INTRODUCTION TO ECONOMICS AND FINANCE Suggested Answers Foundation Examination – Autumn 2010
(a) Diagram of the Circular Flow of Income
(b) WITHDRAWALS 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 country’s Circular Flow of Income. INJECTIONS 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 Income. The funds may be raised by way of taxes or borrowings by the government. of
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.
(a) Economic growth is measured by increase in real GDP accruing over a period of time. (b) The ingredients which influence a country’s rate of Economic Growth are: (i) (ii) (iii) (iv) (v) (vi) quantity and quality of natural resources quantity and quality of human resources supply or stock of capital goods level and quality of technology rate of increase in the level of aggregate demand efficiency of performance of the factors of production
Page 1 of 6
raising its revenue by levy of additional taxes.
Page 2 of 6
(c) The central bank performs the following functions: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) it is the note-issuing agency it is banker to the state it is banker to other banks it is the guardian of the money market through the control of credit it is the lender of last resort it is the custodian of foreign exchange reserves it ensures stability of the internal value of the currency i.4
Unitary Elasticity of Demand:
Demand is unitary elastic when the percent change in the quantity demanded is the same as the percent change in price. It is expressed as a percentage of the amount borrowed for a stated period of time. The government can reduce the size of its debt requirements by: restricting its expenditures to its most essential needs.
A. (b) (i) (ii) Public Debt refers to the borrowings of the government from internal sources or from external sources such as foreign governments or foreign lending institutions.3
(a) Nominal interest rate is the rate that is normally observed and quoted and represents the actual money paid by the borrower to the lender and the effect of inflation is not accounted for.INTRODUCTION TO ECONOMICS AND FINANCE Suggested Answers Foundation Examination – Autumn 2010
(c) The features of an economic system based on capitalism are: (i) (ii) (iii) (iv) (v) (vi) individuals have the right to own private property freedom of individuals to engage in any business pursuit or enterprise individual gain and profit is the motivating factor for all economic activities free competition in all kinds of business activities determination of prices by the interaction of the forces of demand and supply role and involvement of the government in any economic activity is minimal.e. Real rate of interest is arrived at by adjusting the nominal rate of interest for the impact of inflation. price level Determining the interest rates Implementing monetary policy Regulating and supervising the banking industry
However. a decrease in price from OPo to OP1 would result in increase in the quantity demanded from Oqo to Oq1 The area marked A is less and area B is more showing that the decrease in price will result in increase in the quantity demanded and also an increase in the total expenditure. a decrease in price from OPo to OP1 would result in increase in the quantity demanded from Oqo to Oq1. However. the total expenditure would decline as area B is less than area A. In case of relatively elastic demand. a decrease in price from OPo to OP1 would result in increase in the quantity demanded from Oqo to Oq1. the total expenditure would remain unchanged as the area marked A is equal to the area marked B. Relatively Inelastic Demand:
Demand is relatively inelastic when the percent change in quantity demanded is less than the percent change in price. Relatively Elastic Demand:
Demand is relatively elastic when the percent change in the quantity demanded is greater than percentage change in price. In case of relatively inelastic demand.INTRODUCTION TO ECONOMICS AND FINANCE Suggested Answers Foundation Examination – Autumn 2010
In case of unitary elastic demand.
Page 3 of 6
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. (e) Introduction of import quotas to reduce the overall quantity of imports.
A. more than that proportion or less than that proportion would depend on the operation of the laws of constant returns to scale.g. (b) Increasing Returns to Scale arise when proportional increase in all inputs results in a more than proportional increase in the level of output. (c) Domestic deflation by reducing the supply of money and thereby aggregate domestic demand so that the quantity of imported goods decreases. The need to hold money for transactions arises because the payments and receipts of individuals are not exactly synchronised.
A. Decreasing Returns to Scale is a phenomenon witnessed when proportional increase in all inputs results in less than then proportional increase in the output. Speculative motive – The holding of money has an opportunity cost in the form of income foregone by not using the money to purchase an income bearing asset e. increasing returns to scale or decreasing returns to scale.
Page 4 of 6
. The precautionary demand for money arises due to uncertainty regarding the timing and size of payments and receipts. the larger amounts of money balances that would be needed for precautionary purposes.INTRODUCTION TO ECONOMICS AND FINANCE Suggested Answers Foundation Examination – Autumn 2010
A. (d) Increase in domestic interest rate to attract deposits from foreign countries. The higher the level of national income. When the interest rates tend to be low. the output will certainly increase but whether the output will be increased by same proportion.7
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. (g) Stimulating exports by providing subsidies and tax holidays to export-oriented industries. Difficulties in managing and running a large-scale operation may create problems of co-ordination.5
(a) Return to Scale is the rate at which output increases when all the inputs are increased proportionately. whereas exports become more competitive. individuals will retain large amounts in anticipation of increase in interest rates and would have high liquidity preference. When the scale of operations is changed by changing all the inputs in the same proportion. In certain types of manufacturing industries. (b) Increase in import tariffs resulting in increase in cost of imports. a bond. greater wastages and inefficiencies and result in decrease in productivity of labour and capital and other inputs. individuals will hold lesser amounts for speculative purposes and therefore have low liquidity preference. Precautionary motive – Individuals keep money in hand or with banks as a precautionary measure to meet any unforeseen fluctuations in receipts and payments. When interest rates are high. reflecting higher liquidity preference. the Increasing Returns to Scale operates because the larger scale of operations allow managers and workers to specialise in their tasks and make use of more specialised factories.6
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. equipment and other production inputs. (f) Exchange control regulations to restrict outflows of funds from the home country.
