CAF 2 Past Papers

ICAP PAST PAPERS AND
SOLUTION
CAF-02
INTRODUCTION TO ECONOMICS AND FINANCE
(SPRING 2018 - AUTUMN 2020)
By: Hafiz Muhammad Farhan

Certificate in Accounting and Finance Stage Examination
The Institute of 24 September 2020

Chartered Accountants 3 hours – 100 marks
of Pakistan Additional reading time – 15 minutes
Introduction to Economics and Finance

Instructions to examinees:
(i) All the Questions from Section A are compulsory.
(ii) Attempt any FIVE out of SEVEN Questions from Section B.
(iii) Answer in black pen only.
(iv) Multiple Choice Questions must be answered in answer script only.
Section A
Q.1 (a) What is planned economy? State any three drawbacks of planned economy. (04)
(b) Define ‘Capital formation’ and explain the stages involved in the process of capital
formation. (04)
Q.2 (a) What is ‘Diminishing marginal utility’? Explain the law of diminishing marginal
utility with the help of a schedule and the diagram. (07)
(b) List any four factors which may determine price elasticity of demand. (02)
Q.3 (a) What do you understand by the term ‘Economies of scale’? Describe any four ways
by which a firm may achieve internal economies of scale. (06)
(b) State how a firm may increase its overall profitability by exercising price
discrimination. (06)
Q.4 Briefly describe the following diagram and the concept it depicts. (06)
Introduction to Economics and Finance Page 2 of 4
Q.5 Select the most appropriate answer from the options available for each of the following
Multiple Choice Questions (MCQs). Each MCQ carries ONE mark.
(i) Which of the following features is more related to free market economy as compared
to planned economy?
(a) An incentive to innovate
(b) An even distribution of wealth
(c) Full employment of labour
(d) Production of goods for the benefit of the society as a whole
(ii) Micro economics does NOT cover:

(a) consumer behaviour (b) factor pricing
(c) general price level (d) product pricing
(iii) Which of the following statements is NOT correct?

(a) The different combinations of goods can be shown in the form of a budget line
(b) To work out where to draw the budget line it is necessary to divide the price of
each good with consumer’s total income
(c) Any point to the left of the budget line is affordable
(d) The slope of budget line is representative of the relative price between the two
goods
(iv) Under perfect competition, the supply curve of a firm is equal to:
(a) MR curve (b) AR curve
(c) MC curve (d) AC curve
(v) Which of the following is NOT considered to be an assumption of the law of

diminishing marginal utility?
(a) Rational consumer (b) Continuous consumption
(c) No change in quality of goods (d) Ordinal measurement
(vi) In a business cycle, the stage which eventually leads the economy to the state of
inflation is:
(a) Boom (b) Down turn
(c) Recession (d) Trough
(vii) Which of the following is NOT a part of Adam Smith’s canon of taxation?
(a) Equality (b) Economy

(c) Objectivity (d) Convenience
(viii) A reduction in the demand for coal miners is likely to lead the economy to the
following type of unemployment:
(a) frictional (b) structural
(c) voluntary (d) cyclical
(ix) Which of the following would increase the value of multiplier?

(a) The propensity to spend extra income on domestic goods and services is high
(b) The marginal rate of tax on extra income is low
(c) The propensity to spend extra income rather than save is high and consumer
confidence is high
(d) All of the above
(x) The crowding out effect is caused by a:

(a) rise in interest rates reducing private sector investment
(b) rise in interest rates reducing public sector investment
(c) fall in interest rates increasing savings
(d) fall in interest rates reducing consumption
(xi) The currency rate of exchange of a country will tend to increase, if:
(a) the demand for country’s goods and services increases in the foreign markets
(b) the value of the dominant reserve/transaction currency appreciates
significantly
(c) the supply of currency of that country in foreign exchange markets increases
(d) citizens of that country increase import of foreign goods and services
(xii) Which of the following instruments are NOT traded in the capital market?
(a) Corporate bonds (b) Mutual funds

(c) Mortgages (d) Shares
(xiii) In the Keynesian theory of demand for money, the transactions demand for money
is determined by:
(a) the rate of interest
(b) the level of consumers’ income
(c) expected changes in consumer prices
(d) the amount of money in circulation
(xiv) A country’s balance of payment position exhibits:

(a) whether the country saves enough to pay for its imports
(b) whether the country produces enough economic output to pay for its growth
(c) whether the country's currency value is appreciating or depreciating
(d) all of the above
(xv) Which of the following is a financial intermediary?

(a) Commercial bank (b) Federal Government
(c) State Bank of Pakistan (d) Stock exchange
Section B
Q.6 (a) Draw a diagram of the circular flow of national income in a two sector economy
clearly identifying the real flow and money flow. (04)
(b) List down any three factors which cause a shift in:
(i) aggregate demand curve. (03)
(ii) short-run aggregate supply curve. (03)
Q.7 (a) What do you understand by ‘Cost-push inflation’? Briefly describe any four causes of
cost-push inflation. (07)
(b) Describe any three limitations of multiplier. (03)
Q.8 Discuss the concept of inflationary gap in an economy with the help of a diagram. (10)
Q.9 (a) Briefly describe ‘Progressive tax’, ‘Regressive tax’ and ‘Proportional tax’. (03)
(b) State any four characteristics which are necessary for a good tax policy. (02)
(c) Identify and describe five main objectives of fiscal policy. (05)
Q.10 (a) Briefly describe any five roles which State Bank of Pakistan performs as banker to
the Government. (07)
(b) What do you understand by the ‘Quantity theory of money’? (03)
Q.11 (a) What is ‘Keynesian liquidity trap’? Identify any two policies which may help in
overcoming the liquidity trap. (03)
(b) What is meant by the term ‘Money market’? Briefly describe ‘Commercial paper’
and ‘Certificate of deposits’ which are traded on money market. (04)
(c) Describe the functions of money. (03)
Q.12 (a) State how a government may stop exchange rate from falling? Support your answer
with the help of a diagram. (06)
(b) Briefly discuss the constituents of capital/financial account. (04)
(THE END)
INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN
CERTIFICATE IN ACCOUNTING AND FINANCE (CAF) EXAMINATIONS
EXAMINERS’ COMMENTS
SUBJECT SESSION
Introduction to Economics and Finance Autumn 2020
Passing %
Question-wise
Overall
1 2 3 4 5 6 7 8 9 10 11 12
62% 52% 13% 33% 72% 35% 28% 9% 33% 11% 32% 21% 32%
General comments
The passing rate in Autumn 2020 attempt at 32% was almost at par with the previous attempt. Examinees
performed well in part A of the paper, comprising of microeconomic theories and concepts, as compared to
part B, which tested macroeconomic and finance parts of syllabus. Question number 3 in part A and question
numbers 7, 8, 10 and 12 in part B proved to be challenging to the examinees. Examinees are advised to
comprehend the basic economic concepts and refrain from rot learning. They must also pay special attention
to presentation, writing and communication skills for improving their exam performance.
Question-wise common mistakes observed
Question 1(a)
Good performance was observed in this part of the question. However, some of the examinees without
understanding the requirement of the question, discussed market economy instead of command economy.
Question 1(b)
Examinees failed to identify that capital goods include machines, tools, factories, transport equipment,
materials, electricity, etc.
Question 2(a)
• Many examinees failed to comprehend that marginal utility curve (MU) eventually becomes negative
after continuing to decline.
• Many examinees thought that MU initially rise and then fall.
• Some of the examinees mixed up the concept of diminishing marginal utility with equi-marginal
utility.
Examiners’ comments on Introduction to Economics and Finance – CAF Examination Autumn 2020
• Many examinees wasted time in drawing total utility curve and explaining its relationship with MU.
• Some examinees also failed to label the diagram and correlate it with the schedule.
Question 2(b)
Good performance was observed in this part of the question.
Question 3(a)
• Some of the examinees were of the view that reduction in total cost of production results in economies
of scale.
• Majority of the examinees failed to deliberate on the required four ways through which internal
economies of scale can be achieved.
Question 3(b)
• Majority of the examinees, ignoring the requirement of the question, unnecessarily explained price
discrimination and how it may be exercised.
• Answers were limited to the statement that elasticity of demand and separation of markets are necessary
to exercise price discrimination.
• Many examinees, without explanation, also drew diagrams to explain the concept of price discrimination
which was not required at all.
Question 4
• With the exception of few, majority of the examinees failed to identify that the diagram depicted the
concept of consumer equilibrium using indifference curve.
• Many examinees discussed the concept of Equi-marginal utility.
• Majority of the examinees failed to appreciate that each point on the budget line represents a combination
of quantities of products A and B which the consumer can buy at the prevailing prices.
Question 5
MCQ numbers 2, 5, 12 and 13 proved to be challenging for the examinees.
Question 6(a)
• Majority of the examinees failed to identify the money flow and real flow in the diagram showing
circular flow of national income.
• Many examinees drew the diagram of the circular flow of national income in a three or in some cases
four sector economy.
Page 2 of 5
Question 6(b)
• Many examinees failed to distinguish between factors affecting micro economic demand and supply
and macroeconomic or aggregate demand and supply.
• Some examinees mixed up the factors causing shift in aggregate demand and short-run aggregate supply
curves.
Question 7(a)
• Majority of the examinees failed to appreciate that under cost-push inflation the prices of goods rise due
to persistent increase in the cost of production while aggregate demand (AD) remains constant.
• While explaining the causes of cost-push inflation, majority of the examinees presented increase in each
type of cost as a distinct cause for the increase in cost-push inflation such as increase in raw material
cost, wages, import prices, other production costs etc.
• Some examinees discussed increase in direct taxes instead of indirect taxes as one of the reasons for the
increase in cost-push inflation.
Question 7(b)
Majority of the examinees identified the limitations correctly however, they failed to describe them properly.
Question 8
• Majority of the answers were incomplete and examinees failed to fully explain the concept of
inflationary gap in an economy.
• Many examinees mixed up the concept of inflationary gap with that of deflationary gap.
• Explanation with regard to original equilibrium point and its movement due to outward shift in aggregate
demand curve causing consequential increase in price level as well as shift in aggregate supply curve
towards left due to increase in wages was missing from majority of the answer scripts.
• Many examinees also failed to show diagrammatically the movement in aggregate demand and
aggregate supply curves.
Question 9(a)
Majority of the examinees failed to appreciate that it is the percentage of income paid in taxes which
increases or decreases with the increase or decrease in income in case of progressive tax. Similarly, in case
of regressive tax the persons/entities with lower income pay a higher proportion of their income as taxes
instead of a high amount, in absolute term, in taxes as compared to high income persons.
Question 9(b)
• With the exception of few, majority of the examinees instead of stating the characteristics of a good tax
policy only listed the key words without any explanatory statement, such as equitable, flexible, cost
effective etc. making no sense.
• Some examinees stated canons of taxation.
Page 3 of 5
Question 9(c)
Majority of the examinees listed the five objectives of the fiscal policy however, they failed to describe
them properly. In some instances, examinees mixed up the objectives of monetary policy with that of fiscal
policy.
Question 10(a)
• Majority of the examinees who identified the roles of State Bank of Pakistan as a banker to the
Government failed to describe them properly.
• Many examinees, without grasping the question requirement, deliberated on the functions of the central
bank such as lender of last resort to commercial banks, custodian of cash reserve, clearing house etc.
Question 10(b)
• Majority of the answers were limited to producing the equation i.e. MV = PT. Only few examinees were
able to deliberate on the concept of quantity theory of money.
• Some candidates wrongly deliberated on the liquidity preference theory as stated by Keynes.
Question 11(a)
Majority of the examinees correctly identified the two policies that may help in breaking out of liquidity
trap, however, some of them failed to describe them properly.
Question 11(b)
• Majority of the examinees left this part unanswered. Those who attempted the question were restricted
to the statement that commercial paper is a loan issued by the corporation.
• With regard to the certificate of deposit, majority of the answers were limited to the statement that these
are issued by banks and certain amount is payable to the holder after a fixed time.
• Some examinees considered that these are the bonds or a time deposit in which people invest their
money.
Question 11(c)
Some examinees instead of describing on the functions of money discussed the characteristics of money
such as durability, portability, divisibility, uniformity, limited supply and acceptability.
Question 12(a)
• Majority of the examinees failed to draw the correct diagram. Those who drew the diagram did not
label it properly.
• Many examinees were of the view that government can stop the exchange rate from falling by selling
its securities which will keep the demand for foreign currency constant in the market.
Page 4 of 5
• Some examinees opined that by controlling the balance of payment, government can stop the exchange
rate from falling.
Question 12(b)
The performance in this part remained satisfactory.
(THE END)
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Suggested Answers
Certificate in Accounting and Finance – Autumn 2020
Ans.1 (a) Planned economy:

It is a type of economic system in which allocation of resources is decided by the
government rather than markets.
Drawbacks of planned economy:

(i) Lack of profit motive and competition makes the economy inefficient.
(ii) Bureaucratic and slow to respond to changing needs or technology.
(iii) Loss of consumer sovereignty to planners reduces welfare.
(b) Capital formation:

Capital formation is the net capital accumulation for a particular country and
refers to the additions or increase in the stocks of capital in that country. Capital
goods include machines, tools, factories, transport equipment, materials,
electricity, etc.
Stages involved in the process of capital formation

The process of capital formation involves the following three stages:
(i) Creation of savings:

When the average level of income is high then people tend to save more. An
increase in the volume of real savings releases resources which otherwise
would have been devoted to the production of consumption goods.
(ii) Mobilization of savings:

It involves transfer of savings from the households to businesses for
investment.
(iii) Investment of savings:

Investment of savings in real capital is integral for the capital formation.
This can only happen if there are enough entrepreneurial ventures and
businesses that are willing to take risks and embrace uncertainty.
Ans.2 (a) Law of diminishing marginal utility:

It means that additional benefit which a person derives from a given increase of
his stock of a commodity diminishes with every increase in stock that he already
has.
Explanation with the help of schedule and a graph:

We assume that a person is very thirsty. He takes the glasses of water successively.
The marginal utility of the successive glasses of water decreases, ultimately, he
reaches the point of satiety. After this point the marginal utility becomes negative,
if he is forced further to take a glass of water. The behaviour of the consumer is
indicated in the following schedule:
Units of commodity Total utility Marginal utility (MU)

1st glass 10 10
2nd glass 18 8
3rd glass 24 6
4th glass 28 4
5th glass 30 2
6th glass 30 0
7th glass 28 -2
The law of diminishing marginal utility can be explained by the following diagram
drawn with the help of above schedule:
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In the above diagram, the marginal utility of different glasses of water is measured
on the y-axis and the units (glasses of water) on X-axis. The marginal utility curve
has a downward slope. It intersects the X-axis at the point of 6th unit of the
commodity (point "F") where the marginal utility becomes zero. When the MU
curve goes beyond this point, the MU becomes negative. So there is an inverse
functional relationship between the units of a commodity and the marginal utility
of that commodity.
(b) Factors which may determine price elasticity of demand:

Following are the factors which may determine price elasticity of demand:
(i) Nature of the commodity
(ii) Number of substitutes
(iii) Goods having several uses
(iv) Durable goods and perishable goods
Ans.3 (a) Economies of scale:

Reduction in cost per unit resulting from large scale production are known as
economies of scale.
Internal economies of scale can be achieved in the following ways:

(i) Technical economies:
As the firm expands it can use larger and more efficient machines resulting
in greater efficiency and economy.
(ii) Managerial economies:

Larger firms can employ specialist managers to optimise the use of
resources. The cost per unit of clerical and administrative procedures will
also be lower as output grows.
(iii) Trading/commercial economies:

Larger size enables the firm to buy in bulk and sell in bulk, reducing both
the costs of buying and selling. Large businesses have bargaining
advantages and are accorded a preferential treatment by the firms they deal
with.
(iv) Financial economies:

Larger firms have better credibility and can offer better security, making
them a better risk for lenders thus reducing interest rates and financing
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costs.
(b) How a firm can increase its overall profitability by exercising price discrimination:
Price discrimination is profitable if the firm identifies and operates in markets
where elasticity of demand in one market is different from elasticity of demand in
the other market. Or the firm splits up the groups of buyers and prevent goods
from being resold between them.
The monopolist charges a higher price in the market where elasticity is low and
charges a lower price where elasticity is high.
The marginal revenue in the market with high elasticity of demand is greater than
the marginal revenue in the market where elasticity is low.
The monopolist therefore transfers some units of the commodity from the market
where elasticity is low to a market where elasticity is high until the marginal
revenues in both the markets are equal.
The market from which the units are transferred will experience a rise in price and
the market to which the units are transferred will experience a fall in price.
But due to difference in elasticity, marginal revenue (MR) sacrificed will be much
lesser than the MR gained and hence the monopolist would be able to maximize
the overall profitability.
Ans.4
The above diagram demonstrates the concept of consumer equilibrium using

indifference curve.
(i) AM is the budget line (consumer’s price line). Each point on the line represents a
combination of quantities of products A and B which the consumer can buy at the
prevailing prices, given the amount of money the individual has to spend on the
two products. Hence the equilibrium must be on some point on this line.
(ii) Each point on the indifference curve represents the same level of satisfaction. The
level of satisfaction increases as the individual moves from lower indifference
curve to higher indifference curve i.e. the individual is at a lower level of
satisfaction at the combinations represented by IC1 and at a higher level of
satisfaction when on IC2 and so on.
(iii) IC3 is the highest indifference curve to which the individual can go, given the
money and the prices of the goods in the market. The price line is tangent to the
indifference curve at point P which is the point of maximum satisfaction because
all other points on the curve are beyond the budget line.
The indifference curve IC4 is unattainable as it is beyond the budget line AM.
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(iv) Thus the consumer will be in equilibrium when the individual purchases OH
quantities of product A and OJ quantities of product B.
Ans.5 (i) (a) An incentive to innovate

(ii) (c) general price level
(iii) (b) To work out where to draw the budget line it is necessary to divide the price
of each good with consumer’s total income
(iv) (c) MC curve
(v) (d) Ordinal measurement
(vi) (a) Boom
(vii) (c) Objectivity
(viii) (b) structural
(ix) (d) All of the above
(x) (a) rise in interest rates reducing private sector investment
(xi) (a) the demand for country’s goods and services increases in the foreign markets
(xii) (c) Mortgages
(xiii) (b) The level of consumers’ income
(xiv) (d) all of the above
(xv) (a) Commercial bank
Ans.6 (a) Circular flow of national income in a two-sector economy:
(b) (i) Factors causing a shift in aggregate demand curve:

Following are the factors which causes a shift in the aggregate demand curve.
 Consumers have more income and therefore spend more in the
economy
 Firms are producing at optimum and begin investing in the economy
 The government increases its expenditure on infrastructural projects
(ii) Factors causing a shift in short-run aggregate supply curve:

Following are the factors which causes a shift in the short-run aggregate
supply
 Change in factor productivity of both labour and capital
 Change in size and quality of capital stock, through investment
 Change in size and quality of the labour force
Ans.7 (a) Cost-push inflation:

In cost-push inflation, the prices of goods rise due to persistent increase in the cost
of production of goods, while their demand remains consistent.
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Causes of cost-push inflation:
(i) Rising labour costs:

When level of unemployment in an economy is low, skilled labor would be
in a position to demand higher wages which would give rise to cost-push
inflation.
(ii) Expectations of inflation:

When people in an economy anticipate higher inflation, they may demand
higher wages to protect their real income. Higher wages would increase the
costs to a firm which would ultimately fulfil the expectation of higher
inflation.
(iii) Component costs:

An increase in the price of raw materials and other inputs would give rise to
cost-push inflation.
(iv) Higher indirect taxes:

Imposition of indirect taxes would result in higher costs for the firms which
would ultimately pass on to end consumers resulting in cost-push inflation.
(b) Limitations of Multiplier:
(i) Efficiency of production/Elasticity of supply:

If the production system of the country cannot cope with increased demand
for consumption goods and make them readily available, the incomes
generated will not be spent as envisaged.
(ii) Regular investment:

The value of the multiplier will also depend on regular repeated investments.
A steadily increasing level of investment is essential to maintain the
momentum of economic activity.
(iii) Leakages:
Leakages from the circular flow of income would lower the value of
multiplier and extra spending in the economy would have nominal effect,
particularly where there is a high marginal propensity for imports.
Ans.8 Inflationary gap arises when consumption and investment spending are greater than the
resources at full employment. At this level, changes in the aggregate demand will cause
price changes instead of any variation in real output.
The inflationary gap can be explained with the help of following diagram:
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An increase in government spending causes aggregate demand (AD) to shift outward to

AD2. This causes the equilibrium in the economy to move from point A to point B i.e.
beyond LRAS, which is the productive potential of the economy.
This increases the price level from P1 to P2 because if demand increases, consumers on
the aggregate are willing to pay a higher price for goods.
However, equilibrium at point B is unsustainable. To produce this level of output there

would be a shortage of labour in the economy. In the long run, this will increase the
wages, causing a shift in the level of SRAS towards left.
This takes the economy from B to C and increases the price level from P2 to P3.
However, a price rise does not equate to inflation. A persistent increase in price (i.e. two
or more) results in start of inflation.
This therefore means that whenever output is beyond the LRAS, there is a tendency for
inflation to occur. Therefore, it is known as the inflationary gap.
Ans.9 (a) Progressive taxation:

It refers to a situation where the percentage of income paid in taxes increases as
income increases. The principle of progressive tax is: “higher the income, higher
the rate.”
Regressive taxation:
A tax where lower income persons/entities pay a higher fraction of their income as
taxes than higher income persons/entities.
Proportional tax:
Also called a flat-rate-tax is charged at the same percentage on all income levels i.e.
the tax as a percentage of income remains constant as income increases.
(b) Characteristics of a good tax policy:

The characteristics of a good tax policy are:
(i) persons should be required to pay taxes according to their ability i.e. it
should be equitable.
(ii) the tax should be certain and easily understood by all concerned.
(iii) the payment of tax should ideally be related to how and when people
receive and spend their income.
(iv) the cost of collection should be nominal relative to the yield.
(c) Objectives of fiscal policy:

Following are the main objectives of fiscal policy:
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(i) High level of employment: The state expenditure are directed towards
public projects thereby creating employment with productivity.
(ii) Resource mobilization: Fiscal mechanism attempts at resource mobilization

by creating a climate conducive to savings and investments, by influencing
their relative profitability.
(iii) Resource allocation: A fair share of resources is allocated to different sectors

and regions through the budgetary mechanism.
(iv) Economic stability: Undesired pace of inflation or deflation is controlled by

way of taxation and government spending.
(v) Income distribution: Fiscal policy is a combination of taxation and relief

measures which are used to correct imbalances resulting from the unequal
distribution of ownership of income earning assets.
Ans.10 (a) State Bank of Pakistan is the banker to the Government and in that capacity
performs the following functions:
(i) Issuer of currency:

The State Bank has monopoly of issuing currency which is done keeping in
view the overall objectives within an economy.
(ii) Banker to the government:

The State Bank offers advice and funding to the government for financing
projects in the same way a commercial bank would do to its customers.
(iii) Regulator of the banks:

State Bank regulates the banks through banking laws and by means of
monetary policy instruments.
(iv) Exchange rate controls:

The State Bank has a control over country’s foreign currency reserves. It uses
them to overcome short-term exchange rate volatilities and inefficiencies.
(v) Establishment of specialized banks:

In some cases, State Bank allows the creation of banks to serve a particular
purpose, usually not for commercial means. For example, agricultural bank
to provide funds to farmers at subsidized interest rates.
(b) Quantity theory of money:

Quantity theory of money states that there is a direct relationship between
changes in the money supply and the rate of inflation. The theory is based on
equation MV=PT.
MV is the value of total expenditure in a period which must be equal to the value of
goods and services sold in the same period which is PT. The equation is useful as
an explanation of inflation when certain assumptions are made and which, if
accepted, means that the average price level (P) is solely determined by changes in
the money supply (M).
Ans.11 (a) Keynesian liquidity trap

Keynesian liquidity trap is a situation where savings rates are high despite very
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low interest rates, causing monetary policy to be ineffective.
The two policies that may help in breaking out of liquidity trap are as follows:
Fiscal policy:
It is an important instrument in raising aggregate demand, for example running a
larger budget deficit by increasing public expenditure or reducing taxes.
Rising inflation expectations:

High rate of inflation would cause savings to be worthless. This will act as
disincentives for hoarding of cash, as its real value will decrease. Therefore
consumption will increase.
(b) Money market:

It is the financial market for raising short-term credit.
Both ‘Commercial paper’ and ‘Certificate of deposits’ are the instruments of money
market:
(i) Commercial paper:

Commercial paper is an unsecured short-term loan issued by the
company/corporation usually in denominations of 100,000 somewhat
restricting access to small investors. It is issued with the promise to repay
the holder a certain amount by a certain date.
(ii) Certificate of deposits:

These are time deposit with a commercial bank, whereby after a fixed time a
certain level of money will be returned to the holder. This has a slightly
higher yield because the default risk is higher with a bank, than with the
government.
(c) Functions of money:

There are four functions that money undertakes in modern society:
(i) To act as a medium of exchange:
Allowing economic agents to exchange goods without the need to barter.
(ii) To act as a unit of account:

Allowing people to compare the relative price of goods and services through
a common denomination.
(iii) To act as a store of value:

Allowing people to forgo immediate consumption if they have surplus
resources, and to retrieve it at a later date for consumption.
(iv) To act as a standard of deferred payments:

Allows people to consume goods and services in the current time period,
whilst continuing to pay in future periods.
Ans.12 (a) How the government may stop exchange rate from falling:
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Suppose the government wishes the rate to be at Rt. Policy options are:
 Increase the domestic interest rate and hence shift the demand curve for
rupees from D to D1.
 Purchase the surplus rupees (Qs-Qd) using foreign exchange reserves.
Deflate the economy to reduce the demand for imports. This will shift the supply
curve of rupees from S to S1.
(b) Components(Constituents) of capital/financial account:

Following are the components of capital/financial account:
(i) Real foreign direct investment:

A firm setting up a factory in another country.
(ii) Portfolio investment:

a domestic investor buying shares in a business that is already established. Such
investors have little or no control over these companies.
(iii) Financial derivatives:

financial instruments where the underlying value is based on another asset.
(iv) Reserve assets:

these are foreign financial assets held by Central Bank which uses them to cover
deficits and imbalances.
(THE END)
Page 9 of 9
The Institute of 5 March 2020


Instructions to examinees:
(iii) Answer in black pen only.
Section A
Q.1 (a) Identify and briefly discuss any four features which differentiate a market operating
under perfect competition from a monopoly. (06)
(b) What would be the effect of a rise in price of a substitute good on the equilibrium
market price of a good that it is being substituted for? Illustrate your answer with the
help of a diagram. (06)
Q.2 (a) Discuss any four essential features of ‘Islamic economic system’. (04)
(b) What is ‘Division of labour’? Describe any three disadvantages of division of labour. (04)
Q.3 (a) Briefly explain the concept of Relatively Inelastic Demand by using the diagram. (03)
(b) Briefly describe any four factors which are responsible for the success or failure of a
price cartel under oligopolistic market. (04)
Q.4 Discuss the concept and various stages depicted by the following diagram. Also identify the
stage in which rational decision is possible. (08)
(i) The horizontal demand curve parallel to x-axis implies that elasticity of demand is:
(a) zero (b) infinite
(c) equal to one (d) between zero and one
(ii) Which of the following will NOT cause a shift in the Production Possibility Curve?
(a) A fall in unemployment (b) Increase in age of retirement
(c) Technological improvement (d) Capital investment
(iii) Which of the following statements is NOT true?

(a) Ceteris paribus means other things remaining same
(b) One of the economic goals is to maintain price stability
(c) Normative aspect of economics deals with factual questions
(d) Agent is a decision maker within an economic model
(iv) Which of the following statements is correct?

(a) When the average cost is constant, the marginal cost must be falling
(b) When the average cost is rising, marginal cost is lower than average cost
(c) When the average cost is rising, marginal cost is higher than average cost
(d) When the average cost is falling, marginal cost must be rising
(v) Which of the following is NOT a feature of monopolistic competition?

(a) Low barriers to entry and exit
(b) Many firms supplying to the market
(c) Firms can change their actions without influencing the behaviour of other firms
(d) Each firm faces a horizontal demand curve
(vi) Which of the following may be regarded as a positive consequence of inflation?

(a) Improvement in the value of money (b) Benefit to the debtors
(c) Benefit to the creditors (d) Reduction in prices
(vii) Which of the following factors might cause an upward shift in the country’s
consumption function?
(a) A fall in share prices (b) A fall in interest rates
(c) Households deciding to be economical (d) Expectation of recession
(viii) Which of the following is NOT part of public expenditure?
(a) Investment by nationalised industries (b) Spending by local governments

(c) Capital spending of public companies (d) Interest on the national debt
(ix) Structural unemployment is a type of unemployment which:

(a) increases in a recession and falls in a boom
(b) arises due to lack of skills required for a newly created job
(c) arises when persons give up hope of finding a job
(d) occurs as a result of transition from one job to another
(x) By budgeting for a deficit, a government aims to reduce:

(a) consumer spending (b) inflation
(c) rate of economic growth (d) unemployment
(xi) Cheques are NOT money because they:
(a) are issued by the banks instead of the government

(b) are merely instructions to transfer money
(c) have value in exchange but little intrinsic value
(d) are not backed by either gold or silver
(xii) In an economy, there are Rs. 200 million in currency held outside banks,
Rs. 100 million in travellers’ cheques, Rs. 250 million in currency held inside the
banks, Rs. 300 million in checking deposits and Rs. 700 million in savings deposits.
The value of M1 (type of money) is:
(a) Rs. 750 million (b) Rs. 1,200 million
(c) Rs. 1,150 million (d) Rs. 600 million
(xiii) If a country has exports of goods of Rs. 5,300 million, exports of services of
Rs. 1,120 million, imports of goods of Rs. 5,700 million and imports of services of
Rs. 1,420 million, than the value of its balance of trade is:
(a) Rs. 700 million deficit (b) Rs. 400 million deficit
(c) Rs. 300 million deficit (d) Rs. 300 million surplus
(xiv) Which of the following statements is NOT true in context of Keynesian liquidity trap,
where prevailing interest rates are very low?
(a) People may decide to hoard cash
(b) Savings are moved to short-term investment bearing accounts
(c) Monetary policy triggers aggregate demand
(d) Forecast of return on investment is downgraded
(xv) Which of the following does NOT depict the concept of J curve?
(a) In short-run, the current account deficit gets worse before improving
(b) In short-run, import costs increase sharply
(c) In long-run, export revenues remain unchanged
(d) In long-run, high import prices have a contributory effect to inflation
Section B
Q.6 (a) Briefly describe any two methods used for measuring National Income. (04)
(b) What would be the multiplier effect of an increase in investment by Rs. 50 million on
the equilibrium level of income where marginal propensity to consume is 0.8 and the
proportion of additional income that is spent on imported goods is 30%? Illustrate
your answer with the help of a diagram. (06)
Q.7 (a) Explain how equilibrium of aggregate demand (AD) and aggregate supply (AS) may
be achieved under neo-classical approach. Use diagram to illustrate your answer. (07)
(b) What causes an upward or downward shift in the consumption function? Use diagram
stating two determinants of consumption function to support your answer. (03)
Q.8 (a) Describe any four unfavourable consequences of unemployment. (06)
(b) Briefly describe ‘Leading economic indicators’ and ‘Lagging economic indicators’.
Give two examples of each. (04)
Q.9 (a) State four main functions of taxation. (04)
(b) What do you understand by the terms ‘Expansionary fiscal policy’ and
‘Contractionary fiscal policy’? List two tools in respect of each of the above two
policies which the government may use for their implementation. (03)
(c) Explain two basic differences between public and private finance with reference to
‘Adjustment of income and expenditure’ and ‘Deficit financing’. (03)
Q.10 (a) What do you understand by the term credit money? Also describe three types of
credit. (06)
(b) State the matters which the government may consider while raising money from
capital markets. (04)
Q.11 (a) Briefly describe the four primary forces behind the determination of interest rate. (06)
(b) Explain the terms ‘Balance of trade’ and ‘Terms of trade’. (04)
Q.12 (a) Describe any four measures which the government may adopt to correct the balance
of payment position in Pakistan. (06)
(b) Briefly describe the following:

(i) Retail bank (ii) Specialized bank (iii) Mutual funds (04)
(THE END)
SUBJECT SESSION
Introduction to Economics and Finance Spring 2020
Passing %
Question-wise
Overall
1 2 3 4 5 6 7 8 9 10 11 12
43% 50% 43% 28% 37% 18% 16% 16% 45% 12% 10% 33% 33%
General:
Examinees’ performance in part A of the paper was comparatively better as compared to their performance in
part B. Question number 4 in part A and question numbers 6, 7, 8, 10 and 11 in part B proved to be more
challenging to the examinees. Examinees are advised to refrain from selective studies and carefully read the
question paper before attempting to answer the questions.
Question 1(a)
 Some of the examinees without understanding the requirement of the question, discussed the features of only
one of the types of market structure.
 Few examinees also considered monopoly and perfect competition as same type of market structure.
Question 1(b)
 Though majority of the examinees were able to draw the diagram, they failed to explain the concept depicted
by it, as most of the answers were restricted to the statement that ‘Increase in price of a substitute good
would increase the demand for a good which is being substituted for’.
 Many examinees misunderstood the question and explained price effect with the help of indifference curve.
 Examinees also failed to comprehend the shift of equilibrium from point ‘a’ to point ‘b’ in the diagram due to
rise in price of a substitute good and its impact of causing an upward pressure on the price and ultimately
shifting the equilibrium to point ‘c’.
Question 2(a)
Good performance was observed in this part of the question.
Question 2(b)
 Examinees wrongly considered division of labour as splitting of the labour force into small groups according
to their skills and assigning each group a special task. Where in fact division of labour is the splitting of the
production process into a number of individual operations and making each operation the special task of one
worker.
Page 1 of 4
Examiners’ comments on Introduction to Economics and Finance – CAF Examination Spring 2020
 Many examinees also deliberated on the advantages of division of labour instead of its disadvantages.
Question 3(a)
 Most of the examinees did not explain the diagram. Their answers were limited to the definition of relatively
inelastic demand which stated that the percentage change in quantity demanded is less than the percentage
change in price.
 Some examinees explained the concept of relatively elastic demand instead of relatively inelastic demand.
Question 3(b)
Majority of the answers were incomplete and examinees hardly elaborated on only two or three factors which
could be responsible for the success or failure of price cartels under oligopolistic market.
Question 4
 With the exception of few, majority of the examinees failed to explain all the three stages depicted by the
diagram.
 Many examinees discussed marginal price and average price instead of marginal product and average
product.
 Few examinees also failed to identify the correct stage where rational decision was possible.
Question 5
Examinees faced difficulty in identifying the correct choices in cases of MCQ numbers 2, 5, 8, 12 and 13.
Question 6(a)
Some examinees mixed up the concepts of income approach and production approach.
Question 6(b)
 Examinees failed to compute the multiplier effect and explained the diagram incorrectly.
 Many examinees could not even draw the correct diagram.
Question 7(a)
 Although majority of the examinees drew correct diagram, answers were restricted to the statement that
equilibrium occurs at the point where aggregate demand (AD) curve cuts aggregate supply (AS) curve.
 Many examinees misunderstood the question and explained either Keynesian model or inflationary gap.
 Only handful of examinees were able to elaborate on the impact of rise or fall in general price level above or
below the equilibrium point respectively.
 Examinees also failed to deliberate on why equilibrium does not arise at the intersection of LRAS and AD.
Question 7(b)
Majority of the examinees correctly drew the diagram but were able to state only one out of the two determinants
of consumption function.
Page 2 of 4
Question 8(a)
 Majority of the answers were incomplete and examinees were unable to provide all the four unfavourable
consequences of unemployment. In many instances, examinees repeated similar points.
 Many examinees were of the opinion that with the rise in unemployment, inflation also increases ignoring the
fact that the two are inversely proportional to each other.
 Many examinees without understanding the question, deliberated on the types of unemployment.
Question 8(b)
 Majority of the answers were incomplete as examinees either failed to define the indicators or provide
relevant examples of each of the indicators.
 Some examinees mixed up the concepts and defined leading indicators as lagging and vice versa.
Question 9(a)
Many examinees instead of writing about the functions of taxation, stated canons of taxation.
Question 9(b)
 Majority of the examinees correctly defined expansionary and contractionary fiscal policies. However, in
many instances they stated monetary tools instead of fiscal tools for the implementation of these policies.
 Some examinees mixed up the two policies and defined expansionary policy as contractionary and vice
versa.
Question 9(c)
Majority of the examinees failed to properly explain the difference between public and private finance with
reference to deficit financing.
Question 10(a)
 Examinees failed to properly describe the types of credit.

 Most of the examinees were unable to distinguish between consumer credit and trade credit and as a result
mixed up the two types of credit.
Question 10(b)
Majority of the examinees left this part unanswered. Those who attempted the question stated how government
could raise the money from capital market instead of the matters to be considered while raising money from
capital market.
Question 11(a)
Majority of the answers were incomplete as examinees failed to describe all the four required determinants of
interest rate.
Page 3 of 4
Question 11(b)
 Many examinees mixed up the concepts of terms of trade and balance of trade.
 With regard to balance of trade, majority of the examinees did not appreciate that it is a record of
international transactions during a given period of time.
 Some examinees considered both domestic and international transactions as forming part of balance of trade.
 Few examinees included both goods and services as part of balance of trade.
Question 12(a)
Most of the examinees deliberated on general measures for the correction of balance of payment position instead
of Pakistan specific measures.
Question 12(b)
 Majority of the examinees failed to describe mutual funds.

 In case of retail banks, some of the examinees were of the view that these banks provide loan only to
corporate customers.
The End
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Certificate in Accounting and Finance – Spring 2020
Ans.1 (a) The features which distinguish a market operating in an environment of perfect
competition from a market which operates as a monopoly are:
(i) Number of sellers - In conditions of perfect competition there are a large number of
sellers in the market. The individual sellers compete to sell their products in the
market, but in a monopoly there is only a single firm which sells the product.
(ii) Entry and exit of firms- In perfect competition, new firms can freely enter the
industry and inefficient firms can exit if they suffer losses. Under conditions of
monopoly, there are several barriers which are difficult to overcome for prospective
new entrants.
(iii) Options available to buyers - In a market characterised by perfect competition, the

buyers have the option to purchase from any firm in the market. Under conditions of
monopoly, the buyers must purchase from the only seller who dominates the market.
(iv) Earning of normal and super-normal profits - In perfect competition, a firm may earn
super-normal profits in the short-run. In the long-run, the firm can earn only normal
profits as new firms would enter the market and force the prices to fall. Under
conditions of monopoly, a firm can earn super-normal profits in the short-run as well
as in long-run due to the existence of barriers which prevent entry of new firms.
(b) When price of a substitute good increases, the demand for the good that it is being
substituted for increases.
The following diagram shows how an increase in price of A affects equilibrium price and
equilibrium quantity of B:
Initially, equilibrium is at P0Q0. Increase in price of good A causes an increase in demand

for good B resulting in shifting of demand curve to right, from DD to D’D’. Consumers are
now willing to buy Qd quantity (point b) but producers are willing to sell only Q0 quantity
(point a). This shortage of supply over demand (Qd-Q0) causes an upward pressure on the
price. As the price rises, the excess demand falls because quantity demanded decreases
while quantity supplied increases. The supply curve intersects the new demand curve at
point c, so the new equilibrium price is P1 (up from P0) and the new equilibrium quantity is
Q1 (up from Q0).
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Ans.2 (a) (i) Allah is the sustainer: This describes the belief that Allah has created all the
resources available to man and is responsible for feeding and nourishing all the
creatures and human beings. Islam encourages people to do their best to earn a
livelihood using all lawful (Halal) and fair means whilst dissuading idleness.
(ii) Allah is the true owner of everything: Human beings are merely a trustee of resources
but have authority for using them but such authority is subject to certain guiding
principles that are required to be complied with.
(iii) State ownership: Islamic system neither proposes nor prohibits establishing state
owned enterprises. Therefore, a free market exists where entrepreneurs can profit
so long as they abide by the other rules of the Islamic economic system.
(iv) Practicing of moderation: Islam aims for a fair distribution of resources and so the
people are taught to share wealth where they can. In this regard, it proposes a
moderate life style and opposes extravagant as well as excessive misery.
(b) Division of labour:

Division of labour is the splitting of the production process into a number of individual
operations and making each operation the special task of one worker. It involves greater
levels of specialization among the workers.
Disadvantages:
(i) Loss of flexibility:
When workers specialize too much, it may be difficult for them to perform other
tasks in the event of changes in demand.
(ii) Monotony:
Since the workers perform the same task over and over again, they may get bored.
This could result in making mistakes, higher sickness rates and higher labour
turnover.
(iii) Loss of skills/Decline in craftsmanship:

By breaking the production process into a series of separate, simple and often
repetitive tasks, workers are not challenged. This could result in loss of interest in
acquiring new skills.
Ans.3 (a) Relatively Inelastic Demand:
Demand is relatively inelastic when the percent change in quantity demanded, i.e. area
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designated by B in the above diagram, is less than the percent change in price, i.e. area
designated by A in the above diagram.
In case of relatively inelastic demand, a decrease in price from OPo to OP1 would result in
increase in the quantity demanded from Oqo to Oq1.
(b) The failure or success of price cartels under oligopolistic market depends on following
factors:
(i) Control on supply:

For the successful price cartel, firms under oligopolistic market must hold all or
substantial market share.
(ii) Close substitutes:

Success of price cartel depends on non-availability of close substitutes of product
otherwise when higher price is set by oligopolists, the buyers will shift their demand
to close substitutes.
(iii) Price elasticity of demand:

Price cartel will be successful if price elasticity of demand for a product is inelastic.
Otherwise when oligopolists set higher price, buyers contract demand more
proportionately weakening the price cartel.
(iv) Agreement on individual share:

If all the firms in cartel agree on their allotted quota of supply, price cartels would be
successful. However, if firms secretly increase production and sale of the product,
price cartels would collapse because at increased supply, charging a higher agreed-
on price would not be possible.
Ans.4
The above diagram shows the concept of law of variable proportion and its various stages.
According to the law of variable proportion:

As the quantity of one variable input in a production process is increased, with quantities of other
inputs remaining fixed, marginal product first increases, then after reaching a maximum, it starts
decreasing and finally becomes negative.
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Three stages of the law:

