Monetary Policy worksheet
The answer key prints on its own page, so hand out everything before it.
Monetary Policy: practice worksheet
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
2. When the Federal Reserve buys government bonds in the open market, which of the following occurs?
- (A) Money supply decreases, interest rates rise, investment falls
- (B) Money supply increases, interest rates fall, investment rises
- (C) Money supply increases, interest rates rise, investment falls
- (D) Money supply decreases, interest rates fall, investment rises
3. If the required reserve ratio is 20%, the money multiplier is:
- (A) 5
- (B) 10
- (C) 20
- (D) 2
4. Which of the following represents contractionary monetary policy?
- (A) The Fed buys government bonds
- (B) The Fed lowers the discount rate
- (C) The Fed raises the reserve requirement
- (D) The Fed decreases the federal funds rate target
5. 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
6. Which of the following is NOT a function of the Federal Reserve?
- (A) Conducting monetary policy
- (B) Collecting federal income taxes
- (C) Regulating and supervising banks
- (D) Serving as lender of last resort to banks in crisis
7. During a recession with high unemployment, which monetary policy action would be most appropriate?
- (A) Sell government bonds to reduce the money supply
- (B) Raise the discount rate to make borrowing more expensive
- (C) Buy government bonds to lower interest rates and stimulate investment
- (D) Increase the reserve requirement to tighten credit
8. The interest rate effect helps explain why aggregate demand slopes downward. According to this effect:
- (A) Higher price levels increase money demand, raising interest rates and reducing investment
- (B) Higher price levels reduce the real value of wealth, decreasing consumption
- (C) Higher price levels make domestic goods more expensive, reducing net exports
- (D) Higher price levels reduce business confidence, discouraging investment
9. If the Federal Reserve targets an inflation rate of 2% and current inflation is at 4% with the economy operating above potential GDP, the most consistent policy response would be:
- (A) Lower the federal funds rate to stimulate investment
- (B) Raise the federal funds rate to reduce aggregate demand
- (C) Increase government spending through the multiplier effect
- (D) Cut taxes to boost disposable income
10. 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
Monetary Policy: answer key
1. (B) 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. (B) Expansionary operation. When the Fed buys bonds, it credits bank reserve accounts with new money. Those reserves multiply through lending as banks make loans, depositors hold the new funds, and other banks lend against those deposits. The expanded money supply pushes interest rates down, which makes borrowing cheaper. Business investment rises along with interest-sensitive consumer purchases like mortgages and car loans.
3. (A) Money multiplier = 1 / reserve ratio = 1 / 0.20 = 5. Every $1 of new reserves can theoretically support $5 of new money supply as it passes through the banking system. In practice the real multiplier tends to be smaller because banks hold excess reserves and some cash leaks out of the deposit-lending cycle.
4. (C) Raising the reserve requirement locks up more bank deposits as idle reserves, which shrinks lending capacity and pulls money supply down. Contractionary. The other options all expand the money supply. Option A injects reserves. Option B makes emergency borrowing cheaper. Option D signals an expansionary stance, the opposite of contraction. Contractionary moves typically mean selling bonds, raising rates, or tightening reserve rules.
5. (B) 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.
6. (B) Tax collection belongs to the IRS, which is part of the Treasury Department, not the Fed. The Fed handles monetary policy, bank regulation, and emergency lending. The lender-of-last-resort function is why the Fed was created in 1913, specifically to prevent the kind of bank panics that had plagued the US in 1873, 1893, and 1907.
7. (C) Recessions call for expansionary policy. Buy bonds. Add reserves to the banking system. Money supply expands, interest rates drop, and investment-sensitive spending picks up. AD shifts right, real GDP rises, unemployment falls. Each of the other options is contractionary and would make the downturn worse. This is exactly the playbook the Fed followed in March 2020, cutting rates to near zero and buying over $80B in Treasuries per month.
8. (A) When the price level rises, households and firms need more money to conduct the same real transactions. Money demand shifts right, which pushes interest rates up. Higher interest rates discourage investment and interest-sensitive consumption, so real output falls. That's the textbook interest rate effect. Option B describes the wealth effect. Option C describes the exchange rate effect. All three effects together explain why the AD curve slopes downward.
9. (B) Contractionary monetary policy. 4% inflation on a 2% target plus output above potential means the economy is overheating. Raising the fed funds rate tightens credit throughout the economy. Investment and interest-sensitive consumption pull back, AD shifts left, output returns toward potential, and inflation comes down. Option A would pour fuel on the fire. Options C and D are fiscal policy tools controlled by Congress, not the Fed.
10. (D) 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.