Macroeconomics Exam 2 Study Guide: Aggregate Demand & Supply, Money, and Monetary Policy

Aggregate Demand and Aggregate Supply (Chapter 13)

Aggregate Demand (AD)

The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and the rest of the world.

• Why AD is Downward Sloping:

  • Wealth Effect: As the price level falls, the real value of household wealth rises, increasing consumption.

  • Interest-Rate Effect: A lower price level reduces the interest rate, stimulating investment spending.

  • International-Trade Effect: A lower domestic price level makes exports cheaper and imports more expensive, increasing net exports.

• Factors that Shift AD:

  • Changes in interest rates

  • Changes in government purchases

  • Changes in taxes

  • Changes in expectations of households and firms

  • Changes in income/economic growth abroad

  • Changes in exchange rates

Long-Run Aggregate Supply (LRAS)

The LRAS curve is vertical at the potential level of output, indicating that in the long run, output is determined by resources and technology, not by the price level.

• Why LRAS is Vertical: In the long run, prices and wages are flexible, so the economy returns to its potential output regardless of the price level.

• Determinants of LRAS:

  • Size of the labor force

  • Amount of capital stock (physical and human capital)

  • Level of technology

Short-Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping because some input prices are sticky in the short run, so firms increase output as the price level rises.

• Why SRAS is Upward Sloping: Wages and some input prices adjust slowly, so higher prices increase profits and output in the short run.

• Factors that Shift SRAS:

  • Changes in the labor force

  • Changes in capital stock

  • Technological change

  • Changes in expectations about the price level

  • Adjustments to errors in past expectations

  • Supply shocks (e.g., oil price shocks)

  • Natural disasters and pandemics

AD-AS Model: Effects of Changes in AD and SRAS

• Graphical Representation: The intersection of AD, SRAS, and LRAS determines equilibrium output and price level.

• Short-Run to Long-Run Adjustment: If AD or SRAS shifts, the economy moves to a new short-run equilibrium. Over time, input prices adjust, moving the economy back to long-run equilibrium at potential output.

• Self-Corrective Mechanisms: Changes in input prices (like wages) and interest rates help restore long-run equilibrium after a shock.

Example: An increase in government spending shifts AD right, raising output and prices in the short run. Over time, higher wages shift SRAS left, returning output to potential but at a higher price level.

Appendix: Macroeconomic Schools of Thought

• Keynesian Revolution: Emphasizes the role of aggregate demand and government intervention.

• Monetarist Model: Focuses on the role of money supply in determining output and prices.

• New Classical Model: Stresses rational expectations and market clearing.

• Real Business Cycle Model: Attributes fluctuations to real (not monetary) shocks, like technology changes.

• Austrian Model: Emphasizes the importance of individual choice and the dangers of government intervention.

Money and the Banking System (Chapter 14)

Barter and Double Coincidence of Wants

• Barter: Direct exchange of goods and services without money.

• Double Coincidence of Wants: Both parties must want what the other offers, making barter inefficient.

Money: Definition and Benefits

• Money: Any asset accepted as payment for goods, services, or debts.

• Benefits over Barter: Increases efficiency by eliminating the double coincidence of wants and providing a common measure of value.

Types of Money

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

• Receipt Money: Paper receipts for commodity money held in storage.

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

• Fractional Money: System where banks hold only a fraction of deposits as reserves.

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 to settle debts payable in the future.

Criteria for a Medium of Exchange

• Acceptable to most traders

• Standardized quality

• Durable

• Valuable relative to weight

• Divisible

Monetary Aggregates

• M1: Currency in circulation, checking deposits, savings deposits

• M2: M1 plus small-denomination time deposits and noninstitutional money market mutual fund shares

Reserves and Fractional Reserve Banking

• Reserves: Bank deposits held at the central bank or as cash in vaults.

• Fractional Reserve Banking: Banks keep only a fraction of deposits as reserves, lending out the rest.

Money Creation and T-Accounts

• Banks create money by making loans; this process can be shown using T-accounts (balance sheets).

• When a bank makes a loan, it increases both its assets (loans) and liabilities (deposits).

