Economics CFA Level 1 Flashcards

Question

Reading 13 Demand and Supply Analysis: Introduction 3.13 Question 9: The actual incidence of a tax imposed on producers of a good will be borne by: A. producers more than consumers if demand for the good is less price elastic than supply. B. consumers more than producers if the supply of the good is more price elastic than demand. C. consumers and producers equally because the actual incidence of a tax is unaffected by price elasticity.

Answer 1

Answer = B If price elasticity of supply is greater than price elasticity of demand, the impact on the price (net of tax) received by producers will be less than the impact on the price paid by consumers. As a result, consumers will pay a larger share of the tax. The actual incidence of a tax is unaffected by its statutory incidence, but it is affected by the relative elasticity of supply and demand for the good being taxed.

Answer 2

Answer = B A product's demand is elastic if demand increases by a greater percentage than the percentage price cut when prices are cut. For example, if a 1% price cut increases the quantity sold by more than 1%, total revenue increases and demand is said to be elastic.

Answer 3

Answer = B To calculate the cross price elasticity of the quantity demanded of gasoline with respect to the price of bus travel, we must first calculate the quantity of gas demanded: 300- 14(1.5) + 2(12) = 303 The cross elasticity is: (ΔQD / ΔPbus) x (Pbus / QD) = 2 x 12 / 303 = 0.0792 or 0.08

Answer 4

Answer = B If quantity supplied does not respond to a change in price, supply is perfectly inelastic. For perfectly inelastic supply, elasticity equals zero.

Answer 5

Answer = C The cross elasticity of demand for goods that are complements is negative because an increase in the price of one would tend to decrease the quantity demanded of the other. The cross elasticity of demand for substitute goods is positive because an increase in the price of one would tend to increase the quantity demanded of the other.

Answer 6

Answer = A The slope of a consumer’s budget constraint is equal to — Px/ Py. The original slope is —8 / 20 = —0.4, and the slope after the price decreases is —6 / 14 = —0.429. The absolute value of the slope increases (i.e., the budget constraint becomes more steeply sloped).

Answer 7

Answer = B The consumer maximizes utility when MRSXY equals PX/PY. MRSXY is the rate at which the consumer is willing to give up Y for additional X, while the price ratio, PX/PY, is the rate at which the consumer must give up Y to gain additional X. With the values as stated, the price to consume more X exceeds the consumer's willingness to pay. So, moving toward the consumer's equilibrium would require spending a little more on good Y and a little less on good X.

Answer 8

Answer = B Based on utility analysis, the optimum bundle of goods lies on the consumer’s highest attainable indifference curve, at the point where this indifference curve is tangent to the consumer’s budget line. The point of tangency is the only point at which this indifference curve intersects the consumer’s opportunity set of attainable bundles. The consumer would prefer bundles that lie on higher indifference curves, but those bundles are unaffordable given the consumer’s budget constraint.

Answer 9

Answer = C | An inferior good is one that experiences a decline in demand when income rises.

Answer 10

Answer = A For a normal good, both the income and substitution effects are positive (i.e., they tend to increase consumption of the good).

Answer 11

Answer = C In highly competitive market situations, companies tend to earn the normal profit level over time because the ease of market entry allows for other competing companies to compete away any economic profit over the long run. When accounting profit equals normal profit, economic profit is zero. CFA Level I "Demand and Supply Analysis: The Firm," by Gary L. Arbogastand Richard V. Eastin Sections 2.1.1–2.1.2

Answer 12

Answer = C Accounting profit is often an unsatisfactory performance measure from an economic point of view because accounting costs generally do not include the opportunity costs of equity capital. Accounting costs do reflect the cost of depreciation.

Answer 13

Answer = A Because a profit-maximizing firm produces the quantity for which marginal cost equals marginal revenue, marginal cost must equal 25. Average revenue (i.e., price) of 12,000 / 300 = 40 is greater than marginal revenue, therefore the firm earns an economic profit. Because marginal cost is less than price the firm must face a downward sloping demand curve. We cannot conclude that an increase in productive capacity will increase profits.

Answer 14

Answer = C | Maximum profit occurs at the output level at which the difference between total revenue and total costs is greatest.

Answer 15

Answer = A Marginal revenue is the change in total revenue per additional unit produced and sold. At a price of 18, quantity demanded is equal to 500 - 20(18) = 140, and total revenue is 140 x 18 = $2,520. At a price of 17.95, quantity demanded is equal to 500 - 20(17.95) = 141, and total revenue is 141 x 17.95 = $2,530.95. Marginal revenue for the 141st unit is 2,530.95 - 2,520 = $10.95.

Answer 16

Answer = C Diseconomies of scale are present when long-run average cost increases as output increases. The minimum efficient scale is the plant size that produces the quantity of output for which LRAC is at a minimum.

Answer 17

Answer = B The law of diminishing returns states that at some point, as more of a resource is used in a production process, holding other inputs constant, output increases at a decreasing rate. This accounts for the upward slope of the SRMC curve beyond that point. Returns to scale determine the shape of the long-run cost curves.

Answer 18

Answer = B Marginal cost per unit, in the short run, decreases at low levels of output as a result of economies from greater specialization. At higher levels of output, however, it eventually increases because of the law of diminishing returns.

Answer 19

Answer = B The quantity of output at which short-run marginal cost of production is minimized is the same quantity at which the marginal product of inputs (e.g., labor) is maximized. Profit is maximized by producing the output quantity at which marginal revenue equals marginal cost, which is not typically the same quantity at which marginal cost is minimized. The minimum average variable cost is at the output quantity at which it equals marginal cost, but this is also not typically the quantity with minimum marginal cost.

Answer 20

Answer = A The marginal cost curve intersects both the AVC and ATC curves at their minimum points. If the cost of producing the next unit of output (marginal cost) is less than the average cost (variable or total) of the units already produced, producing the next unit will decrease the average cost. If the marginal cost is greater than the average cost of units already produced, then producing another unit will increase the average cost.

Answer 21

Answer = B Neither statement is accurate. The minimum average variable cost will occur at a lower production level than the minimum average total cost. Profit is maximized where marginal revenue equals marginal cost, not where average total cost is minimized.

Answer 22

Answer = C Specialization by workers can increase their proficiency, leading to lower average costs when the firm is large enough to allow specialization.

Answer 23

Answer = B Since the Munich plant is generating revenues greater than costs and the Paris plant is not, Hanover should increase output at the Munich plant and reduce output at the Paris plant.

Answer 24

Answer = A For all firms, profit is maximized at the output where the incremental revenue from selling an additional unit (marginal revenue) is equal to the incremental cost of producing it (marginal cost). Since marginal revenue is still higher than marginal cost, Tetra can expand output.

Answer 25

Answer = A The long-run production decision differs from the short-run production decision in that fixed costs can be changed in the long run but not the short run. Thus, short-run cost curves apply for a given size of a plant, and long-run cost curves can show costs for different size plants.

Answer 26

Answer = B The economic short run is the period in which a firm’s plant size and technology are fixed. All factors of production can be changed in the long run. Input quantities of labor and raw materials can be changed in the short run. One year or the firm’s operating cycle, whichever is longer, is the time frame typically used to distinguish between current and long-lived assets or liabilities on a balance sheet.

Answer 27

Answer = A | In a decreasing-cost industry, the long-run supply curve will have a negative slope.

Answer 28

Answer = C In an increasing-cost industry, as resource costs increase over time, market prices must increase to cover these higher costs.

Answer 29

Answer = B An industry with a downward-sloping long-run industry supply curve is a decreasing-cost industry. In such an industry, input costs decrease as output quantities increase. In the short run, this causes firms to earn economic profits. In the long run, these economic profits attract new entrants to the industry, which reduces the equilibrium selling price of the industry’s output.

