READING 15 MONETARY POLICY

Question 1

Which of the following best describes the type of money issued by central banks today?
A. Commodity-backed money
B. Fiat money
C. Convertible currency

Answer 1

Correct Answer: B

Explanation:
B is correct. Most central banks issue fiat money, which has no intrinsic value and is not backed by physical commodities like gold. Its value comes from the public’s trust and legal status.
A is incorrect. Commodity-backed money refers to currency redeemable for a physical asset (e.g., gold), which is no longer common.
C is incorrect. Convertible currency typically refers to ease of exchange in international markets, not its backing.

Question 2

Which of the following is NOT a role of a central bank?
A. Supplier of legal tender
B. Lender of last resort
C. Distributor of corporate loans

Answer 2

Correct Answer: C

Explanation:
C is correct. Central banks do not distribute corporate loans; commercial banks do.
A is incorrect. Central banks are the sole issuers of a country’s legal tender.
B is incorrect. Central banks act as lenders of last resort in times of financial distress.

Question 3

A central bank aiming to maintain price stability would most likely seek to:
A. Maintain an inflation rate near 0%
B. Target a low, positive inflation rate
C. Peg the exchange rate to a foreign currency

Answer 3

Correct Answer: B

Explanation:
B is correct. Most central banks target an inflation rate around 2–3% to prevent deflation while maintaining price stability.
A is incorrect. Zero inflation increases the risk of deflation, which is harmful to the economy.
C is incorrect. Pegging exchange rates is a policy tool, not a direct objective.

Question 4

Which of the following is a justification for a central bank to act as a lender of last resort?
A. To stabilize the stock market
B. To prevent bank runs during liquidity crises
C. To control foreign exchange reserves

Answer 4

Correct Answer: B

Explanation:
B is correct. Central banks act as lenders of last resort to restore confidence and prevent mass withdrawals from banks.
A is incorrect. Central banks focus on financial system stability, not directly stabilizing markets.
C is incorrect. Managing foreign exchange reserves is a different function.

Question 5

Which statement best explains the impact of pegging a currency to the U.S. dollar?
A. It stabilizes inflation without affecting monetary policy
B. It may cause increased volatility in money supply and interest rates
C. It guarantees economic growth

Answer 5

Correct Answer: B

Explanation:
B is correct. Pegging requires intervention and alignment with U.S. inflation, which can cause instability in interest rates and money supply.
A is incorrect. Pegging directly affects domestic monetary policy.
C is incorrect. Pegging does not guarantee growth and can even hinder it.

Question 6

Legal tender issued by a central bank that is not backed by any tangible commodity is known as:
A. Fiat money
B. Hard currency
C. Soft money

Answer 6

Correct Answer: A

Explanation:
A is correct. Fiat money has no intrinsic value and is backed only by the government’s declaration.
B is incorrect. Hard currency is typically a widely accepted stable currency, not necessarily fiat.
C is incorrect. “Soft money” is not a technical term in this context.

Question 7

One primary objective of monetary policy conducted by a central bank is to:
A. Maximize national exports
B. Stabilize interest rates at low levels
C. Promote price stability

Answer 7

Correct Answer: C

Explanation:
C is correct. Price stability, typically via targeting low inflation, is the main goal of most central banks.
A is incorrect. Export promotion is not a central bank’s objective.
B is incorrect. Stable—not necessarily low—interest rates support economic stability.

Question 8

Which of the following central bank activities best supports efficient payment systems?
A. Issuing government bonds
B. Regulating commercial banks
C. Overseeing clearing and settlement processes

Answer 8

Correct Answer: C

Explanation:
C is correct. Ensuring a smooth payments system is a core function.
A is incorrect. This is a Treasury function.
B is incorrect. While related, it focuses on risk management, not payment processing directly.

Question 9

The central bank of a country that pegs its currency to another country’s currency will most likely:
A. Allow interest rates to float freely
B. Align monetary policy with the anchor country
C. Adopt a flexible exchange rate policy

Answer 9

Correct Answer: B

Explanation:
B is correct. To maintain the peg, the country must match the inflation and interest rates of the anchor country.
A is incorrect. Interest rates often need to be adjusted to support the peg.
C is incorrect. A pegged system is the opposite of flexible.

Question 10

Which of the following is an implication of high inflation for businesses?
A. Lower menu costs
B. Reduced operational complexity
C. Increased need to update prices

Answer 10

Correct Answer: C

Explanation:
C is correct. Menu costs rise because businesses must frequently change prices during inflation.
A is incorrect. Menu costs increase, not decrease.
B is incorrect. Inflation adds complexity, not reduces it.

Question 11

Which role of the central bank is most closely related to national reserves management?
A. Banker to the government
B. Holder of gold and foreign currency reserves
C. Supervisor of the banking system

Answer 11

Correct Answer: B

Explanation:
B is correct. Central banks manage a country’s gold and FX reserves.
A is incorrect. Banking services don’t include reserve management.
C is incorrect. Supervision refers to regulation, not reserves.

Question 12

Shoe leather costs refer to:
A. Government expenditure during inflation
B. Costs of maintaining large inventories
C. Costs incurred by individuals avoiding inflation losses on cash

Answer 12

Correct Answer: C

Explanation:
C is correct. Individuals reduce cash holdings and make more frequent bank visits.
A is incorrect. It is not government related.
B is incorrect. That relates to inventory management, not personal finance behavior.

Question 13

A country’s central bank is best described as:
A. An independent financial intermediary
B. A government agency responsible for fiscal policy
C. A monetary authority controlling money supply

Answer 13

Correct Answer: C

Explanation:
C is correct. Central banks manage the money supply and monetary policy.
A is incorrect. It is not an intermediary.
B is incorrect. Fiscal policy is handled by the government (Treasury).

Question 14

In the absence of a gold standard, money is considered fiat because:
A. It is created by commercial banks
B. It holds value through trust and legal status
C. It can always be converted to foreign currency

Answer 14

Correct Answer: B

Explanation:
B is correct. Fiat money is valuable because it is legally accepted and trusted.
A is incorrect. Central banks issue money, not commercial banks.
C is incorrect. Convertibility does not define fiat money.

