Demand management: monetary policy practice questions.

Which of the following is an example of contractionary monetary policy?

• Cutting income tax rates
• Raising the central bank's interest rate
• Increasing government spending on health
• Reducing the exchange rate

Answer: Raising the central bank's interest rate

Monetary policy is conducted by the central bank; raising the policy rate discourages borrowing and spending, reducing aggregate demand. Tax and spending changes are fiscal policy.

A savings account pays a nominal interest rate of 6% while the inflation rate is 4%. Determine the real interest rate.

• 10%
• −2%
• 1.5%
• 2%

Answer: 2%

Real interest rate = nominal interest rate − inflation rate = 6% − 4% = 2%. Adding the rates (10%) or dividing them (1.5%) are common errors.

Which of the following is an example of expansionary monetary policy?

• The central bank sells government bonds on the open market
• The government increases spending on public infrastructure
• The central bank lowers its policy interest rate
• The central bank raises the minimum reserve requirement for commercial banks

Answer: The central bank lowers its policy interest rate

Cutting the policy rate makes borrowing cheaper, stimulating consumption and investment. Selling bonds and raising reserve requirements are contractionary, and higher government spending is fiscal, not monetary, policy.

A central bank cuts its policy interest rate. Through which channel is aggregate demand most directly increased?

• Government spending rises automatically when interest rates fall
• Cheaper credit encourages households to consume and firms to invest more
• The currency appreciates, making exports more competitive
• Lower interest rates force firms to raise prices, boosting revenue

Answer: Cheaper credit encourages households to consume and firms to invest more

Lower borrowing costs stimulate interest-sensitive consumption and investment, the C and I components of AD. A rate cut tends to depreciate (not appreciate) the currency, and government spending is not set by the central bank.

A central bank operates an inflation target of 2%. Inflation is currently 5% and rising due to strong aggregate demand. Which action is most consistent with its mandate?

• Raise the policy interest rate
• Purchase long-term government bonds (quantitative easing)
• Lower the minimum reserve requirement
• Recommend that the government cut income taxes

Answer: Raise the policy interest rate

With inflation above target because of excess demand, the bank should tighten policy: a higher policy rate dampens borrowing, consumption and investment, shifting AD left. The other options would add stimulus.

Which of the following is NOT a function of a central bank?

• Acting as banker to the government
• Acting as lender of last resort to commercial banks
• Regulating the commercial banking system
• Setting the rates of income tax

Answer: Setting the rates of income tax

Tax rates are decided by the government as part of fiscal policy. The central bank's roles include banker to the government and to commercial banks, lender of last resort, bank regulation and conducting monetary policy.