2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

Paper 01

MCQ
1. Several product combinations on a production possibilities frontier that illustrates X goods on
the horizontal axis and Y goods on the vertical axis have been stated below.

X goods Y goods
0 50
40 40
70 30
85 20
95 10
100 0

According to these data,

I. The opportuning cost takes a constant value at each of the product levels.
II. The technology that is used for the production of X and Y goods are equal in every hand.
III. The resources that are used for the X good are perfect substitutes for Y goods also.
IV. When moving upwards along the production possibilities frontier the rate of
opportunity cost gradually increases.
V. When moving upwards along the production possibilities frontier the rate of opportunity
cost gradually declines.

2. Which of the following statement/statements is/are incorrect,

I. The total amount of goods and services that can be produced by a society is determined
by the amount of productive resources that society owns.
II. The amount of wants that can be fulfilled by each person and the society depends on
the level of income, prices and the amount of time that can be spent on consuming
them.
III. Scarcity is the situation where our limited wants cannot be fulfilled by unlimited
resources due to inefficient use of resources.
IV. Scarcity is common to both rich and poor people.
V. None of the above

3. Which of the following statement/statements is/are correct,

Economic goods is not considered as a subset of all goods.
Any good which satisfies a human need/want is considered as an economic good.
Free goods are not sold at a market price or they don't have a commercial value.
Every good which a price is not charged becomes a free good.
Free good is not a result of a production process, as free goods are supplied with human effort
or human decision.
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

4. A characteristic of ‘New Traditional Economy’?

I. Production and output distribution is based on customs.

II. Promote social equality while harnessing the benefits of market economy.
III. While having the large amount of property ownership with public sector allowing market
mechanism to allocate resources among competing needs
IV. Economic decisions made though a cultural framework based on religion or customs.
V. None of the above

5. A power station burns waste to produce electricity. This also produces a by-product of fertiliser
for farmers. What is the effect in the fertiliser market of an increase in the demand for
electricity?

I. The price of fertiliser falls and the quantity demanded rises.

II. The price of fertiliser falls and the quantity supplied falls.
III. The price of fertiliser rises and the quantity demanded falls.
IV. The price of fertiliser rises and the quantity supplied rises.
V. None of the above

6. In the diagram, D is the demand curve for an

agricultural commodity and S1 is the initial supply
curve. A good harvest causes the supply curve to
shift to S2.

By how much will the demand curve have to shift to

leave farm incomes unchanged?

I. 500 tonnes at all prices

II. 1000 tonnes at all prices
III. 2000 tonnes at all prices
IV. 4000 tonnes at all prices
V. None of the above

7. Which example of consumer behaviour would create consumer surplus?

I. when a consumer does not spend all of her income each month
II. when a consumer pays less than they are willing to pay for a good
III. when a consumer throws away vegetables because they bought too much
IV. when a good is purchased in order to resell it at a higher price
V. All of the above
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8. In the diagram, area OP1M1Q1 is equal to area OP2M2Q2.

What is the value of the price elasticity of demand if the price is halved from P1 to P2?

I. zero
II. +1
III. –1
IV. infinity
V. Cannot be decided.

9. The diagram below shows a firm’s average total cost curve (ATC), with the firm producing an
output of OX. ?
The firm’s productive efficiency will
improve if the

I. Firm makes no adjustment to

output
II. ATC curve shifts upwards for any
given level of output.
III. ATC curve shifts downwards for
any given level of output.
IV. None of the above
V. Both I and III

10. A situation where total revenue equals to total cost is defined as the rate of profit
I. For an industry over a period of years.
II. Minimum required to keep resources in their present usage and is an implicit
cost.
III. Minimum Required to keep the firm in a state of equilibrium.
IV. Earned by producing at the point where marginal cost equals marginal revenue
V. Both II and III

VI. A firm produces good X and good Y when the marginal product of both labour
and capital is diminishing. The table shows the marginal products at a given
output.
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

11. The firm should use ….1….labour and …..2…..capital in the production of X and …..3…… labour
and ……4……. capital in the production of Y.
Marginal
Marginal
product of
product of
labour
capital (units)
(units)

Good X 4 6

Good Y 8 4

Which words complete the gaps 1, 2, 3 and 4 if the firm wished to increase productive efficiency?

1 2 3 4

More Less More Less

More Less Less More

Less More Less More

Less More More Less

More Less Less More

12. Which of the following features indicates that a firm is operating under conditions of perfect
competition?
I. The marginal cost curve cuts the average cost curve at its lowest point.
II. The firm does not advertise.
III. Marginal revenue equals average revenue.
IV. The firm always produces at the optimum.
V. Normal profits are being earned.

