Money/Banking/Monetary Policy Practice Questions
Multiple Choice
Identify the choice that best completes the statement or answers the question.
____1.The amount of required reserves a bank holds depends on the
a. / required reserve ratio.b. / demand-deposit ratio.
c. / excess-reserve ratio.
d. / currency ratio.
____2.Banks decide to increase their excess reserves from 0 percent of total reserves to 10 percent of total reserves. It follows that
a. / the required reserve ratio will rise.b. / banks will reduce outstanding loans.
c. / the money supply will increase.
d. / the simple deposit multiplier will fall.
e. / a and d
____3.When economists say that banks must hold a percentage of their total deposits in reserve form, what does this mean?
a. / It means that banks must hold a fraction of their customers' deposits either as bank deposits at the Federal Reserve, or as vault cash, or both.b. / It means that banks reserve the right to turn away customers a certain percentage of the time.
c. / It means that the fraction of vault cash a bank has cannot be greater than the fraction of bank deposits (it has) at the Federal Reserve.
d. / Essentially, it means that total reserves are greater than required reserves.
e. / none of the above
____4.When commercial banks need more Federal Reserve Notes,
a. / they call the Bureau of Engraving and Printing, which delivers the requested amount.b. / they call the Board of Governors of the Fed, which delivers the requested amount.
c. / they ask their customers to exchange their Federal Reserve Notes for U.S. Treasury securities.
d. / they call the Treasury, which delivers the requested amount.
e. / they call their Federal Reserve District Bank, which delivers the requested amount.
____5.If the Fed purchases government securities from a commercial bank, which of the following will happen?
a. / The Fed will increase the bank's reserves on deposit at the Fed.b. / The Fed will decrease the bank's reserves on deposit at the Fed.
c. / The assets (government securities) of the Fed will decrease.
d. / The assets (government securities) of the Fed will increase.
e. / a and d
____6.When the Fed purchases securities from a member of the public with a check that is cashed,
a. / reserves increase.b. / currency in circulation increases.
c. / the money supply increases.
d. / b and c
e. / all of the above
____7.To decrease the money supply, the Fed may
a. / buy government securities in the open market.b. / decrease the discount rate.
c. / increase the required reserve ratio.
d. / b and c
e. / all of the above
____8.Here is how an open market purchase works: The Fed ______government securities to (from) a commercial bank, which raises the bank's deposits at the ______and increases the bank's ______.
a. / sells; Fed; reservesb. / buys; Fed; reserves
c. / buys; Treasury; discount loans
d. / sells; Treasury; required reserve ratio
e. / buys; Fed; liabilities
Essay
9.Describe the process by which banks create money.
10.Describe the circumstances under which the M1 money supply could fall while the M2 money supply remains constant at the same time.
11.List and describe the three functions of money.
12.Describe the differences between M1 and M2.
13.Explain why it is not necessary for paper money to be backed by some commodity (e.g. gold) before it can have value.
14.Discuss some of the economic symbolism thought by many to be contained in L. Frank Baum’s book The Wonderful Wizard of Oz.
15.List and describe the three major monetary policy tools the Federal Reserve can use to increase the money supply. Be specific in your response regarding which direction the tool would need to change in order for the money supply to grow.
16.Summarize the history of how the Federal Reserve came to have twelve districts.
17.List and describe five of the eight major functions or responsibilities of the Fed.
18.What is the name and make-up of the policymaking group that has the authority to conduct open market operations? Describe how the use of open market operations helps to increase or decrease the money supply.
19.Explain the major differences between the Federal Reserve and the U.S. Treasury.
20.Explain the difference between the discount rate and the federal funds rate. If the Fed wants to lower one of these rates, which one can the Fed change by issuing an order? Describe in detail how the Fed helps to lower the other rate.
Money/Banking/Monetary Policy Practice Questions
Answer Section
MULTIPLE CHOICE
1.ANS:APTS:1DIF:EasyNAT:Analytic
LOC:The role of money
2.ANS:BPTS:1DIF:ModerateNAT:Analytic
LOC:The role of money
3.ANS:APTS:1DIF:ModerateNAT:Analytic
LOC:The role of money
4.ANS:EPTS:1DIF:ModerateNAT:Analytic
LOC:The role of government
5.ANS:EPTS:1DIF:ModerateNAT:Analytic
LOC:Monetary and fiscal policy
6.ANS:DPTS:1DIF:ModerateNAT:Analytic
LOC:Monetary and fiscal policy
7.ANS:CPTS:1DIF:ModerateNAT:Analytic
LOC:Monetary and fiscal policy
8.ANS:BPTS:1DIF:ModerateNAT:Analytic
LOC:Monetary and fiscal policy
ESSAY
9.ANS:
When a customer deposits money into her bank, the bank's reserves rise by an equal amount. In a fractional reserve banking system, the bank is only required to set aside a small portion of this deposit and the bank is free to loan the remainder. In the process of making these new loans, checkable deposits are created for the people who received the loans. Given that checkable deposits are part of the money supply, by extending loans the banking system has increased the money supply.
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of money
10.ANS:
In order for the M1 money supply to fall, one of the components of M1 (checkable deposits, currency held outside banks, or traveler's checks) would have to decline. M2 would remain constant as long as the money that was deducted from M1 was deposited into one of the additional components of M2 (savings deposits, small-denomination time deposits, or retail money market mutual funds).
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of money
11.ANS:
Money serves as a medium of exchange, a unit of account and a store of value. Medium of exchange - In a money economy, money serves as the medium through which transactions are made. Unit of account - Money is the common standard by which value is determined in a money economy (a "yardstick" of value). Store of value - Money will retain value over time.
PTS:1DIF:ModerateNAT:AnalyticLOC:The role of money
12.ANS:
M1 is the narrow definition of the money supply. It only includes money that can be directly used for everyday transactions. M1 consists of traveler’s checks, checkable deposits, and currency held outside banks. M2 is the broad definition of the money supply. M2 is made up of M1 plus savings deposits, small-denomination time deposits, and retail money market mutual funds.
PTS:1DIF:ModerateNAT:AnalyticLOC:The role of money
13.ANS:
The U.S. money supply is no longer backed by gold, but that does not mean that it does not have value. It is the general acceptability of paper money that gives it value. As long as sellers continue to accept paper money as payment in exchange for goods and services that are valuable, the paper money will continue to have value.
PTS:1DIF:ModerateNAT:AnalyticLOC:The role of money
NOT:NEW
14.ANS:
Many people believe that Baum’s well-known work is an allegory for the presidential election of 1896 between William McKinley and William Jennings Bryan. Young Dorothy is thought to represent Bryan (only 36 years old as the Democratic presidential candidate) and her voyage to the Emerald city represents Bryan’s quest to win the presidency and move to the nation’s capital. During this era, the U.S. economy was going through very difficult times which many people blamed on the gold standard. Those people --- including both Bryan and Baum --- believed that a bimetallic monetary standard (using both gold and silver) would lead to an increase in the money supply, thereby helping to pull the economy out of its depression. Other symbolism in the book includes:
Cyclone: The 1896 Democratic convention
Yellow brick road: The gold standard
Scarecrow: Farmers
Tin man: Industrial workers
Cowardly lion: The Populist party
Toto: The Democratic party
Wicked Witch of the West: The gold standard
Dorothy’s silver shoes: Silver
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of money
MSC:Economics 24/7NOT:NEW
15.ANS:
Open market operations are when the Fed buys or sells U.S. government securities in financial markets. In order to increase the money supply, the Fed buys government securities (called an open market purchase). As the Fed makes open market purchases, the money paid by the Fed to the seller of the securities will result in an increase in bank reserves and the money supply will ultimately increase. Another option the Fed uses to increase the money supply is to lower the discount rate. The discount rate is the interest rate charged by the Fed to banks that need to borrow reserves. The lower the discount rate is relative to the federal funds rate, the more likely the banks are to borrow from the Fed. As a bank borrows from the Fed, the bank's reserves increase while the reserves of no other bank decrease, creating an increase in reserves for the banking system. The final monetary policy tool used by the Fed is changing the required reserve ratio. If the Fed wants to increase the money supply, they will decrease the required reserve ratio, allowing banks to loan a larger portion of checkable deposits.
