1.

Megalith plc has authorised share capital of 25,000,000 preference shares
and 100,000,000 ordinary shares. Profit before tax was $27, 800,000. Tax
payable is $6,900,000 and preference dividend payable is $1,900,000. The
company has 95,000,000 ordinary shares in issue, with a market price of
$2.85 and 24,500,000 preference shares in issue, with a market price of
$1.15. What is Megalith plc's P/E number?
A 12.95 B 14.25 C 15.00 D 13.64
Ans P/E ratio = Market price of share/ EPS
EPS= $27.8m - $6.9m - $1.9m / 95m
=19/95 =0.2
PE = 2.85/0.2 = 14.25
If you thought the answer was 15.00, you have used the number of shares
authorised rather than the number issued. If you thought the answer was
12.95, you have included the preference dividend in your earnings figure. If
you thought the answer was 13.64, you have made both of these mistakes.
2. The present value of Megalith's forecast future cash flows is now $267
million. What will happen to this value if Megalith plc's cost of equity rises?
A It will rise B It will fall C It will remain the same D It is impossible to say
Ans B It will fall. The cost of equity is the discount rate for this calculation. An
increase in the discount rate used for a present value calculation will
inevitably produce a fall in the present value computed.
3. Which of the following cannot be true? In the short run, as output falls:
A AVC falls B ATC falls C AFC falls D MC falls
Ans C If output falls, fixed costs are divided over a smaller number of units,
therefore average fixed costs will rise. (It may help you to draw a diagram of
the cost curves, to illustrate this.)
4. Harold Ippoli employs 30 people in his factory which manufactures sweets
and puddings. He pays them $5 per hour and they all work maximum hours.
To employ one more person he would have to raise the wage rate to $5.50
per hour. If all other costs remain constant, the marginal cost of labour is –
Ans- Cost of 31 people (at $5.50 per hour)
170.50
( less ) Cost of 30 people (at $5.00 per hour) 150.00
Marginal cost
20.50
5. Which of the following is NOT true?

A fall in the price of a substitute good would entice consumers away from the original good.A A firm will carry on producing in the short run provided that price at least equals average variable cost B A firm will carry on producing in the short run provided that price at least equals average fixed cost C A firm will carry on producing in the short run provided that total revenue at least equals total variable cost D A firm will stop producing in the long run if total revenue is less than total cost Ans. the firm is not making a normal profit and so will stop producing. If total revenue must at least equal total variable cost. A demand curve is drawn on all except which of the following assumptions? A Incomes do not change. . if total revenue is less than total cost. The market will not be forced from its current equilibrium.Its marginal cost curve where price is greater than average variable costs 7. In the long run. Which one of the following would normally cause a rightward shift in the demand curve for a product? A A fall in the price of a substitute product B A reduction in direct taxation on incomes C A reduction in price of the product D An increase in the price of a complementary product Ans. 8. 6. C Price of the good is constant. price (average revenue) must at least equal average variable cost (so A is true). A price ceiling set above the equilibrium market price will result in: A Market failure B Excess supply over demand C Market equilibrium D Excess demand over supply Ans. D There are no changes in tastes and preferences Ans.B A reduction in income tax will increase 'real' household income. it will not interfere with the working of the price mechanism. and so demand for normal products will shift to the right. This would cause a leftward shift in the demand curve. B Prices of substitutes are fixed.C If the price ceiling is above the equilibrium market price. and is therefore making a contribution towards fixed costs (so C is true).B A firm will carry on producing in the short run provided total revenue at least equals total variable cost. ie quantity demanded will be greater at any given price.C Short run supply curve . A price ceiling only affects the workings of the price mechanism if the ceiling is set below the equilibrium price.

