sources of interest-rate fluctuations: nominal interest rates money and banking money and banking...
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Sources Sources of of
Interest-Rate Fluctuations:Interest-Rate Fluctuations:
Nominal Interest RatesNominal Interest Rates
Money and BankingMoney and BankingMr. VaughanMr. Vaughan
Updated: 2/18/09
After this lecture, you will be able to:
• Explain how changes in expected inflation affect nominal interest rates in long run.
• Describe how monetary growth affects inflation in long run.
• Trace effects of monetary policy on nominal interest rate in short run and long run.
Learning Objectives:Learning Objectives: Part II – Nominal Interest RatePart II – Nominal Interest Rate
2Total Slides: 34
Recall: • Borrowers and lenders care about real interest rate.• But, financial markets set most interest rates in
nominal terms. • So, borrowers and lenders must guess about inflation
rate.
Real Interest Rate Real Interest Rate ++ Expected Inflation Expected InflationNominal Interest RateNominal Interest Rate
Fisher EquationFisher Equation
3Total Slides: 34
Expected Actual
Real Interest Rate 3% ?
Inflation 0% 3%
Nominal Interest Rate ? 3%
Debtors Win/Creditors Lose!
Guessing Wrong Is Costly!Guessing Wrong Is Costly!
4Total Slides: 34
Expected Actual
Real Interest Rate 3% ?
Inflation 3% 0%
Nominal Interest Rate ? 6%
Creditors WinCreditors Win/Debtors Lose!/Debtors Lose!
Guessing Wrong Is Costly!Guessing Wrong Is Costly!
5Total Slides: 34
To avoid losses, debtors and creditors: use all useful information. learn rapidly from mistakes. react quickly to changes in expected inflation.
Implications: “Rational” Expectations = Random forecast errorsChanges in inflation expectations move bond
demand/supply and nominal interest rate rapidly.
Expectations and Nominal RatesExpectations and Nominal Rates
6Total Slides: 34
Quantity of Bonds ($)
NominalInterest Rate
Bond Supply1
Bond Demand1
ia
Qa
Increase in expected inflation reduces expected return on bonds and, thus,
bond demand. a
Bond Demand2
ib
Qb
b
Fisher EquationFisher EquationIn PicturesIn Pictures
7Total Slides: 34
Quantity of Bonds ($)
NominalInterest Rate
Bond Supply1
Bond Demand1
ib
Qb
Increase in expected inflation reduces real cost
of borrowing and, thus, increases bond supply.
b
Bond Supply2
ic
Qc
c
Fisher EquationFisher EquationIn PicturesIn Pictures
8Total Slides: 34
Q*
Bond Supply2
ic
Quantity of Bonds ($)
NominalInterest Rate
Bond Supply1
Bond Demand1
ia
Absent distortions, nominal interest rate will
rise by increase in expected inflation.
expected inflation
a
Bond Demand2
c
Fisher EquationFisher EquationIn PicturesIn Pictures
9Total Slides: 34
NoteNote:: Inflation trends explainInflation trends explain• Rising rates before early 1980s• Falling rates since 1980s• Rate volatility since 1950s
Fisher Equation:Fisher Equation:EvidenceEvidence
10Total Slides: 34
……But what causes (changes in) inflation? But what causes (changes in) inflation?
“Inflation is always and everywhere a monetary phenomenon.”
Milton FriedmanHis Point? In short run, many factors can boost general level of prices Only sustained growth in money supply can produce sustained
rise in prices.
First things first: What is “money?”
11Total Slides: 34
Money in U.S. EconomyMoney in U.S. Economy
Money Supply: Total quantity (dollar volume) of assets providing medium-of-exchange services Currency: Paper bills & coins in public hands. Checkable Deposits: Bank balances depositors can
access on demand by writing check (demand deposits, NOWs)
Traveler’s Checks
This functional definition is M1 (narrow money).
