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AP Macroeconomics Unit 4 - Financial Sector Review

Financial Sector Overview

  • Financial Sector: Network of institutions that link borrowers and lenders.

  • Assets: Tangible or intangible items that hold value.

  • Interest Rate: Price that lenders charge borrowers for loans.

  • Interest-Bearing Assets: Assets that accumulate interest over time (e.g., bonds).

  • Investment: Business spending on tools and machinery; lower interest rates increase investment.

  • Liquidity: Ease of converting an asset to cash; higher liquidity usually means lower returns.

Understanding Bonds and Stocks

  • Bonds: Loans or IOUs that represent debt owed by governments or businesses; bondholders receive interest but no ownership.

  • Stocks: Represent ownership in a corporation; stockholders may receive dividends.

  • Bond Prices & Interest Rates: Inversely related; fixed interest rates persist throughout the bond's lifespan.

Nominal vs. Real Interest Rates

  • Real Interest Rate: Represents the increase in purchasing power - calculated as:
    Real = Nominal - Inflation

  • Nominal Interest Rate: Increase in money without adjusting for inflation - calculated as:
    Nominal = Real + Inflation

Time Value of Money (TVM)

  • Concept that money now is worth more than the same amount in the future due to potential earning ability.

Functions and Definition of Money

  • Money: Accepted medium of exchange for goods and services, distinct from wealth and income.

    • Wealth: Total assets owned.

    • Income: Earnings over time.

  • Commodity Money: Money with intrinsic value.

  • Fiat Money: Money that has no intrinsic value, only value as currency.

Functions of Money

  1. Medium of Exchange: Facilitates trade.

  2. Unit of Account: Standardizes value of goods/services.

  3. Store of Value: Retains value over time.

Characteristics of Effective Money

  1. Generally Accepted

  2. Scarce

  3. Portable and Divisible

Purchasing Power and Money Supply

  • Purchasing Power: Ability of money to buy goods/services; inflation decreases purchasing power.

    • Hyperinflation: Extreme inflation affecting acceptability.

  • Liquidity: Access and usability of an asset as cash.

Money Supply (

  • M1 (Highest Liquidity): Currency, checkable deposits, traveler’s checks.

  • M2 (Near-moneys): M1 plus savings and time deposits.

Banking and Money Supply Expansion

  • Fractional Reserve Banking: Only a portion of deposits is kept in reserve while the rest is loaned out.

  • Money Multiplier:
    Money Multiplier = \frac{1}{Reserve Requirement}

  • Demand Deposits: Money in checking accounts.

  • Required Reserves: Legally mandated percentage banks must hold from demand deposits.

  • Excess Reserves: The portion of reserves banks can lend out.

Money Market Insights

  • Demand for Money:

    • Transaction Demand: Everyday transactions.

    • Asset Demand: Holding money as a store of value.

  • Shifters in Demand for Money: Changes in price levels, income, and technology.

Supply of Money and Monetary Policy

  • Controlled by the Federal Reserve, independent of interest rates.

  • Monetary Policy: Adjusts money supply to impact the economy.

    • Increasing Money Supply:

    1. Decreases interest rates.

    2. Increases investment.

    3. Increases aggregate demand (AD).

    • Decreasing Money Supply: Increases interest rates and decreases AD.

Influences on Money Supply

  • Fed's Actions:

    1. Reserve Requirement: Percentage banks must hold.

    2. Discount Rate: Rate charged to banks; changes influence money supply.

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

Economic Impacts of Money Supply Changes

  • An increased money supply reduces interest rates, boosts investment, and enhances AD.

  • Conversely, reducing the money supply rises interest rates, curtails investment, and lessens AD.

Loanable Funds Market

  • Real Interest Rate: Focus for lenders and borrowers; reflects true return.

  • National Savings: The sum of public and private savings influencing loan availability.

  • Demand Shifters: Include changes in borrowing behaviors by consumers, businesses, and governments.

  • Supply Shifters: Public/private savings behavior and foreign investments.

Final Notes on Monetary Policy Tools

  • Limited Reserves: Changes in reserve requirements or discount rates can significantly impact money supply.

  • Ample Reserves: Interest rates less sensitive to changes in money supply; adjustments to administered rates become crucial.