Economics 112 Professor RaffertyPrinciples of Macroeconomics Spring 2012

Exam #3 Multiple Choice Questions (2 points each)

1. Commodity moneya. can be used to purchase commodities, but not services. b. has little to no value independent of its use as money.c. is backed by a valuable commodity such as gold.d. has value independent of its use as money.

2. The Fed can increase the federal funds rate bya. buying Treasury securities, which increases bank reserves.b. buying Treasury securities, which decreases bank reserves.c. selling Treasury securities, which increases bank reserves.d. selling Treasury securities, which decreases bank reserves.

3. Which of the following best describes how banks create money?a. Banks charge fees for providing financial advice.b. Banks charge higher interest rates on loans that they pay on deposits.c. Banks make loans from reserves.d. Banks create checking account deposits when making loans from excess reserves.

4. Dollar bills in the modern economy serve as money becausea. they have value as a commodity independent of their use as money.b. people have confidence that others will accept them as money.c. they are backed by the gold stored in Fort Knox.d. they can be redeemed for gold by the central bank.

5. If the central bank can act as a lender of last resort during a banking panic, banks cana. satisfy customer withdrawal needs and eventually restore the public’s faith in the banking system. b. borrow more and more money from the central bank, and this will lower its reserves and decrease the public’s faith in the banking system.c. encourage the public to borrow directly from the central bank, and this will worsen the banking panic.d. call in their loans to their customers and eventually restore the public’s faith in the banking system.

6. The situation in which short-term nominal interest rates are pushed to zero, leaving the central bank unable to lower them further is known as:a. a liquidity trap.b. a zero-sum game.c. the Taylor Rule.d. an interest rate panic.

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7. The major shortcoming of a barter economy is a. that goods and services are not traded.b. that money loses value from inflation.c. the requirement of a double coincident of wants.d. the requirement of specialization and exchange.

8. For purposes of monetary policy, the Federal Reserve has targeted the interest rate known as the a. Treasury bill rate.b. prime rate.c. federal funds rate.d. discount rate.

9. Monetary policy refers to the actions the a. Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives.b. Federal Reserve takes to manage government spending and taxes to pursue its economic objectives. c. President and Congress take to manage the money supply and interest rates to pursue its economic objectives.d. President and Congress take to manage government spending and taxes to pursue its economic objectives.

10. Suppose that the equilibrium real federal funds rate is 4 percent, the target inflation rate is 2 percent, the current inflation rate is 5 percent and real GDP is 6 percent below potential real GDP. If the weights for the inflation gap and output gap are both ½ , then according to the Taylor rule the federal funds target isa. 7.5 percentb. 13.5 percentc. 4.5 percentd. 10.5 percent.

11. The quantity theory of money predicts that, in the long run, inflation results from the a. money supply growing at a faster rate than real GDP.b. money supply growing at a slower rate than real GDP.c. velocity of money growing at a faster rate than real GDP.d. velocity of money growing at a lower rate than real GDP.

12. Which of the following is not a consequence of hyperinflation?a. The price level grows in excess of hundreds of percentage points per year.b. Money loses value so rapidly that firms and individuals stop holding it.c. It causes the economy to suffer slow growth.d. Money’s function as a medium of exchange is enhanced.

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13. Using the money demand and money supply model, an open market sale of Treasury securities by the Federal Reserve would cause the equilibrium interest rate toa. not change.b. increase, then decrease.c. decrease.d. increase.

14. Monetary policy could be pro-cyclical if the Federal Reservea. is quick to recognize that a recession has begun and conducts expansionary monetary policy.b. is quick to recognize that a recession has begun and does not conduct expansionary monetary policy.c. is late recognizing that a recession has begun and does not conduct expansionary monetary policy.d. is late recognizing that a recession has begun and conducts expansionary monetary policy.

15. The supporters of monetary growth rule believe that active monetary policy a. destabilizes the economy, increasing the number of recessions and their severity. b. stabilizes the economy, decreasing the number of recessions and their severity.c. cannot change real GDP.d. cannot change the inflation rate.

16. Contractionary monetary policy on the part of the Fed results ina. an increase in the money supply, a decrease in interest rates, and an increase in real GDP.b. an increase in the money supply, an increase in interest rates, and an increase in real GDP.c. a decrease in the money supply, an increase in interest rates, and a decrease in real GDP.d. a decrease in the money supply, a decrease in interest rates and a decrease in real GDP.

17. Banks can continue to make loans untila. excess reserves equal their required reserves.b. actual reserves equal their checking account balances.c. actual reserves equal their required reserves.d. actuals reserves equal their excess reserves.

18. Bank reserves includea. vault cash and deposits with the Federal Reserve.b. customer checking accounts and vault cash.c. deposits with the Federal Reserve and holdings of securities.d. vault cash and loans to bank customers.

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19. The M1 measure of the money supply equalsa. currency plus checking account balances plus traveler’s checks plus savings account balances.b. currency plus checking account balances plus traveler’s checks.c. currency plus checking account balances.d. paper money plus coins in circulation.

20. Which of the following describes what the Fed would do to pursue an expansionary monetary policy?a. use discount policy to raise the discount rate. b. raise the reserve requirements.c. use open market operations to sell Treasury securities.d. use open market operations to buy Treasury securities.

21. Suppose that households became mistrustful of the banking system and decide to decrease their checking accounts and increase their holdings of currency. Using the money demand and money supply model and assuming everything else is held constant, the equilibrium interest rate shoulda. not change.b. increase.c. increase, then decrease.d. decrease.

22. Use the quantity equation to answer this question. Assume the velocity of money growth is 0 percent, real GDP grows at 3 percent per year and that the central bank has target inflation rate of 2 percent. What should the central bank set as the growth rate of the money supply?a. 1 percent.b. 5 percent.c. 1.5 percent.d. 0.67 percent.

23. The required reserves of a bank equal its _____ the required reserve ratio.a. deposits multiplied byb. deposits divided byc. loans divided byd. loans multiplied

24. In economics, money is defined asa. any asset people generally accept in exchange for goods and services.b. the total value of one’s assets in current prices.c. the total value of one’s assets minus the total value of one’s debts, in current prices.d. the total amount of salary, interest, and rental income earned during a year.

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25. The three main monetary policy tools used by the Federal Reserve to manage the money supply area. tax rates, government purchases, and government transfer payments.b. open market operations, the exchange rate of the dollar against foreign currencies, and government purchases.c. open market operations, discount policy, and reserve requirements.d. interest rates, tax rates, and government spending.

Answer One Long Answer Question

1.

a. Explain the textbook interest rate channel for monetary policy. Start with open market operations and go all the way to the effect of monetary policy with the AD/AS model. (20 points)

b. Why does the textbook interest rate channel become ineffective when the federal funds rate falls to 0 percent? (10 points)

c. Explain three reasons why monetary policy might still have an effect on the economy even when the federal funds rate is 0 percent. (20 points)

2.

a. Why are financial institutions vulnerable to “bank runs” and “banking panics”? Make sure that you explain these terms. (20 points)

b. What is a “liquidity” problem and what is a “solvency” problem? Explain how bank runs can turn liquidity problems into solvency problems. (10 points)

c. How should a central bank respond to a bank run or banking panic? (20 points)

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The Fed Banks

Securities

Reserves

Answers to Multiple Choice Questions

1. C or D 6. A 11. A 16. C 21. B

2. D 7. C 12. D 17. C 22. B

3. D 8. C 13. D 18. A 23. A

4. B 9. A 14. A or D 19. B 24. A

5. A or D 10. A 15. A 20. D 25. C

Answers to Long Answer Questions

1. a. The textbook interest rate channel starts off with the Fed conducting open market operations to change the monetary base. For example, if the Fed purchases securities from banks then it pays with it with reserves.

