Monetary Policy: Money Market, Fed Tools, and Transmission

Objectives

• Students will be able to draw a correctly labeled money market graph with the nominal interest rate on the vertical axis and a vertical money supply.
• Students will be able to describe the Fed's three tools (open market operations, the discount rate, the reserve requirement) and the direction each moves the money supply.
• Students will be able to trace the expansionary transmission chain from a bond purchase to a change in real GDP, stating every link in order.
• Students will be able to calculate the money multiplier (1/rr) and the maximum change in the money supply from a given change in reserves.
• Students will be able to explain why an open-market purchase lowers the interest rate while a sale raises it.

Materials (all free, no student accounts needed)

• Monetary Policy module
• Money market sandbox graph
• Trace-the-Shock walkthroughs
• Draw-the-graph FRQ practice
• Monetary Policy question set

Five-minute warm-up, no prep

Open one of these on the projector. Students say what they think happens to price and quantity before anything moves, lock it in, and then the graph plays out step by step. No accounts, nothing graded or stored.

• Crowding Out: Government Deficit Borrowing
• A Rise in National Saving
• US Interest Rates Rise: The Dollar Appreciates

Warm-up (8 min)

• Bell-ringer: 'In September 2019 the overnight repo rate jumped from about 2% to 10% in one morning. What does that tell you about the balance of money supply and money demand that day?' Two minutes, then cold-call.
• Quick check: to fight the 9.1% inflation of June 2022, should the Fed buy bonds or sell bonds? Hold the answer for direct instruction.

Direct instruction (32 min)

• Draw the money market: nominal interest rate on the vertical axis, quantity of money on the horizontal, a vertical MS set by the Fed, a downward MD. Say aloud that the y-axis is nominal, the top labeling error on this graph.
• List the three tools and their direction: buy bonds, lower the discount rate, or lower the reserve requirement all expand MS; the reverse contracts it. Note OMOs are the everyday tool.
• Work the money multiplier: with rr = 10%, a $100M bond purchase supports up to $1B of new money. Stress you start from excess reserves, not the whole deposit.
• Trace the full expansionary chain on the board: Fed buys bonds, reserves up, MS shifts right, nominal rate falls, investment and interest-sensitive consumption rise, AD shifts right, real GDP and price level rise. Number each link.
• Run the contractionary case in reverse using 2022-2023: the Fed sells, the rate rises past 5%, mortgages top 7%, AD shifts left, inflation cools. Point out the buy-big, sell-small memory hook.

Guided practice (30 min)

• Project /graph-walkthroughs and step through 'Expansionary Policy: The Fed Buys Bonds' as a class, pausing to have students predict the interest-rate step before you reveal it.
• Open /sandbox/monetary-policy, give the open-market-purchase scenario, and call a student to shift MS right; the class reads the new nominal rate.
• Same graph, new student: contractionary policy to fight inflation. Have them shift MS left and confirm the rate rises.
• Switch to /frq-practice/draw and assign 'Central Bank Bond Purchase,' 'Discount Rate Cut,' and the reserve-requirement scenario; students draw on devices while the tool checks the MS direction. Circulate to catch any real-rate axis labels.
• Cold-call the chain: 'The Fed buys bonds. Give me every link to real GDP in order.' One student narrates while another writes the arrows on the board.

Independent practice (25 min)

• Students work the /practice/monetary-policy set independently, finishing at least 8 items.
• Free-response: the economy is below potential. (a) State the appropriate open-market operation, (b) draw the labeled money market effect, (c) with rr = 20% and a $50M purchase, compute the maximum money-supply change, (d) draw the AD-AS effect.

Exit ticket

• What belongs on the vertical axis of the money market graph?
• Does the Fed BUY or SELL bonds to lower interest rates and stimulate the economy?
• With a 10% reserve requirement, what is the maximum new money from a $200M bond purchase, and what multiplier did you use?

Homework

• Work through the Monetary Policy module on /macro/monetary-policy and finish the practice questions built into it.
• Complete both open-market walkthroughs on /graph-walkthroughs (purchase and sale) and note what happens to money demand in the long run.

Differentiation

• For early finishers: have them chain the money market to AD-AS to the short-run Phillips curve for one bond purchase, then mark where inflation and unemployment move on the Phillips curve.
• For students who mix up the two interest-rate graphs: give a side-by-side sheet (money market = nominal, vertical MS; loanable funds = real, saving and borrowing) to annotate.
• For a chain scaffold: provide the transmission links out of order and have students number them rather than generate the sequence.

Misconceptions to head off

• Belief: the money market's vertical axis is the real interest rate. Correction: the money market sets the nominal rate; the real rate belongs to the loanable-funds market.
• Belief: the Fed sells bonds to stimulate the economy. Correction: it buys bonds to add reserves and lower rates; selling contracts the money supply. Buy big, sell small.
• Belief: multiply the entire deposit by the money multiplier. Correction: start from excess reserves; a $1,000 deposit at rr = 10% creates at most $9,000 of new money, not $10,000.
• Belief: monetary and fiscal policy use the same graph. Correction: monetary policy shifts the money supply in the money market; the Fed does not change taxes or government spending.