Macro Final Fall 2025 (chat)

The Federal Reserve (The Fed)

  • Role: Central bank of the U.S.; responsible for monetary policy.

  • Structure: Board of Governors, 12 regional Federal Reserve Banks, FOMC (Federal Open Market Committee).

  • Goals: Maximum employment, stable prices, moderate long-term interest rates (dual mandate).

Monetary Policy Instruments

  1. Open Market Operations (OMO)

    • Buying bonds → increases money supply → lowers interest rates

    • Selling bonds → decreases money supply → raises interest rates

  2. Reserve Requirements

    • Lower rr → more lending → money supply increases

    • Higher rr → less lending → money supply decreases

  3. Discount Rate

    • Lower discount rate → easier for banks to borrow → money supply increases

    • Higher discount rate → money supply decreases

Quantity Theory of Money

  • Equation: MV = PY

    • M = money supply

    • V = velocity (assumed constant in the classical view)

    • P = price level

    • Y = real output

  • Implies: Changes in M lead to proportional changes in P (if V and Y are constant).

  • Foundation for money neutrality.

2. AD-AS Model

Aggregate Demand (AD)

  • Shows relationship between price level and total spending.

  • Slopes downward because of:

    1. Wealth effect (higher price level reduces purchasing power)

    2. Interest rate effect (higher price level raises interest rates → lowers investment)

    3. Net exports effect (higher U.S. prices → exports fall)

Determinants of AD

Shifts AD if any component of GDP changes: C, I, G, NX
Examples:

  • ↑ consumer confidence → AD right

  • ↑ interest rates → AD left

  • ↑ government spending → AD right

  • ↓ foreign income → AD left

3. Sticky Wage Theory

  • Part of short-run aggregate supply (SRAS) explanation.

  • Wages are slow to adjust due to contracts, norms, or rigidity.

  • If price level unexpectedly rises:

    • Firms’ revenues ↑ but wages stay fixed → production becomes more profitable → output rises.

  • This creates an upward-sloping SRAS curve.

4. AD/AS Shifters

Shifters of AD

  • Changes in C, I, G, NX

  • Changes in taxes

  • Changes in expectations

  • Monetary or fiscal policy

  • Foreign economic conditions

Shifters of SRAS

  • Changes in input prices (e.g., oil)

  • Changes in wages (sticky short-run; flexible long-run)

  • Supply shocks

  • Changes in productivity

  • Changes in expected price level

Shifters of LRAS

  • Changes in:

    • Labor force

    • Capital stock

    • Technology

    • Natural resources

  • LRAS is vertical at full employment output (Y*).

5. Full Employment Output / LRAS

  • Y* = potential GDP / natural level of output

  • Determined by resources + technology

  • Not affected by price level

  • LRAS shifts only when long-run productive capacity changes.

6. Monetary Policy

Expansionary MP

  • Fed buys bonds / decreases interest rates → AD shifts right

  • Used during recessions

Contractionary MP

  • Fed sells bonds / raises interest rates → AD shifts left

  • Used to fight inflation

7. Theory of Excess Money Balances (Money → Interest Rates Mechanism)

  • When money supply increases:

    • Households hold more money than desired.

    • They buy interest-bearing assets → prices of bonds rise → interest rates fall.

    • Lower interest rates → more investment → AD shifts right.

8. Fiscal Policy

Expansionary Fiscal Policy

  • Increase G or decrease taxes → AD shifts right

Contractionary Fiscal Policy

  • Decrease G or increase taxes → AD shifts left

9. Deficit Spending & The Key Assumption

  • Standard AD analysis assumes:

    No crowding out.

  • Means: Borrowing to fund a deficit does not raise interest rates and reduce private investment.

  • This assumption simplifies the model so that G increases shift AD fully/rightward.

10. The Multiplier Effect

  • Additional spending leads to multiple rounds of increased consumption.

  • Multiplier = 1 / (1 – MPC)

  • Example: If MPC = 0.8 → multiplier = 5

  • A $1 increase in G can increase GDP by $5.

11. Long-Run Self-Correction

  • If economy is in recession:

    • Wages fall → SRAS shifts right → returns to Y*

  • If economy is overheating:

    • Wages rise → SRAS shifts left → returns to Y*

12. Limitations of Stabilization Policy

  • Time lags: recognition, implementation, and effect lags

  • Uncertainty about economic conditions

  • Political constraints

  • Crowding out (for fiscal policy)

  • Liquidity traps / zero lower bound

  • Potential ineffectiveness of expectations

13. Money Neutrality & The Classical View

  • In the long run:

    • Money supply affects nominal variables (price level)

    • Money supply does NOT affect real variables (output, employment, real wages)

  • Long-run belief: Economy returns to Y* regardless of M.

14. International Trade Basics

  • Absolute advantage: producing more with same resources

  • Comparative advantage: producing at a lower opportunity cost → basis for trade

  • Net exports (NX): exports – imports

  • Trade impacts AD via the NX component

  • Stronger dollar → ↓ exports, ↑ imports → AD decreases

  • Weaker dollar → ↑ exports, ↓ imports → AD increases