CHAPTER 24

The loanable funds market is in equilibrium at the real interest rate when
the quantity of loanable funds demanded = the quantity of loanable funds supplied

Changes in Demand and Supply

Financial markets are:
● volatile in the short run
○ comes from fluctuations in either the demand for loanable funds or the supply
of loanable funds
● stable in the long run

an increase in the demand for loanable funds

● An increase in expected profits increases the demand for funds today.
● The real interest rate rises.
● Saving and quantity of funds supplied increases.

an increase in the supply of loanable funds.

● If one of the influences on saving plans changes and saving increases, the supply of
funds increases.
● The real interest rate falls.
● Investment increases.

Government in the Loanable Funds Market

Government enters the loanable funds market when it has a budget surplus or deficit.
● A government budget surplus increases the supply of funds.
● A government budget deficit increases the demand for funds.

the effect of a government budget surplus:

● A government budget surplus increases the supply of funds.
● The real interest rate falls.
● Private saving decreases.
● Investment increases.

the effect of a government budget deficit:

● A government budget deficit increases the demand for funds.
● The real interest rate rises.
● Private saving increases.
● Investment decreases—is crowded out.

the Ricardo-Barro effect.

● A budget deficit increases the demand for funds.
● Rational taxpayers increase saving, which increases the supply of funds.
● Increased private saving finances the deficit.
● Crowding-out is avoided.
CHAPTER 25
What is Money?
Money is any commodity or token that is generally acceptable as a means of payment.

means of payment is a method of settling a debt.

Money has three other functions:

● Medium of exchange
○ A medium of exchange is an object that is generally accepted in exchange for
goods and services.
○ In the absence of money, people would need to exchange goods and services
directly, which is called barter
○ Barter requires a double coincidence of wants, which is rare, so barter is
costly.
● Unit of account
○ A unit of account is an agreed measure for stating the prices of goods and
services.
● Store of value
○ As a store of value, money can be held for a time and later exchanged for
goods and services.

Currency is the notes and coins held by individuals and businesses.

Deposits are money because the owners can use the deposit to make payments.

The two main official measures of money in the United States are M1 and M2:
● M1(means of payments) consists of currency and traveler’s checks and checking
deposits owned by individuals and businesses.
○ All the items in M1 are means of payment, so they are money.
● M2 consists of M1 plus time deposits, saving deposits, money market mutual funds,
and other deposits.
○ Some saving deposits in M2 are not means of payments—they are called
liquid assets.
Liquidity is the property of being instantly convertible into a means of payment with little loss
of value.

Official Measures of Money in Saudi Arabia

The main official measures of money in the Saudi Arabia are M1,M2, and M3:
● M1consists of currency outside a bank and demand deposits (money in bank
accounts).
● M2 consists of M1 plus time & saving deposits (saving accounts in banks)
● M3 consists of M2 plus quasi monetary deposits. (other deposits that can relatively
quickly be made available).
Deposits are Money but Checks Are Not
● In defining money, we include, along with currency, deposits at banks and other
depository institutions.
● A check is an instruction to a bank to transfer money.
● A check is not money, but the deposit on which it is written is money.

Credit Cards Are Not Money?

A credit card enables the holder to obtain a loan, but it must be repaid with money. Credit
cards are not money.

Depository Institutions
A depository institution is a firm that takes deposits from households and firms and makes
loans to other households and firms.
Deposits at three institutions make up the nation’s money They are:
● Commercial banks
○ A commercial bank is a private firm that is licensed by the Comptroller of the
Currency or by a state agency to receive deposits and make loans.
● Thrift institutions
○ Savings and loan associations, savings banks, and credit unions are called
thrift institutions.
● Money market mutual funds
○ A money market mutual fund is a fund operated by a financial institution that
sells shares in the fund and holds assets.

What Depository Institutions Do

● The goal of any bank is to maximize its profits.
● To achieve this objective, the interest rate at which it lends exceeds the interest rate it
pays on deposits.

But the banks must balance profit and prudence:

● Loans generate profit.
● Depositors must be able to obtain their funds when they want them.

