• Chapter :

• Aggregate Demand and Aggregate Supply

11-1
 Tying it all together
• The last chapters have focused separately on
three features of the economy:
1. Output (GDP).
2. Prices.
3. Unemployment.
• These factors do not fluctuate independently.
• A demand and supply model for the
macroeconomy would be useful.
• The model of aggregate demand and aggregate
supply shows how output, prices, and
employment are all tied together as part of a
single economic equilibrium.

11-2
 Aggregate demand
• Aggregate demand is equal to GDP, or AD = GDP = C + I + G + NX.
• The aggregate demand curve shows the relationship between the
overall price level in the economy and output.

Price level
• We are interested in what
happens when the prices
of all goods go up or
2. …increases the amount of down.
P1 goods and services demanded.
1. A decrease in • Price changes are
the price level…
measured by the price
P2
index or inflation.
Aggregate demand

Y1 Y2
Output

11-3
Why does the AD curve slope downward?
• Why the AD curve slopes downward is due to
each component of AD.
1. Consumption (C):
• As prices rise, people reduce consumption
because their real wealth decreases.
– This is called the wealth effect.
2. Investment (I):
• As prices rise, interest rates rise.
• This causes borrowing to decrease and results
in a decrease in investment spending.

11-4
Why does the AD curve slope downward?
3. Government spending (G):
• Most government spending is independent of
the price level.
• Government spending does not contribute to a
downward sloping AD.
4. Net exports (NX):
• When U.S. prices increase, U.S. goods become
relatively more expensive compared to other
countries’ goods.
• Imports increase and exports decrease.
• As price levels increase, net exports decrease.

11-5
 Why does the AD curve slope downward?
• There is a negative relationship between the price
level and three of the national expenditure
components:
1. Consumption – negative relationship.
2. Investment – negative relationship.
3. Government spending – no relationship.
4. Net exports – negative relationship.
• This causes a negative relationship between the
price level and aggregate expenditures.

11-6
 Shifting the aggregate demand curve
The entire aggregate demand curve can also shift in response to non-
price changes in any of the four components of aggregate demand.
A rightward shift of aggregate demand A leftward shift of aggregate demand

Price level Price level

AD 1
AD 2
AD AD 2
1
Output Output

• When a non-price factor increases a • When a non-price factor decreases a

component of AD, the entire AD curve component of AD, the entire AD
shifts to the right. curve shifts to the left.
• GDP is higher at every price level. • GDP is lower at every price level.
11-7
 Shifting the aggregate demand curve
The main non-price factors are as follows:
Category Increase (shift right)
• High expectations about future
income increase consumer spending.
Consumption • Tax cuts increase consumer spending.
• Confidence in the future of the
economy leads firms to expand their
businesses.
Investment
• A tax credit for small businesses
inspires firms to buy new company
cars.
• Increase in government spending
Government spurs spending after a recession.
spending
• A new free trade agreement with
Europe reduces most tariffs and other
restrictions on U.S. goods.
Net exports • Economic growth abroad in China
increases demand for U.S. goods and
services.
Decrease (shift left)
• Low expectations about future income
lead to greater saving and less
spending.
• Higher interest rates discourage
borrowing.
• Firms cut back on spending in order to
weather a recession.
• Taxes on capital increase, leaving less
money for investment.
• Decrease in government spending in
response to concerns about increasing
debt leads to less spending.
• Other countries increase their tariffs
on U.S. goods, making the goods more
expensive.
• The dollar strengthens, making U.S.
goods and services more expensive for
international consumers, decreasing
demand.
11-8
 Active Learning: AD shifts
Indicate whether each of the following situations results in
an increase or decrease in aggregate demand.

1. Consumers feel confident that incomes will

increase significantly in the next year.
2. The government is concerned about
increasing its debt and thus reduces
government spending.
3. China increases the tariffs on U.S. goods.
4. The government awards small factories a
tax credit, which many use to build new
manufacturing plants.

11-9
 Active Learning: AD shifts
Indicate whether each of the following situations results in
an increase or decrease in aggregate demand.

