CFA Level I Economics Practice Questions
Question 1
A central bank wants to increase the money supply and put downward pressure on short-term interest rates using its most commonly used tool of monetary policy implementation. Which action is most consistent with this goal?
- A. Increasing the reserve requirement for commercial banks
- B. Selling government securities in the open market
- C. Purchasing government securities in the open market
- D. Raising the discount rate
Show answer and explanation
Correct answer: C. Purchasing government securities in the open market
Open market operations are the tool most central banks use most frequently to implement monetary policy. Purchasing government securities injects reserves into the banking system, expanding the money supply and putting downward pressure on short-term interest rates.
- A. Wrong — raising reserve requirements reduces banks' lending capacity, contracting the money supply, the opposite of the stated goal.
- B. Wrong — selling securities withdraws reserves from the banking system, contracting the money supply, the opposite of the goal.
- C. Correct.
- D. Wrong — raising the discount rate makes central-bank borrowing more expensive, a contractionary action, not an expansionary one.
Question 2
A central bank has an inflation target of 2.0%, and its estimate of the real trend rate of economic growth is 1.8%. The policy rate is currently set at 3.0%. Using the neutral-rate concept, the policy stance is best described as:
- A. contractionary, because the policy rate exceeds the inflation target
- B. expansionary, because the policy rate is below the estimated neutral rate of 3.8%
- C. neutral, because the policy rate is within one percentage point of the inflation target
- D. contractionary, because the policy rate is above the real trend growth rate
Show answer and explanation
Correct answer: B. expansionary, because the policy rate is below the estimated neutral rate of 3.8%
The neutral nominal policy rate is approximately the real trend growth rate plus the inflation target: 1.8% + 2.0% = 3.8%. A policy rate below neutral is expansionary because it is lower than the rate that neither stimulates nor restrains the economy.
- A. Comparing the policy rate to the inflation target alone is incorrect; the real growth component must be added.
- B. Correct. A 3.0% rate sits below the 3.8% neutral rate, so policy is expansionary.
- C. Closeness to the inflation target does not define a neutral stance; the benchmark is the neutral rate.
- D. Comparing the nominal policy rate with real growth alone mixes nominal and real concepts.
Question 3
The current spot exchange rate is $1.10 per euro (USD/EUR). Expected inflation over the next year is 4% in the United States and 1% in the Eurozone. According to relative purchasing power parity, the approximate expected spot exchange rate in one year is closest to:
- A. $1.133 per euro
- B. $1.067 per euro
- C. $1.100 per euro (unchanged)
- D. $1.144 per euro
Show answer and explanation
Correct answer: A. $1.133 per euro
Relative PPP predicts that the currency of the higher-inflation country depreciates by approximately the inflation differential. Here, the expected percentage change in the USD/EUR rate is approximately inflation_US minus inflation_Eurozone = 4% − 1% = 3%, so the dollar price of one euro is expected to rise (the dollar depreciates) to approximately $1.10 × 1.03 ≈ $1.133. Choice B reverses the direction, Choice C ignores the inflation differential entirely, and Choice D naively adds the raw US inflation rate without netting out Eurozone inflation.
- A. Correct — under relative PPP, S1 ≈ S0 × (1+i_US)/(1+i_Eurozone) = $1.10 × (1.04/1.01) ≈ $1.133; the higher-inflation currency (USD) is expected to depreciate, meaning more dollars per euro.
- B. Incorrect — $1.067 inverts the inflation differential (dividing by the higher-inflation rate instead of the lower one), implying euro depreciation when the euro should actually appreciate.
- C. Incorrect — an unchanged rate ignores the inflation differential entirely; relative PPP predicts the exchange rate moves to offset differing inflation rates.
- D. Incorrect — $1.144 applies the full U.S. inflation rate without dividing by the Eurozone's inflation rate, overstating the expected depreciation.
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A country with a trade deficit sees its currency depreciate. According to the Marshall-Lerner condition, the trade balance will improve in the long run if:
- A. the sum of the absolute price elasticities of demand for exports and imports is less than 1
- B. the price elasticity of import demand is below 1 in absolute value
- C. the sum of the absolute price elasticities of export demand and import demand exceeds 1
- D. domestic saving exceeds domestic investment at the new exchange rate
Show answer and explanation
Correct answer: C. the sum of the absolute price elasticities of export demand and import demand exceeds 1
The Marshall-Lerner condition states that a depreciation improves the trade balance when the sum of the absolute values of the price elasticities of export demand and import demand is greater than 1. Otherwise, price effects dominate volume effects and the trade balance can worsen.
- A. A sum below 1 means volume responses are too weak, and the trade balance would not improve.
- B. Inelastic import demand means the import bill rises with depreciation, which works against improvement.
- C. Correct. The elasticity sum must exceed 1.
- D. This is an accounting identity relating saving, investment, and the current account, not the Marshall-Lerner condition.