CBE Monetary Policy 2 — Questions and Answers
Question 1: Which monetary policy tool involves the Fed buying or selling government securities in the open market?
- Discount rate adjustment
- Reserve requirement changes
- Open market operations (Correct answer)
- Federal funds rate targeting
Correct answer: Open market operations
Open market operations are the Fed's primary tool, where it buys or sells Treasury securities to expand or contract the money supply.
Question 2: When the Fed purchases Treasury securities, what is the immediate effect on bank reserves?
- Reserves decrease, tightening credit
- Reserves increase, expanding credit capacity (Correct answer)
- Reserves remain unchanged, only composition shifts
- Reserves decrease temporarily then recover
Correct answer: Reserves increase, expanding credit capacity
Fed purchases inject reserves into the banking system, increasing banks' capacity to extend loans and expand the money supply.
Question 3: The Taylor Rule suggests that the federal funds rate should rise when:
- Unemployment exceeds its natural rate only
- Inflation exceeds its target or output exceeds potential (Correct answer)
- The dollar appreciates against trading partners
- Long-term bond yields fall below short-term rates
Correct answer: Inflation exceeds its target or output exceeds potential
The Taylor Rule prescribes higher rates when inflation is above target or when output (real GDP) exceeds its potential level.
Question 4: Quantitative easing (QE) differs from conventional monetary policy primarily because QE:
- Targets the federal funds rate instead of asset prices
- Involves purchasing longer-term assets to lower long-term yields (Correct answer)
- Raises the discount rate to attract foreign capital
- Reduces reserve requirements to free up bank lending
Correct answer: Involves purchasing longer-term assets to lower long-term yields
QE targets long-term interest rates by purchasing longer-dated securities (e.g., MBS, 10-year Treasuries) when short-term rates are already near zero.
Question 5: The 'zero lower bound' (ZLB) problem means that:
- Banks cannot pay negative interest on deposits under any circumstances
- Nominal interest rates cannot fall significantly below zero, limiting conventional stimulus (Correct answer)
- The Fed cannot conduct open market purchases once reserves are ample
- Inflation automatically falls to zero when growth stalls
Correct answer: Nominal interest rates cannot fall significantly below zero, limiting conventional stimulus
Nominal interest rates face a practical floor near zero because savers can hold cash, constraining the Fed's ability to use conventional rate cuts.
Question 6: Which of the following best describes the 'liquidity trap'?
- Banks hoard reserves rather than lending, even at very low interest rates (Correct answer)
- Consumers over-leverage when credit is abundant
- The Fed loses control of M2 when reserve ratios rise
- Foreign central banks absorb excess dollar liquidity
Correct answer: Banks hoard reserves rather than lending, even at very low interest rates
A liquidity trap occurs when monetary easing fails to stimulate spending because banks and households prefer holding liquid assets despite low rates.
Question 7: Forward guidance as a monetary policy tool works primarily by:
- Announcing future open market purchase schedules in advance
- Shaping market expectations about the future path of interest rates (Correct answer)
- Requiring banks to pre-commit lending volumes to borrowers
- Publishing quarterly GDP forecasts to guide fiscal policy
Correct answer: Shaping market expectations about the future path of interest rates
Forward guidance influences long-term rates and economic decisions today by signaling how the Fed intends to set rates in the future.
CBE Monetary Policy 2
Which monetary policy tool involves the Fed buying or selling government securities in the open market?