Use this review after the Unit 4 diagnostic. It shows how the seven topics fit together, then gives six questions that each combine two or more topics.
Big ideas of the unit
- Money is one asset among several. Cash and demand deposits are the most liquid but pay little; bonds and stocks pay more but are less liquid and riskier. See Topic 4.1.
- Interest is the price of holding money. Every valda held as money gives up the interest a bond would pay. This is why money demand slopes down.
- Bond prices and interest rates move in opposite directions. A fixed payment is worth less when new bonds pay more.
- Inflation splits a nominal rate into two parts. Nominal = expected real + expected inflation; in hindsight, real = nominal − actual inflation. See Topic 4.2.
- Money is measured by liquidity. M1 is currency plus checkable deposits; M2 adds near-money. Reserves are in the monetary base but not in M1 or M2. See Topic 4.3.
- Banks create money by lending. A loan creates a deposit, so excess reserves can support a multiple of themselves in new money. See Topic 4.4.
- The money market sets the nominal rate. MS is vertical; MD shifts with the price level, real GDP and payment technology. See Topic 4.5.
- Monetary policy works through interest rates. With limited reserves the central bank changes the quantity of reserves; with ample reserves it sets administered rates. Either way, rates change, then investment, AD, output and prices. See Topic 4.6.
- The loanable funds market sets the real rate. Saving supplies funds and investment demands them; government deficits and surpluses move the real rate. See Topic 4.7.
Key relationships and methods
| Idea | Relationship or method | Topic |
|---|---|---|
| Return on a bond | Fixed yearly payment ÷ price; price up → return down | 4.1 |
| Opportunity cost of holding money | Amount held × interest rate on the alternative | 4.1 |
| Setting a nominal rate | Expected real rate + expected inflation | 4.2 |
| Real rate in hindsight | Nominal rate − actual inflation | 4.2 |
| M1 / M2 / monetary base | Currency + checkable deposits / M1 + near-money / currency + reserves | 4.3 |
| Excess reserves | Total reserves − rr × demand deposits | 4.4 |
| Maximum change in money supply | Initial excess reserves × (1 ÷ rr) | 4.4, 4.6 |
| Money market | Nominal rate v. quantity of money; MS vertical, MD down | 4.5 |
| Expansionary tools | Buy bonds, lower rr, lower discount rate, lower interest on reserves | 4.6 |
| Saving | Private = Y − T − C; public = T − G; national = Y − C − G | 4.7 |
| Investment | Closed: = national saving; open: + net capital inflow | 4.7 |
The questions
These are original Marlbridge practice questions, not past exam questions. The rubrics are a suggested Marlbridge rubric, not official scoring. All questions use Valdoria, a fictional country whose currency is the valda (VD) and whose central bank is the Central Bank of Valdoria (CBV); all data are fictional. Unless stated, banks lend all excess reserves, loans are fully redeposited and the public holds no extra cash.
Question 1 (multiple choice · mixed)
Valdoria has limited reserves. The CBV sells government bonds on the open market. Which row correctly describes the short-run effects?
- (A) Money supply falls; nominal interest rate rises; prices of existing bonds rise; the opportunity cost of holding money falls
- (B) Money supply falls; nominal interest rate rises; prices of existing bonds fall; the opportunity cost of holding money rises
- (C) Money supply rises; nominal interest rate falls; prices of existing bonds rise; the opportunity cost of holding money falls
- (D) Money demand falls; nominal interest rate falls; prices of existing bonds rise; the opportunity cost of holding money rises
Answer and explanation
Answer: (B). A sale drains reserves, so MS shifts left and the nominal rate rises. Existing bonds with fixed payments must fall in price to match the higher rate. The rate is the interest given up by holding money, so that cost rises.
- (A) Bond prices move opposite to interest rates, and a higher rate makes holding money more costly.
- (C) describes an open market purchase.
- (D) A bond sale changes the quantity of money, not how much people want to hold.
Question 2 (multiple choice · mixed)
Valdoria’s loanable funds market is in equilibrium at a real interest rate of 4%. Savers and borrowers both come to expect inflation of 3.5% instead of 1%. Nothing else changes. Which is correct for new one-year loans?
- (A) The nominal rate stays at 5%; the real rate falls to 1.5%.
- (B) The nominal rate rises from 5% to 7.5%; the real rate rises to 6.5%.
- (C) The nominal rate stays at 4%, because the loanable funds market sets it.
- (D) The nominal rate rises from 5% to 7.5%; the equilibrium real rate stays at 4%.
Answer and explanation
Answer: (D). Both sides decide in real terms, so the loanable funds curves do not move and the real rate stays at 4%. Expected inflation is built into the contract: 4 + 1 = 5% before, 4 + 3.5 = 7.5% after.
- (A) describes an old contract when inflation rises unexpectedly. New contracts include the new expectation.
