Monetary Policy - AP Macroeconomics

1. What is the discount rate?

   The interest rate charged to commercial banks on loans from the Fed. This rate influences banks' willingness to borrow from the Fed.

2. What is a central bank's balance sheet composed of?

   Assets and liabilities including securities and currency in circulation. Reflects the central bank's monetary policy operations and financial position.

3. What happens when the Federal Reserve raises the discount rate?

   Banks borrow less; money supply decreases. Higher discount rates discourage borrowing, contracting credit availability.

4. Identify the term for the rate at which banks can borrow reserves from each other overnight.

   Federal funds rate. This interbank lending rate influences broader economic interest rates.

5. What is the impact of high inflation on purchasing power?

   Reduces purchasing power. Higher prices mean each dollar buys fewer goods and services.

6. What is the Phillips Curve?

   Shows the inverse relationship between inflation and unemployment. Demonstrates the short-run trade-off between price stability and employment.

7. What is the impact of monetary policy on exchange rates?

   Influences through interest rate changes affecting currency value. Rate changes affect capital flows, strengthening or weakening the currency.

8. What is the primary objective of monetary policy?

   To control inflation and ensure economic stability. Central banks use this dual mandate to maintain price stability and full employment.

9. What is open market operations?

   Buying and selling government securities. The Fed's primary tool for implementing monetary policy through bond transactions.

10. What does a liquidity trap refer to?

    When interest rates are low and savings rates are high, limiting monetary policy effectiveness. Occurs when monetary policy becomes ineffective near zero interest rates.

11. What happens when the Federal Reserve lowers the discount rate?

    Banks borrow more; money supply increases. Lower discount rates encourage borrowing, expanding credit availability.

12. What is the impact of negative interest rates?

    Encourages spending and investment by making saving costly. Penalizes holding cash to stimulate economic activity during deflationary periods.

13. What is the dual mandate of the Federal Reserve?

    To promote maximum employment and stable prices. Balances the goals of full employment with price stability simultaneously.

14. How does the Federal Reserve decrease the money supply?

    By selling government securities. Selling bonds removes money from banks, reducing available reserves.

15. What is the purpose of contractionary monetary policy?

    To reduce inflation and cool an overheating economy. Raises interest rates to slow down an overheated economy.

16. How does the Federal Reserve increase the money supply?

    By purchasing government securities. Buying bonds injects money into banks, increasing available reserves.

17. What is a 'repo' in monetary policy terms?

    Repurchase agreement, a short-term loan for dealers in government securities. A key tool for injecting liquidity into the financial system temporarily.

18. What tool is used to measure the money supply?

    Monetary aggregates like M1 and M2. These statistical measures track different components of money in circulation.

19. What effect does lowering reserve requirements have?

    Increases money supply by allowing more loans. Fewer reserves required means banks can make more loans to borrowers.

20. How does inflation targeting work?

    Central bank sets an explicit inflation rate as policy goal. Provides transparency and accountability by committing to specific inflation levels.

21. What is the concept of 'forward guidance'?

    Communicating future monetary policy intentions to influence expectations. Shapes market expectations about future policy without immediate rate changes.

22. What is quantitative easing?

    Large-scale asset purchases to inject money into the economy. Used when conventional monetary policy reaches the zero lower bound.

23. What effect does raising reserve requirements have?

    Decreases money supply by restricting loans. More reserves required means banks must reduce lending capacity.

24. What is the effect of an increase in the federal funds rate?

    Interest rates increase; borrowing decreases. Higher rates make loans more expensive, reducing economic activity.

25. What is the effect of a decrease in the federal funds rate?

    Interest rates decrease; borrowing increases. Lower rates make loans cheaper, stimulating economic activity.

26. Which institution is primarily responsible for monetary policy in the U.S.?

    The Federal Reserve System. The Fed is the central bank that implements U.S. monetary policy decisions.

27. What does 'lender of last resort' mean?

    Central bank provides funds to financial institutions in crisis. Prevents financial system collapse by providing emergency liquidity when needed.

28. What is a central bank's role in stabilizing the financial system?

    Ensures liquidity and acts as a lender of last resort. Maintains financial stability by preventing bank runs and systemic crises.

29. What is the equation for the quantity theory of money?

    $MV = PY$, where $M$ is money supply, $V$ is velocity, $P$ is price level, and $Y$ is output. Demonstrates how money supply and velocity determine price level and output.

30. What is the difference between M1 and M2 money supply?

    M1 includes cash and checkable deposits; M2 includes M1 plus savings deposits. M2 is broader, including less liquid forms of money than M1.

31. What is meant by 'crowding out' in the context of fiscal policy?

    Government borrowing reduces private investment. Higher government spending raises interest rates, discouraging private investment.

32. What is the relationship between interest rates and bond prices?

    They are inversely related. Rising rates decrease bond values; falling rates increase bond values.

33. Define reserve requirements.

    Minimum reserves banks must hold, set by the Fed. This regulatory tool controls how much banks can lend relative to deposits.

34. What is the role of the Federal Open Market Committee (FOMC)?

    To oversee open market operations and monetary policy. The key Fed committee that meets regularly to set interest rate policy.

35. What is the purpose of expansionary monetary policy?

    To stimulate economic growth and reduce unemployment. Lowers interest rates to boost economic activity during recessions.

36. What is the Fisher Effect?

    The relationship between nominal interest rates, real interest rates, and inflation. Shows how expected inflation affects the gap between nominal and real rates.

37. What is meant by 'monetary neutrality'?

    Money supply changes do not affect real variables in the long run. Only affects nominal variables like prices, not real output or employment.

38. What is the Taylor Rule used for?

    Guiding central banks in setting interest rates. Provides a formula for optimal interest rate based on economic conditions.

Study these flashcards