13. What is the function that commercial banks and the central bank have in common?
I. Acting as a banker’s banker
II. Controlling monetary policy
III. Supervising the banking system
IV. Dealing with foreign exchange
V. They do not have common functions

14. A country is experiencing inflation. What must be increasing?

I. Wage levels
II. Output levels
III. Money spent on goods and services
IV. Money needed to purchase goods and services
V. All of the above
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

15. A closed economy has a banking system consisting of a single bank. The bank operates with a reserve
ratio of 10%. Customers deposit Rs. 8,000 in cash. Assuming no subsequent change in notes and coins in
circulation what is the maximum of loans that the bank can grant?
I. Rs. 8,000
II. Rs. 7,200
III. Rs 80,000
IV. Rs. 72,000
V. Rs. 88,000

16. Currency held by public is 200 million of an economy. Total deposits in commercial banking
system is 1000 million. This banking system do not hold no excess reserves and statutory
reserve ratio (SRR) is 10%. Money multiplier of this economy is,
I. 5
II. 10
III. 4
IV. 3.33
V. 6

17. A person pays Rs. 500 tax when earnings are Rs. 50 000. Which of the following tax payments
would indicate that the country has a regressive tax system if his income rose to 12 000?
I. Rs. 1 000
II. Rs. 1 200
III. Rs. 1 500
IV. Rs. 2 400
V. Rs. 3 000

18. When is the budget described as balanced?

I. When direct taxes and indirect taxes are equal
II. When exports and imports are equal
III. When government spending and government revenue are equal
IV. When the demand for money and the supply of money are equal
V. When government revenue is lower than government expenditure

19. Merit goods are likely to be under provided in a free market economy because their,
I. Private benefits exceed their social benefits
II. Social benefits exceed their social cost
III. Private costs exceed their private benefits
IV. Social benefits exceed their private benefits
V. Social costs exceed their private costs

20. The table below indicates the private and external costs and benefits, resulting from building
a hydro- power electricity station (in Rs billion),
Private benefits 90
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

Private costs 95
External benefits 55
External costs 70
The social cost minus the social benefit equals,
I. Rs. 60 billion
II. Rs. 25 billion
III. Rs. 20 billion
IV. Rs. 15 billion
V. Rs. 5 billion
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

Part A
1.
i. How do you define economic resources? How do you classify them? (2 marks)
 Economic resources are the assets which an economy may have available to supply and
produce goods and services to meet the ever – changing needs and wants of individuals
and society.
 Economic resources are the goods or services available to individuals and businesses
used to produce valuable consumer products.

Classification of Economic resources:

 Land
 Labour
 Capital
 Entrepreneurship

Alternative answer for classification:

 Property resources: Natural resources and Capital

 Human resources: Labour and Entrepreneurship

ii. Explain the problem of scarcity using a production possibilities curve and explain how
opportunity cost relates to the problem of scarcity. (4 marks)
 Scarcity is a situation in which the needs and wants of an individual or group of individuals
exceed the resources available to satisfy their needs.
 It simply means that people want more than what is available. Scarcity limits us both as a society
and as individuals. Limited income keep up from doing and having all that we might like. As a
society, limited resources fix a maximum on the amount of goods and services that can be
produced.

 The above PPC shows all the alternative product combinations possible for an economy if all the
given resources are used to their maximum efficiency under a given state of technology.
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 However, the economy cannot attain a point lying outside the curve (“u”) even though it is
desirable.
 This is because of scarcity, the unlimited needs of the people cannot be met with existing
resources and economy’s maximum production possibility is limited to any point lying on the
curve.

The concept of opportunity cost

 The value of the next best alternative sacrificed whenever we make a choice in production or
consumption is called as opportunity cost
- Opportunity cost is subjective. Only the individual can estimate the expected value of
the best alternative forgone.
- The opportunity cost is essentially linked with the problem of scarcity. Opportunity cost
exists due to resources are scarce and they have alternative uses. Scarcity is the
condition that results from the imbalance between unlimited wants and the limited
resources available for satisfying those wants.
 The fact the goods and services are scarce means that individuals cannot have all of everything
they want. It is therefore necessary to choose among alternatives.
 A sacrifice is involved whenever you make a choice. One of the most important result of this fact
is that whenever you make a choice, you must sacrifice or forgo other opportunities.
 The value of the forgone alternative is the opportunity cost of that alternative.
 The opportunity cost taken in making the decision is called the opportunity cost of the decision.
When there is no scarcity, there is no opportunity cost.

iii. Explain the following situations using production possibility curves in an economy which
produce only consumer goods and capital goods.
a. Increasing opportunity cost (1mark)
 Increasing opportunity cost is a situation on ppc, when the output of one good gets
increased by equal quantities, output sacrificed by the other good gradually rises.
 Under increasing opportunity cost situation, the shape of the ppc become concave to
the origin of ppc.