Depository institutions provide four benefits:

● Create liquidity
● Pool risk
● Lower the cost of borrowing
● Lower the cost of monitoring borrowers

How Depository Institutions Are Regulated

● Depository institutions engage in risky business.
● To make the risk of failure small, depository institutions are required to hold levels of
reserves and owners’ capital equal to or that surpass the ratios laid down by
regulation.
The Central Bank
A Central bank is the public authority that regulates a nation’s depository institutions and
controls the quantity of money.
The Central Banks goals are to keep inflation in check, maintain full employment,
moderate the business cycle, and contribute toward achieving long-term growth.

To achieve its objectives, the central bank uses three main policy tools:

Open market operations

-An open market operation is the purchase or sale of government securities ( a bond of a
debt obligation) by the Central bank from or to a commercial bank or the public.
-When the Central Bank buys securities, it pays for them with newly created reserves held
by the banks.
-When the Central Bank sells securities, they are paid for with reserves held by banks.
-So open market operations influence banks’ reserves.

Last resort loans

-The central bank is the lender of last resort, which means the central bank stands ready to
lend reserves to depository institutions that are short of reserves. The rate that central banks
charge for these reserves is called the discount rate.

Required reserve ratios

-The Central Banks sets the required reserve ratio, which is the minimum percentage of
deposits that a depository institution must hold as reserves.
-The Central Bank rarely changes the required reserve ratio.

How Banks Create Money

Creating Deposits by Making Loans
Banks create deposits when they make loans and the new deposits created are new money.

The quantity of deposits that banks can create is limited by three factors:

The monetary base

-The monetary base is the sum of notes, coins, and banks’ deposits at the central bank.
-The size of the monetary base limits the total quantity of money that the banking system
can create because
Banks have desired reserves.
Households and firms have desired currency holdings.
-And both these desired holdings of monetary base depend on the quantity of money.

Desired reserves
-A bank’s actual reserves consists of notes and coins in its vault and its deposit at the Fed.
-The desired reserve ratio is the ratio of the bank’s reserves to total deposits that a bank
plans to hold.
 Desired currency holding
-People hold some fraction of their money as currency.
-So when the total quantity of money increases, so does the quantity of currency that people
plan to hold.
-Because desired currency holding increases when deposits increase, currency leaves the
banks when they make loans and increase deposits.
-This leakage of reserves into currency is called the currency drain.
-The ratio of currency to deposits is the currency drain ratio.

The Money Creation Process

● The money creation process begins with an increase in the monetary base.
● The Central Bank conducts an open market operation in which it buys securities
from banks.
● The Central Bank for the securities with newly created bank reserves.
● Banks now have more reserves but the same amount of deposits, so they have
excess reserves.
● Excess reserves = Actual reserves – desired reserves.

The Money Multiplier

● The money multiplier is the ratio of the change in the quantity of money to the change
in the monetary base.
● The quantity of money created depends on the desired reserve ratio and the
currency drain ratio.
● The smaller these ratios, the larger is the money multiplier.

Criticism of the money creation model

● Banks lending does not actual depend on the amount of reserves.
● “Banks lend first and look for reserves later.”
● Banks are more limited by profitability considerations. Banks base their lending
decisions on the risk-return trade-off.

The Money Market

The Influences on Money Holding
The quantity of money that people plan to hold depends on four main factors:

The price level

-A rise in the price level increases the quantity of nominal money but doesn’t change the
quantity of real money that people plan to hold.
-If everything becomes more expensive we will hold a larger amount of money.
-Let’s assume that you keep enough money to pay for your lunch in the cafeteria. If lunch
becomes more expensive you will keep more money.

The nominal interest rate

-The nominal interest rate is the opportunity cost of holding wealth in the form of money
rather than an interest-bearing asset.
-A rise in the nominal interest rate on other assets decreases the quantity of real money that
people plan to hold.
 Real GDP
An increase in real GDP increases the volume of expenditure, which increases the quantity
of real money that people plan to hold.

Financial innovation
Financial innovation that lowers the cost of switching between money and interest-bearing
assets decreases the quantity of real money that people plan to hold.

