Unit 4: Financial Sector

a. Define the principal attributes—liquidity, rate of return, and risk—associated with various classes of financial assets, including money. b. Explain the relationship between the price of previously issued bonds and interest rates.

• The most liquid forms of money are cash and demand deposits.
• Other financial assets people can hold in place of the most liquid forms of money include bonds (interest-bearing assets) and stocks (equity).
• The price of previously issued bonds and interest rates on bonds are inversely related.
• The opportunity cost of holding money is the interest that could have been earned from holding other financial assets such as bonds.
• Enduring understanding MEA-3: Money makes it possible to compare the value of goods and services, and interest rates provide a measure of the price of money that is borrowed or saved.

a. Define the nominal and real interest rate. b. Explain the relationship between changes in nominal interest rates, expected inflation, and real interest rates. c. Calculate the nominal and real interest rate.

• A nominal interest rate is the rate of interest paid for a loan, unadjusted for inflation.
• Lenders and borrowers establish nominal interest rates as the sum of their expected real interest rate and expected inflation.
• A real interest rate can be calculated in hindsight by subtracting the actual inflation rate from the nominal interest rate.
• Enduring understanding MEA-3: Money makes it possible to compare the value of goods and services, and interest rates provide a measure of the price of money that is borrowed or saved.

a. Define money and its functions. b. Calculate (using data as appropriate) measures of money.

• Money is any asset that is accepted as a means of payment.
• Money serves as a medium of exchange, unit of account, and store of value.
• The money supply is measured using monetary aggregates designated as M1 and M2.
• The monetary base (often labeled as M0 or MB) includes currency in circulation and bank reserves.
• Enduring understanding MEA-3: Money makes it possible to compare the value of goods and services, and interest rates provide a measure of the price of money that is borrowed or saved.

a. Define key terms related to the banking system and the expansion of the money supply. b. Explain how the banking system creates and expands the money supply. c. Calculate (using data and balance sheets as appropriate) the effects of changes in the banking system.

• Depository institutions (such as commercial banks) organize their assets and liabilities on balance sheets.
• Depository institutions operate using fractional reserve banking.
• Banks’ reserves are divided into required reserves and excess reserves.
• Excess reserves are the basis of expansion of the money supply by the banking system.
• The money multiplier is the ratio of the money supply to the monetary base.
• The size of expansion of the money supply depends on the money multiplier.
• The maximum value of the money multiplier can be calculated as the reciprocal of the required reserve ratio.
• The amount predicted by the simple money multiplier may be overstated because it does not take into account a bank’s desire to hold excess reserves or the public holding more currency.
• Enduring understanding POL-2: The banking system plays an important role in the expansion of the money supply.

a. Define (using graphs as appropriate) the money market, money demand, and money supply. b. Explain (using graphs as appropriate) the relationship between the nominal interest rate and the quantity of money demanded (supplied).

• The demand for money shows the inverse relationship between the nominal interest rate and the quantity of money people want to hold.
• Given a monetary base determined by a country’s central bank, money supply is independent of the nominal interest rate.
• Enduring understanding MKT-3: In the money market, demand for and supply of money determine the equilibrium nominal interest rate and influence the value of other financial assets.

Define (using graphs as appropriate) equilibrium in the money market.

• In the money market, equilibrium is achieved when the nominal interest rate is such that the quantities demanded and supplied of money are equal.
• Enduring understanding MKT-3: In the money market, demand for and supply of money determine the equilibrium nominal interest rate and influence the value of other financial assets.

Explain (using graphs as appropriate) how nominal interest rates adjust to restore equilibrium in the money market.

• Disequilibrium nominal interest rates create surpluses and shortages in the money market. Market forces drive nominal interest rates toward equilibrium.
• Enduring understanding MKT-3: In the money market, demand for and supply of money determine the equilibrium nominal interest rate and influence the value of other financial assets.

a. Explain (using graphs as appropriate) the determinants of demand and supply in the money market. b. Explain (using graphs as appropriate) how changes in demand and supply in the money market affect the equilibrium nominal interest rate.

• Factors that shift the demand for money, such as changes in the price level, and supply of money, such as monetary policy, change the equilibrium nominal interest rate.
• Enduring understanding MKT-3: In the money market, demand for and supply of money determine the equilibrium nominal interest rate and influence the value of other financial assets.

a. Define monetary policy and related terms. b. Explain (using graphs as appropriate) the short-run effects of a monetary policy action. c. Calculate (using data and balance sheets as appropriate) the effects of a monetary policy action.

