Central Banking and the Federal Reserve System

Question 1

The origins of US central banking began in 1781 when Robert Morris obtained a charter to open the Bank of _____________.

Answer 1

North America. Morris wanted to open a central bank modeled on the British Empire’s Bank of England. It did not rise to become a central bank because at that time, US financial markets were decentralized and it was very small compared to other central banks.

Question 2

The second attempt by the US at creating a central bank came in 1791 when the nation’s first Secretary of the Treasury, __________________, was granted a twenty-one year charter by Congress to open the First Bank of the United States.

Answer 2

Alexander Hamilton. He wanted to create a central bank to rival the Bank of England and so it was modeled along those lines. Branches were opened across the country. It was stable and profitable, but the charter was not renewed for fear that too many foreigners had acquired shares in the bank and it would become powerful enough to affect the affairs of other banks.

Question 3

The Second Bank of the United States operated only from 1816 to 1836, after which followed a period of ____-banking.

Answer 3

Free. This was a period where there was no central bank or federal regulation of state banks. Each state had their own rules. It lasted throughout the Civil War period.

Question 4

The Federal Reserve Act of ____ created the Federal Reserve System (FED) of central banking institutions which were supervised by the Federal Reserve Board.

Answer 4

1913.

Question 5

The FED was restructured in 1935 by the Banking Act as a consequence of the ________________.

Answer 5

Great Depression. This event led to many banking collapses which the FED decided not to prevent. This in turn caused an economic and financial collapse in the US. The banking system had become illiquid when the FED was meant to provide liquidity. Thus, reform was essential.

Question 6

The 1935 Act introduced the new _____-member Board of Governors of the FED as the main policy-making unit in the FED.

Answer 6

Seven. These 7 members (or governors) are appointed by the President and confirmed by the Senate for 14 year terms.

Question 7

The 1935 Act also introduced the Federal ___________ Committee comprising of the seven governors and five district FED bank Presidents.

Answer 7

Open Market. The FOMC determines the FED’s open market operations. Thus, many of the day-to-day policy decisions are taken by this group.

Question 8

The President of the Federal Reserve Bank of New York serves as the permanent _____________ of the FOMC and is always a voting member because this bank implements the FED’s open market operations and foreign exchange trading.

Answer 8

Vice Chairman. The FOMC has 12 voting members–the seven members of the Board of Governors and five Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC, and the President of the Federal Reserve Bank of New York serves as the permanent Vice Chairman.

Question 9

The FED board supervises ______ district Federal Reserve banks.

Answer 9

Twelve. This is the structure of the FED. The 12 district banks supervise and regulate the member banks.

Question 10

The FED board is led by its chairperson, currently ______________, who was originally chosen by the President for a four year term.

Answer 10

Alan Greenspan. This is the current chairperson of the FED and he has held this role since 1987. (NOTE: Actually, as of Feb 2006, Ben Bernake has taken this position. However, the textbooks that were used in the development of the Money and Banking exam probably still reference Alan Greenspan as the FED chairperson)

Question 11

Member banks of the FED purchase stock in their district FED bank and can vote in six of the ____ directors of the district bank.

Answer 11

Nine. This is the limit set by law. The stocks they purchase earn them a fixed 6% return. The remaining three directors are selected by the FED Board.

Question 12

The three main activities of the FED are supervising and regulating banks, providing banking services to depository institutions and the Treasury, and determining ________ policy.

Answer 12

Monetary. Determining monetary policy is one of the roles of the FED. So, for example, the reserve rates determined by the FED are a tool of monetary policy.

Question 13

The FED is the US Treasury Department’s ______ agent.

Answer 13

Fiscal. The Federal Reserve System (FED) issues, services, and redeems debts on behalf of the Treasury Department.

Question 14

The FED acts as a depository institution for the Treasury Department, and also manages their Treasury ____________ accounts deposited at private depository institutions.

