Aggregate Demand and Aggregate Supply Analysis

Definitions and Key Concepts

• Aggregate Demand (AD): The total quantity of goods and services demanded across all levels of an economy at a given overall price level and in a given period.

• Aggregate Supply (AS): The total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level.

• Short-Run Aggregate Supply (SRAS): The relationship between the price level and the quantity of goods and services supplied in the short run, when some input prices are sticky.

• Long-Run Aggregate Supply (LRAS): The relationship between the price level and the quantity of goods and services supplied in the long run, when all prices are flexible.

Why is Aggregate Demand (AD) Downward Sloping?

• Wealth Effect: As the price level falls, the real value of household wealth rises, increasing consumption.

• Interest Rate Effect: A lower price level reduces the interest rate, stimulating investment spending.

• International Trade Effect: A lower domestic price level makes exports more attractive and imports less attractive, increasing net exports.

Shifts of AD vs. Movements Along the Curve

• Movement Along AD: Caused by a change in the price level, holding all else constant.

• Shift of AD: Caused by changes in non-price factors such as government policy, consumer confidence, or foreign income.

Variables That Shift Aggregate Demand

• Changes in Government Policies: Fiscal policy (taxes, government spending) and monetary policy (money supply, interest rates).

• Changes in Expectations: Consumer and business optimism or pessimism about the future.

• Changes in Foreign Variables: Exchange rates, foreign income levels.

SRAS vs. LRAS

• SRAS: Upward sloping because some input prices (like wages) are sticky in the short run.

• LRAS: Vertical at the potential output (Y*), reflecting the economy's maximum sustainable output.

Shifts of SRAS vs. Movements Along

• Movement Along SRAS: Caused by a change in the price level.

• Shift of SRAS: Caused by changes in input prices, technology, or supply shocks.

Macroeconomic Equilibrium in the Short and Long Run

• Short-Run Equilibrium: Where AD intersects SRAS; output may differ from potential GDP.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS all intersect; output equals potential GDP.

Characteristics of Macroeconomic Equilibria

• Short-Run: Can have output gaps (recessionary or inflationary).

• Long-Run: Economy self-adjusts to potential output as prices and wages become flexible.

Static vs. Dynamic Model

• Static Model: Assumes no ongoing growth or inflation; focuses on one-time shifts.

• Dynamic Model: Incorporates economic growth, ongoing inflation, and shifting curves over time.

Causes of Inflation

• Demand-Pull Inflation: Caused by increases in aggregate demand.

• Cost-Push Inflation: Caused by increases in the costs of production (e.g., wages, raw materials).

Money, Banks, and the Federal Reserve System

Definitions and Key Concepts

• Money: Any asset that can be easily used to purchase goods and services.

• Functions of Money:

  • Medium of Exchange

  • Unit of Account

  • Store of Value

  • Standard of Deferred Payment

• What Can Serve as Money? Items that are widely accepted, durable, divisible, portable, and stable in value.

• Types of Money:

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

  • Fiat Money: Has no intrinsic value; value is established by government decree (e.g., paper currency).

M1 and M2 Money Supply

• M1: Currency in circulation, checking account deposits, and traveler's checks.

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

Fractional Reserve Banking

• Banks keep only a fraction of deposits as reserves and lend out the rest.

• Reserve Requirement: The minimum fraction of deposits banks are required to keep as reserves.

Money Multiplier and Money Creation Process

• Money Multiplier Formula:

• When banks lend out deposits, new money is created in the economy through the deposit expansion process.

The Federal Reserve System

• The central bank of the United States, responsible for regulating the money supply and overseeing the banking system.

• Key components: Board of Governors, 12 Regional Federal Reserve Banks, Federal Open Market Committee (FOMC).

The Quantity Theory of Money

• Relates the money supply, velocity of money, price level, and output.

• M: Money supply

• V: Velocity of money (average number of times a dollar is spent per year)

• P: Price level

• Y: Real output (GDP)

• If V and Y are constant, increases in M lead to proportional increases in P (inflation).

Monetary Policy

Definitions and Key Concepts

• Monetary Policy: Actions by a central bank to manage the money supply and interest rates to achieve macroeconomic goals.

• Goals of Monetary Policy:

  • Price stability (low inflation)

  • High employment

  • Stability of financial markets and institutions

  • Economic growth

Monetary Policy Tools

• Open Market Operations: Buying and selling government securities to influence the money supply.

• Discount Rate: The interest rate the Fed charges banks for short-term loans.

• Reserve Requirements: Changing the fraction of deposits banks must hold as reserves.

Federal Open Market Committee (FOMC)

• The branch of the Federal Reserve that determines the direction of monetary policy, primarily through open market operations.

Money Supply and Demand

• Money Supply: Set by the central bank; vertical line in the money market graph.

• Money Demand: Downward sloping; as interest rates fall, the quantity of money demanded increases.

Federal Funds Market Graph – Shifts and Interpretation

• Shows the equilibrium federal funds rate (the interest rate banks charge each other for overnight loans).

• Shifts in money supply or demand change the equilibrium rate.

Effects of Monetary Policy

• Expansionary Policy: Increases money supply, lowers interest rates, stimulates investment and aggregate demand.

• Contractionary Policy: Decreases money supply, raises interest rates, reduces investment and aggregate demand.

Interpretation Using Static and Dynamic AD/AS Model

• Monetary policy shifts the AD curve in the AD/AS model, affecting output and price level in both static and dynamic contexts.

The Taylor Rule and Fed Funds Target Rate

• Taylor Rule: A formula that suggests how central banks should set interest rates based on inflation and output gaps.

• i: Nominal federal funds rate

• r*: Real equilibrium federal funds rate

• π: Current inflation rate

• π*: Target inflation rate

• Y: Real GDP

• Y*: Potential GDP

Example: Application of the Taylor Rule

• If inflation is above target or output is above potential, the rule suggests raising the federal funds rate.

• If inflation is below target or output is below potential, the rule suggests lowering the rate.