Federal Reserve Nominee Backs Reduction in Balance Sheet Size

Answer the following questions to check your understanding of the story.

How are Treasury bills, Treasury bonds, and bank reserves classified on the Federal Reserve’s balance sheet?

Treasury bills and Treasury bonds are __________ and bank reserves are __________ on the Federal Reserve’s balance sheet.

a) assets; also assets

b) assets; liabilities

c) liabilities; assets

d) liabilities; also liabilities

Wrong! - Treasury securities are not liabilities; the Fed does not owe the government. Reserves are not assets; they are obligations the Fed must repay to banks on demand.

Well Done! - Treasury securities are the Fed’s assets because they represent loans to the government. Reserves are Fed’s liabilities because they are deposits that commercial banks hold at the Fed and can withdraw on demand.

What is meant by reducing the size of the Fed’s balance sheet?

Reducing the size of the Fed’s balance sheet means ____________.

a) decreasing the Fed’s assets only, particularly Treasury bills and bonds

b) increasing the Fed’s assets, particularly Treasury bills and bonds, and increasing its liabilities, particularly reserves

c) decreasing the Fed’s assets, particularly Treasury bills and bonds, and decreasing its liabilities, particularly bank reserves

d) decreasing the Fed’s liabilities only, particularly bank reserves

Wrong! - Increasing assets and liabilities increases the size of the balance sheet, not decreases it. Reducing assets or liabilities alone does not describe how the Fed shrinks its balance sheet.

Good Job! - Reducing the size of the balance sheet means reducing both assets and liabilities. When the Fed decreases its holdings of Treasury securities (assets), bank reserves (liabilities) decrease by the same amount.

Which of the following monetary policy tools would the Federal Reserve use to reduce the size of its balance sheet?

a) Lower the required reserve ratio

b) Conduct an open market purchase of government securities

c) Conduct an open market sale of government securities

d) Lower the federal funds rate

Wrong! - An open market purchase increases securities and reserves, increasing the size of the Fed’s balance sheet and lowering the federal funds rate. Lowering the required reserve ratio change the composition of reserves, not the size of the Fed’s balance sheet.

That's Right! - An open market sale decreases the Fed’s securities (assets). Banks pay with reserves, so reserves (liabilities) also decrease and the size of the balance sheet is reduced.

Would reducing the size of the Federal Reserve’s balance sheet bring the lower interest rates President Trump wants?

a) No, because an open market sale decreases the money supply and raises the nominal interest rate.

b) Yes, because lowering the required reserve ratio decreases bank reserves and lowers the nominal interest rate.

c) No, because an open market purchase decreases the money supply and raises the nominal interest rate.

d) Yes, lowering the federal funds rate increases the money supply and lowers the nominal interest rate.

Wrong! - Lowering the federal funds rate requires open market purchases, which increase the Fed’s balance sheet and the money supply, lowering the nominal interest rate. Lowering the required reserve ratio does not change total reserves in the banking system.

Correct! - An open market sale decreases reserves. Banks shrink deposits by decreasing loans. The supply of money decreases, raising the nominal interest rate.

Share this: