Macroeconomics Final Exam Study Guide: Economic Growth, Aggregate Demand & Supply, Money, Monetary and Fiscal Policy

Economic Growth and the Financial System

Real GDP and Economic Growth

• Real GDP: The value of all final goods and services produced within a country in a given period, adjusted for inflation.

• Real GDP per person: Real GDP divided by the population; measures average economic output per person.

• Potential GDP: The level of real GDP attained when all firms are producing at capacity.

• Rule of 70: Estimates the number of years for a variable to double, given its annual growth rate.

$\text{Years to double} = \frac{70}{\text{Growth Rate (percent)}}$

• Production Function: Shows the relationship between inputs (capital, labor, technology) and output.

• Diminishing Returns: As more of one input is added, holding others constant, the additional output from each new unit eventually decreases.

Sources of Economic Growth

• Labor Productivity: Output per worker; increases with more capital, better technology, and improved human capital.

• Capital: Physical tools, machinery, and infrastructure used in production.

• Human Capital: Skills, education, and experience of workers.

• New Technology: Innovations that improve production efficiency.

Theories of Economic Growth

• Classical Growth Theory: Predicts that population growth will outpace economic growth, leading to lower living standards due to diminishing returns.

• New Growth Theory: Emphasizes the role of technology and knowledge; profit incentives drive innovation, allowing growth to continue indefinitely.

• Requirements for Economic Growth:

  • Property rights

  • Well-functioning markets

  • Limited government restrictions

• Policies for Economic Growth:

  • Encouraging savings and investment

  • Promoting research and development

  • Facilitating international trade

  • Investing in education

Financial Markets and Savings

• Financial Market: Where funds are transferred from savers to borrowers.

• Direct Access: Investors buy stocks, bonds, or short-term securities directly.

• Indirect Access: Financial intermediaries (banks, mutual funds) channel funds from savers to borrowers.

Bond Prices and Interest Rates

• Bonds pay fixed interest; price and interest rate move inversely.

$\text{Bond Price} = \frac{\text{Coupon Payment}}{\text{Market Interest Rate}}$

Market for Loanable Funds

• Demand: Borrowers (firms, government)

• Supply: Savers (households, firms)

• Interest rate is the price of borrowing; equilibrium where savings equals investment ($S = I$).

National Savings

• Public Savings: Government budget surplus ($T - G$)

• Private Savings: Household and business savings ($Y + TR - T - C$)

• National Savings: $S = S_{private} + S_{public}$

$S = (Y + TR - T - C) + (T - G - TR)$

• Budget Deficit: Government spends more than it collects ($G > T$)

• Budget Surplus: Government collects more than it spends ($T > G$)

Shifts in Loanable Funds Market

• Demand Shifts: Changes in expected profit

• Supply Shifts: Changes in disposable income, savings incentives (e.g., IRAs, 401k), government budget position

• Crowding Out: Government deficits can raise interest rates, reducing private investment

Aggregate Demand and Aggregate Supply (AD/AS)

Aggregate Demand (AD)

• AD curve shows the total quantity of goods and services demanded at different price levels.

• Slopes downward due to:

  • Wealth effect

  • Interest rate effect

  • International trade effect

• Shifts in AD:

  • Government policy (fiscal: changes in G or T; monetary: changes in interest rates)

  • Expectations by firms and households

Aggregate Supply (AS)

• Long-Run Aggregate Supply (LRAS): Vertical because output is determined by resources and technology, not price level.

• Shifts in LRAS: Changes in capital, technology, labor force.

• Short-Run Aggregate Supply (SRAS): Upward sloping due to sticky wages and prices.

• Shifts in SRAS:

  • Changes in capital or technology

  • Expectations about future price level

  • Supply shocks (unexpected changes in input prices)

Equilibrium and Adjustment Mechanisms

• Static Model: Intersection of AD and SRAS determines short-run equilibrium.

• Automatic Mechanism: Economy self-corrects in the long run as wages and prices adjust.

• Short-run shifts affect GDP, inflation, and unemployment; long-run adjustment returns output to potential GDP.

Money, Banks, and the Federal Reserve

Nature and Functions of Money

• Barter Economy: Goods and services exchanged directly; requires double coincidence of wants.

• Money: Anything accepted as payment for goods and services.

• Fiat Money: Value by government decree (e.g., U.S. dollar).

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

• Functions of Money:

  • Medium of exchange

  • Unit of account

  • Store of value

  • Standard of deferred payment

Measuring Money

• M1: Currency, checking deposits, traveler's checks.

• M2: M1 plus savings deposits, small time deposits, money market funds.

Banks and Money Creation

• T-Accounts: Show assets (loans, reserves) and liabilities (deposits).

