Taxes and some government programs act as automatic

stabilizers, reducing size of multiplier

before. This increase in private spending leads to fall in

agg income as more saving means people will spend less

Multiplier
-the marginal propensity to consume (MPC): the increase
in consumer spending when disposable income rises by $1
MPC = ( consumer spending/ disposable income) mpc +
mps = 1
-marginal propensity to save (MPS): the increase in
household savings when disposable income rises by $1
-GDP = (1+MPC + MPC2) x increase in investment
spending
- total increase in real GDP = (1/(1-mpc) x increase in
investment spending
- If size of mps is small, will make multiplier larger (smaller
mpc gets, smaller multiplier gets)
- If multiplier=4, mps=1/4
- Increase in mpc increases multiplier
- The greater the mpc, the greater the multiplier
-If mpc is greater than 0 but less than 1, when disposable
income rises by $1, consumption will rise by less than $1
- Alices disposable income increases by $1000, she
spends $600 of this increase in disposable income. Her
mps=.4, she saves $400
-if slope of agg expenditures curve=.9, multiplier=10
-investment spending increases 50, eq income increases
200. Investment multiplier=4

Accelerator principle- a higher rate of growth in real GDP

leads to higher planned investment spending/ a lower
growth rate of real GDP leads to lower planned investment
spending (investment spending by firms pos related to
expected future growth of rGDP)

Aggregate spending
-autonomous change in aggregate spending is an initial
change in the desired level of spending by firms,
households, or government at a given level of real GDP Y
= (1/(1-mpc) x AAS
-The multiplier is the ratio of the total change in real GDP
caused by an autonomous change in aggregate spending
to the size of that autonomous change (multiplier =
(Y/AAS) = (1/(1-mpc)
-mps=.3, size of multiplier is 3.3
- Slope of planned agg spending line determined by mpc
- Agg spending increases when an increase in planned
investment spending
Consumption function: equation showing how an individual
households consumer spending varies with the
households current disposable income (c = a + mpc x yd)
-a = households autonomous consumer spending
-c = household consumer spending (y-axis)
-yd = household disposable income (x-axis)
- Upward shift in consumption can be caused by increase
in consumer wealth
aggregate consumption function- relationship for the
economy as a whole between aggregate current
disposable income and aggregate consumer spending
-if agg consumption=100 + .75YD, autonomous
consumption=100
-increases with increase in agg wealth
Investment spending
planned investment spending- the investment
spending that businesses plan to undertake during a given
period (depends on market int rate)
-changes when sudden decrease in growth rate of GDP
-depends negatively on: interest rate, existing production
capacity
-depends positively on: expected future real GDP
-Iplanned spending negatively related to int rate
- If investment spending increases in economy, AE shifts
up, increasing income-expenditure equilibrium
US economy going through severe recession. Most
households are trying to save more of their income than

Inventories- stocks of goods held to satisfy future sales

Inventory investment- the value of the change in total
inventories held in the economy during a given period
Unplanned inventory investment- when actual sales are
more or less than businesses expected, leading to
unplanned changes in inventories
- If unplanned inventory investment is positive, means agg
expenediture on goods is less than forecasted
Actual investment spending (I) = Iunplanned + Iplanned
Assumptions underlying multiplier process:
Changes in overall spending lead to changes in aggregate
output. The aggregate price level is fixed
Interest rate is fixed
Taxes, transfers, and government purchases are all zero
Exports and imports are both zero. No foreign trade
Planned aggregate spending- the total amount of planned
spending in the economy
GDP = C + I = C + Iplanned + Iunplanned = AEplanned +
Iunplanned
YD = GDP
AEplanned = C + Iplanned
- Whenever planned aggregate spending exceeds GDP,
unplanned inventory investment is negative
The economy is in incomeexpenditure equilibrium when
aggregate output, measured by real GDP, is equal to
planned aggregate spending
Incomeexpenditure equilibrium GDP is the level of real
GDP at which real GDP equals planned aggregate
spending
In economy with no international trade, gov expenditure,
transfers, taxes, planned agg spending equal to
consumption + Iplanned spending
If multiplier is 4, investment spending falls by 100, change
in eq income = -400
When GDP exceeds planned agg spending, firms reduce
production, thereby reducing GDP
Current disp. Income=most important factor affecting
households consumer spending
When GDP exceeds (falls short) planned agg expenditure,
Iunplanned is pos (neg)
Permanent income hypothesis suggests consumer
spending depends on income people expect over long
term rather than on current income
Income-expenditure eq is when GDP equal to planned agg
spending
Fall in market int rates makes any investment project more
profitable, whether funds were borrowed or came from
retained earnings

