Economics. 14 question(s) in this unit's pool
(2 above the exam). Free up to ten a day; the coach picks which ones based on what you have
already answered and when each is next due.
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
explanation. Questions you have already answered correctly and confidently stay out of the way until they
are due for review again.
Question 1Exam level
A central bank lowers its policy interest rate. Which of the following best describes the PRIMARY transmission mechanism through which this action affects aggregate demand?
How sure are you?
Correct: B. The primary transmission mechanism runs: lower policy rate, then lower commercial lending rates, then cheaper borrowing for businesses and consumers, then increased investment and consumption, then higher aggregate demand. Option A confuses monetary with fiscal policy. Option C confuses the tool (OMO) with the transmission mechanism from the policy rate. The question asks about the transmission, not the tool used to set the rate.
A. Option A confuses monetary with fiscal policy.
C. Option C confuses the tool (OMO) with the transmission mechanism from the policy rate. The question asks about the transmission, not the tool used to set the rate.
Unit: monetary-policy
Question 2Exam level
According to the quantity theory of money (MV = PQ), if the velocity of money (V) remains constant and the money supply (M) increases by 5%, which of the following is most likely to occur in the long run?
How sure are you?
Correct: B. In the long run, classical economists and the quantity theory assume real output (Q) is determined by real factors (capital, labor, technology) and is not permanently affected by money supply changes. Therefore, if M increases 5% and V is constant, P must increase by approximately 5%. Option A (only Q rises) is a short-run Keynesian view. Option C splits the effect. Not supported by the quantity theory's long-run assumption.
A. Option A (only Q rises) is a short-run Keynesian view.
C. You might be tempted to think that an increase in money supply evenly splits between real output and the price level, but the quantity theory of money posits that in the long run, real output is determined by real factors and is not affected by changes in the money supply, thus choice C violates this principle by suggesting real output increases.
Unit: monetary-policy
Question 3Exam level
Which monetary policy tool is most likely frequently used by central banks in developed economies to implement monetary policy?
How sure are you?
Correct: C. Open market operations (buying and selling government securities) are the PRIMARY day-to-day tool of monetary policy in developed economies like the US, UK, and Eurozone. The discount rate signals intent but open market operations are what actually moves the federal funds rate to target. Reserve requirements are rarely changed because frequent adjustments disrupt bank liquidity management. The CFA curriculum explicitly states this. This is one of the most tested exam traps: candidates assume the 'interest rate' tool is primary, but it is OMO.
A. You might be tempted by reserve requirements because they directly control bank lending, but in practice, they are rarely adjusted due to their significant impact on bank liquidity, unlike open market operations which are more frequently used to manage the money supply.
B. You might be tempted by the discount rate because it is often highlighted as a key interest rate, but it primarily serves as a signaling tool rather than the main mechanism for daily policy implementation like open market operations do.
Unit: monetary-policy
Question 4Exam level
The central bank conducts an open market purchase of government securities. Which of the following correctly describes the IMMEDIATE effect on commercial bank reserves and the policy interest rate, most likely?
How sure are you?
Correct: B. When the central bank buys government securities (open market purchase), it pays by crediting banks' reserve accounts, then bank reserves increase. With more reserves available, banks have excess liquidity, reducing the rate at which they lend to each other overnight (the policy rate / federal funds rate), then interest rates fall. This is expansionary monetary policy. The trap in option A reverses both effects; option C correctly identifies reserves increasing but wrongly says rates rise.
A. option A reverses both effects; option C correctly identifies reserves increasing but wrongly says rates rise.
C. You might be thinking that more reserves lead to higher interest rates because you associate increased reserves with higher lending costs, but this confuses the effect of excess liquidity, which actually puts downward pressure on interest rates, not upward.
Unit: monetary-policy
Question 5Harder
A central bank is described as having 'instrument independence' but not 'goal independence.' This most likely means:
How sure are you?
Correct: B. CFA curriculum distinguishes two types of central bank independence. Goal independence: the central bank sets its own inflation or other targets. Instrument independence: the central bank chooses which tools (OMO, reserve requirements, policy rate) to use to hit targets. The US Federal Reserve has both. The ECB has instrument independence; the Bank of England has instrument independence but the government (Treasury) sets the 2% inflation target. A classic exam example. Option A describes full independence (both goal and instrument). Option C is incorrect. Instrument independence is a meaningful form of independence.
A. You might be tempted by choice A if you assume the central bank has full autonomy, but choice A confuses goal independence with instrument independence, implying the central bank can set its own inflation targets, which the question specifies is not the case.
C. Option C is incorrect. Instrument independence is a meaningful form of independence.
Unit: monetary-policy
Question 6Harder
An economy is in a liquidity trap. Which of the following is MOST accurate regarding monetary policy effectiveness in this scenario?
