CHAPTER 36 Interest Rates and Monetary Policy Some newspaper commentators have stated


Interest Rates and Monetary Policy

Some newspaper commentators have stated that the chair of the Federal Reserve Board (Jerome Powell in 2019) is the second most powerful person in the United States, after the U.S. president. That statement is an exaggeration. But there is no doubt about the chair’s influence, nor about the importance of the Federal Reserve and the monetary policy that it conducts. Such policy consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy. The goal of monetary policy is to achieve and maintain price-level stability, full employment, and economic growth. The chair has some big responsibilities!

monetary policy A central bank’s changing of the money supply to influence interest rates and assist the economy in achieving price-level stability, full employment, and economic growth.


Interest Rates

> > LO36.1 Explain how the equilibrium interest rate is determined.

The Fed influences the economy in normal economic times primarily through its ability to change the money supply (M1 and M2) and therefore affect interest rates. Interest is the price paid for the use of money. It is also the price that borrowers must pay lenders for transferring purchasing power to the future, and it is the price that borrowers must pay to use $1 for 1 year. Although there are many different interest rates, we will simply speak of the interest rate unless we state otherwise.

interest The payment made for the use of (borrowed) money.

Let’s see how the interest rate is determined. Because it is a price, we again turn to demand-and-supply analysis for the answer.

The Demand for Money

The public wants to hold some of its wealth as money for two main reasons:

To facilitate purchases (transactions).

To hold as an asset (store of value).

These two sources of money demand are named, respectively, the transactions demand for money and the asset demand for money. Let’s discuss them in sequence.

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Transactions Demand, Dt The first reason people hold money is because it is convenient for purchasing goods and services. Households usually are paid once a week, every 2 weeks, or monthly, but their expenditures are less predictable and typically more frequent. Thus households must have enough money on hand to buy groceries and pay mortgage and utility bills. Businesses, too, need to have money available to pay for labor, materials, and other inputs. The demand for money as a medium of exchange is called the transactions demand for money.

transactions demand for money The amount of money people want to hold for use as a medium of exchange (to make payments); varies directly with nominal GDP.

Nominal GDP is the main determinant of the amount of money demanded for transactions. The larger the total money value of all the goods, services, and resources exchanged in the economy, the larger the amount of money needed to facilitate those transactions. The transactions demand for money varies directly with nominal GDP. We specify nominal GDP because households and firms will want more money for transactions if prices rise or if real output increases. In both instances a larger dollar volume is needed to accomplish the desired transactions.

In Figure 36.1a (Key Graph), we graph the quantity of money demanded for transactions against the interest rate. For simplicity, we assume that the quantity demanded depends exclusively on nominal GDP and is therefore independent of the interest rate. Our simplifying assumption allows us to graph the transactions demand, Dt, as a vertical line. This demand curve is positioned at $100 billion, on the assumption that nominal GDP is $300 billion and each dollar held for transactions purposes is spent an average of three times per year. Thus the public needs $100 billion (= $300 billion/3) to purchase that amount of nominal GDP.

Asset Demand, Da The second reason for holding money derives from money’s function as a store of value. People may hold their wealth either in tangible assets like real estate or in a variety of financial assets, including stocks, bonds, and money. To the extent they want to hold money as an asset, there is an asset demand for money.

asset demand for money The amount of money people want to hold as a store of value; this amount varies inversely with the interest rate.

To understand why people have an asset demand for money, you must compare money with other financial assets, such as bonds. Bonds make regular, substantial interest payments, while money earns either zero interest (currency) or extremely low interest (checking account deposits). Thus, from that perspective, bonds are a more attractive financial asset.

But that’s not the end of the story. Bonds, stocks, and other financial assets are also much riskier than money. Bond prices, for example, sometimes fall, generating capital losses for their owners. By contrast, the value of money is quite steady unless there is a hyperinflation. So while money pays zero interest, it also holds its value much better than bonds and other financial assets under normal circumstances. This gives people a reason to demand money as an asset.

A third reason that people demand money as an asset is because money can be used to immediately purchase other assets when opportunities arise. Money will hold its value when the stock market crashes 20 percent; so anyone holding money can jump in and buy stocks at low, post-crash prices. The only way to “buy the dips” is to have money on hand when the prices of other assets decline.

Knowing these advantages and disadvantages, the public must decide how much of its financial assets to hold as money. Their decision depends primarily on the interest rate. When a household or business holds money, it incurs the opportunity cost of the interest it could have received if it had used that money to purchase bonds. If bonds pay 6 percent interest, for example, then holding $100 as cash or in a noninterest checking account would cost $6 per year of forgone income.

The amount of money demanded as an asset therefore varies inversely with the interest rate (which is the opportunity cost of holding money as an asset). When the interest rate rises, being liquid and avoiding capital losses becomes more costly. So the public reacts by reducing its holdings of money as an asset. By contrast, when the interest rate falls, the cost of being liquid and avoiding capital losses declines. The public therefore increases the amount of financial assets that it wants to hold as money. This inverse relationship just described is shown by Da in Figure 36.1b.

Total Money Demand, Dm As Figure 36.1 shows, we find the total demand for money, Dm, by horizontally adding the asset demand for money to the transactions demand for money. The result is the downward sloping line in Figure 36.1c, which represents the total amount of money the public wants to hold, both for transactions and as an asset, at each possible interest rate.

total demand for money The sum of the transactions demand for money and the asset demand for money.

Recall that the transactions demand for money depends on nominal GDP. A change in nominal GDP will, consequently, shift the total demand for money curve Dm by altering the transactions demand for money. Consider an increase in nominal GDP. That will increase the transactions Page 705demand for money, and that extra transactions demand will shift the total money demand curve to the right. In contrast, a decline in nominal GDP shifts the total money demand curve to the left. As an example, suppose nominal GDP increases from $300 billion to $450 billion, and the average dollar held for transactions is still spent three times per year. Then the transactions demand curve will shift from $100 billion (= $300 billion/3) to $150 billion (= $450 billion/3). The total money demand curve will then lie $50 billion farther to the right at each possible interest rate.

The Equilibrium Interest Rate

We can combine the demand for money with the supply of money to determine the equilibrium interest rate. In Figure 36.1c, the vertical line, Sm, represents the money supply. It is a vertical line because the monetary authorities and financial institutions have provided the economy with some particular stock of money. Here, it is $200 billion.

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Just as in a product market or a resource market, the intersection of demand and supply determines the equilibrium price in the market for money. In Figure 36.1, this equilibrium price is the equilibrium interest rate, ie. At this interest rate, the quantity of money demanded (= $200 billion) equals the quantity of money supplied (= $200 billion).

As you have just seen, changes in the demand for money, the supply of money, or both can change the equilibrium interest rate. We are, however, most interested in changes in the money supply since the Fed can affect the money supply. To that end, please remember this important generalization: An increase in the money supply will lower the equilibrium interest rate, while a decrease in the money supply will raise the equilibrium interest rate.

Interest Rates and Bond Prices

Interest rates and bond prices are inversely related. When the interest rate increases, bond prices fall; when the interest rate decreases, bond prices rise. Why? First understand that bonds are bought and sold in financial markets, with the price of bonds being determined by the interaction of bond demand with bond supply.

Suppose that a bond with no expiration date pays a fixed $50 annual interest payment and is selling for its face value of $1,000. The interest yield on this bond is 5 percent:

Now suppose that the interest rate in the economy rises to 7½ percent from 5 percent. Newly issued bonds will pay $75 per $1,000 loaned. Older bonds paying only $50 will not be sellable at their $1,000 face value. To compete with the 7½ percent bond, the price of those older bonds must fall to $667 to remain competitive. The $50 fixed annual interest payment will then yield 7½ percent to whoever buys the bond:

Next, suppose that the interest rate falls to 2½ percent from the original 5 percent. Newly issued bonds will pay $25 on $1,000 loaned. A bond paying $50 will be highly attractive. Bond buyers will bid up its price to $2,000, where the yield will equal 2½ percent:

These three examples demonstrate that bond prices fall when the interest rate rises and rise when the interest rate falls. There is an inverse relationship between the interest rate and bond prices.

Another way of understanding why bond prices and interest rates move in opposite directions is to look back at the three examples and notice that the annual payment is always fixed at $50. So the more you pay for the right to receive that $50 payment, the lower your rate of return (yield). Here are a few other examples to drive the point home.

