2015 INTRODUCTION TO ECONOMICS AND FINANCE QUESTION BANK CAF-02 ICAP Question Bank P Introduction to economics and finance Second edition published by Emile Woolf Limited Bracknell Enterprise & Innovation Hub Ocean House, 12th Floor, The Ring Bracknell, Berkshire, RG12 1AX United Kingdom Email: info@ewiglobal.com www.emilewoolf.com © Emile Woolf International, January 2015 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without the prior permission in writing of Emile Woolf Publishing Limited, or as expressly permitted by law, or under the terms agreed with the appropriate reprographics rights organisation You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer Notice Emile Woolf International has made every effort to ensure that at the time of writing the contents of this study text are accurate, but neither Emile Woolf International nor its directors or employees shall be under any liability whatsoever for any inaccurate or misleading information this work could contain © Emile Woolf International ii The Institute of Chartered Accountants of Pakistan Certificate in Accounting and Finance Introduction to economics and finance C Contents Page Question and Answers Index v Questions Section A Multiple choice questions Section B Objective test and long-form questions 25 Section C Multiple choice answers 55 Section B Objective test and long-form answers 65 Answers © Emile Woolf International iii The Institute of Chartered Accountants of Pakistan Introduction to economics and finance © Emile Woolf International iv The Institute of Chartered Accountants of Pakistan Certificate in Accounting and Finance Introduction to economics and finance I Index to Objective test and long-form questions and answers QUESTION PAGE ANSWER PAGE CHAPTER – ECONOMIC CONCEPTS 1.1 FACTORS OF DEMAND 25 66 1.2 PRODUCTION POSSIBILITY CURVE 25 67 1.3 ECONOMIC GROWTH 25 67 1.4 ISLAMIC ECONOMIC SYSTEM 27 68 CHAPTER - MICROECONOMICS 2.1 TYPES OF GOODS 27 69 2.2 QUANTUM OF SUPPLY OF A PRODUCT 27 69 2.3 MOVEMENT 27 70 2.4 A MARKET ECONOMY 27 71 CHAPTER – DEMAND AND SUPPLY: ELASTICITIES 3.1 ELASTICITY OF DEMAND 27 73 3.2 ELASTICITY OF DEMAND 27 74 3.3 ELASTICITY OF DEMAND 28 75 3.4 CALCULATE PEDS 28 76 3.5 CONCEPTS OF DEMAND 28 76 © Emile Woolf International v The Institute of Chartered Accountants of Pakistan Introduction to economics and finance QUESTION PAGE ANSWER PAGE 3.6 COFFEE MARKET 28 78 3.7 COMPETITIVE GOODS AND COMPLEMENTARY GOODS 29 79 3.8 PRICE ELASTICITY OF SUPPLY 29 81 3.9 CROSS ELASTICITY OF DEMAND 29 81 3.10 PRICE ELASTICITY OF DEMAND 29 82 3.11 TOTAL EXPENDITURE METHOD 29 82 3.12 PROPORTIONATE OR PERCENTAGE METHOD 29 82 3.13 GEOMETRICAL METHOD 29 83 3.14 NUMERICAL EXERCISE: PRICE ELASTICITY OF DEMAND 29 85 3.15 IMPORTANCE OF PRICE ELASTICITY OF DEMAND 30 85 CHAPTER – UTILITY ANALYSIS 4.1 CONSUMER’S EQUILIBRIUM 30 87 4.2 INDIFFERENCE CURVES 30 88 4.3 CONCEPTS 30 89 4.4 PRICE EFFECT 31 90 4.5 INCOME EFFECT 31 91 4.6 SUBSTITUTION EFFECT 31 92 4.7 LAW OF DIMINISHING UTILITY 31 92 4.8 INDIFFERENCE CURVES 31 93 4.9 INDIFFERENCE CURVES 31 94 4.10 MARGINAL RATE OF SUBSTITUTION 31 96 CHAPTER – COSTS, REVENUES AND FIRMS 5.1 MONOPOLIST PROFIT 32 98 5.2 PERFECT COMPETITION 32 99 5.3 INCREASING RETURNS 32 100 © Emile Woolf International vi The Institute of Chartered Accountants of Pakistan Index to questions and answers QUESTION PAGE ANSWER PAGE 5.4 LARGE FIRMS 32 100 5.5 THE SCALE OF PRODUCTION 32 102 5.6 MONOPOLY AND COMPETITION 34 103 5.7 PROFIT MAXIMISATION AND DEMAND ANALYSIS 35 104 5.8 REVENUES AND COSTS 36 105 5.9 COSTS AND REVENUES 36 106 5.10 TYPES OF COSTS 36 107 5.11 MONOPOLY SETUP 36 108 5.12 CONSUMPTION GOODS 36 108 5.13 EQUILIBRIUM OF THE FIRM 37 109 5.14 MARKET FUNCTIONING 37 110 5.15 FREE FORCES 37 111 5.16 PRICE OUTPUT DETERMINATION 37 112 5.17 OLIGOPOLY AND DUOPOLY: DIFFERENCE 37 113 5.18 PRICE CARTELS AND COLLUSION 37 113 5.19 PRICE LEADERSHIP 37 114 5.20 KINKED DEMAND CURVE 37 114 5.21 NON-PRICE COMPETITION 37 114 CHAPTER – MACROECONOMICS INTRODUCTION 6.1 NATIONAL INCOME 38 114 6.2 MEASURING NATIONAL INCOME 38 115 6.3 CIRCULAR FLOW OF INCOME 38 117 6.4 INJECTIONS AND WITHDRAWALS 38 118 6.5 AGGREGATE SUPPLY: SHORT RUN 38 119 6.6 AGGREGATE SUPPLY: LONG RUN 38 120 6.7 AGGREGATE DEMAND 39 120 © Emile Woolf International vii The Institute of Chartered Accountants of Pakistan Introduction to economics and finance QUESTION PAGE ANSWER PAGE 6.8 MACROECONOMIC EQUILIBRIUM: RECESSION - KEYNESIAN 39 122 6.9 MACROECONOMIC EQUILIBRIUM: INFLATIONARY GAP 39 123 6.10 DEFLATIONARY GAP 39 124 6.11 CALCULATION OF GDP 39 126 6.12 CALCULATION OF GDP 40 127 6.13 CALCULATION OF GDP 40 128 6.14 CALCULATION OF GDP 41 128 CHAPTER – CONSUMPTION, SAVINGS AND INVESTMENT 7.1 CIRCULAR FLOW OF INCOME 41 130 7.2 INVESTMENT AND MEC 42 131 7.3 CONSUMPTION FUNCTION 42 132 7.4 PRIVATE INVESTMENT 42 133 CHAPTER – MULTIPLIER AND ACCELERATOR 8.1 MULTIPLIER 43 134 8.2 MULTIPLIER 43 134 8.3 MULTIPLIER 43 135 8.4 ACCELERATOR QUESTION 44 136 CHAPTER – MONEY 9.1 THE MONEY SUPPLY 45 138 9.2 MONEY SUPPLY AND QUANTITY THEORY 45 139 9.3 IMPORTANT FUNCTIONS 46 141 9.4 UNEMPLOYMENT 46 142 9.5 PHILLIPS CURVE 46 143 9.6 LIQUID FORM 46 144 9.7 MONEY FUNCTIONS 46 145 © Emile Woolf International viii The Institute of Chartered Accountants of Pakistan Introduction to economics and finance Loan stock normally carries a fixed rate of interest, which means that the cost of the borrowing is predictable If interest rates rise in the future, it can be