PRC-3 · Chapter 19
Monetary Policy MCQs with Answers
17 multiple-choice questions on Monetary Policy for PRC-3 Business & Economic Insights. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
The central bank observes that the economy is deeply stuck in a recession with severe unemployment. To stimulate aggregate demand and encourage borrowing by businesses, what specific monetary policy tool should the central bank deploy?
- A) Raise the reserve requirements for commercial banks
- B) Substantially lower the benchmark interest rates
- C) Increase the general sales tax
- D) Sell massive amounts of government bonds on the open market
Show answer & explanation
Answer: B) Substantially lower the benchmark interest rates
Expansionary monetary policy involves lowering interest rates. Cheaper borrowing encourages firms to invest and consumers to spend, boosting aggregate demand to fight the recession.
Question 2
To combat soaring, out-of-control inflation, the central bank initiates a 'contractionary' monetary policy. Which combination of actions represents a contractionary approach?
- A) Raising interest rates and selling government bonds to reduce money supply
- B) Lowering interest rates and buying government bonds
- C) Increasing government spending on infrastructure
- D) Decreasing commercial bank reserve requirements
Show answer & explanation
Answer: A) Raising interest rates and selling government bonds to reduce money supply
To cool down an overheating, inflationary economy, the central bank raises interest rates (making borrowing expensive) and sells bonds (absorbing excess cash from the banking system).
Question 3
Which of the following is NOT a standard tool used by a country's Central Bank to conduct Monetary Policy?
- A) Open Market Operations (buying/selling bonds)
- B) Changing the statutory reserve requirements for banks
- C) Changing the national income tax rates
- D) Altering the benchmark discount rate
Show answer & explanation
Answer: C) Changing the national income tax rates
Changing tax rates and government spending is the domain of Fiscal Policy, managed by the government (Ministry of Finance), not Monetary Policy, which is managed by the Central Bank.
Question 4
When a central bank decides to aggressively 'buy' millions in government securities from commercial banks through Open Market Operations, what is its primary objective?
- A) To reduce the money supply and cause deflation
- B) To inject cash into the banking system to increase the money supply and encourage lending
- C) To increase the national tax revenue
- D) To immediately raise the market interest rate
Show answer & explanation
Answer: B) To inject cash into the banking system to increase the money supply and encourage lending
Buying bonds means the central bank pays cash to commercial banks, increasing their reserves, which allows them to lend more money to the public, stimulating the economy.
Question 5
The central bank increases the 'cash reserve ratio' (the percentage of deposits banks must keep in the vault and cannot lend out). What is the immediate effect of this policy?
- A) It increases the ability of commercial banks to create credit, raising the money supply
- B) It decreases the ability of commercial banks to create credit, reducing the money supply
- C) It directly causes hyperinflation
- D) It immediately lowers the national debt
Show answer & explanation
Answer: B) It decreases the ability of commercial banks to create credit, reducing the money supply
If banks must hold more cash in reserve, they have less money available to lend out. This restricts the credit multiplier effect and tightens the overall money supply.
Question 6
The nation is suffering from soaring inflation. To cool down the economy, the Central Bank decides to use a contractionary monetary policy. Which specific action should the Central Bank take?
- A) Lower the benchmark interest rates
- B) Aggressively sell government bonds in the open market
- C) Decrease the cash reserve ratio for commercial banks
- D) Increase government spending on public works
Show answer & explanation
Answer: B) Aggressively sell government bonds in the open market
Selling government bonds absorbs excess cash from the banking system. With less cash available, banks lend less, slowing down the money supply and curbing inflation.
Question 7
The Central Bank significantly lowers its benchmark discount rate (the rate it charges commercial banks to borrow money). What is the intended macroeconomic effect of this policy?
- A) To make borrowing cheaper, thereby stimulating investment and consumer spending
- B) To intentionally cause a recession
- C) To decrease the total money supply
- D) To increase the national tax revenue
Show answer & explanation
Answer: A) To make borrowing cheaper, thereby stimulating investment and consumer spending
Lowering interest rates is an expansionary policy. Cheaper credit encourages businesses to invest and consumers to spend, boosting aggregate demand.
Question 8
The Central Bank increases the 'Cash Reserve Ratio', requiring commercial banks to keep 20% of their deposits locked in vaults instead of 10%. How does this affect the economy's money supply?
- A) It vastly increases the money supply by multiplying deposits
- B) It decreases the money supply by restricting commercial banks' ability to create credit
- C) It causes immediate hyperinflation
- D) It has absolutely no effect on the money supply
Show answer & explanation
Answer: B) It decreases the money supply by restricting commercial banks' ability to create credit
By forcing banks to hold a higher percentage of deposits in reserve, the central bank directly reduces the amount of money banks can lend out, shrinking the credit multiplier and the money supply.
