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ECONOMIC ENVIRONMENT SOLUTIONS

FOUR QUESTIONS OF 15 MARKS EACH

1.

a) Explain how money functions as a unit of account and a store of money. (4 marks)P46

Unit of account – the price of an item can be measured in terms of how many units of currency it is worth. Money can thus be used to place value on an item. Enables buyers and sellers to agree on what items are worth relative to eachother.

Store of value- most common value for holding wealth since it can be exchanged for goods and services at a later date. The advantage over forms is that it is more convenient and can be used immediately in exchange for other assets. Money is the most liquid form in which wealth can be kept. However money loses value in times of high inflation/loss of purchasing power.

b) Describe 4 roles or functions of the Reserve Bank of Malawi. (4 marks) P53

- Malawi’s central bank

- Monetary authority in Malawi

-Issuer of bank notes and coins

-acts as a banker of government

-Custodian of a country’s gold and other foreign reserves

- Acts as banker for other commercial banks

c) Discuss whether the rate of interest is the only influence on a person’s decision to hold money. (7 marks) P64-66

- mention of the inverse relationship between interest rates and holding money

- interest is earned on bonds while little or no interest is earned by holding money thus quantity demanded will be low when interest rates are high (since the opportunity cost of money is then also high)

-Likewise the quantity of money demanded for speculation will be higher when interest rates and opportunity cost is low.

-mention of transactions motive

-mention of precautionary motive

-mention of liquidity preference

2.

| |Phones |TV’s |

|USA |6000 |2000 |

|China |3000 |500 |

|Total Output |9000 |2500 |

a) Which country has comparative advantage in TV’s ? Explain your answer. (5 marks) P122

- USA has comparative advantage

- If China shifted more resources into increasing output of TV’s, the opportunity cost of each extra TV is 6 phones. However if the USA does the same, the opportunity cost is 3 phones which is less.

b) State five factors that determine comparative advantage (5 marks) P159

- Investment in Research and Development (R &D)

- Movements in the exchange rate

- Long-term rates of inflation

- Import controls such as tariffs and quotas

- Non- price competitiveness of producers

- The quantity and quality of factors of production available

c) An appreciation of the Kwacha would make exports more expensive. True or false? Give reasons for your answer. (5 marks)

- True

- Appreciation of a local currency would make exports more expensive on the world market and should reduce the volume of exports and aggregate demand. It would also give local firms an incentive to keep costs down to remain competitive on the world market. A stronger Kwacha reduces import prices, making the raw materials & components of firms cheaper thus helping to control costs.

- Appreciation might be achieved by an increase in interest rates or through purchase of Kwachas via Central Bank intervention in the forex market.

3.

Inflation (π)

a) Discuss the graph above and explain why the graph cuts through zero.(5 marks) P162

- Phillips curve

- Shows inverse relationship between inflation and unemployment

- When the economy is weak and unemployment is high, inflation is low and

- When the economy is strong and unemployment is low, inflation is high

- The curve cuts through zero on the inflation axis capturing that deflation can happen although it will normally be associated with high unemployment.

b) Define demand pull inflation (10 marks) P151

- Occurs when total demand for goods and services exceeds total supply

- Happens when there has been excessive growth in aggregate demand and there is an inflationary gap

- Often monetary in origin because the authorities allow the money supply to grow faster than the ability of the economy to supply goods and services “too much money chasing too few goods”

- Graph drawn and labeled correctly

- As the economy reaches full employment, labour and raw material shortages means it becomes more difficult for firms to expand production to meet rising demand. Thus the AS curve becomes more inelastic.

- When AD increases from AD to AD1, the economy is still operating at relatively low levels of capacity.

- Output can expand relatively easily so firms will only implement small increases from P to P1

- When aggregate demand increases from AD1 to AD2, the economy is moving towards the full employment of factors of production.

- Many firms chose to increase prices to widen profit margins. Shortages of factors of inputs mean the firms costs of production start to rise

- Furthermore, it is likely that as employment in the economy grows, demand for the goods and services will become more elastic. This will allow firms to pass on large price increases (P1-P2) without any significant fall in demand.

4.

a) Discuss the multiplier according to Keynes. (5 marks) P129, 134

- Any increase in aggregate demand in the economy would result in an even bigger increase in National Income.

