Study sheet: Money Demand Supply and Interest

📋 Course Outline

1. Macroeconomics and Aggregation
2. National Output and Equilibrium
3. Macroeconomic Schools of Thought
4. Aggregate Demand and Supply Model
5. Circular Flow Models
6. National Income Measures
7. Real and Nominal GNP
8. National Income Accounting Review
9. Consumption and Saving Functions
10. Equilibrium Income and Investment
11. National Saving and Investment
12. Keynesian Cross and Thrift
13. Fiscal Policy Multipliers
14. Open Economy and Fiscal Policy
15. Automatic and Discretionary Stabilization
16. Money and Its Evolution
17. Types and Functions of Money
18. Demand and Supply of Money

📖 1. Macroeconomics and Aggregation

🔑 Key Concepts & Definitions

• Microeconomics : studies the economic behavior of individuals, firms, government officials, or relatively small groups, usually assuming that changes in one sector do not affect the rest of the economy.
• Macroeconomics : studies the economy as a whole and examines the combined effects of individual decisions on national output, employment, the general price level, the balance of payments, and economic growth.

★ Must-know

📐 Formula — Aggregate demand is expressed as $AD=C+I+G+X-M$, where consumption, investment, government spending, exports, and imports are represented by C, I, G, X, and M respectively.

• Macroeconomic variables are linked through a continuous causal flow in which changes in demand affect supply and prices, which affect income, which then affects demand again.

📌 Using money as the unit for aggregating output solves the problem of adding physically different goods but creates the need to distinguish real values from nominal values.

Further detail

• Macroeconomic aggregates include:
  • total output
  • total demand
  • total employment and unemployment
  • the general price level
  • the balance of payments
  • the rate of economic growth

📌 Real output is estimated by deflating output measured at current prices with an appropriate price index, converting it into output measured at constant prices.

💡 Memory Hook

Microeconomics studies individual agents, whereas macroeconomics studies economy-wide aggregates.

📖 2. National Output and Equilibrium

🔑 Key Concepts & Definitions

• National product : the sum of the value of all final goods and services produced during the year, excluding intermediate goods.
• National expenditure : the sum of spending on final goods and services produced during the year, including consumption of domestic goods, investment, government expenditure, and exports.
• National income : the sum of wages, salaries, interest, rent, and profits earned by all factors of production, excluding transfer payments.
• Macroeconomic equilibrium : occurs when aggregate demand equals aggregate supply, so no economic forces operate to change the level of national income.

📝 Essential Points

• The circular flow distinguishes: consumption as household expenditure on goods and services, investment as firms’ expenditure on real capital goods for future production, saving as disposable income not spent during the current period

📐 Formula — The equilibrium condition can be written as $AD=Y$ and $I+G+X=S+T+M$, meaning that injections equal withdrawals.

💡 Memory Hook

Output → income → expenditure, linked through the circular flow.

📖 3. Macroeconomic Schools of Thought

🔑 Key Concepts & Definitions

• Rational expectations : statistically optimal predictions of the future formed using all available information, including predictable government policies

★ Must-know

• In 1936, John Maynard Keynes published The General Theory of Employment, Interest and Money, presenting a model that emphasized investment, government spending, taxation, and exports rather than the money supply during depressions.

📌 Classical macroeconomics generally emphasizes self-adjusting markets, whereas Keynesian macroeconomics gives a significant role to government intervention to improve economic performance.

• The new classical school rests on three assumptions:

  • economic agents maximize
  • expectations are rational
  • markets clear

• Rational expectations mean that expectations are statistically the best predictions of the future that can be made using available information, so government policy cannot systematically fool people.

• Classical economists assume that flexible resource and output prices rapidly equate supply and demand, so the economy produces at its natural level of output and involuntary unemployment cannot persist.

• Keynesians argue that information problems and the costs of changing wages and prices create price rigidities, causing markets sometimes to fail to clear and unemployment to persist.

• Expansionary fiscal policy raises aggregate demand through lower tax rates, higher transfer payments, or higher government purchases, while expansionary monetary policy raises the money supply, lowers interest rates, and encourages borrowing and spending.

Further detail

• Monetarism developed as an extension of classical macroeconomic theory and assigns a critical role to money as a determinant of economic outcomes, especially through the work of Milton Friedman in the 1960s and 1970s.

