MEcon Master of Economics Master of Economics: Money, Banks, and Interest Rates 3 — Questions and Answers
Question 1: Which interest rate does the Federal Reserve directly set as its primary policy instrument?
- The 10-year Treasury yield
- The federal funds rate (Correct answer)
- The prime lending rate
- The LIBOR rate
Correct answer: The federal funds rate
The FOMC sets a target range for the federal funds rate—the overnight rate at which depository institutions lend reserves to each other.
Question 2: A yield curve inverts when:
- Short-term rates rise above long-term rates (Correct answer)
- Long-term rates rise above short-term rates
- All maturities yield the same rate
- Real yields become negative
Correct answer: Short-term rates rise above long-term rates
An inverted yield curve occurs when short-term interest rates exceed long-term rates, often signaling an expected future decline in short rates or a recession.
Question 3: Under the fractional reserve banking system, the money multiplier in its simplest form equals:
- Required reserve ratio × monetary base
- 1 divided by the required reserve ratio (Correct answer)
- Excess reserves divided by total deposits
- The ratio of M2 to M1
Correct answer: 1 divided by the required reserve ratio
In the simple deposit multiplier model, an injection of $1 of reserves supports 1/rr dollars of deposits, where rr is the required reserve ratio.
Question 4: Credit rationing occurs in loan markets when:
- Interest rates are too low to clear the market
- Lenders supply less credit than borrowers demand even at prevailing rates due to adverse selection (Correct answer)
- Governments impose usury ceilings above market rates
- Central banks buy all available bonds
Correct answer: Lenders supply less credit than borrowers demand even at prevailing rates due to adverse selection
Stiglitz and Weiss showed that raising interest rates attracts riskier borrowers (adverse selection), so banks may ration credit rather than raise rates to clear excess demand.
Question 5: Which monetary aggregate includes currency in circulation, demand deposits, and other checkable deposits?
- M0
- M1 (Correct answer)
- M2
- M3
Correct answer: M1
M1 comprises the most liquid forms of money: physical currency held by the public plus demand deposits and other checkable deposits at depository institutions.
Question 6: If a central bank raises the interest rate on reserves (IOR), what is the expected effect on bank lending?
- Bank lending increases because banks earn more income
- Bank lending decreases because holding reserves becomes more attractive (Correct answer)
- Bank lending is unaffected because IOR applies only to required reserves
- Bank lending increases due to the wealth effect on depositors
Correct answer: Bank lending decreases because holding reserves becomes more attractive
A higher IOR raises the opportunity cost of lending by making it more profitable for banks to park funds at the central bank, reducing loan supply.
Question 7: In a negative interest rate environment, what unusual behavior does the theory predict from cash-holding consumers?
- Consumers spend more, boosting aggregate demand as intended
- Consumers convert deposits to physical cash to avoid negative deposit rates (Correct answer)
- Consumers increase savings to offset purchasing power losses
- Consumers shift entirely into equities, crashing bond markets
Correct answer: Consumers convert deposits to physical cash to avoid negative deposit rates
When deposit rates turn sufficiently negative, the zero nominal return on cash makes hoarding physical currency rational, limiting the policy's effectiveness.
MEcon Master of Economics Master of Economics: Money, Banks, and Interest Rates 3
Which interest rate does the Federal Reserve directly set as its primary policy instrument?