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Macroeconomics (Acemoglu/Laibson/List) Chapter 11 The Monetary System 11.1 Money 1) When an asset is traded for goods and services it is serving the function of a ________. A) store of value B) unit of account C) loanable fund D) medium of exchange Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Functions of Money 2) When an asset enables people to transfer purchasing power into the future it serves the function of a ________. A) store of value B) unit of account C) medium of exchange D) means of deferred payment Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Functions of Money 3) When an asset is used as a universal yardstick that is used for expressing the worth of different goods and services, it is serving the function of a ________. A) store of value B) unit of account C) medium of exchange D) loanable fund Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Functions of Money 1 Copyright © 2015 Pearson Education, Inc. 4) Which of the following statements is true? A) One of the limitations of using money is that it does not allow for the transfer of purchasing power into the future. B) The necessary condition required for money to function as a medium of exchange is that it also needs to be a store of value. C) Hours of labor that go into producing a product is a better unit of account than paper money. D) When money is used as a yardstick to describe the price of various goods and services, it is serving as a store of value. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Functions of Money 5) Anne works as a babysitter. She uses her wage as a babysitter to buy a pair of roller skates. In this case, money served the function of ________. A) a medium of exchange B) a store of value C) a unit of account D) a means of deferred payment Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: The Functions of Money 6) Ryan saved $50,000 last year in his bank account so that he could buy a car this year. In this case, money served the function of a ________. A) medium of exchange B) store of value C) unit of account D) means of deferred payment Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: The Functions of Money 7) Which of the following statements is true of money? A) Paper money was invented around 1,000 A.D. in China. B) Fiat money was used in the barter system of exchange. C) Paper money was the first form of money to be invented. D) One of the limitations of paper money is that it does not function as a store of value. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Types of Money 2 Copyright © 2015 Pearson Education, Inc. 8) ________ money refers to something that is used as money but that is otherwise worthless and typically has the backing of the government or a central bank. A) Commodity B) Fiat C) Representative D) Federal Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Types of Money 9) The paper currency that is currently being used in the U.S. is an example of ________ money. A) hard B) fiat C) commodity D) price-indexed Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Types of Money 10) In theory, any object ________ could play the role of fiat money. A) that has an unlimited demand B) for which demand is limited C) in unlimited supply D) in limited supply Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: Types of Money 11) Which of the following is true of fiat money? A) Fiat money is not backed by a physical commodity. B) Fiat money is illegal and difficult to counterfeit. C) The technology required to produce fiat money is not widely available. D) The raw materials required for the production of fiat money are available only in a few countries. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Types of Money 3 Copyright © 2015 Pearson Education, Inc. 12) The paper currency used by the U.S. at the beginning of the Civil War was referred to as a demand note because: A) it was used to create the demand for various goods and services. B) demand for the currency was kept constant over the entire period of Civil War. C) the currency could be exchanged for gold on demand. D) it was limited in supply, and there was always an excess demand for the currency in the country. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Non-Convertible Currencies in U.S. History 13) The "gold-standard" is a system in which: A) paper currency is backed by gold. B) people use gold as a medium of exchange. C) gold mining firms own the right to print currency. D) gold is imported into the U.S. in exchange of paper currency. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Non-Convertible Currencies in U.S. History 14) M2 adds together: A) currency in circulation, savings accounts, and held with foreigners. B) currency in circulation, checking accounts, savings accounts, travelers' checks, and money market accounts. C) currency in circulation, checking accounts, savings accounts, travelers' checks, and currency held with foreigners. D) currency in circulation and currency held with foreigners. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Money Supply 15) In the United States, money supply is most commonly referred to as ________. A) M1 B) M2 C) M3 D) M4 Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Money Supply 4 Copyright © 2015 Pearson Education, Inc. 16) Which of the following statements is true? A) Currency in circulation in any economy is likely to be equal to the total money supply in the economy. B) Currency in circulation in any economy is likely to be less than the total money supply in the economy. C) In the United States, currency in circulation accounts for more than 50% of the total money supply. D) In the United States, currency in circulation accounts for less than 1% of the money supply. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Money Supply 17) Sheena gets her paycheck on the first day of every month and spends it over the month to purchase various goods and services. What are the functions that money is performing in this case? Answer: Since Sheena is using money as means to purchase goods and services, it is acting as a medium of exchange. Moreover, she receives her salary on the first of every month and spends it over the month. This implies, money is also acting as a store of value. Difficulty: Medium AACSB: Application of Knowledge Topic: The Functions of Money 18) What is the main difference between the type of money that was used before the invention of the printing press and today? Answer: In the days before the invention of the printing press, most societies used something that is valuable itself as money, for example, gold, silver, chickens, and even goats. Today, in most of the world, money is fiat money. Fiat money refers to something that is used as money but is otherwise worthless and is typically backed by the government or the central bank of a country. Difficulty: Medium AACSB: Analytical Thinking Topic: Types of Money 19) Is there any risk involved in using fiat money? How can it be minimized? Answer: One of the problems of using fiat money is that since it is actually worthless, it is easy to counterfeit. Hence, the risk of counterfeiting fiat money and using it to purchase goods and services is comparatively higher. This problem is partially resolved by having the supply of money controlled by the government. The government can create fiat money that is difficult and illegal to counterfeit. Difficulty: Medium AACSB: Analytical Thinking Topic: Types of Money 5 Copyright © 2015 Pearson Education, Inc. 20) If the money supply in an economy is $100,000, currency in circulation is $50,000, amount in savings accounts is $18,000, travelers' checks is $12,000, and the amount in money market accounts is $9,000, then what is the amount held in checking accounts in the economy? Answer: The total money supply in an economy is the sum of currency in circulation, amount in savings accounts, amount in checking accounts, travelers' checks, and the amount in money market accounts. Hence, the amount in checking accounts is $100,000 - $50,000 - $18,000 $12,000 - $9,000 = $11,000. Difficulty: Medium AACSB: Application of Knowledge Topic: The Money Supply 11.2 Money, Prices, and GDP 1) Which of the following statements correctly highlights a difference between real GDP and nominal GDP? A) Real GDP includes the value of goods and services produced by foreign firms, while nominal GDP does not. B) Real GDP includes the value of goods and services produced by domestic firms in foreign countries, while nominal GDP does not. C) Real GDP strips out the effect of changing prices on the value of goods and services produced, while nominal GDP does not. D) Real GDP does not take into account the value of goods produced and also services provided, while nominal GDP takes these into account. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Nominal GDP, Real GDP, and Inflation 2) Consider an economy that only produces wooden chairs. In 2012, the economy produced 100 wooden chairs priced at $10 each. The nominal GDP of the economy for the year 2012 will be: A) $10. B) $100. C) $1,000. D) $10,000. Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 6 Copyright © 2015 Pearson Education, Inc. Consider an economy that produces only cell phones. In the year 2012, the economy manufactures 275 cell phones, and each cell phone sells at $200. In the year 2013, the economy manufactures 280 cell phones but the price of each cell phone falls to $180. 3) Refer to the scenario above. What is the nominal GDP of the economy in 2012? A) $47,000 B) $49,500 C) $55,000 D) $56,000 Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 4) Refer to the scenario above. What is the nominal GDP of the economy in 2013? A) $47,000 B) $50,000 C) $50,400 D) $55,000 Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 5) Refer to the scenario above. Using 2012 as the base year, what is the real GDP of the economy in 2013? A) $47,000 B) $49,500 C) $55,000 D) $56,000 Answer: D Difficulty: Medium AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 6) Refer to the scenario above. Using 2012 as the base year, what is the real GDP of the economy in 2012? A) $45,000 B) $55,000 C) $57,500 D) $75,000 Answer: B Difficulty: Medium AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 7 Copyright © 2015 Pearson Education, Inc. 7) Refer to the scenario above. Using 2013 as the base year, what is the real GDP of the economy in 2012? A) $40,500 B) $49,500 C) $50,000 D) $52,500 Answer: B Difficulty: Medium AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 8) A researcher finds that for an economy, the nominal GDP in the year 2012 equals the nominal GDP in the year 2013. He also finds that the output of the economy has been the same over the two years. A situation like this is possible only if: A) the annual inflation rate in the economy is negative. B) the annual inflation rate in the economy is zero percent. C) the annual interest rate in the economy is negative. D) the annual interest rate in the economy is zero percent. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: Nominal GDP, Real GDP, and Inflation 9) Which of the following equations is correct? A) Growth Rate of Nominal GDP = Inflation - Growth Rate of real GDP B) Growth Rate of Nominal GDP = Inflation + Growth Rate of real GDP C) Growth Rate of Nominal GDP = Inflation/Growth Rate of Interest Rates D) Growth Rate of Nominal GDP = Growth Rate of Interest Rates/Inflation Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Nominal GDP, Real GDP, and Inflation 10) If the growth rates of nominal GDP and real GDP in an economy are 6% and 2% respectively, the inflation rate in the economy must be: A) 2%. B) 3%. C) 4%. D) 8%. Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 8 Copyright © 2015 Pearson Education, Inc. 11) If the growth rate of nominal GDP and the rate of inflation in an economy are 4% and 1% respectively, the growth rate of real GDP in the economy must be: A) 1%. B) 3%. C) 4%. D) 5%. Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 12) If the growth rate of real GDP and the rate of inflation in an economy are 2% and 1% respectively, the growth rate of nominal GDP in the economy must be: A) 1%. B) 2%. C) 3%. D) 5%. Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Nominal GDP, Real GDP, and Inflation 13) Consider an economy over the years 2008 and 2009. The output in the economy has remained constant over the two years but the prices of all goods and services have halved. In such a situation, A) the nominal GDP of the economy increases over the two years. B) the nominal GDP of the economy remains the same over the two years. C) the real GDP of the economy increases over the two years. D) the real GDP of the economy stays the same over the two years. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: Nominal GDP, Real GDP, and Inflation 14) The quantity theory of money assumes a constant ratio of ________. A) real GDP to nominal GDP B) money supply to nominal GDP C) money supply to real GDP D) money demand to money supply Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Quantity Theory of Money 9 Copyright © 2015 Pearson Education, Inc. 15) The quantity theory of money: A) assumes that the ratio of money supply to nominal GDP increases over time. B) assumes that the ratio of money supply to nominal GDP decreases over time. C) is an exact representation of how the economy behaves in the long-run. D) is a representation of how a change in money supply affects the price level in an economy. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Quantity Theory of Money 16) The ratio of nominal GDP to money supply is referred to as: A) price index. B) Fischer's ratio. C) velocity. D) inflation ratio. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Quantity Theory of Money 17) Velocity of money is the ratio of ________. A) nominal GDP to money demand B) real GDP to money demand C) money supply to money demand D) nominal GDP to money supply Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Quantity Theory of Money 18) If two variables have the same rate of growth over the long run, their ratio will: A) increase over the long run. B) decrease over the long run. C) remain constant over the long run. D) initially decrease and then increase. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Quantity Theory of Money 10 Copyright © 2015 Pearson Education, Inc. 19) The quantity theory of money implies that: A) growth rate of money demand = growth rate of money supply. B) growth rate of money supply = growth rate of nominal GDP. C) growth rate of money supply = growth rate of real GDP. D) growth rate of currency in circulation = growth rate of the price level Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Quantity Theory of Money 20) According to the quantity theory of money, if the growth rate of money supply is 6% and the growth rate of real GDP is 9%, then the growth rate of nominal GDP in the economy will be: A) 3%. B) 6%. C) 9%. D) 15%. Answer: B Difficulty: Medium AACSB: Application of Knowledge Topic: The Quantity Theory of Money 21) If the quantity theory of money holds, then in an economy, A) inflation = growth rate of money supply + growth rate of real GDP. B) inflation = growth rate of money supply - growth rate of real GDP. C) inflation = growth rate of money supply + growth rate of nominal GDP. D) inflation = growth rate of money supply - growth rate of nominal GDP. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Quantity Theory of Money 22) Consider an economy where the growth rate of real GDP is 6% and the annual rate of inflation is 2%. If the quantity theory of money holds, the growth rate of money supply in the economy will be: A) 2%. B) 4%. C) 6%. D) 8%. Answer: D Difficulty: Medium AACSB: Application of Knowledge Topic: The Quantity Theory of Money 11 Copyright © 2015 Pearson Education, Inc. 23) Consider an economy where the growth rate of real GDP is 6% and the growth rate of money supply is 8%. If the quantity theory of money holds, the inflation rate in the economy will be: A) 2%. B) 6%. C) 8%. D) 14%. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Quantity Theory of Money 24) Consider an economy where the growth rate of money supply is 2% and the inflation rate is 2%. If the quantity theory of money holds, the growth rate of real GDP in the economy will be: A) 0%. B) 1%. C) 2%. D) 4%. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Quantity Theory of Money 25) The quantity theory of money implies that: A) inflation is equal to the gap between the growth rate of money supply and the current nominal interest rates. B) inflation is equal to the gap between the growth rate of money supply and the current real interest rates. C) inflation is equal to the gap between the growth rate of money supply and the growth rate of nominal GDP. D) inflation is equal to the gap between the growth rate of money supply and the growth rate of real GDP. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: The Quantity Theory of Money 12 Copyright © 2015 Pearson Education, Inc. 26) According to the quantity theory of money: A) when the gap between the growth rate of money supply and the growth rate of real GDP widens, inflation increases. B) when the gap between the growth rate of money supply and the growth rate of real GDP widens, inflation decreases. C) when the gap between the growth rate of money supply and the growth rate of real GDP widens, real interest rates increase. D) when the gap between the growth rate of money supply and the growth rate of real GDP widens, nominal interest rates decrease. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Quantity Theory of Money 27) Consider two economies: A and B. If the gap between the growth rate of money supply and growth rate of real GDP is larger in country A than in country B, then according to the quantity theory of money: A) the inflation rate will be higher in country A. B) the inflation rate will be lower in country A. C) real interest rates will be higher in country A. D) nominal interest rates will be lower in country A. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Quantity Theory of Money 28) Which of the following statements is true of the quantity theory of money? A) The theory is applicable only in the short run. B) Predictions of the theory can be verified with data. C) The theory states that inflation will always be positive. D) The theory explains the relationship between growth in real GDP and changes in nominal interest rates. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Quantity Theory of Money 13 Copyright © 2015 Pearson Education, Inc. 29) Why is real GDP a more accurate measure of the level of production in an economy than nominal GDP? Explain with an example. Answer: Consider an economy that produces only apples. If the price of apples in 2001 is $1 and the economy produces 10 apples, the nominal GDP of the economy is $10. Now, suppose in 2002, the price of apples doubles without any change in production. In this case, the nominal GDP of the economy in 2002 is $20. However, real GDP in both years is $10 if year 2001 is taken as the base year. So, according to real GDP, output has not changed between the two years. Hence, the real GDP, which accounts for inflation, is a more accurate measure of the level of production than nominal GDP. Difficulty: Medium AACSB: Analytical Thinking Topic: Nominal GDP, Real GDP, and Inflation 30) What does the quantity theory of money imply? If the growth rate of money supply and growth rate of real GDP in an economy are 8% and 6%, respectively, then what is the inflation rate in the economy? Answer: The quantity theory of money implies that inflation is equal to the gap between the growth rate of money supply and real GDP. In this case, inflation rate = growth rate of money supply - growth rate of real GDP = 8% - 6% = 2%. Difficulty: Medium AACSB: Application of Knowledge Topic: The Quantity Theory of Money 31) Suppose an economy's money supply is fixed at $4,000 and its nominal GDP is $800,000. Calculate the velocity of money. Answer: According to the quantity theory of money, the velocity of money is obtained by dividing nominal GDP by money supply. In this case, the velocity of money is $800,000/$4,000 = 50. Difficulty: Hard AACSB: Application of Knowledge Topic: The Quantity Theory of Money 14 Copyright © 2015 Pearson Education, Inc. 32) i) The growth rate of Eduland's money supply in a particular year was 8.5%. What was the growth rate of real GDP if the inflation rate in the same year was 4%? ii) What is likely to happen if the growth rate of money supply doubles in the following year, while the growth rate of real output remains unchanged? Answer: i) According to the quantity theory of money, the ratio of money supply to nominal GDP is constant. Therefore, the rate of growth of money supply must equal the rate of growth of nominal GDP. However, growth rate of nominal GDP is the sum of growth rate of real GDP and the inflation rate. Thus, Rate of Growth in Money Supply = Rate of Growth in Real GDP + Inflation Rate. Thus, the growth rate of real GDP in this case is 8.5% - 4% = 4.5%. ii) If the growth rate of money supply doubles in the following year and the growth rate of real output remains unchanged, the inflation rate will also double. Difficulty: Hard AACSB: Application of Knowledge Topic: The Quantity Theory of Money 11.3 Inflation 1) The rate at which a price index decreases is referred to as the: A) deflation rate. B) depreciation rate. C) cross inflation rate. D) reverse inflation rate. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Inflation 2) Data confirms that the quantity theory of money: A) holds in the long run. B) holds only in the short run. C) holds both in the long run and the short run. D) does not hold either in the short run or in the long run. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: What Causes Inflation? 15 Copyright © 2015 Pearson Education, Inc. 3) Assume that the inflation rate in an economy is measured on the vertical axis and the annualized growth rate of money supply minus the annualized growth rate of real GDP is measured on the horizontal axis on a graph. If a curve is plotted to establish the relationship between both variables, the curve is likely to be: A) vertical. B) horizontal. C) upward sloping. D) downward sloping. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: What Causes Inflation? 4) Which of the following is likely to happen if the annualized growth rate of money supply increases while real GDP remains unchanged? A) The inflation rate will rise. B) The inflation rate will fall. C) The nominal GDP will fall. D) The unemployment rate will rise. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: What Causes Inflation? 5) Which of the following statements best defines hyperinflation? A) It is a situation when the annual rate of inflation in an economy is between 0% to 10%. B) It is a situation when the annual rate of inflation in an economy is between 10% to 20%. C) It is a situation when the annual rate of inflation in an economy is between 20% to 50%. D) It is a situation when the annual rate of inflation in an economy exceeds 50%. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: What Causes Inflation? 6) Hyperinflationary episodes are always related to extremely rapid growth of: A) real GDP. B) interest rates. C) money supply. D) money demand. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: What Causes Inflation? 16 Copyright © 2015 Pearson Education, Inc. 7) One of the main reasons behind hyperinflation episodes is: A) high tax rates. B) large government budget deficits. C) a decrease in real GDP. D) a decrease in the demand for consumer goods. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: What Causes Inflation? 