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INTRODUCTION TO
ECONOMICS AND FINANCE
QUESTION BANK
CAF-02
ICAP
Question
Bank
Introduction to
economics and finance
Notice
Emile Woolf International has made every effort to ensure that at the time of writing the
contents of this study text are accurate, but neither Emile Woolf International nor its directors
or employees shall be under any liability whatsoever for any inaccurate or misleading
information this work could contain.
ii
C
Contents
Page
Questions
Section A
Section B
25
Section C
55
Section B
65
Answers
iii
iv
ANSWER
PAGE
FACTORS OF DEMAND
25
66
1.2
25
67
1.3
ECONOMIC GROWTH
25
67
1.4
27
68
CHAPTER 2 - MICROECONOMICS
2.1
TYPES OF GOODS
27
69
2.2
27
69
2.3
MOVEMENT
27
70
2.4
A MARKET ECONOMY
27
71
ELASTICITY OF DEMAND
27
73
3.2
ELASTICITY OF DEMAND 2
27
74
3.3
ELASTICITY OF DEMAND 3
28
75
3.4
CALCULATE PEDS
28
76
3.5
CONCEPTS OF DEMAND
28
76
QUESTION
PAGE
ANSWER
PAGE
3.6
COFFEE MARKET
28
78
3.7
29
79
3.8
29
81
3.9
29
81
3.10
29
82
3.11
29
82
3.12
PROPORTIONATE OR PERCENTAGE
METHOD
29
82
3.13
GEOMETRICAL METHOD
29
83
3.14
29
85
3.15
30
85
CONSUMERS EQUILIBRIUM
30
87
4.2
INDIFFERENCE CURVES
30
88
4.3
CONCEPTS
30
89
4.4
PRICE EFFECT
31
90
4.5
INCOME EFFECT
31
91
4.6
SUBSTITUTION EFFECT
31
92
4.7
31
92
4.8
INDIFFERENCE CURVES 1
31
93
4.9
INDIFFERENCE CURVES 2
31
94
4.10
31
96
MONOPOLIST PROFIT
32
98
5.2
PERFECT COMPETITION
32
99
5.3
INCREASING RETURNS
32
100
vi
QUESTION
PAGE
ANSWER
PAGE
5.4
LARGE FIRMS
32
100
5.5
32
102
5.6
34
103
5.7
35
104
5.8
36
105
5.9
36
106
5.10
TYPES OF COSTS
36
107
5.11
MONOPOLY SETUP
36
108
5.12
CONSUMPTION GOODS
36
108
5.13
37
109
5.14
MARKET FUNCTIONING
37
110
5.15
FREE FORCES
37
111
5.16
37
112
5.17
37
113
5.18
37
113
5.19
PRICE LEADERSHIP
37
114
5.20
37
114
5.21
NON-PRICE COMPETITION
37
114
NATIONAL INCOME
38
114
6.2
38
115
6.3
38
117
6.4
38
118
6.5
38
119
6.6
38
120
6.7
AGGREGATE DEMAND
39
120
vii
QUESTION
PAGE
ANSWER
PAGE
6.8
MACROECONOMIC EQUILIBRIUM:
RECESSION - KEYNESIAN
39
122
6.9
MACROECONOMIC EQUILIBRIUM:
INFLATIONARY GAP
39
123
6.10
DEFLATIONARY GAP
39
124
6.11
CALCULATION OF GDP 1
39
126
6.12
CALCULATION OF GDP 2
40
127
6.13
CALCULATION OF GDP 3
40
128
6.14
CALCULATION OF GDP 4
41
128
41
130
7.2
42
131
7.3
CONSUMPTION FUNCTION
42
132
7.4
PRIVATE INVESTMENT
42
133
MULTIPLIER
43
134
8.2
MULTIPLIER 1
43
134
8.3
MULTIPLIER 2
43
135
8.4
ACCELERATOR QUESTION
44
136
CHAPTER 9 MONEY
9.1
45
138
9.2
45
139
9.3
IMPORTANT FUNCTIONS
46
141
9.4
UNEMPLOYMENT
46
142
9.5
PHILLIPS CURVE
46
143
9.6
LIQUID FORM
46
144
9.7
MONEY FUNCTIONS
46
145
viii
QUESTION
PAGE
ANSWER
PAGE
INDIRECT TAXES
46
146
10.2
MACROECONOMIC POLICY
46
146
10.3
47
147
10.4
TRADE CYCLE
47
150
10.5
MIXED ECONOMY
48
151
10.6
48
152
10.7
48
153
10.8
48
154
FINANCIAL INTERMEDIATION
48
155
11.2
48
155
11.3
MONEY MARKETS
48
157
11.4
49
157
11.5
TYPES OF BANKS
49
157
11.6
CENTRAL BANKS
49
158
11.7
MONETARY POLICY 1
49
159
11.8
MONETARY POLICY 2
49
160
11.9
49
161
CHAPTER 12 CREDIT
12.1
CREDIT
50
161
12.2
BANKS
50
162
12.3
50
163
51
165
13.2
51
166
ix
QUESTION
PAGE
ANSWER
PAGE
13.3
BALANCE OF PAYMENTS
51
167
13.4
DISEQUILIBRIUM
51
167
13.5
51
168
13.6
51
169
13.7
52
169
13.8
52
170
13.9
52
171
13.10
52
171
52
171
14.2
DERIVATIVES
52
172
14.3
CAPITAL MARKET
53
173
14.4
53
174
SECTION
Land
Labour
Money
Entrepreneurship
Air
Water
Sulphuric acid
Books
Efficiency
Opportunity cost
Equity
Trade-off
Which of the following are regarded as withdrawals from the circular flow of income?
A
increase in resources
decrease in demand
decrease in supply
Recession
CHAPTER 2 - MICROECONOMICS
7
10
price
income level
level of technology
consumer indifference
elasticity of demand
inelastic demand
The supply curve of a factor for a firm that is in perfect competition in the input market
is:
A
elastic
inelastic
perfectly elastic
perfectly inelastic
Which ONE of the following will cause the demand curve for a good to move to the
right (outwards from the origin)?
A
11
12
13
14
a rise in the price of the good will strongly encourage a search for substitutes
When the price of a good is held above the equilibrium price, the result will be
A
excess demand
an increase in demand
The demand for and supply of a good are in equilibrium. An indirect tax is levied on
the good. Which one of the following will show the new equilibrium?
A
A shift to the right in the supply curve of a good, the demand remaining unchanged,
will reduce its price to a greater degree
A
16
Which of the following products is likely to have the lowest price elasticity of demand?
A
Salt
Cars
Houses
Apples
It is a straight line
It is non linear
17
18
19
20
21
22
Sugar
Steel
Garments
Vehicles
If the market price of a product increases from Rs. 35 to Rs. 40 and in response, the
quantity demanded decreases from 1400 units to 1200 units, the value of its price
elasticity of demand is:
A
0.9
1.1
1.2
Which of the following is NOT a method for the measurement of price elasticity of
demand?
A
Total outlay
Total savings
Point method
Arc method
If the price of a good fell by 10% and, as a result, total expenditure on the good FELL
by 10%, the demand for the good would be described as
A
perfectly inelastic
perfectly elastic
unitary elastic
elastic
Which one of the following statements about the elasticity of supply is not true?
A
If the demand for a good is price inelastic, which ONE of the following statements is
correct?
A
If the price of the good rises, the total revenue earned by the producer
increases.
If the price of the good rises, the total revenue earned by the producer falls.
If the price of the good falls, the total revenue earned by the producer increases.
If the price of the good falls, the total revenue earned by the producer is
unaffected.
23
24
negative
unitary
zero
A business, currently selling 10,000 units of its product per month, plans to reduce
the retail price from 1 to 0.90. It knows from previous experience that the price
elasticity of demand for this product is -1.5.
Assuming no other changes, the sales which the business can now expect will be
25
8,500 units
9,000 units
11,000 units
11,500 units
If the demand for a good is price elastic, a fall in price will lead to
(i)
a rise in sales
(ii)
a fall in sales
(iii)
(iv)
26
27
Price elasticity coefficient of 0.2 implies that the %age change in quantity for a 5%
change in price will be:
A
0.2
2.5
28
29
30
31
32
Assume that a fall in price of a commodity form Rs10 to Rs.9 per unit results in an
increase in weekly sales from 100 units to 110 units. Price elasticity of demand would
be:
A
1.9
Unity
Zero
0.9
0.1
Very small or zero Co-efficient of price elasticity of demand means that the good is:
A
a necessity
a comfort
a luxury
Zero
Unity
Infinity
Two
The income elasticity of demand for an income inferior good has an arithmetic sign.
A
Positive
Zero
Negative
No sign
From the demand schedule below, the price elasticity of demand following a fall in
price from Rs 25 to Rs. 20 is:
Price (Rs.)
Quantity (units)
30
15
25
20
20
25
15
30
-1
-1.25
-1.50
-1.75
33
34
If the price of a good fell by 20% but total expenditure on the good remained the
same, the demand curve could be described as
A
Perfectly elastic
Elastic
Perfectly inelastic
Unitary elasticity
36
37
38
The ability to buy more of a product or service when real income increases.
With the principle of diminishing marginal utility in effect, increasing consumption will:
A
39
Both a and c
40
41
Concave
Straight
Convex to Origin
Upward Sloping
42
Price effect
Income effect
Substitution effect
43
Diminishing
Increasing
Constant
b and c above
Under perfect market conditions, the supply curve of a firm is the same as:
A
MC curve
MR curve
AR curve
AC curve
45
46
47
48
49
50
the industry
Normal profit
patents
Operating capacity
quantity demand
derived demand
factor price
cost of production
As its output increases, a firms short-run marginal cost will eventually increase
because of:
A
diseconomies of scale
diminishing returns
51
52
53
54
55
56
A firm that breaks even after all the economic costs are paid, is earning:
A
economic profit
no profit
normal profit
When diminishing returns begin to operate, the total variable cost curve will start to
A
the difference between total fixed costs and total variable costs.
Which of the following always rise when a manufacturing business increases its
output?
(i)
fixed costs
(ii)
marginal cost
(iii)
(iv)
total costs
(iv) only
The minimum price needed for a firm to remain in production in the short run is equal
to
A
marginal cost
10
57
A business employs 11 workers at a wage of 24 per day. To attract one more worker
it raises the wages to 25 per day.
The marginal cost of employing the extra worker is
58
59
60
61
62
12
25
36
The long-run average cost curve for a business will eventually rise because of
A
diseconomies of scale
Economies of scale
A
If the total cost curve is plotted, marginal cost curve can be illustrated by:
A
U shapes curve cutting the total cost curve from its minimum point.
The long term shape of the average cost curve is due to:
A
economies of scale
variable proportions
change in technology
imperfect competition
a and e
b and d
11
63
64
65
66
67
68
In a diminishing cost industry, an increase in industry output causes the Average total
cost curve of a typical firm to shift:
A
Upward
Downward
To the right
To the left
In an increasing cost industry, an increase in output causes the Average total cost
curve of a typical firm to shift.
A
To the left
To the right
Downward
Upward
The firms economic profits must equal zero in the long run
The output price decisions of one firm affect the output price decisions of
other firms in the industry
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
a single firm
two firms
few firms
12
69
70
Which of the following distinguishes oligopoly market from other forms of market
organization?
A
Interdependence of producers
Differentiated products
Price discrimination
71
72
73
II only
III only
I only
II and II
uniform price
different prices
13
75
76
77
78
79
80
Indirect taxes
Depreciation
Rent
Corporate taxes
cost of production
(b)
number of consumers
(c)
(d)
competitive forces
Theory of Demand
Equilibrium of Industry
Increased investment
Increased taxation
Increased consumption
Hyperinflation
Depression
Stagflation
Great depression
embodies the same logic that lies behind an individual firms supply curve
14
81
82
Which of the following represent withdrawals from the circular flow of national
income?
(i)
Distributed profits
(ii)
(iii)
(iv)
Imports
An isolated island community produces only one good, fish. In a typical week the
island's fishermen manage to earn 800 selling their catch to the island's fish
wholesaler. She, in turn, sells the catch to the island's two fish shops for a total of
1,200. To make a profit and pay wages to their employees the two shopkeepers sell
the fish to the island's population for 1,500.
What will be the value of the island's output over the course of a year (52 weeks)?
83
84
140,400
182,000
78,000
36,400
Which ONE of the following would cause a fall in the level of aggregate demand in an
economy?
A
15
86
87
88
89
Which of the following is likely to shift the marginal efficiency of capital (MEC)
schedule to the right?
(1)
(2)
(3)
l only
2 only
3 only
l and 2 only
Which of the following statements does not reflect the Keynesian view of the
economy?
A
The economy will naturally settle at a level of output that ensures full
employment
The level of aggregate monetary demand will affect the level of income
Which of the following describes the effect of improved technology on the marginal
efficiency of capital curve?
A
Which of the following factor is not used in the multiplier formula for the open
economy?
A
16
91
92
93
94
In an economy where, out of every extra 100 of national income, 25 is paid in tax,
10 is spent on imports and 15 is saved, the value of the multiplier will be
A
2.5
10
Which of the following is the basic concept which underlies the accelerator theory of
investment?
A
2.5
1.67
1.25
0.6
CHAPTER 9 MONEY
95
96
medium of exchange
store of value
measure of value
Store of value
Unit of account
Payment of interest
17
97
98
99
100
101
102
103
C
D
Which of the following is not one a Keynesian motive for holding money?
A
Investment motive
Precautionary motive
C
D
Speculative motive
Transaction motive
C
D
C
D
In the Keynesian theory of demand for money, the transactions demand for money is
determined by:
A
Human wealth
Consumer durables
Commodities
the rate of change in money 0wages is positively correlated with the level of
unemployment.
(ii)
(iii)
(iv)
the rate of change in money wages is negatively correlated with the level of
unemployment.
18
104
105
(iv) only
Which of the following is most likely to lead to a fall in the money supply?
A
(ii)
(iii)
(iv)
107
Taxes
Imports
Unemployment
Public expenditure
Sales tax
19
108
109
110
111
Income tax
Sales tax
Property tax
Depression
Inflation
Boom
Recession
It should be equitable
It should be economical
It should be certain
Technological change
Innovation
Capital production
113
Pension fund
Stock exchange
IOU
Draft
Bond
Stock
20
114
115
116
117
118
119
120
Money at call
Customers' deposits
Advances to customers
Reserves
Checking accounts
Loans
If the Reserve Ratio is 40%, and Rs.10,000 is deposited in a commercial bank, what
is the final outcome for the economy?
A
Rs. 4,000
Rs. 10,000
Rs. 25,000
Rs. 40,000
Monetary policy
Fiscal policy
Credit creation
sell securities on the open market and lower the discount rate
buy securities on the open market and raise the discount rate
buy securities on the open market and lower the discount rate
decrease prices
reduce inflation
control lending
21
CHAPTER 12 CREDIT
121
122
123
Consumer spending
Investment spending
Government spending
Exports
A stimulative fiscal policy combined with a restrictive monetary policy will necessarily
cause:
A
The government makes a new issue of bonds and sells them on the open market,
where they are bought by private investors using cheques drawn on their banks.
Which of the following describes the effect this has on the commercial banks?
A
They can raise lending because their cash base will rise.
125
Balance of trade
Balance of payment
Terms of trade
Inflation
22
126
127
128
129
130
131
Which of the following measures would immediately increase the cost of imports?
A
Tariff
Quota
Embargo
Subsidies
increase exports
increase imports
decrease inflation
increase prices
Which ONE of the following would appear as a DEBIT item on the current account of
the balance of payments?
A
The 'current account' of the balance of payments includes all the following items
EXCEPT which ONE?
A
23
133
134
135
136
Which of the following instruments are NOT traded in the capital market?
A
Corporate bonds
Treasury bills
Mortgages
Shares
Other things being equal, all of the following would lead to a rise in share prices
EXCEPT which ONE?
A
Which of the following does not engage in the buying and selling of shares in other
companies?
A
Investment trusts
Stock exchanges
Insurance companies
Pension funds
discount houses buying short term government debt in the discount market
24
SECTION
Explain any four factors on account of which the demand of a product may
change even when its price remains the same.
(06)
(05)
(11)
(07)
(ii)
25
(02)
of
(01)
(b)
The diagram below can be used to illustrate the idea of economic growth.
Complete the following statements about it:
(i)
(ii)
curves.
has
(02)
(iv)
Point Y is currently
(01)
(v)
Assuming that all resources are currently employed, the opportunity cost of
increasing food production from 12 million units to 22 million units is
Your answer should not exceed 5 words
(d)
(01)
(iii)
(c)
(02)
(01)
(02)
State whether each of the following statements about economic growth is true or
false:
(i)
(ii)
(01)
(iii)
(01)
(iv)
(01)
(01)
(16)
26
Explain how the Islamic religion has impacted upon its economic system.
