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AP Macroeconomics > Unit 4 Financial sector > Flashcards

Unit 4 Financial sector Flashcards

1
Q

4.1 v1: what is the difference between money and wealth?

A

Money is anything that can be used to purchase goods and services.

Wealth is the accumulation of savings through purchases of assets with money that occurs over time.

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2
Q

4.1 v1: what are financial assets and some examples?

A

Written claims where a buyer has the right to future income from sellers. Some examples are:
- Loans
- Bonds
- Demand deposits (checking accounts)
- Savings account

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3
Q

4.1 v1: What does it mean if a asset is liquid and what is liquidity?

A

Liquidity is how close an asset is to cash and how easily it can be turned into cash. Cash itself is the most liquid asset.

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4
Q

4.1 v1: How do assets hold value?

A

Assets hold value because they accumulate wealth over time. Storing money in assets allows for the asset to grow over time due to interest over time in the growth of the aggregate economy.

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5
Q

4.1 v1: If someone goes to the bank to get a loan with an interest over time, what is the loan to both of the parties?

A

For the bank, the loan is an financial asset.
For the person borrowing money, the loan is a liability.

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6
Q

4.1 v2: What is the opportunity cost of holding money instead of holding a financial asset?

A

The opportunity cost is the opportunity to earn interest on the financial asset you could have purchased with your cash. The financial assets that have a higher interest rate then cash include bonds.

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7
Q

4.1 v2: what are bonds?

A

bonds are pieces of papers bought from the government with face value and number of years the holder can earn interest on the bond. After the time has expired ther holder will get the face value of the bond as well as the interest earned over time.

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8
Q

4.1 v2: What relationship do bonds and interest rates have and why?

A

bonds and interest rates have an inverse relationship. For example, previous bonds with 5% return a year are less attractive to current bonds with a 6% return. So, the price of the previous bonds go down as buyer are more attracted to financial assets with higher interest rates.

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9
Q

4.2 v1: What are nominal interest rates?

A

Nominal interest rates are rates you see when doing business when financial institutions which are most commonly banks. Most commonly applied to rates paid on loans, and the rates are not adjusted for inflation.

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10
Q

4.2 v1: What is the real interest rate?

A

Real interest rates are the real rate of return earned on investments and loans (financial assets). There rates are adjusted for inflation.

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11
Q

4.2 v1: What is the fisher equation?

A

An equation that helps calculate the real rate of return on investments and how inflation affects the interest rates. The equation is

NIR = RIR + Inflation

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12
Q

4.2 v2: When people choose to purchase a financial asset, what do they take into account?

A

They take into account how much more money they will acquire over the term (Real rate of return), based on the expected / anticipated rate of return.

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13
Q

4.2 v2: What happens to financial assets when expected inflation is not realized and there is unexpected inflation?

A

If inflation is higher than anticipated than the real rate of return on financial assets falls relative to if you had calculated inflation correctly.

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14
Q

4.2 v2: What are fixed and flexible interest rates?

A

Fixed interest rates do not change in response to inflation.
Flexible interest rates change to match their previous real rate of return.

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15
Q

4.2 v2: What do banks and people in general want to do in response to inflation?

A

During inflation, banks and people will want to maintain their real rate of return. If they have a flexible interest rate they will adjust their nominal interest rate to maintain their real rate of return.

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16
Q

4.2 v2: What do banks set using expected inflation?

A

Banks use expected inflation to set nominal interest rates for:
- Terms of a customer loan
- Savings vehicles

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17
Q

4.2 v2: When is Actual inflation calculated?

A

Only after the term of the loan is over.

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18
Q

4.2 v3: What do borrowers, loaners, and savers make decisions on based off what.

A

What they anticipate inflation to be over the term of their loan or savings.

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19
Q

4.2 v3: What is expected / anticipated inflation?

A

Inflation that is predicted actually happening.

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20
Q

4.2 v3: Who benefits for unanticipated inflation and who loses? Why?

