Reading 12 Monetary and Fiscal Policy - Answers

Question #1 of 100 Question ID: 1377653
Promoting economic growth and price stability are the goals of:
A) fiscal policy, but not monetary policy.
B) monetary policy, but not fiscal policy.
C) both fiscal and monetary policy.
Explanation
Both monetary and fiscal policies are used by policymakers with the goals of maintaining
stable prices and producing positive economic growth.
(Study Session 4, Module 12.1, LOS 12.a)
The velocity of transactions in an economy has been increasing rapidly for the past seven
years. Over the same time period, the economy has experienced minimal growth in real
output. According to the equation of exchange, inflation over the last seven years has:
A) increased at a rate similar to the growth rate in the money supply.
B) been minimal, consistent with the slow growth in real output.
C) increased more than the growth in the money supply.
Explanation
The equation of exchange is MV = PY. If velocity (V) is increasing faster than real output (Y),
inflation (P) would have to be increasing faster than the money supply (M) to keep the
equation in balance.
For Further Reference:
(Study Session 1, Module 3.2, LOS 3.k)
CFA® Program Curriculum, Volume 2, page 272

Attempting to influence economic growth and inflation by changing tax rates and
government spending is best described as:
A) a combination of fiscal and monetary policy.
B) monetary policy.
C) fiscal policy.
Explanation
Fiscal policy refers to actions by a government to influence economic activity through

changes in taxes and government spending.
Which of the following statements about achieving proper timing in fiscal policy is least
accurate?
Improvements in quantitative methods have made the occurrence of recessions

A)
or expansions quite predictable.
B) Policy errors are inevitable due to unpredictable events.
There is usually a time lag between when a change in policy is needed and when
C)
the need is recognized by policy makers.
Explanation
One problem in achieving proper timing in fiscal policy is the inability to accurately predict
a recession or expansion.
(Study Session 4, Module 12.3, LOS 12.r)
To determine whether monetary policy is expansionary or contractionary, an analyst should
compare the central bank's policy rate to the:
A) neutral interest rate.
B) target inflation rate.

C) trend rate of real growth.
Explanation
The neutral interest rate is the sum of the trend rate of real economic growth and the
target inflation rate. Monetary policy is expansionary if the policy rate is less than the
neutral interest rate and contractionary if the policy rate is greater than the neutral
interest rate.
(Study Session 4, Module 12.2, LOS 12.m)
The Federal Reserve has decided to increase the federal funds rate (the interest rate that
banks charge each other for overnight loans). To implement this policy, the Federal Reserve
will most likely:
A) sell government securities in the open market.
B) increase currency exchange rates (cause domestic currency to appreciate).
C) set a lower price on Treasury bills and notes that it is auctioning.
Explanation
Selling government securities on the open market reduces bank reserves and drives up
the federal funds rate. The other two statements are incorrect because the Federal
Reserve does not directly control exchange rates or the prices of government securities.
(Study Session 4, Module 12.2, LOS 12.h)
If a monetary policy is focused on combating inflation, which open market actions by the
Federal Reserve will most effectively accomplish this?
A) Sell Treasury securities, causing aggregate demand to decrease.
B) Purchase Treasury securities, causing aggregate demand to decrease.

C) Sell Treasury securities, causing aggregate demand to increase.
Explanation
If the Federal Reserve wants to slow inflation, it needs to decrease aggregate demand (i.e.,
business investment, consumer purchases of durable goods, and exports). To accomplish
this, the Federal Reserve could engage in open market sales of Treasury securities.
Which of the following policy tools is the least likely to be available to the U.S. Federal
Reserve Board?
A) Requiring the banking system to tighten or loosen its credit policies.
B) Buying and selling Treasury securities in the open market.
C) Setting the discount rate at which banks can borrow from the Federal Reserve.
Explanation
The U.S. Federal Reserve can encourage or persuade banks as a whole to tighten or loosen
their credit policies, but it cannot compel them to do so.
Which of the following is the most accurate definition of the velocity of money? The velocity
of money is the:
A) GDP of a country divided by its price level.
B) money supply of a country divided by its price level.
C) GDP of a country divided by its money supply.
Explanation
Velocity is the average number of times per year each dollar is used to buy goods and
services (velocity = nominal GDP / money). Therefore, the money supply multiplied by
velocity must equal nominal GDP. The equation of exchange must hold with velocity
defined in this way. Letting money supply = M, velocity = V, price = P, and real output = Y,
the equation of exchange may be symbolically expressed as: MV = PY.
(Study Session 4, Module 12.1, LOS 12.c)

Assume the U.S. economy is undergoing a recession. In its efforts to stimulate the economy
by trying to influence short-term interest rates the Fed is most likely to take which two
actions?
A) Buy Treasury securities and decrease bank reserve requirements.
B) Sell Treasury securities and decrease bank reserve requirements.
C) Sell Treasury securities and increase bank reserve requirements.
Explanation
If the economy is in a recession, the Fed is likely to attempt to decrease short-term

interest rates. Thus, the Fed will buy Treasury securities and decrease bank reserve
requirements.
Which of the following statements about the relationship between interest rates and the
demand for and supply of money is most accurate? Interest rates affect:
A) the demand for money only.
B) the supply of money only.
C) both the demand for and supply of money.
Explanation
Interest rates only affect the demand for money. With higher interest rates, the
opportunity cost of holding money increases, and people hold less money and more
interest-earning assets. Monetary authorities determine the supply of money. Therefore,
the supply of money is independent of the interest rate.
(Study Session 4, Module 12.1, LOS 12.d)

If households and firms are holding larger real money balances than they desire:
A) the interest rate is higher than its equilibrium rate.
the central bank must sell securities to absorb the excess money supply and
B)
establish equilibrium.
C) the opportunity cost of holding money balances is likely to increase.
Explanation
If real money balances are larger than households and firms desire, the interest rate
(opportunity cost of holding money balances) is higher than its equilibrium rate.
Households and firms will use their undesired cash to buy securities, bidding up securities
prices and reducing the interest rate until the equilibrium rate is achieved. This market
process does not require any action by the central bank.
When the Federal Reserve sells government securities on the open market, bank reserves
are:
decreased, which reduces the amount of money banks are able to lend, causing
A)
a decrease in the federal funds rate.
decreased, which reduces the amount of money banks are able to lend, causing
B)
an increase in the federal funds rate.
increased, which increases the amount of money banks are able to lend,
C)
causing a decrease in the federal funds rate.
Explanation
When the Federal Reserve wants to increase the federal funds rate through open market
operations, it sells government securities. Open-market sales reduce bank reserves and
cause the federal funds rate to increase.

