Monetary policy refers to actions taken by a central bank—in the United States, the Federal Reserve—to influence interest rates and aggregate demand in order to achieve macroeconomic goals such as price stability and full employment.
Types of Monetary Policy
There are two types of monetary policy: expansionary monetary policy and contractionary monetary policy.
Expansionary monetary policy (also called easy monetary policy) is used when the economy is in a recessionary gap. The goal is to lower interest rates, stimulate investment and consumption, and increase real GDP.
Contractionary monetary policy (also called tight monetary policy) is used when the economy is in an inflationary gap. The goal is to raise interest rates, reduce investment and consumption, and decrease real GDP.
The specific tools the Fed uses and how they work depend on whether the banking system has limited reserves or ample reserves—a critical distinction in the AP Macro framework.
Limited Reserves vs. Ample Reserves
Understanding the difference between limited and ample reserve environments is essential for AP Macroeconomics. The tools of monetary policy and the way they are implemented differ depending on which environment a banking system operates in.
In an economy with limited reserves, banks hold just enough reserves to meet requirements, so the money supply is sensitive to changes in reserves. The central bank influences interest rates primarily by changing the money supply through open-market operations and adjustments to the reserve requirement.
In an economy with ample reserves, banks hold far more reserves than required. Because reserves are abundant, changes in the money supply do not effectively change the nominal interest rate. Instead, the central bank influences the nominal interest rate by changing its administered interest rates—rates the central bank sets directly, such as the interest rate paid on reserves.
The banking system in the United States has ample reserves, and the Federal Reserve's key policy tool is interest on reserves.
Many central banks carry out policy to hit a target range for an overnight interbank lending rate, sometimes referred to as the central bank's policy rate. In the United States, this is the federal funds rate—the rate at which banks lend reserves to each other overnight.
Tools of Monetary Policy
The tools of monetary policy include the central bank's discount rate and other administered interest rates (such as interest on reserves), open-market operations, and the required reserve ratio.
Tools in a Limited Reserves Economy
In an economy with limited reserves, the central bank primarily uses these tools to change the money supply, which in turn changes the nominal interest rate:
The discount rate is the interest rate the Federal Reserve charges commercial banks to borrow reserves directly from the Fed. Lowering the discount rate makes borrowing cheaper for banks, encouraging them to borrow more and increasing the money supply. Raising it has the opposite effect.
The reserve ratio (reserve requirement) is the percentage of demand deposits that banks must hold in reserve and cannot lend. Raising the reserve ratio decreases excess reserves and reduces the money supply. Lowering it increases excess reserves and expands the money supply.
Open-market operations involve the buying and selling of government bonds. When the Fed buys bonds, it pays with new money that enters the banking system, increasing reserves and the monetary base. When the Fed sells bonds, money leaves the banking system, decreasing reserves and the monetary base. In an economy with limited reserves, the money multiplier amplifies the effect—the change in the money supply is greater than the change in the monetary base.
Tools in an Ample Reserves Economy (The U.S. Today)
In an economy with ample reserves, open-market operations and reserve requirements are less effective because banks already hold excess reserves far beyond what is required. Changes in the money supply do not effectively move the interest rate.
Instead, the central bank influences the nominal interest rate by adjusting its administered interest rates:
Interest on reserves (IOR) is the interest rate the Federal Reserve pays banks on reserves held at the Fed. This is the Fed's primary policy tool in the current ample-reserves environment. When the Fed raises IOR, banks demand a higher return before lending, which pushes the federal funds rate up. When the Fed lowers IOR, the federal funds rate falls. The IOR effectively sets a floor for the federal funds rate because no bank would lend reserves to another bank at a rate below what the Fed pays.
The discount rate still functions as a ceiling—banks would not borrow from each other at a rate above what the Fed charges directly.
Calculating the Effects of Monetary Policy
Understanding how to work through balance sheets and calculations is a key part of monetary policy analysis. Let's walk through an example.
Example: Open-Market Purchase in a Limited Reserves Economy
Suppose the Fed conducts an open-market purchase of $100 million of government bonds from commercial banks.
Step 1: What happens to reserves and the monetary base? The Fed pays for the bonds by crediting $100 million to the banks' reserve accounts. Reserves increase by $100 million, and the monetary base increases by $100 million.