Answer 30

Answer = B In the short run, the average product of labor curve is first increasing and then decreasing as diminishing marginal returns to that factor take effect. In the short run, the marginal product of labor is first increasing and then decreasing when diminishing marginal returns take effect. The marginal product of labor curve will be above the average product of labor curve initially, and, at some point, will intersect the average product curve at its maximum. When the total product of labor begins to increase at a decreasing rate, the average product of labor will be decreasing.

Answer 31

Answer = A The company should maximize output per monetary unit of input cost. So, it should look for the labor type that has the highest ratio of marginal product to compensation cost (MPinput/Pinput)) . Type of Labor Marginal Product (MP) per Day Compensation per Day MPinput/Pinput Unskilled 200 units 105 × 1.04 = 109.2 200/109.2 = 1.83 Semiskilled 300 units 160 300/160 = 1.88 Skilled 500 units 270 500/270 = 1.85 The company minimizes costs and enhances profitability by adding semiskilled labor rather than the other two types because it has the highest ratio of MP to input price.

Answer 32

Answer = C Perfect competition and oligopoly are characterized by homogeneous/standardized product differentiation. Market Structure Degree of Product Differentiation Perfect competition Homogeneous/ standardized Monopolistic competition Differentiated Oligopoly Homogeneous/ standardized Monopoly Unique product

Answer 33

Answer = B Differentiated products are a feature of monopolistic competition markets. Interdependence is a characteristic of oligopoly markets. Horizontal demand curves facing producers are a feature of perfect competition.

Answer 34

Answer = A A natural monopoly may exist when economies of scale are great. The large economies of scale mean that a single producer results in the lowest production costs.

Answer 35

Answer = A A reduction in output and increase in price under monopoly decrease consumer surplus and welfare compared to perfect competition. A natural monopoly may have lower costs than several competitive suppliers. Monopolists charge the profit maximizing price, not the “maximum price.”

Answer 36

Answer = B In the kinked demand curve oligopoly model, the demand curve facing each firm is more elastic above the current price and less elastic below the current price, because the other firms in the industry will likely match a price decrease by one firm but will not match a price increase. The incentive to cheat on price collusion agreements is illustrated by the Prisoner’s Dilemma game theory. Price discrimination is the method by which a price seeking firm can increase profits by charging different prices to consumers in distinct groups with differing price elasticity of demand.

Answer 37

Answer = B Successful collusion is unlikely in a market that can be characterized as monopolistic competition because low entry barriers would allow new competitors to emerge. Firms in such an industry can earn short-run economic profits and often differentiate their products on quality or price.

Answer 38

Answer = B Greater pricing power for the individual firm and a high concentration ratio suggest Product S is produced in an oligopolistic industry. Product T, with less pricing power for firms and a lower concentration ratio, is most likely producted by an industry characterized by monopolistic competition.

Answer 39

Answer = B This is an example of monopolistic competition, because this market has low barriers to entry and exit, and features product differentiation.

Answer 40

Answer = B Economic profits are zero in the long run under monopolistic competition, but since average cost includes the costs of product differentiation and advertising (branding), there is disagreement over the efficiency of long-run output. Both advertising and product differentiation can create value as consumers prefer more choices and use the advertising and branding information to make purchase decisions. Whether there is an efficient amount of product differentiation or not, the benefits of product differentiation do tend to offset its costs. Whether the benefits of differentiated products totally offset the costs compared to a competitive market with a single (undifferentiated) product is open to debate.

Answer 41

Answer = B A firm will increase production if its marginal revenue is greater than its marginal cost, until it reaches the profit-maximizing output level at which marginal revenue equals marginal cost. Under perfect competition, marginal revenue equals price.

Answer 42

Answer = B Under perfect competition, each firm faces a flat demand curve. This means the price is constant and the marginal revenue line is flat. A company will continue to produce as long as MR > MC, so the competitive company will produce as long as P > MC. It will stop when MC = MR = P.

Answer 43

Answer = B The supply curve for a firm under perfect competition is its marginal cost curve above average variable cost. As long as price exceeds AVC, the firm will produce up to the quantity where MC = Price, which is also MR in this case.

Answer 44

Answer = B Firms’ demand curves are perfectly elastic (horizontal) in a market characterized as perfect competition, so that marginal revenue is equal to price and a firm maximizes profit by producing the output quantity at which marginal cost equals price. In monopoly markets or under monopolistic competition, firm demand curves are downward sloping so that marginal revenue is less than price.

Answer 45

Answer = A In the short run, a perfectly competitive firm’s supply curve is upward sloping, because if the price increases, firms will increase their quantity supplied. The demand curve for a perfectly competitive firm is horizontal. Each firm in a competitive market is a price taker and has no influence on the price of the product.

Answer 46

Answer = B Colluding restricts output and puts upward pressure on price, but cheating actually increases output and ultimately, if enough cheating occurs, puts downward pressure on the price. Colluders cheat to increase their share of the profits.

Answer 47

Answer = B Collusion is an agreement among firms to avoid various competitive practices. The cartel practicing collusion will be similar to a monopoly, causing prices to increase and output to decrease compared to a competitive market.

Answer 48

Answer = A Applying the Nash equilibrium model, Oil Tool will make the best possible decision based on Jones’s potential decisions and Jones will make the best possible decision based on Oil Tool’s potential decisions. If Oil Tool complies, then it must depend on Jones to comply, but complying is not in the interest of Jones. If Jones were to comply, then it must depend on Oil Tool to comply, but complying is also not in the best interest of Oil Tool. Both Oil Tool and Jones will conclude that the best course of action is to cheat on the pricing agreement.

Answer 49

Answer = A Price discrimination involves a single product, not two alternatives. As long as the company faces a downward-sloping demand curve, can identify at least two groups of customers with different price elasticities of demand, and can prevent reselling between groups, the company can profit from price discrimination.

Answer 50

Answer = C Like all price searchers, monopolists will expand output until marginal revenue equals marginal cost. Monopolists do not charge the highest possible price which would be the price resulting in only one sale. A monopolist seeks to maximize profit, not price.

Answer 51

Answer = C Average cost pricing is meant to force a natural monopolist to reduce price to where the firm’s average total cost intersects the market demand curve. This results in higher output and a lower price than would prevail for an unregulated natural monopoly.

Answer 52

Answer = B In some cases, a monopolist may be unable to sell for a profit. Price may be insufficient to cover the per-unit cost of the monopolist, even when operating at the MR = MC rate of output. The monopolist faces a downward-sloping demand curve.

Answer 53

Answer = A Demand curves are not observable so a monopolist must search for the profit maximizing price. Because demand information is not perfect, a monopolist is a price searcher. The other statements are false. Although a monopolist can earn positive economic profits in the long run, they are not guaranteed profit. If average total costs exceed price, the monopolist will lose money. A monopolist maximizes profit where marginal revenue equals marginal cost.

Answer 54

Answer = B A firm in a monopoly position will reduce output to where MC = MR, which will increase price, decrease consumer surplus, and increase producer surplus. A marginal cost pricing strategy refers to regulation which requires a firm to set price equal to marginal cost.

Answer 55

Answer = A All firms maximize profits at the point where marginal revenue equal marginal cost. For a monopolist, this occurs at a lower output level than for a purely competitive firm, because the monopolist has a marginal revenue curve that falls below the demand curve, while the purely competitive firm has a marginal revenue curve that lies along the demand curve.

Answer 56

Answer = C For a price searcher firm, price discrimination can increase profits if the firm has two or more identifiable customer groups with different price elasticities of demand, and if customers who buy the product at a lower price cannot resell it to other customers.

