Section Five Review

THE FINANCIAL SECTOR

Cheat Sheet Notes

Module 22
The relationship between savings and investment spending
o Savings-investment spending identity (savings=investment spending)
o National savings = private savings + budget balance
Private savings=GDP-Taxes-Consumption
o Capital inflow = Exports (funds coming in) imports (funds going out)
Financial system
o Reduce transaction costs
o Reduce risk
o Providing liquidity
Financial assets
o Loans: lots of transaction costs
o Bonds: less transaction costs, risk in defaults, pretty liquid
o Loan-backed securities: more diversified, liquid than loans, some risk
o Stocks: reduces risk for business, more risk for buyers
Financial intermediaries
o Mutual funds
o Pension funds
o Life insurance
o Banks: illiquid loans, liquid deposits
Module 23
We use fiat money
Three roles of money
o Medium of exchange: we use money to get something rather than
bartering
o Store of value: money lasts over time, can be saved. You cant use milk as
money and save it since it would spoil over time
o Unit of account: much clearer to give flat $5 for potatoes rather than
working at the farm for X days in exchange
Measures of money supply
o M1= currency in circulation + checkable bank deposits + travelers checks
o M2= M1 + savings account + short-term CDs + money market
accounts/money market mutual funds
Savings bonds, stocks not included in either
Module 24
In general, a dollar today is worth more than a dollar a year from now
Present value/future value
o FV = Present value x (1+ Interest rate)^(# of years)

o PV = Future value/(1 + Interest rate)^(# of years)

o See video from Kahn Academy
Module 25
Role of banks
o Bank reserves=currency in vaults + deposits at Fed
o T-accounts (aka surprise devil spawn)
Total reserves=excess reserves + required reserves
Required reserves = deposits x required reserve ratio
Excess reserves = total/actual reserves required reserve
When doing a before-loan, after-loan T-chart, remember: theres
T-chart #1, where reserves and deposits increase by the same
amount, no change in money supply. In T-chart #2, though, banks
hold only a fraction of that initial deposit and loan out the excess,
which will decrease reserves, and increase loans by the same
amount, while deposits have no change. This T-chart increases the
money supply.
How banks create money
o Money multiplier = 1/reserve requirement
o Money multiplier x initial increase in money base
Module 26
History/structure of the Federal Reserve Board
o FRB made after Panic of 1907
o Board of Governors and 12 Federal reserve districts
Financial crises
o S&Ls in the 80s screwed housing market
o LCTMs in the 90s ruined asset prices
o Housing bubble of early 2000s
o So 2008 crisis: subprime lending, securitization, deleveraging, and low
interest rates in the housing market contributed to bad stuff
Module 27
What the Fed does
o Federal funds rate: if Fed raises reserve requirements, money supply
decreases. If the Fed lowers reserve requirements, money supply increases
o Discount rate: higher spread, money supply decreases. lower spread,
money supply increases
o Open market operations: Fed buying Treasury bills/open market purchases
increases money supply; Fed selling Treasury bills/open market sales,
decreases money supply
Module 28
Money demand curve
o Higher short term interest rate, higher opportunity cost of holding money
o Lower short term interest rate, lower opportunity cost of holding money
o Short term interest rate = opportunity cost

o For the money demand curve, nominal interest rate = real interest rate for
short term
o Shifting MD: price levels (positively correlated), real GDP (positively
correlated), technology (negatively correlated), institutions (better
banking, MD increases, vice-versa)
Liquidity preference model
o Includes MD and MS
o Shifting MS: FRB uses open-market operations mostly, sometimes
discount window and federal funds rate
o Shifting MS changes interest rate; higher MS, lower interest rate. Lower
MS, higher interest rate
Module 29
Loanable funds market (borrowers and lenders model)
o Care about real interest rate for this model
o Rate of return = 100 X (project revenue-cost of project/cost of project)
o Demand shifters
Perceived business opportunities (better econ quality, higher
demand; vice-versa)
Government borrowing (deficits, higher demand. Surpluses, lower
demand)
o Supply shifters
Private savings behaviors (higher household consumption, lower
supply; vice-versa)
Capital inflow (stable econ, inflow increasing, savings increasing;
poor econ, inflow drops, savings drop)
o Real interest rate = nominal interest rate inflation rate
o On the LFM graph (short-run especially):
Demand and interest rates positively correlated
Supply and interest rates negatively correlated
o In the long-run, changes in the money supply dont affect interest rates

Graph Examples

Liquidity preference model:

http://www.reffonomics.com/TRB/chapter30/moneymarketgraph12.swf
Loanable funds market:
http://www.reffonomics.com/TRB/chapter30/loanablefundsmarket12.swf

Quizlet Links
All vocab from this section (72 words):
http://quizlet.com/77519394/ap-econ-section-5-vocabulary-flash-cards/
All equations from this section (20):
http://quizlet.com/77543117/ap-econ-section-5-equations-flash-cards/

Practice Problems/More Info

http://www.learnerator.com/ap-macroeconomics/q/303/currency
Some of the problems (not necessarily multiple choice) on Mr. Hoyles review
can be helpful with T-charts.
https://sites.google.com/a/jeffcoschools.us/apmacro/unit-5
www.forexfactory.com/attachment.php?attachmentid=764688&d=1313514931
I highly recommend these three for extensive practice:
http://bernardsboe.oncoursesystems.com/school/webpage/documents/cTGG9hcX
PI2faRG2bf/4752279-344845/downloadFile.aspx
https://facweb.northseattle.edu/tskeel/KrugWellsECPS3e_Macro_CH10.pdf
http://advanced-placementmacroe.stafford.forge.schoolfusion.us/modules/locker/files/get_group_file.phtml?
fid=3663549&gid=511697

Videos
Present value Kahn Academy
Loanable funds
T-charts or bank balance sheets
Module 29 Pt. 2 (LFM, Interest rates, short-run, long-run)