(10)
(b)
What are its similarities and differences with the free market economic system?
(06)
(16)
CHAPTER 2 - MICROECONOMICS
2.1 TYPES OF GOODS
Differentiate between substitute goods, complimentary goods and independent goods.
Give two examples of each.
(06)
(09)
2.3 MOVEMENT
Explain what is Movement along the Demand Curve and Shift in the Demand Curve
highlighting the difference between these two concepts. Also illustrate the difference by
means of diagrams.
(09)
Explain how the price system works to allocate resources in a market economy.
(10)
(b)
Describe the main reasons why markets do not always allocate resources in an
efficient manner.
(10)
(20)
What is meant by Elasticity of Demand? List and explain briefly the factors which
determine the Elasticity of Demand of a product.
(07)
(b)
(03)
(10)
(12)
27
Define Arc elasticity of demand and provide the formula to measure it.
(05)
(b)
(03)
(08)
The price elasticity of demand (assume the change comes about from a fall in
price).
(09)
(b)
The total sales revenue earned at the old and new price.
(03)
(12)
28
Requirements:
Using BOTH your knowledge of economic theory AND information in the passage:
(a) (i)
(b)
3.7
identify and explain TWO reasons why the price of coffee has risen
recently, using an appropriate diagram
(ii)
explain the concept of 'price elasticity' and 'demand' AND show how it is
important in determining the size of the rise in coffee prices
(04)
(iii)
explain the meaning of the statement 'the real price of coffee fell even
more steeply'.
(02)
Explain the concept of 'cross elasticity of demand' AND use it to explain the
relationship between the level of coffee prices and the demand for tea.
(07)
(17)
(b)
Explain briefly the factors which determine the Price Elasticity of Demand.
(c)
Illustrate the relationship between the price and quantity demanded with the
help of a diagram when the price elasticity of demand is Elastic, Unitary Elastic
and Inelastic.
3.8
(06)
(06)
(16)
3.9
(04)
(05)
(05)
(05)
(08)
29
Required:
(i)
(05)
(ii)
Calculate changes in total revenue if demand is met in full before and after the
change in price.
(05)
(10)
(08)
Explain why on an indifference map, the curve is convex? What concept does
this represent?
(08)
b)
Explain why this indifference map doesnt fit with economic theory.
(08)
(16)
4.3 CONCEPTS
Explain the following concepts with reference to consumer behaviour, using
appropriate diagrams:
Price effect
Substitution effect
Income effect
(12)
30
4.4
PRICE EFFECT
Define price effect and display price effect using diagrams for.
Substitute goods
Independent goods
Complementary goods.
4.5
(06)
INCOME EFFECT
Define Income effect using diagrams for.
Normal goods
4.6
(06)
SUBSTITUTION EFFECT
Sliding over the same IC is called Substitution effect. Explain with the help of a
diagram.
4.7
4.8
4.9
(05)
(03)
(b)
(02)
(c)
(03)
(d)
With the help of Indifference Curves show how consumers maximize their levels
of satisfaction. Support your decision by drawing a suitable diagram.
(07)
(15)
INDIFFERENCE CURVES 1
(a)
(b)
INDIFFERENCE CURVES 2
(a)
(03)
(b)
(06)
(c)
(04)
(13)
31
(05)
(05)
Explain the equilibrium of a firm under perfect competition, with the help of an
appropriate diagram.
(05)
(10)
(05)
(05)
(b)
using a diagram to illustrate your answer, what determines the optimum scale of
the firm in the long run?
(05)
(c)
explain the different economies of scale that may occur, if a firm grows by merger
or take-over
(04)
(d)
(02)
(16)
The diagram below illustrates the cost structures for different sizes of firm in a
particular industry. Study it and then complete the statements that follow:
32
(i)
(ii)
(iii)
(01)
(v)
(01)
The significance of output level Q1 is that at this level the firm achieves the
scale of production usually referred to as the
Your answer must not exceed 5 words
(iv)
(01)
(01)
The shape of the SRAC curves in the diagram is based on the law of
diminishing returns (also known as the law of variable proportions).
The law states that
Your answer must not exceed 50 words
(vi)
(04)
(01)
(vii) State two specific examples of the phenomenon you identified in (vi) above:
Your answer must not exceed 50 words
(04)
(13)
33
(i)
(ii)
(b)
Assume that, at the profit maximising level of output, the profit earned is
20,000, average cost is 15 and average revenue is 25. Calculate the
profit maximising level of output:
(02)
State whether each of the following statements about monopoly is true or false:
In a monopolistic market:
(i)
(ii)
(01)
although the firm in perfect competition will, in the long run, produce at the
lowest possible average cost, it will not necessarily produce more cheaply
than a monopolistic firm
True or False
(01)
(iii)
(iv)
(01)
34
(c)
Complete the diagram below to show the long run position for a firm in a perfectly
competitive market:
(d)
(04)
A firm in a perfectly competitive market is said to be technically efficient because
it will produce the level of output at which..
Your answer must not exceed 10 words.
(02)
(16)
Price
34
30
27
25
23
21
19
1
2
3
4
5
6
7
Total cost
12
20
34
53
75
102
131
Requirements:
Using BOTH your knowledge of economic theory AND the data above,
(a)
(b)
(02)
(ii)
(02)
Calculate the level of profit at EACH level of output AND identify the profitmaximising level of output.
(02)
(c)
Calculate the price elasticity of demand for the good for a price fall from 25 to
23.
(04)
(d)
Identify the factors which might explain the value of the elasticity of demand for
this good.
(05)
(e)
Explain how you would expect the demand curve for this firm to vary if the
number of firms in the industry were to rise.
(05)
(20)
35
5.8
Total revenue
50
100
150
200
250
300
350
400
450
500
Total costs
110
140
162
175
180
185
194
219
269
325
425
(a)
Calculate the marginal revenue for the firm and state which sort of market it is
operating in.
(04)
(b)
Calculate the firm's fixed costs and the marginal cost at each level of output. (04)
(c)
What level of output will the firm aim to produce and what amount of profit will it
make at this level?
(04)
(d)
Describe and explain the effect on the firm's output and profits of the entry of
new producers into the industry.
(08)
(20)
5.9
(b)
(c)
State the effect of a rise in the firm's costs at all levels of output on:
(i)
(ii)
total profits.
(01)
(1)
State what would happen to the firm's average and marginal revenue curves
and its equilibrium price and output if:
(i)
(2)
(ii)
(2)
Explain the ways in which the firm might attempt to discourage the entry of new
firms into its industry.
(8)
(14)
(10)
(08)
Describe consumption goods and state the main determinants of demand for
these goods.
(02)
36
(b)
5.13
(02)
(b)
State the conditions which are essential for the existence of Perfect
Competition in a market.
(05)
(c)
5.14
Explain by means of a diagram how price and output are determined in the
long-run for a firm operating under conditions of Perfect Competition.
(08)
(15)
MARKET FUNCTIONING
Explain six different features which distinguish a market functioning in an
environment of perfect competition from a market which operates as a monopoly.
(09)
5.15
5.16
FREE FORCES
(a)
How do free forces of demand and supply determine equilibrium price and
equilibrium quantity? Support your answer with the help of a diagram.
(07)
(b)
(06)
(13)
5.17
5.18
5.19
(03)
5.21
(04)
PRICE LEADERSHIP
When price leadership occurs?
5.20
(04)
(04)
NON-PRICE COMPETITION
Write a note on Non-Price Competition.
37
(06)
6.2
NATIONAL INCOME
(a)
(06)
(b)
(06)
(12)
(6)
(14)
(20)
6.3
(04)
(b)
Identify and explain briefly the three different types of Withdrawals and
Injections from the Circular Flow of Income.
(06)
(10)
6.4
(b)
How might the business sector be affected if there were a rise in the savings
rate in households?
(8)
(20)
6.5
6.6
(02)
(b)
Draw a shift in the supply curve as a result of a decrease in the cost of labour
throughout an economy.
(04)
(c)
(06)
(15)
(b)
Is the LRAS more, or less likely to fluctuate than the SRAS? Explain your
answer.
38
(04)
(08)
6.7
AGGREGATE DEMAND
(a)
6.8
What are the 5 components of aggregate demand (AD), and what is the
equation?
(b)
(c)
(02)
(12)
Draw a graph using a Keynesian aggregate supply curve where the economy is
in a deep recession.
(04)
(b)
The government increases spending in the economy. Show how this will change
the equilibrium in the economy. Make particular reference to:
(i)
6.9
(04)
(04)
(06)
(14)
Define an output gap. What are positive and negative output gaps known as? (03)
(b)
(04)
(c)
(09)
(16)
(06)
39
6.12
CALCULATION OF GDP 2
The following data relates to the economy of a country over one year period.
Rs. in million
Consumers expenditures
20,000
4,500
Capital formation
5,100
(100)
Exports receipts
7,000
Imports payments
6,500
Taxes on expenditures
6,000
Subsidy
500
500
2,000
Required
(i)
(ii)
(iii)
(iv)
(v)
(vi)
6.13
CALCULATION OF GDP 3
The Economic Survey of the government of Pakistan discloses the following
Rupees in millions
Government expenditure
7,500
30,000
Imports
6,000
10,500
Consumers expenditure
16,500
12,000
1,500
Exports
6,000
6,000
expenditure approach
(ii)
income approach
(iii)
40
6.14
CALCULATION OF GDP 4
Following data relates to the economy of a country over a year period.
Capital consumption
2,625
Subsidies
450
Exports
9,675
Imports
(9,360)
Consumers expenditure
27,600
Taxes on expenditure
(4,140)
315
(30)
7,380
6,810
Required:
You are required to compute the following, showing necessary workings
a.
b.
c.
Households
E
F
C
Government
Banking system
H
D
A
I
Firms
G
J
Requirements:
(a)
(ii)
(iii)
corporation tax;
(iv)
(v)
41
(5)
(b)
(c)
(ii)
(3)
Explain (with a diagram) how a fall in interest rates will affect the level of
investment.
(4)
(b)
How might the motives for an investment by a government and a private sector
firm differ? And give examples of the projects that they might undertake.
(6)
(c)
(d)
(2)
(4)
(16)
7.4
(a)
(02)
(b)
(c)
(04)
(16)
PRIVATE INVESTMENT
State briefly how a government can influence the level of private investment in the
country.
(10)
42
(03)
(b)
(06)
(09)
8.2 MULTIPLIER 1
Output determination occurs when the savings of all of the households in an economy
are equal to the desired investment opportunities.
The diagram shows an economy in equilibrium.
(04)
(b)
Are the levels of savings and investment planned, or actual levels? Comment on
the significance.
(02)
(c)
Explain how if output was greater than M (i.e. in disequilibrium), the economy
would revert to equilibrium.
(04)
(10)
8.3 MULTIPLIER 2
(a)
Fill in this description of the multiplier: the consumption of one person becomes
the ___ ___ ___
(02)
(b)
Explain, with the help of separate diagrams, why Keynes believed it was
necessary to boost AD during a Depression, and not AS.
(06)
(06)
(c)
(18)
43
Define gross investment, and explain its importance in the accelerator principle.
(04)
(b)
(04)
Example:
Year
Y
(=Output)
Stock of
capital
[1]
(0)
(200)
(600)
200
220
240
250
250
Net
investment
[2]
Depreciation
[3]
Gross
investment
[4]
Using your answer from part (b), determine the rate of change of Gross
investment.
(04)
Example:
Year
Y
(=Output)
% change in Y
Gross
investment
(0)
(200)
200
from (b)
220
from (b)
240
from (b)
250
from (b)
250
from (b)
% change in
gross
investment
The shows the disparity in the rates of change of output and gross investment.
(d)
44
CHAPTER 9 - MONEY
9.1 THE MONEY SUPPLY
(a)
(04)
(b)
(08)
(c)
Describe the methods by which the government can attempt to control the money
supply.
(08)
(20)
11.2
13.1
13.7
11.9
5.8
2.4
3.2
6.0
5.4
3.8
5.3
4.3
7.7
5.7
2.7
3.1
2.8
6.0
6.9
6.1
Rate of
inflation
(% rise in RPI)
12.9
17.6
7.8
15.6
16.9
10.9
8.7
4.2
4.5
6.9
2.4
4.4
4.8
8.2
9.8
5.5
3.7
1.4
2.3
3.5
Requirements:
Using BOTH your knowledge of economic theory AND material contained in the table,
(a)
Describe the apparent relationship between the money supply (M0) and the rate
of inflation.
(04)
(b)
(c)
Describe the extent to which the data given are in line with the predictions of the
quantity theory of money.
(06)
(d)
Explain how the effects of a change in the money supply might differ between the
short run and the long run.
(04)
(06)
(20)
45
Identify the four important functions of money and highlight their significance. (08)
(b)
Keynes has identified three different motives on account of which a person refers
to keep his money in liquid form. Identify these motives and describe their
influence on the liquidity preference of an individual.
(06)
(14)
9.4 UNEMPLOYMENT
(a)
Explain the relationship between Inflation and Unemployment with the help of a
Phillips Curve.
(06)
(b)
(c)
(08)
(18)
(b)
(c)
(3)
9.7
(06)
MONEY FUNCTIONS
Explain what is meant by the term "money" AND explain the functions it performs.
(14)
10.2
INDIRECT TAXES
(a)
What is meant by Indirect Taxes? Give three examples of Indirect Taxes. (02)
(b)
(09)
(11)
MACROECONOMIC POLICY
(a)
In your opinion what are the three most important primary goals of a wellconceived Macroeconomic policy?
Briefly discuss the significance of each of these macroeconomic goals.
(b)
(06)
46
10.3
Distinguish between direct and indirect taxation and explain the principles
underlying a good taxation system.
(06)
(b)
10.4
TRADE CYCLE
The following data refer to the UK economy:
Change in Gross
Domestic
Product from
previous year
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
Requirements:
+ 3.5%
+ 2.8%
- 2.0%
- 1.1%
+ 1.7%
+ 3.7%
+ 2.0%
+ 4.0%
+ 4.0%
+ 4.6%
+ 4.9%
+ 2.2%
+ 0.6%
- 2.3%
- 0.5%
+ 2.0%
+ 3.0%
Change in business
Level of interest
investment
rates
(excluding
(London Inter-Bank
dwellings)
Rate)
from previous year
+10.1%
9%
+ 3.4%
13%
- 3.9%
17%
- 4.8%
13%
+ 8.4%
12%
- 2.0%
10%
+ 4.9%
10%
+ 4.1%
12%
+ 0.5%
10%
+ 17.3%
9%
+ 17.8%
9%
+ 6.1 %
14%
- 3.1 %
15%
- 9.5%
11%
- 5.1 %
10%
- 0.7%
6%
+ 4.6%
5%
(source: HMSO "Economic Trends")
Using BOTH your knowledge of economic theory AND the data above,
(a)
(b)
explain what is meant by the "trade cycle" AND show the recovery and
recession phases of the trade cycle between 1978 and 1994.
(04)
explain briefly what is meant by the accelerator principle AND assess the
extent to which the data show the presence of an accelerator effect.
(08)
(12)
47
10.5
MIXED ECONOMY
(a)
(b)
(08)
(20)
10.6
10.7
(b)
What are some of the leading, coincident and lagging indicators which might
confirm these phases?
(10)
(16)
10.8
(a)
(06)
(b)
Briefly discuss the policy tools usually adopted by the government to achieve
these objectives.
(06)
(12)
11.2
FINANCIAL INTERMEDIATION
(a)
(02)
(b)
Give reasons why commercial banks strive hard to maintain adequate liquidity
at all times.
(02)
(04)
Describe the role of a central bank when it acts as 'banker to the banks and
banker to the government'.
(10)
(b)
(10)
(20)
11.3
MONEY MARKETS
Explain what is meant by the "money market" AND describe the role played by the
major institutions in that market.
(06)
48
11.4
11.5
11.6
11.7
TYPES OF BANKS
a)
What are the two main categories of banks? What are their features? Name
three ways in which they differ.
(08)
b)
What are the drawbacks of a bank increasing its line of credit to customers?
What might affect its ability to do so?
(08)
(16)
CENTRAL BANKS
(a)
(06)
(b)
Is it possible for a Central Bank to meet all of these objectives? Explain your
answer.
(10)
(16)
MONETARY POLICY 1
Suppose a central bank is looking to reign in the level of aggregate demand in an
economy through tightening the money supply. There are a number of options
available to them. Talk through how the following policies would look to achieve this:
11.8
(a)
(10)
(b)
Moral suasion.