1. Consumers feel confident that incomes will Increase

increase significantly in the next year.
2. The government is concerned about
increasing its debt and thus reduces Decrease
government spending.
3. China increases the tariffs on U.S. goods.
4. The government awards small factories a Decrease
tax credit, which many use to build new
manufacturing plants. Increase

11-10
 Aggregate supply
• Aggregate supply is the sum total of the production of all
the firms in the economy
• The aggregate supply curve shows the relationship
between the overall price level in the economy and total
production by firms.
• The AS curve represents production in the economy as a
whole, not just of one good or service. It describes how
much firms decide to produce.
• The economy operates differently in the short run and
long run, so there are two different AS curves.
• The long-run aggregate supply curve (LRAS).
• The short-run aggregate supply curve (SRAS).
11-11
 Short-run aggregate supply (SRAS)
In the short run, the AS curve slopes upward.

• Prices of final goods

Price level

Short-run aggregate
supply (SRAS)
increase more quickly
P2
than input prices.
• An increase in the final
P1
goods’ price level
increases firms’ profits.
• Firms respond by
Y1 Y2
increasing production.
Output

11-12
 Long-run aggregate supply (LRAS)
• The long run is not a set amount of time.
– It is the time required for input prices to fully adjust to economic
conditions.
• When input costs adjust, firms no longer earn positive economic
profits.
• The economy returns to where it started.
• Changes in the price-level do not affect aggregate supply in the long
run.
Price level Long-run aggregate
supply (LRAS) • In the long run, the aggregate
P2
supply curve is fixed.
• The long-run aggregate supply
curve is not affected by the
P1 price level, causing it to be
vertical.
• The LRAS curve represents
potential output in the
economy.
Yp Output

11-13
 The business cycle
• Economies do not always produce to their potential output.
• Business cycles are fluctuations of output around the level of potential
output.
– When output is higher than potential output, the economy is in a boom.
– When output is below potential output, the economy is in a recession.
• The U.S. business cycle has occurred frequently over the last 50 years.
Percent Annual growth rate of
8 real per capita GDP
But notice that the yearly
average fluctuated quite a bit.
6

4 Long-run
average
2 growth

The average real GDP per

0 capita growth rate was
around 3% between 1960
-2 and 2010.

-4
1960 1970 1980 1990 2000 2010
Year 11-14
 Shifts in the SRAS curve
If inputs become more expensive, firms will want to
supply fewer goods at any price level in the short-run.
Price level

LRAS SRAS
• The SRAS curve
shifts to the left.
2

SRAS
1 • Supply shocks are
significant events
that directly affect
production and the
AS curve in the
short run.
Output

11-15
 Shifts in the LRAS curve
In the long run, production decisions are influenced
by inputs, regardless of the overall price level.
Price level

LRAS
2010
LRAS 2020 • The LRAS curve shifts
outward if there is an
increase in available
inputs.
• Everything that shifts
the LRAS also shifts the
Yp
(2010)
Yp Output SRAS.
(2020)

11-16
 Shifts in the LRAS curve
The main factors that shift LRAS are as follows.
Factor Increases LRAS Decreases LRAS

A new law stripping away

Technological innovation allows for
intellectual property rights
Technology greater production using the same
reduces the incentive to
amount of inputs.
innovate.
Foreign investment in factories
Depreciation and wear
Capital and machines increases available
breaks down capital.
capital.
Immigration increases the available Aging population takes
Labor
supply of labor. workers out of the labor force.

Universal primary education gives Reduction of federal college

Education
everyone a chance to go to school. grants.

New energy sources allow factories Climate change permanently

Natural resources to produce more with the same reduces the amount of land
inputs. that can be farmed.

11-17
 Economic Fluctuations
Equilibrium in the national economy is at the point
where AD = AS.
Price level

LRAS
SRAS
• Short-run equilibrium occurs
at the intersection of the AD
and SRAS
• The long-run equilibrium
occurs where the AD curve
P* crosses both the LRAS and
SRAS.
– Prices are at expected levels.
– The short run level of output
is the same as the long run
AD
level of potential output.
Y* Output

11-18
 Effects of a shift in aggregate demand
Using the AD-AS model, the short- and long-run effects of a
rightward shift in AD can be predicted.
Short run Long run
Price level Price level
LRAS LRAS SRAS 2

SRAS SRAS 1

P3 E3
P2 E2 P2 E2
P1 E1 P1 E1

AD2 AD 2

AD1 AD 1

Y1 Y2 Output Y3 Y2 Output

• Increase in consumer confidence • The increase in AD causes wages and

causes AD to increase. input prices to rise.
• Output is above long-run • SRAS decreases.
potential.
• Output returns to original level.
• Prices increase.
• Prices increase again.
11-19
 Effects of a shift in aggregate demand
Using the AD-AS model, the short- and long-run effects of a
leftward shift in AD can be predicted.
Short run Long run
Price level Price level
LRAS LRAS

