4.4.3 Role of central banks Quiz: Pearson Edexcel Economics A, Unit 4

The 20 questions

1. Which is a key function of a central bank in implementing monetary policy?

   • Setting the level of income tax that households pay each year in the annual budget statement
   • Running the country's commercial banks so that they make profits on behalf of the government each year
   • Setting the official interest rate and influencing the money supply to meet an inflation target
   • Deciding the amount of public spending on schools and hospitals in each year of the parliamentary term

2. What does it mean to describe the central bank as the 'banker to the government'?

   • It sets the wages of civil servants and decides the pensions of retired public employees each year in the budget
   • It owns all the commercial banks in the economy and makes all their lending decisions on behalf of the state
   • It lends money to the government without limit and without any repayment or interest requirement at any point
   • It manages the government's bank accounts and helps to issue and redeem government debt on its behalf

3. What is the role of the central bank as 'banker to the banks'?

   • Providing unlimited free money to any bank that asks for it, regardless of its financial position or risk
   • Holding all customer deposits for every bank, so that no commercial bank is allowed to keep money on its own books
   • Acting as a lender of last resort, so that solvent banks facing a liquidity shortage can borrow from it
   • Setting the price of every good that the banks sell to their customers, so that competition is removed

4. Why is the lender of last resort function important?

   • It helps prevent a liquidity crisis from becoming a wider collapse of confidence in the banking system
   • It guarantees that every bank makes a profit each year, regardless of the quality of its loans and investments
   • It removes the need for any regulation, since the central bank can always rescue banks without limit or conditions
   • It ensures that banks never make any loans, since the central bank takes over all lending decisions in the economy

5. Which function of a central bank involves setting rules for banks' capital and liquidity?

   • Implementation of monetary policy, which involves deciding the number of branches that each bank may open
   • Regulation of the banking industry, including prudential rules that help keep banks safe and stable
   • Lender of last resort, which involves setting the wages of all bank employees in the sector each year
   • Banker to the government, which involves deciding the rate of value-added tax for all goods sold in the economy

6. What is the main objective of monetary policy in the UK, as set by the government?

   • To meet an inflation target, currently 2 per cent a year, while supporting growth and employment
   • To set the level of unemployment at zero, regardless of the level of inflation or the state of the economy
   • To abolish the national debt entirely within a single parliamentary term through monetary action alone
   • To keep the exchange rate fixed at a set value against the dollar for every year, regardless of inflation

7. Which action would the central bank typically take to reduce inflation?

   • Cut the official interest rate, which raises borrowing and spending and so reduces the pressure on prices
   • Reduce the official interest rate to zero permanently, which removes all demand pressure from the economy
   • Increase the money supply sharply through unlimited lending, which is the normal way of reducing inflation
   • Raise the official interest rate, which tends to reduce borrowing and spending and so ease price pressure

8. Why might a central bank be given operational independence to set interest rates?

   • It allows the government to set interest rates in line with the electoral cycle and the budget timetable each year
   • It can focus on the long-term inflation target without political pressure to stimulate the economy before elections
   • It removes the need for any inflation target, since independence means that the central bank sets its own goals
   • It means the central bank can ignore the economy completely and set rates on the basis of its own preferences

9. What is quantitative easing?

   • Large-scale purchases of government bonds and other assets by the central bank, to increase the money supply and lower long-term yields
   • A policy of raising taxes on income each year so that the government can repay its debt without any borrowing
   • A policy of setting the exchange rate at a fixed level by buying and selling shares in domestic companies only
   • A policy of selling all government bonds to commercial banks, which reduces the money supply and raises interest rates

10. A central bank wants to influence the economy through the exchange rate as well as interest rates. What is a likely way to do this?

