MEcon Master of Economics Master of Economics: Money, Banks, and Interest Rates 5 â Questions and Answers
Question 1: The 'shadow banking system' refers to:
- Illegal underground lending networks operating outside regulation
- Non-bank financial intermediaries that perform bank-like functions without deposit insurance or central bank access (Correct answer)
- Central bank off-balance-sheet facilities used during crises
- Government-sponsored enterprises such as Fannie Mae and Freddie Mac exclusively
Correct answer: Non-bank financial intermediaries that perform bank-like functions without deposit insurance or central bank access
Shadow banksâmoney market funds, repo markets, securitization vehiclesâchannel credit like traditional banks but lack prudential oversight and emergency liquidity backstops.
Question 2: A bank faces a duration mismatch when:
- Its loans and deposits have the same maturity
- Its long-term assets are funded by short-term liabilities, creating interest rate and liquidity risk (Correct answer)
- Its capital buffer equals its risk-weighted assets
- Its reserve holdings exceed required levels by a large margin
Correct answer: Its long-term assets are funded by short-term liabilities, creating interest rate and liquidity risk
Duration mismatchâborrowing short and lending longâexposes banks to rising interest rates (reducing asset values) and liquidity crises if short-term funding is withdrawn.
Question 3: Under a currency board arrangement, a country's monetary base is fully backed by foreign exchange reserves. What monetary policy tool does this eliminate?
- Open market operations in domestic securities (Correct answer)
- Foreign exchange interventions
- Setting deposit insurance limits
- Regulating commercial bank capital ratios
Correct answer: Open market operations in domestic securities
A currency board must hold foreign reserves equal to the entire monetary base, so it cannot conduct domestic open market operations to adjust money supply independently.
Question 4: The 'money neutrality' proposition in classical economics asserts that:
- Changes in the money supply affect only nominal variables, not real output or employment in the long run (Correct answer)
- Central banks should set a fixed money growth rule to prevent inflation
- Interest rates are unaffected by monetary policy in equilibrium
- Money supply and price level are negatively correlated over time
Correct answer: Changes in the money supply affect only nominal variables, not real output or employment in the long run
Classical money neutrality holds that doubling the money supply doubles prices but leaves real quantitiesâoutput, employment, relative pricesâunchanged in the long run.
Question 5: A repurchase agreement (repo) is best described as:
- A long-term bond issued by governments to repurchase outstanding debt
- A short-term collateralized borrowing in which securities are sold with an agreement to repurchase them at a higher price (Correct answer)
- A central bank program to buy back its own liabilities from commercial banks
- A contract allowing banks to replace non-performing loans with Treasury securities
Correct answer: A short-term collateralized borrowing in which securities are sold with an agreement to repurchase them at a higher price
In a repo, a borrower sells securities (usually Treasuries) to a lender overnight or short-term and agrees to buy them back at a slightly higher price, effectively paying interest.
Question 6: The Taylor Rule provides a prescription for the central bank policy rate based on:
- The ratio of M2 to gold reserves
- Deviations of inflation from target and output from potential (Correct answer)
- The trade balance and exchange rate gap
- The growth rate of commercial bank credit
Correct answer: Deviations of inflation from target and output from potential
The Taylor Rule recommends raising the policy rate when inflation exceeds target or output exceeds potential, and cutting it when the gaps run in the opposite direction.
Question 7: Which phenomenon occurs when nominal interest rates cannot fall below zero (or a slightly negative floor), limiting a central bank's ability to stimulate a depressed economy?
- Hyperinflation spiral
- Zero lower bound (ZLB) / effective lower bound constraint (Correct answer)
- Crowding-out effect
- Velocity trap
Correct answer: Zero lower bound (ZLB) / effective lower bound constraint
At the ZLB, conventional rate cuts are exhausted, forcing central banks to use unconventional tools like QE or forward guidance to provide additional stimulus.
MEcon Master of Economics Master of Economics: Money, Banks, and Interest Rates 5
The 'shadow banking system' refers to: