AP Macroeconomics · Unit 4 · Topic 4.6

The Monetary Policy Study Lab

Monetary policy is how the central bank changes interest rates to push aggregate demand toward full employment and stable prices. AP teaches two ways to do it: the limited-reserves tools that change the money supply, and the ample-reserves tools that set administered rates. Switch between the two frameworks, use the tools to close a recessionary or inflationary gap, and follow the chain from the tool to the interest rate to AD.

1. Run monetary policy

The left graph shows how the tool moves the interest rate. The right graph shows what that rate change does to AD, real GDP, and the price level. Dashed grey lines show where things were before the policy.

Money market limited reserves

AD–AS real GDP and the price level

Try a scenario

Framework

The economy starts in

Open market operations Right = buy bonds, left = sell bonds

Discount rate Rate the Fed charges banks for loans of reserves

Required reserve ratio Share of deposits banks must hold as reserves

Nominal interest rate

5.0%

Investment and consumption

No change

Real GDP

$900B

Price level

92.0

2. Key ideas

Goals

The dual mandate

The Federal Reserve is the U.S. central bank. Congress gave it two goals: maximum employment and stable prices. In a recession it fights unemployment; when the economy overheats it fights inflation.

Direction

Expansionary vs. contractionary

Expansionary monetary policy lowers interest rates to raise spending and shift AD right. Use it to close a recessionary gap. Contractionary policy raises interest rates to shift AD left. Use it to close an inflationary gap.

Limited reserves

Three tools that change the money supply

When reserves are scarce, small changes in reserves move rates. Buying bonds, lowering the discount rate, or lowering the required reserve ratio gives banks more to lend, so the money supply shifts right and the nominal interest rate falls. Open market operations are the tool used most.

Ample reserves

Administered rates

When banks hold plenty of reserves, reserve supply crosses the flat part of reserve demand. Adding or removing reserves leaves the rate unchanged. The Fed moves the policy rate by setting administered rates: interest on reserves and the overnight reverse repurchase (ON RRP) rate. Banks will not lend reserves for less than they can earn at the Fed.

The chain

Monetary transmission mechanism

Tool → interest rate → investment and interest-sensitive consumption → AD → real GDP and the price level. AP free-response answers earn points for each link, so write every step in order.

Bank math

Money multiplier

In the limited-reserves model, the money multiplier is 1 ÷ required reserve ratio. A 10% ratio gives a multiplier of 10. Lowering the ratio raises the multiplier, so each dollar of reserves supports more loans and deposits.

3. Monetary policy cheat sheet

Each row is one tool used in one direction. The last four columns are the AP chain.

Central bank action	Framework	Graph shift	Interest rate	I and C	AD	Real GDP, price level
Buy government bonds (open market purchase)	Limited	MS right	↓	↑	Right	↑, ↑
Sell government bonds (open market sale)	Limited	MS left	↑	↓	Left	↓, ↓
Lower the discount rate	Limited	MS right	↓	↑	Right	↑, ↑
Raise the discount rate	Limited	MS left	↑	↓	Left	↓, ↓
Lower the required reserve ratio	Limited	MS right	↓	↑	Right	↑, ↑
Raise the required reserve ratio	Limited	MS left	↑	↓	Left	↓, ↓
Lower interest on reserves (and ON RRP rate)	Ample	Reserve demand down	↓	↑	Right	↑, ↑
Raise interest on reserves (and ON RRP rate)	Ample	Reserve demand up	↑	↓	Left	↓, ↓
Buy or sell bonds while reserves stay ample	Ample	Reserve supply shifts along the flat part	No change	No change	No change	No change

4. Drawing it on the FRQ

Labels that earn points

Money market: vertical axis Nominal interest rate, horizontal axis Quantity of money. MS is vertical, MD slopes down.
Reserve market (ample reserves): vertical axis Policy rate (or federal funds rate), horizontal axis Quantity of reserves. Draw reserve demand sloping down, then flat; draw supply vertical where demand is flat.
For an IOR change, shift the reserve demand curve up or down and mark the new policy rate on the vertical axis. Leave the supply of reserves where it was.
On the AD–AS graph, label the axes Price level and Real GDP, draw LRAS at Y_f, show AD₁ and AD₂ with an arrow, and mark PL₁, PL₂, Y₁, and Y₂.
Name the exact action: "The Fed should buy bonds" or "lower the interest rate on reserves." Writing "increase the money supply" alone may not earn the point when the question asks for an open market operation.
Write the full chain: interest rate falls, investment and consumption rise, AD increases, real GDP and the price level rise.

Common mistakes

Buying bonds for an inflationary gap. Buying adds reserves and money, which is expansionary. To fight inflation, the Fed sells bonds.
Saying expansionary policy raises rates. Expansionary monetary policy lowers interest rates.
Shifting reserve supply to change the rate in an ample-reserves graph. On the flat part, the rate stays at IOR no matter how many reserves there are.
Confusing monetary and fiscal policy. Taxes and government spending are fiscal policy, set by Congress and the President. The central bank uses rates and reserves.
Shifting SRAS or LRAS with monetary policy. In the short run, monetary policy shifts AD only.
Mixing up the discount rate and the federal funds rate. The discount rate is what the Fed charges banks. The federal funds rate is what banks charge each other.
Getting the reserve requirement backwards. A higher required reserve ratio means less lending, a smaller money multiplier, and a smaller money supply.

5. Practice questions

AP-style multiple choice. Pick an answer to see the explanation.

0 / 0 correct

6. Key terms

The vocabulary for topic 4.6. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 4 terminology guide.