SRAS SRAS 1

SRAS 2
P1 E1 P1 E1
P2 E2 P2 E2
P3
AD 1 E3 AD 1

AD 2 AD 2
Y2 Y1 Output Y2 Y3 Output

• Decrease in consumer confidence • The decrease in AD causes wages and

causes AD to increase. input prices to fall.
• Output is below long run potential. • SRAS increases.
• Prices decrease. • Output returns to original level.
• Prices decrease again.
11-20
Effects of a shift in aggregate demand
Changes in AD in the short and long run are
summarized as follows.
Shift Example Short run Long run

Increase in government Output increases. Output unchanged.

Increase in AD spending: increases G Price increases. Price increases.

Reduction in consumer Output decreases. Output unchanged.

Decrease in AD confidence: reduces C Price decreases. Price decreases.

11-21
 Effects of a shift in aggregate supply
Supply-side shocks can also be analyzed. Suppose a temporary
supply-side shock hits the economy.
Short run Long run
Price level Price level
LRAS LRAS
SRAS 2 SRAS 1

SRAS 1 SRAS 2
E
2 P
P2 E2
2
P1 E1 P E1
1

AD AD
Y2 Y1 Output Y2 Y1 Output

• Temporary supply side shock causes • The decrease in SRAS causes wages to
the SRAS to decrease. fall (price of labor decreases).
• Output falls below long run potential. • SRAS increases.
• Prices increase. • Output increases to original level.
• Prices decrease to original level.
11-22
 Effects of a shift in aggregate supply
Suppose a permanent supply-side shock hits the economy.
Short run Long run
Price level Price level
LRAS 2 LRAS 1 LRAS 2 LRAS 1 SRAS 3

SRAS 2
SRAS 1 E3 SRAS 1
P3
P2 E2

P1 E1 P1 E1

AD AD
Y2 Y1 Output Y3 Y1 Output

• Permanent supply side shock causes
the LRAS to decrease.
• Input prices rise causing the SRAS to
decrease.
• Prices increase and output decreases.
• As prices continue to rise, the SRAS
decreases until it reaches the long run
equilibrium.
• Prices increase again.
• Output decreases to long-run
equilibrium.
11-23
Comparing demand and supply shocks
• The AD/AS model is a powerful tool for:
– Understanding overall economic conditions.
– Formulating policy responses to shocks.
• It is important to distinguish between supply
and demand shocks.
Event What kind of shock?
Temporary increase in the price of oil Short-run supply shock
Technological innovation Long-run supply shock
Drop in consumer confidence Demand shock
Sudden increase in immigration Long-run supply shock

11-24
Active Learning: Demand and supply shocks
Indicate what type of shock is caused by each of
the following situations.
Situation Type of Shock

Consumer confidence increases

A hurricane destroys many

factories on the east coast

There is a large surge in the

number of immigrants into the U.S.
The discovery of new oil reserves
causes a temporary decrease in
the price of oil

11-25
Active Learning: Demand and supply shocks
Indicate what type of shock is caused by each of
the following situations.
Situation Type of Shock

Consumer confidence increases Positive AD shock

A hurricane destroys many

Negative long run supply shock
factories on the east coast

There is a large surge in the

Positive long run supply shock
number of immigrants into the U.S.
The discovery of new oil reserves
causes a temporary decrease in Positive short run supply shock
the price of oil

11-26
Comparing demand and supply shocks
• There are clear predictions about how different types of
shocks will affect prices and output.
• These predictions give clues to what type of shock
occurred.
Supply or demand? Positive shock Negative shock
Short-run: Short-run:
Demand side Output increases Output decreases
Price increases Price decreases
Long-run: Long-run:
Demand side No change in output No change in output
Price increases Price decreases
Short-run: Short-run:
Temporary shock: Output decreases
Output increases
Supply side Price increases
Price decreases
Long-run: Long-run:
Temporary shock:
No change in output No change in output
Supply side
No change in price No change in price
Long-run: Long-run:
Permanent shock:
Output increases Output decreases
Supply side
Price decreases Price increases
11-27
Active Learning: Short- and long-run predictions
For each of the following situations, indicate how the
AD/AS model predicts prices and output will change.

