Social Studies: AP Macroeconomics: Monetary Policy and the Fed Worksheet

Question 1

The economy is in a recessionary gap with high unemployment and output below potential GDP. Identify one monetary policy action the Federal Reserve could take and explain how it would help close the gap.

Accepted Answer

The Federal Reserve could buy government securities through open market operations. This increases bank reserves and the money supply, lowers interest rates, increases investment and interest-sensitive consumption, raises aggregate demand, and helps move real GDP toward potential GDP.

Question 2

Draw a money market graph showing an increase in the money supply. Label the money demand curve, the original money supply curve, the new money supply curve, the original nominal interest rate, and the new nominal interest rate. Explain the change.

Accepted Answer

The money supply curve shifts to the right, while the money demand curve stays the same. The nominal interest rate falls because there is a greater quantity of money available at each interest rate.

Question 3

Suppose the required reserve ratio is 10 percent and a bank receives a new cash deposit of $2,000. If the bank holds no excess reserves, calculate the maximum amount the bank can lend from this deposit.

Accepted Answer

The bank must hold $200 in required reserves because 10 percent of $2,000 is $200. The maximum amount the bank can lend is $1,800.

Question 4

Suppose the required reserve ratio is 20 percent and the banking system receives a new $500 deposit. Calculate the maximum possible increase in the money supply if banks lend all excess reserves and there are no cash leakages.

Accepted Answer

The money multiplier is 1 divided by 0.20, which equals 5. The maximum possible increase in the money supply is $500 multiplied by 5, or $2,500.

Question 5

Explain the difference between the federal funds rate and the discount rate.

Accepted Answer

The federal funds rate is the interest rate banks charge each other for overnight loans of reserves. The discount rate is the interest rate the Federal Reserve charges banks that borrow directly from the Fed.

Question 6

The Federal Reserve raises the interest rate paid on reserve balances. Explain how this policy can reduce the money supply or slow money creation.

Accepted Answer

When the Fed pays a higher interest rate on reserve balances, banks have a stronger incentive to hold reserves instead of making loans. This can reduce lending, slow deposit creation, and decrease growth in the money supply.

Question 7

Draw an aggregate demand and aggregate supply graph for an economy in a recessionary gap. Then show the effect of expansionary monetary policy. Label the initial equilibrium, the new equilibrium, potential output, and the direction of the AD shift.

Accepted Answer

The economy begins with equilibrium real GDP below potential output. Expansionary monetary policy lowers interest rates and increases investment, causing aggregate demand to shift right. The new equilibrium has higher real GDP and a higher price level.

Question 8

An economy is experiencing demand-pull inflation. Identify one contractionary monetary policy action the Federal Reserve could take and explain how it would affect inflation.

Accepted Answer

The Federal Reserve could sell government securities through open market operations. This decreases bank reserves and the money supply, raises interest rates, reduces investment and interest-sensitive consumption, decreases aggregate demand, and helps reduce inflationary pressure.

Question 9

If the Federal Reserve sells $100 million of government securities to commercial banks, what happens to bank reserves and the money supply? Explain.

Accepted Answer

Bank reserves decrease because banks pay the Federal Reserve for the securities. With fewer reserves, banks have less ability to make loans, so the money supply decreases through the money creation process.

Question 10

Use the loanable funds market to show the effect of an increase in government borrowing, holding monetary policy constant. Label the real interest rate and quantity of loanable funds. Explain how this may affect private investment.

Accepted Answer

An increase in government borrowing raises the demand for loanable funds, which increases the real interest rate. The higher real interest rate can crowd out private investment because borrowing becomes more expensive for firms.

Question 11

A bank has $10,000 in deposits, $1,000 in required reserves, and $500 in excess reserves. What is the required reserve ratio, and what is the maximum amount this bank can lend right now?

Accepted Answer

The required reserve ratio is 10 percent because $1,000 divided by $10,000 equals 0.10. The maximum amount this bank can lend right now is $500 because that is its amount of excess reserves.

Question 12

Explain why expansionary monetary policy may be less effective if banks choose to hold excess reserves instead of making loans.

Accepted Answer

Expansionary monetary policy increases reserves, but the money supply grows fully only if banks lend excess reserves and borrowers deposit the funds. If banks hold excess reserves, fewer loans are made, deposit creation slows, and the total increase in the money supply is smaller.

Question 13

Draw a correctly labeled Phillips curve graph and show the likely short-run effect of expansionary monetary policy. Explain the movement on the short-run Phillips curve.

Accepted Answer

Expansionary monetary policy increases aggregate demand, which raises output and lowers unemployment in the short run. On the short-run Phillips curve, the economy moves to a point with a lower unemployment rate and a higher inflation rate.

Question 14

Suppose the Federal Reserve announces that it will keep interest rates lower for longer than expected. Explain how expectations can affect current aggregate demand.

Accepted Answer

If households and firms expect lower interest rates to continue, they may borrow and spend more now. This can increase consumption, investment, and aggregate demand even before additional policy changes occur.

Question 15

A country has a floating exchange rate. The central bank raises interest rates. Explain the likely effect on the value of the country’s currency and on net exports.

Accepted Answer

Higher interest rates can attract foreign financial investment, increasing demand for the country’s currency. The currency appreciates, which makes exports more expensive and imports cheaper, so net exports are likely to decrease.

Social Studies: AP Macroeconomics: Monetary Policy and the Fed

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