Relating the Money Market, Loanable Funds, and AD-AS

Summary:

Increase in government spending results in an increase in interest rates in the money market and loanable funds. This results in an increase in Aggregate Demand. Increasing Aggregate Demand increases price level and GDP. The Fisher Effect has a 1:1 ratio so that if the interest rate increases the price level must increase the same amount

Money Creation and Multiple Deposit Expansion

Summary:

Banks create money buy lending money. The initial loan multiplied by 1/ RR will give you the maximum amount of loans the bank can make. If any banks hold excess reserves it reduces the total amount of loans possible. The process of money being redeposited multiple times is Multiple Deposit Expansion.

Loanable Funds Market

Summary:

The supply of loanable funds depends on how much people have in banks. The more incentive people have to save, the more loanable funds there are. Increasing the demand for money in the money market increases the demand for loanable funds. An increase in the demand for loanable funds also increases the interest rate.

The FED- Tools of Monetary Policy

Summary:

The Reserve Requirement (RR) is the percentage of money from deposits that the bank must keep either as vault money or on reserve with a Fed branch. Altering the RR changes the money supply; the absence or lowering of the RR had a great impact on the cause of the Great Depression. Lowering the discount rate, or the interest rate the Fed charges commercial banks they have loaned money to, should increase the Fed’s loan activities. “Buy Bonds= Big Bucks”, if the Fed buys bonds, it means more money for the people which will ultimately raise the money supply.

Money Market

Summary:

Demand for money is downward sloping because as price level is higher, the quantity demanded is going to be lower. Increasing demand puts upward pressure on interest rate. Supply of money is not related to interest rate and is always constant; without a slope. Shifting the supply of money to the right, then they stabilize interest rate which is helpful in a recession.

Types and Functions of Money

Summary:

The most primitive type of money is commodity money. This is considered items used in place of money. Representative money is the type we use today and fiat money is like I.O.U. Money also has three functions. Money is a medium of exchange, a way for us to get things that we want. Money is also a unit of account in that we equate higher price to higher value or quality.

Fiscal Policy

Changes in expenditures or tax revenue as of the federal government 

2 tools: 

• Taxes - gov't can increase or decrease taxes
• Spending - government can increase or decrease spending 

Deficits, surpluses and debt 

Balanced budget:

• Revenues=expenditures

Budget deficit:

• Revenues < expenditures

Budget surplus:

• Revenues> expenditures

Gov't debt:

• Sum of all deficits- sum of all surpluses 

Gov't must borrow money when it runs a budget deficit from:

• Individuals 
• Corporations
• Financial institutions
• Foreign entities or foreign gov't 

Fiscal policy has two options 

• discretionary fp ( action) 

a.        Expansionary- think deficit 

2. Contractionary- think surplus 

• Non discretionary (no action)

Discretionary v automatic 

Disc: increasing or decreasing gov't spending and/or taxes in order to return the economy to full employment.

Disc policy involved policy makers doing fp in responds to an economic problem 

Auto: unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Auto fp takes place without policy makers having to respond to current economic problems.

Expansionary: combat a recession, gov't spending increase, taxes decrease

Contractionary: combat inflation, gov't spending decrease, taxes increase

Investment Demand Graphs

Real (r%) v. Nominal (i%)

what's the difference?

• Nominal is the observable rate of interest. Real subtracts our inflation (pi%) and is knot ex post facto

How do you compute the real interest rate (r%)? 

• r%=i% - pi%

What then, determines the cost of an investment decision?

• The real interest rate (r%)

Investment Demand Curve (ID)

what is the shape?

• Downward sloping

Why?

• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable 

Shifts in ID

cost of production:

• Lower costs shift ID ->
• Higher costs shifts ID<-

Business taxes:

• Lower bus taxes shift ID ->
• Higher <-

Technological change:

• New technology- >
• Lack of technological change <-

Stock of Capital:

• If an economy is low on capital, then ID ->
• If Econ has much capital then <-

Expectations:

• Positive expectation ->
• Negative expectations <-

Investment Demand

What is investment?

money spent or expenditures on: 

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes 
• Inventories (goods sold by producers)

Expected rates of return

How does business make investment decisions?

• Cost/ benefit analysis

How does business determine the benefits?

• Expected rate of return

How does business count the cost?

• Interest costs

How does business determine the amount of investment that they undertake?

