CIMA BA1 · Chapter 12
The financial system, money and interest rates MCQs with Answers
9 multiple-choice questions on The financial system, money and interest rates for CIMA BA1 Fundamentals of Business Economics. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Which of the following is NOT one of the functions of money?
- A) A medium of exchange
- B) A unit of account
- C) A guarantee of a positive real return
- D) A store of value
Show answer & explanation
Answer: C) A guarantee of a positive real return
Money acts as a medium of exchange, a unit of account, a store of value and a standard of deferred payment. It does not guarantee a positive real return; inflation erodes the purchasing power of money held.
Question 2
Banks and building societies accept short-term deposits and make long-term loans. This process is known as:
- A) Risk transformation
- B) Maturity transformation
- C) Aggregation
- D) Securitisation
Show answer & explanation
Answer: B) Maturity transformation
Maturity transformation allows savers to lend for short periods while borrowers obtain long-term finance. Risk transformation refers to spreading risk across many borrowers, and aggregation means pooling small deposits into larger loans.
Question 3
A bank receives a new cash deposit of $50,000. All banks maintain a reserve ratio of 8% and there are no cash leakages. What is the maximum total increase in bank deposits across the banking system, including the initial deposit?
- A) $625,000
- B) $575,000
- C) $400,000
- D) $54,000
Show answer & explanation
Answer: A) $625,000
Credit multiplier = 1 / reserve ratio = 1 / 0.08 = 12.5. Maximum total deposits = $50,000 x 12.5 = $625,000. Of this, $575,000 is new credit created by lending.
Question 4
The money markets are best described as markets for:
- A) Long-term equity finance for listed companies
- B) The issue and trading of long-dated government bonds
- C) Physical commodities such as metals and oil
- D) Short-term lending and borrowing, typically for periods of less than one year
Show answer & explanation
Answer: D) Short-term lending and borrowing, typically for periods of less than one year
Money markets deal in short-term funds and instruments such as treasury bills, certificates of deposit and commercial paper. Capital markets deal in long-term finance such as shares and long-term bonds.
Question 5
Which of the following is NOT normally a function of a central bank?
- A) Acting as lender of last resort to the banking system
- B) Acting as banker to the government
- C) Accepting deposits from and making loans to members of the general public
- D) Implementing monetary policy, including setting a policy interest rate
Show answer & explanation
Answer: C) Accepting deposits from and making loans to members of the general public
Central banks act as banker to the government and to commercial banks, act as lender of last resort, issue notes, manage reserves and conduct monetary policy. Retail banking for the general public is carried out by commercial banks.
Question 6
A bond with a nominal value of $100 pays an annual coupon of 6% and has a current market price of $80. What is its interest (running) yield?
- A) 6.0%
- B) 7.5%
- C) 4.8%
- D) 32.5%
Show answer & explanation
Answer: B) 7.5%
Interest yield = annual coupon / market price x 100 = $6 / $80 x 100 = 7.5%. Because the bond trades below nominal value, the yield exceeds the coupon rate. 6.0% is the coupon rate on nominal value, 4.8% wrongly multiplies the coupon rate by price / nominal value, and 32.5% wrongly adds the $20 discount to nominal value to the coupon ((6 + 20) / 80), confusing the running yield with a total return to redemption.
Question 7
Which of the following statements about the relationship between interest rates and bond prices is correct?
- A) When market interest rates rise, the prices of existing fixed-interest bonds fall
- B) When market interest rates rise, the prices of existing fixed-interest bonds rise
- C) Bond prices are unaffected by changes in market interest rates
- D) When market interest rates fall, the coupons on existing fixed-interest bonds rise
Show answer & explanation
Answer: A) When market interest rates rise, the prices of existing fixed-interest bonds fall
Existing bonds pay a fixed coupon. If market rates rise, new investors will only buy existing bonds at a lower price so that their yield matches current rates. There is therefore an inverse relationship between interest rates and bond prices.
Question 8
A deposit pays a nominal interest rate of 8% a year and inflation is 3% a year. Using the exact Fisher relationship (not the approximation of subtracting inflation from the nominal rate), what is the real rate of interest (to two decimal places)?
- A) 5.00%
- B) 11.24%
- C) 4.63%
- D) 4.85%
Show answer & explanation
Answer: D) 4.85%
(1 + real rate) = (1 + nominal rate) / (1 + inflation) = 1.08 / 1.03 = 1.048544. Real rate = 4.85% (rounded to two decimal places). 5.00% is the approximation the question excludes, 11.24% multiplies instead of dividing (1.08 x 1.03 - 1) and 4.63% divides the wrong way (1 - 1.03 / 1.08).
Question 9
A normal yield curve slopes upwards, with longer-term interest rates higher than short-term rates. Which of the following helps to explain this?
- A) Short-term borrowing is always riskier than long-term borrowing
- B) The central bank sets long-term rates above its policy rate by law
- C) Investors require a liquidity premium to compensate for tying up funds for longer
- D) Markets expect interest rates to fall sharply in the future
Show answer & explanation
Answer: C) Investors require a liquidity premium to compensate for tying up funds for longer
Liquidity preference theory states that lenders prefer liquidity and require extra return for lending long. Expectations theory adds that an upward slope reflects expected rises in short-term rates. Expected falls in rates would tend to produce a downward-sloping (inverted) curve.