On January 5, the U.S. Federal Reserve (the Fed) bought $10,000,000 of U.S. Treasury
securities in the open market. At the time, the reserve requirement was 25%, and all banks
had zero excess reserves. What is the potential impact of the Fed's purchase on the U.S.
money supply?
A) $10,000,000 increase.
B) $25,000,000 decrease.
C) $40,000,000 increase.
Explanation
Buying securities by the Fed increases the money supply because they are injecting money
into the banking system. The money supply can potentially increase by 1 / 0.25 ×
$10,000,000 = $40,000,000.
The time it takes for policy makers to enact a fiscal policy action is best described as:
A) legislative lag.
B) implementation lag.
C) action lag.
Explanation
The time it takes for fiscal policy actions to be proposed, approved, and implemented is
referred to as action lag.
Policies used with the goal of maintaining stable prices and producing economic growth
include:
A) fiscal policy only.
B) both fiscal policy and monetary policy.

C) monetary policy only.
Explanation
Both fiscal and monetary policies are used to maintain stable prices and produce
economic growth. Fiscal policy does so by mechanisms that involve spending and taxation,
and monetary policy uses central bank tools to modify the availability of money and credit.
What are the three essential qualities an effective central bank should possess?
A) Independence, credibility, and transparency.
B) Credibility, relevance, and reliability.
C) Transparency, independence, and consistency.
Explanation
A central bank that is independent from political interference, possesses credibility, and
exhibits transparency is more likely to achieve its monetary policy objectives than a central
bank that lacks these qualities. The other characteristics listed in the answer choices relate
to financial statements and financial reporting standards.
(Study Session 4, Module 12.2, LOS 12.j)
Banks choose to hold a higher percentage of deposits as reserves because they believe
general business conditions in the economy are subject to greater uncertainty. If all else is
held constant, what is the most likely impact of this action?
The money supply will increase during a period of inflation, but will decrease if
A)
the economy goes into a recession.
B) The money supply will decrease.
C) There will be no effect on the money supply.
Explanation
If banks choose to hold excess reserves, they will decrease their lending. Less bank
lending will cause the money supply to decrease.

The government is reducing its spending to balance the budget, while the central bank is
lowering its official policy rate. What will most likely be the combined effect on the economy?
A) The private sector as a percentage of GDP will increase.
The public and private sectors as a percentage of GDP will neither decrease nor
B)
increase.
C) The public sector as a percentage of GDP will increase.
Explanation
The private sector will expand as a percentage of GDP because (1) the public sector will
decrease as a percentage of GDP due to government spending cuts and (2) lower interest
rates should cause the private sector to expand.
(Study Session 4, Module 12.3, LOS 12.t)
The crowding-out model implies that a:
budget surplus will retard aggregate demand and trigger an economic

A)
downturn.
budget deficit will stimulate aggregate demand and trigger a multiplier effect
B)
which will lead to inflation.
budget deficit will increase the real interest rate and thereby retard private
C)
investment.
Explanation
Increased budget deficits will increase the demand for loanable funds and lead to higher
interest rates and thus lower private investment. Crowding-out implies that an increase in
government spending will choke off private investment and reduce the intended impact of
fiscal policy changes on aggregate demand.
(Study Session 4, Module 12.3, LOS 12.q)

The primary objective of a central bank is typically to:
A) control inflation.
B) stabilize exchange rates.
C) achieve full employment.
Explanation
Although some central banks have other stated goals including stabilizing exchange rates
and achieving full employment, the primary objective for a central bank is to control
inflation and promote price stability.
(Study Session 4, Module 12.1, LOS 12.f)
Which of the following statements best explains how automatic stabilizers work? Even
without a change in fiscal policy, automatic stabilizers tend to promote:
a budget surplus during a recession and a budget deficit during an inflationary

A)
expansion.
a budget deficit during a recession but do not promote a budget surplus during
B)
an inflationary expansion.
a budget deficit during a recession and a budget surplus during an inflationary

C)
expansion.
Explanation
Automatic stabilizers such as unemployment compensation, corporate profits tax, and the
progressive income tax run a deficit during a business slowdown but run a surplus during
an economic expansion. Therefore, they automatically implement countercyclical fiscal
policy without the delays associated with policy changes that require legislative action.
(Study Session 4, Module 12.3, LOS 12.o)

Silvano Jimenez, an analyst at Banco del Rey, is reviewing recent actions taken by the U.S.
Federal Reserve (the Fed) in setting monetary policy. Recently, the Fed decided to increase
the money supply, which has resulted in a decrease in real interest rates. At a staff meeting,
Jimenez brings this matter to the attention of his colleagues and makes the following
statements:
Statement 1: Although the money supply increase has led to a decrease in real interest
rates, we should begin to see U.S. investors decrease their investments abroad and the U.S.
dollar will appreciate in the foreign exchange market.
Statement 2: The Fed's increase in the money supply will increase the amount of imports
into the U.S.
Are Statement 1 and Statement 2 as made by Jimenez CORRECT?
Statement 1 Statement 2
A) Incorrect Correct
B) Incorrect Incorrect
C) Correct Incorrect
Explanation
If the Fed increases the money supply and real interest rates decline, U.S. investors will
seek higher real rates of return abroad and the U.S. dollar will depreciate as the dollar will
be exchanged for foreign currencies in order to buy the foreign investments. Likewise, the
decrease in real interest rates will reduce the inflow of funds from abroad as foreign
investors seek higher rates of return outside the U.S. With a dollar that has depreciated,
U.S. exports should increase, as U.S. products will become cheaper for foreign buyers. As
such, both statements are incorrect.
Unemployment compensation is an example of:
A) an automatic monetary policy stabilizer.
B) a discretionary fiscal policy stabilizer.
C) an automatic fiscal policy stabilizer.
Explanation
Unemployment compensation automatically rises and falls with the business cycle,
therefore it is an example of an automatic fiscal policy stabilizer.
According to the Fisher effect, which of the following interest rates includes a premium for
the expected rate of inflation?
Yields on long-term corporate debt, but not yields on short-term government

