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Chapter 16 – Interest Rates and Monetary Policy

CHAPTER SIXTEEN

INTEREST RATES AND MONETARY POLICY

CHAPTER OVERVIEW

The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around

seven major topics: (1) interest rate determination; (2) the balance sheet of the Federal Reserve Banks;

(3) the tools of monetary policy; (4) Federal Reserve targeting of the Federal funds rate; (5) the

cause-effect chain of monetary policy; (6) an evaluation of the advantages and disadvantages of

monetary policy; and (7) a brief, but important, synopsis of mainstream theory and policies. The purpose

of the concluding sections is to summarize all the macro theory developed so far and fit the pieces

together as an integrated whole for students.

WHAT’S NEW

There is a new Last Word on the worries and unintended consequences of QE, ZIRP, and Operation Twist.

The Last Word in the 19e has been converted to a Key Graph (Key Graph 16.6).

The section on the Term Auction Facility has been removed due to the Fed choosing to retire that facility

in 2011. In place of that section is a discussion about the Fed’s new policy to pay interest on reserves

deposited at the Fed.

There is also a new section on the Fed’s monetary policy initiatives after the great recession; including

QE, Forward Guidance, and Operation Twist.

There is a new learning objective and two new Quick Reviews for this chapter.

All relevant data and tables have been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Identify the goals of monetary policy.

2. Identify two types of demand for money and the main determinant of each.

3. Describe the relationship between GDP and the interest rate and each type of money demand.

4. Explain what is meant by equilibrium in the money market and the equilibrium rate of interest.

5. Explain the relationship between bond prices and the money market

6. List the principal assets and liabilities of the Federal Reserve Banks.

7. Explain how each of the four tools of monetary policy may be used by the Fed to expand and to

contract the money supply.

8. Explain the relative importance of the monetary policy tools.

9. Describe how the Fed targets the Federal funds rate as part of its monetary policy actions.

10. Describe expansionary and restrictive monetary policies, and explain why and how they are used.

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11. Explain the Taylor rule and describe how it relates to current Fed policy.

12. Explain the cause-effect chain between monetary policy and changes in equilibrium GDP.

13. Demonstrate graphically the money market and how a change in the money supply will affect the

interest rate.

14. Show the effects of interest rate changes on investment spending.

15. Describe the impact of changes in investment on aggregate demand and equilibrium GDP.

16. Contrast the effects of an expansionary monetary policy with the effects of a restrictive monetary

policy.

17. List two strengths and three shortcomings of monetary policy.

18. Summarize the connections between AD-AS, the price level, real output, and stabilization (fiscal

and monetary) policy.

19. Define and identify terms and concepts at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS

1. The Federal Reserve Banks have numerous educational publications and videos available for

classroom distribution or use. Ask your district Fed for a catalog of materials available or look for

educational resources at the Federal Reserve websites. Most of the high school level materials are

suitable for adults as well.

2. Plan a visual demonstration of open-market operations. The creation of new reserves in the

banking system seems like a magician’s trick to most students and the further expansion of the

money supply through bank loans, just more smoke and mirrors. This is a good opportunity to get

students involved through role-playing. Assign individual students or small groups parts in the

process: the Fed, commercial banks, bank customers. Walk through several transactions to show

how purchases by the Fed monetize U.S. Government securities, putting dollars in the hands of

bank customers. When the Fed sells U.S. Government securities, the money supply declines as

buyers pay for the bonds.

3. The discussion of the Federal Reserve Bank’s consolidated balance sheet demonstrates the changes

that take place on the Fed’s balance sheet and the commercial bank’s balance sheets as open-market

operations are carried out. Note the focus on open-market operations.

STUDENT STUMBLING BLOCKS

1. Open-market operations are puzzling to students who may not be familiar with bonds in the first

place. Begin by a brief review of the federal government’s debt, which will inform them that there

is trillions of dollars’ worth of government bonds in existence. The latest Federal Reserve Bulletin

will have a table giving the amount of this debt currently held by the Fed. In other words, the Fed

has significant power to affect the money supply by buying or selling these securities. Also remind

students that the Fed deals only in federal government bonds, not corporate stock or bonds.

