Lecture 2B: The Meaning of Interest Rates

Reference: PPT & Chapter 4 of Mishkin (The Economics of Money, Banking, and
Financial Markets)

CONCEPTS

MEASURING INTEREST RATES

- Interest rates are among the most closely watched variables in the economy.
- Yield to maturity is the most accurate measure of interest rates.
- Different debt instruments have different streams of cash payments (also known as cash
flows) with different timing.
- First, we need to be able to know how to compare the value of one kind of debt
instrument with the value of another. This allows us to do the Second -> see how
interest rates are measured.
A. Present Value
- Present value or present discounted value: a dollar paid to you one (1) year from now
is less valuable than a dollar paid to you today.
- WHY? That one dollar is a dollar you could have deposited in an account that
earns interest and have more than a dollar in one (1) year.
- Also, take into account: inflation.
- Simple loan: simplest kind of debt instrument.

Four (4) Types of Credit Market Instruments

- In terms of timing of their cash flow payments
1. A Simple Loan
- Lender provides the borrower with an amount of funds that must be repaid to the
lender at the maturity date, along with an additional payment for the interest.
- Ex. Short-term commercial loans to businesses
2. Fixed-payment Loan (aka Fully Amortized Loan)
- Similar to simple loan except instead of a maturity date, you repay the amount
borrowed by making the same payment (payment = part of the principal & part
of the interest) every period (ex. Every month; parang SPAYLATER lang lol) for
a set number of years.
- Ex. Installment loans like auto loans and mortgages
3. Coupon Bond
- Pays owner a fixed interest payment (coupon payment) every year until the
maturity date, when a specified final amount (face value or par value) is repaid.
- Ex. Coupon bond with $1,000 face value then may coupon payment of $100/year
for 10 years and then repayment of the face value amounting to $1,000 at the
maturity date.
- Four pieces of information: i) Bond’s Face Value; ii) Corporation/Gov’t agency
that issues the bond; iii) Maturity date of the bond, iv) Bond’s coupon rate (dollar
amount of the yearly coupon payment expressed as a percentage of the face
value of the bond).
 - Ex. Capital market instruments like treasury bonds and corporate bonds.
4. Discount Bond (Zero-coupon bond)
- Bought at a price below its face value (at a discount)
- Face value is repaid at the maturity date
- No interest payments unlike a coupon bond

So basically four (4) types of instruments making payments @ different times.

Payment only at maturity dates:

1. Simple Loan
2. Fixed Payment Loan

Payment periodically until maturity:

3. Coupon Bonds
4. Discount Bonds/Zero-Coupon Bonds

Yield to Maturity
- Most accurate measure of interest rates
- Equates present value (PV) of cash flow payments from debt instrument with its value
today
- Today’s value = Present value of all of its future cash flow payments

1) Yield to Maturity on a Simple Loan

- Remember: For simple loans, simple interest rate = yield to maturity (simple
interest rate = interest payment / amount of the loan = 10/100)

2) Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan

 Note:
- When inputting the percentage on the online texas ba ii financial calculator,
instead of using 0.07, use 7 only since it’s 7% not 0.07%

