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Crash Course for
Economics
CFA

Level-I Exam

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Economics






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Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
Elasticity of Supply Elasticity of Demand
Price elasticity of Demand = % change in
Quantity demanded / %change in Price
%change = change in value / Average Value
If absolute value > 1, demand is elastic;
If absolute value < 1, demand is inelastic
If absolute value = 1, demand is unit elastic.
Elastic demand: A small price increase causes a
large decrease in quantity demanded
Inelastic demand: A large price increase causes
a small decrease in quantity demanded
Perfectly elastic demand: A small price
increase reduces the quantity demanded to 0.
Perfectly inelastic demand: A price change
does not affect the quantity demanded.
Income Elasticity Cross Elasticity
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Elasticity of Supply Elasticity of Demand
Price elasticity has two main determinants:
Availability of substitutes: If substitute goods are available, consumer may
switch to a substitute good if price rise. The presence of many substitutes
may tend to increase demand elasticity
Share of budget spent on product: goods that occupy relatively small portion
of your budget will tend to be price inelastic
An inferior good has -ve income elastic
An normal good has +ve income elastic
Income elasticity of Demand =
%change in Quantity demanded
/ %change in real income
Cross elasticity of Demand =
%change quantity demanded /
%change in price of substitute
or complement
Income Elasticity
Cross Elasticity
Q. The cross elasticity of demand for a
substitute good and the income
elasticity for an inferior good are:
Cross elasticity Income elasticity
A. < 0 > 0, < 1
B. < 0 < 0
C. > 0 > 0, < 1
D. > 0 <0
Ans: D

Q. If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy decreases
from 10 to 8 cones, then your elasticity of demand
would be calculated as:




( )
( ) /
( . . )
( . . ) /
.
.
10 8
10 8 2
2 20 2 00
2 00 2 20 2
22%
95%
2 32

+
= =
Relatively Inelastic
Perfectly Elastic
Perfectly Inelastic
Price Elasticity
Price
Quantity/Time
Relatively Elastic
Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
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Elasticity of Supply Elasticity of Demand
Price elasticity of supply = % change in
Quantity supplied / %change in Price
Two main determinants:
Available substitute for raw materials
used to produce the goods
Time elapsed since the last price
change
Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
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Elasticity of Demand, Supply
& Tax Incidence
Consumer &
Producer Surplus
Efficient Resource
Allocation
Idea About
Fairness
Market in Action
Q. Which of the following is least likely to
result in DWL?
Indian Railways
Indian Oil
MTNL
Ans. Indian railways operate in monopoly
market & Indian Oil sells subsidized good.
In both cases DWL are bound to get
created, whereas MTNL operates in a
competitive telecom market
Price ceiling is an upper limit on
the price a seller can charge.
Price floor is the lowest limit on
the price that a buyer can offer for
a good or service.
A deadweight loss results
because less than the efficient
quantity is produced or consumed
Tax revenue from
sellers
Elastic Supply Curve
Tax revenue from
buyers
P
tax
P
E
P
s
Price
S
D
DWL
Quantity
D tax
Q
tax
Q
E
Ttax revenue from sellers
Taxtax revenue from buyers
P
P
E
P
tax
D tax
E
Inelastic Supply Curve
Price
S D
DWL
Quantity
Q
tax
Q
E
Elastic Demand Curve
Tax revenue from
sellers
Tax revenue from
buyers
P
tax
P
E
P
S
Price
S
D
DWL
Quantity
S
tax
Q
tax
Q
E
Inelastic Demand Curve
Tax revenue from
sellers
Tax revenue from
buyers
P
tax
P E
P S
Price
S
D
DWL
Quantity
S
tax
Q
tax
Q
E
Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
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Tax revenue from
sellers
Elastic Supply Curve
Tax revenue from
buyers
P
tax
P
E
P
s
Price
S
D
DWL
Quantity
D tax
Q
tax
Q
E
TTax revenue from sellers
TaxTax revenue from buyers
P
P
E
P
tax
D tax
E
Inelastic Supply Curve
Price
S D
DWL
Quantity
Q
tax
Q
E
Elastic Demand Curve
Tax revenue from
sellers
Tax revenue from
buyers
P
tax
P
E
P
S
Price
S
D
DWL
Quantity
S
tax
Q
tax
Q
E
Inelastic Demand Curve
Tax revenue from
sellers
Tax revenue from
buyers
P
tax
P
E
P
S
Price
S
D
DWL
Quantity
S
tax
Q
tax
Q
E
Elasticity of Demand, Supply
& Tax Incidence
Consumer &
Producer Surplus
Efficient Resource
Allocation
Consumer surplus is the difference b/w
what a consumer is willing to pay for a good
or service & what he actually pays for it
Producer surplus is the difference b/w the
price a producer receives for a unit output &
minimum supply price for (opportunity cost
of) that unit.
Marginal social benefit is the sum of all
consumers marginal benefit from a good or
service. The marginal social benefit curve is
the market demand curve for the good or
service
Idea About
Fairness
Market in Action
Q. If a consumer is ready to pay $300 for i-phone, but has to pay only $199, the
difference of $101 is?
A) Consumer deficit B) Producer surplus C)Consumer
surplus
Ans. Consumer surplus
Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
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Elasticity of Demand, Supply
& Tax Incidence
Consumer &
Producer Surplus
Efficient Resource
Allocation
Idea About
Fairness
Market in
Action
Obstacles to Efficient Resource
Allocation
Price Controls
Taxes, Subsidies & Production quotas
Monopoly
External Benefits
Public Goods & Common Resources
Utilitarianism is the idea that the value
of an economy is maximized when
each individual owns an equal amount
of the resources.
The Symmetry Principle implies that
when an economy is based on private
property & voluntary exchange ,
individual get goods & services that are
equal in value to their contribution to
the economy
Tax revenue from
sellers
Elastic Supply Curve
Tax revenue from
buyers
P
tax
P
E
P
s
Price
S
D
DWL
Quantity
D tax
Q
tax
Q
E
TTax revenue from sellers
TaxTax revenue from buyers
P
P
E
P
tax
D tax
E
Inelastic Supply Curve
Price
S D
DWL
Quantity
Q
tax
Q
E
Elastic Demand Curve
Tax revenue from
sellers
Tax revenue from
buyers
P
tax
P
E
P
S
Price
S
D
DWL
Quantity
S
tax
Q
tax
Q
E
Inelastic Demand Curve
Tax revenue from
sellers
Tax revenue from
buyers
P
tax
P
E
P
S
Price
S
D
DWL
Quantity
S
tax
Q
tax
Q
E
Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
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Parameter Perfect
Competition
Monopoly Monopolistic Market Oligopoly
Product Type Homogenous Well-defined
product with
no substitute
similar yet not
perfectly substitutable
Similar or
differentiated
Number of
Producers
Large no. of
independent
producers
Single firm A large no. of
independent sellers
A small no. of
firms
Market Share Very Small Near 100% Small High
Barriers to Entry No barriers Very high Low High
Price Commanding
Power
Price Takers Price
Searchers
Very Low Follow
Demand Curve Perfectly
Inelastic
Downward
Sloping
Downward sloping Downward
Sloping or
kinked
Price
discrimination
No Yes Low No
Four Firm
Concentration
Ratio
Below 40% 100% 40%-60% Greater than
60%
Herfindahl
Hirschman Index
Less than 1,000 10,000 1,000-1,800 Greater than
1,800
Micro Economics
Elasticity Market & Efficiency Competitive Market
Markets for factors of
Production
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Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Rate of change in price
index over a given period
of time
i = [current price index -
last period price index] /
last period price index
Jobs & Price Level
Aggregate supply Shift in Curve Aggregate Demand
Q Which of the following events is least likely to cause
a downward shift in short-run aggregate supply?
a)A labor stoppage causes the price of steel to rise.
b) Inflation increases from 4% to 7%.
c) Oil exporting countries reduce their production
levels
Ans: B

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Aggregate Supply Shift in Curve Aggregate Demand
Full Employment
Real O/P
Long run Aggregate
supply (SAS)
Price Level
Real O/P (GDP)
Short run Aggregate
supply (SAS)
Aggregate supply in Long run and Short run
Q Which of the following events is least likely to
cause a downward shift in short-run aggregate
supply?
a)A labor stoppage causes the price of steel to rise.
b) Inflation increases from 4% to 7%.
c) Oil exporting countries reduce their production
levels
Aggregate supply - amount of
goods and services produced by an
economy.
Function of the price level - higher
prices bring about a greater amount
of supply in the short run.
The SAS and LAS curves will both shift when:
The full-employment quantity of labor changes
The amt of available capital in the economy changes
As technology improves the productivity capital, labor,
or both.
There are some factors that will shift SAS, but not
affect LAS.
If the wage rate or prices of other productive
inputs increase, the SAS curve will shift to the
left, a decrease in short-run aggregate supply.
When businesses observe a rise in resource
prices, they will decrease their output as the profit
maximizing level of output declines.
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Aggregate Supply Shift in Curve Aggregate Demand
GDP
1
GDP*
Price Level
P
0
P
SR
P
LR
LAS
SAS
1
SAS
0
AD
0
AD
1
Real O/P GDP
Adjustment to a decrease in aggregate demand
LAS
P
2
P
1
P
0
SAS
1
Real GDP
Price Level
Resulting increase in aggregate demand
SAS
0
AD
1
AD
0
Decrease in AD from AD
0
to AD
1
will
lead to a new short-run equilibrium
with the price level at PSR & real
GDP at GDP
1
which is less than full-
employment GDP (a recession)
From an initial state of long-run
equilibrium at the intersection of AD
0

with LAS, assume that aggregate
demand increases to AD
1
. The new
short-run equilibrium will be at over full
employment with real GDP at GDP
1
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Aggregate Supply Shift in Curve Aggregate Demand
Components of aggregate demand:
Consumption (C)
Investment (I)
Government spending (G)
Net exports (X), which is exports minus
imports
Aggregate demand = C + I + G + X
Factors affecting Aggregate Demand:
Expectations about future incomes (C),
inflation (C), and profits (I)
Fiscal policy
Spending G
Taxes or Transfer Payment (Social
Security) C
Monetary policy
Money supply Interest rate C
and I AD
World economy : If country's exchange
rate AD
Q. Increase in money supply will cause
GDP to
1. Increase in both short run and long
run
2. Increase at higher rate in short run
and temporarily increase in long
run
3. Increase in short run and
temporarily increase in long run
Ans. Increase in money supply will
cause GDP to increase at higher rate in
short run due to multiplier effect and
temporarily increase in long run which
reverses and GDP returns to full
employment GDP level
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Jobs Price Level Unemployment & Inflation
Rate of unemployment: No. of
unemployed / no. of people in labor
force.
Labor-force participation rate: Civilian
labor force / civilian population age 16 or
older.
Employment-to-population ratio: %age
of working-age population who are
employed
Aggregate hours: Total hours worked in
a year by all employed people.
Real wage rate: Money wages adjusted
for changes in the price level
Key Labor Market Indicators Types of Unemployment
Frictional unemployment arises from constant
changes in the economy that prevent qualified
workers from being matched with existing job
openings in a timely manner.
Structural unemployment is caused by
structural changes in the economy that eliminate
some jobs while generating job openings for
which unemployed workers are not qualified.
Cyclical unemployment is caused by a change
in the general level of economic productivity.
When the economy is operating at less than full
capacity, positive levels of cyclical unemployment
will be present.
Q. Which of the following is most likely to be an example of structural unemployment?
A) Jack was unable to find new job with a lucrative salary, though he was offered a salary
hike of 15% by another employer
B) Demand for the actuarial candidates are quite high compared to insurance agent
C) John is searching for a new job as he dont have expertise in handling new high rise
crane, which his employer has installed recently
Ans: C
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Jobs Price Level Unemployment & Inflation
Unanticipated inflation: An
unexpected decrease i``n the
purchasing power of (real value of)
currency.
Effects:
Long-term contracts of fixed future
payments decrease in value.
Decreases the value of a fixed-
payment mortgage held by a bank,
Gains and losses in the labor
market:
- real value of the wages
decreases
- gain for employers at the
expense of employees
Even when inflation rates are
correctly anticipated, it has adverse
effects
Higher transaction costs: Time &
effects diverted from producing
activity reduces real GDP
Tax effects: Real after tax returns on
investment are distorted by inflation
Demand Pull & Cost
Push Inflation
Phillips Curve
Unanticipated &
Anticipated Inflation
SR Phillips curve
intersects the LR Phillips
curve at the expected
rate of inflation.
1
Short run PC when
expected inflation=6%
Short run PC when
expected inflation=8%
GDP
F
12
%


10
%


8%


6%


4%

Unemployment
Phillips Curve
Long Run Phillips
Curve
PC
1

PC
2
Inflation
2
GDP
1
GDP
2
Price Level
P
3
P
2
P
1
LRAS
SRAS
1
SRAS
2
AD
2
AD
1
Real GDP
Demand Pull Inflation
SRAS
1

GDP
2

GDP
1

GDP
1

Price
Level
P
3

P
2


P
1

LRAS
SRAS
2

AD
2

AD
1

Real
GDP
Cost Pull
Inflation
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Jobs Price Level Unemployment & Inflation
CPI measures the average price for a defined
"basket" of goods and services that represents
the purchasing patterns of a typical urban
household.
CPI= [(cost of basket at current prices) / (cost of
basket at base period prices)] x 100
CPI bias CPI overstates inflation due to:
New goods: Older products replaced by
newer but initially more expensive products
Quality changes: If the price of a product
increases because the product has improved
Commodity substitution: When 2 goods are
substitutes for each other, consumers increase
their purchases of the relatively cheaper good &
buy less of the relatively more expensive good.
Outlet substitution: When consumers shift
their purchases toward discount outlets & away
from convenience outlets, they reduce their cost
of living in a way the CPI does not capture.
Q. Price of common salt was 5 cents in year 1990
and is presently sold at 20 cents. During the same
period CPI has increased from 154.5 to 365.8. What
has been the change in real price of salt over this
period?
Ans: CPI Multiplier = 365.8/154.5= 2.36, CPI
Adjusted Salt Price = 5*2.36 = 11.8, Real Increase =
20/11.8=> 69.5%
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Function of Money
Quantity of Money
Theory
Demand & Supply for
Money
Federal Reserve &
Supply of Money
Depository
Institution
LAS
P
2
P
1
P
0
SAS
1
Real GDP
Price Level
Resulting increase in aggregate demand
SAS
0
AD
1
AD
0
5%
4%
Demand for
Money
MS
0
Real Money
Interest Rate
Increase in Money Supply
MS
1
(SR)
(LR)
(SR)
Medium of Exchange
Unit of ACCOUNT
Store of value
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Function of Money
Quantity of Money
Theory
Demand & Supply for
Money
Federal Reserve &
Supply of Money
Depository
Institution
Q. What is the maximum increase
in the money supply on Fed
decision if (a) Fed buys $2billion in
securities in the open market
(b)required reserve ratio is 10%
and (c)Currency drain is 2%?
1. $20 bn
2. $17 bn
3. $16 bn
Ans. Change in quantity of money
= (1.02)/(.12)= 8.5; 2 X 8.5 =17
What determines the demand for
money:
Interest rates: Most critical
Inflation: Increase the demand
for nominal money
Real GDP growth: Also
increases the demand for money
(nominal & real)
Money supply measures:
M1 refers to all currency in the
form of traveler's checking
account deposits of individuals &
firms and currency not held in
banks,.
M2 refers to M1 plus time
deposits, savings deposits, &
money-market mutual fund
balances
Money Multiplier: The money
multiplier for a change in the
monetary base thus depends on
both the required reserve ratio and
the currency drain:
money multiplier = (1+ c) /(r + c)
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Discount rate is a rate at
which banks can borrow
reserves from the fed.
Lower Discount rate =>
increased money supply,
decreased interest rates;
Higher rates => decreased
money supply & increase
interest rate.
Reserve Requirement:
Higher %age reduces the
money supply & increases
interest rates; lower %age
increase the money supply
& decreases interest rates.
Opening market
operations: Fed buying &
selling of treasury securities.
Fed purchases increase
cash available for lending,
decreasing interest rates.
Fed sales remove cash,
increasing interest rates
Feds balance sheet
Assets: Gold, deposit with
other central banks, IMF
special drawing rights;
Treasury securities; loans
to bank at the discount rate
Liabilities: U.S. currency in
circulation; banks reserve
deposits
Function of Money
Quantity of Money
Theory
Demand & Supply for
Money
Federal Reserve &
Supply of Money
Depository
Institution
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Equation of exchange
money supply x velocity =
price x real o/p= GDP
Velocity: average number of
times per year each dollar is
used to buy goods and
services (velocity = GDP /
money supply),
Banks
Thrift institutions
Mutual Funds
Their Functions
Create liquidity: Use short-term
deposits to make long-term loans
Act as financial intermediaries:
Lend at lower cost than borrowers
could achieve by seeking out
individual lenders.
Pool default risks: Hold a portfolio
of loans & monitor their risks
Risk management by Depository:
Proportion of various types of loans
Percentage of deposits
Types of deposits
Share of owners capital
Deposit expansion multiplier = 1 /
required reserve ratio
Potential increase in money supply =
deposit expansion multiplier *
increase in excess reserves
Function of Money
Quantity of Money
Theory
Demand & Supply for
Money
Federal Reserve &
Supply of Money
Depository
Institution
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Fiscal Policy refers to Government's use of spending and
taxation, referred as supply side effects.
Monetary Policy Automatic Stabilizer
0%
100%




