Ch.6 Money Market & Monetary Policy

Which of the following statements are correct?

(1) Transactions demand for money is positively related to real national income.

(2) Asset demand is the demand for money as a store of value.

(3) The real interest rate is the cost of holding money.

• (1) and (2) only

• (1) and (3) only

• (2) and (3) only

•  (1), (2) and (3)

Answer explanation

(3) is incorrect. The cost of holding money is the nominal interest rate.

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6.1 Money demand

Which of the following will reduce money demand?

• A rise in real national income

• A rise in the expected price level

• A rise in the time interval between successive income receipts

• None of the above

Answer explanation

Higher price level reduces the purchasing power of money. People will hold less money to avoid the loss in purchasing power.

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6.1 Money demand

Which of the following will raise the transactions demand or asset demand for money?

(1) Real national income increases.

(2) The interest rate falls.

(3) Other assets have less risk.

• (1) and (2) only

• (1) and (3) only

• (2) and (3) only

•  (1), (2) and (3)

Answer explanation

(1) and (2) are correct. Money demand is positively related to real national income and negatively related to the interest rate.

(3) is incorrect. Money has little or zero return when compared to other assets. When it is less risky to hold other assets, people will hold more of them but less money.

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6.1 Money demand

Which of the following will shift the money demand curve from M^d1 to M^d2?

• A fall in the interest rate

• An advance in payment technology

• A change from a weekly payroll to a monthly payroll

• A decrease in the risk of holding other assets

Answer explanation

A rise in the time interval between successive income receipts will increase money demand.

A is incorrect. A fall in the interest rate will result in a downward movement along the same money demand curve.

B and D are incorrect. Money demand decreases and the money demand curve will shift to the left.

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6.2 Interest-rate determination

Refer to the diagram above. Which of the following statements are correct?

(1) When the interest rate is r₀, quantity demanded of money is equal to quantity supplied of money.

(2) When the interest rate is r₁, quantity demanded of money will fall to eliminate the excess demand for money.

(3) When the interest rate is r₂, there is an excess supply of money and the interest rate will tend to fall.

• (1) and (2) only

• (1) and (3) only

• (2) and (3) only

•  (1), (2) and (3)

Answer explanation

(2) is incorrect. The interest rate will rise because of the shortage of money in the money market.

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6.2 Interest-rate determination

The interest rate may increase when there is

• a fall in money demand.

• a rise in money supply.

• a fall in money demand accompanied by a fall in money supply.

• a fall in money demand accompanied by a rise in money supply.

Answer explanation

A fall in the money demand decreases the interest rate, but a fall in the money supply increases the interest rate.

If the money supply falls by a larger amount than the money demand, the interest rate will increase.

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6.2 Interest-rate determination

Which of the following will increase the money supply?

(1) The government lowers the required reserve ratio.

(2) The government issues more money to finance its infrastructure projects.

(3) Commercial banks decrease their investments to increase their excess reserves.

• (1) and (2) only

• (1) and (3) only

• (2) and (3) only

•  (1), (2) and (3)

Answer explanation

(1) is correct. This increases the banking multiplier and then the money supply.

(3) is incorrect. Money supply decreases because less money will be created by banks’ credits.

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6.3 Monetary policy

Which of the following will shift the money supply curve from M^s₁ to M^s₂?

• A fall in the discount rate

• A fall in the required reserve ratio

• An open market purchase

• None of the above

Answer explanation

The money supply curve shifts leftward, i.e., there is a reduction in the money supply.

The events in A, B and C will increase the money supply and the money supply curve will shift to the right.

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6.3 Monetary policy

Suppose the central bank of a country lowers the required reserve ratio. Which of the following will certainly occur as a result?

• The deposits in banks will increase.

• The reserves in banks will decrease.

• The money supply will increase.

• The maximum banking multiplier will increase.

Answer explanation

The maximum banking multiplier = 1 / required reserve ratio

A reduction in the required reserve ratio will increase the maximum banking multiplier.

If the banks decide not to increase lending, there will not be any change in reserves, deposits and money supply.

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6.3 Monetary policy

Suppose the required reserve ratio is 25%. If the central bank makes an open market sale of $10 million in government bonds, what is the maximum change in the money supply?

• An increase of $30 million

• An increase of $40 million

• A decrease of $30 million

• A decrease of $40 million

Answer explanation

The maximum banking multiplier is 4 (= 1/0.25).

Bank reserves decrease by $10 million when people pay for the bonds from their deposits.

Total deposits will decrease $40 million (= 10 million x 4) at maximum.

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6.3 Monetary policy