low cost borrowing If the firm is successful in the future, shareholders may demand an increase in dividends paid, but loan stock holders are restricted to the fixed rate of interest (b) Money supply can be measured in a number of ways and broader definitions include consumer credit as it increase the purchasing power of the population Much of this credit is created by banks As banks lend money to their customers, they create new deposits, increasing the supply of money in the economy An increase in money supply and therefore demand in the economy can lead to inflationary pressure Governments may try to control money supply by increasing rates of interest to make borrowing more expensive or by direct credit controls such as minimum deposit percentages The rate of interest is the most likely option for present governments but its effect depends on the interest elasticity of demand In the housing market interest is not the major consideration of buyers and it is therefore interest inelastic Other markets may react more quickly to interest rate increases, for example consumer electrical goods, often considered to be luxuries The monetary authorities can also attempt to influence interest rates and the money supply through open market operations The Bank of England can sell securities on behalf of the government, directly to the 'non-bank' private sector; i.e the public Most people will withdraw funds from their bank accounts to pay for the securities, reducing banks' liquidity, and thus their overall ability to make loans and create credit money So, as long as the funds are retained by the government, the growth of the money supply will be slowed Excessive government spending leading to heavy borrowing by the government from the banking system, has been blamed for inflation in the past If the government is forced to borrow from the banking system to fund the PSBR, this has the effect of increasing the liquidity and the lending capacity of the banks, allowing them to bring about an increase in credit creation and the money supply Monetarist economists, who have championed this view in the last 20 years or so, argue for cuts in government spending and a reduction in the PSBR to avoid the inflationary effects of an overly rapid growth of the money supply (Note: the PSBR is now known as the Public Sector Net Cash Requirement – PSNCR) 12.2 BANKS (a) Financial intermediaries are institutions, such as banks or building societies, which provide funds for lending long term, by borrowing from other groups of people, on a short term basis Short-term borrowing provides a pool of funds from which those borrowers can maintain liquidity, should they need it, and a pool from which long-term lending can be given The building society instant access account provides a secure home for small amounts of savings, with interest, from a large number of savers This money can be lent long-term to house buyers, at a slightly higher rate of interest, for periods of 20 or 30 years The large number of savers provides protection for those wishing to withdraw money and the long-term loans (b) Commercial banks operate on a fractional reserve system which means that only a small proportion of cash needs to be available at any time to maintain the confidence of depositors The remainder of their assets can be made up of advances or loans to customers, which is a profitable investment © Emile Woolf International 162 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Credit creation can be illustrated by an example which assumes that there is only one bank in the system and that all money is re-deposited in the bank A deposit of £100 will create a liability for the bank, as the money is repayable to the depositor, and an asset of cash If the bank works on a 10% fractional reserve system, it will need to keep 10% of its assets as cash, leaving it free to create advances of up to 90% of its total assets The borrower can spend the advance as the bank will honour the cheque, and as the cheque is deposited in the bank, liabilities will again equal assets The Balance Sheet would appear as follows: Assets £ Cash Advance to B (90% of £1,000) Liabilities £ 100 Depositor A 100 900 Depositor B 900 1,000 1,000 The limitation on credit creation consists fundamentally of the need to exercise prudence Whereas the more lending a bank can do, the more money it is likely to make, it must take care not to overextend its lending activities and face the potentially disastrous consequences of running short of cash Fractional reserve banking depends on the continuing confidence of the bank's customers, who must believe that cash will be available at any time at which they require it From time to time in the past, government has imposed limitations on the ability of banks to create credit, but this has not been an influencing factor in recent years Finally, banks have been able to be more aggressive in their lending over recent years, as the population increasingly uses payment methods, from cheques to credit cards, which not rely on the everyday use of cash 12.3 COMMERCIAL BANKS AND CREDIT CREATION (a) The commercial banks provide several important functions for their business customers Firstly, they have a duty to safeguard any deposits made with them Deposit accounts earn interest for the saver depending on their size and their accessibility For businesses that are looking to store their daily takings overnight before moving them on, the overnight