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Macroeconomics Unit4
| Question | Answer |
|---|---|
| What is a financial system? | A network of institutions that link borrowers and lenders. |
| What institutions are included in the financial system? | Banks, mutual funds, pension funds, and other financial intermediaries. |
| What is an asset? | Anything tangible or intangible that has value. |
| What is a real asset? . | A tangible (physical) asset that has value. Example: A house |
| What is a financial asset? | A claim on a tangible object or on future income. |
| What is financial risk? | Uncertainty about the future value of an asset. |
| What is return? | The profit made on an asset, usually expressed as a percentage. |
| What is ROI (Return on Investment)? | The percentage gain or loss made on an investment. |
| What is an interest rate? | The amount a lender charges a borrower for borrowing money. It is the “price” of a loan. |
| Why do lenders charge interest? | To earn a return for lending money and to compensate for risk and inflation. |
| What are interest-bearing assets? | Assets that earn interest over time. |
| What is a bond? | A loan (IOU) that represents debt the government, business, or individual must repay to the lender. |
| Does a bondholder own part of the company? | No. Bondholders do not have ownership and are paid interest. |
| Example of a bond: | A 30-year U.S. Treasury bond with a face value of $1,000 and a 5% interest rate pays $50 per year for 30 years. |
| What happens if interest rates fall after a bond is issued? | Older bonds with higher interest rates become more valuable and their price rises. |
| What is the relationship between bond prices and interest rates? | They are inversely related. When interest rates fall, bond prices rise. When interest rates rise, bond prices fall. |
| What is a stock? | An equity that represents ownership in a corporation. |
| What can stockholders receive? | A portion of profits paid out as dividends. |
| What is liquidity? | The ease with which an asset can be converted into a medium of exchange (cash). |
| What is the general rule about liquidity and return? | The higher the liquidity, the lower the rate of return. |
| What is the nominal interest rate? | The percentage increase in money paid by the borrower (not adjusted for inflation). |
| Formula for nominal interest rate? | Nominal interest rate = Real interest rate + Expected inflation |
| What is the real interest rate? | The percentage increase in purchasing power paid by the borrower (adjusted for inflation). |
| Formula for real interest rate? | Real interest rate = Nominal interest rate − Expected inflation |
| Example: | If the nominal interest rate is 10% and inflation is 15%, the real interest rate is –5%. |
| Money | Anything generally accepted in exchange for goods and services and serves as a store of value. |
| Why bartering is inefficient | Requires a double coincidence of wants. |
| Double coincidence of wants | Each party must want exactly what the other is offering. |
| Three Functions of Money | Medium of exchange, store of value, unit of account. |
| Three Functions of Money | Medium of exchange, store of value, unit of account. |
| Medium of Exchange | Money is widely accepted as payment for goods and services. |
| Store of Value | Money holds its value over time and can be saved for future use. |
| Unit of Account | Money provides a standard measurement of value for goods and services. |
| Inflation | A sustained increase in the overall price level of goods and services. |
| Effect of inflation | Reduces purchasing power. |
| Purchasing Power | The amount of goods and services a unit of money can buy. |
| When inflation increases | Purchasing power decreases. |
| Characteristics of Money | Portable, durable, divisible, scarce. |
| Portable | Money must be easy to carry and transfer. |
| Durable | Money must last over time and not deteriorate easily. |
| Divisible | Money must be capable of being broken into smaller units. |
| Scarce | Money must be limited in supply to maintain value. |
| Fiat Money | Money that has value because the government declares it legal tender. |
| Commodity Money | Money that has intrinsic value because it is made of a valuable material. |
| Financial Assets | Assets such as savings accounts or bonds that represent a claim on future income. |
| Most liquid asset | Cash. |
| Medium of Exchange Examples | Cash, coins. |
| Store of Value Examples | Savings accounts, bonds. |
| Unit of Account Example | Prices listed in dollars. |
| Standard of Value | Money provides a consistent way to compare the value of goods and services. |
| Hyperinflation | Decreases acceptability |
| What is M1 (Highest Liquidity)? | Currency in circulation, checkable bank deposit, and traveler's checks. |
| What is M2 (Near Moneys)? | Savings deposits, time deposits, and money market funds. |
| Monetary Base (High-Powered Money) | Money that includes currency in circulation and bank reserves. It is the foundation of the money supply. |
| Money Multiplier Formula | Money Multiplier = 1 ÷ Reserve Requirement Ratio If RR = 10% (0.10), multiplier = 10. It represents the net worth of the bank. |
| Reserve Requirement Ratio f a bank. | The percentage of deposits banks must hold as required reserves. In the U.S., it is traditionally 10%. |
| Bank Balance Sheet | A financial statement that shows a bank’s assets and liabilities. It must always balance (Assets = Liabilities + Owner’s Equity). |
| Double-Entry Accounting | An accounting system where every transaction affects at least two accounts to keep the balance sheet balanced. |
