Question 1

According to the theory of liquidity preference, what happens to the equilibrium interest rate if the central bank increases the money supply, holding money demand constant? Use the following equation to support your answer: $$M^S = M^D(r).$$

Accepted Answer

The equilibrium interest rate falls because the supply of money exceeds demand at the original rate.

Question 2

If the Bank of Canada conducts open market operations by buying government bonds, what is the immediate effect on the money supply and the interest rate in a closed economy?

Accepted Answer

Money supply increases and interest rate falls.

Question 3

Suppose the demand for money increases due to higher real GDP. What happens to the equilibrium interest rate and aggregate demand, assuming the money supply is fixed? Use the equation $$M^D = L(Y, r)$$, where $$Y is $$real GDP.

Accepted Answer

Interest rate rises and aggregate demand falls due to higher borrowing costs.

Question 4

In a small open economy with a flexible exchange rate, what is the effect of an expansionary monetary policy on the exchange rate and net exports?

Accepted Answer

The exchange rate depreciates and net exports rise.

Question 5

If the Bank of Canada wants to maintain a fixed exchange rate while expanding the money supply, what must it do in the foreign exchange market?

Accepted Answer

Buy Canadian dollars and sell foreign currency, offsetting the monetary expansion.

Question 6

Which of the following best explains why the aggregate demand curve slopes downward, according to the interest rate effect?

Accepted Answer

As the price level rises, the demand for money increases, raising interest rates and reducing investment and consumption.

Question 7

Suppose the Bank of Canada contracts the money supply in an open economy with a flexible exchange rate. What is the likely effect on the Canadian dollar and aggregate demand?

Accepted Answer

The Canadian dollar appreciates and aggregate demand falls.

Question 8

If the availability of credit cards increases, reducing the amount of cash people want to hold, what happens to the money demand curve and the equilibrium interest rate, assuming the money supply is unchanged?

Accepted Answer

Money demand shifts left and the equilibrium interest rate falls.

Question 9

Which of the following is a key argument against active monetary stabilization policy?

Accepted Answer

Monetary policy tools may affect the economy with a long lag, making stabilization difficult.

Question 10

If the world interest rate rises above the Canadian interest rate and the Bank of Canada allows the exchange rate to be flexible, what is the likely sequence of events?

Accepted Answer

Canadian assets become less attractive, the Canadian dollar depreciates, and net exports rise.

Question 11

Which equation best represents the equilibrium in the money market according to the theory of liquidity preference?

Accepted Answer

$$M^S = M^D$$

Question 12

If households decide to hold more money for holiday shopping, what is the effect on the money demand curve and the equilibrium interest rate, assuming the money supply is fixed?

Accepted Answer

Money demand shifts right and the equilibrium interest rate rises.

Question 13

In the context of monetary policy, what is the opportunity cost of holding money?

Accepted Answer

The interest rate that could be earned on alternative assets.

Question 14

Which of the following best describes the effect of a monetary injection in a closed economy?

Accepted Answer

It lowers the interest rate, increases investment and consumption, and shifts the aggregate demand curve to the right.

Question 15

Why can't the Bank of Canada simultaneously fix the exchange rate and control the money supply?

Accepted Answer

Because fixing the exchange rate requires offsetting interventions that neutralize changes in the money supply.

Question 16

Suppose the Bank of Canada wants to reduce aggregate demand by $$10$$ billion. Would it need to reduce the money supply by more in a closed economy or in an open economy with a flexible exchange rate?

Accepted Answer

More in a closed economy, because the exchange-rate effect is absent.

Question 17

Which of the following is a likely short-run effect of an increase in oil prices in a closed economy?

Accepted Answer

The money demand curve shifts right, raising the equilibrium interest rate.

Question 18

If the Bank of Canada increases the bank rate, what is the effect on commercial bank borrowing and the money supply?

Accepted Answer

Commercial banks are discouraged from borrowing, and the money supply contracts.

The Influence of Monetary Policy on Aggregate Demand

Study Guide - Practice Questions

Study Guide - Flashcards