Suppose That the Following Conditions Describe the Current State of the United States Economy

AP Economics

Unit 3 Practice Exam

Answers in blue

Name:

1. The M1 definition of money includes which of the following?

I. Currency.

II. Demand deposits (checkable deposits).

III. Savings accounts and small time deposits.

IV. Eurodollars.

(A) I only. (B) II only. (C) III only. (D) I and II only.

(E) II, III and IV only.

2. If the legal reserve requirement is 25 percent, the value of the money multiplier is

(A) 2. (B) 4. (C) 5. (D) 10. (E) 1.0.

3. To reduce inflation, the Federal Reserve could (remember, investment is a component of demand!)

(A) Expand the money supply in order to raise interest rates, which increases investment.

(B) Expand the money supply in order to lower interest rates, which increases investment.

(D) Contract the money supply in order to raise interest rates, which decreases investment.

(E) Buy bonds and decrease the discount rate to encourage borrowing.

4. Which of the following actions by the Federal Reserve will result in an increase in banks’ excess reserves?

(A) Buying bonds on the open market.

(B) Selling bonds on the open market.

(D) Increasing the reserve requirement.

(E) Increasing the federal funds rates.

5. Suppose the Federal Reserve buys $400,000 worth of securities from the securities dealers on the open market, If the reserve requirement is 20 percent and the banks hold no excess reserves, what will happen to the total money supply?

(A) It will be unchanged.

(B) It will contract by $2,000,000.

(D) It will expand by $2,000,000.

(E) It will expand by $800,000.

6. Assume that the aggregate price level increases. Which of the following events will occur in the monetary market as a result of this increase?

(A) Nominal and real quantity of money demanded curves will shift.

(B) Neither nominal nor real QoMD curves will shift, points along the curves will move.

(D) Real QoMD will shift and nominal QoMD will move along the curve.

7. Crowding-out refers to

A) A decrease in net exports as a result of a currency declining in value

B) A decrease in government spending as a result of an income tax decrease

C) A decrease in consumption as a result a result of an increase in personal taxes

D) A decrease in real GDP has a result of a supply shock..

E) A decrease in private investment spending as a result of an increase in government spending

8. If the amount of money demanded exceeds the amount supplied, the:

A. demand-for-money curve will shift to the left.

B. money supply curve will shift to the right.

C. interest rate will rise.

D. interest rate will fall.

9. Gold, baseball cards and stones are examples of

A. Fiat money B. commodity money

C. commodity-backed money D. commodity and fiat money

E. Commodity-backed and fiat money

Answer the next questions10-12 on the basis of the following consolidated balance sheet for the commercial banking system. Assume the required reserve ratio is 30 percent. All figures are in billions.

10. The commercial banking system has excess reserves of:

A. $9 billion B. $7 billion

C. $6.1 billion D. $ 5billion E. $0

11. The maximum by which the commercial bank can expand the money supply by lending is:

A. $30 billion B. $23.1 billion

C. $27 billion D. $15 billion E. Zero

12. If the commercial banking system actually loans the maximum amount it is able to lend:

A. reserves and deposits equal to that amount will be gained.

B. excess reserves will be $2.6 billion.

C. excess reserves will fall to $1.7 billion.

D. excess reserves will be reduced to zero.

13. Suppose the Fed wants to reduce the money supply by $400 billion to drive up interest rates and dampen inflation.(Remember the Fed. Reserve requirement is 10%) To accomplish this it could:

A) sell $20 billion of U.S. securities to the banks.

B) buy $20 billion of U.S. securities from the banks.

C) sell $40 billion of U.S. securities to the banks.

D) buy $40 billion of U.S. securities from the banks.

