These are original Marlbridge practice questions, not past exam questions. All questions use Valdoria, the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD) and its central bank is the Central Bank of Valdoria (CBV). All data are fictional. The rubrics are a suggested Marlbridge rubric to help you check your work; they are not an official scoring guideline. Assumptions: unless told otherwise, banks lend all excess reserves and the public holds no extra cash, so the maximum money multiplier applies.
Question 1 (multiple choice · foundation)
Valdoria’s banking system has ample reserves, and the economy is in a recession with high unemployment. Which action by the CBV is most appropriate?
- (A) Sell government bonds on the open market
- (B) Raise the interest rate it pays on reserves
- (C) Lower the interest rate it pays on reserves
- (D) Raise the discount rate
Answer and explanation
Answer: (C). A recession calls for expansionary policy. With ample reserves, the key tool is an administered rate: lowering the interest on reserves lowers the policy rate and other interest rates.
- (A) Selling bonds is contractionary, and with ample reserves it would barely move the policy rate anyway.
- (B) Raising the interest on reserves raises the policy rate, which is contractionary.
- (D) Raising the discount rate makes borrowing reserves more expensive, which is contractionary.
Question 2 (multiple choice · core)
Valdoria has limited reserves and a required reserve ratio of 12.5%. The CBV buys VD 8 bn of government bonds from commercial banks. What is the maximum possible increase in the money supply?
- (A) VD 1 bn
- (B) VD 8 bn
- (C) VD 56 bn
- (D) VD 64 bn
Answer and explanation
Answer: (D). The banks swap VD 8 bn of bonds for VD 8 bn of reserves. No deposits change, so all VD 8 bn is excess reserves. Maximum money multiplier = 1 ÷ 0.125 = 8. Maximum increase = 8 × 8 = VD 64 bn.
- (A) multiplies the purchase by the reserve ratio (8 × 0.125) instead of dividing by it.
- (B) is the change in the monetary base, not the money supply.
- (C) subtracts required reserves first (8 − 1 = 7, then 7 × 8). That method applies only when the bonds are bought from the public and deposited, and then the deposit itself (VD 8 bn) must be added back, giving VD 64 bn again.
Question 3 (multiple choice · core)
The CBV carries out contractionary monetary policy. Which row shows the short-run effects?
- (A) Interest rates rise; investment falls; real output falls; price level falls
- (B) Interest rates rise; investment rises; real output rises; price level rises
- (C) Interest rates fall; investment rises; real output rises; price level rises
- (D) Interest rates rise; investment falls; real output falls; price level rises
Answer and explanation
Answer: (A). Higher interest rates make borrowing more expensive, so investment and interest-sensitive consumption fall. AD shifts left, so both real output and the price level fall in the short run.
- (B) gets the link from interest rates to investment backwards.
- (C) describes expansionary policy.
- (D) gets the price level wrong: a leftward shift of AD lowers it. A falling output with a rising price level would come from a supply shock, not a shift in AD.
Question 4 (multiple choice · stretch)
Valdoria’s banking system has ample reserves. The CBV sells a small amount of government bonds and changes nothing else. What happens to the policy rate, and why?
- (A) It rises, because the supply of reserves shifts left along the sloping part of reserve demand.
- (B) It stays the same, because the supply of reserves still crosses the flat part of reserve demand.
- (C) It falls, because banks receive bonds and so have more assets to lend.
- (D) It rises, because the money multiplier makes the effect on the money supply large.
Answer and explanation
Answer: (B). With ample reserves, supply crosses reserve demand where demand is flat at the interest on reserves. A small leftward shift in supply stays on that flat part, so the policy rate does not change.
- (A) describes a system with limited reserves.
- (C) gets the direction wrong: a sale removes reserves from banks, and in any case the rate does not change here.
- (D) The money multiplier describes how much money banks can create from excess reserves; it does not explain the policy rate in an ample-reserve system.
Question 5 (calculation · core)
Valdoria’s banking system has limited reserves. Banks hold total deposits of VD 600 bn and reserves of VD 120 bn. The required reserve ratio is 20%.
(a) Calculate required reserves and excess reserves. (b) The CBV lowers the required reserve ratio to 15%. Calculate the new required reserves and excess reserves. (c) Calculate the maximum money multiplier at the new ratio and the maximum increase in the money supply. (d) Is this expansionary or contractionary policy? Give one reason why the actual increase might be smaller.
Worked solution
(a) Required reserves = 0.20 × 600 = VD 120 bn. Excess reserves = 120 − 120 = VD 0.
(b) Required reserves = 0.15 × 600 = VD 90 bn. Excess reserves = 120 − 90 = VD 30 bn.
(c) Money multiplier = 1 ÷ 0.15 = 6.67 (to 2 d.p.). Maximum increase in the money supply = 30 ÷ 0.15 = VD 200 bn.