Step 2: Bank balance sheet effect (immediately after the purchase):
| Assets | Change | Liabilities | Change |
|---|---|---|---|
| Government bonds | −$100 million | ||
| Reserves | +$100 million | No change |
The bank swapped one asset (bonds) for another asset (reserves). Total assets are unchanged, and liabilities are unchanged.
Step 3: Apply the money multiplier. In a limited-reserves system, banks will lend out their new excess reserves, and through the deposit creation process, the money supply expands by more than the initial change in reserves. The simple money multiplier is:
If the required reserve ratio is 10% (0.10):
Step 4: Calculate the maximum change in the money supply.
So the maximum increase in the money supply from a $100 million open-market purchase is $1 billion.
Example: Open-Market Sale
If the Fed instead sells $100 million of government bonds, reserves decrease by $100 million, the monetary base decreases by $100 million, and using the same 10% reserve ratio, the maximum decrease in the money supply is:
The key takeaway: in a limited-reserves system, the effect on the money supply is greater than the effect on the monetary base because of the money multiplier. Open-market purchases increase the monetary base and expand the money supply; open-market sales decrease the monetary base and contract the money supply.
The Reserve Market Model
Three models can be used to show the short-run effects of monetary policy: the money market model, the reserve market model, and the AD-AS model.
The reserve market model graphs the market for bank reserves:
- The horizontal axis shows the quantity of reserves.
- The vertical axis shows the federal funds rate (the overnight interbank lending rate).
- Demand for reserves slopes downward—at lower federal funds rates, banks are willing to hold more reserves (and lend less in the interbank market).
- Supply of reserves is determined by the central bank.
In a limited reserves environment, the supply curve is vertical (fixed quantity of reserves), and shifts in supply move the equilibrium federal funds rate—just like shifts in money supply move the interest rate in the money market model.
In an ample reserves environment, the supply of reserves is so large that the demand curve is essentially flat at the rate the Fed pays on reserves (IOR). The Fed shifts interest rates not by changing the quantity of reserves, but by changing its administered rates (moving the flat portion of the demand curve up or down).
Effects of Monetary Policy
Monetary policy is the Federal Reserve's way of correcting the economy when it is in a recessionary gap or an inflationary gap. Expansionary policy is used to close a recessionary gap; contractionary policy is used to close an inflationary gap.
In a Limited Reserves Economy
In a limited reserves environment, the transmission mechanism works through the money supply:
Expansionary policy (recessionary gap): The Fed increases the money supply (e.g., open-market purchase) → the nominal interest rate falls → investment and consumption increase → aggregate demand increases → real GDP rises back toward full employment.
What this looks like on the graphs: In the reserve market model, an open-market purchase shifts the supply of reserves to the right, which lowers the equilibrium federal funds rate. Equivalently, in the money market model, the money supply curve shifts to the right, lowering the nominal interest rate. The lower interest rate stimulates investment and interest-sensitive consumption, so in the AD-AS model, the aggregate demand (AD) curve shifts to the right. This increases both real output (real GDP) and the price level in the short run, helping to close the recessionary gap.
Contractionary policy (inflationary gap): The Fed decreases the money supply (e.g., open-market sale) → the nominal interest rate rises → investment and consumption decrease → aggregate demand decreases → real GDP falls back toward full employment.
What this looks like on the graphs: In the reserve market model, an open-market sale shifts the supply of reserves to the left, which raises the equilibrium federal funds rate. In the money market model, the money supply curve shifts to the left, raising the nominal interest rate. The higher interest rate discourages investment and interest-sensitive consumption, so in the AD-AS model, the AD curve shifts to the left. This decreases both real output and the price level in the short run, helping to close the inflationary gap.
In an Ample Reserves Economy (The U.S. Today)
In an ample reserves environment, the transmission mechanism works through administered interest rates:
Expansionary policy (recessionary gap): The Fed lowers its administered interest rates (e.g., lowers interest on reserves) → the federal funds rate falls → investment and consumption increase → aggregate demand increases → real GDP rises back toward full employment.
What this looks like on the graphs: In the reserve market model, lowering the IOR shifts the flat portion of the demand/supply floor downward, reducing the federal funds rate. In the AD-AS model, lower interest rates increase investment and consumption, shifting the AD curve to the right. Real output increases and the price level rises in the short run.
