Money and Interest Rates
The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2¼ percent.
Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.
So read the beginning of a press release from the Federal Reserve issued on March 18, 2008. (A basis point is equal to 0.01 percentage point. So the statement implies that the Fed lowered the target from 3% to 2.25%.) We learned about the federal funds rate in Chapter 16: it’s the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight-times-a-year meetings, a group called the Federal Open Market Committee sets a target value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells short-term U.S. government debt, known as Treasury bills, to achieve that target.
As we’ve already seen, other short-term interest rates, such as the rates on CDs, move with the federal funds rate. So when the Fed reduced its target for the federal funds rate from 3% to 2.25% in March 2008, many other short-term interest rates also fell by about three-quarters of a percentage point.
How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all?
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The Equilibrium Interest Rate
According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money.
The money supply curve shows how the quantity of money supplied varies with the interest rate.
Recall that, for simplicity, we’re assuming there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 17-3, which illustrates the liquidity preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 17-3 combines the money demand curve, MD, with the money supply curve, MS, which shows how the quantity of money supplied by the Federal Reserve varies with the interest rate.
. The money market is in equilibrium at the interest rate rE: the quantity of money demanded by the public is equal to
, the quantity of money supplied.At a point such as L, the interest rate, rL, is below rE and the corresponding quantity of money demanded, ML, exceeds the money supply,
. In an attempt to shift their wealth out of nonmoney interest-bearing financial assets and raise their money holdings, investors drive the interest rate up to rE. At a point such as H, the interest rate rH exceeds rE and the corresponding quantity of money demanded, MH, is less than the money supply,
. In an attempt to shift out of money holdings into nonmoney interest-bearing financial assets, investors drive the interest rate down to rE.In Chapter 16 we learned how the Federal Reserve can increase or decrease the money supply: it usually does this through open-market operations, buying or selling Treasury bills, but it can also lend via the discount window or change reserve requirements. Let’s assume for simplicity that the Fed, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, MS in Figure 17-3, with a horizontal intercept corresponding to the money supply chosen by the Fed,
. The money market equilibrium is at E, where MS and MD cross. At this point the quantity of money demanded equals the money supply,
, leading to an equilibrium interest rate of rE.
To understand why rE is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, rL, is below rE. At rL the public wants to hold the quantity of money ML, an amount larger than the actual money supply,
. This means that at point L, the public wants to shift some of its wealth out of interest-bearing assets such as CDs into money.
This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of interest-bearing money assets demanded is less than the quantity supplied. So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from rL until the public wants to hold the quantity of money that is actually available,
. That is, the interest rate will rise until it is equal to rE.
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Now consider what happens if the money market is at a point such as H in Figure 17-3, where the interest rate rH is above rE. In that case the quantity of money demanded, MH, is less than the quantity of money supplied,
. Correspondingly, the quantity of interest-bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from rH. It falls until the public wants to hold the quantity of money that is actually available,
. Again, the interest rate will end up at rE.
Monetary Policy and the Interest Rate
Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 17-4 shows what happens when the Fed increases the money supply from 
to 
. The economy is originally in equilibrium at E1, with an equilibrium interest rate of r1 and money supply
. An increase in the money supply by the Fed to
shifts the money supply curve to the right, from MS1 to MS2, and leads to a fall in the equilibrium interest rate to r2. Why? Because r2 is the only interest rate at which the public is willing to hold the quantity of money actually supplied,
.
to
. In order to induce people to hold the larger quantity of money, the interest rate must fall from r1 to r2.So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate.
The target federal funds rate is the Federal Reserve’s desired federal funds rate.
In practice, at each meeting the Federal Open Market Committee decides on the interest rate to prevail for the next six weeks, until its next meeting. The Fed sets a target federal funds rate, a desired level for the federal funds rate. This target is then enforced by the Open Market Desk of the Federal Reserve Bank of New York, which adjusts the money supply through the purchase and sale of Treasury bills until the actual federal funds rate equals the target rate. The other tools of monetary policy, lending through the discount window and changes in reserve requirements, aren’t used on a regular basis (although the Fed used discount window lending in its efforts to address the 2008 financial crisis).