-firm has enough retained earnings to finance investment

project. Market int rate represents the opp cost of using
retained earnings
Expectations of lower disposable income in future would
decrease autonomous consumption and shift consumption
function down

Aggregate demand curve- shows the relationship

between the aggregate price level and the quantity of
aggregate output demanded by households, businesses,
the government and the rest of the world
-downward sloping: 1-wealth effect of a change in
aggregate price level- a higher aggregate price level
reduces the purchasing power of households wealth and
reduces consumer spending 2- interest rate effect of a
change in aggregate price level- a higher aggregate price
level reduces the purchasing power of households; money
holdings, leading to a rise in interest rates and a fall in
investment spending and consumer spending
-AD increases: gov purchases of goods rise, quantity of
money increases, household wealth rises but prices
constant (NOT int rates increase)
-changes in AD can be caused by changes in stock of
physical capital
-when agg price level rises, quantity of agg output
demanded falls
-late 70s, economy sli left along AD curve
-will increase if public becomes more optimistic about
future income
-will decrease if gov raises tax rate
how changes in aggregate price level affect income
expenditure equilibrium
-fall in aggregate price level AEplaned curve shift
upward, leading to rise in equilibrium to right
-AD curve shifts: changes in expectations (consumers
more optimistic AD increases), wealth (real value of
household assets rises, AD increases), stock of physical
capital (if relatively small, AD increases), gov policies,
fiscal (gov increase spending or cut taxes, increase) and
monetary policies (central bank increases quantity of
money, increases), changes in stock market indices (NOT
price level)
-movement along AD curve- when change in aggregate
price level changes purchasing power of consumers
existing wealth (real value of their assets) = wealth effect
of a change in the aggregate price level
-increase in aggregate demand AD curve shifts to the
right
Aggregate supply curve- shows relationship between
aggregate price level and quantity of aggregate output in
economy
-short run AS curve: upward sloping because nominal
wages are sticky in short run (higher agg. Price level
higher profits and increased agg output in short run)
-shifts to left: increase in nominal wages and price of
commodities used for production, decrease in productivity
(NOT increase in int rates)

-productivity increases, SRAS increases (SRAS

curve may shift to right if productivity increases)
-long run agg supply curve- shows rel b/t agg price level
and quantity of agg output supplied that would exist if all
prices, including nominal wages, were fully flexible
-short run macroeconomic equilibrium- quantity agg
output supplied=quantity demanded
-demand shock-shifts agg demand curve, moving agg
price level + agg output in same direction
Negative demand shock-shifts AD curve to left,
reducing agg price level and agg output
-short run: recessionary gap arises: agg. price, agg
output declines, unemployment rises
-long run: nom. Wages fall due to high
unemployment, SRAS shifts to right, agg output rises, agg
price declines
Positive demand shock: short run= increases agg
output an aggregate price level
-supply shock: shifts SRAS curve, moving price level and
agg output in opposite directions
Neg. supply shock- shifts SRAS to left, causing
stagflation (lower agg output and higher agg price level)
Positive supply shock=most preferred type of
shock
Recessionary gap- when aggregate output below potential
output (neg. demand shock)
-will be eliminated because theres downward pressure on
wages, causing SRAS curve to shift to right
-nominal wages will fall, SRAS shifts to right until economy
at full employment
-if eliminated through self-correcting adjustment, eq price
level falls, eq real output increases
Inflationary gap- aggregate (actual) output greater than
potential output: nominal wages increase, SRAS shift to
left until actual GDP equals potential GDP in long run
-as inflationary gap eliminated through self-correcting
adjustment, equilibrium price level increases and eq real
output decreases
-causes SRAS to gradually decrease
-automatically closed by rising wages
- if in short run, in long run, economys self-correcting
mechanism will restore GDP to its potential level
- If government increases taxes by more than is necessary
to close an inflationary gap, end result = economy could
move into a recession
Output gap- percentage difference between actual
aggregate output and potential output [(actual agg.
Output potential output) / potential output] x 100
Potential output-level of output economy would produce if
all prices, including nominal wages were fully flexible
Short run-pd where many production costs can be taken as
fixed
Stagflation-may result from increase in price of imported
oil