A

when inflation is higher then anticipated borrowers are better of and loaners are worse off.
The nominal interest rate stays the same but due to inflation the real interst rate decreases, so the real value of the dollars the borrower has is lower, meaning the bank is receiving dollars of less value then expected.

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21
Q

4.2 v3: If inflation is higher or lower than expected, what happen to the interest rates?

A

When there is unanticipated inflation the real interest rate will rise or fall to make the equation match the nominal interest rate. The loaner is better off if the real interest rate rises and worse off if the real interest rate falls.

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22
Q

4.3 v1: What is fiat money?

A

Currency that hold symbolic value because a government has established that it is money

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23
Q

4.3 v1: What is the real value of money

A

The real value of money is the number of goods and services that money can purchase. This value is not set by the government.

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24
Q

4.3 v1: What are the three functions of money?

A
  • Unit of account
  • Store of value
  • Medium of exchange
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25
Q

4.3 v1: What is a unit of account.

A

A function of money. A unit of account means that people commonly accept money as a way to set prices.
For example, in Europe peoples use euros to set prices. The unit of account is euros

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26
Q

4.3 v1: what is a store of value?

A

A function of money. A store of value means money hold purchasing value over time.

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27
Q

4.3 v1: what is a medium of exchange?

A

A function of money. A medium of exchange means money is used to exchange goods and services. Money as a medium of exchange helps world economies grow faster.

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28
Q

4.3 v2: What is a nations money supply?

A

A nations money supply has something called a monetary base commonly referred to as M0 or MB. The monetary base is made up of two components which is the Currency in circulation and bank reserves.

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29
Q

4.3 v2: How does M1 measure the money supply?

A

measures money through currency in circulation, demand deposits, and saving account in financial institutions. Much larger measure of money then M0

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30
Q

4.3 v2: What is M2 measure of money supply?

A

Measures money through all factors of M1 but also small denominations time deposits and retail money market funds.

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31
Q

4.4 v1: How do commercial banks operate?

A

People store money in banks and earn interest. These demand deposits are liabilities to the bank as they have to pay the money stored back. To earn money, banks loan out a portion of the customer demand deposits to people and businesses to earn interest. These loans are the banks assets.

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32
Q

4.4 v1: What is fractional reserve banking?

A

A policy where banks set a percent of a customer demand deposits the bank must hold in reserves which is known as the reserve requirement. The percent not reserved is loaned out to make interest and generate money to flow throughout the economy. In other words, increasing the money supply.

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33
Q

4.4 v1: What are required reserves?

A

The Percent of demand deposits the bank must hold in reserves.

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34
Q

4.4 v1: What are excess reserves?

A

The percent of demand deposits the bank choose to hold on to. These reserves can be loaned out to individual and businesses.

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35
Q

4.4 v1: What are bank balance sheets?

A

Sheets that shows assets and liabilities of individual banks with both sides being equal to one another. Changes in customer demand deposits affect the size of the bank’s required and excess reserves.

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36
Q

4.4 v1: How is the banking system structured?

A

The banking system is made up of commercial and investments banks among others. The banking system in most countries are regulated by a central bank.

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37
Q

4.4 v2: What is the money multiplier used for in the banking system.

A

The money multiplier is used to determine the maximum changes to the banking system when deposits or withdrawals from demand deposits occur.

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38
Q

4.4 v2: What is the equation for the money multiplier

A

The money multiplier (MM) is:
1 / reserve requirement (rr)

39
Q

4.4 v2: How does money flow between banks

A

When banks loan out their excess reserves, those loans get redeposited into other banks.
Deposits to banks will have excess reserve be loaned out to individuals or businesses. the loan will eventually be deposited into another bank repeating the process.

40
Q

4.4 v2: How is the money multiplier used to find the maximum change over time from deposits?