Pay $100 for the bond, and your rate of return is 50 percent (= $50/$100 × 100)

Pay $500 for the bond, and your rate of return is 10 percent (= $50/$500 × 100)

Pay $5,000 for the bond, and your rate of return is 1 percent (= $50/$5,000 × 100)

The more you pay today for a fixed future amount, the lower your percentage return. Test yourself by calculating what the yield would be on this bond at a price of $900 and at a price of $1,250. Verify that the higher price generates a lower yield.

The Consolidated Balance Sheet of the Federal Reserve Banks

> > LO36.2 List and explain the items in the Fed’s balance sheet.

With this basic understanding of the interest rate, we can turn to monetary policy, which relies on changes in the interest rate to be effective. The 12 Federal Reserve Banks together constitute the U.S. “central bank,” nicknamed the “Fed.” (Global Perspective 36.1 lists some of the world’s other central banks, along with their nicknames.)

The Fed’s balance sheet helps us consider how the Fed conducts monetary policy. Table 36.1 consolidates the pertinent assets and liabilities of the 12 Federal Reserve Banks as of February 28, 2019. You will see that some of the Fed’s assets and liabilities differ from those found on a commercial bank’s balance sheet.


The Fed’s two main assets are securities and loans to commercial banks. (Again, we simplify by referring only to commercial banks, even though the analysis also applies to thrifts—savings and loans, mutual savings banks, and credit unions.)

Securities The $3.8 trillion of securities shown in Table 36.1 are bonds that the Federal Reserve Banks have purchased. The majority consists of $2.1 trillion worth of Treasury bills (short-term securities), Treasury notes (mid-term securities), and Treasury bonds (long-term securities) issued by the U.S. government to finance past budget deficits. These securities are part of the public debt—the money owed by the federal government. The Federal Reserve Banks bought these securities from commercial banks and the public through open-market operations. Although they are an important source of interest income to the Federal Reserve Banks, they are mainly bought and sold to influence the size of commercial bank reserves and, therefore, those banks’ ability to create money by lending. The Fed’s securities holdings also include $1.6 trillion of mortgage-backed securities purchased during and after the mortgage-debt crisis to bail out mortgage lenders.

Loans to Commercial Banks Commercial banks occasionally borrow from Federal Reserve Banks. The IOUs that commercial banks give these “bankers’ banks” in return for loans are listed on the Federal’s balance sheet as “Loans to commercial banks.” They are assets to the Fed because they are claims against the commercial banks. To commercial banks, these loans are liabilities that must be repaid. Through borrowing in this way, commercial banks can increase their reserves.


On the “liabilities and net worth” side of the Fed’s consolidated balance sheet, three entries are noteworthy: reserves, Treasury deposits, and Federal Reserve Notes.

Reserves of Commercial Banks The Fed requires that commercial banks hold reserves against their checkable deposits. The Fed pays interest on these required reserves and also on the excess reserves that banks choose to hold at the Fed. The financial crisis of 2007–2009 and the subsequent slow recovery prompted a massive increase in bank reserves, as banks rushed to keep large reserves as a way of maintaining trust with the public. Reserves at the Fed skyrocketed nearly 2,000-fold, from just $1.5 billion at the start of 2007 to $2.7 trillion in the summer of 2014. They then fell gradually to $1.6 trillion in early 2019, as indicated in Table 36.1.

Commercial bank reserves are listed as a liability on the Fed’s balance sheet. But they are assets on the books of the commercial banks, which still own them even though they are on deposit at the Federal Reserve Banks.

Treasury Deposits The U.S. Treasury keeps deposits in the Federal Reserve Banks and draws checks on them to pay its obligations. To the Treasury, these deposits are assets; to the Federal Reserve Banks, they are liabilities. The Treasury creates and replenishes these deposits by depositing tax receipts and money borrowed through the sale of bonds.

Federal Reserve Notes Outstanding As we have seen, the supply of paper money in the United States consists of Federal Reserve Notes issued by the Federal Reserve Banks. When this money is circulating outside the Federal Reserve Banks, it constitutes a claim against the assets of the Federal Reserve Banks. The Fed thus treats these notes as a liability.

Tools of Monetary Policy

> > LO36.3 Explain the goals and tools of monetary policy.

We can now explore how the Fed can influence the money-creating abilities of the commercial banking system. The Fed has four main tools of monetary control that it can use to alter the reserves of commercial banks, and thus their ability to make new loans.

Open-Market Operations

Bond markets are “open” to all buyers and sellers of corporate and government bonds (securities). The Federal Reserve is the largest single holder of U.S. government securities. The U.S. government, not the Fed, issued these Treasury bills, notes, and bonds to finance past budget deficits. Over the decades, the Fed has purchased these securities from major financial institutions that buy and sell government and corporate securities for themselves and for their customers.

The Fed’s open-market operations consist of bond market transactions in which the Fed either (1) buys or sells government bonds (U.S. securities) outright, or (2) utilizes government bonds as collateral on loans of money. Until the mortgage debt crisis of 2008, the Fed’s open-market operations consisted solely of outright purchases and sales of government bonds. But in recent years it has added repos and reverse repos (loans collateralized with government bonds) to its arsenal of open-market operations.

open-market operations The purchases and sales of U.S. government securities that the Federal Reserve System undertakes in order to influence interest rates and the money supply; one method by which the Federal Reserve implements monetary policy.

The conduit for the Fed’s open-market operations is the trading desk of the New York Federal Reserve Bank. When the Fed buys or sells government bonds, the trading desk at the New York Fed interacts exclusively with a group of 23 large financial firms called “primary dealers.” Most are major investment banks such as JPMorgan Chase and Goldman Sachs. When the Fed borrows or lends Page 709money via repos and reverse repos, the trading desk at the New York Fed interacts with 61 major financial institutions that include major banks, investment management companies, and government-sponsored financial entities such as the Federal National Mortgage Association (Fannie Mae).

Buying Securities Suppose that the Fed decides to have the Federal Reserve Banks buy government bonds. They can purchase these bonds either from commercial banks or from the public. In both cases, the commercial banks’ reserves will increase.

From Commercial Banks When Federal Reserve Banks buy government bonds from commercial banks,

(a) The commercial banks give up part of their holdings of securities (the government bonds) to the Federal Reserve Banks.

(b) The Federal Reserve Banks, in paying for these securities, place newly created reserves in the commercial banks’ accounts at the Fed. (These reserves are created “out of thin air,” so to speak.) The commercial banks’ reserves go up by the amount of the purchase of the securities.

We indicate these outcomes as (a) and (b) on the following consolidated balance sheets of the commercial banks and the Federal Reserve Banks:

The upward arrow shows that securities have moved from the commercial banks to the Federal Reserve Banks. So we enter “− Securities” (minus securities) in the asset column of the commercial banks’ balance sheet. For the same reason, we enter “+ Securities” in the asset column of the Federal Reserve Banks’ balance sheet.

The downward arrow indicates that the Federal Reserve Banks have provided reserves to the commercial banks. So we enter “+ Reserves” in the asset column of the commercial banks’ balance sheet. In the liability column of the Federal Reserve Banks’ balance sheet, the plus sign indicates that although commercial bank reserves have increased, they are a liability to the Federal Reserve Banks because the reserves are owned by the commercial banks.

What is the most important result of this transaction? When Federal Reserve Banks purchase securities from commercial banks, they increase the reserves in the banking system, which then increases the lending ability of the commercial banks.

From the Public The effect on commercial bank reserves is much the same when Federal Reserve Banks purchase securities from the general public through the primary dealers. Suppose the Gristly Meat Packing Company has government bonds that it sells in the open market to the Federal Reserve Banks. The transaction has three elements:

(a) Gristly gives up securities to the Federal Reserve Banks. It receives payment in the form of a check drawn by the Federal Reserve Banks on themselves.

(b) Gristly promptly deposits the check in its account with the Wahoo bank.

(c) The Wahoo bank sends this check against the Federal Reserve Banks to a Federal Reserve Bank for collection. As a result, the Wahoo bank sees an increase in its reserves.

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Two aspects of this transaction are particularly important. First, as with Federal Reserve purchases of securities directly from commercial banks, the purchase of securities from the public increases the lending ability of the commercial banking system. So whether the Fed buys bonds from the public or from commercial banks, the result is the same: When the Fed buys securities in the open market, commercial bank reserves are increased. Second, the Federal Reserve Banks’ purchase of government bonds directly increases the money supply. This direct increase in the money supply takes the form of an increased amount of checkable deposits in the economy as a result of Gristly’s deposit.

Note, however, that the eventual total increase in the money supply can be much larger than the initial direct increase in bank reserves caused by the Fed’s bond purchase from Gristly. If the monetary multiplier discussed in the previous chapter is 5, then a $1,000 purchase of bonds by the Federal Reserve results in a potential of $5,000 of additional money as the result of successive rounds of lending in the banking system. This multiplier effect gives open-market operations a lot of “leverage.” A modest change in reserves caused by Fed purchases or sales of government bonds can generate a much larger change in the overall money supply once the monetary multiplier kicks in.

Selling Securities When the Federal Reserve Banks sell government bonds, commercial banks’ reserves are reduced. Let’s see why.

To Commercial Banks When the Federal Reserve Banks sell securities in the open market to commercial banks,

(a) The Federal Reserve Banks give up securities that the commercial banks acquire.

(b) The commercial banks pay for those securities by drawing checks against their deposits—that is, against their reserves—in Federal Reserve Banks. The Fed collects on those checks by reducing the commercial banks’ reserves accordingly.

The balance-sheet changes—again identified by (a) and (b)—appear in the following balance sheets. The reduction in commercial bank reserves is indicated by the minus sign before the appropriate entry on the Fed’s balance sheet. Also notice the offsetting minus and plus entries for securities on, respectively, the Fed’s balance sheet and the Commercial Banks’ balance sheet.

To the Public When the Federal Reserve Banks sell securities to the public, the outcome is much the same. Let’s put the Gristly Company on the buying end of government bonds sold by the Federal Reserve Banks:

(a) The Federal Reserve Banks sell government bonds to Gristly, which pays with a check drawn on the Wahoo bank.

(b) The Federal Reserve Banks clear this check against the Wahoo bank by reducing Wahoo’s reserves.

(c) The Wahoo bank returns the canceled check to Gristly, reducing Gristly’s checkable deposit accordingly.

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Whether the Federal Reserve Banks sell bonds to the public or to commercial banks, the result is the same: When the Fed sells securities in the open market, commercial bank reserves are reduced. If all excess reserves have already been lent out, this decline in commercial bank reserves will decrease the nation’s money supply by a multiple amount due to the monetary multiplier working in reverse. If the monetary multiplier is 5, then a $1,000 sale of government securities will result in a $5,000 decline in the money supply. And that is true regardless of whether the sale is made to commercial banks or to a member of the general public.

What makes commercial banks and the public willing to sell government securities to, or buy them from, Federal Reserve Banks? The answer lies in the price of bonds and their interest yields. We know that bond prices and interest rates are inversely related. When the Fed buys government bonds, the demand for them increases. Government bond prices rise, and their interest yields decline. The higher bond prices and their lower interest yields prompt banks, securities firms, and individual holders of government bonds to sell them to the Federal Reserve Banks.

When the Fed sells government bonds, the additional supply of bonds in the bond market lowers bond prices and raises their interest yields, making government bonds attractive purchases for banks and the public.

Repos and Reverse Repos In addition to bond purchases and sales, the Fed can also alter the supply of money through collateralized loans known as repos and reverse repos.

A money loan is said to be collateralized when an asset (referred to as collateral) is pledged by the borrower to the lender in order to reduce the financial harm that will be suffered by the lender if the borrower fails to repay the loan. As an example, consider home mortgages. If Paul takes out a home mortgage loan, the home that he is buying will serve as collateral for his home mortgage loan. If Paul fails to repay the loan, ownership of the home will pass to the lender, who can then sell the home on the open market to get back most or all of the money that it lent to Paul.

collateral The pledge of specific assets by a borrower to a lender with the understanding that the lender will get to keep the assets if the borrower fails to repay the loan with cash.

Repos and reverse repos are short-hand names for, respectively, repurchase agreements and reverse repurchase agreements.

When the Fed undertakes a repo transaction, it makes a loan of money in exchange for government bonds being posted as collateral. The Fed’s repo loans are normally overnight loans but can last as long as 65 business days. The Fed holds the bonds posted as collateral until the loan is either repaid or goes into default. If the money is repaid on time, the Fed returns the bonds to the borrower. If the money is not repaid on time, the Fed keeps the bonds.

Reverse repo transactions are repos in reverse. Instead of the Fed lending money against bond collateral, it is the Fed that posts government bonds as collateral when borrowing money from financial institutions.

repo A repurchase agreement (or “repo”) is a short-term money loan made by a lender to a borrower that is collateralized with bonds pledged by the borrower. The name repo refers to how the lender would view the transaction. The same transaction when viewed from the perspective of the borrower would be called a reverse repo.

reverse repo A reverse repurchase agreement (or “reverse repo”) is a short-term money loan that the borrower obtains by pledging bonds as collateral. The name reverse repo refers to how the borrower would view the transaction. The same transaction when viewed by the lender would be called a repo.

The key point is that repos involve the Fed lending money into the financial system whereas reverse repos involve the Fed borrowing money out of the financial system. That means that repos are like open-market purchases of bonds (because both increase the money supply) while reverse repos are like open-market sales of bonds (because both decrease the money supply).

The Reserve Ratio

The Fed can also manipulate the reserve ratio in order to influence the lending ability of commercial banks. Suppose a commercial bank’s balance sheet shows that reserves are $5,000 and checkable deposits are $20,000. If the legal reserve ratio is 20 percent (row 2, Table 36.2), the bank’s required reserves are $4,000. Because actual reserves are $5,000, this bank’s excess reserves are $1,000.

reserve ratio The fraction of checkable deposits that each commercial bank or thrift institution must hold as reserves at its local Federal Reserve Bank or in its own bank vault; also called the reserve requirement.

On the basis of $1,000 of excess reserves, this one bank can lend $1,000; however, as we saw in the previous chapter, the banking system as a whole can create a maximum of $5,000 of new checkable-deposit money over multiple rounds of lending when the reserve ratio is 20 percent (column 7). That’s because the size of the monetary multiplier is equal to 1 divided by the reserve ratio expressed in decimal form. Here in row 2, where the reserve ratio is 20 percent, that implies a monetary multiplier of 5 (=1/0.20). Thus, $1,000 of excess reserves at this one bank can grow into $5,000 (= 5 times $1,000) of money systemwide.

Raising the Reserve Ratio Now, what will happen if the Fed raises the reserve ratio from 20 to 25 percent? (See row 3.) Required reserves will jump from $4,000 to $5,000, shrinking excess reserves at this particular commercial bank from $1,000 to zero. The bank’s lending ability falls to zero.

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We can generalize from this example. Raising the reserve ratio increases the amount of required reserves that banks are required to hold at the Fed. As a consequence, excess reserves will either shrink to a smaller positive amount, or shrink so far that banks will find themselves holding less reserves than are needed to meet the increased reserve requirement. The first scenario diminishes banks’ ability to create money by lending. The second scenario will force banks to shrink checkable deposits and therefore the money supply. In the example in Table 36.2, excess reserves are transformed into required reserves, and our single bank’s money-creating potential declines from $1,000 to zero (column 6). Moreover, the banking system’s money-creating capacity declines from $5,000 to zero (column 7).

What will happen if the Fed increases the reserve requirement to 30 percent? (See row 4.) The commercial bank, to protect itself against the prospect of failing to meet this requirement, will be forced to reduce its checkable deposits and increase its reserves. To reduce its checkable deposits, the bank could let outstanding loans mature and be repaid without extending new credit. To increase reserves, the bank might sell some of its bonds, adding the proceeds to its reserves. Both actions will reduce the money supply.

Lowering the Reserve Ratio What will happen if the Fed lowers the reserve ratio from the original 20 percent to 10 percent? (See row 1.) In this case, required reserves will decline from $4,000 to $2,000, and excess reserves will jump from $1,000 to $3,000. The single bank’s lending (money-creating) ability will increase from $1,000 to $3,000 (column 6), and the banking system’s money-creating potential will expand from $5,000 to $30,000 (column 7). Lowering the reserve ratio transforms required reserves into excess reserves and enhances banks’ ability to create new money by lending.

The examples in Table 36.2 show that a change in the reserve ratio affects the money-creating ability of the banking system in two ways:

It changes the amount of excess reserves.

It changes the size of the monetary multiplier.

For example, when the legal reserve ratio rises from 10 percent to 20 percent, excess reserves decline from $3,000 to $1,000, and the checkable-deposit multiplier decreases from 10 to 5. The money-creating potential of the banking system declines from $30,000 (= $3,000 × 10) to $5,000 (= $1,000 × 5). Raising the reserve ratio forces banks to reduce the amount of checkable deposits they create through lending.

The Discount Rate

Recall that a central bank is a “lender of last resort.” Occasionally, commercial banks have unexpected and immediate needs for additional funds. In such cases, each Federal Reserve Bank will make short-term loans to commercial banks in its district.

When a commercial bank borrows, it gives its local Federal Reserve Bank a promissory note (IOU) drawn against itself and secured by acceptable collateral—typically U.S. government securities. Just as commercial banks charge interest on the loans they make to their clients, so, too, do Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest rate they charge is called the discount rate.

discount rate The interest rate that the Federal Reserve Banks charge on the loans they make to commercial banks and thrift institutions.

As a claim against the commercial bank, the borrowing bank’s promissory note is an asset to the lending Federal Reserve Bank and appears on its balance sheet as “Loans to commercial banks.” Page 713To the commercial bank, the IOU is a liability, appearing as “Loans from the Federal Reserve Banks” on the commercial bank’s balance sheet. [See the two (a) entries on the following balance sheets.]

In providing the loan, the Federal Reserve Bank increases the reserves of the borrowing commercial bank. Since no required reserves need be kept against loans from Federal Reserve Banks, all new reserves acquired by borrowing from Federal Reserve Banks are excess reserves. [These changes are reflected in the two (b) entries on the balance sheets.]

From the commercial banks’ point of view, the discount rate is a cost of acquiring reserves. This fact allows the Fed to alter the discount rate at its discretion in order to incentivize banks to increase or decrease their reserves and thereby increase or decrease the money supply.

A decrease of the discount rate encourages commercial banks to obtain additional reserves by borrowing from Federal Reserve Banks. When commercial banks lend any of these new reserves, the money supply will increase.

An increase of the discount rate discourages commercial banks from obtaining additional reserves by borrowing from the Federal Reserve Banks. Thus the Fed may raise the discount rate when it wants to restrict the money supply.

Interest on Reserves

In 2008, federal law was changed to allow the Federal Reserve to pay interest on the reserves that commercial banks hold at the Fed. Before then, any reserves held on deposit at the Federal Reserve Banks received zero interest. Thus, before 2008, banks had an incentive to keep their reserves as small as possible because any money kept on reserve at the Fed earned a zero percent rate of return.

The new law allowed the Fed to set positive (above zero) interest rates for both required reserves and excess reserves. These interest rates are known, respectively, as interest on required reserves (IORR) and interest on excess reserves (IOER). In practice, however, the IORR rate and the IOER rate have been set at equal values, first at 0.25 percent per year from 2008 through December 2015, and then at successively higher rates as the economy returned to full employment after the Great Recession. In April 2019, both rates were 2.4 percent.

interest on excess reserves (IOER) Interest rate paid by the Federal Reserve on bank excess reserves.

The ability to pay interest on reserves gave the Fed a fourth policy tool by which it can implement monetary policy and either increase or decrease the amount of monetary stimulus in the economy. For example, suppose that the Fed wishes to reduce the amount of bank lending and, consequently, the amount of money circulating in the economy. It can do so by increasing the IOER rate of interest that it pays on excess reserves held at the Fed. The higher the IOER rate, the more incentive banks will have to reduce their risky commercial lending for car, mortgage, and business loans in order to increase their excess reserves and thereby earn the risk-free IOER rate.

By contrast, if the Fed wishes to increase the amount of money that banks lend into the economy, the Fed can lower the interest rate that it pays on excess reserves. The lower rate will make it Page 714less attractive for banks to keep reserves, and, consequently, banks will have a greater incentive to increase consumer and commercial lending and thereby stimulate the economy.

During 2018, the interest rate on excess reserves averaged 1.9 percent and banks held about $1.8 trillion in excess reserves at the Fed. So the Fed paid banks a total of about $34.2 billion (= 0.019 × $2.5 trillion) in interest on excess reserves that year.

Relative Importance

Open-market operations are the most important of the four monetary policy tools because they give the Fed the ability to proactively alter the money supply in a way that will have immediate effects on the economy. The Fed can purchase, sell, borrow, or lend government securities in large or small amounts—and the impact on banks’ reserves is immediate. By contrast, if the Fed lowers the discount rate, banks may or may not come forward to take advantage of it; there may be be little to no change in bank reserves.

Changing the reserve ratio has similar problems. If there are plentiful excess reserves in the banking system, as there have been since the Great Recession, then changes in the required reserve ratio may have zero effect on lending because even a doubling of the reserve ratio (from the current level of 10 percent to 20 percent) would leave banks with excess reserves and, thus, no strong incentive to reduce lending.

The Fed has, however, shown an eagerness in recent years to alter the rate of interest on excess reserves (IOER) as a way of managing bank reserves and the supply of money. After the Great Recession of 2007–2009, the amount of excess reserves in the U.S. banking system peaked at $2.7 trillion in 2014, just as the economy was returning to normalcy. As the unemployment rate fell below 5 percent 2016 and then under 4 percent in 2018, banks had a choice of keeping excess reserves parked at the Fed or lending them into an economy experiencing increasingly robust growth and a strong demand for loans. By gradually raising the IOER rate from 0.25 percent in January of 2015 to 2.4 percent in April of 2019, the Fed was able to slow the rate at which bank lending was increasing (because a higher IOER rate increased the opportunity cost of making new loans). That control, in conjunction with open-market operations, gave the Fed the ability to manage the money supply as it pursued noninflationary increases in real GDP.

Fed Targets and the Taylor Rule

> > LO36.4 Define the Fed’s dual mandate and explain the logic behind the Taylor rule.

Now that you understand the four monetary policy tools, it’s time to study how and when the Fed uses them. The Fed’s overall goal is to comply with the dual mandate given to it by Congress in 1977. The dual mandate states that the Fed’s two highest objectives should be full employment and stable prices. To that end, the Fed has set itself two concrete targets that it pursues simultaneously:

Achieving the full-employment rate of unemployment, which is currently around 4 to 5 percent.

Achieving the Fed’s target rate of inflation, which is currently set at 2 percent per year.

dual mandate The 1977 congressional directive that the Federal Reserve System’s highest priorities should be full employment and price level stability. In practice, the Fed aims for the full-employment rate of unemployment and an inflation rate of 2 percent per year.

full-employment rate of unemployment The unemployment rate at which there is no cyclical unemployment of the labor force; equal to between 4 & 5 percent (rather than zero percent) in the United States because frictional and structural unemployment are unavoidable.

target rate of inflation The publicly announced annual inflation rate that a central bank attempts to achieve through monetary policy actions if it is following an inflation targeting monetary policy.

The Fed’s Unemployment Target

The full-employment rate of unemployment, or natural rate of unemployment, is the unemployment rate that exists in an economy when it is producing at potential output (full employment). Every person who wants a job is employed, so that there is zero cyclical unemployment. Structural and frictional unemployment do remain, however, as there will still be some people either between jobs (frictional unemployment) or in need of retraining after their old jobs were eliminated due to changes in consumer preferences, evolving production technologies, or offshoring (structural unemployment). Thus, the full-employment rate of unemployment is not zero, but rather a modest positive number that reflects frictional and structural unemployment.

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The full-employment rate of unemployment also reflects changes in government industrial policy and labor force regulations, the size of labor force growth relative to the growth rate of the demand for labor, and a wide variety of other factors that affect how much labor is necessary to produce the full-employment level of output, how much labor is available to produce it, and how quickly the frictionally and structurally unemployed return to work. These factors change over time, thereby causing the full-employment rate of unemployment to change over time, too.

For today’s economy, the full-employment rate of unemployment is estimated to lie somewhere between 4 and 5 percent. In March 2019, the median estimate made by Federal Reserve board members and Federal Reserve Bank presidents was 4.3 percent. In practice, this estimate serves as the FOMC’s target rate of unemployment:

If the actual unemployment rate rises appreciably higher than 4.3 percent (say, to 5.0 or 5.5 percent) the Fed will be inclined, other things equal, toward assuming that the economy is decelerating and consequently in need of an expansionary monetary policy (or easy money policy) under which the Fed would (a) increase bank reserves to boost lending and (b) lower interest rates to increase investment spending.