a decrease in the price of all wine would result in: A A more than proportional decrease in the quantity of dry white wine purchased B A less than proportional decrease in the quantity of dry white wine purchased C A less than proportional increase in the quantity of dry white wine purchased D A more than proportional increase in the quantity of dry white wine purchased Ans. the increase in quantity will be proportionally greater than the price fall.Which combination of demand and supply curves would be appropriate for a firm attempting to increase its profits by increasing its market share? A Inelastic demand. a fall in price will increase total spending on the good Qus 7th of 5th chap 12. elastic supply C Inelastic demand. inelastic supply Ans. demand must be elastic. If the absolute value of the price elasticity of demand for dry white wine is greater than one.Which of the following statements is always true if an indirect tax is imposed on a good or service A The price will rise by an amount equal to the tax B The producer will bear more of the tax than the consumer C The price rise will be smaller the greater the price elasticity of demand is D The price rise will be greater the greater the price elasticity of demand is Ans.B To increase market share requires greater quantities of the firm's products to be both demanded and supplied. In the extreme case. reflected in a leftward shift in the demand curve 6th qus of 4th chapter 9.A change in the price of the good itself does not cause a shift in the curve but a movement along it. To sell more. elastic supply D Elastic demand. To produce more. a firm needs to lower price. inelastic supply B Elastic demand. For this to be profitable. . 11. Given that demand is price elastic.D Assuming a normal good. 10. if demand is perfectly elastic. so an increase in the price of one will lead to a reduction in demand for the other. supply must also be elastic. Complementary products tend to be bought and used together.C The price rise will be lower for products with a higher price elasticity of demand. a decrease in price results in a greater quantity being demanded. there will be no increase in the price at all.When demand is price elastic.

by either merger or takeover . firms r price takers .In the short run.Option A would be true if the good or service had a perfectly inelastic demand. it will make supernormal profits 14. Option B would be true if demand was relatively more elastic than supply. but it will not always be true. less likely under perfect competition 13. increased entry barriers . perhaps. but that is the only condition under which it would be true. Horizontal integration – economies of scale . If the prevailing market price is above the lowest point on a firm's average total cost curve. increased market sh . suppliers can sell all their output at the the price in the market so no incentive to cut prices . use of better tech Conglomerates r financial holding Perfect co – no seller & buyer can influence price . no govt interference . to reduce rivalry .The necessary conditions for a firm to be able to discriminate on price are: (i) The firm is a price setter (ii) The markets are kept separate (iii) Price elasticity of demand is different in each market. Aggregate concentration ratio – this measures the sh of total production or employment contributed by the largest firms in the whole eco A lack of barriers to entry in an industry is likely to result in firms being X-inefficient – true in the long run such firms will become X-inefficinet Integration occurs when firms join together .perfect info about the market & homogenous product . usually in the short run . normal profits in d long run . securing supplies .How can a firm in perfect competition make supernormal profits? Ans. though they are. and EPS. a merger Is an amalgamation of at least 2 firms into 1 org . economies of scale . it is usual for sh holders in the old firm to exchange their old sh’s for sh’s in the new firms in agreed proportions General objectives of mergers & takeovers is to increase profits . the number of firms in the market is fixed. Equally. firms r profit maximisers . improved distribution network . to fight off imports . Economies of scale may be possible under any market form. perfect mobility for both products & factors of production . to pool tech Vertical integration – the eliminiation of transaction costs eg removal of middlemen .

All producers sell at the same price because the product is homogenous eg farming Monopoly. customer . or profit from operations. no allocative and tech efficiency . groups of countries fix their exchange rate against a major currency In a mixed economy there are pvt and public sector ROCE =Profit before interest and tax (PBIT) * 100 / avg cap employed Profit before interest and tax. place . income . Capital employed is defined as total assets less current liabilities. economies of scale . At least 2 diff markets . Return on net assets =Operating profit (before interest and tax)*100/ Total assets minus current liabilities .how does a mnonpoly decide price of the product ? ans – either they fix the price & let demand determine the amt supplied or fix the supply and let dd determine the price . the price is likely to be higher and qty supplied lower . a market imperfection & diff elasticities Specific industry regulators can set price caps & reduce barriers to entry Monopsony – a market with single supplier A monopoly has very high avg fixed costs In perfect co all producers charge the same price because products r homogenous Price discrimination in monopoly can be used to increase output and reduce allocative inefficiency Firms only produce at full capacity under perfect co Oligopoly markets do not show price co because producers decisions r interdependent A monoplosits AR curve falls downward because market dd increases as price falls Currency bloc – EU . is profit available for all holders of capital (shares and loans). the price may be lower than the perfect competition Price discrimination may be by – time ( weekends or weekdays ) .

possibly as a result of emerging opportunities or new and impressive products. This dividend valuation model shows the from pg 29 to 34 The present value of Megalith's forecast future cash flows is now $267 million. the number of years' worth of earnings from a share that would be needed to make up the price of buying a share.) ie for both lenders and sh holders EPS =Profit after tax and preference dividends(Profit available for ordinary shareholders ) / Number of equity shares issued ( remember these have to sh’s issued fig not the fig of authorized sh’s ) Price earnings (P/E) ratio ( multiple ratio ) = Market price per share/ EPS he P/E ratio is interesting in that it reflects shareholder opinion about company prospects because it shows. This is usually because they anticipate that their return will improve substantially in the future. A high P/E number indicates that investors are content with a relatively low current return from the share. free cash flow to equity We assume that a constant dividend will be paid each year into the indefinite future. What will happen to this value if Megalith plc's cost of equity rises? It will fall.Earnings per share (EPS) is usually regarded as a measure of how well the company has performed for its equity shareholders specifically . it doesn't take into account the price an investor would have to pay to acquire the share. A high P/E ratio shows that the market is confident about the future prospects of the company. The cost of equity is the discount rate for this calculation. their usefulness is greatest as measures of how a company has performed in the recent past . As a result. ROCE is a more general measure of the overall productivity of capital. . the measure for EPS we looked at earlier only looks at earnings per share. in effect. The earnings yield addresses this shortcoming by comparing the earnings per share with the market price of the share Earnings yield = EPS*100/ market price of the sh ROCE and EPS are both based on historical accounting information. An increase in the discount rate used for a present value calculation will inevitably produce a fall in the present value computed. p/e looks into recent future Measure of long term -Cost of capital is the minimum acceptable return on an investment ( disc factor ) There are two ways to measure this .expected future dividends .

marginal cost is equal to it The relationship between marginal costs and average costs means that the marginal cost curve always cuts through the average cost curve at the lowest point of the average cost curve Qus . When the average cost curve is rising. MC is less than AC. and then starts rising again.(a) It is possible for the average total cost curve to be falling while the average variable cost curve is rising. normal profit is the opportunity cost of preventing the entrepreneur investing elsewhere. It is average fixed costs per unit that fall as output increases. True or false? Ans . Economic costs are different from accounting costs. (a) MC = increase in total cost of production (b) MC = increase in variable cost of production . (c) Marginal cost.. marginal cost lies below it When the average cost curve is horizontal. Accounting profits consist of sales revenue minus the explicit costs of the business relevant costs for decision-making purposes are future costs incurred as a consequence of the decision. There is a 'cross-over' point. It starts by falling. (b) Average cost. and then starts rising. AFC falls as output rises.(a) True. and the fall may be sufficient to outweigh a possible increase in AVC. MC is higher than AC. When the average cost curve is falling. AC changes as output increases. At lowest levels of output. both a and b are correct (a) Total cost. True or false? (b) Marginal fixed costs per unit will fall as output increases. Relevant future costs are the opportunity costs of the input resources to be used. and represent the opportunity costs of the factors of production that are used. It too starts by falling. Total costs of production carry on rising as more and more units are produced. In such a case. though. The MC of each extra unit of output also changes with each unit produced. AC will fall while AVC rises. fairly quickly reaches a lowest level. Marginal . (b) False. (d) AC and MC compared. At highest levels of output.. reaches a lowest level. where MC is exactly equal to AC. Average total cost (AC) comprises average fixed cost (AFC) and average variable cost (AVC). the marginal cost will always be higher than the average cost.