Capital goods

ppc

0 consumer goods
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b. Decrease in exports of capital goods due to economic embargoes (1mark)

 Due to decrease in the export of capital goods due to economic embargoes imposed,
the international trade will get affected.
 As it doesn’t make any impact on county’s capital stock and technology, due to
limitation of capital exports, the current production of capital goods will drop without
making any impact to consumer goods and ppc.

Capital goods

C1

C2

ppc

0 Co1 consumer goods

c. Economic recession(1mark)

 Economic recession is a situation where real output/income and the employment level of
the economy decreases for a short term period of time (at least 2 quarters).
 The main reason for a recession is the loss of aggregate demand for goods and services.
 This is shown by a point inside ppc.

Capital goods

C1

ppc
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0 Co1 consumer goods

d. A rapid increase in consumer demand after the growth of economy (1 mark)

 Due to rapid increase in consumer demand after the growth of the economy the
consumer goods production rises more than the previous production.
 Thereby, a point will move towards new ppc (after growth) from a point on ppc (before
growth) without a change in capital goods.

Capital goods

C1

Ppc1 ppc2
Consumer goods
0 Co1 Co2

iv. “There is a positive relationship between division of labour and the level of production”
Give reasons. (4 marks)
 Increase in productivity
Division of labour leads to specialization. That is per unit labour productivity will increase
significantly.
Eg: When there is division of labour, one employee will produce 4800 pins per day. If there is
no division of labour, an employee can produce either only 1 or a maximum of 20 – Adams
Smith’s example on division of labour

 Appointing the most appropriate employee for the particular task

Different employees have different skills and abilities. Through division of labour employees
can select the task that fits them the most and specialize in it. This will increase productivity.
If one person is required to do many tasks, he or she may not be equally good in all of them,
thus productivity will decrease.

 Increase in experience and skills

By doing the same task over and over again an employee’s experience and skills in that
particular task will increase. This will increase the quality and speed of production.

 Innovations in production techniques

 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

Due to specialization in the task, the employee may be able to discover new and faster
methods for production. New machinery may also be innovated due to this.

 Reduce time consumption

Under division of labour, one person will only be involved in one task. Therefore training and
development is only needed in the particular task. There is no need to spend a long period of
time on training in every task. This will save both time and money. Time is also saved since
employees are not required to switch from one task to another.

v. How does the price mechanism does allocates resources in a free market economy and
state its shortcomings. (4 marks)
 Solving the basic economic problems, what and how much should be produced, how
should the goods and services be produced, for whom to produce through price
mechanism.
 The market price is the signal that indicates to the producers which goods and services
should be produced. Relative prices play three roles and thereby resource allocation is
done in a market economy.
1) Information function
2) Incentive function
3) Rationing function
 What and how much should be produced?
Most profitable goods and services (based on commodity prices)
 How should the goods and services be produced?
At the minimum cost (based on factor prices)
 For whom to produce?
To those who can afford a price.

Disadvantages of price mechanism

 Ignorance of public goods, merit goods and public interest
 Undue competition
 Consideration of personal cost benefit at the cost of social cost benefit (Externalities)
 Income disparity and high levels of poverty
 Ignorance of macro-economic variables
 Social civil unrest
 Ignorance of human, cultural and non-financial values
 Provision of demerit goods in excess
 Non-consideration of ethical and social norms or environmental protection.