A

The equation to find the maximum change over time from a deposit using the money multiplier is:
Amount of new loans (excess reserves) * the money multiplier (MM)

41
Q

4.4 v2: How is the money multiplier used to find the maximum change over time from withdrawals?

A

To equation to find the maximum change over time using the money mutlplier would be:
Withdrawal * tax multiplier - Withdrawal

42
Q

4.5 v1: What is the money market

A

A competitive market where the good being supplied and demanded is money in the form of M1.
also known as the liquid preference model of the interest rate.

43
Q

4.5 v1: what is demand in the money market?

A

Demand in the money market is represents the relationship between the NIR and quantity of money (m1) people want to hold.

44
Q

4.5 v1: Where does demand in the money market come from?

A

Demand in the money market comes from three sources:
Transactions demand. (People need money to buy things)
precautionary demand. (Money needed for unexpected events)
Asset or speculative demand. (Using money as a way to hold wealth)

45
Q

4.5 v1: What is the relationship between the nominal interest rate (NIR) and the quantity of money demanded (QMD). What does this mean for the curve?

A

The relationship is inverse.
When NIR is high, QMD is low. When NIR is low, QMD is high.
This means the demand curve is downwards sloping

46
Q

4.5 v1: what is supply in the money market?

A

It is the amount of money people have access to. The amount of money people have access to is controlled by a central bank and is independent of the nominal interest rate.

47
Q

4.5 v1: What is the curve of the supply in the money market?

A

Since the quantity of money supplied is independent of the nominal interest rate the curve of the money supply in the money market is vertical.

48
Q

4.5 v1: What is the equilibrium of the money market?

A

Occurs when the nominal interest rate is set where current demand (MD) and supply (MS) of money intersect.

49
Q

4.5 v1: what are shortages and surpluses in the money market and how does it affect the interest rates?

A

A surplus is when the IRs is higher than equilibrium. the surplus will lower the IRs. A shortage is when the IRs is lower than equilibrium. The shortage will cause the IRs to rise.

50
Q

4.5 v2: What are the factors that shift the Money demand

A

Aggregate price level
Real GDP (National income)
Technology

51
Q

4.5 v2: How does a change in aggregate price level affect money demand?

A

Higher price levels require more money to make purchases increasing money demand. Lower price levels require less money to make purchases decreasing money demand.

52
Q

4.5 v2: How does a change in real GDP (national income) affect the money demand?

A

When national income increases people will be spending more money so they need more money. when national income decreases people will be spending less money so they need less money.

53
Q

4.5 v2: How does a change in Technology affect the money demand?

A

The easier it is to convert less liquid assets into money, the less money is demanded. The hard it is to convert more liquid assets into money, the more money is demanded. Availability and cost of using money substitutes also affects money demand.

54
Q

4.6 v1: What is monetary policy?

A

A central banks policies of influencing nominal interest rates to help achieve their macroeconomic objectives. These objectives are:
Price stability
Full employment

55
Q

4.6 v1: What do changes in nominal interest rates influence?

A

They impact price level, real output, and unemployment through shifts of aggregate demand.

56
Q

4.6 v1: What options do banks have when they are unable to meet reserve requirements?

A

They can:
Call in loans
Sell assets
Borrow from commercial banks. (policy rate
Borrow from central banks. (discount rate)

57
Q

4.6 v1: What is the policy rate?

A

It is the overnight interbank lending rate. It is the bank that is paid in-between banks from one commercial bank to another when they need to make overnight loans.
Referred to as the federal funds rate in the US.

58
Q

4.6 v1: How do banks work with their monetary policy?

A

Central Banks often set target ranges for their policy rate to guide their monetary policy

59
Q

4,6 v1: How does the expansionary monetary policy work?

A

The expansionary monetary policy is when central banks decrease the nominal interest rate in the short-run to help an economy get out of a recessionary gap.
Lower interest rates leads to less expensive loans leading to more interest sensitive spending (consumption and investment) leading to an increase in AD

60
Q

4.6 v1: How does the contractionary monetary policy work?

