Lecture Notes: Interest Rates and Monetary Policy

Introduction

• Discussion on the current debate about the interest rates in the US.
• The aggressive monetary policy to combat inflation through interest rates.
• Objective: Understand how central banks determine interest rates.
• Overview of financial markets' complexity.

Key Figures in Monetary Policy

• Jerome Powell: Chair of the Federal Reserve.
• Katsuya: Next president of the Bank of Japan.
• Notable alumni from the speaker’s program: Ben Bernanke, Mario Draghi, Stan Fisher.

Institutional Knowledge: Federal Reserve System

• The Federal Reserve is the Central Bank of the US.
• Composed of the Board of Governors and 12 Regional Banks.
• Federal Open Market Committee (FOMC) consists of 7 Governors + rotating 4 regional bank presidents.
• Importance of the Federal Reserve Bank of New York.

Importance of Monetary Policy

• A key policy tool in the short run alongside fiscal policy.
• Monetary policy is nimble compared to fiscal policy, which is less reactive.
• Monetary policy can affect output and price levels in the short run.

Financial Markets and Monetary Policy

• Central banks influence financial markets by affecting interest rates.
• Financial markets simplify to two instruments: money and bonds.
• Money: No return, high liquidity.
• Bonds: Offer returns, not useful for transactions.

The Tradeoff Between Money and Bonds

• Decision based on need for transactions vs. interest rates.
• Higher interest rates encourage holding bonds.

Money Demand and Equilibrium

• Money demand decreases with higher interest rates.
• Nominal income affects money demand.
• Interest rates determined by the equilibrium of money supply and money demand.

Expansionary and Contractionary Monetary Policy

• Expansionary: Increase in money supply, leads to lower interest rates.
• Contractionary: Decrease in money supply, leads to higher interest rates.

Modern Monetary Policy

• Central banks target interest rates, not money supply.
• Money demand is volatile; setting interest rates provides stability.

Open Market Operations

• Central banks buy/sell bonds to adjust money supply.
• Expansionary operations: Central bank buys bonds, increasing money in circulation.

Interest Rate and Bond Price Relationship

• Inverse relationship: Higher bond prices lead to lower interest rates and vice versa.

Advanced Concepts in Monetary Policy

• Introduction of financial intermediaries, primarily banks.
• Banks create money through deposits and hold reserves at the central bank.
• Federal Funds Rate: The interest rate for reserves set by the Federal Reserve.
• Modern central bank operations focus on controlling the federal funds rate.

Historical Context and Conclusion

• Overview of the federal funds rate trends before and after COVID-19.
• The importance of maintaining appropriate interest rates to manage inflation.

Conclusion

• Understanding the mechanism of monetary policy and interest rates is crucial for interpreting financial market behavior and economic strategies.