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

AD/AS Model

Aggregate Demand and Aggregate Supply

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

• Aggregate Demand (AD): Represents the total quantity of goods and services demanded across all levels of the economy at different price levels.

• Aggregate Supply (AS): Shows the total quantity of goods and services that producers in an economy are willing and able to supply at different price levels.

Short Run and Long Run Aggregate Supply

• Short Run Aggregate Supply (SRAS): The SRAS curve is upward sloping, reflecting that as prices rise, producers are willing to supply more due to higher profits.

• Long Run Aggregate Supply (LRAS): The LRAS curve is vertical, indicating that in the long run, output is determined by resources and technology, not by price level.

Key Effects and Shocks

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

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

• International Trade Effect: A lower domestic price level makes exports more competitive, increasing aggregate demand.

• Sticky Prices: Prices and wages do not adjust immediately to changes in economic conditions, leading to short-run fluctuations.

• Supply Shocks: Unexpected events (e.g., oil price spikes) that affect the cost of production and shift the AS curve.

Shifts in AD and AS

• AD Shifters: Changes in consumer confidence, fiscal policy, monetary policy, and global conditions.

• LRAS Shifters: Changes in technology, labor force, capital stock, and natural resources.

• SRAS Shifters: Changes in input prices, wages, and temporary supply shocks.

Long Run vs Short Run Equilibrium

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

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

Problem Solving: AD/AS Analysis

• Use the AD/AS model to analyze the effects of policy changes, shocks, and other events on output and price level.

Money, Banks, and the Federal Reserve System

Definition and Functions of Money

Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts.

• Medium of Exchange: Facilitates transactions by eliminating the need for barter.

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

• Store of Value: Allows individuals to save purchasing power for future use.

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.

Measures of Money Supply

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

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

Banking System

• Balance Sheet: Shows a bank's assets, liabilities, and equity.

• Assets: Loans, reserves, securities.

• Liabilities: Deposits, borrowings.

• Bank Run: Occurs when many depositors withdraw funds simultaneously due to concerns about the bank's solvency.

• Double Coincidence of Wants: A problem in barter systems where two parties must have what the other wants.

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

Reserves and the Federal Reserve

• Required Reserve Ratio: The fraction of deposits banks are required to keep as reserves.

• Excess Reserves: Reserves held by banks above the required minimum.

• Federal Reserve: The central bank of the United States, responsible for monetary policy.

• Discount Rate: The interest rate the Federal Reserve charges banks for short-term loans.

• Federal Funds Rate: The interest rate at which banks lend reserves to each other overnight.

• Moral Hazard: When one party takes more risks because another party bears the cost of those risks.

Money Creation and Money Multiplier

• Simple Money Multiplier: Measures the maximum amount of money that can be created from an initial deposit.

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

Quantity Theory of Money

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

$MV = PY$

• M: Money supply

• V: Velocity of money

• P: Price level

• Y: Real output

Problem Solving

• Analyze M1 and M2, money creation, Fed tools, AD/AS analysis, and quantity theory and growth rates.

Monetary Policy

Overview of Monetary Policy

Monetary policy refers to the actions undertaken by a nation's central bank to control the money supply and achieve macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity.

• Expansionary Monetary Policy: Increases the money supply to stimulate economic activity, typically by lowering interest rates.

• Contractionary Monetary Policy: Decreases the money supply to curb inflation, typically by raising interest rates.

Key Concepts

• Stagflation: A situation of simultaneous high inflation and high unemployment.

• Arbitrage: The practice of taking advantage of price differences in different markets.

Federal Reserve Tools and Rates

• Reservation Rate: (Additional info: Likely refers to the required reserve ratio or interest rate on reserves.)

• IORB Rate: Interest on Reserve Balances; the rate paid by the Fed on reserves held by banks.

• ONRRP Rate: Overnight Reverse Repurchase Agreement rate; a tool for managing short-term interest rates.

• New Fed Tools: Recent innovations in monetary policy instruments.

Problem Solving: AD/AS Analysis

• Apply AD/AS analysis to evaluate the effects of monetary policy changes.

Summary Table: Types of Money

Type of Money	Definition	Example
Commodity Money	Has intrinsic value	Gold coins
Commodity Backed Money	Paper money redeemable for a commodity	Gold certificates
Fiat Money	Value by government decree	US dollar bills

Summary Table: Federal Reserve Tools

Tool	Purpose	Effect on Money Supply
Open Market Operations	Buying/selling government securities	Increase/decrease
Discount Rate	Interest rate for bank loans from Fed	Lowering increases, raising decreases
Required Reserve Ratio	Fraction of deposits banks must hold	Lowering increases, raising decreases
IORB Rate	Interest paid on reserves	Higher rate encourages holding reserves
ONRRP Rate	Short-term interest rate management	Helps set floor for market rates

Additional info: Some terms (e.g., "Reservation Rate") were inferred based on standard macroeconomics curriculum and context.