Chapter 04

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates True/False Questions 1. Federal Reserve interest rate decisions can be vetoed by the U.S. President or the Congress. Answer: False Page: 90 Level: Easy 2. The FOMC is responsible for supervising and regulating depository institutions and foreign exchange traders. Answer: False Page: 93 Level: Easy 3. Four seats on the FOMC are allocated to Federal Reserve Bank presidents on an annual rotating basis. Answer: True Page: 93 Level: Easy 4. The monetary base is the amount of coin and currency in circulation plus reserves. Answer: True Page: 99 Level: Easy 5. There are only 10 Federal Reserve Districts throughout the U.S., each one headed by a Federal Reserve Bank. Answer: False Page: 96-97 Level: Easy 6. The Federal Reserve check clearing system clears about 40 billion checks per year. Answer: False Page: 96-97 Level: Medium 7. The major asset of the Federal Reserve is currency outside banks, and the major liability is U.S. Treasury securities. Answer: False Page: 98 Level: Medium 8. The Check 21 Law is projected to save the banking industry as much as $3 billion per year. Answer: True Page: 97 Level: Easy

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9. Federal Reserve Board members are appointed by the U.S. President and confirmed by the Senate for a non-renewable 14 year term. Answer: True Page: 93 Level: Easy 10. If the FOMC wished to generate faster economic growth, they could issue a policy directive to the Federal Reserve Board Trading desk to purchase U.S. government securities. Answer: True Page: 102-103 Level: Medium 11. An increase in Treasury securities held by the Fed leads to a decrease in the money supply. Answer: False Page: 103 Level: Medium Multiple Choice Questions 12. The primary policy tool used by the Fed to meet its monetary policy goals is: A) Changing the discount rate B) Changing reserve requirements C) Devaluing the currency D) Changing bank regulations E) Open market operations Answer: E Page: 102 Level: Easy 13. The Federal Reserve System is charged with A) Regulating securities exchanges B) Conducting monetary policy C) Providing payment and other services to a variety of institutions D) Setting bank prime rates E) Both B and C Answer: E Page: 94 Level: Easy

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14. The _______________ is a nationwide network jointly operated by the Fed and private institutions that electronically process credit and debit transfers of funds. A) Fedwire B) ACH C) CHIPS D) NASDAQ E) SWIFT Answer: B Page: 97-98 Level: Easy 15. The _____________ is a network linking over 6000 banks with the Federal Reserve that is used to transfer deposits and make loan payments between participants. A) Fedwire B) ACH C) CHIPS D) NASDAQ E) SWIFT Answer: A Page: 97-98 Level: Easy 16. Ceteris paribus, if the Fed was targeting the quantity of money supplied and money demand dropped the Fed would likely ______________. If the Fed was instead targeting interest rates and money demand dropped the Fed would likely _______________. A) increase the money supply, do nothing. B) do nothing, decrease the money supply. C) decrease the money supply, do nothing. D) do nothing, increase the money supply. E) increase the money supply, decrease the money supply. Answer: B Page: 113-114 Level: Difficult 17. Which of the following is the major monetary policy making body of the U.S. FRS? A) FOMC B) OCC C) FRB bank presidents D) U.S. Congress E) Group of ten Answer: A Page: 92-93 Level: Easy

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18. The major liability of the Federal Reserve is A) U.S. Treasury securities B) Depository institution reserves C) Currency outside banks D) Vault cash of commercial banks E) Gold and foreign exchange Answer: C Page: 99 Level: Medium 19. The major asset of the Federal Reserve is A) U.S. Treasury securities B) Depository institution reserves C) Currency outside banks D) Vault cash of commercial banks E) Gold and foreign exchange Answer: A Page: 98 Level: Medium 20. The fed funds rate is the rate that A) Banks charge for loans to corporate customers B) Banks charge to lend foreign exchange to customers C) The Federal Reserve charges on emergency loans to commercial banks D) Banks charge each other on loans of excess reserves E) Banks charge securities dealers to finance their inventory Answer: D Page: 101 Level: Medium 21. The discount rate is the rate that A) Banks charge for loans to corporate customers B) Banks charge to lend foreign exchange to customers C) Banks charge each other on loans of excess reserves D) Banks charge securities dealers to finance their inventory E) The Federal Reserve charges on loans to commercial banks Answer: E Page: 104 Level: Medium

