{"id":607,"date":"2015-05-07T21:44:04","date_gmt":"2015-05-07T21:44:04","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterymacro1xngcxmaster\/?post_type=chapter&p=607"},"modified":"2016-07-28T20:54:15","modified_gmt":"2016-07-28T20:54:15","slug":"monetary-policy-and-economic-outcomes","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-hccc-macroeconomics\/chapter\/monetary-policy-and-economic-outcomes\/","title":{"raw":"Reading: Monetary Policy and Interest Rates","rendered":"Reading: Monetary Policy and Interest Rates"},"content":{"raw":"

The Effect of Monetary Policy on Interest Rates<\/h2>\r\n
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\r\n\r\nA monetary policy that lowers interest rates and stimulates borrowing is known as an expansionary monetary policy<\/em><\/a> or loose monetary policy<\/em><\/a>. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy<\/em><\/a> or tight monetary policy<\/em><\/a>. This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed\u2019s monetary policy practice in recent decades.\r\n
\r\n\r\nConsider the market for loanable bank funds, shown in Figure\u00a014.7. The original equilibrium (E0<\/sub>) occurs at an interest rate of 8% and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0<\/sub>) to S1<\/sub>, leading to an equilibrium (E1<\/sub>) with a lower interest rate of 6% and a quantity of funds loaned of $14 billion. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0<\/sub>) to S2<\/sub>, leading to an equilibrium (E2<\/sub>) with a higher interest rate of 10% and a quantity of funds loaned of $8 billion.\r\n
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\r\n\r\n[caption id=\"attachment_4582\" align=\"aligncenter\" width=\"390\"]\"This Figure 14.7<\/strong>. Monetary Policy and Interest Rates The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.[\/caption]\r\n\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\n \r\n\r\nSo how does a central bank \u201craise\u201d interest rates? When describing the monetary policy actions taken by a central bank, it is common to hear that the central bank \u201craised interest rates\u201d or \u201clowered interest rates.\u201d We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, interest rates change, as shown in Figure\u00a014.7. If they do not meet the Fed\u2019s target, the Fed can supply more or less reserves until interest rates do.\r\n\r\nRecall that the specific interest rate the Fed targets is the federal funds rate<\/em><\/a>. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.\r\n\r\nOf course, financial markets display a wide range of interest rates<\/em><\/a>, representing borrowers with different risk premiums and loans that are to be repaid over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate\u2014which remember is for borrowing overnight\u2014will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the specific interest rates are set by the forces of supply and demand in those specific markets for lending and borrowing.\r\n

Self Check: Open Market Operations<\/h2>\r\nAnswer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not<\/strong> count toward your grade in the class, and you can retake it an unlimited number of times.\r\n

You\u2019ll have more success on the Self Check if you\u2019ve completed the Reading in this section.<\/span><\/p>\r\nUse this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.\r\n\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/567\r\n\r\n<\/div>\r\n

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The Effect of Monetary Policy on Interest Rates<\/h2>\n
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A monetary policy that lowers interest rates and stimulates borrowing is known as an expansionary monetary policy<\/em><\/a> or loose monetary policy<\/em><\/a>. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy<\/em><\/a> or tight monetary policy<\/em><\/a>. This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed\u2019s monetary policy practice in recent decades.<\/p>\n

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Consider the market for loanable bank funds, shown in Figure\u00a014.7. The original equilibrium (E0<\/sub>) occurs at an interest rate of 8% and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0<\/sub>) to S1<\/sub>, leading to an equilibrium (E1<\/sub>) with a lower interest rate of 6% and a quantity of funds loaned of $14 billion. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0<\/sub>) to S2<\/sub>, leading to an equilibrium (E2<\/sub>) with a higher interest rate of 10% and a quantity of funds loaned of $8 billion.<\/p>\n

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\"This<\/p>\n

Figure 14.7<\/strong>. Monetary Policy and Interest Rates The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n

 <\/p>\n

So how does a central bank \u201craise\u201d interest rates? When describing the monetary policy actions taken by a central bank, it is common to hear that the central bank \u201craised interest rates\u201d or \u201clowered interest rates.\u201d We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, interest rates change, as shown in Figure\u00a014.7. If they do not meet the Fed\u2019s target, the Fed can supply more or less reserves until interest rates do.<\/p>\n

Recall that the specific interest rate the Fed targets is the federal funds rate<\/em><\/a>. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.<\/p>\n

Of course, financial markets display a wide range of interest rates<\/em><\/a>, representing borrowers with different risk premiums and loans that are to be repaid over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate\u2014which remember is for borrowing overnight\u2014will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the specific interest rates are set by the forces of supply and demand in those specific markets for lending and borrowing.<\/p>\n

Self Check: Open Market Operations<\/h2>\n

Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not<\/strong> count toward your grade in the class, and you can retake it an unlimited number of times.<\/p>\n

You\u2019ll have more success on the Self Check if you\u2019ve completed the Reading in this section.<\/span><\/p>\n

Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.<\/p>\n

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