Unit 4
Financial Sector
Understand money, banking, and monetary policy
4.1: Financial Assets
Financial Asset
Something that holds financial value, such as stocks, bonds, gold, or real estate.
Bond
An investment that pays interest over time. Buying a government or corporate bond is essentially lending money to that entity.
Stock
A financial asset that represents a share of ownership in a company.
Certificate of Deposit (CD)
An interest-bearing savings account that holds a fixed amount of money for a fixed period, such as six months or a year. Part of the M2 money supply.
Liquidity
How easily an asset can be converted into cash without much loss of value.
Key Points
- Cash is the most liquid asset; a house is the least liquid.
Inverse Relationship between Interest Rates and Bond Prices
When current interest rates go up, the price of previously issued bonds with lower interest rates goes down.
Key Points
- Example: If new $100 bonds pay 5% interest, an old $100 bond paying 3% must be sold for less than $100 to compete.
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4.2: Interest Rates
Interest
The cost of borrowing money.
Nominal Interest Rate
The interest rate stated on a loan, as a percentage of the amount borrowed.
Real Interest Rate
The nominal interest rate adjusted for inflation, showing the true gain in purchasing power for a lender.
Key Points
- Formula: Real Interest Rate = Nominal Interest Rate - Inflation Rate
Expected vs. Actual Inflation
Differences between expected and actual inflation create winners and losers.
Key Points
- If actual inflation is lower than expected, lenders win and borrowers lose.
- If actual inflation is higher than expected, borrowers win and lenders lose.
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4.3: Functions of Money
The Three Functions of Money
To be considered money, something must serve as a medium of exchange, store of value, and unit of account.
Key Points
- Medium of Exchange: Used to buy goods/services, avoiding barter.
- Store of Value: Holds wealth over time without expiring.
- Unit of Account: Standard measure for pricing goods and services.
Money Supply
The total amount of money circulating in an economy, measured in categories based on liquidity.
Key Points
- M1: Most liquid assets (cash and checking deposits).
- M2: M1 plus savings accounts, money market accounts, and CDs.
- Bonds are not part of the money supply.
Monetary Base
All physical currency in circulation plus the reserves banks hold.
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4.4: Banking System
Demand Deposit
Money deposited in a bank account that can be withdrawn on demand.
Required Reserve Ratio (RRR)
The fraction of deposits banks are required to keep in reserve.
Required Reserves
The dollar amount of deposits a bank must hold and cannot lend out.
Excess Reserves
Reserves held by a bank beyond the required amount; can be lent out.
Fractional Reserve Banking System
A banking system where banks keep only a fraction of deposits in reserve and lend out the rest.
Money Multiplier
Shows the maximum potential expansion of the money supply from an initial deposit.
Key Points
- Formula: Money Multiplier = 1 / Required Reserve Ratio
Maximum Potential Expansion of the Money Supply
The total possible increase in the money supply from an initial deposit.
Key Points
- Formula: Maximum Expansion = Initial Excess Reserves x Money Multiplier
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4.5: Money Market
Money Market
Graph showing the relationship between the supply of money and the demand for money, determining the equilibrium nominal interest rate.
Money Demand
Shows the inverse relationship between the nominal interest rate and the quantity of money people want to hold in M1 forms.
Key Points
- Shifters: Changes in price level and changes in real GDP/income.
Money Supply (in the Money Market)
A fixed quantity of money at a given time; shown as a vertical line in the money market.
Equilibrium Nominal Interest Rate
The nominal interest rate where money supply and money demand intersect.
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4.6: Monetary Policy
Central Bank
A country’s “bank for banks.” In the U.S., this is the Federal Reserve, which conducts monetary policy.
Commercial Bank
A bank where individuals and businesses can deposit money, such as Citibank. Can borrow from the central bank.
Monetary Policy
Actions taken by the central bank to manage the money supply and influence economic outcomes.
Expansionary Monetary Policy
Increases the money supply to lower interest rates, encouraging consumption and investment during a recessionary gap.
Contractionary Monetary Policy
Decreases the money supply to raise interest rates, reducing consumption and investment during an inflationary gap.
Tools of Monetary Policy
The main ways a central bank changes the money supply: Required Reserve Ratio, Discount Rate, and Open Market Operations.
Key Points
- Lower RRR → expands money supply; raise RRR → contracts it.
- Lower discount rate → expands; raise discount rate → contracts.
- OMO: Buy bonds → expands; Sell bonds → contracts.
Monetary Policy and the AD-AS Model
Monetary policy affects AD through changes in the money supply, interest rates, and investment/consumption.
Key Points
- Change in money supply → change in nominal interest rate → change in investment & consumption → shift in AD curve → change in Real GDP and Price Level.
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4.7: Loanable Funds Market
Loanable Funds Market
Market showing the interaction of borrowers (demand) and savers (supply), determining the equilibrium real interest rate.
Demand for Loanable Funds
Comes from borrowers; downward-sloping because lower real interest rates make borrowing cheaper.
Key Points
- Shifters: Government deficit spending, borrower expectations.
Supply of Loanable Funds
Comes from savers; upward-sloping because higher real interest rates make saving more rewarding.
Key Points
- Shifters: Savings rate, capital inflow.
Equilibrium Real Interest Rate
The real interest rate where the supply and demand for loanable funds are equal.
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Comprehension Check
Test your understanding with practice questions