ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION 1 EXAMINATION - AUGUST 2012
NOTES:
You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5.
(If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer
not to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.)
TIME ALLOWED:
3 hours, plus 10 minutes to read the paper.
INSTRUCTIONS:
During the reading time you may write notes on the examination paper but you may not commence
writing in your answer book.
Marks for each question are shown. The pass mark required is 50% in total over the whole paper.
Start your answer to each question on a new page.
You are reminded to pay particular attention to your communication skills and care must be taken
regarding the format and literacy of the solutions. The marking system will take into account the content
of your answers and the extent to which answers are supported with relevant legislation, case law or
examples where appropriate.
List on the cover of each answer booklet, in the space provided, the number of each question(s)
attempted.
The Institute of Certified Public Accountants in Ireland,17 Harcourt Street, Dublin 2.
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – AUGUST 2012
Time allowed: 3 hours, plus 10 minutes to read the paper.
You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5.
(If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer not
to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.)
Question 1 is allocated 40 marks and each of the other questions are allocated 20 marks.
1.
Discuss any four of the following:
(i)
(ii)
(iii)
(iv)
(v)
Planned versus Free Market Economies.
The Law of Diminishing Returns.
Canons of Taxation.
Gross Domestic Product versus Gross National Product.
The International Monetary Fund.
(4 x 10 marks each)
[Total : 40 Marks]
2.
(a)
Outline and clearly explain, using relevant diagrams, the determinants of demand.
(b)
Illustrate the impact on price and quantity of an increase in the price of diesel on the market for cars.
(5 marks)
(c)
Explain and illustrate the impact of a price increase on total revenue when a good is:
(i)
(ii)
Elastic
Inelastic.
(10 marks)
(5 marks)
[Total : 20 Marks]
3.
(a)
Explain the difference between perfect competition and imperfect competition, making reference to the market
structure spectrum.
(8 marks)
(b)
Explain why the demand curve for an Oligopolistic firm is 'kinked'.
(c)
'It is possible to identify market failures under the two general headings of efficiency failures and equity
failures' (Turley et al, 2011, p.216).
Discuss this statement, giving examples as appropriate.
(4 marks)
(8 marks)
[Total : 20 Marks]
Page 1
4.
(a)
The relationship between consumption and income is described as the consumption function. Briefly discuss.
(4 marks)
(b)
Define Inflation and discuss the typical causes.
(c)
Explain why it is important/desirable that the rate of inflation in Ireland (or a country that you are familiar with)
should be kept as low as possible.
(6 marks)
(10 marks)
[Total : 20 Marks]
5.
(a)
Explain the difference between Monetary and Fiscal policy.
(6 marks)
(b)
What determines the general level of interest rates?
(c)
Under what circumstance(s) is the European Central Bank likely to increase its interest rate?
(10 marks)
(4 marks)
[Total : 20 Marks]
END OF PAPER
Page 2
SUGGESTED SOLUTIONS
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – AUGUST 2012
SOLUTION 1
Discuss any four of the following:
(i)
Planned versus Free Market Economies.
An “economic system” is the set of institutions within which a community decides what, how and for whom to
produce goods and services. At one extreme there is the centrally planned or command economy and at the
other the free market economy. In between is the mixed economy that is some combination of the two
extremes.
Centrally Planned or Command Economy: is where all decisions pertaining to economics are taken by a
central authority. It is characterised by collective ownership of resources therefore the price mechanism does
not operate e.g. Cuba or North Korea.
A Market Economy is a free enterprise, laissez-faire or capitalist economic system. Land and capital are
privately owned. An economy that decides what, how and for whom goods and services are produced by
channelling individual choice through a market is called a market economy. Markets consist of large numbers
of buyers and sellers and price is determined by supply and demand. Adam Smith and the classical
economists held the “invisible hand” leads to desirable market outcomes.
Mixed Economy. A Mixed economy contains a mixture of private enterprise and state involvement in production
and distribution. The reasons for government involvement are:
•
•
•
•
•
(ii)
To provide goods and services that private industry will not or cannot supply.
To correct inequalities in the distribution of wealth between individuals.
To curb monopoly power.
To overcome frictions e.g. in the movement of labour; and
To relieve shortages e.g. housing.
The Law of Diminishing Returns.
The Law of Diminishing Marginal Returns states that as increasing quantities of a variable factor of production
are combined with a fixed factor of production, a stage will eventually be reached when marginal returns will
begin to decline. The short run is defined as a period during which at least one factor of production is fixed in
supply and since this law is based on the notion of a fixed factor of production it is a short run phenomenon.
