Ecn. 120
Todd Easton
February 2007
Monetary Policy, Interest Rates, and Aggregate Expenditure
Last class we looked at the responsibilities of the Fed. For our purposes, the most important
responsibility of the Fed is controlling the supply of money. Mostly, as we saw in class, the Fed
exercises its control over the money supply through open market operations. In particular, we
saw that the Fed buys Treasury bonds when it wishes to make the money supply bigger. It sells
Treasury bonds when it wishes to make the money supply smaller. 1
This control over the money supply is not important for its own sake. It matters because the
changes in the money supply the Fed brings about affect the level of interest rates in our
economy. The level of interest rates, in turn, affects the level of total spending (aggregate
expenditures). This handout explains how open market operations affect interest rates and how
the Fed decides what level of interest rates it desires. It also explains how the Fed attains its
interest rate target and how changes in interest rates affect the level of spending in the economy.
How open market operations affect interest rates
The Fed conducts open market operations to influence interest rates, but what does that phrase
“interest rates” mean? Begin with an example: Suppose you borrow $2,000 from a bank. You
pay the bank an annual “fee” for the use of their money. That “fee” is the loan’s interest
payment. The interest rate on the loan is the “fee” as a percentage of the loan’s value. For
example, if the interest rate were 5%, then the annual fee would be .05 x $2,000 = $100.
We talk about the Fed influencing interest rates (plural), rather than the interest rate (singular),
because there are many different sorts of loans. People borrow money for five years to buy a car
and for thirty years to buy a house. Corporations and businesses borrow to finance production or
to buy new equipment. Different loans carry different interest rates because the period the
money is lent for differs and because the risk of the loans differs. However, the different interest
rates tend to move together. When car loans are getting more expensive, corporate loans tend to
be getting more expensive too.
We also talk about interest rates, rather than the interest rate, because interest rates on bonds are
just as important to the macroeconomy as interest rates on loans. When large corporations need
money, they can borrow from a bank or they can issue bonds. The expense of borrowing affects
corporations’ spending on equipment—and interest rates on loans are just as important as interest
rates on bonds.
Our textbook sometimes refers to bonds as “securities.” This is because the word bond can be used in two ways:
as a general term for debt securities, or as a specific term for long term debt securities. In the case of US Treasury
securities, the specific term “Treasury bond” refers to debt securities maturing in thirty years. There are also two
other flavors of Treasury debt: Treasury notes mature in two to ten years, while Treasury bills mature in 4 to 26
weeks. To simplify, we will use the term “Treasury bond” in its general sense, to refer to all Treasury
debt securities.
1
2
To understand the Fed’s influence on interest rates, the best place to begin is the market for
Treasury bonds, the bonds the U.S. Treasury sells to finance deficit spending. Suppose the Fed
is buying Treasury bonds. How can that affect interest rates in the economy?
To see how this works, imagine a very simple Treasury bond (see the box below), one that
matures in one year and pays
interest only when it matures.
When the Treasury issues the
bond, it fixes the bond’s face
value and its interest rate. The
face value is the amount the
Treasury will pay the owner of
the bond when it matures, plus
Face value: $1,000
the interest due. Since the
interest rate on our bond is 5%,
the Treasury will pay the bond’s
Interest rate: 5%
owner $1,050.
U.S. Treasury Bond
Here’s the calculation:
$1,000 + (.05 x $1,000) =
$1,000 + $50 =
$1,050.
However, one does not have to wait until a Treasury bond matures to get one’s money back. If I
buy a bond from the Treasury today, I can sell it on the bond market next week. But there is a
catch: the price I sell it for will likely to be higher or lower than the price I bought it for.
The bond market is very competitive, so the price of a bond is determined by supply and
demand. If demand increases after the bond is issued, the price will rise. If demand decreases,
the price will fall. If the Fed starts buying bonds, that adds to demand and raises bond prices.
To go beyond bond prices to bond interest rates, we need one additional concept: yield. The
yield of a bond is just the annual rate of return one earns holding it. Suppose you buy an asset,
hold it for a year, and then sell it. The rate of return you earn is just the rise in the asset’s price
during the year, divided by the price you paid for it. Suppose our simple Treasury bond was
issued on January 1st. If I buy it on that day for its face value, and then hold it until the end of
the year, I would receive $50 more at the end of the year than I paid at the beginning. As a
result, the yield on the
Table 1, Changes in price cause changes in yield
investment would be 5%
A) January 1
B) January 7
[see Column A) of Table 1].
face value
$1,000
$1,000
interest rate
5%
5%
If one pays the face value
price
$1,000
$1,010
for a bond, the yield is the
(1,050-1,000)/1,000=
(1,050-1,010)/1,010=
same as the interest rate.
yield
50/1000=.05=5%
40/1010=.04=4%
However, things are not so
simple if the price rises or
3
falls. If the Fed is buying bonds, it creates a shortage that drives bond prices up. Suppose the
price of our simple Treasury rises to $1,010 as a result. If I decide to sell the bond a week later
to take advantage of the price rise, the person who buys the bond from me will earn a lower yield
for the year than I would have. They pay $10 more for the bond, but they get the same payment
at the end of the year that I would have. As a result, the yield the second buyer earns would be
4% [see Column B) of Table 1].
