than the long-run full employment level and therefore places the current

state of the economy in a recessionary gap.

223. (E) The full employment level of real GDP occurs at the point where
the long-run aggregate supply curve intersects with the horizontal access.
This point represents the level of real GDP that is equivalent to its potential
output.
224. (E) Any increase in the determinants of aggregate demand (C + I + G
+ Xn) will cause a shift of AD to the right. Consumption increasing will
cause GDP to rise as shown by aggregate demand shifting to the right.
225. (C) As aggregate demand shifts left along the short-run aggregate
supply, the general price level (inflation) will decrease and GDP will
decrease, causing the level of unemployment to increase.
226. (E) Choice (E) is correct. This chart shows the classical section of the
AD−AS graph. Increases in demand won’t increase output or employment
any further.
227. (C) Choice (C) is correct. Aggregate supply is vertical when the
economy is at full employment and maximum output because neither
variable can increase further.
228. (B) Choice (B) is the best answer. Keynesian policies can make output
move along the aggregate supply curve by reducing unemployment or
increasing consumption, but shifting the curve requires an increase in the
economy’s production capacity. This could be done through infrastructure
investments.
229. (C) Choice (C) is the best answer. Higher raw material prices reduce
aggregate supply.
230. (A) Choice (A) is correct. This situation will result in an inflationary
gap.

Chapter 4: The Financial Sector

231. (B) Choice (B) is correct. Money is an effective medium of exchange
because it is always accepted as payment, while a merchant might not
accept other goods or services in trade.
232. (B) Choice (B) is correct. M1 money refers to all coins and paper
currency and all money in checking accounts (checkable deposits). This is
the most readily available form of money. Choices (A), (C), and (D) are part
of M2 money.
233. (D) Choice (D) is correct. A bond represents a debt from the issuer to
the person to whom the bond is made. People buy U.S. bonds, and the
government promises to pay back that money plus interest after a certain
period of time.
234. (C) The M1 measure of the money supply is defined as currency in
circulation, traveler’s checks, and checkable deposits.
235. (C) The M2 measure of the money supply is defined as everything that
is a part of M1, certificates of deposit, savings accounts, and money market
mutual funds. Therefore, as currency held by consumers is a part of M1, it
is also a part of M2.
236. (B) Choice (B) is the best answer because checkable deposits are part
of the M1 money supply: money that is the most liquid and easily
accessible. Therefore, M1 would increase and M2 would remain the same.
237. (C) Choice (C) is correct. The money used in the United States is
backed and supported by the U.S. government. The United States does not
have a gold standard anymore as in Choice (D), nor is it backed by valuable
land as in Choice (B). Money has value because the U.S. government
decrees it does.
238 (A) Choice (A) is correct. The long-run aggregate supply curve is
vertical in the long run. The long run represents enough time for producers
to make adjustments to production and workers’ wages to adjust to real
wages. All other choices will have an effect on real GDP.
239. (B) Choice (B) is correct. There is an inverse relationship between the
price of bonds and the established interest rate. This is so because if you
bought a bond for $100 with a 5 percent interest rate and the interest rate
drops to 4 percent over the next few years, then you lost a 1 percent value
on that bond.
240. (A) Choice (A) is correct. The Federal Open Market Committee
(FOMC) is part of the Federal Reserve System where a board of governors
meets to decide monetary policy. They decide to either increase or decrease
the money supply by buying/selling government securities or
raising/lowering interest rates.
241. (A) Choice (A) is correct. Higher interest rates would discourage the
use of credit.
242. (A) The Federal Reserve System utilizes monetary policy to control
the money supply and stimulate the economy. In order to decrease or
increase the money supply, a main tool of the Fed is to buy and sell
government securities from commercial banks. Choices (B), (C), (D), and
(E) are all functions of the Fed, but Choice (A) is the most significant.
243. (E) Choice (E) is correct. M1 money refers to all coins and paper
currency and all money in checking accounts (checkable deposits). The
most significant characteristic of M1 money is that it is held by the public.
Institutions like the federal government and the Fed would not be a part of
M1 money supply.
244. (D) The money creation process is mainly controlled by banks through
their ability to loan to businesses and consumers. This does not print more
money, but simply allows more people to access the available currency in
circulation, creating more spending and saving.