Note that the law does not state that total returns will begin to decline it refers only to the diminution of marginal
returns. The common sense of the law may be realised by considering that if it did not apply the whole
population could be fed by devoting enough workers to the cultivation of a specific area of land.
(iii) Canons of Taxation.
The 'Canons of taxation' were first developed by Adam Smith as a set of criteria by which to judge taxes.
They are still widely accepted as providing a good basis by which to judge taxes.
Smith's four canons were:
1.
The cost of collection must be low relative to the yield
2.
The timing and amount to be paid must be certain to the payer
3.
The means and timing of payment must be convenient to the payer
4.
Taxes should be levied according to ability to pay
Modern economists have added three more canons to these to update and extend them:
5.
A tax must not hinder efficiency or should involve the least loss of efficiency
6.
A tax should be compatible with foreign tax systems (in the UK's case, with Europe's)
7.
Tax should automatically adjust to changes in the rate of inflation (particularly important in high inflation
economies)
The best taxes will tie in with all these. The worst taxes won't!
Page 3
(iv)
Gross Domestic Product versus Gross National Product.
GDP
An estimated value of the total worth of
a country’s production and services,
calculated over the course on one year.
GNP
GDP (+) total capital gains from overseas
investment (-) income earned by foreign
nationals domestically.
Stand for
Gross Domestic Product
Gross National Product
Calculation
C+I+G+NX
C+I+G+NX+(Net income from abroad)
Explanation
Total value of products & Services
produced within the territorial boundary
of a country
Total value of Goods and Services produced
by all nationals of a country (whether within
or outside the country)
Definition
The difference between GDP and GNP is net factor income from abroad. In Ireland GNP is smaller due to the
net factor incomes being repatriated.
In Ireland due to the large amount of repatriated profits by multinationals to their home countries, GNP is a
better and more realistic measure of economic growth. GDP is overinflated.
(v)
The International Monetary Fund.
The IMF encourages expansion in trade by encouraging member countries to adopt sound economic policies.
It monitors economic and financial developments in member countries and gives advice to its members.
Strong advocates of the IMF see the organisation as a benevolent force, a useful and neutral enforcer of
fiscal discipline when asked for help by crisis-stricken countries. Troubled economies with tattered reputations,
and shunned by international money markets, have no-where else to turn for financial help and the IMF, so
often dubbed the ‘lender of last resort’, is glad to provide a helping hand.
Trenchant critics, however, see the IMF not as a global organisation made up of 186 member states ready to
help each other in times of crises with the aid of pooled financial resources.Detractors see the organisation,
dominated by powerful developed countries, as a capitalist-driven organisation dictating to troubled economies
who must sign up to draconian conditions in order to receive IMF help. Critics argue the austere conditions
attached to the IMF’s lending policies leave troubled economies in a worse mess than before the intervention.
(Stiglitz, 2002)
Whatever of the many differing views the IMF provokes, one thing is clear no matter what the perspective: a
country linked to the IMF is a clear indicator the nation is either bankrupt or on the verge of going broke.
Principle roles of the IMF are to:
•
•
•
•
•
Promote exchange rate stability. The IMF promotes international monetary co-operation. It provides a
forum for consultation on international monetary problems. It tries to maintain orderly exchange
arrangements among countries and aims to avoid competitive devaluations.
Orderly correction of balance of payments problems. The IMF lends to member countries with balance
of payments problems to provide temporary financing and to support reform policies aimed at correcting
the underlying problems.
Operation of a multilateral system of payments. The IMF operates this system in respect of current
transactions between members and aims to eliminate foreign exchange restrictions which may hamper
the growth of world trade.
Provision of technical assistance and training. Where a member needs help the IMF will provide this
assistance and training. When the Soviet Union collapsed the IMF stepped in and set up treasury
systems for their central banks to help the transition from centrally planned to market based economic
systems.
Lender of last Resort.
(4 x 10 marks each)
[Total: 40 Marks]
Page 4
SOLUTION 2
(a)
Outline and clearly explain, using relevant diagrams, the determinants of demand.
The Law of demand states that the quantity of a good demanded will fall as price rises and will rise as price
falls ceteris paribus i.e. other things being equal. Quantity demanded of a good is therefore inversely related
to price.
The determinants of Demand are:
•
•
•
•
•
•
•
•
Price of the good itself.