3) Yield to Maturity and Bond Price for a Coupon Bond

Three (3) Important Facts about Yields to Maturity:
1. When the coupon bond is priced at its face value, the yield to maturity equals the
coupon rate.
a. When you put $1,000 in a bank account with an interest rate of 10%, you
can take out $100 every year and you will be left with the $1,000 at the
end of ten years. This process is similar to buying the $1,000 bond with a
10% coupon rate analyzed in Table 1, which pays a $100 coupon
payment every year and then repays $1,000 at the end of ten years. If the
bond is purchased at the par value of $1,000, its yield to maturity must
equal 10%, which is also equal to the coupon rate of 10%. The same
 reasoning applied to any coupon bond demonstrates that if the coupon
bond is purchased at its par value, the yield to maturity and the coupon
rate must be equal.
2. The price of a coupon bond and the yield to maturity are negatively related. As
the yield to maturity rises, the price of the bond falls. As the yield to maturity falls,
the price of the bond rises.
a. It is a straightforward process to show that the bond price and the yield to
maturity are negatively correlated. As i, the yield to maturity, increases, all
denominators in the bond price formula (Equation 3) must necessarily
increase, because the rise in i lowers the present value of all future cash
flow payments for this bond. Hence a rise in the interest rate, as
measured by the yield to maturity, means that the price of the bond must
fall. Another way to explain why the bond price falls when the interest rate
rises is to consider that a higher interest rate implies that the future
coupon payments and final payment are worth less when discounted back
to the present; hence the price of the bond must be lower.
3. The yield to maturity is greater than the coupon rate when the bond price is
below its face value and is less than the coupon rate when the bond price is
above its face value.
a. When the yield to maturity equals the coupon rate, then the bond price is
at the face value; when the yield to maturity rises above the coupon rate,
the bond price necessarily falls and so must be below the face value of
the bond.

4) Yield to Maturity on a Perpetuity

You can also use this equation for coupon bonds with a long term to maturity (more than 20
years).
WHY?
- Cash flows more than 20 years in the future have such small present discounted values
that the value of a long-term coupon bond is very close to the value of a perpetuity with
the same coupon rate.
- Ic which is equal to the yearly coupon payment/price of the security = current yield (freq.
used as an approximation to describe interest rates on long-term bonds).

5) Yield to Maturity on a Discount Bond

Summary:
1. A dollar in the future is not as valuable as a dollar today.
2. A dollar received n years from now is worth only $1/(1+i)n today.
3. The present value of a set of future cash flow payments on a debt instrument equals the
sum of the present values of each of the future payments.
4. The yield to maturity for an instrument = the interest rate that equates the present value
of the future payments on that instrument to its value today.
5. Yield to maturity = measure that most accurately describes the interest rate.
6. Current bond prices and interest rates are negatively related. When the interest rate
rises, the price of the bond falls, and vice versa.
 Lecture 2C: The Behavior of Interest Rates
Reference: PPT & Chapter 4, p.75 of Mishkin (The Economics of Money, Banking, and
Financial Markets)

CHAPTER 4
CONCEPTS

The Distinction Between Interest Rates & Returns

- Interest rate on the bond doesn’t show you the value.
- The security’s return or specifically, its rate of return is the measurement you should
look at.
- Rate of return: the amount of each payment to the owner plus the change in the
security’s value, expressed as a fraction of its purchase price.
- Discrepancy between the yield to maturity and the rate of return shows that the return on
a bond will not necessarily be equal to the yield to maturity on that bond.

- Current yield ic: coupon payment over the purchase price

- Rate of capital gain g: change in the bond’s price relative to the initial price
 - The formula R = ic + g shows that the return on a bond is the current yield ic plus the rate
of capital gain g. This rewritten formula illustrates the point we just discovered.
- Even for a bond for which the current yield ic is an accurate measure of the yield to
maturity, the return can differ substantially from the interest rate.
- Returns will differ substantially from the interest rate if the price of the bond experiences
sizable fluctuations that produce substantial capital gains or losses.

Notes about Bonds:

- The only bonds whose returns will equal their initial yields to maturity are those whose
times to maturity are the same as their holding periods
- A rise in interest rates is associated with a fall in bond prices, resulting in capital losses
on bonds whose terms to maturity are longer than their holding periods.
- The more distant a bond’s maturity date, the greater the size of the percentage price
change associated with an interest rate change.
- The more distant a bond’s maturity date, the lower the rate of return that occurs as a
result of an increase in the interest rate.
- Even though a bond may have a substantial initial interest rate, its return can turn out to
be negative if interest rates rise.

