A2 Practice Questions
Money & Banking
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True / False
Determine whether the statement is true of false based on your understanding of the topic. Provide a brief explanation or justification for your answer. This will help to demonstrate your understanding of the topic.
Keynes' demand for money theory suggests that the demand for money is influenced by three motives: transactions demand, precautionary demand, and speculative demand. T / F
M1 is a broader measure of money supply than M2, as it includes savings deposits and money market mutual funds. T / F
High inflation tends to result in lower interest rates because lenders are willing to accept lower real returns due to the eroding effect of inflation on the value of money. T / F
Economic growth has no impact on interest rates, as interest rates are solely determined by central banks' monetary policy actions. T / F
Government budget deficits can influence interest rates, as increased government borrowing leads to higher demand for credit in the economy. T / F
Central banks use various monetary policy tools, such as open market operations and the discount rate, to influence the money supply and indirectly affect interest rates. T / F
During periods of economic downturn, central banks may implement quantitative easing (QE) to lower short-term interest rates and encourage borrowing and investment. T / F
Central banks may influence longer-term interest rates through forward guidance, which involves communicating their future policy intentions to impact expectations and yield on longer-term financial assets. T / F
Answers
True. Keynes' demand for money theory indeed suggests that the demand for money is influenced by three motives: transactions demand, precautionary demand, and speculative demand.
False. M2 is a broader measure of money supply than M1. M2 includes savings deposits and money market mutual funds, making it a more inclusive measure of money supply.
False. High inflation tends to result in higher interest rates, not lower. Lenders demand higher interest rates to compensate for the loss of purchasing power caused by inflation.
False. Economic growth does impact interest rates. During periods of economic growth, interest rates tend to increase as demand for credit rises.
True. Government budget deficits can influence interest rates because increased government borrowing can lead to higher demand for credit in the economy, resulting in upward pressure on interest rates.
True. Central banks use various monetary policy tools, such as open market operations and the discount rate, to influence the money supply and indirectly affect interest rates.
True. During periods of economic downturn, central banks may implement quantitative easing (QE) to lower short-term interest rates and stimulate borrowing and investment to support economic growth.
True. Central banks may use forward guidance to influence longer-term interest rates by communicating their future policy intentions, which can affect expectations and yield on longer-term financial assets.
Open Market Operations
Carefully read each question and choose the most appropriate answer.
When the government buys bonds in the open market, how does it affect the money supply? (increases/decreases/no impact)
What is the purpose of the government buying bonds through open market operations? (control inflation, stimulate economic growth, reduce money supply)
When the government buys bonds from the public, what happens to the demand for bonds and bond prices? (increases/decreases/no impact)
How does the government selling bonds in the open market impact the money supply? (increases/decreases/no impact)
When the government sells bonds to the public, what happens to the supply of bonds and bond prices? (increases/decreases/no impact)
What happens to the interest rate when bond prices decrease? (increases/decreases/no impact)
When bond prices rise, how does it impact the cost of borrowing for businesses and individuals in the economy? (increases/decreases/no impact)
Answer
Increases. When the government buys bonds, it injects money into the economy, increasing the money supply.
Stimulate economic growth. By buying bonds, the government injects money into the economy, which can increase spending and investment, stimulating economic growth.
Increases. Government bond purchases increase the demand for bonds, which, in turn, leads to higher bond prices.
Decreases. When the government sells bonds, it withdraws money from the economy, reducing the money supply.
Increases. Government bond sales increase the supply of bonds, which can lead to lower bond prices.
Increases. When bond prices decrease, the interest rate or yield on those bonds increases.
Decreases. When bond prices rise, interest rates decrease, making borrowing cheaper for businesses and individuals.
Demand & Supply of Money
Read each scenario and question carefully and provide a concise and well-thought-out answer based on your understanding of liquidity preference theory.
Scenario 1: Economic Boom
Question: During an economic boom, does the demand for money typically increase, decrease, or remain unchanged?
Scenario 2: High Inflation
Question: In an economy experiencing high inflation, does the demand for money change? and how might the central bank respond to address the situation?
Scenario 3: Government Stimulus Package
Question: If the government implements a large stimulus package to boost economic activity, how might this impact the demand for money? Additionally, what implications could this have on the money supply?
Scenario 4: Increase in Interest Rates
Question: If the central bank raises interest rates to control inflation, how does this decision influence the demand for money? What effect does this have on the money supply in the economy?
Scenario 5: Surge in Government Borrowing
Question: In a scenario where the government dramatically increases its borrowing to fund public projects, how does this affect the overall demand for money?
Scenario 6: Decrease in Consumer Confidence
Question: If consumer confidence significantly declines due to economic uncertainties, how does this affect the overall demand for money?
Answer
Scenario 1. During an economic boom, the demand for money typically increases as economic activity rises, leading to higher transactions. This increase in money demand can potentially lead to an expansion of the money supply (movement along the supply curve) as banks respond to higher demand for credit and loans.
Scenario 2. In an economy experiencing high inflation, the demand for money may decreases due to individuals and businesses wanting to hold less cash to avoid losses in value. The central bank may respond by implementing contractionary monetary policy, reducing the money supply to control inflation.
Scenario 3. If the government implements a large stimulus package, it can increase the demand for money as more funds are injected into the economy. This could lead to an expansion of the money supply (movement along the supply curve).
Scenario 4. Higher interest rates may encourage individuals and businesses to hold more bonds, leading to a decrease in money demand and potentially reducing the money supply.
Scenario 5. A surge in government borrowing can increase the demand for money in the economy, potentially leading to higher interest rates.
Scenario 6. A decrease in consumer confidence may lead to an increase in money demand as people hold more cash for precautionary purposes.
Liquidity Trap
Identify the missing words in each blank by analyzing the context of the paragraph
In a liquidity trap, interest rates are so 1. ____ (low/high) that the demand for money becomes 2. ____ (perfectly elastic/perfectly inelastic) even with increases in the money supply. At this point, conventional monetary policy tools, such as open market operations or changes in the central bank's policy rate, become 3. ______ (ineffective/effective) in stimulating borrowing and investment. The economy gets stuck in a situation where increasing the money supply does not lead to significant changes in 4. ______ (interest rates/investment), and overall economic activity remains subdued. Policymakers often face challenges in managing the economy during a liquidity trap, leading to a greater reliance on alternative measures like 5. _____ (fiscal policy/foreign trade) to boost aggregate demand and stimulate growth.
Answer
low
perfectly elastic
ineffective
interest rates
fiscal policy
Loanable Fund Theory
The Classical theory (loanable fund theory) of the rate of interest can be summarised in the following demand and supply schedules:
(a) If the market rate of interest is 10%, outline the sequence of events predicted by the Classical theory.
(b) Suggest two major weaknesses of the theory.
Answer
At 10%, supply of loanable funds exceeds demand; hence the rate of interest falls and, as it does so, savings contract and investment expands until there is equilibrium at 6%.
i. The loanable funds theory relies on the assumption that savings and investment are always equal, known as the savings-investment identity. However, in reality, there can be discrepancies between savings and investment due to factors such as government budget deficits, foreign capital flows, and changes in consumer behavior.
ii. The loanable funds theory typically assumes full employment, meaning all resources are fully utilized. In reality, economies often experience periods of unemployment or underemployment, which can affect the functioning of markets for loanable funds.