Unit 4 Macroeconomics Financial Sector + The Money Market

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Financial assets

Part of the economy made up of institutions that bring together lenders and borrowers, includes banks.

Liquidity

The ease with which a financial assets can be accessed and converted into cash.

Cash

The most liquid asset because it can most quickly and easily be converted into other assets.

Rate of return

Net gain or loss of an investment over a specified time period.

Risk

Chance that an outcome of an investment’s actual gains differ from the expected outcome. (High risk, high reward)

Bond

An interest bearing asset often issued by businesses or governments, sometimes referred to as securities, they have a fixed rate of interest.

Stock

A security that gives you ownership in a company.

Bonds and interest rates

Bond prices and interest rates have an inverse relationship due to people preferring higher interest rates because they are given a greater rate of return.

Barter system

Goods and services are traded directly without money.

Money

Anything that is generally accepted in payment for goods and services, is not the same as wealth or income.

Commodity money

Something that performs that function of money and has intrinsic value. (gold, silver)

Flat money

Something that serves as money but has no other value or uses. (paper money, coins)

3 functions of money

1.) Medium of exchange (used to easily buy g+s)

2.) Unit of account (measures value of all g+s)

3.) Store of value (store purchasing power)

M1

Highest liquidity, money that is currently in circulation.

M2

Near moneys, normally deposits.

Financial sector

Individuals, businesses, and governments borrow and save so they need institutions to help.

Loan

Asset for the lender and liability for the borrower.

Personal finance and investment

Refers to the way individuals and families budget, save, and spend.

Time value of money

Determines the future value of any amount if you know the interest rate and the number of years.

Money market

The demand for money at any given time, people demand a certain amount of liquid assets for two different reasons.

Transaction demand for money

People hold money for everyday transactions.

Asset demand for money

People hold money since it is less risky than other assets.

Money demand shifters

1.) Changes in price level

2.) Changes in income

3.) Changes in technology

Money supply shifters

1.) Reserve requirements

2.) Discount rate

3.) Open market operations

Monetary policy

U.S. money supply is set by the Board of Governors of the Federal Reserve system. (FED)

Federal reserve system

Created in 1913, intended to create trust in banks.

Fractional reserve banking

When banks only hold a small portion of deposits to cover potential withdrawals and loan the rest of the money out.

Demand deposits

Money deposited in a commercial bank to a checking account.

Required reserves

The percentage of deposits that banks must hold by law, set by FED.

Excess reserves

The amount that the bank can loan out.

Initial deposit - required reserves

Balance sheet

A record of a bank’s assets, liabilities and net worth. Must be equal on both sides.

FED increase money supply

• Interest rates decrease

• Investment increases

• AD, GDP and price level increase

FED decreases money supply

• Interest rates increase

• Investment decreases

• AD, GDP and price level decrease

Money multiplier

1 / reserve requirement (ratio)

ex: 1 / .20 = 5

Decreasing the reserve ratio

Used in a recession, banks hold less money and have more excess reserves which creates more money because they loan out the excess. Money supply increase, interest rates fall, AD increases.

Increasing the reserve ratio

Used in inflation, banks hold more money and have less excess reserves, leading to banks creating less money. Money supply decreases, interest rates up, AD decreases.

Deposit expansion multiplier

1 / reserve requirement

(same as money multiplier)

Expansion of money supply

excess reserves x multiplier

ex: 900 × 10 = 9000 from an initial 1000 deposit

Discount rate

The interest rate that the FED charges commercial banks.

Easy money policy

FED decreases discount rate, leading to an increase in money supply.

Tight money supply

FED increases discount rate, leading to a decrease in money supply.

Open market operation

When the FED buys or sells government bonds. Most important and widely used monetary policy.

Buy Big - increase MS

Sell Small - decrease MS

Real interest rates

The percentage increase in purchasing power that a borrower pays, adjusted for inflation.

real interest = nominal interest rate - expected inflation

Nominal interest rates

The percentage increase in money that the borrower pays, not adjusting for inflation.

nominal interest = real interest rate + expected inflation

Loanable funds market

Private sector of supply and demand of loans, shows the effect on real interest rate.

Demand

Inverse relationship between real interest rate and quantity of loans demanded.

Supply

Direct relationship between real interest rate and quantity of loans supplied.

Shifters of demand (loanable funds market)

1.) Changes in perceived business opportunities

2.) Changes in government borrowing

3.) Budget deficit/surplus

Shifter of supply (loanable funds market)

1.) Changes in private saving behavior

2.) Changes in public savings

3.) Changes in foreign investment

4.) Changes in expected profitability

Fischer formula

Shows the relationship between nominal interest rate, real interest rate, and inflation rate. Can be used for GDP and wages.

common formula: i ~ r = n

nom. interest rate = real inflation rate + inflation rate