Chapter Five
Chapter Five
Banking, Interest
Rates and
Monetary policy
The Secret Life of Interest Rates
policy. ir
• Nominal ir ir1
• Should be used in
conjunction with MD
ir
ir1
MD I
QM QM1 I I1
Quantity of Money Quantity of Capital Investment
Investment Linked to AD/AS
Investment in Capital
Expansionary Policy
Price
Nom level SRAS
-inal
ir
PL1
ir PL
ir1 AD1
(C+I1+G)
I
AD (C+I+G)
0 I I1 Y Y1
Quantity of Capital Investment Real Gross Domestic Product
Loanable Funds Market
• The Demand Curve for LF
represents private demand
for Loanable Funds.
• The Supply Curve for LF Real
Loanable Funds Market
represents private savings. ir SLF
• LF model represents the
real ir. (abbrev. “r”)
• Supply of LF (savings) sets r
the Prime Lending Rate.
• Government borrowing to
cover deficit spending will
move DLF to the right. DLF
r1 Pl1
Pl2
r
PL AD1
(C+I+G1)
DLF1 (Private
+
Government) AD2
(C+(I-I1)+G1)
DLF
(Private
Demand)
AD
(C+I+G)
QLF QLF1 Y Y2 Y1
Quantity of Loanable Funds Real Gross Domestic Product
Barro-Ricardo Effect
• The Barro-Ricardo Effect is feedback caused by a
Crowding Out effect.
• Higher interest rates associated with Crowding
Out cause individuals to save more of their
incomes.
• The rise in savings increases the supply of
loanable funds, thereby reducing the real interest
rate.
• The B-R effect has a smaller impact and usually
doesn’t fully negate a crowding out effect.
Monetary Policy
• Money is Neutral: any changes of the
money supply can stabilize the economy.
• Any attempt to grow the economy will result
in inflation.
• At any moment, the money supply is fixed
• The supply of money is controlled by the
Federal Reserve (the FED), using three main
techniques.
• Discount Rate, Fed Funds Rate, & Required
Reserve Ratio.
Expansionary and Contractionary
Policy
• Expansionary Policies are used to increase
the money supply (ex. Decrease RRR,
Discount or Fed Funds Rate)
• Contractionary Policies are used to reduce
the money supply (ex. Raise RRR, Discount
or Fed Funds Rate)
• Interest rates increase and decrease in an
inverse relationship with changes in the
money supply.
The Discount Rate