2. One memory tip suggested by a teacher is to tell students that when the Fed “sells” securities that

“soaks” up money, i.e., the money supply decreases. The link between “sell” and “soak” should be

an easy one for students to remember. Likewise, the Fed’s “purchase” can be associated with

“pump or push.”

3. If you want students to understand why interest rates on bonds vary as described in Money Market

section, you must explain carefully. If bond price — rate relationship is not important for you,

focus only on money — rate relationships.

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LECTURE NOTES

I. Introduction to Monetary Policy

A. Learning objectives – After reading this chapter, students should be able to:

1. Discuss how the equilibrium interest rate is determined in the market for money.

2. Describe the balance sheet of the Federal Reserve and the meaning of its major items.

3. List and explain the goals and tools of monetary policy.

4. Describe the Federal funds rate and how the Fed directly influences it.

5. Identify the mechanisms by which monetary policy affects GDP and the price level.

6. Explain the effectiveness of monetary policy and its shortcomings.

B. Reemphasize Chapter 14’s points: The Fed’s Board of Governors formulates policy, and

twelve Federal Reserve Banks implement policy.

C. The fundamental objective of monetary policy is to aid the economy in achieving

full-employment output with stable prices.

1. To do this, the Fed changes the nation’s money supply.

2. To change money supply, the Fed manipulates size of excess reserves held by banks.

D. Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s

Board of Governors, Ben Bernanke currently, is sometimes called the second most powerful

person in the U.S.

II. The Demand for Money: Two Components

A. Transactions demand, Dt, is money kept for purchases and will vary directly with GDP (Key

Graph 16.1a).

B. Asset demand, Da, is money kept as a store of value for later use. Asset demand varies

inversely with the interest rate, since that is the price of holding idle money (Key Graph

16.1b).

C. Total demand will equal quantities of money demanded for assets plus that for transactions

(Key Graph 16.1c).

III. The Equilibrium Interest Rate and Bond Prices

A. Key Graph 16.1c illustrates the money market. It combines demand with supply of money.

B. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get

money. This causes bond supply to rise, bond prices to fall, and a higher market rate of

interest.

C. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by

buying other assets like bonds. Bond prices rise, and lower market rates of interest result (see

example in text).

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IV. Consolidated Balance Sheet of the Federal Reserve Banks

A. The assets column on the Fed’s balance sheet contains two major items.

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

2. Loans to commercial banks (Note: again commercial banks term is used even though the

chapter analysis also applies to other thrift institutions.)

B. The liability side of the balance sheet contains 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, and

3. Federal Reserve Notes outstanding, our paper currency.

V. Tools of Monetary Policy

A. Open-market operations refer to the Fed’s buying and selling of government bonds.

1. Buying securities will increase bank reserves and the money supply (see Figure 16.2)

a. If the Fed buys directly from banks, then bank reserves go up by the value of the

securities sold to the Fed. See impact on balance sheets using text example.

b. If the Fed buys from the general public, people receive checks from the Fed and then

deposit the checks at their bank. Bank customer deposits rise and therefore bank

reserves rise by the same amount. Follow text example to see the impact.

i. Banks’ lending ability rises with new excess reserves.

ii. Money supply rises directly with increased deposits by the public.

c. When Fed buys bonds from bankers, reserves rise and excess reserves rise by same

amount since no checkable deposit was created.

d. When Fed buys from public, some of the new reserves are required reserves for the

new checkable deposits.

e. Conclusion: When the Fed buys securities, bank reserves will increase and the

money supply potentially can rise by a multiple of these reserves.

f. Note: When the Fed sells securities, points a-e above will be reversed. Bank

reserves will go down, and eventually the money supply will go down by a multiple

of the banks’ decrease in reserves.

g. How the Fed attracts buyers or sellers:

i. When Fed buys, it raises demand and price of bonds, which in turn lowers

effective interest rate on bonds. The higher price and lower interest rates make

selling bonds to Fed attractive.

ii. When Fed sells, the bond supply increases and bond prices fall, which raises

the effective interest rate yield on bonds. The lower price and higher interest

rates make buying bonds from Fed attractive.

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B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required

relative to their customer deposits.

1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any

loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money

supply by a multiple amount of the change in excess reserves.

