AP Macroeconomics Financial Sector — Worked Answer Explanations

Unit 4 · 12 questions explained

Below is a complete answer key for our AP Macroeconomics Financial Sector practice questions. For each question you'll find the correct choice, a full written explanation of how to get there, and — for every wrong answer — a short note on exactly why it's tempting and where it goes wrong. Reading these straight through is one of the fastest ways to find the gaps in a unit before exam day.

Prefer to test yourself first? Take the timed Financial Sector practice test and come back here to review, or head back to the Financial Sector unit overview.

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Question 1 · Easy
A bank has $500 million in deposits and a required reserve ratio of 10%. If the bank holds only required reserves, what is the maximum amount the bank can lend?
- A
  $500 million
  Why not A: 500 million would mean lending all deposits; banks must retain required reserves before lending.
- B
  $50 million
  Why not B: 50 million is the required reserve amount (10% of 500), not the amount available to lend.
- C
  $450 millionCorrect
- D
  $4,500 million
  Why not D: 4,500 million is the money multiplier effect on the entire banking system, not what a single bank can lend from its deposits.
Explanation
Required reserves = $0.10 \times \$ 500\text{M} = $50$ million. The bank must hold $50 M an d c an l e n d t h er e main d er :$ $500\text{M} - \$ 50\text{M} = $450$ million. This is the excess reserves available for loans from a single bank's perspective.

Key takeaway
A single bank can lend its excess reserves = deposits − required reserves. The system-wide money multiplier applies across all banks.
Question 2 · Easy
Which of the following is classified as M1 money supply?
- A
  A 6-month certificate of deposit (CD)
  Why not A: Time deposits like CDs are included in M2 (broader measure) but not M1, which counts only the most liquid forms of money.
- B
  Demand deposits (checking accounts)Correct
- C
  Money market mutual fund shares held by households
  Why not C: Money market mutual fund shares are part of M2, not M1.
- D
  U.S. Treasury bills
  Why not D: T-bills are highly liquid but are considered near-money securities, not money per se; they are not included in M1 or M2.
Explanation
M1 is the narrowest measure of money supply and includes only the most liquid assets: currency in circulation, demand deposits (checking accounts), and other checkable deposits. M2 adds savings deposits, small time deposits, and money market mutual funds.

Key takeaway
M1 = currency + demand deposits + other checkable deposits. M2 = M1 + savings accounts + small time deposits + retail money market funds.
Question 3 · Easy
If the nominal interest rate is 7% and the expected inflation rate is 4%, what is the real interest rate?
- A
  11%
  Why not A: 11% = 7% + 4%; adding the rates gives the nominal rate if the real rate were known, not the real rate itself.
- B
  3%Correct
- C
  4%
  Why not C: 4% is the inflation rate, not the real interest rate.
- D
  7%
  Why not D: 7% is the nominal interest rate; it does not account for the erosion of purchasing power due to inflation.
Explanation
The Fisher equation: $r = i - π^{e}$ , where $r$ is the real rate, $i$ is the nominal rate, and $π^{e}$ is expected inflation. $r = 7% - 4% = 3%$ . The real interest rate represents the true cost of borrowing in terms of purchasing power.

Key takeaway
Fisher equation: $r = i - \pi^e$. Real interest rate = nominal rate − expected inflation. Lenders care about real rates; borrowers compare real rates to real returns.
Question 4 · Easy
The Federal Reserve conducts open market operations by purchasing government securities. What is the immediate effect on the money supply and interest rates?
- A
  Money supply decreases; interest rates rise.
  Why not A: Selling securities (open market sales) decreases the money supply and raises rates; the question describes a purchase, which has the opposite effect.
- B
  Money supply increases; interest rates fall.Correct
- C
  Money supply increases; interest rates rise.
  Why not C: An increase in the money supply shifts the money supply curve right, lowering — not raising — the nominal interest rate in the money market.
- D
  Money supply decreases; interest rates fall.
  Why not D: A decrease in money supply raises rates; the direction of both changes here is internally inconsistent.
Explanation
When the Fed buys government securities (expansionary open market operation), it pays by crediting bank reserves. More reserves → banks can lend more → money supply (M1/M2) expands. In the money market, a rightward shift of money supply lowers the equilibrium nominal interest rate.

