The Federal Reserve and its tools
Grade 12 Social Studies Worksheet - Building Confidence
Circle the best answer.
Read this first
What $1 million earns at Arden Bank (made up)
Choice Interest earned (percent) Expected loss (percent) Hold it at the Fed (earns IORB) 4.00 0.00 Car loans 6.50 1.80 Mortgage loans 5.75 0.60 Small-business loans 8.50 3.20 Note: Arden Bank is made up. Card A (Federal Reserve Board, in our words): The Federal Reserve Act of 1913 created the Fed. Its Board of Governors has 7 members. The Federal Open Market Committee (FOMC) sets monetary policy for the whole country and has 12 voting members: the 7 governors, the president of the Federal Reserve Bank of New York and 4 of the other 11 Reserve Bank presidents. Card B (in our words): The Fed's goals are maximum employment and stable prices, which it defines as inflation of 2 percent a year measured by the PCE price index. Card C (in our words): The interest rate on reserve balances (IORB) is what the Fed pays banks on money they keep in their accounts at the Fed. Expected loss is the bank's estimate of the share of loan money that will not be repaid. A simple rule: a bank lends when a loan's return after expected loss beats the IORB.
With the IORB at 4.00 percent, Pia ranks Arden's four choices by return after expected loss. Which ranking fits the chart?
- Mortgages first, then reserves, then car loans, then business loans, ranked by the smallest loss
- Business loans (8.50), car loans (6.50), mortgages (5.75), then holding reserves (4.00)
- Business loans (5.30), mortgages (5.15), car loans (4.70), then holding reserves (4.00)
- Holding reserves first, since a loan could fail and the 4.00 from the Fed is a sure return
The Fed raises the IORB to 5.00 percent. Bo asks which of Arden's loans still beat holding reserves. Which answer fits?
- Business loans alone beat 5.00, because their rate, 8.50, is the highest of the three loan types
- Business loans and mortgages still beat 5.00; car loans (4.70) do not, so Arden holds reserves instead
- No loan beats it, because a higher IORB makes loans riskier for the bank to hold
- Three kinds of loans still beat 5.00, since each charges more than 5.00 (6.50, 5.75, 8.50)
The IORB goes up to 5.25 percent. Esme asks what happens to Arden's lending and what the Fed intends. Which answer fits?
- Lending rises, because a higher rate means higher returns on the loans Arden might make
- Business loans fall most, because their expected loss of 3.20 is the highest on the chart
- Lending is unchanged, because the loan rates on the chart stay the same after the move
- Mortgage and car lending falls because reserves pay more; the Fed intends slower spending and price rises
Inflation is above 2 percent and jobs are plentiful. Jun asks which move fits card B's goals. Which fits?
- Raise the IORB to push inflation up toward the 2 percent goal, since higher is nearer 2
- Lower the IORB: banks would lend more, which cools spending and brings prices back down
- Leave the IORB alone, because the Fed acts when jobs fall below the maximum level, not when prices rise
- Raise the IORB: banks lend less, which slows spending and the rise in prices
Unemployment is rising and inflation is below 2 percent. Kira asks which move and effect fit card B. Which one?
- Raise the IORB: banks would lend more at higher rates, which lifts spending and creates jobs
- Lower the IORB: it would help prices but cannot help jobs, since banks do not hire workers
- Lower the IORB: reserves pay less, banks lend more, and spending rises to support jobs and prices
- Cut taxes: lower taxes raise spending, and tax rates are the Fed's main tool for jobs and prices
A story says the Fed set the interest rate on your car loan. Luz checks card C. Which reading is best?
- False: the Fed sets mortgage rates but not car-loan rates, because mortgages are bigger loans
- The Fed sets what it pays banks on reserves; banks pick their own loan rates, which follow indirectly
- False: the Fed has no effect on loan rates, since each bank sets its own rate
- True: the IORB is the car-loan rate, so Arden's 6.50 percent is the Fed's number
Suppose all 7 governors agree on a policy vote. Milo asks whether they can carry the FOMC without any Reserve Bank president. Which answer fits card A?
- Yes: the Board has 7 members and the FOMC has 12, so presidents do not vote
- No: the New York president must vote with the governors, since that bank has a permanent seat
- No: a majority of 12 needs 8 votes, so at least one president must agree
- Yes: the 7 governors hold 7 of 12 votes, which is a majority
A site says each of the 12 Reserve Banks sets its own interest rate target. Ren replies using card A. Which reply is strongest?
- The claim is true, because each Reserve Bank president has a vote on the FOMC
- The claim is false because the Board of Governors alone sets policy and the FOMC has no say
- The FOMC's 12 votes set one policy for the whole country, so there is one national policy
- The claim is true for lending rates but false for the IORB, which each bank sets locally
A reader says the 3.20 expected loss means Arden lost 3.20 percent of its business loans last year. Zee checks card C. What is the best reply?
- No: expected loss counts the loans that went bad in a bad year on record
- No: expected loss is an estimate of future losses, not a record of what happened
- Yes: expected loss is the bank's report of what was lost, so 3.20 percent is last year's figure
- Yes: it is the share of the bank's whole income that was lost to bad loans last year
A student says the chart shows the Fed made banks lend less. Ari tests the claim. What would the chart need to show it?
- The chart already shows it: the 3.20 loss on business loans shows the Fed's rate scared banks away
- A second row of returns after the Fed changed the IORB, since this chart shows one IORB
- The chart shows the opposite: loans return more than reserves, so the Fed made banks lend more
- Nothing more: the 4.00 return on reserves is lower than the loan returns, so the Fed made banks lend less