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

Economic Growth and the Financial System

Real GDP and Economic Growth

Economic growth is measured by the increase in real GDP or real GDP per person over time. Real GDP adjusts for inflation, providing a more accurate measure of economic performance.

• 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 (per capita): Real GDP divided by the population; a key indicator of average living standards.

• Potential GDP: The level of output an economy can produce at full employment, when all resources are used efficiently.

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

• Formula: $\text{Years to double} = \frac{70}{\text{Growth Rate (\%)}}$

• Example: If real GDP grows at 2% per year, it will double in approximately 35 years.

Production Function and Diminishing Returns

The 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 Growth: Increases in labor productivity, capital, human capital, and technological progress.

Labor Productivity: Output per worker; a key driver of long-term economic growth.

• Increases with more capital, better education (human capital), and improved technology.

Theories of Economic Growth

• Classical Growth Theory: Predicts that increases in capital and population eventually lead to diminishing returns and a lower standard of living in the long run.

• New Growth Theory: Emphasizes the role of technology and innovation, suggesting that growth can continue indefinitely as technology advances.

Requirements for Economic Growth:

• Well-defined property rights

• Efficient markets

• Limited government restrictions

Policies for Economic Growth:

• Encouraging savings and investment

• Promoting research and development

• Expanding international trade

• Investing in education

Financial Markets and Loanable Funds

Financial markets channel funds from savers to borrowers, facilitating investment and economic growth.

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

• Indirect Access: Financial intermediaries (banks, mutual funds) collect savings and lend to borrowers.

Market for Loanable Funds: Where savers supply funds and borrowers demand them. The interest rate balances supply and demand.

• Equilibrium: Where savings (S) equals investment (I).

• National Savings: Sum of private and public savings.

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

• Private Savings: Household savings after taxes and consumption.

• Savings = Investment: $S = I$ in a closed economy.

Shifts in Demand: Driven by expected profits.

Shifts in Supply: Influenced by disposable income, savings incentives (e.g., IRAs, 401(k)s), and government budget position.

Crowding Out: When government borrowing raises interest rates, reducing private investment.

Aggregate Demand and Aggregate Supply (AD/AS)

Aggregate Demand (AD)

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

• Why AD slopes downward: Wealth effect, interest rate effect, and international trade effect.

• Shifts in AD: Caused by government policy (fiscal: G or T; monetary: interest rate), and 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 or technology.

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

• Shifts in SRAS: Changes in capital, technology, expectations about future prices, or supply shocks (unexpected changes in input prices).

Equilibrium and Adjustment Mechanisms

• Static Model: Shows equilibrium where AD and AS intersect.

• Automatic Mechanism: Economy self-adjusts to shocks over time, moving back to potential GDP.

• Effects: Short-run changes affect GDP, inflation, and unemployment; long-run adjustments restore full employment.

Money, Banking, and the Federal Reserve

Money and Its Functions

• Barter Economy: Direct exchange of goods/services without money.

• Definition of Money: Any asset accepted as payment for goods/services or repayment of debt.

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

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

• 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 a bank's assets (loans, reserves) and liabilities (deposits).

• Fractional Reserve Banking: Banks keep a fraction of deposits as reserves and lend out the rest.

• Reserve Requirement: Minimum fraction of deposits banks must hold as reserves.

• Excess Reserves: Reserves above the required minimum.

• Money Multiplier: The amount the money supply increases with each dollar of new reserves.

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

• Bank Run/Panic: Many depositors withdraw funds simultaneously, risking bank failure.

The Federal Reserve System

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

• Original Goal: Ensure stability of the banking system.

• Interest Rates: Fed Funds rate (rate banks charge each other), Discount rate (rate Fed charges banks).

Tools of Monetary Control

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

  • Buying bonds increases money supply (Ms), lowers interest rates.

  • Selling bonds decreases Ms, raises interest rates.

• Discount Rate: Lowering the rate increases Ms; raising it decreases Ms.

• Reserve Requirements: Lowering requirements increases Ms and the money multiplier; raising them decreases both.

Problems Controlling Ms: Banks may not lend all excess reserves; public may hold more cash.

Quantity Theory of Money

• Equation: $M \times V = P \times Y$

• Growth Rate Form: $\text{Growth rate of } M + \text{Growth rate of } V = \text{Inflation rate} + \text{Growth rate of } Y$

• Inflation/Hyperinflation: Rapid increases in money supply can cause high inflation.

Monetary Policy

Goals of Monetary Policy

• Price stability

• High employment

• Economic growth

• Stability of financial markets/institutions

Money Market

• Money Demand/Supply: Determines equilibrium interest rate.

• Interest Rate: Price of holding money; affects consumption (C), investment (I), government spending (G), and net exports (NX).

• Difference from Loanable Funds Market: Money market focuses on liquidity and short-term rates; loanable funds market on saving/investment and long-term rates.

Bond Prices and Interest Rates

• Bond prices and interest rates move inversely.

• Formula: $\text{Bond Price} = \frac{\text{Coupon Payment}}{\text{Interest Rate}}$ (for perpetuities)

Using Monetary Policy

• Expansionary Policy: Increases Ms, lowers interest rates, boosts AD to fight unemployment.

• Contractionary Policy: Decreases Ms, raises interest rates, reduces AD to fight inflation.

• AS/AD Model: Used to analyze effects on GDP, price level, and unemployment.

Issues with Monetary Policy

• Timing and magnitude of policy shifts

• Targeting money supply vs. interest rate

• Taylor Rule: Sets interest rate based on inflation and output gaps.

• Inflation Targeting: Central bank sets explicit inflation goals.

• Central bank independence

Fiscal Policy (controlled by Federal Government): Fiscal policy can be described as changes in government spending and taxes to achieve macroeconomic policy objectives.

Definition and Types

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

• Automatic Changes: Built-in stabilizers (e.g., unemployment insurance).

  • Government spending and taxes that automatically increase or decrease along with the business cycle.

• Discretionary Changes: Deliberate policy actions by government.

• Expansionary: Increase G or decrease T to boost AD.

• Contractionary: Decrease G or increase T to reduce AD.

Multipliers and Effects

• Government Purchase Multiplier: $\frac{1}{1 - MPC}$

• Tax Multiplier: $-\frac{MPC}{1 - MPC}$

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

Issues with Fiscal Policy

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

• Short-run vs. long-run effects

• Government Budget: Surplus, deficit, or balanced budget; borrowing for long-term projects.

• Tax Policy: Can affect long-run aggregate supply (AS) through incentives.

• Supply Side Economics: Focuses on policies to increase AS (e.g., tax cuts, deregulation).

• Pros and cons of changing G and T

Federal purchases vs Federal​ expenditures

• Federal purchases require that the government receives a good or service in​ return, whereas federal expenditures include transfer payments.

Policy Tool	Expansionary Action	Contractionary Action	Main Effect
Open Market Operations	Buy bonds	Sell bonds	Change money supply, interest rates
Discount Rate	Lower rate	Raise rate	Change bank borrowing, money supply
Reserve Requirement	Lower requirement	Raise requirement	Change money multiplier, money supply
Government Spending (G)	Increase G	Decrease G	Shift AD
Taxes (T)	Decrease T	Increase T	Shift AD