AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/4/4-6)
Unit 4 · Topic 4.6
4.6 Monetary Policy
Monetary policy is how a central bank, such as the Federal Reserve, changes interest rates to steer aggregate demand. Expansionary policy lowers rates to fight a recessionary gap, and contractionary policy raises them to fight an inflationary gap. Which tools work depends on whether the banking system has limited or ample reserves.
Key terms
- open market operations
- discount rate
- interest on reserves
- federal funds rate (policy rate)
- limited vs. ample reserves
- reserve market
Goals and the chain of effects
Central banks aim for goals such as price stability (low, steady inflation) and full employment. The Fed, like many central banks, steers one key interest rate, called the policy rate: what banks charge each other to borrow reserves overnight. In the U.S. that's the federal funds rate, and the Fed announces a target range for it.
Every monetary policy answer follows the same chain.
- Expansionary, for a recessionary (negative) output gap: interest rates fall, so investment and interest-sensitive consumer spending (such as car and home purchases) rise, so AD shifts right. Real GDP and the price level rise, and unemployment falls.
- Contractionary, for an inflationary (positive) output gap: interest rates rise, so investment and consumption fall, so AD shifts left. Real GDP and the price level fall (or inflation slows), and unemployment rises.
Tools with limited reserves
When banks hold few reserves beyond what they're required to, a small change in reserves moves interest rates. So the central bank works by changing the money supply. Each expansionary move shifts MS right in the money market and lowers the nominal interest rate.
| Tool | Expansionary move | Contractionary move | How it works |
|---|---|---|---|
| Open market operations | Buy government bonds | Sell government bonds | Buying pays banks with new reserves, raising the monetary base; lending then grows the money supply by a multiple |
| Required reserve ratio | Lower it | Raise it | A lower ratio turns required reserves into excess reserves and raises the money multiplier |
| Discount rate | Lower it | Raise it | This is the rate the central bank charges banks for loans; a lower rate makes borrowing reserves cheaper |
Tools with ample reserves
U.S. banks now hold far more reserves than they need. With ample reserves, adding or removing some reserves barely moves interest rates. Instead, the Fed changes administered rates: interest rates it sets directly rather than leaving to the market. The key one is interest on reserves (IOR), the rate the Fed pays banks on the reserves they keep at the Fed. The discount rate is another administered rate.
A bank won't lend its reserves to another bank for less than it can earn by leaving them at the Fed. So the policy rate stays close to the interest on reserves rate. Lower interest on reserves and the policy rate falls with it (expansionary). Raise it and the policy rate rises (contractionary).
The reserve market graph
Read which banking system a question describes, then name the tool that fits. You can show monetary policy's short-run effects on the money market, the reserve market or the AD–AS graph.
- Vertical axis: policy rate (in the U.S., the federal funds rate). Horizontal axis: quantity of reserves.
- Demand for reserves (DR): flat at a high rate on the far left, then sloping downward, then flat again on the right at the interest on reserves rate. The high flat part is usually explained as the discount rate: a bank won't pay more than that to borrow reserves, since it can borrow from the central bank instead.
- Supply of reserves (SR): a vertical line at the quantity of reserves the central bank provides.
- Ample reserves: SR crosses DR on its lower flat part, so the policy rate (PR1) equals the interest on reserves rate. Moving SR left or right along that flat part doesn't change the rate. Lowering interest on reserves shifts the flat part down, so the policy rate falls to PR2.
- Limited reserves: SR crosses DR on its downward-sloping part. An open market purchase shifts SR right and lowers the policy rate.
Lags
Monetary policy doesn't work instantly. It takes time to recognize a problem, because data on GDP and unemployment arrive with a delay. It also takes time for the economy to respond after rates change, because firms plan investment months ahead. A central bank can change rates at a single meeting, but the effects on spending can take many months, and by then conditions may have changed.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Limited reserves: sizing an open market operation
Country P has limited reserves and an inflationary gap. Its required reserve ratio is 20%, and its central bank wants to cut the money supply by at most $40 billion. (a) What open market operation should it use, and how large? (b) Explain the effect on the nominal interest rate, AD and the price level.
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- Step 1: (a) To shrink the money supply, the central bank sells government bonds. Banks pay with reserves, so reserves fall.