2.
i. Explain the ‘law of demand’. Why does a demand curve slope downward? (3 marks)
 The quantity demanded varies inversely with the price. The demand curve slopes
downwards to the right. The law of demand states that, if other factors remain
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

constant, an increase in price will reduce the quantity demanded while a fall in price
will increase the quantity.
 A price change has two effects.
o Income effect
o Substitution effect
 Income effect is while all the other demand determinants remain constant (ceters
paribus), the market price of the concerned good gets changed. Thereby, when
price of the concerned good rises while nominal income remains constant, real
income (purchasing power) drops and leads to a drop in quantity demanded and
vise-a-versa.
 Substitution effect is while all the other demand determinants remain constant
(ceters paribus), when price of the concerned good changes. Thereby, when price of
the concerned good increases some of the consumers shift to its substitutes and
thereby quantity demand drops and vise-a-versa.
 Hence, the inverse/indirect/negative relationship between price of the god and
quantity demanded causes the demand curve to slope downwards.

ii. When price of the concern good falls, explain the impact on demand quantity due to
substitution effect and the income effect in the following instances. (3 marks)
a. Concern good is normal good
 Quantity demanded due to substitution effect get increased
(Alternative answer; Substitution effect creates a positive impact on
demand quantity)
 Quantity demanded due to Income effect get increased
(Alternative answer; Income effect creates a positive impact on demand
quantity)

b. Concern good is an inferior good

 Quantity demanded due to substitution effect get increased
(Alternative answer; Substitution effect creates a positive impact on
demand quantity)
 Quantity demanded due to Income effect get decreased
(Alternative answer; Income effect creates a negative impact on
demand quantity)

c. Concern good is a giffen good

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 Quantity demanded due to substitution effect get increased

(Alternative answer; Substitution effect creates a positive impact on
demand quantity)
 Quantity demanded due to Income effect get decreased and it is higher than the quantity
demand increase due to substitution effect

(Alternative answer; Income effect creates a negative impact on demand quantity it is higher than the
positive impact created by the substitution effect)

iii. Below are data for a competitive market for pens

PRICE Ed Qs
20 300 100
40 0 200

a. What is the expenditure that must be incurred by consumers if a unit tax of Rs.6 is
imposed on pens? (02 Marks)
b. What is the total tax burden that is borne by supplier? (02 Marks)
c. Consumer surplus after tax (02 Marks)
d. Producer surplus after tax (02 Marks)
e. Dead weight loss after tax (02 Marks)

a)
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b)

c)

d)
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e)

iv. Explain the concept of price elasticity of demand and name the factors that effect it. (4 marks)
 Price elasticity of demand is the measure of the responsiveness of the quantity demanded
of a good to changes in its own price. (01 Mark)
 It is calculated by dividing the percentage change in quantity demanded by the percentage
change in price which brought it about. It is defined by the following formula:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
(01 mark)

Factors that effect PED:

 The availability of substitutes.
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When there are close substitutes for a product, the demand will be elastic because the
consumers can switch to a substitute when the price of the given good rises.
 The proportion of income spent on the good.
If the consumers spend a small proportion of their income on a good, the demand will be
inelastic.
 Necessities and luxuries
The demand for the necessities will be less elastic than the demand for luxuries.
 Time lag between decisions
 The width of the definition of the product and the market
The wider the definition of the product, the lower will be the elasticity of demand.
 Personal preferences and other factors.
 The price level
The demand is more elastic at a higher price than at a lower price.
 Complements
When two goods are demanded together, the demand for one good will be inelastic. If the
price falls the consumers cannot buy more because they must buy both goods.

3.
i. Why do economists regard normal profit as a cost? (03 marks)

 Normal profit is the minimum expect profit (return) by an entrepreneur as the factor return
for the entrepreneurship that he has supplied for the firm (1/2 mark)
 In other words, if he does not receive at least a return equals to normal profit he will opt out
from the current business and may involve with some other more profitable business
opportunity. (1/2 Marks)
 Thereby, normal profit is the minimum incentive expected by an entrepreneur for the risk
he has taken in starting the business and to justify staying in the current business. (1/2
Mark)
 Thereby as the same way rent, wages, interests are considered as costs since they are the
cost of obtaining land, labour and capital, normal profits should also be considered a cost
since it is the cost of obtaining entrepreneurship (1/2 Mark)
 However, it is an implicit cost but not an explicit cost (1/2 Marks)
 2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

ii. Explain how the law of diminishing returns and the law of returns to scale affect a firm’s cost of
production. (04 marks)

iii. The following diagram shows demand and cost curves of a firm operating in a perfectly
competitive market in the short run.
Price (Rs)

ATC
MC
AVC d1
100

70 d2

60 d3
2022 A/L – LAST 10 – PAPER 01 – MARKING SCHEME The Econ Class

a) If market price is Rs.60/- what is the maximum output this firm decide to produce (1 mark)
90 units ( 01 Mark)
Reason – At price 60/- profit maximization (MC= MR) takes place at quantity of 90 units

b) What is the total fixed cost of this firm (1 mark)

