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

Aggregate Demand and Aggregate Supply Analysis

Definitions and Key Concepts

• 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 potential output at full employment.

Why is Aggregate Demand (AD) Downward Sloping?

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

• Interest Rate Effect: Lower price levels reduce the interest rate, stimulating 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 Aggregate Demand

• Changes in consumer expectations

• Changes in government policies (fiscal and monetary)

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

• Changes in household wealth

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, supply shocks, or expectations of future prices.

Macroeconomic Equilibrium in the Short and Long Run

• Short-Run Equilibrium: Where AD intersects SRAS; output may be above or below potential GDP.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS intersect; economy operates at full employment.

Characteristics of Macroeconomic Equilibria

• Short-run: Output can deviate from potential, unemployment may be above or below natural rate.

• Long-run: Output returns to potential, unemployment at natural rate, only price level changes.

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 ongoing inflation.

Causes of Inflation

• Demand-pull inflation: AD increases faster than AS.

• Cost-push inflation: SRAS decreases due to rising input costs.

• Monetary factors: Excessive growth in money supply.

Money, Banks, and the Federal Reserve System

Definitions and Key Concepts

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

• Functions of Money:

  • Medium of exchange

  • Unit of account

  • Store of value

  • Standard of deferred payment

What Can Serve as Money?

• Must be acceptable, standardized, durable, valuable relative to its weight, and divisible.

Types of Money: Commodity vs. Fiat

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

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

M1 and M2 Money Supply

• M1: Currency in circulation, checking account deposits, and traveler’s checks.

• M2: M1 plus savings deposits, small time deposits, and non-institutional money market funds.

Fractional Reserve Banking

• Banks keep 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 Federal Reserve.

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, creating new deposits and expanding the money supply.

The Federal Reserve System

• The central bank of the United States; regulates money supply and oversees the banking system.

The Quantity Theory of Money

• Relates the money supply, velocity of money, price level, and output.

Equation:

$M \times V = P \times Y$

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

• Implies that, in the long run, inflation results from money supply growing faster than real output.

Monetary Policy

Definitions and Key Concepts

• 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

• Discount rate

• Reserve requirements

Federal Open Market Committee (FOMC)

• The branch of the Federal Reserve that determines the direction of monetary policy, primarily through 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 curve through open market operations, affecting the equilibrium rate.

Effects of Monetary Policy

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

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

Interpretation Using Static and Dynamic AD/AS Model

• Expansionary policy shifts AD right; contractionary shifts AD left.

• Dynamic model incorporates ongoing growth and inflation expectations.

The Taylor Rule and Fed Funds Target Rate

• The Taylor Rule provides a formula for setting the federal funds rate based on inflation, output gap, and equilibrium real rate.

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, Output Gap = actual GDP – potential GDP.

Summary Table: Types of Money

Type	Description	Example
Commodity Money	Has intrinsic value	Gold coins
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 on loans to banks	Alters cost of borrowing for banks
Reserve Requirements	Minimum reserves banks must hold	Impacts lending and money creation

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