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

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 fixed.

• 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.

• Example: If the price level in the U.S. falls, Americans feel wealthier, borrow at lower rates, and foreign buyers purchase more U.S. goods.

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 consumer confidence, fiscal policy, or foreign income.

Variables that Shift Aggregate Demand

• Changes in government policies (taxes, spending)

• Changes in expectations of households and firms

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

SRAS versus LRAS

• SRAS: Upward sloping because some input prices are sticky in the short run.

• LRAS: Vertical at the potential GDP; not affected by the price level in the long run.

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, technology, or supply shocks.

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 Macroeconomic 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 ongoing growth or inflation; used for basic analysis.

• Dynamic Model: Incorporates economic growth, inflation, and shifting curves over time.

Causes of Inflation

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

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

Money, Banks, and the Federal Reserve System

Definitions and Key Concepts

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

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

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

Functions of Money

• Medium of Exchange: Accepted as payment for 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.

What Can Serve as Money?

• Must be acceptable, durable, divisible, uniform, limited in supply, and portable.

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 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 must hold as reserves, set by the central bank.

Money Multiplier

• Shows how much the money supply increases with each dollar of reserves.

• Formula: $\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}$

Money Creation Process

• Banks lend out excess reserves, creating new deposits and expanding the money supply.

• Example: A $1,000 deposit with a 10% reserve ratio can create up to $10,000 in new money.

The Federal Reserve System

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

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

The Quantity Theory of Money

• Relates money supply, velocity, 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 $V$ and $Y$ are constant, increases in $M$ lead to proportional increases in $P$ (inflation).

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, stable inflation)

• High employment

• Economic growth

• Stability of financial markets and institutions

Monetary Policy Tools

• Open market operations (buying/selling government securities)

• Discount rate (interest rate on loans to banks)

• Reserve requirements

Federal Open Market Committee (FOMC)

• Makes key decisions about open market operations and the direction of monetary policy.

Money Supply and Demand

• Money Supply: Controlled by the central bank; typically shown as a vertical line in the money market graph.

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

Federal Funds Market Graph – Shifts and Interpretation

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

• Shifts in money supply or demand change the equilibrium 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 output.

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 and Fed Funds Target Rate

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

• Formula: $i = r^* + \pi + 0.5(\pi - \pi^*) + 0.5\left(\frac{Y - Y^*}{Y^*}\right)$ Where:

  • $i$ = Nominal federal funds rate

  • $r^*$ = Real equilibrium federal funds rate

  • $\pi$ = Current inflation rate

  • $\pi^*$ = Target inflation rate

  • $Y$ = Real GDP

  • $Y^*$ = Potential GDP

Summary Table: Types of Money

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

Summary Table: M1 vs M2

Component	M1	M2
Currency in circulation	✔	✔
Checking deposits	✔	✔
Traveler's checks	✔	✔
Savings deposits		✔
Small time deposits		✔
Money market mutual funds		✔

Additional info: Some explanations and formulas have been expanded for clarity and completeness based on standard macroeconomics curriculum.