Federal Funds Rate

A borrower's loan agreement adjusts with the prime rate. Who sets the prime rate?

1. A.The Federal Open Market Committee, at each of its regularly scheduled meetings.Wrong. The FOMC sets a target for the federal funds rate and publishes no lending rate for bank customers.
2. B.Commercial banks, as the rate charged to their most creditworthy customers.Correct. Prime is a benchmark each bank sets for its best commercial borrowers, and it follows the Fed's policy stance.
3. C.The Board of Governors, as a ceiling on what banks are permitted to charge.Wrong. The Board sets reserve requirements and approves discount rates; it does not cap what banks may charge.
4. D.The Treasury, as part of its management of federal government borrowing costs.Wrong. The Treasury borrows money and manages federal debt, playing no part in setting bank lending rates.

Why: The prime rate is a commercial bank rate, quoted by banks for their strongest borrowers and used as a reference for many floating-rate loans. Banks move it in response to the Fed's policy stance, because the cost of the reserves funding those loans tracks the federal funds market. That relationship is why prime rises after a tightening and falls after an easing, but the decision belongs to the banks themselves. The Fed's own rates are the discount rate it charges banks and the federal funds target it steers toward.

The federal funds rate is best described as the rate at which:

1. A.The Federal Reserve lends reserves directly to a member bank at the discount window.Wrong. That describes the discount rate, which the Fed itself charges rather than a rate negotiated between two banks.
2. B.Commercial banks lend to their most creditworthy corporate customers.Wrong. That is the prime rate, a benchmark each bank publishes for its own strongest customers.
3. C.The Treasury borrows from the public when it auctions short-term bills.Wrong. Bill yields are set at auction by bidders and reflect government borrowing costs, not interbank lending.
4. D.Banks lend reserve balances to one another, typically overnight.Correct. Federal funds are reserve balances one bank lends another for very short periods, usually overnight.

Why: Banks hold reserve balances at the Federal Reserve, and a bank that ends the day short can borrow them from a bank that ends the day long. The price of that very short loan is the federal funds rate, negotiated in the market rather than decreed by anyone. The Fed influences it by adding to or draining reserves, which is why open market operations sit at the center of monetary policy. The rate a bank pays to borrow directly from its own Federal Reserve Bank is the discount rate, a different transaction with a different counterparty.

A commentator reports that the Federal Reserve raised the federal funds rate at its meeting. What is the more precise description of what the Fed actually did?

1. A.It raised the rate it charges banks that borrow reserves at the discount window.Wrong. That is the discount rate, a separate rate on a separate facility in which the Fed is the lender.
2. B.It ordered banks to charge one another more for lending reserves overnight.Wrong. The Fed does not dictate the terms of loans between private banks; it changes the supply of what they lend.
3. C.It raised the reserve requirement, which mechanically lifted the overnight rate.Wrong. Reserve requirements are a distinct tool and are not the mechanism by which a target change is implemented.
4. D.It raised its target for the rate and used its tools to steer the market there.Correct. The committee announces a target and then adds or drains reserves until the market rate settles there.

Why: The federal funds rate is negotiated between banks lending reserves to one another, which makes it a market price rather than something the Fed can post. The FOMC announces a target and then uses its tools, principally the supply of reserves, so that the market clears at that level. Understanding this is what makes the transmission mechanism intelligible: the Fed changes conditions and every other rate in the economy responds. The discount rate is different, because there the Fed is the lender and genuinely does set the price.

Which pairing of a policy action with the body that holds authority to take it is correct?

1. A.Directing purchases and sales of Treasury securities in the open market: the FOMC.Correct. Open market operations are directed by the Federal Open Market Committee and are the Fed's principal working tool.
2. B.Setting the rate of federal income tax paid by corporations: the Board of Governors.Wrong. Tax rates are set by statute, meaning Congress and the President, and the Fed plays no part in them.
3. C.Changing the reserve requirement applied to depository institutions: the Treasury.Wrong. Reserve requirements are a Federal Reserve matter set by the Board of Governors, not by the Treasury.
4. D.Fixing the federal funds rate by decree at a specified level: the FOMC.Wrong. The FOMC announces a target for that rate and steers toward it, while the rate itself is negotiated between banks.

Why: The exam repeatedly tests who owns which lever. Within the Fed, the FOMC directs open market operations, the Board of Governors sets reserve requirements, and discount rates are established by the directors of the individual Reserve Banks subject to the Board's approval. Outside the Fed, taxation and spending belong to Congress and the President. The federal funds rate differs in kind from the others, because it is a market rate the Fed targets rather than a price it fixes.