Understanding Aggregate Demand and Monetary Policy

What is the Wealth Effect in economics?

The Wealth Effect refers to the decrease in purchasing power of money during inflation, affecting the money held by people and firms.

How does the Interest Rate Effect relate to inflation?

Higher prices during inflation lead to less money in banks, making borrowing more expensive as interest rates increase.

What is the Exchange Rate Effect on exports during inflation?

Higher prices decrease demand from other countries, leading to a decrease in exports.

What factors can shift the Aggregate Demand (AD) curve?

Factors include consumer confidence, real value of assets, size of existing physical capital, and government policies.

How does consumer confidence affect the AD curve?

Increased consumer confidence shifts the AD curve to the right, while decreased confidence shifts it to the left.

What impact does the real value of household assets have on the AD curve?

An increase in the real value of household assets shifts the AD curve to the right, while a decrease shifts it to the left.

How does the existing stock of physical capital influence firm spending?

Firms will spend more if the existing stock of physical capital is low and less if there is a large existing supply.

What are the two main tools of government policy that can shift the AD curve?

Fiscal Policy (changing taxes and government spending) and Monetary Policy (adjusting the money supply).

What happens to the AD curve when the money supply increases?

An increase in the money supply shifts the AD curve to the right.

What are sticky wages in economics?

Sticky wages refer to nominal wages that are slow to react to changes in the economy, including compensation and benefits.

What factors can shift the Short-Run Aggregate Supply (SRAS) curve?

Factors include productivity, expectations about inflation, government actions, and resource input prices.

How does productivity affect the SRAS curve?

Increased worker productivity shifts the SRAS curve to the right, while decreased productivity shifts it to the left.

What role do expectations about inflation play in shifting the SRAS curve?

If inflation is expected to rise, workers demand higher wages, shifting the SRAS left; expectations of lower inflation shift it right.

How do government actions like subsidies affect the SRAS curve?

Subsidies to producers shift the SRAS curve to the right, while new taxes on output shift it to the left.

What happens to the SRAS curve when the price of key raw materials increases?

An increase in the price of key raw materials shifts the SRAS curve to the left.

What is the relationship between input prices and the SRAS curve?

Higher input prices, such as commodities and raw materials, decrease supply, shifting the SRAS curve left; lower prices shift it right.

What is the effect of government fiscal policy on the AD curve?

Fiscal policy can shift the AD curve by raising or lowering taxes and changing government spending.

What is the effect of monetary policy on the AD curve?

Monetary policy can shift the AD curve by adjusting the quantity of money in the economy.

What does a decrease in the aggregate price level imply for export demand?

A decrease in the aggregate price level increases export demand.

How does a decrease in consumer confidence affect the AD curve?

A decrease in consumer confidence shifts the AD curve to the left.

What is the significance of the AD curve in the GDP equation?

The AD curve represents the demand for goods and services in the economy, influencing overall economic activity.

How does the size of existing physical capital impact economic growth?

A low existing stock of physical capital encourages firms to invest more, potentially leading to economic growth.

What does the LRAS curve represent?

The LRAS curve represents the potential output and full employment over the long run.

What is stagflation characterized by?

Stagflation is characterized by high unemployment, low output, and high inflation.

Why is stagflation a challenge for policymakers?

Stagflation presents a challenge because inflation is typically addressed by reducing aggregate demand, while output problems are addressed by increasing aggregate demand, which can worsen the situation.

What is an inflationary gap?

An inflationary gap occurs when the new equilibrium RGDP is higher than LRAS, resulting in higher price levels due to demand-pull inflation.

What causes demand-pull inflation?

Demand-pull inflation is caused by a shock on the demand side of the economy.

What is cost-push inflation?

Cost-push inflation occurs due to a negative supply shock that raises the price level while lowering output.

What is stagflation in economic terms?

Stagflation is a combination of high price levels and low RGDP, presenting a dilemma for economic policy.

What is leakage in economics?

Leakage refers to money that is effectively out of the circular flow of the economy.

What are autonomous expenditures?

Autonomous expenditures are spending that occurs regardless of income, which can lead to changes in total expenditure and aggregate demand.

What is the formula for the Marginal Propensity to Consume (MPC)?

MPC = △ Consumption / △ YD (disposable income).

What is the goal of Keynesian Economics?

Keynesian Economics aims to stimulate aggregate demand by increasing government spending.

What are the two types of stabilization policies?

The two types of stabilization policies are monetary policy, which controls the money supply, and fiscal policy, which involves government actions.

What are the two categories of fiscal policy?

The two categories of fiscal policy are tax policy and transfer payments, and direct government spending.

How do increasing taxes affect disposable income?

Increasing taxes reduces the disposable income of consumers and firms, which is contractionary and shifts aggregate demand left.

What are transfer payments?

Transfer payments are direct payments from the government, including stimulus checks, social security, welfare, unemployment benefits, and Medicare/Medicaid.

What does direct government spending include?

Direct government spending includes expenditures on national defense (military) and education at federal, state, and local levels.

What is the Tax Multiplier Equation?

The Tax Multiplier Equation is -((MPC)/(1-MPC)).

How can the multiplier effect influence fiscal policy?

The multiplier can dull the effects of fiscal policy; for example, if the MPS is high, an expansionary fiscal policy may be less effective.

What is an asset in economic terms?

An asset is an item of value expected to provide the holder with future benefits.

What are the three kinds of assets?

The three kinds of assets are real, intangible, and financial.

What is the effect of high MPS on fiscal policy effectiveness?