12Total Slides: 34
U.S. Money StockU.S. Money StockTwo MeasuresTwo Measures
As of October 2008 (Seasonally Adjusted)
Everything in M1
M1 = $1,473.1 billion
M2 = $7,878.9 billion
$ Billions
0
$1,473.1
$7,878.9
•Savings Deposits = $4,032.3
•Small Time Deposits = $1,314.0
•Money Market Mutual Funds = $1,059.6
Total = $6,405.8 billion
•Currency = $795.0•Checkable Deposits = $672.4 •Traveler’s Checks = $5.8
Note: - Currency only 10.1% of M2- Checkable deposits only 8.5% of M2
M2 is “Broad” money – Better measure for policy, scientific purposes13Total Slides: 34
How correlated are M’s?How correlated are M’s?
14Total Slides: 34
Money and InflationMoney and InflationQuantity Theory of MoneyQuantity Theory of Money
Quantity Theory Quantity Theory starts with equation of exchange:
M = Money Supply v = Income Velocity of Money
Average number of times per period each dollar of money supply is spent on nominal GDP
P = GDP Deflator / 100 (general price level)
y = Real GDPNote: P x y = Nominal GDP Equation is tautology (needs assumptions to become theory)
M x v = P x y
15Total Slides: 34
Quantity Theory of MoneyQuantity Theory of MoneyAssumptionsAssumptions
M = Exogenously determined (by government)
v = Not influenced by money (in short run relatively stable)
Determined by “real” factors such as payments technology/institutions, tastes, etc.
y = Not influenced by money (in short run) Determined by “real” factors such as technology, factor
endowments, societal commitment to markets/property rights, etc.
16Total Slides: 34
Quantity Theory of MoneyQuantity Theory of MoneyAssumptions Reasonable?Assumptions Reasonable?
17
Quantity Theory of MoneyQuantity Theory of MoneyImplications of AssumptionsImplications of Assumptions
Equation of Exchange (rate of change form):
Note: If growth in velocity and real output are determined exogenously
by real factors, then changes in prices (only endogenous variable) must be determined by changes in money supply.
Quantity Theory focuses on long run, not short run.
%ΔM + %Δv = %ΔP + %Δ y
18Total Slides: 34
Quantity Theory of MoneyQuantity Theory of MoneyU.S. EvidenceU.S. Evidence
PeriodMoney (M2)
Growth(Average)
Velocity Growth(Average)
Inflation Rate
(Average)
Real GDP Growth(Average)
(1) 1959:Q1 -
1983:Q4 8.4% 0.1% 4.8% 3.6%
(2) 1983:Q4 -
2008:Q45.5% 0.1% 2.5% 3.0%
Notes: All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures
Source: U.S. Department of Commerce, Board of Governors of Federal Reserve
NOTE: Money growth and inflation lower in period (2)!
19Total Slides: 34
Source: McCandless and Weber, 1995
Note:
1. Each point represents 30-year average annual money growth and 30-year average annual inflation
2. All points lie near/on 45-degree line.
Quantity Theory of MoneyQuantity Theory of MoneyCross-Country EvidenceCross-Country Evidence
20Total Slides: 34
Excessive Growth of Money Supply
Excessive Spending on Goods and Services
Inflation
Long-Run Real Growth ≈ 3.2%
Proximate Cause of InflationProximate Cause of InflationExcessive Monetary GrowthExcessive Monetary Growth
Faster than economy’s long-run real growth rate
21Total Slides: 34
Money Supply (M2) Growth: 7.0%
Inflation: 3.7%
Average Annual RatesUnited States
1959:Q1-2008:Q4
Real GDP Growth:
3.3%
VelocityGrowth:
0.1%
Money Growth and InflationMoney Growth and InflationU.S. EvidenceU.S. Evidence
22Total Slides: 34
Money and Nominal Rates Money and Nominal Rates Cross-Country EvidenceCross-Country Evidence
Monetary growth => Inflation => Nominal Interest Rates
Source: Monnet and Weber, 2001
Note:Each point represents average
annual money growth and average annual inflation (circle/square represents average values for one country, 1961-1998).
23Total Slides: 34
Source: Monnet and Weber, 2001
Note:Each point represents average annual
money growth and average annual inflation (circle/square represents average values for one country, 1961-1998).
