hi everybody Jacob Reed here from reviewon.com today we're going to be looking at macroeconomics unit 4 this one is all about financial markets these videos go alongside the total review booklet from review eecon.com so if you're interested head down to the links below also don't forget to like and subscribe let's get into the content since this unit is all about financial markets we're going to start off by talking about some financial assets the first asset we'll discuss is stocks stocks are certificates of ownership for a corporation bonds on the other hand are a certificate that gives the owner the right to be paid back for a loan to a business or the government there is an inverse relationship between the price of bonds and the interest rate money is another financial asset that is the most liquid or most easily spent of all assets it's that money asset that this unit focuses on now money is not what economics is all about but we discuss it a lot in this unit let's talk about the three functions of money now money first of all must be able to be a medium of exchange that means it can be used to buy goods and services the second thing money must be able to do is serve as a unit of account or standard of value that means it can be used as a yard stick or measuring tool to measure relative values the third thing money must be able to do is store value if I work really hard today the value of my work will be stored in the dollars and they will keep their value for the foreseeable future assuming we have low inflation when it comes to measures of the money supply we have three ways of measuring it the first one and most narrow definition of money is the M0 or monetary base measure of the money supply that includes bank reserves and that's money that the bank has in their possession but they haven't yet loaned out and officially bank reserves are not money because they are not a medium of exchange but in the monetary base we also include currency which is cash and coins and that currency is money m1 is another measure of the money supply and that includes money that is usable as a medium of exchange this includes currency the cash and the coins as well as checkable deposits and savings deposits m2 is the most broad definition of money it includes all of M1 plus smalltime deposits that's certificates of deposit for less than $100,000 as well as money market mutual funds next we're going to talk about the Fissure formula the Fissure formula tells us the relationship between nominal and real rates of change the difference between the two is the inflation rate we have a formula it's little i approximately equals little r + pi what do those variables stand for well the little i is the nominal rate of interest the little r is the real interest rate and pi is not 3.14 it's the rate of inflation here's an example to put that formula into use let's say the bank wants a real interest rate of 5% that's the expected rate of return they hope to achieve at the same time the expected rate of inflation is 2% add those together and that tells us the nominal rate of inflation this bank will charge is 7% we can also flip this formula around and work backwards let's say the actual rate of inflation ends up being 3% instead of 2% we can take the nominal rate of interest that the bank charges subtract the 3% actual inflation rate that will give us an actual real interest rate of only 4% since the actual rate of inflation is sometimes different than the expected rate of inflation that tells us that unexpected inflation can help some people and hurt other people here are the two main categories that you need to know borrowers are primarily the group of people that are helped by higher thanex expected rates of inflation that's because they pay lower real interest rates and they pay back their loans with less valuable money or fewer real dollars lenders on the other hand are hurt by higher thanex expected rates of inflation that's because the real interest rate they earn decreases when inflation increases they are also paid back fewer real dollars or less valuable money the next thing we're going to do is look at what is often considered one of the most difficult concepts in AP economics i don't think it's that bad if you take it one step at a time and make sure you understand each little part these are called bank balance sheets first of all on our bank balance sheet we have an asset side and a liability side on the asset side those are the things of value that the bank owns on the liability side those are the things of value that the bank owes to somebody else let's talk about the components of that liability side we have demand deposits those are also called checkable deposits those are checking account deposits that are owed to the bank's customers savings deposits are also there those are the savings accounts deposits and they are also a liability because they are owed to other people finally we have other liabilities those could be loans that the bank owes to other banks to the Federal Reserve or it could even be profit sometimes called owner equity that is owed to the owners of the corporation on the asset side we have total reserves total reserves are the funds that the bank has available to them this is broken up into two categories required reserves and excess reserves let's talk about required reserves first required reserves are a percentage of checkable deposits that percentage is set by the Federal Reserve for monetary policy we'll get to that in a little while the second component of total reserves is excess reserves excess reserves are the funds that the bank has available that they can loan out to find the excess reserves you take the total reserves subtract the required reserves and what's left is excess reserved that's the money the bank can loan out next thing you'll find on the asset side are loans now these aren't loans that the bank has borrowed from other people these are loans the bank has made to their customers