Macro AP Unit 4 Flashcards
Explain why bond prices and interest rates are inversely related.
Bonds are issued with a fixed interest rate. If interest rates increase, people prefer new bonds with higher rates rather than previously issued bonds with lower rates. To sell these previously issued bonds, bond owners must lower the price.
Explain why an increase in unexpected inflation causes a decrease in the real interest rate.
The nominal interest rate a lender earns can be eroded if there is unexpected inflation. Example, if inflation is 5%, a nominal interest rate of 6% earns only 1% in purchasing power due to inflation.
Explain the difference between the money supply and the monetary base.
The money supply includes money in circulation and checkable deposits. The monetary base is smaller and includes money in circulation and bank reserves.
Explain how money serves as a medium of exchange, a store of value, and a unit of account
Money is used to buy and sell goods and services (medium of exchange), save purchasing power for a later date (store of value), and measure the value of different goods and services (unit of account).
Explain why a decrease in the reserve requirement causes the money multiplier to increase.
When the reserve requirement decreases, banks are no longer required to hold as much money in reserve. This allows them to offer more loans and increase the money supply at a faster rate.
Explain why the demand for money is downward sloping.
When the interest rate is high, people prefer to hold less money in cash or in checking accounts and, instead, purchase assets that can earn them these higher interest rates such as bonds.
Explain why interest rates and investment are inversely related.
Investment is when businesses borrow to expand their business. When interest rates are high, borrowers will borrow less since the cost of the loan is higher. A low interest rate encourages more borrowing since the cost of the loan is lower.
Explain how open market operations can increase or decrease the money supply.
When the central bank buys previously issued government bonds it allows banks to lend out more money which increases the money supply. The opposite happens when the central bank sells government bonds.
Explain why a cash deposit of a certain amount creates less money than a purchase of bonds by the central bank of the same amount.
Banks can only lend out a portion of cash deposits so the increase in excess reserves is less than the amount deposited. A bank can lend out all of the money it gets when the central bank buys its bonds since all the funds are added to excess reserves.
Explain how an increase in the money supply affects the overall economy.
When the money supply increases, the nominal interest rate falls. This increases investment and interest-sensitive consumer spending. This increases real GDP and decreases unemployment.
Explain how an increase in deficit spending will cause the real interest rate to increase.
When the government borrows, it decreases the supply of loanable funds available to the private sector. This increases the real interest rate and makes it harder for businesses to borrow.
Explain why an increase in the savings rate will cause the real interest rate to decrease.
More saving increases the supply of loans available. This decreases the real interest rate.