rate is very low Long-term deposits earn a higher rate to compensate for the loss of liquidity Current accounts either earn no or very little interest but give the depositor a safe place to store its funds together with the facility to write cheques and withdraw the funds on demand A second function of the commercial banks is to lend money The interest rates charged on loans, which differ depending on estimated risk and length of loan, are higher than those given to savers The difference is obviously bank profit A third function is to effect an efficient method of transferring money between different accounts within the same branch, between different branches and between different banks Hence they provide a means of transmitting money for payments and receipts between different customers © Emile Woolf International 163 The Institute of Chartered Accountants of Pakistan Introduction to economics and finance Lastly, commercial banks provide a wide range of general financial services to their business customers that are designed specifically to facilitate domestic and international business For instance, they arrange insurance, provide foreign exchange facilities, accept commercial bills, all of which are aimed at making trade easier (b) (i) The credit creating ability of the commercial banks can be explained, initially, within a single bank system If the bank receives deposits of £100 it will learn through experience that a high percentage (up to 90%) of the funds will be left with the bank As a result of this it will be able to lend up to £90 against security thereby creating credit This £90 will eventually be deposited at the bank further raising the base upon which credit can be created In this manner credit can continue to build, governed principally by the prudence of the bank and the cash or liquidity ratio which it decides to keep The rate of growth of credit is determined by the liquidity ratio – translated into the credit creation multiplier Credit will be created in a multi-bank system in exactly the same manner with scope for credit creation still being determined by the initial amount of cash in the system and the liquidity ratios held by the individual banks This process is known as multiple credit creation (ii) To control banks' credit creation ability the central bank must be able to control either directly or indirectly, the banks' liquidity position, upon which their ability to create credit is based There are several methods available The first relates to interest rates While the government, through the central bank, does not fix the rate of interest it will signal the direction and magnitude of change to the markets through its dealings with the discount houses High interest rates will reduce demand for credit from bank customers while at the same time making all bonds, including those issued by government, more attractive This is due to the inverse relationship between the rate of interest and the price of bonds In such circumstances the public will be encouraged to purchase bonds thereby drawing funds from their bank accounts As a result of this the banks' ability to create credit will be reduced, while demand will also fall in response to the high interest rate policy Secondly, there are open market operations This is where the central bank sells government securities on the open market The buyer will pay for these securities with cheques drawn on their commercial bank accounts The central bank will settle these claims against the commercial banks by deducting the appropriate amount from their operational deposits which they have to keep at the Bank This therefore reduces the commercial banks' cash reserves, and thus with less liquidity the banks must restrain their credit creation A further control upon credit creation relates to the size of the cash base established by the central bank, i.e., direct quantitative controls To ensure that a minimum amount of liquidity is retained by commercial banks they can be required to deposit, without interest, a percentage of their balances with the central bank, and these deposits, known as 'Special Deposits', cannot be counted for credit creation purposes Finally, the central bank can issue non-obligatory directives to the commercial banks to encourage them in the direction they would like their credit creation to follow © Emile Woolf International 164 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers CHAPTER 13 – BALANCE OF PAYMENTS AND TRADE 13.1 A BALANCE OF PAYMENTS DEFICIT (a) The balance of payments account records all the transactions between residents of the UK and residents of the rest of the world over a period of time There have been a number of changes in the presentation of the accounts in recent years and transactions are now divided into two main groups; current account and transactions in UK external assets and liabilities which are recorded in the financial account (formerly known as the capital account) The current account records all exports and imports of goods and services whereas the financial account records inflows and outflows of capital The account is drawn up using the double-entry method of bookkeeping and thus it must always balance However, at any moment in time any individual part of the account can be in deficit or surplus If the current account is in deficit it means that the country has spent more on imports than it has received from exports If the financial account is in deficit