The Financial Sector — Hard Practice Quiz
A Macroeconomics cheat sheet for The Financial Sector — every key formula with its symbols defined — plus a hard-level practice quiz to test recall.
Formulas & key concepts
The total value of a household's accumulated savings and assets at a point in time.
A paper claim, such as a stock, bond, loan, or bank deposit, that entitles its owner to future income from the seller.
A tangible object, such as a building or machine, that can be owned and used to generate income.
A requirement to pay income in the future, the flip side of someone else's financial asset.
A financial system exists to reduce transaction costs, reduce risk, and provide liquidity.
The expenses of negotiating and executing a deal.
Uncertainty about future outcomes that involves potential financial losses or gains.
Spreading wealth across many assets with unrelated returns in order to lower overall risk.
Feeling the pain of a given loss more strongly than the pleasure of an equal-sized gain.
How easily an asset can be converted into cash without much loss of value; liquid assets convert easily, illiquid ones do not.
Assets created by pooling many individual loans and selling shares of the pool, making them more diversified and liquid than single loans but harder to value.
An institution such as a mutual fund, pension fund, life insurance company, or bank that channels savers' funds into financial assets.
An intermediary that pools money from many investors to buy a diversified portfolio, letting small savers diversify cheaply.
An intermediary that offers depositors liquid deposits while using those funds to make illiquid loans, a key driver of long-run growth.
For the economy as a whole, total saving always equals total investment spending.
The difference between the government's tax revenue and its spending; a surplus adds to national saving, a deficit subtracts from it.
Any asset that can readily be used to purchase goods and services.
Cash held by the public.
Bank accounts on which customers can write checks or use debit cards.
The total value of all assets in the economy that count as money.
Money's role as the thing people accept in trade for goods and services.
Money's role in preserving purchasing power over time.
Money's role as the common measure in which prices and debts are quoted.
A medium of exchange that has value of its own apart from its use as money, such as gold or silver coins.
Paper money whose value rests on a promise that it can be converted into a commodity such as gold.
Money, like the modern dollar, whose value comes solely from its official status rather than from any underlying commodity.
The narrowest measure of the money supply: currency in circulation, traveler's checks, and checkable bank deposits.
A broader money measure equal to M1 plus near-moneys such as savings deposits that convert easily into cash.
Financial assets that cannot be spent directly but are easily converted into checkable deposits.
Today's worth of a sum to be received in the future, found by discounting with the interest rate; $1 a year from now is worth $1/(1 + r) today.
The present value of a project's benefits minus the present value of its costs; the project with the highest net present value should be chosen.
The currency banks hold in their vaults plus their deposits at the Federal Reserve.
A simple table summarizing a bank's finances, with loans and reserves as assets and deposits as liabilities.
The fraction of bank deposits that a bank keeps as reserves.
The minimum reserve ratio banks must hold, set by the Federal Reserve.
Reserves a bank holds above the legally required amount, which it can lend out.
A wave of withdrawals by depositors who fear a bank will fail, which can push it into actually failing.
A government guarantee that depositors will be repaid, up to a limit, even if their bank fails, which stops most bank runs.
Rules requiring bank owners to hold a cushion of their own capital, reducing the temptation to make overly risky loans with depositors' money.
Legally mandated minimum reserves that banks must hold against their deposits.
When banks lend out their excess reserves, the loans return to the banking system as new deposits, expanding the money supply.
Currency in circulation plus the reserves held by banks; the quantity the Federal Reserve directly controls.
The ratio of the overall money supply to the monetary base.
The institution that oversees the banking system, regulates banks, and controls the monetary base; in the U.S. it is the Federal Reserve.
A severe banking crisis that prompted the creation of the Federal Reserve to centralize reserves and stabilize the money supply.
Widespread bank runs in the early 1930s deepened the Depression and led to federal deposit insurance and the separation of commercial from investment banks.
In the 1980s, poorly regulated thrifts took big speculative losses; insured depositors were repaid with taxpayer funds, and the fallout helped cause a recession in the early 1990s.
A 1990s hedge fund whose heavily leveraged bets collapsed, threatening global credit markets until the New York Fed organized a private bailout.
Bundling loans such as mortgages and selling them as securities, which spread subprime risk throughout the financial system.
Subprime mortgage losses during the mid-2000s housing bubble spread via securitization; when the bubble burst, the Fed and Treasury expanded lending and bought bank shares and debt to prevent another Depression.
The market in which banks borrow and lend reserves to one another overnight.
The interest rate banks charge each other for overnight reserve loans in the federal funds market.
The interest rate the Federal Reserve charges banks that borrow reserves directly from it through the discount window.
