CHAPTER 3

TRUE/FALSE QUESTIONS

(F) 1. The monetary base exceeds the money supply.

(T) 2. The cash-holding behavior of the public affects the monetary base.
(T) 3. The Federal Reserve decreases the monetary base whenever it sells government
securities.
(T) 4. When reserve requirements are increased, interest rates should increase.
(F) 5. If cash drains increase, the Fed may offset their effects with open market sales.
(T) 6. The Fed attempts to control M2 by controlling total reserves of depository
institutions.
(T) 7. The Emergency Economic Stabilization Act of 2008 authorized the increase in
deposit insurance from $100,000 to $250,000.
(T) 8. The experience since 2008 has shown that a decrease in the Fed Funds target
rate will not always lead to fewer excess reserves and an increase in bank lending.
(F) 9. A significant move by the Fed toward a “tight” money policy is likely to
enhance exports.
(T) 10. Housing investment is sensitive to changes in interest rates.
(T) 11. Decreasing interest rates tend to increase financial wealth and encourage
consumer spending.
(F) 12. An increase in the money supply should ultimately cause security prices to
decrease all else equal.
(T) 13. Restrictive monetary policy in the United States may slow down nominal GDP.
(T) 14. Monetarists think changing the money supply impacts economic units directly
rather than just through interest rates.
(F) 15. Increasing interest rates increases wealth and encourages spending.
(F) 16. Easy monetary policy strengthens the dollar.
(T) 17. A prolonged “tight” monetary policy can be associated with falling bond prices.
(T) 18. Stable or growing employment is one of the objectives of monetary policy.
(F) 19. There is definitely a tradeoff between stable prices and full employment.
(T) 20. Unexpected high levels of inflation aid debtors at the expense of lenders.
(T) 21. Changes in velocity make it harder for the Fed to predict how a change in the
money supply will impact the economy.
(T) 22. High debt levels can make it harder for the Fed to stimulate the economy.
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(F) 23. The Fed perfectly controls the money supply.
(T) 24. Interest rates and the money supply tend to vary inversely, at least in the
short term.
(F) 25. Real investment is encouraged by rising interest rates.
(T) 26. Monetary policy first affects financial markets and institutions, then the
real economy.
(F) 27. Full employment means that everyone in the economy has a job.
(F) 28. When the Fed increases the Fed Funds Rate, financial institutions “go to
the Window”.
(F) 29. Whether an increase in the money supply results in real growth or inflation is
impacted by how close the economy is to full capacity.
(F) 30. Monetary policy only works in the long term.
(T) 31. “Cash drains” are an example of a factor that complicates the Fed’s ability to
control the money supply.
(T) 32. Reserve requirements are not useful for “fine tuning” the economy.
(F) 33. According to the Taylor Rule the Fed kept interest rates too high from 2004 to
2006 and helped create the mortgage bubble.
(F) 34. High stock prices are a goal of monetary policy.
(T) 35. The goals of U.S. monetary policy were set by Congress.

(F) 36. The long term trend in ten year Treasury rates was positive from 1981 to
2014.

(T) 37. The Fed purchased over $300 billion in commercial paper during the financial
crisis to prop up this market.

(T) 38. The expected effect of quantitative easing (QE) is to lower long-term interest
rates to boost the economy.

(F) 39. The labor force participation rate had recovered to its pre-crisis levels by 2015.

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 MULTIPLE-CHOICE QUESTIONS

(a) 1. If the Fed decreases interest rates through open market operations then
a. investors and consumers are encouraged to invest and spend more.
b. real GDP growth will fall.
c. inflation will decline.
d. all of the above.

(a) 2. Deposits tend to expand whenever:

a. reserve requirements decrease.
b. the public holds more cash.
c. cash drains increase.
d. monetary policy “tightens”.

(c) 3. An increase in excess reserves will normally cause

a. the Fed Funds rate to rise.
b. planned inventory investment to fall.
c. depository institutions to lend more freely.
d. foreign investors to buy more T-Bills.

(c) 4. The velocity of money measures:

a. the rate of growth of the money supply.
b. the relationship between the monetary base and the money supply.
c. the relationship between the money supply and economic activity.
d. all of the above.
(d) 5. Ordinarily the money supply will decrease if:
a. the Fed makes fewer loans at its discount window.
b. the Fed sells securities on the open market.
c. the Fed raises reserve requirements.
d. all of the above.
(a) 6. In inflation targeting the Fed should ______ interest rates when inflation is ______ the
target rate.
a. increase, above
b. increase, below
c. not change, below
d. decrease, above

(b) 7. If the U.S. dollar increases in value then U.S.

a. import and exports will rise.
b. imports will rise and exports will fall.
c. exports will rise and imports will fall
d. imports and exports will not change.

(b) 8. An increase in the assets of Federal Reserve banks

a. decreases the monetary base.
b. increases the monetary base.
c. has no effect on monetary base.
d. always decreases another Federal Reserve Bank asset.

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(b) 9. Consumption spending should normally increase if
a. financial wealth decreases.
b. reserve requirements decrease.
c. interest rates increase.
d. credit availability decreases.

(d) 10. Generally, plant and equipment investment spending will decrease if
a. interest rates rise while inflation remains unchanged.
b. inflation decreases while interest rates remain unchanged.
c. reserve requirements rise.
d. any of the above
(b) 11. The factors that led to the financial crisis of 2008 include all but which one of the
following?
a. deterioration in bank balance sheets
b. abnormally high interest rates
c. the bursting of the housing bubble
d. increased uncertainty in the economy
(d) 12. Which of the following factors contributed to the problems in the mortgage markets in
the late 2000s?
a. failures of credit ratings agencies to properly evaluate the risk of mortgage
backed securities.
b. pressure from Congress to increase affordable housing to lower income
individuals.
c. the ability to securitize and sell mortgages without retaining any credit risk.
d. all of the above.
(a) 13. Even though the Fed engaged in sustained open market buying and quantitative easing
slow economic growth resulted because
a. banks increased the level of excess reserves as the monetary base grew.
b. capital investment grew too rapidly as a result.
c. depository institutions made too many risky loans to small businesses.
d. foreign investors bought too many Treasury securities.

(c) 14. An expansion in the U.S. money supply

a. will increase domestic interest rates
b. will cause the exchange value of the dollar to increase.
c. will cause U.S. exports to increase.
d. will cause U.S. imports to increase.
(a) 15. If the money supply increases too rapidly
a. inflationary expectations will rise.
b. government spending will decrease.
c. bank lending will decrease.
d. investment spending will fall.
(b) 16. Unemployment should fall if
a. wages increase and people expect prices to rise.
b. wages increase and people expect prices to be stable.
c. interest rates rise more than prices are expected to rise.
d. the money supply decreases.
(d) 17. A contraction in the U.S. money supply should
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 a. increase domestic interest rates
b. cause the exchange value of the dollar to increase.
c. cause U.S. exports to decrease.
d. all of the above.
(c) 18. The intended longer run goal of monetary policy is
a. to lower interest rates.
b. to raise security prices.
c. to increase consumption and investment spending.
d. to reduce government spending.
(d) 19. Which of the following is the correct expression for velocity (V)?
a. V=YxM
b. V=Y+M
c. V=Y-M
d. V = Y/M
(c) 20. Restrictive monetary policy first impacts the market, security prices and
interest rates.
a. money, increasing, decreasing
b. capital, increasing, decreasing
c. money, decreasing, increasing
d. mortgage, increasing, decreasing
(b) 21. Changes in spending caused by changing security values are called the
a. liquidity effect
b. wealth effect
c. income effect
d. reactionary effect
(a) 22. Federal government spending in a closed economy can result in ‘crowding out,’ a term
that means
a. government spending displaces private spending so little real economic growth
occurs.
b. the return on government spending is higher than the return on private
investment.
c. the decline in U.S. exports offsets any change in U.S. imports.
d. future taxes will be reduced due to higher economic growth.

