5 Steps to a 5 AP Macroeconomics 2019

154 ❯ Step 4. Review the Knowledge You Need to Score High

Table 11.1

PROBLEM: HIGH PROBLEM:

UNEMPLOYMENT HIGH INFLATION

Monetary tool could be Buy bonds in an OMO, Sell bonds in an OMO,

used to... lowering the fed funds rate. increasing the fed funds

rate.

Or... Lower the discount rate Raise the discount rate.

Or... Lower the reserve ratio. Raise the reserve ratio.

The effect would be... ↑MS, ↓i %,   ↑I, ↑AD, ↓MS, ↑i %, ↓I, ↓AD,

↑real GDP, ↓unemployment ↓real GDP, ↓price level

To summarize:

•   Lowering the discount rate (or federal funds rate) increases excess reserves in commercial

banks and expands the money supply.

•   Raising the discount rate (or federal funds rate) decreases excess reserves in commercial

banks and contracts the money supply.

Changing the Required Reserve Ratio

Though rarely used, if the Fed wants to increase excess reserves and expand the money

supply, it could change the fraction of deposits that must be kept as required reserves. If the

reserve ratio is 0.50, half of all deposits must be kept in the vault, leaving half to be loaned

as excess reserves. The money multiplier in this case is two. But if the required reserve ratio

were lowered to 0.10, 90 percent of all deposits could be lent as excess reserves. The money

multiplier increases to 10.

So:

•   Lowering the reserve ratio increases excess reserves in commercial banks and expands the

money supply.

•   Increasing the reserve ratio decreases excess reserves in commercial banks and contracts

the money supply.

Table 11.1 summarizes how various tools of monetary policy can be used to target high

unemployment or high inflation.

KEY IDEA

Coordination of Fiscal and Monetary Policy

Congress and the President develop fiscal policy through the annual process of approving

a spending budget and tax law. Chapter 10 showed how fiscal policy can be used to move

the economy closer to full employment, but that it has some weakness, especially in the case

when private investment is crowded out by government borrowing.

The central bank develops monetary policy and is independent of Congress and the

President. This independence of monetary policy is believed to be a critical balance to

fiscal policy that can be heavily politicized. After all, the creators of fiscal policy are elected

by their constituents and might let an upcoming election taint the policy-making process.

The central bank, free of election pressures, can develop monetary policy without this con-

flict of interest and perhaps work to counterbalance the downsides to fiscal policy. Let’s

look at three different scenarios where monetary and fiscal policy might be coordinated

in Table 11.2.

KEY IDEA

TIP

“Monetary

policy does not

affect govern-

ment spending.”

—Elliot,

AP Student