CFA Level 1 - Economics Session 5 - Reading 18

CFA Level 1 - Economics Session 5 - Reading 19 (Notes, Practice Questions, Sample Questions) 1. A distinction between fiscal policy and monetary policy is that fiscal policy: A)is aimed at promoting economic growth, while monetary policy is aimed at promoting price stability. B)is typically expansionary, while monetary policy is typically contractionary. C)concerns taxes and government spending, while monetary policy concerns the money supply (Explanation) : C — The distinction between fiscal and monetary policy is that a country’s government determines fiscal policy through taxes and spending, but its central bank determines monetary policy by controlling the money supply. Both fiscal and monetary policy can be used to promote economic growth and price stability. Either fiscal policy or monetary policy can be expansionary or contractionary. 2. On January 5, the U.S. Federal Reserve (the Fed) bought $10,000,000 of U.S. Treasury securities in the open market. At the time, the reserve requirement was 25%, and all banks had zero excess reserves. What is the potential impact of the Fed's purchase on the U.S. money supply? A)$40,000,000 increase. B)$10,000,000 increase. C)$25,000,000 decrease. (Explanation) : A — Buying securities by the Fed increases the money supply because they are injecting money into the banking system. The money supply can potentially increase by 1 / 0.25 × $10,000,000 = $40,000,000 3. When comparing a barter economy with an economy that uses money as a medium of exchange we would expect increased efficiencies due to a reduction in which of the following? A)The need to specialize. B)Nominal interest rates. C)Transaction costs. (Explanation) : C — Money functions as a medium of exchange because it is accepted as payment for goods and services. Compare this to a barter economy, where if I have goat and want an ox, I have to find someone willing to trade. Finding someone takes time and time is costly. With money, I can sell the goat and buy the ox. Thus, transaction costs are reduced. Having money as a medium of exchange would not reduce the inflation rate, interest rates, or the need to specialize in the production of those goods in which we have a comparative advantage (low opportunity cost producer) 4. On January 3, Logan Industries deposited $1,000,000 in cash at Federal Savings Bank. No excess reserves were present at the time Logan made the deposit and the required reserve ratio is 10%. What is the maximum amount by which Federal Savings Bank can increase its lending? A)$100,000. B)$900,000. C)$10,000,000. (Explanation) : B — Since there are no excess reserves present at the time that Logan deposited the money, the bank would be required to maintain $100,000 ($1,000,000 × 0.10) on reserve and would be able to loan out or increase the money supply by $900,000 5. When additional or excess reserves are injected into the U.S. banking system, the money supply can potentially increase by an amount equal to the additional excess reserves multiplied by which of the following? A)Reciprocal of the required reserve ratio. B)Reciprocal of one minus the required reserve ratio. C)Required reserve ratio (Explanation) : A — The potential deposit expansion multiplier = 1 / (required reserve ratio) The potential increase in the money supply = potential deposit expansion multiplier × increase in excess reserves 6. Banks choose to hold a higher percentage of depths as reserves because they believe general business conditions in the economy are subject to greater uncertainty. If all else is held constant, what is the most likely impact of this action? A)The money supply will decrease. B)The money supply will increase during a period of inflation, but will decrease if the economy goes into a recession. C)There will be no effect on the money supply (Explanation) : A — If banks choose to hold excess reserves, they will decrease their lending. Less bank lending will cause the money supply to decrease 7. The amount of money a commercial bank has available to lend is known as: A)required reserves. B)excess reserves. C)fractional reserves. (Explanation) : B — Excess reserves are the amount of money a commercial bank has available with which to make new loans, after depositing its required reserves with the central bank 8. Which of the following is the most accurate definition of the velocity of money? The velocity of money is the: A)GDP of a country divided by its price level. B)GDP of a country divided by its money supply. C)money supply of a country divided by its price level. (Explanation) : B — Velocity is the average number of times per year each dollar is used to buy goods and services (velocity = nominal GDP / money). Therefore, the money supply multiplied by velocity must equal nominal GDP. The equation of exchange must hold with velocity defined in this way. Letting money supply = M, velocity = V, price = P, and real output = Y, the equation of exchange may be symbolically expressed as: MV = PY. 9. Which of the following relationships in regard to the quantity theory of money is least accurate? A)Money × Velocity = Money Supply × Velocity. B)Nominal GDP = Price × Money Supply. C)Nominal GDP = Money Supply × Velocity = Price × Real Output. (Explanation) : B — The quantity theory of money holds that: Money Supply × Velocity = Nominal GDP = Price × Real Output 10. Which of the following statements about the demand for and supply of money is least accurate? A)As gross domestic product rises, the demand for money balances also rises. B)As inflation rises, the demand for money by households and businesses also rises. C)As the interest rate rises, the supply of money also rises. (Explanation) : C — The supply of money is determined by the monetary authorities and is not affected by changes in interest rates. Thus, the supply of money curve is vertical 11. Which of the following statements about the relationship between interest rates and the demand for and supply of money is most accurate? Interest rates affect: A)the supply of money only. B)both the demand for and supply of money. C)the demand for money only (Explanation) : C — Interest rates only affect the demand for money. With higher interest rates, the opportunity cost of holding money increases, and people hold less money and more interest-earning assets. Monetary authorities determine the supply of money. Therefore, the supply of money is independent of the interest rate 12. The demand for money curve represents the relationship between the quantity of money demanded and: A)the quantity of money supplied. B)short-term interest rates. C)the price level (Explanation) : B — The demand for money curve represents the relationship between short-term interest rates and the quantity of real money that households and firms demand to hold 13. Which of the following statements regarding money demand and supply is least accurate? A)As the Fed reduces the money supply, short-term interest rates decrease. B)The supply curve for money is vertical. C)The supply of money is determined by the monetary authority and is not affected by changes in interest rates (Explanation) : A — As the Fed reduces the money supply, short-term interest rates increase. The other statements concerning the demand and supply for money are true 14. The supply of money is primarily determined by: A)the monetary authorities. B)interest rates. C)inflation. (Explanation) : A — The monetary authorities determine the quantity of money available to the economy. Inflation and interest rates affect the demand for money balances 15. Which of the following statements about the demand and supply of money is most accurate? People who are: A)holding money when interest rates are higher will try to reduce their money balances and, as a result, the demand for money decreases. B)holding money when interest rates are lower will try to increase their money balances and, as a result, the supply of money increases. C)buying bonds to reduce their money balances will increase the demand for bonds with an associated increase in interest rates (Explanation) : A — Buying bonds would drive bond prices up and interest rates down. Selling bonds would have the opposite effect; driving bond prices down and interest rates up. When interest rates are lower, there is an excess demand for money. The supply of money is determined by the monetary authorities 16. If households are holding larger real money balances than they desire, which of the following is least likely? A)The central bank must sell securities to absorb the excess money supply and establish equilibrium. B)The interest rate is higher than its equilibrium rate in the market for real money balances. C)The opportunity cost of holding money balances will decrease (Explanation) : A — If households’ real money balances are larger than they desire, the interest rate (opportunity cost of holding money balances) is higher than its equilibrium rate. Households will use their undesired excess cash to buy securities, bidding up securities prices and reducing the interest rate toward equilibrium. This market process does not require any action by the central bank 17. Which of the following is determined by the equilibrium between the demand for money and the supply of money? A)Money supply. B)Interest rate. C)Inflation rate. (Explanation) : B — Interest rates are determined by the equilibrium between money supply and money demand 18. If the money interest rate is measured on the y-axis and the quantity of money is measured on the x-axis, the money supply curve is: A)downward sloping to the lower right. B)upward sloping to the upper right. C)vertical. (Explanation) : C — The money supply schedule is vertical because it is not affected by changes in the interest rate but is determined by the monetary authorities such as the Federal Reserve System (Fed) in the United States 19. The Fisher effect holds that a nominal rate of interest equals a real rate: A)plus actual inflation. B)plus expected inflation. C)minus expected inflation. (Explanation) : B — The Fisher effect states that a nominal rate of interest equals a real rate plus expected inflation 20. Central banks are most likely to pursue a target inflation rate: A)between 0 and 3%. B)above 3%. C)equal to 0% (Explanation) : A — Central banks typically define price stability as a stable inflation rate of about 2% to 3%. A target of zero is not typically used because it would risk deflation 21. A country is experiencing a core inflation rate of 7% during