ECON 426 Monetary Policy Final Exam

What is the primary implication of Purchasing Power Parity (PPP) for monetary policy?

A) Central banks can control both inflation and exchange rates independently.

B) Central banks must choose between a fixed exchange rate and an independent inflation policy.

C) PPP ensures that interest rates remain stable across countries.

D) PPP eliminates the need for foreign exchange reserves.

B) Central banks must choose between a fixed exchange rate and an independent inflation policy.

What is the "law of one price" in the context of exchange rates?

A) Identical goods should sell for the same price regardless of location.

B) Exchange rates are determined solely by government policy.

C) Interest rates must be equal across countries.

D) Central banks must intervene daily to stabilize exchange rates.

A) Identical goods should sell for the same price regardless of location.

According to capital market arbitrage, what ensures that two equally risky bonds have the same expected return?

A) Government regulation

B) Investor speculation

C) Arbitrage in the capital market

D) Fixed exchange rate policies

C) Arbitrage in the capital market

What is the "impossible trinity" in exchange rate policy?

A) A country cannot have open capital flows, control its domestic interest rate, and fix its exchange rate simultaneously.

B) A country cannot have inflation, unemployment, and trade deficits at the same time.

C) A country must always choose between fiscal policy, monetary policy, and exchange rate policy.

D) A country must always maintain foreign reserves equal to its GDP.

A) A country cannot have open capital flows, control its domestic interest rate, and fix its exchange rate simultaneously.

What is a "sterilized" foreign exchange intervention?

A) An intervention that changes the monetary base.

B) An intervention that offsets the impact on the monetary base by conducting an opposing open market operation.

C) An intervention that permanently increases foreign reserves.

D) An intervention that eliminates the need for capital controls.

B) An intervention that offsets the impact on the monetary base by conducting an opposing open market operation.

What is a major risk of fixed exchange rate regimes?

A) They always lead to higher inflation.

B) They are prone to speculative attacks.

C) They eliminate trade between countries.

D) They prevent the use of fiscal policy.

B) They are prone to speculative attacks.

What was a key feature of the Bretton Woods system?

A) All currencies were pegged to gold.

B) Countries pegged their exchange rates to the U.S. dollar.

C) Exchange rates were allowed to float freely.

D) Capital controls were prohibited.

B) Countries pegged their exchange rates to the U.S. dollar.

What is "dollarization"?

A) A country pegs its currency loosely to the U.S. dollar.

B) A country formally adopts the U.S. dollar as its official currency.

C) A country uses the dollar only for international trade.

D) A country allows its currency to float against the dollar.

B) A country formally adopts the U.S. dollar as its official currency.

What was a major reason for the collapse of Argentina's currency board in 2001?

A) The peso was pegged to the euro instead of the dollar.

B) Excessive government spending and borrowing eroded confidence.

C) The IMF refused to provide any financial assistance.

D) The U.S. Federal Reserve stopped supporting the peg.

B) Excessive government spending and borrowing eroded confidence.

What is a key disadvantage of dollarization for a country?

A) It leads to higher inflation.

B) The country loses control over its monetary policy.

C) It increases the risk of speculative attacks.

D) It requires strict capital controls.

B) The country loses control over its monetary policy.

According to the quantity theory of money, what is the primary cause of high inflation?

A) High government spending

B) Rapid money growth

C) Low productivity growth

D) High unemployment

B) Rapid money growth

What does the equation of exchange (MV = PY) represent?

A) The relationship between money supply and bond prices

B) The link between money supply, velocity, price level, and real output

C) The balance between imports and exports

D) The correlation between interest rates and investment

B) The link between money supply, velocity, price level, and real output

In the long run, what is the relationship between money growth and inflation if velocity and real output are stable?

A) Money growth has no effect on inflation

B) Money growth leads to lower inflation

C) Money growth equals inflation

D) Inflation is determined by fiscal policy, not monetary policy

C) Money growth equals inflation

Why does inflation tend to exceed money growth in high-inflation countries?