(04)
(14)
MONETARY POLICY 2
Suppose a central bank is looking to increase the level of aggregate demand in an
economy through expanding the money supply. Talk through how the following
policies would look to achieve this:
11.9
(a)
Open-Market Operations.
(10)
(b)
Discount-rate policy.
(08)
(18)
(b)
49
CHAPTER 12 CREDIT
12.1
CREDIT
All businesses rely to some extent on credit, in at least a few of its forms. Short
term, as well as medium and long term credit, provide sources of finance to enable a
business to expand or survive the problems of economic recession. The length of
the credit term chosen depends on the life of the asset or project for which the
funding is to be used. Credit also has an effect on the economy as it contributes to
money supply, which can be inflationary, and so the government has a responsibility
to keep it under control.
Using both your knowledge of economic theory and the passage above:
(a)
give two examples of short term credit, medium term credit and long term
credit, available to business.
(03)
(b)
give two examples of consumer credit and explain how this may be of benefit
to a firm.
(03)
(c)
explain why a firm may choose to use long term credit rather than issue
shares.
(d)
12.2
(04)
explain how credit can contribute to the money supply and the ways in which
the government may try to control its growth.
(06)
(16)
BANKS
Commercial banks are an essential part of the business infrastructure. They act as
financial intermediaries, providers of all forms of finance and enable the payment of
debts but at the same time are in business to make profits for their shareholders.
Their position is so strong that they are unlikely to fail to make a profit.
Using both your knowledge of economic theory and the passage above:
12.3
(a)
(04)
(b)
explain how banks can create credit and the limitations of this ability.
(06)
(c)
explain how and why banks can combine the aims of liquidity, profitability and
security when advancing money to customers.
(06)
(16)
Describe the functions of commercial banks AND show how these meet the
needs of business customers.
(06)
(b)
(ii)
how the central bank can restrict the ability of commercial banks to
create credit.
(04)
(14)
50
(04)
(05)
(b)
Describe the main factors that might lead a country to experience a deficit on
the current account of its balance of payments.
(10)
(c)
13.2
13.3
BALANCE OF PAYMENTS
Describe the measures a country may take to correct disequilibrium in the Balance
of Payments.
(07)
13.4
13.5
DISEQUILIBRIUM
(a)
(b)
13.6
What are the four components of the current account? Place the following in
each of the categories:
(i)
Finished goods
(ii)
Tourism
(iii)
(iv)
Overseas aid
(08)
(b)
The capital and financial accounts record the flow of capital and finances
between domestic country and the rest of the world. Describe three of these
flows.
(03)
(c)
Net errors and omissions compensate for discrepancies in current and capital
accounts. If a government had a balance of payments deficit, how could they
balance.
(02)
(13)
Explain a current account deficit with reference to the income and outflow of a
country.
(03)
(b)
51
(06)
(09)
13.7
13.8
13.9
What is a tariff?
(02)
(b)
Explain, with a diagram, how tariffs can help correct a current account deficit.
(10)
(c)
(b)
If the exchange rate was Rs.6: US$1, and the rupee depreciates by 50%, what
will the new exchange rate be?
(02)
(c)
(05)
(5)
14.2
Distinguish between the 'money market' and the 'capital market', and identify
the main institutions which operate in each market.
(08)
(b)
Using examples, show how a business might need to use both the money and
capital markets.
(10)
(c)
Explain the circumstances under which the government might need to use the
capital market.
(06)
(24)
DERIVATIVES
(a)
(b)
What are the two ways that an investor can buy a derivative product? Explain
how they differ, and what the benefits and drawbacks of each are.
(08)
(16)
52
14.3
14.4
CAPITAL MARKET
(a)
What is the main distinction between capital markets and money markets? (02)
(b)
(c)
How might an individual investor have access to the capital market? Describe
in detail.
(06)
(12)
(04)
(04)
(b)
Describe the difference between common stock and preference shares. (06)
(c)
53
54
SECTION
55
CHAPTER 2 - MICROECONOMICS
7
10
D
A is not relevant as this affects the supply curve for the good. A fall in the price of the
good will result in a movement along the curve not a shift of the whole curve, hence B
is not correct. An increase in the price of a complementary good is likely to shift the
whole demand curve to the left i.e., inwards towards the origin, hence C is not correct.
11
D
A consumer will not change the amount normally demanded of a good even if its price
changes provided that it does not affect significantly his or her overall spending pattern.
12
C
When the price of a good is held above the equilibrium price supply will exceed
demand which will cause a surplus of the good, therefore C.
13
C
Indirect taxes such as VAT shift a producer's supply curve to the left. At each price the
producers supply less because part of sales income goes in tax to the government.
14
16
17
18
19
20
A
Elasticity of demand measures how responsive consumers are to changes in price.
Demand is elastic when a fall in price brings about an increase in total expenditure. If
expenditure fell by the same amount as the price fall then demand must be perfectly
inelastic to A.
56
21
C
A, B and D are all true statements about the elasticity of supply. C is to do with
productivity.
22
A
If a good is price inelastic then the ratio of the percentage change in quantity
demanded to the percentage change in price is less than one. In other words the
proportionate change in quantity demanded is less than the proportionate change in
price so an increase in price will increase total revenue and a fall in price will reduce
total revenue. Hence only A is correct.
23
B
B is the correct answer since the definition of an inferior good is one where less is
purchased as income increases.
A is incorrect as this would imply that as incomes rose so would the consumption of the
good, although to a lower extent than the increase in income.
C is incorrect as this implies that more is purchased in line with the rise in income.
D is incorrect as in this case any change in income would have no effect on the amount
purchased.
24
D
Price elasticity of demand =
1.5
x
=
15%
As x is positive it means the quantity demanded has risen by 15%. Hence 10,000 units
plus 15% = 11,500.
25
A
If a good is price elastic then its sensitivity to price changes is high, hence a certain
change in price will give rise to a greater percentage change in quantity demanded.
The correct response is therefore A.
26
27
28
29
30
31
32
33
34
57
36
37
38
39
40
41
42
43
45
46
47
48
49
50
51
52
D
When diminishing returns set in, employing more units of a variable resource with a
fixed amount of other resources will lead to increasingly small increments in output as
total variable costs rise.
53
54
55
D
Fixed costs may remain the same, marginal costs and average variable cost may even
fall if gains from large scale production become available.
56
B
Note we are talking about the short run situation, obviously in the long-run all costs
must be covered.
57
D
The full wage of the extra worker =
25
The extra 1 per worker for all workers already employed (Note: It is not just the new
worker who gets 25 but all workers)
11 1
11
36
58
58
A
The traditional theory of the firm is based on the premise that the objective of a firm is
to maximise profits and will thus strive to achieve this situation by producing at the
equilibrium position where marginal cost equals marginal revenue.
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
B
A is not true, any firm can benefit from economies of scale providing they are of
sufficient size to obtain such economies. C is not true by definition. D is not true,
management can generally be inefficient and still make some good decisions.
D
C
F
B
D
D
A
D
D
A
D
A
A
A
75
76
77
78
79
80
81
D
Withdrawals from the circular flow of income are those amounts not passed on from
firms to households or vice versa. There are three categories of withdrawals - savings,
taxation and imports. The correct response is D because it includes tax payments and
imports - distributed profits and interest paid on bank loans are both types of income
which are passed on from firms to households and are thus not withdrawals.
82
C
The answer is found by adding the value added at each stage of production and
multiplying by 52.
(800 + 400 + 300) 52 = 78,000
59
Answer B is wrong because output has been double counted. Answer A ignores the
contribution of the fishermen and double counts the remainder. Answer D ignores the
contribution of the fishermen.
83
B
The inflationary gap is a Keynesian concept which describes a situation where demand
exceeds the level required to bring about full employment.
84
C
A decrease in the level of imports, a fall in the propensity to save and a decrease in the
level of income tax are all injections into the circular flow of funds and will thus tend to
increase the level of aggregate demand in an economy.
86
D
The inflationary gap is a Keynesian concept which describes a situation where demand
exceeds the level required to bring about full employment.
87
B
Regarding 1, the MEC schedule is essentially the demand curve for investment,
showing the relationship between capital invested and the return on that capital. An
increase in the supply of funds available will reduce the price of capital i.e., the rate of
interest and cause a movement to the right along the same curve. Hence (1) is
incorrect.
Regarding 2, the introduction of cost reducing technology will increase the demand for
investment, i.e., the MEC schedule will shift to the right, hence (2) is correct.
Regarding 3, a reduction of government subsidies will reduce rather than increase the
demand for investment, i.e., (3) is incorrect.
88
A
Keynes argued that it is highly unlikely that the economy will automatically produce that
level of output which employs all resources. The other three answers all reflect the
Keynesian notion that demand management can influence income, output and
employment.
89
B
Improved technology will raise the rate of return at all levels of capital stock. Therefore
the downward sloping (left to right) MEC curve shifts to the right.
91
92
A
An injection into an economy (in this case an increase in income) can be expected to
increase activity not merely by the amount injected but by some multiplying factor essentially as a result of money passing from hand to hand. The recipients of the
increase in income cannot each spend more than the increase but they can spend less.
60
A proportion is bound to be saved. Thus the multiplier is defined as 1 over MPS, the
marginal propensity to save. But other leakages can occur which will make the
multiplier smaller. In the example given these are taxation defined as the marginal
propensity to taxation (MPT) and imports defined as the marginal propensity to import
(MPM). Thus we have :
93
1
1
4
1
10
20
1
10
20
1
1
2
D
The accelerator theory emphasises the importance of changes in consumer demand or
National Income in investment decisions. A, B and C are thus incorrect as the theory
has nothing directly to say about the level of savings, rates of interest or volumes of
commercial bank lending.
94
B
The multiplier is calculated as:
1
rate of leakage
30%
Imports
10%
Saving
20%
= 1 23
CHAPTER 9 MONEY
95
96
97
98
99
100 A
101 B
102 B
103 A
104 C
Only C takes money out of the economy since balances have to be drawn down to pay
for the securities. A reduced quantity of money, other things remaining equal, will lead
to a reduction in the money supply. It should be noted that a sale of government
securities will only have this effect if they are sold to the non-bank public and the
question should perhaps have made this clear, although it would have also made the
answer more obvious.
61
105 B
According to Keynesian liquidity preference theory if the government wishes to
increase the money supply it must purchase bonds and hence their price rises (not falls
as in (ii)) and because of the inverse relationship with the rate of interest, the rate of
interest falls. In such circumstances, the theory suggests, people are less willing to
hold bonds and prefer to hold cash.
115 B
116 C
117 C
118 C
119 D
120 D
CHAPTER 12 - CREDIT
121 B
122 D
123 C
As private investors pay for the bonds, using funds in their bank accounts, the cash
position of the commercial banks will be squeezed. As a result they may be forced to
cut their lending portfolio to maintain an adequate relationship between cash and loans.
62
128 A
Expenditure by tourists is a credit item on the current account and both C and D are
non-current account items, appearing instead under the heading 'transactions in UK
assets and liabilities'.
129 B
A balance of payments deficit occurs when there is a net outflow of funds. With an
expansionary fiscal policy consumers will have more money to spend on imports thus
increasing the outflow of funds without a corresponding inflow since industry is unlikely
to export more due to inflationary pressures and high domestic demand.
130 A
The current account of the balance of payments is the visible balance plus the invisible
balance. The inflow of capital investment by multi-national companies would go in the
capital account, so A.
131 A
A fall in the exchange rate for a country's currency will encourage exports as they will
become relatively cheaper to the foreign importer, hence A is incorrect. B is also wrong
since reducing tariff barriers will open up export markets giving exporting countries
more opportunities. A rise in a country's imports could indicate that that country has a
buoyant and growing economy and in order to meet increased aggregate demand firms
may switch sales to the home market at the expense of exports, however the more
likely explanation is C i.e., a decrease in the marginal propensity to import in other
countries.
134 B
This is rather an ambiguous question; the wording has to be read with care.
135 A
B and D relate to put options, and C means to sell a call option.
136 C
All the others are examples of activities within the parallel markets.
63
64
SECTION
65
FACTORS OF DEMAND
(a)
(b)
66
1.2
For the purpose of simplicity the curve is based on two products only i.e. X and Y
and we assume that all the resources are allocated for producing the two goods
only. The curve indicates that the economy can produce a number of
combinations such as 60 units of X and 100 units of Y or 90 units of X and 60
units of Y and so on.
The cost of an item measured in terms of the alternatives forgone is called its
opportunity cost. Thus, if an economy produces 60 units of X and 100 units of Y
(point H) instead of producing 90 units of X and 60 units of Y (point J), then the
opportunity cost of producing (100-60) more units of Y would be the lost
production of (90-60) units of X.
If the economy produces lesser quantities, it would not be utilizing the full
resources whereas quantities in excess of those represented by the curve cannot
be produced on account of limited resources.
1.3
ECONOMIC GROWTH
(a)
(b)
(i)
the rate at which the gross domestic product per head of population is
growing in real terms, i.e. after allowing for the distorting effects of
inflation.
(ii)
welfare
(i)
production possibility
(ii)
economic growth
(iii)
(iv)
unattainable
(v)
67
(c)
(d)
1.4
(i)
false
(ii)
false
(iii)
true
(iv)
true
Its main influence is how resources are distributed throughout the economy,
rather than the science of improving manufacturing etc.
This has led to a number of features within the system:
State ownership: There is no ban on the state owning an enterprise, however
a free market still exists where entrepreneurs can profit so long as they abide
by the other rules of the Islamic economic system.
Practising of moderation: Islam aims for an equitable distribution of
resources, and so the population is taught to share wealth where they can.
Prohibition of charging interest: It is forbidden for a lending party to earn
interest from a transaction without taking on as much risk. Instead there is a
system whereby both parties must gain or lose from the transaction.
Earnings: must only be made from goods which are allowed in Islamic
teachings.
Ban on hoarding of wealth: As resources should be utilised for a good
cause, rather than remaining in private possession.
Zakat: This is a financial tax on the wealthy in order to aid the poorer in
society.
(b)
Differences:
68
CHAPTER 2 MICROECONOMICS
2.1
TYPES OF GOODS
Substitute goods
Goods are substitutes if an increase in the price of one, increases the demand for
the other.
Example: Petrol and Diesel, Beef and Mutton
Complimentary goods
Goods are compliments if an increase in the price of one decreases the demand for
the other.
Example: Automobile and fuel, Electricity and electrical appliances
Independent goods
Goods are independent if the price change for one has no effect on the demand for
the other.
Example: Beef and text books; shoes and computers.
2.2
69
Price Expectation
Suppliers expectation of future prices affects current supply. An optimistic future
expectation encourages the supplier to reduce the supply and vice versa.
Supply of Related Goods
Increase in supply of one product may increase the supply of its related product,
e.g. increase in supply of meat from goats or cows may result in the increase of
supply of leather.
Nature of Goods
Durable goods have greater supply whereas perishable goods have less supply.
2.3
MOVEMENT
Movement along the demand curve shows the relationship between quantity
demanded and the price of a product. The movement indicates the number of units
that the consumers are willing and able to buy at different price levels during a
specific period of time. It is also indicative of the fact that less quantities of a
product would be demanded at relatively high prices and more quantities would be
demanded at relatively low prices during a specified period.
Shift in the Demand Curve takes place when the demand for a product increases or
decreases due to changes in:
(i)
(ii)
(iii)
(iv)
If the consumers want to purchase more of a product at a given price than they
wanted previously, then there is a shift in the demand curve. An increase in
demand is portrayed by an outward or right movement i.e. shift of the demand
curve. If the consumers purchase less quantities of a product at any given price,
then the demand curve would shift inwards or towards the left.
Movement along the Demand Curve and Shift in the Demand Curve are illustrated
in the following diagrams.
70
Shift in Demand
2.4
A MARKET ECONOMY
(a)
All economies have to have a system for answering the key economic
questions of what to produce and how much, how to produce and to whom to
distribute output given that all resources are finite and thus scarce to a greater
or lesser degree. In a free market economy the answers to these questions
are the outcome of the millions of decisions taken by households and firms.
Households decide how they will allocate their income between saving and
spending and the pattern of spending on the different goods and services that
compete for their favour. They also have to decide upon where and in what
line of activity they will seek to earn that income - where and in what line of
activity they will hire out their labour and whatever property they have
available for hire.
Businesses, on the other hand, have to decide what and how much of each
type of output they will produce, and what resources and how much of each
they will employ in order to produce that output.
In the free market economy it is the price mechanism that co-ordinates all
these decisions and allocates resources. Price conveys information between
consumers, producers and resource suppliers and reconciles their decisions.
This is best illustrated by an example. Diagram 1 below represents the market
for televisions.
