Monetary Policy
Lesson 23

How are Interest Rates Determined?

1. Interest rate -

• Borrowers - interest rate is a cost to borrow money
  • Consumers borrow money to buy houses, cars, appliances, etc.
  • Businesses borrow money to buy machines, equipment, and structures
  • Government borrows money when it has budget deficits
    • Government spending > taxes
• Savers - interest rate is a benefit to savers

2. Interest rate differs

• Maturity - when borrower makes last payment
• Number of payments
• Risk
• However, interest rates tend to move together

Example 1: A saver deposits $1,000 into a savings account that earns 15% (Annual Percentage Rate (APR). At the end of the year:

• Has $1,000 from the starting balance
• Earns $150 (=$1,000 X 0.15) in interest
• Ending balance is $1,150

Example 2: A company borrows $10,000 from a bank and agrees to pay the loan back plus $1,000 for interest.

• The business pays 10% interest (=$1,000 / $10,000)

Example 3: A Treasury bill has a face value, but does not have a stated interest rate on it.

• When the T-bill matures, the investor gets the face value.
• An investor pays $9,000 for a $10,000 T-bill.
  • Investor earns $1,000 interest, or 10%
  • The market price of the bond is $9,000
• If the investor pays $9,500 for the T-bill, he earns $500 in interest or 5%.

As market interest rates increase, market prices for bonds decrease, and vice versa.

3. Demand for money

• Transaction demand - people need money to make transactions
  • Purchase groceries
  • Pay rent
  • Pay credit cards
• Precautionary demand - deal with uncertainty
  • Medical emergency
  • Bail out a relative from jail, etc.
• Store value - retain future purchasing value

4. Demand for money

1. Demand for money is proportional to nominal GDP
   • A larger economy requires more money
2. Interest rate is an opportunity costs
   • If people hold more money, they give up earning interest from a bank
   • At higher interest rates, people hold less money
   • Example
     • If savings rate is 1%, many people would not be concerned about earning interest
     • If savings rate is 15%, more people would deposit money into banks to earn interest.
3. Technology - changes in technology affect people's demand for money
   • Widespread use of credit cards and debit cards reduced people's demand for money

Relationship is shown below

• Real rate of interest is r
• Quantity of money, M

5. Central bank supplies money (S)

• Can make decisions independent of interest rate
• Shown below

6. Equilibrium real interest rate is intersection of supply and demand

The Fed's Balance Sheet

Federal Reserve has a balance sheet; the list is not comprehensive; refer to my course, Money & Banking, for a more extensive analysis

1. The Fed’s Assets:

1. Securities
   • U.S. government securities, like Treasury bills, Treasury notes, and Treasury bonds
2. Discount Loans - the Fed loans funds to banks, helping the bank overcome short-term financial problems.
   • The Fed controls the interest rate on these loans
   • The interest rate is called the discount rate.

2. The Fed’s Liabilities and Capital Accounts:

1. Currency Outstanding:
   • Federal Reserve Notes - currency issued by the Fed, i.e. U.S. money.
2. Deposits by Depository Institutions
   • Banks must hold required reserves in the form of vault cash and/or deposits at the Fed.
   • These deposits are assets to the depository institutions, but liabilities to the Fed.
3. U.S. Treasury Deposits - checking account for U.S. government
   • The U.S. Treasury receives tax payments, collects fees,and sells U.S. government securities

Fed's Tools for Monetary Policy

1. Expansionary monetary policy

• Federal Reserve increases the money supply
  • Bank reserves increase
  • Interest rates decrease (in short run)
    • Federal Funds rate is impacted first
  • Bond market prices increase
• Below is market for money

• Expansionary monetary policy
  • An economy can grow faster
    • A lower real interest rate causes businesses to invest more, having a multiplier effect on economy
    • Causes U.S. dollar to depreciate, which boosts the export sector
    • Lower interest rates increase stock and bond prices, creating a wealth effect.
  • A larger money supply shifts the Aggregate Demand to the right
  • Society may have demand pulled inflation
  • Example - extremely low interest rates between 2000 and 2007 caused a real estate boom
    • U.S. economy was growing from the massive investment in houses
    • Property values were quickly climbing
    • Housing bubble "popped" in 2007, and property values are quickly falling.
    • Many people used Adjustable-Rate Mortgages
      • Mortgage interest rate changes with market interest rates.

