Supply: banks, Fed Money ioio Federal Funds Rate Banks increase lending as interest rates rise...
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Transcript of Supply: banks, Fed Money ioio Federal Funds Rate Banks increase lending as interest rates rise...
Supply: banks, Fed
Money
io
Federal Funds Rate
Banks increase lending as interest rates rise because it is more profitable
The Fed manipulates the amount of reserves in the system.
Supply increases
when the Fed injects
reserves
Banks lend more when the interest
rate increases
Wealth can be held in two forms
Wealth
Assets that earn a return
(bonds)
Assets that do not earn a
return (cash/Deposit
s)
The Demand for Money
Tells us “how much of our wealth we want to hold as cash/Deposits
banks”
The Interest Rate
Represents the Cost of holding cash balances…
what you give up…
The Demand for MoneyInterest Rate The higher the i,
the higher the opportunity cost of holding cash/ reserves
The lower the amount of desired cash (deposits)/reserves
i 0
Md0
The Demand for MoneyInterest Rate
The larger the amount of desired cash (Deposits)/reserves.
As the i falls, the opportunity cost of holding cash/reserves decreases
i 1
Md1
The Federal Funds Rate
Supply: banks + Fed
Demand: Public
Money
io
Federal Funds Rate
As interest rate rises bank’s
quantity demanded drops
The Federal Funds Rate
Supply= excess reserves + Fed
changes
Demand = Banks in need of
reserves
Money
io
Federal funds RateBanks need
more reserves when Deposits
increase
Deposits/ Demand for
reserves increase with
more transactions
Deposits/ Demand for
reserves increase when prices increase
What Determines How Much Money we Want to hold as Deposits?
Prices +We need to hold more cash for more expensive transactions
Real Income +We buy more things: we need more cash for more transactions.
Interest rate -The higher the interest rate the less money we want to hold as cash
The higher prices and Income, the higher the need for cash
The higher the interest rate, the lower the demand for cash
Shifts in the Demand for Money
Increase in prices or Incomes (GDP): shift demand to the rightDecrease in prices or incomes (GDP): shift the demand to the left
When Prices Increase
More expensive transactions require larger cash holdings
The demand for money shifts to the right
i 0
Md0
i 1
Md1
At each i we hold more cash than
before
The demand for bank reserves shifts to the right
When Real Income Increases
We engage in MORE transactions which require larger cash holdings.
The demand for bank reserves shifts to the right
i =5%
500 bill.
i =3%
800700 bill.
900
The Federal Reserve Bank ‘Controls’ the Supply of Money
Open Market Operations.
Changes in the Discount Rate
Changes in the required reserve ratio.
The amount of money in circulation is managed by the fed
Supply
Demand
Quantity Bank Reserves
io
Federal Funds Rate Msi
$
The Public ‘controls’ the Demand for money
When prices increase the demand for money increases
When incomes increase the demand for money increases.
Msi
$
Md
Monetary Policy
The Fed determines the “desired level” for the interest rate
The Fed adjusts the Money Supply until the rate hits the target. Via Open Market Operations. Via changes in required reserves. Via changes in discount rate. Via changes in margin requirements. Via moral suasion.
Relationship Between Bond Prices and the Interest Rate
Bond PPrice:$100
Interest Rate: 5%Interest: $5
Peter purchased this
bond
Bond APrice:$100
Interest Rate: 8%Interest: $8
A month later a new bond “A”Is issued into
the market
Which Bond would you buy?
Peter’s? The new bond “A”?
Bond PPrice:$100
Interest Rate: 5%Interest: $5
Bond APrice:$100
Interest Rate: 8%Interest: $8
Clearly A is better than P: same price but higher interest
What price should Peter ask for to convince you to purchase his bond rather than A?
A Price that would make Peter’s bond more attractive
A price so low, that the interest you earn on Peter’s bond is higher than 8%
Peter’s Bond
If you pay $100 for Peter’s Bond
You receive $105 at maturity
Interest Rate = (105 – 100)/100 = 5%
If you pay $90 for Peter’s Bond
You receive $105 at maturity
Interest Rate = (105 – 90)/ 90 = 16.7%
The lower the price, the
higher the interest rate
What price will give us exactly 8% for Peter’s bond?
If you pay $X for Peter’s Bond
You receive $105 at maturity
Interest Rate = (105 – X)/ X
0.08 X = 105 - X
8% = (105 – X)/ X
X(1.08) = 105
0.08 X + X = 105X(0.08 + 1) = 105
X = $97.22
If Peter needs to sell his bond
It must sell it for LESS than
$97.22 to make i >8%
Since he paid $100 for it, he must sell at a loss….
