Federal Open Market Committee

The FOMC directs the purchase of Treasury securities in the open market. From whom are those securities bought, and what does the Treasury itself receive?

1. A.From the Treasury directly, which receives newly created funds available to spend.Wrong. This is exactly the confusion the arrangement avoids, since the Fed operates in the secondary market rather than funding the government.
2. B.From dealers and banks in the secondary market, and the Treasury receives nothing.Correct. The Fed buys already-issued securities from market participants, paying by crediting reserves to their banks.
3. C.From foreign central banks only, and the Treasury receives the sale proceeds.Wrong. The counterparties are domestic dealers and banks, and confining operations to foreign central banks would not move domestic reserves.
4. D.From the public at a Treasury auction, and the Treasury receives the winning bids.Wrong. An auction is the Treasury selling new debt to raise cash, a financing operation and not a monetary one.

Why: Open market operations are conducted in the secondary market with dealers and banks that already own Treasury securities. When the Fed buys, it pays by crediting reserves to the seller's bank, so bank reserves rise, the money supply expands and short-term rates ease. None of that money reaches the Treasury, which was paid long ago when the securities were first auctioned. Distinguish this from a Treasury auction, where the government sells new debt to finance spending, which is fiscal financing rather than monetary policy.

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.