Aggregate Demand, Money, and Monetary Policy: Study Guide for Exam 3 (Chapters 13–15)

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 fully 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 vs. Movements 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 (fiscal and monetary policy)

• Changes in expectations of households and firms

• Changes in foreign variables (e.g., exchange rates, foreign income)

SRAS vs. 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 vs. Movements 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; output equals potential GDP.

Characteristics of Macroeconomic Equilibria

• Short-run: Output can deviate from potential, unemployment may rise or fall.

• Long-run: Economy self-corrects to potential output, unemployment returns to natural rate.

Static vs. Dynamic Model

• Static Model: Assumes no ongoing growth or inflation; used for basic analysis.

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

Causes of Inflation

• Demand-pull inflation: Caused by rightward shifts in AD.

• Cost-push inflation: Caused by leftward shifts in SRAS (e.g., rising input costs).

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 (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.

Measure	Components
M1	Currency, checking deposits, traveler’s checks
M2	M1 + savings deposits + small time deposits + money market 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 Federal Reserve.

Money Multiplier

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

Formula:

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

Money Creation Process

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

The Federal Reserve System

• The central bank of the United States; 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

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

Equation:

$M \times V = P \times Y$

• 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 Goals

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

• Goals: Price stability, high employment, economic growth, and stability of financial markets.

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 interest rates and the growth of the U.S. money supply.

Money Supply and Demand

• Money Supply: Controlled by the Fed, typically shown as a vertical line (perfectly inelastic) 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).

• 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 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.

Equation:

$\text{Federal Funds Target Rate} = \text{Current Inflation Rate} + \text{Equilibrium Real Fed Funds Rate} + 0.5 \times (\text{Inflation Gap}) + 0.5 \times (\text{Output Gap})$

• Inflation Gap: Difference between actual and target inflation.

• Output Gap: Percentage difference between actual and potential GDP.

Summary Table: Key Monetary Policy Tools

Tool	How It Works	Effect on Money Supply
Open Market Operations	Buying/selling government securities	Buy = Increase; Sell = Decrease
Discount Rate	Interest rate on loans to banks	Lower = Increase; Raise = Decrease
Reserve Requirement	Fraction of deposits banks must hold	Lower = Increase; Raise = Decrease

Example Applications

• Example 1: If the Fed buys government securities, the money supply increases, interest rates fall, and AD shifts right.

• Example 2: If inflation rises above target, the Taylor Rule suggests raising the federal funds rate to cool the economy.

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.