A)
debt.
Neither yields on short-term government debt nor yields on long-term

B)
corporate debt.
Both yields on short-term government debt and yields on long-term corporate

C)
debt.
Explanation
The Fisher effect holds that all nominal interest rates include a premium for expected
inflation.
(Study Session 4, Module 12.1, LOS 12.e)
Which of the following is currently the most-used target for central banks?
A) Money supply targeting.
B) Interest rate targeting.
C) Inflation targeting.
Explanation
Inflation targeting is the most-used tool of central banks for making monetary policy
decisions.
(Study Session 4, Module 12.2, LOS 12.l)

Question ID: 1377658
Question #27 of 100
The amount of money a commercial bank has available to lend is known as:
A) fractional reserves.
B) excess reserves.
C) required reserves.
Explanation
Excess reserves are the amount of money a commercial bank has available with which to
make new loans, after depositing its required reserves with the central bank.
An economy's long-term trend rate of real GDP growth is 3% and the central bank's target
inflation rate is 2%. If the policy rate is 6%, monetary policy is:
A) contractionary.
B) expansionary.
C) neutral.
Explanation
Monetary policy is contractionary when the policy rate is greater than the neutral rate,
which is the sum of the real trend rate of economic growth and the target rate of inflation.
Here, the neutral rate is 3% + 2% = 5% and the policy rate of 6% is greater than the neutral
rate. Monetary policy is expansionary when the policy rate is less than the neutral interest
rate.
Discretionary fiscal policy refers to:
A) active decisions regarding spending and taxing to affect economic growth.
B) buying or selling securities in the open market to influence interest rates.

government spending programs that counteract the business cycle without the
C)
intervention of policymakers.
Explanation
Discretionary fiscal policy, in contrast to automatic stabilizers, refers to active decisions by

the government to affect economic growth through changes in government spending and
taxation. Buying or selling securities in the open market is an example of monetary policy.
The three reasons for holding money are most accurately described as:
A) broad money demand, narrow money demand, and transaction demand.
B) narrow money demand, precautionary demand, and speculative demand.
C) transaction demand, precautionary demand, and speculative demand.
Explanation
The three reasons for holding money are: transaction demand, for buying goods and
services; precautionary demand, to meet unforeseen future needs; and speculative
demand, to take advantage of investment opportunities. Narrow money and broad money
refer to measures of money in circulation.
Which of the following relationships in regard to the quantity theory of money is least
accurate?
A) Money × Velocity = Money Supply × Velocity.
B) Nominal GDP = Money Supply × Velocity = Price × Real Output.
C) Nominal GDP = Price × Money Supply.
Explanation
The quantity theory of money holds that: Money Supply × Velocity = Nominal GDP = Price ×
Real Output.
Arguments for being concerned with the size of a fiscal deficit relative to GDP least likely
include:
A) a likely need for higher future taxes.
B) higher interest rates due to government borrowing.
C) a high proportion of government debt owed to the country’s citizens.
Explanation
That a government owes its own citizens much of its outstanding debt is an argument
against being concerned about fiscal deficits. Arguments for being concerned about fiscal
deficits include the need for higher future taxes and the potential for government
borrowing to increase interest rates and crowd out private investment.
Which of the following statements regarding U.S. Federal Reserve open market operations is
least accurate?
If the Fed wants to stimulate the economy, it will sell Treasury securities to
A)
banks.
When the Fed buys Treasury securities, short-term interest rates will generally
B)
decrease.
C) When the Fed sells Treasury securities, excess reserves decrease.
Explanation
If the Fed intends to stimulate the economy, they will buy, not sell, Treasury securities.
Buying Treasury securities injects reserves into the banking system.
When additional or excess reserves are injected into the U.S. banking system, the money
supply can potentially increase by an amount equal to the additional excess reserves
multiplied by which of the following?
A) Reciprocal of one minus the required reserve ratio.
B) Reciprocal of the required reserve ratio.
C) Required reserve ratio.
Explanation
The potential deposit expansion multiplier = 1 / (required reserve ratio)
The potential increase in the money supply = potential deposit expansion multiplier ×
increase in excess reserves
The demand for money curve represents the relationship between the quantity of money
demanded and:
A) the price level.
B) the quantity of money supplied.
C) short-term interest rates.
Explanation
The demand for money curve represents the relationship between short-term interest
rates and the quantity of real money that households and firms demand to hold.

An individual has just purchased a home by taking on a 30-year fixed rate mortgage. She
would benefit most from this transaction if future inflation rates are:
A) higher than anticipated.
B) exactly as anticipated.
C) lower than anticipated.
Explanation
Inflation that is higher than anticipated will result in a transfer of wealth from lenders to
borrowers.
(Study Session 4, Module 12.1, LOS 12.g)
A country is experiencing a core inflation rate of 7% during a recessionary period of real GDP
growth. If the central bank has a single mandate to achieve price stability and uses inflation
targeting with an acceptable range of zero to 4%, its monetary policy response is most likely
to decrease:
A) GDP growth in the short run.
B) short-term interest rates.
C) the foreign exchange value of the country’s currency.
Explanation
If the central bank has a price stability mandate, it will most likely respond to the above-
target inflation rate by decreasing the money supply, even though GDP growth is in a
recessionary phase. Decreasing the money supply will result in higher short-term interest
rates and appreciation of the currency, but will likely cause GDP growth to decrease
further in the short run.
A distinction between fiscal policy and monetary policy is that fiscal policy:
concerns taxes and government spending, while monetary policy concerns the
A)
money supply.
B) is typically expansionary, while monetary policy is typically contractionary.
is aimed at promoting economic growth, while monetary policy is aimed at

C)
promoting price stability.
Explanation
The distinction between fiscal and monetary policy is that a country's government
determines fiscal policy through taxes and spending, but its central bank determines
monetary policy by controlling the money supply. Both fiscal and monetary policy can be
used to promote economic growth and price stability. Either fiscal policy or monetary
policy can be expansionary or contractionary.
Assuming the economy currently is experiencing high inflation, an example of appropriate
discretionary fiscal policy is:
A) increase the federal funds target rate.
B) reduce government expenditures on major government construction projects.
C) reduce the money supply.
Explanation
Discretionary fiscal policy refers to the federal government's decisions regarding

government spending and taxing. A reduction in government spending on major
government construction projects is likely to lead to a reduction in aggregate demand and
less pressure on prices, reducing inflation.
(Study Session 4, Module 12.3, LOS 12.p)
Monetary policy is most accurately described as actions that influence economic activity by
increasing or decreasing:
A) currency exchange rates.

