AP Macroeconomics Unit 4 (Financial Sector): Financial Assets, Money & Banking, Money Market, Monetary Policy, and Loanable Funds

Financial sector

The part of the economy that channels saving into investment by connecting savers (funds to lend) with borrowers (funds to borrow).

Financial asset

A claim on future payments; you give up money today in exchange for expected future benefits (interest, dividends, or repayment of principal).

Physical asset

A real, tangible investment good (machines, buildings, equipment) used to produce goods and services.

Liquidity

How easily an asset can be accessed and converted into cash; cash is the most liquid asset.

Rate of return

The net gain or loss on an investment over a period of time; higher expected returns are preferred (all else equal).

Risk

The chance that an investment’s actual gains differ from the expected outcome.

Bank deposit

Money in a bank account; it is an asset for the depositor and a liability for the bank.

Demand deposit (checking account)

A highly liquid bank deposit that can typically be used whenever you want (e.g., via debit card).

Deposits as bank liabilities

Customer deposits are liabilities for banks because the bank owes depositors those funds.

Loan

A borrowing arrangement repaid with interest; to the lender, the loan is a financial asset because it is a claim on repayment.

Stock (equity)

A certificate representing ownership in a firm; a claim to a share of ownership.

Equity financing

Raising funds by issuing shares of stock to the public.

Bond

A certificate of indebtedness from an issuer to a bondholder, promising repayment (typically with interest).

Debt financing

Raising investment funds by issuing bonds to the public.

Secondary market

A market where existing financial assets (like bonds) are bought and sold after they are first issued.

Interest rate

The “price” of borrowing money: the percentage return paid to the lender (and cost to the borrower).

Bond price–interest rate inverse relationship

Bond prices and interest rates move in opposite directions: when interest rates rise, existing bond prices fall; when interest rates fall, existing bond prices rise.

Present value (PV)

The current value of a future payment, found by discounting the future value; higher interest rates lower present value (e.g., PV = FV/(1+i)).

Nominal interest rate

The quoted interest rate not adjusted for inflation; measured in dollar terms.

Real interest rate

The interest rate adjusted for inflation; measures the purchasing-power return to lenders (and purchasing-power cost to borrowers).

Fisher equation (AP version)

Relationship linking nominal interest rate, real interest rate, and expected inflation: i = r + π^e (so r = i − π^e).

Expected inflation (π^e)

The inflation rate people anticipate when contracts (like loans and bonds) are set; nominal rates tend to reflect expected inflation.

Positive real interest rate

When the nominal interest rate is higher than inflation, so savers gain purchasing power over time.

Negative real interest rate

When the nominal interest rate is lower than inflation, so savers lose purchasing power and borrowing can become unusually attractive.

Money (macroeconomic definition)

Anything widely accepted as payment for goods and services and to settle debts (distinct from wealth or income).

Fiat money

Money with no intrinsic value (paper and coins) backed by trust that the government maintains its value.

Commodity money

Money that has alternative non-monetary uses (e.g., gold, silver, tobacco) while also functioning as money.

Medium of exchange

A function of money: it is used to buy and sell goods and services, avoiding barter’s double coincidence of wants.

Unit of account

A function of money: it provides a common measure for prices and relative values.

Store of value

A function of money: it transfers purchasing power into the future (works best when inflation is low).

Characteristics of good money

Traits that make money effective: durable, portable, divisible, uniform, limited in supply (scarce), and acceptable (trusted).

Money supply

The quantity of money in circulation as measured by the Fed (commonly using M1 and M2); in the AP money market model it is fixed at a point in time (vertical supply curve).

M1

A very liquid measure of money: currency, checking (demand) deposits, and traveler’s checks.

M2

A broader measure of money: M1 plus savings deposits, small time deposits, money market deposit accounts, and money market mutual funds.

Monetary base (MB/M0)

Currency in circulation plus bank reserves; MB = currency in circulation + bank reserves.

Bank reserves

Funds banks hold (as cash and/or deposits at the Fed) that form the foundation for deposit expansion in fractional reserve banking.

Balance sheet

A statement listing what an institution owns and owes: assets, liabilities, and net worth (bank capital).

Bank capital (net worth)

A bank’s net worth: assets minus liabilities.

Fractional reserve banking

A banking system where banks hold only a fraction of deposits as reserves and can use the rest (excess reserves) to support lending.

Required reserve ratio (rr)

The fraction of deposits that must be held as reserves (often treated as the required ratio in AP).

Reserve requirement

A Fed regulation setting the minimum reserve ratio banks must hold.

Required reserves (RR)

The minimum reserves a bank must hold: RR = rr × D (where D is checkable deposits).

Excess reserves

Reserves held above the required minimum; in the AP model, these are the reserves available to support new lending/deposit expansion.

Deposit creation (money creation via lending)

In the AP model, when a bank makes a loan it credits a borrower’s checking account, creating new deposits and expanding the money supply.

Money multiplier

The maximum deposit expansion from one dollar of excess reserves in the AP model: m = 1/rr, and ΔM = (1/rr) × ΔR.

Money demand

The desire to hold wealth in liquid form (cash/checking) instead of interest-bearing assets; it reflects the opportunity cost of holding money.

Transaction demand for money

Money held to conduct everyday transactions; not related to the interest rate and increases with nominal GDP.

Asset demand for money

Money held as an asset; falls as nominal interest rates rise because the opportunity cost of holding money increases.

Open market operations (OMOs)

The Fed’s buying and selling of government securities: purchases raise reserves and tend to increase the money supply (lower rates); sales reduce reserves and tend to decrease the money supply (raise rates).

Crowding out

When government borrowing increases (often from a budget deficit), raising the real interest rate in the loanable funds market and reducing private investment relative to what it would have been.