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Saturday Quiz – December 19, 2009

Welcome to the billy blog Saturday quiz. The quiz tests whether you have been paying attention over the last seven days.

See how you go with the following five questions. Your results are only known to you and no records are retained.

1. A 10 per cent increase in bank reserves will increase the banks' capacity to make loans by a lesser amount because the banks always keep a minimum volume of reserves to allow the payments system to function efficiently.



2. When bank reserves overall are in excess of the minimum requirements determined by the banks, the commercial banks can profitably eliminate the excess by lending between themselves on the interbank market although this behaviour will drive the overnight interest rate down.



3. Under certain conditions, increasing bank credit can be inflationary. In this regard, as the world economy improves, the central bank will eventually need to reduce the reserves in the banking system to constrain the ability of banks to lend.



4. Central banks have a choice when attempting to stabilise aggregate demand and control inflation. They can set the price of money (via the interest rate) or control the volume of money. In recent years, they have been setting the price and allowing the volume to fluctuate.



5. Quantitative easing involves buying one type of financial asset (private bonds holdings) in exchange for another (reserve balances) with no change in net financial assets in the private sector. This may be inflationary, however, if the increased demand for “long maturity” assets held in the private sector reduces long-term interest rates and the demand for loans increases.





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    This Post Has 6 Comments
    1. Warning: Spoilers Below
      Hi Bill,
      A bit unconvinced about Q5. Interest costs for firms go down if they can borrow cheaply. They will then not increase the prices. Isn’t it?

    2. Dear Ramanan

      The question is suggesting that the only way that QE could work is if the interest rate change stimulates aggregate demand. In turn, it is possible that the rise in nominal investment spending will drive the economy beyond its real capacity and inflation results.

      It is all down to “may” and “if”. It is possible (but highly unlikely). The point is that QE can only work if the demand for credit increases and can only be inflationary if spending growth is too strong. It cannot work by “providing more capacity to the banks to lend”.

      best wishes
      bill

    3. Hi, Bill-

      Love your blog and the quiz. Could you expand a bit on your guide to answers? The questions often have several clauses, some of which are true, some false. So it would be helpful to get a little more guidance on what the nub was, and what the incidentals.

      With respect to Q5, the argument for its inflationary potential is apparent, but the first clause remains puzzling to me. I’ll grant that buying bonds on the public market amounts to transforming the liquid assets of bonds in the private economy into some other liquid asset- money paid out by the Fed into bank reserves, or elsewhere. But shouldn’t there be form of true “printing money” included in the QE concept, such as fiscal spending paid for by new money unbalanced by debt, or direct lending by the Fed to non-bank entities?

      With respect to Q4, does the answer turn on how recent “recent” is? The last year or two- the target interest rate has been ineffective. But in normal times, wouldn’t Q4 be answered true? Or is the whole premise false.. that the volume of money can be controlled under any conditions?

      Thanks!

    4. Steel teeth got me.

      A couple of those were trick questions, with part that was true and part that was false, leading to giving a wrong answer.

    5. Dear Burk

      Thanks for the nice comments.

      You have to consider whether the statement as a whole can be true even if some parts of the statement are true. That is the trick of the examiner after all – to lull the person doing the quiz into security and then confusion!

      Q4 Central banks have a choice when attempting to stabilise aggregate demand and control inflation. They can set the price of money (via the interest rate) or control the volume of money. In recent years, they have been setting the price and allowing the volume to fluctuate.

      In a fiat currency system, the central bank cannot control the volume of money. That makes the proposition false.

      Q5 Quantitative easing involves buying one type of financial asset (private bonds holdings) in exchange for another (reserve balances) with no change in net financial assets in the private sector. This may be inflationary, however, if the increased demand for “long maturity” assets held in the private sector reduces long-term interest rates and the demand for loans increases.

      The statement is true but highly speculative as my response to Ramanan notes. QE has nothing to do with fiscal policy. The commentators say QE is “printing money” but that is totally misleading and probably is why you are thinking it is tied in with fiscal policy. Two errors then arise. First, Governments do not spend by printing money. So that is a poor way of characterising deficits. Second, QE just adds bank reserves in return for other assets held by the private sector. No printing presses are involved!

      best wishes
      bill

    6. Hi Bill,

      (@5:09) Makes sense. Just got tricked by the way the question was written.

      Very poor understanding of the economy by the Fed – refusing to look at an economy from an accounting perspective and doing things which just seem superficially correct (believing lowering interests will increase aggregate demand, whereas balance sheets of various sectors of the US are weak). Galileo once said “By denying scientific principles, one may maintain any paradox.” In this situation, one can say “By ignoring accounting principles, (mainstream) economists may maintain any paradox”

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