When the Federal Reserve conducts open market purchases (buys Treasury securities), what is the immediate effect on bank reserves and the federal funds rate?
AReserves decrease, federal funds rate rises
BReserves increase, federal funds rate falls
CReserves decrease, federal funds rate falls
DReserves increase, federal funds rate rises
When the Fed buys Treasuries, it pays by crediting bank reserves — so reserves increase. More reserves mean banks have more to lend in the overnight market, increasing supply in the federal funds market and pushing the rate down. This is the standard expansionary open market operation.
Question 2 True / False
Quantitative easing is equivalent to 'printing money' because it directly increases the amount of currency circulating in the economy.
TTrue
FFalse
Answer: False
QE swaps one financial asset (bonds held by banks or the public) for another (reserves held at the Fed). Reserves are not currency — they sit on banks' balance sheets at the central bank and don't circulate in the economy unless banks lend them out. QE expands the monetary base but does not automatically increase the money supply in circulation, which is why large QE programs haven't always produced proportional inflation.
Question 3 Short Answer
Explain why cutting the federal funds rate to near zero may fail to stimulate investment during a severe recession.
Think about your answer, then reveal below.
Model answer: In a severe recession, firms may not borrow and invest even at near-zero rates if they expect weak demand, face solvency concerns, or lack confidence in future profits. The transmission mechanism from lower rates to higher investment breaks down when the fundamental problem is expectations or balance-sheet distress rather than the cost of borrowing. This is the liquidity trap: monetary policy pushes on a string.
The Fed funds rate affects investment through a chain: lower Fed funds rate → lower borrowing costs → more investment → higher AD. But each link can break. If banks are unwilling to lend (credit crunch), if firms are too indebted to take on more, or if demand expectations are so depressed that no investment seems profitable, the rate cut transmits poorly. This is why post-2008 policy combined ultra-low rates with fiscal stimulus and unconventional monetary tools.