AP Macro Unit 4

→ network of institutions that link borrowers and lenders → includes banks, mutual funds, pension funds, and other financial intermediaries

anything tangible or intangible that has value

the amount a lender charges borrowers for borrowing money--the "price" of a loan

assets that earn interest over time

when you lose money from fluctuations in market prices

when companies/individuals are unable to fulfill their payment/debt obligations

when the value shrinks from inflation

the ease with which an asset can be converted to a medium of exchange (in general, the higher the liquidity = the lower the rate of return) → cash and demand deposits are the two most liquid forms of money

deposits by customers that can be withdrawn at anytime (EX. checking accounts)

( 1 ) Market Risk ( 2 ) Default Risk ( 3 ) Inflation Risk

(securities) loans or IOUs that represent debt that the government, businesses, or individuals must repay to the lender

(equities) represent ownership of a corporation and the stockholder is often entitled to a portion of the profit paid out as dividends

→ a bond is issued at a specific interest rate that doesn't change throughout the life of the bond → bond price and interest rates are inversely related

the percentage increase in purchasing power that a borrower pays (adjusted for inflation)

Real = nominal interest rate -- expected inflation

the percentage increase in money that the borrower pays (not adjusted for inflation)

Nominal = real interest rate + expected inflation

you can determine the future value of any amount of money ($X) if you know the interest rate (ir) and the number of years (N)

Equation to calculate future value: $X in N Years = $X(1 + ir)^N (ir is expressed as a decimal)

the current worth of some future amount of money

Equation to calculate present value: ($X) / (1 + ir)^N

goods and services are traded directly; there is no money exchanged

Problems with the Barter System ( 1 ) before trade could occur, each trader had to have something the other wanted--this is called the "Double Coincidence of Wants" ( 2 ) some goods cannot be split

anything that is generally accepted as payment for goods and services → NOT the same as wealth or income (wealth is the total collection of assets, income is a flow of earnings per unit of time)

something that performs the function of money and has intrinsic value EX.) gold, silver, cigarettes, etc.

something that serves as money but has no other value or uses EX.) paper money, coins, digital currency

( 1 ) A Medium of Exchange ( 2 ) A Unit of Account (Measure of Value) ( 3 ) A Store of Value

money can easily be used to buy goods and services with no complications of barter system

money measures the value of all goods and services: money acts as a measurement of value

money allows you to store purchasing power for the future

there is no gold standard, money's value comes from our collective belief that it is valuable

( 1 ) Generally Accepted → buyers and sellers have confidence it is legal tender ( 2 ) Scarce → money must not be easily transported and divided ( 3 ) Portable and Dividable → money must be easily transported and divided

the purchasing power of money is the amount of goods and services a unit of money can buy → inflation decreases purchasing power, hyperinflation decreases acceptability

( 1 ) Currency in circulation ( 2 ) Checkable bank deposit (checking accounts) ( 3 ) Savings Accounts

( 1 ) Everything in M1 ( 2 ) Time deposits (CDS = certificate of deposits) ( 3 ) Money market funds

when banks hold a portion of deposits to cover potential withdrawals and then loans the rest of the money out

1 / Reserve Requirement

a record of a bank's assets, liabilities, and net worth (demand deposits in a bank are liability for the bank, asset to the depositor)

the percent that banks must hold by law

the amount that the bank can loan out

( 1 ) Transaction Demand for Money → people hold money for everyday transactions ( 2 ) Asset Demand for Money → people hold money since it is less risky than other assets

the interest rate you could be earning from other financial assets like stocks, bonds, and real estate

there is an inverse relationship → when interest rates increase, quantity demanded falls because individuals would prefer to have interest-earning assets instead → when interest rates decrease, quantity demanded increases, there is no incentive to convert cash into interest earning assets

( 1 ) Change in price level ( 2 ) Change in income ( 3 ) Change in technology

the U.S. Money Supply is set by the central bank and is independent from the interest rate

the Fed is a nonpartisan government office that adjusts the money supply to influence the economy → this is called Monetary Policy

if the money supply increases, a temporary surplus of money will occur; the surplus will cause the interest rate to fall

increase money supply → decrease interest rate → increase investment → increase AD

if the money supply decreases, a temporary shortage of money will occur; the shortage will cause the interest rate to rise

decrease money supply → increase interest rate → decrease investment → decrease AD

the Fed adjusts MS by changing: ( 1 ) The Reserve Requirement (ratios) ( 2 ) The Discount Rate ( 3 ) Open Market Operations

the interest rate that the Fed charges commercial banks

when the Fed buys or sells government bonds (securities) → this is the most important + widely used monetary policy

the interest rate that banks charge on another for one-day loans of reserves

increase discount rate, increase reserve ratios, sell bonds

decrease discount rate, decrease reserve ratios, buy bonds

( 1 ) Interest on Reserves (IOR) → the interest rate that the Federal Reserve pays commercial banks to hold reserves → IOR and the discount rate are examples of administered rates ( 2 ) Administered Rates → interest rates set by the Fed rather than determined in a market → reserves at the Fed have no risk, therefore, banks have no incentive to lend money at an interest rate that is lower than what they can get from the Fed

when there are limited reserves: → banks deposit fewer reserves with the central bank → small changes in the money supply can affect interest rates → the central bank conducts monetary policy by changing the reserve requirement or the discount rate or by using open market operations

when there are ample reserves: → banks deposit a lot of reserves with the central bank → changing the money supply has little to no effect on interest rates → the central bank conducts monetary policy by changing its administered rates (IOR or discount rate)

→ inverse relationship between the Federal Funds Rate and the quantity of reserves demanded → when the Policy Rate is high, banks want to hold less reserves → when the Policy Rate is low, banks want to hold more reserves

( 1 ) Reserve Ratios ( 2 ) Discount Rate ( 3 ) Open Market Operations

(Administered Rates) ( 1 ) Interest On Reserves ( 2 ) Discount Rate

shows the supply and demand of loans and shows the equilibrium interest rates → demand has an inverse relationship between real interest rate and quantity loans demanded → supply has a direct relationship between real interest rate and quantity loans supplied → at the equilibrium real interest rate, the amount that borrowers want to borrow equals the amount lenders want to lend

the amount that households save instead of consume

the amount that the government saves instead of spends

public saving + private saving

the amount of money entering the country

the amount of money leaving the country

capital inflow -- capital outflow

borrowing by businesses and consumers

deficit spending when government spending is greater than tax revenue

( 1 ) Changes in borrowing by consumers ( 2 ) Changes in borrowing by businesses ( 3 ) Changes in borrowing by the government (ex. deficit spending)

( 1 ) Changes in private savings behavior ( 2 ) Changes in public savings behavior ( 3 ) Changes in foreign investment (ex. more inflow of foreign financial capital)

→ demand for loans comes from borrowers/investors → supply for loans comes from lenders/savers

includes money in circulation and bank reserves