AP Macroeconomics : Money Supply

Study concepts, example questions & explanations for AP Macroeconomics

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Example Questions

Example Question #1 : Money Supply

Which of the following are considered open-market activities?

Possible Answers:

Decreasing Taxes

None of these would be considered Open Market Activities

Raising Bank Reserve Requirements

Increasing Government Spending

Selling Government Bonds

Correct answer:

Selling Government Bonds

Explanation:

Selling Government Bonds would be considered open market activities. When the Federal Reserve wants to adjust interest rates, they conduct open market operations - which involves selling government bonds (which raises interest rates by decreasing the money supply) or buying government bonds (which lowers interest rates by increasing the money supply.)

Example Question #2 : Equilibrium

If the Federal Reserve is trying to head off a recession, which of the following is the most likely action that it will take?

Possible Answers:

Cut taxes in order to increase aggregate demand.

Buy bonds via open market operations.

Decrease the reserve requirement for banks.

Increase government spending in order to increase aggregate demand.

Increase the discount rate.

Correct answer:

Buy bonds via open market operations.

Explanation:

The correct answer is that the Federal Reserve would be most likely to buy bonds via open market operations.

Here's why: The most common tool that the Federal Reserve uses to manage recessions is to expand the monetary supply, which makes it cheaper for businesses to borrow money and make capital expenditures, which has a net effect of increasing aggregate demand. In order to increase the money supply, the Federal Reserve buys bonds on the open market (and pays cash for these bonds). The cash that the Federal Reserve pays for these bonds expands the money supply, which has the net effect of decreasing interest rates.

If you understand the theory behind this, but answered "Decrease the Reserve Requirement for Banks", pat yourself on the back - you most likely understand the theory behind the Federal Reserve quite well. However, this is still not a correct answer - the reason is that the question was what would the Federal Reserve be most likely to do. Decreasing Reserve Requirements is a major move by the Federal Reserve, and the Federal Reserve would be much less likely to adjust Reserve Requirements than to adjust interest rates via open market operations.

Example Question #1 : How To Find The Effect Of Reserve Requirements On Money Supply

At a particular bank, the reserve ratio is 10% and excess reserves are $300. The maximum expansion of the money supply that can be generated by that bank is ________.

Possible Answers:

$300

$30,000

$30

$3000

Correct answer:

$3000

Explanation:

The money multiplier is equal to 1/r, where r is the reserve ratio. In this example, the money multiplier is 1/.1 = 10. 

Since the bank has $300 in excess reserves, it can loan out the entire $300, which we then multiply by the money multipler to find the total expansion of the money supply:

The maximum expansion of the money supply generated by that bank is therefore $3000.

If you selected $300, you may have forgotten to multiply by the money multipler.

If you selected $30, you may have multiplied by r rather than 1/r.

If you selected $30,000, you may have thought that the reserve ratio was 1 percent rather than 10 percent.

 

Example Question #1 : Money Supply

Which of the following is not a part of M1?

Possible Answers:

Paper money

Money in a personal savings account

A check that has been written but not yet deposited

Traveler's checks

All of these are a part of M1.

Correct answer:

Money in a personal savings account

Explanation:

Money in a personal savings account would not be considered a part of M1. The reason for this is that money in a savings account is considered to be lacking in liquidity - as a result, money in a savings account is considered to belong to M2.

Example Question #1 : Money Supply

An increase in the money supply curve would most likely result in which of the following situations?

Possible Answers:

A decrease in the real interest rate

An increase in the real interest rate

A decrease in the quantity of money available

No effect on the real interest rate

Correct answer:

A decrease in the real interest rate

Explanation:

As with any supply curve increase, price decreases and quantity increases.

Since in the market for money, price is referred to as the interest rate (i.e. the price of borrowing money), the decrease in price is interpreted as a decrease in the interest rate.

An increase (not a decrease) in the quantity of money available would be expected after an increase in the money supply curve.

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