nominal wage- dollar amount of wage paid

Economy in long run macro eq, AD increases. As economy

moves to short run eq, there will be inflationary gap with
low unemployment

Sticky wages- nominal wages that are slow to fall even in

the face of high unemployment and slow to rise even in
face of labor shortages

In short run, eq price level and eq level of total output are

determined by intersection of SRAS and AD

-shift of SRAS curve:

-commodity prices fall, SRAS increases
-nominal wages fall, SRAS increases

Economy self-correcting when shocks to aggregate

demand affect aggregate output in short run, not long run

Recessions mainly caused by demand shocks, but when a

negative supply shock does happen, resulting recession
tends to be severe

Sources of tax revenue: personal income taxes, taxes on

corporate profits, social insurances taxes, other taxes

If economy currently operating at output level below its

potential real GDP, if government wishes to use fiscal
policy to bring economy back to its potential real GDP, itll
increase government spending

Gov spending: social insurance, nat defense, education,

other goods/services
-if spends extra 5 bill on goods, GDP increases by more
than 5 bill

If labor unions lose memberships/become less popular

production costs fall, SRAS shifts to right, increase
equilibrium GDP, lower aggregate price level

Fiscal policy: use of taxes, gov transfers, or gov prchases

to shift agg demand curve (Ex: increasing reimbursement
amounts under Medicaid, increasing personal income tax
deductions for home ownership, reducing federal subsidies
to state universities (NOT reducing money supply in order
to raise int rate))
(GDP = C + I + G + X IM)
-if current level of rGDP is below potential GDP, policy
would be to increase gov purchases, shifting AD curve to
right

Gov increases income tax rates, aggregate demand cure

shifts to left
Sudden increase in commodity prices, shifts SRAS curve to
left resulting in lower aggregate output
If rGDP less than aggregate expenditure, inventories will
fall, firms will increase future production
Fed reserves been cutting int rate to stimulate
recessionary economy. Interest cuts supposed to increase
investment spending and increase GDP via multiplier
In long run if all prices, including nominal wage, rate
doubled, then aggregate output supplied would remain
unchanged
SRAS curve positively sloped wages are sticky or dont
readily adjust to changes in economic conditions in short
run
In long run, wages and prices considered to be flexible
Consequences of decline in demand during great
depression: falling prices, declining output, surge in
unemployment
Gov purchases of goods differs from changes in
taxes/transfer payments because gov purchases influence
AD directly while changes in taxes/TR influence AD
indirectly
Decrease in supply of money shifts aggregate demand
curve to left
Agg demand curve shifts to left fall in consumers
wealth, decrease in amount of money in circulation, more
pessimistic consumer expectations
Political instability in mid east temporarily interrupts
supply of oil to US: SRAS curve shifts left, output
decreases, prices increase
If prices constant, but theres an increase in value of
financial assets, agg demand shifts to right
Natural disaster destroys part of countrys infrastructure =
type of neg. supply shock, shifts SRAS curve to left
Decrease in energy prices will increase SRAS
Economy wide decrease in commodity prices will shift
SRAS curve to right
Interest rate effect of a change in agg price level occurs
when a higher price level decreases purchasing power of
money resulting in an increase in interest rate

