This Document Contains Chapters 18 to 19 Chapter 18 The International Financial System 18.1 Intervention in the Foreign Exchange Market 1) A central bank ________ of domestic currency and corresponding ________ of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base, everything else held constant. A) sale; purchase B) sale; sale C) purchase; sale D) purchase; purchase Answer: C 2) A central bank ________ of domestic currency and corresponding ________ of foreign assets in the foreign exchange market leads to an equal increase in its international reserves and the monetary base, everything else held constant. A) sale; purchase B) sale; sale C) purchase; sale D) purchase; purchase Answer: A 3) Suppose that the Bank of Japan buys U.S. dollar assets with yen-denominated assets. Everything else held constant, this transaction will cause ________ in the foreign assets held by the Federal Reserve and ________ in the U.S. monetary base. A) an increase; an increase B) an increase; a decrease C) a decrease; an increase D) a decrease; a decrease Answer: A 4) Suppose that the Bank of Japan buys yen-denominated assets with U.S. dollar assets. Everything else held constant, this transaction will cause ________ in the foreign assets held by the Federal Reserve and ________ in the U.S. monetary base. A) an increase; an increase B) an increase; a decrease C) a decrease; an increase D) a decrease; a decrease Answer: D 5) When the central bank allows the purchase or sale of domestic currency to have an effect on the monetary base, it is called A) an unsterilized foreign exchange intervention. B) a sterilized foreign exchange intervention. C) an exchange rate feedback rule. D) a money neutral foreign exchange intervention. Answer: A 6) A foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged is called A) an unsterilized foreign exchange intervention. B) a sterilized foreign exchange intervention. C) an exchange rate feedback rule. D) a money neutral foreign exchange intervention. Answer: B 7) Everything else held constant, if a central bank makes an unsterilized purchase of foreign assets, then the domestic money supply will ________ and the domestic currency will ________. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: B 8) Everything else held constant, if a central bank makes an unsterilized ________ of foreign assets, then the domestic money supply will increase and the domestic currency will ________. A) purchase; appreciate B) purchase; depreciate C) sale; appreciate D) sale; depreciate Answer: B 9) Everything else held constant, if a central bank makes an unsterilized ________ of foreign assets, then the domestic money supply will ________ and the domestic currency will appreciate. A) purchase; increase B) purchase; decrease C) sale; increase D) sale; decrease Answer: D 10) Everything else held constant, if a central bank makes an unsterilized sale of foreign assets, then the domestic money supply will ________ and the domestic currency will ________. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: C 11) Everything else held constant, if a central bank makes an unsterilized ________ of foreign assets, then the domestic money supply will decrease and the domestic currency will ________. A) purchase; appreciate B) purchase; depreciate C) sale; appreciate D) sale; depreciate Answer: C 12) Everything else held constant, if a central bank makes an unsterilized ________ of foreign assets, then the domestic money supply will ________ and the domestic currency will depreciate. A) purchase; increase B) purchase; decrease C) sale; increase D) sale; decrease Answer: A 13) Everything else held constant, if a central bank makes a sterilized purchase of foreign assets, then the domestic currency will ________. A) appreciate B) depreciate C) either appreciate, depreciate, or remain constant D) not be affected Answer: D 14) Because sterilized interventions mean offsetting open market operations, there is no impact on the monetary base and the money supply, and therefore a sterilized intervention A) causes the exchange rate to overshoot in the short run. B) causes the exchange rate to undershoot in the short run. C) causes the exchange rate to depreciate in the short run, but has no effect on the exchange rate in the long run. D) has no effect on the exchange rate. Answer: D 15) Everything else held constant, if a central bank makes a sterilized sale of foreign assets, then the domestic currency will ________. A) appreciate B) depreciate C) either appreciate, depreciate, or remain constant D) not be affected Answer: D 16) If the United States has a current account deficit with England of $1 million, and the Bank of England sells $1 million worth of pounds in the foreign exchange market, then England ________ $1 million of international reserves and its monetary base ________ by $1 million. A) gains; rises B) gains; falls C) loses; rises D) loses; falls Answer: A 17) Explain and demonstrate graphically how an unsterilized purchase of foreign assets leads to overshooting of the exchange rate, and describe the long-run behavior of the exchange rate, everything else held constant. Answer: See figure below. A purchase of foreign assets increases the monetary base and money supply, increasing the price level and decreasing the expected appreciation of the domestic currency. In the short run, this decreased expected appreciation of the domestic currency along with the lower domestic interest rate will decrease the relative expected return on domestic assets causing the domestic currency to depreciate. Over the long run, as the domestic interest rate starts to increase, the domestic currency will start to appreciate, but (assuming money neutrality) will still be at a lower value compared to the starting value. 18.2 Balance of Payments 1) The difference between merchandise exports and imports is called the ________ balance. A) current account B) capital account C) official reserve transactions D) trade Answer: D 2) The account that shows international transactions involving currently produced goods and services is called the A) trade balance. B) current account. C) balance of payments. D) capital account. Answer: B 3) The account that shows international transactions involving financial transactions (stocks, bonds, bank loans, etc.) is called the A) trade balance. B) current account. C) balance of payments. D) capital account. Answer: D 4) Which of the following does not appear in the current account part of the balance of payments? A) A loan of $1 million from Bank of America to Brazil. B) Foreign aid to El Salvador. C) An Air France ticket bought by an American. D) Income earned by General Motors from its plants abroad. Answer: A 5) Of the following, the one that appears in the current account of the balance of payments is A) an Italian investor's purchase of IBM stock. B) income earned by U.S. subsidiaries of Barclay's Bank of London. C) a loan by a Swiss bank to an American corporation. D) a purchase of a British Treasury bond by the Fed. Answer: B 6) Capital ________ are American purchases of foreign assets, and capital ________ are foreign purchases of American assets. A) inflows; outflows B) inflows; inflows C) outflows; outflows D) outflows; inflows Answer: D 7) Which of the following appears in the capital account part of the balance of payments? A) A gift to an American from his English aunt. B) A purchase by the Honda corporation of a U.S. Treasury bill. C) A purchase by the Bank of England of a U.S. Treasury bill. D) Income earned by the Honda corporation on its automobile plant in Ohio. Answer: B 8) The net amount of international reserves that move between governments to finance international transactions is called the ________ balance. A) capital account B) current account C) trade D) official reserve transactions Answer: D 9) If the current account balance shows a surplus, and the capital account also shows a surplus, then the official reserve transactions balance A) must be positive. B) must be negative. C) must be zero. D) can either be positive, negative, or zero. Answer: A 10) A current account surplus indicates that America is ________ its claims on foreign wealth, while a deficit indicates that this country is ________ its claims on foreign wealth. A) reducing; reducing B) reducing; increasing C) increasing; reducing D) increasing; increasing Answer: C 11) Because it provides some indication of what is happening to U.S. claims on foreign wealth and the demand for imports and exports, the ________ is closely followed by economists wanting information on the future movement of exchange rates. A) trade balance B) capital account C) current account balance D) statistical discrepancy Answer: C 12) Economists closely follow the current account balance because they believe it can provide information on the future movement of A) interest rates. B) gold flows. C) exchange rates. D) special drawing rights. Answer: C 18.3 Exchange Rate REgimes in the International Financial System 1) Under a gold standard in which one dollar could be turned in to the U.S. Treasury and exchanged for 1/20th of an ounce of gold and one German mark could be exchanged for 1/100th of an ounce of gold, an exchange rate of ________ marks to the dollar would stimulate a flow of gold from the United States to Germany. A) 7 B) 6 C) 5 D) 4 Answer: D 2) When gold production was low in the 1870s and 1880s, the money supply grew ________ causing ________. A) rapidly; inflation