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Monetary Policy: Understanding the Influence of Money Supply on Prices and Interest Rates, Slides of Economics
An overview of monetary policy, the role of the federal reserve as the central bank, and the relationship between money supply, inflation, deflation, and interest rates. It covers the history of the us dollar being backed by gold, the concept of opportunity cost, and the calculation of real and nominal interest rates. The document also discusses the tools used by the federal reserve to change the money supply and the impact on output and prices.
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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.
Dollar
NOT
backed
by
gold!
1)
Up until
1935,
citizens could redeem
$
in gold @ a rate of
$20.
per ounce.
From
to
1968,
the
US
redeemed
$
held by foreigners only,
@
a rate of
$
an ounce.
Dollar
NOT
backed
by
gold!
3)
From
to
there was only selective foreign redemption.
"Gold Window" closed!
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!
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!
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.
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
$ in your hand right now is worth more than the promise (without risk) of $ in your hand a year from now. - Even with 0 inflation.
Real
Interest
Rate
Example: • You can save money by ordering many items through the mail.
Why do people drive to Walmart?
Real
Interest
Rate
•
If
$
right now to you equals (has same value as)
$1.
one year from now, guaranteed, with zero inflation,
you have a real rate of interest of
5%
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%.
Nominal
Interest
Rate
•
If you thought there was some risk that you might never see your
$1.00,
•
you would add a risk premium.
Interest
Rates
on
Govt.
Securities:
Known as the "Risk
‐
free Rate" = Real rate
+
E
(inflation over life of security)
Interest
Rates
on
Govt.
Securities:
When inflation
,
Risk
‐
free interest rates AND Nominal interest rates
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? 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
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
Recent
Snapshot:
•
October
4,
US Treasury 3 yr. Note rate = 5.97% 36 mo. New Car, Bank of America = 11.70% risk premium = 5.73%
More
Recent
Snap
Shot
•
May
15,
US Treasury 3 yr. Note rate = 2.78% 36 mo. New Car, Bank of America = 10.25% risk premium = 7.47%
MONETARY
POLICY
Federal Reserve can or the money supply in order to change the level of output and prices (Monetary Policy).
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.
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
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.