Chapter 10 Mishkin (10)

Macreconomics: Policy and Practice (Mishkin) Chapter 10 Monetary Policy and Aggregate Demand 10.1 The Federal Reserve and Monetary Policy 1) There are no questions for this section. Answer: 10.2 The Monetary Policy Curve 1) The MP curve indicates the relationship between ________ and the ________. A) taxes; price level B) the real interest rate; inflation rate C) monetary policy; IS curve D) all of the above E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Reflective Thinking 2) The exogenous variable in the monetary policy curve is ________. A) the policy parameter, λ B) the real interest rate C) the autonomous component, D) the federal funds rate E) the inflation rate Answer: E Topic: 10.1 The MP Curve AACSB: Analytical Skills 3) The endogenous variable in the monetary policy curve is ________. A) the policy parameter, λ B) the real interest rate C) the autonomous component, D) the federal funds rate E) the inflation rate Answer: B Topic: 10.1 The MP Curve AACSB: Analytical Skills

1 Copyright © 2012 Pearson Education, Inc.

4) When the Federal Reserve ________. A) drains liquidity, the federal funds rate falls B) drains liquidity, real interest rates fall C) provides more liquidity, the federal funds rate falls D) all of the above E) none of the above Answer: C Topic: 10.1 The MP Curve AACSB: Reflective Thinking 5) The Federal Reserve ________. A) sets the federal funds rate once a year B) controls the interest rate in the short run C) controls the interest rate in the long run D) all of the above E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Reflective Thinking 6) The federal funds rate is ________. A) a real interest rate B) set periodically by Congress C) a nominal interest rate D) all of the above E) none of the above Answer: C Topic: 10.1 The MP Curve 7) A central bank can control the real interest rate precisely, so long as ________ remains constant. A) the nominal interest rate B) monetary policy C) expected inflation D) all of the above E) none of the above Answer: C Topic: 10.1 The MP Curve AACSB: Analytical Skills

2 Copyright © 2012 Pearson Education, Inc.

8) In the very short run ________. A) the real interest rate will be affected by changes in the nominal rate B) monetary policy has an immediate effect on inflation C) the inflation rate is determined by the federal funds rate D) all of the above E) none of the above Answer: A Topic: 10.1 The MP Curve AACSB: Reflective Thinking 9) Which of the following is true about the Taylor principle? A) it explains the link between higher inflation and higher real interest rates B) it is the foundation for an upward sloping MP curve C) it reflects the practice of monetary policy D) all of the above E) none of the above Answer: D Topic: 10.1 The MP Curve AACSB: Reflective Thinking 10) If the central bank did not follow the Taylor principle, an increase in inflation would lead to a decrease in ________. A) the nominal interest B) the real interest rate C) aggregate output D) all of the above E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Reflective Thinking 11) If the central bank did not follow the Taylor principle, an increase in inflation would lead to ________. A) a decrease in the nominal interest rate B) an increase in inflation C) a decrease in aggregate expenditure D) all of the above E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Reflective Thinking

3 Copyright © 2012 Pearson Education, Inc.

12) If expected inflation rises, monetary policy ________. A) is rendered ineffective B) must be tightened, to prevent further increases in inflation and expected inflation C) will prevent any increase in the real interest rate D) is designed to increase the nominal interest rate by more than the increase in expected inflation E) none of the above Answer: D Topic: 10.1 The MP Curve AACSB: Reflective Thinking 13) Autonomous tightening of monetary policy involves ________. A) raising interest rates and shifting the MP curve to the right B) lowering interest rates and shifting the MP curve to the left C) raising interest rates and shifting the MP curve to the left D) lowering interest rates and shifting the MP curve to the right E) none of the above Answer: C Topic: 10.1 The MP Curve AACSB: Reflective Thinking 14) Autonomous easing of monetary policy involves ________. A) raising interest rates and shifting the MP curve to the right B) lowering interest rates and shifting the MP curve to the left C) raising interest rates and shifting the MP curve to the left D) lowering interest rates and shifting the MP curve to the right E) none of the above Answer: D Topic: 10.1 The MP Curve AACSB: Reflective Thinking 15) A movement along the MP curve ________. A) implies an automatic adjustment of the interest rate B) implies an autonomous adjustment to the interest rate C) implies an autonomous adjustment of aggregate demand D) all of the above E) none of the above Answer: A Topic: 10.1 The MP Curve AACSB: Reflective Thinking