8) Printing money to meet government budget deficits: A) helps combat inflation. B) increases the demand for money. C) increases real income. D) acts as a tax on the citizens in an economy. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: What Causes Inflation? 9) The great German hyperinflation during 1922-1923 can be attributed to the: A) absence of financial intermediaries in Germany. B) German government printing money to pay bills. C) emergence of large number of monopolies in Germany. D) economic policy that restricted the import of goods into Germany. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: What Causes Inflation? 10) The cost of inflation will be minimized if: A) the growth rate of inflation exceeds the rate of growth of wages. B) the growth rate of inflation equals the rate of growth of wages. C) money supply is increased during times of high inflation. D) taxes are increased during the periods of high inflation. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Consequences of Inflation 17 Copyright © 2015 Pearson Education, Inc. 11) Business's cost of changing prices is referred to as: A) shoeleather costs. B) menu costs. C) intangible costs. D) inflation tax. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Social Costs of Inflation 12) A worker has negotiated a nominal wage contract with his employer for a period of 3 years. Which of the following will happen if the rate of inflation rises beyond the worker's expectation during this period? A) The worker will be better off. B) The worker will be worse off. C) The worker's real wage will increase. D) The company's shareholders will be worse off. Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: The Consequences of Inflation 13) A retired worker receives a pension that is not indexed to inflation. Which of the following will happen if the rate of inflation rises? A) The retiree will be better off. B) The retiree's purchasing power will fall. C) The retiree's purchasing power will increase. D) The shareholders of the firm in which he worked will lose. Answer: B Difficulty: Medium AACSB: Application of Knowledge Topic: The Consequences of Inflation 14) Suppose you have borrowed money from a bank to buy a house. Which of the following will happen if the inflation rate unexpectedly rises? A) You will be better off. B) You will be worse off. C) The bank's shareholders will be better off. D) The real cost of your mortgage will rise. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Consequences of Inflation 18 Copyright © 2015 Pearson Education, Inc. 15) When prices rise: A) money demand tends to fall. B) money supply tends to rise. C) menu costs tend to fall. D) consumers' purchasing power falls. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: The Social Costs of Inflation 16) Economists often refer to the government revenue obtained from money creation as: A) liquid revenue. B) an inflation tax. C) windfall revenue. D) a supplementary tax. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 17) Government revenue from printing money is referred to as: A) seigniorage. B) menu costs. C) shoeleather costs. D) excise tax Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 18) One advantage of using an inflation tax over other methods of tax collection is that: A) the revenue from inflation tax is extremely high. B) the collection of inflation tax is more organized. C) people who evade other taxes also feel the burden of an inflation tax. D) inflation tax only affects individuals with a high income. Answer: C Difficulty: Hard AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 19 Copyright © 2015 Pearson Education, Inc. 19) A government that generates revenue mostly through an inflation tax faces the risk of: A) hyperinflation. B) mass tax evasion. C) rapidly falling prices. D) a sudden fall in revenue. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 20) Assuming all else equal, inflation can: A) reduce the real interest rate, and increase the real wage rate. B) increase the real interest rate, and reduce the real wage rate. C) reduce both the real interest rate and the real wage rate. D) increase both the real interest rate and the real wage rate. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 21) If real wages fall: A) consumer demand is likely to increase. B) employers are likely to hire more workers. C) the level of economic production will always decrease. D) the level of economic production will always increase. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 22) Which of the following statements correctly identifies a reason why inflation can be used as a countercyclical policy tool? A) Inflation reduces money costs and hence stimulates an economy during slowdowns. B) Inflation increases consumer demand which is necessary for combating slowdowns. C) Inflation sometimes increases the demand for workers that increases output and helps combat slowdowns. D) Inflation increases consumer confidence, which is an absolute necessity to counter act business cycles. Answer: C Difficulty: Hard AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 20 Copyright © 2015 Pearson Education, Inc. 23) How does inflation act as a tax? Answer: Rapidly printing money leads to an increase in the growth rate of money supply that exceeds growth rate of real GDP. This results in inflation in the economy. A higher inflation rate further reduces the buying power of currency. Hence, printing currency reduces the buying power of currency by reducing its value among consumers and producers, but increases the revenue of the government in the form of newly printed notes. Difficulty: Medium AACSB: Analytical Thinking Topic: What Causes Inflation? 24) State two social benefits of inflation. Answer: The social benefits of inflation are as follows: a) Inflation caused by money creation acts as an implicit tax. It increases the government's revenue by transferring purchasing power from consumers and producers in an economy to the government. b) Inflation can temporarily reduce the real interest rate and the real wage rate. This increases an employer's willingness to hire more and produce more. Difficulty: Medium AACSB: Analytical Thinking Topic: The Social Benefits of Inflation 25) The prices of several essential goods in Agraria almost doubled over the last decade. In order to satisfy the voters, the government of Agraria introduced price controls. What is likely to happen after the introduction of these price controls? Answer: Inflation generates voter anger, and politicians sometimes respond by advancing economically destructive schemes, especially price controls. In most of these cases, the policy cure is worse than the disease. Price controls cause problems like long lines and supply disruptions. In addition, price controls are partially undone when some of those consumers who are lucky enough to obtain the good at the official capped price, resell it at a higher price in the underground economy. Hence, price controls create an inefficient incentive for consumers who don't want to consume the good to buy it anyway, just so they can resell it to someone else at a higher price. This is what is most likely to happen in Agraria. Difficulty: Medium AACSB: Application of Knowledge Topic: The Social Costs of Inflation 21 Copyright © 2015 Pearson Education, Inc. 11.4 The Federal Reserve 1) The U.S. central bank is the government institution that: A) controls the money supply and invests in foreign assets. B) monitors financial institutions, controls the money supply, and invests in foreign assets. C) monitors financial institutions, controls the money supply, and sets certain key interest rates. D) monitors financial institutions, controls the money supply, sets certain key interest rates, and decides on political targets. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Central Bank and the Objectives of Monetary Policy 2) In the United States, the central bank is called the: A) Bank of America. B) Federal Reserve Bank. C) Reserve Bank of America. D) National Bank of America. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Central Bank and the Objectives of Monetary Policy 3) The two key objectives of the Fed are: A) low and predictable levels of inflation, and interest rates above 10%. B) zero inflation, and zero unemployment. C) low and predictable levels of inflation, and zero unemployment. D) low and predictable levels of inflation, and maximum levels of employment. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Central Bank and the Objectives of Monetary Policy 4) The policy of attempting to obtain a specific low level of inflation over the long run is referred to as: A) price control. B) inflation targeting. C) the seigniorage policy. D) the minimal inflation policy. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Central Bank and the Objectives of Monetary Policy 22 Copyright © 2015 Pearson Education, Inc. 5) The European Central Bank: A) lays more emphasis on controlling inflation than on controlling employment. B) lays more emphasis on controlling employment than on controlling inflation. C) emphasizes maintaining interest rates below 5%. D) emphasizes maintaining unemployment rates below 5%. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Central Bank and the Objectives of Monetary Policy 6) Which of the following is a role played by the Fed in the U.S. economy? A) It acts as a direct source of funds for new businesses and startups. B) It takes political decisions during periods of recessions. C) It acts as a lender of the last resort in case of bank runs. D) It determines the import duty on raw materials being imported into the country. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: What Does the Central Bank Do? 7) Which of the following tools does the Fed use to pursue its objectives? A) It influences short-run and long-run interest rates. B) It determines the efficient level of government spending. C) It influences market prices through price ceilings and price floors. D) It provides loans to new firms and businesses at extremely low rates of interest. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: What Does the Central Bank Do? 8) Which of the following is likely to happen when the Fed raises the federal funds rate? A) The long-run interest rate will fall. B) The volume of economic activity will increase. C) The labor demand curve shifts to the right. D) The labor demand curve shifts to the left. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: What Does the Central Bank Do? 23 Copyright © 2015 Pearson Education, Inc. 9) Which of the following is likely to happen when the interest rate falls? A) Equilibrium wage rate will fall. B) The labor demand curve will shift to the right. C) The volume of economic activity will reduce. D) The labor demand curve will shift to the left. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: What Does the Central Bank Do? 10) Which of the following statements is NOT a function of the Fed? A) It oversees interbank payment systems. B) It monitors the stockholders' equity of commercial banks. C) It regulates the various stock markets in the economy. D) It ensures that commercial banks report their assets and liabilities with accuracy. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Reserves 11) In the United States, if a customer at HDFC bank writes a check and the recipient of the check deposits the check in Citibank, then the check is cleared by: A) HDFC bank. B) the Fed. C) Citibank. D) either HDFC bank or Citibank. Answer: B Difficulty: Easy AACSB: Application of Knowledge Topic: Bank Reserves 12) Which of the following holds the reserves of private banks in the United States? A) The Fed B) The Pentagon C) The Treasury Department D) Various venture capitalists Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Reserves 24 Copyright © 2015 Pearson Education, Inc. 13) ________ refers to funds available for immediate payment. A) Velocity B) Liquidity C) Term deposits D) Mutual funds Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Reserves 14) A bank is said to have enough liquidity if: A) it holds deposits amounting to at least $100,000. B) it operates for seven days a week for more than 12 hours a day. C) the value of its assets exceeds the value of its liabilities by at least $50,000. D) it has enough funds to conduct its day-to-day businesses and meet the regulatory requirements. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: Bank Reserves 15) The federal funds market refers to the market where: A) banks obtain loans of reserves from each other. B) the federal government borrows overnight funds from the Fed. C) the Fed obtains loans of reserves from central banks of other nations. D) there are no predetermined rates of interest on loans and the highest bidding borrower gets the loan. Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Reserves 16) Which of the following statements is true of the federal funds market? A) No banks are refused loans in the federal funds market. B) In the federal funds market, banks with a shortage of reserves borrow funds, while banks with an excess of reserves lends them out. C) The interbank lending system works more efficiently in periods of financial panic than in periods of financial stability. D) Although the federal funds market aims to provide liquidity to needy banks, it is not very popular as overnight loans are logistically inefficient for large banks. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: Bank Reserves 25 Copyright © 2015 Pearson Education, Inc. 17) A commercial bank's last resort for borrowing reserves is from the: A) federal funds market. B) discount window. C) central government. D) foreign banks. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Obtaining Reserves Outside the Federal Funds Market 18) Which of the following statements is true? A) The discount window in the United States is operated by Citibank. B) The discount window is accessible only to well-performing banks. C) The discount window is operated only in periods of economic expansion. D) When banks borrow from the discount window, it is an admission of trouble. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Obtaining Reserves Outside the Federal Funds Market 19) The ________ is the interest rate that banks charge each other for overnight loans. A) spot interest rate B) federal funds rate C) discount window interest rate D) subsidized banking interest rate Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Reserves 20) The funds being lent in the federal funds market are: A) bank deposits of domestic households. B) reserves at the Fed. C) investments of foreign firms. D) tax revenue earned by the federal government. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Bank Reserves 26 Copyright © 2015 Pearson Education, Inc. 21) The demand curve for reserves is: A) vertical. B) horizontal. C) upward sloping. D) downward sloping. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 22) If a bank has $6 billion in reserves and loans $2 billion to another bank, then the total quantity of reserves demanded is: A) $2 billion. B) $4 billion. C) $6 billion. D) $8 billion. Answer: C Difficulty: Medium AACSB: Application of Knowledge Topic: The Demand Side of the Federal Funds Market 23) Which of the following is true of the quantity demanded of reserves? A) The quantity demanded of reserves is constant over time for almost every bank. B) The quantity demanded of reserves increases as the federal funds rate falls. C) The quantity demanded of reserves increases as the inflation rate increases. D) The quantity demanded of reserves increases at a constant rate over time. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 24) Which of the following changes will cause a downward movement along the demand curve for reserves? A) An increase in deposits held by banks B) A decrease in deposits held by banks C) An increase in the federal funds rate D) A decrease in the federal funds rate Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 27 Copyright © 2015 Pearson Education, Inc. 25) Which of the following is likely to happen to the demand curve for reserves if the federal funds rate increases? A) The demand curve for reserves will shift to the right. B) The demand curve for reserves will shift to the left. C) There will be a downward movement along the demand curve for reserves. D) There will be an upward movement along the demand curve for reserves. Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 26) Assuming all else equal, what is likely to happen to the demand curve for reserves in an economy if it goes through a period of rapid expansion? A) The demand curve for reserves will shift to the right. B) The demand curve for reserves will shift to the left. C) There will be a downward movement along the demand curve for reserves. D) There will be a n upward movement along the demand curve for reserves. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 27) Assuming all else equal, the demand curve for reserves in an economy shifts to the left. Which of the following could be a likely reason for this shift? A) Rapid expansion of the economy B) Rapid contraction of the economy C) An increase in the federal funds rate D) A decrease in the federal funds rate Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 28) Assuming all else equal, if there is a contraction in the quantity of bank account balances, it will cause: A) a downward movement along the demand curve for reserves. B) an upward movement along the demand curve for reserves. C) a leftward shift in the demand curve for reserves. D) a rightward shift in the demand curve for reserves. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 28 Copyright © 2015 Pearson Education, Inc. 29) Assuming all else equal, if a bank expects a bank run in the future: A) there will be a downward movement along its demand curve for reserves. B) there will be an upward movement along its demand curve for reserves. C) its demand curve for reserves will shift to the right. D) its demand curve for reserves will shift to the left. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 30) Which of the following will NOT cause a shift in the demand curve for reserves? A) Business cycles B) Liquidity shocks C) Changes in deposit base D) A change in the federal funds rate Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 31) The supply curve of reserves is: A) downward sloping. B) upward sloping. C) vertical. D) horizontal. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 32) The slope of the supply curve of reserves can be attributed to the fact that: A) the Fed fixes the supply of reserves. B) quantity supplied of reserves increases with the federal funds rate. C) quantity supplied of reserves decreases with the federal funds rate. D) the supply of reserves is arbitrarily set by the World Bank. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 29 Copyright © 2015 Pearson Education, Inc. 33) Everything else remaining unchanged, if the demand curve for reserves shifts to the right and borrowed reserves is zero: A) there will be an increase in both the federal funds rate and the quantity of reserves. B) there will be a decrease in both the federal funds rate and the quantity of reserves. C) there will be a decrease in the federal funds rate but no change in the quantity of reserves. D) there will be an increase in the federal funds rate but no change in the quantity of reserves. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 34) Everything else remaining unchanged, if the demand curve for reserves shifts to the left and borrowed reserves is zero: A) there will be an increase in both the federal funds rate and the quantity of reserves. B) there will be a decrease in both the federal funds rate and the quantity of reserves. C) there will be a decrease in the federal funds rate but no change in the quantity of reserves. D) there will be an increase in the federal funds rate but no change in the quantity of reserves. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 35) At the federal funds market equilibrium, A) both the federal funds rate and the total quantity of reserves tend to fall automatically. B) both the federal funds rate and the total quantity of reserves tend to rise automatically. C) the equilibrium quantity of reserves demanded is equal to the equilibrium quantity of reserves supplied by the Fed. D) the equilibrium quantity of reserves demanded exceeds the equilibrium quantity of reserves supplied by the Fed. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 36) Which of the following financial organizations have the ability to influence the supply of reserves in the United States? A) The Fed B) Only private commercial banks C) Only public sector banks D) The World Bank Answer: A Difficulty: Easy AACSB: Analytical Thinking Topic: The Fed's Influence on the Money Supply and the Inflation Rate 30 Copyright © 2015 Pearson Education, Inc. 37) When the Fed buys or sells government bonds to private banks in exchange for reserves, it is referred to as: A) moral suasion. B) reserve targeting. C) the Fed's dual mandate. D) open market operations. Answer: D Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 38) If the Fed sells government bonds in the open market, it will cause: A) a shift of the supply curve for reserves to the left. B) a shift of the supply curve for reserves to the right. C) an upward movement along the supply curve for reserves. D) a downward movement along the supply curve for reserves. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 39) If the Fed buys government bonds from the open market, it will cause: A) a shift of the supply curve for reserves to the left. B) a shift of the supply curve for reserves to the right. C) an upward movement along the supply curve for reserves. D) a downward movement along the supply curve for reserves. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 31 Copyright © 2015 Pearson Education, Inc. 40) Everything else remaining unchanged, what will happen if the Fed sells government bonds in the open market and borrowed reserves is zero? A) It will cause the equilibrium federal funds rate to rise, but no change in the equilibrium quantity of reserves. B) It will cause the equilibrium federal funds rate to fall, but no change in the equilibrium quantity of reserves. C) It will cause the equilibrium federal funds rate to rise and the equilibrium quantity of reserves to fall. D) It will cause both the equilibrium federal funds rate and equilibrium quantity of reserves to fall. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 41) Everything else remaining unchanged, what will happen if the Fed buys government bonds in the open market and borrowed reserves is zero? A) It will cause both the equilibrium federal funds rate and equilibrium quantity of reserves to fall. B) It will cause the equilibrium federal funds rate to fall and the equilibrium quantity of reserves to increase. C) It will cause the equilibrium federal funds rate to rise, but no change in the equilibrium quantity of reserves. D) It will cause the equilibrium federal funds rate to fall, but no change in the equilibrium quantity of reserves. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 42) If there is a change in the federal funds rate from a target rate due to an increase in the demand for reserves, the Fed can maintain the target by: A) causing the supply curve of reserves to shift to the left. B) causing the supply curve of reserves to shift to the right. C) causing an upward movement along the supply of reserves curve. D) causing a downward movement along the supply of reserves curve. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 32 Copyright © 2015 Pearson Education, Inc. 43) If there is a change in the federal funds rate from a target rate due to a decrease in the demand for reserves, the Fed can maintain the target by: A) causing the supply curve of reserves to shift to the left. B) causing the supply curve of reserves to shift to the right. C) causing an upward movement along the supply of reserves curve. D) causing a downward movement along the supply of reserves curve. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 44) If the nominal interest rate in an economy is 8% and the real interest rate is 4%, the inflation in the economy is: A) 4%. B) 8%. C) 12%. D) 32%. Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 45) If the nominal interest rate in an economy is 6% and the inflation rate in the economy is 10%, then the real interest rate is: A) -4%. B) -6%. C) 6%. D) 10%. Answer: A Difficulty: Easy AACSB: Application of Knowledge Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 46) In an economy, investment is most likely to be dependent on: A) the short-run real interest rate. B) the long-run real interest rate. C) the short-run nominal interest rate. D) the long-run nominal interest rate. Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 33 Copyright © 2015 Pearson Education, Inc. 47) The federal funds rate is a: A) short-term real interest rate. B) short-term nominal interest rate. C) long-term real interest rate. D) long-term nominal interest rate. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 48) Which of the following equations is correct? A) Realized real interest rate = nominal interest rate - realized nominal interest rate B) Realized real interest rate = nominal interest rate + realized inflation rate C) Realized real interest rate = nominal interest rate - realized inflation rate D) Realized real interest rate = realized inflation rate Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 49) If the realized real interest rate in an economy is 6%, the nominal interest rate is 8%, and the expected inflation rate is 8%, then the realized inflation rate in the economy is: A) 2%. B) 4%. C) 6%. D) 8%. Answer: A Difficulty: Medium AACSB: Application of Knowledge Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 50) If the realized real interest rate in an economy is 6%, the realized inflation rate is 8%, and the expected inflation rate is 8%, then the nominal interest rate in the economy is: A) 2%. B) 8%. C) 14%. D) 20%. Answer: C Difficulty: Medium AACSB: Application of Knowledge Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 34 Copyright © 2015 Pearson Education, Inc. 51) Which of the following equations is correct? A) Expected real interest rate = nominal interest rate + expected inflation rate B) Expected real interest rate = nominal interest rate/expected inflation rate C) Expected real interest rate = expected inflation rate/nominal interest rate D) Expected real interest rate = nominal interest rate - expected inflation rate Answer: D Difficulty: Easy AACSB: Analytical Thinking Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 52) If the nominal interest rate in an economy is 9% and the expected inflation rate is 6%, then the expected real interest rate in the economy is: A) 3%. B) 6%. C) 9%. D) 15%. Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 53) If the expected real interest rate in an economy is 6% and the expected inflation rate is 4%, then the nominal interest rate in the economy is: A) 4%. B) 6%. C) 10%. D) 14%. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 54) Changes in the federal funds rate: A) have no effect on the long-run expected interest rate. B) change the long-run expected interest rates in the same direction. C) change the long-run expected interest rates in the opposite direction. D) can change the long-run expected interest rate either in any direction depending on the magnitude of the change in the federal funds rate. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: The Federal Funds Rate and the Long-Run Expected Real Interest Rate 35 Copyright © 2015 Pearson Education, Inc. 55) The model of expectations in which the current level of inflation depends on past levels is referred to as: A) composite expectations. B) adaptive expectations. C) rational expectations. D) realized real expectations. Answer: B Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Two Models of Inflation Expectations 56) George believes that the inflation in this year will be around 9% because it was around 9% in the previous year. George can be said to have: A) marginal expectations. B) rational expectations. C) adaptive expectations. D) composite expectations. Answer: C Difficulty: Easy AACSB: Application of Knowledge Topic: Choice and Consequence: Two Models of Inflation Expectations 57) The model that states that individuals develop their inflation expectations after considering all the available information is referred to as the: A) composite expectations model. B) adaptive expectations model. C) rational expectations model. D) marginal expectations model. Answer: C Difficulty: Easy AACSB: Analytical Thinking Topic: Choice and Consequence: Two Models of Inflation Expectations 58) Before developing an expectation on inflation, Jenny reads through all available material on consumer price indexes and producer price indexes. Later she also reads through recent magazines and newspapers to identify factors that could affect the inflation rate in the coming days. Jenny can be said to have: A) adaptive expectations. B) rational expectations. C) marginal expectations. D) conditional expectations. Answer: B Difficulty: Medium AACSB: Application of Knowledge Topic: Choice and Consequence: Two Models of Inflation Expectations 36 Copyright © 2015 Pearson Education, Inc. 59) If there are no changes in inflation expectations, a fall in the federal funds rate: A) decreases the long-run nominal interest rate and increases the long-run expected interest rate. B) increases the long-run nominal interest rate and decreases the long-run expected interest rate. C) decreases both the long-run nominal interest rate and the long-run expected interest rate. D) increases both the long-run nominal interest rate and the long-run expected interest rate. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Federal Funds Rate and the Long-Run Expected Real Interest Rate 60) If there are no changes in inflation expectations, a sale of government bonds by the Fed in the open market will cause ________. A) both the federal funds rate and long-run expected real interest rate to rise B) both the federal funds rate and long-run expected real interest rate to fall C) the federal funds rate to rise and the long-run expected real interest rate to fall D) the federal funds rate to fall and the long-run expected real interest rate to rise Answer: A Difficulty: Medium AACSB: Analytical Thinking Topic: The Federal Funds Rate and the Long-Run Expected Real Interest Rate 61) If there are no changes in inflation expectations, a purchase of government bonds by the Fed in the open market will cause ________. A) both the federal funds rate and long-run expected real interest rate to rise B) both the federal funds rate and long-run expected real interest rate to fall C) the federal funds rate to rise and the long-run expected real interest rate to fall D) the federal funds rate to fall and the long-run expected real interest rate to rise Answer: B Difficulty: Medium AACSB: Analytical Thinking Topic: The Federal Funds Rate and the Long-Run Expected Real Interest Rate 62) Which of the following statements is true? A) The Fed has the power to dictate the volume of deposits held with commercial banks. B) The rate of inflation in the long run is equal to the rate of growth of real GDP minus the rate of growth of money supply. C) The Fed can influence the money supply in the economy by influencing the required amount of reserves. D) The