SECTION 5 Review

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image Section 5 Review Video

Module 22

  1. Investment in physical capital is necessary for long-run economic growth. So in order for an economy to grow, it must channel savings into investment spending. The price charged per year by lenders to investors and other borrowers for the use of their savings is the interest rate, which is calculated as a percentage of the amount borrowed.

  2. According to the savings–investment spending identity, savings and investment spending are always equal for the economy as a whole. The government is a source of savings when it runs a positive budget balance, also known as a budget surplus; it is a source of dissavings when it runs a negative budget balance, also known as a budget deficit. In a closed economy, savings is equal to national savings, the sum of private savings plus the budget balance. In an open economy, savings is equal to national savings plus capital inflow of foreign savings. When a capital outflow, or negative capital inflow, occurs, some portion of national savings is funding investment spending in other countries.

  3. Households invest their current savings or wealth—their accumulated savings—by purchasing assets. Assets come in the form of either a financial asset, a paper claim that entitles the buyer to future income from the seller, or a physical asset, a claim on a tangible object that gives the owner the right to dispose of it as desired. A financial asset is also a liability from the point of view of its seller. There are four main types of financial assets: loans, bonds, stocks, and bank deposits. Each of them serves a different purpose in addressing the three fundamental tasks of a financial system: reducing transaction costs—the cost of making a deal; reducing financial risk—uncertainty about future outcomes that involves financial gains and losses; and providing liquid assets—assets that can be quickly converted into cash without much loss of value (in contrast to illiquid assets, which are not easily converted).

  4. Although many small and moderate-size borrowers use bank loans to fund investment spending, larger companies typically issue bonds. Bonds with a higher risk of default must typically pay a higher interest rate. Business owners reduce their risk by selling stock. Although stocks usually generate a higher return than bonds, investors typically wish to reduce their risk by engaging in diversification, owning a wide range of assets whose returns are based on unrelated, or independent, events. Most people are risk-averse, viewing the loss of a given amount of money as a significant hardship but viewing the gain of an equal amount of money as a much less significant benefit. Loan-backed securities, a recent innovation, are assets created by pooling individual loans and selling shares of that pool to investors. Because they are more diversified and more liquid than individual loans, trading on financial markets like bonds, they are preferred by investors. It can be difficult, however, to assess their quality.

  5. Financial intermediaries—institutions such as mutual funds, pension funds, life insurance companies, and banks—are critical components of the financial system. Mutual funds and pension funds allow small investors to diversify and life insurance companies allow families to reduce risk.

  6. A bank allows individuals to hold liquid bank deposits that are then used to finance investments in illiquid assets. Banks can perform this mismatch because on average only a small fraction of depositors withdraw their savings at any one time. Banks are a key ingredient in long-run economic growth.

Module 23

  1. Money is any asset that can easily be used to purchase goods and services. Currency in circulation and checkable bank deposits are both considered part of the money supply. Money plays three roles: it is a medium of exchange used for transactions, a store of value that holds purchasing power over time, and a unit of account in which prices are stated.

  2. Over time, commodity money, which consists of goods possessing value aside from their role as money, such as gold and silver coins, was replaced by commodity-backed money, such as paper currency backed by gold. Today the dollar is pure fiat money, whose value derives solely from its official role.

  3. The Federal Reserve calculates two measures of the money supply. M1 is the narrowest monetary aggregate; it contains only currency in circulation, traveler’s checks, and checkable bank deposits. M2 includes a wider range of assets called near-moneys, mainly other forms of bank deposits, that can easily be converted into checkable bank deposits.

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Module 24

  1. The accumulation of interest causes any amount of money loaned today to grow into a larger amount, called the future value, over the loan period.

  2. In order to evaluate a project in which costs or benefits are realized in the future, you must first transform them into their present values using the interest rate, r. The present value of $1 realized one year from now is $1/(1 + r), the amount of money you must lend out today to have $1 one year from now. Once this transformation is done, you should choose the project with the highest net present value.