B) the supply of money and credit.
C) tax rates on income and consumption.
Explanation
Monetary policy attempts to influence economic growth and inflation by increasing or

decreasing the money supply and the availability of credit in the economy. Taxes and
government spending are tools of fiscal policy. Monetary and fiscal policy can both
influence currency exchange rates, but this is not typically their primary goal or tool.
Which of the following is the most likely result of a central bank's shift to an expansionary
monetary policy?
A) Domestic currency appreciates.
B) Exports increase.
C) Interest rates increase.
Explanation
Expansionary monetary policy decreases interest rates. This should cause the domestic
currency to depreciate, which should increase foreign demand for the country's exports.
If a central bank implements an exchange rate targeting policy successfully, the country's
inflation rate is most likely to be:
A) less than that of the target currency.
B) greater than that of the target currency.
C) the same as that of the target currency.
Explanation
Successful exchange rate targeting should result in the same inflation rate in the targeting
country as in the country of the target currency.
The time it takes for a fiscal policy action to affect the economy is best described as:
A) action lag.
B) impact lag.
C) recognition lag.
Explanation
The time it takes for a fiscal policy action, once implemented, to have its effect on the
economy is referred to as impact lag. Recognition lag is the time it takes policymakers to
realize a fiscal policy response is needed. Action lag is the time it takes policymakers to
discuss, enact, and implement fiscal policy measures.
If a bank receives a deposit of $1 million in cash which has been held outside the banking
system and the reserve requirement is 10%, the maximum increase in the money supply
that could result is:
A) $100,000.
B) $900,000.
C) $10,000,000.
Explanation
The maximum increase in the money supply from a fractional reserve banking system is
the money multiplier (1 / reserve requirement) times the amount of a new deposit of cash.
1/0.10 × $1 million = $10 million.

Money functions as a store of value because:
A) money is accepted as the form of payment for goods.
money received for work or goods can be saved to purchase goods or services
B)
in the future.
C) prices of goods and services are expressed in units of money.
Explanation
Money has three primary functions: it provides a store of value because money received
for work or goods can be saved for future consumption; it serves as a unit of account
because prices of all goods and services are expressed in units of money; and it serves as
a medium of exchange because money is accepted as a form a payment.
(Study Session 4, Module 12.1, LOS 12.b)
Assume that the required reserve ratio is 20%, and banks currently have no excess reserves.
If the Federal Reserve then buys $100 million of Treasury bills from the banks, the money
supply could potentially increase by:
A) $100 million.
B) $20 million.
C) $500 million.
Explanation
1 1
Potential expansion multiplier = = = 5
required reserve ratio 0.2
(100)(5) = 500
Question #47 of 100

Which of the following conditions is difficult for monetary policy to address because a
central bank cannot reduce its nominal policy rate much below zero?
A) Deflation.
B) Inflation.
C) Stagflation.
Explanation
Deflation is difficult for central banks to address when policy rates cannot be lowered any
further. Inflation can be addressed by contractionary monetary policy. Stagflation is
difficult to address because monetary policy cannot pursue higher growth and lower
inflation at the same time.
(Study Session 4, Module 12.2, LOS 12.n)
Central banks pursuing expansionary policies may:
A) decrease the policy rate and make open market purchases of securities.
B) decrease the policy rate and make open market sales of securities.
C) increase the policy rate and make open market purchases of securities.
Explanation
Decreasing the policy rate, decreasing reserve requirements, and purchasing securities in
the open market are expansionary monetary policy actions.
The government budget deficit of Country M is increasing. At the same time, the government
budget surplus of Country N is decreasing. Are the fiscal policies of these countries
expansionary or contractionary?
A) Both are contractionary.

B) Both are expansionary.
C) One is expansionary and one is contractionary.
Explanation
Expansionary fiscal policy increases a budget deficit or decreases a budget surplus.

Contractionary fiscal policy decreases a budget deficit or increases a budget surplus.
(Study Session 4, Module 12.3, LOS 12.s)
The Fisher effect describes the relationship between:
A) expected and unexpected inflation.
B) money supply growth and actual inflation.
C) nominal and real interest rates.
Explanation
The Fisher effect states that a nominal interest rate is equal to a real interest rate plus the
expected rate of inflation.
If a bank needs to borrow funds from the Federal Reserve to fund a temporary shortage in
reserves, it would borrow funds at the:
A) discount rate.
B) federal funds rate.
C) prime rate.
Explanation
Banks are able to borrow from the Fed at the discount rate. The federal funds rate is the
interest rate banks charge other banks to borrow reserves from other banks. The prime
rate is the rate that commercial banks charge their best customers.
Assume the Federal Reserve purchases $1 billion of securities in the open market. What is
the maximum increase in the money supply that can result from this action, if the required
reserve ratio is 15%?
A) $850 million.
B) $1.00 billion.
C) $6.67 billion.
Explanation
The money multiplier is 1 / 0.15 = 6.67, so the open market purchase can increase the
money supply by a maximum of $6.67 billion.
If the Federal Reserve wishes to lower market interest rates without changing the discount
rate, it can:
A) buy Treasury securities.
B) increase bank reserve requirements.
C) raise the yield on Treasury securities.
Explanation
Buying Treasury securities pumps money into the economy, lowering interest rates.
Higher reserve requirements will restrict the money supply, causing rates to rise. The
Federal Reserve has no direct control over the yield on existing Treasury securities.

