Definition
Monetary Policy
Actions by the Federal Reserve (central bank) to control money supply and interest rates to influence economic activity. Implemented through tools that include open market operations (a key tool), interest on reserve balances, the discount rate, and reserve requirements (rarely changed; the Fed reduced reserve requirement ratios to zero percent effective March 26, 2020).
When the Fed sells Treasury securities to reduce money supply and raise interest rates, this is contractionary monetary policy designed to combat inflation.
Monetary policy (controlled by the Federal Reserve) is often confused with fiscal policy (controlled by Congress and the President through taxation and government spending).
How is Monetary Policy tested on the exam?
- Distinguishing between expansionary (lower rates, increase money supply) and contractionary (higher rates, decrease money supply) monetary policy
- Understanding who controls monetary policy (Federal Reserve, not Congress or the President)
- Identifying the tools of monetary policy (open market operations, interest on reserve balances, discount rate, reserve requirements)
- Recognizing the relationship between monetary policy actions and their effects on interest rates and money supply
- Understanding the differences between monetary policy and fiscal policy
Regulatory limits
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Inflation target | 2% annually | Fed's long-term inflation goal (PCE inflation) |
Monetary policy = The Fed controlling the money faucet. Key valves: OMO (a main valve), interest on reserve balances (steers the fed funds rate), Discount rate (emergency shutoff), Reserve requirements (rarely touched; set to zero since March 2020). Need more money flowing? Fed buys bonds, lowers rates (turn faucet on = expansionary). Too much money? Fed sells bonds, raises rates (turn faucet off = contractionary). Key: Fed controls the faucet, Congress controls the budget (fiscal policy).
Practice questions
Test your understanding with the questions below. Pick an answer to reveal the explanation.
Robert, a financial advisor, notices that the Federal Reserve has begun purchasing large quantities of Treasury securities in open market operations. One of his clients asks how this might affect her bond portfolio and borrowing costs for a planned home purchase. Which statement most accurately describes the likely impact?
C is correct. When the Fed purchases Treasury securities (expansionary monetary policy), it injects money into the banking system, increasing money supply and putting downward pressure on interest rates. Lower interest rates increase the value of existing bonds (inverse relationship) and reduce borrowing costs for mortgages and other loans.
A is incorrect because it reverses the relationship. Fed purchases lower rates, not raise them. B is incorrect about bond values: when interest rates fall, existing bond prices rise (not fall) because their higher coupon rates become more valuable. D is incorrect because large Fed purchases of Treasury securities put downward pressure on interest rates, including longer-term rates.
The Series 65 exam tests your understanding of how Fed policy actions affect both investment portfolios and client financial decisions. Advisors must recognize that expansionary monetary policy (like quantitative easing) typically benefits existing bondholders while also reducing borrowing costs, creating opportunities for portfolio repositioning and financial planning strategies.
When the Federal Reserve buys Treasury securities to add reserves to the banking system, which tool is it using?
C is correct. Open market operations, the purchase and sale of securities in the open market, are a key Federal Reserve tool. The Federal Open Market Committee (FOMC) specifies their objective. Before the global financial crisis, the Fed used them to adjust the supply of reserve balances and keep the federal funds rate near the FOMC's target.
A (discount rate) is the rate charged to depository institutions that borrow from a Federal Reserve Bank at the discount window; changing it does not involve buying securities. B (reserve requirements) is rarely changed because it's a blunt instrument with powerful effects across the entire banking system. D (margin requirements) is a regulatory tool for securities trading, not a primary monetary policy tool for controlling money supply.
The Series 65 exam frequently tests knowledge of the Fed's policy toolkit. Understanding open market operations as one of the Fed's monetary policy tools helps you recognize how the Fed implements policy decisions and why bond markets react immediately to FOMC announcements about future securities purchases or sales.
Assume a bank has $500 million in deposits and the Federal Reserve raises the reserve requirement from 8% to 10%. How much additional cash must the bank hold in reserve?
B is correct. Calculate the change: Original reserves: $500 million × 0.08 = $40 million. New reserves required: $500 million × 0.10 = $50 million. Additional reserves needed: $50 million - $40 million = $10 million.
A ($5 million) incorrectly calculates just 1% of deposits ($500 million × 0.01) without considering the full 2 percentage point increase. C ($40 million) is the original reserve requirement amount, not the additional amount needed. D ($50 million) is the new total reserve requirement, not the additional amount beyond what was already required.
Reserve requirement calculations show how a change in the required ratio changes the reserves a bank must hold. The ratios have been zero since March 26, 2020, so treat this as a hypothetical. When the Fed raises reserve requirements (contractionary policy), banks must hold more cash and can lend less, reducing money supply. Understanding these calculations helps assess the magnitude of policy changes on the banking system and broader economy.
All of the following are tools of monetary policy used by the Federal Reserve except
C is correct (the exception). Changing corporate tax rates is a fiscal policy tool controlled by Congress and the President, not a monetary policy tool. This is a critical distinction frequently tested on the Series 65 exam.
A is accurate: open market operations (buying/selling Treasury securities) are a key Fed monetary policy tool. B is accurate: the discount rate is a monetary policy tool, set by each Reserve Bank's board of directors subject to review and determination by the Board of Governors. D is accurate: reserve requirements (the percentage of deposits banks must hold in reserve) is a monetary policy tool, though used infrequently due to its powerful systemic effects.
The Series 65 exam tests your ability to distinguish between monetary policy (Federal Reserve actions controlling money supply and interest rates) and fiscal policy (government taxation and spending decisions). Investment advisors must understand this distinction to properly interpret economic news and policy announcements affecting client portfolios.
The Federal Reserve announces it will begin selling Treasury securities from its portfolio and simultaneously raises the discount rate by 0.50%. Which of the following statements about this policy action are accurate?
1. This represents expansionary monetary policy
2. This is likely intended to combat rising inflation
3. The money supply will likely decrease
4. Interest rates will likely rise
C is correct. Statements 2, 3, and 4 are accurate.
Statement 1 is false: This is contractionary monetary policy, not expansionary. Selling securities and raising the discount rate both remove money from the system and increase borrowing costs.
Statement 2 is true: Contractionary monetary policy (reducing money supply and raising rates) is typically used to combat inflation by slowing economic activity and cooling demand.
Statement 3 is true: When the Fed sells Treasury securities, it removes money from the banking system, directly decreasing the money supply. Higher discount rates also discourage bank borrowing, further reducing money creation.
Statement 4 is true: Both actions put upward pressure on interest rates. Selling securities reduces money available for lending, and raising the discount rate increases the baseline cost of borrowing.
The Series 65 exam tests your ability to evaluate the coordinated effects of multiple Fed policy tools and identify whether policy is expansionary or contractionary. Understanding these relationships is essential for advising clients on how Fed actions will likely affect interest-sensitive investments like bonds, preferred stocks, and real estate securities.
What concepts relate to Monetary Policy?
This term is part of this cluster :
Where does Monetary Policy appear on the Series 65 exam?
This term is tested in the following Series 65 exam topics: