Module 17 - Money, the Central Bank and Monetary Policy

Question 1

Money is a medium of exchange; as a result the money supply

I. and disposable annual income are the same thing.
II. and total annual spending are the same thing.
III. will only be held for transactions purposes.

Which of the following is correct?

A. I only.
B. II only.
C. III only.
D. Not I or II or III.

Answer 1

The correct answer is D. Because money is a medium of exchange, it passes from hand to hand in financing purchases or settling debt. As a medium of exchange, money is used in a number of transactions within a year; hence the money supply is much smaller than disposable annual income or total annual spending. Although some money is used for transactions purposes, money is also held for precautionary and speculative purposes.

Question 2

Which of the following is a correct definition of the value of money?

A. The cost of producing money.
B. The buying power of money.
C. The value of gold and silver held by the Treasury.
D. The interest rate.

Answer 2

The correct answer is B. The value of money is determined by its buying power. When price inflation occurs, the same amount of money buys fewer goods and services and so the value of money in terms of its buying power declines. The value of money is unrelated to the cost of its production. In modern times the money supply is not backed by gold or silver. The interest rate is determined by the demand for and supply of money in financial markets.

Question 3

A commercial banking system has $100 million of outstanding demand deposits and cash reserves of $35 million. The desired cash ratio is 1:5.

In the above example, by which of the following amounts could the banking system expand the money supply?

A. $15 million.

B. $75 million.

C. $170 million.

D. $300 million.

Answer 3

The correct answer is B. If the desired ratio of cash reserves to deposits (known as the cash ratio) is 1:5, each $1 of cash reserves can support $5 of deposit liabilities. Therefore, if cash reserves are $35m, this will support $175m in demand deposits. As demand deposits are initially $100 million the banks would be able to expand the money supply by $75m without destroying the desired cash ratio.

Question 4

A commercial banking system has $100 million of outstanding demand deposits and cash reserves of $35 million. The desired cash ratio is 1:5.

The reasons why the situation in the above example persisted and the money supply did not expand are

I. the reserve ratio was too high.
II. there was no additional demand for credit.
III. banks were unwilling to lend more to the type of customer who wished to borrow. Which of the following is correct?

A. I only.
B. II only.
C. I and III only.
D. II and III only.

Answer 4

The correct answer is D. The banks have excess cash reserves and therefore wish to increase lending provided that they can find creditworthy customers. If demand deposits, and therefore the money supply, do not increase, this must mean either that the banks cannot find creditworthy customers or that such customers do not wish further credit.

Question 5

Faced with a deflationary gap, a government has resorted to monetary policy. The appropriate policy action includes

I. increasing commercial bank reserve requirements.

II. purchasing government securities.

III. raising interest rates to attract foreign capital. Which of the following is correct?

A. II only.
B. III only.
C. II and III only.
D. I, II and III.

Answer 5

The correct answer is A. Using monetary policy to curb a deflationary gap requires an expansion of the money supply. Increasing commercial bank reserve require- ments would decrease the money supply; raising interest rates would decrease consumption and investment expenditures. Thus options I and III would not reduce, but would increase, the deflationary gap. The government, by purchasing its own securities (option II), increases the supply of money; this will lead to lower interest rates and hence higher aggregate demand.

Question 6

Which of the following tends to diminish the ability of UK commercial banks to lend money?

A. The raising of interest rates by the Bank of England.
B. The releasing of Special Deposits by the Bank of England.
C. The reduction of the reserve requirement.
D. The occurrence of large-scale net withdrawals of deposits from the commercial banks.

Answer 6

The correct answer is D. Two factors that would diminish the lending of money by commercial banks would be:

(a) a request to hold larger amounts of any deposit as a cash reserve; and
(b) withdrawals of deposits by customers, since this would force banks to call in loans.