If the U.S. Federal Reserve decides to decrease the money supply, which of the following is
most likely to occur in the short run?
A) An increase in the velocity of money similar to decrease in the money supply.
B) An increase in the real rate of interest.
C) A decrease in the unemployment rate.
Explanation
If the U.S. Federal Reserve decreases the money supply, an increase in nominal and real
interest rates will occur. Higher real rates will cause businesses to invest less, which will
cause the unemployment rate to increase. Furthermore, households will decrease
purchases of durable goods, automobiles, and other items that are typically financed at
short-term rates. This will decrease aggregate demand. The decrease in aggregate
demand and expenditures will cause incomes to go down, which further decreases
consumption and investment. Moreover, this decrease in aggregate demand will decrease
real GDP and the price level in the short run and the long run.
(Study Session 4, Module 12.2, LOS 12.i)
Which of the following statements regarding the monetary policy transmission mechanism is
most accurate?
Central banks can control short-term interest rates directly, but long-term
A)
interest rates are beyond their control.
Central banks can control long-term interest rates directly because decisions by
B)
consumers and businesses are based on these rates.
Central banks can control short-term interest rates by increasing the money
C) supply to increase interest rates or by decreasing the money supply to decrease
interest rates.
Explanation
Central banks can control short-term interest rates directly. However, the decisions of
consumers and businesses are based on long-term interest rates, which are beyond the
control of central banks. Increasing the money supply will decrease interest rates and
decreasing the money supply will increase interest rates.

The country of Zurkistan is experiencing both high interest rates and high inflation. The
government passes laws that reduce government spending and increase taxes. It takes
many months before interest rates fall and inflation is reduced. This is an example of:
A) recognition lag in discretionary fiscal policy.
B) action lag and automatic stabilizers.
C) impact lag in discretionary fiscal policy.
Explanation
This is an example of discretionary fiscal policy involving impact lag because it takes time
for the impact of the change in taxing and spending to be felt throughout the economy.
A central bank that wants to increase short-term interest rates is most likely to:
A) sell government securities.
B) issue long-term bonds.
C) decrease bank reserve requirements.
Explanation
Open market operations to sell securities will decrease the outstanding supply of cash
balances and increase short-term interest rates. The central bank does not issue long-
term bonds but may buy and sell bonds issued by the government. Decreasing reserve
requirements or purchasing government securities would tend to decrease short-term
interest rates.
An analyst has determined the projected trend rate of real GDP growth is 2.5% and the
central bank's inflation target is 2.5%. If the central bank policy rate is 5.0%, monetary policy
is most likely:
A) contractionary.
B) expansionary.
C) neutral.
Explanation
The neutral rate of interest is real trend rate of economic growth plus the inflation target.
In this example, the neutral rate = 2.5% + 2.5% = 5.0%. Because the policy rate is the same
as the neutral rate of interest, monetary policy is neither contractionary nor expansionary.
The open market sale of Treasury securities by the Federal Reserve is least likely to result in:
A) a decreased rate of inflation.
B) increased exports of U.S. goods.
C) increased longer-term interest rates.
Explanation
When the Fed sells Treasuries, it causes both short- and long-term interest rates to
increase. This rate increase causes the dollar to appreciate, which reduces foreign demand
for domestic goods, causing exports to decline. The interest rate increase also puts
downward pressure on price levels, which causes inflation to slow.
A central bank is said to have credibility if:
it determines both the policy rate and the method for computing the inflation
A)
rate.
B) it issues inflation reports monthly.
C) economic actors base decisions on the central bank’s stated inflation targets.
Explanation
If a central bank has credibility, economic actors come to believe the inflation rate will be
near the central bank's target and factor this inflation rate into their decisions. Periodic
inflation reports enhance the transparency of a central bank. A central bank that
determines both the policy rate and the method for computing the inflation rate is said to
have independence.
If a central bank's targeted inflation rate is above the current rate, the central bank is most
likely to:
A) increase the overnight lending rate.
B) buy government securities.
C) increase the reserve requirement.
Explanation
Buying government securities is an expansionary policy that would increase the money
supply and allow the inflation rate to increase to the targeted range. Increasing reserve
requirements and overnight lending rates are contractionary and would have the opposite
effects.
An example of a contractionary fiscal policy change is a(n):
A) decrease in a fiscal surplus.
B) increase in a fiscal surplus.
C) increase in a fiscal deficit.
Explanation
An increase in a fiscal surplus or a decrease in a fiscal deficit is contractionary. An increase

in a fiscal deficit or a decrease in a fiscal surplus is expansionary.

The term "automatic stabilizers" refers to:
changes in taxes and expenditure programs legislators automatically enact in

A) response to changes the level of economic activity in order to smooth economic
cycles.
increases in transfer payments and decreases in tax revenues that result from
B)
an economic contraction without new legislation.
government expenditures and tax receipts that are required to balance over the
C) course of the business cycle, although they may be out of balance in any single
year.
Explanation
Automatic stabilizers refers the increase (decrease) in transfer payments such as

unemployment compensation and the decrease (increase) in tax revenue that result from
a decrease (increase) in the level of economic activity. These effects tend to move the
fiscal budget toward a deficit when economic activity decreases and toward surplus when
economic activity increases, and tend to dampen economic cycles.
An argument against being concerned with the size of a fiscal deficit is that a deficit can:
A) cause government borrowing to crowd out private borrowing.
B) lead to higher future taxes that will increase government revenues.
aid in increasing GDP and employment if the economy is operating at less than
C)
potential GDP.
Explanation
One potential argument against being concerned about the size of fiscal deficits is that a
deficit can help increase GDP and employment if output is below potential GDP and the
spending does not divert capital from productive uses. Higher deficits that lead to
crowding out or higher future taxes that result in lower long-term economic growth are
arguments for concern about the size of fiscal deficits.