I hope you can see how Fed open market operations influence bond yields by affecting bond
prices. The effect on interest rates requires just one more step. Suppose the Treasury issues
another batch of new bonds on January 7th. What interest rate will they bear?
The Treasury’s job is to finance deficits at minimum cost to taxpayers, so they set the lowest
possible interest rate on each batch they issue. If the yield on bonds is 4% on January 7, the Fed
will not need to pay so high an interest rate on the new batch as they did the week before. The
rate of return a person gets from investing in the new batch of bonds just needs to match the rate
of return from investing in the old batch. As a result, the Treasury will be able to sell bonds on
January 7th with an interest rate of 4%. So there you are: if the Fed can affect bond yields, then
they can also affect bond interest rates!
Bond interest rates and the federal funds rate
So far, we have talked about bond interest rates and loan interest rates. Banks lend money to
corporations and individuals, but they also lend money to one another. When a bank has excess
reserves, it can make a very short term loan of those reserves in what is called the federal funds
market. The interest rate on such a loan is called the federal funds rate.
Where the target for the federal funds rate comes from
Because these loans are for such a short period, Fed open market operations affect this interest
rate more directly than any other. Since 1995, the Fed communicates monetary policy’s
direction by announcing a target for the federal funds rate. The press release in Exhibit 1
illustrates such a communication. The Fed makes a press release like this one each time the
Federal Open Market Committee (FOMC) meets. [If you want to read the most recent release,
go the Federal Reserve Board’s Monetary Policy page and click on the “FOMC Statement” link.]
4
Exhibit 1, A recent Fed press release announcing a change in the federal funds target rate
Release Date: June 29, 2006
The Federal Open Market Committee decided today to raise its target for the federal funds rate
by 25 basis points to 5-1/4 percent.
Recent indicators suggest that economic growth is moderating from its quite strong pace earlier
this year, partly reflecting a gradual cooling of the housing market and the lagged effects of
increases in interest rates and energy prices.
Readings on core inflation have been elevated in recent months. Ongoing productivity gains have
held down the rise in unit labor costs, and inflation expectations remain contained. However, the
high levels of resource utilization and of the prices of energy and other commodities have the
potential to sustain inflation pressures.
Although the moderation in the growth of aggregate demand should help to limit inflation
pressures over time, the Committee judges that some inflation risks remain. The extent and
timing of any additional firming that may be needed to address these risks will depend on the
evolution of the outlook for both inflation and economic growth, as implied by incoming
information. In any event, the Committee will respond to changes in economic prospects as
needed to support the attainment of its objectives.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F.
Geithner, Vice Chairman; Susan S. Bies; Jack Guynn; Donald L. Kohn; Randall S. Kroszner;
Jeffrey M. Lacker; Sandra Pianalto; Kevin M. Warsh; and Janet L. Yellen.
If the Fed wants to restrain the economy, they announce a rise in their target for the federal funds
rate. In such a situation, we say monetary policy is tightening. If the Fed wants to stimulate the
economy, they announce a drop in their target for the federal funds rate. In that case, we say
monetary policy is easing. In the case of Exhibit 1, the Fed announced a rise in their target for
the federal funds rate “by 25 basis points.” A basis point is 1/100th of a percent, so they
announced a rise from 5.00 to 5.25%.
Each time they meet, the FOMC members must choose among three courses of action: raise their
target for the federal funds rate, leave their target unchanged, or drop their target. How do they
make their decision? To make that choice, they essentially ask themselves this question:
What is the greater risk right now: a
rise in the inflation rate or an end to
economic growth?
5
If they conclude that the greater risk is a rise in the inflation rate, the Fed tightens monetary
policy. In Exhibit 1, we can see that was the decision the FOMC reached on June 29th, 2006 (see
the highlighted passage). The press release discusses signs of slower economic growth,
something that might lead to a lower inflation rate. However, it concludes that high levels of
capacity utilization and high commodity prices may move inflation rates higher in spite of slower
economic growth.
If the FOMC meets and concludes that the risk to economic growth is greater than the risk of a
rising inflation rate, they announce a drop in the federal funds rate and the easing of monetary
policy. That was the decision they reached at a crucial juncture, right before the 2001 recession.
