AP Macro Unit 4

Financial Sector

→ network of institutions that link borrowers and lenders
→ includes banks, mutual funds, pension funds, and other financial intermediaries

Assets

anything tangible or intangible that has value

Interest Rate

the amount a lender charges borrowers for borrowing money--the "price" of a loan

Interest-bearing Assets

assets that earn interest over time

Market Risk

when you lose money from fluctuations in market prices

Default Risk

when companies/individuals are unable to fulfill their payment/debt obligations

Inflation Risk

when the value shrinks from inflation

Liquidity

the ease with which an asset can be converted to a medium of exchange (in general, the higher the liquidity = the lower the rate of return)
→ cash and demand deposits are the two most liquid forms of money

Demand deposit

deposits by customers that can be withdrawn at anytime (EX. checking accounts)

Risks of Buying Assets

( 1 ) Market Risk
( 2 ) Default Risk
( 3 ) Inflation Risk

Bonds

(securities) loans or IOUs that represent debt that the government, businesses, or individuals must repay to the lender

Stocks

(equities) represent ownership of a corporation and the stockholder is often entitled to a portion of the profit paid out as dividends

Bond Prices and Interest Rates

→ a bond is issued at a specific interest rate that doesn't change throughout the life of the bond
→ bond price and interest rates are inversely related

Real Interest Rates

the percentage increase in purchasing power that a borrower pays (adjusted for inflation)

Real = nominal interest rate -- expected inflation

Nominal Interest Rate

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

Nominal = real interest rate + expected inflation

The Time Value of Money

you can determine the future value of any amount of money ($X) if you know the interest rate (ir) and the number of years (N)

Equation to calculate future value:
$X in N Years = $X(1 + ir)^N
(ir is expressed as a decimal)

Present Value of Money

the current worth of some future amount of money

Equation to calculate present value:
($X) / (1 + ir)^N

The Barter System

goods and services are traded directly; there is no money exchanged

Problems with the Barter System
( 1 ) before trade could occur, each trader had to have something the other wanted--this is called the "Double Coincidence of Wants"
( 2 ) some goods cannot be split

Money

anything that is generally accepted as payment for goods and services
→ NOT the same as wealth or income (wealth is the total collection of assets, income is a flow of earnings per unit of time)

Commodity Money

something that performs the function of money and has intrinsic value
EX.) gold, silver, cigarettes, etc.

Fiat Money

something that serves as money but has no other value or uses
EX.) paper money, coins, digital currency

3 Functions of Money

( 1 ) A Medium of Exchange
( 2 ) A Unit of Account (Measure of Value)
( 3 ) A Store of Value

A Medium of Exchange

money can easily be used to buy goods and services with no complications of 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 supply?

there is no gold standard, money's value comes from our collective belief that it is valuable

What makes money effective?

( 1 ) Generally Accepted → buyers and sellers have confidence it is legal tender
( 2 ) Scarce → money must not be easily transported and divided
( 3 ) Portable and Dividable → money must be easily transported and divided

Purchasing Power

the purchasing power of money is the amount of goods and services a unit of money can buy
→ inflation decreases purchasing power, hyperinflation decreases acceptability

M1 (Highest Liquidity)

( 1 ) Currency in circulation
( 2 ) Checkable bank deposit (checking accounts)
( 3 ) Savings Accounts

M2 (Near-Moneys)

( 1 ) Everything in M1
( 2 ) Time deposits (CDS = certificate of deposits)
( 3 ) Money market funds

Fractional Reserve Banking

when banks hold a portion of deposits to cover potential withdrawals and then loans the rest of the money out

The Money Multiplier

1 / Reserve Requirement

Bank Balance Sheets

a record of a bank's assets, liabilities, and net worth
(demand deposits in a bank are liability for the bank, asset to the depositor)

Required Reserves

the percent that banks must hold by law

Excess Reserves

the amount that the bank can loan out

The Demand for Money

( 1 ) Transaction Demand for Money → people hold money for everyday transactions
( 2 ) 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 rate you could be earning from other financial assets like stocks, bonds, and real estate

Interest Rate and the Quantity of Money Demanded

there is an inverse relationship
→ when interest rates increase, quantity demanded falls because individuals would prefer to have interest-earning assets instead
→ when interest rates decrease, quantity demanded increases, there is no incentive to convert cash into interest earning assets

