Download ECONOMIC ENVIRO NMENT

DIPLOMA IN BANKING EXAMINATION
SUBJECT: ECONOMIC ENVIRONMENT
(IOBM- D211)
ANSWERS FOR MAY 2009 EXAMINATIONS
QUESTION 1
a)
i.
Subsistence economy - production for consumption, no specialization
and trade (1 mark)
ii.
Free market economy - production and consumption decisions
determined by forces of demand and supply (1 mark)
iii.
Centrally planned economy - production and consumption determined
by government (1 mark)
iv.
Mixed economy - combines features of free market and centrally
planned economy (1 mark)
b) Malawi has mixed economy
(1 mark)
a) Any TWO of the following: Liberalized current account; privatization of
various companies; floating exchange rate regime; controlled maize and
petroleum product prices; exchange control regulations
(4 marks)
b) A condition where the sum of debits and credits from the current account and
the capital and financial accounts equal to zero
CA+ KA = 0
(5 marks)
QUESTIONS 2
(a)
Under the substitution effect:
Wage rate increases attract more units of labour. Thus, leisure hours are
minimized as its opportunity cost goes up. Increased wages enable
individuals to spend more on other goods and services and less of leisure.
(4 marks)
Under the income effect: As consumption of goods and services increases, the marginal utility of
consumption decreases. On the other hand, as wages increase raises
incomes, demand for leisure goes up because leisure is a normal good.
(4 marks)
(b)
Graph (a)
Graph (b)
i
i
M2
M
M1
O
M1
Md
O
Md
In graph (a) M1 is the demand for active balances which does not vary with
interest rates. M2 is demand for passive balances which is inversely related
to interest rates. An increase in income shifts M1 outwards and the viceversa (apposite) is true. So, total demand (in graph (b)) is the sum of M 1 and
M2 in graph (a), which gives line M in graph (b). Rate changes will cause
movement along curve M.
(7 marks)
QUESTION 3
Comparative advantage is a dynamic concept, thus firms can lose out over time due
to innovations and competition. The assumption of perfect occupational mobility of
factors of production may be wronged because of specialist nature of some
resources in some industries which would make retraining untenable. The second
assumption of constant returns to scale would only apply where technological
advances are ruled out which may not be the case most of the times. Also
specialisation contributes to increasing returns to scale. The assumption of 'no
externalities' may not apply in some firms or industries especially whose survival
depends in integration/ linkages. Finally, transportation costs (which are taken to be
zero in the theory) would make some low cost (in relative terms) countries
uncompetitive on the world markets as access may only be possible at a very
significant freight cost. The final price at the international market includes transport.
Think of landlocked Malawi and coastal Mozambique.
c) As the US dollars realized from the sale of tobacco exports at the tobacco
auction floors are converted into Malawi Kwacha the supply of domestic money
supply increases.
Exports dollars
(5 marks)
QUESTION 4
a) Direct taxes are paid directly to government from the one who ultimately
bears the burden (e.g. income tax while an indirect taxes refer to taxes
which governments collect through intermediaries from the ultimate
bearer of the tax burden e.g. sales taxes, value added tax (VAT)
marks)
b) Tax imposition
Supply + tax
x
a
supply
b
a
p1
a
p
py
y
O
a
Q1
Q
(5 marks)

Consumer surplus is xap (1 mark)

Producer surpluss is paO (1 mark)

Tax imposition raises price level to p1 and reduces quantity
supplied to Q1 (1 mark)

Tax revenue is p1 b y py (1 mark)

Tax imposition reduces consumer or/and producer surplus by
amount of tax revenue (1 mark)
(4

Degree of tax burden depends on price elasticities of demand and
supply (1 mark)
QUESTION 5
(a)
b)
Policy intervention that brings high economic
growth; leads to an increase in incomes; and in turn causes
a rise in demand for imports; which negatively impacts balance of payments
(i)
(ii)
(iii)
GNP is sum of income generated by nationals within and outside the
borders less that of non-residents; GDP is income from both nationals
and non-residents within same borders.
Economic growth is defined as change in national income over given
period; improved welfare is a measure of positive change in living
standards
real per capita income measures welfare or standard of living for
individuals; HDI measures on average welfare of the entire economy
(c )

The earliest form of money were commodities – where intrinsic value
of commodity was equal to exchange value assigned to it

Coins from various kinds of metals initially iron and copper and later
silver and gold

(2 marks)
(2 marks)
Paper money appeared in the 16th century - gold was deposited and
goldsmiths issued certificates of deposits - i.e. fully backed by gold.
(2 marks)

Bank Notes replaced paper money. These were partially backed by
gold and also called fiduciary or credit money.

