EC3115 - Money Supply Quiz 2

1. According to McCallum, the behavioral assumption that the currency-to-deposit ratio (cr) is treated as a constant in the short run is justified because it:

A) Is directly controlled by the Federal Reserve. B) Depends primarily on institutional features that change slowly and predictably. C) Fluctuates wildly with the interest rate. D) Is always equal to the reserve ratio.

The currency-to-deposit ratio is chosen by the public and is assumed to depend on institutional factors (like payment technologies) that change slowly over time. For the purpose of short-run analysis, it is therefore often treated as a trend-dominated variable or a constant.

Source: McCallum, B. T. (1989). Monetary Economics, p. 57.

2. What is the primary risk a bank takes on when it engages in maturity transformation?

A) Credit risk: the risk that borrowers will default on their loans. B) Operational risk: the risk of failure in the bank's internal processes. C) Liquidity risk: the risk of being unable to meet depositors' demands for withdrawals. D) Legal risk: the risk of being sued by customers.

Maturity transformation involves funding long-term, illiquid assets (loans) with short-term, liquid liabilities (deposits). This creates liquidity risk, as a large, unexpected wave of withdrawals could force the bank to liquidate assets at a loss to meet its obligations.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 16, 34.

3. When a borrower repays a loan of $1,000 to a commercial bank, what is the immediate effect on the bank's balance sheet?

A) Assets (Loans) decrease by $1,000 and Liabilities (Deposits) decrease by $1,000. B) Assets (Reserves) increase by $1,000 and Assets (Loans) decrease by $1,000. C) Liabilities (Deposits) decrease by $1,000 and Net Worth increases by $1,000. D) Assets (Loans) decrease by $1,000 and Liabilities (Borrowed Reserves) decrease by $1,000.

Typically, a borrower repays a loan using funds from their deposit account at the same or another bank. This reduces the bank's loan asset and simultaneously reduces its deposit liability. The money supply contracts.

Source: Inferred from balance sheet mechanics in McCallum, B. T. (1989), p. 57.

4. A bank is considered insolvent when:

A) It runs out of physical cash in its vault. B) Its total liabilities exceed its total assets, resulting in negative net worth. C) It cannot meet a single depositor's withdrawal request. D) Its reserve ratio falls below the required minimum.

Insolvency is a balance sheet condition where a firm's liabilities are greater than its assets. This means the value of the owners' stake (net worth) is less than zero, and the bank would be unable to meet all its obligations even if it liquidated all its assets.

Source: General accounting principle, implied by McCallum, B. T. (1989), p. 57-58.

5. If the central bank uses an interest rate instrument (targeting R), how does it respond to an unexpected increase in money demand?

A) It sells bonds to prevent the interest rate from falling. B) It automatically allows the money supply to increase to keep the interest rate at its target. C) It raises the required reserve ratio. D) It keeps the monetary base constant and allows the interest rate to rise.

When targeting an interest rate, the central bank must accommodate shocks to money demand. An increase in money demand would normally push interest rates up. To prevent this, the central bank must increase the supply of reserves (increase H) to meet the higher demand at the target interest rate, causing the money stock to rise.

Source: McCallum, B. T. (1989), p. 64-66.

6. The "inconsistent quartet" highlights the impossibility of simultaneously achieving fixed exchange rates, monetary autonomy, free capital movement, and:

A) A low inflation rate. B) Free international trade. C) A balanced government budget. D) A high rate of economic growth.

The four desirable but mutually exclusive goals are fixed exchange rates, monetary autonomy, free capital movements, and free trade. A country must choose to sacrifice at least one of these objectives.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 41.

7. In the context of the money multiplier, a "leakage" from the re-lending cycle refers to:

A) A bank making a loan to an uncreditworthy borrower. B) The central bank selling government bonds. C) Funds that are not redeposited into the banking system, such as currency held by the public. D) A bank using its reserves to buy physical assets.

A leakage is any part of a loan that does not return to the domestic banking system as a new deposit. The primary leakage is the public's decision to hold some of the funds as currency. This withdraws reserves from the banking system and dampens the multiplier effect.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 27.

