CHAPTER 3

THE FED AND INTEREST RATES

Definition of the Monetary Base
Money Aggregates
M1—”Medium of Exchange”, Currency and
Checking Deposits.
M2– M1+ saving deposits, money market deposit
accounts, overnight repurchase agreements,
Eurodollars, small time deposits.
MZM – M2– small denomination time deposits +
institutional money market mutual funds.
M3 – M2+ institutional money market mutual
funds, large time deposits, and repurchase
agreements and Eurodollars > 1 day maturity
L – All liquid assets economy wide including U.S.
Treasury Bills maturing 1 year or less.
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Objectives of Fed Monetary Policy
Full Employment
Frictional Unemployment
• The rate of unemployment created by job mobility
Structural Unemployment
• Created by immobile workers or poor job skills
(education)
“Natural Rate of Unemployment”
• The rate of unemployment generally tolerated by
governments

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
Economic Growth
Gross Domestic Product (GDP) per Capita
• The general measure of a countries wealth
The goal has been to have a steadily rising
level of real GDP (inflation adjusted)
• This has not been the case however, as inflation
has eaten away at GDP.

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
Price Stability
Goal has been to provide steady average
prices in the economy on average
Inflation
• Book Definition – a continuous rise in average
prices over time.
• Class Definition – An increase in the money supply
resulting in a general rise in average prices as the
purchasing power of the monetary unit falls due
to proliferation and the resulting loss in
purchasing power.

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
Interest Rate Stability
The goal is to provide a steady level of
interest rates reflective of market risk while
reducing interest rate volatility.
Economic/Financial Calculation is more
difficult with uncertainty regarding future
interest rates.

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
Financial System Stability
The Fed as Lender of Last Resort
• The Fed is to stand ready in the event of
catastrophic losses in the financial system
• The Fed would provide liquidity to increase public
confidence in the system

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
Foreign Exchange Stability
A primary goal of the Fed is to provide
stable purchasing power of the U.S. Dollar
relative to foreign currencies
This is expressed in stable exchange rates.
The Fed may seek to weaken the dollar
during economic downturns to increase
exports giving U.S. firms a boost in demand

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
Inconsistencies and Limitations
The Fed can not continually inflate the
money supply as this has serious domestic
and international consequences.
Remember inflation is not your friend
High inflation rates domestically make life
more expensive to live
Likewise, high inflation causes an
international asset drain as U.S. assets are
sent oversees to find more stability in other
markets

Copyright© 2003 John Wiley and Sons, Inc.

Objectives of Fed Monetary Policy
The Alternative (My personal view)
A hard money standard
Eliminating the Fed and tying the U.S. Dollar
to Gold and Silver
The afore mentioned goals thus would be
met
Large and Powerful Banks and Financial
Service firms would not profit as easily
through this system

Copyright© 2003 John Wiley and Sons, Inc.

The Monetary Base and Changes
in the Money Supply
Reserves are a % of the total Liabilities of the
Bank
ie: Total Liabilities of $800 mil. w/ 10% reserve
requirement = $80 mil in required reserves
Excess Reserves
Those in excess of requirements imposed by the
Fed
Banks hold only minimal excess reserves as the
Fed pays no interest on excess reserves held at
the Fed
Copyright© 2003 John Wiley and Sons, Inc.
Impacts of Federal Reserve Policy

Expansionary monetary policy

Open market operations -- purchase securities --
increase bank excess reserves and the monetary
base.
Reserve requirements -- reduce reserve
requirements -- increase excess reserves and
increase the deposit expansion multiplier.
Discount rate -- reduce the rate -- reduce the cost
of borrowing reserves.
Expands the money supply; reduces interest rates.

Copyright© 2003 John Wiley and Sons, Inc.

Impacts of Federal Reserve Policy
(concluded)
Restrictive monetary policy
Open market operations -- sell securities, reduce
bank reserves and the monetary base.
Reserve requirements -- increase reserve
requirements, reduces excess reserves and the
deposit expansion multiplier.
Discount rate -- increase the discount rate and the
cost of borrowing reserve deficiencies.
Reduce the money supply or its growth rate;
increase interest rates.