(b) 23. Monetary policies directed toward increased economic growth may have what impact
upon the value of the dollar in relation to other currencies?
a. increase
b. decrease
c. no effect
d. an unpredictable effect

(a) 24. Monetarists believe that an increase in the money supply, all else equal, will cause:
a. consumption expenditures to rise.
b. investment spending to fall.
c. national income to fall.
d. government expenditures to rise.

(c) 25. M2 includes M1 and in addition,

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 a. currency in circulation
b. demand deposits
c. certain money market accounts
d. bonds

(b) 26. Fiscal policy refers to __________ designed to stimulate growth.

a. increases in the money supply
b. increases in government spending
c. changes in the Fed funds rate
d. changes in rate paid on reserves

(d) 27. The “tools” of monetary policy include all the following except
a. changing the discount rate.
b. open market operations.
c. changes in reserve requirements.
d. changes in the government budget deficit.

(c) 28. The high levels of U.S. government spending and debt has resulted in
a. higher interest rates due to crowding out.
b. lower interest rates due to reduced borrowing demand.
c. increased dependence on foreign investors.
d. decreased private sector indebtedness.

(a) 29. A Keynesian may say that when the Fed increases the money supply but the
economy does not improve the economy may be in a ________.
a. liquidity trap
b. fiscal deficit
c. Taylor target
d. depression

(c) 30. If an economy is in a liquidity trap a Keynesian would say

a. quantitative easing is required.
b. additional open market operations are warranted.
c. fiscal policy stimulus is required.
d. reducing the inflation target is required.

(d) 31. The velocity of money

a. varies inversely with the money supply
b. varies directly with GDP
c. is not under the Fed’s exclusive control
d. all of the above

(c) 32. The influence of Keynesian economics in U.S. policy dates back to the
a. inflationary decade of the 1960s and 1970s
b. post World War II U.S. economy.
c. Great Depression of the 1930s.
d. the financial crisis of 2007-2008.

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(b) 33. Influence of monetary policy on the financial sector is
a. negligible
b. inevitable
c. limited
d. insignificant

(d) 34. Which of the following was a responsibility of the early Federal Reserve System?
a. to control the money supply
b. to safeguard the national payment system
c. to establish a more rigorous bank supervisory system
d. all of the above

(c) 35. The Federal Reserve System established

a. a system for federal chartering of banks.
b. a system for controlling bank note issuance.
c. a source of liquidity for the banking system.
d. the beginning of demand deposit accounts.

(a) 36. Goals of the Federal Reserve include which of the following?

I. Price stability
II. Full employment
III. Financial stability
IV. Foreign exchange rate stability
V. Government budget deficit
VI. Government debt levels

a. I, II, III, IV only

b. IV, V and VI only
c. I, II and III only
d. I, II, III, IV, V and VI

(c ) 37. Inflation is defined as

a. a one-time increase in prices
b. the difference between the interest rate and the exchange rate
c. a continuous increase in the average price level
d. changes in the relative prices of goods and services

(b) 38. Real GDP growth has _________ since the 2007-2008 financial crisis compared
to pre-crisis growth rates.
a. increased
b. decreased
c. stayed the same
d. increased then fallen

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 ESSAY QUESTIONS

1. Explain how the Fed adjusts its balance sheet to increase or decrease the monetary base.

Answer: The Fed controls the bank reserve component of the monetary base and changes the
bank reserve account (liability) chiefly through open market operations—buying or selling U.S.
government securities (asset). When a Fed asset increases, the monetary base increases.