• New classical macroeconomics developed in the 1970s and was associated with Robert Lucas, Thomas Sargent, Robert Barro, Edward Prescott, and Neil Wallace.

📌 Under rational expectations, predictable government policy cannot systematically fool most people because individuals eventually understand the policy being used.

📌 Monetarists oppose stop-go demand management and advocate predictable monetary growth, such as a fixed annual money-supply increase of 3 percent, together with annual government-budget balance.

💡 Memory Hook

Classical approaches trust self-adjusting markets, whereas Keynesian approaches support government intervention.

📖 4. Aggregate Demand and Supply Model

🔑 Key Concepts & Definitions

• Aggregate demand–aggregate supply model : explains macroeconomic output and prices using aggregate demand, short-run aggregate supply, and long-run aggregate supply

📝 Essential Points

• At long-run macroeconomic equilibrium, actual output equals the natural level of output, so the economy has full employment and the actual unemployment rate equals the natural unemployment rate.

• A fall in aggregate demand lowers prices and real output in the short run, raises unemployment above its natural rate, and may eventually restore long-run equilibrium through falling prices and input costs.

• A rise in aggregate demand initially raises prices and real output and lowers unemployment below its natural rate, but eventually higher wages and input prices raise the general price level and return production to the natural level of output.

📌 Classical economists expect a deflationary gap to close rapidly through falling prices without government action, whereas Keynesians expect prolonged unemployment and recommend immediate demand stimulation.

💡 Memory Hook

Demand shock → short-run gap → long-run adjustment.

📖 5. Circular Flow Models

🔑 Key Concepts & Definitions

• Circular flow : the continual movement of money, goods, and services between households and business firms through production, consumption, and capital formation

★ Must-know

📐 Formula — In the Keynesian income approach, income is allocated between consumption and investment according to $Y = C + I$.

• In a two-sector model, households supply factors of production and buy final goods, while businesses buy factor services and sell final goods.

• Injections increase the spending flow, whereas leakages reduce the spending flow in the circular economy.

• Injections are spending items that increase the circular flow, whereas leakages are income withdrawals that reduce spending.

• In the two-sector model, households sell factor services to businesses and purchase final output from businesses, while businesses purchase factor services and sell final output to households.

• The two-sector model assumes: a closed economy, production only by businesses, producers selling all output, consumers spending all income on consumption, no government or other external transactions

📌 The three-sector model adds government expenditure and taxes to the household–business circular flow, while the four-sector model additionally includes foreign trade.

📌 In the four-sector open economy, equilibrium requires total leakages from saving, taxes, and imports to equal total injections from investment, government expenditure, and exports.

Further detail

• The two-sector circular-flow model assumes a closed economy, production only by businesses, sale of all output, consumption of all household income, and no government or other external transactions.

• Greater consumer expenditure increases producers’ income, which encourages greater production and maintains the circular flow of economic activity.

💡 Memory Hook

Spending → producer income → production → further spending.

📖 6. National Income Measures

🔑 Key Concepts & Definitions

• National income accounting : the systematic measurement of aggregate economic activity, particularly national income and its components, within a given period
• Gross national product : the total market value of all final goods and services produced during a given period by resources owned and supplied by a country's citizens, regardless of where production occurs

★ Must-know

📐 Formula — Gross national product equals gross domestic product plus net factor income: $GNP = GDP + NFI$, where $NFI = \text{factor income received from abroad} - \text{factor income paid abroad}$.

📌 Net national product equals GNP minus depreciation, national income equals NNP minus indirect business taxes, and disposable personal income equals personal income minus personal taxes.

• GNP can be measured through the product or value-added approach, the expenditure approach, or the income approach.

📐 Formula — The expenditure approach expresses GNP as $Y = C + I + G + (X-M)$, where C is consumption, I is investment, G is government expenditure, and X−M is net exports.

Further detail

📌 Only final goods and services are counted in national output because including intermediate goods would cause double counting.

💡 Memory Hook

GNP → NNP → NI → PI → DI

📖 7. Real and Nominal GNP

🔑 Key Concepts & Definitions

• Consumer price index : an index used to estimate the percentage change in the prices of a particular basket of consumer goods

★ Must-know

📌 Nominal GNP values final output at the prices of the current period, whereas real GNP values final output at constant prices from a base period.