    • Setting the exchange rate by law at a fixed level, which removes the need for any intervention in currency markets
    • Banning all trade in foreign currency, which prevents any movement in the exchange rate in the domestic economy
    • Raising the wages of workers in export industries, which by itself changes the currency's value in global markets
    • Buying or selling foreign currency reserves, which changes the demand for the domestic currency in foreign exchange markets

11. Which is a potential limitation of using interest rates to control inflation?

    • Changes take time to affect spending and prices, and may hit borrowers and investment more than inflation itself
    • Interest rate changes take effect immediately on all prices in the economy, so there is never any lag or delay
    • Interest rates only affect the government's budget and never affect households or firms in any way
    • Interest rates have no effect on borrowing or spending, so central banks cannot use them to control inflation at all

12. Why might a central bank intervene during a banking crisis even when its main objective is inflation?

    • Banking crises never affect the economy, so the central bank has no reason to intervene in any situation at all
    • Banking crises always raise inflation, so the central bank must intervene only to lower banks' profits in the economy
    • The central bank is required by law to bail out every bank, whatever the cause of its difficulty or risk-taking
    • A financial crisis can disrupt credit and spending, so stability of the banking system supports the wider economy and prices

13. Which of these is a key benefit of an independent central bank with a clear inflation target?

    • Expectations of low inflation are anchored, which can make wage and price setting more stable over time
    • The government can ignore inflation in its budget, since the central bank is responsible for all inflation outcomes
    • Inflation expectations become unanchored, since the public cannot predict the central bank's decisions in any period
    • The central bank no longer needs to publish any information on its decisions or its analysis of the economy

14. What is meant by the central bank acting as 'the bank of the government' in relation to the national debt?

    • The central bank forgives all government debt each year, so that no repayment or interest is ever needed by the state
    • The central bank sets the level of the national debt by law, which cannot be changed by the government in any way
    • The central bank takes ownership of all private property in the country, which then becomes national debt in law
    • The central bank helps manage the issue and servicing of government debt, acting as the government's financial agent

15. Which statement best evaluates the role of a central bank in regulating commercial banks?

    • Regulation reduces systemic risk, but it can also limit lending and may be hard to calibrate without distorting credit
    • Regulation always raises the profits of banks, because rules remove competition and guarantee a return to shareholders
    • Regulation has no purpose, since commercial banks always act in the best interests of the wider economy without rules
    • Regulation is always costless, since stricter rules never reduce lending or the availability of credit to any firm

16. Which body sets the official interest rate for the UK?

    • The Office for National Statistics, which sets the official interest rate after publishing inflation data
    • The Treasury, which sets the official interest rate directly as part of the annual budget each year
    • The Financial Conduct Authority, which sets the official interest rate for all lenders in the country
    • The Monetary Policy Committee of the Bank of England

17. A solvent bank faces a temporary shortage of cash. What should the central bank do as lender of last resort?

    • Lend to it against good collateral so that it can meet its obligations and avoid a wider loss of confidence
    • Set the bank's interest rate on deposits to zero, so that customers withdraw less cash each day
    • Buy all of the bank's shares at a fixed price, so that the bank is taken into state ownership immediately
    • Refuse all lending, so that the bank learns from its mistakes and takes responsibility for its own liquidity

18. Higher interest rates increase mortgage payments for many households. What is the likely effect on consumption?

    • Consumption rises by the same amount as the interest rate rise, since the two always move in the same direction
    • Consumption is unchanged, because mortgage payments are not part of household spending in the economy
    • Consumption falls, since households have less disposable income after mortgage payments rise
    • Consumption rises, since households who pay more interest feel wealthier and so spend more on goods

19. Why can a central bank find it hard to hit a 2 per cent inflation target exactly?

    • Inflation is fixed by law and so can never deviate from the target, which makes exact hitting straightforward
    • Inflation depends only on the exchange rate, which the central bank can fix exactly at any level it chooses
    • The central bank controls all prices directly, so it can set inflation exactly to 2 per cent in any month chosen
    • Policy works with lags, and supply shocks and uncertainty can move inflation away from target for reasons beyond its control

20. Which is an example of the central bank acting as 'banker to the banks'?

    • The central bank providing loans to households to buy homes at a subsidised interest rate each year
    • Commercial banks holding reserve accounts at the central bank and settling payments between themselves through it
    • The central bank managing the government's accounts and arranging the issue of new government bonds each year
    • The central bank setting the fees that customers pay for opening bank accounts at commercial banks

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