AP Econ 4.1-4.7

4 types of financial assets

loans, stocks, bonds, bank deposits

Financial intermeadiaries serve 3 roles:

reduce transaction costs, reduce risk, provide liquidity

Bond price and Interest Rate relationship

The price of previously issued bonds always move in the opposite direction of the interest rate.

Real interest rate=

nominal interest rate- inflation rate

Expected real interest rate=

nominal interest rate-expected inflation rate; if inflation rate is higher than expected, borrowers gain at the expense of the lenders

types of currency

commodity, commodity-backed, fiat 

money serves as a..

medium of exchange, store of value, unit of account

money supply is

the total value of all financial assets in an economy that function as money

M1 is a measure of the money supply that includes

currency in circulation and currency deposited into banks

M2 is a measure of the money supply that includes

everything in M1 and other illiquid assets like CDs and Money Market Accounts

How to measure the money supply

central banks calculate the size of several money aggregates(ex. M1 and M2)

money aggregates

an overall measure of the money supply; measures vary by how money is defined

1st type of monetary aggregate:

monetary base(AKA M0 or MB) which is the total amount of currency in circulation or kept in reserves by central banks 

Which is more liquid? M1 or M2?

M1 is more liquid

M2 includes M1 but adds what?

M2 adds near-moneys: financial assets that aren’t directly usable as a medium of exchange but can be readily converted

Functions of central banks

1. Provides financial services to commercial banks

2. supervises and regulates banks

3. Maintains stability of financial system

4. Conducts monetary policy

What happens when FR sells treasury bonds?

Money supply decreases because the the money the FR received leaves circulation

What happens when FR buys treasury bonds?

Money supply increase because the money that the FR sold went into circulation

Who makes decisions about monetary policy

FOMC: Federal Open Market Committee

What is the money multiplier?

the ratio of the money supply to the monetary base

Money multiplier formula

1/RRR

determinants of money market

changes in aggregate price level, changes in GDP, changes in tech, changes in regulations

Expansionary monetary policy

reducing interest rates, increasing money supply

Contractionary monetary policy

increase interest rates, decreasing money supply

How does the FR enact monetary policy?

1. changing the reserve requirement

2. changing the discount rate

3. changing the federal funds rate

4. open-market operations

When reserves are scarce,

banks must borrow from the Fed at the discount rate

When reserves are neither scarce nor ample,

banks borrow from each other at the federal funds rate

When reserves are ample,

banks don’t need to borrow from the FR or other banks 

What policy works when reserves are ample?

IORB: interest on reserve balances works because when banks don’t need to borrow from FR or other banks, then changing the policy rate is ineffective in controlling the money supply.

Reserve Market graph labels

Sr= federal reserve

D= commercial banks

d= discount rate

p=policy rate

left high part= scarce reserves

middle shifting part= neither scarce nor ample

right low part= ample reserves

y axis: interest rate

x axis: quantity of reserves

Lowering IORB

Expansionary

Increasing IORB

Contractionary

With limited reserves,

changes in supply of reserves shift money supply curve and changes interest rates

What policies work with limited reserves?

Quantitiative policies like OMOs and reserve requirements 

What policies work with ample reserves?

changing nominal interest rate with administered rates so IORB, discount rate

determinants of demand in Loanable funds market

1. changes in perceived business opportunities

2. changes in government borrowing

determinants of supply in Loanable funds market

1. changes in private savings behavior

2. changes in capital finlow

For an open econ:

investment= national savings+ net capital inflow

Rate of return=

(revenue from project-cost of project)/ cost of project x 100

money multiplier extensive:

1/(required reserves/deposits)

how much money supply will increase by:

product of excess reserves and money multiplier extensive