Rs.10 X 100 = Rs. 1000 (01 Mark)
Reason -
Difference between ATC and AVC equals to AFC. At quantity 100, ATC =Rs. 70/- and AVC=
Rs.60/-.
Therefore, AFC at quantity 100 is Rs.10/- (70 -60 =10)
TFC = AFC X Q therefore, TFC = 10 X 100 = Rs. 1000

c) Calculate revenue at which this firm earns normal profits (1 mark)

Rs,60 X 90 = Rs. 5400 (02 Marks)
Reason -
Normal profit takes place at the quantity where MC= MR = lowest ATC.
Thereby, normal profits take place at Rs. 60 and quantity of 90.
Producer revenue = P X Q = 60 X 90 = Rs. 5400/-

d) What is the economic profit at price 100? (1 mark)

Rs.30 X 100 = Rs. 3000 /-(01 marks)
Reason -
When price is Rs. 100/- profit maximization (MC=MR) takes place at 100 units.
Unit profit at quantity 100 = AR – ATC = 100 -70 = Rs.30/-
Total profits at quantity 100 = Unit profit X Q = 30 X 100 = Rs. 3000/-

e) When this firm would decide to close its operation and explain the reason ( 1mark)
 If market price falls below Rs.35/- this firm would decide to close its operation.(01
Marks)
 It is because if market price is below Rs.35/- this firm would not be able to cover even
their average variable cost from market price. (01 Mark)
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f) What is the market price at which this firm continues to operate while making economic
losses? Explain the reason ( 1marks)
 If market price is Rs.35/- or more but less than Rs. 60/- this firm will continue to
operate while making economic losses.(01 Marks)
 It is because if market price is Rs.35/- or more but less than Rs. 60/- this firm would
be able to cover even their average variable cost from market price but will not be
able to cover its average total cost .Thus, they will continue its operations but make
economic losses. (01 Mark)

iv. Why do we make the following conclusions about a firm in perfect competition?

A. the firm is a price taker (1 marks)

 In a perfect competition there are large number of buyers and sellers who are selling a
homogenous product without having any entry or exit barriers. (3 marks)
 Since their quantity supplied is a negligible amount compared to market quantity, they have
to supply at the market price regardless of the quantity that they have to sell. Therefore, they
have to act as a price taker (2 marks)

B. The average revenue and the marginal revenue of the firm are equal (1 marks)
 Average revenue and the price are the same thing
AR= TR/Q
AR=P×Q/Q
AR=P (2 mark)

 Marginal revenue (MR)is the additional revenue earned by selling an additional unit (1/2
marks)
 in a perfectly competitive industry all individual firms act as a price taker, faces a perfectly
elastic demand curve. Each extra unit sold adds its price to total revenue. Therefore, MR=P
AR=P=MR
 Therefore, AR=MR (3 marks)
C. The firm can earn only normal profits in the long run (1 marks)
 If an industry earns economic profits it shows firms in that industry are earning more profits
over and above other industries those can be operated with the same amount of investment
(2 marks)
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 With absence of barriers to entry in perfect competition attracts new firms to a market that
earns normal profits in the long run and will have higher competition (1 mark)
 Therefore, In the long run economic profit will get distributed among many firms and all firms
in the industry earns only normal profits. (1 mark)

v. What are the four types of market structures? Compare and contrast them. (04 marks)
 Perfect competition
 Pure monopoly
 Oligopoly
 Monopolistic competition

Perfect competition Pure monopoly Oligopoly Monopolistic competition

Homogenous products
All economic units have a
perfect knowledge of
market conditions
As the number of firms are
large, the firms are price
takers
There are no barriers to
entry
Perfect mobility of factors
of production and goods
and services facilitates free
entry to an industry
It is assumed that firms
seek maximum profit in
the long run as well as in
the short run under
perfect competition
A single firm controls the A few large firms (4 – 6) Large number of firms
total market supply of the
product There are barriers to The organization is
entry saddled with the excess
The product of the capacity
monopolist could be Price change rarely takes
distinguished from other place as they lead to price No barriers to the entry
goods. wars. of new firms
As there are no close There will be nonprice Firms incur heavy
substitutes to the competition advertising costs in
monopolist’s product, the attempting to retain and
price changes of other Kinked demand curve expand the market
products do not affect his
activities Each firm sells a branded
product. Therefore, there
The monopolist is able to is product differentiation
influence the market
price by varying his
output
The monopolist may
possess a patent right or
control over natural
resources or any such
specific competitive
advantage

Firms are price makers

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Part B
4.
i. Why do people hold money? What effect does the level of income have on the amount of
money people hold? (03 marks)

ii. Present a brief exposition on “the quantity theory of money”. Identify the assumptions
associated with it. (04 Marks)
 Quantity theory of money is the theory that explains there will be a positive (direct)
relationship between general price level (P) and the money supply of the economy (M)
when velocity of money (V) and physical volume of output (T) is constant;(01 mark)
 Therefore quantity theory of money describes that change in money supply make an
increase in general price level.
Ex:- If money supply doubles price level doubles.

