TEST 4 (CHAPTER 32, 33, 34)

What are the three basic functions of money

medium of exchange for goods and services, as a unit of account for expressing price, and as a store of value

7 functions of the Federal Reserve

1. The Fed issues Federal Reserve Notes, the paper currency used in the U.S. monetary system. 2. The Fed sets reserve requirements and holds the mandated reserves that are not held as vault cash. 3. The Fed lends money to banks and thrifts. 4. The Fed provides for check collection. 5. The Fed acts as fiscal agent for the Federal government. 6. The Fed supervises the operation of banks. 7. Finally, and most importantly, the Fed has responsibility for regulating the supply of money, and this in turn enables it to affect interest rates.

What is TARP and how was it funded?

In late 2008 Congress passed the Troubled Asset Relief Program (TARP), which allocated $700 billion—yes, billion—to the U.S. Treasury to make emergency loans to critical financial and other U.S. firms. This was financed with general tax revenue and the issuance of government debt.

What is meant by the term "lender of last resort" and how does it relate to the financial crisis of 2007-2008?

One of the roles of the Federal Reserve is to serve as the lender of last resort to financial institutions in times of financial emergencies. That is, the Federal Reserve stands ready to lend funds to the banking sector to keep credit flowing. The Fed performed this vital role during the Financial Crisis of 2007-2008. Under Fed Chair Ben Bernanke, the Fed designed and implemented several highly-creative new lender-of-last-resort facilities to pump liquidity into the financial system. These facilities, procedures, and capabilities were in addition to both the TARP efforts by the U.S. Treasury and the Fed's use of standard tools of monetary policy (the subject of Chapter 33) designed to reduce interest rates.

How do each of the following relate to the financial crisis of 2007-2008: declines in real estate values, subprime mortgage loans, mortgage backed securities, AIG

Prior to the 2007-2008 financial crisis the banking institutions issued a large number of loans to borrowers that were relatively more 'risky' in the sense that these borrowers were more likely to default on their loans. This was referred to as the sub-prime market. This resulted in a rapid increase in home prices (along with housing market speculation) that was unsustainable (sometimes referred to as a 'bubble'). This problem was also exacerbated by the issuance of mortgage backed securities, which bundled riskier mortgages together, and sold them to investors. In theory, this reduced the risk exposure that banks faced after issuing these loans. This apparent reduction in risk increased the amount of sub-prime loans made by the banks. However, this reduction in risk was an accounting illusion since the banks also made loans to the groups purchasing the mortgage backed securities. When housing prices started to decline and individuals started to default on their mortgages (initially sub-prime borrowers) this reduced or completely eliminated the value of these mortgage backed securities. This caused the financial investors who held these securities to default on their loans from the banks that originally offered the mortgage backed securities (basically the banks issued loans to the individuals who were buying the assets they were selling). Thus, there was a major 'credit crunch' as banks wrote-off the bad loans.

What is the make-up and purpose of the Federal Open Market Committee (FOMC)?

Several entities assist the Board of Governors in determining banking and monetary policy, including the The Federal Open Market Committee, who vote on the Fed's monetary policy and direct the purchase or sale of government securities. 5 of the presidents of the Federal Reserve Banks have voting rights on the FOMC each year, rotating the membership among the 12 banks, except for the president of the NY Fed, who has a permanent voting seat.

How do government and Federal Reserve emergency loans relate to the concept of moral hazard?

TARP indeed saved several financial institutions whose bankruptcy would have caused a tsunami of secondary effects that probably would have brought down other financial firms and froze credit throughout the economy. But this very fact demonstrates the problem of moral hazard. As it relates to financial investment, moral hazard is the tendency for financial investors and financial services firms to take on greater risks because they assume they are at least partially insured against losses.

What is meant when economists say that the Federal Reserve Banks are central banks, quasi-public banks, and bankers' banks?

The 12 Federal Reserve Banks are "central" banks whose policies are coordinated by the Board of Governors. They are quasi-public banks, meaning that they are a blend of private ownership and public control. They are also bankers' banks in that they perform essentially the same functions for banks and thrifts as those institutions perform for the public.

How is the chairperson of the Federal Reserve System selected?

The members of the Board of Governors of the Federal Reserve are selected by the U.S. president and confirmed by the Senate. The seven board members have long terms—14 years—and staggered so that one member is replaced every 2 years. The president selects the chairperson and vice-chairperson of the board from among the members, and they serve 4‑year terms.