At the end of this transaction, banks have more reserves so the monetary base will increase. If the money multiplier is constant then the money supply will increase:

MD

MS2

MS1

B

A

M2M1 Money

Nominal interest rate

i2

i1

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The money supply curve will shift to the right so the equilibrium short-term nominal interest rate will decrease. Long-term nominal interest rates following short-term interest rates with a bit of a lag so long-term nominal interest rates also decrease. If the expected inflation rate is constant then the cost of borrowing funds has decreased so consumption and investment expenditures increase. As a result, the AD curve will shift to the right so the price level and real GDP can change.

b. If the federal funds rate is already 0 percent then the Fed cannot reduce the nominal federal funds rate any further. That means that the Fed cannot reduce long-term real interest rates through standard methods so the Fed has to find some alternative means to affect consumption, investment and net exports.

c. Even if the nominal federal funds rate is already at 0 percent there are three reasons why the Fed may still be able to affect consumption, investment and net exports.

First, the real interest rate is defined as:r=i−πe.

Even if the long-term nominal interest rate is 0 percent we still have:

r=−π e.We also know that the Fed controls the inflation rate in the long-run so if the Fed can commit to increasing the inflation rate then the expected inflation will increase and the long-term real interest rate will decrease. This should increase consumption, investment and net exports.

Second, long-term nominal interest rates depend not only on the current nominal federal funds rate, but also expected future nominal interest rates. If the Fed can credibly commit to keeping the nominal federal funds rate low in the future then this can reduce the long-term nominal interest rate today. Assuming that expected inflation is constant, the long-term real interest rate will decrease.

Third, the Fed has an unlimited ability to create bank reserves so it has an unlimited ability to purchase financial assets such as long-term U.S. Treasury securities and mortgage backed securities. The Fed can use this to purchase lots of long-term U.S. Treasury securities directly which will reduce the long-term nominal interest rate and assuming that expected inflation is constant the long-term real interest rate will also decrease. By purchasing lots of mortgage backed securities this can lead banks to issue more new mortgages because the banks know that they can quickly sell the mortgages to the Fed.

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2.

a. A ‘bank run’ occurs when depositors lose confidence in a bank and become concerned that their checking account deposits, savings account deposits etc. are not safe. As a result, depositors simultaneously withdraw the funds from the bank which can exhaust the banks liquid assets. A ‘banking panic’ occurs when many bank runs occur at exactly the same time.

Financial institutions are vulnerable to bank runs for three reasons. First, banks operate under a fractional reserve system where the banks keep less than 100% of their deposits on hand as cash. Therefore, there is never enough cash or other liquid assets in a bank to pay out all depositors simultaneously. Second, banks have short-term liabilities (deposits), but long-term assets (mortgages, car loans, etc.). These assets can be converted into cash to pay out depositors, but it takes time which banks may not have during a bank run. Third, there is asymmetric information between the bank and the depositors. The bank has far better information than the depositors about the quality of the bank’s loans and the bank has far better information about how many liquid assets the bank owns. Therefore, if a depositor even thinks that a bank is running out of liquid assets or thinks that other depositor might think that then the depositor has an incentive to withdraw his or her funds immediately.

b. One way for a financial institution to deal with a bank run is to sell its long-term assets. However, to raise enough cash the financial institution may have to sell a large amount of their long-term assets which can cause the price of those assets to decrease. Therefore, a bank run can reduce the value of a financial institution’s assets and may turn an otherwise solvent financial institution into an insolvent financial institution.

c. Central banks can prevent bank runs by lending freely to solvent financial institutions that do not have enough liquid assets to meet the surge in withdraws by depositors. The financial institution can use its illiquid assets such as mortgages and other loans as collateral for the loans. Therefore, the financial institution will not be forced to sell assets at low prices so it should remain solvent and depositors should have confidence that they will get their funds if they want them. This later effect should reduce or eliminate the bank run.

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