Money Demand Shifters

( 1 ) Change in price level
( 2 ) Change in income
( 3 ) Change in technology

Money Supply

the U.S. Money Supply is set by the central bank and is independent from the interest rate

The Federal Reserve

the Fed is a nonpartisan government office that adjusts the money supply to influence the economy → this is called Monetary Policy

Increasing the Money Supply

if the money supply increases, a temporary surplus of money will occur; the surplus will cause the interest rate to fall

increase money supply → decrease interest rate → increase investment → increase AD

Decreasing the Money Supply

if the money supply decreases, a temporary shortage of money will occur; the shortage will cause the interest rate to rise

decrease money supply → increase interest rate → decrease investment → decrease AD

Money Supply Shifters

the Fed adjusts MS by changing:
( 1 ) The Reserve Requirement (ratios)
( 2 ) The Discount Rate
( 3 ) Open Market Operations

Discount Rate

the interest rate that the Fed charges commercial banks

Open Market Operations

when the Fed buys or sells government bonds (securities)
→ this is the most important + widely used monetary policy

Federal Funds Rate

the interest rate that banks charge on another for one-day loans of reserves

Actions the Fed could take to decrease the MS

increase discount rate, increase reserve ratios, sell bonds

Actions the Fed could take to increase the MS

decrease discount rate, decrease reserve ratios, buy bonds

Modern Changes to Banking

( 1 ) Interest on Reserves (IOR)
→ the interest rate that the Federal Reserve pays commercial banks to hold reserves
→ IOR and the discount rate are examples of administered rates
( 2 ) Administered Rates
→ interest rates set by the Fed rather than determined in a market
→ reserves at the Fed have no risk, therefore, banks have no incentive to lend money at an interest rate that is lower than what they can get from the Fed

Limited Reserves

when there are limited reserves:
→ banks deposit fewer reserves with the central bank
→ small changes in the money supply can affect interest rates
→ the central bank conducts monetary policy by changing the reserve requirement or the discount rate or by using open market operations

Ample Reserves

when there are ample reserves:
→ banks deposit a lot of reserves with the central bank
→ changing the money supply has little to no effect on interest rates
→ the central bank conducts monetary policy by changing its administered rates (IOR or discount rate)

Reserve Market Model

→ inverse relationship between the Federal Funds Rate and the quantity of reserves demanded
→ when the Policy Rate is high, banks want to hold less reserves
→ when the Policy Rate is low, banks want to hold more reserves

Reserve Market Model (Limited Reserves)

Monetary Policy Used (Limited Reserves)

( 1 ) Reserve Ratios
( 2 ) Discount Rate
( 3 ) Open Market Operations

Monetary Policy Used (Ample Reserves)

(Administered Rates)
( 1 ) Interest On Reserves
( 2 ) Discount Rate

Reserve Market Model (Ample Reserves)

Loanable Funds Market

shows the supply and demand of loans and shows the equilibrium interest rates
→ demand has an inverse relationship between real interest rate and quantity loans demanded
→ supply has a direct relationship between real interest rate and quantity loans supplied
→ at the equilibrium real interest rate, the amount that borrowers want to borrow equals the amount lenders want to lend

Private Saving

the amount that households save instead of consume

Public Saving

the amount that the government saves instead of spends

National Savings

public saving + private saving

Capital Inflow

the amount of money entering the country

Capital Outflow

the amount of money leaving the country

Net Capital Inflow

capital inflow -- capital outflow

Private Investment

borrowing by businesses and consumers

Government Borrowing

deficit spending when government spending is greater than tax revenue

Loanable Funds Market Demand Shifters

( 1 ) Changes in borrowing by consumers
( 2 ) Changes in borrowing by businesses
( 3 ) Changes in borrowing by the government (ex. deficit spending)

Loanable Funds Market Supply Shifters

( 1 ) Changes in private savings behavior
( 2 ) Changes in public savings behavior
( 3 ) Changes in foreign investment (ex. more inflow of foreign financial capital)

Loanable Funds Market Supply & Demand

→ demand for loans comes from borrowers/investors
→ supply for loans comes from lenders/savers

Monetary Base

includes money in circulation and bank reserves