AP Macroeconomics
Mrs. Ungeheier
Study Guide – Section 5 The Financial Sector
Readings:
Module 22:
Saving, Investment, and the Financial System (Pp. 221-230)
Module 23:
The Definition and Measurement of Money (Pp.231-236)
NCEE Macro Unit 4 Activity 34 & 35
Module 24:
The Time Value of Money (Pp. 237-242)
Module 25:
Banking and Money Creation (Pp. 243-252)
NCEE Macro Unit 4 Activity 37
Module 26:
The Federal Reserve System: History and Structure (Pp. 253-261)
NCEE Macro Unit 4 Activity 38
Module 27:
The Federal Reserve System: Monetary Policy (Pp. 262-267)
NCEE Macro Unit 4 Activity 40
Module 28:
The Money Market (Pp. 268-276)
NCEE Macro Unit 4 Activity 39
Module 29:
The Market for Loanable Funds (Pp. 277-290)
NCEE Macro Unit 4 & 5 Activity 41, 43a, 44, & 45
Quizzes (22-29)
M/C Test
Vocabulary Test
Free Response Test
Overview
This section presents the financial sector of the economy and explains how it facilitates
economic activity. It discusses the various types of financial assets, such as savings and
investments, and looks at the financial system. It also discusses institutions and policy, including
banking and the Federal Reserve System. Finally, it explores the money and loanable funds
markets.
Key Terms:
Module 22
Interest rate
Savings-investment spending identity
Budget surplus
Budget deficit
Budget balance
National savings
Module 25
Bank reserves
T-Account
Reserve ratio
Required reserve ratio
Bank run
Deposit insurance
Capital inflow
Wealth
Financial asset
Physical asset Liability
Transaction costs
Financial risk
Diversification
Liquid illiquid loan default loan-backed securities
Financial intermediary
Mutual fund
Pension fund
Life insurance company
Bank deposit
Bank
Module 23
Money
Currency in circulation
Checkable bank deposit
Money supply
Medium of exchange
Store of value
Unit of account
Commodity money
Commodity-backed money
Fiat money
Monetary aggregate
Near-monies
Reserve requirements
Discount window
Excess reserves
Monetary base
Money multiplier
Module 27
Federal funds market
Federal funds rate
Discount rate
Open-market operations
Module 28
Short-term interest rates
Long-term interest rates
Money demand curve
Liquidity preference model of the
interest rate
Money supply curve
Module 29
Loanable funds market
Rate of return
Crowding out
Fisher effect
Module 24
Present value
Net present value
Key Topics To Remember:
The Meaning of Investment
 When macroeconomists use the term investment spending, they almost always mean
“spending on new physical capital.” This can be confusing because in ordinary life we
often say that someone who buys stocks or purchases an existing building is
“investment.” The important point to keep in mind is that only spending that adds to the
economy’s stock of physical capital is “investment spending,” In contrast, the act of
purchasing an asset such as a share of stock, a bond, or existing real estate is “making an
investment.”
 It’s important to understand clearly the three different kinds of capital” physical capital,
human capital, and financial capital.
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o Physical capital consists of manufactured resources such as buildings and
machines.
o Human capital is the improvement in the labor force generated by education and
knowledge.
o Financial capital is funds from savings that are available for investment spending.
So a country that has a positive capital inflow is experiencing a flow of funds
from abroad that can be used for investment spending.
It is important to understand that savings and investment spending are always equal
whether the economy is open or closed. This is an accounting fact and is referred to as
the savings-investment spending identity.
It is good to have a basic idea of the definition of and differences between the types of
financial assets. However, don’t spend lots of time memorizing specific definitions and
detailed distinctions. Strive to understand the categories of assets in the context of the
macroeconomic models we are developing.
What’s Not in the Money Supply?
