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Macroeconomics Unit 4: Financial sector

Banks create money through lending, the Federal Reserve controls the money supply and interest rates, and the loanable funds market links saving and investment.

Covers: Financial assets and interest rates, nominal vs. real interest rates, money and its functions, banking and the money multiplier, the money market, monetary policy, the loanable funds market

Study guide

Financial assets include money, stocks (ownership shares) and bonds (loans to firms or governments). Bond prices and interest rates move in opposite directions. The nominal interest rate is the stated rate, and the real interest rate = nominal rate − expected inflation, the true cost of borrowing.

Money serves as a medium of exchange, a unit of account and a store of value. The money supply is measured as M1 (currency and checkable deposits, now including savings deposits) and M2 (M1 plus small time deposits and money market funds). Banks operate on fractional reserves: they keep required reserves and lend excess reserves. When a bank lends, the money is deposited elsewhere and lent again, expanding the money supply. The money multiplier = 1 ÷ reserve requirement, so the maximum change in the money supply equals excess reserves times the multiplier. A bank's balance sheet (T-account) shows assets (reserves, loans, bonds) and liabilities (deposits).

In the money market, the demand for money slopes downward against the nominal interest rate, and the money supply is vertical, set by the central bank. The Federal Reserve conducts monetary policy. Expansionary policy (buying bonds through open market operations, lowering the discount rate or the interest on reserves, or lowering reserve requirements) increases the money supply, lowers interest rates, increases investment and shifts AD right. Contractionary policy does the opposite to fight inflation. Today the Fed operates with ample reserves and mainly adjusts administered rates like the interest on reserve balances to target the federal funds rate. The loanable funds market sets the real interest rate: supply comes from saving and demand from borrowing for investment. Government budget deficits increase demand for loanable funds, raising real interest rates and crowding out private investment.

In the ample-reserves framework, the reserve market is graphed with the policy rate (the federal funds rate) on the vertical axis and the quantity of reserves on the horizontal axis. Reserve demand slopes down and then flattens at the interest rate on reserves, and the vertical reserve supply crosses it in the flat part. Raising or lowering the administered rates shifts the flat section up or down, moving the policy rate with it, even though the quantity of reserves doesn't change. Holding cash has an opportunity cost: the interest you could earn on bonds. So when the nominal interest rate rises, people hold less money. People demand money for transactions (buying things) and as an asset. An increase in the price level or real GDP raises money demand and shifts it right.

Investment demand slopes downward against the real interest rate, because fewer projects are profitable when borrowing costs more. A change in the interest rate moves along the curve. Changes in expected returns, business taxes, technology or the existing capital stock shift it. Barter requires a double coincidence of wants: each trader must have what the other wants. Money removes that problem by serving as a medium of exchange.

When someone deposits currency already in circulation, M1 doesn't change at first, because cash simply becomes a checkable deposit. Only the new loans the bank makes from excess reserves create money. So the maximum new money equals the excess reserves times the money multiplier, not the whole deposit times the multiplier. When the Fed buys bonds, however, the purchase itself adds new money.

Key ideas

• Bond prices and interest rates move in opposite directions.
• Real interest rate = nominal rate − expected inflation.
• Banks expand the money supply by lending excess reserves.
• The Fed uses open market operations and administered rates to change interest rates.
• Government borrowing can crowd out private investment.

Formulas and rules

Common mistakes

• Thinking the Fed prints money to buy bonds directly from the Treasury; open market operations trade existing bonds with banks.
• Forgetting that a new deposit's required reserves can't be lent out.

Words to know

Financial asset

A claim like money, a stock or a bond.

Stock

A share of ownership in a corporation.

Bond

A loan to a firm or government that pays interest.

Nominal interest rate

The stated interest rate.

Real interest rate

Nominal rate minus expected inflation.

Medium of exchange

Money's use in buying and selling.

Unit of account

Money's use for measuring value.

Store of value

Money's use for holding wealth over time.

M1

Currency, checkable deposits and savings deposits.

M2

M1 plus small time deposits and money market funds.

Fractional reserve banking

Banks keep only a fraction of deposits as reserves.

Required reserves

Deposits a bank must hold back.

Excess reserves

Reserves above the required amount, available to lend.

Money multiplier

1 ÷ reserve requirement.

Federal Reserve

The US central bank, which conducts monetary policy.

Open market operations

The Fed buying or selling government bonds.

Discount rate

The rate the Fed charges banks for loans.

Federal funds rate

The rate banks charge each other for overnight loans.

Interest on reserve balances

The rate the Fed pays banks on reserves, a key policy tool.

Expansionary monetary policy

Increases the money supply and lowers interest rates.

Loanable funds market

Where saving (supply) meets borrowing (demand) to set the real interest rate.

Crowding out

Government borrowing raising interest rates and reducing private investment.

Sample practice questions

23 more questions like these, from level 1 to 5, are in the practice set.