CH15: The Money Supply Process

Question 1

The interest rate charged on overnight loans of reserves between banks is the
A) prime rate.
B) discount rate.
C) federal funds rate.
D) Treasury bill rate.

Answer 1

C) federal funds rate.

Question 2

The quantity of reserves demanded equals
A) required reserves plus borrowed reserves.
B) excess reserves plus borrowed reserves.
C) required reserves plus excess reserves.
D) total reserves minus excess reserves.

Answer 2

C) required reserves plus excess reserves.

Question 3

Everything else held constant, when the federal funds rate is ________ the interest rate paid on excess reserves, the quantity of reserves demanded rises when the federal funds rate ________.
A) above; rises
B) above; falls
C) below; rises
D) below; falls

Answer 3

B) above; falls

Question 4

The opportunity cost of holding excess reserves is the federal funds rate
A) minus the discount rate.
B) plus the discount rate.
C) plus the interest rate paid on excess reserves.
D) minus the interest rate paid on excess reserves.

Answer 4

D) minus the interest rate paid on excess reserves.

Question 5

In the market for reserves, when the federal funds rate is above the interest rate paid on excess reserves, the demand curve for reserves is
A) vertical.
B) horizontal.
C) positively sloped.
D) negatively sloped.

Answer 5

D) negatively sloped.
The demand curve for reserves shows the relationship between the interest rate paid on reserves and the quantity of reserves demanded by banks. When the federal funds rate is above the interest rate paid on excess reserves, banks have an incentive to borrow more funds from the Fed and lend them out at a higher interest rate, earning more income. Therefore, they demand more reserves to meet their reserve requirements and to facilitate their lending activities. This means that the demand curve for reserves slopes downward, as shown in the figure below.

The supply curve for reserves is vertical, because only the Fed can supply reserves. The intersection of the demand and supply curves determines the federal funds rate, which is the market interest rate for overnight loans of reserves between banks.

Question 6

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.

Answer 6

B) the supply curve of reserves is horizontal.
The supply curve for reserves shows the relationship between the interest rate paid on reserves and the quantity of reserves supplied by banks. When the federal funds rate equals the discount rate, banks have no incentive to borrow or lend reserves, because they can earn the same interest rate from either source. Therefore, they supply a fixed amount of reserves at the discount rate, regardless of the demand for reserves. This means that the supply curve for reserves is vertical, as shown in the figure below.

The demand curve for reserves shows the relationship between the interest rate paid on reserves and the quantity of reserves demanded by banks. When the federal funds rate equals the discount rate, banks have no incentive to borrow or lend reserves, because they can earn the same interest rate from either source. Therefore, they demand a fixed amount of reserves at the discount rate, regardless of their excess or required reserves. This means that the demand curve for reserves is horizontal, as shown in the figure below.

Question 7

In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, then 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

Answer 7

A) sale decreases
In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, then an open market purchase of securities increases the supply of reserves, raising the federal funds interest rate, everything else held constant. This is because when the Fed buys securities from banks, it pays them with newly created money, which increases their reserves and lowers their lending rates. This makes borrowing more attractive and encourages banks to lend more to each other at a higher interest rate. The increase in lending creates more demand for reserves in the market, which pushes up the supply curve and raises the federal funds rate. This is shown in the figure below.

An open market sale of securities has the opposite effect: it decreases the supply of reserves, lowering the federal funds interest rate, everything else held constant. This is because when the Fed sells securities to banks, it takes away their excess reserves and raises their lending rates. This makes borrowing less attractive and discourages banks from lending to each other at a lower interest rate. The decrease in lending reduces the demand for reserves in the market, which pulls down the supply curve and lowers the federal funds rate. This is shown in another figure below.