A) Because velocity decreases as inflation rises

B) Because people spend money faster, increasing velocity

C) Because central banks reduce money supply

D) Because real GDP grows rapidly

B) Because people spend money faster, increasing velocity

What is the opportunity cost of holding money?

A) The risk of theft

B) The interest income lost by not holding bonds

C) The fees charged by banks

D) The cost of converting money into foreign currency

B) The interest income lost by not holding bonds

According to Irving Fisher's quantity theory, what assumption leads to the conclusion that money growth directly causes inflation?

A) Velocity and real output are constant

B) Interest rates are highly volatile

C) Government spending is fixed

D) The money multiplier is unstable

A) Velocity and real output are constant

What happens to the demand for money if interest rates rise?

A) Money demand increases

B) Money demand decreases

C) Money demand remains unchanged

D) Money demand depends only on inflation

B) Money demand decreases

Why did the Federal Reserve stop targeting money growth in the 2000s?

A) Because inflation was no longer a concern

B) Because velocity became unstable and unpredictable

C) Because the U.S. dollar was replaced by the euro

D) Because Congress prohibited monetary targeting

B) Because velocity became unstable and unpredictable

What is a key difference between the ECB and the Fed regarding money growth targeting?

A) The ECB believes money demand is stable, while the Fed does not

B) The Fed targets M1, while the ECB targets M3

C) The ECB ignores inflation, while the Fed focuses on it

D) The Fed uses fiscal policy instead of monetary policy

A) The ECB believes money demand is stable, while the Fed does not

What is the primary reason central banks today focus on interest rates rather than money growth for short-term policy?

A) Interest rates are easier to control than money supply

B) Money growth has no impact on the economy

C) Velocity is too unpredictable in the short run

D) Governments prohibit money supply adjustments

C) Velocity is too unpredictable in the short run

What defines potential output in the long run?

A) The level of output where current inflation equals expected inflation

B) The level of output given existing technology and normal resource use

C) The maximum output achievable during an economic boom

D) The output level when unemployment is zero

B) The level of output given existing technology and normal resource use

According to the quantity theory of money, what determines long-run inflation?

A) Government spending

B) Money growth minus growth in potential output

C) Changes in velocity of money

D) Fiscal policy adjustments

B) Money growth minus growth in potential output

What happens when current output exceeds potential output?

A) A recessionary output gap occurs

B) An expansionary output gap occurs

C) Inflation falls below target

D) The central bank lowers interest rates

B) An expansionary output gap occurs

How does the monetary policy reaction curve respond to higher inflation?

A) The central bank lowers the real interest rate

B) The central bank raises the real interest rate

C) The curve shifts to the left

D) The curve becomes vertical

B) The central bank raises the real interest rate

Which component of aggregate expenditure is most sensitive to changes in the real interest rate?

A) Government spending

B) Consumption

C) Investment

D) Net exports

C) Investment

What is the long-run real interest rate (r*)?

A) The rate set by the central bank's inflation target

B) The rate that equates aggregate expenditure with potential output

C) The nominal interest rate minus expected inflation

D) The federal funds rate during a recession

B) The rate that equates aggregate expenditure with potential output

Why does the dynamic aggregate demand (AD) curve slope downward?

A) Higher inflation reduces purchasing power, lowering output demanded

B) Higher inflation prompts the central bank to raise real interest rates, reducing spending

C) Higher inflation increases production costs, reducing supply

D) Higher inflation leads to higher wages, increasing consumption

B) Higher inflation prompts the central bank to raise real interest rates, reducing spending

What shifts the short-run aggregate supply (SRAS) curve to the left?

A) A decrease in expected inflation

B) A decrease in production costs

C) An increase in expected inflation or higher production costs

D) An increase in potential output

C) An increase in expected inflation or higher production costs

In long-run equilibrium, which condition must hold?

A) Current output equals potential output, and inflation equals expected inflation

B) Current output exceeds potential output, and inflation is zero

C) The real interest rate equals zero

D) The nominal interest rate equals the inflation rate

A) Current output equals potential output, and inflation equals expected inflation

What typically causes inflation to rise during a recession?

A) A leftward shift in aggregate demand

B) A rightward shift in aggregate demand

C) An increase in production costs (e.g., oil prices)

D) A decrease in the central bank's inflation target

C) An increase in production costs (e.g., oil prices)

Why do most recessions involve falling inflation?

A) Because they are caused by leftward shifts in aggregate demand

B) Because production costs always decline during recessions

C) Because central banks raise interest rates to combat deflation

D) Because potential output decreases during downturns

A) Because they are caused by leftward shifts in aggregate demand

What is a "supply shock"?

A) An unexpected event that shifts the aggregate demand curve

B) An unexpected event that affects production costs, shifting the short-run aggregate supply (SRAS) curve

C) A change in consumer confidence

D) A permanent increase in government spending

B) An unexpected event that affects production costs, shifting the short-run aggregate supply (SRAS) curve

What defines long-run equilibrium in the economy?

A) Current output equals potential output, and inflation equals expected inflation

B) Current output exceeds potential output, and inflation is zero

C) The real interest rate equals the nominal interest rate

D) Government spending equals tax revenue

A) Current output equals potential output, and inflation equals expected inflation

What happens when the central bank lowers its inflation target (πᵀ)?

A) The monetary policy reaction curve shifts right, increasing inflation

B) The monetary policy reaction curve shifts left, reducing inflation

C) The dynamic aggregate demand (AD) curve shifts right, increasing output

D) The short-run aggregate supply (SRAS) curve shifts left, increasing inflation

B) The monetary policy reaction curve shifts left, reducing inflation

What is "stagflation"?

A) High inflation and high economic growth

B) Low inflation and low economic growth

C) High inflation and low economic growth (stagnation)

D) Deflation and high unemployment

C) High inflation and low economic growth (stagnation)

How does an increase in government purchases affect the economy in the short run?

A) Shifts AD left, reducing output and inflation

B) Shifts AD right, increasing output and inflation

C) Shifts SRAS right, reducing inflation but increasing output

D) Has no effect on output or inflation

B) Shifts AD right, increasing output and inflation

What is the primary tool central banks use to stabilize the economy?

A) Adjusting government spending

B) Shifting the monetary policy reaction curve (interest rate changes)

C) Imposing price controls

D) Changing tax rates

B) Shifting the monetary policy reaction curve (interest rate changes)

Why is discretionary fiscal policy often ineffective for stabilization?

A) It works too quickly

B) It is difficult to implement in a timely manner due to political and data delays

C) It only affects inflation, not output

D) It requires international coordination

B) It is difficult to implement in a timely manner due to political and data delays

What is the likely outcome of a negative supply shock (e.g., higher oil prices)?

A) Lower inflation and higher output

B) Higher inflation and lower output (stagflation)

C) No change in inflation or output

D) Lower inflation and lower output

B) Higher inflation and lower output (stagflation)

How does the economy return to long-run equilibrium after a shock?

A) Through automatic adjustments in inflation expectations and SRAS shifts

B) Only through central bank intervention

C) By increasing government debt permanently

D) By abandoning the inflation target

A) Through automatic adjustments in inflation expectations and SRAS shifts

What opportunity does a positive supply shock (e.g., lower production costs) create for policymakers?

A) A chance to permanently increase output above potential

B) A chance to reduce inflation without causing a recession

C) A need to raise interest rates immediately

D) No significant policy opportunity

B) A chance to reduce inflation without causing a recession

What is the primary purpose of the monetary policy transmission mechanism?

A) To directly control inflation without affecting output

B) To influence aggregate output demanded through changes in the policy interest rate

C) To eliminate all financial crises

D) To replace fiscal policy in economic stabilization

B) To influence aggregate output demanded through changes in the policy interest rate

Which traditional channel of monetary policy involves changes in currency value affecting imports and exports?

A) Interest-rate channel

B) Bank-lending channel

C) Exchange-rate channel

D) Asset-price channel

C) Exchange-rate channel

Why is the interest-rate channel considered "not very powerful"?

