The Federal Reserve System and Open Market operations

Question 1

What is the Federal Reserve System?

Answer 1

The Federal Reserve acquires its unique powers through its ability to issue money.
The Fed is both the government’s bank and the banker’s bank.

Question 2

Why do large private banks keep their own accounts at the Fed?

Answer 2

In part because some banks are required to hold accounts with the Federal reserve and in part because other banks and financial institutions want a safe and convenient place to hold their money.

Question 3

Name the 4 most important assets that serve as means of payment in the United States:

Answer 3

1. Currency - paper bills and coins
2. Total reserves - held by banks at the Fed
3. Checkable deposits - your checking or debit account
4. Savings deposits - money market mutual funds, and small time deposits

Question 4

What’s a liquid asset?

Answer 4

A liquid asset is an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments.

Question 5

Economists have created many definitions of the money supply. Name the three most important ones:

Answer 5

1. The monetary base
2. M1
3. M2

Question 6

Explain the monetary base

Answer 6

Currency and total reserves held at the Fed

Question 7

Explain M1

Answer 7

Currency plus checkable deposits

Question 8

Explain M2

Answer 8

M1 plus savings deposits, money market mutual funds, and small-time deposits

Question 9

What’s fractional reserve banking?

Answer 9

When you open a bank account, the teller doesn’t take your money and puts it into a box labelled with your name. Instead the bank holds a fraction of your account balance in reserve.

Question 10

What’s a ‘reserve ratio’?

Answer 10

The reserve ratio, RR, is the ratio of reserves to deposit.

Question 11

Explain how RR works

Answer 11

If 1$ in cash is held in reserve for every $10 of deposits, the reserve ratio is 1/10.

Question 12

How is the reserve ratio determined by a bank?

Answer 12

The reserve ratio is determined primarily by how liquid banks wish to be.

Question 13

What’s a ‘money multiplier’?

Answer 13

Inverse of the reserve ratio. The money multiplier is the ratio of deposits to reserves. It is the amount with which the money supply expands with each dollar increase in reserves.

Question 14

What is the money multiplier used for?

Answer 14

Tells us how much deposits expand with each dollar increase in reserve.

Question 15

Give an example of the money multiplier.

Answer 15

If the MM is 10, then an increase in reserves of $1000 will lead to an increase in deposits of $10000.

Question 16

How is the change in money supply calculated? (RR and MM)

Answer 16

Change of Money supply = Change of reserves x Money multiplier

Question 17

How can de fed control the money supply?

Answer 17

1. Open market operations - the buying and selling of U.S. government bonds on the open market
2. Discount rate lending and the term auction facility- Federal reserve lending to banks and other financial institutions
3. Paying interest on reserves held by banks at the Fed

Question 18

Explain an ‘Open market operation’

Answer 18

If the fed wants to change the money supply, it usually does so by buying or selling government bonds.

Question 19

What’s quantitative easing?

Answer 19

When the Fed buys longer-term government bonds or other securities

Question 20

What’s quantitative tightening

Answer 20

When the Fed sells longer-term government bonds or other securities

Question 21

Define the federal funds rate

Answer 21

The Federal funds rate is simply the overnight rate for a loan from one major bank to another.

Question 22

What’s the problem of solvency crisis?

Answer 22

Solvency crisis is a potential problem that occurs when banks become insolvent, leaning the value of a bank’s loans falls so far that the bank can no longer pay back its depositors.

Question 23

What’s a liquidity crisis

Answer 23

If all the depositors want their money back at the same time.

Question 24

Explain the Term Auction Facility

Answer 24

The Term Auction Facility had the Fed announce that it wanted to inject a certain quantity of reserves into banks; those funds were then auctioned until the rate was low enough that banks would borrow the money.

Question 25

Explain the discount rate

Answer 25

The discount rate sets an interest rate and then the Fed waits to see how many banks want to borrow.

Question 26

What’s an issue with the discount rate?

Answer 26

Banks may not borrow, for fear of admitting to the market that they are in a weak position.

Question 27

Explain payment of interest on reserves

Answer 27

The Fed can vary the rate of interest that it pays banks on reserves held at the Fed

Question 28

Explain Systematic risk

Answer 28

Systematic risk simply means that the failure of one financial institution can bring down another institution as well, just as if a chain of dominoes were collapsing.

Question 29

Explain the problem of moral hazard

Answer 29

Moral hazard occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out

Question 30

Who controls the Fed?

Answer 30

The Fed has a seven-member board of governors, who are appointed by the president and confirmed by the senate.

Question 31

How long are governors (of the fed) appointed for?

Answer 31

Governors are appointed for 14-year terms and cannot be reappointed. This means a single president will rarely appoint a majority of the board.

Question 32

How is the chairperson of the Fed appointed?

Answer 32

The chairperson of the Fed is appointed by the president from among the members of the Board of Governors and confirmed by the Senate for a term of four years.

Question 33

If the economy is growing faster than its long-run potential growth rate, what should the Fed do to bring the real growth rate back to the long-run potential rate?

Answer 33

Raise the discount rate