Laffer Curve
Tax
rate
Tax
Revenue
Taxes Savings Investment Capital Real GDP
Ricardo Barro effect refers to increase in fiscal
deficit shall cause higher taxes in future
Investment
Sources of investment financing
National savings
Borrowing from foreigners
Government savings
The crowding-out effect occurs when
budget deficits (negative Govt. saving)
caused by expansionary fiscal policy
lead to higher interest rates & lower
private investment.
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Importance of Timing in Fiscal Policy:
Recognition Delay: Time it takes
policy to recognize that a policy
change is necessary.
Administrative or law making delay:
Time lag b/w recognition & final
passage of law or policy change.
Impact delay: Time lag b/w passage
of the law or policy & when its impact
is felt in the economy
Fiscal Multiplier
& factor affecting
fiscal Multiplier
Generational effects of Fiscal policy:
The difference b/w the PV of future
benefits promised to voters (such as
Medicare insurance in the US) & the
currently collected taxes is referred to
as a generational imbalance.
When government expenditures increases, aggregate demand
& GDP increases by some multiple, as wages & payments
received by workers & capital owners lead to future increases
in aggregate expenditures. This is referred to as the
expenditures (Govt. purchases) multiplier.
Government purchases multiplier: A
dollar of government spending
causes more than a $1 increase in
aggregate demand.
Tax multiplier: Tax cuts also have
magnified effects on aggregate
demand, less than government
purchases as some of the tax is saved.
Balanced budget multiplier:
Combined program of government
purchases & taxes, an increase in
spending and equal increase in
taxes will have a stronger positive
effect on aggregate demand
Fiscal Policy refers to Government's use of spending and
taxation, referred as supply side effects.
Monetary Policy Automatic Stabilizer
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Automatic Stabilizer
Automatic stabilizers are built-in fiscal devices
that ensures surplus in a recession & deficits
during booms. Automatic stabilizers minimize
the problem of proper timing. There are 2
main stabilizers:
Induced Taxes: People
drop from the tax rolls
during downturns & are
added to tax rolls (or
enter higher brackets)
during booms.
Corporate tax collection
is lower during
economic downturns
Needs-tested
spending: More
money is paid
out as more
people become
unemployed
Business Cycle
A business cycle is characterized
by fluctuations in economics
activity & has 2 phases
(contraction & expansion) & 2
turning points (through & peak)
Key determinants of business
cycle:
Real GDP
Real income
Employment
Industrial Production
Wholesale-retail sales
Average
Expansion
Contraction
(Recession)
Time
Business Cycle
Business Peak
Real
GDP
Recessionary Trough
Fiscal Policy refers to Government's use of spending and
taxation, referred as supply side effects.
Monetary Policy Automatic Stabilizer
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Impact of expansionary monetary policy on
Inflation rate Small Increase
Real GDP o/p &
employment
Increase
Impact of restrictive monetary policy on:
Inflation rate Small Decrease
Real GDP o/p &
employment
Decrease
Effects of change in Monetary Policy
Alternative monetary policy strategies Fed include:
The McCallum rule, talks about the growth rate of the monetary base. Its main drawback is that shifts in the
demand for money can cause fluctuations in interest rates and aggregate demand.
A rule that targets the growth rate of the money supply may also present problems in that changes in both
money demand and money velocity can cause volatility in aggregate demand and interest rates.
Keeping the foreign exchange rate with other countries currencies stable would cause the domestic inflation
rate to match that of the other countries, over which the Fed has no control.
Inflation rate targeting is used by many central banks, the notable exceptions being those of the U.S. & Japan.
The performance of strict inflation targeting, compared to the Feds method of monetary policy determination is
still subject to debate.
Fiscal Policy refers to Government's use of spending and
taxation, referred as supply side effects.
Monetary Policy Automatic Stabilizer
Macro Economics
Inflation
Aggregate Demand &
Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
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Macro Economics
Inflation
Aggregate Demand
& Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
International Trade and
Capital Flows
Recardian Model of Trade
Has only one factor of
production- labor
Heckscher & Ohlin Model of
Trade- Redistribution of wealth
within each country between
labor and owners of capital
Reasons for Trade restrictions:
1.Infant Industry
2. National Security

Types of trade restrictions include:
Tariffs- Taxes on imported goods collected by govt.
Quota- Limits on the amount of imports allowed over some
period.
Export subsidies Govt. payments to firms that export
goods.
Minimum Domestic Content- requirement that some %age
of product content must be from the domestic country.
Voluntary Export Restraint- A country voluntarily restricts
the amount of goods that can be exported.

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Macro Economics
Inflation
Aggregate Demand
& Supply
Monetary & Fiscal
Policy
Money
Jobs & Price Level
International Trade and
Capital Flows
Effect of tariffs and quotas

Types of Trading
Blocs
Free Trade Areas
Custom Union
Common Market
Economic Union
Monetary Union

Balance Of Payments
include:
1. Current Account
consists of:
A> Merchandise and
services
B> Income Receipts
C> Unilateral Transfers
2. Capital Account
consists of:
A> Capital transfers
B> Sales and purchase
of non financial assets
3. Financial Account
include:
A> Govt. owned assets
abroad
B> Foreign owned assets
in the country

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Trade restrictions:
1. Tariffs
2. Quotas
3. Voluntary Export restraints
Arguments for trade restriction:
1. Developing Industries
2. Anti-dumping agreement
3. National defense industries to be protected