245. (B) Choice (B) is correct. If interest rates increase, more money is
required to pay back loans, from mortgage payments on a house to
everyday purchases with a credit card. This would constrict the money
supply, and the demand for money would decrease.
246. (A) Open market operations are one of three tools available to the
central bank with which it can influence the economy by buying and selling
treasury securities in the bond market. This process makes more or less
currency available in the money market, which influences interest rates and,
as a result, also rates of investment. They can also change the required
reserve ratio (RRR) and increase or decrease the discount rate.
247. (C) A bank’s total reserves are the actual amount the bank has on hand
in its vaults and any money on reserve at the Fed. Choice (C) is the best
answer because it calculates the bank’s cash and money on reserve at the
Fed. All other choices are miscalculations.
248. (A) Choice (A) is correct. Remember that money is created through
debt. If a loan is made to an individual for $5,000, then the bank created
that amount of money into the money supply. Leo’s initial deposit would
only increase the M1 money supply.
249. (B) The central bank requires commercial banks to “reserve” a
percentage of their checkable deposits. The bank is then allowed to lend out
the remainder in order to create profits for the bank through interest on
those loans, as well as helping currency to circulate through the economy.
This process is called fractional reserve banking.
250. (C) A major problem of banks that led to the Great Depression was the
lack of monitoring and influence by the government. Requiring banks to
have a percentage of their money on reserve is a method of controlling and
influencing the banks. Choice (C) is the best answer.
251. (A) Choice (A) is correct. One of the main and most significant goals
of monetary policy instituted by the Federal Reserve Bank is to help the
economy grow or contract based on the current state of the economy. The
economy goes through a business cycle: expansion, peak, contraction,
trough, and recovery. Varying the money supply (to help the economy grow
or contract) is a valuable tool of the Federal Reserve.
252. (C) Choice (C) is correct. M1 money refers to all coins and paper
currency and all money in checking accounts (checkable deposits).
253. (A) Choice (A) is correct. M2 money is M1 money plus savings, time-
related deposits, and noninstitutional money market funds.
254. (A) Choice (A) is correct. The money from S1 to S2 represents a
decrease in the money supply. Any answer that references an increase
should be eliminated. When the money supply decreases, the Fed is
instituting a tight money policy, which would contract the economy. One
significant way to implement this is for the Fed to purchase government
securities.
255. (C) Choice (C) is the best answer because usually the Fed institutes a
contractionary monetary policy as a way to battle inflation. If prices are too
high, then the money supply is too high; therefore, the Fed should reduce
the money supply to combat inflation.
256. (D) Choice (D) is correct. Transactions demand and asset demand
comprise the two components for the demand for money. Transactions
demand is money kept for purchases and has a direct relationship with the
GDP; asset demand is money kept for a store of value for later use and is
inversely related with the GDP.
257. (A) Choice (A) is correct. A stock is a certified piece of paper that
represents a claim of ownership in a business.
258. (A) Choice (A) is correct. A bond represents a debt from the issuer to
the person to whom the bond is made. People buy U.S. bonds, and the
government promises to pay back that money plus interest after a certain
period of time.
259. (B) Choice (B) is correct. The Federal Reserve Bank is responsible for
maintaining the money supply for the United States. The federal
government controls fiscal policy, which involves taxes and government
spending and borrowing.
260. (A) To calculate the money multiplier: 1/RR or 1/0.1 = 10. Then 10 ×
$500 = $5,000. You must then subtract Jack’s original $500, as it was
already in circulation and was not part of the new money created.
Therefore, $5,000 – $500 = $4,500 in new money created.
261. (B) Choice (B) is the best answer because a unit of account is money
being used as a standard of measurement for the value and/or cost of goods
and services.
262. (E) Choice (E) is the best answer because a medium of exchange is an
intermediary used in the exchange of goods and services, such as paper
money.
263. (C) The Federal Reserve System is responsible for implementing
monetary policy. Choices (A), (B), (D), and (E) are all facets of monetary
policy, whereas Choice (C) refers to tax rates, which is part of fiscal policy
and is implemented by the federal government.
264. (C) Choice (C) is the best answer because demand deposits are a
liability of the bank, not an asset. An asset of the bank is anything owned by
the bank. Choices (A), (B), (D), and (E) are assets that belong to a bank.
265. (B) When currency/money is being used to set prices and make
economic calculations, it is being used as a unit of account.