The Distinction Between Real and Nominal Interest Rates

- Real interest rates take inflation into account. Real interest rate = nominal interest rate
less the expected inflation rate.
- When the real interest rate is low, there are greater incentives to borrow and fewer
incentives to lend. (Why? If you’re a lender, you’re earning back at a negative interest
rate of 2%.)
- A similar distinction can be made between nominal returns and real returns. Nom inal
returns, which do not allow for inflation, are what we have been referring to as simply
“returns.” When inflation is subtracted from a nominal return, we have the real return,
 which indicates the amount of extra goods and services that we can purchase as a result
of holding the security.

Summary:
1. The yield to maturity, which is the measure that most accurately reflects the interest
rate, is the interest rate that equates the present value of future payments of a debt
instrument with the instrument’s value today. Application of this principle reveals that
bond prices and interest rates are negatively correlated: When the interest rate rises, the
price of the bond must fall, and vice versa.
2. The return on a security, which tells you how well you have done by holding the security
over a stated period of time, can differ substantially from the interest rate as measured
by the yield to maturity. Long-term bond prices experience substantial fluctuations when
interest rates change and thus bear interest-rate risk. The resulting capital gains and
losses can be large, which is why long-term bonds are not considered safe assets with a
sure return.
3. The real interest rate is defined as the nominal interest rate minus the expected rate of
inflation. It is both a better measure of the incentives to borrow and lend and a more
accurate indicator of the tightness of credit market conditions than is the nominal interest
rate.

CHAPTER 5

Determinants of Asset Demand

PREVIEW
1. Chapter 4 showed us how interest rates are negatively related to the price of bonds.
2. Knowing why bond prices change -> understanding how interest rates fluctuate
(because of their inverse relationship).

Detailed Steps in our Analysis:

1. Derive a demand curve for assets such as money or bonds
a. HOW? We have to understand the determinants of demand for these assets
through portfolio theory
i. Economic theory that outlines criteria that are important when deciding
how much of an asset to buy.
2. After deriving supply curves for these assets, we develop the concept of market
equilibrium
a. The point at which the quantity supplied equals the quantity demanded.
b. This model allows us to explain changes in equilibrium interest rates.

4 Determinants of Asset Demand

1. Wealth - total resources owned by the individual, including all assets.
 a. More resources available to purchase = quantity of assets we demand increases.
b. Ceteris paribus, increase in wealth = increase in quantity demanded of an asset
2. Expected return - total resources owned by the individual, including all assets
a. An increase in an asset’s expected return relative to that of an alternative asset,
holding everything else unchanged, raises the quantity demanded of the asset.
3. Risk - (the degree of uncertainty associated with the return) on one asset relative to
alternative assets
a. Holding everything else constant, if an asset’s risk rises relative to that of
alternative assets, its quantity demanded will fall.
4. Liquidity - (the degree of uncertainty associated with the return) on one asset relative to
alternative assets.
a. The more liquid an asset is relative to alternative assets, holding everything else
unchanged, the more desirable it is and the greater the quantity demanded will
be.

Theory of Portfolio Choice

Supply and Demand in the Bond Market

I. Demand Curve
A. Shows the relationship between the quantity demanded and the price when all
other economic variables are held constant (that is, values of other variables are
taken as given).
 - The demand curve for bonds has a downward slope. This indicates that at
lower prices of the bond, the quantity demanded is higher.
II. Supply Curve
- Shows the relationship between the quantity supplied and the price of bonds,
ceteris paribus.
- Upward sloping because as price increases, ceteris paribus, quantity supplied
increases.
III. Market Equilibrium (Intersection of the Demand and Supply Curves)
A. Quantity of bonds demanded = quantity of bonds supplied
B. Equilibrium or market-clearing price: point where Bd = Bs
C. Excess supply: Quantity of bonds supplied > quantity of bonds demanded.
Borrowers want to sell more bonds than others (lenders-savers) want to buy.
D. Excess demand: Lender-savers want to buy more bonds than others.
IV. Supply and Demand Analysis
A. Supply and demand are always described in terms of stocks of assets not in
terms of flows
B. Asset market approach for understanding behavior in financial markets: The
dominant methodology used by economists because correctly conducting
analyses in terms of flows is very tricky, especially when we encounter inflation.
Announcement

Hi guys,

Here are the instructions for your mid-term exam:

1. It will ONLY be open on November 10, Thursday (11 AM until 2 PM Philippine time). No excuses for
the missed exam (unless you have a medical certificate signed by the Vice Dean).

