BR17A: Bridge: Federal Reserve
Question 1
If the Fed sells bonds in the open market, it is attempting to
A. lower interest rates in order to increase investment spending.
B. lower interest rates in order to decrease investment spending.
C. raise interest rates in order to increase investment spending.
D. raise interest rates in order to decrease investment spending.
Hint
Bond prices and interest rates move in opposite directions: When the price of bonds increases, interest rates fall, and when the price of bonds falls, interest rates increase.Answer
D. raise interest rates in order to decrease investment spending When the Fed sells bonds in the open market, the price of bonds will fall and interest rates will increase. Higher interest rates will, in turn, decrease spending by businesses and consumers. The goal of this policy is to reduce inflation.Question 2
Suppose that after five solid years of economic growth, Eurekaland begins to experience inflationary pressures due to strong consumer and investor confidence. If Eurekaland’s central bank wants to prevent inflation from becoming a major problem, which of the following actions should it take?
A. It should increase the money supply to push interest rates higher.
B. It should reduce the money supply to push interest rates higher.
C. It should increase the money supply to push interest rates lower.
D. It should reduce the money supply to push interest rates lower.
Hint
The money market can be depicted using a standard supply and demand model, with the quantity of money on the x-axis and the interest rate on the y-axis. Given a downward-sloping demand curve (reflecting the negative relationship between the quantity of money demanded and the opportunity cost of holding money), consider what effects shifts of the money supply curve will have on the interest rate and thus on spending.Answer
B. It should reduce the money supply to push interest rates higher. The short-term interest rate is determined by the supply of and demand for money in the money market. The money demand curve is downward-sloping, reflecting the negative relationship between the quantity of money demanded and the opportunity cost of holding money (the interest rate). Thus, a reduction in the money supply—a leftward shift of the vertical money supply curve—pushes up the short-term interest rate, dampening spending and relieving the upward pressure on inflation.Question 3
In the short run, the Fed faces a tradeoff between
A. real GDP growth and employment.
B. inflation and financial stability.
C. inflation and unemployment.
D. moderate interest rates and real GDP growth.
Hint
The Fed can influence interest rates to meet its economic goals, but the goals themselves are sometimes at odds with each other.Answer
C. inflation and unemployment. Lowering interest rates can stimulate growth and create jobs. But the Fed has to raise the money supply to lower interest rates, and an increase in the money supply tends to cause inflation to increase.Question 4
During the Great Recession that began in 2007, the Fed lowered interest rates to almost 0%. What did it do to accomplish this policy?
A. increased the money supply
B. decreased the money supply
C. sold bonds on the open market
D. both increased the money supply and sold bonds on the open market
Hint
When the volume of funds available for banks to lend increases, interest rates fall.Answer
A. increased the money supply The Fed can lower market interest rates by increasing the money supply. Recall that when the Fed buys U.S. bonds, the volume of funds available for banks to lend increases, lowering interest rates.Question 5
After an economy begins to recover, suppose that the Fed quickly raises interest rates back to the level seen before the recession in order to prevent inflation. Which type of Fed policymaker would be more likely to favor this action?
A. Neither doves nor hawks.
B. Doves
C. Both doves and hawks.
D. Hawks