266. (C) Choice (C) is correct. The central bank of the United States is the
Federal Reserve Bank. It is responsible for regulating monetary policy and
the financial system.
267. (A) Choice (A) is correct. M1 money refers to all coins and paper
currency and all money in checking accounts (checkable deposits).
Traveler’s checks are often used as cash by people on vacation and would
therefore be part of the M1 money supply.
268. (A) Choice (A) is the best answer because it correctly calculates the
money multiplier, 1/0.05 = 20.
269. (C) Choice (C) is the best answer because increasing the reserve ratio
will decrease the money supply. If banks are required to increase the
amount of cash they must keep in their vaults, then that decreases the
lending power of the bank. If banks are making fewer loans to businesses
and individuals, then the money supply will decrease.
270. (A) Choice (A) is correct. Remember that there is an inverse
relationship between the price of a bond and inflation.
271. (E) Choice (E) is the best answer because a bank’s biggest liability is
checkable deposits. The banks are responsible for being able to provide and
account for that money on hand. Remember that checkable deposits are part
of M1 money, which is the most liquid and available form of money in an
economy.
272. (A) Choice (A) is correct. Remember that there is an inverse
relationship between the price of a bond and inflation.
273. (B) While all answer choices are items banks would consider assets,
the loans made to customers are the largest segment. The bank expects
repayment, which is why they are assets, and almost all banks loan out
more than the cash they receive from their customers.
274. (C) Choice (C) is correct. Money is an effective measure of value
because it is easier to set a price for goods using money than it is to set a
price using other trade goods.
275. (D) Choice (D) is correct. A dollar bill would be the most liquid store
of value.
276. (A) Choice (A) is correct. Traveler’s checks are considered cash so
they are part of the M1 money supply.
277. (C) Choice (C) is the best answer. A bond is a store of value that
provides investment income in exchange for investment risk. Cash doesn’t
provide any protection from inflation. The consumer does give up liquidity
by purchasing a bond because the bond has to be sold for cash before its
value can be used to purchase goods and services, or held until all of the
interest is collected.
278. (E) Choice (E) is correct. Because the bank took possession of the roll
of quarters, the supply of currency available to consumers, which is part of
M1, has decreased. Meanwhile, the amount of money in savings accounts,
which is part of M2, has increased by the same amount, and since M2
includes M1, the quarters are still in M2.
279. (B) Choice (B) is correct. The store traded the cash for a checkable
deposit, and both of these are included in M1. Neither M1 nor M2 will
change as a result of the transaction.
280. (D) Choice (D) is correct. If prices fall by 75 percent, an item that
costs $1 now only costs $0.25. This means the dollar gained 400 percent in
purchasing power.
281. (B) Choice (B) is correct. A decrease in the money supply or an
increase in the demand for money would result in higher interest rates.
282. (C) The nominal interest rate is determined within the money market.
When the money supply increases, it moves along a downward-sloping
money demand curve, causing the nominal interest rate to decline.
283. (B) Choice (B) is correct. Lower interest rates would encourage the
use of credit.
284. (D) The process of lending, borrowing, and redepositing is called
money creation. When a bank lends to a borrower, it is making some of its
excess reserves from demand deposits available to be used in the economy.
This increases the money supply within the economy through the multiplier
process.
285. (C) Choice (C) is correct. The bank’s reserves are its cash and Federal
Reserve deposits, which add up to $10 million. It has to keep 20 percent of
the value of its reserves but can lend out the other 80 percent, or $8 million.
286. (C) Choice (C) is correct. The bank made loans worth 90 percent of its
assets. If the loans are worth $18 million, its assets are worth $20 million. If
$10 million is at the Fed, cash on hand must be $10 million.
287. (B) Choice (B) is correct. If interest rates decrease, less money would
be needed to pay back loans. The money supply would increase, and the
demand for money would increase.
288. (B) Choice (B) is correct. The loan repayment would reduce the supply
of money by $4,000 and the checking account deposit would have no effect.
289. (D) Choice (D) is correct. When the bank makes a loan, its assets
increase and its liabilities show no change.
290. (D) Choice (D) is correct. The first bank can loan out $1,600, and if
this cash is deposited at another bank, the second bank can loan out $1,280,
and so on. If this process continues, the amount of money created is excess
reserves times (1 divided by the reserve ratio) or $2,000 × 1/(0.20), which is
$10,000.