it means there has been a greater outflow of capital than inflow Generally speaking, a balance of payments deficit usually refers to a current account deficit which thus has to be balanced out by movements in capital in the financial account (b) A deficit on the current account of the balance of payments can be due to one or more factors Firstly, on the domestic front, the economy could be suffering from lower productivity and high rates of inflation than its trading partners which ultimately makes its goods and services uncompetitive in the international market place and thus exports are likely to fall Domestic consumers will, at the same time be increasing their spending on imports which will be relatively cheaper than home produced goods Secondly, a deficit on the current account can be due to an overvalued exchange rate If a country has higher rates of interest than others, this will encourage the inflow of capital funds The demand for the domestic currency will therefore rise and so, as exchange rates are determined by the supply and demand for a currency, the exchange rate will also rise As a result exports will become more expensive to foreign buyers and are therefore likely to fall, and vice versa for imports The current account will move into deficit if the demand for exports and imports is elastic Lastly, excess aggregate demand (AMD) in an economy can lead to a balance of payments deficit The demand for imports is, amongst other things, a function of national income, while demand for exports is dependent on other countries income If domestic AMD rises faster than in the economies of our trading partners, the likely result is an increase in the import bill compared to exports This will especially be the case if there is a high propensity to import This could be made worse if domestically produced goods for the export market are diverted to the home market to meet the increase in demand (c) The size and complexity of international trade makes it unlikely that the current account will be in balance at any period of time, it may be in deficit or it may be in surplus Either way the overall balance of payments account must balance so funds must be used accordingly Financing a deficit involves the use of funds from the financial account to offset deficits in the current account These funds include gold and foreign currency reserves; borrowing from overseas banks or the International Monetary Fund A country's borrowing power obviously is not infinite, and if the deficit persists measures must be taken to correct the situation rather than try to fund it continuously © Emile Woolf International 165 The Institute of Chartered Accountants of Pakistan Introduction to economics and finance Measures to correct a balance of payments deficit include deflationary policies designed to reduce AMD and hence expenditure, such as raising taxes or monetary tools such as raising interest rates The idea is that by reducing AMD in the economy, the demand for imports will fall and one components of the deficit will be corrected Furthermore, if the deflationary measures work on the domestic price level, goods and services will become more competitive on the international market leading to an increase in exports which again should help to correct the deficit Devaluation of a country's currency is another correcting measure This will have the effect of making goods and services cheaper in export markets while imports will become more expensive Providing that the elasticities of demand for both are price elastic it should result in an increase in exports and a reduction in imports In conclusion, financing measures must be seen merely as short term methods of dealing with balance of payments deficits Corrective measures must be used if the deficit becomes long-term 13.2 BALANCE OF PAYMENT AND BALANCE OF TRADE Balance of payment alance of payment is a record of a country’s international trade transactions and capital transactions with other countries during a given period of time Balance of trade alance of trade is a record of a country’s international trade transactions (import and export of goods) with other countries during a given period of time Remedies for an adverse balance of payments (i) Depreciation or devaluation of the home currency results in imports being costlier in terms of the home currency (ii) Increase in import tariffs results in increase in cost of imports (iii) Domestic deflation to reduce aggregate demand domestically so that the quantity of imported goods decreases (iv) Increase domestic interest rate to attract deposits from foreign countries (v) Introduction of import quotas to reduce the overall quantity of imports (vi) Exchange control regulations to restrict outflow of funds from the home country (vii) Introduce measures to boost exports so that there is an increase in flow of funds © Emile Woolf International 166 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 13.3 BALANCE OF PAYMENTS The following measures are usually taken to correct a disequilibrium in the Balance of Payments: (a) Depreciation or devaluation of the home currency which makes the imports costlier and uncompetitive, whereas exports become more competitive (b) Increase in import tariffs resulting in increase in cost of imports (c) Domestic deflation by reducing the supply of money and thereby aggregate domestic demand so that the quantity of imported goods decreases (d) Increase in domestic interest rate