De-escalating During an Interview· httpswww.ncsbn.org1658.h

De-escalating During an Interview:
· https://www.ncsbn.org/1658.htm High-risk behaviors and
client care from the administrator and regulatory administrator’s
standpoint, verbal de-escalation techniques, safety,
interventions, what to do, and what not to do. (video is 55
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De
-
escalating During an Interview:
·
https://www.ncsbn.org/1658.htm
High
-
risk behaviors and client care from th
e administrator
and regulatory administrator’s standpoint, verbal de
-
escalation techniques, safety,
interventions, what to do, and what not to do.
(video is 55 minutes long)

NO CONSIDERATION
FOR plagiar
ism
De-escalating During an Interview:
-risk behaviors and
client care from the administrator
and regulatory administrator’s standpoint, verbal de-escalation
techniques, safety,
interventions, what to do, and what not to do. (video is 55
minutes long)
NO CONSIDERATION FOR plagiarism
Chapter 11 Lecture Summary
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Interest Rates and Monetary Policy
Chapter 16
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education. All rights
reserved.
This chapter starts by introducing the transactions and asset
demand for money and explaining how the interaction of the
demand and supply of money determine the interest rates in the
market. Banks’ balance sheets are used to explain how open
market operations is effective in changing the money supply.
We will learn about tools other than open market operations that
the Fed might use to manipulate the money supply and the
reasons that these tools are chosen, or not chosen. We will then
evaluate expansionary and restrictive monetary policy,
conditions under which these policies should be used, and how
they impact interest rates, investment, and aggregate demand.
We close with a discussion of issues related to monetary policy
and current monetary policy.
*
Interest Rates
The price paid for the use of money
Many different interest rates
Speak as if only one interest rate
Determined by the money supply and money demand
LO1
LO1
Understanding interest rates is a key economic concept. For

example, imagine a gentleman who was beginning a new career
working for an investment firm. He did not have a business
background, but he was a salesman. One evening as he was
discussing his new career with an economist friend, he told his
friend that the reason his firm could offer investors a much
higher return than the banks was because his firm had been
around for over 100 years and, therefore, was considered
“safer” than a bank and did not have to purchase insurance to
safeguard depositors’ funds like banks did. The economist
stopped him and had to explain to him that actually it was the
opposite: His firm had to pay a higher interest rate to investors
to compensate the investors for their increased risk with his
firm because their investments were not insured.
*
Demand for Money
Why hold money?
Transactions demand, Dt
Determined by nominal GDP
Independent of the interest rate
Asset demand, Da
Money as a store of value
Varies inversely with the interest rate
Total money demand, Dm
LO1
LO1
People hold money for many different reasons. One reason is
that it is convenient to have money available to purchase
necessary goods and services. This is referred to as the
transactions demand, or Dt. The larger the value of all goods
and services exchanged in the economy, the larger the amount
of money that will be needed to handle all of the transactions.

The second reason for holding money is the asset demand or Da.
People like to hold some of their financial assets as money
because money is the most liquid of all financial assets. If an
emergency arises where you need funds in a hurry, you will
have access to those funds quickly.
The disadvantage to holding money as an asset is that it is a
non-productive asset. If you bury a pile of money in the
backyard, when you dig it up ten years later, it will be the same
amount that you buried, and ten years later the purchasing
power of the money has probably declined.
The amount of money demanded as an asset is inversely related
to the interest rates, meaning as interest rates go up, the demand
for money as an asset goes down and vice versa.
*
Demand for Money
Rate of interest, i percent
10
7.5
5
2.5
0
Amount of money
demanded
(billions of dollars)
Amount of money
demanded
Amount of money
demanded and supplied
=
+
(a)

Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
(c)
Total
demand for
money, Dm
and supply
Dt
Da
Dm
Sm
5
LO1
LO1
50
100
150
200
50
100
150
200
50
100
150
200
250
300
The total demand for money is the sum of the transactions

demand for money plus the asset demand for money. The
transactions demand for money is assumed to be vertical as it
depends on GDP rather than the interest rate. The asset demand
for money is inversely related to the interest rate, meaning as
interest rates go up, the amount of money demanded goes down.
When we introduce the supply of money into the graphs, we
find an equilibrium point for money.
*
Interest Rates
Equilibrium interest rate
Changes with shifts in money supply and money demand
Interest rates and bond prices
Inversely related
Bond pays fixed annual interest payment
Lower bond price will raise the interest rate
LO1
LO1
Just like in other resource markets, there is an equilibrium
interest rate that will cause the supply of money available to
equal the demand for money. This rate can be thought of as the
market-determined price that borrowers must pay for using
someone else’s money over some period of time.
*
Assets
Securities
Loans to commercial banks
Liabilities
Reserves of commercial banks

Treasury deposits
Federal Reserve Notes outstanding
LO2
Federal Reserve Balance Sheet
Just like any other organization, the Federal Reserve Bank’s
balance sheet reports the assets and liabilities of the
organization as of that point in time. The Fed’s balance sheet
helps us to consider how the Fed conducts monetary policy.
*
April 10, 2013 (in Millions)
Source: Federal Reserve Statistical Release, H.4.1, April 10,
2013, www.federalreserve.gov
Securities
Loans to Commercial
Banks
All Other Assets
Total
Reserves of Commercial
Banks
Treasury Deposits
Federal Reserve Notes
(Outstanding)
All Other Liabilities and
Net Worth
Total
$957,619
439

271,355
$3,229,413
$ 1,851,361
52,478
1,137,087
188,487
$3,229,413
LO2
Federal Reserve Balance Sheet
Assets Liabilities and Net Worth
LO2
The two main assets of the Federal Reserve Banks are securities
and loans to commercial banks. The securities are government
bonds that have been purchased by the Federal Reserve Bank to
increase the supply of money in the economy. Loans to
commercial banks also help the banks to increase their reserves.
The liabilities of the Federal Reserve Banks have three
noteworthy items. The reserves of commercial banks represent
the required reserves that banks must hold to ensure their
stability. These reserves are also listed as assets on the banks’
books. The Treasury Deposits represent the amount of money
the U.S. government has on deposit with the Fed. The
government uses this money to pay its obligations. The Federal
Reserve Notes Outstanding represents the supply of paper
money currently circulating outside of the Federal Reserve
Banks. Over the past couple of years, the balance sheet of the
Fed has increased dramatically as the Fed has taken various
actions to help the economy recover from the recessi on.

*
Central Banks
LO2
LO2
This chart contains some examples of the central banks of other
nations. Like the Federal Reserve System, these banks
coordinate the monetary policies of their countries.
*
Tools of Monetary Policy
Open market operations
Buying and selling of government securities (or bonds)
Commercial banks and the general public
Used to influence the money supply
When the Fed sells securities, commercial bank reserves are
reduced
LO2
LO3
Open market operations are used by the Fed to increase or
decrease the commercial bank reserves available which, in turn,
will affect the amount of money available in the economy.
*
Fed buys bonds from commercial banks

Federal Reserve Banks
+ Securities
+ Reserves of Commercial Banks
(b) Reserves
Commercial Banks
Securities (a)
+Reserves (b)
Assets
Liabilities and Net Worth
LO2
(a) Securities
LO3
Assets
As part of their open-market operations, the Fed will buy or sell
government bonds. If they purchase the bonds from commercial
banks, the commercial banks are in effect transferring part of
their holding of securities to the Fed, which creates new
reserves for the banks in their accounts at the Fed. By
increasing the commercial banks’ reserves, the Fed has
increased their lending capacity.

Fed sells bonds to commercial banks
Federal Reserve Banks
- Securities
- Reserves of Commercial Banks
Commercial Banks
+ Securities (a)
- Reserves (b)
Assets
(a) Securities
(b) Reserves
LO2
LO3
Assets
If the Fed sells government bonds to commercial banks, the
opposite effect occurs. The banks lose reserves, which will
reduce their lending capacity.
Open Market Operations
Fed buys $1,000 bond from a commercial bank

LO2
LO3
New Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
$1000
Excess
Reserves
When the Fed buys government bonds from commercial banks,
it increases the assets of the Fed and increases the reserves of
the commercial banks. This will increase the lending ability of
the commercial banks.
*
Open Market Operations
Fed buys $1,000 bond from the public
LO2
LO3
Check is Deposited
New Reserves
$1000
Total Increase in the Money Supply, ($5000)

$200
Required
Reserves
$800
Excess
Reserves
$1000
Initial
Checkable
Deposit
$4000
Bank System Lending
When the Fed buys government bonds from the public, the
effect is much the same. The assets of the Fed increase, and as
the public deposits the funds into a commercial bank, its
reserves and lending ability will increase.
*
The reserve ratio
Changes the money multiplier
The discount rate
The Fed as lender of last resort
Short term loans
Term auction facility

Introduced December 2007
Banks bid for the right to borrow reserves
LO2
LO3
In addition to open market operations, the Fed has three other
tools available. The Fed can change the reserve ratio, which
will affect the ability of commercial banks to lend. If the
reserve ratio is increased, the money multiplier will decrease
and vice versa.
As the “lender of last resort,” the Fed makes short-term loans to
banks to cover unexpected and immediate needs for additional
funds. The rate that the Fed charges the banks is called the
discount rate. In providing the loan, the Fed increases the
reserves of the borrowing bank. Since there are no required
reserves against loans from the Fed, all new reserves are
considered excess reserves, and as such, they enhance the
ability of the bank to lend. If the Fed raises the discount rate, it
discourages banks from borrowing, and if it lowers the rate, it
encourages banks to borrow.
The term auction facility is another way that the Fed can alter
bank reserves. Twice a month, the Fed auctions off the right for
banks to borrow reserves for 28- and 84-day periods. This tool
allows the Fed to guarantee that the amount of reverses it
wishes to lend will be borrowed and, therefore, will be available
as excess reserves in the banking system to increase lending.
*
The Reserve Ratio
Effects of Changes in the Reserve Ratio
LO2
LO3(1)
Reserve Ratio, %(2)

