CA PRC-03

PRINCIPLES OF
ECONOMICS

STUDY TEXT +
• MULTIPLE CHOICE QUESTIONS
• CHAPTER WISE TEST (NEW)
• FILL IN THE BLANKS
• ICAP MODEL PAPER
• TRUE & FALSE
ALL RIGHTS RESERVED BY THE PUBLISHERS

6th Edition: April 2023

“THE ONE THING

THAT MATTERS IS THE
EFFORT”
 In the name of ALLAH, the Most Gracious, the Most Merciful.

TABLE OF CONTENTS:
Chapter Name Page no.

1 Fundamentals of Economics 1

2 Demand, Supply and Market Equilibrium 37

3 Elasticity of Demand and Supply 64

4 Firm Theory 93

5 National Income 137

6 National Income Determination 157

7 Consumption, saving and Investment 176

8 Multiplier and Accelerator 194

9 Growth, Public Finance and Taxes 211

10 Money 233

11 Inflation and Unemployment 255

12 Banks, Credit and Monetary policy 275

13 Balance of Payment and Trade 295

 ICAP MODEL PAPER

(1) Which of the following is a basic economic problem?

o Lower income and higher taxes
o Unemployment and inflation
o Unlimited wants and limited resources
o Balance of payment deficits and recession

(2) Smart phones have become the latest craze. Everyone wants to have the smart phone and
its sales are increasing. Therefore, the factory has increased production. This is an example
of:
o circular flow
o due process
o opportunity cost
o consumer sovereignty
(3) A price floor set above the market equilibrium price is likely to cause:
o An increase in price and an increase in the quantity traded
o Excess demand
o Excess supply
o A decrease in price and a decrease in the quantity traded
(4) Which of the following would most likely result in failure of price cartel under oligopoly?
o Non-availability of close substitutes
o Existence of control over supply
o Price elasticity of demand is elastic
o Presence of agreement on allotted quota of supply
(5) Which of the following would unambiguously occur when there is a simultaneous decrease
in demand and supply?
o An increase in equilibrium price
o A decrease in equilibrium price
o An increase in equilibrium quantity
o A decrease in equilibrium quantity

(6) Which of the following is NOT a feature of monopolistic competition?

o Freedom of entry and exit to the industry
o Downward sloping demand curve
o Identical products
o Many firms supplying the market

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(7) If the demand curve for a firm’s output is perfectly elastic, then the firm is:
o A monopolist
o Perfectly competitive
o An oligopolistic
o Monopolistically competitive
(8) Slow economic growth and high unemployment refers to:
o Stagflation
o Hyper inflation
o Wage spiral inflation
o Deflation
(9) Murad pays a tax of Rs. 100 on his income of Rs. 1000 while Sohail pays a tax of Rs. 200 on
his income of Rs. 800. Identify the tax system prevailing in the country.
o Progressive
o Regressive
o Proportional
o Equitable
(10) Which one is not part of country’s Gross Domestic Product?
o Salaries of school teacher
o Company profit
o Net income from abroad
o Investment expenditure
(11) Which of the following measures is likely to boost a country’s rate of economic growth?
o Reduction in subsidies
o Tax cuts
o Decrease in government spending
o Reduction in tax rebates
(12) Aggregate supply increases due to increase in:
o labour productivity
o consumer spending
o wage rate
o interest rates
(13) The basic concept which underlies the accelerator theory of investment is:
o investment depends on the level of savings
o investment is inversely related to the rate of interest
o investment is determined by the volume of commercial bank lending
o investment in an economy is a function of output
(14) A Pakistani resident makes an investment in a company resident in United States. This
transaction will be recorded in Pakistan as:
o credit in current account
o debit in current account
o credit in capital account
o debit in capital account
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(15) Which of the following instruments would be expected to give the lowest yield?
(Out of Syllabus)
o Sovereign bonds
o Corporate bonds
o Certificates of deposit
o Shares
(16) In an economy where demand for imports is price inelastic and demand for exports is
price elastic, an appreciation in the value of domestic currency would result in:
o increase in imports spending and decrease in exports revenue
o increase in exports revenue and decrease in imports spending
o increase in imports spending as well as exports revenue
o decrease in imports spending as well as exports revenue
(17) Which of the following is regarded as ‘Fiat money’?
o Gold
o Gold standard
o Credit card
o US dollar
(18) Which one of the following statements is NOT true for a planned economic system?
(Select TWO Options)
o Productive resources are state owned
o Full employment is possible
o Auto-adjusted price mechanism
o Less duplication of resources
(19) Which of the following features are more likely to be found in a free-market economy than
in a planned economy? (Select TWO Options)
o An even distribution of wealth
o An incentive to innovate
o Increase in competition among firms
o Production of goods for the benefit of the society as a whole
(20) Which of the following are held constant along the demand curve? (Select TWO Options)
o Income
o Consumer preference
o Quantity
o Price
(21) The supply curve would shift to the left when: (Select TWO Options)
o price of input goes up
o price of good goes down
o prices of substitute goods go down
o prices of complements go down

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(22) Which of the following may NOT be regarded as strength of a collusive oligopoly?
(Select TWO Options)
o demand curve is determinate
o production techniques and costs of all the firms are similar
o there are no barriers on entry of new firms
o Non-homogeneous products are produced by the firms
(23) Which one of the following assumptions does NOT confer to the law of demand?
(Select TWO Options)
o The prices are expected to decrease in future
o There is no change in the income of consumers
o The size of population is constantly increasing
o The prices of related goods are stable
(24) Which of the following are NOT regarded as the features of perfect competition?
(Select TWO Options)
o Free entry and exit of firms in the market
o Perfect factor mobility
o Production differentiation
o Firms are price makers
(25) Which of the following factors might cause an upward shift in the country’s consumption
function? (Select TWO Options)
o decrease in consumer confidence
o Increase in the value of real estate
o reduction in interest rates
o reduction in the supply of credit
(26) Which of the following is NOT part of public expenditure? (Select TWO Options)
o Transfer payments
o Investment by nationalized industries
o Capital spending of public companies
o national debt servicing
(27) Which TWO of the following constitute injection into the circular flow of income?
o Government expenditures on goods and services
o Investments by businesses
o The value of imports
o postponed consumption
(28) Which of the following normally happen in the recession phase of the business cycle?
(Select TWO Options)
o A rise in the rate of inflation
o A fall in the level of national output
o A rise in the level of unemployment
o A rise in the level of wages

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(29) Which of the following are correct? (Select TWO Options)
o People with low incomes have higher average propensity to spend
o A population with higher percentage of older people have higher average propensity
to save
o National income is said to be in an equilibrium when planned withdrawals from
circular flow of national income are equal to planned injections into circular flow of
national income
o People with high incomes have higher average propensity to spend
(30) Which one of the following statements is NOT true? (Select TWO Options)
o Low interest rates discourage saving
o High interest rates makes it less expensive to borrow
o High interest rates would result in lower disposable income
o Low interest rates encourage consumption
(31) Which one of the following is NOT a cause of cost push inflation? (Select TWO Options)
o Increase in the price of raw material
o Fall in interest rates
o Increase in firm’s profit margins
o Expectation of inflation in the near future
(32) Which of the following are the example of contractionary monetary policy?
(Select TWO Options)
o A decrease in reserve to be maintained with central bank
o Increase in short-term interest rates
o Increase in selling government securities
o A decrease in spending on infrastructure
(33) Which one of the following is NOT part of the country’s current account?
(Select TWO Options)
o Foreign portfolio investment
o Foreign direct investment flows
o Imports of services
o Unilateral transfers to other countries
(34) A devaluation of the currency will normally result in: (Select TWO Options)
o an increased level of economic activity
o a reduction in the current account deficit
o a reduction in the domestic cost of living
o a reduction in profit margins for domestic companies
(35) Which of the following do NOT depict the concept of J curve? (Select TWO Options)
o In long-run, export revenues remain unchanged
o In short-run, import costs increase sharply
o In short-run, the current account deficit gets worse before improving
o In long-run, low import prices contribute to reduce inflation

v
 NOTE for Writing Answer in Number form in Fill in the Blank:
Please note that following with only be considered for marking:
Rounded off number without comma (e.g 13670)
Negative numbers with minus (-) sign (e.g, -15410 )

(36) Following data relates to a country Ruritania which is capable of producing the following
combinations of consumer goods and capital goods with a given quantity of resources and
technology:

Consumer goods 140 120 100 70 0

Capital goods 0 60 80 100 120

Ruritania, after full utilization of its resources, is currently producing 70 units of consumer
goods. What would be the opportunity cost to Ruritania in terms of capital goods if it
decides to produce 50 more units of consumer goods would be units
of capital goods.

NOTE for Writing Answer in Word form in Fill in the Blank:

Please write your answer in lower case (Small letters) only) (e.g., “economics”)

(37) The cost that has been incurred and have also been booked as an expense are called
Cost of) production.

(38) Please write your answer in lower case (Small letters) only)

Price

P0

Q0 Quantity
The above diagram depicts the concept of

(39) Please write your answer in lower case (Small letters) only)

Costs are the cost that have already been incurred but are not
separately shown as an expense while calculating the total cost of production.

(40) If the demand equation for a good is Qd = 20 – P and the supply equation is
Qs = 6 + 1.5 P and the price is set equal to 2.4 above the equilibrium level, there will be
an excess supply of _________________ units

(41) The stage of business cycle, which eventually takes the economy into recession is
________________________.

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(42) Assume that marginal propensity to consume out of disposable income is 0.8 and the rate
of tax is 30% of total income. Under the simple Keynesian model, what would be the total
change in national income if government increases public spending by Rs. 150 million,
would be Rs. ______________________ million.

(43) Assume that in 2020 the nominal gross domestic product of a country is Rs. 500 billion
and the price index is 200. If the price index was 150 in 2013, the real gross domestic
product of the country in 2020 computed in terms of 2013 prices would be
Rs. ____________________ billion.

(44) Forwards, futures, options and swaps are some of the most common types of
___________________ instruments.
(Out of Syllabus)

(45) Please write your answer in lower case (Small letters) only)
BOP

Surplus
+Ve

Deficit
-Ve Time

The above diagram depicts the concept of________________________.

(46) Suppose in an economy, the average price level is 1.3, real value of national output is Rs.
230 billion and the quantity of money in circulation is Rs. 103 billion. The velocity of
circulation would be:_______________________

47) The most effective macroeconomic policy to increase output under fixed exchange rates
and perfect capital mobility would be an ____________________________ fiscal policy.

48) When the average cost is rising, marginal cost is higher than the average cost.
• True
• False

49) With the decrease in interest rate, individuals would be encouraged to consume more.
• True
• False

50) Increasing import duties by means of tariff is one of the monetary measures to overcome
current account deficit.
• True
• False
_______________________________

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 CH-01: FUNDAMENTALS OF ECONOMICS

CHAPTER-01

FUNDAMENTALS OF ECONOMICS

PART-01: DEFINITIONS, NATURE & BRANCHES OF ECONOMICS

1.1 DEFINITION OF ECONOMICS 2
1.2 CHOICE AND SCARCITY 3
1.3 NATURE OF ECONOMICS 4
1.4 BRANCHES OF ECONOMICS 5

PART-02: PRODUCTION, CONSUMPTION & FACTORS OF PRODUCTION:

2.1 FACTORS OF PRODUCTION 7
2.2 PRODUCTION WITH SPECIALINZATION AND DIVISION OF LABOUR 9
2.3 CAPITAL FORMATION 10
2.4 AGENTS/PARTICIPANTS OF AN ECONOMY 11

PART-03: GOODS, ITS TYPE & OPPORTUNITY COST

3.1 TYPES OF GOODS 12
3.2 OPPORTUNIOTY COST 13

PART-04: PRODUCTION POSSIBILITY FRONTIER/CURVE:

4.1PROPERTIES/CHARACTERISTIC OF PPC 16
4.2 ECONOMIC GROWTH/ SHIFT IN PPC 16

PART-05: ECONOMIC SYSTEM

5.1 MARKET ECONOMY/ CAPITALISM 17
5.2 PLANNED/ COMMAND ECONOMY/ SOCIALISM 18
5.3 MIXED ECONOMY 19
5.4 ISLAMIC ECONOMIC SYSTEM 21

PART-06: MULTIPLE CHOICE QUESTIONS & TEST-01

MCQ 25
TEST-01 36

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PART-01: DEFINITIONS, NATURE & BRANCHES OF ECONOMICS

SUBJECT MATTER OF ECONOMICS

Economics is known as mother of social sciences. History of the world is witnessing that man is
continuously striving to solve its major economic issues at individual and state level such as; health
care, illiteracy, poverty, inflation and unemployment.

1.1: DEFINITION OF ECONOMICS

Adam Smith (Classical Definition) – Science of Wealth

He is also known as the father of Economics, has explained it in his book “An Inquiry into nature
and causes of Wealth of Nations” in 1776. According to Smith (1776), economics deals with the
wealth of nations rather than human welfare.
He elaborated how wealth is produced, exchanged, distributed and used.
(i) Production of wealth means that the production of goods and services by combining four
factors of production such as; Land, Labor, Capital and Entrepreneur.

(ii) Exchange of wealth means every individual cannot produce all the goods and services he
needs, for this purpose he must depend upon the goods and services produced by others,
which is only possible with exchange of wealth.

(iii) Distribution of wealth elaborates distribution of generated wealth through combined efforts
of factors of production among those households who have provided them. The wealth which
firms or producers distribute, among factors of production, is termed as rewards of factors of
production.

(iv) Consumption of wealth is the ultimate objective behind its generation. People spend money
or wealth on different goods and services to satisfy wants.

Alfred Marshal (Neo-Classical Definition) – Science of Human welfare

He wrote in his book entitled “principles of Economics” in 1890 that
• Economics is a social science as it studies the people in their ordinary business (day to
day affairs) of life.
• Wealth is the central area of interest.
• Economics anxiously discuss about the welfare (wellbeing) of society

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Lionel Robbins (Modern Definition) – Science of Scarcity and Choice

In his book “nature and significance of economic science” (1932), said “Economics is the science
which studies human behaviour as a relationship between (multiple) ends and scarce (limited)
means (resources) which have alternative uses”.
• Multiple Ends states the ample wants of human beings (means wants are unlimited), the
human wants never came to an end which provide basis of basic economic problem.
• Scarcity of resources. resources to satisfy human needs/wants are insufficient.

Scarce resources can be used alternatively.

For instance, a piece of land can be used for cultivation or to build a factory or house. It’s up-to the
need and priority of humans that what way they want to utilize it.

1.2: SCARCITY & CHOICE

Basic Economic issue arises due to multiplicity of Ends and Scarcity of Means. Every economy
faces a constraint of human, capital and natural resources.

Unlimited Wants > limited Resources

Resources

Economics Resources Free Resources

Limited in Supply e.g. Unlimited in Nature

(Factors of Production) e.g. (Air, Sunlight)

Basic economic problems mean choosing (choice) how to allocate these scarce (limited)
resources to satisfy our needs and wants.

Three fundamental Basic Economic Questions:

(i) What to produce? It depends upon the needs of the society and the use of the available
resources in the most efficient manner
(e.g. either capital goods or consumer goods) (how much land should be allocated for crops
and how much for industry?)

(ii) How to produce? Involves the combination of scarce resources and technique to produce
goods and services
(e.g capital intensive or labour intensive), and

(iii) For whom to produce? Goods are being produced with intensions to sell them who have
ability to buy them. Who will be the potential buyers?

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1.3: NATURE OF ECONOMICS

What Is the nature of Economics? Economics

Science Art

Positive Science Normative Science

A Science or an Art?
Science:
Economics is a science because Science is a systematic study of knowledge and fact which develops
the correlation-ship between cause and effect. In science all the facts must be systematically
collected, classified, analysed, perform experiment and then make a general principle

(i) Positive science deals with factual questions, tested and accepted facts and to develop
some more required laws and principles. (Tells Real situation). It is one which is agreed by
everyone.
Example:
• earth is round and moving around the sun
• our brain passes orders to our body parts to act and react under some existing conditions.
(Tested fact)
• unemployment increases poverty and hurts living standard of the people
• inequitable distribution of income hurts and economic growth of a country in long run
etc.
(ii) Normative science discusses ‘what ought to be/ should be’. Normative science inquires,
offers suggestions to the problems (tells ideal situation). It also involves ethical precepts and
norms of fairness
For example
• pollution is increasing the global temperature, so it must be tackled
• Government should provide basic health care to all citizens; it is normative science.
• social unrest creates political and administrative challenges for state, that’s why it should
be manage in anticipation
• fast growth in population along income inequalities, creates many other social and
economic challenges, so high rate of population growth must be discouraged
• unemployment increases poverty and hurts living standards of the public, so government
should create job opportunities to prevent it

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 CH-01: FUNDAMENTALS OF ECONOMICS

An Art:
“Knowledge is science, action is art.” Art is the practical application of knowledge for achieving
particular goals. Science gives us principles of any discipline however; art turns all these principles
into reality
Example
For example, since someone gathering knowledge and facts through lectures and training about
driving a car is called science, while as he or she takes a drive on road is considered as art.

Conclusion:
In nutshell we can say that “economics is a science and an art as well,”

1.4: BRANCHES OF ECONOMICS

There are two branches of economics i.e., Microeconomics and Macroeconomics

Microeconomics:

Definition Microeconomics is derived from a Greek word “micro” meaning “small” or the
millionth part. This is the branch of economics that investigate the individual
behavior of households and firms and markets in their ordinary business of life
(decision making and allocation of scarce resources).
Factors • It helps in determining market equilibrium
• Market Demand and Supply
• Consumer theory
• Theory of Production
• Costs of Production etc.
Scope • Commodity Pricing: In microeconomics the prices of different goods and
services are determined by demand and supply forces.
• Factor Pricing: Factors of production such as, Land, labour, capital and
entrepreneur, are the core of any production process. Micro economics also
helps in determination of reward of FOP (rent, wages, interest and profit/loss)
which is termed as 'Price Theory’.
• Welfare Theory: Maximization of social welfare is bonded with the optimum
allocation of available economic resources
• Key economic questions; 'What to produce? How to produce? and for whom
to produce? are also discussed in microeconomics
Importance • Study of individual economic agents (Household, Firm etc)
• Allocation of scarce resource:
• Price determination: (With the help pf Price mechanism)
• Helps in formulating economic policies:

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 CH-01: FUNDAMENTALS OF ECONOMICS

(Microeconomics helps economists to instigate macroeconomic policies such as

sustainable growth, price stability, full employment, balance of payment and exchange
rate stability.)
• Assistance of Finance Minister:
(Taxes are the most important component of Public Finance of any country)
limitations • Narrow perspective. (Ignore the implications on whole economy)

• Inappropriate in major areas:

it is observed that while dealing with some crucial economic issues such as;
trade imbalances, for debts and inflation etc., microeconomics doesn’t provide
sufficient aid to solve them
Example:
Rising prices in chicken market does not mean inflation, because fall in prices of other
food and non-food items may overcome this effect and inflation will not occur.

• Weak assumption:
Economic laws often based on variety of assumptions or presumed pre-
conditions. these conditions are found unrealistic in real life individual’s
behavior does not represent the behavior of large segment of the society in
every case
Example:
• A decision may be useful for single unit not may not be useful for whole economy (e.g.,
saving decision).
• If households are facing employment issue in some particular area or in a particular
time period, it may be not reflected in overall unemployment in a macro scenario.

Macroeconomics:

Definition Macroeconomics is the branch of economics concerned with the overall

performance of the economy.
Factors • National Income
• Inflation and unemployment
• Rate of interest
• Public debts etc.
Scope • Economic Growth and Development: (evaluated in term of per capita real income)
• National Income Determination:
• Inflation and Employment:
• Balance of Payments and Trade: (Import and Export in a country)
• Macroeconomic Policies:
(Economic policies such as; Monetary policy, Fiscal policy, Commercial policy,
Exchange rate policy etc., are the preconditions of economic growth and development
of a country.)
Importance • Understanding of complex economic systems: (unemployment, BOP etc.)
• Helpful to achieve predetermine economic targets (sustainable economic
growth.)
• Price stability: (neither inflation nor deflation).

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 CH-01: FUNDAMENTALS OF ECONOMICS

• Balance of Payments:
• Helpful to address the macroeconomic issues:
(Poverty, unemployment, inflation, wage fluctuations, instability of financial markets
etc. Furthermore, it provides corrective measures for severe economic problems.)
Limitation • Excessive Generalization:
Macroeconomics focuses on aggregate rather than individuals. Sometime a
decision which is better for whole not be suitable for individuals

• Heterogeneity is ignored:
Macroeconomics takes the aggregate as homogenous (e.g aggregate demand),
ignoring the internal composition and the structure (individual demand)

• Analysis can be misleading

Aggregate sometime ignores the changes occurred in different sectors, which
can be misleading for economic policy derivation.
Example: In macroeconomic analysis shows a growth in agriculture sector if a good
harvest in rice crop has compensated a bad harvest of cotton.

PART-02: PRODUCTION, CONSUMPTION & FACTORS OF PRODUCTION:

Meaning of Production:
production can be defined as “the process that creates or adds value.”
Production means where the inputs (resources) are processed and transformed into outputs (good
and services).

Meaning of Consumption
the process by which consumers satisfy their want by consuming Goods and Services.

Factors of Production:
Also termed as “Input” or “Economic resource” It’s Include: Land, Labor, Capital and Enterprise.

2.1: FACTORS OF PRODUCTION

Factors of production are the resources (input factors) which are used to produce goods and services
These input factors include: Land, Labor, Capital and Enterprise.

• Human factors: Labor and Entrepreneur

• Non-human factors: Land and Capital

1) Land (N) (Natural Resources)

• All natural and GOD-gifted resources which are used to produce other goods and services are
known as Land, it includes;
• On, inside and outside earth such as; agriculture, minerals, water resources, sunlight and
wind power, mountains, deserts, climate, rain, etc.
• Land is a passive factor of production as it depends upon some other active factor i.e. labour
• Supply of Land is fixed (vertical) and immovable.

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2) Labour (L) (Human resources)

• Labor means physical and mental effort of human being which are used to produced goods
and services e.g. road breaking, mining, teaching, or counseling workers in a factory.
• Human Capital (Productivity of labor) can be enhanced by proper education, training,
division and specialization of labor.
• Labour is an active factor of production, perishable and cannot be stored.

3) Capital: (K) (Man-made resources)

Capital means man-made resources which are used to produce other goods and services. It
includes: machinery, equipment, factories, commercial buildings, hospitals, schools, roads,
railways, docks. Transportation network (roads, railways, airports etc.). Money is not a capital.

4) Enterprise/Entrepreneur (Human resources):

An individual or a group of people who combines all three factors of production, undertakes the
risk to earn profit.
Entrepreneurs create businesses and provide a return (reward) to the other factors of
production.

Rewards (or Income) of Factors of Production:

• Rent: is the reward against use of Land that are fixed in supply.
• Wages: is the reward against Labour for service rendered
• Interest: is the reward against use of Capital.
• Profit: is the reward for the entrepreneur for taking risk.”

Derived Demand:
Demand for factors of production is called derived demand. Producer demand for labour to
produce goods and services. The demand for labour is derived demand

Summary:

FOP Definition Reward Examples

Land GOD-gifted natural Rent agriculture, minerals, water resources,
resources,fixed sunlight and wind power, mountains,
deserts, climate, rain
Labour physical and mental effort of Wages road breaking, mining, teaching, or
human being counseling workers in a factory
Capital man-made resources Interest machinery, equipment, factories,
commercial buildings, hospitals, schools,
roads, railways, docks and MS Word
Entrepreneur Combining all three (FOP), take Profit Sole-Trader services, Shareholder’s
risk to earn profit services

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2.2: PRODUCTION WITH SPECIALINZATION AND DIVISION OF LABOUR:

Division of Labor:
Division of labour, refers to producing goods or services by dividing into a number of tasks that are
carried out by different workers, rather being done by an individual.

Stages involve in Garment Factory: (Cutting section, stitching section, ironing and wrapping, marketing etc.)
Stages involve in small scale Pen maker: (melting of plastic, molding, refilling, and packaging)
Stages involve in large scale Automobile: (assembling, painting, electric work and air-condition system)

Specialization of Labour:
Specialization occurs when workers use specialised skills and knowledge for completing specific
assigned tasks.

Benefits of Specialization:

• Specialization and division of labor:

Division of labour leads to specialization. This refers to dividing the production into a number of
specialised tasks and assigning each task to a particular set of labour. Establishing division of
labour allows people to do specified tasks they are good at rather than doing everything in a
mediocre way as famous saying “A jack of all trades is master of none”.

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• Learning by doing:
Specialisation increase productivity, efficiency levels, reduces average costs and firms benefit
from the economies of scale.
• Saving of time:
It reduces the time required for production. Specialization makes labor highly skilled and
increased efficiency rate. Also, specialisation promotes invention
• Specialization in regional and international contexts:
Some countries have comparative advantages in production.
For example, Pakistan has advantages over other countries in the region in production of
cotton due to fertile soil, climate conditions and rainfall required for this crop. Pakistan should
get specialized in production of cotton rather utilizing its economic resources in multiple crops

2.3: CAPITAL FORMATION:

• Capital formation is the net capital accumulation and refers to the increase in the stocks of
capital in the country over a long period of time.
• current consumption is sacrificed for accumulation of capital goods.
• Capital goods include machines, plants, tools, factories, transport equipment, materials,
electricity, etc.

Stages involved in the process of capital formation:

(i) Creation of savings:

Savings are done by the Individuals or households. People save money by not spending all their
income. The level of savings in a country depends:
• Low present consumption
• More Power and will to save
• High Average level of income
• High Distribution of National income

(ii) Mobilization of savings:

• Transfer of savings from the households to businesses for investment.
• Savings are mobilized through Capital Market.
• Development of capital market is necessary for the increase in rate of capital formation.
• In the Capital market funds are supplied by the individual investors, banks and financial
organizations, insurance companies and government etc.

(iii) Investment of savings:

• Investment of savings in real capital is integral for the capital formation.
• This can only happen if there are enough entrepreneurial ventures and businesses that are
willing to take risks and embrace uncertainty

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2.4: AGENTS/PARTICIPANTS OF AN ECONOMY:

Definition of Agent:
An actor or decision-maker within an economic model.

Types of Agents:
There are four types of agents:

(i) Households: (Consumer, consumption units)

The collective group of individuals who are not only consuming goods and services, but also
providing labour for firms.

Economic Problem:
They allocate scarce income between different goods and services to satisfy their needs.
.
(ii) Firm: (producer, production unit)
The collective group of organizations producing goods and services in an economy.

Economic Problem:
Allocating scarce factors of production (labor, equipment, raw materials) between different
potential products to increase its profits.

(iii) Government: (State)

Also known as “the state”, the organisation that governs over society through a combination
of customs, exercises and laws. Allocating its resources (tax revenue, staff etc.) between
different social needs.

Economic Problem:
Allocating its resources (tax revenue, staff etc.) between different social needs.

(iv) Foreign Traders: (Importers and Exporters)

The collective group who exchanges goods and services between different economies.

PART-03: GOODS, ITS TYPE & OPPORTUNITY COST

Goods are tangible items that satisfy human needs or wants and provide utility. It is directly
consumed by the consumers e.g (All final goods) i.e car, mobile phone, Apple etc.
• Durable goods (that can be used for a longer period of time) e.g. automobiles, furniture and
other household equipment;
• Non-durable goods/Perishable goods (that cannot be used for a longer period of time) e.g.
food, clothing; and
• Services are intangible. E.g. Building work, teaching, transport, medical care, entertainment
etc.

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3.1: TYPES OF GOODS:

On the basis of Income

1) Normal goods:
• Normal goods are those whose demand increases as the income increases such as
milk.
• For normal goods the “income elasticity demand (YED)” is positive. Most of the
goods come under this category

2) Inferior goods:
• Inferior goods are those whose demand decreases as the income increases.
• With the increase in income people tend to move from inferior goods to normal goods.
• The “income elasticity demand (YED)” in case of inferior goods is negative.
• e.g. Inexpensive food, frozen food, long route bus tickets, reconditioned cars, public
transport, second-hand products etc.

3) Superior/Luxury goods:
• Superior goods are those goods whose demand increase more than as the income of
consumer increases
• Income elasticity of demand is positive and greater than 1.
• e.g. a luxury car and Gold ornaments.

Summary:
Goods Income Elasticity of Demand Example
Normal Good Positive Milk, Fresh vegetables
Inferior Good Negative Frozen vegetable, 2nd hand good
Superior Good Greater than 1 luxury car, Gold

On the basis of Consumption

1. Merit Goods: Goods which are socially desirable, create positive externalities in society
(beneficial for society). Examples include Education, Health, Parks.

2. Demerit Goods: Goods which are socially undesirable, create negative externalities
(harmful for society). Examples include Cigarette, Alcohol, drugs etc.

3. Private goods: These are the goods that can be provided separately to different persons with
no costs to be borne by others. It has:
• Rivalry (consumption by one consumer prevents simultaneous consumption by other
consumers), and
• Excludability (Exclude consumers who do not have purchasing power.).
Example: personal mobile, house, bike, Bread etc.

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4. Public goods: are readily available to all the people in a society. It has:
• Non-rivalry (consumption of a good by one person does not reduce the amount
available for others), and
• Non-excludability (cannot exclude a certain person from using such goods).

Examples include National Defense System, High-ways, Street-lights, emergency services etc.

5. Club Goods: are non-rival but excludable till a point where congestion occur. Examples
include Golf clubs, Cinema, social media etc.

Summary:
Goods Characteristic Example
Merit Good Socially desirable, welfare, positive Education, Health,
externalities Parks
Demerit Good Socially undesirable, harmful, negative Cigarette, Alcohol,
externalities drugs

Goods Characteristic Example

Private Good Rivalry Excludability mobile, house, bike, Bread
Public Good Non-Rivalry Non-Excludability National Defense System, High-
ways, Street-lights, emergency
services
Club Good Non-Rivalry Excludability Cinema, social media

3.2: OPPORTUNITY COST

Definition:
The opportunity cost is the value (benefit) of the next best alternative (good or service) foregone.

Examples:
• For students:
sleeping an extra hour or outing with friends is the opportunity cost of attending the lecture.
• For Firm:
The option between different techniques of production is also determined on the basis of
opportunity cost. The revenue foregone by using productive resources to supply good A
rather than using them to supply good B.
• For a government:
The social needs forgone by using resources to provide service A (e.g., education) rather than
service B (e.g., health).

In nutshell, we can say that all economic decisions have their opportunity costs. Production possibility
Frontier is the most appropriate way to explain opportunity cost.

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PART-04: PRODUCTION POSSIBILITY FRONTIER/CURVE:

Definition:

A Production Possibility Frontier/Curve (PPF or PPC) shows different combinations of two goods
that an economy can produce efficiently by using scarce resources with the given technology.

To elucidate the production possibility curve or frontier, we must understand some key concepts;
• Trade-off: To get something we must forgo something else as resources are limited.
• Choices: To grow more of wheat a farmer must sacrifice some of rice as piece of land is
limited.
• Efficient and inefficient use:
Efficiency states that the maximum attainable combinations a society is achieving.
In-efficiency termed as the underutilization of resources due to different macro-economic
affairs such as; any pandemic like COVID-19 when people stop spending on consumer goods
and capital goods, builders stop building more houses etc.
• Growth: Increasing ability to produce more goods and services in an economy over time,
through inventions, innovations, discoveries etc.
• Increasing opportunity cost: Law of diminishing returns increases the opportunity cost by
continuous switching of resources to some other uses.
 Formula
The opportunity cost of X commodity in terms of units of Y given up can be written
𝒀𝟐−𝒀𝟏
as Opportunity Cost: 𝑿𝟐−𝑿𝟏

Assumptions:
To illustrate production possibility frontier in a complex economy is not possible without
simplifying the model through some core assumptions.
• Efficient use of resources: It is assumed that economic resources are used efficiently
• Full employment: It is assumed that all available economic resources are fully employed.
• Input resources are fixed: It is further assumed that economic resources are given and
fixed. The change in quantity and quality of input resources is not possible.
• Two goods model: It is assumed that society’s resources are deployed to produce only TWO
goods like, Capital goods and Consumer goods
• Constant state of technology: It is further assumed that techniques of production remain
unchanged during production process.

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Schedule/Table/Numerical Example:

Possibilities Capital Good Consumer Good

A 0 100
B 1 90
C 2 70
D 3 40
E 4 0

100
A
B
Diagram and Explanation: 90

80
Consumer Good

C
70 H
60

50
D
40
G
30

20

10
E

0 1 2 3 4 PPF0
Capital Good

Point on the PPC: (Efficiency):

PPF shows concept of Economic Efficiency. Each point on PPF shows production which is obtained
by using all resources efficiently.
The curve indicates that the economy can (choose) a number of combinations such as (Point C) 2
units of capital goods and 70 units of consumer goods and so on.
Every choice on PPC has an Opportunity Cost e.g., if option D is selected instead of option C,
opportunity cost of producing 1 more unit of capital goods will be 30 lost units of consumer goods.

Point (G) below the PPC: (Inefficiency):

Any point below the curve indicates that the economy has not produced efficiently. At this point
economy can produced one good without sacrificing the other.

Point (H) above the PPC: (Scarcity/unattainable):

Points outside the frontier are unattainable because of scarcity of resources, but it can be achieved
in long run with some Assumptions.

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4.1: PROPERTIES/CHARACTERISTIC OF PPC:

1. Downward sloping left to right: This implies the trade-off between two goods due to
constraint of input resources.

2. Concave to the origin:

It implies an increase in slope of PPF, as the opportunity cost of producing more of one
product increases due to two reasons:
(i) Law of diminishing returns and,
(ii) Some resources are not compatible for some goods, by switching resources from
compatible goods to non-compatibles, more of one product has to forgo to get a little
of other good.

Example: Land A is more fertile for rice crops and land B is for cotton. By switching land,
A from rice crop to cotton, we will get little of cotton by sacrificing much of rice crop.

4.2: Economic Growth/ Shift in PPC:

During the phase of economic growth of a country, it experiences expansion in its productive
potentials. For example, human resources (doctors, engineers, charted accountants and skilled
entrepreneurial etc.). Such investments enable the agents of an economy to produce more goods and
services than before.

PPC can shift outwards under following conditions:

• when there is an increase in resources available to the economy
• when there is an increase in quality and quantity of labor
• when there is technological progress

100
A
B
90

80
Consumer Good

C H
70

60

50
D
40
G
30

20

10
E

0 1 2 3 4 PPF0
Capital Good

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PART-05: ECONOMIC SYSTEM

An economic system is a system which resolves the basic economic problem by making three
resource allocation decisions i.e. what to produce, how to produce, and for whom to produce.

There are three economic systems:

Type of Economic System Depiction Countries

Free market/ Market All economic decisions are Canada, Chile, Germany, Japan,
Economy/Capitalism (or taken by the free-market forces South Korea
laissez-faire) economy
Command/Planned (or All economic decisions are North Korea, Cuba, Finland,
Socialism) economy taken by a central planning
body (Government)
Mixed economy Combination of market forces Sweden, France, United Kingdom,
and central planning United States, China, Netherland

5.1: MARKET ECONOMY/ CAPITALISM

According to Prof. Loucks “Capitalism is a system of economic organization featured by the private
ownership and the use for private profit of man-made and nature-made capital”.

What is a market economy?

In a market economy, the decisions and choices about allocation of resources are usually taken by
individuals and firms through market forces (Demand and Supply) without intervention of
government (called price mechanism or market mechanism)
Government’s role is restricted to legislation, foreign affairs, peace and security, and currency
issuance

Features
• Laissez Faire/ (hand-off) Approach means (leave alone)
• Price Mechanism: Prices are determined through price mechanism
• Environment of Competitions: In urge of monetary returns every firm tries to exercise all
those steps which others cannot.
• Freedom of Enterprise: Everyone is free to choose profession of his own choice.
• Right of Private Property: Private ownership of factors of production.
• Self Interest: Economic decisions are based on self-interest and profit motives.
(Entrepreneur for maximum profit, landlords for maximum rent/price, Labour for maximum
wages, Consumer for maximum utility)

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Benefits/Merits:
(i) Consumer’s sovereignty: (Freedom of choice for consumers)
(ii) Unhindered price mechanism: (Auto-adjusted price/market mechanism)
(iii) Incentives for agents of economy: (Freedom of entrepreneur and an incentive to innovate)
(iv) Capital accumulation: (By making new investments in the economy the overall capital stock
of the country increases)

Drawbacks/Disadvantages:
(i) Imprudent competition: (Unproductive expenditures on packaging, advertisement and other
marketing tactics to eradicate competitors from the market)
(ii) Threat of economic instability: (Danger of emphasis on luxuries rather than necessitates to
maximize their profits)
(iii) Economic inequalities: (firms maximize their profits at the cost of consumer surplus
(artificial shortage) which enlarge the gap between richer and poorer.)
(iv) Human welfare is a myth: (High prices by creating artificial shortage, exploitation of weak
economic agents, negative externalities etc., compromise the human welfare.)
(v) Cartels and monopolies: (Influential producers restrict entry of the weak and small producer
and enjoy as monopolists. concentration of economic power remains in few hands.
(vi) No provision of public good or social security.

5.2: PLANNED/ COMMAND ECONOMY/ SOCIALISM

Definition:
In a planned economy/ Socialism, the decisions and choices about allocation of resources are made
by the government rather than market.

Features:
• Resources are state-owned.
• A central planning body decides what to produce, how to produce and for whom to produce.
• government determines the prices of factors of production (FOP) and all goods and services.
• Government produces for the entire economy through an administrative process.

Benefits/Merits:
(i) Efficient use of resources: (Less duplication and waste of resources.). Comparative to
capitalism, socialism shows greater efficiency regarding the use of resources.
(ii) Prevention from price discrimination: (prevents from monopolistic practices.)
(iii) Social security: State makes sure the protection of the social rights of the public such as; job
security, life threats and medical care etc.
(iv) Discouragement of monopolistic practice:
(v) Economic stability: (Permits long term industrial and social planning fostering economic
stability.)
(vi) Full employment of the workforce is possible.
(vii) Promotes equal distribution of wealth.

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Drawbacks/Disadvantages:
(i) No care of transparency: (Assignment of most important economic activities may be based
on nepotism rather than on merit and skills)
(ii) Bureaucratic issues: (they do not have an urge to work efficiently which keep the pace of
economic development slow.)
(iii) Incentive less: (pre-defined tenure system of promotion makes them sluggish as do not have
incentive to work hard)
(iv) Loss of consumer sovereignty: (i.e., power to determine what goods and services should be
produced hold by the government)
(v) Less economic freedom: (Through rules and regulations e.g. people remain unable to choose
occupation of their interest.)
(vi) Lack of profit motive and competition makes the economy inefficient
(vii) Likelihood of corruption.

5.3: MIXED ECONOMY:

Definition:
According to Prof. Samuelson, “Mixed economy is that economy in which both public and private
sectors cooperate.”

In simple words we can say: “Mixed economy is a system in which both government and private
individuals share the economic control.”

Types of Mixed Economy:

The mixed economy may be classified in two categories:
• Capitalistic Mixed Economy: It is also called as capitalistically dominating mixed economic
system. This is most popular and workable type of mixed economy where ownership of
private sector remains responsible for utilization of various factors of production, while
government does not interfere in any mode. Government is mainly responsible to ensure
sustainable economic growth without concentration of economic power in the few hands.

• Socialistic Mixed Economy: We can say that in such system the government dominates the
major economic decisions. Under this system government largely shares means of production
while primary economic decisions are taken through controlled market forces. In such
economic system numerous basic and strategic industries are owned by the state and their
operation and management is done through centrally planned bodies.

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Features of Mixed Economy:

1) Co-existence of Private and Public Sector:

2) Personal Freedom:
Freedom of choice regarding economic decision is most prominent feature of mixed economy.
Although government has some controls over economic resources

3) Pricing system
Government control prices through Price monitoring and price fixation (Regulated price)
To avoid monopolies that may exploit consumers by charging high prices.

4) Social Welfare:
(Government protect weak agents of the economy through laws like, minimum wage rate,
support price and labor law etc.

5) Discouragement of economic Inequalities:

(Through taxation and subsidies) e.g. old age allowances, life time medical facilities and need
based scholarships etc

Advantages of Mixed Economic System

• Fair distribution of goods and services especially of public interest.
• It ensures the distribution of rewards on fair basis as government has sound regulations
about it. That means customers will get the best value for what they have spent money.
• Private property rights ensure the automatic allocation of capital resources to the most
innovative and efficient producers which stimulates the capital formation in the country.
• The dominating role of government also makes sure the care of weak agent of the economy
which get exploited under free market mechanism.

Disadvantages of A Mixed Economy

• lack of cooperation between public and private sector.
• Dominating role of government in economic affairs may create inefficiencies due to
bureaucratic controls
• As government has foremost role in business affairs of the country, therefore, sometimes
state regulations and requirements may cause a burden by increasing cost of doing business
for firms

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5.4: ISLAMIC ECONOMIC SYSTEM:

Islamic economic system is constructed on the basis of fundamental principles of Islam which take
guidance from Quran and Sun’nah.

Features of Islamic Economic System:

A number of features in the Islamic economic system will be shared with those of a mixed economy

1) ALLAH is the sustainer:

ALLAH created all the resources and He is responsible for feeding and nourishing all the
creatures and human beings. Islamic economics encourages people to do their best to earn a
livelihood using all lawful (Halal) and fair means.
AL-QURAAN:
Say, “He is Allah, [who is] One, Allah, the Eternal Refuge. He neither begets nor is born, nor is
there to Him any equivalent.” (112: 1-4)

2) ALLAH is the true owner of everything:

Man is merely a trustee of resources and has authority for using them in fair support of his
existence.

AL-QURAAN:
“And to Allah belongs whatever is in the heavens and whatever is on the earth” (3: 180)

3) State ownership:
There is no ban on the state owning an enterprise. However, a free market still exists
where entrepreneurs can profit so long as they abide by the other rules of the Islamic economic
system

4) Practicing of moderation:
Islam focuses on a fair distribution of resources thus population is instructed to share wealth in
middle way.
AL-QURAAN:
“Whatever you lend out in usury to gain value through other people’s wealth will not increase
in God’s eyes, but whatever you give in charity, in your desire for God’s approval, will earn
multiple rewards.” [30:39]

5) Prohibition of charging interest (Riba):

It is forbidden for a lending party to earn interest from a transaction without taking any risk.
Both parties must do business on risk and reward basis.
AL-QURAAN:

“… Allah has allowed trade and has forbidden riba…” [2:275]

“You who believe, beware of God: give up any outstanding dues from riba, if you are true
believers. If you do not, then be warned of war from God and His Messenger.” [2:278-279

“You who believe, do not consume riba, doubled and redoubled. Be mindful of God so that you
may prosper.” [3:130].

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6) Earnings: Earnings must only be made from goods which are allowed in Islamic teachings.

AL-QURAAN:
“O you mankind! Eat of what is on earth, lawful and good; and do not follow the footsteps of the
devil, for he is to you an avowed enemy.” (Qur’ān 2:168)

7) Hoarding of wealth is discouraged:

Islam encourages distribution and discourages hoarding of wealth. Resources should be utilized
for a good cause rather than remaining in private possession.
AL-QURAAN:
“And let those who hoard gold and silver and do not spend them in the way of Allah know that
a severe and painful punishment is awaiting them.” [At-Tauba: 34]

8) Zakat:
Zakat is a financial tax on wealthy people to help poor. It ensures equal distribution of wealth
AL-QURAAN:
“And establish prayer and give zakat, and whatever good you put forward for yourselves – you
will find it with Allah.” (2:110, Qur’an)
“Of their goods, take zakat, so that you might purify and sanctify them.” (9:103, Qur’an)

Note:
The Reference of AL-QURAAN is given only for your Islamic Economic knowledge, it’s not
Examinable.

Comparison of Islamic Economic System and Capitalist Economic System:

Capitalism Islamic system

Distribution of wealth
Full economic liberty and private ownership Fair and equal distribution aimed at balancing
resulting in significant disparities and the distribution of economic resources. Uses
concentrated wealth accumulation. mechanisms such as zakat, sadaqat and bequest
to help re-distribute wealth.
Exploitation
Exploitation of the weak agents through It helps to minimise human exploitation
relatively unlimited authority for economic through prohibition of activities such as usury,
freedom and unhindered private ownership is gambling, speculation and taking interest from
a common practice in capitalism. perceived weaker classes.

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Institutions of interest
Large banking institutions facilitate access to Concept of interest is effectively eradicated by
capital through intermediation and justify introducing legitimate mode of financing such
interest as service charges. as murbaha and musharikah etc.
Monopoly
In capitalism this an accepted reality that firms Public-interest businesses are generally
through cartelisation and other deterrents maintained under joint ownership of the
enjoy high profit on the cost of weak agents of community with direct government
an economy. intervention to prevent such monopolistic
exercises.
Right to ownership
Unrestricted right for private ownership of To prevent concentration of wealth in few
property. This leads to wealth accumulation hands and economic equalities Islamic system
and imbalanced distribution of wealth in supports nationalization of privately owned
society. organization.

Economic freedom
In capitalism firms enjoy unconstrained Economic freedom and profit motive are
economic freedom regarding production and acceptable to a certain extent subject to the
distribution of goods and services to maximize concepts of halal (legitimate) and haram
their profits in any way. (forbidden being unlawful).

Sharia Law:

Sharia law is the branch of statute that formalizes the previously discussed principles of Islamic
economics into law. It is derived from Quran and Sunnah. For example, under Sharia Islamic law:

➢ Making money from money – e.g., charging interest – is usury and therefore not permitted
➢ Wealth should only be generated through legitimate investment in assets and legitimate
trade
➢ Investment in companies involved with gambling, tobacco, and alcohol is prohibited
➢ Short selling and non-asset backed derivatives are not permitted

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Islamic Financing:

There are now a range of products freely available on the global financial markets that comply with
Sharia Islamic law. These include:
• bank current accounts
• mortgages
• personal loans.

Islamic financial model works on the basis of sharing risk

1. Mudaraba:
This is where a financial expert offers specialist investment in which the customer and bank share
profits (a kind of partnership)

2. Musharaka:
This is an investment partnership with profit sharing terms agreed in advance and losses limited
to the initial capital invested. (a kind of partnership)

3. Murabaḥa:
This is a form of credit that enables customers following Islamic principles to make a purchase
without the need to take out an interest-bearing loan. The substance of the transaction is that the
bank buys an item then sells it to the customer on a deferred basis

Murabaha is a sale transaction where the seller discloses the cost and profit to the buyer at the time of
execution of sale. Murabaha is a short-term Islamic facility for meeting asset based working capital
requirement of customers where instead of providing a loan, Meezan Bank sells the required asset to the
customer on spot or deferred basis (Source: Meezan Bank)

4. Ijara:
This is a leasing agreement whereby the bank buys an item for a customer then leases it back to
them over an agreed time period. The bank makes a fair profit by charging rent on the property.

5. Ijara–wa–iqtina
Similar to Ijara but the customer is able to buy the item at the end of the contract

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MULTIPLE CHOICE QUESTIONS

1.1) Economics is best defined as the study of

(a) financial decision-making.
(b) how consumers make purchasing decisions.
(c) choices made by people faced with scarcity.
(d) inflation, unemployment, and economic growth

1.2) Scarcity can best be defined as a situation in which

(a) there are no buyers willing to purchase what sellers have produced.
(b) there are not enough goods to satisfy all of the buyers' demand.
(c) the resources we use to produce goods and services are limited.
(d) there is more than enough money to satisfy consumers' wants

1.3) Because resources are limited

(a) only the very wealthy can get everything they want.
(b) firms will be forced out of business.
(c) the availability of goods will be limited but the availability of services will not.
(d) people must make choices

1.4) “Economics is a science which studies human behaviour as a relationship between _______________________
means which have alternative uses”.
(a) ends and wealth (b) ends and scarce
(c) resource and wealth (d) income and scarce

1.5) Which of the following is a basic economic problem?

(a) Lower incomes and higher taxes (b) Unemployment and inflation
(c) Unlimited wants and scarce resources (d) Balance of payment deficits and recession

1.6) Which of the following is a question answered with positive economic analysis?
(a) Should the college reduce tuition for out-of-state residents?
(b) Should the college charge higher tuition for part-time students?
(c) If the college increased its eligibility requirements for enrollment, will class sizes decline?
(d) Should the college eliminate its athletic program to cut its costs?

1.7) Name of Book of Lionel Robbins is:

(a) Wealth of National
(b) An Essay on Nature and significance of (1932) Economic Sciences
(c) Principles of Economics (1990)
(d) None of above

1.8) __________ economics involves ethical precepts and norms of fairness

(a) Normative (b) Positive
(c) Applied (d) All of above

1.9) Which of the following statements is NOT true?

(a) Ceteris paribus means other things remaining same
(b) One of the economic goals is to maintain price stability
(c) Normative aspect of economics deals with factual questions
(d) Agent is a decision maker within an economic model
1.10) Which of the following statements relate to normative aspect of economics?

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(a) Government should provide basic health care to all citizens

(b) Government provided health care increases public expenditures
(c) Economists are paid more than the accountants
(d) Technology has the great impact on productivity

1.11) Normative economics not only study the economic facts but also put its judgements like, what ought
to be
a) Ture
b) False

1.12) What must be true of a positive statement:

(a) It is one that can be shown the correct or incorrect
(b) It is one that deals with positive changes in economic well being
(c) It is one that is true by definition
(d) It is one which agreed by everyone

1.13) In economics we know a fact that unemployment increases poverty and hurts living standard of the
people, it is said:
(a) Normative Economics (b) Positive Economics
(c) Economics Is an Art (d) Modern Economy

1.14) ___________ Economics not only highlights the economic problems but also suggest solutions.
(a) Normative Economics (b) Positive Economics
(c) Economics Is an Art (d) Modern Economy

1.15) A boat owner employs a crew to catch fish to sell on the market. Which factors of production are
involved in this activity?
(a) labour, capital and enterprise only
(b) labour and enterprise only
(c) land, labour and capital only
(d) land, labour, capital and enterprise

1.16) Which of the following is a measure of income earned by a factor of production?

(a) Indirect taxes (b) Depreciation
(c) Rent (d) corporate taxes

1.17) Which one of the following is NOT a basic question of economic?

(a) What will be produced? (b) Who will produce it?
(c) For whom will it be produced? (d) How will it be produced?

1.18) Economic growth in an industrial society results from:

(a) Technological change (b) Capital production
(c) Innovation (d) All of the above
1.19) Micro economics does NOT cover:
(a) consumer behaviour (b) factor pricing
(c) general price level (d) product pricing

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1.20) Which of the following is NOT associated with macroeconomics?

(a) Study of collective decisions by households or producers.
(b) The role of the State Bank in regulating the money supply.
(c) The economic behaviour of buyers and sellers in particular markets.
(d) Study of issues such as unemployment, inflation, economic growth, etc

1.21) Which of the following is not an issue in macroeconomics?

(a) issues relating to balance of payment
(b) determination of prices in the agricultural sector
(c) relationship between inflation and unemployment
(d) possible effect of a budget deficit on the level of investment

1.22) Which of the following topics are studied in Macro Economics?

(a) Theory of Demand (b) Aggregate Demand and Aggregate Supply
(c) Equilibrium of Industry (d) None of the above

1.23) ________________________________deals with the behaviour of the individual agents of an economy such as;
households, firms, and employees.
a) Microeconomics
b) Macroeconomics

1.24) Microeconomic study doesn’t cover

(a) Consumer Theory (b) Theory Of Firm Behaviour
(c) Theory Of Unemployment (d) Theory Of Market Equilibrium

1.25) What macroeconomics doesn’t cover?

(a) Theory Of Firm Behaviour (b) Theory Of Unemployment
(c) Public Debt (d) Interest Determination

1.26) Normative science deals with the factual questions.

a) True
b) False

1.27) The cost of next best alternative foregone is called:

(a) Explicit cost (b) Economic cost

(c) Accounting cost (d) Opportunity cost

1.28) Which of the following in NOT a participant of an Economy?

(a) Household (b) Government
(c) Land (d) Foreign Traders

1.29) Which of the following is not a factor of production?

(a) Land (b) Labour
(c) Money (d) Entrepreneurship

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1.30) Which of the following is not an economic resource?

(a) Air (b) Sulphuric acid
(c) Water (d) Books

1.31) Microeconomics may be defined as the study of:

(a) the ‘focused picture’ of the national economy
(b) acquisition of new technological skills by the factors of production
(c) a study of the level of aggregate production and reasons for its fluctuations
(d) none of the above

1.32) Which one the following best describes the opportunity cost to society of building a new school?
(a) Increase in Taxes
(b) The money that was spend on school
(c) The running cost of school
(d) The other goods that could have been produced with the resources used to build the school

1.33) Which of the following is NOT a measure of income earned by a factor of production?
(a) Rent (b) Interest
(c) Profits (d) Taxes

1.34) Which of the following, best define Capital?

(a) This refers to all of Earth’s natural resources
(b) This refers to the work done by those who contribute to the production processes.
(c) This refers to man-made resources
(d) This refers to the people who take the risk of production using the other three factors

1.35) Which one is not a participant of economy?

(a) Household (b) Students
(c) Firms (d) Government
1.36) Which one is not a factor of production?
(a) Land (b) Air
(c) Capital (d) Labour

1.37) Which one is non-human factor?

(a) Land (b) Labour
(c) Entrepreneur (d) None of the Above

1.38) Interest is the reward of:

(a) Labour (b) Capital
(c) Land (d) Entrepreneur

1.39) Demand for land is:

(a) Direct Demand (b) Passive Demand
(c) Complementary Demand (d) Derived Demand

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1.40) Which of the following is NOT a Reward of factors of production?

(a) Rent (b) Interest
(c) Capital (d) Wages

1.41) The demand for a Factor of Production is called

(a) quantity demand (b) derived demand
(c) individual demand (d) market demand

1.42) Which of the following is NOT a processing part of Capital formation?

(a) Creation of savings (b) consumption of savings
(c) Mobilization of savings (d) Investment of savings

1.43) Which of the following is NOT a characteristic of Specialization?

(a) when workers use specialized skills and knowledge
(b) Specialization contributes directly to increased productivity levels.
(c) specialization does not promote inventions and innovations
(d) It reduces the time required for production

1.44) _________________________ refers to producing goods or services by dividing into a number of tasks that
are carry out by different workers, rather being done by an individual.
(a) Specialization of labour (b) Division of labour
(c) Capital (d) Entrepreneur

1.45) _____________________________________ refers to increase in existing stock of man-made capital of a country.

(a) Capital accumulation (b) Capital formation
(c) Both (d) None of these

1.46) Which one is the best definition of opportunity cost?

(a) All sacrificing cost (b) To obtain one more unit

(c) Next best alternative forgone (d) None

1.47) Following concept is NOT illustrated by the Production Possibility Curve:

(a) Efficiency (b) Equity

(c) opportunity cost (d) trade-off

1.48) Which of the following will NOT cause a shift in the Production Possibility Curve?
(a) A fall in unemployment (b) Increase in age of retirement
(c) Technological improvement (d) Capital investment
1.49) If a Society is producing inside the production possibilities curve, it means:
(a) Resources are not being used efficiently. (b) There is full employment of resources.

(c) Per capita income is increasing. (d) Income is distributed equally amongst all.

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1.50) The production possibility curve would move inwards when:

(a) there is a change in consumer taste
(b) there is an increase in employment of skilled labour
(c) there is a depletion of natural resources
(d) all of the above

1.51) What is Opportunity Cost if we move from point A to C.