to attract deposits from foreign countries (e) Introduction of import quotas to reduce the overall quantity of imports (f) Exchange control regulations to restrict outflows of funds from the home country (g) Stimulating exports by providing subsidies and tax holidays to exportoriented industries 13.4 DISEQUILIBRIUM (a) Following are some causes of disequilibrium in balance of payment: Natural factors Natural calamities like drought or flood may easily cause disequilibrium in balance of payments These natural calamities can adversely affect agricultural and industrial production Exports may decline and imports may go up, causing a setback in the country’s balance of payment Trade cycles Business fluctuations caused by the operation of trade cycles may also result in dise uilibrium in country’s balance of payments For instance, if there occurs a recession in foreign countries, it may induce a fall in the exports and exchange earning of the country concerned, hence resulting in a disequilibrium in the balance of payments Political instability Political instability results in disrupting the productive potential within the country, thereby causing a decline in exports and an increase in imports Relatively high rate of inflation High rate of inflation as compared to other countries makes the goods produced by that country relatively expensive As a result, its exports decline and the balance of payment runs into a deficit Trade restrictions by other countries Sometimes other countries impose heavy custom duties or fix quotas or ban imports from a country It results in lower exports of that country Inelastic demand for machinery and industrial goods The demand for these goods by less developed countries is inelastic because these less developed countries have no choice since there is shortage of such goods in these countries and to increase their growth rate they are going to need such goods Hence their imports remain high © Emile Woolf International 167 The Institute of Chartered Accountants of Pakistan Introduction to economics and finance (b) The following measures are usually taken to correct a disequilibrium in the Balance of Payments: (i) Depreciation or devaluation of the home currency which makes the imports costlier and uncompetitive, whereas exports become more competitive (ii) Protectionist measures resulting in either partial restriction or complete ban on imports or increase in cost of imports (iii) Domestic deflation by reducing the supply of money and thereby aggregate domestic demand so that the quantity of imported goods decreases (iv) Increase in domestic interest rate to attract deposits from foreign countries (v) Import substitution to reduce the overall quantity of imports (vi) Exchange control regulations to restrict outflows of funds from the home country (vii) Stimulating exports by providing subsidies and tax holidays to exportoriented industries 13.5 BALANCE OF PAYMENTS: COMPONENTS (a) Trade in goods Items that include the import and export of finished goods, semi-finished goods, and component parts for assembly Trade in services These services include tourism, financial services and consultancy Investment income Overseas activity that leads to a flow of money back to the country For example, interest received from domestic investment, the activities of subsidiaries, and dividends earned from owning shares in foreign firms Transfers Items moved between countries such as overseas aid (b) (c) i Real foreign direct investment: a domestic firm setting up a factory in another country, and earning money from that ii Portfolio investment: a domestic investor buying shares in a business that is already established They have no control over these companies iii Financial derivatives: financial instruments where the underlying value is based on another asset iv Reserve assets: a Central Bank will use foreign financial assets to cover deficits and imbalances If there is a deficit, it is balanced by: Selling gold, or other financial reserves Borrowing from other Central Banks © Emile Woolf International 168 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 13.6 CURRENT ACCOUNT DEFICIT CAUSES (a) Running a deficit means that there is a net outflow of demand versus the income that comes into a country This can be thought of as a country “not paying their way” The current account isn’t re uired to balance, because the capital account can run a surplus As we have seen though, running a surplus is sometimes dependent on selling reserve assets, and other unsustainable means (b) There can be many factors across the economy that mean a current account deficit is likely to occur For example: High income elasticity of demand for imports: with strong consumer spending, the volume of imports will increase swiftly Long term decline in manufacturing potential: with a fall in the productive potential of an economy, it is less likely that goods can be produced and exported Changes in commodity prices: if a country imports a high portion of raw material, if these prices swing drastically, then this will increase the current account deficit Or any answer that eludes to more money being spent on imports, than being received on exports 13.7 CURRENT ACCOUNT DEFICIT NONMONETARY MEASURES (a) Tariffs are duties placed upon imports This directly increases the price of imports, making them less attractive to the domestic market (b) The domestic price (where domestic supply equals domestic demand) is