AP Macro Unit 4 The Financial Sector

Unit 4: The Financial Sector

Page 1: Introduction

Overview

Unit 4 delves into the financial sector, which is vital for understanding economic principles in AP Macroeconomics. This section explores the nature of money, financial institutions, interest rates, and personal finance.

Course Details

• Course: AP Macroeconomics

• Instructor: Mrs. Miller

Page 2: Key Definitions

• Money: Refers to anything that can be used to purchase goods and services, acting as a medium for trade and facilitating economic transactions.

• Wealth: The accumulation of savings through the purchase of valuable assets over time, which can contribute to an individual's overall financial security and purchasing power.

• Fiat Money: Refers to paper currency that has no intrinsic value but is declared legal tender by the government, enabling it to serve as a medium of exchange (e.g., U.S. Dollar).

• Financial Asset: Any possession that holds value and comes with a claim to ownership, including various instruments like demand deposits, bonds, and stocks.

• Demand Deposits: Commonly known as checking accounts; these are deposits held at a bank that can be withdrawn at any time without advance notice.

• Bonds: Interest-bearing assets representing a loan to be repaid at a specified future date, often issued by governments or corporations.

• Stocks: Shares that represent ownership in a company, granting shareholders rights to a portion of the company's profits (dividends) and voting rights in company matters.

• Liquidity: The ease with which an asset can be converted to cash without significantly affecting its value, crucial for managing immediate financial needs.

• Financial Institution: Entities such as banks and credit unions that provide various financial services, facilitate transactions, and contribute to the overall stability of the financial system.

• Opportunity Cost of Holding Money: Represents the lost potential interest or returns from holding money, rather than investing it in assets like bonds or stocks that yield returns over time.

Page 3: Functions of Fiat Money

Key Functions

o Unit of Account: Acts as a universally accepted measure to set prices and provide a consistent framework for economic transactions (e.g., dollars, yen).

• Store of Value: Allows individuals to preserve their purchasing power over time, although its effectiveness can be impacted by factors such as inflation.

• Medium of Exchange: Facilitates the efficient exchange of goods and services, reducing transaction costs associated with barter systems.

Money Supply Categories

• M0: Representing the monetary base, includes all physical currency in circulation and reserves held by banks.

• M1: Comprises currency in circulation, checking accounts (demand deposits), and other liquid assets that can be quickly converted into cash.

• M2: Includes M1 in addition to savings accounts and money market funds, which are slightly less liquid but still accessible.

Page 4: Credit vs Debit & Money Supply

Credit Cards

• Nature of Credit: Credit cards do not qualify as money; they instead provide short-term loans that consumers must pay back, often with high interest rates.

• Example of Usage: Purchasing Nike sneakers using a credit card, where payment is typically due within a month, highlights common credit card transactions.

Characteristics of Money Supply

• Backing: Money is essentially an IOU from the government; its purchasing power is intrinsically linked to real economic factors such as inflation rates.

• Effective Money Characteristics: Effective forms of money are generally accepted, scarce, portable, and divisible, enabling them to serve their purposes in an economy efficiently.

• Federal Reserve (FED): The Fed plays a crucial role in supervising banks, providing essential financial services, regulating banking practices, and implementing monetary policy to manage economic stability.

Page 5: Interest Rates

• Nominal Interest Rate (NIR): Defined as the sum of the real interest rate and the inflation rate, providing an overview of the cost of borrowing without considering inflation.

• Real Interest Rate (RIR): Calculated by adjusting the nominal interest rate to account for inflation, reflecting the actual purchasing power interest returns on investments.

• Example: A bank may require a real interest rate of 4%, with inflation factored in, to determine the overall nominal rate from borrowers.

• Borrowing Scenarios: Different inflation rates can significantly impact the real interest earnings, affecting borrowers and investors accordingly.

Page 6: Personal Finance

Key Concepts

• Household Financial Management: How families budget, save, and spend their income, emphasizing the necessity of managing resources effectively for growth and security.

• Assets: Items of monetary value owned by individuals, important for assessing financial health.

• Investment Decisions: Both business spending and individual investments require careful management and strategic planning to enhance asset value and increase wealth.

Bonds vs Stocks

• Bonds: Represent loans or IOUs from governments or companies; they do not confer ownership rights but may offer fixed interest returns.

• Stocks: Represent ownership interests in a company, allowing investors to benefit from profits via dividends and potential capital gains.

Page 7: Money Market Overview

Composition of Money Market

• Supply and Demand Dynamics: The interplay between demand for M1 forms of money (currency, demand deposits, savings) is crucial for understanding the money market's function.

• Demand for Money Determinants: Motivation for everyday purchases alongside precautionary demands for unexpected expenses.

• Speculative Demand: Driven by the desire to preserve wealth, often influenced by prevailing interest rates.

• Inverse Relationship: The quantity of money demanded typically decreases as nominal interest rates rise, indicating diminishing incentives for holding liquid cash.

Page 8: Influences on Money Demand

Interest Rate Effects

• Sensitivity of Demand: Changes in interest rates influence the demand for money, with higher rates generally decreasing the demand and lower rates increasing it.

• Shifting Demand Curve: Factors that can shift the demand curve include changes in aggregate price levels, GDP, income levels, taxation policies, and technological advancements.