Question 8

In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, an open market purchase ________ the ________ of reserves which causes the federal funds rate to fall, everything else held constant.
A) increases; supply
B) increases; demand
C) decreases; supply
D) decreases; demand

Answer 8

A) increases; supply

Question 9

In the market for reserves, if the federal funds rate is above the interest rate paid on excess 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; fall
C) increases; rise
D) decreases; rise

Answer 9

B) increases; fall

Question 10

In the market for reserves, a lower discount rate
A) decreases the supply of reserves.
B) increases the supply of reserves.
C) lengthens the vertical section of the supply curve of reserves.
D) shortens the vertical section of the supply curve of reserves.

Answer 10

D) shortens the vertical section of the supply curve of reserves.
In the market for reserves, a lower discount rate shifts the supply curve of reserves to the left, lowering the federal funds interest rate. This is because a lower discount rate makes it cheaper for banks to borrow from the Fed, which increases their demand for reserves. Banks then supply more reserves to meet their reserve requirements and to facilitate their lending activities. This means that the supply curve of reserves is downward sloping, as shown in the figure below.

The demand curve for reserves shows the relationship between the interest rate paid on reserves and the quantity of reserves demanded by banks. When the federal funds rate equals the discount rate, banks have no incentive to borrow or lend reserves, because they can earn the same interest rate from either source. Therefore, they demand a fixed amount of reserves at the discount rate, regardless of their excess or required reserves. This means that the demand curve for reserves is horizontal, as shown in another figure below.

Question 11

In the market for reserves, a lower interest rate paid on excess reserves
A) decreases the supply of reserves.
B) increases the supply of reserves.
C) decreases the effective floor for the federal funds rate.
D) increases the effective floor for the federal funds rate.

Answer 11

C) decreases the effective floor for the federal funds rate.

Question 12

The opportunity cost of holding excess reserves is the federal funds rate
A) minus the discount rate.
B) plus the discount rate.
C) plus the interest rate paid on excess reserves.
D) minus the interest rate paid on excess reserves.

Answer 12

D) minus the interest rate paid on excess reserves.

Question 13

In the market for reserves, when the federal funds rate is above the interest rate paid on excess reserves, the demand curve for reserves is
A) vertical.
B) horizontal.
C) positively sloped.
D) negatively sloped.

Answer 13

D) negatively sloped.

Question 14

When the federal funds rate equals the interest rate paid on excess reserves
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.

Answer 14

D) the demand curve for reserves is horizontal.

Question 15

The quantity of reserves supplied equals
A) nonborrowed reserves minus borrowed reserves.
B) nonborrowed reserves plus borrowed reserves.
C) required reserves plus borrowed reserves.
D) total reserves minus required reserves.

Answer 15

B) nonborrowed reserves plus borrowed reserves.

Question 16

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.

Answer 16

A) vertical.

Question 17

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.

Answer 17

B) the supply curve of reserves is horizontal.
The demand curve for reserves shows the relationship between the interest rate paid on reserves and the quantity of reserves demanded by banks. When the federal funds rate equals the discount rate, banks have no incentive to borrow or lend reserves, because they can earn the same interest rate from either source. Therefore, they demand a fixed amount of reserves at the discount rate, regardless of their excess or required reserves. This means that the demand curve for reserves is horizontal.

Question 18

In the market for reserves, a lower interest rate paid on excess reserves
A) decreases the supply of reserves.
B) increases the supply of reserves.
C) decreases the effective floor for the federal funds rate.
D) increases the effective floor for the federal funds rate.

Answer 18

C) decreases the effective floor for the federal funds rate.
Banks hold reserves at the Federal Reserve and are paid an interest rate on these reserves, known as the IOER. When the IOER is high, banks have an incentive to hold onto these reserves instead of lending them out. If the IOER is lowered, banks are less incentivized to hold onto reserves and more likely to lend them out in the federal funds market, where banks lend reserves to each other. This increase in lending activity effectively increases the supply of reserves in the market, which, according to the law of supply and demand, lowers the price of reserves, i.e., the federal funds rate.

So, a lower IOER decreases the minimum rate (or “floor”) that banks are willing to lend out their reserves in the federal funds market, thus decreasing the effective floor for the federal funds rate.