2. It's a 35-item exam (mix of multiple choice, short answer form, etc.). No essay or paragraphs.

3. Please focus your review on Lectures 3 and 4 (up to 4d). However, there will be a few items that will
come from the early lectures. Questions are based on the topics discussed in class (pdf of the lectures).
Please review those materials, plus the required reading on the Central Bank topic.

4. No need to log in to Zoom.

5. Please note that this is 30% of your final grade in MONBKNG.

Please don't hesitate to reply in the comments section if you have any questions.

Required Reading: A Note on the Independence and Governance of Asia-Pacific Central

Banks by Neil Angelo Halcon
Summary:

Central Bank Independence

1. Majority of central banks are trying to become independent from their national governments
and are trying to improve their own governance mechanisms to meet the price stability
objective.
2. Why?
a. Kydland and Prescott (1977) published a paper which explained the dynamic
inconsistency in macroeconomic policy which called for:
i. Long-term commitment from the central bank
ii. Conduct of monetary policy without government influence
b. Independence of central bank from the government is crucial for inflation targeting
(IT) economies.
i. New Zealand adopted IT as its monetary policy framework (followed by many
other economies).
ii. Goal of price stability
iii. Under IT, other goals like sustainable economic growth & a low employment
rate are considered “by-products.”
c. Historical accounts disagree.
 i. Post-Second World War period
1. Economic development was seen as a crucial part (not a
by-product) of the central bank’s responsibilities.
ii. Gerald Epstein (2007)
1. Suggested that there should be a return to the historical norm of
central bank policy: goals like employment creation & rapid economic
growth should join the goals of attaining price and financial market
stability.
iii. Dr. Joseph Stiglitz
1. Return of Central Bank as an active economic institution.
2. Inflation targeting should be “abandoned”.
3. WHY? Current rate of price increases in oil and food and inflation in
developing nations would make an inflation targeting central bank
“not credible” and “powerless” in reducing domestic inflation at stable
levels.
iv. Higher level of central bank independence = lower and benign inflation
1. Bade and Parkin, 1988; Grilli, Mascianandaro, and Tabellini, 1991;
Cukierman, 1992; Arnone, Laurens, Segalotto and Sommer, 2007
v. Higher level of central bank independence = higher unemployment rates
1. Cornwall and Cornwall (1998)
2. Fuhrer (1997) and Kilponen (1999)
vi. Because of iv and v. -> suggest that Phillips curve principle by Mankiw (2007)
was valid
1. There is a short-run trade-off between inflation and unemployment.
3. QUESTION? Should a central bank focus its energies on pursuing price stability, or if it
should include employment generation as a complementary policy objective for central banks
in the Asia- Pacific region.
4. Finn Kydland and Edward Prescott (1977)
a. Dynamic inconsistency of economic policy.
b. The difference between the optimal policies that a central bank would announce if it
were considered credible by the public vs. the policies it would carry out after the
public had made decisions on the basis of its expectations.
c. Public can discount announcements of the central bank and the resulting inflation
rate = higher than it needs to be.
d. Higher inflation rate -> Output may or may not rise above the full employment rate.
5. Policymakers incentived to promote surprise inflation (Halcon and De Leon, 2004)
a. Constrained by behavior of rational agents
b. Economy with inflationary bias.
6. Importance of making reform credible over a longer time horizon.
a. Need time consistency in fiscal and monetary policies.
7. The degree of central bank independence refers to the bank’s capability to formulate and
implement its monetary policy in pursuit of a given mandate or primary objective (Abenoja,
1995).
a. Separating CB from national govt affairs to avoid seigniorage (net government
revenues as a direct result of government instructing the CB to finance deficits via
printing of money) (Abel and Bernanke, 2005).
 8. Central bank independence - 5 various dimensions (Amtenbrink, 2004)
i. Institutional independence
1. Sole goal of CB: monetary polic setting. No directives from national
gonvernment/agents/entities.
ii. Legal independence
1. Has a personality where it is able to exercise its powers & functions
with full flexibility and accountability.
iii. Personal independence
1. Fixed and secured terms of office for its decision makers.
2. Protected from summary dismissal.
iv. Functional and operational independence
1. The role of the monetary authority is controlling the monetary base
through utilization of instruments at its disposal.
2. Absence of fiscal dominance that unduly compromises the conduct of
monetary policy.
v. Financial and organizational independence
1. Full budgetary autonomy in carrying out central banking tasks and
functions.
2. This includes setting up own staffing and profit distribution
mechanisms.
9. Arnone, Laurens, Segalotto and Sommer (2007)
a. Global consensus of views on the principles of central banking autonomy:
i. Set price stability as the primary objective of monetary policy
ii. Curtail direct lending to national governments
iii. Ensure full autonomy for setting the policy rate
iv. Ensure no government involvement in policy formulation
b. Steps for central bank reforms:
i. Clarifying the objectives and establishing basic instrument autonomy
ii. Further strengthen instrument autonomy
iii. Further strengthening political autonomy

