Post on 31-Mar-2015
1
MONETARY POLICY
Federal Reserve (Central Bank) controls money supply.
2
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.
3
Dollar NOT backed by gold!
1)Up until 1935, citizens could redeem $ in gold @ a rate of
$20.67 per ounce.
2)From 1935 to 1968, the US redeemed $ held by foreigners only, @ a rate of $35 an ounce.
4
Dollar NOT backed by gold!
3)From 1968 to 1971 there was only selective foreign redemption.
4)1971 "Gold Window" closed!
5
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!
6
What if you stuff your money in a mattress?
What does it cost you?
Zero Inflation?
10% Inflation?
Known as the opportunity cost of holding money!
7
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)
8
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.
9
Interest
Nominal Interest Rate =
real interest rate
+ compensation for inflation
+ default risk premium
10
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.
11
Real Interest Rate
Example:
You can save money by ordering many items through the mail.
Why do people drive to Walmart?
12
Real Interest Rate
If $1 right now to you equals (has same value as) $1.05 one year from now, guaranteed, with zero inflation,
you have a real rate of interest of 5%
13
Nominal Interest Rate
If inflation was expected to be 10% from now until one year from now, what market interest rate would you demand to have, to get your 5% real rate of interest? Assume no risk.
Answer: 15%.
14
Nominal Interest Rate
If you thought there was some risk that you might never see your $1.00,
you would add a risk premium.
15
Interest Rates on Govt. Securities:
Known as the "Risk-free Rate"
= Real rate + E(inflation over life of security)
16
Interest Rates on Govt. Securities:
When inflation , Risk-free interest rates
AND
Nominal interest rates
17
Prime Rate
= real rate + E(Inflation) + small risk
premium.
Given to the most solid businesses and individuals!
18
What Is the Risk Premium Charged by Banks for Auto Loans?
August 25, 1993
US Treasury 3 yr. Note rate = 3.41%
36 mo. New Car, Nations Bank = 7.93%
risk premium = 4.52%
WHY? Bankruptcies
19
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
20
Recent Snapshot:
October 4, 2000
US Treasury 3 yr. Note rate = 5.97%
36 mo. New Car, Bank of America = 11.70%
risk premium = 5.73%
21
More Recent Snap Shot
May 15, 2008
US Treasury 3 yr. Note rate = 2.78%
36 mo. New Car, Bank of America = 10.25%
risk premium = 7.47%
22
MONETARY POLICY
Federal Reserve can or the money
supply in order to change the level of
output and prices (Monetary Policy).
23
3 Tools to Change Money Supply:
Open-market operations (buying and selling treasury bonds, notes, and bills).
Discount rate: Interest rate banks are charged when they borrow from the Fed.
Reserve requirement: % of deposits that must be held by a bank as vault cash or on account with the federal reserve.
24
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
25
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.
26
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.
27
Take A Look at the Following:
Implementation of Monetary Policy
http://www.federalreserve.gov/pf/pf.htm
Please read Chapter 3: The Implementation of Monetary Policy.
Feel free to read the entire publication if you wish.
28
Changing the Money Supply
Increase Money Supply, c.p. Decrease interest rates (price of money) in S.R.
BUT
Increase Money Supply may cause inflation!
Increase interest rates in L.R.
Increase Money Supply too much
Decrease value of money
29
Changing the Money Supply
THEREFORE:
Takes more $ to buy same stuff
Price of stuff Inflation!
30
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
31
Changing the Money Supply
THEREFORE:
Takes less $ to buy same stuff
Price of stuff Deflation!
32
Discretionary Income ( IDIS )
= (ID - Basic Housing bills, Basic Utility bills, Basic Food Bills, Basic transportation bills, Basic clothing, etc.)
(Not payments on credit cards!)
Money you have to spend or save at your discretion!
33
Ceteris Paribus: (Consumption - Production Model)
Low unemp. P iLR
( IDIS)
(1) MS iSR C IV
high unemp. Pr iLR
34
Ceteris Paribus: (Consumption - Production Model)
Low unemp. P iLR
( IDIS)
(1) MS iSR C IV
high unemp. Pr iLR
However:
The low interest rates of 1990 - 1993 did not result in much `ed C!
35
WHY?
(1) Consumer Debt Load maxed out!
(2) Any IDIS from lower i rates being used
to reduce current debt!
(3) People with small debt, saving for fear of
unemployment. (employment insecurity)
(IBM, ATT, Apple, Airlines, Kodak everyday
in paper, layoffs announced!)
36
Ceteris Paribus: (Consumption - Production Model)
Low unemp. Pr iLR
( IDIS)
(2) MS iSR C IV
high unemp. P i
37
Ceteris Paribus: (Consumption - Production Model)
Low unemp. Pr iLR
( IDIS)
(2) MS iSR C IV
high unemp. P iLR
38
Why has Stock Market Been Booming?
People with money in banks, pulling it out
and putting it in
Stock Market for higher return!
39
What affect do low interest rates have on retired people?
retirement income!
Stock Market too risky!