AP MACRO ECONOMCS

Dr. Flores
UNIT 5
THE FINANCIAL SECTOR
MODULES 22-29
 Module 22- Saving, Investment, & the Financial System
• For the economy as a whole savings and investment
spending are always equal (S = I)

If we assume a simple economy then

• Total Income = Total Spending

• Total Income = Consumption + Savings

• Total Spending = Consumption +

Investment

• Consumption + Savings = Consumption

+ Investment
Four Traditional Types of Financial
Assets
• Loans = agreement between lender &
borrower

• Bonds = IOU to repay principal and

interest

• Bank Deposits

• Stocks = A share in ownership of a

company

New form of Assets are Loan-Backed

Securities (a “pooling” of debt
instruments)
 Bond Prices
• The yield on a bond is equal to its annual
interest payment divided by the bond price.
• Therefore , it is also true that:
Bond price = Interest payment / yield
• If a bond pays $50 per year interest, and the
yield should be 8 percent, then the bond price
will be $625:
$625 = $50 / .08

© 2011 Worth Publishers ▪

CoreEconomics ▪ Stone
 Bonds vs. Stocks
Pretend you are going to start a
lemonade stand. You need some money to get
your stand started. What do you do?

• You ask your grandmother to lend you $100 and write

down on a paper: "I owe you (IOU) $100, and I will pay
you back in a year plus 5% interest."
• Your grandmother just bought a bond.
Bonds are loans, or IOUs, that represent debt that the
government or a corporation must repay to an investor. The
bond holder has NO OWNERSHIP of the company.

But, now you need more money…

5
•To get more money, you sell half of your company for $50
to your brother Tom.
•You put this transaction in writing: "Lemo will issue 100
shares of stock. Tom will buy 50 shares for $50."
• Tom has just bought 50% of the business. He is allowed to
make decisions and is entitled to a percent of the profits.

Stockowners can earn a profit in two ways:

1. Dividends, which are portions of a corporation’s
profits, are paid out to stockholders.

2. A capital gain is earned when a stockholder sells stock

for more than he or she paid for it.
A stockholder that sells stock at a lower price than the
purchase price suffers a capital loss.
6
Three Problems Facing Borrowers &
Lenders

Transaction Costs: What is involved in the

loaning of money

Risk: What the lender and the borrower must

consider before agreeing to the loan. This will
dictate the amount of interest to be charged and
the length of the loan to be given.

Desire for Liquidity: The ease with which

the physical asset involved can be transformed
into cash or revenue.
• The effect of time
must always be
considered when
investments are
being discussed
 Credit vs. Debit Cards
Are credit cards money?
A credit card is NOT money. It is a short-term
loan (usually with a higher than normal interest
rate).
Ex: You buy a shirt with a credit card, VISA pays
the store, you pay VISA the price of the shirt
plus interest and fees.

Total credit cards in circulation in U.S: 576.4 million

Average number of credit cards per cardholders: 3.5
Average credit card debt per household : $15,788
9
 Module 23: What is Money?
Money is anything that is generally accepted in
payment for goods and services

Commodity Money- Something that performs the

function of money and has alternative uses.
– Examples: Gold, silver, cigarettes, etc.

Fiat Money- Something that serves as money but

has no other important uses.
– Examples: Paper Money, Coins
10
• In our current financial system, we use fiat
money ,which means it has no intrinsic value,
but is recognized as legal tender.
• In a barter system, goods and services are
traded directly and no money is exchanged.
– This arrangement
requires a double
coincidence of wants.
 What would happen if we didn’t have money?
Problems:
1. Before trade could occur, each trader had to have
something the other wanted.
2. Some goods cannot be split. If 1 goat is worth five
chickens, how do you make an exchange if you only
want 1 chicken?

Example: A heart surgeon might accept only certain goods

but not others because he doesn’t like them (ex: broccoli)
To get the surgery, a pineapple grower must find a broccoli
farmer that likes pineapples. 12
 3 Functions of Money
1. A Medium of Exchange
• Money can easily be used to buy goods and
services with no complications of barter system.
2. A Unit of Account
• Money measures the value of all goods and
services. Money acts as a measurement of value.
• 1 goat = $50 = 5 chickens OR 1 chicken = $10
3. A Store of Value
• Money allows you to store purchasing power for
the future.
• Money doesn’t die or spoil.

