HKDSE Economics Practice Paper: Money, Banking And Monetary Policy

HKDSE Economics Practice Paper: Money, Banking and Monetary Policy

2026-11-03

HKDSE Economics: Money, Banking and Monetary Policy

HKDSE Economics practice paper: 12 questions, 100 marks, 75 minutes on money supply measures, the money multiplier, bond pricing, central bank tools and bank runs, with full worked answers.

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Paper details　Level: S4-S6 | Subject: Economics | Time: 75 minutes | Marks: 100 | Questions: 12

Section A (Questions 1 to 4, 32 marks)

Read each question, quote the formula, substitute the values and give the unit.

#	Question	Answer and marking notes
1	The money and deposit data of an economy are (in billions of dollars): currency held by the public 200, demand deposits 500, savings and time deposits 1,800, negotiable certificates of deposit issued by banks 300, deposits with other deposit-taking companies 200 and foreign currency deposits 400. (a) Find M1. (b) Find M2. (c) Find M3. (d) Explain why foreign currency deposits are excluded from HK dollar M2.	(a) M1 = currency held by the public + demand deposits = 200 + 500 = 700 billion [2]. (b) M2 = M1 + savings and time deposits + negotiable certificates of deposit = 700 + 1,800 + 300 = 2,800 billion [2]. (c) M3 = M2 + deposits with other deposit-taking companies = 2,800 + 200 = 3,000 billion [2]. (d) The money supply is defined in domestic currency and foreign currency deposits are not a domestic medium of exchange, so they are excluded from HK dollar M2 and reported separately [2]. Marking: M1 covers transactional money; M2 and M3 add savings and time deposits and the liabilities of other deposit-taking institutions.
2	In an economy the required reserve ratio is 0.25, the ratio of cash held by the public to deposits is 0.1 and the monetary base is 2,000 billion. (a) Find the simple deposit multiplier. (b) Find the money multiplier. (c) Find the money supply. (d) Explain how cash leakage affects deposit creation.	(a) Simple deposit multiplier = 1 / required reserve ratio = 1 / 0.25 = 4 [2]. (b) Money multiplier = (1 + c) / (r + c) = (1 + 0.1) / (0.25 + 0.1) = 1.1 / 0.35 = 3.14 [2]. (c) Money supply = monetary base x money multiplier = 2,000 x 1.1 / 0.35 = 6,286 billion [2]. (d) Every dollar of cash the public holds is a dollar of reserves the banks cannot lend, so the chain of deposit creation is cut short; the higher the cash leakage ratio, the smaller the money multiplier [2]. Marking: the simple multiplier ignores cash leakage; the money multiplier is (1 + c) / (r + c).
3	A bond has a face value of 10,000 dollars, a coupon rate of 4 per cent paid annually, and matures in three years at face value; the market interest rate is 5 per cent. (a) Find the annual coupon. (b) Find the present value of the bond, to the nearest dollar. (c) State whether the bond sells at a premium or a discount. (d) Explain the effect of a rise in the market interest rate on the bond price.	(a) Annual coupon = 10,000 x 4 per cent = 400 dollars [1]. (b) Present value = 400 / 1.05 + 400 / 1.05^2 + 10,400 / 1.05^3 = 380.95 + 362.81 + 8,983.91 = 9,728 dollars [3]. (c) The present value is below the face value of 10,000 dollars, so the bond sells at a discount [2]. (d) A higher market rate raises the discount rate, lowering the present value of future cash flows, so bond prices and interest rates move in opposite directions [2]. Marking: a bond price is the present value of its cash flows; a coupon below the market rate means a discount.
4	The money demand function of an economy is Md = 800 – 4,000r, in billions of dollars, where r is the annual interest rate, and the money supply is fixed by the central bank at 400 billion. (a) Find the equilibrium interest rate. (b) If the money supply rises to 600 billion, find the new equilibrium rate. (c) If higher real income changes money demand to Md = 900 – 4,000r while supply stays at 400 billion, find the new equilibrium rate. (d) Explain how a rise in income affects money demand.	(a) 800 – 4,000r = 400, so r = 0.10 and the equilibrium rate is 10 per cent [2]. (b) 800 – 4,000r = 600, so r = 0.05 and the equilibrium rate is 5 per cent [2]. (c) 900 – 4,000r = 400, so r = 0.125 and the equilibrium rate is 12.5 per cent [2]. (d) Higher income means more transactions, so the public holds more money for transactions, the demand curve shifts right and, with supply fixed, the interest rate is pushed up [2]. Marking: money demand is inversely related to the interest rate; a shift in demand changes the rate when supply is fixed.

