AP Macroeconomics Unit 4 Monetary Policy: How the Fed Influences Money, Interest Rates, and Inflation

Monetary policy

Actions a central bank takes to influence interest rates, bank lending, and the money supply to achieve macroeconomic goals (e.g., GDP, unemployment, inflation).

Federal Reserve (the Fed)

The central bank of the United States that conducts monetary policy.

Bank reserves

Funds banks hold (as cash or deposits at the Fed) that support lending and affect the money-creation process in the banking system.

Transmission mechanism

The causal chain linking a Fed action to changes in interest rates, investment/consumption, and ultimately aggregate demand and real GDP.

Expansionary monetary policy

Policy intended to increase aggregate demand by increasing reserves/money supply and lowering interest rates to raise investment and real GDP in the short run.

Contractionary monetary policy

Policy intended to decrease aggregate demand by reducing reserves/money supply and raising interest rates to lower investment and reduce inflationary pressure.

Open Market Operations (OMO)

The Fed’s buying and selling of government securities (e.g., Treasury bonds) in the open market to change bank reserves and influence interest rates.

Open market purchase

Fed buys government securities; bank reserves increase, interest rates tend to fall, investment rises, and aggregate demand increases.

Open market sale

Fed sells government securities; bank reserves decrease, interest rates tend to rise, investment falls, and aggregate demand decreases.

Money multiplier (simple deposit multiplier)

In the simplified AP model, the maximum deposit expansion from new reserves; equals m = 1/rr.

Required reserve ratio (rr)

The fraction of deposits banks must hold as required reserves rather than lend out.

Deposit creation process

AP model in which banks lend excess reserves, creating new deposits across banks in repeated rounds (limited by rr).

Maximum change in money supply (ΔM)

In the simple model, ΔM = m × ΔR; represents the maximum potential deposit/money expansion from a reserve change.

Excess reserves

Reserves held by banks above the required minimum; can reduce the realized multiplier relative to the simple AP prediction.

Discount rate

The interest rate the Fed charges banks for short-term loans obtained directly from the Fed through the discount window.

Discount window

Facility through which banks borrow reserves directly from the Federal Reserve.

Reserve requirement

A regulation setting the required reserve ratio; changing it alters the money multiplier and banks’ lending capacity.

Loanable funds market

Model where the real interest rate is determined by the supply of saving available for lending and the demand for borrowing to finance investment (and sometimes government borrowing).

Real interest rate

Interest rate adjusted for inflation; the relevant “price” in the loanable funds model because it reflects the true cost of borrowing in purchasing-power terms.

Nominal interest rate

Quoted interest rate not adjusted for inflation; distinct from the real interest rate emphasized in the loanable funds model.

Demand for loanable funds

Borrowing demand (mainly by firms for investment); slopes downward because lower interest rates make more investment projects profitable.

Supply of loanable funds

Saving made available for lending; slopes upward because higher interest rates encourage more saving.

Crowding out

Reduction in private investment caused by higher real interest rates when government borrowing (e.g., a budget deficit) increases demand for loanable funds.

Quantity theory of money

Framework linking money supply to the price level using MV = PY; with stable velocity, faster money growth than real output growth tends to imply inflation.

Equation of exchange (MV = PY)

Identity where M is money supply, V is velocity, P is price level, and Y is real output; PY equals nominal GDP.