Check. With VD 120 bn of reserves and a 15% ratio, deposits can reach 120 ÷ 0.15 = VD 800 bn, which is VD 200 bn more than now.
(d) Expansionary. Lowering the ratio creates excess reserves that banks can lend. The actual increase may be smaller if banks choose to keep some excess reserves or if people hold some of their loans as cash.
Suggested mark points (4): 1 for VD 120 bn and VD 0; 1 for VD 90 bn and VD 30 bn; 1 for VD 200 bn (multiplying by 6.67 and getting about VD 200 bn is fine); 1 for “expansionary” with a valid reason the increase may be smaller.
Question 6 (constructed response · core)
Valdoria’s real GDP is above its full-employment level and inflation is rising. The banking system has limited reserves, and the required reserve ratio is 10%.
(a) Identify the type of output gap. (b) Identify an open market operation the CBV could use to close the gap. (c) Suppose the CBV’s open market operation is worth VD 10 bn and is carried out with commercial banks. Calculate the change in the monetary base and the maximum change in the money supply. (d) Draw a correctly labelled money market graph showing the effect of your action on the nominal interest rate. (e) Explain the effect of the policy on investment, aggregate demand, real output and the price level.
Worked solution and suggested Marlbridge rubric
(a) An inflationary (positive) output gap.
(b) The CBV should sell government bonds.
(c) Reserves fall by VD 10 bn, so the monetary base falls by VD 10 bn. Maximum money multiplier = 1 ÷ 0.10 = 10, so the money supply can fall by up to 10 × 10 = VD 100 bn.
(d) Axes: Nominal interest rate and Quantity of money. A downward-sloping MD and a vertical MS₁. MS shifts left to MS₂, and the equilibrium nominal interest rate rises from i₁ to i₂.
(e) Higher interest rates raise the cost of borrowing, so investment (and interest-sensitive consumption) falls. AD shifts left, so real output falls towards full employment and the price level falls (or rises more slowly than it otherwise would).
| Point | What earns it |
|---|---|
| 1 | Inflationary (positive) output gap |
| 1 | Sell bonds |
| 1 | Monetary base −VD 10 bn and money supply up to −VD 100 bn |
| 1 | Correctly labelled money market graph with MS shifted left and a higher nominal interest rate |
| 1 | Investment falls, so AD shifts left |
| 1 | Real output falls and the price level falls |
Accept answers carried forward from (b): if a student chose “buy bonds”, later points can still earn credit only if they are consistent with that choice, but (b) does not earn its point.
Question 7 (constructed response · stretch)
A year later, Valdoria’s banking system has changed: banks now hold ample reserves. Inflation is again above the CBV’s target.
(a) Identify the administered rate the CBV should change, and in which direction. (b) Draw a correctly labelled reserve market graph showing the effect of your action on the policy rate. (c) A commentator says the CBV should instead sell a small amount of bonds. Explain why this would not change the policy rate. (d) Six months after the CBV acts, inflation is still above target. Give two reasons, linked to policy lags, why this does not prove the policy has failed.
Model answer and suggested Marlbridge rubric
(a) Raise the interest on reserves.
(b) Axes: Policy rate and Quantity of reserves. A vertical supply of reserves, and a demand curve that slopes down and then becomes flat at the interest on reserves. Supply crosses demand on the flat part at PR₁. Raising the interest on reserves moves the flat part of demand up, so the policy rate rises to PR₂ with the quantity of reserves unchanged.
(c) With ample reserves, supply crosses reserve demand where it is flat. A small sale shifts supply slightly left but it still crosses the flat part, so the policy rate stays at the interest on reserves. Banks have so many reserves that none needs to borrow more, so the overnight rate does not rise.
(d) Any two of: firms take time to cancel or delay investment projects that were already planned, so investment falls only gradually; households take time to change big purchases such as cars and houses; it takes many months for lower AD to feed through to output and prices; data on inflation arrive with a delay, so the latest figures may describe conditions before the policy took effect.
| Point | What earns it |
|---|---|
| 1 | Raise the interest on reserves |
| 1 | Reserve market graph with correct axes, vertical supply and demand flat at the interest on reserves |
| 1 | Flat part of demand moved up and a higher policy rate shown |
| 1 | Explains that a small change in supply stays on the flat part of demand |
| 1 | First valid reason linked to lags |
| 1 | Second valid reason linked to lags |
In (d), two reasons that say the same thing in different words earn only one point.
How did you do?
- Q1, Q6(a)–(b) or Q7(a) wrong: re-read “What monetary policy is” and “The tools” in the study guide.
- Q2, Q5 or Q6(c) wrong: revisit Worked example 1, including both checks.
- Q4, Q7(b) or Q7(c) wrong: revisit “The reserve market model” and Figure 1.
- Q3 or Q6(d)–(e) wrong: revisit “From the policy rate to output and prices” and Worked example 2.
- Q7(d) wrong: revisit “Why monetary policy works with lags”.
Then tick off the topic checklist.