MONETARY POLICY

Federal Reserve (Central Bank)

controls money supply.

MONETARY POLICY
The money supply can/does influence price
levels

Inflation occurs if the money supply

increases, ceteris paribus.

Deflation occurs if the money supply

decreases, ceteris paribus.
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Dollar NOT backed by gold!

Dollar is only backed by "Faith," the fact

most people "want it," and

not enough $ floating around out there

such that everybody can have all they
want!

Interest
The price you pay for using someone else's
money (accounting cost or explicit cost)
OR
holding your own money as cash.
(opportunity cost or implicit cost)

Interest

Nominal interest rates (market rates)

Real interest rates

A return net of inflation and risk premium

Risk-Free interest rates

Government treasury securities, no risk
premium.
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Interest
Nominal Interest Rate =
real interest rate
+ compensation for inflation
+ default risk premium

Real Interest Rate

The real interest rate is the price of money,
net of inflation and risk, that people are
willing to accept for deferring present
consumption until some future time period
$1 in your hand right now is worth more than
the promise (without risk) of $1 in your hand
a year from now.
Even with 0 inflation.

Interest Rates on Govt.

Securities:
Known as the "Risk-free Rate"
= Real rate + E(inflation over life of
security)

Prime Rate
= real rate + E(Inflation) + small risk
premium.

Given to the most solid businesses and

individuals!

What Is the Risk Premium Charged

by Banks for Auto Loans?
Sept. 3, 1996
US Treasury 3 yr. Note rate =

6.42%

36 mo. New Car, Nations Bank =

10.25%

risk premium =

3.83%

Why? Economy humming along rather nicely, unemployment

down, less bankruptcies

10

Recent Snapshot:

October 4, 2000

US Treasury 3 yr. Note rate =

36 mo. New Car, Bank of America =
risk premium =

5.97%
11.70%
5.73%

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Open Market Operations

When the Federal Reserve sells more

treasury securities than it buys:
Money Supply Decreases

When the Federal Reserve buys more

treasury securities than it sells:
Money Supply Increases
12

The Discount Rate

The discount rate is adjusted to
complement open market operations and
to support the direction the Fed is taking
in monetary policy.

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Reserve Requirement
Commercial Banks, Savings Banks,
Savings and Loans, Credit Unions, and
Branches of Foreign Banks are subject to
reserve requirements.
Reserve requirement may range from 8
to 14 percent of demand deposits and
interest-bearing accounts offering
unlimited checking privileges.

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Changing the Money Supply

Decrease Money Supply, c.p.
Increase
interest rates (price of money) in S.R.
BUT
Decrease Money Supply may cause deflation!
Decrease interest rates in L.R.
Decrease Money Supply too much
Increase value of money
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Ceteris Paribus: (Consumption Production Model)

Low unemp.

iLR

( IDIS)
(1)

MS

iSR
high unemp.

IV
Pr

iLR

16

Ceteris Paribus: (Consumption Production Model)

Low unemp.

iLR

( IDIS)
(1)

MS

iSR
high unemp.

IV
Pr

iLR

However:
The low interest rates of 1990 - 1993 did not result
in much `ed C!
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What affect do low interest rates

have on retired people?
retirement income!

Stock Market too risky!

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