Point Good A Good B

A 10 0
B 8 18
C 5 29
D 0 30
(a) 10 (b) 8
(c) 5 (d) 0

1.52) The production possibility frontier is concave to the origin because:

(a) in order to produce one good, resources must be diverted from the other
(b) some resources are better at producing one good and some resources are good at producing
other good
(c) there is always some level of unemployment
(d) all resources contribute towards production equally

1.53) If the production possibility curve moves outward to the right, it means that:
(a) the economy is capable of producing more goods and services than it could produce
previously.
(b) the economy is not able to produce goods and services that it could produce previously.
(c) it is not possible to produce the optimum combination of goods and services.
(d) there is significant decline in population or exhaustion of natural resources

1.54) The slope of a production possibility frontier is called:

(a) marginal rate of substitution (b) marginal utility of product
(c) marginal rate of transformation (d) marginal product

1.55) In the production possibility curve below what combination of two goods cannot be produced given
current levels of resources.

(a) A (b) B
(c) C (d) D

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1.56) Which of the following will move on economy’s P.P.F. outwards? (Select TWO)
(a) Improvement in labour skills (b) A fall in prices
(c) A rise in priced (d) A reduction in unemployment

1.57) In economics a good is called source if:

(a) If Demand is more then it’s supply (b) Only exist in small quantities
(c) Provides welfare to economy (d) If supply is more then it’s demand

1.58) Which of the following is more likely to be found in a free-market economy than in a planned
economy?
(a) An even distribution of wealth
(b) An incentive to innovate
(c) Production of goods for benefit of society as a whole
(d) Full employment of labour

1.59) In deciding what products to produce, the central planners in a planned economy would give least
priority to:
(a) size of economy’s labour force
(b) production capabilities of the economy’s factories
(c) consumer preferences
(d) type of raw materials produced by the economy

1.60) Which one of the following statements is NOT true for a planned economic system?
(a) Productive resources are state owned (b) Auto-adjusted price mechanism
(c) Full employment is possible (d) Less duplication of resources

1.61) Which of the following features is NOT related to capitalist economy?

(a) Consumer sovereignty (b) Profit motive
(c) No conflict between labour and capital (d) Freedom of enterprise

1.62) In which of the following options consumer sovereignty is in the order of highest to lowest?
(a) Market economy, mixed economy, planned economy
(b) Mixed economy, market economy, planned economy
(c) Market economy, planned economy
(d) None of the above

1.63) Capitalism is a system of economic organization featured by the _____________________ ownership

(a) Private (b) Public
(c) Government (d) None of these
1.64) _____________________ is an economic system in which all economic decision such as; what, how and for
whom to produce are largely taken by the state.
(a) Capitalism (b) Socialism
(c) State (d) Government
1.65) Free price mechanism / competition, self-interest, refers to _______________
(a) Socialism (b) Mixed economy
(c) Capitalism (d) Islamic economic system

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1.66) Select any TWO merits of capitalist market.

(a) Unhindered price mechanism (b) Social security
(c) Economic stability (d) An incentive to innovate

1.67) Which of the following concepts is not illustrated by the production possibility curve?
(a) Efficiency (b) Opportunity Cost
(c) Equity (d) Trade-Off

1.68) P.P.F. is concave to the origin because of:

(a) Increasing opportunity cost (b) Decreasing opportunity cost
(c) Efficient use of resources (d) Full Employment

1.69) Rational behind a curvature production possibility curve is;

(a) Scarcity Of Resources (b) Non-Compatibility of Resources
(c) Rising Opportunity Cost (d) Decreasing Opportunity Cost

1.70) About given PPF, which TWO statements are true:

B C
A

(a) A Is Inefficient Use of Resources (b) B Is Most Inefficient Use of Resources

(c) C Is Unattainable (d) All Of Above

1.71) The curvature of the production possibility curve is due to:

(a) Change In Opportunity Cost (b) Increase In Resources
(c) Decrease In Demand (d) Decrease In Supply

1.72) Goods create positive externalities and contribute significantly to the social welfare household are:
(a) Merit Goods (b) Public Goods
(c) Demerit Goods (d) Free Goods

1.73) National defense is the example of:

(a) Private Goods (b) Public Goods
(c) Demerit Goods (d) Club Good
1.74) Goods for which demand decreases as income of households’ increases are known as:
(a) Normal Goods (b) Inferior Goods

(c) Superior Goods (d) Capital Goods

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1.75) ________________ goods are characterised with rivalry and excludability.

(a) Public (b) Demerit
(c) Private (d) Merit

1.76) Goods which are non-excludable and non-rivalrous known as:

(a) Merit goods (b) Public goods
(c) Demerit goods (d) Inferior goods

1.77) A movie theatre may be regarded as an example of

(a) public goods (b) demerit goods
(c) private goods (d) club goods

1.78) A good may be classed as _____________ if it causes positive externalities.

(a) Merit good (b) De-merit good
(c) Public good (d) Private good

1.79) Goods which are deemed to be socially undesirable are known as:
(a) Public goods (b) Private goods
(c) Merit goods (d) Demerit goods

1.80) Free price mechanism, competition, self-interest; refers to:

(a) Socialism (b) Capitalism
(c) Mixed Economic System (d) Command Economy

1.81) Consumer sovereignty, capital accumulation, less waste of resources; refers to:
(a) Capitalism (b) Mixed Economic System
(c) Socialism (d) Socialism

1.82) Which one is not a demerit of socialism?

(a) Cartels (b) Transparency Issue
(c) Bureaucratic Issues (d) Incentive Less
1.83) The central problem of economy is:
(a) To achieve maximum growth in production (b) To allocate resources between alternative
uses
(c) To ensure all resources are fully exploited (d) To overcome inequalities in income
distribution
1.84) Resources allocation refers to the apportionment:
(a) Consumer’s income (b) Productive capacity
(c) Factors of production (d) Raw materials
1.85) The system in which the government keeps its hands off economic decisions is called.
(a) Free market economy (b) Capitalist economy
(c) Laissez – faire economy (d) All of above

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1.86) In command economy resources are allocated by:

(a) Market forces (b) Entrepreneurs
(c) Government decisions (d) None of above

1.87) A centrally planned economy which seeks to maintain full employment can achieve this because.
(a) Economies of scale
(b) Firms are not permitted to earn super normal profit
(c) Net investment can within limits, represents any desired proportion of National product
(d) The public sector is obliged to employ all workers left after private sector demands have been
met

1.88) Which one is not prohibited in Islamic economic system?

(a) Making Of Money
(b) Investment In Prohibited (Haram) Businesses
(c) Short Selling
(d) Investment In Non-Asset Backed Derivatives

1.89) Which of the following is NOT in Islamic Economic System (Select TWO;
(a) Hoarding (b) Nationalization of Property
(c) Riba (d) Equity

1.90) A kind of partnership where a financial expert offers specialist investment in which the customer
and bank share profits is called __________________________ .
(a) Murabaha (b) Mudaraba
(c) Ijara Wa-Iqtina (d) Ijara

1.91) __________________________ is the leasing agreement whereby the bank buys an item for a customer then
leases it back to them over an agreed time period
(a) Ijara (b) Mudaraba
(c) Musharaka (d) Murabaha

1.92) The mode of Islamic financing where a financial expert offers services for managing investment; and
the investor and the expert share profits, is called:
(a) Ijara (b) Mudaraba
(c) Musharaka (d) Murabaha

1.93) _________________________is a form of credit that enables customers following Islamic principles to make
a purchase without the need to take out an interest-bearing loan
(a) Ijara (b) Mudaraba
(c) Musharaka (d) Murabaha

1.94) Islamic mode of financing includes an arrangement in which a person participates with his money
and another with his efforts/expertise. This mode of financing is known as
(a) Ijara (b) Mudaraba
(c) Musharaka (d) Murabaha

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ANSWER KEY

1.1) C 1.2) C 1.3) D 1.4) B

1.5) C 1.6) C 1.7) B 1.8) A
1.9) C 1.10) A 1.11) A 1.12) D
1.13) B 1.14) A 1.15) D 1.16) C
1.17) B 1.18) D 1.19) C 1.20) C
1.21) B 1.22) B 1.23) A 1.24) C
1.25) A 1.26) B 1.27) D 1.28) C
1.29) C 1.30) A 1.31) B 1.32) D
1.33) D 1.34) C 1.35) B 1.36) B
1.37) A 1.38) B 1.39) D 1.40) C
1.41) B 1.42) B 1.43) C 1.44) B
1.45) C 1.46) C 1.47) B 1.48) B
1.49) A 1.50) C 1.51) C 1.52) B
1.53) A 1.54) C 1.55) D 1.56) A,D
1.57) C 1.58) B 1.59) C 1.60) B
1.61) C 1.62) A 1.63) A 1.64) B
1.65) C 1.66) A,D 1.67) C 1.68) A
1.69) C 1.70) A,C 1.71) A 1.72) A
1.73) B 1.74) B 1.75) C 1.76) B
1.77) D 1.78) A 1.79) D 1.80) B
1.81) B 1.82) A 1.83) B 1.84) C
1.85) D 1.86) C 1.87) D 1.88) A
1.89) A,C 1.90) B 1.91) A 1.92) B
1.93) D 1.94) B

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TEST-01
1) Which of the following is not a factor of production?
a) Land b) Money
c) Oil d) Labor
2) In planned economic system profits belongs to government.
a) True b) False

3) Club goods are (Select TWO)

a) Rival b) Non-Rival

c) Excludable d) Non-Excludable
4) If a bank purchases an asset from a third party and then sells it to the company on a deferred basis,
the transaction is known as:
a) Musharaka b) Mudaraba
c) Murabaḥa d) Ijara

5) Which of the following is not permitted in Islamic economic system?

a) Special deposit with the bank in current account
b) Asset backed investment
c) Investment in the traditional market fund
d) legitimate investment in assets

6) Goods which demand decrease as Income increase.

a) Normal goods b) Inferior goods
c) Giffen goods d) Public goods

7) When the fisherman catches a fish and sells in the market the earn return is called?
a) Rent b) Interest

c) Wage d) Profit

8) Which of the following is not a feature of market economy.

a) Freedom of enterprise b) Environment of competition
c) Prices are determined through price d) Social security
mechanism

9) Three fundamental basic economic Questions, what to produce, How to Produce, for whom to
produce is due to ________________?
a) Want b) Need
c) Scarcity d) Opportunity cost

10) Which of the following is NOT the Advantages of Mixed Economic System? (Select TWO)
a) fair distribution of goods and services especially of public interest
b) inefficiencies due to bureaucratic controls
c) government also makes sure the care of weak agent of the economy
d) Government regulations increasing the cost of doing business for firms

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

CHAPTER-02

“DEMAND, SUPPLY AND MARKET

EQUILIBRIUM”

PART-01: DEMAND

1.1 LAW OF DEMAND 38

1.2 INDIVIDUAL AND MARKET DEMAND 39
1.3 WHY IS THE DEMAND CURVE SLOPING DOWNWARD? 40
1.4 EXCEPTIONS OR LIMITATIONS OF THE LAW OF DEMAND 40
1.5 PRACTICAL IMPORTANCE OF LAW OF DEMAND 41
1.6 MOVEMENT ALONG THE DEMAND CURVE AND SHIFT IN DEMAND CURVE: 41

PART-02: SUPPLY

2.1 LAW OF SUPPLY 43

2.2 MOVEMENT ALONG THE SUPPLY CURVE AND SHIFT IN SUPPLY CURVE 44
2.3 RESERVATION PRICE 46

PART-03: MARKETS & PRICE DETERMINATION

1.1 MARKET EQUILIBRIUM 47

1.2 REGULATED PRICE 48
1.3 SHIFT IN DEMAND AND SUPPLY AND THEIR IMPACT ON MARKET EQUILIBRIUM 49
1.4 MARKET FOR PERISHABLE GOODS 51
1.5 MARKET FOR DURABLE GOODS 51

PART-04 E-BUSINESS

E-BUSINESS 52

PART-05: MULTIPLE CHOICE QUESTIONS & TEST-02

MCQ 53
TEST-02 63

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

PART-01: DEMAND:

WANT, NEED and DEMAND:

Needs are the basic requirements of a society i.e. food, cloth and shelter. (Inhaler is a need for
asthmatic patient)
Wants are the desires of society i.e. a heavy bike, AC and chocolate etc.

Demand:
Demand is the quantity of goods and services which buyers are willing and able to buy at different
prices in a given period of time.

Every desire or want is not demand. Demand is the combination of want plus purchasing power

Demand = Want + purchasing Power

1.1: LAW OF DEMAND:

Law of Demand:
“Other things remain same (ceteris paribus), when the price of a product increases, its quantity
demanded decreases and when its price decreases, its quantity demanded increases

Ceteris paribus: a Latin expression which means ‘other things remaining same/constant
Qd = f (P)
However, this law will hold true only if following conditions are held constant

Essentials or Assumptions of the law of demand

1) There is no change in average income of consumers.
2) There is no change in population size.
3) No change in Taste, Fashion and weather
4) No change in Future Expectations (regarding the prices of any product)
5) There is no change in advertisement.
6) There is no change in Direct Tax.
7) No change in prices of related goods. (Price of substitute goods and complement goods)

Demand Table/Schedule:
An individual consumer’s demand curve for product A. Let’s consider, quantity demanded of product
A at different prices.
Price Quantity Demanded
Rs. /Kg (kg)
5 1
4 2
3 3
2 4
1 5

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

Demand Curve:
Price
5

1 Demand curve (D)

O 1 2 3 4 5
Quantity Demanded
Explanation:
• In the graph, we have measured quantity demanded on x-axis and price on y-axis.
• When price is Rs. 5 per kg. the demand is just 1 kg. As price decrease the quantity d demanded
increases and when price is as low as Rs. 1 per kg, the demand is its highest i.e 5 kg. By joining
these points, we derive demand curve “D” which is downward sloping. It indicates that there
is an inverse relationship between price and quantity demand,

1.2: Individual and Market demand

• Individual Demand: Demand by a single consumer (Household) in the market is called

“Individual Demand”.
• Market Demand: Collective demand of all consumers in the market for a particular good
or service is called “Market Demand”.
• Direct Demand: Demand for final good is called direct demand. e.g. mobile, AC, Apple.
• Derived Demand/Resource Demand: Demand for capital goods or factors of production
is called derived demand

 Market demand schedule and curve

Market demand schedule for Good A with three buyers Mr. A, Mr. B and Mr. C.
Last column is showing the market demand for Good A which is the sum of demand for all buyers
at prevailing market prices.

Price Buyers Market Price

per kg
Mr. A Mr. B Mr. C Demand 5
(Rs.)
4
5 1 2 3 6
4 2 3 4 9 3

3 3 4 5 12 2

2 4 5 6 15 1
1 5 6 7 18
0 3 6 9 12 15 18
Quantity Demanded

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

1.3: Why is the demand curve sloping downward:

1) Income Effect of price Increase:

• When price of a product increases, purchasing power (real income) of a consumer decrease.
• People will feel poorer. They will not afford to buy so much of the good with their money.
• This economic theory is known as income effect of a price rise.

2) Substitution Effect of price increase:

When price of a product increases, some existing consumers shift to the other (alternative or
substitute) lower priced good. This is called the substitution effect of a price rise.

3) Law of Diminishing Marginal utility.

1.4: Exceptions or Limitations of the Law of Demand:

There are certain cases wherein the law of demand does not apply. These exceptions or
limitations are as under:

• Basic necessities of life:

The law of demand is not applicable to the basic necessities such as sugar, rice, wheat
because people will keep on buying these commodities regardless of the increase or decrease
in prices.

• Use as confer distinction:

Those goods which possess some distinctive features, are considered as exception of law of
demand. Because as price of such goods increases, their demand increases for a particular
group of society.

• Change in income:
If income of consumer increases, demand of product will increase, even if its price is going
up.

• Ignorance of the consumer:

Due to the lack of market knowledge, consumer may pay the higher price for a product.

• Uncertain conditions:
If high uncertainty is prevailing in the market, and there is a fear of being shortage of a
commodity in near future, people will buy more of it in spite of higher prices.

• Giffin goods:
If price of a good increases its quantity demanded increases and (Vice versa)

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

1.5: Practical importance of law of demand:

(i) Price determination:

The law of demand contributes to the determination of price of a certain commodity. Also,
the producer can see the effect on demand due to increase or decrease in price and can take
decisions accordingly.

(ii) Firm’s decision making: The demand schedule helps the entities plan for future by
analyzing the impact of change in prices on the quantity demanded at both; the national and
international level.

(iii) Helpful for finance minister:

It also helps state in raising taxes e.g., if increase in tax causes the price of a commodity to be
increased and decreases demand significantly, then it will not wise to increase tax as overall
amount of the taxable revenue would remain almost the same.

1.6: Movement along the Demand curve, and shift in Demand curve:

Movement along the demand curve (Change in Quantity Demanded)

• If demand of a product changes due to its own price (endogenous factor), (ceteris paribus) it
is called Change in Quantity Demanded.
• It causes Movement along the demand curve (also called Extension and Contraction in
Demand curve).

Price Movement along the Demand Curve

Price

A
P1

P2 B

Demand Curve (D)

Q1 Q2
Quantity Demanded

The figure has shown the movement along demand curve from point a to b or b to a, due to change
in price of the product from P1 to P2 or vice versa.

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

Shift in Demand: (Change in Demand)

• If demand of a product changes due to its Non price factors (exogenous factor), i.e., (income,
taste, weather, population size, etc.) it is called Change in Demand.
• It causes shift in demand curve from its original point (also called Rise/Fall in Demand
curve).

Price

10

D1

Demand Curve (D)

D2

5 10 15
Quantity Demanded

An increase in the demand for a product is shown in above diagram as a rightward shift in the demand
curve and vice versa.

Factors responsible for change in demand or shift in demand curve

1. Changes in Income:
If a household's income increases, they may purchase more products irrespective of the
increase in their price, thereby increasing the demand for the product.

2. Taste and preference:

Change of taste or liking/disliking can affect demand for a product. For example, someone likes
to use more of sugar but later taste gets change, the demand will for sugar will fall without
bothering its price.

3. Weather conditions:
During the winter season, the demand for tea or coffee is very high because consumers prefer
such things. However, during the summer season the situation is just the opposite as people
prefer soft drinks.

4. Changes in population:
Demand for most goods and services will increase with increase in population.

5. Changes in advertisement:
A successful advertising campaign for a certain good will increase demand for it.

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

6. Price of Substitute Good:

• Substitute Good/competitive good are goods which satisfy the same need and are used in
place of another good.
• An increase in the price of one good A will cause an increase in demand for the other good B
as well as that product will become relatively less expensive.
• E.g Tea and Coffee, Petrol and CNG, butter and Coke and Pepsi.
• XED of substitute goods is positive

7. Price of Complementary Goods:

• Complementary Goods are those goods which are consumed together.
• An increase in the price of one good A will cause decrease in demand for the other good B.
• e.g., cereal and milk, bat and ball, car and petrol.
• XED of complement goods is negative.

PART-02: THEORY OF SUPPLY

Supply:
Supply is the quantity of goods and services which sellers are willing and able to sell at different price
in a given period of time.

Difference between Supply and Stock:

Suppose a farmer has produced 1,000 tons of rice and put into a warehouse waiting for a good price.
Initially he has offered 300 tons of rice at price of Rs. 650 per ton in a market while remaining is left in
the store. In economic theory, the 300 tons which have been offered for sale is considered as supply and
the remaining is called stock.

2.1: LAW OF SUPPLY:

Law of Supply:
If price of a product increases, its quantity supplied increases; and if price of a product decreases, its
quantity supplied decreases, ceteris paribus.

Ceteris paribus: a Latin expression which means ‘other things remaining same/constant
Qs = f (P)
However, this law will hold true only if following conditions are held constant

Essentials or Assumptions of the law of supply:

1) Cost of input (factors of production) remains same.
2) Technology or techniques of production should remain same
3) Indirect taxes and Subsidies on product remain same.
4) Environmental conditions remain same. (For agriculture sector)
5) Number of producers in the market remains same.
6) Government policy do not change over time
7) Prices of the other goods (substitutes in production and complements in production should
remain unaffected.

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Supply Table/Schedule:
The supply schedule shows how much of good sellers are willing and able to sell at different prices.

Price Quantity Supplied

Rs. /Kg (kg)
5 5
4 4
3 3
2 2
1 1

Price
S
Supply Curve:
P0

P1

O Q1 Q0 Quantity Supplied

• A supply curve shows, that keeping all else equal, firms will produce and offer for sale more
of their product at high prices and less for low price
• supply curve will be positively sloped upward due to the positive relationship between price
of the product and quantity supplied in a market.

2.2: Movement along the Supply curve, and shift in Supply curve:

Movement along the Supply curve: (Change in Quantity Supplied)

• If Supply of a product changes due to its own price (endogenous factor), it is called Change
in Quantity Supplied.
• It causes movement along the Supply curve (also called Extension and Contraction in
Supply curve).

Supply Curve (S)

Price

Quantity Supplied

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Shift in Supply: (Change in Supply)

• If Supply of a product changes due to its Non price factors (exogenous factor), it is called
Change in Supply.
• It causes shift in Supply curve from its original point. (Also called Rise/Fall in Supply curve)

Supply Curve (S)

Price

Quantity Supplied

Factors responsible for change in supply or shift in supply curve

1. Resource cost/Input prices:

If price of raw material will increase, it will increase the cost of production and decrease the
supply and profit margin of the firm causes leftward shift in supply curve.

2. State of technology use in production:

Improved technology or techniques of production facilitate firms to produce more units of
output with less resource, causes rightward shift in supply curve. Hence, Profit margin for the
firms increases without changing the price of product to be sold in the market.

3. Indirect Taxes: Business decisions are sensitive to government policies.

Indirect taxes are imposed by the government to goods and services in order to generate
revenue.
Indirect Taxes increase the cost of production and price of the products which reduce the
supply causes leftward shift in supply curve.

4. Subsidies:
Subsidy is a financial assistance given by government to support producer in production
process.
In the case of subsidies, it will decrease cost of production and increase supply causes
rightward shift in supply curve

5. Number of sellers:
Supply of the product increases due to increase in number of sellers in the market causes
rightward shift in supply curve

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5. Substitute in production:
• Substitute in production are goods which are produced in place of another good.
• An increase in the price of one good A will cause decrease in supply for the other good B.
• Example: If profit margin increases in production of school bags, the firms will switch
resources from ladies’ bags to school bags. This substitution in production results in decline
in the supply of ladies’ bags in the market.
• e.g Leather shoe and leather bag, Tube light and Energy savers, Brown and Black shoes

6. Complement in production:
• Complementary are those goods which are produced together.
• An increase in the price of one good A will cause increase in supply for the other good B.
• e.g., Meat and Hide

2.3: RESERVATION PRICE:

Reservation Price is the minimum price which is acceptable by the producer. Below this price,
producer refuses to sell his product.

Significance of the reservation price:

It indicates the price level below which it is not profitable for a firm to supply to the market
.
Factors affecting reservation price:

1) Disposable Income of the buyer:

A firm change reservation price for its commodities according to the disposable income of the
buyers. Higher the consumer income higher the reservation price

2) Substitute goods:
If the substitutes are readily available in the market, then the firm might need to set lower
reservation price for its product and vice versa.

4) Cost of production: Higher cost of production would lead to a higher reservation price and
lower cost of production would result in lower reservation prices.

5) Objectives:
The nature of objectives also plays a key role in the determination of the reservation price for
the firms. For instance, a newly entrant firm has to offered heavy discounts on its products, set
low reservation price in order to capture the market

6) Nature of goods:
Perishable goods have lower reservation price than durable good.

7) Other factors might include the state laws, amount of subsidies, taxes, inflation, economic
conditions etc.

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PART-03: MARKETS & PRICE DETERMINATION

MARKET ENVIRONMENT: Some of the types of market include:

• Local markets
• Regional markets
• National markets
• International markets
• Online or virtual markets

Other types of markets

• Goods market
• Factors or resource market
• Financial markets

THE PRICE MECHANISM:

There are two types of prices that exist in markets:

1. Equilibrium market price: which is determined by market forces, i.e. demand and supply
2. Regulated market price: which is determined by the government,

3.1: Market Equilibrium

Market Equilibrium is a situation at which Quantity demanded is equal to Quantity supplied. At this
equilibrium, Price is said to be Equilibrium market price and Quantity is said to be Equilibrium
market Quantity.

Market Disequilibrium:
Market disequilibrium is a situation where demand is not equal to supply.
1. When Quantity demand is GREATER than supply, there will be a Shortage in the market.
2. When Quantity supply is GREATER than demand, there will be a Surplus in the market.

Tabulation Form:

Price QD QS Comparison of Market Position Price Direction

(Rs.) QD & QS

5 1 5 QD< QS Surplus Will depress the price

4 2 4 QD< QS Surplus Will depress the price
3 3 3 QD= QS Equilibrium Neutral
2 4 2 QD> QS Shortage Will drag the price up
1 5 1 QD> QS Shortage Will drag the price up

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Market Equilibrium Graph:

Market Equilibrium:
Price
Supply (S)
5
Surplus (QS > QD)
4
E
3 Equilibrium Point

2
Shortage (QD > QS)
1
Demand (D)

0 1 2 3 4 5
Quantity
Equilibrium:
The market equilibrium price and quantity come at the intersection of the supply and demand curves.
At a price of Rs3, firms willingly supply what consumers willingly demand.
If a price of Rs. 4 was charged for the good, the supply would exceed demand, there would be a excess
of the good in the market and this would decrease the price. Price would restore back at equilibrium.
If a price of 2 was charged for the good, supply would be less than demand, there would be a shortage
of the good on the market and this would increase the price. . Price would restore back at equilibrium

3.2: REGULATED PRICE:

Regulated price is the price which is set by the government. Government set two types of prices:
1. Minimum price/Price floor (to protect producers)
2. Maximum price/Price ceiling (to protect consumers).

Regulated Price:
Supply (S)

P1 Minimum price
E
Price

P2 Maximum price

Demand (D)

Quantity
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3.3: SHIFT IN DEMAND AND SUPPLY AND THEIR IMPACT ON MARKET EQUILIBRIUM:

Shift in demand and supply occur due to non-price factors:

Effect of change in market equilibrium: (How New market equilibrium is achieved)
Change in market equilibrium affects equilibrium Price and equilibrium Quantity.

Shift in Demand:

1. Rise/Increase in Demand:
Impact of Increase in consumer’s income on market equilibrium:
• Causes rightward shift in Demand curve D0 to D1.
Conclusion:
Increase in Price and Quantity in a market.

Rise in Demand:
Price S0

E
P1

P0

D1
D0
0 Q0 Q1 Quantity
Q0
2. Fall/ Decrease in Demand:
Impact of decrease in demand due to “non-price factors” on market equilibrium:
• Causes leftward shift in Demand curve D0 to D1.
• Conclusion:
Decrease in Price and Quantity

Fall in Demand:
Price S0

E
P0

P1

D0
D1
0 Q1 Q0 Quantity
Q0

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Shift in Supply
3. Increase/Rise in Supply:
Impact of increase in supply due to “non-price factors” on market equilibrium:

• Causes rightward shift in Supply curve S0 to S1.

• Conclusion:
• Price Decrease, Quantity increase
Rise in Supply
S0
Price
S1
P0 E
P1

D0

0 Q0 Q1 Quantity
Q0
4. Decrease/Fall in Supply:
Impact of decrease in supply due to “non-price factors” on market equilibrium:

• Causes leftward shift in supply curve.

• Conclusion:
Price Increase and Quantity decrease
Fall in Supply:
S1
Price
S0
P1 E
P0

D0

0 Q1 Q0 Quantity
Q0
Practice Questions:

What will be the effect on market price and quantity? If:

1. Increase in demand and decrease in supply occur simultaneously in a market
2. Increase in demand and increase in supply occur simultaneously in a market
3. Increase in Supply is more than increase in demand occur simultaneously in a market
4. Increase in Supply is less than decrease in demand occur simultaneously in a market

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3.4: MARKET FOR PERISHABLE GOODS:

Perishable goods:
• Perishable goods are those which have less life to store.
• Such goods have short life, and producer doesn’t produce in bulk to store.
• Producers want to get rid of immediately after production of such goods
• Supplies of such goods mostly remain fixed during a course of time in a market
e.g. demand for dairy products, fruits, vegetables, meats etc.
Perishable Good:
Supply (S)
Price
E1
P1

P0 E0
0
D1

P2 E2

D2 Demand (D0)

0 Q0 Quantity

In this diagram vertical supply curve (perfectly inelastic) shows the supply of perishable goods which once
produced is being offered for sale into market (as cannot be shelved or stored for long time). In perishable
market, price change due to change in demand. D1 shows a rise in demand for perishable goods which is
putting upward pressure on market price and D2 showing fall in demand, putting downward pressure on
market price.

3.5: MARKET FOR DURABLE GOODS:

Durable goods:
• Durable goods are those which have long life and can be stored.
• Typically, these goods are a bit more expensive than perishable.
• In this case the supply curve will be usual positively sloped supply curve then finally vertical).
For example: machinery, motorbike, mobile handsets, etc.

The supply of printers is fixed after a certain quantity available in stock. Although it can be increased
initially by taking more from the store, up to that limit the supply curve will be positively sloped
upward, but once the stock will be exhausted, it will become vertical. After this limit the rising
demand will put drastic pressure on the price of printers.
Durable Good:
Supply (S)
Price

P2 E2

P1 E1
0
P0 E0 D2

D1
D0
0 Q0 Q1 Quantity

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PART-04 E-BUSINESS
E-business or Online Business
E-business, short form of ‘Electronic Business’, generally refers to business activities using
internet. (Also known as ‘Online Business’).
‘It is the process of buying and selling of goods and services or exchange of information regarding
business activities through digitalized systems including internet’.
E-business refers to shopping of goods and services or exchange of information anytime
anywhere.

E-business and Market decisions

Online business has immense impact on decision making process for both buyers and sellers. It
can impact in following ways:

Benefits for business

• It provides a comparative study of different customer and their needs, which helps business
community to take necessary actions accordingly.
• It helps in reduction of inventory and then reduction in storage and other administrative
expenses.
• It helps business men to find new business partners all over the world.
• It helps in speedy marketing of their products which incur less cost as compared to other
traditional channels.
• No or less need for ‘brick-and-mortar’ business handling.

Benefits for customers

• It helps to provide goods of their interest at their door step.
• It helps customers to get benefits of reverse auction.
• Greater choice for customers which ensures more consumer sovereignty.
• Better price bargains as comparison of prices are accessible.
• Better selection of goods is possible as numerous goods and their sublimities are available on
one click.

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MULTIPLE CHOICE QUESTIONS

2.1) The demand for a Factor of Production is called:

(a) quantity demand (b) derived demand
(c) factor price (d) cost of production

2.2) All of the following are determinants of supply except:

(a) Price (b) income level
(c) level of technology (d) objectives of the firms

2.3) Demand curve slopes downward because of:

(a) Consumer indifference (b) Elasticity of demand
(c) Law of diminishing marginal utility (d) Inelastic demand

2.4) If price of commodity increases

(a) Demand will expand (b) Demand will shift leftward
(c) Demand will contract (d) Demand remains constant

2.5) A movement along a supply curve is caused by a:

(a) change in the unit price of the particular product
(b) change in the number of producers
(c) change in the level of technology
(d) change in supply of the particular product

2.6) If Demand increase with the increase in its price, the concept related to:
(a) Substitute goods (b) Normal goods

(c) Giffen good (d) Inferior good

2.7) Which one of the following will NOT shift the demand curve for a normal good to the left?
(a) A fall in consumers incomes (b) A rise in the price of the normal good

(c) A rise in the price of a complementary good (d) A fall in the price of the substitute good

2.8) Which ONE of the following will cause the demand curve for a good to move to the
right (outwards from the origin)?

(a) A decrease in the costs of producing the good

(b) A fall in the price of the good
(c) An increase in the price of a complementary good
(d) An increase in the price of a close substitute good

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2.9) When the price of a good is held above the equilibrium price, the result will be
(a) excess demand (b) a shortage of the good
(c) a surplus of the good (d) an increase in demand

2.10) Extension of supply curve from the given graph is:

(a) S to S1 (b) S1 to S
(c) A to B (d) B to A

2.11) Due to increase of Price of good A. The demand of good of B decreases. These goods are;
(a) Substitute goods (b) Complementary goods
(c) Club good (d) Inferior good

2.12) Which of the following is held constant along the demand curve?
(a) Price (b) Quantity
(c) Income (d) Both (a) and (b)

2.13) The supply curve would shift to the left when:

(a) price of good goes down (b) taxes of government go down
(c) prices of substitute goods go down (d) prices of complements go down

2.14) What effect on Giffen graph is due to price?

(a) Positive (b) Negative
(c) No (d) Both

2.15) X and Y are substitute in consumption. If price of X increase.

(a) Demand for X decrease (b) Demand for Y decrease
(c) Demand for X increase (d) Demand for Y increase

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2.16) Which one of the following assumptions does NOT confer to the law of demand?
(a) There is no change in the income of consumers
(b) There is no substitute for the good
(c) The prices of related goods are unstable
(d) The size of population is stable

2.17) Movement in demand curve caused by:

(a) Increase in future expectation (b) Increase in price of own product
(c) Increase in population (d) None of these

2.18) In a free market, price is determined by:

(a) The consumers (b) The producers
(c) Cost view (d) Market forces

2.19) If the price of a substitute of commodity X falls, the demand for X will?
(a) Rise (b) Fall
(c) Remains unchanged (d) Both a & b depends on conditions

2.20) All else equal, if demand for a product fall greater than fall in supply, then which of the option will
be the correct option?
(a) price will fall with decrease in quantity (a) Price will rise with increase in quantity
(b) Price will increase with fall in quantity (c) Price will fall with increase in quantity

2.21) Due to COVID-19 world has gone for lockdown. Consequently, in international market the prices for
petroleum products have shown historical cut along with less consumption of Oil too. In economic
theory this is known as?
(a) Contraction in quantity demanded (b) Extension in quantity supply
(c) Fall in demand (d) Fall in supply

2.22) Which one is not a precondition of law of demand?

(a) Price of substitutes (b) Income of the consumer
(c) Wages (d) Population

2.23) Which one is not a precondition of law of supply?

(a) Oil prices (b) Income of the consumer
(c) Wages (d) None of the above

2.24) Rise in demand for Face Masks during Covid-19 is termed as:
(a) Movement along demand curve (b) Rise in demand
(c) Inward shift in demand curve (d) Increase in price of Face Mask

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2.25) Toyota motors has shown historical decline in its sales during Covid-19. In economic terminology it
is known as:
(a) Fall in demand (b) Inward shift in demand curve
(c) Change in demand (d) All of above

2.26) Change in demand and supply due to other factors are described as:
(a) Change in demand and supply (b) Rise or fall in demand and supply
(c) Shift in demand and supply curve (d) All of above

2.27) Fall in supply of a product greater than fall in demand will cause:
(a) Decrease in price and quantity (b) Decrease in price and increase in
quantity
(c) Increase in price and quantity (d) Increase in price and decrease in
quantity
2.28) A price above than market price will show:
(a) A surplus (b) A shortage
(c) Equilibrium (d) Maximum price

2.29) A support price or minimum price always set:

(a) Above than equilibrium price (b) Below than equilibrium price
(c) At equilibrium price (d) It depends upon elasticity

2.30) Rise in demand for leather in foreign market the supply of beef will increase in domestic market. It
will affect market for beef and:
(a) Price and quantity of beef will decrease (b) Price and quantity of beef will increase
(c) Price of beef will decrease and quantity (d) Price of beef will increase and quantity
will increase will decrease

2.31) An increase in price of butter will affect the market for margarine (substitute):
(a) Price and quantity of margarine will decrease
(b) Price and quantity of margarine will increase
(c) Price of margarine will increase and quantity will decrease
(d) Price of margarine will decrease and quantity will increase

2.32) Reservation price is:

(a) Minimum price set by government
(b) Maximum price set by government
(c) Minimum price a producer is willing to get for its product
(d) Maximum price a buyer is willing to pay for its product

2.33) Which one is most important factor of reservation price?

(a) Disposable income of consumer (b) Availability of substitutes
(c) Cost of production (d) All of above

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2.34) Increase in labour productivity can cause:

(a) Shift in supply curve to right (b) Shift in supply curve to left
(c) Shift in demand for labour curve to left (d) Shift in demand for labour curve to right

2.35) A surplus in goods market will _____________price.

(a) Decrease (b) Increase
(c) Remain stable at equilibrium (d) It depends upon market conditions

2.36) Demand for land is:

(a) Less elastic (b) Derived demand
(c) Resource demand (d) b&c

2.37) Supply curve for Land is:

(a) vertical (b) horizontal
(c) negatively sloped (d) positively sloped

2.38) Demand curve for Normal goods is downward sloping to the right because of:
(a) Price effect (b) Income effect
(c) Substitution effect (d) All of above

2.39) Which one of the following rightward shifting in market demand curve?
(a) Change in product price (b) Change indirect taxes
(c) Change in subsidies (d) Change in money income of consumers

2.40) A rise in demand for petrol by motorists likely to follow a rise in:
(a) The price of second-hand car (b) The price of steel
(c) Bus fares (d) Motor vehicle tax

2.41) Demand for factors of production is known as:

(a) Individual demand (b) Market demand
(c) Derived demand (d) Effective demand

2.42) Which of the following is not complement to cars?

(a) Petrol (b) CNG
(c) Navigation Systems (d) I – Phone

2.43) The Demand for fashion goods is not affected by:

(a) Price of goods it self (b) Income of consumers
(c) Quality of product (d) Age

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2.44) If the price of tea falls, which one of the following outcomes would be expected?
(a) A fall in the demand of coffee (b) A rise in price of coffee
(c) A rise in the demand of coffee (d) A fall in the demand of drinking cups

2.45) A good having negative income effect is called:

(a) Normal good (b) Inferior goods
(c) Public good (d) Merit good

2.46) The part of output which not offered to sale in market is called:
(a) Supply (b) Stocks
(c) Buffer stock (d) None of above

2.47) Supply curve of perishable good is always:

(a) Horizontal (b) Vertical
(c) Upward to the right (d) Downward to the right

2.48) Following will cause a leftward shifting in market supply curve.

(a) Increase in price of good (b) Improvement in technology
(c) Increase in direct taxes (d) Increased in indirect taxes

2.49) Indirect taxes & subsidies both increases in the same proportion on a product following will be the
effect on market supply curve.
(a) Supply curve will shift towards right (b) Supply curve will shift towards left
(c) No change (d) Change along the same supply curve

2.50) The government introduces a maximum price below the equilibrium price level. What effect will this
have on market?
(a) Surplus (b) Shortage
(c) No change (d) None of above

2.51) The government introduces a minimum wage rate beyond he equilibrium wage rate. What effect will
this have on labour market.
(a) Unemployment (b) Surplus of labour
(c) Decrease in labour demand (d) All of the above

2.52) X and Y both are substitute. Select any TWO correct statements
(a) Increase in price of X, decrease in demand of Y
(b) Increase in price of X, increase in demand of Y
(c) Decrease in price of X, decrease in demand of Y
(d) Decrease in price of X, increase in demand of Y

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2.53) The diagram shows the demand curve for good A.

What could cause a movement along the curve from 2 to 3?

.
(a) A change in season (b) A change in price of good A
(c) A change in cost of production (d) A change in price of substitute good

2.54) A price floor set above the market equilibrium price is likely to cause
(a) excess supply (b) excess demand
(c) a decrease in price and a decrease in the (d) an increase in price and an increase in
quantity traded the quantity traded

2.55) If the government sets the maximum price of a product below the market equilibrium price, it would
lead to:
(a) excess supply (b) market equilibrium
(c) excess demand (d) economies of scale

2.56) The demand for and supply of a good are in equilibrium. An indirect tax is levied on the good. Which
one of the following will show the new equilibrium?
(a) A shift in the supply curve to the right
(b) A shift in the demand curve to the right
(c) A shift in the supply curve to the left
(d) A shift in the demand curve to the left

2.57) During the year, a flood destroyed significant portion of agricultural land used to produce rice. What
would be the short-run effect on supply diagram for rice?
(a) A movement down the existing supply (b) A shift to the right of the supply curve
curve
(c) A shift to the left of the supply curve (d) A movement up the existing supply
curve

2.58) Which of the following would unambiguously occur when there is a simultaneous?
decrease in demand and supply?
(a) An increase in equilibrium price (b) A decrease in equilibrium price
(c) An increase in equilibrium quantity (d) A decrease in equilibrium quantity

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Data for Questions 59 to 63:

Market Equilibrium: Bringing Demand and Supply Together

Figure 1
2.59) Figure 1 illustrates the supply and demand for t-shirts. If the actual price of t-shirts is $7, there is an
(a) excess demand of 8 t-shirts. (b) excess supply of 8 t-shirts.
(c) excess demand of 10 t-shirts. (d) excess supply of 10 t-shirts.

2.60) Figure 1 illustrates the supply and demand for t-shirts. If the actual price of t-shirts is $15, there is
an
(a) excess demand of 8 t-shirts. (b) excess supply of 8 t-shirts.
(c) excess demand of 10 t-shirts. (d) excess supply of 10 t-shirts.

2.61) Figure 1 illustrates the supply and demand for t-shirts. If the actual price of t-shirts is $7, we would
expect that
(a) demand will decrease until quantity demanded equals quantity supplied.
(b) supply will increase until quantity demanded equals quantity supplied.
(c) price will increase until quantity demanded equals quantity supplied.
(d) there will be no change since the market is in equilibrium.

2.62) Figure 1illustrates the supply and demand for t-shirts. If the actual price of t-shirts is $15, we would
expect that
(a) demand will decrease until quantity demanded equals quantity supplied.
(b) supply will increase until quantity demanded equals quantity supplied.
(c) price will decrease until quantity demanded equals quantity supplied.
(d) there will be no change since the market is in equilibrium.

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2.63) Figure 1illustrates the supply and demand for t-shirts. If the actual price of t-shirts is $10, we would
expect that
(a) demand will decrease until quantity demanded equals quantity supplied.
(b) supply will increase until quantity demanded equals quantity supplied.
(c) price will increase until quantity demanded equals quantity supplied.
(d) there will be no change since the market is in equilibrium.

2.64) If the demand for one good decrease when the price of another good decreases, the two goods are
______________ goods
(a) Normal (b) Inferior
(c) Complementary (d) Substitute

2.65) If the cost of producing a product goes down, this will cause the equilibrium price of the product to
go down, and the equilibrium quantity of the product to go up.
(a) True
(b) False

2.66) If the quantity of a product demanded is greater than the quantity of a product supplied, there is
pressure in the market to push the price downward.
(a) True
(b) False

2.67) If demand and supply both increases simultaneously in same proportion” then market price will
_____________ and quantity _______________.
(a) Increase, increase (b) decrease, increase
(c) same, decrease (d) same, increase

Figure 2
Data for Questions 68 to 70:

2.68) Figure 2 illustrates a set of supply and demand curves for hamburgers. Original demand is D1 and
supply is S1. An increase in supply and an increase in quantity demanded are represented by a
movement from

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(a) point d to point c. (b) point a to point c.

(c) point d to point b (d) point c to point d

2.69) Figure 2. An increase in demand and an increase in quantity supplied are represented by a
movement from
(a) point b to point a. (b) point c to point d
(c) point d to point a (d) point b to point d

2.70) Figure 2.A decrease in supply and an increase in demand are represented by a movement from
(a) point d to point c. (b) point c to point b.
(c) point b to point d (d) point c to point a

ANSWER KEY

2.1) B 2.2) B 2.3) C 2.4) C

2.5) A 2.6) C 2.7) B 2.8) D
2.9) C 2.10) C 2.11) B 2.12) C
2.13) D 2.14) A 2.15) D 2.16) C
2.17) B 2.18) D 2.19) B 2.20) A
2.21) C 2.22) C 2.23) B 2.24) B
2.25) D 2.26) D 2.27) D 2.28) A
2.29) A 2.30) C 2.31) B 2.32) C
2.33) D 2.34) A 2.35) A 2.36) D
2.37) A 2.38) D 2.39) D 2.40) C
2.41) C 2.42) D 2.43) A 2.44) A
2.45) B 2.46) B 2.47) B 2.48) D
2.49) C 2.50) B 2.51) D 2.52) B,C
2.53) B 2.54) A 2.55) C 2.56) C
2.57) C 2.58) D 2.59) A 2.60) B
2.61) C 2.62) C 2.63) D 2.64) D
2.65) A 2.66) B 2.67) D 2.68) A
2.69) C 2.70) D

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 CH-02: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

TEST-02

Q-1) Price ceiling is the price which is set by the government to:
a) Protect producer b) Protect consumer
c) Floating exchange rate d) None of the above

Q-2) Select most appropriate answer. Demand contract, if,

a) Price of commodity increases b) Price of substitute decrease
c) Price of complementary increase d) Income of consumer decrease

Q-3) Movement in demand curve caused by:

a) Increase in price of own product b) Increase in future expectation
c) Increase in population d) None

Q-4) Due to flood the agricultural production has been reduced what will be the effect on supply curve?
a) Increase movement along the supply curve
b) Decrease movement along the supply curve
c) Shift supply curve to the right
d) Shift supply curve the left

Q-5) Goods which demand increase as Price increase.

a) Inferior goods b) Giffin goods
c) Normal goods d) Luxury goods
Q-6) Which TWO of the followings are not assumptions of Law of demand?
a) No change in Indirect taxes b) No change in direct taxes

c) Cost of input remain same d) No change in advertisement.

Q-7) Which of the followings is not a Benefit for business as per E-business?
a) No or less need for ‘brick-and-mortar’ business handling.
b) It helps business men to find new business partners all over the world.
c) Better price bargains as comparison of prices are accessible.
d) It provides a comparative study of different customer and their needs

Q-8) In perishable good market, prices are changed due to supply.

a) True b) False
Q-9) If the substitutes are readily available in the market, then the firm might need to set higher
reservation price for its product
a) True b) False
Q-10) If Price of complement in production increases, then supply of other good will be:
a) Increase and decrease equilibrium b) Decrease and decrease equilibrium

c) Increase and increase equilibrium d) Decrease and Increase equilibrium

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

CHAPTER-03

“ELASTICITY OF DEMAND AND SUPPLY”

PART-01: ELASTICITY OF DEMAND

1.1: DEFINITION AND DEGREE OF ELASTICITY OF DEMAND 65

1.2: CALCULATION AND INTERPRETATION OF ELASTICITY OF DEMAND: 68
1.3: DETERMINANTS/FACTORS AFFECTING/INFLUENCING ELASTICITY OF DEMAND: 71
1.4: PRACTICAL IMPORTANCE / SIGNIFICANCE OF ELASTICITY OF DEMAND 72

PART-02: OTHER VARIANTS OF ELASTICITY OF DEMAND

2.1: INCOME ELASTICITY OF DEMAND (YED): 73

2.2: CROSS ELASTICITY OF DEMAND (XED): 74

PART-03: PRICE ELASTICITY OF SUPPLY

3.1: DEFINITION AND TYPES OF ELASTICITY OF SUPPLY: 75

3.2: DETERMINANTS/FACTORS AFFECTING ELASTICITY OF SUPPLY: 77
3.3: TIME AND ELASTICITY OF SUPPLY 78

PART-04: PRICE INSTABILITY AND ROLE OF GOVERNMENT

4.1: PRICE INSTABILITY: 79

4.2: COBWEB THEORY: 79
4.3: GOVERNMENT’S POLICIES TO INCREASE PRICE STABILITY: 81

PART-05: MULTIPLE CHOICE QUESTIONS & TEST-03

MCQ 82
TEST-03 92

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

Elasticity:
Measure of the responsiveness of a change in one variable due to another variable.

Types: Price Elasticity of demand (PED)

Two types of Elasticities:
• Elasticity of Demand Income Elasticity of demand (YED)
• Elasticity of Supply
Cross Elasticity of demand (XED)

PART-01: ELASTICITY OF DEMAND

The law of demand states the relationship between price and quantity of demand for a certain good
but, it does not explain that how much of an increase or decrease in quantity demanded occurs due
to a change in price. The elasticity of demand explains the level of change in quantity demanded in
response to change in price.

1.1: DEFINITION AND DEGREE OF ELASTICITY OF DEMAND

Definition of Price Elasticity of Demand (η):

Degree of responsive of change in demand to the change in its price is called elasticity of demand.
OR
Price Elasticity of Demand is the ratio of the percentage change in quantity demanded to the
percentage change in price of a good.

percentage change in Quantity demanded % Δ Qd

PED (η) = =
percentage change in Price %ΔP

Estimation/Types of Elasticity of Demand:

There are mainly three types of elasticity of demand regarding a product. They are:
a) Price elasticity of demand:
Proportionate change in quantity demanded/Proportionate change in price

b) Income elasticity of demand:

Proportionate change in quantity demanded/Proportionate change in income.

c) Cross-elasticity of demand or elasticity of demand between related goods:

It is the proportionate change in quantity demanded for product A / proportionate change in
price of product B.

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

Degree of Elasticity of Demand:

Price
1) Perfectly Inelastic Demand:
• If quantity demanded does not change P1
with change in its price, it is called
Perfectly inelastic demand.

(Demand totally unaffected/unresponsive P0

by change in price)

• PED = 0 Demand curve (D)

• Slope of Demand curve is vertical, parallel
0 Q0
to y-axis
Quantity Demanded

2) Inelastic/Less elastic Demand: Price

• If percentage change in quantity
demanded is lesser than percentage P1
change in its price, it is called Inelastic
demand.
P0
• PED < 1.

• Slope of Demand curve is sharp/steeper

Demand curve (D)
0 Q1 Q0
Quantity Demanded

Price

3) Unit/Unitary Elastic Demand: P1

• If percentage change in quantity
demanded is equal to percentage change
in its price, it is called Unit elastic demand
P0

• PED = 1.
Demand curve (D)

0 Q1 Q0
Quantity Demanded

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

4) Elastic Demand: Price

• If percentage change in quantity

demanded is greater than percentage P1
change in its price, it is called elastic P0
demand

• PED > 1. Demand curve (D)

• Slope of Demand curve is

0 Q1 Q0
shallow/flatter.
Quantity Demanded

5) Perfectly Elastic Demand: Price

• A nominal (minuscule) change in price
will largely (infinitely) affect the demand
for the product., it is called Perfectly Demand curve (D)
elastic supply P0

• Slope of Demand curve is horizontal,

parallel to x-axis.

• PED = ∞ (infinite).
0 Q0 Q1
Quantity Demanded

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

1.2: METHODS TO MEASURE ELASTICITY OF DEMAND:

1. Percentage Method (Point Elasticity of Demand and Arc Elasticity of Demand).

2. Total Revenue or Total Expenditure or Total Outlay Method.
3. Geometric Method.

1) Percentage Method:
To get the accurate value of elasticity of demand we will use percentage method, which describes
the ratio between percentage change in quantity demanded to percentage change in its price.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 % Δ Qd

PED (η) = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
=
%ΔP

(i) Point method: Price

When elasticity of demand is to be measured for

P1
a very small change in price, such as in case of
P0
petroleum and electricity rate, we use point
elasticity of demand.
Formula:
D
𝑄1−𝑄0
% Δ Qd ×100
PED = = η = 𝑄0
𝑃1−𝑃0
%ΔP ×100 O Q0 Q1 Quantity Demanded
𝑃0

Example-01
The price of petrol decreases from Rs.12 to Rs.11.75. At the same time, the quantity of petrol
demanded increases from 100 to 101. The price elasticity of demand for petrol (by using point
formula) is:
Answer:
Price Quantity Demand
12 100
11.75 101
Change - 0.25 +1

𝑄1−𝑄0 101−100
% Δ Qd ×100 ×100
100
PED = =η = 𝑄0
𝑃1−𝑃0 = 11.75−12
%ΔP ×100 ×100
𝑃0 12

1
PED = = -0.48 (Ignoring the -ve sign, PED = 0.48) inelastic demand
2.083

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(ii) Arc method:

Price
When elasticity of demand is to be measured for
a significant change in price, such as poultry,
dairy or case of crops etc., it is said to be arc P1 a
elasticity of demand.
In Arc elasticity, average of both points is P0
b
used as base to calculate percentage change. D
Formula:
% Δ Qd Δ Qd 𝑃(𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑖𝑐𝑒)
PED = % Δ P = ΔP
x Qd (Average quantity)
OR
O Q1 Q0 Quantity Demanded
Q1 − Q0 𝑃1 + 𝑃0
η = ×
Q1 + Q0 𝑃1 − 𝑃0

Example-02: (Arc method)

Compute the price elasticity of a product if an increase in the price of the product from Rs. 8 per
unit to Rs. 12 per unit causes a decrease in its demand from 300
units to 100 units.
Answer:
Price Quantity Demand
8 300
12 100
Q1 −Q0 𝑃1 +𝑃0
PED = η = ×
Q1 +Q0 𝑃1 −𝑃0

100−300 12+8
PED = η = 100+300 × 12−8 = -2.5 (Ignoring the -ve sign, PED = 2.5) Elastic demand

Interpretation of Price Elasticity of Demand:

• Elastic demand = sensitive to price changes
• Inelastic demand = insensitive to price changes
1) Sign Shows (Types of Good)
➢ If Answer is “Negative”, it is a normal good.
➢ If Answer is “Positive”, it is a giffen good.

2) Numeric value Shows (Elasticity of demand)

Absolute value of coefficient or Degree of Elasticity
numerical value of Elasticity
E=0 Perfectly Inelastic Demand
0<E<1 Relatively inelastic Demand
E=1 Unitary elastic Demand
E>1 Elastic Demand
E = ‘Infinity (∞)’ perfectly elastic Demand

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2) Total Revenue/Total Expenditure/Total Outlay Method:

This method was first proposed by Alfred Marshal. In this method we compare the changes in total
expenditure/revenue before and after the changes in price.
The total expenditure method offers a simple solution to determine whether a good has Inelastic,
unitary or elastic demand without any Calculation.

• Elastic Demand:
If price and total revenue move in opposite direction (i.e. increase in price decreases total revenue.)
then demand will be elastic.
Price (P) Demand (Q) Total Revenue (TR = P X Q)
Price

D
10 15 150

15 6 90 Quantity Demanded

• Unit elastic Demand:

If total revenue does not change with the change in prices, then demand will be unit elastic.
Price (P) Demand (Q) Total Revenue (TR = P X Q)
Price

10 15 150
D
15 10 150 Quantity Demanded

• Inelastic Demand:
If price and total revenue move in same direction (i.e. increase in price increases total revenue) then
demand will be inelastic.
Price (P) Demand (Q) Total Revenue (TR = P X Q)
Price

10 15 150
D
15 14 210 Quantity Demanded

Relationship between Price elasticity of Demand and Revenue.

The effect of a price change on revenue depends on the elasticity of demand.

• If P.E.D. is elastic, a fall in price increases revenue.
• If P.E.D. is inelastic, a rise in price increases revenue.
• If P.E.D. is unitary, a price change leaves revenue unchanged

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(3) Geometric Method: (Geometrical measure of point elasticity of demand)

Geometric method is used to measure elasticity of demand at any pint on the demand curve.
The formula to measure elasticity of demand is:
𝑙𝑜𝑤𝑒𝑟 𝑝𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒
η =
𝑢𝑝𝑝𝑒𝑟 𝑝𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒

1) Elasticity on a demand curve is different at different points. Demand is unit elastic at center,
from center to above, Demand is elastic and from center to lower Demand is inelastic

𝐴𝐸
PED at point A = = Elastic (E > 1)
𝐴𝐹

Price F

A ( E ˃ 1) Elastic

B ( E = 1) Unit Elastic

C ( E ˂ 1) Inelastic

E
O Quantity Demanded

1.3: DETERMINANTS OF ELASTICITY OF DEMAND:

Determinants are those factors, which affect the degree of elasticity of demand. Such determinants
are very helpful while formulating economic business plans for both government and individuals.