4 Copyright © 2012 Pearson Education, Inc.

16) A shift of the MP curve ________. A) implies an automatic adjustment of the interest rate B) implies a direct policy action of the Federal Reserve C) does not alter the relationship between inflation and the interest rate D) all of the above E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Reflective Thinking 17) The MP curve may be used to represent ________. A) movements of the real interest rate as a direct policy action of the Federal Reserve B) movements of the real interest rate that are independent of direct Federal Reserve action C) how the real interest rate is related to the inflation rate D) all of the above E) none of the above Answer: D Topic: 10.1 The MP Curve AACSB: Reflective Thinking 18) The MP curve may be used to represent how ________. A) movements of the inflation rate are determined by the real interest rate B) monetary policy responds to changes in the real interest rate C) movements of the real interest rate are related to the inflation rate D) all of the above E) none of the above Answer: C Topic: 10.1 The MP Curve AACSB: Reflective Thinking 19) A decision to increase the parameter λ in the MP curve is an example of ________. A) autonomous easing B) leftward movement along the curve C) rightward movement along the curve D) endogenous response E) autonomous tightening Answer: E Topic: 10.1 The MP Curve AACSB: Analytical Skills

5 Copyright © 2012 Pearson Education, Inc.

20) Before the financial crisis of 2007, inflation was on the rise. According to the MP curve, this would lead to ________. A) an increase in the real interest rate B) an upward shift of the MP curve, if policymakers opted for autonomous tightening C) a decrease in aggregate output D) all of the above E) none of the above Answer: D Topic: 10.1 The MP Curve AACSB: Reflective Thinking 21) As the financial crisis became more severe in 2008, the Federal Reserve undertook a(n) ________ of monetary policy, an effect of which is to ________ inflation. A) contraction; raise B) easing; raise C) contraction; lower D) easing; lower E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Reflective Thinking 22) Throughout 2008, inflation and the real interest rate declined together. The cause is a combination of ________. A) monetary policy easing and declining autonomous spending B) declining autonomous spending and movement along a fixed MP curve C) monetary policy tightening and inversion of the MP curve D) increased government spending and movement along a fixed MP curve E) none of the above Answer: A Topic: 10.1 The MP Curve AACSB: Analytical Skills

6 Copyright © 2012 Pearson Education, Inc.

MP Curve

23) Referring to the graph above, a movement from point H to point I might represent ________. A) the increase in the inflation rate that occurs when the real interest rate rises B) the automatic response of monetary policy to an increase in the inflation rate C) an autonomous tightening of monetary policy D) any of the above E) none of the above Answer: B Topic: 10.1 The MP Curve AACSB: Analytical Skills 24) On the graph above, which pair of points best represents the impacts in the U. S. of the financial crisis and policy response from 2007 through 2008? A) H to I B) K to G C) I to H D) K to F E) G to J Answer: E Topic: 10.1 The MP Curve AACSB: Analytical Skills 25) On the graph above, which pair of points best represents a scenario in which the nominal interest rate and expected inflation decline equally? A) I to H B) G to K C) I to J D) K to F E) J to H Answer: D Topic: 10.1 The MP Curve AACSB: Analytical Skills 7 Copyright © 2012 Pearson Education, Inc.

