INSTITUTE OF BANKERS IN MALAWI
ECONOMIC ENVIRONMENT
(DIPLOMA IN BANKING)
MAY 2011 SOLUTIONS
BY: KONDWANI MLILIMA
MODEL ANSWERS
SECTION A:
QUESTION 1
(a)
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Motive 1 (transaction demand)
1
o Held as medium of exchange
1
o To facilitate payments
o Demand depends on total value of transactions
1
o Demand depends on level of income
Motive 2 (precautionary demand)
1
o Held as medium of exchange
o Allows for unpredictable transactions
1
o A function of national income
1
Motive 3 (speculative demand)
1
o Related to the ‘store of value’ function of money
1
o Affected by interest rate, which is the opportunity cost of holding cash versus interestbearing assets
1
o The higher the interest rate the lower the demand
(b)
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Labour is a homogenous factor of production
The quantities of the other factors of production are held constant
There is perfect competition in both the labour market and goods market
2
2
2
QUESTION 2 (3 marks each)
(a)
(i) R&D: issue of patents protects some firms
3
(ii) Tariffs: protect domestic firms
3
(iii) Inflation: differences in price increases over time matters
3
(iv) Exchange rate: the movements alter the price of either imports or exports and affects
competitiveness
3
1
(i) Factor endowment: quantity and quality of inputs matter
3
QUESTION 3
a)
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(b)
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HDI stands for Human Development Index
1
HPI stands for Human Poverty Index
HDI is based on the following development indicators: education, income and life expectancy 2
HPI is based on the following human life factors: longevity, knowledge, economic provisioning
and social inclusion
2
GDP includes defensive expenditures e.g. those aimed at mitigating negative externalities
GDP does not include non-marketed output e.g. housework
GDP does not include illegal businesses or some transactions for the informal sector
GDP does not account for externalities – positive or negative
GDP does not measure economic inequality
2
2
2
2
2
QUESTION 4
(a)
 Consumption by one person does not reduce amount available to others
 Do not have opportunity cost
1
1
(b)
 a family member does not sell a service when working for his’er own household
1
 the output is non-marketed; so, it does not form part of GDP
1
 on the other hand, the gardener is formally employed and gets paid for working; so, his’er
output is accounted for in GDP
1
(c)
 A command economy is where all key economic decisions are made by government while in a
mixed economy both elements of free enterprise markets and command economy come into
play
2
 Government enterprises are privatised
2
 Markets are deregulated to allow more competition
2
 Production subsidies are phased out
2
 The economy opens up to FDI
2
2
SECTION B
QUESTION 5
(a)
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Raise government spending
Cut taxes
Cut interest rates
Increase money supply
1
1
1
1
(b)
 Accommodation: central bank lending to commercial banks whereby the latter are short of
liquidity
2
 Open market operations: it is done via sale or purchase of financial securities (e.g. treasury bills)
in order to reduce or raise money supply and influence interest rates
2
 Reserve asset requirements: banks are required by central bank as a matter of policy to keep a
certain proportion of its liabilities at the central bank (or on its own but in liquid assets)
2
 Credit ceilings: a law is passed that prohibits banks from exceeding a certain level of outstanding
loans to the public
2
 Deposit rate control: here financial institutions are advised as to the rate they can pay on
deposits
2
 Moral suasion: central bank persuades commercial banks to behave in an expected manner to
achieve policy objectives
2
(c)
Classicals:
 government should be allowed to play only the wealth distribution role
 government should only deal with market failures
 government should not run businesses
 government businesses are really owned by nobody
 government businesses do not embrace competitiveness
 so, they support privatisation
Socialists:
 Privatisation leads to profiteering
 This happens at the expense of workers, quality of service, and society as a whole
 National assets are controlled by foreigners
1
1
1
1
1
1
1
2
1
3
QUESTION 6
SRAS3
Price
SRAS1
P3
10
P2
P1
AD1
Y1 Y3 Y2
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AD2
Real output
Multiplier effect explains how a change in AD will have far-reaching impact on equilibrium
national income
2
When there is a trigger e.g. a cut in taxes or increased government expenditure, companies will
need to increase production to meet the extra demand
2
On the graph, this is the movement from AD1 to AD2, which increases output from Y1 to Y2 and
the price level from P1 to P2
2
But if supply is inelastic (SRAS3), output increase will not reach Y2 but Y3, thus only aggravate
inflation (new price level will be P3)
2
Also with increased demand the central bank may raise interest rates, thus curtail borrowing by
firms to expand or increase supply
2
QUESTION 7
(a)
Transactions with foreign countries:
 Money supply increases with increases in foreign reserves
1
 So, exports and capital inflows raise money supply
1
 So, imports and capital outflows reduce money supply
1
Government transactions:
 Government deposits at the central bank or sale of Treasury bills for expenditure financing have
the same impact of reducing money supply because liquidity is withdrawn from circulation 1
 The converse is true with the purchase of Treasury bills
1
4
(b)
LRAS
Price
P2
P1
6
AS2
AD
AS1
Q2 Q1 Qf
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Income
Cost-push inflation occurs when firms increase prices to protect margins after facing a rise in the
cost of production
2
When production costs soar, the supply curve shifts inward from AS1 to AS2 and the price goes
up to P2 from P1
2
This causes aggregate demand to fall to Q2 from Q1
2
Causes:
o Rising cost of imports or imported inflation
1
o Rising labour costs
1
o Higher indirect taxes
1
QUESTION 8
(a)
 Narrow money or M1
 The components are: currency in circulation and demand deposits
1
2
(b)
 Advantages: convenient and more liquid
 Disadvantage: loses purchasing power during high inflation periods
1
1
(c)
Consumption
Consumption
5
45
Real disposable Income
5
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The standard Keynesian consumption function is presented as:
C = a + cYd (where C is consumption and Yd is disposable income)
2
Consumer spending rises with income
2
Rise in spending is at a rate below that of income
2
‘a’ is autonomous expenditure, where real disposable income is zero but one still consumes out
of savings (i.e. dis-saving). It is the intercept.
2
‘c’ is the marginal propensity to consume, which falls between 0 and 1. It is the slope of the
consumption function
2
– THE END –
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