AP Macro Unit 4: The Financial Sector & Monetary Policy

Financial Assets

Written claims where the buyer has the right to future income from the seller.

Liquidity

The ease with which an asset can be converted into cash without significant loss of value.

Return (Rate of Return)

The profit earned on an investment relative to its cost.

Risk

The uncertainty that an investment will earn its expected rate of return.

Direct Relationship

High-risk assets generally must offer a higher potential return to entice investors.

Stock (Equity)

Represents partial ownership in a firm; stockholders have a claim on profits and usually voting rights.

Bond (Securities)

A certificate of indebtedness; the borrower promises to pay back the principal plus fixed interest payments.

Loan

An agreement between a lender and a borrower, usually non-tradable unlike bonds.

Inverse Relationship

As interest rates rise, bond prices fall; as interest rates fall, bond prices rise.

Nominal Interest Rate

The stated interest rate paid on a loan or bond, not adjusted for inflation.

Real Interest Rate

The interest rate adjusted for the effects of inflation, measuring increase in purchasing power.

Fisher Equation

A formula to calculate the real interest rate: rₕₑₐₗ = iₙₒₘᵢₐₗ - πₑₓₚₑᵣᵢₙₜⁱₐₗ.

Medium of Exchange

An asset that is generally accepted for the payment of goods and services.

Unit of Account

Measures the relative value of goods and services.

Store of Value

Allows purchasing power to be saved for future use.

Commodity Money

Money that has intrinsic value, e.g., gold or salt.

Fiat Money

Money that has no intrinsic value and is valued by government decree.

M1

A measure of the money supply that is very liquid, including cash and checkable deposits.

M2

A measure of the money supply that is less liquid, including M1 plus savings deposits and small time deposits.

Monetary Base

Currency in circulation plus bank reserves.

Fractional Reserve Banking

A banking system where banks hold a fraction of deposits in reserve and lend out the rest.

Required Reserves

The specific percentage of deposits that banks are required to hold.

Excess Reserves

The amount of reserves banks hold above the required minimum, which can be lent out.

Money Multiplier

The formula that shows the maximum amount of money that can be created with a change in reserves.

Crowding Out

When government borrowing increases interest rates which decreases private investment.

Money Market

A market that determines the supply and demand for real money balances.

Loanable Funds Market

A market where savers supply money and borrowers demand money at a determined real interest rate.

Open Market Operations (OMO)

The buying and selling of government bonds by the Fed to influence the money supply.

Discount Rate

The interest rate charged by the Fed to banks for short-term loans.

Reserve Requirement

The percentage of deposits that banks must keep on reserve, regulated by the Fed.

Administered Interest Rates

Interest paid to banks on reserves held at the Fed.

Aggregate Demand (AD)

The total demand for goods and services in an economy.

Transaction Demand

The demand for money based on the need to purchase goods and services.

Asset Demand

The demand for money held as a store of value.

Shifters of Money Demand

Factors such as price level, real GDP, and technology that can shift the demand for money.

Supply of Loanable Funds

The total amount of money available for borrowing in the economy.

Demand for Loanable Funds

The total amount of money demanded by borrowers in the economy.

Real Interest Rate ($r$)

The interest rate that accounts for inflation.

Investment ($I$)

Expenditures on capital goods that will be used for future production.

Interest-Sensitive Consumption ($C$)

Consumer spending that is affected by changes in interest rates.

Fiscal Policy

Government spending and taxation policies designed to influence economic activity.

Expansionary Fiscal Policy

Government policy aimed at increasing economic growth, often via higher deficit spending.

Deficit Spending

When government spending exceeds revenue, necessitating borrowing.

Price Level

The average of current prices across the entire spectrum of goods and services produced in the economy.

Technology's Impact on Money Demand

Innovations like credit cards that reduce the need to hold physical cash.