Straub 1

Chris Straub
Mr. Bozzone
AP Macroeconomics Period 7
February 13, 2019
Page 743 Discussion Questions 2, 4, 5
2. What is the basic objective of monetary policy? What are the major strengths of monetary
policy? Why is monetary policy easier to conduct than fiscal policy?

Monetary policy has the basic objective of assisting the economy achieve a non-
inflationary level of total output and full-employment.
The major strengths of monetary policy are the flexibly and speed it offers
compared to fiscal policy. As the Board of Governors is independent and removed from
political pressures, it is usually successful in keeping the price level stable as well as
controlling inflation.
Monetary policy is controlled by the seven current members of the Board of
Governors, whereas an agreement must be reached by both houses of Congress as well as
pass the President’s desk for a change in fiscal policy to be put into effect. Therefore,
monetary policy takes a much shorter time to be changed than fiscal policy.

3. Distinguish between the federal funds rate and the prime interest rate. Why is one higher
than the other? Why do changes in the two rates closely track one another?

The federal funds rate is the interest rate charged between banks on overnight
loans in order to meet their reserve requirements. The prime interest rate works as a
benchmark for various short-term loans made by banks to individuals and businesses.
The prime interest rate is always higher than the federal funds rate because loans
made to individuals or business are riskier than loans to other banks. Loans using the
prime interest rate also usually last for longer periods of time.
The changes in the two rates closely track each other because if there are low
prices, the Fed will increase the federal target rate. This in turn leads to a decrease in
borrowing and lending between banks. The demand for money will remain unchanged in
the immediate short-run but the supply will decrease, increasing the prime interest rate.

5. Suppose that you are a member of the Board of Governors of the Federal Reserve
System. The post-2008 economy is experiencing a sharp rise in the inflation rate. What
change in the federal funds rate would you recommend? How would your recommended
change get accomplished? What impact would the actions have on the lending ability of
the banking system, the real interest rate, investment spending, aggregate demand, and
inflation?
 Straub 2

In this situation, the Board of Governors should increase the federal funds rate in
order to decrease the supply of money. The Fed can increase the federal funds rate
by selling government securities to both banks and the public, receiving money in
exchange. Banks which purchased government securities would have purchased
the bonds using their reserves, therefore decreasing their ability to lend. The bank
would then raise its real interest rate to make up the deficit, causing investment
spending to decrease. Aggregate demand would decrease; inflation would
decrease.