Aggregate Demand, Money, and Monetary Policy: Study Guide for ECON 2013 Exam 3

Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Definitions

• Aggregate Demand (AD): The total quantity of goods and services demanded across all levels of an economy at a given overall price level and in a given period.

• Short-Run Aggregate Supply (SRAS): The total production of goods and services available in an economy at different price levels in the short run, when some input prices are sticky.

• Long-Run Aggregate Supply (LRAS): The total production when all prices, including wages, are flexible; represents the economy's potential output.

Why is Aggregate Demand (AD) Downward Sloping?

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

• Interest Rate Effect: Lower price levels reduce the demand for money, decreasing interest rates and increasing investment spending.

• International Trade Effect: A lower domestic price level makes exports more attractive and imports less attractive, increasing net exports.

Shifts of AD versus Movement Along AD

• Movement Along AD: Caused by a change in the price level, holding all else constant.

• Shift of AD: Caused by changes in non-price factors such as expectations, fiscal policy, or foreign variables.

Variables that Shift AD

• Changes in consumer expectations or wealth

• Changes in government policies (fiscal or monetary)

• Changes in foreign variables (exchange rates, foreign income)

SRAS versus LRAS

• SRAS: Upward sloping due to sticky wages and prices; firms increase output as prices rise.

• LRAS: Vertical at potential GDP; output is determined by resources, technology, and institutions.

Shifts of SRAS versus Movement Along SRAS

• Movement Along SRAS: Caused by a change in the price level.

• Shift of SRAS: Caused by changes in input prices, expectations, supply shocks, or labor productivity.

Macroeconomic Equilibrium in the Short and Long Run

• Short-Run Equilibrium: Where AD intersects SRAS; output may differ from potential GDP.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS intersect; output equals potential GDP.

Characteristics of the Macro Equilibria

• Short-run: Output can be above or below potential, unemployment may not be at the natural rate.

• Long-run: Output at potential, unemployment at the natural rate, no pressure for price level change.

Static versus Dynamic Model

• Static Model: Assumes no economic growth, constant potential GDP, and no ongoing inflation.

• Dynamic Model: Incorporates economic growth, shifting LRAS and AD over time, and ongoing inflation.

Causes of Inflation

• Rightward shifts in AD (demand-pull inflation)

• Leftward shifts in SRAS (cost-push inflation)

• Monetary expansion increasing the money supply

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

Definitions

• Money: Any asset that can be used to purchase goods and services or settle debts.

• Bank: A financial intermediary that accepts deposits and makes loans.

• Federal Reserve System (the Fed): The central bank of the United States.

What is Money?

• Money is anything that is generally accepted as payment for goods and services or repayment of debt.

Functions of Money

• Medium of Exchange: Used to buy and sell goods and services.

• Unit of Account: Provides a common measure for valuing goods and services.

• Store of Value: Retains value over time for future purchases.

• Standard of Deferred Payment: Used to settle debts payable in the future.

What Can Serve as Money?

• Physical commodities (e.g., gold, silver)

• Paper currency (fiat money)

• Bank deposits (checkable deposits)

Types of Money – Commodity vs Fiat

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

• Fiat Money: Has value by government decree; no intrinsic value (e.g., U.S. dollar bills).

M1 and M2 Money Supply

• M1: Currency in circulation, checkable deposits, and traveler's checks.

• M2: M1 plus savings deposits, small time deposits, and money market mutual funds.

Fractional Reserve Banking

• Banks keep only a fraction of deposits as reserves and lend out the rest.

Reserve Requirement

• The minimum fraction of deposits banks are required to keep as reserves, set by the central bank.

Money Multiplier

• The ratio of the amount of deposits created by banks to the amount of new reserves.

Formula:

$\text{Simple Money Multiplier} = \frac{1}{\text{Reserve Ratio}}$

Money Creation Process

• Banks lend out excess reserves, which are redeposited and re-lent, multiplying the money supply.

The Federal Reserve System

• Central bank of the U.S.; regulates money supply and oversees the banking system.

• Key components: Board of Governors, 12 regional Federal Reserve Banks, Federal Open Market Committee (FOMC).

The Quantity Theory of Money – Velocity and Inflation

• Relates the money supply to the price level and output.

Equation:

$M \times V = P \times Y$

• Where M = money supply, V = velocity of money, P = price level, Y = real output.

• If velocity and output are constant, increases in M lead to proportional increases in P (inflation).

Chapter 15: Monetary Policy

Definitions

• Monetary Policy: Actions by the central bank to manage the money supply and interest rates to achieve macroeconomic goals.

Monetary Policy Goals

• Price stability (low and stable inflation)

• High employment

• Stability of financial markets and institutions

• Economic growth

Monetary Policy Tools

• Open Market Operations: Buying and selling government securities to influence the money supply.

• Discount Rate: Interest rate charged to banks for borrowing from the Fed.

• Reserve Requirements: Changing the required reserve ratio for banks.

Federal Open Market Committee (FOMC)

• Body within the Fed that sets monetary policy, especially open market operations.

Money Supply and Demand

• Money Supply: Controlled by the Fed; vertical line in the money market graph.

• Money Demand: Downward sloping; as interest rates fall, quantity of money demanded rises.

Federal Funds Market Graph – Shifts and Interpretation

• Shows the equilibrium federal funds rate (interest rate banks charge each other for overnight loans).

• Fed can shift the supply of reserves to influence the federal funds rate.

Effects of Monetary Policy

• Expansionary Policy: Increases money supply, lowers interest rates, stimulates AD and output.

• Contractionary Policy: Decreases money supply, raises interest rates, reduces AD and inflation.

Interpretation Using Static and Dynamic AD/AS Model

• Monetary policy shifts AD in the static model; in the dynamic model, it also affects inflation and growth over time.

The Taylor Rule, Fed Funds Target Rate

• The Taylor Rule provides a formula for setting the federal funds rate based on inflation and output gaps.

Equation:

$\text{Federal Funds Target Rate} = \text{Current Inflation Rate} + \text{Equilibrium Real Fed Funds Rate} + \frac{1}{2}(\text{Inflation Gap}) + \frac{1}{2}(\text{Output Gap})$

• Where Inflation Gap = actual inflation – target inflation, and Output Gap = actual GDP – potential GDP.

Summary Table: Types of Money

Type	Definition	Example
Commodity Money	Has intrinsic value	Gold coins, silver
Fiat Money	Value by government decree	U.S. dollar bills

Summary Table: Monetary Policy Tools

Tool	Description	Effect
Open Market Operations	Buying/selling government securities	Changes money supply and interest rates
Discount Rate	Interest rate for banks borrowing from Fed	Influences cost of bank reserves
Reserve Requirements	Minimum reserves banks must hold	Alters lending capacity

Additional info: The above notes expand on the review guide by providing definitions, explanations, and formulas for each topic, ensuring a comprehensive and self-contained study resource.