Diagram 1
The demand curve is drawn on the assumption that, other things being equal,
more televisions will be demanded at a lower price than at a higher price; and
the supply curve on the assumption that more will be supplied by television
producers at a higher price than at a lower price. Now if demand exceeds
supply as at price P1 then producers seeing the shortage respond by raising
price and producing more. Price adjusts to its equilibrium P2, supply increases
from Q1, demand contracts from Q3 and the quantity bought and sold rises to
Q2. In the opposite situation of excess supply, stocks of televisions would build
up, and producers would let price fall in order to sell more. This fall in price
would bring about a rise in demand, a contraction of supply and a
reconciliation of production and consumption plans at Q2 with price P2.
71
Diagram 2
While the free market system works to answer the key questions referred to
earlier it is not always problem free or efficient in its operation nor in the
results that it produces. The free market system assumes certain conditions in
the market place. Firstly perfect communications are necessary so that
information regarding changing conditions is quickly transmitted without
distortion throughout the market in order for resources to be relocated where
the system indicates. If either the communication is imperfect or resources are
not mobile the system will be less than efficient. In reality reallocating
resources is likely to be quite slow in that resources are often industrially,
occupationally and/or geographically not very mobile.
Secondly, market power on the part of producers can reduce the extent to
which price signals respond to demand changes. Furthermore it is also
assumed that producers are free to enter and leave the market as a natural
response to changing market conditions i.e., there are no barriers of entry or
exit. This is clearly not the case.
Thirdly, producers base their supply plans on price and the costs that they
incur in production, while consumers base their consumption plans on price
and the benefit they themselves derive from their purchases. This is a problem
as it means that producers do not take account of costs that they avoid but
that their production activities impose on society e.g., pollution; and
consumers do not take account of wider benefits to society that are associated
72
with, for example, merit goods like health facilities. Hence the existence of
externalities can lead to a sub-optimal allocation of resources.
A fourth issue is that the distribution of income produced is likely to be highly
unequal. Those who own sought after property and whose labour commands
a high price do well. But at the other extreme those with no property and who
remain out of employment get nothing from the market system.
A final matter is that the market allocative mechanism guarantees neither full
employment, low inflation nor a sound balance of payments. All are the
concern of government intervention, indeed as are all the other problems of
the market cited above.
ELASTICITY OF DEMAND
(a)
(b)
(i)
(ii)
(iii)
(iv)
Time Factor Demand for many products is more elastic in the long
run than in the short run.
(i)
(ii)
(iii)
73
3.2
ELASTICITY OF DEMAND 2
(a)
The price elasticity of demand (PED) for a product (or factor of production) is a
measure of the responsiveness of demand for the product (measured by the
quantity demanded in a given time period) to a change in price of the product.
It may be calculated using the formula:
PED
Since the effect of an increase in price is usually a fall in demand quantity, the
numerical value of PED will be negative; however the negativity is customarily
ignored in quoting the value of PED.
When the quantity effect exceeds the price effect the demand for the good is
said to be price elastic. If however, the quantity effect is less significant than
the price change which has brought it about, the demand is inelastic.
Income elasticity of demand is a measure of the responsiveness of demand to
changes in income. It may be calculated using the formula:
YED
When the change in income is greater than the effect on demand, the good is
said to be income inelastic. If the rise in demand is greater than the change in
income, the good is said to be income elastic. For some goods, known as
inferior goods, as income rises demand falls. For normal goods, as
consumers' income rises, they are likely to buy more of the goods, income and
quantity demanded move in the same direction and YED will be positive.
However, if we considered say, poor cuts of meat, as consumers' income rise
they are likely to choose better cuts of meat and less of the cheaper cuts.
These are said to be inferior goods for which the YED is negative.
The value of the PED is influenced by several factors. Firstly the availability of
substitutes. If consumers are able to easily switch from one product to an
alternative, the effect of a price increase in the one will cause a large fall in
quantity demanded i.e., demand will be elastic.
The proportion of household income spent on a good will affect its elasticity.
The smaller the proportion of income spent on a commodity the less any price
change will affect demand.
Goods which are addictive, e.g. cigarettes will tend to show inelastic demand.
Lastly, in the long term consumers may be able to adapt their consumption to
other products which were not acceptable substitutes immediately following a
price increase. Thus demand will be inelastic in the short run becoming more
elastic in the long run.
As was stated earlier, whether the YED of a good is positive or negative
depends on whether the good is normal or inferior, however the current
standard of living of the consumer also is a determining factor. In counties
where a high standard of living is enjoyed, when income expands, sales of
consumer durables such as televisions, washing machines etc, will rise. Basic
commodities, such as potatoes, rice toothpaste etc, are probably high, while
that of basic commodities is likely to be low. By contrast third world economies
are likely to have the reverse pattern, as much of the population is unable to
afford even basic commodities. Thus the YED for the same product will vary
according to the general income level of the economy in which it is being sold.
74
(b)
Since the total revenue received by a company is the price of the product
multiplied by the quantity sold, the elasticity of demand will determine the
effect of an increase in price on the total revenue. It follows that the principal
importance of PED is in assessing the effect of changes in price on the total
revenue of a company and hence on the size of that company. This
information will be of significance to the managers within a business who will
use the information in deciding whether, or to what extent, price should be
raised or lowered. It should be noted, however, that the effect on costs is also
significant, since the firm should be maximising profits rather than revenue.
Manager in associated markets (e.g. suppliers of raw materials or
components) and suppliers of factors of production will also be interested in
the PED of the product as known or predicted price changes in the principal
market will determine the demand from that market for parts, labour etc.
Once again, as with PED, business people can use the YED for a product to
help sales and production planning as they can use the information to forecast
the impact of changes in income upon demand for individual products. As an
economy grows and incomes rise firms need to be producing goods which
have a high YED in order to ensure the business grows and sales increase.
This may entail a switching of resources from the production of goods which
have a low YED to those with a high YED. Alternatively, existing products
may be graded to give them a higher YED. Knowledge of YED is therefore
very important for a business when deciding on its future product range.
3.3
ELASTICITY OF DEMAND 3
(a)
P2 P1
Arc elasticity
B
Price
P1P0
Price
P2 P1
P2 P 1
1
E= 2
Where Q1 is the original
quantity and Q2 is the new
quantity. P1 is the original
price and P2 is the new price.
(b)
Q1Q
QQ
01
Quantity Demand
The elasticity of demand on a single point on a demand curve is called point elasticity
of demand whereas the elasticity at two different points on the demand curve is
Arc Elasticity of demand. Point elasticity of demand is used to measure very small
changes in price and quantity demanded whereas arc elasticity measure is used for
determining higher changes in demand and price.
75
3.4
CALCULATE PEDS
1.
a)
b)
ld price
ew price
2.
a)
b)
3.
a)
b)
- .
- .
ld price
ew price
ld price
ew price
3.5
CONCEPTS OF DEMAND
76
3.6
(a)
77
COFFEE MARKET
Market price is determined by the
Price
S1
D
P1
P
S1
D
S
Q1
Quantity
The measure will be negative for a normal demand curve as clearly a rise in
price would be expected to reduce the quantity demanded and vice versa. It
can be used to determine the extent of a rise resulting from a reduction in
supply.
If demand is elastic the percentage rise in price will be relatively small to a fall
in demand. If demand is inelastic the percentage rise in price will be relatively
larger than the fall in demand.
The market price prevailing includes the effect of inflation. The 'real price' of
coffee would be the current market price after adjusting for inflation. As the
period from 1986 to 1993 was a period of rapid inflation the 'real price' would
have fallen considerably more than the 15% drop in retail price.
(b)
3.7
78
(a) (i)
(ii)
(ii)
(iii)
Necessity: The more necessary a product is, the lower the elasticity, as
people will buy it no matter what the price is, such as medicine, wheat
etc.
(iv) Time: The elasticity is higher in the long run, as more and more people
stop demanding the good if high price persists.
79
Elastic Demand
Inelastic Demand
80
3.8
3.9
Time
in the long run, firms can adjust all factor inputs to change supply
easily
Production time
Stocks
Capacity
Factor mobility
If X.E.D. is negative, the two goods are in joint demand i.e., complements.
If X.E.D. is zero, the two products are unrelated i.e. independent goods.
b)
c)
81
...
Revenue gained ..................
P
A
P1
B
. .. . . . . ...... .. . . .
...............................................................................................
.............................................................................
..
. . . . . . . . . ....
..........................................................................................
.... ....
.............................................................................................
.. . . .....
...................................
. . . . . . . . .............
Q1
Q2
(a)
P2
P2
Revenue lost
K
. . .. . .. . .
..........................................................................................................
...
...................................................................................
....
P1
D1
D2
Q
Q2 Q1
(b)
Figure (a) Elastic demand and revenue. Since the price decrease results in a
proportionately larger increase in quantity demanded, revenue rises. (b) elastic
demand and revenue. Since the price increase results in a proportionately smaller
decrease in quantity demanded, revenue rises.
If with a change in price total expenditure remains the same, the elasticity of
demand is unit elastic.
(ii)
(iii)
82
PED
= 16
=2
PED =
Q P
.
P Q
= 10
Qd
16 10
2 x 96
= 96
0.83 or inelastic
Q1 Q 0 P1 P0
x
Q1 Q 0 P1 P0
10 P 0
100 Q0
5 P1
300 - Q1
300 100
300 + 100
5 + 10
5 10
- 1.5 or elastic
Note: Point elasticity of demand is measured on a single point on a demand curve while arc
elasticity of demand is measured between two points on a demand curve.
83
Y
B
D
Price D
n, u
tha
r
e
t
a
gre
RA =
B
=
E R
nity
l
ES =
D
E= S
ess
it
un
n
a
th
D
O
qd A
Fig. 2
RA
Elasticity at point 'R' is (-) RB and it is clear that lower portion is greater so elasticity
SC
is greater than unity and elasticity at 'S' is (-) SD and it is clear that lower portion is
smaller than the upper portion so elasticity is less than unity.
The formula for determining elasticity utilizes the percentage change, not the absolute
change, in quantity demanded relative to price. In the upper half of the price range
(the lower half of the range of quantity), any decrease in price is bound to be relatively
small in percentage terms because the base price is relatively high. By the same
token, the corresponding increase in quantity must be relatively high in percentage
terms because the base quantities from which the percentage is calculated are
relatively low. This is illustrated in Figure, which shows that the upper half of the
demand line is elastic, whereas the lower half is inelastic. At the half point, the
demand is unitary elastic. In fact, as long as the demand is a straight line, as in
Figure, we can state that it will have an elastic half and an inelastic half with unitary
elasticity occurring right in the middle. If the demand curve is not linear, then the
relationship between range of prices and elasticity does not hold.
Figure
Price
Elastic (E > 1)
E=
1
Inelastic (E < 1)
84
Quantity
Percentagechangein demand
Percentagechangein price
Product A:
Change in demand
Demand
25
x 100 5%
500
Change in price
x 100
Price
-5
x 100 = - 12.5%
40
5
x 100 = - 0.4 (inelastic)
- 12.5
Product B:
Percentage change in demand =
Percentage change in price =
Price elasticity of demand =
100
100 33.3%
300
-10
x 100 14.29
70
33.3
= - 0.807 (inelastic)
14.29
2.
For producers
The producers can increase the prices of those goods for which elasticity of
demand is inelastic and avoids increase in prices for those goods for which
elasticity of demand is elastic.
85
3.
Price discrimination
A monopolist charges higher price from those persons whose income is high
and elasticity of demand is elastic while charges low price from poor.
4.
Determination of fare
The concept of elasticity of demand is kept in view while determining
transportation fares e.g. Pakistan Railways charges fares at different rates
from different persons depending upon demand elasticity of the passengers.
5.
Joint demand
in case of goods which are sold, purchased or used jointly, higher price is
charged for goods having inelastic demand and lower price is charged for
goods having elastic demand.
6.
For exporters
Exporters are charging high prices for goods having inelastic demand and
lower price for goods having elastic demand.
7.
8.
Wages
If the demand for a particular type of labor is inelastic, the labor union can
easily get higher wages from the entrepreneurs for the workers.
9.
10.
The government
1.
2.
3.
86
11.
CONSUMERS EQUILIBRIUM
The consumer is said to be in equilibrium when he obtains the maximum possible
satisfaction from his purchases, given the prices in the market and the amount of
money he has for making purchases.
The assumptions applicable to the indifference curve approach are as
follows:
the customer has an indifference map showing his scale of preferences for
various combinations of the two commodities. (suppose Product A and B)
each of the goods is homogenous and divisible; and
the consumer acts rationally, that is, he tries to maximize his satisfaction.
Conditions of Equilibrium
Thus two conditions must be satisfied for a consumer to attain equilibrium.
(i)
(ii)
It can further be explained with the help of an indifference map as shown below:
87
(i)
The price line facing the consumer is AM, given a certain amount of money he
has to spend on products A and B and their prices in the market.
(ii)
Since his income and the relative prices of the two goods to be purchased are
shown by the price-income line AM, his equilibrium must be on some point on
this line. That is why this line is called the price- opportunity line.
(It is the line that contains all the possible opportunities of combining the two
goods that are open to our hypothetical consumer.)
4.2
(iii)
(iv)
IC3 is the highest indifference curve to which he can go, given the money he
has and the prices of the goods in the market. The price line (is tangent to)
touches it at point P which is the point of maximum satisfaction.
(v)
Thus the consumer will be in equilibrium at the point P, i.e., he will be buying
OH of product A and OJ of product B.
INDIFFERENCE CURVES
(a)
(b)
88
4.3
CONCEPTS
Price Effect:
The effect on a consumers indifference curve resulting from a change in the
relative price of good A if the price of good and the consumers income remains
the same, is known as Price Effect.
If the price of good A falls then the indifference curve will shift upwards, meaning
that the consumer can buy more of both product A and B with the same income.
Price Effect
Substitution Effect:
Substitution effect means the effect on the indifference curve due to change in
quantity of goods purchased due to change in relative prices with no change in
income.
If the price of good A increases and the price of good B falls, the consumer will
decrease the consumption of good A and increase the consumption of good B.
Substitution Effect
89
Income Effect:
Income Effect means the effect on the indifference curve due to a change in the
income of the consumer with no change in prices of both the goods.
When the income of the consumer increases, the quantity purchased of both
goods A and B shall increase.
Income Effect
4.4
PRICE EFFECT
A change in consumer's equilibrium because of change in relative prices of goods is
known as price effect.
(i)
Figure 1 shows the price effect for substitute goods.
(ii)
Figure 2 presents the case of independent goods which says if the price
consumption curve is horizontal it means commodity X and commodity Y are
unrelated goods (independent goods).
(iii) Figure 3 displays the case of complimentary goods that shows if the price
consumption curve slopes upward, commodity X and commodity Y are
complementary goods.
(1)
Substitute goods
Units of Commodity Y
E1
E2
IC1
x1
IC2
B x2
Units of Commodity X
90
PCC
B1
E1 E 2 E3
IC1
4.5
PCC
IC2 IC 3
x1 x2
x3
Unit of Commodity X
(2)
When Com X(3)and Com Y
When Com X and Y are complimentary
are complimentary
goods
goods
Unit of Commodity Y
Unit of Commodity Y
unrelated goods
(independent goods)
(1) (2)
Com
and Com
Y are
Com X
andX Com
Y are
PCC
E3
y1
y2
y3
IC3
E2
IC2
E1
IC1
x1
x2 x3
Unit of Commodity X
INCOME EFFECT
A change or shift in consumer's equilibrium because of change in income of the
consumer while prices of the goods remain unchanged is known as income effect.
(i)
(ii)
(ii)
(1)
I.C.C.
Commodity Y
E2
E3
IC 3
E1
IC2
IC1
Commodity Y
x1 x2 x3
(2)
(iii)
Commodity Y is an
Commodity
Y iscommodity
a
inferior
inferior
commodity
E1
E2 E 3
I.C.C.
IC 3
IC1 IC 2
D GX
B
Commodity X
D
B
Commodity X
Y
I.C.C.
(iv)(3)
Commodity X is an
inferior
commodity
inferior
commodity
Commodity Y
E3
E 2 IC 3
E1
O
IC2
IC 1
B
D G
Commodity X
91
4.6
SUBSTITUTION EFFECT
When consumers e uilibrium changes because of change in relative prices of goods
it is called price effect and if price changes but the consumer's income also changes
in such a way as to leave their total utility unchanged the quantities of goods
consumed will still change; because consumer will buy more of goods whose relative
price, has fallen and less the goods whose relative price, has risen. When a
consumer purchases more of the good whose price has fallen and has become even
cheaper to relative good although increase in real income because of fall in price of
good 'X' has been withdrawn is known as substitution effect or sliding over the same
I.C.