The demand for money is the relationship between the quantity of real money demanded
and the nominal interest rate when all other influences on the amount of money that people
wish to hold remain the same.

A rise in the interest rate brings a decrease in the quantity of real money demanded.
A fall in the interest rate brings an increase in the quantity of real money demanded.

Shifts in the Demand for Money Curve

● decrease in real GDP or a financial innovation decreases the demand for money and
shifts the demand curve leftward.
● An increase in real GDP increases the demand for money and shifts the demand
curve rightward.

Money Market Equilibrium

● Money market equilibrium occurs when the quantity of money demanded equals the
quantity of money supplied.
● Adjustments that occur to bring about money market equilibrium are fundamentally
different in the short run and the long run.

Long-Run Equilibrium
● As the real interest rate falls, consumption expenditure and investment increase.
Aggregate demand increases.
● With the economy at full capacity (production can not increase), the price level rises.

The Quantity Theory of Money

The quantity theory of money is the proposition that, in the long run, an increase in the
quantity of money brings an equal percentage increase in the price level.
The quantity theory of money is based on the velocity of circulation and the equation
of exchange.

The velocity of circulation is the average number of times in a year a dollar is used to
purchase goods and services in GDP.

Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money
M:
V = PY ÷ M.
The equation of exchange states that
MV = PY.
So in the long run, the change in P is proportional to the change in M.
CHAPTER 27
Aggregate Supply
The quantity of real GDP supplied is the total quantity of goods and services that firms
produce during a given period.
Aggregate supply is the relationship between the quantity of real GDP supplied and the price
level.
We distinguish two time frames associated with different states of the labor market:

Long-run aggregate supply

-Long-run aggregate supply is the relationship between the quantity of real GDP supplied
and the price level when real GDP equals potential GDP.
-Potential GDP is independent of the price level.
-So the long-run aggregate supply curve (LAS) is vertical at potential GDP.
-In the long run, the quantity of real GDP supplied is potential GDP.

Short-run aggregate supply

-Short-run aggregate supply is the relationship between the quantity of real GDP supplied
and the price level when the money wage rate, the prices of other resources, and potential
GDP remain constant (prices are sticky in the short run).
-A rise in the price level with no change in the money wage rate and other factor prices
increases the quantity of real GDP supplied.
-The short-run aggregate supply curve (SAS) is upward sloping.
-the quantity of real GDP supplied increases if the price level rises.

Changes in Aggregate Supply

Aggregate supply changes if an influence on production plans other than the price level
changes.
These influences include:

Changes in potential GDP

When potential GDP increases, both the LAS and SAS curves shift rightward.
Potential GDP changes for three reasons:
● An increase in the full-employment quantity of labor
● An increase in the quantity of capital (physical or human)
● An advance in technology
 Changes in money wage rate (and other factor prices)
The effect of a rise in the money wage rate.
● Short-run aggregate supply decreases and the SAS curve shifts leftward.
● Long-run aggregate supply does not change.

The quantity of real GDP demanded, Y, is the total amount of final goods and services
produced that people, businesses, governments, and foreigners plan to buy.
This quantity is the sum of consumption expenditures, C, investment, I, government
expenditure, G, and net exports, X – M.
That is,
Y = C + I + G + X – M.

Buying plans depend on many factors and some of the main ones are
● The price level
● Expectations
● Fiscal policy and monetary policy
● The world economy

Aggregate Demand
Aggregate demand is the relationship between the quantity of real GDP demanded and the
price level.
The aggregate demand curve (AD) plots the quantity of real GDP demanded against
the price level.
A rise in the price level decreases the quantity of real GDP demanded. Hence, the
aggregate demand curve (AD) is downwards sloping.

Changes in Aggregate Demand

A change in any influence on buying plans other than the price level changes aggregate
demand.
The main influences on aggregate demand are
Expectations
-Expectations about future income, future inflation, and future profits change aggregate
demand.
-Increases in expected future income increase people’s consumption today and increases
aggregate demand.
-A rise in the expected inflation rate makes buying goods cheaper today and increases
aggregate demand.
-An increase in expected future profits boosts firms’ investment, which increases aggregate
demand.

