AP Macro Unit 4

3 functions of money

medium of exchange, unit of account, and a store of value

medium of exchange

a tool that allows you to make a purchase

unit of account

a measure of the value of goods and services

store of value

doesn’t die or spoil

money types

commodity money, specie money, fiat money

commodity money

when a resource or good is used as money

ex. when ramen is used as currency in prison

specie money

a commodity metal, historically gold or silver, backing money or currency

fiat money

money whose purchasing power derives from a declaratory fiat of the government issuing it

3 types of liquidity

M1(high liquidity), M2(medium liquidity), M3(low liquidity)

liquidity

how easy it is to access and convert an asset into cash (liquidized)

M1(high liquidity)

coins, currency, and check-able deposits plus savings deposits (money market accounts, personal, and checking accounts) in general is money supply

M2(medium liquidity)

M1 plus time deposits (CDs= certificates of deposit), and mutual funds below $100 k

M3(low liquidity)

M2 plus time deposits above $100k

why we need financial markets

individuals, businesses, and the government all borrow and save, so they need institutions to help with this

financial sector

network of institutions that link borrowers and lenders

assest

anything tangible/ intangible that is owned

liability

anything that is owed

financial assets

stock, bonds, and loans

stock

ownership of a company

bond

loan to a company or government

bond prices

there is a secondary market for bonds where people can sell bonds that they own. There is a direct relationship between demand and bond prices. There is an inverse relationship between bond prices and interest rates

the demand for money

at any given time, people demand a certain amount of liquid assets (money) for everyday purchases. inverse relationship between nominal interest rate and quantity demanded.

money demand shifters

changes in price level and income

the supply for money

the US money supply is set by the board of governors of the federal reserve system

FED system

non-partisan government office that sets and adjusts the money supply to adjust the economy. this is monetary policy!!

increasing the money supply

if the FED increases the money supply, a temporary surplus of money will occur, causing rates to fall

what happens to aggregate demand when money supply increases

when money supply increases, interest rates decrease, causing investment to increase and ultimately causing aggregate demand to increase

what should the Fed do with gov. securities to increase the money supply

buy gov. securities

what should the Fed do with gov. securities to decrease the money supply

sell gov. securities

open market operations

when the Fed buys or sells gov. bonds (securities). This used to be the most important and widely used monetary policy

the discount rate

the interest rate the Fed charges commercial banks

what should the Fed do to the discount rate to increase the money supply

decrease the discount rate (easy money policy)

what should the Fed do to the discount rate to derease the money supply

increase the the discount rate (tight money policy)

money multiplier

1/r

in a recession, the Fed lowers the reserve ratio

(banks hold less money and have more excess reserves, they create more money by loaning out excess, and money supply increases, interest rates fall, and AD goes up)

during inflation, the Fed increases the reserve ratio

banks hold more money and have less reserves, they create less money, money supply decreases, interest rates go up, and AD goes down

using reserve requirement

in a recession, the Fed lowers the reserve ratio. During inflation, the Fed increases the reserve ratio

federal funds rate

the interest the banks charge one another for 1 day loans of reserves

interest on reserves

when a bank has reserves, they keep them with the Fed in return for guaranteed interest

what will the Fed do interest on reserves to lower the money supply

they will increase the interest rates

what will the Fed do interest on reserves to raise the money supply

they will decrease the interest rates

what do banks do to their interest rates when the Fed increases interest rates on reserves

banks will raise their interest rates

what do banks do to their interest rates when the Fed decreases interest rates on reserves

banks will lower their interest rates

number one rule of the bank balance sheet

liabilities must equal assets

liabilities categories (rights side of balance sheet)

demand deposits (dd)/ check-able deposits, bank debt, and owners equity (stock shares)

assets categories (left side of balance sheet)

required reserves (rr), securities (federal bonds), and customer loans

demand deposits (dd)/ check-able deposits

cash deposits from the public (checking account)

bank debt

the amount the bank borrowed to fund its operations

owners equity (stock shares)

values of stocks held by the public ownership of bank shares

required reserves (rr)

percentage of demand deposits only. anything more is considered excess reserves

securities (federal bonds)

bonds purchased by the bank, or new bonds sold to the bank by the Fed. These can be purchased from the bank and turned into cash that immediately becomes available as “excess reserves”

customer loans

loans owed to the bank by prior customers