• Ease with which an asset can be converted into cash without significant loss of value
• Most liquid: Currency, checking deposits
• Less liquid: Savings accounts, money market accounts
• Least liquid: Stocks, bonds, real estate
• Liquidity preference: people prefer more liquid assets, but less liquid assets typically pay higher returns

• Stocks (equity): Ownership share in a corporation
• Potential for capital gains and dividends
• Higher risk, higher expected return
• Residual claim on assets (after bondholders paid)
• Bonds (debt): Loan to corporation or government
• Fixed interest payments (coupon) until maturity
• Lower risk than stocks (especially government bonds)
• Priority claim on assets if bankruptcy

• Inverse relationship: bond price up -> yield down
• When interest rates rise, existing bonds with lower coupon rates become less attractive -> price falls
• Formula: Current yield = Annual coupon payment / Current bond price
• Example: $100 annual coupon,$1000 face value, bond price falls to $800 -> yield = 100/800 = 12.5%

$\text{Real Interest Rate} \approx \text{Nominal Interest Rate} - \text{Inflation Rate}$

Exact Fisher Equation: $(1 + \text{Real Rate}) = \frac{1 + \text{Nominal Rate}}{1 + \text{Inflation Rate}}$

• Nominal interest rate: Stated rate without adjustment for inflation
• Real interest rate: Purchasing power gain from lending/investing
• Higher unexpected inflation reduces real interest rate
• Important for investment decisions: investors care about real returns

• Accepted in exchange for goods and services
• Eliminates double coincidence of wants problem from barter
• Most important function of money
• Example: Using dollars to buy groceries

• Common measure of value for all goods and services
• Allows price comparison and calculation
• Enables accounting and contracts
• Example: Quoting prices in dollars, pesos, yuan

• Preserves purchasing power over time
• Allows people to save and postpone purchases
• Money imperfect store during high inflation
• Alternatives: gold, real estate, stocks

• M1 (narrowest): Currency in circulation + demand deposits (checking) + traveler's checks
• Most liquid forms of money
• Used directly for transactions
• M2 (broader): M1 + savings deposits + small time deposits (<$100,000) + money market funds
• Less liquid but can be quickly converted to cash
• More closely related to economic activity and inflation
• M3 (not officially tracked): M2 + large time deposits + institutional money market funds

• Banks hold only a fraction of deposits as reserves
• Remainder lent out to earn interest
• Reserves = currency in bank vault + deposits at Federal Reserve
• System creates money through lending process
• Most countries use fractional reserve system

• Required reserves: Minimum reserves banks must hold by regulation
• Required reserve ratio (rr) set by central bank
• Required reserves = rr × Deposits
• Excess reserves: Reserves held above required minimum
• Can be lent out to earn interest
• Basis of money creation
• Banks may hold excess reserves during financial uncertainty

Money Multiplier Formula: $\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement Ratio}}$

$\text{Maximum Change in Money Supply} = \text{Money Multiplier} \times \text{Change in Reserves}$

• Example: Reserve requirement = 10% (0.10)
• Money multiplier = 1/0.10 = 10
• $100 new reserves -> potential$1,000 increase in money supply
• Actual multiplier smaller due to:
• Cash holdings (currency drain)
• Excess reserves held by banks

• Interest rates: Higher rates -> higher opportunity cost of holding money -> lower quantity demanded (movement along curve)
• Income: Higher income -> more transactions -> money demand increases (shifts right)
• Price level: Higher prices -> need more money for transactions -> money demand increases (shifts right)
• Expectations: Expected interest rate changes or economic conditions affect money demand

• Determined by central bank (Federal Reserve in US)
• Independent of interest rate
• shifts only when Fed changes policy
• Perfectly inelastic with respect to interest rates

• Money demand = Money supply
• Determines short-term interest rates
• Fed changes money supply -> interest rate changes
• Changes in money demand (income, price level) -> interest rate changes
• Money market equilibrium connects to loanable funds market and AD-AS model

• Monetary policy: Control money supply and interest rates
• Lender of last resort: Lend to banks in crisis (discount window)
• Bank regulation: Supervise and regulate banking system
• Payment system: Process checks and electronic payments
• Currency issuer: Issue and distribute currency

• Most frequently used monetary policy tool
• Fed buys or sells government securities (bonds)
• Expansionary: Fed buys bonds -> pays with new reserves -> money supply increases
• Contractionary: Fed sells bonds -> removes reserves from economy -> money supply decreases
• Advantages: flexible, precise, quickly implemented

• Interest rate Fed charges banks for borrowing from discount window
• Higher discount rate -> banks borrow less -> reserves decrease -> money supply decreases
• Lower discount rate -> banks borrow more -> reserves increase -> money supply increases
• Signal of Fed policy stance
• Less frequently used than open market operations

• Minimum fraction of deposits banks must hold as reserves
• Lower requirement -> banks can lend more -> money supply increases
• Raise requirement -> banks must hold more reserves -> money supply decreases
• Rarely changed in US (blunt instrument)
• Some countries have zero reserve requirements

• Traditional framework before 2008
• Banks held minimal excess reserves
• Fed controlled money supply through open market operations
• Fed funds rate fluctuated based on supply and demand for reserves
• Money multiplier relatively stable

• Current framework after 2008 financial crisis
• Fed pays interest on reserves (IOR)
• Banks hold large quantities of excess reserves
• Fed funds rate controlled by setting IOR and ON RRP rate
• Open market operations used to maintain ample reserves
• Money multiplier less relevant

• Fed pays interest on both required and excess reserves
• Sets floor for short-term interest rates
• Banks won't lend below IOR (risk-free alternative)
• Tool for controlling Fed funds rate in ample reserves regime
• Allows Fed to maintain large balance sheet

• Rates set administratively by Fed rather than market forces
• Include: Interest on Reserves (IOR), Overnight Reverse Repo (ON RRP) rate
• Establish corridor for short-term interest rates
• Primary tool in ample reserves framework
• ON RRP rate provides floor for money market funds

• Borrowers: businesses (investment), households (mortgages, loans), government (budget deficit)
• Inverse relationship with interest rate: higher rates -> less borrowing
• Investment demand curve slopes downward
• Government borrowing unaffected by interest rate in short run (fixed deficit)
• Total demand = private investment + government borrowing

• Lenders: households saving, foreign capital inflows
• Direct relationship with interest rate: higher rates -> more saving
• Savings supply curve slopes upward
• Higher returns encourage saving over consumption
• Foreign capital attracted by high domestic interest rates

• Supply = Demand for loanable funds
• Determines real interest rate (adjusted for inflation)
• Government borrowing shifts demand right -> higher interest rates
• Increased savings shifts supply right -> lower interest rates
• Market clearing rate coordinates saving and investment

• Government budget deficit -> increased borrowing -> demand for loanable funds shifts right -> real interest rates rise -> private investment decreases
• Complete crowding out: In classical (long-run) model, private investment decreases exactly equal to government borrowing
• Partial crowding out: In Keynesian (short-run) model, some crowding out, but multiplier effects increase output
• Reduces long-run economic growth (lower investment -> lower capital stock)
• More significant when economy near full employment