Use the following exhibit to answer questions 14-16

Assets / Liabilities
RR $30,000
ER $ 0
Loans? / $200,000 DD

14. The required reserve is

A) .10 B) .15 C) .20 D) .25 E) Unknown

15. The total outstanding loans of this bank is

A) $230, 000 B) $200,000 C) $170,000

D) $30,000 E) Unknown

16. Sam receives his $1, 000 monthly “tips” in cash and deposits it in the bank above. The bank is now able to grant new loans in the amount of:

A) $700.00 B) $800 C) $850 D) $1,000

E) No loans can be created

Free Response

1. Assume that the Federal Reserve System sells bonds in the open market, and that commercial banks hold no excess reserves.

(a) Explain in detail how the Federal Reserve's action affects the commercial banks' reserves and the interest rates.

(b) Show graphically what happens in the money market when the Federal Reserve sells bonds.

(i) Aggregate demand

(ii) Output

(iii) The price level

2. Janet Smith deposits $1,000 of her cash holdings in her checking account at First Federal Bank. The reserve requirement is 20 percent and the bank has no excess reserves.

(a) What is the immediate effect of her deposit on the money supply? Explain why.

(b) What is the maximum amount of money First Federal can initially loan out? Explain how you determined this amount.

I. I Grading Rubric for Macroeconomics Question 1: 5 points

Part (a): 2 points

1 point for bank reserves will fall because demand deposits are used by the public to buy securities (leading to an outflow of reserves).

1 point for any one of the following:

i. Banks cut back on lending or call in loans, putting upward pressure on the interest rate

ii. Sale of bonds decreases the money supply and raises the interest rate

iii. Sale of bonds represents an increase in the supply of bonds, lowing the price of bonds, and increasing interest rates

Part (b): 1 point

A complete, correct, and well labeled graph of the money market must show that the supply of money decreases (shifts leftward), and thus the equilibrium interest rate rises.

Part (c): 2 points (each item, i.-iv. Is worth ½ point)

i. Explain that investment falls as a result of higher interest rates.

ii. Explain that aggregate demand falls because investment is a component of AD. (Accept a decrease in interest-sensitive consumption spending causing a decrease in AD).

iii. Explain that output falls because of decrease in AD.

iv. Explain that the price level falls because of decrease in AD.

Note: Besides counting points, the answer may be looked at as a whole and ultimately judged by its overall quality. The final total should mean something in terms of the overall quality of the answer. A 5 should reflect an excellent answer, but not necessarily a perfect one; a 4, an excellent answer with a flaw; a 3, a good answer; a 2, an adequate answer; a 1, a seriously deficient answer, but still an answer. A 0 has no relevant economic answer to the question. A dash (-) is given for an unresponsive or blank answer.

Correct answer:

Since both cash and checking account balances (demand deposits) are part of the money supply (M1),

there will be no change in the money supply from her switching dollars between cash and her checking

account. With an additional $1,000 of cash reserves, First Federal may increase its loans by $800. With a

20 percent reserve requirement, $200 of the $1,000 must be kept as required reserves. The money supply

could experience a net increase of $4,000. With a 20 percent reserve requirement, the money supply

multiplier is 5. A new cash deposit of $1,000 could generate a $5,000 increase in the money supply;

taking into account the reduction of $1,000 in cash, the money supply increases by $4,000. Alternatively,

the $800 of new reserves available for loans can generate a $4,000 increase in the money supply. (In this

later case the $1,000 of lost cash is replaced exactly by the $1,000 of required reserves. So, the maximum

change in the money supply is the $4,000.) The full increase in the money supply will not occur when

funds are not fully redeposited (i.e., a leakage to cash or currency) or if banks hold excess reserves.

2+2+2+1 =7 points

(a) 1 point No immediate change in the money supply

1 point Currency falls but demand deposits increase (M= ¯ C+ D)

(b) 1 point $800

1 point 1000 – 200 of required reserves = 800

(where 200 = 1000 x 0.20)

1 point $4000 found by: $1000 x 5 and then subtract the $1000 that was already part of the

money supply: $5000-1000 = $4000

or $4000 found by multiplying $800 x 5

(where 5 = Money multiplier = 1/ rr = 1/ 0.2)

Alternate explanation worth 1 point: $5000 found by $1000 x 5