📐 Formula — Real GNP is calculated as $\text{Real GNP} = \frac{\text{Nominal GNP} \times 100}{\text{Price index}}$.

📐 Formula — The annual inflation rate is calculated as $\text{Inflation rate} = \frac{CPI_t-CPI_{t-1}}{CPI_{t-1}} \times 100$.

Further detail

📐 Formula — Per-capita income is calculated as $PCI = \frac{GNP}{\text{population}}$ and is used to compare economic growth across countries.

• When nominal GNP is 66 billion dollars and the price index is 110, real GNP equals 60 billion dollars using the real-GNP formula.

💡 Memory Hook

Nominal GNP uses current prices, whereas real GNP uses base-year prices.

📖 8. National Income Accounting Review

★ Must-know

📌 Gross national product measures output produced by factors of production owned by a country's residents, whereas gross domestic product measures output produced within the country's borders.

📐 Formula — Using the expenditure approach, gross national product equals consumption, investment, government purchases, and net exports: $Y=C+I+G+NX$.

📌 Real GNP is valued at base-period prices, whereas nominal GNP is valued at the prices of the current period.

Further detail

📐 Formula — The inflation rate in 1993 was calculated as $\frac{148.2-144.5}{144.5}\times 100=2.6\%$.

• The GDP deflator is the ratio of nominal GDP to real GDP and measures the rise in prices relative to the base period.

💡 Memory Hook

Nominal GNP uses current prices, whereas real GNP uses base-period prices.

📖 9. Consumption and Saving Functions

🔑 Key Concepts & Definitions

• Disposable income : the income consumers can choose to spend or save during a given period

★ Must-know

📐 Formula — Disposable income equals consumption plus saving: $Y_d=C+S$, so saving equals disposable income minus consumption: $S=Y_d-C$.

📐 Formula — The marginal propensity to consume is the change in consumption divided by the change in disposable income, and the marginal propensity to save satisfies $MPC+MPS=1$.

📐 Formula — The Keynesian consumption function is $C=a+bY_d$, where a is autonomous consumption and b is the marginal propensity to consume.

Further detail

📐 Formula — The average propensity to consume is total consumption divided by total disposable income: $APC=\frac{C}{Y_d}$.

📌 Dissaving occurs when consumption expenditure exceeds disposable income, producing a negative saving flow.

💡 Memory Hook

Higher disposable income → higher consumption and saving.

📖 10. Equilibrium Income and Investment

🔑 Key Concepts & Definitions

• Investment demand : the desired change in the nation's capital stock, including newly produced structures and equipment, new residential construction, and changes in business inventories

★ Must-know

📐 Formula — In a closed economy with government, the income identity is $Y=C+I+G$, and with a constant tax rate t the consumption function becomes $C=a+b(1-t)Y$.

📐 Formula — The equilibrium income level in a closed economy with a constant tax rate is $Y=\frac{1}{1-b(1-t)}(a+I+G)$.

📌 Investment demand varies inversely with the interest rate: a lower interest rate encourages investment, whereas a higher interest rate discourages it.

Further detail

• For the example with $C=500+0.6Y_d$, $I=300$, $G=500$, and $t=0.2$, spending equilibrium occurs at an income of approximately 2,500.

💡 Memory Hook

Consumption and investment → aggregate spending → equilibrium income.

📖 11. National Saving and Investment

★ Must-know

📐 Formula — In a closed economy, total saving equals private saving plus government saving and satisfies $S=I$.

📐 Formula — In an open economy, total saving is private saving plus government saving plus rest-of-world saving, and it satisfies $S=I$.

📐 Formula — Private saving is disposable income minus consumption: $S_p=(Y+F+N-T)-C$.

📐 Formula — Government saving is taxes minus transfers, interest payments, and government purchases: $S_g=T-F-N-G$.

Further detail

📐 Formula — Rest-of-world saving equals the negative of net exports: $S_r=-X$.

💡 Memory Hook

Closed economies balance domestic saving against investment; open economies add rest-of-world saving.

📖 12. Keynesian Cross and Thrift

🔑 Key Concepts & Definitions

• Keynesian cross : a graph showing the equilibrium nominal GNP where aggregate nominal demand equals aggregate nominal supply

★ Must-know

📌 An expansionary gap exists when aggregate nominal demand exceeds aggregate nominal supply, causing unplanned inventory declines and inducing firms to increase production.