- Step 2: Money multiplier = 1 ÷ 0.20 = 5. Bond sale needed = $40 billion ÷ 5 = $8 billion.
- Step 3: (b) In the money market, MS shifts left, so the nominal interest rate rises.
- Step 4: Higher interest rates reduce investment and interest-sensitive consumption, so AD shifts left. Real GDP falls toward full employment and the price level falls (or rises more slowly).
Answer: (a) Sell $8 billion of government bonds. (b) The nominal interest rate rises, AD decreases, and the price level and real GDP fall.
- Example 2
Ample reserves: the reserve market
Country Q's banking system has ample reserves, and its economy is in a recessionary gap. (a) What monetary policy action should its central bank take? (b) Describe a correctly labeled reserve market graph that shows the effect on the policy rate.
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- Step 1: (a) With ample reserves, the central bank changes administered rates. To expand the economy, it lowers interest on reserves.
- Step 2: (b) Axes: policy rate on the vertical axis, quantity of reserves on the horizontal axis.
- Step 3: Draw DR1 sloping down, then flattening at the original interest on reserves rate. Draw a vertical SR that crosses DR1 in that flat part, and label the policy rate PR1.
- Step 4: Lowering interest on reserves shifts the flat part of demand down to DR2. SR doesn't move. The new intersection, still on the flat part, is at a lower policy rate, PR2.
- Step 5: Then finish the chain: lower rates raise investment and consumption, so AD shifts right and real GDP rises.
Answer: Lower interest on reserves; the flat part of reserve demand shifts down and the policy rate falls from PR1 to PR2.
- Example 3
Using the wrong tool for the system (classic trap)
In an economy with ample reserves, a student says the central bank should buy bonds to lower the policy rate. What's wrong with this answer?
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- Step 1: Buying bonds adds reserves, which shifts SR to the right.
- Step 2: With ample reserves, SR already crosses DR on its flat part. Moving SR to the right along a flat line leaves the policy rate where it was, at the interest on reserves rate.
- Step 3: To lower the policy rate, the central bank should lower its administered rates, such as interest on reserves.
Answer: With ample reserves, buying bonds barely changes the policy rate; the central bank should lower interest on reserves instead.
Common mistakes
- Mixing up fiscal and monetary tools. Changing taxes or government spending is fiscal policy; monetary policy uses bond purchases and sales, reserve requirements and administered rates.
- Using limited-reserves tools on an ample-reserves question. With ample reserves, change administered rates such as interest on reserves.
- Skipping the interest rate step. Write 'interest rates fall, so investment rises, so AD increases'; jumping from 'buy bonds' straight to 'AD increases' leaves out the explanation.
- Getting the direction of a bond trade backwards. Buying bonds adds reserves and is expansionary; selling bonds removes reserves and is contractionary.
On the exam
- Free-response questions state whether the banking system has limited or ample reserves. That phrase tells you which tool to name: an open market operation (limited) or a change in interest on reserves (ample).
- Expect to draw either the money market or the reserve market and show the change in the interest rate, then carry the effect through to AD, real GDP and the price level.
- You may need to calculate the size of an open market operation: the target change in the money supply ÷ the money multiplier.
Connected topics
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Check yourself
4 questions on 4.6 Monetary Policy. Pick an answer to see if you got it, and why.
The central bank of Country Y operates with ample reserves. Its reserve market graph has the policy rate on the vertical axis and the quantity of reserves on the horizontal axis.
The demand for reserves slopes downward when reserves are scarce and becomes flat at the interest rate the central bank pays on reserves, currently 3.0 percent. The supply of reserves is a vertical line that crosses the demand curve in its flat section, so the policy rate is about 3.0 percent.
Hypothetical scenario
The central bank decides to raise its policy rate to about 3.5 percent. Which action would accomplish this?
Suppose that instead the central bank buys a modest amount of bonds, shifting the supply of reserves to the right while it still crosses demand in the flat section. What happens to the policy rate?
If the central bank raises the interest rate it pays on reserves, what is the most likely short-run effect on the economy?
On a reserve market graph, which of the following indicates that the central bank is operating with limited reserves?
0 of 4 answered