Unit 4: Financial Sector

Bond

loan that a bondholder gives to a company or government. In return, they pay you interest over time and promise to repay the original cost of the bond (the principal) by a set date.

Asset

anything of monetary value owned by a person or business

Liquidity

A measurement of the speed & ease you can turn your asset into cash (savings/checking accounts)

Interest rate

annual percentage of the amount of a loan (principal) that the borrower will pay to the lender; price of borrowing

date of maturity

the day the issuer (gov’t/company) must pay back the principal amount (og cost) to the bondholder

Relationship between the price of previously issued bond and current interest rates

Inverse relationship

• new bonds issued at higher interest rates are more attractive making older bonds with lower rates less valuable so price will go down

Nominal Interest Rate

Rate of interest paid for a loan (including bonds), unadjusted for inflation

• Real Interest Rate + Expected Inflation

Real Interest Rate

rate of interest paid for a loan, adjusted for inflation

• Nominal interest rate - Expected Inflation

Unexpected Inflation

real rate of return on fixed rate savings and loans lower. When unexpected inflation is higher than anticipated, borrowers are better off, and lenders are worse off

• Borrowers benefit from unanticipated inflation because if they pay a fixed-interest-rate loan, they will be paying back their loan with dollars of less value.

US dollars is Fiat Money

Its value comes from government backing, not physical commodities like gold

Unit of Account

people commonly accept money as a way to set prices

Stores value

money holds purchasing power over time

• inflation can undercut money’s ability to store value

Medium of exchange

money’s use as a medium of exchange has helped economies grow faster

• barter economies vs money economies

Monetary Base (M0)

Currency and bank reserves

M1

currency in circulation, demand deposits, and savings accounts

M2

M1+ small denomination time deposits + retail money market funds

Liability

something that is owed that you (like the bank) are responsible for

Bank accounts that are liabilities of a commercial bank

• Savings account (storing money long-term and earning interest)

• Checking account (for everyday spending)

How demand deposits can not just be a liability but also an asset

Money from someone else’s bank account can be used as a loan for another person. The bank can loan out a fraction of that money to earn interest

Fractional reserve banking

The federal reserve (America’s central bank) determines the percentage of the demand deposits (checking and savings account money) that a bank must hold in reserve (cannot loan out)

Excess reserves

deposited money that a bank is allowed to loan out

• the mechanism that a central bank can expand or decrease the money supply in the banking system

Required reserves

money that a bank is required to hold in its’ vault or on deposit with the Federal Reserve

In order to keep track of all their money, what do businesses need to make sure of?

Assets = Liabilities. These two sides must balance in order to properly account for all the money

Money Multiplier

helps determine the maximum amount that a change in deposits can change the money supply

• 1/reserve requirement

Determine the max amount that the money supply could change when a deposit is made

MM x Change in Excess Reserves = Maximum Amount that the deposit can change the money supply

Demand money

at any given time, people demand (hold) a certain amount of money for

3 Reasons People demand money

• Transactions Demand: to buy G & S

• Precautionary Demand: just in case money

• asset or speculative demand: hold money because other investments don’t seem promising

Explain why quantity of money demanded will be low when the nominal interest rate is high

You will want to put your money in your savings accounts so your money can grow interest

3 Shifters of the Demand for Money Line

• changes to price levels: when prices level increases, people need more money

• changes to real gdp (national income): people held more money in a booming economy to spend it; held less in a recession because you don’t need to spend as much

• changes to technology: people held more money because the process of withdrawing money was very tedious

What government entity controls the nation’s supply of money? What is this called?

The Federal Reserve, Monetary Policy

What will encourage an increase in the demand for investment?

Lower interest rates because the price of borrowing is less

What type of relationship do interest rates and quantity of investment have?

inverse relationship

How can the reserve requirement/ratio be used to carry out Monetary Policy?

The central bank can increase/decrease the reserve requirement which will increase/decrease excess reserves and thus the money supply

• inc rr = dec money supply

• dec rr = inc money supply

Discount rate

interest rate that the central bank will charge commercial banks

How can changing the discount rate be used to increase or decrease the money supply?

• Increase the money supply:

Lower the discount rate to encourage banks to borrow from the central bank

• Decrease the money supply:

Increase the discount rate to discourage banks to borrow from the central bank

Open Market Operations

The central bank buying or selling government securities (treasury bonds) to the open market or from the open market

Loanable funds market

supply and demand for loanable money

3 groups that demand loanable funds

households for consumption, businesses for capital investment, government for deficit spending

Relationship between real interest rates and quantity of loans demanded

Inverse relationship. When the real interest rate increases, the quantity of loans demanded decreases because the price of borrowing is higher.

Supply of loanable funds

all income that people have chosen to save in a bank (which the bank will lend out) rather than use for their own consumption

Relationship between quantity supplied of loanable funds and real interest rate

Direct relationship. High interest rate=more money deposited into savings account.

Administered Rate

Interest on Reserves; interest rate the central bank will pay commercial banks for money on deposit with the central bank