TUTORIAL 9

CENTRAL BANKS AND TOOLS OF MONETARY POLICY

Part 1: Review questions

1. Distinguish the difference between central banks and commercial banks
2. Tools of monetary policy: advantages and disadvantages

Part 2. Multiple-choice questions

1. The federal funds rate

A. Is usually several percentage points above the discount rate.
B. Is set by the Board of Governors.
C. Is the interest rate banks charge each other when making overnight loans of
reserves.
D. Is the interest rate the Fed charges when lending reserves to a bank.

2. An open market purchase of securities by the Federal Reserve system will

A. increase the demand for Federal funds.
B. increase the supply of Federal funds.
C. reduce the demand for Federal funds.
D. reduce the supply of Federal funds.

3. An increase in the discount rate can:

A. reduce the supply of Federal funds and increase the Federal funds rate.
B. reduce the demand for Federal funds and reduce the Federal funds rate.
C. increase the demand for Federal funds and increase the Federal funds rate.
D. increase the supply of Federal funds and reduce the Federal funds rate.

4. An increase in the reserve requirement ratio will:

A. reduce the supply of Federal funds and increase the Federal funds rate.
B. increase the supply of Federal funds and reduce the Federal funds rate.
C. increase the demand for Federal funds and increase the Federal funds rate.
D. reduce the demand for Federal funds and reduce the Federal funds rate.

5. Sometimes the Fed purchases a security and the seller agrees to buy the
security back. This is called a
A. TRAPS
B. Matched sale-purchase transaction
C. Reverse repurchase
D. Repurchase agreement

6. Which of the following is not an advantage of open market operations

compared to other methods of changing the money supply?
A. Open market operations are easily reversible.
B. Open market operations are done at the Fed's initiative.
C. Open market operations do not need the approval of Congress.
D. Open market operations can be implemented quickly.

7. The demand for reserves has a negative slope because

A. A lower Federal Funds rate increases deposits and increases required reserves.
B. A higher Federal Funds rate increases the cost of excess reserves so that
banks wish to hold smaller amounts of reserves.
C. A lower Federal Funds rate induces banks to borrow more from the Federal
Reserve System, decreasing reserves.
D. A higher Federal Funds rate reduces the required reserve ratio and the amount of
required reserves.

8. The shape of the supply curve for reserves

A. Depends on the relationship between the Federal Funds rate and the discount
rate.
B. Is vertical at the level of reserves determined by the Fed because banks have no
influence on the supply of reserves.
C. Is upward-sloping because as the Federal Funds rate rises, banks are more willing
to supply reserves for lending.
D. Is horizontal at the Federal Funds rate set by the Fed, because banks can borrow as
much as they want at that rate.

9. When the Fed sells government securities on the open market,

A. The Federal Funds rate rises.
B. The Federal Funds rate falls.
C. The Federal Funds rate remains unchanged.
D. The volume of reserve lending in the Federal Funds market increases.

10. If the Fed eliminated reserve requirements,

A. banks would keep no reserves.
B. banks would still keep reserves because of the need for vault cash.
C. the money supply would grow out of control.
D. the money multiplier would be undefined.

11. The objective of a defensive open market operation is to:

A. change the money supply.
B. prevent a change in the monetary base.
C. increase the monetary base.
D. decrease the monetary base.

12. An advantage of using reserve requirement changes to control the money

supply is:
A. they affect all banks equally.
B. they ease banks' liquidity management concerns.
C. banks' cost of adjusting to them is low.
D. it is easy to achieve small changes in the money supply.

13. The primary role of discount lending is now

A. To allow the Fed to easily control the money supply.
B. To allow the Fed to act as the lender of last resort to troubled banks.
C. To influence the Federal Funds rate.
D. To provide a source of low-cost funds to banks so they can increase their
profitability.
14. In the market for reserves, when the federal funds interest rate is below the
discount rate, the supply curve of reserves is
A. vertical.
B. horizontal.
C. positively sloped.
D. negatively sloped.

15. When the federal funds rate equals the discount rate
A. the supply curve of reserves is vertical.
B. the supply curve of reserves is horizontal.
C. the demand curve for reserves is vertical.
D. the demand curve for reserves is horizontal.