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Are financial assets like stocks and bonds part of the money supply? No, not under any
definition, because they’re not liquid enough.
o M1 consists, roughly speaking, of assets you can use to buy groceries: currency,
traveler’s checks, and checkable deposits.
o M2 is broader: it includes things like savings accounts, which can easily and quickly be
converted into M1.
o Normally, for example, you can switch funds between your savings and checking
accounts with a click of a mouse or a call to an automated phone service. By contrast,
converting a stock or a bond into each requires selling the stock or bond—something that
usually takes some time and also involves paying a broker’s fee. That makes these assets
much less liquid than bank deposits. So stocks and bonds, unlike bank deposits, aren’t
considered money.
It is important to understand the distinction between assets and liabilities. Make sure you clearly
understand what an asset and a liability are, and then recognize that any financial instrument
represents both an asset and a liability. For example, a mortgage represents a liability for the
borrower and an asset for the lender; a checking account deposit represents a liability for the bank
providing the check service and an asset to the individual depositing the funds.
Present Value
 Understanding present value requires grasping two important points.
o First, a dollar today is worth more than a dollar in the future. If you receive a dollar
today, you can either spend the dollar immediately (and enjoy the benefits of what you
buy with it) or you can save the dollar (and earn interest on it until you decide to spend it
in the future). In either case, spending now or saving for later, you gain more from
having the dollar right away.
o Second, the interest rate determines the trade-off between receiving a dollar today and
receiving it tomorrow.
 The interest rate is what borrowers are willing to pay to have a dollar to spend immediately and
what lenders must receive in order to give up their dollar until a future date. Approach present
value with this in mind and you will be better able to apply the concept to decision making when
costs and/or benefits come in the future than if you try to memorize a formula without
understanding its underlying principles.
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Creating Money
 The idea that banks can “create” money can be difficult to understand unless you understand the
definition of money and how it is measured. When we say that banks create money, we don’t
mean that they create is in the same way they did before the Civil War—by printing certificates
that could be redeemed for silver coins on demand. We mean that banks are able to expand the
money supply through lending.
 Today, dollar bills are printed by the Treasury Department and issued into the economy by
regional Federal Reserve banks, Banks no longer create currency. But recall that the supply of
money in the economy consists of more than currency. The M1 definition of money includes
currency in circulation, traveler’s checks, and checkable bank deposits. It is through loans, which
change the amount of checkable deposits, that banks create money. Because we have a fractional
reserve banking system (banks are required to keep only a fraction of their deposits as cash in
their vaults or on deposit at the Fed), which banks receive a new deposit, they can increase their
loans. When they make a loan, they increase the amount of checkable deposits, therefore
increasing the money supply.
 It is important to understand the definition and the distinction between the monetary base, the
money supply, and reserves. The money supply is the value of financial assets in the economy
that are considered money: this would include cash in the hands of the public, checkable bank
deposits, and traveler’s checks. Bank reserves are composed of the currency banks hold in their
vaults plus their deposits at the Federal Reserve. The monetary base is the sum of currency in
circulation and bank reserves. The monetary base is smaller than the money supply.
When Is a Central Bank Not a Central Bank? When It’s 12 Banks (a Board of Governors, and an
FOMC).
 The central bank of the United States is more than a single bank—it is a multi-part system. When
the fed was created in 1913, its creation was influenced by the politics and geography of the
country at that time (for example, look at the locations of the 12 regional Federal Reserve Banks).
The Federal Reserve System has both public and private elements, as well as regional banks
spread across the country. The important parts of the Federal Reserve System are summarized
below.
 The Board of Governors is a government agency located in Washington, DC. It oversees the
Federal Reserve System. The board has 7 members, appointed by the President and approved by
the Senate for a 14-year term. Because governors can be appointed to complete the terms of a
governor who did not complete his or her 14-year term (and then serve their own 14-year term),
some governors serve more than 14 years. The Chairman of the Board of Governors is appointed
every 4 years.
