Aggregate Demand and Aggregate Supply (Chapter 13)

Aggregate Demand (AD)

The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and the rest of the world. It is downward sloping due to several key effects:

• Wealth Effect: As the price level falls, the real value of household wealth increases, leading to higher consumption.

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

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

Factors that shift AD:

• Changes in interest rates

• Government purchases

• Taxes

• Expectations of households and firms

• Economic growth abroad (foreign income)

• Exchange rates

Long-Run Aggregate Supply (LRAS)

The LRAS curve is vertical, reflecting the economy's potential output when all resources are fully employed. In the long run, output is determined by the supply of labor, capital, and technology, not by the price level.

• Determinants of LRAS: Labor force, capital stock, technological progress.

• LRAS shifts right with increases in these factors.

Short-Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping because, in the short run, an increase in the price level leads to higher profits and output, as some input prices are sticky.

• Factors that shift SRAS:

  • Labor force

  • Capital stock

  • Technological change

  • Expectations about the price level

  • Adjustments to errors in past expectations

  • Supply shocks (e.g., oil price shocks)

  • Natural disasters, pandemics

AD-AS Model: Effects and Adjustment Process

• Changes in AD or SRAS shift the respective curves, affecting output and the price level.

• Graphical analysis shows movement from short-run equilibrium to new long-run equilibrium.

• Self-corrective mechanisms: Over time, input prices and interest rates adjust, moving the economy back to potential output.

Example: A negative supply shock (e.g., oil price spike) shifts SRAS left, raising prices and reducing output in the short run. Over time, wages and input prices adjust, shifting SRAS back right.

Appendix: Macroeconomic Schools of Thought

• Keynesian Revolution: Emphasizes the role of aggregate demand and government intervention.

• Monetarist Model: Focuses on the role of money supply in determining output and prices.

• New Classical Model: Stresses rational expectations and market clearing.

• Real Business Cycle Model: Attributes fluctuations to real (not monetary) shocks, such as technology changes.

• Austrian Model: Highlights the importance of capital structure and the effects of monetary policy on business cycles.

Money, Banking, and the Federal Reserve System (Chapter 14)

Barter and Double Coincidence of Wants

• Barter: Direct exchange of goods and services without money.

• Double Coincidence of Wants: For barter to occur, each party must want what the other offers.

Money: Definition and Benefits

• Money: Any asset accepted as payment for goods, services, or debts.

• Benefits over barter: Increases efficiency by eliminating the double coincidence of wants.

Types of Money

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

• Receipt Money: Paper receipts representing commodity money held in reserve.

• Fiat Money: No intrinsic value; value by government decree (e.g., U.S. dollar).

• Fractional Money: System where banks hold only a fraction of deposits as reserves.

Functions of Money

• Medium of Exchange: Used to buy goods and services.

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

• Store of Value: Retains value over time.

• Standard of Deferred Payment: Used for future payments.

Criteria for a Medium of Exchange

• Acceptable to most traders

• Standardized quality

• Durable

• Valuable relative to weight

• Divisible

Monetary Aggregates

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

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

Reserves and Fractional Reserve Banking

• Reserves: Deposits banks keep on hand or at the central bank.

• Fractional Reserve Banking: Banks keep only a fraction of deposits as reserves, lending out the rest.

Money Creation and the Money Multiplier

• Banks create money by making loans; the process can be illustrated with T-accounts.

• Money Multiplier: The ratio of the money supply to the monetary base.

Formula:

Scarce-Reserves vs. Ample-Reserves Regime

• Scarce-Reserves: Central bank controls money supply by adjusting reserves.

• Ample-Reserves: Central bank influences rates directly; reserves are abundant.

Bank Runs and Bank Panics

• Bank Run: Many depositors withdraw funds simultaneously due to fears of insolvency.

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

Federal Reserve System and FDIC

• Federal Reserve System: Central bank of the U.S., responsible for monetary policy.

• Federal Deposit Insurance Corporation (FDIC): Insures deposits to maintain confidence in the banking system.

Federal Open Market Committee (FOMC)

• Responsible for open market operations (buying/selling government securities).

• Voting Members: Board of Governors and five regional Federal Reserve Bank presidents (rotating).

Monetary Policy and Open Market Operations

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

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

• T-accounts can illustrate the effects on bank reserves and the money supply.

Security and Shadow Banking System

• Security: A financial asset that can be traded (e.g., bonds, stocks).

• Shadow Banking System: Non-bank financial intermediaries (e.g., investment banks, hedge funds) that provide credit but are less regulated.

Quantity Theory of Money and Hyperinflation

• Quantity Equation:

• Quantity Theory: Predicts that inflation results when the money supply grows faster than real output.

• Formula for Inflation:

• Hyperinflation: Extremely high inflation, often caused by governments monetizing their debt.

Monetary Policy Goals (Chapter 15, Section 15.1)

• Price Stability: Keeping inflation low and predictable.

• High Employment: Achieving the natural rate of unemployment.

• Stability of Financial Markets and Institutions: Preventing financial crises.

• Economic Growth: Promoting rising living standards over time.

Key Macroeconomic Formulas (All Chapters)

Note: Mastery of these formulas is essential for exams; formula sheets are not permitted.