AP Econ Unit 4

financial sector

• network of institutions that link borrowers and lenders

• includes banks, mutual funds, pension funds & other financial intermediaries

3 tasks of financial system

1. reduce transaction cost

2. reduce risk

3. provide liquididy

assets

anything tangible or intangible that has value

interest rate

the amount a lender charges borrowers for money, the price of a loan or cost of money

interest-bearing assets

assets that earn interest over time eg bonds

investment

always refers to businesses increasing capital stock (machinery & tools)

liquidity

the ease with which an asset can be converted to cash

stocks

• aka “equities”

• represent ownership of a corporation

• stockholder hopes value of equity rises & they can make a capital gain (sell for more than they purchased it for)

bonds

• aka “securities”

• loans issued by gov, business, or individual

• issuer of debt must repay to the lender for a specific period of time

  • the bond holder has no ownership of the company & is paid interest on the bond

  • a bond is issued at a specific interest rate that doesn’t change throughout the life of the bond

• higher liquidity than stocks

• investors always consider new interest rates to older bonds

  • bond prices & interest rates are inversely related

savings account

bank/credit union keeps your $ safe while sometimes paying low variable interest rate

• sometimes have min balance requirement

• aka “demand deposits because depositor can claim $ at any time

Certificate of Deposit

type of savings account that pays a fixed interest rate on your set deposit for a set period of time

*lower liquidity & higher interest rate than savings account

Nominal interest rates

• % increases in $ that the borrower pays (not adjusted for inflation)

• nominal = real interest rate + inflation

real interest rates

• the % increase in purchasing pwr that a borrower pays (adjusted for inflation)

• real=nominal interest rate - expected inflation

first form of money

barter system

• goods & services traded directly no “medium of exchange”

problems

• double coincidence of wants necessary (both parties must want what the other has)

• some goods cannot be split

what is money

anything that is generally accepted in payment for goods & services or in the repayment of debts

wealth

accumulation of assets over time

income

flow of earnings per unit of time

functions of money

1. medium of exchange

2. unit of account

3. store of value

medium of exchange

• used to buy goods & services with no complications of barter system

• a medium of exchange must be

  • standardized

  • accepted

  • divisible

  • portable

  • long lasting

unit of account

used to measure value in the economy

store of value

allows you to store purchasing power for the future

evolution of money

• commodity money: item performs the function of money & has intrinsic value

• fiat money: something that serves as money due to government decree but has no other value or uses

M1

• most liquid assets - $ used in everyday transactions

  • currency in circulation

  • checkable bank demand deposits (checking account)

  • savings deposits (ex money market account)

M2

• less liquid- short term savings vehicles

  • M1

  • time deposits (Certificate of deposits)

    • terms >7 days $<100000

  • money market funds

money market accounts

• type of bank account that earns higher interest than a savings account & allows checks/debit card options

  • usually limits # of withdrawals per month

money market funds

• type of mutual fund (pools investors money together)

  • invests in short-term bonds

  • not FDIC insured

monetary Base (M0)

• all physical currency in circulation & the reserves held by commercial banks @ the federal reserve

• M0 grows when the federal reserve buys bonds from banks or when more ppl hold cash/coins

assets

what a bank owns

• required reserves

• excess reserves

• loans

• securities/bonds

• physical assets

liabilities

what a bank owes

• demand deposits

• other deposits

• debts/liabilities

• owner equity (profit owed to bank’s owners)

balance sheet

a record of a bank’s assets liabilities & net worth

reserves

the portion of deposits that banks have not lent out

required reserves (rr)

% of deposits banks must hold by law

excess reserves

the amount the bank can loan out

fractional-reserve banking

a system in which banks hold a fraction of their deposits as reserves

money multiplier

1/rr

Why do ppl demand money?

1. transaction demand for money

2. asset demand for money

transaction demand for money

ppl hold money for everyday transactions

asset demand for money

ppl hold money since its less risky than other assets

money demand shifters

• changes in aggregate price level

  • if inflation increases…

• changes in real GDP

  • if someone gets more $…

• changes in tech

  • ATM’s affect on society

• changes in banking institutions

  • invention of interest bearing checking account

demand for money graph

supply of money is…

set by central bank independent from the interest rate

Money supply ~

monetary base

*monetary policy

when MS increases…

interest rates decrease → investments increase → AD, GDP, & PL increase

when MS decreases…

interest rates increase → investments decrease → AD, GDP, & PL decrease

federal reserve

• created in 1913 as 12 regional banks spread across US

  • independent of gov & w/o a single bank controlling all policies

structure of the fed

• board of governors

• chairman

• 12 federal reserve districts

board of governors

• 7 members appointed for 14 year terms

• governors guide the fed’s policy actions

chairman

1 member of the board is selected by the president to serve as chairman for a 4 year term

12 federal reserve districts

1 federal reserve bank per district which reports economic activity in its district

3 Shifters of Money Supply

1. reserve requirement

2. discount rate

3. open market operations

reserve requirement

the % of deposits banks must hold in reserve

discount rate

• the interest rate the fed charges commercial banks

  • to increase money supply the fed should decrease the discount rate

  • to decrease money supply the fed should increase the discount rate

open market operations

• the fed buys or sells government bonds (securities)

  • to increase the money supply the fed should buy bonds

  • to decrease the money supply the fed should sell bonds

  • *buy→big sell→small

Federal funds rate

the interest rate banks charge each other for one-day loans of reserves (if a bank has insufficient funds to meet the fed’s reserve requirement")