Money, Banking, and Aggregate Supply: Macroeconomic Study Notes

Money, Banking, and Aggregate Supply

Review of Open Market Operations

Open market operations are a primary tool used by the Federal Reserve (Fed) to influence the money supply and the monetary base in the economy.

• Open Market Operations: The Fed buys or sells government securities (usually Treasury bonds) to change the monetary base.

• Monetary Base: Defined as the sum of currency in circulation and bank reserves.

• Money Multiplier Effect: A change in the monetary base leads to a larger change in the money supply due to the process of banks lending out reserves.

• Example: When the Fed buys $100 million in Treasury bonds from a bank, the bank's reserve account increases by $100 million, enabling it to lend more and thus expand the money supply.

The Fed’s Balance Sheet

The Federal Reserve's balance sheet records its assets and liabilities, reflecting its operations and policy tools.

• Assets: Include securities (Treasury bonds, mortgage-backed securities), discount loans, central bank liquidity swaps, and gold/foreign currency.

• Liabilities: Include reserve accounts (held by banks), Federal Reserve notes (cash), the Treasury General Account, and other accounts (e.g., for international organizations).

• Monetary Base: Calculated as reserve accounts plus Federal Reserve notes.

Assets	Liabilities
Securities (Treasury bonds, MBS)	Reserve Accounts (banks)
Discount Loans	Federal Reserve Notes (cash)
Central Bank Liquidity Swaps	Treasury General Account
Gold & Foreign Currency	Other Accounts (WB, UN, IMF, etc.)
	Bank Capital

How the Fed Pays for Securities

The Fed can pay for securities in two main ways, both of which increase the monetary base:

• Reserves: The most common method; the Fed credits the selling bank's reserve account, allowing the bank to lend more.

• Cash (Federal Reserve Notes): The Fed issues physical currency, which is also a liability on its balance sheet.

• Analogy: Similar to a medieval bank issuing receipts for gold deposits; the Fed issues reserves or notes in exchange for securities.

Types of Securities Held by the Fed

The Fed holds only very safe assets to maintain stability and confidence in the financial system.

• Treasury Securities: U.S. government bonds considered risk-free due to the government's creditworthiness.

• Mortgage-Backed Securities (MBS): Pools of mortgages, often insured by government agencies, providing diversification and reduced risk.

Other Items on the Fed’s Balance Sheet

• Treasury General Account: The U.S. government's main bank account at the Fed.

• Other Accounts: Accounts for international organizations (e.g., UN, IMF).

• Bank Capital: Acts as a buffer against changes in asset values.

• Ownership: The Fed is a mix of public and private; all U.S. banks are required to contribute capital, but leadership is appointed by the President and confirmed by the Senate.

Discount Loans: The Fed as Lender of Last Resort

Discount loans are emergency loans provided by the Fed to banks, especially during financial crises.

• Discount Loans: Directly add reserves to banks' accounts, with the interest rate charged known as the discount rate.

• Money Multiplier: These loans have the same expansionary effect on the money supply as open market purchases.

• Example: After the 9/11 attacks, the Fed kept the discount window open, leading to a sharp increase in excess reserves.

Monetary Base Expansion and Inflation

Increasing the monetary base can lead to inflation if not matched by an increase in real output.

• Logic: If the monetary base and money supply increase rapidly without a corresponding rise in productivity, the value of money falls, leading to inflation.

• Debate: While not all economists agree on the magnitude, monetary expansion is widely considered a contributing factor to inflation.

Aggregate Demand and Aggregate Supply Framework

Business Cycle Theory

Macroeconomics seeks to explain fluctuations in GDP growth and inflation over time, contrasting with microeconomics, which focuses on individual markets.

• Microeconomics: Studies price and quantity in a single market.

• Macroeconomics: Examines the overall price level and real GDP using aggregate supply and demand.

Aggregate Demand and Aggregate Supply (AD-AS) Model

The AD-AS model is a fundamental tool for analyzing the overall economy.

• Axes: Y-axis represents the price level; X-axis represents real GDP.

• Curves: Aggregate Demand (AD) and Aggregate Supply (AS) determine equilibrium price level and real GDP.