Contractionary policy (inflationary gap): The Fed raises its administered interest rates (e.g., raises interest on reserves) → the federal funds rate rises → investment and consumption decrease → aggregate demand decreases → real GDP falls back toward full employment.
What this looks like on the graphs: In the reserve market model, raising the IOR shifts the floor upward, increasing the federal funds rate. In the AD-AS model, higher interest rates reduce investment and consumption, shifting the AD curve to the left. Real output decreases and the price level falls in the short run.
In both environments, monetary policy influences interest rates, aggregate demand, real output, and the price level. The difference is how the central bank moves interest rates—through money supply changes (limited reserves) or through administered rate changes (ample reserves).
Lags in Monetary Policy
In reality, there are lags to monetary policy caused by the time it takes to recognize a problem in the economy (recognition lag) and the time it takes the economy to adjust to the policy action (impact lag). These lags mean that monetary policy does not produce instant results and can sometimes take effect after economic conditions have already changed.
Vocabulary
The following words are mentioned explicitly in the College Board Course and Exam Description for this topic.
| Term | Definition |
|---|---|
| AD-AS model | An economic model that shows the relationship between aggregate demand and aggregate supply to illustrate macroeconomic equilibrium and the effects of policy changes. |
| adjustment lag | The time it takes for the economy to respond and adjust to a monetary policy action after it has been implemented. |
| aggregate demand | The total quantity of goods and services demanded across an entire economy at different price levels. |
| central bank | A financial institution responsible for implementing monetary policy and managing a country's money supply and banking system. |
| contractionary monetary policy | Central bank actions that decrease the money supply and raise interest rates to reduce inflation and cool down an overheating economy. |
| discount rate | The interest rate at which a central bank lends to commercial banks, used as a tool of monetary policy. |
| expansionary monetary policy | Central bank actions that increase the money supply and lower interest rates to stimulate economic growth and reduce unemployment. |
| federal funds rate | The interest rate at which commercial banks lend reserve balances to each other overnight, targeted by the Federal Reserve as its primary policy rate. |
| full employment | An economic condition where all available labor resources are being used efficiently and unemployment is at its natural rate. |
| inflationary output gap | A positive output gap occurring when actual real output exceeds the full-employment level of output, putting upward pressure on prices. |
| interest on reserves | The interest rate paid by a central bank to commercial banks on the reserves they hold, used as a monetary policy tool. |
| lags | Delays between the time a policy action is taken and when its effects are fully realized in the economy. |
| monetary base | The total amount of money created by a central bank, consisting of currency in circulation and bank reserves. |
| monetary policy | Central bank actions that influence the money supply, interest rates, aggregate demand, real output, price level, and exchange rates. |
| money market model | An economic model that shows the relationship between the money supply, money demand, and interest rates. |
| money multiplier | The factor by which the money supply increases relative to an increase in the monetary base through the lending activities of commercial banks. |
| nominal interest rate | The stated interest rate on a loan or investment, not adjusted for inflation. |
| open market operations | The buying and selling of government securities by a central bank to influence the money supply and monetary base. |
| policy rate | The target interest rate set by a central bank for overnight interbank lending to influence overall monetary conditions. |
| price level | The average of all prices of goods and services produced in an economy, typically measured by price indices like the CPI. |
| price stability | A macroeconomic goal in which the general price level of goods and services remains relatively constant over time. |
| real output | The total production of goods and services in an economy adjusted for inflation, measured in constant dollars. |
| recognition lag | The time it takes for policymakers to identify and recognize that a problem exists in the economy. |
| required reserve ratio | The percentage of deposits that commercial banks are required to hold in reserve rather than lend out, used as a monetary policy tool. |
| reserve market model | An economic model that illustrates the relationship between the supply and demand for bank reserves and the federal funds rate. |
Frequently Asked Questions
What is monetary policy and how is it different from fiscal policy?