B) rapidly; disinflation C) slowly; deflation D) slowly; disinflation Answer: C 3) The fixed exchange rate regime established at a meeting in New Hampshire in 1944 has been known as the A) General Agreement on Tariffs and Trade. B) Bretton Woods system. C) International Settlement Fund. D) Balance of Payments Compliance Accord. Answer: B 4) Under the Bretton Woods system, the organization assigned the task of making loans to countries that were experiencing balance of payments difficulties is known as the A) World Bank. B) International Development Association. C) International Monetary Fund. D) Federal Reserve System. Answer: C 5) The Bretton Woods agreement created the ________, which was given the task of promoting the growth of world trade by setting rules for the maintenance of fixed exchange rates and by making loans to countries that were experiencing balance of payments difficulties. A) IMF B) World Bank C) Central Settlements Bank D) Bank of International Settlements Answer: A 6) The World Bank is an international organization that: A) promotes the growth of trade by setting rules for how tariffs and quotas are set by countries. B) makes loans to countries to finance projects such as dams and roads. C) makes loans to countries with balance of payment difficulties. D) helps developing countries that have been having difficulties in repaying their loans to come to terms with lenders in the West. Answer: B 7) Under the Bretton Woods system, the United States was designated as the A) reserve-currency country. B) fixed-rate country. C) par-standard country. D) dollar-standard country. Answer: A 8) Under a fixed exchange rate regime, if the domestic currency is initially ________, that is, ________ par, the central bank must intervene to sell the domestic currency by purchasing foreign assets. A) overvalued; below B) overvalued; above C) undervalued; below D) undervalued; above Answer: D 9) Under a fixed exchange rate regime, if the domestic currency is initially undervalued, that is, above par, the central bank must intervene to sell the ________ currency by purchasing ________ assets. A) domestic; foreign B) domestic; domestic C) foreign; foreign D) foreign; domestic Answer: A 10) Under a fixed exchange rate regime, if the domestic currency is initially ________, that is, ________ par, the central bank must intervene to purchase the domestic currency by selling foreign assets. A) overvalued; below B) overvalued; above C) undervalued; below D) undervalued; above Answer: A 11) Under a fixed exchange rate regime, if the domestic currency is initially overvalued, that is, below par, the central bank must intervene to purchase the ________ currency by selling ________ assets. A) domestic; foreign B) domestic; domestic C) foreign; foreign D) foreign; domestic Answer: A 12) Under a fixed exchange rate regime, if a central bank must intervene to purchase the ________ currency by selling ________ assets, then, like an open market sale, this action reduces the monetary base and the money supply, causing the interest rate on domestic assets to rise. A) domestic; foreign B) domestic; domestic C) foreign; foreign D) foreign; domestic Answer: A 13) Under a fixed exchange rate regime, if a central bank must intervene to purchase the domestic currency by selling foreign assets, then, like an open market sale, this action ________ the monetary base and the money supply, causing the interest rate on domestic assets to ________. A) increases; rise B) increases; fall C) reduces; rise D) reduces; fall Answer: C 14) When the domestic currency is initially overvalued in a fixed exchange rate regime, the central bank must intervene in the foreign exchange market to ________ the domestic currency, thereby allowing the money supply to ________. A) purchase; decline B) sell; decline C) purchase; increase D) sell; increase Answer: A 15) When the domestic currency is initially undervalued in a fixed exchange rate regime, the central bank must intervene in the foreign exchange market to ________ the domestic currency, thereby allowing the money supply to ________. A) purchase; decline B) sell; decline C) purchase; increase D) sell; increase Answer: D 16) Under a fixed exchange rate regime, if a country has an overvalued exchange rate, then its central bank's attempt to keep its currency from ________ will result in a ________ of international reserves. A) depreciating; gain B) depreciating; loss C) appreciating; gain D) appreciating; loss Answer: B 17) Under a fixed exchange rate regime, if a country has an ________ exchange rate, then its central bank's attempt to keep its currency from depreciating will result in a ________ of international reserves. A) undervalued; gain B) undervalued; loss C) overvalued; gain D) overvalued; loss Answer: D 18) Under a fixed exchange rate regime, if a country has an undervalued exchange rate, then its central bank's attempt to keep its currency from ________ will result in a ________ of international reserves. A) depreciating; gain B) depreciating; loss C) appreciating; gain D) appreciating; loss Answer: C 19) Under a fixed exchange rate regime, if a country has an ________ exchange rate, then its central bank's attempt to keep its currency from appreciating will result in a ________ of international reserves. A) undervalued; gain B) undervalued; loss C) overvalued; gain D) overvalued; loss Answer: A 20) Under a fixed exchange rate regime, if a country's central bank runs out of international reserves, it cannot keep its currency from A) depreciating. B) appreciating. C) deflating. D) inflating. Answer: A 21) Under a fixed exchange rate regime, a country that depletes its international reserves in an attempt to keep its currency from ________ will be forced to ________ its currency. A) depreciating; revalue B) depreciating; devalue C) appreciating; revalue D) appreciating; devalue Answer: B 22) Under a fixed exchange rate regime, a central bank that does not want to acquire international reserves to keep its currency from ________ will decide to ________ its currency. A) depreciating; revalue B) depreciating; devalue C) appreciating; revalue D) appreciating; devalue Answer: C 23) Under a fixed exchange rate system, countries that ran large, persistent balance of payments deficits would ________ international reserves, thereby pressuring them into ________ their exchange rate. A) gain; devaluing B) gain; revaluing C) lose; devaluing D) lose; revaluing Answer: C 24) Under a fixed exchange rate system, countries that ran large, persistent balance of payments surpluses would ________ international reserves, thereby pressuring them into ________ their exchange rate. A) gain; devaluing B) gain; revaluing C) lose; devaluing D) lose; revaluing Answer: B 25) A balance of payments ________ is associated with a loss of international reserves, while a balance of payments ________ is associated with a gain. A) surplus; surplus B) surplus; deficit C) deficit; surplus D) deficit; deficit Answer: C 26) A balance of payments deficit is associated with a ________ of international reserves, while a balance of payments surplus is associated with a ________. A) loss; loss B) loss; gain C) gain; loss D) gain; gain Answer: B 27) To keep from running out of international reserves under the Bretton Woods system, a country had to implement ________ monetary policy to ________ its currency. A) expansionary; strengthen B) expansionary; weaken C) contractionary; strengthen D) contractionary; weaken Answer: C 28) Under the Bretton Woods system, when a country adopted an expansionary monetary policy, thereby causing a balance of payments ________, the country would eventually be forced to implement ________ monetary policy. A) deficit; expansionary B) deficit; contractionary C) surplus; expansionary D) surplus; contractionary Answer: B 29) Because the United States was the reserve-currency country under the Bretton Woods system, it could run large balance of payments ________ without ________ significant amounts of international reserves. A) deficits; losing B) deficits; gaining C) surpluses; losing D) surpluses; gaining Answer: A 30) The Bretton Woods system was one in which central banks A) bought and sold their own currencies to keep their exchange rates fixed. B) agreed not to intervene in the foreign exchange market to maintain a fixed exchange rate regime that had existed prior to World War I. C) agreed to limit domestic money growth to the average of the five largest industrial nations. D) agreed to limit domestic money growth to the average of the seven largest industrial nations. Answer: A 31) The Bretton Woods system broke down in the early 1970s for all but one of the following reasons: A) deficit countries losing international reserves were not willing to devalue their currencies. B) surplus countries were not willing to revalue their currencies upwards. C) surplus countries were not willing to pursue more expansionary policies. D) the United States had been pursuing an inflationary monetary policy to reduce domestic unemployment. Answer: A 32) To maintain fixed exchange rates when countries had balance of payments deficits and were losing international reserves, the ________ would loan ________ countries international reserves contributed by other members. A) IMF; deficit B) IMF; surplus C) World Bank; deficit D) World Bank; surplus Answer: A 33) Under the Bretton Woods system, the IMF could encourage ________ countries to pursue ________ monetary policies that