| Assets (for a Bank) | Things the bank owns or money owed to the bank. Examples: • Required reserves • Excess reserves • Loans |
| Liabilities (for a Bank) | Money the bank owes to others. Examples: • Demand deposits • Owner’s equity |
| Required Reserves | The percentage of deposits banks are legally required to keep. Example: 10% of deposits in the U.S. |
| Excess Reserves | Reserves held by a bank above the required amount. This is the amount the bank can loan out. |
| Fractional Reserve Banking | A banking system where banks keep only a fraction of deposits as reserves and loan out the rest. |
| Financial Assets | A contractual claim to something of value. Four main types: • Bank deposits • Stocks • Bonds • Loans |
| Owner’s Equity | Money owed to the owners of a bank. It represents the net worth of the bank. |
| Money Market | The market where the demand for and supply of money determine the nominal interest rate. |
| Demand for Money | The amount of liquid assets people are willing and able to hold at various interest rates. |
| Why do people demand money? | • To buy goods and services (transactions motive) • For emergencies or unexpected expenses (precautionary motive) • To hold wealth instead of other financial assets (asset motive) |
| What happens to quantity demanded of money when interest rates increase? | Quantity demanded decreases because people prefer interest-earning assets instead of holding cash. |
| Relationship Between Interest Rates and Quantity of Money Demanded | Inverse relationship — as interest rates rise, quantity of money demanded falls. |
| Opportunity Cost of Holding Money | The interest you give up by holding cash instead of putting it in an interest-earning asset. |
| Money Demand Curve | Downward sloping because of the inverse relationship between interest rates and quantity of money demanded. |
| How to Label the Money Market Graph X-axis: Quantity of Money (billions of dollars) Curve: MD (Money Demand) | Y-axis: Nominal Interest Rate |
| What Causes the Money Demand Curve to Shift? | • Changes in price level • Changes in income • Changes in technology |
| Increase in Price Level | Shifts money demand right (people need more money for transactions). |
| Increase in Income | Shifts money demand right (more spending → more demand for money). |
| Advances in Technology (e.g., digital payments) | Can shift money demand left (less need to hold physical cash). |
| Transactions Motive | People demand money to buy goods and services. |
| Money demand in the money market consists of what two components? | Asset demand and transactions demand. |
| What shape is the money supply curve in the money market? | Horizontal because it is set by the Federal Reserve. |
| What determines the interest rate in the money market? | The interaction of the demand for money and the fixed money supply. |
| Who determines the money supply in the United States? | The Federal Reserve (the central bank), not Congress. |
| How does the Federal Reserve increase the money supply through open market operations? | By buying government bonds. |
| How does the Federal Reserve decrease the money supply through open market operations? | By selling government bonds. |
| What is the interest rate the Federal Reserve charges commercial banks for loans? | The discount rate. |
| What is the most commonly used tool of monetary policy? Open market operations. | |
| What happens when the Federal Reserve sells bonds on the open market? | Money supply decreases and interest rates increase. |
| When is expansionary monetary policy most appropriate? | When real GDP is falling or the economy is in recession. |
| Which monetary policy action helps resolve a recession? | Lowering the reserve requirement. |
| If the Federal Reserve increases the money supply, what happens to interest rates, investment, and aggregate demand? | Interest rates decrease, investment increases, and aggregate demand increases. |
| Which policy would be inappropriate if the Fed is trying to reduce inflation? | Reducing the federal funds rate. |
| How does the Fed purchasing bonds affect the economy? | Real output increases, employment increases, and the price level increases. |
| Which fiscal and monetary policy combination helps reduce an inflationary gap? | Decreasing government spending and the Fed selling bonds. |
| What is the reserve requirement? | The percentage of deposits banks must hold and not loan out. |
| What happens if the Federal Reserve increases the reserve requirement? | Banks lend less money, decreasing the money supply. |
| What happens if the Federal Reserve decreases the reserve requirement? | Banks lend more money, increasing the money supply. |
| What happens to interest rates when the money supply increases? | Interest rates decrease. |
| What happens to interest rates when the money supply decreases? | Interest rates increase. |
| What happens to aggregate demand when interest rates decrease? | Investment increases, which increases aggregate demand. |
| What happens to aggregate demand when interest rates increase? | Investment decreases, which decreases aggregate demand. |
| What open market operation would the Fed use during a recession? | Buying government bonds to increase the money supply. |
| How does buying bonds affect the money market graph? | The money supply curve shifts to the right and the interest rate falls. |
| How does a decrease in interest rates affect aggregate demand? | Investment increases, causing aggregate demand to shift right. |
