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 for analyzing 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 firms are willing and able to produce at different price levels.

Short Run vs. Long Run Aggregate Supply

• Short Run Aggregate Supply (SRAS): Upward sloping due to sticky wages and prices; output can increase as prices rise.

• Long Run Aggregate Supply (LRAS): Vertical at the potential output level; reflects full employment and resource utilization.

Key Effects and Shocks

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

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

• International Trade Effect: Lower domestic prices make exports more competitive, increasing net exports.

• Sticky Prices: Prices and wages do not adjust immediately, causing short-run fluctuations.

• Supply Shocks: Unexpected events (e.g., oil price changes) that shift the AS curve.

Shifts in AD and AS

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

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

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

Equilibrium

• Long Run vs. Short Run Equilibrium: In the short run, output and prices can deviate from their long-run levels due to shocks and sticky prices. In the long run, the economy returns to full employment output.

Problem Solving: AD/AS Analysis

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

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

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.

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

• Store of Value: Maintains 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: Value by government decree; not backed by a physical commodity.

Measures of Money Supply

• M1: Currency in circulation + checkable deposits.

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

Banking System

• Balance Sheet: Shows assets (loans, reserves) and liabilities (deposits).

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

• Reserves: Funds held by banks to meet withdrawal demands.

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

• Excess Reserves: Reserves above the required minimum.

Federal Reserve System

• Discount Rate: Interest rate charged by the Fed to banks for short-term loans.

• Federal Funds Rate: Interest rate for interbank overnight loans.

• Moral Hazard: Risk that banks take excessive risks, expecting government bailouts.

Money Creation and Multiplier

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

• Quantity Theory of Money: $MV = PY$ where $M$ is money supply, $V$ is velocity, $P$ is price level, and $Y$ is real output.

Problem Solving

• Calculate M1, M2, and analyze money creation using the multiplier.

• Apply Fed tools to AD/AS analysis and assess effects on growth rates.

Example: If the required reserve ratio is 10%, the money multiplier is $\frac{1}{0.10} = 10$.

Monetary Policy

Overview of Monetary Policy

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

• Expansionary Monetary Policy: Increases money supply and lowers interest rates to stimulate economic activity.

• Contractionary Monetary Policy: Decreases money supply and raises interest rates to curb inflation.

Monetary Policy Tools

• Open Market Operations: Buying and selling government securities to influence the money supply.

• Discount Rate: Adjusting the rate at which banks borrow from the central bank.

• Reserve Requirement: Changing the required reserve ratio for banks.

• Interest on Excess Reserves (IOER Rate): Paying interest on reserves held at the central bank.

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

• New Fed Tools: Additional mechanisms developed for monetary policy implementation.

Other Concepts

• Stagflation: Simultaneous high inflation and unemployment.

• Arbitrage: Profiting from price differences in different markets.

• Reservation Rate: (Additional info: Likely refers to the interest rate paid on reserves or a similar policy tool.)

Problem Solving: AD/AS Analysis

• Use AD/AS model to evaluate the effects of monetary policy changes on output and price level.

Example: Expansionary monetary policy shifts AD right, increasing output and price level in the short run.

Money Supply Measure	Components
M1	Currency in circulation, checkable deposits
M2	M1, savings deposits, small time deposits, money market funds

Additional info: Some terms (e.g., ONRRP Rate, Reservation Rate) are inferred as advanced monetary policy tools based on context.