expansionary: increase in gov purchases, reduction in

taxes, increase in gov transfers, increases aggregate
demand (shifts AD curve to right) (can close recessionary
gap, moving economy to new SR eq = LR eq)
-leads to increase in rGDP larger than initial rise in
aggregate spending caused by policy
--Ex: decision to build more aircraft carriers to keep
employment high
contractionary: reduces aggregate demand, gov transfers,
and gov purchases, increases taxes, shifts AD curve to left
(can close inflationary gap, moving economy to new short
run eq = long run eq)
-leads to fall in rGDP
-significant lags: takes time collecting/analyzing economic
data for gaps, development of spending plan, and
implementation of plan (spending money)
--time lags with implementation suggest that increases in
spending to fight recessionary gap may occur too late
multiplier effect:
-size of shift of AD curve depends on type of fiscal policy
-multiplier on changes in gov purchases: 1/(1-mpc), larger
tha multiplier on changes in taxes or transfers mpc/(1mpc), because any part of any change in taxes or
transfers is absorbed by savings
-changes in gov purchases have more powerful
effect on economy than equal sized changes in taxes or
transfers
AEplanned curve shifts:
Increase in gov purchases pushes AEplanned up, leading
to rise in equilibrium rGDP
Lump sum taxes dont depend on taxpayers income
Increase in transfers leads to initial rise in consumer
spending, shifts AEplanned up, but initial rise is less than
size of transfer; eventual rise of rGDP may be more or less
than transfer (multiplier may be more or less than 1)
Automatic stabilizers- rules governing taxes, some
transfers (reduce size of multiplier, automatically reduce
size of fluctuations in cycle)
-Gov spending and taxation rules that cause fiscal policy
to be expansionary when economy contracts and
contractionary when economy expands
-because of its role and discretionary fiscal policy, the
historical record of US since 70s shows that the budget
tends to move into a deficit during recessions
Discretionary fiscal policy-deliberate actions by policy
makers rather than from business cycle

-may fail to stabilize economy or make economy less

stablelags in implementation

spending, will decrease spending today to save for future

higher taxes

Budget balance: Sgov = T TR G

-discretionary expansionary fiscal policies-increased gov
purchases, higher gov transfers, lower taxes-reduce
budget balance for that year (involves using gov spending
or tax policy to affect aggregate demand)
-if legislation introduced to require balanced budget at all
times, fiscal policy couldnt operate as automatic stabilizer
of business cycle
-congress increases personal income tax rates to balance
budget automatic stabilizers will decrease
contractionary impact of decrease in AD
Expansionary fiscal policies- make budget surplus smaller
or budget deficit bigger

Presence of automatic stabilizer in gov tax revenue that

occurs when GDP rises, decreases the size of multiplier

Contractionary fiscal policies- smaller gov purchases of

goods, smaller gov transfers, higher taxes-increase budget
balance for yr, make budget surplus bigger/budget deficit
smaller (includes increased taxes)
-decreasing gov expenditures
Cyclically adjusted budget balance-estimate of budget
balance if rGDP was at potential output or if actual output
=potential output
- Cyclically adjusted budget deficit fluctuates less than
actual budget deficit
Budget deficit as % of GDP rises during recessions, falls
during expansions, moves closely in tandem w/
unemployment rate
Persistent budget deficits have long run consequences
because lead to increase in public debt (gov debt held by
individuals outside gov)
deficit-difference between amount of money gov spend
and amount it receives in taxes
-budget tends to move into deficit when unemployment
rate increases
debt-sum of money gov owes at particular point in time
-public debt may crowd out investment spending, which
reduces LR economic growth
--public debt-GDP ratio for US in 2011 was more or less
same as that of other wealthy countries
---if gov debt increasing but GDP increasing faster, go
debt-GDP ratio falling
implicit liabilities: spending promises, like SS benefits,
made by governments that are effectively a debt despite
fact that they arent included in usual debt stats
Mpc=.8, gov increases spending by 100 bill, financing this
spending with 100 bill tax increase. rGDP will expand by
100 bill
Cut in taxes (gov transfers) increases (decreases)
disposable income and consumption, shifting AD curve to
right (left)
If economy experiences decline in overall spending,
contraction, gov could counter by increasing gov spending
Changes in taxes and gov transfers shift AD curve by less
than equal sized changes in gov purchases
Theory of Ricardian equivalence- argues that expansionary
fiscal policy wont have effect on economy because
consumers, anticipating higher future taxes to pay for gov

