Unit IV. Financial Sector
This is a prime example of a "Free Loader"
This is a prime example of a "Free Loader"

(Definitions from cleverstocks)

A) Money, Banking, & Financial Markets
  1. Defenition of Money, Stocks, and Bonds:
    1. Money: A commodity or asset, such as gold, an officially issued currency, coin or paper note, that can be legally exchanged for something equivalent, such as goods or services.
    2. Stocks: A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.
    3. Bonds: A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.
  2. The Time Value of Money
    1. Because of Interest Rates, there is an Opportunity Cost to holding onto money. If the Real Interest Rate(Interest Rate - Inflation) is known, then it is possible to accurately project the future value of Present Day Money.
      • FV = PV(1+i)^n
        • Where FV = Future Value, PV = Present Value, n = number of years, and i = Real Interest Rate.
    2. Likewise, if an amount of Future Money is known, it is possible to discover what the Present Valueof that money would be. This is best seen through an example:
      • Hi. I'm the Calculator That'll help you do the Math on this page. Until you need me, I'll calc-you-later!
        Hi. I'm the Calculator That'll help you do the Math on this page. Until you need me, I'll calc-you-later!
        Let's say you are told that a friend will give you $1,000 ten years from now. This sounds very generous, but how much money would that be in todays dollars? For this exapmle, let us assume the Inflation rate is 2%, and the Interest Rate is 8%.
        • The equation for Present Value (PV) can be derived from the eq'n for Future Value. Using simply Algebra, we discover the new equation is....
          • PV = FV / (1 + i)^n
        • Real Interest Rate, or i, is (Interest Rate - Inflation Rate) which in this case is (8% - 2%) = 6%, or .06 . Future Value (FV) is the $1,000, and the number of years (n) is 10.
          • Plug this info into the eq'n, and get PV = $1,000 / (1+.06)^10
            • So 1000 / (1.79) = $558.66
      • So, although your friend is still being nice, there are in reality only giving you about $558 instead of 1,000 bucks
  3. Measures of Money Supply
    1. external image 10110-Clipart-Picture-Of-A-Dollar-Sign-Mascot-Cartoon-Character-With-Welcoming-Open-Arms.jpgM1: A category of the money supply that includes all physical money such as coins and currency; it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts.
    2. M2: A category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds
    3. M3: a stupid category that is no longer used (bc it was stupiz)

  4. Banks and the Creation of Money
    And on the Third Day, Bernanke raised his Right Hand and said, "Let there be Moneyz!"
    And on the Third Day, Bernanke raised his Right Hand and said, "Let there be Moneyz!"
    1. Money can, for all intents and purposes, be "Created" by Banks. How does this seemingly nonsensical statement work? No fear, I will inform you in a way so that even your pathetic mind will be able to comprehend (seriously though, you've gotta be pretty pathetic if you're reading this.... O.o )
    2. People give banks $$$. The Required Reserve Ratio, or 'RR', is a percentage of that $$$ that banks gotta keep. So let's do an example (yay!). Assume (you know what we make ourselves when we assume...) RR = 2, and a person puts $10,000 in a bank (*Word from the wise: never put your money into a bank. Banks are EVIL & you cant trust them. Keep your $$$ hidden under your mattress* - מזרונים)
      • In this example, the bank needs to hold onto 2% of $10,000, or $200.
        • So where does the remaining $9800 go????
          • The bank (those sly little devils) loans out that remaining $9800.
            • That Money will, inevitably, return to the bank (ex. if $9800 was borrowed by a person paying on their home, then that person pays the realtor the $9800, and most (if not all--but this deals w/Marginal Propensity to Save, which is a story for another day) of that money is put back into the bank.
          • So what happened here? Basically the Bank created money. As you, being the wise economist that you must be if you are reading this, are probably seeing how a cycle ensues. The bank keeps 2% of the $9800 coming in, and loans out the rest, & so on & so on & so on & no so & so so & no no & so on & son on & nos...
          • How much $$$ can the bank create though? You would think that its hard to predict, but actually there is a Handy Dandy, Supery Dupery, Equation! (yay!)
Hey, I'm back again! And remember, friends don't let friends Drink and Derive!
Hey, I'm back again! And remember, friends don't let friends Drink and Derive!

            • Money Bank Creates = Money Multiplier * Excess Reserves
              • But what is this "Money Multiplier" that I speak of ??? Well, quite simply, it is the Reciprocal (math term...) of the Required Reserve Ratio. In this example it would be 1/.02, or 50. The Excess Reserves is the difference of the (Incoming Money - Required Reserves). In this example, it would be ($10,000 - $200) = $9,800.
            • Therefore, the bank has just created a whompin' 50 * $9,800 = $490,000 !!!!!!! //gasp
            • [I'm getting tired of that Calculator dude.....]

  1. Money Demand & The Money Market
From Welkerswikinomics
From Welkerswikinomics

    1. Money Demand is, well, the demand of Money. This seemingly simply concept is deceptively VERY IMPORTANT!!! In fact, the Money Demand Graph is one of the 3 KEY graphs that you need in order to succeed in the wonderful sarcasm realm of Macroeconomics.
    2. The Money Market Graph plots the Money Demand vs. Money Supply (MS) . Note how MS is a vertical line; this is because the Supply of money is unaffected by the vertical axis, which is the Nominal Interest Rate.
      1. Money Supply can, however, shift whenever the Fed creates policy to increase/decrease the money supply. This is similar to the earlier discussion of how banks can "Create" money.
    3. For more info on the Money Market Graph, see this link Click Here (Do it; do it nao!)external image 101025_cartoon_087_a15358_p465.gif
    4. Please notice how a High Money Supply equates to a low Nominal Interest Rate (important). Also, we can take this a step further if you put your thinking cap on. You see, a low interest rate means Investment Spending will increase, thus increasing Aggregate Demand. And by now I would hope that you know that an increase in AD will result in a higher equilibrium Price Level. A high price level equates to High Inflation
      1. So where did that long tanget land us to? Well, quite simply it proves the idea which I'm sure you already had; the higher the Money Supply, the less its worth, and so a high MS results in higher inflation.
      2. (See the epic cartoon to the left which 100% explains my point

  1. Loanable Funds Market
    1. Eerily similar to the Money Market, please take note that these 2 Graphs are NOT the same. See the above link for me details on the subtle, yet important, differences between these 2 HIGHLY important graphs ktnxbai
    2. According to our beloved wikipedia, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption. Savers supply the loanable funds, and borrowers demand loanable funds.
      1. So it has the same basics of the Money Market graph, but the definition of the Demand & Supply is different.
      2. This is the Graph; Note that the y-axis is the "Interest Rate", NOT nominal interest rate
        This is the Graph; Note that the y-axis is the "Interest Rate", NOT nominal interest rate
B) Central Banks & Control of Money Supply
  1. This stuff is as simple as 3.14159265...
    This stuff is as simple as 3.14159265...
    As you have probably guessed already, since banks can "create" money, then they can control the Money supply. But who controls the Banks? Why, the Central Bank (Federal Reserve of course!external image hand-tools.jpg
  2. Tools of Central Bank Policy
    1. Open Market Operation
    2. The Discount Rate
    3. Reserve Requirements
      Click on Link to follow the link. hahahaha I <3 puns
      Click on Link to follow the link. hahahaha I <3 puns
  3. Note that these terms are BOLDED. This is because this is muy importante!!! Here is a link, provided by the government (Big Brother is watching' you O.o ), that goes into detail of each one in case you didnt want to listen to my ramblings about each Tool. -------------->
  4. So here's my explaination of each of these tools:
    1. Reserve Requirement:
      1. Let's start w/the easy one. We already talked about the RR, and how it affects the amount of $$$ that can be made by the banks. Recall that the formula is: Money Bank Creates = Money Multiplier * Excess Reserves and recall that Money Multiplier = 1 / RR.
      2. So $$$ Created = Excess Reserves / RR. Therefore, a high RR equates to a lower amount of $$$ Created, and vice versa.
      3. However, the Fed does not actively change the RR, because that would wreak havoc on the banks (which would be bad).
    2. The Discount Rate
      1. The Discount Rate is the percent interest charged by the Fed for banks to loan money from them. Naturally, as the interest rate is high, banks tend to borrow less money. If the interest rate is low (as it, as of '11, currently is) banks are more apt to borrow. This increases their amount of Excess Reserves, and using the Handy-Dandy Formula above, you can see it in turn increased the amount of Money Created.
    3. Open Market Operations
      No, not THAT kind of "Operation"!
      No, not THAT kind of "Operation"!
      1. And now time for the last, but yet probably the most important, of the 3 tools: Open Market Operations.
      2. This is where the Fed sells, or buys, BONDS.Bonds are basically slips of paper which the Fed declares are worth something (and so therefore they are).
        1. When the Fed sells Bonds to Banks, banks must pay the Fed with Money. This decreases their excess reserves, and so decreases the Money Created & Money Supply.
        2. And, as you probably figured, this process can work in reverse. Banks can buy bonds from banks, which increases their excess reserves, then increases MS, which in turn decreases the interest rate, which increases Investment spending, which increases Aggregate Demand, which increases the Price Level (aka Inflation), which results in a movement to the the right along the Philip's Curve, ......
So there you have it. This is all the basic components of my Section. Now its up to YOU to piece them all together and realize how EVERYTHING in Macroeconomics is inter-related. A reasonable question on the AP test may very well just be "The economy is facing high inflation. What should the Fed do?" The answer would be (as you now know) to buy bonds to increase the Interest Rates, which lowers AD. As I said, its all interconnected, and good luck Young Padawan! May the Force be with you!

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Oh, and btw, I finally got rid of that Calculator...
Just enough battery power for one more pun:   "Did you know that Math jokes are the first sine of madness? "
Just enough battery power for one more pun: "Did you know that Math jokes are the first sine of madness? "

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