The world economy

The world economy influences aggregate demand in two ways:
-A fall in the foreign exchange rate lowers the price of domestic goods and services relative
to foreign goods and services, which increases exports, decreases imports, and increases
aggregate demand.
-An increase in foreign income increases the demand for domestic exports and increases
aggregate demand.
 Fiscal policy and monetary policy
-Fiscal policy is the government’s attempt to influence the economy by setting and changing
taxes, making transfer payments, and purchasing goods and services.
-A tax cut or an increase in transfer payments increases households’ disposable
income—aggregate income minus taxes plus transfer payments.
-An increase in disposable income increases consumption expenditure and increases
aggregate demand.

an increase in government expenditure increases aggregate demand.

The Central Bank’s attempt to influence the economy by changing the interest rate and
adjusting the quantity of money is called monetary policy.

An increase in the quantity of money increases buying power and increases aggregate
demand.
A cut in interest rates increases expenditure and increases aggregate demand.

Monetary Policy is ineffective under a fixed exchange rate. One cannot no longer use
monetary policy to alter inflation and smooth the business cycles. Fiscal policy is still
effective.

If the Central Bank increases the quantity of money, the value of money decreases. This
puts a pressure on the domestic currency to depreciate. The Central Bank has to sell foreign
currency and buy domestic currency to keep the fixed exchange rate. As the Central Bank
buys domestic currency, this currency is taken out of circulation and the money supply
decreases again.

Macroeconomic Trends and Fluctuations

Short-run macroeconomic equilibrium
occurs when the quantity of real GDP demanded equals the quantity of real GDP
supplied at the point of intersection of the AD curve and the SAS curve.
If real GDP is below equilibrium GDP, firms increase production and raise prices…
… and if real GDP is above equilibrium GDP, firms decrease production and lower prices.

Long-run macroeconomic equilibrium

occurs when real GDP equals potential GDP—when the economy is on its LAS
curve.
Long-run equilibrium occurs at the intersection of the AD and LAS curves.
The Business Cycle in the AS-AD Model
-The business cycle occurs because aggregate demand and the short-run aggregate supply
fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential
GDP.
-An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential
GDP.
-A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP.
-A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real
GDP.

Fluctuations in Aggregate Demand

● the effects of an increase in aggregate demand.
● An increase in aggregate demand shifts the AD curve rightward.
● Firms increase production and the price level rises in the short run.

Fluctuations in Aggregate Supply

● The SAS curve shifts leftward.
● Real GDP decreases and the price level rises.
● The economy experiences stagflation.

Macroeconomic Schools of Thought

The Classical View
A classical macroeconomist believes that the economy is self-regulating and that
business cycle fluctuations are the efficient responses of a well-functioning market economy.

The Keynesian View

A Keynesian macroeconomist believes that to achieve and maintain full employment,
active help from fiscal policy and monetary policy is required.
The central idea is that wage rates don’t fall easily. So if there is a recessionary gap,
there is no automatic mechanism for getting out of a recession.

The Multiplier
Two-Way Link Between Aggregate Expenditure and Real GDP Other things remaining the
same:
● An increase in real GDP increases aggregate expenditure.
● An increase in aggregate expenditure increases real GDP.

Two expenditure components of the GDP equation are themselves depended on income:
consumption and imports
GDP=Y=C(Y)+I+G+X-M(Y)

Fiscal Policy
Fiscal Stimulus
An increase in government expenditure or a tax cut increases aggregate expenditure.
The multiplier process increases aggregate demand
Monetary Policy
Increase in the Supply of Money
The increase in the supply of money decreases the real interest rate and investment
increases.
This leads to an increase in aggregated demand.

Inflation in the AS-AD Model

Inflation Short Run
In the short run inflation can be caused by an increase in aggregated demand or a
decrease in aggregated supply.

Inflation in the Long Run

Potential GDP increases because the quantity of labor grows, capital is accumulated,
and technology advances.
The LAS curve shifts rightward.
If the quantity of money grows faster than potential GDP, aggregate demand
increases by more than long-run aggregate supply.
The AD curve shifts rightward faster than the rightward shift of the LAS curve.