a recessionary period of real GDP growth. If the central bank has a single mandate to achieve price stability and uses inflation targeting with an acceptable range of zero to 4%, its monetary policy response is most likely to decrease: A)GDP growth in the short run. B)short-term interest rates. C)the foreign exchange value of the country’s currency. (Explanation) : A — If the central bank has a price stability mandate, it will most likely respond to the above-target inflation rate by decreasing the money supply, even though GDP growth is in a recessionary phase. Decreasing the money supply will result in higher short-term interest rates and appreciation of the currency, but will likely cause GDP growth to decrease further in the short run 22. Which of the following is least likely to be a function of the central bank? A)Issue currency. B)Control money supply. C)Tax collection. (Explanation) : C — The three functions of a central bank are to issue a country’s currency, regulate its banking system, and to manage the money supply. Tax collection is typically conducted by a government agency created specifically to carry out that function 23. If a bank needs to borrow funds from the Federal Reserve to fund a temporary shortage in reserves, it would borrow funds at the: A)federal funds rate. B)prime rate. C)discount rate (Explanation) : C — Banks are able to borrow from the Fed at the discount rate. The federal funds rate is the interest rate banks charge other banks to borrow reserves from other banks. The prime rate is the rate that commercial banks charge their best customers 24. If a monetary policy is focused on combating inflation, which open market actions by the Federal Reserve will most effectively accomplish this? A)Sell Treasury securities, causing aggregate demand to decrease. B)Purchase Treasury securities, causing aggregate demand to decrease. C)Sell Treasury securities, causing aggregate demand to increase. (Explanation) : A — If the Federal Reserve wants to slow inflation, it needs to decrease aggregate demand (i.e., business investment, consumer purchases of durable goods, and exports). To accomplish this, the Federal Reserve could engage in open market sales of Treasury securities 25. When the Federal Reserve sells government securities on the open market, bank reserves are: A)increased, which increases the amount of money banks are able to lend, causing a decrease in the federal funds rate. B)decreased, which reduces the amount of money banks are able to lend, causing a decrease in the federal funds rate. C)decreased, which reduces the amount of money banks are able to lend, causing an increase in the federal funds rate (Explanation) : C — When the Federal Reserve wants to increase the federal funds rate through open market operations, it sells government securities. Open-market sales reduce bank reserves and cause the federal funds rate to increase 26. Assume the U.S. economy is undergoing a recession. In its efforts to stimulate the economy by trying to influence short-term interest rates the Fed is most likely to take which two actions? A)Sell Treasury securities and increase bank reserve requirements. B)Sell Treasury securities and decrease bank reserve requirements. C)Buy Treasury securities and decrease bank reserve requirements (Explanation) : C — If the economy is in a recession, the Fed is likely to attempt to decrease short-term interest rates. Thus, the Fed will buy Treasury securities and decrease bank reserve requirements 27. Which of the following statements regarding U.S. Federal Reserve open market operations is least accurate? A)If the Fed wants to stimulate the economy, it will sell Treasury securities to banks. B)When the Fed buys Treasury securities, short-term interest rates will generally decrease. C)When the Fed sells Treasury securities, excess reserves decrease (Explanation) : A — If the Fed intends to stimulate the economy, they will buy, not sell, Treasury securities. Buying Treasury securities injects reserves into the banking system 28. What are the three essential qualities an effective central bank should possess? A)Independence, credibility, and transparency. B)Understandability, relevance, and reliability. C)Transparency, comprehensiveness, and consistency. (Explanation) : A — A central bank that is independent from political interference, possesses credibility, and exhibits transparency is more likely to achieve its monetary policy objectives than a central bank that lacks these qualities. The characteristics listed in the other answer choices relate to financial statements and financial reporting standards 29. Silvano Jimenez, an analyst at Banco del Rey, is reviewing recent actions taken by the U.S. Federal Reserve (the Fed) in setting monetary policy. Recently, the Fed decided to increase the money supply, which has resulted in a decrease in real interest rates. At a staff meeting, Jimenez brings this matter to the attention of his colleagues and makes the following statements: Statement 1: Although the money supply increase has led to a decrease in real interest rates, we should begin to see U.S. investors decrease their investments abroad and the U.S. dollar will appreciate in the foreign exchange market. Statement 2: The Fed’s increase