The raising of interest rates by the Bank of England will increase the cost to commercial banks of borrowing from the Bank of England but will not diminish their ability to lend money; indeed, a higher interest rate may increase the flow of deposits to commercial banks. The releasing of Special Deposits by the Bank of England and the reduction of the

Question 7

Mr Smith receives a tax rebate of $100, which he deposits in his account at his bank, which is part of a banking system operating on a cash ratio of 10 per cent. The maximum possible increase in money supply that can result from this transaction, including his original deposit, is

A. $190.
B. $910.
C. $1000.
D. $1100.

Answer 7

The correct answer is C. An amount of $100 deposited in a bank with a cash ratio of 10 per cent means that the bank must retain $10 but can loan out the remaining $90. If that $90 is in turn deposited in a bank, $9 (i.e. 10 per cent) must be retained, and $81 can be loaned out. This process will continue, the ultimate increase in the money supply being $100 + $90 + $81 + … = $1000. The mathematical formula for the credit creation multiplier is 1/cash ratio = 1/0.1 (0.1 = 10 per cent). The total expansion equals the initial deposit × multiplier = $100 × 10 = $1000.

Question 8

Money exist in different types, name them

Answer 8

Coins, Notes, bank Deposits.

Question 9

Money has the following functions, name.

Answer 9

A medium of exchange

A unit of account

A store of wealth

Question 10

For money to function as the medium for exchange it has to have the following characteristics:

Answer 10

• Widely acceptable
• High value/weight ratio
• Divisible in order to settle debts of different denominations
• Not easily produced, counterfeited, or debased in value

Question 11

Discuss Cloakroom Banking

Answer 11

Cloakroom Banking is the banking system in which the bank purely acts as a store for the safekeeping of wealth, but does not contribute itself to the money supply.

Question 12

Discuss Fractional Reserve Banking

Answer 12

Fractional Reserve Banking is a system where the deposit liabilities exceed the bank holdings of cash (formerly gold). Fractional reserve banking depends on the banks ability to maintain confidence and convertibility.

Under fractional reserve banking banks are under influence of two competing pulls:

• The pull of profitability: cash earns no interest, so the bank is interested in lending out the cash and convert it to interest bearing accounts.
• The pull of liquidity: the banks have to keep sufficient cash on hand in order to satisfy the demand of their customers for cash.

Question 13

Discuss bonds

Answer 13

A bond is a legally enforceable obligation to pay cash to the bearer, normally issues by a government or company. A bond has a redemption date and a redemption value specifying the cash amount and the date on which the issuer pays the bearer. Usually the bond also has a coupon payment, which is a specific sum of money that has to be paid by the bond issuer yearly. The purchase price of a bond is determined by demand and supply in the market.

Question 14

Discuss the investment multiplier, credit multiplier and cash ratio

Answer 14

Question 15

The creation of bank deposits is limited by:

Answer 15

• The banks propensity to keep cash for liquidity purposes (as represented by the cash ratio)
• The public’s propensity to hold cash (when the propensity to hold cash is high, more cash is not returned to a bank)

Question 16

The function of a central bank is to control the commercial banks around it in a way as to support the monetary policies of the economy. It acts as:

Answer 16

• the banks’ banker
• lender of last resort
• the government’s bank and
• the manager of public debt.

Question 17

The central bank controls monetary policy by regulating the supply of money and the cost and availability of credit. Discuss:

Answer 17

The central bank controls monetary policy by regulating the supply of money and the cost and availability of credit. One way to control the supply of money is by buying and selling bonds in the open market: by buying bonds the central bank increases the money supply and lowers the cost of borrowing, by selling bonds it decreases the money supply and increases the cost of borrowing. Through changes in the money supply and the cost of money the central bank can influence aggregate demand and consumption (mostly in consumer durable goods) thus income, etc. For example if the interest rates are lowered, investment projects that were previously unprofitable are now viable and will be undertaken.