13
 Types of Money
Liquidity- ease with which an asset can be
accessed and converted into cash (liquidized)

M1 (High Liquidity) - Cash, Traveler’s Checks

and Checkable Deposits. In general, this is known
as the MONEY SUPPLY

M2 (Medium Liquidity) - M1 plus other “near

money” such as savings accounts (CD’s) and
mutual funds

M3 (Low Liquidity) – No longer used

14
 Functions of Money
• Money is often used as a store of wealth
because it has such a high level of liquidity.
– The liquidity of an asset is determined by how
fast, easily, and reliably it can be converted into
cash.
– Money is the most liquid asset because, as the
medium of exchange, it requires no conversion.
 Answer the Following Question
• M1 consists of
– A) Currency plus savings accounts
– B) Currency plus excess reserves held by banks
– C) Currency plus travelers checks plus checkable
deposits
– D) Demand deposits plus savings deposits plus
travelers checks
 Answer
• M1 consists of
– A) Currency plus savings accounts
– B) Currency plus excess reserves held by banks
– C) Currency plus travelers checks plus checkable
deposits. Correct!
– D) Demand deposits plus savings deposits plus
travelers checks
 Module 24: The Time Value of Money

• Present Value : The use of interest rates to

compare the value of a dollar realized today
with the value of a dollar realized later.
Defining Present Value

• Let Fv = future value of $

Pv = present value of $
r = real interest rate
n = # of years

• The Simple Interest Formula

Fv = PV x ( 1 + r )n

Pv = fv / (1 + r)n
 Application of the formula
• Using the formula fv = (1 + r) * pv in a one year example with $100 at
10%
• FV = $100*(1.10) = $110
• So, one year in the future, $100 in the present will be worth $110.

• Now let’s lend the money for a period of 2 years:

• Repayment in two years = $100(1.10)*(1.10) = $121
• FV = PV(1+r)*(1+r) = PV(1+r)2

• Money today has more value than same amount in the future.

• Interest paid on savings and interest charged on borrowing is designed

to equate the value of dollars today with the value of future dollars.
 Module 25: What Banks Do
Financial Intermediary: use deposits to
finance loans

• Bank Reserves: $ held in vault or by Fed

• T – Account

• Reserve Ratio: the % of deposits held in

reserve

• Required Reserve Ratio: the minimum that

must be held in reserve
To Protect Against Bank Runs the Following
Regulations are in effect
• FDIC : Insured to $250K
• Capital Requirements: Owners must hold more
assets than the value of the deposits (usually at
least 7% more)
• Reserve Requirements: Reserve ratio is
presently 10% of all checkable deposits
• Discount Window: Ability to borrow from the
Fed to avoid having to sell assets at below
market prices
 Money Creation is similar to the Multiplier
Effect of Fiscal Policy
The money multiplier measures the potential or
maximum amount the money supply can
increase when new deposits enter the system
but some money will “leak out” of the banking
system and reduce the multiplier
• The money multiplier is defined as:
Money Multiplier = 1/Reserve Requirement
So if Fed adds $100 to monetary base (increased
reserves) the money supply will increase by $1000.
1/.10=10 and 10 x 100 = 1000
FED controls Monetary Base (reserves and currency in circulation) but Money
Supply is different because bank reserves ARE NOT part of the Money Supply
and Checkable Deposits are not part of the Monetary Base
 Modules 26 & 27
The Federal Reserve System
 The Supply for Money
The U.S. Money Supply is set by the Board of
Governors of the Federal Reserve System (FED)
Interest Rate
(ir) SMoney The FED is a nonpartisan
government office that sets and
adjusts the money supply to adjust
20% the economy
5%
This is called Monetary Policy.

