MACRO PART 2 Handout Guide (See Handouts for Help)SECTION 9a).docx

MACRO PART 2 Handout Guide (See Handouts for Help)
SECTION 9
a)-d) HO17 P2,3
SECTION 10
a)-c) HO17 P3
d) HO17 P4
e) I did in class
f) HO17 P7
g) HO17 P10
SECTION 11
a) HO18 P2
b) HO18 P5 top
c) HO18 ↓D↑S
d) HO18 ↑D↓S
SECTION 12
a) HO20 P4 top
b) HO21 P4 bottom
c) HO21 P5 top
d) HO21 P5 bottom
e) HO21 P6 top
f) HO21 P7 bottom right
SECTION 13
a) HO22 P6
b) HO22 P7 top
c) HO22 P7 bottom
d) HO23 I showed how in class
e) HO23 P1
f) HO23 P4 bottom
g) HO23 P3 or P4 top depending on what you did in f)
h) HO23 P5 bottom 2 graphs

SECTION 14
a) HO24 P1,2
b) HO24 P10 2 graphs
c) HO24 P12
d) HO24 P2
e) HO24 P3
f) HO24 P4
g) HO24 P6
SECTION 15
a) HO21 P4 bottom
b) HO21 P5 top
c) HO27 P8
d) HO25 P2
e) HO25 P3 only move to the left, not back
f) HO21 P3
g) HO27 P11
SECTION 16
a) HO26 P1
b) HO26 P2
c) HO26 P3 2 graphs
d) HO26 P4 other direction (decrease)
SECTION 17
a) HO27 P3 top 2 paragraphs
b) HO27 P9 top and P11. Also look at HO17 for 3 methods.
c) HO27 P6 and P8. Also look at HO17 for 3 methods.
d) HO27 P5 bottom graph. Ripple pages 8 bottom thru 11
e) HO27 P5 top graph. Ripple pages 6 thru 8
Handout #25P
Inflation
Up, Up and Maybe Away

Inflation is an ongoing process in which there is a broad
increase in the price level and money is losing its purchasing
value. Changes in the money supply cause changes in the price
level. Changes in the price level can be one-time or a persistent
rise in the rate at which the price level increases.
Demand-Pull Inflation
A one-time demand induced price increase comes from a
outward shift in aggregate demand, such as an increase in the
money supply or a component of GDP—C, I, G or NX.
The one-time demand induced increase will lead to an increase
in aggregate demand and the economy will be in an inflationary
gap—the price level will be higher, real GDP will be higher
than Qn and unemployment will be lower than Un. Since the
economy is self-regulating, the shortage in the labor market
with U < Un will lead to wages being bid up. Higher wages lead
to increased costs to producers, which in turn leads to a
decrease in SRAS back to Qn. Basically, a demand-induced
change leads the self-regulating economy back the full
employment level of real GDP, at a higherpricelevel.
Demand-pull inflation rises from continual outward shifts in
aggregate demand which are caused by continuous increases in
the money supply.
Continual increases in the money supply will lead to continual
increases in aggregate demand and the economy will be in
repeated inflationary gaps—in repeated cycles, the price level
will be higher, real GDP will be higher than Qn and
unemployment will be lower than Un. Since the economy is
self-regulating, the shortage in the labor market with U < Un
will lead to wages being bid up. Higher wages lead to increased
costs to producers, which in turn leads to a decrease in SRAS
back to Qn. Basically, continuous increases in the money supply
leads the self-regulating economy back the full employment
level of real GDP, at higher and higher price levels—a demand-

pullinflation spiral.
Cost-Push Inflation
A one-time supply induced price increase comes from an inward
shift in aggregate supply, such as an oil price shock.
The one-time supply shock will lead to a decrease in short-run
aggregate supply and the price level will be higher, real GDP
will be lower than Qn and unemployment will be higher than
Un. Since the economy is self-regulating, the surplus in the
labor market with U > Un will lead to wages being bid down.
Lower wages lead to lower costs to producers, which in turn
leads to an increase in SRAS back to Qn. Basically, a one-time
supply-induced change leads the self-regulating economy right
back to the full employment level of real GDP, at the
originalprice level.
Inflation that results from an initial increase in costs is called
cost-push inflation. The two main sources of increases in costs
are an increase in wage rates or an increase in the prices of raw
materials. Inflation occurs only if, in response to the higher
price level, the force that initially decreased aggregate supply
recurs so that aggregate supply continues to decrease and, at the
same time, the Fed continues to increase the money supply and
in turn aggregate demand—a cost-pushinflation spiral.
Expected Inflation
Expectations play a large role in economic decisions.
Expectations are formed in basically two ways: adaptive
expectations and rational expectations. Adaptive expectations
are made based on what has happened in the past. History is
projected into the future. If inflation has been at 3% per year,
you will expect inflation to be 3% this year and make your
decisions accordingly. Rational expectations are based on

adaptive expectations but include any additional knowledge
available to you. Your decision is based on all relevant
knowledge. If the Fed announces that it is targeting an inflation
rate of 2%, you would change your forecast to a lower rate of
inflation, even if the rate has been 3% for several years.
When inflation is correctly anticipated, the money wage rate
changes to keep up with the anticipated inflation; money wage
rates are real wage rates plus expected inflation rates. So when
the AD curve shifts rightward, increasing the price level, the
money wage rate increases and the SRAS curve shifts leftward
simultaneously If the increase in the price level is fully
anticipated, then the money wage rate rises by the same
percentage so that the real wage rate remains constant. There
are no deviations from full employment. The magnitude of the
shift in AD equals that in SRAS so that actual GDP remains
equal to potential GDP and the economy moves up along the
LRAS curve with no change in GDP—just a higher price level
as expected.
If inflation is not perfectly anticipated, the money wage rate
changes but by a different percentage than the price level. As a
result, the real wage rate changes and there are deviations from
full employment. (Real wage rate = money wage rate/price
level. If the price level increases more than expected inflation,
the denominator increases more than the numerator and real
wage decreases, causing firms to hire more labor and increase
output. If price level increases less than expected inflation,
denominator increases less than numerator and real wage
increases, causing firms to hire less labor and decreasing
output.) So if inflation is not correctly anticipated, there will be
a movement along the SRAS and output will change. If inflation
is correctly anticipated, there will not be any change in output
along the SRAS.
If aggregate demand grows faster than anticipated, the price
level is higher than expected, real GDP exceeds potential GDP,
and the economy behaves as if it were in a demand-pull

inflation.
If aggregate demand grows slower than anticipated, real GDP is
less than potential GDP and the economy behaves as if it were
in a cost-push inflation.
Real GDP
Price Level
$
LRAS
Qn
AD
AD1
SRAS

Q1
P
P1
P2
SRAS1
Price Level
$
LRAS
AD

AD1
(Money supply increases)
SRAS
P
P1
P2
SRAS1
(demand-pull)
AD2

SRAS2
(demand-pull)
P5
P4
P3
SRAS3
(demand-pull)
AD3

P6
Real GDP
Qn
Q1
Price Level
$
LRAS
AD
SRAS

Real GDP
Qn
Q1
P
P1
SRAS1
1
2
SRAS3

(cost-push)
AD
Real GDP
Price Level
$
LRAS
Qn
AD1

SRAS
Q1
P
P1
P2
SRAS1
(cost-push)
AD2

SRAS2
(cost-push)
P5
P4
P3
AD3
P6
Real GDP
Price Level

$
LRAS
Qn
AD
AD1
SRAS
P
P1
SRAS1

ADActual
Real GDP
Price Level
$
LRAS
Qn
AD
SRAS
Q1

P
P1
PEXPECTED
ADExpected
EXPECTED INFLATION LOWER THAN ACTUAL
INFLATION SO LOWER ( IN MONEY WAGES (SMALLER (
SRAS
SRAS1
SRAS1
EXPECTED INFLATION HIGHER THAN ACTUAL
INFLATION SO BIGGER ( IN MONEY WAGES (LARGER (
SRAS

P
P1
PEXPECTED
ADExpected
Page 6 of 6
#26P
4/9/13
Handout #24P
Fiscal Policy
Mr. Fix-It
So now let’s look at government’s tinkering with the economy.
Fiscal policy is when the government uses its spending or taxes
to deliberately smooth out the macroeconomic fluctuations of
the business cycle or achieve other economic goals such as
stable price, low unemployment, and economic growth.
· Expansionary fiscal policy tries to raise aggregate demand

(AD) or total expenditures (TE). An increase in government
spending (G) would increase AD/TE. A decrease in taxes would
raise disposable income which would increase consumption (C),
which in turn would increase AD/TE. This type of fiscal policy
would be used for a recessionary gap.
· Contractionary fiscal policy tries to decrease raise aggregate
demand (AD) or total expenditures (TE) by reducing
government spending (G) or raising taxes which lowers
disposable income and decreases consumption (C), which in
turn would increase AD/TE. This type of fiscal policy would be
used for an inflationary gap.
There two other ways to look at government fiscal policy. The
first is automatic fiscal policy. This happens when government
spending automatically contracts without any action having to
be undertaken by anyone. The best example of this is when a
recession starts to kick in, workers lose their jobs. The workers
go to the unemployment office and file unemployment claims
for benefits. The increase in benefits automatically increases
government spending which is precisely the expansionary fiscal
policy that you would want to apply.
The second is discretionary fiscal policy which requires
someone in government to do something to initiate and
implement policy action. In general, this means Congress has to
act because they control government expenditures through the
budget and taxes.
There are three states of the government budget: surplus, deficit
and balanced. A government surplus exists when government
tax revenues and other income exceeds government
expenditures. There is an excess of funds left over and
government enters the loanable funds market as a lender. A
budget deficit occurs when government spending outstrips the
money it receives, and there is a shortage of funds. Government
will operate as a borrower in the loanable funds market to cover
its budget shortfall. When the budget is balanced, money in will
equal money out for the government.