that total output has started to fall. Technical economies arise in the production process. Tech eco . it follows that the average total cost per unit will also be falling as output increases (b) However. They are also called plant economies of scaleA large firm also benefits from economies of scale by overcoming indivisibilities internal economies of scale are potentially more significant than external economies to a supplier of a product or service for which there is a large consumer market. This does not necessarily mean. (c) The second reason is the utilisation of indivisibilities. because fixed costs do not change when one extra unit of output is produced Total variable costs therefore vary with output in the short run as well as in the long run. The first is the effects of the division of labour and specialisation.Dimensional economies of scale arise from the relationship between the volume of output and the size of equipment (eg storage tanks) needed to hold or process the output. . Economies of scale mean that the long run average costs of production will continue to fall as the volume of output rises.fixed costs = 0. (a) the sgort run variable cost per unit is more or less constant (eg wages costs and materials costs per unit of output are unchanged). and the average variable cost per unit is constant. External economies of scale are potentially significant to smaller firms who specialise in the ancillary services to a larger industry it is generally accepted that in any industry there is a minimum efficient scale of production which is necessary for a firm to achieve the full potential economies of scale in the short run a firm will carry on producing provided its total revenue exceeds total variable costs because this means it is making a contribution towards fixed costs. If the average fixed cost per unit is falling as output rises. If output increases more than in proportion to inputs (for example doubling all inputs trebles output) there are beneficial economies of scale. If output increases in the same proportion as inputs (for example doubling all inputs doubles output) there are said to be constant returns to scale. It is important that you appreciate that diminishing returns set in once the rate at which the increase in productivity from adding an extra unit of a factor of production starts to fall. however. there are other reasons for the initial fall in average total cost.

ie there might be management diseconomies of scale. A company might take over or merge with another company in a completely different business altogether. a firm can increase barriers to entry stopping new entrants joining the industry. because there are no longer third parties trying to make a profit – It should also increase the reliability of supplies (which is an important requirement for flexible manufacturing techniques) • By increasing control over the sources of supplies and/or the sales and distribution network. Therefore. in the long run a firm will only carry on producing if total revenue is greater than or equal to total cost. there are no fixed costs. owing to lack of familiarity with businesses acquired. If one industry declines. or if average revenue (price) is greater than or equal to average cost. a firm will only carry on producing if it is making at least a normal profit Conglomerate diversification. ie lower costs. • The creation of a monopoly will be unacceptable to government Vertical integration Advantages • Gives the firm greater control over its sources of supply (backward vertical integration) or over its end markets (forward vertical integration).In the long run. in the long run. Disadvantages • Top management might be unable to handle the running of a large firm efficiently. so all costs are variable. Otherwise few economies of scale unless production now becomes better co-ordinated through its various stages. and so having greater influence in the market and chance to earn supranormal profits and raise prices. – This should improve cost efficiency between the various stages of production. Diversification Advantages • Risks are spread by operating in several industries. – Technical economies (use of larger machines or more specialised machines) – Managerial economies (greater specialisation of middle managers) – Commercial economies (bulk buying and selling) – Financial economies (ability to borrow money more cheaply) – Risk-bearing economies (some greater spread of products made within the same general market should help the firm to spread its risks) – Knowledge economies (consolidating research and development facilities to advance technical knowledge) • To increase market share with the possibility of achieving monopoly or oligopoly status. This means that. • Achieves financial economies of scale and possibly some commercial economies. This form of merger is diversification Horizontal expansion or integration Advantages • Economies of scale from larger production quantities. others may thrive. • . • Economies of scale in finance and administration. Disadvantages • Possible management diseconomies of scale. by definition.