1. Necessities or Luxuries:
• Demand for necessities is inelastic because people cannot avoid these goods, whatever the
price level. e.g. wheat, salt, milk, rice, medicines, sugar.
• Demand for luxuries or comfort good is relatively elastic as people can stay without using
the product shortly, e.g. branded car, iphone

2. The possibility of substitution:

• If there are close substitutes for a good, its demand is likely to be more elastic.
For example, a rise in the price of coffee will cause people to take more tea
• If there are no close substitutes within the same price range, the demand for a commodity is
more likely to be inelastic as people do not have any option to switch, e.g. electricity

3. The case of complementary goods:

• Complementary goods are those goods which are used together, e.g. car and petrol
If price of one good (Car) decrease, demand for its complement (petrol) increase, will make
demand inelastic.
• If price of one good (Car) increase, demand for its complement (petrol) decrease, will make
demand elastic

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

4. Habit of brand loyalty (Addiction):

• Demand will be inelastic, if consumers are loyal to their brand and unwilling to change their
demand even if price increases. e.g., Tobacco, TV-show, Hand wash, branded car, cloths,
i-phone
• If there is no consumer loyalty, demand will be elastic.

5. Time Period:
• In short time (in case emergency) demand will be inelastic (e.g. to buy lifesaving medicines)
because we cannot postpone such demand.
• The longer the time-period involved, the greater the elasticity of demand is likely to be. This
is because it takes time to adjust to a change in price. (e.g. to buy House or Car)

6. Proportion of income spent for a product:

The smaller the proportion of total income spent on a commodity, the more inelastic will be
demand for it. For example, a rise in the price of tomato ketchup will not stop people buying
it, because it is less frequently purchased, and it does not account for a great deal of a
person’s total expenditure. e.g Salt, tomato ketchup and match box.

1.4: APPLICATION OR IMPORTANCE OF ELASTICITY OF DEMAND

The importance of elasticity of demand can be viewed from the following:

For Finance Minister (taxation)

• The concept of elasticity of demand guides him to impose more taxes on goods, having
inelastic demand i.e., tobacco, electricity, luxury cars and apartments to increase Tax revenue.
• However, if they tax a good with elastic demand, this may cause demand to decrease to a great
extent and tax revenue will be less than before

Price determination
Producer can charge higher prices for those goods having inelastic demand and lower price
having elastic demand.

Guidance for monopolists:

• In the case of inelastic goods, price will be higher and it will be sold in a smaller quantity as
the monopolists know that the consumer will buy the product at any price as demand is
inelastic.
• In case of market demand for elastic goods, price will be kept low intentionally to retain the
maximum buyers with the product and demand for the good is stimulated through some
other activities such as promos, exhibitions, or advertisement etc.

Determination of fares:
• Fares of road transportations, such as buses, taxis etc. is low due to elastic demand because
if price on transport were increased there would be some substitute, like, railways, uber, etc.
• However, for inelastic transport, such as airways, the fare is quite high as there is no other
alternative for a person to get to one place form another as quickly as by air.

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

For Balance of Trade and Payments:

Exporters are charging high prices for goods having inelastic demand and lower price for
goods having elastic demand. If demand of an export-product is inelastic, an increase in price
will improve “Balance of Payment” of country.

Decision making during economic recessions:

Elasticity helps firms to predict, that which product with what intensity will hit during
recession, when the income shrinks. Accordingly, firm can change their decision to avoid their
losses.

PART-02: OTHERS ELASTICITIES OF DEMAND:

2.1: INCOME ELASTICITY OF DEMAND:

Definition:
Income elasticity of demand is the measure of the responsiveness of demand to a change in
consumer’s income.
OR
Income Elasticity of Demand is the ratio of the percentage change in quantity demanded to the
percentage change in income.

percentage change in Quantity demanded % Δ Qd

YED = =
percentage change in income %ΔY

Interpretation of in Income Elasticity of Demand:

➢ Sign Shows (Types of Good)

• If Answer is “Negative”, it is an inferior good. (Increase in income, decrease its demand)
• If Answer is “Positive”, it is a normal good. (Increase in income, increase its demand)

➢ Numeric value Shows (Elasticity of demand)

• If YED is < +1, (0 to +1) it means good is basic necessity. (Income inelastic)
• If YED is = +1, it means good is normal. (Unit elastic)
• If YED is > +1, it means good is luxury. (Income elastic)

Example-03: (Numerical)
A person’s income increases from Rs. 10,000 to Rs.15,000.
As a result, their demand for a product goes from 50 units to 40 units. (Using Arc method)
Answer:
Income Quantity Demand
10,000 50
15,000 40

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

Q1 −Q0 𝑦1 +𝑦𝑜
PED = η = ×
Q1 +Q0 𝑦1 −𝑦0

40−50 15,000+10,000
PED = η = 40+50 × 15,000−10,000
= -0.56 (inferior good having inelastic demand)

2.2: CROSS ELASTICITY OF DEMAND or CROSS PRICE ELASTICITY OF DEMAND:

Definition:
Cross elasticity of demand is the measure of the responsiveness of demand for a good A to a change
in price of good B.
OR
Cross Elasticity of Demand is the ratio of the percentage change in quantity demanded of good A to
the percentage change in price of good B.

percentage change in Quantity demanded of good A % Δ Qd A

XED = = % Δ Pof B
percentage change in price of good B

Interpretation of Sign in Cross Elasticity of Demand:

• If Answer is “Positive”, it is substitute good. (Positive Cross Elasticity),
(As the demand for one product moves in the same direction to the change in price of other
product.) e.g., Coke and Pepsi, butter and margarine.

• If Answer is “Negative”, it is complementary good. (Negative Cross Elasticity)

(As the demand for one product moves in the opposite direction to the change in price of
other product).
e.g., cell phone and charger, shoe pair and shoelaces.

• If Answer is “Zero”, goods are independent. (Zero Cross Elasticity)

e.g., Shoe and Apple

Unlike price elasticity of demand, the coefficient of cross elasticity of demand may be positive or
negative.
Example-04: (XED of Substitute good)

Price of Good A Quantity Demand of Good B

110 200
100 150
Q −Q 𝑃1 +𝑃𝑜
XED = Q1 +Q0 × P1−𝑃0
=
1 0
150−200 100+110
× = +3 (Positive sign shows that the products are substitutes.)
150+200 100−110

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Example-05: (XED of Complement good)

Price of Good A Quantity Demand of Good B

100 200
110 150
Q −Q 𝑃1 +𝑃𝑜
XED = Q1 +Q0 × P1−𝑃0
=
1 0
150−200 110+100
150+200
× 110−100 = -3 (Negative sign shows that the products are complements.)

PART-03: PRICE ELASTICITY OF SUPPLY

3.1: DEFINITION AND DEGREE OF ELASTICITY OF SUPPLY:

Definition of Price Elasticity of Supply:

Price elasticity of supply is the measure of the responsiveness of supply to a change in its price.
OR
Price Elasticity of Supply is the ratio of the percentage change in quantity supplied to the percentage
change in price of a good.
percentage change in Quantity supplieded % Δ Qs Q −Q 𝑃1 +𝑃𝑜
PES (η) = = = Q1 +Q0 ×
percentage change in Price %ΔP 1 0 P1−𝑃0
Degree of Elasticity of Supply:

S
1) Perfectly Inelastic Supply: Price
P1
• If quantity supplied of a good does not
change with change in price, it is called
Perfectly inelastic supply.
• (Supply is totally unresponsive by P0
change in price)
• ES = 0
• Slope of Supply curve is vertical, parallel
to y-axis
O Q0 Quantity Supplied

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

S
2) Inelastic/Less elastic Supply: Price
• If percentage change in quantity P1
supplied is lesser than percentage
change in price, it is called Inelastic
supply.
• ES < 1.
P0
supply curve will be sharp/steeper.

Price QS
100 50
200 60 Q0
O Q1 Quantity Supplied
(Arc method):
Ans: ES = +0.27 (Inelastic)

Price S
3) Unit/Unitary Elastic Supply:
• If percentage change in quantity
P1
supplied is equal to percentage change
in price, it is called Unit elastic supply
• PES = 1. P0

Price QS
100 50
200 100
(Arc method): Q0 Q1
O
Ans: Es = + 1 (Unitary Elastic) Quantity Supplied

Price
4) Elastic Supply:
• If percentage change in quantity
supplied is greater than percentage
change in price, it is called elastic S
supply. P1
• ES > 1. P0
• supply curve will be shallow/flatter.
Price QS
100 50
200 110 Q0
O Q1
(Arc method): Quantity Supplied
Ans: Es = + 1.125 (Elastic)

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

Price
5) Perfectly Elastic supply:

• A nominal (minuscule) change in price

will largely (infinitely) affect the demand
for the product., it is called Perfectly
elastic supply
P0 S

• the demand curve will be parallel line to

the horizontal axis

• PES = ∞ (infinity)
0 Q0 Q1
Quantity Supplied

i. If a linear supply curve intersects the price axis, the curve is elastic at all points.
ii. If a linear supply curve intersects the quantity axis, the curve is inelastic at all the points.
iii. If a linear supply curve intersects the origin, the elasticity is unity at all pints along supply
curve.
Note: in case of non-linear supply curve these rules are not compatible.

3.2: DETERMINANTS/FACTORS AFFECTING ELASTICITY OF SUPPLY:

• The degree of elasticity of supply depends how promptly producers can respond to the change in
demand in a market.
• If the supply of a good can be expanded or contracted comparatively easily in response to any
change in price, then it is elastic.
• If, however, supply remains comparatively fixed despite to any change in price, then supply in
inelastic

Cost of Production:
• If cos of production is low, its supply will be elastic because it’s easy for producer to produce
more goods.
• If cos of production is high, supply will be inelastic

The number of firms in the industry.

• The greater the number of firms in an industry, the more elastic is the industry supply. As
firms can respond to change in demand fairly easily.
• Lower the seller in the market, demand will be inelastic

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The availability of stock:

• If stocks are available with firms, then supply will be relatively more elastic because an
increase in demand can be met with an increase in supply without any change in structure
etc.
• If business has no stock, so it cannot fulfil more demand making supply inelastic

Existence of spare capacity:

• If the industry is operating below full capacity or it has spare capacity within existing
structure, then supply will be more elastic, because firm can increase supply by using vacant
factors.
• Conversely, if firm is already using its available resources at its full capacity, the supply will
be inelastic

Ease of switching resources:

• If the firm has ability to switch its factors of production to other products, the supply will be
elastic, because firm can respond to any change of demand in a market.
• Conversely, if firm has such resources which cannot be used in production of other goods, the
supply will be inelastic.

Time:
• Some goods take short time to complete their production process, have elastic supply. E.g.,
industrial goods
• Conversely some goods take long time to be completed, have inelastic supply. E.g.,
agriculture goods

3.3: TIME AND ELASTICITY OF SUPPLY

In very short-run (or momentary or immediate market period)

supply is perfectly inelastic because there is insufficient time to change output

In short-run/short time
Although the plant capacity is fixed, with little alterations in techniques of
production or with more efficient use of resources, supply can be adjusted up to a little extent, and
supply is therefore relatively inelastic

In long-run
In long run or long period all required adjustment can be made, including change in structure of the
building, plant size etc., in order to meet any change in demand and therefore supply will be highly
elastic.

Time Supply
Momentary Perfectly inelastic
Short-run Inelastic
Long-run Elastic

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PART-04: PRICE INSTABILITY AND ROLE OF GOVERNMENT

4.1: PRICE INSTABILITY:

Prices are most volatile (instable) when supply and demand both are inelastic

Example#1 : Analysis of Corn Market (Price Instability)

Internationally market for corn fluctuate greatly

Inelastic Demand & Supply:
throughout the year
Effect on Supply: Price S1 S0
• Supply of corn is uncertain due to good
P1
or bad harvest. E1
Effect on Demand:
• Demand for corn is inelastic (change in P0 E0
price more than change in quantity)
• Many food processes rely on corn and
D0
cannot substitutes other grain for it.
O Q1 Q0 Quantity

4.2: COBWEB THEORY:

The cobweb theorem is an economic model which explains that how little economic shocks can swell
up due to producer’s behaviour. Essentially, it is the result of information failure, where producers
decide their current level of output on the average price they obtained previously.

Assumptions of cobweb model

• We are dealing with agriculture industry, where time lags are involved in production.
• It is assumed that current prices will continue next year. Farmers have to decide, that how
much to produce a year in advance.
• Price is the function of preceding period’s supply
• The commodity concerned is perishable
• If price was low, then some farmers will no longer stay with this crop next year.

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Diagram
The diagram below demonstrates how the price mechanism adjusts price and quantity from one
year to the next. COBWEB THEORY:
S0
Price

P1
P3

P2

D0

O Q1 Q3 Q2 Quantity
Explanation:
1. First cycle:
Suppose due to bad harvest supply of Rice decreases below equilibrium at Q1 and price reaches
to P1 above equilibrium.

2. Second cycle:
Due to higher price in cycle1, this induced the farmer to produce more Rice at Q2. The excess
supply reduced the price at P2.

3. Third cycle:
In response to the low price in second cycle, farmers got disappointed and some farmers left the
production of Rice, this reduces the supply of Rice in this cycle. This low production again pushes
the price up at P3.

Price and quality will continue to oscillate (swing), though the market will approach equilibrium
at the market clearing price.

• Convergent case of cobweb:

At the equilibrium point, if the demand curve is more elastic than the supply curve, we get the
price volatility falling, and the price will converge on the equilibrium.

• Divergent case of cobweb:

Price will diverge from the equilibrium when the supply curve is more elastic than the demand
curve.

• Perpetual case of cobweb:

Fluctuations may also remain of constant magnitude, if the supply and demand curves have
exactly the same slope or elasticity of demand is exactly equal to the elasticity of supply.

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4.3: GOVERNMENT POLICIES TO INCREASE PRICE STABILITY:

Buffer stock scheme:

Price of a good is the main source of income for individuals and firms that work in the agriculture
sector.
Therefore, in order to ensure that they receive a stable, predictable income and Prevent
farmers/producers going out of business because of a drop in prices, the government often acts to
stabilize the price. This is usually done by the government through a buffer stock scheme,

Buffer Stock Scheme:

(S0)
Price

(S1)

E0
P0
E1
P1

(D)

Q0 Q1
Quantity

Disadvantages of Buffer Stock Scheme:

• Higher opportunity cost:

The main disadvantage that comes from this policy is the upfront cost of purchasing excess
stock above the market price. This requires capital that, as we have seen through the concept
of opportunity cost, could be spent meeting other policy objectives.

• Apprehension of excess production:

It can also encourage over-production of certain commodities, as the pricing signal of the
market mechanism is no longer in action.

• Administrative concerns:
There are also a lot of administrative and storage costs associated with the maintaining levels
of buffer stocks.

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PART-05 MULTIPLE CHOICE QUESTIONS

3.1 Which of the following products is likely to have the lowest price elasticity of demand?
(a) Salt (b) Cars
(c) Houses (d) apples

3.2 Which of the following has the most inelastic demand?

(a) Fuel (b) Wheat
(c) Meat (d) Sugar

3.3 Production and employment in which of the following industries would be least affected by recession?
(a) Sugar (b) Steel
(c) Garments (d) Vehicles

3.4 If the market price of a product increases from Rs. 35 to Rs. 40 and in response, the quantity demanded
decreases from 1400 units to 1200 units, the value of its price elasticity of demand is:
(using Arc method)
(a) 0.9 (b) 1
(c) 1.1 (d) 1.2

3.5 Which of the following is NOT a method for the measurement of price elasticity of demand?
(a) Total outlay (b) Total savings
(c) Point method (d) Arc method

3.6 If the price of a good fell by 10% and, as a result, total expenditure on the good FELL by 15%, the
demand for the good would be described as
(a) perfectly inelastic (b) Inelastic
(c) unitary elastic (d) elastic

3.7 When there is a small change in the quantity demanded of a product in response to a small charge in
its price. Elasticity will be known as:
(a) Point elasticity (b) Arc-elasticity
(c) Gross elasticity (d) None of the above

3.8 If the demand for a good is price inelastic, which ONE of the following statements is correct?
(a) If the price of the good rises, the total revenue earned by the producer increases.
(b) If the price of the good rises, the total revenue earned by the producer falls.
(c) If the price of the good falls, the total revenue earned by the producer increases.
(d) If the price of the good falls, the total revenue earned by the producer is unaffected.

3.9 Elasticity of demand depends upon:

(a) proportion of income spent on the (b) income elasticity of demand.
particular good
(c) substitution elasticity of demand. (d) all of the above.

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3.10 An inferior good is one which has an income elasticity of demand that is
(a) positive but less than unity (b) negative
(c) unitary (d) zero

3.11 If percentage change in quantity demanded is greater than percentage change in price demand said
to be:
(a) Less elastic (b) More elastic
(c) Inelastic (d) Perfectly elastic

3.12 If total consumer’s expenditure increases in response to price fall, demand is:
(a) Relatively elastic (b) Relatively inelastic
(c) Unitary elastic (d) All of the above

3.13 If the price of a good fell by 20% but total expenditure on the good remained the same, the demand
curve could be described as
(a) Perfectly elastic (b) Elastic
(c) Perfectly inelastic (d) Unitary elasticity

3.14 The horizontal demand curve parallel to x-axis implies that elasticity of demand is:
(a) Zero (b) Infinite
(c) equal to one (d) between zero and one

3.15 Increase in price, increase Total revenue, the demand is?

(a) Elastic (b) Perfectly elastic
(c) Inelastic (d) Perfectly inelastic

3.16 Increase in price, increase Total revenue, the demand is Elastic.

(a) True (b) False

3.17 If the demand is perfectly inelastic, then curve is (Select any TWO)
(a) Horizontal (b) Parallel to x-axis
(c) Vertical (d) Parallel to y-axis.

3.18 If the quantity of a commodity demanded remains unchanged as its price changes the coefficient of
price elasticity of demand is:
(a) Greater than one (b) Equal to one
(c) Smaller than one (d) Equal to zero

3.19 Let quantity demanded decreases from 30 to 10 as price of the product increases from 200 to 400.
Price elasticity of demand would be:
(a) 2.5 (b) 1.5
(c) 0.5 (d) zero

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3.20 In geometric method, demand is elastic from center to lower demand curve
(a) True (b) False

3.21 If price of one good A decrease, demand for its complement good B increase, will make demand
inelastic.
(c) True (d) False

3.22 A shop sells chocolate birthday cakes. When the price was Rs.15 it sold 40 cakes. It reduced the price
to Rs.10 and sold 60 cakes. What can be concluded from this?
(a) The firm will make less profit because the price has fallen.
(b) The firm will make more profit because sales have increased.
(c) The price elasticity is inelastic because demand only increased by 50 %.
(d) There is unit price elasticity because the firm’s revenue remained the same after the price
Change

3.23 If price increase from 2 to 4. Use percentage method to solve. (Calculate PED)

4 8 12
(a) 3/5 (b) 2/5
(c) 1/5 (d) 2/6

3.24 Select any TWO options in which demand is totally unaffected by change in price.
(a) Demand is perfectly inelastic (b) Demand is perfectly elastic
(c) Demand curve is horizontal (d) Demand curve is vertical

3.25 If the price of a good fell by 5% and as a result, total expenditure on the good fell by 10% the demand
for the good would be:
(a) Elastic (b) Unitary elastic
(c) Inelastic (d) Perfectly elastic

3.26 A firm with existing sales of 1,000,000 units per annum is planning to increase the price of a product
from Rs. 100 to Rs. 120 per unit. If price elasticity of demand for that product is 1.25, assuming no
other changes, the sale of the firm after price increase would be:
(a) 1,250,000 units (b) 750,000 units
(c) 1,200,000 units (d) 800,000 units

3.27 If PED is -2.5, it means good is ___________________, having __________________ demand.

(a) Giffen, Elastic (b) Inferior, Elastic
(c) Normal, Inelastic (d) Normal, elastic

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3.28 If YED is -0.75, it means good is ___________________, having __________________ demand.

(a) Inferior, Elastic (b) Inferior, Inelastic
(c) Normal, Inelastic (d) Normal, elastic

3.29 If XED is +1.75, it means good is ___________________, having __________________ demand.

(a) Complementary, Elastic (b) Independent, Inelastic
(c) Substitute, Inelastic (d) Substitute, elastic

3.30 Lithium is an essential metal for the production of electric cars. Following a 10% increase in the price
of lithium, supplies increase by 15%. This led to a 5% increase in the price of electric cars.
What is the price elasticity of supply (PES) for lithium?
(a) 0.75 (b) 1.50
(c) 2.5 (d) 0.25

3.31 The price of bread rose by 5% and the quantity demanded fell by 4%. What was the price elasticity
of demand for bread?
(a) -0.75 (b) -0.6
(c) -0.8 (d) -0.25

3.32 A business, currently selling 10,000 units of its product per month, plans to reduce the retail price
from £1 to £0.90. It knows from previous experience that the price elasticity of demand for this
product is -1.5. Assuming no other changes, the sales which the business can now expect will be
(a) 8,500 units (b) 9,000 units
(c) 11,000 units (d) 11,500 units

3.33 If a straight-line demand curve is tangent to a curvilinear demand curve, the elasticity of the two
demand curves at the point of tangency is:
(a) The same (b) Different
(c) Can be the same (d) It depends on the location of the point of
tangency

3.34 In a country where the demand for petrol (gas) is price-inelastic, the incidence of any increase in
petrol tax will be mainly on
(a) the company that refines the oil. (b) the motorist who buys the petrol.
(c) the petrol station that sells the petrol. (d) the wholesale company that stores the
petrol.

3.35 A negative income elasticity of demand for a commodity indicates that as income increase then
amount of the commodity purchased:
(a) Rises (b) Falls
(c) Remain the unchanged (d) Any of the above

3.36 Very small or zero Co-efficient of price elasticity of demand means that the good is:
(a) a necessity (b) a comfort
(c) a luxury (d) any of the above

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3.37 Price elasticity coefficient of 0.2 implies that the _______________%age change in quantity for a 5%
change in price will be:
(a) 0.2 (b) 2.5
(c) 5 (d) 1

3.38 Assume that a fall in price of a commodity form Rs10 to Rs.9 per unit results in an increase in weekly
sales from 100 units to 110 units. Price elasticity of demand would be: (Using Point method)
(a) 1.9 (b) Unity
(c) 2 (d) Zero

3.39 If the amounts of two commodities purchased both increase or decrease when the price of one
change, the cross elasticity of demand between them is:
(a) Negative (b) Positive
(c) Zero (d) One

3.40 The standard measure for measuring demand and supply elasticity is
(a) Zero (b) Unity
(c) Infinity (d) Two

3.41 The income elasticity of demand for an income inferior good has an arithmetic sign.
(a) Positive (b) Zero
(c) Negative (d) No sign

3.42 Income elasticity of demand for inferior goods is always:

(a) Positive (b) Negative
(c) Zero (d) Infinity

3.43 Price elasticity of demand for Giffen goods is always.

(a) Positive (b) Negative
(c) Zero (d) Infinity

3.44 Cross elasticity of demand for complementary goods is always.

(a) Positive (b) Negative
(c) Zero (d) Infinity

3.45 From the demand schedule below, the price elasticity of demand following a fall in
price from Rs 25 to Rs. 20 is: (Using Point method)

Price (Rs.) Quantity (units)

30 15
25 20
20 25
15 30

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

(a) -1 (b) -1.25

(c) -1.5 (d) -1.75

3.46 The quantity demanded for Alpha decreases from 300 units to 250 units, when the price of Beta
increases from Rs. 50 to Rs. 55. Determine the Cross Price Elasticity of Demand (XED)
(a) – 1.91 (b) + 1.91
(c) – 2.91 (d) +0.91

3.47 With the drop in price of smartphones from Rs. 80,000 to Rs. 70,000, the quantity demanded by the
consumers, in a particular market, increases from 20,000 phones to 30,000 phones per month. Calculate
the elasticity of demand under percentage method and identify the type of elasticity
(a) +3 (b) 2.5
(c) – 2.5 (d) -3

3.48 Which of the following is NOT a method for the measurement of price elasticity of demand?
(a) Total outlay (b) Total savings
(c) Point method (d) Arc method

3.49 Which of the following is NOT an importance of Elasticity of demand.

(a) For finance minister (b) Guidance for monopolist
(c) Income spent on goods (d) Price determination

3.50 Demand for cars decrease when their prices increase. However, demand may also decrease when
income of consumers decrease. Price and income elasticities of cars are said to be:
(a) elastic; negative (b) elastic; positive
(c) inelastic; negative (d) inelastic; positive

3.51 If cross elasticity of demand between Goods X and Y is negative then:

(a) the demand for both X and Y is price inelastic
(b) X and Y are complements
(c) X and Y are substitutes
(d) the demand for both X and Y is price elastic

3.52 Which one of the following statements about the elasticity of supply is not true?
(a) It tends to vary with time.
(b) It is a measure of the responsiveness of supply to changes in price.
(c) It is a measure of changes in supply due to greater efficiency.
(d) It tends to be higher for manufactured goods than for primary products

3.53 The price of a product is Rs. 3 and the quantity supplied is 10 units. When price is increased to Rs. 7
the quantity supplied increases to 12 units. The supply is:
(a) perfectly elastic (b) elastic
(c) inelastic (d) perfectly inelastic

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3.54 When only a small proportion of a consumer's income is spent on a good

(a) the demand for the good will be highly price elastic
(b) the good is described as 'inferior'
(c) a rise in the price of the good will strongly encourage a search for substitutes
(d) the demand for the good will be price inelastic

3.55 Over a long period of time:

(a) demand becomes more elastic and supply becomes less elastic.
(b) demand becomes less elastic and supply becomes more elastic.
(c) both demand and supply become more elastic.
(d) both demand and supply become less elastic

3.56 If the demand for a good is price elastic, a fall in price will lead to
(i) a rise in sales
(ii) a fall in sales
(iii) a rise in total expenditure on the good
(iv) a fall in total expenditure on the good
Which of the above are correct?

(a) (i) and (iii) only (b) (i) and (iv) only
(c) (ii) and (iii) only (d) (ii) and (iv) only

3.57 Main determinant of Elasticity of Demand is:

(a) Time period (b) Brand loyalty
(c) Possibility of substitution (d) All of the above

3.58 Demand for cars decrease when their prices increase. However, demand may also decrease when
income of consumers decrease. Price and income elasticities of cars are said to be:
(a) elastic; negative (b) elastic; positive
(c) inelastic; negative (d) inelastic; positive

3.59 As the period of time to supply a product into a market in order to meet the demand is increasing
the elasticity of supply also.
(a) Increasing (b) Decreasing
(c) Remains same (d) None of the above

3.60 A shift to the right in the supply curve of a good, the demand remaining unchanged, will reduce its
price to a greater degree.
(a) The more elastic the demand curve (b) The less elastic the demand curve
(c) The elasticity of demand is unity (d) Supply curve is more inelastic

3.61 Elasticity supply of perishable goods is generally:

(a) Perfectly elastic (b) More elastic
(c) Unitary elastic (d) Less elastic

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3.62 In the below diagram, curve “C” having elasticity of supply.

(i) Less elastic

(ii) More elastic
(iii) Unitary elastic
(iv) Inelastic

(a) (i) & (iv) (b) (i) & (iii)

(c) (iii) (d) (iii) & (iv)

3.63 Elasticity of supply of durable goods is generally

(a) Unitary elastic (b) More elastic
(c) Inelastic (d) Less elastic

3.64 In_____ partial adjustment can be made to enable producers to increase the supply of the product.
(a) very short run (b) short run
(c) long run (d) All of these

3.65 In ____________, it can be expected that the whole supply position will change.
(a) very short run (b) short run
(c) long run (d) All of these

3.66 In the below diagram supply curve represents.

(i) Perishable good

(ii) Perfectly inelastic good
(iii) Normal good
(iv) Durable good

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 CH-03: ELASTICITY OF DEMAND AND SUPPLY

(a) (i) & (ii) (b) (ii) & (iv)

(c) (ii) & (iii) (d) (ii) & (iv)

3.67 The elasticity of supply in momentary or immediate market period is ____________________

(a) perfectly inelastic (b) perfectly elastic
(c) elastic (d) Inelastic

3.68 The supply of a particular product will be more inelastic.

(a) The longer it takes to produce the good
(b) The longer the good can be store
(c) The greater the number of firms in the industry
(d) The greater the amount of spare capacity in the industry

3.69 If a linear supply curve intersects the price axis, the curve is inelastic at all points
(a) True (b) False

3.70 Some goods take long time to complete their production process, having elastic supply.
(a) True (b) False

3.71 If business has no stock, so it cannot fulfil more demand making supply inelastic
(a) True (b) False

3.72 Which of the following is NOT an assumption of COBWEB theory.

(a) Concept relate to agriculture sectors (b) No time lag is involved in production
(c) Concept relate to Perishable goods (d) Price is the function of previous year’s
supply

3.73 The oscillations in a cobweb cycle will decay towards equilibrium if.
(a) The supply is perfectly inelastic
(b) The supply is perfectly elastic
(c) The supply curve is steeper than the demand curve.
(d) The demand curve is steeper than the supply curve

3.74 Price convergence case of cob-web model depends upon:

(a) Elasticity of supply is greater than elasticity of demand
(b) Elasticity of demand is greater than elasticity of supply
(c) Elastic of demand is perfectly elastic
(d) Elasticity of supply is perfectly less elastic

3.75 Price divergence case of cob-web model depends upon:

(a) Elasticity of supply is greater than elasticity of demand
(b) Elasticity of demand is greater than elasticity of supply
(c) Elastic of demand is perfectly elastic
(d) Elasticity of supply is perfectly less elastic

3.76 Buffer stock helps government:

(a) To protect producers
(b) To encourage production of a particular product
(c) To maintain price stability into market
(d) All of above

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3.77 For buffer stock, government may face:

(a) Over production of a particular crop
(b) Less opportunity cost
(c) Less administrative expense
(d) b & c

3.78 For price stability buffer stock policy can be used by government for:
(a) Agricultural goods (b) Primary goods
(c) Perishable goods (d) All of the above

ANSWER KEY

3.1 A 3.2 B 3.3 A 3.4 C

3.5 B 3.6 B 3.7 A 3.8 A

3.9 D 3.10 B 3.11 B 3.12 A

3.13 D 3.14 B 3.15 C 3.16 B

3.17 C,D 3.18 D 3.19 B 3.20 B

3.21 A 3.22 D 3.23 A 3.24 A,D

3.25 C 3.26 B 3.27 D 3.28 B

3.29 D 3.30 B 3.31 C 3.32 D

3.33 A 3.34 B 3.35 B 3.36 A

3.37 D 3.38 B 3.39 A 3.40 B

3.41 C 3.42 B 3.43 A 3.44 B

3.45 B 3.46 A 3.47 D 3.48 B

3.49 C 3.50 B 3.51 B 3.52 C

3.53 C 3.54 D 3.55 C 3.56 A

3.57 D 3.58 B 3.59 B 3.60 D

3.61 D 3.62 C 3.63 B 3.64 B

3.65 C 3.66 A 3.67 A 3.68 A

3.69 B 3.70 B 3.71 A 3.72 B

3.73 C 3.74 B 3.75 A 3.76 D

3.77 A 3.78 D

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TEST-03
Q-1) Increase in price, increase Total revenue, the demand is?
a) Elastic b) Perfectly elastic
c) Inelastic d) Perfectly inelastic

Q-2) If the income elasticity of a demand for a good is positive but less than 1, then the good will be;
a) Luxuries b) Substitute

c) Necessities d) Inferior

Q-3) If demand is elastic and supply is inelastic then decrease in supply will:
a) Increase in price equilibrium is more than increase quantity equilibrium
b) Increase in price equilibrium is less then decrease quantity equilibrium
c) Decrease in price equilibrium is more than decrease quantity equilibrium
d) Decrease in price equilibrium is less then decrease quantity equilibrium

Q-4) If the demand curve is perfectly inelastic then curve will be (Select TWO)
a) Horizontal b) Vertical
c) Parallel to x-axis d) Parallel to y-axis

Q-5) If elasticity is zero then goods are?

a) Dependent b) Independent

Q-6) The demand for a good rise from 20,000 to 25,000 following a reduction in price from $20 to $18.
What is the price elasticity of demand? (Using the point elasticity of demand method)
a) -2.1 b) -2.5
c) +2.1 d) +2.5

Q-7) Sales of Good T are currently 10,000 per year, and income elasticity of demand for Good T is + 1.5. If
household incomes rise by 4%, what will be the new annual sales of Good T?
a) 10,600 b) 10,400
c) 9,600 d) 9,400

Q-8) When only a small proportion of a consumer's income is spent on a good:

a) The good is described as 'inferior'
b) The good is a luxury good
c) The demand for the good will be highly price elastic
d) The demand for the good will be price inelastic

Q-9) If supply curve is more elastic than the demand curve then price will.
a) Convergent case of cobweb b) Divergent case of cobweb

Q-10) The demand for a product will tend to be inelastic when:

a) It has very few close substitutes
b) It has low demand.
c) It tends to be purchased by people on subsistence incomes
d) It has a wide range of different uses

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 CH-04 FIRM THEORY

CHAPTER-04
“FIRM THEORY”

PART-01: PRODUCTION

1.1: SHORT RUN PRODUCTION FUNCTION/LAW OF RETURN 94

1.2: LONG RUN PRODUCTION FUNCTION/RETURN TO SCALE 97
1.3: LONG RUN COSTS (Economy & Diseconomy of Scale) 98
1.4: DERIVING A LONG RUN AVERAGE COSTS/ENVELOP RELATIONSHIP 99

PART-02: COSTS OF PRODUCTION

2.1: EXPLICIT AND IMPLICIT COSTS: 100

2.2: TYPES OF COST/ SHORT RUN COSTS: 101
2.3 LAWS OF COSTS: 103
2.4: WHY THE SHORT RUN AVERAGE COST CURVE IS U-SHAPED: 104
2.5: COMPARATIVE STUDY OF PRODUCTION AND COST: 104

PART-03: REVENUE

3.1: REVENUE CURVES UNDER DIFFERENT COMPETITIONS 105

PART-04: MARKET STRUCTURE

4.1: PERFECT COMPETITION 107

4.2: MONOPOLISTIC COMPETITION 111
4.3: MONOPOLY 114
4.4: OLIGOPOLY 119

PART-05: GOLABALIZATION

122

PART-06: MULTIPLE CHOICE QUESTIONS & TEST-04

MCQ 124
TEST-04 136

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 CH-04 FIRM THEORY

PART-01: PRODUCTION

Production:
Production is the activity of making goods and services by combining input resources (factors of
production).
The main objective of the consumer is to maximize their utility, while the firm is to maximize its
profit.

Production function:
Production function is a relationship between input and output of the firm
 Mathematically,
Q = 𝑓( L, K )

Where, Q stands output or production, 𝑓represents the function, L for Labour, K for Capital

For example, if you are running a garments unit. The quantity outfits is your output, whereas labour,
machines, raw material and building etc., are required inputs.

There are two types of production function:

• Short run production function/Law of return
• Long run production function/ Law of return to scale

Cost behavior over different timescales.

Short run: is a period of time in which at least one factor of production must remain fixed. Short
run cost is equal to fixed plus variable cost

Long run: is a period of time in which it is possible to vary output by varying all factors of
production within the given state of technology. In long run all of the cost will be variable

1.1: LAWS OF RETURNS/ RETURN TO FACTORS/ LAW OF VARIABLE

PROPORTIONS/ SHORT RUN PRODUCTION FUNCTION:

In short run, we assume labour is the only variable factor, whereas the capital is fixed.
Q = 𝑓( L, 𝑘̅ )
Definition:
When we apply variable factor labour (L) into fixed factors of production Capital (K), marginal
product (MP) and Average product (AP) would continue to increase up to a certain point, after that
the MP and AP start to decrease and finally MP become negative.

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Assumptions:
• Short run: This law operates only in short run. As in long run we can change the techniques of
production so, productivity of the labour can be increased.

• Labour is the only variable input factor: In this model labour is assumed as variable input
factor.
• Constant state of technology: Due to short run its further assumed that there is no possibility
to change the existing technology, otherwise the marginal product can increase.

• Homogeneous input factors: This law is effective only, when all the input factors are
homogeneous (equally efficient).

• Possibility to combine the input factors: It is further assumed that there is no constraint to
combine the resources in order to get output. All the resources are attuned with one another.

Total Product (TP): (Output)

Total product is amount of goods and services produced by utilizing all the available inputs in given
period of time.

Average Product (AP): (per labour unit output)

How much of the good that is produced on average by a certain input factor i.e. labour or capital.
𝑻𝒐𝒕𝒂𝒍 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑄 𝑄
𝑨𝑷 = 𝑰𝒏𝒑𝒖𝒕 𝒇𝒂𝒄𝒕𝒐𝒓
, APL = 𝐿 , APK = 𝐾

Marginal Product (MP): (Slope of TP)

• It is rate of change in total product by using an extra unit of input.
• marginal product expresses the contribution of an additional input factor to the total product.
∆ 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝒑𝒓𝒐𝒅𝒖𝒄𝒕
𝑴𝑷 =
∆ 𝒊𝒏 𝒊𝒏𝒑𝒖𝒕 𝒇𝒂𝒄𝒕𝒐𝒓

∆𝑄 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 ∆𝑄 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡

MPL = = , MPK = =
∆𝐿 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑙𝑎𝑏𝑜𝑢𝑟 𝑖𝑛𝑝𝑢𝑡 ∆𝐾 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑝𝑢𝑡
Table:

Fixed Factor Variable Total Product Marginal Product Average Stages

of Factor of (TP) (MP) Product
Production Production (Output) (△ in TP / △ in L) (AP)
(Capital) (Labor) (TP / TL)
1 0 0 - 0
1 1 2 2 2 Stage-1
1 2 6 4 3
1 3 12 6 4
1 4 16 4 4 Stage-2
1 5 18 2 3.6
1 6 18 0 3
1 7 16 -2 2.28 Stage-3

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Explanation:

Stage 1- Law of increasing returns:

• TP increases at a increasing rate.
• MP increases and reaches a maximum.
• AP increases

Stage 2- Law of diminishing returns:

• TP increases at a slower rate and reaches its maximum point.
• MP equal to AP then decreases and become equal to zero.
• AP continue to increase, reaches maximum then start decreasing.

Stage 3- Law of negative returns:

• TP start decreasing.
• MP becomes negative
• AP continue to fall but will always greater than zero.

Diagram:

Conclusion: A rational producer will stop its production at stage-II, where MP remains positive.

Summary:

Stages TP MP AP
I Increase Increase, then maximum Increase
II Increase Decrease, then zero Increase, maximum then Decrease
III Decrease Negative Decrease but positive

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Relationships between Productivity Curves:

1) Relationship between MP and TP:
• If MP is positive, TP increases.
• If MP is zero, TP is maximum.
• If MP is negative, TP decreases

2) Relationship between MP and AP:

• If MP > AP, AP increases.
• If MP = AP, AP is at its maximum.
• If MP < AP, AP decreases.

1.2: LONG RUN PRODUCTION FUNCTION/RETURN TO SCALE:

Long run production function when firm is capable to alter all its input factors including those which
were fix in our previous discussion is referred to as short run production function.

Q = f (L, K)
Returns to Scale:
Relation between output and variation in only one input factor is known as returns to factor.
The relation between output and variation in all inputs, taken together, is termed as returns
to scale (as all the input factors are variable here).

1. Increasing returns to scale: If the rate of change in output is greater than the all input,
this is called Increasing return to scale. It occurs due to Economies of Scale (by using more
financial resources, qualified and trained staff with advance administration and technology).
During this phase, Long-run average cost of firm decreases.

2. Constant returns to scale: If the rate of change in output is equal to all input, this is called
constant return to scale. It occurs due to constant Economies of Scale. During this phase,
Long-run average cost of firm remain same.

3. Decreasing returns to scale: If the rate of change in output is lesser than rate of change
in all inputs, this is called Decreasing return to scale. It occurs due to Diseconomies of Scale.
During this phase, Long-run average cost of firm increases.

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1.3: LONG RUN AVERAGE COSTS

Economies and Diseconomies of Scale:

Economies of scale:
Economies of scale exist when long run average costs decline as output expands. It is the advantages
of large-scale production

Cost Long Run Average Cost

LRAC
C
C1

C2

Economies of Scale Diseconomies of Scale

0 Q1 Q2 Output
Graph’s Explanation:
In the graph above, a firm’s ATC in long run is expressed using a relatively flatter cost curve. It is
explained with output along X-axis, that as firm expands its output from Q1 to Q2, its average cost
falls from C1 to C2, where the firm is experiencing the economies of scale up to Q2. Furthermore, as
firm expands its output beyond the Q2, the economies of scale exhausted. Here, the firm is facing
diseconomies of scale, which cause an increase in long run ATC.

Reasons of Economies of Scale:

Firm can enjoy in long run that causes fall in cost of production for a firm e.g.

1. Specialization in Labour:
Skilled and specialized labour along with division of work among the large number of workers
causes diminishing cost for the firm.

2. Technological factors: It’s better to run a large comprehensive machine rather than use
different small machines to avoid extra cost.

3. Buying in bulk leads to discounts from sellers. As firms are not only one input resource, they can
get multiple discounts on different raw materials, supplies, and other inputs.

4. Financial economies/Cost of capital large firm can acquire loan from capital markets at more
favourable rates. As large firms have heavy accounts with banks, such as salary account, trading
accounts etc., resultantly, they have good bargaining position in banks to sanction loan at more
attractive interest rates, (causing a greater decrease in cost of production).

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5. Repairing and maintenance

Large scale businesses have a number of plants operational which make repairing workshops
and services available at their door step (reducing the transportation and time cost involved).

6. Start-up cost
Many businesses sometime become more crucial. Firms have to spent a minimum budget just to
start a business regardless of the projected sales, such as product development, product and
packaging design, printing etc. Such cost decreases on average as output increases

7. Cost of advertisement and other commercial activities such as exhibitions and billboard
hoarding etc., decreases as output increases.

Diseconomies of scale:
Diseconomies of scale exist when long run average costs increases as output expands. It is the
disadvantages of large-scale production

Factors/Reasons of Diseconomies of Scale:

1. Coordination among units:
In large scale organization is an expensive activity. Such coordination requires a lot of budget to
install monitoring systems.

2. Hierarchy of management
Communication and Coordination problems between workers and departments. So many cost-
effective decisions sometime suffer by not taking decision in time.
3. Staff overhead:
Over staff tends to grow more than proportionately with output, again raising unit cost.

4. Labour unrest or tension:

prevailing among the workers due to various industrial disputes. Such factors reduces worker’s
efficiency and cause an increase in unit cost.

1.4: LONG RUN AVERAGE COSTS/ENVELOP RELATIONSHIP

Cost ENVELOP CURVE

SRAC3
SRAC1 LRAC
SRAC2 C

Economies of Scale Diseconomies of Scale

0 Q1 Q2 Q3 Output

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Suppose a firm is using different plants to produce a wide range of production named plant 1, 2 and
3 associated with three short run cost curves, SRAC1, SRAC2 and SRAC3 respectively.
The long run ATC curve is also termed as “envelope curve”.

These short run average cost curves are also called plant curves.

Long run ATC is the sum of all short run ATCs at the point of tangency. The points of tangency
between long run ATC and short run ATC curves do not occur at the minimum points of the short run
ATC curves except at the point where the minimum efficient scale (MES) is achieved

If the firm tries to produce an output which is greater than Q1 but less than Q2, then it chooses
SAC2 since SAC1 involves higher costs. Also, for outputs larger than Q3, the firm uses SAC3. Summing
up, we can say that in the long run, the firm employs the plant yielding maximum output at minimum
cost per unit
Hence, Long-run average cost curve is the envelope (cover) of short-run average cost curves. The
optimal scale for a plant is found at that point where the long run average cost is at its lowest.

PART-02: COSTS OF PRODUCTION

The overall costs incurred for producing goods and services is called the cost of production.
These costs include monetary payments (rewards of factors of production) and non- monetary
payments (opportunity cost or forgone benefits)

2.1: EXPLICIT AND IMPLICIT COSTS:

Explicit costs: (Also called out-of-pocket cost)

are the costs that have been incurred and have also been booked as an expense by an accountant.
These are the expenses that are paid out costs and involve cash outflows from the business.

Examples include: interest obligations, wages paid to the workers, utility expenses, raw material
payments and building rents etc

Implicit costs: (Also called Non-Cash Cost or Opportunity cost)

are the costs that have already been incurred but are not separately shown as an expense while
calculating the total cost of production.

Examples include:
• Rent that a shop owner could receive on buildings instead of not doing business is an implicit
cost for landlord.
• Salary that an individual could receive by working for someone else instead of operating his
own commercial activity
• opportunity cost, Normal profit etc.

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NOTE:
• Accountant consider only Explicit cost, while Economist consider both Explicit and Implicit cost.
Total Economic Cost = Explicit Cost + Implicit Cost
• Accounting Profit = Sales revenue – Explicit cost
• Economic Profit = Sales revenue - Explicit cost - Implicit cost

Example:
Mr. Hasnan currently works for a law firm. He has planned his own legal practice, where he expects
to earn Rs.200,000 per year once he establishes himself. To run his own law firm, Zain would
have to quit his current job, where he is earning an annual salary of Rs.125,000. This would be
an implicit cost (opportunity cost) of opening his own firm. To run his own firm, he would need an
office and supporting staff. He has found the perfect office, which rents for Rs.50,000 per year.
He could hire supporting staff for Rs. 35,000 per year. If these figures are accurate, would Hasnan’s
legal practice be profitable?

Answer:
Economic profit = Total Revenues – (Explicit Costs+ Implicit Costs)

Accounting profit = Rs.200,000 - Rs.50,000 - Rs. 35,000 = Rs.115,000

Economic Loss =Rs.200,000 – (Rs.85,000 + Rs.125,000) =(Rs.10,000) per year
Conclusion:
Hasnan would be losing Rs.10,000 per year.

2.2: TYPES OF COST/ SHORT RUN COSTS:

(i) Fixed Cost: (FC)

A fixed input factor is that which remains unchanged while making any change in output
FC is the cost which a firm compensates to its fixed input factors and remains unchanged
during the production process.

Examples: Rent, salary Expense, Interest on capital, Insurance premium etc.

(ii) Variable Cost: (VC)

Variable factor (VC) fluctuates with variation in production.

Examples: Raw material, Electricity expense etc.

(iii) Total Cost: (TC)

Total Cost means cost of the production of all units. (Fixed + variable)
Total Cost = Fixed Cost + Variable Cost.
OR
Total Cost = Average Cost * Quantity

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Fixed Cost, Variable Cost & Total Cost:

TC = FC + VC TC
COST

TVC
TC

TFC

TFC
TVC

QUANTITY

(iv) Marginal Cost: (MC)

• Where, the marginal cost (MC) or incremental cost is the additional cost of producing an
extra unit of given product.
• Marginal cost represents the slope of total cost function as; A firm can avoid MC by not
producing the extra unit

Marginal Cost = ΔTC / ΔQ (i.e. Change in Total Cost / Change in Quantity)

(v) Average Fixed Cost: (AFC)

Average Fixed Cost = Fixed Cost / Quantity

(vi) Average Variable Cost: (AVC)

Average Variable Cost = Variable Cost / Quantity

(vii) Average Total Cost: (ATC) = (ATC = AFC + AVC)

𝑻𝑪 𝑻𝑭𝑪 𝑻𝑽𝑪
= +
𝑸 𝑸 𝑸

Average Total Cost (ATC or AC) = Total Cost / Quantity

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2.3: LAWS OF COSTS

Units of Fixed Variable Total Marginal A.F.C A.V.C A.C (Rs.)

Output Costs Costs Costs Costs (Rs.) (Rs.)
(Q) (Rs.) (Rs.) (Rs.) (Rs.)

0 10 0 10 - - - -
1 10 10 20 10 10 10 20
2 10 19 29 9 5 9.5 14.5
3 10 27 37 8 3.3 9 12.33
4 10 35 45 8 2.5 8.75 11.25
5 10 47 57 12 2 9.4 11.4
6 10 67 77 20 1.6 11.17 12.83
7 10 103 113 36 1.4 13.3 16.14

Explanation:

It is clear from the above schedule that the fixed cost is unchanged throughout that is 10 but Average
Fixed Cost is diminishing because when output increases, the fixed costs spread over the total output
and hence, Average Fixed Cost is diminishing due to law of increasing returns.
As output increases, the MC decreases until the third unit. It then remains constant until the fourth
unit after which it increases.
Relationship between the Cost Curves:

Relationship with ATC, AVC, AFC, MC:

MC AVC
COSTS

ATC

AFC

AVC

AFC

Quantity

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Relationship between MC and (AC)/AVC Curve:

Marginal Cost curve cuts the Average Cost curve at its minimum point.

1. When MC is less than AC, AC decreases.

2. When MC is equal to AC, AC is at its minimum.
3. When MC is greater than AC, AC increases but at a slower rate than the MC.

NOTE:
• Relationship between MC and AVC Curve is same as above just replace word AC with AVC.
• MC is the Supply Curve of the firm

2.4: WHY THE SHORT RUN AVERAGE COST CURVE IS U-SHAPED:

Short-run average cost curve is U shaped, because:
• The average cost is made up of an average fixed cost per unit plus an average variable cost
per unit. ATC = AFC + AVC.
• As the firm’s output rises, the average fixed cost will fall because the total fixed cost is being
spread over an increasing number of units. Average Fixed Cost is diminishing due to law of
increasing returns. However, at the same time, average variable cost will be rising because of
law of diminishing returns to the variable factor.

Hence the curve falls on account of spread of fixed costs and rises when the variable costs start rising
after a certain level, thus giving the curve a U shape

2.5: COMPARATIVE STUDY OF PRODUCTION AND COST:

1) Stage-01 Law of Increasing Return also called Law of decreasing Cost:

2) Stage-02 Law of Constant Return also called Law of Constant Cost:

3) Stage-03 Law of diminishing Return also called Law of increasing Cost:

MC/MP Stage-02
Diagram: 6
Stage-01 Stage-03
2
MC
5

2
MP
1

1 2 3 4 5 6

Units of Variable FOP

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PART-03: FIRM’S REVENUE

Total Revenue:
Revenue is that income (money) which a firm earns by selling its goods into market.

Total revenue = sale price x total sale (TR= P x Q)

Total Revenue = Average Revenue x Total Output sold (TR = AR x Q)

Average Revenue: (AR=Price)

Average revenue is the average price a firm received from market against its sold products

Average Revenue = Total Revenue / Units sold (AR = TR/Q)

Marginal Revenue: (Slope of TR)

Marginal Revenue is the additional income from selling an additional unit of quantity.

Marginal Revenue = Change in Total Revenue / Change in Quantity sold (∆TR/∆Q)

3.1: REVENUE CURVES UNDER DIFFERENT MARKET STRUCTURES

• Perfect Competition
• Imperfect Competition (Monopolistic Competition, Monopoly & Oligopoly)

Revenue Curves under Perfect Competition:

A market structure where price remains same at each level of production is called perfect
competition.

Price Quantity Total Average Marginal

Revenue Revenue Revenue

P Q PxQ TR/Q ∆TR/∆Q

10 1 10 10 10 10 P = AR = MR = D`
10 2 20 10 10 `

10 3 30 10 10
10 4 40 10 10
10 5 50 10 10 1 2 3 4 5
Output/Quantity`

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Revenue Curves under Imperfect Competition:

In imperfect competition, firm enjoys complete liberty to determine its price and output.
Consequentially, firm make necessary changes in its price to maximize its total revenues
In imperfect competition, firm faces a down slopping demand curve, average revenue equals to price
and marginal revenues remain lesser than its price (P = AR > MR).

Price Quantity Total Average Marginal

Revenue Revenue Revenue

P Q PxQ TR/Q ∆TR/∆Q

10 1 10 10 10
9 2 18 9 8
8 3 24 8 6
7 4 28 7 4
6 5 30 6 2
5 6 30 5 0
4 7 28 4 -2
3 8 24 3 -4

Diagram:

P/AR/MR
10
9
8
7
6
5
4
3
2
P = AR = D
1
1 2 3 4 5 6 7 8 9 10
Output/Quantity`
MR

NOTE:
In Perfect Competition: P = AR = MR but In Imperfect Competition: P = AR > MR
AR = demand curve

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PART-04: MARKET STRUCTURE

Equilibrium of the Firm:

Equilibrium of the Firm is the point at which the firm has no incentive either to expand or contract
its output. A firm would not change its level of output as it is earning maximum profits at this point.
It is the point:

• where MC = MR (necessary condition)

• and MC cuts MR from below. (Sufficient condition)

4.1: PERFECT COMPETITION

Definition of Perfect Competition:

“Perfect competition is a market in which a large number of sellers are selling homogenous products
and no barriers to entry.”

Examples: Rice market, Egg market and Chicken market etc.

Pre-Conditions/Features of Perfect Competition:

1. Large numbers of buyers and sellers:

There are large number of buyers and sellers operating in the market. No single buyer or seller
is able to influence the market price due to very small proportion of the total market

2. Homogenous product:
An identical product means no individual producer can charge more for a good that could be
considered superior.

3. Free entry and exit:

There are no restrictions, legal or otherwise on the firms to enter or exit from the market.

4. Perfect knowledge of prices:

Buyers and sellers are fully aware of prices in the market.

5. Absence of Transportation costs:

If the same price is to exist throughout a market, it is necessary that the transport cost should
be zero or negligible

6. Perfect factor mobility:

Factors of production are perfectly mobile, allowing free long-term adjustments to be made by
the firm.

7. Perfectly Elastic Demand:

Demand curve of a Perfect competition is perfectly elastic.

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8. Firms are price takers:

Firms accept the market price that is given, and have no influence on changing it.

Price S Revenue TR

10 E 10 AR=MR

Qe Q Q
Price taker
Product Market

Profit Maximization in Short Run:

In short run, firm is not independent, as far as all input resources are concerned. And the firm is facing
input constraint and is not capable of increasing its level of output beyond some limits. This
inflexibility of input resources causes a sharp incline in its marginal and average cost of productions.

Profit and Loss Situations:

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = TR – TC :TC = (explicit and implicit cost)

1. Super-Normal Profit (Abnormal or Excess/Economic Profit):

• Extra profit over and above normal profit (TR is higher than both explicit and implicit cost).
• If TR > TC, firms is enjoying profits

2. Normal Profit (Economic Profit = 0)

• A normal profit is the minimum level of profit required to keep existing firms in
production, yet being insufficient to attract new firms into the industry.
• The normal profit is only cause of implicit cost of the firm. (Opportunity cost of the
owner's resources.)
• If TR = TC, then firm is in break-even

3. Sub-Normal Profit (Economic Loss)

• If TR < TC, firms is facing losses

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(i) Super normal profit:

A firm is earning super normal profit when its short run average cost (SAC) is less than average
revenue (AR).

Price/Revenue/Costs
TR = (AR x Q) OPEQ SMC

TC = (AC x Q) OABQ SAC

Profit = TR > TC = APEB P

E
AR = MR = D
Super Normal Profit
A B

O Q
Output/Quantity`
(ii) Normal profit:
A firm is earning normal profit when its short run average cost (SAC) is equal to average revenue
(AR). (At this point SAC is tangent to AR)
SAC
TR = (AR x Q) OPEQ SMC
Price/Revenue/Costs

TC = (AC x Q) OPEQ
E
TR = TC (Normal Profit) P AR = MR = D

0 Q Quantity`

(iii) Sub-Normal profit:

A firm is earning Sub-normal profit (a loss) when its short run average cost (SAC) is greater
than average revenue (AR). In case of losses a firm tries to minimize its losses by changing its
variable factors only.
SAC
TR = (AR x Q) OPEQ
Price/Revenue/Costs

SMC

TC = (AC x Q) OABQ B
A
Loss = TC > TR = PABE P Sub-Normal Profit E
AR = MR = D

O Q
Quantity
`

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(iv) Shut-down point under Perfect Competition:

Shut-down is the point in short-run, where price is equal to average variable cost (P = AVC).