Answer 57

Answer = C These conditions characterize monopolistic competition. By contrast, monopolies and oligopolies have high barriers to entry and involve either a single seller (monopoly) or a small number of interdependent sellers (oligopoly). Similar to monopolistic competition, pure competition involves a large number of independent sellers. With pure competition, products are homogeneous (not differentiated), no barriers to entry exist (not low barriers to entry), and the demand schedule is horizontal (not downward sloping) and perfectly elastic (not highly elastic).

Answer 58

Answer = C Product Quantity Produced in 2012 (1) Quantity Produced in 2013 (2) Product Unit Prices in 2012 (3) Product Unit Prices in 2013 (4) (5) = (2) × (4) X 351.0 352.0 13.3 13.8 4,857.6 Y 179.0 182.5 N/A 11.1 2,025.8 Nominal GDP in 2013 equals the sum of the last column: 6,883.4 Real GDP 2013 = Nominal GDP 2013 x 100 / GDP deflator = 6,883.4 x 100 / 102.4 = 6,722.1 Real GDP 2013 = P(x)2012 x Q(x)2013 + P(y)2012 x Q(y)2013 6,722.1 = (13.3 x 352.0) + P(y)2012 x 182.5 P(y)2012 = 11.2

Answer 59

Answer = A Because aggregate income is the same as aggregate output, measuring GDP by summing incomes or expenditures should produce the same value, except for a statistical discrepancy that results from using different data sources. The sum-of-value-added method of calculating GDP records the sum of the increases in value of goods and services at each stage of their production and distribution. The resulting total for GDP is the same as that reached by the value-of-final-output method because the sum of value added to a good at all stages of processing is equal to its selling price. Both methods calculate GDP based on expenditures.

Answer 60

Answer = B If the GDP deflator is 106.5, the price level has increased 6.5% since the base period and nominal GDP is 6.5% greater than real GDP. Because the base period is not necessarily the previous year, we cannot conclude that 6.5% is the annual inflation rate.

Answer 61

Answer = B | Indirect business taxes are not subtracted because they are included in national income.

Answer 62

Answer = A The LM curve illustrates a positive relationship between real income and the real interest rate, holding the real money supply constant. The IS curve illustrates a negative relationship between real income and the real interest rate, holding the marginal propensity to save constant.

Answer 63

Answer = C Because the real money supply is held constant in constructing each LM curve, holding the nominal money supply constant and changing the price level results in a new LM curve with a different real money supply. The intersections of the IS curve with LM curves at each price level illustrate a negative relationship between the price level and real income, i.e., the aggregate demand curve.

Answer 64

Answer = B Falling money wages would cause businesses to increase (profit-maximizing) output levels at each price level for final goods and services. Changes in the price level of goods and services are represented by a movement along a short-run aggregate supply curve, not a shift in the curve. A rise in resource prices will decrease aggregate supply. An increase in government spending will shift the aggregate demand curve but not the aggregate supply curve.

Answer 65

Answer = A An increase in expected future incomes will cause consumers to increase current expenditures (reduce current savings) in anticipation of the higher future incomes. An increase in the money supply will tend to decrease interest rates which will lead to increased consumer spending on durable goods and increased investment by businesses. Both effects increase aggregate demand.

Answer 66

Answer = B A decrease in the money supply will cause short-term interest rates to increase, decreasing investment and consumption spending and thereby decreasing AD. A decrease in taxes will increase disposable incomes, consumption spending, and AD. If the foreign exchange value of the domestic currency decreases, the country’s products become relatively less expensive to foreign buyers, while foreign goods become relatively more expensive to domestic buyers. As a result, net exports increase, which increases AD.

Answer 67

Answer = B In the short run, real GDP can be less than its full-employment level (a recessionary gap that causes downward pressure on prices) or more than its full-employment level (an inflationary gap that causes upward pressure on prices). In long-run macroeconomic equilibrium, actual real GDP is equal to potential real GDP and there is no upward or downward pressure on the price level.

Answer 68

Answer = C Factors that affect long-run aggregate supply (potential real GDP) include the quantity of labor available, the quantity of capital available, and the level of technology. An increase in aggregate hours worked is an increase in the quantity of labor, which increases long-run aggregate supply. An increase in expected inflation does not affect long-run aggregate supply, but causes aggregate demand to increase as consumers make purchases sooner and businesses increase investment in anticipation of higher profits. A decrease in the real wage rate increases short-run aggregate supply but does not affect long-run aggregate supply.

Answer 69

Answer = A Long-run aggregate supply is related to the level of technology and the available quantities of labor and capital. If the prices of productive inputs increase, short-run aggregate supply decreases (the SRAS curve shifts to the left), but long-run aggregate supply (potential real GDP) is unaffected.

Answer 70

Answer = A Short-run equilibrium may occur above full employment, for example as a result of an increase in aggregate demand caused by a decrease in taxes. Both employment and the price level increase in the short run. Above-full employment causes upward pressure on wages that will reduce short-run aggregate supply until, in the long run, output returns to its full-employment level with a still-higher equilibrium price level.

Answer 71

Answer = B The manager’s investment decisions are most consistent with expectations of a recessionary gap. In a recession, commodity prices and interest rates are likely to decrease. Decreasing interest rates should increase the prices of high-quality bonds. An inflationary gap would likely cause interest rates to increase, which would decrease bond prices. An inflationary gap or stagflation conditions would likely result in increasing commodity prices.

Answer 72

Answer = A In the short run, an increase in the money supply will increase aggregate demand. The new short-run equilibrium will be at a higher price level and a greater level of real output (GDP).

Answer 73

Answer = C Stagflation is a period of economic contraction with increasing inflation, typically brought on by a sharp decrease in aggregate supply. Investments in equities tend to perform poorly in an economic contraction due to decreasing profitability of companies. Fixed income investments decrease in price when nominal interest rates increase due to increases in inflation. Commodity prices tend to increase with inflation.

Answer 74

Answer = B | The total hours worked remained unchanged, and accordingly, the growth of the economy will not change.

Answer 75

Answer = B The late expansion phase is characterized by acceleration of growth rate, decreasing of unemployment rate, and increasing of inflation rate.

Answer 76

Answer = C Declines in real personal income and industrial production, which are coincident indicators, and the increase in inventories relative to sales, a lagging indicator, suggest the economy is most likely in a contraction phase. Inventory-to-sales ratios tend to increase when sales decrease unexpectedly.

Answer 77

Answer = B Real business cycle theory, which derives from applying utility theory and budget constraints to macroeconomic models, is associated with the New Classical school.

Answer 78

Answer = B The Keynesian school of macroeconomics believes that increasing the money supply or increasing government spending (such as with a stimulus package) will increase real GDP and combat recession. Monetarists believe economic growth is best supported through a policy of steady and predictable money supply increases. The neoclassical school of thought believes that economic cycles will correct themselves through a rapid adjustment of the prices of key productive inputs that restores the economy to full employment.

Answer 79

Answer = C Frictional unemployment results from the time necessary to match workers with available jobs and is not related to economic cycles. Cyclical unemployment results from economic cycles. Singh’s description of structural unemployment is accurate.

Answer 80

Answer = C Unemployment due to workers lacking the necessary skills for a changing job market is called structural unemployment. Gold will likely seek work elsewhere as a bookkeeper. There was no broad economic downturn that would suggest cyclical unemployment. This is an example of frictional unemployment.

Answer 81

Answer = B Since the labor force is the sum of employed and unemployed, a decrease in the labor force with the number employed held constant will decrease the unemployment rate (the number of unemployed divided by the labor force). The labor force participation rate is the labor force divided by the working-age population. If the labor force decreases while the working-age population remains the same, the participation rate will decrease.

Answer 82

Answer = C The consumer price index (CPI) is the average cost of a basket of goods and services, weighted to represent the purchases of a typical household, and indexed to a reference base period. The inflation rate is a percentage change in a price index such as the CPI. Inflation as measured by the CPI is believed to overestimate the actual increase in the cost of living because it does not account for structural changes such as new goods, quality improvements, or consumers shifting their purchases to lower-priced goods.