Price of other goods/products, substitutes or compliments. A substitute is a good that exactly replaces
a good. Increase the price of a substitute good and the demand for our good increases, and vice verse.
A complement is a good that is consumed in conjunction with our good. Increase the price of a
complement and you decrease the demand for our good, and vice verse.
Income available.When income increases consumers buy more of most goods and vice versa. But, this
does not happen for all goods. Goods that do increase demand as income increases are known as
normal goods (milk). Goods that decrease in demand as income increases are known as inferior goods
(black and white TVs).
Price and availability of money and credit. If the cost of credit rises, the demand for a good will fall, and
vice verse.
Market size/Population. Any increases in population will cause demand to increase, this can be clearly
shown in segmented markets e.g. the increased demand as a result of a baby boom, and vice verse.
Tastes and Preferences. If peoples tastes and preferences change, i.e. their desire to buy a particular
fashion, demand will either increase or decrease.
Expectations. Expectations of changes in any of the above will cause demand to change.
Other influences (weather, temperature, reputation etc).
Movement along a demand curve occurs when the price of the good itself changes.
Diagram correctly labeled demonstrating a movement along a demand curve.
Diagram explained.
Shifts in a demand curve occur when any of the other factors change i.e. price of other goods, income,
tastes/preferences and population.
Diagram correctly labeled demonstrating a shift of a demand curve.
Diagram explained.
(b)
(10 marks)
Illustrate the impact on price and quantity of an increase in the price of diesel on the market for cars.
An increase in the price of a complementary good. A complementary good is a good that is consumed in
conjunction with another good e.g. bread and butter or as in this case diesel and cars. So to increase the price
of diesel should cause the demand for cars to decrease. This is demonstrated by a shift in the demand curve
in and to the left. This brings the market to a situation of disequilibrium, causing excess supply to exist in the
market place. This excess supply is then slowly eroded as price decreases bringing the market to a new
equilibrium.
Overall impact: Decrease price, decrease quantity.
Diagram correctly labeled demonstrating the adjustment process.
Marks Allocated 2 + 3 marks.
(5 marks)
Page 5
(c)
Explain and illustrate the impact of a price increase on total revenue when a good is:
(i)
(ii)
Elastic
Inelastic.
If the product is elastic to increase price will cause a decrease in revenue and conversely if the price
decreases, total revenue (TR) will increase/rise.
If the product is inelastic, to increase price will cause an increase in revenue and conversely if the price
decreases, total revenue (TR) will decrease/fall.
Graphically
(5 marks)
[Total : 20 Marks]
Page 6
SOLUTION 3
(a)
Explain the difference between perfect competition and imperfect competition, making reference to the market
structure spectrum
Under perfect competition, there are many buyers and sellers in the industry. The firms are price takers and
cannot influence price, as such they must always compete at their maximum level of efficiency. There are no
barriers to entry. Firms attempt to maximize profits. In the short run if firms are making a supernormal profit,
new firms enter the market place and reduce profit, as a result of increasing supply and driving the price
downwards to a position where all forms in the industry will only make a normal profit, thereby enabling firms
only earn normal profit in the long run. If firms are making a loss they exit the industry. Firms are therefore
typically maximizing the utilization of resources and producing at all times at the minimum cost –point. In the
short-run, it is possible for an individual firm to make a profit. This situation is shown in this diagram, as the
price or average revenue, denoted by P, is above the average cost denoted by C .
However, in the long period, positive profit cannot be sustained. The arrival of new firms or expansion of
existing firms (if returns to scale are constant) in the market causes the (horizontal) demand curve of each
individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal
revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic
profit). Its horizontal demand curve will touch its average total cost curve at its lowest point.
The term Imperfect Competition is used to describe a form of market structure with the following
characteristics:
●
●
●
●
●
Product differentiation exists. The goods that are supplied by different producers are not homogeneous
but they are very close substitutes.
There is freedom to enter the industry and freedom for firms to exit the industry. Thus firms have the
right and the opportunity to supply competitive products.
There is perfect knowledge as to the level of profit being earned by all firms in the industry.
There are many buyers and many sellers each of whom act independently.
Firms are profit maximisers.
In the light of these characteristics of this form of market structure the long run equilibrium of the firm can be
determined. The individual firm is subject to a downward sloping demand curve because of the availability of
close substitutes. The firm will be at equilibrium producing a level of output at which marginal cost is equal to
marginal revenue and at this particular level of production marginal cost will be increasing faster than marginal
revenue; since this is the optimum level of production for a firm that seeks to earn as much profit as possible.
It can also be determined that at this long run equilibrium the firm will be earning Normal Profit because there
is perfect knowledge as to the level of profitability in the industry and other firms have freedom to enter the
industry if they so desire.
Monopolies, Monopolistically competitive firms and Oligopolists are described as imperfect competition.
Marks Allocated 2 x 3 + 2 discussion marks each.
(8 marks)
Page 7
(b)
Explain why the demand curve for an Oligopolistic firm is 'kinked'.
Oligopolistic markets tend to be characterised more by non-price competition rather than significant price
flexibility and the kinked demand curve model is one example of a possible scenario.
If they increase price, then they will lose a large share of the market because they become uncompetitive
compared to other firms, therefore demand is elastic for price increases. If firms cut price then they would gain
a big increase in Market share, however it is unlikely that firms will allow this. Therefore other firms follow suit
and cut price as well.
Therefore demand will only increase by a small amount:
Demand is inelastic for a price cut, this suggests that prices will be rigid in Oligopoly.
This also suggests that a change in Marginal Cost still leads to the same price, because of the kinked demand
curve (remember profit max occurs where MR = MC).
Marks allocation: (Diagram correctly labelled and explained 2 + 2)
(4 marks)
(c)
'It is possible to identify market failures under the two general headings of efficiency failures and equity failures'
(Turley et al, 2011, p.216).
Discuss this statement, giving examples as appropriate.
Market failure is a concept within economic theory wherein the allocation of goods and services by a free
market is not efficient. That is, there exists another conceivable outcome where a market participant may be
made better-off without making someone else worse-off.
Efficiency failures are, in general, associated with the presence of some effect that is not incorporated or
internalised into the price paid by consumers and/or the cost incurred by producers. These effects are typically
referred to as externalities. But, even if the market assumes away the efficiency characteristics, it is highly
likely that society will not like the equity implications of the efficient allocation that the market chooses. As
such, society in general deems that the market generally fails with respect to equity or equality considerations.
Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that
are not efficient – that can be improved upon from the societal point-of-view.
Market failures are often associated with information asymmetries, non-competitive markets, principal–agent
problems, externalities, or public goods.
The existence of a market failure is often used as a justification for government intervention in a particular
market. Economists, especially microeconomists, are often concerned with the causes of market failure, and
possible means to correct such a failure when it occurs. Such analysis plays an important role in many types
of public policy decisions and studies.
Page 8
However, some types of government policy interventions, such as taxes, subsidies, bailouts, wage and price
controls, and regulations, including attempts to correct market failure, may also lead to an inefficient allocation
of resources, sometimes called government failure. Thus, there is sometimes a choice between imperfect
outcomes, i.e. imperfect market outcomes with or without government interventions. But either way, if a market
failure exists the outcome is not pareto efficient. Mainstream neoclassical and Keynesian economists believe
that it may be possible for a government to improve the inefficient market outcome.
Marks Allocated 8 marks each.
(8 marks)
[Total: 20 Marks]
Page 9
SOLUTION 4
(a)
The relationship between consumption and income is described as the consumption function. Discuss.
The Keynesian Theory of consumption is that current real disposable income is the most important
determinant of consumption in the short run. Real Income is money income adjusted for inflation. It is a
measure of the quantity of goods and services that consumers have buy with their income (or budget).
For example, a 10% rise in money income may be matched by a 10% rise in inflation. This means that real
income (the quantity or volume of goods and services that can be bought) has remained constant.
The Keynesian Consumption Function
Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)
The standard Keynesian consumption function is as follows:
C = a + c Yd where,
C= Consumer expenditure
a = autonomous consumption. This is the level of consumption that would take place even if income was zero.
If an individual's income fell to zero some of his existing spending could be sustained by using savings. This
is known as dis-saving.
c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in
income. Simply, it is the percentage of each additional pound earned that will be spent.
There is a positive relationship between disposable income (Yd) and consumer spending (Ct). The gradient
of the consumption curve gives the marginal propensity to consume. As income rises, so does total consumer
demand.
A change in the marginal propensity to consume causes a pivotal change in the consumption function. In this
case the marginal propensity to consume has fallen leading to a fall in consumption at each level of income.
This is shown below:
Key Consumption Definitions
Average propensity to consume = Total consumption divided by total income
Average propensity to Save = Total savings divided by total income (also known as the Saving Ratio
Page 10
A Shift in the Consumption Function
The consumption - income relationship changes when other factors than income change - for example a rise
in interest rates or a fall in consumer confidence might lead to a fall in consumption spending at each level of
income.