- (B) adds the 2.5-point rise in expected inflation to the real rate as well as to the nominal rate.
- (C) The loanable funds market sets the real rate, not the nominal rate.
Question 3 (constructed response · mixed)
Valdoria has limited reserves and a required reserve ratio of 10%; no bank holds excess reserves. The CBV buys VD 12 billion of government bonds from households, who deposit the payment in their checking accounts.
(a) Calculate the immediate change in M1 and in the monetary base. Explain each. (b) Calculate the change in banks’ required and excess reserves. (c) Calculate the maximum total change in the money supply. (d) Draw a correctly labelled money market graph showing the effect on the nominal interest rate. (e) Explain one reason why the actual change in the money supply could be smaller than in (c).
Worked solution and suggested Marlbridge rubric
(a) M1 +12: households swapped bonds, which are not money, for checking deposits. The monetary base +12: the CBV pays by adding to banks’ reserves.
(b) Required reserves rise by 0.1 × 12 = 1.2. Reserves rose by 12, so excess reserves rise by 12 − 1.2 = 10.8.
(c) Multiplier = 1 ÷ 0.1 = 10. Lending can add up to 10.8 × 10 = 108. Total = 12 + 108 = VD 120 billion (the same as 12 × 10).
(d) Axes “Nominal interest rate” and “Quantity of money”. Downward-sloping MD; vertical MS₁ shifts right to MS₂; the rate falls from i₁ to i₂.
(e) Banks may keep some excess reserves rather than lend them, or borrowers may hold part of their loans as cash, so each round of lending is smaller.
| Point | What earns it |
|---|---|
| 1 | M1 +12, because bonds are not money but deposits are |
| 1 | Monetary base +12, because reserves rise |
| 1 | Required +1.2 and excess +10.8 |
| 1 | Total of VD 120 billion |
| 1 | Correct axes, vertical MS, downward MD |
| 1 | MS shifts right and i₂ below i₁ |
| 1 | Valid reason the expansion is smaller |
Total: 7 points. An answer of 108 in (c) misses that the first 12 of deposits is already new money.
Question 4 (constructed response · mixed)
Valdoria’s real GDP is VD 1,060 billion and potential output is VD 1,000 billion. Money demand is Qd = 1,100 − 60i (VD billion; i is the nominal rate in per cent). The money supply is VD 860 billion. The banking system has limited reserves and a required reserve ratio of 25%.
(a) Identify the output gap and calculate its size. (b) Calculate the equilibrium nominal interest rate. (c) The CBV wants a nominal rate of 6%. Calculate the change in the money supply needed, and the open market operation with commercial banks that could achieve it. (d) A previously issued bond pays a fixed VD 54 a year. Treating its return as yearly interest ÷ price, calculate its price at the old and new rates. (e) Explain how the policy affects investment, and then AD, real output and the price level in the short run.
Worked solution and suggested Marlbridge rubric
(a) An inflationary (positive) output gap of 1,060 − 1,000 = VD 60 billion (6% of potential).
(b) 1,100 − 60i = 860, so 60i = 240 and i = 4%.
(c) At 6%, Qd = 1,100 − 360 = 740, so the money supply must fall by VD 120 billion. With a multiplier of 1 ÷ 0.25 = 4, the CBV should sell VD 30 billion of bonds to banks: reserves fall by 30, and deposits must shrink by up to 30 × 4 = 120.
(d) At 4%: 54 ÷ 0.04 = VD 1,350. At 6%: 54 ÷ 0.06 = VD 900. The price falls by VD 450 as the rate rises.
(e) Firms compare each project’s expected return with a higher cost of borrowing, so fewer projects go ahead: investment falls, and so do purchases made on credit, such as cars. AD shifts left: real output falls back towards VD 1,000 billion and the price level falls (or inflation slows).
| Point | What earns it |
|---|---|
| 1 | Inflationary gap of VD 60 billion |
| 1 | i = 4% |
| 1 | Money supply falls by VD 120 billion |
| 1 | Sell VD 30 billion of bonds |
| 1 | Bond prices VD 1,350 and VD 900 |
| 1 | Higher borrowing cost cuts investment, so AD shifts left |
| 1 | Real output falls towards potential and the price level falls |
Total: 7 points. “Sell bonds” without the amount earns the fourth point only if (c) shows the 120 ÷ 4 reasoning.
Question 5 (constructed response · mixed)
Valdoria’s loanable funds market (VD billion per year):
| Real interest rate | 2% | 3% | 4% | 5% | 6% | 7% |
|---|---|---|---|---|---|---|
| Quantity demanded (private) | 160 | 150 | 140 | 130 | 120 | 110 |
| Quantity supplied | 100 | 120 | 140 | 160 | 180 | 200 |
(a) Identify the equilibrium real interest rate and quantity. (b) The government borrows an extra VD 60 billion at every real rate to finance a deficit. Draw a correctly labelled graph showing the change, and find the new equilibrium. (c) Calculate the change in private investment, and explain why it changes. (d) Everyone expects inflation of 3%. Calculate the nominal rate on new loans before and after the change in (b). (e) A firm borrows at the new nominal rate, but actual inflation turns out to be 5%. Calculate the real rate in hindsight and state who gains.
