CH 2 Economics FXXXG3ZA5W PDF

Level
I of the CFA® 2022 Exam

Questions with Answers - Economics
Offered by AnalystPrep
Last Updated: Oct 7, 2022
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Table of Contents
8 - Topics in Demand & Supply Analysis 3

9 - The Firm & Market Structures 41
10 - Aggregate Output, Prices and Economic Growth 67
11 - Understanding Business Cycles 108
12 - Monetary & Fiscal Policy 132
13 - International Trade and Capital Flows 174
14 - Currency Exchange Rates 193
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© 2014-2022 AnalystPrep.
Reading 8: Topics in Demand & Supply Analysis
Q.168 What is the price elasticity of soybeans, given that if the price goes up by 40%, the quantity
demanded goes down by 15%?
A. 0.3750
B. 0.6250
C. 2.6667
T he correct answer is A.
Price elasticity is simply the change in demand relative to the change in price. Change in demand =
-15% (negative because the quantity reduces as the price goes up) Change in price = 40% (positive
because the price has gone up)
%ΔQ
Price Elasticity =
%ΔP
Where Q represents the quantity demanded, whereas P represents a price. T hus,
−0.15∣
Price Elasticity = ∣∣ 0.3750
∣ 0.40 ∣∣ =
3
Q.169 T he price of a good has decreased from $100 to $45 in one year. Over that time, the demand
for the good has also decreased from 10,000 units per day to 8,000 units per day. How would you best
describe the price elasticity?
A. Elastic.
B. Inelastic.
C. Unitary elasticity.
T he correct answer is B.
Price elasticity of demand shows the responsiveness, or elasticity, of the quantity demanded of a
good or service to a change in its price when nothing but the price changes. It can be calculated as
the percentage change in quantity demanded divided by the percentage change in price.
When elasticity is 1, <1, or >1, it is said to be unitary elastic, inelastic, and elastic, respectively.
New demand− Old demand 8, 000 − 10, 000
Percentage change in demand = = × 100 = −20
Old demand 10,000
New price − Old price 45 − 100
Percentage change in price = = × 100 = −55
Old price 100
−20
Price elasticity = = 0.36
−55
Since 0.36 < 1, demand is inelastic.

A i s i ncorrect. Elasticity is said to be elastic if it is greater than 1. Demand is elastic if the change
in price leads to a greater change in demand.
C i s i ncorrect. Elasticity is said to be unitary elastic if it is equal to 1. Demand is unitary elastic if a

percentage change in price leads to an equal percentage change in demand.
4
Q.649 How will the demand for air travel be affected if the prices of train travel increase?
A. T he demand for air travel will increase due to a leftward shift in the demand curve.
B. T he demand for air travel will increase due to a movement along the demand curve.
C. T he demand for air travel will increase due to a rightward shift in the demand curve.
T he correct answer is C.
T rain travel and air travel are substitute goods. T hus, the increase in train travel price will intend
people to substitute it with other modes of transport. Hence, it will cause a shift in the demand
curve of air travel tickets toward the right causing the quantity demanded for air travel tickets to
increase.
A i s i ncorrect. A leftward shift indicates that demand has decreased. Increasing the price of a
substitute will increase and not decrease the demand for the other product.
B i s i ncorrect. Movements along the demand curve are caused by changes in prices, which in
return affect the quantity of goods that a consumer can purchase.
Q.650 At equilibrium; supply = demand

T he supply function is given by Qs = 400 + 75P and the demand function is given by Qd = 2,000 -
125P. At price P = 10, the excess supply is closest to:
A. 0.
B. 400.
C. 600.
At price P=10; Qs = 400 + (75*10) = 1,150

At price P=10, Qd = 2,000 - 125(10) = 750
T hus, excess supply is 1,150 - 750 = 400.
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Q.655 How is the supply curve represented when its slope is 1?
A. A vertical line.
B. A horizontal line.
C. A 45-degree line.
T he slope of a supply curve is the change in quantity relative to the change in price. When the slope
of the supply curve is 1, the change in quantity is equal to the change in price. T hus, the curve 45-
degree line.
Q.657 If the cross-price elasticity is 1.5, then the goods are:
A. substitutes with elastic cross-price elasticity.
B. substitutes with inelastic cross-price elasticity.
C. complimentary with inelastic cross-price elasticity.
Cross price elasticity relates to two goods. It is the change in the quantity of one good relative to the
change in the price of another good. Cross Price elasticity is positive for substitute goods ( goods
that can replace each other; for example, tea and coffee.
T he cross-price elasticity is positive, which reflects that the goods are substitutes because the
increase in the price of one increases the quantity demanded of the other. T hus, they have a positive
relationship. Also, since the change in quantity is more than the change in price/ the elasticity (1.5) is
greater than 1, the cross-price elasticity of the demand is elastic.
B i s i ncorrect. An elasticity of 1.5 is elastic, not inelastic.
C i s i ncorrect. Complementary goods are sold separately but used alongside each other; for
example, purchasing a car will mean purchasing fuel for the car. T he elasticity is equally inelastic and
not elastic.
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Q.665 If the income of a consumer is 120, the price of good X is 20, and the price of good Y is 15,
then which of the following best describes the change in the slope of the budget line if the price of
good X suddenly moves to 10?
A. T he slope of the budget line would change from -4/3 to -2/3.
B. T he slope of the budget line would change from 3/4 to 3/2.
C. T he slope of the budget line would change from -3/4 to -3/2.
A budget line is a downward sloping straight line that shows the possible number of ways a consumer
can purchase two goods given their prices and given the consumer’s income.
T he slope of the budget line is the price of good X divided by the price of good Y. It is negative
because the budget line is downward sloping.
Slope = - X/Y
Slope X=20; Y=15 = -20/15 = -4/3
Slope X=10; Y=15 = -10/15 = -2/3
Q.669 If the price of good Y decreases, the quantity consumed also decreases. T herefore, we can
say that for good Y:
A. the negative substitution effect overpowers the positive income effect. It is a Giffen
good.
B. the negative substitution effect overpowers the positive income effect. It is a normal
good.
C. the positive income effect overpowers the negative substitution effect. It is a Giffen
good.
Good Y is an example of Giffen goods. Giffen goods are inferior goods whose price effect outweighs
the substitution effect. Consumers are unable to afford the next level of consumption. T herefore,
they will have to buy a good even with an increase in the price of the good. T he miller and Jensen
rice stud in China is the perfect example of Giffen goods. T he rice price increased, yet consumers’
demand for rice increased because they could not afford the next level of consumption, which was
meat.
For Giffen goods, the positive income effect is so strong that it overpowers the negative substitution
effect. T herefore, when prices rise, the quantity demanded rises and vice versa.
Note: T he negative substitution effect occurs when there are few substitutes for a product or when
the substitutes are of low quality.
7
Q.672 At equilibrium, abnormal profits are:
A. Accounting profit - Normal profit = 0.
B. Accounting profit + Normal profit > 0.
C. Accounting profit - Normal profit < 0.
Abnormal profits are also known as economic profits (which are accounting profit - normal profit)
and are equal to 0 at equilibrium. At this point, firms have the incentive to stay in the industry as
they are covering both implicit and explicit costs.
Q.674 Why is the marginal revenue always less than the price for firms facing imperfect
competition?
A. T he marginal revenue (MR) is not always less than the price.
B. T his happens because the average revenue (AR) is always decreasing.
C. T his happens because the price equals the average revenue (Price = AR).
T he marginal revenue is not ALWAYS less than the price; it is equal to the price for the 1st quantity.
For additional quantities, the marginal revenue is less than the price since a firm in an imperfect
competition has to lower its prices to sell additional units.
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Q.677 What is the implication of the marginal cost (MC) curve intersecting the average variable
costs (AVC) and the average total cost (AT C) curves from below? I. AT C and AVC are "U"-shaped.
II.When MC is below AT C or AVC, both AT C and AVC are decreasing.
A. I only.
B. II only.
C. Both I and II.
When MC is below AT C and AVC, both AT C and AVC are decreasing. When MC is above AT C and
AVC, both AT C and AVC are increasing. T hus, we conclude that AT C and AVC are initially decreasing,
and then increasing, which gives them their "U" shape.
Q.678 If the price elasticity coefficient of the demand curve for paper clips is equal to 1.2, demand
is:
A. elastic.
B. inelastic.
C. unit elastic.
When the magnitude of the own-price elasticity coefficient has a value greater than one, demand is
said to be elastic. When that magnitude is less than one, demand is said to be inelastic. And when the
elasticity coefficient is equal to one, demand is said to be unit elastic or unitary elastic.
9
Q.679 When the average revenue (AR) is greater than or equal to the average variable cost (AVC)
but less than the total average cost (AT C), what should most likely happen to a firm in a perfectly
competitive industry?
A. T he firm should shut down.
B. T he firm is at the break-even point where economic profit is 0.
C. T he losses are smaller than the losses that the firm would have incurred if production
stopped.
Some costs are fixed in the short run. T herefore, as long as AR>AVC, the firm can operate in the
short run as the long-run costs (machinery and land) have already occurred. If the firm shuts down
immediately, it would incur larger losses than it is incurring in the short run.
Q.680 Profit maximization condition for firms under imperfect competition is:
A. Marginal revenue (MR) > Marginal cost (MC); Total revenue (T R) = Total costs (T C).
B. Marginal revenue (MR) = Marginal cost (MC); Total revenue (T R) - Total cost (T C) is at
its maximum.
C. Marginal revenue (MR) = Marginal cost (MC); Total revenue (T R) - Total cost (T C) is at
its minimum.
Suppose the firm produces beyond the point where MR=MC, it will incur losses, and T R-T C is the
profit. As the question says, we need to maximize profit, so T R-T C should be at its maximum.
10
Q.681 What does each point on the long-run average total cost (LRAT C) curve represent?
A. T he minimum efficient scale.
B. T he various minimum average total costs.
C. T he minimum long-run average total cost.
As the long-run average total cost (LRAT C) curve is drawn from different plant sizes or sizes of
operation, each point on the LRAT C represents the minimum AT C for each output level for a given
plant size scale operation.
Q.682 T he downward sloping segment of the long-run average total cost (LRAT C) curve represents:
A. economies of scale, increasing returns to scale.
B. economies of scale, decreasing returns to scale.
C. diseconomies of scale, increasing returns to scale.
It represents economies of scale because the addition of input is decreasing the cost and increasing
the output. Also, this part represents the size of operations having the least amount of minimum
AT C.
On the other hand, the upward sloping represents diseconomies of scale.
11
Q.1378 What will be the impact on the consumption of a good if the substitution effect of that good is
positive and the income effect of the good is negative but smaller than the substitution effect?
A. Consumption of that good increases.
B. Consumption of that good decreases.
C. Consumption of that good can either decrease or increase.
A positive substitution effect implies that consumers can still afford a good or a service even if the
good or service price increases or the consumers' income declines. A negative income effect
implies that an increase in consumers' income will decrease the demand for that particular good or
service.
A negative income effect that is smaller than the substitution effect and a positive substitution effect
that is overriding the negative income effect implies that if the consumer's income increases or the
good or service price increases, there will be an increased demand for the good/service.
Q.1379 A good that has a positive income effect whose consumption increases with a fall in price is
known as a/an:
A. normal good.
B. inferior good.
C. Veblen good.
Normal goods are those goods whose consumption increases with a decrease in prices.
B i s i ncorrect. Inferior goods are goods whose consumption decreases as income increases. A
case example is consumers avoiding cheap stores (and as a result decreasing demand for those
products) when their income increases.
C i s i ncorrect. Veblen goods are special case goods. T hey are normal goods that have a positive
income effect and whose price effect outweighs the substitution effect. T hey symbolize wealth. A
yacht is a good example of Veblen goods. An increase in demand for Veblen goods reflects consumer
preferences.
12
Q.1381 Which of the following goods will have an upward sloping demand curve?
A. Giffen good.
B. Veblen Good.
C. Both Giffen and Veblen goods.
Both Giffen and Veblen goods have upward-sloping demand curves, as their consumption decreases
with a decrease in prices.
Q.1382 Which of the following terms is most appropriate for a good for which demand increases as
the price increases?
A. Giffen good.
B. Veblen Good.
C. Inferior good.
A Giffen good is a low-income, non-luxury product for which demand increases as the price increases
and vice versa. A Giffen good has an upward-sloping demand curve which is contrary to the
fundamental laws of demand which are based on a downward sloping demand curve.
B i s i ncorrect.A Veblen good is a good where demand rises as price rises because people feel its
higher price reflects greater status. Veblen goods are typically high-quality goods that are made well,
are exclusive, and are a status symbol. Veblen goods are generally sought after by affluent consumers
who place a premium on the utility of the good. Examples of Veblen goods include designer jewelry,
yachts, and luxury cars. Option B is incorrect because the increase in demand for a Veblen good
reflects consumer tastes, preferences, and snob appeal, unlike a Giffen good, where higher demand
is directly attributable to the price increase.
C i s i ncorrect. Inferior good describes a good whose demand drops when people's incomes rise.
T hese goods fall out of favor as incomes and the economy improve as consumers begin buying more
costly substitutes instead.
13
Q.1390 T he demand function for tea is QD = 650 - 3P. Describe the price of tea as a function of
demand.
A. Price of tea = 216.67 - 3QD.
B. Price of tea = 650 - 0.33QD.
C. Price of tea = 216.67 - 0.33QD.
Since the demand function is QD= 650 - 3P, we can derive the price with a simple algebra
manipulation of making P the subject of the equation.
3P = 650 − QD
650 QD
= −
3 3
⇒ P = 216.67 − 0.333QD
Q.1392 T he demand function of wheat is Qd = 274 - 1.5P. If the quantity demanded is 100, then the
price of wheat is closest to:
A. 116.
B. 122.
C. 137.
T he demand function of wheat is Qd = 274 - 1.5P

Since we have Qd as 100, we simply replace Qd with 100 and make P the subject of the equation: 100
= 274 - 1.5P
-174 = -1.5P
P = 116
14
Q.1395 Ferries and tramways are substitutes for one another. What effect will the increase in the
price of ferry tickets have on the demand for tramway tickets?
A. A shift of the demand curve to the left.
B. A shift of the demand curve to the right.
C. An increase in demand for ferry tickets.
Since ferries and tramways are substitutes, an increase in the price of ferry tickets will decrease
the demand for ferry tickets and people will switch to tramways. Hence, the demand curve for
tramway tickets will shift to the right.
Q.1417 Given the demand function of smart T Vs Qd = 200,000 - 8,000P, calculate the price elasticity
of smart T Vs at a price P = 4.
A. -0.97
B. -0.19
C. 1.19
Price elasticity is calculated as a percentage change in the quantity over the percentage change in
price. T he formula to determine the point price elasticity of demand is:
∂Q P
×
∂P Q
In the formula above, ∂Q/∂P is the partial derivative of the quantity demanded taken with respect to
the good’s price, P is a specific price for the good, and Q is the quantity demanded associated with
the price P .
∂Q
T hus, = −8, 000
∂P
4
price elasticity of demand = −8, 000 × = −0.19
200, 000 − 8, 000(4)
15
Q.1419 Sisli Holdings is a home improvement company with revenues of $410 million for the current
year. Assuming salaries of 10% of revenues, Selling, General and Administrative Expenses (SG&A) of
23%, and interest costs of 40% of revenues, calculate the accounting profit for Sisli Holdings.
A. $110.7 million.
B. $117.07 million.
C. $210.7 million.
Accounting profit = Revenues - Total accounting (explicit) cost

Salaries = 10% × $410 million = $41 million
SG&A = $94.3 million
Interest payment = $164 million
Accounting profit = ($410 - $41 - $94.3 - $164) million = $110.7 million
Q.1420 Which of the following return measures considers the implicit cost or opportunity cost of
resources supplied to the firm by the owners?
A. Total revenue.
B. Economic profit.
C. Accounting profit.
Economic profit considers the implicit cost or opportunity cost of resources supplied to the firm by
the owners. Economic profit is the difference between total monetary revenue and total costs, but
total costs include both explicit and implicit costs. Economic profit includes the opportunity costs
associated with production and is, therefore, lower than accounting profit. Economic profit also
accounts for a longer span of time than accounting profit.
A i s i ncorrect. Total revenue is simply the Total income earned by a firm. Revenue does not
consist of any costs.
B i s i ncorrect. Economic profit consists of only explicit costs. Explicit costs are costs that have
to be paid for directly, using the firm’s tangible assets. On the other hand, implicit or opportunity
costs mostly represent foregone opportunities.
16
Q.1421 Which of the following costs is least likely considered in the calculation of accounting profit?
A. Sales commission expense
B. Interest expense
C. Payment to firm's equity owner
In accounting profit, the implicit cost (or any payment to the equity owners of the firm) is not
considered:
Accounting Profit = Revenue − Explicit costs
Where sales commission expense and interest expense are both explicit costs.
Payment to the firm’s equity owner is an implicit cost. Implicit costs are included in the calculation
of economic profit:
Economic Profit = Revenue − Total costs
Where Total costs = Explicit costs + Implicit costs
17
Q.1422 Mr. Jan earned an accounting profit of INR 690,000 in the first fiscal year of his firm ABC
Start-Up. He left his marketing job for this business which previously paid him IRN 150,000 per
year. He also invested his property as a warehouse for his business which could have been rented
out for INR 170,000 per year. Considering the provided information, Mr. Jan's economic profit is
closest to:
A. INR 370,000.
B. INR 540,000.
C. INR 520,000.
Economic profit = Accounting profit − Implicit opportunity cost
Implicit costs are opportunity costs incurred when a firm uses assets/resources that it already owns.
Foregoing employment in order to use the skills to run a business is an implicit cost.
Foregoing rent so as to use the building as a warehouse is an implicit cost.
Economic profit = INR 690, 000 − INR 150, 000 − INR 170, 000 = INR 370, 000
B is incorrect. T he cost of foregoing rent has been left out in the calculation of economic profit.
C is incorrect. T he cost of foregoing employment has been left out in the calculation of economic
profit.
Q.1423 A payment to a resource above the minimum payment required for the resource is called
a/an:
A. economic rent.
B. opportunity cost.
C. Maintenance cost.
Economic rent is a payment to a resource in excess of the minimum payment to retain the resource
in its current use.
B i s i ncorrect. Opportunity cost is the cost foregone when a firm uses its already existing
resources.
C i s i ncorrect. Maintenance cost is the cost incurred in keeping assets in good working conditions.
18
Q.1424 Taksim Inc. is a solar panel manufacturing firm with an accounting profit of $9 billion. If the
cost of equity capital is $2.5 billion, the firm's normal profit is closest to:
A. $2.5 billion.
B. $6.5 billion.
C. $11.5 billion.
We know that:
Normal profit = Accounting profit − Economic profit
First, we need to calculate economic profit, which is given by:
Accounting profit − Cost of capital = $9 billion − $2.5 billion = $6.5 billion
Since cost of capital is an implicit cost.

Finally,
⇒ Normal profit = $9 billion − $6.5 billion = $2.5 billion
Q.1426 A firm that has a horizontal demand curve is called a:
A. price taker.
B. price maker.
C. price searcher.
A horizontal demand curve occurs because of the presence of perfect substitutes and perfect
knowledge among consumers; if a firm raises its prices, then there will be no demand for that firm’s
products. T his curve is seen among firms that operate under the perfect competition market
structure. Such firms sell their produce at a constant price, hence a horizontal demand curve.
19
Q.1430 T he vertical distance between the average variable cost and the average total cost is equal to
which of the following costs?
A. Marginal cost.
B. Average fixed cost.
C. Average marginal cost.
T he difference between the average variable cost (AVC) and the average total cost (AT C) is always
equal to the average fixed cost (AFC).
Q.1431 In which of the following perfect competition situations will a firm shut down in the long
run?
A. T he average revenue is greater than the average variable cost and the average total cost.
B. T he average revenue is less than the average variable cost but greater than the average
total cost.
C. T he average revenue is greater than the average variable cost but less than the average
total cost.
If the average revenue is greater than the average variable cost but less than the average total cost,
the firm will exit in the long run. Average revenue that is less than the average total cost implies that
the firm operates at a loss.
A i s i ncorrect. If a firm’s average revenue is greater than its average total costs, then the firm is
operating at a profit and should, therefore, not be shut down.
B i s i ncorrect. A firm will shut down in the short run if its average revenue is greater than, and not
less than, its average variable cost but less than, and not greater, than its average total cost.
20
Q.1432 A firm reported revenue of $1.9 million for the year. Assuming that the average variable cost
is $1.7 million and the fixed cost is $3.6 million, the firm should most likely :
A. shut down in the short run.
B. continue to operate in the short run.
C. shut down in the short-run and re-open in the long-run.
If the average revenue is greater than the average variable cost but less the average total cost, the
firm will continue to operate in the short run. In this case, AVC < AR < AT C. Even if not earning at
least a zero economic profit, the firm may find it advantageous to continue operating in the short run.
T he revenue can at least settle the variable costs and may also partially pay the fixed costs. In the
long run, the firm will suffer losses because it will not settle its implicit charges.
A i s i ncorrect. A firm should be shut down in the short run if its average revenue is less than both
its variable and fixed costs.
C i s i ncorrect. A firm cannot reopen in the long run if its revenue is less than its fixed costs.
Q.1433 In which of the following perfect competition situations will a firm shut down in the short
run?
A. T he average revenue is less than the average variable cost.
B. T he average revenue is less than the average variable cost but greater than the average
total cost.
C. T he average revenue is greater than the average variable cost but less than the average
total cost.
In the long run, if a firm cannot earn at least zero economic profit, it will not operate because it is
not covering the opportunity cost at all of its factors of production, labor, and capital. However, in
the short run, a firm might find it advantageous to continue to operate even if it is not earning at least
zero economic profit. If the average revenue is less than the average variable cost, a firm will shut
down in the short run.
B i s i ncorrect. A firm will shut down in the short run if the average revenue is less than both the
average variable cost and the average fixed cost.
C i s i ncorrect. A firm will continue operating in the short run but shut down in the long run if the
average revenue is greater than the average variable cost but less than the average total cost.
21
Q.1434 T he downward sloping segment of the long-run average total cost curve indicates:
A. economies of scale.
B. diseconomies of scale.
C. the minimum efficient scale.
T he downward sloping segment of the long-run average total cost curve indicates economies of
scale, while the upward sloping segment of the long-run average total cost curve indicates
diseconomies of scale. Diseconomies of scale occur when the total cost of production increases
with each additional unit of input.
Q.1436 T he breakeven quantity of production under perfect competition is the quantity for which:
A. Price = Total revenue.
B. Price = Average total cost.
C. Total revenue = Marginal revenue.
T he breakeven quantity of production under perfect competition is the quantity for which 'Price =
Average total cost' and 'Total revenue = Total cost'.
22
Q.1437 Which of the following industries have a downward-sloping supply curve?
A. Constant cost industries.
B. Increasing cost industries.
C. Decreasing cost industries.
A decreasing cost industry has a downward-sloping supply curve because as more firms enter the
industry and output increases, the cost of production decreases.
A i s i ncorrect. A constant cost industry is an industry whose production cost remains the same
even with increased output. T he supply curve of a constant cost industry is a horizontal line.
B i s i ncorrect. As the name suggests, an increasing cost industry is an industry whose production
cost increases as output increases. Increasing cost industries have an upward supply curve.
Q.1438 If the marginal product of capital is 90, the cost of capital is 9, the marginal product of labor
is 85, and the cost of labor is 7, then:
A. conditions for cost minimization exist.
B. conditions for cost minimization do not exist.
C. conditions for cost minimization can occur if the cost of labor is 9.
Cost minimization occurs at a point where the marginal product of labor divided by the cost of labor
is equal to the marginal product of capital divided by the cost of capital.
Conditions for cost minimization do not exist because the marginal product of labor divided by the
cost of labor (85/7=12.14) does not equal the marginal product of capital divided by the cost of capital
(90/9=10).
23
Q.2455 If the average total cost of production is $10 per unit and the marginal cost is $11, then it is
likely that:
A. the firm is operating at the lowest average cost output level.
B. the firm is operating above the minimum average cost output level.
C. the firm is operating below the minimum average cost of production level.
If marginal cost is greater than the average cost, then average costs are increasing as output
increases. T herefore, it is a point to the right of the minimum average cost point.
Q.2458 T he demand curve for a good is given by:
Q = 1, 000 − 10P
If the price, currently at $50, increases by 5%, the percent change in demand is closest to:
A. -5%.
B. -3.3%.
C. 6.7%.
Price elasticity is calculated as a percentage change in the quantity over the percentage change in
price. T he formula to determine the point price elasticity of demand is:
∂Q P
×
∂P Q
In the formula above, ∂Q/∂P is the partial derivative of the quantity demanded taken with respect to
the good’s price, P is a specific price for the good, and Q is the quantity demanded associated with
the price P .
∂Q ∂
T hus, = ∂P (Q = 1, 000 − 10P ) = −10.
∂P
50
Price elasticity of demand = −10 × = −1
1, 000 − 10(50)
24
Recall also that the price elasticity can be defined as:
Percentage change in demand

= −1
Percentage change in price
However, we are given:
Percentage change in price = 5% = 0.05
So,
Percentage change in demand

= −1
0.05
Percentage change in demand = -0.05, which implies that demand will decrease by 5%.
Q.2464 Suppose that the price elasticity of demand for movie tickets is -1.2. All else equal, if the
theater increases the price per ticket, then:
A. the revenues from ticket sales will increase.
B. the revenues from ticket sales will decrease.
C. the revenues from ticket sales will remain unchanged.
For each one percent increase in price, the quantity of tickets will decrease by 1.2 percent, and
consequently (Revenue = Price × Quantity) will decrease.
A i s i ncorrect. If the price elasticity were positive, then the revenue would have moved in the
same direction as the price; a price increase would have increased the revenue from the sale of
tickets.
C i s i ncorrect. For revenue from the sale of tickets to have remained unchanged, the price
elasticity would have needed to be 0.
25
Q.2465 In the current market for LB cell phones, marginal revenue is greater than marginal cost. In
this situation, LB should:
A. increase the output of cell phones.
B. decrease the output of cell phones.
C. make no change to the output quantity of cell phones.
As long as the next unit generates more additional revenue than the additional cost, it is profitable to
increase output.
Q.3123 T he demand curve for cinema tickets is given by the equation:
QdC = 20, 000 − 1500P Cinema − 200P P opcorn
Where P Cinema and P P opcorn indicate the prices of cinema tickets and popcorn sold at the snack bar,
respectively.
If the current demand is equal to 4,000 tickets and the price of popcorn is 5.0, then the cross-price
elasticity of demand for cinema tickets, with respect to the price of popcorn, is closest to:
A. -3.75.
B. -0.25.
C. 0.25.
T he point cross-price elasticity is calculated as:
ΔQdC P P opcorn
EPd opcorn = ×
ΔP P opcorn QdC
5.0
= −200 × = −0.25
4, 000
ΔQ d
C
Since is equivalent to the coefficient on the price of the popcorn (-200).
ΔP P opcorn
Note that since cinema tickets and any snack bar items such as popcorn are presumably
complemented, it makes sense that the sign of the cross-price elasticity is negative.
26
Q.3124 T he demand curve for Pepsi at a convenience store is given by the equation:
QP eps i = 40– 1.5P P eps i + 1.8P Coke + 0.5I
Where P P eps i and P Coke indicate the prices of Pepsi and Coke, respectively, and I indicates the
average annual income (in thousands of dollars) of people living in the region. Moreover, the
quantities of the beverages are given in thousands.
T he average annual income in the region is $42 thousand per year. If the price of Pepsi is $1.25
while Coke costs $1.30, then the elasticity of demand for Pepsi, with respect to the price of Coke, is
closest to:
A. 0.038.
B. 0.25.
C. 0.42.
To calculate the cross-price elasticity, it will be necessary to first calculate the quantity of demand
for Pepsi, QPepsi :
QP eps i = 40– 1.5(1.25) + 1.8(1.30) + 0.5(42) = 61.47 units
T he cross-price elasticity of Pepsi with respect to the price of Coke is calculated as:
ΔQdP eps i P Coke

EPd eps i = ×
ΔP Coke QdP eps i
= (1.8)(1.30/61.47)
≈ 0.038
Where 1.8 is obtained by partially deriving the quantity of Pepsi with respect to the price of Coke.
Since Coke and Pepsi are typically perceived as close substitutes (an increase in the price of one
item causes an increase in demand of the other), it makes sense that the cross-price elasticity is
positive.
27
Q.3125 T he (theoretical) Giffen good is best explained as:
A. a normal good for which the income effect is larger than the price effect.
B. a normal good for which the income effect is smaller than the price effect.
C. an inferior good for which the income effect is larger than the price effect.
T he concept of a Giffen good is such that it would be most likely to occur if it was an inferior good
that constituted a relatively large portion of the budget. Increases in income reduce the demand for
inferior goods, all else equal. For an inferior good, increases in income increase demand.
Although a decrease in its price should induce a substitution effect toward greater consumption of
the now cheaper good, it is more than offset by the income effect. T he price drop would increase
real income, and the reduction in consumption resulting from that increased income would be
greater than the substitution effect produced by the lower price. T he net result would be a
reduction in consumption resulting from the lower price. Giffen goods lack obvious substitutes.
T hey are mainly rare occurrences. An example would be the Miller and Jensen rice study in China.
T he demand for rice increased despite an increase in price because the consumers could not afford
the next level of consumption.
Q.3126 An inferior good is best defined as a good for which:
A. the income elasticity is negative.
B. the own-price elasticity is negative.
C. the demand curve is upward sloping.
By definition, an increase in income will cause consumers to reduce their consumption of inferior
goods.
C i s i ncorrect. A Veblen good is one for which the demand curve slopes upward, explained as a
“conspicuous consumption good.” A higher price increases its exclusivity, making it more desirable
to those who choose to buy it.
28
Q.3127 Which of the following measures indicates a normal good?
I. Income elasticity equals -0.2.
II. Own price elasticity equals -0.2.
III. Income elasticity equals 0.2.
A. III only.
B. II only.
C. I & II only.
Positive income elasticity of demand is associated with normal goods; an increase in income will lead
to a rise in demand.
T he fact that the own-price elasticity is positive or negative does not imply a normal good. A negative
income elasticity implies that an increase in income leads to a decrease in demand. Negative income
elasticity is seen in inferior goods.
Q.3128 Which of the following measures indicates an inferior good?
A. Income elasticity equals -0.2.
B. Income elasticity equals 0.2.
C. Own price elasticity equals -0.2.
Negative income elasticity of demand is associated with inferior goods; an increase in income will
lead to a fall in demand and may lead to changes to more luxurious substitutes.
B i s i ncorrect. A positive income elasticity represents a normal good. An increase in income leads
to an increased demand for the good.
C i s i ncorrect. Own price elasticity is not a determinant of whether a good is inferior or not.
29
Q.3129 Steve White typically buys 10 cups of coffee each week from the local coffee shop at a
price of $3.95. T he shop recently reduced the price to $3.30. At that price, he purchased 12 cups.
T his best demonstrates:
A. the income effect.
B. the substitution effect.
C. the marginal propensity to consume.
If prices fall, known as deflation, and nominal income remains the same, then consumer's nominal
income can purchase more goods, and they will generally do so. T he decreased price gave White
more purchasing power. He can use this to purchase more cups of coffee using the same amount of
his earnings.
B i s i ncorrect. T he substitution effect states that an increase in the price of a good will encourage
consumers to buy alternative goods. In this question, there is no mention of alternative goods.
C i s i ncorrect. T he marginal propensity to consume refers to the proportion of additional income

spend as opposed to saved.
Addi ti onal Expl anati on
Income effect
T he income effect is the situation in which, as a good’s price falls, real income rises and, if this good
is normal, more of it will be purchased. Assume that the price of a good you regularly purchase falls,
while your income and prices of all other goods remain unchanged. T his is referred to as the
increase in the purchasing power or real income.
Consumers tend to buy more of those goods in such cases. So when the price of a good—say, coffee
—falls, most consumers would tend to buy more coffee because of the increase in their real income.
It is important to note that the consumer’s money income (the number on the paycheck) is assumed
to remain unchanged, the real income has risen because one can now buy more coffee—and other
goods, too—as a result of the fall in the price of that one good.
Marginal Propensity to Consume (MPC)
MPC is a macroeconomic concept defined as the proportion of any increase in national income that
goes on consumption. T here is an increase in disposable income (income after taxes and transfers).
T his means that the consumer has additional income to consume.
For example, assume that for each £10 billion rise in national income, there is an £8 billion rise in
consumption. T he marginal propensity to consume is £8 billion/£10 billion = 0.8.
30
Q.3130 A manufacturer doubles the number of workers on the production line and increases output
by only 40 percent. T his demonstrates:
A. the increasing marginal cost of labor.
B. the constant returns to capital additions.
C. the diminishing marginal returns to labor.
Although there are twice as many workers, the output change is far less than doubled. T his is
because the increased output attributable to each additional worker eventually decreases.
Q.3131 At a fruit packing plant, a 5 percent increase in the number of worker hours per week yields
a 4.5 percent increase in the quantity of output. However, a 20 percent increase in the number of
worker hours yields only a 12 percent increase in output. T his indicates that at current output
levels:
A. there is insufficient capital employed in the plant.
B. there are diminishing returns to labor in the plant.
C. there are increasing returns to scale in the plant.
By definition, diminishing marginal returns are the situation in which increasing the quantity of input
leads to decreasing increases in output per unit of additional input.
31
Q.3132 You have been provided a firm's cost structure:
Q T FC T VC AFC AVC TC AT C MC
0 8,500 0 - - 8, 500 - -
1 8,500 4,000 8,500 4,000 12, 500 12,500 4,000
2 8,500 8,800 4,250 4,840 17, 300 8,650 4,800
3 8,500 14,520 2,833 4,400 23, 020 7,673 5,720
4 8,500 21,296 2,125 5,324 29, 796 7,449 6,776
5 8,500 29,282 1,700 5,856 37, 782 7,556 7,986
6 8,500 38,652 1,417 6,442 47, 152 7,859 9,370
Given the cost structure in the table above, the firm should shut down in the short run if the
marginal revenue (market price per unit, for a firm in a perfectly competitive industry) is less than:
A. 4,000.
B. 4,800.
C. 7,673.
Although it could not fully recover the total cost unless the price meets or exceeds the AT C, losses
are reduced provided the price is more than the average variable costs. For example, if the price was
4,100, then producing one unit would pay the variable cost and contribute 100 towards paying the
fixed cost, which is better than losing the entire fixed cost by shutting down.
32
Q.3133 You have been provided a firm's cost structure:
Q T FC T VC AFC AVC TC AT C MC
0 8,500 0 - - 8, 500 - -
1 8,500 4,000 8,500 4,000 12, 500 12,500 4,000
2 8,500 8,800 4,250 4,840 17, 300 8,650 4,800
3 8,500 14,520 2,833 4,400 23, 020 7,673 5,720
4 8,500 21,296 2,125 5,324 29, 796 7,449 6,776
5 8,500 29,282 1,700 5,856 37, 782 7,556 7,986
6 8,500 38,652 1,417 6,442 47, 152 7,859 9,370
Given the cost structure in the table above, if the per-unit market price is at 7,400 or less, the firm
should most likely :
A. shut down in the long run.
B. shut down in the short run.
C. operate profitably by producing 4 units.
A price of 7,400 is below the minimum average total cost achieved at an output level of 4 units.
Between 4,000 and 7,449, the firm can reduce losses in the short run by continuing to operate
provided they choose an output level such that total variable costs are recovered. For example, if
the price was 4,100, then producing one unit would pay the variable cost and contribute 100 towards
paying the fixed cost, which is better than losing the entire fixed cost by shutting down. In the long
run, they can operate only if the price is high enough to recover the average total cost.
B i s i ncorrect. A firm can shut down in the short run its average marginal revenue is less than both
the average variable and total costs.
C i s i ncorrect. T he firm cannot be profitable if it sells its output at a price lower than the total
fixed costs.
33
Q.3134 A firm is operating at the breakeven level of output if:
A. the selling price per unit equals the marginal revenue.
B. the selling price equals marginal cost and is above the average total cost.
C. the selling price equals the sum of average fixed cost and average variable cost.
In this case, the price (shown in the image below as P2) will equal the average total cost (AT C),
since average fixed cost + average variable cost = average total cost.
Q.3135 If the selling price is greater than the average variable cost but less than average total cost,
the firm will most likely :
A. shut down in the short run.
B. shut down in the long run.
C. continue operating at a profit.
If the price is less than the average total cost, then it is not receiving enough to recover all costs
fully. In the short run, it may minimize the losses by continuing to operate, provided it recovers
more than the variable costs, but eventually, plant and equipment wear out and must be replaced.
A i s i ncorrect. A firm will shut down in the short run if its selling price is less than both the
average variable and the average total costs.
C i s i ncorrect. A firm will continue to operate at a profit if its selling price is greater than both the
average variable costs and the average total costs.
34
Q.3136 A perfectly competitive firm should shut down immediately if it is operating such that:
A. the selling price is less than the marginal cost.
B. the selling price is less than the average variable cost.
C. the selling price is less than the average total cost but greater than the average variable
cost.
Producing another unit in this circumstance will have incremental variable costs that are greater
than the revenue received. It operates at a point such that the marginal revenue is below the
average total cost curve and below the variable cost curve. T he firm will rather shut down since it
will experience greater losses by continuing to operate.
Q.3137 An analyst notes that there are a large number of automobile assembly plants throughout the
United States of America, and they have become very similar in size and operations. T his most likely
indicates that the plants are operating in:
A. an output range of increasing returns to scale.
B. an output range of decreasing returns to scale.
C. an output range that minimizes long-run average costs.
Over the long run, competitive pressures and profit maximization will drive plants to the minimum of
the long-run average cost curve. T herefore, there is an optimal plant size that will face constant
returns to scale. Larger plants will face decreasing returns to scale, and smaller plants will face
increasing returns to scale.
35
Q.3138 A manufacturer operating at the minimum of its short-run average cost curve is suddenly
facing an unexpected increase in demand. At least in the short run, to meet this demand, the
manufacturer is more likely to:
A. incur higher average costs due to increasing returns to scale.
B. incur lower average costs due to increasing returns to scale.
C. incur higher average costs due to decreasing returns to scale.
Increasing output to meet the increased demand forces the manufacturer to exceed the minimum
average cost output level. Beyond the minimum point, it will face decreasing returns to scale.
Q.3139 In a single firm industry for which economies of scale continue well beyond all estimates of
total market demand for the product, it is likely that if a new firm enters the market, the:
A. average total costs will rise as a consequence of returns to scale.
B. average total costs for the product will fall as a consequence of returns to scale.
C. average total costs will fall as both firms will operate below the previous output level.
T his structure is known as a natural monopoly. Splitting the market means that both firms could
reduce average costs further by driving the other firm out of the market and capturing the
economies of scale to a greater extent. In the long run, rather than the competition forcing lower
prices, one of the firms will be forced out since larger output levels permit lower average costs,
which gives the larger firm a cost advantage.
36
Q.3270 T he demand curve for electricity is given by the equation:
QElec = 20– 15P Elec + 2P Gas + 0.2I
Where P Elec and P Gas indicate the prices of electricity and natural gas, respectively, and I indicates
the average annual income (in thousands of dollars) of people living in the region.
T he unit price of electricity is $0.25 and gas costs $0.18 per unit. Given that the average annual
income in the region is $50 thousand per year, the elasticity of electricity demand, with respect to
its own price, is closest to:
A. -3.27.
B. -0.14.
C. 1.5.
To calculate the price elasticity, it will be necessary first to calculate the quantity of electricity
demand, QElec :
QE lec = 20 − 15(0.25) + 2(0.18) + 0.2(50) = 26.61 units
T he own-price elasticity of electricity is calculated as:
ΔQdElec P Elec 0.25

EPd Elec = × = (−15) ≈ −0.14
ΔP Elec QdElec 26.61
ΔQ d ec
El
Note: is given by the partial derivative of the quantity of electricity with respect to the price
ΔP E lec
of electricity.
37
Q.3271 T he demand curve for Pepsi at a convenience store is given by the equation:
QP eps i = 40– 1500P P eps i + 1800P Coke + 5I
Where P P eps i and P Coke indicate the prices of Pepsi and Coke, respectively, and I indicates the
average annual income (in thousands of dollars) of people living in the region.
T he average annual income in the region is $42 thousand per year. If the price of Pepsi is $1.25 and
Coke costs $1.30, then the elasticity of demand for Pepsi, with respect to its own price is closest to:
A. -2.62.
B. 0.25.
C. 3.27.
To calculate the income elasticity, it will be necessary to first calculate the quantity of demand for
Pepsi, QP eps i.
QP eps i = 40– 1500(1.25) + 1800(1.30) + 5(42) = 715 units
T he own-price elasticity of Pepsi is calculated as:
ΔQdP eps i P P eps i 1.25

EPd P eps i = × = (−1, 500) ≈ −2.62
ΔP P eps i QdP eps i 715
Where -1500 is the partial derivative of the quantity of Pepsi with respect to the price of Pepsi.
Since Coke is typically perceived as a close substitute for Pepsi, it makes sense that the price
elasticity of Pepsi is substantially greater than one in magnitude.
38
Q.3272 T he demand curve for cinema tickets is given by the equation:
QdC = 20, 000 − 1500P C inema − 200P P opcorn + 40I
Where P Cinema and P P opcorn indicate the prices of cinema tickets and popcorn sold at the snack bar,
respectively, and I indicates the average annual income (in thousands of dollars) of people living in
the region.
If the current demand is equal to 6,200 tickets and the price of popcorn is $5.00 while cinema
tickets cost $10.00, then the elasticity of demand for cinema tickets, with respect to income, is
closest to:
A. -3.75.
B. -0.35.
C. 0.35.
To calculate the income elasticity, it will be necessary to calculate the average regional income level
first.
QC = 6, 200 = 20, 000 − (1500)(10) − (200)(5) + 40I
T herefore, I = 55.
T he income elasticity is calculated as:
ΔQdC I 55
d
EP P ×
opcorn
= = (40) × ≈ 0.35
ΔI QdC 6, 200
Δ Q d
Where ΔI has been obtained by partially deriving the quantity of cinema tickets with respect to
=40
the income earned by the people in the region.
Since cinema ticket sales are likely to increase with wealth, it makes sense that the income
elasticity sign is positive. Note that this demonstrates that cinema tickets are a normal good.
39
Q.3828 Suppose that for a manufacturer their total costs are currently greater than their total
revenue. In the short run, the manufacturer should:
A. shut down.
B. shut down if fixed cost is greater than marginal revenue.
C. shut down if marginal cost is greater than marginal revenue.
In the short run, if marginal revenue is greater than marginal cost, any revenue that is left over after
paying the variable costs can be used to pay for some portion of the fixed costs. T his is a better
outcome than shutting down and not recovering any of the fixed costs.
Q.3829 T he market demand function for item A is a function of its price, income, and the price of
item B.
Own-price elasticity of demand for item A −0.5

Income elasticity of demand for item A 0.4
Cross-price elasticity of demand for item A 0.8
with respect to the price of item B
Given this information, which of the following statements is most accurate?
A. Item A is an inferior good.
B. Demand for item A is elastic.
C. Items A and B are substitutes.
A positive coefficient of cross-price elasticity means that when the price of item B goes up, the
demand for item A also goes up. T his behavior is coherent with the fact that A and B are substitutes.
40
Reading 9: The Firm & Market Structures
Q.174 Which of the following statements is least likely accurate?
A. If a quota is greater than what would normally be produced, prices should rise.
B. Due to fewer exchanges between buyers and sellers, taxation creates a deadweight loss.
C. T he incidence of taxes will tend to fall on the side of the market that has the lowest
elasticity.
A quota is a limited quantity of a particular product that can be produced, exported, or imported. If
the quota is greater than what would be normally produced, there will be no effect on price.
Q.684 In a monopolistic competition, the firm will most likely expand its output until:
A. Average revenue (AR) = Average cost (AC).
B. Marginal revenue (MR) = Marginal cost (MC).
C. Marginal revenue (MR) = Average total cost (AT C).
On the left of the MR = MC point, additional revenue generated by adding additional factors is
positive so it will keep expanding. On the right of the MR = MC point, additional revenue generated is
less than additonal cost which will incur losses to the firm.
41
Q.685 A market structure where the competitive firm decreases its price as compared to the
dominant firm will result in:
A. an increase in the demand of the competitive firm in the short run.
B. an increase in the market share of the dominant firm in the long run.
C. both A) and B).
Recall that the dominant firm has a lower cost of production. Competing firms (followers) will lose
market share if they offer lower prices because they cannot profitably sustain the lower selling
price (often at or below cost) in the long run.
Q.687 Which of the following is least likely a characteristic of an oligopoly?
A. All firms have identical products
B. A few firms take higher shares of the market.
C. Each firm faces a downward-sloping demand curve.
In an oligopoly, a small number of producers sell products that can be similar or differentiated.
Although product differentiation is not required for an oligopoly to form, if a firm can successfully
differentiate its products by developing a position that potential customers see as unique, it will gain
market power and resist competition more easily.
Optons B and C are correct characteristics of an oligopoly.
42
Q.688 At present time, the firm's Output = 800, Price = 0.22, Total cost (T C) = 600, and Marginal
cost (MC) = 0.20. We can say that the firm is:
A. maximizing profit.
B. making positive marginal profit.
C. making negative marginal profit.
T he point where Marginal revenue (MR) > Marginal cost (MC) is making positive marginal profits.
T he firm can produce a new unit at a cost of $0.20 and sell it for $0.22. However, the firm is not
maximizing profits as the marginal profits don't cover total costs at the output level at which it is
right now.
Q.689 Which of the following is the name given to the demand curve in an oligopolistic pricing
strategy?
A. Vertical demand curve.
B. Kinked demand curve.
C. horizontal demand curve.
T he oligopolist faces two opposing demand systems, one for price increase and another for price
decrease. Competitors can meet a price decrease by lowering their costs, but they will not match a
price rise. As a consequence, the demand curve is kinked.
43
Q.690 In the case of the Cournot model, firms most likely :
A. do cooperate and collude.
B. compete in output quantities.
C. compete on product differentiation.
In the case of the Cournot model, each firm determines its profit-maximizing production level by
assuming that the other firm's output will not change.
A i s i ncorrect. Firms do not cooperate or collude. Both firms act rationally and strategically,
maximizing profit given their competitors' output decisions.
C i s i ncorrect. All firms produce a homogeneous product, so there is no product differentiation.
Q.691 A kinked demand curve in an oligopoly indicates which of the following?
A. A decrease in price by one firm will be followed by its competitors.
B. An increase in price by one firm will be followed by its competitors.
C. Both increase and decrease in price by one firm will be followed by its competitors.
T he kinked demand curve suggests that firms will face different effects for both increasing price or
decreasing price. If a firm increases the price, there is likely to be a significant fall in demand.
Demand is, therefore, price elastic, and consumers will switch to its rival firms, which is why option
A is incorrect.
On the other hand, if a firm cuts its price, other firms will not want to see this fall in market share
and so they will respond by also cutting prices to follow the first firm.
T his leads to the kinked demand curve for which the curve is elastic to a price increase and inelastic
to a price decrease.
44
Q.693 Which of these is least likely a feature of a monopolistic market?
A. No pricing power.
B. One supplying firm.
C. High barriers to entry.
T he firm has some pricing powers as the firm is a price seeker and profit maximizer.
Exam tip: It's in the case of perfect competition that the firms have no pricing power.
45
Q.694 A pharmaceutical company is a monopoly with high barriers of entry with the demand function
defined as:
QD = 60 − 0.2P
Where P is the price.

T he slope of the marginal revenue curve is closest to:
A. -10.
B. -8.
C. -5.
We have:
QD = 60 − 0.2P
So that:
P = 300 − 5QD
We know that:
T R = P × Q = 18000 − 300Q − 60P + P Q = 300Q − 5Q2
T hus,
∂T R
MR = = 300 − 10Q
∂Q
From the equation above equation:
Slope = −10
46
Q.695 In the case of collusion, firms agree to:
A. share technologies.
B. share profits/losses.
C. produce an agreed quantity of output.
T he firms agree to produce an agreed quantity of output. For example, OPEC has employed
production or supply quotas on various occasions since March 1982 in an effort to control oil prices.
T hus, industry profits are maximized.
Q.1439 A firm has a perfectly horizontal demand curve. Which of the following would best describe
the market structure of this industry?
A. Monopoly.
B. Perfect competition.
C. Monopolistic competition.
Perfect competition is a type of market structure which has a perfectly elastic (horizontal) market
demand curve because there is not any firm in the market that has the power to affect the market
price.
47
Q.1440 In which of the following forms of market structures is it most important for a firm to
consider price moves and other firms' strategies?
A. Oligopoly.
B. Monopoly.
In an oligopoly, it is important for a firm to consider price moves and strategies of other firms in the
market.
B i s i ncorrect. In a monopoly, there is only one firm.
C i s i ncorrect. Barriers to entry and exit in a monopolistic competitive industry are low, and the
decisions of any one firm do not directly affect those of its competitors.
Q.1441 T he main differentiating characteristic between perfect competition and monopolistic

competition is the:
A. taxation.
B. pricing power.
C. number of firms.
While the number of firms is fairly large in both forms, there is no pricing power for the firms in
perfect competition whereas, in monopolistic competition, firms have some pricing power. In order
to actually raise their prices, the firms must be able to differentiate their products using strategies
such as branding or marketing.
48
Q.1444 In which of the following conditions can a firm in a perfectly competitive market maximize
its profit?
A. Demand = Price = Marginal cost.
B. Demand = Price > Marginal revenue.
C. Demand = Price = Marginal revenue < Marginal cost.
In perfect competition, firms profit by producing and selling the quantity demanded, which is the
point where marginal cost, average cost, marginal revenue, average revenue, and price all intersect.
Q.1445 Soybeans Corp. operates in a perfectly competitive market. What is the most likely impact
on the equilibrium price and quantity if the market demand decreases?
A. T he equilibrium price and quantity will decrease.
B. T he equilibrium price and quantity will increase.
C. T he equilibrium price will decrease while the equilibrium quantity will increase.
Recall that the price and total quantity demanded is set by the market and not each individual firm -
firms are price takers under perfect competition. If the market demand decreases in a perfectly
competitive market, then the equilibrium price and quantity will both decrease for all firms all other
factors held constant.
Q.1446 Which of the following is the definition of downsizing?
A. Decreasing the prices to reduce economic losses.
B. Decreasing the plant size to reduce economic losses.
C. Decreasing the quantity supplied to reduce economic losses.
Downsizing is the process whereby a corporation makes itself smaller in response to changing
market circumstances, for example, layoffs to meet a leftward shift in market demand.
49
Q.1448 Which of the following characteristics is least likely to describe monopolistic competition?
A. High barriers to entry.
B. Large number of independent seller.
C. Differentiated and innovative products.
Monopolistic competition is a type of imperfect competition such that many producers sell products
that are differentiated from one another (e.g. by branding or quality) and hence are not perfect
substitutes. Characteristics of monopolistic competition are low barriers to entry, a large number of
firms, and differentiated products. Firms compete on price, quality, and marketing.
Q.1449 Which of the following is an assumption of price movements in the kinked demand curve of
an oligopoly?
A. Decreases and increases in prices will be followed by other firms.
B. An increase in price will be followed by other firms, but a decrease in prices will not be
followed by other firms.
C. A decrease in price will be followed by other firms, but an increase in prices will not be
followed by other firms.
In an oligopoly, a decrease in price will be followed by other firms, but an increase in price will not
be followed by the other firms. T his assumption is based on the kinked demand curve.
T he kinked demand curve suggests that firms will face different effects for both increasing price or
decreasing price. If a firm increases the price, there is likely to be a significant fall in demand.
Demand is, therefore, price elastic, and consumers will switch to its rival firms.
On the other hand, if a firm cuts its price, other firms will not want to see this fall in market share
and so they will respond by also cutting prices to follow the first firm.
T his leads to the kinked demand curve for which the curve is elastic to a price increase and inelastic
to a price decrease.
50
Q.1450 T he Cournot model of oligopoly assumes that the number of firms in the oligopoly is:
A. 1.
B. 2.
C. 3.
T he Cournot model of oligopoly assumes that there are only 2 firms (duopoly) in the market.
Q.1451 Which of the following is least likely to be used as a pricing strategy in a monopoly?
A. Single price strategy.
B. Interdependent pricing.
C. Discriminating pricing strategy.
Single price and discriminating pricing strategies are used by firms in a monopoly form of market
structure.
Si ngl e pri ce means that it charges the same price for each unit it sells.
Di scri mi nati ng pri ci n is a selling strategy that charges customers different prices for the same
product or service based on what the seller thinks they can get the customer to agree to. For
example, if a consumer calls to remove its landline phone service, the firm will probably offer him a
reduced price.
Interdependent pri ces are a characteristic of the kinked demand curve in an oligopoly. T his simply
means that firms cannot act independently of each other.
51
Q.1452 Utopia Railways is a monopolist rail service in Canada. To apply an effective discriminating
pricing strategy, which of the following assumptions is least likely to be considered?
A. All consumers have the same elasticities of demand.
B. Utopia Railways faces a downward-sloping demand curve.
C. T here are measures preventing customers from reselling to other customers at higher
prices.
T he assumptions of a discriminating pricing strategy are:

1. T here are two groups of customers with different elasticities of demand.
2. T he firm faces a downward-sloping curve.
3. T here are measures preventing customers from reselling to other customers at higher prices.
Q.1453 Which of the following oligopolistic models assumes that there is one significant firm in the
market by its greater market share and scale and all other firms follow the price set by the
significant firm?
A. Sweezy's model.
B. Cournot's model.
C. Stackelberg's model.
T he Stackelberg dominant firm model assumes that there is one firm that has a significantly large
market share because of its greater scale and its lower cost structure and all other firms follow the
dominant firm.
52
Q.1454 Which of the following market structures has a defined short-run supply curve?
A. Monopoly.
B. Perfect competition.
Only perfect competition has a defined short-run supply curve, which is that portion of the marginal
cost curve that lies above the minimum of the average variable cost curve.
Monopoly, oligopoly, and monopolistic competition do not have defined supply curves because of
their downward-sloping demand curves.
Q.1455 Earth, Sun, Moon, and Star firms have market shares of 28%, 22%, 15%, and 10%
respectively. T he 4-firm Herfindahl-Hirschman Index is closest to:
A. 0.1593.
B. 0.1609.
C. 0.1871.
4-firm HHI = 0.282 + 0.222 + 0.152 + 0.12 = 0.1593
Q.1456 Earth, Sun, Moon, Star and Mars firms have market shares of 28%, 22%, 15%, 10% and 4%
respectively. T he 4-firm Herfindahl-Hirschman Index after the merger of the firms Moon and Star is
closest to:
A. 0.1625.
B. 0.1790.
C. 0.1909.
Since combined market shares of Moon and Star will be 15%+10% = 25%, the 4-firm HHI =
0.282+0.222+0.252+0.042 = 0.1909.
53
Q.1457 In which of the following forms of market structures does a firm make output and pricing
decisions based on the anticipated actions of its competitors?
A. Oligopoly.
B. Monopoly.
C. Perfect competition .
Firms operating in an oligopolistic market structure have the tendency to make pricing and quantity
decisions based on the anticipated actions of their competitors. T here is a high degree of
interdependence among competitors with little pricing and quantity decisions taken in isolation.
Q.2466 For a firm operating in a perfectly competitive market, the optimal output quantity will be
selected such that:
A. marginal cost is less than market price.
B. marginal cost is less than marginal revenue.
C. marginal cost is equal to marginal revenue.
Firms in all industries optimize by choosing the output level such that marginal revenue equals
marginal cost, but in the competitive case, it will also equal the market price. Furthermore,
competition will drive all firms to their minimum total cost point such that, in equilibrium, marginal
revenue = marginal cost = price = minimum average cost.
54
Q.2468 If banking is a competitive industry in which all banks are operating in ranges where they are
facing substantial economies of scale, then we will most likely see:
A. mergers and industry consolidation.
B. more competitive pricing from smaller banks.
C. less attention to customer service in smaller banks.
If there are economies of scale, then larger banks have a cost advantage over smaller banks.
T herefore, smaller banks cannot successfully compete on price. T he cost advantage of greater size
will, all else equal, result in mergers and general industry consolidation.
Q.2469 In a segment of the software market, the three top firms have 40 percent, 15 percent and 10
percent of the market. T he Herfindahl-Hirschmann index for the top three firms is closest to:
A. 0.19.
B. 0.63.
C. 0.75.
T he HHI is equal to 0.402 + 0.152 + 0.102 = 0.1925
55
Q.3140 Leonardo's Pizza Palace is the only restaurant in the entertainment district of a large city
serving pizza. T his restaurant would most likely be best described as operating in an industry that is:
A. monopolistic.
B. perfectly competitive.
C. perfectly monopolistic.
T here are no significant barriers to entry, many alternative restaurants, and over the long term, little
chance of capturing economic rents. However, the product has some monopoly characteristics in
that it is differentiated and there is only one Leonardo's. In that vein, the restaurant could have some
limited monopoly power. If it attempts to exercise that monopoly power, any rents gained will only
increase the likelihood that a close copy will open nearby and attempt to duplicate its success.
Q.3141 In an industry with no barriers to entry or exit in which there are zero economic profits, we
are likely to also find firms operating in an environment such that:
A. marginal cost is equal to marginal revenue but less than price.
B. products are highly differentiated, and non-price competition is typical.
C. there is equality between price, marginal revenue, marginal cost, and average cost.
In a perfectly competitive industry, there are many small price-taking firms selling homogeneous
products and producing at the minimum average cost. At that point, marginal cost, marginal revenue,
price, and average cost will be equal.
56
Q.3142 T he toothpaste manufacturing industry in the U.S., where only a few large manufacturers
such as Proctor & Gamble produce somewhat differentiated, but arguably quite similar products, is
best described as:
A. oligopoly.
B. monopoly.
C. perfectly competitive.
Although one might consider toothpaste a commodity, there is an emphasis on competing by

advertising and or introducing new products rather than competing on price. T he market is
dominated by a few large manufacturers such as Proctor & Gamble, producing a relatively large
number of somewhat differentiated, but arguably quite similar products.
Q.3143 Within an industry, each firm selects an output level such that marginal revenue equals
marginal cost. T his decision process is optimal for:
A. all firms, independent of industry structure.
B. all industrial structures except for monopolies.
C. all industrial structures except for monopolies and oligopolies.
For perfectly competitive price-taking firms, marginal revenue and price will be equal since they
face an essentially horizontal (perfectly elastic) demand curve. For monopolies, the output is chosen
such that marginal revenue and marginal cost are equal, but the demand curve is downward sloping,
so the price will be set above the marginal revenue.
In choosing the output to produce, the monopolist follows the marginal principle, which states that
the profit-maximizing output is that output where marginal revenue equals marginal cost. If marginal
revenue is greater than marginal cost, the monopolist should increase output. If marginal revenue is
less than marginal cost, the monopolist should decrease output.
57
Q.3144 For monopolies:
A. marginal revenue is equal to the market price, and demand is perfectly elastic.
B. marginal revenue is less than the price because the demand curve is downward sloping.
C. economic rents may be obtained, but marginal cost is greater than average cost at the
profit maximizing quantity.
For perfectly competitive firms, demand is perfectly elastic, but not for monopolies. Monopolies
face downward sloping demand and can restrict supply to sustain a price above marginal cost. With a
restricted supply, marginal revenue will lie above the minimum average cost.
Q.3145 For perfectly competitive firms to remain in the industry:
A. they must become larger than their competitors.
B. they will operate at the minimum average cost point.
C. they must operate below the minimum average cost for the industry.
Surviving firms will all operate at the point of optimal scale which will minimize average costs.
A i s i ncorrect. No firm will be large enough to dominate or influence the market.
C i s i ncorrect,as shown on the graph above.
Q.3146 For monopolies to maximize the benefit of being able to set the market price, they should:
A. be in an industry with highly elastic demand.
B. be in an industry facing unitary elastic demand.
C. be in an industry that has an inelastic demand curve.
Simply put, if the demand is elastic, then increasing the price will simply cause consumers to reduce
their purchases of the good. If the industry is one with inelastic demand, then increasing the price by
any amount will not be offset by the percentage reduction in purchase quantities.
58
Q.3147 Oligopolies are likely to:
A. lower prices to steal market share from their competitors.
B. engage in non-price competition to avoid mutually destructive price wars.
C. set prices such that marginal revenue is slightly below marginal cost but above average
total cost.
In all cases, firms choose output such that marginal revenue equals marginal cost, but monopolies
then restrict output to set higher prices and gain economic rents. Oligopolies have less power to do
this. If the oligopolists cooperate, they can jointly set higher prices and lower output to generate
economic rents just as monopolies do since they face a downward-sloping demand curve.
Consequently, it is in their interest to avoid price wars.
Q.3148 An unregulated monopolist is operating in a market where the elasticity of demand is -1.2.
Increasing the selling price by 10 percent will:
A. increase revenue but lower economic profit.
B. allow the monopolist to earn even greater economic rents.
C. result in the monopolist receiving less revenue than before.
Increasing the price by 10 percent will reduce the quantity of sales volume by 12 percent.
T herefore, the loss in sales quantity will more than offset the increase in price. Monopoly power is
greater in markets where demand elasticity is low.
59
Q.3150 A pharmaceutical company has been awarded a patent given it monopoly rights to produce a
prescription drug for which there are no competing drugs. During the life of the patent, if the
company is trying to maximize profits, it will:
A. be unlikely to increase prices above marginal cost.
B. choose an output level such that price equals marginal cost.
C. choose a price corresponding to a demand such that marginal cost equals marginal
revenue.
In all industry structures, it makes sense to choose output such that marginal revenue equals
marginal cost. However, for the monopolist, which faces a downward-sloping demand curve, the
marginal revenue is less than the price.
Q.3151 A manufacturer of plastic drainage tile, operating in a perfectly competitive environment,

will have a short-run supply curve determined by:
A. the portion of its marginal cost which lies above the average total cost.
B. the portion of its marginal cost curve which lies above the average variable cost.
C. the portion of its marginal revenue curve that lies above the minimum fixed cost.
For all firms, output is chosen such that marginal revenue equals marginal cost. In the short run,
even if the firm is not recovering all of the fixed costs (AT C), it will reduce losses, as long as it
recovers more than the variable costs (AVC).
60
Q.3152 A firm operating in a perfectly competitive industry sets output by equating marginal
revenue and marginal cost. It will then:
A. choose a price above the marginal cost to ensure a profit.
B. set a price just below the market price to increase market share.
C. accept the market price as given and choose output accordingly.
T he firm has no power to affect price; therefore, the price will equal marginal revenue. Output will
be set such that marginal revenue equals marginal cost, and average total cost is at its minimum:
61
Q.3153 In the long run, firms operating in a perfectly competitive industry will most likely :
A. set prices just above marginal cost to control competition.
B. use product differentiation and innovation to gain market share.
C. operate at the minimum average cost on their long-run average cost curves.
Firms operating at the minimum average total cost on their long-run average cost curves is the key
benefit of competition. Production converges to the most efficient and lowest cost technology, and
no producer has the market power to earn more than normal profits.
62
Q.3154 In a monopolistically competitive market, the long-run equilibrium will be at prices that are:
A. set as a monopolist would choose.
B. determined as the consequence of a kinked demand curve.
C. similar to the outcome of a perfectly competitive market structure.
In the long run, without barriers to entry, the market will more closely represent a perfectly
competitive market than a monopoly.
Option B is incorrect. T he kinked demand curve is a feature of oligopolies.
Q.3155 For a monopolist, in the long run:
A. inefficiencies and high prices can prevail.
B. the competition will lead to greater efficiency and lower prices.
C. inefficiencies and high prices will be eliminated by the desire to maximize profits.
Without competitive pressure on their higher prices, monopolies can simply pass the costs of
inefficiency and waste to the consumer, even in the long term, unless their monopoly position
changes, for example through the expiration of a patent or the introduction of government
regulation.
63
Q.3156 For an oligopoly, in the long run, the pressure of competition on prices:
A. is of less importance than non-price competition.
B. drives the oligopoly to the same equilibrium as perfect competition.
C. as with perfectly competitive industries, eliminates monopolistic pricing decisions.
Oligopolies have a tendency to engage in non-price competition. Barriers to entry typically prevent
the perfectly competitive outcome, although over the very long term, new entrants may reduce the
market share of the market leader and force efficiency and pricing improvements. If the oligopolists
are able to cooperate, tacitly or otherwise, they have the ability to jointly operate similarly to a
monopoly.
Q.3157 T he use of concentration ratios to estimate whether a potential merger should be blocked
due to the potential of increasing monopolistic behavior:
A. may overstate the risk if there are low barriers to entry.
B. may overstate the risk if the industry is too broadly defined.
C. may understate the risk if the products are highly differentiated.
T he potential for new entrants may be sufficient in some industries with low barriers to entry to
prevent monopoly behavior by a single or small number of existing producers.
64
Q.3159 T he Herfindahl-Hirschman Index is a concentration ratio which:
A. is often employed by regulators to adjust for the demand elasticity concern of such ratios.
B. uses the squares of the market shares of the largest firms but does not consider demand
elasticity.
C. uses the squares of the market shares of the largest firms and addresses the problem of
demand elasticity.
T he concentration ratio uses the squares of the market shares of the firms but does not adjust in any
way for demand elasticity.
Q.3161 In order to encourage the development of new drugs and to maximize innovation in the
pharmaceutical industry, it would be best if government regulations designed to:
A. force an oligopolistic structure on the industry to increase competition.
B. allow monopolies to temporarily capture economic rents from new drugs.
C. prevent any mergers that would permit the new firm to control more than 10 percent of
the market.
T he intention of a patent is to permit the developer of a new drug to recover the research and
development costs of the new drug. Without the temporary formation of a monopoly, as is the case
with patent protection, drug companies could not risk the expenditures of development and clinical
trials.
65
Q.3830 An industry has 5 firms, whose market shares are respectively 52%, 15%, 13%, 12% and 8%.
Using the Herfindahl-Hirschman Index (HHI), this industry would have an equivalent number of
equal-sized firms that is closest to:
A. 2.0111
B. 3.0248
C. 4.8524
HHI = 0.522 + 0.152 + 0.132 + 0.122 + 0.082 = 0.3306
1 1
Equivalent number of firms = = = 3.0248
HHI 0.3306
66
Reading 10: Aggregate Output, Prices and Economic Growth
Q.178 Aggregate supply is best defined as:
A. the total supply of goods and services all firms plan on selling during a period of time.
B. the potential output level at each labor force.
C. the effect of prices input on goods output.
Aggregate supply is the total supply of goods and services all firms plan on selling during a period of
time.
Q.179 Which of the following will cause a rightward shift of the aggregate demand curve?
A. A decrease in taxes
B. A stock market crash
C. Newly introduced taxation on financial capital
A shift to the right of the aggregate demand curve implies that demand has increased. A decrease in
taxes will increase the amount of consumer wealth. Consequently, this should increase demand.
Options B and C are incorrect. A stock market crash and newly introduced taxation on financial
capital will reduce the amount of wealth available to consumers. Consequently, this will decrease
demand. Decreased demand will shift the aggregate demand curve to the left.
Q.696 Real GDP measures of the economy ignore:
A. inflation.
B. base year prices.
C. output quantity.
Real GDP is calculated on base year prices. T hus, it ignores the changes in the prices throughout the
years and, hence, ignores inflation.
67
Q.697 Unemployment benefits and disability benefits are part of:
A. personal income.
B. personal disposable income.
C. both A) and B).
Unemployment benefits and disability benefits are part of personal income as they affect purchasing
power. Also, personal disposable income = personal income - taxes. T hus, it is part of personal
disposable income too.
Q.698 What will most likely happen if the interest rates decrease in a conventional monetary policy
environment?
A. Savings (S) will increase.
B. Investments (I) will decrease.
C. Savings minus investments (S - I) will decrease.
A decline in interest rates will make borrowing cheaper. Consumer and business spending will
increase, resulting in a decrease in savings (favorable current consumption). Investment by firms
whose cost of capital is low will increase. Since savings are decreasing and investments increasing, it
follows that savings-investments will decrease.
A is incorrect. Savings will decrease, not increase.
B is incorrect. Investments will increase, not decrease.
68
Q.699 In which of the following cases will the money market be in equilibrium?
If the money demand increases:
A. due to an increase in prices.
B. due to a change in patterns of consumer behavior.
C. with an increase in income.
An increase in money demand from an increase in income can be offset by higher real interest rates.
T his would decrease money demand and restore equilibrium.
Q.700 T he liquidity-money (LM) curve shifts when:
A. there is an increase in prices.
B. there is a change in the real money supply.
C. there is a shift in money demand.
T he LM (Liquidity Money) curve is used to model the general equilibrium of price levels; it shows
the various combinations of interest rates and real income for which the money market is in
equilibrium. T he LM curve shifts as a result of changes in money supply and money demand. An
increase in the money supply shifts the LM curve to the right, whereas a decrease in the money
supply shifts the LM curve to the left. T herefore, a change in money supply will shift the LM curve.
Options A and C are incorrect. A change in prices or a shift in money demand will enable equilibrium
to be achieved at different points along the same money supply curve.
69
Q.701 What does the intersection of the investment/saving (IS) and the liquidity-money (LM) curves
most likely represents?
A. T he equilibrium of the goods market.
B. T he equilibrium of the money market.
C. Simultaneous equilibrium between the goods and the money markets.
T he intersection of the IS and the LM curves is a point on the aggregate demand (AD) curve where
the goods market and the money market both are in equilibrium. T herefore, there is an equilibrium
between income and expenditure and an equilibrium between real money supply and real interest
rates.
Q.703 T he aggregate supply curve:
A. is perfectly inelastic in the short run.
B. is perfectly inelastic in the long run.
C. is perfectly elastic.
In the long run, supply is inelastic, as shown as the black long-run aggregate supply (LRAS) curve
below. Firms have reached their production capacity, and thus a price increase may not necessarily
mean an increase in the quantity of goods produced.
Option A is incorrect. In the short run, supply is elastic, as shown as the green short-run aggregate
supply (SRAS) curves below. An increase in price results in an increase in the quantity of goods that
can be produced. T his is because firms can have their workers work overtime to increase output.
70
Q.704 What will happen to the aggregate demand (AD) curve if the government cuts taxes?
A. T he AD curve will shift leftward.
B. T here will be an upward movement along the AD curve.
C. T he AD curve will shift rightward.
A decrease in taxes increases the disposable income of the people in the country and leads to higher
consumption. T hus, it increases consumer spending and shifts the AD curve rightward.
Option A is incorrect. A decrease and not an increase in demand will shift the AD curve to the left.
Option B is incorrect. An upward movement along the AD curve is caused by changes in prices and
not changes in demand.
Q.705 When aggregate demand (AD) decreases, it results in a recessionary gap. Which of the
following is the most likely response?
A. T he government uses contractionary fiscal policy to boost economic growth.
B. A technological upgrade.
C. T he SRAS shifting to the right as workers accept lower nominal wages.
Economists are divided about the correct policy prescription to combat a recessionary gap. Some
economists argue that the economy will self-correct without any government intervention. T he
rationale is that the combination of lower prices and high unemployment – caused by the decline in
aggregate demand may lead to workers accepting lower nominal wages. Lower input prices would
lead to the SRAS curve shifting to the right – pushing the economy back to full employment.
Other possible policy prescriptions include the use of expansi onary monetary and/or fiscal policy.
71
Q.706 What happens to the prices in the long run when the aggregate demand increases and the
economy recovers from an inflationary gap (classical approach)?
A. T he prices increase.
B. T he prices decrease.
C. T he prices remain the same as the economy comes back to equilibrium.
An inflationary gap shifts the aggregate demand (AD) to the right, which causes upward pressure on
price levels. Firms compete for workers and raw material, which shifts the short-run aggregate
supply (SRAS) curve to the left. Hence, at the new equilibrium point, the output remains the same
but prices are higher.
Q.707 What happens when the aggregate demand (AD) increases in the short run?
A. Unemployment increases and real GDP increases
B. Unemployment decreases and real GDP increases
C. Unemployment decreases and real GDP decreases
An increase in AD will create an inflationary gap (shown in the image below), further creating
upward pressure on the price levels and increasing competition amongst producers for workers,
consequently decreasing unemployment. As the price level increases, the producers produce more.
T hus, the output increases, leading to an increase in real GDP in the short run.
72
Q.997 A population of students has a class average of 68. To find the probability of selecting 25
students with grades greater than or equal to 70 given a standard deviation of 4, the most appropriate
test to use is;
A. z-test.
B. t-test, two tails.
C. t-test, one tail.
T he mean of the population is known, but its standard deviation is not known. T he t statistic is used
when the mean and standard deviation of the population is not known. We will therefore use the t
statistic and not the z statistic to test this question. If the sample were large (n>30), we would have
used a z test as per the central limit theorem.
In this case, n < 30, and we need to deduce greater than the mean. T hus, we would use a one-tail test
t-test.
T wo-tailed tests have an equal sign. One-tailed tests are either “greater than” or “less than.”
A i s i ncorrect: T he z-test would have been preferable where the sample was large (n>30) as per
the central limit theorem.
B i s i ncorrect: T wo-tailed tests have an equal sign. One-tailed tests are either "greater than" or
"equal to."
73
Q.1458 Which of the following is the measure of the total market value of goods and services
produced in a country over a specific period of time?
A. GNP
B. GDP
C. PDI
GDP or Gross Domestic Product is the measure of the total market value of goods and services
produced in a country in a specific time.
A is incorrect. Gross National Product (GNP) is the measure of the market value of goods and
services produced by a country’s citizens regardless of the citizens' physical location.
C is incorrect. Personal Disposable Income (PDI) is obtained by subtracting Personal taxes from
Personal Income.
Q.1460 In which of the following expenditure methods is GDP calculated by adding the additional
value created at each stage of production and distribution?
A. Income approach
B. Value of final output method
C. Sum of value-added method
In the sum of the value-added method, the additional value created at each stage of production and
distribution is added to calculate the GDP. T his avoids double-counting the value of intermediate
goods.
B is incorrect. T he value of the final output method only considers the value at the final sale.
However, both methods (value of final output and the sum of value added) result in the same answer.
74
Q.1461 Samuel Lopez wants to calculate the GDP of a specific country without considering
inflation's effect on prices. Which of the following is the most appropriate GDP measure Lopez
should use?
A. Nominal GDP
B. Real GDP
C. GDP based on current prices
Real GDP is calculated using prices from a base year, thus removing the effect of changes in prices
due to inflation.
A is incorrect. Nominal GDP considers the effect of inflation: Nominal GDP = Real GDP + Expected
Inflation
Q.1463 T he nominal GDP of Normandia is $780 billion for the current year. If the GDP deflator is
117, then the real GDP of Normandia is closest to:
A. $912.6 billion.
B. $0.76 trillion.
C. $666.67 billion .
Real GDP = Nominal GDP / GDP deflator = 780/1.17 = 666.67
75
Q.1464 Which of the following is the most appropriate equation for calculating real GDP using the
expenditure approach?
A. Consumption + Investment + Government spending + Net exports
B. Consumption + Investment + Government spending - Net exports
C. Consumption + Investment + Government spending + Statistical discrepancy
Real GDP can be calculated using either the expenditure or the income approach methods.
T he expenditure approach considers the total amount spent on goods and services produced in the
economy within a given period of time.
T he components of the equation for calculating the real GDP using the expenditure approach is:
GDP = Consumption + Investment + Government spending + Net exports.
On the other hand, the income approach considers the aggregate income earned in an economy by
households, companies, and the government of that economy during a specific time period. Using the
income approach:
GDP = Total national income + Sales tax + Depreciation + Net foreign factor income
Q.1465 Which of the following is the most appropriate term for the adjustment of the differences
between the GDP calculated using the income approach and GDP calculated using the expenditure
approach?
A. Capital consumption allowance
B. Statistical discrepancy
C. T ransfer payments
Differences in calculation methods and incomplete data sources sometimes lead to different values
that should theoretically be equal. Statistical discrepancy is the adjustment for the differences
between the GDP calculated using the income approach and the expenditure approach.
76
Q.1466 Which of the following is least likely a component of national income?
A. Interest Income
B. Rent
C. Net exports
National Income is the income received by a country from all factors of production during a financial
year.
National Income = Compensation of employees
+ Corporate and government profits before taxes
+ Interest Income
+ Unincorporated net income of businesses
+ Rent
+ Indirect Business taxes
- Subsidies
'Net exports' is a component of the GDP equation under the expenditure approach.
Q.1467 Which of the following is the most appropriate equation for personal disposable income
(PDI)?
A. PDI = National income + T ransfer payments to household - Indirect taxes - Corporate

taxes - Undistributed corporate profits
B. PDI = National income + T ransfer payments to household - Indirect taxes - Corporate

taxes - Undistributed corporate profits - Personal taxes
C. PDI = Personal income + Personal taxes
T he appropriate equation of personal disposable income is:

PDI = National income + T ransfer payments to household - Indirect taxes - Corporate taxes -
Undistributed corporate profits - Personal taxes
or
PDI = Personal income - Personal taxes
77
Q.1468 Which of the following equations represents the fiscal balance?
A. Government spending - Taxes
B. Export - Imports
C. Consumption + Savings + Taxes
Fiscal balance = Government spending - Taxes

A negative value refers to a budget surplus (the government has collected more than it has spent),
and a positive value refers to a budget deficit (the government has spent more than it has collected).
Q.1469 If savings are $400 billion, investments are $200 billion, and net exports are -$165 billion,
then the fiscal balance is closest to:
A. a fiscal deficit of $365 billion.
B. a fiscal surplus of $35 billion.
C. a fiscal surplus of $365 billion.
A government can use its savings to: invest, finance government deficits, or to build up financial
claims for or against other economies. T his gives a savings function of
S = I + (G − T ) + (X − M)
Rearranging the savings function gives us the fiscal deficit formula:
G − T = (S − I) − (X − M)
Where
G-T = Government expenditure – Taxes
S-I = Savings – Investments
X-M = Net exports (Exports – Imports)
T herefore;
Fiscal Deficit (Surplus) = $400 − $200 − (−$165) = $365
78
Q.1470 What will be the impact of a decrease in real interest rates on the investments/savings (IS)
curve?
A. A decrease in the aggregate income
B. An increase in the aggregate income
C. A decrease in the investment
On the IS curve, the real interest rate and the aggregate income have an inverse relationship. A
decrease in interest rate will increase investments, and increased investment increases the demand
for goods, increasing income.
Q.1471 On the very short-run aggregate supply (VSRAS) curve, it is assumed that all the prices or
input costs like wages, raw material, etc.:
A. are variable.
B. are fixed.
C. vary with the lag.
In the very short-run aggregate supply (VSRAS) curve, it is assumed that all the prices or input costs
are considered fixed which is why producers can increase or decrease the output without affecting
prices.
T he VSRAS curve is perfectly elastic.
79
Q.1472 Which of the following is perfectly inelastic?
A. Very short-run aggregate supply curve (VSRAS)
B. Short-run aggregate supply curve (SRAS)
C. Long-run aggregate supply curve (LRAS)
It is assumed that all wages and input prices vary in the long run, so there is no supply effect. T he
LRAS curve is perfectly inelastic.
T he short-run and the very short supply curves are a lot more elastic. It is assumed that the prices
or input costs in the short run and the very short run are fixed. T herefore, producers can increase
or decrease the output without affecting prices.
Q.1474 T he impact of a pessimistic view of declining future sales in Iraq will most likely :
A. shift the Iraqi aggregate curve to the right.
B. create a movement upward along the Iraqi aggregate demand curve.
C. shift the Iraqi aggregate demand curve to the left.
If the businesses have a pessimistic view, then they will not make further investments, thus
decreasing the aggregate demand and shifting the AD curve to the left.
A is incorrect. An increase, and not a decrease in demand, will shift the aggregate demand curve to
the right.
B is incorrect. Changes in price cause changes along the aggregate demand curve.
80
Q.1476 Which of the following is most accurate regarding expansionary monetary policies?
A. Money supply decreases while aggregate demand increases.
B. Money supply increases and aggregate demand also increases.
C. Money supply increases while aggregate demand decreases.
T he purpose of an expansionary monetary policy is to increase the supply of money in the economy;
this is done by lowering interest rates, decreasing reserve requirements, and buying securities from
the public through the central bank. Lower interest rates will encourage more borrowing. As a
result, businesses and individuals will have more money to invest and spend, leading to increased
aggregate demand.
Q.1477 What will be the impact on the aggregate supply curve of Canada if the government decides
to increase taxes and decrease the maximum labor hours per day (holding the wages and labor
constant)?
A. Decrease in the aggregate supply
B. Increase in the aggregate supply
C. Both decisions have different impacts on aggregate supply
An increase in taxes will increase input prices. T hus, producers will produce less output. A decrease
in labor hours (holding wages and labor constant) will decrease productivity, decreasing the aggregate
supply.
81
Q.1478 In the long run, equilibrium prices are at $240. What would be the economic term used for a
situation where short-term prices are at a disequilibrium at $220?
A. Recessionary gap
B. Inflationary gap
C. Expansionary gap
In a recessionary gap, prices are below the long-run equilibrium prices. T he supply of goods and
services is in excess of the aggregate demand.
B and C are incorrect. An inflationary or expansionary gap occurs when the real output is greater
than the potential output. In this case, it would have been an inflationary/expansionary gap if the
short-term prices would have been greater than $240.
Q.1479 Which of the following conditions will put upward pressure on prices?
A. Recessionary gap
B. Inflationary gap
C. Long-run prices gap
When an inflationary gap occurs, the price level of goods and services will rise to make up for the
increased demand and insufficient supply. T his rise in prices is called demand-pull inflation.
82
Q.1480 Which of the following is the appropriate measure when investors are expecting a decrease
in the aggregate demand?
A. Increase investment in defensive firms
B. Increase investment in cyclical companies
C. Decrease investment in long-maturity fixed income securities
When investors expect a decrease in the aggregate demand, they should increase investments in
defensive companies (companies that remain afloat even during economic contractions) and long-
maturity fixed income securities and decrease investments in cyclical companies.
B is incorrect. When expecting a decrease in aggregate demand, Investors should decrease their
investments in cyclical companies (Companies that are in demand only when the economy is doing
well).
C is incorrect. Investors should increase their investments in long-maturity fixed income

investments if they expect a decrease in aggregate demand. T hat way, Investors are assured of
earning interests, in addition to getting their investments back at a later date, probably after the
economy has stabilized, and aggregate demand is back to normal.
Q.1481 High unemployment and increased inflation due to an unexpected sharp decrease in the
aggregate supply is called:
A. deflation.
B. stagflation.
C. recession.
Stagflation is a combination of both stagnation and inflation.

