15.2 How a Central Bank Executes Monetary Policy

True or false?

The federal funds rate is a long-term interest rate.

False

The federal funds rate is the interest rate at which one bank lends funds to another bank overnight; therefore, it is a short-term interest rate.

Suppose the Fed sells $25,000 in bonds to Luna Corporation. Luna pays for the bonds with a check drawn on Fifth Third Bank, which the Fed deposits. Which of the following happen when Fifth Third Bank pays the check?

Select the correct answer below:

Fifth Third Bank's reserves in the Fed are increased by $25,000 and the reserves in the entire banking system are increased by $25,000.

Fifth Third Bank's reserves in the Fed are increased by $25,000 and the reserves in the entire banking system are decreased by $25,000.

Fifth Third Bank's reserves in the Fed are decreased by $25,000 and the reserves in the entire banking system are increased by $25,000.

Fifth Third Bank's reserves in the Fed are decreased by $25,000 and the reserves in the entire banking system are decreased by $25,000.

Fifth Third Bank's reserves in the Fed are decreased by $25,000 and the reserves in the entire banking system are decreased by $25,000.

When the Fed sells bonds, money flows from the buyers of the bonds (Luna bank) to the Fed. This process reduces the commercial bank's reserve balance with the Fed and reduces the reserves in the entire banking community.

Which of the following is true regarding the reserve requirements?

Select the correct answer below:

The Fed often makes large changes to them because they are a power monetary policy tool.

The Fed does not change them much at all because taxation is a more impactful monetary policy tool.

The Fed uses them more than other tools in order to achieve monetary policy goals.

The Fed makes small changes to them almost every year.

The Fed makes small changes to them almost every year.

In early 2015, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. In practice, the Fed rarely uses large changes in reserve requirements to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply, while loosening requirements too much would create a danger of banks inability to meet withdrawal demands.

Which of the following is true of open market operations?

Select the correct answer below:

Open market operations involves the buying and selling of stocks on the New York Stock Exchange

Open market operations target the amount of currency in the market.

Open market operations involve the purchase and sale of government securities.

Open market operations is the process of changing the reserve ratio in the banking system.

Open market operations involve the purchase and sale of government securities.

The most common monetary policy tool in the U.S. is open market operations. These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate

The Federal Reserve sells government securities to __________.

Select the correct answer below:

increase the money supply and decrease interest rates

increase the money supply and increase interest rates

decrease the money supply and decrease interest rates

decrease the money supply and increase the interest rates

decrease the money supply and increase the interest rates

When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the money supply in circulation and decreasing the Federal Funds Rate. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy and the Federal Funds Rate.

Why does changing the discount rate up or down have little impact on a bank's behavior?

Select the two correct answers below.

Select all that apply:

Because banks are expected to first borrow from other available sources, like other banks.

Because the Federal Reserve charges a higher discount rate than the rate of federal funds.

Because of regulations which limit the amount of funds available at the discount windows.

Because of congressional limits on the ability of the Federal Reserve to provide banks with loans.

Because banks are expected to first borrow from other available sources, like other banks.

Because the Federal Reserve charges a higher discount rate than the rate of federal funds.

In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the rate of federal funds. Given that it is rare for banks to borrow from the Fed, changing the discount rate up or down has little impact on bank's behavior. More importantly, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.