in the money supply will increase the amount of imports into the U.S. Are Statement 1 and Statement 2 as made by Jimenez CORRECT? Statement 1 Statement 2 A)Correct Incorrect B)Incorrect Incorrect C)Incorrect Correct (Explanation) : B — If the Fed increases the money supply and real interest rates decline, U.S. investors will seek higher real rates of return abroad and the U.S. dollar will depreciate as the dollar will be exchanged for foreign currencies in order to buy the foreign investments. Likewise, the decrease in real interest rates will reduce the inflow of funds from abroad as foreign investors seek higher rates of return outside the U.S. With a dollar that has depreciated, U.S. exports should increase, as U.S. products will become cheaper for foreign buyers. As such, both statements are incorrect 30. If a country’s economy is growing at an unsustainably rapid rate and the central bank decreases its target overnight interest rate, the country’s: A)long-term rate of economic growth will increase. B)expected rate of inflation is likely to decline. C)inflation rate is likely to increase. (Explanation) : C — The central bank should increase target interest rates when the economy is growing at an unsustainable (above-full-employment) level. Decreasing the target overnight rate is likely to further increase aggregate demand and cause inflation to accelerate, which will be detrimental to the long-term growth rate of the economy 31. If the U.S. Federal Reserve decides to decrease the money supply, which of the following is most likely to occur in the short run? A)An increase in the velocity of money similar to decrease in the money supply. B)An increase in the real rate of interest. C)A decrease in the unemployment rate (Explanation) : B — If the U.S. Federal Reserve decreases the money supply, an increase in nominal and real interest rates will occur. Higher real rates will cause businesses to invest less, which will cause the unemployment rate to increase. Furthermore, households will decrease purchases of durable goods, automobiles, and other items that are typically financed at short-term rates. This will decrease aggregate demand. The decrease in aggregate demand and expenditures will cause incomes to go down, which further decreases consumption and investment. Moreover, this decrease in aggregate demand will decrease real GDP and the price level in the short run and the long run 32. An economy’s long-term trend rate of real GDP growth is 3% and the central bank’s target inflation rate is 2%. If the policy rate is 6%, monetary policy is: A)expansionary. B)contractionary. C)neutral. (Explanation) : B — Monetary policy is contractionary when the policy rate is greater than the neutral rate, which is the sum of the real trend rate of economic growth and the target rate of inflation. Here, the neutral rate is 3% + 2% = 5% and the policy rate of 6% is greater than the neutral rate. Monetary policy is expansionary when the policy rate is less than the neutral interest rate 33. Which of the following statements regarding the monetary policy transmission mechanism is most accurate? A)Central banks can control long-term interest rates directly because decisions by consumers and businesses are based on these rates. B)Central banks can control short-term interest rates directly, but long-term interest rates are beyond their control. C)Central banks can control short-term interest rates by increasing the money supply to increase interest rates or by decreasing the money supply to decrease interest rates (Explanation) : B — Central banks can control short-term interest rates directly. However, the decisions of consumers and businesses are based on long-term interest rates, which are beyond the control of central banks. Increasing the money supply will decrease interest rates and decreasing the money supply will increase interest rates. 34. Which of the following statements best explains how automatic stabilizers work? Even without a change in fiscal policy, automatic stabilizers tend to promote: A)a budget surplus during a recession and a budget deficit during an inflationary expansion. B)a budget deficit during a recession but do not promote a budget surplus during an inflationary expansion. C)a budget deficit during a recession and a budget surplus during an inflationary expansion. (Explanation) : C — Automatic stabilizers such as unemployment compensation, corporate profits tax, and the progressive income tax run a deficit during a business slowdown but run a surplus during an economic expansion. Therefore, they automatically implement countercyclical fiscal policy without the delays associated with policy changes that require legislative action 35. When an economy dips into a recession, automatic stabilizers will tend to alter government spending and taxation so as to: A)reduce interest rates, thus stimulating aggregate demand. B)reduce the budget deficit (or increase the surplus). C)enlarge the budget deficit (or reduce the surplus) (Explanation) : C — During a recession unemployment is high, so the government will pay out more in unemployment compensation at the exact time that tax receipts from corporations and individuals are low. This will increase the size of the deficit and also