AP Macroeconomics Unit 4 Cheatsheet: Financial Sector

Three Key Attributes:

• Liquidity: How easily converted to cash. Cash and demand deposits are most liquid.
• Rate of Return: Interest or dividends earned.
• Risk: Probability of losing value.

Asset Types:

• Money (cash, demand deposits) — liquid, no return
• Bonds — interest-bearing, inverse price-yield relationship
• Stocks — equity ownership, variable return

Bond Price & Interest Rate: When interest rates rise, previously issued bond prices fall (and vice versa). Holding money means forgoing interest from bonds—this is the opportunity cost.

Central Bank Tools:

• Open Market Operations (OMOs) — buy/sell securities
• Discount Rate — rate charged to banks for borrowing
• Required Reserve Ratio — % of deposits banks must hold
• Interest on Reserves — rate paid on bank reserves (U.S. focus)

How OMOs Work:

• Purchase: Increases reserves → increases monetary base → increases money supply
• Sale: Decreases reserves → decreases monetary base → decreases money supply

Policy Types:

• Expansionary: Increase money supply → lower interest rates → boost investment & consumption (fight recession)
• Contractionary: Decrease money supply → raise interest rates → reduce spending (fight inflation)

Transmission: Policy affects interest rates → affects investment & consumption → affects aggregate demand → affects output & price level.

Lags: recognition lag (identifying the problem) + implementation lag (enacting the policy); impact lag is the time for the policy to affect the economy.

Closed Economy:

National Savings = Public Savings + Private Savings

• Public Savings = Tax Revenue − Government Spending
• Private Savings = Income − Taxes − Consumption

Open Economy:

Investment = National Savings + Net Capital Inflow

• Net Capital Inflow = Foreign investment in domestic assets − Domestic investment abroad
• If capital inflow is positive, domestic investment can exceed national savings

Key Insight: A country running a budget deficit (negative public saving) must increase private saving and/or attract net foreign capital inflows to maintain investment.