Overview

The financial sector plays a crucial role in channeling funds from savers to borrowers, influencing interest rates, investment, and overall economic activity. It includes money markets, banks, central banking, and various financial instruments. Understanding how this sector operates is key to analyzing the effects of monetary policy and financial shocks.

Key Themes and Concepts

• Money and Financial Assets: Money is a medium of exchange, unit of account, and store of value. Financial assets include currency, checking accounts, stocks, and bonds.
• Time Value of Money: Future value and present value calculations show the relationship between time, interest, and money.
• Money Supply: Measured by M1 (currency + demand deposits) and M2 (M1 + savings deposits, money market funds).
• Money Creation: Banks create money through fractional reserve lending. The money multiplier determines the maximum amount of money created from an initial deposit.
• Money Demand: Depends on interest rates, income, and price level. Individuals hold money for transactions, precaution, and speculation.
• Money Market: Graph shows equilibrium interest rate where money supply intersects money demand. Central banks shift the supply to influence rates.
• Loanable Funds Market: Explains real interest rate determination through saving and investment demand. Shocks to either side affect capital formation.
• Central Bank and Monetary Policy:
  • Tools: Open market operations, reserve requirements, discount rate.
  • Goals: Price stability, full employment, moderate long-term interest rates.
  • Quantity Theory of Money: MV = PQ shows the relationship between money supply and nominal GDP.
• Nominal vs. Real Interest Rates: Real interest rate = nominal rate − inflation rate. Determines the true cost of borrowing.

Quick Tip

Money isn’t just printed — it’s created through banking activity. Central banks control the money supply to manage interest rates, but individuals and businesses shape money demand. Understanding these markets helps explain inflation, investment, and economic cycles.