Stage I:
In this stage, AP is maximum (R) whereas TP increases initially at increasing rate (L) and
thereafter it increases at diminishing rate (L to M). MP also increases initially and reaches its
maximum (N) however, later on it begins to diminish and becomes equal to AP (O). In this stage
MP exceeds or is equal to AP.
Stage II:
In this stage, TP continues to increase at diminishing rate and reaches its maximum point (G).
Correspondingly MP diminishes rapidly and becomes zero (C). AP starts from its maximum (R)
and thereafter it begins to decrease. In this stage, MP is less than AP.
Stage III:
In this stage, TP starts diminishing, AP also continues to decline and MP turns negative thus law
of variable proportions firmly manifests itself.
A rational producer will not opt to stop production at Stage I because his fixed factor will remain
underutilized and he will be foregoing the opportunity of increasing production by increasing the
quantity of the variable factor whose average product continues to rise throughout in Stage I. He
will also not choose Stage III where not only average product is falling but also the total product
is falling and marginal product is negative. He would opt to produce in Stage II, where the
marginal product continues to remain positive.
Ans.5 (i) (b) infinite

(ii) (a) A fall in unemployment
(iii) (c) Normative aspect of economics deals with factual questions
(iv) (c) When the average cost is rising, marginal cost is higher than average cost
(v) (d) Each firm faces a horizontal demand curve
(vi) (b) Benefit to the debtors
(vii) (b) A fall in interest rates
(viii) (c) Capital spending of public companies
(ix) (b) arises due to lack of skills required for a newly created job
(x) (d) unemployment
(xi) (b) are merely instructions to transfer money
(xii) (d) Rs. 600 million
(xiii) (b) Rs. 400 million deficit
(xiv) (c) Monetary policy triggers aggregate demand
(xv) (c) In long-run, export revenues remain unchanged
Ans.6 (a) (i) Expenditure approach:

This method arrives at national income by adding up all the expenditure incurred on
goods and services during the year.
(ii) Income approach:

This method measures the national income after it has been distributed and appears
as income earned or received by individuals of the country.
In this method, national income is calculated by adding up the rent of land, wages of
employees, interest on capital and profit earned by entrepreneurs/firms.
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(b) Multiplier effect:
In the above diagram, SS is the saving curve and II is the investment curve. These two
curves intersect at point E and hence, the equilibrium level of income is determined. If now
there is an increase in investment by Rs. 50 million, then II curve will shift upward to the
position of I’I’ and the two curves I’I’ and SS will intersect at point E’ which would be the
new equilibrium level of income. Hence, the diagram shows that an increase in investment
by Rs. 50 million would increase the national income by Rs. 100 million (1 ÷ (1-MPC +
MPM) × change in investment) i.e. 1÷(1-0.8+0.3). Thus the value of multiplier is equal
to 2.
Ans.7 (a) Equilibrium of AS and AD:

The equilibrium of aggregate supply (AS) and aggregate demand (AD) under neo-classical
approach is illustrated below:
In the above diagram, price level is measured on y-axis and real national output on x-axis.
AD is the aggregate demand curve whereas LRAS is the long run aggregate supply and
SRAS is the short run aggregate supply curves.
The macro economy is in equilibrium at the point where SRAS (value of output produced
within an economy) is equal to AD (level of demand for goods and services).
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The reason why equilibrium does not arise at the intersection of LRAS and AD is that LRAS
is the productive potential in the economy. Whereas SRAS is what is actually being
supplied in the macro economy, and is therefore what equilibrium should be based upon.
If the general price level is above the equilibrium point, then firms will persistently find
that their stocks remain unsold. This then indicates that they should cut back on further
production, to reduce the level of inventory.
If, however, the general price level is below the equilibrium point, then demand will
outstrip supply, stocks will quickly become run down, thus signaling to producers that they
should increase supply.
These mechanisms ensure that the macro economy is restored to equilibrium.
(b) Shifts in the consumption curve:

An increase or decrease in the level of consumption at each level of disposable personal
income respectively shifts the consumption function upward or downward.
In the following diagram, the consumption function has shifted upward. (C1 to C2). This
means consumers are spending a larger percentage of their income. This could be due to:
 positive forecasts about economic prospects increasing consumer confidence; or
 reduction in price level increasing consumers’ real wealth. (wealth effect)
Similarly, the consumption function may shift downward (C1 to C3) with the increase in
the price level (decrease in real wealth) or increase in consumer pessimism with regard to
future economic prospects. (decrease in consumer confidence).
Ans.8 (a) The unfavourable consequences of unemployment are:
(i) Loss of output – Unemployment results in the under-performance of the economy

and low levels of output of goods and services. Consequently, there is a decline in the
level of national income.
(ii) Loss of human capital – Unemployment leads to gradual erosion of the work skills of
the unemployed workers and deterioration in their capacity to perform satisfactorily
in future.
(iii) Increase in inequality in distribution of wealth – Unemployment results in loss of

Page 6 of 10
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incomes and decline in savings of unemployed persons. This leads to more

inequitable distribution of wealth among the citizens.
(iv) Social costs – Unemployment brings social problems of mental depressions, increase
in crime rates and causes personal suffering to the unemployed workers and their
families.
(b) Leading economic indicators:

The nature of these indicators is that they are used to forecast at what stage the economy
will be in, at some time in the future.
These in particular give an indication for whether a peak or trough will be reached in the
following 3-12 months.
(i) Index of business confidence
(ii) Manufacturers’ new orders
Lagging economic indicators:

These indicators are used to assess whether an economy has reached a peak or trough 3-
12 months after it would have occurred.
(i) Consumer Price Index (i.e. level of inflation)
(ii) Average duration of unemployment
Ans.9 (a) Functions of taxation:

Following are the four main functions of taxation:
(i) Fiscal:
Taxes play their role in the formation of the budget necessary for the realization of
national and holistic government programmes. It funds the government
expenditures.
(ii) Allocation:
It acts as a means of distributing wealth among various groups of citizens: wealthy to
poor, as a means of maintaining a social stability.
(iii) Regulatory:
This function is aimed at achieving specific goals of the taxation policy through the
taxation mechanism.
(iv) Incentive:
It stipulates special taxation arrangements for certain members of society as a result
of past achievement. This function has a social facet.
(b) Expansionary fiscal policy:

A macroeconomic policy that seeks to increase the rate of economic growth.
Contractionary fiscal policy:

A macroeconomic policy that seeks to slow down the rate of economic growth.
List of tools which the government may use to implement expansionary or contractionary
fiscal policies.
Expansionary:
 Tax cuts
 Tax rebates
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 Increased government spending
Contractionary:
 Increase taxes
 Reduce subsidies
 Wage freeze
(c) Basic difference between public and private finance:

(i) Adjustment of income and expenditure:
An individual determines his expenditure according to his revenue and the
government adjusts its revenue to its expenditure.
For instance; while an individual knows his fixed income and spends his money
accordingly, the state first estimates the total expenditure and then imposes the taxes
accordingly.
(ii) Deficit financing:

In case of deficit financing, the government has an option to print currency notes and
create money to meet the expenditure.
On the other hand, individual cannot create money by printing currency notes or by
such other means.
Ans.10 (a) Credit money:

Any monetary claim against a physical or legal person that can be used for the purchase of
goods and services. For instance, IOU’s, bonds and money market accounts. Virtually any
form of financial instrument that is not repaid immediately is considered credit money
Types of credit:
Following are the kinds of credit which are classified according to the type of users:
(i) Trade credit/Commercial credit/Mercantile credit

This exists between a customer and a seller, usually in the commercial sector. A
purchaser can order a good, receive the good, and then pay for it after a certain
period of time. The credit terms will often mean that the amount has to be paid after
30, 60 or 90 days.
(ii) Bank credit

This type of credit exists when an individual or firm goes to a bank, receives an
amount of money upfront, and then pays back the amount over a period of time.
Bank credit can have varying terms of how much needs to be paid back, and by what
time.
(iii) Consumer credit/Retail credit

A consumer credit agreement often occurs between a retailer and a consumer. In
exchange for store credit (i.e. currency to spend at the establishment) a consumer
can pay the amount back over a certain period of time.
(b) Following are the matters which the government may consider while raising money from
capital markets:
(i) Rate of interest that needs to be paid to investors

(ii) Length of time to pay back
(iii) The risk factor of them not returning money to investors
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(iv) Alternative methods of raising capital (increasing taxes, etc.)
Ans.11 (a) Determinants of interest rate:
(i) Supply and demand

The interest rate depends upon the supply and demand of the credit. An increase in
demand would lead to an increase in the rate of interest whereas a decrease in
demand would lead to a decrease in the rate of interest.
On the contrary an increase in the supply of credit would decrease the rate of
Interest and a decrease in supply of credit would cause an increase in the rate of
interest.
(ii) Inflation rate

Interest rate rises with the rise in actual or expected inflation rate.
(iii) Government
The government has a say in the determination of the interest rates by way of
devising the monetary policy.
(iv) Type of loan

The interest rate on different type of loans depends on multiple factors, such as
credit risk, time, tax considerations etc. Risk refers to the likelihood of loan being
repaid. The higher the risk the more the return. Time is also an important factor. Long
term loans are riskier because of the time interval involved and the inflation, making
them more costly in terms of interest rates.
(b) Balance of trade

Balance of trade is a record of a country’s international trade transactions (import and
export of goods) with other countries during a given period of time. The Balance of trade is
in deficit when a country’s imports exceeds its exports and vice versa.
Terms of trade
The quantity of domestic goods that a country must give up to obtain a unit of imported
goods is called the terms of trade.
Ans.12 (a) Corrective measures for improving balance of payment position in Pakistan:
(i) Establishment of labour intensive industries:
Since labour is cheaper in Pakistan therefore labour intensive industries can be set
up and the products from such industries could be exported.
(ii) Export tariffs:

Reducing export duties will help us make our exports competitive in the
international market. Foreign countries would prefer to buy our products because of
reduced prices.
(iii) Joint ventures:

Establishing joint ventures with foreign investors can give a boost to our sales
outside the country.
(iv) Controlled imports:

Imports of all luxury items should be discouraged and only the needed items should
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be imported.
(b) (i) Retail bank: A bank targeted at the mass-market in which individual customers can
purchase/obtain mortgages, checking accounts, personal loans, and other bank
services.
(ii) Specialized bank: A bank targeted to a specific section of the economy in which firms
and customers can have access to specialized forms of banking services.
(iii) Mutual funds:

 Mutual funds are investment vehicles where many investors pool their
resources together to be invested in a variety of financial instruments.
 These are operated by professional money managers having specialist
knowledge of money markets and capital markets.
 These allow individual investors to diversify their investment which otherwise
might not be possible for investor with small amount of capital.
(THE END)
Page 10 of 10

Instructions to candidates:
Section A
Q.1 (a) Briefly explain why the production possibility curve is downward sloping and concave
to the origin. (03)
(b) What do you understand by the term ‘Market economy’? What are its main features?
Also state any four drawbacks of market economy. (05)
Q.2 (a) Describe the concept of long-run equilibrium of a firm under monopolistic
competition with the help of a diagram. (08)
(b) With the drop in price of smartphones from Rs. 80,000 to Rs. 70,000, the quantity
demanded by the consumers, in a particular market, increases from 20,000 phones to
30,000 phones per month. Calculate the elasticity of demand under percentage
method and identify the type of elasticity. (02)
Q.3 (a) What do you understand by ‘Reserve price’? Describe any six factors which may
influence the reserve price of a seller. (07)
(b) Show a graphical interaction of marginal cost, average variable cost, average fixed
cost and average total cost curves. (Explanation of the graph is not required) (02)
Q.4 Briefly describe the following diagram and the concept it depicts: (08)
(i) Which one of the following statements is NOT true for a planned economic system?
(a) Productive resources are state owned (b) Auto-adjusted price mechanism
(c) Full employment is possible (d) Less duplication of resources
(ii) A movie theatre may be regarded as an example of:

(a) public goods (b) private goods
(c) demerit goods (d) club goods
(iii) Which one of the following assumptions does NOT confer to the law of demand?
(a) There is no change in the income of consumers

(b) There is no substitute for the good
(c) The prices of related goods are unstable
(d) The size of population is stable
(iv) Which one of the following assumptions is related to the law of variable proportion?
(a) Continuous improvement in techniques of production
(b) All factors of production are proportionately varied
(c) There is no scarcity of the factors of production
(d) The factors are able to be combined to make a product
(v) Which one of the following is NOT a feature of perfect competition?

(a) Firms are price makers
(b) Perfect factor mobility
(c) Free entry and exit of firms in the market
(d) Products are homogenous
(vi) Which one of the following defines the economic growth rate?
(a) Increase in real investment (b) Increase in GDP
(c) Increase in real GDP (d) Increase in GDP deflator
(vii) Which one of the following statements is NOT true?
(a) High interest rates makes it less expensive to borrow

(b) Low interest rates discourage saving
(c) High interest rates would result in lower disposable income
(d) Low interest rates encourage consumption
(viii) A expansionary fiscal policy combined with a restrictive monetary policy would result
in:
(a) budget deficit to decrease (b) taxes to increase
(c) government expenditure to decrease (d) interest rates to increase
(ix) Which one of the following is NOT an outcome of the central bank’s expansionary
monetary policy?
(a) Increase of money supply in the economy
(b) Decrease in market rate of interest
(c) Increase in exchange rate
(d) Increase in aggregate demand
(x) Which one of the following is NOT part of the country’s current account?
(a) Export of goods (b) Foreign direct investment flows
(c) Unilateral transfers to other countries (d) Imports of services
(xi) Which one of the following is NOT a cause of cost push inflation?
(a) Increase in the price of raw material
(b) Fall in interest rates
(c) Increase in firm’s profit margins
(d) Exchange rate depreciation
(xii) What would be the velocity of circulation of money in an economy in which the
average price level is 1.8, real GDP is Rs. 260 billion and the nominal money supply is
Rs. 117 billion?
(a) 4.0 (b) 3.2 (c) 4.8 (d) 0.8
(xiii) The use of exchange control to overcome balance of payment deficit results in:
(a) decrease in imports (b) decrease in exports
(c) decrease in price level (d) decrease in national income
(xiv) Under which of the following circumstances, the value of the multiplier would be
higher?
(a) When both marginal propensity to consume and marginal propensity to import
are low
(b) When marginal propensity to consume is low and marginal propensity to import
is high
(c) When marginal propensity to consume is high and marginal propensity to
import is low
(d) When both marginal propensity to consume and marginal propensity to import
are high
(xv) Which one of the following will NOT be the result of devaluation of domestic
currency on the foreign exchange market?
(a) Export becomes less expensive in terms of foreign currency
(b) Imports become more expensive in terms of domestic currency
(c) Export volumes will increase
(d) Import volumes will increase
Section B
Q.6 (a) From the following data, compute GDP, GNP and NNP at market price:
Rs. in billion
Domestic consumption 290
Taxes on expenditures 76
Government expenditures 57
Capital formation 65
Exports 89
Imports 83
Subsidy 18
Net property income from abroad 11
Capital depreciation 25 (04)
(b) Describe three different types of Injections and Withdrawals from the Circular Flow
of Income. (06)
Q.7 (a) What is ‘Demand-pull inflation’? Briefly describe how fiscal and monetary stimulus
may cause demand-pull inflation. (05)
(b) Briefly describe any four determinants of savings. (05)
Q.8 (a) What do you understand by ‘Liquidity preference theory’? Describe the influence of
the motives identified by Keynes, on the liquidity preference of an individual. (07)
(b) Describe any three short-run factors which may affect marginal efficiency of capital
and investment. (03)
Q.9 (a) Describe any three benefits of economic growth. (03)
(b) The importance of public finance can be easily understood by its functions. Describe
any two main functions of public finance as emphasized by Musgraves. (04)
(c) Assume in a closed economy with no government intervention, Rs. 1 billion increase
in investment results in Rs. 5 billion increase in consumption. Compute the value of
marginal propensity to consume. (03)
Q.10 (a) Briefly describe any three tools which are available to the Central bank for controlling
money supply in an economy. (06)
(b) There are different types of financial instruments that can be classified as money. State
four types of money categorised by its liquidity. (04)
Q.11 (a) Describe the concept of ‘Deflationary gap’ with the help of a diagram. (04)
(b) Briefly describe the term ‘Derivatives’ and state the main objective of exchange traded
derivatives. (03)
(c) State three advantages and three disadvantages of direct taxation. (03)
Q.12 (a) What is ‘Balance of payment’? Describe any five causes due to which a country may
have a deficit in balance of payments. (07)
(b) Briefly describe the monetary measures which may be taken by the government to
correct balance of payments deficit. (03)
(THE END)
SUBJECT SESSION
Introduction to Economics and Finance Autumn 2019
Passing %
Question-wise
Overall
1 2 3 4 5 6 7 8 9 10 11 12
50% 22% 47% 16% 73% 64% 35% 22% 16% 14% 34% 19% 43%
General comments
Although overall performance exhibited considerable improvement from last attempt, question number 4 in part
A and question numbers 9, 10 and 12 in part B proved to be more challenging to the examinees. Further,
examinees are again advised not to attempt extra questions from part B as it only results in waste of time.
In order to get better results, examinees are strongly advised to read the question paper clearly and follow the
instructions provided therein. They are also advised to develop their writing and presentation skills which will
also help them in their future examinations.
Question 1(a)
 Although majority of the examinees answered it well, some of the examinees mixed up the concept of
marginal rate of transformation with marginal rate of substitution.
 Examinees mixed up the concept of Production Possibilities Curve (PPC) with the concept of consumer
equilibrium.
Question 1(b)
 Examinees correctly explained the definition of Market economy, however, they failed to elaborate its main
features. Majority of the answers were only confined to self-interest, profit motive and laissez faire.
 Some of the examinees wrongly considered the drawbacks of market economy as its features.
Question 2(a)
 Most of the answers were confined to the statements such as, marginal revenue is equal to marginal cost and
average revenue is equal to average cost.
 With regard to the type of profit which can be earned in long-run under the monopolistic competition,
examinees had divided opinions, some of them correctly discussed that only a normal profit can be earned
whereas in view of others it was either a supernormal or sub-normal profit or even in some cases examinees
discussed that a firm would sustain a loss in long-run.
 Many examinees also failed to draw a proper diagram. It lacked the basic concept that under a long-run, LAC
curve is always tangent to AR curve at a point which is vertical to the point where LMC cuts MR curve from
below.
Page 1 of 4
Examiners’ comments on Introduction to Economics and Finance Autumn 2019
Question 2(b)
 Only few examinees were able to correctly compute and identify the type of elasticity of demand.
 Most of the answers remained incomplete. Many of those who although correctly computed the elasticity of
demand failed to identify that it was a relatively elastic demand. Some of them thought that it was an
inelastic demand while others considered it to be perfectly elastic.
 Many examinees switched the numerator with the denominator in the formula and arrived at a wrong result.
Question 3(a)
 Most of the examinees correctly defined the reserve price. However, many of them failed to identify and
describe all the six required factors which may influence the reserve price.
 Some examinees did not read the question properly and described the reserve price from buyer’s perspective.
Question 3(b)
Most of the examinees were able to correctly draw only marginal cost or average total cost curves. Majority of
them were perplexed while drawing the average fixed cost curve and average variable cost curves. Some
examinees drew a horizontal straight line to depict average fixed cost curve.
Question 4
 With the exception of few, none of the examinees were able to identify that the diagram was related to the
law of Equi-Marginal Utility.
 Majority of the answers were limited to only describing the indifference curves.
 Many examinees either could not identify the budget line or failed to acknowledge the concept depicted by it.
Question 5
Good performance was observed in this question.
Question 6(a)
 Some examinees made computational errors and included taxes on expenditures and subsidy as component
of GDP at market price.
 Few examinees also computed GDP, GNP and NNP at factor cost which was not required at all.
Question 6(b)
Some examinees mixed up the injections with withdrawals whereas few examinees only identified the injections
and withdrawals without any explanation.
Question 7(a)
 Many examinees failed to properly explain demand pull inflation. With the exception of few, most of the
answers were limited to the statement that in demand pull inflation, the aggregate demand exceeds aggregate
supply.
 While explaining how fiscal stimulus may cause demand pull inflation, many examinees did not mention the
effects of multiplier.
 Similarly while explaining monetary stimulus, many examinees failed to appreciate the impact of fall in
interest rates on increase in demand.
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Question 7(b)
Some examinees identified the four determinants of savings however, they failed to describe them properly.
Question 8(a)
Majority of the examinees were able to define the liquidity preference theory and two out of the three motives
i.e. transactions and precautionary motives. However, they failed to explain speculative motive and viewed it as
a store of value.
Question 8(b)
 Majority of the examinees were not able to define all the three short-run factors.
 Many examinees wrongly defined current rate of investment, technological development, rate of growth of
population etc. as short-run factors where in fact these are the long-run factors.
Question 9(a)
Most of the examinees identified and described the benefits of economic growth, however, some of them found
it challenging to describe the benefits.
Question 9(b)
 Majority of the examinees identified the functions of public finance however, description in most of the cases
was either inadequate or incorrect.
 Many examinees thought that providing social welfare and building of infrastructure are the only functions of
public finance.
Question 9(c)
Except for writing the equation 1/1-MPC, majority of the examinees completely failed to compute the MPC.
Question 10(a)
 In majority of the cases, only one or two tools for controlling the money supply were identified. The answers
were inconclusive and limited to the increase or decrease of interest rates.
 Most of the examinees were unable to distinguish between the interest rate and discount rate.
 Some examinees wasted time in explaining exchange rate policy.
Question 10(b)
Majority of the examinees failed to identify the types of money categorised by its liquidity. They mostly
considered fiat money, paper money, plastic money, cheques etc. as types of money categorised by its liquidity.
Question 11(a)
 Many examinees plotted incomplete diagram. Those who drew the diagram correctly could not explain it
properly.
 Many examinees even failed to appreciate that actual level of national income lies at the point where
aggregate demand is equal to the short-run aggregate supply. Similarly many examinees could not identify
the production potential of the economy and as a result failed to highlight deflationary gap on the diagram.
Page 3 of 4
Question 11(b)
Some examinees failed to properly describe the term derivatives. The answers were varied in nature and
generally seemed to be the product of guess work. With regard to the objective of exchange traded derivatives,
the most common one line answer was that ‘it reduces the risk’ where in fact it reduces the level of counterparty
risk as trades are done by means of regulated contracts through a clearing house.
Question 11(c)
Majority of the examinees’ correctly deliberated on the advantages and disadvantages of direct taxation.
Question 12(a)
 While explaining balance of payment, answers were restricted to the statement that it is the difference
between country’s imports and exports.
 Most of the examinees either did not state all the five required causes of deficit in balance of payment or
could not explain them properly. The only factors which they considered were; increase in import and
decrease in export.
Question 12(b)
 Incomplete answers were produced.

