AP® Macroeconomics Unit 4: Financial Sector
Topic 4.1- Financial Assets Topic 4.2- Nominal v. Real Interest Rates
1. What is the financial sector? The part of the economy 1. Equation for the nominal interest rate
made up of institutions (like banks) that bring Real interest rate + expected inflation
together lenders and borrowers 2. Equation for the real interest rate
2. Define liquidity The ease in which an asset can be Nominal interest rate - expected inflation
converted into a medium of exchange. Cash is liquid
Nominal Real Actual
buy a home is not very liquid.
interest rate interest rate inflation
3. What is a bond? A bond is an interest-baring asset
often issued by businesses or the government. Bonds 7% 4% 3%
are also called “securities”. 4% -1% 5%
4. Why are interest rates and bond prices inversely 6% 8% -2%
related? People prefer higher interest rates because
they give a greater rate of return. If rates for new 2% -3% 5%
bonds go up, people would prefer them to previously 3. Will the real interest rate increase, decrease,
issued bonds. This causes the price of previously or stay the same when actual inflation is
issued bonds to decrease. greater than expected inflation? Decrease
Topic 4.3- Definition, Measurement, and Functions of Money
1. What are the three 2. Why are assets like cash and checkable deposits considered money but
functions of money? bonds and real estate are not? Money only included assets that can be
Medium of exchange used as a medium of exchange. You can’t buy things with bonds.
Unit of account
Store of value 3. What is M1 money supply and M2 money supply? M1 money supply
includes currency and checkable deposits. M2 money supply includes
M1 and “near monies” link savings deposits and certificates of deposits
Topic 4.4- Banking and the Expansion of the Money Supply
1. What is the difference between Use the bank balance sheet to answer the questions
assets and liabilities? Assets are Assets Liabilities
something owned and liabilities Total Reserves $5,000 Demand Deposits $20,000
are something owed that must be Loans $15,000 Owner’s Equity $10,000
paid back. Treasury Bonds $10,000
2. Define demand deposits
Total $30,000 Total $30,000
Deposits by customers that can be
withdrawn at any time (ex: 6. If the reserve requirement is 10%, how much is this bank’s
checking accounts) required reserves and excess reserves?
3. Define required reserves The Required reserves = $2,000 Excess reserves = $3,000
amount of deposits that banks must 7. What is the maximum possible increase in the money supply if
legally hold. The amount they the bank loans out all its’ excess reserves?
cannot loan out. $30,000 ($3,000 x 10)
4. Define fractional reserve banking 8. Assume a customer deposits $5,000, would the money supply
Process where banks hold a initially increase, decrease, or stay the same? Explain
portion of deposits in reserve and Stay the same. The $5000 is already part of the money supply
loan the rest of the money out 9. After the $5,000 deposit, calculate the new demand deposits
5. What is the equation for the money and excess reserves?
multiplier? Demand deposits=$25,000 Excess reserves = $7,500
1/Reserve requirement 10. What is the maximum possible increase in the money supply
from the $5000 deposit? $45,000 (initial loan x multiplier)
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Topic 4.5- The Money Market
1. What is the transaction demand for money? 5. Draw the demand and supply of money and
People demand money to make everyday label the equilibrium nominal interest rate ir1
purchases. This is not affected by the interest rate
2. What is the asset demand for money? When
people demand money as a liquid asset because
they prefer it to other non-liquid assets like
bonds
3. Why is the demand for money downward-
sloping? When interest rates are high people
prefer less money since they can earn a higher
rate of return by owning bonds instead.
4. Why is the supply for money vertical? The
money supply is set by the central bank and is
unrelated to the nominal interest rate.
6. What are the shifters of money demand (MD)? 7. What are the shifters of money supply (MS)?
Changes in price level- Inflation requires consumer Reserve ratio - the percent of deposits that banks
to hold more cash for financial transactions. must hold in reserve
Changes income- Growth in the economy leads to a Discount rate (DR)- the interest rate that the FED
increase in the demand for money charges commercial banks
Changes in taxation - Government policies such as Open market operations (OMO)- when the FED
changing the capital gains tax buys or sells government bonds (securities)
Topic 4.6- Monetary Policy
1. What is monetary policy? Monetary policy is 7. Fill in the blanks below:
when a central bank manipulates the money
supply to adjust interest rates and influence the Monetary Initial Res. Maximum
overall economy Policy Change Req Change in MS
2. An increase in the reserve requirement causes the Fed Buys
$10 billion .2 ↑$50 billion
money supply to _↓_ and interest rates to _↑_. Bonds
3. If the central bank sells bonds, the money supply Fed Sells
$30 billion .5 ↓$60 billion
will _↓_, interest rates _↑_, and investment _↓_. Bonds
4. If the reserve requirement decreases, the money ↓ Res. Req. $10 billion .1 ↑$100 billion
supply will _↑_ and interest rates _↓_.
5. If the central bank decreases the discount rate, ↑ Res. Req. $6 billion .2 ↓$30 billion
the money supply will _↑_ and interest rates _↓_. ↑ Dis. Rate $20 billion .25 ↓$80 billion
6. If the central bank buys bonds the money supply
will _↑_ , interest rates _↓_, and investment _↑_. ↓ Dis. Rate $4 billion .1 ↑$40 billion
8. What is the difference between the 9. What is the difference between the money supply and the
discount rate and the federal funds monetary base? The money supply includes money in
rate? The discount rate is the circulation and demand deposits. The monetary base
interest rate the Fed charges banks. includes money in circulation and bank reserves
The federal funds rate is the interest 10. Does open market operations initially change the money
rate that banks charge each other for supply, the monetary base, or both?
overnight loans. The Fed has direct Only the monetary base. Buying/selling bonds initially
control of the DR but not the FFR. change excess reserves which are part of the monetary base
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Topic 4.6- Monetary Policy (continued)
11. Show what happens on each graph when the central bank uses monetary policy to close the gap
12. Add arrows to explain the process: SM↑ → ir↓ → I↑ and C↑ → AD↑ → Full Employment
13. Show what happens on each graph when the central bank uses monetary policy to close the gap
14. Add arrows to explain the process: SM↓ → ir↑ → I↓ and C↓ → AD↓ → Full Employment
Topic 4.7- The Loanable Funds Market
1. Draw the loanable funds market and label 2. What shifts the demand for loanable funds?
the equilibrium real interest rate r1 Anything that changes the amount of borrowing and
investment (e.g. changes in perceived business
opportunities and government borrowing)
3. What shifts the supply for loanable funds? Anything
that changes lending or savings (eg. changes in
private or public savings, changes in the profitability
of loans, changes in lending by foreigners)
4. Why does the loanable funds market involve real
interest rates rather than nominal interest rates?
Lenders and borrowers account for inflation when
they make decisions. Lenders ignore nominal rates
of return and focus on real rates of return adjusted
for inflation)
5. If the government increases borrowing, will the real interest rate increase or decrease? Increase
6. A decrease in business investment would _↓_ real interest rates and _↓_ the quantity of loans
7. An increase in private savings would _↓_ real interest rates and _↑_ the amount of physical capital
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