Macroeconomics Exam Review: Banking, Monetary Policy, Fiscal Policy, and Aggregate Demand/Supply

Banking and the Money Supply

Fractional Reserve Banking

Fractional reserve banking is a system in which banks keep only a fraction of deposits as reserves and lend out the remainder. This system allows banks to create money through lending.

• Required Reserves: The minimum amount of reserves a bank must hold, usually set by the central bank as a percentage of deposits.

• Excess Reserves: Any reserves held by a bank above the required minimum.

• Money Multiplier: The process by which an initial deposit leads to a greater final increase in the total money supply.

Formula for Required Reserves:

$\text{Required Reserves} = \text{Required Reserve Ratio} \times \text{Deposits}$

Formula for Money Multiplier:

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

Example: If a bank has $500,000 in deposits and the required reserve ratio is 10%, required reserves are $50,000. Excess reserves are any reserves above this amount.

Monetary Policy and the Federal Reserve

Open Market Operations

The Federal Reserve (Fed) conducts monetary policy primarily through open market operations, buying or selling government securities to influence the money supply and interest rates.

• Expansionary Monetary Policy: The Fed buys government securities, increasing bank reserves and the money supply, which typically lowers interest rates and stimulates economic activity.

• Contractionary Monetary Policy: The Fed sells government securities, decreasing bank reserves and the money supply, which typically raises interest rates and slows economic activity.

Example: If the Fed purchases $120,000 worth of bonds, the money supply increases by the purchase amount multiplied by the money multiplier.

Fiscal Policy

Government Spending and Taxation

Fiscal policy refers to the use of government spending and taxation to influence the economy. It is used to manage aggregate demand, stabilize the economy, and address inflation or unemployment.

• Expansionary Fiscal Policy: Increasing government spending or decreasing taxes to stimulate economic growth.

• Contractionary Fiscal Policy: Decreasing government spending or increasing taxes to slow down inflation.

Example: If the economy is operating above potential output, contractionary fiscal policy (such as raising taxes or cutting spending) can help reduce inflationary pressures.

Aggregate Demand and Aggregate Supply Analysis

AD-AS Model

The Aggregate Demand (AD) and Aggregate Supply (AS) model is used to analyze fluctuations in output and price levels in the economy.

• Aggregate Demand (AD): The total quantity of goods and services demanded across all levels of price.

• Short-Run Aggregate Supply (SRAS): The total quantity of goods and services firms are willing to produce at each price level in the short run.

• Long-Run Aggregate Supply (LRAS): The total quantity of goods and services firms are willing to produce when all resources are fully employed.

Shifts in AD and AS:

• AD shifts right with increases in consumer spending, investment, government spending, or net exports.

• SRAS shifts right with increases in productivity or decreases in input costs.

• LRAS shifts right with long-term growth factors such as technological innovation or increases in labor force.

Example: A new technology that raises potential output shifts the LRAS curve to the right, increasing the economy's capacity to produce goods and services.

Sample Multiple Choice Topics

• Bond Markets: Changes in demand for bonds affect equilibrium price and interest rates.

• Money Supply: Determined by the central bank and affected by reserve requirements and open market operations.

• GDP Growth: Calculated using growth rates and the rule of 70 ($\text{Years to Double} = \frac{70}{\text{Growth Rate}}$).

• Government Spending: Includes purchases, transfer payments, and interest payments.

• Automatic Stabilizers: Fiscal mechanisms that automatically adjust government spending or taxes in response to economic changes.

Key Tables

Bank Balance Sheet Example

Assets	Liabilities
Reserves: $75,000	Deposits: $500,000
Loans: $425,000	Net Worth: $1,000

Important Equations

• $\text{Required Reserves} = \text{Required Reserve Ratio} \times \text{Deposits}$

• $\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}$

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

• $\text{Years to Double} = \frac{70}{\text{Growth Rate}}$

Additional info:

• These notes cover topics from chapters on banking, monetary and fiscal policy, aggregate demand and supply, and economic growth, all central to a college-level macroeconomics course.

• Diagrams referenced in the original file (AD-AS graphs) illustrate shifts in aggregate demand and supply, showing effects on output and price level.