Questions
1. The Fed. Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed
district banks.
ANSWER: Two attempts to establish a central bank in the 1800s had failed. In the late 1800s and
2. FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to
achieve these goals?
3. Open Market Operations. Explain how the Fed increases the money supply through open market
operations.
4. Policy Directive. What is the policy directive, and who carries it out?
5. The Beige Book. What is the Beige book and why is it important to the FOMC?
ANSWER: The Beige book is a consolidated report of regional economic conditions in each of the 12
6. Reserve Requirements. How is money supply growth affected by an increase in the reserve
requirement ratio?
7. Control of Money Supply. Describe the characteristics that a measure of money should have if it is
to be manipulated by the Fed.
8. FOMC Economic Presentations. What is the purpose of economic presentations during a POMC
meeting?
ANSWER: Economic presentations offer the FOMC information about the prevailing economic
9. Open Market Operations. Explain how the Fed uses open market operations to reduce the money
supply.
10. Open Market Operations. Why do the Fed’s open market operations have a different effect on
money supply than do transactions between two depository institutions?
ANSWER: When the Fed engages in a purchase of Treasury securities from a depository institution,
11. Discount Window Lending During Credit Crisis. Explain how and why the Fed extended
its discount window lending to nonbank financial institutions during the credit crisis.
ANSWER: In 2008, the Fed expanded its role by lending to other types of institutions. In March
2008, the Fed’s discount window provided funding to rescue Bear Stearns, a large securities firm that
On the following day, the Fed expanded its role further by announcing that it would provide
emergency loans to the about 20 primary dealers that serve as key financial intermediaries for the
12. The Fed versus Congress. Should the Fed or Congress decide the fate of large financial institutions
that are near bankruptcy?
ANSWER: The Fed might argue that the credit crisis is a threat to the financial system and that it
needed to intervene to prevent a bigger crisis. Some critics might argue that the Fed has too much
13. Bailouts by the Fed. Do you think that large financial institutions should have been rescued by the
Fed during the credit crisis?
ANSWER: Some supporters of a government rescue would argue that the credit crisis would be
worse if the large financial institutions were not rescued. However, others might argue that the
14. The Fed’s Impact on Unemployment. Explain how the Fed’s monetary policy affects the
unemployment level.
ANSWER: The Fed’s monetary policy affects interest rates, which affect the cost of borrowing by
15. The Fed’s Impact on Home Purchases. Explain how the Fed influences the monthly mortgage
payments on homes. How might the Fed indirectly influence the total demand for homes by
consumers?
ANSWER: The Fed influences interest rates, which affect the rate paid by homeowners on mortgages.
When the Fed reduces interest rates, it reduces the monthly payment to be made on new mortgages.
16. The Fed’s Impact on Security Prices. Explain how the Fed’s monetary policy may indirectly affect
the prices of equity securities.
ANSWER: The Fed’s monetary policy influences the aggregate demand for products and services,
17. Impact of FOMC Statement. How might the FOMC statement (following the committee’s meeting)
stabilize financial markets more than if no statement were provided?
ANSWER: If a statement was not provided, investors would have to guess at the conclusion of the
18. Fed Facility Programs During the Credit Crisis. Explain how the Fed’s facility programs improved
liquidity in some debt markets.
ANSWER: The Fed established facilities that provided loans to financial institutions that were willing
to invest in some types of debt securities, such as bonds that were backed by consumer loans. In this
19. Consumer Financial Protection Bureau. As a result of the Financial Reform Act of 2010, the
Consumer Financial Protection Bureau was established, and housed within the Federal Reserve.
Explain the role of this bureau.
ANSWER: The bureau is responsible for regulating financial products and services, including online
20. Eurozone Monetary Policy. Explain why participating in the eurozone causes a country to give up its
independent monetary policy and control over its domestic interest rates.
ANSWER: When a country adopts the euro as its currency, it is subject to the monetary policy of the
European Central Bank (ECB), which controls the supply of euros in the banking system. The ECB
21. The Fed’s Power. What should be the Fed’s role? Should it be focused only on monetary
policy? Or should it be allowed to engage in the trading of various types of securities in order
to stabilize the financial system when securities markets are suffering from investor fears and
the potential for high default risk?
