Monetary Policy and Open Market Operations

Open market operations

Purchases or sales of government securities by the central bank in
the open market for bonds to change the supply of money
Expansionary open market operation: purchases of government
securities (government bonds) by the central bank to increase
(expand) the money supply
Contractionary open market operation: sales of government
securities by the central bank to decrease (contract) the money
supply

Monetary Policy and Open Market Operations

Open market purchases in which the central bank increases the
money supply by buying bonds lead to an increase in the price of
bonds and a decrease in the interest rate.
The purchase of bonds by the central bank shifts the money supply
to the right.
Open market sales in which the central bank decreases the money
supply by selling bonds lead to a decrease in the price of bonds and
an increase in the interest rate.
The selling of bonds by the central bank shifts the money supply to
the left.

Figure 4.4: The Effect of an Increase in the Money Supply on the

Interest Rate

Effect of an Increase in the Money Supply on the Interest Rate

An increase in the supply of money by the central bank leads to a
decrease in the interest rate.
How?
The central bank increases the money supply: the money supply

curve shifts rightward from to .

Agents (households or firms) have more money than they want to
hold at an initial interest rate : surplus (or excess supply) of money

Effect of an Increase in the Money Supply on the Interest Rate

Q: What do agents do with the extra money?
They are most likely to use the money to buy short-term bonds
Buying short-term assets such as bonds drives up their prices and
drive down their interest rates
The decrease in the interest rate increases the quantity demanded
of money so it equals the now larger money supply
The money market achieves a new equilibrium at <

Example(4.1): Money Market Equilibrium

Suppose that money demand is given by = $(0.25 ) where $Y
is $100. Also, suppose that the supply of money is $20.
a) What is the equilibrium interest rate?
(Ans.)
Equilibrium condition: = (in nominal terms)
$20 = $100 0.25
$20 = $25 $100
$100 = $5
= 0.05 ( 5%)

Example(4.1): Money Market Equilibrium

b) If the Federal Reserve Bank wants to increase i by 10 percent points
(e.g., from 2% to 12%), at what level should it set the supply of money?
(Ans.)
Equilibrium condition: =
= $100 0.25 0.15 = $100 0.1 = $10.

Example (4.2): Money Market Equilibrium

Suppose that the money demand function is

= 1000 100,
where is the interest rate in percent. The money supply is 1000
and the price level is 2.
a) What is the equilibrium interest rate?
(Ans.)
Equilibrium condition:

1000
2

= 1000 100

500 = 1000 100

=

500
100

= 5%.

(in

real terms)

Example (4.2): Money Market Equilibrium

b) Assume that the price level is fixed. What happens to the

equilibrium interest rate if the supply of money is raised from 1,000 to
1,200?
(Ans.)
Equilibrium condition:

1200
2

= 1000 100

600 = 1000 100

=

400
100

= 4%.

Thus, increasing the money supply from 1,000 to 1,200 causes the
equilibrium interest rate to fall.

Example (4.2): Money Market Equilibrium

d) If the Fed wishes to raise the interest rate to 7%, what money supply
should it set?
(Ans.)
Equilibrium condition:

= 1000 100 7

= .

Bond Prices and Interest Rates

What determined in bond markets is not interest rates, but bond
prices. We want to show that the interest rate on a bond can be
inferred from the price of the bond.
The relationship between bond prices and interest rates depends on
an important concept called the present value.
Present value
The value of funds today that will be received in the future

Bond Prices and Interest Rates

4.8 : $ =

$
+

or =

$$
$

or =

$
$

where $ is the present value of a bond and $ is future value.

The higher the price of the bond, the lower the interest rate;
the lower the price of the bond, the higher the interest rate.

Bond market went up (rallied) today

The price of bonds went up, and therefore interest rates went
down.
Treasury yields held lower, with the 10-year yield at 2.12% and
the 2-year yield at 0.67%.

Example (4.3): Bond Price vs. Interest Rate

Suppose the bonds in the economy are one-year bonds bonds that
promises a payment of a given number of dollars, say $1000, a year
from now. What is the value of money received in the future equal to
the value of money today (called present value)?
(Ans.)
$ = $ (1 + ) $ =

$
1+

If = 0.01( 1%), then $ =

If = 0.111, then $ =

$1000
1+0.111

$1000
1+0.01

= $990.

= $900.

