Monetary Policy

The Money Market Model

The money market model is a supply-and-demand graph, but instead of a product market it tracks the price of holding cash versus lending it out. The vertical axis is the nominal interest rate. Horizontal axis is the quantity of money.

Money supply (MS) is near-vertical because the Federal Reserve decides how much money exists in the system. That quantity does not change just because market interest rates happen to move up or down. Money demand (MD) slopes downward. When rates are high, holding cash is expensive because every idle dollar means forgone bond returns, so people economize on their cash balances. When rates are low, cash is cheap to hold and people keep more on hand. Where MS crosses MD, you get the equilibrium interest rate.

If the market rate sits above equilibrium, people realize they are holding more money than they want at that high opportunity cost. They buy bonds, which drives bond prices up, and yields fall back toward equilibrium. Below equilibrium, the opposite pressure pushes rates back up. September 2019 showed how violently this can play out in real life. The overnight repo rate, normally hovering near the Fed's 2% target, spiked to 10% in a single morning when supply and demand for reserves fell out of balance. The New York Fed had to inject $75 billion in emergency liquidity before lunch, then committed to $100 billion in daily repo operations. The crisis lasted about two weeks but it was a vivid demonstration of what the money market model describes on paper.

The Federal Reserve's Tools

Three primary instruments, each targeting bank reserves from a different angle. The tools have evolved since the Fed was founded in 1913 but the underlying logic has stayed consistent.

Open market operations (OMOs) are the workhorse. The Fed buys government bonds from banks and credits their reserve accounts with newly created money. Banks end up sitting on excess reserves and lend them out. Through the money multiplier, a single bond purchase ripples into a much larger expansion of total money supply. Selling bonds reverses the flow, drains reserves, contracts supply. During spring 2020 the Fed was buying more than $80 billion in Treasuries per month plus $40 billion in mortgage-backed securities, flooding the system with liquidity on a scale that dwarfed even 2008-2009 QE.

The discount rate is what the Fed charges commercial banks for short-term emergency loans from the discount window. Lower it and banks can borrow reserves more cheaply, which encourages lending. Raise it and borrowing gets expensive. In practice banks treat the discount window as a last resort. Borrowing from it carries a stigma, signaling to regulators and competitors that something might be wrong.

The reserve requirement used to dictate the fraction of customer deposits banks had to hold back rather than lend out. Lowering it freed deposits for lending and raised the money multiplier. Raising it locked up reserves and constrained lending. In March 2020 the Fed dropped the reserve requirement to zero for the first time ever, and that change remains in effect. It fundamentally altered how the Fed manages the reserve system.

The Federal Funds Rate

Every six weeks, financial markets around the world obsess over a single number. The federal funds rate, the interest rate banks charge each other for overnight loans of excess reserves. It is the Fed's primary policy target.

A common misconception is that the FOMC just decrees this rate into existence. It does not work that way. The committee announces a target range, then the Fed's trading desk at the New York Fed conducts open market operations to shift the money supply until the actual overnight rate in the interbank market matches the target. When the FOMC declared an emergency cut to near-zero on March 15, 2020, the open market desk immediately began buying massive quantities of Treasuries and mortgage-backed bonds to push reserves into the system and drag the actual rate down.

One overnight lending rate between banks sounds like an obscure technicality, but it sets the floor for the entire credit market. When the fed funds rate moves, banks adjust the prime rate, which reprices mortgages, auto loans, corporate debt, credit card interest. A decision made in the Eccles Building in D.C. reaches a young couple financing their first home in suburban Ohio within weeks. That transmission from overnight interbank lending to household borrowing costs is what gives monetary policy its reach into the real economy.

Expansionary Monetary Policy

By late March 2020 the U.S. economy was in a textbook recessionary gap. GDP collapsing at an annualized rate above 30%, unemployment applications arriving at state offices by the millions, real output falling well below potential. The Fed's response was expansionary policy, "easy money," designed to lower borrowing costs and encourage private spending.

The transmission chain goes like this. Fed buys bonds, or cuts the discount rate, or lowers the reserve requirement. Bank reserves rise, money supply increases, MS shifts right on the money market graph. Equilibrium interest rate falls. Cheaper borrowing encourages firms to invest in factories, equipment, hiring. Households take on mortgages, car loans, other interest-sensitive spending. Investment (I) and consumption rise. AD shifts right, closing or narrowing the output gap.

On the money market diagram, MS moves right and the interest rate drops. That lower rate is the bridge connecting the Fed's financial-market actions to real economic activity in factories and offices and shopping centers. If expanding the money supply did not produce a decrease in the interest rate, nothing would happen to the real economy. The interest rate channel is everything in this model.

Contractionary Monetary Policy

June 2022. The Bureau of Labor Statistics reported CPI up 9.1% over the prior twelve months, the steepest annual increase since November 1981. Real GDP running above potential, employers competing fiercely for scarce workers, grocery and gas and rent prices climbing month after month. A clear inflationary gap. Chair Powell and the FOMC pivoted to contractionary policy, "tight money," and the transmission mechanism ran in reverse.