Monetary policy is the central bank’s use of tools—open-market operations, the discount rate, interest on reserves, and the required reserve ratio—to influence bank reserves, the monetary base, and short-run nominal interest rates to meet macro goals like price stability and full employment (CED EK POL-1.D.1–6). An expansionary action (e.g., open-market purchase or lower administered rates) raises reserves, lowers interest rates, boosts investment and consumption, shifts AD right, and raises real output and the price level in the short run; contractionary policy does the opposite (EK POL-1.D.3, 1.D.6–8). Monetary policy works through interest-rate changes and has recognition and transmission lags (EK POL-1.E.1). Fiscal policy, by contrast, is government changes to spending and taxes enacted by the legislature; it affects AD directly (spending or tax multipliers) and can cause crowding out that interacts with interest rates. For AP exam work, use the money-market, reserve-market, or AD-AS graphs and be ready to calculate reserve/money-supply effects (see the Topic 4.6 study guide: https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh, unit overview: https://library.fiveable.me/ap-macroeconomics/unit-4, and practice problems: https://library.fiveable.me/practice/ap-macroeconomics).
How does the Federal Reserve actually control interest rates?
The Fed controls interest rates mainly by setting short-term administered rates and by managing bank reserves. In the U.S. (an ample-reserves system) the Fed: 1) sets interest on reserves (IOR/IOER) and the discount rate (EK POL-1.D.2, D.6), which put a floor/anchor on overnight rates; 2) conducts open-market operations to supply or drain reserves when needed (EK POL-1.D.3, D.5). Together these actions steer the federal funds rate (the Fed’s overnight policy rate) toward its target. Lowering administered rates or buying securities tends to lower market interest rates, raising investment and consumption (expansionary); raising rates or selling securities does the opposite (contractionary)—affecting AD, output, and prices in the short run (EK POL-1.D.6, D.8). For AP exam prep, know the tools, how they shift reserves/money supply, and how that changes the federal funds rate and AD (see the Topic 4.6 study guide: https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh). For practice, try problems at https://library.fiveable.me/practice/ap-macroeconomics.
I'm confused about open market operations - when the Fed buys bonds, why does that increase the money supply?
When the Fed buys bonds in open-market operations, it pays for them by depositing money into the sellers’ bank accounts. For banks that means their reserves at the Fed increase. More reserves = bigger monetary base (EK POL-1.D.3). With extra reserves, banks can make more loans. When a bank lends, new deposit money is created (the money multiplier effect), so the overall money supply rises by more than the initial reserve injection in systems with limited reserves (EK POL-1.D.4). In practice the U.S. system has ample reserves, so the Fed often works through administered rates (like interest on reserves) to influence short-term interest rates rather than relying only on multiplier effects (EK POL-1.D.2, EK POL-1.D.6). For AP work, be ready to show this with a simple bank balance sheet or money-market graph (CED says you can use graphs/balance sheets). For a focused review, see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and try practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between the federal funds rate and the discount rate?
The federal funds rate is the overnight interest rate banks charge each other for loans of reserves; it's the market (interbank) rate the Fed targets to influence short-run nominal interest rates and aggregate demand (EK POL-1.D.5, EK POL-1.D.6). The discount rate is the interest rate the Federal Reserve charges when a bank borrows directly from the Fed’s discount window—an administered rate set by the Fed. Practically: fed funds = peer-to-peer overnight borrowing; discount = borrowing from the central bank. The Fed typically uses open-market operations and interest on reserves to steer the fed funds rate; the discount window is a backstop and less used. For AP exam purposes, remember the fed funds rate is the Fed’s target policy/overnight interbank rate and changing administered rates (like discount or interest on reserves) helps the Fed influence broader interest rates and AD (see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics)).
How do I calculate the money multiplier and when do I use it?
Money multiplier tells you how much the money supply can change for a given change in bank reserves. The simple formula (when banks hold no excess reserves and people keep deposits in banks) is: - Money multiplier = 1 / required reserve ratio (r). Example: if r = 0.10, multiplier = 1/0.10 = 10. A more realistic formula that includes currency held by the public (c) and banks’ desired reserves (rr) is: - Multiplier = 1 / (rr + c). When to use it: use the multiplier to calculate the effect of an open-market purchase/sale on the money supply in an economy with limited reserves (CED EK POL-1.D.4). On the AP exam you may be asked to compute changes using reserve/deposit balance sheets or to show how an open-market operation changes the monetary base and, via the multiplier, the money supply (CED: calculate effects of monetary policy). For topic review see the Fiveable study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and try practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
Can someone explain why lowering interest rates is supposed to help during a recession?