Cheque accounts uses signed papers to make payments against
account balances

(2 marks)
(2 marks)
Electronic payments - continuous technological innovation in the
monetary sector has brought electronic methods of payment – e.g.
smartcards.
QUESTION 6
(a)
Frictional unemployment:
(2 marks)
o Caused by people changing jobs.
o Jobs are available but those looking for them are not aware (or have no
information).
o Or jobs that are available offer unattractive remuneration to the seekers.
(3 marks)
Structural unemployment:
o Caused by technological changes.
o For example, in labour-capital substitution, more capital is demanded
(than labour)
o Occurs when skills do not match the jobs that are available. (3 marks)
(b)
(c)
(i)
Inflation is defined as the general increase in the price of goods and
services.
(2 marks)
(ii)
Demand-pull inflation occurs when demand is greater than supply or
when money supply grows faster than production.
(2 marks)
(iii)
Cost-push inflation is caused by the rise in the cost of production e.g.
when prices of factor of production (e.g. land) go up.
(2 marks)
(i)
Calculate real interest from the products’ yields given as yield minus
inflation rate:
5 – 12
=
-7 ~ savings
13/5 – 12
=
1.5 ~ 91-day
11 – 12
=
-1 ~ 182-day
7 - 12
=
-5 ~ fixed
15-12
=
3 ~ bond
So the good investments or products are those with positive real
interest, that is, 91-day Treasury bill and the 3-year bond whose real
interest is 1.5% and 3%, respectively.
(4 marks)
(ii)
The two products give a return which is greater than inflation, which
implies one is sure that at least the same value is retained during the
year.
(4 marks)
QUESTION 7
a) Keynesian demand management policies advocate adjustment of the level of
aggregate demand to arrive at full employment equilibrium while supply side
policies advocate influencing the level of aggregate supply to achieve
economic growth. (4 marks)
b) Increasing government expenditure; reducing taxation; reducing interest
rates; increasing money supply. (4 marks)
c)
LRAS1
LRAS2
Price
level
pe
Y1
Y2
YFC2 national income
( 5 marks)
Supply side policies cause a shift in the long run aggregate supply curve from
LRAS1 to LRAS2 withiout affecting price level (3 marks)
d) The fertilizer subsidy scheme translates into reduced cost of agricultural
production. As such increased agricultural output is achievable without
causing an increase in the price level. During the past two years Malawi
agricultural production has improved tremendously whilst inflation has been
relatively stable.
QUESTION 8
(a)
[per month]
2006/07
Tax
0-4000
6000
>10,000
0
600
12,000
12,600
2007/08
Tax
0-5000
5000
>10,000
0
500
14,000
14,500
So government has reduced tax burden for the low-income group and varied
the burden for the higher income group.
(4 marks)
(b)
(i)
He is worse off. Now paying K14,500 in taxes as opposed to K12,600
earlier>
(12 marks)
(ii)
(iii)
K14,500 - K12,600
=
The average tax rate (new) is
14,500 x
100
50,000
K1,900.
(2 marks)
=
29%
(2 marks)
Income tax regulates consumption behaviour (at household)
and investment behaviour (at firm) as it directly affects how much disposable incom
e is left to consumption and reinvestment (which may impact on employment). so,
any increase would be a deterrent and the opposite is true. surtax or VAT may be
applied to products or services which government does not support e.g. on
cigarettes or alcohol. any government may remove or reduce taxes (e.g. excise or
import duties) in sectors where it wants to encourage investment or consumption.