Question

Question 1: True, False or uncertain

Explain whether each of the following statement is true, false or uncertain. Start your answer by selecting one of the three statements – “True”, “False” and “Uncertain” and then provide arguments to justify your selection (be brief and concise in less than 100 words). You need to make assumption clear, reasonable and explicit if making any. The quality and logic of arguments determine your marks. (4 marks each)

1. An increase in the money multiplier (M) and a decrease in the reserve ratio (R) occur during the financial crisis.
2. Nominal interest rates are always higher than real interest rates.

Answer 1

Answer a. False. This is because, during the financial crisis, the central bank pursued quantitative easing. This means they would increase the monetary base to include buying bonds from banks to give them greater cash reserves. In turn, this would increase the money multiplier and overall money supply. But that didn't happen. After all, the banks didn't want to lend any extra money. Furthermore, banks were trying to grow their reserves following the credit crisis and previous commitments to over-extension of loans.

Answer b. True. A nominal interest rate contains two parts: a real interest rateand an inflation premium. According to the Fisher Effect, if the inflation rate increases and the nominal interest rate remains constant, the real interest rate will fall. The lender’s real return drops as a result of a faster decline in the purchasing power. If the nominal interest rate and expected inflation rate both increase at the same rate, which means the inflation premium is compensated, the real interest rate will remain unchanged.