Money Multiplier

• The money multiplier shows how much the money supply increases for each dollar of reserves.

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

Scarce-Reserves vs. Ample-Reserves Regime

• Scarce-Reserves: Central bank controls money supply by adjusting reserves.

• Ample-Reserves: Central bank sets interest rates directly; reserves are abundant.

Bank Runs and Bank Panics

• Bank Run: Many depositors withdraw funds simultaneously, fearing bank insolvency.

• Bank Panic: Widespread bank runs threaten the banking system.

Federal Reserve System and FDIC

• Federal Reserve System (Fed): U.S. central bank, regulates money supply and banking system.

• Federal Deposit Insurance Corporation (FDIC): Insures deposits up to a certain limit, reducing risk of bank runs.

Federal Open Market Committee (FOMC)

• FOMC is responsible for open market operations (buying/selling government securities).

• Voting Members: Board of Governors (7) + 5 regional Fed bank presidents (rotating basis).

Monetary Policy and Open Market Operations

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

• Open Market Operations: Buying/selling government securities to influence the money supply. Shown using T-accounts: Fed buys securities, increases bank reserves, expands money supply.

Security and Shadow Banking System

• Security: A financial asset (e.g., bond, stock) that can be traded.

• Shadow Banking System: Non-bank financial intermediaries (e.g., investment banks, hedge funds) that provide credit but are less regulated.

Quantity Theory of Money

• Quantity Equation: $MV = PY$

• Quantity Theory: Predicts that inflation equals the growth rate of the money supply minus the growth rate of real output.

• Formula: $\text{Inflation} = \text{Growth rate of money supply} - \text{Growth rate of real output}$

Hyperinflation

• Very high inflation, often caused when governments print money to finance deficits (monetize their debt).

Monetary Policy Goals (Chapter 15, Section 15.1)

• Price Stability: Keeping inflation low and predictable.

• High Employment: Achieving the natural rate of unemployment.

• Stability of Financial Markets and Institutions: Preventing financial crises.

• Economic Growth: Fostering conditions for long-term increases in output.

Key Macroeconomic Formulas (All Chapters)

Concept	Formula (LaTeX)
Net exports	$\text{Net exports} = \text{Exports} - \text{Imports}$
GDP (Expenditure approach)	$Y = C + I + G + NX$
Economic growth rate	$\text{Growth} = \frac{\text{Real GDP}_2 - \text{Real GDP}_1}{\text{Real GDP}_1} \times 100$
Labor force	$\text{Labor force} = \text{Employed} + \text{Unemployed}$
Unemployment rate	$\text{Unemployment rate} = \frac{\text{Unemployed}}{\text{Labor force}} \times 100$
Labor force participation rate	$\text{LFPR} = \frac{\text{Labor force}}{\text{Working-age population}} \times 100$
Employment-population ratio	$\text{EPR} = \frac{\text{Employed}}{\text{Working-age population}} \times 100$
Inflation rate	$\text{Inflation rate} = \frac{P_2 - P_1}{P_1} \times 100$
GDP deflator	$\text{GDP deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$
Consumer Price Index (CPI)	$\text{CPI} = \frac{\text{Expenditure in current year}}{\text{Expenditure in base year}} \times 100$
Amount in year X dollars	$\text{Amount in year X} = \text{Amount in year Y} \times \frac{\text{Price level year X}}{\text{Price level year Y}}$
Real variable	$\text{Real variable} = \frac{\text{Nominal variable}}{\text{CPI}} \times 100$
Real interest rate	$\text{Real interest rate} = \text{Nominal interest rate} - \text{Inflation rate}$
Years to double (Rule of 70)	$\text{Years to double} = \frac{70}{\text{Growth rate}}$
Multiplier	$\text{Multiplier} = \frac{\text{Money supply}}{\text{Monetary base}}$
Quantity equation	$PY = MV$
Quantity theory (inflation)	$\text{Inflation} = \text{Growth rate of money supply} - \text{Growth rate of real output}$

Note: You must memorize these formulas for the exam; formula sheets are not allowed.