A

The contractionary monetary policy is when central banks increase the nominal interest rate in the short-run to help an economy get out of a inflationary gap.
Higher interest rates leads to more expensive loans leading to less interest sensitive spending (consumption and investment) leading to an decrease in AD

61
Q

4.6 v1: what are the monetary policy lags?

A

Recognition lag: Central banks time to collect and analyze the data needed to recognize problems in the economy.
Impact lag: Time for the economy to adjust after policy action is taken

62
Q

4.6 v2: What causes interest rates to shift in the limited reserves framework.

A

Interest rate shifts are brought about through changes in the money supply

63
Q

4.6 v2: What is the limited reserves framework?

A

A banking system in which:
- reserves are limited
- RR is not zero
- commercial banks hold RR and possibly excess reserves
- Monetary policy works by changing the supply of excess reserves and therefore, the supply of money

64
Q

4.6 v2: How do changes in money supply affect the S and D graph for money?

A

When MS increases the line shifts right and left if Ms decreases. A decrease in MS will lead to an increase of interest rates and vice versa

65
Q

4.6 v2: How do central banks influence the money supply?

A

Through their monetary policy tools which are:

Required reserve ratio (Rrr). % of DD banks must hold is reserves.
Discount rate (Dr). the IR commercial banks must pay to borrow from the central bank.
Open-Market operations (OMO). Central banks buying and selling of bonds.

66
Q

4.6 v2: How does the reserves requirement ratio affect the money supply?

A

If Rrr falls banks have more excess reserves to lend so MS increases and NIRs decrease. The opposite it true for when Rrr rises.

67
Q

4.6 v2: How does the discount rate affect the money supply?

A

If Dr decreases banks will be encouraged to lend more so MS increase and NIRs fall. The opposite is true when Dr increase.

68
Q

4.6 v2: How do open-market operations affect the money supply?

A

When the central banks buys bonds banks excess reserves increase so Ms rises and NIR fall. When central banks sell bonds the opposite is true.

69
Q

4.6 v2: What do OMO cause change in?

A

It causes changes in reserves so the monetary base changes.

70
Q

4.6 v2: What magnitude of effect does an OMO have on MS in a limited reserves environment?

A

In a limited reserves environment OMO has a larger effect of MS than the monetary base because of the money multiplier

71
Q

4.6 v2: what effect does a change of excess reserves have on loans and deposits?

A

An increase in excess reserves leads to banks making more loans, which leads to more deposits, which creates more excess reserves. An decrease in excess reserves does the opposite.

72
Q

4.6 v2: How do you find the maximum possible change to the MS as a result of an OMO?

A

the equations is
Change to MS = (OMO amount)(MM)

73
Q

4.6 v3: what is ample reserves framework?

A

A banking system in which:
Reserves are abundant
Rrr is zero
Changing MS no longer leads to changes in NIRs.
Requires different monetary tools

74
Q

4.6 v3: What is the reserves market model graph and what is it specifically used for?

A

It is a graph used specifically for the ample reserves framework.
It has a vertical curve representing supply of reserves and a top and bottom flat line connected by a downward sloping curve representing demand reserves.
The policy rate is set at the intersection of Demand and supply

75
Q

4.6 v3: Where do supply and demand reserves intersect of the reserves market model graph?

A

It will always intersect at the bottom flat line in an ample reserves environment.

76
Q

4.6 v3: If the Supply curve of reserves intersects on the downwards sloping portion of the reserves market model graph, what framework would it represent?

A

It would represent the limited reserves framework.

77
Q

4.6 v3: what effect does buying bonds have on the reserves market model graph?

A

Buying bonds is used to maintain ample reserves. Buying bonds will increase the monetary base (ample reserves) but will have no effect on nominal interest rates (policy rate)

78
Q

4.6 v3: How does the federal reserve board (Fed) influence the nominal interest rates?