these are IUS they have value and it's the value of whatever money was loaned to the customers finally we have other assets the bank has all kinds of things of value the building itself the desks etc that stuff is assets and the value of it goes on the asset side the last thing you need to be aware of is that assets and liabilities will always be equal on the bank balance sheet if they aren't equal you've gone wrong somewhere and you need to double check your math now manipulating the values within a bank balance sheet is something you should be able to do we're going to go over an example right now but if you still need some help make sure you head over to review econ.com and check out the bank balance sheet game that I have there let's say a customer of this bank puts $100 cash in their checking account let's see how that will impact this bank balance sheet first of all demand deposits is going to increase by $100 now that's also going to have to balance out on the other side here we're going to have total reserves increase by $100 because the customer gave them $100 and now the bank has that $100 they owe it on the liability side but they also have it on the asset side that total reserves is $100 but it will be broken into two different values if there's a 10% reserve requirement set by the Federal Reserve $10 of it will be required reserves and the rest of it $90 will be excess reserves that can be loaned out the next thing we're going to talk about is the money multiplier the money multiplier tells us how many dollars worth of new loans deposits and money can be created from excess reserves here's how that works just a reminder we have a $100 deposit with a 10% reserve requirement when the first customer deposits that $100 $90 of it can be loaned out that money will eventually be redeposited and then 90% of that $81 will be loaned out again that is $81 of new money then that $81 will be eventually redeposited and 90% of that $72.90 here will also be loaned out and then redeposited this will happen over and over and over again and the new loans are new money because every new amount that is redeposited in a checking account is money because checkable deposits are part of the M1 money supply in order to find out how much money can be created from the excess reserves you take one and divide it by the reserve requirement here are some examples with a 10% reserve requirement we will have a multiplier of 10 with 20% we will have a multiplier of 5 25% 4 33 and a3% 3 and 50% 2 those are the most common numbers you're going to see on your exams for this example we're going to look at a multiplier of 10 because the reserve requirement right now is 10% and 1 divided by 10% is 10 so we're going to take the money multiplier and multiply that by the excess reserves that tells us how much new money loans and deposits will be created from those excess reserves you may also need to include the original amount depending on the question you're being asked on your exams getting back to the example we just looked at we've got $90 worth of excess reserves we're going to take that and multiply it by the multiplier of 10 and that gives us $900 worth of new loans that can be created since the original amount of $100 wasn't alone we're just going to leave it at that $900 if we're looking at new amounts of money we take the $90 and times that by the multiplier of 10 that's $900 worth of new money that's created and we again don't add in the original amount because remember it was a cash deposit into the checking account and as a result it was already part of the M1 money supply so we're going to leave this number at $900 as well if we were asked how many deposits were created on the other hand it would be a little bit different first we take the excess reserves of $90 and times it by 10 which gives us $900 worth of new deposits but then we also need to add in that original $100 again because that was a new deposit from the start as a result the total amount of new deposits that would be created as a result of this first new deposit of $100 is $1,000 worth of deposits the money multiplier tells us the maximum amounts of new loans deposits and money that can be created from excess reserves in reality the numbers will be much lower and that's because we have some leakages within this model first of all many banks hold excess reserves and they don't loan out as much as they could the second leakage comes from consumers holding on to cash rather than depositing their money into their banks the next thing we're going to do is look at the money market graph just like other markets we've learned we've got a supply curve and a demand curve we're going to look at the demand curve first money demand is based on the fact that the opportunity cost of holding money is the nominal interest rate when nominal interest rates are high people demand fewer dollars because the opportunity cost of holding your money as cash increases likewise when the interest rate is low the opportunity cost for holding your assets as cash decreases and people will demand more dollars when we graph it out we've got the nominal interest rate there on the y-axis we've got the quantity of money down here on the x-axis and we have a downward sloping demand curve because there's an inverse relationship between the quantity of money that people will demand and that nominal interest rate so when interest rates fall the quantity of money demanded will increase just like other demand curves this demand curve can shift the demand for money is comprised of two things first we have the asset demand for money that's the desire to hold your wealth as money because money itself is an asset and it's a liquid asset the second part of the demand for money is the transaction demand for money that's because money is needed in order to buy goods and services what determines the transaction demand for money is the formula for GDP c plus I plus G plus XN the other part we need to look at is the