Economics (McConnell), AP Edition, 20th Edition Chapter (25).docx

Chapter 34: Interest Rates and Monetary Policy Multiple-Choice Questions 1. In the money market, (A) the demand for money consists of asset and transactions demand (B) the supply of money is horizontal (C) the interest rate is determined by the demand for money (D) Congress determines the money supply (E) Congress and the Fed jointly determine an appropriate interest rate (A) Asset demand is money people hold as savings for future use; transactions demand is the money people hold in order to make purchases. Difficulty: Easy Style: Factual AP Economics Curricular Requirement Macroeconomics: Money Demand Book Section: The Demand for Money 2. The Federal Reserve increases the money supply when it (A) buys bonds (B) increases the reserve requirement (C) lowers taxes (D) increases the discount rate (E) increases government spending (A) When the Fed buys bonds, bank reserves increase, allowing banks to loan out more funds and increase the money supply. Increasing the reserve requirement and discount rate reduce the money supply. Taxes and spending are fiscal policies controlled by Congress rather than the Fed. Difficulty: Easy Style: Factual AP Economics Curricular Requirement Macroeconomics: Tools of Central Bank Policy Book Section: Open-Market Operations 3. The interest rate the Fed charges commercial banks for loans is the (A) reserve requirement (B) real interest rate (C) prime rate (D) discount rate (E) federal funds rate (D) Changes in the discount rate can provide commercial banks the incentive to borrow more or less from the Fed, changing the reserves available for loans. If the discount rate increases, banks with insufficient reserves will have to pay more to borrow funds from the Fed. If the cost of borrowing from the Fed has increased, then banks will be discouraged from excessive lending that would require them to borrow additional funds at a higher discount rate. Difficulty: Easy Style: Factual AP Economics Curricular Requirement Macroeconomics: Tools of Central Bank Policy Book Section: The Discount Rate 4. The most commonly used tool of monetary policy is (A) the reserve requirement (B) the discount rate (C) open market operations (D) tax rates (E) government spending (C) Open market operations, the Fed's buying and selling of government bonds, allow the Fed to make minor changes in the money supply quickly and easily. Difficulty: Easy Style: Factual AP Economics Curricular Requirement Macroeconomics: Tools of Central Bank Policy Book Section: Relative Importance 5. If the Federal Reserve sells bonds on the open market, the (A) money supply and interest rate both increase (B) money supply decreases and the interest rate increases (C) money supply increases and the interest rate does not change (D) money supply and interest rate both decrease (E) money supply increases and the interest rate decreases (B) By selling bonds, the Fed absorbs money from people or commercial banks, and the lower money supply causes an increase in the interest rate. Difficulty: Easy Style: Factual AP Economics Curricular Requirement Macroeconomics: Money Market and the Equilibrium Nominal Interest Rate Book Section: Open-Market Operations 6. Expansionary monetary policy is most appropriate when (A) the unemployment rate is low (B) the inflation rate is high (C) real GDP is falling (D) the money supply is high (E) interest rates are low (C) Expansionary monetary policy is appropriate during a recession, when unemployment tends to be high and the inflation rate low. Increasing the money supply lowers interest rates in an effort to stimulate spending. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policies Book Section: Expansionary Monetary Policy 7. Which of the following policies would be appropriate to resolve a recession? (A) Increasing the federal funds rate (B) The Fed selling bonds to a commercial bank (C) Increasing the discount rate (D) Raising the prime rate (E) Lowering the reserve requirement (E) By lowering the reserve requirement, the Fed increases the excess reserves available for banks to loan. With the creation of excess reserves, banks will issue new loans and increase the total of checkable deposits. That will increase the money supply. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policy Book Section: Expansionary Monetary Policy 8. If the Federal Reserve increases the money supply, how will interest rates, capital investment, and aggregate demand be affected? Interest Rates Capital Investment Aggregate Demand (A) Increase Increase Increase (B) Decrease Decrease Decrease (C) Increase Decrease Increase (D) Decrease Increase Increase (E) Increase Decrease Decrease (D) An increase in the money supply lowers the interest rate, which will lead more firms to borrow for capital investment; capital spending then increases aggregate demand in the economy. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Demand-Side Effects Book Section: Effect of an Expansionary Monetary Policy 9. Which of the following policies would be inappropriate if the Federal Reserve is trying to reduce the inflation rate? (A) Selling bonds on the open market (B) Increasing the discount rate (C) Reducing the federal funds rate (D) Increasing the reserve requirement (E) Reducing the money supply (C) Reducing the federal funds rate encourages firms to issue new loans based on excess reserves. If the federal funds rate decreases, it is less expensive for banks to take out overnight loans from other banks. This would increase the money supply, a policy exacerbating inflation. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policies Book Section: Restrictive Monetary Policy 10. How will the Fed's purchase of bonds likely affect real output, employment, and price level? Real Output Employment Price Level (A) Decrease Decrease Decrease (B) Increase Increase Decrease (C) Decrease Decrease Increase (D) Increase Decrease Decrease (E) Increase Increase Increase (E) The Fed's purchase of bonds increases the money supply, thereby reducing interest rates and leading to more capital investment. As aggregate demand increases, real GDP increases, employment increases as workers are hired to make the additional output, and prices rise due to the increase in aggregate demand. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Demand-Side Effects Book Section: Effects of an Expansionary Monetary Policy 11. Which combination of fiscal and monetary policy actions would be most effective in reducing an inflationary gap? (A) Increasing taxes and decreasing the reserve requirement (B) Decreasing government spending and the Fed selling bonds (C) Decreasing taxes and increasing the discount rate (D) Increasing government spending and decreasing the discount rate (E) Increasing taxes and the Fed buying bonds (B) A decrease in government spending directly lowers aggregate demand. The Fed's purchase of bonds reduces the bank reserves available for loans, thereby lowering the money supply and reducing aggregate demand. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Policy Mix Book Section: Restrictive Monetary Policy 12. Which of the following policy combinations would be most effective in promoting long-run economic growth? Taxes Reserve Requirement Open Market Operations (A) Increase Increase Buy (B) Increase Decrease Buy (C) Decrease Decrease Sell (D) Decrease Increase Sell (E) Decrease Increase Buy (B) The key to promoting long-run economic growth is low interest rates. If taxes are increased, government demand for loanable funds is reduced, and interest rates fall. Both lowering the reserve requirement and the central bank’s purchase of government bonds will increase the money supply and lower interest rates. Lower interest rates will increase business investment, which increases long-run aggregate supply, promoting long-run economic growth. Difficulty: Hard Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Policy Mix Book Section: Expansionary Monetary Policy 13. When interest rates rise, current bond prices (A) rise because people view them as a more attractive investment (B) rise because fewer firms will offer bonds at the higher interest rates (C) fall because the fixed interest rate on current bonds is lower than the interest rate on newly-issued bonds (D) fall because the value of the dollar has decreased (E) fall because the newly-issued bonds are more expensive and are therefore more likely to increase in value over time (C) When newly-issued bonds offer higher interest rates, the price of current bonds must fall to compete with them, until the interest per dollar invested is equal between the bonds. Difficulty: Hard Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Money, Banking, and Financial Markets Book Section: Interest Rates and Bond Prices 14. Assume that price levels for goods and services rise 10 percent and the money supply remains constant. Money demand, interest rates, transaction demand, and asset demand will most likely change in the following ways. Money Nominal Transaction Asset Demand Interest Rate Demand Demand (A) Increases Increases Increases Increases (B) Increases Increases Decreases Decreases (C) Increases Increases Increases Decreases (D) Constant Constant Increases Decreases (E) Constant Constant Decreases Increases (C) Higher price levels will require more money to purchase goods and services, causing transaction demand to increase. If the money supply is held constant and money demand increases, nominal interest rates will increase. If nominal interest rates increase, the quantity demanded for holding money as a store of value will decrease. Difficulty: Hard Style: Application AP Economics Curricular Requirement Macroeconomics: Money Demand Book Section: The Demand for Money 15. When interest rates increase, asset demand for money (A) increases because people can earn more money from investing than they can from holding it in cash (B) decreases because people would choose to buy more products, converting the money to transactions demand (C) increases because the demand for bonds would increase (D) decreases because the opportunity cost of holding money as an asset increases (E) increases because the money supply is increasing (D) Holding money in cash produces no income, while holding those savings in a bond or a bank account generates interest. When the interest rate increases, the opportunity cost (forgone income) for holding that money in cash increases, so people reduce their asset demand for money. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Money Demand Book Section: The Demand for Money 16. When the Fed engages in open market operations, it buys bonds from I. the public II. commercial banks and thrifts III. the federal government IV. corporations (A) I only (B) III only (C) I and II only (D) III and IV only (E) I, II, III, and IV (C) The Fed buys bonds from the public and commercial banks and thrifts so that it can change the amount of demand deposits and excess reserves in banks. This affects the amount of funds available for loan, changing the money supply. Difficulty: Medium Style: Factual AP Economics Curricular Requirement Macroeconomics: Tools of Central Bank Policy Book Section: Open-Market Operations Questions 17-19 assume that the required reserve ratio is 20 percent and that the Fed engages in an open market purchase of $1,000 of government securities. 17. The central bank buys $1,000 of government securities only from commercial banks. The maximum change in excess reserves, banking system loans, and the total money supply will be Excess Banking System Total Money Reserves Loans Supply (A) $ 1,000 $ 5,000 $ 5,000 (B) $ -1,000 $ -4,000 $ -5,000 (C) $ 200 $ 800 $ 1,000 (D) $ 0 $ -5,000 $ -1,000 (E) $ 800 $ 4,000 $ 5,000 (E) The central bank (Fed) purchase of $1,000 of government securities from only commercial banks will create an initial $1,000 in excess reserves in the banking system. Because the bank is allowed to loan the entire $1,000, the maximum increase in banking system loans and in the money supply will be $5,000. Difficulty: Medium Style: Application AP Economics Curricular Requirement Macroeconomics: Creation of Money Book Section: Open-Market Operations 18. The central bank purchases $1,000 of government securities only from the public. The maximum change in excess reserves, banking system loans, and the money supply will be Excess Banking System Money Reserves Loans Supply (A) $ 800 $ 4,000 $ 5,000 (B) $ -1,000 $ -4,000 $ -5,000 (C) $ 200 $ 800 $ 1,000 (D) $ 0 $ -5,000 $ -1,000 (E) $ 1,000 $ 5,000 $ 5,000 (A) The central bank purchases $1,000 of government securities only from the public, which then deposits that $1,000 into their commercial banks. In this case, the commercial banks will have initially only $800 in excess reserves to create new loans, with the remaining $200 held as required reserves. With a multiplier of 5, the banking system will create $4000 in new loans, so the total increase in the money supply will be $5,000, the initial deposit plus the total of new loans created. Difficulty: Medium Style: Application AP Economics Curricular Requirement Macroeconomics: Creation of Money Book Section: Open-Market Operations 19. The central bank purchase of $1,000 of government securities will create the following changes to money demand, money supply, and nominal interest rates. Money Demand Money Supply Nominal Interest Rates (A) Increase Increase Uncertain (B) Decrease Decrease Uncertain (C) Constant Increase Decrease (D) Constant Decrease Increase (E) Increase Constant Increase (C) The central bank purchase of $1,000 of government securities will increase the money supply. This rightward shift will decrease nominal interest rates. Money demand will remain constant, but there will be an increase in the quantity of money demanded. Difficulty: Medium Style: Application AP Economics Curricular Requirement Macroeconomics: Creation of Money Book Section: Open-Market Operations 20. If the Fed wanted to pursue a contractionary monetary policy, which of the following options might it consider? I. Decrease the discount rate. II. Increase personal income taxes. III. Purchase government securities. IV. Sell government securities. V. Decrease government spending. (A) I and III only (B) I, II, and III only (C) II, IV, and V only (D) III only (E) IV only (E) The Fed’s sale of government securities would decrease the money supply, increase nominal interest rates, and decrease real output. Decreasing government spending and increasing personal income taxes are fiscal, not monetary, policy options. Decreasing the discount rate and purchasing government securities are expansionary monetary policy options. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policies Book Section: Restrictive Monetary Policy 21. The Federal Reserve’s most important influence on the economy is its power to cause short-run changes in I. aggregate supply II. the money supply III. fiscal policy IV. interest rates (A) I only (B) III only (C) II and IV only (D) I, II, and IV only (E) I, II, III, and IV (C) The Fed’s tools of monetary policy allow it to change the money supply, therefore changing interest rates. These monetary policy tools affect aggregate demand in the short run, though changes in interest rates can affect long-run aggregate supply as a result of investment. Fiscal policy is conducted by Congress and the President, not the Fed. Difficulty: Easy Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policies Book Section: Interest Rates 22. When the Fed purchases a bond from I. a commercial bank, the excess reserves increase by the full amount of the bond purchase II. a commercial bank, the money supply increases III. the public, the excess reserves increase by the amount of the bond purchase minus the reserve requirement IV. the public, the money supply decreases (A) I and II only (B) III and IV only (C) I and III only (D) I, II, and III only (E) I, III, and IV only (D) Bond purchases from either commercial banks or the public increase the money supply. When the Fed buys from a commercial bank, all of that money is available to be loaned as excess reserves. But when the Fed buys from the public, it issues a check that the customer deposits in a demand deposit account, which is subject to the reserve requirement. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Tools of Central Bank Policy Book Section: Open-Market Operations 23. An increase in the required reserve ratio has all of the following effects EXCEPT (A) Excess reserves decrease. (B) The interest rate increases. (C) The money supply decreases. (D) The money multiplier decreases. (E) Aggregate demand increases. (E) An increase in the required reserve ratio requires the banks to hold a larger percentage of demand deposits in vault cash or on deposit with the Fed, reducing the banks’ capacity to issue loans. As interest rates rise, firms and consumers reduce the quantity of money they demand for investment and interest-sensitive loans, reducing aggregate demand. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Demand-Side Effects Book Section: The Reserve Ratio 24. An increase in the discount rate (A) encourages firms to borrow from commercial banks for investment (B) discourages households from investing in Treasury bonds (C) encourages consumers to borrow from commercial banks for interest-sensitive purchases (D) discourages commercial banks from borrowing from the Fed (E) encourages the Fed to borrow from the U.S. Treasury by buying bonds (D) The discount rate is the interest rate the Fed charges member banks for loans. If banks must pay a higher interest rate, they are discouraged from borrowing from the Fed, which holds down the excess reserves which banks could loan to customers. Difficulty: Easy Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Tools of Central Bank Policy Book Section: The Discount Rate 25. If the Fed increases the discount rate, the money supply, interest rate, capital investment, and aggregate demand would change in the following ways. Money Supply Interest Rate Capital Investment Aggregate Demand (A) Increase Increase Increase Increase (B) Increase Decrease Increase Increase (C) Decrease Increase Decrease Decrease (D) Decrease Increase Increase Increase (E) Decrease Decrease Decrease Decrease (C) If the Fed increases the discount rate, banks reduce their borrowing from the Fed, reducing excess reserves. The money supply decreases, which causes an increase in interest rates. As borrowing becomes more expensive, firms reduce capital investment, which reduces aggregate demand. Difficulty: Medium Style: Application AP Economics Curricular Requirement Macroeconomics: Demand-Side Effects Book Section: Effects of a Restrictive Monetary Policy Free-Response Question The United States economy is experiencing a significant recession. (a) Identify the open market operation the Fed could take to return the economy to full employment output. (b) Using a correctly labeled graph of the money market, show the effect of the open market operation on each of the following. (i) The money supply (ii) The interest rate (c) Explain how the change in interest rate in (b) (ii) affects aggregate demand. (d) Using a correctly labeled aggregate demand-aggregate supply graph, show the effect of the change in aggregate demand on each of the following. (i) Real output (ii) Price level Free-Response Explanation 8 points (1 + 3 + 1 + 3) (a) 1 point: 1 point is earned for stating that the Fed will purchase bonds. (b) 3 points: 1 point is earned for a correctly labeled money market graph, with the vertical money supply shifting to the right. 1 point is earned for showing that the money supply will increase. 1 point is earned for showing that the interest rate will decrease. (c) 1 point: 1 point is earned for explaining that when the interest rate falls, firms increase investment and consumers borrow more to increase interest-sensitive spending. Both factors result in an increase in aggregate demand. (d) 3 points: 1 point is earned for a correctly labeled aggregate demand-aggregate supply graph, with the aggregate demand curve shifting to the right. 1 point is earned for showing that the real output increases. 1 point is earned for showing that the price level increases. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policies Book Section: Monetary Policy, Real GDP, and the Price Level