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CHAPTER 16. THE MONETARY SYSTEM

Money: the set of assets in an economy that people regularly use to buy goods and
services from other people.

1. The function of money:

- Medium of exchange (phương tiện trao đổi): an item that buyers give to
sellers when they want to purchase goods and services.

- Unit of account (đơn vị tài khoản): the yardstick people use to post prices
and record debts.

- Store of value: an item that people can use to transfer purchasing power
from the present to the future.

2. Kinds of money

- Commodity money (tiền hàng hoá): money takes the form of a commodity
with intrinsic value.

- Fiat money (tiền định danh): money without intrinsic value that is used as
money because of government decree.

Bank and Money Supply

Reserves: deposits that banks have received but have not loaned out.

Here is the T-account for First National Bank if the economy’s entire $100 of
money is deposited in the bank.
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Fractional-reserve banking: a banking system in which banks hold only a

fraction of deposits as reverse.

Reverse ratio: the fraction of deposits that banks hold as reverse.

Let's suppose that the First National has a reverse ratio of 1/10, or 10 percent.

Money multiplier: the amount of money the banking system generates with each
dollar of reverse each money will generate dollar of money

In the case above, $100 will generate $100 x = $1,000

How the Fed Influences the Quantity of Reverses

1) To increase the money supply, the Fed instructs its bond traders at the New
York Fed to buy bonds from the public in the nation’s bond markets.

The open market operations (OMO): The purchase and sale of U.S. government
bonds by the Fed.

2) Discount rate (lãi suất vay): the interest rate on the loans that the Fed
makes to banks when they feel they do not have enough reserves on hand, either to
satisfy regulators, meet depositor withdrawals, make new loans, or for some other
business reason.
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3) Reserve requirement “ít sử dụng”: The Fed also influences the reserve ratio
by altering reverse requirements (the regulations in the minimum amount of
reserves that banks must hold against deposits.

➢ Money supply and the Fed fund rate

➢ Problem of controlling Money supply

- Household has more currency=> banks: fewwer loans=> MS decrease
- Banks holds more reverse=>fewer loans=> MS decrease

QUICK QUIZ

1. The money supply includes all of the following EXCEPT

a. metal coins.

b. paper currency.
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c. lines of credit accessible with credit cards.

d. bank balances accessible with debit cards.

2. Chloe takes $100 of currency from her wallet and deposits it into
her checking account. If the bank adds the entire $100 to reserves, the
money supply ________, but if the bank lends out some of the $100, the
money supply ________.

a. increases, increases even more

b. increases, increases by less

c. is unchanged, increases

d. decreases, decreases by less

3. If the reserve ratio is 1⁄4 and the central bank increases the
quantity of reserves in the banking system by $120, the money supply
increases by

a. $90.

b. $150.

c. $160.

d. $480.

MS = MM x currency= 1/R x 120 = 1/(1/4) x 120=4x120=480

4. A bank has capital of $200 and a leverage ratio of 5. If the value of

the bank’s assets declines by 10 percent, then its capital will be reduced
to

a. $100.
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b. $150.

c. $180.

d. $185.

5. Which of the following actions by the Fed would reduce the money
supply?

a. an open-market purchase of government bonds

b. a reduction in banks’ reserve requirements

c. an increase in the interest rate paid on reserves

d. a decrease in the discount rate on Fed lending

6. In a system of fractional-reserve banking, even with- out any action

by the central bank, the money sup- ply declines if households choose to
hold ________ currency or if banks choose to hold ________ excess
reserves.

a. more, more

b. more, less

c. less, more

d. less, less

Lecture 17. MONEY GROWTH AND INFLATION

P: Price level (CPI or GDP Deflator), measured in money [basket of goods].

1/P: Value of money.

Inflation increases=> P increases=>Value of money decreases.

