Read Module 26, p. 253, 255-257. The AP Macroeconomics exam tests very rarely on structure and concepts like “central bank.” The information here will give you all you need on structure and how the Fed works. Be sure to look at the pretty map on p. 256.
Read Module 27. Pay close attention to what happens during open-market operations, which will be the most commonly tested part of the financial sector on the exam. Remember, when we buy the bonds, we’re creating debt and expanding the money supply. When we sell the bonds, we’re satisfying debt and contracting the money supply. Also, pay attention to the difference between monetary base and money supply with open-market operations.
Review PowerPoint on the Federal Reserve and Monetary Policy. The PowerPoint does a good job highlighting what happens to monetary base and monetary supply in open-market operations.
Review Multiple Choice #3 and #4 on p. 261.
Review FRQ #1 on p. 261.
Review Multiple Choice on p. 266.
Review FRQs #1 and #2 on p. 267.
There were no questions on the Financial Sector Test for the history and structure of the Federal Reserve. If any questions show up on my test, they will be on the number of districts in the Federal Reserve System, the makeup of the Federal Open Market Operations Committee (FOMC), the Board of Governors and their terms.
Review Financial Sector Test questions on monetary policy.
If the Federal Reserve buys $250 million worth of U.S. Treasury bills in the open market, and the reserve ratio is 10%, then at most the money supply will:
increase by $2,500 million.
increase by only $250 million.
increase by only $25 million.
decrease by only $250 million.
Answer: A. When the Federal Reserve buys bonds, we know the money supply will increase. B and E are wrong for this reason. Eliminate them. With vengeance. Use the money multiplier to find the maximum expansion of the money supply. 1/0.10 = 10. 10 x $250 million = $2,500 million. Eliminate C and D. Remember with open market purchases and sales, the required reserve does not apply.
When the Fed decreases bank's reserves through an open-market operation:
loans increase, the federal funds rate rises, and the discount rate rises.
the monetary base decreases, loans decrease, and the money supply decreases.
the monetary base decreases, loans decrease, and the money multiplier decreases.
Answer: D. To decrease reserves, the Federal Reserve would conduct a sale of bonds. A and C are wrong. The immediate effect would be on the monetary base, which deals with bank reserves. B and E are wrong. Selling the bonds would decrease the monetary base, which means that there is less money to lend out. There is nothing in this prompt indicating that the required reserve ratio has been increased, which in turn would decrease the money multiplier. D is the only answer that correctly shows the relationship between the monetary base and money supply.
If the required reserve ratio is 10%, and the Fed performs an open market sale of $100, what is the maximum possible change in the money supply resulting from this sale?
Answer: B. This question is testing on whether you know to ignore the required reserve when it comes to open-market operations, and if you can apply the money multiplier correctly. 1/0.10 = 10. 10 x $100 = $1,000.
If the Federal Reserve wants to discourage banks from borrowing directly from the Fed and thus decrease the monetary base, the Fed would likely:
increase the discount rate.
increase the federal funds rate.
increase the reserve requirement.
sell U.S. Treasury bills in an open market operation.
increase the tax on investment spending.
Answer: A. This question asks whether you know that borrowing directly from the Federal Reserve involves the discount rate, and to apply how the discount rate would be used to discourage banks. The Federal Reserve would increase the discount rate, which in turn would cost the banks more to borrow from the Fed. B is wrong. The federal funds rate is the rate used when banks borrow from each other. C is wrong. Increasing the reserve requirement would reduce the amount of loans that can be made. D is wrong. Selling T-bills in OMO would contract the money supply, not discourage banks from borrowing. E is wrong. Increasing taxes is fiscal policy.
When a bank borrows from the Federal Reserve, it pays the:
required reserve ratio.
federal funds rate.
Answer: B. This is a concept question. You either knew it or you didn’t. I put this in as a gimme question from #19.
Review the following questions.
The three primary policy tools available to the Federal Reserve include
Suppose a hypothetical economy that uses a checkable-deposits-only monetary system has a required reserve ratio of 10%. When the central bank in this economy sells $10 million worth of Treasury bills, this will
Decrease the money supply by 10%.
Decrease the money supply by $10 million.
Decrease the money supply by $100 million.
Decrease the money supply by $1 million.
The opportunity cost of holding money
Is always greater than the short-term interest rate.
Is the difference between the interest rate on assets that are not money and the interest rate on assets that are money.
Is the long-term interest rate.
Is always zero because it costs you nothing to hold money.