Question 15

A key feature of central banks’ role as the “sole supplier of currency” is that:
A. It ensures automatic currency convertibility
B. It creates competition in currency markets
C. It grants exclusive authority to issue legal tender

Answer 15

Correct Answer: C

Explanation:
C is correct. Central banks have the legal right to issue currency.
A is incorrect. Convertibility depends on policy.
B is incorrect. Currency issuance is not competitive.

Question 16

The Federal Reserve’s mandate includes all of the following EXCEPT:
A. Maximum employment
B. Moderate long-term interest rates
C. A fixed inflation target

Answer 16

Correct Answer: C

Explanation:
C is correct. The Fed has goals, but not a strict inflation target like other central banks.
A & B are incorrect. These are explicit parts of the Fed’s dual mandate.

Question 17

A central bank purchases domestic currency in the foreign exchange market. This will most likely:
A. Depreciate the domestic currency
B. Increase inflation in the domestic economy
C. Increase the exchange rate (appreciate currency)

Answer 17

Correct Answer: C

Explanation:
C is correct. Buying its own currency reduces supply, causing appreciation.
A is incorrect. That would result from selling, not buying.
B is incorrect. It would reduce money supply, possibly reducing inflation.

Question 18

Which of the following is a valid reason for not targeting zero inflation?
A. It discourages saving
B. It increases risk of deflation
C. It leads to political instability

Answer 18

Correct Answer: B

Explanation:
B is correct. Zero inflation heightens deflation risk, which can stall economic growth.
A is incorrect. Moderate inflation may reduce real returns but not directly discourage saving.
C is incorrect. Not necessarily linked to political outcomes.

Question 19

The term “monetary policy” best refers to:
A. Government taxation and spending
B. Central bank actions to control money supply
C. Regulation of international trade

Answer 19

Correct Answer: B

Explanation:
B is correct. Monetary policy involves controlling interest rates and money supply.
A is incorrect. That’s fiscal policy.
C is incorrect. Trade regulation is separate.

Question 20

Which of the following best describes the impact of central banks on long-term interest rates?
A. Central banks target long-term rates directly
B. Central banks influence long-term rates via short-term policy actions
C. Central banks have no influence on long-term interest rates

Answer 20

Correct Answer: B

Explanation:
B is correct: Long-term rates are affected by expectations shaped by central bank policy.
A is incorrect: Central banks usually target short-term rates.
C is incorrect: Their influence is indirect but significant.

Question 21

Which of the following is most likely to be considered the central bank’s primary tool for influencing short-term interest rates in the United States?
A. Discount rate
B. Reserve requirement
C. Open market operations

Answer 21

Correct Answer: C

Explanation:
Open market operations are the most commonly used tool by the Federal Reserve to influence short-term interest rates, particularly the federal funds rate.
A is incorrect. While the discount rate influences borrowing costs, it’s used less frequently.
B is incorrect. Reserve requirements are powerful but rarely adjusted due to their disruptive nature

Question 22

A central bank lowers the discount rate. Which of the following best describes the likely impact on the money supply and interest rates?
A. Money supply increases; interest rates decrease
B. Money supply decreases; interest rates increase
C. Money supply is unaffected; interest rates increase

Answer 22

Correct Answer: A

Explanation:
A lower discount rate reduces the cost of borrowing for banks, encouraging more borrowing and increasing the money supply, which tends to lower market interest rates.
B is incorrect. This would occur if the rate was raised.
C is incorrect. Money supply is affected as banks borrow more.

Question 23

The federal funds rate is:
A. Set directly by the Fed as a fixed rate
B. The rate banks charge each other for short-term reserves
C. The interest rate on Treasury bills

Answer 23

Correct Answer: B

Explanation:
The federal funds rate is the market-determined interest rate at which banks lend reserves to one another overnight.
A is incorrect. The Fed sets a target, but not the actual rate.
C is incorrect. Treasury bill rates are different and determined by auctions.

Question 24

Which of the following best describes a repurchase (repo) agreement?
A. A central bank purchases long-term government bonds from the public permanently
B. A temporary sale of securities with an agreement to repurchase them later at a higher price
C. A type of open market operation that increases bank reserve requirements

Answer 24

Correct Answer: B

Explanation:
A repo agreement is a short-term loan where the central bank buys securities and the bank agrees to repurchase them later at a higher price, with the price difference acting as interest.
A is incorrect. That describes a permanent open market operation.
C is incorrect. Repo agreements do not directly change reserve requirements.

Question 25

Which of the following tools is least likely used by central banks on a regular basis? A. Reserve requirement changes B. Open market operations C. Policy interest rate adjustments

Answer 25

Correct Answer: A Explanation: Reserve requirement changes are rare due to their broad and disruptive impact on the banking system. B is incorrect. Open market operations are used frequently. C is incorrect. Policy rate changes are also common tools.

Question 26

An increase in reserve requirements is most likely to: A. Increase lending and reduce interest rates B. Reduce bank lending capacity and increase interest rates C. Leave the money supply unchanged

Answer 26

Correct Answer: B Explanation: Higher reserve requirements mean banks must hold more funds as reserves, reducing their lending capacity and thereby raising interest rates. A is incorrect. That would happen with lower reserve requirements. C is incorrect. The money supply is reduced.

Question 27

Which of the following best describes how a central bank uses open market operations to lower interest rates? A. It sells government securities to absorb liquidity B. It buys government securities to inject liquidity C. It raises the policy rate

Answer 27

Correct Answer: B Explanation: By buying securities, the central bank injects cash into the banking system, increasing reserves and lowering interest rates. A is incorrect. Selling securities removes liquidity. C is incorrect. Raising the policy rate would tighten monetary conditions.

Question 28

If the central bank wants to reduce inflationary pressure, which of the following actions is most appropriate? A. Lower the policy rate B. Buy government securities C. Increase the reserve requirement

Answer 28

Correct Answer: C Explanation: Increasing reserve requirements reduces lending, lowers the money supply, and helps control inflation. A is incorrect. Lowering rates would stimulate the economy further. B is incorrect. Buying securities increases liquidity.

Question 29

A higher central bank policy rate will most likely lead to: A. Greater bank lending and higher inflation B. Lower interest rates and higher investment C. Reduced lending and lower inflation

Answer 29

Correct Answer: C Explanation: Higher policy rates make borrowing more expensive, reducing lending and dampening inflation. A is incorrect. Higher rates discourage lending. B is incorrect. Investment usually falls as rates rise.

Question 30

A decrease in the policy rate by the central bank will most likely lead to: A. Currency depreciation B. Lower consumer spending C. Tighter credit conditions

Answer 30

Correct Answer: A Explanation: Lower interest rates make the domestic currency less attractive to foreign investors, which tends to cause currency depreciation. B is incorrect. Lower rates usually increase spending. C is incorrect. Lower rates ease credit.

Question 31

Which of the following most accurately describes the goal of expansionary monetary policy? A. Decrease inflation expectations B. Encourage borrowing and stimulate economic growth C. Reduce consumer demand

Answer 31

Correct Answer: B Explanation: Expansionary policy aims to boost economic activity by making borrowing cheaper, encouraging investment and consumption. A is more aligned with tight policy. C is the opposite of expansionary intent.

Question 32

Which of the following effects is least likely to occur when a central bank purchases securities? A. Increase in money supply B. Decrease in short-term interest rates C. Increase in bank reserve requirements

Answer 32

Correct Answer: C Explanation: Purchasing securities increases money supply and lowers interest rates but does not change reserve requirements. A and B are both expected outcomes.

Question 33

Which of the following is most likely to be directly controlled by a central bank? A. Real GDP growth B. Policy interest rate C. Stock market returns

Answer 33

Correct Answer: B Explanation: Central banks have direct control over policy interest rates, such as the discount or repo rate. A and C are influenced indirectly at best.

Question 34

Which of the following is the primary interest rate used by the European Central Bank (ECB) for monetary policy? A. Federal funds rate B. Discount rate C. Refinancing rate

Answer 34

Correct Answer: C Explanation: The ECB's main policy rate is the refinancing rate, used in repo agreements with commercial banks. A is for the U.S. B is not used by the ECB.

Question 35

Which of the following statements about open market operations is most accurate? A. Buying securities raises interest rates B. Selling securities reduces the money supply C. Selling securities increases the liquidity in the system

Answer 35

Correct Answer: B Explanation: Selling securities withdraws cash from the system, reducing money supply and raising interest rates. A is incorrect. Buying lowers rates. C is incorrect. Selling reduces liquidity.

Question 36

Which of the following best explains why a decrease in the policy rate encourages bank lending? A. It raises the cost of holding reserves B. It makes borrowing from the central bank cheaper C. It increases required reserves

Answer 36

Correct Answer: B Explanation: Lower policy rates reduce the borrowing cost for banks, encouraging them to lend more. A is incorrect. Policy rates don’t affect reserve costs. C is incorrect. Reserve requirements are a separate tool.

Question 37

Which monetary policy tool involves changing the percentage of deposits banks must hold? A. Discount rate B. Reserve requirement C. Federal funds rate

Answer 37

Correct Answer: B Explanation: Reserve requirements are the fraction of deposits banks must keep in reserve. A is a rate banks pay when borrowing from the central bank. C is a market rate between banks.

Question 38

An increase in interest rates is most likely to cause: A. A rise in consumption and investment B. Depreciation of the domestic currency C. A decrease in aggregate demand

Answer 38

Correct Answer: C Explanation: Higher rates make borrowing more expensive, which reduces spending and investment, lowering aggregate demand. A is incorrect. Consumption tends to fall. B is incorrect. Currencies usually appreciate with higher rates.

Question 39

Which of the following best explains why open market operations are preferred by central banks? A. They are slow to implement but have a lasting effect B. They provide precise and flexible control over the money supply C. They permanently alter bank capital structures

Answer 39

Correct Answer: B Explanation: Open market operations are precise, quick, and reversible, making them the most preferred tool by central banks. A is incorrect. They are fast, not slow. C is incorrect. OMOs do not affect bank capital.

Question 40

Which of the following best describes the monetary transmission mechanism? A. The process by which fiscal policy affects the price level B. The channels through which changes in the policy rate affect inflation and economic activity C. The relationship between government spending and inflation

Answer 40

Correct Answer: B Explanation: B is correct. The monetary transmission mechanism explains how a change in the central bank's policy rate works its way through the economy to influence inflation, aggregate demand, and price levels. A is incorrect. This refers to fiscal policy, not monetary. C is incorrect. Government spending is a fiscal tool, not part of the monetary transmission mechanism.

Question 41

An increase in the central bank’s policy rate is least likely to: A. Decrease consumer spending B. Increase bond prices C. Strengthen the domestic currency

Answer 41

Correct Answer: B Explanation: B is correct. An increase in the policy rate raises discount rates, which decreases bond prices. A is incorrect. Higher borrowing costs reduce consumption. C is incorrect. Higher interest rates attract foreign capital, strengthening the domestic currency.

Question 42

A rise in interest rates tends to lead to a fall in equity prices because: A. Firms become more profitable B. Discounted cash flows decrease in value C. Dividends are paid more frequently

Answer 42

Correct Answer: B Explanation: B is correct. Higher interest rates increase the discount rate used to value future cash flows, lowering present values and thus stock prices. A is incorrect. Higher rates usually reduce profits due to increased borrowing costs. C is incorrect. Dividend frequency is unrelated to interest rates.

Question 43

Which of the following is most likely to occur when the central bank implements contractionary monetary policy? A. Currency depreciation B. Increased investment spending C. Decline in aggregate demand

Answer 43

Correct Answer: C Explanation: C is correct. Higher rates raise borrowing costs, which reduces spending and investment, lowering aggregate demand. A is incorrect. The currency typically appreciates, not depreciates. B is incorrect. Investment generally falls, not rises, when rates go up.

Question 44

Which channel of the monetary transmission mechanism is directly related to consumer and business confidence? A. Exchange rate B. Expectations C. Asset prices

Answer 44

Correct Answer: B Explanation: B is correct. Expectations refer to how people think the economy will perform. If expectations worsen, spending and investment decline. A is incorrect. Exchange rates affect trade, not expectations directly. C is incorrect. Asset prices affect wealth, not expectations per se.

Question 45

Which statement best explains why higher interest rates may lead to a stronger domestic currency? A. They reduce imports B. They encourage foreign investment in domestic financial assets C. They improve domestic wage growth

Answer 45

Correct Answer: B Explanation: B is correct. Higher rates make domestic assets more attractive, increasing foreign capital inflows and demand for the domestic currency. A is incorrect. Imports are more influenced by exchange rates than interest rates directly. C is incorrect. Interest rate changes do not immediately affect wages.

Question 46

A decrease in policy rate will most likely lead to which of the following? A. Lower household wealth B. Decrease in investment spending C. Increase in aggregate demand

Answer 46

Correct Answer: C Explanation: C is correct. Lower rates reduce borrowing costs, encouraging spending and investment, which boosts aggregate demand. A is incorrect. Lower rates typically raise asset prices, increasing wealth. B is incorrect. Investment usually increases, not decreases.

Question 47

Which of the following is a primary effect of a fall in bond prices due to rising interest rates? A. Increased household consumption B. Lower household wealth effect C. Increased government transfers

Answer 47

Correct Answer: B Explanation: B is correct. Falling asset prices reduce perceived wealth, causing households to spend less. A is incorrect. Consumption usually falls, not increases. C is incorrect. Transfers are fiscal policy tools, not tied to asset prices directly.

Question 48

Which of the following would most likely occur first in the transmission mechanism following a central bank interest rate hike? A. Decline in exports B. Reduction in stock market wealth C. Increase in short-term bank lending rates

Answer 48

Correct Answer: C Explanation: C is correct. The first and direct impact of a policy rate hike is an increase in other short-term rates, such as those charged by banks. A is incorrect. This occurs later through currency appreciation. B is incorrect. Asset prices adjust quickly but not before lending rates change.

Question 49

A central bank raises the policy rate to fight inflation. Which of the following would NOT support the intended goal? A. Higher borrowing costs leading to reduced consumer spending B. Currency appreciation reducing demand for exports C. Rising stock prices increasing household wealth

Answer 49

Correct Answer: C Explanation: C is correct. Rising stock prices create a wealth effect that could boost consumption, counteracting the goal of reducing inflation. A is incorrect. This helps reduce inflation by lowering demand. B is incorrect. Currency appreciation reduces export demand, helping lower inflation.

Question 50

When a central bank adopts an expansionary monetary policy by purchasing government securities, which of the following is the most immediate effect? A. A decrease in the inflation rate B. A decrease in bank reserves C. An increase in the money supply

Answer 50

Correct Answer: C Explanation: Buying securities injects money into the banking system, increasing reserves and expanding the money supply. A is incorrect. inflation may rise, but not immediately. B is incorrect. reserves increase, not decrease.

Question 51

Question 2: What typically happens to the interbank lending rate when bank reserves increase due to central bank intervention? A. It increases due to higher competition B. It decreases as lending becomes easier C. It remains unchanged

Answer 51

Correct Answer: B Explanation: More reserves mean banks are more willing to lend → lending rate drops. A is incorrect. less competition for funds exists. C is incorrect. the increase in reserves directly influences the rate downward.

Question 52

How does expansionary monetary policy affect short-term interest rates? A. Increases them due to higher inflation B. Decreases them due to excess liquidity C. Leaves them unchanged

Answer 52

Correct Answer: B Explanation: More loanable funds → higher supply → short-term interest rates fall. A is incorrect. inflation rises after rates drop. C is incorrect. rates are directly impacted by policy changes.

Question 53

Which of the following best explains why long-term interest rates may fall after an expansionary monetary policy? A. Decreased investor demand for bonds B. Lower expectations for inflation C. Increased money supply lowers equilibrium rates

Answer 53

Correct Answer: C Explanation: The rise in loanable funds and investor confidence lowers long-term rates. A is incorrect. demand typically rises. B is a possible effect but not the primary mechanism in this context.

Question 54

A decline in real interest rates due to expansionary monetary policy is most likely to: A. Strengthen the domestic currency B. Attract foreign capital C. Weaken the domestic currency

Answer 54

Correct Answer: C Explanation: Lower interest = less return for foreign investors = reduced demand = depreciation. A is incorrect. currency weakens, not strengthens. B is incorrect. foreign capital typically flows out, not in.

Question 55

How does a decrease in long-term interest rates affect business investment? A. Reduces it due to higher costs B. Increases it due to cheaper borrowing C. Has no effect on investment decisions

Answer 55

Correct Answer: B Explanation: Cheaper long-term borrowing encourages businesses to invest in capital projects. A is the opposite of what happens. C is incorrect. interest rates are a key driver of investment.

Question 56

What is a likely outcome for consumers when interest rates fall under expansionary policy? A. Increase in durable goods purchases B. Reduction in borrowing activity C. Shift from spending to saving

Answer 56

Correct Answer: A Explanation: Lower interest = cheaper loans → more spending on homes, cars, and appliances. B is incorrect. borrowing typically increases. C is incorrect. saving often declines.

Question 57

A weaker domestic currency due to monetary policy typically: A. Makes exports cheaper for foreign buyers B. Reduces foreign demand for domestic goods C. Has no effect on international trade

Answer 57

Correct Answer: A Explanation: Depreciation = foreign buyers pay less for domestic goods = higher demand. B is the opposite of what occurs. C is incorrect. exchange rates heavily influence trade.

Question 58

Which of the following is not a component that increases aggregate demand after expansionary monetary policy? A. Rising consumer spending B. Lower business investment C. Increased net exports

Answer 58

Correct Answer: B Explanation: Investment rises, not falls. A and C both increase aggregate demand.

Question 59

What is the most likely final effect of expansionary monetary policy in the short run? A. Lower GDP and higher unemployment B. Higher inflation and increased employment C. Constant inflation with no GDP change

Answer 59

Correct Answer: B Explanation: Expansionary policy boosts demand → raises GDP, employment, and prices. A is associated with contractionary policy. C contradicts short-run economic behavior.

Question 60

Which of the following best defines operational independence of a central bank? A. The central bank can set both the policy rate and the inflation target without government approval. B. The central bank can independently determine short-term interest rates to achieve a given inflation target. C. The central bank reports its inflation forecasts and policy decisions to the public on a scheduled basis.

Answer 60

Correct Answer: B Explanation: B is correct. Operational independence means the central bank has the authority to set policy tools (like the interest rate) needed to achieve a predefined goal, such as inflation control. A is incorrect. This describes target independence, not operational independence. C is incorrect. This describes transparency, not operational independence.

Question 61

A central bank is said to have target independence when it: A. Independently sets interest rates in response to inflationary pressures. B. Establishes how inflation is measured and sets the inflation target. C. Publishes its economic forecasts and monetary policy decisions.

Answer 61

Correct Answer: B Explanation: B is correct. Target independence allows the central bank to define its inflation target, how inflation is measured, and the timeframe for achieving the target. A is incorrect. This describes operational independence, not target independence. C is incorrect. This is a feature of transparency, not target independence.

Question 62

Which quality of a central bank is most directly associated with reducing political interference in monetary policy decisions? A. Credibility B. Independence C. Transparency

Answer 62

Correct Answer: B Explanation: B is correct. Independence ensures that the central bank can act without political pressure, which is vital when making unpopular decisions like tightening monetary policy. A is incorrect. Credibility relates to the market’s trust that the central bank will follow through on its stated policies. C is incorrect. Transparency deals with how openly the central bank communicates its decision-making process and assumptions.

Question 63

A central bank is considered credible if: A. Its inflation reports are detailed and published regularly. B. Its policy targets align with those set by the political leadership. C. Market participants believe it will achieve its stated inflation target.

Answer 63

Correct Answer: C Explanation: C is correct. Credibility is based on the belief that the central bank will do what it says. If people expect 3% inflation because the bank says so, their behavior (e.g., wage negotiations) reflects that. A is incorrect. Regular reporting supports transparency, not credibility on its own. B is incorrect. Aligning with political leadership may actually reduce credibility if the bank appears to be politically influenced.

Question 64

A government with high levels of debt chooses to set its own inflation targets. What is the most likely market response? A. Greater confidence in inflation stability, due to more direct fiscal control. B. Reduced inflation expectations, as governments are more cautious. C. Loss of credibility in inflation control, due to potential conflict of interest.

Answer 64

Correct Answer: C Explanation: C is correct. Governments may be tempted to allow higher inflation to reduce the real burden of debt, so markets may view targets set by governments (not central banks) as lacking credibility. A is incorrect. Central banks are typically seen as more reliable in maintaining inflation targets, not governments. B is incorrect. Historical evidence suggests the opposite—governments are not always cautious with inflation.

Question 65

Which of the following best exemplifies transparency in a central bank's operations? A. The central bank shares its view on future economic indicators and policy actions. B. The central bank is free from political interference when setting policy rates. C. The central bank controls both the target and the tools of monetary policy.

Answer 65

Correct Answer: A Explanation: A is correct. Transparency involves communicating clearly about how and why monetary policy decisions are made. B is incorrect. That refers to independence, not transparency. C is incorrect. That describes a combination of target and operational independence, not transparency.

Question 66

Why do credible inflation targets often become self-fulfilling? A. The central bank uses automatic stabilizers to adjust inflation expectations. B. Market participants align their behavior (e.g., wages, pricing) with the target. C. The central bank simultaneously manages inflation and employment.

Answer 66

Correct Answer: B Explanation: B is correct. If the public trusts the central bank to meet a 3% inflation target, they plan accordingly—leading to price and wage behaviors that help ensure 3% inflation actually occurs. A is incorrect. Automatic stabilizers are fiscal tools, not monetary policy tools. C is incorrect. While central banks may consider employment, this does not explain the self-fulfilling nature of inflation expectations.

Question 67

Which of the following best describes interest rate targeting as used by central banks in the past? A. Decreasing money supply when interest rates rise above the target band B. Increasing money supply when interest rates rise above the target band C. Targeting the exchange rate instead of inflation

Answer 67

Correct Answer: B Explanation: Central banks increased the money supply when market interest rates rose above the target band to bring them down. A is incorrect because decreasing the money supply when interest rates rise would push them higher, not lower. C is incorrect because exchange rate targeting is a different policy framework.

Question 68

Which of the following countries currently uses inflation targeting? A. United States B. Brazil C. China

Answer 68

Correct Answer: B Explanation: Brazil is one of the countries that employs inflation targeting. A is incorrect because the U.S. Federal Reserve does not explicitly follow inflation targeting by law. C is incorrect because China primarily manages monetary policy through other tools and does not explicitly follow inflation targeting.

Question 69

Which of the following best describes the neutral interest rate? A. A rate that leads to negative inflation B. A rate that neither stimulates nor slows economic growth C. A policy rate set equal to the inflation target

Answer 69

Correct Answer: B Explanation: The neutral interest rate is the rate that keeps the economy growing at its long-term potential without causing inflation or deflation. A is incorrect because the neutral rate does not lead to negative inflation. C is incorrect because the policy rate and inflation target are separate concepts.

Question 70

If the policy rate is below the neutral interest rate, monetary policy is considered: A. Contractionary B. Expansionary C. Deflationary

Answer 70

Correct Answer: B Explanation: A policy rate below the neutral rate stimulates economic activity — expansionary policy. A is incorrect because contractionary policy occurs when the policy rate is above the neutral rate. C is incorrect because deflation is a possible outcome, not a policy stance.

Question 71

What is the most common inflation target among countries that use inflation targeting? A. 1% with no deviation B. 0% ±2% C. 2% ±1%

Answer 71

Correct Answer: C Explanation: Most inflation-targeting countries aim for 2% inflation, allowing a deviation of ±1%. A is incorrect because 1% is not the typical target. B is incorrect because a 0% target risks deflation.

Question 72

Why is 0% not commonly used as an inflation target? A. It causes inflation to overshoot regularly B. It allows for mild deflation, which is good C. Variations around 0% may lead to deflation, which is disruptive

Answer 72

Correct Answer: C Explanation: Deflation can harm economic stability, making a small positive target (like 2%) more desirable. A is incorrect because 0% does not necessarily cause overshooting. B is incorrect because deflation is not considered beneficial.

Question 73

Which of the following is most likely a goal of inflation targeting? A. Influencing past inflation B. Anchoring expectations for future inflation C. Stabilizing foreign currency reserves

Answer 73

Correct Answer: B Explanation: Inflation targeting focuses on expected future inflation (typically two years ahead). A is incorrect because past inflation cannot be influenced. C is incorrect because stabilizing reserves is more related to exchange rate targeting.

Question 74

Which monetary policy action is consistent with maintaining a fixed exchange rate when the domestic currency depreciates? A. Selling foreign currency reserves to buy domestic currency B. Increasing money supply through bond purchases C. Lowering interest rates to stimulate growth

Answer 74

Correct Answer: A Explanation: To support a falling domestic currency, a central bank sells foreign reserves and buys its own currency, decreasing money supply. B is incorrect because increasing money supply weakens the currency. C is incorrect because lower rates also weaken the currency.

Question 75

Exchange rate targeting can cause which of the following challenges for a country? A. Reduced volatility of money supply B. Limited control over domestic interest rates C. Complete independence of monetary policy

Answer 75

Correct Answer: B Explanation: Countries that target exchange rates often must align their interest rates with those of the anchor currency, limiting their policy autonomy. A is incorrect because exchange rate targeting usually increases money supply volatility. C is incorrect because it reduces, not increases, monetary independence.

Question 76

If a central bank sells domestic currency in the foreign exchange market, the likely immediate effect is: A. A decrease in the domestic money supply B. A depreciation of the domestic currency C. An increase in domestic interest rates

Answer 76

Correct Answer: B Explanation: Selling domestic currency increases its supply and reduces its value. A is incorrect because selling domestic currency increases money supply. C is incorrect because interest rates tend to fall with increased money supply.

Question 77

What happens when a country runs out of foreign reserves under a fixed exchange rate system? A. It can continue defending the currency B. It may have to abandon the exchange rate target C. It will shift to inflation targeting automatically

Answer 77

Correct Answer: B Explanation: Without reserves, it cannot support the currency and may need to let it float. A is incorrect because it cannot defend the currency without reserves. C is incorrect because the shift to inflation targeting is a policy decision, not automatic.

Question 78

The net effect of exchange rate targeting is that the targeting country: A. Maintains full control over its domestic inflation rate B. Imports the inflation and interest rates of the anchor country C. Has greater flexibility in responding to local economic shocks

Answer 78

Correct Answer: B Explanation: By pegging to another currency, the country mirrors that country’s inflation and interest rates. A is incorrect because control is limited, not maintained. C is incorrect because flexibility is reduced.

Question 79

Which of the following is most consistent with expansionary monetary policy? A. Raising the policy rate above the neutral rate B. Reducing money supply to control inflation C. Setting the policy rate below the neutral rate

Answer 79

Correct Answer: C Explanation: A lower-than-neutral rate encourages borrowing and economic growth. A is incorrect because it is contractionary. B is incorrect because it is used to tighten policy.

Question 80

Under exchange rate targeting, an appreciation of the domestic currency above the target requires the central bank to: A. Buy domestic currency using foreign reserves B. Sell domestic currency to increase its supply C. Increase interest rates to support the currency

Answer 80

Correct Answer: B Explanation: Selling domestic currency increases supply, causing its value to fall back to target. A is incorrect because this action supports, not weakens, the currency. C is incorrect because higher rates strengthen the currency further.

Question 81

Which monetary policy regime is most likely to create volatility in the money supply? A. Inflation targeting B. Exchange rate targeting C. Interest rate smoothing

Answer 81

Correct Answer: B Explanation: Maintaining a fixed exchange rate often requires aggressive buying/selling of currency, affecting money supply. A is incorrect because inflation targeting allows more stable control over money supply. C is incorrect because smoothing aims to minimize volatility

Question 82

Which of the following best explains why long-term interest rates might decline even as a central bank raises short-term rates? A. The money supply is increasing rapidly B. Inflation expectations are falling C. A liquidity trap has formed

Answer 82

Correct Answer: B Explanation: B is correct. When market participants expect a monetary policy to reduce inflation successfully, long-term inflation expectations decline. Since long-term bond yields include an inflation premium, lower expected inflation reduces long-term rates. A is incorrect. An increasing money supply typically raises inflation expectations, increasing long-term rates. C is incorrect. A liquidity trap involves high demand for money regardless of rates, not falling long-term rates due to inflation expectations.

Question 83

The term "bond market vigilantes" refers to: A. Bondholders who advocate for higher inflation to increase yields. B. Investors who sell long-term bonds in response to inflationary policies. C. Central bankers who monitor the bond market for monetary policy clues.

Answer 83

Correct Answer: B Explanation: B is correct: "Bond market vigilantes" are investors who react to inflationary policies by selling long-term bonds, which increases long-term yields. A is incorrect. They are concerned about inflation, not supportive of it. C is incorrect. Central bankers are not referred to as vigilantes.

Question 84

A liquidity trap is characterized by: A. High inflation and aggressive tightening. B. Low interest rates and high demand for money. C. Rising bond yields and increasing money velocity.

Answer 84

Correct Answer: B Explanation: B is correct: In a liquidity trap, people prefer holding cash even when interest rates are near zero, making monetary policy ineffective. A is incorrect: Inflation is not characteristic of a liquidity trap. C is incorrect: Money velocity typically falls during a liquidity trap.

Question 85

Which of the following best describes the central bank's limitation in a deflationary environment? A. Inability to raise reserve requirements. B. Policy rates cannot be reduced below zero. C. Short-term rates become volatile.

Answer 85

Correct Answer: B Explanation: B is correct. The nominal interest rate cannot go below zero (zero lower bound), limiting the effectiveness of expansionary monetary policy. A is incorrect. Changing reserve requirements is still an available tool. C is incorrect. Rates tend to be stable at low levels during deflation.

Question 86

If inflation expectations increase due to monetary expansion, long-term bond yields are likely to: A. Decrease due to increased liquidity. B. Stay constant as the central bank controls all rates. C. Increase due to the inflation premium.

Answer 86

Correct Answer: C Explanation: C is correct. Long-term bond yields rise to reflect higher expected inflation, increasing the inflation premium. A is incorrect. More liquidity can lower short-term rates, but inflation expectations drive long-term yields. B is incorrect. The central bank influences but does not control long-term rates.

Question 87

Quantitative easing is most likely to be used when: A. The economy is overheating. B. Short-term interest rates are near zero. C. The reserve requirement is too low.

Answer 87

Correct Answer: B Explanation: B is correct. QE is typically implemented when conventional monetary tools are ineffective, especially when rates are at or near zero. A is incorrect. QE is not used in overheating conditions. C is incorrect. QE is unrelated to reserve requirements.

Question 88

In the aftermath of the 2008 crisis, banks were hesitant to lend because: A. Interest rates were too high. B. Their equity capital was reduced. C. Reserve requirements increased sharply.

Answer 88

Correct Answer: B Explanation: B is correct. Banks lost equity capital and sought to rebuild it, reducing lending despite increased reserves. A is incorrect. Rates were historically low. C is incorrect. Reserve requirements did not increase sharply.

Question 89

If the central bank’s credibility is high, the impact of monetary policy on long-term interest rates will be: A. Large and persistent. B. Small and limited. C. Negligible due to zero lower bound.

Answer 89

Correct Answer: B Explanation: B is correct. When policy is credible, inflation expectations remain anchored, minimizing long-term rate changes. A is incorrect. Lack of credibility would cause larger swings. C is incorrect. The zero lower bound applies to short-term rates, not long-term expectations.

Question 90

One limitation of monetary policy is when banks hold excess reserves instead of lending. This typically occurs when: A. Credit risk is low. B. Economic uncertainty is high. C. Inflation expectations rise.

Answer 90

Correct Answer: B Explanation: B is correct. High uncertainty discourages banks from making loans, even when liquidity is available. A is incorrect. Low credit risk should encourage lending. C is incorrect. Rising inflation expectations could increase lending, not reduce it.

Question 91

Which of the following is a direct effect of quantitative easing (QE)? A. Increased consumer prices B. Reduced long-term interest rates C. Reduced central bank credibility

Answer 91

Correct Answer: B Explanation: B is correct. QE involves purchasing long-term securities to push long-term rates lower. A is incorrect. QE may lead to inflation, but it's not a direct effect. C is incorrect. If well-communicated, QE can support credibility.

Question 92

An example of monetary policy ineffectiveness is: A. Banks increasing lending after a rate cut B. Lower inflation expectations after tightening C. No change in borrowing despite liquidity increase

Answer 92

Correct Answer: C Explanation: C is correct. When liquidity is abundant but demand for borrowing is low, monetary policy fails to stimulate growth. A is incorrect. That would indicate effective policy transmission. B is incorrect. Lower expectations after tightening is a desired outcome.

Question 93

Which tool allows central banks to influence long-term interest rates during liquidity traps? A. Quantitative easing B. Reserve requirement adjustments C. Currency intervention

Answer 93

Correct Answer: A Explanation: A is correct. QE targets long-term rates through asset purchases when conventional tools fail. B is incorrect. Reserve changes mainly affect short-term lending. C is incorrect. Currency intervention affects exchange rates, not directly long-term interest rates.

Question 94

What is the primary risk of shifting credit risk from banks to the public sector through QE? A. Reduced money supply B. Loss of central bank independence C. Taxpayers bearing potential losses

Answer 94

Correct Answer: C Explanation: C is correct. When central banks buy risky assets, credit risk shifts to taxpayers if defaults occur. A is incorrect. QE increases the money supply. B is incorrect. While a concern, it's not the primary risk in this context.

Question 95

Why might expansionary monetary policy be ineffective during deflation? A. Interest rates rise automatically B. Nominal rates are already at zero C. Banks are required to lend regardless

Answer 95

Correct Answer: B Explanation: B is correct: Once rates hit zero, further stimulus via rate cuts is impossible, reducing policy effectiveness. A is incorrect. Interest rates generally fall in deflation, not rise. C is incorrect. Banks are not obligated to lend.

Question 96

What is a consequence of increased expected inflation on the bond market? A. Lower demand for real assets B. Higher long-term bond yields C. Lower central bank reserve levels

Answer 96

Correct Answer: B Explanation: B is correct. Expected inflation increases yields due to a higher inflation premium. A is incorrect. Inflation often increases demand for real assets. C is incorrect. Reserve levels are managed independently.

Question 97

Which of the following is least likely to happen during a liquidity trap? A. Cash balances increase B. Central bank loses control of short-term rates C. Individuals prefer holding money over securities

Answer 97

Correct Answer: B Explanation: B is correct. Central banks still control short-term nominal rates; the issue is lack of monetary transmission. *A and C are typical of liquidity traps.

Question 98

A credible inflation target leads to: A. Greater volatility in long-term rates B. Stabilization of inflation expectations C. Reduction in short-term rate sensitivity

Answer 98

Correct Answer: B Explanation: B is correct. Credible targets anchor expectations, reducing inflation surprises. A is incorrect. It reduces, not increases, volatility. C is incorrect. Short-term rate effectiveness is unchanged.

Question 99

The purchase of long-term securities under QE aims to: A. Increase fiscal deficit B. Stimulate exports C. Lower borrowing costs

Answer 99

Correct Answer: C Explanation: C is correct. Lowering long-term yields reduces borrowing costs and encourages investment. A is incorrect. QE is a monetary tool, not fiscal. B is incorrect. QE may affect currency, but it’s not the primary goal.

Question 100

If monetary policy increases money supply but banks hold the reserves, what is most likely to happen? A. Interest rates will increase B. Inflation will rise sharply C. Lending will remain subdued

Answer 100

Correct Answer: C Explanation: C is correct. If banks do not lend, money supply growth doesn’t translate into economic activity. A is incorrect. Rates may stay low. B is incorrect. Without velocity, inflation does not spike.

Question 101

In a scenario where both fiscal and monetary policies are expansionary, which of the following outcomes is most likely? A. Lower interest rates and a contraction in private sector activity B. Higher interest rates and a contraction in government spending C. Lower interest rates and growth in both public and private sectors

Answer 101

Correct Answer: C Explanation: Expansionary monetary policy lowers interest rates; expansionary fiscal policy increases public spending and/or cuts taxes, stimulating the economy. A is incorrect. Expansionary policy would not cause contraction. B is incorrect. Expansionary fiscal policy implies increased government spending, not contraction.

