Introduction to Economics and Finance

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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 Introduction to Economics and Finance
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Certificate in Accounting and Finance – Autumn 2020

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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 Introduction to Economics and Finance
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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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 Introduction to Economics and Finance
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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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 Introduction to Economics and Finance
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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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 Introduction to Economics and Finance
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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)

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