• Compare expected rate of return to interest cost 

-if expected return > interest cost, then invest

- if expected return < interest cost, then do not invest

AD/AS Graphs

Full employment

• Full employment equilibrium where AD intersects SRAS and LRAS at the same point 

Recessionary Gap

• A recessionary gap exists when equilibrium occurs below full employment output

Inflationary Gap

• an inflationary gap exists when equilibrium occurs beyond full employment output 

Aggregate Supply

The level of Real GDP (GDP_r) that firms will produce at each price level (PL)

Long Run Aggregate Supply (LRAS): 

• period of time where input prices are completely flexible and adjust to changes in the price level 
• in the long-run, the level of GDP_r supplies is independent of price-level
• the LRAS marks the level of full employment in the economy (analogous to PPC)
• Because input prices are completely flexible in the long-run, changes in price-level do not change firms' real profits and therefore do not change firms' level of output. This means that the LRAS is vertical at the economy's level of full employment.

Short Run Aggregate Supply:

• period of time where input prices are sticky and do not adjust to changes in the price-level
• In the short run, the level of GDP_r supplied is directly related to the price level 
• 

Changes in SRAS 

1. an increase is seen as a shift to the right
2. A decrease is seen as a shift to the left 
3. The key to understand the shift is per unit cost of production 
4. Per unit cost of production= total input cost/ total output cost 

Determinants of SRAS shifts

1. Input prices
2. Productivity 
3. Legal institutional environment 

Input prices 

• domestic resources prices:
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)
• Foreign resource prices:
• Market power:
• Increases in resource prices will cause shifts to the left
• Decreases will cause shifts to the right 

Productivity = total output/ total inputs

• more productivity = lower unit production cost= SRAS shifts right 
• Lower productivity = higher unit production cost= shift to the left 

Legal-Institutional Environment 

·         taxes and subsidies:

·         Taxes ($ to gov't) on business increase per unit production cost = shift left

·         Subsidies($ from gov't) to business reduce per unit production cost = shift right 

·         Government regulation:

·         Gov't regulation created a cost of compliance = shift left 

·         Deregulation reduced compliance costs = shift right 

AD (Continued)

Determinants of AD

1.       Consumption:

·         Household spending affected by:

a.       consumer wealth:

                                                             i.      more wealth = more spending (AD shifts right)

                                                             ii.      Less wealth= less spending (AD shifts left)

b.      Consumer expectations:

                                                            i.      Positive expectations = more spending 

                                                            ii.      Negative expectations = less spending 

3. Household indebtedness:

                                                             i.      Less debt= more spending 

                                                             ii.      More debt= less spending 

4. Taxes:

                                                             i.      Less taxes= more spending

                                                             ii.      More taxes= less spending

2.       GDP

·         Investment spending sensitive to:

a.       the real interest rate:

                                                             i.      Lower real interest rate= more investment (AD shifts right)

                                                             ii.      Higher = less important (AD shifts left)

b.      Expected returns:

                                                             i.      Higher expected returns = more investment (AD shifts right)

                                                             ii.      Lower expected returns= less investment (AD shifts left)

•Expected returns are influenced by:

•Expectations of future profitability

•Technology

•Degree of excess capacity

•Business Taxes

3.       Government spending

                                                             i.      More government spending (AD shifts right) 

                                                             ii.      Less government spending (AD shifts left)

4.       Net exports 

a.       exchange rates (international value of ):

                                                            i.      Strong $= more imports, fewer exports (AD SHIFTS LEFT)

                                                            ii.      Weak $ = fewer imports, more exports (AD shifts right)

b.      Relative income:

                                                            i.      Strong foreign economy = more exports (AD shifts right) 

                                                            ii.      weak foreign economy = less exports  (AD shifts left) 

Aggregate Demand

Why is AD downward sloping?

1. Real-Balance Effect:

·         higher price levels reduce the purchasing power of money 

·         This decreases the quantity of expenditures

·         Lower price level increase purchasing power and increase expenditures (i.e. Balance in your bank is $50,000 but inflation erodes purchasing power, you're likely to reduce your spending)

2.    Interest Rate Effect:

·         when price level increases, lenders need to charge higher interest rates to get REAL return on their loans 

·         Higher interest rates discourage consumer spending and business investment (i.e. Increase in price leads to increase 5 to 25%. Less Liberty to take out a loan to improve business)

3.    Foreign Trade Effect:

·         when US price level increases, foreign buyers purchase fewer US goods and Americans buy more foreign goods 

·         Exports fall and imports rise causing real GDP to fall [X_n decrease](I.e. If price triples in US, Canada will no longer buy US goods causing quantity demanded to fall) 

Shifters of AD 

GDP= C+Ig+G+Xn

There are 2 parts to a shift in AD

1.    a change in C, Ig, G, and/ or Xn

2.    A multiplier effect that produces a greater change when the original change in the 4 components

• Increase= AD shifts right
• Decrease= AD shifts left