1. Section 5

2. Banking and Money

3. Key Terms Interest Rate Bank Deposit Discount Window
Savings-investment spending identity
Bank
Excess Reserves
Money
Monetary Base
Budget Surplus
Currency in circulation
Money Multiplier
Budget Deficit
Checkable Bank Deposits
Central Bank
Budget Balance
Money Supply
Commercial Bank
National Savings
Medium of Exchange
Investment Bank
Capital Inflow
Store of Value
Federal Funds Market
Wealth
Unit of Account
Federal Funds Rate
Financial Asset
Commodity Money
Discount Rate
Physical Asset
Commodity-backed Money
Open-market Operation
Liability
Fiat Money
Short-term Interest Rates
Transaction Costs
Monetary Aggregate
Long-term Interest Rates
Financial Risk
Near-moneys
Money Demand Curve
Diversification
Future Value
Liquidity Preference Model of the interest rate
Liquid
Present Value
Illiquid
Net Present Value
Money Supply Curve
Loan
Bank Reserves
Loanable Funds Market
Default
T-account
Rate of Return
Loan-backed Securities
Reserve Ratio
Crowding Out
Financial Intermediary
Required Reserve Ratio
Fischer Effect
Mutual Fund
Bank Run
Pension Fund
Deposit Insurance
Life Insurance Company
Reserve Requirements

4. Key Formulas
Savings-Investment Spending Identity: Savings = Investment Spending Budget Balance = tax revenue – gov’t spending – transfer payments National Saving = Savings + Budget Balance

5. Key Formulas
M1 = currency and coin + traveler’s checks + checking deposits M2 = M1 + near moneys Monetary Base = Bank Reserves + Currency in Circulation Money Supply = Currency in Circulation + Checkable Bank Deposits

7. Key Formulas
Future Value: FV = PV(1+r)t Present Value: PV = FV/(1+r)t

8. Key Formulas
Money Multiplier = 1/rr rr = reserve ratio *know the difference between “reserves”, “required reserves”, “excess reserves”, and “reserve ratio”

9. Key Formulas
Rate of Return = (revenue – cost)/cost * 100 Real Interest Rate = Nominal Interest Rate - Expected Inflation Nominal Interest Rate = Real Interest Rate + Expected Inflation

10. Key Graphs Assets Liabilities T-accounts Loans $1,800,000
Cash Reserves $200,000
Deposits $2,000,000
In this example the bank is holding 10% of its deposits in reserve

11. Money Market Fed controls the MS
4 shifters of MD – technology, PL, realGDP, institutions

12. Crowing Out Effect

13. Liquidity Preference Model

14. The Two Models
According to the liquidity preference model, a fall in the interest rate results in an increase in I spending, and following that an increase in RGDP and Consumption
The increase in RGDP results in an increase in consumption AND savings (through the multiplier)
How much do savings rise? Because of the savings-investment identity we know that savings = investment
So a fall in the interest rate leads to higher investment spending, and the resulting increase in RGDP generates exactly enough additional savings to match the rise in investment spending.
After a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded
Note: In the long run, changes in the money supply DO NOT affect the interest rate.

15. AP Exam Tips
The amount of savings is equal to the amount of investment.
Know the roles (medium of exchange, etc.) and types of money (fiat, etc.).
The term “money supply” usually refers to M1.
Understand T-accounts, they often show up on exams.
Banks do not print money, only the Treasury can do that.
Excess reserves are important because these reserves are what banks can lend out to borrowers.
The money multiplier is 1/rr where rr is the reserve ratio.
The Federal Reserve = the Fed = the central bank.
The most important function of the Fed is to conduct monetary policy. Three tools: RR, Discount Rate, OMO.
The interest rate, r, used in the money market graph is the nominal interest rate.
Changes in aggregate price level, rGDP, technology and banking institutions shift the money demand curve.
Use real interest rate, r, for the loanable funds market graph. This refers to the fact that the real interest rate and nominal interest rate rise and fall together with expectations about inflation. If the question asks about or references the real interest rate, label the graph with the real interest rate.
The incentive to lend money is higher when the interest rate is higher. This is why the supply of loanable funds is upward sloping.

16. Practice Question
Suppose RGDP is $2.5 trillion and potential GDP is $1 trillion and the reserve requirement is 20%? Based on sound macroeconomic policy, what should the government do?
1.5 = x*1/0.2
1.5 = x*5
x=1.5/5
x=300 bill