Unit 5: The Financial Sector Modules 22-29

Module 22 Key Terms & Review YOYO! The vocabulary in this module will aid in your understanding of Unit 5, but is unlikely to be emphasized on the AP Exam. 1. 2. 3. 4. 5.

Module 23 Key Terms & Review YOYO! Easy concepts that WILL be tested on the AP Exam. 1. 2. 3. 4. 5.

Module 24 Key Terms & Review Net present value 1. 2. 3. 4. 5.

Time Value of Money

Economic Decision Making Cost/benefit analysis is difficult because the benefits & costs of a decision do not always occur at the same time Chicken nuggets: benefit now / cost now = College degree: benefit later / cost now = Car loan: benefit now / cost later = Would you rather have $1 today or $1 next year? What factors affect your decision?

Borrowing, Lending, & Interest You wish to purchase the new Nimbus 2000 racing broom for $1,000. Your parents have agreed to give you the $$ for being such a good kid. Receive the money at graduation: Receive the money now: Moral of the story:

Present Value Costs & benefits that you will receive in the future must be converted to present values in order to make better decisions What amount would you be willing to accept today as a substitute for receiving $1 a year from now?

Present Value cont. Interest rate (r) = 10% Future value of $Z in N years = Present value of $1 ~ how much would you need to set aside today to have $1 in N years?

Let’s practice! Net present value = the present value of current & future benefits minus the present value of current & future costs 3 options: $100 now, no cost Net present value = Pay $10 now, receive $115 in a year $119 now, pay $20 in one year

Module 25 Key Terms & Review Bank reserves Reserve ratio Bank run Deposit insurance Discount window Excess reserves Monetary base 1. 2. 3. 4. 5.

Banking & Money Creation Fractional Reserve Banking System Banks must keep a certain % of their depositors’ $$ on hand (or in their account @ the Fed) to handle the daily demand for cash

T-accounts Both sides must ALWAYS balance. Deposits are a liability to a bank because their customers can withdraw the $$ at any time Reserves are an asset because the money is not out in circulation Loans are an asset because they represent $$ owed to the bank What happens when people want to withdraw more than $100,000???

Give me my money you @#&* !!! Bank runs! When too many depositors want to withdraw their money at the same time Bank regulations should prevent this from happening Give me my money you @#&* !!!

Bank regulations Deposit insurance Capital requirements Reserve requirements Discount window

Determining the Money Supply Banks affect the money supply by

Money creation Harry finds $100 in the Room of Requirement and opens up a checking account @ Gringotts. Has the money supply changed? How much does Gringotts have to keep in their vault if the reserve requirement is 10%? Hermione comes into Gringotts for a broom loan. How much can they lend her? .

Money Creation cont. Now that a new account has been created, the process begins again… Hermione deposits her $90 in the Bank of Gryffindor. How much does the bank have to keep in their vault?

The Money Multiplier How much money will be created if all of the money is loaned out and redeposited back into the banking system? Money multiplier = Original deposit of $100 turns into Change in total money supply =

Is this for real? Sort of… In reality, not all available money is borrowed and not all loans are redeposited into the system  Fed controls the monetary base 

Module 26 Key Terms & Review Central bank Commercial bank Investment bank Savings & Loans 1. 2. 3. 4. 5.

The 3rd greatest man who ever lived…

The Structure of the Fed Board of Governors 12 District Banks Federal Open Market Committee

District Banks

Module 27 Key Terms & Review Federal funds rate Discount rate Open-market operation 1. 2. 3. 4. 5.

The Functions of the Fed Provide financial services to depository institutions (banks) & the government Supervise and regulate banks Maintain the stability of the financial system (no pressure!) Conduct monetary policy

Tools of the Fed Reserve requirement Discount rate Fed can raise or lower to alter bank reserves & loans What if a bank can’t meet their reserve requirement? Discount rate

Tools cont. Open-market operations The Fed holds government savings bonds (Treasury bills) as assets

Module 28 Key Terms & Review Short term interest rates Long-term interest rates Money demand curve Money supply curve 1. 2. 3. 4. 5.

The Demand for Money Why do people hold money? What is the opportunity cost of holding money? What is the relationship between the interest rate and the opportunity cost of holding cash?

Short-term v. Long-term rates Short-term interest rate Long-term interest rate We care more about short-term interest rates because they are more relevant to our decision to hold cash

Money Demand Curve Indirect relationship between the nominal interest rate and the quantity demanded of money Shifts in the money demand curve

Money & Interest Rates The FOMC meets 8 times a year to set a target federal funds rate, which influences all short-term interest rates How do they do this?

Module 29 Key Terms & Review Rate of return Crowding out Fisher effect 1. 2. 3. 4. 5.

Loanable Funds Market For the economy as a whole, savings = Financial markets bring savers & borrowers together

Shifts in the Loanable Funds Market Demand Supply

Inflation & Interest rates Expectations about future inflation have a huge impact on interest rates See Module 14 “Winners and Loser from Inflation” Fisher effect Both borrowers & lenders change their demands based on inflation expectations

Short-run Determination of the Interest Rate

Types of Monetary Policy Easy money = expansionary Increase MS to stimulate AD ___ securities ___ the reserve ratio ___ the discount rate Tight money = contractionary / restrictive Decrease MS to slow down AD

Helpful Hints Money converted from cash  a checking account does NOT change the total amount of M1, just its composition Reserve requirement applies to Checking and savings accounts Money earned by the public from the sale of a bond Reserve requirement does NOT apply to Money earned by a bank from the sale of a bond to the Fed Money that a bank borrows from the Fed (discount rate) Total change in demand deposits Include the cash that was converted to a checking account Total change in the money supply Do NOT include cash – it was already part of M1

Crowding-out effect Or there’s the easier way to look at it…  Government deficit spending leads to an increase in the # of government savings bonds available Greater supply of bonds = lower price = higher rate of return on your investment Bonds look more attractive to savers = other institutions that offer investments have to raise their interest rates to compete for customers Higher interest rates hurt borrowers (decrease in C and Ig) Banks will use loanable funds to invest in bonds = less available to consumers and businesses Or there’s the easier way to look at it…  Government borrowing is part of the demand for money Increase in demand leads to higher interest rates