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 . a firm may earn super-normal profits in the short-run. the buyers must purchase from the only seller who dominates the market. (d) Earning of Normal and Super-normal Profits . Under conditions of monopoly. a firm can earn super-normal profits in the short-run as well as in long-run due to the existence of barriers which prevent entry of new firms.In conditions of perfect competition there are a large number of sellers in the market.INTRODUCTION TO ECONOMICS AND FINANCE Suggested Answers Foundation Examination – Autumn 2010
A.In a market characterised by perfect competition. On the other hand. there are several barriers which are difficult to overcome for prospective new entrants. Under conditions of monopoly. 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. The price of a currency is allowed to rise or fall according to the prevailing demand and supply conditions. and therefore consumers have to pay higher prices than under conditions of perfect competition. The extent of intervention by the authorities is substantial only when speculative forces threaten macroeconomic policies. (e) Price Discrimination . (b) Fixed Exchange Rate Regime: In a Fixed Exchange Rate regime. the rate is fixed at a certain predetermined level by the national monetary authority and can be changed only by a government decision. the exchange rates are allowed to move broadly between upper and lower bound in line with the market forces with a gradual adjustment in the exchange rate to reflect underlying real economic factors.Consumer welfare is considered to be maximum under conditions of perfect competition as every individual firm strives to produce at its optimum level. (b) Entry and Exit of Firms. (c) Managed Floating Exchange Rate System: In a Managed Floating Exchange Rate system. In the long-run. The monetary authority intervenes by buying and selling foreign exchange to maintain the exchange rate at the prescribed level.In perfect competition.A firm under perfect competition cannot sell at discriminatory prices as the prices are given and an individual seller cannot influence the price.
(g) Consumer Welfare . A monopolist can increase the total revenues by discriminating among the buyers and charging higher prices from buyers whose demand is inelastic and lower prices from customers whose demand is elastic. A monopolist often charges higher prices from the customers and can manipulate the level of output to obtain maximum revenues.Under conditions of perfect competition. The authorities intervene by buying and selling foreign exchange in the market. the prices are lower and the output is larger. new firms can freely enter the industry and inefficient firms can exit if they suffer losses. the currency exchange rates are left entirely to the market forces and there is no official intervention by the monetary authority.In perfect competition.
A. the firm can earn only normal profits as new firms would enter the market and force the prices to fall. the buyers have the option to purchase from any firm in the market. but usually they are limited to managing the daily fluctuations caused mainly by capital movements and hold the rate within certain limits. (c) Options available to Buyers .
Page 5 of 6
. a monopolist is in a position to manipulate his output even at sub-optimum levels. (f) Price of Products and Level of Output . Under conditions of monopoly.9
(a) Freely Fluctuating Exchange Regime: In a Freely Fluctuating Exchange Rate regime.
Fiscal Measures: (iv) increasing the direct taxes would decrease disposable income in the hands of the public. thus the overall interest rate increases and people save more and spend less (iii) selling securities to the public so that money flows from the people to the government and the public have less money to spend.
A.10 Inflationary pressures can be controlled by adopting the following measures: (a) Monetary Measures: (i) raising the reserve ratio of banks.INTRODUCTION TO ECONOMICS AND FINANCE Suggested Answers Foundation Examination – Autumn 2010
A. therefore. When disposable income decreases. demand falls. (vii) controlling prices to prevent unfair price increases by oligopolies and cartels (viii) rationing essential goods to control the amount of the goods given to each family according to their needs. the price level falls (v) curbing government spending to reduce demand and decrease prices.
Other Measures: (vi) encouraging imports of essential items to increase supply of goods in high demand. thus less funds are available for commercial banks to advance loans (ii) raising the bank rates.11 (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv)
(a) (a) (c) (a) (b) (b) (d) (a) (b) (b) (c) (d) (d) (b) (b)
MC curve Salt Rent it is a straight line the industry the level of satisfaction is the same normal profit cost of production net exports increase hedge against inflation a certificate of deposit all of the above all of the above the change in total utility as a result of consuming an additional unit of a product the Pakistan rupee is undervalued relative to the dollar
Page 6 of 6