In recent times, the US government had operated “in the red” by
running deficits. Continual deficits have added to the growing
public debt or what the government owes its creditors, now
exceeding $16.7 trillion. This situation creates a generational
imbalance where the current generation is enjoying lower taxes
and benefits while passing off the obligation to fully cover
those benefits to future generations.
There are two categories of budget deficits, structural and
cyclical. Structured deficits are planned to be deficits. This
happens when Congress deliberately passes a budget where
expenditures exceed revenues. This type of deficit would occur
even if the economy were operating at full employment. A
cyclical deficit is the part of the deficit that occurs when the
economy takes a downturn in economic activity, adding more to
the total. So the total deficit equals the structural plus the
cyclical deficit.
There are three government multipliers that operate on fiscal
policy changes.
· The expenditure multiplier is the multiplication effect of a
change in government spending on goods and services (G) on
aggregate demand or total expenditures. When G increases, real
GDP (Y) increases, which in turn increases consumption (C) as
the spending works its way through the economy. If the
expenditure multiplier is 5, then a $100 increase in G, will raise
AD/TE by $500.
· The autonomous tax multiplier is the multiplication effect of a
change in taxes on aggregate demand or total expenditures. A
decrease in taxes will raises disposable income (YD) which in
turn raises consumption (C) and thus AD/TE. However, this
fiscal policy multiplier will have a smaller effect on AD/TE
than the expenditure multiplier because of the marginal
propensity to consume (MPC). Since the change in YD will be
multiplied by the MPC which is less than 1, AD/TE will not
increase by the whole amount of the tax decrease. If the MPC
is .8, the tax multiplier will be 5 calculated by [1/(1-MPC)]. So

if taxes are lowered by $100, YD will increase by $100 and C
will increase by .8*$100, or $80. Then AD/TE will rise by
$80*5 or $400. Note this is less than the $500 increase in
AD/TE that the expenditure multiplier produced on $100 change
in government spending.
· The balanced budget multiplier is the multiplication effect on
aggregate demand or total expenditures from a simultaneous
equal change in government spending and taxes that does not
crease a surplus or deficit. It will have a small positive or
negative effect because the expenditure multiplier has a larger
impact than the offsetting tax multiplier. If fiscal policy
increased both G and taxes by $100, the increase in G would
result in +$500 in AD/TE while the increase in taxes would
yield -$450. So the net effect would be +$50.
Expansionary fiscal policy applied to a recessionary gap in the
AD/AS model would look like the graph below. First, the initial
fiscal policy would increase aggregate demand, shifting the AD
curve to the right. As the multiplier effects build, the AD curve
shifts all the way out to return the economy to full employment.
Contractionary fiscal policy applied to an inflationary gap in the
AD/AS model would work the other way. First, the initial fiscal
policy would decrease aggregate demand, shifting the AD curve
to the left. As the multiplier effects build, the AD curve shifts
all the way in to return the economy to full employment.
If you know the amount of the gap of real GDP that is needed to
bring the economy to full employment, you can calculate the
size of the fiscal policy you need to implement. The dollar
amount will be different if changing government spending is the
method used or if tax changes are used.
In the TP/TP model, expansionary fiscal policy applied to a
recessionary gap in the economy would look like the graph
below. If the economy is in a recessionary gap, Qe is less than

Qn and the TE line should shift up to the point where
TP=TE=QN. Let’s say that the gap in Real GDP is $5000. Using
the MPC of .8 and multiplier of 5, we can calculate the change
in G that is need to bring the economy back to full employment
by dividing the gap, $5000 by the multiplier 5. That means we
need to increase government spending by $1000 so when it is
multiplied by 5 , we will get the $5000 we need to close the
gap.
In the TP/TP model, contractionary fiscal policy applied to an
inflationary gap in the economy would look like the graph
below. If the economy is in an inflationary gap, Qe is greater
than Qn and the TE line should shift down to the point where
TP=TE=QN. Let’s say that the gap in Real GDP is again $5000.
Using the MPC of .8 and multiplier of 5, we can calculate the
change in taxes that is need to bring the economy back to full
employment by dividing the gap, $5000 by the multiplier 5 and
then dividing the result by the MPC. The tax increase would
thus need to be $1250, as compared to the $1000 ΔG above, A
increase in taxes of $1250 would give a decrease in
consumption of .8*$1250 or $1000 which is what we need to
close the $5000 gap with a multiplier of 5
There are real world problems with implementing fiscal policy,
besides the fact that precise knowledge of what should be done
is not achievable. There are five “lag” problems that really get
in the way of effectively correcting the economy’s movements
· The data lag: Policymakers are not aware of changes in the
economy as soon as they happen because the data is not yet
available. Data statistics take time to accumulate and develop to
measure what is happening in the economy.
· The wait-and-see lag: After the data indicates a change in the
economy, policymakers will usually wait to see if the change is

temporary or ongoing. Data can bounce up and down from
month to month.
· The legislative lag: Once policymakers decide that there has
been a change in the economy, a decision has to be reached on
whether or not to implement fiscal policy. If policy is to be
implemented, a particular plan of fiscal policy has to be
proposed (President or Congress), politically debated, amended,
and passed by Congress. This can take many months.
· The transmission lag: After the fiscal policy is passed, it has
to move through the bureaucratic process to be implemented.
This might include bids, design, contracts etc. and could take
quick a long time—maybe years.
· The effectiveness lag: After the fiscal policy is actually
implemented, it takes time to work its way through the
economy.
The net effect of these lags is that by the time the fiscal policy
actually takes effect, the economic problem 1) may no longer
exist, 2) may not exist to the degree it did, or 3) may have
changed altogether to another problem. So the fiscal policy may
actually cause a new problem such as over-correction.
One other issue with fiscal policy is crowding-out. Crowding-
out occurs when an action by the government, quite often taken
to implement fiscal policy, causes an opposite movement in the
private sector. For example, when government spending (G)
increases, any budget deficit will also increase, and the
government enters the loanable funds market as a borrower.
Real interest rates are driven up to a higher level because of the
increase in the demand for loanable funds. The increase in the
real interest rate in turn, decreases both consumption and
investment which offsets the expansionary effects on real GDP

from the increase in government spending. Another example
would be if government spends more on building public
libraries, private sector spending on books could decrease,
causing consumption to fall.
There can be no crowding-out, partial crowding-out, or
complete crowding-out. With no crowding-out, fiscal policy has
its full impact on real GDP. Partial crowding-out causes fiscal
policy to have a smaller impact on real GDP because of the
offset by the private sector. Complete crowding out results in no
change in real GDP when fiscal policy is implemented by the
government.
For a recessionary gap, you can see the three different effects of
crowding-out below.
In an inflationary gap, just the opposite occurs.
Fiscal policy can have effects on the supply side of the economy
as well as on aggregate demand. Imposing a tax on income—
labor, interest, and capital—has an effect on the economy in
several ways. First, a tax on labor income reduces the supply of
labor. That reduction in the supply of labor causes potential
GDP to decrease and reduces output in the short-run and long-
run. The before-tax wages rise but the after-tax wages fall—
referred to as the income tax wedge. Since employers are paying
the higher before-tax wages, they employ less labor and since
workers are only receiving the lower after-tax wage, less labor
is supplied.
A decrease in potential real GDP along the production function
will shift the LRAS and the SRAS into the left causing a
decrease in QN and an increase in the price level.
SHAPE * MERGEFORMAT

Taxes on consumption add to the tax wedge. Taxes on
consumption raise the prices worker have to pay for goods and
services which is equivalent to a drop in the real wage rate. The
higher are the taxes on goods and services, the lower is the
after-tax wage rate, and the lower the incentive to supply labor.
Taxes on interest income and capital earnings also affect the
incentive to save and invest. A tax on interest income decreases
the supply of loanable funds. The leftward shift in the supply of
loanable funds increases the before-tax real interest rate but
also creates a tax wedge so that the after-tax real interest rate
falls. Investors would pay a higher interest rate on funds
borrowed and savers would earn a small amount on funds saved.
Because of the tax wedge effects of taxes on employment and
saving, a higher tax rate does not always result in higher tax
revenues. Tax revenues are calculated by the tax rate times the
tax base or earnings. But if a higher tax rate causes reduced
labor hours, the tax base could actually decrease more than the
increase in the tax rate and tax revenues would go down rather
than up. The Laffer curve shows this relationship between tax
rates and tax revenues.
AD1
(Expansionary fiscal policy)
AD2
(After multiplier)

Real GDP
Price Level
LRAS
Qn
AD
Qe
P
P1
P2

SRAS
AD1
(Contractionary fiscal policy)
AD2
(After multiplier)
Real GDP
Price Level
LRAS
Qn

AD
Qe
P
P1
P2
SRAS
Real GDP
TE, TP
$

TE
TP
QE
$1000
(G
QN
$5000
TE1
A

B
Real GDP
TE, TP
$
TE
TP
QE
$1000
(C
From (tax $1250

QN
$5000
TE1
B
A
Economy starts here
Govt trying to go here
AD1
(Expansionary Fiscal Policy

3
2
1
Real GDP
Price Level
LRAS
Qn
AD
SRAS

SRAS1
During lags, economy moves here on its own
Ends up here after economy self-corrected
4
AD2
(Smaller impact of fiscal policy with partial crowding out)
AD1
(Full impact of fiscal policy with no crowding out)

Real GDP
Price Level
LRAS
Q1
no crowding out
AD
Q3
total crowding out
out
P

P1
P2
SRAS
AD3
(No impact of fiscal policy with complete crowding out)
1 no private offset
2 some private offset
total private offset 3
Q2

partial crowding out
AD2
(Smaller impact of fiscal policy with partial crowding out)
AD1
(Full impact of fiscal policy with no crowding out)
Real GDP
Price Level
LRAS
Q1

no crowding out
AD
Q3
total crowding out
out
P
P1
P2
SRAS

AD3
(No impact of fiscal policy with complete crowding out)
1 no private offset
some private offset 2
total private offset 3
Q2
partial crowding out
Higher Before-Tax Wages
Labor Hours

Real Wage Rate
LS
QL
LD
LS1
Lower Employment QL1
Lower After-Tax Wages
Income Tax Wedge
We

Real GDP
Labor Hours
PF
QL
Potential GDP
QL1
Lower Potential GDP1

Pe
Q
Price Level
QN
D
P1
QN1
SRAS

SRAS1
LRAS
LRAS1
Tax Revenues
Tax Rate
Maximum Tax Revenues
0%
100%

( Tax Rate ( ( Revenues
( Tax Rate ( ( Revenues
Page 12 of 12
#24P MAC
3/26/13
Handout #23P
Multiplier
And So On, And So On, And So On . . . .
The multiplier is a key concept in the Keynesian view of the
economy. The multiplier shows how a change in spending works
its way through to changing real GDP.
There are two kinds of spending—autonomous which is
independent of income or real GDP, and induced spending
which is related to changes in income or real GDP. Looking at
the consumption function, C0 is an autonomous element and
(MPC)(YD) is an induced element, because it changes with
income.
Autonomous consumption, investment or government spending
changes with real GDP held constant. After autonomous

spending changes, what then happens to real GDP? The
multiplier shows that a change in autonomous spending results
in an even larger change in real GDP.
The multiplier (m) is 1 divided by (1-MPC) or
1
1-MPC
It can also be thought of as ∆ Real GDP or Y/∆Autonomous
Spending..
The multiplier is used to predict the change in real GDP.
∆Real GDP = m * ∆Autonomous Spending
It works like this. Suppose the MPC is .75. Suppose there is a
$100 increase in government spending (autonomous). Income or
real GDP will increase by $100. The $100 increase in income
will cause an increase in induced consumption of $75 (MPC of
.75 times ∆YD of $100). The $75 increase in consumption is an
increase in income of $75. That increase in income causes an
increase in induced consumption of $56.25 (MPC of .75 times
∆YD of $75). The $56.25 increase in consumption is an increase
in income of $56.25. That increase in income causes an increase
in induced consumption of $42.19 (MPC of .75 times ∆YD of
$56.25). And so on, and so on and so on.
The net result will be a total increase in real GDP of $400

