Aggregate Demand and Aggregate Supply Analysis

Aggregate Demand (AD)

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: As the price level rises, the real value of household wealth falls, leading to lower consumption.

• Interest-Rate Effect: Higher price levels increase interest rates, reducing investment spending.

• International-Trade Effect: A higher domestic price level makes exports more expensive and imports cheaper, reducing net exports.

• Movements vs. Shifts:

  • A movement along the AD curve occurs when the price level changes, holding all else constant.

  • A shift in the AD curve occurs when a component of real GDP (consumption, investment, government purchases, or net exports) changes for reasons other than the price level.

• 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 spending.

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

  • Foreign income: Changes in the economic growth of trading partners.

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

Aggregate Supply (AS)

The aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied. There are two key 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.

  • LRAS is vertical at the level of potential GDP (full-employment output), determined by the number of workers, technology, and capital stock.

  • Potential GDP increases over time as these factors grow.

• Short-Run Aggregate Supply (SRAS):

  • Upward sloping because some prices and wages are "sticky" due to contracts, slow adjustments, and menu costs.

  • Describes the relationship between the price level and the quantity of goods and services supplied in the short run, holding other factors constant.

  • A change in the price level causes a movement along the SRAS; other factors shift the curve.

• 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 supply shocks (e.g., natural disasters, pandemics)

• Supply Shock: An unexpected event that shifts the SRAS curve.

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs where the AD and SRAS curves intersect. In the long run, equilibrium is at the intersection of AD, SRAS, and LRAS.

• Recession:

  • AD shifts left or SRAS shifts left, moving equilibrium left of LRAS.

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

  • Over time, wages and prices adjust, shifting SRAS right and restoring long-run equilibrium.

  • Stagflation: A combination of inflation and recession, often due to a supply shock.

• Expansion/Boom:

  • AD shifts right, moving equilibrium right of LRAS.

  • Results in lower unemployment and higher inflation.

  • Firms and workers anticipate higher prices, shifting SRAS left and restoring long-run equilibrium at a higher price level.

Dynamic Aggregate Demand and Aggregate Supply Model

The dynamic model incorporates ongoing economic growth and inflation.

• LRAS shifts right over time as the economy grows.

• AD also typically shifts right due to increases in spending.

• SRAS shifts right, except when high inflation is expected.

• Inflation usually occurs when total spending (AD) increases faster than production (LRAS).

• Long-run equilibrium is restored at a higher price level if AD grows faster than LRAS.

Money, Banks, and the Federal Reserve System

What Is Money and Why Do We Need It?

Money is any asset that people are generally willing to accept in exchange for goods, services, or repayment of debts. It serves several essential functions in the economy.

• Asset: Anything of value owned by a person or firm.

• Barter: Direct exchange of goods and services, requiring a double coincidence of wants.

• Functions of Money:

  • Medium of Exchange: Widely accepted for payment.

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

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

  • Standard of Deferred Payment: Facilitates future payments.

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

• Fiat Money: Authorized by a central bank, has no intrinsic value, and is not backed by a commodity.

• Central Bank: Issues fiat money (e.g., the Federal Reserve in the U.S.).

• Confidence: Fiat money's value depends on public confidence in its stability.

Measuring Money in the United States

• M1: Currency in circulation, checking account deposits, and savings account deposits.

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

• Debit Cards: Access checking accounts (the account is money, not the card).

• Credit Cards: Not considered money.

How Do Banks Create Money?

Banks create money by making loans, which increases the money supply through the process of deposit creation.

• Reserves: Deposits kept as cash in the bank or at 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 of deposits created from an initial deposit.

Formula:

• Simple deposit multiplier:

For example, with a 10% required reserve ratio (), the multiplier is .

• In practice, the actual multiplier is lower due to banks holding excess reserves and not all funds being redeposited.

• When banks gain reserves, they make new loans and expand the money supply; when they lose reserves, they contract lending and the money supply.

The Federal Reserve System

The U.S. banking system is a fractional reserve system, where banks keep less than 100% of deposits as reserves.

• 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 central bank (Federal Reserve) provides loans to banks to prevent panics.

• Federal Reserve Structure:

  • 12 regional Federal Reserve districts.

  • Board of Governors in Washington, D.C.

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

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

• 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 interest rate (discount rate) charged to banks for borrowing from the Fed.

  3. Reserve Requirements: Changing the required reserve ratio.

• Commercial Banks: Accept deposits and make loans.

• Securities: Financial assets (stocks, bonds) that can be traded.

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

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

The Quantity Theory of Money

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

• Quantity Equation:

  • = Money supply

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

  • = Price level

  • = Real output (real GDP)

• Velocity of Money:

• Measures:

  • Money supply (): M1

  • Price level (): GDP deflator

  • Real output (): Real GDP

  • Nominal GDP:

• Quantity Theory of Money: Assumes velocity is constant.

• Growth Rate Form:

  • Growth rate of + Growth rate of = Growth rate of (inflation) + Growth rate of

  • If is constant, then:

  • Inflation rate = Growth rate of money supply − Growth rate of real output

• 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).