The substitution effect can be shown with the help of a diagram:
Product y
Y1
E1
PCC
E2
Y2
E3
IC2
IC1
X1
X3
X2
Product - X
In the figure x1, x2, is price effect and x1 x3 is the substitution effect.
4.7
(b)
(c)
(ii)
(iii)
(iv)
(v)
92
(d)
4.8
The point at which a consumer can maximize his level of satisfaction can be
demonstrated by means of Indifference Curve diagram as shown below:
(i)
The price line facing the consumer is AM, given the amount of money
the individual has to spend on products A and B at the prices prevailing
in the market.
(ii)
(iii)
(iv)
IC3 is the highest indifference curve to which the individual can go,
given the money and the prices of the goods in the market. The price
line is tangent to the indifference curve at point P which is the point of
maximum satisfaction.
(v)
Thus the consumer will be in equilibrium at the point P, i.e., when the
individual purchases OH quantities of product A and OJ quantities of
product B.
INDIFFERENCE CURVES 1
(a)
(ii)
(iii)
(iv)
93
(b)
(i)
(iii)
(iv)
(v)
4.9
INDIFFERENCE CURVES 2
(a)
94
(b)
Convex to Origin:
The indifference curve is convex to the origin when we have more units of commodity
X. Every next unit of Commodity X is giving less and less satisfaction, therefore less
and less units of commodity Y will be sacrificed that is marginal rate of substitution
(MRS) of Commodity X, for Commodity Y, goes on falling.
Y
Community Y
MRS is falling
g
1C 1
O
(i)
Community X
Community Y
MRS is constant
c
1C
O
(ii)
Community X
Y
a
b
Community Y
c
d
MRS
is increasing
e
g
k
1C
95
Community X
(c):
The main property of the indifference
curves is that Indifference curves do
not intersect each other. Suppose
that there are two indifference curves
IC1 and IC2 intersecting each other
as shown in the figure. IC2 is higher
indifference curve, IC1, is lower
Indifference curve. Therefore, it can
be concluded from the intersection of
indifference curves .
Community Y
A
C
1C1
B
1C 2
Community
X
Units of
commodity
(X)
(Y)
16
8:1
3:1
1:1
Combinations
Marginal Rate of
Substitution
Above table shows that MRS is diminishing from 8:1 to 1:1. It can also be explained
with the help of a figure.
96
Y
A
y1 16
12
Community Y
y2 8
y3
C
D
y4 4
x1
x2
x3
x4
Community X
Y2Y1
X 2 X1
or
AA
A B
97
MONOPOLIST PROFIT
Profit Maximisation
A monopolist keeps on producing as long as Marginal Revenue is greater than
Marginal Cost i.e. MR>MC.
As soon as marginal cost exceeds marginal revenue, his profit will start declining.
Hence, the profit will maximize when MR = MC.
MC = Marginal cost
MR = Marginal revenue
AC = Average cost
The reason for the MC and AC curves to be dish shaped is explained by the law of
returns which describes three phases of the curve:
1. Increasing returns (MC goes down)
As output begins to increase, the large manufacturing processes/equipment still not
fully utilised means that TC only increases slightly. The additional labour can be
productive as they can always use the equipment to its full potential, for example.
As such the MC is relatively low.
2. Constant returns (MC goes sideward)
At this point, labour is producing its optimal output per unit. The marginal cost is
therefore at its lowest.
3. Diminishing returns (MC goes up)
The more labour is employed, the less marginal output they are able to produce.
This could be a result of too many people to efficiently operate/ rotate use of
machinery. The cost increases more and more to generate an extra unit of output,
because of labour exhibiting diminishing returns in the short run.
98
5.2
PERFECT COMPETITION
(a)
(ii)
Homogenous product:
The products produced by all firms are standard or identical. Any
difference will allow the producer to charge different price.
(iii)
(iv)
(v)
(b)
Explanation:
Under perfect competition the firm can sell as much as it wants without
affecting the price, therefore MR=AR of the product.
Therefore, under perfect competition, the firm keeps on producing as long as
MR is greater than MC.
When the MC exceeds MR the profit will start declining.
Therefore, the profit will maximize when MR = MC.
Therefore, the firm is in equilibrium at point L.
99
5.3
INCREASING RETURNS
The law of increasing return states that as additional units of a variable factor are
employed while other factors remain the same, the production increases at a
higher rate.
The higher rate of increase continues so long as there in no deficiency of an
essential factor in the process of production. As soon as there occurs a wrong or
defective combination in productive process, the marginal productivity begins to
decline.
Application of the law of increasing return in the manufacturing industry:
The increasing return mainly arises due to the fact that large scale production is
able to secure certain economies of scale, both internal and external.
These advantages may be on account of division of labour, specialized machinery,
commercial advantages of buying and selling wholesale, utilization of by-products,
use of extensive publicity and advertisement, availability of cheap credit etc.
The law of increasing return operates as long as the plant is producing below
capacity. The increase in the marginal return continues till the plant begins to
produce its full capacity.
This can be illustrated as follows:
The productivity of the variable factor will vary. This will cause the shape of the cost
curves to change from being linear to being curvi-linear.
5.4
LARGE FIRMS
(a)
100
(b)
Trading economies larger size enables the firm to buy in bulk and sell
in bulk, reducing both the costs of buying and selling. Advertising costs
can also be reduced as I advertisement can sell one item or a million
items the larger the quantity the lower the cost per item.
Financial economies larger firms can offer more assets as security and
are less dependent on one product or market, making them a better risk
for lenders and reducing the interest rate on loans and other forms of
finance.
As the firm expands its size, in the long run, it is able to take advantage of
economies of scale and average cost falls. After a certain level of output is
reached all economies of scale have been achieved and this point on the
average cost curve is called minimum efficient scale. Further output beyond
this point can result in the same average cost per unit, but eventually average
cost will start to rise, as diseconomies of scale are produced. Diseconomies
of scale are essentially the result of communication problems as the firm
grows too large. In addition, the larger the organisation becomes, the more
difficult it becomes to co-ordinate the activities of all of the people involved.
This will result in the duplication and omission of work due to confusion over
areas of responsibility. Finally, the larger the organisation, the greater the
difficulty for management to ensure that subordinates are carrying out the
tasks allocated to them.
The level of output at which minimum efficient scale is reached will vary with
different industries. Where very large output quantity is needed to achieve
minimum efficient scale, the number of firms in the industry would be few, for
example, coal mining. In industries where minimum efficient scale can be
achieved with relatively small output quantity, the number of firms can be
much greater, for example, hairdressing.
101
(c)
Merger tends to imply that firms have joined amicably whereas take-over
implies that one firm has absorbed another against its wishes. However, the
result is the same in that two firms have become one.
Merged firms may produce different products or the same product at a
different stage of the production process (vertical integration). In either case,
technical and trading economies may not be available. However, in horizontal
mergers, where both firms are involved in producing the same good at the
same stage of production such economies may well be available.
In all cases, firms may obtain economies by reducing staff in centralised
functions, such as accounting, personnel or human resource functions and
computer or systems functions. All firms may also benefit from financial
economies as the larger firm has more assets to use as security, reducing
interest rates and increasing the sources from which funds may be obtained.
(d)
5.5
Large size firms may have monopoly power within a domestic Economy which
may appear to be against the public interest. But such size may be needed to
enable the firm to compete on a global basis. In such cases, the domestic
economy can benefit from employment and the taxation of profits, which can
be used for the benefit of the whole economy. In addition, there are
circumstances where a large firm can produce more cheaply, and offer a lower
price, than a number of smaller competing firms. This is the case when there
are heavy capital costs involved in setting up in business; hence, it would be
less cost effective to have two competing rail networks in the UK. This is
known as a natural monopoly.
(i)
(ii)
(iii)
(iv)
(v)
(b)
(i)
false
(ii)
false
(iii)
true
102
5.6
(i)
(b)
(c)
(d)
(i)
false
(ii)
true
(iii)
true
(iv)
true
Revenue / cost
103
5.7
Total
Marginal
Total
Marginal
Price
cost
cost
revenue
revenue
34
12
12
34
34
30
20
8
60
26
27
34
14
81
21
25
53
19
100
19
23
75
22
115
15
21
102
27
126
11
19
131
29
133
7
The marginal cost is the extent to which total costs change when output
is changed by one unit.
Marginal revenue is the change in revenue obtained when sales are
changed by one unit.
(b)
Quantity
sold
1
2
3
4
5
6
7
Total
revenue
34
60
81
100
115
126
133
Total
cost
12
20
34
53
75
102
131
Profit
22
40
47
47
40
24
2
From the table in (a) above it can be seen that the profit-maximising level of
output is 4 as this is where marginal cost at 19 equals marginal revenue
which is a condition of profit-maximisation.
(c)
Thus if the price falls from 25 to 23 and demand rises from 4 to 5 units as
indicated in the table in (a) above, the price elasticity of demand will be:
PED
(d)
1
4
2 / 25
25%
3.125
8%
A PED value of 3.125 indicates that demand for the good is elastic, the
proportionate change in quantity demanded being greater than the
proportionate fall in price. The major influence on elasticity of demand is the
availability of close substitutes. Thus it is possible in this case that substitutes
exist and consumers have switched following a rise in price. The good could
also be one which accounts for a large proportion of consumers' incomes.
104
In which case, a relatively small change in price will have a big impact on
disposable incomes available to purchase the good. Lastly the time period
over which these changes occur is relevant since demand elasticity rises over
time as consumers have time to consider and then alter their purchasing
habits following a price rise.
(e)
If the number of firms in the industry rose there would be a twofold effect on
the demand curve for this firm. Firstly more firms would mean more
alternatives for consumers to consider, and the more substitute goods
available the more elastic the demand curve would become for this individual
firm within the industry.
Secondly, it is likely that the extra firms would result in a smaller market share
for each firm. A fall in demand means that less is now demanded at each and
every price, hence this firm's demand curve will move inwards from right to
left.
5.8
Total revenue
Marginal revenue
Total cost
Marginal cost
0
110
1
50
50
140
30
2
100
50
162
22
3
150
50
175
13
4
200
50
180
5
5
250
50
185
5
6
300
50
194
9
7
350
50
219
25
8
400
50
269
50
9
450
50
325
56
10
500
50
425
100
(a) Marginal revenue is defined as the addition to total revenue from producing
one more unit. The marginal revenue is the same at all levels of output i.e.
total revenue increases by 50 each time an extra unit is produced. Marginal
revenue is therefore constant throughout and must be the same as average
revenue, or price. Graphically, average revenue in thus a horizontal straight
line i.e., the demand curve is perfectly elastic. This can happen only under
conditions of perfect competition and this firm is operating in a perfect market.
(b)
The fixed costs of a firm are those which, in the short run at least, do not vary
with output. Fixed costs have to be paid even when output is zero and they
are the only ones paid when no production is taking place, since variable costs
are incurred only when output is being produced. The firm's fixed costs are
therefore the total cost of zero output re 110.
The marginal costs are the additions to total cost of producing extra units, and
are shown in the table.
(c)
The firm aims to maximise profits and it will do this where the marginal
revenue gained from selling the last unit is just equal to the marginal cost of
producing that unit. The only output level where marginal revenue equals
marginal cost is 8 units, where both MR and MC are 50. The firm will thus
produce 8 units.
Profit equals total revenue minus total cost. At 8 units this is 400 269 =
131.
105
(d)
There are no barriers to entry in a perfect market and so new producers can
come in. They will do so, however, only if there is enough profit to attract them
in i.e., only if the existing firm (or firms) is making a supernormal profit. The
industry will be in equilibrium, i.e. new firms will stop entering, when all firms
are making a normal profit. Normal profit is that amount of profit which will just
keep a firm in business and it is earned when the firm covers all its costs,
including the opportunity cost of giving up the next best alternative
employment.
The entry of new producers will reduce the supernormal profit being earned by
the existing firm and will also cause its output to fall. This can be illustrated
graphically.
When new firms enter the market, the industry supply curve increases i.e.
shifts to the right. The new supply curve S2 interacts with the original demand
curve and causes market price to fall from P1 to P2. Each firm therefore
receives a lower price and average and marginal revenue curves fall from AR1
to AR2 and from MR1 to MR2. The firm's output is reduced from Q1 to Q2.
Output and price will continue to fall as new firms continue to enter until all
firms are earning just normal profit - there is now no further incentive for any
more firms to join the industry.
In conclusion, the firm's output and profits will both fall as new producers enter
the market.
5.9
(b)
(i)
An increase in the firm's costs will cause equilibrium price to rise and
output to fall.
(ii)
(i)
(ii)
New firms entering the industry would shift average revenue and
marginal revenue to the left, causing equilibrium price and output to fall.
106
(c)
5.10
reducing price (limit pricing) to particularly affect new firms with high
start-up costs
reducing price to very low levels (price wars) and sustaining losses for
short periods of time as longer established firms may survive where new
firms cannot
TYPES OF COSTS
TABLE
The concept of total costs, average total costs, average fixed costs, average variable
costs and marginal costs can be explained with the help of a schedule. Fixed cost of
the firm is 30.
Units
of
Output
Q
1
2
3
4
5
6
7
8
9
10
TFC
TVC
30
30
30
30
30
30
30
30
30
30
30
40
45
50
60
72
89
110
135
170
ATC =
TC=(TFC AFC=TFC/Q
AFC +
+ TVC)
AFC
AVC=TVC/Q AVC
AVC
60
70
75
80
90
102
119
140
165
200
30
15
10
7.5
6
5
4.3
3.75
3.3
3
30
20
15
12.5
12
12
12.7
13.75
15
17
60
35
25
20
18
17
17
17.5
18.3
20
MC
30
10
5
5
10
12
17
21
25
35
It is clear from the above schedule that the fixed cost is unchanged throughout that is
30 but Average Fixed Cost is diminishing because when output increases, the fixed
costs spread over the total output and hence, Average Fixed Cost is diminishing due
to law of increasing returns.
Relationship between Marginal Costs and Average Total Cost
1.
It is clear from the table that from 1st unit to 6th unit average total cost is
diminishing and marginal cost is less than average total cost.
2.
Marginal cost at 7th unit is equal to Average Total Cost and Average Total
Cost is minimum.
3.
Average total cost is increasing from 8th unit to 10th unit and marginal cost is
also increasing but average total cost is increasing at a slower rate than the
marginal cost.
107
5.11
Average variable cost is increasing from 7th to 10th unit and marginal cost is
also increasing but marginal cost is increasing at a faster rate than the
Average Variable Cost.
MONOPOLY SETUP
Disadvantages of having a monopoly setup.
5.12
(i)
(ii)
Quite often a monopolist enjoys control over vital resources and might take
decisions which may not be in the public interest. For example, in case of
strategically important industries such as, steel mills, electricity generation
and nuclear plants etc.
(iii)
Mostly the monopolists are less receptive towards innovation as they are
already earning super normal profits.
(iv)
(v)
They do not use resources in the most efficient possible way. That is
combining factors of production so as to minimize average unit cost.
Therefore there are no economies of scale. Eventually a monopoly will
produce less and sell at higher prices than combination of firms in a
competitive market.
CONSUMPTION GOODS
(a)
Consumption goods are products and services that are directly consumed by
the customer himself, and are not bought with the purpose of either reselling
or using in production of products/services to sell.
The demand for consumption goods is determined by:
(i)
(ii)
wealth of consumers
prices of substitutes
108
(b)
Q P Q P
Q
P
Q P
- 12,000 12
48,000
1
- 12,000
12
48,000
- 12
4
5.13
Equilibrium of the Firm is the point at which the firm has no incentive either to
expand or contract its output. A firm would not change its level of output as it
is earning maximum profits at this point.
(b)
The essential conditions for the existence of conditions for perfect competition
are:
(i)
(ii)
Homogenous product
The products produced by all firms are standard or identical. Any
difference will allow the producer to charge different price.
(iii)
(iv)
(v)
109
(c)
The equilibrium of a firm under perfect competition and in the long run is
depicted by the following diagram:
Under conditions of perfect competition, the same price prevails in the market
and hence sale of each additional unit produces the same revenue and
therefore MR=AR=P(Price) . PL is the line which represents MR as well as
AR. LRMC is the marginal cost curve which depicts the increase in cost on
account of production of each additional unit. With the sale of each additional
unit the total profit of the firm would increase till such time that the LRMC
remains below the Marginal Revenue Curve i.e. PL. The profit will be
maximum when the LRMC Curve cuts PL from below at which stage LRMC
would be equal to Marginal Revenue. At this stage the firm would be
producing OM units.
In the long run, the firms are able to increase/decrease their output by varying
their equipment. Therefore, in the long run no firm is in a position to earn
super normal profits. If price increases and the firms start earning super
profits, other firms enter the market or present firms increase their output. If
price decreases and there are below normal profits, firms exit the market.