would strengthen their currency or eliminate their balance of payment deficits. A) surplus; expansionary B) surplus; contractionary C) deficit; expansionary D) deficit; contractionary Answer: D 34) Under the Bretton Woods system, the IMF could encourage deficit countries to pursue contractionary monetary policies that would ________ their currency or eliminate their balance of payment ________. A) strengthen; surpluses B) strengthen; deficits C) weaken; surpluses D) weaken; deficits Answer: B 35) A weakness of the Bretton Woods system was that the ________ had no way to force surplus countries to either revalue their exchange rates upwards or pursue more expansionary policies. A) IMF B) World Bank C) European Exchange Rate Mechanism (ERM) D) Bank of International Settlements Answer: A 36) Under the Bretton Woods system, a country running a balance of payments deficit ________ international reserves, and had to implement ________ monetary policy to strengthen its currency. A) lost; expansionary B) lost; contractionary C) gained; expansionary D) gained; contractionary Answer: B 37) Under the Bretton Woods system, a country running a balance of payments ________ lost international reserves, and had to implement ________ monetary policy to strengthen its currency. A) surplus; expansionary B) surplus; contractionary C) deficit; expansionary D) deficit; contractionary Answer: D 38) Under the Bretton Woods system, a country running a balance of payments surplus ________ international reserves, and had to implement ________ monetary policy to weaken its currency. A) lost; expansionary B) lost; contractionary C) gained; expansionary D) gained; contractionary Answer: C 39) Under the Bretton Woods system, if IMF loans were insufficient to prevent ________ of a currency, then the country was allowed to devalue its currency by setting a new, ________ exchange rate. A) depreciation; lower B) depreciation; higher C) appreciation; lower D) appreciation; higher Answer: A 40) As a result of its power to dictate loan terms to borrowing countries (under the Bretton Woods system), the IMF could encourage ________ countries to pursue ________ monetary policies that would strengthen their currency or eliminate their balance of payments deficits. A) surplus; contractionary B) surplus; expansionary C) deficit; contractionary D) deficit; expansionary Answer: C 41) Because central banks have not been willing to give up their option of intervening in the foreign exchange market, the current international financial system can best be described as a A) variable-pegged exchange rate system. B) moving-pegged exchange rate system. C) hybrid of a fixed exchange rate and flexible exchange rate system. D) flexible-exchange, dollar-pegged exchange rate system. Answer: C 42) The current international financial system is a managed float exchange rate system because A) exchange rates fluctuate in response to, but are not determined solely by, market forces. B) some countries keep their currencies pegged to the dollar, which is not allowed to fluctuate. C) all countries allow their exchange rates to fluctuate in response to market forces. D) all countries peg their currencies to the dollar which is allowed to fluctuate in response to market forces. Answer: A 43) Policymakers in a country with a balance of payments surplus may not want to see their country's currency appreciate because this would A) hurt consumers in their country by making foreign goods more expensive. B) hurt domestic businesses by making foreign goods cheaper in their country. C) increase inflation in their country. D) decrease the wealth of the country. Answer: B 44) Under the current managed float exchange rate regime, countries with balance of payments deficits frequently do not want to see their currencies depreciate because it makes ________ goods more expensive for ________ consumers and can stimulate inflation. A) foreign; foreign B) foreign; domestic C) domestic; foreign D) domestic; domestic Answer: B 45) Countries with surpluses in their balance of payments frequently do not want to see their currencies ________ because it makes their goods ________ expensive abroad. A) appreciate; less B) appreciate; more C) depreciate; less D) depreciate; more Answer: B 46) Countries with balance of payments deficits do not want to see their currencies ________ because it makes foreign goods ________ expensive for domestic consumers. A) appreciate; less B) appreciate; more C) depreciate; less D) depreciate; more Answer: D 47) Under the current managed float exchange rate regime, countries with ________ in their balance of payments frequently do not want to see their currencies ________ because it makes their goods more expensive abroad and foreign goods cheaper in their countries. A) surpluses; depreciate B) deficits; depreciate C) surpluses; appreciate D) deficits; appreciate Answer: C 48) Under the current managed float exchange rate regime; countries with surpluses in their balance of payments frequently do not want to see their currencies appreciate because it makes their goods ________ expensive abroad and foreign goods ________ in their countries. A) more; cheaper B) more; costlier C) less; cheaper D) less; costlier Answer: A 49) Under the current managed float exchange rate regime, countries with balance of payments ________ frequently do not want to see their currencies ________ because it makes foreign goods more expensive for domestic consumers and can stimulate inflation. A) surpluses; depreciate B) deficits; depreciate C) surpluses; appreciate D) deficits; appreciate Answer: B 50) Which of the following is true? A) Special drawing rights are loans to countries made by the IMF. B) Changes in the quantity of special drawing rights are tied to changes in the quantity of gold. C) Special drawing rights are a paper substitute for gold. D) Special drawing rights are not held as international reserves. Answer: C 51) An ECU was A) a paper substitute for gold issued by the IMF. B) a loan by European countries to the IMF. C) a paper currency issued by the European Common Market. D) a monetary unit created by the European Monetary System. Answer: D 52) Under the Exchange Rate Mechanism of the European Monetary System, when the British pound depreciated below its lower limit against the German mark, the Bank of England was required to buy ________ and sell ________, thereby ________ international reserves. A) pounds; marks; losing B) pounds; marks; gaining C) marks; pounds; gaining D) marks; pounds; losing Answer: A 53) Under the Exchange Rate Mechanism of the European Monetary System, when the British pound depreciated below its lower limit against the German mark, the German central bank was required to buy ________ and sell ________, thereby ________ international reserves. A) pounds; marks; losing B) pounds; marks; gaining C) marks; pounds; gaining D) marks; pounds; losing Answer: B 54) Under the Exchange Rate Mechanism of the European Monetary System, when the German mark depreciated below its lower limit against the British pound, the Bank of England was required to buy ________ and sell ________, thereby ________ international reserves. A) pounds; marks; losing B) pounds; marks; gaining C) marks; pounds; gaining D) marks; pounds; losing Answer: C 55) Under the Exchange Rate Mechanism of the European Monetary System, when the German mark depreciated below its lower limit against the British pound, the German central bank was required to buy ________ and sell ________, thereby ________ international reserves. A) pounds; marks; losing B) pounds; marks; gaining C) marks; pounds; gaining D) marks; pounds; losing Answer: D 56) In September 1992, the Bundesbank attempted to keep the mark from appreciating relative to the British pound, but it failed because participants in the foreign exchange market came to expect the A) appreciation of the mark. B) depreciation of the mark. C) revaluation of the dollar. D) end of the Exchange Rate Mechanism. Answer: A 57) The East Asia currency crisis in 1997 started in A) Japan. B) Thailand. C) South Korea. D) the Philippines. Answer: B 58) Between May and July 1997, concerns about the large current account deficit in Thailand and the weakness in the Thai financial system caused speculators to suspect that Thailand might be forced to A) devalue its currency. B) sell baht to prop up its value. C) buy dollars to prop up the baht. D) impose capital controls. Answer: A 59) Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed exchange rate system. What alternative policies are available to eliminate the overvaluation of the exchange rate? Answer: See the figure below. The par value is above the equilibrium value, resulting in overvaluation of the exchange rate. One approach is to pursue contractionary monetary policies, raising interest rates and increasing the demand for domestic assets. This process continues until equilibrium at par value is restored. Another alternative is for the central bank to purchase domestic currency by selling foreign assets. 60) Assume that a fixed exchange rate is overvalued. Describe the situation of a speculative crisis against this currency. What can the central bank do to defend the currency? Why might the alternative of devaluation be preferable? Answer: When the speculative attack begins, the expected depreciation of the domestic currency increases substantially, decreasing the demand for domestic assets. Contractionary monetary policy is needed to increase domestic interest rates enough to defend the currency. The cost to the central bank in terms of the costs of intervention and the contractionary effect on the economy may make devaluation preferable. 18.4 Capital Controls 1) A capital ________ can promote financial instability in an emerging-market country because it is what forces a country to ________ its currency. A) inflow; devalue B) inflow; revalue C) outflow; devalue D) outflow; revalue Answer: C 2) A capital ________ can promote financial instability in an emerging-market country because it can lead to a lending boom and excessive risk-taking on the part of banks, which helps trigger a ________. A) inflow; financial crisis B) inflow; currency devaluation C) outflow; financial crisis D) outflow; currency devaluation Answer: A 3) A case for capital inflow controls can be made because capital inflows A) can cause a lending boom and lead to excessive risk taking. B) never finance productive investments. C) always finance productive investments. D) are less likely to cause financial crises than regulation of banking activities. Answer: A 4) Which of the following is not a disadvantage of controls on capital outflows? A) The controls may lead to excessive risk taking by the domestic banks. B) They are seldom effective during a crisis. C) Capital flight may increase after they are put in place. D) Controls often lead to an increase in government corruption. Answer: A 18.5 The Role of the IMF 1) In the 1990s this agency has acted like an international lender of last resort to cope with financial instability. A) World Bank B) European Central Bank C) IMF D) International Bank for Reconstruction and Development Answer: C 2) An international lender of last resort creates a serious ________ problem because depositors and other creditors of banking institutions expect that they will be protected if a crisis occurs. A) moral hazard B) adverse selection C) public choice D) strategic choice Answer: A 3) An international lender of last resort creates a serious moral hazard problem because ________ and other ________ of banking institutions expect that they will be protected if a crisis occurs. A) depositors; debtors B) depositors; creditors C) borrowers; debtors D) borrowers; creditors Answer: B 4) Critics of the IMF contend that its lending in the Mexican crisis, which was used to bail out foreign ________, set the stage for the ________ crisis because these ________ expected to be bailed out if things went wrong. A) lenders; East Asian; borrowers B) lenders; East Asian; lenders C) borrowers; Russian; borrowers D) borrowers; Russian; lenders Answer: B 5) Critics of the IMF contend that its lending in the ________ crisis, which was used to bail out foreign lenders, set the stage for the ________ crisis because these lenders expected to be bailed out if things went wrong and thus provided funds that were used to fuel excessive risk taking. A) Russian; Mexican B) Russian; East Asian C) Mexican; Russian D) Mexican; East Asian Answer: D 6) An advantage of an international lender of last resort is its ability to prevent ________, in which a successful speculative attack on one currency leads to attacks on others; its disadvantage is the problem of ________ if creditors expect to be protected if a crisis occurs. A) contagion; moral hazard B) contagion; adverse selection C) currency virus; moral hazard D) currency virus; adverse selection Answer: A 7) An advantage of an international lender of last resort is its ability to prevent ________, in which a successful speculative attack on one currency leads to attacks on others; its disadvantage is the problem of ________ if creditors expect to be protected if a crisis occurs. A) contagion; moral hazard B) contagion; adverse selection C) currency virus; moral hazard D) currency virus; adverse selection Answer: A 18.6 International Considerations and Monetary Policy 1) In the early 1970s, the U.S. ran large balance of payments ________, causing an ________ dollar and an ________ German mark. A) deficits; undervalued; overvalued B) deficits; overvalued; undervalued C) surpluses; undervalued; overvalued D) surpluses; overvalued; undervalued Answer: B 2) In response to the overvalued dollar in the early 1970s, the German Bundesbank bought ________ and sold ________ to keep the exchange rate fixed, gaining international reserves. A) marks; dollars B) marks; pounds C) dollars; marks D) dollars; pounds Answer: C 3) In response to the overvalued dollar in the early 1970s, the German Bundesbank bought dollars and sold marks to keep the exchange rate fixed, gaining international reserves. The huge purchase of international reserves meant that the German monetary base began to ________, leading to ________ growth in the German money supply. A) decline; sluggish B) decline; rapid C) grow; sluggish D) grow; rapid Answer: D 4) The German central bank gained international reserves in the early 1970s because it sold ________ to prevent mark ________. A) marks; appreciation B) dollars; appreciation C) marks; depreciation D) dollars; depreciation Answer: A 5) Since the abandonment of the Bretton Woods system, balance of payments considerations have become ________ important, and exchange rate considerations ________ important in the conduct of monetary policy. A) more; less B) more; more C) less; less D) less; more Answer: D 6) If a central bank does not want to see its currency fall in value, it may pursue ________ monetary policy to ________ the domestic interest rate, thereby strengthening its currency. A) expansionary; raise B) contractionary; raise C) expansionary; lower D) contractionary; lower Answer: B 7) If a central bank does not want to see its currency ________ in value, it may pursue contractionary monetary policy to raise the domestic interest rate, thereby ________ its currency. A) fall; strengthening B) fall; weakening C) rise; strengthening D) rise; weakening Answer: A 8) If a central bank does not want to see its currency rise in value, it may pursue ________ monetary policy to ________ the domestic interest rate, thereby weakening its currency. A) expansionary; raise B) contractionary; raise C) expansionary; lower D) contractionary; lower Answer: C 9) If a central bank does not want to see its currency ________ in value, it may pursue expansionary monetary policy to lower the domestic interest rate, thereby ________ its currency. A) fall; strengthening B) fall; weakening C) rise; strengthening D) rise; weakening Answer: D 10) If a central bank does not want to allow the domestic currency to appreciate, it will ________ international reserves by selling its currency, thereby ________ the monetary base and increasing the risk of higher inflation. A) lose; decreasing B) lose; increasing C) acquire; decreasing D) acquire; increasing Answer: D 11) If a central bank does not want to allow the domestic currency to depreciate, it will ________ international reserves by purchasing its currency, thereby ________ the monetary base and increasing the risk of higher unemployment. A) lose; decreasing B) lose; increasing C) acquire; decreasing D) acquire; increasing Answer: A 12) A central bank's attempt to prevent an appreciation of its currency can stimulate domestic inflation if the ________ of its currency leads to ________ international reserves which ________ the monetary base. A) purchase; higher; increases B) purchase; lower; decreases C) sale; lower; decreases D) sale; higher; increases Answer: D 13) A central bank's attempt to prevent an appreciation of its currency can stimulate domestic inflation if the ________ of foreign currencies leads to ________ international reserves which ________ the monetary base. A) purchase; higher; increases B) purchase; lower; decreases C) sale; lower; decreases D) sale; higher; increases Answer: A 18.7 To Peg or Not To Peg: Exchange-Rate Targeting as an Alternative Monetary Policy Strategy 1) A monetary policy strategy that uses a fixed exchange rate regime that ties the value of a currency to the currency of a large, low inflation country is called ________ targeting. A) exchange-rate B) currency C) monetary D) inflation Answer: A 2) Under an exchange-rate targeting rule for monetary policy, a crawling peg A) fixes the value of the domestic currency to a commodity such as gold. B) fixes the value of the domestic currency to that of a large, low-inflation country. C) allows the domestic currency to depreciate at a steady rate so that inflation in the pegging country can be higher than that of the anchor country. D) allows the domestic currency to depreciate at a steady rate so that inflation in the pegging country can be lower than that of the anchor country. Answer: C 3) An advantage to exchange-rate targeting is it helps keep inflation under control by tying the inflation rate for ________ traded goods to what is found in the ________ country. A) domestically; anchor B) domestically, domestic C) internationally; anchor D) internationally; domestic Answer: C 4) Exchange-rate targeting allows a central bank to ________, thus this will ________ the probability of policy developing a time-inconsistency problem. A) be governed by a policy rule; decrease B) follow discretionary policy; decrease C) be governed by a policy rule; increase D) follow discretionary policy; increase Answer: A 5) Which of the following is not an advantage to exchange-rate targeting? A) It provides a strong nominal anchor to keep inflation under control. B) It