CA Foundation P4 · Chapter 8
Money Market MCQs with Answers
15 multiple-choice questions on Money Market for CA Foundation P4 Business Economics. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Reserve money (high-powered money) consists of:
- A) Currency in circulation, bankers' deposits with the RBI and other deposits with the RBI
- B) Currency with the public and demand deposits with banks
- C) Time deposits and demand deposits of banks
- D) Government securities held by commercial banks
Show answer & explanation
Answer: A) Currency in circulation, bankers' deposits with the RBI and other deposits with the RBI
Reserve money (M0) = currency in circulation + bankers' deposits with RBI + 'other' deposits with RBI. It is called high-powered money because the banking system creates a multiple of it as money supply.
Question 2
When the central bank purchases government securities in the open market, it:
- A) Absorbs liquidity from the banking system
- B) Raises the cash reserve ratio
- C) Reduces the money supply
- D) Injects liquidity and increases the reserves of banks
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Answer: D) Injects liquidity and increases the reserves of banks
In an open market purchase, the central bank pays for securities by crediting banks' reserves, which increases liquidity and the capacity to lend. Open market sales have the opposite effect.
Question 3
The currency-deposit ratio is 0.2 and the reserve-deposit ratio is 0.1. If high-powered money is Rs. 500 crore, the money supply is:
- A) Rs. 2,000 crore
- B) Rs. 5,000 crore
- C) Rs. 1,500 crore
- D) Rs. 6,000 crore
Show answer & explanation
Answer: A) Rs. 2,000 crore
Money multiplier m = (1 + c) / (c + r) = (1 + 0.2) / (0.2 + 0.1) = 1.2 / 0.3 = 4. Money supply = m x H = 4 x 500 = Rs. 2,000 crore. Using the simple multiplier 1/r = 10 would wrongly give Rs. 5,000 crore.
Question 4
The most fundamental function of money, which removes the need for a double coincidence of wants, is its function as a:
- A) Store of value
- B) Medium of exchange
- C) Standard of deferred payment
- D) Unit of account
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Answer: B) Medium of exchange
Under barter, trade requires a double coincidence of wants. Money as a generally accepted medium of exchange removes this difficulty. Store of value, standard of deferred payment and unit of account are other functions.
Question 5
Money that is accepted as legal tender by government decree but is not backed by any commodity is called:
- A) Commodity money
- B) Fiat money
- C) Near money
- D) Full-bodied money
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Answer: B) Fiat money
Fiat money derives its value from government order and public confidence, not from intrinsic value or backing. Full-bodied money has intrinsic value equal to its face value, and near money refers to highly liquid assets such as time deposits.
Question 6
According to Keynes, the three motives for holding money are:
- A) Consumption, saving and investment motives
- B) Transactions, precautionary and speculative motives
- C) Income, business and asset motives
- D) Profit, liquidity and safety motives
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Answer: B) Transactions, precautionary and speculative motives
Keynes' liquidity preference theory identifies the transactions motive (day-to-day payments), the precautionary motive (unforeseen contingencies) and the speculative motive (holding money to take advantage of expected changes in bond prices and interest rates).
Question 7
In Keynesian theory, the 'liquidity trap' refers to a situation where:
- A) Banks refuse to lend because of high reserve requirements
- B) At a very low interest rate the demand for money becomes perfectly elastic, so increases in money supply do not lower the interest rate
- C) People hold no money for speculative purposes
- D) The demand for money is perfectly inelastic with respect to interest rate
Show answer & explanation
Answer: B) At a very low interest rate the demand for money becomes perfectly elastic, so increases in money supply do not lower the interest rate
At a very low interest rate, everyone expects rates to rise (bond prices to fall), so people prefer to hold cash. The speculative demand curve becomes horizontal; additional money is simply held, and monetary policy becomes ineffective in reducing the interest rate.
Question 8
Using Fisher's equation MV = PT, if money supply M = Rs. 500 crore, velocity V = 6 and volume of transactions T = 1,500 crore units, the price level P is:
- A) 2
- B) 0.5
- C) 18
- D) 3
Show answer & explanation
Answer: A) 2
P = MV / T = (500 x 6) / 1,500 = 3,000 / 1,500 = 2. Reversing the ratio gives 0.5.