The steps are summarized as follows Iimage):

Instruments of a Central Bank:

1. Monopoly of Note Issue
2. Ability to dictate cash ratio for commercial banks
3. Ability to set reserve requirements for commercial banks
4. Ability to set credit controls (e.g. the level of initial payments and repayment periods on hire purchase contracts)
5. Ability t issue direct instructions to commercial banks and other financial institutions
6. Ability to control open market operation (e.g. buying and selling of government bonds in the open market)

Question 18

Explain Hire Purchase

Answer 18

Hire purchase is a form of credit. The customer agrees to buy goods from a supplier/retailer and to pay for those goods in installments. The customer has the right to possess and use the goods from the time the contract is made. The supplier or the finance company keeps ownership of the goods until all payments are completed. Until the contract is completed the customer cannot sell the goods without the knowledge and agreement of the finance company. The banks are in the business of lending money (extending credit) and are thus actively involved in transacting in hire purchase contracts. The central bank can manage monetary policy by putting controls on the banks lending activities, which obviously includes hire purchase contracts.

Question 19

If an economy were experiencing a deflationary period it would mean that
I. the general price level was decreasing
II. the unemployment rate was increasing
III. the growth rate of GNP was negative

Which of the following is correct?
A. I only
B. I and II only
C. II and III only
D. I, II and III

Answer 19

The correct answer is A. By definition a deflationary period is one in which the price index, or general level of prices, has decreased. Thus I is correct. While deflationary periods historically have been associated often with depression, i.e. periods of high unemployment and decreasing GNP these are not necessary conditions. It is possible for falling prices to be associated with rising employment and positive economic growth especially towards the end of a depression. Thus II and III are wrong.

Question 20

Money must possess the following characteristics. It must
I. be created by government or other central authority
II. never change its value
III. be widely acceptable for the settlement of debts

Which of the following is correct?
A. I and III only
B. II only
C. III only
D. I, II and III

Answer 20

The correct answer is C. Money by definition can be anything which is acceptable for the settlement of debts. Thus III is correct. While today all major currencies are government/national bank controlled, in some societies forms of money other than coins and bank notes are used to trade and settle debts, e.g. gold. Thus I is wrong. To be a satisfactory store of wealth the value of money, in terms of its purchasing power, must be relatively stable; however during the last century the purchasing power of every major currency decreased, (one dollar today buys less than one dollar thirty years ago), normally by a small amount per year. Thus II is wrong.

Question 21

In a fractional reserve system, commercial banks could issue notes in excess of their gold reserves. This fractional reserve system could operate successfully only if
I. a small proportion of the bank notes were presented for conversion into gold at one time
II. the value of the gold held in all banks’ vaults equalled the sum of all the bank notes issued

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 21

The correct answer is A. When the public recognised under cloakroom banking that banks could always turn their receipts into gold these receipts or early bank notes become ‘good as gold’ and these notes went from hand to hand in settlement of debts. The banks discovered that they could issue notes in excess of their gold holdings because only a small proportion of bank notes were ever ‘cashed in’ at one time. Thus I is correct. Since all fractional reserve system banks acted in the same way the total of all notes exceeded the sum of all gold holdings in the banks. Thus II is wrong.

Question 22

Today banks hold cash because
I. cash earns interest for the banks at the going rate
II. the higher the proportion of assets held in the form of cash the smaller the risk and the greater the profitability of banks

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 22

The correct answer is D. Banks earn no interest on cash held since banks only earn interest by loaning out money (thus I is wrong) and therefore the higher the proportion of assets held by the banks in the form of cash the smaller will be the proportion of profitable business in which the bank can indulge, i.e. making loans. Thus II is wrong also.

Question 23

A commercial bank system which was fully loaned up had a cash ratio of 1:5. The cash ratio was decreased to 1:7. By how much could the bank expand its interest bearing deposits?

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

Answer 23

The correct answer is D. Consider the formula ΔD = d×ΔC where d = 1/ cash ratio.

When the cash ratio = 1:5  and ΔC was $100  ΔD = $500 When the cash ratio = 1:7  and ΔC was $100  ΔD = $700 The increase in deposits resulting from the decrease in the cash ratio is $200, i.e. $700 − $500 and $200/$500 = 40%

Question 24

The functions of the central bank are
I. to control the commercial banks to support the monetary policy in a country
II. to serve as the government’s bank
III. to manage the national debt
Which of the following is correct?