📌 A contractionary gap exists when aggregate nominal demand falls below aggregate nominal supply, causing unplanned inventory accumulation and inducing firms to reduce production.

📐 Formula — The simple expenditure multiplier is $k=\frac{1}{1-MPC}$, so an MPC of 0.9 gives a multiplier of 10.

📌 The paradox of thrift states that if households try to save a larger proportion of income, consumption and aggregate demand fall, reducing national income and potentially reducing the actual amount saved and invested.

Further detail

📐 Formula — With consumption $C=500+0.6y$ and planned investment $I^*=300$, aggregate nominal demand is $AND=C+I^*$ and equilibrium occurs at $y=2000$.

💡 Memory Hook

Demand above supply → inventories fall → production rises; demand below supply → inventories build → production falls.

📖 13. Fiscal Policy Multipliers

🔑 Key Concepts & Definitions

• Fiscal policy : the use of government taxation and spending to alter macroeconomic outcomes

★ Must-know

📐 Formula — In the three-sector model, aggregate demand is $AD=C+I+G$ and aggregate supply is $AS=C+S+T$.

📐 Formula — With consumption $C=a+b(Y-T)$, lump-sum taxes, investment $I$, and government purchases $G$, equilibrium income is $Y=\frac{1}{1-b}(a-bT+I+G)$.

📐 Formula — The government expenditure multiplier is $G_m=\frac{\Delta Y}{\Delta G}=\frac{1}{1-b}$.

📐 Formula — The lump-sum tax multiplier is $T_m=\frac{\Delta Y}{\Delta T}=-\frac{b}{1-b}$.

📐 Formula — When the increase in government spending equals the increase in taxes, the balanced-budget multiplier is $B_m=1$, so national income increases by the amount of the increase in government spending.

Further detail

• In a fiscal strategy, desired new injections equal the recessionary gap, while desired new leakages equal the inflationary gap.

💡 Memory Hook

Government spending raises income, whereas taxation reduces it; equal changes produce a unit balanced-budget multiplier.

📖 14. Open Economy and Fiscal Policy

🔑 Key Concepts & Definitions

• Visible export : a domestically produced good that is physically transported to and sold in an overseas market, generating foreign exchange
• Invisible export : a service produced for foreigners domestically or overseas that generates foreign exchange for the home country
• Capital export : capital placed abroad as portfolio investment, foreign direct investment in physical assets, or bank deposits

📝 Essential Points

📐 Formula — With proportional taxation and linear imports, the four-sector equilibrium income is $Y=\frac{a-bT+I+G+X-M}{1-b(1-t)+g}$, where $b$ is the marginal propensity to consume, $t$ is the proportional tax rate, and $g$ is the marginal propensity to import.

📐 Formula — The foreign trade multiplier with proportional taxes is $\frac{\Delta Y}{\Delta X}=\frac{1}{1-b(1-t)+g}$ when consumption, taxes, and imports are linear functions of income.

💡 Memory Hook

Exports add demand, imports withdraw demand, so net trade changes the multiplier.

📖 15. Automatic and Discretionary Stabilization

🔑 Key Concepts & Definitions

• Automatic stabilizers : built-in features that create or enlarge a budget deficit during a recession and create or enlarge a budget surplus during an inflationary boom without new legislation
• Discretionary fiscal policy : a deliberate change in laws or appropriation levels that alters government revenues or expenditures to achieve macroeconomic goals
• Contractionary fiscal policy : a consciously designed decrease in government demand or increase in tax collections intended to move nominal GNP from its current equilibrium to a lower target level

📝 Essential Points

• During a recession, automatic stabilizers reduce tax revenues and increase government expenditures, while during an economic boom they increase tax revenues and decrease government spending.

📌 Keynesians view expansionary fiscal policy as useful below potential output, whereas New Classical economists argue that higher future taxes and forces toward full-employment equilibrium make macroeconomic policy ineffective.

💡 Memory Hook

Automatic stabilizers act without new legislation; discretionary policy requires deliberate government action.