Examples:
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$1 can buy 1 cake => $1= 1 cake

$2 can buy 1 cake => $1 = ½ cake

1. The Quantity Theory of Money:

➢ Money supply (MS) in the real world: determined by
- Fed. [Trong làm bài mình giả sử chỉ có Fed control]
- The banking system.
- Consumers.
➢ Money demand (MD):
- How much wealth people want to hold in liquid form.
- Depend on P: P increases=>Value of money decreases=>Quantity MD
increases (negatively with value of money, other things equal)
- People want to hold more money=> MD decreases.
➢ Diagram:

Giải thích:

- Value of Money tỉ lệ nghịch với Price Level, nên hai trục nghịch đảo với nhau.
- Lúc đầu, Fed cố định MS1 bất chấp sự thay đổi giá cả vẫn cố định một
khoảng supply như vậy=> MS thẳng đứng (vertical).
- Nhắc lại: P (Price level) increases=>1/P (Value of money)
decreases=>Quantity MD increases. Vì Quantity DM tỉ lệ nghịch với 1/P
=>MD dốc xuống.
- Giao (Intersect) của MS và MD là A (Equilibrium point). Sẽ có 2 equilibrium:
Equilibrium value of money = ½ và Equilibrium price level = 4.
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- Fed tăng MS từ $1000 lên $2000. Excess MS, con người có nhiều tiền hơn=>
chi nhiều hơn mua hàng hóa hoặc cho mượn tiền=>Hàng hóa chỉ có giới
hạn=> P tăng.
- Còn theo đồ thị: Equilibrium point mới là B=>P tăng=>1/P giảm.
 Increase MS => 1/P decrease and P increase.
➢ Nominal variables: measured in monetary units.
➢ Real variables: measured in physical units.
➢ A relative price:
𝑃1
- The price of one good relative to another: 𝑃2

- Example: relative price of ice-cream in terms of cake:

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑐𝑒 − 𝑐𝑟𝑒𝑎𝑚 $2/𝑖𝑐
= = 0.5 𝑐𝑎𝑘𝑒 𝑝𝑒𝑟 𝑖𝑐𝑒 − 𝑐𝑟𝑒𝑎𝑚
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑎𝑘𝑒 $4/𝑐𝑎𝑘𝑒
➢ Real wage là một dạng đặc biệt của relative price.

𝑊 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑤𝑎𝑔𝑒 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟

𝑅𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 = = =
𝑃 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 & 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

- Example:

Nominal wage = VND 15mil

P (cơm IU) = VND 30000

𝑊 15𝑚𝑖𝑙
𝑅𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 = 𝑃(𝑐ơ𝑚 𝐼𝑈) = 30000 = 500 (dĩa cơm IU)

➢ Classical Dichotomy: the theory separate nominal & real variable.

In the long run:
MS increase or decrease:
Nominal variables increase or decrease.
Real variables do not change.
➢ Monetary neutrality: the proposition that changes in MS do not affect real
variables (relative price and others …)
- Example:

+ Initial condition:
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Pice-cream = $2

Pcake = $4 => Relative Pice-cream/cake = 2/4=0.5

+ Nominal prices double

Pice-cream= $4

Pcake= $8 => Relative Pice-cream/cake=4/8=0.5

➢ Velocity of Money: The rate at which money change hand.

Y= Real GDP =>unchanged
P=Price level
Nominal GDP= P x Y
V= Velocity => unchanged
M= Money supply => increase=>increase inflation & Nominal GDP & P
𝑉×𝑀 = 𝑃×𝑌
- Velocity formula:
𝑃×𝑌
𝑉=
𝑀
- Example:

2020: Y= 800, MS =$2000, P=$5, V constant

2021: The Fed increase MS by 5%, to

a. Calculate Nominal GDP and P in 2021, and the inflation rate 2020-2021.

