Money Supply

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.

Two economists debate a recession. One urges higher government spending to lift aggregate demand; the other argues that steady growth in the money supply matters most and that spending programs are largely self-defeating. Their positions are best labeled:

1. A.Keynesian and monetarist, respectively.Correct. Keynesian analysis prescribes fiscal demand management, while monetarism concentrates on the growth of the money supply.
2. B.Monetarist and Keynesian, respectively.Wrong. This reverses the two schools, assigning the spending prescription to the side that distrusts it.
3. C.Monetarist and supply-oriented, respectively.Wrong. The first position is not monetarist, and the second says nothing about incentives to produce.
4. D.Keynesian and mercantilist, respectively.Wrong. The second view concerns money growth, not trade surpluses and the accumulation of foreign reserves.

Why: Keynesian theory holds that output is driven by aggregate demand and that government spending and tax changes can fill the shortfall when private demand is weak. Monetarist theory holds that the quantity of money is the dominant influence on nominal activity and prices, and that discretionary fiscal action is offset or arrives too late. The practical difference between them is which lever each school reaches for, fiscal or monetary. Both accept that policy affects the economy; they disagree over which instrument does the work.

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.

The Fed credits reserves to a bank by buying securities from it. Why does the money supply typically rise by more than the amount of reserves added?

1. A.The Fed credits each bank's reserve account repeatedly until its policy target is reached.Wrong. The purchase occurs once, and the expansion that follows comes from the banking system rather than repeated Fed action.
2. B.Banks are required by rule to lend a fixed multiple of any new reserves they receive.Wrong. No rule compels lending; banks lend because idle reserves earn less than loans, and they may hold them instead.
3. C.The bank lends most of the new reserves, and the borrower's deposit funds further lending.Correct. Each loan creates a deposit, part of which is lent again, so one injection supports several rounds of deposits.
4. D.The Treasury issues additional currency to match the reserves the Fed has created.Wrong. Currency in circulation responds to the public's demand for cash and is not issued to match reserve creation.

Why: When the Fed adds reserves, a bank keeps only the portion it must hold against deposits and can lend the rest. The borrower's spending becomes a deposit at another bank, which in turn holds a fraction and lends the remainder, and the process repeats in diminishing rounds. Deposits, and therefore the money supply, end up expanding by a multiple of the original injection. That multiple shrinks when banks choose to hold excess reserves or when borrowers do not want loans, which is why adding reserves does not always produce the expected expansion.