Untitled Flashcards Set

Financial Assets

Financial assets: Assets that derive value from a contractual claim, such as stocks, bonds, and bank deposits.

Money

Money: Any asset widely accepted as a medium of exchange.

Types of money:

• Fiat money: Has no intrinsic value; value comes from government decree (e.g., U.S. dollar).

• Commodity-backed money: Can be exchanged for a fixed amount of a commodity (e.g., gold standard).

• Commodity money: Has intrinsic value (e.g., gold, silver, cattle).

Purposes of money:

1. Medium of exchange – Used for transactions.

2. Store of value – Maintains purchasing power over time.

3. Unit of account – Standard measure of value.

Stocks and Bonds

• Stocks: Represent ownership in a company.

• Bonds: Debt instruments where the issuer promises to repay with interest.

Values of Financial Markets

• Lower transaction costs: Easier buying and selling.

• Lower individual risk: Diversification reduces exposure to risk.

• More liquidity: Easier to convert assets into cash.

Time Value of Money

Formula: FV=PV(1+r)tFV = PV(1+r)^tFV=PV(1+r)t

• FV: Future value

• PV: Present value

• r: Interest rate

• t: Time in years

• This formula shows how money grows over time due to interest.

Measures of Money Supply

• M1: M1=Currency+Checkable deposits+Traveler’s checks\text{M1} = \text{Currency} + \text{Checkable deposits} + \text{Traveler’s checks}M1=Currency+Checkable deposits+Traveler’s checks

• M2: M2=M1+Savings deposits+Money market funds+Small time deposits\text{M2} = \text{M1} + \text{Savings deposits} + \text{Money market funds} + \text{Small time deposits}M2=M1+Savings deposits+Money market funds+Small time deposits

Banks and Money Creation

• Money multiplier: 1Reserve Requirement\frac{1}{\text{Reserve Requirement}}Reserve Requirement1​

• Reserve requirements: The minimum fraction of deposits banks must hold in reserves.

• T-accounts and changes to deposits: Shows how deposits and reserves change within a bank’s balance sheet.

• T-accounts and bond sales: Reflect how a bank’s assets and liabilities adjust when bonds are bought or sold.

Money Demand

• Shape: Downward-sloping.

• Determinants:

  1. Interest rates

  2. Real GDP

  3. Price level

  4. Financial innovation

Money Market and Equilibrium Nominal Interest Rate

• Shape of money supply: Vertical (fixed by central bank).

• Graph: Y-axis = Nominal interest rate, X-axis = Quantity of money.

Central Bank and Money Supply

Monetary policy tools:

• Reserve requirement: Lowering increases money supply; raising decreases it.

• Discount rate spread: Interest rate charged by central bank on loans to banks.

• Interest paid on reserves: Higher interest incentivizes banks to hold reserves, reducing lending.

• Open market operations: Buying Treasury bills increases money supply, selling decreases it.

Fiscal Policy Terms

• Expansionary policy: Increases aggregate demand (e.g., tax cuts, more government spending).

• Contractionary policy: Decreases aggregate demand (e.g., tax hikes, spending cuts).

• Discretionary policy: Direct government action to stabilize the economy.

• Transfer payment: Government payments without exchange of goods/services (e.g., Social Security).

• Automatic stabilizer: Policies that naturally counteract economic fluctuations (e.g., unemployment benefits).

Fiscal Policy Effectiveness

• More effective for demand shocks: Directly impacts spending and GDP.

• Less effective for supply shocks: Cannot fix productivity issues; may cause inflation.

Expansionary Fiscal Policy

1. Increased government spending

2. Tax cuts

3. Increased transfer payments

Contractionary Fiscal Policy

1. Decreased government spending

2. Tax increases

3. Reduced transfer payments

Transfer Payments vs. Government Spending

• Transfer payments: Money given without receiving goods/services (e.g., welfare).

• Government spending: Direct purchase of goods/services (e.g., infrastructure).

Problems with Fiscal Policy

• Time lags: Delayed effects due to legislative and implementation delays.

Multipliers

• Spending multiplier: 11−MPC\frac{1}{1 - MPC}1−MPC1​ (Used for government spending changes).

• Tax multiplier: −MPC1−MPC-\frac{MPC}{1 - MPC}−1−MPCMPC​ (Used for tax changes, smaller than spending multiplier).

Automatic Stabilizers

• Taxes: Revenue falls in recessions, rises in booms.

• Unemployment benefits: Payments increase in recessions, decrease in expansions.

Federal Reserve and Monetary Policy

• Open market operations: Buying/selling government bonds.

• Reserve ratio: Required reserves relative to deposits.

• Federal funds rate: Interest rate banks charge each other for overnight loans.

• Discount rate: Interest rate banks pay to borrow from the Fed.

• Quantitative easing: Large-scale asset purchases to stimulate economy.

• Government securities: Bonds issued by the government.

Theories and Models

• Liquidity preference model: Money demand depends on interest rates.

• Money neutrality theory: In the long run, changes in money supply only affect prices, not real GDP.

• Quantity theory of money: MV=PYMV = PYMV=PY (Money supply affects price levels).

• Equation of exchange: MV=PQMV = PQMV=PQ, where VVV is velocity and QQQ is output.

• Velocity of money: How fast money circulates in the economy.

Monetary Policy Types

• Contractionary: Reduces money supply (higher interest rates).

• Expansionary: Increases money supply (lower interest rates).

Equation of Exchange

MV=PQMV = PQMV=PQ (Money supply × Velocity = Price level × Output).

Nominal GDP and Money Supply

• If velocity is constant and money supply increases by $5 billion, nominal GDP increases by $5 billion.

Bonds

1. Bond prices and interest rates are inversely related.

2. Bonds are a form of debt financing.

Money Supply Categories

• M1: Currency, checkable deposits, traveler’s checks.

• M2: M1 + savings deposits, money market funds, small time deposits.

Monetary Base vs. Money Supply

• Monetary base: Currency + bank reserves.

• Money supply: Includes broader forms like checking and savings deposits.

Money Market

• Uses nominal interest rates (inflation is already factored into expectations).

• Money supply is vertical because it is fixed by the central bank.

• Money demand is downward-sloping because higher interest rates make holding money less attractive.

Determinants of Money Demand

1. Wealth (real GDP) – More income = higher money demand.

2. Technology – Easier access reduces need for cash.

3. Price level – Higher prices require more cash.

4. Trust in institutions – If trust is high, people hold less cash.

Determinant of Money Supply

• Controlled by the Federal Reserve through monetary policy.