2%
DMoney
200 Quantity of Money
27
(billions of dollars)
Interest S&D of Money Interest Investment Demand
Rate (i) Rate (i)
SM SM1
10% 10%

5% 5%

2% 2%
DM DI
200 250 QuantityM Quantity of Investment
PL AD/AS
AS
The FED increases the
money supply to
PL1 stimulate the economy…
PLe 1. Interest Rates Decreases
2. Investment Increases
3. AD, GDP and PL Increases
AD AD1
28
Qe Q1 GDPR
Interest S&D of Money Interest Investment Demand
Rate (i) Rate (i)
SM1 S
M
10% 10%

5% 5%

2% 2%
DM DI
175 200 QuantityM Quantity of Investment
PL AD/AS
AS
The FED decreases the
money supply to slow
PLe
down the economy…
1. Interest Rates increase
PL1 2. Investment decreases
AD
3. AD, GDP and PL decrease
AD1
29
Q1 Qe GDPR
 The federal funds rate is the interest rate that
banks charge one another for one-day loans
necessary to meet their reserve requirements.

The FED influences the banks by setting a target

rate & using bond transactions to hit the target.
The federal funds rate fluctuates due to market
conditions & banks are NOT obligated to lend at
that rate.

30
• The Federal Reserve uses three primary tools
in the pursuit of monetary policy:

– Reserve Requirements
– The Discount Rate
– Open Market Operations

These tools are used to increase or

decrease the money supply.
 #1. The Reserve Requirement
Only a small percent of your bank deposit is in the
safe. The rest of your money has been loaned out.
This is called “Fractional Reserve Banking”

The FED sets the amount that banks must hold

The reserve requirement (reserve ratio) is

the % of deposits that banks must hold in
reserve and NOT loan out)

- When the FED increases the money supply it increases

the amount of money held in bank deposits. 32
1. If there is a recession, what should the FED do to
the reserve requirement? (Explain the steps.)
Decrease the Reserve Ratio
1. Banks hold less money and have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD goes up

2. If there is inflation, what should the FED do to the

reserve requirement? (Explain the steps.)
Increase the Reserve Ratio
1. Banks hold more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down

33
 The Money Multiplier
Example: Assume the reserve ratio in the US is 10%
You deposit $1000 in the bank
The bank must hold $100 (required reserves)
The bank lends $900 out to Bob (excess reserves)
Bob deposits the $900 in his bank
Bob’s bank must hold $90. It loans out $810 to Jill
Jill deposits $810 in her bank
SO FAR, the initial deposit of $1000 caused the CREATION
of another $1710 (Bob’s $900 + Jill’s $810)

1
Money
Multiplier = Reserve Requirement (ratio)

34
 Practice
Don’t forget the Monetary Multiplier!!!!
1. If the reserve requirement is .5 and the FED
sells $10 million of bonds, what will happen to
the money supply?
2. If the reserve requirement is .1 and the FED
buys $10 million bonds, what will happen to
the money supply?
3. If the FED decreases the reserve requirement
from .50 to .20 what will happen to the money
multiplier?
35
 #2. The Discount Rate
The Discount Rate is the interest rate that the
FED charges commercial banks.
Example:
• If Banks of America needs $10 million, they borrow it
from the U.S. Treasury (which the FED controls) but they
must pay it back with interest.

To increase the Money supply, the FED should

_________
DECREASE the Discount Rate (Easy Money Policy).
To decrease the Money supply, the FED should
_________
INCREASE the Discount Rate (Tight Money Policy).

36
 #3. Open Market Operations
• The FED buys / sells government bonds (securities).
• This is the most important and widely used
monetary policy
To increase the Money supply, the FED should
_________
BUY government securities.
To decrease the Money supply, the FED should
SELL
_________ government securities.

How are you going to remember?

Buying bonds means Bigger money supply
Selling bonds means Smaller money supply
37
Just like ordinary banks The FED uses a simple “T” to
determine its balance sheet between assets and
liabilities
• When the Fed buys U.S. Treasury bills from a
commercial bank, it pays by crediting the
bank’s reserve account by an equal amount.
– This increases the monetary base because it
increases bank reserves
• When the Fed sells U.S. Treasury bills to
commercial banks, it debits the banks’
accounts
– This reduces reserves and the monetary base
• The change in bank reserves caused by open­-­
market operations doesn’t directly affect the
money supply. Instead, it starts the money
multiplier in motion.
• If the Fed buys $100 million in T-bills from
commercial banks, they would lend out their
additional reserves, immediately increasing the
money supply by $100 million.

• Some of those loans would be deposited back into

the banking system, increasing reserves again and
permitting a further round of loans, leading to a rise
in the money supply.