• Central banks implement monetary policies to achieve macroeconomic goals, such as price stability.
• The tools of monetary policy may include the central bank’s discount rate and other administered interest rates (e.g., interest on reserves), open market operations, and the required reserve ratio. The tools used and the way in which they are implemented differ between economies that have limited reserves in their banking system and economies that have ample reserves in their banking system. (The banking system in the United States has ample reserves, and the Federal Reserve’s key policy tool is interest on reserves.)
• When the central bank conducts an open-market purchase (sale), reserves increase (decrease), thereby increasing (decreasing) the monetary base.
• When the central bank conducts an open-market purchase (sale) in an economy with limited reserves, the effect on the money supply is greater than the effect on the monetary base because of the money multiplier.
• Many central banks carry out policy to hit a target range for an overnight interbank lending rate, sometimes referred to as the central bank’s policy rate. (In the United States, this is the federal funds rate.)
• Central banks can influence the nominal interest rate in the short run, which in turn will affect investment and consumption. [See also EK MKT-5.G.2 for the influence on net capital inflows.] In an economy with limited reserves, the central bank can influence the nominal interest rate by changing the money supply. In an economy with ample reserves, changes in the money supply do not effectively change the nominal interest rate; instead, the central bank can influence the nominal interest rate by changing its administered interest rates.
• Expansionary or contractionary monetary policies are used to restore full employment when the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap.
• Monetary policy can influence interest rates, aggregate demand, real output, and the price level. [See also EK MKT-5.E.3 for the effect on exchange rates.]
• A money market model, a reserve market model, and/or the AD–AS model may be used to demonstrate the short-run effects of monetary policy.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

Define why there are lags to monetary policy.

• In reality, there are lags to monetary policy caused by the time it takes to recognize a problem in the economy and the time it takes the economy to adjust to the policy action.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

a. Define (using graphs as appropriate) the loanable funds market, demand for loanable funds, and supply of loanable funds. b. Explain (using graphs as appropriate) the relationship between the real interest rate and the quantity of loanable funds demanded (supplied).

• The loanable funds market describes the behavior of savers and borrowers.
• The demand for loanable funds shows the inverse relationship between real interest rates and the quantity demanded of loanable funds.
• The supply of loanable funds shows the positive relationship between real interest rates and the quantity supplied of loanable funds.
• Enduring understanding MKT-4: The interaction of borrowers, who demand loanable funds, and savers, who supply loanable funds, determines the equilibrium real interest rate.

Define national savings in both a closed and an open economy.

• In the absence of international borrowing and lending, national savings is the sum of public savings and private savings.
• For an open economy, investment equals national savings plus net capital inflow.
• Enduring understanding MKT-4: The interaction of borrowers, who demand loanable funds, and savers, who supply loanable funds, determines the equilibrium real interest rate.

Define (using graphs as appropriate) equilibrium in the loanable funds market.

• In the loanable funds market, equilibrium is achieved when the real interest rate is such that the quantities demanded and supplied of loanable funds are equal.
• Enduring understanding MKT-4: The interaction of borrowers, who demand loanable funds, and savers, who supply loanable funds, determines the equilibrium real interest rate.

Explain (using graphs as appropriate) how real interest rates adjust to restore equilibrium in the loanable funds market.

• Disequilibrium real interest rates create surpluses and shortages in the loanable funds market. Market forces drive real interest rates toward equilibrium.
• Enduring understanding MKT-4: The interaction of borrowers, who demand loanable funds, and savers, who supply loanable funds, determines the equilibrium real interest rate.

a. Explain (using graphs as appropriate) the determinants of demand and supply in the loanable funds market. b. Explain (using graphs as appropriate) how changes in demand and supply in the loanable funds market affect the equilibrium real interest rate and equilibrium quantity of loanable funds.

• The loanable funds market can be used to show the effects of government spending, taxes, and borrowing on interest rates.
• Factors that shift the demand (such as an investment tax credit) and supply (such as changes in saving behavior) of loanable funds change the equilibrium interest rate and the equilibrium quantity of funds.
• Enduring understanding MKT-4: The interaction of borrowers, who demand loanable funds, and savers, who supply loanable funds, determines the equilibrium real interest rate.