 Quantity theory of money can be explain using exchange equation of money

V×M=P×T

(01 mark – even without the explanation of each letter full marks )

V- Velocity of money (average frequency that a unit of money is spent on goods and
services produced domestically in a specific period of time)
M – Money supply (quantity of money)
P – Price level
T- Physical volume of output (this is constant when an economy reaches its full
employment)
 Quantity theory of money is based on main two assumptions. (01 mark if both assumptions are
correct)
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1. Velocity of money (V) is constant.

2. Physical volume of output (T) is constant since economy has reached its full
employment level

iii. Distinguish between money, near money and money substitutes (04 marks)
Money

 Money is any object or record, that is generally accepted as payment for goods and services
and repayment of debts (generally accepted as a medium of exchange) in a given country or
socio-economic context. (1/2 marks)
 Therefore, money is an objective or record that has 100% liquidity (perfect liquidity) in a given
country or socio-economic context. (1/2 marks)
 Money performs following four functions can be considered as money, (if all functions are
mentioned 1/2 mark if not no marks)
o Medium of exchange
o Unit of account
o Store of value
o Standard of differed payment

Near Money

 Near money is non- cash assets which can readily be converted into cash, thereby assets
those do not have perfect liquidity but a very high liquidity. (1/2 marks)

 Near money has main 3 characteristics: ( even if only (a) is mentioned full marks) (1/2
marks)

a. it does not perform the function of medium of exchange

b. it performs the function of store of value
c. it can easily be converted to cash (medium of exchange)
Ex;- Saving deposits, Treasury bills, Treasury bonds, Debentures (any one of the examples ,
1/2 marks)
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Money substitutes

 These are the mediums those can be used as temporary medium of exchange but cannot be
used as store of value. (1/2 marks)

 Money substitutes have main 2 characteristics: (1/2 marks)

a. it perform the function of medium of exchange on temporary basis

b. it does not performs the function of store of value

Ex;- Credit cards (1/2 marks)

iv. Assume a competitive banking system in which commercial banks operate at a statutory
reserve ratio of 10%. They collectively hold deposits from the public of Rs. 5000 million. The
total money supply (M1) is Rs. 7000 million.
a. Suppose in this market money multiplier is equals to 2 (two). If so, how much of
additional reserve percentage this banking system holds?(1 marks)
Working I

Money Supply (M)

Money Multiplier = High Powered Money (H)

Money Supply (M)

High Powered Money (H) =
Money Multiplier

7000
High Powered Money (H) =
2

High Powered Money (H) = 3500 Millions (01 mark)

Working II

Million

High Powered Money (H) 3500

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(less) Currency held by public (Cp) 2000

Actual Reserves 1500 (01 mark)

Working III

Millions

Actual Reserves 1500

Deposits X SRR
Statutory Reserves 500
(less) 5000 X 10%

Excess Reserves 1000

(Excess Reserves /
20% (01 Mark)
Excess Reserve Percentage Deposits) X 100%

(If only answer is provided without workings only 01 mark)

b. If this banking system decides to hold no excess reserves and assuming no money leak
out from the banking system what would be the new money multiplier in this economy
(Round off your answer to nearest two decimal points). (1 marks)

Working I

When multiple expansion takes place

Impact on Deposits Million

Excess Reserve X 1/SRR 1000 X 1/10% 10000 (1 marks)

Working II

New Balance Sheet

Millions Millions

Deposits 15000 Reserves 1500

Loans 13500
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Total 15000 Total 15000

Working III

Million

Currency held by public (Cp) 2000

Deposits 15000

Money Supply 17000 (01 mark)

Working IV

Money Supply (M)

Money Multiplier =
High Powered Money (H)

17000 Million
Money Multiplier =
3500 Million

= 4.86 (02 marks)

= 4.86 (02 marks)

(If only answer is provided without workings only 02 mark)

c. If all information in part (b) held constant Velocity of money circulation is 4 (four) and
real GDP is 20,000 million. Calculate GDP deflator of this economy? (1 marks)
Working I