Long-Run Aggregate Supply (LRAS)

LRAS represents the economy's potential output when all prices are fully flexible.

• Shape: Vertical, indicating that changes in the price level do not affect output in the long run.

• Reason: All input and output prices adjust together, so relative prices and incentives remain unchanged.

• Formula: $\text{Profits} = \text{Revenue} - \text{Costs} = (P_{\text{output}} \times Q) - (P_{\text{inputs}} \times Q_{\text{inputs}})$

• Key Insight: If all prices double, there is no change in real output because relative prices are unchanged.

Factors That Shift LRAS

LRAS shifts when the economy's potential output changes.

• Capital Stock: More machinery and buildings increase potential GDP.

• Labor: Population growth or immigration increases the labor force.

• Resources: Discovery or depletion of natural resources.

• Technology: Innovations and efficiency improvements.

• Growth Rate: LRAS typically shifts rightward at about 2% per year.

Short-Run Aggregate Supply (SRAS) and Sticky Wages

In the short run, some prices, especially wages, adjust slowly, causing the SRAS curve to slope upward.

• Sticky Wages: Due to long-term contracts, slow hiring, and renegotiation difficulties, wages do not adjust quickly.

• SRAS Shape: Upward sloping because when the price level rises but wages are sticky, firms' profits increase, leading to higher output.

• SRAS Shifters: Everything that shifts LRAS also shifts SRAS, plus changes in wages, input prices (oil, energy), regulations, and currency fluctuations.

Wage Adjustments and SRAS Dynamics

Changes in wages affect the position of the SRAS curve.

• Wages Increase: Costs rise, SRAS shifts left.

• Wages Decrease: Costs fall, SRAS shifts right.

• Adjustment Process:

  1. Prices rise, moving along SRAS (output increases).

  2. Wages eventually catch up.

  3. SRAS shifts left.

  4. Economy returns to LRAS at a higher price level.

Other Input Prices and SRAS

• Energy Prices: Increases in oil, electricity, or natural gas prices shift SRAS left (e.g., 1970s oil crisis).

• Regulations: Environmental or other regulations can increase production costs, shifting SRAS left.

• Currency Depreciation: Makes imported inputs more expensive, shifting SRAS left.

Policy Implications of Sticky Wages

There is debate among economists about the persistence of deviations from potential GDP and the role of government intervention.

• Activist View: Deviations can last for years (e.g., Great Depression); government intervention is necessary for stabilization.

• Non-Activist View: Wages adjust quickly; government intervention may worsen outcomes; the economy should self-correct.

• Key Disagreement: The actual degree of wage stickiness.

Aggregate Demand (AD)

GDP Components

Aggregate demand is determined by the sum of expenditures on goods and services in the economy.

• Formula: $GDP = C + I + G + X - M$

• C: Consumption (households)

• I: Investment (firms)

• G: Government spending

• X - M: Net exports (exports minus imports)

Determinants of Consumption

Consumption is the largest component of GDP and is influenced by several factors.

• Disposable Income (Yd): Income after taxes plus transfers; $Y_d = Y - \text{Taxes} + \text{Transfers}$

• Savings/Wealth: Past income saved can be used for current consumption.

• Borrowing: Access to credit allows households to spend future income today.

• Lifetime Income Hypothesis: Consumption depends on expected lifetime disposable income, not just current income.

Factors Shifting Consumption

• Taxes: Higher taxes reduce disposable income and consumption.

• Transfers: Increased government transfers raise consumption.

• Wealth Changes: Changes in stock market or housing values affect consumption.

• Access to Credit: A healthy banking system enables borrowing and smooths consumption.

• Interest Rates: Higher rates increase the cost of borrowing, reducing consumption.

• Expectations: Uncertainty about future income can reduce current consumption.

Role of the Financial System in Consumption

The financial system is crucial for enabling stable consumption patterns.

• Borrowing: Allows households to spend based on expected future income.

• Access to Savings: Facilitates the use of past income for current needs.

• System Failures: Financial crises (e.g., Great Depression, 2008 crisis) disrupt borrowing and saving, leading to sharp declines in consumption and severe recessions.

• Importance: Consumption accounts for about two-thirds of GDP, so disruptions have major macroeconomic effects.