Situation Short run Long run

An increase in consumption à
positive AD shock.

Unusually high rainfall increases

current year wheat crop yields à
negative SRAS shock.

The FED increases interest rates

which discourages borrowing à
negative AD shock.

11-28
Active Learning: Short- and long-run predictions
For each of the following situations, indicate how the
AD/AS model predicts prices and output will change.

Situation Short run Long run

An increase in consumption à • Output increases

positive AD shock. • Prices increase

Unusually high rainfall increases

• Output decreases
current year wheat crop yields à
• Prices increase
negative SRAS shock.

The FED increases interest rates

• Output decreases
which discourages borrowing à
• Prices decrease
negative AD shock.

11-29
Active Learning: Short- and long-run predictions
For each of the following situations, indicate how the
AD/AS model predicts prices and output will change.

Situation Short run Long run

An increase in consumption à • Output increases • Output returns to original level

positive AD shock. • Prices increase • Prices increase

Unusually high rainfall increases

• Output decreases • Output returns to original level
current year wheat crop yields à
• Prices increase • Prices return to original level
negative SRAS shock.

The FED increases interest rates

• Output decreases • Output returns to original level
which discourages borrowing à
• Prices decrease • Prices decrease
negative AD shock.

11-30
 The role of public policy
• It can take a long time for the economy to fully
adjust to demand and supply shocks.
• Waiting for adjustments is often difficult on
producers and consumers.
• Voters often call upon politicians to respond
during a recession.
• The government can try to boost the economy
out of a recession through government
spending.

11-31
 The role of public policy
• The government can try to counter this
negative demand shock by spending more to
cause aggregate demand to increase.
• Such policies are challenging to implement.
– It is difficult to gauge the overall effect of
government spending on AD.
– It is rare to perfectly design policy to restore AD to
its original level.
– Government intervention impacts the long-run
outcomes.

11-32
 Government spending to counter negative
demand shocks
The government may respond to a housing crisis as shown below.
Housing-market crash Government stimulus
Price level Price level
LRAS LRAS

SRAS SRAS

P1
E1 P3 E3
P2 E2 P2
E2
AD 1 AD 1
AD 3
AD 2 AD 2

Y2 Y1 Output Y2 Y3 Output

• The crash of the housing market • Government spending increases AD.

causes AD to decrease.
• Short term price level falls.
• Short term output falls.
• Equilibrium price level increases.
• Output increases, but is still lower
than the original level.
11-33
 Government spending to counter negative
supply shocks
The government may respond to Midwestern drought as shown below.
Drought shifts aggregate supply Government response
Price level Price level
LRAS LRAS
SRAS 2 SRAS 2

SRAS 1 SRAS 1
P P3 E3
2 E2 P2 E2
P E1 P1 E1
1 AD 2

AD AD 1

Y2 Y1 Output Y2 Y1 Output

• The drought causes SRAS to • Government spending increases AD.

decrease. • New equilibrium prices are higher.
• Short term prices rise. • Output increases to the original
• Short term output falls. level.

11-34
 Government spending summarized
• The long-run result of government
intervention is higher prices, but output may
more quickly return to long-run levels.
• Why would the government ever choose to
intervene?
– The speed of recovery could be slow otherwise.
– Lower prices are not always good for certain goods
and services.
• Government spending is a short-term policy
action used to address short-term shocks.

11-35
 Summary
• The AD/AS model helps to understand what
drives prices, unemployment, and GDP in
context of the economy.
• AD shows the relationship between overall
prices and total demand in the economy.
• AD is downward-sloping because consumption,
investment, and net exports all decrease when
prices rise.

11-36
 Summary
• AS shows the relationship between overall
prices and total production.
• There are two supply curve: one for the short
run and one for the long run.
– The SRAS is upward-sloping because it takes time
for prices and/or wages to adjust.
– The LRAS curve is vertical because supply doesn’t
depend on prices in the long run.

11-37
 Summary
• Positive AD shocks result in increased prices
and output in the short run.
– In the long run, output returns to its original level
and prices rise higher.
• Negative AD shocks result in lower prices and
output in the short run.
– In the long run, output returns to its original level
and prices fall further.

11-38
 Summary
• Prices and output only change in the long run
when there are permanent AS shocks.
• The government can increase spending to
counteract shocks in the short run.
– Increases in government spending produce higher
prices in the long run.