How sure are you?
Correct: B. A liquidity trap occurs when the policy rate is near zero (zero lower bound) and further cuts are impossible. Nominal rates cannot go meaningfully below zero. At this point, money demand is perfectly elastic: individuals and banks hold any additional money as cash rather than spending or lending it, because the opportunity cost of holding cash (interest foregone) is near zero. Additional money supply injections have no effect on spending or AD. Option A is incorrect. It is precisely because rates cannot fall further that the trap exists. Option C describes a different (incorrect) mechanism. The issue is not bond supply, it is the behavioral response at near-zero rates.
A. Option A is incorrect. It is precisely because rates cannot fall further that the trap exists.
C. Option C describes a different (incorrect) mechanism. The issue is not bond supply, it is the behavioral response at near-zero rates.
Unit: monetary-policy
Question 7Exam level
The current policy rate is 1.5%. A central bank economist estimates the neutral interest rate at 3.0%. The current monetary policy stance is most likely described as:
How sure are you?
Correct: B. The neutral (natural) interest rate is the rate consistent with stable inflation and full employment. It is neither stimulative nor restrictive. When the policy rate is BELOW the neutral rate, monetary policy is EXPANSIONARY (stimulative). Borrowing is cheaper than the equilibrium rate, encouraging more investment and consumption. When above the neutral rate, policy is CONTRACTIONARY. Policy rate (1.5%) < Neutral rate (3.0%), then Expansionary stance. This is a high-frequency exam trap: candidates confuse the direction of the comparison.
A. You might be thinking that a lower rate indicates less economic stimulation, but this confuses the direction of monetary policy impact; when the policy rate is below the neutral rate, it actually encourages more spending and investment, making the policy expansionary, not contractionary.
C. Choosing C might tempt you if you confuse the neutral interest rate with the overall economy being in equilibrium, but the neutral rate specifically refers to the interest rate, not the entire economic state, so a policy rate below the neutral rate indicates an expansionary stance, not a neutral one.
Unit: monetary-policy
Question 8Exam level
A central bank raises its benchmark interest rate by 75 basis points. Which of the following most accurately describes the effect on existing fixed-rate bond prices, most likely?
How sure are you?
Correct: B. Bond prices and interest rates move inversely. When the central bank raises rates, newly issued bonds offer higher yields. Existing bonds with lower fixed coupons become less attractive by comparison. Investors demand a lower price to compensate for the below-market coupon. Mathematically, the discount rate in the bond's present value formula increases, reducing PV. This is one of the most tested exam traps at the intersection of monetary policy and fixed income. Option A confuses rate increases with higher coupon income. The coupon on existing bonds does not change. Option C ignores the market price adjustment.
A. Option A confuses rate increases with higher coupon income. The coupon on existing bonds does not change.
C. Option C ignores the market price adjustment.
Unit: monetary-policy
Question 9Exam level
Monetary policy operates with three types of lags. Which of the following correctly sequences these lags, most likely?
How sure are you?
Correct: B. The correct sequence is: (1) Recognition lag. The time it takes for policymakers to identify that the economy has changed and requires action; (2) Response lag. The time required for the central bank to deliberate, decide, and implement a policy change; (3) Transmission lag. The time it takes for the policy change to actually work through the financial system and affect real economic variables (investment, consumption, AD). These lags mean monetary policy may stimulate an already-recovering economy, potentially causing overshooting. A major limitation. Option A reverses the sequence. Option C puts response before recognition, which is impossible.
A. Choosing A might seem logical if you think the central bank acts immediately upon recognizing an economic issue, but this sequence violates the fundamental concept that policymakers first need to identify the economic problem (recognition lag) before they can respond to it, making the transmission lag the last step in the process.
C. Option C puts response before recognition, which is impossible.
Unit: monetary-policy
Question 10Exam level
Which of the following scenarios most likely represents contractionary monetary policy?
How sure are you?
Correct: B. Selling government securities (open market sale) is contractionary: banks use reserves to pay for the securities, then bank reserves decrease, then banks have less to lend, then credit tightens, then interest rates rise, then investment and consumption fall, then AD decreases. Option A (lowering reserve requirement) is EXPANSIONARY because banks are required to hold less, freeing up more funds for lending. Option C (reducing discount rate) is EXPANSIONARY because borrowing from the central bank becomes cheaper, encouraging banks to hold fewer excess reserves. All three options test the direction of policy. The most common error type on this topic.
A. Option A (lowering reserve requirement) is EXPANSIONARY because banks are required to hold less, freeing up more funds for lending.
C. Option C (reducing discount rate) is EXPANSIONARY because borrowing from the central bank becomes cheaper, encouraging banks to hold fewer excess reserves.