2. Lowering the reserve ratio decreases the required reserves and expands excess reserves.

Gain in excess reserves increases banks’ lending ability and, therefore, the potential

money supply by a multiple amount of the increase in excess reserves.

3. Changing the reserve ratio has two effects.

a. It affects the size of excess reserves.

b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10

percent to 20 percent, the multiplier falls from 10 to 5.

4. Changing the reserve ratio is very powerful since it affects banks’ lending ability

immediately. It could create instability, so Fed rarely changes it.

5. Table 16.2 provides illustrations.

C. The third “tool” is the discount rate, which is the interest rate that the Fed charges to

commercial banks that borrow from the Fed.

1. An increase in the discount rate signals that borrowing reserves is more difficult and will

tend to shrink excess reserves.

2. A decrease in the discount rate signals that borrowing reserves will be easier and will

tend to expand excess reserves.

D. The fourth “tool” is Interest on Reserves

1. In 2008, federal law was changed so that the Federal Reserve could pay banks interest on

reserves held at the Fed.

2. An increase in the interest rate on reserves at the Fed reduces bank lending and a decrease

in the interest rate on reserves at the Fed increases bank lending.

E. For several reasons, open-market operations give the Fed most control of the four “tools.”

1. Open-market operations are most important. This decision is flexible because securities

can be bought or sold quickly and in great quantities. Reserves change quickly in

response.

2. The reserve ratio is rarely changed since this could destabilize bank’s lending and profit

positions.

3. Changing the discount rate has become a passive tool of monetary policy. During the

financial crisis of 07- 08, banks borrowed billions as the discount rate was decreased by

the Fed.

4. During the financial crisis, banks became more reluctant to borrow from the Fed, so the

Fed created the term auction facility, allowing banks to borrow anonymously. It was so

effective; many believe this will be the Fed’s primary tool when the banking system

requires quick injections or withdrawals of reserves.

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VI. Targeting the Federal Funds Rate

A. The Federal funds rate is the interest rate that banks charge each other for overnight loans.

B. 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.

1. The Fed will increase the availability of reserves if it wants the Federal funds rate to fall

(or keep it from rising).

2. Reserves will be withdrawn if the Fed wants to raise the Federal funds rate (or keep it

from falling).

C. The Fed may use an expansionary monetary policy if the economy is experiencing a

recession and rising rates of unemployment.

1. The Fed will initially announce a lower target for the Federal funds rate, and then use

open-market operations (buying bonds in this case). The Fed may also lower the reserve

ratio or the discount rate.

2. Increasing reserves will generate two results:

a. The supply of Federal funds will increase, lowering the Federal funds rate.

b. Through the money multiplier process, a greater expansion of the money supply will

occur. (See Chapter 15 for a refresher on that process)

3. Expansionary monetary policy will put downward pressure on interest rates, including the

prime interest rate – the benchmark interest rate used by banks to set many other interest

rates.

D. Restrictive monetary policy is used to combat rising inflation.

1. 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.

2. Reducing reserves will produce results opposite of what we saw for an expansionary

monetary policy.

a. The reduced supply of Federal funds will raise the Federal funds rate to the new

target.

b. Multiple contraction of the money supply, through the money multiplier process

(Chapter 15).

3. Restrictive monetary policy results in higher interest rates, including the prime rate.

E. Consider This … The Fed as a Sponge

If reserves in the banking system are like a bowl of water, the Fed can use open-market

operations as a sponge that can change the amount of water (reserves) in the bowl.

1. If there are too many reserves, the Fed “soaks up” the excess by selling bonds.

2. If the Fed wants more reserves in the system, it “squeezes the sponge” by buying bonds.

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F. The Taylor Rule – Stanford economist John Taylor has proposed a rule for targeting the

Federal funds rate. It assumes a target inflation rate of 2% and has three components:

1. If real GDP rises by 1 percent above potential, the Federal funds rate should be raised by

one-half a percentage point.

2. If inflation rises by 1 percentage point above its target, the Federal funds rate should be

raised by one-half a percentage point.

3. When real GDP is at its potential and inflation is at its target, the Federal funds rate

should be at 4% (implying a real interest rate of 2%).

4. The rules work in reverse as well, if real GDP is below its potential and inflation is below

the 2% target.

