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 cash 30Deposits at Fed 20Securities 60Loans 380Deposits 400Borrowing from Fed 10Required reserve ratio 10%

Assets Liabilities

RES

SEC 60LOANS

Vault Cash

30

DEP

BOR 10

Dep at Fed

The Banking System and the Federal Reserve Board

Required reserves =

Required reserve

ratio Deposits

Excessreserves = Actual

reserves Requiredreserves

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 PoseWith 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? _________

10500

50

more 90

= 10% = 40= 50 = 10

410

390

400 = 414041 = 9

400500

20

480

50

380

41050050 = 0

= 50

NB: When a bank has excess reserves, it can

issue more loans.

Lab 5.1

Because 10% 500 = 50Why 500?

Fed Uses Its “Tools” to Conduct Monetary Policy

Open market operationsDiscount rateRequired reserve ratio

The Fed purchases or sells Treasury bills (T-bills) that have been previously issued by the U.S. Treasury.

Assets Liabilities

RES 50

SEC 60

Vault Cash

30

BOR 10

Dep at Fed

20LOANS 480

DEP 500

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’ MS’

Contractionary ExpansionaryMonetary

Policy

Contractionary

DEP decreases

MS curve shifts left

Expansionary

DEP increases

MS curve shifts right

Roles of the Federal Reserve BoardFed 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 BoardWashington, DC

Pay to the order of Kate$5Janet Yellen

Fed

Kate’s Bank

Open Market Operation: Purchase of $5

Kate

Assets Liabilities

RES

SEC 60

LOANS

Vault Cash

30

DEP

BOR 10

Dep at Fed

505 500550

2025

480

5055

525

With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______

10

550

55

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? _________

more45

Required reserves =

Required reserve

ratio Deposits

= 10% = 50500550 = 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

500 550

MD

5.0

3.8

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

RES 50

SEC 60

Vault Cash

30

BOR 10

Dep at Fed

20LOANS 480

DEP 50055

25

525

550

Lab 5.2

T-Bill

KateAmherst, MA

Pay to the order of the Fed$5Kate

Fed

Kate’s Bank

Open Market Operation: Sale of $5

Kate

Assets Liabilities

RES

SEC 60

LOANS

Vault Cash

30

DEP

BOR 10

Dep at Fed

495 500450

2015

480

5045

435

With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______

10

450

45

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? _________

fewer45

Required reserves =

Required reserve

ratio Deposits

= 10% = 50500450 = 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

500450

MD

5.0

6.3

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

RES 50

SEC 60

Vault Cash

30

BOR 10

Dep at Fed

20LOANS 480

DEP 50045

15

435

450

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) CurveMP 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’

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.