Answer 14

Tax and Loan. Treasury Tax and Loan (TT&L) accounts are special checking accounts the Treasury Department has with private depository institutions. Most Treasury payments to people and businesses originate from Federal Reserve banks, not private banks.

Question 15

The FED operates systems for the Treasury to sell new securities and make principal and interest payments on outstanding securities. Therefore, as the fiscal agent, depository institution, and manager of TT & L accounts, the FED could be said to be the __________’s bank.

Answer 15

Government. The Federal Reserve System performs all these functions for the US Treasury Department, so it would be accurate to say that the FED acts as a bank for the government.

Question 16

The key monetary policy tool of the ________ banks is the discount rate.

Answer 16

District. The discount rate is the rate the FED charges to depository institutions when they borrow from the FED. The district banks propose this rate to the FED board, and they accept or reject it. This rate is usually lower than the money market rate.

Question 17

Notice that we’ve discussed two main tools the FED uses to influence monetary policy–setting the reserve requirements for banks, and setting the discount rate. The third main tool the FED uses, which we’ve briefly alluded to, is where the FED constantly buys and sells U.S. government securities in the financial market, which in turn influences the level of ________ in the banking system.

Answer 17

Reserves. Influencing the level of reserves affects the federal funds rate - the interest rate at which banks borrow reserves from each other.

All banks are subject to reserve requirements, but frequently fall below requirements in the carrying out of day-to-day business. To meet requirements they have to borrow from each other’s reserves.

The more the banks are borrowing from each other, the more of a market it creates for reserve funds, which means it raises the federal funds interest rate. This is how the Fed can increase or decrease the federal funds rate, which will impact (over time) every other interest rate charged by U.S. banks.

This can get kind of confusing, so to boil it down–the Fed buys and sells U.S. government securities to influence the level of reserves in the banking system, which in turn affects the federal funds rate (the interest rate at which banks borrow reserve funds from each other), which in turn affects every other interest rate charged by banks.

Question 18

The FED has three programs to provide depository institutions with borrowed funds - extended credit for exceptional circumstances, extended credit for ________ needs, and adjustment credit.

Answer 18

Seasonal. This is usually for smaller institutions that face large seasonal needs that they cannot supply without disrupting their normal portfolio.

Note that these three programs for providing banks with borrowed funds are called discount window programs, because the banks borrow from the FED at the discount rate.

Question 19

Adjustment credit refers to loans advanced for a maximum of __ days to aid institutions by meeting needs that cannot be reasonably satisfied from market sources.

Answer 19

14. This is the cap applied by the FED and this loan is intended to meet unexpected or temporary liquidity needs.

Question 20

The FED views ___________ as a privilege, not a right, and hence the following are considered unacceptable reasons for borrowing: to support loan or investment expansion, to benefit from the differential between market and discount rates, to substitute for normal fund sources, and to substitute capital.

Answer 20

Discounting. The bank should have adequate capital without having to borrow from the FED.

Question 21

Research has shown that when the spread between the discount rate and the federal funds rate is _____, then borrowing from the FED tends to go up and this could be construed as evidence of the profit incentive to borrow from the FED.

Answer 21

Large. Generally, only large banks borrow directly from the Fed and get the benefit of borrowing at the lower discount rate. Since the large banks lend to the small banks at the federal funds rate, that means that when the spread between the discount rate and funds rate grows, the profit for the large banks grow. Therefore, banks have a better profit margin when borrowing from the FED.

So, even though banks aren’t technically allowed to borrow from the FED to benefit from this spread, it is arguable that some profit based discounting takes place.

Question 22

When the FED informs everyone that the ________ rate is changed, an announcement effect occurs.

Answer 22

Discount. On the day after the discount rate changes, the market rates move in the same direction as the discount rate, albeit temporarily, as a signal of FED monetary policy. This is called an “announcement effect.”

Question 23

The main supervisory functions of the Federal Reserve Banks include currency distribution, processing _________ of payments, funds transfer between depository institutions, research on economic conditions, and issuance and redemption of federal debt.

