Unit 4

AP Macroeconomics – Unit 4 Review Sheet

Unit 4: Financial Sector

Key Vocabulary Terms

• Financial Sector – The part of the economy made up of institutions (like banks) that bring together savers and borrowers.

• Asset – Anything of value that is owned.

• Liability – A debt or obligation owed to others.

• Interest – The cost of borrowing money or the return on saving money.

• Nominal Interest Rate – The interest rate actually paid or received without adjusting for inflation.

• Real Interest Rate – The interest rate adjusted for inflation (Real = Nominal – Inflation).

• Money – Anything that serves as a medium of exchange, unit of account, and store of value.

• M1 – A narrow definition of the money supply: currency, demand deposits, and other checkable deposits.

• M2 – A broader measure: includes M1 plus savings deposits, time deposits, and money market funds.

• Liquidity – How easily an asset can be converted into cash without losing value.

• Money Market – The market for short-term loanable funds and monetary instruments.

• Money Demand – The desire to hold money rather than other assets; downward-sloping with respect to the interest rate.

• Money Supply – The total amount of money in circulation, assumed to be vertical (fixed) when set by a central bank.

• Fractional Reserve Banking – A banking system where banks hold a fraction of deposits as reserves and loan out the rest.

• Required Reserve Ratio – The minimum percentage of deposits that banks must keep in reserve.

• Money Multiplier – The amount of money the banking system generates with each dollar of reserves (1 / reserve ratio).

• Federal Reserve System (The Fed) – The central bank of the United States, which conducts monetary policy.

• Monetary Policy – Central bank actions aimed at influencing the money supply and interest rates to achieve macroeconomic goals.

• Open Market Operations – The Fed’s buying and selling of government securities to influence the money supply.  A critical tool in the Fed’s pre-2008 Limited Reserves “toolbox”.  Its use in the Fed’s post 2008 Ample Reserves is limited to increasing or decreasing the amount of reserves, not directly  influencing interest rates.   

• Discount Rate – The interest rate the Fed charges banks for short-term loans. It is one of the Fed’s Administrative Rates in the Ample Reserves Regime.

• Federal Funds Rate – The interest rate banks charge each other for overnight loans of reserves.

• Administrative Rates – The three interest rates directly controlled by the Fed that are used to “channel” the FFR.  These are the Interest on Reserve Balances rate (IORB), the Overnight Reserve Repurchase rate,  (ONRRP), and the Discount Rate. 

Key Concepts and Skills

Understanding the Role of the Financial Sector

• Explain how the financial system links savers and borrowers.

• Differentiate between financial assets and liabilities.

• Analyze how interest rates affect saving and borrowing decisions.

Money, Banking, and the Money Market

• Define the functions and types of money (M1 and M2).

• Explain the concept of liquidity and how it applies to money.

• Graph the money market, showing how the nominal interest rate is determined.

• Understand money demand and factors that cause it to shift.

Monetary Policy and the Federal Reserve

• Describe the tools of monetary policy used in Limited Reserves Regime (used by the Fed prior to 2008): open market operations, discount rate, reserve requirements.

• Explain how the Fed currently changes the money supply and interest rates using Ample Reserves Regime, (“channeling” the FFR by using the Fed’s administrative rates – IORB, ONRRP, Discount Rate) to influence the economy.

• Differentiate between expansionary and contractionary monetary policy.

Money Creation and the Money Multiplier

• Understand how banks create money through fractional reserve banking.

• Calculate the simple money multiplier (1 / reserve ratio).

• Determine the total change in the money supply given an initial deposit and reserve ratio.

💵 FUNCTIONS OF MONEY

1. Medium of Exchange

• Used to buy and sell goods and services.

• Eliminates the inefficiencies of barter (no need for a “double coincidence of wants”).

2. Store of Value

• Keeps its value over time so people can save and use it later.

• Inflation reduces its effectiveness as a store of value.

3. Unit of Account

• Provides a standard measure of value, making it easy to compare prices and costs.

💰 CHARACTERISTICS OF MONEY

1. Durable – Long-lasting and doesn’t wear out easily.

2. Portable – Easy to carry and transfer.

3. Divisible – Can be split into smaller units.

4. Uniform – All forms are the same (e.g., all $20 bills are equal).

5. Limited in Supply – Can’t be too abundant or it loses value.

6. Acceptable – Must be accepted as payment.

💧 LIQUIDITY

• How quickly an asset can be converted into cash without losing value.

• Cash = most liquid asset.

• Real estate, bonds, stocks = less liquid.

💸 KINDS OF MONEY

1. Commodity Money

• Has intrinsic value (e.g., gold, silver, salt).

2. Representative Money

• Backed by a physical commodity (e.g., gold certificates).

3. Fiat Money

• Has value by government decree (not backed by gold); e.g., U.S. dollar.

💵 CURRENCY & DEMAND DEPOSITS

• Currency: Physical money (coins + paper bills).