291. (B) Choice (B) is correct. The same process works in reverse. The
amount of money removed from the money supply would be $4,000 ×
(1/0.25), which is $16,000.
292. (C) Choice (C) is correct. The Federal Reserve can increase the supply
of money by reducing the reserve requirement for commercial banks, or it
can reduce the discount rate.
293. (C) Choice (C) is correct. The Federal Reserve can reduce the supply
of money by raising the reserve requirement or increasing the discount rate.
294. (B) Choice (B) is correct. The bank loaned out 80 percent of its
reserves, which is $32 million. The remaining 20 percent of its reserves
must be worth $8 million, for a total of $40 million. If the bank has $20
million in cash on hand, it must have another $20 million at the Federal
Reserve for its total reserves to equal $40 million.
295. (B) This is also equivalent to the value of the bond purchase times the
money multiplier. If the reserve ratio is 20 percent: $1,000 bond
purchase/0.20 = $5,000, just as the money multiplier is 1/RR or 1/0.20 = 5,
multiplied by the bond purchase: $1,000 × 5 = $5,000.
296. (E) When money is held by banks or borrowers as currency rather than
redeposited or loaned out, it causes the multiplier effect to be decreased, as
the money does not freely circulate to be multiplied by future banks.
Therefore, the only way that the maximum amount of money creation can
take place is if banks loan out all of their excess reserves and borrowers
redeposit all of their borrowed funds.
297. (B) Choice (B) is correct. The Federal Reserve can buy government
securities to increase the money supply, in addition to reducing the discount
rate or reducing the reserve requirement.
298. (B) Choice (B) is correct. A shift in the money supply to the right is an
increase in the money supply, which could be produced by the Federal
Reserve buying government securities on the open market.
299. (E) Choice (E) is the best answer. Increasing the money supply is one
way to stimulate the economy out of a recession.
300. (A) Choice (A) is the best answer because selling government
securities would decrease the money supply and as a result decrease
inflation. Choices (D) and (E) are incorrect because income taxes are
included only in fiscal policy.
301. (C) An expansionary monetary policy aims to increase the money
supply and increase aggregate demand. As a result, employment will
increase. Choice (C) is the best answer.
302. (A) Choice (A) is correct. You must use the money multiplier to
answer this question. 1/(1 − MPC) or 1/(1 − 0.7) = 1/0.3 = 3.33. Then 3.33
× 10 = 33 billion.
303. (B) Choice (B) is correct. Money is being used as a unit of account for
the hamburger.
304. (A) Choice (A) is correct. The hamburger restaurant deposited the
money in the bank as a store of value.
305. (C) The price of previously issued bonds and interest rates are inverse,
or move in opposite directions. Therefore, if interest rates are falling due to
the securities purchase, bond prices will rise.
306. (D) The buying and selling of securities on the open market is called
open market operations. When the central bank engages in open market
operations to combat a recession, it will buy securities to increase the
money supply and decrease the interest rate.
307. (E) A rising price level will cause more consumers within the
economy to keep cash or currency on hand in order to buy the things that
they need.
308. (A) In the money market, a downward-sloping curve represents the
relationship between the two axes. Those are the nominal interest rate and
the quantity of money.
309. (D) Choice (D) is the best answer. If the money supply shifts to the
right, the interest rate falls.
310. (A) Choice (A) is correct. The Federal Reserve decides whether the
money supply shifts to the left or the right. Other organizations can only
change the demand for money.
311. (C) Choice (C) is correct. The bank has reserves worth $40 million
(cash plus Federal Reserve deposits). It must keep 5 percent of this, which
is $2 million. It can lend out the other $38 million.
312. (C) Choice (C) is the best answer. The interest rate would fall from 6
percent to 4 percent.
313. (E) Choice (E) is the best answer. A money supply of $50 billion
would result in a 6 percent interest rate, so if the interest rate is higher than
that, the money supply must be lower.
314. (E) Choice (E) is correct. The interest rate would change from 6
percent to less than 3 percent.
315. (B) Choice (B) is correct. On the DM3 curve, the interest rate is 9
percent when the money supply is $20 billion.

Chapter 5: Long-Run Consequences of

Stabilization Policies
316. (D) The government can implement fiscal policy through taxes and
spending.