AP Macroeconomics Unit 4 – Financial Sector: Ultimate Study Notes

Money

Definition

  • Money: Any item that is generally accepted as payment for goods and services.

  • Functions:

    • Medium of exchange – eliminates barter

    • Unit of account – measures value

    • Store of value – maintains value over time

    • Standard of deferred payment – used for future payments

AP Tip

  • Money must be widely accepted, durable, divisible, portable, and stable in value.

Memory Trick

  • M-U-S-S → Medium, Unit, Store, Standard

Types of Money

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

  • Fiat money: No intrinsic value; backed by government decree (e.g., U.S. dollars)

Money Supply

Components

  • M1: Cash, coins, checking accounts

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

AP Tip

  • M1 is highly liquid; M2 includes less liquid forms

Shifters of Money Supply

  • Controlled by central bank (Federal Reserve)

  • Tools:

    • Open Market Operations (OMO): Buying ↑ money supply, Selling ↓ money supply

    • Discount rate: Interest Fed charges banks; ↓ rate → ↑ money supply

    • Reserve requirement: ↓ requirement → ↑ lending → ↑ money supply

Memory Trick

  • O-D-R → Open market, Discount, Reserve

Banks and Fractional Reserve Banking

Fractional Reserve System

  • Banks keep only a fraction of deposits as reserves; lend out the rest

  • Creates money through lending → money multiplier effect

Money Multiplier

Money Multiplier = 1 ÷ Reserve Ratio

AP Tip

  • Smaller reserve ratio → larger money multiplier → more lending

Memory Trick

  • “Fractional reserves = fraction stays, multiplier grows”

Loanable Funds Market

Definition

  • Market where savers supply funds and borrowers demand funds

  • Determines real interest rate

Shifters

  • Demand for loanable funds (Investment): Business expectations ↑ → demand ↑

  • Supply of loanable funds (Savings): Household saving ↑ → supply ↑

AP Tip

  • Real interest rate balances savings and investment

  • FRQs may ask to show shifts of supply and demand curves

Memory Trick

  • S-I → Savings supply, Investment demand

Money Market

Definition

  • Market for liquidity (money)

  • Determines nominal interest rate

Shifters

  • Money demand ↑ → nominal interest rate ↑

  • Money supply ↑ → nominal interest rate ↓

AP Tip

  • Distinguish loanable funds (real interest rate) vs money market (nominal interest rate)

Memory Trick

  • Money = Nominal interest; Loanable = Real interest

Federal Reserve (Central Bank)

Functions

  • Control money supply

  • Lender of last resort

  • Stabilize banking system

Tools of Monetary Policy

  • Open Market Operations (OMO) – buy/sell government bonds

  • Discount Rate – interest rate for banks

  • Reserve Requirement – fraction banks must hold

Monetary Policy Types

  • Expansionary: ↑ money supply → lower interest rates → AD ↑

  • Contractionary: ↓ money supply → higher interest rates → AD ↓

AP Tip

  • FRQs often ask to show AD shift due to Fed policy on AD/AS diagram

Memory Trick

  • E-C → Expansionary = Combat Recession, Contractionary = Combat Inflation

Key Terms to Remember

  • Money: Medium, Unit, Store, Standard

  • M1 & M2

  • Fractional reserve banking, Money multiplier

  • Loanable funds vs Money market

  • Federal Reserve tools: OMO, Discount rate, Reserve requirement

  • Expansionary vs Contractionary monetary policy

Memory Trick

  • M-F-L-M-F → Money, Fractional reserve, Loanable funds, Money market, Fed