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

Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Definitions

• 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.

• Aggregate Supply (AS): The total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level in a given period.

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.

• 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 fiscal policy, monetary policy, expectations, or foreign income.

Variables that Shift AD

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

• Changes in Expectations: Consumer and business optimism or pessimism about the future.

• Changes in Foreign Variables: Changes in foreign income or exchange rates.

Short-Run Aggregate Supply (SRAS) versus Long-Run Aggregate Supply (LRAS)

• SRAS: Shows the relationship between the price level and the quantity of goods and services supplied in the short run, when some input prices are sticky.

• LRAS: Shows the relationship in the long run, when all prices are flexible; vertical at the potential output (Y*).

• Example: In the short run, wages may not adjust immediately, so firms can increase output when prices rise. In the long run, wages and other input prices adjust, and output returns to potential.

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, expectations of future prices, or supply shocks.

Macroeconomic Equilibrium in the Short- and Long-Run

• Short-Run Equilibrium: Occurs where AD intersects SRAS; output may be above or below potential.

• Long-Run Equilibrium: Occurs where AD, SRAS, and LRAS all intersect; output is at potential (full employment).

Characteristics of the Macroeconomic Equilibria

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

• Long-Run: Economy self-adjusts to potential output as wages and prices become flexible.

Static versus Dynamic Model

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

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

Causes of Inflation

• Demand-Pull Inflation: Caused by increases in aggregate demand.

• Cost-Push Inflation: Caused by decreases in aggregate supply (e.g., rising input costs).

Chapter 14: Money, Banks, and the Federal Reserve System

Definitions

• Money: Any asset that is generally accepted in exchange for goods and services or for repayment of debt.

• Bank: A financial intermediary that accepts deposits and makes loans.

• Federal Reserve System (the Fed): The central bank of the United States.

What is Money?

• Money is anything that is widely accepted as payment for goods and services.

Functions of Money

• Medium of Exchange: Used to buy and sell goods and services.

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

• Store of Value: Maintains value over time.

• Standard of Deferred Payment: Used to settle debts payable in the future.

What Can Serve as Money?

• Items that are durable, portable, divisible, uniform, and widely accepted (e.g., coins, currency, electronic balances).

Types of Money – Commodity vs Fiat

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

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

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 are required to keep as reserves, set by the central bank.

Money Multiplier

• The ratio of the amount of deposits created by banks to the amount of new reserves.

• Formula:

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

Money Creation Process

• Banks create money by making loans; each loan increases the money supply by a multiple of the original deposit.

• Example: A $1,000 deposit with a 10% reserve requirement can create up to $10,000 in new money.

The Federal Reserve System

• The central bank of the U.S., responsible for monetary policy, supervising banks, and providing financial services.

• Composed of the Board of Governors, 12 regional Federal Reserve Banks, and the Federal Open Market Committee (FOMC).

The Quantity Theory of Money – Velocity and Inflation

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

Chapter 15: Monetary Policy

Definitions

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

Monetary Policy Goals

• Price stability (low and stable 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)

• The branch of the Federal Reserve that determines the direction of monetary policy, primarily through open market operations.

Money Supply and Demand

• Money Supply: Controlled by the Fed; 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

• 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, increases output and employment.

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

Interpretation Using Static and Dynamic AD/AS Model

• Monetary policy shifts AD in the AD/AS model.

• Expansionary policy shifts AD right; contractionary shifts AD left.

• Dynamic model incorporates ongoing growth and inflation.

The Taylor Rule, 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.

• Formula:

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

• Helps guide monetary policy decisions.