Shut-down condition:
The market price that forces a firm to exit the market. This occurs when P < AVC
• In the short run the firm will continue to produce as long as total revenue covers total variable
costs or Price per unit is greater than or equal to Average Variable Cost
(P > AVC, P = AVC).
• If price is below AVC (P < AVC) firm must shut-down its business because at this stage LOSS
include not only fixed costs but also a portion of variable costs.
• It is, therefore, feasible for a firm not to shut down (in the short run) if P<AC.
SAC
SMC
Price/Revenue/Costs

SAVC

E
P AR = MR = D

Shut-Down Point

O Q
Quantity`

Profit Maximization in Long Run:

In long-run firms earn only normal profit.
• If firm earns super normal profit, other firms enter the market. This will increase the supply and
decrease the price. Thus, super normal profit converts into normal profit. New entrants will
eliminate economic profit.
• In case of sub-normal profit (a loss), the existing firms exit the market. This will decrease the
supply and increase in price. Thus, Sub-normal profit converts into normal profit
Therefore, in the long run, the price always reverts back to the position where all firms are
earning normal profits. Exit of the firm will eliminate the loss
• A firm is earning normal profit when its long run average cost (LAC) is equal to average revenue
(AR), (LAC = AR). (At this point LAC is tangent to AR)

TR = (AR x Q) OPEQ
TC = (AC x Q) OPEQ
TR = TC (Normal Profit)

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4.2: MONOPOLISTIC COMPETITION: (Blend of monopoly and pure competition)

Definition:
A market structure where many sellers produce similar, but not identical, goods. Each producer can
set price and quantity without affecting the marketplace as a whole.

In case of hand wash liquids, although, many similar brands are available in the market, however,
every brand has its own customer group, which are ready to accept any price change by the firm. If
the firm raises the price, some customers would move to the substitute, but not all of them

Examples:
• Hairdressers, Soaps, Restaurants/ Hotels, Shoes outlet

Features/Characteristic of Monopolistic Competition:

1. Large number of firms:

Such markets consist of large number sellers, and everyone is controlling a small share of market.

2. Differentiated products:
Differentiated (Non-homogenous) products are sold in monopolistic competition.

3. Fewer barriers for firm’s entry or exit:

Product differentiation makes a little difficult for competitions to survive.

4. High degree of brand loyalty:

Due to product differentiation (with increase in quality), customers have high degree of brand
loyalty.

5. Non-price competition:
Due to product differentiation and brand loyalty in monopolistic competition, sellers compete on
factors other than the price. Such as advertisement, product development, better distribution,
after sale services, etc.

Demand curve under monopolistic competition is downward sloping, relatively elastic

Profit Maximization in Short Run:

A monopolistic firm’s demand curve is relatively elastic, as there are many close substitutes available
in market, and firm has relatively less control over price.

Graphs General Explanation:

In monopolistic competition, firm is able to control price. Its AR curve and MR curve are downward
sloping and are not identical because firm has to reduce its price to sell more output. The firm will
produce as long as MR>MC. Firm’s profit maximization (or equilibrium point) will be where MC = MR
and MC cuts MR from below.

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(i) Super normal profit:

A firm is earning super normal profit when its short run average cost (SAC) is less than average
revenue (AR).

TR = (AR x Q) OADQ
Super Normal Profit:
TC = (AC x Q) OBEQ
SMC SAC
Profit = TR > TC = ABCD A D

Revenue/Costs
Super Normal Profit C
B
C
E
AR

MR
O Q
Quantity
(ii) Normal profit:
A firm is earning normal profit when its short run average cost (SAC) is equal to average revenue
(AR). (At this point SAC is tangent to AR)

Normal Profit:
TR = (AR x Q) OADQ
SMC SAC
TC = (AC x Q) OADQ
Revenue/Costs

D
TR = TC (Normal Profit) A

E
AR

MR
O Q
Output
(iii) Sub-Normal profit:
A firm is earning Sub-normal profit (a loss) when its short run average cost (SAC) is greater
than average revenue (AR).
SAC
TR = (AR x Q) OADQ SMC
Revenue/ Costs

C
TC = (AC x Q) OBCQ B
Sub-Normal Profit
A D
Loss = TC > TR = ABCD
E AR

O Q
Quantity MR

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Profit Maximization in Long Run:

In long-run firms earn only normal profit.

A firm is earning normal profit when its long run average cost (LAC) is equal to average revenue (AR),
(LAC = AR). (At this point LAC is tangent to AR)

TR = (AR x Q) OADQ
LMC LAC
TC = (AC x Q) OADQ

TR = TC (Normal Profit)

Revenue/Costs
D
A

E
AR

O Q
Quantity MR

Advantages of Monopolistic Competition:

• No significant barriers to entry.
• Differentiation increases consumer choice.
• More efficient than Monopoly.
• More informed consumers about market due to advertisement.

Disadvantages of Monopolistic Competition:

• Differentiation can be unnecessary:
most often such differentiations have no value (i.e. artificial difference).

• Wasteful competition:
Resources spent on competitive advertising against one another could arguably

• Prices are higher as compared to perfect competition.

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4.3: MONOPOLY

Definition:
“Monopoly is a market structure where there is only single seller supplying (unique product) to the
whole market, having no close substitute.

Examples:
1. Water and Power Development Authority (WAPDA)
2. Sui Northern Gas Private Limited (SNGPL)
3. Pakistan Telecommunication Company Limited (PTCL)
4. Pakistan Railway

Features of Monopoly:
• Single seller of good. (Having entire control over market supply.)
• Selling unique product having no close substitute.
• Heavy barriers for new entrants:
• Firm is price maker.
• Firm earns super normal profit in long-run.
• Firm is inefficient because it’s not producing goods at lowest AC.

Equilibrium under Monopoly:

short-run equilibrium graph of the monopoly is similar to monopolistic competition.

Monopolist earn Super-normal profit in the long run.

A firm is earning super normal profit when its average cost (SAC) is less than average revenue (AR)
or charging a price above AC.

TR = (AR x Q) OBCQ
TC = (AC x Q) OADQ
Super Normal Profit = TR > TC = ABCD
The firm doesn’t produce efficiently because it is not at lowest AC. This is because it
deliberately restricts output to raise price.

LRMC
LRAC
C
B
Revenue/Costs

Super Normal Profit

C D
A

AR

O Q
Quantity
MR

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The monopolist can deter entry from competitors (Barrier):

Monopolist is able to maintain very high barriers that’s why other firms will not be able to enter into
the market.

• Control over key inputs (Resources):

Resourceful firms can create monopoly by controlling the essential inputs for some industry such
as; cotton, sugar cane or oil seeds to have entire control over this input. Although, this not an easy
task, but competitors can be discouraged through such exercises.

• Structural Barrier.
As monopolist firms have large scale of production to deal with whole industry, like, economies
of scale. which enables them to produce a product at such a lowest average cost that other firms
cannot match. This is called a natural monopoly.

• Cost management.
If a firm has ability to adopt a cheaper way of producing the good, it can prevent entry of new
firms in the industry.

• Predatory pricing or Dumping pricing,

It is a strategy to keep competitors out of market. In this pricing strategy prices of goods or
services are intentionally kept at such a low level that the rival firms cannot compete and have
no other option but to leave the market.

• Regulatory barriers.
Sometimes, state authorities may decide to allow only a particular firm to deal a particular
product in a region. In such situation, no other firm can enter into market. E.g. License etc.

• Legal barriers:
Patents and exclusive rights which a firm has on a certain good, where other firms are not allowed
to enter. e.g right to extract oil or precious metals.

Price discrimination:
Price discrimination refers the strategy of selling same product to different customers on different
prices to maximize profit.

Example:
• Telephone calls – Different prices for peak and off-peak calls
• Hotel rates – Different for working days and weekends.
• Different price for a movie on weekend and on other week days.
• Electricity rate - Different for domestic and commercial users.
• Price cut offer for a product off-season
• Discount on bulk buying as compared to small buying

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Pre-Conditions of price discrimination:

1. Firm should be a price maker:

For a successful price discrimination, it is mandatory that a firm must have the ability to set price
and output for its product.

2. Elasticity of demand: Elasticity of demand should be different for each group of buyer, e.g.
Higher price is charged in case of inelastic demand and lower for elastic demand.

3. Special Order:
When goods are being supplied to special orders, a monopolist can easily charge discriminating
prices because in this case, buyers do not compare prices.

4. Prevention from resale: Prevention from reselling the product one sold enables firms to
discriminate prices for a good in different markets. Otherwise, buyers will purchase a product in
low price market segment and sell them on high prices by themselves.

5. Segregation of market:
Firm must be able to segregate the market on the basis of the income or degree of elasticity of
demand of different classes of the society

The monopolist can increase his profit by charging a higher price in the market where elasticity is
low (market A) and charges a lower price where elasticity is high (market B).

The MR of market B (having high elastic demand) is greater than the MR of market A (having low
elastic demand)

Conclusion:
Revenue After Price discrimination > Revenue Before Price discrimination

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Advantages of a monopoly

1. Stability of prices:
Prices in a monopolistic environment are relative stable (because they are price maker) as
for in a competitive market, where the prices are set by the unhindered market forces
(demand and supply).

2. Benefit from economies of scale:

Monopolist is able to achieve economy of scale which lower the long run average cost. This is
the argument for natural monopolies.

3. Dominant domestically allows for international competitiveness:

A firm can then operate internationally at a much more competitive rate.

4. Able to take a long-term approach:

This allows for investment in long term projects, rather than short term

5. Earn Supernormal profits:

Profits can be used for technological improvement, such as investment in R&D

6. Source of essential public utilities:

State controlled monopolies help in producing and making goods that are essential and
important for public utilities like public transport facilities, water and electricity resources,
etc.

Drawback/ Disadvantages of a monopoly

1. Price is higher than in a competitive market
2. loss of consumer surplus because consumer buy goods at higher price due to Less choice.
3. restrict competition by placing barriers to entry
4. less receptive towards innovation as they are already earning super normal profits.
5. Price discrimination. (Charge different prices for same product, from different sets of
consumers).
6. Provide Inferior (Low) quality of product due to lack of competition.
7. Large Scale diseconomies occur usually during the organizational expansion. A monopolist
firm may become inefficient because it is harder to coordinate and communicate at big scale.

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Inefficient use of existing resources in Monopoly:

• Technical inefficiency
When a firm is not producing the maximum output from the minimum quantity of inputs.
e.g. firm hiring too many employees to produce output, or using outdated capital

• Productive inefficiency
Productive inefficiency occurs when a firm is not producing at its lowest average cost.

Cost
ATC
C2
C1

Q2 Q1 Output
• X-inefficiency
X-inefficiency occurs when a firm is not producing at its lowest possible cost This causes the
average cost of production to be higher than necessary.

Cost AC2 (Actual)

AC1 (potential)

Output

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4.4: OLIGOPOLY
Definition:
An industry dominated by a few large suppliers selling similar or differentiated goods is called
Oligopoly.

Examples:
• Airlines
• Media Industry
• Automobile Industry
• Cellular Phone Services
• Beverages

Features/Characteristics of Oligopoly:

1. Few seller’s markets:

In oligopoly there are few large firms with a high Concentration Ratio (market share).

2. Homogenous or differentiated goods:

An oligopoly may be homogenous oligopoly or differentiated oligopoly
• Homogenous (e.g., Rice, sugar, petrol and cement etc.) or
• Differentiated (e.g., mobile phones, cars, cigarettes, garments).

3. Interdependence of firms:
In oligopoly the policies of every producer directly affect others, because the products are good
substitutes. Consequently, oligopolist are interdependence in decision making.

4. Maximum advertisement:
Because of interdependence and being good substitutes, oligopolistic firm spends much in
advertisement to attract customers.

5. Indeterminate demand curve:

Since under oligopoly the exact behaviour pattern of a producer cannot be ascertained, the
demand curve cannot be drawn accurately and with definiteness.

6. Heavy Barriers for entry:

One of the most important features of oligopoly is the existence of barriers such as;
• Patents or Copyrights,
• requirement of large capital,
• Control over essential inputs, etc.
such barriers prevent new entrants into industry. As a result, firms can earn super profits in the
long run.

7. Firms are different in size:

Another feature of oligopoly is the lack of uniformity in size of firms. Some firms may be very
large (dominant) and other firms may be of small size.

8. Lack of market information:

Consumers in oligopolistic markets lack detailed market information and are susceptible to the
market strategies of the suppliers

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Types of Oligopolies:

1. Collusive oligopoly
2. Non-Collusive oligopoly

1. Collusive oligopoly: (Cartel)

Definition:
“A price cartel is defined as the group of the firms getting together to determine market price and
output.”

As prices under oligopoly are highly dynamic and unpredictable, firms often establish a collusive
agreement. Although at present such collusions or price cartels are illegal in some countries, few
firms consider such agreements as need of the hour.
Organization of petroleum exporting countries (OPEC) is one of the most popular models of price
cartel including prominent member countries; Saudi Arabia, United Arab Emirates, Venezuela,
Republic of the Congo etc.

Following are the pre-conditions to create a price cartel among firms:

1. Only very few firms are operating which are all well known to each other.
2. They are open with each other regarding costs and production methods
3. There is a dominant firm.
4. Production techniques and costs of all the firms are similar.
5. Price Elasticity of Demand: Cartels are effective if demand is inelastic
6. They produce similar products.
7. There are significant barriers on entry of new firms.
8. The market is stable (that is no price war and price rivalry).
9. Non - intervention by the Government to hinder Collusions.

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A price cartel can be harmful to society because of following reasons:

1. Higher prices:
Member firms generate supper profit on the cost of buyers by charging higher price
2. Lack of lucidity:
Members may agree to hide prices or withhold information, such as the hidden charges in credit
card transactions.
3. Restricted output:
In order to increase market price, members keep restricted output to create relative shortage in
market.
4. Poor quality goods:
As under collusive oligopoly, members have a set price for their products, so they do not bother
to improve quality of products individually

2. non-collusive oligopolies – kinked demand curve: (Price War)

Theory of oligopoly suggests that, once a price has been determined, it will not change except
competitor’s change its price. Each firm is independent regarding the price and output policy.
The demand curve for oligopolistic firm will become a bend shaped and termed as kinked demand
curve

1. Each seller’s attitude depends on the attitude of his rivals. (Interdependent to each other)

2. At the starting position, the firm supplies Q0 at a price of P0.

3. Price increase (ignorance to price change, elastic demand curve i.e., e>1)
Conversely, if firm A initiates a price increase and the rival firms ignore it, it will cause a
substantial decrease in demand for firm A. Consequently, the demand curve will become more
elastic.

4. Price decrease (matching to price change, less elastic demand curve i.e., e< 1)
Assume that if firm A reduces its price and rival firms will do the same, the market share will be
distributed proportionately among all the firms as there is no reason to increase share of any
particular firm. Resultantly the demand curve will become relatively inelastic.

Revenue/cost
NON-MATCHING PRICE MATCHING
PIRCE Elastic Demand Less elastic demand

MC
Kink
P0

AR (d)

Q0 Output
MR

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Advantages of Oligopoly:
• Members of an oligopoly might be able to set prices (though this might be illegal).
• Oligopolistic firms are able to make large profits as there are few players in the market.
• Barriers to entry allow an oligopolistic firm to maintain profits in the long term.
• Customers are easily able to make price comparisons among the few players existing in the
market and this may lead to competitive pricing.
• Stable prices in the market make planning easier for both the supplier and the customer.

Disadvantages of Oligopoly/Price cartel:

• Price setting in an oligopoly might prove disadvantageous to customers.
• Innovation of small players in the industry is stifled.
• An oligopolistic firm is able to make good profits on an ongoing basis so there may be no
incentive for product improvement.
• Oligopolistic industries can suffer from price wars.

Duopoly:
Duopoly is a kind of Oligopoly where only two dominant sellers selling a product. (Uniform price)
• Soft drink industry (Coke and Pepsi)
• Airline industry (Boeing and Airbus)

PART-05: GLOBALIZATION

Globalization:
Means expansion of business transaction globally as well as the domestic boundaries of the country,
including exchange of knowledge, physical technology and goods and services etc

Impact of Globalization on Firm’s Behavior

Globalization leads to increase competition as government alleviates trade barriers for free
mobility of goods and services among the nations.

Globalization impacts the businesses on different ways.

• Division of labour:
Globalization allows the free movement of goods and services among the nations. It
encourages international trade which forces firms to produce goods at large scale. It allows
firms to adopt division of labour which promotes specialization and decreases the cost of
production.

• Economies of scale:
As discussed earlier, under globalization governments alleviate trade restrictions which
gives big push to scale of production of the firms. Increasing scale of production allows firms
to reap economies of scale.

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• Encourage competition:
Globalization allows firms to invest across the world. Firms from developed countries move
their capital resources to other nations which creates competitive market environment for
existing firms and help in abolishing monopolies.

• Higher productivity:
Increasing resource mobilization enables firm to adopt modern techniques of production
which help in increasing productivity.

• Availability of capital:
Globalization allows financial institution to expand their lending across the world. It makes
easier for firms to avail capital resources to overcome their hardships. It enables firms to use
modern expensive technology to improve quantity and quality of their products.
These factors will cause to decrease in cost of production for firms.

(These factors will cause to decrease in cost of production for firms.)

Cost of globalization
• Damaging for infant industry
• Structural unemployment
• Environmental concerns
• Trade imbalances
• Inflation risk

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MULTIPLE CHOICE QUESTIONS

4.1) Technical relationship between inputs and output of firms is known as:
a) Investment b) Production Function
c) Consumption Function d) None of the above

4.2) A time period in which at least one input remains fixed while other are variable is termed as:
a) Marked period b) Short-Run
c) Long-Run d) Very Short-Run

4.3) According to Law of variable proportion, marginal product & average product curves intersect each
other at the point where:
a) Marginal product is zero b) Average product is zero
c) Average product is at its maximum d) Marginal product is at its maximum

4.4) According to Law of variable proportion when total production is at its maximum marginal
production will be:
a) Minimum b) Negative
c) Maximum d) Zero

4.5) Which one of the following assumptions is related to the law of variable proportion?
a) Continuous improvement in techniques of production
b) All factors of production are proportionately varied
c) There is no scarcity of the factors of production
d) The factors are able to be combined to make a product

4.6) Which of the following is NOT included in the explicit costs of a firm?
a) Wages paid to labour b) Interest paid for borrowed capital
c) Payments for purchases of materials d) Normal profit
4.7) With 50 units of labour, a firm can produce 1,800 units of output. With 60 units of labour the firm can
produce 2,100 units of output. The marginal product of labour is:
a) 0.33 b) 3
c) 30 d) 300

4.8) Which of these is NOT a component of cost function of a product?

a) Market price of the product b) Operating technology of the plant
c) Operating capacity d) all of the above

4.9) Cost of production on extra unit of given product is known as:

a) Marginal cost b) Average cost
c) Variable cost d) Economic cost

4.10) Cost reducing benefits of large scale

a) Economics of scale b) Diseconomies of scale
c) the firm’s need to break even d) All of the above

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4.11) As its output increases, a firm’s short-run marginal cost will eventually increase because of:
a) diseconomies of scale b) a lower product price
c) the firm’s need to break even d) diminishing returns

4.12) The long-term shape of the average cost curve is due to:
a) economies of scale
b) variable proportions
c) change in technology
d) imperfect competition
e) diseconomies of the scale
f) a and e
g) b and d
h) none of the above

4.13) When diminishing returns begin to operate, the total variable cost curve will start to:
a) fall at an increasing rate b) rise at a decreasing rate
c) fall at a decreasing rate d) rise at an increasing rate

4.14) Cost of doing business which accountant records in expenditure records only known as:
i) Explicit cost
ii) Accounting cost
iii) Implicit cost
iv) Economic cost

a) (i) & (iii)

b) (i) & (ii)
c) (ii) & (iii)
d) (ii) & (iv)

4.15) Marginal cost is best defined as

a) the difference between total fixed costs and total variable costs.
b) costs which are too small to influence prices.
c) the change in total costs when output rises by one unit.
d) fixed costs per unit of output.

4.16) Marginal cost curve intersects Average total cost curve at:
a) the minimum point of ATC
b) the minimum point of MC
c) the minimum points of both the MC and ATC
d) all of the above

4.17) The 'law of diminishing returns' can apply to a business only when
a) all factors of production can be varied b) at least one factor of production is fixed.
c) all factors of production are fixed. d) capital used in production is fixed.

4.18) Which of the following always rise when a manufacturing business increases its output?
(i) fixed costs
(ii) marginal cost
(iii) average variable cost
(iv) total costs

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a) (i) and (ii) only b) (ii) and (iii) only

c) (iii) and (iv) only d) (iv) only

4.19) The minimum price needed for a firm to remain in production in the short run is equal to:
a) average fixed cost b) average variable cost
c) average total cost d) marginal cost

4.20) A business employs 11 workers at a wage of Rs. 24 per day. To attract one more worker it raises the
wages to Rs. 25 per day. The marginal cost of employing the extra worker is
a) Rs. 1 b) Rs. 12
c) Rs. 25 d) Rs. 36

4.21) Hasnan Limited employs 100 skilled workers at a wage rate of Rs.2,800 per week. To attract 10 more
workers, it raises the wage rate to Rs.3,000 per week. The marginal cost of employing the extra workers
a) Rs. 20,000 b) Rs. 30,000
c) Rs. 50,000 d) Rs. 200

4.22) A firm that breaks even after all the economic costs are paid, is earning:
a) economic profit b) no profit
c) normal profit d) super normal profit

4.23) The long-run average cost curve for a business will eventually rise because of
a) the law of diminishing returns
b) increasing competition in the industry
c) limits to the size of the market for the good
d) diseconomies of scale

4.24) Which of the following will always increase when a manufacturing business increases its output?
a) Fixed costs b) Marginal cost
c) Total costs d) Average variable cost

4.25) In a diminishing cost industry, an increase in industry output causes the Average total cost curve of a
typical firm to shift:
a) Upward b) Downward
c) To the right d) To the left

4.26) Diseconomies of scale occur when:

a) long run average costs begin to rise b) short run average costs begin to rise
c) long run average costs begin to fall d) short run average costs begin to fall

4.27) Which of the following statements is correct?

a) When the average cost is constant, the marginal cost must be falling
b) When the average cost is rising, marginal cost is lower than average cost
c) When the average cost is rising, marginal cost is higher than average cost
d) When the average cost is falling, marginal cost must be rising

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4.28) Shahid has employed 25 workers to whom he pays wages at the rate of Rs. 150 per day. He is now
intending to increase the wage rate of all workers by Rs. 20 per day in order to attract one additional
worker. Given that all other costs remain constant, the marginal cost of labour per day would be:
a) Rs. 20 b) Rs. 170
c) Rs. 670 d) Rs. 4,420

4.29) Sufficient condition for a firm to be in equilibrium is:

a) A.R. = Price b) M. R. = M.C
c) M.C. = A. R d) Marginal cost equal to marginal
revenue while it is increasing
4.30) Economies of scale
a) can be gained only by monopoly firms
b) are possible only if there is a sufficient demand for the product
c) do not necessarily reduce unit costs of production
d) depend on the efficiency of management

4.31) In an increasing cost industry, an increase in output causes the Average total cost curve of a typical firm
to shift.
a) To the left b) To the right
c) Downward d) Upward

4.32) The long-run average cost curve for a business will eventually rise because of:
a) The law of diminishing returns
b) Increasing competition in the industry
c) Limits to the size of the market for the good
d) Diseconomies of scale

4.33) If the total cost curve is plotted, marginal cost curve can be illustrated by:
a) U shapes curve cutting the total cost curve from its minimum point.
b) a straight line cutting the curve at its lowest point.
c) a straight line cutting the curve at its lowest point
d) the slope of a tangent to the curve at any given output

4.34) If price and marginal revenue are the same then the demand curve must be:
a) perfectly inelastic and vertical b) highly elastic and downward sloping
c) perfectly elastic and horizontal d) highly inelastic and downward sloping

4.35) In a perfectly competitive market firm are:

a) Price maker b) Very large
c) In small number d) Price taker

4.36) A firm will shut-down its business:

a) It faces normal loss b) It earns zero profit
c) A.V.C. > A.R. d) A.C. > A.R.
4.37) A firm, in the short run, would stop production if:
a) marginal cost was equal to marginal revenue
b) total costs were equal to total revenue
c) total revenue was less than total variable cost
d) total revenue was less than total fixed cost

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4.38) A firm has revenue of Rs.2,000,000 explicit costs of Rs.1,200,000 and opportunity costs of equity capital
of Rs.120,000 and salary foregone from alternative employment by owner Rs.60,000.
What is the accounting profit ____________ and economic profit______________?
a) 800,000, 740,000 b) 680,000, 720,000
c) 800,000, 620,000 d) 2,000,000, 720,000

4.39) Which of the following is NOT a feature of monopolistic competition?

a) Low barriers to entry and exit
b) Many firms supplying to the market
c) Firms can change their actions without influencing the behaviour of other firms
d) Each firm faces a horizontal demand curve

4.40) Under perfect market conditions, the supply curve of a firm is the same as:
a) MC curve b) MR curve
c) AR curve d) AC curve

4.41) With the increase in output, a firm’s short-run marginal cost will eventually increase because of:
a) diseconomies of scale b) lower product price
c) the firm’s need to break even d) diminishing returns

4.42) Which of the following statement is correct with respect to relationship between the average cost curve
and marginal cost?
a) Average cost curve will slope downwards when marginal cost is less than average cost
b) Average cost curve will slope upwards when marginal cost is less than average cost
c) Average cost curve will slope downwards when marginal cost is more than average cost
d) There is no direct relationship between average cost curve and marginal cost

4.43) In a perfectly competitive market ___________ is/are the price maker(s):

a) the individual firm b) the industry
c) a large number of consumers d) the trade association

4.44) The demand curve for the product of a firm operating under conditions of perfect competition would
be:
a) identical to the marginal revenue
b) intersecting the marginal revenue curve at the point where marginal cost is equal to
marginal revenue
c) perfectly inelastic
d) Inelastic

4.45) Which one of the following is NOT a feature of perfect competition?

a) Firms are price makers b) Perfect factor mobility
c) Free entry and exit of firms in the d) Products are homogenous
market

4.46) Which one of the following would not act as a barrier to the entry of new firms into an industry?
a) Economies of scale
b) Perfect consumer knowledge
c) High fixed costs of production
d) Brand loyalty

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4.47) Under perfect competition.

If A.R. = M.R. = M.C = Price

Firm is earning.

(i) Normal profit

(ii) Sub normal profit
(iii) Zero economic profit
(iv) Super normal profit

a) (i) & (iii)

b) (i) & (iv)
c) (ii) & (iv)
d) (iii) & (iv)

4.48) An industry is a group of firms:

a) located in the same geographical area
b) producing similar products
c) which supply the various inputs needed to produce a final product
d) owned by a corporation

4.49) A market has a larger number of firms, a downward sloping market demand curve low barriers on entry
in the long-run. The market structure could be:
(i) Perfect competition
(ii) Monopolistic competition
(iii) Oligopoly

a) Only (ii)
b) (i) & (ii)
c) (i) & (iii)
d) (ii) & (iii)

4.50) Which of the following would you expect to be the long-run attributes of an industry under monopolistic
competition?
(i) Firms operate below full capacity.
(ii) Each firm faces a horizontal demand curve
(iii) There is product differentiation

a) (i) & (iii)

b) (ii) & (iii)
c) (ii) & (i)
d) None of the above

4.51) What happens as output rises?

a) Average fixed cost falls b) Average fixed cost rises
c) Average variable cost remains constant d) Average variable cost rises

4.52) Explicit cost is also termed as out-of-pocket cost such as; interest obligations, wages paid to the workers,
utility expenses, raw material payments and building rents
a) True b) False

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4.53) Fill the missing values:

Units of Variable Total Marginal A.F.C A.V.C A.C (Rs.)

Output cost (Rs.) Costs Costs (Rs.) (Rs.)
(Q) (Rs.) (Rs.)

0 ? 5 - - - -
1 ? 12 7 ? ? 12
2 ? ? 6 ? 6.5 9
3 ? 23 ? 1.67 ? ?
4 ? ? 8 ? 6.5 7.75

4.54) Fill the missing values:

Output Total Average Marginal

Product Product Product

1 5 ? 5
2 ? ? 8
3 24 ? ?
4 ? ?9 ?

4.55) The following information refers to a firm producing shoes. At which level of output does the firm
maximise profits? total output of pairs of shoes.

Total output total cost total revenue

A 100 1000 1300

B 200 1800 2200
C 300 2700 3000
D 400 3200 3400

a) A b) B
c) C d) D

4.56) When diminishing returns begin to operate, the total variable cost curve will start to:
a) fall at an increasing rate b) rise at a decreasing rate
c) fall at a decreasing rate d) rise at an increasing rate

4.57) Economies of scale are those factors which reduce the average cost of business
a) True b) False

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4.58) When do economies of scale take place?

a) in the short run b) if variable factors become fixed
c) when all factors of production are fixed d) when all factors of production are
variable

4.59) A firm produces five units of output at an average cost of Rs.20 per unit. The cost of the sixth unitis
Rs.26. What is the average cost of six units?
a) Rs.11 b) Rs.21
c) Rs.7.8 d) Rs.520

4.60) Following data has been provided to the Chief Executive Officer of a monopoly firm:
• Marginal revenue Rs. 10 Marginal cost Rs. 11
• Average revenue Rs. 16 Average cost Rs. 12
To maximise profit the firm should:
a) reduce price and increase output b) reduce price and reduce output
c) increase price and increase output d) increase price and reduce output

4.61) Which of the following is NOT a feature of monopolistic competition?

a) Freedom of entry and exit to the b) Downward sloping demand curve
industry
c) Identical products d) Many firms supplying the market

4.62) Which of the following is NOT a feature of monopolistic competition?

a) Low barriers to entry and exit
b) Many firms supplying to the market
c) Firms can change their actions without influencing the behaviour of other firms
d) Each firm faces a horizontal demand curve

4.63) Which of the following may be barriers to entry preventing new firms from entering the monopoly
market.
(i) Scale of production
(ii) Branding
(iii) Perfect mobility
(iv) Perfect knowledge

a) (i) & (ii)

b) (ii) & (iv)
c) (iii) & (iv)
d) (i) & (iv)

4.64) Which one of the following is NOT a barrier to entry into a monopoly market?
a) Significant economies of scale b) Heavy potential advertising costs
c) Large capital requirements d) Constant returns to scale

4.65) Monopoly power may be based on:

a) economies of large-scale production b) patents
c) control of key natural resources d) all of the above

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4.66) Price discrimination is not possible for a monopolist in two distinct markets if:
a) Two markets having same elasticity of demand
b) Two markets having different elasticity of demand
c) Two markets having different size
d) Two markets having same size

4.67) Which of the following is the example of price discrimination?

a) Peak and off-peak call charges b) A doctor charging higher consultancy
fees in posh area
c) Business and economy class flights d) Both (a) and (b)

4.68) KARACHI ELECTRIC is an example of

a) Oligopoly
b) Monopolistic Competition
c) Perfect Competition
d) Monopoly

4.69) The cooking oil industry can be an example of:

a) Oligopoly b) Monopolistic Competition
c) Perfect Competition d) Monopoly

4.70) Duoplists producing homogeneous products will in the long run charge:
a) uniform price b) different prices
c) any of the above d) none of the above

4.71) Duopoly is a special case of which of the following:

a) Perfect competition b) Monopoly
c) Monopolistic competition d) Oligopoly

4.72) Oligopoly is a type of market organization in which there exists:

a) a single firm b) two firms
c) a large number of firms d) few firms

4.73) Which of the following distinguishes oligopoly market from other forms of market organization?
a) Interdependence of producers b) Differentiated products
c) Firms are price takers d) Price discrimination

4.74) All members of a cartel:

a) produce at the same average cost b) produce where their MC equals price
c) independent price and output policy d) share the market equally

4.75) A cartel is a collusive agreement: (Select TWO)

a) among largest firms in an industry
b) among smallest firms in an industry
c) sanctioned by the government
d) among firms to increase profit by reducing output

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4.76) Which of the following would most likely result in failure of price cartel under oligopoly?
a) Non-availability of close substitutes b) Existence of control over supply
c) Price elasticity of demand is elastic d) Presence of agreement on allotted quota
of supply

4.77) Which of the following may NOT be regarded as strength of a collusive oligopoly?
a) production techniques and costs of all the firms are similar
b) there are no barriers on entry of new firms
c) similar products are produced by the firms
d) the market is stable

4.78) What does it mean to say that firms in an oligopoly are interdependent?
a) The firms must charge identical prices for the products
b) The firm’s economic profits must equal zero in the long run
c) Barriers block the entry of new firms into the industry
d) The output price decisions of one firm affect the output price decisions of other firms in
the industry

4.79) If marginal revenue is Rs. 50 and marginal cost is Rs. 40, the firm seeking profit maximization would:
a) increase price b) reduce output
c) reduce price d) increase output

4.80) Which one of the following is NOT a feature of perfect competition?

a) Firms are price makers b) Perfect factor mobility
c) Free entry and exit of firms in the market d) Products are homogenous

4.81) The diagram below shows the short-run cost and revenue conditions for a firm in perfect competition.
The firm’s output is ̅𝑶̅̅̅𝑸̅̅̅ and market price is OP. to achieve long-run market equilibrium in the industry.

a) Some firms must leave the industry

b) Firms must charge a higher price
c) new firms must enter the industry
d) Existing firms tries to increase demand by reducing prices

4.82) In kink demand curve, if firm A increase it price, then what will be the behaviour of firm B? Firm B will
a) Decrease it price b) not change it price
c) Increase it price d) None of these

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4.83) A firm is operating in an industry where many firms are producing similar products. Each firm is able
to set prices of its products without affecting the market place as a whole. The firm is most likely
operating in:
a) Monopoly b) Oligopoly
c) perfect competition d) monopolistic competition

4.84) How is a government most likely to prevent the growth of monopolies?

a) by encouraging mergers in the private sector
b) by establishing nationalised industries
c) by promoting the benefits of economies of scale
d) by reducing barriers to entry into an industry

4.85) In long run perfect competition?

a) P = MC = MR = AVC b) P = MC = MR greater than AVC
c) P = MC = MR less than AVC d) P = MC = MR = AC

4.86) Which of the following increase or decrease with increase or decrease of production level?
a) Variable cost b) Average fixed cost
c) Marginal cost d) Financial cost

4.87) Monopolistic competition is a market situation in which many sellers and buyers come together for
homogeneous goods, and there are no barriers for new entry and exit of the firms
a) True b) False

4.88) Price discrimination means charging different prices for a different product from different consumers
a) True b) False

4.89) X-inefficiency occurs when a firm is not producing at its lowest possible cost.
a) True b) False

4.90) Price Cartel is an arrangement of setting price lower than market price by creating some formal or
informal agreements to control market supply.
a) True b) False

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ANSWER KEY

4.1) B 4.2) B 4.3) C 4.4) D

4.5) D 4.6) D 4.7) C 4.8) A
4.9) A 4.10) A 4.11) D 4.12) F
4.13) D 4.14) B 4.15) C 4.16) A
4.17) B 4.18) D 4.19) B 4.20) D
4.21) C 4.22) C 4.23) D 4.24) C
4.25) B 4.26) A 4.27) C 4.28) C
4.29) D 4.30) B 4.31) D 4.32) D
4.33) D 4.34) C 4.35) D 4.36) C
4.37) C 4.38) C 4.39) D 4.40) A
4.41) D 4.42) A 4.43) B 4.44) A
4.45) A 4.46) B 4.47) A 4.48) B
4.49) A 4.50) A 4.51) A 4.52) A
4.53) - 4.54) - 4.55) - 4.56) D
4.57) A 4.58) D 4.59) B 4.60) D
4.61) C 4.62) D 4.63) A 4.64) D
4.65) D 4.66) A 4.67) D 4.68) D
4.69) B 4.70) A 4.71) D 4.72) D
4.73) A 4.74) A 4.75) A,D 4.76) C
4.77) B 4.78) D 4.79) D 4.80) A
4.81) A 4.82) B 4.83) D 4.84) D
4.85) D 4.86) A 4.87) B 4.88) B
4.89) A 4.90) B 4.91) 4.92)

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 CH-04 FIRM THEORY

TEST-04

Q-1) Which of the following are NOT characteristics of Oligopoly?

a) Few sellers b) Price taker

c) Homogeneous or differentiated product d) Maximum advertisement

Q-2) The sum of all short run ATCs at the point of tangency is called?
a) Long run AVC
b) Long run ATC

Q-3) Which of the following are features of monopolistic competition (Select TWO):
a) Free entry and exist b) Perfect knowledge of market
c) Downward sloping demand curve d) large sellers

Q-4) ATC is equal to:

a) AFC + VC b) FC + VC
c) AFC + AVC d) MC

Q-5) Non-collusive is a part of;

a) Monopolistic b) Monopoly
c) Perfect competition d) Oligopoly

Q-6) Long run average cost decrease / (cost reduced in long run) in _________________
a) Economy of scale b) Diseconomy of scale
c) Constant return to scale d) All of these

Q-7) Normal profit means where economic profit ________________

a) Less than 1 b) Greater than 1
c) Equal to 1 d) Equal to 0

Q-8) Monopolist can charge high Price where elasticity is _______?

a) Low b) High

Q-9) Natural monopoly means?

a) Small scale production b) Diseconomy of scale

c) Production at lowest average cost that d) Produced homogeneous good

other firms cannot match

Q-10) In kink demand curve, if firm A increase it price, then what will be the behavior of firm B? Firm B will
a) Decrease it price b) not change it price
c) Increase it price d) None

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CHAPTER-05
“NATIONAL INCOME”
PART-01: MACROECONOMICS OBJECTIVES:

PART-02: NATIONAL INCOME CONCEPTS

2.1: NATIONAL INCOME: 138

2.2: METHODS TO MEASURES NATIONAL INCOME: 140
2.3: CIRCULAR FLOW OF NATIONAL INCOME: 144
2.4: DIFFICULTIES IN MEASURING NATIONAL INCOME 146

PART-03: MULTIPLE CHOICE QUESTIONS & TEST-05

MCQ 147
TEST-05 156

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 CH-05 NATIONAL INCOME

HISTORICAL BACKGROUND
Great depression of 1930s is considered a breakthrough in development of Macroeconomics. At that
time, economists were struggling to understand reasons for this great depression. Eminent British
economist, John Maynard Keynes presented his revolutionary theory that enabled economists to
understand causes and corrective measures about it.

Part-01: MACROECONOMICS OBJECTIVES:

MACROECONOMIC OBJECTIVES /GOVERNMENT ECONOMIC POLICIES:

Governments attempt to manage national economy to improve the welfare of the citizens of their
country. They achieve this through their macroeconomic policies.

Economic Growth:
This would increase the wealth of the country and hopefully the standard of living of the population

Full employment/low unemployment:

Unemployment is a waste of resource (unemployed people do not contribute within the economy)
and can have a high social cost in terms of poverty that might result from it. Higher employment
levels increase aggregate demand (the total demand in the economy) and promotes growth.

Low/Stable Inflation:
Low level of inflation is desirable but high inflation erodes (spoil) wealth and reduces consumer
confidence

Equilibrium in Balance of Payment:

Government should maintain a balance between exports and imports. (Earnings from exports and
other inward flows to the economy is equal to payments for imports and other outward flows from
the economy)

PART-02: CONCEPTS OF NATIONAL INCOME

2.1: NATIONAL INCOME

National income:

According to Samuelson:
• “It is the loose name we give for the money measure of the overall annual flow of goods and
services in an economy”.
• “National Income is the market value of all goods and services produced in a country during a
given time period usually one year’.”

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Some key points to remember to proceed with National Income are:

1. National income, National Output and National product are used as synonyms.
2. National income is the market value of all goods and services.
3. It is the only money value of goods and services as physical goods and services cannot be added
or subtracted.
4. Only final goods and services will be taken in to account
5. It is the measure for only one year
6. Goods and services, produced only through legal channels, will be considered in national income

Gross Domestic Product (GDPMP):

GDP is the total market value of all the final goods and services, which are produced within a country
during a year. GDP is the aggregate demand in an economy. It includes only that income which is
generated by using domestic resources of a country.

GDPMP = C + I + G + (X – M)

• Nominal GDP is the value of GDP evaluated at current market prices (i.e. GDP with inflation).

• Real GDP is the value of GDP evaluated at base year (constant) market prices
(i.e. GDP without inflation)
Since, it is an inflation-corrected figure so it is deemed to be an accurate indicator of economic
growth.
Real GDP= Nominal GDP / GDP Deflator

(Where GDP Deflator = 1 + Inflation Rate)

• GDP deflator is a price index that measure rate of inflation in a country.

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
Real GDP = 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟

Gross Domestic Product (GDP) at factor cost (FC):

GDPFC = GDPMP – indirect tax + subsidy

Per-capita Income:
Per-capita Income is the average income of people of a country. It is a measure to estimate standard
of living of the nationals of a country.

GDP per capita = National Income / Population

GDP per capita is an indicator of a country’s standard of living.
For Example
If the total national income of a country was Rs. 24,000 million annually and total population was
120 million, then the per capita income will be;

24,000 millions
Per Capita Income = 120 millions
== Rs. 200

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2.2 METHODS TO MEASURES NATIONAL INCOME

National incomeTO
: METHODS canMEASURES
be measuredNATIONAL
by any of the following methods:
INCOME:
1. Expenditure method
2. Income method and
3. Product/Output/ Value Added method.

1. Expenditure Method:

Definition:
National income can be computed under expenditure method by adding total expenditure done by
all the agents of an economy during course of one year

GDP = C + I + G + (X – M)

Personal consumption expenditures (𝐂):

It includes all consumer expenditure of people of a country. It does not include expenditures on some
fixed assets like purchase of house.

Gross domestic investment (𝐈):

It includes all expenditures on capital goods such as; building new factories, installation of new
plants, constructions of warehouses etc.

Government expenditures (𝐆):

All the expenditures made by government either for development or non-development. It includes
expenditure on public office accessories, infrastructure (roads, dams etc.), defense, education or
healthcare etc.

Net Exports (𝐗 − 𝐌):

Net exports are calculated as; Export of a country during one year – Import of the country in same
year.

Format:

Description Amount
Consumption Expenditure (C): 1000
+ Gross Private Investment/ Capital Formation (I): 700
+ Government Spending (G): 1200
+ Exports (X) 400
(-) Imports (M) (600)

Gross Domestic Product (GDP at Market Price) = C + I + G + X - M = 2700

(-) Indirect Tax (Tax on expenditures) (500)
+ Subsidy 300

Gross Domestic Product (GDP at Factor cost) = 2500

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 CH-05 NATIONAL INCOME

Precautions:
• Avoid double counting:
While calculating national income using expenditure approach, we should add any expenditure
only once.

• Expenditure only for newly produced goods:

Expenditure on reconditioned or used goods such as; used car, old building, second hand plant
etc., is to be excluded. Because such sales either do not reflect current production or involve
double counting.

2. Income Method:

The total value of all the incomes earned from producing goods and services during the year.
National Income = Rent + Wages + Interest + Profit

Description Amount
Rent before tax 800
Wages before tax 600
Interest on capital 350
Profits before tax 750
National Income (GDPFC) 2500

Precautions:
While calculating national income using product approach, we need to consider some precautions as
given below:

• Transfer Payments: While calculating national income some of payments received by

households without performing any marketable activity must be avoided. For example, pensions
fund, gifts, scholarships etc.

• Income earned through illegal activities: Any income earned or received through illegal
activities such as theft, robbery, smuggling, bribery etc., not be included in national income.

Transfer Payment:
Transfer payment means income which is received by households without performing an
economic activity. e.g. Pensions funds, Gifts, Charity, Zakat, Sadaqat, scholarships etc.

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3. Product/Output /Value-added method

Under this method, an economy is divided into different sectors of production; i.e.
• Primary sector (agriculture, mining etc.)
• Secondary sector (manufacturing and construction; and
• Tertiary sector (services)
and then net value of all final goods and services produced during the year are added i.e.

National Income = Value of Final goods/services – Value of Intermediate goods/services

(all sectors)

Stage of Production Current Market Value Added At each stage

Value of Final
Goods
1st Wheat (Farmer) 10 10
2nd Flour (Mill) 30 20
3rd Baked Bread (Shop) 40 10
4th Customer 70 30
National Income/ (GDPFC) 70

Difficulties/Precautions associated with Output Method:

• Avoid double counting:
While calculating national income using product approach, sometimes there is a threat of double
counting.

• Goods and services rendered free of cost:

In real world there are so many goods and services which are rendered free of cost. Such as pick
and drop facility provided by father to his kids, services provided by housewife domestically and
kitchen gardening etc. All these activities are to be ignored as to find out the market value of such
activities is not possible.

• Avoid sale of old or used goods: In order to measure all current outputs, we must include
market value of any addition to inventories. The goods once sold will not be considered again as
their value has been calculated already.

• Value-added approach: This method of computing national income helps us to avoid double
counting of any value. It provides more précised picture of national income.

Gross National Product (GNP) at factor cost (FC):

GNP is the money value of all the final goods and services produced by the Nationals of a country by
using both domestic and foreign resources, during a period of one year”. GNP is relatively a broader
term than GDP.
A country’s GDP, plus any income earned by residents from overseas investments, minus income
earned by overseas residents within the domestic economy.

GNPFC = GDPFC + net property/foreign income from abroad

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Important points to note about GNP:

1. GNP is the production of the citizens of a country only

2. Only final goods and services would be considered in national income accounting to avoid the
doubt of double counting.
3. Goods and services produced in current year will be taken
4. Only money value of goods and services will be taken as different units of goods and services
cannot be added or subtracted.

Net National Product (NNP) at factor cost FC / ACTUAL NATIONAL INCOME:

N.I/ NNPFC = GNPFC – capital depreciation

The rationale behind deduction of depreciation is to get the more appropriate estimate of national
income. Because the value of an asset declines throughout the year by using it in order to produce
goods and services

Personal Income:
Personal income is the total income of all the individuals, actually received during a period of one
year. P. I = NNP - undistributed profit/retained earnings,
- Social security contributions
- corporate income taxes
+ Transfer payments

Undistributed Corporate Profits:

Some part of the profit generated by the organization is often not been distributed among the shareholders
with the intention of ploughing back or as safeguard for some rainy days.

Social Security Contributions:

It is a contribution into the social security fund of the government for the benefit of its employees in case of
emergencies.

Corporate Profit Taxes:

The amount of profit which is not distributed among the shareholders. It is a liability of the enterprise to pay
in form of taxes to the government.

Transfer Payments:
It is known as “unearned income” or income received without performing any economic activity. It is simply
transferred from one to another on charity or donation bases.

Disposable personal income: (DPI)

Disposable personal income is the total net amount left with the individuals and households when
they have paid all direct taxes.

DPI = Personal income – Personal tax.

Personal tax is a tax levied on the annual earnings of an individual i.e income tax, wealth tax etc.
This is also known as direct tax

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Summary:

Expenditures • Consumption
Approach
• Investment
• Government
• Exports-Imports
Less Indirect Tax + Subsidies
Income Approach

• Wages •GDP at factor cost

• Rental Income •+Net foreign income
• Interest •GNP at factor cost
• Profits •-depreciation
(Excluding transfer payments) •NNP at factor cost = National
Income
Product Approach

• Agriculture
• Manufacturing
• Individual Services
• Institutional Services
etc.

2.3: CIRCULAR FLOW OF NATIONAL INCOME: (For Closed Economy)

The above flow chart shows: Circular flow of income describes that how the income produced by
firms is redistributed among the factors of production.

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• Household provide factors of production such as; land, labour, capital and entrepreneurial
services to the firms. (1)
• Thus, they get rewards against their factors of production in the form of rent, wages, interest
and profits. (2)
• Firm produce Goods and Services by using FOP. (3)
• Subsequently households spend their income on different goods and services that they need
which ultimately goes in the pockets of firm owners. (4)
• Outer flow is called “Money flow” and inner flow is called “Real flow”

• It is clear here that the money value of final goods and services is exactly equal to the aggregate
amount of rewards to the factors (if all the rewards are met at full). This way the income keeps
on flowing in the country throughout the year and termed as circular flow of national income.

“Output = expense = Income”

Withdrawals and Injections in Circular Flow of Income: (For Open Economy)

Leakages/ Withdrawals: means outflow of income from the circular flow of income

1. Savings (S)
Savings is a part of income which is not spent on consumer goods and services. These savings are
withdrawals from the Circular Flow of Income

2. Taxation (T)
The amount of taxes paid to the government is not available for spending by the households and
is therefore considered as withdrawals.

3. Imports (M)
The expenditures incurred on the purchase of imported goods and services are considered to be
withdrawals from a country’s Circular Flow of Income

Injections: means inflow of income from the circular flow of income.

1. Investments (I)
Investments in capital goods are a form of spending on future output and therefore considered
as injection of funds into the Circular Flow of Income.

2. Government Spending (G)

The funds (raised by way of taxes or borrowings) spent by the government are injections in
the Circular Flow of Income.

3. Exports(X)
The goods and services produced by the firms in the country and exported, result in income from
abroad and are therefore injections in the Circular Flow of Income

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2.4: Difficulties in measuring national income

1. Lack of trained staff:

Collection, compilation and analysis of statistical data is a highly technical exercise and
availability of sufficient trained staff is often difficult.

2. Illiteracy/unreliable record keeping:

Due to illiteracy many producers keep unreliable data of their production.

3. Inadequate information caused by poor collection procedures

4. Some income cannot be recorded:

• Undocumented/Black/Shadow Economy Transactions.
• Non-market (Do-it-yourself activities) and barter transactions

5. Price fluctuations:
Mainly as a result of unstable forces of demand and supply in a country like Pakistan prices of
the commodities tend to fluctuate frequently. As a result, the accurate calculation of national
income measurement becomes difficult.

6. Earning of foreign firms: A large number of foreign firms, especially in underdeveloped

countries such as Pakistan, invest their money. Their earning makes it more difficult for national
income calculators of a country to determine which part of their income should be added or
ignored.

Importance of National Measurement:

• Assessment of economic performance:

National income statistics help government to assess the economic performance of the country.
Persistent increase in national income represents that the economy is growing.

• Measuring living standards of people:

Data about National Income is used to estimate the per-capita income of a country
Natioanal Income
( Population ), which determine the standard of living of the people.

• To estimate distribution of national income:

National income statistics also help us to examine distribution of national output among the
factors of production.

• Helping in economic planning:

State authorities need some statistics about the economy to formulate effective economic
planning. Various economic policies such as commercial policy, monetary policy and fiscal policy
are based upon the economic data of a country.

• Comparing economic growth among the countries:

National income statistics also used to make a comparison among different economies of the
world.

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MULTIPLE CHOICE QUESTIONS

5.1) Which of the following topics are studied in Macro Economics?

a) Theory of Demand
b) Aggregate Demand and Aggregate Supply
c) Equilibrium of Industry
d) None of the above

5.2) Macroeconomics is not concerned with.

a) The level of output of goods and services.
b) The general level of prices
c) The growth of income
d) Labour productivity

5.3) Macro-economics is also known as:

a) Price Theory b) Theory of Distribution
c) Theory of Income & Employment d) Theory of Production

5.4) Which of the following is NOT an objective of government economic policies?

a) low unemployment b) Economic Growth
c) Provide credits d) Stable Inflation

5.5) The market value of all the products goods and services, which are produced within a country during
one financial year is known as:
a) G.D.P. b) G.N.P.
c) National Income d) Disposable Income

5.6) The monetary value of the flow of goods and services produced by the economy during one year
after the adjustment of indirect taxes and subsidies is known as:
a) Personal Income b) Disposable Income
c) National Income d) G.D.P.

5.7) Which statement is true for National Income?

a) Only final goods will be considered
b) Goods and services, produced only through legal channels
c) It is usually taken for one year
d) All of the above

5.8) Gross domestic investment is the component of national accounting using ________.
a) Income approach b) Product approach
c) Expenditure approach d) Value added approach

5.9) NNPfc = …………?

a) GNPfc + Depreciation – tax + subsidies
b) GNPmp - Depreciation – tax + subsidies
c) GNPfc + Depreciation + tax + subsidies
d) GNPfc + Depreciation + tax - subsidies

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5.10) Consider the following data for a country:

Items Rs. in billion
Consumer expenditure 250
Government expenditure 500
Imports 100
Taxes 20
Depreciation 5

Based on the above data, the GDP for the economy would be:
a) Rs. 625 billion b) Rs. 850 billion
c) Rs. 650 billion d) Rs. 825 billion

5.11) Using values given in table, NNP is.

Items Rs. (millions)

GDP 500
Income received from abroad 250
Income taken to abroad 200
Depreciation 20
Indirect Tax 25
Subsidies 80

a) 530 b) 570
c) 500 d) 480

5.12) GNP is always

a) Less than NNP b) More than NNP
c) Equal to NNP d) Calculated from NNP

5.13) The following data related to the National Income of a country:

Items Rs. in billion

Consumer’s expenditure 25,000
Gross investment 5,000
Government expenditure 5,000
Exports 4,000
Imports (6,000)
G.S.T. (4,000)
Subsidies 1,000
Depreciation allowance (1,000)
Net factor income from abroad 2,000

The National Income at factor price is:

a) 33,000 b) 34,000
c) 31,000 d) 30,000

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5.14) _________is a precaution to calculate national income by income approach.

a) Transfer Payments b) Tax collected by federal government
c) Wages d) None of the above

5.15) Transfer payments means

a) Bank loans
b) The payment without work
c) Tax payments
d) Payments made to all factors of production

5.16) Which one is the highest value?

a) GDP b) NNP
c) Personal Income d) GNP

5.17) Undistributed profits are considered

a) Income earned but not received b) Income received but not earned
c) Income earned and received d) None of the above

5.18) GDP deflator is use to estimate

a) Gross National Product b) Personal Income
c) Net National Product d) Inflation

5.19) Which of the following diagrams shows an inflationary gap?

5.20) Which one is not an injection for circular flow of National Income?
a) Postponed consumption b) Public sector spending
c) Private investment d) Exports

5.21) When there is rising inflation in the economy then

a) Real GNP is greater than Nominal GNP
b) Nominal GNP greater than real GNP
c) GNP and real GNP increase at the same rate
d) There is no effect on such calculations

5.22) By deducting personal tax from personal income, we get

a) Personal Income b) GNP at factor cost
c) NNP at market price d) Personal Disposable Income

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5.23) Capital consumption is defined as

a) Reduction of value of an asset over the year
b) Decrease in value by using an asset over than capacity
c) Wastage of assets by not using it over the time
d) None of the above

5.24) Per-Capita Income, also known as average income of people of a country, is a measure to estimate
the life standards of the nationals of a country.

a) True b) False

5.25) Personal income =

a) National income - retained earnings + Social security - corporate taxes + Transfer payments
b) National income - retained earnings - Social security - corporate taxes + Transfer payments
c) National income - retained earnings - Social security - corporate taxes - Transfer payments
d) National income - retained earnings + Social security - corporate taxes + Transfer payments

5.26) Which of the following is a measure of income earned by a factor of production?

a) Indirect taxes b) Depreciation
c) Rent d) Corporate taxes

5.27) Which one can affect the national income accounting adversely?
a) Total value of cotton produced in a country
b) Domestic work done by households
c) By adding value of resold car during same year
d) All of above

5.28) In the long-run, price is determined by:

a) cost of production b) number of consumers
c) influence of tastes and fashion d) competitive forces

5.29) Which of the following is not a withdrawal from circular flow of income:
a) Savings b) Investment
c) Imports d) Taxes

5.30) Which of the following are correct about Real GDP? (Select TWO)
a) inflation adjusted b) inflation is not adjusted
c) calculated on current year price d) calculated on base year price

5.31) If nominal GDP is Rs.200 million and inflation rate in an economy is 15%. Find the real GDP.
a) Rs.30 million b) Rs.173.91 million
c) Rs.1333 million d) Rs.200 million

5.32) If GNP rose from 5 billion rupees to 10 billion rupees and in the same period price rose by 50%
a) real GNP fell by 100% b) real GNP fell by 50%
c) real GNP remain unchanged d) real GNP will increase by 50%

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5.33) G.D.P. estimated at base year price is known as:

a) Nominal G.D.P. b) Real G.D.P.
c) G.D.P. at purchasing power parity d) All of the above

5.34) Net National production is also known as:

a) National Income at Factor Price b) National Income at Market Price
c) GDP at Market Price d) Personal Income

5.35) Living standard of people is calculate by

a) Real GDP per person b) Nominal GDP per person
c) Net national product d) Gross domestic product

5.36) If GDP is Rs.220,000 and population is 1100. Per capita income will be?
a) 1100 b) 200

c) 11 d) 300

5.37) If gross output of a country in current year is 5,000 units & price of output in current year is Rs.100
per unit and in base year Rs.50 per unit. Real G.D.P. of the country would be:
a) 50,0000 b) 100,0000
c) 25,0000 d) None of the above

5.38) Which of the following constitute(s) injection into the circular flow of income?
a) Investments by businesses b) Government expenditures on goods
and services
c) The value of exports d) All of the above

5.39) Which of the following represent withdrawals from the circular flow of national income?
(i) Distributed profits
(ii) Interest paid on bank loans
(iii) Income tax payments
(iv) Imports

a) (i) and (ii) only b) (ii) and (iii) only

c) (i) and (iii) only d) (iii) and (iv) only

5.40) Income which is received without any factor services is known as ________________.
a) Personal income b) Retained earnings
c) Transfer payments d) Disposable income

5.41) Income which earned but not received by the factors of production is known as ________________.
a) Personal income b) Retained earnings
c) Transfer payments d) Disposable income

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5.42) Total income received by all the legal residents of an economy in one financial year.
a) National Income at Factor Price b) National Income at Market Price
c) Personal Income d) Disposable Income

5.43) Transfer Payment doesn’t include:

a) Charity b) Gift
c) Profit d) Social security benefit

5.44) Gross annual value of Circular of flow of income is known as:

a) G.D.P. b) G.N.P.
c) National Income d) Disposal Income

5.45) The following data related to the National Income of a country:

Items Rs. in billion

Pre-tax wages of workers 10,000
Pre-tax profit of firms 12,000
Rent received by land 8,000
Taxes deducted out of rent 2,000

The National income at factor price of country is:

a) 30,000 b) 24,000
c) 32,000 d) 20,000

5.46) Expenditure on reconditioned or used goods such as; used car, old building, second hand plant etc.,
is to be included In National income
a) True b) False

5.47) Which of the following expenditure are not included in G.D.P.

a) Expenditure made by the firms b) Consumer’s Expenditure
c) Government Expenditure d) Net foreign trade expenditure

5.48) Which of the following adjustment is called factor price adjustment.