The stock market crash that began early in 2000 resulted partly from over-investment in
telecommunications equipment. In the second half of 2000, investment spending dropped
sharply, especially in telecommunications, and employment growth slowed. The Fed responded
to that slowing by changing monetary policy’s direction (as you can see in the highlighted
passage in Exhibit 2).
Exhibit 2, A Fed press release just before the 2001 recession began
Release Date: January 3, 2001
The Federal Open Market Committee decided today to lower its target for the federal funds
rate by 50 basis points to 6 percent.
In a related action, the Board of Governors approved a 25-basis-point decrease in the
discount rate to 5-3/4 percent, the level requested by seven Reserve Banks. The Board also
indicated that it stands ready to approve a further reduction of 25 basis points in the discount
rate to 5-1/2 percent on the requests of Federal Reserve Banks.
These actions were taken in light of further weakening of sales and production, and in the
context of lower consumer confidence, tight conditions in some segments of financial
markets, and high energy prices sapping household and business purchasing power.
Moreover, inflation pressures remain contained. Nonetheless, to date there is little evidence
to suggest that longer-term advances in technology and associated gains in productivity are
abating.
The Committee continues to believe that, against the background of its long-run goals of
price stability and sustainable economic growth and of the information currently available,
the risks are weighted mainly toward conditions that may generate economic weakness in
the foreseeable future.
6
Finally, if the FOMC meets and concludes that the risk of a rise in the inflation rate is about the
same as the risk of an end to economic growth, they leave their target for the federal funds rate
unchanged. That is what they did in their meetings from June 2006 to January 2007.
How the Fed attains target for the federal funds rate
Once the Fed sets a target for the federal funds rate, how do they attain it? They attain it though
open market operations, through buying and selling Treasury bonds. For example, when they
raised the target from 5% to 5.25% on June 29th, the Fed’s bond trading desk sold bonds. Their
bond sales pushed bond prices down and bond yields up. As a result, interest rates in the
economy generally rose—including the federal funds rate.
The graph below shows that the Fed’s bond trading desk is generally able to keep the federal
funds rate close to the target. To see the June 2006 to January 2007 period, during which the
target was 5.25%, look at the area circled on the far right of the graph.
The Federal Funds Rate for the Last Ten Years
8
7
6
Rate
5
4
3
2
1
24
07
-0
1-
25
20
06
-0
1-
26
20
05
-0
1-
28
20
04
-0
1-
29
20
03
-0
1-
30
20
02
-0
1-
31
20
01
-0
1-
02
20
00
-0
2-
03
20
19
99
-0
2-
04
2-0
98
19
19
97
-0
2-
05
0
Date
How changes in interest rates affect aggregate expenditure
When the Fed changes monetary policy, it is with the goal of restraining the economy or of
stimulating it. How do open market operations, and the resulting change in interest rates, do
this? They do it through their effect on interest-sensitive spending.
7
For example, think about the rise in interest rates the Fed set in motion on June 29th. Higher
interest rates reduced both planned investment and consumption below what they would
otherwise have been. If businesses have to pay a higher interest rate when they borrow money to
buy equipment and build factories, they will buy and build less. If households have to pay a
higher interest rate to borrow, they too will spend less. The following diagram describes the
effect of a rise in interest rates on two key components of aggregate expenditures:
↑ Interest rates
↓I & ↓C
Two parts of aggregate expenditures are particularly interest sensitive: purchases of new houses
and purchases of new cars.i As a result, monetary policy does not have an even effect on
aggregate expenditures. Tight monetary policy especially reduces production of houses and cars.
For example, workers in construction and the wood products industry are more likely to be
victims of tight monetary policy than employees of hospitals and restaurants.
In Closing
Chapter 10 of our textbook taught us about what the money supply is and about how monetary
policy tools can be used to influence it. This reading builds on Chapter 10 by explaining the
practical importance of monetary policy. In particular, it explains how open market operations
affect interest rates. When the Fed buys bonds, for example, it raises bond prices and lowers
bond yields. Lower yields on existing bonds cause lower interest rates on newly issued bonds
and on newly made loans.
This reading also explains how—and why—the Fed regulates interest rates. It uses a particular
interest rate, the federal funds rate, as its indicator of the price of credit. The members of the
Federal Open Market Committee (FOMC) evaluate economic conditions and decide whether the
Fed should raise the federal funds rate, lower it, or leave it unchanged. The FOMC lets the
public know the direction of monetary policy by announcing its target for the federal funds rate.
For example, if it announces a reduction in the federal funds rate, the public knows the Fed will
be buying bonds to lower interest rates in the economy. Doing that should raise planned
investment, personal consumption expenditures, and aggregate expenditures.
i
I say new houses and cars because purchases of owner-occupied houses and used cars are not included in aggregate
expenditure. Those purchases just redistribute prior years’ production; they do not influence production this year.