Macro Lecture 7: Money and the Federal Reserve Board
The Money Market and the Nominal Interest Rate
Review
To illustrate the money market, we place the nominal interest rate (i)
on the vertical axis and the quantity of money (M) on the horizontal
axis as illustrated in figure 7.1. Like any market, the money market is
composed of two parts: demand and supply.
 The demand curve is downward sloping; as the nominal
interest rate rises, the quantity of money demanded
decreases.
 The supply curve is vertical; as we will see, the Federal
Reserve Board fixes the quantity of money supplied.
The money market is in equilibrium whenever the quantity of money
demanded equals the quantity of money supplied; that is, an
equilibrium exists whenever the nominal interest rate equals i*.
i (%)
MS
i*
MD
Figure 7.1: Money market
Recall that it is imperative to distinguish between money and income:
 Money refers to the financial assets that we own that can be
used to purchase goods and services: the cash in our wallet and balances of our checking
and savings accounts.
 Income refers to how many dollars we earn over the course of a year.
Review: Demand Curve for Money
The demand curve for money answers a series of questions:
How much money would be demanded if the nominal interest rate were ______,
given that everything else relevant to the demand for money remains the same?
Claim: As the nominal interest rate rises, the quantity of money demanded decreases; that is, the
money demand curve is downward sloping.
To justify this claim we must not confuse money and income. If we do, the notion of the demand
for money becomes silly. We would always like to have more income, wouldn’t we? To
understand what economists mean by the demand for money, review the conceptual definition of
money:
Money: A medium of exchange; that which is accepted in exchange for goods and
services.
Now, consider the following points:
 Money earns no (or nearly no) interest. The cash earns no interest. Its nominal
interest rate equals 0. The balance of your checking account earns a pitifully low
interest rate and the balance of your savings account earns only slightly more.
For all practical purposes, the money that you hold earns no interest.
 As the nominal interest rate rises:
o Interest earning assets (CD’s, Treasury bonds, corporate bonds, etc.) become
more attractive because they are earning more interest.
o As interest earning assets become more attractive, money becomes relatively
less attractive.
o Individuals seek to hold more interest earning assets and less money.
The nominal interest rate is the opportunity cost of money – what is foregone when
money is held.
 The demand curve for money is downward sloping as illustrated in figure 7.2.
M
2
Supply Curve for Money
The supply curve for money is vertical. To understand this we shall study the role that the Federal
Reserve Board plays in the banking system.
Recall our simplified bank balance sheet:
Assets
Reserves
Vault Cash
30
Dep at Fed
20
Securities
Loans
Liabilities
50
Deposits
60
480 Borrowing
500
10
Question: Which balance sheet entry counts as money? That is, which entry can we use to
purchase goods and services?
Decreases
Increases
Answer: We use our checking deposits. We can purchase
money supply
money supply
goods and services by writing checks, as long as our
i (%)
checking account balance is sufficient. Also, in the age of
MS’
MS
MS’
smart phones we can transfer funds from our saving
accounts to our checking accounts in seconds. So,
effectively our savings account deposits also constitute
money.
We will now see how the Federal Reserve Board uses its
tools to affect the quantity of money in our economy. When
the Fed decreases the money supply and the money supply
(MS) curve shifts left; alternatively, when the Fed increases
the money supply the money supply (MS) curve shifts right.
See figure 7.2.
M
Figure 7.2: Monetary policy and the
money supply curve
Federal Reserve Board's Policy Tools
Primarily, the Federal Reserve Board uses three policy tools to
control the money supply:
 Open market operations;
 Discount rate;
 Required reserve ratio.
The first tool, open market operations, is the most important. Accordingly, we shall focus on it.
3
Open Market Operations
The Fed performs an open market purchase whenever it buys or sells government bonds. Note that the
Federal Reserve Board does not issue government bonds. Who issues them? The U.S. Treasury issues
government bonds whenever the federal government runs a deficit. When the Fed performs an open
market operation, it is buying or selling government bonds that have been issued previously by the
U.S. Treasury. To understand how an open market operation affects the banking system we shall use
our simplified illustration:
Assets
Liabilities
Reserves
50 Deposits
500
Vault Cash
30
Dep at Fed
20
Securities
60
Loans
480 Borrowing
10
Required
reserve
 Deposits
ratio
=
10%
500