 Many examinees discussed fiscal measures instead of monetary measures.
(THE END)
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Ans.1 (a) Production Possibility Curve (PPC):

The PPC is downward sloping and concave to the origin because of the following reasons:
Downward sloping:
The reason for being downward sloping is that in order to increase the production of one
good, resources must be diverted from the other, hence decreasing the production of that
good. This happens due to scarcity of resources.
Concave to the origin:

The reason for being concave to the origin is because of increasing marginal rate of
transformation (MRT) or opportunity cost. some of the economy’s resources are better at
producing Good A, and some are better at producing Good B. Increasing MRT means more
and more unit of one good is to be sacrificed to get an additional unit of another good. This
change in the opportunity cost of producing each good, at various levels of production, is
what causes the curve to be concave.
(b) Market economy:

It is an economic system in which production and prices are determined by the free forces
of demand and supply that is unrestricted competition between privately owned business
instead of government. Government’s role is restricted to legislation, foreign affairs, peace
and security, and currency issuance.
Features:
Following are some of the main features of market economy:
 Reliance on the market and price mechanism to allocate resources
 Private ownership and control of factors of production
 Self-interest and profit motive motivate economic decisions
 Wages and other factor payments are set by the market.
Drawbacks:
Market economy has following drawbacks:
(i) Inequalities of income will lead to socially undesirable resource allocation
(ii) Ignores social costs of production and consumption decisions
(iii) Danger of emphasis on luxuries rather than necessities
(iv) Failure to plan long-term
Ans.2 (a)
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The above diagram depicts the concept of long run equilibrium of a firm under
monopolistic competition.
In the above diagram, AR = Average revenue curve, MR = Marginal revenue curve, LAC =
Long run average cost, LMC = Long run marginal cost.
In the long run the firms earns normal profit as new firms enter the industry and starts
production due to which supply increases and the price falls. The average revenue curve is
more elastic (i.e. flatter), since large number of substitutes are available in the long-run.
AR is tangent to the LAC at P. The equilibrium output in the long-run is OM and the
corresponding price is MP (=OP’). Therefore, at this point the firm is in equilibrium as both
average revenue and average cost is at MP and the firm is earning normal profits.
In the long-run, the following two conditions must hold. i.e.

Marginal Revenue = Marginal Cost and
Average Revenue = Average Cost
(b) Elasticity of demand: Percentage method

30,000 − 20,000 10,000
Percentage change in quantity demanded = ⇒ ⇒ 40%
(30,000 + 20,000) ÷ 2 25,000
70,000 – 80,000 – 10,000
Percentage change in price = ⇒ ⇒ – 13.33%
(70,000 + 80,000) ÷ 2 75,000
40%
Price elasticity (η) = ⇒ –3
– 13.33%
3 > 1, therefore demand is relatively elastic.
Ans.3 (a) Reserve price:

The price below which a seller refuses to sell his product is called the reserve price.
Factors which may influence the reserve price of a seller:
Following are some of the factors which may influence the reserve price of a seller:
 Future price: It depends upon the seller’s expectations regarding the future price. If he
expects a high future price, the reserve price will be higher and vice-versa.
 Future costs: If the costs are expected to fall, the reserve price will be lower and vice-
versa.
 Liquidity preference: The more urgent is the seller’s need for cash; the lower will be
the reserve price.
 Stock carrying cost/period: In case of higher carrying cost or longer carrying period
the reserve price would be lower.
 Nature of goods: If the goods are perishable, the seller cannot keep them for long
periods and consequently the reserve price will be low. Consequently, in case of
durable goods the reserve price will be high.
 Past costs: Although past costs are not relevant, yet, some obstinate seller’s attach too
much importance to costs incurred in the past and fix a high reserve price though it
may result in a greater loss.
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(b) Graphical representation of costs:
Ans.4
The above diagram depicts the concept of Law of Equi-Marginal Utility.
According to the law of Equi-Marginal Utility, a consumer maximizes his total utility with his
limited income when marginal utility of the last rupee spent on each commodity is equal. This is
achieved at marginal rate of substitution i.e. marginal utility of A divided by marginal utility of B
is equal to price of A divided by price of B.
In the above diagram, MN is the budget line representing the combination of two goods i.e. A and
B that the consumer can afford with limited income at his disposal. U, U 1 and U2 are various
indifference curves. An indifference curve that lies to the right of another represents a higher
value of satisfaction than the other. Therefore, U1 is attainable, but inefficient whereas U2 is
unattainable. The consumer maximizes his total utility at point O on an indifference curve which
is tangent to the budget line. Also, at point O, marginal utility per rupee spent on good A equals
the marginal utility per rupee spent on good B. At no other point could the consumer have a
higher utility given the constraints of the budget line.
Ans.5 (i) (b) Auto-adjusted price mechanism

(ii) (d) club goods
(iii) (c) The prices of related goods are unstable
(iv) (d) The factors are able to be combined to make a product
(v) (a) Firms are price makers
(vi) (c) Increase in real GDP
(vii) (a) High interest rates makes it less expensive to borrow
(viii) (d) Interest rates to increase
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(ix) (c) Increase in exchange rate

(x) (b) Foreign direct investment flows
(xi) (b) Fall in interest rates
(xii) (a) 4.0
(xiii) (a) Decrease in imports
(xiv) (c) When marginal propensity to consume is high and marginal propensity to import is
low
(xv) (d) Import volumes will increase
Ans.6 (a) (i) GDP at market price Rs. in billion

Domestic consumption 290
Government expenditures 57
Total expenditures 412
Add: Exports 89
Less: Imports (83)
418
(ii) GNP at market price

GDP at market price [As computed above] 418
Add: Net property income from abroad 11
429
(iii) NNP at market price

GNP at market price [computed above] 429
Less: Capital depreciation (25)
404
(b) INJECTIONS INTO THE CIRCULAR FLOW OF INCOME

Investments
Investments in capital goods are a form of spending on future output which is addition to
the expenditure and are therefore considered as injection of funds into the Circular Flow of
Income.
Government Spending
The funds spent by the government are injections in the Circular Flow of Income. The
funds may be raised by way of taxes or borrowings by the government.
Exports
The goods and services produced by the firms in the country and exported, result in
income from abroad and are therefore injections in the Circular Flow of Income.
WITHDRAWALS FROM THE CIRCULAR FLOW OF INCOME
Savings
Households do not spend all their income and save a certain portion. These savings are
withdrawals from the Circular Flow of Income.
Taxation
The amount of taxes paid to the government is not available for spending by the
households and is therefore considered as withdrawals from the Circular Flow of Income.
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Imports
The expenditures incurred on the purchase of imported goods and services accrue to firms
in foreign countries and therefore constitute withdrawals from a country’s Circular Flow of
Income.
Ans.7 (a) Demand-pull inflation:

- In demand-pull inflation, the aggregate demand for goods persistently exceeds their
supply. As the demand for goods is more than the total supply of goods at current price,
there is a tendency for increase in prices. Demand-pull inflation is generally observed in a
situation of full employment.
Fiscal and monetary stimulus causing demand-pull inflation.
Fiscal stimulus:
Fiscal stimulus will increase aggregate demand in the economy. Given the effects of
multiplier, an increase in government spending would result in greater increase in demand
which would lead to demand-pull inflation.
Monetary stimulus:
Monetary stimulus such as fall in interest rates, buying of government securities etc. would
trigger an increase in demand and may lead to a situation where ‘too much money chasing
too few goods’. The surplus demand would increase the price level and therefore, demand-
pull inflation.
(b) Determinants of savings:

(i) Level of income
Saving is determined by the level of income. There is a direct relation between the
two i.e., savings increase as the level of income increases.
(ii) Net wealth

A household’s net wealth is the value of all assets owned by a household, less any
liabilities or debt owed. A decrease in net wealth would make consumers less
inclined to spend and more inclined to save at each income level.
(iii) Interest rate

Interest is the reward for increasing savings by reducing consumption and the
amount paid by borrowers for current spending power. An increase in interest rate,
other things held constant, will lead to less spending and thus higher savings.
(iv) Objective and institutional factors

Factors such as political stability and security of property encourage people to save
more. Similarly, an established system of banks and other financial institutions
promotes savings by way of interest earning motives.
Ans.8 (a) Liquidity preference theory:

Liquidity preference theory states that all factors remaining the same, people prefer to hold
cash (liquidity) rather than assets that are illiquid. They will, however, be paid a premium
to hold more illiquid assets.
The three motives for holding money in liquid form are:
(i) Transactions motive:

Individuals need money to meet their day-to-day requirements of purchases of goods
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and services. The need to hold money for transactions arises because the payments
and receipts of individuals are not exactly synchronized. The liquidity preference or
transactions demand for money will increase either by an increase in the real
national income or an increase in the general price level or any combination of the
two.
(ii) Precautionary motive:

Individuals keep money in hand or with banks as a precautionary measure to meet
any unforeseen fluctuations in receipts and payments. The precautionary demand
for money arises due to uncertainty regarding the timing and size of payments and
receipts. The higher the level of national income, the larger amounts of money
balances that would be needed for precautionary purposes, reflecting higher liquidity
preference.
(iii) Speculative motive:

The holding of money has an opportunity cost in the form of income foregone by not
using the money to purchase an income bearing asset e.g. a bond. When interest rates
are high, individuals will hold lesser amounts for speculative purposes and therefore
have low liquidity preference. When the interest rates tend to be low, individuals will
retain large amounts in anticipation of increase in interest rates and would have high
liquidity preference.
(b) Factors that affect investment and MEC:

Short-run factors:
(i) Demand for product:
If demand for particular product is expected to grow, it would induce the firms to
make investment thereby, shifting MEC curve to the right.
(ii) The state of confidence:

If firms are optimistic about the favourable economic changes such as fall in costs,
they would expect the greater returns and be willing to make investments.
(iii) Liquid assets

If the assets an entrepreneur holds can easily be sold for cash then it may result in
more investment.
Ans.9 (a) Benefits of Economic Growth:

Following are benefits of economics growth:
(i) Higher Employment/lower unemployment
Real economic growth gives rise to higher employment. This is because with higher
levels of output, firms tend to employ more workers.
(ii) Increased tax revenues
Growth boosts the government finances by way of taxes that in turn help to reduce
the budget deficit.
(iii) Enterprise confidence
Sustained economic development casts a positive impact on company profits and
raises business confidence.
(b) Functions of public finance:

According to Musgraves, the major functions of public finance are the following:
(i) Allocative function
The allocative function refers to the role of government that it plays in providing
resources to extend support to the public goods. The examples include expenditure
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on infrastructure, national defence, etc.

The budgetary policy divides the total resources among private and social goods by
which the mix of social goods is chosen.
(ii) Distributive function
The government plays the distributive role by way of deciding as to whom the
resources should be allocated. Practically it means setting the balance between free
market outcomes and distribution through taxes and other means with a view to
reducing economic inequalities and yielding optimal income distribution.
(c) Computation of marginal propensity to consume:

The formula for the multiplier in a closed economy with no government is:
1 1 MPS = Marginal propensity to save
OR
MPS 1 − MPC MPC = marginal propensity to consume
From the above information the value of multiplier can be inferred as 5 (5÷1=5)
Therefore, the marginal propensity to save = 1÷5 = 0.2
As MPS + MPC = 1
Therefore MPC = 1 – 0.2 = 0.8
Ans.10 (a) The tools available to Central Bank to control money supply are as follows:
The reserve ratio A change in the reserve ratio changes the amount of reserves the banks
are required to keep with the central bank. Consequently the funds available for lending i.e.
money supply changes with the change in reserve ratio.
Open market operation When the central bank buys securities in the open market from
commercial banks or general public, the funds available with them will increase and vice
versa.
Discount rate it is the rate of interest which central bank charges on the loans it grants to
the commercial banks. The interest on such loans being discounted at the time the loan is
negotiated rather than collected at the time the loan is repaid.
A decline in the rate encourages commercial banks to borrow from the central bank,
thereby enhancing their ability to extend credit to the public and enhancing money supply.
The position is reversed when discount rate is increased.
(b) Types of money categorised by its liquidity:

Following are the types of money categorised by its liquidity:
 Transactional money (M0): it is used to buy and sell things within an economy
 Checking accounts (M1): money that is in peoples’ accounts that they have immediate
access to
 Savings deposits (M2): money that belongs to people, but which they cannot access
immediately
 Large time assets (M3): such as institutional money market funds
Ans.11 (a) When the equilibrium in the economy is at less than its production potential, there exists a
deflationary gap.
The deflationary gap can be explained with the help of following diagram:
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In the above diagram, short run aggregate supply is shown by the line SRAS and aggregate
demand by the line AD.
The actual level of national income is at the intersection of AD and SRAS i.e. at Ye whereas
Yf is the national income at full employment.
The gap between actual level of national income and national income at full employment
i.e. Ye and Yf is called a deflationary gap, as the price level is below of what it would be with
full employment in the economy.
(b) Derivatives:
Derivative is an instrument whose price is dependent on one or more underlying asset(s).
It is a contract between two parties. The price of a derivative changes with the change in
the underlying asset(s).
Objective of exchange traded derivatives (ETD):

The main objective of ETD is to reduce the level of counterparty risk, as trades are done by
means of regulated contracts through a clearing house.
(c) Advantages of direct taxation:

 Equitable: people with higher incomes pay more to the society than those with less
income, creating a more equitable distribution of (net) wealth.
 Cost of collection is low: it is an economical way of raising revenues, saving expense.
 Relative certainty: the government can estimate how much it will receive allowing
better planning of projects.
Disadvantages of direct taxation:

 Possible to evade: it is possible to falsify tax claims meaning the correct amount is not
always paid.
 Unpopular: the end user will often try to find ways to avoid paying it.
 Discourage savings/ investment: if too high, then it would leave consumers and firms
less money to put to other causes and larger investor would explore investment
outside the country.
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Ans.12 (a) Balance of payment:

The Balance of Payments is a systematic and complete record of a county’s transactions
with other countries which takes place over a period of time. The Balance of Payments is in
deficit when a country’s outflows are more than the inflows.
Causes of deficit in balance of payment:

Following are some of the causes of deficit in balance of payment:
(i) Natural factors

Natural calamities like drought or flood may easily cause disequilibrium in balance of
payments. These natural calamities can adversely affect agricultural and industrial
production. Exports may decline and imports may go up, causing a deficit in the
country’s balance of payment.
(ii) Trade cycles

Business fluctuations caused by the operation of trade cycles may also result in
deficit in country’s balance of payments. For instance, if there occurs a recession, it
may induce a fall in the exports and exchange earning of the country concerned
resulting in a deficit in the balance of payments.
(iii) Political instability

Political instability results in disrupting the productive potential within the country,
thereby causing a decline in exports.
(iv) Relatively high rate of inflation

High rate of inflation as compared to other countries makes the goods produced by
that country relatively expensive. As a result, its exports decline and the balance of
payment runs into a deficit.
(v) Trade restrictions by other countries

Sometimes other countries impose heavy custom duties or fix quotas or ban imports
from a country. It results in lower exports of that country.
(b) Monetary measures

Following measures may be taken by the government to correct balance of payments
deficit:
(i) Exchange rate depreciation
Reducing the rate of exchange of domestic currency in terms of foreign currency
would make the imports costlier and uncompetitive, whereas exports become more
competitive.
(ii) Deflation
A decline in the price level domestically may increase the attractiveness of domestic
goods on the international market, thereby increasing exports.
(iii) Exchange control

In an extreme situation, by restricting access to foreign exchange, the central bank
can control the level of imports.
(THE END)
Page 9 of 9

Section A
Q.1 (a) Briefly describe the following diagram and the concept which it reflects. (04)
(b) What is meant by ‘Costs of production’? Briefly describe implicit and explicit costs
and give two examples of each. (04)
Q.2 (a) What is an indifference curve? Briefly explain three main characteristics of
indifference curves. (06)
(b) Describe the concept of ‘change in supply’ with the help of a diagram. (05)
Q.3 (a) What do you understand by the laws of increasing returns and diminishing returns?
List four basic assumptions underlying the law of diminishing returns. (04)
(b) How does the law of increasing returns apply to the industrial sector? (03)
Q.4 (a) Mixed economy is a system in which free markets coexist with government
intervention. Explain the role of the government in a mixed economy. (06)
(b) What do you understand by the term ‘Goods’ as commonly used in economics?
Briefly describe ‘Public goods’ and give two examples of public goods. (03)
(i) The slope of a production possibility frontier is called:

(a) marginal rate of substitution (b) marginal utility of product
(c) marginal rate of transformation (d) marginal product
(ii) Following data has been provided to the Chief Executive Officer of a monopoly firm:
Marginal revenue Rs. 10 Marginal cost Rs. 11
Average revenue Rs. 16 Average cost Rs. 12
To maximise profit the firm should:
(a) reduce price and increase output
(b) reduce price and reduce output
(c) increase price and increase output
(d) increase price and reduce output
(iii) If the shape of an indifference curve is concave, it implies:

(a) diminishing marginal rate of substitution
(b) increasing marginal rate of substitution
(c) constant marginal rate of substitution
(d) none of these
(iv) A price floor set above the market equilibrium price is likely to cause:
(a) excess supply
(b) excess demand
(c) a decrease in price and a decrease in the quantity traded
(d) an increase in price and an increase in the quantity traded
(v) If cross elasticity of demand between Goods X and Y is negative then:

(a) the demand for both X and Y are price inelastic
(b) X and Y are complements
(c) X and Y are substitutes
(d) the demand for both X and Y are price elastic
(vi) Which of the following factors is NOT used in the multiplier formula?
(a) Marginal propensity to save (b) Marginal propensity to import
(c) Marginal propensity to tax (d) Marginal propensity to export
(vii) Crowding out is a result of:

(a) high government expenditure (b) low government expenditure
(c) high taxes (d) none of these
(viii) Which of the following is NOT part of a country’s Gross Domestic Product?
(a) Company profit (b) Net income from abroad
(c) Salaries of school teacher (d) Investment expenditure
(ix) Which of the following measures is likely to boost a country’s rate of economic
growth?
(a) Tax cuts (b) Reduction in tax rebates
(c) Reduction in subsidies (d) Decrease in government spending
(x) Which one of the following is most likely to lead to a rise in aggregate demand?
(a) Decrease in government expenditure (b) Decrease in income tax rate
(c) Increase in autonomous savings (d) Increase in rate of interest
(xi) If an excess demand for money exists in the economy, then as the money market
moves towards equilibrium, the short term interest rates are expected to:
(a) fall as treasury bill prices rise (b) fall as treasury bill prices fall
(c) rise as treasury bill prices rise (d) rise as treasury bill prices fall
(xii) A US resident sets up a factory in Pakistan. This transaction will be recorded in

Pakistan as:
(a) credit in current account (b) debit in current account
(c) credit in capital account (d) debit in capital account
(xiii) Which of the following is NOT a motive for holding money?

