Overview
This lecture explains how central banks, particularly the US Federal Reserve, determine and influence interest rates through monetary policy, focusing on the mechanisms, key institutions, and the role of financial markets.
Central Banks and Interest Rates
- The Federal Reserve (Fed) is the US central bank; its chair and board set monetary policy.
- Interest rates are a primary tool for managing economic output in the short run.
- Monetary policy acts faster than fiscal policy due to fewer bureaucratic hurdles.
- Central banks influence output primarily in the short term; in the long term, effects are mostly on prices and inflation.
Institutional Structure and Policy Tools
- The Fed has a Board of Governors and 12 regional banks; interest rates are set by the Federal Open Market Committee (FOMC).
- Most countries have similar structures, though some, like the ECB, represent multiple nations.
- The two main policy tools are monetary policy (central bank actions) and fiscal policy (government spending/taxes).
Money, Bonds, and Financial Markets
- People can hold wealth as money (liquid, used for transactions, no interest) or bonds (pay interest, less liquid).
- The tradeoff between holding money or bonds becomes important when interest rates are high.
- Money demand is downward-sloping: higher interest rates lead to less demand for money and more for bonds.
- Money demand is also affected by nominal income; higher income increases money demand at every interest rate.
Determining Interest Rates: Basic Model
- In a simple system (no banks), the central bank sets money supply, and the market determines the interest rate where money supply equals money demand.
- Fluctuations in money demand cause interest rates to be volatile if money supply is fixed.
- Modern central banks target an interest rate and supply whatever money is needed to maintain it.
Open Market Operations
- Central banks change the money supply via open market operations: buying bonds (expansionary, lowers interest rates) or selling bonds (contractionary, raises rates).
- Buying bonds increases their price and lowers the interest rate due to their inverse relationship.
- Increases in nominal income or money demand also pressure interest rates upward unless money supply grows accordingly.
Central Banks and Financial Intermediaries
- Banks create additional money through deposits (checkable accounts) which are counted as money.
- Banks must hold a fraction (reserves) of deposits at the central bank.
- The demand for central bank money (reserves) is a fixed fraction of total deposits.
Federal Funds Rate and Modern Operations
- The interest rate set by the central bank is the federal funds rate—the rate banks charge each other for overnight reserves.
- The Fed adjusts the supply of reserves to keep the federal funds rate at its target level.
- Changes in the federal funds rate affect other interest rates in the economy.
- The federal funds rate cannot go below zero as holding cash always offers a zero percent rate.
Key Terms & Definitions
- Interest Rate — the cost of borrowing money, typically set by the central bank.
- Money Demand — the desire to hold liquid assets for transactions rather than interest-earning assets.
- Open Market Operations — central bank activities of buying/selling bonds to influence the money supply.
- Federal Funds Rate — the overnight interest rate at which banks lend reserves to each other.
- Reserves — bank deposits held at the central bank.
- High-Powered Money (Central Bank Money) — money directly controlled by the central bank, including currency and reserves.
- Expansionary Monetary Policy — increasing money supply to lower interest rates.
- Contractionary Monetary Policy — decreasing money supply to raise interest rates.
Action Items / Next Steps
- Review how open market operations shift money supply and impact equilibrium interest rates.
- Prepare for the next lecture focusing on the market for bank reserves.
- Attend the next class session on Tuesday.