The Target Versus the Market
Over the years, the Federal Reserve has changed the way in which monetary policy is implemented. In the late 1970s and early 1980s, it set a target level for the money supply and altered the monetary base to achieve that target. Under this operating procedure, the federal funds rate fluctuated freely. Today the Fed uses the reverse procedure, setting a target for the federal funds rate and allowing the money supply to fluctuate as it pursues that target.
A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works. That is, you’ll sometimes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate.
In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money. The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate. It’s important not to confuse a change in the Fed’s operating procedure with a change in the way the economy works.
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Figure 17-5 shows how this works. In both panels, rT is the target federal funds rate. In panel (a), the initial money supply curve is MS1 with money supply
, and the equilibrium interest rate, r1, is above the target rate. To lower the interest rate to rT, the Fed makes an open-market purchase of Treasury bills. As we learned in Chapter 16, an open-market purchase of Treasury bills leads to an increase in the money supply via the money multiplier. This is illustrated in panel (a) by the rightward shift of the money supply curve from MS1 to MS2 and an increase in the money supply to
. This drives the equilibrium interest rate down to the target rate, rT.
Panel (b) shows the opposite case. Again, the initial money supply curve is MS1 with money supply
. But this time the equilibrium interest rate, r1, is below the target federal funds rate, rT. In this case, the Fed will make an open-market sale of Treasury bills, leading to a fall in the money supply to
via the money multiplier. The money supply curve shifts leftward from MS1 to MS2, driving the equilibrium interest rate up to the target federal funds rate, rT.
Long-Term Interest Rates
Earlier in this chapter we mentioned that long-term interest rates—rates on bonds or loans that mature in several years—don’t necessarily move with short-term interest rates. How is that possible, and what does it say about monetary policy?
Consider the case of Millie, who has already decided to place $10,000 in U.S. government bonds for the next two years. However, she hasn’t decided whether to put the money in one-year bonds, at a 4% rate of interest, or two-year bonds, at a 5% rate of interest. If she buys the one-year bond, then in one year, Millie will receive the $10,000 she paid for the bond (the principal) plus interest earned. If instead she buys the two-year bond, Millie will have to wait until the end of the second year to receive her principal and her interest.
You might think that the two-year bonds are a clearly better deal—but they may not be. Suppose that Millie expects the rate of interest on one-year bonds to rise sharply next year. If she puts her funds in one-year bonds this year, she will be able to reinvest the money at a much higher rate next year. And this could give her a two-year rate of return that is higher than if she put her funds into the two-year bonds today. For example, if the rate of interest on one-year bonds rises from 4% this year to 8% next year, putting her funds in a one-year bond today and in another one-year bond a year from now will give her an annual rate of return over the next two years of about 6%, better than the 5% rate on two-year bonds.
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The same considerations apply to all investors deciding between short-term and long-term bonds. If they expect short-term interest rates to rise, investors may buy short-term bonds even if long-term bonds bought today offer a higher interest rate today. If they expect short-term interest rates to fall, investors may buy long-term bonds even if short-term bonds bought today offer a higher interest rate today.
As this example suggests, long-term interest rates largely reflect the average expectation in the market about what’s going to happen to short-term rates in the future. When long-term rates are higher than short-term rates, as they were in 2010, the market is signaling that it expects short-term rates to rise in the future.
This is not, however, the whole story: risk is also a factor. Return to the example of Millie, deciding whether to buy one-year or two-year bonds. Suppose that there is some chance she will need to cash in her investment after just one year—say, to meet an emergency medical bill. If she buys two-year bonds, she would have to sell those bonds to meet the unexpected expense. But what price will she get for those bonds? It depends on what has happened to interest rates in the rest of the economy. Bond prices and interest rates move in opposite directions: if interest rates rise, bond prices fall, and vice versa.
