Section 5

Banking and Money

Key Terms Interest Rate Bank Deposit Discount Window Savings-investment spending identity Bank Excess Reserves Money Monetary Base Budget Surplus Currency in circulation Money Multiplier Budget Deficit Checkable Bank Deposits Central Bank Budget Balance Money Supply Commercial Bank National Savings Medium of Exchange Investment Bank Capital Inflow Store of Value Federal Funds Market Wealth Unit of Account Federal Funds Rate Financial Asset Commodity Money Discount Rate Physical Asset Commodity-backed Money Open-market Operation Liability Fiat Money Short-term Interest Rates Transaction Costs Monetary Aggregate Long-term Interest Rates Financial Risk Near-moneys Money Demand Curve Diversification Future Value Liquidity Preference Model of the interest rate Liquid Present Value Illiquid Net Present Value Money Supply Curve Loan Bank Reserves Loanable Funds Market Default T-account Rate of Return Loan-backed Securities Reserve Ratio Crowding Out Financial Intermediary Required Reserve Ratio Fischer Effect Mutual Fund Bank Run Pension Fund Deposit Insurance Life Insurance Company Reserve Requirements

Key Formulas Savings-Investment Spending Identity: Savings = Investment Spending Budget Balance = tax revenue – gov’t spending – transfer payments National Saving = Savings + Budget Balance

Key Formulas M1 = currency and coin + traveler’s checks + checking deposits M2 = M1 + near moneys Monetary Base = Bank Reserves + Currency in Circulation Money Supply = Currency in Circulation + Checkable Bank Deposits

Key Formulas Future Value: FV = PV(1+r)t Present Value: PV = FV/(1+r)t

Key Formulas Money Multiplier = 1/rr rr = reserve ratio *know the difference between “reserves”, “required reserves”, “excess reserves”, and “reserve ratio”

Key Formulas Rate of Return = (revenue – cost)/cost * 100 Real Interest Rate = Nominal Interest Rate - Expected Inflation Nominal Interest Rate = Real Interest Rate + Expected Inflation

Key Graphs Assets Liabilities T-accounts Loans $1,800,000 Cash Reserves $200,000 Deposits $2,000,000 In this example the bank is holding 10% of its deposits in reserve

Money Market Fed controls the MS 4 shifters of MD – technology, PL, realGDP, institutions

Crowing Out Effect

Liquidity Preference Model

The Two Models According to the liquidity preference model, a fall in the interest rate results in an increase in I spending, and following that an increase in RGDP and Consumption The increase in RGDP results in an increase in consumption AND savings (through the multiplier) How much do savings rise? Because of the savings-investment identity we know that savings = investment So a fall in the interest rate leads to higher investment spending, and the resulting increase in RGDP generates exactly enough additional savings to match the rise in investment spending. After a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded Note: In the long run, changes in the money supply DO NOT affect the interest rate.

AP Exam Tips The amount of savings is equal to the amount of investment. Know the roles (medium of exchange, etc.) and types of money (fiat, etc.). The term “money supply” usually refers to M1. Understand T-accounts, they often show up on exams. Banks do not print money, only the Treasury can do that. Excess reserves are important because these reserves are what banks can lend out to borrowers. The money multiplier is 1/rr where rr is the reserve ratio. The Federal Reserve = the Fed = the central bank. The most important function of the Fed is to conduct monetary policy. Three tools: RR, Discount Rate, OMO. The interest rate, r, used in the money market graph is the nominal interest rate. Changes in aggregate price level, rGDP, technology and banking institutions shift the money demand curve. Use real interest rate, r, for the loanable funds market graph. This refers to the fact that the real interest rate and nominal interest rate rise and fall together with expectations about inflation. If the question asks about or references the real interest rate, label the graph with the real interest rate. The incentive to lend money is higher when the interest rate is higher. This is why the supply of loanable funds is upward sloping.

Practice Question Suppose RGDP is $2.5 trillion and potential GDP is $1 trillion and the reserve requirement is 20%? Based on sound macroeconomic policy, what should the government do? 1.5 = x*1/0.2 1.5 = x*5 x=1.5/5 x=300 bill