Module 25

  1. Banks allow depositors immediate access to their funds, but they also lend out most of the funds deposited in their care. To meet demands for cash, they maintain bank reserves composed of both currency held in vaults and deposits at the Federal Reserve. The reserve ratio is the ratio of bank reserves to bank deposits. A T-account summarizes a bank’s financial position, with loans and reserves counted as assets, and deposits counted as liabilities.

  2. Banks have sometimes been subject to bank runs, most notably in the early 1930s. To avert this danger, depositors are now protected by deposit insurance, bank owners face capital requirements that reduce the incentive to make overly risky loans with depositors’ funds, banks must satisfy reserve requirements—a legally mandated required reserve ratio, and the Federal Reserve stands ready to lend money to banks through the discount window.

  3. When currency is deposited in a bank, it starts a multiplier process in which banks lend out excess reserves, leading to an increase in the money supply—so banks create money. If the entire money supply consisted of checkable bank deposits, the money supply would be equal to the value of reserves divided by the reserve ratio. In reality, much of the monetary base consists of currency in circulation, and the money multiplier is the ratio of the money supply to the monetary base.

Module 26

  1. The Federal Reserve or “the Fed” is the central bank of the United States. In response to the Panic of 1907, the Fed was created to centralize holding of reserves, inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.

  2. The Great Depression sparked widespread bank runs in the early 1930s, which greatly worsened and lengthened the depth of the Depression. Federal deposit insurance was created, and the government recapitalized banks by lending to them and by buying shares of banks. By 1933, banks had been separated into two categories: commercial (covered by deposit insurance) and investment (not covered). Public acceptance of deposit insurance finally stopped the bank runs of the Great Depression.

  3. The savings and loan (thrift) crisis of the 1980s arose because insufficiently regulated S&Ls engaged in overly risky speculation and incurred huge losses. Depositors in failed S&Ls were compensated with taxpayer funds because they were covered by deposit insurance. However, the crisis caused steep losses in the financial and real estate sectors, resulting in a recession in the early 1990s.

  4. As housing prices rose between 2003 and 2006, lenders made large quantities of questionable mortgage loans. When housing prices tumbled, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system. To prevent another Great Depression, the Fed and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank shares, and purchased private debt. Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 raised the question of whether a wider safety net and broader regulation were needed in the financial sector.

Module 27

  1. The Fed regulates banks and sets reserve requirements. To meet those requirements, banks borrow and lend reserves in the federal funds market at the federal funds rate. Banks can also borrow from the Fed at the discount rate.

  2. Open-market operations by the Fed are the principal tool of monetary policy: the Fed can increase or reduce the monetary base by buying U.S. Treasury bills from banks or selling U.S. Treasury bills to banks.

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Module 28

  1. The money demand curve arises from a trade-off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short-term interest rates, not long-term interest rates. Changes in the aggregate price level, real GDP, technology, and institutions shift the money demand curve.

  2. According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shifting the money supply curve. In practice, the Fed uses open-market operations to achieve a target federal funds rate, which other short-term interest rates generally follow.

Module 29

  1. The hypothetical loanable funds market shows how loans from savers are allocated among borrowers with investment spending projects. In equilibrium, only those projects with a rate of return greater than or equal to the equilibrium interest rate will be funded. By showing how gains from trade between lenders and borrowers are maximized, the loanable funds market shows why a well-functioning financial system leads to greater long-run economic growth. Government budget deficits can raise the interest rate and can lead to crowding out of investment spending. Changes in perceived business opportunities and in government borrowing shift the demand curve for loanable funds; changes in private savings and capital inflows shift the supply curve.

  2. Because neither borrowers nor lenders can know the future inflation rate, loans specify a nominal interest rate rather than a real interest rate. For a given expected future inflation rate, shifts of the demand and supply curves of loanable funds result in changes in the underlying real interest rate, leading to changes in the nominal interest rate. According to the Fisher effect, an increase in expected future inflation raises the nominal interest rate by the same number of percentage points, so that the expected real interest rate remains unchanged.