Chapter 7: The Asset Market, Money, and Prices

What Is Money? The Functions of Money

• Money is any asset that is widely accepted as payment for goods and services or for the repayment of debts.

• The three main functions of money are:

  • Medium of Exchange: Facilitates transactions by eliminating the need for barter.

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

  • Store of Value: Retains value over time, allowing individuals to transfer purchasing power into the future.

• Example: U.S. dollars are used to buy groceries, quoted as prices, and can be saved for future purchases.

Measuring Money—The Monetary Aggregates (M1, M2)

• Monetary aggregates are measures of the total amount of money in the economy.

• M1: Includes currency in circulation, checkable deposits, and traveler's checks.

• M2: Includes all of M1 plus savings deposits, small time deposits, and retail money market mutual funds.

• Example: If you have $100 in cash and $500 in a checking account, both are part of M1 and M2.

The Money Supply

• The money supply is the total quantity of money available in the economy at a given time.

• It is determined by the central bank (e.g., the Federal Reserve) and the banking system.

• Changes in the money supply can influence inflation, interest rates, and economic activity.

Portfolio Allocation and the Demand for Assets

• Individuals allocate their wealth among different assets based on expected return, risk, and liquidity.

• Expected Return: The anticipated profit from holding an asset.

• Risk: The uncertainty associated with the return on an asset.

• Liquidity: The ease with which an asset can be converted into cash without significant loss of value.

• Asset Demand: The desire to hold various assets depends on these factors.

• Example: Money is highly liquid but typically earns little or no interest; stocks are riskier but may offer higher returns.

The Demand for Money

• The demand for money refers to the amount of wealth people wish to hold in the form of money rather than other assets.

• Key determinants include income, interest rates, and the price level.

• The general money demand function is: where is money demand, is the price level, is real income, is the real interest rate, and is expected inflation.

• Example: As income rises, people demand more money for transactions.

Key Macroeconomic Variables that Affect Money Demand

• Income (): Higher income increases money demand.

• Interest Rate (): Higher interest rates increase the opportunity cost of holding money, reducing money demand.

• Expected Inflation (): Higher expected inflation reduces the real value of money, decreasing money demand.

Elasticities of Money Demand

• Elasticity measures the responsiveness of money demand to changes in income and interest rates.

• The elasticity formula is: where is the income elasticity and is the interest rate elasticity of money demand.

• Example: If , a 10% increase in income raises money demand by 5%.

The Asset Market Equilibrium

• Asset market equilibrium occurs when the supply of money equals the demand for money.

• At equilibrium: where is the nominal money supply and is the price level.

• Changes in money supply or demand shift the equilibrium interest rate.

Chapter 8: Business Cycles

What Is a Business Cycle?

• A business cycle is the fluctuation of aggregate economic activity over time, typically measured by changes in real GDP.

• It consists of periods of expansion (growth) and contraction (recession).

• Example: The U.S. economy experienced a recession in 2008-2009 followed by a recovery.

Comovement and Persistence

• Comovement: Many macroeconomic variables move together during the business cycle (e.g., output, employment, consumption).

• Persistence: Economic expansions and contractions tend to last for several quarters or years.

The American Business Cycle: The Historical Record

• The U.S. has experienced repeated cycles of booms and recessions since the 19th century.

• Major recessions include the Great Depression (1930s) and the Great Recession (2007-2009).

Business Cycle Facts

• Variables can be classified by their behavior relative to the business cycle:

  • Procyclical: Move in the same direction as GDP (e.g., consumption, investment).

  • Countercyclical: Move in the opposite direction (e.g., unemployment rate).

  • Acyclical: No clear pattern with the cycle.

  • Leading Variables: Change before the overall economy (e.g., stock prices).

  • Coincident Variables: Change at the same time as the economy (e.g., industrial production).

The Index of Leading Indicators

• The Index of Leading Indicators is a composite measure used to predict future economic activity.

• Includes variables such as new orders for capital goods, stock prices, and consumer expectations.

Chapter 9: The IS-LM/AD-AS Model

FE Line: Equilibrium in the Labor Market

• The FE (Full Employment) line represents equilibrium in the labor market, where labor supply equals labor demand.

• Output at full employment is given by: where is total factor productivity, is capital, and is full-employment labor.

• Factors that shift the FE line: Changes in labor supply, productivity, or capital stock.

The IS Curve: Equilibrium in the Goods Market

• The IS curve shows combinations of output and interest rates where the goods market is in equilibrium.

• Goods market equilibrium condition: where is desired saving, is output, is desired consumption, is government spending, and is desired investment.

• Factors that shift the IS curve: Changes in fiscal policy (G, T), consumer confidence, or investment demand.

The LM Curve: Asset Market Equilibrium

• The LM curve shows combinations of output and interest rates where the asset (money) market is in equilibrium.

• Asset market equilibrium condition: where is money supply, is price level, is output, is real interest rate, and is expected inflation.

• Factors that shift the LM curve: Changes in money supply, price level, or money demand.

General Equilibrium in the Complete IS-LM Model

• General equilibrium occurs where the IS and LM curves intersect, determining the equilibrium output and interest rate.

• All three markets (goods, money, and labor) are in equilibrium at this point.

Applying the IS-LM Framework: A Temporary Adverse Supply Shock

• A temporary negative supply shock (e.g., oil price spike) shifts the FE line left, reducing full-employment output.

• This leads to higher prices and lower output in the short run.

Price Adjustment and the Attainment of General Equilibrium

• Over time, prices adjust, moving the economy toward long-run equilibrium where output returns to its natural level.

• Short-run deviations can occur due to sticky prices or wages.

The Effects of a Monetary Expansion

• An increase in the money supply shifts the LM curve right, lowering interest rates and increasing output in the short run.

• In the long run, prices rise, and output returns to its natural level (monetary neutrality).

Classical Versus Keynesian Versions of the IS-LM Model

• Classical Model: Prices and wages are flexible; the economy quickly returns to full employment.

• Keynesian Model: Prices and wages are sticky; output can deviate from full employment for extended periods.

Monetary Neutrality

• Monetary neutrality is the idea that changes in the money supply affect nominal variables (like prices) but not real variables (like output) in the long run.

Aggregate Demand and Aggregate Supply

• The AD-AS model combines aggregate demand (AD) and aggregate supply (AS) to determine the equilibrium price level and output.

• Aggregate Demand (AD): Shows the relationship between the price level and the quantity of goods and services demanded.

• Aggregate Supply (AS): Shows the relationship between the price level and the quantity of goods and services supplied.

Factors that Shift the AD and AS Curves

• AD Shifters: Changes in monetary policy, fiscal policy, consumer confidence, or foreign demand.

• AS Shifters: Changes in input prices, technology, or labor supply.

Equilibrium in the AD-AS Model (Short Run and Long Run)

• Short-Run Equilibrium: Where the AD curve intersects the short-run AS curve; output may differ from full employment.

• Long-Run Equilibrium: Where the AD curve intersects the long-run AS curve; output equals full-employment output.

Monetary Neutrality in the AD-AS Model

• In the long run, changes in the money supply only affect the price level, not real output.

• This is consistent with the concept of monetary neutrality.