| How does an increase in aggregate demand affect real output and price level? | Both real output and price level increase. |
| What is the demand for loanable funds? | The desire to borrow money for investment or spending. |
| What does the demand for loanable funds represent? | Borrowing by businesses and the government. |
| Why is the demand curve for loanable funds downward sloping? | Lower interest rates make borrowing cheaper, so more borrowing occurs. |
| What is the supply of loanable funds? | The amount of money available for lending. |
| Where does the supply of loanable funds come from? | Savings from households, businesses, and the government. |
| Why is the supply curve for loanable funds upward sloping? | Higher interest rates encourage people to save more money. |
| What is the equilibrium in the loanable funds market? | The point where the supply of loanable funds equals the demand for loanable funds. |
| What does the equilibrium interest rate determine? | The price of borrowing and the amount of lending in the market. |
| What factors can increase the demand for loanable funds? | Increased borrowing by consumers, businesses, or the government. |
| What factors can decrease the demand for loanable funds? | Reduced borrowing by consumers, businesses, or the government. |
| What causes the supply of loanable funds to increase? | Higher savings from households, businesses, or the government. |
| What causes the supply of loanable funds to decrease? | Lower savings from households, businesses, or the government. |
| What happens when the government runs a budget deficit? | The government borrows more money, increasing demand for loanable funds. |
| What effect does increased government borrowing have on interest rates? | Interest rates tend to rise. |
| What is the crowding out effect? | When government borrowing reduces the amount of loanable funds available for private investment. |
| What happens to the loanable funds market during political instability? | Demand for loanable funds may decrease because consumers and businesses borrow less. |
| How can political instability affect the supply of loanable funds? | Foreign investors may withdraw money from the country, decreasing the supply of loanable funds. |
| What is capital flight? | When foreign investors withdraw their money from a country due to economic or political concerns. |
| How do reserve requirements affect the money supply? | Higher reserve requirements reduce the money supply, while lower reserve requirements increase it. |
| What happens when the central bank sells bonds? | The money supply decreases because money is taken out of the economy. |
| What happens when the central bank buys bonds? | The money supply increases because money is injected into the economy. |
| How do interest rates affect saving behavior? | Higher interest rates encourage more saving, while lower interest rates discourage saving. |
| What is private saving? | The portion of income that households and businesses save rather than spend. |
| What is public saving? | Government revenue minus government spending. |
| What is national saving? | The sum of private saving and public saving. |
| Expansionary monetary policy In the short run: | Money supply increases Nominal interest rate decreases Real interest rate decreases |
| Effect of selling bonds by the Federal Reserve | Reserves: decrease Money supply: decrease Interest rates: increase |
| Action that increases banks' excess reserves | Buying bonds on the open market |
| Federal funds rate facts | Not the same as the discount rate It is the interest rate banks charge each other for short-term loans Influenced by open market operations |
| Fractional reserve banking example | A bank lends out $5,000 of its excess reserves |
| Loanable funds market when businesses expect higher future sales | Demand for loans: increase Real interest rate: increase |
| Effect of increased government spending on money market | Demand for money: increase Nominal interest rates: increase |
| Reserve Market | A market where banks borrow and lend reserves to each other. |
| When did the Fed stop requiring reserves and why do we still study reserve requirements? | 2020 and other countries still use them. |
| Limited reserves | A situation where banks have small amounts of reserves, making the reserve requirement more binding. |
| Ample reserves | A situation where banks hold large amounts of reserves, so reserve requirements don’t really matter. |
| What do banks do regardless of the reserve requirement? | They keep lots of reserves. |
| Interest rate the Fed offers on reserves | About 2% |
| Effect of interest on reserves in the reserve market | Creates a floor on the graph. |
| Discount rate | The interest rate banks pay to borrow from the Fed. |
| Ceiling (in the reserve market) | The discount rate acts as a ceiling for interest rates. |
| Effect of ample reserves on monetary policy | Changes in money supply have minimal impact on the market. |
| What does the Fed use in an ample reserves system? | Interest on reserves (IOR) and the discount rate. |
| Another name for IOR and discount rate tools | Administered interest rates. |
| Expansionary policy (in reserve market terms) | Increases reserves, shifting supply right and lowering interest rates. |
| Contractionary policy (in reserve market terms) | Decreases reserves, shifting supply left and raising interest rates. |
| Policy rates | Interest rates set by the Fed to influence the economy. |
| Relationship between reserves and interest rates | More reserves → lower rates; fewer reserves → higher rates. |
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