𝑃×𝑌 5×800
2020: 𝑉 = = =2
𝑀 2000

2021: Nominal GDP =𝑃 × 𝑌 = 𝑀 × 𝑉 = 2100 × 2 = 4200

𝑀×𝑉 4200
2021: 𝑃 = = = 5.25
𝑌 800

(5.25−5) 0.25
Inflation rate (2020-2021) = = = 0.05
5 5

b. Suppose Y change and increase to 824 in 2021. Compute the inflation rate.
𝑀×𝑉 4200
2021: 𝑃 = = = 5.1
𝑌 824
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(5.1−5)
Inflation rate (2020-2021)= = 2%
5

- Real GDP constant: Inflation rate = money growth rate.

- Real GDP is growing: Inflation rate < money growth rate.
2. Hyperinflation:
➢ The inflation tax: When government print money to pay for it spending.
- Inflation tax is not the actual legal tax pays for government.
- More cash=>r increase=>inflation in the long run.
- If people hold securities, real estates or other assets it does not affect.
- If people hold money=>reduce the value of money
➢ The fisher effect: An increase in the rate of money growth raises the rate of inflation
but does not affect any real variable.

Nominal interest rate = Real interest rate + Inflation rate

- In the long run, money is neutral:

Inflation increases => nominal interest rate increase=>real interest
rate is unchanged.
➢ The costs of inflation:
➢ Quiz

1. The classical principle of monetary neutrality states that changes in the money supply do
not influence ________ variables and is thought most applicable in the ________ run.

a. nominal, short

b. nominal, long

c. real, short

d. real, long

2. If nominal GDP is $400, real GDP is $200, and the money supply is $100, then

a. the price level is ½, and velocity is 2.

b. the price level is ½, and velocity is 4.

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c. the price level is 2, and velocity is 2.

d. the price level is 2, and velocity is 4.

3. According to the quantity theory of money, which variable in the quantity equation is
most stable over long periods of time?

a. money

b. velocity

c. price level

d. output

4. Hyperinflations occur when the government runs a large budget ________, which the
central bank finances with a substantial monetary ________.

a. deficit, contraction

b. deficit, expansion

c. surplus, contraction

d. surplus, expansion

5. According to the quantity theory of money and the Fisher effect, if the central bank
increases the rate of money growth,

a. inflation and the nominal interest rate both increase.

b. inflation and the real interest rate both increase.

c. the nominal interest rate and the real interest rate both increase.

d. inflation, the real interest rate, and the nominal interest rate all increase.
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Lecture 18. OPEN – ECONOMY MACROECONOMICS

BASIC CONCEPTS

Closed economy: not interact with other economy.

Open economy: interact freely with other economy.

1. The International Flows of Goods and Capital

➢ Net export: NX=X-M
➢ Factors influence NX, X, M:
- Consumers’ preferences
- Prices of goods.
- Exchange rates
- Income.
- Transportation costs.
- Government policies.
➢ Trade surplus: NX>0=>X>M.
➢ Trade deficit: NX<0 => X<M.
➢ Balanced trade: X=M.
➢ Net capital outflow (Net foreign investment)

NCO = (domestic buy foreign) – (foreign buy domestic)

= (Money => foreign) – (Money => domestic)

= Cash Outflow – Cash Inflow

- NCO>0: Capital Outflow

- NCO<0: Capital inflow
- Foreign direct investment: Domestic residents actively manage the foreign
investment (Example: McDonalds opens a fast – food outlet in Moscow)
- Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds
supplying “loanable funds” to a foreign firm.
➢ An accounting identity: NCO = NX
NCO = NX = S-I
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- Trade surplus: X>M

NX>0

Y> Domestic spending (C+I+G)

S>I

NCO>0

- Trade deficit: X<M

NX<0
Y< Domestic spending (C+I+G)
S<I
NCO < 0
- Domestic buys foreign goods => domestic pays with their currency or
asset=>foreign acquires domestic asset=> NCO decreases.
- Foreign buys domestic goods=> foreign pays with their currency or
asset=>domestic acquires foreign asset=>NCO increases.
2. The Prices for International Transactions: Reak and Nominal Exchange Rates.
➢ Nominal exchange rate: $1=VND 23,056.
➢ Appreciation (strengthening): Increase the value of the currency.
➢ Depreciation (weakening): Decrease the value of the currency.
➢ The real exchange rate:
𝑒×𝑃
𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 =
𝑃∗
P = domestic price
P*= foreign price (in foreign currency)
e = nominal exchange rate.
- Example: $1=VND 23,056.