(i) Indirect taxes
(ii) Subsides
(iii) Capital consumption allowance
(iv) Net factor income from abroad

a) (i) & (iii) b) (ii) & (iii)

c) (iii) & (iv) d) (i) & (ii)

5.49) Net increases in the capital stocks of a country is called:

(i) Net investment
(ii) Net savings
(iii) Net capital formation
(iv) Net consumption

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a) (i) & (ii) b) (i) & (iii)

c) (ii) & (iii) d) (iv)

5.50) Which of the following TWO are NOT Injections in Circular Flow of Income?
a) Savings b) Investment
c) Imports d) Government spending

5.51) A country’s measured national income per capital falls but its inhabitants experience a rise in
consumption. What could explain this?
a) A decrease in net foreign remittances b) A fall in population
c) An increase in trade deficit d) A rise in negative externalities

Data for Question 52 to 58:

Following data relates to the economy of a country over a year period.
Rs. In Millions
Capital consumption 2625
Subsidies 450
Exports 9675
Imports (9360)
Consumer’s expenditure 27600
Taxes on expenditure (4140)
Net property income from abroad 315
Value of physical decrease in stocks (30)
Gross domestic fixed capital formation 7380
General government final consumption 6810

5.52) You are required to compute Gross Domestic Product (GDP) at market price.
a) 42075 b) 38385
c) 42390 d) 38700

5.53) You are required to compute Gross Domestic Product (GDP) at factor cost.
a) 42075 b) 38385
c) 42390 d) 38700

5.54) You are required to compute Gross National Product (GNP) at market price.
a) 42075 b) 38385
c) 42390 d) 38700

5.55) You are required to compute Gross National Product (GNP) at factor cost.
a) 42075 b) 38385
c) 42390 d) 38700

5.56) You are required to compute National Income at Market price.

a) 42075 b) 38325
c) 39765 d) 38500

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5.57) You are required to compute National Income at factor cost

a) 41075 b) 36075
c) 45390 d) 32300

5.58) If sale value of output of firms is Rs.45 billion and cost of goods purchased by firms from outside
firms is Rs.10 billion. G.D.P. of country would be:
a) Rs.45 billion b) Rs.35 billion
c) Rs.55 billion d) Rs.50 billion

5.59) Which of the following TWO are NOT difficulties while measuring national income?
a) Do-it-yourself activities b) barter transactions
c) Goods and services, produced only d) based on final market value of goods
through legal channels and services

5.60) When calculating national income through Value added method, we ignore
a) Rent of self-occupied home
b) Income earned through capital investment
c) Salaries being paid to house maids, home taxi drivers
d) None of these

5.61) Which of the following is NOT part of a country’s Gross Domestic Product?
a) Company profit b) Net income from abroad
c) Salaries of school teacher d) Investment expenditure

5.62) Which one is NOT the most relevant problem regarding calculating national income?
a) Unreliable record keeping b) Lack of trained staff
c) Illegal activities d) Poor collection procedure

5.63) G.D.P = ___________________________

a) C + I + G + (K - M) b) C+I+G-M
c) C + I + (X - M) d) C + I + G + (X - M)

5.64) The following data relates to an open economy

Consumption expenditure 0.4Yd

Investment expenditure (Rs.) 300 million

Government expenditure (Rs.) 600 million
Exports (Rs.) 500 million
Imports 0.28Y

Where Y is the national income and Yd is the disposable income which is equal to 70% of the national
income. Calculate equilibrium level of national income

a) 748 b) 524
c) 1400 d) 3421

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ANSWER KEY

5.1) B 5.2) D 5.3) C 5.4) C

5.5) A 5.6) C 5.7) D 5.8) C

5.9) B 5.10) C 5.11) A 5.12) B

5.13) C 5.14) A 5.15) B 5.16) D

5.17) A 5.18) D 5.19) B 5.20) A

5.21) B 5.22) D 5.23) A 5.24) A

5.25) B 5.26) C 5.27) C 5.28) D

5.29) B 5.30) A,D 5.31) B 5.32) D

5.33) B 5.34) B 5.35) A 5.36) B

5.37) C 5.38) D 5.39) D 5.40) C

5.41) B 5.42) C 5.43) C 5.44) A

5.45) C 5.46) B 5.47) A 5.48) D

5.49) B 5.50) A,C 5.51) C 5.52) A

5.53) B 5.54) C 5.55) D 5.56) C

5.57) B 5.58) B 5.59) C,D 5.60) A

5.61) B 5.62) C 5.63) D 5.64) C

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TEST-05
Q-1) Transfer payments include: (Select TWO)
a) Bank loan b) Payment without work
c) Tax payment d) Government subsidies and pension fund
Q-2) Per capita income calculation show:
National income (Billion) Total Population (Million)
Year 1 180,000 225
Year 2 192,100 226
a) Improved
b) Not Improved

Q-3) If Injections are less than withdrawals then:

a) National income to rise b) Unemployment to rise
c) Inflation to rise d) Balance of payment to improve
Q-4) The aggregate demand is 120 billion, government spending is 30 billion, investment is 30
billion, Import is 25 billion. Find export
a) 55 b) 65
c) 75 d) 85
Q-5) National income is: (Select TWO)
a) measure for only one year b) Only Intermediate goods will be
considered
c) Only final goods will be considered d) Calculate on physical goods and services
Q-6) GDP deflator is equal to:
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
a) 𝑥 100 b) 𝑥 100
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

c) 𝑥 100 d) 𝑥 100
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑙𝑜𝑔𝑥

Q-7) NNP is calculated by (Select TWO);

a) GNP – depreciation
b) GDP + net income from abroad – depreciation
c) GDP + Tax – Subsidy – depreciation
d) GDP + net income from abroad

Q-8) When calculating national income through Value added method, we ignore
a) Rent of self-occupied home
b) Income earned through capital investment
c) Salaries being paid to house maids, home taxi drivers
d) None of these
Q-9) Which of the following is the injection in the circular flow of income.
a) measure for only one year b) Only Intermediate goods will be
considered
c) Only final goods will be considered d) Calculate on physical goods and services
Q-10) Formula to calculate Real GDP is:
a) P0Q0 b) PnQn

c) P0Qn d) PnQ0

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CHAPTER-06
“NATIONAL INCOME DETERMINATION”

PART-01: NATIONAL INCOME EQUILIBRIUM

1.1: AGGREGATE DEMAND (AD) 153

1.2: AGGREGATE SUPPLY (AS) 155
1.3: NATIONAL INCOME EQUILIBRIUM: 158
1.4: OUTPUT GAP: 160
1.5: CHANGES IN BOTH AD AND SRAS:

PART-03: MULTIPLE CHOICE QUESTIONS & TEST-06

MCQ 162
TEST-06 171

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1.1: AGGREGATE DEMAND:

Definition:
Aggregate Demand is the total amount of goods and services demanded within an economy at a given
price level in a given time period.

Equation of Aggregate Demand is:

AD = C + I + G + (X – M)
Components of aggregate demand
• Private Consumption (C): consumer expenditure on goods and services
• Gross Private Investment (I): Investment on capital goods
• Government spending (G: Government expenditures in an Economy
• Net Exports (X-M):
➢ Level of exports (X): Goods are sold to outside country
➢ Level of imports (M): Goods are purchased from outside country

Aggregate Demand Curve (AD Curve):

Aggregate Demand Curve shows how much GDP will be demanded at each general price level.
AD curve is downward sloping, meaning that as the price level decreases, the level of demand in the
economy increases.
Price Level

P1

P2

AD

Y1 Y2

Real National Output

The y-axis represents the price level of all final goods and services in the economy. On the x-axis is
the Real National Output.

Shifts in the AD curve:

Shift in aggregate demand will be due to non-price factors of AD. e.g. change in any of the component
of AD
Price Level

P0

AD0 AD1
Y0 Y1
Real National Output

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Effective Demand:

In Keynes’s macroeconomic theory, effective demand is the point of equilibrium where aggregate
demand = short run aggregate supply (AD = SRAS).

Actual expenditure in an economy is based on existing/ actual income, rather than if the economy
was at its productive potential (when all resources are fully utilized) is referred to as effective
demand.

1.2: AGGREGATE SUPPLY (AS)

Aggregate Supply (AS):
Aggregate Supply is the total supply of goods and services produced within an economy at a given
price level, in a given time period

Aggregate Supply Curve (AS Curve):

Aggregate Supply Curve show the direct relationship between a country’s real output and general
price level. Rising price levels expand the overall economic activity of the country.

1. Short Run Aggregate Supply (SRAS):

SRAS
Price Level

P2

P1

Y1 Y2
Real National Output

Shifts in the SRAS Curve:

There are exogenous factors that are likely to cause a shift in a SRAS curve.

Factors responsible for shift in SRAS

factors causing shift forwards or backwards in short run aggregate supply are
• Change in factor productivity of both labour and capital
• Change in size and quality of capital stock, through investment
• Change in size and quality of the labour force
• Change in unit cost of labour (i.e., wages)
• Change in producer taxes or subsidies
• Change in inflationary expectations (e.g., causing a rise in inflation, and a rise in wages,
causing supply to shift inwards)

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Price Level
SRAS1 SRAS2

P1

Y1 Y2
Real National Output

2. Long Run Neo-classical AS Curve:

• Shape of Long run aggregate supply curve is quite different from SRAS due to the concept of full
employment.

Full Employment (Yf):

‘Full employment is a situation where all available resources of an economy are fully utilized. In
other words, full employment reflects situation of a country when no more production is
possible’.

• In the short run, supply changes to the price level, as the factors of production are adjusted to
enable the most efficient use of resources.

• In the long run supply stays independent of the price level. It is determined by the overall
productivity of the resources in the economy.
➢ LRAS represents the productive potential of the economy (Full employment level).
➢ LRAS is independent of the price level, and signifies the upper limit of the capacity in the
economy, the curve is a vertical line.

LRAS

SRAS
Price Level

P2

P1

Y1 Yf Real Output

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Economic Growth and Shift in LRAS Curve

LRAS will shift only if there is a permanent change in resources. For example:
• Increase in quantity and productivity of the factors of production,
• Improvement in labour skills.
• Improvement technology.
• Exploring new natural resources.

Price Level
LRAS1 LRAS2

Y1 Y2
Real National Output
=

3. Keynesian Aggregate Supply Curve

Keynes believe that there is no distinction between the short run and the long run.

• At start when economy is in recession AS curve will be flatter, because resources are not being
fully utilized. At this stage output increases without increase in the price level because
economy will just use up spare capacity to produce national output.
• Keynesians still believe that when the economy reaches its productive potential, the AS curve
will be vertical.
• Beyond this productive potential there is only increase in price not real output.

AS
Price Level

P0 Full employment
level

Real National Output Ymax

Potential Output

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1.3: NATIONAL INCOME EQUILIBRIUM:

Macro Economics equilibrium: Where (AD = SRAS)

The macroeconomy is in equilibrium at the point where SRAS (value of output produced within an
economy) is equal to AD (level of demand for goods and services) not in LRAS.

• LRAS is that this is the productive potential in the economy.

• SRAS is what is actually being supplied in the macroeconomy,

1.4: OUTPUT GAP:

The difference between actual output of an economy and potential output of an economy is known
as the output gap.
TWO possible conditions of output gap for an economy are:
• Negative Gap: Where an economy is performing below its productive potential. (Yf).
Actual output (AD) < Potential output

• Positive Gap: Where an economy is performing beyond its productive potential. (Yf)
Actual output (AD) > Potential Output.

NEGATIVE GAP OR DEFLATIONARY GAP: (If Actual output is less than potential output.)

Deflationary (or recessionary) gap exists when the equilibrium/ aggregate demand in the economy
is less than the production potential (Full employment level). It represents that due to recessionary
conditions the economic resources are not being fully utilized. This low AD causes a fall in overall
price level which is termed as deflationary gap.

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LRAS

Price Level
SRAS

Pf Full employment
level

E
Pe
ADf

Deflationary
Gap
ADe

Ye Yf
Real National Output
In the graph, gap between Yf and Ye represents a negative gap, which occurred due to fall in ADf
even less than productive potential i.e., Yf.

Positive Gap or Inflationary Gap: (If Actual output is greater than potential output.)

Inflationary gap exists when the equilibrium/ aggregate demand in the economy is beyond the
productive potential ((Full employment level)). It represents that the aggregate expenditures (due to
expansionary conditions) is increasing rapidly. Therefore, economic resources are insufficient to
meet the potential demand. This high AD causes a rise in overall price level which is termed as
inflationary gap.

LRAS
Price Level

SRAS
E
Pe

Pf Full employment level

ADe

Inflationary
Gap
ADf

Yf Ye
Real National Output
In the graph, gap between Yf and Ye represents a inflationary gap, which occurred due to rise in ADf
beyond the productive potential i.g Yf. If aggregate expenditures increase in an economy from ADf to
ADe, then the overall price level will also rose up from Pf to Pe. It will create an inflationary gap in
the economy.

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1.5: CHANGES IN BOTH AD AND SRAS:

AD demand and SRAS changes due to non-price factors.

1) Shift in Aggregate Demand

(i) Increase in Aggregate Demand:

Increase in Aggregate demand is due to

• Increase in any component of AD,
• Expansionary fiscal or
• Expansionary monetary policies
Conclusion:
price level and GDP both will increase

(ii) Decrease/Leftward Shift in Demand:

Decrease in Aggregate demand is due to

• Decrease in any component of AD,
• Contractionary fiscal or
• Contractionary monetary policies
Conclusion:
price level and GDP both will decrease

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2) Shift in Aggregate Supply

(iii) Increase in Aggregate Supply:

Increase in Aggregate supply is due to

• increase in factors of production or
• decrease in production cost
Conclusion:
price level decrease and GDP will increase

(iv) Decrease/leftward Shift in Supply:

Decrease in Aggregate supply is due to

• decrease in factors of production or
• increase in production cost
Conclusion:
price level increase and GDP will decrease

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MULTIPLE CHOICE QUESTIONS

6.1) Which one is a component of Aggregate Demand?

a) Personal consumption b) Personal Investment
c) Subsidies d) All of above

6.2) Which one is NOT considered in Aggregate Demand?

a) Demand for cotton b) Demand for salt
c) Demand for labour d) None of the above

6.3) If exports become more attractive for foreign firms, then the Aggregate Demand Curve
a) Rise and shift rightward b) Fall and shift rightward
c) Rise and shift inward d) Fall and shift inward

6.4) Which is NOT a cause of inward shift of aggregate demand curve?

a) Consumers begin to spend more
b) Firms have wave of optimism
c) Government spending more on power generation projects
d) None of the above

6.5) Actual expenditure in an economy is based on existing/ actual income, rather than if the economy
was at its productive potential is known as
a) Individual demand b) Effective demand
c) Aggregate demand d) None of the above

6.6) Which cause a shift in Aggregate Supply curve to left?

a) Decrease in labour productivity
b) Increase in overall spending
c) Decrease in government spending on development projects
d) Decrease in foreign direct investment

6.7) Change in inflationary expectations will cause

a) Vertical Aggregate Supply curve
b) Positively sloped aggregate supply curve
c) Shift in aggregate supply curve
d) None of above

6.8) Long run aggregate supply curve is vertical due to

a) Flexability of existing resources
b) Firms have ability to switch resources to other production
c) Government have no control over production decisions
d) Full utilization of existing resources

6.9) A vertical aggregate supply curve shift to right ward if

a) Permanent change in productive potential
b) Change in technology
c) Change in government spending
d) Change in beaviours of consumers

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6.10) Inflationary gap represents when

a) Aggregate demand exceeds over production potential of the economy
b) Aggregate demand exceeds over the firm’s expectations
c) Aggregate supply remains less than in aggregate supply in short run
d) Aggregate supply exceeds over aggregate demand in short run

6.11) If aggregate demand is less than productive potential of an economy then it is known as
a) Negative output gap b) Positive output gap
c) Inflationary gap d) None of the above

6.12) An output gap is said to be an inflationary gap if

a) Aggregate demand exceeds over aggregate supply in short run
b) Aggregate demand exceeds over aggregate supply in long run
c) Aggregate demand remains less than aggregate supply in short run
d) Aggregate demand remains less than aggregate supply in long run

6.13) If rise in aggregate demand is greater than increase in short run aggregate supply curve then
a) Price and output level will increase
b) Price and output level will decrease
c) Price will increase and output level will decrease
d) Price will decrease and output will increase

6.14) If rise in aggregate demand is lesser than increase in short run aggregate supply curve then
a) Price and output level will increase
b) Price and output level will decrease
c) Price will increase and output level will decrease
d) Price will decrease and output will increase

6.15) If aggregate demand and aggregate supply increase in same proportion

a) Price and output level will increase
b) Price and output level will decrease
c) No change in price level and fall in output
d) No change in price level and rise in output

6.16) A positive output gap leads to

a) A rise in overall price level
b) A fall in overall price level
c) No change in price level
d) It depends on magnitude of change in demand and supply

6.17) Which one can be responsible factor of an inflationary gap?

a) Rising household consumptions b) Rising investment
c) Rising government spending d) All of the above

6.18) Which one is NOT a workable step to overcome an inflationary gap?

a) Rising government spending b) Rising direct taxes
c) Decrease in government spending d) Increase in interest rate
6.19) Inflationary gap depicts economy is in
a) Its peak b) Its trough
c) Recession d) Recovery

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6.20) Rise in minimum wage level is a workable step to

a) Overcome inflationary gap b) Inflationary gap
c) Irrelevant d) All of above

6.21) Aggregate supply curve

a) Is the sum of individual supply curves in the economy
b) Is a market supply curve
c) Embodies the same logic that lies behind an individual firm’s supply curve
d) None of the above

6.22) An inflationary gap exists in an economy when

a) The government has a budget deficit
b) Aggregate demand is greater than the full employment level of income
c) Withdrawals exceed injections at the full employment level of income
d) The money supply rises faster than national income

6.23) Which one of the following would cause a fall in the level of aggregate demand in an economy?
a) A decrease in the level of imports
b) A fall in the propensity to save
c) A decrease in government expenditure
d) A decrease in the level of income tax

6.24) Which of the following cannot cause shift in short-run aggregate supply?
a) Productivity of labour b) Indirect taxes
c) Direct taxes d) Subsidies

6.25) Long-run aggregate supply represents.

a) The productive potential of an economy
b) Total labour supply
c) Relationship between price and taxes
d) Total natural resources

6.26) Which of the following cannot cause shift in long run aggregate supply?
a) New technology b) Improvement in labour skills
c) Price level d) Natural resources

6.27) Keynesian aggregate supply curve is always:

a) Upward to the right
b) Downward to the right
c) Horizontal & vertical after full employment
d) Vertical

6.28) Difference between potential G.D.P and actual G.D.P. is called:

a) Inflation b) Deflation
c) Output gap d) G.D.P. Deflator
6.29) G.D.P. deflator is a ratio between:
a) Inflationary gap & deflationary gap
b) Inflation and disinflation
c) Nominal G.D.P. and Real G.D.P.
d) None of the above

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6.30) If government expenditure increases what will the effect on price level and output level.
a) Both increases
b) No change
c) Output increase and no change in price level
d) Price level increase and no change in output level

6.31) If wage rate in economy increases what will be effect on price level.
a) Increase b) Decreases
c) No change d) Rate of inflation decrease

6.32) If government expenditures and wage rate increases in the same proportion what will be effect on
economy.

(i) Output increase

(ii) No change in output
(iii) Price level increases
(iv) Output decrease

a) (i) & (iii) b) (ii) & (iv)

c) (iii) & (iv) d) (ii) & (iii)

6.33) Deflationary gap can be reduced by:

(i) Increase in government expenditure
(ii) Increase in consumer’s expenditure
(iii) Decrease in indirect taxes
(iv) Increase in subsidies

a) (i) & (ii) b) (iii) & (iv)

c) (ii) & (iii) d) (i) & (iv)

6.34) If aggregate demand gone beyond the full employment it is said to be:
(i) Inflationary gap
(ii) Deflationary gap
(iii) Ideal equilibrium
(iv) Positive output gap

a) (i) & (ii) b) (i) & (iv)

c) (ii) & (iv) d) (ii) & (iii)

6.35) A continuous or persistent rise in general price level is called:

a) Inflation b) Deflation
c) Disinflation d) Stagflation

6.36) A fall in rate of inflation is called:

a) Inflation b) Inflationary gap
c) Disinflation d) Deflation

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6.37) Which of the following is NOT become a reason for shifting Long run aggregate supply.
a) Improvement technology b) Exploring new natural resources
c) Increase in income level d) All of these

6.38) A particular situation beyond the full employment where only general price level increases with no
change in level of output is called _________________.
a) Inflation b) Inflationary gap
c) Disinflation d) Deflation

6.39) Keynesians believe that when economy reaches its productive potential the A.S. curve will be __
a) Horizontal b) Vertical
c) Downward d) upward

6.40) If the economy is not at full output, they believe that the A.S. curve will be __
a) Horizontal b) Vertical
c) Downward d) upward

6.41) In the above diagram A.D curve shifts towards right as a result price level & output level both
increases. What is the cause of shift in A.D curve?

a) Decrease in government expenditure b) Expansionary Fiscal policy

c) Contractionary monetary policy d) None of the above

6.42) Pakistan’s economy after Covid-19 currently facing a situation of:

a) Deflationary gap or recessionary gap
b) Inflation gap
c) Ideal equilibrium
d) None of the above

6.43) The aggregate demand curve would shift to the right if:
a) government taxes increase b) government spending increase
c) government spending decreases d) the nominal money supply decreases

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 CH-06 NATIONAL INCOME DETERMINATION

6.44) Which of the following topics are studied in Macro Economics?

a) Theory of Demand b) Aggregate Demand and Aggregate
Supply
c) Equilibrium of Industry d) None of the above

6.45) Which of the following would decrease aggregate demand?

a) Increased investment b) Increase in export revenue
c) Increased taxation d) Increased consumption

6.46) ____________________________________is the total supply of goods and services produced within an
economy at a given overall price level, in a given time period.’

6.47) An inflationary gap exists in an economy when

a) the government has a budget deficit
b) aggregate demand is greater than the full employment level of income
c) withdrawals exceed injections at the full employment level of income
d) the money supply rises faster than national income

6.48) A deflationary gap exists in an economy when:

a) aggregate demand is less than the full employment level of income
b) injections exceed withdrawals at the full employment level of income
a) the government has a budget surplus
b) none of the above

6.49) Aggregate supply increases due to increase in: (Select any TWO)
a) labour productivity b) consumer spending
c) low wage rate d) interest rates

6.50) When the national income is in equilibrium, an increase in investment causes the equilibrium to
change. Which change of equivalent value would bring national income to its original equilibrium
level?
a) Decrease in government spending b) Increase in government spending
c) Decrease in government taxes d) Increase in exports

6.51) Shape of Long run aggregate supply curve is quite different from SRAS due to the concept
of____________.
a) Full employment b) Economic growth
c) Aggregate demand d) All of these

6.52) Which of the following is TRUE about full employment level.

a) all available resources of an economy are not fully utilized
b) when more production is possible’.
c) supply stays independent of the price level
d) Represents the actual productivity of the economy

6.53) Which of the following is NOT the responsible Factors for shift in SRAS
a) Change in unit cost of labour b) Change in producer taxes or
subsidies
c) Change in inflationary expectations d) Change in direct Tax

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6.54) Full-employment equilibrium occurs when

a) real GDP exceeds potential GDP b) real GDP equals potential GDP
c) potential GDP exceeds real GDP d) a result of an increase in long-run
aggregate supply

6.55) The inflationary gap may only be bridged by:

a) raising the government spending b) raising the output level
c) raising the price level d) raising the employment level

6.56) A deflationary gap exists in an economy when:

a) aggregate demand is less than the full employment level of income
b) injections exceed withdrawals at the full employment level of income
c) the government has a budget surplus
d) none of the above

6.57) Long Run Aggregate Supply (LRAS) curve is a vertical line because it is:
a) dependent on price level and signifies the upper limit of the capacity in the economy
b) dependent on price level and signifies the lower limit of the capacity in the economy
c) independent of price level and signifies the upper limit of the capacity in the economy
d) independent of price level and signifies the lower limit of the capacity in the economy

6.58) The gap between Ye to Yf shows __________________________.

LRAS
Price Level

SRAS

Pf

E
Pe
AD0

ADe

Ye Yf
Real National Output

a) Inflationary gap b) deflationary gap

c) positive output gap d) No gap

6.59) An inflationary gap exists in an economy when

a) The government has a budget deficit
b) Aggregate demand is greater than the full employment level of income
c) Withdrawals exceed injections at the full employment level of income
d) The money supply rises faster than national income

6.60) Which one of the following would cause a fall in the level of aggregate demand in an economy?
a) A decrease in the level of imports
b) A fall in the propensity to save
c) A decrease in government expenditure
d) A decrease in the level of income tax

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6.61) The aggregate supply curve:

a) Is the sum of the individual supply curves in the economy
b) Is a market supply curve
c) Embodies the same logic that lies behind an individual firm’s supply curve
d) None of the above

6.62) The aggregate demand curve would shift to the right if:
a) Government taxes increase
b) Net exports increase
c) Government spending decreases
d) The nominal money supply decreases

6.63) Which of the following would decrease aggregate demand?

a) Increase investment b) Increase in export revenue
c) Increased taxation d) Increased consumption

6.64) Aggregate Supply Curve show the direct relationship between a country’s real output and general
price level.
a) True b) False

6.65) Actual expenditure in an economy is based on existing/ actual income, rather than if the economy
was at its productive potential is referred to as effective demand.
a) True b) False

6.66) LRAS represents the actual productive level of the economy.

a) True b) False

6.67) LRAS will shift only if there is a temporary change in resources.

a) True b) False

6.68) Negative gap means when an economy is performing below its productive potential (Yf)
a) True b) False

6.69) Exploration of new natural resources causes leftward shift in LRAS.

a) True b) False

6.70) According to Keynes AS curve will be positively sloped.

a) True b) False

6.71) The macroeconomy is in equilibrium at the point where SRAS is equal to LRAS.
a) True b) False

6.72) If the economy is at long run equilibrium, then, real GDP equals potential GDP.
a) True b) False

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ANSWER KEY

6.1) D 6.2) C 6.3) A 6.4) D

6.5) B 6.6) A 6.7) C 6.8) D

6.9) A 6.10) A 6.11) A 6.12) B

6.13) A 6.14) D 6.15) D 6.16) A

6.17) D 6.18) A 6.19) A 6.20) B

6.21) D 6.22) B 6.23) C 6.24) C

6.25) A 6.26) C 6.27) C 6.28) C

6.29) C 6.30) A 6.31) A 6.32) D

6.33) A 6.34) B 6.35) A 6.36) C

6.37) C 6.38) B 6.39) B 6.40) A

6.41) B 6.42) A 6.43) B 6.44) B

6.45) C 6.46) Aggregate 6.47) B 6.48) A

supply
6.49) A,C 6.50) A 6.51) A 6.52) C

6.53) D 6.54) B 6.55) A 6.56) A

6.57) C 6.58) B 6.59) B 6.60) C

6.61) D 6.62) B 6.63) C 6.64) A

6.65) A 6.66) B 6.67) B 6.68) A

6.69) B 6.70) B 6.71) B 6.72) A

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 CH-06 NATIONAL INCOME DETERMINATION

TEST-06

Q-1) Effective demand is the actual expenditure in an economy is based on existing/ actual income,
rather than if the economy was at its productive potential.
a) True b) False

Q-2) Which of the following is not a Factor responsible for increase in SRAS
a) Expectation to rise in inflation b) Increase in capital stock
c) Increase in unit cost of labour d) Increase in investment

Q-3) LRAS represents the actual output of the economy.

a) True b) False

Q-4) Which of the following is true about LRAS.

a) independent of the price level b) signifies the upper limit of an economy
c) the curve is a vertical line d) All of the these

Q-5) LRAS will shift only if there is a permanent change in resources. Select TWO reason which causes a
shift in LRAS.
a) Increase in disposable income b) Exploring new natural resources
c) Improvement technology d) Temporary increase in labor

Q-6) Keynesians still believe that when the economy reaches its productive potential, the AS curve will
be increasing.
a) True b) False

Q-7) Macro Economics equilibrium: Where (Select TWO)

a) Demand = supply b) Aggregate demand = aggregate long run
supply
c) Aggregate demand = aggregate short run d) Withdrawals = injections
supply

Q-8) Decrease in Aggregate demand is due to

a) Decrease in any component of AD b) Expansionary fiscal
c) Contractionary fiscal d) Expansionary monetary policies

Q-9) What does Negative Gap means?

a) Where an economy is performing equal to its productive potential
b) Where an economy is performing below its productive potential
c) It is a Deflationary gap
d) Actual output (AD) > Potential Output.

Q-10) Inflationary gap exists when the equilibrium/ aggregate demand in the economy is below the
productive potential ((Full employment level)).
a) True b) False

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PRINCIPLES OF ECONOMICS CH-07: CONSUMPTION, SAVING AND INVESTMENT

CHAPTER-07
“CONSUMPTION, SAVING AND
INVESTMENT”

PART-01: CONSUMPTION:
1.1: KEYNESIAN THEORY OF CONSUMPTION 177

PART-02: SAVINGS
2.1: SAVINGS AND ITS DETERMINANTS 180

PART-03: INVESTMENT
3.1: RATE OF INTEREST & MARGINAL EFFICIENCY OF CAPITAL 181
3.2: SHIFT IN MEC 183
3.3 GOVERNMENT MEANS OF INFLUENCING INVESTMENT 183

PART-04: NATIONAL INCOME EQUILIBRIUM

4.1: CONSUMPTION AND INVESTMENT APPROACH 184
4.2: SAVINGS AND INVESTMENT APPROACH 185

PART-05: MULTIPLE CHOICE QUESTIONS & TEST-07

MCQ 186
TEST-07 193

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Part-01: CONSUMPTIONS:

Consumption:
Fraction of disposable income, that household spend on consumer goods and services is called
consumption.’
Income = Consumption + Savings

𝐘=𝐂+𝐒

1.1: KEYNESIAN THEORY OF CONSUMPTION

Keynes proposed a mathematical formula for consumption function as follows:

𝐂 = 𝒇 (𝐘)

and 𝐂 = 𝐂𝐨 + CY

• “C” stands for Consumption

• “Co” represents autonomous consumption (exogenous factor which does not depend on
consumer’s income)
• “CY “represents the induced consumption (endogenous factor, which directly depends on
consumer’s income)
• “C” represents the slope of consumption function or marginal propensity to consume (MPC)

Types of Consumptions:

• Autonomous Consumption (Co):

It is minimum amount of consumption even at zero level of income. .e.g food, shelter and
cloth.

• Induced Consumption (CY): It is part of consumption which changes with the change in
income).

Keynes’ Psychological Law of Consumption:

People increase their consumption as their income increases, but not by as much as their income
increases. There are 3 propositions

1. Aggregate consumption can increase due to increased aggregate income, but

the increase in consumption will be less than the increase in income. (MPC < 1)
2. What is not consumed, is saved.
3. The increase in income will lead to increased consumption or savings (MPC + MPS = 1)

Marginal Propensity to Consume (MPC):

It is ratio of change in consumption to change in disposable income.

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
MPC = (0 < MPC < 1)
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

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Marginal Propensity to Save (MPS):

It is ratio of change in saving to change in disposable income.

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑣𝑖𝑛𝑔
MPS = (0 < MPS < 1)
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

Average Propensity to Consume (APC):

It is ratio of consumption to disposable income. APC = 𝐶
𝑌

Consumption Table:

Income (Y) Consumption Saving MPC MPS APC APS

Rs. Million (C) (S)
0 50 -50 - - - -
100 100 0 0.5 0.5 1 0
200 150 50 0.5 0.5 0.75 0.25
300 200 100 0.5 0.5 0.67 0.33
400 250 150 0.5 0.5 0.62 0.38
500 300 200 0.5 0.5 0.60 0.4

Graphs of Consumption and Saving:

• The above graph explains that consumption increasing along with increase in income. But
rate of change in consumption is lesser than change in income which leads to an increase in
saving which is shown in lower panel of the figure. Beyond in Y* the saving curve become
positive.
• 45o is Income line also known as helping line.
• Income lesser than Y* shows that initially consumption is greater than income, but beyond
Y* consumption become less than the income.

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Shifts in the consumption curve

Changes in some variables (other than disposable income) can shift the consumption curve.

Factors responsible for shift in consumption function

1. Disposable income:
Higher the disposable income higher the consumption causes increase in consumption curve.

2. Distribution of Wealth:
If it is unequal, more of the income is in the hands of rich people with a lower propensity to
consume. A more equal distribution increases consumption.

3. Expectations of price changes:

If prices are expected to rise, then the population will move to spend their income quicker in the
present, hence increasing consumption

4. Changes in Fiscal Policy:

If low-income households are taxed more, then overall consumption decreases.

5. Changes in Interest Rates:

As interest rates increase, it usually decreases the amount of disposable income (by increasing
mortgage repayments etc.) and thus reduces consumption.

6. Advances in technology: Advances in technology may also increase in consumption. This is

because of new products, such as mobile, AC etc.

Example:
Income increases by Rs.10,000 and Rs.7,000 is spent on consuming goods, and Rs.3,000 is saved.
Then the MPC ad MPS are:
MPC = 7000 = 0.7, MPS = 3000 = 0.3 ;
10,000 10,000

0.7 + 0.3 = 1

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PART-02: SAVING:

Definition of Saving:
Saving is a part of disposable income which is not consumed i.e.
Saving = Income – Consumption
Saving Function:
𝐒 = 𝒇(𝐘)
and 𝐒 = −𝑺𝒐 + 𝒔𝒀
Determinants of Saving:

1. Level of Income:

savings increase as the level of income increases

2. Net Wealth: (Assets – Liabilities)

A decrease in wealth encourages people to save more at each income level.

3. Interest Rate:
An increase in interest rate, other things held constant, will lead to less spending on things that
are purchased on credit and thus higher savings.

4. Objective and Institutional Factors:

Factors such as political stability and security of property encourage people to save more.
Similarly, an established system of banks and other financial institutions promotes savings by
way of interest earning motives. Whereas, high and widespread indirect taxes are likely to force
consumer to spend more on maintaining standard of living which will cause a reduction in
personal savings.

5. Motivations for saving:

There are multiple factors that motivate individuals and firms to save more e.g., to provide for
future needs, to undertake new business projects, to build reserve against unforeseen
circumstances.

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PART-03: INVESTMENT:

Definition: Investment
Expenditure done by households or firms on new capital goods is called investment.’

Investment Function:
𝐈 = 𝒇 (𝐘)

Or I = Io + mY

I = represents volume of investment,

Io = is autonomous investment and
Y = is national output or income.
m = is the marginal propensity to invest.

Types of Investment:

Autonomous Investment: (Io)

Autonomous investment is independent of income means investment remains unaffected with an

increase or decrease in national income of a country. Autonomous investment is generally done by
government for welfare maximization without intension of earning income.
Examples:
Infrastructure, school and hospitals etc.

Induced Investment: (IY)

This investment directly depends upon a country’s national income. In other words, such investment
varies with variation in income. These investments are usually made by private investors with the
intention to generate profit
Examples: Industries, factories, Malls, corporate sectors etc.

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3.1: RATE OF INTEREST & MARGINAL EFFICIENCY OF CAPITAL:

Determinants of Investment:

1. Market rate of interest:

• An interest rate is the percentage of pri2cipal charged by the lender for the use of its money.
• Market rate of interest is the rate at which a firm or household must pay for funds in the present,
which will be paid back in the future. This rate is expressed as a percentage of the principal.
• There is an inverse relationship between the rate of interest and investment (MEC).

2. Marginal efficiency of capital (MEC): (expected rate of return)

According to Keynes analysis, market rate of interest remains constant in short run. Therefore, it
is the MEC which determine the level of investment in an economy.

Marginal efficiency of capital is the discount rate which makes the present value of the
prospective yield from the capital asset equal to its supply price.”

MEC Schedule:
The MEC schedule is a curve represents expected return on various combinations of interest rates
and investment.

In the graph, a downward slope of MEC shows the inverse relationship between MEC and level of
investment in a country in a given time. A movement along MEC curve from point a to b represents
that people increase the level of investment as market rate of interest decreases (attractive expected
returns).

There are TWO reasons for negative slope of MEC curve:

• Due to increase in level of investment, demand for capital goods increases and then cost of capital
of goods too (supply price of capital).

• Supply increases in product market along with an increase in investment which causes a fall in
price of products.

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3.2: Outward Shift in MEC Curve:

Shift in MEC results in change in level of investment due to change in factors other than market
interest rate. In above graph above, shift of MEC to MEC1 expresses greater investment on prevailing
interest i.e., r1.

The following other factors might cause an outward shift in MEC curve:

1. Change in sentiment
If businessmen are optimist over future economic growth, there will be increase in investment.

2. Change in wage rates: Rising wage rates give upward push to cost of production. All else remain
equal, rising cost of production will make investment less attractive, hence MEC falls and MEC
curve will shift to left and vice versa.

3. Change in income:
If income of firms increases, perhaps through a tax concession or similar, then there will be more
opportunity to invest.

4. Population growth:
If rate of population growth is increasing dramatically, then this will serve to boost future
demand for goods, and thus encourage investment.

5. Current rate of investment:

If current rate of investment in an industry is low, then the marginal returns (MEC) will be high,
causes increase in investment.

6. Quantity of capital goods already in existence

If many substitute goods exist already, then it is less advantageous to invest, as the MEC will be
less in that industry

7. Tax rates
Anything that serves to reduce the profitability of venture, will reduce the MEC. Taxes on inputs
or other parts of the process will do just this.

3.3: Government means of influencing investment

The government can influence the level of private investment in several ways:

1. Control interest rates: keeping interest rates low will encourage loans by private parties
which increase investment in an economy

2. To Encourage investing firms: Government increase level of investment by offering

investment grants, by lowering the cost of investment, by providing tax incentives etc.

3. Seek To stimulate business confidence: By developing and announcing an economic policy

for continuous growth encourage investors to invest.

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4. Encourage technological developments: By financing research and development of its own as

well as for private firms and Investment in education become source of investment.

5. Influencing the volume of consumption: Sometimes the government indirectly influence the
level of investment. For instance, a policy to control the growth in the money supply, would help
in credit control and would in turn affect consumer spending, especially in consumer durable
goods.

6. Government spending: Higher government spending in infrastructure cerates demand which

stimulates investment by the private sector.

Part-04: NATIONAL INCOME EQUILIBRIUM:

4.1: Consumption and investment Approach

The economy is in equilibrium when Total spending (C+I) cross the 45-degree line (Y), because the
total output is then exactly equal to planned levels of consumption and investment in the economy.
Withdrawals equal to injections. An economy is said to be in equilibrium when aggregate
expenditures are equal to aggregate income.
C+I
45o

C+I

Y1 Ye Y2
National Output

Disequilibrium in output determination

Disequilibrium occurs at any point other than equilibrium on the graph.

If economy is at below equilibrium:

Spending is more than output. There will be shortage of inventories because consumers are trying
to buy more output than is being produced. Producers will increase their production and staff.
GDP/Output will increase and reaches to the equilibrium level

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4.2: Savings and investment Approach

Equilibrium between savings and investment

Output determination occurs when the savings of all of the households in an economy are equal to
the desired investment opportunities.

According this approach, S=I is the key condition for equilibrium national income.
Any level of national income beyond or before this level, eventually drags towards equilibrium
through some automatic forces. Investment should be autonomous

Let’s view this diagrammatically:

S&I
Saving & Investment

S >I
E
I I
S <I

Income
Y1 Y Y2

Saving and Investment are equal at point E. So Ye is the equilibrium level of output. Any level
of income other than Ye, such as Y1 and Y2 are not stable. At Y1 the level of investment is
greater than planned savings which will be pulled to level of income Ye. Conversely if income
level exceeds over Ye, here saving is greater than investment which will push Y towards Ye.
Hence, level of income will be stable at point E where S=I.
The actual savings, and actual investment will always match, as calculated by statisticians.

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MULTIPLE CHOICE QUESTIONS

7.1) National Income equilibrium maintains at:

a) Consumptions = Investment b) Consumptions = Savings
c) Saving = Investment d) Saving > Investment

7.2) Which one is an investment spending?

a) Buying a car for domestic purpose b) Building a house for family use
c) Spending on plant and machinery d) All of the above

7.3) According to Keynes consumption increases along increase in income but with:
a) Lesser proportion b) Greater proportion
c) Same proportion d) None of above

7.4) If C = 80 + 0.5Y and S = -60 + 0.3Y, then Y=?

a) 120 b) 100
c) 110 d) 80

7.5) If C = 80 + 0.2Y and S = -60 + 0.3Y, then Y=?

a) 30 b) 50
c) 60 d) 40

7.6) If C = 80 + 0.5Y then:

a) MPC >MPS b) MPS = MPC
c) MPC < MPS d) It depends on the variation in income

7.7) If S = -60 + 0.3Y, then Y=?

a) MPC > MPS b) MPC < MPS
c) MPC = MPS d) MPS =APC

7.8) Which of the following statements about the consumption curve is correct?
a) The consumption curve lies above the forty-five degrees line at the break-even point
b) The consumption curve lies below the forty-five degrees line at the break-even point
c) The consumption curve intersects the forty-five degrees line at the break-even point
d) None of the above

7.9) MPC + MPS =?

a) Equal to 1 b) Greater than 1
c) Lesser than 1 d) It depends

7.10) High and widespread indirect taxes are likely to force:

a) Saving curve to shift left b) Consumption curve to shift left
c) Saving curve to shift right d) None of the above

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7.11) According to given table find the missing values:

Autonomous and Induced Consumption

(Y) Co C = Co+ cY MPC APC
0 50 50 - 0
100 G 100 0.5 1
200 50 H 0.5 0.75
300 50 200 0.5 Q
400 50 250 R 0.62
500 50 300 0.5 0.60

a) G=50, H=100, R=0.5, Q= 0.57

b) G=50, H=170, R=0.5, Q= 0.67
c) G=50, H=150, R=0.5, Q= 0.67
d) G=50, H=1750, R=0.25, Q= 0.57

7.12) According to Keynes while making new investment people focus on two factors
a) Savings b) Market rate of interest
c) Marginal efficiency of capital d) consumption

7.13) Changes in the distribution of disposable income

a) Cause upward shifts in the consumption function
b) Cause downward shift in the consumption function
c) Have no effect upon the consumption function
d) Both a & b are possible

7.14) Which one describes market rate of interest?

a) The rate at which a firm or household must pay for funds in the present, which will be
paid back in the future.
b) The rate at which a firm or household keep funds in the present, which will be paid back
in the future.
c) The rate at which a firm or household must deposit funds in present, which will be paid
back in the future.
d) The rate at which a firm or household must hold physical assets in the present, which will
be paid back in the future

7.15) Which one is NOT a responsible factor for shift in MEC?

a) Change in sentiments b) Change in wage rate
c) Population growth d) None of the above

7.16) When will savings increase in a country?

a) When interest rate rises
b) When inflation increases
c) When more credit cards are issued by the banks
d) When production of consumer goods decreases

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7.17) Which of the following is likely to shift the marginal efficiency of capital (MEC) schedule to the right?
(1) An increase in the supply of funds available
(2) Introduction of cost reducing technology
(3) A reduction of government subsidies on investment
a) l only b) 2 only
c) 3 only d) l and 2 only

7.18) Which of the following statements does not reflect the Keynesian view of the economy?
a) The economy will naturally settle at a level of output that ensures full employment
b) Government can move the economy towards full employment by managing aggregate
demand
c) Measures to stimulate private consumption will raise the level of income
d) The level of aggregate monetary demand will affect the level of income

7.19) Which of the following describes the effect of improved technology on the marginal efficiency of capital
curve?
a) It will shift it to the left
b) It will shift to the right
c) The curve will be unaffected
d) The curve will become more inelastic

7.20) Level of consumption which depends upon level of income is called:

a) Autonomous consumption b) Induced consumption
c) Total consumption d) None of the above

7.21) According to Keynesian psychological law of consumption value of M.P.C. would be:
a) 0 ≤ M.P.C. ≤ 1 b) 0 < M.P.C. < 1
c) M.P.C. < 1 d) M.P.C. > 1

7.22) In a two sectorial economy

a) M.P.C. + M.P.S. = 1 b) M.P.C. + M.P.S. < 1
c) M.P.C. + M.P.S. > 1 d) M.P.S. > 1

7.23) y – intercept of consumption (a) function in following diagram represents:

a) Autonomous consumption b) Induced consumption

c) Total consumption d) All of the above

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7.24) Most important determinant of consumption function is:

a) Rate of interest b) Distribution of wealth
c) Real income d) Further expectation

7.25) Part of income which not consumed but kept by consumers at their home is called:
a) Savings b) Investment
c) Consumption d) Hoardings / Leakage

7.26) Net increase in the physical capital stocks of an economy is called:

a) Savings b) Consumption
c) Hoarding d) Investment

7.27) Level of investment which depends upon level of income or investment that is motivated by the margin
of profit is called:
a) Net investment b) Autonomous investment
c) Induced investment d) Foreign direct investment

7.28) The rate of discount which makes the present value of the prospective yield from the capital asset
equal the supply price is called.
a) Market rate of interest b) Bank rate
c) Marginal efficiency of capital d) K.I.B.O.R

7.29) Change in savings with respect to change in level of income is called:

a) A.P.S. b) M.P.S
c) A.P.C d) A.P.S.

7.30) Value of M.P.S. in a two sectorial economy is:

a) 0 < M.P.S. < 1 b) 0 ≤ M.P.S. ≤ 1
c) M.P.S. > 0 d) M.P.S. < 1

7.31) If consumption function is:

C = 500 + 0.75 y value of MPS would be:
a) 0.75 b) 0.25
c) 500 d) 0.5

7.32) If M.P.C. is greater for the poor than the rich then a redistribution of income in favour of the rich will:
a) Increase the value of multiplier b) Decrease the M.P.S.
c) Increase the value of imports d) Raise the level of savings

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PRINCIPLES OF ECONOMICS CH-07: CONSUMPTION, SAVING AND INVESTMENT

7.33) The diagram shows the relationship between consumption and income in an economy which of the
following statement is incorrect. (Select TWO)

a) At zero level of income consumption is zero

b) At y2 saving is zero
c) At y1 consumption is greater than income
d) At y2 income is more than consumption

7.34) Which of the following is correct?

a) People with low incomes have higher average propensity to spend
b) National income is said to be in an equilibrium when planned withdrawals from circular flow of
national income are equal to planned injections into circular flow of national income
c) People with high incomes have higher average propensity to spend
d) Both (a) and (b)

7.35) The diagram shows the consumption function of a country. What would cause the consumption
function to shift from C1 to C2.

(i) The expectation of increase in G.S.T.

(ii) The expectation of reduction in subsidies
(iii) An increase in interest rates
(iv) An increase in direct taxes

a) (i) & (ii) b) (ii) & (iii)

c) (i) & (iii) d) (i) & (iv)

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PRINCIPLES OF ECONOMICS CH-07: CONSUMPTION, SAVING AND INVESTMENT
7.36) The diagram shows the consumption function given that the level of income is O𝑌̅, what does the
distance r ̅̅̅̅
𝐴𝐵 represents,

a) Autonomous consumption b) Induced consumption

c) A.P.C. d) Dissaving

7.37) Which of the following does not cause Rightward shift in MEC?
a) Population growth b) Change in income
c) Surplus productive capacity d) Rate of interest

7.38) Autonomous investment means:

a) which remains unaffected with an increase in national income
b) investment is initiated by government for welfare maximization
c) is independent of income
d) All of these

7.39) Autonomous investment is not influenced by the change in level of .

a) Income b) saving
c) Profits d) Sales

7.40) Postponed consumption of household and individual is called

a) Investment b) Saving
c) Income d) Expenditure

7.41) Which of the following is not a determinant of consumption?

a) Real income b) Change in interest rate
c) Change in Fiscal policy d) Cost of production

7.42) Which of the following relate to Keynes’ Psychological Law of Consumption:

a) Aggregate consumption can increase due to increased aggregate income
b) What is not consumed, is saved.
c) The increase in income will lead to increased consumption or savings
d) All of these

7.43) is the discount rate which makes the present value of the prospective yield from the
capital asset equal to its supply price.”
a) Marginal efficiency of capital b) Market rate of interest
c) Marginal propensity to consume d) Marginal propensity to save

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PRINCIPLES OF ECONOMICS CH-07: CONSUMPTION, SAVING AND INVESTMENT

7.44) Marginal Propensity to Consume (MPC) is the ratio of change in consumption to change in output
a) True b) False

7.45) If low-income households are taxed more, then overall consumption decreases.
a) True b) False

7.46) Income increases by Rs.20,000 and Rs.14,000 is spent on consuming goods. Then the MPS would be
0.7
a) True b) False

7.47) If business is pessimist over future economic growth, there will be increase in investment.
a) True b) False

7.48) Autonomous investment is usually made by private investors with the intention to generate profit
c) True d) False

ANSWER KEY

7.1) C 7.2) C 7.3) A 7.4) B

7.5) D 7.6) B 7.7) A 7.8) C

7.9) A 7.10) A 7.11) C 7.12) B,C

7.13) D 7.14) A 7.15) D 7.16) A

7.17) B 7.18) A 7.19) B 7.20) B

7.21) B 7.22) A 7.23) A 7.24) C

7.25) A 7.26) D 7.27) C 7.28) C

7.29) B 7.30) A 7.31) B 7.32) D

7.33) A,D 7.34) D 7.35) A 7.36) B

7.37) C 7.38) D 7.39) A 7.40) B

7.41) D 7.42) D 7.43) A 7.44) B

7.45) A 7.46) B 7.47) B 7.48) B

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TEST-07

Q-1) Postponed consumption is called:

a) Investment b) Income
c) Saving d) Autonomous consumption

Q-2) Which of the following does not cause Rightward shift in MEC?
a) Population growth b) Change in income
c) Surplus productive capacity d) Excess demand
Q-3) Autonomous investment is not influenced by the change in level of _______________.
a) Income b) Output
c) Profits d) Sales

Q-4) Household saving is equal to: (select TWO)

a) Income – Taxes b) Income – Taxes – Consumption
c) Income only d) Income – Consumption
Q-5) Which of the following is not a determinant of consumption?
a) Disposable income b) Change in interest rate
c) Change in Fiscal policy d) GDP
Q-6) In the given graph, “Co” represents:
C = a +by
Consumption

a
b

Co

45o
National Income (Y)

a) Autonomous consumption b) Induced consumption

c) Total Consumption d) Average propensity to consume

Q-7) Increase in investment causes increase in MEC.

a) True b) False

Q-8) The government can influence the level of private investment by: (Select TWO)
a) Government spending b) Reducing subsidies
c) Stimulating business confidence d) Increasing tax revenue

Q-9) According to consumption and Investment approach, if economy is at below equilibrium.

a) Output will decrease b) There is Surplus of inventory
c) Spending is more than output d) Decrease productivity

Q-10) Marginal propensity to consume can be greater than 1.

a) True b) False

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 CH-08: MULTIPLIER AND ACCELERATOR

CHAPTER-08

“ MULTIPLIER, ACCELERATOR &

BUSINESS CYCLE”

PART-01: MULTIPLIER PRINCIPLE: 195

1.1: 195
MULTIPLIER EXTENSION: 197

PART-02: ACCELERATOR PRINCIPLE: 198

2.1: MULTIPLIER, ACCELERATOR INTERACTION AND NATIONAL INCOME: 199

PART-03: BUSINESS CYCLE: 200

3.1: PHASES & CHARACTERISTIC OF BUSINESS CYCLE: 201

PART-04: MULTIPLE CHOICE QUESTIONS & TEST-08

MCQ 202
TEST-08 210

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 CH-08: MULTIPLIER AND ACCELERATOR

PART-01: MULTIPLIER PRINCIPLE:

Concept of multiplier moves around the basic phenomenon. That is “Spending of one is income to the
other”.

Investment Multiplier: (simple closed economic model)

Investment multiplier is the ratio of the change in total output due to the change in investment.
Keynes definition: “Smaller change in investment causes greater change in output.”

∆𝑌 ∆𝑌
Multiplier = ∆𝐼 , K = ∆𝐼 , or ΔY =k(ΔI)

Value of multiplier (k) lies between: (1 < K < ∝)

For example:
Investment increases by Rs. 2000 billion as result of change in investment by Rs. 500 billion, then the
multiplier will be 4

Multiplier formula:
Multiplier = 1/ (MPS + MPT + MPM)

Positive Multiplier and Negative Multiplier: (Multiplier works in both directions).

• Positive Multiplier refers to a greater increase in final output due to a small increase in
investment.
• Whereas Negative Multiplier refers to greater fall in final output from a tiny decrease in
investment

Working of the Multiplier:

Assume that MPC is 0.8, which means MPS is 0.2. Further, assume that Rs. 1,000 is introduced in the
economy.
If there is an increase in investment in an economy by Rs.1000, and the overall effect on the total
output of the economy was Rs.5000, then the multiplier effect would be equal to 5.

Round Initial Change in Income Change in Change in Saving

Investment (∆I) (∆Y) Consumption (∆C) (∆S)
1 1000 1000 800 200
2 800 640 160
3 640 512 128
- 2560 2048 512
Total 1000 5000 4000 1000

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 CH-08: MULTIPLIER AND ACCELERATOR

S&I

S
I2
Δ I = 1000
I1
ΔY=5000

Y1 Y2 Output (Y)

In the graph above, MPC is assumed to be 0.8 and initial change in investment of Rs. 1,000. The
investment of Rs. 1,000 will lead to an in GNP by Rs.5,000.

Therefore, each Rs.1 of investment has been “multiplied” 5 times.

Assumptions of Multiplier:
1. Constant marginal propensity to consume:
In multiplier model, it is assumed that there is no change in marginal propensity to consume. Any
change in MPC, can affect total change in the final output.

