AP macro unit 4

ECONOMIC GROWTH: Comes from increases in human capital and physical capital.

● Savings = Investment Spending

● National Savings + Capital Inflow = Investment Spending

Financial asset types:

● Loans

● Bonds (bonds & interest rates for bonds are inversely related)

● Loan-backed securities

● Stocks

● Bank Deposits

Financial Intermediaries types:

● Mutual Funds

● Life insurance companies

● Pension funds

● Banks (meant to reduce transaction costs, reduce risk, and provide liquidity)

● Inflation & Interest rate:

○ Inflation rate: [ (PL in Year 2 - PL in Year 1) / PL in Year 1 ] * 100

■ Inflation does not make everyone poorer (because increase in wages &

increase in price of goods → no real change)

■ Nominal interest rate is unadjusted for inflation.

■ Real interest rate = Nominal interest rate - actual interest rate

■ Higher inflation than expected:

● Winners: Borrowers since they have to return funds with a lower

value.● Losers: Lenders

■ Lower inflation than expected:

● Winners: Lenders since they get funds with higher values

● Losers: Lenders

● Interest rate: Additional rate charged by lenders to borrowers for money lent.

● National Savings = Private savings + budget balance

Capital inflow: Net inflow of funds into a country.

● Liquid: If an asset can be converted into cash without much loss of value (most liquid

form is cash).

● Illiquid: If an asset loses a lot of value when converted to cash.

Diversification: When an investor invests in several different assets to avoid total loss.

Money (any asset accepted as a means of payment):

○ Roles in economy

■ Medium of exchange (used to trade for G&S)

■ Unit of account (can be stored and saved without losing value)

■ Store of value (A commonly accepted measure to set prices and make

economic calculations.)

● Types

■ Commodity money (Medium of exchange that also has intrinsic value.)

■ Commodity-backed money (Medium of exchange with no intrinsic value

but can be converted to valuable goods.)

■ Fiat Money (Medium of exchange that gets its value from the government

deciding it does.)

● Is measured using monetary aggregates M1 & M2

M1 = Currency in circulation + traveler’s checks + checkable bank deposits

M2 = Currency in circulation + traveler’s checks + checkable bank deposits +

near-moneys (savings account, time deposits, small denotation CDs)

● Present and future worth of a dollarA dollar’s worth today > a dollar’s worth in the future (because of inflation)

Net Present Value = PV of current & future benefits - PV of current & future

costs

● Banks:

○ Accept and keep funds as deposits; keep part of deposits and lend the rest out.

(T-accounts are used to show one’s liabilities and assets.)

Ex.

● Bank runs: When a lot of depositors go to the bank and demand their money at

the same time are caused by rumors that a bank failure has occurred. Therefore,

bank regulations have been created to prevent bank-runs and ensure

depositors' money

■ Deposit insurance (guarantees security of the first $250,000 of every bank

account)

■ Reserve requirements (banks are required to maintain the required reserve

ratio)

■ Discount Window (banks can get loans and money from the FED)

■ Capital requirements (assets have to be > deposits)

● Can decrease the money supply by removing currency in circulation and putting

them in bank vaults

● Can increase the money supply by making loans and creating money

■ Through the money multiplier process

■ Money multiplier = 1 / reserve ratio■ Money multiplier: Total amount created from every $ increase in

monetary base.

■ Total Increase in checkable bank deposits = (excess reserves) / (reserve

ratio)

Banks have required reserves and excess reserves (basis for the creation of money)

● Required reserve ratio: Portion of deposits banks are required to keep as reserves.

MONEY MARKET:

● Short-term interest rates tend to move together.

○ Affects the money supply, unlike long-term interest rates.

● Demand for money is driven by the opportunity cost of holding money and short-term

interest rate (money that could be earned from holding other assets).

● Money demand (relationship of quantity of money demanded and interest rate) shifters.

Aggregate Price level: Increase in aggregate price level increases money demand

● Changes in Real GDP (Increase in GDP increases money demand)

● Changes in technology (Inventions that decrease difficulty of changing assets to

currency in circulation increase money demand.)

● Changes in institutions

■ Increase - Decrease -

Money Supply (shows relationship of quantity of money supplied and interest rate) shifters are

monetary policy tools.

● Reserve requirement (lower required reserve ratio increases money supply)● Discount rate (lower discount rate increases money supply)

● Open-Market operations (Fed buying more T-bills increases money supply.)

■ Increase: Decrease:

Money Supply is chosen by the FED and does not change from changes in the interest rate.

Liquidity Preference Model (name for money market model)

● Equilibrium is achieved when the nominal interest rate is such that money demand &

money supply are equal.

● Surplus and shortages are created in the money market when economy is not at the

equilibrium interest rate.

MARKET FOR LOANABLE FUNDS:

● Suppliers - savers/lenders

● Demanders - borrowers

● Demand curve shifters

○ Changes in perceived business opportunities (optimistic beliefs increase demand)

○ Changes in government borrowing (more borrowing increases demand)

■ Increase - Decrease -● Supply curve shifters

● Changes in private savings behavior (them saving more increase supply)

● Changes in capital inflows (optimistic views of country from other countries increases

supply)

Increase - Decrease -

National Savings = public savings + private savings

■ In open economy, investment = national savings + net capital inflow.

Model:

FISHER EFFECT:

A rise in expected future inflation → a rise in the interest rate

A fall in expected future inflation → a fall in the interest rate● Government spending can cause lower investment spending from the crowding out

effect. The equilibrium interest rate for the liquidity preference model & the loanable

funds model are the same in the short-run & long-run.

FEDERAL RESERVE:

● Functions:

○ Provides financial services (ex. Holds reserves, clears checks)

○ Supervises banking institutions (ex. Makes sure they follow required reserve

ratio.)

○ Maintains stability of financial system (provides liquidity to all commercial

banks)

○ Conducts monetary policy

● Expansionary

◆ Decrease in required reserve ratio

◆ Lower discount rate

◆ Fed buying more T-bills (has greatest effect on money

supply)

● Contractionary

◆ Increase in required reserve ratio

◆ Increase in discount rate◆ FED sells T-bills (has greatest effect on money supply)

Most banks strive to stay on the federal funds rate!KEY:

UMP - Unemployment

PL - Price level

MB - Market basket

G&S - Goods and services

PV - Present value

FV - Future value

RGP - Real gross domestic product

AD - Aggregate demand

SRAS - Short-run aggregate supply

LRAS - Long-run aggregate supply

SRPC - Short-run phillip’s curve

LRPC - Long-run phillip’s curve

PPC - Production possibilities curve