AP Macroeconomics Unit 4: Financial Sector

What is money?

Money is anything that serves as a medium of exchange

What are the three functions of money?

Medium of exchange

What makes money effective?

Generally accepted

What is liquidity?

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

What is a medium of exchange?

An item accepted as payment for goods and services.

What is a unit of account?

A standard numerical unit of measurement of the market value of goods and services.

What is a store of value?

The function of money that allows it to retain value over time.

What are the components of the money supply?

M1 and M2.

What is included in M1?

Currency

What is included in M2?

All of M1 plus savings deposits

What is the role of banks in the economy?

To take deposits and make loans

What is fractional reserve banking?

A banking system in which only a fraction of bank deposits are backed by actual cash on hand.

What is required reserve ratio?

The minimum fraction of customer deposits that each bank must hold as reserves.

What is excess reserves?

The reserves held by a bank beyond what is required.

How do banks create money?

By loaning out a portion of deposits.

What is the money multiplier?

1 / reserve requirement.

What happens to the real interest rate when nominal rates stay the same but inflation increases?

The real interest rate decreases.

Why are bond prices and interest rates inversely related?

When new bonds offer higher interest rates

What is the function of the financial sector in the economy?

It connects savers who deposit money with borrowers who need funds.

How do banks create money in the economy?

Through the fractional reserve system

What is the reserve requirement?

The percentage of deposits that banks are required to keep in reserve and not loan out.

What is the money multiplier formula?

Money multiplier = 1 / Reserve requirement.

What is the Federal Reserve (The Fed)?

The central bank of the United States responsible for monetary policy.

What are the main tools of monetary policy?

Open market operations

What are open market operations?

The Fed's buying or selling of government bonds to regulate the money supply.

What happens when the Fed buys bonds?

It increases the money supply and lowers interest rates.

What happens when the Fed sells bonds?

It decreases the money supply and raises interest rates.

What is the discount rate?

The interest rate the Fed charges commercial banks for short-term loans.

How does changing the discount rate influence the economy?

Raising the rate discourages borrowing

What is the federal funds rate?

The interest rate banks charge each other for overnight loans.

Why is the federal funds rate important?

It influences other interest rates and is a key target for the Fed's monetary policy.

What is the loanable funds market?

A hypothetical market that shows the interaction between borrowers and lenders determining the real interest rate.

What causes the supply of loanable funds to shift right?

Increases in savings

What causes the demand for loanable funds to shift right?

Increases in investment opportunities or government borrowing (budget deficit).

What is crowding out?

When increased government borrowing raises interest rates

What is the difference between crowding out and expansionary fiscal policy?

Expansionary fiscal policy increases government spending or cuts taxes to boost demand; crowding out is the side effect where higher interest rates reduce private investment.

What is M1 in the money supply?

M1 includes physical currency

What is M2 in the money supply?

M2 includes all of M1 plus savings deposits

What is the difference between M1 and M2?

M1 is more liquid and used for transactions

What is fiat money?

Money that has no intrinsic value but is accepted as currency because the government says it is legal tender.

What is commodity money?

Money that has intrinsic value

What are financial intermediaries?

Institutions like banks that connect savers with borrowers.

What is a bond?

A loan that represents debt to be repaid with interest over time

What is a stock?

A share of ownership in a company that may provide dividends and capital gains.

Why would investors choose bonds over stocks?

Bonds are less risky and provide fixed interest payments

Why would investors choose stocks over bonds?

Stocks have a higher potential return and the opportunity for dividends and capital gains.

What is the relationship between interest rates and investment?

Inversely related; as interest rates rise

Why are lower interest rates good for economic growth?

They encourage more borrowing and investing by businesses and consumers.

What is capital inflow?

The movement of financial capital into a country from foreign investors.

How does capital inflow affect the loanable funds market?

It increases the supply of loanable funds

What happens when a country has a budget surplus?

The government saves more than it spends

What happens when a country has a budget deficit?

The government borrows

What is the time value of money?

The concept that money today is worth more than the same amount in the future due to its earning potential.

How do interest rates reflect the time value of money?

They compensate lenders for the opportunity cost of lending money over time.

What is monetary policy?

Central bank actions that manage the money supply and interest rates to influence the economy.

What’s the goal of expansionary monetary policy?

To stimulate the economy by increasing the money supply and lowering interest rates.

What’s the goal of contractionary monetary policy?

To slow down the economy by decreasing the money supply and raising interest rates.

What is the liquidity preference theory?

A theory that suggests people demand money based on how much liquidity they need for transactions.

What shifts the demand for money?

Changes in price level

What shifts the supply of money?

Only actions by the central bank (e.g.

How does an increase in the money supply affect nominal interest rates?

It lowers nominal interest rates.

How does a decrease in the money supply affect nominal interest rates?

It raises nominal interest rates.

How does inflation affect borrowers and lenders?

Unexpected inflation benefits borrowers and hurts lenders because the real value of repayment falls.

Why might the Fed be cautious about lowering interest rates too much?

It could overheat the economy and cause inflation.

Why is the reserve requirement rarely changed by the Fed?

Because it’s a powerful tool that can have large and unpredictable effects on the banking system.

What is the dual mandate of the Federal Reserve?

To promote maximum employment and stable prices.