MONETARY POLICYMONETARY POLICY

MONETARY POLICYMONETARY POLICY

The money supply can/does The money supply can/does influence price levelsinfluence price levels

Inflation occurs if the money Inflation occurs if the money supply increases, ceteris paribus.supply increases, ceteris paribus.

Deflation occurs if the money Deflation occurs if the money supply decreases, ceteris paribus.supply decreases, ceteris paribus.

What if you stuff your money What if you stuff your money in a mattress? in a mattress?

What does it cost you?What does it cost you?

Zero Inflation?Zero Inflation?

10% Inflation?10% Inflation?

Known as the opportunity cost of Known as the opportunity cost of holding money!holding money!

InterestInterestThe price you pay for using someone The price you pay for using someone

else's money (accounting cost or else's money (accounting cost or explicit cost)explicit cost)

OROR

holding your own money as cash.holding your own money as cash.

(opportunity cost or implicit cost)(opportunity cost or implicit cost)

InterestInterest Nominal interest rates (market rates)Nominal interest rates (market rates)

Real interest ratesReal interest rates A return net of inflation and risk A return net of inflation and risk

premiumpremium

Risk-Free interest ratesRisk-Free interest rates Government treasury securities, no risk Government treasury securities, no risk

premium.premium.

InterestInterest

Nominal Interest Rate Nominal Interest Rate = =

real interest ratereal interest rate

+ compensation for inflation+ compensation for inflation

+ default risk premium+ default risk premium

Real Interest RateReal Interest RateThe real interest rate is the price of The real interest rate is the price of

money, net of inflation and risk, money, net of inflation and risk, that people are willing to accept that people are willing to accept for deferring present for deferring present consumption until some future consumption until some future time periodtime period 1000 Toman in your hand right now 1000 Toman in your hand right now

is worth more than the promise is worth more than the promise (without risk) of 1000 Toman in your (without risk) of 1000 Toman in your hand a year from now. hand a year from now.

Even with 0 inflation.Even with 0 inflation.

Real Interest RateReal Interest Rate

Example: Example:

You can save money by ordering You can save money by ordering many items through the mail. many items through the mail.

Why do people drive to Why do people drive to shahrvand?shahrvand?

Real Interest RateReal Interest Rate If $1 right now to you equals If $1 right now to you equals

(has same value as) $1.05 one (has same value as) $1.05 one year from now, guaranteed, with year from now, guaranteed, with zero inflation,zero inflation,

you have a real rate of interest you have a real rate of interest of 5%of 5%

Nominal Interest RateNominal Interest Rate If inflation was expected to be If inflation was expected to be

10% from now until one year 10% from now until one year from now, what market interest from now, what market interest rate would you demand to have, rate would you demand to have, to get your 5% real rate of to get your 5% real rate of interest? Assume no risk. interest? Assume no risk.

Answer: 15%.Answer: 15%.

Nominal Interest RateNominal Interest Rate If you thought there was some If you thought there was some

risk that you might never see risk that you might never see your 1000 Tomans,your 1000 Tomans,

you would add a risk premium.you would add a risk premium.

Interest Rates on Govt. Interest Rates on Govt. Securities:Securities:

Known as the "Risk-free Rate"Known as the "Risk-free Rate"

= Real rate + = Real rate + EE(inflation over life of (inflation over life of security)security)

Interest Rates on Govt. Interest Rates on Govt. Securities:Securities:

When inflation , Risk-free When inflation , Risk-free interest rates interest rates

ANDAND

Nominal interest rates Nominal interest rates

Prime RatePrime Rate

= real rate + = real rate + EE(Inflation) + small (Inflation) + small riskrisk

premium.premium.

Given to the most solid Given to the most solid businesses and individuals!businesses and individuals!

What Is the Risk Premium Charged What Is the Risk Premium Charged by Banks for Auto Loans?by Banks for Auto Loans?

Tir 25, 1387Tir 25, 1387

Iran Treasury 3 yr. Note rate = 3.41%Iran Treasury 3 yr. Note rate = 3.41%

36 mo. New Car, Nations Bank =36 mo. New Car, Nations Bank = 7.93% 7.93%

risk premium = 4.52%risk premium = 4.52%

WHY?WHY? Bankruptcies Bankruptcies

What Is the Risk Premium Charged What Is the Risk Premium Charged by Banks for Auto Loans?by Banks for Auto Loans?