Answer 83

Answer = C By reducing employee illness, the new technology will increase the output per hour per worker, which will decrease the unit labor cost. As the unit labor cost decreases, cost-push inflation decreases. The technology does not affect demand and accordingly should not affect demand-pull inflation.

Answer 84

Answer = C Demand-pull inflation depends upon the relationship between actual and potential GDP and industrial capacity utilization. The higher the rate of capacity utilization or the closer actual GDP is to potential, the more likely an economy will suffer shortages, bottlenecks, a general inability to satisfy demand, and hence, price increases.

Answer 85

Answer = A Both processes require repeated expansionary policy actions to result in inflation. The demand-pull inflation process originates with an increase in aggregate demand from either expansion of the money supply or an increase in the federal deficit when the economy is already at its full-employment level. Persistent increases in the price level (inflation) will only result if policy makers repeatedly attempt to increase real GDP above the full-employment level through monetary or fiscal expansion. Although cost- push inflation originates with an increase in the price of an important productive resource, it only results in inflation if the monetary authorities repeatedly increase the money supply to counteract the (short-term) reductions in real GDP that result from further increases in the price of the productive input.

Answer 86

Answer = B Cost-push inflation is initiated by an increase in the price of a key productive input, which reduces short-run aggregate supply, decreasing real GDP to below its full- employment level (a recessionary gap), and increasing the price level. If the central bank responds by expanding the money supply, aggregate demand will increase, moving real GDP toward its full-employment level but increasing the price level further. If additional increases in input prices reduce SRAS and cause the central bank to further expand the money supply to restore full employment, cost-push inflation results.

Answer 87

Answer = C Money’s function as a medium of exchange permits the indirect trade of goods and services, which greatly increases the efficiency of carrying out transactions compared to barter. Its function as a unit of account permits buyers and sellers to calculate how much a good or service is worth in terms of other goods and services. Money’s function as a store of value allows the holder to save it, delaying consumption to a later time without reducing the amount he can consume.

Answer 88

Answer = A | Reducing the reserve requirement will increase the money supply, money multiplier, and new deposits.

Answer 89

Key words: “money creation process” Answer = A The quantity theory of money hypothesizes that a change in the money supply, at full employment, will cause a proportional change in the price level because velocity and real output will be unaffected. According to the equation of exchange, MV = PY, output of goods and services produced, Y, at full employment cannot change, so the price level, P, must increase.

Answer 90

Answer = C Potential expansion multiplier = 1 / (required reserve ratio) = 1 / 0.2 = 5 (100)(5) = 500

Answer 91

Answer = A The equation of exchange is MV = PY. If velocity (V) is increasing faster than real output (Y), inflation (P) would have to be increasing faster than the money supply (M) to keep the equation in balance.

Answer 92

Answer = B The quantity theory focuses on the quantity of money. The quantity theory states that velocity is not affected by monetary policy. Increasing banks’ excess reserves would most likely lead to higher inflation.

Answer 93

Answer = A Increases in expected future incomes will decrease savings, which will decrease the supply of financial capital and increase the equilibrium interest rate. If the demand for financial capital rises, interest rates also rise; so both changes tend to increase the equilibrium interest rate.

Answer 94

Answer = C From an initial equilibrium, an increase in real money balances will leave households and businesses with more money than they wish to hold, so they will purchase interest- bearing securities, driving their prices up and yields down until a new equilibrium short-term rate is established.

Answer 95

Answer = B At interest rates below 4% (the long-term equilibrium rate), the quantity of money demanded exceeds the quantity of money supplied. At below-equilibrium rates, investors will sell bonds to obtain the desired extra cash. As they sell more bonds, the prices of bonds fall, and interest rates start to move back towards the 4% equilibrium.

Answer 96

Answer = B The concept of money neutrality implies that an increase in the money supply will leave real variables like output and employment unaffected. The real rate of interest will be unaffected by money supply changes but inflation and inflation expectations will be affected.

Answer 97

Answer = B A reduction in the money supply (leftward shift) leads to an increase in nominal rates. Furthermore, on the basis of the quantity theory of money, a reduced money supply makes money more valuable (thus a higher interest rate), which reduces aggregate price levels.

Answer 98

(Part 2.1.7) Answer = C The Fisher effect states that a nominal interest rate is the sum of a real interest rate and the expected inflation rate.

Answer 99

Answer = C Central banks control the growth of a country’s money supply through their monetary policy actions. Many central banks also regulate their countries’ banking systems and issue their countries’ currencies. Fiscal policy (taxation and government spending) is generally the responsibility of a country’s executive and legislative officials.

Answer 100

Answer = A Inflation that is unexpected, or higher than expected, shifts wealth from lenders to borrowers. Unexpected deflation has the opposite effect. Because interest rates include a premium for expected inflation, an inflation rate that matches expectations does not shift wealth from lenders to borrowers.

Answer 101

Answer = C Either higher-than-expected or lower-than-expected inflation can cause producers to misinterpret unexpected changes in the price level as signals of increases or decreases in demand, and produce more or less than the equilibrium quantity of output.

Answer 102

Answer = A When a central bank purchases securities, bank reserves increase. The banks therefore have excess reserves and are able to increase their lending, increasing the money supply.

Answer 103

Answer = C Selling government bonds results in a reduction of bank reserves and reduces their ability to lend, causing a decline in money growth through the multiplier mechanism and hence leads to a contraction in the economy. “Monetary and Fiscal Policy,” Andrew Clare and Stephen Thomas Sections 2.3.2.1, 2.3.2.3

Answer 104

Answer = A In implementing monetary policy, central banks have three primary tools available to them: open market operations, setting the official policy rate, and reserve requirements. When the central bank purchases securities (open market operations), it increases the reserves held by private sector banks. These increased reserves lead to a reduction in interest rates on money market securities and, ultimately, to a reduction in other interest rates in the economy.

Answer 105

Answer = C Central banks have three primary tools available to them: open market operations, setting the official policy rate, and reserve requirements.

Answer 106

Answer = B | Open market operations are the U.S. Federal Reserve’s most often used tool for changing the money supply.

Answer 107

Answer = C With exchange rate targeting, a central bank’s ability to increase the value of the domestic currency is limited by the amount of foreign reserves the country has available to buy its own currency in the foreign exchange market. While inflation targeting and interest rate targeting have limitations (e.g., liquidity trap conditions may exist, interest rates are bounded by zero), the central bank’s resources are not typically a limitation.

Answer 108

Answer = B To reduce inflation, the central bank would attempt to decrease the rate of growth in the money supply. By increasing the interest rate at which member banks may borrow reserves, the central bank can decrease those banks’ willingness to lend, which will decrease money supply growth. Open market purchases or a lower reserve ratio would tend to increase money supply growth and inflation.

Answer 109

(19.h, 55.a) Answer = A Open market operations to sell securities will decrease the outstanding supply of cash balances and increase short-term interest rates. The central bank does not issue long-term bonds but may buy and sell bonds issued by the government. Decreasing reserve requirements or purchasing government securities would tend to decrease short-term interest rates.

Answer 110

Answer = A Selling government securities on the open market reduces bank reserves and drives up the federal funds rate. The other two statements are incorrect because the Federal Reserve does not directly control exchange rates or the prices of government securities.

Answer 111

Answer = B An increase in the quantity of money at full employment will reduce interest rates in the short run, which would increase short-run aggregate demand above full employment. This causes wage demands to increase, which in turn reduces short-run aggregate supply. In the long run, real GDP reverts to its full-employment level with an increase in price level equal to the percentage increase in the quantity of money.