The Fed's main policy tool: buying Treasury bills from banks to raise the monetary base, or selling them to lower it.
Shows how the quantity of money people want to hold falls as the interest rate rises; it reflects the trade-off between liquidity and the opportunity cost of holding money.
The interest that could have been earned on other assets, determined by short-term rather than long-term interest rates.
The money demand curve shifts with changes in the aggregate price level, real GDP, technology, and financial institutions.
The theory that the interest rate is set in the money market by the money demand curve and the money supply curve.
The federal funds rate the Fed aims for using open-market operations; other short-term interest rates tend to move with it.
A model showing how savers' funds are allocated among borrowers' investment projects, funding only those with a return at least equal to the equilibrium interest rate.
The profit an investment project earns expressed as a percentage of its cost.
When government budget deficits push up the interest rate and reduce private investment spending.
Demand for loanable funds shifts with business opportunities and government borrowing; supply shifts with private savings and capital inflows from abroad.
A rise in expected future inflation raises the nominal interest rate one-for-one, leaving the expected real interest rate unchanged.
Practice quiz
An individual's wealth consists of a house valued at $500,000$, a mortgage of $300,000$, and $100,000$ in individual company stocks. They are risk-averse and decide to sell all their individual stocks to invest in a diversified mutual fund. How does this action immediately affect their total wealth and their overall financial risk?
- Wealth increases by $100,000$; financial risk decreases.
- Wealth remains unchanged; financial risk decreases.
- Wealth decreases due to transaction costs; financial risk increases.
- Wealth remains unchanged; financial risk increases.
Answer: Wealth remains unchanged; financial risk decreases.
A small business needs a $50,000$ loan for expansion, and an individual has $50,000$ in savings they wish to invest. Explain how a commercial bank, acting as a financial intermediary, facilitates this interaction in a way that addresses the three tasks of a financial system, particularly considering the bank's role in managing liquidity and risk.
- The bank reduces transaction costs by directly matching the saver to the business, but increases risk for the saver.
- The bank pools the saver's funds with others, reducing the saver's risk through diversification, provides liquidity to the saver, and lowers transaction costs for both parties.
- The bank transforms the illiquid loan into a liquid asset for the business, but does not reduce risk for the saver.
- The bank primarily focuses on reducing transaction costs for the business, while the saver bears all the risk of the loan.
Answer: The bank pools the saver's funds with others, reducing the saver's risk through diversification, provides liquidity to the saver, and lowers transaction costs for both parties.
Suppose the Federal Reserve conducts an open-market operation by buying $200$ million in Treasury bills from commercial banks. If the required reserve ratio is $10\%$, and banks hold no excess reserves and the public holds no additional currency, what is the maximum potential increase in the money supply (M1)?
- $20$ million
- $200$ million
- $2,000$ million
- $20,000$ million
Answer: $2,000$ million
According to the liquidity preference model, if the Federal Reserve aims to lower the federal funds rate, what open-market operation would it undertake, and how would this action affect the money market and the opportunity cost of holding money?
- Sell Treasury bills, which decreases the money supply, shifting the money supply curve left and increasing the opportunity cost of holding money.
- Buy Treasury bills, which increases the money supply, shifting the money supply curve right and decreasing the opportunity cost of holding money.
- Sell Treasury bills, which increases the money supply, shifting the money supply curve right and decreasing the opportunity cost of holding money.
- Buy Treasury bills, which decreases the money supply, shifting the money supply curve left and increasing the opportunity cost of holding money.
Answer: Buy Treasury bills, which increases the money supply, shifting the money supply curve right and decreasing the opportunity cost of holding money.
A country's government significantly increases its budget deficit by increasing spending without raising taxes. According to the Savings-Investment Spending Identity and the Loanable Funds Market model, how would this action likely affect the equilibrium interest rate and private investment spending, assuming no change in private savings or capital inflows from abroad?
- The supply of loanable funds would increase, leading to a lower interest rate and increased private investment.
- The demand for loanable funds would increase, leading to a higher interest rate and decreased private investment (crowding out).
- The supply of loanable funds would decrease, leading to a higher interest rate and increased private investment.
- The demand for loanable funds would decrease, leading to a lower interest rate and increased private investment.
Answer: The demand for loanable funds would increase, leading to a higher interest rate and decreased private investment (crowding out).
Consider a historical transition from a system where currency was commodity-backed money (e.g., convertible to gold) to a modern system of pure fiat money. How does this change fundamentally alter the "store of value" and "medium of exchange" roles of money, and what is the primary basis for its value in the fiat system?