• A sale of T-Bills has the reverse effect: bank reserves

fall, requiring banks to reduce their loans, leading to
a fall in the money supply.
 Open-Market Operations is
the purchase and sale of
Treasuries
Module 28:The Money
Market
(Supply and Demand for Money)

42
Demand for money has an inverse relationship
between nominal interest rates and the
quantity of money demanded

1. What happens to the quantity demanded of

money when interest rates increase?
Quantity demanded falls because individuals
would prefer to have interest earning assets
instead of borrowed liabilities

2. What happens to the quantity demanded when

interest rates decrease?
Quantity demanded increases. There is no
incentive to convert cash into interest earning43
assets
 The Demand for Money
Inverse relationship between interest rates and
the quantity of money demanded
Nominal Interest
Rate (ir)

20%

5%

2%

DMoney
0
Quantity of Money
44
(billions of dollars)
 The Demand for Money
What happens if price level increase?
Money Demand Shifters
Nominal Interest
Rate (ir)
1. Changes in price level
2. Changes in income
20%
3. Changes in taxation that
affects investment
5%

2% DMoney1
DMoney
0
Quantity of Money
(billions of dollars) 45
 Increasing
Interest Rate
the Money Supply
(ir) SM SM1 If the FED increases the
money supply, a temporary
10%
surplus of money will occur
at 5% interest.
5% The surplus will cause the
interest rate to fall to 2%
2% How does this
DM affect AD?
200 250 Quantity of Money
(billions of dollars)
Increase Decreases Increases Increases AD
money supply interest rate investment 46
 Decreasing
Interest Rate
the Money Supply
(ir) SM1 SM If the FED decreases the money
supply, a temporary shortage
10%
of money will occur at 5%
interest.
5% The shortage will cause the
interest rate to rise to 10%
2% How does this
D affect AD?
M
150 200 Quantity of Money
(billions of dollars)
Decrease Increase Decrease Decrease AD
money supply interest rate investment 47
The Money Demand curve slopes down and to the right because, all
else being equal, higher interest rates increase the opportunity cost
of holding money, thus leading public to reduce quantity of money it
demands
 Factors that can cause the MD Curve to shift

• Changes in Aggregate Prices

• Changes in Real GDP

• Changes in banking technology (ex: ATM’s)

• Changes in Banking Institution Regulations

The Equilibrium Interest
Rate
• Liquidity Preference
Model of the
Interest Rate (rates
are determined by
supply and demand
of money)

• Equilibrium interest
rate is rate where
quantity demanded
equals quantity
supplied
2007B Practice FRQ: Just Do the Graph for (b)

52
2007B Practice FRQ

53
Module 29:Loanable Funds Market

54
 Is an interest rate of 50% good or bad?
Bad for borrowers but good for lenders
The loanable funds market brings together those
who wish to borrow with those who want to lend

Demand- Inverse relationship between real

interest rate and quantity loans demanded
Supply- Direct relationship between real
interest rate and quantity loans
supplied
This is NOT the same as the money market.
(supply is not vertical)
55
 Loanable Funds Market
At the equilibrium real interest rate the amount
borrowers want to borrow equals the amount lenders
want to lend.
Real Interest
SLenders
Rate

re

DBorrowers
QLoans Quantity of Loans 56
 Loanable Funds Market
Demand Shifters Supply Shifters
1. Changes in perceived 1. Changes in private
business opportunities savings behavior
2. Changes in government 2. Changes in public
borrowing savings
• Budget Deficit 3. Changes in foreign
investment
4. Changes in expected
profitability
5. Budget Surplus

57
 Loanable Funds Market
Example: The Gov’t increases deficit spending
Government borrows from private sector
Increasing the demand for loans
Real Interest
SLenders
Rate

Real interest
r1 rates increase
causing
re
crowding out!!

D1
DBorrowers
QLoans Q1 Quantity of Loans 58
 Loanable Funds

S
Real Interest Rates %

Equilibrium occurs when

the quantity of loanable
3
funds demanded equals the
quantity supplied.

300

Loanable Funds (billions of dollars)

Two Models of the Interest
Rate
2007B Practice FRQ (just do parts a and b)

61
2007B Practice FRQ

62
2007B Practice FRQ

63