Answer 112

Answer = C When the Federal Reserve purchases Treasury securities in the open market, the supply of loanable funds increases and interest rates decrease, with the likely result of increasing economic growth. One of the Fed’s intermediate targets is the federal funds rate that banks charge each other for loans. When the Fed conducts open market operations, it is generally to adjust the federal funds rate to its target level. The Fed cannot simply dictate the federal funds rate as it can the discount rate, so it must use open market operations to achieve its target. The purpose of using the federal funds rate is to achieve the Fed’s primary goal of price level stability (or predictable inflation rates). In pursuing price level stability, the Fed also attempts to achieve its secondary goal of sustainable real GDP growth, which occurs when real GDP and potential GDP are close to each other.

Answer 113

Answer = B Central bank sales of securities reduce excess reserves in the banking system, causing interbank lending rates and other short-term interest rates to increase. If the monetary policy transmission mechanism operates normally, long-term interest rates should also increase, the domestic currency should appreciate, and economic growth and inflation should decrease.

Answer 114

Answer = A With a decline in economic activity and domestic inflation, the currency of the developing country would start to rise against the dollar. To protect the exchange rate target, the developing country’s monetary authority will purchase foreign exchange reserves and sell its own currency. This will increase the domestic money supply, decrease short-term interest rates and increase foreign exchange reserves.

Answer 115

Answer = A Quantitative easing (QE) is an “unconventional” approach to monetary policy and is operationally similar to open market purchase operations but conducted on a much larger scale. The additional reserves created by central banks in a policy of quantitative easing can be used to buy any assets. The idea is that this additional reserve will kick-start lending, causing broad money growth to expand, which will eventually lead to an increase in real economic activity. CFA Level I “Monetary and Fiscal Policy,” Andrew Clare and Stephen Thomas Sections 2.5.1, 2.5.2

Answer 116

Answer = B While the central bank can control short-term interest rates, their relationship to long-term interest rates is not direct or proportionate. Long-term nominal interest rates include a premium for expected inflation. If a central bank’s policy actions to reduce short-term rates cause market participants to expect higher future inflation, long-term rates will not decrease as much as short-term rates, and may actually increase. Open market operations by the central bank directly change the amount of bank excess reserves. Because various forms of short-term financing are close substitutes, the relationship among different short-term rates is closer than the relationship between short-term rates and long-term rates.

Answer 117

Answer = B Unemployment insurance is an example of an automatic stabilizer that is not subject to the action lag of discretionary fiscal policy tools. One reason why the unemployment rate is a lagging indicator is the fact that employers are slow to lay off employees early in recessions and slow to add employees early in expansions, because frequent hiring and firing has high costs. Another reason is that early in expansions, more discouraged workers (who are not counted as unemployed because they are out of the labor force) may begin seeking work (thereby re-entering the labor force) than the number of new jobs that are available, which increases the unemployment rate.

Answer 118

Answer = C Automatic stabilizers are built-in features that tend to automatically promote a budget deficit during a recession and a budget surplus during an inflationary boom, without a change in policy.

Answer 119

Answer = A According to the Keynesians, policymakers can use the budget to diminish aggregate demand through restrictive fiscal policy. Reducing government expenditures and/or increasing tax rates should lead to a decline in the expected size of the budget deficit or an increase in the budget surplus.

Answer 120

Answer = B | The tendency for a government borrowing to decrease private sector investment is called the crowding-out effect.

Answer 121

Answer = C Increased government borrowing would decrease, not increase, the profitability of corporate investment projects since it will tend to increase interest rates and required rates of return in general.

Answer 122

Answer = C The crowding-out effect refers to a reduction in private borrowing and investment as a result of higher interest rates generated by budget deficits that are financed by borrowing in the private loanable funds market.

Answer 123

Answer = B The fiscal policy multiplier is positive for government spending and negative for taxes. Increasing taxes will decrease aggregate demand. The balanced budget multiplier (for equal-sized increases in government spending and taxes) is positive but less than the multiplier for spending only.

Answer 124

Answer = B The fiscal multiplier is 1 / [1 - C(1 - T)] where C: marginal propensity to consume = consumption / disposable income T: the tax rate Assuming pre-tax income of $100 Disposable income $100 × (1 – 0.25) = $75 Marginal propensity to consume $70 ÷ $75 = 0.933 The fiscal multiplier 1÷ [1 – (0.933 × (1 – 0.25))] = 3.33 With government expenditure of $1.25 billion, total incomes and spending will rise by $1.25 Billion × 3.33 = $4.2 Billion

Answer 125

Answer = B Aggregate demand rises when the government increases spending by the same amount as it raises taxes since the marginal propensity to spend out of disposable income is less than 1, and hence for every dollar less in disposable income, spending only falls by $c (where c is the marginal propensity to consume). Aggregate spending will fall less than the tax rise by a factor c. This additional output will, in turn, lead to further increases in income and output through the multiplier effect.

Answer 126

Answer = B GDP measures the market value of all final goods and services produced by factors of production located within a country during a given period. GNP measures the market value of all final goods of services produced by factors of production supplied by residents of country, regardless of where they are located. Production by UK citizens working in the US is included UK’s GNP and the US’s GDP.

Answer 127

Answer = C Gross domestic product (GDP) and gross national product (GNP) measure the value of final goods and services produced during the period. Gains from reselling assets purchased in an earlier period do not reflect current production and are not counted in GDP or GNP. The difference between GDP and GNP is that GDP measures output produced by factors of production located within the country, while GNP measures output produced by factors supplied by the country’s citizens.

Answer 128

Answer = C A country has a comparative advantage if its opportunity cost for producing a product is less than the opportunity costs of its trading partners. Notice the cost of a table in units of chairs is lowest for Country A. Country Tables Chairs Comparative Advantage (Chairs/Tables) A 60 80 1.33 B 40 60 1.50 C 40 × 1.1 = 44 80 × 0.9 = 72 1.64

Answer 129

Answer = B A country has a comparative advantage if its opportunity cost for producing a product is less than its trading partners: the cost of a computer in units of phones is lowest for Country X. Country Computers Phones Opportunity Cost of Computers (Phones per Computer) Opportunity Cost of Phones (Computer per Phones) X 600 900 1.5 0.67 Y 400 800 2.0 0.5 Country X has an absolute advantage over country Y in producing both computers and phones.

Answer 130

Answer = B A comparative advantage arises if one entity can produce an item at a lower opportunity cost than another. An absolute advantage in producing a good (or service) arises if one entity can produce that good at a lower cost or use fewer resources in its production than its trading partner. Even if a country does not have an absolute advantage in producing any of its goods, it can still gain from trade by exporting the goods in which it has a comparative advantage. The country with the lower opportunity cost (with the comparative advantage) should specialize and produce its low opportunity cost item and the other country should produce the high opportunity cost item, trading the goods between each other to make both better off.

Answer 131

Answer = A The opportunity cost of one unit of leather for Ymer is 20 / 25 = 0.80 units of cheese, and the opportunity cost of one unit of cheese is 25 / 20 = 1.25 units of leather. The opportunity cost of one unit of cheese for Hokah is 30 / 35 = 0.86 units of leather, and the opportunity cost of one unit of leather is 35 / 30 = 1.167 units of cheese. Ymer has an absolute advantage in both cheese and leather, but has a comparative advantage only in leather.

Answer 132

Answer = A In this case, there are no clear potential benefits from trade because the countries’ opportunity costs of production are equal. Colfax’s opportunity cost of rice = 10/ 15 = 0.67 units of plastic, and Birklund’s opportunity cost of rice = 12 / 18 = 0.67 units of plastic. Colfax’s opportunity cost of plastic = 15 / 10 = 1.5 units of rice, and Birklund’s opportunity cost of plastic = 18 / 12 = 1.5 units of rice.

