Monetary Policy and the Money Market

Monetary policy is the central bank's way of moving aggregate demand, and in the Financial Sector unit of AP Macroeconomics it is tested as a chain: tool, money market, interest rate, spending, output. Break one link and the answer loses points.

The money market graph

• The vertical axis is the nominal interest rate; the horizontal axis is the quantity of money.
• Money demand slopes down: a higher interest rate makes holding cash more costly.
• Money supply is vertical: the central bank sets it, and it does not depend on the interest rate.

An increase in money supply shifts the vertical line right and lowers the nominal interest rate. An increase in money demand, for example from higher nominal income, raises the interest rate.

The tools

With limited reserves (the classic model on the graph above):

• Open market operations: buying bonds adds reserves and raises the money supply; selling bonds does the opposite.
• Reserve requirement: a lower requirement lets banks lend more.
• Discount rate: a lower rate makes borrowing reserves cheaper.

With ample reserves (how the central bank operates today): it sets administered rates, chiefly the interest rate on reserve balances. Raising that rate raises the federal funds rate and other short-term rates. The current course framework covers both.

The chain

Expansionary policy in a recession:

1. The central bank buys bonds or lowers its administered rates.
2. The nominal interest rate falls.
3. Investment and interest-sensitive consumption rise.
4. Aggregate demand shifts right.
5. Real GDP rises, unemployment falls, the price level rises.

Contractionary policy runs every link in reverse.

The money multiplier

money multiplier = 1 / reserve requirement

Worked example: the reserve requirement is 10%. The central bank buys $5 million of bonds from a commercial bank. The bank's excess reserves rise by $5 million, so the maximum change in the money supply is 5 × (1/0.10) = $50 million.

The FRQ approach

Draw the money market with labeled axes, shift the correct curve, then write the chain in order with an arrow for each step. Name the tool precisely: "buy bonds", not "increase money".