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Money and Interest Rates

MBA 774Macroeconomics

Class Notes – Part 2

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What is Money?

• Medium of exchange– Allows transactions not based on barter– Avoids the need for a “double coincidence of

wants”

• Unit of account– Common measure of value for goods, services, and

contracts

• Store of value– Allows for transfer of wealth through time– Most liquid of all assets

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Types of Money

• Pure Commodity– Scarce commodity is agreed on as “money”– For example: gold, silver, cattle, cigarettes

• Commodity Standard– Certificates representing claims on a commodity are

issued and used instead of the commodity itself– For example: the US was once on a “gold standard”

• Fiat Money– Money established by government decree– Fiat money has no intrinsic value

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US Measures of Money

• Currency = Bills and coins outside U.S. Treasury, Federal Reserve Banks and the vaults of depository institutions

• M1 = Currency plus travelers’ checks, demand deposits, other checkable deposits

• M2 = M1 plus savings deposits, small-denomination time deposits, retail money market mutual funds, and overnight repurchase agreements

• M3 = M2 plus large-denomination time deposits, institutional money funds, and Eurodollars (discontinued in 2005)

• L = M3 plus other liquid securities such as savings bonds and short-term Treasury securities

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US Money Supply Statistics

Measure USD Billions % of M3 1-yr %Chg

Currency 741 10.8% 3.5%

M1 1,358 19.7% -1.0%

M2 6,879 100.0% 4.4%Source: Federal Reserve Statistical Release H.6

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The US Federal Reserve

• Federal Reserve System is the US “central bank”– Foreign counterparts include the European Central

Bank (ECB), The Bank of England, and the Bank of Japan

• Founded in 1913 by congress, “to provide the nation with a safer, more flexible, and more stable monetary and financial system.”

• Primary functions are– Monetary policy– Banking supervision and regulation– Providing certain services (e.g., check clearing)

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The US Federal Reserve (2)

• The “System” is composed of 12 regional banks and a Board of Governors in Washington, DC– Governors, the Chairman and Vice-Chairman are

appointed by the President and confirmed by the Senate

• Monetary policy is overseen by the “Federal Open Market Committee” or FOMC which includes– Board of Governors– Fed Bank of NY President– 4 other regional bank presidents on a rotating basis

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Monetary Policy (1)

• About every six weeks the FOMC meets to determine monetary policy for the US

• In practice, this means determining the target for the “Federal Funds Rate” – an inter-bank overnight interest rate

• Fed decreases (increases) the Fed Funds rate by buying (selling) government securities which increases (decreases) the available money supply– The Federal Reserve Bank of NY makes these

purchases or sales on the open market--hence the name Federal Open Market Committee.

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Monetary Policy (2)

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Fed Funds Target

Fed Funds Actual

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The Fed’s Actions around 9/11

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Fed Funds Actual

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Stock Markets Re-open

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Monetary Policy (3)

• The official objectives of US monetary policy are, “economic growth in line with the economy's potential to expand, a high level of employment, stable prices (that is, stability in the purchasing power of the dollar), and moderate long-term interest rates.”

• Conceptually, the Fed will raise (the real) interest rate if GDP is greater than “Potential GDP” and vice-versa

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Aside: Real vs. Nominal Rates

• It is often said that the interest rate is the “cost of money.” Is this true?

• Ultimately, we use money to obtain consumption goods

• Think of the interest rate in terms of trading some real amount of consumption in one time period for some real amount of consumption in another time period– Note however, borrowing and lending contracts are

stated in nominal terms.

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Aside: Real vs. Nominal Rates

• The real rate of interest (R*) can be defined as approximately,

Real Interest Rate =

Nominal Interest Rate - Anticipated Inflation

• In 2004, what was R* in the – the US? – Japan?

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Monetary Policy (4)

• Potential GDP is the rate of economic activity that leads to stable prices and employment

• Intuitively it is the amount of output that is generated by utilizing all available resources at there highest sustainable level.

• Algebraically, we can think of it asPotGDP = (aggregate hours available for work)

x(average output per hour)

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Monetary Policy (5)

• Economists often discuss the Potential GDP Growth Rate which is approximately

PotGDP Growth = Labor Force Growth Rate

+ Productivity Growth Rate

• We can calculate PotGDP Growth with this formula for the last 50 years

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Historical Potential GDP

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%Productivity Growth

Labor Force Growth

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Better Estimates of PotGDP

0.0%

1.0%

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4.0%

5.0%

6.0%

PotGDP-Congressional Budget Office Estimates

PotGDP-( 5yr- Moving Average from Previous Graph)

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Monetary Policy and the GDP Gap

Monetary Policy Regime Change

Note: GDP Gap = (Actual GDP - PotGDP) / PotGDP

-10.0%

-5.0%

0.0%

5.0%

10.0%19

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1960

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2005

Real Fed Funds

GDP-Gap

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NAIRU

• Another way of thinking about potential output is the equilibrium rate of unemployment or NAIRU (Non-accelerating Inflation Rate of Unemployment)

• NAIRU is the rate of unemployment below which there will be inflationary pressures

• The exact level of NAIRU is an issue of debate.– Most economists believe it is somewhere between

4% and 6% in the US and Japan. Probably higher in Europe (7-8%).

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Monetary Policy and NAIRU

Monetary Policy Regime Change

Note: U-NAIRU is actual unemployment minus NAIRU and is sometimes called the employment gap.

