Principles of Macroeconomics - Monetary Policy Practice Set

Fill in the Blanks

1. The fact that money can be immediately used in exchange, whereas valuable jewelry cannot, illustrates the fact that money is very _________.

2. The measure of the money supply that includes currency in circulation and checking accounts is called __________.

3. The percentage of deposits that the Central Bank orders banks to keep in their vaults or in deposits at the Central Bank is called ________________.

4. When the central bank buys or sells government bonds on the open market, it is conducting ____________.

5. Suppose the Central Bank buys bonds on the open market. By doing so, it is increasing the _______________ which is the currency in circulation plus bank reserves.

6. The ratio of the money supply to the monetary base is called the _______________

7. The interest rate that the Central Bank charges banks on overnight loans it makes to banks so they can to meet their reserve requirements is called the ______________.

8. A financial instrument that commits its seller to pay a fixed amount every year, in addition to repaying the amount of the principal on a particular date in the future, in return for the loan of funds, is called a _______________.

9. The nominal interest rate minus inflation is the ______________.

10. When the central bank sells securities to commercial banks, the Total or Actual Reserves______________ by the amount of __________________.

True or False

1. When a government finances its expenditures by printing money rather than collecting taxes, this can lead inflation.

2. Nelson takes a $100 bill he had in his wallet and deposits it into his checking account. Thus, M1 increases by $100.

3. The most common monetary policy tool used by the Central Bank is changing the discount rate.

4. A contractionary or "tight" money policy entails a decrease in the money supply, M1, leading to a lower interest rate.

5. When the Central Bank conducts open market operations, it is either trying to keep the federal funds rate at its existing level, or trying to push the federalal funds rate up or down.

6. Increases in the legal reserve requirement increase the amount of money the banking system can create.

7. Checkable deposits are the bank's asset; the loan it makes possible is the bank's liability.

8. If a bank is allowed to lend $900 on a new deposit of $1,000, then the reserve requirement ratio is 0.10

9. The potential money creation associated with a new deposit may be larger than the actual money creation because not all of the money that is made available for loans is actually loaned out

10. Banks keep all of their checking deposits as reserves.

Problems

1. Suppose the Central Bank buys $5 million worth of government bonds from TrustMe bank.
a. Show the changes in the Central Bank's Balance sheet, and the changes in TrustMe bank's balance sheet.
b. How much in new loans can TrustMe Bank make, given this change in its balance sheet? (Assume the borrowers deposit the amount they borrow in other banks.)
c. Assume that when the new loans are deposited in other banks in the banking system, all these banks loan out all of their excess reserves. Assume further that the money multiplier equals 2. By how much has the money supply increased from the Central Bank's bond purchase?

2. Suppose you received a gift of $2000 cash on your 21st birthday. Further suppose you used it to purchase a bond with no expiration date that pays annual interest of $100.
a. What is the annual yield rate on your bond?
b. What will be the market price of your bond if the interest rate on newly issued bonds of similar risk rises to 6%?
c. Alternatively, what will be the market price of your bond if the interest rate on newly issued bonds of similar risk falls to 4%?

Multiple Choice Questions

1. Which of the following is not a reason why an unexpected bout of inflation is harmful to an economy?
a. It wipes out the value of people's savings.
b. It hurts people on fixed incomes, such as retired people who receive non-indexed pensions.
c. It redistributes wealth from debtors to creditors.
d. It creates menu costs.
e. It creates uncertainty, which makes financial planning for the future more difficult.

2. Which of the following is the most liquid?
a. A $20 bill in your pocket
b. A gold necklace
c. Three shares of Microsoft stock
d. A savings account in your bank.
e. A new Toyota Prius automobile

3. Which of the following is not one of the characteristics necessary for commodity money to be used as money?
a. It must be durable.
b. It must be portable.
c. It must be generally acceptable.
d. It must be differentiated.
e. It must be scarce.

