again and permitting a further round of loans, and so on, leading to a rise in the money
supply. An open -market sale has the reverse effect: bank reserves fall, requiring banks
to reduce their loans, leading to a fall in the money supply.
Economists often say, loosely, that the Fed controls the money supply—checkable
deposits plus currency in circulation. In fact, it controls only the monetary base—
bank reserves plus currency in circulation. But by increasing or reducing the mone-
tary base, the Fed can exert a powerful influence on both the money supply and
interest rates. This influence is the basis of monetary policy, discussed in detail in
Modules 28 and 29.266 section 5 The Financial Sector
Module 27 AP Review
Check Your Understanding
- Assume that any money lent by a bank is deposited back in the
banking system as a checkable deposit and that the reserve ratio
is 10%. Trace out the effects of a $100 million open -market
purchase of U.S. Treasury bills by the Fed on the value of
checkable bank deposits. What is the size of the money
multiplier?Solutions appear at the back of the book.
Tackle the Test: Multiple-Choice Questions
- Which of the following is a function of the Federal Reserve
System?
I. examine commercial banks
II. print Federal Reserve notes
III. conduct monetary policy
a. I only
b. II only
c. III only
d. I and III only
e. I, II, and III - Which of the following financial services does the Federal
Reserve provide for commercial banks?
I. clearing checks
II. holding reserves
III. making loans
a. I only
b. II only
c. III only
d. I and II
e. I, II, and III
3. When the Fed makes a loan to a commercial bank, it charges
a. no interest.
b. the prime rate.
c. the federal funds rate.
d. the discount rate.
e. the market interest rate.
4. If the Fed purchases U.S. Treasury bills from a commercial
bank, what happens to bank reserves and the money supply?
Bank reserves Money supply
a. increase decrease
b. increase increase
c. decrease decrease
d. decrease increase
e. increase no change
5. When banks make loans to each other, they charge the
a. prime rate.
b. discount rate.
c. federal funds rate.
d. CD rate.
e. mortgage rate.