PTS:1DIF:ModerateNAT:AnalyticLOC:Monetary and fiscal policy
16.ANS:
The prevailing popular opinion of the time was to have a small number of districts, as few as six to eight. However, then Secretary of State William Jennings Bryan, called for fifty district banks. A compromise was reached and the Federal Reserve Act stated that "not less than eight nor more than twelve cities" would be designated as Federal Reserve district headquarters. A commission of three persons was set up to draw the district boundaries and the locations of the district banks. The commission determined that there should be twelve districts and they determined the boundaries based upon prevailing trade patterns. Some banks protested this proposal and filed petitions for review of the plan with the Federal Reserve Board. When the board members appeared to be about to vote in favor of reducing the number of districts, one of the supporters of the original twelve banks turned to the attorney general of the U.S., protesting that the board did not have the authority to override the commission's decisions. The attorney general gave that opinion and the board ultimately accepted the attorney general's opinion.
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of government
MSC:Economics 24/7
17.ANS:
The eight major functions or responsibilities of the Fed are: controlling the money supply, supplying the economy with paper money, providing check-clearing services, holding depository institutions' reserves, supervising member banks, serving as the government's banker, and serving as the lender of last resort, and serving as the fiscal agent for the Treasury.
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of government
18.ANS:
The group responsible for conducting open market operations is the Federal Open Market Committee (FOMC). The FOMC is made up of twelve members. They are the seven board members, the president of the New York Federal Reserve District Bank, and four other Federal Reserve District Bank presidents (who rotate on and off the committee every year). In order to decrease the money supply, the Fed sells government securities (called an open market sale). As the Fed makes an open market sale, the money paid to the Fed by the buyer of the securities will result in a decrease in bank reserves and the money supply will ultimately decrease.
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of government
19.ANS:
Although many people confuse the Treasury and the Fed, each has its own distinct role to play. The U.S. Treasury is a budgetary agency, while the Federal Reserve is a monetary agency. The Treasury is responsible for managing the financial affairs of the federal government. In this capacity they collect the taxes and borrow the funds necessary to pay for government expenditures. The Fed is primarily concerned with the availability of money and credit for the entire economy, in doing so they help to provide a stable monetary framework for the economy. Unlike the Treasury, the Fed can create money “out of thin air”. The Treasury mints the coins, and the Fed issues paper money. The Treasury issues Treasury securities, but the Fed does not.
PTS:1DIF:DifficultNAT:AnalyticLOC:The role of government
NOT:NEW
20.ANS:
The federal funds rate is the interest rate that banks charge one another for borrowing funds, while the discount rate is the interest rate that the Fed charges banks that borrow funds from them. The discount rate is the rate that the Fed can change by issuing an order. The federal funds rate is determined in the federal funds market. The Fed changes the federal funds rate by changing the amount of reserves in the banking system. More specifically, if the Fed wants to lower the federal funds rate they will need to exert downward pressure on this rate in the federal funds market. They can do this by conducting an open market purchase. This purchase would inject more reserves into the banking system, thereby increasing the supply of reserves in the federal funds market. As in any other market, when the supply increases the “price” paid (in this case, the federal funds rate) to get that item would decline.
PTS:1DIF:DifficultNAT:AnalyticLOC:Monetary and fiscal policy
NOT:NEW