Section B (Questions 5 to 8, 36 marks)

Answer the following, showing full working and the formula used.

#	Question	Answer and marking notes
5	An economy is in recession and the central bank considers easing monetary policy. (a) State and briefly explain three conventional monetary policy tools of a central bank. (b) If the central bank buys 500 billion of government securities in the open market and the required reserve ratio is 0.2, find the maximum increase in bank deposits. (c) Explain how quantitative easing differs from conventional open market operations. (d) Explain one reason why monetary policy transmission may fail.	(a) Open market operations: buying or selling government securities to change bank reserves; changing the required reserve ratio: altering funds available for lending; changing the discount window rate: altering the cost to banks of borrowing reserves [3]. (b) Maximum new deposits = 500 / 0.2 = 2,500 billion [2]. (c) Conventional operations adjust short term rates on a modest scale, while quantitative easing buys assets, including long term bonds, on a large scale to push down long term rates and expand the central bank balance sheet, and is used when the policy rate is near zero [2]. (d) If banks will not lend or firms will not borrow, extra reserves need not become loans and deposits, so transmission fails; policy also works with lags [2]. Marking: the tools act on bank reserves; quantitative easing is an unconventional tool.
6	Inflation in an economy rises to 8 per cent and the central bank raises the policy rate from 2 to 4 per cent. (a) Find the rise in the policy rate. (b) If inflation later falls to 5 per cent while the nominal rate stays at 4 per cent, find the real interest rate before and after. (c) Explain three channels through which a rate rise reduces aggregate demand. (d) Explain why a rate rise may cause the local currency to appreciate.	(a) The rise is 4 – 2 = 2 percentage points [1]. (b) The real rate was 2 – 8 = -6 per cent before and 4 – 5 = -1 per cent after [3]. (c) Higher rates raise borrowing costs and cut investment and consumer durables; they raise the return on saving so people save rather than spend; and falling asset prices create a negative wealth effect, so aggregate demand falls [3]. (d) Domestic rates above foreign rates attract capital inflows seeking higher returns, raising demand for the local currency, which appreciates under a floating rate [2]. Marking: the real rate is the nominal rate minus inflation; policy works through aggregate demand.
7	A bank has the following balance sheet in millions of dollars: reserves 120, loans 700, securities 180; deposits 900 and capital 100. The required reserve ratio is 12 per cent. (a) Find the reserve ratio. (b) If depositors withdraw 45 million in total, find the new reserve ratio and state whether the legal requirement is met. (c) Explain the difference between liquidity risk and solvency risk. (d) Explain how deposit insurance reduces bank runs.	(a) Reserve ratio = 120 / 900 = 13.3 per cent [2]. (b) After withdrawals of 45 million, deposits are 855 million and reserves 75 million, so the ratio is 75 / 855 = 8.8 per cent, below the 12 per cent requirement of 102.6 million; the bank must sell securities or borrow about 27.6 million [3]. (c) Liquidity risk is a shortage of cash to meet withdrawals although assets still exceed liabilities, while solvency risk is assets falling below liabilities so that net worth is negative [2]. (d) Deposit insurance protects small depositors, removing the incentive to withdraw first, so panic runs are reduced and trouble at one bank is less likely to become systemic [2]. Marking: the required ratio applies to deposits; liquidity and solvency are different risks.
8	In an economy the money supply is 800 billion, the velocity of circulation is 5 and real output is 2,000 billion. (a) Use the equation of exchange MV = PY to find the price level. (b) If the money supply rises by 20 per cent while velocity and real output are unchanged, find the new price level and the inflation rate. (c) If real output also grows by 5 per cent, find the new price level and the inflation rate. (d) Explain why the link between money growth and inflation is unstable in the short run.	(a) MV = PY gives 800 x 5 = 4,000, so P = 4,000 / 2,000 = 2.0 [2]. (b) The money supply rises 20 per cent to 960, so 960 x 5 = 4,800 and P = 4,800 / 2,000 = 2.4, an inflation rate of 20 per cent [3]. (c) Real output rises 5 per cent to 2,100, so P = 4,800 / 2,100 = 2.29 and the inflation rate is (2.29 – 2.0) / 2.0 = 14.3 per cent [2]. (d) In the short run velocity and real output move with interest rates, expectations and spare capacity, so part of any money growth is absorbed by output and velocity and the money-price link is not mechanical [2]. Marking: P = MV / Y; money neutrality holds only in the long run.

