AP Macro 4.5 Money Market Quiz

What happens to the demand for money when the interest rate increases?

• It increases because people prefer to hold more money.

• It decreases because people prefer to invest in interest-bearing assets.

• It remains unchanged because interest rates do not affect money demand.

• It fluctuates unpredictably.

Answer explanation

When interest rates increase, the opportunity cost of holding money rises, leading people to prefer investing in interest-bearing assets instead. Thus, the demand for money decreases.

Which of the following best describes the supply of money in an economy?

• It is determined by the central bank and is fixed in the short term.

• It is determined by the demand for money and fluctuates daily.

• It is determined by the interest rate and varies with it.

• It is determined by the government budget and fiscal policy.

Answer explanation

The supply of money is primarily controlled by the central bank, which sets monetary policy. In the short term, this supply is relatively fixed, making the first choice the best description of money supply in an economy.

How does an increase in the money supply typically affect interest rates in the short run?

• Interest rates increase because there is more money available.

• Interest rates decrease because there is more money available.

• Interest rates remain unchanged because money supply does not affect them.

• Interest rates fluctuate unpredictably.

Answer explanation

An increase in the money supply means more money is available for lending, which typically leads to lower interest rates in the short run as banks have more funds to lend and compete for borrowers.

Explain how the money market reaches equilibrium.

• When the demand for money equals the supply of money, the interest rate adjusts to bring the market to equilibrium.

• When the central bank sets the interest rate, the market automatically reaches equilibrium.

• When the government intervenes, the market reaches equilibrium.

• When inflation is zero, the market reaches equilibrium.

Answer explanation

The money market reaches equilibrium when the demand for money equals the supply of money. At this point, the interest rate adjusts to balance the two, ensuring that the market operates efficiently.

Which monetary policy tool involves the central bank buying or selling government securities to influence the money supply?

• Discount rate

• Open market operations

• Reserve requirements

• Interest on reserves

Answer explanation

Open market operations involve the central bank buying or selling government securities to directly influence the money supply, making it the correct choice. The other options relate to different aspects of monetary policy.

Analyze the impact of a decrease in reserve requirements on the money supply and interest rates.

• The money supply decreases and interest rates increase.

• The money supply increases and interest rates decrease.

• The money supply remains unchanged and interest rates decrease.

• The money supply increases and interest rates increase.

Answer explanation

A decrease in reserve requirements allows banks to lend more, increasing the money supply. This increase typically leads to lower interest rates as more money is available for borrowing, making the correct choice: the money supply increases and interest rates decrease.

According to the liquidity preference theory, why do people hold money?

• For speculative purposes only.

• For transactions, precautionary, and speculative purposes.

• For precautionary purposes only.

• For transactions purposes only.

Answer explanation

According to liquidity preference theory, people hold money for three main reasons: transactions (to buy goods), precautionary (to cover unexpected expenses), and speculative (to invest when opportunities arise). Thus, the correct choice is the second one.

Evaluate the effect of a central bank's decision to increase the discount rate on the economy.

• It encourages banks to borrow more, increasing the money supply.

• It discourages banks from borrowing, decreasing the money supply.

• It has no effect on the money supply.

• It directly increases inflation.

Answer explanation

Increasing the discount rate makes borrowing more expensive for banks, leading to reduced borrowing. This results in a decrease in the money supply, as banks are less likely to take loans from the central bank.

What is the relationship between interest rates and the quantity of money demanded, according to the liquidity preference theory?

• Direct relationship: as interest rates increase, the quantity of money demanded increases.

• Inverse relationship: as interest rates increase, the quantity of money demanded decreases.

• No relationship: interest rates do not affect the quantity of money demanded.

• Fluctuating relationship: it varies depending on other economic factors.

Answer explanation

According to liquidity preference theory, there is an inverse relationship between interest rates and the quantity of money demanded. As interest rates increase, holding money becomes more costly, leading to a decrease in the quantity of money demanded.

Discuss how a central bank can use open market operations to combat inflation.

• By buying government securities, increasing the money supply and reducing interest rates.

• By selling government securities, decreasing the money supply and increasing interest rates.

• By lowering the discount rate, increasing the money supply.

• By increasing reserve requirements, decreasing the money supply.

Answer explanation

To combat inflation, a central bank sells government securities, which decreases the money supply and raises interest rates. This reduces spending and borrowing, helping to control inflation.