Contrariwise, if the actual unemployment rate falls much below below 4.3 percent (say, to less than 3.8 or 3.5 percent), the Fed will be inclined, other things equal, toward assuming that the economy is in danger of a burst of inflation as firms bid up resource prices in an attempt to produce more than the full-employment level of output. That presumption will suggest a restrictive monetary policy (or tight money policy) under which the Fed would (a) decrease bank reserves to reduce lending and (b) raise interest rates to decrease investment spending.

target rate of unemployment The Fed’s desired unemployment rate, equal to the full-employment rate of unemployment, which is estimated to be between 4 and 5 percent for the U.S. economy.

expansionary monetary policy Federal Reserve System actions to increase the money supply, lower interest rates, and expand real GDP; an easy money policy.

restrictive monetary policy Federal Reserve System actions to reduce the money supply, increase interest rates, and reduce inflation; a tight money policy.

The Fed’s Inflation Target

The unemployment rate cannot by itself determine whether monetary policy should be expansionary, restrictive, or neutral. The Fed must also consider whether inflation is above or below the Fed’s target rate of inflation, which has been set at 2 percent since it was first established in 2012.

Why 2 Percent? There are several reasons why 2 percent was selected as the Fed’s inflation target, rather than, say, 10 percent or zero percent.

Compensating for Upward Measurement Bias There is a consensus among economists that the Consumer Price Index and other measures of inflation have an upward bias, meaning that they tend to say that inflation is higher than it actually is.

The upward bias in inflation measurement is estimated to be around half a percent, or 0.5 percent. That fact implies that it would be dangerous for the Fed to have an inflation target of less than 0.5 percent. To see why, imagine that the Fed sets an inflation target of zero and then uses contractionary monetary policy to guide measured inflation down to that target rate. In that situation, the fact that measured inflation has a 0.5 percent upward bias will imply that actual (unbiased) inflation will be about a half a percent lower, or negative 0.5 percent. That is deeply problematic because deflations usually only happen if the economy is in a severe recession, like the Great Depression of the 1930s or the Great Recession of 2007–2009. Thus, to avoid accidentally putting the economy into a recession by conducting an overly contractionary monetary policy, the Fed must set an inflation target of at least positive 0.5 percent.

Protecting Savers On the other hand, the Fed does not want to set too high an inflation target because it will want to avoid any substantial loss of purchasing power on the part of fixed-income receivers, savers, and creditors who fail to anticipate it. An inflation rate of 10 percent or even 5 percent would cause noticeable harm to those who are caught unaware. It is also the case that individuals and businesses begin to complain about inflation when it reaches 4 or 5 percent per year. Knowing these facts, the Fed has opted for a 2 percent inflation target as a way of balancing the need to have a target greater than 0.5 percent with the need to not let inflation get uncomfortably high.

Assisting Downward Wage Flexibility A low but positive rate of inflation also helps to overcome the downward inflexibility of real wages by giving firms the ability to lower real wages by simply keeping nominal wages fixed as the 2 percent rate of inflation chips away at their purchasing power. This matters because it is the real wage that determines real labor costs and the willingness of employers to hire additional employees. By making it easier for real wages to decline, the Fed makes it more Page 716likely that when a recession strikes and millions are unemployed, real wages can adjust downward and thereby increase the number of workers that firms want to hire. (See Chapter 29 for the details.)

Avoiding the Zero Lower Bound A target rate of 2 percent should also help the Fed avoid the zero lower bound problem, in which any nominal interest rate lower than zero will cause people to withdraw money from their checking accounts, thereby reducing reserves in the banking system and putting contractionary pressure on the economy. The 2 percent target rate helps avoid that situation by helping the public form its inflationary expectations. Just as long as the Fed is believed to be credible in its pronouncements, people will believe that it will use its control over the money supply to achieve the 2 percent rate of inflation that it has set as its inflation target. That, in turn, will ensure that nominal interest rates should always be at least 3 or 4 percent.

zero lower bound problem The constraint placed on the ability of a central bank to stimulate the economy through lower interest rates by the fact that nominal interest rates cannot be driven lower than zero without causing depositors to withdraw funds from the banking system and thus reduce the ability of banks to stimulate the economy via lending.

inflationary expectations The public’s forecast about likely future inflation rates; influenceable by central bank policy actions, including a credible target rate of inflation.

We know that should be the case because of the equation presented in Chapter 29 that tells us that the nominal interest rate = real interest rate + expected inflation. If people believe the Fed about its inflation target, then expected inflation on the right-hand side of that equation will be 2 percent. That will mean that the left-hand side, the nominal interest rate, will also have to be at least 2 percent. In fact, it should be even higher by the amount of the real interest rate that lenders demand as compensation for the use of their money. Since that real rate of interest is likely to be at least 1 to 2 percent, the nominal interest rate should be at least 3 or 4 percent, which is high enough that if the economy were to enter into a recession, the Fed would have plenty of room to cut interest rates and stimulate the economy before having to worry about the zero lower bound problem.

Balancing Inflation and Unemployment Other things equal, the Fed will be more inclined toward a restrictive monetary policy if the actual rate of inflation is above the target rate, and more inclined toward an expansionary monetary policy if actual inflation is below the target rate. But it must also consider whether the unemployment rate is above or below the full-employment rate of unemployment. The two parts of the dual mandate must be pursued in tandem.

The Bullseye Chart

To help you visualize how the Fed pursues the dual mandate, consider Figure 36.2, which presents the Federal Reserve Bank of Chicago’s dual-mandate “bullseye chart” as of March 2019. The red dot indicates where the actual unemployment rate and actual inflation rate stood in March 2019. By contrast, the center of the bullseye plots the Fed’s two target rates.

The position of the red dot relative to the center of the bullseye indicates the amounts by which actual unemployment and actual inflation differed from the Fed’s target rates in March 2019. As an exercise, you can look up the current unemployment and inflation rates and plot the spot that represents them. Is your spot close to the center of the bullseye?

Using the Taylor Rule to Aim for the Bullseye

What should the Fed do when actual inflation and actual unemployment differ from the center of the dual-mandate bullseye? It depends on where the red dot lies relative to the center of the bullseye.

Northwest and Southeast: No Conflicts If the red dot that plots actual inflation and unemployment is located to the northwest or southeast of the center of the bullseye, the Fed will have no confusion as to the stance of monetary policy. In those two quadrants, the actual inflation and unemployment rates will both suggest the same policy stance.

Northwest of the Center If the current combination of actual employment and actual inflation is to the northwest of the center of the bullseye (that is, at any point where actual inflation exceeds 2 percent and actual unemployment is less than 4.3 percent), the economy is probably overheating and a restrictive monetary policy is in order. A higher interest rate will reduce aggregate demand, thereby putting downward pressure on prices while simultaneously cooling off the labor market. The actual inflation rate should fall downward, toward the 2 percent inflation target. The actual unemployment rate should rise upward, toward the 4.3 percent estimate of the full-employment rate of unemployment.

Southeast of the Center Now consider the situation for points to the southeast of the center of the bullseye. For those points, actual inflation is less than 2 percent while actual unemployment is higher than 4.3 percent. Any such combination suggests an economy operating below potential output. For these points, an expansionary monetary policy is appropriate. Lower interest rates will stimulate aggregate demand, thereby reducing the unemployment rate down toward the 4.3 percent estimate of Page 717the full-employment rate of unemployment while simultaneously raising the inflation rate up towards the Fed’s 2 percent target.

Southwest and Northeast: Conflicts Things are not so clear-cut for the other two quadrants. As you are about to see, the Fed will not easily know what to do because the inflation rate and unemployment rate will be suggesting opposite policy stances.

Southwest of the Center To the southwest of the center of the bullseye (actual inflation less than 2 percent, actual unemployment less than 4.3 percent), the Fed will be in a policy predicament. The fact that the actual unemployment rate is below the full-employment rate of unemployment will suggest that the Fed should be inclined toward a restrictive monetary policy. But the fact that the inflation rate is below 2 percent suggests that a stimulatory policy is in order.

Northeast of the Center The opposite problem exists in the northeast quadrant (actual inflation greater than 2 percent, actual unemployment higher than 4.3 percent). There, the unemployment rate will be suggesting an expansionary monetary policy (to reduce the unemployment rate down to the 4.3 percent target) while the inflation rate will be suggesting a contractionary monetary policy (to reduce the inflation rate down to 2 percent).

Putting Policy Weights on Inflation and Unemployment Complicating matters even further is the fact that very few policymakers would give equal weight to inflation and unemployment. Indeed, if inflation remains mild there may not be much harm if it exceeds its 2 percent target. By contrast, every bit of cyclical unemployment represents not only personal misery for those left unemployed but also permanently lost output that cannot be recovered. So policymakers will probably be more worried about unemployment than inflation. If so, we need a model of Fed behavior that can capture how monetary policy will be determined when policymakers worry more about unemployment than inflation. Several such models have been developed. The most famous is the Taylor Rule.

