Aggregate Demand, Aggregate Supply, and Money: Study Notes for Principles of Macroeconomics

Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Aggregate Demand

The aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the price level. The aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and foreign buyers.

• Wealth Effect: As the price level rises, the real value of household wealth falls, leading to lower consumption.

• Interest-Rate Effect: Higher price levels increase interest rates, reducing investment spending.

• International-Trade Effect: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports.

• Movements vs. Shifts:

  • A movement along the AD curve occurs when the price level changes, holding other factors constant.

  • A shift of the AD curve occurs when a component of real GDP (consumption, investment, government purchases, or net exports) changes for reasons other than the price level.

• Variables that Shift AD:

  • Monetary policy: Actions by the Federal Reserve to manage the money supply and interest rates.

  • Fiscal policy: Changes in federal taxes and government purchases.

  • Changes in expectations of households and firms about the future.

  • Changes in foreign income.

  • Changes in the exchange rate (value of the US dollar).

Example: If the government increases its purchases, aggregate demand shifts to the right, increasing real GDP and the price level in the short run.

Aggregate Supply

The aggregate supply (AS) curve shows the relationship between the price level and the quantity of real GDP supplied. There are two versions: long-run (LRAS) and short-run (SRAS).

• Long-Run Aggregate Supply (LRAS):

  • Vertical at the level of potential or full-employment GDP.

  • Determined by the number of workers, technology, and capital stock.

  • Shifts right over time as the economy grows.

• Short-Run Aggregate Supply (SRAS):

  • Upward sloping due to sticky wages and prices (contracts, slow wage adjustments, menu costs).

  • Movement along SRAS occurs with a change in the price level.

  • SRAS shifts with changes in:

    • Labor force or capital stock

    • Productivity

    • Expected future price level

    • Adjustments to past errors in price level expectations

    • Prices of important natural resources or supply shocks (e.g., oil price spike, natural disaster)

Example: A sudden increase in oil prices (a negative supply shock) shifts SRAS to the left, raising the price level and reducing real GDP.

Macroeconomic Equilibrium in the Long Run and the Short Run

Equilibrium occurs where AD and SRAS intersect. Long-run equilibrium is at the intersection with LRAS.

• Recession:

  • AD shifts left or SRAS shifts left, moving equilibrium left of LRAS.

  • Results in higher unemployment and lower inflation (if AD shifts) or higher inflation (if SRAS shifts).

  • Eventually, wages and prices adjust, shifting SRAS right and restoring long-run equilibrium.

• Stagflation: A combination of recession and inflation, usually due to a supply shock.

• Expansion/Boom:

  • AD shifts right, moving equilibrium right of LRAS.

  • Results in lower unemployment and higher inflation.

  • SRAS shifts left as expectations adjust, restoring long-run equilibrium at a higher price level.

Example: An increase in consumer confidence shifts AD right, causing a short-run boom and higher inflation until SRAS adjusts.

Dynamic Aggregate Demand and Aggregate Supply Model

The dynamic model incorporates ongoing economic growth and inflation.

• LRAS shifts right over time as the economy grows.

• AD typically shifts right due to population growth, technological progress, and policy changes.

• SRAS also shifts right, except when high inflation is expected.

• Inflation occurs when AD increases faster than LRAS.

Example: If total spending (AD) grows faster than productive capacity (LRAS), the price level rises (inflation).

Chapter 14: Money, Banks, and the Federal Reserve System

What Is Money, and Why Do We Need It?

Money is any asset that is generally accepted in exchange for goods and services or for payment of debts. It solves the inefficiencies of barter, which requires a double coincidence of wants.

• Functions of Money:

  1. Medium of Exchange: Accepted as payment for goods and services.

  2. Unit of Account: Provides a standard measure of value.

  3. Store of Value: Retains value over time, allowing deferred consumption.

  4. Standard of Deferred Payment: Facilitates transactions over time.

• Types of Money:

  • Commodity Money: Has intrinsic value (e.g., gold, silver).

  • Fiat Money: Authorized by government, has no intrinsic value (e.g., modern US dollar).

• Central Bank: Issues fiat money; in the US, this is the Federal Reserve.

Example: The US dollar was once backed by gold (commodity money), but is now fiat money, backed only by government decree and public confidence.

How Is Money Measured in the United States Today?

• M1: Currency in circulation + checking account deposits + savings account deposits.

• M2: M1 + small-denomination time deposits + noninstitutional money market fund shares.

• Debit cards access checking accounts (money), but the card itself is not money.

• Credit cards are not money; they are a means of borrowing.

Example: If you deposit $100 in your checking account, it is counted in M1.

How Do Banks Create Money?

Banks create money by making loans. They keep a fraction of deposits as reserves and lend out the rest, which is redeposited and re-loaned, expanding the money supply.

• Reserves: Cash in vault or on deposit with the Federal Reserve.

• Required Reserves: Legally required minimum reserves, based on deposits.

• Required Reserve Ratio (RR): Fraction of deposits banks must hold as reserves.

• Excess Reserves: Reserves held above the required minimum.

• Simple Deposit Multiplier:

  • Formula: $\text{Simple deposit multiplier} = \frac{1}{RR}$

  • Shows the maximum possible increase in deposits from a new reserve.

• In practice, the actual multiplier is lower due to banks holding excess reserves and borrowers holding cash.

• When banks gain reserves, they make new loans, expanding the money supply; when they lose reserves, they reduce loans, contracting the money supply.

Example: With a 10% required reserve ratio, a $1,000 deposit could, in theory, support up to $10,000 in new deposits ($\frac{1}{0.1} = 10$).

The Federal Reserve System

The US uses a fractional reserve banking system, where banks keep less than 100% of deposits as reserves. The Federal Reserve (the Fed) is the central bank, responsible for monetary policy and financial stability.

• Bank Run: Many depositors withdraw funds simultaneously due to loss of confidence.

• Bank Panic: Multiple banks experience runs at the same time.

• The Fed acts as a lender of last resort to prevent panics.

• The Fed was established in 1914, with 12 regional districts and a central Board of Governors in Washington, DC.

• The Federal Open Market Committee (FOMC) manages open market operations and the money supply.

• Monetary Policy Tools:

  1. Open Market Operations: Buying and selling Treasury securities to influence the money supply.

     • To increase money supply: Fed buys securities.

     • To decrease money supply: Fed sells securities.

  2. Discount Policy: The discount rate is the interest rate charged on loans to banks.

  3. Reserve Requirements: The Fed can change the required reserve ratio.

• Commercial Banks: Accept deposits and make loans.

• Securities: Financial assets (stocks, bonds) that can be traded.

• Securitization: Bundling loans into securities for sale in secondary markets.

• Shadow Banking System: Non-bank financial firms (investment banks, hedge funds) that engage in lending and investing but are less regulated.

Example: During the 2008 financial crisis, the Fed used open market operations and discount loans to stabilize the banking system.

The Quantity Theory of Money

The quantity theory of money links the money supply to the price level and real output using the quantity equation:

• Quantity Equation: $M \times V = P \times Y$

  • $M$ = Money supply

  • $V$ = Velocity of money (average number of times each dollar is used in transactions)

  • $P$ = Price level

  • $Y$ = Real output (real GDP)

• Velocity: $V = \frac{P \times Y}{M}$

• Assuming velocity is constant, the growth rates of the variables add:

  • Growth rate of money supply + Growth rate of velocity = Inflation rate + Growth rate of real output

  • If velocity is constant, then:

  $\text{Inflation rate} = \text{Growth rate of money supply} - \text{Growth rate of real output}$

• If money supply grows faster than real GDP, inflation results; if slower, deflation occurs; if equal, price level is stable.

• Hyperinflation: Extremely high inflation rates (over 50% per month).

Example: If the money supply grows by 5% per year and real GDP grows by 2%, the inflation rate is approximately 3%.

Scenario	Money Supply Growth	Real GDP Growth	Inflation Outcome
Money supply grows faster than GDP	High	Low	Inflation
Money supply grows slower than GDP	Low	High	Deflation
Money supply grows at same rate as GDP	Equal	Equal	Stable price level

Additional info: The velocity of money can fluctuate in the short run, especially during financial crises or periods of rapid technological change in payments systems.