Answer 133

Answer = B | As a country opens up to trade, the benefit accrues to the abundant factor which is labor in Country A.

Answer 134

Answer = C In the Heckscher-Ohlin model, the source of comparative advantage is the relative amounts of labor and capital that are available in each country. Countries with more capital available relative to labor available will have a comparative advantage in producing capital-intensive goods, while countries with more labor available relative to capital will have a comparative advantage in labor-intensive goods.

Answer 135

Answer = C In the Heckscher-Ohlin model, trade results in a redistribution of wealth within each country between workers and the owners of capital. The price of the relatively less scarce (more available) factor of production in each country will increase and cause redistribution of income toward that factor (to workers in a country with a comparative advantage in labor-intensive goods, and to owners of capital in a country with a comparative advantage in capital-intensive goods). The statements describing the Ricardian and Heckscher-Ohlin models are accurate.

Answer 136

Answer = C The large country is able to cause the foreign exporter to reduce price in order to retain market share. In the large country, domestic producers gain from higher volume and the government gains from collecting the tariff. The sum of these two gains must exceed the deadweight loss to domestic consumers to achieve a national welfare gain. The change in terms of trade causes income redistribution from the foreign exporter to the domestic producer.

Answer 137

Answer = C Placing a tariff on an imported good increases the goods domestic price, which reduces the quantity demanded. However, the quantity supplied by domestic firms increases with the domestic equilibrium price, as does producer surplus for domestic firms.

Answer 138

Answer = A While under specific conditions a country that is a large importer of a good can increase its own economic welfare and that of other importing countries by imposing a tariff that decreases the world price of the good, imposing a tariff does not increase global economic welfare under any circumstances. For one or more countries to benefit from the imposition of a tariff, it must be the case that any net gains in economic welfare are offset by an even greater welfare loss in the exporting countries.

Answer 139

Answer = C A common market structure incorporates all aspects of the customs union and extends it by allowing free movement of factors of production among members.

Answer 140

Answer = C Customs unions adopt uniform trade restrictions with non-members. Customs union members do not adopt a single currency. Both free trade areas and customs unions remove trade barriers among their members.

Answer 141

Answer = C If the domestic government collects the full value of the import license, a quota can have the same economic result as a tariff. Quota rents are the gains to those foreign exporters who receive import licenses under a quota if the domestic government does not charge for the import licenses. With respect to the importing country, import quotas, tariffs, and voluntary export restraints all decrease consumer surplus and increase producer surplus.

Answer 142

Answer = A Note that the borrowing from a bank in Singapore is not a current account transaction. Transaction Current Account (US$ millions) Bought raw material from Indonesia –50.0 Sold food products to France 65 Received royalty fees from its branch in the United Kingdom 0.5 Donated to charitable institution in Africa –0.1 Borrowed from a bank in Singapore Omit Paid legal fees to its German legal consultant company –1.2 Received interest coupon from its investment in Eurobonds issued in Luxembourg 0.8 Total 15 CFA Level I "International Trade and Capital Flows,” by Usha Nair-Reichert and Daniel Robert Witschi Sections 4.2–4.3

Answer 143

Answer = A | Sales and purchases of non-financial assets in a country are accounted for in the capital account.

Answer 144

``` Answer = C CA = Sp – I + (T – G – R) CA = Current Account balance Sp = Private sector savings I = Investments T = Taxes G = Government spending R = Transfers ∆CA = -25 – (-25) + (100 – 50 – 0) = 50 ```

Answer 145

Answer = A GDP measures the market value of all final goods and services produced by factors of production (such as labor and capital) located within a country, therefore Swiss GDP includes the accounting services provided within Switzerland. GNP measures the market value of all final goods and services produced by factors of production supplied by residents of a country, regardless of whether such production takes place within the country or outside of the country. Therefore, GNP includes the accounting services produced by a French citizen abroad. CFA Level I “International Trade and Capital Flows,” Usha Nair-Reichert and Daniel Robert Witschi Sections 2.1, 4.4

Answer 146

Answer = C Closely affiliated with The World Bank Group, the International Bank for Reconstruction and Development (IBRD) provides low or no-interest loans and grants to developing countries that have unfavourable credit or no access to international credit markets.

Answer 147

Answer = A Promoting economic growth and reducing world poverty are among the primary goals of the World Bank. The IMF primarily promotes the growth of international trade, supports exchange rate stability, and provides a forum for cooperation on monetary problems internationally. The WTO has a primary focus on reaching trade agreements and settling trade disputes.

Answer 148

Answer = A (?) 5.5% is correct. The CFA Example is wrong with wrong formula. (1 + 5%) x (1 + 2%) / (1 + 1.5%) - 1 = 5.5%

Answer 149

Answer = A Real exchange rate = Nominal spot exchange rate × CPI of the foreign country / CPI of the domestic country Change in the real exchange rate = [(1 + Change in exchange rate) × (1 + Change in price level in foreign country)] / (1 + Change in price level in domestic country) –1 (1 + 7.5%) x (1 - 4%) / (1 + 2.5%) - 1 = 0.7%

Answer 150

Answer = A For the base period, three years ago, the real exchange rate is the same as the nominal exchange rate, 1.32 USD/EUR. The real exchange rate over the period has changed from 1.32 to 1.40 x (112 / 118) = 1.3288. This increase in the real USD/EUR exchange rate indicates that the base currency (EUR) has appreciated in real terms, so that eurozone goods are now more expensive in real terms to U.S. consumers.

Answer 151

Answer = A The real exchange rate increased from 2.50 PTR/BAL to (3.00 PTR/BAL x 110/120) = 2.75 PTR/BAL. Note that the real exchange rate at the base period is equal to the nominal exchange rate because the CPIs are both 100 for the base period. The purchasing power of one PTR worth of domestic goods has decreased. When the real exchange rate (expressed as d/f) increases, exports of goods and services become relatively less expensive.

Answer 152

Answer = B | The real exchange rate is calculated as 0.75 BDE/TOL x 110/105 = 0.79 BDE/TOL.

Answer 153

Answer = B The purchase of machinery is an import and affects the current account, not the capital account, so it is ignored. The purchase of a non-produced, non-financial asset such as a patent affects the capital account. The impact on the capital account in AUD is: = USD20,000 (1 EUR/1.29USD) (AUD1.24/EUR) = 19,225AUD CFA Level I “International Trade and Capital Flows,” Usha Nair-Reichert and Daniel Robert Witschi Section 4.2 “Currency Exchange Rates,” William A. Barker, Paul D. McNelis, and Jerry Nickelsburg Section 3.2

Answer 154

Answer = A CAD/GBP = (USD/EUR) × (EUR/GBP) ÷ (USD/CAD) Spot Rate of CAD/GBP = 1.3960 × 1.2850 ÷ 1.0110 = 1.7743 Expected Spot Rate of CAD/GBP = 1.3860 ×1.2790 ÷ 1.0300 = 1.7211 To determine the appreciation of the Canadian dollar (CAD) relative to the British pound , the British pound (GBP) is the price currency and the Canadian dollar is the base currency, giving rise to the following calculation: 1.7743 / 1.7211 - 1 = 3.09%

Answer 155

``` Answer = A Spot Rate Expected Appreciation Expected Spot Rate in One Year USD/EUR 1.30 x (1 + 1.75%) = 1.323 CAD/USD 0.95 x (1 - 0.25%) = 0.948 CHF/EUR 1.22 x (1 + 0.75%) = 1.229 CAD/CHF = (USD/EUR) × (CAD/USD) ÷ (CHF/EUR) = 1.020 ```

Answer 156

Answer = A The TRT/PSG cross rate is 5.5 x 8.0 = 44 TRT/PSG. Because the answer choices are quoted as PSG/TRT, we need to invert this result: 1 / 44 = 0.0227 PSG/TRT.

