Financial Sector

Besides cash, you can hold your wealth as stocks (a share of ownership in a company) or bonds (a loan to a company or government that pays interest), and every asset trades off liquidity, risk and rate of return. When interest rates rise, the price of bonds that were already issued falls, and when rates fall, their price rises. The interest you give up by holding cash instead of bonds is the opportunity cost of holding money.

A nominal interest rate is the rate a loan actually charges, before adjusting for inflation; the real interest rate is what's left after inflation. When a loan is made, the nominal rate is roughly the real return the lender wants plus the inflation both sides expect. After the fact, real rate = nominal rate − actual inflation: for example, 7% nominal with 3% inflation is a 4% real rate.

Money is whatever people will take in exchange for goods and services, and it does three jobs: medium of exchange, unit of account and store of value. M1 is the most liquid money: currency, checkable deposits and, since 2020, savings deposits. M2 adds less liquid near-monies such as small time deposits (like CDs) and money market funds. The monetary base counts only currency in circulation plus banks' reserves.

Banks keep only a fraction of their deposits as reserves (fractional reserve banking). A bank's balance sheet, or T-account, lists assets such as reserves and loans on one side and liabilities such as demand deposits on the other. Required reserves are deposits × the required reserve ratio, and anything above that is excess reserves, which banks can lend out. As loans are spent and redeposited, new excess reserves can grow the money supply by at most excess reserves × the money multiplier (1 ÷ the required reserve ratio). The real increase is smaller if banks keep extra reserves or people hold more cash.

The money market graph puts the nominal interest rate on the vertical axis and the quantity of money on the horizontal axis. Money demand (MD) slopes downward because a higher interest rate raises the cost of holding cash, money supply (MS) is a vertical line set by the central bank, and they cross at the equilibrium nominal interest rate (i1) and quantity (Q1). A higher price level or more real GDP shifts MD right and raises the interest rate. In a limited-reserves system, an increase in the money supply shifts MS right and lowers it.

Monetary policy is how a central bank, such as the Federal Reserve, moves interest rates. Expansionary policy lowers rates, which raises investment and consumer spending and shifts AD right to fight a recession; contractionary policy does the opposite to fight inflation. With limited reserves, the central bank changes the money supply using open market operations (buying bonds adds reserves), the required reserve ratio or the discount rate. With ample reserves, as in the U.S. today, it changes administered rates such as interest on reserves to move its policy rate (the federal funds rate in the U.S.). On the reserve market graph, the policy rate is on the vertical axis and the quantity of reserves on the horizontal axis. The demand for reserves slopes down and then flattens out at the administered rate. With ample reserves, the vertical supply of reserves crosses demand in that flat part. So lowering the administered rate shifts the flat part down and lowers the policy rate.

The loanable funds market graph puts the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. Supply (SLF) slopes upward and comes from savers; demand (DLF) slopes downward and comes from borrowers; they cross at r1 and Q1. More saving shifts supply right and lowers the real interest rate, while more borrowing, such as firms responding to an investment tax credit or a government covering a deficit, shifts demand right and raises it.