Central Bank Governance

10. Amtenbrink (2004)
a. 3 pillars of Central Bank governance rely upon its
i. Independence
ii. Accountability
iii. Transparency
b. “Guidebook” similar to the IMF’s Code of Good Practices on Transparency in
Monetary and Financial Policies is the best option
11. Hall (2003)
a. No “one size fits all” best practice governance framework.
b. Central banks should continue aiming for monetary policy excellence and corporate
governance on their own.
12. Crowe and Mead (2008)
a. More independent central banks = more likely to be highly transparent
 b. Transparency is also positively correlated with measures of national institutional
quality
c. Enhanced transparency practices are associated with the private sector making
greater use of information provided by the central bank.
13. Tuladhar (2005)
a. Under the governance structure of an inflation-targeting central bank, high
transparency and public accountability are deemed crucial
i. They are used for anchoring public expectations of the inflation process.
b. To maintain accountability, target breaches need to be publicly examined in
accordance with the terms set out when determining the inflation target.
14. Van der Cruijsen and Eijffinger (2007)
a. The tendency that more substantial research are being devoted to improving central
bank transparency and communication to the business sectors, the national
government and the general public as a whole.
b. Improved transparency and communication leads to:
i. The ability to move financial markets
ii. The potential to help the CB attain overall macroeconomic stability
iii. Central bank communication as a governance component had gradually
developed into a vital instrument in a central banker’s toolbox in managing
market expectations.

Inflation and Unemployment

15. Unemployment & inflation
a. “Twin evils” of the macroeconomy
b. Among the most difficult and politically sensitive economic issues that policy makers
face.
c. High rates of unemployment & inflation -> intense public concern because
implications are direct & visible.
d. The Phillips curve illustrates that based on United States data, a negative or an
inverse relationship exists between inflation and unemployment (Abel and
Bernanke, 2005).
i. Supported by Mankiw (2007) and Batini et al. (2006) and IMF (2006)

