IB DP Economics: Monetary policy – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – the IB holds copyright in its own papers. Use these alongside the official past papers available through your school or the IB store.

This set covers monetary policy, sub-topic 3.5 of Unit 3. It follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. Questions 8, 9 and 10 are HL only; the rest suit SL and HL. All data is from Tavoria, an invented country, and is illustrative. The study guide and revision notes explain the content; the course page is IB DP Economics. Draw each diagram on paper as you answer, since the answers below describe them in words.

Questions

1. Define monetary policy. [2]

2. In Tavoria a saver is offered two accounts.

(a) One pays a nominal rate of 5.5% while inflation is 2.0%. Calculate the real interest rate. [1] (b) The other pays 2.5% while inflation is 4.0%. Calculate the real rate and explain what it means for the saver and for a borrower. [3]

3. Outline two goals of monetary policy, other than low and stable inflation. [4]

4. Tavoria is in a recession. Potential output is 800 bn tavs and actual real GDP is 740 bn tavs.

(a) Calculate the size of the gap as a percentage of potential output. [2] (b) Using AD/AS curves, explain how looser monetary policy could close this gap. [4]

5. Tavoria’s potential output is 1,000 bn tavs and its actual real GDP is 1,060 bn tavs. Explain, with reference to an AD/AS diagram, how contractionary monetary policy could close the gap. [5]

6. A price index in Tavoria rises from 120.0 to 123.6 over a year. The inflation target is 2%. Calculate the inflation rate, compare it with the target and suggest the likely direction of interest rates. [4]

7. Evaluate the effectiveness of monetary policy, with reference to its constraints and strengths. [8]

8. (HL only) Banks in Tavoria must hold 12.5% of deposits as reserves. A customer deposits 800 tavs. Assume banks lend all they can and every loan is redeposited. Calculate the money multiplier, the maximum total deposits and the new money created, and explain why the figure is a maximum. [5]

9. (HL only) The central bank of Tavoria wants to reduce demand. Explain how any two of these tools would do so: open market operations, minimum reserve requirements, the central bank’s minimum lending rate. [6]

10. (HL only) In Tavoria’s money market, demand for money is Md = 500 - 40r (r is the interest rate in %, Md in bn tavs) and the central bank fixes the money supply at 300 bn tavs.

(a) Calculate the equilibrium interest rate. [2] (b) The bank uses quantitative easing and raises the supply to 340 bn tavs. Calculate the new equilibrium rate. [2] (c) Explain what happens next to spending in the economy as a whole. [2]

11. Tavoria’s economy has been in recession for a year. The policy rate is 0.5%, households are anxious about jobs and firms have cut investment plans. Evaluate how far monetary policy can promote growth and low unemployment in this situation. [10]

Answers

1. Control of the money supply and interest rates [1] by the central bank, to influence the economy (aggregate demand) [1]. [2] Examiner insight: A “define” answer needs both the instruments and the body that controls them; naming only “interest rates” is incomplete.

2. (a) Real rate = 5.5% - 2.0% = 3.5% [1]. [1] (b) Real rate = 2.5% - 4.0% = -1.5% [1]. The saver’s purchasing power falls [1], while a borrower gains because the real value of the debt falls [1]. [3] Examiner insight: Keep the minus sign and the percentage unit; an answer of 1.5% with no sign contradicts the explanation that follows.

3. Two goals, each earning a mark for naming and a mark for outlining. Low unemployment [1]: lower rates raise AD and the demand for labour [1]. Reducing business cycle fluctuations [1]: rates rise in a boom and fall in a downturn to smooth output [1]. (Also acceptable: a stable environment for long-term growth, or external balance.) [4] Examiner insight: “Outline” is a brief account; a goal with no explanation gains only the naming mark, so add one clause on how policy serves it.

4. (a) Gap = 740 - 800 = -60 bn [1]; -60 / 800 x 100 = -7.5% [1]. [2] (b) A cut in the policy rate lowers borrowing costs [1]. C and I rise [1]. AD shifts right from AD1 to AD2 [1]. Real GDP rises from 740 towards 800 bn, unemployment falls, and the price level rises a little [1]. [4] Examiner insight: A labelled diagram with axes, both AD curves, AS, the old and new equilibria and the full-employment level supports the written chain; leave out none of these labels.