price level if either of those things change it's going to increase or decrease that demand for money and just like we've seen with other demand curves a rightward shift is going to be an increase and a leftward shift is going to be a decrease now let's talk about the money supply curve the money supply is determined by the actions of the central bank in an economy with scarce reserves as a result there is no relationship between the nominal interest rate and the quantity of money that is going to be supplied and that gives us a vertical money supply curve that is perfectly inelastic so at high nominal interest rates we will have one quantity of money and at low nominal interest rates we will have the same quantity of money the actions of the central bank can increase or decrease the supply of money and that will cause a rightward shift for an increase and a leftward shift for a decrease just like we've had on previous supply curves when you graph these two curves together it gives us our equilibrium nominal interest rate and our equilibrium quantity of money if either of these curves shifts just like any other market you've learned it will change the equilibrium price and quantity it's just here that the equilibrium price is called the nominal interest rate next we're going to go over monetary policy and how central banks can target interest rates to move the economy around to fight inflation and unemployment and there are two systems for targeting these interest rates one is the ample reserve system and the scarce reserve system the scarce reserve system uses the money market to target those interest rates while the ample reserve system uses the reserves market to target those interest rates in the United States the Federal Reserve has an ample reserve system and so the Federal Reserve targets the policy rate the Federal Funds rate in the reserves market the next thing we're going to do is look at how the central bank of an economy with scarce reserves can change the money supply they have three tools at their disposal the first one is called open market operations open market operations is the buying or selling of government bonds or securities the second one is called the discount rate the discount rate is the interest rate that the central bank charges banks for overnight loans the third one is the reserve requirement the reserve requirement as we've already mentioned is the percentage of money that the banks cannot loan out that money stays as required reserves when new deposits are made all three of these tools are used to target the policy rate in the United States the federal funds rate is the policy rate that's the interest rate that banks charge each other for overnight loans central banks with scarce reserves target that policy rate through changes in the money supply just like we saw with new bank deposits actions of the central bank can multiply through the economy as well let's say for example the central bank makes an open market purchase of $10 million worth of government securities with a 10% reserve requirement that will give us a money multiplier of 10 we take that $9 million of excess reserves that's because a bond dealer will receive $10 million and they will deposit it into their checking account leaving $1 million as required reserves and $9 million as excess reserves you take that $9 million of excess reserves times it by the 10 multiplier and that gives us $90 million of new loans that will be created we don't add in the original amount because it was not a loan new deposits on the other hand are going to be $100 million and that's because that original amount the $10 million purchased will be immediately deposited by the bond dealer into their checking account so the number of deposits created here is $100 million worth new money also is 100 million because that new $10 million purchase is new money that was created when the Federal Reserve holds those funds it isn't money but when it is deposited into the bond dealers's checking account it is money so if we have an ample reserve system within an economy the central bank is going to use the reserves market graph the reserves market graph has the policy rate there on that yaxis and the quantity of reserves on the x-axis the demand for reserves has an upward portion that is flat followed by a downward sloping portion and last we have a flat portion at the bottom there the upper flat portion is at the discount rate and the lower portion there moves up or down with changes in interest on reserves then we also have the supply of reserves and that is determined by actions of the central bank in an ample reserve system when the supply of reserves intersects that demand curve in the downward sloping portion then we have scarce reserves and there changes in reserves will actually increase or decrease the policy rate but when the supply of reserves intersects the demand curve on the lower flat portion then we have ample reserves and changes in the supply of reserves will not impact the policy rate as a result central banks with ample reserves must use different policy tools now one of those policy tools for an ample reserve system is open market operations open market operations are only used to buy and sell bonds to increase or decrease the supply of reserves buying reserves is going to shift that supply of reserves to the right and it can be used to maintain an ample reserve system the demand curve on the other hand moves with changes in administered rates the upper flat portion changes with the discount rate and the lower flat portion changes with interest on reserves and it is that interest on reserves rate that is the key policy tool that is used by central banks with ample reserves the Federal Reserve is one of those central banks so if we have an economy with a recessionary gap as we have here the economy is going to have high unemployment and the central bank can use expansionary monetary policy to fight that unemployment if the central bank