Question 9
Which of the following tools is exclusively the domain of Monetary Policy (managed by the Central Bank) rather than Fiscal Policy (managed by the Government)?
- A) Changing corporate income tax rates
- B) Adjusting national spending on infrastructure
- C) Open Market Operations (buying/selling treasury bills)
- D) Changing the General Sales Tax (GST)
Show answer & explanation
Answer: C) Open Market Operations (buying/selling treasury bills)
Monetary policy involves managing the money supply and interest rates through tools like open market operations, reserve ratios, and discount rates. Taxes and spending are fiscal policy.
Question 10
The country is suffering from out-of-control inflation. The Central Bank initiates a 'contractionary' monetary policy to cool the economy. What specific action should it take?
- A) Lower the benchmark interest rates
- B) Aggressively sell government bonds in the open market
- C) Decrease the cash reserve ratio for banks
- D) Increase government spending on public works
Show answer & explanation
Answer: B) Aggressively sell government bonds in the open market
Selling bonds absorbs excess cash from commercial banks. With less cash, banks lend less, reducing the money supply and curbing inflationary spending.
Question 11
The Central Bank drastically lowers its benchmark discount rate (the rate it charges commercial banks to borrow). What is the intended macroeconomic effect?
- A) To make borrowing cheaper, stimulating investment and aggregate demand
- B) To instantly cause a recession
- C) To decrease the total money supply
- D) To decrease national trade deficits
Show answer & explanation
Answer: A) To make borrowing cheaper, stimulating investment and aggregate demand
Lowering interest rates is an expansionary policy that reduces the cost of borrowing, thereby encouraging businesses to invest and consumers to spend.
Question 12
The Central Bank raises the 'Cash Reserve Ratio', legally requiring commercial banks to lock 20% of their deposits in vaults instead of 10%. How does this affect the money supply?
- A) It greatly increases the money supply
- B) It decreases the money supply by restricting banks' ability to create credit
- C) It immediately causes hyperinflation
- D) It has absolutely no effect
Show answer & explanation
Answer: B) It decreases the money supply by restricting banks' ability to create credit
By forcing banks to hold a higher percentage of cash in reserve, they have less money available to lend out, shrinking the credit multiplier and tightening the money supply.
Question 13
At the time of its establishment, the authorized capital of the State Bank of Pakistan (SBP) was officially:
- A) PKR 3 Billion
- B) PKR 5 Billion
- C) PKR 30 Million
- D) PKR 500 Million
Show answer & explanation
Answer: C) PKR 30 Million
Historically, the authorized capital of the State Bank of Pakistan upon its creation was PKR 30 Million.
Question 14
In regulating the national money supply, the Central Bank engages in 'Open Market Operations'. This specific tool involves:
- A) Buying and selling government bills, bonds, and securities in the economy
- B) Changing the corporate income tax rate
- C) Increasing the commercial cash reserve requirement
- D) Forcing banks to close branches
Show answer & explanation
Answer: A) Buying and selling government bills, bonds, and securities in the economy
Open Market Operations refer strictly to the central bank buying (to inject cash) or selling (to absorb cash) government securities in the open market.
Question 15
A central bank operates under an 'inflation targeting' mandate. If current inflation appears to be soaring way above the target level, what action should the central bank take?
- A) The bank will raise benchmark interest rates
- B) The bank will aggressively increase the money supply
- C) The bank will lower the cash reserve ratio
- D) The bank will buy back massive amounts of government bonds
Show answer & explanation
Answer: A) The bank will raise benchmark interest rates
To combat high inflation, the central bank implements contractionary policy by raising interest rates to make borrowing expensive and slow down aggregate demand.
Question 16
When the Central Bank drastically increases the required 'Cash Reserve Ratio' for commercial banks, what is the direct effect on the economy?
- A) It greatly increases the money supply
- B) It decreases the money supply by restricting banks' ability to create credit
- C) It immediately causes hyperinflation
- D) It increases consumer spending
Show answer & explanation
Answer: B) It decreases the money supply by restricting banks' ability to create credit
A higher reserve ratio forces commercial banks to lock more cash in vaults, leaving less money to lend out, which shrinks the credit multiplier and money supply.
Question 17
Which of the following actions constitutes an 'Expansionary Monetary Policy' designed to pull an economy out of a severe recession?
- A) The central bank aggressively selling government bonds
- B) The central bank drastically lowering its discount/bank rate
- C) The government building massive new highways
- D) The central bank raising the reserve ratio
Show answer & explanation
Answer: B) The central bank drastically lowering its discount/bank rate
Lowering the discount rate makes borrowing cheaper for commercial banks and consumers, injecting liquidity and encouraging spending to fight a recession.