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

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 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 rises, increasing consumption.

• Interest Rate Effect: Lower price levels decrease 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.

• Example: If the price level decreases, consumers feel wealthier and spend more, businesses invest more, and exports rise.

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 income.

Variables that Shift Aggregate Demand

• Changes in Consumer Expectations

• Changes in Government Policies: Fiscal policy (taxes, government spending) and monetary policy (money supply, interest rates)

• Changes in Foreign Variables: Exchange rates, foreign income

• Example: An increase in government spending shifts AD to the right.

SRAS versus LRAS

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

• LRAS: Vertical at the potential output (Y*), reflecting full employment and flexible prices.

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.

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

Characteristics of Macroeconomic Equilibria

• Short-Run: Can have recessionary or inflationary gaps.

• Long-Run: Economy self-adjusts to potential output.

Static versus Dynamic Model

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

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

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 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 money market mutual funds.

• Example: M1 is more liquid than M2.

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.

Money Multiplier and Money Creation Process

• Money Multiplier Formula:

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

• Money Creation: When banks make loans, they create new deposits, increasing the money supply.

• Example: With a 10% reserve ratio, the money multiplier is 10.

The Federal Reserve System

• The central bank of the United States; regulates the 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 of Exchange:

$M \times V = P \times Y$

• 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 Goals

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

• Goals:

  • Price stability (low 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)

• Makes key decisions about interest rates and the growth of the U.S. money supply.

Money Supply and Demand

• Money Supply: Set by the central bank; vertical line in the money market graph.

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

Federal Funds Market Graph – Shifts and Interpretation

• Federal Funds Rate: The 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.

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

• Example: During a recession, the Fed may buy government securities to lower interest rates.

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

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

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

• Inflation Gap: Difference between actual and target inflation.

• Output Gap: Difference between actual and potential GDP.

Concept	Definition	Example/Application
Aggregate Demand (AD)	Total demand for goods and services at various price levels	AD curve shifts right with increased government spending
Money Multiplier	Amount of money created per dollar of reserves	With 10% reserve ratio, multiplier is 10
Expansionary Monetary Policy	Increases money supply to lower interest rates	Fed buys bonds during recession
Taylor Rule	Formula for setting target interest rate	Fed raises rates if inflation is above target

Additional info: Academic context and examples have been added to expand on the review guide points and ensure the notes are self-contained for exam preparation.