11-39
• Money and the Monetary System

11-40
 Objectives: What will you learn in this
chapter?
• What the main functions of money are and
what makes something a good choice for
money.
• How to explain the concept of fractional-
reserve banking and the money multiplier.
• What role the central bank plays and what the
Federal Reserve’s (Fed) dual mandate is.
• How the Fed conducts monetary policy.
• How monetary policy affects interest rates, the
money supply, and the broader economy.
11-41
 What is money? Functions of money
• Money is the set of all assets that are regularly
used to directly purchase goods and services.
• Money serves three main functions:
1. Store of value: Money represents a certain amount of
purchasing power.
2. Medium of exchange: money can be used to
purchase goods and services.
– A barter system is where people directly offer a
good or service for another good or service.
3. Unit of account: money provides a standard unit of
comparison.

11-42
 What makes for good money?
• There are two basic considerations that make
certain money better than others.
• Stability of value:
– Early versions of money generally took the form of a
physical material that was durable and had intrinsic
value.
– Money does not need intrinsic value to maintain
stability.
• Convenience:
– Technology has allowed for the development of more
convenient forms of money.
• For example, paper money is more convenient than gold
coins.

11-43
 Commodity-backed money versus fiat
money
• Any form of money that can be legally
exchanged into a fixed amount of an
underlying commodity is commodity-backed
money.
– The most common underlying commodity is gold.
• Money created by rule, without any
commodity backing it, is fiat money.
– U.S. currency is backed only by the trust that the
government will keep the value of money relatively
constant.
11-44
Banks and the money-creation process
• Paper money made it possible for banks to
create money through a process called
fractional-reserve banking.
• The primary way that banks earn money is
through lending a fraction of deposited funds
and collecting interest on those loans.
– Demand deposits are funds held in bank accounts
that can be withdrawn by depositors at any time,
without advance notice.

11-45
Banks and the money-creation process
• Reserves refers to the money that banks keep
on hand.
• The reserve ratio is the ratio of the total
amount of demand deposits at the bank to the
amount kept as cash reserves.
– Required reserves is the amount that a bank is
legally required to keep on hand.
– Excess reserves is any additional amount that a
bank chooses to keep beyond the required
reserves.

11-46
• If money has intrinsic value, it has:
•
• A. value unrelated to its use as money.
• B. value only as its use as money.
• C. value that sets its value as money.
• D. None of these is true.

11-47
• An example of a good that can be used for
money that has no intrinsic value is:
•
• A. gold.
• B. paper dollar bills.
• C. cigarettes.
• D. None of these has intrinsic value.

B
11-48
• The primary way that banks earn money is:
•
• A. through lending funds and collecting
interest on those loans.
• B. through the accumulation of deposits.
• C. by lending money to the government.
• D. by the government paying them to regulate
the financial system.

A
11-49
• Modern banks in the United States can keep
reserves as:
•
• A. commodity money only.
• B. a deposit at the Federal Reserve.
• C. gold.
• D. All of these are ways banks hold reserves.

B
11-50
Banks and the money-creation process
The money creation process occurs through banks repeatedly
accepting deposits and lending out a fraction of the deposits.
One One Oneld
gold go in
gold co
coin coin

Original deposit of
1,000 gold coins

100 gold coins

held on reserve
(10% of original deposit)

900 gold coins

loaned out
(90% of original deposit)

One One One Oneld

gold gold gold go in
coin coin coin co

One
gold
One
gold
coin

coin
g o ne
co ld
O

in

Deposit of
900 more gold coins
Total deposits = 1,000 gold coins + 900 gold coins = 1,900 gold coins

11-51
Banks and the money-creation process
A simple way to account for a bank’s transactions is by using
T-account formatting to record changes in banks assets and
liabilities.
Original deposit Bank makes its first loan

Assets Liabilities Assets Liabilities

Cash: $1,000 Deposit: $1,000 Loan: $900 Deposit: $1,000
Required
reserves: $100

The loan is deposited in The bank loans out 90%

the bank of its new deposits

Assets Liabilities Assets Liabilities

Loan: $900 Deposit: $1,900 Loans: $1,710 Deposit: $1,900
New cash Required
deposit: $900 reserves: $190
Required
reserves: $100

The above process increases money by $900.