A. I and II only
B. II and III only
C. I, II and III
D. Not I, not II, not III

Answer 24

The correct answer is C. This is a definitional question. The three functions noted all lie in the province of the central bank.

Question 25

An expansionary monetary policy involves the central bank buying bonds. For the policy to work however which of the following conditions must prevail?

A. Consumption and/or investment expenditure must be interest elastic
B. The cash ratio must decrease
C. Potential output must be increasing
D. Government expenditure must be independent of interest rates

Answer 25

The correct answer is A. When the central bank buys bonds the money supply increases and, assuming no offsetting increase in the demand for money, the price of money, i.e. interest rate (R) will fall. To the extent that consumption/investment expenditures are functions of R aggregate demand will increase and total output will increase; the monetary policy will be expansionary. The cash ratio need not decrease for this to occur and changes in aggregate demand can be independent of potential output. Thus B and C are wrong. If government expenditure is a function of interest rates this would reinforce the consumption/investment effect but it is not a necessary condition. Thus D is also wrong.

Question 26

Open market operations influence
I. the cost of borrowing
II. the supply of money
Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 26

The correct answer is C. Open market operations consist of the central bank buying/selling bonds. When the bank buys bonds it injects money into the system and when it sells bonds, the buyers of the bond part with money, taking it out of the system. Thus II is true. The cost of borrowing, the interest rate, is determined like any goods or services, i.e. by demand and supply. Thus given level of any demand for money, alterations in the supply by buying/selling bonds will alter the interest rate. Thus I is true also.

Question 27

With an expansionary policy which of the following is INCORRECT?

A. I only
B. II only
C. II and III only
D. III only

Answer 27

The correct answer is A. In the expansionary mode buying bonds leads to increasing cash reserves, increasing bank deposits, easier and cheaper credit and an increase in aggregate demand. Thus I is incorrect, making A the correct answer.

Question 28

With a contractionary policy which of the following is INCORRECT?

A. I only
B. I and II only
C. I, II and III
D. Not I, not II, not III

Answer 28

The correct answer is D. In the contractionary mode selling bonds leads to a decrease in cash reserves, a decrease in bank deposits and a decrease in aggregate demand. Thus none of I, II and III is wrong.

Question 29

Faced with an inflationary gap the government has resorted to monetary policy. The appropriate action includes
I. increasing commercial bank reserve requirements
II. purchasing government securities
Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 29

The correct answer is A. The goal of the government is to decrease aggregate demand. Increasing reserve requirements will decrease money supply, raise interest rates and make consumption/investment and possibly other expenditures lower than they otherwise would have been. Thus I is true. Purchasing government securities, however, injects money into the system, an expansionary effect. Thus II is wrong.

Question 30

Which of the following is correct?
In the short run monetary policy will not affect significantly

A. aggregate demand
B. national output
C. potential output
D. the unemployment rate

Answer 30

The correct answer is C. Changes in the money supply affect the cost of money, the interest rate, which in turn affects consumption and investment expenditure, aggregate demand, national output and the gap between potential and national output which in turn determines the unemployment rate. Thus A, B and D are wrong. Potential output is a function of the quality and quantity of the labour force and capital stock neither of which is affected significantly in the short run by interest rate changes.

Question 31

If an economy were experiencing an inflationary period it would mean that

I. consumption expenditure was increasing rapidly
II. the unemployment rate was falling
III. the general price level was increasing

Which of the following is correct?

A. II and III only
B. III only
C. I, II and III
D. Not I, not II, not III

Answer 31

The correct answer is B. By definition an inflationary period is one in which the general level of prices is increasing. While historically inflationary periods are often accompanied by an economic boom, rapidly increasing consumption/investment expenditures and a falling unemployment rate these are not always so. Consumption expenditures could be decreasing, constant or increasing slowly and the unemployment rate could be static or increasing in the presence of rising prices.

