ECO 4223 EXAM 2 PRACTICE
QUESTIONS WITH ANSWERS &
RATIONALES – MONEY AND FINANCIAL
MARKETS (FRACTIONAL RESERVE
BANKING, FED TOOLS, ASSET DEMAND,
STOCK/BOND VALUATION)
Fractional Reserve Banking and Money Supply (Q1–Q5)
1. In a system with fractional-reserve banking:
A. All banks must hold reserves equal to a fraction of their loans
B. All banks must hold reserves equal to a fraction of their deposits
C. Banks hold no reserves
D. Reserves equal 100% of deposits
Answer: B
Rationale: In fractional-reserve banking, banks keep only a portion of deposits as
reserves and lend out the remainder; the reserve base is deposits, not loans .
2. In a 100% reserve banking system, if a customer deposits $100 in currency
into a bank, then the money supply:
A. Increases by $100
**B.** Remains unchanged
**C.** Decreases by $100
D. Increases by more than $100
Answer: B
Rationale: Currency in circulation decreases by $100 while checkable deposits increase
by $100, leaving the total money supply unchanged .
,3. If the reserve-deposit ratio (rr) increases while the currency-deposit ratio (cr)
remains unchanged and the monetary base (B) remains unchanged, then:
A. The money supply increases
B. The money supply decreases
C. The money supply remains unchanged
D. The money multiplier increases
Answer: B
Rationale: A higher reserve ratio means banks lend out a smaller share of deposits, the
deposit multiplier decreases, and the money supply contracts .
4. If reserves in the banking system increase by $100, then under the simple
deposit creation model, when the required reserve ratio is 0.25, checkable
deposits will increase by:
A. $100
**B.** $200
C. $400
**D.** $500
Answer: C
Rationale: Simple deposit multiplier = 1/rr = 1/0.25 = 4, so $100 × 4 = $400 .
5. The monetary base consists of:
A. Currency in circulation and Federal Reserve notes
B. Currency in circulation and reserves
C. Reserves and government securities
D. Currency in circulation and checkable deposits
Answer: B
Rationale: Monetary base (high-powered money) = currency in circulation + bank
reserves .
Federal Reserve Monetary Policy Tools (Q6–Q12)
,6. To reduce the money supply, the Fed should:
A. Buy government bonds
B. Sell government bonds
C. Lower the discount rate
D. Lower the interest rate on reserves
Answer: B
Rationale: Open market sales drain reserves from the banking system, contracting the
monetary base and the money supply .
7. When the Fed conducts an open market sale, it:
A. Increases the monetary base
B. Decreases the monetary base
C. Leaves the monetary base unchanged
D. Increases reserves but decreases currency
Answer: B
Rationale: Selling securities withdraws funds from the banking system, reducing
reserves and thereby reducing the monetary base .
8. To prevent banks from using excess reserves to make loans that would
increase the money supply, the Fed could conduct an open market ______ and
______ the interest rate paid on bank reserves:
A. Sale; raise
B. Purchase; lower
C. Sale; lower
D. Purchase; raise
Answer: A
Rationale: Open market sales absorb reserves, and raising the interest rate on reserves
incentivizes banks to hold reserves rather than lend, both suppressing money creation .
9. If the Fed wishes to increase the money supply, it should:
, A. Decrease the discount rate
B. Increase the discount rate
C. Sell government bonds
D. Raise the reserve requirement
Answer: A
Rationale: A lower discount rate reduces the cost of borrowing reserves from the Fed,
encouraging lending and expanding the money supply .
10. Direct loans made by the Fed to member banks are called:
A. Discount loans
B. Federal funds loans
C. Treasury loans
D. Repurchase agreements
Answer: A
Rationale: Borrowing by banks from the Fed's discount window is called discount loans
or borrowed reserves .
11. The interest rate charged by the Federal Reserve on loans to banks is called:
A. Federal funds rate
B. Discount rate
C. Prime rate
D. Treasury rate
Answer: B
Rationale: The discount rate is the interest rate the Fed charges on loans to depository
institutions; the federal funds rate is the interbank overnight lending rate .