Unit: monetary-policy
Question 11Harder
An economy experiences stagflation (simultaneous high inflation and high unemployment). Which of the following BEST describes the challenge this poses for monetary policy?
How sure are you?
Correct: B. Stagflation (supply shock-driven inflation with high unemployment) creates an impossible dilemma for monetary policy. Raising rates fights inflation but increases unemployment further. Lowering rates reduces unemployment but worsens inflation. Monetary policy is designed to navigate the inflation-unemployment trade-off (Phillips Curve relationship), but stagflation breaks this trade-off. Both problems exist simultaneously. CFA curriculum notes this as a key limitation: monetary policy cannot address supply-side shocks (e.g., oil price spikes) without sacrificing one goal. Option A is a reasonable central bank response but is not the 'best description of the challenge.' Option C worsens inflation.
A. Option A is a reasonable central bank response but is not the 'best description of the challenge.
C. You might be tempted to choose lowering rates to boost employment, thinking it balances both issues, but this violates the principle that monetary policy actions in stagflation worsen one condition; lowering rates here would exacerbate inflation without effectively solving stagflation.
Unit: monetary-policy
Question 12Harder
Under an inflation-targeting framework, a central bank with high credibility announces it will raise rates to bring inflation from 4% back to its 2% target. Compared to a central bank with low credibility making the same announcement, inflation expectations are MOST likely to:
How sure are you?
Correct: A. Central bank credibility is a core concept in the CFA curriculum. When a central bank has a strong track record of hitting its targets, rational agents immediately adjust their inflation expectations downward upon any credible announcement. Even before the rate hike is implemented. This expectation channel is itself part of the transmission mechanism. A low-credibility central bank must actually raise rates more aggressively and for longer to achieve the same reduction in inflation because market participants do not believe the commitment. Option B ignores the critical role of expectations in modern monetary transmission. Option C has the credibility effect reversed.
B. Option B ignores the critical role of expectations in modern monetary transmission.
C. This reverses which central bank markets actually trust. Skepticism about stated intentions describes the low-credibility bank, whose track record gives the market no reason to believe the announcement without seeing rates actually rise. A high-credibility bank has already earned that trust, so its announcement alone moves expectations down immediately, without waiting for the hikes to happen, which makes its expectations fall faster, not slower.
Unit: monetary-policy
Question 13Above the exam
A central bank cuts its policy rate to near zero during a severe recession but the economy remains stagnant, with banks reluctant to lend and firms unwilling to borrow even at very low rates. Combining the concept of a liquidity trap with the tools available to monetary policy, the central bank's most likely NEXT step, if it wants to provide further monetary stimulus, is to:
How sure are you?
Correct: B. Near the zero lower bound, conventional monetary policy (adjusting a short-term policy rate) loses much of its traction, a situation described as a liquidity trap: further small rate cuts do little to induce additional borrowing or lending when demand for credit is already weak. Central banks facing this constraint have turned to unconventional tools, most notably quantitative easing, which directly purchases longer-term assets to push down longer-term yields and inject liquidity into the financial system through a different channel than the short-term policy rate.
A. Conventional rate cuts do NOT remain fully effective without limit; that is exactly what a liquidity trap describes, additional cuts near zero have sharply diminishing effect on lending and borrowing behavior, which is why central banks turn to other tools rather than simply continuing to cut.
C. Raising reserve requirements forces banks to hold MORE reserves and lend LESS, which is a contractionary, not expansionary, tool; it moves in exactly the wrong direction for a central bank trying to stimulate a stagnant economy.
Unit: monetary-policy
Question 14Above the exam
A central bank's policy rate decisions operate with an 'impact lag' before they affect the real economy. Inflation is currently at target, but leading indicators suggest a significant inflationary surge is likely in 18 months given current loose policy. Combining the concept of policy lags with a forward-looking approach to monetary policy, the central bank's most likely appropriate action today is to:
How sure are you?
Correct: B. Monetary policy operates with recognition, decision, and impact lags; by the time a policy change takes effect, months may have passed. A central bank that waits until inflation has already surged before tightening will see its tightening take effect only well after the surge has already done damage. Forward-looking policy therefore acts on reliable LEADING signals of future inflation now, so that the delayed impact of today's action arrives roughly when the anticipated problem would otherwise hit.
A. Reacting only to current, at-target inflation ignores the policy lag problem entirely: if the bank waits for inflation to actually appear in the data before acting, its own policy response will not take effect until well after that, compounding rather than containing the surge.
C. Waiting until the surge has already materialized guarantees that the policy's own impact lag pushes its effect even further out, past the point where it would have been most useful; forward-looking action specifically exists to counter this timing problem.