Question 102

If the government increases its spending while the central bank raises interest rates, the expected result is: A. Lower GDP and lower interest rates B. Higher government share of GDP and higher interest rates C. Shrinking public sector and lower private investment

Answer 102

Correct Answer: B Explanation: Expansionary fiscal policy increases government spending (raising its GDP share), while contractionary monetary policy raises interest rates. A is incorrect. Interest rates would rise, not fall. C is incorrect. Public sector would expand, not shrink.

Question 103

Which policy mix is most likely to result in reduced aggregate demand and higher interest rates? A. Contractionary fiscal and contractionary monetary policy B. Expansionary fiscal and expansionary monetary policy C. Expansionary fiscal and contractionary monetary policy

Answer 103

Correct Answer: A Explanation: Both contractionary policies reduce demand and monetary tightening increases interest rates. B is incorrect. That combination would increase demand. C is incorrect. Fiscal expansion offsets some of the contraction from tight money.

Question 104

When contractionary fiscal policy is combined with expansionary monetary policy, what is the likely outcome? A. Lower interest rates and an increase in private sector activity B. Higher interest rates and decreased government spending C. Lower interest rates and reduced private consumption

Answer 104

Correct Answer: A Explanation: Fiscal contraction reduces government borrowing; monetary expansion lowers rates → more private consumption and investment. B is incorrect. It mixes correct and incorrect elements; interest rates should fall. C is incorrect. Lower rates generally increase private consumption.

Question 105

Which of the following statements best describes the interaction of expansionary fiscal and contractionary monetary policy? A. It lowers both public and private spending due to high interest rates B. It increases aggregate demand but may lead to crowding out C. It results in falling interest rates and rising inflation

Answer 105

Correct Answer: B Explanation: Fiscal expansion increases demand; monetary contraction raises rates, potentially crowding out private investment. A is incorrect. Public spending rises, not falls. C is incorrect. Interest rates rise, not fall.

Question 106

In a policy mix of contractionary fiscal and contractionary monetary policy, the most likely impact is: A. High inflation and lower unemployment B. Falling GDP and rising interest rates C. Stronger private sector expansion

Answer 106

Correct Answer: B Explanation: Both policies reduce economic activity. Monetary tightening also raises interest rates. A is incorrect. These policies aim to reduce inflation and likely raise unemployment. C is incorrect. Private sector shrinks due to tighter financial conditions.

Question 107

Which combination of policies would most likely lead to increased consumption and output but decreased government share of GDP? A. Expansionary fiscal and monetary policy B. Contractionary fiscal and expansionary monetary policy C. Expansionary fiscal and contractionary monetary policy

Answer 107

Correct Answer: B Explanation: Government contracts spending (reducing its share), while low interest rates from monetary expansion boost consumption and output. A is incorrect. Government share of GDP would rise. C is incorrect. Higher rates limit private activity.

Question 108

Which of the following best explains why the combination of expansionary fiscal and monetary policy has a greater impact than either policy alone? A. It decreases the monetary base B. It reduces the fiscal multiplier C. It leads to lower real interest rates and increased investment

Answer 108

Correct Answer: C Explanation: Combined stimulus increases inflation expectations and lowers real rates, encouraging spending. A is incorrect. Money base increases under expansionary monetary policy. B is incorrect. Multiplier increases with supportive monetary policy.

Question 108

The fiscal multiplier is likely to be highest for which of the following? A. Broad-based tax cuts for corporations B. Transfer payments targeted to low-income individuals C. Across-the-board tax rebates for middle-income earners

Answer 108

Correct Answer: B Explanation: Low-income individuals are more likely to spend any additional income, increasing GDP more. A is incorrect. Corporate tax cuts often lead to saving or stock buybacks. C is incorrect. The impact is positive but generally lower than targeted transfers.

Question 109

Which of the following is most likely to occur in an economy with contractionary fiscal policy and expansionary monetary policy? A. Increase in government borrowing B. Decline in interest rates and rise in private investment C. Simultaneous contraction of private and public sectors

Question 110

Which of the following correctly ranks fiscal stimulus options from most to least effective, based on the fiscal multiplier? A. Transfer payments to the poor > Tax cuts for workers > Broad-based transfers B. Tax cuts for workers > Broad-based transfers > Transfer payments to the poor C. Broad-based transfers > Tax cuts for workers > Transfer payments to the poor

Answer 110

Correct Answer: A Explanation: Poor individuals tend to spend more of what they receive. Workers follow, and broad transfers are less targeted. B and C are incorrect. They misorder the effectiveness based on empirical evidence.

Question 111

In which policy mix is government spending most likely to increase relative to GDP? A. Expansionary monetary and contractionary fiscal B. Expansionary fiscal and contractionary monetary C. Contractionary fiscal and monetary

Answer 111

Correct Answer: B Explanation: Fiscal expansion increases government’s GDP share. A is incorrect. Fiscal contraction reduces spending. C is incorrect. Both shrink government activity.

Question 112

What is a likely outcome when expansionary monetary policy is not accompanied by supportive fiscal policy? A. Lower interest rates and limited increase in aggregate demand B. High inflation and unsustainable GDP growth C. Sharp increase in government’s share of economic output

Answer 112

Correct Answer: A Explanation: Monetary policy alone may not stimulate demand sufficiently, especially in liquidity traps or if banks don’t lend. B is incorrect. No fiscal support limits overheating. C is incorrect. Government’s GDP share rises only with fiscal expansion.

Question 113

Why might fiscal policy be less effective if the central bank is simultaneously pursuing contractionary policy? A. Higher interest rates may crowd out private sector investment B. Low inflation expectations amplify fiscal stimulus C. Monetary contraction increases fiscal multipliers

Answer 113

Correct Answer: A Explanation: Higher rates make borrowing costlier for households and businesses, reducing effectiveness of fiscal expansion. B is incorrect. Low inflation expectations dampen, not amplify, stimulus. C is incorrect. Fiscal multipliers are typically lower with tight money.