• Possible management diseconomies of scale. expectations or the distribution of household income.Expertise can be shared across areas which would previously have been unconnected. therefore average fixed costs will rise.5 C If output falls. from one point to another. fixed costs are divided over a smaller number of units. owing to lack of familiarity with businesses acquired. C is nothing to do with costs. provided that there is no change in the prices of other goods. A demand curve shows how the quantity demanded will change in response to a change in price provided that all other conditions affecting demand are unchanged – that is. then a firm's average revenue (AR) and marginal revenue (MR) will be identical. but the demand curve itself remains the same. We know that the firm will supply . These changes in quantity demanded in response to a change in price are called expansions or contractions in demand. to illustrate this. The price has changed. when there is a change in the conditions of demand. B results in rising unit costs in the short run. 5 Which of the following cannot be true? In the short run. tastes. (It may help you to draw a diagram of the cost curves. Short run supply curve If we assume there is a single. changes in demand caused by changes in price are represented by movements along the demand curve. as output falls: A Average variable costs falls B Average total cost falls C Average fixed cost falls D Marginal costs falls 6 The tendency for unit costs to fall as output increases in the short run is due to the operation of: A Economies of scale B The experience of diminishing marginal returns C Falling marginal revenue D Increasing marginal returns Ans . the quantity demanded will change even if price remains constant.) 6 D The benefits of specialisation and the division of labour could allow increasing marginal returns Economies of scale only operate in the long run. constant selling price for all firms. Disadvantages • No technical or commercial economies of scale. Factors determining demand for a good • The price of the good • The size of households' income (income effect) • The price of other substitute goods (substitution effect) • Tastes and fashion • Expectations of future price changes • The distribution of income among households. Shifts of the demand curve . and the quantity demanded changes (prompting a movement along the curve). We can show this as Price = Average Revenue = Marginal Revenue.

Consequently. the firm's chosen levels of output (forming its supply curve) are as shown in Figure 5 below Fig 5 from pg 77 to 78 The prices of other goods. for example. Technological developments which reduce costs of production (and increase productivity) will raise the quantity of supply of a good at a given price a change in price will cause a change in supply along the supply curve. D There are no changes in tastes and preferences ans C Full chap 5 Externalities: the differences between private and social costs. Goods in joint supply include. Public goods: goods which cannot be provided privately because if they are. the goods concerned are called substitutes in supply.where MC = MR in order to maximise profit. A rightward (or downward) shift of the curve shows an expansion of supply and may be caused by the factors below. regardless of whether they have paid for them or not. more will be supplied and there will be an accompanying increase in the supply of cow hide. When a supplier can switch readily from supplying one good to another. B Prices of substitutes are fixed. for example a reduction in the cost of raw material inputs (b) A fall in the price of other goods. . We therefore expect that (ceteris paribus) the supply of one good will rise as the prices of other goods fall (and vice versa) (c) Technological progress. Changes in technology. C Price of the good is constant. If the price of beef rises. The production of other goods becomes relatively less attractive as their price falls. When a production process has two or more distinct and separate outputs. the goods produced are known as goods in joint supply or complements in production. • Merit goods: goods which need to be provided in the long-term public interest. which reduces unit costs and also increases production capabilities (d) Improvements in productivity or more efficient use of existing factors of production. individuals would have no incentive to pay for these goods. A change in other supply conditions will cause a shift in the supply curve itself. (a) A fall in the cost of factors of production. An increase in the price of one such good would make the supply of another good whose price does not rise less attractive to suppliers. As a result. Firms are therefore likely to shift resources away from the goods whose price is falling and into the production of higher priced goods that offer increased profits. everyone will benefit from them. meat and hides. which again will reduce unit cost A demand curve is drawn on all except which of the following assumptions? A Incomes do not change.