Therefore, in the long run, the price always reverts back to the position where
all firms are earning normal profits.
5.14
MARKET FUNCTIONING
The features which distinguish a market functioning in an environment of perfect
competition from a market which operates as a monopoly are:
(a) Number of Sellers - In conditions of perfect competition there are a large
number of sellers in the market. The individual sellers compete to sell their
products in the market, but in a monopoly there is only a single firm which sells
the product.
(b) Entry and Exit of Firms- In perfect competition, new firms can freely enter the
industry and inefficient firms can exit if they suffer losses. Under conditions of
monopoly, there are several barriers which are difficult to overcome for
prospective new entrants.
110
5.15
FREE FORCES
(a)
In the above diagram, there is only one price P at which the quantity
demanded and the quantity supplied is equal and this is the point where the
market is deemed to be in equilibrium. Thus Q is the equilibrium quantity and
P is the equilibrium price.
111
At prices and quantities other than the equilibrium, either demand exceeds
supply or supply exceeds demand.
For instance at price P1 supply exceeds demand resulting in unsold stocks.
The reaction of suppliers would be to accept lower prices than P1 to
encourage sales. This reduction in price will lead to a contraction in supply
and an expansion in demand until equilibrium is reached at price P.
Conversely, at price P2 demand exceeds supply resulting in a shortage. This
excess demand will lead to an increase in market price. As a result the
demand will contract and supply will expand until equilibrium is reached at
price P.
(b)
5.16
Non-homogenous products
112
(i)
(ii)
Normal Profit
(iii)
Losses
113
5.19
PRICE LEADERSHIP
Price Leadership occurs when all the firms realize that price initiated by one firm is
beneficial to them, so follow the leader and charge the same price. Price leadership
firm may not be of big size but its price and output policy is followed by other
oligopoly firms.
5.20
Ol o ol D
C v o Sw
z s Mo
l of Oligopoly:
Sweezy believed that the rival firm will follow a price decrease policy but may not
follow a price increase policy. This gives a kink in the demand curve. The kinked
demand curve shows that the demand curve will be more elastic before a certain
point and inelastic after that point. Before price cartel it behaves like monophonic
completion and after price cartel is formed it behaves like monopoly. Therefore, the
curve is initially elastic and then inelastic.
5.21
NON-PRICE COMPETITION
Oligopolies tend to avoid price competition because competitors will match any
price cuts. Firms wishing to increase sales are more likely to use non-price
competition such as:
(i)
(2)
(3)
(ii)
(iii)
NATIONAL INCOME
(a) (i)
(ii)
114
(iii)
Expenditure Method:
This method arrives at National Income by adding up all the expenditure
made on goods and services during the year.
The National Income is found by summing up all the conventional and
the investment expenditure by individuals, corporations and the
government of a country during the given period.
(b)
6.2
The calculation of the national income is based on the concept of the circular
flow of output, expenditure and income and the assumed equality of each of
these stages of the flow. Given this concept, it should be possible to sum total
income and total output and the results should be the same. On this basis, the
official figures show the calculation of national income by each of the three
methods:
(i)
The expenditure method totals payments made for final goods and
services. It shows the following main items: consumer spending, public
authorities' current spending on goods and services, capital investment
(termed gross domestic fixed capital formation) and the value of the
change in stocks of goods and goods being made. These items give
total domestic expenditure. When adjusted for imports, exports and
property income from abroad the total becomes the gross national
product (national expenditure).
(ii)
115
(iii)
The output method is found by summing all the totals of value added by
each business and industry sector and the various sectors of public
health, education, administration etc.
All three methods should produce the same total figure however in practice
this is not usually the case mainly due to the enormity of the number of
transactions being aggregated.
(b)
116
6.3
(b) WITHDRAWALS
A withdrawal is where money exits the circular flow of income, and is no longer
passed between agents.
Savings Households do not spend all their income and save a certain portion.
These savings are withdrawals from the Circular Flow of Income
Taxation The amount of taxes paid to the government is not available for
spending by the households and is therefore considered as withdrawals from
the Circular Flow of Income
Imports The expenditures incurred on the purchase of imported goods and
services accrue to firms in foreign countries and therefore constitute withdrawals
from a countrys Circular Flow of Income.
INJECTIONS
An injection is where money enters the circular flow of income from an external
source, meaning that it can then be passed between agents.
Investments - Investments in capital goods are a form of spending on future
output which is addition to the expenditure and are therefore considered as
injection of funds into the Circular Flow of Income
Government Spending - The funds spent by the government are injections in
the Circular Flow of Income. The funds may be raised by way of taxes or
borrowings by the government.
Exports The goods and services produced by the firms in the country and
exported, result in income from abroad and are therefore injections in the
Circular Flow of Income.
117
6.4
Figure 1 shows that in simplistic terms, the behaviour of the national economy
is determined by the circular flow of income between two principal agencies,
households and firms. Households will spend their income on things
purchased from firms, this is consumption. Firms, however, will spend all their
income on hiring factors of production i.e., land, labour, capital and
entrepreneurship from households. Hence, what households spend on
consumption is in fact what firms have paid out to them in terms of factor
rewards. Thus total sales revenue of firms should equal total consumption of
households, assuming all income is spent. Clearly this is not the case.
Households do not spend all their income on consumptions, some is disposed
of by way of savings, taxation and payments for imported goods. These are
the withdrawals from the circular flow. Conversely, there are inflows into the
circular flow in the form of capital investment undertaken by firms, government
expenditure and payments made by foreigners in order to purchase UK goods
i.e. exports. These are known as injections.
If withdrawals and injections are equal, the circular flow will remain in
equilibrium and there will be no change in the level of national income.
However, if for instance, injections rise and thus spending exceeds available
output, national incomes will rise. Producers will react by increasing output in
the following period to meet the increased demand. As the national income
grows, so too will withdrawals as households choose to save some of their
increase in income or spend on imports. When the increase in withdrawals
finally matches the original increase in injections, national income will be
restored to an equilibrium level albeit a higher one.
(b)
118
6.5
The shift from SRAS1 to SRAS2 shows an increase in aggregate supply at each
price level
119
(c)
6.6
The following are reasons for a backward shift in SRAS. Other answers that
refer to a change in SRAS are acceptable, as long as it doesnt refer to a
movement along the curve
i.
ii.
iii.
iv.
v.
vi.
Going from the short run to the long run, the aggregate supply curve gets
steeper. This is because in the long run resources are used at their most
efficient point. The long run aggregate supply curve (LRAS) is a vertical line
as it is completely independent of the price level.
(b)
Less likely.
y its nature, it is assumed that the LRAS curve doesnt fluctuate too greatly.
Instead, if there are significant, permanent changes to the productive potential
of the economy, then this will lead to a shift.
An increase in the quantity and productivity of the factors of production, or an
advance in technological capabilities in the economy would cause an increase
in the productive potential, and therefore the LRAS.
A lot of changes in the SRAS come about from resources becoming more or
less efficient. However because the LRAS assumes full efficiency, it isnt
affected by these changes.
6.7
AGGREGATE DEMAND
(a)
120
(b)
(c)
Definition: Effective demand
Actual expenditure in an economy is based on existing/ actual income, rather
than if the economy was at its productive potential (when all resources are fully
utilised).
This asserts that agents in an economy will only make expenditures with a
percentage of their income, rather than an assumption that if the economy is
in the long run, all income could possibly be used to fuel aggregate demand.
121
6.8
(b)
The key point to note is that the level of output increases proportionately more
than the price level. In a deep recession/ depression the price level wont
increase at all.
(c)
Important here is to show that there is an SRAS and an LRAS, rather than one
supply curve.
Equilibrium in both cases should be to the left of the LRAS
An increase in AD leads to an increase in output, but also to an increase in the
price level.
122
6.9
The difference between the actual output of an economy, and the production
potential of an economy is known as the output gap.
Definition: Output gap
The difference between potential GDP and actual output in an economy.
A positive output gap is known as an: inflationary gap
A negative output gap is known as a: deflationary gap
(b)
The key point is that the equilibrium of AD and SRAS is beyond the LRAS
(c)
The key point is that after a while, the SRAS shifts upwards and equilibrium is
restored on the LRAS, however at a higher price level.
123
6.10
DEFLATIONARY GAP
Deflationary gap:
124
(ii)
(iii)
(iv)
125
6.11
CALCULATION OF GDP
(a)
Consumer expenditures
Rs. 1,100,000
(ii)
Government expenditures
Rs.
Total expenditure
Rs. 1600,000
Exports
Rs.
(iii)
Total
(iv)
Imports
() 400,000
1,600,000
Income Approach
Income received by the labor force (Pretax)
Rs. 900,000
Rs. 700,000
400,000
2,000,000
500,000
Rs. 1,600,000
Rs. 2,000,000
Rs. () 400,000
Rs. 1,600,000
IMPORTANT NOTES
Note NO. 1
GDP at market prices = Consumption expenditures + Federal Govt. expenditures +
Capital formation physical decrees in stocks + ExportsImports
Note NO. 2
GNP at market prices = GDP at market prices (+) Net property income earned from
abroad.
Note NO. 3
GDP at factor cost
subsidies
Note NO. 4
GNP at factor cost
abroad.
Note NO. 5
National income at factor cost
capital
126
6.12
CALCULATION OF GDP 2
(i)
Rs. million
Consumption expenditure
20,000
4,500
Capital formation
5,100
Total Expenditure
29,600
(100)
29,500
Exports
7,000
Total
36,500
Imports
(6500)
30,000
(iii)
30,000
(ii)
30,500
30,000
Taxes on expenditure
(6000)
Total
24,000
Subsidy
(iv)
500
500
24,500
24,500
500
25,000
(v)
(vi)
25,000
(2000)
23,000
30,500
( - ) Capital consumption
(2,000)
28,500
127
6.13
CALCULATION OF GDP 3
(i)
Consumers expenditures
16,500
(b)
Government expenditure
7,500
(c)
Total exports
6,000
(d)
(ii)
Total expenditures
30,000
Total imports
(6,000)
Total expenditures
24,000
10,500
(b)
12,000
Total income
22,500
(c)
1,500
Total income
(iii)
24,000
30,000
(b)
6.14
24,000
CALCULATION OF GDP 4
(a)
(i)
Consumers expenditure
(ii)
(iii)
Total
(iv)
41,790
Physical decrease
Total
(v)
41,760
Exports
Total
(vi)
51,435
Imports
Rs. 42075
128
(b) GDP at factor costs = GDP at market price Taxes on expenditure + subsidies.
(i)
Rs. 42,075million
(ii)
Subsidies
(iii)
Taxes on expenditure
Rs. 38,385
(c) GNP at market prices = GDP at market prices + Net property income earned
from abroad.
(i)
(ii)
Rs. 42,390
(d) GNP at factors cost= GDP at factor cost + net property income from
abroad.
(i)
(ii)
Rs. 38,700
(e) National income at factor cost= GNP at factor cost () Capital Consumption
(i)
(ii)
Capital consumption
Rs. 36,075
(f)
(i)
Rs. 42,390
(ii)
Capital consumption
Rs.(2,625)
Rs. 39,765
129
(b)
(i)
(ii)
(iii)
(iv)
(v)
(i)
(ii)
(c)
(i)
exports
government spending
investment
imports
taxation
savings
130
7.2
A fall in interest rates should decrease the cost of investment relative to the
potential yield that the investment might bring, thereby increasing the
likelihood that investment will occur.
Firms will invest if the discounted yield (i.e. the benefit) exceeds the cost of the
project
The MEC schedule shows the total level of investment which will take place in
the economy at each level of the interest rate.
(b)
(c)
(d)
The MEC curve can shift outwards if the expected rate of return increases.
This could be due to:
131
7.3
CONSUMPTION FUNCTION
(a)
Each household has an income, with which they can choose to either spend
on goods and services immediately (i.e. consume), or choose to not spend it
in the current period (i.e. save).
Income = Consumption + Savings
(b)
change in consumption
,
change in income
MPC
2.
3.
132
7.4
PRIVATE INVESTMENT
(a) The government can influence the level of private investment in several ways:
(i)
Control interest rates: By keeping interest rates low, for example, the
government might encourage a higher volume of investments, whereas
by allowing interest rates to rise, the government would probably cause
the volume of investment to fall. Government can influence interest rates.
(ii)
133
MULTIPLIER
(a)
Multiplier is the ratio of the increase in Total National Income to the Initial
increase in National Income that brought about the change.
Formula of Multiplier
=
Y
I
8.2
(ii)
(iii)
Leakages: Leakages from the circular flow of income would make the
value of multiplier very low and extra spending in the economy would
have nominal effect, particularly where there is a high marginal
propensity for imports.
(iv)
(v)
MULTIPLIER 1
(a)
(b)
Planned.
There is a time lag between when investment decisions are made, and the
eventual change in output.
It will not necessarily follow that agents in the economy will follow this level,
however it is the intent that is important.
134
(c)
8.3
Which means firms will not invest (because there will not be the demand
to meet it)
Firms not investing will reduce the eventual output in the economy
MULTIPLIER 2
(a)
income of another
(b)
The increase in AD has caused output to increase from Y to Y , but the price
level remains unchanged.
This shows how a boost in AD has the effect of increasing output, thereby
helping the economy move out of depression.
If aggregate supply is boosted
The types of policies that Keynes argued were not necessary were ones that
looked to increase the competitiveness or capacity of supply. Examples of
these are measures to reduce wages, or the cost of raw material.
From the point of being in a depression, Keynes argued that there would be
no change in the output of the economy, because AD would remain stubbornly
fixed. This is illustrated below.
135
The increase in AS has had no effect on the equilibrium output because the AS
curve remains horizontal at that stage.
(c)
Choose from:
Marginal Propensity to Consume: how much of income generated through
the investment will be spent on other goods and services in the economy. If
MPC is high, then the multiplier effect is stronger
Tax rate: how much of this income will be returned to the government in the
form of tax. The lower the tax rate, the higher the multiplier effect
Marginal Propensity to Import: how likely individuals are spend their income
outside of the domestic economy, which reduces the impact of the multiplier
Supply-side capacity of the economy: if there is no spare capacity in the
economy, an increase in government investment may lead to inflation, which
would lessen the real effects of the investment
Time lag: planned investment takes time to implement. There could be many
years before the effects of the multiplier are felt.
8.4
ACCELERATOR QUESTION
(a)
136
(b)
Example:
Year
Y
(=Output)
Stock of
capital
[1]
(0)
(200)
(600)
200
600
220
Net
investment
[2]
Depreciation
[3]
Gross
investment
[4]
60
60
660
180
60
240
240
720
180
66
246
250
750
90
72
162
250
750
75
75
(c)
Example:
(d)
Year
Y
(=Output)
% change in Y
Gross
investment
% change in
gross
investment
(0)
(200)
200
60
220
10
240
240
9.1
246
2.5
250
4.17
162
-34.1
250
75
-53.7
300
137
CHAPTER 9 MONEY
9.1
(b)
138
The theory assumes that V is constant and that the economy is at full
employment hence the volume of transactions is fixed at a constant level
which reflects the full employment level of output. Applying these assumptions
to the equation, the average price level P will therefore be determined solely
by M, the quantity of money in circulation. An increase in the money supply
will lead directly to a proportionate rise in the price level.
The rationale for this result is that it is assumed that people hold money only
as a means of purchasing goods and services i.e., a transactions motive, and
they do not have a speculative motive. Beginning with a position of equilibrium
as regards desired money holdings, if the money supply is increased people
will find that they are holding more money than they need to cover their
transaction requirements, they will therefore spend the excess on goods and
services. As the economy is assumed to be at full employment output cannot
increase in the short term so prices will rise.
(c)
There are various means by which the government can attempt to control the
money supply. Firstly, open market operations. This involves the buying and
selling of bills by the Bank of England on behalf of the government on the
open market. Such action will inevitably affect the credit-creating abilities of
the commercial banks. For example, if the Bank of England sells bills, the
public will obviously need to pay for them by drawing on their accounts with
the commercial banks. As these banks have to maintain a stable ratio
between cash and loans, they will have to cut back on their lending and hence
the growth of the money supply will be curtailed.
The government, through the Bank of England, has an unpublished band of
interest rates which it wishes to prevail within the economy. It can influence
the direction of movement of rates through the Treasury Bill issue which
results in all major financial institutions altering their rates accordingly. If the
government raises interest rates this reduces the demand for money since
less people will want to take out bank loans, thus less money is created.
Thirdly the government could make use of special deposits. These have not
been used since 1981 but are still available should circumstances prove
necessary. They involve the deposit of a certain proportion of the commercial
banks' assets at the Bank of England. This effectively reduces their ability to
create credit and thus would support a contractionary monetary policy.
A further alternative is Treasury directives. These are guidelines on lending
policy issued by the Bank of England to which the commercial banks are
expected to adhere.
Lastly, the government could reduce the growth in the money supply by
controlling the Public Sector Borrowing Requirement (PSBR). If it restricts the
PSBR it will in turn mean less finance is required and will reduce the need for
certain methods of government borrowing which lead to increases in the
money supply.
9.2
The figures in the table show no clear relationship between the money supply
(M0) and the rate of inflation. For example over the three year period from
1976 to 1978 inclusive, when the growth of the money supply rose steadily,
inflation jumped around from 12.9% to 17.6% then right back down to 7.8%. In
1979 M0 fell from 13.7% the previous year to 11.9%, however in the same
period inflation rose from 7.8% to 15.6%. There were periods (1983,
1988,1993 to 1995) when M0 grew more than 6% but inflation was moving at
less than 5%, and other periods when inflation was well above 6% but M0 was
139
well below 4% (1981, 1982, 1985 and 1990). In the final three years M0
remained steady at around 6% but inflation increased from 1.4% to 2.3% and
finally to 3.5%.
(b)
(d)
The effects of a change in the money supply in the short and long run will vary
depending on whether a Keynesian or a Monetarist view is being used.
Keynesian theory suggests, taking an increase in the money supply as an
example, that an increase in expenditure on financial assets will result and
hence a fall in interest rates (an increase in the demand for bonds
automatically results in a fall in the rate of interest.) This fall in interest rates
will stimulate the demand for consumption and investment goods although in a
relatively small way as, according to Keynes, expenditure is interest rate
inelastic. The lower rates will however mean consumers will have more money
to spend on goods and services as the cost of mortgages and other domestic
loans decrease. In the short run the increase in demand will be met by spare
140
capacity in the economy, so prices will remain steady. In the long run
however, if all the spare capacity is used up and if productivity has not
improved the increase in demand could cause prices to rise.
Monetarists believe that increases in the money supply will lead to a rise in
demand for all goods and services. In the short run this extra spending can
lead to a rise in prices, but producers will expand output as a response to the
higher demand. In the long run producers will realise that in real terms they
are no better off and output will return to the level it was before the rise in the
money supply. This is known as the natural unemployment level of national
income. If there are further money supply increases prices alone will rise
without any increase in output.
9.3
IMPORTANT FUNCTIONS
(a)
(i)
Medium of exchange
It removes the inconvenience of a barter system.
(ii)
(iii)
(iv)
Store of value
Money serves as a store of value and it helps a person keep his assets
liquid.
(b)
Transaction motive
The transaction demand for money is the demand for money to carry on day
to day dealings/ transactions. There exists a direct relationship between the
transactions demand for money and the level of income. The higher the level
of income the higher will be the transactions motive.
Precautionary motive
Precautionary demand for money arises out of peoples desire to save money
for unforeseen circumstances. The amount of money held under this motive
will depend on the nature of the individual and on the conditions in which he
lives.
Speculation motive
The speculative motive refers to the desire of a person to hold ones
resources in liquid form to take advantage of market movements regarding
future changes in the rate of interest or bond prices. The amount of money
held under speculation motive is influenced by the level of income and rate of
interest.
141
9.4
UNEMPLOYMENT
(a)
(i)
The curve crosses the horizontal axis at a positive value for the
unemployment rate. This means that zero inflation will be associated
with some unemployment; it is not possible to achieve zero inflation
and zero unemployment at the same time.
(ii)
(b)
(c)
142
Cyclical unemployment
Such unemployment increases in recession when aggregate demand
and prices are falling and decreases in boom period when aggregate
demand and prices are on the rise.
Structural unemployment:
When an economy undergoes structural changes for example when
the economy moves from one sector to another or from primary goods
to value added goods etc. re-adjustments are needed. In such
situations those workers who are unable to acquire the new skills or
are otherwise reluctant to change their jobs become unemployed.
Technological unemployment:
Due to technological development machines replace labour resulting
in unemployment of this sort. However when the productivity
increases it generates demand for other types of goods and the
unemployment starts reducing as the workers acquire newer skills.
9.5
PHILLIPS CURVE
(a)
(b)
The trade off between unemployment and inflation can be explained like so:
At point A, the trade off between inflation and unemployment is great, because
resources are near full capacity.
At point B though, there is more spare capacity in the economy, meaning that the
level of wage inflation is low.
143
(c)
The argument that Friedman put forward was that each SRPC was based
upon a fixed expectation of inflation. If there was an increase in the
expectation of inflation, then this would cause the SRPC to shift higher.
In his opinion, boosting AD would only have a short run effect on
unemployment. In the long run, people would adjust their expectations to
account for higher inflation, and a new SRPC curve would form.
This can be shown in the diagram below:
9.6
LIQUID FORM
The motives for retaining money in liquid form are:
Transactions motive Individuals need money to meet their day-to-day
requirements of purchases of goods and services. The need to hold money for
transactions arises because the payments and receipts of individuals are not
exactly synchronised. The liquidity preference or transactions demand for money
will increase either by an increase in the real national income or an increase in the
general price level or any combination of the two.
144
9.7
Money functions
Anything may serve as money providing it is readily acceptable as a method of
payment and is generally available. In order to qualify as such the commodity
chosen must be divisible, portable and durable. The normal forms of money used
today in most economies are coins, notes, bank and building society deposits, none
of which are desirable for themselves but for what they can do. Thus, money has
some important functions which can be summarised as follows:
(i)
A medium of exchange
Anything which will act as a medium of exchange is money. Bank notes, coins,
cigarettes, luncheon vouchers, cheques, all have this quality or have had it
within certain communities at certain periods of time. The more widely
acceptable the item is for the settlement of debts, the more satisfactory it is as
money. Luncheon vouchers, for example, are completely acceptable in
payment for lunches at appropriate shops, but they are not usable for anything
else. Items such as this are sometimes known as 'partial money'.
(ii)
Measure of value
It must be capable of being used as a measure of value, or unit of account.
This means that a good or service which is being exchanged between a buyer
and a seller can be precisely valued. Also, accounts may be kept and
transactions recorded, using money as the recording medium. In times of
inflation, this function is threatened and confidence in the measurement of
value is diminished.
(iii)
145
(iv)
Store of wealth
Money can be used to preserve purchasing power so that people may build up
a store which is then available for future needs or for passing on to their
children. In an inflationary situation, however, bank notes and bank deposits
become less acceptable than rights to the ownership of physical assets, such
as Stock Exchange securities, or the physical property itself e.g., land,
buildings, works of art or postage stamps.
10.2
INDIRECT TAXES
(a)
(b)
(ii)
(iii)
(iv)
(v)
(vi)
MACROECONOMIC POLICY
(a)
146
10.3
Direct taxes can be defined as those taxes that are levied directly on the
intended taxpayer. They are principally taxes on income and capital and in
the UK take the main forms of income tax, corporation tax, capital gains tax
and inheritance tax. Indirect taxes then become those taxes that are levied on
the intended taxpayer via some third party. These are taxes on expenditure
and in the UK are Value Added Tax (VAT) and specific sales taxes, mainly
customs and excise duties (e.g. on petrol, tobacco and alcohol).
Underlying a good taxation system is a set of principles described by Adam
Smith in his Wealth of Nations as the four canons of taxation. They were,
firstly, equity. Taxes should be levied according to the ability to pay of the
taxpayer. A progressive tax is considered an equitable tax since it takes a
higher proportion of income in tax as income rises, it therefore can be used to
redistribute wealth away from the rich to the poor.
The second canon is that of certainty. The taxpayer should know when the
tax should be paid, how much should be paid and which transactions give rise
to a tax liability. Thus a tax should not be too complicated nor riddled with
special arrangements or exemptions and most importantly it should not be
avoidable.
Convenience is the third canon. The tax should be convenient to pay, not
involving the taxpayer in time-consuming activities, hence ideally collected
when people receive and spend their income.
The fourth canon is that of economy; the tax should be cheap to collect, not
burdened by administrative cost. This is something of a problem in the
collection of income tax in the UK, as the tax is complex and difficult to
147
A major shift from direct taxation to indirect taxation will affect a business in
terms of its cost structure and the demand for its products. Lower direct
taxation will reduce a companys corporation tax charge, thus raising its profits
after tax. If the company then retains these profits and invest them is say new
technology, the company will inevitably become more efficient and thus
reduce its costs of production. Unit costs are also likely to fall due to lower
employment costs; employers ational Insurance contribution are a form of
direct taxation, if these are reduced, companies may hire more labour or just
incorporate the lower labour cost into their price, making their products more
competitive.
Direct taxation is often argued to be a form of tax which discourages hard
work and enterprise. Lower direct taxation could act therefore, as a spur of
firms to become more innovative, developing new techniques and new
products.
Having looked at the way a reduction in direct taxation is likely to affect a
business, we can now consider the impact of an increase in indirect taxation
on the same business.
A production, or indirect, tax is a tax on goods and services. The effects of
indirect tax in the market place will depend upon the relative elasticities of
demand and supply and the extent of the tax charge.
As far as supply and demand analysis is concerned the imposition of a
production tax is treated as an increase in business costs. This is because
the firms in the market now incur an additional expenditure each time they
sell extra units, this expenditure; being the amount of tax which has to be
passed to government. At first consideration it might appear that a simple
solution of passing the entire amount of the tax on to the consumer would be
appropriate. However, the extent to which firms are able to do this depends
upon the relative elasticities of demand and supply. The following diagram
indicates the effects of this.
Diagram 1 the imposition of an indirect tax
148
As the diagram shows, the effect of the tax increase is indicated by a leftward
shift of the supply curve. This signifies that the firms in the market have
incurred an increase in costs, in this instance arising from the government
demand that tax should be raised on the sales of the goods in question. As
can be seen, the equilibrium price increases from P1 to P2 which results in a
contraction in demand from Q1 to Q2. The proportion of the tax paid by the
consumers is the increase in price attributable to the tax change. Obviously
this is the difference between P1 and P2. However, the consumers do not bear
the entire burden of the tax. As shown on the diagram the total tax increase is
indicated by the vertical distance between the two supply curves marked as
ab. Thus, if the consumers are contributing P2 P1 (or ac) the producers are
contributing the rest, shown as cb.
The extent to which firms can pass on the tax increase depends upon the
elasticity of demand in relation to the elasticity of supply. For example, if
demand is perfectly inelastic it is possible to pass on the entire tax burden
because consumers will be prepared to purchase the good at any price.
However, if this is not the case then the burden must be shared. In diagram 1
demand is more inelastic than supply, and it can be seen that the consumer
bears a large proportion of the tax burden. However, in the diagram below
demand is relatively elastic, and supply less so, resulting in the opposite
outcome.
Diagram 2 the imposition of an indirect tax elastic demand
As the diagram shows the consumers bear a small proportion of the tax
increase (ac), while the producers bear a much larger proportion (cb).
Thus, although the elasticity of demand is an important determinant of the
incidence or burden of an indirect tax, we cannot ignore the elasticity of
supply.
If demand is more inelastic, the consumer shoulders the major part of the
burden. If supply is more inelastic, the producer bears the lion's share of the
burden.
Note also that the larger the elasticities of demand and supply for a good, the
greater will be the reduction in output following a rise in indirect taxation on
that good. For, if the combined elasticities are high, not only will the firm have
to absorb most of the tax increase itself but output will also fall resulting in a
fall in total revenue. This represents an additional burden on the producer.
149
10.4
TRADE CYCLE
(a)
The trade cycle is a term used to describe the changes in economic activity
over a period of time. The economy moves in a roller-coaster type of figure
from periods of boom at the high points to periods of recession at the low
points recovering again up to another high and so on in a regular pattern.
During the boom period the rate of growth of output is high with low
unemployment, low interest rates but probably rising prices. As the economy
dips down into recession all these characteristics gradually reverse.
The data given in the question illustrates the trade cycle scenario. The
downswing starts in 1979 with only a 2.8% change in GDP compared with
3.5% the previous year. The decline continues until 1982 when the rate of
growth of GDP starts to rise again; the recovery period peaks in 1998 (apart
from a blip year in 1984) when the downswing starts again bottoming out in
1992 with recovery showing in 1993.
(b)
The accelerator principle suggests that changes in the level of demand are a
more important determinant of investment than the rate of interest. The
principle stresses the relationship between the level of net investment (i.e.,
investment over and above that necessary to maintain the present productive
capacity) and changes in National Income which determines aggregate
demand. This can be summarised using the formula:
Net Investment (I) = VY
where
Y =
change in demand
100
110
10
20
150
40
80
175
25
50
185
10
20
185
Year
I (excluding replacement)
The example illustrates that net investment depends on the rate of growth of
demand not the absolute level, and that changes in the rate of growth of
demand produce magnified changes in investment, and when the rate of
increase of demand falls the absolute level of net investment falls. The data
for the UK appears to support the accelerator principle. The falls in investment
in 1980/81 and 1990/93 were significantly greater than the falls in GDP for the
same years, whilst the high positive changes in investment in 1978, 1982,
1984, 1987, 1988 and 1994 were much higher than the growth in GDP in the
same years.
150
10.5
MIXED ECONOMY
(a)
(b)
151
10.6
Recession/ depression
With unemployment levels high, incomes low, consumer demand low and
investment low, the economy slips into a state where output remains very low.
There is an under-utilisation of resources as machinery lies dormant. Business
confidence is extremely low, as profits and prices go lower and lower.
Economic activity is at its lowest, meaning the business cycle is at its trough.
Recovery
From the low point, there is an increase in levels of economic activity as
demand begins to increase slightly. With an increase in demand, production
increases, causing an increase in investment.
This causes a steady rise in output, incomes and business confidence. This
leads to an increase in investment, somewhat helped by banks increasing
credit.
Assets in the economy begin to be utilised again, and levels of GNP increase
once more.
b)
Discussion will indicate how in a recession, these figures will have a negative
outlook on the economy, whereas when the economy moves into a recovery
stage, the outlook of the indicators will improve.
Leading economic indicators
The nature of these indicators is that they are used to forecast at what stage
the economy will be in, at some time in the future. These in particular give an
indication for whether a peak or trough will be reached in the following 3-12
months.
152
Industrial production
Personal incomes
Interest rates **
Average income
10.7
(b)
153
10.8
In the diagram, Aggregate Supply is shown by the line AS. Aggregate supply
means the total supply of goods and services in the economy.
The aggregate supply curve will be upward sloping, an increasing price level
implies that many firms will be receiving higher prices for their products and will
increase their output.
In the economy as a whole, supply will at some point reach a labour constraint,
when the entire labour force is employed. When there is full employment, and
firms cannot find extra labour to hire, they cannot produce more even when price
rise, unless there is some technical progress in production methods. The
aggregate supply curve will therefore rise vertically when the full employment level
of output is reached (AS in the diagram).
Aggregate demand (AD) is total desired demand in the economy, for consumer
goods and services, and also for capital goods, no matter whether the buyers are
households, firms or government.
The AD curve will be downward sloping as quantities demanded will increase
when the price falls.
A national economy will reach equilibrium where the aggregate demand curve and
aggregate supply curve intersect i.e. at Y (as shown in the diagram). Price levels
will be at P. Y therefore represents the level of satisfied demand in the economy.
154
11.2
FINANCIAL INTERMEDIATION
(a)
(b)
The important reasons why commercial banks strive hard to maintain sufficient
liquidity are:
(i)
(ii)
155
influence the exchange rate. If the government considers the exchange rate is
too high, the bank will sell sterling and vice versa if it is too low.
A further role of the bank is as banker to the commercial banks, who keep
their operational deposits with the bank and, from these, they settle daily interbank indebtedness arising from cheque transactions. The bank's relationship
with the commercial banks also helps it in its role of administering government
policy. It can request them to control their lending or, if desired, it could reintroduce reserve requirements or order the placing of special-deposits with
the bank.
The bank acts as a lender of last resort to the banking system as a whole via
the discount houses. If the banks become short of liquid funds, for example, at
times of the year when large tax payments are made, the bank will relieve the
shortage by either buying bills from the banks in the normal way or the banks
would call in money at call with the discount houses. In turn the discount
houses may choose to call upon the bank to act as lender of last resort to
them. The bank always stands ready to come to the assistance of the banking
system in times when it is threatened by cash shortage in order to avoid any
confidence crisis.
(b)
156
11.3
MONEY MARKETS
The 'money market' is really several inter-connected wholesale money markets all
dealing in the lending and borrowing of short-term funds. Because they so closely
intermesh they are often regarded as one entity.