(a) Inflationary motive (b) Precautionary motive
(c) Transaction motive (d) Speculative motive
(xiv) A contractionary monetary policy in an open economy with a flexible exchange rate
would possibly steer the economy towards a:
(a) higher domestic interest rate and exchange rate appreciation
(b) higher domestic interest rate and exchange rate depreciation
(c) lower domestic interest rate and exchange rate appreciation
(d) lower domestic interest rate and exchange rate depreciation
(xv) Which of the following financial markets usually acts as an intermediary between
those looking to raise finance, and those looking to invest?
(a) Capital market
(b) Derivation market
(c) Money market
(d) Both (a) and (b)
Section B
Q.6 (a) Define ‘Average propensity to consume’ and ‘Marginal propensity to consume’. How
are these calculated? (04)
(b) Briefly describe ‘Autonomous investment and Induced investment’. Who may
undertake such investments? In respect of each of the above types of investment, draw
investment curve and give two examples. (06)
(Note: Explanation of the curves is not required)
Q.7 (a) What do you understand by ‘Consumer price index’ (CPI)? Also explain how it is
calculated. (04)
(b) Briefly describe four costs associated with high inflation. (06)
Q.8 (a) Describe four limitations of fiscal policy. (06)
(b) State two advantages and two disadvantages of indirect taxation. (04)
Q.9 (a) The problems of barter system led to the evolution of money in its current form.
Discuss how money resolved these problems. (03)
(b) State two advantages and two disadvantages of credit money. (04)
(c) Briefly describe the ‘Quantity theory of money’. (03)

Q.10 (a) Exchange rate may either be fixed or floating. State three advantages of each of these
types of exchange rates. (06)
(b) Briefly describe the components of a current account. (04)
Q.11 (a) What is meant by the term ‘Coincident economic indicators’ in the context of
assessment of a country’s economic stage in a business cycle? Also identify the
economic characteristics which are usually observed during recessionary periods. (05)
(b) State four types of difficulties which are usually associated with the measurement of
national income. (03)
(c) Compute the multiplier, if in an economy, out of every additional Rs. 100 of national
income, 8% is saved, 15% is paid in taxes and 17% is leaked from the economy in
imports. (02)
Q.12 (a) Briefly describe how the level of aggregate demand may reduce when a central bank
changes the reserve requirements for commercial banks. (05)
(b) What do you understand by the term ‘Inverse J curve’? Explain the concept with the
help of a diagram. (05)
(THE END)
SUBJECT SESSION
Introduction to Economics and Finance Spring 2019
Passing %
Question-wise
Overall
1 2 3 4 5 6 7 8 9 10 11 12
21.6% 30.8% 5.1% 36.4% 60.1% 36.6% 7.3% 27.1% 22.2% 30.1% 24.9% 17.0% 30%
General comments
Although overall performance exhibited slight improvement from last attempt, questions in part B proved to be
challenging to the candidates. Further, regardless of repeated emphasis in the past, some candidates attempted
extra questions from part B and wasted precious time.
Candidates are strongly advised to improve their writing and presentation skills and refrain from reproducing rot
learnt material.
Question 1(a)
 Although candidates correctly identified the diagram, they could not explain the impact of increase or
decrease in price by the oligopolist on the quantity demand.
 The diagram was unnecessarily re-produced which resulted in loss of precious time.
Question 1(b)
 The terms ‘Explicit or Implicit’ costs were either not properly defined or both concepts were mixed up.
 Those who correctly defined the term ‘Implicit cost’ failed to give proper examples of it.
Question 2(a)
 Candidates correctly explained the characteristics of an indifference curve, however, they failed to define the
curve itself. Most of the answers were general in nature and lacked the concept of total satisfaction derived
by a consumer from the use of two commodities.
 Many candidates thought that indifference curve is related to the production of two goods.
 The curve was unnecessarily drawn which was not required at all.
Question 2(b)
 Incomplete diagrams were prepared.

 Diagrams lacked proper explanation.
 Candidates wrongly deliberated on the concept of change in quantity supplied instead of change in supply.
Page 1 of 4
Examiners’ comments on Introduction to Economics and Finance Spring 2019
Question 3(a)
 Candidates confused the concept of diminishing return with diminishing marginal utility. Further, only one
or two assumptions were listed.
 Some of the candidates opined that variable product instead of units of variable factors of production should
be homogeneous.
Question 3(b)
Candidates failed to answer this part of the question. Those who answered were only confined to the statement
that increasing returns arise due to economies of scale.
Question 4(a)
The roles such as distribution of income, price control, production of merit goods, framework of law etc. were
mentioned without elaborating on them as to why and how the income is distributed or the price is controlled by
the government.
Question 4(b)
Fresh air and water resources were incorrectly mentioned as the examples of public goods.
Question 5
Good performance was observed in this question.
Question 6(a)
 Both concepts were mixed up.

 Formulas to compute APC and MPC were not provided.
Question 6(b)
 Candidates failed to identify who may undertake such investments.

 A negative slope was drawn for induced investment curve instead of a positive slope.
Question 7(a)
Candidates failed to explain how CPI may be calculated.
Question 7(b)
 Only one or two costs associated with high inflation were described.
 Types of inflation were explained instead of the costs associated with high inflation.
Question 8(a)
 Candidates were able to correctly describe only two or three limitations of fiscal policy.
 Some candidates without comprehending the question, deliberated on monetary policy.
Page 2 of 4
 With regard to the time lag, candidates were of the opinion that it is the difference between the time when the
policy is formulated and the time when it is implemented instead of the time when the action is taken and the
time when the fiscal measure has its impact felt.
Question 8(b)
Good performance was observed in this part.
Question 9(a)
 Answers revolved round the functions of money and candidates could not differentiate between the functions
and the characteristics of money.
 Candidates were unable to explain how money solved the problem of barter system.
 Candidates also deliberated on the types of money which was not required at all.
Question 9(b)
Candidates limited their answer to the advantages and disadvantages of using credit cards.
Question 9(c)
Except for writing the equation MV = PT or MV = PY, candidates completely failed to elaborate the concept of
quantity theory of money.
Question 10(a)
 Only one or two advantages of fixed or floating exchange rates were stated.
 The advantages of two types of exchange rates were mixed up.
 Candidates wasted time in explaining what may be regarded as a fixed or a floating exchange rate.
Question 10(b)
Candidates while describing trade in goods and services misunderstood the concept and explained the sale and
purchase of goods and services locally instead of import and export of tangible and intangible goods and
services.
Question 11(a)
 Instead of defining the coincident economic indicators, candidates deliberated on different stages in the
business cycles.
 The economic characteristics of recession was not clearly identified and was mixed up with recovery and
depression.
Question 11(b)
Candidates were only able to write the key words with regard to the difficulties associated with the measurement
of national income, such as double counting, non- monetized transactions etc. without stating what they meant
by these terms.
Page 3 of 4
Question 11(c)
The effect of leakages from the economy while computing the value of multiplier was ignored.
Question 12(a)
 Answers were confined to the statement that increasing the reserve requirement would leave less money with
the commercial banks for lending.
 Candidates deliberated on both the consequences i.e. when reserve requirement is increased by the central
bank and when it is reduced by the central bank.
 The effect of multiplier in case of increase in the level of reserves that the commercial banks must hold, was
ignored.
Question 12(b)
 Incomplete answers were produced and in some cases, the concept of J curve instead of inverse J curve was
explained.
 Candidates plotted a wrong diagram without showing any surplus or deficit.
 Diagram was plotted without offering any explanation in this regard.
The End
Page 4 of 4
Suggested Answers
Ans.1 (a) The given diagram is of the kinked demand curve.
Theory of oligopoly suggests that once a price has been determined, it will not
change except to react to a competitor’s price change.
This means that members of a non-collusive oligopoly face a kinked (Bend) demand
curve as the reaction of competitors to a price change depends on whether price is
increased or decreased.
At the starting position the firm supplies Q0 at a price of P0.
Price increase
If the oligopolist raises price above P0 the rivals will maintain their price in order to
make the firm lose customers. Demand will move along the more elastic portion of
the demand curve to the left of Q0.
Price decrease
If the oligopolist cuts price below P0 then rivals will cut price too and hence there
will be little or no increase in demand. The firm will be forced on to the less elastic
portion of its demand curve to the right of Q0.
(b) Cost of production:

The overall costs incurred for producing a good or a service are called the costs of
production.
Explicit costs are the costs that have been incurred and have also been booked as an
expense. These are the expenses that are paid out costs and involve cash outflows
from the business.
Examples:
Examples include: salaries paid to the employees, prices of materials, overheads etc.
Implicit costs are the costs that have already been incurred but are not separately
shown as an expense while calculating the total cost of production.
Examples:
Examples include: salary of the entrepreneur, return on entrepreneur’s own
investment etc.
Ans.2 (a) Indifference curve:

An indifference curve shows the total satisfaction derived by a consumer from the
use of two commodities. It is drawn on the assumption that for all possible points
on an indifference curve, total satisfaction of the consumer remains the same.
Hence, the consumer is indifferent as to the combinations lying on an indifference
curve.
Characteristics of indifference curve:

Following are the characteristics of indifference curve:
(i) Negatively sloped

An indifference curve will slope from left to right. This is because if someone
increases consumption of one good, in order to maintain the same level of
satisfaction, he must decrease his consumption of the other.
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(ii) Higher indifference curve equals higher level of utility

An indifference curve that lies to the right of another represents a higher level
of satisfaction than the curve to the left.
(iii) Convex to the origin

In this instance, convexity means being bowed to the origin. The shape of the
curve has to do with how much of one good does a consumer want to
exchange for another in order to maintain the same level of utility. If the goods
are not perfect substitutes, it would be represented by indifference curves
which are convex to the origin.
(b) Change in supply:

When supply of a commodity changes due to change in non-price factor, it is said to
be a change in supply. It is represented by the shifting of supply curve from its
original place as shown in the following diagram:
Suppose SS is the supply curve before the change. S' S' shows a decrease in supply
because at the same price PM ( = P' M') less is offered for sale, i.e., OM' instead of
OM. S" S" shows an increase in supply because at the same price PM (= P" M") more
is offered for sale, i.e., OM" instead of OM.
Ans.3 (a) The law of increasing returns:

When a variable factor of production is applied while other factors remain constant,
there is a more than proportional increase in the output.
The law of diminishing returns:

If additional units of a variable input factor are added to a given quantity of fixed
input factors, a situation would be eventually reached in which each additional unit
of the variable factor would add less to the total output than the previous unit.
Assumptions underlying the law of diminishing returns:

Following are the four basic assumptions underlying the law of diminishing returns
(increasing cost):
(i) There is no change in the techniques of production or method of technology.
(ii) The law is applicable in the short run as the supply of one or other factor
cannot be increased within the short span of time.
(iii) All units of variable factors of production are assumed to be homogenous.
Page 2 of 10
Suggested Answers
(iv) The output is measured in physical units like tonnes, kilograms, etc.
(b) Application of the law of increasing returns to the industrial sector:

The increasing return mainly arises due to the fact that large scale production is
able to secure certain economies of scale, both internal and external.
These advantages may be on account of division of labour, specialized machinery,

commercial advantages of buying and selling wholesale, utilization of by-products,
use of extensive publicity and advertisement, availability of cheap credit, etc.
The law of increasing return operates as long as the plant is producing below
capacity. The increase in the marginal return continues till the plant begins to
produce its full capacity.
Ans.4 (a) In a mixed economy, government plays an important role to overcome the
inadequacies of free market economy. It includes:
(i) Distribution of income

To correct the unequal distribution of income and wealth that may exist
under free market system, government needs to reallocate income in an
economy. Quite often this involves raising taxes on high earners or luxury
items and spending them on providing facilities for general public.
(ii) Price control

To restrain the monopolies that may exploit consumers by charging
exorbitant prices under free market economy, government sometimes acts to
control prices for certain essential goods and services, either by becoming the
supplier for such commodities or imposing strict regulations on suppliers.
(iii) Production of merit goods

Government might introduce subsidies when there is a lack of incentive for
suppliers to produce the desired quantity of merit goods.
(iv) Framework of law

The government regulates and controls commercial activity to prevent
possible excesses or shortages that might occur in a completely free market
due to manipulation by influential traders and manufactures, etc.
(b) Goods:
In economics, goods refer to the products that satisfy human needs or wants and
provide utility.
Public goods:
A public good is a good whose benefits are social or collective.
Examples:
 national defense system
 highway network
Ans.5 (i) (c) marginal rate of transformation

(ii) (d) increase price and reduce output
(iii) (b) increasing marginal rate of substitution
(iv) (a) excess supply
(v) (b) X and Y are complements
Page 3 of 10
Suggested Answers
(vi) (d) Marginal propensity to export

(vii) (a) high government expenditure
(viii) (b) Net income from abroad
(ix) (a) Tax cuts
(x) (b) Decrease in income tax rate
(xi) (d) rise as treasury bill prices fall
(xii) (c) credit in capital account
(xiii) (a) Inflationary motive
(xiv) (a) higher domestic interest rate and exchange rate appreciation
(xv) (a) Capital market
Ans.6 (a) Average propensity to consume:

The average propensity to consume is a relationship between total consumption
and total income in a given time period. It is the ratio of aggregate consumption to
aggregate income.
Computation:
The formula for its computation is as under:
𝐶
𝐴𝑃𝐶 =
𝑌
Where, C stands for aggregate consumption and Y for aggregate income.
Marginal propensity to consume:

When income changes consumption also changes. Marginal propensity to consume
is the ratio of change in consumption to change in income.
Computation:
The formula for its computation is as under:
∆𝐶
𝑀𝑃𝐶 =
∆𝑌
Where, ∆𝐶 stands for change in consumption and ∆𝑌 for change in income.
(b) Autonomous investment:

Investment which is independent of the level of income or profits is called
autonomous investment.
Autonomous investment depends more on population growth and technical

progress than on anything else and is ordinarily undertaken by public bodies, or
private organisations not pursuing profit.
Page 4 of 10
Suggested Answers
Autonomous investment curve:
Examples:
 Construction of highways
 Street lighting
 Other infrastructure projects
Induced investment:
Investment which varies with change in national income is called induced
investment
This type of investment is usually undertaken by private enterprises in pursuit of

maximising profit. The greater the margin, the more will be invested until the
economic gains no longer outweigh the costs.
Induced investment curve:
Examples:
 Improvements to machinery
 Human capital (i.e. staff training that will generate an economic return)
 New assets
Ans.7 (a) CPI:

Consumer price index (CPI) is a measure of the weighted average of prices of a
basket of goods and services. It is calculated by taking price changes for each item
in the predetermined basket, averaging them, and weighing them based on the
importance of eachand then determining the weighted average. This average is
compared with the base year to compute the CPI.
(b) Costs of inflation:

Following are the costs associated with high inflation:
(i) Income redistribution:
Page 5 of 10
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Higher inflation can have a regressive effect on lower income families.

Especially if the price of food and utilities increases drastically.
(ii) Fall in real incomes:

If wages are cut (to help tackle inflation) then this means that real incomes
have reduced.
(iii) Negative real interest rates:

If the savings interest rate is lower than inflation, than those who rely on
savings as their income will become poorer with the passage of time.
(iv) Cost of borrowing:

In response to high inflation, governments may increase the interest rates.
This will increase the cost of businesses getting a loan, which may stifle
investment.
Ans.8 (a) Limitations of fiscal policy:

Following are the limitations of fiscal policy:
(i) Forecasting
The fiscal policy is devised around predictions of various economic activities.
For the fiscal policy to work as desired, these predictions need to be
reasonably accurate. However, making reasonably accurate prediction is not
easy.
(ii) Time lag

Time lag means the difference between the time the action is taken and the
time when the fiscal measure has its impact felt.
(iii) Crowding out

Increased government spending for stimulating aggregate demand might
result in crowding out i.e. decreasing the size of private sector due to
increased government spending.
(iv) Tax
Raising taxes to reduce deficit reduces Aggregate Demand. Moreover, it may
cause demotivation to work. Consequently a fall in productivity might be
observed and Aggregate Supply may fall.
(b) Advantages of indirect taxation:
 Change the pattern of demand: the government can alter the demand for a
product say imported and luxury goods.
 Can correct externalities: if a product causes direct external costs (e.g. health
costs associated with alcohol or cigarettes), the tax can be used to lower
down the consumption.
Disadvantages of indirect taxation:

 Increases inequality: regardless of their incomes, people are faced with the
same tax on a good.
 Causes cost-push inflation: increases the price of inputs for goods.
Page 6 of 10
Suggested Answers
Ans.9 (a) Functions of money which resolved the problems of barter system:
Following are the four functions of money which resolved the problems of barter
system:
(i) To act as medium of exchange:

Barter system lacks the ability to exchange. Finding someone with opposite
needs is problematic in complex society. Money acts as a medium which is
acceptable to all.
(ii) To act as a unit of account:

Fixing a measure across different types of products was complicated under
barter system. Money acts as a unit of account allowing people to compare
the relative prices of goods and services through a common denomination.
(iii) To act as a store of value:

Barter system lacks the ability to store value, particularly when goods are
perishable. Money acts as a store of value allowing people to forgo immediate
consumption if they have surplus resources, and to retrieve it later.
(iv) To act as a standard of deferred payment:

Barter system lacks the ability to allow people to consume the goods now and
pay for them in future. Money as a standard of deferred payment solved this
problem as it is easier to pay at a future date.
(b) Advantages and disadvantages of credit money:
Advantages of credit money:

 Allows immediate consumption of expensive goods, based on future earnings.
 Allows firms to invest, expand and generate future revenue, rather than use
internally generated funds.
Disadvantages of credit money:

 There is often an element of risk involved that the person issuing credit may
not receive full payment.
 It may lead to over spending.
(c) Quantity theory of money:

Quantity theory of money states that there is a direct relationship between changes
in the money supply and the rate of inflation. The theory is based on equation
MV=PT.
MV is the value of total expenditure in a period which must be equal to the value of
goods and services sold in the same period which is PT. The equation is useful as an
explanation of inflation when certain assumptions are made and which, if accepted,
means that the average price level (P) is solely determined by changes in the money
supply (M).
Ans.10 (a) Advantages of fixed exchange rate:

 Avoids damaging speculation effect against the local currency
 Promotes trade as importers and exporters are protected from exchange rate
risks
 Government has to pursue responsible economic policies domestically
because excess aggregate demand and inflation would make it very difficult
to support the currency in the long term.
Page 7 of 10
Suggested Answers
Advantages of floating exchange rate:

 The need for government intervention in the foreign exchange markets is
eliminated.
 It helps to correct balance of payments disequilibrium.
 Frees the policy instruments of government to concentrate on internal issues
such as unemployment and inflation.
 Variations in the rates of exchange act as a check against invasion of the
inflationary and deflationary forces.
(b) Components of current account:
(i) Trade in goods

This component includes import and export of tangible items such as finished
goods, semi-finished goods and component parts for assembly etc.
(ii) Trade in services
It includes intangible items such as tourism, financial services and
consultancy, etc.
(iii) Income
It refers to the overseas activity that leads to a flow of money back to the
country. For example, interest received from direct investment, the activities
of subsidiaries and dividends earned from owning shares in foreign firms, etc.
(iv) Unilateral transfers

It includes receipts and payments that take place without anything receiving
in return. For example, donations, personal remittances, aid and grants, etc.
Ans.11 (a) Coincident economic indicators:

These indicators are events and measures that indicate a peak or trough. These
include:
 Number of people in employment
 Industrial production
 Personal incomes
 Size of manufacturing and trade
The economic characteristics which are most commonly observed during a

recessionary period are:
(i) decline in demand for labour followed by layoffs and increase in
unemployment rates.
(ii) fall in demand for capital goods, consumer durable goods and luxury items
and downward trend in their prices.
(iii) sharp drop in business profits.
(iv) decline in volume of shares traded on the stock exchanges and fall in their
prices.
(v) decline in the demand for credit accompanied by drop in interest rates.
(b) Difficulties faced in measuring national income:

(i) Non-monetized transactions such as services of housewives and agricultural
products used by farmers for own consumption are generally not considered
while measuring the national income.
(ii) The barter transactions may either be totally ignored or included on the basis
of approximation.
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Suggested Answers
(iii) Income of foreign firms creates complications i.e. whether to include it in

national income of the country of operation or country of origin.
(iv) Collection, compilation and analysis of statistical data is a highly technical and
difficult exercise and availability of sufficient trained staff is often difficult.
(c) Computation of multiplier:
Calculation of the value of multiplier:
Multiplier = 1 ÷ (sum of the propensities to save + tax + import)
= 1÷ (0.08+0.15+0.17) = 1÷0.4 = 2.5
Ans.12 (a) The central banks are able to reduce the level of aggregate demand in an economy
by changing the reserve requirements, as described hereunder:
(i) When a central bank increases the level of reserves that the commercial
banks must hold, the commercial banks have to reduce the level of loans that
they give out. A certain reduction in the level of reserves that commercial
banks must hold translates, through the multiplier effect, in a much bigger
contraction in the overall money that they loan out. This causes the money
supply to decline.
(ii) As the money supply contracts, money becomes “tight” (i.e. less available and
more expensive). This reduced level of money in the economy raises the
interest rate, and reduces the amount of credit available in the economy.
Consequently interest rates rise and firms/individuals looking for investment
are discouraged from borrowing, and spending more money.
(iii) As a result of the above aggregate demand reduces.
(b) Inverse J curve:
The opposite of J-curve concept is inverse J-curve, where countries attempt to

rebalance a current account surplus by appreciating exchange rate.
The inverse J-curve shows how in the short run, the surplus may further increase
before decreasing. This concept is depicted below:
The inverse J curve effect is observed in trade balances because the stronger
currency initially translates into more cheaper imports and costlier exports, leading
to a bigger initial trade surplus.
Page 9 of 10
Suggested Answers
However, in long-run, because the affected country’s exports are now expensive in
currency terms, they start to fall as foreign demand for the high-priced option
decreases. Local consumers also purchase fewer of the locally produced expensive
goods and substitute them with comparable imported goods which have now
become more affordable. As a result, the trade balance eventually deteriorates and
the surplus decreases to a lower level than it was at before the exchange rate
appreciated.
The lag is caused by the fact that importers and exporters have to honor pre-existing
contracts, so the trade volumes initially remain unchanged even though the
exchange rate and relative prices have changed.
Therefore, in the above diagram, starting from Point B, the surplus first increases in
the short-run and goes down into a deficit as time goes on.
(THE END)
Page 10 of 10

Section A
Q.1 (a) The basic economic problem is the scarcity of resources and the multiplicity of ends.
Discuss how following participants in an economy make decisions to deal with that
problem:
(i) households (ii) firms
(iii) government in market economy (iv) government in mixed economy (06)
(b)
From the above diagram of Production Possibility Frontier, describe what the
following points/curve depict:
(i) point G (ii) point H (iii) curve XY (03)
Q.2 Consider the following schedule that pertains to the product of a firm engaged in the
manufacture and sale of consumer products:
Price (Rs.) 150 120

Quantity demanded (Units) 20 24
From the above schedule:

(a) determine the price elasticity of demand using expenditure method and percentage
method. (04)
(b) recommend the course of action the firm may adopt along with appropriate
justification. (02)
Q.3 (a) What do you understand by ‘Consumer equilibrium’? (02)

(b) In the study of consumer equilibrium, price effect is the aggregate of substitution effect
and income effect. Explain it with the help of a diagram assuming that:
goods are normal and substitute of each other.
price of one good changes whereas consumer income and price of the other good
remain constant. (08)
Q.4 (a) Explain the concept of economies and diseconomies of scale with the help of long run
average cost curve. Also mention two factors that lead to economies and diseconomies
of scale. (07)
(b) One of the characteristics of a monopolist is the ability to engage in price

discrimination. Mention any three conditions required for price discrimination. (03)
(i) In deciding what products to produce, the central planners in a planned economy
would give least priority to:
(a) size of economy’s labour force
(b) production capabilities of the economy’s factories
(c) consumer preferences
(d) type of raw materials produced by the economy
(ii) Which of the following would most likely result in failure of price cartel under
oligopoly?
(a) Non-availability of close substitutes
(b) Existence of control over supply
(c) Price elasticity of demand is elastic
(d) Presence of agreement on allotted quota of supply
(iii) The supply curve would shift to the left when:

(a) price of good goes down
(b) taxes of government go down
(c) prices of substitute goods go down
(d) prices of complements go down
(iv) A consumer with fixed income at his disposal would maximize his utility at a point
where:
(a) marginal utility per rupee from each good is same
(b) marginal utility from each good is same
(c) marginal utility from each good is maximized
(d) marginal utility per rupee from each good is maximized
(v) Which of the following is not an advantage of floating exchange rate?