4. Suppose Tabatha takes $500 from her savings account and deposits it in her checking account. What is the change in M1 and M2?
a. M1 increases and M2 decreases
b. M1 increases and M2 remains unchanged
c. M1 and M2 both increase
d. M2 increases and M1 remains unchanged
e. M1 and M2 both remain unchanged

5. Which of the following is not one of the functions of the Central Bank?
a. Performing banking functions for private banks
b. Issuing bonds
c. Regulating banks
d. Promoting confidence and stability in the financial sector
e. Conducting monetary policy.

6. An open market purchase by the State Bank of Pakistan (SBP)
a. increases bank reserves, loans, and deposits, and thus increases the money supply.
b. decreases bank reserves, loans, and deposits, and thus decreases the money supply.
c. increases bank reserves, loans, and deposits, and thus decreases the money supply.
d. decreases bank reserves, loans, and deposits, and thus increases the money supply.
e. None of the above.

7. Suppose the SBP buys $15 million worth of government bonds from CrazyBank. Which of the following is CrazyBank most likely to do?
a. Reduce its outstanding loans by $15 million.
b. Borrow more reserves from SBP
c. Borrow more reserves from other banks.
d. Make new loans totaling about $15 million.
e. None of the above

8. Suppose SBP makes an open market purchase of $3 million from commercial banks. Assume that the money multiplier equals 2. What is the change in the money supply?
a. The money supply has increased by $1.5 million.
b. The money supply has increased by $6 million.
c. The money supply had decreased by $1.5 million.
d. The money supply has decreased by $6 million.
e. None of the above.

9. Suppose SBP makes an open market sale of $8 million in bonds to commercial banks. Assume the money multiplier is equal to 2. What is the change in the money supply?
a. The money supply has increased by $4 million.
b. The money supply has decreased by $4 million.
c. The money supply has increased by $16 million.
d. The money supply has decreased by $16 million.
e. None of the above.

10. Which of the following is not one of the Central Bank's monetary policy tools?
a. Buying bonds on the open market
b. Selling bonds on the open market
c. Raising or lowering taxes
d. Raising or lowering the reserve requirement ratio
e. Raising or lowering the discount rate

11. Suppose the Central Bank wanted to engage in an expansionary monetary policy. Which of the following should it do?
a. Sell bonds on the open market.
b. Increase the reserve requirement ratio.
c. Increase the discount rate.
d. Buy bonds on the open market.
e. Lower taxes.

12. The rate determined in the private market for overnight loans of reserves among banks is called the
a. federal funds rate b. discount rate c. prime rate d. interest rate e. None of the above.

13. Which of the following best describes the sequence of events in the conduct of contractionary monetary policy using open market operations?
a. The Central Bank raises the interest rate, which leads to a decrease in investment spending and a decrease in the supply of federal funds, which decreases aggregate demand and output.
b. The Central Bank decreases investment spending, which leads to a decrease in aggregate demand and output, and a decrease in the supply of federal funds and the interest rate.
c. The Central Bank sells bonds, which decreases the supply of federal funds, which raises the interest rate, which leads to a decrease in intended investment spending, aggregate demand and output.
d. The Central Bank buys bonds, which increases the supply of federal funds, which lowers the interest rate, and leads to a decrease in intended investment spending and aggregate demand and output.
e. The Central Bank lowers the interest rate, which leads to an increase in intended investment spending and an increase in the supply of federal funds, which decreases aggregate demand and output.

14. What happens to bond prices and their interest rate when the Central Bank makes a sizeable open market purchase?
a. The price of bonds rises and their interest rate falls.
b. The price of bonds falls and their interest rate rises.
c. The price of bonds rises and their interest rate rises.
d. The price of bonds falls and their interest rate falls.
e. The price of bonds and their interest rate remain unchanged.

15. What is the difference between the nominal and real interest rate?
a. The nominal interest rate is the real interest rate minus the rate of inflation.
b. The real interest rate is the nominal rate plus the rate of inflation.
c. The real interest rate is the nominal rate minus the rate of inflation.
d. The nominal interest rate is the real interest rate plus the rate of inflation.
e. There is no difference between real and nominal interest rates.