Macroeconomics Study Notes: Aggregate Demand & Supply, Money & Banking, and Monetary Policy (Ch. 9–11)

Aggregate Demand and Aggregate Supply (AD-AS Model)

Introduction to the AD-AS Model

The Aggregate Demand–Aggregate Supply (AD-AS) model is a fundamental framework in macroeconomics used to analyze short-run economic fluctuations, changes in real GDP, price levels (inflation), and business cycles such as recessions and expansions. It integrates both the demand side (spending) and the supply side (production) of the economy.

• Short-run fluctuations: Explains why output and prices change in the short term.

• Business cycles: Helps understand periods of recession and expansion.

Aggregate Demand (AD)

• Definition: Aggregate Demand is the total demand for goods and services in an economy at various price levels.

• Formula: $Y = C + I + G + NX$

• Components of AD:

  1. Consumption (C): Household spending, influenced by income, consumer confidence, and taxes.

  2. Investment (I): Firm spending on capital goods (machinery, buildings); highly sensitive to interest rates.

  3. Government Spending (G): Expenditures on public goods and services, determined by fiscal policy.

  4. Net Exports (NX): Exports minus imports; affected by exchange rates and the global economy.

Why the AD Curve is Downward Sloping

• Wealth Effect: Higher price levels reduce real wealth, leading to lower consumption.

• Interest Rate Effect: Higher prices increase money demand, raising interest rates and reducing investment.

• International Trade Effect: Higher domestic prices make exports less competitive and imports more attractive, reducing net exports.

Movements vs. Shifts in AD

• Movement along AD: Caused only by changes in the price level.

• Shift of AD: Caused by changes in spending behavior, policy, or expectations.

Determinants of AD Shifts

• Monetary Policy: Lower interest rates increase borrowing and shift AD right; higher rates shift AD left.

• Fiscal Policy: Increased government spending or lower taxes shift AD right.

• Expectations: Optimism increases spending (AD right); pessimism decreases spending (AD left).

• Foreign Sector: A strong domestic currency reduces exports (AD left); a weak currency increases exports (AD right).

Aggregate Supply (AS)

Short-Run Aggregate Supply (SRAS)

• Definition: Shows the relationship between the price level and output in the short run.

• Shape: Upward sloping.

• Reasons for Upward Slope:

  1. Sticky Wages: Wages adjust slowly; rising prices increase firm profits, encouraging more production.

  2. Menu Costs: Costs of changing prices cause firms to delay adjustments.

  3. Misperceptions: Firms may misinterpret price changes as changes in demand.

Shifts in SRAS

• Shift Right (Increase in Supply): Lower wages/input costs, improved technology/productivity, increased labor or capital.

• Shift Left (Decrease in Supply): Higher wages/raw material costs, negative supply shocks (e.g., oil crisis), higher expected inflation.

Long-Run Aggregate Supply (LRAS)

• Key Idea: In the long run, output is determined by productive capacity, not the price level.

• Shape: Vertical.

• Determinants of LRAS: Labor force size, capital stock, and technology.

• LRAS Shifts: More workers, better technology, or economic growth shift LRAS right.

Macroeconomic Equilibrium

• Short-Run Equilibrium: Where AD intersects SRAS.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS all intersect; economy is at full employment.

Economic Fluctuations

• Recession: AD shifts left; GDP, employment, and price level decrease.

• Inflationary Gap: AD shifts right beyond LRAS; price level rises (inflation).

Money and Banking

Definition and Functions of Money

• Money: Anything accepted for buying goods/services or paying debts.

• Functions of Money:

  1. Medium of exchange

  2. Unit of account

  3. Store of value

  4. Standard of deferred payment

Types of Money

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

• Fiat Money: No intrinsic value; value is based on government trust.

Money Supply in Canada

Measure	Includes
M1+	Cash + chequable deposits
M1++	M1+ plus savings deposits

Banks and Money Creation

• Banks: Accept deposits and make loans, thereby creating money.

• Fractional Reserve Banking: Banks keep only a fraction of deposits as reserves; the rest is loaned out.

The Money Multiplier

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

• Example: If reserve ratio is 10%, multiplier = 10.

• Real World Limitations: Banks may hold excess reserves and people may keep cash, reducing the actual multiplier.

Monetary Policy

Definition and Goals

• Monetary Policy: Actions by the Bank of Canada to control the money supply and influence interest rates.

• Goals:

  1. Price stability (low inflation)

  2. High employment

  3. Stable financial markets

  4. Economic growth

Tools of Monetary Policy

• Open Market Operations: Buying bonds increases money supply; selling bonds decreases money supply.

• Interest Rates (Main Tool): Lowering rates increases borrowing and spending; raising rates decreases spending.

Money Demand

• Downward Sloping: Higher interest rates reduce the quantity of money demanded.

Types of Monetary Policy

Type	When Used	Effects
Expansionary	During recession	Lower interest rates, increase consumption/investment/AD/GDP
Contractionary	During inflation	Raise interest rates, decrease spending/AD/inflation

Monetary Policy and the AD-AS Model

• Expansionary Policy: Shifts AD right.

• Contractionary Policy: Shifts AD left.

Limitations of Monetary Policy

• Time Lags: Delays in data collection, decision-making, and policy impact.

• Liquidity Trap: When interest rates are near zero, monetary policy may become ineffective.

Exam Tips and Quick Summary

• Always explain the direction of shifts, effects on GDP, and effects on the price level.

• Use proper terms: AD, SRAS, LRAS.

• Distinguish between short run and long run.

• Key Equations and Relationships:

  • AD = C + I + G + NX

  • AD curve: downward sloping; SRAS: upward sloping; LRAS: vertical

  • Lower interest rates shift AD right; higher costs shift SRAS left

  • Expansionary policy increases GDP; contractionary policy reduces inflation