UNIT
4 Macroeconomics
SHORT FREE-RESPONSE
SAMPLE QUESTIONS
Answer
Key
Answers to Sample Short Free-Response Questions
*1. The reserve requirement for the banking system is 20 percent. Currently Third National Bank has
no excess reserves. Then Behroz deposits $100 in her checking account at Third National.
(A) Explain, without using a mathematical formula, why Behroz’s deposit can lead to an increase
in the money supply that is greater than $100. The bank may make loans (or buy securities)
based on excess reserves (80 percent of Behroz’s deposit). The bank does make loans based on
excess reserves, and the deposit created by the loan is redeposited in the banking system (fractional reserves). Answer must go one more step in loan and redeposit scenario: for example,
show more than $100 of money created!
Grading Rubric: Part (A) = 3 points
Loan equals deposit minus required reserves. (1 point)
Bank makes loan or buys securities. (1 point)
Loan is redeposited in banking system. (1 point)
(B) Discuss two limitations of this process.
The possible limitations to the process are
■
the bank willingly holds excess reserves.
■
customers do not want to borrow.
■
cash leakages.
Grading Rubric: Part (B) = 2 points
One point for each correct limitation, up to two points.
Notes on scoring: Besides counting points, the answer may be looked at as a whole and ultimately
judged by its overall quality. The final total should mean something in terms of the overall quality of the answer. A score of five points should reflect an excellent answer, but not necessarily perfect; four an excellent answer with a flaw; three a good answer; two an adequate answer; one a
seriously deficient answer but still an answer; zero all else.
* Actual free-response question from a past AP test. Reprinted by permission of the College Entrance Examination Board, the copyright owner. For limited use by NCEE.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
4 Macroeconomics
SHORT FREE-RESPONSE
SAMPLE QUESTIONS
Answer
Key
2. The Federal Reserve has three primary tools to expand or contract the money supply.
(A) List the three tools.
Open market operations (buying and selling Treasury securities)
Required reserve ratio
Discount rate
(B) Which tool does the Fed use most often? Open market operations
(C) Explain why the Federal Reserve uses the tool you indicated in Question 2(B).
With open market operations, the Fed has more immediate and more controlled influence on
the money supply. If the money supply increases at a rate faster than output is increasing, it
will be inflationary.
3. Milton Friedman has said, “Inflation is primarily a monetary phenomenon.”
(A) Describe the conditions under which an increase in the money supply would be inflationary.
If the money supply increases at a rate faster than output is increasing, it will be inflationary.
(B) Use an aggregate supply and aggregate demand graph to show the conditions under which
increases in the money supply are entirely inflationary.
PRICE LEVEL
SRAS
AD1
AD
REAL GDP
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
577
UNIT
4 Macroeconomics
SHORT FREE-RESPONSE
SAMPLE QUESTIONS
Answer
Key
4. Explain the statement that the Federal Reserve can “target” the size of the money supply or the
interest rate, but not both. As we saw in our study of the money market, it is the interaction
between the supply of money and the demand for money that determines the interest rate. The Fed
controls the money supply. If the Fed targets the money supply, then as the demand for money
changes, so will the interest rate. If the Fed targets the interest rate, it must change the money supply to adjust for changes in the demand for money to maintain the desired interest rate. Thus, the
Fed cannot control both the money supply and the interest rate simultaneously.
5. Suppose the required reserve ratio is 0.20.
(A) What would be the value of the deposit expansion multiplier?
5
(B) Discuss why it is unlikely that a new deposit of $1,000 to a checking account would result in
the money supply fully increasing as indicated by the deposit expansion multiplier.
Banks may choose to hold excess reserves, or borrowers may want fewer loans than banks have
available. Or people may not redeposit the money in the banking system. Any one of these
occurrences would limit the money expansion.
6. Banks can borrow reserves either at the federal funds rate or at the discount rate.
(A) Define the federal funds rate. The federal funds rate is the interest rate at which financial institutions can borrow short-term reserves from one another.
(B) Define the discount rate. The discount rate is the interest rate at which financial institutions
can borrow short-term funds from the Federal Reserve.
(C) Under what conditions would banks borrow at the discount rate? In general, banks prefer to
borrow in the federal funds market. Borrowing from the Federal Reserve, in general, means
that the Federal Reserve will review the operations of the bank. Most banks would prefer not to
come under this scrutiny. However, if the bank is able to loan the funds to earn a profit and the
discount rate is much lower than the federal funds rate, or if the bank cannot borrow in the
federal funds market, then the bank will borrow from the Federal Reserve.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.