The Taylor Rule

The stance of monetary policy is a matter of policy discretion by the members of the FOMC. At each of their meetings, committee members assess whether the current monetary stance—expansionary, contractionary, or neutral—remains appropriate for achieving the twin goals of low inflation and full employment. If the majority of the FOMC members conclude that a change is needed, the FOMC adjusts how it is handling the four monetary policy tools at its disposal.

A rule of thumb suggested by economist John Taylor roughly matches the FOMC’s actual policy decisions during many time periods. It is based on economists’ widely held belief, noted above, that central bankers are willing to tolerate modest positive rates of inflation if doing so will help to generate full employment.

To capture that preference, the Taylor rule takes into account both the Fed’s 2 percent inflation target as well as its 4.3 percent unemployment target by assuming that the two major components of the Fed’s interest-rate targeting decisions will be:

The inflation gap (= current actual inflation rate – 2 percent inflation target)

The unemployment gap (= current actual unemployment rate – 4.3 percent unemployment rate target)

Taylor rule A monetary rule proposed by economist John Taylor that would stipulate exactly how much the Federal Reserve System should change real interest rates in response to divergences of real GDP from potential GDP and divergences of actual rates of inflation from a target rate of inflation.

inflation gap The difference between the current actual rate of inflation and the central bank’s target rate of inflation; a key component of the Taylor Rule.

unemployment gap The difference between the actual rate of unemployment and the full-employment rate of unemployment, which is believed to be between 4 and 5 percent for the U.S. economy.

There are of course many interest rates in the economy, but the one that the Taylor rule assumes the Fed will target is the nominal risk-free interest rate, specifically the interest rate on short-term U.S. government bonds (which are considered almost riskless because the chances of a U.S. government default are virtually zero). By manipulating this interest rate, the Fed can affect all of the other interest rates in the economy, including home mortgage interest rates, credit card interest rates, and the interest rate on small business loans.

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There are several ways to express the Taylor rule mathematically.1 The most intuitive version is:

The real risk-free interest rate is the minimum real rate of return that lenders demand for the use of their money. Based on historical data, the real risk-free interest rate is normally about 2 percent per year. Substituting that value into the Taylor rule gives us:

Predicting Fed Policy with the Taylor Rule We can use the Taylor rule to predict the Fed’s interest rate target and thus whether it will pursue an expansionary monetary policy (to lower interest rates from their current level) or a contractionary monetary policy (to raise interest rates from their current level).

Suppose, for example, that the current actual inflation rate is 3 percent and the current actual unemployment rate is 3.3 percent. Then the inflation gap would be 1 percent (= 3 percent actual inflation −2 percent target inflation) and the unemployment gap would be negative 1 percent (= 3.3 percent actual unemployment rate −4.3 percent target unemployment rate). Substituting those values into our equation, we find that the Fed’s target interest rate will be 6.5 percent [= 2 percent real risk free rate + 3 percent current actual inflation rate + 0.5 × inflation gap of 1 percent − 1.0 × unemployment gap of minus 1 percent].

Similarly, let’s suppose that the Fed is hitting the dual-mandate bullseye dead center. In that case, actual inflation is equal to the target rate of 2 percent and actual unemployment is equal to the target rate of 4.3 percent. Substituting those values into the Taylor rule tells us that when the economy is operating at the Fed’s dual-mandate sweet spot, the Fed will want target an interest rate of 4 percent [= 2 percent real risk free rate + 2 percent current actual inflation rate + 0.5 × inflation gap of zero − 1.0 × unemployment gap of zero].

Favoring the Unemployment Gap over the Inflation Gap Note that in the Taylor rule equation, the coefficient on the inflation gap is 0.5 while the coefficient on the unemployment gap is 1.0. This reflects the fact that policymakers care more about the unemployment gap than they care about the inflation gap. In fact, they are assumed to care twice as much about the unemployment gap because the unemployment gap’s coefficient of 1.0 is twice as large as the inflation gap’s coefficient of 0.5.

This weighting gives us a hint as to how the Fed will deal with situations in which the economy is operating in either the southwest or northeast quadrants of the bullseye chart. Those are the quadrants in which inflation and unemployment give contradictory signals about monetary policy. The Taylor rule’s coefficient weights on the unemployment gap and the inflation gap tell us that the Fed will resolve the contradictory signals by targeting an interest rate that puts twice as much weight on closing the unemployment gap as it does on closing the inflation gap.

A Caveat Please understand that the Fed has no official allegiance to the Taylor rule. It is free to change interest rates however it deems appropriate. Thus, while the Taylor rule has correctly predicted the FOMC’s behavior during some periods, we should not be surprised that Fed policy has diverged from the Taylor rule in other periods, including during and after the financial crisis of 2007–2008.

The Diminished Role of the Federal Funds Rate Also note that the interest rate targeted by the Fed has varied over time. Before the 2007–2009 financial crisis, the Fed exclusively targeted the federal funds rate, which is the interest rate at which banks with excess reserves can lend all or part of their excess reserves (“federal funds”) to banks with deficient reserves.

The Federal Funds Rate Before the Financial Crisis Before the financial crisis, the Fed used open market operations to alter the size of bank reserves. Those changes in bank reserves would then alter the amount of borrowing and lending in the federal funds market, thereby altering the equilibrium federal funds rate.

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Those changes in bank reserves would also cascade through the financial markets, raising or lowering other interest rates, too, including those for home mortgages, car loans, and credit cards. If the federal funds rate went up, so did all those other rates; if the federal funds rate went down, so did all those other rates. Thus, by controlling the federal funds rate, the Fed also controlled whether monetary policy was contractionary, expansionary, or neutral all over the economy.

The Federal Funds Rate After the Financial Crisis Things were very different after the financial crisis. The Fed could no longer target the federal funds rate exclusively because, as we discussed in the previous chapter, the banking system became so awash in reserves that there were no longer any banks that needed to borrow reserves to meet their reserve requirements. The federal funds market (in which the federal funds rate is determined) shriveled, and the federal funds rate became largely irrelevant as an indicator of bank lending and credit creation.

The Fed still sets a target for the federal funds rate. But it currently manages bank reserves and monetary stimulus by raising or lowering the interest rate that it pays on excess reserves, the IOER rate. Other things equal, the higher the IOER rate, the more banks will be satisfied holding money as reserves at the Fed rather than lending it out to business and individuals. So, by adjusting the IEOR rate, the Fed can stimulate or restrict lending, money creation, and interest rates (including the federal funds rate, which now closely tracks the IEOR rate) even though the banking system remains awash in reserves.

Monetary Policy, Real GDP, and the Price Level

> > LO36.5 Explain how monetary policy affects real GDP and the price level.

We have identified and explained the tools of expansionary and contractionary monetary policy. We now want to explain how monetary policy affects investment, aggregate demand, real GDP, and the price level.

Cause-Effect Chain

The four diagrams in Figure 36.3 (Key Graph) will help you understand how monetary policy works toward achieving its goals.

Market for Money Figure 36.3a represents the market for money. It brings together the demand curve for money Dm as well as three supply curves for money: Sm1, Sm2, and Sm3.

Recall from the start of this chapter that the total demand for money is composed of the transactions demand for money plus the asset demand for money. Demand curve Dm represents that sum.

Each of the three money supply curves is represented by a vertical line. That’s because each line represents a different amount of money supply determined by the Fed. Since the Fed can set whatever supply of money it wants independently of the interest rate, each money supply curve plots as a vertical line (indicating that the quantity of money is independent of the interest rate).

The equilibrium interest rate is the rate at which the amount of money demanded equals the amount supplied. If the supply of money is $125 billion (Sm1), the equilibrium interest rate is 10 percent. With a money supply of $150 billion (Sm2), the equilibrium interest rate is 8 percent; with a money supply of $175 billion (Sm3), the equilibrium rate is 6 percent.

You know from Chapter 30 that the real (rather than the nominal) interest rate is critical for investment decisions. So here we assume that Figure 36.3a portrays the real interest rate.

Investment These 10, 8, and 6 percent real interest rates are carried rightward to the investment demand curve in Figure 36.3b. This curve shows the inverse relationship between the interest rate—the cost of borrowing to invest—and the amount of investment spending. At the 10 percent interest rate, it will be profitable for the nation’s businesses to invest $15 billion; at 8 percent, $20 billion; at 6 percent, $25 billion.