[(1/(1-.75)) * $100]. The multiplier is 4 in this case.
Graphically, you can see the larger increase in real GDP
compared to the increase in autonomous spending. First, let’s
look at the multiplier in the TE/TP model.
The TE curve shifts up by the change in autonomous spending.
When that happens, the equilibrium moves from A to B. Real
GDP increases by an amount equal to the multiplier times the
change in autonomous spending, from Q1 to Q2.
If you use the numeric example above with an MPC of .75,
RGDP at $2000, and an increase in G of $100, it would look
like
If you know how much you need real GDP to increase in the
case of a recessionary gap, you can calculate how much the
change in G or taxes needs to be to get the economy back to the
full employment level of output. The change in G, which is
autonomous spending, would come from dividing the necessary
change in real GDP by the multiplier. In the above example with
an MPC of .75, if you knew that the shortfall of real GDP was
$600, you could divide $600 by the multiplier of 4 and know
that you had to increase government spending by $150. The
multiplier of 4 times the $150 increase in autonomous G would
ultimately increase real GDP by the $600 you need to get back
to full employment level of output.
The government could also try to increase TE by lowering taxes
to increase consumption which would be considered induced
consumption since Yd is changed. However, this change is not
autonomous like a change in government spending—it affects
induced spending instead by changing disposable income. In
this case, it is important to take into account the MPC. So now
you would take the change you need (shortfall/multiplier) and
divide by the MPC to see how you need to change taxes. This
will always be a larger amount than the change in government
spending. In our example, you would divide the needed change

of $150 by .75 and that tells you that you would need to lower
taxes by $200. The lower taxes would increase disposable
income by $200 and consumers would spend .75 of that to get
the necessary $150 increase in induced spending.
The multiplier works exactly the same when the economy is in
an inflationary gap. Let’s say that the MPC is .8 and the
economy is in an inflationary gap of $1000. You would divide
$1000 by the multiplier of 5 and know that you had to lower
government spending by $200. Or, you could increase taxes by
$200 divided by .8, or $250, to decrease C by $200 you need.
Two important things to note about the multiplier in reality, not
theory. First, the change in real GDP takes time to work its way
through. It doesn’t happen immediately. Second, remember the
underlying assumption that there are idle resources available at
each expenditure round. With no idle resources to bring into
production, real GDP could not increase.
Keynes’ TE/TP model focuses on the short run. When firms find
their inventories changing in an unexpected fashion, they
change their production not their prices. But eventually they
also change prices. To study the determination of the price level
and real GD, we have to use the AS-AD model. The AD curve is
related to the TE curve. The TE/TP model and the multiplier tell
us how far the AD curve shifts when autonomous expenditure
changes.
The TE curve shows how aggregate expenditure depends on real
GDP (through the effects of disposable income), other things
remaining the same. The AD curve shows how equilibrium
aggregate expenditure depends on the price level, other things
remaining the same. A change in the price level changes
autonomous expenditure, which shifts the TE curve, generates a
new level of equilibrium expenditure, and creates a new point
on the AD curve. A change in autonomous expenditure at a
given price level shifts the TE curve, generates a new level of

equilibrium expenditure, and shifts the AD curve by an amount
equal to the change in autonomous expenditure multiplied by
the multiplier.
Suppose the price level increases from P1 to P2. The real
balance, interest rate and international trade effects show that a
rise in the price level decreases consumption expenditure. On
the simple TE/TP model (left), autonomous expenditures such
as C0, I and G will decrease and cause the TE curve to shift
down, and real GDP decreases from Q1 to Q2.
Changes in expenditures will shift both the TE curve and the
AD curve. Suppose the economy is at full employment level of
output and G increases from G1 to G2. On the simple TE/TP
model, the TE curve will shift up by the amount of the increase
in G, and real GDP increases from QN to Q1 as the change in G
is multiplied.
On the AD/AS model, the change in G shifts the AD curve out
by the increase in G and then the AD moves further out to Q1 as
the multiplier takes effect, at a constant price level PE. But the
price level will begin to rise as a response to the increase in
AD, moving to P1 and with the rise in price level, the quantity
demanded of real GDP will drop to Q2 in an inflationary gap.
The multiplier is smaller once price level effects are taken into
account. The more that the price level changes (the steeper the
SRAS curve), the smaller the multiplier in the short run.
With the rise in the price level and corresponding decrease in
quantity demand of real GDP, TE will decrease, shifting lower
in the TE/TP model.
In the long run, as the economy moves back to full employment
level of output in the AD/AS model, increasing the price level
again, the TE curve will move down to its original point. In the

long run, the multiplier is zero.
A
B
Change in autonomous spending such as G or I
Real GDP
TE, TP
$
TE2
TP
Q2

Q1
TE1
Change in real GDP
�
greater than change in spending
�
(G $100
Real GDP
TE, TP
$

TE2
TP
$2400
$2000
TE1
(G $150
Real GDP
TE, TP
$
TE2

TP
QN=$2600
QE=$2000
TE1
$600
(C $150
BY (T $200
Real GDP
TE, TP

$
TE2
TP
QN=$2600
QE=$2000
TE1
$600
(G $200
Or
(C $200

BY (T $250
Real GDP
TE, TP
$
TE1
TP
QN=$2000
QE=$3000
TE2

$1000
Real GDP
TP
TE2
TE1
TE/TP Model
Q11
Q2
C01 at P1

C02 at P2
TE, TP
$
Real GDP
AD1
AD/AS Model
Q2
Q1
P1

P2
Price Level
TE
Real GDP
TP
TE1
TE/TP Model
QN1
Q1

G2
G1
TE, TP
$
Constant PE
Real GDP
AD
Q1
QN

Constant PE
When prices adjust P1
Price Level
AD1 multiplied
SRAS
LRAS
ΔG
Q2
AD/AS Model

Real GDP
TP
TE1
2
TE
TE/TP Model
QN1
Q1
G2

G1
TE, TP
$
Constant PE
TE2
Q2
Page 5 of 5
#23P MAC
3/26/13
Handout #22P
Keynesian View of the Economy

Takes a Licking But Won’t Keep Ticking
John Maynard Keynes challenged the beliefs of the classicists.
Based on the evidence of the Great Depression, he felt that the
economy was basically unstable, for a number of reasons.
1) Interest rates do not balance savings and investment—Keynes
felt that changes in the interest rate would not necessarily cause
changes in saving to be exactly offset by an equal change in
investment. In this case, aggregate demand will not
automatically equal aggregate supply, a necessary assumption
for the classicists.
Total Expenditures (TE) = C + I + G + NX. If savings increase,
C will fall, ceteris paribus. If lower interest rates from the
increased savings do not cause I to rise by the same amount that
C dropped, total expenditures will end up lower than before. If
output equaled TE at the start, then now aggregate supply is
greater than aggregate demand.
Keynes believed that savings would not necessarily change if
interest rates changed—he felt that savings levels were more
responsive to changes in income. Keynes also felt that
investment was responsive to interest rates but there were other
factors such as expected profits, technology changes and
innovations, with even larger impacts on changing investment
levels. So if interest rates dropped but profits from a possible
investment project were expected to be low, there might not be
any increase in investment, even with lower interest rates.
2) Wage rates are inflexible downward—Keynes felt that
surpluses in the labor market would not lead to lower wages. He
felt that wages were inflexible downward. Without falling
wages, the price level would not fall, and no increase in real
GDP demanded would be forthcoming. In other words, the
economy could not fix itself and can be stuck in an recessionary
gap.
3) Prices are not always flexible downward —Keynes felt that
anti-competitive forces in the economy could prevent prices
from falling. Again, if the price level could not fall sufficiently,

no increase in real GDP demanded would be forthcoming and
again, the economy could not fix itself.
Keynesian or Income-Expenditure (TE-TP) Model of the
Economy
The Keynesian model applies to the very short run in which
firms have fixed the prices of their goods and services. As a
result in this model, the price level is fixed and so total
expenditures or aggregate demand determines real GDP.
Total Expenditures (TE) = C + I + G + NX. Of these
components, the consumption function is the most important.
Keynes developed a consumption function to analyze how
consumption responds to changes. The consumption function is:
C = C0 + (MPC)(Yd). Or, in English, consumption equals
autonomous consumption plus the marginal propensity to
consume times disposable income. The MPC time Yd is called
induced consumption because it depends on disposable income.
Autonomous consumption (C0) is a constant level of
consumption, representing a basic level of consumption that
does not depend on disposable income. Autonomous
consumption changes from factors other than disposable
income.
The marginal propensity to consume is a number between zero
and one, representing the portion of each additional dollar of
disposable income that is spent on consumption. It is the ratio
of ∆ in consumption to ∆ in disposable income, or ∆C/∆Yd.
And, since disposable income is either spent or saved, 1-MPC is
the MPS, or marginal propensity to save. It can be calculated as
the ratio of ∆ in saving to ∆ in disposable income.
Working through the consumption function, consumption can be
increased by increasing any of its components: C0, MPC, or Yd.
However, increasing C0 will increase only the level of
consumption, while increasing MPC or Yd will also change the

level of saving.
There is also the average propensity to consume (APC) which
shows the portion of total (not additional!) disposable income
spent on consumption. It is the ratio of total consumption to
total disposable income, or C/Yd. And again, since disposable
income is either spent or saved, 1-APC is the APS, or average
propensity to save, or S/∆Yd.
The simple Keynesian model uses the consumption function to
create a total expenditure function and curve, based only on
domestic spending, excluding the foreign sector (though your
book includes imports in its discussion). The simple model also
assumes a constant level of I and G.
TE = C0 + (MPC)(Yd) + I + G
Graphically, the TE curve is upward sloping to the right.
*Aggregate planned expenditures (AE) in your book
The total production curve in the Keynesian model is a 45o line
which represents all the points where TE or AE = Real GDP.
The Three States of the Economy
Using the Keynesian model, in this closed economy:
· total expenditures (TE) can be equal to total production (TP)
· total expenditures (TE) can be less than total production (TP)
· total expenditures (TE) can be greater than total production
(TP)
In the last two states (disequilibrium), the economy would move
toward the first state (equilibrium). Business inventories would
be the mechanism for the economy’s adjustment.
Producers hold some level of business inventory that is optimal.
In the state of the economy where TE < TP, firms will notice
that their inventories are growing. Since they wish to keep the