According to the quantity theory of money, the most appropriate means to combat inflation
is to:
A) increase the excess reserves of banks.
B) reduce the money supply.
C) reduce the velocity of money.
Explanation
The quantity theory focuses on the quantity of money. The quantity theory states that
velocity is not affected by monetary policy. Increasing banks' excess reserves would most
likely lead to higher inflation.
Which of the following is least likely to be a function of the central bank?
A) Issue currency.
B) Regulate the banking system.
C) Collect tax payments.
Explanation
The three functions of a central bank are to issue a country's currency, regulate its
banking system, and to manage the money supply. Tax collection is typically conducted by
a government agency created specifically to carry out that function.
Arguments for being concerned about the size of a fiscal deficit least likely include:
A) a reduction in long-term economic growth.
B) Ricardian equivalence.
C) the crowding-out effect.
Explanation
If Ricardian equivalence holds, private savings will increase in anticipation of the future
taxes required by a fiscal deficit. The crowding-out effect of government borrowing on
private investment and the reduction in long-term economic growth due to higher future
taxes argue in favor of being concerned about the size of a fiscal deficit.
Central banks that are able to define how inflation is computed and determine its desired
level are best described as having:
A) operational independence.
B) target independence.
C) transparency.
Explanation
Target independence means the central bank defines how inflation is computed, sets the
target inflation level, and determines the horizon over which the target is to be achieved.
Central banks that have operational independence are allowed to determine the policy
rate. Transparency refers to the degree to which central banks report to the public on the
state of the economic environment and is one of the three essential qualities of an
effective central bank.
Contractionary monetary policy is least likely to decrease consumption spending by
decreasing:
A) expectations for economic growth.

B) securities prices.
C) the foreign exchange value of the currency.
Explanation
Contractionary monetary policy is likely to increase the value of the domestic currency in
the foreign exchange market, which decreases foreign demand for the country's exports.
Contractionary monetary policy should cause both securities prices and expectations for
economic growth to decrease, each of which is likely to cause consumers to decrease
spending.
The time it takes for policy makers to determine that the economy requires a fiscal policy
action is best described as:
A) action lag.
B) impact lag.
C) recognition lag.
Explanation
Recognition lag refers to the time it takes for fiscal policy makers to determine the need
for a policy action. Action lag is the time it takes policymakers to discuss, enact, and
implement fiscal policy measures. Impact lag is the time it takes for a fiscal policy measure
to have its effect on the economy.
Policies that can be used as tools for redistribution of wealth and income include:
A) both fiscal policy and monetary policy.
B) fiscal policy only.
C) monetary policy only.
Explanation
Fiscal policy can be used as a tool for redistribution of income and wealth, through a
variety of taxation and spending policies.
Xanadu attempts to decrease its inflation rate by implementing contractionary monetary
policy. Which of the following is most likely to be the long-run effect on Xanadu's trade
balance as a result of the monetary policy change?
A) Remain the same.
B) Improve.
C) Worsen.
Explanation
Contractionary monetary policy likely will cause higher domestic interest rates and attract
foreign capital. As foreign capital flows in, the currency will appreciate relative to other
currencies. The higher cost of its currency will result in higher cost exports that become
less attractive to other countries. Xanadu's trade balance will most likely worsen.
The crowding-out effect suggests that:
as government spending increases, so will incomes and taxes, and the higher
A)
taxes will reduce both aggregate demand and output.
greater government deficits will drive up interest rates, thereby reducing private
B)
investment.
C) government borrowing will lead to an increase in private savings.
Explanation
The crowding-out effect refers to a reduction in private borrowing and investment as a
result of higher interest rates generated by budget deficits that are financed by borrowing
in the private loanable funds market.
Frequent changes in advertised prices are one of the costs of:
A) unexpected inflation only.
B) both expected and unexpected inflation.
C) expected inflation only.
Explanation
Inflation imposes "menu costs" on an economy as businesses must frequently change

their advertised prices, regardless of whether inflation is expected or unexpected.
Assume that the long-term equilibrium money market interest rate is 4% and the current
money market interest rate is 3%. At this current rate of 3%, there will be an excess:
supply of money in the money market, and investors will tend to be net buyers
A)
of securities.
demand for money in the money market, and investors will tend to be net
B)
sellers of securities.
demand for money in the money market, and investors will tend to be net
C)
buyers of securities.
Explanation
At interest rates below 4% (the long-term equilibrium rate), the quantity of money
demanded exceeds the quantity of money supplied. At below-equilibrium rates, investors
will sell bonds to obtain the desired extra cash. As they sell more bonds, the prices of
bonds fall, and interest rates start to move back towards the 4% equilibrium.
Central banks are most likely to pursue a target inflation rate:
A) between 2% and 3%.
B) between 0% and 2%.
C) equal to 0%.
Explanation
Central banks typically define price stability as a stable inflation rate of about 2% to 3%. A
target of zero is not typically used because it would risk deflation.
Which one of the following Federal Reserve monetary policies, when pursued in line with the
U.S. government's fiscal policies, would help increase aggregate demand during a period of
high unemployment?
A) A decrease in the discount rate.
B) An increase in the reserve requirements for financial institutions.
C) The sale of bonds by the Fed.
Explanation
A decrease in the Fed's lending rate is a monetary tool that the Fed can use to increase the
money supply, thereby increasing aggregate demand during recessionary times when
there is high unemployment. An increase in the reserve requirements and the sale of
bonds by the Fed would all be restrictive monetary policies that would reduce the amount
of money in the economy and reduce aggregate demand.
When an economy dips into a recession, automatic stabilizers will tend to alter government
spending and taxation so as to:
A) reduce the budget deficit (or increase the surplus).
B) reduce interest rates, thus stimulating aggregate demand.
C) enlarge the budget deficit (or reduce the surplus).
Explanation
During a recession unemployment is high, so the government will pay out more in
unemployment compensation at the exact time that tax receipts from corporations and
individuals are low. This will increase the size of the deficit and also maintain aggregate
demand during recessionary periods.
Arguments against being concerned about the size of a fiscal deficit include:
A) higher future taxes.
B) Ricardian equivalence.
C) the crowding-out effect.
Explanation
Ricardian equivalence suggests that it does not matter whether a government finances its
spending with debt or a tax increase because the effect on the total level of demand in the
economy is the same. Arguments for being concerned about the size of the fiscal deficit
include the crowding-out effect of government borrowing taking the place of private
sector borrowing and the negative effects on work incentives and entrepreneurship from
higher future taxes.
The Fisher effect holds that a nominal rate of interest equals a real interest rate:
A) minus the observed inflation rate.
B) plus the observed inflation rate.
C) plus the expected inflation rate.
Explanation
The Fisher effect states that a nominal rate of interest equals a real rate plus expected
inflation.
The supply of money is primarily determined by:
A) inflation.
B) interest rates.
C) the monetary authorities.
Explanation
The monetary authorities determine the quantity of money available to the economy.
Inflation and interest rates affect the demand for money balances.

