Unit 4: Financial Sector

Financial sector

The network of institutions and markets that transfers funds from savers to borrowers/investors, reducing risk and matching them efficiently.

Real investment

Spending on physical capital (e.g., machines, buildings, software) that increases the economy’s productive capacity.

Expected rate of return

The anticipated net gain from an investment project, usually compared to the real interest rate when deciding whether to invest.

Real interest rate

The interest rate adjusted for inflation; measures the change in purchasing power from lending/borrowing.

Financial asset

A legal/financial claim to future payment (future income), not a physical input like a machine.

Money

An asset accepted as payment (a medium of exchange) in transactions.

Liquidity

How easily an asset can be converted to cash (or used to buy things) quickly with little or no loss in value; cash is the most liquid.

Rate of return

The net gain or loss of an investment over a period of time.

Risk

The chance that actual outcomes (gains/losses) differ from expected outcomes; higher risk generally requires a higher expected return.

Stock

A claim on (share of) ownership in a firm, giving the holder a claim on profits and assets.

Equity financing

Raising funds for investment by issuing shares of stock to the public.

Bond

A certificate of indebtedness: a loan from the bondholder to the issuer, repaid with interest.

Bond principal

The amount originally borrowed that must be repaid by the issuer.

Bond maturity date

The date when the bond’s principal is repaid to the bondholder.

Secondary market (bonds)

A market in which previously issued bonds are bought and sold, changing ownership after the original issue.

Debt financing

Raising investment funds by borrowing, often by issuing bonds to the public.

Bond price–interest rate inverse relationship

Bond prices and interest rates move in opposite directions because bond coupon payments are fixed (rates up → existing bond prices down; rates down → prices up).

Loan

Borrowing money and repaying it later with interest.

Credit card

Access to revolving borrowing (a loan mechanism), not money and not part of the money supply.

Demand deposit

A checking account balance that can be withdrawn/transferred on demand; counted in M1.

Nominal interest rate

The quoted interest rate in money (dollar) terms, not adjusted for inflation.

Expected inflation (πe)

The inflation rate people/lenders expect in the future; used in the Fisher relationship.

Fisher effect

The idea that higher expected inflation leads to higher nominal interest rates (holding the real rate constant).

Fisher approximation

AP Macro approximation linking rates and inflation: r ≈ i − πe (equivalently, i ≈ r + πe).

Positive real interest rate

Occurs when the nominal interest rate exceeds inflation (i > π), so lenders gain purchasing power.

Negative real interest rate

Occurs when the nominal interest rate is below inflation (i < π), so lenders lose purchasing power; borrowing becomes more attractive.

Fiat money

Money with no intrinsic value whose value is based on trust and government backing (modern paper/coin currency).

Commodity money

Money that has intrinsic value and an alternative non-monetary use (e.g., gold, silver).

Medium of exchange

A function of money: it is widely accepted in payment for goods and services.

Unit of account

A function of money: it is the standard measure for quoting and comparing prices/values.

Store of value

A function of money: it transfers purchasing power into the future (works best when inflation is low).

Money supply

The quantity of money in the economy as measured by aggregates like M1 and M2; in the money market model it is treated as fixed at a point in time.

M1

The most liquid money supply measure: currency, coins, checking (checkable) deposits, and traveler’s checks.

M2

A broader money measure: M1 plus savings deposits, small time deposits, money market deposit accounts, and money market mutual funds.

Opportunity cost of holding money

The interest income forgone by holding non-interest-bearing money instead of interest-bearing assets (like bonds).

Monetary base (MB or M0)

Currency in circulation plus bank reserves; MB = C + R.

Fractional reserve banking

A banking system where banks hold only a fraction of deposits as reserves and lend out the rest.

Bank balance sheet (T-account)

A table showing a bank’s assets and liabilities, where total assets must equal total liabilities.

Bank reserves

Funds banks hold to meet withdrawals and legal requirements (vault cash plus deposits at the central bank).

Required reserves (RR)

The minimum reserves a bank must hold: RR = rr × D (required reserve ratio times deposits).

Excess reserves (ER)

Reserves above what is required: ER = R − RR; the portion that can be loaned out.

Simple money multiplier

Under simplifying assumptions, maximum deposit creation factor: m = 1/rr; maximum ΔD = (1/rr) × ΔR.

Money demand curve

A downward-sloping relationship between the nominal interest rate and quantity of money demanded, based on the opportunity cost of holding money.

Shifters of money demand

Factors that shift money demand (e.g., real GDP, price level/nominal GDP, transaction costs/payment technology).

Open-market operations (OMOs)

The Fed’s buying and selling of government securities to change bank reserves and the money supply (buy → MS up; sell → MS down).

Federal funds rate

The interest rate on short-term loans of reserves between banks; the Fed often targets this rate using OMOs.

Discount rate

The interest rate the Fed charges banks for short-term loans from the Fed; lower encourages bank borrowing of reserves, higher discourages it.

Reserve requirement

A policy tool setting the required reserve ratio (rr); lower rr increases potential lending/deposit creation, higher rr reduces it.

Loanable funds market

A model where the real interest rate is determined by the supply of saving/lending and the demand for borrowing to finance investment (and government borrowing).

Crowding out

When increased government borrowing raises the real interest rate in the loanable funds market, reducing private investment.