Aggregate Demand and Aggregate Supply (Chapter 13)

Aggregate Demand (AD)

The aggregate demand curve shows the relationship between the overall price level and the quantity of goods and services demanded in the economy.

• Why AD is Downward Sloping:

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

  • Interest-Rate Effect: Lower price levels reduce the demand for money, decreasing interest rates and increasing investment spending.

  • 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 maximum sustainable output, determined by resources and technology.

• Why LRAS is Vertical: In the long run, output is determined by the supply of labor, capital, and technology, not by the price level.

• Determinants of LRAS (Shifters):

  • Labor force size

  • Capital stock (physical and human capital)

  • Technological progress

Short-Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping because some input prices are sticky in the short run, so higher prices can increase output.

• Why SRAS is Upward Sloping: As the price level rises, firms are willing to produce more due to temporarily higher profits.

• Factors that Shift SRAS:

  • Labor force size

  • 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

• Effects of Changes in AD and SRAS: Shifts in AD or SRAS change equilibrium output and price level in the short run.

• Graphical Representation: The intersection of AD, SRAS, and LRAS determines equilibrium.

• Adjustment to Long-Run Equilibrium: If the economy is not at long-run equilibrium, input prices and interest rates adjust, moving the SRAS curve until the economy returns to potential output.

• Self-Corrective Mechanisms: Changes in input prices (like wages) and interest rates help restore long-run equilibrium after shocks.

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 business cycles to real (not monetary) shocks, such as technology changes.

• Austrian Model: Highlights the importance of individual actions and criticizes government intervention.

Money and the Banking System (Chapter 14)

Barter and Double Coincidence of Wants

• Barter: 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: Facilitates trade, eliminates double coincidence of wants, increases efficiency.

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: Only a fraction of money is backed by 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 to settle debts payable in the future.

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 and at the central bank.

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

• Money Creation (T-Accounts): Banks create money by making loans; each loan increases the money supply.

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

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 (Fed): Central bank of the U.S., conducts monetary policy.

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

Federal Open Market Committee (FOMC)

• FOMC: Main body for monetary policy decisions; voting members include the Fed Board of Governors and regional Fed bank presidents.

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 the money supply (can be shown using T-accounts).

• Security: A financial instrument, such as a bond, traded in open market operations.

• Shadow Banking System: Non-bank financial intermediaries that provide credit but are not regulated like banks.

Quantity Theory of Money

• Quantity Equation:

• Predictions about Inflation: If money supply grows faster than real output, inflation results.

Hyperinflation

• Very high inflation, often caused when governments finance deficits by creating money (monetizing 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 crises and maintaining confidence.

• Economic Growth: Fostering conditions for rising living standards.

Key Macroeconomic Formulas

Example: If the money supply grows by 5% and real output grows by 2%, predicted inflation is 3%.