Checkable Deposits(3)
Actual Reserves(4)
Required Reserves(5)
Excess Reserves,
(3) –(4)(6)
Money-Creating Potential of
Single Bank, = (5)(7)
Money-Creating Potential of Banking System(1)
10$20,000$5000$2000$3000$3000$30,000(2) 20 20,000 5000
4000 1000 1000 5000(3) 2520,000 5000 5000 0 0
0(4) 30 20,000 5000 6000-1000-1000 -3333
This table shows that a change in the reserve ratio affects the
money-creating ability of the banking system as a whole in two
ways, (1) by changing the amount of excess reserves, and (2)
changing the size of the monetary multiplier.
Open market operations are the most important
Reserve ratio last changed in 1992
Discount rate was a passive tool
Interest on reserves
LO2
LO3
The open market operations are the most important tool in the
Fed’s arsenal. It gives the Fed great flexibility in controlling
the money supply, and the impact on the money supply is swift.
The other tools are typically only used in special circumstances.
For example, the last change in the reserve ratio came in 1992
and was done more to shore up banks and thrifts in the
aftermath of the 1990-1991 recession than to impact the money

supply. In 2008, federal law was changed so that the Federal
Reserve could for the first time pay banks interest on reserves.
By changing the interest rate the Federal Reserve can encourage
or discourage banks to keep reserves, thereby influencing the
amount of lending banks do.
*
The Federal Funds Rate
Rate charged by banks on overnight loans
Targeted by the Federal Reserve
FOMC conducts open market operations to achieve the target
Demand curve for Federal funds
Supply curve for Federal funds
LO3
Instead of leaving excess reserves at the Federal Reserve Banks,
which typically pay less interest than commercial banks, when
banks have excess reserves, they will prefer to loan them to
other banks that temporarily need the money to meet their own
reserve requirements. The rate charged by the commercial bank
on these overnight loans is referred to as the federal funds rate.
It serves as the equilibrium rate for this market of bank
reserves. The Federal Reserve targets this rate by manipulating
the supply of reserves that are offered in the market. Typically
this is done by buying or selling government bonds. The FOMC
meets regularly to choose a desired federal funds rate and then
directs the Federal Reserve Bank of New York to undertake the
open market operations needed to achieve that rate.
*
The Federal Funds Rate

Federal Funds Rate, Percent
3.5
Quantity of Reserves
Df
Sf 3
4.0
4.5
Sf 1
Sf 2
Qf3
Qf1
Qf2
Using Open Market Operations
LO3
LO4
In this example, we are assuming that the Fed desires a 4%
interest rate. The demand curve is downward sloping because
lower interest rates give banks greater incentives to borrow.
The supply curve for Federal funds is horizontal at the desired
rate because the Fed uses open market operations to manipulate
the supply to keep it there.
*
Monetary Policy
Expansionary monetary policy
Economy faces a recession
Lower target for Federal funds rate
Fed buys securities
Expanded money supply

Downward pressure on other interest rates
LO3
LO4
During times of recession and unemployment, as in the past
couple of years, the Fed will initiate expansionary monetary
policy. The idea is to increase the supply of money in the
economy in order to increase borrowing and spending. One of
the problems with the recovery today is that while spending has
increased some, borrowing is actually down. It seems ironic
that when people save instead of borrow, it can actually be
detrimental to the economy. If the Fed feels the economy is
overheating or heading into a period of inflation, it will switch
to restrictive monetary policy. This policy involves increasing
the interest rate to reduce borrowing and spending, which
should curtail the expansion of aggregate demand and keep
prices down.
*
Monetary Policy
Restrictive monetary policy
Periods of rising inflation
Increases Federal funds rate
Increases money supply
Increases other interest rates
LO3
LO4
During times of rising inflation, the Fed will switch to a more
restrictive monetary policy. In order to keep prices down, the
Fed will increase the interest rate in order to reduce borrowing
and spending, which will hopefully slow the expansion of

aggregate demand that is driving up the price levels.
Monetary Policy
LO4
This figure illustrates the changes in the prime interest rate and
the Federal funds rate in the United States between 1998-2013.
The two rates move together.
Taylor Rule
Rule of thumb for tracking actual monetary policy
Fed has 2% target inflation rate
If real GDP = potential GDP and inflation is 2%, then targeted
Federal funds rate is 4%
Target varies as inflation and real GDP vary
LO3
LO4
The Taylor rule was developed by economist John Taylor and
builds upon the theory that most economists have which is that
central banks are willing to tolerate a small positive inflation
rate if doing so helps the economy achieve its potential output.
The Taylor Rule assumes that the Fed has a 2% target inflation
rate and follows three basic rules when setting its target for the
Federal funds rate: (1) When real GDP = potential GDP and
inflation is at the target rate of 2%, the Federal funds rate
should be 4%. (2) For each 1% increase of real GDP above
potential GDP, the Fed should raise the real Federal funds rate
by ½%. (3) For each 1% increase in the inflation rate above the
2% target rate, the Fed should raise the real Federal funds rate

by ½%.
*
Monetary Policy, Real GDP, Price Level
Affect on real GDP and price level
Cause-effect chain
Market for money
Investment and the interest rate
Investment and aggregate demand
Real GDP and prices
Expansionary monetary policy
Restrictive monetary policy
LO4
LO5
This next section will discuss how monetary policy affects the
economy’s levels of investment, aggregate demand, real GDP,
and prices.
*
Monetary Policy and Equilibrium GDP
10
8
6
0
Q1
Qf
Q3

$125
$150
$175
$15
$20
$25
P2
P3
Sm1
Sm2
Sm3
Dm
ID
AD1
I=$15
AD2
I=$20
AD3
I=$25
(a)
The market
for money
(b)
Investment
demand
(c)
Equilibrium real
GDP and the
Price level
AS

LO5
Rate of Interest, i (Percent)
Amount of money
demanded and
supplied
Amount of investment
Price Level
Real GDP
An expansionary monetary policy that shifts the money supply
curve rightward in (a) lowers the interest rate from 10% to 8%
which results in the investment spending in (b) to increase from
$15 to $20 billion and causes aggregate demand to increase.
This shifts the aggregate demand curve rightward from AD1 to
AD2 in (c) so that real output rises to the full employment level
Qf along the horizontal dashed line. Conversely, a restrictive

monetary policy will cause the money supply curve to shift
leftward, thereby increasing the interest rate, decreasing
investment and aggregate demand.
*
Q1
Qf
Q3
P2
P3
AD1
I=$15
AD2
I=$20
AD3
I=$25
(c)
Equilibrium real
GDP and the
Price level
AS
Q1
Qf
Q3
P2
P3
AD1
I=$15
AD2
I=$20
AD3

I=$25
(d)
Equilibrium real
GDP and the
Price level
AS
a
b
c
AD4
I=$22.5
Monetary Policy and Equilibrium GDP
LO4
LO5
Price Level
Real GDP
Price Level
Real GDP
In (d), the economy at point a has an inflationary output gap
because it is producing above potential output.

Expansionary Monetary Policy
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, lowers the discount rate,
or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
CAUSE-EFFECT CHAIN
LO5
This chain illustrates the causes and effects of expansionary
monetary policy. When faced with the problems of
unemployment and recession, the Fed takes actions to increase
the money supply, which should eventually lead to real GDP
rising. Unfortunately, it is not an immediate reaction so the Fed
may overshoot the mark, which can lead to inflation.
*
Restrictive Monetary Policy
Problem: Inflation

Fed sells bonds, increases reserve ratio, increases the discount
rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
CAUSE-EFFECT CHAIN
LO5
In times of inflation, the Fed practices restrictive monetary
policy and decreases the supply of money, which should lead to
a decrease in the inflation rate. However, because prices tend
to be inflexible, if the Fed is not careful, their actions can lead
to a recession.
*
Evaluation and Issues
Advantages over fiscal policy
Speed and flexibility
Isolation from political pressure
Monetary policy is more subtle than fiscal policy
LO6

Compared to fiscal policy, which involved the government
changing its taxing and spending policies, monetary policy has
several advantages. It can quickly be changed to fit the current
economic conditions, and because the members of the Fed’s
Board of Governors served fixed terms and are appointed, not
elected, they are not subject to the political pressures that
Congress is under.
*
Recent U.S. Monetary Policy
Highly active in recent decades
Responded with quick and innovative actions during the recent
financial crisis and the severe recession
Critics contend the Fed contributed to the crisis by keeping the
Federal funds rate too low for too long
LO6
Given the fact that the recession was declared to have officially
ended in June of 2009, many economists will continue to debate
whether the Fed’s actions helped or hindered the recovery. Over
the past decade, the Fed has acted quickly to attempt to
stimulate the economy, even lowering the Federal funds rate to
almost zero.
*
After the Great Recession
Slow recovery especially in terms of employment
Zero interest rate policy
Zero lower bound problem

Quantitative easing
Forward commitment
Operation Twist
LO6
To help stimulate the economy after the Great Recession, the
Fed implemented the zero interest rate policy, quantitative
easing, Operation Twist and forward guidance. Under the zero
interest policy, the Fed aimed to keep short-term interest rates
near zero to stimulate the economy. When growth remained
weak the Fed had to find a way to deal with the zero lower
bound policy under which a central bank is constrained in its
ability to stimulate the economy through lower interest rates
since you cannot have a negative interest rate. Their next
response was quantitative easing which is similar to open-
market operations but is not intended to lower interest rates but
rather stimulate increased lending. In the second round the Fed
engaged in forward commitment, preannouncing exactly how
much it was going to buy. This continued until the Maturity
Extension Program, better known as Operation Twist, was
introduced in September 2011. This program was designed to
reduce long-term interest rates.
*
Problems and Complications
Lags
Recognition and operational
Cyclical asymmetry
Liquidity trap
LO5
LO6

The lags complicate monetary policy because although its
impact is faster than fiscal policy, there is still a three to six
month delay that can cause problems and end up with the Fed
overshooting its targets. Economists also feel that monetary
policy is more effective dealing with slowing expansions and
controlling inflations than it is with helping the economy
recover from a severe recession. Even though the Fed may
create excess reserves during periods of recession, that does not
mean the banks will loan the money out. This is why in the
recent recessionary period, the U.S. turned more towards the
use of fiscal policy to attempt to spend its way out of the
recession. Which policies actually succeeded we will probably
never figure out.
*
The Big Picture
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Aggregate
Supply
Input
Resources
With Prices
Productivity
Sources
Legal-
Institutional
Environment
Consumption

(Ca)
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
LO6
This figure illustrates the many concepts and principles
discussed in the preceding chapters and how they relate to one
another.
*
Worries about ZIRP, QE, and Twist
Government spending crowded out private spending
Large budget deficits by the Federal government would lead to
huge interest costs

Low interest rates punish savers
LO6
While most economists feel that the Fed’s aggressive use of
ZIRP and QE were warranted by the severity of the recession,
there are concerns about the long-run impact. The extremely
low interest rate encourage Congress to overspend in efforts to
stimulate the economy. Once interest recover, the Federal
government will be faced with huge interest costs which will
take away from other programs. The extremely low interest
rates all punish savers who may have been living off the interest
generated by their investments. Pension plans and retirement
funds were also negatively impacted by the low rates leading to
concerns about the long-term ability of those funds to meet their
obligations.
*
Money Creation
Chapter 15
McGraw-Hill/Irwin
reserved.
This chapter explains how the banking system creates money
and increases the money supply. The balance sheets of the
banks are used to show how different transactions impact the
banks and the money supply. You will learn the difference
between excess and required reserves. You will learn how the
money multiplier impacts the money supply. Lastly, we will
discuss the bank panics of the 1930s.

