Chapter 14

1. During an inflationary period, policy makers who use the AS/AD model would probably recommend an open market A) sale of government securities that reduces interest rates. B) purchase of government securities that reduces interest rates. C) sale of government securities that raises interest rates. D) purchase of government securities that raises interest rates.

2. A) B) C) D)

Bank of Canada sales of government bonds _____ bank reserves and _____ the money supply. increase, increase decrease, decrease decrease, increase increase, decrease

3. A) B) C) D)

Monetary regimes do not set policy on the basis of a predetermined framework. rely on the discretion of monetary policy officials. use predetermined rules to set monetary policy. produce greater variation in expected inflation than individual monetary policies.

4. A) B) C) D)

The Bank of Canada wants to increase the money supply. It should buy bonds. sell bonds. pass a law that raises interest rates. pass a law that lowers interest rates.

5. A) B) C) D)

Common features of inflation targeting include setting a rate of inflation high enough to insure the economy is never below potential income. making long-run price stability the only objective of monetary policy. central banks try to keep their policy confidential. the central bank must be held accountable if the inflation target is not reached.

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6. A) B) C) D)

One tool of monetary policy is changing the tariff rates. the bank rate. income tax rates. exchange rates.

7. A) B) C) D)

If the Bank of Canada undertakes contractionary monetary policy the effect will be to shift the AD curve out to the right. AD curve in to the left. SAS curve up. SAS curve down.

8. A) B) C) D)

Interest rates and bond prices move together. move in opposite directions. sometimes move together and sometimes move in opposite directions. are not related.

9. A) B) C) D)

The central bank in the United States is called the Bank of the United States. the American Central bank. the Bundesbank. the Federal Reserve Bank.

10. When prices are fixed, a monetary policy that affects nominal income and real income by the same amount must result in the shift of A) both the AD and SAS curves. B) only the AD curve. C) only the SAS curve. D) neither the SAS curve nor the AD curve.

11. If the interest rate is 7 percent and the Bank of Canada's target is 8 percent, the Bank of Canada is most likely to adopt which of the following policies? A) A sale of government bonds. B) A purchase of government bonds. C) A reduction in the bank rate. D) A more expansionary monetary policy.

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12. A) B) C) D)

If prices are perfectly flexible, monetary policy affects both nominal and real income. affects real income but not nominal income. affects nominal income but not real income. doesn't affect real or nominal income.

13. A) B) C) D)

Which of the following monetary policies reduces aggregate demand and output? A decrease in the overnight financing rate. An open market purchase of government bonds. An increase in the bank rate. An open market purchase of Treasury Bills.

14. A) B) C) D)

Expansionary monetary policy tends to increase both income and interest rates. increase income and reduce interest rates. decrease both income and interest rates. decrease income and increase interest rates.

15. A) B) C) D)

Which of the following is an example of an expansionary monetary policy? Raising the bank rate. Raising the overnight financing rate. Selling bonds. Buying bonds.

16. A) B) C) D)

The interest rate on government bonds equals the bond's price expressed as a percentage of its annual payment. equals the bond's annual payment expressed as a percentage of its price. is affected only indirectly by changes in bond prices or annual payments. is not related to bond prices or annual payments.

17. A) B) C) D)

The consequences of inflation include reducing the purchasing power of a nation's money supply. increasing the value of a nation's exchange rate. helping those in fixed incomes. encouraging individuals and firms to undertake transaction costs to keep their wealth in investments that earn a rate of interest at, or above, the rate of inflation.

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18. Suppose the desired reserve ratio is 20% and there are no cash holdings. A $1 billion purchase of government securities by the Bank of Canada will A) increase the potential amount of checkable deposits in the banking system by $5 billion. B) increase the potential amount of checkable deposits in the banking system by $1 billion. C) reduce the potential amount of checkable deposits in the banking system by $1 billion. D) reduce the potential amount of checkable deposits in the banking system by $5 billion.

19. A) B) C) D)

In the balance sheet of a chartered bank, demand (checkable) deposits are liabilities. net worth. assets. equal to liabilities plus net worth.

Use the following to answer question 20:

20. Refer to the graph above. Monetary policy that shifts the AD curve from AD0 to AD1 but does not affect the price level A) decreases nominal output but not real output. B) decreases both real and nominal output. C) decreases real output but not nominal output. D) doesn't decrease real or nominal output.

21. A) B) C) D)

Many interest rates are related to the overnight financing rate through the open market operations of the Bank of Canada. the term structure of interest rates. the fixed relation between the prime rate and the overnight rate. cash management operations.

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22. A) B) C) D)

According to the AS/AD model, a contractionary monetary policy increases interest rates, raises investment, and increases income. decreases interest rates, raises investment, and increases income. increases interest rates, reduces investment, and decreases income. decreases interest rates, reduces investment, and decreases income.

23. A) B) C) D)

Common features of inflation targeting include all of the following EXCEPT: the main goal of monetary policy is long-run price stability. the central bank is not rigid in establishing a numerical target for inflation. central banks try to keep monetary policy transparent. the central bank must be held accountable if the inflation target is not reached.

24. A) B) C) D)

Which of the following two countries adopted inflation targeting first? Canada and New Zealand. Canada and the United Kingdom. The United States and Australia. The Australia and the United Kingdom.

25. Monetary policy is one of the two main macroeconomic tools governments use to influence the aggregate economy, the other being A) fiscal policy. B) foreign policy. C) trade policy. D) immigration policy.

Use the following to answer question 26:

Price level

AD1 AD0 Real output

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26. Refer to the graph above. Which of the following changes in monetary policy would shift the aggregate demand curve from AD0 to AD1? A) An open market sale of securities. B) A reduction in the bank rate. C) An increase in the bank rate. D) An increase in the overnight financing rate.

27. A) B) C) D)

Common features of inflation targeting include all of the following EXCEPT: income stability and not price stability is the main goal of monetary policy. the central bank must establish a numerical target for inflation and a time table for achieving it. central banks try to keep monetary policy transparent. the central bank must be held accountable if the inflation target is not reached.

28. Suppose that investment is not very responsive to interest rates, so that a sizable increase in interest rates has only a minor effect on investment. In this case, monetary policy would A) have no effect on output. B) have a modest effect on output at best. C) have a substantial effect on output. D) have a massive effect on output.

29. A) B) C)

In the European Union, each country maintains independent control of its own monetary policy. countries have given up significant control of monetary policy to the European Central Bank. the governors of the European Central Bank are elected and must be members of the European Parliament. D) the Bundesbank has been given authority to administer European monetary policy.

30. A) B) C) D)

In January 1987, the value of Monetary Conditions Index (MCI) would have been -10. -1. 0. 10.

31. A) B) C) D)

The lower the Monetary Conditions Index (MCI), the looser is monetary policy. the tighter is monetary policy. the higher is the trade-weighted Canadian dollar exchange rate index. the higher is the 90-day commercial paper rate relative to 1987.

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32. If a contractionary monetary policy reduces nominal income by more than it reduces real income, it must be true that prices A) are perfectly flexible. B) are at least partially flexible. C) are completely inflexible. D) have fully adjusted to the change in aggregate demand.

33. A) B) C) D)

The distinction between real and nominal interest rates makes it easier to assess the impact of monetary policy. makes it harder to assess the impact of monetary policy. does not affect the assessment of monetary policy since nominal interest rates are observable. does not affect the assessment of monetary policy since real interest rates are observable.

34. Which of the following actions on the part of the Bank of Canada will result in an increase in the money supply? A) Decreasing the amount of loans made to commercial banks. B) Buying government bonds in the open market. C) Selling government bonds in the open market. D) Increasing the bank rate.

35. A) B) C) D)

A monetary regime is preferred to a monetary policy because a monetary policy is too closely related to fiscal policy. a monetary regime takes into account feedback effects. a monetary policy takes into account feedback effects. One is not preferred to the other; the two are essentially the same thing.

36. A) B) C) D)

The higher the Monetary Conditions Index (MCI), the looser is monetary policy. the tighter is monetary policy. the lower is the trade-weighted Canadian dollar exchange rate index. the lower is the 90-day commercial paper rate relative to 1987.

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Use the following to answer question 37:

37. A) B) C) D)

Refer to the graph above. Monetary policy that shifts the AD curve from AD0 to AD1 is expansionary. contractionary. neither expansionary nor contractionary since it does not affect output. neither expansionary nor contractionary since it does not affect inflation.

38. A bear market in bonds exists when bond prices are falling. In such an environment, interest rates A) are falling. B) are constant. C) are rising. D) may rise or fall depending on how fast bond prices fall.

39. A) B) C) D)

An open market sale by the Bank of Canada has a tendency to increase bond prices and interest rates. increase bond prices and decrease interest rates. decrease bond prices and interest rates. decrease bond prices and increase interest rates.

40. A) B) C) D)

Other things being equal, a rise in interest rates can be expected to increase the quantity of investment. decrease the quantity of investment. have no effect upon the quantity of investment. increase equilibrium income.

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41. Which of the following statements about the Bank of Canada is false? A) The Bank of Canada is a Crown corporation. B) The Governor of the Bank is appointed by the Prime Minister from among the elected members of the House of Commons. C) The Board of Directors of the Bank are nonspecialists in monetary economics who have little influence over the direction of monetary policy. D) The Bank acts as the government's banker.

42. Which of the following actions by the Bank of Canada would likely cause short-term interest rates to rise? A) Open market sales of government bonds. B) Open market purchases of government bonds. C) A decrease in the bank rate. D) A decrease in the overnight financing rate.

43. A) B) C) D)

Common features of inflation targeting include all of the following EXCEPT: there is no one main goal of monetary policy. the central bank must establish a numerical target for inflation and a time table for achieving it. central banks try to keep monetary policy transparent. the central bank must be held accountable if the inflation target is not reached.

44. A) B) C) D)

The purpose of an expansionary monetary policy is to reduce investment spending. shift the aggregate demand curve to the left. raise interest rates and restrict credit availability. lower interest rates and increase credit availability.

45. A) B) C) D)

Which of the following two countries adopted inflation targeting first? Canada and New Zealand. Canada and the United States. The United States and New Zealand. The United States and the United Kingdom.

46. A) B) C) D)

An open market purchase raises bond prices and reduces interest rates. raises both bond prices and interest rates. reduces bond prices and raises interest rates. reduces both bond prices and interest rates.

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Use the following to answer question 47:

47. Refer to the graph above. Suppose the economy is initially at A but then the Bank of Canada adopts an expansionary monetary policy. If the economy is in the Keynesian range, the new equilibrium will be at A) A. B) B. C) C. D) D.

48. A) B) C) D)

Common features of inflation targeting include maintaining an inflation rate consistent with international considerations. making long-run price stability the only objective of monetary policy. central banks try to keep monetary policy transparent. making sure some consideration is given to the inflation rate when trying to achieve goals having higher priorities.

49. Suppose an expansionary monetary policy reduces nominal interest rates. If this is the case, it follows that the expansionary monetary policy must have A) reduced expected inflation. B) increased expected inflation. C) increased expected inflation less than it reduced real interest rates. D) reduced real interest rates less than it increased expected inflation.

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50. If the interest rate is 9 percent and the Bank of Canada's target is 8 percent, the Bank of Canada is most likely to adopt which of the following policies? A) A sale of government bonds. B) An increase in the discount rate. C) A purchase of government bonds. D) A more contractionary monetary policy.

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Answer Key
1. C Response: An open market sale of government securities increases the supply of bonds, driving down bond prices and increasing interest rates. Higher interest rates in turn depress investment and output. 2. B Response: Open market sales of government bonds reduce the reserves of the banking system. As reserves fall, banks must replenish them by either issuing fewer loans or calling in old loans, both of which reduce the money supply. 3. C Response: A monetary regime is a predetermined statement of the policy that will be followed in a given situation. 4. A Response: The Bank of Canada does not pass laws. When the Bank of Canada buys bonds, it lowers the interest rate but it does not lower interest rates by law. 5. D Response: See the discussion in the textook. 6. B Response: A change in the bank rate is one form of monetary policy. 7. B Response: Contractionary monetary policy increases interest rates which reduces investment, a component of aggregate expenditures. The AD curve shifts to the left by a multiple of the decline in investment. 8. B Response: The interest rate is the ratio of the annual bond payment and the bond price. 9. D Response: The central bank in the U.S. is the Federal Reserve Bank. 10. B Response: In this case, the entire increase in AD is translated into an equivalent increase in real income. This is only possible if the shift in the AD curve is not offset by a shift in the SAS curve. 11. A Response: Since the interest rate is too low relative to the Bank of Canada's target, the Bank of Canada should push interest rates up using a contractionary monetary policy such as a sale of government bonds. 12. C Response: In this case, changes in aggregate demand resulting from expansionary or contractionary monetary policy are translated entirely into price changes with no change in output.
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13. C Response: An increase in the bank rate is a signal that banks should tighten up their lending. Interest rates will rise, causing investment, aggregate demand, and output to decline. 14. B Response: Expansionary monetary policy shifts the AD curve out, increasing income. It reduces interest rates because it increases bank reserves and the supply of credit. 15. D Response: A bond purchase by the Bank of Canada will increase the money supply. 16. B Response: See the discussion in the text. 17. A Response: See the discussion in the textbook. 18. A Response: The money multiplier equals 1/(r+c), which equals 5 in this case. Since a $1 billion purchase of government securities injects $1 billion of reserves into the banking system, demand deposits can increase by a maximum of $5 billion. 19. A Response: Since banks have an obligation to meet the withdrawals of their depositors, demand deposits are liabilities. 20. B Response: Since the price level is fixed, a shift of the aggregate demand curve to the left must reduce both real and nominal output. 21. B Response: The term structure of interest rates relates short-term and long-term interest rates. 22. C Response: Contractionary monetary policy raises interest rates by reducing the money supply. Higher interest rates depress investment and output by making it more expensive for businesses to borrow and invest. 23. B Response: Typically central banks establish a numerical target for inflation and a time table for reaching it. 24. A Response: Canada and New Zealand adopted inflation targeting before the other countries mentioned. 25. A Response: Fiscal policy affects the aggregate economy through changes in taxes and government outlays. 26. B Response:
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27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