Fed sells bonds, raises the discount rate, or increases the reserve requirement. Bank reserves contract, money supply shrinks, MS shifts left. Equilibrium interest rate rises. Borrowing becomes expensive for firms weighing capital investments and for households considering big purchases. Investment and interest-sensitive consumption decline, AD shifts left, upward pressure on prices eases.

Between March 2022 and July 2023 the FOMC raised the federal funds rate from near-zero to a target range of 5.25%-5.50%, the fastest tightening cycle in four decades. Mortgage rates climbed above 7%. Auto loan rates pushed past 8%. Corporate borrowing costs rose sharply. The mechanism worked exactly as the model predicts. Squeeze demand by making credit expensive.

The Transmission Mechanism

What actually connects a bond purchase at the New York Fed's trading desk to a family signing a mortgage in Phoenix or a manufacturer breaking ground on an assembly line in Tennessee?

The transmission mechanism traces every link. Full sequence: Fed action changes the money supply, which changes the interest rate, which changes investment spending, which shifts aggregate demand, which changes real GDP and the price level. Each link depends on the one before it. Break any single link and the policy fails to reach the real economy.

Weak links exist and they matter. If money demand is nearly flat (highly elastic), even a large rightward shift in MS barely moves the interest rate. If businesses are deeply pessimistic about future demand, rock-bottom rates still will not convince them to borrow and build. That was the story through much of 2009 and 2010 when banks sat on mountains of excess reserves and nobody wanted loans. This asymmetry explains a lot. Monetary policy tends to be more effective at cooling an overheating economy than at reviving a depressed one. Paul Volcker demonstrated the cooling half in 1980-82, crushing double-digit inflation by pushing the fed funds rate above 20% and accepting a brutal recession as the cost. The Fed's struggle to spark recovery after the 2008 financial crisis demonstrated the other half.

Two graphs tell the full story. The money market diagram covers the first three links, Fed action through the interest rate change. The AD/AS model picks up the rest, investment response through the change in GDP and prices. AP free-response questions frequently require you to walk through both graphs step by step.

Monetary Policy and the Phillips Curve

The Phillips Curve is the inflation-unemployment mirror of everything the Fed does. Expansionary policy, buy bonds, lower rates, shifts AD right, output rises, unemployment drops, inflation rises. On the short-run Phillips Curve the economy moves up and to the left. Lower unemployment traded for higher inflation.

Volcker's early-1980s rate hikes traced the opposite path. AD shifted left, unemployment soared past 10% by end of 1982, inflation collapsed from double digits to under 4% by 1983. On the Phillips Curve that is movement down and to the right. The cost was a severe recession that devastated manufacturing communities across the Midwest.

Powell's 2022-2023 tightening followed the same directional logic. Fed funds rate climbed from near-zero to above 5%, and the Phillips Curve predicted what came next. Inflation fell from the 9.1% peak toward 3% while unemployment initially stayed remarkably low before gradually showing signs of cooling in sectors like tech and commercial real estate.

The long-run Phillips Curve is vertical at the natural rate of unemployment, mirroring the vertical LRAS at full-employment output. Monetary policy can move the economy along the short-run curve but cannot permanently push unemployment below the natural rate. Try it and the SRPC itself shifts upward as workers and firms bake higher expected inflation into wage and price decisions. Unemployment returns to the natural rate but inflation settles at a permanently higher level.

Connecting the monetary policy chain to the Phillips Curve on AP free-response questions is where strong answers separate from mediocre ones. Fed buys bonds, rates fall, AD shifts right, Phillips Curve registers lower unemployment and higher inflation. Being able to trace that full sequence across multiple graphs, money market, AD/AS, Phillips Curve, is where the points are on exam day.

Worked Example

The Fed purchases $100 million in government bonds. Reserve requirement is 10%. Trace the full chain.

Money multiplier. With a 10% reserve requirement, multiplier = 1 / 0.10 = 10. That initial $100 million reserve injection can support up to $1 billion in new money supply as banks lend excess reserves, those loans get deposited elsewhere, those banks lend again, and so on until reserves are fully committed.

Money market graph. MS shifts right by $1 billion. Money demand has not changed yet because income and price level have not adjusted. Equilibrium interest rate falls. How much it falls depends on the slope of MD. Steeper money demand means a larger swing in the interest rate, flatter means a smaller one.

Real economy. Lower rates reduce borrowing costs for firms and households. Investment projects that were marginally unprofitable at higher rates become viable. AD shifts right, real GDP rises, price level increases along the SRAS curve. The recessionary gap narrows.

End to end: Fed buys bonds, bank reserves rise, money supply expands by the multiplied amount, interest rate falls, investment rises, AD shifts right, GDP increases. The AP exam can ask about any single step in this sequence, so practice running the chain in both the expansionary and contractionary directions until it becomes automatic.