*
Fractional Reserve System
The Goldsmiths
Stored gold and gave a receipt
Receipts used as money by public
Made loans by issuing receipts
Characteristics:
Banks create money through lending
Banks are subject to “panics”
LO1
LO1
The development of a functioning banking system is key to the
economic development of any system. Banking developed as
early traders recognized that carrying gold around to use in
transactions was both unsafe and inconvenient. Goldsmiths
would take the gold, store it in a safe place, and give the trader
a receipt which could then be used in place of the gold. The
trader could give the receipt to another party who could then go
to the goldsmith and retrieve the gold.
As the system developed, the goldsmiths discovered that owners
rarely actually came back for the gold, so some goldsmiths
began issuing excess paper receipts as loans to merchants,
producers, and really just about anyone whom they felt would
pay back the loan. This was the beginning of the fractional
reserve system still in use today. The only way that the system
can fail is if every depositor demands their funds back at the
same time, causing a run on the bank. Today’s banking system
has many safeguards in place to secure deposits and prevent
panics from occurring.
*

Fractional Reserve System
Balance sheet
Assets = Liabilities + Net Worth
Both sides balance
Necessary transactions
Create a bank
Accept deposits
Lend excess reserves
LO1
LO1
Here we move into what is almost a basic bookkeeping exercise
explaining how businesses use accounts to track information
and compute balances, all the while maintaining an equality in
their balance sheet accounts.
*
A Single Commercial Bank
Transaction #1
Vault cash: cash held by the bank
LO1
LO2
Assets
Creating a Bank
Balance Sheet 1: Wahoo Bank
Cash

$250,000
Stock Shares
$250,000
Investors have created a bank and organized it as a corporation
by contributing a total of $250,000 cash to the bank in exchange
for ownership shares in the bank worth $250,000.
*
Transaction #2
Acquiring property and equipment
LO1
LO2
Assets
Acquiring Property and Equipment
Cash
$10,000
Stock Shares
$250,000
Property
240,000
The business acquires a building and some equipment for cash.
This did not affect the total net worth of the bank but was rather
an exchange of one asset for another asset.
*

Transaction #3
Commercial bank functions
Accepting deposits
Making loans
Accepting Deposits
Cash
$110,000
Checkable
Deposits
$100,000
Property
240,000
Stock Shares
250,000
LO1
LO2
Assets
In this slide, the bank has actually increased its value by
accepting deposits from customers. The deposits are recorded
as liabilities of the bank, as the bank must return the money to
the customers upon request. The assets of the bank also
increase as the bank now has more cash.
*

Transaction #4
Depositing reserves in a Federal Reserve bank
Required reserves
Reserve ratio
LO2
LO2
Reserve
ratio
=
Commercial bank’s
Required reserves
Commercial bank’s
Checkable-deposit liabilities
Banks are not required to keep 100% of their deposits on hand
at all times because the probability that all customers will ask
for their money back at the same time is small. If all customers
did return to demand their money at the same time, this would
be referred to as a “run on the bank.”
*
The Fed can establish and vary the reserve ratio within limits
set by Congress
Required reserves help the Fed control lending abilities of
commercial banks
LO2
LO2

Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0-$12.4 Million
$12.4 - $79.5 Million
Over $79.5 Million
Noncheckable nonpersonal
savings and time deposits
0%
3
10
3%
3
8-14
0
0-9
In addition to reserves, commercial bank deposits are also
protected through other means such as insurance.
*
Transaction #4
Assume the bank deposits all cash on reserve at the Fed
LO2
Assets

Depositing Reserves at the Fed
Cash
$0
Checkable
Deposits
$100,000
Property
240,000
Stock Shares
250,000
Reserves
110,000
Here the bank has transferred all of its cash to the Federal
Reserve Bank to serve as required reserves.
*
Excess reserves
Actual reserves - required reserves
Required reserves
Checkable deposits x reserve ratio
Example:
Checkable deposits $100,000
Reserve ratio 20%
LO2
LO2
In our example, the excess reserves would equal $90,000, which
is actual reserves of $110,000 minus the required reserve of

$20,000.
*
Transaction #5
Clearing a check
$50,000 check reduces reserves and checkable deposits
LO2
LO2
Assets
Clearing a Check
Checkable
Deposits
$50,000
Property
240,000
Stock Shares
250,000
Reserves
$60,000
Now we see that when a customer writes a check against his
balance, it reduces the reserves and the checkable deposits by
the amount of the check.
*

Money Creating Transactions
Transaction #6a
Granting a loan
$50,000 loan deposited to checking
LO3
LO3
Assets
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Checkable
Deposits
$100,000
Property
240,000
Stock Shares
250,000
Reserves
$60,000
Loans
50,000
Now we are actually creating new money as opposed to just
moving around old money. A bank’s loans are its assets.
Having someone owe you money is a good thing (having them
actually pay you is even better). Here both assets and deposits
increased.
*

Transaction #6b
Using the loan
$50,000 loan cashed
LO3
LO3
Assets
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Checkable
Deposits
$50,000
Property
240,000
Stock Shares
250,000
Reserves
$10,000
Loans
50,000
A single bank can only lend an amount
equal to its preloan excess reserves
Here the customer with the loan wrote a check which came out
of our bank and went into another bank. The other bank’s
reserves would have increased while ours decreased by the
amount of the check.
*

Transaction #7
Bank buys government securities
from a dealer
Deposits payment into checking
New money is created
LO3
LO3
Assets
Buying Government Securities
Checkable
Deposits
$100,000
Property
240,000
Stock Shares
250,000
Reserves
$60,000
Securities
50,000
Buying government securities has the same effect as lending:
new money is created.
*
Profits, Liquidity, and the Fed Funds Market
Conflicting goals
Earn profit

Make loans to earn interest
Buy securities to earn interest
Maintain liquidity
Alternative?
Overnight bank loans
Federal funds rate
LO3
LO3
Obviously, the events of the past couple of years illustrate the
fact that even with the restrictions in place, it is a difficult
balancing act for a bank to earn a profit while maintaining
sufficient liquidity to handle those periods of lows that
naturally occur in the business cycle.
*
The Banking System
Multiple-deposit expansion
Assumptions:
20% required reserves
All banks “loaned up”
Banks lend all of their excess reserves
A $100 bill is found and deposited
Multiple deposits can be created
LO4
LO4
As the checks of one bank are deposited into another, the
illusion of new money exists and leads to even more new money
being created.
*

Bank
(1)
Acquired
Reserves
and Deposits
(2)
Required
Reserves
(3)
Excess
Reserves
(1)-(2)
(4)
Amount Bank Can
Lend; New Money
Created = (3)
Bank A $100 $20 $80 $80
Bank B $80 $16 $64 $64
Bank C $64 $12.80 $51.20 $51.20
Bank D $51.20 $10.24 $40.96 $40.96
The process will continue…
The Banking System
LO4
LO4
This table illustrates the creation of new money based on a
single $100 deposit made into one bank. Each subsequent bank
can lend a smaller portion of $100 after factoring in their
reserve requirement, but overall total deposits in all banks will

increase.
*
Bank A
Bank B
Bank C
Bank D
Bank E
Bank F
Bank G
Bank H
Bank I
Bank J
Bank K
Bank L
Bank M
Bank N
Other Banks
Bank
(1)
Acquired
Reserves
and Deposits
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
(4)
Amount Bank Can

Lend; New Money
Created = (3)
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
21.99
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96

32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
The Banking System
LO4
LO4

This shows that, in total, the original $100 deposit will end up
adding $400 in new money into the system.
*
The Monetary Multiplier
LO5
LO5
Monetary
multiplier
=
1
required reserve ratio
=
1
R
The money multiplier is a key measure in banking that helps to
predict the money supply that will be available to drive
economic growth. As you can see from the formula, if the
reserve requirement is 20%, the money multiplier will be 1
divided by 0.2, which is 5. We can then use the money
multiplier multiplied by the excess reserves to determine the
maximum checkable-deposit creation that will be provided by
the new money entering the system.
*
The Monetary Multiplier

Maximum amount of new money created by a single dollar of
excess reserves
Higher R, lower m
Reversibility
Making loans creates money
Loan repayment destroys money
LO5
Ironically, one of the items that is slowing current economic
growth is people paying down credit card balances and other
loans; this is, in effect, removing money from the system.
*
Banking, Leverage, and Financial Instability
Leverage is the use of borrowed money to magnify profits and
losses
Modern banks use lots of leverage
Thus small losses can drive banks into insolvency
By using leverage, a bank can use borrowed money to invest
which leads to greater profits for investors if things go well but
increased losses if things go bad. The government in the past
has stepped in to bail out banks who made bad investment
decisions leading to a moral hazard. If banks do not have to
assume the risk of bad decisions, there is no incentive for them
to make more conservative decisions in the future. Bankers
have lobbied the government against any attempt to require
lower leverage levels so the current regulatory system relies on
bank supervisors who attempt to prevent the banks from making
bad loans. That system was unable to prevent the 2007-2008
financial crisis.
*