In stagflation, sharp declines in aggregate supply cause an increase in prices (increased inflation) and
decreased economic growth and production. In return, this decreases the rate of employment.
A is incorrect. Deflation is negative inflation and not increased inflation.
C is incorrect. During a recession, there is high unemployment, but there is not increased inflation.
Recession is more like consecutive periods of economic decline.
83
Q.1482 Which of the following describes a situation where the short-run real GDP is less than the
full employment GDP on the long-run aggregate supply (LRAS)?
A. Recessionary gap
B. Expansionary gap
C. Inflationary gap
When real GDP is below full employment GDP, it is called a recessionary gap or output gap.
T herefore, the ''expansionary gap'' is the least likely option.
An expansionary gap occurs when the real GDP is above the full employment or the potential GDP.
Q.1483 Which of the following functions describes the relationship between aggregate output, labor,
capital, and productivity?
A. Supply function
B. Factors of production
C. Production function
T he production function describes the relationship between aggregate output, labor, capital, and
productivity. Mathematically, it is written as:
Y = A × f (L , K)
Were A stands for total factor productivity, K for capital, and L for labor.
84
Q.1484 Which of the following is the most appropriate definition of the total factor productivity
(T FP)?
A. It is a multiplier that quantifies the amount of output growth that an increase in capital and
labor cannot explain.
B. It describes the relationship between aggregate demand and labor, capital, and productivity.
C. It is the modified version of the production function.
Total factor productivity is a multiplier in the production function quantifying the output growth that
an increase in capital and labor cannot explain.
Mathematically, the production function is written as:
Y = A × f (L , K)
Were A stands for total factor productivity, K for capital, and L for labor.
Q.1486 Assume that the labor's percentage share in national income is 65% for a specific country. If
the growth in technology, labor, and capital are 1%, 2%, and 3% respectively, then the growth in
potential GDP is closest to:
A. 6%.
B. 3.35%.
C. 4.5%.
Growth in potential GDP depends on the rate at which technological advances, labor, and capital
grow, as summarized in the equation below:
Growth in potential GDP = Growth in technology + W L(growth in labor) + W C(growth in capital)
Growth in potential GDP = 1% + (0.65 × 2%) + (0.35 × 3%) = 3.35%
85
Q.1487 Which of the following measures would most likely be necessary for a country with a ''high
capital per labor'' to increase the growth in its GDP?
A. Increased growth in technology
B. Increased capital
C. Increased productivity
In developed countries where capital per labor is high, an economy will experience diminishing
marginal productivity. For these countries, economists argue that growth in GDP can only be
achieved by growth in technology.
Q.2470 US Presidential candidate, Donald T rump, has promised to build a wall across the US-Mexico
border and to deport all illegal workers currently living in the country. In terms of the aggregate
supply dynamics, the most likely result of this policy in the current economic environment would
be:
A. a leftward shift in the US aggregate supply curve resulting in a higher price level.
B. a leftward shift in US aggregate demand resulting in a lower price level.
C. a rightward shift in aggregate supply resulting in higher real output.
T he reduction of the labor force would be a supply shock, moving aggregate supply leftward.
86
Q.3162 You have been provided the following table:
20X8 20X9
Nominal GDP 1, 602, 309 1, 601, 210
Real GDP (Constant 20X2 dollars) 1, 324, 222 −
Implicit GDP Price deflator 121 119
Based on the information presented, which of the following statements is correct when comparing
20X9 to the previous year?
A. Nominal GDP decreased, while real GDP decreased by a smaller amount.
B. Nominal GDP decreased, in part because of deflation, while real GDP rose.
C. Nominal GDP decreased while real GDP fell slightly due to inflation.
Real GDP 20X9 = Nominal GDP/Price deflator × 100 = 1,601,210/119 × 100 = 1,345,555.
T herefore, we can see that the economy grew, in real terms.
A and C are both incorrect. Real GDP increased from 1,324,222 in 20X8 to 1,345,555 in 20X9.
Q.3163 If real GDP decreased from one year to the next, it must be the case that:
A. prices rose more than output increased.
B. prices decreased more than the output decreased.
C. the actual quantity of goods produced decreased.
T he computation of real GDP is specifically designed to rule out the effects of price changes.
T herefore, if real GDP decreased, the actual quantity of goods produced decreased.
87
Q.3164 If nominal GDP decreased, then it must be the case that:
A. prices fell, and actual output either increased or decreased.
B. real GDP must have also decreased.
C. real GDP may have changed little, increased or decreased.
Either a decline in real GDP or a decrease in the price level, ceteris paribus, will cause a decrease in
nominal GDP. If both real output and prices change in opposite directions, then a decrease in nominal
GDP will result as long as a decline in price or a decline in real output is larger in magnitude than any
change that would, by itself, increase nominal GDP. For example, a 5% increase in the price level
accompanied by an 8% decrease in real output will decrease nominal GDP.
Q.3165 In Canada, real GDP fell by 6 percent for the year 2000. If nominal GDP decreased by 7
percent, then it must be that:
A. the implicit GDP deflator also decreased by about 1 percent.
B. the implicit GDP deflator increased by about 1 percent.
C. the implicit GDP deflator decreased by 8 about percent.
In order for nominal GDP to decrease more than real GDP, the additional decrease must be explained
by a drop in the price level. In this case, a decrease in the implicit GDP deflator of approximately
one percent is sufficient to explain the 7 percent decrease in nominal GDP.
Note to candidates: It is a helpful practice to convince yourself by constructing the following
example: Set year one real GDP, nominal GDP and implicit price deflator equal to 100. Following the
question above, set nominal GDP and real GDP equal to 93 and 94, representing 7 percent and 6
percent respective changes in nominal and real GDP. Calculate the implicit GDP deflator as:
Nominal GDP/Real GDP * 100 = 98.9 ≈ 99, or a 1 percent decrease from the base year value of 100.
88
Q.3166 A small island nation has a nominal GDP equal to 100 million. Real GDP is reported as 95
million. T he implicit GDP deflator for this country is approximately equal to:
A. 105.3.
B. 95.0.
C. 104.1.
Implicit price deflator = Nominal GDP/Real GDP * 100 = 105.26 ≈ 105.3.
Q.3167 T he tiny island nation of Barbados has a fixed exchange such that its currency, the Barbados
dollar, is held at a value of B$2 = US$1. T his means that any change in the real GDP of Barbados
must:
A. be explained by changes in domestic output.
B. be a result of changes in the implicit US GDP deflator and local real GDP.
C. be a result of changes in domestic prices only.
T he estimate of real GDP is intended to remove the impact of changes in prices, so the fact that it
has a fixed exchange rate is not really relevant. Candidates should, however, note that tying the local
currency to the US dollar also means that the country will experience US inflation.
89
Q.3168 T he national accounts of a small economy contain the following information (in millions of
R$):
Consumer spending on final goods and services 700

Gross private domestic investment 300
Government spending on final goods and services 270
Exports 35
Imputed income from owner-occupied housing 2
Net Exports −10
T he GDP of this economy is closest to:
A. R$1,302 million.
B. R$1,303 million.
C. R$1,260 million.
GDP = C + I + G + (X − M)
= 700 + 300 + 270 + (−10)
= 1, 260
Candidates should note that the purpose of the amount for imputed income from owner-occupied
housing is to create confusion. T he amount is not part of the above GDP formula and should not be
included in the GDP calculation. T he amount for exports should equally not be included because it
has already been factored in net exports.
Net exports = Exports − Imports
90
Q.3169 In Canada, national income and GDP are distinguished on the following basis:
A. GDP = National income + Statistical discrepancy
B. National income = GDP + Statistical discrepancy + Capital consumption allowance
C. GDP = National income + Capital consumption allowance + Statistical discrepancy
Note to candidates: Be aware that not all countries allocate the statistical discrepancy that arises
from differences between the income-based and expenditure approaches to calculating GDP in the
same manner that Statistics Canada does.
Q.3170 In Canada, personal disposable income equals:
A. personal income minus indirect business taxes minus personal income taxes.
B. personal income minus personal taxes.
C. personal income minus housing costs and personal taxes.
By definition, personal disposable income equals personal income minus personal taxes.
91
Q.3171 Given the following representations:
S = domestic savings
I = investment
G = government expenditures on goods and services
T = taxes
X = exports
M = imports
C = Consumption
Which of the following three statements is correct?
A. S = I + (G-T ) + (X-M)
B. S = C + I + (G-T ) + (X-M)
C. C = S + I – (G-T ) – (X-M)
T his represents the fundamental relationship between savings, investment, the fiscal balance, and
the trade balance.
T he easiest way to remember this is by remembering that a government can use its savings to
invest, finance government deficits, or finance trade deficits.
S = I + (G − T ) + (X − M)
92
S = domestic savingsI = investment
G = government expenditures on goods and services
T = taxes
X = exports
M = imports
F = transfer payments
A. S = C + I +F + (G-T ) + (X-M)
B. C = S + I + F – (G-T ) – (X-M)
C. S = I + (G-T ) + (X-M)
the trade balance.
T he easiest way to remember this is by remembering that a government can use its savings to
invest, finance government deficits, or finance trade deficits.
S = I + (G − T ) + (X − M)
Q.3173 Economists distinguish between the long-run and short-run aggregate supply curves, to
distinguish between:
A. the (short-term) one-year planning horizon and the longer-term future.
B. the short term in which capital is fixed versus the time over which capital is variable.
C. the short term over which workers cannot adjust to wage changes versus the longer-term
over which expectations and wages can reach equilibrium.
T his is not defined in absolute terms but it indicates that in the short run, one cannot overnight build
new plants and make radical changes to the quantity of equipment. In the long term, however, all
factors of production are variable.
93
Q.3174 In 2007, housing prices dropped almost overnight as a result of what some economists
referred to as a correction from prices that formed in a market bubble. Financial assets also dropped
in value. T he subsequent changes in GDP could be best explained as:
A. a movement along the aggregate demand (AD) curve to a lower price level and less output.
B. a shift in the aggregate supply (AS) curve, such that supply decreased at all price levels.
C. a leftward shift in the aggregate demand (AD) curve as a consequence of reduced wealth.
Investors who already owned homes saw the equity in their homes and their retirement investment
portfolios shrink. T herefore, simply put, they were less willing to make purchases. T his evaporation
of consumption spending was a driver of the recession that followed.
Q.3175 Capacity utilization is at very high levels, nearing 90 percent, and companies are
experiencing an inability to meet order delivery deadlines. In light of this, we would expect:
A. a rightward movement along the aggregate supply curve to meet the demand.
B. a rightward shift in the aggregate demand curve as firms increase investment spending.
C. a leftward shift in the aggregate demand curve as consumers reduce spending due to higher
price levels.
Capacity utilization is the extent to which an enterprise uses its installed productive capacity. T he
relationship between output produced with the installed equipment and the potential output produced
with it if capacity was fully used.
T he evidence from the US Federal Reserve and OECD countries indicates that as capacity utilization
reaches 80 to 85 percent, the additional investment spending by firms shifts the aggregate demand
curve to the right.
94
Q.3176 All else equal, an increase in income taxes will cause a:
A. leftward movement along the aggregate demand curve as consumers reduce spending.
B. rightward shift in the aggregate demand curve as businesses adjust by passing along any tax
consequences in the form of higher prices.
C. leftward shift in aggregate demand since consumption spending will be diverted to paying
taxes.
Consumption expenditures are a large portion of aggregate demand, and any increase in taxes leaves
less disposable income to purchase goods and services. Consequently, the aggregate demand curve
shifts to the left.
A is incorrect. Changes in price cause movements along the demand curve.
B is incorrect. A rightward shift in the aggregate demand curve implies that demand has increased. If
the taxes had been reduced, then there would have been a rightward shift in the aggregate demand
curve.
Q.3177 Increasing the money supply is most likely to:
A. increase output in the near term but serve only to increase prices in the longer term.
B. have no immediate effect on output but only decrease prices since there is more money
circulating in the economy.
C. simply increase the rate of inflation with no effect on the level of output.
In simple terms, the expansionary monetary policy stimulates demand in the near term, but in the
long term, the output will return to the long-term natural level, and only the inflationary effect on
price levels will remain.
95
Q.3178 As the Chinese economy grows, we would expect that it would cause:
A. the US aggregate demand to shrink as domestic goods are replaced by Chinese goods.
B. the Japanese aggregate demand to shift right as Chinese consumers import more Japanese
goods.
C. Australian exports to shrink and Australian aggregate demand to shift left.
As the Chinese economy expands, Chinese consumers demand more goods, including imports from
Japan. T his increases the net exports of Japan, shifting aggregate demand to the right in Japan.
Q.3179 All else equal, an increase in the training and skill of the available labor force will:
A. shift the aggregate demand curve to the right.
B. shift the aggregate supply curve to the right.
C. cause a movement along the aggregate supply curve.
Presumably, a more skilled labor force will be more efficient and more productive. Consequently,
they will be able to produce more output. T his will shift the aggregate supply curve to the right.
A i s i ncorrect. Demand is not affected by workers’ skills.
C i s i ncorrect. Movements along the supply curve are caused by changes in prices.
96
Q.3180 An increase in aggregate demand will most likely :
A. raise real GDP, lower the unemployment rate, and lower the aggregate price level.
B. raise real GDP, lower the unemployment rate, and raise the aggregate price level.
C. raise real GDP, raise the unemployment rate, and lower the aggregate price level.
T his is easily understood as a rightward movement in the aggregate demand curve.

In simple terms, if demand increases, more workers will be needed to meet the increasing demand,
thus lowering the unemployment rate. Increased demand for goods and services will lead to an
increased price and a higher GDP.
Q.3181 A decrease in aggregate supply will most likely:
A. lower real GDP, lower the unemployment rate, and lower the aggregate price level.
B. lower real GDP, lower the unemployment rate, and raise the aggregate price level.
C. lower real GDP, raise the unemployment rate, and raise the aggregate price level.
Less production requires fewer employee hours, resulting in higher unemployment. If aggregate
supply shifts left, ceteris paribus, equilibrium will occur at a lower output and a higher price level
(demand for the few available goods and services will put upward pressure on the prices of the goods
and services.)
Q.3182 A rightward shift in both aggregate demand and aggregate supply will most likely :
A. raise real GDP and lower the aggregate price level.
B. raise real GDP and raise the aggregate price level.
C. raise real GDP and have an indeterminate effect on the aggregate price level.
A rightward shift of the aggregate supply curve will lower the aggregate price level. A rightward shift
in the aggregate demand curve will have the opposite effect. If both curves shift, we need to know
the magnitude of the shifts to be able to assess which effect will dominate.
97
Q.3183 A decrease in aggregate supply will most likely :
A. raise real GDP and lower the aggregate price level.
B. lower real GDP and raise the aggregate price level.
C. lower real GDP and lower the aggregate price level.
T his is easily understood as a leftward movement in the aggregate supply curve.

Less production requires fewer employee hours, resulting in higher unemployment. If aggregate
supply shifts left, ceteris paribus, equilibrium will occur at a lower output and a higher price level
(demand for the few available goods and services will put upward pressure on the prices of the goods
and services.)
Q.3184 If the economy is currently experiencing very low unemployment, an upward pressure on
prices accompanied by some shortages in production and supply commitments being met by depleting
inventories, then the economy is currently best characterized as:
A. at its long-run full employment equilibrium.
B. experiencing a short-run recessionary gap.
C. experiencing a short-run inflationary gap.
In the short run, the economy can produce above its long-run equilibrium output level by using
overtime and or running down inventories. T his condition, where the economy faces upward
pressure on prices and is surpassing its long-run equilibrium output level, is by definition, an
inflationary gap.
98
Q.3186 An economy is currently experiencing a combination of very low, or possibly negative
growth, and a rising price level. T his economy is best characterized as being:
C. experiencing short-run stagflation.
During the Carter administration, the US experienced a prolonged period of stagflation driven by the
wage-price spiral. Supply shocks had driven the AS leftward, and in this new reality, the economy
was close to full employment. Demands for wage increases served only to further drive up prices
with little to no accompanying increase in output.
As can be seen by the following graph, stagflation leads prices higher while output decreases.
Q.3187 An economy is currently operating below its potential output level. T his economy is best
characterized as being:
C. experiencing a short-run inflationary gap.
An economy currently operating below its potential output level is the definition of a recessionary
gap.
99
Q.3188 Suppliers in an economy are meeting demands for their products by reducing inventories of
finished goods and running overtime shifts. T he resulting economy is best characterized as:
A. operating at its full employment equilibrium.
B. operating at a short-run equilibrium in excess of the long-run full employment level.
C. operating at a long-run equilibrium in excess of the long-run full employment level.
In the short run, producers can meet the growing demand by drawing down inventories or putting in
overtime. In the long run, this cannot be sustained and will place upward pressure on the price level
and or encourage additional capital investments to meet the higher level of demand.
Q.3189 Suppliers in an economy are facing reduced demands for their products. Consequently, they
are accumulating inventories of finished goods and or reducing employee hours. T he resulting
economy is best characterized as:
A. operating at its full employment equilibrium.
B. operating at a short-run equilibrium below the long-run full employment level.
C. operating at a long-run equilibrium below the long-run full employment level.
T his is a recessionary gap. In the short run, producers adjust to reduced demand by building up
inventories of finished goods, or shortening worker hours. In the long run, this cannot be sustained
and will place downward pressure on the price level and encourage reductions in capital, or at least
reductions in additions to capital to adapt to the lower level of demand.
100
Q.3190 Economic growth is most likely defined as measuring the percentage change in:
A. real GDP.
B. per capita real GDP.
C. real GDP or per capita real GDP.
Growth in the overall economy is captured as the measure of changes in real GDP. Changes in per
capita GDP indicate changes in the ability of the average person to buy goods and services or as an
indicator of the standard of living.
Q.3191 Improvements in educational and training attainment within a country are most likely to:
A. increase aggregate demand.
B. increase productive efficiency and real GDP per capita.
C. reduce aggregate supply due to demands for higher wages.
If any input, or the use of any input, becomes more efficient, then this results in a rightward shift in
aggregate supply and growth in real GDP. Without simultaneously increasing the population, the
output per capita, or real GDP per capita, will also increase.
Q.3192 Increases in capital investments are likely to:
A. increase aggregate demand.
B. increase productive efficiency and real GDP per capita.
C. reduce aggregate supply due to demands for higher wages.
Capital investments are a company’s investments in permanent fixed assets. With additional capital,
each worker hour will be more productive, which will increase output and output per worker. With
greater production in terms of real GDP per worker, workers will also experience an increase in
their living standards.
101
Q.3193 Increases in immigration to a country are likely to result in:
A. reductions in aggregate demand.
B. reduced aggregate supply and reduced real GDP per capita.
C. increased aggregate supply and growth in real GDP.
Increasing the labor supply due to additional immigration will provide a rightward shift in aggregate
supply just as the addition of any other productive resource would generate. T his results in an
expansion of equilibrium real GDP. Candidates should also give some thought to what effect additional
immigration will have on aggregate demand and its consequences on real output levels in equilibrium.
Q.3194 Relatively small increases in capital investment in developing economies with large
populations, such as China in the 1990s, are most likely to produce:
A. large percentage increases in real GDP.
B. very large percentage increases in GDP per capita growth rates in the long term.
C. very large nominal increases in GDP per capita.
If an economy has a low output level, then a minor improvement in production has a large
percentage impact. To illustrate, if you have a million dollars, presenting you with another dollar has
a near-zero impact on your wealth. But, if you have only one dollar and are presented with another
dollar, that is a one hundred percent improvement in your wealth. China has a very large population
and, in the past, had comparatively little capital.
102
Q.3196 Sustained growth in real GDP per capita requires:
A. continuous large additions to the capital stock and to the population.
B. continuous large additions to the capital stock.
C. continuous technological improvements to increase factor productivity.
On a per-capita basis, the only means of continually increasing GDP is to improve factor productivity,
via technological improvements to capital or labor.
Q.3197 T he sustainable GDP per capita growth rate in a developing economy:
A. will always exceed that of a developed country due to its low capitalization.
B. will, in the long run, be the same as that of a developed economy.
C. exceed the short run growth rates typically achieved by adding to their capital stock.
Initially, developing countries can experience large rates of growth since they are likely to be
undercapitalized. In the long run, wealth improvements across all countries will tend to converge,
limited by rates of technological improvement and the optimal mix of labor and capital.
Q.3198 Sustainable growth rates in GDP:
A. cannot exceed the rate of growth of total factor productivity.
B. can increase dramatically with the development of technological improvements.
C. can be increased by additional increments to capital and labor.
Without any improvements in factor productivity, growing the economy simply by proportionally
increasing all inputs can be sustainable only until physical limits on any natural resources or other
inputs are encountered. However, if the productivity or efficiency of the productive factors can be
improved through technology, then a new sustainable growth rate can be achieved.
103
Q.3263 In Mexico, real GDP rose by 6 percent for the year 20X5. If nominal GDP increased by 7
percent, then it must be that:
A. the implicit GDP deflator also decreased by about 1 percent.
B. the implicit GDP deflator increased by about 1 percent.
C. the implicit GDP deflator increased by about 8 percent.
In order for nominal GDP to increase more than real GDP, the additional increase must be explained
by an increase in the price level. In this case, an increase in the implicit GDP deflator of
approximately one percent is sufficient to explain the 7 percent increase in nominal GDP.
Note to candidates: It is a helpful practice to convince yourself by constructing the following

example: Set year one real GDP, nominal GDP, and implicit price deflator equal to 100. Following the
question above, set nominal GDP and real GDP equal to 107 and 106 to represent the 7 percent and 6
percent respective changes in nominal and real GDP. Calculate the implicit GDP deflator as:
Nominal GDP/Real GDP * 100 = 100.9 ≈ 101, or a 1 percent increase from the base year value of
100.
104
Q.3264 You have been given the following table:
20X5 20X6
Nominal GDP 1,373,845 1,450,647
Real GDP (Constant 2002 dollars) 1,248,950 1,283,758
Implicit GDP Price deflator - -
Based on the information presented, the implicit price deflators for 20X5 and 20X6 are closest to:
A. 91 and 88, respectively.
B. 89 and 92, respectively.
C. 110 and 113, respectively.
Real GDP = Nominal GDP * 100/GDP price deflator.
GDP price deflator = Nominal GDP/Real GDP * 100
GDP price deflator20X5 = 1,373,845/1,248,950 * 100 = 110
105
S = domestic savings I = investment
G = government expenditures on goods and services T = taxes
X = exports M = imports
F = transfer payments
A. C = S + I +F + (G-T ) + (X-M)
B. C = S + I + F + (G-T ) – (X-M)
C. S = I + (G-T ) + (X-M)
the trade balance.
To remember this much better, remember that a government uses its savings for either of the
following three reasons: to invest (I), to finance government deficits (G-T ), or to finance trade
deficits (X-M).
106
Q.3269 You have been given the following table:
20X7 20X8
Nominal GDP 1, 530, 600 1, 602, 309
Real GDP (Constant 2002 dollars) 1, 308, 205 1, 324, 222
Implicit GDP Price deflator - -
Based on the information presented, the implicit price deflator for 20X7 and 20X8 are closest to:
A. 117 and 121, respectively.
B. 113 and 115, respectively.
C. 110 and 113, respectively.
Real GDP = Nominal GDP * 100/GDP price deflator

GDP price deflator = Nominal GDP/Real GDP * 100.
GDP price deflator20X7 = 1,530,600 /1,308,205 * 100 = 117
107
Reading 11: Understanding Business Cycles
Q.180 Which one of the following is least likely a stage of the business cycle?
A. Peak.
B. Growth.
C. Contraction.
T he growth phase is a phase of the industry life cycle, which is mentioned in Equity Investments –
Introduction to Industry and Company Analysis.
Options A and C are correctly depicted as phases of the business cycle. T he four phases of the
business cycle are:
1. Expansi on: defined by the growth of global economic activity. Its features include
economic growth, upward pressure on prices, and an increase in employment.
2. Peak : represent the highest value reached by some quantity in a certain period of time. A
peak is discovered when the economy produces the highest output, inflation pressures
prices to rise, and the unemployment rate is at its lowest.
3. Contracti on: happens when there’s negative economic growth or an economic decline.
Prices decline and the unemployment rate increases.
4. Trough: defined as the lowest points of business cycles. Here, the economy has hit a rock
bottom out of which the next expansion phase will emerge.
108
Q.181 An economy in deflation is most likely :
A. An economy where inflation decreases over time.
B. An economy with consistently negative inflation growth.
C. an economy with slow economic growth occurring simultaneously as high rates of

inflation.
An economy in deflation is an economy with a consistently negative inflation growth. It is a decrease

in the price level due to a reduced supply of money in an economy. During a period of deflation, the
inflation rate falls below 0%.
A i s i ncorrect. An economy where inflation decreases over time is called an economy in
disinflation.
C i s i ncorrect An economy with slow economic growth occurring simultaneously as high inflation
rates is known as stagflation.
109
Q.182 Which of the following statements is least likely accurate?
A. T he employment rate is the percentage of the labor force that is employed.
B. T he labor force is comprised of all of the members of a particular population who are able
to work.
C. If the labor force participation rate declines and the number of people unemployed
remains unchanged, the unemployment rate will decrease.
Let's first define our ratios:
No. of unemployed persons

Unemployment rate =
Labor force
Labor force
Labor force participation rate =
Adult population
T herefore, if the denominator (Labor force) of the unemployment rate decreases and the numerator
(Number of people unemployed) remains unchanged, the unemployment rate will i ncrease.
Exam tip: Use examples with numbers! Let say,
No of unemployed 1
Unemployment rate = = = 10%
Labor force 10
Now, the Labor force declines, therefore the Unemployment rate now equals 1/9 = 11%. We can
see that the unemployment rate has increased. T hus, "the unemployment rate will decrease" is the
least likely option.
Q.1012 T he key indicators of the current phase of the business cycle is most likely :
A. Unemployment and GDP.
B. Inventory levels and GDP.
C. Unemployment and inventory levels.
Unemployment and GDP are key indicators of the current phase of the business cycle. T hey can be
seen simultaneously as the size of the economy expands or contracts.
B and C are i ncorrect. Inventory levels are important but are not a key indicator of the current
phase of the business cycle.
110
Q.1013 When the economy bounces back from a prolonged period of contraction, the inventory
turnover ratio of most companies will most likely :
A. Start to increase.
B. Start to decrease.
C. Remain unchanged.
T he trough is defined as the lowest point of business cycles. Here, the economy has hit rock
bottom, out of which the next expansion phase will emerge. Sales will increase, and accumulated
inventories will be depleted. T herefore, the inventory turnover ratio (Sales/Avg. inventory) will
increase over the following years.
B i s i ncorrect. Inventory turnover will not start to decrease because sales will increase, and from
the inventory turnover ratio (Sales⁄(Avg. inventory)), an increase in sales will increase the inventory
turnover ratio.
C i s i ncorrect. Both the numerator and the denominator of the inventory turnover ratio will
change; subsequently, the ratio is also expected to change.
Q.1014 Which of the following is least likely an effect of hyperinflation?
A. Borrowers gain at the expense of lenders.
B. T he public transfers wealth to the government.
C. Reduction in the amount of real private and public debt.
Reduction in the amount of real private and public is not an effect of hyperinflation but an advantage
of inflation.
A i s i ncorrect. Borrowers gaining at the expense of lenders is an effect of hyperinflation. For
interest rates on fixed rates remain steady for the duration of the loan term. T his means the monthly
repayments remain the same and consume a smaller percentage of business revenue than in the past.
B i s i ncorrect. Hyperinflation transfers wealth from the general public, which holds money, to the
government, which issues money.
111
Q.1015 If a country's domestic currency appreciates relative to foreign currencies, exports will
most likely :
A. Increase.
B. Decrease.
If a country's domestic currency appreciates, goods become more expensive to foreign buyers,
resulting in exports decreasing.
A i s i ncorrect. If a country’s domestic currency depreciates relative to foreign currencies,
exports will increase.
C i s i ncorrect. Exports will remain unchanged if the domestic currency remains unchanged
relative to foreign currencies.
Q.1016 What happens during the peak of the business cycle?
A. Inflation increases; consumer spending and investment increase at an increasing rate.
B. Inflation increases; consumer spending and investment increase at a decreasing rate.
C. Inflation decreases; consumer spending and investment increase at an increasing rate.
An increasing GDP makes consumer spending and investment increase but at a decreasing rate. As
consumer demand increases, price increases, and inflation increases. A peak is discovered when the
economy produces the highest output, inflation pressures prices to rise, and the unemployment rate
is lowest.
112
Q.1018 An aircraft technician in Morocco resigned from his job 6 months ago and has been looking
for a new job ever since. T he technician has handed his resume to 4 other aircraft maintenance
firms. T his situation most likely refers to:
A. Cyclical unemployment.
B. Frictional unemployment.
C. Structural unemployment.
Frictional unemployment results from the time lag necessary to match employers with specific
employee needs.
A i s i ncorrect. Cyclical unemployment is a type of unemployment related to the cyclical trends in
the business cycle, most often the results of a decrease in demand.
C i s i ncorrect. Structural unemployment occurs when workers are unable to fill available jobs
because they lack the necessary skills required by the firms in the economy.
113
Q.1020 You have been provided the following table:
Price 20X5 Price 20X6 Quantity (in million)

Onion 2 3 200
Potato 1 2.5 50
Wheat 3 4 100
T he consumer price index (CPI) is closest to:
A. 25.44
B. 129.44
C. 150.00
To find the CPI in any year, divide the cost of the market basket in year t by the cost of the same
market basket in the base year.
(Cost of basket 20X6)

