Macroeconomics Unit 4: Financial Markets

Introduction

• Presented by Jacob Reed from ReviewEcon.com
• Focus on financial markets
• Accompanied by total review booklet from ReviewEcon.com

Financial Assets

Stocks

• Certificates of ownership for a corporation.

Bonds

• Certificates that give the owner the right to be paid back for a loan to a business or government.
• Inverse relationship between bond prices and interest rates.

Money

• The most liquid financial asset, easily spent.
• Money functions in economics even if not the central focus.

Functions of Money

1. Medium of Exchange: Used to buy goods and services.
2. Unit of Account: Standard of value, measuring relative values.
3. Store of Value: Maintains value over time, assuming low inflation.

Measures of Money Supply

• M0 (Monetary Base): Includes bank reserves and currency (cash and coins).
• M1: Currency plus checkable and savings deposits.
• M2: M1 plus small time deposits and money market mutual funds.

Fischer Formula

• Relates nominal interest rate and real interest rate, factoring in inflation.
• Formula: i ≈ r + π
  • i = nominal interest rate
  • r = real interest rate
  • π = inflation rate
• Example calculation shows how real interest rates are affected by expected vs actual inflation.

Impact of Inflation on Borrowers and Lenders

• Borrowers benefit from unexpected inflation (lower real interest rates).
• Lenders are hurt by unexpected inflation (decreased real interest rates).

Bank Balance Sheets

Overview

• Assets Side: What the bank owns.
• Liabilities Side: What the bank owes.

Liabilities

• Demand Deposits: Checkable deposits owed to customers.
• Savings Deposits: Savings accounts owed to account holders.
• Other Liabilities: Loans owed by the bank.

Assets

• Total Reserves: Funds available to the bank included:
  • Required Reserves: Set percentage of deposits.
  • Excess Reserves: Additional funds that can be loaned out.
• Loans: Loans given to customers (IOUs).
• Other Assets: Physical assets, such as buildings.

Balancing Act

• Assets must equal liabilities on the balance sheets.

Money Multiplier

• Indicates how much new money can be generated from excess reserves.
• Formula: 1 / Reserve Requirement.
• Example with 10% reserve requirement shows how new deposits generate new money.

Money Market Graph

Demand for Money

• Influenced by the nominal interest rate:
  • High rates lead to lower money demand.
  • Low rates increase money demand.
• Asset Demand: Wealth held as cash.
• Transaction Demand: Money needed for purchases, determined by GDP (C + I + G + XN).

Supply of Money

• Vertical Money Supply Curve: No relation to interest rates; determined by central bank actions.
• Changes in supply shift the curve right (increase) or left (decrease).

Monetary Policy

Central Bank Actions

• Two systems: Ample Reserve System and Scarce Reserve System.
• Ample Reserve: Targets policy rate in reserves market.
• Scarce Reserve: Targets interest rates via the money market.

Tools for Changing Money Supply

1. Open Market Operations: Buying/selling government securities.
2. Discount Rate: Interest rate charged for overnight loans to banks.
3. Reserve Requirement: Percentage of deposits banks must hold as reserves.

Effects of Monetary Policy

• Expansionary policies reduce interest rates, increasing gross investment and aggregate demand.
• Contractionary policies increase interest rates, curbing investment and helping to fight inflation.

Loanable Funds Market

Overview

• Supply Curve: Saving supply (upward sloping).
• Demand Curve: Investment demand (downward sloping).
• Equilibrium interest rate and quantity determined by the intersection of curves.

Crowding Out Effect

• Government deficit raises interest rates, reducing gross investment.
• Surplus decreases demand for loans or increases supply, lowering interest rates.

Conclusion

• Extensive coverage of financial markets.
• Resources available for further study and practice at ReviewEcon.com.
• Encouragement to like, subscribe, and utilize review materials for success in exams.