2. How does the Federal Reserve control the money supply by controlling the size of the monetary
base? Note the tools of monetary policy and how each can affect the monetary base and money
supply.
Answer: By controlling the monetary base, the Fed substantially influences the money supply.
To meet reserve requirements, depository institutions must deal in monetary base assets by either
depositing adequate reserves with the Fed or holding adequate quantities of Federal Reserve
Notes in their vaults. Either way, they earn no interest. The more they hold above requirements,
the more they want to avoid lost interest income. Excess reserves appear as the Fed buys on the
open market, lends at the Discount Window, or cuts reserve requirements. As depository
institutions lend or invest excess reserves, new loans or investments increase M1 and finance
purchases in the real sector. By expanding or contracting the monetary base, the Fed increases or
decreases excess reserves, thus raising or lowering incentive to lend or invest, thus encouraging
or discouraging expansion in real sector.

3. What should happen to consumption if the monetary base increases? Explain.

Answer: Excess increase, pressuring the “benchmark” Fed Funds Rate downward. As
depository institutions lend or invest excess reserves, the deposit component of M1 expands.
Falling interest rates and increased credit availability make saving less attractive than spending,
increase the value of existing fixed-rate financial assets in which prior savings may have been
invested, and lower the financing costs of “big ticket” items, thus encouraging additional
consumption.

4. What exactly is the Fed Funds Rate, and how is it used in setting monetary policy?
Answer: The Fed targets but does not set the Fed Funds Rate. The Fed Funds Market is a Fed-
sponsored system in which depository institutions lend and borrow excess reserves among
themselves. Thus the Fed Funds Rate (FFR) is set by market forces as they bargain with each
other. The FFR is a “benchmark” rate in the financial system—it normally represents the lowest
possible cost of loanable funds to a depository institution. The Fed substantially influences the
FFR in the short term by controlling overall availability of reserves. However, the Fed cannot
set the Fed Funds Rate in the long run because factors in the real sector ultimately determine
credit demand.

5. List and briefly describe the channels of transmission of monetary policy.

Answer:
Business investment in real assets. Present values of future cash flows depend significantly on
interest rates, as do costs of financing. Monetary policy thus involves material incentives or
disincentives for business investment.

Consumer spending for durable goods & housing. Much consumer spending is on credit.
Falling interest rates tend to encourage spending; rising rates to discourage spending.

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 Net exports (gross exports minus gross imports). Interest rates affect exchange rates, which
affect imports and exports. Monetary policy thus usually affects net exports.

6. The Federal Reserve has engaged in a program of quantitative easing, or QE, which creates
money for buying long-term U.S. Treasury bonds and mortgages in the market. What has been
the impact of QE on security prices and the economy?

Answer:
1. Buying bonds pushes down their yields and the interest rates across the debt markets that are
closely tied to U.S. Treasury rates.
2. Lower borrowing costs should help some homeowners finance and should help businesses to
apply for loans through cheaper credit. Larger corporations can access money at cheap rates in
financial markets while mid and small businesses can borrow at lower costs from financial
institutions. Even with QE, the economic growth rate has been slow to recover for several
reasons including increased capital requirements at banks, strict regulation on risky lending and
weak loan demand. The banks have increased excess reserves so the money supply has not
grown as fast as QE would suggest.

7. Why has the U.S. not seen increases in interest rates even though borrowing demand has been
high? Can the government borrow and spend without limit without impacting the economy?
Explain.

Answer: The reasons for the lack of crowding out even though we have had large borrowing
demand are the increase in the money supply and the large capital inflows from overseas agents
that have purchased U.S. government debt and other U.S assets. The high level of U.S.
indebtedness and our current account deficit imply a dependence on foreign financing of the U.S.
budget deficit. The United States is thus now dependent on foreigners’ willingness to invest in
the United States and is more vulnerable to global economic shocks as a result. So far the rest of
the world seems willing to invest in the U.S. If the U.S. government and private sectors invest
the money wisely so as to generate growing income and GDP then the U.S. will be able to repay
its debts and continue to have a growing standard of living. If not then future generations may
face slower growth. A future financial crisis related to U.S. debt levels is possible, but does not
seem likely as the rest of the world does not have many good safe liquid alternatives in which to
invest other than the U.S.

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