is working in a scarce reserve system it is going to buy bonds lower the discount rate or lower the reserve requirement to increase the money supply that will decrease the nominal interest rate leading to greater gross investment if there are ample reserves decreasing the interest rate on reserves will also decrease the policy rate they could also decrease the discount rate which lowers the upper portion of that demand curve or they could decrease both of them which is decreasing administered rates either way we have a lower policy rate those lower interest rates increase gross investment shifting that aggreate demand curve to the right increasing real output and decreasing unemployment and if it's done just right we're back to long run equilibrium if on the other hand we have an inflationary gap then central banks will use contractionary monetary policy to fight inflation if there are scarce reserves they can sell bonds raise the discount rate and raise the reserve requirement to decrease the money supply that will mean higher interest rates and less gross investment in the ample reserve system they will increase interest on reserves that increases the federal funds rate or the policy rate they could also increase the discount rate which moves the upper portion as well or both of them together which is increasing administered rates either way we see higher interest rates which means less gross investment shifting that aggregate demand curve to the left restoring long run equilibrium and resulting in a lower price level which means we have successfully fought inflation the last graph you need to know for this unit is called the loanable funds market the loanable funds market is the demand and supply for long-term loans here we're going to have the real interest rate on that y ais abbreviated with little r we're going to have the quantity of loanable funds there on the x-axis and our demand curve is a downward sloping investment demand labeled ID that is the demand by businesses for gross investment the downward sloping investment demand curve tells us there's an inverse relationship between the real interest rate and the quantity of loanable funds demanded to purchase physical capital at high interest rates we will have low quantities of investment demanded and at low interest rates we will have higher quantities of investment demanded in the loanable funds market what shifts that investment demand curve well it's anything that can impact the potential profit for new investments changes in economic outlook investment tax credits and countless other things if there's an increase in expected rate of returns for new investments you're going to see that investment demand curve shift to the right or if they decrease we will see it shift to the left the supply curve in the loanable funds market is often called the savings supply it is the money that is saved by households and it's available for loans we see an upward sloping saving supply curve in the loanable funds market and that's because there is a direct relationship between the real interest rate and the quantity of loanable funds that will be supplied by households so when real interest rates rise the quantity of loanable funds available will also rise here are some things that can shift that saving supply curve changes in disposable income for households increases in the household income will increase supply decreases in household income will decrease supply the economic outlook if people expect a recession they'll save more for example and foreign investment when foreign investors put money in our loanable funds market by saving in the United States that will increase the supply of loanable funds for example if we see any of those things increase it will of course shift our supply to the right and if they decrease it will shift it to the left if we put both of these curves on the same graph we can find our equilibrium real interest rate and the equilibrium quantity of loanable funds and if either of those curves shift it will change the real interest rate and the equilibrium quantity there is one more concept you need to know about when it comes to understanding the loanable funds market you'll learn more about it in the next unit it's called crowding out crowding out is the idea that an increase in the government deficit will increase interest rates and reduce gross investment you can graph an increase in the deficit caused by an increase in government spending or a decrease in government taxes as an increase in investment demand because the government is having to borrow more so they demand more loans alongside businesses or another way of looking at it is they reduce the supply available for businesses either of these methods is acceptable on the AP macroeconomics exam i suggest you use the one that your teacher uses but either way that interest rate increases as a result of the increase in the deficit and that higher interest rate will mean less gross investment leading to lower growth in the overall economy if on the other hand the government has a budget surplus or a decrease in the deficit that will do the opposite it means the government won't have to borrow quite as much money and you can graph that as a decrease in the demand for loanable funds or an increase in the supply of loanable funds either way the real interest rate falls and gross investment within the economy will increase we got through it that was a lot of information there and if you knew it all you are on your way to acing your next exam if you need a little more help head down to the links below where there are lots of games and activities from review.com to help you study and practice the skills you need for that next exam if you want to support this channel make sure you like and subscribe and then head over to reviewcon.com and pick up the total review booklet with everything you need to know to pass your final exam or AP economics exam thank you very much i'll see you guys next time