5. While the Fed has roughly followed the Taylor rule in recent years, it has also deviated

under certain circumstances (e.g. the threat of deflation)

VII. Monetary Policy, Real GDP, and the Price Level

A. Cause-effect chain:

1. Money market impact is shown in Key Graph 16.5.

a. Supply of money is assumed to be set by the Fed.

b. Interaction of supply and demand determines the market rate of interest, as seen in

Figure 16.5a.

c. Interest rate determines amount of investment businesses will be willing to make.

Investment demand is inversely related to interest rates, as seen in Figure 16.5b.

d. Effect of interest rate changes on level of investment is great because interest cost of

large, long-term investment is sizable part of investment cost.

e. As investment rises or falls, equilibrium GDP rises or falls by a multiple amount, as

seen in Figure 16.5c and 16.5d.

2. Expansionary monetary policy: The Fed takes steps to increase excess reserves, which

lowers the interest rate and increases investment which, in turn, increases aggregate

demand and real GDP. (See Column 1, Table 16.3)

3. Restrictive monetary policy is the reverse of an expansionary monetary policy: Excess

reserves fall, which raises interest rate, which decreases investment, which, in turn,

reduces aggregate demand and inflation. (See Column 2, Table 16.3)

VIII. Monetary Policy: Evaluation and Issues

A. Strengths of monetary policy:

1. It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities

daily.

2. It is less political. Fed Board members are isolated from political pressure, since they

serve 14-year terms, and policy changes are more subtle and not noticed as much as fiscal

policy changes. It is easier to make good, but unpopular decisions.

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B. Recent monetary policy

1. When the economy suddenly slowed at the end of 2000, the Fed cut interest rates twice in

January 2001.

2. To counter the recession that began in March 2001, the Fed pursued an easy money

policy that saw the prime interest rate fall from 9.5 percent at the end of 2000 to 4.25

percent in December 2002.

3. The Fed has been praised for incurring only a mild recession in 2001 and mitigating the

economic impacts of the September 11, terrorist attacks and the large decline in the stock

market in 2001 – 2002.

4. In response to strong economic growth in 2004, the Fed began a series of quarter–

percentage-point increases in the Federal funds rate. Those increases continued well into

2006.

5. In response to the financial crisis which began in the summer of 2007, the Fed decreased

the discount rate by a ½ percentage point in August 2007 and decreased the Federal funds

rate from 5.25% to 2% between September 2007 and April 2008. As discussed in chapter

14, the Fed introduced the term auction facility in December 2007.

6. Between October 2008 and December 2008, the Fed decreased the Federal funds rate to 0

– .25% where it remained through September 2013and the prime interest rate fell from

7.33% in December 2007 to 3.25% through 2013.

7. Critics contend that the Fed contributed to the financial crisis by keeping rates too low

too long leading to excessive borrowing. Others argued that interest rates were low

because of inflows of savings from foreigners into the U.S.

C. Consider This … Up, Up, and Away

1. During the severe recession, the Fed’s total assets increased from $8.85 billion in

February 2008 to $2,317 billion in March 2010 due to large increases in the number of

U.S. securities, mortgage backed securities and other financial assets owned by the Fed

and loans from the Fed to increase the liquidity of the financial system.

2. Liabilities increased from $43 billion in February 2008 to $1148 billion in March 2010

because many banks put their reserves in accounts with the Fed.

3. In March 2010, bank reserves held by the Fed were greater than checkable deposits

turning the fractional reserve system into a 100% plus reserve system. This provides

banks with enormous excess reserves to increase lending once they stabilize.

D. After the Great Recession

1. The U.S. economy recovered very slowly after the Great Recession. In 2013 the total

number of people with jobs was 135.5 million, which is still below the peak in

January 2008, where 138.1 million people were employed.

2. There was a number of innovative monetary policy initiatives designed to stimulate

GDP and employment growth.

a. Zero Interest Rate Policy (ZIRP)

b. Quantitative Easing (QE). This was done in a number of phases and with Forward

Commitment.

c. Operation Twist: Purchasing long-term bonds and selling short-term bonds.

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E. Problems and complications:

1. 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 is a lag of at least 3 to 6 months before the

changes will have their full impact.

