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

Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Definitions

• Aggregate Demand (AD): The total demand for goods and services in an economy at a given overall price level and in a given period.

• Aggregate Supply (AS): The total supply of goods and services that firms in an economy plan on selling during a specific time period.

Why is Aggregate Demand (AD) Downward Sloping?

• Wealth Effect: As the price level falls, the real value of money increases, leading to higher consumer spending.

• Interest Rate Effect: Lower price levels reduce interest rates, stimulating investment and consumption.

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

• Example: If the price level drops, 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.

• Shift of AD: Caused by changes in non-price factors such as consumer confidence, government spending, taxes, and net exports.

Variables that Shift AD

• Changes in Consumption: Income, taxes, consumer confidence.

• Changes in Investment: Interest rates, business expectations.

• Changes in Government Spending: Fiscal policy decisions.

• Changes in Net Exports: Exchange rates, foreign income.

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

• SRAS: Shows the relationship between the price level and quantity of goods and services supplied in the short run; upward sloping due to sticky wages and prices.

• LRAS: Vertical at the potential GDP; reflects the economy's maximum sustainable output.

• Example: In the short run, firms may increase output if prices rise, but in the long run, output is determined by resources and technology.

Shifts of SRAS versus Movement Along SRAS

• Movement Along SRAS: Caused by changes in the price level.

• Shift of SRAS: Caused by changes in input prices, productivity, or supply shocks.

Macroeconomic Equilibrium in the Short- and Long-Run

• Short-Run Equilibrium: Occurs where AD intersects SRAS.

• Long-Run Equilibrium: Occurs where AD, SRAS, and LRAS intersect; the economy is at potential GDP.

• Example: If AD increases, output rises in the short run, but in the long run, only prices rise.

Characteristics of the Macroeconomic Equilibria

• Short-Run: Output may deviate from potential GDP; unemployment may be above or below the natural rate.

• Long-Run: Output returns to potential GDP; unemployment returns to the natural rate.

Static versus Dynamic Model

• Static Model: Assumes no growth, constant price level, and fixed potential GDP.

• Dynamic Model: Incorporates economic growth, changing price levels, and shifting potential GDP.

Causes of Inflation

• Demand-Pull Inflation: Caused by increases in AD.

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

• Example: Oil price shocks can cause cost-push inflation.

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

Definitions

• Money: Any item that is generally accepted as payment for goods and services.

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

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

What is Money?

• Money is a medium of exchange, a unit of account, and a store of value.

Functions of Money

• Medium of Exchange: Facilitates transactions.

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

• Store of Value: Retains purchasing power over time.

What Can Serve as Money?

• Items must be widely accepted, durable, divisible, portable, and stable in value.

• Example: Gold, coins, paper currency.

Types of Money – Commodity vs Fiat

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

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

M1 and M2 Money Supply

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

• M2: M1 plus savings deposits, small time deposits, and money market 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 must hold as reserves.

Money Multiplier

• The money multiplier shows how much the money supply increases for a given increase in reserves.

• Formula:

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

Money Creation Process

• Banks lend out deposits, creating new money through the multiplier effect.

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

The Federal Reserve System

• The central bank of the U.S., responsible for monetary policy, regulating banks, and ensuring financial stability.

• Composed of 12 regional banks and a Board of Governors.

The Quantity Theory of Money – Velocity and Inflation

• Relates money supply, velocity, price level, and output.

• Equation:

$M \times V = P \times Y$

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

• Implies that increases in money supply lead to inflation if velocity and output are constant.

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 inflation)

• High employment

• Financial market stability

• Economic growth

Monetary Policy Tools

• Open Market Operations: Buying and selling government securities.

• Discount Rate: Interest rate charged to commercial banks for borrowing from the Fed.

• Reserve Requirements: Regulations on the minimum reserves banks must hold.

Federal Open Market Committee (FOMC)

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

Money Supply and Demand

• Money supply is controlled by the Fed; money demand depends on interest rates and economic activity.

• Money market equilibrium determines the interest rate.

Federal Funds Market Graph – Shifts and Interpretation

• The federal funds rate is the interest rate banks charge each other for overnight loans.

• Shifts in money supply or demand affect the equilibrium federal funds rate.

• Example: An increase in money supply lowers the federal funds rate.

Effects of Monetary Policy

• Expansionary Policy: Increases money supply, lowers interest rates, stimulates AD.

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

• Impacts output and price level in the short run.

Interpretation Using Static and Dynamic AD/AS Model

• Monetary policy shifts AD curve; expansionary policy shifts AD right, contractionary shifts AD left.

• Dynamic model incorporates changes in potential GDP and inflation expectations.

The Taylor Rule, Fed Funds Target Rate

• The Taylor Rule provides a formula for setting the federal funds rate based on inflation and output gaps.

• Equation:

$\text{Federal Funds Rate} = \text{Inflation Rate} + 2 + 0.5 \times (\text{Inflation Gap}) + 0.5 \times (\text{Output Gap})$

• Helps guide monetary policy decisions.