Federal Reserve Balance Sheet

B is correct. When the Fed expands its balance sheet by purchasing securities (quantitative easing), it injects money into the financial system and puts downward pressure on interest rates across all bond markets. Lower interest rates cause existing bond prices to rise due to the inverse relationship between rates and prices. Even though the Fed is buying Treasuries and MBS, the effect ripples through all fixed-income markets, including corporate bonds.

A is incorrect because balance sheet expansion represents looser (expansionary) monetary policy, not tighter policy. This puts downward pressure on rates and upward pressure on bond prices, not the reverse. C is incorrect because Fed purchases affect the entire interest rate structure. When the Fed lowers yields on Treasuries and MBS through large purchases, investors seeking higher returns move to corporate bonds, increasing demand and pushing those prices up as well. D is incorrect because Fed purchases lower yields, not raise them. The Fed is adding demand (buying securities), which increases prices and decreases yields across the bond market.

B is correct. Treasury securities and mortgage-backed securities (MBS) constitute the vast majority of the Federal Reserve's assets, representing over 95% of the balance sheet. The Fed accumulates these securities primarily through open market operations and quantitative easing programs. As of 2022, the Fed held over $8 trillion in these securities.

A (gold and foreign currency) represents a minimal portion of Fed assets, largely unchanged since the gold standard ended. These are historical holdings, not actively managed policy tools. C (discount window loans) fluctuates based on bank borrowing needs but typically represents a small fraction of total assets. The discount window is a short-term lending facility, not a major balance sheet component. D is incorrect because the Fed does not hold corporate bonds or equity securities. The Fed is authorized to purchase only U.S. government securities (Treasuries) and agency MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Purchasing corporate debt or equities is outside the Fed's legal mandate.

C is correct. When the Fed allows securities to mature without replacement (quantitative tightening or balance sheet runoff), it removes its demand from the bond market. As a major buyer steps away, there is less demand for bonds, which puts upward pressure on yields (interest rates). This is contractionary monetary policy designed to tighten financial conditions and combat inflation.

A is incorrect because balance sheet reduction decreases the money supply, not increases it. When securities mature, the Fed receives principal payments and effectively removes that money from circulation by not reinvesting it. This drains liquidity from the banking system. B is incorrect because reduced Fed demand puts upward pressure on interest rates, not downward. While bonds become more scarce on the Fed's balance sheet, the overall market supply increases relative to demand, pushing prices down and yields up. D is incorrect because the Fed is explicitly NOT replacing maturing securities with new purchases. Balance sheet runoff means allowing assets to roll off without reinvestment, which decreases bank reserves, not increases them.

D is correct (the EXCEPT answer). The Federal Reserve does NOT require Congressional approval to expand its balance sheet. The Fed operates independently and can conduct open market operations (buying and selling securities) at the discretion of the Federal Open Market Committee (FOMC). This independence is fundamental to the Fed's ability to conduct monetary policy without political interference.

A is accurate: the Fed's balance sheet grew from approximately $900 billion in 2007 to over $4.5 trillion by 2015 through multiple rounds of quantitative easing (QE1, QE2, QE3, Operation Twist). Additional expansion occurred during the COVID-19 pandemic, reaching over $8 trillion by 2022. B is accurate: the majority of Fed assets are U.S. Treasury securities and agency mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. These are purchased in the open market as part of monetary policy operations. C is accurate: the Fed's primary liabilities are currency in circulation (Federal Reserve notes, i.e., paper dollars) and reserve balances that commercial banks hold at the Fed. When the Fed buys securities, it credits bank reserve accounts, increasing liabilities to match the asset purchases.

B is correct. Statements 1, 2, and 4 are accurate.

Statement 1 is TRUE: Balance sheet expansion through securities purchases is the definition of quantitative easing (QE), which is an expansionary (stimulative) monetary policy. The Fed uses QE when traditional interest rate cuts are insufficient or when rates are already near zero.

Statement 2 is TRUE: When the Fed purchases securities, it pays by crediting the reserve accounts of commercial banks. This directly increases bank reserves (a Fed liability) and injects liquidity into the financial system. Higher reserves give banks more capacity to lend, expanding the money supply.

Statement 3 is FALSE: Balance sheet expansion through QE puts downward pressure on interest rates, not upward. By purchasing massive quantities of bonds, the Fed increases demand for bonds, which raises prices and lowers yields. This was the intended effect: to push long-term interest rates down and make borrowing cheaper to stimulate economic activity.

Statement 4 is TRUE: The Fed explicitly conducted this balance sheet expansion in March 2020 and beyond as an emergency response to the COVID-19 pandemic and resulting economic shutdown. The policy was designed to ensure market functioning, lower borrowing costs, and support economic recovery during an unprecedented crisis.