who are willing and able to
use it most efficiently in the long run.
• Act as an automatic stabilizer to inflation.
 Rationale
• Much of the internal doings of the U.S. (and
World) economy have to do with monetary and
fiscal policy decisions which affect interest rates.
• Any understanding of Economics is incomplete
without knowledge of how interest rates affect and
are affected by every other component of the
economy.
• Savings and Investment in Capital are where the
individual interfaces with these policies.
• Most individuals understand interest rates
imperfectly if at all.
 Key Topics Regarding ir

• Identify models that should be used to

demonstrate economic theories and discuss
when to use which model.
• Identify important concepts and how to apply
them.
• Discuss ir using appropriate vocabulary
balancing jargon with concrete explanations
in plain English.
 Key Concepts
• What are Interest Rates?
• Real vs. Nominal
• Money Supply and the Federal Reserve
• Money Demand
• Loanable Funds Market
• Fiscal policy and its impact on interest rates
• Crowding-Out Effect
• Bond Market
• Foreign Capital Injections and Leakages
 The Relation Between Capital Investment
and Interest Rates
• Interest Rates DETERMINE the quantity of
Capital Investment and Savings in the Economy.
• Interest is the Opportunity Cost or “Price” paid for
the use of money
• Borrowers pay lenders for money to be used now,
and repay later with interest
• Savers earn interest because they are letting a
lender use their money now
• Lenders are financial intermediaries.
• Interest rate is stated as a percentage
 Real ir vs. Nominal ir
• Appropriate abbreviations for Interest rate
include “ir”, “i”, and “r” (always lower-
case)
• Nominal: loosely means “in name only”
• Nominal ir discussed in terms of current
price level
• Real: loosely means “adjusted for inflation”
• Real ir discussed in terms of actual
purchasing power.
 How Nominal and Real Relate
• (Calculate) Nominal ir
– Inflation Rate
= Real ir
• If Nominal ir goes up, Real ir doesn’t
necessarily increase.
• If Real ir goes up, Nominal ir will follow.
 Graphic Models for ir
• Interest rates play a role in various graphic
models, the key is to figure out if they are
nominal or real ir.
• The Money Market Model is used to discuss
the supply of money as defined by the FED.
(nominal ir)
• The Loanable Funds Market is used to
reflect the saving and borrowing habits of the
private sector. (real ir)
 Money Market Model
• Used to target the Money Market Model

Fed Funds Rate

through monetary Nominal
ir
MS MS1

policy. ir
• Nominal ir ir1
• Should be used in
conjunction with MD

AD/AS and QM QM1

Quantity of Money
Investment Demand
models (Next Slide)
 Money Market Linked to Demand for
Capital Investment
Expansionary Policy Investment Demand
Nominal MS MS1 Nominal
ir
ir

ir

ir1

MD I

QM QM1 I I1
Quantity of Money Quantity of Capital Investment
 Investment Linked to AD/AS

Investment in Capital
Expansionary Policy
Price
Nom level SRAS
-inal
ir
PL1
ir PL

ir1 AD1
(C+I1+G)

I
AD (C+I+G)

0 I I1 Y Y1
Quantity of Capital Investment Real Gross Domestic Product
 Loanable Funds Market
• The Demand Curve for LF
represents private demand
for Loanable Funds.
• The Supply Curve for LF Real
Loanable Funds Market
represents private savings. ir SLF
• LF model represents the
real ir. (abbrev. “r”)
• Supply of LF (savings) sets r
the Prime Lending Rate.
• Government borrowing to
cover deficit spending will
move DLF to the right. DLF

• Changes in the savings QLF

habits of the private sector Quantity of Loanable Funds
shift SLF
Loanable Funds Theory of Interest
• The supply of loanable funds comes from
savers who deposit money in banks.
• Supply is positively-sloped because
people need an incentive to delay current
spending.
• Demand is negatively-sloped since higher
ir discourage borrowing and spending.
• Government borrows money from this
market when taxes don’t cover the bills.
 Control of Interest Rates
• The majority of influence on interest rates
comes from the private sector.
• Rates react to changes in the individual desire
of private citizens to consume or invest in
capital. (or to save…)
• Investment spending and the interest
sensitive components of consumption
spending are inversely related to interest
rates.
• The desire to save is positively related to ir.
 Definitions of Money
• The Money Supply is broken down into
three categories:
M1: Cash, Currency, Checkable
Deposits, NOW accounts, etc…
M2: Savings (under $100,000), Short
time deposits, CD’s, MMF’s, etc…
M3: Deposits in excess of $100,000
and other long time deposits
 The Demand for Money

• This is a uniquely Macroeconomic concept

• At any given time, there is a finite quantity

of money in circulation (M2 is Inelastic).

• The transaction demand (M1) depends on

GDP because incomes = expenditures.
 Fiscal Policy
• Most expansionary government spending
programs are financed through borrowing.
• Budget deficits will increase the demand for
loanable funds and cause real ir to rise
• Contractionary fiscal policy will cause budget
surplus
• Budget surplus will reduce the demand for
money and reduce interest rates
 Deficit Spending
• Government demands loanable funds to
pay for deficit fiscal spending
• By increasing the D for LF, the real ir
increases. Loanable Funds Mkt.
Real
ir

Qty. of Loanable Funds

 Crowding Out
• The increased real ir caused by deficit
fiscal spending causes a decrease in private
Investment spending and the interest-
sensitive component of Consumption
spending.
• This lost investment and consumption is
said to have been crowded out.
• Crowding out is an effect, never a cause.
 Crowding Out and AD/AS
Deficit Fiscal Policy
Real ir SLF (Private Savings) Price
Level
AD shifts to AD1 when G increases
Then shifts back to AD2 as I falls due to
the increase in interest rates.
SRAS

r1 Pl1
Pl2
r
PL AD1
(C+I+G1)

DLF1 (Private
+
Government) AD2
(C+(I-I1)+G1)
DLF
(Private
Demand)
AD
(C+I+G)
QLF QLF1 Y Y2 Y1
Quantity of Loanable Funds Real Gross Domestic Product
 Barro-Ricardo Effect
• The Barro-Ricardo Effect is feedback caused by a
Crowding Out effect.
• Higher interest rates associated with Crowding
Out cause individuals to save more of their
incomes.
• The rise in savings increases the supply of
loanable funds, thereby reducing the real interest
rate.
• The B-R effect has a smaller impact and usually
doesn’t fully negate a crowding out effect.
 Monetary Policy
• Money is Neutral: any changes of the
money supply can stabilize the economy.
• Any attempt to grow the economy will result
in inflation.
• At any moment, the money supply is fixed
• The supply of money is controlled by the
Federal Reserve (the FED), using three main
techniques.
• Discount Rate, Fed Funds Rate, & Required
Reserve Ratio.
 Expansionary and Contractionary
Policy
• Expansionary Policies are used to increase
the money supply (ex. Decrease RRR,
Discount or Fed Funds Rate)
• Contractionary Policies are used to reduce
the money supply (ex. Raise RRR, Discount
or Fed Funds Rate)
• Interest rates increase and decrease in an
inverse relationship with changes in the
money supply.
 The Discount Rate

• This is the interest rate that banks pay to

borrow emergency cash from the FED
• Also known as the “Overnight” rate.
• Short term loans cover checkable deposits
held by the banks and the FED.
• These are determined at the district level but
are adjusted with input from D.C.
• The FED is the lender of last resort.
 Required Reserves Ratio
• Banks are required to retain some of their
deposits on hand in the form of vault cash or
on deposit at a federal reserve bank.
• The quantity of reserve is determined as a
percentage of checkable deposits.
• That percentage is called the RRR or
Required Reserve Ratio.
• 1/RRR = Simple Deposit Expansion
Multiplier
• The multiplier determines the total growth of
the money supply from checkable deposits.
 Fed Funds Rate
• AKA the “Immediate rate”, it is the ir that
banks charge each other to borrow money
• The supply of money relative to the demand
for it determines the ir.
• The FFR is not set at a particular %, but is
“targeted” by changing the money supply
through the purchase or sale of bonds on the
open market.
• Buying bonds from the public pumps money
into the economy, selling bonds takes money
out of the system.
 The Bond Market
• Bonds are loans made to the government by
individuals and institutions with a
guaranteed rate of return and a clearly
defined time limit.
• Bond Prices and ir are inversely related
• Governments (state, federal, and local) use
the sale of bonds to pay for deficit spending.
• The FED buys and sells bonds to stabilize
the economy after deficit spending.
• Bond rates send signals to both domestic and
international buyers.
 Net Foreign Investment (Reading
assignment)

• Define and discuss in detail

– Capital Inflow and
– Capital Outflow.