Open Market Operations

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.

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.

Shortly after an initial public offering is completed, a customer buys shares of the same issuer in the open market through her broker. What does the firm owe her?

1. A.Nothing beyond a confirmation, since prospectus delivery ends at effectiveness.Wrong. The obligation extends past the offering itself, which is exactly what distinguishes a recent IPO.
2. B.A final prospectus, because delivery is required for a period after an IPO.Correct. Aftermarket purchasers of a recently public issuer are entitled to the prospectus for a defined period.
3. C.A preliminary prospectus, since the aftermarket price is not yet established.Wrong. The preliminary version belongs to the cooling-off period and lacks the final offering price.
4. D.A copy of the registration statement, including all of the exhibits filed with it.Wrong. The full filing is publicly available, but what must be delivered to the customer is the prospectus.

Why: Prospectus delivery is not confined to buyers in the offering itself. For a period following an initial public offering, firms must deliver the final prospectus to customers buying in the aftermarket as well, on the reasoning that information about a newly public company has not yet been widely absorbed. The requirement is shorter for a company that was already public before the offering, since information about it already circulates. In every case the document delivered is the final prospectus carrying the offering price, not the preliminary version.