Monetary Policy

A depositor asks which body stands behind the balance in her checking account at an insured commercial bank. The correct answer is:

1. A.The Federal Reserve, because it regulates member banks and holds their reserve balances.Wrong. The Fed conducts monetary policy and supervises banks, but it does not insure the deposits themselves.
2. B.The Securities Investor Protection Corporation, because a bank is a financial institution.Wrong. That body covers customer securities and cash held at a failed broker-dealer, not deposits at a bank.
3. C.The Federal Deposit Insurance Corporation, which insures deposits at its member banks.Correct. Deposit insurance at member banks is the FDIC's function, subject to the applicable coverage limits.
4. D.The Treasury, because insured bank deposits are direct obligations of the federal government.Wrong. A deposit is an obligation of the bank, and the government's role runs through the insurance program instead.

Why: The federal financial agencies each own a distinct function, and confusing them is a reliable source of wrong answers. Deposit insurance is administered by the FDIC, which pays insured depositors when a member bank fails. The Federal Reserve conducts monetary policy and supervises banks but insures nothing. The securities-side counterpart is a separate corporation covering assets held at a failed broker-dealer, and neither program protects against investment losses.

Congress extends the duration of unemployment benefits during a downturn. This action is:

1. A.Fiscal policy, because it changes federal spending in order to support demand.Correct. Fiscal policy is federal taxing and spending, and extending a benefit program is a spending decision by Congress.
2. B.Monetary policy, because it places additional money into circulation.Wrong. Money paid out in benefits is money the Treasury already raised, and the money supply is the Fed's province.
3. C.Fiscal policy, but only if the extension is financed with newly issued federal debt.Wrong. How the spending is financed affects the deficit, not whether the action counts as fiscal policy.
4. D.Monetary policy, because it is a deliberate response to changing economic conditions.Wrong. Responding to economic conditions is what both branches of policy do, so it distinguishes nothing here.

Why: The dividing line is who acts and with what instrument. Fiscal policy is Congress and the President working through taxation and federal spending; monetary policy is the Federal Reserve working through the supply of reserves and the cost of credit. Extending a benefit program is an appropriation, so it falls on the fiscal side however it is funded. Had the Fed instead bought securities to add reserves to the banking system, that would be monetary policy aimed at the same downturn.

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.

The federal government runs a budget surplus and uses it to retire outstanding Treasury debt. Considered on its own, this action is:

1. A.Expansionary fiscal policy, because bondholders receive cash that they are free to spend.Wrong. Bondholders are repaid principal they already owned, which is a swap of assets rather than new income.
2. B.Contractionary fiscal policy, because the government withdraws more than it puts back.Correct. A surplus means taxes collected exceed spending, so the fiscal balance drains demand from the economy.
3. C.Contractionary monetary policy, because retiring bonds shrinks the money supply.Wrong. Retiring Treasury debt is a Treasury action, and only Fed operations alter bank reserves as a matter of policy.
4. D.Neutral, because the money simply moves from taxpayers across to bondholders.Wrong. Taxpayers surrendered spendable income while bondholders received a return of capital, so the two do not cancel.

Why: The fiscal stance is measured by whether the government takes more out of the private economy in taxes than it puts back through spending. A surplus does exactly that, so its immediate effect on aggregate demand is contractionary whatever is done with the money afterward. Repaying bondholders returns principal rather than creating income, so it does not offset the drain. Contrast this with the Fed buying bonds in the open market, which does add reserves and is expansionary monetary policy.