AS/AD, Money Supply, and the Great Depression: Macroeconomic Study Notes

Aggregate Supply and Aggregate Demand (AS/AD)

Overview

The AS/AD model is a fundamental framework in macroeconomics for analyzing the total supply and demand in an economy. This set of notes covers the money supply process, the conditions and causes of the Great Depression, and the macroeconomic responses to major economic shocks.

• Money and the Money Supply Process: Understanding how money is created and measured is essential for analyzing macroeconomic stability.

• Conditions Leading up to the Great Depression: Examines the economic environment prior to the 1929 crash.

• Causes of the Great Depression: Focuses on the factors that triggered the most severe economic downturn in modern history.

Money

Functions of Money

Money serves several critical roles in the economy:

• Medium of Exchange: Facilitates transactions by eliminating the need for barter.

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

• Store of Value: Allows individuals to save purchasing power for future use.

Types of Money

Commodity Money vs. Fiat Money

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

  • Gold Standard: Currency is guaranteed to purchase a fixed amount of gold.

    • In the US, 1834-1933: $20.67 per ounce fixed rate.

    • Bretton Woods (Post WWII-1971): International system of fixed exchange rates based on gold.

• Fiat Money: Has no intrinsic value; its value is decreed by government as legal tender.

Measuring Money

Monetary Aggregates

• M1: Most liquid assets; includes currency, traveler's checks, demand deposits, and other checkable deposits.

• M2: Includes M1 plus small denomination time deposits, savings deposits, money market deposit accounts, and money market mutual fund shares.

Players in the Money Supply Process

Key Institutions

• Central Bank (Federal Reserve): Regulates the money supply and implements monetary policy.

• Banks (Depository Institutions): Act as financial intermediaries, accepting deposits and making loans.

• Depositors: Individuals and businesses who hold money in banks.

• Open Market Operations: The purchase or sale of government bonds with the private sector to influence the money supply.

Money Creation and Deposit Expansion

Single Bank Example

When a bank receives excess reserves, it can loan out these funds, creating a checking account for the borrower and increasing the money supply.

Assets	Liabilities
Securities +$100	Checkable deposits +$100
Reserves +$100
Loans +$100

Deposit Creation with Reserve Requirement

Assuming a 10% reserve requirement, banks must hold a fraction of deposits as reserves, allowing the rest to be loaned out and further increasing deposits in the banking system.

Bank	Increase in Deposits ($)	Increase in Loans ($)	Increase in Reserves ($)
First National	0.00	100.00	0.00
A	100.00	90.00	10.00
B	90.00	81.00	9.00
C	81.00	72.90	8.10
D	72.90	65.61	7.29
E	65.61	59.05	6.56
F	59.05	53.14	5.91
Total for all banks	1,000.00	1,000.00	100.00

Deposit Multiplier Formula

• Required Reserves ($RR$) = Total Reserves ($R$)

• $RR = r imes D$

• Dividing both sides by $r$:

• $D = rac{1}{r} imes R$

• Change in deposits: $riangle D = rac{1}{r} imes riangle R$

Limits to Deposit Expansion

• Holding Cash: Stops the deposit expansion process, as currency does not multiply through the banking system.

• Banks' Use of Excess Reserves: Banks may choose not to loan out all excess reserves, limiting money creation.

• Depositors' and Banks' Decisions: Choices about holding currency and excess reserves affect the overall money supply.

Banking Crises

Solvency and Liquidity

• Solvency: Occurs when a bank's assets no longer match its liabilities, leading to potential failure.

• Liquidity: Occurs when a bank cannot meet withdrawal demands, often resulting in a bank run.

The Great Depression: Causes and Effects

Economic Conditions and Shocks

• Roaring 20's: Period of economic prosperity preceding the crash.

• Black Tuesday: Stock market crash of 1929, marking the start of the Great Depression.

• Bank Failures: 1920-1933 saw 9,000 banks fail, with $6.8 billion in deposits lost.

• Aggregate Demand Shocks:

  • Wealth effect: Loss of wealth due to stock market crash.

  • Bearishness: Investment fell by 81%.

  • Collapse of money supply: Solvency and liquidity crises.

• Macroeconomic Impact:

  • Unemployment reached 25%.

  • GDP fell by 33%.

  • Deflation of 25%.

Institutional Reform After the Great Depression

Banking Reform

• Banking Act of 1933 (Glass-Steagall Act):

  • Lender of last resort

  • Creation of the Federal Open Market Committee (FOMC)

  • Federal Deposit Insurance Corporation (FDIC)

  • Separation of commercial and investment banking

  • Prevention of bank competition (Regulation Q: interest rate ceilings)

Macroeconomic Policy Responses

Classical vs. Keynesian Approaches

• Classical Approach: Advocated for laissez-faire policies, expecting the economy to self-correct through wage and price flexibility.

• Keynesian Approach: Emphasized aggregate demand management, recommending government intervention to "lean against the wind" and restore full employment.

Recovery and Policy Changes

The New Deal and Monetary Policy

• The New Deal (Franklin D. Roosevelt):

  • Glass-Steagall Act (1933)

  • WPA Works Progress Administration

  • Social Security Act

  • National Labor Relations Act

  • Unemployment insurance

• Monetary Policy:

  • End of the gold standard (June 1933)

  • Move to fiat currency

  • Expansionary policy: FOMC bond purchases, lowering interest rates, increasing money supply

• World War II: Unemployment did not fall below 10% until WWII, which temporarily shifted the economy to a command structure.

Expectations, Inertia, and Stagflation

Monetary Targeting and Unemployment

• Unanticipated Expansionary Monetary Policy: Can lower unemployment below the natural rate if not expected.

• Expectations Adaptation: Over time, expectations adjust, wages and prices rise, and the effect of policy diminishes.

• Stagflation: Occurs when inflation and unemployment rise simultaneously, often due to supply shocks or poor policy credibility.

• Rational Expectations School: Argues that only unanticipated policy can affect real variables; anticipated policy is neutralized by agents' expectations.

Key Equations

• Deposit Multiplier: $D = \frac{1}{r} \times R$

• Change in Deposits: $\triangle D = \frac{1}{r} \times \triangle R$

Example: Deposit Expansion

If the reserve requirement is 10% ($r = 0.1$) and reserves increase by $100, the total increase in deposits is:

$\triangle D = \frac{1}{0.1} \times 100 = 1,000$

Additional info: These notes integrate historical context, institutional reforms, and theoretical models to provide a comprehensive understanding of macroeconomic dynamics during the Great Depression and beyond.