Money, Banking, and Financial Institutions
Chapter 14
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All
rights reserved.
McGraw-Hill/Irwin
reserved.
*
In this chapter, we start by looking at the functions of money
and the definitions of the money supply. Then there is a
discussion of the factors that back the money supply. In this
chapter, you will be introduced to the U.S. banking system, in
particular, the Federal Reserve. You will learn about their
functions and how the Fed has been set up. Then we will talk
about the financial crisis of 2007–08 and how the financial
system has changed as a result. In the Last Word, electronic
banking is addressed.
Functions of Money
Medium of exchange
Used to buy/sell goods
Unit of account
Goods valued in dollars
Store of value
Hold some wealth in money form
Money is liquid

LO1
LO1
Which function of money is considered the most important
depends upon circumstances. In economics, we typically focus
on money as a medium of exchange and a store of value. We
use money as a unit of account in measuring GDP and other
economic measures. As a medium of exchange, money allows
an economy to function efficiently. Without it, trade would be
difficult as each party would have to seek out someone else who
has the desired product or service and then trade. If the party
with the desired product does not want the good, there might
have to multiple exchanges in order to get the desired product.
As a unit of account, money provides a consistent way to value
business activity so comparisons can be made. As a store of
value money allows for a person to amass wealth without having
to keep actual products which might not be possible to keep
long-term.
*
Money Definition M1
M1
Currency
Checkable deposits
Institutions offering checkable deposits
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
LO1
LO2

Note that checkable deposits include smaller components such
as traveler’s checks. Currency includes coins and paper money.
Currency is referred to as token money, which means the face-
value of the currency is unrelated to its intrinsic value. This
means the face-value of the currency exceeds the actual value of
the piece of paper it is printed on or the value of the metal in
the coin. At one time, coins were actually made of valuable
metals such as gold or silver. Today, those coins’ actual values
are worth more than the face-value of the metal in the coin.
Collectively, S & Ls, mutual savings banks, and credit unions
are known as “thrifts.”
Currency held by the US Treasury is excluded from M1, as are
any checkable deposits of the government and of the Federal
Reserve that are held by commercial banks or thrifts.
*
Money Definition M2
M2
M1 plus near-monies
Savings deposits including money market deposit accounts
(MMDA)
Small-denominated time deposits
Money market mutual funds (MMMF)
LO1
LO2
Small-denominated time deposits are less than $100,000.
M2 money supply is about 5 times larger than M1.
These types of accounts are readily available for withdrawal
from the institution holding the deposit.
*

Money Definitions
LO1
LO2
This chart shows in graphical form the distribution of M1 and
M2 and helps to illustrate the fact that M1 is a small fraction of
the total money supply. Most of the supply is tied up in some
type of time deposit, which means the money may not be
available when needed.
*
What “Backs” the Money Supply?
Guaranteed by government’s ability to keep value stable
Money as debt
Why is money valuable?
Acceptability
Legal tender
Relative scarcity
LO2
LO3
Credit cards are not considered money; however, they allow
businesses and individuals to “economize” the use of money.
Debit cards come from checking accounts and are considered
money. At one time, the money supply of a nation was linked
to the nation’s gold supply, on what was called the gold
standard. Most nations moved away from the gold standard
because managing the supply of money is more sensible than
linking it to gold or some other commodity whose supply might
change arbitrarily. In modern society people are willing to

accept money in exchange for goods or services because they
know they will be able to exchange the money for other goods
or services. Our currency is designated as legal tender by the
United States government, which means it is deemed a valid and
legal means of paying any debt that was contracted in dollars.
Money derives part of its value from its scarcity. The supply of
money is controlled by monetary authorities to ensure it retains
its value or “purchasing power.”
*
What “Backs” the Money Supply?
Prices affect purchasing power of money
Hyperinflation renders money unacceptable
Stabilizing money’s purchasing power
Intelligent management of the money supply – monetary policy
Appropriate fiscal policy
LO2
LO3
The purchasing power of money is the amount of goods and
services a unit of money will buy. If the price level of goods
goes up, the value of a dollar goes down in a reciprocal
relationship. Periods of hyperinflation happen when
governments issue so many pieces of paper currency that the
purchasing power of each is totally undermined. Post-World-
War I Germany experienced hyperinflation that many historians
contributed to the Second World War. Governments have a
vested interest in ensuring a stable money supply to keep the
economy on a steady pace.
*

Federal Reserve - Banking System
Historical background
Board of Governors
12 Federal Reserve Banks
Serve as the central bank
Quasi-public banks
Banker’s bank
LO3
LO4
The Federal Reserve System serves as the monetary authority
who controls the money supply for our country. Congress
passed the Federal Reserve Act of 1913 to try to prevent the
acute problems in the banking system that had plagued the
country early in the twentieth century. The Board of Governors
is the central authority. The seven Board members are
appointed by the U.S. president for 14-year terms that are
staggered so that one member is replaced every two years. The
long term provides the Board with continuity, experienced
membership, and independence from political pressures.
The 12 Federal Reserve Banks implement the decisions of the
Board of Governors and are aided by the Federal Open Market
Committee. The Banks are quasi-public banks meaning they
blend private ownership and public control. Each Bank is
privately owned by the private commercial banks in its district.
Unlike private institutions, however, they are not motivated by
profit but rather seek to promote the well-being of the economy
as a whole. They perform essentially the same services for
commercial banks as those institutions perform for the public.
In emergency circumstances, the Banks become the “lender of
last resort” to the banking system. After 9/11, the Fed lent $45
billion to U.S. banks and thrifts to ensure the stability of the
banking system. Under normal circumstances the Fed lends
around $150 million per day.
*

Federal Reserve – Banking System
Commercial Banks
Thrift Institutions
(Savings and Loan Associations,
Mutual Savings Banks,
Credit Unions)
The Public
(Households and
Businesses)
12 Federal Reserve Banks
Board of Governors
Federal Open Market Committee
LO3
LO4
The Federal Open Market Committee is a group of 12
individuals, including the seven members of the Board of
Governors, the president of the New York Federal Reserve
Bank, and four of the remaining presidents of Federal Reserve
Banks on 1-year rotating terms. They meet regularly to direct
the purchase and sale of government securities. The purpose of
these activities is to control the nation’s money supply and
influence interest rates.
LO3
The 12 Federal Reserve Banks
LO4

Note the concentration of banks in the northeast. This reflects
population densities at the time that the Federal Reserve System
was set up. At that time, the west was largely unsettled and
still wilderness so there was not a great demand for banks.
*
Federal Open Market Committee
Aids Board of Governors in setting monetary policy
Conducts open market operations
Commercial banks and thrifts
6,000 commercial banks
8,500 thrifts
LO3
LO4
The most common thrift institutions are credit unions. In
addition to being subject to the monetary control of the Fed,
banks and thrifts are subject to regulation by various agencies
such as the Federal Deposit Insurance Corporation and the
National Credit Union Association. Both banks and thrifts are
required to keep a certain percentage of their checkable deposits
as reserves.
*
Financial Institutions
LO4
LO4
This bar chart represents the 12 largest financial institutions in

the world as of 2012. Their assets have all been translated into
U.S. dollars for comparison purposes.
*
Federal Reserve Functions
Issue currency
Set reserve requirements
Lend money to banks
Collect checks
Act as a fiscal agent for U.S. government
Supervise banks
Control the money supply
LO4
LO5
Note that contrary to public opinion, the Fed does not “set” the
interest rate that most people pay. It sets a discount rate that it
charges to banks for short-term loans, which then contributes to
the rate that the banks charge customers on their loans. While
the Fed has the ability to issue Federal Reserve Notes, the paper
currency used in the U.S. monetary system, they do not print the
money. That task is still performed by the U.S. Mint. The Fed
also facilitates the movement of money by providing the
banking system with a means of collecting on checks. It also
acts as the fiscal agent for the federal government by collecting
money owed to the government from taxes and assisting with
the government spending of equally large amounts. The Fed
makes periodic examinations to asses bank profitability, to
ascertain that banks perform in accordance with the many
regulations to which they are subject, and to uncover
questionable practices or fraud. After the financial crisis of
2007-2008, Congress increased the Fed’s supervisory powers.
*

Federal Reserve Independence
Established by Congress as an independent agency
Protects the Fed from political pressures
Enables the Fed to take actions to increase interest rates in
order to stem inflation as needed
LO4
LO5
There are two types of federal agencies: independent agencies
and executive agencies. Executive agencies fall directly under
the control of the President and, therefore, may be prone to
political pressures. Independent agencies do not report directly
to the executive branch of government. As an independent
agency, the Fed to avoids the political pressures on Congress
and the executive branch that sometimes result in inflationary
fiscal policies.
*
The Financial Crisis of 2007 and 2008
Mortgage Default Crisis
Many causes
Government programs that encouraged home ownership
Declining real estate values
Bad incentives provided by mortgage-backed bonds
LO5
LO6
The causes of the financial crisis of 2007-2008 are still being
debated, but most authorities feel that the mortgage default

crisis was a key component. Most banks and regulators had
mistakenly believed that the innovation known as “mortgage-
backed securities” had eliminated most of the bank’s exposure
to mortgage defaults. Mortgage-backed securities are bonds
backed by mortgage payments. It was thought that this was a
smart business decision as these mortgage-backed securities
transferred any future default risk on those mortgages to the
buyer of the bond, instead of the bank. Unfortunately, the
banks took the money that they received for the bonds and
loaned it to other investors, and once the defaults started, it was
like a house of cards. Once one card was removed, the whole
house collapsed.
Visit http://crisisofcredit.com/ for a great video explanation.
*
Securitization- the process of slicing up and bundling groups of
loans into new securities
As loans defaulted, the system collapsed
“Underwater” homeowners abandoned homes and mortgages
LO5
LO6
The system probably could have survived the failure of one type
of loan, but unfortunately, all three systems collapsed at once.
Interest rates increased on adjustable mortgages at the same
time that house prices fell. Borrowers began to fall behind on
their mortgages as the economy slowed and their payments
increased. Many just literally walked away from their houses
and their mortgages, leaving the mortgage holder with a
property that was worth significantly less than the value of the
loan.
*

Failures and near-failures of financial firms
Countrywide: second largest lender
Washington Mutual: largest lender
Wachovia
Other firms came close
LO5
LO6
The big mortgage holders ran into trouble because they held
large amounts of the bad debt because of the failure of the
mortgage-based securitization system. Countrywide and
Washington Mutual were both saved from bankruptcy by other
banks who bought them out. As the direct mortgage lenders
struggled, the troubles grew to include other financial
institutions, many of whom had to take advantage of massive
emergency loans made available by the Federal Reserve.
*
Troubled Asset Relief Program (TARP)
Allocated $700 billion to make emergency loans
Saved several institutions from failure
LO6
LO7
Congress passed TARP in 2008 to try to save the financial
institutions that were adversely affected by the crisis. However,
the process of the government “bailing out” a business is

subject to much debate. Is the moral hazard that was created
when the federal government bailed out those firms that made
bad investment decisions benefiting those firms and, in effect,
penalizing firms who played by the rules? Do some firms make
risky investments knowing that they are “too big to fail” and
that, therefore, government will step in and save them?
*
The Fed’s lender-of-last-resort activities
Primary Dealer Credit Facility
Term Securities Lending Facility
Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility
Commercial Paper Funding Facility
LO6
LO7
The Fed’s total assets rose from $885 billion in February 2008
to $1,903 billion in March 2009 due to a huge rise in securities
owned by the Fed. These securities were purchased to help bail
out struggling financial institutions.
*
Money Market Investor Funding Facility
Term Asset-Backed Securities Loan Facility
Interest Payments on Reserves
LO6
LO7

Like TARP, the Fed’s extraordinary actions during these times
intensified the moral hazard by limiting losses that otherwise
would have resulted from institutions’ bad financial decisions.
*
Post-Crisis U.S. Financial Services
Major Categories of Financial Institutions
Commercial Banks
Thrifts
Insurance Companies
Mutual Fund Companies
Pension Funds
Securities Firms
Investment Banks
LO7
LO8
During the financial crisis of 2007-2008, there was tremendous
consolidation in the industry, and this blurred the lines between
segments. More than 200 banks were shut down by the FDIC,
and their assets were transferred to other banks. Major
investment banks opted to become commercial banks to gain
access to emergency Federal Reserve loans.
*
Major Categories of Financial Institutions
LO7
LO8InstitutionDescriptionExamplesCommercial BanksState and
national banks that provide checking and savings accounts and
make loansJP Morgan Chase, Bank of America, Citibank, Wells

FargoThriftsSavings and loan associations, mutual savings
banks, credit unions that offer checking and savings accounts
and make loansCharter One, New York Community
BankInsurance CompaniesFirms that offer policies through
which individuals pay premiums to insure against
losePrudential, New York Life, Northwestern Mutual,
HartfordMutual Fund CompaniesFirms that pool customer
deposits to purchase stocks or bondsFidelity, Vanguard,
Putnam, Janus, T Rowe PricePension FundsInstitutions that
collect savings from workers throughout their working years
and then invest the funds to pay retirement benefitsTIAA-
CREF, Teamsters’ Union, CalPERsSecurities FirmsFirms that
offer security advice and buy and sell stocks and bonds for
clientsMerrill Lynch, Smith Barney, Charles SchwabInvestment
BanksFirms that help corporations and governments raise
money by selling stocks and bondsGoldman Sachs, Morgan
Stanley, Deutsche Bank, Nomura Securities
These are examples of some of the largest financial institutions
in each category.
Post-Crisis U.S. Financial Services

Wall Street Reform and Consumer Protection Act
Passed to help prevent many of the practices that led to the
crisis
Critics say it adds heavy regulatory costs
LO7
LO8
Many critics say this regulation was unnecessary as regulators
already had the tools that they needed, they just weren’t using
them. It is too soon to evaluate whether this law will help to
prevent another financial crisis.
*
Too Big to Fail
Wall Street Reform and Consumer Protection Act of 2010
Decision made not to criminally prosecute HSBC bank because
of economic effect
Instead of prosecuting officers of HSBC Bank for laundering
money for the Sinaloa drug cartel, Assistant U.S. Attorney
General Lanny Breuer made the decision to fine the company on
the rationale that a criminal prosecution might lead to the
collapse of the company which could have an negative effect on
the economy. This concept of being “too big to fail” as led for
a call to a return of the financial system in which the big
financial firms are broken up into smaller entities that could be
allowed to fail without catastrophically affecting the entire
financial system. An attempt to put that separation into practice
was passed in 2010 as part of the Wall Street Reform and
Consumer Protection Act, better known as the Volker Rule after
former Federal Reserve Chairman Paul Volker, but as of 2013 it
had yet to be implemented.

*
McGraw-Hill/Irwin
rights reserved.
Fiscal Policy, Deficits, and Debt
Chapter 13
McGraw-Hill/Irwin
reserved.
*
This chapter explores the tools of government stabilization
policy in terms of the aggregate demand-aggregate supply (AD-
AS) model. Next, this chapter examines fiscal policy measures
that automatically adjust government expenditures and tax
revenues when the economy moves through the business cycle
phases. The recent use and resurgence of fiscal policy as a tool
is discussed, as are problems, criticisms, and complications of
fiscal policy.
The material on the public debt discusses two false concerns
associated with a large public debt: (1) the debt will force the
U.S. into bankruptcy; and (2) the debt imposes a burden on
future generations. The debt discussion, however, also entails a
look at substantive economic issues. Potential problems of a
large public debt include greater income inequality, reduced
economic incentives, and crowding out of private investment.
The last word examines social security and Medicare shortfalls.

Fiscal Policy
Deliberate changes in:
Government spending
Taxes
Designed to:
Achieve full-employment
Control inflation
Encourage economic growth
LO1
*
Discretionary fiscal policy refers to the deliberate manipulation
of taxes and government spending by Congress to alter real
domestic output and employment, control inflation, and
stimulate economic growth. “Discretionary” means the changes
are at the option of the Federal government. Discretionary
fiscal policy changes are often initiated by the President, on the
advice of the Council of Economic Advisers (CEA). You can
find information on the CEA at http://whitehouse.gov; they are
found under “The Administration” tab, in the “Executive Office
of the President” section.
Expansionary Fiscal Policy
Use during a recession
Increase government spending
Decrease taxes
Combination of both
Create a deficit
LO1
LO1
*

Expansionary fiscal policy is used to combat a recession. The
problem during a recession is that aggregate demand is too low,
so increasing government spending and/or a reduction in taxes
will increase aggregate demand. Expansionary fiscal policy
will create a deficit.
Expansionary Fiscal Policy
Real GDP (billions)
Price level
AD2
AD1
$5 billion
increase in
spending
Full $20 billion
increase in
aggregate demand
AS
$490
$510
P1
LO1
Recessions
Decrease AD
LO1
*
This figure shows the expansionary fiscal policy.

Expansionary fiscal policy uses increases in government
spending or tax cuts to push the economy out of recession. In an
economy with a MPC of .75, a $5 billion increase in
government spending, or a $6.67 billion decrease in personal
taxes (producing a $5 billion initial increase in consumption),
expands aggregate demand from AD2 to the downsloping
dashed curve. The multiplier then magnifies this initial increase
in spending to AD1. So real GDP rises along the horizontal axis
by $20 billion.
Contractionary Fiscal Policy
Use during demand-pull inflation
Decrease government spending
Increase taxes
Combination of both
Create a surplus
LO1
LO1
*
When demand-pull inflation occurs, contractionary policy is the
remedy. The problem with inflation is that aggregate demand is
too high so the government will decrease government spending
and/or increase taxes to cause aggregate demand to fall. When
the government uses contractionary fiscal policy, it will create a
surplus.
Contractionary Fiscal Policy
Real GDP (billions)
Price level
AD3

AD4
$3 billion initial
decrease in
spending
Full $12 billion
decrease in
aggregate demand
AS
$502
$522
P2
AD5
$510
d
b
a
P1
c
LO1
LO1
*
This figure shows the effects of contractionary fiscal policy.
Contractionary fiscal policy uses decreases in government
spending, increases in taxes, or both, to reduce demand-pull
inflation. Here, an increase in aggregate demand from AD3 to
AD4 has driven the economy to point b and ratcheted the price
level up to P2, where it becomes inflexible downward. If the

economy’s MPC is .75 and the multiplier therefore is 4, the
government can either reduce its spending by $3 billion or
increase its taxes by $4 billion (which will decrease
consumption by $3 billion) to eliminate the inflationary GDP
gap of $12 billion (= $522 billion - $510 billion). Aggregate
demand will shift leftward, first from AD4 to the dashed
downsloping curve to its left, and then to AD5. With the price
level remaining at P2, the economy will move from point b to
point c and the inflationary GDP gap will disappear.
Policy Options: G or T?
To expand the size of government
If recession, then increase government spending
If inflation, then increase taxes
To reduce the size of government
If recession, then decrease taxes
If inflation, then decrease government spending
LO1
LO1
*
Economists tend to favor higher G during recessions and higher
taxes during inflationary times if they are concerned about
unmet social needs or infrastructure. Both actions either expand
or preserve the size of government.
Others tend to favor lower T for recessions and lower G during
inflationary periods when they think government is too large
and inefficient. Both of these actions either restrain the growth
of government or reduce taxes.
Built-In Stability

Automatic stabilizers
Taxes vary directly with GDP
Transfers vary inversely with GDP
Reduces severity of business fluctuations
Tax progressivity
Progressive tax system
Proportional tax system
Regressive tax system
LO2
*
Built-in stability arises because net taxes change with GDP
(recall that taxes reduce incomes and therefore, spending). It is
desirable for spending to rise when the economy is slumping
and vice versa when the economy is becoming inflationary.
Automatic stability reduces instability, but does not eliminate
economic instability.
Tax revenues vary directly with GDP; income, sales, excise, and
payroll taxes all increase when the economy is expanding and
all decrease when the economy is contracting.
Transfer payments like unemployment compensation and
welfare payments vary indirectly with the economic business
cycles. Unemployment compensation and welfare payments
decrease during economic expansion. Unemployment
compensation and welfare payments increase during economic
contractions.
The size of automatic stability depends on the responsiveness of
changes in taxes to changes in GDP: The more progressive the
tax system, the greater the economy’s built-in stability.
A progressive tax system means the average tax rate rises with
GDP.
A proportional tax system means the average tax rate remains
constant as GDP rises.
A regressive tax system means the average tax rate falls as GDP
rises.

However, tax revenues will rise with GDP under both the
progressive and the proportional tax systems, and they may rise,
fall, or stay the same under a regressive tax system.
Built-In Stability
G
T
Deficit
Surplus
GDP1
GDP2
GDP3
Real domestic output, GDP
Government expenditures, G,
and tax revenues, T
LO2
LO2
*
This figure shows built-in stability. Tax revenues, T, vary
directly with GDP, and government spending, G, is assumed to
be independent of GDP. As GDP falls in a recession, deficits
occur automatically and help alleviate the recession. As GDP
rises during expansion, surpluses occur automatically and help
offset possible inflation.
Evaluating Fiscal Policy
Is the fiscal policy…

Expansionary?
Neutral?
Contractionary?
Use the cyclically adjusted budget to evaluate
LO3
LO3
*
Another name for the cyclically adjusted budget is the full -
employment budget. The cyclically adjusted budget measures
what the Federal budget deficit or surplus would be with
existing taxes and government spending if the economy is at
full-employment. Fiscal policy is neutral when the tax revenues
equal government expenditures after adjusting for the reduction
in revenues from a recession. The cyclically adjusted budget
deficit is zero in year 1 and year 2.
Fiscal policy is expansionary when the cyclically adjusted
budget deficit is zero one year and there is a deficit the next.
Fiscal policy is contractionary when the cyclically adjusted
budget deficit is zero one year and is followed by a cyclically
adjusted budget surplus the next year.
See the next two slides for graphs.
Cyclically Adjusted Budgets
G
T
GDP2
GDP1
Government expenditures, G, and
tax revenues, T (billions)
(year 2)
(year 1)

$500
450
a
b
c
LO3
LO3
*
This figure shows the cyclically adjusted deficits in this graph.
The cyclically adjusted deficit is zero at the full -employment
output GDP1. But it is also zero at the recessionary output
GDP2 because the $500 billion of government expenditures at
GDP2 equals the $500 billion of tax revenues that would be
forthcoming at the full-employment GDP1. There has been no
change in fiscal policy.
Cyclically Adjusted Budgets
G
T1
GDP4
GDP3
Government expenditures, G, and
tax revenues, T (billions)
(year 4)
(year 3)
$500

450
d
e
f
475
425
g
T2
h
LO3
LO3
*
This figure shows cyclically adjusted deficits in this graph.
Discretionary fiscal policy, as reflected in the downward shift
of the tax line from T1 to T2, has increased the cyclically
adjusted budget deficit from zero in year 3 (before the tax cut)
to $25 billion in year 4 (after the tax cut). This is found by
comparing the $500 billion of government spending in year 4
with the $475 billion of taxes that would accrue at the full -
employment GDP3. Such a rise in the cyclically adjusted deficit
(as a percentage of potential GDP) identifies an expansionary
fiscal policy.
Recent U.S. Fiscal Policy

LO4
*
This table shows Federal deficits (-) and surpluses (+) as
percentages of GDP, 2000–2012. Observe that the cyclically
adjusted deficits are generally smaller than the actual deficits.
This is because the actual deficits include cyclical deficits,
whereas the cyclically adjusted deficits eliminate them. The
expansionary fiscal policy of the early 1990s became
contractionary from 1999 to 2001. In 2002 President Bush
passed tax cuts and increased unemployment benefits, thereby
increasing the cyclically adjusted deficit. The 2003 Bush tax
cut increased the standardized budget deficit as a percentage of
potential GDP. Federal budget deficits are expected to persist
for many years to come.
Fiscal Policy: The Great Recession
Financial market problems began in 2007
Credit market freeze
Pessimism spreads to the overall economy
Recession officially began December 2007 and lasted 18 months
LO4
LO4
*
In 2008 Congress passed an economic stimulus package of $152
billion consisting of checks to taxpayers, veterans, and social
security recipients and some tax breaks for businesses. This
package didn’t work to stimulate the economy as hoped. So in
2009, the American Recovery and Reinvestment Act was
enacted and consisted of $787 billion of tax rebates and large
amounts of government expenditures. This came after the

government spent $700 billion for financial institutions in the
TARP.
Budget Deficits and Projections
LO4
LO4
*
This figure shows Federal budget deficits and surpluses, actual
and projected, for fiscal years 1994-2018(in billions of nominal
dollars).
Global Perspective
LO4
LO4
*
The Global Perspective shows cyclically adjusted budget
deficits or surpluses as a percentage of potential GDP for
selected nations. Because of the global recession, in 2012 all
but a few of the world’s major nations had cyclically adjusted
budget deficits. These deficits varied as percentages of potential
GDP, but they each reflected some degree of expansionary
fiscal policy.
Problems, Criticisms, & Complications
Problems of Timing
Recognition lag

Administrative lag
Operational lag
Political business cycles
Future policy reversals
Off-setting state and local finance
Crowding-out effect
LO4
LO5
*
Recognition lag is the elapsed time between the beginning of a
recession or inflation and awareness of this occurrence.
Administrative lag is the difficulty in changing policy once the
problem has been recognized. Operational lag is the time
elapsed between the change in policy and its impact on the
economy.
A political business cycle may destabilize the economy:
Election years have been characterized by more expansionary
policies regardless of economic conditions.
Households may believe that the tax reduction is temporary and
save a large portion of their tax cut, reducing the magnitude of
the effect desired by policy makers.
State and local finance policies may offset federal stabilization
policies. They are often procyclical because balanced-budget
requirements cause states and local governments to raise taxes
in a recession or cut spending making the recession possibly
worse. In an inflationary period, they may increase spending or
cut taxes as their budgets head for a surplus.
“Crowding‑ out” may occur with government deficit spending.
It may increase the interest rate and reduce private spending
which weakens or cancels the stimulus of fiscal policy.

Current Thinking on Fiscal Policy
Let the Federal Reserve handle short-term fluctuations
Fiscal policy should be evaluated in terms of long-term effects
Use tax cuts to enhance work effort, investment, and innovation
Use government spending on public capital projects
LO4
LO5
*
Some economists oppose the use of fiscal policy, believing that
monetary policy is more effective, or that the economy is
sufficiently self-correcting.
Most economists support the use of fiscal policy to help “push
the economy” in a desired direction, and the use of monetary
policy more for “fine tuning.”
Economists agree that the potential impacts (positive and
negative) of fiscal policy on long-term productivity growth
should be evaluated and considered in the decision-making
process, along with the short-run cyclical effects.
The U.S. Public Debt
$16.4 trillion in 2012
The accumulation of years of federal deficits and surpluses
Owed to the holders of U.S. securities
Treasury bills
Treasury notes
Treasury bonds
U.S. savings bonds
LO4
LO5
*

The national or public debt is the total accumulation of the
Federal government’s total deficits and surpluses that have
occurred through time. Deficits (and by extension the debt) are
the result of war financing, recessions, and lack of political wil l
to reduce or avoid them.
Treasury bills are short-term securities.
Treasury notes are medium-term securities.
Treasury bonds are long-term securities.
U.S. savings bonds are long-term, non-marketable securities.
LO4
LO5
*
This figure shows the ownership of the total public debt, 2012.
LO4
LO5
*
This figure shows the federal debt held by the public, excluding
the Federal Reserve, as a percentage of GDP, 1970-2012.
Global Perspective
LO4
LO5

*
Global Perspective: Publicly Held Debt: International
Comparisons
Although the U.S. has the highest public debt in absolute terms,
a number of countries owe more relative to their ability to
support it (through income, or GDP).
Interest charges on debt
Largest burden of the debt
2.3% of GDP in 2012
False Concerns
Bankruptcy
Refinancing
Taxation
Burdening future generations
LO4
LO5
*
Interest charges are the main burden imposed by the debt
because government always has to at least pay the interest on
their debt in order to remain in good credit standing.
Can the federal government go bankrupt? There are reasons
why it cannot.
The government can raise taxes to pay back the debt, and it can
borrow more (i.e. sell new bonds) to refinance bonds when they
mature. Corporations use similar methods—they almost always
have outstanding debt. Of course, refinancing could become an
issue with a high enough debt-to-GDP ratio. Some countries,
such as Greece, have run into this problem. High and rising

ratios in the United States might raise fears that the U.S.
government might be unable to pay back loans as they come
due. But, with the present U.S. debt-to-GDP ratio and the
prospects of long-term economic growth, this is a false concern
for the United States.
The government has the power to tax, which businesses and
individuals do not have when they are in debt.
Does the debt impose a burden on future generations? In 2009
the per capita federal debt in U.S. was $37,437. But the public
debt is a public credit—your grandmother may own the bonds
on which taxpayers are paying interest. Some day you may
inherit those bonds that are assets to those who have them. The
true burden is borne by those who pay taxes or loan government
money today to finance government spending. If the spending
is for productive purposes, it will enhance future earning power
and the size of the debt relative to future GDP and population
could actually decline. Borrowing allows growth to occur when
it is invested in productive capital.
Substantive Issues
Income distribution
Incentives
Foreign-owned public debt
Crowding-out effect revisited
Future generations
Public investment
LO4
LO6
*
Repayment of the debt affects income distribution. If working
taxpayers will be paying interest to the mainly wealthier groups
who hold the bonds, this probably increases income inequality.