11-52
 Active Learning: Money creation
A bank accepts a $1,000 deposit. If the bank has
a reserve ratio of 20% and loans out the rest,
find the change in assets and liabilities.
Assets Liabilities
Loans: $2,000 Deposit: $2,500

Required $500
reserves

11-53
 Active Learning: Money creation
A bank accepts a $1,000 deposit. If the bank has
a reserve ratio of 20% and loans out the rest,
find the change in assets and liabilities.
Assets Liabilities
Loans: $2,000 + Deposit: $2,500 +
800 = 1,000 =
$2,800 $3,500
Required $500 +
reserves 200 =
$700

11-54
• Banks create money in the economy by:
•
• A. loaning out part of each deposit, which will be
redeposited by someone else.
• B. charging higher interest on loans than savings.
• C. charging higher interest on savings than loans.
• D. Only the government can create money.

11-55
Banks and the money-creation process
• The money creation process continues with
repeated cycles of lending and depositing of
funds.
• The money multiplier is the ratio of money
created by the lending activities of the banking
system to the money created by the central bank:
!
Money multiplier =
"#$#%&# %'()*

• In a fractional-reserve banking system, banks keep

less than 100% of their deposits on reserves.
11-56
Active Learning: The money multiplier
Use the money multiplier equation to fill in the
blanks in the following table.

Situation Reserve ratio Money Multiplier

A 10%
B 5%

C 5

11-57
Active Learning: The money multiplier
Use the money multiplier equation to fill in the
blanks in the following table.

Situation Reserve ratio Money Multiplier

A 10% 1/.10 = 10
B 5% 1/.05 = 20

C 1/5 = 20% 5

11-58
• We know how many dollars banks create using
the:
•
• A. money multiplier.
• B. federal funds.
• C. demand deposits.
• D. interest rate.

11-59
• The larger is the reserve ratio, the:
•
• A. smaller is the money multiplier, and the less
money will be created in the economy.
• B. smaller is the money multiplier, and the more
money will be created in the economy.
• C. larger is the money multiplier, and the less
money will be created in the economy.
• D. larger is the money multiplier, and the more
money will be created in the economy.

A.
11-60
• If people decide to hold some of their cash and not
deposit it, then:
•
• A. the money multiplier overestimates how much
money will be created in the economy.
• B. the money multiplier underestimates how much
money will be created in the economy.
• C. the reserve ratio is not fully functioning, and should
be raised.
• D. the reserve ratio is not fully functioning, and should
be lowered.

A.
11-61
• If the money multiplier is approximated to be
4, then the reserve ratio must be:
•
• A. 25 percent.
A
• B. 2.5 percent.
• C. 5 percent.
• D. 4 percent.

11-62
• If the money multiplier is approximated to be 10,
it means:
•
• A. banks create 10 dollars in deposits from each
original deposit of a dollar.
• B. banks create approximately 10 times the
amount of cash in the economy.
• C. the economy overall has 10 times the amount
of deposits as cash that exists.
• D. All of these are true.

D
11-63
 Measuring money
• The money supply is the amount of money
available in the economy.
– The money supply is managed by the Fed.
• The Fed classifies different types of money by
their liquidity.
– The monetary base includes cash and bank
reserves, sometime referred to as hard money.
– M1 includes cash plus checking account balances.
– M2 includes M1 plus savings accounts and other
financial instruments.

11-64
 Measuring money
Each measure provides a distinct understanding
of the financial system.
Hard money, M1, and M2 over time

Trillions of U.S. dollars

• M1 indicates liquidity.
10
M2 • M2 indicates savings.
9
8 • M2 is a measure of the
7
6
money multiplier when
5 compared to the
4
3 Hard money
monetary base.
2 M1

1
0
1984 1989 1994 1999 2004 2009

11-65
 Managing the money supply
• The central bank is the institution responsible
for managing the nation’s money supply and
coordinating the banking system.
• In the U.S., the central bank is the Federal
Reserve, which has been mandated by Congress
to conduct monetary policy to perform two
essential functions:
1. Manage the money supply.
2. Act as a lender of last resort.
• Monetary policy refers to the actions made by
the central bank to manage the money supply.
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 Managing the money supply
The Federal Reserve System has a seven-member Board of Governors
and twelve regional banks that collectively act as the central bank of
the U.S.