Results from the Pooled Least Squares Regression

16. Three (3) observations for relating CBIG indices with inflation variables
a. The accountability/transparency component
i. Negative & significant on all regressions using the 3 inflation variables.
b. The foreign exchange policy component
i. Positive & significant
c. Inflation results were mixed
i. Consistent with past studies that consensus on inverse relationship between
CBIG indices & inflation is still subject to further evaluation.
17. Two (2) observations for relating CBIG indices with unemployment variables
a. The accountability/transparency component
i. Negative relationship with unemployment
 b. The price stability component
i. Negatively related in all the three unemployment variables
ii. This result validated the Epstein (2007) argument: that the unemployment
rate could be a complement for inflation rates under increased CBIG indices.
18. The negative relationships on the price stability objective and the accountability /
transparency components of CBIG on both inflation and unemployment variables:
a. Show that Phelps’ claim (2006) was correct: that the inflation and R 5
January-February 2010 unemployment relationship is also a matter of institutions
and governance mechanisms which formulate structural policies.
19. The positive relationship with the legal, political, exchange rate and monetary policy
components
a. Show that an increase in these CBIG components could possibly increase the rate of
unemployment.

Implications for Inflation Targeting Central Banks

20. Asia-pacific central banks under the inflation targeting framework should not worry too much
about the call of Dr. Stiglitz to abandon inflation targeting for two (2) reasons:
a. Central bank independence was already established as an institutional requirement
i. For successful inflation targeting but also
ii. For creating a credible monetary authority insulated away from national
government affairs
b. The inflation targeting framework uses a comprehensive set of information to
accurately calibrate adjustments in policy interest rates – wherein part of the
comprehensive set is the fluctuations in the rate of unemployment, as well as on the
adjustments in labor wages.
c. Aside from central bank independence -> good governance of institutions & having
incentive structures = important for growth and development (North, 1990).
d. Also, even if monetary policy actions cannot directly handle the unemployment
situation, central banks keep a constant and close watch on any unusual or sudden
increase in the unemployment rates (Tetangco, 2005).
21. In the end, economic stability is anchored on
a. Price stability, which ensures that a currency preserves its purchasing power and
retains public trust.
b. It also includes a stable financial system with a considerably vibrant capital
market.
c. This is the responsibility of central banks – for their monetary policy actions
ensures control of the price level over the medium and long term (Papademos,
2007).
Lecture 3A - The Money Supply Process
I. 3 Players in the Money Supply Process
A. Central Bank
B. Banks
C. Depositors
II. Central Bank’s Balance Sheet
A. Liabilities
1. Currency in Circulation
2. Reserves
B. Assets
1. Securities
2. Loans to Financial Institutions
III. Control of the Monetary Base
A. MB = C + R
IV. Federal Reserve Open Market Operations
A. Open Market Purchase
1. Expansion of reserves in the banking system by an equal amount
2. Purchase of bonds -> Expands reserves (Central bank pays for the bonds
with reserves)
3. Increases the monetary base by an amount equal to the amount of purchase
B. Open Market Sale
1. Central Bank deducts amount from the dealer’s deposit account
2. Central Bank reserves (liabilities) decrease by the same amount
V. Overview of the Fed’s Ability to Control the Monetary Base
A. Nonborrowed monetary base = monetary base minus borrowings from the central
bank (borrowed reserves)
VI. Multiple Deposit Creation: A Simple Model
VII. 3 Critiques of the Simple Model
A. If proceeds from B ank A are not deposited but are kept in currency, nothing is
deposited in Bank B and the deposit creation ceases.
B. If banks do not make loans/buy securities in the full amount of their excess reserves,
no deposits will be made in Bank B, and this will stop the deposit creation process.
C. It is not just the central bank who is the only player whose behavior influences the
level of deposits and therefore the money supply.
VIII. Factors that Determine the Money Supply
A. Changes in the Nonborrowed Monetary Base
1. Money Supply & Nonborrowed Monetary Base +
a) Open Market Purchases -> Increase in nonborrowed monetary base
b) Open Market Sales -> Decrease in nonborrowed monetary base
B. Changes in Borrowed Reserves
1. Money Supply & Borrowed Reserves +
a) Increase in loans provided by the Central Bank -> Additional
borrowed reserves -> Increases amount of the monetary base and
reserves -> Multiple deposit creation occurs -> Money Supply
Expands
C. Changes in the Required Reserve Ratio
 1. Money Supply & Required Reserve Ratio -