If $1 = VND 23,000 => US dollars depreciate.

If $1 = VND 24,000 => US dollars appreciate.

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 Nếu Depreciate: US Dollars đang mất giá hơn bình thường so với
VND=>hàng US sẽ rẻ hơn=>Export nhiều hơn qua VN=> Depreciate benefits
EXPORT.
 Nếu Appreciate: US Dollar đang có giá hơn=> Hàng US sẽ tự động đắt
hơn=>EXPORT giảm=> Hàng VN rẻ hơn vì VND depreciate=> Import hàng
VN => IMPORT tăng => Apppreciate benefits IMPORT.
➢ Law of one price: A good should sell for the same price in all markets.
➢ Arbitrage: Take advantage of price differences for the same item in different
markets.
- Example: Tea in VN: $3/kg

Tea in US: $4/kg.

 Arbitrage (Không tính các chi phí vận chuyển): Quick profit: buy tea in VN
and sell it in US=>PVN increase & PUS decrease=>equal.
➢ Purchasing – power parity: a unit of any given currency should be able to buy the
same quantity of goods in all countries.
𝑒 × 𝑃 = 𝑃∗
𝑃∗
𝑒=
𝑃
P* increases => e increases=> The value money of domestic increase=> appreciation.
P* decreases=> e decreases=> The value money of domestic decrease=>depreciation.
- Limitations:

Many goods are not easily traded (Price differences on such goods cannot be
arbitraged away)

Even tradable goods are not always perfect substitutes (Price differences reflect
taste differences.)

Quiz

1. Comparing the U.S. economy today to that of 1950, one finds that today, as a percentage
of GDP,

a. exports and imports are both higher.

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b. exports and imports are both lower.

c. exports are higher, and imports are lower.

d. exports are lower, and imports are higher.

2. In an open economy, national saving equals domestic investment

a. plus the net outflow of capital abroad.

b. minus the net exports of goods and services.

c. plus the government’s budget deficit.

d. minus foreign portfolio investment.

3. If the value of a nation’s imports exceeds the value of its exports, which of the following
is NOT true?

a. Net exports are negative.

b. GDP is less than the sum of consumption, investment, and government purchases.

c. Domestic investment is greater than national saving.

d. The nation is experiencing a net outflow of capital.

4. If a nation’s currency doubles in value on foreign exchange markets, the currency is said
to ________, reflecting a change in the ________ exchange rate.

a. appreciate, nominal

b. appreciate, real

c. depreciate, nominal

d. depreciate, real

5. If a cup of coffee costs 2 euros in Paris and $6 in New York and purchasing-power parity
holds, what is the exchange rate?

a. 1/4 euro per dollar

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b. 1/3 euro per dollar

c. 3 euros per dollar

d. 4 euros per dollar

6. The theory of purchasing-power parity says that higher inflation in a nation causes the
nation’s currency to ________, leaving the ________ exchange rate unchanged.

a. appreciate, nominal

b. appreciate, real

c. depreciate, nominal

d. depreciate, real

Lecture 19. A MACROECONOMIC THEORY OF THE OPEN

ECONOMY

➢ Open economy: S = I + NCO

- Supply of loanable funds: national savings (S)
- Demand for loanable funds: domestic investment (I) and net capital outflow (NCO)

➢ The market for loanable funds: (left=>right)

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r increase=> S increase=> I decrease=> NCO decrease.

➢ The market for foreign currency exchange:

NCO=NX
- NCO: Supply of dollars
- NX= Demand for dollars

- E: Real value of a dollar in the market for foreign – currency exchange.

- E increase/decreases => S unchanged => D decreases/increases => Our currency

appreciates/depreciates.
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- US (domestic) buy imported goods: S increase, D decrease.