Money serves as a unit of account because:
A) money is accepted as the form of payment for goods.
money received for work or goods can be saved to purchase goods or services
B)
in the future.
C) prices of goods and services are expressed in units of money.
Explanation
Money has three primary functions: it serves as a unit of account because prices of goods
and services are expressed in units of money; it provides a store of value because money
received for work or goods can be saved to purchase goods or services at another time;
and it serves as a medium of exchange because money is accepted as a form a payment.
The most likely reason for deflation to persist despite expansionary monetary policy is:
A) a liquidity trap.
B) bond market vigilantes.
C) inelastic demand for money.
Explanation
Deflation is often associated with liquidity trap conditions. A liquidity trap is a situation in
which demand for money becomes highly elastic. Expanding the money supply has little
effect on economic activity under these conditions because individuals and firms choose
to hold the additional money in cash. "Bond market vigilantes" is an expression referring
to the fact that expansionary monetary policy may cause long-term interest rates to
increase, instead of decreasing as intended, if bond market participants expect the
expansionary policy to increase future inflation rates.

When the central bank increases short-term interest rates, its monetary policy is best
described as:
A) contractionary.
B) accommodative.
C) expansionary.
Explanation
When the central bank increases short-term interest rates, it is attempting to decrease the
growth rate of money and credit in an economy, and policy is said to be contractionary,
restrictive, or tight. Accommodative or expansionary monetary policy attempts to increase
the growth rate of money and credit (e.g., by decreasing short-term interest rates).
Assuming the federal government maintains a balanced budget, the most likely effects of a
tax increase on government expenditures and real GDP are:
Government
Real GDP
Expenditures
A) Decrease Decrease
B) Increase Decrease
C) Increase Increase
Explanation
The amount of the spending program exactly offsets the amount of the tax increase,
leaving the budget unaffected (balanced budget). The multiplier effect is stronger for
government spending versus the tax increase. Therefore, the balanced budget multiplier
will be positive. All of the government spending enters the economy as increased
expenditure, whereas only a portion of the tax increase results in lessened expenditure
(determined by the marginal propensity to consume), because part of the tax increase will
come from the savings of the taxpayer (determined by the marginal propensity to save).

A central bank has operational independence if it can independently determine:
A) the policy rate.
B) the horizon over which to achieve its inflation target.
C) how inflation is calculated.
Explanation
A central bank is said to have operational independence if it has the authority to

determine the policy rate independently. Determining how inflation is calculated and the
time horizon for achieving its target rate of inflation refer to a central bank that has target
independence.
Which of the following statements about the demand for and supply of money is least
accurate?
A) As gross domestic product rises, the demand for money balances also rises.
As inflation rises, the demand for money by households and businesses also
B)
rises.
C) As the interest rate rises, the supply of money also rises.
Explanation
The supply of money is determined by the monetary authorities and is not affected by
changes in interest rates. Thus, the supply of money curve is vertical.
Which of the following is determined by the equilibrium between the demand for money
and the supply of money?
A) Interest rate.
B) Money supply.
C) Inflation rate.
Explanation
Interest rates are determined by the equilibrium between money supply and money
demand.
Compared to the costs of inflation that is unexpected, costs of inflation that is correctly
anticipated are most likely to be:
A) equally severe.
B) less severe.
C) more severe.
Explanation
Costs of inflation are less severe when inflation is correctly anticipated than when inflation
is unexpected. Unexpected inflation results in wealth being transferred from lenders to
borrowers. In addition, producers might misallocate resources if they cannot determine
whether an increase in the price of their output reflects inflation or a genuine increase in
demand.
Which of the following fiscal and monetary policy scenarios is most likely to increase the size
of the public sector relative to the private sector?
A) Contractionary fiscal and monetary policy.
B) Expansionary fiscal policy and contractionary monetary policy.
C) Expansionary monetary policy and contractionary fiscal policy.
Explanation
Expansionary fiscal policy tends to expand the public sector. Contractionary monetary
policy tends to contract the private sector.

If a country's economy is growing at an unsustainably rapid rate and the central bank
decreases its target overnight interest rate, the country's:
A) expected rate of inflation is likely to decline.
B) inflation rate is likely to increase.
C) long-term rate of economic growth will increase.
Explanation
The central bank should increase target interest rates when the economy is growing at an
unsustainable (above-full-employment) level. Decreasing the target overnight rate is likely
to further increase aggregate demand and cause inflation to accelerate, which will be
detrimental to the long-term growth rate of the economy.
Which of the following statements about the demand and supply of money is most accurate?
People who are:
holding money when interest rates are lower will try to increase their money
A)
balances and, as a result, the supply of money increases.
holding money when interest rates are higher will try to reduce their money
B)
balances and, as a result, the demand for money decreases.
buying bonds to reduce their money balances will increase the demand for
C)
bonds with an associated increase in interest rates.
Explanation
Buying bonds would drive bond prices up and interest rates down. Selling bonds would
have the opposite effect; driving bond prices down and interest rates up. When interest
rates are lower, there is an excess demand for money. The supply of money is determined
by the monetary authorities.

Which of the following statements best explains the importance of the timing of changes in
discretionary fiscal policy? Changes in discretionary fiscal policy must be timed properly if
they are going to:
A) enable the government to control the money supply.
B) exert a stabilizing influence on an economy.
C) help the government achieve a balanced budget.
Explanation
Proper timing of discretional policy is needed to reduce economic instability. If timed

incorrectly, the fiscal policy change could increase rather than reduce economic instability.
Which of the following statements regarding money demand and supply is least accurate?
A) As the Fed reduces the money supply, short-term interest rates decrease.
The supply of money is determined by the monetary authority and is not

B)
affected by changes in interest rates.
C) The supply curve for money is vertical.
Explanation
As the Fed reduces the money supply, short-term interest rates increase. The other
statements concerning the demand and supply for money are true.
A central bank follows an inflation targeting monetary policy. If the permissible band is plus-
or-minus 2% around the target inflation rate, the central bank is most likely to choose a
target inflation rate of:
A) 0%.
B) 1%.
C) 3%.
Explanation
Because they consider deflation to be disruptive to an economy, central banks typically

choose inflation targets and bands that do not include a negative rate of inflation.
Which of the following is least likely a function or objective of a central bank?
A) Issuing currency.
B) Keeping inflation within an acceptable range.
C) Lending money to government agencies.
Explanation
Lending money to government agencies is not typically a function of a central bank.