D. Money Supply Response to Changes in the Factors

1. Just look at the money multiplier formula to see the effect
2. Rise in currency ratio -> increases the money multiplier
Lecture 3B - Tools of Monetary Policy

Preview
The Fed
- Focuses on the federal funds rate (the interest rate on overnight loans of reserves from one
bank to another) as the primary instrument of monetary policy
- Effect on the Money Supply
- Direct effect on the federal funds rate

Demand and Supply in the Market for Reserves

Demand Curve
- 2 Components of the Amount of Reserves:
1. Required Reserves = Required Reserve Ratio x Amt of deposits on which reserves
are required
2. Excess Reserves
- When federal funds rate is above the rate paid on excess reserves (ioer)
- As the federal funds rate decreases, opportunity cost of holding excess reserves
falls.
- Everything else constant, quanty of reserves demanded rises
- Demand curve for reserves slopes downwards
- When federal funds rate is below the rate paid on excess reserves (ioer)
- Banks don’t lend in the overnight market at a lower interest rate.
- They’ll just keep on adding to their holdings of excess reserves indefinitely.
- As a result, demand curve for reserves, Rd becomes flat (infintely elastic) at
ioer

Supply Curve
- 2 Components of the Suply of Reserves
1. Nonborrowed Reserves (NBR)
a. Supplied by the Fed’s open market operations
2. Borrowed Reserves
a. Amount of Reserves borrowed from the Fed
b. Id = discount rate
i. Primary cost of borrowing from the Fed is the interest rate charged by
the Fed on these loans.
ii. Set at a fixed amount above the federal funds target rate
iii. Changes when the target changes
3. If the federal funds rate iff is below the discount rate id
a. Banks will not borrow from the Fed.
b. Borrowed reserves = zero because borrowing in the federal funds market is
cheaper.
 c. Supply of reserves = Amount of nonborrowed reserves supplied by the Fed,
NBR
d. Supply Curve will be vertical
4. If the federal funds rate iff is above the discount rate id (if it begins to rise above
the discount rate)
a. Banks will not borrow in the federal funds market at all.
b. Banks will borrow from the Fed at the discount rate.
c. The federal funds rate cannot rise above the discount rate.
i. As a result, the supply curve becomes flat.

Market Equilibrium
- When Rs = Rd
- When federal funds rate is above the equilibrium at i2ff
- More reserves are supplied than are demanded (excess supply)
- Federal funds rate falls to i*ff (shown by the downward arrow)
- When federal funds rate is below the equilibrium rate at i1ff
- More reserves are demanded than are supplied (excess demand)
- Federal funds rate rises (upwards arrow)
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate
- 4 Tools of Monetary Policy:
- Open Market Operations
- Discount Lending
- Reserve Requirements
- Interest rate paid on excess reserves
- These tools affect the:
- Market for Reserves
- Equilibrium Federal Funds Rate
1. Response to an Open Market Operation

- Depends on whether the suply curve initially intersects the demand curve in its:
- Downward-sloped section or in its
- Flat section

Fig. A (Intersection of the supply curve and the demand curve in the downward-sloped
section)
- Open Market Purchase -> Greater quantity of reserves supplied
- True at any given federal funds rate because of the higher amount of Nonborrowed
Reserves, which rises from NBR1 to NBR2.
- Open market purchase leads to a
- Shift in the supply curve to the right from R1s to R2s
- Moves the equilibrium from point 1 to point 2 lowering the federal funds
rate from iff1 to iff2
- Open market sale leads to a
- Decrease in the quantity of nonborrowed reserves supplied
- Shift in the supply curve to the left causing the federal funds rate to rise
 - Note that Fed usually keeps the federal funds rate target above the interest paid on excess
reserves.

Fig. B (Intersection of the supply curve on the flat section of the demand curve)
- Open market operations = no effect on the federal funds rate.
- Open market purchase leads to a
- Shift in the supply curve to the right from R1s to R2s.
- Federal funds rate remains unchanged at ioer because the interest rate paid on
excess reserves ioer sets a floor for the federal funds rate.