- Foreign buy US goods: S decrease, D increase.

➢ The effects of a budget deficit:

- National saving falls (S<I).
- The real interest rate rises.
- Domestic investment and net capital outflow both falls.
- The real exchange rate appreciates.
- Net exports fall (or, the trade deficit increases).
- Raise the country debt.
➢ Budget deficit:
- Key: LF market determines r => r determines NCO => NCO determines S=> S
determines E => E determines NX.
Loanable funds Net capital Outflow
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- Budget deficit: S of LF shift left => r increase => NCO decrease => E increase =>
NX decrease.

- Remind: Budget deficit => Crowding out=> Less investment=> NX decreases=>

Reduce productivity growth and living standard.

➢ Investment Incentives:
Loanable funds Net capital outflow

- Tax incentives: Demand of LF increase => r increases => NCO decrease => E
increase (appreciates) => NX decrease
- Remind: Tax incentives => increase investment => increase productivity growth and
living standard.
➢ Trade policy: Government policies=> imports or exports.
- Tariff: Tax on import.
- Import quota: Limit the quantitative.
- Voluntary export restriction: Cấm vận
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- Import quota:

Import quota: does not change S & D in LF=> r unchanged=> NCO unchanged=> S
unchanged => Import decrease => NX increase => D shift right => E increase.
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- Capital flight:

Loanable fund Net capital outflow

Capital flight: Foreign investors sell all assets and pull out of their capital.
NCO increase & shift right => r increase => S shift right => E decrease => NX increase.
Quiz
1. Holding other things constant, an increase in a nation’s interest rate reduces
a. national saving and domestic investment.
b. national saving and the net capital outflow.
c. domestic investment and the net capital outflow.
d. national saving only.
2. Holding other things constant, an appreciation of a nation’s currency causes
a. exports to rise and imports to fall.
b. exports to fall and imports to rise.
c. both exports and imports to rise.
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d. both exports and imports to fall.

3. The government in an open economy cuts spending to reduce the budget deficit. As a
result, the interest rate ________, leading to a capital ________ and a real exchange rate
________.
a. falls, outflow, appreciation
b. falls, outflow, depreciation
c. falls, inflow, appreciation
d. rises, inflow, appreciation
4. The nation of Ectenia has long banned the export of its highly prized puka shells. A
newly elected president, however, removes the export ban. This change in policy will cause
the nation’s currency to ________, making the goods Ectenia imports ________ expensive.
a. appreciate, less
b. appreciate, more
c. depreciate, less
d. depreciate, more
5. A civil war abroad causes foreign investors to seek a safe haven for their funds in the
United States, leading to ________ U.S. interest rates and a ________ U.S. dollar.
a. higher, weaker
b. higher, stronger
c. lower, weaker
d. lower, stronger
6. If business leaders in Great Britain become more confident in their economy, their
optimism will induce them to increase investment, causing the British pound to ________
and pushing the British trade balance toward ________.
a. appreciate, deficit
b. appreciate, surplus
c. depreciate, deficit
d. depreciate, surplus

LECTURE 20. AGGREGATE SUPPLY AND AGGREGATE DEMAND

➢ Classical economics:
- The Classical Dichotomy: Real Vs. Nominal
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- The neutrality of money: Changes in the MS affect Nominal, not Real.

In the short run: Change MS or P (nominal) can affect Y or u-rate (real)

➢ Aggregate demand (Assume G is fixed): Y=C+I+G+NX

- Wealth Effect: P increase=> Real value of money decrease=> C decrease
(consumers are healthier) =>Qd decrease
- Interest - rate Effect: P increase=> Need more dollars=>Sell bonds and other
assets=> r increase=> I decrease=>Qd decrease.
- Exchange – rate Effect: P increase => r increase => US dollar appreciates=> E
increase => NX decrease => Qd decrease.
 3 tác động này là do P thay đổi trước chứ không phải một yếu tố khác làm thay đổi
C, I, NX=> Move along từ Y1 lên Y2
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- Shift Aggregate Demand curve:

Changes in C:
+ Stock market boom/ crash. (thị trường chứng khoán tăng bùng nổ hay
giảm xuống đáy)
+ Preferences: consumption/ saving tradeoff (tiêu dùng hay tiết kiệm)
+ Taxes hikes/cuts (Tăng/ giảm thuế).
Changes in I:
+ Firms buys new computers, equipment, factories.
+ Expectations, optimism/pessimism.
+ Interest rate.
+ Monetary policy.
+ Investment Tax credit or other tax incentives.
Changes in G:
+ Federal spending, ex: defense.
+ State & local spending, ex: roads, schools.
Changes in NX:
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+ Booms/recessions in countries that buy our exports (tăng/giảm dựa vào

nước tiêu thụ).
+ Appreciation/depreciation Exchange rate.

➢ Aggregate Supply Curve

- Short run: up – ward sloping.

- Long run: vertical.
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- Long – run Aggregate Supply:

YN: The natural rate of output also called potential output, unemployment output.
YN determined by Economy’s stocks: Labor (L), Capital (K), Natural resources (N),
Technology (A).
P increase => YN unchanges.
- Shift LRAS curve:

Changes in L/ natural rate of unemployment:

+ Immigration

+ Baby-boomers retire.

+ Government policies reduce natural u-rate.

Changes in K or H:

+ Investment in factories, equipment.

+ More people get college degrees.

+ Factories destroyed by a hurricane.

Changes in natural resources:

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+ Discovery of new mineral deposits.

+ Reduction in supply of imported oil.

+ Changing weather patterns that affect agricultural production

Changes in technology:

+ Productivity improvements from technological progress.

- Short – run aggregate supply:

P: Price (giá thực)

PE: Expected price (giá kì vọng)

Three theories: Increase P => Increase Y => SRAS slope upward.

+ Sticky wage theory: Nominal wages are sticky in the short run, they adjust
sluggishly.

When Price level increase =>P increase but PE unchanges=> Production is more
profitable=> Increase production => Real GDP increase.

+ Sticky price theory: many prices are sticky in the short run (menu cost: cost of
printing new menus, the time required to change price tags).
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Fed increase MS unexpectedly:

Firms without menu costs can raise their price immediately.
Firms with menu costs wait to raise prices. With relatively low prices=>
Increase demand=> Increase production => Increase real GDP.
+ The misperceptions Theory: Price of one good increase=>the firm may
believe its relative price increase=>increase production=>Increase real GDP.

In the long run: PE = P, AS curve is vertical.

- Shift SRAS curve:

+ Stock market crash:
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C decrease=>AD shift left=> At B: P & Y lower => increase unemployment

Overtime PE decrease => SRAS shift right => At C: Y and unemployment back
initially.
+ Stock market boom:

Stock Boom in Canada => Income of Canadians people increase=> C in Canada

increase=> NX in US increase=> AD shift right => At B: P &Y higher =>
decrease unemployment.
Over time PE increase=> SRAS shift left=> At C: Y & unemployment back
initially.
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+ Oil prices rise:

Oil price cost increase => SRAS shift left => At B: P higher, Y lower =>
unemployment higher.
A->B: stagflation
Government do nothing: unemployment higher=> wages fall=> SRAS
shift right=> B->A

Government use monetary policy and fiscal policy => increase AD => AD
shift right=> B->C => Y back to YN, P also higher.
 Prepared by Trần Đức Thành – TA Macroeconomics