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22. The Fed offers three types of discount window loans. _______ credit is offered to small institutions with demonstrable patterns of financing needs, _______ credit is offered for short term temporary funds outflows, and _______ credit may be offered at a higher rate to troubled institutions with more severe liquidity problems. A) Seasonal; extended; adjustment B) Extended; adjustment; seasonal C) Adjustment; extended; seasonal D) Seasonal; primary; secondary E) Adjustment; seasonal; extended Answer: D Page: 106 Level: Medium 23. Before 2003 the discount window loan rate was set A) below the target fed funds rate B) above the target fed funds rate C) equal to the target fed funds rate D) equal to the repurchase rate Answer: A Page: 105-106 Level: Medium 24. A decrease in reserve requirements could lead to a(n) A) Increase in bank lending B) Increase in the money supply C) An increase in the discount rate D) Both A and B E) Both A and C Answer: D Page: 106-107 Level: Medium 25. Bank A has an increase in deposits of $10 million dollars and reserve requirements are 10%. Bank A loans out 90% of the increase. This amount winds up deposited in Bank B. Bank B lends out 90%, and this amount winds up deposited in Bank C. What is the total increase in deposits resulting from these three banks? A) $10.00 million B) $19.00 million C) $22.33 million D) $27.10 million E) $30.00 million Answer: D Page: 106-107 Level: Medium Rationale: 10+(10× 0.90) + (9× 0.90)

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26. The Fed changes reserve requirements from 10% to 8%, thereby creating $450 million in excess reserves. The total change in deposits (with no drains) would be A) $486 million B) $5.625 billion C) $0.489 billion D) $3.795 billion E) None of the above Answer: B Page: 106-107 Level: Medium Rationale: (1/0.08) × $450 mill 27. If the Fed wishes to stimulate the economy it could I. Buy U.S. government securities II. Raise the discount rate III. Lower reserve requirements A) B) C) D) E)

I and III only II and III only I and II only II only I, II and III

Answer: A Page: 110 Level: Medium 28. Currently the Fed sets monetary policy by targeting A) The Fed funds rate B) The prime rate C) The level of non-borrowed reserves D) The level of borrowed reserves E) The stock market Answer: A Page: 115 Level: Easy 29. If the Federal Reserve were to buy dollars by selling yen the result would be to _____ the supply of U.S. dollars and _____ the exchange rate in terms of the number of yen per U.S. dollar. A) Increase, lower B) Increase, raise C) Decrease, lower D) Decrease; raise Answer: D Page: 116 Level: Medium

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30. From October 1983 to July 1993 the Federal Reserve targeted A) Fed funds rate B) Borrowed reserves C) Nonborrowed reserves D) M1 E) M3 Answer: B Page: 115 Level: Medium 31. Recently oil prices have risen in the U.S, generating concerns that inflation may increase. If the Fed wishes to ensure that inflation does not get out of hand the Fed could: A) Intervene in the currency markets to push the value of the dollar down. B) Decrease the discount rate. C) Lower the target fed funds rate. D) Lower the target money supply growth rate. E) Reduce reserve requirements at banks. Answer: D Page: 111-112 Level: Medium 32. The Fed changes reserve requirements from 10% to 12%, thereby eliminating $650 million in excess reserves. The total change in deposits (with no drains) would be (rounded) A) $5.417 billion B) $6.630 billion C) $0.130 billion D) $4.934 billion E) None of the above Answer: A Page: 108 Level: Medium Rationale: (1/0.12) × $650 mill 33. The Fed increases bank reserves in the system by $75 million. If there are no drains the expected change in bank deposits is A) $82.5 million B) $945 million C) $750 million D) $1,500 million E) $655 million Answer: C Page: 108 Level: Medium Rationale: (1/0.10) × $75 mill