provides an automatic rule for policy to help avoid the time-inconsistency problem. C) It is simple and clear so that the public can easily understand it. D) It increases the accountability of policymakers. Answer: D 6) Under exchange-rate targeting, the central bank in the targeting country ________ lose the ability to pursue its own independent monetary policy and any shocks to the anchor country is ________ transmitted to the targeting country. A) does; directly B) does not; directly C) does; not directly D) does not; not directly Answer: A 7) Both France and the United Kingdom successfully used exchange-rate targeting to lower inflation in the late 1980s and early 1990s by tying the value of their currencies to the A) U.S. dollar. B) German mark. C) Swiss franc. D) Euro. Answer: B 8) Which of the following is not a disadvantage of exchange-rate targeting? A) It relies on a stable money-inflation relationship. B) The targeting country gives up an independent monetary policy. C) The targeting country is left open for a speculative attack. D) It can weaken the accountability of policymakers. Answer: A 9) Two reasons for an industrialized country to adopt an exchange-rate targeting regime are if the country ________ conduct successful monetary policy on its own, and if the country wants to ________ integration of the domestic economy with its neighbors. A) cannot; encourage B) cannot; discourage C) can; encourage D) can; discourage Answer: A 10) An emerging market country that successfully used exchange-rate targeting to lower its inflation from above 100 percent in 1988 to below 10 percent in 1994 (before devaluation) was A) Thailand. B) Mexico. C) The Philippines. D) Indonesia. Answer: B 11) Because many emerging market countries have not developed the political or monetary institutions that allow the successful use of discretionary monetary policy, A) they have little to gain from pegging their exchange rate to an anchor country like the U.S. or Germany. B) they have little to gain from using a nominal anchor, because it would mean a monetary policy that is overly expansionary. C) they have very little to gain from an independent monetary policy, but a lot to lose. D) they would be better off giving their central bankers the independence to use discretion, rather than take their discretion away through any nominal anchor. Answer: C 12) Emerging market countries are in effect between a rock and a hard place because A) they would be wise to adopt the monetary policy of the United States by pegging their currencies to the dollar, but this policy leaves them open to speculative attacks. B) to avoid speculative attacks on their currencies they must peg their exchange rates to an anchor country, but this means giving central bankers in these countries too much discretion. C) to avoid speculative attacks on their currencies they must peg their exchange rates to an anchor country, but this means giving central bankers in these countries too little discretion. D) by adopting the monetary policy of the anchor country through an exchange rate peg, these countries allow for too little monetary expansion and thereby sacrifice economic growth for price stability. Answer: A 13) When a domestic currency is completely backed by a foreign currency and the note-issuing authority establishes a fixed exchange rate to this foreign currency, then the country is said to have A) created a currency board. B) undergone dollarization. C) adopted a managed exchange system. D) adopted an exchange rate monetary system. Answer: A 14) When a country forgoes its own currency and starts using another country's currency as its own, we say that this country has A) created a currency board. B) undergone dollarization. C) adopted a managed exchange system. D) adopted an exchange rate monetary system. Answer: A 15) The revenue a government gains from issuing money is A) interest. B) rent. C) seignorage. D) the national dividend. E) the inflation tax. Answer: C 16) A country that dollarizes A) maximizes its seignorage. B) earns the same amount of seignorage as it would with a currency board. C) earns the same amount of seignorage as it would with exchange-rate targeting. D) eliminates its seignorage. E) must pay seignorage to other governments to use their currency. Answer: D 17) The seignorage for a government is greater for ________ than for ________. A) dollarization; a currency board B) dollarization; exchange-rate targeting C) dollarization; monetary targeting D) dollarization; inflation targeting E) exchange-rate targeting; dollarization Answer: E 18) Exchange-rate targeting is not an option for the United States because A) the United States is already dollarized. B) the United States is too large. C) the Fed has adopted a monetary targeting strategy. D) the Fed has adopted an inflation targeting strategy. Answer: B 19) The monetary policy strategy that provides an automatic rule for the conduct of monetary policy is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: A 20) The monetary policy strategy that does not allow the policy to focus on domestic considerations is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: A 21) The monetary policy strategy that results in the loss of an independent monetary policy is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: A 22) The monetary policy strategy that directly ties down the price of internationally traded goods is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: A 23) Explain an additional disadvantage for a country undergoing dollarization compared to a currency board or other exchange-rate targeting regimes. Answer: The additional disadvantage to dollarization is that the government loses seignorage. Seignorage is the income that a government earns by issuing its own currency. 24) Explain the 1992 crisis that led to the breakdown of the European Union's Exchange Rate Mechanism. What disadvantages of exchange-rate targeting were exhibited during this crisis? Answer: The 1992 crisis began with Germany raising interest rates in 1990 to stem inflationary pressures from reunification. This demand shock was immediately transmitted to the other nations in the exchange-rate mechanism. Thus, these countries did not have independent monetary policies and were subject to shocks from the anchor country. This gave rise to the second problem. Speculators bet that these other countries would not want the increased unemployment resulting from the tight monetary policy. Betting that their commitment was weak, speculators bet against these currencies, and a number were forced to devalue or drop out of the ERM. The disadvantages illustrated by this are the lack of independent policy subjecting member nations to shocks from the anchor nation, and the possibility of speculative attacks when commitment is felt to be weak. Chapter 19 The Demand for Money 19.1 Quantity Theory of Money 1) The quantity theory of money is a theory of how A) the money supply is determined. B) interest rates are determined. C) the nominal value of aggregate income is determined. D) the real value of aggregate income is determined. Answer: C 2) Because the quantity theory of money tells us how much money is held for a given amount of aggregate income, it is also a theory of A) interest-rate determination. B) the demand for money. C) exchange-rate determination. D) the demand for assets. Answer: B 3) The average number of times that a dollar is spent in buying the total amount of final goods and services produced during a given time period is known as A) gross national product. B) the spending multiplier. C) the money multiplier. D) velocity. Answer: D 4) The velocity of money is A) the average number of times that a dollar is spent in buying the total amount of final goods and services. B) the ratio of the money stock to high-powered money. C) the ratio of the money stock to interest rates. D) the average number of times a dollar is spent in buying financial assets. Answer: A 5) If the money supply is $500 and nominal income is $3,000, the velocity of money is A) 1/60. B) 1/6. C) 6. D) 60. Answer: C 6) If the money supply is $600 and nominal income is $3,000, the velocity of money is A) 1/50. B) 1/5. C) 5. D) 50. Answer: C 7) If the money supply is $500 and nominal income is $4,000, the velocity of money is A) 1/20. B) 1/8. C) 8. D) 20. Answer: C 8) If the money supply is $600 and nominal income is $3,600, the velocity of money is A) 1/60. B) 1/6. C) 6. D) 60. Answer: C 9) If nominal GDP is $10 trillion, and the money supply is $2 trillion, velocity is A) 0.2. B) 5. C) 10. D) 20. Answer: B 10) If nominal GDP is $8 trillion, and the money supply is $2 trillion, velocity is A) 0.25. B) 4. C) 8. D) 16. Answer: B 11) If nominal GDP is $10 trillion, and velocity is 10, the money supply is A) $1 trillion. B) $5 trillion. C) $10 trillion. D) $100 trillion. Answer: A 12) If the money supply is $2 trillion and velocity is 5, then nominal GDP is A) $1 trillion. B) $2 trillion. C) $5 trillion. D) $10 trillion. Answer: D 13) If the money supply is $20 trillion and velocity is 2, then nominal GDP is A) $2 trillion. B) $10 trillion. C) $20 trillion. D) $40 trillion. Answer: D 14) Velocity is defined as A) P + M + Y. B) (P × M)/Y. C) (Y × M)/P. D) (P × Y)/M. Answer: D 15) The velocity of money is defined as A) real GDP divided by the money supply. B) nominal GDP divided by the money supply. C) real GDP times the money supply. D) nominal GDP times the money supply. Answer: B 