RealNominalRate interest=interest  of raterateinflation r= i  Goods and services (G&S) purchased Goods and services (G&S) produced  AD  AS  C + I + G  GDP Equilibrium  (%) G&S AD AS AD Question: How many final goods and services would be purchased if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? AS Question: How many final goods and services would be produced if the inflation rate (  ) were _______ percent, given that all other factors relevant to supply remained the same? = = = Review: Aggregate Demand/Aggregate Supply Model Aggregate Demand (AD) curve is downward sloping Aggregate Supply (AS) curve is upward sloping Aggregate Demand Curve – Putting It All Together Question: Why Is the aggregate demand curve downward sloping? i = Nominal interest rate  = Inflation rate r = Real interest rate Notation: G&S = Final goods and services

Fed’s Goal: Stabilize the Economy 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  Loans become more costly  Households and firm purchase fewer goods and services  Economy “slows down” Inflation rate (  ) decreases  Real interest rate (r) decreases  Loans become less costly  Households and firm purchase more goods and services  Economy “speeds up” Taylor principle  Economy stabilizes Taylor Principle: How the Federal Reserve Board (Fed) Stabilizes the Economy The Fed does so by using its throttle, the real interest rate.  In the entire economy fewer goods and services (G&S) purchased  In the entire economy more goods and services (G&S) purchased

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). FP  (%) r (%) Taylor Principle and the Fed Policy (FP) Curve FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? Taylor Principle The Fed policy (FP) curve is upward sloping to stabilize the economy.

Fed increases the real interest rate (r) FP  (%) r (%) AD  (%) G&S AD Question: How many final goods and services would be purchased, if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? Deriving the Aggregate Demand (AD) Curve FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? Inflation rate (  ) increases Loans become more costly Households and firms purchase less Fewer goods and services purchased   Taylor principle (FP curve)  C and I decrease  AD = C + I + G decreases Question: How does the Fed influence the real interest rate (r)?

To understand how the Fed affects the real interest rate (r) we study the money market. Demand Curve for Money (MD): 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? i (%) M MD Income: How much you earn over the course of a year. Conceptual Definition of Money: The medium of exchange. The financial assets that you own that can be used to purchase goods and services. Money and Income Differ. Operational Definition of Money: M1 = Cash + Checking Deposits M2 = M1 + Savings Deposits The nominal interest (i) rate rises.  Interest earning assets (CD’s, Treasury bonds, corporate bonds, etc.) become more attractive because they are earning more interest.  Individuals seek to hold more interest earning assets.  To hold more interest earning assets individuals hold less money. The demand curve for money is downward sloping MS i* Question: Why is the demand curve for money (MD) downward sloping? Question: Why is the supply curve for money (MS) vertical? Claim: The Fed controls the money supply.

Fed Uses Its Monetary Policy Tools to Control the Money Supply Open market operations Discount rate Required reserve ratio Open market operation: 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 constitutes money? That is, which entry can we use to purchase goods and services? Deposits. DEP M i (%) MS MS’ Decrease the money supply Increase the money supply Monetary Policy Decrease the money supply  DEP decreases  MS curve shifts left Increase the money supply  DEP increases  MS curve shifts right Roles of the Federal Reserve Board Fed Monitors Banks Fed Acts as the Bank’s Bank Question: How does the Fed control the money supply? Banking System Required Reserve Ratio = 10% Required reserves = Required reserve ratio  Deposits =10%  Is the bank “loaned up?” 500 = 50 Excess reserves = (Actual) reserves  Required reserves = 50= 0 Yes  50 Question: How do open market operations affect the bank’s deposits? Study the banking system 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? _________

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 Kate’s deposits at her bank decrease by $5. Bank’s deposits at its bank, the Fed, decrease by $5. Aside: Would reducing loans create a disruption at the bank?

