Vocabulary List
- Financial Market: A market where financial instruments like stocks, bonds, and loans are bought and sold.
- Loanable Funds Market: The market for borrowing and lending money, where interest rates are determined.
- Interest Rate: The cost of borrowing money or the return on savings, expressed as a percentage.
- Money: Any medium of exchange that is widely accepted in transactions.
- Money Supply: The total amount of money available in an economy, including cash and deposits.
- Liquidity: How easily an asset can be converted into cash without losing value.
- Monetary Policy: The use of the money supply and interest rates by a central bank to influence the economy.
- Central Bank: An institution that manages a country’s currency, money supply, and interest rates.
- Example: The Federal Reserve in the U.S.
- Open Market Operations (OMO): The buying and selling of government securities by the central bank to regulate the money supply.
- Reserve Requirement: The fraction of deposits that banks must hold as reserves.
- Discount Rate: The interest rate charged by the central bank on loans to commercial banks.
- Money Multiplier: The factor by which a change in reserves impacts the overall money supply, calculated as 1 / Reserve Ratio.
- Fractional Reserve Banking: A system in which banks keep a fraction of deposits in reserves and lend out the rest.
- Bond: A fixed-income security representing a loan made by an investor to a borrower.
- Stock: A financial asset that represents ownership in a company.
- Time Value of Money: The concept that money today is worth more than the same amount in the future due to its potential earning capacity.
- Nominal Interest Rate: The interest rate not adjusted for inflation.
- Real Interest Rate: The nominal interest rate adjusted for inflation, calculated as Nominal Rate – Inflation Rate.
- Inflation Targeting: A monetary policy strategy aimed at maintaining a specific inflation rate.
- Quantity Theory of Money: A theory stating that an increase in the money supply leads to proportional increases in prices (inflation).
- Velocity of Money: The rate at which money circulates in the economy, calculated as Nominal GDP / Money Supply.
- Crowding Out Effect: When government borrowing increases interest rates, reducing private investment.
- Financial Intermediary: An institution (e.g., banks, mutual funds) that connects borrowers and savers.
- Capital Market: A financial market where long-term securities, like stocks and bonds, are traded.
- Credit Market: A market for loans and debt instruments.
Need to test your financial knowledge? Check out our AP Free Response Questions on the Financial Sector.
1. Role of the Financial Sector
The financial sector serves as the backbone of an economy, facilitating the flow of funds between savers and borrowers. It includes:
- Financial Intermediaries: Banks, credit unions, mutual funds, and insurance companies.
- Financial Markets: Stock and bond markets.
The sector ensures:
- Efficient allocation of resources.
- Support for investment and growth.
- Stability and liquidity for economic activities.
2. The Loanable Funds Market
The loanable funds market determines the equilibrium interest rate and quantity of loans.
Supply of Loanable Funds
- Comes from savings by households, businesses, and governments.
- Higher interest rates encourage saving, increasing the supply of loanable funds.
Demand for Loanable Funds
- Comes from borrowers like businesses (for investment) and governments (to finance deficits).
- Lower interest rates encourage borrowing, increasing demand for loanable funds.
Graph of Loanable Funds Market
- X-axis: Quantity of loanable funds.
- Y-axis: Real interest rate.
- Upward-sloping supply curve: Reflects that higher interest rates incentivize more saving.
- Downward-sloping demand curve: Reflects that lower interest rates encourage borrowing.
3. Money and Its Functions
Money serves three main purposes:
- Medium of Exchange: Facilitates transactions without the need for barter.
- Store of Value: Retains purchasing power over time.
- Unit of Account: Provides a standard measure for prices.
Types of Money
- Commodity Money: Has intrinsic value (e.g., gold, silver).
- Fiat Money: Has value because the government declares it as legal tender (e.g., U.S. dollar).
4. The Money Supply and Monetary Policy
Money Supply
- M1: Includes currency, demand deposits, and travelers’ checks.
- M2: Includes M1 plus savings accounts, time deposits, and money market funds.
Tools of Monetary Policy
- Open Market Operations (OMO):
- Buying bonds increases the money supply (expansionary policy).
- Selling bonds decreases the money supply (contractionary policy).
- Discount Rate:
- Lowering the rate encourages borrowing and increases the money supply.
- Raising the rate discourages borrowing and decreases the money supply.
- Reserve Requirement:
- Lowering the reserve ratio increases the money supply (more lending).
- Raising the reserve ratio decreases the money supply (less lending).
Goals of Monetary Policy
- Control inflation.
- Stabilize the economy.
- Promote employment and growth.
5. Real vs. Nominal Interest Rates
- Nominal Interest Rate: The stated rate of interest, not adjusted for inflation.
- Real Interest Rate: Reflects the true cost of borrowing after adjusting for inflation.
- Formula: Real Interest Rate = Nominal Interest Rate – Inflation Rate.
Example
If the nominal interest rate is 5% and inflation is 2%, the real interest rate is 3%.
6. Financial Markets and Instruments
Types of Financial Markets
- Stock Market: Where shares of companies are bought and sold.
- Bond Market: Where governments and corporations borrow money by issuing bonds.
Financial Instruments
- Stocks: Represent ownership in a company and provide dividends.
- Bonds: Represent loans to borrowers who pay interest over time.
7. Fractional Reserve Banking and the Money Multiplier
In a fractional reserve system, banks keep a portion of deposits as reserves and lend the rest.
- Money Multiplier Formula:
- 1 / Reserve Ratio
- Example: If the reserve ratio is 10%, the money multiplier is 10.
- Impact: A $1,000 deposit with a 10% reserve ratio can create up to $10,000 in new money.
8. Monetary Policy and the Economy
Expansionary Monetary Policy
- Increases the money supply to lower interest rates.
- Boosts investment and consumer spending.
- Used during recessions to stimulate the economy.
Contractionary Monetary Policy
- Decreases the money supply to raise interest rates.
- Reduces inflation by curbing demand.
- Used during periods of high inflation.
9. Quantity Theory of Money
Expressed as: MV = PQ
- M: Money supply.
- V: Velocity of money (how often money is spent).
- P: Price level.
- Q: Real output (GDP).
Implications:
- If M increases faster than Q, inflation occurs.
- Stable velocity and controlled money supply are key to avoiding inflation.
10. The Crowding Out Effect
When government borrowing increases, it raises interest rates, reducing private investment.
Example
If the government borrows heavily to fund a project, businesses may find it more expensive to take out loans, leading to reduced private investment and slower economic growth.
Mark is an A-Level Economics tutor who has been teaching for 6 years. He holds a masters degree with distinction from the London School of Economics and an undergraduate degree from the University of Edinburgh.