Tir. 3, 1388Tir. 3, 1388

Iran Treasury 3 yr. Note rate = 6.42%Iran Treasury 3 yr. Note rate = 6.42%

36 mo. New Car, Nations Bank =36 mo. New Car, Nations Bank = 10.25% 10.25%

risk premium = 3.83%risk premium = 3.83%

Why? Economy humming along rather nicely, Why? Economy humming along rather nicely, unemployment down, less bankruptciesunemployment down, less bankruptcies

Recent Snapshot:Recent Snapshot: Tir 4, 1389Tir 4, 1389

Iran Treasury 3 yr. Note rate = Iran Treasury 3 yr. Note rate = 5.97%5.97%

36 mo. New Car, Bank of America =36 mo. New Car, Bank of America = 11.70%11.70%

risk premium = risk premium = 5.73%5.73%

MONETARY POLICYMONETARY POLICY

Government Reserve can or Government Reserve can or the money the money

supply in order to change the level supply in order to change the level of of

output and prices (Monetary output and prices (Monetary Policy).Policy).

3 Tools to Change Money 3 Tools to Change Money Supply:Supply:

Open-market operations (buying and Open-market operations (buying and selling treasury bonds, notes, and selling treasury bonds, notes, and bills).bills).

Discount rate: Interest rate banks Discount rate: Interest rate banks are charged when they borrow from are charged when they borrow from the Fed.the Fed.

Reserve requirement: % of deposits Reserve requirement: % of deposits that must be held by a bank as vault that must be held by a bank as vault cash or on account with the federal cash or on account with the federal reserve.reserve.

Open Market OperationsOpen Market Operations When the Government Reserve When the Government Reserve

sells more treasury securities than sells more treasury securities than it buys: it buys:

Money Supply DecreasesMoney Supply Decreases

When the Government Reserve When the Government Reserve buys more treasury securities buys more treasury securities than it sells:than it sells:

Money Supply IncreasesMoney Supply Increases

The Discount RateThe Discount Rate

The discount rate is adjusted to The discount rate is adjusted to complement open market complement open market operations and to support the operations and to support the direction the Fed is taking in direction the Fed is taking in monetary policy. monetary policy.

Reserve RequirementReserve Requirement Commercial Banks, Savings Banks, Commercial Banks, Savings Banks,

Savings and Loans, Credit Unions, Savings and Loans, Credit Unions, and Branches of Foreign Banks are and Branches of Foreign Banks are subject to reserve requirements.subject to reserve requirements.

Reserve requirement may range Reserve requirement may range from 8 to 14 percent of demand from 8 to 14 percent of demand deposits and interest-bearing deposits and interest-bearing accounts offering unlimited accounts offering unlimited checking privileges.checking privileges.

Changing the Money SupplyChanging the Money SupplyIncreaseIncrease Money Supply, c.p. Money Supply, c.p. DecreaseDecrease

interest rates (price of money) in S.R.interest rates (price of money) in S.R.

BUTBUT

Increase Increase Money Supply may cause inflation!Money Supply may cause inflation!

Increase Increase interest rates in L.R.interest rates in L.R.

IncreaseIncrease Money Supply too much Money Supply too much

Decrease Decrease value of moneyvalue of money

Changing the Money SupplyChanging the Money Supply

THEREFORE:THEREFORE:

Takes more Rials to buy same Takes more Rials to buy same stuffstuff

Price of Price of stuff stuff Inflation!Inflation!

Changing the Money SupplyChanging the Money SupplyDecreaseDecrease Money Supply, c.p. Money Supply, c.p. IncreaseIncrease

interest rates (price of money) in S.R.interest rates (price of money) in S.R.

BUTBUT

DecreaseDecrease Money Supply may cause Money Supply may cause deflation!deflation!

DecreaseDecrease interest rates in L.R. interest rates in L.R.

DecreaseDecrease Money Supply too much Money Supply too much

Increase Increase value of moneyvalue of money

Changing the Money SupplyChanging the Money Supply

THEREFORE:THEREFORE:

Takes less Rials to buy same Takes less Rials to buy same stuffstuff

Price of Price of stuff stuff Deflation!Deflation!

Discretionary Income ( IDiscretionary Income ( IDISDIS ) )

= (I= (ID D - Basic Housing bills, Basic Utility - Basic Housing bills, Basic Utility bills, Basic Food Bills, Basic bills, Basic Food Bills, Basic transportation bills, Basic clothing, etc.)transportation bills, Basic clothing, etc.)

(Not payments on credit cards!)(Not payments on credit cards!)

Money you have to spend or save at Money you have to spend or save at your discretion!your discretion!

Why has Stock Market Been Why has Stock Market Been Booming?Booming?

People with money in banks, People with money in banks, pulling it out pulling it out

and putting it inand putting it in

Stock Market for higher return!Stock Market for higher return!

What affect do low interest rates What affect do low interest rates have on retired people?have on retired people?

retirement income!retirement income!

Stock Market too risky!Stock Market too risky!

References:References: N.c.State university-College of Agriculture and Life science –Dr. N.c.State university-College of Agriculture and Life science –Dr.

herman_sampsonherman_sampson