When a bank issues a new loan: Bank Assets: Everything the banks own and everything others owe the banks. Bank Liabilities: Everything the banks owe others. Vault cash30 Deposits at Fed20 Securities60 Loans380 Deposits400 Borrowing from Fed10 Required reserve ratio10% Assets Liabilities RES SEC60 LOANS Vault Cash30 DEP BOR10 Dep at Fed The Banking System and the Federal Reserve Board Required reserves = Required reserve ratio  Deposits Excess reserves = Actual reserves  Required reserves LOANS and DEP increase by the amount of the new loan; RES are unaffected; Subsequent transactions change the composition of deposits, but not the overall level. Key Questions to Pose With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______ Since loans and deposits increase by the same amount when a bank issues a new loan and reserves are unaffected, how many ____________ loans can banks issue? _________ more90 =10%  = 40 =50  = = = = 0 = 50 NB: When a bank has excess reserves, it can issue more loans.  Lab 5.1 Because 10%  500 = 50 Why 500?

Fed Uses Its “Tools” to Conduct Monetary Policy Open market operations Discount rate Required reserve ratio The Fed purchases or sells Treasury bills (T-bills) that have been previously issued by the U.S. Treasury. Assets Liabilities RES50 SEC60 Vault Cash30 BOR10 Dep at Fed20 LOANS480 DEP500 Question: Which balance sheet entry counts as money? That is, which entry can we use to purchase goods and services? Answer: Deposits. DEP M1 = Cash + Checking Deposits M2 = M1 + Savings Deposits M i (%) MSMS’ Contractionary Expansionary Monetary Policy Contractionary  DEP decreases  MS curve shifts left Expansionary  DEP increases  MS curve shifts right Roles of the Federal Reserve Board Fed Monitors Banks Fed Acts as the Bank’s Bank Question: Which item on the balance sheet is part of the money supply? DEP

T-Bill Federal Reserve Board Washington, DC Pay to the order of Kate$5 Janet Yellen Fed Kate’s Bank Open Market Operation: Purchase of $5 Kate Assets Liabilities RES SEC60 LOANS Vault Cash30 DEP BOR10 Dep at Fed With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______ Since loans and deposits increase by the same amount when a bank issues a new loan and reserves are unaffected, how many ____________ loans should banks issue? _________ more 45 Required reserves = Required reserve ratio  Deposits =10%  = = 55 Kate’s deposits at his bank increase by $5. Bank’s deposits at its bank, the Fed, increase by $5.

M i (%) MS’ MS MD Open Market Operation: Purchase of $5 Bank deposits increase by 50 from 500 to 550  Money supply (MS) curve shifts right  Nominal interest rate falls Assets Liabilities RES50 SEC60 Vault Cash30 BOR10 Dep at Fed20 LOANS480 DEP  Lab 5.2

T-Bill Kate Amherst, MA Pay to the order of the Fed$5 Kate Fed Kate’s Bank Open Market Operation: Sale of $5 Kate Assets Liabilities RES SEC60 LOANS Vault Cash30 DEP BOR10 Dep at Fed With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______ Since loans and deposits increase by the same amount when a bank issues a new loan and reserves are unaffected, how many ____________ loans should banks issue? _________ fewer 45 Required reserves = Required reserve ratio  Deposits =10%  = = 45  Macro Lab 5.2: Open Market Purchase Kate’s deposits at her bank decrease by $5. Bank’s deposits at its bank, the Fed, decrease by $5.

M i (%) MS’ MS MD Open Market Operation: Sale of $5 Bank deposits decrease by 50 from 500 to 450  Money supply (MS) curve shifts left  Nominal interest rate rises Assets Liabilities RES50 SEC60 Vault Cash30 BOR10 Dep at Fed20 LOANS480 DEP  Lab 5.3

The Federal Reserve Board and the Taylor Principle IS Question: What would GDP equal if the real interest rate were _____ percent, given that all other relevant factors remained the same? r (%) GDP IS When the inflation rate (  ) increases the Fed “slows down” the economy by increasing the real interest rate (r). When the inflation rate (  ) decreases the Fed “speeds up” the economy by decreasing the real interest rate (r). Inflation rate (  ) increases  Real interest rate (r) increases  GDP decreases  Fewer goods and services are produced  Economy “slows down” Inflation rate (  ) decreases  Real interest rate (r) decreases  GDP increases  More goods and services are produced  Economy “speeds up” Taylor principle IS curve is downward sloping  Economy stabilizes Taylor Principle Fed’s Goal: Stabilize the economy

The Taylor Principle and the Monetary Policy (MP) Curve MP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _____ percent? r (%)  (%) MP When the inflation rate (  ) increases the Fed “slows down” the economy by increasing the real interest rate (r). When the inflation rate (  ) decreases the Fed “speeds up” the economy by decreasing the real interest rate (r). Inflation rate (  ) increases  Real interest rate (r) increases  GDP decreases  Fewer goods and services are produced  Economy “slows down” Inflation rate (  ) decreases  Real interest rate (r) decreases  GDP increases  More goods and services are produced  Economy “speeds up” Taylor principle IS curve is downward sloping  Economy stabilizes The monetary policy (MP) curve formalizes the Taylor principle. Claim: MP curve is upward sloping The positive slope of the MP curve captures the Taylor principle.

Autonomous Monetary Policies and the Monetary Policy (MP) Curve MP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _____ percent? r (%)  (%) Autonomous contractionary monetary policy increases the intercept. The monetary policy curve shifts up; consequently, the Fed becomes “tougher” on inflation. The Fed responds to a given rate of inflation with a larger increase in the real interest rate. Autonomous expansionary monetary policy decreases the intercept. The monetary policy curve shifts down; consequently, the Fed becomes “easier” on inflation. The Fed responds to a given rate of inflation with a smaller increase in the real interest rate. MP MP’ The Monetary Policy (MP) Curve: A Summary The Fed’s application of the Taylor principle causes the monetary policy (MP) curve to be upward sloping. The autonomous monetary policies pursued by the Fed shifts the entire monetary policy (MP) curve.