Money and Banking: five questions to try now
Real past-paper questions, the answer key from the mark scheme, and the explanation that goes with it. No account needed to answer them.
Question 1
In 1936 Keynes explained how economic policy can be used to increase aggregate demand and prevent an economic depression.
Which policy supports Keynes’ theory?
Answer: B.
Keynes's argument in 1936 was that in a depression private spending will not revive on its own, because firms will not invest while demand is weak and households will not spend while incomes are falling, so the government must add to demand itself. Increasing expenditure and cutting taxation does that from both sides at once, and the multiplier makes the eventual rise in income larger than the initial injection. Raising interest rates and reducing liquidity is contractionary and would deepen the depression, which is the opposite of the prescription. Encouraging consumer saving rather than expenditure is the paradox of thrift: it may be prudent for one household but if everyone does it, spending falls, incomes fall, and total saving need not rise at all, which is one of Keynes's central points. Preventing the free movement of capital is a policy about international finance rather than about the level of domestic demand, and it does nothing to put spending into the circular flow.
Question 2
In the Quantity Theory of Money equation, MV = PT, V is defined as the income velocity of circulation. Which change would tend to reduce the value of V?
Answer: A.
Velocity measures how many times each unit of money is spent in a year, so anything that leaves people holding LARGER average money balances slows it down. Being paid monthly instead of weekly does exactly that: a worker paid once a month receives a bigger sum and holds much of it idle for weeks before spending it, so average balances rise and each dollar turns over less often. V falls, which is A. The other three all speed money up. Higher interest rates raise the opportunity cost of holding money, so people keep less of it and spend or lend more quickly. Cash machines let people draw money as they need it instead of holding a buffer, again cutting balances. Credit cards let purchases be made without holding money at all. All three raise V rather than reducing it.
Question 3
The central bank of a country creates cash to purchase government bonds from the commercial banks. What is this called?
Answer: B.
Quantitative easing is the creation of new central bank money to buy assets, usually government bonds, from banks and other financial institutions. The purpose is to raise the price of those bonds and so push their yields down, which lowers longer-term interest rates that conventional policy reaches only indirectly, and to leave the banks holding reserves rather than bonds in the hope that they lend more. The description in the stem, cash created to purchase government bonds from commercial banks, is that policy exactly. Liquidity preference is Keynes's theory of why people choose to hold money rather than interest-bearing assets, so it explains the demand for money rather than naming an action by a central bank. The transmission mechanism is the route by which a change in interest rates works through borrowing, spending and the exchange rate to output and prices, so it describes the consequences of policy rather than the policy. Supply-side policy acts on the economy's productive capacity through training, taxes and regulation, which is a different department of policy altogether.
Question 4
An individual’s demand curve for an active money balance will move to the left if there is an increase in the
Answer: A.
The correct answer is A) frequency of income payments.
Explanation:
According to the quantity theory of money, the demand for money is influenced by factors such as the level of income and the price level in the economy. However, the frequency of income payments directly affects the demand for money balances for transactions.
If the frequency of income payments increases, individuals will receive more money more frequently. This means they will need to hold less money in their active balances to facilitate transactions because they are receiving income more frequently. As a result, the demand for active money balances will decrease, causing the demand curve to shift to the left.
On the other hand, changes in the general price level, individual's income, or rate of interest would not directly impact the frequency of income payments and thus would not cause a shift in the demand curve for an active money balance. These factors may influence the level of the demand for money but not in the context of the frequency of income payments.
Explanation:
According to the quantity theory of money, the demand for money is influenced by factors such as the level of income and the price level in the economy. However, the frequency of income payments directly affects the demand for money balances for transactions.
If the frequency of income payments increases, individuals will receive more money more frequently. This means they will need to hold less money in their active balances to facilitate transactions because they are receiving income more frequently. As a result, the demand for active money balances will decrease, causing the demand curve to shift to the left.
On the other hand, changes in the general price level, individual's income, or rate of interest would not directly impact the frequency of income payments and thus would not cause a shift in the demand curve for an active money balance. These factors may influence the level of the demand for money but not in the context of the frequency of income payments.
Question 5
Other things being equal, what is most likely to result from an increase in a country’s interest rates?
Answer: A.
Higher interest rates make it more rewarding to hold money in that country, so funds move in from abroad seeking the better return, a capital inflow, which is A. B is the opposite of what follows: that inflow means more buyers of the currency, so it tends to APPRECIATE rather than depreciate. C and D both misread the domestic effect. Dearer borrowing and better returns on saving discourage households from spending, so consumption falls rather than rises, and they raise the cost of financing new projects while making the required rate of return harder to beat, so investment falls too. Every one of the three wrong options describes what a CUT in interest rates would do.
What this practice covers
These questions are drawn from past CIE 9708 papers and filtered to money and banking. You answer, you find out immediately whether you were right, and you get the reasoning for the correct option and for each distractor. Wrong answers go to a mistakes locker so you can come back to exactly those.
Practice is free. You need an account only so your progress and your mistakes are still there next time.
What examiners see students get wrong here
These are the errors that cost marks on money and banking, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- Saying banks lend out depositors' money one to one, missing the creation of new deposits.
- Confusing the credit multiplier with the income multiplier from 9.2.
- Using the reserve ratio the wrong way round, dividing by 10 rather than by 0.10.
- Treating the theoretical maximum as what actually happens.
- Saying QE is the central bank printing money to give to the government.
- Listing the four functions of money without explaining the double coincidence of wants.
- Confusing liquidity with profitability. The most liquid assets typically earn the least, which is precisely the trade-off a bank manages.
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Money and Banking revision notes.