AP Macro Unit 4

why do we have a financial sector

Individuals, businesses, and government borrow and save. They need institutions to help.

fincancial sector

network of insitutions that link borrowers and lenders. Includes banks, mutural funds, pension funds, and other financial intermediaries. Reduces transactional costs.

assets

anything tangible or intaginble that has value

intrest rate

the amount a lender charges borrowers for borrowing money.

“the price of a loan”

intrest bearing assets

assets that can earn intrest over time

ex: bonds

personal finance

the way individuals and families budget, save, and spend

investment

Business spending on tools and machinery. Capital stock investment. Low interest rate increases investment

liquidity

the ease with which an asset can be converted to a medium of exchange (cash). The higher the liquidity, the lower the rate of return.

bonds (securities)

Loans or IOUs that represent debt that the government, business, or individual must repay the lender. The bond holder has no ownership of the company and is paid interest.

stocks (equities)

represent ownership of a corperation and the stockholder is often entitled to a portion of the profit paid out as dividents

risks to buying assets

market risks: loss of money due to market fluctuations

inflation risks: when the value of your investment(NOT MACRO ONE) shrinks due to inflation

default risk: when companies or individuals are unable to fufill their debt or payment obligations

a bond is offered at a

specific and non-changing intrest rate

people want bonds at

higher interest rates

bonds can be sold

before they mature

if you sold the original higher bond

buyers would bid up the price since they would rather have the higher

bond and interest rate are

inversly related

real interest rates

the percentage increase in puchasing power that a borrower pays (adjusted for inflation). When expected inflation is larger real will be negative.

real ir=nominal ir-expected inflation

nominal interest rate

the percentage increase in money that a borrower pays (not adjusted for inflation).

Future value of money

Amount of $ in N years= $X(1+ir)^N

present value

the current worth of some future amount of money

present value of $X in N years= $X/(1+ir)^N

The barter system

What we would use if we did not have money. Goods and services are traded directly. No exchange of money

Problems with the barter system

• Double coincidence of wants: before trade can occur, each trader has to have something the other wants

• Some goods can not be split: chickens, giant rocks, etc.

Money

Anything that is generally accepted as payment for goods and services. NOT the same as wealth and income

wealth

total collection of assets

income

flow of earnings per unit of time

Commodity Money

Something that performs the value of money and has intristic value

gold, silver, cigarettes

Fiat money

Something that serves as money but has no other uses or value

Paper money, coins, digital currency

Three functions of money

• medium of exchange

• unit of account (meausre of value)

• store of value

Medium of exchange

Money can be used to buy goods and services with no complications of the barter system

A unit of account (measure of value)

Money measures the value of all goods and services. Money acts as a measurement of value.

A store of value

money allows you to store purchasing power for the future

What backs the money standard

Not gold. Comes from our collective belief that it is valuable

What makes money effective

Generally accepted: buyers and seller have confidence that it is legal tender

Scarce: money must not be easily reproduced

Portable and dividable: money must be easily transported and divided

Purchasing power of money

the amount of goods and services a unit of money can buy

Inflation

decreases the purchasing power of money

hyperinflation

decreases acceptabillity

Liquidity

ease with which an asset can be accessed and used as a medium of exchange

M1 (highest liquidity) (narrowest definition of money)

• Currency in circulation (money in your wallet)

• Checkable bank deposits (checking accounts)

• Saving deposists (money market accounts)

M2 (near moneys)

ALL OF M1+

• Time deposits (CDs= certificate of deposits)

• Money market funds

Both M1 and M2

Earn little to no interest so the opportunity cost of holding liquid money is the interest you could be earning

you want to have the highest liquidity for

paying taxes

Fractional reserve banking

When a bank holds a portion of deposits to cover potential withdraws and then loans the rest of the money out and collects interest

the money multiplier

1/reserve requirement ratio

demand deposits

money deposited in a comerical bank in a checking account. Considered M1 because you can take it out at any time

demand deposit for bank

liability

demand deposit for depositer

asset

required reserves

the amount that a bank must hold by law

excess reserves

the amount that the bank can loan out

balance sheet

a record of a bank’s assets, liabilities, and net worth

asset

something that you own

liability

something that you owe

the demand for money

at any given time, people demand a certain amount of liquid assets/money.