Section C (Questions 9 to 12, 32 marks)

Show fuller working and explanation, with units in every answer.

#	Question	Answer and marking notes
9	An economy operates a currency board under which 7.8 units of local currency are issued against each US dollar of reserves. (a) If foreign reserves are 40 billion US dollars, find the maximum monetary base. (b) If there is a net inflow of 2 billion US dollars, find the change in the monetary base. (c) Explain how local interest rates adjust automatically under this system. (d) Explain the conflict between a fixed exchange rate and an independent monetary policy.	(a) Maximum monetary base = 400 x 7.8 = 3,120 billion [2]. (b) A net inflow of 2 billion US dollars raises the monetary base by 2 x 7.8 = 15.6 billion [2]. (c) Inflows raise reserves and the monetary base and push local rates down; if the base contracts, rates rise and funds flow out until the exchange rate returns to its level, so rates adjust passively to defend the rate [2]. (d) Under a fixed rate, interest rates must serve the exchange rate target and cannot also control local inflation and unemployment, so the central bank gives up an independent monetary policy and can have only one of the two [2]. Marking: a currency board backs the monetary base fully with foreign reserves; the interest rate is the adjustment mechanism rather than a policy tool.
10	(a) Outline three functions of banks as financial intermediaries. (b) Explain how information asymmetry between depositors and borrowers leads to adverse selection. (c) Explain how moral hazard affects a bank lending decision. (d) Give one institutional arrangement that reduces information asymmetry.	(a) Banks pool small deposits into large loans, achieving economies of scale; they diversify loan portfolios to spread risk; and they use specialist skills to assess borrowers, lowering screening and monitoring costs [3]. (b) Borrowers know their own risk better than the bank, and those willing to pay high rates tend to be the risky ones, so pricing at average risk drives out safe borrowers and leaves mainly risky ones, which is adverse selection [2]. (c) After the loan is made, borrowers may change the use of funds or take excessive risk and the bank cannot monitor fully, so it demands collateral and covenants and may ration credit [2]. (d) For example, requiring listed firms to disclose financial statements, setting up a credit reference database, or requiring independent audits [1]. Marking: adverse selection occurs before the contract and moral hazard after it.
11	Unemployment in an economy is 7 per cent and inflation is 6 per cent. (a) Explain the conflict between policy objectives facing the central bank. (b) Using the Phillips curve, explain how the unemployment and inflation trade-off differs in the short run and the long run. (c) Explain the importance of central bank independence. (d) Give one situation in which monetary policy cannot solve unemployment.	(a) Unemployment at 7 per cent calls for easing to stimulate demand while inflation at 6 per cent calls for tightening, so the two objectives conflict [2]. (b) The short run Phillips curve shows a trade-off, so expansion lowers unemployment but raises inflation; in the long run, once expectations adjust, the curve is vertical at the natural rate, so policy can change inflation but cannot lower unemployment permanently [3]. (c) Independence stops governments from expanding the money supply for short term electoral gain, making policy credible, stabilising inflation expectations and lowering the cost of disinflation [2]. (d) If unemployment is structural, such as a skills mismatch or industrial restructuring, demand management cannot create suitable jobs and education and retraining are needed [1]. Marking: the trade-off exists in the short run only; structural unemployment is beyond monetary policy.
12	A bank offers two five-year loans: loan A at a nominal annual rate of 6 per cent compounded monthly, and loan B at 6.2 per cent compounded annually. The amount borrowed is 200,000 dollars. (a) Find the effective annual rate of loan A. (b) State which loan has the lower borrowing cost. (c) Find the equal monthly payment on loan A, to the nearest dollar. (d) Explain why loans should be compared using the effective annual rate rather than the nominal rate.	(a) Effective annual rate of loan A = (1 + 0.06 / 12)^12 – 1 = 6.17 per cent [2]. (b) Loan A at 6.17 per cent is below loan B at 6.2 per cent, so loan A has the lower cost [2]. (c) With a monthly rate of 0.5 per cent and 60 instalments, the payment is 200,000 x 0.005 / (1 – 1.005^-60) = 3,867 dollars [2]. (d) The effective annual rate converts compounding frequency into one annual basis, while the nominal rate states only the quoted coupon and cannot compare the true cost of different repayment schedules [2]. Marking: the effective rate allows for compounding; compare loans on the same basis.

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