A rise in household wealth or a rise in consumer's expectations might lead to an increased level of consumer
demand at each income level (an upward shift in the consumption curve).
Marks Allocated 4 marks.
(4 marks)
(b)
Define Inflation and outline and discuss the typical causes.
Price is the relationship between a quantity of money and a quantity of goods. Thus the higher the price of a
good the lower the value of a unit of money in terms of that good, and by extension if the price of goods in
general is rising then the value of a unit of currency is falling. Inflation can be described as an increase in the
general price level or a reduction in the value of a unit of currency. It is described by many as ‘too much money
chasing too few goods.
Cost Push Inflation
Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to
maintain their profit margins. There are many reasons why costs might rise:
Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on
exports of these commodities or alternatively by a fall in the value of the Euro in the foreign exchange markets
which increases the Irish price of imported inputs.
Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause
is important in those industries which are ‘labour-intensive’. Firms may decide not to pass these higher costs
onto their customers (they may be able to achieve some cost savings in other areas of the business) but in
the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to
which any business can absorb higher wage expenses.
Higher indirect taxes imposed by the government – for example a rise in the rate of excise duty on alcohol
and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an
extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers)
who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden
of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel,
then this would contribute to a rise in cost-push inflation.
Demand Pull Inflation
Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In
these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of
reasons – some of which occur together at the same moment of the economic cycle
•
A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces
the foreign price of Irish or European exports. If consumers buy fewer imports, while foreigners buy
more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards.
Page 11
•
•
•
•
A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real
disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount
of income will now buy a greater real volume of goods and services. Both factors can take aggregate
demand and real GDP higher and beyond potential GDP.
The rapid growth of the money supply – perhaps as a consequence of increased bank and building
society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation
are monetary – in particular when the monetary authorities permit an excessive growth of the supply
of money in circulation beyond that needed to finance the volume of transactions produced in the
economy.
Rising consumer confidence and an increase in the rate of growth of house prices – both of which
would lead to an increase in total household demand for goods and services
Faster economic growth in other countries – providing a boost to Irish exports overseas.
Finally, the wage price spiral – “expectations-induced inflation”
Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are
unlikely to accept pay rises less than their expected inflation rate because they want to protect the real
purchasing power of their incomes. For example a booming economy might see a rise in inflation from 3% to
5% due to an excess of AD. Workers will seek to negotiate higher wages and there is then a danger that this
will trigger a ‘wage-price spiral’ that then requires the introduction of deflationary policies such as higher
interest rates or an increase in direct taxation.
Marks Allocated 3 x 3 +1 marks each.
(10 marks)
(c)
Explain why it is important/desirable that the rate of inflation in Ireland should be kept as low as
possible.
The reason why it is important the rate of inflation should be kept as low as possible is because of its many
undesirable and economically disruptive effects.
These undesirable features include:
•
A loss of international competitiveness which is particularly important in an economy as open as the
Irish economy
•
Business planning becomes more difficult.
•
There are cash flow implications as historical cost depreciation policies fail to provide adequate
resources for the replacement of assets.
•
Lessens the efficiency of money in fulfilling its economic functions. This can occur to such an extent that
there develops a significant movement into holding assets in a non-cash form
•
Considerable redistributive effects occur in the course of which those on fixed income and the
economically vulnerable suffer most.
•
Saving behaviour is discouraged as borrowers gain at the expense of savers.
•
When intervention becomes necessary policy induced recessions introduced to tackle inflation can be
very costly in terms of increased unemployment and lost output.
Marks Allocated 6 marks.
(6 marks)
[Total: 20 Marks]
Page 12
SOLUTION 5
(a) Outline and discuss the difference between Monetary and Fiscal policy.
Monetary policy involves changing the interest rate and influencing the money supply. Fiscal policy involves
the government changing tax rates and levels of spending to influence aggregate demand in the economy.
They are both used to pursue policies of higher economic growth or controlling inflation.
Monetary Policy
Monetary policy is usually carried out by the Central Bank / Monetary authorities and involves:
•
Setting base interest rates.
•
Influencing the supply of money.
How Monetary Policy Works
•
The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the
inflation target, due to economic growth being too quick, then they will increase interest rates.
•
Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading
to lower aggregate demand and lower inflation.
•
If the economy went into recession, the Central Bank would cut interest rates.
