Monetary Policy Practice Questions

8 representative multiple-choice questions on monetary policy for AP Macroeconomics, drawn from our 39-question bank for this module. Work through each one, then open “Show answer” for the correct choice and an explanation. For scored, timed practice across the full bank, take a full practice test.

Prefer to read? The same questions, with answers

1. 1. The Federal Reserve's primary tool of monetary policy is:

   • A. Changing the discount rate
   • B. Open market operations (buying/selling government bonds)
   • C. Adjusting the reserve requirement
   • D. Setting the federal funds rate directly
   Show answer

   Correct answer: B. Open market operations (buying/selling government bonds)

   Open market operations run the show. The FOMC meets every six weeks and decides direction, then the New York Fed's trading desk buys or sells Treasury bonds to hit the target. Option A is used only rarely. Option C is largely historical; the Fed dropped reserve requirements to zero in March 2020. Option D is a common misconception. The FOMC sets a target range for the fed funds rate, and the trading desk uses OMOs to steer the actual market rate into that range.

2. 2. On a money market graph, an increase in the money supply by the Federal Reserve results in:

   • A. A leftward shift of MS, raising the interest rate
   • B. A rightward shift of MS, lowering the interest rate
   • C. A rightward shift of MD, raising the interest rate
   • D. A leftward shift of MD, lowering the interest rate
   Show answer

   Correct answer: B. A rightward shift of MS, lowering the interest rate

   Expansionary policy shifts MS right. The new intersection with MD happens at a lower interest rate, which is the whole point. Money demand doesn't shift because income and prices haven't adjusted yet. The falling interest rate is the link that carries monetary policy out of the financial markets and into the real economy through investment and consumption decisions.

3. 3. Suppose the required reserve ratio is 10% and a bank receives a new deposit of $10,000. What is the maximum amount by which the money supply can ultimately increase?

   • A. $1,000
   • B. $9,000
   • C. $90,000
   • D. $100,000
   Show answer

   Correct answer: D. $100,000

   Money multiplier = 1 / 0.10 = 10. Maximum increase = $10,000 × 10 = $100,000. That original deposit sits in the first bank, which holds $1,000 as required reserves and lends out $9,000. The next bank receives that $9,000, keeps $900, and lends $8,100. Each round loses 10% to required reserves. Summed to infinity, the expansion totals $100,000. Real-world multipliers tend to be smaller because banks hold excess reserves and cash leaks out of the banking system.

4. 4. The Federal Reserve's dual mandate requires it to pursue:

   • A. Low inflation and a balanced federal budget
   • B. Maximum employment and stable prices (low inflation)
   • C. Economic growth and increased government revenue
   • D. Financial stability and low mortgage rates
   Show answer

   Correct answer: B. Maximum employment and stable prices (low inflation)

   Congress gave the Fed a dual mandate in the 1977 amendment to the Federal Reserve Act: maximum employment AND stable prices (typically interpreted as 2% inflation). These two goals can conflict, which is the central challenge of monetary policymaking. Volcker's 1980-82 disinflation drove unemployment above 10% on purpose to break inflation. Powell's 2022-23 rate hikes had to balance the same tension. Option A mixes in budget balance, which is Congress's job, not the Fed's. The 1977 amendment followed a decade of serious economic turmoil and reflected a deliberate policy choice to treat employment and price stability with equal weight.

5. 5. At a 20% reserve ratio, a bank has $900 in excess reserves. What is the maximum new money the system can create?

   • A. $4,500
   • B. $1,800
   • C. $4,000
   • D. $9,000
   Show answer

   Correct answer: A. $4,500

   900 x 5 = $4,500. The same excess reserves create half as much money as they did at a 10% ratio, because each bank in the chain now keeps twice as much back. Comparing this against the earlier $9,000 is the clearest demonstration of what the reserve requirement actually does.

6. 6. Inflation turns out to be 6% when both parties expected 2%, on a loan with a 5% nominal rate. Who gains?

   • A. The lender, because the nominal rate is fixed
   • B. The borrower, because the realised real rate is negative
   • C. Neither, because the contract adjusts
   • D. Both, because inflation raises all incomes
   Show answer

   Correct answer: B. The borrower, because the realised real rate is negative

   The realised real rate is 5 - 6 = -1%, so the borrower repays in money worth less than expected and the lender loses purchasing power. Unanticipated inflation redistributes from lenders to borrowers; it is anticipated inflation that gets priced into the nominal rate in advance and hurts nobody in this way.

7. 7. In the loanable funds market, what causes the supply of loanable funds to increase?

   • A. An increase in business investment demand
   • B. A fall in the real interest rate
   • C. An increase in national saving
   • D. An increase in government borrowing
   Show answer

   Correct answer: C. An increase in national saving

   Supply of loanable funds comes from saving, so anything that raises national saving shifts it right. Options B and C are increases in DEMAND for funds. Option D describes a movement along the supply curve rather than a shift of it, which is the distinction this market is most often used to test.

8. 8. Why is actual money creation usually smaller than the money multiplier predicts?

   • A. Central banks cap the number of loans
   • B. Interest rates prevent lending
   • C. The formula is wrong
   • D. Banks hold excess reserves and the public holds cash, so not every dollar is re-lent
   Show answer

   Correct answer: D. Banks hold excess reserves and the public holds cash, so not every dollar is re-lent

   The multiplier assumes banks lend every dollar of excess reserves and the public redeposits all of it. In reality banks keep buffers, especially in a downturn, and people hold currency, so each round of the chain leaks. The multiplier is therefore a maximum, not a forecast, and the gap widened sharply after 2008.