AP Macroeconomics Notes on Monetary Policy

Vocabulary

  1. Monetary Policy: Actions by the central bank to control the money supply and interest rates to achieve macroeconomic goals.
  2. Central Bank: An institution that manages a country’s currency, money supply, and interest rates (e.g., the Federal Reserve in the U.S.).
  3. Federal Reserve (Fed): The central bank of the United States.
  4. Open Market Operations (OMO): The buying and selling of government securities by the central bank to influence the money supply.
  5. Discount Rate: The interest rate charged by the central bank on loans to commercial banks.
  6. Reserve Requirement: The fraction of deposits that banks are required to keep in reserve and not loan out.
  7. Federal Funds Rate: The interest rate at which banks lend reserves to each other overnight.
  8. Expansionary Monetary Policy: Policies aimed at increasing the money supply to stimulate economic growth.
  9. Contractionary Monetary Policy: Policies aimed at reducing the money supply to control inflation.
  10. Money Supply: The total amount of money circulating in the economy.
  11. Inflation: A sustained increase in the general price level of goods and services.
  12. Deflation: A sustained decrease in the general price level of goods and services.
  13. Quantitative Easing (QE): A non-traditional monetary policy where the central bank buys financial assets to inject liquidity into the economy.
  14. Liquidity: The ease with which an asset can be converted into cash.
  15. Nominal Interest Rate: The stated interest rate not adjusted for inflation.
  16. Real Interest Rate: The interest rate adjusted for inflation (Nominal Interest Rate – Inflation Rate).

Want to test your knowledge of Monetary Policy? Check out these AP Macro Free Response Questions on Monetary Policy.

Overview of Monetary Policy

Monetary policy refers to the actions taken by a country’s central bank to manage the economy by controlling the money supply and interest rates. These actions aim to achieve macroeconomic objectives such as price stability, full employment, and economic growth.

Tools of Monetary Policy

  1. Open Market Operations (OMO):
    • The most commonly used tool by central banks.
    • Involves the buying and selling of government bonds:
      • Buying bonds: Increases the money supply (expansionary policy).
      • Selling bonds: Decreases the money supply (contractionary policy).
  2. Discount Rate:
    • The interest rate the central bank charges commercial banks for borrowing funds.
    • Lowering the discount rate encourages borrowing and increases the money supply (expansionary).
    • Raising the discount rate discourages borrowing and decreases the money supply (contractionary).
  3. Reserve Requirement:
    • The percentage of deposits that banks must hold as reserves.
    • Lowering the reserve requirement increases the money supply (expansionary).
    • Raising the reserve requirement decreases the money supply (contractionary).
  4. Interest on Excess Reserves (IOER):
    • The interest rate paid by the central bank on reserves held by commercial banks.
    • Adjusting this rate can influence how much banks lend to the economy.
  5. Quantitative Easing (QE):
    • Used in situations where traditional tools are insufficient (e.g., near-zero interest rates).
    • The central bank purchases financial assets, such as long-term bonds, to inject liquidity and stimulate lending.

Types of Monetary Policy

  1. Expansionary Monetary Policy:
    • Goal: Stimulate economic growth, especially during a recession.
    • Methods:
      • Lowering interest rates (Federal Funds Rate, Discount Rate).
      • Buying government bonds (OMO).
      • Reducing the reserve requirement.
    • Effects:
      • Increases investment and consumption.
      • Boosts aggregate demand (AD).
      • Reduces unemployment but may increase inflation.
  2. Contractionary Monetary Policy:
    • Goal: Control inflation when the economy is overheating.
    • Methods:
      • Raising interest rates.
      • Selling government bonds (OMO).
      • Increasing the reserve requirement.
    • Effects:
      • Decreases investment and consumption.
      • Reduces aggregate demand (AD).
      • Controls inflation but may increase unemployment.

How Monetary Policy Affects the Economy

  1. Aggregate Demand (AD):
    • Monetary policy primarily impacts AD by influencing investment and consumption.
    • Lower interest rates reduce the cost of borrowing, encouraging spending and investment.
    • Higher interest rates increase the cost of borrowing, discouraging spending and investment.
  2. Money Market Graph:
    • Shows the supply and demand for money.
    • The central bank controls the money supply, which is shown as a vertical line.
    • Interest rates adjust based on changes in the money supply or demand for money.
  3. Loanable Funds Market:
    • Shows how monetary policy affects savings and investment.
    • Expansionary policy increases funds available for borrowing, reducing interest rates.
    • Contractionary policy decreases funds available, increasing interest rates.
  4. Phillips Curve:
    • Demonstrates the short-term tradeoff between inflation and unemployment.
    • Expansionary policy moves the economy up along the curve (lower unemployment, higher inflation).
    • Contractionary policy moves the economy down along the curve (higher unemployment, lower inflation).

Limitations of Monetary Policy

  1. Time Lags:
    • Recognition Lag: Time to recognize an economic issue.
    • Implementation Lag: Time for the central bank to enact policy.
    • Effectiveness Lag: Time for the policy to impact the economy.
  2. Liquidity Trap:
    • Occurs when interest rates are very low, and monetary policy becomes ineffective in stimulating borrowing and spending.
  3. Global Influences:
    • Exchange rates and international capital flows can reduce the effectiveness of domestic monetary policy.
  4. Inelastic Investment and Consumption:
    • If businesses and consumers are not responsive to lower interest rates, the policy may not achieve its desired effects.

Summary of Key Relationships

  • Lower Interest Rates: Increase borrowing, investment, and AD.
  • Higher Interest Rates: Decrease borrowing, investment, and AD.
  • Money Supply and Inflation: Increasing the money supply can lead to higher inflation if the economy is at full capacity.
  • Monetary Policy Goals: Price stability, full employment, and sustainable economic growth.

Practice Questions

  1. What are the three main tools of monetary policy, and how does each tool affect the money supply?
  2. Explain how expansionary monetary policy affects the Phillips Curve in the short run.
  3. Why might monetary policy be less effective during a liquidity trap?
  4. Using the money market graph, illustrate the effect of contractionary monetary policy.
  5. Compare and contrast expansionary and contractionary monetary policy in terms of their effects on interest rates and aggregate demand.

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