Changes in the interest rate mainly affect the investment component of total spending, although they also affect spending on durable consumer goods (such as autos) that are purchased on credit. Changes in the real interest rate greatly affect investment spending because of the large cost and long-term nature of capital purchases. Capital equipment, factory buildings, and warehouses are tremendously expensive. In absolute terms, interest charges on funds borrowed for these purchases are considerable. So the lower the interest rate, the more firms are willing to invest.

Similarly, the interest cost on a house purchased with a home mortgage loan is quite large. A 0.5 percent increase in the interest rate could amount to tens of thousands of dollars over the duration of the loan.

In brief, the impact of changing interest rates is mainly on investment (and, through that, on aggregate demand, output, employment, and the price level). Moreover, as Figure 36.3b shows, investment spending varies inversely with the real interest rate.

Equilibrium GDP Figure 36.3c shows the impact that our three real interest rates (and their corresponding levels of investment spending) have on aggregate demand. Aggregate demand curve AD1 is associated with the $15 billion level of investment spending, AD2 with the $20 billion level of investment spending, and AD3 with $25 billion level of investment spending. Other things equal, higher investment spending shifts the aggregate demand curve to the right.

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Suppose the money supply in Figure 36.3a is $150 billion (Sm2), producing an equilibrium interest rate of 8 percent. In Figure 36.3b we see that this 8 percent interest rate will bring about $20 billion of investment spending. This $20 billion of investment spending joins with consumption spending, net exports, and government spending to yield aggregate demand curve AD2 in Figure 36.3c. The equilibrium levels of real output and prices are Qf = $900 billion and P2, as determined by the intersection of AD2 and the aggregate supply curve AS.

To test your understanding of these relationships, explain why each of the other two levels of money supply in Figure 36.3a results in a different interest rate, level of investment, aggregate demand curve, and equilibrium real output.

Effects of an Expansionary Monetary Policy

Recall that real-world price levels tend to be downwardly inflexible. Thus, with our economy starting from the initial equilibrium where AD2 intersects AS, the price level will be downwardly inflexible at P2 so that aggregate supply will be horizontal for values of real output to the left of Qf. Thus, if aggregate demand decreases, the economy’s equilibrium moves leftward along the dashed horizontal line shown in Figure 36.3c.

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Such a decline would happen if the money supply fell to $125 billion (Sm1), shifting the aggregate demand curve leftward to AD1 in Figure 36.3c. The result is a real output of $880 billion, $20 billion less than the economy’s full-employment output level of $900 billion. The economy will be experiencing recession, a negative GDP gap, and substantial unemployment. The Fed therefore should institute an expansionary monetary policy.

To increase the money supply, the Fed will take some combination of the following actions: (1) buy or borrow (repo) government securities from banks and the public in the open market, (2) lower the legal reserve ratio, (3) lower the discount rate, or (4) reduce the interest rate that it pays on excess reserves. The intended outcome is an increase in bank reserves, which will, in turn, increase bank lending and the money supply. That increase in the money supply will then help to drive down the interest rate, thereby increasing investment, aggregate demand, and equilibrium GDP.

For example, an increase in the money supply from $125 billion to $150 billion (Sm1 to Sm2) reduces the interest rate from 10 to 8 percent in Figure 36.3a, which in turn boosts investment from $15 billion to $20 billion in Figure 36.3b. This $5 billion increase in investment shifts the aggregate demand curve rightward by more than the increase in investment because of the multiplier effect. If the economy’s MPC is 0.75, the multiplier will be 4, meaning that the $5 billion increase in investment shifts the AD curve rightward by $20 billion (= 4 × $5 billion) at each price level. Specifically, aggregate demand shifts from AD1 to AD2, as Figure 36.3c. shows. This rightward shift in the aggregate demand curve along the dashed horizontal line will eliminate the negative GDP gap by increasing GDP from $880 billion to the full-employment GDP of Qf = $900 billion.2

Effects of a Restrictive Monetary Policy

Next we consider restrictive monetary policy. We will use graphs a, b, and d of Figure 36.3 to demonstrate the effects of a restrictive monetary policy. Figure 36.3d represents exactly the same economy as Figure 36.3c but adds some extra curves that relate only to restrictive monetary policy. You should consequently ignore Figure 36.3c as we go through this section.

To see how restrictive monetary policy works, first consider a situation in which the economy moves from operating at a full-employment equilibrium to operating at more than full employment, so that inflation is a problem and restrictive monetary policy is appropriate. Assume that the economy begins at the full-employment equilibrium where AD2 and AS intersect. At this equilibrium, Qf = $900 billion, and the price level is P2.

Next, assume that the money supply expands from $150 billion to $175 billion (Sm3) in Figure 36.3a. The result is an interest rate of 6 percent, investment spending of $25 billion rather than $20 billion, and aggregate demand AD3. As the AD curve shifts to the right from AD2 to AD3 in Figure 36.3d, the economy moves along the upward Page 723sloping AS curve until it reaches an equilibrium at point a, where AD3 intersects AS. At the new equilibrium, the price level has risen to P3 and the equilibrium level of real GDP has increased to $910 billion, indicating an inflationary GDP gap of $10 billion (= $910 billion − $900 billion). Aggregate demand AD3 is excessive relative to the economy’s full-employment level of real output Qf = $900 billion. To rein in spending, the Fed will institute a restrictive monetary policy.

The Federal Reserve Board will direct Federal Reserve Banks to undertake some combination of the following actions: (1) sell or lend (reverse repo) government securities to banks and the public in the open market, (2) increase the legal reserve ratio, (3) increase the discount rate, or (4) increase the interest rate that it pays on excess reserves. The intended outcome is an increase in bank reserves, which will, in turn, decrease bank lending and money creation. That decrease in the money supply will then help to raise the interest rate, thereby decreasing investment, aggregate demand, and equilibrium GDP.

But the Fed must be careful about just how much to decrease the money supply. The problem is that prices are inflexible at price level P3. As a result, the dashed horizontal line to the left of point a in Figure 36.3d becomes relevant, and the Fed cannot simply lower the money supply to Sm2 in Figure 36.3a. If it did that, investment demand would fall to $20 billion in Figure 36.3b, and the AD curve would shift to the left from AD3 back to AD2. But because of inflexible prices, the economy’s equilibrium will move to point c, where AD2 intersects the horizontal dashed line to the left of point a. The economy will enter a recession, with equilibrium output below the full-employment output level Qf = $900 billion.

To achieve full employment, the Fed needs to move the AD curve back only from AD3 to AD4 so that the economy comes to equilibrium at point b. This outcome will require a $10 billion decrease in aggregate demand so that equilibrium output will fall from $910 billion at point a to Qf = $900 billion at point b. The Fed can achieve this shift by setting the supply of money in Figure 36.3a at $162.5 billion. To see how the process works, draw in a vertical money supply curve in Figure 36.3a at $162.5 billion and label it as Sm4. It will be exactly halfway between money supply curves Sm2 and Sm3. Notice that the intersection of Sm4 with the money demand curve Dm results in a 7 percent interest rate. In Figure 36.3b, this 7 percent interest rate results in investment spending of $22.5 billion (halfway between $20 billion and $25 billion). Thus, by setting the money supply at $162.5 billion, the Fed can reduce investment spending by $2.5 billion, lowering it from the $25 billion associated with AD3 down to only $22.5 billion. This decline in investment spending initially shifts the AD curve only $2.5 billion to the left of AD3. But then the multiplier process works its magic. Because the multiplier is 4 in our model, the AD curve ends up moving by a full $10 billion (= 4 × $2.5 billion) to the left, to AD4. This shift moves the economy to equilibrium b, returning output to the full-employment level and eliminating the inflationary GDP gap.3

Column 2 in Table 36.3 summarizes the cause-effect chain of a restrictive money policy.



▸ The Fed engages in an expansionary monetary policy when it increases the money supply to reduce interest rates and increase investment spending and real GDP.

▸ The Fed engages in a restrictive monetary policy when it reduces the money supply to increase interest rates and reduce investment spending and inflation.

▸ When pursuing a restrictive monetary policy, the Fed must be careful to take into account downward price stickiness and its effect on the size of the multiplier.

Monetary Policy: Evaluation and Issues

> > LO36.6 Explain the advantages and shortcomings of monetary policy.

Monetary policy has become the dominant component of U.S. national stabilization policy. It has two key advantages over fiscal policy:

Speed and flexibility.

Isolation from political pressure.