higher than the world price (Wp) The level of imports is determined by the supply and demand for goods at different price levels At Wp, Qd – Qs must be imported With the addition of a tariff, the world price increases, and as such a smaller amount is needed to be imported (Qd1 – Qs1) This therefore improves the current account deficit © Emile Woolf International 169 The Institute of Chartered Accountants of Pakistan Introduction to economics and finance (c) 13.8 Quotas: a government may fix a permanent amount of a good that may be imported into a country Restricting the quantity decreases the level of imports, thereby improving the current account deficit Export promotion: a government can help exporters sell their goods and services on the international market through organising exhibitions and trade fairs, as well as striking diplomatic deals Import substitution: a country can reduce the level of imports that buy, by becoming more self-reliant and producing these goods and services domestically This can be done through providing specialist training, subsidies and tax assistance CURRENT ACCOUNT DEFICIT MONETARY MEASURES (a) More attractive (b) Rs.9: US$1 50% of = (6+3=9) Depreciates means more rupees per dollar (c) The J-curve is an interesting continuation of one of the main combative strategies to a current account deficit: exchange rate depreciation To recap, the logic behind depreciating the exchange rate is that exports will become relatively cheaper, whereas imports will become relatively more expensive Hence, it will redress the imbalance in the balance of payments However, the J-curve shows how in the short run, the deficit may get worse before improving This shows how, starting from Point A, the deficit increases before swinging up and going into a surplus as time goes on © Emile Woolf International 170 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Why is this the case? Assuming that economy starts at Point A, the government decides to devalue the currency The reason the deficit first gets bigger is to with a time lag Producers and consumers will take time to adjust to the change in currencies Producers, for example will have orders with firms in other countries at agreed prices, and not be able to respond to the price change Export revenues may therefore not rise immediately However import revenues may increase sharply due to high inelastic demand for foreign goods This would make the deficit greater After time, firms will be able to adjust to the favourable currency conditions, and export revenues should be seen to rise It should be said though, that a devalued currency will lead to higher import prices, and therefore have a contributory effect to inflation As this is usually a government’s macroeconomic priority, many will be wary of undertaking a policy that could so directly increase inflation 13.9 OPEN MARKET OPERATIONS Open market operations means the sale and purchase of government securities by the central bank in the open market (Inter-bank market) The purpose of open market operation is to maintain monetary stability In an inflationary situation the central bank sells the government securities and reduces the excessive money in circulation to reduce inflationary pressure In case of deflation, the central bank purchases government securities and increases the money supply to reduce deflation 13.10 CHANGE IN EXCHANGE RATES A rise in the exchange rate has the effect of making exports more expensive and imports cheaper Those firms dependent on price for sales in export markets will become less competitive and could lose market share Firms competing against imported goods will have to reduce prices to maintain competitiveness Firms importing raw materials or components may benefit from lower import prices, which serve to reduce their costs CHAPTER 14 – FINANCIAL MARKETS 14.1 USE OF MONEY AND CAPITAL MARKETS (a) The capital market and money markets are not places where financial instruments are traded but rather a process or set of institutions that organise and facilitate the buying and selling of capital instruments The money markets are a number of inter connected wholesale markets for short-term funds The major participants are the Bank of England, discount houses, the banks, local authorities, building societies and large companies These markets can be further sub-divided into the traditional or discount market and parallel markets The traditional market is where the Government, © Emile Woolf International 171 The Institute of Chartered Accountants of Pakistan Introduction to economics and finance through the Bank of England and the discount houses, buy and sell short term debt to the commercial banks and companies The parallel markets are used for firms and local authorities The capital market services the long term financial requirements of companies and the institutions which provide long term finance are The Stock Exchange, The Alternative Investment Market, The Over the Counter Market and the Venture Capital Market The Stock Exchange is essentially the market for the issued securities of public companies, government bonds, local authority and other publicly owned institution loam Without the ability to sell long-term securities easily, few people would be prepared to risk making their money available to businesses or public authorities (b) The money market is used by firms who need to borrow funds in the shortterm since payment and receipts very rarely