CPI = × 100
(Cost of basket 20X5)
3 × 200 + 2.5 × 50 + 4 × 100

= × 100
2 × 200 + 1 × 50 + 3 × 100
1125
= × 100
750
= 150
Q.1021 When expected wage inflation is high in the short term, output will most likely :
A. Increase.
B. Decrease.
C. Remain unchanged/no direct effect.
Expected wage inflation increases operating costs for the firms in the economy. T his puts upward
pressure on wages, which shifts the short-run aggregate supply (SRAS) to the left. T hus, prices
increase and output decreases.
114
Q.1022 Which of the following is a leading economic indicator?
A. Consumer price index.
B. Average weekly hours worked in manufacturing.
C. Employment creation in non-agricultural sectors.
Hours worked are thought to be a leading indicator of future change in the economy. Firms adjust to
demand changes by adding (reducing) hours worked instead of hiring (laying off) employees in the
short term.
A i s i ncorrect. Consumer price index is a lagging economic indicator.
C i s i ncorrect. Employment creation in non-agricultural sectors is a coincident economic indicator.
Q.1023 In the long run, when money supply increases, real GDP most likely :
A. Increases.
B. Decreases.
C. Remains unchanged.
Money neutrality implies that changes in the money supply only affect nominal variables such as
wages, price levels, and the exchange rate. According to the Quantity T heory of Money, an increase
in the money supply does not affect the real output of an economy or the speed with which money
changes hands. However, it will cause nominal prices to increase.
115
Q.1525 In which of the following phases of the business cycle is economic growth most likely slow
but positive?
A. Peak
B. T rough
C. Expansion
When businesses are in the peak phase, consumer spending, business investment, and employment
are slow but positive.
B i s i ncorrect.T he trough is defined as the lowest point of business cycles. Here, the economy
has hit rock bottom, out of which the next expansion phase will emerge. T he economic growth rate,
demand and supply of goods, and employment rate reach their lowest possible level at this phase.
C i s i ncorrect During expansion, the economic indicators such as employment, demand, and supply
of goods, income, and wages, grow significantly during the expansion stage.
Q.1526 T he business cycle phase which is followed by the recovery phase is most likely known as:
A. T rough.
B. Expansion.
C. Contraction.
When contraction declines and reaches a trough, then the economy begins its expansion phase.
B i s i ncorrect. T he expansion phase is followed by the peak phase
C i s i ncorrect. T he contraction phase is followed by the trough phase.
116
Q.1527 When inventories start to accumulate, the inventories-to-sales ratio reaches its above-
normal level. Which phase of the business cycle is most likely associated with an increased
inventories-to-sales ratio?
A. Peak
B. T rough
C. Expansion
When the economy reaches its peak phase, sales start decreasing, and inventories start
accumulating. In this phase, the inventories-to-sales ratio is at its highest level.
Q.1529 T he school of thought where economists believe the economy has a high tendency to
perform at its full-employment equilibrium and where business cycles are short-term deviations
from the long-term full employment is most likely known as:
A. Monetarist school.
B. T he Keynesian school.
C. T he Neoclassical school.
T he neoclassical school of economists believes that the economy has a high tendency to perform at
its full-employment equilibrium and business cycles are short-term deviations from the long-term full
employment.
T he neoclassical analysis depends on the fact that the market will reach equilibrium because of the
availability of the free-market condition, also known as the invisible hands of demand and supply. T his
school of thought believes that in a period of economic contraction or recession, the government
should avoid making policies intended to pull the economy out of recession. Rather, the market
forces should take full effect, for it is through the forces of demand and supply that the economy can
bounce back quickly from the recession. When the economy stabilizes or when all markets clear
and/or when the economy is at equilibrium, supply will equal demand.
A i s i ncorrect. T he monetarist school campaign on maintaining a steady money supply growth.
T herefore, there must be an interplay of monetary and fiscal policy if the economy is to experience
steady growth.
B i s i ncorrect. Keynesian school believes that market forces are insufficient to bring the economy
out of recession. Even if the market forces can alleviate a recession, it won't be easy to achieve in
the short run. Hence in the short run, they support government intervention through fiscal policy to
solve a recession.
117
Q.1530 In which of the following phases of the business cycle is inflation most likely decreasing with
a lag?
A. Peak.
B. Recovery.
C. Contraction.
In the contraction phase, GDP growth, employment, and consumer spending decrease, while inflation
is also decreasing but with a lag. Inflation is a lagging indicator that peaks long after an expansion in
economic activity have ended.
A i s i ncorrect. In the peak phase, economic activity measures show a decelerating rate of growth,
businesses slow their rate of hiring, the growth rate of capital spending growth rate starts to slow
down, and inflation further accelerates.
B i s i ncorrect In the recovery phase, GDP and other measures of economic activity stabilize and
then begin to increase, layoffs slow but the unemployment rate remains high. Business turn to
temporary employees to meet rising product demand. T here is an upturn in consumer and business
spending Inflation remains moderate and may continue to fall.
Q.1531 Which of the following schools of economists applies the utility theory and argues that the
government should not counteract business cycles?
A. Real business cycle theory.
B. Neoclassical and Austrian schools.
C. Keynesian and monetarist schools.
Real business-cycle theory (RBC theory) is a class of new classical macroeconomics models that
applies the utility theory in which expansions and recessions are efficient market responses to
external shocks.
B i s i ncorrect. Neoclassical and Austrian schools argue that the government should not counteract
business cycles, but are not based on utility theory.
C i s i ncorrect. Keynesian and monetarist schools argue that the government should counteract
business cycles.
118
Q.1533 Price levels in Greece have decreased consistently over the past four years from 108 to
102. What is the most appropriate term for the changes in price levels in Greece?
A. Deflation
B. Disinflation
C. Hyperinflation
Deflation involves a fall in price levels due to a reduced supply of money in an economy and a
negative inflation rate.
B i s i ncorrect. Disinflation is simply a reduction in the inflation rate, such as going from 9% one
year to 7% the next year. It occurs when the rate at which the prices are rising is diminishing.
C i s i ncorrect. Hyperinflation is a sudden, excessive, and out-of-control overall price increase in

an economy.
Q.1534 Which of the following is most likely brought about by technological changes that make the
job skills of many workers obsolete?
A. Cyclical unemployment.
C. Structural unemployment.
Structural unemployment is caused by long-term changes in the economy that make the job skills of
many workers obsolete. For example, robots or machinery sometimes replace the human workers
who previously held jobs doing those tasks.
A i s i ncorrect. Cyclical unemployment depends on cycles that occur because of economic growth
and decline.
B i s i ncorrect. Frictional unemployment happens when workers change jobs or transition from
one job to another.
119
Q.1536 Which of the following price indexes measures most likely excludes energy and food items
from the basket for calculation purposes?
A. Core inflation.
B. Headline inflation.
C. Wholesale price index.
Core inflation refers to the price index that excludes energy and food items from the basket for
calculation purposes because food and energy prices are deemed too volatile.
B i s i ncorrect. Headline inflation refers to the inflation rate calculated based on the price index
that includes all goods and services in an economy.
C i s i ncorrect. Wholesale price index reflects the price changes experienced by domestic
producers in a country.
Q.1537 Products used in the calculation of the price index are often improved. As the quality
increases, the prices of these products also increase, thus causing an upward bias in the index.
Which of the following techniques can most likely be used to adjust the index for the quality bias?
A. Fisher index
B. Hedonic pricing
C. Headline inflation
T he hedonic pricing method is used to adjust the index for the quality bias. T his method removes any
price differential attributed to a change in quality by adding or subtracting the estimated value of that
change from the price of the old item.
A i s i ncorrect. T he fisher index is a consumer price index (CPI) used to measure the price level of
goods and services over a given period. It is used to measure the price level and cost of living in an
economy and calculate inflation. T he index corrects for the upward bias of the Laspeyres Price
Index and the downward bias of the Paasche Price Index by taking the geometric average of the two
weighted indices.
C i s i ncorrect.Headline inflation is the inflation rate calculated based on the price index that
includes all goods and services in an economy.
120
Q.1538 Russia's supply of food products has decreased because of the increasing wage rates, input
prices, and duties on imported raw materials. T his shortage of supply has increased the prices of
goods in Russia. Which of the following is most likely associated with the increase in prices due to
the shortage in supply?
A. Cost-pull inflation.
B. Cost-push inflation.
C. Demand-push inflation.
Cost-push inflation is caused by a shortage in the supply of goods due to the increase in input prices.
A i s i ncorrect. T here is no such thing as cost-pull inflation.
C i s i ncorrect. Demand-pull inflation occurs when there is an increase in aggregate demand.
Q.1539 T he basket used for the price index in Tomorrowland was 100 burgers and 150 pizzas last
year. T his year, the basket has increased to 150 burgers and 200 pizzas. Prices for burgers and pizzas
last year were $5 and $6 respectively, while in the current year, the prices have increased to $8 and
$7 respectively.
T he Paasche index for the current year is closest to:
A. 133.33%
B. 152.84%
C. 185.71%
T he Paasche index is calculated as the Laspayer index, but it uses current-period quantity weights
with current and base prices.
150 × 8 + 200 × 7 2, 600

Paasche index = = = 133.33%
150 × 5 + 200 × 6 1, 950
121
Q.1540 Macedonia is a country where an increase in money supply, government spending, consumer
spending, and a high GDP growth rate has shifted the aggregate demand curve to the right of the full
employment GDP curve. T hus, increased demand has increased the price level of goods.
Which of the following is the most appropriate term for changes in price levels in Macedonia?
A. Cost-push inflation
B. Demand-pull inflation
C. Demand-push inflation
Demand-pull inflation occurs when there is an increase in aggregate demand. In demand-pull inflation,
there exists an excess demand for limited goods and services. All four sectors of the economy
compete for the demand of the too few units of goods and/or services available. T herefore, ''too
much money chasing too few goods'' induce inflation.
A i s i ncorrect. Cost-push inflation is caused by a reduction in the aggregate supply caused by a rise
in the cost of production.
C i s i ncorrect. T here is no such thing as demand-push inflation.
Q.1541 Which of the following is most likely a coincident economic indicator?
A. T he Consumer Price Index (CPI)
B. T he Consumer Confidence Index® (CCI)
C. Personal income minus transfer payments
'Personal income minus transfer payments' is a coi nci dent economic indicator because it changes
direction roughly at the same time as peaks and troughs in business cycles.
A i s i ncorrect. T he consumer price index (CPI) is a l aggi ng indicator of inflation.
B i s i ncorrect. Consumer confidence is a l eadi ng indicator according to the Organisation for

Economic Co-operation and Development (OECD).
122
Q.1542 Which of the following is least likely a leading economic indicator?
A. S&P 500 prices.
B. Building permits.
C. T he change in the Consumer Price Index for services.
T he Conference Board is a US industry research organization that computes leading, lagging, and
coincident indicators for the United States and nine other countries plus the Euro area (Eurozone). It
includes the change in the Consumer Price Index for services as a lagging indicator.
A i s i ncorrect Leading indicators help with anticipating cyclical turns up or down and allow
strategists and others to position themselves and their companies in a secure and timely way to
benefit from movements in the economic cycle. S&P 500 prices are a leading indicator because
stock prices anticipate economic turning points, both up and down; their movements offer a useful
early signal on economic cycles.
B i s i ncorrect Building permits are leading indicators because most localities require permits
before a new building can begin. T his gauge foretells new construction activity.
Q.2471 Suppose that the economy is at or very near the full employment level. An increase in
government expenditure for goods and services most likely :
A. Result in stagflation.
B. Result in a short-run equilibrium above the full employment level.
C. Result in a new equilibrium at the full employment level and a higher price level.
Government expenditure, also called public spending, includes all government consumption,
investment, and transfer payments. An increase in government expenditure on goods and services
may lead to an equilibrium where the output level is above full employment in the short run.
Stagnation is a prolonged period of little or no growth in an economy. It is highlighted by periods of
high unemployment and involuntary part-time employment. Stagnation can occur as a temporary
condition, such as a growth recession or temporary economic shock, or as part of a long-term
structural condition of the economy.
123
Q.2472 From 1930 to 1933, the price of bread fell from $0.32/kg to $0.30/kg. T his most likely
represents a period of:
A. Inflation.
B. Deflation.
C. Disinflation.
Deflation is defined as a fall in the general price level. It is a negative rate of inflation.
A i s i ncorrect. Inflation refers to a sustained rise in the overall level of prices in an economy.
C i s i ncorrect. Disinflation is a decrease in the rate of inflation.
Q.2473 For 1981, 1982, and 1983, the year-to-year changes in the Canadian CPI were 10.0, 12.5, and
10.9 percent, respectively. For 1984 and 1985, although prices continued to rise, the year-to-year
changes declined to 5.8 and 4.3 percent, respectively.
T he 1984 and 1985 changes most likely indicate a period of:
A. Deflation.
B. Stagflation.
C. Disinflation.
Disinflation is a decline in the inflation rate, such as from 10% to 5%. Disinflation is very different
from deflation because, during a period of disinflation, the inflation rate remains positive, and the
aggregate price level keeps rising (although at a slower speed).
A i s i ncorrect. Deflation is a decrease in the price level due to a reduced supply of money in an
economy. In deflation, the inflation rate falls below 0%.
B i s i ncorrect. Stagnation is a prolonged period of little or no growth in an economy.
124
Q.2474 Recovery from a recession is most likely to be preceded by:
A. A reduction in building permits issued and manufacturer's new orders for capital goods.
B. An increase in average weekly hours and a reduction in average weekly unemployment

insurance claims.
C. A reduction in the average duration of unemployment and a reduction in consumer credit

outstanding to personal income.
Average weekly hours and average weekly unemployment insurance claims are leading indicators of
the business cycle. An increase in average weekly hours and a reduction in average weekly
unemployment insurance claims signals that the economy is recovering.
Q.3199 An analyst wishing to assess if the economy is moving out of a recession and into the
expansion phase is most likely looking for:
A. A deceleration in the rate of inflation.
B. An upturn in expenditures for housing and consumer durables.
C. A decline in average consumer expectations for business and economic growth.
Upturns in consumer spending, which typically lead the expansion phase of the business cycle, are
more pronounced in housing and consumer durables.
A i s i ncorrect. Inflation decreases during recessions and increases during expansions (recoveries).
C i s i ncorrect. Average consumer expectations for business and economic growth is a leading
indicator. Its decline indicates an impending recession.
125
Q.3200 An analyst wishing to assess whether the economy has reached the peak of the business
cycle would most likely be best advised to look for indications that:
A. Businesses have slowed their rate of hiring.
B. Businesses have begun to purchase heavy equipment.
C. T he economy is showing moderate or possibly falling rates of inflation.
During the expansion phase, businesses ramp up hiring to meet the demands of the expansion. Near
the peak, there is no additional pressure to meet deliveries, and hiring slows down.
B i s i ncorrect. Businesses purchasing heavy equipment is a leading indicator that would show the
end of the depression and the beginning of a recovery.
C i s i ncorrect. Inflation decreases during recessions and increases during expansions (recoveries).
Q.3201 During a recession in a developing country, the national government capitalized a significant
number of infrastructure projects using deficit spending. Which of the following school of economic
thought is most likely to be appropriate in explaining the actions of this government?
A. Keynesian school
B. Monetarist school
C. Neoclassical school
T he Keynesian school of thought is founded on the government's intervention through fiscal policies.
For instance, the national government responds to the recession by using deficit spending to fund
infrastructure projects.
B i s i ncorrect. Monetarism emphasizes the role of governments in controlling the amount of
money in circulation. T hey argue that monetary policy is more effective than fiscal policy.
C i s i ncorrect. T he neoclassical economists favor limited government intervention.
126
Q.3202 T he monetarist view of Milton Friedman would most likely assert that Keynes view
overlooked the important aspect that:
A. Government spending would invariably result in lower interest rates.
B. T he money supply would automatically adjust to compensate for fiscal policy.
C. Any government action would likely occur too late, ultimately making the situation worse.
Friedman recognized the flaw in the Keynesian view that the government could correct all problems.
He foresaw the excessive growth in government and its results and the oversight in Keynesian
theory that there was ultimately a problem with government spending being pushed to excess and
debt servicing costs, creating an economic crisis.
Q.3203 T he monetarist view of Milton Friedman in comparison to the Keynesian view, most likely ,
has:
A. More emphasis on government spending and carefully allocating spending to winners.
B. A greater reliance on markets, and a fear that government is more likely to make things
worse.
C. a reluctance to wait for markets to correct and more emphasis on government actions to
correct imbalances.
Although Friedman acknowledged that it might take time for markets to self-correct, he believed in a
very limited role for government and a strong reliance on the market's invisible hand. He went as far
as advocating the reimplementation of the gold standard to limit the capacity of the central bank – an
extension of government – to adversely impact the economy via monetary policy.
127
Q.3204 T he fundamental monetarist prescription for limiting a recession would most likely be to:
A. Continue to expand the money supply at predictable rates.
B. T ighten credit, reduce M2, and increase government spending.
C. Focus on lowering interest rates and wait for the market to self-correct.
T he mainstay of the monetary theory was a focus on limiting the government's role in response to a
fear that it tended only to make things worse. Government actions should be limited to a predictable
and transparent plan to expand to the money supply at or close to the rate of average growth in GDP.
Q.3205 T he closure of a large steel plant in a medium-sized city will lead to unemployment best
described as:
A. Seasonal unemployment.
C. Long-term or structural unemployment.
Long-term or structural employment. T his has happened in many steel towns where steel companies
found it difficult to compete with foreign suppliers of steel that were using more modern and more
efficient smelting technologies. Since workers who have spent large parts of their lives working at
the steel plant are unlikely to find employment in other industries quickly, they may be unemployed
for a long period.
A i s i ncorrect. Seasonal unemployment refers to the time period when the demand for labor or
workforce is lower than normal under certain conditions; however, such a situation is only
temporary, and employment reverts to normal thereafter.
B i s i ncorrect. Frictional unemployment happens when workers change jobs or transition from
one job to another.
128
Q.3207 An economy that had inflation rates above 40 percent enters a period during which the
inflation rate drops to only 10 percent. T his economy most likely experienced:
A. Deflation.
B. Disinflation.
C. Hyperinflation.
Disinflation is a drop in the rate of inflation.

A i s i ncorrect. Deflation is an overall drop in the price level, which leads to a negative rate of
inflation such as -10%.
C i s i ncorrect. Hyperinflation occurs when the inflation rate exceeds 50% for a period of a month.
Q.3208 Criticisms of the Laspeyres price index, used to estimate inflation rates, include:
A. An upward bias is due to the quality bias.
B. A downward bias due to the new product bias.
C. A downward bias due to the substitution effect.
As products improve over time, the basket of goods used in computing the index will have an upward
bias since it fails to automatically adjust for the increased value as product quality rises.
B i s i ncorrect. T he new product bias results in an upward bias in the inflation rate.
C i s i ncorrect. T he substitution bias leads to an upward bias.
129
Q.3209 Inflation, caused by a supply shock such as that experienced when oil supplies are suddenly
restricted, would be described as:
C. Demand-pull inflation.
As producers respond to the supply shock by passing cost increases along to their customers, the
result is cost-push inflation.
C i s i ncorrect. Demand-pull inflation is when aggregate demand grows rapidly, outpacing aggregate
supply. Economists often refer to this as "too many dollars chasing too few goods."
Q.3210 A rapid increase in demand results in a general rise in prices and, subsequently, in workers
asking for wage increases to compensate for the higher cost of living. T his is most likely known as:
C. Demand-pull inflation.
T he initial increase in demand sets off a spiral of price and wage increases where workers request
wage increases, which producers then pass through in the form of higher prices.
B i s i ncorrect. Cost-push inflation is inflation caused by an increase in prices of inputs such as raw
material and labor. T he question states that there is a "rapid increase in demand," which is why
demand-pull inflation is the most likely answer.
130
Q.3211 Which of the following would most likely provide the basis for an index of leading indicators if
an economy were expected to begin an economic expansion?
A. Average duration of unemployment
B. Employees on nonagricultural payrolls
C. Average weekly hours for manufacturing workers
Businesses tend to adjust the hours of existing workers before hiring new ones in an expansion (or
before laying off current workers at the onset of a recession). Consequently, the average weekly
hours for manufacturing workers measure tend to lead to changes in the business cycle.
A i s i ncorrect. Average duration of unemployment is a lagging indicator.
B i s i ncorrect. Employees on non-agricultural payroll are a coincident indicator.
131
Reading 12: Monetary & Fiscal Policy
Q.865 Which of the following is least likely an effect of an expansionary monetary policy?
A. Price levels decrease.
B. Bonds, equities, and asset prices increase.
C. Banks' short-term lending rates decrease.
An expansionary monetary policy is a monetary policy that is put in place when central banks
believe the economy is slowing and inflation and monetary trends are weakening. An expansionary
policy will increase aggregate demand and, therefore, increase price levels.
B i s i ncorrect. An effect of an expansionary monetary policy is an increase in the prices of bonds,
equities, and assets due to the increase in the money supply.
C i s i ncorrect. A decrease in short-term lending rates is one of the tools that is used to implement
an expansionary monetary policy.
Q.866 A decrease in the inter-bank lending rate will most likely cause:
A. T he domestic currency to depreciate.
B. An increase in inflation and a decrease in employment.
C. A decrease in inflation and an increase in employment.
A decrease in real interest rates causes the currency to depreciate in the foreign exchange market.
As a result, inflation and employment will increase because aggregate demand increases.
132
Q.867 What is the most likely policy response to a high inflation rate due to supply shocks?
A. An expansionary monetary policy.
B. A contractionary monetary policy.
C. T here is no exact policy prescription.
A supply shock is an unexpected event that changes the supply of a product or commodity, resulting
in a sudden change in its price. Supply shocks can be negative (decreased supply) or positive
(increased supply); however, they are almost always negative and rarely positive.
T he two main issues from a supply shock (a recession and high inflation) typically require opposite
policies from a country’s central bank.
To decrease inflation, the central bank could decrease the money supply (increasing the real interest
rate) and reduce aggregate demand, but that would only make the recession deeper.
Or they could increase real output by decreasing interest rates, stimulating aggregate demand, but
that would likely cause even higher inflation. As such, there is no exact policy prescription for a
supply shock.
Q.868 Given that unexpected inflation is a situation where expected inflation and actual inflation
differ, which of the following is least likely an effect of unexpected inflation?
A. Risk premia in borrowing rates and the prices of other assets.
B. Constant changes in the advertised price of goods and services.
C. Less reliable information about the demand and supply from a change in prices.
Both A and B are costs incurred due to unexpected inflation, but constant changes in price tags of
goods and services are attributable to high expected inflation.
A i s i ncorrect. Unanticipated (unexpected) inflation gives rise to risk premia in borrowing rates
and the prices of other assets.
C i s i ncorrect. Unexpected inflation can reduce the information content of market prices.
133
Q.869 What is the most likely effect of a contractionary monetary policy at the same time as an
expansionary fiscal policy?
A. Both aggregate demand and interest rates increase.
B. Both aggregate demand and interest rates decrease.
C. Aggregate demand increases while interest rates decrease.
Aggregate demand increases due to the expansionary fiscal policy, and interest rates are higher due to
increases in government borrowing and the tight monetary policy.
Q.870 Which of the following will most likely occur if the government increases taxes?
A. T he aggregate demand curve will shift to the left.
B. T he aggregate demand curve will shift to the right.
C. T here will be upward movement along the aggregate demand curve.
T he increase in taxes will decrease consumption and thus decrease aggregate demand. T he aggregate
demand curve will shift to the left.
B i s i ncorrect. A decrease in government taxes will result in the aggregate demand curve shifting
to the right.
C i s i ncorrect. A decrease/increase in government taxes will result in a shift in the aggregate