2. Continuous spending:
For the creation of the state of multiplier, the investment has to be continuous.

3. No change in price level:

Despite the change in income, there should be no change in prices of goods. Any change in good’s
prices can change consumption pattern.

4. Full employment has not achieved:

If there is no spare capacity in the economy or economy is operating at full employment, an
increase in the government investment may lead to inflation, which would lessen the ‘real’ effects
of the investment

5. No change in Tax rate:

Any change in tax rate causes to change in disposable income which further affects the
consumption pattern. Hence for smooth process of multiplier, a stable fiscal policy is needed

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 CH-08: MULTIPLIER AND ACCELERATOR

1.1: MULTIPLIER EXTENSION:

1. Tax Multiplier (Kt) (Multiplier in closed economic model in presence of government)

FLUCTUATIONS
• Marginal propensity to tax (MPT);
the percentage of income that is paid to the government in the form of tax
1
Kt = 𝑀𝑃𝑆+𝑀𝑃𝑇

Suppose the people are saving 30% of their income voluntarily and paying 20% as tax to the
government then the tax multiplier will be: ________________ (Ans = 𝐾𝑡 = 2)

2. Import Multiplier Km (Multiplier in An Open Economic Model)

• Marginal Propensity to Import (MPM)
is the percentage of income that is used to buy goods and services outside of the domestic
economy.
1
Km = 𝑀𝑃𝑆+𝑀𝑃𝑇+𝑀𝑃𝑀

Suppose people are saving 30% of their income voluntarily and paying 20% as tax to the government.
In addition, people are also spending 10% of their income on imports, then the value of multiplier
will be: ________________ (Ans = 𝐾m = 1.67)

Note:
MPS, MPT and MPM are the Withdrawals /Leakages
There is an inverse relationship between leakages and Multiplier

Multiplier effect: limitations:

1. Full employment level:
If economy is at full employment level, then multiplier will be ineffective and further increase in
investment will cause increase in prices and NOT much increase in GDP.

2. Leakages:
Leakages from the circular flow of income would make the value of multiplier very low and extra
spending in the economy would have nominal effect in GDP

3. Availability of consumer goods: Operation of multiplier works only if consumer goods are
available in surplus. If sufficient amount of consumer goods is not available, consumers will not
be able to spend their income along any increase in their income.

4. Time lag:
There is a time lag exists between when the initial investment will be made, and when the full
effects of the multiplier will be felt.

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 CH-08: MULTIPLIER AND ACCELERATOR

PART-02: ACCELERATOR PRINCIPLE (β):

According to “J.M. Clark” demand for capital goods increases as result of increase in demand for
consumer goods, which ultimately induces firms to make more investment.

Definition: Accelerator principle (β):

Smaller change in output causes greater change in investment. If output increases, then firms will
have to invest more in order to maintain a higher output.

I = 𝑓 (Y),
whereas
ΔI
ΔI = β (𝛥Y) or β =ΔY

Assumptions of Accelerator Principle:

1. Capital-Output ratio remains same.

2. Existing plants are operating at full capacity:

Installation of new plants would be necessary in order to meet any change in demand for
consumer goods. As for available reserve capacity, production at plants can be increased without
making new investments.

3. Availability of resources:
There is surplus availability of resources to provide more plants and equipment needed to
produce consumer goods. If it is not so, then the demand for new plants to produce consumer
goods will not be viable.

4. Flexibility in production:
Existence of high degree of flexibility in production process for smooth functioning of this model.

5. Credit money is considered to be elastic: Credit is considered to be elastic, such that funds for
induced investment are readily available.

Explanation of Acceleration Principle:

Year Y % Required Net Depreciation Gross % change

(Output) Change Stock of investment or investment in
in Y capital [2] replacement [4] gross
[1] cost investment
[3]
T 100 - 200 - - - -
T+1 100 0 200 0 10 10 -
T+2 120 20 240 40 10 50 400
T+3 140 16.67 280 40 12 52 4
T+4 160 14.3 320 40 14 54 3.8
T+5 160 0 320 0 16 16 -70.4

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 CH-08: MULTIPLIER AND ACCELERATOR
Explanation:

In this example,
[1]: Capital: output ratio = 2:1
[2]: Net investment = 2*change in output compared to previous year
[3]: Depreciation = 5%*Stock of previous year’s capital
[4]: Gross investment = Net investment + depreciation (replacement cost)
Every year one plant has to be replaced

• This shows how when output is increasing, the level of gross investment jumps up dramatically.
• On the flipside, if output begins to drop, then we see a sharp decrease in the level of investment.
• This is why it is called the accelerator effect: a change in output accelerates the change in the
investment.

Limitations of Accelerator Effect:

Existence of Spare Capacity:

There may be spare capacity within the firm which means it does not need to increase net investment
by such a large amount – its existing resources could manage.

Adjustment /Time Lag cost:

Time and cost required to adjust level of capital stock are not considered in this simple model. These
costs may be business costs due to installation of new machinery.

Full Employment is not yet reached:

Accelerator principle works only if full employment level in an economy has not yet reached. If once
full employment has reached, then resources like labour and capital will no longer available to
produce consumer goods. Therefore, accelerator principle will become ineffective.

Constant Capital-Output ratio is impracticable:

Accelerator principle is workable only if there is a constant C.O.R., which is not possible practically.

Sustainable increase in demand for consumer goods:

Accelerator principle works only if there is a long-term increase in demand for consumer goods.

2.1: MULTIPLIER, ACCELERATOR INTERACTION AND NATIONAL INCOME

According to Samuelson, cyclical fluctuation in economic activity over the time is due to interaction
FLUCTUATIONS
between the multiplier and accelerator.

Suppose that output (Economy) is growing

• This induces investment (Io) via the accelerator principle.
• The new investment gives further rise to output through the multiplier effect.
• This means that the rate of growth of output will be self-sustaining. However, the rate of
growth will eventually meet a point where GNP can no longer keep up.
• If this is the case, the level of (desired) output will soon exceed the production capability of
the economy.
• Consequently, the rate of investment in the economy will have to decrease, as firms would no
longer want to commit resources, when there will not be demand to meet it.

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 CH-08: MULTIPLIER AND ACCELERATOR
Output (Economy) is slow down
• When output slows, there is a sharp decline in investment due to negative accelerator.
• Decrease in investment leads to sharp decrease in output, due to the reverse effect of the
multiplier.
• This effect will then be accelerated again, causing output in the economy to drop significantly.

To explain how multiplier-accelerator interaction causes to economic fluctuations, we use following

table and given information:
Co = 10, MPC = 0.5
Induced Investment = ΔC (2)

Multiplier, Accelerator Interaction

Total Change in
Induced Y
Years Co cY = 0.5Y Economic situation
Investment(ΔCx2)
(C+I)
0 10 0 0 10
Increasing Output
1 10 5 10 25
(Economic Growth)
2 10 12.5 15 37.5
3 10 18.8 12.6 41.4 Peak/Boom
4 10 20.7 3.8 34.5
Decreasing Output
5 10 17.2 -3.5 23.8
(Economic Downturn)
6 10 11.8 -10.6 11.1
Lowest Output
7 10 5.5 -12.6 2.9
(Depression)
8 10 1.4 -8 3.3
Increasing Output
9 10 1.6 0.4 12
The above table shows cyclical fluctuations in the economy, also called business cycle.

Part-03: BUSINESS CYCLE

Business Cycles:
Business cycle describes the recurring fluctuations of output that an economy experiences over a
long period of time. The patterns of output fluctuations are known as business cycles.

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 CH-08: MULTIPLIER AND ACCELERATOR

3.1: PHASES AND CHARACTERISTIC OF BUSINESS CYCLE:

:
1. Peak/ Boom:
Peak is the phase of business cycle where economic activities is at highest level and cannot
expand further.
HIGH
Aggregate Economic Business confidence Investment Employment
demand growth/Output

Bank Credit Rate of interest Inflation General Price Level and Profits of
businesses

2. Recession/ Downturn:
At this stage, economic activity begins to slow down just after the peak. Deflation is a recessionary
indicator because price goes down.
DECREASING
Aggregate Economic Business confidence Investment Employment
demand growth/Output

Bank Credit Rate of interest Inflation General Price Level and Profits of
businesses

3. Depression/ Trough:
Long recession is called Depression. At this stage economic activity is at its lowest, meaning the
business cycle is at its trough.
LOW
Aggregate Economic Business confidence Investment Employment
demand growth/Output

Bank Credit Rate of interest Inflation General Price Level and Profits of
businesses

4. Recovery/Revival:
From the low point, there is an increase in levels of economic activity as aggregate demand begins
to increase slightly.
The depression does not last forever. Economy gradually converts itself into revival and the cycle
continues.
INCREASING
Aggregate Economic Business confidence Investment Employment
demand growth/Output

Bank Credit Rate of interest Inflation General Price Level and Profits of
businesses

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 CH-08: MULTIPLIER AND ACCELERATOR

MULTIPLE CHOICE QUESTIONS

8.1) All else equal greater the value of MPC_____________________ the value of Multiplier.
a) Lesser b) Greater
c) remains unchanged d) there is no relationship between both of
them

8.2) If marginal propensity to consume is 0.5, an increase in level of investment by Rs. 1000 will cause an
increase in overall output by?
a) 2,000 b) 20,000
c) 1,500 d) 15,000

8.3) If MPC = 0.4 and MPT = 0.2 then the tax multiplier will be:
a) 1.25 b) 2.25
c) 1.5 d) 2.5

8.4) Capital to output ratio stands for:

a) Amount of goods can be produced with given amount of capital
b) Capital required to produce goods of worth Rs. 1
c) Ratio of capital goods to consumer goods
d) Consumer goods to capital goods

8.5) Near to full employment level the multiplier effect will be?
a) lesser
b) greater
c) zero
d) there is no relation between multiplier and full employment level

8.6) Which situation reflects a recovery?

a) firms begin to scale back their production greater
b) steady rise in output, incomes and business confidence
c) issue credit more freely
d) All of these

8.7) If government has decided to increase its spending, it will:

a) Reduce multiplier b) Increase the effect of multiplier
c) Not affect the multiplier d) It will work with other economic forces

8.8) With increase in direct taxes, the value of output multiplier will:
a) Increase b) Decrease
c) Unchanged d) Other factors are missing to reply exact.
8.9) With perfectly inelastic Aggregate supply curve, any change in MPC the change in output level will be:
a) Increase b) Decrease
c) zero d) Relatively greater change

8.10) _______________ is NOT a financial asset.

a) Bond b) Building
c) Stock d) Not of the above

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8.11) Multiplier effect will be lesser if:

a) Less business confidence prevailing in the economy
b) Business is uncertain
c) People prefer to save rather spending
d) All of the above

8.12) During Covid-19 the multiplier effect will be:

a) Smaller b) Greater
c) Same as before Covid-19 d) Have no effect

8.13) The basic factor behind economic fluctuations in long run:

a) An affective monetary policy b) An affective fiscal policy
c) An affective commercial policy d) Multiplier, Accelerator interaction

8.14) Which of the following factor is not used in the multiplier formula for the open economy?
a) Marginal propensity to save b) Marginal propensity to import
c) Marginal propensity to tax d) Marginal propensity to export

8.15) The concept of the Multiplier discusses:

a) Savings and investments b) Income and investments
c) Income and expenditure d) Income and savings

8.16) In an economy where, out of every extra £100 of national income, £25 is paid in tax, £10 is spent on
imports and £15 is saved, the value of the multiplier will be
a) 2 b) 2.5
c) 5 d) 10

8.17) Which of the following is the basic concept which underlies the accelerator theory of investment?
a) Investment depends on the level of savings
b) Investment is inversely related to the rate of interest
c) Investment is determined by the volume of commercial bank lending
d) Investment rises when there is an increase in the rate of growth of demand in the economy

8.18) In a given economy, of each additional £1 of income, 30% is taken in taxes, 10% is spent on imports and
40% is spent on domestically produced goods.
a) 2.5 b) 1.67
c) 1.25 d) 0.6

8.19) The four main phases of a business cycle do not include:

a) Depression b) Inflation
c) Boom d) Recession

8.20) Which of the following is NOT the features of multiplier formula?

a) MPM b) MPX
c) MPT d) MPS

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8.21) If MPS=0.1, MPM=0.2, MPT= 0.2, then value of import multiplier will be
a) 2.5 b) 5.2
c) 2 d) 5

8.22) Greater the value of MPS, ________________________the value of investment multiplier.

a) More b) Lesser
c) Constant d) No change

8.23) Value of Accelerator Principle depends mainly depends on:

a) C.O.R b) Value of Depreciation
c) Net Investment d) All of the above

8.24) Coefficient which represents change in level of national income with respect to change in investment is
known as:
a) Multiplier b) Accelerator
c) Aggregate demand d) Effective demand

8.25) If consumption function is: C = 500 + 0.75y, then Value of multiplier would be:
a) 0.75 b) 500
c) 5 d) 4

8.26) Value of multiplier (k) lies between:

a) 1<K<∝ b) 0<K<1
c) 0<K<∝ d) -∝<K<+∝

8.27) If M.P.T. = 0.2 and M.P.C. = 0.7 value of multiplier would be:
a) 5 b) 4
c) 2 d) 1

8.28) Greater the slope of saving function _______ will be size of multiplier.
a) Smaller b) Greater
c) 1 d) ∝

8.29) Greater the slope of consumption function _______ will be the size the multiplier
a) Smaller b) Greater
c) 1 d) ∝

8.30) Gross investment = Net investment + ____________.

a) Depreciation b) Investment for replacement
c) Capital consumption d) All of the above
8.31) Working direction of multiplier and accelerator is always:
a) Different b) Same
c) Neutral d) None of the above

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8.32) Coefficient which represents change in level of investment with respect to change in national income is
known as:
a) Autonomous investment b) Multiplier
c) Accelerator d) M.E.C

8.33) If saving function is S = -500 + 0.5y value of multiplier would be:

a) 4 b) 5
c) 0.5 d) 2

8.34) In the concept of multiplier ________ is assume to be zero.

a) Leakage / hoarding b) Saving
c) Consumption d) Investment

8.35) In the given diagram the lines C + I and C + I represents levels of aggregate demands corresponding to
a change in level of investment. The value of multiplier is equal to:

a) EB / CD b) CD / EB
c) A.E / CD d) CD / AE

8.36) What is wrong in the following diagram?

S/I
S
E1
II
E
I

y Y1
-SO

a) ΔI>Δy b) Saving is too steep

c) M.P.C. > 1 (looks to be) d) All of the above

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8.37) A trade cycle is consisting of ___________ phases:

a) Two b) Three
c) Four d) Five

8.38) Deflation is __________ indicator.

a) Good b) Recessionary
c) Leading d) Lagging

8.39) Annual raise in G.D.P. is called.

a) New capital formation b) Economic growth
c) Boom d) Recovery

8.40) A growing economy also means that there may be _______ pressures.
a) Inflationary b) Deflationary
c) Inconstancy d) None of the above

8.41) In an open economy, the marginal propensity to consume is 0.7 and the proportion of additional income
that is spent on imported goods is 20%. National income is Rs. 100,000 and the current account is in
balance. What would be the new equilibrium of national income if the government increases its
expenditure by Rs. 50,000?
a) Rs. 100,000 b) Rs. 200,000
c) Rs. 250,000 d) Rs. 50,000

8.42) What would be the multiplier effect of an increase in investment by Rs. 50 million on the equilibrium
level of income where marginal propensity to consume is 0.8 and the proportion of additional income
that is spent on imported goods is 30%?
a) N.I increase by Rs. 50 million b) N.I decrease by Rs. 100 million
c) N.I decrease by Rs. 50 million d) N.I increase by Rs. 100 million

8.43) Select any TWO limitations of multiplier:

a) Full employment has not achieved
b) Change in tax rate
c) Continuous spending
d) sufficient amount of consumer goods is not available

8.44) Which of the following is the function of multiplier

a) I = f (Y) b) I = f (k)
c) K = f (Y) d) Y = f (I)

8.45) In accelerator, investment is the function of _______________?

a) GDP b) Consumption
c) Income d) Growth
8.46) Negative Multiplier refers to greater fall in final output from a tiny increase in investment

a) True b) False

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8.47) Which of the following is the multiplier formula under Closed economy.
a) 1/ (MPS + MPT + MPM) b) 1/ (MPS + MPT)
c) 1/ (MPS + MPM) d) 1/ (MPS + MPM)

8.48) Period of a business cycle in which real GDP is increasing is called:

a) Recovery b) Downturn
c) Recession d) Trough

8.49) The four main phases of business cycle are

a) boom, inflation, recession and recovery
b) inflation, recession, recovery and boom
c) recession, downturn, recovery and growth
d) boom, downturn, recession and recovery

8.50) In a given economy, out of every additional Rs. 1,000 of national income, Rs. 200 is taken in taxes, Rs.
100 is spent on imports and Rs. 500 is spent on domestically produced goods. The multiplier is:
a) 1.25 b) 2
c) 2.5 d) 1.67

8.51) The basic concept which underlies the accelerator theory of investment is
a) investment depends on the level of savings
b) investment is inversely related to the rate of interest
c) investment is determined by the volume of commercial bank lending
d) investment in an economy is a function of output

8.52) If there is an increase in investment in an economy by Rs. 250 million and marginal propensity to
consume is 3/4, then overall effect on the total output of the economy would be
a) Rs. 1,000 million b) Rs. 333.33 million
c) Rs. 187.50 million d) Rs. 750 million

8.53) Which of the following situations would cause the value of the multiplier to fall
a) A fall in the level of government expenditure
b) A rise in the marginal propensity to consume
c) A rise in the marginal propensity to save
d) A fall in business investment

8.54) Which of the following does not normally happen in the recession phase of the business cycle?
a) A fall in the level of national output b) A rise in the rate of inflation
c) A rise in the level of unemployment d) All of the above

8.55) Which of the following is NOT a major determinant of the consumption function?
a) Political instability b) Real income
c) Distribution of wealth d) Changes in fiscal policy
8.56) A central bank is likely to increase interest rates when economy is in a phase of
a) Prosperity b) Downturn
c) Recession d) trough

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8.57) Which of the following factors is NOT used in the multiplier formula?
a) Marginal propensity to save b) Marginal propensity to import
c) Marginal propensity to tax d) Marginal propensity to export

8.58) Under which of the following circumstances, the value of the multiplier would be higher?

a) When both marginal propensities to consume and marginal propensity to import are low
b) When marginal propensity to consume is low and marginal propensity to import is high
c) When marginal propensity to consume is high and marginal propensity to import is low
d) When both marginal propensities to consume and marginal propensity to import are high

8.59) In a business cycle, the stage which eventually leads the economy to the state of inflation is:
a) Boom b) Down turn
c) Trough d) Recession

8.60) Which of the following does not normally happen in the recession phase of the business cycle?
a) A fall in the level of national output b) A rise in the rate of inflation
c) A rise in the level of unemployment d) All of the above

8.61)The four main phases of a business cycle do NOT include:

a) Depression b) Inflation
c) Boom d) Recession

8.62) A prolonged and deep recession is called:

a) Hyperinflation b) Depression
c) Stagflation d) Great depression

8.63) Which of the following marks the beginning of a contraction in the business cycle
a) Peak b) Trough
c) Expansion d) Recession

8.64) Which of the following may NOT be regarded as a characteristic of economic boom phase in the
business cycle?
a) Falling asset prices b) Lower unemployment
c) Higher inflation d) High GDP

8.65) If consumption function is C = 500 + 0.5y and injection are 1000 then the change in national income
will be:
a) 2,000 b) 5,000
c) 2,500 d) 1,000

8.66) Which of the following would increase the value of multiplier?

a) The propensity to spend extra income on domestic goods and services is high
b) The marginal rate of tax on extra income is low
c) The propensity to spend extra income rather than save is high and consumer confidence is
high
d) All of the above

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ANSWER KEY

8.1) B 8.2) A 8.3) A 8.4) A

8.5) A 8.6) D 8.7) B 8.8) B
8.9) C 8.10) B 8.11) D 8.12) A
8.13) D 8.14) D 8.15) B 8.16) A
8.17) D 8.18) B 8.19) B 8.20) B
8.21) C 8.22) B 8.23) D 8.24) A
8.25) D 8.26) A 8.27) C 8.28) A
8.29) B 8.30) D 8.31) B 8.32) C
8.33) D 8.34) A 8.35) B 8.36) D
8.37) C 8.38) B 8.39) B 8.40) A
8.41) B 8.42) D 8.43) A,C 8.44) D
8.45) C 8.46) B 8.47) B 8.48) A
8.49) D 8.50) B 8.51) D 8.52) A
8.53) C 8.54) B 8.55) A 8.56) A
8.57) D 8.58) A 8.59) A 8.60) B
8.61) B 8.62) B 8.63) D 8.64) A
8.65) A 8.66) D 8.67) 8.68)

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TEST-08
Q-1) An increase in the MPT increases the multiplier coefficient.
a) True b) False

Q-2) In view of acceleration principle, which two of the following are NOT determinants of level of
investment?
a) Change in demand of goods and services b) Change in income
c) Change in sentiments d) Change in interest rate

Q-3) Which of the following statement is correct.

a) 0 < MPC < -1 b) 0 < MPC < 1

c) 0 < MPC > 1 d) All of these

Q-4) Multiplier will always _________________ 1.

a) Less than b) Greater than
c) Equal to d) None

Q-5) If marginal prosperity to consume is 0.8 and tax rate is 30% the increase in investment by
Rs. 50 will increase the national income to _______________?
a) 100 b) 50
c) 500 d) 167

Q-6) If MPC = 0.7, MPT = 0.2 and MPM = 10% then value of multiplier will be?
a) 5 b) 3.33
c) 1 d) 1.67

Q-7) Increase in National income is 3600 billion, by increase in Investment by 1200 billion then
multiplier is:
a) 3 b) 4
c) 5 d) 1.3333

Q-8) Which of the following is a limitation of accelerator principle;

a) Constant Capital output ratio b) Full employment is reached
c) Credit is elastic d) There would be Spare capacity

Q-9) Which of the following increases multiplier effect?

a) Increases in MPT b) Increases in MPS
c) Increases in MPM d) Increases in MPC

Q-10) Select any TWO limitations of multiplier:

a) If sufficient amount of consumer goods is not available
b) No change in tax rate
c) Continuous spending
d) If full employment is achieved.

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CHAPTER-09

“ GROWTH, PUBLIC FINANCE

AND TAXES ”
PART-01: ECONOMIC GROWTH
1.1: ROSTOE’S STAGES OF ECONOMIC GROWTH: 212
1.2: INDICATORS OF GROWTH AND RECESSION: 212
1.3: COSTS AND BENEFITS OF ECONOMIC GROWTH: 213

PART-02: PUBLIC FINANCE:

2.1: DIFFERENCE BETWEEN PUBLIC AND PRIVATE FINANCE: 214

PART-03: FISCAL POLICY

3.1: TOOLS OF FISCAL POLICY: 215
3.2: TYPES OF FISCAL POLICY: 216
3.3: OBJECTIVES AND LIMITATIONS OF FISCAL POLICY: 217

PART-04: TAXATION
4.1: FUNCTION OF TAXATION: 218
4.2: TYPES/KINDS OR CLASSIFICATION OF TAX: 218
4.3: CANONS (OR PRINCIPLES) OF TAXATION: 221

PART-05: MULTIPLE CHOICE QUESTIONS & TEST-09

MCQ 223
TEST-09 232

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Part-01: ECONOMIC GROWTH

Economic Growth:
• According to Friedman, “economic growth is an expansion of system in one or more
dimensions without a change in its structure.”
• Economic growth in macroeconomics means long term increase in economic activity.
• An outward shift in a country’s ‘production possibility curve’ reflects growth of the economy.

(Real GDP of 𝐘𝟏 – Real GDP of 𝐘𝟎)

Growth Rate (%) = Real GDP of 𝐘𝟎
𝑥 100

1.1: ROSTOW’S STAGES OF ECONOMIC GROWTH:

:
1. Pre-take of stage:
A stage where economy is switching from traditional farming to modern farming with limited
use of mechanization.

2. Take of stage:
This stage reflects the age of industrial revolution. Although majority of people remain
dependent on agriculture, yet agriculture assumes relatively less important.

3. Drive to maturity:
As technology becomes more relevant in the economy, industry gets more diversified.

4. Age of mass consumption:

In this stage leading sectors produce consumer durables. As per-capita income increase, people
enjoy high living standards.

1.2: INDICATORS OF GROWTH AND RECESSION:

:
1. Leading Economic Indicators: (Signal Future Events)
The nature of these indicators is that they are used to forecast at what stage the economy will
be in, at some time in the future. These in particular give an indication for whether a peak or
trough will be reached in the following 3-12 months.

Indicators Growth Recession

Index of business confidence High Low
Manufacturers’ new orders High Low
New building permits for private housing High Low
Money supply High Low

2. Coincident Economic Indicators: (Ongoing Events)

These indicators are events and measures that occur at the same time as peak or trough occurs.
They are used by governments to assess at what stage the economy is.

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Indicators Growth Recession

Number of people in employment High Low
Industrial production High Low
Personal incomes High Low
Manufacturing and trade sales High Low

3. Lagging Economic Indicators: (Based On Events Already Happened)

These indicators are used to assess whether an economy has reached a peak or trough 3-12
months after it would have occurred.

Indicators Growth Recession

Consumer Price Index (i.e., measures of inflation) High Low
Average duration of employment High Low
Interest rates High Low
Average income (per capita income) High Low

1.3: COST AND BENEFITS OF ECONOMIC GROWTH:

:
Advantages/ Benefits: Disadvantages/Costs:
1. Higher living standards: 1. Environmental concerns:
An increase in the real income of the Fast growth may be at the expense of the
individuals in an economy natural environment. Rapid growth can
create negative externalities or e.g., air
pollution, noise pollution, water pollution etc.

2. High employments: 2. Income Inequality

with economic growth, the capacity in an Growth create inequality among
economy increases and therefore there is Economic agent because large fraction of
more opportunity for employment within economic gain goes to only few hands (i.e.,
society. entrepreneur).

3. Fiscal Benefits: 3. Risk of inflation

with higher GDP growth, firms and Average income increases during rapid
individuals will increase the amount of taxes economic growth increase aggregate demand
that they pay. This gives government better which can lead to demand-pull inflation
opportunity to meet their objectives

4. Reduction in poverty: 4. Social Cost

With economic growth, level of poverty Fast economic growth leads to inflation and
decreases. People have more income to meet progressive taxes decrease the ability to meet
their basic needs of life. their basic requirements. To maintain living
standards, people have to work more which
compromises their health and leisure

5. Current account deficit

Economic growth causes an increase in
spending on imports and consequently
observed a current account deficit

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Part-02: PUBLIC FINANCE:

Definition of Public Finance:

Public finance is the branch of economics which describes the income and expenditure of the public
authorities and deals how does the government raise the finances for its ever-increasing expenditure.

Scope of Public Finance:

Following are the four major segments of public finance:

1. Public Expenditures:
It describes objectives and kinds of public expenditures, which helps to evaluate the overall
economic performance of a country.

2. Public Revenue (Income):

It is also termed as public income. It covers main sources of government revenue i.e., tax and non-
tax. Furthermore, it tells how changes in public revenue collection affect economic performance
of a country.

3. Public Debt:
Public debt arises when government expenditures exceed over its revenues, it forces government
to depend on public borrowing. This section of public finance explains the need, sources and
impact of public debt. Furthermore, it suggests various measures to manage public debt.

4. Financial Administration:
This section deals with administration of public finance. It includes the economic policy making
and its implementation to achieve various stated economic objective.

2.1: DIFFERENCE BETWEEN PUBLIC AND PRIVATE FINANCE:

Private Finance Public Finance

Adjustment of income It Moves from Income to It Moves from Expenditures to
and expenditure Expenditures. Income
Budgeting Annual Budgeting Is Optional Annual Budgeting Is Obligatory

Borrowing Only External Borrowing Is Internal And External Borrowing Is

Available. Possible
Different objectives Primary Objective Is Profit Primary Objective Is Social Welfare
Provision for the Individuals plan for short-run Government plans for the long-run,
future focusing on quick returns. for future generations.
Secrecy Of Financial Secrecy Is a Personal Matter Government Is Bound to Public
Matters

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PART-03: FISCAL POLICY

Fiscal Policy:
Fiscal policies are policies undertaken by a government to achieve macroeconomic objectives by
influencing aggregate demand through government spending and revenue.

3.1: TOOLS OF FISCAL POLICY:

1. CHANGES IN GOVERNMENT REVENUE:
Government revenue is the amount of money received by the state.
Government collects revenues through two sources, i.e. tax revenues and non-tax revenues.

• Tax Revenue:
Tax is one of the most important sources of government revenue such as, income tax,
property tax, wealth tax, gain tax etc.
• Non-Tax Revenue:
Non-tax revenues include interest and dividends received by the government, fee and
penalties, rent income against government property, royalties, trading profits of government
entities, income from post offices, receipts from civil administration, fees received for
providing different public services et

2. CHANGES IN GOVERNMENT EXPENDITURE:

Spending made by the government to achieve the fiscal objectives and increase the general
welfare of the people is known as government expenditures.
There are two types of government expenditures:

• Development expenditures:
This kind of expenditure is made exclusively for development purposes. Development
projects such as, roads network, communication system, agricultural development, railways,
utility services and irrigation etc.
• Non-Development expenditures:
It includes expenditure incurred on defense, social services, to maintain law and order
situation, general administration, debt servicing and subsidies

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3.2: TYPES OF FISCAL POLICY:

1. Expansionary Fiscal Policies/ Anti-Deflationary Policy: (Government exp > Tax revenue)
Expansionary Fiscal Policies seeks to increase economic growth, employment and export by:
• Increase in government spending.
• Decrease in taxes (e.g., tax cuts and provide tax exemptions)

2. Contractionary Fiscal Policies/ Anti-Inflationary Policy: (Government exp < Tax revenue)
Contractionary Fiscal Policies seeks to slow down the rate of economic growth or to control
inflation in an economy by
• Decrease in government spending.
• Increase in taxes (e.g., imposed new taxes or Increase Tax rate)

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3.3: OBJECTIVES AND LIMITATIONS OF FISCAL POLICY:

Objectives of Fiscal Policies:

1. Economic growth:
Most economists agree that consistent, gradual economic growth is favorable.

2. High employment:
Governments have a social objective to ensure high levels of employment.

3. Low inflation:
Ensuring the price level remains stable avoids persistent problems throughout the economy.

4. Equilibrium in Balance of Payments:

This ensures that the value of a country’s imports and exports are equal.

5. Equilibrium in Fiscal budget/ Run a balanced budget:

Government expenditure, revenue and national debt must be balanced enough.

Limitations of Fiscal Policies:

1. Forecasting:
Fiscal policy involves prediction of various economic activities e.g., government expenditure,
multiplier, or estimated tax receipts. It is difficult to predict accurately all these activities

2. Time-lag:
In general, there exists a time lag where an action is needed and the time when the fiscal results
witness.

3. Crowding-out Effect:
Crowding-Out effect means increase in Government Expenditure for stimulating aggregate
demand may lead to decrease in Private Expenditure by increasing rate of interest.

4. Negative impact of Tax:

Raising taxes in order to reduce Aggregate Demand may cause demotivation to work.
Consequently, a fall in productivity might be observed and Aggregate Supply may fall.

5. Lack of Coordination with Monetary Policy:

Successful fiscal policy largely depends upon the coordination with Monetary Policy. Any lack in
this regard will leads to failure of fiscal policy

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PART-04: TAXATION

Taxes are mandatory contributions levied on individuals or corporations by a government. Taxation

is the main source of government income to meets its expenditures.

4.1: FUNCTION OF TAXATION:

Following are different functions (or purposes) of taxes:

• Fiscal:
Government can use tax to influence Aggregate Demand and allocate tax revenue on various
projects in the economy.

• Allocation:
Fair distribution of income among various segments of society depends on effective system
of taxation. e.g. (Income transfer from Rich to Poor)

• Regulatory:
Tax helps governments in demand management to achieve its predetermined goals.
Government controls spending patterns of different agents of economy by changing tax base and
tax rates e.g., (higher tax on harmful and luxury goods)

• Incentive:
stipulating special tax arrangements or Tax cut for certain members of society/investors as a
result of past achievement.

4.2: TYPES/KINDS OR CLASSIFICATION OF TAX:

Taxes can be classified on basis of, rate of tax and ability to shift the burden of tax.
• Direct Tax and Indirect Tax (on the basis of ability to shift burden of tax)
• Progressive and Proportional Tax (on the basis of rate of tax)

DIRECT TAX:
A tax paid directly to the government by the person on which it was imposed. Burden of tax cannot
be shifted to anyone else”.

Example:
➢ Income Tax
➢ Property Tax.
➢ inheritance tax,
➢ capital gains tax
➢ corporation tax

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Advantages Disadvantages
• Equitable: • Possible to evade:
Higher income higher the tax, lower income Direct taxes are easy to evade because the tax
lowers the tax, creating an equal distribution of payers do not declare their exact or actual
wealth. income and wealth.
• Economical: • Unpopular:
Direct Taxes are economical in nature. Cost of People do not feel good when they are asked to
collection of such taxes is less compared to pay a fraction of their income and try to find
revenue collection. ways to avoid tax.
• certainty: Discourage savings/ investment:
The government can estimate how much it will If taxes are too high, then it would leave
receive tax, allowing better planning of projects. consumers and firms less money to save and
• Elastic/Flexible: invest.
If a government needs to raise revenues • Less incentive to work hard:
quickly, it can do so by raising direct taxes. Direct Tax usually affect to that segment of
• Anti-Inflationary: Direct taxes reduces the society which struggle more to earn more
disposable income and causes a leftward shift income.
in aggregate demand that is why it helps in
controlling demand pull inflation

INDIRECT TAX:
If the burden of tax is possible to shift to someone else is called ‘Indirect Tax’. Indirect tax is that in
which impact (initial burden) of tax and incidence (ultimate burden) of tax dose not remain on the
same identity. This kind of tax is collected usually by adding in to product prices.

Examples:
➢ General Sales Tax (VAT)
➢ Customs Duty
➢ Excise Duty,
➢ Fuel Taxes

Advantages Disadvantages
• Can correct externalities: • Regressive:
If a product causes direct external costs (e.g., A tax applied uniformly, taking a larger
Health costs associated with alcohol or percentage of income from low-income
cigarettes), the tax can be used to mitigate earners than high-income earners therefore
these. poor feel more burden than rich. e.g., GST
• Evasion is difficult: • Cause cost-push inflation:
Indirect taxes cannot be evaded because tax Indirect tax is collected by adding it in price of
amount is already included in the final price of the product, which cause to an increase in
price level.
a product.
• Establish a “black market”:
• Allows people greater choice: If taxes make prices too high, can force people
Consumers make choices and then tax is paid. to source the goods from alternate (sometimes
• Wide-ranging: illegal) markets.
Indirect Tax is wide-ranging as it covers a vast • Higher uncertainty:
majority which is exempted from direct tax If in a recession, people are buying less goods,
(Low-income group or poor people). then this will decrease tax revenue.
• Helpful in controlling demerit goods: • Distorts the market:
(Alcohol or cigarettes) Can lead to disequilibrium in the market for
products that have been taxed.

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1. Progressive taxation:
A tax where the percentage of income paid in taxes increases as income increases (“higher the
income, higher the rate.”) e.g., income tax on salaries.

Advantages Disadvantages
• Built-in stabilizer: Progressive tax works as • Discourages economic activity: Progressive
built-in stabilizer as its rate is auto adjusted. tax discourages macroeconomic activity,
Progressive tax is helpful for aggregate demand because tax rate increases along an increase in
management. income of the citizens. High rate of tax trims
• Equitable: It is argued that a progressive tax is down the saving ability and then reduces the
relatively equitable as high amount of tax is pace of capital formation.
collected from rich class and less from poor. • Persuasion of tax evasion: Progressive tax is
• Relative certainty: Tax slabs for progressive discouraging for high income groups;
tax are well defined for tax payers. Therefore, therefore, they may evade tax at the very least.
this tax is relatively certain as tax payer are well • Invasion of individual rights: Opponents of
aware that when and how much tax they have progressive tax argue that it is a sort of invasion
to pay. of individual rights as they feel it as punishment
• Anti-inflationary: Supporters of progressive of their efforts.
tax argue that it helps to curb (control) the • Loss of government revenue: Progressive tax
inflationary pressures in the economy as high is usually treated as direct tax and therefore, is
rate of taxes on high income groups restraint easy to evade. With high degree of tax evasion
their spending government has to face a loss in its revenue
collection.

2. Regressive taxation:
This is a tax system in which poor shares more burden of tax as compare to rich one. A tax where
lower income persons pay a higher fraction of their income as taxes than higher income persons
e.g., sales tax.

3. Proportional/Flat tax:
A tax which is charged at the same percentage on all income levels.
e.g., Income tax in a particular slab, income tax on companies, withholding Tax and ZAKAT.

Advantages Disadvantages
• Unambiguous: • Dose not satisfy cannon of equality:
There is no ambiguity for tax payers in Opponents have a strong argument against
proportional tax. As tax rate is flat for everyone proportional tax. According to them it does not
during a certain time period. Therefore, people satisfy the cannon of equality. As tax rate
are well aware about it. remains fixed for all income groups, hence poor
feel more burden because. Suppose 17% GST is
• Relatively justified: In proportional tax, rate imposed on food.
of tax remains fixed for all rich and poor • Relatively inelastic:
irrespective of tax base. Hence, it seems to be Proportional tax contributes less to total tax
more justified as it does not create any collection of a country. Amount collected
discrimination among various income groups through this tax system is relatively smaller
of a society. than other form of taxes.
• Widens income inequalities:
• Does not impede (stop) incentive to work: As said earlier that tax rate remains fixed for all
Proportional tax does not pose any threat to rich and poor groups of the society. Hence, it
working hard or household’s savings, as seems to be relatively unjustified. It widens
everyone pays a uniform and flat rate of tax. income inequalities in the society.

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Numerical Example:

Suppose Mr. Saad pays a tax of Rs. 200 on his income of Rs. 2000

(1) If increase in Income to Rs. 4000 and paid Tax of Rs. 350 on it. Tax system will
be_______________________? (8.75%, Regressive Tax).

(2) If increase in Income to Rs. 4000 and paid Tax of Rs. 400 on it. Tax system will
be_______________________? (10%, Proportional Tax).

(3) If increase in Income to Rs. 4000 and paid Tax of Rs. 500 on it. Tax system will
be_______________________? (12.5%, Progressive Tax).

4.3: CANONS (OR PRINCIPLES) OF TAXATION:

The canons of taxation refer to the qualities that a good taxation system from administrative point of
view.

Four canons of taxation by Adam Smith:

Four main canons of taxation as suggested by Adam Smith are explained below:

1. Canon of Equality:
“The subjects of every state ought to contribute towards the support of the government, as nearly
as possible, in proportion to their respective abilities, that is, in proportion to the revenue which
they respectively enjoy under the protection of the state.”

Tax should be paid in proportion to the ability of the tax payer. This requires progressive taxation
where tax payers have to pay higher rate of tax as their income increases to ensure equality.

2. Canon of Certainty:
“The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of
payment, the manner of payment, the quantity to be paid ought all to be clear and plain to the
contributor and to every other person.”

All the tax payers should be informed as to why and when they have to pay a particular sum of
tax. Government should also be certain about the amount of the tax so that it can include correct
estimates of income in the budget.

3. Canon of Convenience:
“Every tax ought to be levied at the time or in the manner in which it is most likely to be
convenient for the contributor to pay it.”

Time and manner of tax payment should be convenient for the tax payers.
For example, consumers paying taxes at the time of purchase of goods or services or tax being
deducted at the time of payment of salaries.

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4. Canon of Economy:
“Every tax ought to be so contributed as both to take out and to keep out of pockets of the people
as little as possible, over and above what it brings into the public treasury of the state.”

According to this canon, tax should be economical in terms of its collection. There should be no
embezzlement during tax collection process.

Other Canons of Taxation:

• Fiscal Adequacy or Productivity:

Taxes should be levied in such a way that the government is able to meet the expenses without
damage the economic activity/productivity.

• Canon of Flexibility/Elasticity:
The tax system should not be rigid which means it should be able to adjust to changing Conditions
of the government. E.g., the tax revenues should increase as the state expenditure increases.

• Canon of Simplicity:
Tax system should be simple enough for everyone to understand so that tax collectors are not
involved in corruption or oppression.

• Canon of Diversity:
There should be a large variety of direct and indirect taxes so that every citizen who is able to pay
can do so. Different taxes should be imposed on different sectors of economy like, industry,
agriculture, services sector and trade etc.

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MULTIPLE CHOICE QUESTIONS

9.1) Economic growth in an industrial society results from:

a) Technological change b) Innovation
c) Capital production d) All of the above

9.2) Along with the benefits, certain costs are also associated with economic growth. These include:
a) high unemployment b) decrease in tax revenue
c) inflation d) stagflation

9.3) Which one of the following defines the economic growth rate?
a) Increase in real investment b) Increase in GDP
c) Increase in real GDP d) Increase in GDP deflator

9.4) Which of the following measures is NOT likely to boost a country’s rate of economic growth?
a) Tax cuts b) Tax rebates
c) Reduction in subsidies d) Increase in government spending

9.5) Which of the following is the cost of economic growth.

a) Low unemployment b) Reduction in poverty
c) Risk of inflation d) Higher living standard

9.6) Which of the following is a tool of expansionary policy?

a) Increase taxes b) Reduce subsidies
c) Allow tax rebates d) Freeze wages

9.7) Sales tax on food items is an example of

a) direct tax b) fixed tax
c) progressive tax d) regressive tax

9.8) Which one is not a lagging indicator of growth?

a) Consumer Price Index b) Rate of Unemployment
c) New permits for housing d) None of the above

9.9) If real GDP of a country is Rs. 200 billion in 2021 and Rs. 220 is 2022. Find the growth rate of a country
in 2022.
a) 5% b) 8%
c) 10% d) 20%

9.10) _____________ indicators are events and measures that occur at the same time a peak or trough occurs.
a) Leading b) Coincidence
c) Lagging d) All of these

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9.11) Which of the following indicator indicate that economy will be reached at particular phase in next few
months?
a) Leading b) Coincidence
c) Lagging d) All of these

9.12) Which of the following TWO does not belong to Leading indicators.
a) Personal incomes b) Manufactures new orders
c) Interest rate d) Money supply

9.13) Which of the following measures is likely to boost a country’s rate of economic growth?
a) Tax cuts b) Reduction in tax rebates
c) Reduction in subsidies d) Decrease in government spending

9.14) Which one is a coincident economic indicator?

a) Number of people in employment b) Industrial production
c) Personal incomes d) All of above

9.15) That branch of economics which describe the mechanism to collect taxes for state and their spending to
perform various functions is known as:
a) Monetary policy b) Trade policy
c) Public finance d) Anti-inflationary policy

9.16) _________ arises when government expenditure exceeds over its revenue:
a) Public revenue b) Public debt
c) Direct taxes d) Subsidies

9.17) In case of budget deficit, a government can borrow from:

a) External sources b) Internal sources
c) I.M.F. d) Both internal and external sources

9.18) The amount of debt owed by the central government of a country to its various creditors is known as:
a) Public debt b) Business debt
c) Consumer’s debt d) National debt

9.19) Which one is not a component of ‘Public Finance’?

a) Public Expenditures b) Government Revenue
c) Public Debt d) Privat Spending

9.20) Which one is NOT a pre-requisite of private finance?

a) Secrecy b) Annual Budgeting
c) Adjustment of Income to Expenditures d) None of the above

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9.21) Which are of the following is the largest item of expenditure of Government of Pakistan.
a) Interest payment b) Education
c) Defense d) Grants of subsidies

9.22) Which of the following is / are components of public debt?

1. Public borrowing
2. Treasury bills
3. Securities issued by central bank

a) 1 only b) 1 and 2
c) 2 only d) 1, 2 and 3

9.23) By budgeting for a deficit, a government aims to reduce:

a) consumer spending b) inflation
c) rate of economic growth d) unemployment

9.24) Main tools of fiscal policy are:

a) Changes in government revenue b) Changes in government expenditure
c) Public sector borrowing d) All of the above

9.25) Fiscal policy that seeks to increase the rate of economic growth is known as:
a) Expansionary Fiscal Policy b) Contractionary Fiscal Policy
c) Stable Policy d) None of the above

9.26) Due to _______ aggregate demand curve shifts towards left.

a) Expansionary Fiscal Policy b) Contractionary Fiscal Policy
c) Stable economic Policy d) Increase in rate of interest

9.27) Which of the following would reduce inflation?

a) an increase in direct taxes b) an increase in indirect taxes
c) increase in government spending d) increase in income

9.28) Fiscal deficit can be controlled by

a) increasing taxes b) reducing subsidies
c) reducing public expenditure d) all of the above

9.29) Which of the following is an objective of fiscal policy?

a) Zero inflation b) Reduced money supply
c) Low exchange rates d) Stable economic growth

9.30) Which of the following is NOT regarded as a tool of fiscal policy?

a) Private investment b) Transfer payments
c) Taxation d) Government spending

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9.31) Which of the following policies help in increasing economic growth?

a) Increase in taxes b) Increase in government spending
c) Reduction in subsidies d) Wage freezes

9.32) An expansionary fiscal policy combined with a restrictive monetary policy would result in:
a) budget deficit to decrease b) taxes to increase
c) government expenditure to decrease d) interest rates to increase

9.33) The crowding out effect is caused by a:

a) rise in interest rates reducing private sector investment
b) rise in interest rates reducing public sector investment
c) fall in interest rates increasing savings
d) fall in interest rates reducing consumption

9.34) Which of the following should NOT be the aim of a government?

a) Inequality of incomes b) Price stability
c) Economic growth d) Full employment

9.35) Basic intension of government is to achieve:

a) Keep employment high b) Stable exchange rate
c) Equilibrium in Balance of Payments d) a&c

9.36) In the below diagram actual equilibrium output of economy is ya and government wants to achieve fuel
employment that is yf.

Which of the following would be most likely to achieve this?

a) Increase taxation b) Increase interest rates

c) Increase in government expenditure d) Reduce the budget deficit

9.37) Which of the following would reduce inflation?

a) an increase in direct taxes b) an increase in indirect taxes
c) increase in government spending d) increase in income

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9.38) Which one is NOT an instrument of ‘Fiscal Policy’?

a) Change in government expenditure b) Change in Bank Rate
c) Change in government revenues d) None of the above

9.39) Expansionary Fiscal Policy involves:

a) Increases government spending b) Increase in taxes
c) Increase in minimum wage d) None of the above

9.40) Contractionary Fiscal Policy involves:

a) Increase taxes b) Reduce government expenditures
c) Wage freezes d) All of above

9.41) Fiscal deficit can be controlled by

a) increasing taxes b) reducing subsidies
c) reducing public expenditure d) all of the above

9.42) Decreasing the size of private sector due to increased government spending is termed as
a) Contractionary Fiscal Policy b) Crowding out
c) Economic recession d) Liquidity Trap

9.43) Degree of shifting of tax burden is high in:

a) Direct Taxation b) Indirect Taxation
c) Progressive Taxation d) Proportional Taxation

9.44) Major drawback of Direct Taxation is:

a) Unpopular b) Discourage savings
c) Tax evasion d) All of the above

9.45) Which one is an advantage of Indirect Taxation?

a) Regressive b) Decreases cost-push inflation
c) Evasion is difficult d) None of the above

9.46) Which one is NOT a drawback of progressive taxation?

a) Persuasion of tax evasion b) Invasion of individual rights
c) Less loss of government revenue d) Relative certainty

9.47) If burden of tax cannot be shifted to anyone. It is said to be:

a) Direct tax b) Indirect tax
c) G.S.T. d) V.A.T.

9.48) If burden of tax can be shifted to anyone else it is said to be:

a) Direct tax b) Indirect tax
c) Income tax d) Personal tax

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9.49) __________________ taxes are also known as taxes on expenditure.

a) Direct taxes b) Indirect taxes
c) Personal taxes d) Income taxes

9.50) In a particular slab income tax is a:

a) Progressive tax b) Regressive tax
c) Proportional tax d) Indirect tax

9.51) Which of following is not a progressive tax.

a) G.S.T. b) Income tax
c) Wealth tax d) Property tax

9.52) Tax which causes leftward shifting in aggregate supply curve is known as:
a) Indirect tax b) G.S.T.
c) V.A.T. d) All of the above

9.53) Out of the following, which is the most important source of revenue to the state?
a) Import tariff b) Service tax
c) Wealth tax d) Sales tax

9.54) The difference between total expenditure and total amount of receipts is referred to as
a) Primary deficit b) Revenue deficit
c) Budget deficit d) Fiscal deficit

9.55) Government budget is said to be balanced when:

a) Government expenditure exceeds tax receipts
b) Government tax receipts exceed expenditure
c) Government spending decreases and revenues increase
d) Government expenditure equals tax revenue

9.56) Fiscal deficit can be controlled by reducing:

a) Taxes b) Imports
c) Unemployment d) Public expenditure

9.57) Which of the following would cause income inequalities?

a) Increased unemployment allowance b) Progressive taxation
c) Regressive taxation d) Full employment

9.58) A benefit of tariff is:

a) More competition b) Increased choice
c) More trade d) Increased government revenue

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9.59) Which of the following is NOT a part of Adam Smith’s canon of taxation?
a) Equality b) Economy
c) Objectivity d) Convenience

9.60) Which one of the following is NOT a feature of a good tax system?
a) It should be equitable b) It should be economical
c) The rate should be same for everybody d) It should be certain

9.61) Which of the following is a direct tax?

a) Sales tax b) Capital gains tax
c) Federal excise duty d) Value added tax

9.62) The imposition of indirect taxes would likely result in:

a) demand-pull inflation b) cost-push inflation
c) wage spiral inflation d) deflation

9.63) The “ability to pay principle” can best be demonstrated by:

a) Jumble sale tax b) Excise tax
c) Highway toll tax d) Personal income tax

9.64) Which of the following is an example of indirect tax?

a) Income tax b) Sales tax
c) Capital gains tax d) Property tax

9.65) The main function of taxation is:

a) Fiscal function b) Allocation of resources
c) Regulatory d) All of the above

9.66) Mohsin pays income tax of Rs. 2,500 on his earnings of Rs. 20,000. Danish pays Rs. 4,000 income tax on
his earnings of Rs. 32,000. Kinza pays Rs. 5,000 income tax on her earnings of Rs. 40,000. The income tax
system is:
a) Regressive b) Proportional
c) Progressive d) Equitable

9.67) Murad pays a tax of Rs. 100 on his income of Rs. 1000 while Sohail pays a tax of Rs. 200 on his income of
Rs. 800. Identify the tax system prevailing in the country.
a) Progressive b) Regressive
c) Proportional d) Equitable

9.68) If income tax of Rs. 500 is charged on an income of Rs. 5,000, then, compared to this, which of the
following would indicate a regressive tax scale?
a) Tax of Rs. 1,000 on an income of Rs. 10,000
b) Tax of Rs. 1,500 on an income of Rs. 20,000
c) Tax of Rs. 3,500 on an income of Rs. 30,000
d) Tax of Rs. 4,500 on an income of Rs. 40,000

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9.69) “Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient for
the contributor to pay it.”
a) cannon of convenience b) Canon of economy
c) Canon of certainty d) Canon of equality

9.70) Income tax follows:

a) Cannon of equality b) Cannon of certainty
c) Cannon of economy d) All of the above

9.71) Crowding out is a result of:

a) high government expenditure b) low government expenditure
c) high taxes d) none of these

9.72) Which of the following is NOT part of public expenditure?

a) Investment by nationalised industries b) Spending by local governments
c) Capital spending of public companies d) Interest on the national debt

9.73) Which of the following is NOT a part of Adam Smith’s canon of taxation?
a) Equality b) Economy
c) Convenience d) Objectivity

9.74) Which of the following TWO are not the advantages of direct tax.
a) Technological change b) Equitable
c) Less incentive to work hard d) Anti-Inflationary

9.75) Economic growth is an expansion of economic system in one or more dimensions

without a change in its structure.
a) True b) False

9.76) A proportional tax is that wherein the rate of tax remains unchanged irrespective of
change in tax base.
a) True b) False

9.77) A tax is said be ‘indirect tax’ if the burden of tax cannot be shifted to anyone else”.
a) True b) False

9.78) A Regressive Tax is that in which poor shares less burden of tax as compare to rich one.
a) True b) False

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ANSWER KEY

9.1) D 9.2) C 9.3) C 9.4) C

9.5) C 9.6) C 9.7) D 9.8) C
9.9) C 9.10) B 9.11) A 9.12) A,C
9.13) A 9.14) D 9.15) C 9.16) B
9.17) D 9.18) D 9.19) D 9.20) B
9.21) A 9.22) D 9.23) D 9.24) D
9.25) A 9.26) B 9.27) A 9.28) D
9.29) D 9.30) A 9.31) B 9.32) D
9.33) A 9.34) A 9.35) A 9.36) C
9.37) A 9.38) B 9.39) A 9.40) D
9.41) D 9.42) B 9.43) B 9.44) D
9.45) C 9.46) D 9.47) A 9.48) B
9.49) B 9.50) C 9.51) A 9.52) D
9.53) D 9.54) C 9.55) D 9.56) D
9.57) C 9.58) D 9.59) C 9.60) C
9.61) B 9.62) B 9.63) D 9.64) B
9.65) D 9.66) B 9.67) B 9.68) B
9.69) A 9.70) D 9.71) A 9.72) C
9.73) D 9.74) A, C 9.75) A 9.76) A
9.77) B 9.78) B

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TEST-09

Q-1) Which Tax is more equitable?

a) Progressive b) Regressive
c) Proportional d) Flat

Q-2) Which TWO of the following relates to lagging economic.

a) Average duration of employment b) Index of business confidence
c) Industrial production d) Interest rate

Q-3) Mr. A paid Rs.100 tax on his income Rs.1000 and Mr. B paid Rs.200 tax on his income Rs.800. The type
of tax is:
a) Equality b) Progressive

c) Regressive d) Proportional

Q-4) Indirect tax is an example of Income tax.

a) True b) False

Q-5) Which of the following are limitation of Fiscal policy? (Select TWO)
a) Time lag b) Low inflation
c) Crowding out effect d) Run a balanced budget

Q-6) Which of the following is best define Progressive tax?

a) Tax increase, when income increase
b) Tax increase, when income decrease
c) Tax decrease, when income increase
d) Tax same, when income increase

Q-7) Expansionary fiscal policy seeks to increase economic growth, employment and export by:
(Select TWO)
a) Increase government spending b) decrease government spending
c) decrease in taxes d) increase in taxes

Q-8) If government want to increase economic growth. (Select TWO)

a) Decrease tax b) Increase government spending

c) Reduce subsidy d) Increase tax

Q-9) Indirect Taxes are those taxes which are not only levied on Customer by retailers.
a) True b) False

Q-10) Which of the following is not advantage of direct Tax (Select TWO)
a) Equitable b) Unpopular
c) Economical d) Evasion

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CHAPTER-10

“ MONEY ”

PART-01: INTRODUCTION TO MONEY

1.1: BARTER SYSTEM: (Era of Absence of Money) 234
1.2: MONEY AND ITS EVOLUTION 235
1.3: FUNCTIONS AND CHARACTERISTICS OF MONEY 237
1.4: VIEWS OF ECONOMIST ABOUT ROLE OF MONEY 238

PART-02: DEMAND FOR MONEY 238

2.1: KEYNES’ LIQUIDITY PREFERENCE THEORY: 239
2.2: KEYNES’ LIQUIDITY TRAP: 241

PART-03: SUPPLY OF MONEY

3.1: TYPES OF MONEY 242
3.2: METODS OF CONTROLLING THE MONEY SUPPLY: 242
3.3: QUANTITY THEORY OF MONEY: 243

PART-04: RATE OF INTEREST

244

PART-04: MULTIPLE CHOICE QUESTIONS & TEST-10

MCQ 246
TEST-10 254

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PART-01: INTRODUCTION TO MONEY

1.1: BARTER SYSTEM: (Era of Absence of Money)

‘Barter is the exchange of one economic good or service for another’.

