Financial Sector
This domain covers money, banking, and the Federal Reserve: functions of money, M1 and M2, fractional reserve banking and deposit expansion, Fed tools, the demand for money, loanable funds, and the link between bond prices and interest rates. Questions often trace a policy action through reserves, the money supply, interest rates, and spending.
Money and banking
- Functions of money: medium of exchange, unit of account, and store of value.
- M1 = currency + checkable deposits + travelers checks; M2 = M1 + savings deposits, small time deposits, and retail money market funds.
- Fractional reserves: with required reserve ratio rr, the simple money multiplier is 1 / rr.
- Excess reserves and currency holdings make actual deposit expansion smaller than the simple multiplier predicts.
Federal Reserve tools
- Open market operations: buying securities raises reserves, lowers the federal funds rate, and increases the money supply.
- The Fed also uses the discount rate, reserve requirements, and interest on reserves.
- The Fed targets the federal funds rate; it does not set that rate directly.
- Bond prices and interest rates move inversely.
Loanable funds
- Supply comes from saving; demand comes from investment; the real interest rate clears the market.
- Government deficits shift demand right, raising interest rates and crowding out some investment.
Worked example
With a required reserve ratio of 20%, the simple money multiplier is 1 / 0.20 = 5. A new $1,000 deposit can support $5,000 in total deposits, including the initial deposit, or $4,000 in new money. If the Fed buys $10 billion of government securities, bank reserves rise by $10 billion and the money supply could rise by up to $50 billion if banks lend out all excess reserves and the public holds no extra currency.
Traps that cost marks
- The money multiplier is an upper bound; excess reserves and cash leakages reduce it.
- Bond prices and yields move in opposite directions.
- M1 is narrower than M2; savings deposits are not in M1.
- The discount rate is not the federal funds rate; the Fed influences the latter through open market operations.
- The Fed cannot precisely control both the money supply and the interest rate at once.