Answer 23

Clearings. This is one of their tasks - to process clearings of electronic and non-electronic payments. This includes clearing checks.

Question 24

The FED supervises the US payments system because of considerable risk of negative _____________ or systemic risk, as these systems are extremely complicated.

Answer 24

Externalities. Systemic risk is the risk that some depository institutions may not be able to meet their credit agreement terms because of a failure by other institutions to settle transactions that may or may not be related.

Question 25

The role of the FED in deposit expansion is that if it purchases securities, then it increases total ________ at banks and therefore raises the size of the monetary base.

Answer 25

Deposits. The FED is the only institution capable of creating depository institution reserves through open market purchases of securities. In other words, this is how they create new reserves in banks, which would in turn lower the federal funds rate–the rate at which banks borrow reserve funds from each other.

As we discussed earlier, if they do the opposite–if they sell securities, this is how they reduce the reserves, which in turn would raise federal fund rates (and consequently affect all other interest rates charged by the bank).

Question 26

Open market operations are the sale and purchase of securities by the FED and can be classified as dynamic or _________.

Answer 26

Defensive. Defensive operations are open market operations designed to offset undesirable effects in the base due to factors such as tax collection by the Treasury. Dynamic market operations are both sales and purchases of securities to raise or lower the monetary base so as to hit policy targets.

Question 27

Total reserves at depository institutions reduce and the size of the monetary base shrinks when the FED conducts an open market ____.

Answer 27

Sale. This means the FED sells securities to a dealer. This is as we discussed earlier; when the FED sells securities, it reduces the total reserves at banks, and when it buys securities, it increases the reserves.

Question 28

The account manager at the FOMC would normally view a defensive open market operation as a _________ measure, so instead of purchasing securities, a repurchase agreement could be used instead.

Answer 28

Temporary. A repo agreement is one where the FED purchases securities and the seller agrees to repurchase those securities at a future date.

Question 29

The opposite arrangement of a repo agreement is the ____________ or matched sale purchase which temporarily contracts (shrinks) the monetary base.

Answer 29

Reverse repo. Reverse repo is where the FED temporarily sells securities, so the total reserve is temporarily reduced.

Question 30

Monetary __________ are primarily determined by the amount of Transaction Deposits, and therefore the open market operations of the FED can substantially influence the country’s money stock.

Answer 30

Aggregates. As you recall, monetary aggregates are measures of a country’s money stock (also called money supply), and includes M1, M2, and M3. Monetary aggregates are liquid assets that could qualify as money. Therefore, transaction deposits would be a substantial proportion of the monetary aggregates.

Open market operations (buying and selling of securities) influences the total reserves in U.S. banks. Remember, reserve requirements are a percentage of deposits that depository institutions must hold in reserve and not lend out. For example, with a 10 percent reserve requirement on net transaction accounts, a bank that experiences a net increase of $200 million in these deposits would be required to increase its required reserves by $20 million.

In other words, to support more deposits, a bank must hold more reserves. If the Fed causes the reserve total to increase, then obviously the banks will be able to support more deposits, which would increase the money stock.

Question 31

The _____________ is the amount of currency plus total reserves in the banking system.

Answer 31

Monetary base.

Question 32

The only way the FED can change the monetary base is by changing the quantity of ________, the amount of reserves or both.

Answer 32

Currency. This is because the monetary base is the total of currency and total reserves.

Question 33

Apart from open market operations, the FED can induce depository institutions to borrow reserves from their discount windows. So, when the borrowing increases, the monetary base will ____ and vice versa.

Answer 33

Rise. As you recall, the discount window refers to the borrowing programs the FED offers to banks at the discount rate, and includes three main programs: extended credit for exceptional circumstances (usually simply referred to as extended credit), extended credit for seasonal needs (also known as seasonal credit), and adjustment credit.

The Fed can influence banks to borrow more reserves, which means that total reserves will rise. As we learned earlier, the monetary base is the total of currency and total reserves, so when the borrowing increases, the monetary base increases.