26) Suppose the nominal interest rate is five percent, and the inflation rate rises from two percent to three percent. Might an increase in the nominal interest rate to 5.5 percent be consistent with the Taylor Principle? If not, what consequences might ensue? Answer: Yes, it might be. The Taylor Principle requires that the nominal interest rate rise by more than the increase in expected inflation. If expected inflation has not changed, or has increased by less than half a percentage point, then the increase in the nominal interest rate implies an increase in the real interest rate. If expected inflation has increased by more than 0.5%, then the real interest rate has declined, which will encourage more spending that might fuel further increases in inflation. Topic: 10.1 The MP Curve AACSB: Reflective Thinking 27) A key concern of monetary policy makers is credibility. In particular, that people believe that inflation will not deviate far from a rate consistent with a healthy macroeconomy. How might credibility affect the slope of the monetary policy curve? Answer: Credibility implies that the monetary policy curve will be relatively flat. When inflation expectations rely more on confidence in monetary policy and less on the latest fluctuations, small changes in the real interest rate suffice to prevent changes in inflation from acquiring momentum. Topic: 10.1 The MP Curve AACSB: Reflective Thinking 28) Suppose the economy is just recovering from a recession and all signs now point to robust growth. How might this transition from recovery to expansion be reflected in the monetary policy curve? Answer: The monetary policy curve will have been relatively low, as policy makers kept interest rates as low as possible to hasten recovery from the recession. Once the recession is over, the monetary policy curve will shift up, since low interest rates are no longer appropriate, and to reduce the danger that spending will climb too rapidly and cause inflation to rise. The curve may become steeper, as well, so that any increases in inflation are countered by substantial increases in the real interest rate. Topic: 10.1 The MP Curve AACSB: Reflective Thinking 29) If the monetary policy curve is correct, then policy makers care only about inflation and not at all about aggregate output and unemployment. Comment. Answer: The monetary policy curve is a concise expression of monetary policy, highlighting policy makers' concern with inflation stability. Policy concerns other than inflation are represented by shifts of the MP curve, so that the real interest rate may change independently of the inflation rate. Moreover, the goal of inflation stability implies the need to be responsive to macroeconomic conditions in general, since the behavior of inflation is closely linked to changes in aggregate output and unemployment. Topic: 10.1 The MP Curve AACSB: Reflective Thinking

8 Copyright © 2012 Pearson Education, Inc.

10.3 The Aggregate Demand Curve 1) The AD Curve ________. A) demonstrates how central banks respond to changes in interest rates by changing the inflation rate B) shows how changes in equilibrium output affect the inflation rate C) explains long run fluctuations in output and inflation D) all of the above E) none of the above Answer: E Topic: 10.2 The AD Curve AACSB: Reflective Thinking 2) The MP Curve ________. A) demonstrates how central banks respond to changes in inflation with changes in the interest rate B) shows how changes in interest rates affect equilibrium output C) explains short run fluctuations in output and inflation D) all of the above E) none of the above Answer: A Topic: 10.2 The AD Curve AACSB: Reflective Thinking 3) The IS Curve ________. A) demonstrates how central banks respond to changes in inflation with changes in the interest rate B) shows how changes in interest rates affect equilibrium output C) explains short run fluctuations in output and inflation D) all of the above E) none of the above Answer: B Topic: 10.2 The AD Curve AACSB: Reflective Thinking 4) The AD Curve ________. A) indicates the level of aggregate output corresponding to different goods-market-clearing levels of the interest rate B) is downward sloping, because with higher inflation comes higher interest rates and lower spending, so equilibrium aggregate output declines C) explains how inflation affects output in the short run D) all of the above E) none of the above Answer: D Topic: 10.2 The AD Curve AACSB: Reflective Thinking 9 Copyright © 2012 Pearson Education, Inc.