optimal level of inventory on hand, they will cut back total
production. As TP falls, it will become closer to the level of
TE. This process will continue until TP = TE, where firms will
reach their optimal inventory and maintain TP at that level. No
incentive to change will remain, ceteris paribus.
In the state of the economy where TE > TP, firms will notice
that their inventories are falling. Since they wish to keep the
optimal level of inventory on hand, they will increase total
production. As TP rises, it will become closer to the level of TE
and again, this process will continue until TP = TE, where firms
will reach their optimal inventory and maintain TP at that level.
No incentive to change will remain, ceteris paribus.
Total expenditures (TE) equal to total production (TP)
Total expenditures (TE) not equal to total production (TP)
The TE/TP model will only show short run equilibrium unless
the level of full employment output is known (include all labels
if asked to draw the TE/TP model).
Note that there is nothing to relate the equilibrium point of
TP=TE to the full-employment real GDP level. In this
framework, the economy could easily be in a recessionary gap,
at an output less than full employment output, with no
automatic force operating to push output higher. Unless you
know where QN is, do not draw it on the graph of the TE/TP
model.
If the economy is in a recessionary gap, Qe is less than Qn –
that would show on the TE/TP model graph with the vertical
line for Qn drawn to the right of the intersection of TP and TE,
like in the graph below. That shows that Qe is less than Qn and
which mean that unemployment was greater than Un.

If the economy is in an inflationary gap, Qe is greater than Qn –
that would show on the TE/TP model graph with the vertical
line for Qn drawn to the left of the intersection of TP and TE,
like in the graph below. That shows that Qe is greater than Qn
which would mean that unemployment was less than Un.
If the economy is in long run equilibrium, Qe is equal to Qn –
that would show on the TE/TP model graph with all the lines
meeting at the same point. The vertical line for Qn is drawn at
the intersection of TP and TE, like in the graph below (include
all labels).
There is an underlying assumption in the Keynesian model that
there are idle resources available at each expenditure round. If
there were no idle resources to bring into production, real GDP
could not increase. In that case, the autonomous spending
increase would only increase prices.
Because the Keynesian model assumes prices are constant until
full employment output is reached (changes are real, not
nominal below QN) and idle resources exist at each expenditure
level, any change in aggregate spending changes output only. In
the AD/AS model, with the assumption of constant prices and
idle resources, Keynes’ theory shows an increase in aggregate
demand before full employment output is reached (meaning
there are idle resources) increases QE but not price.
the economy is already at full employment level of output, an
increase in aggregate demand will only increase prices, not
output.
Disposable Income

Consumption
C
Slope=MPC<1
C0
C0
Real GDP
Total Expenditures (TE)*
TE*
Slope=MPC<1

G
I
C0
Real GDP
Total Expenditures (TE)
Slope= 1
TP (TE=Real GDP)
45o

Real GDP
TE, TP
$
TE
TP
QE
TE=TP
Real GDP
TE, TP
$

TE
TP
QE
$TE=$TP
TE=TP
$TE > $TP
$TE < $TP
Falling inventories, increase output
Rising inventories, decrease output

Real GDP
TE, TP
$
TE=C+I+G
TP
C0+I+G
TE=TP
QE
Slope=MPC

45o
Real GDP
TE, TP
$
TE
TP
QE <
TE=TP
QN

U>UN
Real GDP
TE, TP
$
TE
TP
QE
TE=TP
QN <

U<UN
Real GDP
TE, TP
$
TP
TE
QN = QE
U=UN
TE=TP

AS
Price Level
QE
QN
Natural Real GDP at full employment
AD
Real GDP
AD1
QE1
PE

AS
Price Level
QN
AD
Real GDP
AD1
PE1
PE

of 10
#22P MAC
3/26/13
Handout MACRO #21P
Classical View of the Economy
Build It and They Will Come
Classicists believe the economy will fix itself, based on Say’s
Law. That law states that supply creates its own demand and
production will create sufficient demand to purchase all goods
and services produced. The supplying of goods is
simultaneously the demanding of other goods. Aggregate supply
(AS) will always equal aggregate demand (AD).
Why would someone produce more than they would consume?
In order to trade it for something else they want being produced
by someone else. This is how the production of a good creates a
demand for other goods.
According to the classicists, Say’s Law works in both a barter
and money economy. In a money economy, producers receive
money for the goods they produce. But they don’t have to spend
all the money they receive on other goods—they can save it:
savings equals disposable income minus consumption. That
would seem to mess up Say’s Law—supply of goods might not
create sufficient demand for all goods and services produced
because part of the money stream would leave the consumption
stream.
The classicists’ answer to the Say’s Law dilemma is to assume
flexible interest rates.

If there is a decrease in consumption (C) with a corresponding
increase in savings, the supply of loanable funds will increase.
That, of course, drops the interest rate. With a lower interest
rate, borrowers increase the quantity of loanable funds
demanded for investment. So in our GDP equation, C + I + G +
NX = GDP, the classicists state that through lower interest
rates, when C goes down, I goes up. Or when C goes up, higher
interest rates will cause I to go down. Everything will still stay
in balance with SRAS still equaling AD.
Classicists also assume that prices and wages are fully flexible
and can adjust to changes in the economy.
The Self-Regulating Economy
Under these assumptions, the economy is self regulating. In
other words, if things get out of whack, the economy will
naturally move back to equilibrium, on its own.
Suppose aggregate demand decreases. There is now a
recessionary gap, output is lower than natural real GDP and
there is a surplus in the labor market. The surplus causes both
real and money wages to fall.
As wages fall, reducing costs, the SRAS curve moves out,
increasing output closer to the natural real GDP level. The price
level decreases and the quantity demanded of real GDP
increases. The same process will continue until output equals
natural real GDP.
Suppose there is an increase in aggregate demand. There is now
an inflationary gap, output is higher than natural real GDP and
there is a shortage in the labor market. The shortage causes real
and money wages to rise.
As wages rise, increasing costs, the SRAS curve moves in,
decreasing output closer to the natural real GDP level. The price
level increases and the quantity demanded of real GDP

decreases. The same process will continue until output equals
natural real GDP.
In both cases, the economy moves back to the long run
equilibrium level of output at the natural real GDP level.
However, the price level will be different. In the case of the
recessionary gap, the price level will be lower after all
adjustments in the long run. In the case of the inflationary gap,
the price level will end up higher in the long run.
Inflationary Gaps
So, in a self correcting economy, when there is an initial change
in aggregate demand, the AD curve will shift right or left. In the
case of an increase in aggregate demand, we see an inflationary
gap.
In the short run, QE > QN , U < UN and P has increased. Now
that the economy is in an inflationary gap, the economy begins
to correct itself in the long run through the labor market.
Because U < UN, there is a shortage in the labor market which
exerts upward pressure on wages. As wages rise, so do costs for
producers so there is a decrease in SRAS and it moves left. The
process continues until the economy is back at full employment
level of real GDP.
The economy ultimately ends up at long run equilibrium at the
natural rate of unemployment, full employment level of real
GDP, but at a higher price level (inflation).
Recessionary Gaps
In the case of a decrease in aggregate demand, we see a
recessionary gap.
In the short run, QE < QN , U > UN and P has decreased. Now
that the economy is in a recessionary gap, the economy begins
to correct itself in the long run through the labor market.

Because U > UN, there is a surplus in the labor market which
exerts downward pressure on wages. As wages fall, so do costs
for producers so there is an increase in SRAS and it moves
right. The process continues until the economy is back at full
employment level of real GDP.
Fiscal Policy Choices
Fiscal policy, or what actions the government should take when
the economy is not at full employment, for the classicists is
fairly simple: do nothing to interfere with the natural economic
processes. This public policy of non-interference is known as
lassez-faire. If the economy will regulate itself, any interference
by the government will just get in the way. Classicists rely on
the invisible hand.
Long Run Aggregate Supply
Long-run aggregate supply is associated with the institutional
PPF and potential GDP. The physical PPF shows possible output
in the economy given the physical restraints of finite resources
and the current state of technology. The institutional PPF shows
the possible output including any institutional constraints. An
institutional constraint is anything that prevents the economy
from achieving the maximum real GDP that is physically
possible, such as laws like minimum wage or the normal
structure of the economy. For example, a major cause of the
difference between the physical and the institutional PPF is job
search time for frictional and structural unemployment. This is
normal to the economy and means that 100% of all labor
resources will never be employed—the norm is for the economy
to operate at its natural unemployment rate. So the institutional
PPF will always be less than the PPF.
Anything that increases the PPF and institutional PPF, such as

economic growth or an increase in resources and/or technology,
will increase both short-run aggregate supply and long-run
aggregate supply. Both SRAS and LRAS curves will shift right,
reflecting the fact that the economy now has a higher level of
potential GDP and can produce a higher level of real GDP in
both the short run and the long run.
When SRAS and LRAS shift, a new long-run equilibrium is
established for the economy. QN increases and the price level
drops.
ie
Loanable Funds
Interest Rate (i)
S
Qe
D

S1
ie1
Qe1
Real Wage
Labor Demand (Businesses)
At QN
Labor Hours
Labor Supply (Households)
Surplus of Labor

We1
We
Too High Now
Labor Demand1 (Businesses)
At Qe<QN
QL1
Less than
QN Full Employment
U<UN

QLe
At
QN Full Employment
U=UN
Price Level
LRAS
Qe1
AD2
Real GDP
Short run equilibrium

SRAS1
QN
P1
P2
AD1
SRAS2
Real Wage
At QN

Labor Hours
Shortage of Labor
We1
At Qe>QN
QL1
Greater than
QN Full Employment
U<UN

QLe
At
QN Full Employment
U=UN
We
Too Low Now
Price Level
LRAS
Qe

AD2
Real GDP
SRAS1
QN
P1
P2
AD1
SRAS2

Price Level
Qe
AD1
Real GDP
SRAS
QN
P1
P

AD
Short Run:
(AD ( (P (QE>QN (U<UN
Inflationary Gap
LRAS
Long run equilibrium
Price Level
Qe
AD1
Real GDP

SRAS
QN
P1
P2
SRAS1
Long Run:
Labor shortage ( (Wages ( (Costs ( (SRAS to QN ( (P (QE=QN
(U=UN
Long Run Equilibrium