Lowering interest rates is expansionary monetary policy. The Fed (or central bank) usually does this by increasing reserves—often via open-market purchases—so banks lend more and the overnight policy rate (like the federal funds rate) falls (CED: EK POL-1.D.3, EK POL-1.D.5–6). Lower nominal interest rates reduce the cost of borrowing, so interest-sensitive spending (investment, some consumption like big-ticket durables) rises. That shifts AD right in the short run, raising real GDP and lowering cyclical unemployment (EK POL-1.D.7–8). You show this on an AD-AS or money-market graph for the exam (CED: EK POL-1.D.9). Remember there are recognition and transmission lags—policy takes time to observe effects (EK POL-1.E.1). For a quick review and practice on these graphs and mechanisms, check the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and more practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between expansionary and contractionary monetary policy?
Expansionary monetary policy = central bank actions to increase money supply or lower short-run interest rates to fight a recessionary (negative) output gap. Common tools: open-market purchases (reserves ↑, monetary base ↑), lowering administered rates (e.g., interest on reserves or discount rate), or lowering required reserves (EK POL-1.D.2–4,6). Short-run effects: interest rates fall → investment and interest-sensitive consumption rise → AD shifts right → real output ↑ and price level may rise (use money-market or AD-AS to show this) (EK POL-1.D.6,8,9,7). Contractionary monetary policy = actions to decrease money supply or raise short-run interest rates to fight inflationary (positive) output gaps. Tools: open-market sales, raise administered rates, increase reserve requirements. Short-run effects: interest rates rise → investment and consumption fall → AD shifts left → real output ↓ and price level falls. Remember lags: recognition and transmission take time (EK POL-1.E.1). For more AP-aligned review, see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I don't understand the money market graph - why does the money supply curve look vertical?
Think of the money supply curve as the amount of nominal money the central bank has decided to put into the economy at a point in time. In the standard money-market graph (vertical axis = nominal interest rate, horizontal axis = quantity of money), the supply curve is vertical because the central bank sets the money stock (or the monetary base) independently of the interest rate in the short run. That means changes in the interest rate don’t change the quantity of money supplied—only monetary policy actions (open-market purchases/sales, changing reserves or administered rates) shift the vertical curve left or right. Remember the CED: you use the money-market model to show short-run effects of monetary policy (EK POL-1.D.9). If you want extra practice or step-by-step examples, check the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and more unit resources (https://library.fiveable.me/ap-macroeconomics/unit-4) or practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do I know when to use the AD-AS model vs the money market model for monetary policy questions?
Use the money market / reserve model when you need to show how a central bank action works through banking reserves and interest rates; e.g., open-market operations → reserves/monetary base → money supply (money multiplier if reserves are limited) → nominal interest rate. Use it to explain changes in the federal funds rate, bond prices, or how administered rates (interest on reserves) operate (EK POL-1.D.2, D.3, D.6). Use the AD–AS model when you need to show the macro outcome (aggregate demand, real GDP, price level, short-run output gaps, and cyclical unemployment). After you show the interest-rate change in the money/reserve model, shift AD in the AD–AS graph to show short-run effects on output and price level (EK POL-1.D.8, D.7). On AP FRQs, expect to draw AD–AS for short-run price/output effects and a money or reserve market graph to show how policy changes interest rates (CED says you may use both)—practice both (study guide: https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh; unit overview: https://library.fiveable.me/ap-macroeconomics/unit-4). For more practice Qs, see https://library.fiveable.me/practice/ap-macroeconomics.
What happens to aggregate demand when the Fed raises interest rates?
When the Fed raises interest rates (e.g., raises its administered rate like interest on reserves or pushes up the federal funds rate), nominal interest rates rise. Higher rates make borrowing more expensive, so interest-sensitive consumption and investment fall. That reduces aggregate demand (AD)—on an AD-AS graph AD shifts left. Short run: lower AD → lower real GDP and a lower price level (output falls toward a recessionary gap and unemployment rises). Over time, policymakers watch recognition and transmission lags before judging full effects (CED EK POL-1.E.1). On the AP exam you’d show this with an AD-AS diagram and explain the transmission mechanism (higher rates → ↓ I and C → leftward AD shift) as in Topic 4.6 (see the study guide: https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh). For extra practice, try relevant AD-AS and money-market problems on Fiveable (https://library.fiveable.me/practice/ap-macroeconomics).
