AP Macroeconomics Unit 4 Review

Problems with the Barter System (2)

1) "Double Coincidence of Wants"; each trade must have something the other wants

2) Not all goods can be split

3 Functions of Money

1) Medium of Exchange

2) Unit of Account

3) Store of Value

What makes money effective? (3)

1) Generally Accepted

2) Portable/Dividable

3) Scarce

Commodity Money vs Fiat Money

Commodity money has intrinsic value while fiat money does not

Inflation on Purchasing Power

Inflation decreases purchasing power and rapid inflation decreases acceptability

M1 Liquidity

1) Currency in circulation

2) Checkable bank deposits (checking accounts)

3) Traveler's checks

M2 Liquidity

1) All of M1

2) Savings deposits (money market accounts)

3) Time deposits (certificates of deposit)

4) Money market funds

What is the opportunity cost of holding liquid money?

The interest you could be earning

Assets

anything tangible or intangible that is OWNED

Liability

anything that is OWED

Loan

an AGREEMENT between a lender and a borrower, usually with an interest rate (a loan is an ASSET for the LENDER and LIABILITY for the BORROWER)

Bonds

loans that represent debt that the government, business, or individual must repay the lender; a bond holder has NO ownership of the company

Stocks

represents the ownership of a corporation and that stockholder is often entitled to a portion of the profit

What is the relationship between BOND PRICE and INTEREST RATES?

inversely related

Why do people demand a certain amount of liquid assets (money)? (2)

1) Transaction Demand for Money- people hold money for everyday transactions

2) Asset Demand for Money- people hold money since it is less risky than other assets

What is the opportunity cost of hold keeping money in your pocket or checking account?

The interest you could be earning from other financial assets like stocks, bonds, and real estate

What happens to the quantity demanded of money when interest rates increase?

Quantity demanded falls because individuals prefer to have interest earning assets instead

What happens to the quantity demanded of money when interest rates decrease?

Quantity demanded increases because there is no incentive to convert cash into interest earning assets

Money Demand Shifters (3)

1) Changes in Price Level

2) Changes in Income

3) Changes in Technology

Increasing Money Supply

- creates a SURPLUS

- MS line shifts RIGHT

- increase money supply, decrease interest rate, increase investment, increase aggregate demand (increase GDP and PL)

Decreasing Money Supply

- creates a SHORTAGE

-MS line shifts LEFT

- decrease money supply, increase interest rate, decrease investment, decrease aggregate demand (decrease GDP and PL)

Fractional Reserve Banking

when banks hold only a small portion of deposits to cover potential withdrawals and then loans the rest of the money out

What would happen if we all went to the bank to withdraw money at the same time?

Bank run

Demand Deposits

money deposited in a commercial bank in a checking account

- demand deposits are a LIABILITY for the BANK and an ASSET for the DEPOSITOR

Required Reserves

the percent that banks must hold by law

Excess Reserves

the amount that the bank can loan out

Why would the FED ever want to slow down the economy?

to fight inflation

Money Supply Shifters (3)

1) Setting Reserve Requirements (Ratios)

2) Lending Money to Banks and Thrifts (Discount Rates)

3) Open Market Operations (Buying and Selling Bonds)

Reserve Requirement (Ratio)

the percent of deposits that the banks must hold in reserve (the percent they can NOT loan out)

If there is a RECESSION, what should the FED do to the reserve requirement?

- decrease the reserve ratio

- banks hold less money and have more excess reserves

- money supply increases, ir decreases, AD increases

If there is INFLATION, what should the FED do to the reserve requirement?

- increase the reserve ratio

- banks hold more money and have less excess reserves

- money supply decreases, ir increases, AD decreases

Discount Rate

the interest rate that the FED charges commercial banks

Easy Money Policy

decreasing discount rate to increase money supply

Tight Money Policy

increasing discount rate to decrease money supply

Open Market Operations

when the FED buys or sells government bonds/securities (most important and widely used)

If the FED buys government securities...

money supply will increase

If the FED sells government securities...

money supply will decrease

Real Interest Rate

the percentage increase in purchasing power that the borrower pays adjusted for inflation

Nominal Interest Rate

the percentage increase in purchasing power that the borrower pays not adjusted for inflation

Loanable Funds Market

the private sector supply and demand of loans

- shows the effect on REAL INTEREST RATE

- demand; INVERSE btw real ir and quantity loans demanded

- supply; DIRECT btw real ir and quantity loans demanded

- NOT the same as money market (supply is NOT vertical)

What happens at the equilibrium interest rate of a loanable funds market graph?

the amount borrowers want to borrow is equal to the amount lenders want to lend

What happens when real interest rates increase?

crowding out

Loanable Funds Market Demand Shifters (2)

- Changes in Perceived Business Opportunities

- Changes in Government Borrowing (Budget Deficit or Surplus)

Loanable Funds Market Supply Shifters (4)

- Changes in Private/Public Savings

- Changes in Foreign Investment

- Changes in Expected Profitability