In the U.S., the institution charged with determining the size of the monetary base and with regulating the banking system is the:
U.S. Senate Banking Committee.
President’s Council of Economic Advisors.
If the Federal Reserve wanted to increase the money supply, it could:
Increase the personal tax rate, decrease the required reserve ratio, and buy bonds on the open market.
Decrease the personal tax rate, decrease the required reserve ratio, and buy bonds on the open market.
Suppose that the Federal Reserve sells $500 in U.S. Treasury bills, and as a result the money supply falls by $5,000. The reserve ratio is:
If the Federal Reserve wants to increase the monetary base, the Fed might:
Engage in an open market purchase of Treasury bills.
Increase the discount rate.
Increase the reserve ratio.
Decrease personal income taxes.
Increase the federal funds rate.
Suppose the Federal Reserve were to engage in open-market operations by buying $100 million of U.S. Treasury bills. Which of the following would be the end result of such an action?
The money supply would stay the same.
The money supply would decrease by $100 million.
The money supply would increase by $100 million.
The money supply would increase by more than $100 million.
The money supply would increase, but by less than $100 million.
Suppose the reserve ratio is 10% when the Fed buys $25,000 of U.S. Treasury bills from the banking system. If the banking system does not want to hold any excess reserves, _____ will be added to the money supply.
If the Fed conducts a $10 million open-market sale and the reserve requirement is 20%, the maximum change in the money supply is:
An increase of $10 million.
A decrease of $10 million.
A decrease of $8 million.
A decrease of $50 million.
An increase of $50 million.
If the Fed conducts an open-market purchase:
Bank reserves decrease and the money supply decreases.
Bank reserves increase and the money supply increases.
Bank reserves decrease and the money supply increases.
Bank reserves increase and the money supply decreases.
Bank reserves increase and the money supply does not change.
Answer: B. This is a factual question, and these are the tools for monetary policy.
Answer: B. This is a factual question.
Answer: C. This question tests whether you know to ignore the money multiplier when it comes to open-market operations, and applying the money multiplier to an open-market sale. 1/0.10 = 10. 10($10 million) = $100 million.
Answer: B. The opportunity cost of holding money is what you’re giving up when you hold on to it. In other words, when you’re not putting it in a bank to gain interest. B fits this idea, albeit rather wordily.
Answer: D. If you picked anything else, smack your forehead really hard.
Answer: B. We want to increase the money supply, which means we’re conducting expansionary monetary policy. C, D and E can be eliminated immediately. Personal tax rates is a tool of fiscal policy, not monetary. A is wrong. If the Federal Reserve increases the federal funds rate, then that costs banks more money to borrow, and they’d be less inclined to do so. Also, selling bonds on the open market would decrease the money supply.
Answer: C. This question is one of the more difficult types that could show up. It’s asking you to work backwards to find the denominator in the required reserve ratio (1/rr). Still, the clues are there. $500 in T-bills and $5000 in money supply. $5000/$500 = 10. 1/rr = 10. rr = 0.1. Win.
Answer: A. Open market purchases increase the monetary base, which in turn increases the money supply. (Sales do the opposite). B and E are wrong. Increase the discount or federal funds rate would deter banks from borrowing, which would decrease the monetary base and money supply. C is wrong. Increasing the reserve ratio would increase the amount of reserve banks would have to hold, making less loans, and decreasing the monetary base available to make loans, and thus the money supply. D is wrong. That’s fiscal policy.
Answer: D. In an open-market purchase, the money supply would increase. A and B are wrong for this reason. C is wrong. It fails to use the money multiplier. Even though no reserve ratio is given, we can assume that there is one, and thus it would have to apply. If it lists no reserve requirement, then multiply by 10 for the 10% reserve requirement set by the Fed. (10)($100 million) = $1,000 million. E is wrong for this reason.
Answer: E. 10% is the required reserve ratio, which means 10 is the money multiplier. (10)($25,000) = $250,000.
Answer: D. A and E are wrong. Eliminate immediately. This is an open-market sale. B and C are wrong. They fail to apply the money multiplier. C goes a step further and takes out money for the required reserve, which is bad. 1/0.2 = 5. (5)($10 million) = $50 million.
Answer: B. Open market purchases increase bank reserves, and in turn, the money supply. A is wrong. A describes what happens in an open market sale. C and D are wrong. Bank reserves and money supply is a direct relationship, not an indirect one. E is wrong. It fails to take into account of changes in monetary base affecting the money supply.