coincide A company which is expanding may find bank overdraft, debtors and stock rising and the money market provides a service for firms who have inadequate working capital Creditors will also rise during this period so it may be necessary to extend trade credit in order to satisfy customer requirements Examples of money market instruments include loans and overdrafts, trade credit, hire purchase, leasing, bills of exchange and commercial paper The capital market is used by firms who need to borrow funds over the long term for investment purposes Where retained profit is inadequate long-term borrowing may be found although such a policy would have an adverse effect on the gearing ratio If the market thinks highly of a company, it will be easy to raise new capital through a rights issue via the Stock Exchange The Alternative Investment Market(AIM) is geared towards attracting young and fast growing businesses with the aim of promoting enterprise, innovation and employment The major provider of funds to this market are the pension funds and insurance companies (c) 14.2 Governments have been using the capital markets since 1694 when the Bank of England was set up Up until the end of the second world war it was primarily used to finance various wars However, since the Bank was nationalised in 1946, fiscal policy has played a much greater role in the regulation of economic activity and successive governments have deliberately run a budget deficit or surplus Depending on where we were on the trade cycle, the level of economic activity falls, unemployment rises leading to an increase in welfare payments and incomes and profit fall leading to a fall in government tax revenue Such a phase is likely to lead to an increase in the public sector borrowing requirement whereby the government through the Bank of England are forced to sell long term government securities known as bonds or gilts DERIVATIVES (a) An instrument whose price is dependent on one or more underlying asset(s) It is merely a contract between two parties Changes in the underlying asset(s) can cause great fluctuations in the price of the derivative Share: not a derivative An investor will see profits rise and fall in direct correlation with the share price Option: is a derivative Though there will be some correlation with the share price, the value of the derivative will still retain value even in if the share price falls © Emile Woolf International 172 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (b) Over the counter and through an Exchange: OTC vs ETD OTC derivatives The conditions for establishing and trading an OTC derivative are much less strict than exchange traded derivatives (ETDs) The issue and trade of each instrument is on an individual basis, meaning a financial intermediary (usually investment bank) will ‘make a market’ between buyers and sellers Benefits: greater flexibility with regard to the terms of the deal Drawbacks: the level of risk is much higher as counter parties can be affected if the trade loses a lot of money ETDs A derivative must meet certain strict criteria to be traded on an exchange There are variables (maturity length, credit rating etc) that can be controlled for to allow a derivative to be traded on an exchange Benefits: ETDs reduce the risk involved with a transaction by ensuring that whenever a party goes “long” (i.e will see reward if the underlying price increases) there is another party that is “short” The fact that these two positions are e ualled off (“net zero”) means the overall risk is reduced if the underlying price moves drastically Performing the trade through an official exchange also reduces the level of counterparty risk, as trades are done through a clearing house Drawbacks: reduces the quantity of derivative products that can be traded if they don’t meet the criteria 14.3 CAPITAL MARKETS (a) The main distinction between money and capital markets is the good that is traded Whereas in money markets it is short-term credit, in capital markets it is for longer term investments The capital market has instruments that have a maturity length of over a year, whereas money markets are less than this (b) The main types of organisation that operate in the markets are as follows: Corporations Commercial banks Stock exchanges Investors Nonbank institutions (insurance companies/ mortgage banks) Corporations mainly use capital markets to fund long term projects that they wish to undertake They use a commercial bank to deal with the mechanics of taking their offering to the market, which usually happens on a stock exchange It is then investors who, using commercial banks again, will purchase the instruments that are being sold (c) The sums of money necessary to trade on the capital markets means it is rarely possible for an individual investor can gain access However, it is possible to so through a mutual fund investment vehicle © Emile Woolf International 173 The Institute of Chartered Accountants of Pakistan Introduction to economics and finance This is where many investors pool their resources together to be invested in a variety of financial instruments that we have laid out above They are operated by professional money managers who have specialist knowledge of the money, and capital markets The investment objectives of each mutual fund are explained in the investment prospectus, and investors choose ones that best fits their profile The main advantage of a mutual fund is that it