Minneapolis

Boston
Chicago
Cleveland
Philadelphia NewYork
Kansas St. Board of Governors,
San City Louis Richmond Washington D.C.
Francisco

Atlanta
Dallas

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 Managing the money supply
• In addition, five of the twelve regional bank
presidents serve on the Federal Open Market
Committee, or FOMC.
– Carries full responsibility for setting the overall
direction of monetary policy and guiding the money
supply.
• The Fed has a twin or dual mandate:
– Ensuring price stability: Enacting monetary policy that
meets the needs of the economy while keeping prices
constant over time.
– Maintaining full employment: Enacting monetary
policy that keeps the economy strong and stable.

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 Tools of monetary policy
• The Fed achieves these mandates by managing
the money supply through three main tools.
1. The reserve requirement is the amount of money
banks must hold in reserve.
2. The discount window is the lending facility that
allows banks to borrow reserves from the Fed.
• The discount rate is the interest rate charged by the Fed
for loans through the discount window.
3. Open-market operations are sales or purchases of
government bonds by the Fed to or from banks
on the open market.
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 Tools of monetary policy
• These transactions directly impact the money supply.
– Contractionary monetary policy is when money supply is
decreased to lower aggregate demand.
– Expansionary monetary policy is when money supply is
increased to raise aggregate demand.
• Open market operations also affect the inter-bank
lending market, the federal funds market.
– The federal funds rate is the interest rate at which banks
lend reserves to one another.
• The Fed affects the federal funds rate through
changes in the supply of reserves by conducting
contractionary and expansionary monetary policy.

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• The definition of M2 includes:
•
• A. cash and checking account balances.
• B. hard money and savings account balances.
• C. cash, checking account, and savings account
balances.
• D. cash, checking accounts, savings accounts,
and other financial instruments where money is
locked away for a specified period of time.

D
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• The Federal Reserve System has 12:
•
• A. regional banks.
• B. members on its Board of Governors.
• C. member banks.
• D. basic functions.

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• The "dual mandate" refers to the:
•
• A. twin responsibilities of the Federal Reserve, to use
monetary policy to ensure price stability and maintain
full employment.
• B. orders given to both the Federal Reserve and the
Treasury department to ensure price stability.
• C. responsibility given to the Federal Reserve and the
Congress to conduct monetary and fiscal policy
respectively, to ensure price stability.
• D. None of these is true.

A
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• Which of the following tools is used most often
by the Fed for changing the supply of money?
•
• A. Open market operations
• B. Reserve requirement
• C. Discount window
• D. Interest rate

A
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• If the Fed wanted to increase the money supply, they
could:
•
• A. increase the reserve requirement, reducing the
reserve ratio.
• B. decrease the reserve requirement, reducing the
reserve ratio.
• C. increase the reserve requirement, increasing the
reserve ratio.
• D. decrease the reserve requirement, increasing the
reserve ratio.

B
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• The lending facility that allows any bank to
borrow reserves from the Fed is called:
•
• A. the discount window.
• B. the reserve window.
• C. the reserve rate.
• D. the borrower of last resort.

A
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• Open-market operations are:
•
• A. sales or purchases of government securities,
by the Fed to or from banks on the open market.
• B. regulations that sets the minimum fraction of
deposits banks must hold in reserve.
• C. allows any bank to borrow reserves from the
Fed at a special interest rate, called the discount
rate.
• D. None of these is true.

A
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• If the Fed wishes to increase the money supply, it can:
•
• A. sell a bond to bank, and take the money it receives
in exchange out of circulation in the economy.
• B. buy a bond from a bank, giving the bank cash in
return, which it can then lend out.
• C. sell a bond to a bank, and take the money it
receives and lend it out to someone else.
• D. buy a bond from a bank, requiring the bank to hold
the money it receives as excess reserves.

B
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 The economic effects of monetary policy
• Monetary policy primarily influences the economy through changes
in the interest rate.
• Changes in the interest rate, in turn, affect the appeal of borrowing
and lending, which can have significant impacts on the economy.

The liquidity-preference model • The liquidity-preference model

Interest rate, r refers to the idea that the
Monetary supply quantity of money people
want to hold is a function of
the interest rate.
– This means the money demand
r* curve slopes downward.
– The Fed sets the money supply,
Monetary
demand which means the money supply
curve is set by monetary policy.
Q*
Quantity of money

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 The economic effects of monetary policy
The liquidity-preference model explains how the
Fed’s actions can change interest rates.