maintain aggregate demand during recessionary periods 36. The term "automatic stabilizers" refers to the fact that: A)legislators automatically change the tax structure and expenditure programs to correct upswings and downswings in business activity. B)government expenditures and tax receipts automatically balance over the course of the business cycle, although they may be out of balance in any single year. C)with given tax rates and expenditure policies, a rise in national income tends to produce a surplus, while a decline tends to result in a deficit (Explanation) : C — Automatic stabilizers are built-in fiscal devices that ensure deficits in a recession and surpluses during booms. Automatic stabilizers minimize the problem of proper timing 37. Unemployment compensation is an example of: A)an automatic monetary policy stabilizer. B)an automatic fiscal policy stabilizer. C)a discretionary fiscal policy stabilizer (Explanation) : B — Unemployment compensation automatically rises and falls with the business cycle, therefore it is an example of an automatic fiscal policy stabilizer 38. Assuming the economy currently is experiencing high inflation, an example of appropriate discretionary fiscal policy is: A)reduce government expenditures on major government construction projects. B)reduce the money supply. C)increase the federal funds target rate. (Explanation) : A — Discretionary fiscal policy refers to the federal government’s decisions regarding government spending and taxing. A reduction in government spending on major government construction projects is likely to lead to a reduction in aggregate demand and less pressure on prices, reducing inflation 39. The crowding-out model implies that a: A)budget surplus will retard aggregate demand and trigger an economic downturn. B)budget deficit will increase the real interest rate and thereby retard private investment. C)budget deficit will stimulate aggregate demand and trigger a multiplier effect which will lead to inflation (Explanation) : B — Increased budget deficits will increase the demand for loanable funds and lead to higher interest rates and thus lower private investment. Crowding-out implies that an increase in government spending will choke off private investment and reduce the intended impact of fiscal policy changes on aggregate demand 40. Which of the following statements best explains the importance of the timing of changes in discretionary fiscal policy? Changes in discretionary fiscal policy must be timed properly if they are going to: A)exert a stabilizing influence on an economy. B)help the government achieve a balanced budget. C)enable the government to control the money supply (Explanation) : A — Proper timing of discretional policy is needed to reduce economic instability. If timed incorrectly, the fiscal policy change could increase rather than reduce economic instability 41. The country of Zurkistan is experiencing both high interest rates and high inflation. The government passes laws that reduce government spending and increase taxes. It takes many months before interest rates fall and inflation is reduced. This is an example of: A)impact lag in discretionary fiscal policy. B)action lag and automatic stabilizers. C)recognition lag in discretionary fiscal policy (Explanation) : A — This is an example of discretionary fiscal policy involving impact lag because it takes time for the impact of the change in taxing and spending to be felt throughout the economy 42. Which of the following statements about achieving proper timing in fiscal policy is least accurate? A)There is usually a time lag between when a change in policy is needed and when the need is recognized by policy makers. B)Improvements in quantitative methods have made the occurrence of recessions or expansions quite predictable. C)Policy errors are inevitable due to unpredictable events (Explanation) : B — One problem in achieving proper timing in fiscal policy is the inability to accurately predict a recession or expansion 43. The government budget deficit of Country M is increasing. At the same time, the government budget surplus of Country N is decreasing. Are the fiscal policies of these countries expansionary or contractionary? A)Both are contractionary. B)Both are expansionary. C)One is expansionary and one is contractionary. (Explanation) : B — Expansionary fiscal policy increases a budget deficit or decreases a budget surplus. Contractionary fiscal policy decreases a budget deficit or increases a budget surplus 44. Which one of the following Federal Reserve monetary policies, when pursued in line with the U.S. government’s fiscal policies, would help increase aggregate demand during a period of high unemployment? A)A decrease in the discount rate. B)The sale of bonds by the Fed. C)An increase in the reserve requirements for financial institutions (Explanation) : A — A decrease in the Fed’s lending rate is a monetary tool that the Fed can use to increase the money supply, thereby increasing aggregate demand during recessionary times when there is high unemployment. An increase in the reserve requirements and the sale of bonds by the Fed would all be restrictive monetary policies that would reduce the amount of money in the economy and reduce aggregate demand