A) Because investment decisions are insensitive to interest rates

B) Because it only affects government spending

C) Because it requires international coordination

D) Because it operates only during recessions

A) Because investment decisions are insensitive to interest rates

How does the bank-lending channel transmit monetary policy?

A) By altering the supply of funds available for banks to lend

B) By directly controlling stock prices

C) By setting fixed exchange rates

D) By eliminating all borrowing risks

A) By altering the supply of funds available for banks to lend

What is the balance-sheet channel's key mechanism?

A) Lower interest rates reduce borrowers' net worth, worsening credit conditions

B) Lower interest rates increase asset prices, improving borrowers' net worth and credit access

C) It only affects large corporations, not households

D) It requires deflation to be effective

B) Lower interest rates increase asset prices, improving borrowers' net worth and credit access

How does expansionary monetary policy affect household consumption via the asset-price channel?

A) By reducing home values and discouraging spending

B) By raising stock and real estate prices, increasing perceived wealth

C) By eliminating all household debt

D) By fixing interest rates permanently

B) By raising stock and real estate prices, increasing perceived wealth

What was a major consequence of the 2007-2009 financial crisis on monetary policy transmission?

A) It made traditional channels more effective

B) It obstructed credit flows due to heightened asymmetric information

C) It eliminated the need for central banks

D) It stabilized asset prices permanently

B) It obstructed credit flows due to heightened asymmetric information

What is the primary argument against using interest rates to combat asset-price bubbles?

A) Bubbles are too difficult to identify in real-time

B) Interest rates have no effect on asset prices

C) Bubbles always correct themselves without intervention

D) Central banks lack authority to adjust interest rates

A) Bubbles are too difficult to identify in real-time

What is the "effective lower bound" (ELB) problem in monetary policy?

A) Nominal interest rates cannot fall significantly below zero, limiting policy options

B) Inflation cannot exceed 2%

C) Central banks cannot raise interest rates above 5%

D) It only applies to fiscal policy

A) Nominal interest rates cannot fall significantly below zero, limiting policy options

What is a deflationary spiral?

A) A self-reinforcing cycle where falling prices lead to higher real interest rates and reduced spending

B) A temporary drop in inflation followed by rapid recovery

C) A policy tool used to stimulate growth

D) A consequence of excessive government spending

A) A self-reinforcing cycle where falling prices lead to higher real interest rates and reduced spending

Which unconventional monetary policy tool involves central banks purchasing long-term securities?

A) Forward guidance

B) Quantitative easing

C) Fiscal stimulus

D) Currency manipulation

B) Quantitative easing

How has the shift toward capital market financing affected monetary policy transmission?

A) Reduced reliance on banks weakened the bank-lending channel

B) Made traditional channels more predictable

C) Eliminated the need for balance-sheet adjustments

D) Ensured permanent financial stability

A) Reduced reliance on banks weakened the bank-lending channel

What is the primary purpose of the IS-LM model?

A) To analyze long-term economic growth

B) To study short-run equilibrium in goods and money markets

C) To predict stock market fluctuations

D) To measure international trade balances

B) To study short-run equilibrium in goods and money markets

Which assumption is critical for the IS-LM model?

A) Perfectly flexible prices

B) Fixed prices in the short run

C) No government intervention

D) Zero unemployment

B) Fixed prices in the short run

In the IS curve equation, what does the "I" represent?

A) Inflation

B) Investment (which depends negatively on interest rates)

C) Imports

D) Income tax

B) Investment (which depends negatively on interest rates)

What does the Keynesian multiplier (1/(1-c₁)) imply?

A) A change in autonomous spending causes a larger change in equilibrium output

B) Interest rates have no effect on output

C) Savings always equal investment

D) Government spending is always ineffective

A) A change in autonomous spending causes a larger change in equilibrium output

Why does the LM curve slope upward?

A) Higher income increases money demand, requiring higher interest rates to balance money supply

B) Higher income reduces investment demand

C) Central banks always raise rates with GDP growth

D) Lower interest rates increase savings

A) Higher income increases money demand, requiring higher interest rates to balance money supply

What happens to the IS curve during expansionary fiscal policy?