LRAS
Price Level
LRAS
Qe
AD
Real GDP
SRAS
QN

P
P1
AD1
Short Run:
(AD ( (P (QE<QN (U>UN
Recessionary Gap
Price Level
LRAS

Qe
SRAS1
Real GDP
SRAS
QN
P2
P1
AD1

Long Run:
Labor surplus ( (Wages ( (Costs ( (SRAS to QN ( (P (QE=QN
(U=UN
Long Run Equilibrium
Institutional PPF U=UN
Physical
PPF
QN
Price Level
LRAS

Real GDP
SRAS
QN
P
AD
Institutional PPF U=UN
QN
QN1
Price Level

LRAS
Real GDP
SRAS
QN
P
AD
LRAS1
SRAS1
QN1

P1
Page 7 of 7
#21P
3/20/13
Handout MACRO - #20P
Three States of the Economy
Too Hot, Too Cold, Just Right
In the short run, aggregate supply slopes upward to the right
showing the positive relationship between price level and
quantity supplied of real GDP. In the long run, aggregate
supply is simply the level of potential real GDP produced at full
employment or when the unemployment rate is at its natural
level.
The economy can be in any of three states: a recessionary gap,
an inflationary gap, or in long-run equilibrium.
· A recessionary gap occurs when, at its short run equilibrium,
the economy is producing less than the natural real GDP.
In a recessionary gap, the quantity of real GDP being produced
is below the full employment level of output, which means that
unemployment is higher than its natural rate. There is a surplus
of labor in the labor market.
· An inflationary gap occurs when, at its short run equilibrium,
the economy is producing more than the natural real GDP.

In an inflationary gap, the quantity of real GDP being produced
is above the full employment level of output, which means that
unemployment is lower than its natural rate. There is a shortage
in the labor market.
· Long run equilibrium occurs when, at its short run
equilibrium, the economy is producing the same level of output
as the natural real GDP.
In long run equilibrium, the quantity of real GDP being
produced is the same as the full employment level of output
(potential GDP), which means that unemployment is at its
natural rate. The labor market is also in equilibrium.
Price Level
LRAS
QN
(Potential GDP)
AD

Real GDP
SRAS
Pe
Price Level
LRAS
Qe
AD
Real GDP

SRAS
< QN
U>UN
Pe
Real Wage
At QN
Labor Hours

Surplus of Labor
We1
We
Too High Now
At Qe<QN
QL1
Less than

QN Full Employment
U<UN
QLe
At
QN Full Employment
U=UN
LRAS
Price Level
Qe
AD

Real GDP
SRAS
QN <
U<UN
Pe
Real Wage
At QN

AD
Real GDP
Short & long run equilibrium
SRAS
QN =
U=UN
Pe
Real Wage
At QN

Labor Hours
QLe
At
QN Full Employment
U=UN
We
Page 4 of 4
#20P
3/20/13

Handout MACRO #19P
Aggregate Supply and Aggregate Demand
Good Things in a Bigger Package
Aggregate Demand
Aggregate demand is the total quantity demanded of real GDP at
all price levels. The aggregate demand curve (AD) looks just
like a market demand curve, sloping downward to the right,
showing an inverse relationship between the price level and the
quantity demanded of real GDP. Remember, real GDP =
Consumption [C] + Investment [I] + Government [G] + (Exports
– Imports) [NX].
The AD curve slopes downward showing the inverse
relationship between price level and quantity demanded of real
GDP for three reasons:
1) The real balance effect—when the price level falls, the
purchasing power of consumers increases and they can buy more
goods and services with the same amount of money. C will
increase. When the price level rises, the purchasing power of
consumers decreases and they can buy fewer goods and services
with the same amount of money. C will decrease.
2) The interest rate effect—when the price level falls,
consumers can save more without reducing the goods and
services they purchase. When consumers save more, interest
rates go down.
Simplistically, there is a supply and demand for loanable funds
in an economy. The supply of loanable funds comes from savers
and the demand for loanable funds comes from borrowers for
investment (I). The equilibrium price of loanable funds is the
interest rate—savers receive interest and borrowers pay interest.
When interest rates go down, the quantity demanded of real
GDP by consumers and businesses goes up because the cost of

borrowing is cheaper and they can buy more goods and services.
C & I will increase. When interest rates go up, the quantity
demanded of real GDP by consumers and businesses goes down
because the cost of borrowing is higher and they can buy fewer
goods and services. C & I will decrease.
3) The international trade effect—when the price level in the
U.S. economy drops, U.S. goods are relatively cheaper than
goods in other countries, ceteris paribus. Consumers in other
countries will buy more U.S. goods and fewer foreign goods
than before, so exports will increase and thus NX will increase.
U.S. consumers will also buy more U.S. goods and fewer
foreign goods than before, so imports will decrease and thus NX
will increase.
When the price level in the U.S. economy rises, U.S. goods are
relatively more expensive than goods in other countries, ceteris
paribus. Consumers in other countries will buy fewerU.S. goods
and more foreign goods than before, so exports will decrease
and thus NX will decrease. U.S. consumers will also buy fewer
U.S. goods and more foreign goods than before, so imports will
increase and thus NX will decrease.
Factors Influencing Aggregate Demand
As with market demand, there are various factors or
determinants that can change aggregate demand. These factors
work through the components C, I, G and NX. Some factors can
influence more than one component.
1) Consumption Factors
a) Wealth—changes in wealth will change consumption. If
wealth, which is simply the value of all monetary and non-
monetary assets, increases then consumption will increase.
When consumption increases, aggregate demand increases. The
AD curve shifts outward to the right. A decrease in wealth will
decrease consumption and thus aggregate demand. The AD
curve will shift inward to the left.

b) Expectations of future prices and income—just like with the
market demand curve, if individuals expect future prices to be
higher, they will buy more now. Consumption will increase and
thus aggregate demand will increase. The AD curve will shift
outward to the right. If individuals expect future prices to be
lower, they will wait to buy and consume less now.
Consumption will decrease and thus aggregate demand will
decrease. The AD curve will shift inward to the left.
If individuals expect their future income to be higher, they will
increase consumption, which will in turn increase aggregate
demand. The AD curve will shift outward to the right. If
individuals expect their future income to be lower, they will
decrease consumption, which will in turn increase aggregate
demand. The AD curve will shift inward to the left.
c) Interest rate—if the interest rate falls, individuals will
increase consumption, especially on consumer durables like cars
and appliances. Aggregate demand will then increase and the
AD curve will shift outward to the right. If the interest rate
rises, individuals will decrease consumption and aggregate
demand will also decrease. The AD curve will shift inward to
the left.
d) Income Taxes—when income taxes go down, consumers’
disposable income goes up and consumption will increase as
will aggregate demand. The AD curve will shift outward to the
right. When income taxes go up, consumers’ disposable income
goes down and consumption will decrease. Aggregate demand
will also decrease and the AD curve will shift inward to the left.
2) Investment Factors
a) Interest rate—if the interest rate falls, businesses will
increase investment because the costs of investment projects are
lower. Aggregate demand will then increase and the AD curve
will shift outward to the right. If the interest rate rises, fewer
investment projects will be undertaken and both investment and
aggregate demand will decrease. The AD curve will shift inward
to the left.

b) Expectations of future sales—if businesses expect future
sales to be higher, they will gear up now to produce more. More
investment projects will be undertaken and investment will
increase. Aggregate demand will increase and the AD curve will
shift outward to the right. If businesses expect future sales to be
lower, they hold off on investment and thus aggregate demand
will decrease. The AD curve will shift inward to the left.
c) Business Taxes—when business taxes go down, business
profits go up and investment will increase as will aggregate
demand. The AD curve will shift outward to the right. When
business taxes go up, profitability goes down and investment
will decrease. Aggregate demand will also decrease and the AD
3) Net Exports Factors
a) Foreign real national income—if income rises in other
countries, foreigners will buy more U.S. goods and services.
Exports will increase, so net exports will increase and so will
aggregate demand. The AD curve will shift outward to the right.
If income falls in other countries, foreigners cut back on
purchases of U.S. goods and services. Exports will decrease, so
net exports will decrease and so will aggregate demand. The AD
b) Exchange rate—if the exchange rate of U.S. currency for
other countries’ currency falls or depreciates, requiring less
foreign currency for each $1, U.S. goods become relatively
cheaper than before. Foreigners can buy more U.S. goods and
services with the same amount of foreign currency. Conversely,
foreign goods are now more expensive to Americans, as it will
take more dollars to buy the same priced good. Exports will
increase while imports will decrease. Net exports will rise, and
thus aggregate demand increases. The AD curve will shift
outward to the right.
If the exchange rate of U.S. currency for other countries’
currency rises or appreciates, requiring more foreign currency
for each $1, U.S. goods become relatively more expensive than
before. Foreigners can buy fewer U.S. goods and services with

the same amount of foreign currency. Conversely, foreign goods
are now less expensive to Americans, as it will take fewer
dollars to buy the same priced good. Exports will decrease
while imports will increase. Net exports will fall, and thus
aggregate demand decreases. The AD curve will shift inward to
the left.
Aggregate Supply
Aggregate supply is the total quantity supplied of real GDP at
all price levels. Aggregate supply includes both short-run
aggregate supply and long-run aggregate supply. The short run
is a period of indeterminate length where supply cannot fully
adjust to changes, due to some fixed factors such as technology
or capital stock. The long run is a length of time where all
necessary adjustments can be made in response to changes in
the economy. The economy has two supply curves—an
aggregate short-run supply curve and an aggregate long-run
supply curve.
The aggregate short-run supply curve (SRAS) looks just like a
market supply curve, sloping upward to the right, showing a
positive relationship between the price level and the quantity
supplied of real GDP. Costs of the factors of production are the
primary determinant of supply, with labor costs being the
largest component of costs for producers in the aggregate.
Therefore, changes in wage rates will have a major effect on
supply in the economy, but the effects are different depending
on whether the change was in nominal (money) wage rates or
real wage rates.
Nominal wages are real wage rates expressed at the current
price level (in other words, in current dollars). The real wage
rate is the equilibrium wage set by supply and demand in the
labor market, at the base year price level (in other words, with
inflation removed). You can calculate the real wage rate by
dividing real wages by the price level. So a drop in the price
level causes real wages to increase and an increase in the price
level will cause real wages to fall, ceteris paribus.
When the price level changes and the money wage rate and

