Unit 4 · 18 to 23% of the exam

Unit 4 practice test: Financial Sector

twelve questions, every option explained

12 exam-style questions from the unit, free, with an explanation for every option. Most are multiple choice, as on the real exam; a few ask for a number or have you shift a curve on a graph, and sets share one data table, graph or scenario. Covers: Financial Assets; Nominal v. Real Interest Rates; Definition, Measurement, and Functions of Money; Banking and the Expansion of the Money Supply; The Money Market; Monetary Policy; The Loanable Funds Market.

Start at question 1

Scenario

Three places for $5,000 of savings

Dana has saved $5,000 from a summer job and is weighing three choices: keep it in a checking account that pays almost no interest, buy a bond issued by a large company that pays a fixed 5% a year for ten years, or buy shares of stock in a young technology company whose price has swung up and down a lot.

1. Which of Dana's choices is the most liquid?

  1. The checking account
  2. The company bond
  3. The technology stock
  4. The three are equally liquid
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Liquidity is how easily an asset becomes spendable money without losing value. Money itself is the most liquid asset.

  • Correct: The checking account: Right: checking deposits can be spent right away, at full value, so they are the most liquid.
  • The company bond: A bond must be sold first, and its price may have changed, so it is less liquid than a checking deposit.
  • The technology stock: Stock must be sold first and its price swings, so it is less liquid than a checking deposit.
  • The three are equally liquid: They differ: money in checking is spendable at once, while the bond and stock must be sold at an uncertain price.

2. If Dana buys the company bond, what is she doing?

  1. Buying part ownership of the company
  2. Opening a deposit at the company
  3. Paying the company for future goods
  4. Lending money to the company
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A bond is an IOU: the issuer borrows and promises fixed interest payments and repayment at the end.

  • Buying part ownership of the company: Ownership is what a share of stock gives. A bond is a loan.
  • Opening a deposit at the company: Companies do not take deposits; banks do. A bond is a loan to the company.
  • Paying the company for future goods: A bond buys no goods. It is a promise to repay borrowed money with interest.
  • Correct: Lending money to the company: Right: a bond is a loan; the company promises to pay interest and repay the amount borrowed.

3. Why might the technology stock offer Dana a higher expected return than the checking account?

  1. Its return is guaranteed by the company
  2. It carries more risk, so buyers want more return
  3. It is more liquid than a checking account
  4. Its price can rise but not fall
Show the answer

Assets trade off liquidity, risk and return: a riskier, less liquid asset has to offer a higher expected return to attract buyers.

  • Its return is guaranteed by the company: Stock returns are not promised; the company owes stockholders no fixed payment.
  • Correct: It carries more risk, so buyers want more return: Right: savers take on a risky asset when they expect to be paid more for the risk.
  • It is more liquid than a checking account: Stock is less liquid than checking. Higher return comes with more risk, not more liquidity.
  • Its price can rise but not fall: The scenario says its price swings both ways; that risk is why its expected return is higher.

4. A year after Dana buys the bond, interest rates on new company bonds rise to 7%. What happens to the market price of Dana's bond?

  1. It rises, since rates on bonds went up
  2. It stays the same, since her payment is fixed
  3. It falls, since new bonds pay more
  4. It falls, since the company now pays her less
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A rise in market interest rates lowers the price of existing bonds that pay a lower fixed rate.

  • It rises, since rates on bonds went up: Higher rates on new bonds make Dana's 5% bond less attractive, so its price falls.
  • It stays the same, since her payment is fixed: Her payment is fixed, so her bond's price has to fall for a buyer to earn the new, higher rate.
  • Correct: It falls, since new bonds pay more: Right: a buyer can get 7% elsewhere, so they pay less than she did for her 5% bond.
  • It falls, since the company now pays her less: The company still pays her 5% a year; the price falls because new bonds pay more.

Scenario

Limited reserves and rising prices in Pell

The invented country of Pell has a central bank that operates with limited reserves: banks hold few reserves beyond what is required, so the amount of reserves sets the money supply. Pell's economy is producing above full employment, and the price level is rising quickly.

5. Pell's central bank uses an open market operation to close the inflationary gap. Which operation should it use, and what does it do to bank reserves?

  1. Buy government bonds, which adds reserves
  2. Sell government bonds, which adds reserves
  3. Sell government bonds, which drains reserves
  4. Buy government bonds, which drains bank reserves
Show the answer

With limited reserves, selling bonds is contractionary: it lowers reserves and the money supply, raising interest rates.