A) Shifts left (output decreases)

B) Shifts right (output increases)

C) Becomes vertical

D) Unaffected

B) Shifts right (output increases)

Under a fixed exchange rate regime, expansionary monetary policy:

A) Is ineffective (money supply adjusts to maintain the peg)

B) Strengthens the currency

C) Always causes hyperinflation

D) Requires no central bank intervention

A) Is ineffective (money supply adjusts to maintain the peg)

In the Mundell-Fleming model, what does the "MC" curve represent?

A) Money supply

B) Interest rate parity condition (arbitrage in capital markets)

C) Marginal cost of production

D) Government budget constraint

B) Interest rate parity condition (arbitrage in capital markets)

A depreciation of the real exchange rate (TCR) in an open economy will:

A) Reduce net exports (X-M)

B) Increase net exports (X-M)

C) Have no effect on trade

D) Only affect inflation

B) Increase net exports (X-M)

Under flexible exchange rates, expansionary fiscal policy may:

A) Crowd out net exports via currency appreciation

B) Always lead to higher interest rates

C) Have no effect on output

D) Fix trade deficits permanently

A) Crowd out net exports via currency appreciation

What is a key difference between IS-LM and Mundell-Fleming models?

A) IS-LM ignores exchange rates

B) Mundell-Fleming assumes a closed economy

C) IS-LM only applies to hyperinflation

D) Mundell-Fleming excludes monetary policy

A) IS-LM ignores exchange rates

A devaluation under fixed exchange rates aims to:

A) Reduce foreign reserves

B) Boost competitiveness by lowering the real exchange rate

C) Increase domestic interest rates permanently

D) Eliminate the central bank

B) Boost competitiveness by lowering the real exchange rate

What is the primary reason banks are prone to runs?

A) They hold too much cash

B) They provide liquidity to depositors while holding illiquid assets

C) They refuse to honor withdrawal requests

D) They are always insolvent

B) They provide liquidity to depositors while holding illiquid assets

What is the key difference between a bank's solvency and liquidity?

A) Solvency means a bank has enough reserves, while liquidity means it has positive net worth

B) Solvency means assets exceed liabilities, while liquidity means the bank can meet withdrawal demands

C) Liquidity refers to long-term stability, while solvency refers to short-term cash flow

D) They are the same concept

B) Solvency means assets exceed liabilities, while liquidity means the bank can meet withdrawal demands

What was a major consequence of Lehman Brothers' collapse in 2008?

A) A surge in public trust in shadow banks

B) A credit freeze in both collateralized and uncollateralized lending

C) Immediate government bailouts for all banks

D) Elimination of moral hazard in banking

B) A credit freeze in both collateralized and uncollateralized lending

What is the main purpose of the government safety net in banking?

A) To eliminate all bank failures

B) To protect investors, ensure competition, and safeguard financial stability

C) To guarantee unlimited profits for banks

D) To replace private banking with public ownership

B) To protect investors, ensure competition, and safeguard financial stability

How does deposit insurance contribute to moral hazard?

A) By encouraging banks to take excessive risks, knowing depositors are protected

B) By preventing banks from making loans

C) By requiring banks to hold 100% reserves

D) By eliminating bank runs entirely

A) By encouraging banks to take excessive risks, knowing depositors are protected

What is the "too-big-to-fail" problem?

A) Small banks are exempt from regulations

B) Large banks take on excessive risk because they expect government bailouts

C) Banks are prohibited from merging

D) Only shadow banks are allowed to fail

B) Large banks take on excessive risk because they expect government bailouts

What is the primary role of the Federal Deposit Insurance Corporation (FDIC)?

A) To regulate international banks

B) To guarantee depositors' funds up to a limit if a bank fails

C) To lend money to insolvent banks indefinitely

D) To set interest rates for loans

B) To guarantee depositors' funds up to a limit if a bank fails

What was a key flaw in the lender-of-last-resort system during the 2007-2009 crisis?