Money and Nominal RatesMoney and Nominal RatesCross-Country EvidenceCross-Country Evidence
24Total Slides: 34
Money and Nominal Rates Money and Nominal Rates U.S. EvidenceU.S. Evidence
Monetary growth => Inflation => Nominal Interest Rates
25Total Slides: 34
• Fed implements monetary policy by purchasing/selling Treasuries.
• Transactions are called open-market operations.
– Open-market purchases increase bank reserves and reduce bond supply.
– Open-market sales reduce bank reserves and increase bond
supply.
Short-term effect on nominal interest rate is called liquidity effect.
Money and Nominal Rates Money and Nominal Rates Short RunShort Run
26Total Slides: 34
Bond Supply1
aia
Qa Quantity of Bonds
NominalInterest Rate Bond Demand1
Suppose Fed buys Treasuries in open
market. Bond supply will fall, and nominal interest rate will fall.
Bond Supply2
ib
Qb
b
Example:Example:Fed in ActionFed in Action
27Total Slides: 34
Fed buys and sells Treasuries to stabilize economy. • Weakening economy: Fed buys Treasuries to lower
interest rates and stimulate economy.• Overheating economy: Fed sells Treasuries to raise
interest rates and slow economy.
Why ConductWhy ConductOpen-Market Operations?Open-Market Operations?
28Total Slides: 34
• Balancing short-run goalsshort-run goals of monetary policy (a stable, high-growth economy) with long-run goalslong-run goals (low inflation) is challenging.
• High inflation and nominal interest rates of 1970s1970s were due to excessive focusexcessive focus on short runshort run.
Art of Central BankingArt of Central Banking
29Total Slides: 34
Does easy money lower nominal interest rate?
Short runShort run: : Open-market purchases lower nominal interest rate.
Long runLong run::When economy perks up, nominal rate starts rising.If monetary stimulus is excessive, inflation starts rising.Bond demanders/suppliers adjust inflation expectations, further raising nominal rate.
Putting It All TogetherPutting It All TogetherLinking the Long and Short RunLinking the Long and Short Run
30Total Slides: 34
Does easy money lower nominal interest rates?
Time
Nominal Interest Rate
0
Initial rate
Longrun
Shortrun
Time path of actual nominal rates
Putting It All TogetherPutting It All TogetherLinking the Long and Short RunLinking the Long and Short Run
31Total Slides: 34
Why were nominal rates lower in later period?
YearAverage3-Month
T-Bill RateYear
Average3-Month
T-Bill Rate
1978 7.2% 1993 3.0%
1979 10.0% 1994 4.3%
1980 11.5% 1995 5.5%
1981 14.0% 1996 5.0%
1982 10.7% 1997 5.1%
You try it!You try it!
32Total Slides: 34
Money growth and inflation were lower!Money growth and inflation were lower!
Year
Prior Year's Money Growth
(M2)
Inflation Rate (CPI)
Average 3-Month
T-Bill Rate
Year
Prior Year's Money Growth
(M2)
Inflation Rate (CPI)
Average 3-Month
T-Bill Rate
1978 10.3% 7.6% 7.2% 1993 1.6% 3.0% 3.0%1979 7.5% 11.3% 10.0% 1994 1.5% 2.6% 4.3%1980 7.9% 13.5% 11.5% 1995 0.4% 2.8% 5.5%1981 8.6% 10.3% 14.0% 1996 4.1% 3.0% 5.0%1982 9.7% 6.2% 10.7% 1997 4.8% 2.3% 5.1%
Yearly Average (1978-82)
8.8% 9.8% 10.7%Yearly
Average (1978-82)
2.5% 2.7% 4.6%
You try it!You try it!
33Total Slides: 34
Sources Sources of of
Interest-Rate Fluctuations:Interest-Rate Fluctuations:
Nominal Interest Rates?Nominal Interest Rates?
Money and BankingMoney and BankingMr. VaughanMr. Vaughan
Questions Questions overover
Total Slides: 34
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