CFA Practice Question

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CFA Practice Question

The nation of Economica has increased their M1 money supply by 10% over the last year by printing currency. This policy causes no price inflation. Which of the following could explain this phenomenon?

I. The nation of Islandia begins using the Economican currency as a reserve.
II. Aggregate output increases in Economica.
III. The Central Bank begins a government debt buy-back program.
A. I, II, III
B. I, II
C. I only
Explanation: Under the basic price level equation P = M / Y (Price Level = Money Supply / Output, ignoring the velocity of money for the moment), a 10% increase in the money supply would result in an increase in the price level. One obvious thing that could prevent price inflation would be a corresponding increase in output. Another possibility would be some reduction in the money available for the purchase of goods, such as a foreign nation holding domestic currency as a reserve.

When Central Banks buy government debt, they usually do so with newly printed cash, and even if not, a debt buy-back would serve to decrease interest rates, which would result in an expansion of the money supply.

User Contributed Comments 2

User Comment
george2006 debt buy back --> lower interest rate --> increase money supply --> price to go up. but the question says no inflation so it is not a correct answer.
davcer It says which of the options can explain the phenomenon, so both i and iii explain no inflation but with ii inflation si obvious
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