Trade restriction which have little support:
1. Protect jobs
2. Create jobs
3. Low wage countries depress wage rates in high wage
countries
Economics
Foreign
Exchange
Exchange Rate &
Balance of Payments
Trading with
the World
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Nominal & real
exchange rate
Balance of
Payments
The nominal exchange rate
is Amount of currency that
is required to buy one unit
of other currency
The real exchange rate
reflects the cost of
purchasing an identical
basket of goods with 2
different currencies
Real exchange rate
=E*(P/P*)
Demand & supply in
foreign exchange
current a/c + capital a/c + Official
reserve a/c =0
Current account: Records trade in
goods and services, transfer
payments, net profits and interests
earned on assets abroad
Capital account : Records
transactions in financial assets and
land
Official settlement account :
Records changes in official reserves
which are gold, foreign currency,
SDRs
Exchange rate policies:
There are 3 fundamental type
of exchange rate policies:
Fixed Rate
Floating Rate
Crawling exchange rate
Economics
Foreign
Exchange
Exchange Rate &
Balance of Payments
Trading with
the World
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D
0
D
1
E
1
E
0
USD per INR
S
1
S
0
Quantity of INR
Decrease in
supply of INR
Increase in demand
for INR
Demand and Supply shifts in the foreign Exchange markets
Nominal & real
exchange rate
Balance of
Payments
Demand & supply in
foreign exchange
There are 3 factors that determine the
demand for & supply of the currency
Interest rates for deposits in the
currency
Future exchange rate expectation
Demand for domestic products in
international market is
Exchange rate policies:
There are 3 fundamental type
of exchange rate policies:
Fixed Rate
Floating Rate
Crawling exchange rate
Economics
Foreign
Exchange
Exchange Rate &
Balance of Payments
Trading with
the World
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Direct & Indirect
Quotes
Cross Currency
Rates
Direct Quotes: Domestic currency per
unit of foreign currency
Indirect Quotes: Foreign currency per
unit of domestic currency
Spot Rate &
Forward rate
Cross rates are the Exchange
rates between two currencies
derived from exchange rate
with a common third currency
When rates quoted by
dealer/bank are different from
cross rates obtained
theoretically, triangular
arbitrage may be possible
Forward Discount
& Premium
Bid Price: price, the dealer will pay for
1unit of base currency. It is smaller &
listed first
Ask Price: price, at which dealer will sell
1unit of base currency. It is higher &
listed second
% Spread =
100
price ask
price bid price ask

Q. The bid ask quote for GBP in India is

78.20 78.50 (GBP:INR) . In New York the
bid ask quote for Indian Rupee is 46
46.30 (USD:INR). What is the GBP:USD
ask as a cross rate.
Ans. GBP:USD
ask
= 78.5/46 = 1.7065
Economics
Foreign
Exchange
Exchange Rate &
Balance of Payments
Trading with
the World
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Direct & Indirect
Quotas
Cross Currency
Rates
Spot Rate &
Forward rate
Spot rates are the exchange rates for
the immediate delivery of the currency
Forward rates are the exchange of
currencies in future at the exchange
rate agreed today
Covered Interest Arbitrage: It is the
trading strategy that exploits mispricing
b/w spot & fwd rates.
Q. Let the exchange rate for USD and GBP is 1.65$ per GBP
and forward rate is 1.60$ per GBP. Assuming Interest rate
parity holds then in which country will be the interest rate
higher.
Ans. Forward price of a $ is quoting a lower price than the
current spot p[rice indicating that $ is expected to appreciate
going forward and thus quoting a premium in forward market.
Assuming interest rate parity to hold true UK must be having
higher interest rate relative to US, because of which GBP is
expected to depreciate.
Forward Discount
& Premium
Forward Premium (discount) =



If forward price of Rs/$ is lesser
than spot price of Rs/$ Then, Rs is
quoted as forward premium
days contract
forward of no.
360
rate spot
rate spot rate forward

|
|
.
|

\
|
Economics
Foreign
Exchange
Exchange Rate &
Balance of Payments
Trading with
the World
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Question 1
The demand for home dcor doubles when the average family income of Saunderland
increases from $15,000 per annum to $20,000 p.a. The income elasticity for home
dcor is
A. Greater than 1, and Less than 2
B. Less than 1
C. Greater than 2



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Answer 1
C.




33 . 2
17500 / 5000
5 . 1 / 1
Income Avg I/
Q Q/Avg
= =
A
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Question 2
Production at B leads to a loss due to inefficient production. This loss in efficiency is
known as
A.Deadweight loss
B.Utilitarian loss
C.Producer loss

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Answer 2
A.
When production occurs at a point other than the equilibrium point the consumer
surplus & the producer surplus is decreased by an amount. This is known as
deadweight loss.

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Question 3
If the price of the product does not change when the supply of the product increases
from zero to infinity. Then the supply elasticity for the product is most likely
A. Perfectly elastic
B. Unit Elastic
C. Perfectly inelastic

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Answer 3
A.