Central bank functions include controlling the country's money supply to keep inflation
within acceptable levels and promoting a sustainable rate of economic growth, as well as
issuing currency and regulating banks.
A government that is implementing a contractionary fiscal policy is most likely to:
A) increase spending on public works.
B) decrease income tax rates.
C) decrease transfer payments to households.
Explanation
Decreasing spending or increasing taxes are contractionary fiscal policy actions. Increasing
spending or decreasing taxes are expansionary.
Robert Necco and Nelson Packard are economists at Economic Research Associates. ERA
asks Necco and Packard for their opinions about the effects of fiscal policy on real GDP for
an economy currently experiencing a recession. Necco states that real GDP is likely to
increase if both government spending and taxes are increased by the same amount.
Packard states that if both government spending and taxes are increased by the same
amount, there is no expected net effect on real GDP.
Are the statements made by Necco and Packard CORRECT?
Necco Packard
A) Correct Incorrect
B) Incorrect Correct
C) Incorrect Incorrect
Explanation
Necco is correct because the multiplier effect is stronger for government expenditures
versus government taxes. All of the increase in government spending enters the economy
as increased expenditure, whereas only a portion of the tax increase results in lessened
expenditure (determined by the marginal propensity to consume), because part of the tax
increase will come from the savings of the taxpayer (determined by the marginal
propensity to save). Packard is incorrect; the effect on real GDP of an increase in
government spending combined with equal increase in taxes will be positive because the
multiplier effect is stronger for government spending versus the tax increase.
If the money interest rate is measured on the y-axis and the quantity of money is measured
on the x-axis, the money supply curve is:
A) downward sloping to the lower right.
B) upward sloping to the upper right.
C) vertical.
Explanation
The money supply schedule is vertical because it is not affected by changes in the interest
rate but is determined by the monetary authorities such as the Federal Reserve System
(Fed) in the United States.
When comparing a barter economy with an economy that uses money as a medium of
exchange we would expect increased efficiencies due to a reduction in which of the
following?
A) Nominal interest rates.
B) Transaction costs.
C) The need to specialize.
Explanation
Money functions as a medium of exchange because it is accepted as payment for goods

and services. Compare this to a barter economy, where if I have goat and want an ox, I
have to find someone willing to trade. Finding someone takes time and time is costly. With
money, I can sell the goat and buy the ox. Thus, transaction costs are reduced. Having
money as a medium of exchange would not reduce the inflation rate, interest rates, or the
need to specialize in the production of those goods in which we have a comparative
advantage (low opportunity cost producer).

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Question #1 of 100 Question ID: 1377653

A) fiscal policy, but not monetary policy.

B) monetary policy, but not fiscal policy.

C) both fiscal and monetary policy.

(Study Session 4, Module 12.1, LOS 12.a)

Question #2 of 100 Question ID: 1377707

A) increased at a rate similar to the growth rate in the money supply.

B) been minimal, consistent with the slow growth in real output.

C) increased more than the growth in the money supply.

For Further Reference:

(Study Session 1, Module 3.2, LOS 3.k)

CFA® Program Curriculum, Volume 2, page 272

CFA® Program Curriculum, Volume 2, page 291

Question #3 of 100 Question ID: 1377650

A) a combination of fiscal and monetary policy.

Fiscal policy refers to actions by a government to influence economic activity through

(Study Session 4, Module 12.1, LOS 12.a)

Question #4 of 100 Question ID: 1377738

Improvements in quantitative methods have made the occurrence of recessions

B) Policy errors are inevitable due to unpredictable events.

(Study Session 4, Module 12.3, LOS 12.r)

Question #5 of 100 Question ID: 1377716

To determine whether monetary policy is expansionary or contractionary, an analyst should

compare the central bank's policy rate to the:

A) neutral interest rate.

B) target inflation rate.

(Study Session 4, Module 12.2, LOS 12.m)

Question #6 of 100 Question ID: 1377699

A) sell government securities in the open market.

B) increase currency exchange rates (cause domestic currency to appreciate).

C) set a lower price on Treasury bills and notes that it is auctioning.

For Further Reference:

(Study Session 4, Module 12.2, LOS 12.h)

CFA® Program Curriculum, Volume 2, page 291

Question #7 of 100 Question ID: 1377690

A) Sell Treasury securities, causing aggregate demand to decrease.

B) Purchase Treasury securities, causing aggregate demand to decrease.

(Study Session 4, Module 12.2, LOS 12.h)

Question #8 of 100 Question ID: 1377695

A) Requiring the banking system to tighten or loosen its credit policies.

B) Buying and selling Treasury securities in the open market.

(Study Session 4, Module 12.2, LOS 12.h)

Question #9 of 100 Question ID: 1377657

A) GDP of a country divided by its price level.

B) money supply of a country divided by its price level.

C) GDP of a country divided by its money supply.

(Study Session 4, Module 12.1, LOS 12.c)

A) Buy Treasury securities and decrease bank reserve requirements.

B) Sell Treasury securities and decrease bank reserve requirements.

C) Sell Treasury securities and increase bank reserve requirements.

If the economy is in a recession, the Fed is likely to attempt to decrease short-term

(Study Session 4, Module 12.2, LOS 12.h)

Question #11 of 100 Question ID: 1377668

A) the demand for money only.

B) the supply of money only.

C) both the demand for and supply of money.

(Study Session 4, Module 12.1, LOS 12.d)

Question #12 of 100 Question ID: 1377667

A) the interest rate is higher than its equilibrium rate.

C) the opportunity cost of holding money balances is likely to increase.