Reserve Market: AP Macro Exam Prep

Overview of Macroeconomics - Unit 4: Limited Ample Reserves and the Reserve Market

Analogy: Money as Blood in the Economy

  • Importance of Money Supply

    • Money is likened to the lifeblood of the economy; necessary for health and function.

    • Historical context: During the Great Depression, a 30% decrease in the money supply exacerbated economic struggles.

  • Limited Reserves

    • If banks hold little excess reserves, new money flows into the economy quickly.

    • Results in lower interest rates due to increased lending.

    • Note: A noticeable effect on the economy – akin to feeling symptoms of anemia.

  • Ample Reserves

    • Ample reserves in banks make new money additions or removals less impactful.

    • Changes in the money supply do not significantly alter lending behavior or interest rates.

    • Comparable to having plenty of blood in the body; changes go unnoticed.

Traditional Monetary Policy Effectiveness

  • Policies Depending on Reserve Levels

    • The impact of changing reserve ratio, discount rate, or conducting open market operations hinges on existing reserve levels.

    • Limited reserves lead to noticeable economic effects from these policies.

    • Ample reserves render these traditional methods ineffective.

  • Alternative Measures

    • The Central Bank may need to adjust the interest on reserves to influence the economy when ample reserves are present.

Graphical Representation

  • Labeling the Graph

    • Y-axis: Policy Rate

    • X-axis: Quantity of Reserves

  • Graph Details

    • Demand Curve (A1): Horizontal at first, then downward sloping, then horizontal again indicating limited to ample reserves.

    • Supply of Reserves (A2): Vertical supply curve reflects the limited reserve portion.

    • Policy Rate Dynamics (B):

      • Increased money supply lowers policy rates in limited reserves.

      • Beyond a point, changes in reserves do not affect policy rates.

  • Increasing Interest Rates in Ample Reserves

    • Central Bank actions: Increase interest on reserves to exert upward pressure on interest rates.