Bond Prices and Interest Rates

Q: Why does a lender charge the interest rate on loans?
(i) Compensation for inflation
(ii) Compensation for default risk the chance that the borrower will
not pay back the loan
(iii) Compensation for the opportunity cost of waiting to spend
money
Notice that these three factors vary from lender to lender and from
loan to loan.

Example (4.4): Present Value for Multiple Years

Suppose that you are willing to loan money for two years if you receive
10% interest in each of the two years. What is the present value of the
payment, $1,210 that will be paid back at the end of the second year?
(Ans.)
$1210
= $ 1 + 0.10 1 + 0.10
= $(1 + 0.10)2
$ =

$1210
(1+0.10)2

= $1,000

The $1,210 you would receive two years from now has a present
value of$1,000.

Present Value for Multiple Years

General formula: 4.6 : $ =

$
+

(i) The higher the interest rate, the lower the present value of a
future payment; the lower the interest rate, the higher the present
value of a future payment: $ and $ .
(ii) The longer an investor has to wait to receive a payment, the less
value it will have for him or her: $ .
$ =
$ =

$1,000,000
(1+.)
$1,000,000
(1+.)

=
=

$1,000,000
$385,543 and $ =
= $148,644

(1+.)
$1,000,000
$92,296 and $ =
= $295,303

(1+.)

Present Value for Multiple Years

Economists use the term time value of money to refer to the fact that
the value of a payment changes depending on when the payment is
received.
Time value of money
The way the value of a payment changes depending on when the
payment is received
Anyone who buys a financial asset, such as a share of stock or a bond,
is really buying a promise to receive certain payments in the future.
Thus, the price of a financial asset should equal the present value of
the payments an investor expects to receive from owning that asset.

Example (4.5): Coupon and Interest Rate

Consider the case of a five-year coupon bond that pays an annual
coupon of $60 and has a face value of $1,000. What is the price of
the bond?
(Ans.)
Coupon
The interest on a bond, which is a flat dollar amount that is
regularly paid each time period and that does not change during the
life of the bond
$ =

$60
(1+)

$60
(1+)2

$60
+
(1+)3

$60
(1+)4

For = 5% (0.05), = $1,043.29.

$60
+
(1+)5

$1,000
(1+)5

Coupon and Interest Rate

General Formula for C:
A bond makes coupon payments, , has a face value (), and
matures in years.
4.7 :
=

(1+)

+
(1+)2

(1+)3

+ +

(1+)

$
(1+)

An increase in interest rates reduces the prices of existing financial

assets, and a decrease in interest rates increases the prices of existing
financial assets.

Example (4.6): Discount Bonds and Interest Rate

Suppose that you pay a price of $961.54 for a $1,000 face value oneyear Treasury bill. U.S. Treasury bills are discount bonds, which means
they do not pay a coupon but are sold at a discount to their face value.
a) What is the interest rate on the Treasury bill?
(Ans.)

$$
=
100
$
1000961.54
=
100
961.54

= 4%

Example (4.6): Discount Bonds and Interest Rate

b) Suppose that the day after you purchased your Treasury bill,
investors decided they will only buy one-year Treasury bill if they
receive an interest rate of 5% on their investment. What will be the
price at which you could sell your Treasury bill to another investor?
(Ans.)
$ =

$
(1+)

$1,000
(1+0.5)

= $952.38

As a result of an increase in the interest rate for Treasury bill from 4%

to 5%, you have suffered a capital loss of $9.16:
$952.38 - $961.54 = -$9.16.

Determining the Interest Rate (): Method II

In this section, we see that the money supply is determined not

only by the central bank policy but also by the behavior of
households (which hold money) and banks (in which money is held).
Financial intermediaries
Institutions that receive funds from people and firms and use these
funds to buy financial assets or to make loans to other people and firms
Financial intermediation
The process of transferring funds from savers to borrowers

Central Bank Balance Sheet

Federal Reserve Bank
Assets
$900
Securities
(bonds)
Gold
$100
Total assets

$1000

Liabilities
Currency held by
nonbank public
Vault cash held
by banks
Reserve deposits
Total liabilities

$700
$100
$200
$1000

Currency issued by the central bank (the Fed) and held either by
the nonbank public or in vaults of private-sector banks is a debt
obligation of the Fed.