Shifts in the money supply curve

Interest rate, r
• Expansionary monetary
MSc MS* MS e
policy results in a higher
quantity of money and
rc
lower interest rates.
• Contractionary monetary
r*
policy results in a lower
re
MD quantity of money and
Qc Q* Qe higher interest rates.
Quantity of money

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 Active Learning: The money supply
For each of the following situations, indicate the
effect (increase or decrease) on the money
supply and interest rate.

Change in money
Situation supply Change in interest rate
The Federal Reserve
conducts open-market
bond purchases.
The Federal Reserve sells
government bonds on the
open market.

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 Active Learning: The money supply
For each of the following situations, indicate the
effect (increase or decrease) on the money
supply and interest rate.

Change in money
Situation supply Change in interest rate
The Federal Reserve
conducts open-market Increase Decrease
bond purchases.
The Federal Reserve sells
government bonds on the Decrease Increase
open market.

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 Expansionary monetary policy
Expansionary monetary policy Expansionary monetary policy and the AD/AS model

Interest rate, r Price level

LRAS

MS 1 MS 2 SRAS

P2
r1 P1

r2 AD 2

Money
demand
AD 1
Q1 Q2 Y1 Y2
Quantity of money Real GDP

• During a recession, expansionary • The aggregate demand curve shifts out.

monetary policy decreases the interest • Price and output increase.
rate.
• Cheaper to borrow and less rewarding
to save money.
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 Contractionary monetary policy
Contractionary monetary policy Contractionary monetary policy and the AD/AS model
Interest rate, r Price level
LRAS
MS MS SRAS
2 1

P1
r2 P2

r1 AD 1

AD 2
MD

Q2 Q1 Y2 Y1
Quantity of money Real GDP

• During overheating, contractionary • The aggregate demand curve shifts in.

monetary policy increases the interest • Prices and output decrease.
rate.
• More expensive to borrow and
encourages saving.
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 The economic effects of monetary policy
Analyzing the use of monetary policy shows how
policy can work in ideal cases, but it is rare for the
world to work so cleanly.

Challenges Advantages
• The Fed faces time lags • The Fed does not have to
and imperfect wait for politicians to come
information. to a policy consensus.
– A few months can pass • The Fed is made up of
before the Fed’s actions prominent economic
make their impact. policy-makers.
– Mistiming of monetary – It is their job to make sure
policy could make they fully understand the
economic conditions nuances of the overall
worse. economy.

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 Two interconnected markets
• One concern is how the lending market is affected
during times of expansionary monetary policy.
• That is, it may be that extra borrowing causes a
shortage of loanable funds, as the demand from
borrowers increases and the supply from savers
decreases.
• This leads to two very different models of the way
the world works:
1. The Federal Reserve determines the interest rate by
managing the supply and demand for money.
2. The market as a whole determines the interest rate
by the interaction of savers and borrowers.

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 Two interconnected markets
These two models are connected by the dynamics of the economy.

Liquidity-preference model Market for loanable funds

Interest rate Interest rate

MS 1 MS 2 Savings 1

Savings 2
r1 r1

r2
r2

MD
Investment

Q1 Q2 Q1 Q2
Quantity of dollars Quantity of dollars

• When the Fed acts to lower interest • Some of this increase in output is saved.
rates, it spurs borrowing and increases • Shifts the supply of loanable funds outward
output in the economy. to equalize interest rates between models.
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 Summary
• The three main functions of money are a store
of value, a medium of exchange, and a unit of
account.
• Money needs to have stability of value to be
convenient.
• Banks create money by lending through the
fractional reserve banking.
• The money multiplier is the ratio of money
created by the lending activities to the money
created by the central bank.

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 Summary
• The Fed classifies different types of money by
their liquidity.
– M1 includes hard money plus checkable deposits.
– M2 includes M1 plus money in savings accounts
and CDs.
• The central bank maintains the money supply
and coordinates the banking system.
• The Federal Reserve has a dual mandate:
– Ensure price stability.
– Maintain full employment.

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 Summary
• Monetary policy includes changing the reserve
requirement, lending through the discount
window, and engaging in open-market
operations.
• The liquidity-preference model explains that
the demand for money is a function of the
interest rate.
• The Fed may want to engage in expansionary
or contractionary monetary policy depending
on the economic circumstances.

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