Copyright© 2003 John Wiley and Sons, Inc.

Effects of Federal Reserve
Policy in the Financial System
Changes in the Money Supply
When the Fed either increases the monetary base
or reduces reserve requirements, banks’ excess
reserves increase.
Excess reserves are loaned out or invested.
Transaction deposits increase as loaned or
invested funds are deposited.
The money supply increases.

Copyright© 2003 John Wiley and Sons, Inc.

Effects of Policy Changes
Changes in Interest Rates
Expansion of the monetary base or reductions in
reserve requirements increase bank liquidity.
Federal Funds rate declines.
Price of other money market securities increase
(rates decline) as banks invest their liquidity.
Loan rates and other security rates decline with
continued increases in bank liquidity.
Monetary policy starts in the bank money market
and spreads to other financial institutions and
markets and to the real economy.
Copyright© 2003 John Wiley and Sons, Inc.
Effects of Policy Changes
Credit availability is increased with the
expansion of bank liquidity and reduced
interest rates.
Wealth Effects -- reduced interest rates
(increased security prices) increases the
wealth of individuals.
Increased wealth prompts increased spending.
Increased spending has a current income, Y,
impact and a multiplier effect in future income
periods.

Copyright© 2003 John Wiley and Sons, Inc.

Short-Run Effects of Monetary Policy

Monetary policy affects spending

Investment.
Consumption.
State and local government.
Effects of Monetary Policy on Changes
in Investment
Investment demand, traditionally, has been
sensitive to changes in interest rates.

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Short-Run Effects of Monetary Policy
(continued)

Housing investment -- both credit

availability and mortgage rates have been
impacted severely by monetary policy.
Plant and equipment investment is related
to expected rates of return relative to the
cost of financing.
Planned inventory investment is sensitive
to the cost and availability of credit.

Copyright© 2003 John Wiley and Sons, Inc.

Short-Run Effects of Monetary Policy
(continued)

Consumption expenditures are affected

several ways:
Increased or decreased holdings of money
affect spending.
Credit availability and interest rate levels
affect the purchase of durable goods.
Changes in wealth affect spending in the
current period.
Copyright© 2003 John Wiley and Sons, Inc.
Short-Run Effects of Monetary Policy
(concluded)

Foreign trade is affected by monetary policy.

Increased interest rates increase the value of the
dollar relative to the other currencies.
Increased dollar exchange rates encourage
imports; discourage exports.
State and Local Government Expenditures
Monetary policy affects capital project
expenditures.
Higher interest rates limit expenditures.

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Changes in the Discount Rate

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Change in Money Supply and
Interest Rates and the Economy

Copyright© 2003 John Wiley and Sons, Inc.

Long-Run Effects of Monetary Policy

Expectations are affected by current,

short-run monetary policy actions.
High money growth to stimulate the
economy may increase interest rates
(interest rate effects).
Market expects inflation from near-term
policy action.
Investors sell long-term bonds, prices fall,
and interest rates increase.
Copyright© 2003 John Wiley and Sons, Inc.
Long-Run Effects of Monetary Policy
(concluded)
Expected inflation may cause increased
spending and borrowing and increased
interest rates.
Pay back lower value debts.
Buy before the price goes up psychology.
May move the economy to inflationary income
levels.
Cost increases (interest and labor) faster than
price increases will cause reductions in investment
spending.

Copyright© 2003 John Wiley and Sons, Inc.

Practical Considerations in Monetary
Policy
Expectations may nullify intent of policy.
Time lags in implementing monetary
policy reduce its effectiveness.
Political pressures influence Federal
Reserve policy.

Copyright© 2003 John Wiley and Sons, Inc.

Complications in Implementing Policy

The Velocity of Money

The rate money changes hands in the
economy
V= Y/M or M x V = Y
• V= Velocity
• M= Money Supply
• Y= GDP

Copyright© 2003 John Wiley and Sons, Inc.