The money market can be sub-divided into the traditional or discount market and the
parallel markets. The traditional market participants include the Government, via the
Bank of England and the discount houses who buy and sell short-term debt to the
commercial banks, building societies and companies.
The parallel markets developed in the 70's and 80's and comprise the euro-currency
market, the dollar certificate of deposit (CD) market and several sterling markets.
The four main sterling markets are the CD market, the commercial paper market,
the inter-bank market and the local authority market. The parallel money markets
developed partly as a need to get round the restrictions of the monetary authorities
and partly to meet legitimate financial needs, for example where companies wish to
lend excess funds in the short term. Transactions are usually arranged through
brokers rather than the principals directly.
11.4
If the company has been planning new investments, it might re-consider the
decision to invest if it is intended to finance the investments by borrowing.
(3)
The increase in interest rates might result in a stronger currency, with the
countrys currency rising in value against other currencies. This would make
any exports more expensive to foreign buyers. The manufacturer might
therefore suffer a fall in export orders.
The manufacturer might also be affected eventually by the effect of a higher interest
rate on the economy generally, through the transmission mechanism. Higher
interest rates might eventually result in a fall in consumer spending. If this happens,
demand in the domestic market for computer games is likely to fall.
11.5
TYPES OF BANKS
(a)
157
b)
The main drawback is that by issuing too much credit, a bank may not be able
to fulfil all of the demands placed on it by its depositors.
It can also lead to inflation in the economy, if too much money is circulating.
For this reason, a number of safeguards are put in place to ward off this risk
11.6
Size of reserve ratio: the lower the ratio requirements are, the more
credit can be created. In many countries, there is a minimum level
(usually
) that banks must adhere to, so that there isnt too much
credit within the economy
Liquidity Preferences: how much cash people want to hold. If, say,
there is high inflation, then people may not wish to hold their money in
banks where the real value is set to diminish
CENTRAL BANKS
(a)
(b)
There are numerous objectives that monetary policy looks to achieve and, as
we shall see, it is not possible to satisfy all of them.
Price stability: keeping inflation low and steady for a more stable
economic performance
Though these objectives are all desirable, it is not possible to achieve all of
these at once some conflict between them exists
Price stability vs. full employment
By undertaking monetary policy to increase full employment, a central bank
could undertake policies to increase aggregate demand. Doing so could drive
up inflation, putting more pressure on the price stability target
158
11.7
MONETARY POLICY 1
(a)
Suppose the central bank is looking to reduce the level of aggregate demand
in an economy, they can do so through manipulating the reserves that
commercial banks must hold. In order that the reserves are kept safe,
commercial banks will have them deposited at the central bank.
1.
Reduce reserves available to banks: the central bank controls the level
of reserves that commercial banks must hold with them. By decreasing
the level of reserves that they must hold, and keeping the reserve ratio
constant, the commercial banks must reduce the level of loans that they
give out
2.
3.
4.
High interest rates reduce the wealth of firms and individuals, causing a
drop in consumption and investment. This causes a shift to the left of
aggregate demand (AD = C+I+G+(X-M)). In short, tight money has a
contractionary effect on aggregate demand.
5.
This is a very important aspect of what a central bank does. By affecting the
level of reserves that commercial banks must hold, they are able to affect the
level of output and spending in the real economy. This is a powerful tool for
the central bank.
(b)
Moral suasion
The central bank can also discourage behaviour from banks by simply
conducting personal discussions with them, and persuading them not to go
through with actions that may jeopardise the wider objectives that the central
bank has.
This is not a particularly easy instrument to measure, but is nevertheless an
important part of the central banks arsenal.
159
11.8
MONETARY POLICY 2
(a)
The central bank can buy or sell government securities on the open market, to
change the level of reserves that are held by commercial banks.
Lets suppose that the central bank wishes to increase the level of aggregate
demand in the economy; the process will follow like so:
(b)
1.
2.
The bonds are bought from dealers in government bonds, who in turn
have bought them from commercial banks, and other financial
institutions.
3.
4.
5.
Discount-rate policy
The central bank makes loans to commercial banks. When banks are
borrowing, this helps to increase their total level of reserves, and when the
level of borrowing declines, the total reserves declines.
It is difficult for a central bank to set the exact level of borrowing that occurs
between commercial banks and itself. It may believe that commercial banks
need to borrow more, but it is not possible for them to set precise levels.
The central bank can however encourage more borrowing by lowering the
discount rate that it offers to commercial banks, as a means to induce them
into borrowing more.
1.
2.
3.
These loans are used for capital investment and consumption in the
economy
4.
The discount rate is used as a proxy against which banks offer interest rates
to individuals in the economy. In the press, the discount-rate can also be
referred to as the base rate.
The logic goes that commercial banks will charge a premium on the base rate
that will remain constant throughout. If the base rate falls, the interest rate
faced by consumers will fall also, hence affecting the activity in the real
economy.
160
11.9
(b)
The key issue here is that the SRAS and AD both need to shift outwards.
The central bank can increase the level of AD through an expansionary
monetary policy, such as Open-Market Operations or reducing the discount
rate to commercial banks
The government can increase SRAS through providing a subsidy to firms on
their output.
Another alternative could be:
The central bank selling domestic reserves to devalue the exchange rate and
to encourage exports (increasing AD) and;
The government increasing SRAS by increasing subsidies to firms.
Graphically, it should be represented as follows:
CHAPTER 12 CREDIT
12.1
CREDIT
(a)
Issue of ordinary shares involves giving away part of the ownership of the firm
as each ordinary share carries 1 vote. This means that the ownership
proportion of each existing shareholder is diluted, unless it is maintained by
the purchase of a corresponding number of shares from the new issue. The
issue of debentures by a public limited company gives the holder liquidity, as
such loan stock can be sold on the Stock Exchange, but does not give a share
of ownership. Such stock may be preferred by lenders as it can be secured
on the assets of the company, giving a degree of protection in the case of non
payment of interest or capital.
161
Loan stock normally carries a fixed rate of interest, which means that the cost
of the borrowing is predictable. If interest rates rise in the future, it can be low
cost borrowing. If the firm is successful in the future, shareholders may
demand an increase in dividends paid, but loan stock holders are restricted to
the fixed rate of interest.
(b)
12.2
BANKS
(a)
(b)
162
Cash
Advance to B (90% of 1,000)
Liabilities
100
Depositor A
100
900
______
Depositor B
900
______
1,000
______
1,000
______
12.3
The commercial banks provide several important functions for their business
customers. Firstly, they have a duty to safeguard any deposits made with
them. Deposit accounts earn interest for the saver depending on their size and
their accessibility. For businesses that are looking to store their daily takings
overnight before moving them on, the overnight rate is very low. Long-term
deposits earn a higher rate to compensate for the loss of liquidity. Current
accounts either earn no or very little interest but give the depositor a safe
place to store its funds together with the facility to write cheques and withdraw
the funds on demand.
A second function of the commercial banks is to lend money. The interest
rates charged on loans, which differ depending on estimated risk and length of
loan, are higher than those given to savers. The difference is obviously bank
profit.
A third function is to effect an efficient method of transferring money between
different accounts within the same branch, between different branches and
between different banks. Hence they provide a means of transmitting money
for payments and receipts between different customers.
163
(i)
(ii)
To control banks' credit creation ability the central bank must be able to
control either directly or indirectly, the banks' liquidity position, upon
which their ability to create credit is based. There are several methods
available.
The first relates to interest rates. While the government, through the
central bank, does not fix the rate of interest it will signal the direction
and magnitude of change to the markets through its dealings with the
discount houses. High interest rates will reduce demand for credit from
bank customers while at the same time making all bonds, including
those issued by government, more attractive. This is due to the inverse
relationship between the rate of interest and the price of bonds. In such
circumstances the public will be encouraged to purchase bonds thereby
drawing funds from their bank accounts. As a result of this the banks'
ability to create credit will be reduced, while demand will also fall in
response to the high interest rate policy.
Secondly, there are open market operations. This is where the central
bank sells government securities on the open market. The buyer will pay
for these securities with cheques drawn on their commercial bank
accounts. The central bank will settle these claims against the
commercial banks by deducting the appropriate amount from their
operational deposits which they have to keep at the Bank. This therefore
reduces the commercial banks' cash reserves, and thus with less
liquidity the banks must restrain their credit creation.
A further control upon credit creation relates to the size of the cash base
established by the central bank, i.e., direct quantitative controls. To
ensure that a minimum amount of liquidity is retained by commercial
banks they can be required to deposit, without interest, a percentage of
their balances with the central bank, and these deposits, known as
'Special Deposits', cannot be counted for credit creation purposes.
Finally, the central bank can issue non-obligatory directives to the
commercial banks to encourage them in the direction they would like
their credit creation to follow.
164
(b)
A deficit on the current account of the balance of payments can be due to one
or more factors. Firstly, on the domestic front, the economy could be suffering
from lower productivity and high rates of inflation than its trading partners
which ultimately makes its goods and services uncompetitive in the
international market place and thus exports are likely to fall. Domestic
consumers will, at the same time be increasing their spending on imports
which will be relatively cheaper than home produced goods.
Secondly, a deficit on the current account can be due to an overvalued
exchange rate. If a country has higher rates of interest than others, this will
encourage the inflow of capital funds. The demand for the domestic currency
will therefore rise and so, as exchange rates are determined by the supply and
demand for a currency, the exchange rate will also rise. As a result exports will
become more expensive to foreign buyers and are therefore likely to fall, and
vice versa for imports. The current account will move into deficit if the demand
for exports and imports is elastic.
Lastly, excess aggregate demand (AMD) in an economy can lead to a balance
of payments deficit. The demand for imports is, amongst other things, a
function of national income, while demand for exports is dependent on other
countries income. If domestic AMD rises faster than in the economies of our
trading partners, the likely result is an increase in the import bill compared to
exports. This will especially be the case if there is a high propensity to import.
This could be made worse if domestically produced goods for the export
market are diverted to the home market to meet the increase in demand.
(c)
The size and complexity of international trade makes it unlikely that the current
account will be in balance at any period of time, it may be in deficit or it may
be in surplus. Either way the overall balance of payments account must
balance so funds must be used accordingly. Financing a deficit involves the
use of funds from the financial account to offset deficits in the current account.
These funds include gold and foreign currency reserves; borrowing from
overseas banks or the International Monetary Fund. A country's borrowing
power obviously is not infinite, and if the deficit persists measures must be
taken to correct the situation rather than try to fund it continuously.
165
13.2
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
166
13.3
BALANCE OF PAYMENTS
The following measures are usually taken to correct a disequilibrium in the Balance
of Payments:
(a) Depreciation or devaluation of the home currency which makes the imports
costlier and uncompetitive, whereas exports become more competitive.
(b) Increase in import tariffs resulting in increase in cost of imports.
(c) Domestic deflation by reducing the supply of money and thereby aggregate
domestic demand so that the quantity of imported goods decreases.
(d) Increase in domestic interest rate to attract deposits from foreign countries.
(e) Introduction of import quotas to reduce the overall quantity of imports.
(f)
(g) Stimulating exports by providing subsidies and tax holidays to exportoriented industries.
13.4
DISEQUILIBRIUM
(a)
167
(b)
(ii)
(iii)
13.5
Trade in goods
Items that include the import and export of finished goods, semi-finished
goods, and component parts for assembly
Trade in services
These services include tourism, financial services and consultancy
Investment income
Overseas activity that leads to a flow of money back to the country. For
example, interest received from domestic investment, the activities of
subsidiaries, and dividends earned from owning shares in foreign firms
Transfers
Items moved between countries such as overseas aid.
(b)
(c)
i.
ii.
iii.
iv.
168
13.6
Running a deficit means that there is a net outflow of demand versus the
income that comes into a country. This can be thought of as a country not
paying their way
The current account isnt re uired to balance, because the capital account can
run a surplus. As we have seen though, running a surplus is sometimes
dependent on selling reserve assets, and other unsustainable means
(b)
There can be many factors across the economy that mean a current account
deficit is likely to occur. For example:
Or any answer that eludes to more money being spent on imports, than being
received on exports
13.7
Tariffs are duties placed upon imports. This directly increases the price of
imports, making them less attractive to the domestic market.
(b)
The domestic price (where domestic supply equals domestic demand) is higher
than the world price (Wp).
The level of imports is determined by the supply and demand for goods at
different price levels.
At Wp, Qd Qs must be imported.
With the addition of a tariff, the world price increases, and as such a smaller
amount is needed to be imported (Qd1 Qs1)
This therefore improves the current account deficit
169
(c)
13.8
Import substitution: a country can reduce the level of imports that buy,
by becoming more self-reliant and producing these goods and services
domestically. This can be done through providing specialist training,
subsidies and tax assistance.
More attractive
(b)
Rs.9: US$1.
50% of 6 = 3. (6+3=9).
Depreciates means more rupees per dollar
(c)
This shows how, starting from Point A, the deficit increases before swinging up
and going into a surplus as time goes on
170
13.9
The capital market and money markets are not places where financial
instruments are traded but rather a process or set of institutions that organise
and facilitate the buying and selling of capital instruments.
The money markets are a number of inter connected wholesale markets for
short-term funds. The major participants are the Bank of England, discount
houses, the banks, local authorities, building societies and large companies.
These markets can be further sub-divided into the traditional or discount
market and parallel markets. The traditional market is where the Government,
171
through the Bank of England and the discount houses, buy and sell short term
debt to the commercial banks and companies. The parallel markets are used
for firms and local authorities.
The capital market services the long term financial requirements of companies
and the institutions which provide long term finance are The Stock Exchange,
The Alternative Investment Market, The Over the Counter Market and the
Venture Capital Market. The Stock Exchange is essentially the market for the
issued securities of public companies, government bonds, local authority and
other publicly owned institution loam. Without the ability to sell long-term
securities easily, few people would be prepared to risk making their money
available to businesses or public authorities.
(b)
The money market is used by firms who need to borrow funds in the shortterm since payment and receipts very rarely coincide. A company which is
expanding may find bank overdraft, debtors and stock rising and the money
market provides a service for firms who have inadequate working capital.
Creditors will also rise during this period so it may be necessary to extend
trade credit in order to satisfy customer requirements. Examples of money
market instruments include loans and overdrafts, trade credit, hire purchase,
leasing, bills of exchange and commercial paper.
The capital market is used by firms who need to borrow funds over the long
term for investment purposes. Where retained profit is inadequate long-term
borrowing may be found although such a policy would have an adverse effect
on the gearing ratio. If the market thinks highly of a company, it will be easy to
raise new capital through a rights issue via the Stock Exchange. The
Alternative Investment Market(AIM) is geared towards attracting young and
fast growing businesses with the aim of promoting enterprise, innovation and
employment. The major provider of funds to this market are the pension funds
and insurance companies.
(c)
14.2
Governments have been using the capital markets since 1694 when the Bank
of England was set up. Up until the end of the second world war it was
primarily used to finance various wars. However, since the Bank was
nationalised in 1946, fiscal policy has played a much greater role in the
regulation of economic activity and successive governments have deliberately
run a budget deficit or surplus. Depending on where we were on the trade
cycle, the level of economic activity falls, unemployment rises leading to an
increase in welfare payments and incomes and profit fall leading to a fall in
government tax revenue. Such a phase is likely to lead to an increase in the
public sector borrowing requirement whereby the government through the
Bank of England are forced to sell long term government securities known as
bonds or gilts.
DERIVATIVES
(a)
172
(b)
14.3
CAPITAL MARKETS
(a)
The main distinction between money and capital markets is the good that is
traded. Whereas in money markets it is short-term credit, in capital markets it
is for longer term investments. The capital market has instruments that have a
maturity length of over a year, whereas money markets are less than this.
(b)
The main types of organisation that operate in the markets are as follows:
Corporations
Commercial banks
Stock exchanges
Investors
Corporations mainly use capital markets to fund long term projects that they
wish to undertake. They use a commercial bank to deal with the mechanics of
taking their offering to the market, which usually happens on a stock
exchange. It is then investors who, using commercial banks again, will
purchase the instruments that are being sold.
(c)
173
14.4
On the capital markets, there are a number of different instruments that can be
bought or sold. These broadly fit into two categories: debt and equity. Debt is
a corporation issuing an agreement to repay a certain sum at a later date, and
equity is selling rights of ownership in the company.
(b)
There are two different types of shares that are traded on stock exchanges,
and they differ in their characteristics. The two are:
(c)
The way in which a government would utilise the capital markets is on the debt
side, as they do not have equity themselves that they can sell off.
The two main instruments that are available to them are:
Debentures: A debt instrument where there is no physical asset used as
collateral. Instead, a government or firms creditworthiness is used by
investors to adjudicate the risk involved.
174
175
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2015
INTRODUCTION TO
ECONOMICS AND FINANCE
QUESTION BANK