• Transactional demand for money

• Asset Demand for money

transactional demand for money

people hold money for everyday transactions

asset demand for money

people hold money since it is less risky than other assets

what is the opportunity cost of holding money in your pocket or checking account

The interest you could be earning from other financial assets like stocks, bonds, and real estate

what is the realtionship between interest rate and quantity demanded

inverse

when interest rates increase

quantity demanded falls because people would rather have interest bearing assets instead

when interest rates decrease

quantity demanded increases because there is no incentive to convert cash into interest bearing assets since they will not earn as much interest.

when interest rate decreases

the opportunity cost with holding money in your pocket or checking account also decreases

change in quantity of money demanded is a

movement along the curve

money demand shifters

1. change in price level

2. change in income

3. change in technology

the supply for money

For the US, it is set by the central bank and it is independent from interest rate, meaning it is a vertical line.

When money supply increases

there is a temporary surplus of money at that interest rate causing interest rates to fall

when the money supply decreases

there is a temporary shortage of money at that interest rate causing interest rates to rise

Increases in the money supply on AD

Increase money supply→ decrease ir → increase investment → increase AD

Decrease in the money supply on AD

decrease money supply → increase ir → lower investment → lower AD

federal reserve

regulate banks and make sure people have faith in our financial system

The shifters of money supply

• Reserve Requirement: the percentage of deposits that a bank must hold by law

  • Increase RR, decrease MS

  • Decrease RR, increase MS

• Open market operations: the fed buys and sells government issued bonds to private banks

  • Buy makes MS go bigger, sell makes MS go smaller

• Discount rate: the interest rate that the fed charges banks for loans.

  • Increase DR, decrease MS

  • Decrease DR, increase the MS

If there is a recession (Reserve requirement)

Fed should lower the resereve requirement so that banks hold less money and can loan more out, creating more money.

Money supply will increase so interest rates decrease and aggregate demand increases.

if there is inflation (Reserve requirement)

Fed should increase the reserve requirement so banks hold more money in reserves and create less money

When money supply decreases, interest rates increase, AD decreases

To increase the money supply with the discount rate (easy money policy)

it should be lowered

To decrease the money supply with the discount rate (tight money policy)

it should be raised

To increase the money supply with open market operations

Fed should buy bonds

To decrease the money supply with open market opperations

Fed should sell bonds

The Federal Funds Rate

Interest rate that banks charge each other for one day loans.

Expansionary monetary policy (in limited reserves)

Increase the money supply

Contractionary monetary policy (in limited reserves)

Decrease the money supply

Interest on Reserves (IOR)

The amount that the Fed pays banks to hold reserves

Administered rates

Interest rates that the Fed sets rather than ones determined in a market

2 examples of administered rates

interest on reserves and discount rate

Limited reserves

• Banks deposit few reserves with teh central bank

• small changes in the money supply affect the interest rate

• central bank conducts monetary policy by changing the reserve requirement, the discount rate, and open market operations

Ample reserves

• Banks deposit a lot of resources with the central bank

• Changing the money supply has little to no effect on the interest rate

• Central bank raises and lowers the administered reates for monetary policy

Relationship between federal funds rate and quantity of reserves demanded

Inverse.

• When the federal funds rate increases, banks want to hold less reserves

• When the federal funds rate decreases, banks want to hold more reserves

Discount rate as a ceilling

The discount rate acts as max rate that banks are willing to pay and borrow from because if the FFR is higher than that why would they pay higher when the government which has little to no risk involved is offering lower?

IOR as a floor

The IOR acts as the lowest interest rate that banks will go for becuase why only get a lower return when the federal bank will be higher.

What can the central bank do to decrease rates in ample reserves?

They can decrease the IOR and the discount rate. This will decrease interest rates which also increases aggregate demand.

BOOM! expansionary monetary policy

What can the central bank do to increase rates in ample reserves?

Increase the IOR and discount rate. This increases interest rates which also decreases aggregate demand.

BOOM! contractionary monetary policy

Tools for limited vs tools for ample reserves

Limited

1. Discount rate

2. Reserve ratio

3. open market operations

Ample

1. administered rates

Use discount rate for both!

Why do borrowers and lenders focus on real interest rates?

Represent the real rate of return

A 50% real interst rate is

Bad for borrowers but good for lenders

The loanable funds market

Shows the supply and demand of loans and shows the equilibrium real interest rate

relationship between demand and supply

Demand has an inverse relationship

Supply has a direct relationship

Supply curve is made up of

Lenders and savers

The demand curve is made up of

borrowers and investors

Savings

make loaning possible. The supply of loans is the amount of money saved

private saving

amount that households save instead of consume

public saving

the amount that the government saves instead of consumes

changes in private and public saving both

shift the supply of loanable funds

National savings

public + private saving

Who else contributes to the supply?

Foreigners. They can lend us money so our supply also relies on the amount of money entering and leaving the country