8. If a bank borrows from the central bank's discount window, how does this affect its balance sheet?

A) Assets (Reserves) increase and Net Worth increases. B) Assets (Reserves) increase and Liabilities (Borrowed Reserves) increase. C) Liabilities (Deposits) increase and Liabilities (Borrowed Reserves) increase. D) Assets (Loans) increase and Liabilities (Deposits) increase.

Borrowing from the discount window provides the bank with reserves, so its assets (Reserves) increase. At the same time, this creates a debt to the central bank, so its liabilities (Borrowed Reserves) increase by the same amount.

Source: McCallum, B. T. (1989). Monetary Economics, p. 57.

9. The Currency School of the 19th century argued that:

A) The money supply was endogenous and would adjust to the needs of trade. B) Banks should be free to issue as many notes as they wished. C) Control over the primary money (base money) provided control over the broader money supply. D) Interest rates were the only valid tool of monetary policy.

The Currency School believed in an exogenous money supply. They argued for a direct, stable link (multiplier) between the primary money (gold and central bank notes) and the broader money supply created by banks. Therefore, controlling the base would control the total money supply.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 15.

10. If the money multiplier $m=2.5$ and the currency-deposit ratio $c=0.5$, what must the reserve ratio $r$ be?

A) 10% B) 15% C) 20% D) 25%

Start with the formula $m = \frac{c + 1}{c + r}$. Rearrange to solve for r: $r = \frac{c + 1}{m} - c$. Substitute the given values: $r = \frac{0.5 + 1}{2.5} - 0.5 = \frac{1.5}{2.5} - 0.5 = 0.6 - 0.5 = 0.1$. A ratio of 0.1 is 10%.

Source: Derived from formula in EC3115 - Monetary Economics Unit E Lectures, Slide 30.

11. The "real balance effect" links the monetary and real sectors by suggesting that a change in the price level affects:

A) The nominal interest rate. B) The profitability of firms. C) The government budget deficit. D) Households' real wealth and thus their spending.

The real balance effect, described by Patinkin, posits that changes in the price level alter the real value of money holdings (M/P). This change in real wealth influences household consumption decisions, thereby creating a direct link from the monetary side (prices) to the real side (spending).

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 65

12. If a central bank strictly targets the monetary base (H-instrument), what is the consequence of an unexpected increase in banks' desire to hold excess reserves?

A) The money supply will increase. B) The interest rate will fall. C) The money supply will decrease. D) The monetary base will automatically increase.

An increased desire to hold excess reserves means the reserve ratio (r) increases. This causes the money multiplier (m) to fall. With the monetary base (H) held constant by the central bank, a smaller multiplier results in a smaller total money supply (M = m x H).

Source: McCallum, B. T. (1989), p. 62-63

13. Which monetary standard is most associated with the "price-specie-flow mechanism"?

A) Fiat Money Standard B) Classical Gold Standard C) Bretton Woods System D) A Currency Basket Peg

The price-specie-flow mechanism, first described by David Hume, is the theoretical automatic adjustment process under the classical gold standard. It holds that gold (specie) flows between countries to correct trade imbalances, causing price level changes that restore equilibrium.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 36

14. A primary reason for the collapse of the Bretton Woods system was:

A) The growing conflict between maintaining fixed exchange rates and pursuing domestic monetary autonomy. B) The discovery of new gold mines, which devalued the US dollar. C) A global shift towards free trade, which was incompatible with fixed rates. D) The refusal of the IMF to allow countries to adjust their parities.

This is a key aspect of the "inconsistent quartet." As capital became more mobile, countries found it impossible to simultaneously maintain a fixed exchange rate and use monetary policy to address domestic issues like unemployment. The desire for monetary autonomy eventually won out.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 41-42

15. If the money multiplier is 3.0 and the reserve ratio is 20%, what is the currency-deposit ratio?

A) 10% B) 20% C) 30% D) 40%

Using $m = \frac{c + 1}{c + r}$, we get $3.0 = \frac{c + 1}{c + 0.2}$. This gives $3(c + 0.2) = c + 1 \Rightarrow 3c + 0.6 = c + 1 \Rightarrow 2c = 0.4 \Rightarrow c = 0.2$. The ratio is 20%.