other resource prices remain constant, real GDP departs from
potential GDP and there is a movement along the SRAS curve.
The SRAS curve slopes upward showing the positive
relationship between price level and quantity supplied of real
GDP. This slope reflects that a higher price level combined with
a fixed money wage rate, lowers the real wage rate, The lower
real wage rate in turn increases the quantity of labor firms
employ which increases the real GDP that firms produce.
Producers increase output or real GDP in the short run for three
main reasons:
1) Sticky Wages—due to inflexibility in wages from long-term
contracts and other factors, when the price level falls, firms
might still be locked into a nominal wage rate. That would mean
that their real wages have risen and they will cut back output
and hire fewer workers. With sticky wages, a drop in the price
level will result in a decrease in the quantity supplied of real
GDP. An increase in the price level will cause an increase in
real GDP supplied because real wages will fall when nominal
wages are inflexible.
2) Sticky Prices—not all prices will adjust quickly. For some
industries, there are costs to adjusting prices. When the price
level drops, some firms will choose not to lower their prices
immediately because of the cost and because they are not sure if
the price level decrease is permanent or temporary. While they
hold off on lowering their prices, they will not be able to sell
the same level of output as before, so these firms will reduce
the quantity supplied. A decrease in the price level results in a
decrease in quantity supplied of real GDP, while a price level
increase results in an increase in quantity supplied of real GDP.
3) Misperceptions—if producers and workers can’t tell if
changes in prices and wages are real or nominal, they will not
know how to react when the price level changes. Producers may
see higher prices as a signal to increase output when actually

the higher prices are a result of an increase in the overall price
level. Producers may increase output when in reality they
should keep it constant, or even decrease production. In the
same way, workers can’t tell if higher wages are the result of an
overall price increase or if real wages have risen. Due to the
confusion, when price levels increase, output will increase, until
things become clearer. When price levels fall, output will fall
until producers and workers can tell which type of price change
has occurred—real or nominal.
Factors Influencing Short Run Aggregate Supply
As with market supply, there are various factors or determinants
that can change aggregate supply. Basically, anything that
increases costs to producers will decrease supply and anything
that reduces costs to producers will increase it.
1) Money Wage Rates—changes in money wage rates have a
major impact on the costs of producers, and thus are a major
influence on short run aggregate supply. If money wages
decrease, supply will increase and the SRAS will shift outward
to the right. If money wages increase, supply will decrease and
the SRAS will shift inward to the left.
2) Prices of Non-labor Inputs—changes in other inputs to the
production process have an impact on the costs of producers. If
prices of non-labor inputs decrease, supply will increase and the
SRAS will shift outward to the right. If prices of non-labor
inputs increase, supply will decrease and the SRAS will shift
inward to the left.
3) Supply Shocks—there can be adverse or beneficial natural or
other supply shocks to the economy. Any supply shock that
decreases costs will increase supply and the SRAS will shift
outward to the right. Any supply shock that increases costs will
decrease supply and the SRAS will shift inward to the left.
Short-run aggregate supply changes and the SRAS curve shifts
when there is a change in the money wage rate or other resource
prices. A rise in the money wage rate or other resource prices
decreases short-run aggregate supply and shifts the SAS curve
leftward.

Short Run Equilibrium
Aggregate demand and short run aggregate supply interact to
establish an equilibrium price level and quantity of real GDP,
just like in a market.
Any change in aggregate demand or short run aggregate supply
will change the short run equilibrium, just like in the market.
Long Run Aggregate Supply
In the long run, aggregate supply is simply the level of potential
GDP — real GDP produced at full employment or when the
unemployment rate is at its natural level. Only frictional and
structural unemployment is occurring and there is no cyclical
unemployment. The long run aggregate supply (LRAS) is a
vertical line at the level of GDP associated with potential GDP,
also known as natural real GDP (QN). LRAS represents the
output the economy produces when all adjustments have taken
place and there are no more inflexibilities or misperceptions.
When the price level, the money wage rate, and other resource
prices change by the same percentage, real GDP remains at
potential GDP and there is a movement along the LRAS curve.
In the long run, the money wage rate and other resource prices
change in proportion to the price level. So moving along the
LRAS curve both the price level and the money wage rate
change by the same percentage.
LRAS illustrates the relationship between the quantity of real
GDP supplied and the price level in the long run when real GDP
equals potential GDP and shows that potential GDP does not
depend on the specific price level. Potential GDP increases
when the full employment quantity of labor increases, labor
productivity increases, the quantity of capital increases, or
technology advances. When potential GDP increases, both long-
run and short-run aggregate supply increase, and the LRAS and

SRAS curves both shift to the right. A decrease in potential
GDP would shift both LRAS and SRAS to the left.
Changes in the price level have no effect on potential GDP so
the LRAS does not shift when the price level changes. Price
level changes move along the LRAS while changes in potential
GDP move the whole LRAS curve.
And Then Unemployment
Changes in aggregate demand or aggregate supply also change
the unemployment rate. If real GDP rises, from an increase in
AD or SRAS, more workers are needed to produce the higher
output. Thus the unemployment rate will drop. If there is a
decrease in AD or SRAS, workers will be laid off, and the
unemployment rate will rise.
ie
Equilibrium interest rate
Interest Rate (i)
S
Qe
Equilibrium quantity exchanged in the market

D
Loanable Funds
Pe
Short run equilibrium price level
Price Level
SRAS
Qe
Short run equilibrium real GDP
AD
Real GDP

Price Level
LRAS
Potential GDP (QN)
U=UN
Page 2 of 8
#19P
3/19/13
Handout MACRO #18P
Exchange Rates
Just Between Friends
Foreign currency is the money of other countries, in any form
and is exchanged in the foreign exchange market, like any other

good. The price of one nation’s currency in terms of another
currency is the nominal exchange rate.
Movements in one currency against another currency are
referred to as either appreciation or depreciation. Appreciation
means that the value of one currency rises against another
currency and depreciation means that the value of one currency
drops against another. Appreciation of the dollar means that
more of a foreign currency is need to buy it while depreciation
means less of a foreign currency is needed to buy it. Another
way to think of it is that when the dollar appreciates it buys
more foreign currency, and when the dollar depreciates, it buys
less foreign currency. Automatically, when one currency
appreciates, the other depreciates.
Your purchasing power is really affected by fluctuations in
currency rates. Let’s say you go to Italy and you want to buy
some shoes. You take $400 with you to spend. Shoes cost €100
(euros).
Exchange Rate
Other Way Exchange Rate
Price in Dollars
Price in Euros
Effect on You
Original
$1 = €1/2
€1 = $2
$200
€100
You can buy 2 pairs of shoes
Dollar Appreciates (Worth More)
$1 = €1
(Buys more euros)
€1 = $1

(Buys fewer dollars)
$100
€100
$100 cheaper so you can buy 4 pairs of shoes
Dollar Depreciates (Worth Less)
$1 = €1/4
(Buys fewer euros)
€1 = $4
(Buys more dollars)
$400
€100
$200 more expensive so you can only buy 1 pair of shoes
As the dollar appreciates, foreign goods become cheaper, and if
the dollar depreciates, foreign goods become more expensive.
When the dollar appreciates, foreigners cut back on their
purchases of American goods, and exports will decrease and
imports will increase as Americans purchase more of the now
cheaper foreign goods. If the dollar depreciates, exports will
increase and imports decrease, as American and foreign
consumers turn away from the relatively higher priced foreign
goods toward the now bargain American goods.
In the foreign exchange market, supply and demand determine
the price of currency or the nominal exchange rate. But in this
market, when you have one currency, let’s say dollars, and you
want to exchange them for euros, you are at the same time
supplying dollars and demanding euros. So factors that affect
the demand for a countries currency will also affect the supply
of the currency.
The quantity demanded of a currency will depend on its
exchange rate. If the exchange rate rises, less quantity will be
demanded and if the exchange rate falls, more will be
demanded. This is represented by movements along the demand

curve for currency.
SHAPE * MERGEFORMAT
The quantity demanded of currency will be determined by two
things – the exports effect and the expected profit effect. The
exports effects shows how when the exchange rate is low, US
exports are cheaper than foreign goods. With cheaper US
exports, foreigners want to buy more US goods which are priced
in dollars. So in order to pay for the increased quantity of US
goods, a higher quantity of dollar currency is demanded.
Conversely, if the exchange rate rises, US exports are more
expensive, foreigners want to buy less US goods, and so they
don’t require as many US dollars to pay for them.
The expected profits effect comes from the speculative buying
and selling of currencies by currency traders. Traders wish to
buy a currency when the exchange rate is low so they can sell
the currency when the rate rises in the future and make a profit.
Thus the quantity demanded of a currency will be higher when
the exchange rate is low. Conversely, when the exchange rate is
high, if traders bought the currency now, they would more
likely make a loss, so the quantity demanded is low.
Changes in the demand for currency will depend on:
· World demand for US exports. An increase in world demand
for US exports (for reasons other than the exchange rate like
changes in foreign real national income) means foreigners will
need more US dollars to pay for the higher exports. The demand
curve for US dollars will shift out and to the right and the
equilibrium exchange rate will increase.
SHAPE * MERGEFORMAT

A decrease in world demand for US exports will work just the
opposite and shift the demand for US dollars in to the left.
SHAPE * MERGEFORMAT
· The differential between US interest rates and foreign interest
rates. Since the market for loanable funds is a world market,
when US real interest rates are higher than the world interest
rate, investors will want to invest in financial assets in the US
which are priced in dollars. The demand curve will shift out to
the right, resulting in a higher exchange rate. Obviously, if the
interest rate differential between the US and the world is
negative, meaning that interest rates are lower in the US, the
demand for US dollars to buy US financial assets will decrease
and the demand curve will shift left.
· The expected U.S. exchange rate. If the exchange rate for the
US dollar is expected to increase, traders could expect to make
a profit by buying US dollars today and selling them in the
future for a higher price. So the demand for US dollars today
would increase. If the exchange rate was expected to fall in the
future, the demand for dollars today would decrease. Note that
an increase in the US exchange rate would mean a fall in the
foreign currency exchange rate.
The quantity supplied of currency will also be determined by
two things – the imports effect and the expected profit effect.
The imports effects shows how when the exchange rate is high,
US goods are more expensive than foreign goods. With cheaper
foreign imports, American consumers want to buy more foreign
goods which are priced in foreign currencies. A higher quantity
of US dollar currency is offered to buy foreign currencies to pay
for the increased imports. Conversely, if the exchange rate
drops, US exports are cheaper, US consumers want to buy less

