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Flashcards · AP® Macroeconomics · Unit 4

Unit 4: Financial Sector flashcards

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4.1 Financial Assets

What are money, bonds and stocks?
Financial assets: claims to future payments. Money (cash and demand deposits) is the most liquid. A bond is an interest-bearing loan to a government or firm. A stock is a share of ownership (equity), not a loan.
What are liquidity, rate of return and risk?
Liquidity: how easily an asset can be spent or turned into money without losing value. Rate of return: the gain as a % of the cost. Risk: the chance the return differs from what you expected. More liquid assets pay less; higher expected returns come with more risk.
How are bond prices and interest rates related?
Inversely. The interest payment on an existing bond is fixed, so when market rates rise its price falls (a capital loss if sold), and when rates fall its price rises.
A bond will pay VD 840 in one year and the market interest rate is 5%. What is its price today?
840 ÷ 1.05 = VD 800.
What is the opportunity cost of holding money?
The interest forgone on other assets such as bonds, not inflation. Holding VD 12,000 as cash when bonds pay 3% costs VD 360 a year.
Why do people hold less money when interest rates rise?
Holding money costs more in interest forgone, so people move funds into interest-bearing assets.

4.2 Nominal v. Real Interest Rates

What is the difference between nominal and real interest rates?
The nominal rate is the rate paid on a loan, not adjusted for inflation: a return in money. The real rate is adjusted for inflation: a return in purchasing power. Real = nominal − inflation.
How is the nominal rate on a new loan set?
Nominal rate = expected real rate + expected inflation. Lenders who want a 2% real rate and expect 5% inflation charge 7%.
How do you find the real interest rate in hindsight?
Real = nominal − actual inflation. A 6% loan with 9% inflation earned −3%: the real rate is negative whenever inflation is above the nominal rate.
A deposit pays 4% nominal and prices fall by 1%. What is the real rate?
4 − (−1) = 5%. Deflation raises the real rate.
Who gains when inflation is higher than expected?
Borrowers, because the real rate is lower than planned. Unexpectedly low inflation, or deflation, makes the real rate higher, and lenders gain.
Expected inflation rises from 3% to 5% and the expected real rate stays at 2%. What happens to the nominal rate?
It rises by the same 2 points, from 5% to 7%.

4.3 Definition, Measurement, and Functions of Money

What are the three functions of money?
Medium of exchange (used to pay), unit of account (used to state and compare values, as on a price tag) and store of value (holds purchasing power for later). Inflation weakens money as a store of value.
What problem of barter does money solve?
The double coincidence of wants: in barter, each side must want exactly what the other offers.
What are M1 and M2?
M1 = currency in circulation + demand (checkable) deposits. M2 = M1 + savings deposits + small time deposits + retail money market funds. M2 already includes M1, so never add them together.
What is the monetary base?
Currency in circulation plus bank reserves (vault cash and deposits at the central bank). Reserves are not part of M1.
Currency 50, demand deposits 130, savings 200, small time deposits 40, retail money funds 30, bank reserves 20. Find M1, M2 and the base.
M1 = 50 + 130 = 180. M2 = 180 + 200 + 40 + 30 = 450. Monetary base = 50 + 20 = 70.
How do a cash deposit and a move from checking to savings affect M1 and M2?
A cash deposit: currency falls and deposits rise by the same amount, so M1 is unchanged. Checking to a savings account or certificate of deposit: M1 falls and M2 is unchanged.
Are credit cards money?
No. They are a way to borrow.

4.4 Banking and the Expansion of the Money Supply

What is fractional reserve banking?
Banks keep only a fraction of deposits as reserves and lend the rest. Required reserves = required reserve ratio × demand deposits; excess reserves = total reserves − required reserves.
How do banks create money?
By lending their excess reserves. A loan creates a new demand deposit, which is spent and redeposited, so the process repeats in ever-smaller rounds.
Diagram: what goes on each side of a bank's balance sheet (T-account)?
Assets = liabilities + owners' equity. Reserves and loans are assets. Demand deposits are liabilities, never assets.
What is the money multiplier?
Money supply ÷ monetary base, with a maximum of 1 ÷ rr; rr = 5% gives 20. Maximum change in the money supply = initial excess reserves × multiplier. A higher rr lowers the multiplier.
A bank has demand deposits of 2,500 and reserves of 300, with rr = 10%. How much can it lend?
Required reserves = 0.1 × 2,500 = 250, so excess reserves = 300 − 250 = 50 (VD million). One bank can lend only its excess reserves.
Why does the simple money multiplier overstate money creation?
It assumes banks lend all excess reserves and every loan is fully redeposited. If banks hold excess reserves or the public holds more currency, expansion is smaller.
A customer deposits VD 1,000 of cash; rr = 10%. What is the maximum change in the money supply?
The deposit itself only changes the form of money. Excess reserves = (1 − 0.1) × 1,000 = VD 900, so the maximum change = 900 × 10 = VD 9,000.