rGDP=400 bill, gov collects 25% of any increase in rGDP in

form of taxes, mpc=.8. if potential output equals 250 bill,
gov could close inflationary gap by increasing gov
spending by 60 bill
mpc=.8, potential output=800 bill, tax multiplier = -4
Mpc=.8, potential output=800. Gov spending multiplier=5
Mpc=.8, potential output=800. If rGDP=700, recessionary
gap
can close recessionary gap by lowering corporate income
tax rate
can close inflationary gap with decrease in gov purchases
nat. debt rises in yrs where fed gov incurs a deficit
when economy in recession, tax receipts decrease but
unemployment insurance payments increase
current spending for social stuff= 40% of fed. Spending
Japan 1990s: expansionary gov spending put into effect to
prop up aggregate demand
Examples of gov transfers: prescription drugs for low
income individuals, unemployment insurance, disability
pension (NOT reimbursement of personal income tax
withheld)
-reduction in TR decreases disposable income and
consumption, shifting AD curve to left
Fed govs largest source of tax revenue=personal and
corporate income taxes
Money demand:
-Short term int rates- int rates on financial assets that
mature within 6 months or less
-Long term int rates- int rates on financial assets that
mature # of yrs in future
-Money demand curve: shows relationship between
quantity of money demanded and interest rate
--higher int rate leads to higher opp cost of holding money
and reduces quantity of money demanded
Shifts:
-changes
-changes
-changes
-changes

in
in
in
in

aggregate price level

rGDP
tech
institutions

Liquidity preference model- int rate determined by supply

and demand for money, money supply represented by
vertical line
Money supply curve- shows how nominal quantity of
money supplied varies with int rate
Target fed funds rate-fed reserves desired fed funds rate
(fed reserve does this via open market ops)
Expansionary monetary policy- increases AD, shifts curve
to right
-lowers int rate because it increases agg demand

Contractionary monetary policy- reduces AD, shifts curve

to left; works by discouraging investment spending
Inflation targeting- when central bank sets explicit target
for inflation rate/sets monetary policy to hit target
If int rate below eq rate, supply of nonmonetary financial
assets greater than demand for them
Increase in money supply reduces int rate, increases AD,
but eventual rise in nominal wages leads to fall in SRAS,
agg output falls back to potential output
In long run, changes in money supply affect agg price
level but not rGDP or int rate
When ind decides to hold money instead of other assets,
that ind is giving up the int that could have been earned
by holding other types of assets
Short term interest rates tend to move together
Monetary neutrality: changes in money supply have no
real effect on economy, so mon policy ineffectual in long
run
If int rate below eq rate, supply of non monetary financial
assets is greater than demand for them
To expand money supply, fed reserve would have to
engage in an open purchase of treasury bills
1985-2004: fed reserve tended to cut int rates when
economy had a recessionary gap and raise int rates when
economy had inflationary gap
If nominal quantity of money demanded is proportional to
agg price level, increase in price level from 100-120,
increases nominal quantity of money demanded from 700
to 840
Quantity equation says velocity of money=(P*Y)/M
Loanable funds model, contractionary monetary policy:
shifts supply curve for loanable funds to left
-model focuses on supply of funds from lenders, demand
from borrowers
Nominal quantity of money= 300 bill, velocity=5,
nGDP=500 bill. Price level=3
Short term int rates refer to rates on financial assets due
within 6 months or less
If checking account has int rate of 1%, tbill has int rate of
3%, opp cost of holding cash in checking account is 2%
If at current int rate the demand for money is 300 bill and
supply of money is 200 bill, int rate will rise
If agg price level doubles, money demanded at any given
int rate will also double
We hold money to reduce transaction costs
Money demand curve is downward sloping because lower
int rate decreases opp cost of holding money
If zero maturity asset has int rate of 1% and gov treasury
bill has int rate of 2%, opp cost of holding zero maturity
asset as money is 1%

