AP Econ unit 4

Commodity Money

something that performs the function of money and has intrinsic value (ex. gold coin)

Fiat money

something that serves as money but has no other value or uses (ex. paper dollar)

Functions of money

1. medium of exchange: must be easily used to buy goods & services with no complication of a barter system

2. unit of account: must measure the value of all goods and services

3. store of value: allows you to store purchasing power for the future

Liquidity

ease with which an asset can be accessed and used as a medium of exchange

M1

money in circulation, checkings accounts, and savings accounts

• most liquid

M2

ANYTHING IN M1 plus certificates of deposits and money market accounts

• money with restrictions on it that make it less accessible

Monetary base

total amount of money in circulation and in bank reserves

financial sector

network of institutions that link borrowers and lenders

financial intermediary

an institution that transforms the savings from individuals into financial assets (for the saver) and liabilities (for the borrower)

• ex. banks, credit unions, etc

asset

a resource with economic value

• financial: bank deposits, stocks, bonds, loans

• real: real estate, collectibles, etc (physical things)

• interest bearing: asset that earns interest over time

Interest rate

the amount a lender charges borrowers for borrowing money

• the price of a loan

stocks

represent ownership of a corporation

• an asset!

bonds (securities)

loans that represent debt the government (or business/individual) must repay to the lender

• when interest rates rise the price of previously issued bonds will decrease because they will earn less interest than the current bonds

relationship between risk and liquidity

inverse!

• the more liquid something is (like cash) the less risky it is

nominal interest rates

rates that are paid on a loan and is not adjusted for inflation

• rates you see when doing business with a financial institution

Real interest rate

rates adjusted for inflation

• real rate of return earned on a financial asset or paid back on loans

• NIR= RIR+inflation

fractional reserve banking

practice of keeping a percentage of demand deposits on hand and loaning out the rest

demand deposits

money deposited in a commercial bank that can be taken out at any time

reserve requirement

legal obligation to keep a minimum amount of reserves

excess reserves

the remainder of the deposited money that banks are not required to keep on hand

t accounts

tool for describing the financial position of a business by showing assets on the left and liabilities on the right

• each side must equal each other

money multiplier

1/ reserve requirement

• money multiplier x FIRST increase in the money supply= max potential change

• money from the fed is not in the money supply

motives to have liquid money

• transaction motive: need for liquid money for every day transactions

• asset motive: people hold money since it is less risky than other assets

Money Market graph

• (liquid) Money Demand curve: downward sloping because as interest rates decrease people are less likely to convert cash into interest earning assets

• Money supply curve: vertical because it is not affected by NIR

factors that shift money demand curve

• change in price level

• change in national income

• changes in technology

Monetary policy

a central banks policies of influencing interest rates to achieve economic goals

• interest rates impact the price level, real output, and unemployment through shifts in AD

policy rate

rate banks charge each other for loans

• known as federal funds rate in the US

Discount rate

rate the fed charges banks for a loan

expansionary monetary policy

decrease NIR in the short run to help increase AD and pull economy out of a recessionary gap

contractionary policy

Increase NIR to decrease AD and help pull economy down from an inflationary gap

Limited reserve system

1. required reserve ratio → decrease allows banks to lend out more excess reserves (inc M1) or an increase reduces the amount of money that is loaned out (dec M1)

2. discount rate → decrease encourages banks to lend more (inc M1) or increasing discourages lending (dec M1)

3. Open Market Operations → buying bonds increases banks excess reserves (inc M1) selling bonds decreases excess reserves (dec M1)

• buy bonds bigger, sell bonds smaller

Ample reserves system

a banking system where…

• reserves are abundant

• the required reserve ratio is 0

• changing the money supply no longer leads to changes in NIR

• banks do not loan out all of their reserves

ample reserve tools

1. interest on reserves: the interest rate commercial banks earn on the reserves they store with the fed

2. discount rate: interest rate charged to banks to get loans from the fed

ample reserve market graph

y axis: Policy rate

x axis: reserve quantity

curves: reserves demand curve and reserves supply curve

floor: IOR

ceiling: discount rate