and the market operated successfully. output would be Y. 3 It may lead to production inefficiencies and a wastage of resources. This is the concept of social marginal costs. at price Px. and the amount of the good produced should be X. Merit goods are different from public goods in that they are divisible Indirect taxes are levied on expenditure on goods or services as opposed to direct taxation which is applied to incomes. A selective indirect tax is imposed on some goods but not on others (or is imposed at a higher rate on some goods than on others). (a) If a free market exists. Education is one of the chief examples of a merit good. but now marginal cost also includes the cost to society of producing an extra unit of output. If a firm's private costs are adjusted to take account of social costs. If an indirect tax is imposed on a good. This is because although the price to consumers includes the tax. . non exclusive Merit goods are considered to be worth providing to everyone irrespective of whether everyone can afford to pay for them. the revenue the suppliers receive is only the net-of-tax price Pg 128 to 131 6 Which of the following are weaknesses of a completely free-enterprise economic system? 1 It only reflects private costs and private benefits. the tax will shift the supply curve upwards (leftwards) by the amount the tax adds to the price of each item. the supply curve should shift leftwards. Here. Indirect taxation may be used to improve the allocation of resources when there are damaging externalities. involve so much 'spill-over' of externalities that they are difficult to provide except as public goods whose production is organised by the government. Figure 1 shows two possibilities. the profit maximising level of production for a firm (and therefore the level of production a firm will aim for) is that where marginal cost equals marginal revenue. 2 and 3 . the amount of the good produced will be determined by the interaction of demand (curve D) and supply curve S.if pricing policy is to maximise net social benefit then it also needs to include externalities when calculating costs. A 1 and 2 only B 2 and 3 only C 1 and 3 only D 1. at price Py (b) If social costs are taken into account. its optimum level of production will still occur when MC = MR. Pg 124 fig Some goods. because their consumption is in the long-term public interest. by their very nature. 2 It may lead to serious inequalities in the distribution of income and wealth. As we will see in detail in a later chapter.

7 B Social cost is the sum of the private cost to a firm plus the external cost to society as a whole. Equally. who pays the tax? A It is shared between supplier and consumer in proportions equal to the relative prices before and after the increase.7 Muddy Waters Co is an industrial company which has altered its production methods so that it has reduced the amount of waste discharged from its factory into the local river. 10 C The price rise will be lower for products with a higher price elasticity of demand. but the external costs will have fallen. social cost is the sum of production costs (private costs) plus the cost of pollution (external cost). Which of the following is an external benefit of the project? A The increased trade of local shops B The increased traffic in the neighbourhood C The increased profits for the sports firm D The increased building on previous open land 9 The government has just increased the tax on tobacco. Option B would be true if demand was relatively more elastic than supply. 8 A This is correct because the benefits to local shops are additional to the private benefits of the sports firm and as such are external benefits. 9 C As the consumer's consumption is not altered by the price rise. but it will not always be true. Assuming that the demand for cigarettes is completely inelastic. since increased volumes of traffic are harmful to the environment. the supplier can pass the price rise on in full. . but that is the only condition under which it would be true. B The supplier C The consumer D It is shared between supplier and consumer in proportions equal to the relative quantities sold before and after the increase. The firm's private costs might have been increased by the measures to reduce pollution. B is an external cost of the project. C is a private benefit for the firm. Option A would be true if the good or service had a perfectly inelastic demand. Which of the following is most likely to be reduced? A Total private costs B Social costs C External benefit D Variable costs 8 Much Wapping is a small town where a municipal swimming pool and sports centre have just been built by a private firm. so that total social costs should have fallen too. which is unlikely. if demand is perfectly elastic. In the extreme case. there will be no increase in the price at all. Builder Co. D would only be an external benefit if a building is better for society than the use of open land. 10 Which of the following statements is always true if an indirect tax is imposed on a good or service: A The price will rise by an amount equal to the tax B The producer will bear more of the tax than the consumer C The price rise will be smaller the greater the price elasticity of demand is D The price rise will be greater the greater the price elasticity of demand is 6 D The need to limit or avoid these weaknesses is the chief argument in favour of some government involvement in the allocation of economic resources – ie in favour of a mixed economy or even a command economy. Here.