imports, and so they don’t require as many US dollars to pay for
foreign currency.
The expected profits effect works just the opposite as for
demand. Traders wish to sell a currency when the exchange rate
is high to reap a profit. Thus the quantity supplied of a currency
will be higher when the exchange rate is high. Conversely, when
the exchange rate is low, traders are more likely make a loss, so
the quantity supplied is smaller.
Changes in the supply of currency will depend on:
· US demand for foreign imports. An increase in US demand for
foreign imports (for reasons other than the exchange rate like
changes in US real national income) will increase the supply of
US currency as US consumers will offer more US dollars to pay
for the higher imports. The supply curve for US dollars will
shift out and to the right and the equilibrium exchange rate will
fall.
SHAPE * MERGEFORMAT
A decrease in US demand for foreign imports will work just the
opposite and shift the supply of US dollars in to the left.
SHAPE * MERGEFORMAT
· The differential between US interest rates and foreign interest
rates. In the opposite direction from demand, when US real
interest rates are higher than the world interest rate, US
investors will want to invest in fewer foreign financial assets.
US investors will not need to offer as many dollars to buy
foreign assets, so the supply curve will shift in to the left,
resulting in a higher exchange rate. Obviously, if the interest

rate differential between the US and the world is negative,
meaning thatinterest rates are lower in the US, the supply of US
dollars to buy more profitable foreign financial assets will
increase and the supply curve will shift right.
· The expected foreign exchange rate. If the exchange rate for
foreign currency is expected to increase, US traders could
expect to make a profit by buying foreign currencies today and
selling them in the future for a higher price. So the supply of
US dollars today would increase to pay for the purchase of
foreign currency. If the foreign currency exchange rate was
expected to fall in the future, the supply of dollars today would
decrease as traders backed off their speculative purchasing.
Note that an increase in the foreign currency exchange rate
would mean a fall in the US exchange rate.
Because in this market, demanding one currency is at the same
time supplying another currency, the final impact on exchange
rates will depend on both demand and supply changes in
response to a factor change.
xre
Quantity of US currency
Exchange Rate
S

Qe
D
Qe1
xre
Exchange Rate
S
Qe
D

D1
xre1
xre
Exchange Rate
S
Qe
D

D1
xre1
Qe1
xre1
Exchange Rate
S
Qe

D
S1
xre1
Qe1
Qe
xre1
Exchange Rate

S
D
S1
xre1
Qe1
Page 1 of 6
#18P
3/4/13
Handout #17P
Money
The Root of All Reserves
Money is any good that is widely accepted in trade and for
repayment of debt. People can use money for trade rather than
having to barter. People accept money because they know other
people will accept it. Money makes the economy more efficient,

frees up resources and makes everyone better off. Money serves
three functions:
· Medium of exchange—people can use money for trade rather
than having to barter.
· Unit of account—provides a common measure for values.
· Store of value—can maintain its value over time to some
satisfactory degree.
The money supply is measured in two ways.
· M1 is the narrow definition and includes only currency outside
of banks, checkable deposits and traveler’s checks. These are
totally liquid assets. Liquid asset
are asset that are easily and cheaply turned into cash.
· M2 is the broader definition and includes M1 plus savings
deposits, money market deposit accounts or non-institutional
mutual funds, small denomination time deposits like CDs, These
financial assets are just slightly less liquid than M1.
The Federal Reserve System (the Fed) is the central bank of the
U.S. The Federal Reserve System has a number of functions,
including:
· Controlling the money supply
· Providing paper money to the economy
· Providing check clearing services
· Holding banks reserves
· Supervising member banks
· Serving as the government’s banker
· Serving as the lender of last resort

· Handling the sales of US Treasury securities
These functions control the money supply through the nation’s
banking system. It works through the required reserve ratio for
banks. Banks only hold part of their deposits on hand as
reserves. The required percentage banks must hold is set by the
Fed.
In a simplified banking system with only one bank, suppose the
bank receives a brand new $1000 bill as a deposit from
customer 1. Though customer 1 could require his/her $1000 at
any time, the bank is only required to hold part as reserves.
Suppose the required reserve ratio set by the Fed is 10%. That
means that the bank only has to hold onto $100 as require
reserves out of the $1000 deposit and it can loan the rest out,
charging interest on the loan, and earning income that way. So
the bank loans out $900 to a borrower, customer 2, and he/she
puts that $900 in his/her checking account at the bank. The bank
has to keep $90 as required reserves and is free to loan out
$810. So it does, to customer 3, who then deposits the $810 loan
proceeds into his/her checking account. The bank has to keep
$81 of this deposit as reserves, and has $729 to loan out to
customer 4. And so on, and so on, and so on. . . . . .
Here’s the bank’s activities:
Total Reserves (
Required Reserves (10%) (
Loans (
New Deposits
$1000.00
$1000.00

$100.00
$900.00
$900.00
$900.00
$90.00
$810.00
$810.00
$810.00
$81.00
$729.00
$729.00
$729.00
$72.90
$656.10
$656.10
$656.10
$65.61
$590.49
$590.49
$590.49
$59.05
$531.44
$531.44
$531.44
$53.14
$478.30
$478.30
$478.30
$47.83
$430.47
$430.47
$430.47
$43.05
$387.42
$387.42
$387.42

$38.74
$348.68
$348.68
$348.68
$34.87
$313.81
$313.81
And so on
And so on
And so on
And so on
By the time the process is all the way done, the money supply
will have increased by $10,000 with $1000 from the initial new
$1000 bill and $9000 from the banking system. The total change
in the money supply can be calculated by the simple deposit
multiplier which is
1 divided by the required reserve ratio (r). The multiplier would
calculate the maximum total change in money supply as
∆M1 or M2
=
1 * ∆Bank reserves from original deposit of funds
r
In our example, this would be 1/.10 * $1000 or $10,000.
The process works in reverse to decrease the money supply—
banks have to hold onto repaid loan funds to meet their
reserves, rather than loan them out again. That shrinks the

money supply through the simple deposit multiplier operating
on the required reserve ratio, r.
When calculating the maximum change in the money supply, it
matters whether the initial deposit into the banking system is
new to the money supply or was already part of the money
supply, just not in the banking system. If the money is new to
the money supply, the maximum is calculated using the full
multiplication: initial deposit in the bank * 1/r. However, if the
deposit was already part of the money supply, you have to
subtract it out at the end: (initial deposit * 1/r)-initial deposit.
Two things have to happen to reach the maximum change in the
money supply. First, there can’t be any cash leakages. All the
loans have to be re-deposited in the bank—if not, a smaller
amount will be multiplied at every level afterward and the
change in the money supply cannot reach the maximum. Second,
the bank has to loan all its excess reserves. If the bank keeps
part of the reserves it could otherwise loan, a smaller amount
will be multiplied at every level afterward and the change in the
money supply cannot reach the maximum.
The Fed can change the money supply through reserves in
several ways:
· Open market operations—if the Fed purchases securities from
banks, it deposits money to pay for the securities in the bank’s
reserve account. This increase in reserves can then be loaned,
and through the simple deposit multiplier, expand M1 or M2. If
the Fed sells securities to a bank, it removes reserves from the
bank’s reserve account which reduces reserves and in turn the
amount that the bank can now loan. Open market purchases by
the Fed expand the money supply and open market sales by the
Fed contract the money supply.
· The required reserve ratio—the Fed can raise of lower the
percentage of deposits that a bank is required to hold as
reserves. If the Fed lowers the required reserve ratio, some of
the bank’s required reserves will suddenly become excess

reserves and the money supply will expand. If the Fed increases
the required reserve ratio, banks will have to increase required
reserves which means there will be less to loan out and the
money supply will contract.
· The discount rate—this is the interest rate that the Fed charges
to banks to borrow funds from the Fed. If the Fed lowers the
discount rate, more banks will borrow funds from the Fed,
which increases their reserves, and expands the money supply.
If the Fed increases the discount rate, fewer banks will borrow
funds from the Fed, and banks reserves will decrease,
contracting the money supply.
The main point to remember—anything that increases reserves
in the banking system will increase the money supply. Anything
that reduces reserves will contract it.
Quantity Theory of Money
Changes in the money supply change the price level. This effect
is analyzed through the equation of exchange. This equation
states that
Money supply (M) * Velocity of money (V) = Price level (P) *
Real GDP (Y) or (Q)
or MV = PQ
The velocity of money is simply the number of times annually
that the money supply is spent on final goods and services in
the economy. Suppose the economy has a money supply of $100
and during the year $700 of final goods and services was
purchased. That means that each dollar of the money supply was
spent an average of 7 times on final goods and services.
V = PQ or V = $700 so V = 7
M $100
MV measures total expenditures, also known as aggregate

demand, and PQ measures nominal GDP. If MV measures total
expenditures, then MV = C + I + G + NX.
The equation of exchange leads to the simple quantity theory of
money. If you assume that velocity and real GDP are constant
(in the short-run), then changes in the money supply will make
a proportional change in the price level, or $∆M = %∆P. Or,
increases in the money supply lead to inflation.
The equation of exchange results in the statement
P = MV
Q
If real GDP is assumed to change also, then you have three
influences on the price level
· Inflationary influences—increases in money supply, increases
in velocity (numerator) or decrease in real GDP (denominator)
· Deflationary influences—decreases in money supply,
decreases in velocity (numerator) or increase in real GDP
(denominator)