4.5 The Money Market

What is the money market?
It compares the money people want to hold with the money that exists. Its price is the nominal interest rate, the opportunity cost of holding money instead of bonds.
Graph: describe the money market graph.
Nominal interest rate on the vertical axis, quantity of money on the horizontal. Money demand (MD) slopes down; money supply (MS) is vertical, set by the central bank. Equilibrium is where they cross. Label both axes and both curves.
What shifts money demand?
A higher price level or higher real GDP shifts MD right and raises the nominal rate; falls shift it left. A change in the interest rate is a movement along MD.
What happens when the interest rate is above equilibrium?
There is a surplus of money: people buy bonds, bond prices rise and the interest rate falls. Below equilibrium, people sell bonds and the rate rises.
Graph: the central bank buys bonds. Describe the money market graph.
Nominal interest rate on the vertical axis, quantity of money on the horizontal. MS shifts right; MD does not move. The new equilibrium nominal interest rate is lower. Selling bonds shifts MS left and raises the rate.
Money demand is Qd = 500 − 25i (VD bn, i in %) and the money supply is VD 400 bn. Find the equilibrium rate.
500 − 25i = 400 gives i = 4%. At 6%, Qd = 350, a surplus of money of VD 50 bn, so the rate falls.

4.6 Monetary Policy

What is monetary policy?
Central bank action on interest rates and the money supply to reach goals such as price stability and full employment. The policy rate is the target for the overnight interbank lending rate (the federal funds rate in the United States).
What are the expansionary and contractionary settings of each tool?
Expansionary: buy bonds (open market operations), lower the required reserve ratio, lower the discount rate, lower the interest on reserves. Contractionary: the opposite of each.
How does monetary policy work with limited and with ample reserves?
Limited reserves: the central bank moves rates by changing the quantity of reserves and so the money supply. Ample reserves: extra reserves do not move the rate, so it changes administered rates, mainly interest on reserves. The United States has ample reserves.
What is the chain of effects of expansionary monetary policy?
Policy action → interest rates fall → investment and interest-sensitive consumption rise → AD shifts right → real output rises, unemployment falls, price level rises.
The central bank buys VD 12 bn of bonds from banks; rr = 25% and reserves are limited. Find the changes in the base and the money supply.
The monetary base rises by VD 12 bn. Maximum change in the money supply = 12 × (1 ÷ 0.25) = VD 48 bn.
What is the difference between the discount rate and the policy rate?
The discount rate is what the central bank charges when it lends to banks. The policy rate is the rate banks charge each other for overnight loans.
An economy with ample reserves has high inflation. What should the central bank do?
Raise the interest on reserves: a contractionary move that raises interest rates, lowers spending and shifts AD left.

4.7 The Loanable Funds Market

What is the loanable funds market?
A model of savers lending to borrowers, with the real interest rate as its price. Demand: borrowers (investing firms, households, a government in deficit). Supply: savers (households, firms, foreign lenders, a government in surplus).
Graph: describe the loanable funds graph.
Real interest rate on the vertical axis, quantity of loanable funds on the horizontal. Demand slopes down; supply slopes up; equilibrium is where they cross. Unlike the money market, supply is not vertical and the axis shows the real rate.
How do you calculate private, public and national saving?
Private = Y − T − C. Public = T − G (negative in a deficit). National = Y − C − G. With Y = 400, C = 290, T = 60 and G = 75: 50, −15 and 35.
Graph: an investment tax credit is introduced. Describe the loanable funds graph.
Real interest rate on the vertical axis, quantity of loanable funds on the horizontal. Demand shifts right; supply does not move. The real interest rate and the quantity of loanable funds both rise.
What happens when households save more?
The supply of loanable funds shifts right: the real interest rate falls and the quantity of loanable funds rises.
How is investment linked to saving?
Closed economy: investment = national saving. Open economy: investment = national saving + net capital inflow. National saving of 120 and an inflow of 15 give investment of 135.

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