Macroeconomics Study Guide: AD/AS Model, Money & Banking, and Monetary Policy

Aggregate Demand and Aggregate Supply (AD/AS) Model

Aggregate Demand (AD)

The aggregate demand curve shows the relationship between the overall price level and the quantity of goods and services demanded in the economy. It slopes downward due to three main effects:

• Wealth Effect: As the price level falls, the real value of household wealth increases, leading to higher consumption.

• Interest Rate Effect: Lower price levels reduce the demand for money, decreasing interest rates and stimulating investment and consumption.

• International Trade Effect: A lower domestic price level makes exports more attractive and imports less attractive, increasing net exports.

Aggregate Supply (AS)

• Short-Run Aggregate Supply (SRAS): The SRAS curve is upward sloping because some prices (especially wages) are sticky in the short run, meaning they do not adjust immediately to changes in economic conditions.

• Long-Run Aggregate Supply (LRAS): The LRAS curve is vertical at the potential output (full employment output), reflecting the economy's maximum sustainable output.

Sticky Prices

• Prices and wages are "sticky" in the short run due to contracts, menu costs, and slow adjustments, causing the SRAS curve to slope upward.

Supply Shocks

• Unexpected events that affect aggregate supply, such as oil price shocks or natural disasters, can shift the SRAS curve.

Shifters of AD, LRAS, and SRAS

• AD Shifters: Changes in consumer expectations, fiscal policy (government spending/taxes), monetary policy (interest rates, money supply), foreign income, and exchange rates.

• LRAS Shifters: Changes in resources, technology, and institutions that affect the economy's productive capacity.

• SRAS Shifters: Changes in input prices (wages, raw materials), expected future prices, and supply shocks.

Short Run vs. Long Run Equilibrium

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

• Long Run Equilibrium: Occurs where AD, SRAS, and LRAS intersect; the economy operates at full employment output.

Problem Solving: AD/AS Analysis

• Analyze shifts in AD or AS and their effects on output, price level, and unemployment.

• Example: An increase in government spending shifts AD right, raising output and price level in the short run.

Money, Banks, and the Federal Reserve System

Money and Its Functions

• Money: Any asset that is widely accepted as payment for goods and services.

• Functions of Money:

  • Medium of Exchange: Facilitates transactions.

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

  • Store of Value: Retains value over time.

Types of Money

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

• Commodity-Backed Money: Paper money redeemable for a commodity.

• Fiat Money: Has value by government decree; not backed by a physical commodity.

• Currency: Physical coins and paper money in circulation.

Measuring Money: M1 and M2

• M1: Currency in circulation, checkable deposits, and traveler's checks.

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

Banking Concepts

• Assets: What a bank owns (loans, reserves).

• Liabilities: What a bank owes (deposits).

• Balance Sheet: A financial statement showing assets and liabilities.

• Bank Run: When many depositors withdraw funds simultaneously due to fears of insolvency.

• Barter: Direct exchange of goods/services; requires double coincidence of wants.

• Checkable Deposits: Deposits in bank accounts that can be withdrawn by writing a check.

Fractional Reserve Banking

• Banks keep only a fraction of deposits as reserves and lend out the rest.

• Reserves: Funds held by banks to meet withdrawals.

• Excess Reserves: Reserves above the required minimum.

The Federal Reserve and Its Tools

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

• Required Reserve Ratio: The fraction of deposits banks must hold as reserves.

• Discount Loans: Loans from the Fed to banks.

• Discount Rate: Interest rate on discount loans.

• Federal Funds: Reserves held by banks at the Fed.

• Federal Funds Rate: Interest rate on overnight loans between banks.

• Open Market Operations: The Fed buys/sells government securities to influence the money supply.

• Quantitative Easing: Large-scale asset purchases by the Fed to inject liquidity.

Money Creation and the Money Multiplier

• Simple Money Multiplier: Shows how much the money supply increases with each dollar of reserves.

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

Quantity Theory of Money

• Relates the money supply to the price level and output.

$M \times V = P \times Y$

• Where M is the money supply, V is velocity, P is the price level, and Y is real output.

Problem Solving

• Calculate M1 and M2 using definitions.

• Analyze money creation using the money multiplier.

• Apply Fed tools to AD/AS analysis.

• Use the quantity theory to relate money growth to inflation.

Monetary Policy

Monetary Policy Overview

Monetary policy refers to actions by the central bank to manage the money supply and interest rates to achieve macroeconomic goals such as price stability, full employment, and economic growth.

Types of Monetary Policy

• Expansionary Monetary Policy: Increases the money supply and lowers interest rates to stimulate aggregate demand (used during recessions).

• Contractionary Monetary Policy: Decreases the money supply and raises interest rates to reduce aggregate demand (used to combat inflation).

Stagflation

• A situation with high inflation and high unemployment, often caused by supply shocks.

New Fed Tools

• Arbitrage: Taking advantage of price differences in different markets.

• Reservation Rate: The rate at which banks are willing to lend reserves.

• Interest on Reserve Balances (IORB) Rate: The interest rate paid by the Fed on reserves held by banks.

• Overnight Reverse Repurchase Agreement (ONRRP) Rate: The rate the Fed pays on overnight reverse repurchase agreements, setting a floor for short-term interest rates.

Problem Solving: AD/AS Analysis with Monetary Policy

• Analyze the effects of monetary policy on aggregate demand, output, and price level using the AD/AS model.

• Example: An expansionary policy shifts AD right, increasing output and price level in the short run.

Summary Table: Key Money Concepts

Term	Definition	Example
Commodity Money	Money with intrinsic value	Gold coins
Fiat Money	Money by government decree, no intrinsic value	U.S. dollar bills
M1	Currency + checkable deposits + traveler's checks	Cash in wallet, checking account balance
M2	M1 + savings deposits + small time deposits + money market funds	Savings account balance
Required Reserve Ratio	Fraction of deposits banks must hold as reserves	10% of deposits
Federal Funds Rate	Interest rate on overnight loans between banks	Targeted by the Fed

Additional info: Some definitions and examples were expanded for clarity and completeness.