What does this mean?
When interest rates rise: when new bonds come into the market with higher interest
rates…I can still sell old bonds for cash, but I will lose money in the transaction.
When interest
rates rise, bond bond prices drop
The Relationship Between Bond Prices and the Interest Rate
Bond PPrice:$100
Interest Rate: 10%Interest: $10
Peter purchased this
bond
Bond APrice:$100
Interest Rate: 5%Interest: $5
A month later a new bond “A”Is issued into
the market
Clearly P is better than A: same price but higher interest
What price will give us exactly 5% for Peter’s bond?
If you pay $X for Peter’s Bond
You receive $110 at maturity
Interest Rate = (110 – X)/ X
0.05 X = 110 - X
5% = (110 – X)/ X
X(1.05) = 110
0.05 X + X = 110X(0.05 + 1) = 110
X = $104.76
If Peter needs to sell his bond
He can now sell it for MORE than $100
Since he paid $100 for it, he will make a profit ….
When interest
rates fall, bond prices
increase
What does this mean?
When interest rates fall: when new bonds come into the market with lower interest rates…I can sell my bonds at a profit.
Bond MarketSupply of bonds
Demand for bonds
P0
Bond Market: Fed Sells BondsSupply of bonds
Demand for bonds
P0
P1
Bond Price falls: Interest
Rates Increase
Bond Market: Fed Buys BondsSupply of bonds
Demand for bonds
P0
P1
Bond Price rises: Interest
Rates Decrease
Monetary Policy
Changing the Money Supply in order to affect Aggregate
Spending
The Effect of an Increase in the Money Supply
The fed increases Ms by:• Reducing the required reserve ratio (r)• Buying bonds in the Open Market• Reducing the Discount Rate (d)An increase in Ms is represented as a rightward shift in the Money Supply line
i
$
Ms0 Ms
1
When the Fed Wants to Reduce Unemployment
Use Expansionary Monetary Policy
Increase the Money Supply
Decrease the interest rate.
Increase demand for goods and services
The Effect of a Decrease in the Money Supply
The fed decreases Ms by:• Increasing the required reserve ratio (r)• Selling bonds in the Open Market• Increasing the Discount Rate (d)A decrease in Ms is represented as a leftward shift in the Money Supply line
i
$
Ms0Ms
1
When the Fed Wants to Reduce Inflation
Use Contractionary Monetary Policy
Decrease the Money Supply
Increase the interest rate.
Decrease Aggregate Demand
Supply
Demand
Quantity Bank Reserves
ffro
Federal Funds Rate Ms
i
$
Md
Supply of bonds
Demand for bonds
P0
i
Questions to prepare for the testUse a diagram to show the effect on reserves, the money
supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step.
1. The fed increases/decreases the required reserve ratio
2. The fed buys/sells bonds in the open market
3. Fed increases/decreases the discount rate.
4. Prices increase/decrease
5. Incomes decrease/decrease
EventDemand
for Reserves
Supply of Reserves
Federal Funds Rate
BanksLoan
sDeposits Md/Ms
Interest Rate(i)
Increase in Required Reserve Ratio (r)
b 1 Ms
Decrease in Required Reserve Ratio (r)
b 2 Ms
Buy Bonds b 3 Ms
Sell Bonds b 4 Ms
Increase in Discount Rate
b 5 Ms
Decrease in Discount Rate
b 6 Ms
Increase in Prices same 7 Md
Decrease in Prices same 8 Md
Increase in Incomes (GDP) An economic Expansion
same 9 Md
Decrease in Incomes (GDP) Economic Recession
same 10 Md
1. More banks in need of reserves, fewer banks with excess reserves, banks try to beef up their reserves by making fewer loans thus decreasing deposits and the money supply.
2. Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply.
3. Fed injects more reserves: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply.
4. Fed erases reserves from the system: Fewer banks in need of reserves, more banks with excess reserves, banks with excess reserves make more loans thus increasing deposits and the money supply.
5. Banks borrow less from fed more from other banks (increase demand for reserves); banks beef up their reserves (instead of using expensive fed loans for emergencies) (decrease in supply): decrease loans, deposits and money supply.
6. Banks borrow more from fed less from other banks (decrease demand for reserves); banks decrease their excess reserves (instead of using their own, they use cheap fed loans for emergencies) (increase in supply): increase loans, deposits and money supply.
7. Increase in demand for reserves, increase in demand for money.8. Decrease in demand for reserves, decrease in demand for money9. Increase in demand for reserves, increase in demand for money.10. Decrease in demand for reserves, decrease in demand for money.