Harder questions from 30 November quiz.

There were only a few questions less than half got right. They included:

7) If the required reserve ratio is 10 per cent, an extra dollar of reserves can increase banking-system deposits by as much as

B) $10. Only 45% of you got this; nearly as many answered $0.10, which is ''not thinking.' The required reserve ratio is required reserves divided by deposits; if that is 10%, you have to divide $1 of reserves by $10 of deposits to get 10%. So an extra dollar of reserves can allow deposits to increase by as much as $10.

12) If the interest rate decreases, people will want to hold larger money balances because

B) the opportunity cost of holding money is lower than before. The opportunity cost of holding money is the interest rate, which you could earn if you held an interest-earning asset rather than money, and when something gets cheaper [lower opportunity cost] you expect people to do more of it, so yes, this is the reason. 48% of you got this right. But 40% of you must have been spooked by all the 'B and C' type answers on the last midterm, because you said B and C, where C was 'the price of bonds is expected to go up.' That is a good distractor, but it doesn't make sense. Why would you want to hold more money if the price of bonds was going to increase? Wouldn't you rather hold the bonds and make a profit? In any case, if the interest rate has decreased, the price of bonds will have gone up already, not be expected to in the future.

14) The Fed engages in open market operations and sells government securities. The result is

B) higher interest rates. If the Fed sells securities, (a) the price of securities will tend to go down [supply has increased], and when the price of securities/bonds goes down, the interest rate is going up; and (b) commercial bank reserves are being destroyed, i.e. reduced, which means that there is less supply of reserves to the Federal Funds market and commercial banks are able to make less total loans, so if demand in both cases has not changed the interest rate will go up. Wrong answers were all over the place.

20) Suppose that firms and workers believe that the inflation rate will be 3 percent this year. Instead inflation is 6 percent. Which of the following occurs as a result of this unanticipated inflation?

C) Profits will be higher than expected because real wage rates have been set too low. 42% of you got this. If actual inflation is higher than anticipated inflation [i.e. we have unanticipated inflation], wages that were set in money terms on the assumption of the expected (anticipated) inflation rate will turn out to be lower in real terms than expected, because the price level of output turns out to be higher than expected. In turn, this means that firms will make bigger profits than expected -- they sell their output at the higher output prices, but they only have to pay wages based on the original [too low] expectation of inflation [true for at least some of them for at least some time, so overall profits will do this]. Incidentally, this is the main reason the SRAS curve slopes up to the right -- when output prices rise without all input prices having risen commensurately, it becomes more profitable to produce so firms produce more -- remember?