Source: Derived from formula in EC3115 - Monetary Economics Unit E Lectures, Slide 30

16. The "secondary sector" of the financial system, in the context of the Currency/Banking school debate, refers to:

A) The central bank. B) The commercial banking system. C) Non-bank financial intermediaries. D) The stock market.

In this historical context, the primary sector was the monetary authority providing base money. The secondary sector was the commercial banking system that created money (banknotes and deposits) on top of that base.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 15

17. What is the effect on the money supply if the central bank raises the discount rate?

A) It directly increases the money supply. B) It has no effect on the money supply. C) It may decrease the money supply by discouraging banks from borrowing reserves. D) It directly decreases the required reserve ratio.

Raising the discount rate makes it more expensive for banks to borrow reserves from the central bank. This discourages borrowing, leading to a smaller monetary base than would otherwise be the case, and thus a smaller money supply.

Source: McCallum, B. T. (1989), p. 57

18. The post-1971 international monetary system is often called a "non-system" because:

A) It lacks an explicit set of rules or an external anchor like gold for national monetary policies. B) International trade ceased to be important. C) Central banks no longer have any influence. D) All currencies are pegged to a single commodity basket.

The term, popularized by Williamson, refers to the absence of a formal, agreed-upon structure like the gold standard or Bretton Woods. National authorities have discretion over their fiat currencies without being bound by a commitment to an external standard.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 45

19. In the simple banking model where a reserve ratio acts as a "tax", the credit spread widens because:

A) The deposit rate must fall. B) The loan rate must rise to compensate for non-interest-earning reserves. C) The central bank taxes bank profits directly. D) Competition between banks is reduced.

The reserve requirement forces banks to hold a portion of their assets in a non-interest-bearing form. To maintain their profit margin (or satisfy the zero-profit condition), they must increase the return on their earning assets (loans), thus widening the spread over what they pay on deposits.

Source: EC3115 - Monetary Economics Unit E Lectures, Slides 43-45

20. Which of the following is a key benefit of a fiat money system over a commodity money system?

A) It guarantees a stable price level. B) It has a long and stable history. C) It is immune to government mismanagement. D) It economizes on the real resource costs associated with the monetary standard.

A major advantage of fiat money is that it is virtually costless to produce. It avoids the significant real resource costs of mining and maintaining a stock of a physical commodity (like gold) simply for it to serve as money.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 34, 47

21. If a bank has $500M in deposits and a net worth of $50M, and its only other liability is $50M in borrowed reserves, what is the value of its total assets?

A) $500M B) $550M C) $600M D) $450M

The accounting identity is Assets = Liabilities + Net Worth. Total liabilities are Deposits + Borrowed Reserves = $500M + $50M = $550M. Therefore, Total Assets = $550M + $50M = $600M.

Source: Derived from accounting identity in McCallum, B. T. (1989), p. 57

22. The ability of financial intermediaries to offer assets with greater "predictability of value" than the assets they hold is a key part of:

A) Maturity and risk transformation. B) Setting monetary policy. C) Enforcing government regulations. D) The price-specie-flow mechanism.

This describes the outcome of risk transformation. By pooling risks, intermediaries create liabilities (deposits) that have a stable, predictable nominal value, which is a much more desirable feature for savers than holding a claim on a single, risky loan.

Source: McCallum, B. T. (1989), p. 27

23. A "run" on a bank occurs when:

A) The bank makes too many profitable loans. B) A large number of depositors try to withdraw their funds simultaneously due to a loss of confidence. C) The central bank sells bonds to the bank. D) The bank's net worth becomes positive.

A bank run is a crisis of confidence where depositors, fearing the bank may fail, rush to withdraw their funds all at once. Since the bank only holds a fraction of deposits as reserves, it cannot meet all demands and will fail if the run is severe enough.

Source: Lewis, M. K., & Mizen, P. D. (2000), p. 34

24. If the central bank wants to sterilize the effect of a foreign exchange inflow on the monetary base, it will:

A) Buy domestic government bonds. B) Lower the reserve requirement. C) Lower the discount rate. D) Sell domestic government bonds.

A foreign exchange inflow (e.g., from an export surplus) increases the monetary base. To sterilize, or offset, this increase, the central bank must conduct an operation that reduces the monetary base by an equal amount. An open market sale of domestic bonds achieves this by draining reserves from the banking system.

Source: Lewis, M. K., & Mizen, P. D. (2000), p. 42

25. The total money supply (M) will be equal to the monetary base (MB) only if:

A) The reserve ratio is zero. B) The currency-deposit ratio is zero. C) The money multiplier is exactly 1. D) The central bank stops open market operations.

The relationship is M = m x MB. Therefore, M = MB only when the multiplier m = 1. This would happen in a 100% reserve banking system where banks do no lending (r=1), or in an economy with no banks where all money is currency.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 27

26. The "Banking School" believed that the money supply was:

A) Endogenous, adjusting to the needs of the economy. B) Exogenous, determined solely by the central bank. C) A constant multiple of the gold stock. D) Irrelevant for economic activity.

The Banking School's core tenet was the endogeneity of money. They argued that the money supply expands and contracts based on the demand for credit from businesses (the "needs of trade"), and that any attempt to rigidly control it would be harmful.

Source: Lewis, M. K., & Mizen, P. D. (2000), p. 15

27. If a bank has a reserve ratio of 100%, its deposit multiplier is:

A) Infinite. B) 1. C) 0. D) 10.

If r=1 (100% reserves), the bank makes no loans. The re-lending cycle never starts. The money multiplier m = (c+1)/(c+1) = 1. The money supply is equal to the monetary base.

Source: Implied by EC3115 - Monetary Economics Unit E Lectures, Slide 22

28. The "gold export point" represents the exchange rate at which it becomes cheaper to:

A) Buy foreign currency on the market instead of shipping gold. B) Buy foreign goods instead of domestic goods. C) Hold gold as an asset instead of currency. D) Settle international debts by shipping gold instead of buying foreign currency.

When the domestic currency weakens to the gold export point, it means its value on the foreign exchange market is so low that it is more economical to convert the domestic currency to gold, pay the shipping and insurance costs, and use the gold to pay foreign debts.

Source: Lewis, M. K., & Mizen, P. D. (2000), p. 36

29. Which of the following would cause the money multiplier to increase?

A) A decrease in the reserve ratio (r). B) An increase in the currency-deposit ratio (c). C) An open market sale by the central bank. D) An increase in the discount rate.

A decrease in the reserve ratio (r) means banks lend out a larger fraction of each deposit, strengthening the re-lending cycle and increasing the multiplier. An increase in 'c' or the discount rate would decrease the multiplier, and an open market sale affects the base, not the multiplier.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 30

30. The balance sheet of a firm or bank must balance because:

A) Of central bank regulations. B) Of the zero-profit condition. C) Net worth is defined as the residual of Assets minus Liabilities. D) All assets must be held as reserves.

This is a fundamental accounting identity. Net Worth is not an independent item but is defined as the value that makes the two sides of the balance sheet equal (Assets = Liabilities + Net Worth).

Source: McCallum, B. T. (1989), p. 57-58

31. The "lender of last resort" function is intended to mitigate what kind of risk for the banking system?

A) Credit risk B) Liquidity risk C) Market risk D) Legal risk

The lender of last resort (usually the central bank) provides emergency liquidity to solvent but illiquid banks that are facing a bank run or other temporary funding crisis. This directly addresses liquidity risk, not the risk of loans defaulting (credit risk).

Source: General principle, related to Lewis, M. K., & Mizen, P. D. (2000), p. 34

32. In the Poole analysis, if the money supply process is highly unstable (e.g., volatile multiplier) and money demand is stable, which instrument provides better control over the money stock?