Question 9
According to the Cambridge cash-balance equation M = kPY, if k = 0.25 and nominal income PY = Rs. 8,000 crore, the demand for money is:
- A) Rs. 2,000 crore
- B) Rs. 32,000 crore
- C) Rs. 4,000 crore
- D) Rs. 800 crore
Show answer & explanation
Answer: A) Rs. 2,000 crore
M = k x PY = 0.25 x 8,000 = Rs. 2,000 crore. Here k is the proportion of nominal income people wish to hold as cash balances; it is the reciprocal of income velocity (1/0.25 = 4). 32,000 results from dividing by k.
Question 10
In the RBI's monetary aggregates, broad money (M3) is equal to:
- A) Currency with the public plus demand deposits only
- B) M1 plus net time deposits with the banking system
- C) M1 plus post office savings deposits
- D) Currency in circulation plus bankers' deposits with RBI
Show answer & explanation
Answer: B) M1 plus net time deposits with the banking system
M1 = currency with the public + demand deposits with banks + other deposits with RBI. M3 = M1 + net time deposits of the banking system. M2 adds post office savings deposits to M1. Currency plus bankers' deposits with RBI form part of reserve money (M0).
Question 11
An increase in the cash reserve ratio (CRR) will, other things being equal:
- A) Increase the money multiplier
- B) Reduce the money multiplier and the money supply
- C) Have no effect on bank lending
- D) Increase the high-powered money base
Show answer & explanation
Answer: B) Reduce the money multiplier and the money supply
A higher CRR requires banks to keep a larger share of deposits with the central bank, leaving less to lend. In the formula (1 + c)/(c + r), a higher r reduces the multiplier and therefore the money supply.
Question 12
The repo rate is the rate at which:
- A) Banks lend to their most creditworthy customers
- B) The RBI lends short-term funds to banks against eligible government securities
- C) The RBI absorbs surplus funds from banks without collateral
- D) Banks lend to each other in the call money market
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Answer: B) The RBI lends short-term funds to banks against eligible government securities
Under a repurchase agreement (repo), banks sell securities to the RBI with an agreement to buy them back, effectively borrowing from the RBI. The rate charged is the repo rate, the main policy rate. Absorption of liquidity is done through reverse repo or the standing deposit facility.
Question 13
Under the amended RBI Act, 1934, the policy repo rate required to achieve the inflation target is determined by:
- A) The Ministry of Finance alone
- B) The Board of Directors of each commercial bank
- C) The Monetary Policy Committee
- D) The Securities and Exchange Board of India
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Answer: C) The Monetary Policy Committee
The 2016 amendment to the RBI Act provided a statutory basis for a flexible inflation targeting framework and constituted a Monetary Policy Committee, which decides the policy repo rate by majority vote.
Question 14
In the Baumol-Tobin inventory approach to transactions demand for money, an increase in the interest rate will:
- A) Increase the average money balance held for transactions
- B) Leave transactions demand unaffected, as it depends only on income
- C) Increase transactions demand proportionately with the interest rate
- D) Reduce the average money balance held for transactions
Show answer & explanation
Answer: D) Reduce the average money balance held for transactions
Baumol and Tobin showed that the optimal average cash balance is proportional to the square root of (2bY / r), where b is the brokerage cost and r the interest rate. A higher r raises the opportunity cost of holding cash, so people hold less money and make more frequent conversions. Thus even transactions demand is interest-sensitive, contrary to the simple Keynesian view.
Question 15
Milton Friedman's restatement of the quantity theory treats the demand for money as:
- A) Purely a function of the transactions motive
- B) Determined only by the speculative motive
- C) Perfectly elastic at all interest rates
- D) Demand for a capital asset, depending on wealth and the returns on alternative assets
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Answer: D) Demand for a capital asset, depending on wealth and the returns on alternative assets
Friedman regarded money as one form in which wealth is held. Demand for real balances depends on permanent income (wealth), the ratio of human to non-human wealth, expected returns on bonds, equities and physical goods (expected inflation), and tastes. This makes money demand a stable function.