Why are there lags in monetary policy and what types of lags exist?
There are lags because policy makers first need to detect a problem and then the economy needs time to respond. AP calls out two broad sources: recognition lag (time to notice a recession or inflation—data revisions mean this can be a few months) and the economy’s adjustment lag (how long the transmission mechanism takes to change AD, output, and prices). You can break those into three common types: - Recognition lag: collecting and confirming data (GDP, unemployment, inflation)—often several months. - Decision/implementation lag: time for the Fed to meet and change the policy rate or carry out open-market ops—usually days to weeks. - Transmission (effect) lag: after rates change, investment, consumption, AD, and SRAS shift; effects on output and price level can take quarters to years. On the exam, you should explain these with the money-market/AD-AS models and name specific tools (federal funds rate, open-market operations) (see the Topic 4.6 study guide: https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh). For extra practice, try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
How does monetary policy work differently in economies with limited reserves vs ample reserves?
In a limited-reserves system, banks hold few excess reserves, so an open-market purchase raises reserves and—via the money multiplier—increases the money supply a lot. The central bank changes the money supply to move the nominal interest rate, which then affects investment, AD, real output, and prices (use money market or AD-AS graphs to show this). In an ample-reserves system (like the U.S.), banks already hold lots of reserves, so changing reserves doesn’t reliably change the money supply or overnight rates. Instead the central bank uses administered rates (especially interest on reserves) to set the policy/federal funds rate directly. So: limited reserves → OMO + reserve ratio matter, transmission through money multiplier; ample reserves → policy works mainly by changing administered interest rates, not by changing the money base. This distinction is tested in short-run policy questions on the AP (Topic 4.6). For a quick review, see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and more practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the reserve market model and when do I need to use it on the AP exam?
The reserve market model shows banks lending reserves to each other overnight (the market for reserves) and how the central bank’s actions change the overnight rate (e.g., the federal funds rate). Use it when a question focuses on interbank lending, short-run interest-rate control, or how changes in reserves or administered rates (discount rate, interest on reserves) move that overnight rate. The CED says you can use a money market model, a reserve market model, and/or AD–AS to show short-run effects of monetary policy (EK POL-1.D.5–D.7). When to pick it on the AP: choose the reserve market model for FRQs or MCQs asking about the federal funds rate, open-market operations’ effect on bank reserves, or how interest on reserves changes bank behavior. Use the money market or AD-AS when the focus is money demand/supply or aggregate demand/output/price level. For more review and examples, see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
If the Fed wants to fight inflation, should they buy or sell government securities?
They should sell government securities (open-market sale). Selling Treasury bonds reduces bank reserves and the monetary base (EK POL-1.D.3), which is contractionary—money supply falls, nominal interest rates rise (EK POL-1.D.6), investment and interest-sensitive consumption fall, aggregate demand shifts left, and inflationary pressure eases (EK POL-1.D.7–8). Short run: previously issued bond prices fall and you get higher yields; net financial capital may flow in if domestic interest rates rise. On the AP exam you’d show this with a money-market or AD-AS diagram and label the policy as contractionary monetary policy (Topic 4.6). For a quick review, see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics) to drill these graphs and explanations.
I'm studying for the FRQ - how do I show the effects of monetary policy on multiple graphs at once?
Do three linked graphs side-by-side: money market (or reserve market), AD–AS, and one financial market (bond or FX). Steps: 1) Label axes and initial equilibria on all graphs (money supply/MD with i on vertical, AD–AS with PL and Y, bond price or foreign exchange with price on vertical). 2) Show the policy (e.g., expansionary OMO = open-market purchase): shift MS right in the money/reserve market → interest rate falls (i1 to i2). 3) On AD–AS, show AD shifting right (lower i → more I and C) and mark new short-run PL and Y. 4) On bond/FX graph, show bond prices up (or currency depreciates if lower rates cause capital outflow) and explain the link in one sentence. Always label curves, old/new equilibria, and directions of shifts—the FRQ rubric requires correctly labeled graphs and showing changes (Skill 4). For quick review and more examples, see the Topic 4.6 study guide (https://library.fiveable.me/ap-macroeconomics/unit-4/monetary-policy/study-guide/gKjFf4lqzvav9TCjFNoh) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).