Compared with fiscal policy, monetary policy can be quickly altered. Recall that congressional deliberations may delay the application of fiscal policy for months. In contrast, the FOMC is free to update monetary policy on a daily basis if necessary.

Also, because members of the Board of Governors are appointed and serve 14-year terms, they are relatively isolated from lobbying and need not worry about retaining their popularity with voters. Thus, the Board, more readily than Congress, can engage in politically unpopular policies (such as higher interest rates) that may be necessary for the economy’s long-term health. Moreover, monetary policy is subtler and more politically neutral than fiscal policy. Changes in government spending directly affect the allocation of resources, and changes in taxes can have extensive political ramifications. Because monetary policy works more subtly, it is more politically palatable.

Recent U.S. Monetary Policy

The Fed has been very busy over the last 20 years.

The Mortgage Default Crisis The mortgage default crisis that began during the late summer of 2007 posed a grave threat to the financial system and the economy. The Fed responded with several actions. In August, it lowered the discount rate by half a percentage point. Then, between September 2007 and April 2008, it lowered the target for the federal funds rate from 5.25 percent to 2 percent. The Fed also took a series of extraordinary actions to prevent the failure of key financial firms.

By late 2008, it was clear that the U.S. economy faced a crisis unequaled since the dark days of the Great Depression of the 1930s. The Fed responded with a series of innovative monetary policy initiatives to stimulate GDP and employment.

The Fed began by moving toward a zero interest rate policy, or ZIRP, in December 2008. Under ZIRP, the Fed aimed to keep short-term interest rates near zero to stimulate the economy. It lowered its target for the federal funds rate drastically, down to a targeted range of zero to 0.25 percent. It also acted aggressively as a lender of last resort, purchasing securities from banks and other financial institutions in order to provide them with the liquidity they needed to make timely debt payments and avoid bankruptcy.

zero interest rate policy (ZIRP) A monetary policy in which a central bank sets nominal interest rates at or near zero percent per year in order to stimulate the economy.

The immediate crisis was resolved by late 2009, after which the Fed no longer had to act as a lender of last resort. But with the unemployment rate rising toward 10 percent, the Fed had to figure out a way to continue stimulating the economy even though ZIRP meant that short-term interest rates were as low as they could go without violating the zero lower bound.

The Fed’s solution was to use open-market operations to buy trillions of dollars worth of medium- and long-term financial assets, including mortgage-backed securities and longer-maturity U.S. government bonds. This strategy came to be known as quantitative easing, or QE, because the Fed’s goal was not to reduce short-term interest rates further (since they were already near the zero lower bound) but to increase the quantity of reserves in the banking system as a way of encouraging lending. Since the purchases were of mostly medium- and long-run bonds, the policy of QE also helped to lower medium- and long-run interest rates by driving up the prices of medium- and long-run bonds.

quantitative easing (QE) An open-market operation in which bonds are purchased by a central bank in order to increase the quantity of excess reserves held by commercial banks and thereby (hopefully) stimulate the economy by increasing the amount of lending undertaken by commercial banks; undertaken when interest rates are near zero and, consequently, it is not possible for the central bank to further stimulate the economy with lower interest rates due to the zero lower bound problem.

By the close of 2015, the Fed felt that various economic indicators were signaling that monetary stimulus could end. For example, the unemployment rate had fallen back to just 5.0 percent in 2015 after reaching 10.0 percent in 2009. The FOMC decided that the Fed could abandon ZIRP and QE while attempting to raise interest rates back up to normal levels using the mechanisms we discussed earlier in this chapter, such as raising the IOER rate. Over the next four years, interest rates gradually increased and the economy continued to improve. By early 2019, the unemployment rate stood at just 3.8 percent and the economy was operating at or slightly above full employment.

Part of this normalization process was quantitative tightening, or QT, which can be thought of as QE in reverse. Starting in the summer of 2017, the Fed began selling the huge stockpile of financial assets, mostly bonds, that it had accumulated under QE. The open-market sale of these assets lowered bond prices, which in turn caused interest rates to rise.

quantitative tightening The opposite of quantitative easing. An open-market operation in which bonds are sold by a central bank in order to decrease the quantity of excess reserves held by commercial banks and thereby (hopefully) restrain the economy by decreasing the amount of lending undertaken by commercial banks. The bond sales also raise interest rates by decreasing bond prices.

Problems and Complications

U.S. monetary policy faces both limitations and complications.

Recognition and Operational Lags Recall from Chapter 33 that fiscal policy is hindered by three delays, or lags—a recognition lag, an administrative lag, and an operational lag. Monetary policy also faces a recognition lag and an operational lag, but because the Fed can implement policy changes within hours, it avoids the long administrative lag of at least several months that hinders fiscal policy.

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Monetary policy is subject to a recognition lag because normal weekly and monthly fluctuations in economic activity and the price level mean that the Fed may not be able to quickly recognize when the economy is truly starting to recede or when inflation is really starting to rise. Once the Fed acts, monetary policy is also subject to an operational lag of at least 3 to 6 months because that much time is typically required for interest-rate changes to have any substantial impacts on investment, aggregate demand, real GDP, and the price level. These recognition and operational lags make it harder for the Fed to precisely target and time monetary policy actions.

Cyclical Asymmetry and the Liquidity Trap Monetary policy may be highly effective in slowing expansions and controlling inflation but much less reliable in pulling the economy out of a severe recession. Economists say that monetary policy may suffer from a cyclical asymmetry. The metaphor of “pushing on a string” is often invoked to capture this problem. Imagine the Fed standing on the left-hand side of Figure 36.3d, holding one end of a “monetary-policy string.” And imagine that the other end of the monetary-policy string is tied to the AD curve. Because the string would go taut if pulled on, monetary policy may be useful in pulling aggregate demand to the left. But because the string would go limp if pushed on, monetary policy will be rather ineffective at pushing aggregate demand to the right.

cyclical asymmetry The idea that monetary policy may be more successful in slowing expansions and controlling inflation than in extracting the economy from severe recession.

The reason for this asymmetry is the asymmetric way in which people act in response to changes in bank reserves. If pursued vigorously, a restrictive monetary policy can deplete commercial banking reserves to the point where banks are forced to reduce the volume of loans. The result is a contraction of the money supply, higher interest rates, and reduced aggregate demand. Consequently, the Fed can almost certainly achieve a restrictive goal.

By contrast, the Fed cannot be certain of achieving an expansionary goal by adding reserves to the banking system. That’s because it may run into a liquidity trap, in which adding more reserves to commercial banks’ accounts at the Fed has little or no effect on lending, borrowing, investment, or aggregate demand. For example, during the Great Recession, the Fed created billions of dollars of excess reserves that drove the federal funds rate to as low as 0.15 percent. Nevertheless, commercial bank lending stalled throughout the first 15 months of the recession and remained weak even after the Fed implemented ZIRP and QE over the following five years. Banks were fearful that loans would not be paid back. So they preferred large reserves over lending.

liquidity trap A situation in a severe recession in which the central bank’s injection of additional reserves into the banking system has little or no additional positive impact on lending, borrowing, investment, or aggregate demand.

Other Issues and Concerns The liquidity trap scenario demonstrates that the Fed is not omnipotent. An expansionary monetary policy can suffer from a “you can lead a horse to water, but you can’t make it drink” problem. The Fed can create excess reserves, but it cannot guarantee that banks will want to make additional loans. Households and businesses can frustrate the Fed, too, by not wanting to borrow. And when the Fed buys securities from the public, people may choose to pay off existing loans with the money they receive, rather than increasing their spending on goods and services.

The liquidity trap that occurred during the severe recession was a primary reason why the Congress turned so forcefully toward fiscal policy in 2009. With monetary policy maxed out, Congress approved the gargantuan American Recovery and Redevelopment Act, which authorized the infusion of $787 billion of tax cuts and government spending in 2009 and 2010. This spending helped to ensure stimulus even after interest rates had fallen toward zero and banks were sitting on reserves rather than lending.

The “Big Picture”

> > LO36.7 Describe how the various components of macroeconomic theory and stabilization policy fit together.

Figure 36.4 (Key Graph) brings together the analytical and policy aspects of macroeconomics discussed in this and the eight preceding chapters. This “big picture” shows how the many concepts and principles that we have covered relate to one another and how they constitute a coherent theory of the price level and real output in a market economy.

Study this diagram and you will see that the price level, output, employment, and income all result from the interaction of aggregate supply and aggregate demand. The items shown in red relate to public policy.

McConnell, C. (2020). Economics (22nd ed.). McGraw-Hill Higher Education (US).