Perfectly Elastic
Price
Elasticity
Price
Quantity/Time
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Question 4
John notices that when the price of a Product Z is increased from $15 to $25. The
demand declines from 40 units to 35 units. He also notices that the income elasticity of
the product is negative. The price elasticity of the product is closest to and the product
is an
A. 0.27 ; inferior good
B. 0.47; normal good
C. 0.30 ; normal good

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Answer 4
A.
Price elasticity = %Q = 5/37.5 = 0.27
%P 10/20
When demand reduces with an increase in income the good is an inferior good & the
income elasticity is negative.


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Question 5
The least likely method of government intervention in farm production is through
A. Production quotas
B. Taxes
C. Subsidies

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Answer 5
B.
The two methods of government intervention in farm production are through the use of
a) production quotas and b) subsidies. Taxes are a form of intervention but are
generally not used to control farm production.
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Question 6
In the case of Enron scandal, the principal-agent problem occurred least likely in which
of the following two cases;
Principal Agent
A. Stockholders CEO
B. Stockholders Auditors
C. CEO Stakeholders

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Answer 6
C.
Stockholders/stakeholders are the ultimate principal. They have a stake in the
company and the CEO is an agent appointed by them to oversee the companys
activities
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Question 7
The HHI for the silicon wafer industry in Saunderland is closest to
Firm Market Share
A 50%
B 10%
C 10%
D 5%
E 5%
ROI* 20%
*ROI Rest of Industry constituting 8 firms each with 2.5% market share

A. 3150
B. 2800
C. 5950

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Answer 7
B.
Herfindahl-Hirschman Index is calculated for the industry as follows:

HHI = 502 + 102 + 102 + 52 + 52 + 8 * (2.52) = 2,800

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Question 8
A shoemaker Zeebok requires producing 150 units per day. The cost of labor is $20
and the cost of capital is $550 per unit. Calculate the most likely economical method of
production
Quantity of Inputs
Labor Capital
Manual Method 220 50
Automated Method 10 120

A. Automated and requires $56,400 per day
B. Manual and requires $31,900 per day
C. Manual and requires $34,500 per day

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Answer 8
B.
Manual Method requires = $ 20*220 + 550*50 = $31,900
Automated Method requires = $ 20*10 + 550*120= $66,200

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Question 9
ZenithCorp. a major utility company runs 4 thermo-nuclear generators supplying
electricity to the Greater Manhattan region. The company is planning to set up a 5th
generator to meet the ever increasing demand for electricity. While analyzing the
business plan the company CFO notices that by adding one more units there is a
positive but declining increase in marginal cost. This indicates that the total cost curve
and the average total cost curve is most likely
Total Cost Curve Average Total Cost
A. Increasing Decreasing
B. Increasing Increasing
C. Decreasing Increasing

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Answer 9
A.
When marginal cost increases in a declining manner the total costs increases however
the average total cost starts decreasing.
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Question 10
When an additional unit of labor is added to a companys work force then the marginal
returns increase initially but decline after a certain point. This is most likely the result of
A. Economies of scale
B. Law of diminishing returns
C. Diseconomies of scale

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Answer 10
B.
The law of diminishing returns occurs when the marginal product of an additional
worker is less than the marginal product of the previous worker. As more workers are
added there is less for them to do.


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Question 11
Which of the following statements best explains how automatic stabilizers work? Even
without a change in fiscal policy, automatic stabilizers tend to promote:
A. A budget deficit during a recession and a budget surplus during an inflationary
expansion.
B. A budget surplus during a recession and a budget deficit during an inflationary
expansion.
C. A budget deficit during a recession but do not promote a budget surplus during an
inflationary expansion.
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Answer 11
A.
A Budget deficit during a recession and a budget surplus during an inflationary
expansion
Automatic stabilizers such as unemployment compensation, corporate profits tax, and
the progressive income tax run a deficit during a business slowdown but run a surplus
during an economic expansion. Therefore, they automatically implement
countercyclical fiscal policy without the delays associated with policy changes that
require legislative action.

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Question 12
In a perfectly competitive market the lowest possible long run average total cost occurs
most likely at the point where MC (Marginal Cost) SR Firm Supply Curve, ATC (
Average Total Cost)
A. MC > SR Firm Supply Curve=ATC
B. MC=SR Firm Supply Curve=ATC
C. MC<SR Firm Supply Curve<ATC


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Answer 12
B.





MC
ATC
AVC
Quantity
P
r
i
c
e

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Question 13
The benefit that a person receives from consuming one or more unit of a good or
service is known as
A. Allocative benefit
B. Increasing benefit
C. Marginal benefit


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Answer 13
C.
Marginal benefit (MB) is the benefit that a person receives from consuming one or
more unit of a good or service. The MB is measured as the maximum amount that a
person is willing to pay for one or more unit of the good or service.