16. In the market for reserves, an open market ________ the supply of reserves,
raising the federal funds interest rate, everything else held constant.
A. sale decreases
B. sale increases
C. purchase increases
D. purchase decreases

17. Suppose on any given day there is an excess demand of reserves in the
federal funds market. If the Federal Reserve wishes to keep the federal funds
rate at its current level, then the appropriate action for the Federal Reserve
to take is a ________ open market ________, everything else held constant.
A. defensive; sale
B. dynamic; sale
C. dynamic; purchase
D. defensive; purchase

18. In the market for reserves, an open market purchase ________ the supply of
reserves and causes the federal funds interest rate to ________, everything
else held constant.
A. decreases; fall
B. increases; rise
C. increases; fall
D. decreases; rise

Part 3. Problems and applications

Chapter 16: problem 2, 4, 6, 15, 23, 24
2. During the holiday season, when the public’s holdings of currency increase, what
defensive open market operations typically occur? Why?
When the public’s holding of currency increases, during Christmas, the currency–
checkable deposits ratio increases and the money supply falls. To counteract this
decline in the money supply, the Fed will conduct a defensive open market purchase
to increase the Monetary base temporarily during Christmas time.
4. If float decreases to below its normal level, why might the manager of domestic
operations consider it more desirable to use repurchase agreements to affect the
monetary base, rather than an outright purchase of bonds?

Float is money in the banking system that is counted twice, for a brief time,
because of delays in processing checks. Federal Reserve float is money that
appears simultaneously in the Federal Reserve accounts of two depository
institutions. When check clearing is delayed, funds in the process of collection
appear in the accounts of both the institutions that receive the checks for deposit
and the institutions upon which the checks are drawn. Thus, float inflates, for a
brief time, the amount of money in the banking system.
When a bank receives a check for deposit, it provisionally credits the account of
the check depositor and later collects the funds from the bank upon which the
check is drawn. Rather than sort all the checks and send each one back to the
bank it was drawn upon for settlement, depository institutions transfer many of
their checks to Federal Reserve Banks for collection. In turn, Reserve Banks pay
the depositing banks for the total amount of the checks, and then collect the funds
from the banks on which the checks are drawn. The Federal Reserve processes
about one-third of all checks in the United States.
Changes in float tend to be temporary, therefore, it is more desirable to use
repurchase agreements to affect the monetary base, rather than an outright
purchase of bonds

6. “The federal funds rate can never be above the discount rate.” Is this statement true,
false, or uncertain? Explain your answer.
In theory, it is true. The discount rate should act as an upper bound in the federal
funds market because if the fed funds rate ever went above the discount rate, banks
would not borrow in the fed funds market, but only borrow from the discount window
(which would eventually drive the fed funds rate down).
However, in practice, the fed funds rate does rise above the discount rate due to
perceived stigma of borrowing from the discount window. Banks may prefer to pay a
higher federal funds rate than potentially signal to other banks that they are in a weak
financial position.
15. Compare the methods of controlling the money supply—open market operations,
loans to financial institutions, and changes in reserve requirements—on the basis of
the following criteria: flexibility, reversibility, effectiveness, and speed of
implementation.

OMO’s: Selling or Buying of government securities by the Fed in the market.

Flexibility: very high
Reversibility: very high
Effectiveness: very effective
Speed of implementation: easy to implement and of a very rapid impact

Required Reserve Requirement: Determination of the liquidity in the form of deposits

in the Federal Reserve that the Fed ask the banks to have in proportion of their
deposits.
Flexibility: very low
Reversibility: very low
Effectiveness: effective but difficult to control because it affects a wide array of
different matters.
Administrative Cost: High.
Speed of implementation: Very low.

Discount Rate: Rate that is charged by the Fed to banks which come for funds at its
discount window.
Flexibility: not very high, but difficult to set in the “right” level due to uncertainties
associated with the functioning of financial markets.
Reversibility: easy to move, but the effects on the money supply are quite
unpredictable.
Effectiveness: Difficult to assess beforehand.
Administrative Ease: not as easy as the OMO’s
Speed of Implementation: quite high.

23. If a switch occurs from deposits into currency, what happens to the federal funds
rate? Use the supply and demand analysis of the market for reserves to explain your
answer.
The switch from deposits into currency lowers the amount of reserves as was shown in
the T-accounts and this lowers the supply of reserves at any given interest rate, thus
shifting the supply curve to the left. The fall in deposits also leads to lower required
reserves and hence a shift in the demand curve to the left.
However, because the fall in required reserves is only a fraction of the falling the
supply of reserves (because the required reserve ratio is much less than one), the
supply curve shifts left by more than the demand curve. Thus if the discount rate is
initially above the fed funds target, the fed funds rate will rise. However, if the fed
funds rate is at the discount rate, then the fed funds rate will remain at the discount
rate.

24. Why is it that a decrease in the discount rate does not normally lead to an increase
in borrowed reserves? Use the supply and demand analysis of the market for reserves
to explain.
The decrease in the discount rate will not lead to an increase in borrowed reserves
when the equilibrium interest rate is still below the new (lower) discount rate.