📖 16. Money and Its Evolution

🔑 Key Concepts & Definitions

• Money : any generally accepted commodity chosen by common consent to serve as a medium of exchange for goods and services and to settle debts
• Barter economy : a system in which one good is exchanged directly for another without using money
• Commodity money : money that has value as a commodity apart from its value as money, such as gold, silver, or tobacco used in exchange
• Fiat money : something with little commodity value that is accepted as a medium of exchange because of law or tradition

★ Must-know

• The main disadvantages of barter are: lack of double coincidence of needs, absence of a common unit of account, difficulty in making credit sales and purchases, difficulty storing wealth or generalized purchasing power

Further detail

• A substance suitable as primitive money should be:
  • relatively rare
  • easily carried
  • stored without spoiling
  • divisible into smaller portions

💡 Memory Hook

Barter → primitive money → commodity money → fiat money

📖 17. Types and Functions of Money

🔑 Key Concepts & Definitions

• Fiat money : has little commodity value but is accepted as a medium of exchange because law or tradition gives it acceptance, such as paper money or a Yap stone
• Credit money : has no value apart from its exchange value and is accepted because sellers expect other sellers to accept it

★ Must-know

• Money performs four functions:
  • medium of exchange
  • unit of account or measure of economic value
  • standard of deferred payments
  • store of value or liquid wealth

Further detail

• Desirable commodity money should be:

  • easily verifiable
  • intrinsically useful
  • conveniently transportable
  • divisible

• Token money has a monetary value or purchasing power greater than its production cost and its value in alternative uses, as with dollar bills and coins.

💡 Memory Hook

M-U-S-S: medium of exchange, unit of account, standard of deferred payment, store of value

📖 18. Demand and Supply of Money

🔑 Key Concepts & Definitions

• Interest rate : the price paid for using money, usually expressed as a percentage of the initial amount of money called the principal
• IS curve : HICKS — combinations of interest rates and income levels at which saving equals investment and the product market is in equilibrium
• LM curve : combinations of interest rates and income levels at which the demand for money equals the fixed money supply and the money market is in equilibrium
• General equilibrium : exists when the IS and LM curves intersect at one combination of income and interest rate, producing simultaneous equilibrium in the product and money markets

📝 Essential Points

📌 Money is demanded for transactions, to facilitate exchanges of goods and services, and as an asset, to be held as wealth in liquid form.

• The three motives for holding money are:
  • the transactions motive
  • the precautionary motive
  • the speculative motive

📐 Formula — Transactions and precautionary demand for money can be represented as $L_{t+p}=K(Y)$, where $Y$ is national income and $K$ is the fraction of income kept for these purposes.

📐 Formula — Speculative demand for money is represented as $L_s=L(r)$, where $r$ is the interest rate, and it is a negative function of that rate. — Keynes

📌 An increase in the required reserve ratio reduces the money supply, whereas a decrease in the ratio increases the money supply.

• When the central bank buys securities, bank reserves and the money supply increase; when it sells securities, bank reserves decrease.

• The money market reaches equilibrium where the downward-sloping money-demand curve intersects the vertical money-supply curve.

📌 The nominal interest rate is expressed in the current value of money, whereas the real interest rate is expressed in constant or inflation-adjusted value of money.

📌 A low-interest-rate monetary policy increases investment and expands the economy, whereas a high-interest-rate monetary policy discourages investment and constrains the economy.

• 🔄 The IS curve is derived by: finding the saving-investment intersection at each interest rate, recording the corresponding income level, connecting the resulting interest-income combinations

📌 The IS curve slopes downward because a lower interest rate increases investment and income, creating a negative relationship between interest rates and income in the real sector.

📌 With a fixed money supply, a higher income level increases money demand and therefore requires a higher interest rate to restore money-market equilibrium, making the LM curve upward sloping.

💡 Memory Hook

Transactions → precaution → speculation

📊 Synthesis Tables

Macroeconomic schools

School	Main emphasis	Policy view
Classical	Self-adjusting markets	Limited government intervention
Keynesian	Investment, government spending, taxation, and exports	Government intervention can improve performance
Monetarist	Money supply as a determinant of outcomes	Skepticism toward active fiscal policy
New classical	Rational expectations and market clearing	Government intervention is likely to worsen outcomes

Schools of Macroeconomic Thought

School	Market adjustment	Policy view
Classical	Prices and wages adjust rapidly; full employment is restored	Laissez-faire
Keynesian	Price rigidities can sustain unemployment	Active fiscal and monetary policy
Monetarist	Discretionary policy creates instability	Predictable monetary growth
New classical	Rational expectations and continuously clearing markets limit policy effects	Demand management is ineffective