Fiscal Policy
Fiscal Policy is carried out by the government and involves changing:
•
Level of government spending
•
Levels Taxation
To increase demand and economic growth, the government will cut tax and increase spending (leading to a
higher budget deficit)
To reduce demand and reduce inflation, the government can increase tax rates and cut spending (leading to
a smaller budget deficit)
Example of Expansionary Fiscal Policy
In a recession, the government may decide to increase borrowing and spend more on infrastructure spending.
The idea is that this increase in government spending creates an injection of money into the economy and
helps to create jobs. There may also be a multiplier effect, where the initial injection into the economy causes
a further round of higher spending. This increase in aggregate demand can help the economy to get out of
recession.
If the government felt inflation was a problem, they could pursue deflationary fiscal policy (higher tax and
lower spending) to reduce the rate of economic growth.
Marks Allocated 2 x 3 marks each.
(6 marks)
(b)
What determines the general level of interest rates?
There are essentially two theories which purport to explain how the rate of interest is determined. Firstly, the
loanable finds theory which explains the rate of interest in terms of the supply and demand for loanable funds.
The demand comes from potential investors, whereas the supply comes from potential savers. Secondly, is
the liquidity preference theory. This originated from Keynes and essentially is based on the concept of money
as a liquid asset, interest being the payment for the loss of that liquidity. Thus it is the demand and supply of
money that determines which determines the interest rate.
Loanable Funds theory
According to the Loanable Funds Theory of Interest, the rate of interest is calculated on the basis of demand
and supply of loanable funds present in the capital market.
The Loanable Funds Theory of Interest advocates that both savings and investments are responsible for the
determination of the rates of interest in the long run. On the other hand, short-term interest rates are calculated
on the basis of the financial conditions of a particular economy. The determination of the interest rates in case
of the Loanable Funds Theory of the Rate of Interest, depends essentially on the availability of loan amounts.
The availability of such loan amounts is based on certain factors like the net increase in currency deposits,
the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh
capitals.
According to the loanable funds theory of interest the nominal rate of interest is determined by the interaction
between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the
Page 13
demand for loanable funds would lead to an increase in the interest rate and the vice versa is true. Conversely
an increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and
supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and
direction of movement of the demand and supply of the loanable funds.
Liquidity Preference Theory
The cash money is called liquidity and the liking of the people for cash money is called liquidity preference.
According to Keynes people demand liquidity or prefer liquidity because they have three different motives for
holding cash rather than bonds etc.
1.
2.
3.
Transaction Motive
Precaution Motive
Speculative Motive
The interaction of demand and supply of money determines the interest rate.
In the above diagram L is the demand for money and the M is the supply of money. This gives an equilibrium
rate of interest i (5%). At any rate of interest above i , the supply of money exceeds demand and this will pull
down the rate of interest, while at any rate of interest below i the demand for money exceed supply and this
will bid up the rate of interest. Once the rate of interest is established at i, it will remain at this level until there
is a change in the demand for money and or the supply of money. This implies that the authorities have two
choices
Marks Allocated 2 x 4 + 2 marks each.
(10 marks)
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(c)
Under what circumstance(s) is the European Central Bank likely to decide to increase its interest
rate?
The prime objective of the European Central Bank is the safeguarding of the integrity (or value) of the Euro
currency. Since the value of money is its purchasing power, or the rate at which it exchanges for goods and
services, if there is inflation in the economy then the value of a unit of the currency is lessening in value. The
ECB has declared its target rate of inflation to be 2% so if inflation is in danger of going above this level then
the ECB is likely to deflate economic activity within its area of influence through increasing its interest rate.
One of the ways in which an increase in interest rates would impact on the level of activity in the Irish economy
is through the effect of such action on the value of the Euro. An increase in interest rates within the euro zone
would cause an inflow of international funds into the area and a consequent increase in the foreign exchange
value of the Euro. This appreciation in the value of the Euro makes our exports to noneurozone countries
more expensive and imports from those areas cheaper relative to domestically produced competitive goods.
The upward pressure on costs in the economy arising from the increase in interest rates would put further
pressure on our efforts to retain competitiveness against competitors from outside the Euro zone. Thus,
imports for these areas may enjoy price advantages against domestic products.
Obviously the precise effect of these developments on our balance of (international) trade depends on
(i)
the proportion of our international trade which takes place outside the euro zone,
(ii)
the extent to which our international competitors have not been subject to same economic
developments,
(iii) the price elasticity of demand for our exports
(iv) our price elasticity of demand for imports.
Marks Allocated 4 marks.
(4 marks)
[Total: 20 Marks]
END OF PAPER
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