What it covers: Money, banking, the money market, monetary policy, and the loanable funds market.
Exam weight: About 18–23% of the AP Macroeconomics exam.
The big question: What is money, how do banks create it, and how does the central bank use it to influence interest rates and the broader economy?
Big Ideas covered: Money & Trust, Money Creation, and Central Bank Influence.
Key topics at a glance
Financial Assets
Bond prices and interest rates move inversely. Rising market rates make existing fixed-rate bonds less attractive, lowering their price.
Real vs. Nominal Interest Rates
Real rate ≈ nominal rate − expected inflation. The real rate reflects the true cost of borrowing or return on saving.
Functions & Measures of Money
Medium of exchange, store of value, unit of account. M1 (most liquid) vs. M2 (M1 + savings, CDs, money market funds).
Banking & Money Creation
Fractional reserve banking: banks hold a required reserve ratio and lend out excess reserves, creating new money.
The Money Multiplier
Money multiplier = 1 ÷ required reserve ratio. A single new deposit expands into a much larger total increase in the money supply.
The Money Market
Money demand (downward-sloping) meets money supply (vertical, set by the Fed) to determine the nominal interest rate.
Monetary Policy
Tools: open market operations, the discount rate, reserve requirements. Expansionary = ↑ money supply, ↓ rates. Contractionary = the reverse.
Loanable Funds Market
Savers (supply) meet borrowers (demand) to set the real interest rate. Government deficits can raise rates and crowd out investment.
The key terms you must know
Medium of exchange / store of value / unit of account — the three functions of money.
M1 / M2 — measures of the money supply, from most to less liquid.
Required reserve ratio — the fraction of deposits banks must hold rather than lend out.
Money multiplier — 1 ÷ required reserve ratio; shows the maximum expansion of the money supply.
Money market — money demand and supply determining the nominal interest rate.
Open market operations — the Fed buying/selling government securities to change the money supply.
Expansionary / contractionary monetary policy — increasing or decreasing the money supply to shift interest rates and aggregate demand.
Loanable funds market — savers and borrowers determining the real interest rate.
Key themes to remember
Money only works because people trust it. Its value comes from acceptance and stability, not any physical backing.
Banks create money by lending, not printing. Every new loan (beyond required reserves) expands the money supply.
The Fed controls the money supply; the market for loanable funds determines the real rate. Don't confuse the money market (nominal rate, vertical supply set by the Fed) with the loanable funds market (real rate, both curves can shift).
Monetary policy works through interest rates. Changing the money supply changes interest rates, which changes investment and consumption, which shifts AD.
Common exam traps
Don't confuse the money market with the loanable funds market. Money market = nominal interest rate, vertical money supply curve set by the Fed. Loanable funds market = real interest rate, both supply and demand can shift.
The money multiplier gives a maximum, theoretical expansion. In reality, banks may hold excess reserves and not lend the full amount, so actual expansion is often smaller.
Buying bonds (open market purchases) increases the money supply; selling bonds decreases it. Many students reverse this.
A lower required reserve ratio increases the money multiplier — don't assume the relationship is direct rather than inverse.
M1 is a subset of M2, not a separate, unrelated measure. M2 = M1 + additional less-liquid assets.