Question 19

Everything else held constant, in the market for reserves, when the federal funds rate is 3%, lowering the discount rate from 5% to 4%
A) lowers the federal funds rate.
B) raises the federal funds rate.
C) has no effect on the federal funds rate.
D) has an indeterminate effect on the federal funds rate.

Answer 19

C) has no effect on the federal funds rate.
The discount rate is the interest rate charged by the Federal Reserve for lending reserves to commercial banks. When the discount rate is lowered from 5% to 4%, it becomes cheaper for banks to borrow money from the Federal Reserve. However, this change does not affect the federal funds rate when it is already lower than the new discount rate.

The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. When the federal funds rate (3%) is below the discount rate (even after it has been lowered to 4%), banks would still prefer to lend to each other at the federal funds rate rather than borrow from the Federal Reserve at the higher discount rate. Therefore, lowering the discount rate in this scenario does not affect the federal funds rate.

Question 20

Everything else held constant, in the market for reserves, when the federal funds rate is 5%, lowering the discount rate from 5% to 4%
A) lowers the federal funds rate.
B) raises the federal funds rate.
C) has no effect on the federal funds rate.
D) has an indeterminate effect on the federal funds rate.

Answer 20

A) lowers the federal funds rate.

Question 21

Everything else held constant, in the market for reserves, when the federal funds rate is 1%, increasing the interest rate paid on excess reserves from 1% to 2%
A) lowers the federal funds rate.
B) raises the federal funds rate.
C) has no effect on the federal funds rate.
D) has an indeterminate effect on the federal funds rate.

Answer 21

B) raises the federal funds rate.

Question 22

Everything else held constant, in the market for reserves, when the federal funds rate equals the discount rate, lowering the discount rate
A) increases the federal funds rate.
B) lowers the federal funds rate.
C) has no effect on the federal funds rate.
D) has an indeterminate effect of the federal funds rate.

Answer 22

B) lowers the federal funds rate.

Question 23

Everything else held constant, in the market for reserves, when the federal funds rate equals the interest rate paid on excess reserves, raising the interest rate paid on excess reserves
A) increases the federal funds rate.
B) lowers the federal funds rate.
C) has no effect on the federal funds rate.
D) has an indeterminate effect of the federal funds rate.

Answer 23

A) increases the federal funds rate.

Question 24

Everything else held constant, the vertical section of the supply curve of reserves is lengthened when the
A) discount rate increases.
B) discount rate decreases.
C) federal funds rate rises.
D) federal funds rate falls.

Answer 24

A) discount rate increases.
The vertical section of the supply curve of reserves represents the range of federal funds rates where banks prefer to borrow from the Federal Reserve at the discount rate rather than from other banks at a higher federal funds rate.

When the discount rate increases, the cost of borrowing from the Federal Reserve increases. This means that banks would only borrow from the Federal Reserve if the federal funds rate is significantly higher than the increased discount rate. As a result, the range of federal funds rates where banks prefer to borrow from the Federal Reserve (i.e., the vertical section of the supply curve of reserves) is lengthened.

Question 25

State whether the following statement is true or false AND explain why: “A decrease in the discount rate will always cause a decrease in the federal reserve funds rate.”

Answer 25

False. Since the discount rate is set above the federal funds rate, a decrease in the discount rate will only cause a decrease in the federal funds rate if the discount rate is decreased below the original federal funds rate level. If the decrease in the discount rate is such that the new rate is still above the federal funds rate, then the federal funds rate does not change, everything else held constant.

Question 26

Explain the Fed’s three tools of monetary policy and how each is used to change the money supply. Does each tool affect the monetary base or the money multiplier?

Answer 26

The three tools are open market operations, the purchase and sale of government securities; discount policy, controlling the price and quantity of discount loans to banks; and reserve requirements, setting the percentage of deposits that banks must hold in reserve. Open market operations and the discount rate affect the monetary base, and reserve requirements affect the money multiplier.

Question 27

State whether the following statement is true or false AND explain why: “An increase in the interest rate paid on excess reserves will always cause an increase in the federal reserve funds rate.”