Since interest must be paid out of government revenues, a large
debt and high interest can increase the tax burden and may
decrease incentives to work, save, and invest for taxpayers.
A higher proportion of the debt is owed to foreigners (about 29
percent) than in the past, and this can increase the burden since
payments leave the country. But Americans also own foreign
bonds and this offsets the concern.
Some economists believe that public borrowing crowds out
private investment, but the extent of this effect is not clear. See
the next slide for the graph.
There are some positive aspects of borrowing even with
crowding-out. If borrowing is for public investment that causes
the economy to grow more in the future, the burden on future
generations will be less than if the government had not
borrowed for this purpose. Public investment makes private
investment more attractive. For example, new federal buildings
generate private business; good highways help private shipping,
etc.
Crowding-Out Effect
Real interest rate (percent)
Investment (billions of dollars)
ID1
ID2
a
b
c
Increase in
investment
demand

Crowding-out
effect
LO4
LO6
5
10
15
20
25
30
35
40
0
2
4
6
8
10
12
14
16
*
This figure shows the investment demand curve and the
crowding-out effect. If the investment demand curve (ID1) is
fixed, the increase in the interest rate from 6 percent to 10
percent caused by financing a large public debt will move the
economy from a to b, crowding out $10 billion of private
investment, and decreasing the size of the capital stock
inherited by future generations. However, if the public goods
enabled by the debt improve the investment prospects of
businesses, the private investment demand curve will shift

rightward, as from ID1 to ID2. That shift may offset the
crowding-out effect wholly or in part. In this case, it moves the
economy from a to c.
Social Security, Medicare Shortfalls
More Americans will be receiving benefits as they age
Social security shortfalls
Income during retirement
Funds will be depleted by 2033
Medicare shortfalls
Medical care during retirement
Funds will be depleted by 2024
*
Social Security is the major public retirement program in the
United States. Half of the tax (6.2%) is paid by individuals and
half is paid by employers (another 6.2%).
The Medicare program is the U.S. health care program for
people age 65 and older in the United States. Half of the tax
(1.45 %) is paid by individuals and half is paid by employers
(another 1.45%).
There is an impending long-run shortfall in Social Security
funding. It is a “pay-as-you-go” system, meaning that current
revenues are used to pay current retirees (instead of paying
from funds accumulated over time). Despite efforts to build a
trust fund, eventually Social Security revenues will fall below
payouts to retirees. Baby boomers are entering retirement age
and living longer, meaning that there will be more recipients
receiving payouts for longer periods of time.
The ratio of the number of workers contributing to the system
for each recipient has declined.

Social Security, Medicare Shortfalls
Possible options “to fix” include:
Increasing the retirement age
Increasing the portion of earnings subject to the social security
tax
Disqualifying wealthy individuals
Redirecting low-skilled immigrants to higher-skilled, higher
paying work
Defined contribution plans owned by individuals
*
Numerous solutions have been suggested and each has an
economic trade-off: reduce benefits by reducing direct
payments, taxing benefits, and/or increasing the age at which
workers are eligible to receive benefits (already part of the
system), increase revenues by raising payroll taxes, increase the
trust fund by setting aside more of current system revenues, or
by investing trust fund monies in corporate stocks and bonds.
Additionally, one solution is to allow workers to invest half of
their payroll taxes in approved stock and bond funds –
sometimes referred to as “privatizing” Social Security. There
are many possible solutions, and the political process may well
result in a combination of the many policies proposed.
McGraw-Hill/Irwin
rights reserved.
The Relationship of the Aggregate Demand Curve to the
Aggregate Expenditures Model
Chapter 12 Appendix

McGraw-Hill/Irwin
reserved.
*
This appendix presumes knowledge of the aggregate
expenditures model discussed in chapter 11.
The aggregate demand curve is derived from the aggregate
expenditures model by allowing the price level to change and
observing the effect on the aggregate expenditures schedule and
thus on equilibrium GDP.
Derivation of Aggregate Demand
Price Level
Aggregate Expenditures
45°
AE2 (at P2 )
AE3 (at P3 )
AE1 (at P1 )
Q3
Q2
Q1
Real Domestic Product, GDP
AD
P3
P2
P1

1
2
3
LO1
LO1
LO1
LO5
LO7
*
In Figure 1 we are deriving the aggregate demand curve from
the aggregate expenditures model. Both models measure real
GDP on the horizontal axis.
Suppose the initial price level is P1 and aggregate expenditures
is AE1. Equilibrium real domestic output is Q1. There will be
a corresponding point on the aggregate demand curve (Point
If price rises to P2, aggregate expenditures will fall to AE2
because purchasing power of wealth falls, interest rates may
rise, and net exports fall. Then new equilibrium is at Q2. That
If price rises to P3, real asset balance value falls, interest rates
rise again, net exports fall and new equilibrium is at Q3. This
Technically, the aggregate demand curve is found by drawing a

Aggregate Demand Shifts
AE2 (at P1 )
AE1 (at P1 )
Q1
Q2
AD1
P1
AD2
LO5
LO7
*
Figure 2 shows shifts of the aggregate expenditures schedule
and of the aggregate demand curve. When there is a change i n
one of the determinants of consumption, investment, or net
exports, there will be a change in the aggregate expenditures as
well. The change in aggregate expenditures is multiplied and
aggregate demand shifts by more than the initial change in
spending. The text illustrates the multiplier effect of a change
in investment spending. Shift of AD curve = initial change in
spending x multiplier.
McGraw-Hill/Irwin
rights reserved.

Aggregate Demand and Aggregate Supply
Chapter 12
McGraw-Hill/Irwin
reserved.
*
This chapter introduces the concepts of aggregate demand and
aggregate supply, explaining the shapes of the aggregate
demand and aggregate supply curves and the forces that cause
them to shift. Additionally, the equilibrium levels of prices and
real GDP are considered. The chapter analyzes the effects of
shifts in the aggregate demand and/or aggregate supply curves
on the price level and size of real GDP. This is a “variable
price-variable output” model unlike the previous chapter that
was an immediate short-run model where prices were assumed
fixed. As you will see, this chapter’s model can distinguish
between the immediate-short-run, the short-run, and the long-
run.
Aggregate Demand
Real GDP desired at each price level
Inverse relationship
Real balances effect
Interest effect
Foreign purchases effect
LO1
LO1
*
Aggregate demand is a schedule or curve that shows the various
amounts of real domestic output that domestic and foreign

buyers desire to purchase at each possible price level. The
aggregate demand curve shows an inverse relationship between
price level and real domestic output.
(The explanation of the inverse relationship is not the same as
for demand for a single product, which centered on substitution
and income effects. Substitution effect doesn’t apply within the
scope of domestically produced goods, since there is no
substitute for “everything.” Income effect also doesn’t apply in
the aggregate case, since income now varies with aggregate
output.)
The explanation of the inverse relationship between price level
and real output in aggregate demand are explained by the
following three effects.
Real balances effect: When price level falls, the purchasing
power of existing financial balances rises, which can increase
spending.
Interest rate effect: A decline in price level means lower
interest rates that can increase levels of certain types of
spending.
Foreign purchases effect: When price level falls, other things
being equal, U.S. prices will fall relative to foreign prices,
which will tend to increase spending on U.S. exports and also
decrease import spending in favor of U.S. products that compete
with imports (similar to the substitution effect).
Aggregate Demand
Price level
AD
LO1
0
LO1

*
This figure depicts the aggregate demand curve. The
downsloping aggregate demand curve, AD, indicates an inverse
(or negative) relationship between the price level and the
amount of real output purchased.
Changes in Aggregate Demand
Determinants of aggregate demand
Shift factors affecting C, I, G, Xn
2 components involved
Change in one of the determinants
Multiplier effect
LO1
LO2
*
Determinants of aggregate demand are the “other things”
(besides price level) that can cause a shift or change in demand.
Effects of the following determinants are discussed in more
detail on the slides following the graph.
1. Changes in consumer spending, which can be caused by
changes in several factors: consumer wealth, consumer
expectations, household debt, and taxes.
2. Changes in investment spending, which can be caused by
changes in several factors: interest rates. Another factor is
expected returns which are a function of: expected future
business conditions, technology, degree of excess capacity, and
business taxes. Changes in government spending Changes in net
export spending unrelated to price level, which may be caused
by changes in other factors such as: national incomes abroad
and exchange rates.

Changes in Aggregate Demand
Price level
AD1
AD3
AD2
LO1
0
LO2
*
This figure shows changes in aggregate demand.
A change in one or more of the listed determinants of aggregate
demand will shift the aggregate demand curve. The rightward
shift from AD1 to AD2 represents an increase in aggregate
demand; the leftward shift from AD1 to AD3 shows a decrease
in aggregate demand. The vertical distances between AD1 and
the dashed lines represent the initial changes in spending.
Through the multiplier effect, that spending produces the full
shifts of the curves.
Consumer Spending
Consumer wealth
Household borrowing
Consumer expectations
Personal taxes
LO1
LO2

*
Consumer wealth is the difference between household assets
(homes and stocks and bonds) and liabilities (loans and credit
cards). The value of the assets can change and the consumer
will react by spending more as asset values increase and
spending less as asset values decrease.
Households can borrow in order to spend more which increases
AD and if the household reduces spending in order to pay off
household debt, AD decreases.
Expectations of future higher incomes or higher prices will
increase current household spending and AD; expectatio ns of
lower household spending or lower prices will decrease AD.
A reduction in personal income taxes increases disposable
income and increases spending by the household, increasing
AD; an increase in taxes will decrease disposable income and
decrease household spending, decreasing AD.
Investment Spending
Real interest rates
Expected returns
Expectations about future business conditions
Technology
Degree of excess capacity
Business taxes
LO1
LO2
*
Investment spending is spending on capital goods. Increases in
investment spending increases AD; decreases in investment
goods decreases AD.