2. Response to a Change in the Discount Rate

Fig. A (Intersection of the demand curve and the supply curve in the vertical section)
- No discount lending and borrowed reserves, BR, are zero.
- When discount rate is lowered by the Fed from id1 to id2, the horizontal section of the
supply curve falls to R2s but the intersection of the supply and demand curves
remains at point 1.
- No change in the equilibrium federal funds rate.
- Since the Fed usually keeps the discount rate above its target for the federal funds
rate, most changes in the discount rate have no effect on the federal funds
rate.
Fig. B (Intersection of the demand curve and the supply curve in the horizontal section)

- Some discount lending (BR > 0)

- Changes in the discount rate do affect the federal funds rate
- In this case, initially discount lending is positive and the equilibrium federal funds rate
equals the discount rate, i1ff = i1d .
- When the discount rate is lowered by the Fed from i1d to i2d , the horizontal section of
the supply curve Rs2 falls
- moving the equilibrium from point 1 to point 2, and the equilibrium federal funds rate
falls from i1ff to i2ff (= i2d, as shown in panel (b). In this case, BR increases from BR1 to
BR2.
3. Response to a Change in Required Reserves

- When the required reserve ratio increases -> required reserves increase -> quantity of
reserves demanded increases for any given interest rate.
- Rise in the required reserve ratio -> shift in the demand curve to the right from Rd1 to Rd2.
- This moves the equilibrium from point 1 to point 2.
- This results in the increase of the federal funds rate from i1ff to i2ff.
- When the Fed raises reserved requirements, the federal funds rate rises.
- When the Fed decreases reserve requirements, the federal funds rate falls.
- This is because a decline in the required reserve ratio -> lowers quantity of reserves
demanded -> shifts the demand curve to the left -> federal funds rate fall.
 4. Response to a Change of Interest on Excess Reserves
- Depends on whether the supply curve intersects the demand curve in its downward-sloping
section or its flat section.

Fig. A. Intersection occurs on the demand curve’s downward-sloping section where the
equilibrium federal funds rate > interest paid on excess reserves.
- When the interest rate on excess reserves ioer1 rises to ioer2, the horizontal section of the
demand curves rises to Rd2 but the intersection of the supply and demand curve remains at
point 1.
Fig. B. Intersection occurs on the demand curve’s flat section where the equilibrium federal
funds rate = interest paid on excess reserves.
- When the interest rate on excess reserves ioer1 rises to ioer2, the equilibrium federal funds
rate rises from iff1 = ioer1 to iff2 = ioer2.
- When the federal funds rate is at the interest rate paid on excess reserves, a rise in the
interest rate on excess reserves raises the federal funds rate.

5. How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal
Funds Rate

Conventional Monetary Policy Tools

1. Open Market Operations
2. Discount Policy & the Lender of Last Resort
3. Reserve Requirements

Relative Advantages of the Different Monetary Policy Tools

1. Open Market Operations
a. Occur at the initiative of the Fed who has complete control over their volume.
b. Flexible & precise, can be used to the exact extent desired.
c. Easily reversed by the Fed.
d. Can be implemented quickly (no administrative delays)
Failure of Conventional Monetary Policy Tools in a Financial Panic
- When the economy experiences a full-scale financial crisis, conventional monetary policy
tools cannot do the job, for 2 reasons.
1. First, the financial system seizes up to such an extent that it becomes unable to
allocate capital to productive uses, and so investment spending and the economy
collapse.
2. Second, the negative shock to the economy can lead to the zero-lower-bound
problem.

Nonconventional Monetary Policy Tools and Quantitative Easing

- Also known as non-interest rate tools
- Four (4) forms:
1. Liquidity provision
- Discount window expansion
- Term Auction Facility
- New Lending Programs
2. Asset purchases
- Large-scale asset purchases
3. Forward guidance
4. Negative interest rates on bank deposits at a central bank