demand curve and not a movement along the demand curve.
134
Q.871 Short-term repurchase agreements are most likely included in:
A. M3 money supply.
B. M2 money supply.
C. M1 money supply.
Repurchase agreements are included in M3, which is the broader range of money supply.
M1 includes currency, checkable deposits, etc. It is the narrower form of the money supply.
M2 includes M1 plus savings deposits, certificates of deposit, etc.
M3 includes M2 plus large and long-term deposits, repurchase agreements, etc.
Q.872 What would happen to money demand if the Reserve Bank of India announces an increase in
interest rates from next year onwards? Which type of money demand would be associated with it?
A. An increase in money demand is associated with transaction demand.
B. A decrease in money demand is associated with speculative demand.
C. An increase in money demand is associated with speculative demand.
Money available to take advantage of the investment opportunity that arises in the future is
speculative demand. T his is inversely proportional to returns. When returns are high, people would
like to invest rather than hold money. T hus, money demand decreases.
A i s i ncorrect. Money balances that are held to finance transactions are referred to as transactions
money balances. As the gross domestic product (GDP) grows over time, transactions balances will
also tend to grow.
C i s i ncorrect. Speculative demand for money relates to the demand to hold speculative money
balances based on the potential opportunities or risks that are inherent in other financial instruments
(e.g., bonds). Speculative money balances consist of monies held in anticipation that other assets will
decline in value. But in choosing to hold speculative money balances rather than bonds, investors
give up the return that could be earned from the bond or other financial assets. T herefore, the
speculative demand for money will tend to fall as the returns available on other financial assets rises.
135
Q.873 An hypothetical economy has the following deposits in three different banks:
Money deposited in bank A=$10,000; and reserve ratio=25%.
Money deposited in bank B=$8,000; and reserve ratio=20%.
Money deposited in bank C=$5,000; and reserve ratio=20%.
Find the total money created from this data.
A. $105,000
B. $115,000
C. $120,000
New deposits
Money created =
Reserve requirement
Bank A:
10, 000
= 40, 000
0.25
Bank B:
8,000
= 40, 000
0.20
Bank C:
5,000
= 25, 000
0.20
Total amount of money 'created' from these deposits = 105,000
136
Q.874 All else being equal, a larger money supply most likely :
A. Raises market interest rates.
B. Lowers market interest rates.
C. Has no effect on market interest rates.
All else being equal, a larger money supply lowers market interest rates. Conversely, a tighter
money supply tends to raise market interest rates. T he current level of liquid money (supply)
coordinates with the total demand for liquid money (demand) to help determine interest rates.
Q.875 If the money supply curve shifts to the left, interest rates will most likely :
A. Increase.
B. Decrease.
A leftward shift in the money supply curve will create excess demand for money and households and
firms will sell securities, which will increase the interest rates. A shift in the money supply curve to
the right would decrease interest rates.
Q.876 What is the primary objective of most central banks?
A. Controlling inflation.
B. Maintaining price stability.
C. Controlling unemployment.
Controlling inflation and unemployment are functions of central banks, but the primary objective of
most central banks is to maintaining price stability.
137
Q.1490 When a central bank increases the supply of money and credit in an economy, it is referred
to as a (an):
A. Contractionary policy.
B. Restrictive monetary policy.
C. Expansionary monetary policy.
An expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase
the rate of monetary expansion to stimulate the growth of a domestic economy.
A i s i ncorrect. A contractionary monetary policy is a type of monetary policy intended to reduce
the rate of monetary expansion to fight inflation.
B i s i ncorrect. Restrictive monetary policy is also known as contractionary monetary policy.
Q.1491 Which of the following is least likely a function of money?
A. Store of value.
B. Collateral for a loan.
C. Medium of exchange.
T he three main functions of money are medium of exchange, a unit of account, and store of value.
138
Q.1492 According to European Central Bank (ECB), debt securities with a maturity of up to two
years are part of which of the following aggregate categories of money?
A. M1
B. M2
C. M3
According to the European Central Bank (ECB), M3 is the sum of M2, repurchase agreements,
money market fund shares/units, and debt securities with a maturity of up to two years.
M1 is the sum of currency in circulation and overnight deposits, and M2 is the sum of M1, deposits
with an agreed maturity of up to two years and deposits redeemable at notice of up to three months.
Q.1493 Calculate the money multiplier of King's bank that has excess reserves of $5 million if the
reserve requirement by the central bank is 15%.
A. 4x
B. 6.67x
C. 33.34x
T he money multiplier shows how many times money can be created out of total reserves. It is
calculated as;
1
Money multiplier =
Reserve requirement
In this situation, the money multiplier for King's bank is
1
= 6.67
15%
139
Q.1494 All else being equal, estimate the changes in price levels if the money supply increases by
7%.
A. Price levels will increase by 7%.
B. Price levels will decrease by 7%.
C. Price levels will increase by more than 7%.
Money supply × Velocity = Price level × Real output. (MV=PY)
If all other variables are held constant, then a 7% increase in money supply will increase price levels
by 7%.
Q.1495 T he belief that inflation can be controlled with the money supply since real variables are not
affected by monetary variables is most likely associated with:
A. Money velocity.
B. Money neutrality.
C. Accommodative policies.
T he monetarist belief that inflation can be controlled with money supply since real variables are not
affected by monetary variables is called money neutrality.
A i s i ncorrect. T he velocity of money is the average number of times a dollar is used to purchase
final goods and services during a year.
C i s i ncorrect. Accommodative monetary policy means a policy of allowing the money supply to
rise in line with national income and the demand for money. It will also usually involve lower interest
rates. It is also known as expansionary monetary policy.
140
Q.1496 Individuals and businesses hold money for many purposes which, in turn, moves the demand
for money. Which of the following is least likely a reason for holding money?
A. Held to defend inflation.
B. Precautionary demands.
C. Need for undertaking transactions.
Precauti onary demand: money is held as a precaution against uncertainty. People desire to hold
money in case of an emergency.
Transacti onal demand: people hold money because they need it to carry out business and
financial transactions, and;
Specul ati ve demand: money is held in speculation or forecast for a future decline in the prices of
assets or goods and services, whereby the holders of money can benefit by purchasing later at lower
prices.
Q.1497 What will most likely be the preference for individuals and companies if interest rates have
recently been increased?
A. Demand to hold money will increase.
B. Demand to hold money will decrease.
C. Demand to hold money will not be affected.
At higher interest rates the demand to hold money decreases. T his is because the opportunity cost of
holding money increases, and firms and individuals would prefer to hold less money and invest in
higher-yielding financial assets.
141
Q.1498 What is the most likely impact on money supply if interest rates are above the equilibrium
interest rate?
A. Excess supply.
B. Excess demand.
C. Decreased supply.
When interest rates are above the equilibrium rates, there is excess supply of money.
When rates are below equilibrium rates there is excess demand of money.
Q.1499 T he real interest rate if the nominal interest rate is 11% and inflation is 3.5% is most likely ?
A. 7.5%
B. 13.5%
C. 14.5%
Nominal interest rate = Real interest rate + Inflation
T herefore,
Real interest rate = 11% − 3.5% = 7.5%
142
Q.1500 Which of the following assumes that real rates are static and changes in nominal interest
rates are due to changes in price levels?
A. Fisher effect.
B. Paasche index.
C. Money neutrality.
T he Fisher effect assumes that real rates are stable over time and changes in nominal interest rates
are due to changes in price levels or inflation.
B i s i ncorrect. T he Paasche Price Index is a price index used to measure the general price level
and cost of living in the economy and to calculate inflation.
C i s i ncorrect. Money neutrality is the belief that inflation can be controlled with money supply
since real variables are not affected by monetary variables.
Q.1501 Which of the following is least likely the role of a central bank?
A. Lender of last resort.
B. Conductor of monetary policy.
C. Setting tax rates on interest on savings.
A central bank is normally the lender of last resort and conductor of the monetary policy, but the
determination of all tax rates is normally the preserve of the government and is in fact a fiscal policy
issue. Other roles of central bans include currency regulation, control of commercial banks, banker,
fiscal agent and adviser to the government, controller of credit, and custodian of cash reserves of
commercial banks.
143
Q.1502 In India, the price index was 116 last year, and the price level index this year is 123. If the
real interest rate in India is 5.5%, then the nominal interest rate is closest to:
A. 8%.
B. 11.5%.
C. 12.5%.
T his question can be solved using the Fischer effect:
Nominal interest rate = Real interest rate + Expected inflation
123
Expected inflation = − 1 = 6.03%
116
Nominal rate = 5.5% + 6% = 11.5%
Q.1503 T he 'shoe leather cost' is related to costs appearing from:
A. Inflation.
B. Deflation.
C. Disinflation.
‘Shoe leather cost’ refers to the cost of time and effort (especially the opportunity cost of time and
energy) that people spend trying to counteract the effects of inflation, such as holding less cash and
making frequent trips to the bank. High inflation results in many costs related to the frequent
changes in the prices of goods and services due. T he shoe-leather cost is related to costs appearing
from individuals making frequent trips to the bank.
144
Q.1507 T he Central Bank of Lalalinia wants to increase the supply of money. Which of the following
policies will most likely increase the supply of money in the economy?
A. Increasing the policy rate.
B. Decreasing the reserve requirement.
C. Selling securities on the open market.
Decreasing the reserve requirement will increase the capacity of banks to lend money. Hence, the
supply of money will increase.
A i s i ncorrect. Increasing the policy rate (also known as the bank rate) the central bank would
reduce the amount of money in circulation within an economy.
C i s i ncorrect. Selling securities in the open market reduces commercial banks’ reserves. T his
reduces the amount of money they can lend out reducing the money supply.
Q.1508 Identify a monetary policy tool that will most likely decrease the money supply in the
economy.
A. Selling securities in the open market.
B. Decreasing the reserve requirement.
C. Buying securities on the open market.
When a central bank sells securities in the open market, it collects money in exchange. T herefore,
it decreases the supply of money in the market.
B i s i ncorrect. T he law requires commercial banks to keep a certain percentage of their total
deposits as a reserve. Decreasing the reserve ratio increased the amount of money commercial
banks can lend out. T his increases the money supply in the economy.
C i s i ncorrect. Buying securities in the open market increases commercial banks’ reserves. T his
increases the amount of money they can lend out, reducing the money supply.
145
Q.1509 What will most likely happen to financial asset prices if the central bank decides to increase
rates?
A. Prices will increase.
B. Prices will decrease.
C. Prices will remain unaffected.
T he present value or prices of assets will decrease as interest rates increase. A higher discount rate
will be used to calculate the present value of assets.
Q.1510 Identify the set of qualities that are most likely essential for central banks to succeed in their
inflation-targeting policies.
A. Independence, secrecy, and credibility.
B. Independence, transparency, and credibility.
C. Interdependence, transparency, and authority.
T he set of qualities that are essential for central banks to succeed in its inflation targeting policies
are independence, transparency, and credibility.
Q.1511 Determine the most likely impact on domestic exports of a country through its transmission
mechanism if its interest rates decrease?
A. Exports will increase.
B. Exports will decrease.
C. Exports will remain unaffected.
As the interest rates decrease, the local currency will depreciate. T he depreciation of the local
currency will make the domestic exports cheaper for foreign buyers and imports will be more
expensive for domestic buyers.
146
Q.1512 Which of the following is the most commonly used inflation target?
A. 1%
B. 2%
C. 3%
T he most commonly used inflation rate target is 2% with a standard deviation of +/-1%.
Negative inflation rates are called deflation which is considered dangerous for the economy.
Q.1513 Which of the following is the most widely used mechanism for making monetary policy
decisions?
A. Interest rate targeting.
B. Inflation rate targeting.
C. Exchange rate targeting.
Inflation targeting is the most commonly used mechanism for monetary policy decisions. It adjusts
rates to influence inflation.
Q.1514 Identify the most appropriate equation for a neutral interest rate.
A. Neutral interest rate = Real trend rate for economic growth + Inflation.
B. Neutral interest rate = Long-term sustainable growth rate + Policy rate.
C. Neutral interest rate = Real trend rate for economic growth + Long-term sustainable
growth rate.
T he neutral interest rate is given by:
Neutral interest rate = Real trend rate for economic growth + Inflation
147
Q.1515 Determine the most likely state of the monetary policy in a country if the interest rate is
above the neutral interest rate?
A. Expansionary policy.
B. Contractionary policy.
C. Easing monetary policy.
When the interest rate is above the neutral real interest rate, it is a contractionary monetary policy.
A i s i ncorrect. An expansionary policy aims to reduce interest rates and raise the money supply.
C i s i ncorrect. Easing monetary policy will have an expansionary effect that will increase
aggregate demand, reduce interest rates, and subsequently reduce the growth of the private and
public sectors.
Q.1516 Investors that see future money supply growth as inflationary and believe that future asset
prices will make long-term bonds unattractive and will increase the long-term interest rates are
called:
A. Hedgers.
B. Regulators.
C. Bond Market vigilantes.
Bond vigilantes see future money supply growth as inflationary and believe future asset prices will
make long-term bonds unattractive and increase long-term interest rates.
A i s i ncorrect. A hedge is an investment position intended to offset potential losses or gains that a
companion investment may incur.
B i s i ncorrect. Regulators are not investors.
148
Q.1517 Which of the following is least likely an objective of fiscal policy?
A. Liquidity trap.
B. Controlling inflation.
C. Increasing industrial or agricultural output.
A liquidity trap is a limitation of monetary policy. When interest rates are close to zero and savings
rates are high, it renders monetary policy ineffective. In a liquidity trap, consumers choose to avoid
purchasing T reasury securities and keep their funds in savings because of the prevailing belief that
interest rates will soon rise, which would push bond prices down.
B i s i ncorrect. Controlling inflation is an objective of fiscal policy. T he fiscal policy acts as a
significant alternative to controlling the inflation rate because when taxes increase, the demand for
goods and services decreases.
C i s i ncorrect. Fiscal policy can influence in direct or indirect ways certain sectors of the
economy. For example, some policies have a direct impact on the value of land in the agricultural
sector. Also, the agricultural sector is very capital-intensive. A good fiscal policy can affect the
relative demand and competitiveness of exports for agricultural products. T herefore, fiscal policy
can be used to increase the output of some sectors in the economy.
Q.1518 Bob Jarislowsky bought wine for his birthday party at a price of $200 + $20 VAT. VAT is an
example of which of the following fiscal policy tool?
A. Direct taxation: Spending tool
B. Direct taxation: Revenue tool
C. Indirect taxation: Revenue tool
Direct and indirect taxes are revenue tools of fiscal policy. VAT and sales taxes are examples of
indirect taxes, while income taxes, capital gain taxes, and corporate taxes are examples of direct
taxes.
149
Q.1520 If the marginal propensity to consume is 60% and taxes are 30%, the fiscal multiplier is most
likely :
A. 1.72
B. 1.90
C. 3.33
1
Fiscal multiplier =
(1 − MPC(1 − Tax))
1
=
(1 − 0.6(0.7))
= 1.72
Q.1521 T he time governments take to discuss, vote and enact fiscal policies is most likely called:
A. Action lag.
B. Impact lag.
C. Recognition lag.
T he time governments take to discuss, vote, and enact fiscal policies is called the action lag.
B i s i ncorrect. T he impact lag is the time it takes for corrective monetary and fiscal policies,
designed to smooth out the economic cycle or respond to an adverse economic event, to affect the
economy once they have been implemented.
C i s i ncorrect. Recognition lag is the delay between when an economic shock occurs and when it
is recognized by economists, central bankers, and the government.
150
Q.1522 A country in which the government is enacting an expansionary fiscal policy which will
reduce private investments and the aggregate demand simultaneously may result in:
A. Crowding out.
B. A liquidity trap.
C. A supply shortage.
When the government enacts expansionary fiscal policies, it may crowd out private investments and
reduce the aggregate demand.
B i s i ncorrect. A liquidity trap is when interest rates are close to zero and savings rates are high,
rendering monetary policy ineffective.
C i s i ncorrect. In economic terms, a shortage is a condition where the quantity demanded is

greater than the quantity supplied at the market price.
Q.2456 Most central banks routinely redeem existing treasury securities and originate new ones. If
the central bank decreases its net sales of T reasury securities, this is most likely a(n):
A. Contractionary fiscal policy.
B. Expansionary monetary policy.
C. Contractionary monetary policy.
One can think of the sale of treasuries as reducing the amount of currency in the economy as
currency is collected in exchange for more treasuries. A reduction in net sales indicates that relative
to redemptions, sales of new securities are reduced, which leaves more cash in the economy.
A i s i ncorrect. Fiscal policy involves utilizing government spending and altering tax revenue to
influence some economic aspects. Fiscal policy is a government function and not a central bank one.
C i s i ncorrect. A contractionary monetary policy would result in the central bank increasing its
net sales of treasury securities.
151
Q.2459 T he capacity of a central bank to successfully implement expansionary monetary policy may
be limited by:
A. Current high levels of interest rates.
B. An excess of foreign exchange reserves.
C. T he absence of a liquid market for the country's T reasury securities.
If the central bank faces a market that is not fully able to absorb new T reasury securities, it will not
be able to conduct the transactions necessary to utilize monetary policies.
A i s i ncorrect. Current high-interest rates give central banks room to reduce interest rates by a
good amount and therefore implement an expansionary monetary policy.
B i s i ncorrect. Foreign exchange reserves are assets denominated in a foreign currency that a
central bank holds. T hese may include foreign currencies, bonds, treasury bills, and other
government securities. Central banks can use these assets to implement an expansionary monetary
policy.
Q.2460 Most central banks consider it the primary role of the bank to most likely be:
A. Ensuring financial stability.
B. Ensuring stable growth in GDP
C. Managing the security of those making deposits in bank accounts.
T he main objective performed by a central bank is ensuring financial stability. Depending on the
country, central banks might have other objectives: controlling inflation, unemployment, interest
rates, or exchange rates. However, all of these are in line with the main objective of ensuring
financial stability.
152
Q.2461 If the central bank reduces the reserve requirements and increased net redemptions
(purchases) of T reasury securities, then:
A. Interest rates would rise, and bank lending activities would decrease.
B. Banks would increase lending activities, and the money supply would increase.
C. Banks would decrease the acceptance of deposits, and the money supply would decrease.
Both of these actions by the central bank increase the money supply. Lowering the reserve
requirement will have the effect of banks being able to lend more which would increase the money
supply and stimulate economic growth. Increasing the net purchases of T reasury securities means
more cash is left in circulation, which again increases the money supply.
Q.2475 An expansionary fiscal policy may most likely include:
A. Reductions in government expenditures and reductions in taxes.
B. Increases in government expenditures and increases in tax credits.
C. Reductions in interest rates and Increases in government expenditures.
Government expenditures (G) are part of aggregate demand, so any increases in G will shift aggregate
demand to the right and encourage growth in the economy. A tax credit is an amount of money that
taxpayers can subtract directly from taxes owed to their government. Unlike deductions, which
reduce the amount of taxable income, tax credits reduce the actual amount of tax owed. T his will
result in an increase in aggregate demand.
A i s i ncorrect. Reduction in government expenditures is a contractionary fiscal policy.
C i s i ncorrect. Adjustments to interest rates are not part of fiscal policy.
153
Q.2476 In a high inflation environment, it is most likely to be profitable to:
A. Borrow money and purchase real assets.
B. Lend money to those wishing to buy real assets.
C. Borrow money and purchase real assets if nominal interest rates are less than the real
rate of interest plus the rate of inflation.
If there is inflation, interest rates should equal the real rate of interest, plus an inflation premium
sufficient to offset the anticipated loss in purchasing power of the currency used to repay the loan.
T his is the Fisher effect, R = r + p + rp. If nominal rates are lower than what is needed to
compensate the lender for inflation and the real interest rate, then borrowing now would permit the
borrower to repay the loan with ''cheap money'' while still having the value of the real asset.
Q.2477 Primary objectives of fiscal policy are most likely to:
A. Control inflation and unemployment.
B. Ensure stable prices and low-interest rates.
C. Manage the economy through the government's ability to influence GDP.
Because government expenditures are a significant part of aggregate demand, the government can
directly alter GDP. It can also adjust taxes and other policies to influence aggregate demand and
aggregate supply.
A i s i ncorrect. Control inflation and unemployment are objectives of central banks.
B i s i ncorrect. Monetary policy is better suited to addressing price stability and interest rates.
154
Q.3212 Fiscal policy is best described as:
A. Government activities centered on alleviating the unequal distribution of wealth.
B. Government targeting interest rates and extensions of credit to affect the economy.
C. Government actions through the adjustment of expenditures and taxes to influence the
economy.
Fiscal policy is a tool used to control the macroeconomy by altering taxes or government purchases
of goods and services. Since government expenditures are a large component of aggregate demand,
fiscal policy significantly influences the economy.
A i s i ncorrect. Alleviating the unequal distribution of wealth is one of the objectives of fiscal
policy.
B i s i ncorrect. Interest rate targeting is a function of the central bank.
Q.3213 T he quantity of M1 money in an economy is most likely :
A. Limited to the value of the gold backing the currency.
B. Expanded by banks within a fractional reserve system.
C. Controlled by the central bank solely by adjusting the quantity being printed.
To explain, if a bank must hold 10 percent of its deposits as a reserve to accommodate withdrawals
as needed, then it could lend out the remaining 90 percent. If those loans are then used to purchase
goods and services, and the proceeds from those sales are deposited in other banks, each of those
banks could, in turn, retain only 10 percent of the deposits and lend the remaining 90 percent of the
receipts. In this way, the money in the system is expanded.
155
Q.3214 In an economy with a 15 percent reserve requirement, a new deposit of $3,000 will create
money in the amount of:
A. $450.
B. $3,450.
C. $20,000.
To calculate the amount of money created, use the formula “New deposit/ Reserve requirement”,
which in this case equals,
$3, 000
= $20, 000
0.15
Q.3215 In an economy with a 20 percent reserve requirement, a new deposit of $180,000 will
create money in the amount of:
A. $36,000
B. $144,000
C. $900,000
To calculate the amount of money created, use the formula “New deposit/ Reserve requirement”,
which in this case equals,
$180, 000
= $900, 000
0.20
156
Q.3216 Under the quantity theory of money, if money neutrality holds, then a change in the quantity
of money would have the following effect(s):
A. Real output is unaffected, and only the price level will change.
B. Real output will increase in response to the stimulus of additional money.
C. Money will circulate through the economy more rapidly, and prices will be unaffected.
T he key identity is MV = PY, where nominal money supply (M), the price level (P), and the real
income/expenditure (Y) V is assumed to remain constant, so increasing M will only require that the
price level rises to adjust to the new quantity of money.
Q.3217 T he quantity theory of money gave rise to a group of economists known as monetarists, who
held the view that:
A. T he growth rate of the money supply should be used to adjust the velocity of money.
B. T he price level, or inflation, could be controlled simply by adjusting the money supply.
C. Increasing the money supply would simply increase output, with no effect on inflation.
Monetari sm is an economic theory that focuses on the macroeconomic effects of the supply of
money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the
money supply is inherently inflationary, and that monetary authorities should focus solely on
maintaining price stability.
157
Q.3218 T he Fisher effect facilitates the explanation as to why wise investors won't necessarily
move their savings deposits to the country that pays the highest interest rate. Which of the following
is most accurate with regard to the Fischer effect?
A. Investors seek the highest nominal rate of interest since they want the highest nominal
ending value.
B. Provided investors know the nominal rate of interest, they will also know the inflation
rate that will occur over the investment horizon.
C. Investors are seeking the highest real ending value, which means they require a high real
return, plus compensation for the expected rate of inflation, in selecting the nominal return.
T his is the logic underlying the Fisher effect. As stated in your reading, the nominal interest rate
equals the real rate of interest plus the expected rate of inflation. Investors ultimately care about
the real rate of return, which dictates the amount of “stuff ” they will be able to buy with the
proceeds.
Note to candidates: Astute readers will recognize that the Fisher effect representation in the reading
is technically incorrect. T he equals sign should rightfully be replaced by an “ approximately equal”
symbol, since as you will see in more carefully constructed explanations, there is actually a third
term, the product of the real rate of interest and the inflation rate. In most typically encountered
situations, with low real rates of interest and low inflation rates, this third term will be trivially
small. However, especially for those intending to become analysts, it is important to note that there
are cases where it will make a great deal of difference. Consider, for example, the severe
hyperinflation of Zimbabwe (more than 11.2 million percent in 2008) or even less stratospheric but
still high rates of inflation that have been more commonly encountered.
158
Q.3219 An investor notes that savings accounts in Brazil are earning 12 percent, whereas Canadian
savings accounts are paying only 0.5 percent. In this case, the investor should:
A. Borrow money in Canada, convert it to Brazilian reais, and deposit it in Brazil in order to
generate a near-riskless profit.
B. Borrow money in Brazil and deposit it in Canada after converting to Canadian dollars to
generate a near-riskless profit.
C. Determine the real rate of interest expected, after adjusting for expected inflation in both
countries, before any further analysis or action.
As a simple explanation, if the inflation rate in Brazil is for example, close to 12 percent, it is
possible that the real rate of return will be lower than would be the case if the money was deposited
in a Canadian savings account, in spite of the seemingly very low nominal rate of interest paid in
Canada. Currency exchange rates will also adjust to reflect any differences in the rates of return that
are possible in the two countries until there is no arbitrage opportunity differences in real returns
across the two countries.
Q.3220 An investor is contemplating relocating to one of countries A, B, or C. A, B, and C have the

nominal interest rates on savings accounts of 5, 8, and 10 percent, respectively. He also notes that
the expected inflation rates in A, B, and C are 1, 3, and 7 percent, respectively. On this basis, if the
investor were to rank the attractiveness of placing deposits in the three countries from best to
worst, (s)he should most likely rank them as:
A. C, B, A.
B. A, B, C.
C. B, A, C.
(S)he should rank them as on the basis of expected real rate of interest as B, A, C. Savings accounts
in country B, after adjusting for expected inflation, are expected to pay approximately 5 percent in
real terms, as opposed to 4 and 3 percent for countries A and C, respectively. T he real rate of return
will be approximately equal to the nominal rate minus the expected rate of inflation. T he real rate of
interest expected will indicate the extra amount of goods and services that can be gained through the
deposit as opposed to only the nominal quantity of money paid. Simply put, you must consider the
effect of inflation since high levels of inflation mean the value of the money in purchasing power
terms is being eroded.
159
Q.3221 Most central banks are most likely responsible for:
A. Depositor protection and as a bank for the government.
B. T he regulation of financial services and as lenders of last resort to banks.
C. Being guardians of the payment system and supervisors of the banking system.
Central banks typically do not have a regulatory responsibility for financial services other than their
role in establishing control mechanisms for the system of actual banks. Depositor protection is a
role that often falls to deposit insurance agencies and other depository regulatory entities.
Q.3222 Nearly all central banks most likely have an explicitly stated role to:
A. Ensuring financial stability.
B. Preserve confidence in the financial system.
C. Facilitate a sustainable growth rate in GDP and the money supply.
Many other objectives appear as part of the objectives of central banks, but the appearance of a
statement to ensure financial stability is a very commonly stated goal across numerous countries.
B i s i ncorrect. Central banks' role as liquidity providers help restore confidence in the financial
system by enabling banks to meet their short-term payment obligations. However, this is not a
universal role.
C i s i ncorrect. Facilitating a sustainable growth rate in GDP is an aim of fiscal policy
160
Q.3223 Central bankers focus on controlling the price level, or inflation, because high levels of
inflation:
A. Will necessitate higher nominal interest rates reducing the central bank's ability to
control the money supply when necessary.
B. Will cause workers to demand higher wage settlements and investors to demand higher
rates of return on investment, reducing potential GDP.
C. Are also likely to coincide with greater volatility of inflation which makes it more
probable that economic agents will bear higher costs of unexpected inflation rates.
Anticipated inflation can be built into prices and contracts, but high inflation rates make it less
predictable, which impairs business investment decision-making. Unanticipated inflation rates, higher
or lower than expected, will harm either borrowers or lenders depending on whether inflation turns
out to be higher or lower than expected at the time borrowers and lenders agreed to the terms of
any loans.
Q.3224 T he central bank of the UK was set out to make changes to be fully transparent by publishing
its money targets well in advance. In this way, if the plan had worked:
A. T he unanticipated part of the inflation rate was intended to be zero.
B. T he inflation rate was intended to be zero, making business decision-making simpler.
C. T he government could then take advantage of inflation rate surprises as a means of

creating a hidden tax.
T he intention of transparency was to eliminate unexpected surprises in changes to the inflation rate.
Expected inflation by itself creates little burden on decision makers since it is possible to plan for
known effects. Unanticipated inflation, however, creates winners and losers as a result of a risk that
is neither controllable by economic agents nor related to operating a business or making employment
decisions.
161
Q.3225 T he central bank has many tools with which it can influence the macroeconomy. One of the
primary tools is most likely to employ:
A. Direct adjustments to the prime rate of interest offered by commercial banks.
B. Controlling access to the payment system by nonbanks and commercial enterprises.
C. Open market operations to adjust the quantity of government securities held by investors.
Open market operations, in which government securities are purchased by the central bank, result
in additional money being introduced into the economy. Issuing more new securities has the opposite
effect since investors must exchange money for the new securities, reducing the money in
circulation.
Q.3226 T he central bank has many tools with which it can influence the macroeconomy. One of the
primary tools it is most likely to employ is:
A. Adjusting the refinancing rate.
B. Direct adjustments to the prime rate of interest offered by commercial banks.
C. Regulating the activities of investment banks as an alternative to depository accounts.
T he central bank can borrow or lend from the banks by using repurchase agreements. T his buying
and selling of government securities is one of the means through which it can affect the interest
rates.
Note: T he refinancing rate in the Euro-zone serves the same purpose as the Federal funds rate in the
US. (T he European counterpart of the Fed is the ECB - European Central Bank)
162
Q.3227 T he central bank announces an intention to increase the official interest rate. In terms of
effects on the economy, which of the following is most likely to occur?
A. Consumers are likely to view the increase as a positive signal and make more purchases in
light of their revised expectations.
B. Domestic exporters are likely to see a decline in profits as the currency is likely to
appreciate making exports less attractive to foreign buyers.
C. T he increase in rates is likely to increase the growth rate of the economy since investors
will seek to take advantage of the higher interest rate environment.
With higher interest rates, the currency is likely to appreciate, which in effect appears as an
increase in price to foreign buyers who must buy the local currency to purchase the products
produced for export. Higher interest rates slow consumption spending since consumers will find
buying on credit a more expensive prospect.
Q.3228 Which of the following are most likely to be affected by a change in the central bank's policy
rate?
A. Exchange rates.
B. Interest rate expectations.
C. Exchange rates and interest rate expectations.
An increase in interest rates can signal that more increases may be forthcoming and since exchange
rates and interest rates are directly linked, both interest rates and exchange rates will be affected.
163
Q.3229 Which in the following is most likely a characteristic of a successful central bank?
A. Close affiliation with the national government.
B. T ransparency and independence from the government.
C. Capacity and the ability to act without revealing their intentions in advance.
Independence, transparency, and credibility are seen as important qualities of successful central
banks.
A i s i ncorrect. A central bank should be free from any political influences. Central banks and
political parties at times differ in goals. For example, when inflation rises, the central bank wants to
reduce the supply of money. T his leads to a decrease in economic growth. On the other hand,
politicians aim to increase employment and boost economic growth.
C i s i ncorrect. Ability to act without revealing their intentions in advance is not a characteristic of
a successful central bank.
Q.3230 Some central banks have focused on exchange rate targeting by managing the domestic
currency to maintain an acceptable exchange rate with a reference currency, rather than focusing
on inflation. In such cases, the central bank is most likely able to take this approach:
A. Because inflation in the country is already low and simply not a priority.
B. Because it is in essence handing over control of inflation to the central bank controlling
the reference currency.
C. Because this typically occurs only in large economies that already have strong economic
ties to the currency selected as the target.
T his is not typical of large developed economies but more common in small developing economies.
T he result is that the central bank, in some cases by setting a fixed exchange rate with a major
currency is, in the process, importing the monetary policy and its inflation effects from the
economy that is the source of the reference currency. An example is the tiny island nation of
Barbados, which maintains a fixed exchange rate of 2 Barbados dollars per US dollar.
164
Q.3231 Many central banks focus on achieving set targets for inflation close to 2 percent. A target of
zero percent is not typically considered because:
A. Inflation rate targeting is not a precise science, and there is a fear of creating persistent
deflation that is difficult to correct.
B. People have become accustomed to getting wage increases or increased prices for their
goods and services over time, so a target of zero would not be credible.
C. Inflation has a positive effect on consumer confidence that supports growth in the
economy since supply must expand to meet the growing increases in demand.
T here is a fear of creating persistent deflation that is difficult to correct if a set target of zero
percent is set. Japan is an example of this particular problem.
Q.3232 When a central bank elects to lower interest rates, the expected consequences include an
increased likelihood of:
A. An increased economic growth, potentially higher inflation, and depreciation of the

domestic currency.
B. An increased economic growth, potentially higher inflation, and appreciation of the

domestic currency.
C. A decreased economic growth, potentially higher inflation, and depreciation of the

domestic currency.
Lowering the interest rate has a stimulatory effect on the economy, which raises the possibility of
inflation. It would also cause the currency to depreciate, making the country's exports more
attractive to foreign purchasers.
B i s i ncorrect. Increasing interest rates will cause an appreciation of the domestic currency.
C i s i ncorrect. Lowering interest rates will increase economic growth while increasing interest
rates will decrease economic growth.
165
Q.3233 When the central bank of a small economy elects to set a target value for the exchange rate:
A. T he money supply becomes more stable.
B. Domestic interest rates and inflation become more stable.
C. T he domestic money supply and interest rates can become more volatile.
If the central bank is managing the exchange rate, then its purchases and sales of foreign currency
used to manage the exchange rate will create additional volatility in the domestic money supply and
interest rates.
Q.3234 T he neutral rate is most likely :
A. Easily pinpointed as the rate which would neither cause a contraction or an expansion.
B. Higher than the rate that would cause a contraction and lower than the rate which would
stimulate economic expansion.
C. Often difficult to specify precisely, but specified in theory as lying between low,
expansionary interest rates and the high, contractionary rates.
T he neutral rate of interest is not simple to specify with precision but should be equal to the trend
growth rate + the inflation rate target.
A i s i ncorrect. T he neutral rate is not easy to pinpoint
B i s i ncorrect. Interest rates below the neutral rate are considered expansionary, and higher rates
would be contractionary.
166
Q.3235 Central banks can utilize inflation rate targeting and other actions to manage the money
supply, inflation, and interest rates. Which of the following characterizations would most likely
apply?
A. Inflation rate targeting is simple to manage, but the money supply may be challenging to
measure and stabilize.
B. Most central banks have the ability to set interest rates with great precision, which in the
process means that inflation rate targeting is easily managed.
C. Achieving inflation targets is more art than science and the market operations needed are
vulnerable to countervailing actions by bond market participants.
Expectations can be altered by central bank actions but not always in a direction that reinforces the
policy action. T herefore, the management of interest rate or inflation targets can prove very
challenging.
Q.3236 Central banks may find limitations in terms of the effectiveness of monetary policy in which
of the following situations?
A. Environments where interest rates are modest, and inflation rates are low.
B. Environments where interest rates are near zero and consumers simply hold onto any
additional infusions of money.
C. Environments where interest rates are near zero and consumers rapidly spend any
additional infusions of money to purchase more consumption goods.
Japan, at least partly, illustrates this problem. Once interest rates are near zero, the stimulatory
effect of further rate cuts is negligible. If consumers are willing to simply hold onto ever larger
amounts of cash, without any spending, expansionary actions are likely to have no effect. T he
situation in Japan is further compounded by persistent deflation. If prices are falling, it makes sense
to defer purchases which slows economic growth.
167
Q.3237 Expansionary fiscal policy measures may include:
A. Reducing personal income taxes and buying new aircraft for the military.
B. Easing interest rates and buying treasury bonds to encourage economic activity.
C. Reducing the regulatory burden by reducing or eliminating environmental regulations.
Fiscal policy tools include adjusting taxes and altering government purchases to affect aggregate
demand.
B i s i ncorrect. Easing interest rates and buying treasury bonds are tools used to implement
monetary policy.
C i s i ncorrect. Reducing the regulatory burden is not a fiscal policy measure.
Q.3238 Which of the following is most likely a reasonable argument to support using a fiscal deficit
as a tool to stimulate an expansion?
A. If unemployment is high, then the crowding out effect is of less concern.
B. Additional taxes to offset the deficit at future points could be distortionary.
C. Fiscal policy is set by the government and may be manipulated solely for political gain.
One worry is that government borrowing could crowd out private investment, but this is less likely
if unemployment is high. Unemployment may, in fact, be reduced as a result of the government's
actions.
168
Q.3239 Which of the following statements about the size of the national debt relative to GDP is most
likely a reasonable and truthful statement?
A. In the end, the central bank can print more money to pay the debt.
B. Over the long run, the crowding-out effect may have a significant negative effect on
capital accumulation.
C. For countries such as Canada and South Korea, most of the debt is held by foreigners, so
the burden of the debt carrying costs is more severe than for countries such as the USA.
In the short run, crowding out is unlikely to be significant but may have serious negative
consequences over the long run.
A i s i ncorrect. Zimbabwe is the obvious example of why printing more money is likely to destroy
confidence and generate severe negative consequences.
C i s i ncorrect. Canada and South Korea have very low foreign ownership of their debt.
Q.3240 Changes to existing taxes or the introduction of new taxes are fiscal policy tools available to
governments. Which of the following statements is most likely a reasonable statement of fact?
A. Increases in income tax rates could arguably cause a large enough disincentive to labor
that tax revenue actually falls.
B. Income taxes in countries such as Canada and the USA are highly regressive and,
therefore, are easily criticized in terms of fairness.
C. Converting to a flat income tax would improve fairness since such a structure would
proportionately transfer a much greater tax burden from the poor to the wealthy.
T his relates to the work of Arthur Laffer, which formed the basis of significant steps to reduce taxes
in the Reagan-T hatcher era. T he income taxes in Canada and the USA, as well as many other
countries, are, for the most part, successful in their intent to be progressive. Although fair in the
sense that all would pay the same fraction of their income, flat taxes are not progressive in the sense
that higher-income rates would not face higher marginal tax rates.
169
Q.3241 Which of the following is least likely a true statement about using fiscal policy tools to
regulate the business cycle?
A. It may take considerable time to recognize that the economy is slowing. Consequently, any
fiscal policy actions may be too late.
B. Once a need for an expansionary action is recognized, it may take considerable time to put
a plan, such as a capital expenditure program, into action.
C. Increases in government spending will move the economy smoothly to the full
employment level without the inflationary risks presented by monetary adjustments.
T here are several sources of lag in the process of selecting, implementing, and generating a
measurable impact when setting fiscal policy. Because of the challenges in determining where the
economy is, in terms of the business cycle and the challenges in quickly measuring the impact of any
policy actions, any effort to use government expenditure programs to reach full employment may, in
fact, push the economy toward the problems associated with labor shortages and inflationary
pressure.
Q.3242 Which of the following is most likely an example of an expansionary fiscal policy action
available to the government?
A. T he introduction of higher taxes on alcohol and tobacco.
B. Lowering the official interest rate through the repurchase agreements market.
C. Making available federal money for “shovel ready” capital improvement projects.
Shovel ready is a phrase used to describe a construction project considered to be at an advanced