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

 (%) G&S AD AS AD Question: How many final goods and services would be purchased if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? AS Question: How many final goods and services would be produced if the inflation rate (  ) were _______ percent, given that all other factors relevant to supply remained the same? Goods and services (G&S) purchased Goods and services (G&S) produced =  AD  AS =  C + I + G =  GDP Equilibrium Aggregate Demand/Aggregate Supply Model Aggregate Demand (AD) curve is downward sloping Aggregate Supply (AS) curve is upward sloping Aggregate Supply Curves Question: Why is the aggregate supply (AS) curve upward sloping?

AS Question: How many final goods and services would be produced if the inflation rate (  ) were _______ percent, given that all other factors relevant to supply remained the same? Long Run Aggregate Supply (LRAS) Curve Claims: The AS curve Is upward sloping. Vertical Placeholder for potential GDP (GDP P ) We will shortly explain precisely what we mean by potential GDP. Aggregate Supply (AS) Curve Intersects the LRAS curve at the expected inflation rate,  E. G&S LRAS AS EE GDP P  (%) Preview: The Aggregate Supply Curves

Question: Why is the expected inflation rate important? Answer:Wages are typically set for a specified time in the future. Workers base their wage demands on the rate of inflation they expect in the future. Employers base the wage concessions they are willing to make on the rate of inflation they expect in the future. Wage increases are based on the expected inflation rate. Expected inflation rate Affects  wages in the upcoming year Affect  firm costs in the upcoming year Expected Inflation Rate Potential GDP (GDP P ): The value of GDP whenever the actual inflation rate (  ) equals the expected inflation rate (  E ) Stable Start: For many, many years: Annual Increase=2.0% in Prices GDP = 2,000 Firm Costs: Firms incur only labor costs Simplifying Assumptions Potential GDP (GDP P ) = 2,000 Annual Increase=2.0% in Wages  Actual Inflation=2.0% Rate (  )  Expected Inflation=2.0% Rate (  E ) Increase  in Firm=2.0% Costs

P Previous = 100 MC Previous MR Previous MC Current MR Current P Current = 102 G&S  (%) 2.0%  E =2.0 LRAS GDP P = 2,000 Q (bushels)50 Aggregate Supply Curves Atkins’ Apple Orchard SRAS Curve Questions: How many final goods and services would be produced if the inflation rate were _____ % given that all other factors relevant to supply remained the same? 2.0 Wages and hence firm costs increase by 2.0% Mr. Atkins’ apple production unchanged. Anything special about Mr. Atkins orchard? Generalization: Whenever the actual inflation rate (  ) equals the expected inflation rate (  E ), final goods and services produced equals potential GDP (GDP P ) LRAS curve is a place mark for potential GDP (GDP P ) No. Anything special about apple production? No.

P Previous = 100 MC Previous MR Previous MC Current MR Current P Current = 103 G&S  (%) 3.0% 2.0%  E =2.0 LRAS GDP P = 2,000 Q (bushels)50 Aggregate Supply Curves Atkins’ Apple Orchard SRAS Curve Questions: How many final goods and services would be produced if the inflation rate were _____ % given that all other factors relevant to supply remained the same? 3.0 Wages and hence firm costs increase by 2.0% Mr. Atkins’ apple production increases. Anything special about Mr. Atkins orchard or apple production? 3.0 Generalization: Whenever the actual inflation rate (  ) is greater than the expected inflation rate (  E ), final goods and services produced is greater than potential GDP (GDP P ) LRAS curve is a place mark for potential GDP (GDP P ) No.

P Previous = 100 MC Previous MR Previous MC Current MR Current P Current = 101 G&S  (%) 1.0% 2.0%  E =2.0 LRAS GDP P = 2,000 Q (bushels)50 Aggregate Supply Curves Atkins’ Apple Orchard SRAS Curve Questions: How many final goods and services would be produced if the inflation rate were _____ % given that all other factors relevant to supply remained the same? 1.0 Wages and hence firm costs increase by 2.0% Mr. Atkins’ apple production decreases. Anything special about Mr. Atkins orchard or apple production? AS Generalization: Whenever the actual inflation rate (  ) is less than the expected inflation rate (  E ), final goods and services produced is less than potential GDP (GDP P ) LRAS curve is a place mark for potential GDP (GDP P ) No.