  • Buy government bonds, which adds reserves: Buying bonds does add reserves, but more reserves raise the money supply and push AD and prices higher: expansionary.
  • Sell government bonds, which adds reserves: Selling is the right operation, but banks pay for the bonds with reserves, so reserves fall, not rise.
  • Correct: Sell government bonds, which drains reserves: Right: banks pay for the bonds with reserves, so reserves and the money supply fall and interest rates rise.
  • Buy government bonds, which drains bank reserves: The central bank pays for bonds it buys with new reserves, so buying adds reserves, and it is expansionary.

6. After the bond sale, what happens to Pell's price level and real output in the short run?

  1. Both fall
  2. Both rise
  3. The price level falls and real output rises
  4. Neither changes, because the money supply is not part of AD
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Contractionary monetary policy raises interest rates, lowers interest-sensitive spending and shifts AD left, lowering the price level and real output.

  • Correct: Both fall: Right: higher interest rates cut investment and consumption, so AD shifts left; the price level and real output fall.
  • Both rise: Higher interest rates reduce spending, so AD falls, not rises.
  • The price level falls and real output rises: A leftward shift of AD lowers both, not just the price level.
  • Neither changes, because the money supply is not part of AD: The money supply works through interest rates, which change investment and consumption, parts of AD.

7. What happens to the prices of existing bonds in Pell after the central bank sells bonds?

  1. They rise, because bonds are in demand
  2. They fall, as interest rates rise
  3. They do not change, because bonds are not money
  4. They rise, because interest rates rise
Show the answer

A central bank sale of bonds lowers bond prices and raises interest rates.

  • They rise, because bonds are in demand: The central bank is adding bonds to the market, which pushes prices down.
  • Correct: They fall, as interest rates rise: Right: selling bonds pushes bond prices down, which is the same as interest rates rising.
  • They do not change, because bonds are not money: The money supply falls through the bond sale itself, which lowers bond prices.
  • They rise, because interest rates rise: Bond prices move opposite to interest rates.

8. A lender wants a real interest rate of 2% and expects inflation of 4%. What nominal interest rate should it charge, in percent?

Type a number (%). A four-function calculator is allowed, as on the exam.

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Nominal = real + expected inflation rate: 2+4=6%2 + 4 = 6\%.

  • Answer: 6 %

9. On a commercial bank's balance sheet, which of these is a liability?

  1. Its customers' checkable deposits
  2. The loans it has made
  3. Its reserves at the central bank
  4. The government bonds it holds
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Assets are what the bank owns or is owed (reserves, loans, bonds); liabilities are what it owes (deposits).

  • Correct: Its customers' checkable deposits: Right: the bank owes deposits to its customers on demand.
  • The loans it has made: Loans are assets: borrowers owe the bank.
  • Its reserves at the central bank: Reserves are assets the bank owns.
  • The government bonds it holds: Bonds the bank owns are assets: the government owes the bank.

10. A bond pays $60 of interest a year. Hana buys it for $1,200. What interest rate does she earn on what she paid, in percent?

Type a number (%). A four-function calculator is allowed, as on the exam.

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Divide the yearly payment by the price paid: 601200×100=5%\frac{60}{1200} \times 100 = 5\%.

  • Answer: 5 %

11. A central bank that operates with limited reserves buys $20 million of government bonds from commercial banks. The required reserve ratio is 0.2. What is the most the money supply can increase, in millions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

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Banks receive $20 million of new reserves with no new deposits, so all of it is excess. Money multiplier = 1 / 0.2 = 5, so the most the money supply can grow is $20 million x 5 = $100 million.

  • Answer: 100

12. What does liquidity measure?

  1. How much interest an asset pays each year
  2. How likely an asset is to lose value
  3. How easily an asset becomes money without losing value
  4. How many people own the asset
Show the answer

Liquidity is the ease of turning an asset into money, the medium people spend, without a loss in value.

  • How much interest an asset pays each year: That is its return. Liquidity is about turning an asset into money.
  • How likely an asset is to lose value: That is risk. Liquidity is about how easily it becomes spendable money.
  • Correct: How easily an asset becomes money without losing value: Right: money is perfectly liquid; a house is far less so.
  • How many people own the asset: Ownership counts are not liquidity. Liquidity is about converting the asset to money.