Aggregate Demand and Supply, Money, and the Federal Reserve: Study Notes for 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, and the government, both domestically and internationally.

• 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 (such as government purchases) changes.

• Variables that Shift the AD Curve:

  • 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 relative to domestic income.

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

Example: An increase in government spending shifts the AD curve to the right, increasing real GDP and the price level in the short run.

Aggregate Supply

The aggregate supply side is divided into long-run and short-run perspectives.

• Long-Run Aggregate Supply (LRAS) Curve: Shows the relationship between the price level and the quantity of real GDP supplied in the long run. In the long run, real GDP is determined by the number of workers, technology, and capital stock, and occurs at potential or full-employment GDP.

• Short-Run Aggregate Supply (SRAS) Curve: Shows the relationship between the price level and the quantity of real GDP supplied in the short run. The SRAS curve is upward sloping due to sticky wages and prices, slow wage adjustments, and menu costs.

• Movements vs. Shifts:

  • A change in the price level causes a movement along the SRAS curve.

  • Other factors shift the SRAS curve.

• Factors that Shift SRAS:

  • Changes in the labor force or capital stock.

  • Changes in productivity.

  • Changes in the expected future price level.

  • Adjustments by workers and firms to previously over- or underestimated price levels.

  • Changes in the price of important natural resources or events such as natural disasters or pandemics (supply shocks).

Example: A sudden increase in oil prices shifts the SRAS curve to the left, causing higher inflation and lower output (stagflation).

Macroeconomic Equilibrium in the Long Run and the Short Run

Macroeconomic equilibrium occurs where the AD and SRAS curves intersect. In the long run, equilibrium is at the LRAS level.

• Recession:

  • If AD shifts left, short-run equilibrium moves left of LRAS, increasing unemployment and reducing inflation. Eventually, lower prices shift SRAS right, restoring long-run equilibrium at a lower price level.

  • If SRAS shifts left (e.g., due to a supply shock), short-run equilibrium moves left of LRAS, increasing both unemployment and inflation (stagflation). Over time, SRAS shifts back right as prices adjust.

• Expansion/Boom: If AD shifts right, short-run equilibrium moves right of LRAS, decreasing unemployment and increasing inflation. Eventually, higher expected prices shift SRAS left, restoring equilibrium at a higher price level.

• Stagflation: A combination of inflation and recession, usually resulting from a supply shock.

Example: During the 1970s oil crisis, the US experienced stagflation due to a leftward shift in SRAS.

A Dynamic Aggregate Demand and Aggregate Supply Model

The static AD-AS model assumes constant price levels and no long-run growth. The dynamic model incorporates continual increases in real GDP, shifting LRAS and AD to the right over time, and SRAS shifting right except when high inflation is expected.

• Inflation typically occurs when total spending (AD) increases faster than production (LRAS).

• Long-run equilibrium is restored at a higher price level if AD shifts further right than LRAS.

Example: If the money supply grows rapidly, AD shifts right faster than LRAS, causing 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 serves several essential functions in the economy.

• Functions of Money:

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

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

  • Store of Value: Maintains value over time, allowing deferred consumption.

  • Standard of Deferred Payment: Facilitates transactions over time.

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

• Fiat Money: Authorized by a central bank, has no intrinsic value but is accepted by trust in the issuer.

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

Example: The US dollar is fiat money, no longer backed by gold or silver.

How Is Money Measured in the United States Today?

The money supply is measured using two main definitions:

• M1: Currency in circulation plus checking and savings account deposits.

• M2: Includes M1 plus small-denomination time deposits and noninstitutional money market fund shares.

• Debit Cards: Access checking accounts but are not money themselves.

• Credit Cards: Not considered money.

Example: A $100 bill and a checking account balance are both part of M1.

How Do Banks Create Money?

Banks create money by making loans from deposits. They keep a fraction of deposits as reserves and lend out the rest, which increases the money supply.

• Reserves: Deposits kept as cash in the bank or with the Federal Reserve.

• Required Reserves: Legally mandated minimum reserves based on deposits.

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

• Excess Reserves: Reserves held above the required minimum.

• Simple Deposit Multiplier: The maximum amount the money supply can increase based on new reserves.

Formula:

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

• In practice, the actual multiplier is lower due to banks holding excess reserves and borrowers not redepositing all funds.

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

Example: With a 10% required reserve ratio, a $1,000 deposit could, in theory, support up to $10,000 in new deposits.

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) acts as the central bank, providing stability and managing the money supply.

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

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

• Lender of Last Resort: The Fed promises to make loans to banks to prevent panics.

• Federal Reserve Structure: 12 districts, Board of Governors in Washington, DC, and the Federal Open Market Committee (FOMC) which manages open market operations.

• Monetary Policy Tools:

  1. Open Market Operations: Buying and selling Treasury securities to control 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 like stocks and bonds.

• Securitization: Transforming loans into securities that can be traded.

• Shadow Banking System: Non-bank financial firms (e.g., investment banks, hedge funds) that provide credit and investment services.

Example: The Fed buys $1 billion in Treasury securities, increasing bank reserves and the money supply.

The Quantity Theory of Money

The quantity theory of money links the money supply to the price level and real output. It is based on the quantity equation:

$M \times V = P \times Y$

• M: Money supply (measured by M1)

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

• P: Price level (measured by the GDP deflator)

• Y: Real output (real GDP)

Alternatively, velocity can be expressed as:

$V = \frac{P \times Y}{M}$

• The theory assumes velocity is constant.

• Growth rates can be added when variables are multiplied:

$\text{Growth rate of } M + \text{Growth rate of } V = \text{Inflation rate} + \text{Growth rate of } Y$

• If velocity is constant, then:

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

• If the money supply grows faster than real GDP, inflation results.

• If the money supply grows slower than real GDP, deflation occurs.

• If the money supply grows at the same rate as real GDP, the price level is stable.

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

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