There are several problems with barter system:

1. Lack of double coincidence of wants:

Fundamental condition for barter system to take place is the existence of ‘coincidence of wants.
It refers to a situation where both parties (buyers and sellers) are able to offer something which
is acceptable for each of them simultaneously.

2. Difficult to decide Rate of exchange:

An agreed ‘rate of exchange’ must prevail among parties to exchange their products. It is not an
easy task to find a rate of exchange which is acceptable for everyone at the same time, e.g. We
may establish that one bag of grain is of equivalent value to one bag of wool. However, how much
is one apple worth? So, it is difficult to decide Rate of exchange in barter.

3. Lack of Storing/saving:
In barter system storing of wealth in form of perishable goods was impossible

4. Lack of Divisibility:
Sometime it is not possible to divide the goods to exchange for goods, e.g. A table for a bag of grain
or a hen for a cow.

5. Transfer of wealth:
In absence of money the transfer of wealth was another serious issue. Most of the goods are
immoveable like house and agriculture land etc.

6. Difficulties in Tax collection:

Government collects taxes and spent it on different development and non-development projects.
In absence of money, if tax is collected in form of goods, it is not possible to spend it on
development projects.

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1.2: MONEY AND ITS EVOLUTION

Money:
An officially-issued legal tender that is generally acceptable as a medium of exchange and at the same
time acts as a measure and a store of value

Evolution of money:
Evolution of money is one the biggest contribution in human history. Historically, we see that money
is not an overnight invention, but it evolved with the passage of time.

Following are the stages of evolution of money described in detail:

1. Commodity money
Commodity money system is where commodities are exchanged for making transaction (such as
animals, stones, bones, tobacco, arrows etc., were used as medium of exchange.

2. Metallic money
As the human civilization progressed, the only commodities used as means of exchange became
metals such as gold and silver.
• These metals have intrinsic value.
• It is too dangerous to carry them
• gold and silver are scarce in nature
• It may be in abundant due to accidental discoveries of ore deposits.

There were TWO types of metallic money:

• Full bodied money: It refers to that form of money in which the intrinsic value (value of the
metal used in that coin) is equal to the face value (value printed on coin).
• Token money: It refers to that form of money in which the intrinsic value is less than its face
value.

3. Paper money (Fiat money)

Due to the inconvenience and threat offered by the metallic money, paper money got developed.
Paper money is a piece of printed paper with engraving on it by government.

Fiat Money: Fiat money has no intrinsic value. Fiat money is a government-issued currency that
is not backed by a commodity. For Example, currency issued by government as legal tender paper
money.

Advantages of Paper Money

• It does not require precious metals. Furthermore, the printing of currency notes is simple and
cheaper than minting coins.
• It helps government to increase money supply to finance its development projects without
imposing new taxes.
• Paper money is easy to transfer as compared to metallic money.

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Disadvantages of Paper Money

• Danger of inflation is a serious threat of paper money. There is a high probability of over
issuance of currency notes as no metallic requirement are attached with it.
• It is usually accepted within the domestic boundaries of a country. (No value outside the
country)
• Paper money has limited age than coins, as it can be torn or burned

There are TWO main kinds of paper money:

• Convertible: The government promises to change this currency into gold if demanded.
• Inconvertible: Against such money the government has no promise to give gold if demanded.

4. Bank money:
Such as cheques (is not itself money but it performs all the functions of money)

5. Credit money:
A contractual agreement whereby a borrower receives something of value in the present, in
exchange for payment in the future, generally with interest, e.g. bonds and money market
accounts.

Advantages of credit money

• Allows immediate consumption of expensive goods, based on future earnings (this includes
houses, education, cars, which could otherwise not be bought).
• Allows firms to invest, expand and generate future revenue, rather than using retained
earnings.
• Government can also increase its spending by issuing bonds which is a type of credit.

Disadvantages of credit money

• There is often an element of risk involved that the person issuing credit may not receive full
payment from the person receiving credit.
• It may not be possible to establish trust between parties.
• Credit may also cause of inflation

6. Electronic money:
Such as Debit and Credit cards, online payments (Bank transfer, Jazz Cash and Easy paisa)

7. Digital money:
Such as Bitcoin (Cryptocurrencies are decentralized networks based on blockchain technology.)
(Cryptocurrencies are Not in our syllabus, Its only for informative purpose)

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1.3: FUNCTIONS AND CHARACTERISTICS OF MONEY

Functions of Money:
1. To act as a medium of exchange:
Allowing economic agents to exchange goods without the need to barter.

2. To act as a unit of account:

Allowing people to compare the relative price of goods and services through a common
denomination.

3. To act as a store of value:

Money can be stored and allowing people to forgo immediate consumption if they have a surplus
of resources, and can be used for future consumption.

4. To act as a standard of deferred payments:

Allowing people to consume goods and services in a current time period, whilst continuing to pay
in future periods.

Characteristics of Money:
1. General Acceptability: People will prefer money only it is accepted in exchange of their goods
and services and if they are certain that it would be acceptable when they need to pay it
somewhere else

2. Stability: A good money should be stable. If value of money will be unstable, then it cannot
perform its function as a measure of value and especially as a standard of deferred payments.
This is because people cannot trust while lending or accepting their payment in future as its
value would be ambiguous

3. Durability:
Money should be durable, retain the same shape and substance, and not deteriorate over an
extended period of time. This is important to maintain the functions of medium of exchange and
store of value.

4. Transportability:
money can be easily moved between locations when such an exchange is necessary. In its
current paper form, money can be easily transported

5. Divisibility:
money can be divided into small denominations to facilitate exchange of a variety of goods.

6. Non-counterfeitability:
It should not easily duplicate. It will fail as a medium of exchange if people can create money
easily. So, government should use secret elements (such as watermarking) to make the process
of duplication more difficult.

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1.4: VIEWS OF ECONOMIST ABOUT ROLE OF MONEY

• Classical economists
Classical economists believed that there should be no demand for money, as money is neutral.
Money is used to balance out the forces of demand and supply in the market system. Money
plays a passive role in the economy.

• Keynesian economists
Keynesian believed that there is demand for money to influence aggregate demand. Money also
acts as a store of value and can be used to purchase goods and services in the future.

• Monetarist’s economist:
Monetarists believed that aggregate expenditures in the economy are influenced by the market
rate of interest. If monetary policies are used to increase aggregate demand, employment and
economic growth, it may cause a short-term boost in output but will ultimately lead to inflation
in the economy.

PART-02: DEMAND FOR MONEY

Definition:
• ‘All else equal, demand for money is the amount of money which people wish to hold at a
given time at different rates of interest’.
• In other words, demand for money is the desired amount of holding financial assets in form
of cash or bank deposit (rather than making investment).
• In Nutshell, demand for money is the desire to holding cash or liquid assets.

Factors affecting demand for money:

1. Interest Rate: (Primary determinant)

Interest is the opportunity cost of holding liquid assets. Rather holding cash one can earn
handsome amount of interest by lending it to someone else. Higher interest rate decreases the
demand for money and vice versa.
Demand Schedule and Demand Curve:

Demand for Money Schedule Rate of Interest “r”

Demand for
Rate of Interest
Money 10%
(%)
(Rs. Billions)
10 100 8%

8 200 6%

6 300
MD
4 400
MD1 MD2 MD3
2 500 Money demand

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Rate of Interest “r”

2. Increase in financial innovation:
Increase in Financial innovations such as Debit
Card, Credit Card and Electronic payments
reduce the need for people to withdraw cash in
order to purchase goods and services and will
cause leftward shift in MD Curve.

MD
MD1

Money demand

3. Level of GDP: Rate of Interest “r”

Real income and employment increase due
to an increase in GDP. This will cause
an increase in the demand for money at 10%
Consequently, there is an outward shift in
the demand for money 8%

4. Level of Prices: 6%
Increase in general price level, increase the MD1
demand for money MD

MD1 MD2 MD3

Money demand

2.1: KEYNES’ LIQUIDITY PREFERENCE THEORY:

Liquidity preference theory states that all factors remaining the same, people prefer to hold cash
(liquidity) rather than illiquid assets (Bond). They will, however, be paid a premium to hold more
illiquid assets.
There is inverse relationship between rate of interest and money demanded”.

Motives of Holding Money in Liquid Form:

1. Transactional motives:
People hold money to carry day to day transactions. This depends upon the level of income. The
higher the level of income the higher will be the transactions motive.

2. Precautionary motives:
People’s desire to save money for unforeseen circumstances such as accident or disease etc. This
motive will depend on the nature of the individual and on the conditions in which he lives.

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3. Speculative motives:
Another important aspect of demand for money is that people want to make more money with their
existing money stock. People hold money to take advantages of changes in price of bonds. Money held
for speculative motives depends on market rate of interest. If market rate of interest is expected to
fall, people buy bonds and sell them when price of bond increases.

Note:
• Transactional demand for money remains unaffected to any change in rate of interest.
• Precautionary demand for money is inversely related to market rate of interest but relatively
inelastic.
• Speculative demand for money is also inversely related to the interest rate but relatively
elastic.

Bond:
An investment that is bought up front by an investor, and which then pays a fixed amount in return
at regular time periods (usually annually).
Bond price = 1 / rate of interest
Example:
Suppose a bond is issued for Rs.4,000, and its annual return is Rs.400. This means the annual rate of
interest is 10%. If the market interest rate falls to 5%, then the price of the bond will increase to
Rs.8,000. This is because, in order to maintain an annual return of Rs.400, Rs.8,000 would need to be
invested in another asset.

• There is an inverse relationship between the rate of interest, and the speculative demand for
money.
• There is inverse relationship between market interest rate and price of a bond.

Total demand for money:

Aggregating the transactional, precautionary and speculative demand for money, we get the total
demand for money. This is sometimes known as the liquidity preference curve, and is inversely related
to the rate of interest.

Total Demand Transactional Precautionary Speculative

for Money (MD) = Demand for + Demand for + Demand for
Money Money Money

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2.2: KEYNES’ LIQUIDITY TRAP:

A situation where prevailing interest rates are very low (called critical rate of interest), and savings
rates are high, causing monetary policy to be ineffective.

Any effort to change in interest by changing money supply becomes useless. According to Keynes
Liquidity Trap, people wait for good time for purchasing bonds. They prefer to hold liquid money
(cash balances) which makes monetary policy ineffective.

Rate of Interest Liquidity Preference Curve

MS1 MS2 MS3

Liquidity Trap

r0 MD

M1 M2
Demand for Money and Supply

Overcoming the liquidity trap:

A number of policies can help to break out of the liquidity trap:

• Fiscal policy:
becomes a very important instrument in raising demand, for example running a larger budget
deficit.

• Rising inflation expectations:

Higher inflation will cause savings to be worth less. This will disincentive for hoarding of cash,
as its real value will decrease. Therefore, consumption will increase.

• Expectations of Increase in interest rates: If government. borrows from commercial banks,

so as rate of interest increases. As a result, individuals start purchasing bonds and with this
inflow of resources into financial system, economy will slowly pull out from the liquidity trap.

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PART-03: SUPPLY OF MONEY: (MS)

Supply of Money:
Total amount of money in circulation or in existence in a country at a given time. It includes
currency notes, currency coins, banks demand deposits etc.

3.1: TYPES OF MONEY:

Types of money categorized by its liquidity:

1. Transactional money (M0): which is used to buy and sell things within an Economy.
M0 = Notes and Coins in circulation.

2. Checking accounts (M1): money that is in peoples’ accounts that they have immediate access
M1 = M0 + current account (demand deposits)

3. Savings deposits (M2): money that belongs to people, but which they cannot access immediately.
M2 = M1 + saving account (Time deposits)

4. Large time assets (M3): M3 = M2 + institutional money market funds (Long term deposits).

Note:
As we move from M0 to onward, money become illiquid. supply of money must be limited.

Importance of money supply:

Lowering the interest rate, make borrowing easy for people causes increase in money supply
which directly affecting the level of investment and consumption within an economy.

3.2: METODS OF CONTROLLING THE MONEY SUPPLY:

There are various means by which the government can attempt to control the money supply.

1. Open market operations

Buying and selling of government securities by the central bank in open market. selling of
government securities decrease money supply and vice versa.

2. Interest rates
If the government raises interest rates this reduces the demand for money since less people will
want to take out bank loans, thus less money is created. (a contractionary monetary policy.)

3. Special deposits
A government can require commercial banks to deposit a certain proportion of their assets at the
central bank to control money supply.

4. Government borrowing
The government can influence the money supply with the level of its own borrowing:
• higher borrowing by the government reduces the money supply;
• lower borrowing by the government increases the money supply.

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3.3: QUANTITY THEORY OF MONEY:

Quantity theory of money:

An eminent economist “Irving Fisher” states that supply of money is directly proportion to Price
level and inversely proportion to the value of money.

Money supply ∝ price level

Money supply 1/∝ value of money

thus, Value of money 1/∝ Price level

‘Quantity Theory of Money states that Velocity of money (V) and total goods and services (T)
remaining unchanged, changes quantity of money supplied cause direct and proportional change in
price level’
.
Mathematically,
MV = PT
• M=Money supplied,
• V=Velocity of circulation of money (rate at which money is exchanged in an economy in a
given time).
• P=Price level,
• T = total goods and services
Example:
Suppose, in a given condition of an economy;
M = 100 (Rs. billions), V = 10, P = 20, T = 50 (million units)
Keeping V and T constant, if M becomes twice i.e 200, then the price level will be calculated as follows:
𝐌𝐕 = 𝐏𝐓
𝐌𝐕
P=
𝐓
𝟐𝟎𝟎𝐱𝟏𝟎
P=
𝟓𝟎
P = 𝟒𝟎
Hence, as we double the money supply (M), price level is doubled which means that value of money
has fallen to one half.

CALCULATION OF VELOCITY (V): V = GDP / Supply of Money

Assumptions of the Theory:

• Velocity of money remains constant.
• Amount of goods and services remain unchanged.
• Money is required to spend on goods and services.
• ‘P’ is a passive factor which is affected by other factors.
• Full employment has reached in economy

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PART-04: RATE OF INTEREST

INTEREST RATE:
Interest is the amount charged by a lender to a borrower on the principal borrowed. Interest rate is
calculated on the percentage of principal and on per annum basis.

• Nominal interest rate: (rate with inflation)

Nominal interest rate is the actual interest rate paid on any borrowing.

Example:
if a borrower pays Rs. 10 on every 100 rupees lent to him. The nominal interest rate is 10%.

• Real interest rate:

It is the rate without inflation. (Inflation adjusted.)

Example:
if a bond compounds annually and has a nominal interest rate of 10% and the inflation rate is
6% then the real interest rate is only 4%.

Determinants of Interest Rate:

Supply and demand for credit Money

• The interest rate depends upon the supply and demand of credit money.
An increase in demand of credit money would lead to an increase in the rate of interest
(and vice-versa).
• An increase in the supply of credit money would decrease the rate of interest (and vice-versa).

Determination of Interest Rate

MS
Market rate of interest (%)
Market Rate of Interest (%)

MD

M
Demand and Supply (Money)

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Change in supply of money:

Government will try to increase interest rate by reducing Money supply in an economy to shrink
consumption, inflation and investment in the country. This will happen when:

• Central bank will sell securities in open market

• Bank reserves will decline
• Commercial banks have less lending power
• Overall money supply will fall
• Inflation rate will be low

Note: All the factors are reversed with decrease the interest rate

MS2 MS MS1
Market rate of interest

r2

r
(%)

r1
MD

M2 M M1
Demand and Supply (Money)

In the graph, due to increase in money supply the MS shift to MS1 which lowering the interest rate to
r1. While a decrease in money supply shift MS to MS2 which cause an increase in interest rate to r2

Process of changing interest rate due to different policies adopted by central bank is given below:

Money goes Commercial Less funds

Selling of Money Interest rate
to central Bank reserves available for
securities supply falls goes up
bank decreases lending

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MULTIPLE CHOICE QUESTIONS

10.1) Money does NOT function as a:

a) medium of exchange b) hedge against inflation
c) store of value d) measure of value

10.2) Which of the following is not a function of money?

a) Store of value b) Unit of account
c) Standard of deferred payment d) Payment of interest

10.3) Which of the following is NOT a method of holding wealth?

a) Bonds and equities b) Human wealth
c) Consumer durables d) Commodities

10.4) Which of the following is regarded as ‘Fiat money’?

a) Gold b) Gold standard
c) Credit card d) US dollar

10.5) Which problem of ‘Barter system’ is solve by function of money ‘act as a medium of exchange’?
a) Coincidence of wants b) Rate of exchange
c) Indivisibility of goods d) Store of value

10.6) Money in which the intrinsic value is less than its face value:
a) Full bodied money b) Token money
c) Convertible money d) None of the above

10.7) Mutual funds are considered as form of:

a) Mo b) M1
c) M2 d) M3

10.8) In barter system tax collected in form of ___________ it is not possible to spend it on development
projects.
a) Money b) Goods
c) Dollar d) None of the above

10.9) Money does not function as a:

a) Medium of exchange b) Hedge against inflation
c) Store of value d) Measure of value

10.10) Which of the following is not a function of money?

a) Store of value b) Unit of account
c) Standard of deferred payment d) Payment of interest

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10.11) According to classical economists’ money acts as lubricant to allow a smoother interaction between:
a) Market forces b) Buyers and sellers
c) Demand and supply d) All of the above

10.12) According to monetarists aggregate expenditures in the economy are influenced by:
a) Market focus b) Credit money
c) Exchange rate d) Market of interest

10.13) Money which having no intrinsic value is called:

a) Commodity money b) Fiat money
c) Full bodied money d) Token money

10.14) Which of the following is not an advantage of paper money?

a) Saving of precious metals b) Portability
c) Economy / Low cost d) Stable value

10.15) Any monetary claim against physical or legal person can be used for the purchase of goods and
services are called.
a) Money b) Fiat money
c) Credit money d) Token money

10.16) Disadvantage of credit money is / are:

a) Risk of bad debt b) Lack of trust
c) Inflation d) All of the above

10.17) Characteristic of good money is / are:

a) General acceptability b) Stability of value
c) Durability d) All of the above

10.18) Other things remaining the same amount of money. Which people wish to hold at given time at
different rates of interest is called.
a) Fiat money b) Commodity money
c) Supply of money d) Demand for money

10.19) Nominal interest and money demanded are

a) Directly proportion b) Inversely proportion
c) Irrelevant d) It depends upon the elasticity of demand
for money

10.20) Which defines demand for money?

a) Gold b) Real estate
c) Long term security d) All of the above

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10.21) The term “precautionary motive” has been discussed in:

a) Quantity theory of money b) Theory of consumer behaviour
c) Liquidity preference theory d) Multiplier accelerator theory

10.22) Which of the following is not one a Keynesian motive for holding money?
a) Investment motive b) Precautionary motive
c) Speculative motive d) Transaction motive

10.23) In the Keynesian theory of demand for money, the transactions demand for money is determined by:
a) The rate of interest b) The level of consumers’ income
c) Expected changes in consumer prices d) The amount of money in circulation

10.24) Which of the following is not a method of holding wealth?

a) Bonds and equities b) Human wealth
c) Consumer durables d) Commodities

10.25) Pace of financial innovations will affect:

a) Demand for money b) Supply of money
c) Liquidity preference d) a&c

10.26) If market rate of interest increases by 5% then the demand for bonds will:
a) Decrease b) Increase
c) Remain unaffected d) Insufficient information to make any
decision

10.27) If velocity of money is 10, real output is 10,000 and price level is 20 then the nominal stock of money is:
a) 20,000 b) 10,000
c) 2,000 d) 1,000

10.28) If demand for money is interest elastic, then, any increase in interest rate will:
a) Push demand for money curve to left with lesser proportion
b) Push away the demand for money curve to right with lesser proportion
c) Pull demand for money curve to left with higher proportion
d) None of the above

10.29) Which one is NOT a relevant variable in demand for money are:
a) Financial innovations b) Real GDP

c) interest rate d) None of the above

10.30) If interest rate increases by 10% then the real value of money will:
a) Fell by 10% b) Fell more than 10%
c) Increase by 10% d) Increase less than 10%

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10.31) Which of the following is not a determinant demand for money?

a) Rates of interest b) Price level / inflation
c) G.D.P. d) Special deposits

10.32) Which of the following factor will not cause shift in money demand curve?
a) G.D.P. b) Financial innovation
c) Rates of interest d) Inflation

10.33) According to Keynesian liquidity preference model following are the motives for demand for money.
a) Transactionary motive b) Precautionary motive
c) Speculative motive d) All of the above

10.34) A situation where prevailing interest rates are low and liquidity preferences are high, causing
monetary policy to be ineffective is called.
(i) Depression
(ii) Liquidity trap
(iii) Recovery
(iv) Boom

a) (i) & (ii) b) (i) & (iii)

c) (iii) & (iv) d) Only (ii)

10.35) Causes of liquidity trap are:

(i) Depression
(ii) Inflation
(iii) Deflation
(iv) Lack of business confidence

a) (ii) & (iv) b) (i) & (ii)

c) (i), (iii) and (iv) d) Only (iv)

10.36) In the below diagram Situation from A to C shows.

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a) Ineffectiveness of monetary policy b) Liquidity trap

c) Depression d) All of the above

10.37) In order to overcome liquidity trap following policies can be helpful.

a) Increase on government expenditure b) Raise in inflationary expectations
c) Increase in money demand d) All of the above

10.38) Which defines best as money supply?

a) money people have in their pockets b) money in checking accounts
c) money in time deposits d) all of above

10.39) Money supply can be shrunk by:

a) Selling securities by central bank b) Rising bank rate
c) Decreasing interest rate d) a&b

10.40) If M=100, V=10, T=20 then P=?

a) 100 b) 50
c) 150 d) 10

10.41) Which of the following is most likely to lead to a fall in the money supply?
a) A fall in interest rates
b) Purchases of government securities by the central bank
c) Sales of government securities by the central bank
d) A rise in the amount of cash held by commercial banks

10.42) According to Keynesian liquidity preference theory, an increase in the money supply will
a) Raise the price of financial assets b) Increase in price of bonds
c) Lower the rate of interest d) All of above

10.43) Govt can attempt to control the money supply by following policy.
a) Open market operation b) Bank rate policy
c) Government borrowing d) All of the above

10.44) Which one is NOT a determinant of demand for money?

a) Level of real national income b) The level of interest rates
c) Price Level d) Marginal Efficiency of Capital

10.45) Which one is most sensitive to interest rate?

a) Precautionary demand for money b) Transactional demand for money
c) Speculative demand for money d) All of the above are equally sensitive
10.46) Which one is perfectly inelastic to interest rate?
a) Precautionary demand for money b) Transactional demand for money
c) Speculative demand for money d) All of the above are equally sensitive

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10.47) Classical quality theory of money was presented by:

a) Adam Smith b) Keynes
c) Irving Fisher d) Robbins

10.48) Velocity of circulation of money can be determine by:

a) G.D.P. / Money supply b) Money supply / G.D.P.
c) Nominal G.D.P. / Real G.D.P. d) None of the above

10.49) Suppose in an economy, the average price level is 1.3, real value of national output is Rs. 230 billion
and the quantity of money in circulation is Rs. 103 billion. The velocity of circulation would be:
a) 2.90 b) 1.60
c) 0.72 d) 0.58

10.50) Which of the following best describes Keynesian Liquidity trap?

a) High interest rates, low savings rates b) Low interest rates, high savings rates
c) High interest rates, high savings rates d) Low interest rates, low savings rates

10.51) Which of the following is NOT a motive for holding money?

a) Inflationary motive b) Precautionary motive
c) Transaction motive d) Speculative motive

10.52) What would be the velocity of circulation of money in an economy in which the average price level is
1.8, real GDP is Rs. 260 billion and the nominal money supply is Rs. 117 billion?
a) 4 b) 3.2
c) 4.8 d) 0.8

10.53) The term “Precautionary motive” has been discussed in:

a) Quantity theory of money b) Theory of consumer behaviour
c) Liquidity preference theory d) Multiplier accelerator theory

10.54) Which of the following is not one a Keynesian motive for holding money?
a) Investment motive b) Precautionary motive
c) Speculative motive d) Transaction motive

10.55) In the Keynesian theory of demand for money, the transactions demand for money is determined by:
a) the rate of interest b) the level of consumers’ income
c) expected changes in consumer prices d) the amount of money in circulation

10.56) In the Keynesian theory of demand for money, the transactions demand for money is determined by:
a) the rate of interest b) the level of consumers’ income
c) expected changes in consumer prices d) the amount of money in circulation

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10.57) According to the Quantity Theory of Money, if the money supply is Rs. 125 million, the average price
level is Rs. 5 and national output is Rs. 300 million, the velocity of circulation of money is:
a) 4 b) 8
c) 12 d) 16

10.58) Market rate of interest is determined by:

a) Central bank b) Commercial bank
c) Demand & supply of money d) Inflation

10.59) Government may increase the money supply through open market operations but such measures are
likely to result in short-term interest rates to:
a) rise and increase the demand for money
b) rise and reduce the demand for money
c) fall and increase the demand for money
d) fall and reduce the demand for money

10.60) According to Monetarist Economist, aggregate demand is influenced by ________________

a) Income b) Government expenditure
c) Rate of interest d) Investment

10.61) According to Quantity theory of Money, money supply is directly proportional to _______
a) Value of money b) Price level
c) Demand for money d) Income of consumer

10.62) According to ___________________ economist. Money can be used to facilitate transactions; money can be
used to purchase goods and services in the future
a) Classical b) Keynesian
c) Monetarists d) None of these

10.63) Function of money best described as: (Select TWO)

a) Medium of exchange b) Barter system
c) Unit of account d) Not a Standard of deferred payment

10.64) Which two are not motives of liquidity preference theory;

a) Saving b) Precautionary
c) Transactional d) Interest rate

10.65) If money supply is of 90 million. Total 600,000 Transaction are done having General Price of 300. What
is velocity _________:
a) 5 b) 4
c) 3 d) 2

10.66) Paper Money are all currency notes issued by Commercial Bank.
a) True b) False

10.67) Convertible money is that which cannot be converted into gold as there is no gold at back of such
money.
a) True b) False

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10.68) Liquidity Trap is a situation where prevailing interest rates are low and liquidity preferences are high,
causing monetary policy to be ineffective.
a) True b) False

10.69) All else equal, supply of money is the amount of money which people wish to hold at a given time at
different rates of interest.
a) True b) False

10.70) Credit Money is any monetary claim against physical or legal person that can be used for the purchase
of goods and services.
a) True b) False

10.71) As we move from M0 to onward, money become liquid and supply of money is limited
a) True b) False

10.72) If nominal rate is 15% and inflation rate is 6% then Real rate will be 21%.
a) True b) False

ANSWER KEY

10.1) B 10.2) D 10.3) B 10.4) D

10.5) A 10.6) B 10.7) D 10.8) B
10.9) B 10.10) D 10.11) D 10.12) D
10.13) B 10.14) D 10.15) C 10.16) D
10.17) D 10.18) D 10.19) B 10.20) A
10.21) C 10.22) A 10.23) B 10.24) B
10.25) D 10.26) B 10.27) A 10.28) C
10.29) D 10.30) C 10.31) D 10.32) C
10.33) D 10.34) A 10.35) C 10.36) D
10.37) D 10.38) D 10.39) D 10.40) B
10.41) C 10.42) D 10.43) D 10.44) D
10.45) C 10.46) B 10.47) C 10.48) A
10.49) A 10.50) B 10.51) A 10.52) A
10.53) C 10.54) A 10.55) B 10.56) B
10.57) C 10.58) C 10.59) C 10.60) C
10.61) B 10.62) B 10.63) A,C 10.64) A,D
10.65) D 10.66) B 10.67) B 10.68) A
10.69) B 10.70) A 10.71) B 10.72)

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 CH-10: MONEY

SELF TEST-10

Q-1) In quantity theory of money, if M = 90 million, P = 30,000, T = 6000 then find the value of V?
a) 2 b) 3
c) 4 d) 5

Q-2) Liquidity trap occur where:

a) Interest Rate closer to zero b) Money demand decrease

c) Bond price decrease d) Interest Rate closer maximum

Q-3) Increase in demand for credit money ___________ interest rate

a) Increase
b) Decrease

Q-4) Which of the following about credit money is correct (select TWO);
a) Increase indirect consumption b) Reduce inflation
c) Firm expand revenue and other retained d) Inclines people to spend less
earning

Q-5) Which two are not motives liquidity preference theory;

a) Saving b) Transactional
c) Interest rate d) Precautionary

Q-6) Which of the following is NOT considered as Credit instruments?

a) IOU b) Draft
c) Bond d) Stock

Q-7) Function of money best described as: (Select TWO)

a) Medium of exchange b) Barter system
c) Unit of account d) Not a Standard of deferred payment

Q-8) Money That is in people’s accounts and they have immediate access is called?
a) Transactional money b) Checking accounts
c) Savings accounts d) Large time assets

Q-9) Which of the following is NOT a method of controlling the money supply?
a) Open market operation b) Transactional money
c) Interest rate d) Government borrowing

Q-10) According to Monetarist Economist, aggregate demand is influenced by ________________

a) Income b) Government expenditure
c) Rate of interest d) Investment

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CHAPTER-11

“ INFLATION & UNEMPLOYMENT ”

PART-01: INFLATION
1.1: INFLATION 256
1.2: DEGREES OF INFLATION: 257
1.3: COST/EFFECT OF INFLATION: 258
1.4: DEMAND-PULL INFLATION: 259
1.5: COST-PUSH INFLATION: 260

PART-02: UNEMPLOYMENT:
2.1: TYPES OF UMEMPLOYMENT: 262
2.2: UNFAVORABLE COSEQUENCE OF UMEMPLOYMENT: 264
2.3: MEASURES TO REDUCE UMEMPLOYMENT: 264
2.4: PHILLIPS CURVE: 265
2.5: LONG-RUN PHILLIPS CURVE: 266
2.6: NATURAL RATE OF UNEMPLOYMENT: 266

PART-04: MULTIPLE CHOICE QUESTIONS & TEST-11

MCQ 267
TEST-11 274

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Part-01: INFLATION:

Inflation:
• ” A persistent increase in the general price level and then fall in real value of money.”
• Coulborn: “Too much money chasing too few goods.”
• Samuleson: “It is a measure of rate of increase in general price level of a predetermined
basket of goods and services of an economy’.”

Key points regarding Inflation:

• It is about an absolute rise in price level rather relative rise
• Only rise in value of goods and services not in change in prices of financial instruments
• It considers average price of a basket of goods rather a particular good
• It considers only persistent rise in overall price level rather of a particular year

Real vs Nominal prices

Real rate
A price change adjusted for inflation. (Price without inflation)

Nominal rate
A price change unadjusted for inflation. (Price with inflation)

Real rate = Nominal rate – inflation rate

Measuring inflation
Consumer prices index (CPI)
A measure of the weighted average of prices of a basket of goods and services.

How to measure CPI:

1. The CPI is calculated by taking price changes for each item in the predetermined Basket of goods
and services.
2. Weighted are assigned to each item by their importance.
3. Finally weighted average is calculated.

CPI (2021) = Total weighted index/Total weight

CPI = Σ (Price x Weight) / Σ weights

CPI = (10x1100)/100 = 110

Calculation of Inflation:

Inflation Rate (%) = (Price Level of Y1 – Price Level of Y0)/ Price Level of Y0 * 100

Suppose price level was 110 in 2021 and 120 in 2022. Then rate of inflation in 2022 will be:
9.09% = (120 –110)/ 110 * 100

Assume the base index is 100. If the price of bread increases from Rs.150 to Rs.165 (10%) then the
new price index would be 110.

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Limitations of CPI as a measure:

• Not fully representative:

It is not fully representative because of different spending habits. Single vs married or rich vs
poor families.

• Changing quality of goods and services:

Price increases may be due to difference in quality of goods and services not due to inflation

• Index-number problems: it is debatable which is the most appropriate “base year”.

• Spending pattern: It ignores the spending pattern of individuals.

1.2: DEGREES OF INFLATION:

1. Moderate inflation:
It is also called low inflation, when rate of inflation remains within the range of 1% - 20% per
annum. On the lower side if it remains less than 5% p.a, we will call it as moderate/creeping
inflation and on the side if it exceeds over 5% p.a, we called it trotting inflation.

2. Hyperinflation (rapid inflation):

Prices increase so quickly at a rate of 1,000,000,000% annually and money becomes worthless.
It is no longer a store of value, and cannot be used for transactions. Prices increase so quickly that
people begin to hoard “things” that can be used to barter. The most extreme example observed
in Zimbabwe in 2008, it was estimated 79,600,000,000%.

3. Deflation:
Consistently decreases in average price level is called deflation. A recent example of deflation
is Japan in the 1990s.

4. Stagflation:
Stagflation means slow economic growth combined with high unemployment leading to
economic stagnation with higher inflation and reduced gross domestic product.

5. Wage spiral inflation:

Wage spiral inflation mean rising wages and rising prices or inflation. Increase in wages causes
increase in cost of production, that lower the supply for goods and services which in turn causes
a rise in the prices of products.

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1.3: COST/EFFECT OF INFLATION:

• Fixed income group:

Higher inflation can have a regressive effect on lower income families and elderly people in
society. Especially if the price of food and utilities increases drastically.

• Debtors and creditors:

Debtors benefit from inflation because inflation reduces the value of money or purchasing power,
and debtors pay less in real terms. Conversely, creditors suffer during period of inflation because
they receive less in real terms.

(Real interest = Nominal Interest - Inflation)

• Business uncertainty (Entrepreneurs):

With high and volatile inflation, businesses are less likely to commit to big projects, as they are
uncertain as to the economic future.

• Fixed income group:

Higher inflation can have a regressive effect on lower income families, and elderly people in
society. Especially if the price of food and utilities increases drastically.

• Investors:
As we shall see in a later section, in response to high inflation, governments may increase the
interest rates. This will increase the cost of businesses getting a loan, which may stifle investment.

• Government:
Rapid inflation also hurts government in different ways. It reduces the purchasing power of the
people and government has to spend more money to compensate purchasing power.
Furthermore, rising inflation forces government to have a cut on its expenditures, while it
reduces the pace of development of a country.

• Business competitiveness:
when selling comparable goods, the country with lower inflation will have a lower price and
therefore have much better international competitiveness.

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Kinds /Types or Causes of Inflation

• Demand-Pull inflation
• Cost-Push inflation

1.4: DEMAND-PULL INFLATION:

Demand-pull inflation:
Demand-pull inflation arises due to increase in Aggregate demand in a country. As the AD for goods
is more than the AS of goods at current price, there is a tendency for increase in prices. Once the full
employment level in an economy has achieved, pace of demand-pull inflation gets more severe.

Example:
If economy is expanding, people spend more on consumer goods and government spend more on
infrastructural development. All these factors shift the aggregate demand outward. Rising demand
for goods and services will give further push to price levels.

Reasons for demand-pull inflation are:

• Fiscal stimulus:
If there is an increase in government spending and decreases in taxes with the given
effect of multiplier would result in greater increase in AD which would lead to demand-pull
inflation.

• Monetary stimulus:
A fall in interest rates may spark an increase in demand, therefore leading to “too much money
chasing too few goods”. The surplus money in the economic system would increase the price level
and therefore inflation.

• Depreciation of the exchange rate:

If exports become cheaper to foreigners, and a comparative number of imports aren’t bought,
then AD will shift outwards, causing a rise in the level of inflation.

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• Increase in Export:
Increase in export (other countries buying from local country) will increase the AD in a country,
causes demand-pull inflation.

Remedies/Solution to demand-pull inflation:

Inflation can be controlled/reduced by Decreasing Aggregate Demand, this can be done through
Contractionary Policies i.e.

Contractionary Fiscal Policies:

• By Decreasing government spending
• By Increasing Taxes (e.g. Value Added Tax) to discourage spending.

Contractionary Monetary Policies:

• Raise interest rates: this will reduce consumers’ real disposable income to control further
demand.
• Reduce money supply: by removing money from circulation, the central authority reduces the
ability to demand more

1.5: COST-PUSH INFLATION:

Cost-push inflation:
It is supply side inflation. An increase in price level as a result of an increase in cost of production is
usually known as cost push inflation. Rising cost of production, due to increase in wages or due to
cost of other inputs, will discourage investors and as a result, level of production will fall. Under such
circumstances the short run aggregate supply curve (SRAS) will shift leftward. Prevailing shortage in
market will put upward pressure on market price level.

Cost-Push Inflation LRAS

SRAS2

SRAS1

E2
Price Level

P2
E1
P1

AD1

Y2 Y1 Yf Output (Y)

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The main causes of Cost-push inflation are:

• Rising labour costs:

When level of unemployment in an economy is low, skilled labor would be in a position to demand
higher wages which would give rise to cost-push inflation.

• Component costs:
An increase in the price of raw materials and other inputs would give rise to cost-push inflation.

• Wage-price spiral:
Increase in wages causes increase in cost of production, that lower the supply for goods and
services which in turn causes a rise in the prices of products which would lead to cost-push
inflation.

• Higher indirect taxes:

Such as increased duties on fuel or particular types of food will increase the final cost of goods
sold, resulting in cost-push inflation.

• Depreciation of the Exchange rate:

Fall in exchange rate increase the prices of imported good. Expensive imported goods increase
the cost and decrease aggregate supply which would lead to cost-push inflation.

Remedies to Cost Push Inflation:

Increase Aggregate Supply by controlling cost of inputs i.e.

• Limit wage increases:

wages can be a significant input cost. By keeping wages low, this will reduce the upward pressure
on final prices.

• Limit cost of utilities:

Government can reduce inflation by reducing the cost of utilities (e.g. energy)

• Appreciation of the Exchange rate:

By appreciating local currency in relation to the currency it is importing from. This will reduce
the costs of imported goods.

• Subsidies and Indirect Taxes:

Provision of subsidies and reduction in indirect taxes reduces the cost of production and hence
helps in a controlling cost push inflation.

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Part-2: UNEMPLOYMENT:

Unemployment
The state of being unemployed, actively searching for job and unable to find work.
𝑈𝑛𝑒𝑚𝑝𝑙𝑦𝑒𝑑 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
Unemployment Rate = x 100
𝑇𝑜𝑡𝑎𝑙 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒

2.1: TYPES OF UMEMPLOYMENT:

1. Long Run Unemployment:
Unemployment which arises for a long period and is permanent in nature.

• Demand-deficient/Cyclic unemployment: when an economy is in recession or a period of

low growth, aggregate demand may be deficient to meet the potential output in an economy.
Firms therefore cutback production and reduces the amount of labour.

For example:
In COVID-19, the world is going through a severe recession. Demand for consumer durables and
services are decreasing sharply due to prolong lockdown and other non-workable SOPs

AS
Price Level

P0 Full employment
level

AD0
P1

AD1

Y1 Y0
Real National Output Unemployment

• Structural unemployment:
➢ It is unemployment that arises through inefficiencies in the labour market.
➢ This often occurs through a misalignment of skill sets in certain geographical
locations.
➢ It is more prominent if labour is unwilling to move geographically in search of new
work, or if firms are unwilling to take on people with different skill sets.

For example:
Workers working with old typewriter for many decades reluctant to move with new modern
computerized system, so they become unemployed

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• Real wage/Classical unemployment:

also known as classical unemployment, occurs when wages are kept artificially high through
powerful trade unions. A higher minimum wage means that the demand for labour is less,
because firms cannot afford to employ too many people.

For example:
Suppose strong labour unions, force government to increase minimum wage rate. Due to
increase in wages firms will demand fewer workers which can create unemployment in the
country

Wage Unemployed
s labor force SL
WMin Minimum Wage

W1

DL

DL L1 SL Quantity of Labour
2. Short Run Unemployment:
Unemployment which arises for a short period and then disappears

• Frictional unemployment:
some unemployment is inevitable as workers move from one job to another. Such
unemployment occurs when there is a shortage of a particular type of workers at one place
and similar type of workers are in surplus at some other place or people searching for better
job. It is a temporary unemployment

• Voluntary unemployment:
occurs when people are not willing to work at the prevailing wage rate. It may be more
beneficial for them to receive social security, rather than go into a job and to pay tax.

• Seasonal Unemployment:
Unemployment which arises due to seasonal variation is called seasonal unemployment

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2.2: UNFAVORABLE COSEQUENCE OF UMEMPLOYMENT:

Unemployment is harmful for economy by many aspects.

1. It creates a greater loss of GDP of a country. Unemployed labour force does not participate in
economic activity and government. has to face a shortfall in tax collections.
2. Unemployment also causes an increase in poverty. People without jobs remain unable to feed
their families.
3. It causes greater disparities in income distribution
4. Due to unemployment national output falls, this makes the current account deficit worst.
5. “Empty minds are devil’s workshops”. Unemployed people slip into social evils such as theft,
robbery and other street crimes.

2.3: MEASURES TO REDUCE UMEMPLOYMENT:

1. By utilizing labour intensive technology, demand for labour can be increased which can be
helpful to reduce unemployment.
2. Agricultural reforms can also help government to overcome seasonal unemployment. Culture
of multiple cropping should be encouraged to keep the labour force busy with different crops
throughout the year.
3. Mismatch with new technology is another reason for being unemployed. Government should
promote on job and off job training sessions to enhance their abilities to cope the frequent
structural changes in industrial sector.
4. Government should promote self-employment schemes. In this regard, financial and
technical support should be provided.
5. Rapid growth in population is another reason of rising unemployment. Government should
take necessary steps to control population to address this issue.

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2.4: PHILLIPS CURVE:

In 1958, an economist from New Zealand, named William Phillips, published a study of the historical
link between unemployment and the rate of change of money wages.

PHILLIPS CURVE:
According to the Phillips Curve (PC), there is an inverse relationship between unemployment and
wage inflation. “A trade-off between inflation and unemployment.”

• As unemployment falls, labour shortages may begin to occur where skilled labour is in short
supply. This puts upward pressure on wages. Increase in wages leads to increase cost of
production causes Cost-Push Inflation.

Diagram:
Inflation Rate (%)

A
P2

B
P1

U2 U1
Unemployment Rate (%) PC

In the graph above, unemployment rate is along X-axis whereas inflation rate is along Y-axis. An
increase in inflation rate from P1 to P2 is the cost of a decrease in unemployment from U1 to U2

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2.5: LONG-RUN PHILLIPS CURVE:

Long-Run Phillips Curve:

Monetarist Economist Milton Friedman agreed that there is a trade-off between unemployment and
inflation exist only in the short run, not in the long run. According to Friedman, with words “higher
inflation and higher unemployment”.

Diagram and Explanation:

According to the Friedman, short-run Phillips’s curve (SRPC) is based upon a fixed expectation of
inflation. If there is an increase in the expectation of inflation, then this would cause the SRPC to shift
higher. Boosting AD would only have a short run effect on unemployment.
LRPC
Inflation Rate (%)

B C
8%

5% A SRPC2

SRPC1

U1 UN
Unemployment Rate (%)

• The economy begins in equilibrium at A.

• There is an increase in government spending to boost AD, decreasing unemployment and taking
the economy to point B where inflation is 8%
• A point B, firms’ costs and individuals’ wage demands increase, meaning output falls,
unemployment rises, and hence SRPC1 shifts to SRPC2.

Conclusion:
This means that in the short run, a trade off may occur, however in the long run, it is not possible to
expand beyond the vertical LRPC. LRPC is also called as Natural rate of Unemployment (UN).
Vertical long run Philips curve states that “there is no trade-off in long run”.

2.6: NATURAL RATE OF UNEMPLOYMENT: (NRU): (Type of Voluntary unemployment)

Even when the labour market is in equilibrium, there is a level of unemployment exist in the economy
which is unavoidable. This is known as the natural rate of unemployment.

• Frictional (Voluntary unemployment) +

• Structural Unemployment (mismatched with new technology)

NRU = Frictional Unemployment + Structural Unemployment

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MULTIPLE CHOICE QUESTIONS

11.1) If the price of bread increases from Rs.150 to Rs.165. Inflation rate will be?
a) 10% b) 5%
c) 2% d) 8%

11.2) If price index for year 2018 was 89.5 and during 2019 it become 91.5 then 2019 CPI will be:
a) 2% b) 2.5%
c) 2.2% d) 1.9%

11.3) A creeping inflation is:

a) Less than 5% b) Less than 2%
c) Less than 10% d) zero percent

11.4) Who gets benefit from inflation?

a) Debtor b) Creditor
c) Fixed income group d) All of above

11.5) A fall in interest rate can cause:

a) Cost push inflation b) Demand pull inflation
c) Expected inflation d) Wage spirals

11.6) Depreciation of domestic currency can cause:

a) A fall in AD b) A fall in AS
c) A rise in AD d) Both (a) and (b)

11.7) Which one in NOT a cause of cost-push inflation?

a) Rising labour cost b) Government spending on labour
development
c) Higher indirect taxes d) Rising Oil prices

11.8) A demand-pull inflation can be restricted by:

a) Limit wage increase b) Increase in direct taxes
c) Limit government spending d) All of the above

11.9) Which of the following would reduce inflation?

a) Increase in government spending b) Increase in direct taxes
c) Increase in indirect taxes d) All of the above

11.10) Value of money and inflation are:

a) Directly proportion b) Inversely proportion
c) Irrelevant d) Depends upon magnitude of change in rate
of inflation

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11.11) Which of the following is correct about inflation?

a) Rise in budget deficit b) Rise in price level
c) Fall in value of money d) b & c

11.12) Which one is the cause of inflation?

a) An increase in money supply with increase in production accordingly
b) An increase in money supply with decrease in production accordingly
c) An increase in money supply more than increase in production
d) An increase in money supply lesser than increase in production

11.13) Which one account for cost push inflation?

a) Increase in population b) Increase in indirect taxes
c) Increase in direct tax d) Increase in imports

11.14) Central bank can ________________________to control inflation:

a) Sell government securities b) Buy government securities
c) Rising discount rate d) a & c

11.15) Which is NOT a distortion to C.P.I?

a) Changing quality of products b) Spending pattern
c) Future expectations d) None of the above

11.16) Which one is most effective remedy to control inflation?

a) Raising interest rates b) Raising direct taxes
c) Reducing money supply d) All of above

11.17) Rise in discount rate by 10%, the inflation will:

a) Increase b) Decrease
c) Increase by 10% d) Decrease by 10%

11.18) Persistent rise in general price levels and then fall in real value of money is called:
a) Deflation b) Recession
c) Inflation d) Disinflation

Price index of current year – price index of base year

11.19) ________ = , Above formal represents.
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
a) R.P.I. (Retail Price Index) b) C.P.I. (Consumer’s Price Index)
c) S.P.I. (Sensitive Price Index) d) None of the above

11.20) If rate of inflation remains within the range of 1% - 2% per annum it said to be:
a) Moderate inflation b) Hyperinflation
c) High inflation d) Deflation

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11.21) Which of the following would reduce inflation?

a) An increase in direct taxes b) An increase in indirect taxes
c) Increase in government spending d) Increase in income

11.22) In the given diagram due to Fiscal stimulus aggregate demand shift towards right it will create.

a) Demand pull inflation b) Cost push inflation

c) Imported inflation d) Exceptional inflation

11.23) When faced with demand pull inflation, the response is to reduce the level of demand in the economy
by:
a) Raise in interest rate b) Raise in direct taxes
c) Reduce money supply d) All of the above

11.24) In the following diagram due to increase in wage rate S.R.A.S. shift towards left as result economy faces.

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 CH-11: INFLATION & UMEMPLOYMENT

a) Cost push inflation b) Demand pull inflation

c) Import cost push inflation d) Stagflation

11.25) Devaluation of currency will cause:

(i) Imported inflation (import cost push)
(ii) Demand pull inflation
(iii) Cost push inflation
(iv) Monetary inflation

a) (ii) & (iii) b) (i) & (iii)

c) (i), (ii) & (iii) d) (iii) & (iv)

11.26) Continuous or persistent rise in general price level due to devaluation of currency is known as
a) Import Cost Push inflation b) Monetary Inflation
c) Demand Pull Inflation d) Both a and c

11.27) Rise in wages increases the disposable income of people, which therefore increases demand for goods,
increasing prices. The rising price cause greater demand for higher wages therefore increasing
disposable income and so on ……. This effect is known as
a) Depression b) Stagflation
c) Wage – price spiral d) Demand pull inflation

11.28) Persistent rise in general price level due to increase in indirect taxes is known as:
a) Demand pull inflation b) Cost push inflation
c) Import cost push inflation d) Monetary inflation

11.29) The Phillips curve indicates that there is a trade-off between the objectives of:
a) inflation and economic growth b) inflation and unemployment
c) inflation and balance of payments d) inflation and exchange rate

11.30) On a short-run Phillips Curve, high rates of inflation coincide with:

a) low interest rates b) high unemployment rates
c) low unemployment rates d) low discount rates

11.31) According to the theory underlying the Phillips curve:

(i) the rate of change in money wages is positively correlated with the level of unemployment.
(ii) there is a natural rate of unemployment in the economy.
(iii) money wage stability is only possible at full employment.
(iv) the rate of change in money wages is negatively correlated with the level of unemployment.
Which of the above statements is correct?
a) (ii) and (iv) b) (i), (ii) and (iii)
c) (i), (iii) and (iv) d) (iv) only

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11.32) Slow economic growth and high unemployment refers to:

a) Stagflation b) Hyper inflation
c) Wage spiral inflation d) Deflation

11.33) An increase in unemployment rate along cost push inflation refers to:
a) Mild inflation b) Stagflation
c) Hyper inflation d) None of above

11.34) Rising unemployment during recession:

a) Cyclical unemployment b) Demand deficient unemployment

c) Frictional unemployment d) a & b

11.35) Unemployment that arises through inefficiencies in the labour market is:
a) Frictional unemployment b) Structural unemployment
c) Voluntary unemployment d) Seasonal unemployment

11.36) Natural rate of unemployment is the combination of :

a) Frictional and cyclical b) Frictional and seasonal
c) Frictional and structural d) Cyclical and structural

11.37) A situation where unemployment increases with high rate of inflation it is said to be:
a) Deflation b) Recovery
c) Stagflation d) Wage spiral

11.38) Long run Philips curve depicts?

a) A Trade-off between inflation and unemployment
b) No Trade-off between inflation and unemployment
c) High inflation along existing natural rate of unemployment
d) b & c

11.39) A situation in which labor force searching for job is unable to do so is known as:
a) Unemployment b) Recession
c) Stagflation d) None of the above

11.40) Unemployment which arises due to recession or deficient aggregate demand is known as:
a) Demand deficient unemployment b) Structural unemployment
c) Real wage unemployment d) Voluntary unemployment

11.41) ____________ occurs when people choose not to enter the labour force at the prevailing wage rate.
a) Frictional unemployment b) Structural unemployment
c) Voluntary unemployment d) Seasonal unemployment

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11.42) Unemployment which arises due to increases in wage rate is called.

a) Real wage unemployment b) Demand deficient unemployment
c) Structural unemployment d) Voluntary unemployment

11.43) Structural unemployment arises through _______________ of the labour market

a) Demand deficient b) Inefficiencies

c) Wage increase d) None of the above

11.44) Structural unemployment often occurs due to _____________ of skill sets

a) Misalignment b) advancement
c) enhancement d) All of the above

11.45) Relationship between rate of inflation and rate of unemployment is presented by a diagram known as:
a) L.R.A.S. b) S.R.A.S.
c) Aggregate demand d) Phillip’s curve

11.46) According to Milton Friedman Long-run Phillip’s curve is always.

a) Upward to right b) Downward to the right
c) Vertical d) Horizontal

11.47) Unemployment which arises due to increase in wage rate is called

a) Structural Unemployment b) Demand Deficient Unemployment
c) Real Wage Unemployment d) Frictional Unemployment

11.48) Which of the following is not lead to inflation?

a) Increase in money supply b) Increase in interest rate
c) Increase in tax exemption d) Increase government expenditure

11.49) Unemployment during the recession is called _____________________. (Select TWO)

a) Structural unemployment b) Cyclic unemployment
c) Frictional unemployment d) Demand deficient unemployment

11.50) Consumer price index (CPI) is a measure of the weighted average of prices of a basket of goods and
services.’
a) True b) False
11.51) Demand-pull inflation is an increase in price level in result of an increase in cost of production.
a) True b) False

11.52) Wage-price spiral means rise in wages increases the disposable income of people, which therefore
increases demand for goods, increasing prices.
a) True b) False

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11.53) “A short-run Philips Curve demonstrates an inverse relationship between unemployment and
inflation”.
a) True b) False

11.54) Structural unemployment is a kind of unemployment arises when people are searching for or are
transitioning from one job to another.
a) True b) False

11.55) Inflation is a measure of rate of increase in general price level of a predetermined basket of goods and
services of an economy’.
c) True d) False

11.56) Natural rate of unemployment is equal to frictional unemployment plus seasonal unemployment.
a) True b) False

ANSWER KEY

11.1) A 11.2) C 11.3) A 11.4) A

11.5) B 11.6) C,B 11.7) B 11.8) D

11.9) B 11.10) B 11.11) D 11.12) C

11.13) B 11.14) D 11.15) C 11.16) D

11.17) B 11.18) C 11.19) B 11.20) A

11.21) A 11.22) A 11.23) D 11.24) A

11.25) C 11.26) D 11.27) C 11.28) B

11.29) B 11.30) C 11.31) A 11.32) A

11.33) B 11.34) D 11.35) B 11.36) C

11.37) C 11.38) D 11.39) A 11.40) A

11.41) C 11.42) A 11.43) B 11.44) A

11.45) D 11.46) C 11.47) C 11.48) B

11.49) B,D 11.50) A 11.51) B 11.52) A

11.53) A 11.54) B 11.55) C 11.56) B

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TEST-11

Q-1) Average price level sustained decrease is called:

a) inflation b) deflation

c) recession d) stagflation

Q-2) The sum of frictional and structural unemployment is called:

a) Demand deficient unemployment b) Cyclic unemployment

c) Natural rate of unemployment d) Wage classical unemployment

Q-3) When inflation rate below 5% then it is said to be __________________ inflation:

a) Trotting b) Creeping
c) Moderate d) Stagflation

Q-4) Identify the type of unemployment when wages are set above equilibrium wage?
a) Frictional b) Cyclical
c) Structural d) Wage-classical

Q-5) Unemployment during the recession is called _____________________. (Select TWO)

a) Structural unemployment b) Cyclic unemployment
c) Frictional unemployment d) Demand deficient unemployment

Q-6) Which of the following will not lead to inflation? (Select TWO)
a) Increase in money supply b) Increase in interest rate
c) Increase in tax exemptions d) Increase in competition

Q-7) According to Friedman long run Philips curve is ______________ at natural rate of unemployment.
a) Positive b) Negative
c) Vertical d) Horizontal

Q-8) In Philip’s curve, higher inflation refers to ____________________ unemployment

a) Lower b) Higher
c) No change d) Same

Q-9) Inflation means rise in value of goods and services and prices of financial instruments
a) True b) False

Q-10) slow economic growth combined with high unemployment is called ________________?
a) Deflation b) Inflation
c) Stagflation d) Moderate inflation:

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 CH-12: Banks, Credit and Monetary Policy

CHAPTER-12

“ Banks, Credit and Monetary Policy ”

PART-01: BANKS:
1.1: STATE BANK OF PAKISTAN: 276
1.2: OTHER BANKS: 278
1.3: FUNCTIONS OF COMMERCIAL BANKS: 279

PART-02: CREDIT:
2.1: TYPES OF CREDIT 279
2.2: ADVANTAGES & DISADVANTAGES OF CREDIT 280
2.3: CREDIT CREATION PROCESS: 281

PART-03: MONETARY POLICY:

3.1: TYPES OF MONETARY POLICY: 283
3.2: INSTRUMENTS OF MONETARY POLICY: 284
3.3: OBJECTIVES OF MONETARY POLICY: 286
3.4: LIMITATIONS OF MONETARY POLICY: 286

PART-04: MULTIPLE CHOICE QUESTIONS & TEST-12:

MCQ 287
TEST-12 294

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 CH-12: Banks, Credit and Monetary Policy

Part-01: BANKS:

Central bank:
Central bank is known as the father of banking system or watch dog of monetary system of the
country. It is also concerned with meeting a number of objectives such as:

• provide banking and other financial services to commercial banks and government.
• currency stability, credit control, Economic growth, full employment, low inflation and
equilibrium in balance of payment.
• To implement policies of the state and to exercise its power of issuance currency and its
circulation in the country’.