- The store of value becomes inherently tied to the commodity, while the medium of exchange role is strengthened by government decree.
- The store of value becomes less stable, but the medium of exchange role is enhanced by the intrinsic value of the commodity.
- The store of value and medium of exchange roles are maintained, but the basis of value shifts from a commodity promise to government decree and public trust.
- The store of value is eliminated, and the medium of exchange role is solely dependent on international trade agreements.
Answer: The store of value and medium of exchange roles are maintained, but the basis of value shifts from a commodity promise to government decree and public trust.
The Great Depression saw widespread bank runs, leading to the implementation of deposit insurance. The $2008$ Financial Crisis, however, involved a different mechanism of systemic risk. How did securitization contribute to the spread of risk in $2008$, and why did this crisis necessitate broader interventions beyond just deposit insurance, such as capital requirements for banks?
- Securitization concentrated risk in a few large banks, making deposit insurance ineffective; capital requirements were needed to prevent future bank runs.
- Securitization diversified risk, making the system more robust; the crisis was primarily due to a lack of deposit insurance for investment banks.
- Securitization spread subprime mortgage risk throughout the financial system, making many institutions vulnerable, not just those facing traditional bank runs; capital requirements aimed to ensure banks had sufficient buffers against such widespread losses.
- Securitization made loans more liquid, which reduced overall risk; the crisis was a result of insufficient government intervention in the housing market.
Answer: Securitization spread subprime mortgage risk throughout the financial system, making many institutions vulnerable, not just those facing traditional bank runs; capital requirements aimed to ensure banks had sufficient buffers against such widespread losses.
Project X requires an initial investment of $1,000$ and promises a return of $1,100$ in one year. Project Y requires an initial investment of $1,500$ and promises a return of $1,700$ in two years. If the current interest rate is $4\%$, which project has a higher Net Present Value (NPV), and what is the approximate rate of return for each project?
- Project X has a higher NPV ($57.69$) with a rate of return of $10\%$; Project Y has an NPV of $71.74$ with a rate of return of approximately $6.45\%$.
- Project Y has a higher NPV ($71.74$) with a rate of return of approximately $6.45\%$; Project X has an NPV of $57.69$ with a rate of return of $10\%$.
- Project X has a higher NPV ($100$) with a rate of return of $10\%$; Project Y has an NPV of $200$ with a rate of return of approximately $6.45\%$.
- Project Y has a higher NPV ($1,700$) with a rate of return of approximately $6.45\%$; Project X has an NPV of $1,100$ with a rate of return of $10\%$.
Answer: Project Y has a higher NPV ($71.74$) with a rate of return of approximately $6.45\%$; Project X has an NPV of $57.69$ with a rate of return of $10\%$.
A risk-averse investor currently holds $100\%$ of their financial assets in a single, highly volatile technology stock. They are concerned about financial risk. Explain how investing in a diversified mutual fund, or alternatively, in loan-backed securities, could reduce their overall financial risk, and why this strategy is particularly beneficial for a risk-averse individual.
- Both mutual funds and loan-backed securities increase risk by spreading investments too thinly, which is detrimental to a risk-averse investor.
- Mutual funds offer diversification across many assets, reducing idiosyncratic risk, while loan-backed securities pool many loans, also offering diversification, both appealing to a risk-averse individual who feels losses more strongly than gains.
- Mutual funds reduce risk by guaranteeing returns, while loan-backed securities eliminate risk entirely, making them ideal for risk-averse investors.
- Investing in a mutual fund increases liquidity but does not reduce risk, whereas loan-backed securities are too complex for a risk-averse investor.
Answer: Mutual funds offer diversification across many assets, reducing idiosyncratic risk, while loan-backed securities pool many loans, also offering diversification, both appealing to a risk-averse individual who feels losses more strongly than gains.
A commercial bank receives a new checkable deposit of $5,000$. The required reserve ratio set by the Federal Reserve is $8\%$. If the bank decides to hold an additional $2\%$ of the new deposit as excess reserves, what is the initial amount the bank can lend out, and what is the maximum potential increase in the money supply (M1) that can result from this initial deposit, assuming the money multiplier process continues fully?
- The bank can lend out $4,500$; the maximum potential increase in the money supply is $57,500$.
- The bank can lend out $4,500$; the maximum potential increase in the money supply is $62,500$.
- The bank can lend out $4,000$; the maximum potential increase in the money supply is $50,000$.
- The bank can lend out $4,900$; the maximum potential increase in the money supply is $61,250$.
Answer: The bank can lend out $4,500$; the maximum potential increase in the money supply is $62,500$.
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