2014 AP Macro Exam FRQ question 2
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2. The Federal Reserve can influence the supply of money.
(a) Assume the Federal Reserve targets a lower federal funds rate.
(i) What open market operation can the Federal Reserve use to achieve a lower target?
The Federal reserve has three tools at their control,,, OMO Open market operations (buying and/or selling bonds), reserve requirement (increase /decrease), discount rate (increase/decrease).
1st you must know what the federal funds rate is - cheat sheet.
The Federal Funds Rate is the interest rate that commercial banks charge one another in loaning out their excess reserves.
The example above shows an increasing Federal funds rate,, we want a decreasing Federal Funds rate.
Answer - if the Fed was to buy bonds,, the MS, increases and the Nom. IR, Nominal interest rate decreases,, thus lowering the rate of interest the commercial banks will charge each other in loaning out their excess reserves.
(ii) Given your answer to part (i) what will happen to the price of bonds.
If the Fed buys bonds,,, the price of bonds will increase. The easiest way to understand this is to think about supply and demand,, demand for bonds goes up... price of bonds increase.
Better yet understand that interest rates and Bond Prices are inversely related.
FED Cheat Sheet here.
Answer - if the fed is buying bonds then the price of bonds is increasing.
(b) Using a correctly labeled graph of the money market, show the effect of the open market operation fro part (a) (i) on the nominal interest rates.
Cheat sheet -
You must know how to draw and label a money market graph from memory.
Answer - if the fed is buying bonds,, then it is paying for those bonds in cash,,, citizens are giving up their bonds and receiving cash. The money supply is therefore increasing. As the money supply increases nominal rates are falling. Look Below.
(c) Assume the Federal reserve buys government bonds from commercial banks. Based only on this transaction, will the level of required reserves in the commercial banks increase, decrease, or remain the same?
You should understand that the required reserves are required for customers demand deposits (checkable accounts),, cash from selling assets does not effect the banks reserve requirements.
Answer - Fed's purchase of bonds will not initially affect commercial banks required reserves.
(d) another monetary policy action involves changing the discount rate. Define the discount rate.
Answer - the discount rate is the interest rate that the Fed charges banks for borrowing from it's discount window.
How I would have looked at the college board
after Reading some of these questions.
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