1.1: STATE BANK OF PAKISTAN:

The "State Bank of Pakistan (SBP)" is the central bank of Pakistan that plays role in the management
of financial systems of the country. The basic features of State Bank of Pakistan are to prepare the
monetary policy of the government of Pakistan, and organization, management of the entre
economic, banking, and financial systems. National Bank of Pakistan is the largest commercial bank
of Pakistan. Authorized Capital of SBP at the time of establishment was PKR 30 billion.

Functions of Central Bank (SBP):

1. Sole supplier of currency:

The central bank has the responsibility of supplying the notes and coins throughout a country. It
also has greater control over it.

Two systems are usually adopted to issue currency notes:

• Fixed Fiduciary System: This system allows the note issuing authority to issue currency
notes up to a certain limit without backing reserves or precious metals etc. But any note
issued beyond this limit must be backed by 100% reserves.

• Proportional Reserve System: This is a flexible system of note issuance and is popular in
most of the countries of the world. Under this system central bank can issue currency notes
by keeping a certain percentage of reserves in form of gold, silver or foreign currencies.
(In Pakistan reserve requirement varies from 30% - 40%)

2. Banker to the government:

It offers advice upon the public debts of a country through working with a government. And also
providing funding to governments for its projects, in the same way a commercial bank would to
its customers.

3. Banker to the banks:

By holding cash reserves from each bank for safe keeping, the central bank brings a level of
protection to the banks. Further, a central bank can offer a counselling service to commercial
banks if ever they find themselves in financial difficulty, and in need of advice.

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 CH-12: Banks, Credit and Monetary Policy

4. Lender of last resort:

If a commercial bank is unable to use other sources to meet its financial requirements, then they
use the central bank. This brings greater liquidity to the system, and helps protect savers’
deposits.

5. To control inflation:
SBP uses method of open market operation techniques. such as for controlling the currency
circulation in the country, fixing rate of interest, fixing the foreign exchange rate and controlling
the banking loans in the country.

6. Promotes Islamic Banking:

SBP gave the order to the commercial bank that they establish a separate counter for consumers
wishing to deposit in an Islamic mode of investment then.

7. Promotes Export and discourage Imports

SBP makes possible for exporters to get easy foreign remittance in the country and also
discouraged unnecessary import from foreign country, particularly luxury goods and services

8. Exchange rate controls:

The central bank has control over a country’s foreign currency, and gold reserves. These are used
in times to manipulate the exchange rates and to achieve objectives, such as the balance of
payments.

9. Custodian of Monetary Reserves:

Central bank serves as custodian of monetary reserves such as gold and foreign currencies.

10. Clearing agent:

As all commercial banks have accounts with the central bank, when undertaking transactions,
they can do so within the central bank, reducing the necessity of issuing and transferring cash.

11. Established Financial institutes:

To improve the performance of financial and economic matters of Pakistan. For facilitation of
government and general consumers, SBP establishes NBP (National Bank of Pakistan). it is an
agent to SBP that handles treasury transactions for the government of Pakistan

12. Establish specialised banks:

The govern men t of Pakistan established two banks under SBP for the promotion of the
agriculture sector and the industry sector, Zarai Taraqiyati Bank (ZTB) and Industrial
Development Bank of Pakistan (IDBP).
Both banks give soft loans to consumers for the development of the agriculture and industrial
sectors

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1.2: OTHER BANKS:

Bank:
• “A financial institute licensed by the government to receive deposits, which then invests these
funds in a number of securities.”
• “Bank is a financial institution which receives deposits and issues loans.”
• Bank is ‘a financial institution which is engaged in borrowing and lending of money.”

Financial intermediaries:
A financial institution through which savers can indirectly provide funds to borrowers. e.g. banks,
mutual funds and pension funds.

Types of banks:

1. Commercial bank
A bank targeted at the mass-market in which individual customers can purchase bank services:
mortgages, checking accounts, personal loans, and other bank services.
For example: Meezan Bank, Askari Bank, MCB Bank etc.

2. Investment banks:
Investment banks acts as a financial intermediary that undertakes a number of financial services
for clients. Investment banks do not accept deposits.
For example: Al-Baraka Islamic Bank, Ammar Investment, Bank Alfalah, Bank Al-Habib Ltd., etc.

3. Retail bank:
A retail bank is often a branch of a commercial bank that deals with the deposits and loans from
large businesses and corporations.

4. Cooperative bank:
This is a type of financial institution that provides banking and other financial services to its
members

5. Specialized bank:
A bank targeted to a specific section of the economy in which firms and customers can have access
to specialized forms of banking services.

For example: the Agricultural Development Bank of Pakistan (ADBP) provides long, medium- and
short-term loans to agriculturalists, IDBP, (SME) and HBFC

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1.3: FUNCTIONS OF COMMERCIAL BANKS:

• Receiving Deposits: commercial bank is to receive deposits to earn profit (in form of interest).

• Advancing Loans:
Banks issues loan against some returns (interest) to those who need funds for their domestic or
business activities.

• Lockers Facility:
Commercial banks also offer some safety lockers to general public to keep their valuables such
as jewellery and other secret documents. Banks charge a nominal fee against this facility.

• Credit Creation:
This is a process by which commercial banks generate funds for further loans. This process will
be covered in detail in subsequent section of this chapter

• Discounting of Bills of Exchange: Bill of exchange is an instrument which is used to make a

credit transaction possible. Seller of goods receives documentary evidence, guaranteeing that
buyer will make payment within promised time. If seller needs money before its promised time,
he can get money from bank against this bill of exchange. Bank will deduct some amount as the
payment is being made before maturity. This process is called discounting of bill of exchange.

Part-02: CREDITS:

Credit or Credit money:

A contractual agreement whereby a borrower receives something of value in the present, in exchange
for payment in the future, generally with interest. E.g., IOU’s, bonds and money market accounts.

Maturity
Period of time for which a financial instrument remains outstanding

2.1: TYPES OF CREDIT

• Bank credit:
This type of credit exists when an individual or firm goes to a bank, receives an amount of money
against some security and then pays back the amount over a period of time.

• Trade credit:
This exists between a customer and a seller, usually in the commercial sector. A purchaser
can order a good, receive the good, and then pay for it after a certain period of time
i.e.,30, 60 or 90 days.

• Advances:
Amount taken in advance from any customer with promise of providing goods in future.

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2.2: ADVANTAGES & DISADVANTAGES OF CREDIT

Advantages of credit:
The credit money has the following advantages:

Spending & consumption:

Credit money allows immediate consumption of expensive goods, based on future earnings (this
includes houses, education, cars, which could otherwise not be bought).

Economic policies:
If there are inflationary trends in the economy, government increases the interest rate. This directs
people to convert their cash in credit money to gain interest. This will reduce the cash holdings and
will help to decrease inflation.

Working of banks & financial institutions:

Credit money is the basis for the functions and operations of banks and financial institutions.

International trade:
Credit money has also greatly expanded the international trade. The difference between costs of
production among various parts of world can be calculated with money to value scarce as well as
abundant resources. This difference in costs leads to the gains of international trade

Government:
Governments need credit money to perform all such functions as maintenance of law and order,
defense expenditure, provision of justice, pension etc.

Disadvantages of credit money:

The Inflation Problems:

Credit creation might increase money supply in the country which may cause inflation.

Creation of monopolies:
Commercial banks generally advance loans to large scale enterprises, industrialists and business due
to their strong financial position. This may lead to establish monopolies.

Economic Instability:
Excess credit creation becomes a cause of inflation and over investment which may result in
Economic Instability

Unproductive loans:
Easily available credit money turns into unproductive loans which become wasteful use of credit
money.

Income inequalities:
Only rich can meet pre-conditions for obtaining credit. They can get heavy loans and make more
money by investing them into more profitable activities.

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2.3: CREDIT CREATION PROCESS:

To understand this system, we will use hypothetical data regarding different banks engaged in the
process. Suppose banks are engaged in the process of credit creation. Bank A receives a new deposit
(initial deposit) or Rs. 1000 million. Assuming the reserve requirement of central bank is 10%, a bank
can issue a new loan of Rs. 900 million (90% of the deposited amount).

HOW MUCH MONEY CAN BE CREATED? / CREDIT MONEY MULTIPLIER:

Credit money multiplier is reciprocal of reserve ratio (in case of no leakage of cash withdrawal).
How much money, banks can create if the reserve ratio (r) is 10% and initial deposit is Rs. 1000
million
1 1
Money Multiplier (MM) = Reserve Ratio = 10% = 10

Total Credit Creation = Initial deposits x MM

= 1000 x 10 = 10,000

Credit Money Multiplier (With Leakage):

1
Total Credit Creation = Initial Deposit x Reserve Ratio+Leakage

PROCESS OF CREDIT CREATION

POSITION OF BANK New Deposited New loan NEW RESERVES

(10%)

Bank A 1000 900 100

Bank B 900 810 90
Bank C 810 729 81
Sum of remaining 7290 6561 729
Banks (Balancing)
Total 10,000 9,000 1,000

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Assumptions of Credit Creation:

• Unchanged reserve requirements by central bank:

Reserve requirements should remain same. Changing reserve requirements by central bank can
cause a greater fluctuation in lending ability of commercial banks.

• Amount of initial deposit:

Amount of credit is dependent on the initial size of the money supply. The larger this is, the more
credit can be created.

• No prompt cash requirements:

Cash requirements by depositors can affect the process of credit creation. Hence, it is assumed
that there are no immediate cash requirements in the economy.

• Excess reserves by commercial banks:

Some banks will choose to hold additional reserves for strategic reasons. The fact that they hold
onto more of their reserves, means that they pass on less to the next bank, and therefore the effect
of the multiplier will decrease.

• Developed banking system:

It is further assumed that a developed banking system, along with financial innovations are
existing in the country which keeps cash requirements limited in the country.

Limitations of credit creation:

• Total amount of cash:

Amount of credit is dependent on the initial size of the money supply. The larger this is, the more
credit can be created.

• Size of reserve ratio:

The lower the ratio requirements are, the more credit can be created. In many countries, there is
a minimum level (usually 20%)

• Liquidity Preferences:
In period of high inflation, people may not wish to hold their money in banks that would mean
less money is available to banks thereby less credit would be created.

• Availability of quality securities:

If high valued collateral assets are not available, less credit would be created and vice versa.

• Central Bank policies:

The central bank may utilise a number of instruments to control how much credit is created by
banks.

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Part-03: MONETARY POLICY

Monetary policy
• “The policy which is adopted by central bank of a country to control supply of money and
credit is knows as monetary policy”.
• “Monetary policy refers to measures taken by central bank to influence macroeconomic
activity especially by controlling money supply and credit by changing rates of interest.”

3.1: TYPES OF MONETARY POLICY:

Types of Monetary Policy:

1. Expansionary Policy/Anti Deflationary Monetary Policy

2. Contractionary Policy/Anti-Inflationary Monetary Policy

Expansionary policy LRAS

An expansionary monetary policy means,

when the central bank wishes to increase SRAS
the level of aggregate demand within an
economy.
Price Level

P1
Expansionary monetary policy is used to
achieve
P0
• Economic growth
• Full employment AD1
• Equilibrium in Balance of payment

AD0
Y0 Y1 Yf Real Output
Contractionary policy LRAS

A Contractionary monetary policy means,

SRAS
when the central bank wishes to decrease
the level of aggregate demand within an
economy.
Price Level

P0
Contractionary monetary policy is used to
lower the inflation. P1
AD0

AD1

Y1 Y0 Yf Real Output

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3.2: INSTRUMENTS OF MONETARY POLICY:

There are two types of Instruments

1. Quantitative Controls:
2. Qualitative Controls:

1. Quantitative Controls:

Open Market Operations: (OMO)

Open market operations mean buying and selling of government securities by the central bank in the
open market

If central bank wishes to reduce the level of aggregate demand in the economy:

• central bank will sell government securities to dealers and commercial banks in the market.
• In return, dealers and commercial banks pay money to the central banks.
• As cash in hand of commercial banks decrease, their ability to create money decreases.
• Consequently, the level of money supply tightens, and aggregate demand declines.

Fall in cash
Bought by Tight Rising
Selling of reserves of Control on
commerce Money Interest Fall in AD
Securities commerci Inflation
-al banks Supply Rate
al banks

Reserve requirements:
In order to keep the reserves safe, commercial banks will have deposited some particular percentage
at the central bank.

The central banks are able to reduce the level of aggregate demand in an economy by changing the
reserve requirements:

• By increasing the level of reserves, this reduces the amount of credit available in the economy.
• Lower the availability of credit, lower the money supply in the economy.
• Consequently, interest rates rise and firms are discouraged from borrowing to invest more
money.
• The effect of tight money reduces the level of aggregate demand (AD) = (C+I+G+(X-M),
causing a drop in output, employment and inflation.

Increase in Lesser Tight Rising

Less Control on
Reserve ability to money Interest Fall in AD
Investment Inflation
Ratio loan out supply Rates

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Discount Rate (or Bank Rate) Policy:

It is also called discount rate. It is a rate at which central bank rediscount bills of exchange. By
discounting a bill of exchange actually central bank is providing loan to commercial banks. By
changing the bank rate, central bank indirectly influences the market rate of interest

Increasing Rising Lessen Tight Rising Control on

Cost of loan able Money Interest Fall in AD
Bank Rate Inflation
Borrowing funds Supply Rates

Exchange Rates:
Central bank can buy or sell foreign currencies to ensure that exchange rate does not adversely affect
the economy.

Credit Rationing:
Fixing the maximum limit of loan issue, by central bank to its member commercial banks is called
credit rationing. By changing this limit central bank can control money supply in the economy.

2. Qualitative Controls:

Changes in Marginal Requirements:

Marginal Requirement refers to the difference between value of security demanded by central bank
to advance loan to commercial banks and the amount of loan actually issued. Central bank advances
loan to commercial banks against some securities. In order to control money supply central bank can
change this margin.

Moral Persuasion:
Central bank can morally persuade commercial banks to take specific steps that are consistent with
the central bank’s macroeconomic objectives. This can be done through personal discussion and by
issuing non-obligatory directives.

Direct Action:
This is a severe action that Central bank exercises only when commercial bank does not cooperate or
refuses to follow the policies of central bank. The central bank may take direct action in a number of
ways such as;
• It can impose fine and penalty to bank who is not cooperating.
• It may refuse discount facility to the bank under consideration.
• It may change the rates over the bank rate for particular bank etc.

Special Deposit:
Central Banks offers special deposits to commercial banks for short term on which it offers more
attractive rate of interest than the market. This deposit reduces money supply in market.

Prudential Control:
Central Bank can control credit by issuing some articles & regulations related to credit volume which
are known as Prudential control

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3.3: OBJECTIVES OF MONETARY POLICY:

1. Inflation: Keeping inflation low and steady for a more stable economic performance.
2. Economic growth: With appropriate economic policy, the government wishes to develop overall
per capita income within the country.
3. Exchange rate stability: Achieve stable exchange rates between countries in part through
adjusting the balance of payments.
4. Full employment: It is necessary to increase production and demand for goods, allowing
resources to be fully utilised for the economy to reach full employment.
5. Credit control: Making banks exercise control over their issuance of credit, but also ensuring
that the most vulnerable in society are receiving their fair share.
6. Correction of Current Account Deficit: One of the major objectives of monetary policy is the
correction of balance of payment or current account deficit. It can be done by variation in rate of
interest specially on bonds.

Conflict between Objectives:

It is not possible to achieve all of these objectives at once – some conflict exists between them.

1. Price stability versus full employment:

If economy want to achieve full employment, central bank will apply EMP (Expansionary policy)
to increases aggregate demand. Doing so could drive up inflation, putting more pressure on the
price stability target.

2. Economic growth vs exchange rate stability:

In order to boost economic growth, a central bank may decide to manipulate exchange rates to
increase the likelihood of exports. Doing so could cause instability in exchange rates.

3. Economic growth vs credit control:

A way to grow the economy might be through the expansion of credit, as it would spur investment
and spending. However, this comes with heightened economic risk of credit defaulting.

3.4: LIMITATIONS OF MONETARY POLICY:

1. Existence of non-monetary sector:

In developing Countries large portion of society are not using money for exchange (for example
bartering in rural areas), then monetary policy fails to implement its policies.

2. Existence of non-banking financial institutions:

These are organizations that offer credit to consumers, however do not come under the
supervision of the central bank.

3. High liquidity in financial markets:

If the central bank tries to tighten money supply, agents can counter this by creating their own
liquidity.

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4. Time lags:
The effects of a monetary policy will often take time to occur. Therefore, a central bank must
have to predict what will happen in the future, and implement policies accordingly. Sometimes
however there will be too much uncertainty for these policies to be correct.

5. Lack of co-ordination between monetary and fiscal policies:

In simple terms, monetary policies are implemented by the central bank, and fiscal policies are
implemented by the government. If the two organisations do not co-ordinate, they cannot
achieve their objectives.

LRAS
SRAS
Govt.

E2
CB
P2
Price Level

E1
P1

AD2
AD1

Y1 Y2 Yf Real Output (Y)

MULTIPLE CHOICE QUESTIONS

12.1) Which one of the following is not an asset of a commercial bank?

a) Balances at the central bank b) Money at call
c) Customers' deposits d) Advances to customers

12.2) Which of these appears as a liability on a bank’s balance sheet?

a) Reserves b) Checking accounts
c) Loans d) Investments and securities

12.3) If the reserve ratio is 40%, and Rs.10,000 is deposited in a commercial bank, what is the final outcome
for the economy?
a) Rs. 4,000 b) Rs. 10,000
c) Rs. 25,000 d) Rs. 40,000

12.4) Which of the following is not the function of a central bank?

a) Lender of the last resort b) Monetary policy
c) Fiscal policy d) Credit creation

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12.5) Which of the following is a central bank unable to do?

a) Influence banks to tighten or loosen their credit policies
b) Create a climate of monetary ease or restraint
c) Directly set market interest rates
d) Influence the interest rate on new treasury bonds

12.6) To counteract a recession, the central bank should:

a) Raise the reserve requirement and the discount rate
b) Sell securities on the open market and lower the discount rate
c) Buy securities on the open market and raise the discount rate
d) Buy securities on the open market and lower the discount rate

12.7) An increase in the cash reserve ratio would:

a) Decrease prices b) Reduce inflation
c) Control lending d) All the above

12.8) Which of the following is most likely to be affected by a change in interest rates?
a) Consumer spending b) Investment spending
c) Government spending d) Exports

12.9) A stimulative fiscal policy combined with a restrictive monetary policy will necessarily cause:
a) Gross domestic product to increase b) Gross domestic product to decrease
c) Interest rate to fall d) Interest rates to rise

12.10) The government makes a new issue of bonds and sells them on the open market, where they are
bought by private investors using cheques drawn on their banks.
Which of the following describes the effect this has on the commercial banks?

a) They can raise lending because their cash base will rise.
b) There is no effect on bank lending.
c) They must cut lending to maintain an appropriate ratio of cash to loans.
d) They will only be able to increase long term loans.

12.11) Which of the following is a financial intermediary?

a) Pension fund b) International monetary fund
c) State bank of Pakistan d) Stock exchange

12.12) Which of the following is not considered to be a credit instrument?

a) IOU b) Draft
c) Bond d) Stock

12.13) Which one is not a function of commercial bank?

a) Exchange rate determination b) Note issue
c) Exchange control d) All of the above

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12.14) Which function is performed by commercial bank?

a) Credit creation b) Utility services
c) Underwriting services d) All of above

12.15) If reserve requirement by central banks is 10% then a deposit of Rs.100,000 will increase to deposits
by:
a) 1,100,000 b) 110,000
c) 1,000,000 d) 1,010,000

12.16) Higher the reserve requirement:

a) Slower the process of credit creation b) Faster the process of credit creation
c) Will stop the process of credit creation d) Increase the rate of inflation

12.17) Reserve requirements by central bank and credit creation is:

a) Directly proportion b) Inversely proportion
c) Irrelevant d) Same

12.18) System of note issue by central bank in which 100% gold requirement is mandatory:
a) Proportionate reserve system b) Fixed fiduciary system
c) Deficit financing d) None of the above

12.19) Which function is performed by central bank?

a) Lender of the last resort b) Exchange control
c) Clearing agent d) All of the above

12.20) Custodian of the monetary reserve is:

a) Commercial bank b) Specialized bank
c) Cooperative bank d) None of the above

12.21) Which one is not considered as a quantitative control of central bank?

a) Changing reserve requirements b) Bank rate
c) OMO d) Moral persuasion

12.22) Direct action taken by central bank involves:

a) Fine and penalty to banks b) Refuse to discounting
c) Discrimination of interest rate among d) All of the above
banks

12.23) which one is not a conflict between objective of monetary policy?

a) Price stability and full employment b) Exchange rate stability and economic
growth
c) Economic growth vs credit control d) Economic growth and credit creation

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12.24) A contractionary monetary policy doesn’t involve?

a) Increasing interest rate b) Rising discount rate
c) Selling of government securities d) Increasing ATM limit

12.25) A process in which commercial bank gets loan form central bank is:
a) Credit rationing b) Discounting
c) Clearing house d) All of above

12.26) A financial institution which is engaged in borrowing and lending is called:

a) Financial intermediaries b) Commercial bank
c) Retail bank d) All of the above

12.27) __________ is contractual agreement whereby a borrower receives something of value in present in
exchange for payment in the future generally with interest.
a) Money b) Fiat money
c) Credit d) Foreign exchange

12.28) A bank targeted to a specific section of economy in which firms and consumers can have access to
specialized forms of banking services is known as:
a) Commercial bank b) Retail bank
c) Investment bank d) Specialized bank

12.29) The rate of interest that is inflation adjusted is known as:

a) Nominal rate of interest b) Real rate of interest
c) Bank rate d) Discount rate

12.30) When central bank wishes to stimulate the level of aggregate demand within an economy, it likely to
use.
a) Liberal monetary policy b) Expansionary monetary policy
c) Inflationary monetary policy d) All of the above

12.31) In the given diagram aggregate demand shift towards right. It is the result of following policy

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 CH-12: Banks, Credit and Monetary Policy

a) Decrease in rate of interest b) Decrease in reserve ratio

c) Purchasing bonds d) All of the above

12.32) In the following diagram supply of money is perfectly inelastic. According Keynes. In this situation
monetary policy will be.

a) Ineffective b) Very effective

c) Uncertain d) None of the above

12.33) Value of credit money multiplier is reciprocal of.

a) Reserve ratio b) Bank rate
c) Exchange rate d) Bond price

12.34) Duration of trade credit is generally not more than.

a) 30 days b) 60 days
c) 90 days d) One year

12.35) Inefficient and liberal credit policies can lead to:

a) Inflation b) Creation of monopolies
c) Economic instability d) All of the above

12.36) Which one of the following would leads to a rise in bond price?
a) A fall in rate of interest b) A rise in rate of interest
c) An increase in liquidity preference d) A fall in reserve ratio

12.37) The difference between rate of inflation and nominal rate of interest is known as:
a) Bank rate b) KIBOR
c) Real rate of interest d) Discount rate

12.38) Which of the following would be likely to occur if there is an increase in money supply by central bank:
(i) Inflation
(ii) Fall in rate of interest
(iii) Fall in exchange rate
(iv) Fall in price of bonds

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 CH-12: Banks, Credit and Monetary Policy

a) (i) & (ii) b) (ii) & (iv)

c) (i) & (iii) d) (iii) & (iv)

12.39) Which one of the following is/are the intermediate target of monetary policy?
(i) Market rate of interest
(ii) Supply of money
(iii) Economic growth
(iv) Inflation

a) (i) & (iv) b) (i) & (ii)

c) (ii) & (iii) d) (iii) & (iv)

12.40) If central bank wishes to reduce the rate of inflation which of the following policy / policies would be
appropriate.
(i) A rise in bank rate
(ii) A rise in reserve ratio
(iii) Restrictions on the level of imports
(iv) Promotion of exports
a) (iii) & (iv) b) (ii) & (iv)
c) (i) & (iii) d) (i) & (ii)

12.41) If central bank wishes to reduce current account deficit which of the following policy would be
appropriate.
a) A rise in rates of interest on bonds b) A rise in reserve ratio
c) Fixed exchange rate d) None of the above

12.42) Main objectives of monetary policy are ___________.

a) Certain b) Conflicting
c) Uncertain d) long-term

12.43) In order to increase sales of bonds, Central bank increases

a) Bank Rate b) Reserve Ratio
c) Credit Quota d) All of the above

12.44) Authorized Capital of SBP at the time of establishment was:

a) PKR 3 billion b) PKR 5 billion
c) PKR 30 billion d) PKR 500 billion

12.45) Which bank provide service to its members only.

a) Commercial bank b) Retail bank
c) Specialized bank d) Cooperative bank

12.46) A Bank is ‘A financial institute licensed by the government to receive deposits, which then invests
these funds in a number of securities.
a) True b) False

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12.47) An expansionary monetary policy will be used when the central bank wishes to reduce the level of
demand within an economy.
a) True b) False

12.48) Financial intermediaries are a financial institution through which savers can indirectly provide funds
to borrowers
a) True b) False

12.49) A retail bank acts as a financial intermediary that undertakes a number of financial services for clients.
a) True b) False

12.50) Open market operations mean buying and selling of foreign securities by the central bank in the open
market
a) True b) False

12.51) Fixing the maximum limit of loan issue, by central bank to its member commercial banks is called
credit rationing.
a) True b) False

12.52) Cooperative bank is a type of financial institution that provides banking and other financial services
to its members only.
c) True d) False

ANSWER KEY
12.1) C 12.2) B 12.3) C 12.4) C

12.5) C 12.6) D 12.7) D 12.8) B

12.9) D 12.10) C 12.11) A 12.12) D

12.13) D 12.14) D 12.15) C 12.16) A

12.17) B 12.18) B 12.19) D 12.20) D

12.21) D 12.22) D 12.23) D 12.24) D

12.25) B 12.26) D 12.27) C 12.28) D

12.29) B 12.30) D 12.31) D 12.32) A

12.33) A 12.34) C 12.35) D 12.36) A

12.37) C 12.38) A 12.39) B 12.40) D

12.41) A 12.42) B 12.43) A 12.44) C

12.45) D 12.46) A 12.47) B 12.48) A

12.49) B 12.50) B 12.51) A 12.52) A

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TEST-12
Q-1) Which of the following is a lender of last resort?
a) SBP b) NBP

c) Industrial bank of Pakistan d) Agriculture development bank of

Pakistan
Q-2) Reserve ratio is 10%, leakage is 8% and initial deposit is 10 million. Calculate total credit creation.
a) 100 million b) 55.55 million
c) 125 million d) None of the above

Q-3) Which is not included in Central bank monetary policy.

a) Market operations b) Reserve requirement
c) Exchange rate d) Discount rate

Q-4) Which of the following is NOT the objective of Monetary policy.

a) To keep inflation low b) Exchange rate stability

c) To control fiscal deficit d) Credit control

Q-5) Which of the following is not a function of commercial bank;

a) Education loan b) Providing Locker facility
c) Controlling credits d) Discounting bill of exchange

Q-6) Which of the following is not the quantitative control of monetary policy?
a) Bank rate b) Credit rationing

c) Special deposit d) Change in reserve requirement

Q-7) Which of the following not function of qualitative control;

a) Change in marginal requirement b) Direct Action

c) Moral persuasion d) Reserve requirement

Q-8) Which of the following is not the feature of State bank of Pakistan?
a) Issuance of currency b) Credit creation

c) Clearing agent d) Exchange rate control

Q-9) Which TWO of the following are correct about contractionary monetary policy.
a) Increase in rate of interest b) decrease in rate of interest

c) Increase in money supply d) decrease in money supply

Q-10) Which of the following is a tool for light/loose monetary policy? (Select TWO)
a) Increase money supply
b) Increase services requirement
c) Buying securities in open market by central bank
d) Increase rate of interest

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CHAPTER-13

“ Balance of Payment and Trades ”

PART-01: BALANCE OF PAYMENT

1: 296
1.1: TERM OF TRADE: 298
1.2: IMPORTANCE OF BALANCE OF PAYMENTS CALCULATION 298
1.3: CURRENT ACCOUNT DEFICIT 299

PART-02: EXCHANGE RATE:

2: 301
2.1: TYPES OF EXCHANGE RATE SYSTEMS: 302
2.2: GOVERNMENT POLICY TO INFLUENCE EXCHANGE RATES: 303
2.3: DEVALUATION (J-CURVE): 304
2.4: REVALUATION (INVERSE OF J-CURVE): 306

PART-03: MULTIPLE CHOICE QUESTIONS & TEST-13

MCQ 307
TEST-13 313

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Part-01: BALANCE OF PAYMENT:

What is a Balance of Payment Account?

Balance of payment is a comprehensive record of a country’s economic transactions (Import and
Export) with rest of the world during course of one year. This systematic annual record of such
transactions is known as balance of payments.

It is made up by a combination, in a country, of:

• The current account
• The capital accounts
• Official financing account

Summary Balance of Payments as per BPM6- June 2021

(Rs. (billions))

Balance of Payments (A Hypothetical Data)

BOP Items Rs. (billions) Rs. (billions) Rs. (billions)
a) Current Account Exports Imports Net Balance
(Rs. billions)
Trade-in-Goods 10 (22) -12
Trade-in-Services 11 (29) -18
Investment Income /Primary Income 24 (48) -24
Unilateral Transfers/Secondary 16 (12) +4
Income
Total of Current Account -50

b) Financial and Capital Account:

Net Foreign Direct Investment +30
Net Portfolio investment -25
Net Financial derivatives +5
Financial Account Balance +10
Net Official Reserves Assets +20
Net Govt.'s Borrowings +18
Capital Account Balance +38
Total of Financial and Capital Account (10 + 38) +48
Errors & Omissions +2
Overall Balance of Payments 0

Note:
Positive figure represents inflow (exports/credit); negative figure represents outflow (i.e.
imports/debit).

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The current account = (records all exports and imports of goods and services)
The current account is made up of Trade-in-Goods, Trade-in-Services, Investment Income and
overseas transfers.

1. Trade-in-Goods:
This includes imports and exports of physical goods e.g., finished goods, semi-finished goods, and
component parts for assembly

2. Trade-in-Services:
These services include tourism, financial services and consultancy.

3. Investment Income /Primary Income:

Overseas activity that leads to a flow of money back to the country.
• interest received from direct investment,
• the activities of subsidiaries,
• dividends earned from owning shares in foreign firms

4. Unilateral Transfers/Secondary Income:

This includes payments and receipts of worker Remittances or overseas aid.

The capital and financing account = (records inflows and outflows of capital.)
These accounts record the flow of capital and finances between the domestic
country and the rest of the world.

Financial Account:
1. Real Foreign direct investment:
A domestic firm setting up a factory in another country.

2. Portfolio investment:
A domestic investor buying shares in a business that is already established. Such investors have
no control over these companies.

3. Financial derivatives:
financial instruments where the underlying value is based on another asset.

Capital Account:
4. Reserve assets:
Central Bank will use official reserve assets (e.g., Foreign Currency, Gold) to cover deficits and
imbalances.

Net errors and omissions:

If there is a deficit, it is balanced by:
• Selling gold, or other financial reserves
• Borrowing from other Central Banks

If there is a surplus, it is balanced by:

• Buying gold, or other financial reserves
• Paying off debts

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Deficit in balance of payments

A deficit in balance of payments usually refers to a current account deficit that means the country
has spent more on imports than it has received from exports.

Balance of Trade: (BOT)

Balance of Trade include imports and exports of visible goods (i.e., tangible goods like mobile, Oil,
machinery, shoes) only.

Balance of Payment: (BOP)

Includes both visible and invisible goods (i.e., intangible like financial, IT, insurance and consultancy
services).

1.1: TERM OF TRADE: (TOT)

Terms of trade:
TOT is the ratio of export prices to import prices.

TOT = index of export prices / index of import price x 100

Example:
Suppose, over a given time period the export price index is raised by 20% and the
import price index raised by 10%, then the terms of trade can be calculated as:
𝟏𝟐𝟎
Terms of Trade = x100
𝟏𝟏𝟎

TOT = 109.09 or approx. 109 means the terms of trade have improved by 9%.
Any change greater than 100 shows improvement in TOT and vice versa

• The terms of trade are said to improve when export prices rise faster than import prices and
vice versa.
• Improving terms of trade do not necessarily result in a fall in the balance of payments deficit.
This is because the terms of trade refer to prices whereas the balance of payments takes both
prices and quantities into account.
• For example, an improvement in the terms of trade caused by an increase in the price of exports
may bring about a proportionately greater fall in the demand for exports leading to a worsening
of the balance of payments situation

1.2: IMPORTANCE OF BALANCE OF PAYMENTS CALCULATION

Balance of payment is an important indicator to check direction of economic performance of a

country. It helps state authorities to take significant policy decision.

1. A deficit in BOP helps government to work on weak areas of the economy.

Example: Suppose that the balance of payments of a country is in deficit, means volume or
value of exports is less than its imports. Then government should struggle to improve its
export quantity or quality.

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2. A protection policy of the government gets guidance from position of balance of

payments.
Example: If balance of payments of a country is in deficit, it means government should put
some restrictions on imports or should provide subsidies to improve its balance of payments.
3. Position of balance of payments also helps government for budget allocation among
different sectors of the economy.
Example: government should allocate sizeable amount in budget on those sectors of the
country which has shown poor performance in recent years.
4. It provides guidance to state institutions to make sound fiscal and monetary policies
in the country.
Example: If balance of payments is in deficit, means government should reduce interest rate
to boost its investment or increase its expenditures to support production process.
5. Devaluation policy about home currency is also based on position of balance of
payments.
 Example: In case of deficit, government should encourage exports or discourage imports.
Devaluation policy can be an effective tool in this regard

1.3: CURRENT ACCOUNT DEFICIT

What is a current account deficit?
Current Account Deficit (or Deficit in Balance of Payment) means outflow of funds (i.e., imports) of a
country is greater than inflow of funds (i.e., exports).
The current account is not required to be balanced, 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.

Causes of Current Account Deficit:

1. High income elasticity of demand for imports:
With strong consumer spending, the volume of imports will increase swiftly.

2. 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.

3. 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.

4. Inelastic imports:
One of the major reasons of current account deficit is inelastic imports.

5. Domestic Inflation:
If a country is facing high inflation, then individual of country starts preferring cheap imports
which increases current account deficit

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Corrective measures to current account deficit:

There may be monetary and non-monetary measures to correct current account deficit:

1. Monetary measures:
• Deflation:
Decrease in price of goods in domestic market (PAK) attracts foreigner to buy more goods
from this market, hence export will increase in PAK, causes correct in BOP.

• Exchange Controls on foreign reserves:

In an extreme version, a monetary authority may restrict general public to deal in foreign
exchange reserve to restrict import.

• Depreciation in Exchange Rate:

In case of depreciation of currency, export become cheaper and import become expensive.
This increase export and decrease import will correct the BOP.

2. Non-monetary measures to correct current account deficit:

• Tariffs:
These are duties placed upon imports. This directly increases the price of imports, making
them less attractive to the domestic market. This also gives domestic suppliers more
protection to increase the supply of their own goods.
Price Domestic
Supply

Po

World price + Tariff

WP + T
WP World price
Import Domestic
Demand

Qs1 Qs2 Qo Qd2 Qd1 Quantity

Import

• Quotas:
A government may fix a permanent amount of a good that may be imported into a country.

• Export promotion:
A government can help exporters to sell their goods and services on the international market
through organising exhibitions and trade fairs.

• Import substitution:
A country can reduce the level of imports that it buys, by becoming more self-reliant and
producing these goods and services domestically. This can be done through providing
specialist training, subsidies and tax assistance.

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Part-02: EXCHANGE RATE:

Exchange rate:
The exchange rate is the price of one currency expressed in terms of another currency.

Key Points:
• The level of demand for PKR is a direct function of foreign demand for Pakistani exports.
• The level of supply of PKR is a direct function of Pakistani demand for imports. The country
will sell PKR balances in order to obtain the foreign currency needed to buy them.
• There is demand for some currencies as an international medium of exchange.

Diagram of foreign exchange market

Exchange Rate of PAK Rs. In term of US $:

Exchange
Appreciation in

Rate
local currency

SRS
ER Rise

E
Dollar/Rs
Depreciation in
local currency

ER Fall

DRS

0
Quantity of Currency

Depreciation: Low/Fall in exchange rates:

A low exchange rate (a weak exchange rate) means that a local currency is worth less of the foreign
currency. Low exchange rate.
• making imports more expensive (Foreign goods are less attractive in Pakistan)
• making exports cheaper (Pakistani goods are more attractive for USA)

Example: Weak Pakistani rupee or low exchange rate from a Pakistani perspective
If the exchange rate moved to Rs. 200 to $1 the relative prices would change as follows:
a. How much would a Rs. 100,000 export cost in the USA?
Answer: 100,000 / 200 = $500
b. How much would a $500 import cost in Pakistan?
Answer: 500 x 200 = Rs.100,000
Example:
• If the price of a car costs Rs.40,000, and the exchange rate between US$ and Rs. was 1:4, then the car
would cost $10,000 to somebody buying in the USA.
• Every time a car is sold in US$, it increases exports, thus balancing the current account deficit.
• By depreciating the exchange rate to say 1:5, then the car would now be worth $8,000.

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• This will increase demand for cars that Pakistan exports, as well as increasing the price of any goods
that it may import. Therefore, correcting a current account deficit.

Appreciation: High exchange rates:

A high exchange rate (a strong exchange rate) means that a local currency is worth more of the
foreign currency. High exchange rate.
• making imports cheaper (Foreign goods are more attractive in Pakistan)
• making exports expensive (Pakistani goods are less attractive USA)
Example: Strong Pakistani rupee or a high exchange rate from a Pakistani perspective
Suppose the exchange rate is Rs. 100 to $1.
a. How much would a Rs. 100,000 export cost in the USA?
Answer: 100,000 / 100 = $1000
b. How much would a £1000 import cost in Pakistan?
Answer: 1000 x 100 = Rs.100,000

2.1: TYPES OF EXCHANGE RATE SYSTEMS:

A Government can follow two types of exchange rate policies i.e.

1. Flexible or Floating Exchange Rate System
2. Fixed Exchange Rate System

Flexible or Floating Exchange Rate System:

Definition:
Floating exchange rate is the rate set by the free forces of demand and supply of the currency in the
foreign exchange markets.

Advantages of Floating Exchange Rate System:

• Avoid the need for government intervention in the foreign exchange markets.
• Government can concentrate on internal issues such as unemployment and inflation.
• Governments do not have to spend or even hold foreign currency reserves.
• Deficit or surplus in Balance of payment is automatically corrected.

Fixed Exchange Rate System:

Definition:
Fixed exchange rate is the rate set at a fixed parity against one or more foreign currencies. In this
case the government agrees to buy or sell at this rate to stop fluctuations.

Advantages of Fixed Exchange Rate System:

• Avoids damaging speculation against the currency.
• Promotes free-trade as importers and exporters are released from exchange rate risk.
• Forces governments to follow responsible economic policies at home because excess
aggregate demand and inflation would make it very difficult to support the currency in the
long term.

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2.2: GOVERNMENT POLICY TO INFLUENCE EXCHANGE RATES:

The government may wish to influence exchange rates for a number of reasons:
• To stabilise the currency against the pressures of short-term speculation.
• To provide greater stability in order to encourage domestic firms to export more.
• To stimulate demand for exports or to reduce imports.

Main Policy instruments

• The domestic interest rate:
Raising the interest rate attracts speculative funds from abroad and increases demand for
rupees.

• Intervention purchasing or selling of currency by a central bank:

A central bank offers to buy or sell domestic currency at a set price. This means the rate will
not fall or rise above this rate.

• Structural adjustments to the behaviour of the economy:

Policy action to remove the sources of the deficits or surpluses which are causing the rate to
depreciate or appreciate

How government manage exchange rate to achieve reduction in import duties predetermined
goals.
Exchange
Rate SRs 1

S0Rs

Target Rate

Exchange Rate

DRs 1
D0Rs

Qd Qe Qs

If the government wishes that the rate be at Rt. Policy options are:
• Increase the domestic interest rate and hence shift the demand curve for rupees to D1.
• Purchase the surplus rupees of Qs - Qd using foreign exchange reserves.
Deflate the economy to reduce the demand for imports. This will shift the supply curve of rupees back
to S1

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2.3: DEVALUATION (J-CURVE):

Devaluation:
Devaluation means deliberately weakening the domestic currency against others; usually by
reducing its parity value within a fixed rate system.

The objective is to reduce balance of payments deficits by:

• making imports more expensive;
• making exports cheaper.

Reasons behind J-curve

In short Run (Inelastic Export and Import):

• Exports become cheaper while imports become expensive.
• Demand for exports increases but due to limited production capacity firms remain unable to
substantially increase in its exports immediately (inelastic exports)
• Demand for import decreases but due to limited import substitutes, substantial decrease in
import volume is not possible (inelastic imports)
• Hence in short run trade balance gets more worsen.

In Long Run (Elastic Export and Import):

• Exports become cheaper while imports become expensive.
• Firms are able to respond to the rising demand for exports (elastic exports)
• Substantial fall in demand for import because, import substitutes are available in long run
(elastic imports)
Hence, in long run trade balance will improve

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The effectiveness of the policy:

The effectiveness of the policy depends on:

The price elasticity of demand for imports.

If the demand is inelastic then a rise in the price of imports will not significantly reduce the import.
It will however increase total expenditure on imports thus deepening the deficit.

Demand for imports may be inelastic due to:

• Firmly entrenched preferences for overseas goods;
• Lack of flexibility of domestic firms to replace imports;
• Dependence on imported raw materials and food.

The price elasticity of demand for exports.

If demand for exports is price inelastic then a fall in their price will not significantly increase the
export. It will however reduce total income from export thus deepen the deficit.
Demand for exports may be inelastic due to:
• Poor perceived quality of exports;
• Lack of flexibility of domestic firms to take advantage of export demand

Deficit in BOP

Devaluation

Export Cheaper &

Import Expensive

Short Run Long Run

e.d < 1 e.d > 1

Lesser receipts More receipts

More payments Lesser payments

Worsen BOP Improved BOP

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2.2: REVALUATION (INVERSE OF J-CURVE):

Revaluation:
Revaluation removes current account surplus by making exports expensive and imports cheaper. If
a country revalues its currency, current account balance experiences inverse J-curve.
Inverse of J-Curve
BOP +ve

Time
BOP -ve

Effect of Revaluation on Current Account:

Revaluation removes current account surplus by increasing imports and decreasing exports.
If a country revalues its currency, its current account balance experiences inverse J-Curve. In short-
run current account surplus may get better before decreasing.

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MULTIPLE CHOICE QUESTIONS

13.1) If the American dollar is overvalued relative to the Pakistan rupee:

a) Pakistani goods are cheaper than US goods.
b) The Pakistan rupee is undervalued relative to the dollar.
c) The rupee price of the dollar must rise.
d) The cost of Pakistani goods in the United States must be increasing

13.2) Index price of exports ÷ index price of imports is equal to:

a) Balance of trade b) Balance of payment
c) Terms of trade d) Inflation

13.3) Which of the following measures would immediately increase the cost of imports?
a) Tariff b) Quota
c) Embargo d) Subsidies

13.4) Currency is usually devalued to:

a) Increase exports b) Increase imports
c) Decrease inflation d) Increase prices

13.5) Which one of the following would appear as a debit item on the current account of the balance of
payments?
a) Payment of interest on debts owed to overseas commercial banks
b) Expenditure by tourists visiting the country
c) Overseas capital investment by domestic companies
d) Repayment of debts to overseas central banks

13.6) Which of the following is most likely to cause a country's balance of payments to move towards a
deficit?
a) A devaluation of that country's currency
b) An expansionary fiscal policy
c) A contractionary fiscal policy
d) A rise in the rate of domestic saving

13.7) The 'current account' of the balance of payments includes all the following items except which one?
a) The inflow of capital investment by multinational companies
b) Exports of manufactured goods
c) Interest payments on overseas debts
d) Expenditure in the country by overseas visitors

13.8) Why does one country purchase the currency of another country? (Select any TWO)
a) To sell bonds and stocks b) To purchase bonds and stocks
c) To sell items from other countries d) To purchase items from other countries

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13.9) Which one is the core part of balance of payments?

a) Current account b) Capital account
c) Financing account d) All of above

13.10) Which one is not the part of current balance of payments?

a) Trade in goods b) Trade in services
c) Financial derivatives d) Transfers

13.11) Which one is not the part of financing account?

a) Trade in services b) Financial derivatives
c) Portfolio investment d) Reserve assets

13.12) Balancing of bop deficit is possible through:

a) Buying of gold b) Paying-off deficit
c) Borrowing from other central banks d) All of the above

13.13) A term of trade refers:

a) Ratio of export price to import price b) Ration of import price to export price
c) Net exports d) None of the above

13.14) If in given period of time price index for export increased by 20% and price index of import raised by
10%, then the terms of trade will be:
a) 120 b) 109
c) 119 d) 99

13.15) During a given period of time if terms of trade (TOT) is 112, it is said:
a) TOT has declined by 12% b) TOT has improved by 12%
c) Depreciated by 2% d) Appreciated by 2%

13.16) Which one cause to deficit in BOP?

a) Import of primary goods and export of finished goods
b) Import of finished goods and export of primary goods
c) High income elasticity of import
d) b & c

13.17) When quota is more effective than tariff in order to improve balance of payments?
a) When export is more elastic b) When import is more elastic
c) When export is less elastic d) When import is less elastic

13.18) Depreciation of domestic currency is workable step of the state to improve balance of payments only if:
a) Country has export surplus b) There is no foreign debt
c) Import substitutes are available d) All of the above

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13.19) A depreciation of domestic currency will:

a) Make export cheaper b) Make export expensive
c) Make import cheaper d) Make no difference

13.20) High exchange rate for Pakistan will make:

a) Make export cheaper b) Make import expensive
c) Make export expensive d) No difference

13.21) If exchange rate moved to Rs 200 to $1, how much Rs.100000 export cost in U.S Dollar?
a) $ 50,000 b) $ 5,000
c) $ 500 d) $ 50

13.22) Demand for import will be price inelastic if:

a) High dependence on imported raw material
b) People are used to purchase imported goods
c) Import substitutes are not available
d) All of above

13.23) If exchange rate gets change from 100: 1 to 200: 1 it will make:
a) Increase in exports and decrease in imports
b) Increase in imports and decrease in exports
c) Increase in balance of payment deficit
d) A & b

13.24) Certain economies may want to appreciate their currency so as to temper demand, and make their
exports relatively more expensive trade in goods, it will make j-curve:
a) First deepen then improvement b) First improvement then worsens
c) inverse j-curve d) B & C

13.25) A record of all transactions that occur during a year between the residents of a country and overseas
residents is known as:
a) Balance of trade b) Terms of trade
c) Exchange rate d) Balance of payment

13.26) Balance of imports & exports of only visible items of a country during one year is known as:
a) Balance of payment at current account b) Balance of payment at capital account
c) Balance of trade d) Terms of trade

13.27) Balance of external assets & liability of an economy during one year is known as:
a) Balance of payment at capital account b) Balance of payment at current account
c) Balance of trade d) Terms of trade

13.28) The sum of the balance of payment accounts must always be _________.
a) Surplus b) Deficit
c) Zero d) None of the above

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13.29) A current account deficit must be matched by _______ in capital account.

a) Surplus b) Deficit
c) External assets d) All of the above

13.30) Trade of services like education services and tourism services are known as:
a) Trade of invisible items b) Trade of visible items
c) Balance of trade d) All of the above

13.31) If imports of a country are more than its exports. Balance of payment will be:
a) Favourable b) Unfavourable
c) Balance d) Zero

13.32) Surplus in balance of payment would lead to:

a) Revaluation of currency b) Devaluation of currency

c) Economic growth d) Rise in rate of interest

13.33) Economic growth in a country can leads to:

(i) Current account surplus
(ii) Current account deficit
(iii) Rise in rates of interest
(iv) Improvement in terms of trade

a) (ii) & (iv) b) (ii) & (iii)

c) (i), (iii) & (iv) d) (i) & (iii)

13.34) Devaluation of currency by a government can leads to:

(i) Increase in exports
(ii) Decrease in imports
(iii) Improvement in balance of payment in short-run
(iv) Improvement in terms of trade

a) (i) & (ii) b) (iii) & (iv)

c) (ii) & (iv) d) (i) & (iv)

13.35) The ratio between export price index of current year & import price index of current year is known as:
a) Balance of payment b) Balance of trade
c) Terms of trade d) Current account balance

13.36) An improvement in terms of trade means that there is necessary improvement in.
a) Balance of payment at current account b) Balance of payment at capital account
c) Balance of trade d) All of the above

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13.37) An improvement in terms of trade will be advantageous for a country if:

a) Imports are less elastic
b) Exports are less elastic
c) Imports & exports both are less elastic
d) Imports & exports both are more elastic

13.38) Devaluation of currency will be advantageous for an economy if:

a) Imports are less elastic
b) Export is less elastic
c) Imports & exports both are less elastic
d) Import & exports both are more elastic

13.39) _________ shows how in the short-run, the deficit may get worse before improving as a result of
devaluation of currency.
a) Terms of trade b) J-curve
c) Current account balances d) All of the above

13.40) Which of the following would occur if under free floating exchange rate, governments were to impose
a tariff on imports?
a) Devaluation of currency b) Revaluation of currency
c) No effect on exchange rate d) Increase the balance of payment deficit

13.41) Free floating exchange rates promote:

a) Speculation against currency b) Auto adjustment of BOP
c) Exchange companies d) All of the above

13.42) Under free floating exchange rate system, a government that offers more attractive investment
opportunities than its trading partners could experience.
a) Current account surplus b) Current account deficit
c) Balance of trade surplus d) Improvement in terms of trade

13.43) Devaluation of currency will be successful in improving Balance of Payment if

a) Elasticity of Exports is greater than 1
b) Elasticity of Imports is greater than 1
c) Elasticity of Exports + Elasticity of Imports is greater than 1
d) Elasticity of Import is 0

13.44) Net errors and omissions represent a value needed to ensure that accounts in the balance of
payments statement sum to one.
a) True b) False
13.45) Floating rate is set by the unhindered forces of demand and supply for the currency on the foreign
exchange markets.
a) True b) False

13.46) Invisible goods are often intangible, and include things like financial services, insurance and capital
flows.
a) True b) False

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13.47) Fixed rate is set at a fixed parity against one or more foreign currencies and the government agrees
to buy or sell at this rate to stop fluctuations.
a) True b) False

13.48) Disadvantages of Fixed Exchange Rate System is that its Promotes free-trade as importers and
exporters are released from exchange rate risk.
a) True b) False

13.49) In short run BOP goes deficit because Demand for exports increases but due to limited production
capacity firms remain unable to substantially increase in its exports immediately
a) True b) False

13.50) Balance of Trade include imports and exports of visible and invisible goods.
a) True b) False

13.51) Revaluation removes current account surplus by making exports expensive and imports cheaper
a) True b) False

13.52) Floating exchange rate is the rate set at a fixed parity against one or more foreign currencies.
a) True b) False

ANSWER KEY
13.1) B 13.2) C 13.3) A 13.4) A

13.5) A 13.6) B 13.7) A 13.8) B,D

13.9) D 13.10) C 13.11) A 13.12) C

13.13) A 13.14) B 13.15) B 13.16) D

13.17) C 13.18) D 13.19) A 13.20) C

13.21) C 13.22) D 13.23) A 13.24) D

13.25) D 13.26) C 13.27) A 13.28) C

13.29) A 13.30) A 13.31) B 13.32) A

13.33) C 13.34) A 13.35) C 13.36) D

13.37) C 13.38) D 13.39) B 13.40) B

13.41) D 13.42) C 13.43) A 13.44) B

13.45) A 13.46) A 13.47) A 13.48) B

13.49) A 13.50) B 13.51) A 13.52) B

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TEST-13
Q-1) _______________________ is the rate set at a fixed parity against one or more foreign currencies.
a) Flexible exchange rate b) Fixed exchange rate
c) Floating exchange rate d) None of the above

Q-2) Pakistan is facing BOP deficit and has floating exchange rate. Which is true?
a) The injections are greater than b) External value of PKR to rise
withdrawals
c) External value of PKR to fall d) AD is increasing

Q-3) Certain economies may want to appreciate their currency so as to temper demand, and make their
exports relatively more expensive. This concept relates to ______________.
a) J-Curve
b) Inverse of J-Curve

Q-4) Suppose, over a given time period the export price index is raised by 15% and the import price index
raised by 8%, then the terms of trade will be:
a) 187.5 b) 87.5%
c) Deficit by 6.48% d) 106.48

Q-5) If rate of inflation in abroad is less than Pakistan, then effect on Pakistan economy will be;
a) Pakistan export will increase b) Pakistan export will likely to increase
c) Pakistan export will likely to decrease d) Pakistan import will likely to increase

Q-6) What is the function of tariff? (Select TWO)

a) Decrease government revenue b) increases the price of imports

c) improves the current account deficit. d) Provide less protection to domestic

suppliers

Q-7) Which of the following is not a monetary measure to correct current account deficit;
a) Exchange rate b) Quotas
c) Export promotion d) Deflation

Q-8) Central bank carries gold and foreign currency reserves;

a) True b) False

Q-9) Select any TWO Advantages of floating exchange rates

a) Avoids the need for government intervention in the foreign exchange markets
b) Avoids damaging speculation against the currency.
c) Promotes free-trade as importers and exporters are released from exchange rate risk.
d) automatically to correct balance of payments (exchange rate) disequilibrium

Q-10) Current account/balance of payment account deficit can be balanced by: (Select TWO)
a) Selling gold and other reserves b) Borrowing from central bank
c) buying gold and other reserves d) paying off debt

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 CHAPTER WISE TEST- ANSWER KEY:

TEST-01:

1) B 2) A 3) B,C 4) C 5) C
6) B 7) D 8) D 9) C 10) B,D

TEST-02:

1) B 2) A 3) A 4) D 5) B
6) A,C 7) C 8) B 9) B 10) C

TEST-03:

1) C 2) C 3) B 4) B,D 5) B
6) B 7) A 8) C 9) B 10) a

TEST-04:

1) B 2) B 3) C,D 4) C 5) D
6) B 7) D 8) A 9) C 10) B

TEST-05:

1) B,D 2) A 3) B 4) D 5) A,C
6) B 7) A,B 8) A 9) A,C 10) C

TEST-06:

1) A 2) C 3) B 4) D 5) B,C
6) B 7) C,D 8) A,C 9) C 10) B

TEST-07:

1) C 2) C 3) A 4) B,D 5) D
6) A 7) B 8) A,C 9) C 10) B
 TEST-08:

1) B 2) C,D 3) B 4) B 5) A
6) D 7) A 8) D 9) D 10) A,D

TEST-09:

1) A 2) A,D 3) C 4) B 5) A,C
6) A 7) A,C 8) A,B 9) B 10) B,D

TEST-10:

1) B 2) C 3) B 4) D 5) B,D
6) B,D 7) C 8) A 9) B 10) C

TEST-11:

1) B 2) C 3) B 4) D 5) B,D
6) B,D 7) C 8) A 9) B 10) C

TEST-12:

1) A 2) B 3) C 4) C 5) C
6) C 7) D 8) B 9) A,D 10) A,C

TEST-13:

1) B 2) C 3) B 4) D 5) D
6) B,C 7) B,C 8) A 9) A 10) A,B