A higher MPS means that consumption and investment will have a lesser effect on aggregate demand if money is being saved rather than spent.

What are the three kinds of assets?

Real, intangible, and financial assets.

What are real assets?

Physical assets such as real estate or land ownership.

What are intangible assets?

Property that does not have a physical form, such as copyrights or trademarks.

What are financial assets?

Currency, stocks, and bonds.

What does liquidity of assets refer to?

How easily assets can be turned into cash.

Which assets are considered the most liquid?

Currency (cash) and demand deposits.

Why are real and intangible assets considered non-liquid?

They cannot be easily traded for cash.

What is a bond?

A promise by the government or business to repay a certain amount of money within a particular time frame.

How does a bond differ from a stock?

A bond allows someone to become a lender to a company, while a stock represents partial ownership in a company.

How is equity (net worth) determined for a company?

By subtracting liabilities from assets.

What is a liability?

What the company owes to individuals.

What is financial risk?

The danger of losing money for individuals, businesses, or the government.

What are interest rates?

The cost of borrowing money.

How do interest rates affect bond prices?

Bond prices move inversely to interest rates; if interest rates increase, bond prices decrease, and vice versa.

What role does the Federal Reserve System play in the economy?

It acts as the central bank for the United States and influences interest rates.

What is the Nominal Interest Rate?

The rate of interest paid for a loan, unadjusted for inflation.

What is the Real Interest Rate?

The nominal interest rate adjusted for inflation, calculated as: Real interest rate = nominal interest rate - inflation.

What is money?

Any asset accepted as a means of payment for goods and services.

What are the three functions of money?

Medium of exchange, unit of account, and store of value.

What are the two kinds of money?

Commodity money and fiat money.

What is commodity money?

Money that has value and performs the function of money, such as silver, gold, or cigarettes.

What is fiat money?

Money that serves as money but has no other use or value, such as paper money or coins.

What is the money supply?

The total amount of money in circulation.

How is the money supply measured?

Using monetary aggregates designated as M1 and M2.

What is included in the monetary base (M0 or MB)?

Currency in circulation and in bank reserves, including deposits.

What constitutes M1?

Currency held by the public, checkable bank deposits, and travelers checks.

What constitutes M2?

M1 plus savings deposits, money market deposits, certificates of deposit (CDs), time deposits, and money market funds.

What is M0 in terms of money supply?

Monetary base (MB); measure of all the currency in circulation and deposits kept by banks and other depository institutions in their accounts at the Federal Reserve.

What does M1 include?

Cash, Traveler's Checks, Savings Accounts, and Checkable Deposits.

What is M2 in terms of money supply?

M1 plus other 'near money' such as certificates of deposit (CDs) and mutual funds.

How is Future Value calculated?

Future Value = $X in N Years = $X (1 + ir)^N.

What is the formula for Present Value of $X in 1 Year?

Present Value = $X / (1 + ir)^N.

What role do banks play in the economy?

Banks make loans and receive deposits, holding funds or securities for depositors.

What is a demand deposit?

Money deposited in a commercial bank in a checking account.

What is the purpose of a balance sheet for banks?

To monitor assets, liabilities, and net worth.

What are reserve requirements for banks?

A certain percentage of money that banks must keep in reserves.

What are excess reserves?

Any amount over a bank's required reserves, which can expand the money supply.

What is Fractional Reserve Banking?

A system where banks loan out a portion of deposits while keeping the rest as required reserves.

How is the money multiplier defined?

Money Multiplier (MM) = 1 / rr (reserve ratio).

How do you calculate the Actual Money Multiplier (AMM)?

AMM = MS / MB (Money Supply / Monetary Base).

What is the difference between monetary base (MB) and money supply (MS)?

MB includes bank reserves and currency in circulation, while MS includes checkable bank deposits and currency in circulation.

What is Monetary Policy?

Actions taken by a central bank to monitor a nation's money supply and interest rates.

What is an expansionary monetary policy?

A policy aimed at increasing the money supply and lowering interest rates to encourage economic growth.

What is a contractionary monetary policy?

A policy aimed at decreasing the money supply and raising interest rates to stabilize economic growth during high inflation.

What are the three tools of the Central Bank to influence interest rates?

Open market operations, required reserve ratio, and discount rate.

What are open market operations?

Actions by the central bank to change the money supply by buying or selling government bonds.

How does the Federal Funds Rate affect interest rates?

An increase in the Federal Funds Rate results in higher interest rates on mortgages and consumer loans.

What happens during an economic recession in terms of monetary policy?

The central bank typically implements expansionary policy to increase money supply and lower interest rates.

What is the effect of a contractionary monetary policy?

It is used when unemployment is too low and output and inflation are too high, aiming to stabilize economic growth.

What happens to interest rates when the federal funds rate is lowered?

Interest rates decrease.

What is the required reserve ratio in the context of monetary policy?

It is the amount of reserves that banks must hold at a given time, established by the central bank.

How does raising the reserve ratio affect a bank's ability to loan money?

It reduces the bank's ability to loan out money.

What action can the central bank take during high inflation regarding the reserve ratio?

The central bank can raise the reserve ratio.

What is the effect of lowering the reserve ratio during a recession?

It encourages more loans and increases the money supply.

What is the discount rate?

It is the interest rate charged by the central bank for loans to financial institutions and commercial banks.

How does increasing the discount rate affect the money supply?

It slows the growth of the money supply.

What monetary policy action can the central bank take to encourage loans during economic hardship?

Lower the discount rate.