• Demand Deposits: Checking account balances; can be withdrawn on demand.

💲 MONEY SUPPLY

M1 (Most Liquid)

• Currency in circulation

• Demand deposits (checking accounts)

• Traveler’s checks

M2 (Broader)

• M1 + savings deposits

• Small time deposits (CDs)

• Money market mutual funds

🏦 FINANCIAL INTERMEDIARIES

Institutions that connect savers and borrowers:

• Banks

• Credit unions

• Insurance companies

• Investment funds

They reduce risk and improve efficiency in the financial system.

🏛 THE FEDERAL RESERVE SYSTEM (“THE FED”)

Fed’s Place in Government

• Independent central bank (not part of the federal government but accountable to Congress).

• Created in 1913 by the Federal Reserve Act.

Fed’s Structure

1. Board of Governors: 7 members appointed by the President (14-year terms).

   • Chairman: The public face of the Fed (e.g., Jerome Powell).

2. 12 Regional Federal Reserve Banks: Operate across the U.S.

3. Federal Open Market Committee (FOMC):

   • 7 Governors + 5 regional bank presidents.

   • Makes decisions about open market operations and interest rates.

⚙ FUNCTIONS OF THE FED

1. Controls money supply and interest rates (Monetary Policy).

2. Regulates and supervises banks.

3. Serves as the government’s bank.

4. Serves as the banker’s bank (lender of last resort).

5. Maintains stability of the financial system.

📉📈 FED ACTIONS TO FIGHT RECESSION & INFLATION

💰 MONEY MARKET

Money Demand (MD)

• Downward sloping: As interest rates fall, people hold more money.

• Influenced by:

  • Changes in price level

  • GDP

  • Technology (digital banking reduces MD)

Changes in Money Demand

• ↑ Price level or income → ↑ MD (shift right)

• ↓ Price level or income → ↓ MD (shift left)

💵 MONEY SUPPLY (MS)

Two systems:

1. Limited Reserves Regime (Old System)

• Fed controls quantity of reserves.

• Money supply is vertical (fixed) on graph.

Tools (Limited Reserves Toolbox)

Problems in Controlling Money Supply

• Time lags

• Unpredictable bank lending

• People’s behavior (cash vs. deposits)

📊 INVESTMENT GRAPH CONNECTION

• As interest rates ↓ → investment ↑ → AD ↑

• As interest rates ↑ → investment ↓ → AD ↓

• Links Money Market → Investment → AD/AS Graph

💼 AMPLE RESERVES REGIME (New System, post-2008)

Catalyst for Switch

• 2008 Financial Crisis → Fed massively expanded reserves.

Event Indicating Full Commitment

• 2019–2020: Fed adopted the ample reserves system permanently.

Key Concepts

• Reserve Balance Accounts: Bank reserves held at the Fed.

• Federal Funds Transactions: Short-term loans between banks.

• Federal Funds Rate (FFR): The interest rate banks charge each other overnight.

Fed’s Policy Rate = FFR

Fed targets this rate to control overall interest rates.

🧰 AMPLE RESERVE TOOLBOX

🏦 MARKET FOR RESERVES

• Shows supply & demand for bank reserves.

• Fed adjusts IORB and ON RRP to guide the FFR.

📈 CONNECTION TO AD/AS GRAPH

• ↓ FFR → ↓ interest rates → ↑ investment → ↑ AD → ↑ GDP (fight recession)

• ↑ FFR → ↑ interest rates → ↓ investment → ↓ AD (fight inflation)

💹 MONEY MULTIPLIER & BANK BALANCE SHEETS

Reserve Requirement

• Fraction of deposits banks must hold as reserves.

T-Account (Bank Balance Sheet)

Assets: Reserves + Loans
Liabilities: Deposits

Formula for Money Multiplier

Money Multiplier=1Reserve Ratio\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}Money Multiplier=Reserve Ratio1​

Example:
Reserve ratio = 10% → multiplier = 10 → $1,000 in reserves = $10,000 in deposits.

Definitions

• Demand Deposits: Money in checking accounts.

• Required Reserves: Portion banks must hold (cannot loan).

• Excess Reserves: Can be loaned out to create new money.

💵 BONDS

Key Terms

• Annual Interest Income:

  Interest Payment=Face Value×Interest Rate\text{Interest Payment} = \text{Face Value} \times \text{Interest Rate}Interest Payment=Face Value×Interest Rate

• Bond Yield:

  Yield=Interest PaymentPrice of Bond\text{Yield} = \frac{\text{Interest Payment}}{\text{Price of Bond}}Yield=Price of BondInterest Payment​

• Sell at Discount: Market price < face value (interest rates ↑).

• Sell at Premium: Market price > face value (interest rates ↓).

Relationship Between Interest Rates & Bond Prices

• Inverse relationship:

  • When interest rates rise → bond prices fall.

  • When interest rates fall → bond prices rise.