Reserve Requirement

Among the Federal Reserve's monetary tools, the reserve requirement is best characterized as:

1. A.The bluntest and least frequently used, because a change affects every institution at onceCorrect — its large multiplied effect is why the Fed prefers open market operations for routine adjustment.
2. B.A rule that governs how much credit a broker-dealer may extend to customersThat is Regulation T. The reserve requirement applies to bank deposits.
3. C.The most precise tool, used to make small daily adjustments to the money supplyDaily fine tuning is done through open market operations. Reserve requirement changes are rare and sweeping.
4. D.A fiscal tool requiring congressional approval before it can be changedThe Fed sets the reserve requirement on its own authority; no legislation is involved.

Why: The reserve requirement is the Fed's bluntest and least frequently used tool. A change to it affects every depository institution simultaneously and has a large multiplied effect on lending capacity, so the Fed relies instead on open market operations for routine adjustment.

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.