enough stage of development for building to begin soon. T he term generally implies that planning is
more or less complete, approval permits are in place, and laborers can get to work once sufficient
funding is secured.
A i s i ncorrect. Increases in taxes are contractionary.
B i s i ncorrect. Interest rate adjustments are aspects of monetary policy available to central banks.
170
Q.3243 Under the assumption that wages and prices are rigid, which of the following statements is
most likely correct if the government implements a contractionary fiscal policy in combination with
an expansionary monetary policy?
A. T he public sector will shrink as a percentage of GDP.
B. T he private sector will shrink as a percentage of GDP.
C. T his strategy will set a low-interest rate environment without affecting GDP.
Contractionary fiscal policy is a form of fiscal policy that involves increasing taxes, decreasing
government expenditures or both in order to fight inflationary pressures.
Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. T hat
increases the money supply, lowers interest rates, and increases aggregate demand. It boosts growth
as measured by gross domestic product.
If the government implements a contractionary fiscal policy in combination with an expansionary

monetary policy, the public sector will shrink, and the private sector will grow.
Q.3244 Under the assumption that wages and prices are rigid, which of the following statements is
most likely correct if the government implements a contractionary fiscal policy in combination with
a contractionary monetary policy?
A. Aggregate demand will decline.
B. T he public sector will shrink as a percentage of GDP.
C. T he private sector will shrink as a percentage of GDP.
With higher taxes, higher interest rates, and reduced government expenditures, aggregate demand,
both public and private, will fall.
171
Q.3267 T he central bank has many tools with which it can influence the macroeconomy. Which of
the following is least likely to be used by most central banks in developed countries due to its
potentially disruptive effects on banks?
A. Open market operations.
B. Adjusting the official policy rate.
C. Adjusting reserve requirements.
Although adjusting the reserve requirement is a powerful tool in terms of impact on money creation,
it can also be difficult for banks to adjust needed reserves rapidly.
Q.3831 Debora Eaton is analyzing money supply and demand in the nation of Nigeria. Based on her
preliminary findings, Eaton has determined that the interest rate where there will be no excess
money balances is 6.5%. Holding all else constant, if bonds offer an interest rate of 6.2%:
A. Bond prices will increase.
B. Bond supply will increase.
C. Individuals will decrease their money holdings.
If bonds offer a rate below the equilibrium rate of interest - in this case, below 6.5% – there would
be an excess demand for money with individuals seeking to increase their money holdings as
corporations and individuals sell their bonds. T he higher selling activity will increase the supply of
bonds. In doing so, the prices of bonds will fall, and the interest rate offered will increase until it
reaches its equilibrium.
172
Q.3832 T he Moroccan government authorities have launched a program whereby they intend to
enhance spending on public infrastructure and develop schools and hospitals. To offset the effects of
the fiscal policy, the country’s central bank is reducing the money supply. What are the most likely
implications of the two policies on Morocco’s economy?
A. Interest rates will be reduced.
B. Reduction in private sector demand.
C. Growth in private and public sectors.
An easy fiscal policy will lead to a rise in aggregate output. If this policy is accompanied by a tight
monetary policy, interest rates will rise and have a negative effect on private sector demand. While
the public sector may expand due to increased government spending, the private sector will shrink
due to a fall in demand.
Q.3836 If the money supply curve shifts to the left, interest rates will most likely :
A. Increase.
B. Decrease
C. Remain unaffected in the short-run.
A leftward shift in the money supply curve will create excess demand for money, and households and
firms will sell securities, which will increase interest rates.
173
Reading 13: International Trade and Capital Flows
Q.185 In short terms, gross national product (GNP) is most likely :
A. T he market value of all the goods and services produced in one year by the citizens of a
country.
B. T he market value of all the goods and services consumed in one year by the citizens of a
country.
C. T he market value of all the goods and services produced in one year by the citizens of a
country minus the market value of all the goods and services consumed in one year by the
citizens of a country.
Gross national product (GNP) is the market value of all the goods and services produced in one year
by labor and property supplied by the citizens of a country. Unlike gross domestic product (GDP),
which defines production based on the geographical location of production, GNP indicates allocated
production based on the location of ownership. In fact, it calculates income by the location of
ownership and residence. So its name is also the less ambiguous gross national income.
GNP is an economic statistic that is equal to GDP plus any income earned by residents from
overseas investments minus income earned within the domestic economy by overseas residents.
174
Q.190 A country has the following:
Exports of goods and services $6, 000, 000

Investment income received from foreigners $1, 000, 000
Imports of goods and services $3, 000, 000
Investment income payment made to foreigners $2, 000, 000
T he country's account balance is closest to:
A. $0.
B. $2,000,000.
C. $12,000,000.
T he account balance is a double-entry system in which every transaction involves both a debit and
credit. Debit entries reflect purchases of imported goods and services, purchases of foreign financial
assets, payments received for exports, and payments (interest and principal) received from debtors.
Credit entries reflect payments for imported goods and services, payments for purchased foreign
financial assets, and payments to creditors.
$6, 000, 00 + $1, 000, 000 − $3, 000, 000 − $2, 000, 000 = $2, 000, 000
Q.877 Income from capital owned by foreigners invested within a country is most likely ?
A. Not included in both the GDP and the GNP.
B. Included in the GNP but not included in the GDP.
C. Included in the GDP but not included in the GNP.
Income from capital owned by foreigners invested within a country is included in the GDP as it is
income generated by resources within the country but not included in the GNP because foreigners
earn it. GNP measures the market value of the produce generated by citizens of a country regardless
of their locations (whether they are within or outside the country.)
175
Q.878 T he following table shows the number of hours necessary to produce one unit of electronics
in both England and India:
Country Ipads Personal Computers

England 200 170
India 160 150
Which country most likely has an absolute advantage in producing Ipads and personal computers?
A. India has an absolute advantage in producing both iPads and personal computers.
B. England has an absolute advantage in producing both iPads and personal computers.
C. England should specialize in the production of personal computers and exchange them for
iPads produced in India.
India can produce both goods at a lower cost than England. India needs 160 (150) hours to produce
one iPad (Personal Computer), whereas England needs 200(170) hours. T herefore, India has an
absolute advantage for both iPads and PCs.
B i s i ncorrect. England does not have an absolute advantage in iPads production or personal
computers because India can produce both products at a lower cost than England.
C i s i ncorrect. India has a comparative advantage for PCs over iPads. It takes them 1.06 times
more hours ( 160 200
150
= 1.06) to build a PC but 1.17 times more hours ( 170 = 1.17) to build an iPad. As a
result, both countries can maximize their use of resources if India specializes in building PCs and
exchanges them for iPads built in England.
Q.879 T he slope of the production possibility frontier is most likely ?
A. Does not represent the opportunity cost at all.
B. T he opportunity cost of goods on the X axis in terms of goods on the Y axis.
C. T he opportunity cost of goods on the Y-axis in terms of goods on the X-axis.
T he production possibility frontier (PPF) curve is a curve that shows the number of goods X and Y
can produce when both goods depend on the same resources for production.
We measure the slope of the PPF by the amount of good X that should be given up to produce one
more unit of good Y.
176
Q.882 What most likely happens to the consumer surplus of the importing country when tariffs are
imposed?
A. T he consumer surplus increases.
B. T he consumer surplus decreases.
C. T here is no change in the consumer surplus.
A tariff is a tax on imported goods; It is a trade restriction meant to protect domestic producers
against competition from international producers. A consumer surplus happens when the price that
consumers pay for a product or service is less than the price they're willing to pay. T he tax will
make imports expensive, resulting in a decrease in consumer surplus (Citizens will now have to pay
more than they were willing to pay for a good/service). Imposing tariffs will increase locally
produced products.
A i s i ncorrect. It contradicts option B. Consumer surplus always increases as the price of a good
falls and decreases as the price of good rises. When tariffs are imposed on imported goods, the
consumption of locally produced products will increase, and consumer surplus generally declines as
consumption rises.
C i s i ncorrect. An imposition of tariffs will result in a change in the consumer surplus, as explained
above.
Q.883 Which of the following concerning trade restriction is most likely to be correct?
A. If a country is small, it can benefit by imposing a tariff.
B. T he imposition of tariffs will reduce government revenues.
C. T he imposition of tariffs by a government will increase its revenue.
T rade restrictions (or trade protection) are government policies that limit the ability of domestic
households and firms to trade freely with other countries. T he impositions of tariffs by a
government will most likely increase the government's revenue since it is a tax on imports
accumulated by the importing country.
A i ncorrect. A large nation, by definition, is large enough to affect the global price of its imports and
exports. A large country will benefit from implementing a tariff if its terms of trade increase enough
to offset the welfare loss caused by inadequate resource allocation.
B i s i ncorrect. T he government gains from tariffs through tax revenues collected on imports.
177
Q.885 What is the most likely effect of export subsidies on the domestic country?
A. A decrease in prices and a decrease in consumer surplus.
B. An increase in prices and a decrease in consumer surplus.
C. An increase in prices and an increase in consumer surplus.
An export subsidy is an incentive meant to make producers want to export their produce instead of
selling them locally. Export subsidies benefit the producers. T he domestic supply of goods will
reduce since all producers will be exporting their produce. As a result, this will increase the prices
of goods and decrease consumer surplus domestically (Domestic buyers will now have to pay more
than they were willing for a product). A consumer surplus happens when the price that consumers
pay for a product or service is less than the price they're willing to pay.
A i s i ncorrect. Export subsidies will lead to an increase in prices of locally produced products.
C i s i ncorrect. An increase in the prices of goods will decrease consumer surplus.
Q.886 Capital restrictions are most likely ?
A. Not beneficial in the long run as well as in the short run.
B. Beneficial in the long run and may or may not be beneficial in the short run.
C. Not beneficial in the long run and may or may not be beneficial in the short run.
A government or a central bank imposes capital restrictions to control the inflow and outflow of
foreign money in a country's economy. Controls include taxes, tariffs, volume restrictions, etc.,
whereas regulations include foreign exchange, tax regulation, credit regulation, and investment
restrictions. Capital restrictions decrease economic welfare. However, these can be beneficial in
the short run when the market is uneasy as it does not let immediate capital outflow.
A i s i ncorrect. Capital restrictions during financial crisis episodes provide temporary reliefs and
provide countries sufficient time to restructure their economies.
B i s i ncorrect. Capital restrictions are not beneficial in the long run.
178
Q.887 In the Utopian Union, all members have established a common institution and economic policy.
Furthermore, all barriers to import and export of goods and services have been removed between
participating countries, and all barriers to the movement to labor and capital have also been removed.
T he Utopian Union is an example of:
A. A free trade area.
B. A monetary union.
C. An economic union.
An economic union incorporates all aspects of a common market and requires common economic
institutions and coordination of economic policies among members.
A i s i ncorrect. As the name suggests, a free trade area is when countries come together and decide
to trade freely, with limited or completely no barriers, amongst each other.
B i s i ncorrect. A monetary union is basically an agreement between two or more governments to

share the same currency.
Q.888 Income receipts are most likely a part of:
A. T he capital account.
B. T he current account.
C. T he financial account.
A current account is used to measure the inflow and outflow of goods and services. T hese include
foreign income from dividends on stock holdings and interests on debt securities. T he current
account is decomposed into four sub-accounts: the merchandise trade, services, income receipts,
and unilateral transfer. Income receipts include the income derived from the ownership of assets,
such as income for foreign investments and dividends and interest payments.
A i s i ncorrect. Capital Accounts measure international capital transfers.
C i s i ncorrect. Financial Accounts measure international money flaws that are related to
investments.
179
Q.1543 Which of the following most likely measures the total goods and services produced by labor
and capital of a country’s citizens?
A. National income.
B. Gross national product (GNP).
C. Gross domestic product (GDP).
Gross national product measures the total goods and services produced by labor and capital of a
country’s citizens employed within the country and abroad.
A i s i ncorrect. National Income is the value of the produce of a country during a financial year; it
is a component of GDP.
C i s i ncorrect. GDP measures the market value of goods and services in a country during a
specified time. GDP includes the market value created by both citizens and non-citizens.
Q.1544 A citizen of Lithuania is operating a printing business in T urkey where he earns €5,000/year.
In which of the following will his earnings be measured?
A. GNP of T urkey.
B. GDP of Lithuania.
C. GNP of Lithuania.
Gross National Product (GNP) measures the market value of all final goods and services produced by
production factors (such as labor and capital) supplied by residents of the country, regardless of
whether such production takes place within the country or outside of the country. In this case, the
earnings will be included in the GNP of Lithuania. T he earnings will also be included in the GDP of
T urkey. GDP measures the market value of goods and services within a country’s borders produced
by both citizens and non-citizens.
A i s i ncorrect. T he income of the individual would have been included in the calculation of
T urkey’s GNP if they were a citizen of T urkey.
B i s i ncorrect. T he income would have been included in the calculation of Lithuania’s GDP if it
was earned in Lithuania.
180
Q.1545 A country that can produce a good at a lower cost or use fewer resources than another
country is said to have a/an:
A. Absolute advantage.
B. Resources advantage.
C. Comparative advantage.
Absolute advantage refers to the ability of a country to produce a greater quantity of a good than
competitors using the same amount of resources.
Example: Let us say the U.S. can produce one car for USD 10,000 while Mexico can produce the
same car for USD 7,000. Mexico is said to have an absolute advantage in the production of cars.
Comparative advantage is when a country can produce a good or service at a lower relative
opportunity cost. Countries can use comparative advantage to increase production by letting the
country with a comparative advantage in producing a good or service be the one to produce it.
Q.1546 Rhajib Ismail is a Pakistani citizen living and working in India with an annual income of
800,000 Rupees. In which of the following will his earnings most likely be measured?
A. GDP of India.
B. GNP of India.
C. GDP of Pakistan.
GDP measures the total goods and services produced by citizens and foreigners within the country.
In this case, the earnings will be included in the calculations of the GDP of India. T he earnings will
also be measured in the GNP of Pakistan. GNP measures the market value of goods and services
produced by the citizens of a country regardless of the citizens’ locations.
B i s i ncorrect. T he income would be included in the GNP of India if Rhajib was an Indian citizen.
C i s i ncorrect. T he income would be included in the GDP of Pakistan if it was earned in Pakistan.
181
Q.1549 In Canada, the cost of producing one kilogram of cheese and yogurt is $30 and $45, while the
cost of producing one kilogram of the same items in the United States is $50 and $40, respectively.
Calculate the opportunity cost of producing yogurt in terms of cheese in Canada.
A. 0.67
B. 1.125
C. 1.5
$30
T he opportunity cost of producing yogurt in terms of cheese in Canada is = 0.67.
$45
Q.1550 How many factors of production does the Heckscher-Ohlin model of trade most likely
consider?
A. 1
B. 2
C. 3
T he Heckscher-Ohlin model of trade considers two factors of production – labor and capital.
182
Q.1551 In contrast to the Heckscher-Ohlin model of trade, the Ricardian model considers only one
factor of production. Identify the factor that the Ricardian model considers.
A. Labor.
B. Capital.
C. Raw material
In the Heckscher-Ohlin model (also known as the factor-proportions theory), both capital and labor
are variable production factors. T hat is, each good can be produced with varying combinations of
labor and capital. According to this model, differences in the relative endowment of these factors are
the source of a country’s comparative advantage. T his model assumes that technology in each
industry is the same among countries, but it varies between industries. On the other hand, the
Ricardian trade model considers only labor as a production factor for the comparative advantage
analysis.
Q.1552 Which of the following is least likely a reason for a government to impose trade restrictions?
A. To protect new or infant industries.
B. To avoid comparative advantage over other countries.
C. To protect goods that are crucial to a country's defense.
If a country has a comparative advantage in certain goods, it will most likely capitalize on them
instead of imposing trade restrictions.
A i s i ncorrect. A government imposes trade restrictions to protect domestic producers from
foreign competition.
C i s i ncorrect. T rade restrictions are implemented to protect certain industries deemed tactically
important for safeguarding national security. Defense industries most often receive a significant level
of protection as it is viewed as crucial to the national interest.
183
Q.1555 Which of the following is least likely associated with the imposition of capital restrictions?
A. To maintain fixed exchange rates.
B. T he prohibition of foreign investments in certain domestic industries.
C. Providing domestic capital to foreign investors to invest in the domestic country.
Capital restrictions are measures undertaken by a government or a central bank to control the
inflow and outflow of foreign money in a country's economy. Capital restrictions prohibit the inflow
of foreign capital into domestic markets. T hey are thought to decrease economic welfare.
A i s i ncorrect. For countries with a fixed exchange rate target, controlling capital flows is used to
achieve the target exchange rate. Fixed exchange rates can help a government maintain low inflation,
which ultimately can help keep interest rates low and encourage consumer spending.
B i s i ncorrect. Capital restrictions prohibit the inflow of foreign capital into domestic markets.
Capital restrictions are thought to decrease economic welfare.
Q.1556 Which of the following is least likely a strategy used by governments to protect domestic
goods?
A. Licenses.
B. Import quotas.
C. A decrease in tariffs.
A decrease in tariffs placed on imported goods will increase the foreign imported goods and decrease
the demand for domestically produced goods. Reduced tariffs will reduce the costs of imported goods,
increasing the competition for domestically produced goods.
A i s i ncorrect. A license is a limited ability to import specific goods and services. It is a type of
tariff. For example, there could be a restriction on imported cars, and licenses would be granted to
certain companies allowing them to act as importers. In addition, a large fee might be charged for a
license to be issued. T his expense will eventually be passed on to buyers of the imported product.
B i s i ncorrect. Import quotas are restrictions on the number of goods and services that can be
imported. Restricting the import of goods and services leads to an increased demand for domestic
goods and services, thereby protecting domestic producers.
184
Q.1557 Which of the following most likely exhibits the least level of integration among members?
A. Customs union.
B. Free trade area.
C. Economic union.
In free trade areas, all barriers to the flow of goods and services among members are eliminated, but
each member maintains its own policies against non-members.
A i s i ncorrect. A customs union improves on the integration fostered by FTAs by forging a standard
trade policy against non-members.
C i s i ncorrect An economic union takes the spirit of integration to an even higher level compared
to a customs union. It incorporates all aspects of a common market and, in addition, requires
common economic institutions and coordination of economic policies among members.
Q.1558 Which of the following is most likely a trade agreement in which barriers on the movement
of labor and capital goods among members are removed, but members do not adopt common
economic policies?
A. Monetary union.
B. Economic union.
C. Common markets.
In common markets, member countries remove all the restrictions regarding import-export goods
and services, adopt a standard set of trade restrictions on non-members, and remove barriers to labor
and capital goods movement among members. However, members do not adopt common economic
policies.
A i s i ncorrect. A monetary union is basically two or more governments coming together and
agreeing to share a common currency.
B i s i ncorrect. In an economic union, members adopt common economic policies on regulating

products, capital and labor, and freedom of movement of goods and services.
185
Q.1559 Which of the following is least likely included in the current account in the balance of
payments (BOP)?
A. Sales and purchase of non-financial assets.
B. Receipts of raw material and manufactured goods exported.
C. Foreign income from dividends on stock holdings and debt securities.
T he sales and purchases of non-financial assets are included in the Capital Account. In the current
accounts, receipts and payments of goods and services, foreign income receipts from stocks and
bonds, and money received from remittances and direct financial aid are included. A current account
is basically used to measure the inflows and outflow of goods and services.
Q.1560 T he account of the balance of payments (BOP) of Canada which includes Canadian
government-owned assets abroad is most likely the:
A. Capital account.
B. Current account.
C. Financial account.
A financial account has two sub-accounts: government-owned assets in foreign countries and foreign-
owned assets in the domestic country.
A i s i ncorrect. A Capital Account measures international capital transfers, acquiring or disposing of
non-financial assets required for production.
B i s i ncorrect. A Current Account measures the inflow and outflow of goods and services.
186
Q.1561 Which of the following situations will most likely result in a current account surplus?
A. Imports are lower than exports.
B. Exports are lower than imports.
C. Lower rate of private saving, higher government deficit, and higher rate of domestic
investments
T he current account equation is:
Exports − Imports = Private savings + Government savings − Investments
Greater exports than imports will result in a current account surplus.
Q.1562 Which of the following is most likely an international organization that aims to reduce
poverty?
A. World bank.
B. World T rade Organization.
C. International Monetary Fund.
T he World Bank is a vital source of financial and technical support to developing countries whose
mission is to fight poverty with passion and professionalism.
B i s i ncorrect. T he World T rade Organization is a global organization that ensures that trade flows
smoothly and freely.
C i s i ncorrect. T he International Monetary Fund’s main function is to lend foreign currencies to

its members during crisis periods.
187
Q.3245 Which of the following statements is most accurate?
A. GNP includes net exports, which GDP excludes.
B. Countries with large numbers of citizens working abroad will have large differences
between GDP and GNP.
C. GNP includes and GDP excludes the value of intermediate goods such as automobile parts
transferred from the USA to subsidiary assembly plants in Canada.
GDP excludes any final goods and services produced by a country’s citizens while working outside of
the country, while GNP includes the market value of goods and services produced by a country’s
citizens regardless of the physical location of the citizens.
A i s i ncorrect. Both GNP and GDP include net exports.
C i s i ncorrect. Neither GDP nor GNP includes the value of intermediate goods. GDP and GNP
consider the market value of finished goods and services. Including the value of intermediate goods
will lead to double counting.
A. T rade liberalization will lead to the elimination of most domestic firms due to foreign
competition.
B. T rade liberalization provides more consumer choice and improved opportunities for many
exporters.
C. T rade liberalization will result in all job opportunities moving to highly populated countries
such as China.
T rade liberalization refers to the act of removing or reducing restrictions/barriers of trade between
countries.
As trade barriers are removed, consumers have more choices. Exporters are also presented with
more markets, which can lead to higher prices for their goods.
Opponents of free trade point to the potential for greater income inequality and the loss of jobs in
developed countries due to import competition. However, these may only be short-term costs. In
the long run, resources are likely to be more effectively employed.
188
Q.3247 A worker in Fuscalia can produce either 5 guitars or 10 baseball caps per day. A worker in
Westonia can produce 4 guitars or 20 baseball caps per day. Which of the following is correct?
A. Westonia has a comparative as well as an absolute advantage in producing guitars.
B. Fuscalia has a comparative as well as an absolute advantage in producing baseball caps.
C. Westonia has an absolute advantage in producing baseball caps, and Fuscalia has a
comparative advantage in producing guitars.
Westonia can produce more baseball caps with the same resources giving it an absolute advantage in
producing baseball caps. Fuscalia can produce more guitars with the same resources giving it an
absolute advantage in producing guitars. A country has a comparative advantage in producing goods
and services if it can produce a good/service at a lower relative opportunity cost.
Fuscal i a
T he opportunity cost of producing one guitar is two baseball caps.
T he opportunity cost of producing one baseball cap is ½ guitars.
Westoni a
T he opportunity cost of producing one guitar is five baseball caps
T he opportunity cost of producing one baseball cap is 1/5 guitars
To produce one more guitar, Fuscalia must give up only two baseball caps, whereas Westonia must
give up 5.
Fuscalia has a lower opportunity cost, and hence a comparative advantage in the production of
guitars.
Westonia has a lower opportunity cost, and hence a comparative advantage in the production of
baseball caps.
189
A. T he Hecksher-Ohlin model attributes differences in comparative advantage to differences

in labor productivity.
B. T he Ricardian model would attribute differences in comparative advantage to differences

in labor productivity.
C. T he Ricardian model would attribute differences in comparative advantage to differences

in factor endowments.
In the Ricardian model, labor is the only factor that explains differences in comparative advantage.
T he Hecksher-Ohlin model attributes differences in comparative advantage to differences in factor
endowments.
Q.3249 In Barbados, foreigners are not generally permitted to own land. Although there are many
exceptions made, the more obvious being the presence of major hotels from the USA and other
countries dotting the beachfront, these restrictions are classified as:
A. Import quotas.
B. Capital restrictions.
C. Domestic content provisions.
Capital restrictions impose limits on the ability of foreigners to own domestic assets and or limits on
citizens’ ability to own foreign assets.
A i s i ncorrect. Import quotas are restrictions on the amount of goods and services that can be
imported.
C i s i ncorrect. Domestic content provisions are restrictions that require that items procured
using funds given by the congress be manufactured in the United States.
190
Q.3250 Which of the following conditions would least likely need to be present for a large country to
increase its welfare by imposing a tariff?
A. Its trading partner does not retaliate.
B. T he exporter reduces the price of its goods.
C. T he deadweight loss from the tariff is smaller than the benefit of its terms of trade.
T he exporter reduces the price of its goods to retain some of the market shares it could lose if it did
not lower its price. It is a response to a large country imposing a tariff, but it is not a requirement
for it to increase its welfare by imposing a tariff. However, a large country can increase its welfare
by imposing a tariff if:
1) its trading partner does not retaliate and,
2) the deadweight loss as a result of the tariff is smaller than the benefit of improving its terms of
trade.
Q.3251 T he introduction of an import quota on German manufactured automobiles would:
A. Generate the same revenue as a tariff for the country’s government.
B. Make the consumers of the importing country better off by sheltering their car
manufacturers from foreign competition.
C. Limit the importation of cars and permit the German auto importers to fully offset the
expected loss in sales by raising the prices of their cars.
T here is a deadweight loss created by either an import quota or a tariff. Using a quota, consumers
have less choice, and the quota could create the equivalent of a monopoly pricing opportunity for the
importers.
191
Q.3252 T he welfare improving benefits of trading blocs and common markets are best explained by
which of the following?
A. T rade creation.
B. T rade diversion.
C. T rade creation and trade diversion.
T rade creation is of mutual benefit to trading partners and improves welfare. It occurs when
regional integration results in replacing higher-cost domestic production with lower-cost imports
from other members.
T rade diversion would involve the replacement of a low-priced source with a high-priced member
country source. T his would be a reduction in welfare.
Q.3253 T he reasons for countries imposing capital restrictions are most likely to include which of
the following?
A. To protect strategic or military interests.
B. To prevent domestic investors from gaining higher rates of return abroad.
C. To ensure foreigners cannot unduly influence the election of government officials.
Controlling who can invest in strategic industries such as telecommunications is a frequently

imposed restriction.
B i s i ncorrect. Capital restrictions’ is not to prevent domestic investors from gaining higher return
rates abroad.
C i s i ncorrect. T he goal of capital restrictions is not to ensure foreigners can not unduly influence
election of government officials.
192
Reading 14: Currency Exchange Rates
Q.187 All else being equal, if the Australian dollar goes from USD 0.8 to USD 0.9, goods produced in
Australia and consumed in the United States will usually be:
A. cheaper for Americans.
B. more expensive for Americans.
C. the same price as before for Americans.
T he Australian dollar is now more expensive in terms of US dollars. T herefore, Americans will be
paying more USD to get the same amount of Australian dollar as before; Instead of paying USD 0.8,
they will now have to pay 0.9 (an extra 0.1).
A i s i ncorrect. T he amount would have been cheaper if the Australian dollar had depreciated
relative to the US Dollar.
C i s i ncorrect. T he price would have been constant if the rate had not increased.
193
Q.940 Which of the following must most likely happen for the balance of trade to improve?
A. savings must increase.
B. domestic production must decrease.
C. investments must be greater than savings.
Using the fundamental relationship among domestic saving, investment, the fiscal balance, and the
trade balance:
S = I + (G − T ) + (X − M)
C = Consumer spending on final goods and services