16) The equation of exchange states that the quantity of money multiplied by the number of times this money is spent in a given year must equal A) nominal income. B) real income. C) real gross national product. D) velocity. Answer: A 17) In the equation of exchange, the concept that provides the link between M and PY is called A) the velocity of money. B) aggregate demand. C) aggregate supply. D) the money multiplier. Answer: A 18) The equation of exchange is A) M × P = V × Y. B) M + V = P + Y. C) M + Y = V + P. D) M × V = P ×Y. Answer: D 19) Irving Fisher took the view that the institutional features of the economy which affect velocity change ________ over time so that velocity will be fairly ________ in the short run. A) rapidly; erratic B) rapidly; stable C) slowly; stable D) slowly; erratic Answer: C 20) In Irving Fisher's quantity theory of money, velocity was determined by A) interest rates. B) real GDP. C) the institutions in an economy that affect individuals' transactions. D) the price level. Answer: C 21) The classical economists' conclusion that nominal income is determined by movements in the money supply rested on their belief that ________ could be treated as ________ in the short run. A) velocity; constant B) velocity; variable C) money; constant D) money; variable Answer: A 22) The view that velocity is constant in the short run transforms the equation of exchange into the quantity theory of money. According to the quantity theory of money, when the money supply doubles A) velocity falls by 50 percent. B) velocity doubles. C) nominal incomes falls by 50 percent. D) nominal income doubles. Answer: D 23) Cutting the money supply by one-third is predicted by the quantity theory of money to cause A) a sharp decline in real output of one-third in the short run, and a fall in the price level by one-third in the long run. B) a decline in real output by one-third. C) a decline in output by one-sixth, and a decline in the price level of one-sixth. D) a decline in the price level by one-third. Answer: D 24) The classical economists believed that if the quantity of money doubled, A) output would double. B) prices would fall. C) prices would double. D) prices would remain constant. Answer: C 25) The classical economists' contention that prices double when the money supply doubles is predicated on the belief that in the short run velocity is ________ and real GDP is ________. A) constant; constant B) constant; variable C) variable; variable D) variable; constant Answer: A 26) For the classical economists, the quantity theory of money provided an explanation of movements in the price level. Movements in the price level result A) solely from changes in the quantity of money. B) primarily from changes in the quantity of money. C) only partially from changes in the quantity of money. D) from changes in factors other than the quantity of money. Answer: A 27) If initially the money supply is $1 trillion, velocity is 5, the price level is 1, and real GDP is $5 trillion, an increase in the money supply to $2 trillion A) increases real GDP to $10 trillion. B) causes velocity to fall to 2.5. C) increases the price level to 2. D) increases the price level to 2 and velocity to 10. Answer: C 28) If initially the money supply is $2 trillion, velocity is 5, the price level is 2, and real GDP is $5 trillion, a fall in the money supply to $1 trillion A) reduces real GDP to $2.5 trillion. B) causes velocity to rise to 10. C) decreases the price level to 1. D) decreases the price level to 1 and decreases velocity to 2.5. Answer: C 29) According to the quantity theory of money demand, A) an increase in interest rates will cause the demand for money to fall. B) a decrease in interest rates will cause the demand for money to increase. C) interest rates have no effect on the demand for money. D) an increase in money will cause the demand for money to fall. Answer: C 30) Fisher's quantity theory of money suggests that the demand for money is purely a function of ________, and ________ no effect on the demand for money. A) income; interest rates have B) interest rates; income has C) government spending; interest rates have D) expectations; income has Answer: A 31) ________ quantity theory of money suggests that the demand for money is purely a function of income, and interest rates have no effect on the demand for money. A) Keynes's B) Fisher's C) Friedman's D) Tobin's Answer: B 32) Irving Fisher's view that velocity is fairly constant in the short run transforms the equation of exchange into the A) Friedman's theory of income determination. B) quantity theory of money. C) Keynesian theory of income determination. D) monetary theory of income determination. Answer: B 19.2 Is Velocity a Constant? 1) The empirical evidence regarding the velocity of money indicates that velocity tends to be ________; that is, velocity ________ when economic activity contracts. A) procyclical; declines B) countercyclical; declines C) countercyclical; increases D) procyclical; increases Answer: A 2) Evidence since 1915 indicates that velocity has A) grown at a fairly constant rate, even in the short run. B) fluctuated too much in the short run to be viewed as a constant. C) trended downward since 1950 due to technological and financial innovations. D) remained fairly constant in the short run, but tends to slowly increase. Answer: B 3) In the 20th century, velocity has A) been quite stable over periods as long as a decade. B) grown at a constant rate. C) been quite volatile. D) been quite stable over short, two year periods. Answer: C 4) Velocity, over the business cycle, tends to A) rise during economic contractions. B) fall during economic expansions. C) stay constant. D) fall during economic contractions. Answer: D 5) Until the Great Depression, economists did not recognize that velocity A) increases during severe economic contractions. B) declines during severe economic contractions. C) declines during rapid economic expansions, since money growth fails to keep pace. D) fails to decline during economic contractions. Answer: B 19.3 Keynes's Liquidity Preference Theory 1) The Keynesian theory of money demand emphasizes the importance of A) a constant velocity. B) irrational behavior on the part of some economic agents. C) interest rates on the demand for money. D) expectations. Answer: C 2) Keynes hypothesized that the transactions component of money demand was primarily determined by the level of A) interest rates. B) velocity. C) income. D) stock market prices. Answer: C 3) Keynes argued that the transactions component of the demand for money was primarily determined by the level of people's ________, which he believed were proportional to ________. A) transactions; income B) transactions; age C) incomes; wealth D) incomes; age Answer: A 4) Keynes hypothesized that the precautionary component of money demand was primarily determined by the level of A) interest rates. B) velocity. C) income. D) stock market prices. Answer: C 5) Keynes argued that the precautionary component of the demand for money was primarily determined by the level of people's ________, which he believed were proportional to ________. A) incomes; wealth B) incomes; age C) transactions; income D) transactions; age Answer: C 6) The demand for money as a cushion against unexpected contingencies is called the A) transactions motive. B) precautionary motive. C) insurance motive. D) speculative motive. Answer: B 7) Keynes hypothesized that the speculative component of money demand was primarily determined by the level of A) interest rates. B) velocity. C) income. D) stock market prices. Answer: A 8) The speculative motive for holding money is closely tied to what function of money? A) Store of wealth B) Unit of account C) Medium of exchange D) Standard of deferred payment Answer: A 9) Of the three motives for holding money suggested by Keynes, which did he believe to be the most sensitive to interest rates? A) The transactions motive. B) The precautionary motive. C) The speculative motive. D) The altruistic motive. Answer: C 10) Because Keynes assumed that the expected return on money was zero, he argued that people would A) never hold money. B) never hold money as a store of wealth. C) hold money as a store of wealth when the expected return on bonds was negative. D) hold money as a store of wealth only when forced to by government policy. Answer: C 11) The Keynesian theory of money demand predicts that people will increase their money holdings if they believe that A) interest rates are about to fall. B) bond prices are about to rise. C) expected inflation is about to fall. D) bond prices are about to fall. Answer: D 12) If people expect nominal interest rates to be higher in the future, the expected return to bonds ________, and the demand for money ________. A) rises; increases B) rises; decreases C) falls; increases D) falls; decreases Answer: C 13) If people expect nominal interest rates to be lower in the future, the expected return to bonds ________, and the demand for money ________. A) increases; increases B) increases; decreases C) decreases; increases D) decreases; decreases Answer: B 14) Keynes argued that when interest rates were low relative to some normal value, people would expect bond prices to ________ so the quantity of money demanded would ________. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease Answer: C 15) Keynes argued that when interest rates were high relative to some normal value, people would expect bond prices to ________ , so the quantity of money demanded would ________. A) increase; increase B) increase; decrease C) decrease; decrease D) decrease; increase Answer: B 16) According to Keynes's theory of liquidity preference, velocity increases when A) income increases. B) wealth increases. C) brokerage commissions increase. D) interest rates increase. Answer: D 17) Keynes's theory of the demand for money implies that velocity is A) not constant but fluctuates with movements in interest rates. B) not constant but fluctuates with movements in the price level. C) not constant but fluctuates with movements in the time of year. D) a constant. Answer: A 18) Because interest rates have substantial fluctuations, the ________ theory of the demand for money indicates that velocity has substantial fluctuations as well. A) classical B) Cambridge C) liquidity preference D) Pigouvian Answer: C 19) Keynes's liquidity preference theory indicates that the demand for money A) is purely a function of income, and interest rates have no effect on the demand for money. B) is purely a function of interest rates, and income has no effect on the demand for money. C) is a function of both income and interest rates. D) is a function of both government spending and income. Answer: C 20) Keynes's theory of the demand for money is consistent with A) countercyclical movements in velocity. B) a constant velocity. C) procyclical movements in velocity. D) a relatively stable velocity. Answer: C 21) Keynes's theory of the demand for money is consistent with ________ movements in ________. A) countercyclical; velocity B) procyclical; velocity C) countercyclical; expectations D) procyclical; expectations Answer: B 22) Keynes's model of the demand for money suggests that velocity is A) constant. B) positively related to interest rates. C) negatively related to interest rates. D) positively related to bond values. Answer: B 23) Keynes's liquidity preference theory indicates that the demand for money is A) constant. B) positively related to interest rates. C) negatively related to interest rates. D) negatively related to bond values. Answer: C 24) Keynes's model of the demand for money suggests that velocity is ________ related to ________. A) positively; interest rates B) negatively; interest rates C) positively; bond values D) positively; stock prices Answer: A 25) Keynes's liquidity preference theory indicates that the demand for money is ________ related to ________. A) negatively; interest rates B) positively; interest rates C) negatively; income D) negatively; wealth Answer: A 26) The Keynesian demand for real balances can be expressed as A) Md = f(i,Y). B) Md/P = f(i). C) Md/P = f(Y). D) Md/P = f(i,Y). Answer: D 27) Explain the Keynesian theory of money demand. What motives did Keynes think determined money demand? What are the two reasons why Keynes thought velocity could not be treated as a constant? Answer: Keynes believed the demand for money depended on income and interest rates. Money was held to facilitate normal transactions and as a precaution for unexpected transactions. For both of these motives, money demand depended on income. People also held money as an asset, for speculative purposes. The speculative motive depends on income and interest rates. People hold more money for speculative purposes when they expect bond prices to fall, generating a negative return on bonds. Since money demand varies with interest rates, velocity changes when interest rates change. Also, since money demand depends upon expectations about future interest rates, unstable expectations can make money demand, and thus velocity, unstable. 19.4 Further Developments In The Keynesian Approach 1) The Baumol-Tobin analysis suggests that A) velocity is relatively constant. B) the transactions component of the demand for money is negatively related to the level of interest rates. C) the speculative motive is non existent. D) velocity is unrelated to the transactions motive. Answer: B 2) The Baumol-Tobin analysis suggests that an increase in the brokerage fee for buying and selling bonds will cause the demand for money to ________ and the demand for bonds to ________. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease Answer: B 3) The Baumol-Tobin analysis suggests that a decrease in the brokerage fee for buying and selling bonds will cause the demand for money to ________ and the demand for bonds to ________. A) increase; increase B) increase; decrease C) decrease; decrease D) decrease; increase Answer: D 4) In the Baumol-Tobin analysis of transactions demand for money, either an increase in ________ or a decrease in ________ increases money demand. A) income; interest rate B) interest rates; brokerage fees C) brokerage fees; income D) interest rate; income Answer: A 5) In the Baumol-Tobin analysis of the demand for money, either an increase in ________ or an increase in ________ increases money demand. A) income; interest rates B) brokerage fees; interest rates C) interest rates; the price level D) brokerage fees; income Answer: D 6) In the Baumol-Tobin analysis of transactions demand, scale economies imply that an increase in real income increases the quantity of money demanded ________, while an increase in the price level increases the quantity of money demanded ________. A) proportionately; less than proportionately B) more than proportionately; proportionately C) less than proportionately; proportionately D) proportionately; more than proportionately Answer: C 7) Tobin's model of the speculative demand for money improves on Keynes's analysis by showing that A) the speculative demand for money is interest insensitive. B) the transactions demand for money is interest insensitive. C) people will hold a diversified portfolio. D) people will hold money or bonds but not both. Answer: C 8) Tobin's model of the speculative demand for money shows that people hold money as a store of wealth as a way of A) reducing risk. B) reducing income. C) avoiding taxes. D) reducing transactions cost. Answer: A 9) Tobin's model of the speculative demand for money shows that people hold money as a ________ as a way of reducing ________. A) medium of exchange; transaction costs B) medium of exchange; risk C) store of wealth; transaction costs D) store of wealth; risk Answer: D 10) Tobin's model of the speculative demand for money shows that people can reduce their ________ by ________ their asset holdings. A) wealth; diversifying B) risk; specializing C) return; diversifying D) risk; diversifying Answer: D 11) Because Treasury bills pay a higher return than money and have no risk A) the transactions demand for money may be zero. B) the precautionary demand for money may be zero. C) the speculative demand for money may be zero. D) all three of the above motives for holding money will be zero. Answer: C 12) The speculative demand for money may not exist because A) banks now pay interest on some types of checkable deposits. B) there are alternative riskless assets paying higher returns than the return on money. C) the transactions demand can be shown to depend on interest rates. D) government regulations have eliminated risk in the financial markets. Answer: B 13) What factors determine the demand for money in the Baumol-Tobin analysis of transactions demand for money? How does a change in each factor affect the quantity of money demanded? Answer: The factors are real income, the price level, interest rates, and the brokerage cost of shifting between money and bonds. Increases in real income increase money demand less than proportionately, since the model predicts scale economies in transactions demand. Increases in prices increase money demand proportionately, since the demand is for real balances. The quantity of money demanded varies inversely with interest rates, since interest is the opportunity cost of holding money. The brokerage fee is the cost of converting other assets (bonds) into money. An increase in this cost increases money demand. 19.5 Friedman's Modern Quantity Theory of Money 1) Friedman's argument that competition among banks will tend to keep the difference between the return on bonds and money relatively constant implies that changes in ________ will have ________ on the demand for money. A) interest rates; a big impact B) income; a big impact C) income; little effect D) interest rates; little effect Answer: D 2) Since the elimination of interest rate ceilings on deposits, the implicit interest rate on money more closely approaches bond interest rates. This suggests that changes in interest rates will A) have a larger impact on money demand. B) have a smaller impact on money demand. C) no longer affect the speculative demand for money. D) no longer affect the transactions demand for money. Answer: B 3) According to Milton Friedman, the demand for money is insensitive to interest rates because A) the demand for money is insensitive to changes in the opportunity cost of holding money. B) competition among banks keeps the opportunity cost of holding money relatively constant. C) people base their investment decisions on expected profits, not interest rates. D) transactions are not subject to scale economies as wealth increases. Answer: B 4) In Friedman's modern quantity theory, velocity depends upon the ratio of A) money to prices. B) actual to permanent income. C) interest rates to actual income. D) prices to interest rates. Answer: B 5) In Friedman's modern quantity theory, velocity