Financial Sector: every key term you need (+ practice quiz)

More AP Macroeconomics guides

• Basic Economic Concepts
• Supply, Demand, Elasticity
• National Income & Price
• Long-Run Growth

Money Functions

Medium of exchange, store of value, unit of account. Enables trade, saving, pricing. Fiat money: backed by government, not commodity.

Money Supply (M1, M2)

M1: currency + checking accounts (immediate spending). M2: M1 + savings, money market (less immediate).

Central Bank (Fed)

Controls money supply, sets interest rates, regulates banking. In US: Federal Reserve. Independent agency.

Monetary Policy

Fed controls money supply/interest rates to achieve goals: stable prices, full employment. Expansionary (↑ money) or contractionary (↓ money).

Open Market Operations (OMO)

Fed buys/sells government securities. Buy = inject money (expansionary). Sell = remove money (contractionary).

Discount Rate

Interest rate Fed charges banks. High rate = discourages borrowing (contractionary). Low rate = encourages borrowing (expansionary).

Reserve Requirement

Percentage of deposits banks must hold as reserves (can't lend). Decrease = banks lend more (expansionary). Rare tool now.

Interest Rates & Inflation

Real interest rate = nominal rate - inflation. Fed targets nominal; real affected by inflation expectations.

Yield Curve

Plot interest rates vs. maturity. Normal: upward (longer = higher rate). Inverted: downward (signals recession).

Bank Multiplier

Deposit multiplies through banking system. If reserve requirement 20%, multiplier = 5. $100 deposit → $500 money creation.

Unit 4 Summary

Money enables trade. Central bank controls supply via OMO, discount rate, reserves. Monetary policy affects interest rates, inflation, employment.

Liquidity

How quickly an asset converts to a medium of exchange without loss of value. Currency is most liquid; real estate is among the least.

Money Demand Curve

Downward sloping against the nominal interest rate, which is the opportunity cost of holding money rather than interest-bearing assets.

Shifts in Money Demand

Higher price levels or higher real GDP increase transactions demand and shift money demand right, raising the nominal interest rate.

Money Supply Curve

Drawn vertical because the central bank sets the quantity of money independent of the interest rate.

Required vs Excess Reserves

Required reserves are the mandated fraction of demand deposits. Excess reserves are holdings above that, and only excess reserves can be lent out.

Simple Money Multiplier

1 divided by the required reserve ratio. A 10 percent ratio gives a maximum multiplier of 10 on new excess reserves.

Why the Multiplier Falls Short

Cash leakage from the banking system and banks voluntarily holding excess reserves both reduce actual money creation below the theoretical maximum.

T-Account

A bank balance sheet with assets (reserves, loans, securities) on the left and liabilities plus net worth (demand deposits, owners' equity) on the right.

Bond Prices and Interest Rates

Bond prices and yields move inversely. When the Fed buys bonds, bond prices rise and interest rates fall.

Federal Funds Rate

The overnight rate banks charge each other for reserves. It is the Fed's principal policy target, adjusted through open market operations.

Interest on Reserves

Paying interest on reserve balances sets a floor under short-term rates; raising it encourages banks to hold reserves rather than lend.

Quantity Theory of Money

MV = PQ. If velocity and real output are stable, growth in the money supply translates roughly one-for-one into inflation.

Velocity of Money

The average number of times a dollar is spent on final goods per year, equal to nominal GDP divided by the money supply.

Money Neutrality

In the long run, changes in the money supply affect the price level and nominal variables but leave real output and employment unchanged.

Monetary Policy Transmission

Money supply increase, then nominal interest rate falls, then investment and interest-sensitive consumption rise, then AD shifts right.

Liquidity Trap

When nominal interest rates approach zero, further money injections may fail to lower rates or stimulate borrowing, limiting monetary policy.

Taylor-Style Rule Thinking

Policy rates should rise when inflation is above target or output is above potential and fall when the opposite holds.

Real vs Nominal in Loan Markets

Lenders set the nominal rate as the desired real rate plus expected inflation. Errors in that expectation redistribute wealth between borrower and lender.

Fiscal and Monetary Policy Conflict

Simultaneous fiscal expansion and monetary contraction leave the effect on real GDP ambiguous while unambiguously raising the real interest rate.

Discount Window vs Federal Funds

The discount rate is what banks pay to borrow from the Fed; the federal funds rate is what they pay to borrow from each other, and it is usually lower.

Fractional Reserve Banking

Banks hold only a fraction of deposits as reserves and lend the rest, which is how the banking system multiplies an initial deposit into a larger money supply.

Assets vs Liabilities for a Bank

Loans and securities are assets because others owe the bank; customer demand deposits are liabilities because the bank owes depositors.