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Credit Sprint's Guide to Macroeconomics Unit 4: Financial Sector

AP® weight 18–23%CLEP® weight 15–20%

Money serves as a medium of exchange, unit of account and store of value. Banks create money by lending excess reserves. The Federal Reserve sets monetary policy, the money market determines the nominal interest rate, and the loanable funds market determines the real interest rate.

What you need to know

  • M1 includes currency, checkable deposits and other liquid deposits like savings.
  • On a bank's balance sheet, deposits are liabilities; reserves and loans are assets.
  • Money multiplier = 1 ÷ reserve requirement; maximum new money = excess reserves × multiplier.
  • With limited reserves, buying bonds raises the money supply and lowers the nominal interest rate.
  • With ample reserves, the Fed steers rates mainly with the interest it pays on reserves.
  • Bond prices and interest rates move in opposite directions.
  • Loanable funds: saving is supply, borrowing is demand; the price is the real interest rate.

Formulas

Money multiplier = 1 ÷ reserve requirement
Max change in money supply = Excess reserves × Money multiplier
Real interest rate = Nominal rate − Expected inflation

Exam traps

Watch forA cash deposit does not change the money supply by itself; only the loans it enables do.
Watch forOne bank can lend only its own excess reserves; the multiplier applies to the whole system.
Watch forFed buys bonds = expansionary. Fed sells bonds = contractionary.

Key terms

  • Functions of money: Medium of exchange, unit of account and store of value.
  • M1: Currency in circulation plus checkable deposits and other liquid deposits like savings.
  • Required reserves: Deposits × reserve requirement. The share of deposits a bank must hold.
  • Excess reserves: Total reserves − required reserves. What a bank can lend.
  • Money multiplier: 1 ÷ reserve requirement. Max new money = excess reserves × multiplier.
  • Open market operations: The Fed buying (expansionary) or selling (contractionary) government bonds.
  • Discount rate: The rate the Fed charges banks that borrow reserves directly from it.
  • Interest on reserves: The rate the Fed pays banks on reserve balances. The main tool in an ample-reserves system.
  • Federal funds rate: The interest rate banks charge each other for overnight loans of reserves.
  • Ample reserves: A system where banks hold so many reserves that the Fed sets rates with administered rates, not bond trades.
  • Money demand: Shifts right when the price level or real GDP rises; slopes down against the nominal interest rate.
  • Loanable funds market: Savers supply funds, borrowers demand them; the price is the real interest rate.
  • Fisher equation: Real interest rate = nominal interest rate − expected inflation.
  • Bond prices and rates: Move in opposite directions. When rates rise, existing bond prices fall.

Practice questions

Five of the 45 Unit 4 questions in Credit Sprint. Every choice is explained in the app.

1. A customer deposits $1,000 in cash. The reserve requirement is 10%. What is the maximum increase in the money supply from new loans across the banking system?
  1. $9,000
  2. $1,000
  3. $10,000
  4. $900
  5. $100
Show answer

$9,000. Excess reserves of $900 × multiplier of 10 = $9,000.

2. Nominal GDP rises as the economy expands. In the money market:
  1. Money demand shifts left
  2. Nothing changes
  3. Money demand shifts right and the nominal interest rate rises
  4. Money supply shifts right
  5. The Fed must raise the money supply
Show answer

Money demand shifts right and the nominal interest rate rises. More transactions mean people want to hold more money.

3. The Federal Reserve's dual mandate is:
  1. A fixed exchange rate
  2. Low unemployment only
  3. High stock prices
  4. A balanced budget and low taxes
  5. Maximum employment and stable prices
Show answer

Maximum employment and stable prices. Those are the two goals Congress set for the Fed.

4. The Fed sells $50 million in bonds. The reserve requirement is 20%. The maximum decrease in the money supply is:
  1. $50 million
  2. $10 million
  3. $250 million
  4. $200 million
  5. $100 million
Show answer

$250 million. $50M × (1 ÷ 0.2) = $250M.

5. Which group sets the Federal Reserve's target for the federal funds rate?
  1. The Federal Open Market Committee (FOMC)
  2. Congress
  3. The Treasury Department
  4. Commercial banks
  5. The President
Show answer

The Federal Open Market Committee (FOMC). It meets about eight times a year to set policy.