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Question 14
A public good is a good or service that is consumed by everyone, even if they dont pay
for it, then which of the following describes an external benefit
A. Benefit that accrues to people other than the buyer of the good or service
B. Benefit that accrues due to external factors like exchange rates, inflation etc.
C. Benefits that accrues to the consumer of a good or service


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Answer 14
A.
When an old building is restored or a park is built in a locality the benefit accrues to
other people other than the owner of the building or the owner of the land on which the
park was built. An external benefit is thus the benefit that accrues to other people other
than the buyer of a good.



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Question 15
Which of the following is least likely an obstacle in achieving the efficient allocation of
resources
A. Price Ceiling
B. Monopoly
C. Competition

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Answer 15
C.
The five items that are a significant obstacle to an efficient allocation of resources in
the market economy are: a. price ceilings & price floors b. taxes, subsidies & quotas c.
monopoly d. external costs & benefits e. public goods & common resources.


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Question 16
Consider a firm in an oligopoly market that believes the demand curve for its product is
more elastic above a certain price than below this price. This belief fits most closely to
which of the following models?
A. Dominant firm model.
B. Kinked demand model.
C. Variable elasticity model.


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Answer 16
B.
The correct answer is Kinked demand model.
The kinked demand model assumes that each firm in a market believes that at some
price, demand is more elastic for a price increase than for a price decrease.

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Question 17
An insulin user is most likely to pay the entire tax when the demand and supply curves
for insulin injectibles are respectively;
Demand Curve Supply Curve
A. Inelastic Elastic
B. Elastic Perfectly Inelastic
C. Perfectly inelastic Elastic

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Answer 17
A.
The buyer pays the tax when the demand curve is perfectly inelastic and the supply
curve is perfectly elastic. The seller will pay it when the demand curve is perfectly
elastic and the supply curve is perfectly inelastic.
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Question 18
A high concentration ratio is most likely observed in
A. Perfect competitive market
B. Oligopoly
C. Monopolistic competition


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Answer 18
B.
In an oligopoly there is a high concentration ratio and the HHI is more than 1,800.


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Question 19
A corporation has all of the following advantages except
A. Owners have limited liability
B. Professional management
C. Ease of set up

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Answer 19
C.
Advantages of a corporate setup is that owners of shares in a corporation have a
limited liability and they can take advantage of a professional management.
Proprietorships and partnerships are easy to set up.


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Question 20
Sally has decided to give up working as an Investment Banker and set up a restaurant
in London, all of the following can be considered as an opportunity cost except
A. interest on restaurant loan
B. salary foregone
C. perks foregone

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Answer 20
A.
The opportunity costs include a) explicit cost b) implicit cost. Wages foregone &
interest on deposits foregone are examples of implicit costs.



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Question 21
An employee stated that the electricity is being produced at ZenithCorp. at a point
above the Production Possibility Frontier (PPF). This most likely indicates that
A. Production is inefficient
B. The employee is wrong
C. Production is efficient


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Answer 21
B.
All the points below the Production Possibilities Frontier (PPF) are possible though
production is very inefficient. Maximum efficiency occurs on the PPF curve. However
all points above the curve are not possible.


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Question 22
All of the following are the characteristics of a perfectly competitive market except
A. Many firms sell identical products to many buyers
B. No entry barriers
C. Information asymmetry between buyers & sellers

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Answer 22
C.
Characteristics of a perfectly competitive market are a) many firms in the market b)
undifferentiated products c) no entry barriers d) no first mover advantage e) information
symmetry



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Question 23
The Laffer curve shows that an increase in the tax rate:
A. Will not change total tax revenue.
B. Will increase total tax revenue.
C. Can either increase or decrease total tax revenue



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Answer 23
C.
The correct answer is Can either increase or decrease total tax revenue.
The Laffer curve shows that at Sow tax rates an increase in rates will increase total tax
revenue, bur beyond some rate, further increases will actually decrease total tax
revenue.

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Question 24
Which of the following would be counted as frictional unemployment?
A. Due to the negative growth of GDP, Smith was laid off.
B. Johnson was fired from his job after he got into an argument with his foreman, and
has not sought a new job.
C. Although there were jobs available, Jones was unable to find an employer with an
opening.

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Answer 24
C.
The correct answer is Although there were jobs available, Jones was unable to find an
employer with an opening.
One of the causes of frictional unemployment is that information regarding prospective
employees and employers is costly and sometimes hard to find. The other cause of
frictional unemployment is that both employees and employers may spend some time
looking for information that will match them up.
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