ANSWER: This is open ended, as there is no perfect answer. Students should recognize that
the Fed’s role during the financial crisis went far beyond monetary policy. Yet, it can be
22. The Fed and Mortgage-Backed Securities How has the Fed used mortgage-backed
securities in recent years, and what has it been trying to accomplish?
ANSWER: The Fed purchased large amounts of mortgage-backed securities during 2008 and
2009 in an attempt to calm investors’ fears that the value of these securities would decline
23. The Fed and Commercial Paper. Why and how did the Fed intervene in the commercial
paper market during the credit crisis?
ANSWER: After Lehman Brothers failed in 2008, thereby defaulting on the commercial
paper it had issued, investors feared that other financial institutions with large holdings of
24. The Fed and Long-Term Treasury Securities. Why did the Fed purchase long-term
Treasury securities in 2010, and how did this strategy differ from the Fed’s usual operations?
ANSWER: The Fed’s purchases of long-term Treasury securities differed from its normal
open market operations, which focus on short-term Treasury securities. By purchasing
25. The Fed and TALF. What was TALF, and why did the Fed create it?
ANSWER: TALF was the term asset–backed facility that the Fed created in 2008 to provide
financing to financial institutions purchasing high-quality bonds backed by consumer, credit
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
a. “The Fed’s future monetary policy will be dependent on the economic indicators to be reported
this week.”
b. “The Fed’s role is to take the punch bowl away just as the party is coming alive.”
The Fed attempts to prevent the economy from becoming too strong by slowing the economy
c. “Inflation will likely increase because real short-term interest rates currently are negative.”
Negative real short-term interest rates imply that the inflation rate exceeds the existing nominal
Managing in Financial Markets
As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so
that you can forecast the demand for products sold by your firm. You realize that the Federal Reserve
implements monetary policy—and that the federal government implements spending and tax policies, or
fiscal policy—to affect economic growth and inflation. However, it is difficult to achieve high economic
growth without igniting inflation. Although the Federal Reserve is often said to be independent of the
administration in office, there is much interaction between monetary and fiscal policies.
Assume that the economy is currently stagnant and that some economists are concerned about the
possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this
year than in the previous five years. Assume that the Federal Reserve chairman’s term will expire in four
months and that the president of the United States will have to appoint a new chairman (or reappoint the
existing chairman). It is widely known that the existing chairman would like to be reappointed. Also
assume that next year is an election year for the administration.
a. Given the circumstances, do you expect that the administration will be more concerned about
increasing economic growth or reducing inflation?
While answers may vary among students, the administration is normally most concerned with
b. Given the circumstances, do you expect that the Fed will be more concerned about increasing
economic growth or reducing inflation?
The Fed tends to focus on maintaining a low level of inflation, because of the possibility that
sustained high inflation can cause high interest rates, which may result in a sluggish economy in
c. Your firm is relying on you for some insight on how the government will influence economic
conditions and therefore the demand for your firm’s products. Given the circumstances, what is
your forecast of how the government will affect economic conditions?
There is no definite answer, but some possible expectations are as follows. First, both policies
may focus on economic growth for political or other reasons. In this case, there is a high
Flow of Funds Exercise
Monitoring the Fed
Recall that Carson Company has obtained substantial loans from finance companies and commercial
banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months.
Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making
acquisitions. The company expects that it will need substantial long-term financing and plans to borrow
additional funds either through loans or by issuing bonds. The Carson Company is also considering the
issuance of stock to raise funds in the next year.
Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It
subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets.
It recently received an alert from the service that suggested the Fed has been selling large holdings of its
Treasury securities in the secondary Treasury securities market.
a. How should Carson interpret the actions by the Fed? That is, will these actions place
upward or downward pressure on the price of Treasury securities? Explain.
b. Will these actions place upward or downward pressure on Treasury yields? Explain.
c. Will these actions place upward or downward pressure on interest rates? Explain.
The actions will place upward pressure on interest rates because there would be a reduction in