Interest Rates and Monetary Policy

The Fed has many “tools” to help run the US banking and money supply systems.
 
The main tools:

• The buying and selling of Bonds
• The Discount Rate 
• The Reserve Requirement

The Fed's PRIMARY influence is on the money supply and interest rates. 

interest: the price paid for the use of money


Demand for Money

• people demand money for   
• transactions  
• assets 

inverses relationship between b/t interest rate and the quantity of money demanded
 
Supply of Money 

• inelastic (set by the Fed)
• manipulated by the Fed

Supply and demand for money gives 
us the nominal interest rate.

A Selection of Different Interest Rates
Fed Funds Rate

• Background on the FFR  
• Cash in the vault earns no interest  
• banks don't like to let excess reserves sit idle 
• loan money to each other overnight  
• (in order to balance deposit accounts each day) 

• FFR is the interest rate they use to loan each other this money
• The Federal Reserve "targets" this rate by suggesting its raising or lowering and uses bonds to accomplish the targets.
• The FFR influences other interest rates, so if you can adjust it, you can adjust interest rates overall.

Prime Rate

• the interest rate banks charge their most "credit worthy" borrowers.
• Historically, the prime rate, in the US, has been set about 3% above the Fed Fund Rate.

Private Rates

• These loan rates are set by supply and demand
• Examples: 
• car companies "selling" "zero interest" loans, 
• special student rate loans, etc.
• Payday lenders 
• Any rate below the Fed Fund Rate probably has some kind of financial trick attached to the contract.

 Monetary Policy: The central bank's attempts to influence the economy through manipulating the money supply.  
most common tool: buying and selling bonds 

A brief word about bonds

• Bond: contract promising to repay borrowed money on a designated date and to pay interest on the way. (An IOU) 
• bonds are a type of security; a tradable financial asset 
• (Bonds can be bought and sold on the bond market)
• high liquid assets 

Two "modes" of Monetary Policy
1. Expansionary policy

• increases the total supply of money in the economy more rapidly than usual 

used to try to combat unemployment in a recession 

• lowering interest rates to encourage borrowing and spending
• increase in AD, expand real output
• "easy money"

Lower the FFR, open market operations

• buy bonds = big bucks
• increase reserves in the banking system 
• increase the money supply

2. Restrictive policy

• expands the money supply more slowly than usual or even shrinks it. 

Used to fight inflation (avoid the resulting distortions and deterioration of asset values)

• "tight money"
• increase the interest rate to reduce borrowing and spending
• slow the expansion of AD, hold down PL increases 

Raise the FFR, Open Market Operations (normally)

• Sell bonds  = small bucks
• absorb reserves in the banking system 
• decrease the money supply

Recall our other tools. How might these be used?

• The Discount Rate 
• The Reserve Requirement

The Discount Rate

• FDIC member banks, and other eligible institutions, may borrow short term loans directly from the Federal Reserve.  
• This is the "discount window", and is set above the Fed Fund Rate.
• Banks do not like to use the window, since it appears to be a move of "last resort"
• Set by the Fed