 The Federal Open Market Committee (COMC) makes decisions about monetary policy. The
FOMC has 12 voting members at any given time. It is made up of the 7 members of the Board of
Governors, the president of the New York Federal Reserve Bank, and the other 11 regional
Federal Reserve Bank presidents. Only 4 of the other 11 regional Federal Reserve Bank
presidents vote at any given time. Voting seats are rotated among the 11 other regional Federal
Reserve Bank presidents.
Open-Market Operations: Buying and Selling Treasury Bills, Notes, and Bonds
 The term “open-market operations” refers to buying and selling United States Treasury securities
(Treasury bills, notes, and bonds). Treasury securities are bought and sold through auctions held
by the Federal Reserve Bank of New York—that is, they are sold on the “open-market.”
o Treasury securities are sold both to finance the federal government debt and to implement
monetary policy.
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The U.S. Treasury Department must regularly borrow to finance the federal
government’s debt. Approximately one-half of the national debt is held in Treasury
securities.
o The Treasury Department sells many of these securities through auctions held at the
Federal Reserve Bank of New York. Most Treasury securities sold through Federal
Reserve auctions are bought by primary dealers.
 Primary dealers are financial institutions that buy and sell large quantities of
government securities and have established business relationships with the New
York Federal Reserve bank. Currently, there are approximately 19 primary
dealers. Others can purchase Treasury bills, notes and bonds from banks or
brokers in the secondary market.
In addition to selling securities to finance the federal debt, the New York Fed’s Open Market
Desk buys and sells Treasury bills, notes, and bonds to carry out the monetary policy designated
by the FOMC. The Open Market Desk adds reserves to the banking system when it buys
Treasury securities; it drains reserves when it sells Treasury securities.
Remember that when the Fed purchases Treasury bills, it injects reserves into the banking system,
increasing the money supply, and that when the Fed sells Treasury bills, it removes reserves from
the banking system, decreasing the money supply.
Which Interest Rate?
 There are many different interest rates in the economy. For example, there are mortgage interest
rates, automobile loan interest rates, credit card interest rates, and the prime interest rate. The
different interest rates tend to move in the same general direction, moving together like a “web”
of interest rates.
 It is important that you are able to distinguish between two important interest rates in our
macroeconomic models, the federal funds rate and the discount rate.
o The federal funds rate is the interest rate banks charge each other for overnight loans. It
is set in the federal funds market, but is targeted by the Fed. Other interest rates tend to
follow the federal funds rate, rising when it rises and falling when it falls. The other
interest rate in our macroeconomic models is the discount rate.
o The discount rate is the interest rate the Fed charges banks to borrow. The discount rate
is set directly by the Fed.
 You will sometimes hear people say that interest rates do not reflect the supply and demand for
money since the Fed sets the interest rate. In fact, the federal funds rate is determined by the
supply and demand for money in the money market. The only difference is that the Fed adjusts
the supply of money to achieve its target interest rate.
Which Model?
 To discuss monetary policy and interest rates, we have used both the liquidity preference model
(the money market) and the loanable funds model. In this module, we have shown how these two
models are related.
 So how do you know which model to use if you are asked to explain how monetary policy will
affect the macroeconomy? You must understand both models and be prepared to discuss either
one.
 Pay particular attention to the labels on the axes and curves, and the slope of the supply curve in
each graph. Since the Federal Reserve determines the supply of money in the economy, the
equilibrium quantity of money is not affected by the interest rate—therefore the money supply
curve is vertical in the money market. As the interest rate rises, the quantity of loanable funds
supplied increases—the incentive to save is higher when interest rates are higher. Therefore, the
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supply curve for loanable funds has a positive slope. You may be asked specifically to use one or
the other of these models to explain your answer to questions dealing with monetary policy.
When you are not asked specifically to use one model or the other, remember that the money
market determines the interest rate in the short-run and the loanable funds market determined the
interest rate in the long-run.
o Use the money market to discuss short-run changes and the loanable funds market to
discuss changes in the long run. However, in some cases it is possible to explain a
situation using either model. In these cases, just be certain that you explanation is
consistent and correct for the model you choose.
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