Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Aggregate Demand

The aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the price level. The aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and foreign buyers.

• Wealth Effect: A higher price level reduces the purchasing power of wealth, leading to lower consumption.

• Interest-Rate Effect: A higher price level increases interest rates, reducing investment spending.

• International-Trade Effect: A higher price level makes domestic goods more expensive relative to foreign goods, reducing net exports.

• Movements vs. Shifts: A change in the price level causes a movement along the AD curve. A change in any component of real GDP (such as government purchases) shifts the AD curve.

• Variables that Shift AD:

  • Monetary Policy: Actions by the Federal Reserve to manage the money supply and interest rates.

  • Fiscal Policy: Changes in federal taxes and government purchases.

  • Expectations: Changes in optimism or pessimism among households and firms.

  • Foreign Income: Changes in the growth rate of foreign economies.

  • Exchange Rates: Changes in the value of the U.S. dollar relative to other currencies.

Aggregate Supply

The aggregate supply (AS) curve shows the relationship between the price level and the quantity of real GDP supplied. There are two versions: long-run (LRAS) and short-run (SRAS).

• Long-Run Aggregate Supply (LRAS):

  • Shows the relationship in the long run between the price level and real GDP supplied.

  • Determined by the number of workers, technology, and capital stock.

  • Occurs at potential or full-employment GDP, which grows over time.

• Short-Run Aggregate Supply (SRAS):

  • Upward sloping due to sticky wages and prices (contracts, slow wage adjustments, menu costs).

  • Movement along SRAS occurs with a change in the price level; shifts occur with changes in other factors.

• Factors that Shift SRAS:

  • Changes in the labor force or capital stock.

  • Changes in productivity.

  • Changes in the expected future price level.

  • Adjustments to past errors in price level expectations.

  • Changes in the price of important natural resources or events like natural disasters (supply shocks).

Macroeconomic Equilibrium in the Long Run and Short Run

Equilibrium occurs where AD and SRAS intersect. Long-run equilibrium is at the LRAS level.

• Recession:

  • AD shifts left or SRAS shifts left, causing output to fall below potential GDP.

  • Results in higher unemployment and lower inflation (if AD shifts) or higher inflation (if SRAS shifts).

  • Eventually, wages and prices adjust, shifting SRAS right and restoring equilibrium.

• Stagflation: A combination of inflation and recession, usually from a supply shock.

• Expansion/Boom:

  • AD shifts right, output temporarily exceeds potential GDP, unemployment falls, and inflation rises.

  • SRAS shifts left as expectations adjust, restoring equilibrium at a higher price level.

Dynamic Aggregate Demand and Aggregate Supply Model

The dynamic model incorporates ongoing growth and inflation.

• LRAS shifts right over time due to economic growth.

• AD typically shifts right as spending increases.

• SRAS shifts right unless high inflation is expected.

• Inflation occurs when AD increases faster than LRAS.

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

What Is Money, and Why Do We Need It?

Money is any asset that is generally accepted in exchange for goods and services or for payment of debts. It serves several key functions in the economy.

• Functions of Money:

  • Medium of Exchange: Accepted as payment for goods and services.

  • Unit of Account: Provides a standard measure of value.

  • Store of Value: Maintains value over time, allowing deferred consumption.

  • Standard of Deferred Payment: Used to settle debts payable in the future.

• Types of Money:

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

  • Fiat Money: Authorized by a central bank, has no intrinsic value but is accepted by trust (e.g., U.S. dollar).

• Central Bank: Issues fiat money and manages the money supply (in the U.S., the Federal Reserve).

How Is Money Measured in the United States Today?

The money supply is measured using two main definitions: M1 and M2.

• M1: Currency in circulation and checking account deposits.

• M2: Includes M1 plus savings deposits, small time deposits, and noninstitutional money market fund shares.

• Debit Cards: Access checking accounts but are not money themselves.

• Credit Cards: Not considered money.

How Do Banks Create Money?

Banks create money by making loans. They use deposits to make loans and buy securities, keeping only a fraction as reserves.

• Reserves: Deposits kept as cash in the bank or with the Federal Reserve.

• Required Reserves: Legally mandated minimum reserves based on deposits.

• Required Reserve Ratio (RR): The fraction of deposits banks must hold as reserves.

• Excess Reserves: Reserves held above the required minimum.

• Money Creation Process:

  • Banks lend out excess reserves, creating new deposits in the banking system.

  • This process continues, multiplying the initial deposit throughout the system.

• Simple Deposit Multiplier: The maximum amount the money supply can increase based on new reserves.

Formula:

• In practice, the actual multiplier is lower due to banks holding excess reserves and borrowers holding cash.

• When banks gain reserves, they make new loans and the money supply expands; when they lose reserves, the money supply contracts.

The Federal Reserve System

The U.S. uses a fractional reserve banking system, where banks keep less than 100% of deposits as reserves. The Federal Reserve (the Fed) acts as the central bank.

• Bank Run: Many depositors withdraw funds simultaneously due to loss of confidence.

• Bank Panic: Multiple banks experience runs at the same time.

• Lender of Last Resort: The Fed provides loans to banks to prevent panics.

• Federal Reserve Structure:

  • 12 regional districts; main authority is the Board of Governors in Washington, D.C.

  • The Federal Open Market Committee (FOMC) manages open market operations and the money supply.

• Monetary Policy Tools:

  1. Open Market Operations: Buying and selling Treasury securities to influence the money supply.

     • To increase money supply: Fed buys securities.

     • To decrease money supply: Fed sells securities.

  2. Discount Policy: The discount rate is the interest rate charged on loans to banks.

  3. Reserve Requirements: The Fed can change the required reserve ratio.

• Commercial Banks: Accept deposits and make loans.

• Securities: Financial assets like stocks and bonds.

• Securitization: Transforming loans into securities that can be traded.

• Shadow Banking System: Non-bank financial firms (investment banks, hedge funds) that engage in lending and investing but are less regulated.

The Quantity Theory of Money

The quantity theory of money links the money supply to the price level and output in the economy.

• Quantity Equation:

• M: Money supply (measured by M1)

• V: Velocity of money (average number of times each dollar is used in transactions)

• P: Price level (measured by the GDP deflator)

• Y: Real output (real GDP)

• Thus, is nominal GDP.

Velocity Formula:

• Quantity Theory of Money: Assumes velocity is constant; changes in the money supply directly affect the price level.

• Growth Rate Form:

• If velocity is constant, then:

• Implications:

  • If money supply grows faster than real GDP, inflation occurs.

  • If money supply grows slower than real GDP, deflation occurs.

  • If money supply grows at the same rate as real GDP, the price level is stable.

• Hyperinflation: Extremely high inflation rates (over 50% per month).

Example: If the money supply grows by 5% per year and real GDP grows by 2% per year, the inflation rate will be approximately 3% per year.