A little side note: As we also learned, more reserves means more transaction deposits, which means more money stock (supply).

Question 34

The FED can alter the reserve ratio as this would cause the monetary base to rise or fall without affecting _____ reserves.

Answer 34

Total. The monetary base is the total reserves (the bank deposits at the Federal Reserve plus vault cash) plus the currency held outside of the banks. You should know that when the monetary base rises, the money supply rises, and vice-versa.

What happens when the reserve requirements (ratio) are raised? That means the bank has to hold on to a higher percentage of money from deposits. So in other words, with the same amount of money in reserve, it can support less deposits, which means less money supply.

Or, if the Fed lowers the reserve ratio, then the bank can support more deposits, which means increased money supply, and increased monetary base–all without affecting total reserves.

Question 35

A _____ occurs during the check clearing process when the FED credits one bank’s reserve account without deducting the corresponding amount from the bank from which the check was drawn.

Answer 35

Float. This affects the monetary base since total reserves at the crediting bank experiences a temporary rise.

Question 36

The money multiplier measures the actual change in the ____________ for a dollar change in the monetary base.

Answer 36

Money supply. Money multiplier = Money supply / Monetary base

For example, if the money multiplier is 3.4, a $1 million increase in the monetary base will causes a $3.4 million increase in the money supply.

Question 37

The money multiplier is not constant over time because of changes in the desirability of using currency in and the volatility of holdings in excess ________, and this in turn complicates the FED’s job in ascertaining how its policies affect monetary aggregates.

Answer 37

Reserves. Banks do hold on to small amounts of excess reserves for unexpected situations. For example, in the deposit expansion process, the bank that holds excess reserves will choose to make fewer loans or buy fewer securities than they would if they did not choose to hold excess reserves.

Question 38

The credit multiplier is the number that tells us how much total _____ and securities at depository institutions will change as a result of a change in the monetary base.

Answer 38

Loans. The money multiplier measures change in money supply versus monetary base; the credit multiplier measures change in credit (loans and securities) versus monetary base.

Question 39

The ______ multiplier is largely affected by the factors that affect the money multiplier.

Answer 39

Credit. Credit expansion normally follows deposit expansion and therefore the basic elements that affect the money multiplier also affect the credit multiplier.

Question 40

The FED can vary the reserve requirements in order to control _____ supply.

Answer 40

Money. As we discussed earlier, increasing reserve requirements (aka reserve ratio) decreases the quantity of deposits the banks can support, which means reduced money supply. Decreasing reserve requirements obviously has the opposite effect.

Question 41

The FED’s main assets are treasury securities, US agency securities, discount window loans, gold certificates, special ______________ certificates, foreign currency reserves and cash items being collected.

Answer 41

Drawing rights. Gold used to be the money standard in the US. The Treasury Department used to sell gold to the FED in return for money. The Treasury issued gold certificates to the FED. Therefore, it is a FED asset.

Question 42

The FED’s liabilities include federal reserve notes, bank reserve deposits, US Treasury deposits, foreign official deposits, deferred availability cash items and ______________.

Answer 42

Equity capital. Over 80% of the FED’s liabilities are Federal Reserve Notes (FRN). This is the currency issued by the FED and which we use to purchase small goods & services (look at the bills in your wallet and they say “Federal Reserve Note” on the front). It is a liability in that if Congress closed down the FED, then the FED would owe an individual with $1, $1 worth in goods and services at the time of closure.

Question 43

Congress believed that the creation of the Fed was necessary as a regulatory body of financial institutions to prevent negative externalities and because such an institution would function as the lender of ___________.

Answer 43

Last resort. This means that the FED would be the organization willing and able to lend money to a temporarily illiquid bank (but still solvent) so that a loss of public confidence could be avoided–not only in that bank, but potentially other banks. Negative externalities are unpleasant spillovers from interactions between two parties into the whole system.