Federal Short Term Interest Rate – Actions by monetary authorities, such as the Fed and other central banks around the world, affect interest rates and thus employment, output and prices. However, the relationship between central bank actions and economic performance is far from straightforward. The process is summarized by a money transfer system. A system that explains how central bank actions affect aggregate economic variables, particularly real GDP. (shown in Figure 10.2 “The Currency Transfer System”), which is the heart of this chapter. Monetary intermediation is more than a theory that economists came up with to try to understand monetary policy. That sums it up
The central bank targets short-term nominal interest rates. Changes in these rates cause changes in long-term real interest rates, which affect spending on investment and durable goods, which ultimately lead to changes in real GDP.
Federal Short Term Interest Rate
The monetary system explains how the actions of the Central Bank affect aggregate economic parameters, and in particular gross national product (real GDP). More specifically, it shows how changes in the Central Bank’s target interest rate affect different growth rates in the economy and thereby affect spending in the economy. Through open market operations, the Fed aims to a
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Nominal interest rate The number of additional dollars that must be repaid for each dollar borrowed. . Changes in those rates, on the other hand, have an effect
Nominal interest rate. Changes in long-term nominal interest rates lead to changes in long-term real interest rates The rate of return specified in goods, not money. . Changes in long-term real interest rates affect investments. Purchases of new goods that increase capital stock, enabling an economy to produce more output in the future. and durable products Products that last through many uses. costs Finally, changes in spending affect real GDP. We will analyze each step in this process.
This chapter focuses on the effects of Fed actions, but essentially the same analysis applies to studies of monetary policy in other countries. Pathways of influence are largely independent of the country we study, although the magnitude of policy effects may vary across countries. Monetary policy differs between countries more because of the goals set by different central banks than because of the transmission system.
On February 2, 2005, the Federal Open Market Committee (FOMC) decided to raise the federal funds rate to 2.5 percent. the word
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Is key here. If you listen to the TV news, you might get the impression that the Fed sets interest rates. It does not. It affects them, with more or less success at different times.
Figure 10.3 “Target and Real Federal Funds Rate, 1971–2005” shows the target and actual federal funds rate between 1971 and 2008. From this figure, it is clear that the target and real federal funds rates go together. We can conclude that the first stage of the money transfer system is reliable. The Fed can influence the federal funds rate. So far so good, at least for this season. As we will see later, when we look at more recent events, the Fed was much less successful in targeting the federal funds rate during the financial crisis of 2007 and 2008.
The next question is, do movements in the federal funds rate lead to corresponding movements in long-term interest rates? “Long-term” refers to asset types that have a maturity of at least 1 year, and especially assets that have a maturity of 5 years, 10 years, or even longer. Arbitrage The act of buying and then selling an asset to take advantage of a profit opportunity. between different assets means that the annual interest rates of assets with different maturity dates. The period in which an asset falls to maturity. they are linked Therefore, the Fed’s actions to affect short-term interest rates also affect long-term interest rates.
Figure 10.4 “Short-term and long-term interest rates” shows the relationship between interest rates and long-term interest rates. Broadly speaking, these long-term rates move with the federal funds rate. But it is also clear that the longer the debt term, the less sensitive the interest rate is to changes in the federal funds rate.
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This is one of the difficulties the central bank faces: it can target short-term interest rates very precisely, but its effect on long-term interest rates is much less precise. Since, as we will see, many economic decisions depend on long-term interest rates, the Fed’s ability to influence the economy is imperfect. Some writers have pointed out that the central bank is an omnipresent institution that can move the economy at will. There is no doubt that the Fed has a lot of power over the economy. However, the central bank’s influence is severely limited by the fact that it cannot control long-term interest rates with the same precision as it affects the federal funds rate.
The central bank’s ability to influence long-term interest rates is much more limited than its ability to influence short-term interest rates.
So far in this chapter we have been considering nominal interest rates, but we know that the decisions of firms and households are based on real interest rates. The relationship between the nominal interest rate and the real interest rate is given by the Fisher equation:
To use this relationship, we simply subtract inflation from the nominal interest rate. So if the nominal interest rate were 15 percent, as in the early 1980s, and inflation was 12 percent, the real interest rate would be 3 percent. But if inflation were higher, say 18 percent, the real interest rate would be less than 3 percent.
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Figure 10.5 “Real and nominal interest rates” shows the nominal and real yield of a one-year government bond. Since inflation is positive, nominal interest rates are higher than real interest rates. The chart shows that nominal interest rates and real interest rates tend to move very close. At the beginning of the eighties, for example, real interest rates were negative. Presumably, when households borrowed money in the early 1980s, they did not expect a negative return on their savings, but expected nominal interest rates to be higher than inflation. From that perspective, negative real interest rates are the result of higher than expected inflation.
The central bank’s ability to influence long-term nominal interest rates through its influence on the federal funds rate clearly also extends to real interest rates. However, the connection is not perfect. In some cases, nominal interest rates are unrelated to real interest rate movements.
Changes in nominal interest rates often lead to changes in real interest rates, but the relationship between them is imperfect.
Real interest rates affect spending by both households and businesses. The main categories of purchases affected by interest are the following:
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What do these have in common? In each case, the purchase generates a stream of profits that spans a significant period of time. If a company builds a new plant or buys a new machine, it usually expects to be able to use that plant and equipment for years or decades. When a household buys a new home, it expects to live there for a long time or sell it to someone else who can live there. If you buy a durable good like a new car or refrigerator, you expect to reap the benefits of that purchase for several years.
Figure 10.6 “Real interest rates and consumption of durable goods” shows the relationship between real interest rates and consumption of durable goods. The higher the real interest rate, the lower the expenditure on durable goods. Of course, the relationship does not have to be a straight line; we just drew it like this for simplicity. As you can imagine, monetary policy makers are very interested in exactly what this relationship looks like. They want to know exactly how much change in spending on durable goods is likely to occur as a result of a certain change in interest rates.
At higher interest rates, companies are less likely to borrow for investment projects and households are less likely to borrow to buy housing and durable goods such as new cars. Thus, spending on durable goods is lower at higher interest rates and vice versa.
To better understand why interest rates affect spending on durable goods, consider a company’s purchase of a machine. Companies outsource such because they expect the machine to deliver a stream of profits not only in the present but also for several years to come. A machine is a capital good; is used in the production of other products and is
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Used in the production process. The fact that engine returns accumulate over several years is what we meant by the term
It is not correct to simply add up profit streams in different years because a dollar today is often worth more than a dollar next year. Why? If you take a dollar today and put it into a savings account at
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