Quiz
1. When the economy goes into a recession, real GDP _____ and unemployment _____.
a. rises, rises
b. rises, falls
c. falls, rises
d. falls, falls
2. A sudden crash in the stock market shifts
a. the aggregate-demand curve.
b. the short-run aggregate-supply curve, but not the long-run aggregate-supply curve.
c. the long-run aggregate-supply curve, but not the short-run aggregate-supply curve.
d. both the short-run and the long-run aggregate-supply curves.
3. A change in the expected price level shifts
a. the aggregate-demand curve.
b. the short-run aggregate-supply curve, but not the long-run aggregate-supply curve.
c. the long-run aggregate-supply curve, but not the short-run aggregate-supply curve.
d. both the short-run and the long-run aggregate-supply curves.
4. An increase in the aggregate demand for goods and services has a larger impact on
output ________ and a larger impact on the price level ________.
a. in the short run, in the long run
b. in the long run, in the short run
c. in the short run, also in the short run
d. in the long run, also in the long run
5. Stagflation is caused by
a. a leftward shift in the aggregate-demand curve.
b. a rightward shift in the aggregate-demand curve.
c. a leftward shift in the aggregate-supply curve.
d. a rightward shift in the aggregate-supply curve.
 Prepared by Trần Đức Thành – TA Macroeconomics

LECTURE 21. THE INFLUENCE OF MONETARY AND FISCAL

POLICY OF AGGREGATE DEMAND

 Focus on the short – run of interest – rate effect.

➢ The theory of Liquidity Preference:
- Money supply: fixed by central bank, does not depend on interest rate.
- Money demand: reflect how much wealth people want to hold in liquid form.
Variables influence MD: Y, r and P. \
+ Real Income (Y): Increase Y => Increase MD, other things equal. (people
want to consume more =>need more money).
+ Interest (r)=> The opportunity cost of holding money: Increase r=> decrease
MD (buy bonds with higher r), other things equal.
+ Price (P): Increase P=> increase MD, other things equal. (Y unchanged,
want to buy g&s, P increase, need more money).
➢ AD slopes downward:
- The wealth effect.
- The interest rate effect => MOST IMPORTANT.

Decrease P => MD decrease => MD shift left=> r decrease => I & Y increase
(produce more).
- The Exchange-rate effect
➢ Monetary policy
- Increase Money Supply: Increase MS=> MS shift right=> r decrease=> AD shift
right=> Y increase.
 Prepared by Trần Đức Thành – TA Macroeconomics

- Decrease Money Supply: Decrease MS=> MS shift left=> r increase => AD shift
left=> Y decrease=> P unchange => People feel poor

-
➢ Fiscal Policy: setting the level of government spending and taxation by
government policymakers.
- Expansionary: G increase and/or T decrease => AD shift right.
- Contractionary: G decrease and/or T increase => AD shift left.
The multiplier effect:
+ Marginal propensity to consume:
∆𝐶
𝑀𝑃𝐶 =
∆𝑌
Example: We have $100: Consume $80 and save $20
∆𝐶 80
𝑀𝑃𝐶 = = = 0.8
∆𝑌 100
 Prepared by Trần Đức Thành – TA Macroeconomics

+ The multiplier:
1
∆𝑌 = ∆𝐺
1 − 𝑀𝑃𝐶

Y increase -> MD shift right

The Crowding - out effect:
- Áp dụng với expansionary fiscal policy raises the r.

G increase=>AD shift right=> Y increase=>MD increase=>R increase => I decrease

=> AD shift left.
Changes in Taxes:
T decrease => Spend more, C increase=> AD increase=> AD shift right.
Fiscal policy might affect AS
A cut tax: people work more => Y increase => AS increase.
Government spending: G increase => build road => more effective in the long
run => Y increase => AS increase.
 Prepared by Trần Đức Thành – TA Macroeconomics

Quiz
1. If the central bank wants to expand aggregate demand, it can ________ the
money supply, which would ________ the interest rate.
a. increase, increase
b. increase, decrease
c. decrease, increase
d. decrease, decrease
2. If the government wants to contract aggregate demand, it can _______
government purchases or ________ taxes.
a. increase, increase
b. increase, decrease
c. decrease, increase
d. decrease, decrease
3. The Federal Reserve’s target rate for the federal funds rate
a. is an extra policy tool for the central bank, in addition to and independent of the
money supply.
b. commits the Fed to set a particular money supply so that it hits the announced target.
c. is a goal that is rarely achieved, because the Fed can determine only the money
supply.
d. matters to banks that borrow and lend federal funds but does not influence aggregate
demand.
4. With the economy in a recession because of inadequate aggregate demand, the
government increases its purchases by $1,200. Suppose the central bank adjusts the
money supply to hold the interest rate constant, investment spending is fixed, and
the marginal propensity to consume is 2/3. How large is the increase in aggregate
demand?
a. $400
b. $800
c. $1,800
d. $3,600
 Prepared by Trần Đức Thành – TA Macroeconomics