5. Gap = +60 bn, 6% of potential [1]. Raising the policy rate makes borrowing dearer and saving more rewarding [1]. C and I fall [1]. AD shifts left from AD1 to AD2 [1]. Real GDP falls back towards 1,000 bn and pressure on the price level eases, at some cost to short-run growth and jobs [1]. [5] Examiner insight: Say the AD curve moves left. Candidates often write that “inflation falls” without showing which curve shifts, which leaves the diagram unconnected to the argument.

6. Inflation = (123.6 - 120.0) / 120.0 x 100 [1] = 3.0% [1]. This is 1 percentage point above the 2% target [1]. The central bank would be likely to raise interest rates to reduce AD [1]. [4] Examiner insight: Write out the numbers you substitute; “suggest” needs a direction and a reason, not the direction alone.

7. Constraints: with rates close to zero there is little scope to cut further [1], so the central bank may be unable to stimulate a deep recession [1]. Low consumer and business confidence means cheap credit may not be used [1], so AD may not rise [1]. Strengths: rates can be changed in small steps and quickly reversed [1], and time lags are shorter than for some other policies [1]. Counter-point: monetary policy acts on demand, so it is weak against cost-push inflation or structural unemployment [1]. Judgement: it is most effective for moderate gaps when confidence is reasonable; in a deep slump it may need support from other policies [1]. [8] Examiner insight: An evaluation scores best when each strength meets a limitation and the answer ends in a judgement linked to circumstances, not a list.

8. (HL only) Multiplier = 1 / 0.125 = 8 [1]. Maximum total deposits = 800 x 8 = 6,400 tavs [1]. New money = 6,400 - 800 = 5,600 tavs [1]. It is a maximum because banks may hold reserves above the minimum [1], and customers may keep some cash instead of redepositing it [1]. [5] Examiner insight: Distinguish total deposits from new money; stopping at 6,400 counts the original 800 twice.

9. (HL only) Two tools, each earning a mark for the tool, one for the mechanism and one for the link to AD. Open market sales: the central bank sells government bonds [1], banks’ reserves fall so lending falls [1], interest rates rise and C and I fall, so AD falls [1]. Higher reserve requirement: banks must hold more of each deposit [1], so the multiplier falls and less is lent [1], reducing C and I and so AD [1]. (Raising the minimum lending rate: banks pay more to borrow, so market rates rise, which reduces C and I and so AD.) [6] Examiner insight: End each tool with its effect on AD; stopping at “banks lend less” leaves the last analytical step undone.

10. (HL only) (a) 500 - 40r = 300 [1], so r = 200 / 40 = 5% [1]. [2] (b) 500 - 40r = 340 [1], so r = 160 / 40 = 4% [1]. [2] (c) The supply of money shifts right and the interest rate falls from 5% to 4% [1]. Cheaper borrowing raises C and I, so AD shifts right [1]. [2] Examiner insight: Put the supply curve as a vertical line and the rate on the vertical axis; showing the equation set equal to supply earns the method before any arithmetic.

11. Explain: lower rates could raise C and I, shifting AD right and raising real GDP, which would reduce cyclical unemployment [1] [1]. Constraint 1: at 0.5% there is little room to cut further [1], so policy may be unable to push AD enough [1]. Constraint 2: with households anxious and firms cautious, extra credit may go unused [1], so the AD shift may be small [1]. Strength: monetary policy can be adjusted in steps and reversed [1]. Counter-point: if the cause of the recession is a fall in confidence rather than the cost of credit, other policies may do more [1]. Judgement: given the low rate and low confidence, monetary policy alone is unlikely to be enough here [1] [1]. [10] Examiner insight: Use the facts in the stem (0.5%, anxiety, cut investment plans); an answer that is true of any recession usually earns less than one tied to the case.

Where marks are usually lost

• Reversing the real rate calculation or adding inflation.
• Omitting the sign on a negative real rate.
• Diagrams without axes, labels or the gap marked.
• Explaining a cut in rates but not saying AD shifts right.
• Treating monetary policy as supply-side.
• Listing constraints and strengths without weighing them or reaching a judgement.
• Ignoring the case details in an evaluation question.
• (HL) Forgetting to subtract the original deposit when finding new money.
• (HL) Drawing the money supply sloping upwards.

Next steps

• Review with the revision notes and the study guide.
• Tick off the content on the printable checklist and visit the IB DP Economics course page.
• Check the wider unit with the macroeconomics measuring and managing practice set.
• Try the free 10-minute diagnostics.
• Book a free trial class.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020, sub-topic 3.5.