A) The Fed could not distinguish between illiquid and insolvent institutions

B) The Fed refused to lend to any banks

C) Shadow banks had no need for liquidity

D) Deposit insurance was abolished

A) The Fed could not distinguish between illiquid and insolvent institutions

What is the purpose of capital requirements for banks?

A) To restrict competition among banks

B) To ensure banks hold enough reserves to absorb losses

C) To eliminate all risk in banking

D) To prevent banks from holding any government bonds

B) To ensure banks hold enough reserves to absorb losses

What was a major outcome of the Dodd-Frank Act (2010)?

A) It ended all government guarantees for banks

B) It required annual stress tests for systemically important financial institutions (SIFIs)

C) It abolished the FDIC

D) It eliminated capital requirements

B) It required annual stress tests for systemically important financial institutions (SIFIs)

What are intermediaries required to disclose to financial markets?

A) Customer transaction details

B) Their balance sheets

C) Employee salaries

D) Marketing strategies

B) Their balance sheets

What is the purpose of disclosing accounting information to financial markets?

A) To increase bank profits

B) To allow regulators and markets to assess a bank's balance sheet quality

C) To reduce competition among banks

D) To hide financial risks from depositors

B) To allow regulators and markets to assess a bank's balance sheet quality

What is a major challenge in calculating risk-weighted assets?

A) It is too simple and straightforward

B) It is difficult to measure accurately

C) Banks refuse to report their assets

D) Regulators do not require it

B) It is difficult to measure accurately

What is the CAMELS rating system used for?

A) Determining bank stock prices

B) Evaluating the health of banks based on capital, asset quality, management, earnings, liquidity, and risk sensitivity

C) Calculating customer satisfaction

D) Setting interest rates for loans

B) Evaluating the health of banks based on capital, asset quality, management, earnings, liquidity, and risk sensitivity

What is the purpose of stress tests for large banks?

A) To increase bank fees

B) To assess prospective capital needs during economic downturns

C) To reduce the number of bank branches

D) To eliminate competition among banks

B) To assess prospective capital needs during economic downturns

What is a key difference between micro-prudential and macro-prudential regulation?

A) Micro-prudential focuses on individual banks, while macro-prudential aims to prevent systemic risks

B) Micro-prudential only applies to small banks

C) Macro-prudential ignores financial stability

D) There is no difference; they are the same

A) Micro-prudential focuses on individual banks, while macro-prudential aims to prevent systemic risks

What is a proposed feature of "narrow banks"?

A) They can invest in high-risk assets

B) They would hold 100% reserves

C) They would not be regulated

D) They would only serve corporate clients

B) They would hold 100% reserves

What does the Dodd-Frank Act require for SIFIs (Systemically Important Financial Institutions)?

A) Annual stress tests

B) Exemption from all regulations

C) Elimination of capital requirements

D) No government oversight

A) Annual stress tests

What is a major challenge for regulators due to financial globalization?

A) Reduced need for cooperation across borders

B) Increased need for coordination among different regulatory agencies

C) Banks becoming simpler in structure

D) Fewer financial risks to monitor

B) Increased need for coordination among different regulatory agencies

What is a proposed macro-prudential policy to manage systemic risk?

A) Fixed capital requirements at all times

B) Capital requirements that vary with the business cycle

C) No regulation of financial institutions

D) Only monitoring small banks

B) Capital requirements that vary with the business cycle

The new classical misperception theory states that

A) The firms may mispercept relative and general price changes.

B) The firms only produce in islands.

C) The firms always optimally decide prices.

D) none of the above.

A) The firms may mispercept relative and general price changes.

The Keynesian view that leads to a short run positively slope aggregated supply is related to

A) Flexible nominal prices.

B) Competitive markets.

C) rigidity of long-term contracts and imperfect competition

D) none of the above

C) rigidity of long-term contracts and imperfect competition

Changes in long run aggregate supply curve includes

A) changes in nominal prices.

B) increases in productivity growth (output produced per unit of input.

C) short run supply shocks

D) none of the above.

B) increases in productivity growth (output produced per unit of input.