5. If the central bank in the preceding question instead holds the money supply
constant and allows the interest rate to adjust, the change in aggregate demand
resulting from the increase in government purchases will be
a. larger.
b. the same.
c. smaller but still positive.
d. negative.
6. Which of the following is an example of an automatic stabilizer? When the
economy goes into a recession,
a. more people become eligible for unemployment insurance benefits.
b. stock prices decline, particularly for firms in cyclical industries.
c. Congress begins hearings about a possible stimulus package.
d. the Federal Reserve changes its target for the federal funds rate.
Lecture 22. THE SHORT RUN TRADEOFF BETWEEN INFLATION AND
UNEMPLOYMENT
➢ The Phillips Curve: shows the short – run trade – off between inflation and
unemployment.
➢ Aggregate Demand Vs. Phillips Curve
- Aggregate Demand ~ Inflation ~ 1/unemployment rate
High/Low AD => High/Low Inflation => Low/High unemployment rate.

➢ The long – run Phillips curve:

Prepared by Trần Đức Thành – TA Macroeconomics

➢ The short – run Phillips curve:

Unemployment rate = Natural rate of unemployment – a(Actual inflation –
Expected Inflation)
+ Expansionary policy

+ Contrationary policy:
 Prepared by Trần Đức Thành – TA Macroeconomics

Quiz
1. When the Federal Reserve increases the money supply and expands aggregate
demand, it moves the economy along the Phillips curve to a point with ________
inflation and ________ unemployment.
a. higher, higher
b. higher, lower
c. lower, higher
d. lower, lower
2. If the Federal Reserve increases the rate of money growth and maintains it at the
new higher rate, eventually expected inflation will ________ and the short-run
Phillips curve will shift ________.
a. decrease, downward
b. decrease, upward
c. increase, downward
d. increase, upward
3. When an adverse supply shock shifts the short-run aggregate-supply curve to the
left, it also
a. moves the economy along the short-run Phillips curve to a point with higher inflation
and lower unemployment.
b. moves the economy along the short-run Phillips curve to a point with lower inflation
and higher unemployment.
c. shifts the short-run Phillips curve to the right.
 Prepared by Trần Đức Thành – TA Macroeconomics

d. shifts the short-run Phillips curve to the left.

4. Advocates of the theory of rational expectations believe that
a. the sacrifice ratio can be much smaller if policymakers make a credible commitment to
low inflation.
b. if disinflation catches people by surprise, it will have minimal impact on
unemployment.
c. wage and price setters never expect the central bank to follow through on its
announcements.
d. expected inflation depends on the rates of inflation that people have recently observed.
5. From one year to the next, inflation falls from 5 to 4 percent, while unemployment
rises from 6 to 7 percent. Which of the following events could be responsible for this
change?
a. The central bank increases the growth rate of the money supply.
b. The government cuts spending and raises taxes to reduce the budget deficit.
c. Newly discovered oil reserves cause world oil prices to plummet.
d. The appointment of a new Fed chair increases expected inflation.
6. From one year to the next, inflation rises from 4 to 5 percent, while
unemployment rises from 6 to 7 percent. Which of the following events could be
responsible for this change?
a. The central bank increases the growth rate of the money supply.
b. The government cuts spending and raises taxes to reduce the budget deficit.
c. Newly discovered oil reserves cause world oil prices to plummet.
d. The appointment of a new Fed chair increases expected inflation.
GOOD LUCK!