💶AP Macroeconomics Unit 4 – Financial Sector

Key Financial Institutions

• Commercial banks accept deposits, provide loans, and offer various financial services to individuals and businesses
  • Checking and savings accounts allow customers to store and access their money
  • Loans include mortgages, car loans, and personal loans for consumers as well as business loans for companies
• Investment banks help companies and governments raise capital by underwriting and selling securities (stocks and bonds)
• Insurance companies provide protection against financial losses due to events such as accidents, illness, or death
  • Offer products like life insurance, health insurance, and property insurance
  • Collect premiums from policyholders and pay out claims when covered events occur
• Pension funds manage retirement savings for employees and provide income during retirement years
• Mutual funds pool money from many investors to purchase a diversified portfolio of securities, allowing individuals to invest in a variety of assets with a single purchase

Money and Its Functions

• Money serves as a medium of exchange, facilitating transactions between buyers and sellers without the need for barter
• It acts as a unit of account, providing a standard measure of value for goods and services
  • Prices can be easily compared and recorded using a common monetary unit (U.S. dollars)
• Money is a store of value, allowing individuals to save and preserve purchasing power over time
• It serves as a standard of deferred payment, enabling borrowing and lending by providing a means to repay debts in the future
• Characteristics of money include durability, portability, divisibility, uniformity, limited supply, and acceptability

Banking System and Money Creation

• The banking system consists of the central bank and commercial banks, which together create and manage the money supply
• Commercial banks accept deposits from customers and use a portion of these funds to make loans, a process known as fractional reserve banking
  • Banks are required to hold a fraction of deposits as reserves, while the remainder can be lent out
  • When banks make loans, they create new money in the form of bank deposits, increasing the money supply
• The money multiplier effect occurs when banks lend out a portion of their deposits, which then become new deposits in other banks, allowing for further lending and money creation
• The central bank (Federal Reserve in the U.S.) influences the money supply through monetary policy tools such as setting reserve requirements, conducting open market operations, and adjusting the discount rate

Interest Rates and Monetary Policy

• Interest rates represent the cost of borrowing money and the return on savings
  • Nominal interest rates are the stated rates, while real interest rates account for inflation
• The central bank sets the target for the federal funds rate, which influences short-term interest rates throughout the economy
• Monetary policy refers to the actions taken by the central bank to manage the money supply and interest rates to achieve economic goals such as price stability and full employment
  • Expansionary monetary policy involves lowering interest rates and increasing the money supply to stimulate economic growth
  • Contractionary monetary policy involves raising interest rates and reducing the money supply to combat inflation
• The yield curve depicts the relationship between bond maturities and their corresponding interest rates, providing insights into market expectations and economic conditions

Financial Markets and Instruments

• Financial markets facilitate the flow of funds between savers and borrowers, allowing for efficient allocation of capital
• Capital markets include stock markets, where companies raise equity capital by issuing shares, and bond markets, where companies and governments raise debt capital by issuing bonds
  • Primary markets involve the initial issuance of securities, while secondary markets allow for the trading of existing securities
• Money markets are short-term financial markets where instruments with maturities of less than one year are traded (Treasury bills, commercial paper)
• Derivatives markets involve financial instruments whose value is derived from an underlying asset (options, futures, swaps)
• Other financial instruments include asset-backed securities, which are backed by pools of loans or other financial assets, and exchange-traded funds (ETFs), which track the performance of a particular index or asset class

Role of Central Banks

• Central banks, such as the Federal Reserve in the U.S., are responsible for conducting monetary policy and maintaining financial stability
• They act as the lender of last resort, providing liquidity to the banking system during times of financial stress
• Central banks regulate and supervise commercial banks to ensure the safety and soundness of the banking system
  • They set capital requirements, which determine the amount of equity banks must hold relative to their assets
  • They conduct stress tests to assess banks' resilience to adverse economic conditions
• Central banks manage the country's foreign exchange reserves and intervene in foreign exchange markets to influence the value of the domestic currency
• They also play a role in promoting financial inclusion and consumer protection

Financial Regulation and Stability

• Financial regulation aims to maintain the stability and integrity of the financial system, protect consumers, and prevent financial crimes
• Prudential regulation focuses on ensuring the safety and soundness of financial institutions through capital requirements, liquidity standards, and risk management guidelines
• Market conduct regulation aims to protect consumers and promote fair and transparent practices in financial markets (disclosure requirements, anti-fraud measures)
• Deposit insurance protects depositors' funds in case of bank failures, helping to maintain confidence in the banking system (FDIC in the U.S.)
• Macroprudential regulation addresses systemic risks that can threaten the stability of the entire financial system, such as excessive leverage or interconnectedness among financial institutions
• International coordination of financial regulation is important due to the global nature of financial markets (Basel Accords, Financial Stability Board)

Impact on Economic Growth and Development

• An efficient and stable financial system is crucial for economic growth and development by allocating capital to productive investments
• Financial intermediation helps to mobilize savings and channel them into investments, supporting capital formation and productivity growth
• Access to credit enables businesses to expand and innovate, creating jobs and driving economic growth
  • Microfinance institutions provide small loans to entrepreneurs and small businesses, promoting financial inclusion and economic development in underserved communities
• Well-functioning financial markets facilitate risk management and diversification, allowing businesses and individuals to manage financial risks and make long-term investments
• Financial sector development can contribute to poverty reduction by providing access to financial services and enabling wealth creation
  • Mobile banking and digital financial services have expanded financial inclusion in developing countries
• However, financial crises and instability can have severe negative impacts on economic growth and development, highlighting the importance of effective financial regulation and risk management