Economy operating at potential output and increase in

money supply. Agg output will rise above potential output,
nominal wages will rise, and SRAS will shift leftward
If money supply decreases by 5%, in long run price level
drops by 5%
In long run, monetary policy only affects agg price level,
doesnt affect agg output, is neutral
Amount of money that people demand is negatively
related to int rate
If congress places $5 tax on each atm transaction, real
demand for money will likely increase
Available international evidence for 1970-2000 shows that
the increase in quantity of money leads to proportionate
increase in agg price level
SRAS curve is upsloping ( higher agg price level leads to
higher output since most production costs are fixed in
short fun), LRAS curve is vertical
Velocity of money is # of times money turns over within
given time frame
Reasons Japanese tend to keep large amount of cash: low
crime rate, int rates have been below 1% since 90s, retail
sector dominated by small, mom and pops stores that
dont use credit card technology (NOT banks have
invested heavily in credit card technology)
30% increase in agg price level will not affect real demand
for money
If economy experiencing inflationary gap,fed should
conduct contractionary monetary policy to decrease agg
demand
FOMC sets target int rate for next 6 wks
If rGDP=400, nGDP=480, price level=1.2, nominal
quantity of money=240, velocity of money is 2
In long run, changes in money supply affect only price
level but dont change agg output
Other things equal, increase in int rate leads to fall in
investment and consumer spending
People forgo int and hold money to reduce their
transactions costs

Commodity money-good used as medium of exchange

that has other uses
- Change in commodity prices causes shift in short run
aggregate supply curve
Commodity backed money- medium of exchange with no
intrinsic value whose ultimate value is guaranteed by
promise that it can be converted into valuable goods
Fiat money-medium of exchange whose value derives
entirely from its official status as a means of payment (US
dollar defined as fiat money, because it was created by an
act of law)
Monetary aggregate- overall measure of money supply

Near moneys-financial assets that cant be directly used

as medium of exchange but can readily be converted into
cash or checkable bank deposits
M1: assets you can use to buy groceries: currency,
travelers checks, checkable deposits (about 100% of M1)
M2: broader, includes things like savings accounts that
can easily and quickly be converted to M1 (includes M1)
- Economists definition of money: currency, checkable
bank deposits, coins (NOT bonds)
Savings account- asset that belongs to M2 but not M1
- Monetary aggregates from most liquid to least liquid: M1,
M2, M3
Bank run- many of banks depositors try to withdraw funds
due to fears of bank failure
-often proved contagious
- may start as result of rumor that bank is in financial
trouble, many banks depositors try to withdraw their
funds due to fears of a bank failure, often lead to loss of
faith in other banks, causing additional bank runs (NOT
typically ony happen to small banks with few financial
assets)
-possibility almost eliminated by gov by instituting capital
and reserve requirements, deposit insurance (NOT loan
guarantee)
Deposit insurance- guarantees that banks depositors will
be paid even if bank cant come up with funds, up to a
max amount per account (FDIC currently guarantees first
250,000 of each account)
Capital requirements- regulators require that owners of
banks hold substantially more assets than value of bank
deposits; in practice, banks capital =7% or more of their
assets
Reserve requirements- rules set by Fed Reserve that
determine min reserve ratio for a bank (Ex: min reserve
ratio for checkable bank deposits is 10%)
Discount window-arrangement where fed reserve stands
ready to lend money to banks in trouble
Excess reserves- bank reserves over and above its
required reserves
-increase in bank deposits from $1000 in excess reserves=
1000/rr
Ex: reserve requirement=10%, withdrawal=5000: as result
of withdrawal, excess reserves decrease by 4500

