Economics Micro & Macro (CliffsAP)

The Effects of Monetary Policy

The following tables illustrate the effects of monetary policy on various portions of the economy.

Discount Rate Effect Reason

Raise Less money Banks borrow less money because of higher interest.

Lower More money Banks have more money in reserves.

Reserve Requirement Effect Reason

Raise Less money Banks are required to keep more and lend less to borrowers.

Lower More money Banks keep less in vaults and lend more to borrowers.

Open Market Operations Effect Reason

Buying More money The Fed gives money to banks in exchange for bonds.

Selling Less money The Fed takes money from banks in exchange for bonds.

Monetary Perspectives

Macroeconomic theories have been formed to shed light on situations that deal with instability and imbalance. These
theories range from supply-side remedies to demand-side remedies. For the AP exam, it is important for you to under-
stand different macroeconomic perspectives.

Classical Theory

Classicalists believe that there is a true correlation between supply and prices. If there is a change in the money supply,
this change will have a direct effect on aggregate demand. A change in aggregate demand in turn affects GDP and em-
ployment. If there is an increase in the money supply that is greater than the growth rate of the economy, the result will
be an increase in the price level. Classicalists also believe that the economy is self-correcting, so if any unbalance exists
in the price level, aggregate demand, or aggregate supply, the economy will eventually return to an equilibrium state.

Monetarist Theory

The monetarist view is a branch of the classical theory. Monetarists argue that the Fed inadvertently contributes to eco-
nomic instability on occasion by changing interest rates. According to monetarists, the Fed should shift its focus from
interest rates to focusing on balancing the money supply with the growth rate of GDP (the economy). This change in
focus will lessen the likelihood of the Fed contributing to macroeconomic instability. Essentially, monetarists insist that
the Fed mimics the money supply with the growth rate of real GDP.

Keynesian Theory

Keynesians believe that any change in the money supply will initially affect interest rates. Once interest rates have been
affected, aggregate demand responds to the change in interest rates. Any change in monetary policy influences the
money supply. This change in money supply directly affects interest rates, which then either encourages or discourages
borrowers and consumers. Keynesians essentially believe that the Fed can use discretionary monetary policy to remedy
economic problems through interest rates and aggregate demand.

Part II: Macroeconomics