5) The AD Curve ________. A) indicates the level of aggregate output corresponding to different goods-market-clearing levels of the inflation rate B) is downward sloping, because with higher inflation comes lower interest rates and lower spending, so equilibrium aggregate output declines C) explains how inflation affects output in the short run D) all of the above E) none of the above Answer: C Topic: 10.2 The AD Curve AACSB: Reflective Thinking 6) Factors that shift the AD Curve include ________. A) the inflation rate B) aggregate output C) taxes D) all of the above E) none of the above Answer: C Topic: 10.2 The AD Curve AACSB: Reflective Thinking 7) In the aggregate demand curve, the endogenous variable is ________. A) output B) inflation C) the real interest rate D) real money balances E) none of the above Answer: A Topic: 10.2 The AD Curve AACSB: Analytical Skills 8) An increase in the real interest rate occurs when ________. A) monetary policy responds automatically to an increase in inflation B) expected inflation increases, relative to the nominal interest rate C) an increase in autonomous spending causes an increase in equilibrium output D) all of the above E) none of the above Answer: A Topic: 10.2 The AD Curve AACSB: Analytical Skills

10 Copyright © 2012 Pearson Education, Inc.

9) A decrease in the real interest rate occurs when ________. A) there is an autonomous tightening of monetary policy B) expected inflation increases, relative to the nominal interest rate C) a decrease in autonomous spending causes a decrease in equilibrium output D) all of the above E) none of the above Answer: B Topic: 10.2 The AD Curve AACSB: Analytical Skills 10) Factors that shift the AD Curve include ________. A) government purchases B) autonomous investment C) taxes D) all of the above E) none of the above Answer: D Topic: 10.2 The AD Curve AACSB: Reflective Thinking 11) Factors that shift the AD Curve include ________. A) autonomous net exports B) autonomous inflation C) autonomous interest rates D) all of the above E) none of the above Answer: A Topic: 10.2 The AD Curve AACSB: Reflective Thinking 12) If people begin to generally feel better about the future ________. A) autonomous consumption should rise B) autonomous investment should rise C) the AD curve will shift to the right D) all of the above E) none of the above Answer: D Topic: 10.2 The AD Curve AACSB: Reflective Thinking

11 Copyright © 2012 Pearson Education, Inc.

13) If government cuts taxes ________. A) after tax income should increase shifting AD to the left to a lower equilibrium level of output B) after tax income should increase shifting AD to the right to a higher equilibrium level of output C) after tax income and the equilibrium level of output remain unchanged D) after tax income remains unchanged but the equilibrium level of output would increase E) none of the above Answer: B Topic: 10.2 The AD Curve AACSB: Reflective Thinking 14) An increase in autonomous spending leads to higher ________. A) inflation B) output C) real interest rate D) all of the above E) none of the above Answer: B Topic: 10.2 The AD Curve AACSB: Analytical Skills 15) An increase in inflation leads to higher ________. A) output B) spending C) real interest rate D) all of the above E) none of the above Answer: C Topic: 10.2 The AD Curve AACSB: Analytical Skills 16) A change in inflation leads to shifts of the ________ curves. A) MP, IS, & AD B) MP & IS, but not AD C) IS & AD, but not MP D) MP, but not IS nor AD E) none of the above Answer: E Topic: 10.2 The AD Curve AACSB: Analytical Skills

12 Copyright © 2012 Pearson Education, Inc.

17) If the Federal Reserve raises interest rates in an autonomous tightening ________ . A) the MP curve shifts up, there is an upward movement along the IS curve, and the AD curve shifts to the left to a lower level of equilibrium output B) the MP curve shifts down, there is a downward movement along the IS curve and the AD curve shifts to the right to a higher level of equilibrium output C) the MP curve shifts up, there is a downward movement along the IS curve and the AD curve shifts to the right to a lower level of equilibrium output D) the MP curve shifts down, there is an upward movement along the IS curve and the AD curve shifts to the left to a higher level of equilibrium output E) none of the above Answer: A Topic: 10.2 The AD Curve AACSB: Reflective Thinking 18) If the Federal Reserve raises interest rates in an autonomous tightening ________ . A) the MP curve shifts up, raising the real interest for any given level of the inflation rate B) there is an upward movement along the IS curve C) the AD curve shifts to the left D) all of the above E) none of the above Answer: D Topic: 10.2 The AD Curve AACSB: Reflective Thinking 19) Shifts of the ________ curves result from autonomous monetary policy. A) MP, IS, & AD B) MP & IS, but not AD C) IS & AD, but not MP D) MP, but not IS nor AD E) none of the above Answer: E Topic: 10.2 The AD Curve AACSB: Analytical Skills 20) The IS curve is Y = 20 - 1.5r, and the aggregate demand curve is Y = 15.5 - 0.3π. The monetary policy curve is ________. A) r = 4.5 - 1.8π B) r = 20 + 0.3π C) r = 3 + 0.2π D) Y = 17.75 + 0.6π E) none of the above Answer: C Topic: 10.2 The AD Curve AACSB: Analytical Skills

13 Copyright © 2012 Pearson Education, Inc.

21) The IS curve is Y = 20 - 1.5r, and the aggregate demand curve is Y = 15.5 - 0.3π. When the interest rate is 7 percent, the inflation rate is ________ percent. A) 14.6 B) 9.5 C) 3.6 D) 20 E) none of the above Answer: D Topic: 10.2 The AD Curve AACSB: Analytical Skills 22) The IS curve is Y = 20 - 1.5r, and the aggregate demand curve is Y = 15.5 - 0.3π. When the inflation rate is 3 percent, output is ________. A) 20 B) 14.6 C) 9.5 D) 3.6 E) none of the above Answer: B Topic: 10.2 The AD Curve AACSB: Analytical Skills 23) The aggregate demand curve is Y = 15 - 0.2π when the inflation rate falls from 6 percent to 5 percent. Then, output increases from 13.8 to 17. The response of monetary policy to the inflation decline has been ________. A) autonomous tightening B) automatic adjustment C) autonomous easing D) to increase autonomous spending E) none of the above Answer: C Topic: 10.2 The AD Curve AACSB: Analytical Skills 24) Suppose the monetary policy curve is r = 5 + 0.8π, and the current values for output and inflation are 16.8 and 2 percent, respectively. An increase in global resource prices pushes the inflation rate to 4 percent. Policy makers estimate that the monetary policy in place, responding to 4 percent inflation, will bring output down to 13.6, a decline considered excessive. Instead, they implement an autonomous easing of monetary policy to lower output from 16.8 to 16. Assuming no change in the slope of the monetary policy curve, determine the new curve. Answer: From the given monetary policy curve, the real interest rate was initially 6.6 percent, and would rise to 8.2 percent in response to the increase in inflation from 2 percent to 4 percent. Since this increase in the real interest rate would cause output to decline from 16.8 to 13.6, we know that the IS curve is Y = 30 - 2r. If output is to be 16, the real interest rate must be 7 percent. The monetary policy curve with slope 0.8 and coordinates 4, 7 is r = 3.8 + 0.8π. Topic: 10.2 The AD Curve AACSB: Analytical Skills 14 Copyright © 2012 Pearson Education, Inc.

25) Suppose the demand curve is Y = 38 - 3π, and the current values for output and the real interest rate are 29 and 7 percent, respectively. A decrease in inflation leads to a new output level of 32 and real interest rate at 6 percent. The monetary policy curve is ________. Answer: The inflation rate falls from 3 percent to 2 percent. The corresponding real interest rates are 7 percent and 6 percent, so the MP curve is r = 4 + π. Topic: 10.2 The AD Curve AACSB: Analytical Skills 26) When the inflation rate falls, what happens, and why, to the MP, IS, and AD curves? Answer: A decrease in the inflation rate will, typically, raise the real interest rate, given the nominal interest rate, because expected inflation will have fallen. To prevent this increase in the real interest rate, which would cause spending and output to decline, the central bank lowers the nominal interest rate by more than the decrease in expected inflation. This movement down to the left along the MP curve corresponds to movement down to the right along the IS curve, because the lower real interest rate increases consumption, investment, and net exports. Movement down to the right along the AD curve shows the increase in output that has resulted from the decrease in the inflation rate. Topic: 10.2 The AD Curve AACSB: Analytical Skills 10.4 The Money Market and Interest Rates 1) The liquidity preference theory distinguishes between ________. A) nominal and real quantities B) money and financial assets C) buying goods and earning interest income D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 2) "Real money balances" refers to ________. A) the quantity of goods and services that money can buy B) gold and silver C) money that is actually available to be spent D) all of the above E) none of the above Answer: A Topic: 10.3 The Money Market and Interest Rates