Wealth of Nations, when Smith discussed a sort of wagonway through the air, referring to paper money
Ex of double coincidence of wants: a car mechanic who
wants a TV finding an owner of an electronics store who
wants a car repaired
Most liquid=$50 bill
Money multiplier = 1/reserve ratio
- If reserve ratio is 25%, money multiplier is 4
-reserve ratio: fraction of its deposits that bank holds as
reserves
- if rr falls, multiplier increases
Money supply wouldnt be affected by individuals 10,000
cash deposit in a bank
If bank has deposits of $100,000, cash on hand of $10,000
and $15,000 on deposit at fed reserve, required reserve
ratio is .20, then bank has excess reserves of $5,000
(Assets) loans-900,000; reserves:100,000 (liabilities)
deposits 1,000,000 reserve ratio=10%, fed reserve sells
11,00 worth of treasury bills to banking system. If banking
system doesnt want to hold any excess reserves, 110000
will be subtracted from money supply
Rr=10%, withdraws 5,000 from checkable bank deposit.
Banks dont hold excess reserves + public holds no
currency, only checkable bank deposits. Banks balance
sheet after withdrawal: reserves and checkable deposits
decrease by 5,000
Banking system doesnt hold excess reserves, rr=20%. If
sam deposits 500 cash into account, system can increase
money supply by 2,000
Rr=20%, deposits 1000 check into account, bank doesnt
want to hold excess reserves. Max expansion in money
supply possible is 4,000
Public holds 50% of money supply in currency, rr=20%.
Banks hold no excess reserves. Customer deposits 6,000
in checkable deposit. As result of deposit, banks loans
increase by 4,800
Tuition at State university this yr is 8000 illustrates unit
of account

Monetary base- sum of currency in circulation and bank

reserves (Bank reserves part of monetary base)
Money multiplier-ratio of money supply to monetary base
Currency in circulation- component of both monetary base
and money supply

Banks dont lend out all of funds placed in their hands by

depositors because they have to satisfy any depositor who
wants to withdraw funds

Fed funds market- allows banks that fall short of reserve

requirement to borrow funds from banks with excess
reserves

Economy lacking medium of exchange uses a barter

system
-money plays role of medium of exchange when use it to
buy groceries

Fed reserves main liabilities; currency and bank reserves

Federal funds rate- int rate determined in fed funds market

Discount rate- rate of interest the Fed charges on loans to
banks

Fed responsibilities: control monetary base,

oversee/regulate banking system, set discount rate (NOT
mint bills/coins)

Open market operations- principal tool of monetary policy:

fed can increase or reduce monetary base by buying gov
debt from banks or selling gov debt to banks (when fed
reserve buys/sells treasury bills)
-used by fed reserve to change money supply

If fed reserve wants to lower int rates, it can increase

money supply by buying treasury bills
Money market in eq. fed reserve bank decides to purchase
tbills in open market operation. Result will be fall in int
rate as money supply curve shifts outward

3 main monetary policy tools: reserve requirements,

discount rate, open market purchases
If Fed conducts open market purchase, bank reserves
increase and money supply increases
Fed reserve bank of US not exactly part of US gov but not
really private institution either
To close inflationary gap using monetary policy, fed
reserve should decrease money supply to decrease
investment and consumer spending and shift AD curve to
left

To increase money supply, central bank could lower

discount rate, make open market purchases, lower reserve
requirements
In long run, changes in money supply dont affect int rate
Explanation for why Fed never buys US treasury bills
directly from fed gov: it could be a route to disastrous
inflation
Fed funds rate is int rate on reserves that banks lend to
each other, controlled by fed open market committee and
quantity of money individuals want to hold rises

If economy in recessionary gap, fed reserve should

conduct expansionary monetary policy by increasing the
money supply
-to close gap using monetary policy, fed reserve should
increase money supply to increase investment and
consumer spending and shift AD curve to right

To fight inflation, fed reserve should conduct

contractionary monetary policy to raise int rates, shifting
AD curve to left
Fed reserve buying tbills leads to increase in money
supply