2. Cyclical asymmetry may exist: a restrictive monetary policy works effectively to reduce

inflation, but an expansionary monetary policy is not always as effective in stimulating

the economy from recession. You can pull on a string to effectively shift the AD to the

left, but you cannot push on a string to shift the AD to the right.

3. The liquidity trap means that an increase in banks’ liquidity has little or no effect on

lending, borrowing, investment, or aggregate demand. It’s like, “you can lead a horse to

water but you can’t make him drink.” The Fed can’t guarantee that the excess reserves it

creates will be loaned and create more spending.

4. The liquidity trap occurred during the severe recession which is the reason fiscal policy

became so important.

IX. Key Graph: The Big Picture (Key Graph 16.6)

A. Fiscal and monetary policy are interrelated. The impact of an increase in government

spending will depend on whether it is accommodated by monetary policy. For example, if

government spending comes from money borrowed from the general public, it may be offset

by a decline in private spending, but if the government borrows from the Fed or if the Fed

increases the money supply, then the initial increase in government spending may not be

counteracted by a decline in private spending.

B. Study Key Graph 16.6 and you will see that the levels of output, employment, income, and

prices all result from the interaction of aggregate supply and aggregate demand. In particular,

note the items shown in red that constitute, or are strongly influenced by, public policy.

X. LAST WORD: Worries about ZIRP, QE, and Twist

A. ZIRP, QE, and Operation Twist provided massive economic stimulus during and after the

Great Recession. But there remain many worries about unintended consequences.

B. When the financial crisis reached its peak, the Fed acted aggressively to prevent bank runs

and stabilize the financial system by acting as a lender of last resort.

C. As a result of this aggressive policy by the Fed, the government could borrow (deficit

spending) at historically low rates. This raised the concern about large budget deficits.

D. A long term concern is once these policies end the government will face a very large interest

cost on outstanding debt.

E. Low interest rates also hurt pension plans by reducing projected interest earnings, which

might reduce promised payouts for retirees in the future.

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QUIZ

1. The asset demand for money:

A. is unrelated to both the interest rate and the level of GDP.

B. varies inversely with the rate of interest.

C. varies inversely with the level of real GDP.

D. varies directly with the level of nominal GDP.

2. The opportunity cost of holding money:

A. is zero because money is not an economic resource.

B. varies inversely with the interest rate.

C. varies directly with the interest rate.

D. varies inversely with the level of economic activity.

3. A contraction of the money supply:

A. increases the interest rate and decreases aggregate demand.

B. increases both the interest rate and aggregate demand.

C. lowers the interest rate and increases aggregate demand.

D. lowers both the interest rate and aggregate demand.

4. If the amount of money demanded exceeds the amount supplied, the:

A. demand-for-money curve will shift to the left.

B. money supply curve will shift to the right.

C. interest rate will rise.

D. interest rate will fall.

5. If the interest rate increases, there will be a(n):

A. Decrease in the amount of money held as assets

B. Decrease in the transactions demand for money

C. Increase in the transactions demand for money

D. Increase in the amount of money held as assets

6. In the consolidated balance sheet of the Federal Reserve Banks, loans to commercial banks are:

A. A liability of the Federal Reserve Banks and commercial banks

B. An asset of the Federal Reserve Banks and commercial banks

C. A liability of the Federal Reserve Banks and an asset for commercial banks

D. An asset of the Federal Reserve Banks and a liability for commercial banks

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7. In recent years, the Fed often communicated its intentions to restrict or expand monetary policy

by announcing a change in targets for the:

A. Exchange rate

B. Federal funds rate

C. Prime interest rate

D. Consumer price index

8. A newspaper headline reads: “Fed Cuts Federal Funds Rate for Fifth Time This Year.” This

headline indicates that the Federal Reserve is most likely trying to:

A. Reduce inflation in the economy

B. Raise interest rates

C. Ease monetary policy

D. Tighten monetary policy

9. The level of GDP will tend to increase when:

A. Reserve requirements are increased

B. There is an increase in the discount rate

C. The Federal Reserve buys government securities in the open market

D. The Federal Reserve sells government securities in the open market

10. Which is considered a strength of monetary policy compared to fiscal policy?

A. The ability to increase the budget deficit

B. The ability to decrease the budget surplus

C. Its protection from political pressure

D. Its cyclical asymmetry

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