Chapter 4 AP Macro Studying

The Opportunity Cost of Cash

• Cash is a financial asset that is most convenient but comes at an opportunity cost.
• Holding cash means missing out on potential interest earnings.
• There are trade-offs with checking accounts like more liquidity versus less interest.
• A certificate of deposit offers higher interest, but limits access to the funds. Storing cash is convenient, but it does not generate interest.
• Cash may be preferred for smaller payments despite digital payments.

The Financial System

• The role is to enable investment by connecting savers with opportunities to purchase financial assets.
• Financial assets lack physical form, yet provide owners future income.
  • For example, a loan serves as an asset for the lender while being a liability for the borrower.
• Physical assets are tangible and come with ownership rights, like cars or houses.
• Liabilities represent obligations someone has to pay money in the future, including loans.

Three Functions of the Financial System

Reducing Transaction Costs

• A financial system works to lower costs of making financial deals, such as legal fees.
• Large organizations tend to issue bonds/large bank loans instead of negotiating multiple small loans.
• Issuing bonds is a tool that assists businesses to generate capital without individual loan talks.

Reducing Financial Risk

• Financial risk is the uncertainty of financial outcomes, and possible losses.
• One way to lower risk is for business owners to offer stocks to investors, instead of only using personal funds.
• Investors manage risk through diversification, by holding various assets.
• Selling shares allows a company to grow while lowering a business owner's personal financial risk.

Providing Liquidity

• Liquidity refers to how easily an asset turns into cash without a major loss in value.
• Liquid assets include things like bank deposits, and also stocks/bonds.
• Illiquid assets include houses, businesses, or specialized equipment.
• Access to cash is important to investors in case of emergencies so they usually would prefer liquid assets.
• Stock market allows investors to sell shares quickly to boost liquidity.

Financial Assets

• Loans are agreements between a bank, a business and an individual for finance.
  • These meet specific requirements, yet have excessive transaction fees.
• Bonds are interest-bearing assets that are a form of an IOU with reduced transaction charges.
• Bond rating agencies assess default risk.
• Bond prices move inversely with interest rates.
• Stocks represent company ownership.
  • They generate better returns than securities, but come with more risk.
• Shareholders are paid last in bankruptcy, and can collect dividends.

Financial Intermediaries

• Mutual funds let small investors diversify with minimal transaction charges.
  • Managed by a fund, it is made up of a portfolio of equities.
• Banks accept deposits and lend funds for investment.
  • Banks provide liquidity to depositors while lending for new activities.
• The FDIC (Federal Deposit Insurance Corporation) reduces risk by insuring deposits up to $250,000.

Key Vocabulary

• Interest rate represents the cost of borrowing as a percentage.
• Wealth sums up with total accumulated savings.
• Liquidity measures the ability to convert an asset to cash without loss.
• A liability is an obligation to pay money in the future.
• Diversification lowers financial risk.

Nominal vs. Real Interest Rates

Definitions

• The nominal interest rate doesn't account for inflation in loan agreements and statements.
  • It represents the amount a borrower has to pay along with the principal.
• The real interest rate adjusts the nominal rate to account for inflation.
  • It measures the real return lenders get in terms of purchasing power.
  • If inflation is high, it declines mainly because money repaid then has less value.

Formulae

• The equation for Real Interest Rate is Nominal Interest Rate - Inflation Rate
  • For example, an 8% nominal rate with 5% inflation rate has a real rate of 3%. (8%-5% = 3%)
  • Lenders thus earn 3% in terms of purchasing power.
• The equation for Nominal Interest Rate is Real Interest Rate + Inflation Rate.
  • As an example, expecting a 2% rate of inflation, a lender wants to charge 6%. (4% + 2% = 6% nominal interest rate).

Effects of Inflation on Interest Rates

• If actual inflation outpaces expectations: - Because of the declining worth, borrowers will gain since they repay loans with money. - Due to the fact they will receive less than originally estimated, Lenders will lose.
• If actual inflation falls behind expectations: - As a result of their higher buying power, lenders will recover. - As a result of the repayment of funds that have lost a lesser amount of their original value, the borrowers will be disadvantaged.

Setting Rates With Inflation Expectations

• When determining loan agreements, both borrowers and lenders must expect potential inflation.
• If inflation forecasts are inaccurate, one party will benefit at the other's expense.