Decrease in demand for money results in decrease in price

level

When short term int rate falls, opp cost of holding money
falls

Sale of bonds by fed reserve raises int rates, reduces

money supply

Ex of bank regulations designed to prevent bank runs:

reserve requirements, deposit insurance, capital
requirements (NOT Fed funds rate)

3 chief characteristics of money: serves as medium of

exchange, acts as store of value, unit of account (NOT
highly illiquid asset)

After 1873, US gov guaranteed value of dollar in terms of

gold

When bank deposit is withdrawn and kept as currency,

bank reserves decrease and the monetary base doesnt
change

If it looks like a bank wont meet the fed reserve banks

reserve requirement, normally it will first turn to other
member banks and borrow at federal funds rate

Banks illiquid because their loans are less liquid than their
deposits

Among liabilities of banks are deposits

Demand for money higher in Japan than US because

Japanese int rates very low in comparison

Tradeoff a firm faces when using retained earnings or

borrowed funds is the same when it spends money on an
investment project

Economy is in the long run equilibrium. The federal reserve lowers the key interest rate the
aggregate demand curve will shift to AD2
Scenario: Assets and Liabilities of the Banking System

If reserve ratio is 6% and banking system doesnt want to hold excess reserves, $666,667 will be
added to money supply
Long run aggregate supply curve is vertical
Stock market crashes, aggregate demand curve shifts to the left
If fed increases the quantity of money in circulationinterest rates increase, investment increases,
aggregate demand curve shifts to the right
If Fed buys bonds money supply increases, raises bond prices, lowers interest rates
Interest rate effect: an increase in price level causes people to increase their money holdings which
increases interest rates and decreases investment spending

In short run, increase in net exports = panel a

If economy is at point X, the appropriate fiscal policy is decrease taxes and increase gov spending
Gov could reduce budget allocations to interstate highway maintenance to close an inflationary gap
using fiscal policy

If supply of money shifts from S1 to S2, fed must have bought gov bonds in the open market

If economy is producing an output level of Y1, then economy is in an inflationary gap and
contractionary fiscal policy can remove the gap
If currency in circulation-100 mill, demand deposits- 500, savings deposits-300 mill and travelers
checks-10 mill. M1 money supply is 610 mill

Economy is at point E, adjustment process = nominal wages increase, short run aggregate supply
curve shifts left until actual and potential output are equal
Flight to safety in 3/08- investors purchasing treasury bills, driving interest rates down because they
feared the safety of other assets
Raising taxes shifts the aggregate demand curve to the left

Panel B shows what happens when the fed decides to lower money supply, increase interest rates
If economy experiencing inflationary gap, the fed would sell government bonds, which would decrease
money supply and increase interest rates, panel B
Central bank could lower discount rate, make open market purchases, lower reserve requirements to
increase money supply
A cut in taxes increases disposable income and consumption, therefore shifting aggregate demand
curve to right
Short run aggregate supply curve would shift to left: increase in nominal wages and price of
commodities used for production, decrease in productivity (NOT increase in interest rates)

Movement from AD1 to AD3 could be caused by increased gov purchases, increased gov transfers,
decreased taxes
Most liquid asset would a $50 bill (NOT 100 shares of Apple stock, econ textbook, $50 gift card)
The reserve requirement is 20%, and Leroy deposits his $1,000 check received as a graduation gift in
his checking account. The bank does NOT want to hold excess reserves. Max expansion in money
supply possible = $4000

Increase taxes to close inflationary gap- appropriate response by government

MPC=.8, gov spending decreases by 50 million. Equilibrium GDP will decrease by 250 mill

If economy is currently at Y1 and investment spending increases AD1 will shift to right, reflecting a
multiplied increase in real GDP at every price level
Bank deposits 100,000, loans of 75,000, cash on hand of 10,000, 15,000 on deposit at fed reserve.
Reserve ratio = 25%
Bank has excess reserves of 800 and reserve ratio is 20%. If andy deposits 1000 of cash into checking
account and bank lends 600 to molly, bank can lend an additional 1,000