Financial Sector

• A financial asset is anything that holds value and can be traded — money, bonds, stocks, and Certificates of Deposit (CDs) are the main examples in this course.
• A bond is essentially a loan: the buyer pays money now in exchange for fixed interest payments plus the return of the original amount (principal) at maturity.
• Bond prices and interest rates (yields) move in opposite directions. Since a bond promises a fixed future dollar payment, paying more for that bond today means earning a lower percentage return (yield); paying less means earning a higher yield.

• The nominal interest rate is the stated rate, not adjusted for inflation.
• The real interest rate adjusts the nominal rate for (expected) inflation, reflecting the true change in purchasing power: Real interest rate ≈ Nominal interest rate − Expected inflation rate (the simplified Fisher equation used in this course).
• The real rate is what actually matters to savers and borrowers deciding whether a loan or a savings account is worthwhile in terms of real purchasing power.

• Money serves three functions: medium of exchange (used to buy things), unit of account (a common measure of value/prices), and store of value (holds purchasing power over time).
• Monetary base (M0): currency in circulation + bank reserves — the narrowest measure, and the "raw material" the Fed directly controls.
• M1: currency in circulation + demand deposits (checking-account balances) + other checkable deposits — the most liquid, spendable-right-now measure.
• M2: M1 + savings deposits + small-denomination time deposits/CDs + retail money market funds — broader, including "near money" that takes a small extra step to spend.

• Banks operate under fractional reserve banking: they must hold a set fraction of deposits (the reserve requirement) as reserves, and may lend out the rest (excess reserves).
• Money multiplier = 1 ÷ reserve requirement. As loans get spent, redeposited, and re-lent throughout the banking system, a single new deposit can expand the total money supply by far more than its original amount.
• A basic bank balance sheet: Assets (reserves, loans, securities, property) = Liabilities (demand deposits) + Net worth/capital.

• The Money Market graph shows the nominal interest rate (vertical axis) against the quantity of money (horizontal axis).
• Money Supply is vertical — set directly by the Fed, not dependent on the interest rate.
• Money Demand slopes downward — at a higher interest rate, the opportunity cost of holding non-interest-bearing money rises, so people want to hold less of it.
• Equilibrium in this market determines the nominal interest rate.

This is the most detail-heavy topic, because the Fed's actual tools have changed since the 2008 financial crisis — this course covers both systems.

In a "limited reserves" system

The traditional model, where banks hold few reserves beyond what's required:

• The Fed has three tools: change the reserve requirement, change the discount rate (the rate the Fed charges banks to borrow reserves directly from it), or conduct open market operations (buying or selling government bonds).
• To fight a recession (expansionary): decrease the reserve requirement, decrease the discount rate, and/or buy bonds. All three increase bank reserves and the money supply, lowering interest rates.
• To fight inflation (contractionary): do the reverse — increase the reserve requirement, increase the discount rate, and/or sell bonds.

In an "ample reserves" system

Today's actual environment, where banks hold far more reserves than required:

• Small changes in reserves no longer move interest rates, since reserves are already abundant. Instead, the Fed sets administered rates directly.
• The discount rate acts as a ceiling — banks won't borrow from each other above this rate, since they could just borrow from the Fed instead.
• Interest on Reserves (IOR) acts as a floor — banks won't lend to each other below this rate, since they could just hold reserves and earn IOR instead.
• The federal funds rate (the rate banks actually charge each other, also called the policy rate) settles somewhere between these two administered rates. This is modeled with the reserve market graph (not the money market graph): a vertical supply of reserves, and a demand for reserves that's flat at the discount rate ceiling, flat at the IOR floor, and downward-sloping in between.
• To fight a recession: the Fed lowers both the discount rate and IOR, pulling the federal funds rate down within the new, lower range. Open market operations still happen, but mainly to maintain ample reserves, not to directly move rates.
• To fight inflation: the Fed raises both rates instead.

Transmission to the rest of the economy

Connecting back to Units 2 and 3: lower interest rates → higher quantity of investment demanded (movement along the investment demand curve) and more interest-sensitive consumer spending (cars, appliances) → AD increases. Lower domestic interest rates also make domestic bonds relatively less attractive to foreign investors → demand for the domestic currency falls → the currency depreciates → net exports rise, adding further to AD.

• The Loanable Funds Market models the market for savings and borrowing: Supply = national saving (private + public); Demand = borrowing, mainly for investment.
• Unlike the Money Market, this graph determines the real interest rate — because savers and borrowers care about the return/cost in terms of actual purchasing power, not just the stated rate.
• Determinants that shift this market: changes in private saving, changes in government borrowing (deficits/surpluses), and changes in investment demand (profit expectations, business taxes, technology).