-5.0%

0.0%

5.0%

10.0%

1955

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Real Fed Funds

U-NAIRU

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Other Mechanisms for Monetary Policy

• The Fed also has two other ways of controlling monetary policy– The discount rate– Reserve requirements

• Reserve requirements (rr) directly affect the level of money via the “money multiplier” (1/rr)– Example, if the reserve requirement is 20% of

deposits then the money multiplier is 1/0.2 = 5

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Fractional Reserve Banking

• The Fed buys a $1,000 (market value) treasury bond from a bond dealer

• The dealer deposits the $1,000 proceeds into its bank, FirstBank– Money supply increases by $1,000

• FirstBank only has to keep $200 as reserves and loans the $800 balance:

FirstBanks Balance SheetAssets LiabilitiesReserves $200 Deposits $1,000Loans $800

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Fractional Reserve Banking (2)

• Assume FirstBank made an $800 computer loan to a student. Money supply increases to $1,800

• The student buys a computer at BestBuy which deposits the $800 at its bank, SecondBank

• SecondBank also loans out all but 20% SecondBank Balance Sheet

Assets LiabilitiesReserves $160 Deposits $800Loans $640

• Now money supply = 1,000 + 800 + 640 = 2,440

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Fractional Reserve Banking (3)

• This practice of keeping 20% reserves and loaning out the rest continues indefinitely

• However, the ultimate increase in the money supply (MS) is finite and equal to

MS = D / rrMS = $1,000 / 0.2

MS = $5,000

where D is the original increase in money by the Fed[ Mathgeeks note, its a converging geometric sequence:

1+x+x2+x3+... = 1/(1-x) where x = (1-rr) ]

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Fed Reserve Requirements Requirement

Type of Deposit % of Deposits Effective Date

Net transaction accounts $0 million-$8.5 million 0 12/21/06

$8.5 million-$45.8 million 3 12/21/06

More than $45.8 million 10 12/21/06

Nonpersonal time deposits 0 12/27/90

Eurocurrency liabilities 0 12/27/90Required reserves must be held in the form of deposits with Federal Reserve Banks or vault cash. Nonmember institutions may maintain reserve balances with a Federal Reserve Bank indirectly, on a pass-through basis, with certain approved institutions. Under the Monetary Control Act of 1980, depository institutions include commercial banks, savings banks, savings and loan associations, credit unions, agencies and branches of foreign banks, and Edge Act corporations.

See also: http://www.federalreserve.gov/monetarypolicy/0693lead.pdf

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Interest Rates

• There are lots of important USD interest rates – Federal funds rate – Discount rate – Prime rate – Commercial paper rate – LIBOR and Eurodollar (similar for other currencies)– T-bill, T-note, T-bond rate– Swap rates– Corporate bond rates– Overnight repurchase rate or “Repo” rate

• Rates depend on credit risk, liquidity, and maturity

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Government Issues

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3-month T-Bill

20-year T-Bond

Term Spread

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Corporate Bonds

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Moody's AAA Corp

Moody's Baa Corp

Baa Credit Spread (over Treasuries)

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A Model of the Money Market

• More detail about what affects interest rates

• For now consider “money” to be M1

• Also we assume that the money supply is controlled by the central bank (e.g., the US Federal Reserve)

• Specifically, the central bank fixes the amount of money in the aggregate economy (MS) at a level it desires regardless of other factors

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Individual Money Demand

• Individuals’ demand for money is based on– The expected (real) return on money:

• Money (M1) pays little or no interest• => higher interest rates will lead to less demand for

money

– The riskiness of the return• The risk of holding money comes from variation in the

price level. Why?

– Liquidity• The primary value associated with money is derived

from liquidity• Since a primary use of money is as a medium of

exchange, this implies an increase in the value of individual transactions increases the demand for money

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Aggregate Money Demand

• Aggregate money demand is the sum of demand for money by all households and firms in the economy

• In aggregate we can say the determinants of the aggregate demand for money are– The interest rate– The price level (think CPI)– Real national income (or GNP or GDP)

• Because this determines the need for liquidity

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Aggregate Money Demand

• Define aggregate money demand asMD = P * L(R,Y) or MD / P = L(R,Y)

where, MD = Aggregate money demand P = Price level R = Interest rate Y = Real national income (or GNP or GDP)

and,L decreases as R increasesL increases as Y increases

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Aggregate Money Demand

L(R,Y)

Interest Rate (R)

Aggregate Real Money (M/P)

L(R,Y1)

Interest Rate (R)

L(R,Y2)

Increase in Y

Aggregate Real Money (M/P)

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Equilibrium in the Money Market

In equilibrium, MS = MD = P*L(R,Y)

Aggregate Real Money Demand L(R,Y)

Interest Rate (R)

Real Money Supply

R1

MS/P

2

3

1

R2

R3

Q2 Q3 Aggregate Real Money (M/P)

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Increase in Money Supply

Suppose the money supply increases from M1/P to M2/P

Aggregate Real Money Demand L(R,Y)

Interest Rate (R)

Real Money Supply Increases

R1

M1/P

2

1

R2

M2/PAggregate Real Money (M/P)

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Increase in GDP

Suppose real income (GDP) increases from Y1 to Y2

L(R,Y2)

Interest Rate (R)

Real Money Supply

R1

MS/P

2

1’1

R2

Q1’

L(R,Y1)

Aggregate Real Money (M/P)