I = Gross private domestic investment
G = Government spending on final goods and services for both current consumption and investment
in capital goods
X = Exports
M = Imports
If we rearrange the above equation so that:
(X − M) = (S − I) − (G − T )
Since the balance of trade is the difference between the exports and imports for a given period of a
country, consumption will automatically decrease when savings increase. A decrease in consumption
implies that this will lead to less absorption of goods and services domestically. It will also lead to a
decrease in imports and a decrease in foreign borrowing, which will improve the balance of trade.
B i s i ncorrect. If domestic production decreases, then the exports decrease, and hence the
balance of trade deteriorates.
C i s i ncorrect. Based on the equation above, if investments are greater than the savings, the left-
hand side of the equation decreases, hence the balance of trade.
194
Q.942 Currency depreciation will most likely have a large effect on a country's trade balance if:
A. goods exported and imported have close substitutes.
B. goods exported and imported have less elastic demand.
C. goods imported represent a larger proportion of overall expenditure.
When goods exported and imported have c l o s e substitutes, then the currency depreciation will
make foreign goods more expensive (Since the local citizens will now have to use more of their
money to purchase one unit of the imported goods). T herefore, the country's citizens will shift to
domestic substitutes.
B i s i ncorrect. If goods exported and imported have less elastic demand, then currency
depreciation will not affect a country’s trade balance as such.
C i s i ncorrect. T he level of government expenditure is an exogenous activity. T hat is, many

government spending decisions are insensitive to the current economic activity, the level of interest
rates, the currency exchange rate, and other economic factors.
195
Q.943 An investor is interested in earning a risk-free profit on 100 United Arab Emirates Dirham
(DUB) by venturing into the Canadian market. He finds out that the DUB/CAD exchange rate is 0.4,
and the futures exchange rate DUB/CAD one year from today is 0.45. Given that the risk-free
interest rate in Canada is 5%, and the risk-free rate in the United Arab Emirates is only 2%, the
amount of risk-free profit earned in terms of DUB is closest to:
A. 12.5.
B. 16.125.
C. 18.125.
100
100 DUB invested =
0.4
= 250 CAD invested
Interest earned = 250 CAD × 5%
= 12.5 CAD
T hus,
Total amount = 250 CAD + 12.5 CAD = 262.5 CAD
262.5 CAD converts into (262.5 × 0.45) = 118.125 DUB in the future
Interests earned in Dubai would be 2% × 100 DUB = 2 DUB
T herefore,
Profit = 118.125 DUB − 102 DUB = 16.125 DUB
A i s i ncorrect. It represents the interest earned in the Canadian Investment.
C i s i ncorrect. It represents interest earned from Canadian investment, after converting to DUB,
and ignoring the United Arab Emirates risk free rate of interest.
196
Q.945 If in 2001, Dollar/Euro=3.67, and in 2002, Dollar/Euro=4.67, we most likely would say that:
A. T he Euro has depreciated.
B. T he dollar has depreciated.
C. T he dollar has appreciated.
Foreign exchange currencies are usually quoted as a quote/base. Dollar/Euro implies that the dollar is
the quote currency, whereas the euro is the base currency. Normally, the base currency is set to be
equal to 1.
T he rate in 2001 implies that 1 Euro is equal to 3.67 USD. T he rate in 2002 implies that 1 Euro is
equal to 4.67 USD.
In 2002, We will have to spend one more dollar to purchase 1 Euro worth of goods and services.
T herefore, the dollar has depreciated against the Euro, and the Euro has appreciated against the
dollar.
A and C are i ncorrect. T hey contradict option B.
Q.946 Appreciation of a country's currency would most likely means that:
A. T rade deficits would increase.
B. T rade deficits would decrease.
C. T rade deficits are not affected.
T rade deficits occur because the currency's appreciation makes imports cheaper (less of the local
currency will be needed to purchase one unit of the country it is importing from), and this would
mean more imports and higher trade deficits.
Appreciation of a country’s currency will equally mean that exports will reduce. Non-locals will
need to pay more for that country’s goods. As a result, non-locals will prefer not to purchase the
products of that country.
T he trade deficit would have decreased if that country’s currency had depreciated.
B i s i ncorrect. T rade deficits would decrease if the country’s currency depreciates.
C i s i ncorrect. Contradicts option B.
197
Q.947 All things being equal, inflation in a country would most likely lead to:
A. Depreciation in its currency.
B. Appreciation in its currency.
C. No effect on real exchange rates.
Inflation in a country leads to depreciation in its currency. If the price levels in a country (and hence
inflation goes up), consumers will increase their purchase of relatively cheap foreign goods, leading
to an overflow of that country’s currency in the foreign exchange market. T he greater supply of
that country’s currency in the foreign exchange market will weaken the currency and lead to its
depreciation.
B and C are i ncorrect. T hey contradict option A, given the explanation above.
Q.948 What would most likely happen to the real exchange rate if the nominal exchange rate of
Dollar/Euro decreases and the inflation remains the same?
A. T he exchange rate would decrease.
B. T he exchange rate would increase.
C. T he exchange rate will remain unchanged.
T he cost of one unit of real goods and services in Europe would decrease in relation to earlier.
We could also use the real rate of inflation formula to solve this question.
Real Rate of Inflation = Nominal rate of Inflation + Inflation premium
Assume that the real rate is 8%, the nominal rate is 6%, and the inflation premium is 2%.
If the inflation premium remains at 2% and the nominal rate reduces to 5%; the real rate of inflation
will be equal to 5% + 2% = 7% .
As seen above, a decrease in the nominal rate, assuming the inflation premium remains the same,
leads to a decrease in the real rate.
198
Q.949 Real money accounts are most likely on which side of the market?
A. T he broker.
B. T he sell-side.
C. T he buy-side.
Real money account refers to mutual funds, insurance companies, and other institution accounts that
do not use derivatives. T hus, they are on the buy-side.
A and B are i ncorrect. T he sell-side comprises large banks, whereas the broker side comprises
financial firms that provide platforms for the buying and selling of domestic and foreign currencies.
Q.950 What can we say about a country's imports when foreign currencies depreciate?
A. Imports get cheaper.
B. Imports get more expensive.
C. T here is no effect on imports.
When foreign currencies depreciate, the local currency appreciates. T hus, the price of imported
goods becomes cheaper because it takes less local currency to buy goods in foreign currencies. T he
opposite is true when foreign currencies depreciate.
199
Q.1564 T he CPIs of India and Pakistan are 132 and 121, respectively. If the nominal exchange rate is
1.32 PKR/INR, then the real exchange rate for India is closest to:
A. 0.69.
B. 0.83.
C. 1.44.
Domestic inflation
Real exchange ratef/d = Nominal exchange ratef/d × ( )
Foreign inflation
132
= 1.32 × ( )
121
= 1.44
We could also arrive at the same conclusion using the following formula:
Foreign inflation
Real exchange rated/f = Nominal exchange rated/f × ( )
Domestic inflation
1 121
=( )×( )
1.32 132
= 0.6944
1
= 1.44
0.6944
Note: T he numerators and denominators (PKR and INR) have to cancel each other out in all
circumstances.
A i s i ncorrect. It is the real exchange rate for Pakistan.
Foreign inflation
Real exchange rated/f = Nominal exchange rated/f × ( )
Domestic inflation
1 121
=( )×( )
1.32 132
= 0.6944
B i s i ncorrect. It multiplies the reciprocal of the exchange rate with the ratio (Domestic
inflation/Foreign inflation).
1 132
( )×( ) = 0.8264
1.32 121
200
Q.1565 If the exchange rate of Euros in terms of dollars has increased from 1.12 USD/EUR to 1.24
USD/EUR, then the most likely impact on prices of goods denominated in Euros is that:
A. Euro-denominated goods cost less in terms of USD.
B. Euro-denominated goods cost more in terms of USD.
C. Euro-denominated goods cost the same in terms of USD.
If the exchange rate has increased, the goods denominated in Euro will cost more in terms of USD.
Initially, 1.12 USD could purchase one EUR, but now we need 1.24 USD, a difference of 0.12, to
purchase one EUR. Consumers using USD will, therefore, have to pay an additional 0.12 USD per
Euro.
Q.1566 If the real exchange rate of USD/JPY decreases, which of the following is the most likely
correct?
A. US exports are cheaper for Japanese clients.
B. Japanese exports are more expensive to US clients.
C. US exports are more expensive to Japanese clients.
When the real exchange rate USD/JPY falls, then the domestic currency gains. T herefore, US
exports are more expensive and Japanese imports are cheaper in the US.
A i s i ncorrect. It contradicts option C.
B i s i ncorrect. Due to the fall in USD/JPY exchange rate, Japanese exports to the US must be
cheap to US clients.
201
Q.1568 Which of the following is most likely a sell-side participant in the forex market?
A. Large banks
B. Individual retail accounts
C. Privately held companies
T he foreign exchange market comprises two major sell sides; the buy and sell-side. T he buy-side
comprises clients who undertake their transactions through large banks, whereas the sell-side
comprises large banks.
T he sell-side participants in the forex markets are large multinational banks.
Q.1569 Due to the upcoming elections in the U.S., the CAD/USD currency exchange rates have risen
from 1.17 to 1.31. T he percentage change in the value of the USD in terms of CAD is closest to:
A. -10.68%
B. 11.96%
C. 10.68%
To calculate the percentage change in the value of the USD in terms of the CAD, we can simply
calculate the change 1. 31
− 1 = 0.1196.
1. 17
T his shows that the USD has appreciated 11.96% against the CAD. However, we cannot say the CAD
has depreciated 11.96% against the USD.
A i s i ncorrect. It represents the percentage change of the CAD in terms of the USD, which is
( 1.131)
calculated as − 1 = −0.10687. T his shows that the CAD has depreciated 10.687% against the
( 1.117)
USD.
C i s i ncorrect. It represents the absolute depreciation rate of CAD against USD.
202
Q.1570 T he exchange rates AUD/NZD has fallen from 1.01 to 0.90 in 1 year. Calculate the
percentage change in the value of the AUD in terms of NZD.
A. -12.12%
B. -10.89%
C. 12.12%
To calculate the percentage change in the AUD value in terms of NZD, we will divide the rate by
one.
AUD/NZD = 1.101 = 0.99 and NZD/AUD = 0.190 = 1.11
Now, we can simply calculate the change 1. 11
− 1 = 0.1212.
0. 99
T his shows that the AUD has appreciated 12.12% against the NZD.
A i s i ncorrect. We cannot say that the NZD has depreciated -12.12% against the AUD.
B i s i ncorrect. It represents the depreciation rate of NZD against AUD.
Q.1571 T urkey and Russia are two countries with a high level of bilateral trade relationships. Due to
recent economic crises in Russia, the exchange rate has gone from 19.10 RUB/T RY to 23.15
RUB/T RY. Which of the following is most accurate regarding this change in exchange rates?
A. T he T urkish Lira has depreciated.
B. T he T urkish Lira has appreciated.
C. T he Russian Ruble has appreciated.
In this question, RUB is the price currency, whereas T RY is the base currency.
It previously cost 19.1 RUB to buy 1 T RY, whereas now it costs 23.15 RUB to purchase the same 1
T RY. T herefore, the RUB has depreciated against the T RY, and the T RY has appreciated against the
RUB.
203
Q.1572 If the currency exchange rate between the U.S.A. and Europe is 1.11 USD/EUR, and the
rates between the U.A.E. and the U.S.A. is 3.30 AED/USD, then the current exchange rate of AED
per EUR is closest to:
A. 0.34
B. 2.97.
C. 3.66.
To calculate the cross rates between AED and EUR, we will simply cross-multiply both terms to
eliminate the U.S. dollar:
USD/EUR (1.11) × AED/USD (3.30) = AED/EUR 3.66 i.e. (1.11 × 3.30)
A i s i ncorrect. It divides USD/EUR with AED/USD.
B i s i ncorrect. It divides AED/USD with USD/EUR.
Q.1574 T he USD/GBP spot exchange rate is 0.6985. Assuming a 1-year forward rate quoted as +9.5
point, the 1-year forward USD/GBP rate is closest to:
A. 0.6995.
B. 0.6976.
C. 10.20
Each quoted point, or a basis point, in a forward exchange rate is equal to 0.01% or 0.0001 or
1/10,000. T herefore, +9.5 = 0.00095, and the forward USD/GBP rate is 0.6985 + 0.00095 = 0.69945.
B i s i ncorrect. It subtracts 0.00095 from 0.6985 instead of adding.
C i s i ncorrect. It adds +9.5 directly into 0.6985.
204
Q.1575 T wo hypothetical currencies, ABC and XYZ, are trading at the spot rate of 1.60 ABC/XYZ. If
the interest rate in ABC's country is 7% and 5% in XYZ's country, and the actual 1-year forward rate
is 1.62, which of the following is most accurate?
A. Arbitrage profit opportunity does not exist.
B. Arbitrage profit can be earned by buying the forward contract at 1.62.
C. Arbitrage profit can be earned by selling the forward contract at 1.62.
Since the actual forward rate of 1.62 is lower than the arbitrage-free forward rate of 1.6304, i.e.,
1. 07
(1.60 × ), an arbitrage opportunity exists. Arbitrage profit can be earned by buying the forward
1. 05
contract at 1.62. A risk-free profit of 0.0104, i.e., (1.6304 − 1.62) was made by buying low and selling
high.
A and C are i ncorrect. T hey contradict option B.
Q.1576 T he CHF/USD spot exchange rate is currently trading around 0.9500 on major FOREX
exchanges. Assuming a 1-year forward rate quoted as -25 points, the 1-year forward CHF/USD rate is
closest to:
A. 0.9475.
B. 0.9525.
C. -24.05.
Each (1) quoted point in forward exchange quotations is typically equal to 0.0001 or 1/10,000, since a
point is the last digit of a quotation. T herefore, -25 points = 0.0025.
Forward CHF/USD rate = 0.95 − 0.0025 = 0.9475
B i s i ncorrect. It adds the basis points instead of subtracting.

C i s i ncorrect. Subtracts the basis points from the spot rate directly without dividing with 10,000.
205
Q.1577 T wo hypothetical currencies – ABC and XYZ – are trading at a spot rate of 1.60 ABC/XYZ. If
the interest rate in ABC and XYZ's countries is 7% and 5%, respectively, the arbitrage-free forward
rate ABC/YXZ is closest to:
A. 1.6000.
B. 1.5701.
C. 1.6304.
T he arbitrage-free forward exchange rate can be calculated as the
Spot rate (ABC/XYZ) × ( ABC interest rate

).
XYZ interest rate
1. 07
T he arbitrage-free forward rate for ABC/XYZ is (1.60 × ) = 1.6304.
1. 05
A i s i ncorrect. Represents 1.60 ABC/XYZ spot rate.
B i s i ncorrect. It divides XYZ's interest rate with ABC's interest rate. T hat is:
XYZ interest rate
Forward rate ABC/YXZ = Spot rate (ABC/XYZ) × ( )
ABC interest rate
1.05
= (1.60 × )
1.07
= 1.5701
Q.1578 LeGrandia is a newly formed country that does not have its currency. Which of the following
is least likely option available for LeGrandia?
A. Crawling peg.
B. Monetary union.
C. Formal dollarization.
A crawling peg is an exchange rate regime that is used by countries that already have their currency.
A crawling peg is used to control currency moves, especially during threats of devaluation. It
involves buying and selling the currency in a coordinated manner to keep the currency within a
range (band of rates).
B and C i s i ncorrect. According to the IMF, if a country does not have its currency, it can use the
currency from another country (formal dollarization), or it can use the currency from the union it is
a member of (monetary union).
206
Q.1579 In which of the following exchange rate strategies can a country most likely make an explicit
commitment to exchange its domestic currency for a specified foreign currency at a fixed rate?
A. Target zone.
B. Fixed peg arrangement.
C. Currency board arrangement.
In a currency board arrangement, a country makes an explicit commitment to exchange its domestic
currency for a specified foreign currency at a fixed rate.
A i s i ncorrect. A target zone is a strategy in which countries agree to maintain their currency
exchange rates within a specified margin.
B i s i ncorrect. In a fixed peg arrangement, as the name suggests, the value of a currency is
fixed/pegged onto the value of another currency or a measure of value, for example, gold.
Q.1580 T he exchange rate strategy in which the domestic currency is permitted to fluctuate
between the horizontal bands +1% and -1% against a single or a basket of foreign currencies is most
likely called a:
A. target zone.
B. crawling peg.
C. fixed peg arrangement.
In conventional fixed peg arrangements, the domestic currency is permitted to fluctuate between
the horizontal bands +1% and -1% against a single or a basket of foreign currencies.
A i s i ncorrect. A target zone is where countries maintain their currencies within a specific set
margin.
B i s i ncorrect. Crawling peg is an exchange rate regime used by countries that already have their
currency. A crawling peg is used to control currency moves, especially during threats of devaluation.
It involves buying and selling the currency in a coordinated manner to keep the currency within a
range (band of rates)
207
Q.1581 Which of the following is the most appropriate statement about the Marshall-Lerner
condition?
A. Depreciation of the domestic currency will decrease the trade deficit.
B. Appreciation of the domestic currency will decrease the trade deficit.
C. Depreciation of the foreign currency will decrease the trade deficit.
T he Marshall-Lerner condition assumes that when the domestic currency depreciates, the exports
become cheaper for foreigners, and imports become more expensive for domestic clients. Hence,
the total revenue from exports increases, and expenditures on imports decrease, which will
decrease the trade deficit.
Q.1582 Which of the following statements is most appropriate about the J-curve?
A. If the domestic currency depreciates, there will be a short-term increase in deficit

followed by a long-term decrease in the deficit.
B. If the domestic currency appreciates, there will be a short-term decrease in deficit

followed by a long-term increase in the deficit.
C. If the domestic currency depreciates, there will be a short-term decrease in deficit

followed by an increase in the deficit in the long term.
T he J-curve, a theory and not a curve, assumes that if the domestic currency depreciates, there will
be a short-term increase in deficit followed by a long-term decrease in deficit because import and
export contracts often require delivery payment in the future.
208
Q.3254 If the exchange rate quote for the euro (USD/EUR) changes from 1.3500 to 1.2600, then in
approximate terms:
A. the euro depreciated by 6.7%, and the dollar appreciated by 7.1%.
B. the dollar depreciated by 6.7%, and the euro appreciated by 7.1%.
C. the euro appreciated by 6.7%, and the dollar depreciated by 7.1%.
You can think of this as the change in the price of the euro expressed in US dollars. If the exchange
rate moved from 1.3500 to 1.2600, then the percentage change in the euro quote is
1. 2600
− 1 = −0.06667 or depreciation of approximately 6.7%. Conversely, the percentage change in
1. 3500
( 1.12600)
1. 3500
the indirect quote is −1 = –1 = 0.0714 or 7.1% .
1. 2600
( 1 )
1. 3500
Q.3256 If the euro is quoted in US dollar terms as 1.4225 (USD/EUR), and the peso is quoted as
0.079 (USD/MXN), then the cross rate of MXN/EUR must be closest to:
A. 11.21
B. 25.61
C. 18.01
T he necessary cross rate equals:
USD USD −1
MXN/EUR = ×( )
EUR MXN
= 1.4225 × (0.079)−1
= 18.01
209
Q.3257 T he exchange rate regime adhered to by Canada, the USA, and the United Kingdom would be
best described as:
A. A target zone.
B. A managed float.
C. An independent float.
Canada, the USA, and the United Kingdom use an independent float as their exchange rate regime.
However, even those countries classified as using an independent float regime will sometimes
intervene in foreign exchange markets to influence the value of their domestic currency.
A note on influencing the domestic currency value: In general, as interest rates are lowered, more
people can borrow more money. T he result is that consumers have more money to spend, causing
the economy to grow and inflation to increase.
Inflation pressure will cause the domestic currency to depreciate. As such, the exports of the
domestic country will increase, and its imports will decrease, making the balance of payments (X-M)
less negative in the case of the U.S., Canada, and the United Kingdom.
A i s i ncorrect. A target zone is a strategy in which countries agree to maintain their currency
exchange rates within a specified margin.
B i s i ncorrect. In a managed float, a central bank has to regularly intervene in the forex market to
influence the value of its domestic currency.
Q.3258 T he exchange rate regime adhered to by China, Bolivia, and Iraq, would be best described as:
A. A crawling peg.
B. A managed float.
C. An independent float
A crawling peg is an exchange rate regime that allows depreciation or appreciation to happen
gradually. It is usually seen as a part of a fixed exchange rate regime.
B i s i ncorrect. In a managed float, a central bank has to regularly intervene in the forex market to
influence the value of its domestic currency.
C i s i ncorrect. In an independent float regime, the foreign exchange market determines the value
of a country’s currency. T he value is dependent on the demand and supply of that particular
currency relative to other currencies.
210
Q.3259 Some countries such as Ecuador and Panama have adopted the currency of another country.
Such a regime would be best described as:
A. dollarized.
B. a crawling peg.
C. an independent float.
Dollarization is the use of a foreign currency in parallel to or instead of the domestic currency.
B i s i ncorrect. A crawling peg is an exchange rate system that allows the fluctuation of currencies
within a band of rates.
C i s i ncorrect. An independent float is an exchange rate system that is flexible and purely
dependent on the market forces of supply and demand of foreign and domestic currencies.
Q.3260 Categories of participants on the buy side of foreign exchange markets would least likely
include:
A. Leveraged accounts and retail accounts.
B. Corporate accounts and real money accounts.
C. Large banks such as Citigroup and Deutsche Bank.
T he foreign exchange market participants can be divided into two large subgroups: the buy and the
sell-side. T he buy-side consists of clients who transact through large banks, whereas the sell-side
consists of large banks.
T he buy-side can generally be broken down into the types of participants listed in answers A and B.
211
Q.3262 T he Canadian dollar is quoted in US dollar terms as 1.2025 (CAD/USD), and the peso is quoted
as 12.4500 (MXN/USD). T he cross rate of MXN/CAD must be closest to:
A. 16.9095.
B. 10.3534.
C. 11.5000.
1
T he necessary cross rate equals 12.4500 (MXN/USD) × (CAD/USD) = 10.3534 (MXN/CAD) .
1. 2025
Q.3265 If the exchange rate quote for the Brazilian real (BRL/USD) changes from 3.1625 to 3.5000,
then in approximate terms:
A. the real depreciated by 9.6%, and the dollar appreciated by 10.7%.
B. the dollar depreciated by 9.6%, and the real appreciated by 10.7%.
C. the dollar appreciated by 9.6%, and the real depreciated by 10.7%.
T he percentage change in the dollar is calculated as 3. 5000

− 1 = 0.1067 or 10.7% . T he change in the
3. 1625
( 3.15000)
real is − 1 = −0.0964 or a depreciation of 9.6%.
( 1 )
3. 1625
212
Q.3266 If the exchange rate quote for the Mexican peso (MXN/USD) changes from 11.9500 to
12.4000, then in approximate terms:
A. the peso depreciated by 3.8%, and the dollar appreciated by 3.6%.
B. the dollar depreciated by 3.8%, and the peso appreciated by 3.6%.
C. the dollar appreciated by 3.8%, and the peso depreciated by 3.6%.
In the initial quote, you could buy 11.9500 pesos per US dollar. After the change, the US dollar would
buy 12.4000 pesos. T he peso fell in value against the dollar. In percentage terms, it fell by
11. 9500
− 1 = −0.036 or 3.6%. T he dollar appreciated by 12. 4000
− 1 = 0.0377 or 3.8%.
12. 4000 11. 9500
Q.3833 If the market demand for a product always responds positively to an increase in price
resulting in a positively sloped demand curve, the product is most likely classified as:
A. Giffen
B. Normal
C. Inferior
In the case of Giffen goods, the magnitude of the income effect is larger and negative such that it
overpowers the substitution effect. T his will result in a positively sloped demand curve and imply
that consumers will buy more (less) of the product when price increases (decreases).
In normal goods, the market demand’s response to price changes is always inverse; a price decrease
will increase quantity demanded, producing a negatively sloped demand curve. In the case of inferior,
non-Giffen goods, an increase in income will cause the consumer to buy less of the good. Demand
curves are negatively sloped for inferior goods in general.
213
Q.3834 T he CPIs of India and Pakistan are 132 and 121, respectively. If the nominal exchange rate is
1.32 PKR/INR, then the real exchange rate for India is closest to:
A. 1.78
B. 1.44
C. 1.12
Domestic inflation
Real exchange rate = Nominal exchange rate × ( )
Foreign inflation
132
= 1.32 × ( ) = 1.44
121
We could also arrive at the same conclusion using the following formula:
Foreign inflation
Real exchange rate = Nominal exchange rate × ( )
Domestic inflation
1 121
=( )×( ) = 0.6944
1.32 132
1
= = 1.44
0.6944
214

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Level

I of the CFA® 2022 Exam

Questions with Answers - Economics

Last Updated: Oct 7, 2022

prohibited. Infringers will be prosecuted in their local jurisdictions. ”

8 - Topics in Demand & Supply Analysis 3

Where Q represents the quantity demanded, whereas P represents a price. T hus,

Since 0.36 < 1, demand is inelastic.

C i s i ncorrect. Elasticity is said to be unitary elastic if it is equal to 1. Demand is unitary elastic if a

Q.650 At equilibrium; supply = demand

At price P=10; Qs = 400 + (75*10) = 1,150

Q.657 If the cross-price elasticity is 1.5, then the goods are:

A. substitutes with elastic cross-price elasticity.

B. substitutes with inelastic cross-price elasticity.

C. complimentary with inelastic cross-price elasticity.

A. T he slope of the budget line would change from -4/3 to -2/3.

B. T he slope of the budget line would change from 3/4 to 3/2.

C. T he slope of the budget line would change from -3/4 to -3/2.

A. Accounting profit - Normal profit = 0.

B. Accounting profit + Normal profit > 0.

C. Accounting profit - Normal profit < 0.

A. T he marginal revenue (MR) is not always less than the price.

B. T his happens because the average revenue (AR) is always decreasing.

C. Both I and II.

A. T he firm should shut down.

B. T he firm is at the break-even point where economic profit is 0.

A. T he minimum efficient scale.

B. T he various minimum average total costs.

C. T he minimum long-run average total cost.

A. economies of scale, increasing returns to scale.

B. economies of scale, decreasing returns to scale.

C. diseconomies of scale, increasing returns to scale.

A. Consumption of that good increases.

B. Consumption of that good decreases.

C. Consumption of that good can either decrease or increase.

C. Both Giffen and Veblen goods.

A. Price of tea = 216.67 - 3QD.

B. Price of tea = 650 - 0.33QD.

C. Price of tea = 216.67 - 0.33QD.

T he demand function of wheat is Qd = 274 - 1.5P

A. A shift of the demand curve to the left.

B. A shift of the demand curve to the right.

C. An increase in demand for ferry tickets.

Accounting profit = Revenues - Total accounting (explicit) cost

A. Sales commission expense

C. Payment to firm's equity owner

Accounting Profit = Revenue − Explicit costs

Economic Profit = Revenue − Total costs

Where Total costs = Explicit costs + Implicit costs

Economic profit = Accounting profit − Implicit opportunity cost

Foregoing rent so as to use the building as a warehouse is an implicit cost.

Normal profit = Accounting profit − Economic profit

First, we need to calculate economic profit, which is given by:

Accounting profit − Cost of capital = $9 billion − $2.5 billion = $6.5 billion

Since cost of capital is an implicit cost.

⇒ Normal profit = $9 billion − $6.5 billion = $2.5 billion

Q.1426 A firm that has a horizontal demand curve is called a:

B. Average fixed cost.

C. Average marginal cost.

A. shut down in the short run.

B. continue to operate in the short run.

C. shut down in the short-run and re-open in the long-run.

A. T he average revenue is less than the average variable cost.