Unit 4 The Financial Sector 💸

What is money defined as?

Anything that can be used to purchase goods and services.

How is wealth defined?

An accumulation of savings through the purchase of assets.

What are financial assets?

Written claims where buyers have the right to future income from sellers.

What is the core characteristic of a financial asset?

It holds value that can be stored or traded and typically earns returns.

What forms can financial assets take?

Demand deposits, cash, loans, stocks, bonds, and physical assets like land and homes.

What is liquidity in the context of financial assets?

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

Which asset is considered the most liquid?

Cash.

How do checking accounts rank in terms of liquidity?

They are easily transferable to cash.

Why are stocks considered low liquid assets?

Due to a lack of willing buyers and sellers.

What is the rate of return?

What you gain from investing in an asset.

What type of return do bonds provide?

A fixed rate of return in the form of interest payments.

What is the risk associated with stocks?

They can gain or lose value quickly.

What is a bond?

A piece of paper issued by governments or corporations to raise money, which pays back interest.

What is the term of a bond?

The amount of years that the bond will earn interest and be held by an owner.

What is the relationship between bond prices and interest rates?

They have an inverse relationship.

What do shareholders profit from?

If stock prices rise or if the company pays dividends.

What is the opportunity cost of holding money?

The interest the money could be earning in an interest-bearing asset.

What are nominal interest rates?

Interest rates paid on a loan that are not adjusted for inflation.

What are real interest rates?

The real rate of return earned on financial assets or paid on loans, adjusted for inflation.

What is the Fisher equation?

Nominal interest rate = real interest rate + inflation.

If expected inflation is 8% and the real interest rate is 4%, what is the highest nominal interest rate you would pay?

12%.

How do unexpected inflation rates affect financial assets?

The real value of financial assets falls.

What happens to Emma's real rate of return if inflation increases after she buys a bond?

It decreases.

What happens to the nominal interest rate if expected inflation is 2% and lenders want a real interest rate of 6%?

Lenders will charge 8% on loans.

What is the effect of higher unexpected inflation on fixed-rate savings and loans?

It makes the real rate of return lower.

What is the difference between expected inflation and unexpected inflation?

Higher unexpected inflation lowers the real rate of return on fixed-rate savings and loans.

How does unexpected inflation affect borrowers and lenders?

When unexpected inflation is higher than expected, borrowers benefit while lenders lose.

Define money.

Money is any asset accepted as a means of payment.

What is wealth defined as?

Wealth is the acquisition of financial assets over time that hold real value.

What type of money is the United States dollar considered?

Fiat Money, as it has value because the government declares it as money.

What determines the real value of money?

The real value is determined by how many goods and services it can purchase.

What does a unit of account mean in relation to money?

It means money is commonly accepted as a way to set prices and compare the value of goods.

What is a store of value?

A characteristic of money that allows it to hold purchasing power over time.

How can inflation affect the store of value of money?

Inflation can decrease money's ability to store value, requiring more dollars to purchase the same goods over time.

What is a medium of exchange?

Money can be used to exchange goods and services, facilitating economic growth.

What are the four types of money supply?

M0 (monetary base), M1 (currency + demand deposits), M2 (M1 + small time deposits), M3 (M2 + larger liquid assets).

What is the reserve requirement in fractional reserve banking?

The percentage of customers' checking accounts that banks must keep in reserves.

What is the role of the central bank in the banking system?

The central bank regulates the banking system and sets monetary policy.

What is a balance sheet or T-account in banking?

A visual representation of a bank's assets and liabilities.

How does the lending cycle increase the money supply?

Deposits are loaned out, spent, and redeposited, restarting the cycle and multiplying the money supply.

What is the money market?

The market where the demand for money and the supply of money interact.

What is the nominal interest rate in the money market?

The price of the money market, representing the opportunity cost of holding money.

What factors influence money demand?

Price level, real GDP/income, and technology affecting transaction costs.

What is the Federal Reserve's role in the money supply?

The Federal Reserve sets the money supply and controls it through monetary policy.

What are the shifters of the money supply?

Open market operations, discount rate, reserve requirement, and federal funds rate.

What happens to the money market equilibrium when nominal interest rates are high?

A surplus will drive down the interest rates.

What is monetary policy?

A central bank's policies to influence nominal interest rates to achieve full employment and price stability.

What is the relationship between investment demand and nominal interest rates?

Investment demand is negatively associated with the nominal interest rate.

How do interest rates influence the economy?

They affect price levels, real output, and unemployment by increasing or decreasing aggregate demand.

What can banks do when they cannot meet the reserve requirement?

They can call in loans, sell assets, borrow from the central bank at the discount rate, or borrow from other banks at the policy rate.

What is the policy rate in the United States?

The federal funds rate, which is the overnight interbank lending rate.

What is expansionary monetary policy?

It involves decreasing nominal interest rates to stimulate the economy out of a recession.

What is contractionary monetary policy?

It involves increasing nominal interest rates to combat inflation.

What effect does a lower interest rate have on borrowing?

It makes borrowing cheaper, leading to increased interest-sensitive spending and higher aggregate demand.

What is a recognition lag?

The time it takes for central banks to collect and analyze data to recognize economic problems.

What is an impact lag?

The time it takes for the economy to adjust to a new policy.

How do interest rate changes affect the money supply in a limited reserves framework?

Interest rate changes are influenced by shifts in the money supply.

What happens when the required reserve ratio decreases?

Banks have more excess reserves to lend, increasing the money supply and decreasing nominal interest rates.

What is the discount rate?

The interest rate that commercial banks pay to borrow from the central bank.

What happens when the central bank buys bonds?

Excess reserves increase, leading to an increase in the money supply and a decrease in nominal interest rates.

What is the money multiplier?

It is calculated as 1 divided by the required reserve ratio, reflecting how banks can create money through lending.

What is the loanable funds market?

It is a market where loans are demanded and supplied, determining how much money is available for lending.

Who are the buyers and sellers in the loanable funds market?

Buyers are borrowers (individuals, businesses, governments), and sellers are savers (households, foreign investors, governments with surpluses).

What is the real interest rate?

It is the nominal interest rate minus inflation, representing the actual cost of borrowing.

What happens to the quantity of loans demanded when real interest rates rise?

The quantity demanded decreases because borrowing becomes more expensive.

What factors can increase the demand for loans?

Expectations of future economic growth, government deficit spending, increased foreign demand for currency, and higher consumer confidence.

What factors can increase the supply of loans?

Changes in saving habits, fiscal policy leading to budget surpluses, and increased foreign investment.

What determines equilibrium in the loanable funds market?

It is where the quantity of loans demanded equals the quantity of loans supplied.

What happens when the real interest rate is high?

More people prefer to save rather than borrow, causing a surplus of funds.

What happens when the real interest rate is low?

More people prefer to spend rather than save, causing a shortage of funds.

What occurs when demand for loans increases?

The demand curve shifts right, leading to a rise in the real interest rate.

What occurs when supply of loans increases?

The supply curve shifts right, leading to a decrease in the real interest rate.

How does government deficit spending affect the loanable funds market?

It increases demand for loans, which raises interest rates.

How does a higher savings rate affect the loanable funds market?

It increases the supply of loans, which lowers interest rates.