Looking at growth rates, the equation of exchange is:
(Money growth rate) + (Growth rate of velocity) = (Inflation
rate) + (Real GDP growth rate). You can rearrange this equation
by subtracting the (Real GDP growth rate) from both sides,
That gives you:
(Inflation rate) = (Money growth rate) + (Growth rate of
velocity) ( (Real GDP growth rate).
If velocity is assumed to remain constant, then in the long run
the inflation rate equals the growth rate of the quantity of
money minus the growth rate of potential GDP. In periods of
hyperinflation, or rapidly increasing price levels in excess of
50% per month, velocity will not remain constant but will be
rapidly increasing also.
The Market for Money
There is a market for money, which is different from the market
for loanable funds.
People like to hold some of their wealth in the form of money,
creating a demand for money.
The quantity of money that people plan to hold depends on:
· The Price Level: The higher the price level, the more money
people will want to hold.
· The Nominal Interest Rate: The nominal interest rate is the
opportunity cost of holding money, so an increase in the
nominal interest rate decreases the quantity of real money
demanded.
· Real GDP: An increase in real GDP increases the quantity of
money people plan to hold.
· Financial Innovation: Any financial innovation that enables
people to more easily access their financial accounts, like
ATMs and debit cards, or increases the opportunity cost of

holding money (interest paid on checking accounts) affects the
demand for money.
The demand curve for money shows the relationship between
the quantity of real money demanded and the interest rate,
which is the cost for holding money. By holding money, people
are foregoing the opportunity to make income through interest
earnings. When interest rates are high, you are giving up the
chance to earn more income, so you become less willing to hold
your wealth in cash or non-interest earning deposit accounts.
The negative relationship between the interest rate and the
quantity of money demanded means the demand for money
curve is downward sloping.
The supply of money is fixed at whatever level the Fed has set
it at. The supply curve will be a vertical line at that quantity.
If the Fed increases the money supply by:
a) open market purchase, or
b) decreasing the required reserve ratio, or
c) decreasing the discount rate,
the money supply curve will move out to the right because all of
these methods will increase bank excess reserves that can be
loaned. At the current nominal interest rate, this causes a
surplus of money and people will buy more of everything,
including bonds. The demand for bonds will increase which
drives the price of bonds up. When bond prices increase, real
interest rates decrease (PBONDS and ireal always move in
opposite directions). Since nominal interest rate = real interest
rate + expected inflation, nominal interest rates decrease also
down to inom1.
If the Fed decreases the money supply by:

a) open market sale, or
b) increasing the required reserve ratio, or
c) increasing the discount rate,
the money supply curve will move in to the left because all of
these methods will decrease bank excess reserves that can be
loaned. At the current nominal interest rate, this causes a
shortage of money and people will sell bonds to turn their bonds
into money. The supply of bonds will increase which drives the
price of bonds down. When bond prices decrease, real interest
rates increase (PBONDS and Ireal always move in opposite
directions). Since nominal interest rate = real interest rate +
expected inflation, nominal interest rates increase also up to
inom1.
A change in real GDP or financial innovation changes the
demand for money and shifts the money demand curve. An
increase in real GDP increases the demand for money and shifts
the money demand curve to the right, ultimately increasing the
short-run nominal interest rate.
A new financial innovation or a decrease in real GDP will
decrease the demand for money and shifts the demand for
money curve leftward, ultimately decreasing the short-run
nominal interest rate.
In the long run, the real interest rate is determined by supply
and demand in the loanable funds market. Since the nominal
interest rate equals the real interest rate plus the expected
inflation rate, the nominal interest rate cannot adjust to balance
the demand and supply in the market for money. Instead the
price level adjusts to create that balance. When the Fed changes
the quantity of money, the price level changes (in the long run)

by a percentage equal to the percentage change in the quantity
of money (remember the equation of exchange). So the %
change in M will equal the % change in P in the long run.
When the price level changes, the expected rate of inflation will
change too. That will in turn change the nominal interest rate.
The change in the nominal interest rate changes the opportunity
cost or price of holding money, so the quantity demanded of
money will increase or decrease, shown as a movement along
the demand curve for money.
Quantity of Real Money
inom
MS (M1 or M2, set by the Fed)
MD
Nominal Interest Rate
inom

MS1
MD
inom1
AFTER ireal (
MS
MONEY SURPLUS
Buy bonds (DBONDS
(PBONDS ((ireal ((inom

(Money Supply
inom
MS1
MD
inom1
AFTER ireal (

MS
MONEY SHORTAGE
Sell bonds (SBONDS
(Money Supply
inom1
MS
MD1

( Real GDP(
(Money Demand
MD
inom
MONEY SHORTAGE
Sell bonds (SBONDS

inom
MS
MD
(Financial Innovation or (Real GDP(
(Money Demand
MD1
inom1

MONEY SURPLUS
Buy bonds (DBONDS
Page 10 of 10
#17P
2/28/13
Welcome to Macroeconomics in Middle Earth!
Part 2*
Fernanda Matos De Oliveira
Page 32 of 46 1/30/13
*Quotes from The Lord of the Rings, or The Hobbit by JRR
Tolkien. Nothing written in italics applies to the questions—it’s
there just for Tolkien fun. Go forth and read!!!
Section 9
Treebeard runs the MENB (Middle Earth National Bank) with
“branches” all over the Shire. Merry Brandybuck makes a
deposit in the Shire’s MENB of $100 from the loot he brought
back from his travels in Wilderland.

'One felt as if there was an enormous well behind them, filled
up with ages of memory and long, slow steady thinking; but
their surface was sparkling with the present: like sun
shimmering on the outer leaves of a vast tree, or on the ripples
of a very deep lake. I don't know, but it felt as if something that
grew in the ground -- asleep, you might say, or just feeling
itself as something between root-tip and leaf-tip, between deep
earth and sky -- had suddenly waked up, and was considering
you with the same slow care that it had given to its own inside
affairs for endless years.'
a) If the reserve rate is set at 15%, how much of Merry’s
deposit must the bank keep? How much can the bank loan out to
Pippin Took?
The bank must keep=15%×100=$15
Loan (excess reserves)=$100-(100×0.15)=$85
b) What would be the maximum change to the money supply
from a)? Where does the change come from and by what
formula? Show reserve and loan amounts for the first 6 levels.
Maximum change to money supply=(1/0.15)×85=$566.67. The
change comes from the excess reserves.
YOU DON’T SUBTRACT OUT THE INITIAL DEPOSIT
HERE—IT IS NEW TO M1 FROM OUT OF THE COUNTRY.
ALSO NEED TABLE SHOWING FIRST SIX LEVELS IN

BANKING SYSTEM
c) Suppose Bilbo took $500 out of an old box he had buried at
Bag End (Bilbo’s house in the shire) and put it in MENB. What
would be the maximum change to the money supply if the
reserve rate was now 20%?
RR=0.2
Total Reserves=$500
Excess reserves=$500-(0.2×500)=$400
Maximum change to money supply=(1/0.2)×400=$2000
d) What two assumptions are included in calculating the
maximum change in the money supply in a)? Explain the
difference between a) and c).
Assumptions
· Banks hold NO excess reserves
· Individuals DON’T hold money
We would expect the maximum change to money supply to be
higher in c than in a because of a higher reserve rate in c.
Although the reserve rate is higher in b, the total reserves are
high enough to make the maximum change to money supply to
be the highest.
THE MAIN DIFFERENCE IS A IS NEW TO MONEY SUPPLY,
C IS NOT
'Of course we understand,' said Merry firmly. 'That is why we
have decided to come. We know the Ring is no laughing matter;
but we are going to do our best to help you against the Enemy.'
Section 10
The Federal Council of Elrond (Fed) controls the banking
system in Middle Earth. The Council is responsible for

controlling the money supply and implementing monetary
policy.
a) The Council wishes to expand the money supply. Describe
precisely how this would work through open market operations
and effects on reserves. NOTHING ELSE
The council can use open market operations to expand money
supply. What the economy basically needs is for monetary
policy to ease its current policy stance. The council needs to
purchase bonds and securities from the people on behalf of the
government. By purchasing bonds and securities, money will be
ploughed back to individuals. In addition, the council needs to
lower the reserve requirements to increase the supply of money.
This will mean that banks will be required to keep less in
required reserves, thereby increasing the excess reserves given
out as loans. LOOK AT THE HANDOUT 17 WHERE IT
TALKS ABOUT WHAT HAPPENS TO RESERVES WITH AN
OM PURCHASE.
b) The Council wishes to decrease the money supply. Describe
precisely how this would work through the required reserve
ratio and effects on reserves.
If the council wishes to decrease money supply following an
increase in inflation, it can choose to increase the required
reserve ration. By doing this, required reserves will increase,
and hence there will be less excess reserves. Bank will be
compelled to reduce the proportion of loans they give to
individuals and firms. The economy will experience a decrease
in money supply.
c) The Council wishes to decrease the money supply. Describe
precisely how this would work through the discount rate and
effects on reserves.

If the council wishes to decrease money supply through the
discount rate, it can achieve so by increasing the discount rate.
This will mean that financial institutions will have to pay more
in terms of interests for the money they borrow from the central
bank. They will pass on this effect to individuals and firms by
increasing their interest rates. In terms of reserves, the council
should increase the reserves so that banks have less to give out
in terms of loans. Overall, these policies will make the money
supply to reduce. LOOK AT THE HANDOUT 17 WHERE IT
TALKS ABOUT WHAT HAPPENS TO RESERVES WITH
HIGHER DISCOUNT RATE
If the money supply in Middle Earth is $10,000, velocity of
money is a constant 3, the price level is 2.0, and output is
constant at 15,000,
d) What is aggregate demand? What is nominal GDP? How did
you get your answer?
Aggregate demand is the same as the output, which 15,000
Nominal GDP=Money supply×Velocity
Nominal GDP=10,000×3
Nominal GDP=$30,000

or
Nominal GDP=Real output×Price level
Nominal GDP=15,000×2
Nominal GDP=$30,000
e) The Council increases the money supply by $1,000. What is
the net effect of the increase in the money supply in this case?
Graph the impact on the Middle Earth economy with a constant
level of real GDP and velocity (simple AD/AS model). Use
actual numbers.
I DID THIS IN CLASS. THERE IS NO SRAS ONLY 1
VERTICAL AS CURVE AT 15,OOO. REST IS OK.
When the money supply is increased, the Aggregate Demand
curve shifts to the right from AD to AD1. However, this
increase in aggregate demand is offset by a decrease in supply,
which causes the short run aggregate supply curve to shift
leftwards from SRAS to SRAS1. Although real GDP remains
constant, the price level increases from 2 to 2.2.
LRAS
Price
SRAS
1
2.2
SRAS
2

AD
1
AD
$15,000
Real GDP (Output)
f) Explain exactly and draw how the change in e) affects the
money market in the short run. What are the dynamics that make
the nominal interest rate adjust in the long run? (don’t use
numbers—answer in general terms)
MS
MS
1
Nominal interest rate
MD
Money Quantity
An increase in money supply causes a rightward shift of the
money supply curve from MS to MS1. As a result the quantity
of money will increase. Nominal interest rates adjust in the
long-term due to changes in the expected inflation. YOU

DON’T SHOW INTEREST RATES MOVING ON YOUR
GRAPH. ALSO, YOU HAVE TO INCLUDE THE BOND
MARKET DYNAMICS. LOOK IN HANDOUT 17
g) Now suppose that the Council implements a technological
innovation with ATM’s in Middle Earth. Graph the change in
the money market and explain how the change comes about.
(don’t use numbers—answer in general terms)
MS
Nominal interest rate
MD
MD
1
Money Quantity
A technological innovation with ATM’s is likely to shift money
demand to the left. This is because use of Automatic Teller
Machines would allow individuals in Middle Earth to hold less
cash.
YOU DON’T SHOW INTEREST RATES MOVING ON YOUR
GRAPH. ALSO, YOU HAVE TO INCLUDE THE BOND
MARKET DYNAMICS. LOOK IN HANDOUT 17
Section 11

MACRO PART 2 Handout Guide (See Handouts for Help)SECTION 9a).docx

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