The shift in the aggregate demand curve could be produced by a reduction in the bank rate and thus a reduction in the overnight financing rate. The result would be higher investment and aggregate demand. A Response: Typically the main goal of monetary policy is long-run price stability. B Response: If investment is insensitive to interest rates, aggregate demand will also be insensitive, reducing the effectiveness of monetary policy. B Response: See the text for a discussion of the European Central Bank. C Response: In January 1987, i = 7.9 and s = 91.33 (you should know this from the MCI formula), using the formula for the MCI given in the textbook: 100 s 91.33 1 91.33 91.33 MCI = (i 7.9) + ( )( ) = (7.9 7.9) + ( )( )=0+0=0. 3 91.33 3 91.33 A Response: See the discussion in the textbook. B Response: As long as real income declines, prices are not perfectly flexible. Nonetheless, because nominal income falls by more than real income, prices are somewhat flexible. B Response: Since real interest rates are unobservable because expected inflation is unobservable, the impact of monetary policy is more difficult to assess. B Response: Buying government bonds increases bank reserves and the availability of credit, causing the money supply to increase. B Response: Monetary regimes are predetermined rules of what the Bank of Canada will do in certain situations; they take feedback effects into account; a regime presets monetary policy. B Response: See the discussion in the textbook. B Response: Contractionary monetary policy would reduce economic activity and shift the AD curve in. C Response: The interest rate is the ratio of the annual bond payment and the bond price. If bond prices are falling, interest rates must be rising. D
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40.

41.

42.

43.

44.

45.

46.

47.

48.

49.

50.

Response: As the Bank of Canada sells bonds the supply of bonds goes up, decreasing bond prices and raising interest rates. B Response: Higher interest rates increase the cost of borrowing, making it more expensive for businesses to borrow to finance new investment projects. B Response: See the text for a discussion of the structure of the Bank of Canada. A Response: An open market sale of government bonds by the Bank of Canada increases the supply of bonds, causing a drop in bond prices and an increase in short-term interest rates. A Response: Typically the main goal of monetary policy is long-run price stability. D Response: Expansionary monetary policy increases aggregate demand by reducing interest rates and increasing the supply of credit available to businesses and consumers. The aggregate demand curve shifts to the right. A Response: Canada and New Zealand adopted inflation targeting before the other countries mentioned. A Response: As the Bank of Canada buys bonds and reduces their supply, their price rises. Since bond prices and interest rates are inversely related, interest rates will fall. B Response: The increase in aggregate demand resulting from the expansionary monetary policy is translated entirely into higher output in the Keynesian range with no change in the price level. C Response: See the discussion in the textbook. C Response: An expansionary monetary policy normally reduces real interest rates and raises expected inflation. If nominal interest rates fall, it follows that real interest rates must have gone down more than expected inflation went up. C Response: Since the interest rate is too high relative to the Bank of Canada's target, the Bank of Canada should push interest rates down using an expansionary monetary policy such as a purchase of government bonds.

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