is procyclical because A) money demand depends on permanent income, which is more stable than actual income. B) money demand depends on actual income, which is more stable than permanent income. C) velocity depends upon interest rates, which are stable over the business cycle. D) velocity depends upon interest rates, which move procyclically. Answer: A 6) In Friedman's modern quantity theory, the implied formula for velocity is A) V = Md/f(i). B) V = Y/f(Yp). C) V = f((Yp)/Y. D) V = Y/f(i). Answer: B 7) According to Milton Friedman, income declines relative to permanent income during a business cycle contraction, causing the demand for money relative to actual income to increase, thereby causing velocity to A) rise. B) decline. C) remain unchanged, since velocity depends only on interest rates. D) decline, provided that interest rates increase when the economy contracts. Answer: B 8) What factors determine money demand in Friedman's modern quantity theory? How does each affect money demand? What determines velocity in Friedman's theory? What effect do interest rates have on velocity? Answer: In Friedman's theory, increases in permanent income increase money demand. Increases in the returns on bonds relative to money and the returns on equities relative to money decrease money demand. Increases in the returns on goods relative to the return on money, which is the expected rate of inflation relative to the return on money, decrease money demand. Velocity is determined by the ratio of actual to permanent income. As actual income increases in an expansion, permanent income increases less rapidly, so money demand increases less rapidly than income, and velocity rises (and vice versa for contractions). Interest rates do not affect velocity in Friedman's theory, since the relative returns on money and other assets are predicted to remain relatively constant. 19.6 Distinguishing Between the Friedman and Keynesian Theories 1) According to Milton Friedman, income rises relative to permanent income during a business cycle expansion, causing the demand for money relative to actual income to decrease, thereby causing velocity to ________. A) rise B) decline C) remain unchanged, since velocity depends only on interest rates D) decline, provided that interest rates increase when the economy contracts Answer: A 2) A central question in monetary theory is whether or to what extent the quantity of money demanded is affected by changes in ________. A) the price level B) inflation C) income D) interest rates Answer: D 3) If interest rates do not affect the demand for money, then velocity is ________ likely to be ________. A) more; stable B) more; unstable C) more; procyclical D) less; stable Answer: A 4) The ________ sensitive is the demand for money to interest rates, the more unpredictable velocity will be, and the link between the money supply and aggregate spending will be ________ clear. A) more; more B) more; less C) less; more D) less; less Answer: B 5) The more sensitive is the demand for money to interest rates, the ________ unpredictable velocity will be, and the link between the money supply and aggregate spending will be ________ clear. A) more; more B) more; less C) less; more D) less; less Answer: B 6) The ________ sensitive is the demand for money to interest rates, the ________ unpredictable velocity will be, and the link between the money supply and aggregate spending will be less clear. A) more; more B) more; less C) less; more D) less; less Answer: A 19.7 Empirical Evidence on the Demand for Money 1) The evidence on the interest sensitivity of the demand for money suggests that the demand for money is ________ to interest rates, and there is ________ evidence that a liquidity trap exists. A) sensitive; substantial B) sensitive; little C) insensitive; substantial D) insensitive; little Answer: B 2) In the liquidity trap a small change in interest rates produces ________ change in the quantity of money demanded. A) a small B) no C) a proportionate D) a very large Answer: D 3) In a liquidity trap, monetary policy has ________ effect on aggregate spending because a change in the money supply has ________ effect on interest rates. A) no; no B) no; a large C) no; a small D) a large; a large Answer: A 4) In the liquidity trap, monetary policy ________. A) has a large impact on interest rates B) has a small impact on interest rates C) has no impact on interest rates D) has a proportionate impact on interest rates Answer: C 5) In the liquidity trap, the money demand curve ________. A) is horizontal B) is vertical C) is negatively sloped D) is positively sloped Answer: A 6) Evidence suggests that a liquidity trap is possible when ________. A) real interest rates are at zero B) real interest rates are at or just above zero C) nominal interest rates are at zero D) nominal interest rates are at or just above zero Answer: C 7) The reason that economists are so interested in the stability of velocity is because if the demand for money is not stable, then steady growth of the money supply A) is going to promote price stability at the expense of low unemployment. B) is going to promote low unemployment at the expense of price stability. C) is an ineffective way to conduct monetary policy. D) can still be used to conduct monetary policy if the goal is price stability. Answer: C 8) Describe what the liquidity trap is. Explain how it can be problematic for monetary policymakers. Answer: The liquidity trap describes the situation in which the demand for money is insensitive to changes in interest rates (i.e., the money demand curve is infinitely elastic). In this case, monetary policy has no direct affect on aggregate spending because a change in the money supply will not affect interest rates. 19.8 APPENDIX: A Mathematical Treatment of the Baumol-Tobin and Tobin Mean-Variance Models 1) The absence of money illusion means that A) as real income doubles, the demand for money doubles. B) as interest rates double, the demand for money doubles. C) as the money supply doubles, the demand for money doubles. D) as the price level doubles, the demand for money doubles. Answer: D 2) If there are economies of scale in the transactions demand for money, as income increases, money demand A) increases proportionately. B) increases less than proportionately. C) increases more than proportionately. D) does not change. Answer: B 3) Comparing Tobin's model of the speculative demand for money with Keynesian speculative demand A) both models imply that individuals hold only money or only bonds. B) the Keynesian model implies individuals diversify their asset holdings, while the Tobin model predicts that individuals hold only money or only bonds. C) the Tobin model implies individuals diversify their asset holdings, while the Keynesian model predicts that individuals hold only money or only bonds. D) both models imply that individuals diversify their asset holdings. Answer: C 4) In the Baumol-Tobin model, given that total costs for an individual equals where T0 = monthly income, b = brokerage costs, and C = amount raised from each bond transaction, derive the so-called square root rule. Answer: An individual will minimize their costs. Thus, the optimal level of C is found as follows: Since money demand is the average desired holdings of cash balances, C/2: The last expression is the square root rule. 19.9 APPENDIX: Empirical Evidence on the Demand for Money 1) In one of the earliest studies on the link between interest rates and money demand using United States data, James Tobin concluded that the demand for money is A) sensitive to interest rates. B) not sensitive to interest rates. C) not sensitive to changes in income. D) not sensitive to changes in bond values. Answer: A 2) Starting in 1974, the conventional M1 money demand function began to A) severely underpredict the demand for money. B) severely overpredict the demand for money. C) predict more precisely the demand for money. D) do none of the above. Answer: B 3) Starting in 1974, the conventional M1 money demand function began to severely ________ the demand for money. Stephen Goldfeld labeled this phenomenon "the case of the missing ________." A) underpredict; velocity B) overpredict; velocity C) underpredict; money D) overpredict; money Answer: D 4) Conventional money demand functions tended to ________ money demand in the middle and late 1970s, and ________ velocity beginning in 1982. A) overpredict; overpredict B) overpredict; underpredict C) underpredict; overpredict D) underpredict; underpredict Answer: A 5) Researchers at the Federal Reserve found that M2 money demand functions performed ________ in the 1980s, with M2 velocity moving ________ with the opportunity cost of holding M2. A) poorly; erratically B) poorly; closely C) well; erratically D) well; closely Answer: D 6) In the early 1990s, M2 growth underwent a dramatic ________, which some researchers believe ________ be explained by traditional money demand functions. A) surge; cannot B) surge; can C) slowdown; cannot D) slowdown; can Answer: C 7) In the late 1990s, M2 velocity ________, suggesting a ________ normal relationship between M2 and macroeconomic variables. A) stabilized; less B) stabilized; more C) slowed; less D) slowed; more Answer: B Test Bank for The Economics of Money, Banking and Financial Markets Frederic S. Mishkin 9780321599797, 9780134734200, 9780133836790, 9780134734606, 9780134733821
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