Aggregate Demand, Money, and Monetary Policy: Study Notes 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 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 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 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 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 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 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 vs. 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

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

• 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: Used to buy goods and services.

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

• Store of Value: Retains value over time.

• Standard of Deferred Payment: Used for future payments.

What Can Serve as Money?

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

Types of Money: Commodity vs. Fiat

• Commodity Money: Value from the commodity itself (e.g., gold coins).

• Fiat Money: Value from government order; not backed by a physical commodity.

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 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 Federal Reserve.

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.

The Federal Reserve System

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

• 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:

$M \times V = P \times Y$

• M: Money supply

• V: Velocity of money

• P: Price level

• Y: Real output

Assuming velocity and output are constant, increases in money supply lead to proportional increases in the price level (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 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, 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).

• Shifts in money supply or demand change 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.

The Taylor Rule and Fed Funds Target Rate

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

Equation:

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

• Inflation Gap: Difference between actual and target inflation.

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

Example: Application of the Taylor Rule

• If equilibrium real rate is 2%, current inflation is 3%, inflation gap is 1%, and output gap is -2%:

$\text{Target Rate} = 2\% + 3\% + 0.5 \times 1\% + 0.5 \times (-2\%) = 2\% + 3\% + 0.5\% - 1\% = 4.5\%$

Additional info: The Taylor Rule is a guideline, not a strict rule, and the Federal Reserve may consider other factors in practice.