Fed can reduce the growth of money supply by increasing the growth in bank reserves. Answer: C Difficulty: Medium AACSB: Analytical Thinking Topic: The Federal Funds Rate and the Long-Run Expected Real Interest Rate 37 Copyright © 2015 Pearson Education, Inc. 63) What is meant by the term "inflation targeting"? What is the Fed's objective regarding inflation? Answer: Inflation targeting refers to the policy of attempting to obtain a specific low level of inflation over the long run. The Fed aims to keep inflation low and predictable. Difficulty: Easy AACSB: Analytical Thinking Topic: The Central Bank and the Objectives of Monetary Policy 64) Why is the Fed referred to as the "lender of last resort"? Answer: Sometimes the federal funds market can fail. For example, during a financial panic, banks with excess reserves do not know who they can trust. They don't know which banks are solvent and which banks are not. Accordingly the banks with excess reserves may be unwilling to lend these reserves out. In such a crisis, the Fed can step in and provide reserves to the banks that need them and is hence referred to as the "lender of the last resort." Difficulty: Medium AACSB: Analytical Thinking Topic: Bank Reserves 65) Explain the shapes of the demand curve for reserves and the supply curve of reserves. Answer: The demand curve for reserves shows the relationship between the quantity of reserves demanded and the federal funds rate. It is a downward sloping curve. This is because a higher federal funds rate increases the cost of holding reserves and reduces the quantity of reserves demanded by optimizing banks. The supply of reserves is determined by the central bank of a nation. Hence, it is vertical. Difficulty: Medium AACSB: Analytical Thinking Topic: The Demand Side of the Federal Funds Market 66) What are open market operations? If the economy is experiencing a recession, what kind of open market operations should the Fed undertake? Answer: When the Fed buys or sells government bonds from/to private banks in exchange of reserves held by those private banks at the Fed, it is referred to as an open market operation. When an economy is going through a recession, the Fed should buy government bonds from private banks to stimulate the economy. Difficulty: Medium AACSB: Analytical Thinking Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 38 Copyright © 2015 Pearson Education, Inc. 67) Is there any difference between borrowing from the federal funds market and borrowing from the discount window? Explain. Answer: The federal funds market refers to the market where banks obtain overnight loans of reserves from one another. On the other hand, when banks are not granted funds from the federal funds market, they can borrow from the Fed. This is referred to as borrowing from the discount window. Difficulty: Medium AACSB: Analytical Thinking Topic: Choice and Consequence: Obtaining Reserves Outside the Federal Funds Market 68) Differentiate between the adaptive expectations and the rational expectations models of inflation. Answer: The adaptive expectations model of inflation states that inflationary expectations are determined by the level of inflation in the recent past. Conversely, the rational expectations model assumes that people have highly sophisticated beliefs about inflation that rationally incorporate all the information available to them. Difficulty: Medium AACSB: Analytical Thinking Topic: Choice and Consequence: Two Models of Inflation Expectations 39 Copyright © 2015 Pearson Education, Inc. 69) Suppose the U.S. economy is recovering from a long recession. How will this affect the demand curve for reserves and the federal funds rate? Explain with a diagram. Answer: The diagram below shows the federal funds market. D1 is the initial demand curve for reserves and S is the supply curve of reserves. In an economy that is coming out of recession, private banks need to obtain liquidity so they can make new loans to their customers–for instance, a manufacturing firm that wishes to expand production by building a new factory. Reserves provide liquidity that can be used to fund these loans. Therefore, the demand curve for reserves is likely to shift to the right from D1 to D2 when the economy is recovering. The equilibrium federal funds rate is the rate at which the demand for reserves equals the supply of reserves. If the demand curve shifts to the right, the equilibrium federal funds rate will rise from r1 to r2. Difficulty: Medium AACSB: Application of Knowledge Topic: The Demand Side of the Federal Funds Market; The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 70) What can the central bank of Autarkia do to lower the rate which banks charge each other for overnight loans? How will this affect the economy if it is facing a downturn? Answer: The central bank of Autarkia can increase the supply of reserves. This can be done by buying government bonds from private banks. Such a transaction is referred to as an open market operation. If the central bank buys government bonds from private banks, the supply curve of reserves will shift to the right. The demand for reserves will equal the supply of reserves at a lower federal funds rate. If the federal funds rate falls, the banks will be able to make more loans. The easy availability of loans will boost economic activity in the economy. Difficulty: Medium AACSB: Application of Knowledge Topic: The Supply Side of the Federal Funds Market and Equilibrium in the Federal Funds Market 40 Copyright © 2015 Pearson Education, Inc. 71) Rising inflation is the pressing concern of the government of Greatland. Suggest a suitable monetary policy that the Central Bank should adopt to lower the rate of inflation. Answer: In order to lower the rate of inflation using monetary policy, the central bank of Greatland needs to raise the rate which banks charge each other for overnight loans, called the federal funds rate. This can be done using four different tools. First, the central bank can reduce the quantity of bank reserves by using open market operations. Second, it can increase the reserve requirement. Third, it can increase the interest rate that it pays on reserves. Fourth, it can increase the discount rate. All of these policies will increase the federal funds rate and have a related effect on the interest rates that households and firms face for borrowing. Consequently, a rise in the federal funds rate reduces the rate of loan growth to households and firms, reducing the rate at which the money supply grows, and reducing the rate of inflation. Difficulty: Medium AACSB: Application of Knowledge Topic: The Fed's Influence on the Money Supply and the Inflation Rate 72) Suppose the interest rate which banks in Techland charge each other for overnight loans is 5%, the long-run nominal interest rate is 4.5%, and the long-run expected inflation rate is 3%. i) What is the long-run expected real interest rate? ii) How will the long-run expected real interest rate be affected if the central bank of Techland starts purchasing government bonds from banks? Answer: i) The long-run expected real interest rate can be obtained by subtracting the long-run expected inflation rate from the long-run nominal interest rate. Therefore, long-run expected real interest rate in this case is 4.5% - 3% = 1.5%. ii) If the central bank of Techland starts purchasing government bonds from private banks, the supply of reserves will increase. This will lead to a fall in the cost of borrowing funds for private banks. As a result, they will be able to make more loans. This will lead to a decrease in the longrun nominal interest rate. If the long-run expected inflation rate remains unchanged, the long-run expected real interest rate will fall. Difficulty: Medium AACSB: Application of Knowledge Topic: The Relationship Between the Federal Funds Rate and the Long-Run Real Interest Rate 41 Copyright © 2015 Pearson Education, Inc.