A) The monetary base (H) instrument. B) The reserve ratio instrument. C) A fiscal policy instrument. D) The interest rate (R) instrument.

If the money supply curve is volatile and the money demand curve is stable, fixing the interest rate (R-instrument) will result in a more stable money stock outcome. The central bank accommodates the money supply shocks to keep R constant, and since money demand is stable, the resulting quantity of money is also stable.

Source: McCallum, B. T. (1989), p. 71

33. What is the effect on the money supply if the public decides to shift funds from currency to bank deposits?

A) The money supply increases. B) The money supply decreases. C) The money supply is unchanged. D) The monetary base increases.

This action lowers the currency-deposit ratio (c). A lower 'c' means less leakage from the banking system, which increases the money multiplier. For a given monetary base, a higher multiplier leads to a larger money supply.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 31

34. A key feature of the post-1971 "non-system" is:

A) All currencies are pegged to gold. B) Exchange rates are permanently fixed. C) National monetary authorities have wide discretion and are not bound by an external anchor. D) Capital controls are universal and strictly enforced.

The defining characteristic of the current system is that major currencies are fiat monies, with governments having the discretion to choose their own monetary policy (e.g., inflation targets, exchange rate regimes) without commitment to an external standard like gold.

Source: Lewis, M. K., & Mizen, P. D. (2000), p. 45

35. If a bank has $100M in assets and a net worth of -$10M, it is:

A) Liquid B) Insolvent C) Profitable D) Over-leveraged

Negative net worth means the value of the bank's liabilities ($110M in this case) exceeds the value of its assets ($100M). This is the definition of insolvency.

Source: General accounting principle.

36. The ability of a bank to transform a portfolio of risky loans into relatively safe deposit liabilities is an example of:

A) Maturity transformation B) Issuing fiat currency C) Open market operations D) Risk transformation (pooling)

This is risk transformation, achieved through diversification or risk pooling. By holding many independent loans, the overall risk of the portfolio is much lower than the risk of any single loan, allowing the bank to issue much safer liabilities (deposits).

Source: McCallum, B. T. (1989), p. 27

37. If the central bank sets a reserve requirement of 100%, the money multiplier is:

A) 1 B) 0 C) Infinite D) 10

If r=1, banks hold 100% of deposits as reserves and make no loans. The re-lending cycle never starts. The money multiplier m = (c+1)/(c+1) = 1. The money supply is equal to the monetary base.

Source: Implied by EC3115 - Monetary Economics Unit E Lectures, Slide 30

38. The "velocity of money" in the equation of exchange is defined as:

A) The speed at which the central bank prints money. B) The interest rate on government bonds. C) The average number of times a unit of money is used in transactions per period. D) The rate of growth of the money supply.

Velocity measures the rate at which money circulates in the economy to facilitate transactions. A higher velocity means each unit of money is being used more frequently to support a given level of nominal spending.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 51

39. According to the simple example in the lecture slides, if velocity increases, what happens to average money balances for a given level of nominal spending?

A) They increase. B) They decrease. C) They remain unchanged. D) The effect is ambiguous.

Velocity and average money balances are inversely related. If each unit of money is working harder (higher velocity), then fewer units of money (lower average balances) are needed to support the same level of total spending.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 54

40. The Patinkin real balance effect argues that a fall in the price level:

A) Reduces real wealth and decreases spending. B) Has no effect on real spending. C) Makes exports more expensive. D) Increases real wealth (real balances) and increases spending on goods.

A fall in the price level (P) increases the real value of nominal money holdings (M/P). This increase in real wealth makes households feel richer, inducing them to increase their consumption of goods and services.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 66-67

41. The classical dichotomy is the idea that:

A) Real and nominal variables are separated, with money affecting only nominal variables. B) The central bank and the government are separate entities. C) Assets and liabilities are on different sides of the balance sheet. D) The money supply and money demand are always equal.

This is the core concept of the classical dichotomy. It proposes that the real economy (output, employment, relative prices) is determined by real factors (technology, preferences), and the monetary sector only determines the overall price level. Money is a "veil".