12. To lower the federal funds rate, the Fed should:
A. Sell government bonds
B. Buy government bonds
QUESTIONS WITH ANSWERS &
RATIONALES – MONEY AND FINANCIAL
MARKETS (FRACTIONAL RESERVE
BANKING, FED TOOLS, ASSET DEMAND,
STOCK/BOND VALUATION)
Fractional Reserve Banking and Money Supply (Q1–Q5)
1. In a system with fractional-reserve banking:
A. All banks must hold reserves equal to a fraction of their loans
B. All banks must hold reserves equal to a fraction of their deposits
C. Banks hold no reserves
D. Reserves equal 100% of deposits
Answer: B
Rationale: In fractional-reserve banking, banks keep only a portion of deposits as
reserves and lend out the remainder; the reserve base is deposits, not loans .
2. In a 100% reserve banking system, if a customer deposits $100 in currency
into a bank, then the money supply:
A. Increases by $100
**B.** Remains unchanged
**C.** Decreases by $100
D. Increases by more than $100
Answer: B
Rationale: Currency in circulation decreases by $100 while checkable deposits increase
by $100, leaving the total money supply unchanged .
,3. If the reserve-deposit ratio (rr) increases while the currency-deposit ratio (cr)
remains unchanged and the monetary base (B) remains unchanged, then:
A. The money supply increases
B. The money supply decreases
C. The money supply remains unchanged
D. The money multiplier increases
Answer: B
Rationale: A higher reserve ratio means banks lend out a smaller share of deposits, the
deposit multiplier decreases, and the money supply contracts .
4. If reserves in the banking system increase by $100, then under the simple
deposit creation model, when the required reserve ratio is 0.25, checkable
deposits will increase by:
A. $100
**B.** $200
C. $400
**D.** $500
Answer: C
Rationale: Simple deposit multiplier = 1/rr = 1/0.25 = 4, so $100 × 4 = $400 .
5. The monetary base consists of:
A. Currency in circulation and Federal Reserve notes
B. Currency in circulation and reserves
C. Reserves and government securities
D. Currency in circulation and checkable deposits
Answer: B
Rationale: Monetary base (high-powered money) = currency in circulation + bank
reserves .
Federal Reserve Monetary Policy Tools (Q6–Q12)
,6. To reduce the money supply, the Fed should:
A. Buy government bonds
B. Sell government bonds
C. Lower the discount rate
D. Lower the interest rate on reserves
Answer: B
Rationale: Open market sales drain reserves from the banking system, contracting the
monetary base and the money supply .
7. When the Fed conducts an open market sale, it:
A. Increases the monetary base
B. Decreases the monetary base
C. Leaves the monetary base unchanged
D. Increases reserves but decreases currency
Answer: B
Rationale: Selling securities withdraws funds from the banking system, reducing
reserves and thereby reducing the monetary base .
8. To prevent banks from using excess reserves to make loans that would
increase the money supply, the Fed could conduct an open market ______ and
______ the interest rate paid on bank reserves:
A. Sale; raise
B. Purchase; lower
C. Sale; lower
D. Purchase; raise
Answer: A
Rationale: Open market sales absorb reserves, and raising the interest rate on reserves
incentivizes banks to hold reserves rather than lend, both suppressing money creation .
9. If the Fed wishes to increase the money supply, it should:
, A. Decrease the discount rate
B. Increase the discount rate
C. Sell government bonds
D. Raise the reserve requirement
Answer: A
Rationale: A lower discount rate reduces the cost of borrowing reserves from the Fed,
encouraging lending and expanding the money supply .
10. Direct loans made by the Fed to member banks are called:
A. Discount loans
B. Federal funds loans
C. Treasury loans
D. Repurchase agreements
Answer: A
Rationale: Borrowing by banks from the Fed's discount window is called discount loans
or borrowed reserves .
11. The interest rate charged by the Federal Reserve on loans to banks is called:
A. Federal funds rate
B. Discount rate
C. Prime rate
D. Treasury rate
Answer: B
Rationale: The discount rate is the interest rate the Fed charges on loans to depository
institutions; the federal funds rate is the interbank overnight lending rate .
12. To lower the federal funds rate, the Fed should:
A. Sell government bonds
B. Buy government bonds
