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Unit V – Financial Sector (20-25% of AP Macroeconomics exam) Objectives: NCEE Content Standard 11 – Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services. NCEE Content Standard 12 – Interest rates, adjusted for inflation, rise and fall to balance the amount saved with the amount borrowed, which affects the allocation of scarce resources between present and future uses. NCEE Content Standard 18 – A nation’s overall levels of income, employment, and prices are determined by the interaction of spending and production decision made by all households, firms, government agencies, and others in the economy. NCEE Content Standard 19 – Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future prices. NCEE Content Standard 20 – Federal government budgetary (fiscal) policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices. Vocabulary: (Big topics in bold) Saving (Public vs Private) Investment Personal Investment Stock Market Bond Market Primary and Secondary Market Stocks: Advantages/Disadvantages Bonds: Advantages/Disadvantages Diversification Liquidity Bonds Prices Interest Rates Time Value of Money SEC Risk and Return Loanable Funds Market National Savings Deficits versus Surplus Crowding Out Functions of Money Commodity versus Fiat Money Supply Definitions Functions of FED Federal Reserve Tools Fractional Reserve Banking Open Market Operations Reserve Requirement Excess Reserves Discount Rate Monetary Policy Federal Funds Rate and Target Taylor Rule Inflation Targeting Theory of Liquidity Preference Nominal versus Real Monetary Neutrality Fisher Effect Numbers and Formulas: Benefit Cost Analysis (MB >= MC) Money Multiplier Visuals: Loanable Funds Model Money Market Model Aggregate Model AP Macroeconomics Activity Book (answers to Unit 4 M/C sample questions for Unit 5) 1. A 4. E 7. C 10. D 13. E 16. D 19. B 2. B 5. D 8. B 11. A 14. A 17. C 3. D 6. E 9. D 12. C 15. B 18. D Unit V Calendar: Monday Tuesday 19 Unit 4 Test Wednesday 20 Bonds Hwk: Read Module 22 Hwk: Unit 5 RP due Wed., 1/11 Hwk: Read Module 29 (p. 276281) 12/24 3 9 Hwk: Read Modules 29 (p.281-285) and 32 23 Loanable Funds, Risk versus Return Hwk: Read Modules 2327, AP Macro Activity 4-5 No School 4 5 6 FED Tools Tools cont. Models Hwk: AP Macro Activity 4-6 Hwk: Read Module 28 Hwk: Read Module 31 and AP Macro Activity 4-4 10 Policy cont. Friday 22 Stocks Hwk: AP Macro Activities 4-1, 4-3 Hwk: AP Macro Activity 4-7 21 Savings and Investment Vacation January 2 No School Monetary System Monetary Policy Thursday 11 12 13 Policy: Short Run versus Long Run Optional Unit 5 Test 2:15-3:00 Optional Unit 5 Test 2:15-3:00 Hwk: AP Macro Activity 4-9 Please sign up by Fri., Jan.6 Please sign up by Fri., Jan. 6 What you should know at the end of this unit: Students recognize that saving means not consuming all current income, and investment refers to the production and purchase of machines, buildings, and equipment that can be used to produce more goods and services in the future. The U.S. financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks, and mutual funds. All of these institutions act to direct the resources of households that want to save some of their income into the hands of households and firms that want to borrow. The purpose of two major types of financial assets: Stocks and Bonds Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. Risk-averse people can reduce risk by buying insurance, diversifying their holdings, and choosing a portfolio with lower risk and lower return. Efficient Market Hypothesis states that financial markets process valuable information rationally, so a stock price always equals the best estimate of the value of the underlying business. (continue on next page) Money serves three functions. As a medium of exchange, it provides the item used to make transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future. Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: it would be worthless if it were not used as money. The Federal Reserve, the central bank of the United States, is responsible for regulating the US Monetary System. The FED chairman is appointed by the President and confirmed by Congress every four years. The chairman is the lead member of the Federal Open Market Committee, which means about every six weeks to consider changes in monetary policy. The FED controls the money supply primarily through open-market operations. The purchase of government bonds increases money supply, and the sale of government bonds decreases the money supply. The Fed can also expand the money supply by lowering the reserve requirements or decreasing the discount rate, and it can contract the money supply by raising the reserve requirements or increasing the discount rate. Monetary Policy (an increase in the money supply reduces the equilibrium interest rate for any given price level. Because a lower interest rate stimulates the investment spending, the aggregate demand curve shifts to the right and vice versa) The Federal Reserve has in recent years set monetary policy by choosing a target for the federal funds rate, a short term interest rate at which banks make loans to one another. As the FED achieves its target, it adjust money supply. The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation. Keynes proposed the theory of liquidity preference to explain the determinants of the interest rate and how the rate will adjust to balance the supply and demand for money. An increase in the price level raises money demand and increases the interest rate that brings the money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and thereby, the quantity of goods and services demanded. The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that money neutrality approximately describes the behavior of the economy in the long run. A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation. According to the Fisher Effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same.