Millions

V X M = Nominal GDP

4 X 17000 = 68000 (01 Mark)

Working II

Nominal GDP
GDP Deflator =
Real GDP (01 Mark)
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68000
GDP Deflator =
20000

= 3.4 (2 marks)

(Even if the answer is provided as 340% accepted as correct and 02 marks)

(If only answer is provided without workings only 02 mark)

v. What do you mean by “high Powered money”? Explain briefly how high powered money is
created by a central bank. (03 marks)
High Powered money
 Base money is the financial assets that provide foundation to money supply of an
economy. Therefore this is known as high powered money, reserve money or monetary
base. (1 marks)
 Money supply (M) of the economy is multiple times higher than high-powered money
(H) of the economy. Relationship between high powered money and the money supply
can be presented using following equation.
 Money supply (M) = Money multiplier (m) X High-powered money (H) or M=mH (1/2
marks)
 High-powered money is comprised of main 4 components. (even if part (d) is not there
give 1 mark)
a. Currency held by public (Cp)
b. Currency held with commercial banks (Ckb)
c. Commercial banks deposits held by Central Bank (RR)
d. Deposits of other institutions held by Central Bank (DOI)

H = Cp + Ckb + RR + Doi

How high powered money may be created

 There are main two mechanisms those are used by central bank to release high powered
money to economy.
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a. Acquisition of net domestic assets ( ½ marks)

b. Acquisition of net foreign assets ( ½ marks)
 Acquisition of net domestic assets
Example:- ( any one of the examples ½ marks)
 Loans given to government by central bank
 Loans given to commercial banks by central bank
 Central bank engages in repo and reverse repo agreements with commercial
banks
 Changes of other net domestic assets of central bank
 Transferring profits of central bank to government
 Acquisition of net foreign assets
 Example: - ( any one of the examples ½ marks)
 Operations in the domestic foreign exchange market
 Purchase foreign currency receipts through foreign currency loans and grant
them to government
 Sells foreign exchange to the government

vi. Explain what is meant by the ‘enhanced monetary policy framework’ and using an appropriate
diagram explain how does ‘enhanced monetary policy framework’ would be used by the
Central Bank in order to achieve economic and price stability. (03 marks)

(02 Marks For the diagram)

 At present, the Central Bank conducts monetary policy within an enhanced monetary
policy framework with features of both monetary targeting and flexible inflation
targeting (FIT).
 Under this enhanced monetary policy framework, the Central Bank attempts to
stabilise inflation in mid-single digits over the medium term, while supporting the
growth momentum of the economy and flexibility in exchange rate management.
 In terms of operational aspects of this framework, the Central Bank uses its policy
instruments to guide short term interest rates, particularly the average weighted call
money rate (AWCMR) as the operating target.
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 The Central Bank conducts its Open Market Operations (OMO) within the corridor of
interest rates formed by its policy rates i.e. the standing deposit facility rate
(formerly the repurchase rate) and the standing lending facility rate (formerly the
reverse repurchase rate), to achieve the intended inflation path.
 Policy rates are periodically reviewed and adjusted appropriately, if necessary, to
guide the interest rate structure of the economy with a view to achieve the desired
path of inflation.
(Any of the 3 right points 03 marks)

5.
i. Distinguish between ‘merit goods and ‘demerit goods’ and give an example for each category
(04 marks)

Merit goods Demerit goods

Goods that society values and judges that

everyone should have irrespective of
Goods that society values and judges to be bad
a) whether the individual wants them or not or
for society and individual
b) whether the individuals can afford them or
not since they create broad social merits

Under-consumed due to, Over-consumed due to

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a) imperfect information – individuals are a) imperfect information – individuals are

unaware of long-term benefits and positive unaware of long-term detriments and negative
externalities externalities

b) affordability – individuals are well aware of

long-term benefits but cannot afford these
products b) habits or addictions

a) Consumption of merit goods is believed to

generate positive externalities (MSB exceeds Consumption of demerit goods leads to a fall in
MPB) social welfare (MSC exceeds MPC)

b)These are both excludable & rivalrous b)These are both excludable & rivalrous

Government should promote merit goods

either consumption OR Government should demote merit goods either

a) by countering imperfect information - a) by countering imperfect information -

Increasing awareness of the long term benefits Increasing awareness of the long term detriments
or regularising OR

b) by providing them free of charge or at a

concessionary price for the people who cannot b) by providing imposing taxes or controlling
afford. consumption through regulation