Central Bank Balance Sheet

Monetary base (MB) or high-powered money (H)
= reserve deposits + currency (including both currency held by the
nonbank public and vault cash held by banks)
= $200 + ($700 + $100)
= $1000

Private Banks Balance Sheet

Private Bank
Assets
Vault cash

Liabilities
$100

Deposits

$3000

Total liabilities

$3000

Reserve deposits $200

Loans

$2700

Total assets

$3000

Banks keep as reserves some of the funds (or deposits) they receive.

Private Banks Balance Sheet

Reserves
The deposits that banks have received but have not lent out

Reserves are held partly in cash and partly in an account the banks
have at the central bank:
reserves by a bank
= cash in its vault + its reserves at the central bank
= $100 + $200 = $300.

Bank Reserves
Banks hold reserves for three reasons:
(i) Meet some depositors demand for withdrawal
(ii) Meet the demand for checks
(iii) Satisfy reserve requirements by law
Reserve requirements: reserve requirement set by the central bank
that banks must hold reserves in some proportion of their checkable
deposits

Bank Reserves
Reserve ratio or reserve-deposit ratio

()
=
()
bank reserves ()
=
bank checkable deposits ()
$
=
= . ( )
$

Creation of Money by Banks

Q: How does the bank affect the money supply?
A: The bank can affect the money supply by loaning out excess
reserves (reserves that exceed required reserves - a minimum
amount required by law) at some interest or by buying securities.
100-percent-reserve banking
All deposits are held as reserves: banks simply accept deposits,
place the money in reserves, and leave the money there until the
depositor makes a withdrawal or writes a check against the balance

Creation of Money by Banks

If the banks hold 100 percent of deposits in reserves, the banking
system does not affect the supply of money.
Fractional-reserve banking
A system under which banks keep only a fraction of their deposits
in reserve
A system in which the reserve-deposit ratio is less than one
In a system of fractional-reserve banking, banks create money by
making loans.

Creation of Money by Banks

Suppose that no one in the economy holds cash and banks lend to their
limits, and that the Fed buys $100 of securities from an investor.
Federal Reserve Bank
Assets

Liabilities

Securities (bonds)

$900 + $100 Currency held by

= $1000
nonbank public

$700

Gold

$100

Vault cash held by banks

$100

Reserve deposits

$200 + $100
= $300
$1100

Total assets

$1100

Total liabilities

Creation of Money by Banks

Private Bank (first stage)
Assets
Vault cash
$100
Reserve deposits
Loans
Total assets

$200 + $100
= $300
$2700
$3100

Liabilities
Deposits

Total liabilities

Excess reserves
= reserves ($100 + $300) required reserves
= $400 - $310 (=$3100*0.1) = $90

$3000 + $100
= $3100

$3100

Creation of Money by Banks

Private Bank (second stage)
Assets
Vault cash
$100
Reserve deposits

$300

Loans

$2700 + $90
= $2790
$3190

Total assets

Liabilities
Deposits

Total liabilities

$3100 + $90
= $3,190

$3190

Excess reserves
= reserves ($100 + $300) required reserves ($3190 x 0.10)
= $400 - $319 = $81

Creation of Money by Banks

Private Banks in the Banking Industry (final stage)
Assets
Liabilities
Vault cash
$100
Deposits
Reserve deposits $200 + $100
= $300
Loans
$2700 + $900
= $3600
Total assets
$4000

Total liabilities

$3000 + $1000
= $4000

$4000

Excess reserves
= reserves ($100 + $300) required reserves ($4000 x 0.1)
= $400 - $400 = $0

Creation of Money by Banks

Initial deposit = $100
First bank lending = 1 $100
Second bank lending = 1 1 $100 = 1 2 $100
Third bank lending = 1 1 2 $100 = 1 3 $100

Total increase in money supply

= 1 + 1 + 1 2 + 1 3 + $100

=
(1

)
$100()
=0

1
1 1

$100 = $100 , given that no one holds cash

Creation of Money by Banks

General formula:

4.11 : = , given that no one in the economy holds

cash

For example, =

1
0.1

$100 = $1,000.

Open-market purchases increase the monetary base (MB or H) and

thus money supply.
MB (or H) = reserve deposits + currency (including both currency
held by the nonbank public and vault cash held by banks)

Creation of Money by Banks

Only banks have the legal authority to create assets (such as checking
accounts) that are part of the money supply.
Therefore, banks are the only financial institutions that directly
influence the money supply.
Note that although fractional-reserve banking system creates money,
it does not create wealth.
In other words, the creation of money by the banking system
increases the economys liquidity, not its wealth.