Ch 16 Interest Rates and Monetary Policy 04 22 2014 The Fed uses Monetary Policy to change the supply of money this changes interest rates FFR Changes in FFR cause changes in spending like Investment spending or Consumer Spending RGDP Money supply is important because too much will cause inflation and too little will cause recession Important Interest Rates 1M dollars currently 0 1 4 Federal Funds Rate FFR interbank over night lending rate of at least Discount Rate rate at which FED lends to banks when banks borrow from the FED currently 0 75 Prime Rate rate banks charge their most preferred customers currently 3 25 T Bill Rate rate that the treasury pays to lenders to the treasury National Debt currently 0 13 Mortgage Rate rate on houses currently 4 45 for 30 year mortage Taylor Rule of the economy Determines the optimal interest rate Fed fund rate FFR or in other words it tells the Fed how much money supply should be given the current state FFR Actual inflation rate Long term Federal Fund Rate Inflation rate target inflation GDPGap If the FED thinks that the economy is heading downward then it would want to lower the FFR If the FED thinks that the economy is heading upward then it would want to raise the FFR What should the Fed do once it has the FFR The money market is like any other market there is a supply and demand for money and it determines the equilibrium rate of interest The money Supply curve is a vertical line because the amount is fixed by Fed policy it does not depend on other economic variables Money demand depends on the opportunity cost of holding money Why do we hold money instead of gaining interest on it Transaction Demand for Money so we can purchase goods and Speculation Demand for Money so we can have cash to take advantage of investment opportunities Precautionary Demand for Money the money people want in case of services emergency But how much money we hold also depends on the interest rate that s why the demand for money is downward sloping at higher interest rates we hold less money because the opportunity cost of holding money is very high If there is an increase in money supply and the MS curve shifts to the right the interest rate falls The quantity supplied of money is greater than the quantity demanded so the banks lower the interest rate to get people and businesses to borrow The lower interest rate will cause an increase in Investment spending and consumer durable goods spending any spending that is interest the money sensitive People start borrowing money for all kinds of purposes trips business etc and the demand of money rises until equilibrium is reached again The Fed can increase money supply to get out of a recession 6 Ways Fed can change Money Supply Open Market Operations the purchase and sale of U S government bonds by the Fed Buy money supply Reserve Requirement regulations on the minimum amount of reserves that banks must hold against deposits requirement will money supply Discount Rate the interest rate on the loans that the Fed makes to banks discount rate will money supply Paying Interest on Reserves In Oct 2008 Fed began paying interest on banks reserves Term Auction Facility The Fed holds two auctions each month at which banks bid for the right to borrow reserves for 28 day and 84 day periods Quantitative Easing Fed Buys specific amount financial assets from commercial banks and other private institutions in order to lower interest rate 04 22 2014 04 22 2014