Fig 1 and 2 on pg 136 Note that in Figure 2. Thus the demand curve for the firm is perfectly elastic at price P1 Pg 143-147 Fig 12 on pg 148 Study the diagram in Figure 12 above. and therefore increase profits. At what price and output level would the firm maximise its sales revenue? Answer At the point where MR = 0.When a firm can sell all its extra output at the same price. This is because we are assuming that all output is produced for a single market. all units are sold at the same price. that marginal revenue should equal marginal cost (MC = MR). then the marginal revenue per unit obtained from selling extra units will be less than the previous price per unit (see Figure 2). (c) At output Z. but the price at which all the X units would be sold is PX. A monopolist will have the usual Ushaped cost curves. MR will be negative. perfect info . This is true for any firm. as we have seen. Pg 138 to 141 'price takers'. There is no point charging a lower price than the market price because the firm can sell all its output at the given price. If any more units are sold. Price PZ and output Z. Total revenue will be maximised at Z. and hence a reduction in total revenue. thereby reducing total revenue The condition for profit maximisation is. PY. and the price at which all Z units would be sold is Pz. . the marginal revenue from the last unit produced and sold is MRY. In other words. the MR must be less than the AR. the marginal revenue earned from the last unit produced and sold is MRX. It is important that you should understand what the MR and AR (demand) curves are showing us in Figure 12. unable to influence the market price individually. producers act to maximize their profits. If the price per unit must be cut in order to sell more units. (b) Similarly. the marginal revenue from the last unit produced is zero. The marginal revenue per unit from selling extra units at a fixed price must be the same as the average revenue (see Figure 1). the AR 'curve' will be a straight horizontal line on a graph. As long as marginal revenue exceeds marginal cost. but the price at which all Y units would be sold on the market is. but the price must be reduced for all units sold. not just for the extra units. at any given level of sales. where a single price will prevail. at output quantity Y. when the AR is falling as more units are sold. from the AR curve for Y output. This is found by looking at the price level on the AR curve associated with output X. an increase in output will add more to revenues than to costs. The firm has to reduce its selling price to sell more. Further sales will lead to negative MR. (a) At output quantity X.

that means that more dollars can be obtained for each pound.0010 discount. it will be a coincidence if the forward rate turns out to be the same as the spot rate on that future date. Advantages of fixed exchange ratesfiscal policy becomes more effective .5906 – 1.Because the forward rate is quoted at a discount. This differential reflects expectations of the movements in the various currencies between the current time and the date the forward rate becomes due. that means that fewer euros can be obtained for each dollar. The $/£ spot rate is currently quoted at 1.0012 – 0.9192 Govt uses its official reserves to create en axact match b/w ss and dd Using the official reserves will therefore cancel out a surplus or deficit on the current account and non-official capital transactions in their balance of payments.9200 and the 3 month forward rate at 0. The rate is therefore 1. the larger the quoted premium or discount will be.0006 – 0. A balance of payments surplus would call for an addition to the official reserves.The €/$ spot rate is currently quoted at 0.6100 and the 1 month forward rate at 0.9000 – 0.0008 premium. The longer the duration of a forward contract.Because the forward rate is quoted at a premium. A government might be forced to reduce demand in the domestic economy (for example by raising taxes and so cutting the demand for imports) in order to maintain a currency's exchange rate and avoid a devaluation.6110 Qus . .8988 – 0. and a balance of payments deficit calls for drawings on official reserves. A fixed rate system also imposes economic disciplines on countries in deficit (or surplus) Dis – loss of flexibility . Sol .5900 – 1. and a premium is therefore subtracted from the spot rate. The forward rate is not a forecast of what the spot rate will be on a given date in the future. Required Calculate the actual forward rate Ans . The rate is therefore 0. Required Calculate the actual forward rate.Pg 149 till wherever required forward price is the spot price ruling on the day a forward exchange contract is made plus or minus the interest differential for the period of the contract. The expected exchange rate movements are likely to reflect interest rate differentials between the two countries . but may be quoted at a discount or premium to the spot rates Forward rate cheaper Quoted at discount Forward rate more expensive Quoted at premium A discount is therefore added to the spot rate. Forward rates are not always quoted in full.

