AP Macroeconomics - The Financial Sector Notes

Financial Sector Overview

• Unit 4: Focuses on the financial sector in AP Macroeconomics.

Functions of Money

1. Medium of Exchange

   • Money facilitates buying goods/services without barter complications.

2. Unit of Account

   • Money provides a standard measure of value for goods/services.

3. Store of Value

   • Money allows individuals to save purchasing power for future use.

Liquidity

• Definition: Ease of converting an asset to cash.

• Examples:

  • Liquid: Cash, checking accounts.

  • Very Liquid: Savings accounts, time deposits.

  • Kind of Liquid: Stocks, bonds.

  • Not Very Liquid: Real estate.

Rate of Return

• Definition: The earnings from an investment over time, expressed as a percentage.

• Example: Investing $100 at a 1% interest rate yields $1 over a year.

• Risk: Possibility of not earning expected returns.

Bonds vs. Stocks

Stocks

• Represents ownership in a company.

• Ways to Profit:

  1. Dividends: Share of profits.

  2. Capital Gain: Selling stock at a higher price.

• Risk Level: High; prices fluctuate.

Bonds

• Loans made to companies/governments, paid with interest.

• Example: Buying a $1,000 bond at 3% yields $30 annually.

• Risk Level: Low; interest is steady until maturity.

Comparison

Bond Prices vs Interest Rate

• Inversely Related:

  • If interest rates rise, bond prices fall due to lower demand for lower-yielding bonds.

  • If interest rates fall, bond prices rise as they become more attractive.

Sources of Value for Money

1. Commodity Money: Valuable in itself (e.g., gold, silver).

2. Representative Money: Backed by a commodity (e.g., old U.S. dollars).

3. Fiat Money: No intrinsic value, relies on government decree (e.g., U.S. dollars).

Money Supply

• Importance: Influences inflation and spending levels.

1. M0 (Monetary Base): Cash + reserves.

2. M1: Most liquid (cash + checking accounts).

3. M2: Less liquid (M1 + savings, CDs).

Real vs Nominal Interest Rates

• Nominal Interest Rate: Unadjusted for inflation.

• Real Interest Rate: Adjusted for inflation (e.g., 5% nominal and 2% inflation results in a 3% real rate).

Fractional Reserve Banking

• Definition: Banks keep a fraction of deposits in reserve and lend the rest.

• Required Reserves (RR): Minimum must be kept, determined by the Fed.

• Excess Reserves (ER): Any reserves banks can lend out.

Money Creation & the Money Multiplier

• Process: Banks create money by lending excess reserves. The cycle leads to more money circulating than initially deposited.

• Example: $1,000 deposit with a 10% RR can lead to $10,000 in total created money after several loans.

Money Market

• Interaction: Money demand and supply determine the nominal interest rate.

• Demand for Money (MD): Downward sloping as holding cash has an opportunity cost.

• Supply of Money (MS): Fixed by the Fed, vertical curve.

• Equilibrium: Where the quantity of money demanded equals the quantity supplied.

Monetary Policy

• Definition: Refers to how the Fed controls the money supply and interest rates to stabilize the economy.

• Goals: Control inflation, achieve full employment, stimulate economic growth.

• Types: Expansionary and contractionary policies to manage economic conditions.

• Tools:

  1. Reserve Requirement: Adjusts funds banks must hold.

  2. Discount Rate: Rate banks pay for loans from the Fed.

  3. Open Market Operations: Buying/selling bonds to influence money supply.

Conclusion

• Understanding the financial sector, the roles of money, and the intricacies of banking and monetary policy is crucial for navigating macroeconomic principles.