Answer 157

Answer = A We can calculate the current USD/EUR cross rate as 104.2 / 76.6 = 1.3603 USD/EUR. The original USD/EUR cross rate was 100 / 80 = 1.2500 USD/EUR. Thus, the USD has depreciated relative to the EUR. While it is correct to say that the EUR has appreciated 4.2% relative to the JPY (104.2 / 100 — 1) = 4.2%, it is not correct to say that the JPY has depreciated by the same percentage. To calculate the percentage change in the JPY relative to the EUR, we need to invert the quotes. One year ago, the quote was 0.0100 EUR/JPY and now the quote is 0.0096 EUR/JPY. (0.0096 / 0.0100 — 1) = 0.0403 or 4.0% depreciation in the JPY relative to the EUR.

Answer 158

Answer = A | The PAS/LDR cross rate is (1.70 BCS/LDR) / (3.2 BCS/PAS) = 0.5313 PAS/LDR.

Answer 159

``` Answer = B Step 1: Find the spot rate for the EUR/AUD Spot = Forward Rate – Forward Points Spot = 1.4300 - 400 / 10,000 = 1.3900 Step 2: Calculate current cross rate USD / AUD = 0.7500 x 1.3900 = 1.0425 ``` CFA Level I “Currency Exchange Rates,” William A. Barker, Paul D. McNelis, and Jerry Nickelsburg Sections 3.2 and 3.3

Answer 160

Answer = B Covered interest arbitrage will ensure identical terminal values by investing the same initial amounts at the respective country’s domestic interest rates: GBP investment: ₤1 × (1 + 0.016025 × 180/360) = ₤1.008013 NZD investment: NZ$2.0979 × (1 + 0.032875 × 180/360) = NZ$2.13238 The forward rate is determined by equating these two terminal amounts: NZD/GBP forward Rate = NZ$2.13238 /₤1.008013/ = 2.115429 Forward points = (Forward – Spot) × 10,000 = (2.1155– 2.0979) × 10,000 = 175.3 =176 (rounded)

Answer 161

Answer = B The currency with the higher (lower) interest rate will always trade at a discount (premium) in the forward market. The lower interest rate in the domestic country will be offset by the appreciation of the domestic country’s currency over the investment horizon.

Answer 162

Answer = B | Arbitrage-free forward = 2.875 WSC/BDR x [(1 + 0.015 / 2) / (1 + 0.03 / 2)] = 2.8538 WSC/BDR.

Answer 163

Answer = C In a conventional fixed peg arrangement, a country pegs its currency within a margin of ±1% versus another currency or a basket that includes the currencies of its major trading or financial partners. Market-determined exchange rates are a characteristic of an independently floating exchange rate regime.

Answer 164

Answer = B | Arbitrage-free forward rate = 1.3382 USD/EUR x (1.025 / 1.035) = 1.3253 USD/EUR.

Answer 165

Answer = C The currency with the higher interest rate should depreciate over time by approximately the amount of the interest rate differential. We know that PKR is expected to appreciate (and thus the VKN depreciate) over the period because the PKR is trading at a forward premium. Thus, VKN should have an interest rate higher than that for PKR by the amount of the forward premium, or approximately 3.0% + 2.3% = 5.3%.

Answer 166

Answer = B Investing the domestic currency at the domestic interest rate should earn the same return as buying a foreign currency at the spot exchange rate, investing at the foreign interest rate, and selling the foreign currency proceeds at the forward exchange rate. If both currencies trade freely and participants can enter forward contracts, arbitrage trading will cause the percentage difference between the forward and spot exchange rates to be approximately equal to the difference between interest rates in the two countries.

Answer 167

Answer = B Under the elasticities approach, a currency depreciation will lead to a greater reduction in a trade deficit when export demand and/or import demand are more elastic. The demand for luxury goods is relatively elastic, while the demand for goods without good substitutes or for goods that represent only a small portion of consumer expenditures is relatively inelastic.

Answer 168

Answer = C Under a currency board arrangement, the monetary authority agrees to exchange its domestic currency for a foreign currency at a fixed rate. A fixed peg arrangement allows variation within a band of ±1% around the target exchange rate. With dollarization, a member country does not have a domestic currency of its own.

Answer 169

Answer = B Under the elasticities approach, currency depreciation will result in greater improvement in the trade deficit when either import or export demand becomes more elastic. One shortcoming of the elasticities approach is that it considers trade flows and ignores capital flows. The absorption approach considers both. Under the absorption approach, depreciation of the domestic currency will improve the balance of trade if it increases domestic savings (i.e., increases national income relative to expenditures).

Answer 170

Answer = B The effect of demand-pull inflation is an increase in the aggregate demand, which, in turn, leads to an increase (initially) in commodity prices. CFA Level I “Understanding Business Cycles,” by Michele Gambera, Milton Ezrati, and Bolong Cao Sections 4.2.4–4.2.4.2

Answer 171

Answer = B In a CBS, the monetary authority has an obligation to maintain 100% foreign currency reserves against the monetary base. It therefore cannot lend to troubled financial institutions. As long as the country under a fixed parity regime maintains its exchange peg, the central bank can serve as a lender of last resort. CFA Level I “Currency Exchange Rates,” William A. Barker, Paul D. McNelis, and Jerry Nickelsburg Sections 4.3.2, 4.3.3

Answer 172

Answer = B The absorption approach to analyzing how to improve a trade deficit suggests that in the absence of excess capacity in the economy, currency devaluation provides only a temporary improvement in a country’s trade deficit that will reverse after the decrease in real domestic wealth from the currency depreciation is restored. It also concludes that a long-term improvement in the trade deficit requires either an improvement in the fiscal deficit or an increase in the excess of domestic savings over domestic investment.

Answer 173

Answer = C The J-curve effect refers to a plot of the trade deficit over time when the domestic currency depreciates (the foreign currency appreciates). The trade deficit gets worse initially but then improves over time, either because export and import demand are more elastic in the long run or because existing contracts for future delivery are fixed in foreign currency terms in the short run.

Answer 174

C Veblen goods violate the fundamental axioms of demand theory, whereas Giffen goods do not. CFA Level I "Demand and Supply Analysis: Consumer Demand," Richard V. Eastin and Gary L. Arbogast Sections 6.4, 6.5

Answer 175

C If demand is elastic, a 1% reduction in price increases the quantity sold by more than 1%. CFA Level I "Demand and Supply Analysis: Introduction," Richard V. Eastin and Gary L. Arbogast Section 4.1

Answer 176

C The supply of a given piece of land is perfectly inelastic because of its limited availability. Land is a natural resource and subject to the law of diminishing returns. Although land can be considered an input to the production of goods and services, it is not considered produced goods. CFA Level I "Demand and Supply Analysis: The Firm," Gary L. Arbogast, and Richard V. Eastin Sections 3.1.2, 3.2.2

Answer 177

A A firm in a perfectly competitive environment with total costs equal to total revenue and marginal costs greater than marginal revenue is operating at the upper breakeven point. Therefore, it should decrease the level of production to enter profit territory. CFA Level I "Demand and Supply Analysis: The Firm," Gary L. Arbogast and Richard V. Eastin Section 3.1.4

Answer 178

B The cross-price elasticity is positive, indicating that as the price of Y increases, more of X is demanded, thus making X and Y substitutes. CFA Level I "Demand and Supply Analysis: Introduction," Richard V. Eastin and Gary L. Arbogast Sections 4.1, 4.3, 4.4

Answer 179

A Export subsidies interfere with the functioning of the free market and result in a deadweight loss to society. The deadweight loss arises on the producer side because the higher subsidized price causes inefficient producers to remain in the market. On the consumer side, the higher price causes those that would have purchased at the lower price to be shut out of the market. CFA Level I “International Trade and Capital Flows,” Usha Nair-Reichert and Daniel Robert Witschi Section 3.3

Answer 180

Answer = A The primary monetary policy goal of most major central banks is to maintain price stability. CFA Level I “Monetary and Fiscal Policy,” Andrew Clare and Stephen Thomas Section 2.3

