Financial Sector in AP Macroeconomics Unit 4 Review

The financial sector is critical in the economy, enabling the movement of money and resources. It includes banks, investment firms, and insurance companies, providing essential services to individuals and businesses. The financial sector's operation is crucial for understanding economic flow and monetary stability.

Key Financial Institutions

• Commercial Banks
  • Accept deposits and provide loans
  • Offer financial services like checking and savings accounts
  • Types of loans include mortgages, car loans, personal and business loans
• Investment Banks
  • Aid in capital raising for companies and governments by underwriting and selling securities
• Insurance Companies
  • Offer protection against financial losses (e.g., life, health, property insurance)
  • Collect premiums and pay out claims
• Pension Funds
  • Manage retirement savings and provide income during retirement
• Mutual Funds
  • Pool money from investors to buy a diversified portfolio of securities

Money and Its Functions

• Medium of Exchange: Facilitates transactions without barter
• Unit of Account: Standard measure of value
  • Enables easy price comparison using a common monetary unit
• Store of Value: Preserves purchasing power over time
• Standard of Deferred Payment: Allows borrowing and lending, enabling repayment of debts
• Characteristics of Money: Durability, portability, divisibility, uniformity, limited supply, and acceptability

Banking System and Money Creation

• Banking System Composition
  • Central bank and commercial banks manage the money supply
  • Fractional reserve banking involves banks accepting deposits and lending a portion
  • Money multiplier effect allows new deposits and lending
• Role of Central Bank (e.g., Federal Reserve)
  • Influences money supply via reserve requirements, open market operations, and discount rate adjustments

Interest Rates and Monetary Policy

• Interest Rates: Cost of borrowing and return on savings
  • Nominal vs. Real interest rates (consider inflation)
• Monetary Policy Goals: Manage money supply and interest rates to achieve stability and employment
  • Expansionary Policy: Lowering rates to stimulate growth
  • Contractionary Policy: Raising rates to control inflation
• Yield Curve: Shows bond maturities vs. interest rates, reflecting economic conditions

Financial Markets and Instruments

• Financial Markets: Enable fund flow between savers and borrowers
• Capital Markets: Stock and bond markets for raising capital
  • Primary Markets: Initial issuance of securities
  • Secondary Markets: Trading existing securities
• Money Markets: Short-term instruments (e.g., Treasury bills)
• Derivatives Markets: Instruments derived from underlying assets (options, futures)
• Other Instruments: Asset-backed securities, ETFs

Role of Central Banks

• Monetary Policy and Financial Stability
  • Lender of last resort
  • Regulate and supervise commercial banks
  • Set capital requirements and conduct stress tests
• Foreign Exchange Management
  • Manage reserves and influence currency value
• Promoting Financial Inclusion and Consumer Protection

Financial Regulation and Stability

• Prudential Regulation: Ensures stability via capital requirements and risk management
• Market Conduct Regulation: Consumer protection and fair practices
• Deposit Insurance: Ensures depositor confidence (e.g., FDIC)
• Macroprudential Regulation: Addresses systemic risks
• International Coordination: Due to global financial market integration

Impact on Economic Growth and Development

• Efficient Financial System
  • Allocates capital to productive investments
  • Supports capital formation and productivity growth
• Access to Credit
  • Enables business expansion and innovation
  • Microfinance promotes financial inclusion
• Risk Management in Financial Markets
  • Facilitates long-term investments and diversification
• Financial Sector and Poverty Reduction
  • Provides access to services, enabling wealth creation
  • Mobile banking enhances financial inclusion in developing regions
• Impact of Financial Crises
  • Can severely affect economic growth, emphasizing regulation and risk management importance