Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Definitions

• Aggregate Demand (AD): The total demand for goods and services in an economy at a given overall price level and in a given period.

• Aggregate Supply (AS): The total supply of goods and services that firms in an economy plan on selling during a specific time period.

• Short-Run Aggregate Supply (SRAS): The relationship between the price level and the quantity of goods and services supplied in the short run.

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

Why is Aggregate Demand (AD) Downward Sloping?

• Wealth Effect: As the price level falls, the real value of money increases, leading to higher consumer spending.

• Interest Rate Effect: Lower price levels reduce interest rates, stimulating investment spending.

• International Trade Effect: Lower domestic price levels make exports more attractive and imports less attractive, increasing net exports.

• Example: If the price level decreases, consumers feel wealthier and spend more, businesses invest more, and exports rise.

Shifts of AD versus Movement Along AD

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

• Shift of AD: Caused by changes in non-price factors such as consumer confidence, government spending, or net exports.

Variables that Shift AD

• Changes in Consumption: e.g., consumer confidence, taxes.

• Changes in Investment: e.g., interest rates, business expectations.

• Changes in Government Spending: e.g., fiscal policy.

• Changes in Net Exports: e.g., foreign income, exchange rates.

SRAS versus LRAS

• SRAS: Upward sloping due to sticky wages and prices.

• LRAS: Vertical at the economy's potential output (full employment GDP).

• Example: In the short run, firms may increase output if prices rise, but in the long run, output is determined by resources and technology.

Shifts of SRAS versus Movement Along SRAS

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

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

Macroeconomic Equilibrium in the Short- and Long-Run

• Short-Run Equilibrium: Where AD intersects SRAS.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS all intersect.

• Example: If AD increases, output and price level rise in the short run; in the long run, only the price level rises as SRAS adjusts.

Characteristics of Macroeconomic Equilibria

• Full Employment: Long-run equilibrium occurs at potential GDP.

• Short-Run Deviations: Output can be above or below potential GDP.

Static versus Dynamic Model

• Static Model: Assumes no growth, constant potential GDP.

• Dynamic Model: Incorporates economic growth, inflation, and changes in potential GDP.

Causes of Inflation

• Demand-Pull Inflation: Caused by increases in AD.

• Cost-Push Inflation: Caused by decreases in SRAS (e.g., rising input costs).

• Example: Oil price shocks can cause cost-push inflation.

Chapter 14: Money, Banks, and the Federal Reserve System

Definitions

• Money: Any item that is generally accepted as payment for goods and services.

• Bank: A financial institution that accepts deposits and makes loans.

• Federal Reserve System: The central bank of the United States.

What is Money?

• Money is a medium of exchange, a unit of account, and a store of value.

Functions of Money

• Medium of Exchange: Facilitates transactions.

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

• Store of Value: Retains purchasing power over time.

What Can Serve as Money?

• Items must be widely accepted, durable, divisible, portable, and stable in value.

• Example: Gold, coins, paper currency.

Types of Money – Commodity vs Fiat

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

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

M1 and M2 Money Supply

• M1: Currency, demand deposits, traveler's checks.

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

• Example: M1 is more liquid than M2.

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 must hold as reserves, set by the Federal Reserve.

Money Multiplier

• The amount by which the money supply increases as a result of a new deposit.

• Formula:

Money Creation Process

• Banks lend out deposits, creating new money through the multiplier effect.

• Example: A $1,000 deposit with a 10% reserve ratio can create up to $10,000 in new money.

The Federal Reserve System

• Consists of 12 regional banks, Board of Governors, and the Federal Open Market Committee (FOMC).

• Regulates money supply and supervises banks.

The Quantity Theory of Money – Velocity and Inflation

• Quantity Theory Equation:

• M: Money supply

• V: Velocity of money

• P: Price level

• Y: Real output

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

Chapter 15: Monetary Policy

Definitions

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

Monetary Policy Goals

• Price stability (low inflation)

• High employment

• Stability of financial markets

• Economic growth

Monetary Policy Tools

• Open Market Operations: Buying and selling government securities.

• Discount Rate: Interest rate charged to banks for borrowing from the Fed.

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

Federal Open Market Committee (FOMC)

• Sets monetary policy, especially open market operations.

Money Supply and Demand

• Money supply is controlled by the Fed; money demand depends on interest rates and income.

• Federal Funds Market Graph: Shows equilibrium between supply and demand for reserves.

Federal Funds Market Graph – Shifts and Interpretation

• Shifts in supply or demand for reserves change the federal funds rate.

• Example: Expansionary policy increases supply, lowering the rate.

Effects of Monetary Policy

• Expansionary Policy: Increases money supply, lowers interest rates, stimulates AD.

• Contractionary Policy: Decreases money supply, raises interest rates, reduces AD.

Interpretation Using Static and Dynamic AD/AS Model

• Expansionary policy shifts AD right, increasing output and price level.

• Contractionary policy shifts AD left, decreasing output and price level.

The Taylor Rule, Fed Funds Target Rate

• Taylor Rule Formula:

• Used to guide the Fed's interest rate decisions based on inflation and output gaps.