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34. If the Fed is targeting interest rates and money demand falls the appropriate policy response would be to A) Decrease the level of bank reserves B) Decrease the discount rate C) Sell U.S. Treasury securities holdings D) Cut the government budget deficit E) None of the above Answer: A Page: 113 Level: Medium 35. Suppose the Fed buys $2 billion worth of yen from commercial bank currency traders in exchange for $2 billion in deposit accounts at the Federal Reserve. Which of the following would occur as a result, ceteris paribus? I. The value of the dollar against the yen would rise II. The U.S. money supply would increase III. U.S. interest rates would fall A) B) C) D) E)

I only II only I and II only II and III only I, II and III

Answer: D Page: 116 Level: Difficult 36. The major monetary policy making arm of the Federal Reserve is the A) Board of Governors B) Council of Federal Reserve Bank Presidents C) Office of the Comptroller of the Currency D) Federal Reserve Bank of New York E) None of the above Answer: E Page: 93 Level: Medium Rationale: The Federal Open Market Committee is the correct answer.

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37. In the area of bank supervision, which of the following are functions of the Federal Reserve Banks? I. Examinations of state member banks II. Approval of member bank and bank holding company acquisitions III. Deposit insurance A) B) C) D) E)

I only I and II only II and III only I and III only I, II and III

Answer: B Page: 93 Level: Medium 38. The Check 21 Act effective in October 2004 does which of the following? A) Allows bank customers to better take advantage of bank float B) Requires banks to immediately clear all customer deposits C) Prohibits the Fed from being involved in check clearing to prevent unfair competition with private check clearing agencies D) Authorizes the use of an electronic image to facilitate paperless check clearing Answer: B Page: 97 Level: Medium 39. A bank has $890 million in checkable deposits. The bank has $110 million in reserves. The banks required reserves are _____________ and its excess reserves are _____________. A) $110 million ; $0 B) $780 million ; $110 million C) $89 million ; $21 million D) $123 million ; 13 million E) $45 million ; $65 million Answer: C Page: 100 Level: Medium

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40. The Fed wants to temporarily decrease the level of bank reserves for 1 day. The best way for the Fed to do this would be to A) Lower the reserve requirement for bank deposits B) Instruct the Trading Desk to enter into repurchase agreements C) Instruct the Trading Desk to enter into reverse repurchase agreements D) Increase the Discount Rate E) Intervene in the currency markets and buy foreign currency Answer: C Page: 104 Level: Difficult 41. Suppose the current fed funds target interest rate is 4.25%. Under current policy, the Discount Rate on primary credit would be ___ and the Discount Rate on secondary credit would be ___. A) 4.75%; 5.25% B) 3.75%; 3.50% C) 3.25%; 2.75% D) 5.25%; 5.75% E) 5.25%; 3.25% Answer: D Page: 106 Level: Medium Short Answer Questions 42. What are the four major functions of the Federal Reserve System? Answer: 1. Conducting monetary policy 2. Supervising and regulating depository institution 3. Maintaining the stability of the financial system 4. Providing payment and other services to institutions Page: 93 Level: Easy

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43. The twelve Federal Reserve Banks perform what functions? Answer: 1. Assist in monetary policy 2. Supervise and regulate district state chartered member banks and bank holding companies 3. Serve as commercial bank for U.S. Treasury 4. Distribute and replace currency 5. Provide check clearing services 6. Provide wire transfer services 7. Provide economic research for monetary policy Page: 94 Level: Medium 44. How do Federal Reserve Banks generate income? Do they require supplemental funding from Congress? Answer: • Interest earned on government securities acquired in open market transactions • Interest earned on reserves that banks are required to deposit at the Fed • Fees from services and membership fees • The Fed generates positive net income and does not need supplemental funding Page: 91 Level: Easy 45. The Federal Reserve largely worked to decrease interest rates from 2001 until 2004. Since then the Fed has begun raising interest rates once more? Why did the Fed lower rates in the prior time period and why did the Fed switch to increasing interest rates in 2004 and 2005? Answer: In the prior period the Fed felt the main risk was from recession and at times deflation due to the terrorist attacks in September 2001 and the end of the bull market in stocks. In order to stimulate economic growth the Fed allowed rapid money supply growth and lowered interest rates. In 2004 and 2005 rising commodity prices, particularly oil prices contributed to greater worries of building inflationary pressures in the economy. Declines in the U.S. dollar also contributed to inflation worries. This prompted the Fed to begin a series of interest rate hikes to preempt inflationary pressures in the economy. Page: None Level: Difficult 46. What are the main responsibilities of the FOMC? Answer: Promote full employment; promote economic growth; promote price stability; promote sustainable pattern of international trade Page: 93 Level: Easy