=
50
Since (actual) reserves equal required reserves, banks cannot make any additional loans. The bank is
loaned up.
Required
reserves
=
Open market purchase of $5: The Fed buys $5 worth of T-bills from Kate (a private individual). Do
not make this more complicated than it is. Figure 7.3
T-Bill
keeps it straightforward by following the movement
of the T-bill and the Fed’s check.
Fed
Federal Reserve Board
 In exchange for the T-bill, the Fed gives
Washington, DC
Kate one of its checks, a Federal Reserve
Pay to the order of Kate
$5
Bank’s deposits at
Board check made out for $5.
Ben Bernanke
Fed rise by $5.
 What will Kate do with this check? Kate
Fed Check
will deposit the check in her bank account
by taking the check to her bank and handing
it to a bank teller. Kate’s deposits rise by
Kate’s deposits at
Bank
$5.
the bank rise by $5.
 What will the bank do with the check? Just
Figure 7.3: Open market purchase
as you and I deposit the checks that we
receive at our banks, a bank deposits the
checks that it receives at its bank, the Fed. The bank’s deposits at the Fed will rise by $5.
Summary: When the Fed performs an open market purchase of 5:
 Kate’s deposits rise by 5.
 The bank’s deposits at the Fed rise by 5.
Assets
Reserves
Vault Cash
Dep at Fed
Securities
Loans
Liabilities
55 50
30
25 20
Deposits
Kate
60
480 Borrowing
505 500
+5
10
Remember that deposits at the Fed are part of the bank’s reserves. Accordingly, actual reserves
have risen by 5, from 50 to 55.
4
What has happened to required reserves? Reserves have risen by 5 and deposits have risen by 5
also from 500 to 505:
Required
Required
reserve
=
 Deposits
reserves
ratio
=
10%
505

=
50.5
(Actual) reserves are 55 and required reserves are 50.5. The bank has excess reserves of 4.5.
When a bank has excess reserves what will it do? It will issue more loans. How many additional
loans? To address this recall the key questions:
 With actual reserves of 55 and a required reserve ratio of 10%, how many deposits can
the bank be liable for? 550 because 10%  550 = 55.
 Since loans and deposits change by the same amount when a bank issues a new loan and reserves
are unaffected, how many additional loans can the bank issue? 45 because 550  505 = 45.
Assets
Reserves
Vault Cash
30
Dep at Fed
25 20
Securities
Loans
Others
+45
Liabilities
55 50
Deposits
Kate
Others
550 505 500
+5
+45
60
525 480
Borrowing
10
Now, what are required reserves?
Required
Required
=
reserve
 Deposits
reserves
ratio
=
10%
550

=
55
(Actual) reserves equal required reserves. Since there are no excess reserves, the bank cannot
issue any additional new loans. The bank is loaned up.
Summary: When the Fed performs an open market purchase of 5:
 (Actual) reserves increase by 5.
 Deposits increase by 50.
 Loans increase by 45.
An open market purchase expands the money supply because deposits have increased.
5
i (%)
Recall that the money demand curve is downward sloping. Money
earns no or virtually no interest. As the nominal interest rate
increases, interest earning assets become more attractive;
consequently, we hold more interest earning assets and less money.
Figure 7.4 illustrates the benchmark case:
Benchmark Case
Money supply
Nom interest rate (i)
MS
5.0
500
5.0%
MD
We have just seen that an open market purchase of 5 increases
deposits by 50 from 500 to 550. Since deposits are part of the money
supply, the money supply increases and the money supply curve
shifts right by 50 as illustrated in figure 7.5. When the Fed performs
an open market purchase, the nominal interest rate falls.
M
500
Figure 7.4: Money market - Benchmark
case
i (%)
An open market purchase increases the money supply. The money
supply curve shifts right reducing the nominal interest rate. Macro
lab 7.1 allows us to check our logic:

Macro Lab 7.1: Open Market Purchase
MS
MS
5.0
3.8
MD
500
550
M
Figure 7.5: Money market – Open market
purchase
Next, instead of considering an open market purchase we will consider an open market sale.
6
Open market sale of $5: The Fed sells $5 worth of T-bills to Kate (a private individual). Again, do
not make this more complicated than it is.
Figure 7.6 keeps it straightforward by
T-Bill
following the movement of the T-bill and
Kate’s check.
Fed
Kate
 In exchange for the T-bill, Kate
Amherst, MA
gives the Fed one of her checks,
Pay to the order of the Fed
$5
Bank’s deposits at
a check made out for $5.
Kate
Fed fall by $5.
Fed Check
 What will the Fed do with Kate’s
check? The Fed returns Kate’s
check to her bank. When it does
so, it reduces the bank’s deposits
Kate’s deposits at
Bank
at the Fed by 5.
the bank fall by $5.
 What will the bank do with the
Figure 7.6: Open market sale
check? The bank reduces Kate’s
balance by $5 and returns the
check to Kate. Kate’s deposits at the bank fall by $5.
So, what will happen to the balance sheet? Kate’s deposits will fall by 5 and the bank’s deposits
at the Fed will fall by 5:
Assets
Liabilities
Reserves
45 50 Deposits
495 500
Vault Cash
30
Kate
5
Dep at Fed
15 20
Securities
60
Loans
480 Borrowing
10
Remember that deposits at the Fed are part of the banks’ reserves. Accordingly, (actual) reserves
have fallen by 5, from 50 to 45.
What has happened to required reserves? Deposits have also fallen by 5 from 500 to 495:
Required
Required
=
reserve
 Deposits
reserves
ratio
=
10%
495

=
49.5
(Actual) reserves are 45 and required reserves are 49.5. The bank has negative excess reserves of
4.5. The bank now must reduce its loans. How many fewer loans? To address this recall the key
questions:
 With actual reserves of 45 and a required reserve ratio of 10%, how many deposits can
the bank be liable for? 450 because 10% x 450 = 45.
 Since loans and deposits change by the same amount when a bank issues a new loan and reserves
are unaffected, how many fewer loans will the bank issue? 45 because 495  450 = 45.
Assets
Reserves
Vault Cash
30
Dep at Fed
15 20
Securities
Loans
Others
45
Liabilities
45 50
Deposits
Kate
Others
5
45
450 495 500
60
435 480
Borrowing
10
7
Now, what are required reserves?
Required
Required
=
reserve
 Deposits
reserves
ratio
=
10%
450

=
45
(Actual) reserves equal required reserves. Excess reserves are 0 and the bank is now loaned up.
Summary: An open market purchase of 5:
 (Actual) reserves decrease by 5;
 Deposits decrease by 50;
 Loans decrease by 45.
An open market sale contracts the money supply because deposits have decreased.
At first glance, it may appear that a reduction in loans would be disruptive to the banking system.
In fact, it need not be for two reasons:
 First, some loans that banks issue are “callable” which means that at any point in time the
bank can ask its customers to repay the loans immediately. Bank customers who have
such loans should be prepared for this.
 Second, loans that are not callable are paid off over time. Home mortgages provide an
important example. Banks cannot demand that a home owner repays the full amount of
his/her mortgage immediately, home mortgages are not callable. Every month a
homeowner pays off a portion of his/her mortgage, however. Consequently, unless a bank
issues new loans, the loan component of the bank’s balance sheet will naturally decrease
every month.
We have just seen that an open market sale of 5
decreases deposits by 50 from 500 to 450.
Consequently, the money supply decreases and the
money supply curve shifts left by 50 as illustrated
in figure 7.7. When the Fed performs an open
market sale, the nominal interest rate rises.
i (%)
MS
MS
6.3
5.0
An open market sale decreases the money supply.
The money supply curve shifts left raising the
nominal interest rate. Macro lab 7.2 allows us to
check our logic.
MD
450
500
M
Figure 7.7: Money market – Open market
sale

Macro Lab 7.2: Open Market Sale