Monetary Policy: 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
Price stability can be said to occur if the measured value of the consumer prices index (CPI) is unchanged during the year.
Which statement is correct?
Answer: D.
The correct answer is D: different weightings of items used in the calculation of CPI mean that price stability can occur in many ways.
The CPI is a weighted average. Each item in the basket carries a weight reflecting its share of typical household spending, so a price change in a heavily weighted item moves the index far more than the same percentage change in a lightly weighted one. An unchanged index therefore does not require unchanged prices: a large rise in a small-weight item can be offset by a small fall in a large-weight item, and countless such combinations produce the same overall figure.
Why the other options are wrong:
The CPI is a weighted average. Each item in the basket carries a weight reflecting its share of typical household spending, so a price change in a heavily weighted item moves the index far more than the same percentage change in a lightly weighted one. An unchanged index therefore does not require unchanged prices: a large rise in a small-weight item can be offset by a small fall in a large-weight item, and countless such combinations produce the same overall figure.
Why the other options are wrong:
- A demands that no individual price changes. That would produce a stable index but is not necessary for one, it confuses a sufficient condition with a required one.
- B counts the number of items rising and falling. This ignores weights entirely, which is exactly what the question is testing. Two hundred small-weight rises can be outweighed by one large-weight fall.
- C denies that offsetting changes can produce stability, when offsetting changes are precisely how a stable index normally arises in practice.
Question 2
A country has a floating exchange rate. Its current account on the balance of payments moves from a surplus to a deficit.
Which rate is likely to increase in the short run as a consequence of this worsening of its current account?
Answer: D.
The correct answer is D: the unemployment rate.
Net exports are a component of aggregate demand. When the current account moves from surplus to deficit, exports have weakened relative to imports, so net exports fall and aggregate demand shifts inward. Domestic firms, particularly exporters and those competing with imports, face fewer orders, cut output and shed workers. Unemployment therefore rises in the short run.
Why the other options are wrong:
Net exports are a component of aggregate demand. When the current account moves from surplus to deficit, exports have weakened relative to imports, so net exports fall and aggregate demand shifts inward. Domestic firms, particularly exporters and those competing with imports, face fewer orders, cut output and shed workers. Unemployment therefore rises in the short run.
Why the other options are wrong:
- A, the economic growth rate, falls rather than rises. Lower aggregate demand means slower output growth.
- B, the exchange rate, is likely to fall. Under a floating system a current account deficit means more of the domestic currency is being sold to buy imports than is being bought to purchase exports, so the currency depreciates. This is the strongest distractor, and getting it right depends on remembering which way the currency flows move.
- C, the interest rate, need not change. A central bank might raise rates to defend the currency, but with a floating exchange rate there is no obligation to do so, and weak demand would argue for lower rates.
Question 3
A government wants to use an expansionary monetary policy. What should the government increase?
Answer: D.
The correct answer is D) the money supply.
Explanation:
1. Expansionary monetary policy aims to stimulate economic growth by increasing the money supply in the economy, which can lead to lower interest rates, increased borrowing, and higher levels of investment and consumption.
2. Increasing credit regulations (option A) would be a contractionary measure, as it would restrict the availability of credit to borrowers, leading to a decrease in spending and economic activity.
3. Increasing the exchange rate (option B) typically involves a central bank intervening in the foreign exchange market to strengthen the domestic currency relative to other currencies. While a stronger currency can have some benefits, such as making imports cheaper, it is not typically a primary tool used in expansionary monetary policy.
4. Increasing the interest rate (option C) is a contractionary measure as it makes borrowing more expensive, which can reduce investment and consumption in the economy. Expansionary monetary policy usually involves lowering interest rates to encourage borrowing and spending.
Therefore, the government should increase the money supply (option D) to implement an expansionary monetary policy.
Explanation:
1. Expansionary monetary policy aims to stimulate economic growth by increasing the money supply in the economy, which can lead to lower interest rates, increased borrowing, and higher levels of investment and consumption.
2. Increasing credit regulations (option A) would be a contractionary measure, as it would restrict the availability of credit to borrowers, leading to a decrease in spending and economic activity.
3. Increasing the exchange rate (option B) typically involves a central bank intervening in the foreign exchange market to strengthen the domestic currency relative to other currencies. While a stronger currency can have some benefits, such as making imports cheaper, it is not typically a primary tool used in expansionary monetary policy.
4. Increasing the interest rate (option C) is a contractionary measure as it makes borrowing more expensive, which can reduce investment and consumption in the economy. Expansionary monetary policy usually involves lowering interest rates to encourage borrowing and spending.
Therefore, the government should increase the money supply (option D) to implement an expansionary monetary policy.
Question 4
A government wants to operate a tighter monetary policy.
What would it increase?
Answer: B.
The correct answer is B: the interest rate.
Tighter monetary policy means restraining the growth of demand through the monetary channel, and the standard instrument is a higher interest rate. Raising rates increases the cost of borrowing for households and firms and increases the reward for saving, so consumption and investment fall and aggregate demand growth slows.
Why the other options are wrong:
Tighter monetary policy means restraining the growth of demand through the monetary channel, and the standard instrument is a higher interest rate. Raising rates increases the cost of borrowing for households and firms and increases the reward for saving, so consumption and investment fall and aggregate demand growth slows.
Why the other options are wrong:
- A, a budget surplus, is fiscal policy. Running a surplus is contractionary and would tighten policy overall, but it operates through taxation and government spending, not through money and credit.
- C, the money supply, is the wrong direction. Tighter monetary policy reduces the money supply; increasing it is expansionary.
- D, rates of taxation, is again fiscal policy rather than monetary.
Question 5
An economy is experiencing a period of deflation.
What must be happening?
Answer: A.
The correct answer is A: the average price level is falling.
Deflation is defined as a sustained fall in the general price level, a negative inflation rate. That is the whole content of the term, so it is the only thing that must be happening.
Why the other options are wrong:
Deflation is defined as a sustained fall in the general price level, a negative inflation rate. That is the whole content of the term, so it is the only thing that must be happening.
Why the other options are wrong:
- B, falling output, often accompanies deflation but is not required. Prices can fall because of a favourable supply shock, a technology improvement or a collapse in commodity prices, while output continues to grow. That is "good" deflation.
- C, a falling rate of inflation, is disinflation, not deflation. This is the most important distinction in the question: if inflation falls from 5% to 2%, prices are still rising, just more slowly. Deflation requires the rate to be below zero.
- D, the real value of money falling, is exactly backwards. When prices fall, a given sum of money buys more goods, so the real value, the purchasing power, of money rises. This is why deflation encourages people to postpone purchases and hold cash, which can deepen a downturn.
What this practice covers
These questions are drawn from past CIE 9708 papers and filtered to monetary policy. 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 monetary policy, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- “Monetary policy means only changing interest rates.”
- “A lower interest rate always increases borrowing.”
- “The central bank sets every interest rate in the economy.”
- “More money automatically creates the same percentage increase in real output.”
- “Expansionary monetary policy shifts LRAS right.”
- “Contractionary policy lowers all prices.”
- “Devaluation is always a monetary-policy tool.”
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Monetary Policy revision notes.