This means that Millie will face extra risk if she buys two-year rather than one-year bonds, because if a year from now bond prices fall and she must sell her bonds in order to raise cash, she will lose money on the bonds. Owing to this risk factor, long-term interest rates are, on average, higher than short-term rates in order to compensate long-term bond purchasers for the higher risk they face.
As we will see later in this chapter, the fact that long-term rates don’t necessarily move with short-term rates is sometimes an important consideration for monetary policy.
The Fed Reverses Course
We began this section with the Fed’s announcement of March 18, 2008, that it was cutting its target interest rate. This particular action was part of a larger story: a dramatic reversal of Fed policy that began in September 2007.
Figure 17-6 shows two interest rates from the beginning of 2004 to mid-2011: the target federal funds rate, decided by the Federal Open Market Committee, and the effective, or actual, rate in the market. As you can see, the Fed raised its target rate in a series of steps from late 2004 until the middle of 2006; it did this to head off the possibility of an overheating economy and rising inflation (more on that later in this chapter). But the Fed dramatically reversed course beginning in September 2007, as falling housing prices triggered a growing financial crisis and ultimately a severe recession. And in December 2008, the Fed decided to allow the federal funds rate to move inside a target band between 0% and 0.25%. From 2009 to mid-2011, the Fed funds rate was kept close to zero in response to a very weak economy and high unemployment.
Figure 17-6 also shows that the Fed doesn’t always hit its target. There were a number of days, especially in 2008, when the effective federal funds rate was significantly above or below the target rate. But these episodes didn’t last long, and overall the Fed got what it wanted, at least as far as short-term interest rates were concerned.
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Quick Review
- According to the liquidity preference model of the interest rate, the equilibrium interest rate is determined by the money demand curve and the money supply curve.
- The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate and uses open-market operations to achieve that target.
- Long-term interest rates reflect expectations about what’s going to happen to short-term rates in the future. Because of risk, long-term interest rates tend to be higher than short-term rates.
Check Your Understanding 17-2
Question
+KOITZzdrRYRhZ7miCWwVIBnPieb/iw1614rSANzvnfyubeqR87f/9N/EIe+kLrq0ryqcJp1C2qHFBI4zo9qnUMLs8dwuFWmDuXjUzOajjt37vzI7FUt3RSt1D6A8pEy9ywj+YUjV3yLw9eBbMUYWNaOzZN86y3yiKV4mMrvB4rwut6btbZPNdaeIA6A0EOPxOjU01utoDLUEoLLPASyG5GeXpD1FO5rozZ5hcvvXyoCt1sduYSUT9Ui5ZGvwYbVq1M+IpxIk77KhpAaipvmE3++FqB0qFzFF7nrsxXaPZh5wEPyWwVGnJImVjE7Wnv2/UrMtwttRIhCydPPlbUYiwghf0m3qmjRoPeZDqZSi3JUkK3le9mDVJXTj9XSR3xwOPHwFNdJ0IVx7X9tBsQZV4vs4HViVFXwJevHjW50aMxl7/C+sDkpZzSyKklHImI4f8cXkWTfXEc=In the accompanying diagram, the increase in the demand for money is shown as a rightward shift of the money demand curve, from MD1 to MD2. This raises the equilibrium interest rate from r1 to r2.
Question
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In order to prevent the interest rate from rising, the Federal Reserve must make an open-market purchase of Treasury bills, shifting the money supply curve rightward. This is shown in the accompanying diagram as the move from MS1 to MS2.
Question
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Frannie is better off buying a one-year bond today and a one-year bond tomorrow because this allows her to get the higher interest rate one year from now.Question
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Frannie is better off buying a two-year bond today because it gives her a higher interest rate in the second year than if she bought two one-year bonds.
Solutions appear at back of book.