Key takeaway
OMO purchase → ↑ bank reserves → ↑ money supply → ↓ interest rates. OMO sale has the opposite effect.
Question 5 · Easy
Which of the following best describes the role of the money market diagram in macroeconomics?
- A
  It shows how the price level is determined by the interaction of AD and AS.
  Why not A: Price level determination is shown in the AD/AS model, not the money market diagram.
- B
  It determines the nominal interest rate through the interaction of money supply and money demand.Correct
- C
  It shows how commercial banks create money through the fractional reserve process.
  Why not C: The money creation process is illustrated through T-accounts and the money multiplier, not the money market supply-demand diagram.
- D
  It illustrates the trade-off between inflation and unemployment.
  Why not D: The inflation-unemployment trade-off is shown on the Phillips curve, not the money market.
Explanation
The money market diagram plots the nominal interest rate against the quantity of money. The vertical money supply curve (controlled by the Fed) and the downward-sloping money demand curve intersect to determine the equilibrium nominal interest rate. Shifts in either curve change the equilibrium rate.

Key takeaway
Money market: vertical supply (Fed-controlled) + downward-sloping demand → equilibrium nominal interest rate. Fed shifts supply; GDP/price level shifts demand.
Question 6 · Easy
The required reserve ratio is 20%. If the Fed injects $1,000 in new reserves into the banking system, what is the maximum potential expansion of the money supply?
- A
  $1,000
  Why not A: 1,000 assumes a multiplier of 1, meaning banks do not lend out any excess reserves beyond the initial injection.
- B
  $5,000Correct
- C
  $200
  Why not C: 200 = 20% × 1,000, which is the required reserve on the initial deposit, not the total money expansion.
- D
  $10,000
  Why not D: 10,000 would result from a multiplier of 10, which requires a 10% reserve ratio, not 20%.
Explanation
Money multiplier $= \frac{1}{required reserve ratio} = \frac{1}{0.20} = 5$ . Maximum money expansion $= 5 \times \$ 1{,}000 = $5, 000$ . Each dollar of new reserves supports multiple rounds of deposit creation as banks lend, deposits are redeposited, and new loans are made.

Key takeaway
Money multiplier $= \frac{1}{\text{reserve ratio}}$. Maximum $\Delta M = \text{multiplier} \times \Delta \text{reserves}$. This is a theoretical maximum; actual expansion may be less.
Question 7 · Easy
The Fed raises the discount rate. How does this tool of monetary policy affect commercial bank lending?
- A
  Banks borrow more from the Fed, increasing reserves and expanding lending.
  Why not A: A higher discount rate makes borrowing from the Fed more expensive, discouraging banks from taking Fed loans — the opposite direction.
- B
  Banks borrow less from the Fed, reducing reserves and contracting lending.Correct
- C
  Banks immediately reduce their required reserve ratio.
  Why not C: Required reserve ratios are set by the Fed as a separate tool; they are not directly changed by the discount rate.
- D
  Banks increase open market purchases of government securities.
  Why not D: Open market operations are conducted by the Fed, not commercial banks; commercial banks cannot conduct OMOs.
Explanation
The discount rate is the interest rate the Fed charges commercial banks for short-term loans (borrowing reserves). A higher discount rate raises the cost of borrowing from the Fed, so banks borrow less. With fewer borrowed reserves, banks have less to lend, contracting the money supply (contractionary monetary policy).

Key takeaway
Discount rate ↑ → banks borrow less from Fed → fewer reserves → ↓ lending → ↓ money supply (contractionary). Discount rate ↓ has the opposite effect.
Question 8 · Easy
In the money market, an increase in real GDP will shift money demand because:
- A
  Higher GDP reduces the need to hold money for transactions.
  Why not A: Higher GDP means more transactions, requiring more money to be held — demand rises, not falls.
- B
  Higher GDP increases the volume of transactions, raising the demand for money.Correct
- C
  Higher GDP causes the Fed to expand money supply automatically.
  Why not C: The Fed does not automatically expand supply in response to GDP growth; money supply is set by the Fed's deliberate policy decisions.
- D
  Higher GDP lowers the opportunity cost of holding money.
  Why not D: The opportunity cost of holding money is the nominal interest rate; higher GDP raises demand for money, shifting the curve right — it does not lower the opportunity cost.
Explanation
Money demand (the transactions motive) rises with nominal GDP: more transactions require more money to be held. When real GDP rises, households and firms conduct more economic transactions and need to hold more liquidity. This shifts the money demand curve rightward, raising the equilibrium interest rate if money supply is unchanged.