Worked solution and suggested Marlbridge rubric
(a) 4% and VD 140 billion.
(b) Axes “Real interest rate” and “Quantity of loanable funds”. Demand shifts right from D₁ to D₂ (220, 210, 200, 190, 180, 170). D₂ meets supply at 6% and VD 180 billion.
(c) The government takes 60 of the 180, leaving 120 for private borrowers (the original demand at 6%). Private investment falls by VD 20 billion, from 140: the higher real rate means fewer projects earn more than the cost of borrowing.
(d) Before: 4 + 3 = 7%. After: 6 + 3 = 9%.
(e) 9 − 5 = 4%, below the 6% expected. The firm (the borrower) gains, because it repays in valdas that buy less than planned.
| Point | What earns it |
|---|---|
| 1 | 4% and VD 140 billion |
| 1 | Graph: real interest rate and quantity of loanable funds on the axes, demand shifted right |
| 1 | New equilibrium 6% and VD 180 billion |
| 1 | Private investment falls by VD 20 billion |
| 1 | Explains the fall through the higher real rate |
| 1 | Nominal rates 7% and 9% |
| 1 | Real rate 4%, with the borrower gaining because inflation was higher than expected |
Total: 7 points. A supply-side answer (supply shifts left by 60) is acceptable if the curves are labelled and private investment is still 120. “Nominal interest rate” on the vertical axis does not earn the graph point.
Question 6 (constructed response · mixed)
Nadia runs a bakery in Valdoria. She keeps VD 30,000 in a checking account that pays no interest. One-year government bonds pay 5%.
(a) Calculate her yearly opportunity cost of holding this money. (b) She moves VD 18,000 into a small time deposit. State the effect on M1 and on M2. (c) The bond rate rises to 8%. Calculate the opportunity cost of the VD 12,000 left in her checking account, and explain how her likely response is shown in the money market. (d) Give one reason, using the attributes of financial assets, why she keeps some money in checking instead of buying bonds. (e) Her bank has a required reserve ratio of 15% and no excess reserves. She deposits VD 2,000 of cash takings into her checking account. State the effect on M1, and calculate the change in her bank’s excess reserves.
Worked solution and suggested Marlbridge rubric
(a) 30,000 × 0.05 = VD 1,500 a year.
(b) M1 falls by VD 18,000; M2 is unchanged, because small time deposits are in M2.
(c) 12,000 × 0.08 = VD 960 a year. Holding money now costs more, so she is likely to hold less: a movement up along the money demand curve, not a shift.
(d) Liquidity: she must pay suppliers at once, and bonds must be sold first. Or risk: if rates rise again, a bond’s price falls and she could sell at a loss.
(e) M1 is unchanged: currency falls by 2,000 and checking deposits rise by 2,000. Reserves rise by 2,000 but required reserves rise by only 0.15 × 2,000 = 300, so excess reserves rise by VD 1,700, which the bank can now lend.
| Point | What earns it |
|---|---|
| 1 | VD 1,500 |
| 1 | M1 −18,000 and M2 unchanged |
| 1 | VD 960 |
| 1 | Higher rate → less money held, shown as a movement along MD |
| 1 | Liquidity or risk reason, linked to her need to pay or to bond price falls |
| 1 | M1 unchanged, with currency down and deposits up |
| 1 | Excess reserves rise by VD 1,700 |
Total: 7 points. In (c), “money demand shifts left” earns no point: the interest rate is on the axis.
How did you do?
- Q1, Q4(d) or Q6(a)–(d) lost marks: bonds, liquidity and the cost of holding money. Tick off the Topic 4.1 checklist.
- Q2, Q5(d) or Q5(e) lost marks: nominal and real rates. Use the Topic 4.2 checklist.
- Q3(a) or Q6(b), (e) lost marks: measuring money. Use the Topic 4.3 checklist.
- Q3(b)–(c), (e) or Q6(e) lost marks: reserves and the multiplier. Use the Topic 4.4 checklist.
- Q3(d), Q4(b) or Q6(c) lost marks: the money market. Use the Topic 4.5 checklist.
- Q1, Q4(a), (c), (e) lost marks: policy tools and effects. Use the Topic 4.6 checklist.
- Q5(a)–(c) lost marks: loanable funds. Use the Topic 4.7 checklist.
If several topics still feel shaky, go back to the Unit 4 diagnostic and follow its “Your next step” table.