Healthcare, education, public libraries,

Vaccinations to prevent deceases Alcohol, cigarettes, drugs, addiction to gambling

ii. Use a diagram to explain how, negative externalities of production results to market failure?
(4 marks)
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A production related negative externality is

an unrelated third party experiencing a cost
due to production of a good or service. (1/2
Mark)
Eg: Due to air pollution by a factory nearby
villages are experiencing respiratory
problems.(1/2 mark)

When there are negative externalities social

cost is higher than the private cost thereby
market mechanism allocates higher amount of
resources for these products than the optimum
level of resource allocation. (Current market quantity will be higher than optimum market quantity.)(1
mark)
Correct graph: 2 marks

iii. ‘Market failure takes place due to inefficiency of resource allocation, inequality of resource
allocation and macro-economic instability. Explain each of the concepts and show how market
failure takes place due to each of these situations. (04 marks)
 Inefficiency of resource allocation takes place due to the fact that all markets do not
become perfectly competitive markets. (1/2 Marks)
 Most efficient resource allocation would only take place if all market of the economy
becomes perfectly elastic and would be able to produce goods and services
combinations desired by consumers at the lowest possible resource cost. When
markets have imperfect competition, inefficiency of resource allocation would take
place (1/2 Marks)
 Due to inefficiency of resource allocation following situations would takes place and it
will lead in to market failure:
a. Non provision of public goods
b. Under provision of demerit goods
c. Existence of demerit goods
d. Missing markets ( For some goods markets are not available)
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e. Factor immobility
( any of the 03 points ½ mark)
 Inequality of resource allocation takes place when market economy distributes
resources unequally among households due to the disparity of income distribution. (1/2
Marks)
 In a market economy household income is dependent on many factors such as amount
of labour scarified, level of education, hereditary properties, factor prices, personal
fortune etc. Thereby, even though market economy is fully efficient in production still
there can have many disparities in between household. (1/2 Marks)
Ex;- Amount of milk used by a child in a poor household is equals to the milk consumed
by a dog in a rich household
 Inequality of resource allocation may lead to political and social unrest of the economy
and that will lead in to market failure. (1/2 Marks)
 Macro-economic instability takes place due to the volatility that creates in the economy.
This is often shown by the business cycle. (1/2 Marks)
 Due these economic volatility unemployment, inflation etc would vary from time to time
and it may lead in to market failure. (1/2 Marks)

iv. Explain how tax principle of "ability to pay" and "principle of benefit" contradicts with each
other? (4 marks)
 Principle of benefit refers to that the taxes should be paid to the government according
to the amount of services received by the government. (01 mark)
 Principle of ability to pay refers to that the taxes should be charged according to a
person’s ability to pay taxes. (01 mark)
 It is conflicting as people with less income rely more on government to fulfill their needs
whereas people with a higher ability do not rely much on the govt. for fulfilling their
needs. (01 mark)
 There by more benefit is passed on to people with lower ability when services are
provided by the government. (01 mark)
 Thereby how tax principle of "ability to pay" and "principle of benefit" contradicts with
each other.
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v. What changes do you observe in Sri Lanka’s government current expenditure during the period
2015 – 2020? (4 marks)
 The current expenditure has been decreasing since 2015, but has recorded an increase in
2019 and 2020.

Gov. current 2015 2016 2017 2018 2019 2020

expenditure as a
percentage of GDP 15.5 % 14.7 % 14.5 % 14.5 % 16.1 % 17.0 %

 Higher expenditure on subsidies & transfers, salaries & wages, and interest payments
contributed to the increase in recurrent expenditure.
 Expenditure on interest rates has reduced over time, but still remains the highest
component of expenditure according to the economic classification.

2017 2018 2019 2020

(as a percentage of total recurrent expenditure)

Interest payments 38 % 41 % 39 % 36 %

Salaries & wages 31 % 30 % 30 % 30 %

Transfers to households 18 % 10 % 18 % 23 %

Other goods & services 9% 9% 9% 7%

Transfers to public
4% 4% 4% 2.4%
institutions

 The transfers to households has increased by 5% from 2019 to 2020.

 The highest composition of recurrent expenditure according to the functional
classification was on interest payments in 2018.

2016 2017 2018

(as a percentage of total recurrent expenditure)

General public services 19 % 19 % 18 %

Economic services 24 % 23 % 21 %

Social services 31 % 30 % 30 %

Other (interest payments) 26 % 28 % 31 %

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