Key takeaway
Money demand shifts right when real GDP or the price level rises (more transactions needed). This raises the equilibrium interest rate, holding money supply constant.
Question 9 · Easy
Which of the following correctly describes the Federal Reserve's policy tools for controlling the money supply?
- A
  Open market operations, the discount rate, and the required reserve ratio.Correct
- B
  Government spending, taxation, and the discount rate.
  Why not B: Government spending and taxation are fiscal policy tools controlled by Congress and the President, not the Federal Reserve.
- C
  Open market operations, the prime rate, and income tax rates.
  Why not C: The prime rate is set by commercial banks (not the Fed), and income tax rates are fiscal policy; only OMOs are correctly listed here.
- D
  The exchange rate, open market operations, and government spending.
  Why not D: The exchange rate is not directly controlled by the Fed in a floating exchange rate system, and government spending is fiscal policy.
Explanation
The Federal Reserve has three main monetary policy tools: (1) Open market operations — buying/selling government securities to change bank reserves; (2) Discount rate — interest rate on loans to commercial banks; (3) Required reserve ratio — fraction of deposits banks must hold as reserves. Together these control the money supply and credit conditions.

Key takeaway
Fed's three monetary policy tools: open market operations (most used), discount rate, and required reserve ratio. Fiscal tools (spending, taxes) belong to Congress/President.
Question 10 · Medium
A bank's T-account shows: Assets — Reserves $40M, Loans \$ 160M; Liabilities — Deposits $200M. The required reserve ratio is 15%. How much can this bank lend in additional loans?
- A
  $10 millionCorrect
- B
  $30 million
  Why not B: 30 million = 200M × 15%; this is the required reserves amount, not the excess reserves available for lending.
- C
  $160 million
  Why not C: 160 million is the existing loan portfolio; the question asks about additional loans from current excess reserves, not total existing loans.
- D
  $0 (the bank is already at its lending limit)
  Why not D: Required reserves = $200 M \times 0.15 =$ 30M, but the bank holds $40 M . E x cess =$ 10M, so there is still lending capacity.
Explanation
Required reserves = $\$ 200\text{M} \times 0.15 = $30$ million. Current reserves = $40 M . E x cessr eser v es =$ $40\text{M} - \$ 30\text{M} = $10$ million. The bank can lend out its entire excess reserves, or $10 million in additional loans.

Key takeaway
Excess reserves = actual reserves − required reserves. A bank can lend its excess reserves. Required reserves = deposits × reserve ratio.
Question 11 · Medium
Expansionary monetary policy is expected to increase real GDP in the short run through which transmission mechanism?
- A
  ↑ Money supply → ↓ interest rates → ↑ investment → ↑ AD → ↑ real GDPCorrect
- B
  ↑ Money supply → ↑ interest rates → ↑ saving → ↑ investment → ↑ real GDP
  Why not B: An increase in money supply lowers interest rates (not raises them); higher rates would discourage investment, not stimulate it.
- C
  ↑ Money supply → ↓ taxes → ↑ disposable income → ↑ consumption → ↑ real GDP
  Why not C: Tax changes are fiscal policy; monetary policy operates through interest rates and credit conditions, not directly through tax cuts.
- D
  ↑ Money supply → ↑ government spending → ↑ AD → ↑ real GDP
  Why not D: Government spending is a fiscal tool set by Congress; the Fed's monetary policy does not directly control government expenditures.
Explanation
The monetary policy transmission mechanism: Fed ↑ money supply → money supply curve shifts right in money market → nominal interest rate falls → lower borrowing costs stimulate business investment (I) and interest-sensitive consumption (C) → aggregate demand shifts right → real GDP rises in the short run.

Key takeaway
Monetary transmission: ↑ money supply → ↓ interest rates → ↑ investment → ↑ AD → ↑ real GDP. Opposite for contractionary monetary policy.
Question 12 · Medium
The interest rate on bonds and the price of bonds have an inverse relationship. If the Federal Reserve conducts open market sales of bonds, what happens to bond prices and interest rates?
- A
  Bond prices rise; interest rates fall.
  Why not A: OMO sales flood the market with bonds, reducing bond prices (not raising them), and the inverse relationship means rates rise.
- B
  Bond prices fall; interest rates rise.Correct
- C
  Bond prices and interest rates both rise.
  Why not C: Bond prices and interest rates move inversely; they cannot both rise simultaneously.
- D
  Bond prices fall; interest rates fall.
  Why not D: Bond prices and yields move inversely: falling bond prices mean higher yields (interest rates), not lower ones.
Explanation
The Fed sells bonds → bond supply in the market increases → bond prices fall. Because a bond's yield = fixed coupon/price, lower bond price → higher yield (interest rate). Additionally, the Fed absorbs bank reserves in the sale, tightening credit. Both mechanisms raise interest rates, consistent with contractionary OMO.

Key takeaway
Bond prices and interest rates move inversely. OMO sales: ↑ bond supply → ↓ bond price → ↑ interest rates (and ↓ bank reserves → contractionary).