15 Copyright © 2012 Pearson Education, Inc.

3) The liquidity preference theory ________. A) distinguishes between nominal and real quantities B) shows that demand for real balances depends on real income C) shows that demand for real balances depends on the nominal interest rate D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 4) ________ is a good measure of the opportunity cost of holding money. A) The real interest rate B) Liquidity preference C) Real income D) The inflation rate E) none of the above Answer: E Topic: 10.3 The Money Market and Interest Rates 5) Demand for real money balances depends on ________. A) the price level B) the real interest rate C) the opportunity cost of holding money D) all of the above E) none of the above Answer: C Topic: 10.3 The Money Market and Interest Rates 6) According to liquidity preference theory, as real income increases, so does ________. A) the supply of real money balances B) the demand for real money balances C) the real interest rate D) all of the above E) none of the above Answer: B Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 7) According to liquidity preference theory, an increase in the price level would ________. A) decrease the demand for real money balances B) increase the supply of real money balances C) decrease the real interest rate D) all of the above E) none of the above Answer: E Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 16 Copyright © 2012 Pearson Education, Inc.

8) According to liquidity preference theory, an increase in the price level would ________. A) increase the demand for real money balances B) decrease the supply of real money balances C) decrease the real interest rate D) all of the above E) none of the above Answer: B Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 9) The endogenous variable in the liquidity preference function is ________. A) demand for real money balances B) the nominal interest rate C) real income D) the price level E) none of the above Answer: A Topic: 10.3 The Money Market and Interest Rates AACSB: Analytical Skills 10) The liquidity preference function shows that as ________. A) real income decreases, so does the demand for real money balances B) the nominal interest rate increases, so does the demand for real money balances C) real income decreases, so does the real interest rate D) all of the above E) none of the above Answer: A Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 11) As the nominal interest rate increases ________. A) it becomes more costly to hold money instead of bonds B) the quantity of money demanded falls C) the opportunity cost of holding money rises D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking

17 Copyright © 2012 Pearson Education, Inc.

12) As the nominal interest rate increases ________. A) it becomes more costly to hold bonds instead of money B) the quantity of money demanded rises C) the opportunity cost of holding money rises D) all of the above E) none of the above Answer: C Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 13) As income rises ________. A) the number of transactions households and firms undertake should increase B) wealth also rises C) demand for real money balances should increase D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 14) The demand for real money balances ________. A) is downward sloping with respect to prices B) is downward sloping with respect to interest rates C) is downward sloping with respect to income D) all of the above E) none of the above Answer: B Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 15) Why is the demand for real money balances downward sloping? A) because the opportunity cost of holding money decreases as interest rates decrease B) because when the interest rate falls the quantity of money demanded increases C) because lower interest rates encourage firms and households to increase their money holdings D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking

18 Copyright © 2012 Pearson Education, Inc.

16) The supply curve for money ________. A) is upward sloping with respect to interest rates B) is fixed to a specified interest rate C) is fixed regardless of the interest rate D) is downward sloping with respect to interest rates E) none of the above Answer: C Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 17) Increased liquidity in the banking system occurs when ________. A) people buy more bonds B) the demand for real money balances declines C) banks buy more bonds from the central bank D) all of the above E) none of the above Answer: E Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 18) Typically, central banks increase the supply of money by ________. A) buying bonds from banks B) printing currency C) directing the government to issue more money to banks D) all of the above E) none of the above Answer: A Topic: 10.3 The Money Market and Interest Rates 19) Which of the following is true with regard to the supply of money? A) an open market sale of government securities will increase liquidity B) an open market purchase of government securities will decrease liquidity C) liquidity and the money supply are directly related D) all of the above E) none of the above Answer: C Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking

19 Copyright © 2012 Pearson Education, Inc.

20) Which of the following is true with regard to the supply of money? A) an open market purchase of government securities will increase liquidity B) an open market sale of government securities will decrease liquidity C) liquidity and the money supply are directly related D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 21) A decrease in income ________. A) lowers money demand for any given interest rate B) lowers interest rates ceteris paribus C) leads to a leftward shift of the money demand curve D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 22) When people are holding money in excess of their demand for real money balances ________. A) the nominal interest rate will fall B) they increase their purchases of goods and services C) the central bank buys bonds to correct the imbalance D) all of the above E) none of the above Answer: A Topic: 10.3 The Money Market and Interest Rates AACSB: Analytical Skills 23) A rightward shift of the money supply ________. A) may come about from an increase in the quantity of money supplied by the Federal Reserve B) may come about from a decrease in the price level C) leads to a decrease in interest rates ceteris paribus D) all of the above E) none of the above Answer: D Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking

20 Copyright © 2012 Pearson Education, Inc.

24) A leftward shift of the money supply ________. A) may come about from an increase in the quantity of money supplied by the Federal Reserve B) may come about from an increase in the price level C) leads to a decrease in interest rates ceteris paribus D) all of the above E) none of the above Answer: B Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 25) If the nominal interest rate is above the equilibrium level ________. A) the supply of real money balances will fall B) the quantity of real money balances people are holding is too low, and is rising C) people are selling financial assets in order to increase real money balances D) all of the above E) none of the above Answer: E Topic: 10.3 The Money Market and Interest Rates AACSB: Analytical Skills 26) If the nominal interest rate is above the equilibrium level ________. A) purchases of bonds and other assets will cause the interest rate to fall B) issuance of bonds and other assets will cause the supply of real money balances to increase C) the opportunity cost of holding money is low, and is rising D) all of the above E) none of the above Answer: A Topic: 10.3 The Money Market and Interest Rates AACSB: Analytical Skills 27) When the Federal Reserve increases the money supply, people ________. A) increase their purchases of bonds and other financial assets B) may, in the short run, increase their purchases of goods and services C) decrease the quantity of money holdings D) all of the above E) none of the above Answer: B Topic: 10.3 The Money Market and Interest Rates AACSB: Analytical Skills

21 Copyright © 2012 Pearson Education, Inc.

28) Why is the demand for real money balances related to the nominal interest rate, rather than the real interest rate? Answer: Because expected inflation is irrelevant to deciding between money versus interestbearing assets. Whether expected inflation is high or low, interest-bearing assets generate income at the nominal interest rate, and that income is the opportunity cost of holding money. Expected inflation implies a reduction in the purchasing power of money affecting equally both money held and money received as interest income. Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking 29) If your local bank buys a few billion dollars worth of government securities, what happens to the economy's money supply? Answer: If the seller of the bonds is another private business, there is no effect on the money supply. The money that might have supported spending and lending by the buying bank is now available for lending and spending by the seller(s) of the bonds. However, if the seller of the bonds is the Federal Reserve, then the money supply is reduced, since the decline in liquidity at the buying bank is not offset by an increase in liquidity elsewhere in the economy. (The bank's deposit at the Fed is reduced by the amount of its bond purchase; the money is not transferred to a different account, but ceases to exist.) Topic: 10.3 The Money Market and Interest Rates AACSB: Reflective Thinking d Y 30) Suppose real output is 12,500, and the demand for real money balances is M = - 125i. P

4

If the equilibrium interest rate is 7 percent, calculate the money supply . If the central bank sets the interest rate at 8 percent, what is the new money supply? Answer: Plugging the given output and interest rate in the demand equation, the money supply (equals money demand) is 2,250. When the interest rate is 8 percent, the money supply is 2,125. Topic: 10.3 The Money Market and Interest Rates AACSB: Analytical Skills

22 Copyright © 2012 Pearson Education, Inc.