2. Contractionary (Restrictive) monetary policy

• Federal Reserve decreases the money supply
  • Bank reserves decrease
  • Interest rates increase (in short run)
    • Federal Funds rates increases
    • A real higher interest rate causes businesses to invest less
    • A lower investment causes economy to grow slower.
  • Bond market prices decrease
• Below is market for money

• Contractionary monetary policy
  • Slows the economy and to help lower inflation
    • Price level may not fall, because prices tend to be inflexible downward
  • A smaller money supply shifts the Aggregate Demand to the left

3. Federal Reserve Tools

(i) Open Market Operations

• Fed's most important tool
• Very flexible
  • If Fed bought too many U.S. securities, it can turn around and sell them.
• If Fed purchases U.S. government securities, bank reserves increase
  • Expansionary monetary policy
• If Fed sells U.S. government securities, bank reserves decrease.
  • Contractionary monetary policy
• Fed could buy any type of assets, but usually focuses on U.S. government securities
  • Fed buys U.S. securities from the private market
  • The Fed is independent of the U.S. Treasury
  • Buying directly from the U.S. Treasury could jeopardize the Fed's independence.
• Example 1: Federal Reserve buys $50,000 in U.S. Treasury securities from U.S. bank, the T-accounts are below:
  • Bank reserves are a liability to the Fed
  • Money supply increases and interest rates decrease

U.S. Bank

Federal Reserve

• Example 2: Federal Reserve sells a ;$20,000 U.S. Treasury securities to U.S. bank, the T-accounts are below:
  • Money supply decreases and interest rates increase

U.S. Bank

Federal Reserve

(ii) Discount Rate

• The Fed can grant loans to financial institutions
• The Fed sets the interest rate on the loan called the discount rate
  • A bank may have to put up collateral for the Fed loan.
• If the Fed increases the discount rate, banks borrow less.
  • Contractionary monetary policy
• If the Fed decreases the discount rate, banks borrow more.
  • Expansionary monetary policy
• Benefits
  • The Fed is the “Lender of the last resort.”
  • If a bank has trouble with liquidity or needs reserves, the Fed is the last place to go.
  • The Fed extended credit to financial institutions during the stock market crash in 1987, preventing a recession.
• Problems
  • A bank may try to profit from a Fed loan. A bank may borrow from the Fed at a low interest rate and grant loans for higher interest rates.
  • Borrowing from the Fed is a privilege and not a right!
  • European central banks charge a higher interest rate than the market rate, penalizing banks from borrowing from the central bank.
  • Not a good tool for monetary policy.
    • If Fed needs to increase money supply, it cannot force banks to take loans.
• Example 3: Federal Reserve grants a $100,000 loan to U.S. Bank. The transaction is shown below:
  • Money supply increases and interest rates decrease

U.S. Bank

Federal Reserve

(iii) Reserve Requirements - the ratio of reserves to deposits that banks must hold to satisfy depositors’ withdrawals.

• Not a good tool for monetary policy
  • Small changes in the reserve requirements have a significant and disruptive impact on the banking system
    • i.e. the money multiplier
  • The Fed rarely changes the reserve
• If the Fed raises the reserve requirements, banks have to hold more reserves.
  • Contractionary monetary policy
• If the Fed lowers reserve requirement, banks have excess reserves and can grant more loans.
  • Expansionary monetary policy

Monetary Policy

1. Monetary policy - more flexible and faster than fiscal policy

• Congress can take a long time before implementing a policy.
• Federal Reserve Board for Fed meet regularly and can come up with decisions quickly.

2. Monetary policy suffers from the same lags as fiscal policy

1. Recognition (or information) lag - takes time to collect data
   • Recession - two consecutive quarters of negative growth for real GDP
   • If government takes 3 months to collect data, then economy could already be in a recession
2. Administrative lag - government requires time to make a decision
   • The Fed can make decisions much quicker than Congress and the President
3. Impact lag - takes time for the monetary policy to impact the economy
   • Could be a from a six to twelve month delay for fiscal policy to impact economy

3. Monetary policy can become ineffective

• During 1990s, Japan went into a recession for a decade
  • Business and consumers were so pessimistic, when the Japanese central bank lowered the interest rate, it had no impact on the economy.
• Cyclical asymmetry - the belief the restrictive monetary policy is effective while expansionary monetary is not so effective
  • Low interest rates many not change behavior, but high interest rates do.

4. Central banks choose certain variables and use monetary policy to achieve targets for those variables.

• Taylor Rule - Taylor developed rules for the Federal Reserve that stabilized the Federal Funds rate.
• Inflation Target - central banks maintain a low inflation rate
  • Countries
    • Canada
    • New Zealand
    • Sweden
    • United Kingdom

Countries that have central banks independent from government have low inflation rates.

Terminology