A

Through their monetary policy tools which are administered interest rates. Two examples of administered interest rates are:
Discount rates: interest rates commercial banks earn on the funds in their reserves balance accounts with the Fed
interest on reserves: Interest rates commercial banks must pay to borrow from the Fed

79
Q

4.6 v3: How does interest on reserves operate in the reserve model market graph?

A

Increases to interest on reserves (IOR) move the lower bound on the reserves market model up and vice versa. Serves as the Fed’s primary monetary policy tool.

80
Q

4.6 v3: How do discount rates operate in the reserve market model graph?

A

Increases to the discount rate move the upper bound up on the reserves market model and vice versa.

81
Q

4.6 v3: What effect does a increase in administered interest rates have on reserve market model graph?

A

A increase in administered reserves leads to a increase in policy rate causing a increase in other nominal interest rates. This is a contractionary policy because interest sensitive spending and AD will decrease.
The upper and lower bounds will be raised as a result of the increase.

82
Q

4.6 v3: What effect does a decrease in administered interest rates have on reserve market model graph?

A

A decrease in administered reserves leads to a decrease in policy rate causing a decrease in other nominal interest rates. This is a expansionary policy because interest sensitive spending and AD will increase.
The upper and lower bounds will be lowered as a result of the decrease.

83
Q

4.7 v1: What is the loanable funds market (loans)?

A

How much money in the form of loans consumers, businesses, and the government are requiring which is determined by expectation of return on investment.

84
Q

4.7 v1: What is the price of borrowing money? What does the “price” stand for? What type of “price” is used?

A

The price of borrowing money is the real interest rate or how much they pay to borrow the money. The real rate is used instead of nominal as loans usually take place over a longer period of time

85
Q

4.7 v1: What does the real interest rate equal?

A

Real IR = Nominal IR - Inflation

86
Q

4.7 v1: What does the demand of loans represent?

A

It represents the amount of loans being demanded by consumers, producers, and the government.

87
Q

4.7 v1: When are demands for loans high or low?

A

When IR are high demand is low. When IR are low demand is high.

88
Q

4.7 v1: When is supply for loans high or low?

A

When IR are high supply is high. When IR are low supply is low

89
Q

4.7 v1: What is supply for loans in a closed and open economy?

A

In an closed economy supply is equal to national saving. The equation is Public + Private savings.
In an open economy supply is equal to national savings plus net capital inflow.

90
Q

4.7 v1: What is equilibrium is loanable funds market.

A

Where the interest rates and quantity of loans are equal to each other meaning the amount of loans that are being saved and available to be lent out are equal to the amount demanded of loans.

91
Q

4.7 v2: What is a shortage in a loanable funds market? Why do shortages occur?

A

When the interest rates are below equilibrium (Too low), the loanable funds market has a shortage.
A shortage causes loans demanded to be greater then loans supplied.
When interest rates are low, the loans are cheap so people want to get more loans. however, when interest rates are low return on saving in banks is less creating less loans supplied.

92
Q

4.7 v2: What is a surplus in a loanable funds market?

A

When the interest rates are above equilibrium (Too high), the loanable funds market has a surplus.
A surplus causes loans supplied to be greater then loans demanded.
When interest rates are high return on saving in banks is highcreating more loans. However, high interest rates mean more expensive loans causing less loans to be demanded.

93
Q

4.7 v2: What causes changes or shifts in demand in the loanable fun market.

A

Changes in expected rate of return / return on investment.
When people expect their investments to yield more, demand of loans increase shifting the demand curve to the right. The opposite is true when expectations of returns is low.
Shifts in demand cause the equilibrium and supply to change.

94
Q

4.7 v2: What causes changes or shifts in supply in the loanable funds market.

A

Changes in habits of savings.
when people are unsure of the economy, they will want to save more and thus put their money into a savings shifting the supply curve to the right. the opposite is true when people are confident in the economy.
Shifts in supply cause the equilibirum and demand to change as well

AP Macroeconomics (6 decks)

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