• Fractional Reserve Banking: Banks keep a fraction of deposits as reserves.

• Reserve Requirement: Minimum reserves set by the Fed.

• Excess Reserves: Reserves above the required minimum.

• Money Multiplier: Amount of money created from an initial deposit.

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

• Bank lending increases money supply; withdrawals or loan defaults can cause bank runs/panics.

The Federal Reserve System

• Organization: Board of Governors, Federal Open Market Committee (FOMC).

• Original Goal: Ensure financial stability.

• Interest Rates: Fed Funds rate (bank-to-bank overnight loans), Discount rate (Fed to banks).

Tools of Monetary Control

• Open Market Operations: Buying/selling government bonds to change money supply.

  • Buying bonds increases money supply ($\uparrow M_s$)

  • Selling bonds decreases money supply ($\downarrow M_s$)

• Discount Rate: Lowering rate encourages borrowing ($\uparrow M_s$), raising rate discourages it ($\downarrow M_s$).

• Reserve Requirements: Lowering increases money multiplier, raising decreases it.

Problems Controlling Money Supply

• Banks may not lend all excess reserves.

• Public may hold more cash, reducing deposit creation.

Quantity Theory of Money

$M \times V = P \times Y$

• M: Money supply

• V: Velocity of money

• P: Price level

• Y: Real output

$\text{Growth Rate of M} + \text{Growth Rate of V} = \text{Inflation Rate} + \text{Growth Rate of Y}$

• Rapid money supply growth can cause inflation or hyperinflation.

Monetary Policy

Goals of Monetary Policy

• Price stability

• High employment

• Economic growth

• Stability of financial markets and institutions

Money Market

• Money demand and supply determine equilibrium interest rate.

• Interest rates affect aggregate demand via consumption (C), investment (I), government spending (G), and net exports (NX).

• Money market differs from loanable funds market (short-term vs. long-term focus).

Bond Prices and Interest Rates

• Bond prices and interest rates move in opposite directions.

Using Monetary Policy

• Expansionary Policy: Increases money supply, lowers interest rates, boosts AD (fights unemployment).

• Contractionary Policy: Decreases money supply, raises interest rates, reduces AD (fights inflation).

• AS/AD model shows effects on GDP, price level, and unemployment.

Issues with Monetary Policy

• Timing and magnitude of policy shifts can affect effectiveness.

• Debate over targeting money supply vs. interest rates (Taylor Rule, inflation targeting).

• Central bank independence is important for credibility.

Fiscal Policy

Definition and Types

• Fiscal Policy: Government changes in spending (G) and taxes (T) to influence the economy.

• Automatic Stabilizers: Built-in changes (e.g., unemployment insurance) that occur without new laws.

• Discretionary Policy: Deliberate changes in G or T.

Expansionary vs. Contractionary Fiscal Policy

• Expansionary: Increase G or decrease T to boost AD (fight recession).

• Contractionary: Decrease G or increase T to reduce AD (fight inflation).

Multipliers

• Government Purchase Multiplier: Effect of a change in G on GDP.

• Tax Multiplier: Effect of a change in T on GDP.

$\text{Government Multiplier} = \frac{1}{1 - MPC}$

$\text{Tax Multiplier} = -\frac{MPC}{1 - MPC}$

• MPC: Marginal Propensity to Consume

AS/AD Analysis and Fiscal Policy

• Fiscal policy shifts AD, affecting output, price level, and unemployment.

• Crowding Out: Government borrowing may raise interest rates, reducing private investment.

• Short-run effects can differ from long-run outcomes.

Government Budget and Long-Run Effects

• Budget surplus: G < T; deficit: G > T; balanced: G = T.

• Borrowing for long-term public works can boost growth if well-targeted.

• Tax policy can affect long-run aggregate supply (AS) via incentives.

• Supply Side Economics: Focuses on policies that increase AS (e.g., lower taxes, deregulation).

• Pros and cons exist for changing G and T; effectiveness depends on timing, structure, and economic context.

Summary Table: Key Concepts

Concept	Definition	Key Equation
Real GDP	Inflation-adjusted value of output
Rule of 70	Years to double at given growth rate	$\text{Years} = \frac{70}{\text{Growth Rate}}$
Money Multiplier	Potential increase in money supply from new reserves	$\frac{1}{\text{Reserve Ratio}}$
Quantity Theory of Money	Relationship between money, prices, and output	$M \times V = P \times Y$
Government Multiplier	Change in GDP from change in G	$\frac{1}{1 - MPC}$
Tax Multiplier	Change in GDP from change in T	$-\frac{MPC}{1 - MPC}$