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 62

42. What is the primary liability of the Federal Reserve?

A) Government securities. B) Gold certificates. C) The monetary base (currency and reserves). D) Loans to commercial banks.

The liabilities of the central bank are the items it owes: currency in circulation (which it must honor) and the reserves commercial banks have deposited with it. Together, these items constitute the monetary base.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 4

43. If the money multiplier is 4 and the monetary base is $200 billion, the money supply is:

A) $50 billion B) $800 billion C) $200 billion D) $400 billion

The money supply is the money multiplier times the monetary base. M = m x MB = 4 x $200 billion = $800 billion.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 27

44. Which of the following is NOT a primary function of money?

A) Medium of exchange B) Unit of account C) Store of value D) Source of high investment returns

The three classical functions of money are medium of exchange, unit of account, and store of value. While money is a store of value, it is typically a poor one compared to other assets because it often earns no interest and loses purchasing power to inflation. It is not held for high returns.

Source: Lewis, M. K., & Mizen, P. D. (2000). Monetary Economics, p. 5

45. The "re-lending cycle" is broken if:

A) Loan proceeds are held as currency instead of being redeposited. B) The central bank raises the interest rate. C) The government increases taxes. D) The bank makes a profitable loan.

The cycle depends on loaned funds being redeposited into the banking system, creating new reserves for the next bank to lend. If the funds are held as currency, they leak from the banking system and cannot be used to support further lending.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 26

46. A central bank open market SALE of bonds leads to:

A) An increase in commercial bank reserves and an expansion of the money supply. B) A decrease in commercial bank reserves and an expansion of the money supply. C) A decrease in commercial bank reserves and a contraction of the money supply. D) An increase in commercial bank reserves and a contraction of the money supply.

When the central bank sells bonds, commercial banks pay for them using their reserves. This drains reserves from the banking system, reducing the monetary base and leading to a multiple contraction of the money supply.

Source: EC3115 - Monetary Economics Unit E Lectures, Slide 8 (inferred)

47. The demand for a bank's excess reserves is inversely related to the interest rate because the interest rate represents the:

A) Profit from holding reserves. B) Opportunity cost of holding reserves. C) Risk associated with making loans. D) Administrative cost of holding reserves.

Holding non-interest-bearing reserves means forgoing the interest that could have been earned by lending those funds out. A higher market interest rate means a higher opportunity cost, giving banks a greater incentive to minimize excess reserves.

Source: McCallum, B. T. (1989), p. 58

48. In the context of the gold standard, what did Walter Bagehot mean when he said "8 per cent will bring gold from the moon"?

A) That gold is extremely scarce. B) That gold mining is very profitable at high interest rates. C) That gold is not sensitive to interest rates. D) That international capital flows were highly sensitive to interest rate differentials.

Bagehot was highlighting the power of the Bank rate to attract international capital. Because exchange rates were credibly fixed, a high interest rate in London would attract large, short-term capital inflows (gold) from other financial centers seeking the higher return, thus stabilizing the exchange rate.

Source: Lewis, M. K., & Mizen, P. D. (2000), p. 38

49. If a bank has $1,000M in assets and $920M in liabilities, its net worth is:

A) $80M B) $1,920M C) -$80M D) $920M

Net Worth = Assets - Liabilities. So, Net Worth = $1,000M - $920M = $80M.

Source: McCallum, B. T. (1989), p. 57

50. The money supply is defined as M = C + D. The monetary base is defined as MB = C + R. The money supply is larger than the monetary base because:

A) C is always very large. B) In a fractional reserve system, D is a multiple of R. C) The central bank adds extra money. D) R is always negative.

The money multiplier process in a fractional reserve system ensures that the total volume of deposits (D) created is a multiple of the reserves (R) held by the banking system. Since M includes all of D, while MB includes only the fraction R, M is necessarily larger than MB.

Source: EC3115 - Monetary Economics Unit E Lectures, Slides 5, 18

EC3115: The Supply of Money and Monetary Standards (Quiz 2)

Multiple-Choice Quiz