Answer 27

False. If the interest rate paid on excess reserves is set below the federal funds rate, an increase in the interest rate paid on excess reserves will only cause an increase in the federal funds rate if the interest rate paid on excess reserves is increased above the original federal funds rate level. If the increase in the interest rate paid on excess reserves is such that the new rate is still below the federal funds rate, then the federal funds rate does not change, everything else held constant.

Question 28

Before the global financial crisis, ________ were the most important monetary policy tool because they were the primary determinant of changes in the ________, the main source of fluctuations in the money supply.
A) open market operations; monetary base
B) open market operations; money multiplier
C) changes in reserve requirements; monetary base
D) changes in reserve requirements; money multiplier

Answer 28

A) open market operations; monetary base

Question 29

Open market purchases raise the ________ thereby raising the ________.
A) money multiplier; money supply
B) money multiplier; monetary base
C) monetary base; money supply
D) monetary base; money multiplier

Answer 29

C) monetary base; money supply

Question 30

Open market purchases ________ reserves and the monetary base thereby ________ the money supply.
A) raise; lowering
B) raise; raising
C) lower; lowering
D) lower; raising

Answer 30

B) raise; raising

Question 31

The two types of open market operations are
A) offensive and defensive.
B) dynamic and reactionary.
C) active and passive.
D) dynamic and defensive.

Answer 31

D) dynamic and defensive.

Question 32

There are two types of open market operations: ________ open market operations are intended to change the level of reserves and the monetary base, and ________ open market operations are intended to offset movements in other factors that affect the monetary base.
A) defensive; dynamic
B) defensive; static
C) dynamic; defensive
D) dynamic; static

Answer 32

C) dynamic; defensive

Question 33

Discount policy affects the money supply by affecting the volume of ________ and the ________.
A) excess reserves; monetary base
B) borrowed reserves; monetary base
C) excess reserves; money multiplier
D) borrowed reserves; money multiplier

Answer 33

B) borrowed reserves; monetary base

Question 34

The discount rate is
A) the interest rate the Fed charges on loans to banks.
B) the price the Fed pays for government securities.
C) the interest rate that banks charge their most preferred customers.
D) the price banks pay the Fed for government securities.

Answer 34

A) the interest rate the Fed charges on loans to banks.

Question 35

The most common type of discount lending that the Fed extends to banks is called
A) seasonal credit.
B) secondary credit.
C) primary credit.
D) installment credit.

Answer 35

C) primary credit.

Question 36

The most common type of discount lending, ________ credit loans, are intended to help healthy banks with short-term liquidity problems that often result from temporary deposit outflows.
A) secondary
B) primary
C) temporary
D) seasonal

Answer 36

B) primary

Question 37

When the European System of Central Banks uses long-term refinancing operations, it is similar to the Federal Reserve using
A) dynamic open market operations.
B) defensive open market operations.
C) discount policy.
D) reserve requirements.

Answer 37

A) dynamic open market operations.

Question 38

The equivalent to the Federal Reserve’s discount rate in the European System of Central Banks is the
A) federal funds rate.
B) marginal lending rate.
C) deposit facility rate.
D) lombard rate.

Answer 38

B) marginal lending rate.

Question 39

Which of the following statements about the deposit facility in the Eurosystem are correct?
A) Banks are paid an interest rate that is typically 100 basis points below the target financing rate.
B) The prespecified interest rate on the deposit facility provides a floor for the overnight market interest rate.
C) The interest rate on reserves set by the ECB is not always positive.
D) All of the above.
E) Only A and B.

Answer 39

D) All of the above.

Question 40

The European System of Central Banks signals the stance of its monetary policy by setting a target for the
A) federal funds rate.
B) overnight cash rate.
C) lombard rate.
D) reserve rate.

Answer 40

B) overnight cash rate.

Question 41

When the European System of Central Banks uses main refinancing operations, it is similar to the Federal Reserve using
A) dynamic open market operations.
B) defensive open market operations.
C) discount policy.
D) reserve requirements.

Answer 41

B) defensive open market operations.