Macro Quiz 4.1-4.4

Which of the following best describes the nominal interest rate on a mortgage loan that a bank offers to a customer?

• It is the real interest rate divided by the price level.

• It is the real interest rate minus the expected inflation rate.

• It is the interest rate charged by the bank.

• It is the interest rate charged by the bank minus the expected inflation rate.

• It is the interest rate charged by the bank minus the interest rate the bank pays to its depositors.

Answer explanation

The nominal interest rate is the unadjusted, stated rate of interest charged by the bank, independent of any expected changes in the price level. Also, the nominal interest rate is the real interest rate plus the expected inflation rate. The change in the price level is added to the real interest rate to find the nominal interest rate.

If the interest rate on loans before adjusting for inflation is 9%, and the expected inflation rate is 4%, then which of the following must be true?

• Lenders are expected to receive an additional 4% on their loaned funds.

• Borrowers are expected to pay an additional 4% on their borrowed funds.

• The expected real interest rate is 9%.

• The expected real interest rate is 13%.

• The nominal interest rate is 9%.

Answer explanation

.The interest rate on loans before adjusting for inflation rate is the nominal interest rate, which is 9%. When adjusted for inflation lenders will receive a real interest rate of 5%, which is the nominal interest rate (9%) minus the expected inflation rate (4%).

Which of the following will happen when interest rates increase in an economy?

• The cost of borrowing will decrease.

• The spending multiplier will decrease.

• Investment spending will increase.

• The price of previously issued bonds will increase.

• The opportunity cost of holding money will increase.

Answer explanation

The opportunity cost of holding money is the interest that could have been earned from holding other financial assets. An increase in interest rates therefore increases the opportunity cost of holding money.

Also, the cost of borrowing will increase, not decrease, when interest rates increase. The spending multiplier will not change as a result of an increase in interest rates because it's determined by the marginal propensity to consume. Investment spending will also decrease, as a result of an increase in interest rates. An increase in interest rates increases the cost of borrowing and therefore discourages investment spending. Last, the price of previously issued bonds will decrease, not increase, as a result of an increase in interest rates.

Sam pays monthly installments on a five-year fixed interest rate auto loan. If the expected inflation rate increases, which of the following will happen?

• Sam will pay a lower nominal interest rate.

• Sam will pay a higher nominal interest rate.

• Sam will pay a lower real interest rate.

• Sam will pay a higher real interest rate.

• Sam will pay higher monthly installments.

Answer explanation

The real interest rate is the nominal interest rate adjusted for inflation and is equal to the nominal interest rate minus the expected inflation rate. Therefore, if the expected inflation rate increases, the real interest rate paid on the loan will decrease.

On the other hand, nominal interest rates on fixed interest rate loans are not affected by changes in inflation.

Also, monthly installments on fixed rate loans are not affected by inflation.

• 1

• 2

• 4

• 5

• 20

Answer explanation

The money multiplier is the inverse of the required reserve ratio, which is the ratio of required reserves to demand deposits.

The required reserve ratio =$20,000/$100,000=0.2

The money multiplier =1/0.2=5

In the narrowest definition of money, M1, savings accounts are excluded because they are

• not a medium of exchange

• not insured by federal deposit insurance

• available from financial institutions other than banks

• a store of purchasing power

• interest-paying accounts

Answer explanation

They are not considered as liquid as a checking account. With a checking account, using a debit card from the account is essentially using the cash. This is not possible to do from a savings account. The ability to gain interest has nothing to do with defining money into categories such as M1 and M2.

Which of the following describes a major difference between stocks and bonds?

• Stocks represent ownership in a corporation, and bonds represent a loan to a corporation.

• Bonds represent ownership in a corporation, and stocks represent a loan to a corporation.

• Stocks are counted in gross domestic product, and bonds are not counted.

• Bonds are counted in gross domestic product, and stocks are not counted.

• Bonds pay dividends, and stocks earn interest.

The money-creating ability of the banking system will be less than the maximum amount indicated by the money multiplier when

• interest rates are high

• the velocity of money is rising

• people hold a portion of their money in the form of currency

• the unemployment rate is low

• the government's budget is in deficit

Answer explanation

When people hold on to a portion of their money, they are not placing it in banks and thus a portion of that money isn't available to be loaned out by the banks, decreasing the amount of money created in the system

Under a fractional reserve banking system, banks are required to

• keep part of their demand deposits as reserves

• expand the money supply when requested by the central bank

• insure their deposits against losses and bank runs

• pay a fraction of their interest income in taxes

• charge the same interest rate on all their loans

The transaction demand for money is very closely associated with money’s use as a

• store of value

• standard unit of account

• measure of value

• medium of exchange

• standard of deferred payment

Answer explanation

Transaction demand is the amount of money needed to buy goods; money as a medium of exchange means that it is used in order to buy goods or services (as it is a financial transaction)