Interest Rates and Monetary Policy

Read this introduction to Assignment 16. Then, read Chapter 16, “Interest Rates and Monetary Policy,” on pages 307–331 in your textbook Macroeconomics.

Interest Rates This chapter explains how the Federal Reserve affects out- put, employment, and the price level of the economy. The Fed’s Board of Governors formulates policy, and 12 Federal Reserve Banks implement policy. The fundamental objective of monetary policy is to aid the economy in achieving full- employment output with stable prices. To do this, the Fed changes the nation’s money supply by manipulating the size of excess reserves held by banks.

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Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s Board of Governors is some- times called the “second most powerful person in the United States” (after the President).

The work of the Fed focuses on the interest rate, and on the supply and demand in the market for money. The total demand for money is made up of a transaction demand and an asset demand. Transaction demand is money kept for purchases, and will vary directly with GDP. Asset demand is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that’s the price of holding idle money. The total demand will equal the quanti- ties of money demanded for assets plus that for transactions.

The money market combines the demand for money and the supply of money. If the quantity demanded exceeds the quantity supplied, people will sell assets like bonds to get money. This causes the bond supply to rise, bond prices to fall, and a higher market rate of interest. In contrast, if the quantity supplied exceeds the quantity demanded, people will reduce their money holdings by buying other assets like bonds. Bond prices will rise, and lower market rates of interest will result.



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The Consolidated Balance Sheet of the Federal Reserve Banks The assets column on the Fed’s balance sheet contains the following two major items:

1. Securities, which are federal government bonds that are purchased by Fed

2. Loans to commercial banks

The liability side of the balance sheet contains the following three major items:

1. Reserves of banks held as deposits at Federal Reserve Banks

2. U.S. Treasury deposits of tax receipts and borrowed funds

3. Federal Reserve Notes outstanding (our paper currency)

“Tools” of Monetary Policy As we examine the Federal Reserve Banks’ consolidated bal- ance sheet, we can consider how the Fed can influence the money-creating abilities of the commercial banking system. The Fed has the following four tools of monetary control:

1. Open-market operations, which refers to the Fed’s buying and selling of government bonds

2. The reserve ratio, which is the fraction of reserves required relative to their customer deposits

3. The discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed

4. The term auction facility, which was introduced in December 2007 in response to the mortgage debt crisis. Under the term auction facility, the Fed holds two auctions each month, and banks bid for the right to borrow reserves for 28 days.



Lesson 4 79

Targeting the Federal Funds Rate The Federal Reserve focuses monetary policy on the interest rate that it can best control: the federal funds rate, which is the interest rate that banks charge each other for overnight loans. Banks lend to each other from their excess reserves, but because the Fed is the only supplier of federal funds (the currency used as reserves), it can set the federal funds rate and then use open-market operations to make sure that rate is achieved. The Fed will increase the availability of reserves if it wants the federal funds rate to fall (or keep it from rising). Reserves will be withdrawn if the Fed wants to raise the federal funds rate (or keep it from falling).

The Fed may use an expansionary monetary policy if the economy is experiencing a recession and rising rates of unemployment. The Fed will initially announce a lower target for the federal funds rate, then use open-market operations to buy bonds from banks and the public. The Fed may also lower the reserve ratio or the discount rate. Increasing reserves will generate two results:

1. The supply of federal funds will increase, lowering the federal funds rate

2. Through the money multiplier process, a greater expan- sion of the money supply will occur

Expansionary monetary policy will put downward pressure on interest rates, including the prime interest rate, which is the benchmark interest rate used by banks to set many other interest rates.

Restrictive monetary policy is used to combat rising inflation. The initial step is for the Fed to announce a higher target for the federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve ratio and/or discount rate is also an option. The reduced supply of federal funds will raise the federal funds rate to the new target. Restrictive monetary policy results in higher interest rates, including the prime rate.



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Monetary Policy: Evaluation and Issues The major strengths of monetary policy are its speed and flexibility, and its isolation from political pressures. The Federal Reserve has been successful many times since the 1990s in countering recession by lowering the interest rate, and in controlling inflation by raising the interest rate.

However, monetary policy does have problems and compli- cations. Recognition and operational lags impair the Fed’s ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Although policy changes can be implemented rapidly, there’s a lag of at least three to six months before the changes will have their full impact.

Cyclical asymmetry may exist. A restrictive monetary policy may work effectively to brake inflation, but an expansionary monetary policy isn’t always as effective in stimulating the economy out of recession.

After you’ve carefully read the assigned pages in your text- book and before moving on to the next assignment, complete Self-Check 16, as well as the chapter’s online quiz at Compare your answers for the self-check with those at the end of this study guide.

Self-Check 16 Indicate whether each of the following statements is True or False.

______ 1. The Fed decreases interest rates by selling government securities.

______ 2. The federal funds rate and the prime interest rate typically change in opposite


______ 3. In the last half of the 1990s, monetary policy was highly ineffective in Japan,

but highly effective in the United States.




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Self-Check 16 ______ 4. An expansionary monetary policy is one that reduces the supply of money.

______ 5. The term auction facility is the most frequently used monetary policy tool.

______ 6. According to the Taylor rule, if real GDP falls by 1 percent below potential GDP,

the Fed should lower the federal funds rate by one-half a percentage point.

______ 7. When the Fed auctions reserves through the term auction facility, the interest

rate is set by the rate offered by the highest bidder.

______ 8. Bond prices and interest rates are directly or positively related.

______ 9. The higher the interest rate, the larger the amount of money that will be demanded

for transaction purposes.

______ 10. Changes in the interest rate are more likely to affect consumer spending than

investment spending.

______ 11. A change in the reserve ratio will have no effect on the amount of the banking

system’s excess reserves.

______ 12. The asset demand for money varies inversely with the nominal GDP.

Check your answers with those on page 125.



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