As real interest rates increase, the cost of borrowing increases
and subsequently less will be borrowed resulting in less money
spent, reducing AD. On the other hand, a decrease in real
interest rates will increase borrowing and subsequently
investment spending will increase AD.
If business owners and managers are optimistic about future
expected returns they will spend more now increasing AD and if
expected returns are less than favorable they will spend less
now reducing AD.
New technologies enhance future expected returns and thus
motivate businesses to spend money on the new technology
increasing AD.
If excess capacity increases, businesses will decrease current
spending, decreasing AD. If excess capacity decreases,
businesses will increase spending in order to expand operations,
increasing AD.
An increase in business taxes will decrease the amount of after -
tax income for businesses, reducing the amount of spending
businesses are capable of, reducing AD. A decrease in business
taxes will have the opposite effect on AD.
Government Spending
Government spending increases
Aggregate demand increases (as long as interest rates and tax
rates do not change)
More transportation projects
Government spending decreases
Aggregate demand decreases
Less military spending
LO1
LO2
*

Other things equal, if government spending increases, AD
increases. An example of government spending is more, or less,
transportation projects.
If government spending decreases, AD decreases. An example
of this is more, or less, military spending.
Net Export Spending
National income abroad
Exchange rates
Dollar depreciation
Dollar appreciation
LO1
LO2
*
If net export spending rises, AD rises. If net export spending
declines, AD declines. As the national incomes of trading
partners of the U.S. increase, they are more able to purchase
U.S. produced goods and services which increases AD. If the
foreign nations’ incomes decline, the opposite occurs.
If the dollar depreciates relative to another country’s currency,
AD increases. Depreciation of the dollar encourages U.S.
exports since U.S. products become less expensive, as foreign
buyers can obtain more dollars for their currency. Conversely,
dollar depreciation discourages import buying in the U.S.
because our dollars can’t be exchanged for as much foreign
currency.
AD can decrease through changes in currency exchange rates if
the U.S. dollar appreciates relative to another country’s
currency. The currency appreciation of the dollar discourages
U.S. exports because now U.S. goods are relatively more
expensive than before since it takes more of the foreign
currency to buy the U.S. dollar. This will also encourage more

import spending since the U.S. dollar can buy more of another
nation’s currency than before. Net exports will decline which
reduces AD.
Aggregate Supply
Total real output produced at each price level
Relationship depends on time horizon
Immediate short run
Short run
Long run
LO2
LO3
*
Aggregate supply is a schedule or curve showing the level of
real domestic output available at each possible price level. The
relationship is determined on the basis of whether input prices
and output prices are fixed or flexible.
In the immediate short run, both input prices and output prices
are fixed. The input prices are fixed by contractual agreements
such as labor contracts. Output prices may be fixed as a result
of issuance of catalogs or price lists that are in effect for a
stated period of time.
In the short run, input prices are fixed but output prices are
variable.
In the long run, input prices and output prices can vary.
AS: Immediate Short Run
Price level

ASISR
Qf
Immediate-short-run
aggregate supply
P1
0
LO2
LO3
*
This figure illustrates aggregate supply in the immediate short
run. In the immediate short run, the aggregate supply curve
ASISR is horizontal at the economy’s current price level, P1.
With output prices fixed, firms collectively supply the level of
output that is demanded at those prices.
Aggregate Supply: Short Run
Price level
0
Qf
AS
Aggregate supply
(short run)
LO2
LO3
*
The figure shows the aggregate supply curve in the short run.
The upsloping aggregate supply curve AS indicates a direct (or
positive) relationship between the price level and the amount of

real output that firms will offer for sale. The AS curve is
relatively flat below the full-employment output because
unemployed resources and unused capacity allow firms to
respond to price-level rises with large increases in real output.
It is relatively steep beyond the full-employment output because
resource shortages and capacity limitations make it difficult to
expand real output as the price level rises.
AS slopes upward because with input prices fixed, rising prices
increase real profits and declining prices result in decreases in
real profits.
Aggregate Supply: Long Run
Price level
ASLR
Qf
0
Long-run
aggregate
supply
LO2
LO3
*
This figure reflects aggregate supply in the long run. The long-
run aggregate supply curve, ASLR, is vertical at the full-
employment level of real GDP (Qf) because in the long run
wages and other input prices rise and fall to match changes in
the price level. So price-level changes do not affect firms’
profits and thus they create no incentive for firms to alter their
output. In the long run, the economy will produce the full-
employment output level no matter what the price level is

because profits always adjust to give firms exactly the right
profit incentive to produce exactly the full employment output
level.
Changes in Aggregate Supply
Determinants of aggregate supply
Shift factors
Collectively position the AS curve
Changes raise or lower per-unit production costs
LO2
LO4
*
Determinants of aggregate supply are the “other things” besides
price level that cause changes or shifts in aggregate supply at
each price level.
Changes that reduce per-unit production costs shift the
aggregate supply curve to the right; changes that increase per-
unit production costs shift AS left.
(References to “aggregate supply” in the remainder of the
chapter apply to the short run curve unless otherwise noted.)
Changes in Aggregate Supply
Price level
AS1
AS3
AS2

0
LO2
LO4
*
This figure illustrates changes in aggregate supply. A change in
one or more of the AS determinants listed on the next slide will
shift the aggregate supply curve. The rightward shift of the
aggregate supply curve from AS1 to AS2 represents an increase
in aggregate supply; the leftward shift of the curve from AS1 to
AS3 shows a decrease in aggregate supply.
Input Prices
Domestic resource prices
Labor
Capital
Land
Prices of imported resources
Imported oil
Exchange rates
LO2
LO4
*
A change in input prices, either domestic or imported resource
prices, will impact aggregate supply.
Domestic resource prices: Labor market experiences an increase
in supply which decreases wages, reduces per-unit production
costs and increases AS. If the labor market saw a decrease in
the supply of labor, say due to older workers retiring, wages
would increase, per-unit production costs would increase and
AS would shift left. Capital and land prices affect AS the same

way as labor costs. If their prices fall, AS shifts right; if their
prices increase, AS shifts left.
Prices of imported resources: imported resources add to
domestic supplies and act to reduce per-unit production costs
which increases aggregate supply; an increase in the pri ce of
imported resources, such as oil, acts to increase per-unit
production costs which decreases aggregate supply.
Exchange rate fluctuations can cause changes in per-unit costs
too. If the dollar appreciates, U.S. producers will be able to
purchase imported resources more cheaply, reducing per-unit
production costs and increasing AS. If the dollar depreciates,
imported resources become more costly, increasing per-unit
production costs, which decreases AS.
Productivity
Real output per unit of input
Increases in productivity reduce costs
Decreases in productivity increase costs
LO2
LO4
Per-unit production cost
=
total input cost
total output
Productivity
=
total output
total inputs
*
Changes in productivity (productivity = real output divided by

input) can cause changes in per-unit production cost (production
cost per unit = total input cost divided by units of output). If
productivity rises, unit production costs will fall. This can shift
aggregate supply to the right and lower prices. The reverse is
true when productivity falls. Productivity improvement is very
important in business efforts to reduce costs.
Legal-Institutional Environment
Legal changes alter per-unit costs of output
Taxes and subsidies
Extent of government regulation
LO2
LO4
*
A change in the legal institutional environment can change per -
unit production costs and change aggregate supply. Higher
business taxes increase costs for businesses and reduce short
run aggregate supply. Business subsidies lower production costs
and increase short run aggregate supply.
It is costly for businesses to comply with government
regulation. More regulation increases per-unit production costs
for businesses and shifts the aggregate supply curve to the left.
Deregulation will reduce per-unit production costs and shift the
AS rightward.
Equilibrium
100
92
502
510

514
a
b
AD
AS
0
LO3
LO5Real Output Demanded
(Billions)Price Level
(Index Number)Real Output
Supplied
(Billions)$506108$513 508104 512 510100 510 51296 507
51492 502
Price level (index numbers)
*
This figure shows the equilibrium price level and equilibrium
real GDP. The intersection of the aggregate demand curve and

the aggregate supply curve determines the economy’s
equilibrium price level. At the equilibrium price level of 100 (in
index-value terms), the $510 billion of real output demanded
matches the $510 billion of real output supplied. So the
equilibrium GDP is $510 billion.
Changes in Equilibrium
Price level
AD1
AS
P1
P2
Q2
Q1
Qf
AD2
0
LO4
LO6
*
This figure shows an increase in aggregate demand that causes
demand-pull inflation. The increase in aggregate demand from
AD1 to AD2 causes demand-pull inflation, shown as the rise in
the price level from P1 to P2. It also causes an inflationary GDP
gap of Q1 minus Qf. The rise in the price level reduces the
size of the multiplier effect. If the price level had remained at

P1, the increase in aggregate demand from AD1 to AD2 would
increase output from Qf to Q2 and the multiplier would have
been at full strength. But because of the increase in the price
level, real output increases only from Qf to Q1 and the
multiplier effect is reduced.
Decreases in AD: Recession
Price level
AD1
AS
P1
P2
Q1
Q2
Qf
AD2
c
a
b
0
LO4
LO6
*
This figure shows a decrease in aggregate demand that causes a
recession. If the price level is downwardly inflexible at P1, a
decline of aggregate demand from AD1 to AD2 will move the

economy leftward from a to b along the horizontal broken-line
segment and reduce real GDP from Qf to Q1. Idle production
capacity, cyclical unemployment, and a recessionary GDP gap
(of Q1 minus Qf) will result. If the price level were flexible
downward, the decline in aggregate demand would move the
economy depicted from a to c instead of from a to b.
Decreases in AD: Recession
Prices are downwardly inflexible
Fear of price wars
Menu costs
Wage contracts
Efficiency wages
Minimum wage law
LO4
LO6
*
If AD decreases, recession and cyclical unemployment may
result. Prices don’t fall easily.
Fear of price wars keeps prices from being reduced. Businesses
fear that if they decrease their price, their rivals may decrease
their price even more which could result in a “price war”:
successively deeper and deeper price cuts which result in
reduced profits for all of the firms.
Menu costs discourage repeated price changes. Menu costs are
the costs businesses incur from printing new price lists or
catalogs, re-pricing inventory, and communicating new prices to
customers. Firms may wait and see if the decline in aggregate
demand is permanent.
Large parts of the work force are under wage contracts that are
not flexible, therefore businesses can’t afford to reduce the
price of their products.

De-escalating During an Interview· httpswww.ncsbn.org1658.h

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