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47. Explain how a change in open market operations can affect a new college graduate. Answer: If the Fed increases bank reserves or changes their price, interest rates on all loan types will be affected. For instance, if the Fed acts to lower interest rates, corporations will likely have more projects with positive NPVs, leading to more spending and more jobs. A college graduate is then more likely to get hired, and your interest rates on new cars, homes etc. will likely be lower, not to mention that the value of your stock holdings would probably go up. Page: 111 Level: Easy 48. How have recent changes in Discount Window credit programs affected the use of this tool for monetary policy? Answer: In the past the discount rate was kept below the fed funds rate to allow troubled banks who could not obtain private credit to borrow on an emergency basis. Changes in the announced discount rate signaled to investors about the way the fed wanted interest rates to move. Under the new rules however, the discount rate is generally tied to the current fed funds rate target. This largely eliminates the use of the discount rate as a signal to the market. In recent years the FOMC has announced a target fed funds target rate and the Discount Rate is adjusted as the fed funds target is changed. Page: 106 Level: Difficult 49. Explain how the deposit multiplier works. Answer: Suppose the Fed increases bank reserves via open market operations. The bank now has too many excess reserves that earn no interest so it seeks to loan the funds out. The lent funds are deposited in another bank. The second bank keeps some funds in the form of required reserves and lends the rest. The second loan is also redeposited at another bank and a portion of those funds are lent again, etc., etc. At the limit a change in reserves increases deposits by the amount equal to ∆ reserves x 1/reserve requirement. Page: 108 Level: Medium 50. The Fed wishes to expand the money supply. What three things can they do? Which has the most predictable effects? Be specific. Answer: Buy U.S. government securities Decrease the discount rate Decrease reserve requirements Buying U.S. government securities has the most predictable effect Page: 110 Level: Easy

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51. Is there a tradeoff between controlling domestic inflation and maintaining a sustainable pattern of international trade? Answer: Yes if the U.S. curtails money supply growth to the point that U.S. inflation is lower than inflation elsewhere, the dollar will tend to appreciate against foreign currencies. With a strong dollar the U.S. will tend to import more and export less leading to a large and potentially unsustainable trade balance. Page: None Level: Medium 52. Suppose that oil prices hit an all time high of $100 a barrel, driving U.S. inflation up to 7% per year. At the same time, increasing foreign competition has generated unacceptably high levels of unemployment in the U.S. You are the Chair of the Federal Reserve. What do you suggest? Answer: This is a very difficult scenario for the Fed Chair. It is called stagflation and the combination of high inflation and unemployment reduces the effectiveness of any monetary policy action to provide sustained relief to the economy's problem. Increasing bank excess reserves and lowering interest rates may reduce unemployment temporarily, but these actions will also likely exacerbate inflation, drive up wages and with a higher labor supply cost, eventually drive unemployment back up. The end result is that the employed and the unemployed face higher prices. Alternative policy actions may include fiscal spending, removing the factor(s) causing the problems (such as a supply constraint causing a lack of oil availability), or perhaps stimulating greater global growth to get U.S. domestic demand growing. Page: None Level: Difficult 53. Why is it important for the economies of Europe to converge in order for the European Central Bank (ECB) to effectively implement monetary policy for Europe? Answer: If several European Union (EU) countries are experiencing rapid growth and inflation and other EU countries are suffering from a recession it will be very difficult for the ECB to maintain an effective monetary policy that will be appropriate for the two groups. Interest rates will either be too low to stop inflation in the high growth countries and/or too high to foster better economic growth in the low growth countries. Page: 118 Level: Medium

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