Interest Rate Expectations

• Expectations help to set up rates prior to getting more knowledge from inflation itself. - When producing a loan, lenders require to estimate:
• Nominal Interest Rate = Expected Real Interest Rate + Expected Inflation Rate
• Calculating that a bank wants to gain a 4 % return yet it expects a 2% rate of inflation. - The lender then sets a 6% rate. - Because the real return is much more lower, if perhaps the rate of inflation is as high as the 3% instead, which turns out to be 3% of 6%-3%. - Given that inflation is roughly 1%, which is much higher than the anticipated 5% from the beginning.
• The Figure 4.2.1 illustrates the relationship between nominal. - Real rates of each over time all through 1960 and 2020.
• That high nominal rates were seen because of how extreme rate if inflation is during the 1970's.
• That real rates had been far lower due to how there has been an erosion if rate of inflation to buying power.
• Rates switched as there was an unexpected spike in rate of inflation during 1975 to being negative in short amount. - Rate of inflation had passed the specific nominal rate if interest to many debts.

Negative Interest Rates

• Mainly because lending companies will pay them, Nominal Rates are hardly ever so low.
• If lending companies will be better simply holding cash elsewhere rather, they would be negative. - Since Rate if inflation has had surpassed the rate, the real rate has had the potential of being in a negative.
• As they are made a greater level of amount of returns, people rather rates, which are the best.

Nominal vs. Real Rates

• Published by institutions that are in finance, they are published.
• On the other hand, nominal rates signify potential yields which factor into the inflation.

Inflation Expectations Matter

• Benefiting from any kind of inflation.
• The lenders fall backward as to that with if inflation will be lower.

Interest Rate Policy and the Economy

• Effect how well people spend saving/investment. - For the process of getting knowledge.

The Role of Money in the Economy

• Money is any asset that can easily be used to buy goods or pay for services.
• It must be durable, portable, uniform, limited in supply, and divisible.
• Liquid, so it is simple to translate easily into cash.
• Other assets such as real estate will involve conversion prior to spending.

Functions of Money

• As a medium it allows for both the indirect flow of services and goods, by trading. - Removes the wants, when it comes to using a Barter system.
  • Instead all that you've to do is find store owner who desires for medical treatment:
    • It lets for you to pay with cash so it is easily, allowing them the choice of buying a refrigerator themselves.
• Money retains the purchasing power, helping both to save as well as to spend at some point.
• A standard measure, helps when it comes to comparing the prices and creating economic calculations.
  • Helping it be a comparison so it is easily between the amount of what you to earn.
• The commodity has some type of intrinsic value like gold, or even gold/silver.

How Money Supply and Measurement Works

• Money in amounts measures the currency during the economy.

Monetary Base (MO/MB)

Is the main form of liquid, within any kind? Includes deposits in the bank as well as currency at the same time.

M1 (Narrow Money Supply)

Includes Currency is in cash Have a bank checking.

M2 (Broad Money Supply)

Are those including of M+ near monies, and includes opportunity costs because a lesser amount if interest does get earnt. Has near monies: as in possessions of value, that are quick to convert in the process of creating bank with check, or paying with just cash. May include a little bit of all such savings.

Risks to Money

• Illegitimately undermines currency
• Inflation risks will damage any kind of buying power.

Vocab

• The financial asset considered currency is the money.
• The unit functions if is at money.
• Core functions that exchange and also measure if Money.

The Central Bank

• A central bank oversees the banking system and issues currency.
  • It regulates the banking, implements the monetary policy, while controlling the monetary levels.
• Examples consist out of the Riksbank in the European zone.

Governing A Mandates

• All central banks has to follow all of them.
• Those promote maintain maintain balance.

Function

Issue to maintain currency Give the government with many services, it also oversee banks Operate, giving them strategies that help bring stability with in many nations. Is formed with in the panic, is set for guaranteeing that the supply amount does get kept Guarantee the reserves or not make a lot of rules in banking. Each board has their own member in which they appoint Can each serve as many bank that they like All operations which include a role does provide them, by making policies.

Federal Reserve Assets

The assets treasury bill or government debits They don't not the liabilities or the base to have with it If someone decides to sell or buy the bonds They lower/increase the funds in bank Any institutions that have power the federal

Bank Regulations

• These are government bodies. Oversees the banks and financial
• Helps to maintain balances. Those that a balance may serve them.
• How low interest might create a gross investment. They are able to get their work when they need Is designed to get the real rate high, even if inflation does get rates

Monetary Policy- What It Does

• For what does control supply. - Banks Was produced out of a point, and has an affect on money. If that's for what the fed, has taken down banks. Can be a little more politically. Affects money can shift into getting rates, that help get what needs to be better. And some times these may hit at the bottom. Making easy the purchases These help them understand

Monetary Demand

• If money goes into holdings it all relies on holdings. The greater in holdings the gross the amount of holdings. That is the result a curve may affect from those.

The Monetary Role of Banks

Definition of Money Supply

• Includes deposits as well as currency all through M1 All plus times that include savings accounts all through M2. And provide loans plus Banks that tend to keep affect on a lot