Receipts in the balance of payments (external balance) come from exports of goods and services and inflows of capital The balance of payments accounts have three parts: (a) Current account The current account can be subdivided as follows: Visibles • Trade in goods dividends) • Transfers Invisibles • Trade in services • Income (interest. Financial account The balance on the financial account is made up of flows of capital to and from the non-government sector. such as government loans to other countries. overseas bodies . Movements on government foreign currency reserves are also included under this heading. Similarly. and speculative flows of currency ('hot money'). such as direct investment in overseas facilities. (b) Capital account (c) Financial account Net errors and ommisions . these 'hot money' movements will still be shown as inflows in the financial account even though they are shortterm capital movements. (a) Income from employment of UK residents by overseas firms (b) Income from capital investment overseas (such as dividends and interest earned) Transfers are also divided into two parts: (a) Public sector payments to. bonds and so on). So if the current account is in deficit it must be matched by a surplus on the capital or financial . profit. portfolio investment (in shares.Countries regard devaluation as an indicator of failure of economic policy and often resist devaluation until long after it should have taken place . if speculators buy up £ sterling in response to interest rate or exchange rate movements. (b) Non-government sector payments to and receipts from bodies such as the EU Capital account The capital account balance is made up of public sector flows of capital into and out of the country.A positive balancing item indicates unrecorded net exports: a negative one. net imports. and receipts from. Income is divided into two parts. A government cannot correct a balance of payments current account deficit through its own budget. The sum of the balance of payments accounts must always be zero.

High income elasticity of demand for imports increases demand for imports as national income grows. If a country has a current account deficit this represents a net withdrawal from the circular flow of income. This means that banks and other firms will owe more money abroad and the government may also be borrowing from abroad. equilibrium will not exist if these things require the government to introduce measures which create unemployment or higher prices. If there is a surplus (+) on the current account we would expect this to be matched by a similar negative amount on the assets and liabilities section. and so a deficit on a country's current account will be deflationary. If there is a deficit (-) on the current account the result will be a similar positive amount on the assets and liabilities section. the exchange rate remains stable and autonomous credits and debits are equal in value (the annual trade in goods and services is in overall balance). However. representing how the deficit has been 'financed'. over a period of years. so demand for exports only grows slowly despite foreign national incomes growing. Low income elasticity of demand in foreign markets. Equally a country might have low exports because its own domestic market is growing. Bal of trade – deficit or surplus in goods only A balance of payments is in equilibrium if. hence its producers will concentrate on domestic sales rather than looking to export .'If the balance of payments always balances why do we hear about deficits and surpluses?' Ans .If a UK exporter sells goods to a foreign buyer: (a) The value of the export is a plus in the current account of the balance of payments (b) The payment for the export results in a reduction in the deposits held by foreigners in UK banks (a minus in the assets and liabilities section) When we use the phrases 'deficit' or 'surplus on the balance of payments' what we actually mean is a deficit or surplus on the current account.accounts. sacrifice economic growth or impose trade barriers (eg import tariffs and import quotas). since it is responsible for the 'reserves'. Qus . overseas loans) (b) Decreased liabilities to non-residents (paying off our loans abroad) This will involve not only banks and other firms but it may also involve the government too. This will consist of inward investment and/or increased overseas indebtedness. This will take the form of: (a) Additional claims on non-residents (for example.

the volume of demand would fall by less than their cost goes up. (a) If demand for imports is inelastic. There will be a net fall in export prices. (b) If demand for imports is elastic. mport quotas will be put up [Note: A devaluation occurs when the value of a currency is lowered in a fixed exchange rate system. The volume of imports would fall. so that the total value of imports would rise. the cost of imported raw materials will rise. the total value of imports would fall since the fall in volume would outweigh the increase in unit costs. but perhaps not by much. . and so producers will have to put up their prices to cover their higher costs. A depreciation occurs when an exchange rate is reduced under a floating exchange rate system. depreciation in value . as explained above. although whether or not the total value of imports fell too would depend on the elasticity of demand for imports.] (Appreciation of a currency will have converse effects to those of a depreciation. If a country imports raw materials and exports manufactured goods which are made with those materials.Current a/c deficits – resrves will drain out .) The cost of imports would rise as a result of currency depreciation because more domestic currency would be needed to obtain the foreign currency to pay for imported goods.