Answer 181

Answer = B The inflation rate is measured as [(CPI this year – CPI last year) / CPI last year] × 100. In this case, [(252 – 246) / 246] × 100 = 2.439%. CFA Level I “Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao Section 4.2

Answer 182

Answer = A Gross domestic product (GDP) can be defined in term of either output or income: • it is the market value of all final goods and services produced within the economy in a given period of time (output definition) or, equivalently, • it is the aggregate income earned by all households, all companies, and the govern¬ment within the economy in a given period of time (income definition). CFA Level I “Aggregate Output, Prices, and Economic Growth,” Paul R. Kutasovic, and Richard G. Fritz Section 2.1

Answer 183

Answer = C In a perfectly competitive market, sellers have no pricing power and thus sell their product at the price established by demand and supply in the market – the market equilibrium price. CFA Level I “The Firm and Market Structures,” Richard G. Fritz and Michele Gambera Section 3.3

Answer 184

Answer = C Average weekly initial claims for unemployment insurance is a leading indicator of economic activity. A decrease in these claims is an indicator of rehiring, which signals the start of an economic recovery. CFA Level I “Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao Section 5.1

Answer 185

Answer = A As suggested particularly by the earliest RBC models, a person is unemployed because he or she is asking for wages that are too high CFA Level I “Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao Section 3.3.1

Answer 186

Answer = C Unemployment rate = 95/750 = 12.7% CFA Level I “Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao Sections 4.1, 4.1.1

Answer 187

Answer = C Second-degree price discrimination involves using the quantity purchased as the basis for the pricing of a particular good. CFA Level I "The Firm and Market Structures," Richard G. Fritz and Michele Gambera Section 6.4

Answer 188

Answer = B "Demand and Supply Analysis: The Firm," Gary L. Arbogast and Richard V. Eastin Section 2.2 Normal profit is the level of accounting profit needed to just cover the implicit opportunity costs ignored in accounting costs. This profit is all that a firm needs to earn in the long run to remain in business. Failing to earn normal profits over the long run has a debilitating impact on the firm's ability to access capital and to function properly as a business enterprise. Economic profit (also known as abnormal or supernormal profit) is accounting profits in excess of implicit opportunity costs.

Answer 189

Answer = A "Demand and Supply Analysis: Consumer Demand," Richard V. Eastin and Gary L. Arbogast Section 6.2 "Aggregate Output, Prices, and Economic Growth," Paul R. Kutasovic and Richard G. Fritz Section 3.3.1 "Currency Exchange Rates," William A. Barker, Paul D. McNelis, and Jerry Nickelsburg Sections 5.1, 5.2 At full employment, a weaker currency reduces the purchasing power of all domestic currency denominated assets (including the present value of current and future income). Households respond by reducing general expenditures and increasing savings. This response is the wealth effect and reflects the proportion of one's income that is saved (or spent).

Answer 190

Answer = A "Aggregate Output, Prices, and Economic Growth," Paul R. Kutasovic and Richard G. Fritz Sections 3.3.2, 3.3.3 An increase in the supply of human capital will increase the resource base and cause the SRAS to shift to the right.

Answer 191

Answer = B “International Trade and Capital Flows,” Usha Nair-Reichert and Daniel Robert Witschi Sections 4.1, 4.2 Current Account Amounts with Signs and Grouped Appropriately: 399388 Transaction Amount Totals Export of goods and services and income receipts 13,409 Export of goods and services 10,000 Investment income received from foreigners 3,409 Import of goods and services and income payments -16,735 Import of goods and services -14,216 Investment income payments made to foreigners -2,519 Net unilateral current transfers -761 Unilateral current transfers received 346 Unilateral current transfers paid -1,107 Current account balance -4,087

Answer 192

Answer = B "Demand and Supply Analysis: Introduction," Richard V. Eastin and Gary L. Arbogast Section 4.2 The more time that has elapsed since a price change, the more elastic the demand. For example, if gas prices rise, consumers cannot quickly change their mode of transportation but will likely do so in the longer run.

Answer 193

Answer = C "The Firm and Market Structures," Richard G. Fritz and Michele Gambera Sections 2.1, 2.2, 4 The characteristics of monopolistic competition include a large number of competitors, low pricing power, and the production of differentiated products (through advertising and other non-price strategies), but these still result in some pricing power. The ease of entry results in zero economic profits in the long run.

Answer 194

Answer = C "Aggregate Output, Prices, and Economic Growth," Paul R. Kutasovic and Richard G. Fritz Section 3.3.1 A boom in the stock market increases the value of financial assets and household wealth. An increase in household wealth increases consumer spending and shifts the aggregate demand curve to the right.

Answer 195

Answer = C “Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao Section 4.1 For a given working-age population, a decline in the labor force participation rate (often caused by an increase in discouraged workers) reduces the labor force. If the number of people employed remains the same while the labor force becomes smaller, the number of workers defined to be unemployed must be smaller and thus the unemployment rate lower. Labor force participation rate = Labor force/Working age population Unemployment rate = Unemployed/Labor force

Answer 196

Answer = A "Demand and Supply Analysis: The Firm," Gary L. Arbogast and Richard V. Eastin Section 3.1 Shutdown is defined as a situation in which the firm stops production but still confronts the payment of fixed costs in the short run. In the short run, a business can operate at a loss as long as it covers its variable costs even though it is not earning sufficient revenue to cover fixed costs. If variable costs cannot be covered in the short run, the firm will shut down operations and simply absorb the unavoidable fixed costs.

Answer 197

Answer = C “International Trade and Capital Flows,” Usha Nair-Reichert and Daniel Robert Witschi Section 3.3 Export subsidies interfere with the functioning of the free market and result in a deadweight loss to society. The deadweight loss arises on the producer side because the higher subsidized price causes inefficient producers to remain in the market. On the consumer side, the higher price causes those that would have purchased at the lower price to be shut out of the market.

Answer 198

Answer = C “Monetary and Fiscal Policy,” Andrew Clare and Stephen Thomas Sections 2.3.2.1, 2.3.2.2 Selling government bonds results in a reduction of bank reserves and reduces their ability to lend, causing a decline in money growth through the multiplier mechanism and hence a contraction in the economy.

Answer 199

Answer = A "Demand and Supply Analysis: Introduction," Richard V. Eastin and Gary L. Arbogast Section 3.13 Price floors lead to overproduction.

Answer 200

Answer = B “Monetary and Fiscal Policy,” Andrew Clare and Stephen Thomas Sections 3.1.1, 3.1.2, 3.1.3 Expansionary policy increases government borrowing, which may divert private sector investment from taking place, which results in an effect known ascrowding out. Increases in capital gains tax rates and increases in public spending are forms of contractionary fiscal policy; they serve as automatic stabilizers and thus do not coincide with discretionary fiscal expansion.

Answer 201

Answer = B “Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao Section 5.1 Average weekly initial claims for unemployment insurance is a leading indicator of economic activity. A decrease in these claims is an indicator of rehiring, which signals the start of an economic recovery.

Answer 202

Answer = A "Demand and Supply Analysis: Introduction," Richard V. Eastin and Gary L. Arbogast Section 4.1 Arc price elasticity of demand is calculated as: %AQ/%AP = (AQ/Qavg) / (AP/Pavg). In this case, (20/110)/(2/14) = 1.27 rounded to 1.3.

Economics CFA Level 1 Flashcards

(226 cards)