Question 32

Which of the following is the difference between ‘cloakroom’ banking (CB) and ‘fractional reserve banking’ (FRB)?

A. Only coins and notes were legal tender in CB; FRB includes also bank deposits
B. In CB all loans were backed by an equivalent amount of gold; in FRB only a fraction was so backed thus the name
C. Only in CB could bank notes be issued to the public
D. 100% convertibility was possible under FRB but not under CB

Answer 32

The correct answer is B. CB operated with gold and receipts only (earliest bank notes 100% backed with gold); bank deposits emerged only with banks. Under FRB receipts were issued but were not 100% gold backed. Thus A, C and D are wrong.

Question 33

Which of the following is correct?

The banking system today is a fractional reserve system in which commercial banks add to the money supply by

A. printing money
B. creating deposits in excess of their reserve requirements
C. buying gold on world markets up to 10% of their deposits
D. adjusting interest rates to match household savings with investment demand

Answer 33

The correct answer is B. This is a definitional question of what modern banks do. By long experience banks have found that if cash reserves are a certain percentage of deposit liabilities they can maintain convertibility, i.e. convert deposits into cash on demand. Since this percentage is normally a small proportion of deposits held it allows them to create deposits in excess of their reserve requirements.

Question 34

Which of the following explains why banks have a cash ratio, i.e. hold a given percentage of their assets in cash?

A. To meet demands for investment projects
B. To meet demands for cash
C. To control the demand for money thus affecting interest rates
D. To control the supply of money thus affecting interest rates

Answer 34

The correct answer is B. Commercial banks are subject to two competing forces, the desire for profits and the desire for liquidity. Cash held in banks earns no interest but to maintain confidence banks must be able to meet demands for cash and thus the cash ratio; the lower the cash ratio the more funds available for interest earning assets.

Question 35

A commercial banking system has $250m of outstanding demand deposits, cash reserves of $50m and is operating with a cash ratio of 1:10. By how much could this banking system expand the money supply?

A. $50m
B. $250m
C. $500m
D. $2000m

Answer 35

The correct answer is B. The maximum by which the money supply could expand with cash reserves of $50m and a cash ratio of 1:10 is $500m. Since currently only $250m of demand deposits exist a further $250 is possible.

Question 36

The central bank has certain powers enabling it to carry out its functions in operating monetary policy is an economy.

They are
I. sole power of note issue
II. buying and selling of government bonds
III. dictating reserve requirements

Which of the following is correct?
A. I only
B. II only
C. II and III only
D. I, II and III

Answer 36

The correct answer is D. This is a definitional question. The three factors noted are some of the powers assigned to central banks to enable them to control monetary policy.

Question 37

A contractionary monetary policy involves the central bank selling bonds. For the policy to work however it is necessary for

I. the interest to fall to discourage savings
II. commercial banks to increase the reserve requirement
III. interest rates to exceed inflation rates

Which of the following is correct?
A. I and II only
B. III only
C. I, II and III
D. Not I, not II, not III

Answer 37

The correct answer is D. For contractionary monetary policy to work it is necessary that the resultant rise in interest rates will make consumption/investment expenditures decrease leading to a fall in aggregate demand, the goal of a contractionary policy. This I is wrong. It is neither necessary for the reserve requirements to increase simultaneously nor for the real interest rate to be positive. Thus II and III are wrong.

Question 38

A commercial banking system with a desired cash ratio of 1:10 has cash reserves of $100m and outstanding demand deposits of $900m. It follows that
I. the money supply expansion is at a maximum $100m + $900m = $1bn
II. consumption/investment expenditures in this system are interest rate inelastic

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 38

The correct answer is D. The cash ratio of 1:10 with cash reserves of $100m permits expansion of the money supply by $1bn ($100m × 10). Thus I is wrong. The fact that the banks have excess cash reserves does not imply consumption/investment expenditures are independent of interest rates; it may mean that no additional credit is sought by bank customers, and/or those who do wish to borrow at going rates are not credit worthy. Thus II is wrong also.