(a) It minimizes government intervention in foreign exchange markets
(b) It automatically corrects disequilibrium in balance of payments
(c) It stimulates demand for exports
(d) It frees policy instruments of government
(vi) Which of the following best describes Keynesian Liquidity trap?

(a) High interest rates, low savings rates (b) Low interest rates, high savings rates
(c) High interest rates, high savings rates (d) Low interest rates, low savings rates
(vii) The imposition of indirect taxes would likely result in:

(a) demand-pull inflation (b) cost-push inflation
(c) wage spiral inflation (d) deflation
(viii) When the national income is in equilibrium, an increase in investment causes the
equilibrium to change. Which change of equivalent value would bring national income
to its original equilibrium level?
(a) Decrease in government spending (b) Increase in government spending
(c) Decrease in government taxes (d) Increase in exports
(ix) A central bank is likely to increase interest rates when economy is in a phase of:
(a) prosperity (b) downturn (c) recession (d) trough
(x) For reducing inflationary pressure, the most appropriate combination of policies for a
central bank would be:
(a) increase reserve requirement, reduce discount rate and sell government securities
(b) increase reserve requirement, increase discount rate and sell government
securities
(c) increase reserve requirement, reduce discount rate and buy government securities
(d) increase reserve requirement, increase discount rate and buy government
securities
(xi) Given below is the Consumer Price Index (CPI) of a country for four years:
Year 2014 2015 2016 2017
CPI 500 550 600 650
Based on the above schedule, which of the following statements is correct?
(a) The rate of inflation has been consistently rising from 2015 to 2017
(b) The rate of inflation in 2016 is 10%
(c) The rate of inflation is the highest in 2017
(d) The rate of inflation has been consistently falling from 2015 to 2017
(xii) The expectation of fall in prices would result in:
(a) shift of current consumption curve to the left
(b) shift of current consumption curve to the right
(c) no change on current consumption curve
(d) shift of current savings curve to the left
(xiii) A firm is operating in an industry where many firms are producing similar products.
Each firm is able to set prices of its products without affecting the market place as a
whole. The firm is most likely operating in:
(a) monopoly (b) oligopoly
(c) perfect competition (d) monopolistic competition
(xiv) Which of the following statements is correct regarding instruments of financial
market?
(a) Derivatives are equity instruments traded on money market
(b) Certificate of deposits are subject to higher default risk than treasury bill
(c) Debentures are short term money market instruments
(d) Both (a) and (b)
(xv) The basic concept which underlies the accelerator theory of investment is:
(a) investment depends on the level of savings
(b) investment is inversely related to the rate of interest
(c) investment is determined by the volume of commercial bank lending
(d) investment in an economy is a function of output
Section B
Q.6 (a) What do you understand by ‘Marginal efficiency of capital (MEC)’? Explain the
relationship between rate of interest and the level of investment with reference to MEC
with the help of a diagram. (08)
(b) Explain the impact of decrease in interest rates on firms and individuals. (02)
Q.7 (a) Sometimes the governments weaken the domestic currency deliberately with the
objective of reducing balance of payments deficits by making imports more expensive
and exports less expensive. Describe the factors upon which the effectiveness of such
policy depends. (05)
(b) Why do governments interfere to influence the foreign exchange rates? List the policy
instruments available to a government to influence the foreign exchange rates. (05)
Q.8 (a) Explain four main canons of taxation as suggested by Adam Smith that are usually
considered by a government while designing the tax system of the country. (08)
(b) There is a series of events that occur throughout the business cycle but there are certain
indicators that can be identified and used to assess at what stage the economy is in.
List any two such indicators under the headings of:
(i) Leading economic indicators (ii) Lagging economic indicators (02)
Q.9 (a) Discuss the non-monetary corrective measures which a country may take to overcome
its current account deficit. (04)
(b) From the following data, compute the overall balance of payments of the country duly
segregated between current and capital accounts:
Net balance
Balance of payment item
(in billion)
Investment income (15)
Portfolio investment flows 10
Overseas transfers 25
Trade in goods (75)
Short-term banking flows (5)
Foreign direct investment flows 20
Trade in services 20
Changes to reserves of gold / foreign currency 15 (06)
Q.10 Monetary policy can play a vital role in influencing the use of money and credit within an
economy in order to achieve certain objectives.
Briefly discuss:
(a) objectives of monetary policy and how these objectives can be achieved. (05)
(b) limitations of credit creation in achieving economic objectives. (05)
Q.11 (a) The economy is in equilibrium at the point where short run aggregate supply (value of
output produced within an economy) is equal to aggregate demand (level of demand
for goods and services). Explain the equilibrium of economy with the help of a diagram
where a government has increased its spending and there is a rise in wage rates. (07)
(b) List any three factors that may cause a shift in:
(i) aggregate demand curve (ii) short-run aggregate supply curve (03)
Q.12 (a) From the following data, compute Gross National Product (GNP) at market price and
at factor cost:
Rs. in billion
Consumers’ expenditures 450
Taxes on expenditures 175
Government spending 120
Exports receipts 50
Imports payments 110
Subsidy 15
Capital depreciation 40 (05)
(b) Briefly discuss the main features of:
(i) mutual funds (ii) derivatives (05)
(THE END)
SUBJECT SESSION
Introduction to Economics and Finance Certificate in Accounting and Finance -
Autumn 2018
General:
The overall performance in this attempt showed slight improvement as passing ratio rose
to 28.6% as compared to 23.7% in the previous attempt. Most of the students showed
weak conceptual understanding and lack of knowledge, even where the questions were
quite straight forward. Many students gave irrelevant answers as they reproduced rote
learnt material at the mere hint of a key term. Many students wasted time in producing
lengthy answers despite the limited requirements of the questions.
95% of the students attempted all the questions but performance in questions 3, 4, 6, 7
and 10 were very poor. Some students attempted more than the required number of
questions from Section B and wasted precious time.
Question-wise comments
Question 1(a)
The question required a brief discussion on how specific participants in an economy

make decisions to deal with the economic problem. The answers related to households
and firms were mostly satisfactory but the students were unable to clearly differentiate
between decisions made by Governments in market economy and mixed economy
resulting in giving similar answer in either case.
Some students discussed circular flow of income which was totally irrelevant.
Question 1(b)
This part was well attempted and many candidates secured full marks. However, a
number of students could not perform well in sub-part (iii). Many students wrote lengthy
explanations whereas only a one-line answer for each sub-part was sufficient.
Question 2(a)
In this part of the question, the students were required to calculate the price elasticity of
demand using expenditure method and by percentage method. About 40% of the students
performed well in this part as they knew the formulas and also applied them correctly.
Many students confused expenditure method with percentage method and vice versa and
some students even attempted arc and point methods. Some students performed the
calculation part of the expenditure method correctly but interpreted the result incorrectly.
Page 1 of 5
Examiners’ Comments on Introduction to Economics and Finance -
Autumn 2018
Question 2(b)
This part was poorly attempted. Majority of the students did not read the question
carefully. Rather than commenting on the inelasticity of demand, as calculated in part (a),
many candidates tried to elaborate the relative benefits and drawbacks of the two
methods of calculation. Many students gave general recommendations while discussing
the concept of elasticity instead of giving specific recommendation based on the given
situation. Some students even suggested to adopt one method over other to respond to the
given price elasticity of demand.
Question 3(a)
Although the overall performance in this question was very poor, the performance in this
part was relatively better. However, a number of students got confused between
consumer equilibrium and market equilibrium. Many candidates wrote about equi-
marginal utility which was not required.
Question 3(b)
This part was very poorly attempted though some students gave perfect answers as well.
Most of the diagrams were incomplete. In most cases the substitution effect was not
demonstrated. Moreover, instead of drawing one diagram showing income, price and
substitution effects, a number of students prepared separate diagrams showing income
effect and price effect. As is commonly observed, the explanation was quite poor and the
labeling was inadequate.
Question 4(a)
The performance in this part of the question was below average as only about 20% of the
candidates secured passing marks. The requirement was to explain economies and
diseconomies of scale with the help of a long-run average cost curve.
Generally the candidates were able to draw the U-shaped curve. However, the economies
and diseconomies were not correctly marked on the curve. The explanation once again
lacked content. Factors leading to economies of scale were well described but only few
could explain the factors leading to diseconomies of scale.
Question 4(b)
This was a simple question requiring conditions required under which a monopolist can
resort to price discrimination. However, only about 50% of the candidates gave the
correct answer. Moreover, some candidates elaborated the conditions too much, which
was not required. They did not seem to understand that the requirement was only to
mention the condition, rather than explaining them. They even failed to notice that it was
just a 3 mark question.
Page 2 of 5
Autumn 2018
Question 5
This question contained 15 MCQs. This time the performance in this question was much
weaker as compared to last many attempts as only 45% of the candidates secured passing
marks. Most of the errors were seen in MCQs 3, 5, 10 and 11.
Question 6(a)
The performance in this part of the question was quite poor. A large number of students
ignored the requirement to define the term Marginal Efficiency of Capital. The diagram
was easily drawn, but the explanation focused more on relationship between interest rate
and marginal efficiency of capital rather than interest rate and investment. Many
candidates did not seem to understand that there is an inverse relationship between
interest rate and investment and not between investment and MEC. Some students
mentioned a direct relationship between rate of interest and investment instead of an
inverse relationship. Many students prepared schedules and calculations also, which were
not required. In many cases diagrams were not clearly labelled and in some cases even
diagrams were not labelled at all.
Question 6(b)
This question was generally well attempted. Still, there were many candidates who
thought that the impact of decrease in interest rates for the firm and the individuals would
be the same.
Question 7
Less than 50% of the candidates chose to attempt this question and even then, the
performance was very poor.
Question 7(a)
Governments sometimes devalue their currencies to reduce balance of payment deficit.

The students were supposed to describe the factors on which the effectiveness of such a
policy depends.
Most of the candidates produced irrelevant answers. The majority only explained how
devaluation affects imports, exports and foreign direct investment rather than explaining
the factors which contribute to the effectiveness of the policy. Some candidates also
discussed fixed and floating exchange rates which was totally irrelevant. Some candidates
discussed measures which the government should take to succeed in its efforts which was
also not relevant to the requirement of the question.
Page 3 of 5
Autumn 2018
Question 7(b)
The performance in this part also remained poor. Many students could not differentiate
between influencing the foreign exchange rate and devaluation and only mentioned the
purpose of devaluation. As regards the policy instruments most of the answers mentioned
only one of them i.e. purchasing and selling of foreign currency. Many candidates
omitted this part altogether.
Question 8(a)
This part of the question was very well attempted and most of the candidates who
attempted it obtained high marks.
Question 8(b)
This part was poorly attempted as most of the candidates were not familiar with the terms
‘Leading indicators’ and ‘Lagging indicators’. Consequently, many candidates who did
well in part (a), omitted this part altogether. Many students used guesswork as they
seemed to believe that leading means important and lagging means relatively
unimportant.
Question 9(a)
This part of the question was also attempted well by most of the students. However, there
were few who mentioned monetary measures instead of non-monetary measures or
mentioned both of them.
Question 9(b)
The performance in this part was also good. Most of the candidates were able to place the
items under the correct heads and calculated the current and capital account balances
correctly. However, rarely was there a mention of the errors and omissions figure and the
overall balance of payments. Some candidates computed the overall balance of payments
without distinguishing between current and capital accounts.
Question 10(a)
Most of the students correctly identified the objectives of monetary policy. However,
many students mentioned credit creation as one of the objective which was not correct.
Further, in the latter part of the question which required a discussion on how they can be
achieved using monetary policy, the candidates appeared confused and mixed up between
fiscal and monetary policy.
Page 4 of 5
Autumn 2018
Question 10(b)
This part required a discussion of the limitations of credit creation in achieving economic
objectives. The term credit creation spurred a considerable number of candidates to
explain credit creation in detail and they ignored the requirement of the question
completely.
Question 11(a)
Average performance was witnessed in this part of the question. About 60% of the
students drew the diagram correctly. Some students showed complete lack of
understanding as they drew upward sloping demand curve. Again many students could
not label the diagram correctly and lost easy marks. About 50% of those candidates who
drew the diagram correctly, explained the outward shift of the aggregate demand curve
but failed to properly explain the impact of increase in wages.
Question 11(b)
Most of the candidates were able to identify the factors which cause shift in aggregate
demand curve but were unable to identify the factors which cause shift in short-run
aggregate supply curve.
Question 12(a)
Average performance was witnessed in this part. Many students appeared confused
between GDP and GNP at market price. Moreover, only few could calculate or even
attempted to calculate GNP at factor cost. Further, many candidates did not show the
calculations and hence lost marks where their answers differed.
Question 12(b)
This question was attempted quite well. However, mutual funds part of the question was
better answered than the derivatives part.
THE END
Page 5 of 5
Suggested Answers
Note:
The suggested answers are provided for the guidance of the students. However, there are alternative
solution(s) to the questions which are also considered by the Examination Department while marking
the answer scripts.
Ans.1 (a) (i) Households

These are individuals having limited income at disposal. They attempt to allocate
scarce income between goods and services to attain maximum satisfaction.
(ii) Firms
These are businesses/organizations having limited factors of production (land, labor,
capital and enterprise). They attempt to allocate scarce factors of production between
potential products and services where profit is maximized.
(iii) Government in market economy

Governments in market economy has low or no interference in the allocation of
resources. It relies on the market and price mechanism for allocation of resources by
allowing freedom to other economic participants to decide.
(iv) Government in mixed economy

In mixed economy, only some very critical decisions are taken by the government
with regard to allocation of resources for the purpose of ensuring minimum or
maximum supply of goods and services.
(b) (i) Point G

This point depicts a situation where resources are not being fully utilized.
(ii) Point H
This point depicts that given the production capacity of an economy, it is not
attainable.
(iii) Curve XY
It depicts all possible combinations of two alternative goods that an economy can
produce with the resources available to it.
Ans.2 (a) Expenditure method

Revenue = Price × Quantity demanded (qd)
At Rs. 150
Revenue = 150 × 20
= Rs. 3,000
At Rs. 120
Revenue = 120 × 24
= Rs. 2,880
The decline in price resulting in less increase in QD resulting in total revenue decreasing,
therefore PED is inelastic i.e. less than unity.
Percentage method
Page 1 of 8
Suggested Answers
(b) Recommendation
Since the price elasticity of demand for the firm’s goods is inelastic (less than unity), the
firm should seek either to increase the price or maintain it because the reduction in price
would result in reduced revenue.
Ans.3 (a) The consumer is said to be in equilibrium when maximum possible satisfaction is obtained
from the individual’s purchases / when budget line and indifference curve are tangent, at
the prices prevailing in the market and given the amount of money the individual possesses
for making purchases.
(b)
The initial equilibrium of the consumer is at E where indifference curve (IC1) is tangent to
budget line AB. The fall in price of good X (assuming consumer income and price of Y
remain constant) would result in new equilibrium at E' as consumer would buy more of
good X and less of good Y. This price effect is an aggregate of income effect and
substitution effect.
Page 2 of 8
Suggested Answers
The change in price would result in increase in real income of consumer. To determine the
substitution effect, the effect of increase in real income is eliminated so that consumer
remains at original indifference curve (IC1). To achieve this, a dotted line CD parallel to
budget line AB1 is drawn. The new budget line is tangent to IC1 at E''.
E to E'' represents the substitution effect and E'' to E' represents income effect. E to E'
represents the price effect which is the aggregate of substitution effect and the income effect.
Ans.4 (a)
It can be seen from the above diagram that initially as the output of the firm increases, the
unit cost declines i.e. firm is achieving economies of scale due to large scale of production
and long run average cost curve goes down.
After certain level of output is reached, average cost curve remains constant. This point is
called minimum efficient scale as unit costs are minimized because of maximization of
economies of scale. In the above diagram, this level of output is Qmes.
Any further increase in production level results in rising unit costs due to inefficiencies
generated by diseconomies of scale which in the above diagram is depicted by the rise in
long-run average cost curve.
Factors that lead to economies of scale include:
 Trading – ability to buy in bulk quantities at more optimal prices.

 Financial – larger firms are in a better position of borrowing at favorable terms
 Technical – better efficiency through larger quantities of output
 Managerial – ability to employ specialist managers to increase efficiencies
 External – development of specialized labor force when firms cluster together
Factors that lead to diseconomies of scale:
 Control – too big firm may be difficult to manage and management may lose control
 Local/firm’s infrastructure – there might be strains on local/firm’s infrastructure as
the scale of activities increases.
(b) Three conditions that are required for price discrimination:

 Firm must have monopoly power in terms of setting prices.
 Each group of buyers must have a different elasticity of demand so that consumer
surplus can be extracted.
Page 3 of 8
Suggested Answers
 Market is divided into sub-markets and each such sub-market is absolutely separate
i.e. it should not be possible to freely transfer units of the commodity from one sub-
market to another.
 It should not be possible for the buyers in the dearer market to freely sneak into the
cheaper market to take advantage of the low price.
Ans.5 (i) (c) consumer preferences

(ii) (c) Price elasticity of demand is elastic
(iii) (d) prices of complements go down
(iv) (a) marginal utility per rupee from each good is same
(v) (c) It stimulates demand for exports
(vi) (b) Low interest rates, high savings rates
(vii) (b) cost-push inflation
(viii) (a) Decrease in government spending
(ix) (a) prosperity
(x) (b) increase reserve requirement, increase discount rate and sell government securities
(xi) (d) The rate of inflation has been consistently falling from 2015 to 2017
(xii) (b) shift of current consumption curve to the right
(xiii) (d) monopolistic competition
(xiv) (b) Certificates of deposits are subject to higher default risk than treasury bill
(xv) (d) investment in an economy is a function of output
Ans.6 (a) MEC can be explained as the rate of discount that would make the present value of the
prospective yields from the capital asset equal to its supply price.
There is an inverse relationship between the rate of interest and the level of investment i.e.
higher the rate of interest, lower the level of investment and vice versa. This relationship in
terms of MEC, can be explained with the help of following diagram:
In the above diagram, MEC curve represents the level of investment that will take place in
the economy at various levels of interest rate. At interest rate ro, investment Io is
marginally efficient i.e. has a net present value of 0 (or its internal rate of return equals rate
of interest). All points to the left of the MEC have a positive net present value. If the
interest rate falls to r1, then further investment would become feasible up to total
investment I1 which is now marginally efficient.
Page 4 of 8
Suggested Answers
(b) A decrease in interest rate would impact firms and individuals as follows:
 Firms would be encouraged to invest more as it would be easier for firms to earn an
adequate return on project since cost of investment has reduced.
 Individuals would be discouraged to save more as their savings would give low return
and they would likely incline towards more consumption.
Ans.7 (a) The effectiveness of policy of devaluing the domestic currency depends on:
 Price elasticity of demand for imports

If price elasticity of demand for imports is inelastic, then making imports more
expensive will not significantly reduce the volume of demand for imported goods and
services. It will more likely increase total expenditure on imports thus further
deepening the balance of payments deficit thus making such policy ineffective.
 Price elasticity of demand for exports

If price elasticity of demand for exports is inelastic, then making exports less
expensive will not significantly increase the volume of demand for exported goods
and services. It will more likely reduce total revenue from exports thus further
deepening the balance of payments deficit thus making such policy ineffective.
(b) Governments often interfere to influence the foreign exchange rates because of the
following reasons:
(i) To stabilize the currency against the pressures of short-term speculations.
(ii) To stimulate demand for exports or to reduce imports.
Policy instruments available to government to influence foreign exchange rates:

(i) Setting of domestic interest rate.
(ii) Central bank’s intervention in purchasing or selling of currency.
(iii) Structural adjustments to the behavior of the economy.
Ans.8 (a) Four main canons of taxation as suggested by Adam Smith are explained below:
(i) Canon of Equality:

According to canon of equality, tax should be paid in proportion to the ability of the
tax payer i.e. the amount of revenue generated by (income of) tax payer. This requires
progressive taxation where tax payers have to pay higher rate of tax as their income
increases.
(ii) Canon of Certainty:

According to this canon, there should be no ambiguity as to the timing, manner and
amount of tax payment expected from tax payer. Tax budgets are given publicity and
transparency to make the tax payers aware of as to why and when they are expected
to pay a particular sum.
(iii) Canon of Convenience:

According to this canon, time and manner of tax payment should be convenient for
the tax payers. For example, consumers paying taxes at the time of purchase of goods
or services or tax being deducted at the time of payment of salaries.
(iv) Canon of Economy:

According to this canon, tax should be economical in terms of its collection. Tax
policies should be as such to ensure maximum tax is collected and in the most
economical manner.
Page 5 of 8
Suggested Answers
(b) (i) Leading economic indicators:

 index of business confidence
 manufacturers’ orders
 building permits for private housing
 money supply
(ii) Lagging economic indicators:

 consumer price index (i.e. level of inflation)
 average duration of unemployment
 interest rates
 average income
Ans.9 (a) A country may take any or combination of following non-monetary measures to overcome
current account deficit:
(i) Increasing import duties by means of tariff thereby, making the imports expensive.
(ii) Fixing the quantity of goods that may be imported by means of quotas to restrict the level
of imports.
(iii) Helping exporters to promote locally manufactured goods in international market by
organizing exhibitions, trade fairs and striking diplomatic deals.
(iv) Encouraging manufacturing and consumption of locally produced goods and services /
import substitution by means of providing specialist training, subsidies and tax reliefs.
(b) Computation of the overall balance of payments of the country:

Net balance
Balance of payment item
(in billion)
Current account
Trade in goods (75)
Trade in services 20
Investment income (15)
Overseas transfers 25
Current account balance (45)
Capital account
Foreign direct investment flows 20
Portfolio investment flows 10
Short-term banking flows (5)
Changes to reserves of gold / foreign currency 15
Capital account balance 40
Net errors and omissions 5
Overall balance of payments 0
Ans.10 (a) Objectives of monetary policy and the means to attain them:
(i) Price stability to keep the inflation low by managing the supply of money.
(ii) Economic growth by encouraging consumption and investments.
(iii) Exchange rate stability by effective utilization of policy instruments.
(iv) Full employment by encouraging consumption and investments by allowing resources
to be fully utilized.
(v) Credit control by regulating commercial banks through central bank (discount rate
policy, reserve requirements, open market operations, etc.).
Page 6 of 8
Suggested Answers
(b) Limitations of credit creation in achieving economic objectives:
(i) The initial size of money supply. If initial size of money supply is lower, less credit
would be created and vice versa.
(ii) Liquidity preference of people. In period of high inflation, people may not wish to
hold their money in banks that would mean less money is available to banks thereby
less credit would be created.
(iii) Availability of quality securities. If high valued collateral assets are not available, less
credit would be created and vice versa.
(iv) Economic conditions of trade and business. In the period of depression, investors
would be less inclined to borrow thereby limiting the role of credit creation.
Ans.11 (a) Illustration:
The existing equilibrium is at point A. An increase in government spending would shift the
aggregate demand curve outwards (i.e. from AD1 to AD2) and now the equilibrium is
determined at point B. However, rise in wage rates would shift the short-run aggregate
supply curve inwards (i.e. from SRAS1 to SRAS2) and the new equilibrium is determined
at point C which would mean that increase in government spending has been cancelled out
by increase in wage rates and output level returns to the same level as before.
(b) (i) Aggregate demand curve

– Change in consumer income
– Change in government spending
– Imports or exports becoming more or less attractive
– Change in firms’ expectations of economy
(ii) Short-run aggregate supply curve

– Change in factor productivity (labor and capital)
– Change in size and quality of capital stock
– Change in size and quality of labor force
– Change in unit cost of labor
– Change in producer taxes or subsidies
– Change in inflationary expectations
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Suggested Answers
Ans.12 (a) GNP at market price:

Rs. in billion
Consumers’ expenditures 450
Government spending 120
Total expenditures 710
Add: Exports receipts 50
Less: Imports payments (110)
GDP at market price 650
GNP at market price 660
GNP at factor cost:

Rs. in billion
GNP at market price 660
Less: Taxes on expenditures (175)
Add: Subsidy 15
GNP at factor cost 500
(b) Mutual Funds

 Mutual funds are investment vehicles where many investors pool their resources
together to be invested in a variety of financial instruments.
 These are operated by professional money managers having specialist knowledge of
money markets and capital markets.
 These allow individual investors to diversify their investment which otherwise might
not be possible for an investor with small amount of capital.
Derivatives
 Derivative is merely a contract between two parties.
 Its price is dependent on one or more underlying asset(s).
 They are traded over the counter (OTC) and/or on an exchange.
(THE END)
Page 8 of 8

Section A
Q.1 (a) What do you understand by the term ‘Capital formation’? Briefly describe the stages
involved in the process of capital formation. (04)
(b) Following data relates to a country Ruritania which is capable of producing the
following combinations of consumer goods and capital goods with a given quantity of
resources and technology:
Consumer goods 140 120 100 70 0

Capital goods 0 60 80 100 120
Required:
(i) With the help of above data, draw a production possibility curve. (03)
(ii) Ruritania, after full utilization of its resources, is currently producing 70 units of
consumer goods. What would be the opportunity cost to Ruritania in terms of
capital goods if it decides to produce 50 more units of consumer goods? (01)
Q.2 (a) Define the law of ‘Equi-marginal utility’ and list the assumptions underlying the law.
Also describe any two limitations of the law of equi-marginal utility. (07)
(b) List the factors which determine the price elasticity of demand of a commodity. Briefly
describe what characteristics of a commodity are indicated by a negative or a positive
sign of ‘Income elasticity of demand’ and ‘Cross price elasticity of demand’ of that
commodity. (06)
Q.3 Describe the following diagram and the concept which it depicts. (06)
Q.4 (a) Briefly describe why the short-run average cost curve is U shaped. (05)
(b) Describe the law of variable proportion. Also state the assumptions on which the law of
variable proportion is based. (03)
(i) The mode of Islamic financing where a financial expert offers services for managing
investment; and the investor and the expert share profits, is called:
(a) Ijara (b) Mudaraba (c) Musharaka (d) Murabaha
(ii) Which of the following statements relate to normative aspect of economics?

(a) Government should provide basic health care to all citizens
(b) Government-provided health care increases public expenditures
(c) Economists are paid more than the accountants
(d) Technology has great impact on productivity
(iii) If the demand equation for a good is Qd = 20 – P and the supply equation is
Qs = 6 + 1.5 P and the price is set equal to 2.4 above the equilibrium level, there will be
an excess:
(a) demand of 6 units (b) supply of 6 units
(c) demand of 12 units (d) supply of 18 units
(iv) The price of a product is Rs. 3 and the quantity supplied is 10 units. When price is
increased to Rs. 7 the quantity supplied increases to 12 units. The supply is:
(a) perfectly elastic (b) elastic
(c) inelastic (d) perfectly inelastic
(v) Which of the following may NOT be regarded as strength of a collusive oligopoly?
(a) production techniques and costs of all the firms are similar
(b) there are no barriers on entry of new firms
(c) similar products are produced by the firms
(d) the market is stable
(vi) Assume that marginal propensity to consume out of disposable income is 0.8 and the
rate of tax is 30% of total income. Under the simple Keynesian model, what would be
the total change in national income if government increases public spending by Rs. 150
million?
(a) Rs. 187.5 million (b) Rs. 341 million (c) Rs. 525 million (d) Rs. 750 million
(vii) Assume that in 2017 the nominal gross domestic product of a country is Rs. 500 billion
and the price index is 200. If the price index was 150 in 2010 what would be the real
gross domestic product of the country in 2017 computed in terms of 2010 prices?
(a) Rs. 125 billion (b) Rs. 166.67 billion (c) Rs. 375 billion (d) Rs. 666.7 billion
(viii) Which of the following marks the beginning of a contraction in the business cycle?
(a) Peak (b) Trough (c) Expansion (d) Recession
(ix) Government may increase the money supply through open market operations but such
measures are likely to result in short-term interest rates to:
(a) rise and increase the demand for money
(b) rise and reduce the demand for money
(c) fall and increase the demand for money
(d) fall and reduce the demand for money
(x) Consider the following data for a country:

Rs. in billion
Consumer expenditure 250
Government expenditure 500
Imports 100
Taxes 20
Depreciation 5
Based on the above data, the aggregate demand for the economy would be:
(a) Rs. 625 billion (b) Rs. 850 billion (c) Rs. 650 billion (d) Rs. 825 billion
(xi) Which of the following policies help in increasing economic growth?

(a) Increase in taxes (b) Increase in government spending
(c) Reduction in subsidies (d) Wage freezes
(xii) Which of the following is NOT regarded as a money market instrument?

(a) Commercial papers (b) Certificate of deposits
(c) Treasury bills (d) Bonds
(xiii) Which of the following policy combination is likely to solve a deficit on the current
account of the balance of payment in an economy with a floating exchange rate?
(a) Decrease interest rates and increase income tax rates
(b) Increase interest rates and decrease income tax rates
(c) Decrease interest rates and decrease income tax rates
(d) Increase interest rates and increase income tax rates
(xiv) Suppose in an economy, the average price level is 1.3, real value of national output is
Rs. 230 billion and the quantity of money in circulation is Rs. 103 billion. The velocity
of circulation would be:
(a) 2.90 (b) 1.60 (c) 0.72 (d) 0.58
(xv) The most effective macroeconomic policy to increase output under fixed exchange rates
and perfect capital mobility would be:
(a) an expansionary monetary policy (b) a revaluation of the domestic currency
(c) an expansionary fiscal policy (d) an increase in taxes
Section B
Q.6 (a) Identify and describe the stage of business cycle which eventually takes the economy
into recession. (04)
(b) Alongside the benefits of economic growth, certain costs are also associated with it.
Identify and discuss the costs associated with economic growth. (06)
Q.7 (a) What is a capital market? State its main objectives. (03)
(b) What do you understand by the term ‘Derivatives’? State the main objective of
exchange traded derivatives. (03)
(c) The current account, the capital account and the financial account make up country’s
balance of payments.
Briefly describe the components of the financial account. (04)

Q.8 (a) State Keynes’ Psychological Law of Consumption and the allied propositions. (04)
(b) Briefly describe any four objective factors which influence the consumption function in
an economy. (06)
Q.9 (a) Identify four main objectives of fiscal policy and briefly describe how these objectives
may be achieved. (04)
(b) In recent times, public expenditure has increased enormously. Briefly describe any four
principal causes of growing public expenditure of nations. (06)
Q.10 (a) What do you understand by the term ‘Bank’? Briefly describe the following:
(i) Retail bank (ii) Specialized bank (iii) Investment bank (06)
(b) Identify any eight functions of a central bank. (04)
Q.11 (a) What is meant by ‘Exchange rate’? Briefly describe the impact of fall in exchange rate
on a country’s exports and imports. (04)
(b) Illustrate with the help of a diagram, how the government may stop exchange rate
from falling. (06)
Q.12 (a) The following data relates to an open economy:
Consumption expenditure 0.4Yd

Investment expenditure (Rs.) 300 million
Government expenditure (Rs.) 600 million
Exports (Rs.) 500 million
Imports 0.28Y
Where Y is the national income and Yd is the disposable income which is equal to
70% of the national income.
Required:
Calculate the following, showing necessary workings:
(i) equilibrium level of national income. (02)
(ii) fiscal surplus/deficit, if the rate of taxation is 30%. (02)
(b) According to the monetary economist Milton Friedman, a trade-off exists between
unemployment and wage inflation but only in the short-run. In the long-run, no such
trade-off exists.
Explain, with the help of a diagram, the arguments put forward by Friedman in this
regard. (06)
(THE END)
SUBJECT SESSION
Introduction to Economics and Finance Certificate in Accounting and Finance -
Spring 2018
General:
The overall result declined to 23.7% as compared to previous attempt when 33.3% of
the candidates secured passing marks. Although most of the questions were on topics
examined several times in the past, poor performances were witnessed in question
numbers 4, 11 and 12. The performance in Questions 11 and 12 was even more
surprising as these were part of Section B where the candidates had the choice of not
attempting them. This is suggestive of the fact that candidates resort to selective
study and rote learning rather than acquiring conceptual understanding. However,
candidates performed well in question numbers 5, 8 and 9.
Over the last few attempts, a growing tendency of answering extra question in
section B has been observed. The candidates are therefore strongly advised to refrain
from answering extra questions as it does not earn them any extra marks and results
in waste of time and sometimes a question remains unanswered in the compulsory
section.
Question-wise comments
Question 1
This question consisted of two parts. The overall performance was average as 33% of
the candidates secured passing marks. Part-wise comments are given below:
Question 1(a)
Most of the candidates were able to correctly define the term ‘Capital formation’.
However, with regard to the stages involved in the process of capital formation,
many candidates were only able to list the three stages without description. Few
candidates envisaged consumption, distribution and innovation to be the stages
involved in the process of capital formation.
Page 1 of 7
Examiners’ Comments on Introduction to Economics and Finance - Spring 2018
Question 1(b)
The candidates were required to draw a production possibility curve (PPC) with the
given set of data. Majority of the candidates correctly plotted the PPC but failed to
label the diagram correctly and could not secure full marks on it. Many candidates
also lost marks by using improper scale on both x and y-axis which resulted in a
straight line PPC.
Majority of the candidates also failed to appreciate that opportunity cost in sub-part
(ii) of part 1(b) would be 40 units of capital goods.
Question 2
This question consisted of two parts. The overall performance was average as 31% of
the candidates secured passing marks. Part-wise comments are given below:
Question 2(a)
This part required definition of law of ‘Equi-marginal utility’, the assumptions

underlying the law and its limitations. Generally, the candidates seemed to lack
conceptual understanding. Some students only wrote that when the marginal utility
of the two commodities is equal it is called Equi-Marginal Utility without referring to
maximisation of total utility and consumer’s limited income. Some candidates did
not comprehend the question correctly and explained the concept of indifference
curve. However, the assumptions and the limitations were correct in most cases
although most of the candidates could not mention all the assumptions.
Question 2(b)
The first part of this question required candidates to list the factors which determine
the elasticity of demand whereas the second part was related to the characteristics
indicated by the negative or a positive sign of ‘Income elasticity of demand’ and
‘Cross price elasticity of demand’ of a commodity.
The first part was performed well by majority of the candidates. However, some
candidates deliberated on factors affecting the demand instead of elasticity of
demand.
In the second part, majority of the candidates were only able to identify the type of
commodity which bears a positive or a negative sign both in case of income elasticity
and cross price elasticity of demand but could not elaborate on the reason behind
such sign. A number of candidates lacked clarity and mixed up the characteristics of
both income elasticity and cross price elasticity of demand.
Page 2 of 7
Question 3
A diagram was provided in this question and candidates were required to explain the
diagram and the concept depicted by it. The performance on this question remained
below average. However, the performance improved considerably from the last
attempt when this type of question was asked for the first time; as 18% of the
candidates secured passing marks as compared to only 4% in the previous attempt.
About 2% of the successful candidates with good conceptual understanding managed
to score 80% or more marks on the question.
Replies of about 50% of the students were limited to the identification of the concept
depicted by the diagram which earned them only one or two marks. Some candidates
only identified that the diagram depicted a firm earning normal profit in the long-run
but did not identify the type of market structure such as perfect competition,
imperfect competition, oligopoly or monopoly. Some candidates erroneously stated
that the diagram depicts a long-run equilibrium under monopolistic competition.
Many candidates again wasted time in drawing the diagram which was already
provided in the question paper. Such wastage of time affects the candidate’s ability to
perform well in the other questions.
Question 4
This question consisted of two parts and was among one of the worst attempted
questions in the paper as only 5% of the candidates scored passing marks, whereas,
more than 50% of the candidates could not secure any mark. However, at least some
of the candidates managed to secure full marks also. Part-wise comments are given
below:
Question 4(a)
This part required candidates to describe why the short-run average cost curve is U
shaped. Though the topic had been tested previously also, the candidates failed to
define the concept. Most of the answers were not only incomplete but also irrelevant
and somehow revolved around the concepts of economies and dis-economies of
scale. Some candidates thought that the U shape of the cost curve is due to the
operation of law of variable proportion whereas others attributed it to factors such as
production efficiency, inefficiency of labour force, breakdown of machinery, etc.
Question 4(b)
This part asked candidates to describe the law of variable proportion and the
assumptions on which the law is based. Again, the performance was very poor. Most
of the candidates lacked conceptual understanding and related the law of variable
proportion to increase or decrease of cost and the return of the firm.
Page 3 of 7
Question 5
The performance in this MCQ based question remained satisfactory as 41% of the
candidates secured passing marks whereas about 2% of the candidates secured 80%
or more marks. Most incorrect answers were witnessed in MCQs iii, vi, vii, viii and
xv. In this question also, many candidates wasted time in writing the entire answer
instead of mentioning just the alphabet representing the answer, such as (a), (b), (c)
or (d).
Question 6
This question consisted of two parts. The overall performance remained poor as only
22% of the candidates who chose to attempt this question were able to secure passing
marks and about 25% of these students could not secure any mark. Part-wise
comments are given below:
Question 6(a)
The overall performance was very poor. Majority of the candidates failed to identify
‘Downturn’ as the stage of business cycle which eventually takes the economy into
recession. Most of the candidates drew a diagram and wasted considerable time
explaining various stages in detail although the requirement was just to explain the
stage preceding Recession.
Question 6(b)
The performance in this part was better than that of part (a). Many candidates were
able to identify and define at least one or two costs associated with economic growth.
However, some candidates did not comprehend the requirement of the question and
deliberated on the benefits of economic growth which had not been asked.
Question 7
This question consisted of three parts. The overall performance remained below
average as only 25% of the candidates who chose to attempt this question were able
to secure passing marks. Part-wise comments are given below:
Question 7(a)
This part required the candidates to explain ‘Capital market’ and also state its
objectives. The performance remained poor as most of the candidates did not have a
clear idea of a capital market. Many candidates wasted time by listing the
instruments used by the capital market and the institutions involved in the capital
market.
Many candidates did not have any knowledge about the objectives of capital market.
They tried guesswork and stated objectives such as economic growth, decrease in
inflation, increase of output, etc.
Page 4 of 7
Question 7(b)
This part required the candidates to explain the term ‘Derivatives’ and state the main
objective of exchange traded derivatives. Good performance was witnessed in this
part of the question. Most of the candidates correctly provided the definition.
However, only about 50% could state the main objective of exchange traded
derivatives.
Question 7(c)
This part required candidates to describe the components of financial account. The
performance remained average as most of the candidates who correctly listed the
components such as, real foreign direct investment, portfolio investment, financial
derivatives and reserve assets failed to describe them correctly. Some candidates
listed current account and capital account as the components of financial account
and also listed the transactions posted to such accounts. Some candidates were of the
view that total imports and exports as well as total government expenditure and taxes
are the components of financial account.
Question 8
This question consisted of two parts. The overall performance was good as 53% of
the candidates who chose to attempt it secured passing marks. Part-wise comments
are given below:
Question 8(a)
This part required the candidates to state Keynes’ Psychological law of Consumption
and its allied propositions. The performance remained good as majority of the
candidates correctly defined the law and stated its three related propositions. The
most common error made by the students was that they only produced the law but
did not mention the three propositions.
Question 8(b)
This part asked candidates to describe any four objective factors which influence the
consumption function in an economy. The performance in this part was average.
Some candidates only provided the list of objective factors without any description.
Majority of the students mentioned two or three factors only.
Question 9
This question also consisted of two parts. The overall performance was good as 50%
of the candidates who chose to attempt this question were able to secure passing
marks. Part-wise comments are given below:
Page 5 of 7
Question 9(a)
This part required candidates to identify four main objectives of fiscal policy and
describe how these objectives may be achieved. Majority of the candidates performed
well on the question. Candidates could not score full marks either due to their failure
in identifying all the four objectives of fiscal policy or due to incomplete description
of how such objectives may be achieved. Moreover, some candidates wrote the
objectives of monetary policy instead of fiscal policy.
Question 9(b)
In this part, the candidates were required to state the reasons for continuously
growing public expenditure. The performance in this part was also good. However,
those candidates lost marks who gave incomplete description or who were confused
between public and private expenditure.
Question 10
This question consisted of two parts. The overall performance was above average as
40% of the students who chose to attempt this question secured passing marks. Part-
wise comments are given below:
Question 10(a)
The performance remained average as most of the candidates correctly defined the
terms ‘bank’ and ‘specialized bank’ but failed to define the terms ‘retail bank’ and
‘investment bank’. With regard to investment bank majority of the answers were
only confined to the statement that ‘it assists institutions in raising capital or
providing advice’.
Question 10(b)
The performance was good as most of the candidates scored passing marks.
However, only few students managed to identify more than six functions of central
bank.
Question 11
This question consisted of two parts. Though the question was based on basic
economic concept of exchange rate, the overall performance remained disappointing.
Despite the fact that only 52% of the candidates chose to attempt this question, only
11% of these candidates secured passing marks. Part-wise comments are given
below:
Question 11(a)
The performance was average. Most of the candidates correctly defined exchange
rate but could not properly explain the impact of fall in exchange rate on a country’s
exports and imports. Most of them only stated that fall in exchange rate would make
Page 6 of 7
the imports expensive and exports cheaper but did not specify whether exports and
imports would increase or decrease as a result thereof. Some of the candidates gave
exactly the opposite answer i.e. fall in exchange rate would decrease exports and
increase imports.
Question 11(b)
The performance in this part was very poor. Majority of the candidates who
answered part (a) did not attempt this part. Candidates who attempted this part were
barely able to draw the diagram without proper labelling and explanation. Few
candidates, without understanding the requirement of the question, deliberated on
the concept of J curve.
Question 12
This question consisted of two parts. Only 23% of the candidates chose to attempt
this question and even among them, only 11% could secure passing marks. Part-wise
comments are given below:
Question 12(a)
In this part, the candidates were required to compute the equilibrium level of
national income and fiscal surplus/deficit from the given set of data. Majority of the
candidates who answered part (b) left this part unanswered. Many candidates who
attempted this part, only stated the formula for the computation of equilibrium level
of national income. Most of the students failed to adjust the disposable income while
computing the consumption expenditure. Further, very few students computed
surplus/deficit.
With regard to the computation of surplus/deficit, very few candidates attempted to

compute it.
Question 12(b)
This part of the question required candidates to explain with the help of a diagram,
the arguments put forward by Milton Friedman with regard to non-existence of a
trade-off, in the long-run, between unemployment and wage inflation. The
performance remained very poor. Most of the candidates who attempted the
question were only able to draw a partial diagram showing trade-off between
unemployment and wage inflation. Only a handful of candidates were able to
explain that short-run Phillips curve (SRPC) is based upon fixed expectation of
inflation and that if there is an increase in the expectation of inflation then this would
cause the SRPC to shift higher. Hardly any candidate was able to explain the reasons
of shifting of SRPC1 curve to SRPC2 curve. Many candidates ended up explaining
the concept of Phillip curve.
THE END
Page 7 of 7
Suggested Answers
Ans.1 (a) Capital formation:

Capital formation is the net capital accumulation for a particular country and refers
to the additions or increase in the stocks of capital in that country. Capital goods
include machines, tools, factories, transport equipment, materials, electricity, etc.
Stages involved in the process of capital formation

The process of capital formation involves the following three stages:
(i) Creation of savings:

When the average level of income is high then people tend to save more. An
increase in the volume of real savings releases resources which otherwise
would have been devoted to the production of consumption goods.
(ii) Mobilization of savings:

It involves transfer of savings from the households to businesses for
investment.
(iii) Investment of savings:

Investment of savings in real capital is integral for the capital formation. This
can only happen if there are enough entrepreneurial ventures and businesses
that are willing to take risks and embrace uncertainty.
(b) (i) Production possibility curve:
(ii) Opportunity cost of producing 50 more units of consumer goods would be 40

units of capital goods.
Ans.2 (a) Equi-marginal utility:

According to the law of Equi-Marginal Utility, a consumer maximizes his total
utility with his limited income when marginal utility of the last rupee spent on each
commodity is equal.
Assumptions of Law of Equi-Marginal Utility:

(i) The consumer behaves rationally and seeks to maximize his total satisfaction
(ii) Utility is measurable in cardinal terms/quantitative terms
Page 1 of 10
Suggested Answers
(iii) The consumer has a given scale of preference for the goods in consideration
(iv) The consumer has perfect knowledge of utility derived from goods
(v) Wants and goods are substitutable
(vi) Prices of goods remain unchanged
(vii) Consumer income is fixed
(viii) The marginal utility of money is constant
Limitations of the Law of Equi-Marginal Utility:

Consumer expenditure may not conform to the law due to the following
limitations:
(i) Consumers do not make conscious calculations

The operation of the law involves calculations and comparison of the
expected satisfaction from an amount of money spent on alternative goods
and services. However, consumer expenditure is also based on habit rather
than conscious calculation and comparison of utility per unit of currency.
(ii) Consumer ignorance

Consumers may be unaware of other available alternatives. In this case no
substitution could take place and the law would not operate.
(iii) Custom and fashion

Some purchases are made based on custom or fashion rather than on the
basis of a rational appraisal of utility. This would distort the operation of the
law.
(iv) Indivisibility of goods

The operation of the law assumes that goods and services are divisible so that
the optimum point might be reached. However, this may not be the case in
practice. This prevents the marginal utilities from becoming equalised.
(v) Underlying assumptions

The operation of the law rests on a series of assumptions which might not
hold in practice.
(b) Factors which determine the price elasticity of demand of a commodity:

Following are the factors which determine the price elasticity of demand:
(i) The availability of substitutes
(ii) The proportion of consumer’s income spent
(iii) The number of uses of a commodity
(iv) Complementarity between goods
(v) Time period
Classification of the goods according to the sign of IED and XED:

Income elasticity of demand (IED):
 A normal good will always have a positive income elasticity of demand,
because as income increases, demand for the product also increases.
 An inferior good will always have a negative income elasticity of demand,
because as income increases, demand for the product will decrease, as
consumers switch to better alternatives.
Page 2 of 10
Suggested Answers
Cross price elasticity of demand (XED):

 A complementary good has a negative cross price elasticity of demand,
because the two factors i.e. Good A’s price, and Good B’s quantity move in
opposite directions.
 A substitute good has a positive cross price elasticity of demand, because the
two factors i.e. Good A’s price, and Good B’s quantity move in the same
direction.
Ans.3
The above diagram depicts the concept of long run equilibrium of a firm under perfect
competition.
In perfect competition every purchaser and seller is so small relative to the entire market
that he cannot influence the market price by increasing or decreasing his purchases or
output. Therefore, the market price remains the same regardless of firm’s output.
The demand curve is completely horizontal, which means that sale of each additional unit
produces the same revenue and therefore MR=AR=P(Price). MC is the marginal cost
curve which depicts the increase in cost on account of production of each additional unit.
With the sale of each additional unit the total profit of the firm would increase till such
time that the MC remains below the Marginal Revenue Curve i.e. PL. The profit will be
maximum at point R where MC curve cuts PL from below because above this point each
additional unit will cost more than the revenue it would generate. At this stage (i.e. point
R) Marginal Cost would be equal to Marginal Revenue and the firm would be producing
OM units.
In the long run, the firms are able to increase /decrease their output by varying their
equipment. Therefore, in the long run no firm is in a position to earn super normal profits
and all firms earn normal profit which is depicted by the area OPRM where the total cost
and total revenue of the firm are the same.
Ans.4 (a) Short-run average cost curve is U shaped:

The average cost is made up of an average fixed cost per unit plus an average
variable cost per unit.
Average fixed cost will fall as the level of output rises. Spreading fixed costs over a
larger amount of output is a major reason why (short-run) average costs per unit
falls as output increases.
Page 3 of 10
Suggested Answers
The standard assumption about the variable costs is that up to a certain level of
output, the variable cost per unit is more or less constant (e.g. wages and material
costs per unit of output remain unchanged).
Nevertheless, there is evidence that average variable costs rise when output
increases beyond a normal capacity level.
Average variable costs will therefore begin to rise at some point, even if there are
no overtime payments or use of more skilled labour.
As variable costs per unit rise, the average total cost per unit will rise too.
Hence the curve falls on account of spread of fixed costs and rises when the
variable costs start rising after a certain level, thus giving the curve a U shape.
(b) Law of variable proportion:

As the quantity of one factor is increased, with others remaining fixed, the
marginal product of that factor will decline.
Assumptions of the law of variable proportion:

The law is dependent on the following assumptions:
(i) Constant state of technology:
if technology improves, the marginal product could increase also.
(ii) Fixed amount of other factors / Factor proportions are variable:

they must stay constant to be able to test it. It operates in the short run
because in the long run fixed input becomes variable.
(iii) Possibility to combine factors:

the factors must be able to be combined to make a product.
Ans.5 (i) (b) Mudaraba

(ii) (a) Government should provide basic health care to all citizens
(iii) (b) supply of 6 units
(iv) (c) inelastic
(v) (b) there are no barriers on entry of new firms
(vi) (b) Rs. 341 million [formula is 1/(1-MPC (1-t)) or 1/(1-0.8 x (1-0.3)) x 150]
(vii) (c) Rs. 375 billion [formula is 500/200 x 150]
(viii) (a) Peak
(ix) (c) fall and increase the demand for money
(x) (c) Rs. 650 billion [formula is C + G – X or 250 + 500 - 100]
(xi) (b) increase in government spending
(xii) (d) Bonds
(xiii) (d) Increase interest rates and increase income tax rates
(xiv) (a) 2.9 [formula is v = p x y / m or 1.3 x 230/103]
(xv) (c) an expansionary fiscal policy
Page 4 of 10
Suggested Answers
Ans.6 (a) The stage of business cycle which takes the economy into recession:
Downturn is the stage where the economic activity begins to slow down.
When demand begins to decrease, firms begin to scale back their production and
investment plans. There is a steady decline in output, profits, prices and
employment as demand falls, and firms respond by reducing their output.
Banks reduce the credit they issue, firms reduce orders that they place, and people
begin to lose their jobs, which further decreases the level of aggregate demand. This
eventually takes the economy into a state of recession.
(b) The costs associated with economic growth.

Following are some of the costs associated with economic growth.
(i) Inflation:
When economy grows too quickly, Aggregate Demand exceeds Aggregate
Supply because of which economic growth is not sustainable as it results in
positive output gap which prompts the firms to push up their prices.
(ii) Current account deficit:

Economic growth causes an increase in spending on imports which
consequently causes a deficit on the current account.
(iii) Inequality:
More often increase in the rate of economic growth results in an increased
level of inequality because the growth may benefit a small section of the
society more than the others.
(iv) Negative externalities / Environmental costs:

Rapid growth can give rise to plenty of environmental concerns; which
includes noise pollution, air pollution, road congestion, household and
industrial waste, deforestation, etc.
Ans.7 (a) Capital market:

Capital market is the financial market which is largely used to raise long-term
finance and capital.
Objectives of capital market:

Capital market plays a vital role in mobilizing the savings and making them
available to the enterprising investors.
It facilitates the buying and selling of capital instruments.
The capital market provides long-term debt and equity finance for the government
and corporate sector.
(b) Derivatives:
Derivative is an instrument whose price is dependent on one or more underlying
asset(s). It is a contract between two parties. The price of a derivative changes with
the change in the underlying asset(s).
Objective of exchange traded derivatives (ETD):

The main objective of ETD is to reduce the level of counterparty risk, as trades are
done by means of regulated contracts through a clearing house.
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(c) Components of financial account:

Following are the components of financial account with brief description of each:
(i) Real foreign direct investment:

A firm setting up a factory in another country.
(ii) Portfolio investment:

a domestic investor buying shares in a business that is already established.
Such investors have little or no control over these companies.
(iii) Financial derivatives:

financial instruments where the underlying value is based on another asset.
(iv) Reserve assets:

these are foreign financial assets held by Central Bank which uses them to
cover deficits and imbalances.
Ans.8 (a) Keynes’ Psychological Law of Consumption:

According to Keynes Psychological Law of Consumption, people increase their
consumption as their income increases, but not by as much as their income
increases.
The law consists of three related propositions:

(i) Aggregate consumption can increase due to increased aggregate income, but
the increase in aggregate consumption will be less than the increase in
income. This is because as basic necessities are fulfilled, people begin to save
additional income.
(ii) What is not spent on consumption is saved. (∆Y=∆C+∆S)
(iii) The increase in aggregate income will lead to increased consumption or

savings. It is not possible for savings and consumption to decrease when
income increases.
(b) Objective factors influencing the consumption function:

Following are the factors which influence consumption function in an economy:
(i) Real income:

Increase in real income would lead to increase in consumption and vice versa.
(ii) Distribution of income:

Change in pattern of income distribution would result in change of
consumption. A more equal distribution of wealth will raise the propensity to
consume.
(iii) Expectations of price changes:

If prices are expected to rise, people will be motivated to spend more and
accumulate goods, hence increase in consumption.
(iv) Changes in fiscal policy:

Reduction in taxes would leave more post-tax incomes with the people and
this will stimulate higher expenditure on consumption.
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(v) Changes in interest rates:

Decrease in interest rates would increase the amount of disposable income of
people and thus encourage consumption.
Ans.9 (a) Objectives of fiscal policy:

Following are the objectives of fiscal policy:
(i) High level of Employment: The state expenditure are directed towards public
projects thereby creating employment with productivity.
(ii) Resource Mobilization: Fiscal mechanism attempts at resource mobilization by

creating a climate conducive to savings and investments, by influencing their
relative profitability.
(iii) Resource Allocation: A fair share of resources is allocated to different sectors

and regions through the budgetary mechanism.
(iv) Economic stability: Undesired pace of inflation or deflation is controlled by way

of taxation and government spending.
(v) Income Distribution: Fiscal policy is a combination of taxation and relief

measures which are used to correct imbalances resulting from the unequal
distribution of ownership of income earning assets.
(b) Principal causes of growing public expenditure:

Following are some of the reasons of continuous increase in public expenditure:
(i) Welfare state ideology:

the state is expected to promote the wellbeing of its citizens in every respect
i.e. politically, economically and socially. With increased number of
functions and higher expectations, State needs more to spend on public
expenditure than before.
(ii) Size of population:

because of ever-increasing size of population the government has to cater to
the structural and social needs of the increased population.
(iii) Technological developments:
technological advancements play an integral role in the economic growth of
the country but at the same time also cost a lot. For instance, invention of
combustion engine led to the manufacturing of automobiles for which roads
and highways were necessary to be built thus increasing the government
expenditure.
(iv) Ability to tax:

As the economies are growing, the government’s ability to generate
revenues/taxes is increasing making it possible to increase expenditure to
provide better facilities to the public.
(v) Expansion in social services:

there has been a remarkable expansion in social services such as education
and public health services leading to the development of schools, colleges,
educational institutes, hospitals and medical centres that in turn require
finances for establishment and stability.
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(vi) Provision of public utility services:

Another significant increase in the public expenditure is due to an augmented
provision of public utility services such as electricity, water and transport
services.
(vii) Political and social factors:

The government expenditure also increases due to various political and social
factors.
For instance, ministers are pressurized to undertake more activities to bring

about changes in their home districts.
(viii) Economic development:

Whether developed or under-developed, every country eyes on the economic
development in order to reach economic stability and higher standard of
living of its people. Developed countries wish to retain their progress and aim
for even higher milestones whereas developing countries are anxious to reach
there. Undoubtedly, therefore the budgets get swollen more and more with
every passing year.
(ix) War and the national defence:

Wars have always been a great threat for every country. Even in modern
times the fear has only increased, making countries spend more on the
national defence. Countries at war have to ultimately spend heavily on the
subject.
Ans.10 (a) Bank:

A financial institute licensed by the government to receive deposits, which then
invests these funds in a number of securities.
(i) Retail bank:

A bank targeted at the mass-market in which individual customers can
purchase/obtain mortgages, checking accounts, personal loans, and other
bank services.
(ii) Specialized bank:

A bank targeted to a specific section of the economy in which firms and
customers can have access to specialized forms of banking services.
(iii) Investment bank:

A financial intermediary that undertakes a number of financial services for
clients such as raising capital, underwriting securities and other assets,
providing advice, etc.
The investment bank can also aid companies with acquiring funds, and
facilitate a number of transactions through utilising the financial markets.
An investment bank does not accept deposits.
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(b) Functions of a central bank:

(i) issuing currency notes
(ii) banker to the state
(iii) banker to other banks
(iv) guardian of the money market through the control of credit
(v) lender of last resort
(vi) maintaining the external value of the domestic currency
(vii) custodian of foreign exchange reserves
(viii) ensures stability of the internal value of the currency i.e. price level
(ix) overall economic stability of the country
(x) clearing agent for commercial banks
Ans.11 (a) Exchange rate:

The exchange rate is the price of one currency expressed in terms of another
currency.
Impact of fall in exchange rate on country’s exports and imports:

As the exchange rate falls, the demand for country’s exports extends as
depreciation makes exports cheaper and increases the competitiveness of exporting
firms.
As the exchange rate falls, imports look less attractive as imported goods become
more expensive for both the direct consumer and the domestic producer using them
for further processing. Consequently, country’s demand for imports contracts.
(b) How the government may stop exchange rate from falling:
Suppose the government wishes the rate to be at Rt. Policy options are:
 Increase the domestic interest rate and hence shift the demand curve for rupees
from D to D1.
 Purchase the surplus rupees (Qs-Qd) using foreign exchange reserves.
Deflate the economy to reduce the demand for imports. This will shift the supply
curve of rupees from S to S1.
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Ans.12 (a) (i) Equilibrium level of national income:

The equilibrium level of national income is given by:
Y=C+I+G+X-Z
OR Y = 0.4 Yd + 300 + 600 + 500 – 0.28Y
Y = 0.4×0.7Y + 1,400 – 0.28Y
Y = 0.28Y + 1,400 – 0.28Y = 1,400
(ii) Fiscal surplus / deficit:

The fiscal balance is given by:
T – G where T is the income from taxes and G is the government expenditure.
Therefore, T = 1,400 × 30% = 420 and
420 – 600 = 180 million (deficit)
(b) With the help of a diagram, explanation of the arguments put forward by Milton
Friedman with regard to long run Phillips curve and a trade-off between
unemployment and inflation:
Milton Friedman’s argument was that each short-run Phillips curve (SRPC) is
based upon a fixed expectation of inflation. If there is an increase in the expectation
of inflation, then this would cause the SRPC to shift higher.
Diagrammatically it can be illustrated as follows:
In the above diagram, The economy begins in equilibrium at A.
When there is an increase in government spending to boost Aggregate Demand

(AD), the unemployment decreases from U1 to U2 and takes the equilibrium to
point B where inflation is 6%.
At point B, firms’ costs and individuals’ wage demands increase, meaning output
falls, unemployment rises, and hence SRPC1 shifts to SRPC2.
Therefore, in the short run, a trade off may occur, however in the long run, it is not
possible to expand beyond the long-run Phillips curve (LRPC).
(THE END)
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ICAP PAST PAPERS AND

INTRODUCTION TO ECONOMICS AND FINANCE

(SPRING 2018 - AUTUMN 2020)

By: Hafiz Muhammad Farhan

The Institute of 24 September 2020

Introduction to Economics and Finance

(ii) Micro economics does NOT cover:

(iii) Which of the following statements is NOT correct?

(v) Which of the following is NOT considered to be an assumption of the law of

(a) Equality (b) Economy

(ix) Which of the following would increase the value of multiplier?

(x) The crowding out effect is caused by a:

(a) Corporate bonds (b) Mutual funds

(xiv) A country’s balance of payment position exhibits:

(xv) Which of the following is a financial intermediary?

(b) Describe any three limitations of multiplier. (03)

(b) What do you understand by the ‘Quantity theory of money’? (03)

(c) Describe the functions of money. (03)

(b) Briefly discuss the constituents of capital/financial account. (04)

CERTIFICATE IN ACCOUNTING AND FINANCE (CAF) EXAMINATIONS

Question-wise common mistakes observed

Good performance was observed in this part of the question.

MCQ numbers 2, 5, 12 and 13 proved to be challenging for the examinees.

The performance in this part remained satisfactory.

Ans.1 (a) Planned economy:

Drawbacks of planned economy:

(b) Capital formation:

Stages involved in the process of capital formation

(i) Creation of savings:

(ii) Mobilization of savings:

(iii) Investment of savings:

Ans.2 (a) Law of diminishing marginal utility:

Explanation with the help of schedule and a graph:

Units of commodity Total utility Marginal utility (MU)

(b) Factors which may determine price elasticity of demand:

Ans.3 (a) Economies of scale:

Internal economies of scale can be achieved in the following ways:

(ii) Managerial economies:

(iii) Trading/commercial economies:

(iv) Financial economies:

The above diagram demonstrates the concept of consumer equilibrium using

Ans.5 (i) (a) An incentive to innovate

Ans.6 (a) Circular flow of national income in a two-sector economy:

(b) (i) Factors causing a shift in aggregate demand curve:

(ii) Factors causing a shift in short-run aggregate supply curve:

Ans.7 (a) Cost-push inflation:

Causes of cost-push inflation:

(i) Rising labour costs:

(ii) Expectations of inflation:

(iii) Component costs:

(iv) Higher indirect taxes:

(b) Limitations of Multiplier:

(i) Efficiency of production/Elasticity of supply:

(ii) Regular investment:

An increase in government spending causes aggregate demand (AD) to shift outward to

However, equilibrium at point B is unsustainable. To produce this level of output there

Ans.9 (a) Progressive taxation:

(b) Characteristics of a good tax policy:

(c) Objectives of fiscal policy:

(ii) Resource mobilization: Fiscal mechanism attempts at resource mobilization

(iii) Resource allocation: A fair share of resources is allocated to different sectors

(iv) Economic stability: Undesired pace of inflation or deflation is controlled by

(v) Income distribution: Fiscal policy is a combination of taxation and relief