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.

• Why AD is 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 cheaper and imports more expensive, increasing net exports.

• Factors that Shift AD:

  • Interest Rates: Higher interest rates decrease AD; lower rates increase AD.

  • Government Purchases: Increases in government spending shift AD right.

  • Taxes: Higher taxes reduce AD; lower taxes increase AD.

  • Expectations: Optimism about future income or profits increases AD.

  • Income/Economic Growth Abroad: Higher foreign income increases demand for exports, shifting AD right.

  • Exchange Rates: A depreciation of the domestic currency increases exports, shifting AD right.

Long-Run Aggregate Supply (LRAS)

The LRAS curve is vertical at the potential level of output, indicating that in the long run, output is determined by resources and technology, not the price level.

• Why LRAS is Vertical: In the long run, prices and wages are flexible, so the economy returns to full employment output regardless of the price level.

• Determinants of LRAS (Shifters):

  • Labor Force: Increases in the labor force shift LRAS right.

  • Capital Stock: More physical or human capital increases LRAS.

  • Technology: Technological progress shifts LRAS right.

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: An increase shifts SRAS right.

  • Capital Stock: More capital shifts SRAS right.

  • Technological Change: Advances shift SRAS right.

  • Expectations about Price Level: If firms expect higher future prices, SRAS shifts left.

  • Adjustments to Past Expectations: Corrections to previous errors can shift SRAS.

  • Supply Shocks: Sudden changes in input prices (e.g., oil) shift SRAS.

  • Natural Disasters/Pandemics: Negative events shift SRAS left.

AD-AS Model: Effects of Changes in AD and SRAS

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

• Short-Run to Long-Run Adjustment: If AD or SRAS shifts, the economy moves to a new short-run equilibrium. Over time, input prices adjust, moving the economy back to long-run equilibrium at potential output.

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

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, like technology.

• Austrian Model: Emphasizes the importance of individual choice and the dangers of government intervention.

Money and the Banking System (Chapter 14)

Barter and Double Coincidence of Wants

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

• Double Coincidence of Wants: Both parties must want what the other offers, making barter inefficient.

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, allowing specialization and trade.

Types of Money

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

• Receipt Money: Paper representing a claim on a commodity.

• 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: Bank deposits held at the central bank or as cash in vaults.

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

Money Creation and T-Accounts

• Banks create money by making loans; this process can be illustrated using T-accounts (balance sheets showing assets and liabilities).

• When a bank makes a loan, it increases both its assets (loans) and liabilities (deposits).

Money Multiplier

• The money multiplier shows how much the money supply increases for each dollar of reserves.

• Formula:

Scarce-Reserves vs. Ample-Reserves Regime

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

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

Bank Runs and Bank Panics

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

• Bank Panic: Widespread bank runs threaten the banking system.

Federal Reserve System and FDIC

• Federal Reserve System (Fed): The 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)

• Sets U.S. monetary policy.

• Voting Members: 7 Board of Governors + 5 of 12 regional Federal Reserve Bank presidents (rotating basis).

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. T-accounts show how these operations affect bank reserves and deposits.

Security and Shadow Banking System

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

• Shadow Banking System: Non-bank financial intermediaries (e.g., investment banks, hedge funds) that provide credit outside traditional banking.

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 print money to finance deficits (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 (All Chapters)

Example: Calculating the Unemployment Rate

• If there are 150 million employed and 10 million unemployed, the labor force is 160 million.

• Unemployment rate:

Additional info: For each formula, ensure you understand the variables and how to apply them to real-world data. Practice using these formulas with sample problems to prepare for the exam.