gives individual investors access to the market A mutual fund portfolio can be constructed to be diversified, and across a range of securities For an investor with a small amount of capital, this would be near impossible to replicate However, by becoming a shareholder in a mutual fund, the investor can participate in the gains or losses of the fund Each share in a mutual fund can often be sold or purchased at the Net Asset Value (NAV) of the fund 14.4 CAPITAL MARKET INSTRUMENTS (a) On the capital markets, there are a number of different instruments that can be bought or sold These broadly fit into two categories: debt and equity Debt is a corporation issuing an agreement to repay a certain sum at a later date, and equity is selling rights of ownership in the company (b) There are two different types of shares that are traded on stock exchanges, and they differ in their characteristics The two are: Common stock: An instrument issued by companies that can be obtained via the primary or secondary market Investment in the business means part-ownership of the company, and also rights and privileges – such as voting power, and the ability to hold a position An investor in debt is entitled to interest payments, the equity holder may or may not be paid dividend, depending on the company’s policy There is a high risk factor involved, as the price of the stock can fluctuate greatly Holders of the instrument rank at the bottom of the scale if the company were to go into liquidation Preference shares: An instrument issued by companies that rank higher than common stock in terms of scale of preference They possess the same characteristics as equity in that its value is based upon the share price fluctuating However it also acts similar to debt instrument, in that dividends are fixed, and the holder does not hold any voting rights The rates of return are formed on a much more individual basis, and there is more emphasis on the forces of supply and demand, rather than pegging to an official rate of interest (c) The way in which a government would utilise the capital markets is on the debt side, as they not have equity themselves that they can sell off The two main instruments that are available to them are: Debentures: A debt instrument where there is no physical asset used as collateral Instead, a government or firm’s creditworthiness is used by investors to adjudicate the risk involved © Emile Woolf International 174 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Bonds: An investor will buy debt from a government or corporation in exchange for a fixed return at various points of time, and then the principal (amount paid for it) There are two features that determine the price of a bond: credit quality and duration A longer held bond will have a higher interest rate returned, due to the time value of money A bond issued by a riskier institution will also yield a higher interest rate, as there is less of a chance that the amount can be paid back Sovereign bonds are also an acceptable answer The considerations for the government are: Rate of interest that needs to be paid to investors Length of time to pay back The risk factor of them not returning money to investors Alternative methods of raising capital (increasing taxes etc.) © Emile Woolf International 175 The Institute of Chartered Accountants of Pakistan Head Office-Karachi: Chartered Accountants Avenue, Clifton, Karachi-75600 Phone: (92-21) 99251636-39, UAN: 111-000-422, Fax: (92-21) 99251626, e-mail: info@icap.org.pk Regional Office-Lahore: 155-156, West Wood Colony, Thokar Niaz Baig, Raiwind Road, Lahore Phone: (92-42) 37515910-12, UAN: 111-000-422, e-mail: lahore@icap.org.pk Islamabad Office: Sector G-10/4, Mauve Area, Islamabad UAN: 111-000-422, Fax: (92-51) 9106095, e-mail: islamabad@icap.org.pk Faisalabad Office: 36-Z, Commerical Center, Near Mujahid, Hospital Madina Town, Faisalabad Phone: (92-41) 8531028, Fax: (92-41) 8503227, e-mail: faisalabad@icap.org.pk Multan Office: 3rd Floor, Parklane Tower, Officers’ Colony, Near Eid Gaah Chowk, Khanewal Road, Multan Phone: (92-61) 6510511-6510611, Fax: (92-61) 6510411, e-mail: multan@icap.org.pk Peshawar Office: House No 30, Old Jamrud Road, University Town, Peshawar Phone: (92-91) 5851648, Fax: (92-91) 5851649, e-mail: peshawar@icap.org.pk Gujranwala Office: 2nd Floor, Gujranwala Business Center, Opp Chamber of Commerce, Main G.T Road, Gujranwala Phone: (92-55) 3252710, e-mail: gujranwala@icap.org.pk Sukkur Office: Admin Block Sukkur IBA, Airport Road, Sukkur Phone: (92-71) 5806109, e-mail: sukkur@icap.org.pk Quetta Office: Civic Business Center, Hali Road, Quetta Cantt Phone: (92-81) 2865533, e-mail: quetta@icap.org.pk Mirpur AJK Office: Basic Health Unit (BHU) Building Sector D, New City Mirpur, Azad Jammu and Kashmir e-mail: mirpur@icap.org.pk 2015 INTRODUCTION TO ECONOMICS AND FINANCE QUESTION BANK ... Accounting and Finance Introduction to economics and finance I Index to Objective test and long-form questions and answers QUESTION PAGE ANSWER PAGE CHAPTER – ECONOMIC CONCEPTS 1.1 FACTORS OF DEMAND... in Accounting and Finance Introduction to economics and finance C Contents Page Question and Answers Index v Questions Section A Multiple choice questions Section B Objective test and long-form... in Accounting and Finance Introduction to economics and finance A Multiple choice questions CHAPTER – ECONOMIC CONCEPTS Which of the following is not a factor of production? A Land B Labour C