UNIT 4

financial markets

Channels private savings into investment spending and government borrowing.

investment spending

Spending on new productive physical capital, such as machinery and structures, and on changes in inventories.

government borrowing

The amount of funds borrowed by the government in the financial markets.

financial intermediaries

Financial institutions through which savers can indirectly provide funds to borrowers.

assets

Money and other valuables belonging to an individual or business.

liquidity

The ease with which an asset can be converted into cash.

risk

Degree of uncertainty of return on an asset; in business, the likelihood of loss or reduced profit.

money

Cash and demand deposits.

bond

A loan (IOU) to the government or business that must be repaid to the lender.

stock

Certificate representing equity (ownership) in a company.

personal finance

The way individuals and families budget, save, and spend.

demand deposits

Balances in bank accounts that depositors can access on demand by writing a check.

rate of return

Percentage of increase in the value of savings from earned interest.

relationship between price of bonds and interest rates

Inverse relationship.

nominal interest rates

Percentage increase in money that the borrower pays not adjusting for inflation.

formula for nominal interest rates

Nominal interest rate = Real interest rate (RIR) + expected inflation.

real interest rates

Percentage increase in purchasing power that a borrower pays (adjusted for inflation).

real interest rates indicate

The amount of goods and services a unit of money can buy.

how real interest rates are calculated

Real interest rate = nominal interest rate - expected inflation.

money

Any asset that is accepted as a means of payment.

wealth

Collection of assets.

income

Flow of earnings per unit of time.

functions of money

1. Medium of exchange 2. Unit of account 3. Store of value.

medium of exchange

Any item sellers generally accept and buyers generally use to pay for a good or service.

barter

Exchange goods without involving money.

unit of account

A measurement of value that allows comparison of prices.

store of value

Store purchasing power for future use.

money aggregates

Overall measures of the money supply.

M0 (or MB)

The monetary base; currency in circulation and bank reserves.

M1

Currency in circulation plus checkable bank deposits.

M2

M1 plus savings accounts, certificates of deposit, and other liquid assets.

fractional reserve banking

A banking system in which banks hold only a fraction of deposits as reserves.

banks use excess reserves

To make loans.

excess reserves

A bank's reserves over and above its required reserves.

loans are

Assets for the bank and liabilities for the borrower.

bank balance sheets (T accounts)

Banks record their assets, liabilities, and net worth with these.

asset

Items of ownership.

liabilities

Claims of the non-owners.

net worth

The claims of the owners against the firm's assets.

reserve requirement

The percentage of deposits that banking institutions must hold in reserve.

reserve ratio

The fraction of deposits that banks hold as reserves.

excess reserves =

Actual reserves - required reserves.

a bank can only loan an amount equal to its excess reserves

True.

simply money multiplier

The ratio of the money supply (M1) to the monetary base (M0).

simply money multiplier indicates

The change in M1 from the new excess reserves created by new deposits.

limitation of the simply money multiplier

It may overstate the predicted amount because it doesn't consider banks' desire to hold excess reserves.

how the simply money multiplier is calculated

(1)/(RR ratio).

transaction demand for money

The demand for money based on the desire to facilitate transactions.

asset demand for money

The amount of money people want to hold as a store of value; varies inversely with the interest rate.

opportunity cost of holding money

The interest you could be earning from other finances like stocks, bonds, and real estate.

relationship between interest and quantity of money demanded

Inverse.

shifters of money demanded

1. Changes in PL 2. Changes in RGDP 3. Changes in technology.

money supply curve

Shows how the quantity of money supplied varies with the interest rate.

monetary policy

The actions of a nations central bank to manage the money supply to stabilize the economy.

money market graph

At equilibrium, Qm = MS; nominal interest rate is determined by MS = MD.

relationship between interest rate and asset rate

Positive.

the federal reserve

The central bank of the US that regulates the banking industry.

why does the Fed use monetary policy

To counter SR output gaps.

effective monetary policy must be

Counter cyclical.

how can the Fed manipulate the MS and change IR

Change the reserve requirement, conduct open market operations, and target a specific discount rate.

open market operations

The purchase and sale of U.S. government bonds by the Fed.

recessionary output gap

Requires expansionary cyclical policy.

inflationary output gap

Contractionary monetary policy.

changing the reserve requirement in a recession

Decrease the reserve ratio.

changing the reserve requirement when there is inflation

Increase the reserve ratio.

relationship between reserve ratio and MS

Inverse.

the discount rate

The interest rate that the fed charges commercial banks to borrow money.

when the fed buys securities from banks

It directly increases the reserves of the commercial bank.

federal funds

The balances that banks maintain in their accounts at the fed.

federal funds rate

The target interest rate set by the fed at which banks borrow and lend their extra reserves.

ample reserves system

A Federal Reserve policy that keeps enough reserves in the banking system to control interest rates.

under an ample reserves system

Changing the MS has little or no effect on interest rates.

administered rates

Interest rates set by the Fed rather than determined in a market.

interest on reserve balances (IORB)

Interest rate paid by the fed on funds held in the banks' reserve balance accounts.

do reserves at the fed have a risk

No.

under contractionary policy

The fed will increase the IORB.

under expansionary policy

The fed will decrease the IORB.

the reserve market model

There is an inverse relationship between the Federal Funds Rate and the quantity of reserves demanded.

what happens if the fed buys bonds from banks when there are limited reserves?

Banks will have more reserves.

what happens if the fed buys bonds from banks when there are ample reserves?

The interest rate does not change.

what can the CB do to change IR when there are ample reserves

Decrease or increase interest on reserves.

when the fed increases the MS

Interest rates decrease.

who demands loanable funds and who supplies them

Borrowers demand, savers supply.

loanable funds market

A hypothetical market that illustrates the demand for funds by borrowers and the supply of funds by lenders.

demand for loanable funds shifters

1. Changes in perceived business opportunities 2. Changes in government borrowing.

supply of loanable funds shifters

1. Changes in public and private saving behavior 2. Changes in foreign investment.

closed economy

National savings = public savings + private savings.

open economy

Investment = national savings + net capital inflow.