- This came about because any increase in demand would lead to more people being employed

- If more people were employed, they would spend the extra earnings. This would lead to even more spending which led to even more employment which led to even more income which then led to even more spending…..

- The length of the process would depend on how much of the extra income was spent each time.

- If the initial recipients of the extra spending saved it all, then the process would stop very quickly as no one else would get their hands on the extra income

- However if they spent it all, the knock on effects of the extra spending would carry on for some time.

- Therefore the higher the level of leakages, the lower the multiplier

- Multiplier = 1/(1-Marginal propensity to consume)

- The higher the propensity to consume, the greater the multiplier effect

b) Governments of developing countries often argue that the economy has improved while they have been in power. Explain what economic indicators might be used to support their argument and discuss the usefulness of that data in illustrating an improvement in a developing economy. (10 marks)

Candidates should distinguish between quantitative and qualitative data and suggest different data which might be useful. They could mention the data used for measuring standards of living – GDP, HDI; they could mention data related to government policy – rate of interest changes, inflation, unemployment, balance of payments, crime; they could mention data that companies might be interested in – profits, growth, market share, consumer perception of products sold; they could mention information consumers might be interested in – income levels, assets, house prices, differences in rates of pay between jobs.

PART B

FOUR QUESTIONS 20 MARKS EACH

1. Escom is currently undergoing a privatization process. Once this process is complete, service delivery to consumers will greatly improve.

Do you agree or disagree with this statement. P105 (20 marks)

▪ Define privatization – process of transferring property or service from public ownership to private ownership

▪ Mention the type of privatization relevant to this case, asset sale

▪ Conclusion should be supported

Discussion of arguments for privatization (any 6):

▪ Performance – government may be motivated only when poor performance becomes politically sensitive.

▪ Improvements – government may put off improvements due to political sensitivity

▪ Corruption – decisions made for policital reasons

▪ Accountability – managers in privatization are accountable to shareholders

▪ Goals – other than business goals

▪ Capital – lack of capital by governments

▪ Security

▪ Lack of market discipline

▪ Concentration of wealth

▪ Profits

▪ Political influence

Discussion of arguments against privatization (any 6)

▪ Performance

▪ Downsizing

▪ Profiteering

▪ Concentration of wealth

▪ Natural monopolies

▪ Political influence

▪ Improvements

▪ Civil liberty concerns

▪ Capital

▪ Lack of market discipline

▪ Cuts in essential services

Discuss obstacles to privatization:

▪ Shocks in the short term e.g mass redundancies can lead to civil unrest

▪ The economy could be affected if the private company prefers cheaper inputs which are imported. Most government run institutions insist on local supplies.

2. One aim of government economic policies is Balance of Payment (BOP) stability. Whether a country has a deficit or surplus in its current account is influenced by a number of factors, such as exchange rate and it’s governments trade policies.

a) Describe two aims of a government economic policy, other than BOP stability (4 marks) P13

- full employment. Low unemployment as possible means best use of resources

- price stability. Can create certainty and encourage investment

- economic growth. Has the potential to raise living standards

b) Explain the stages of the economic cycle (10 marks)

Economic Boom. Characterized by

-rising employment and real wages

-high demand for inputs

-Government tax revenue will be rising quickly

-company profits and investments increase

-high utilization rate of existing resources

Economic slowdown. Characterized by

- Rate of growth decelerates but national output is still rising

Recession. Characterized by

-Declining aggregate demand for output

-Contracting employment

-Sharp fall in business confidence

-Heavy price discounting and de stocking

- less inflationary pressure and less demand for imports

-increased government borrowing

c) Give three disadvantages of economic growth ? (6 marks) P173

1. Inflation. If the economy grows too quickly, there is a risk of inflation as demand races ahead of the ability of the economy to supply goods and services. Producers then take advantage of this by raising prices for consumers (cost push inflation)

2. The environmental impact. For example if the wealth of the population increases, this could cause overconsumption of de-merit goods, This can negatively effect people’s quality of life and may also affect a country’s ability to sustain its growth rate e.g over-exploitation of fish stocks.

3. Inequitable distribution of the gains from economic growth can cause civil unrest.

4. Changing the earth at explosively accelerating rates, to whatever purpose, inevitably conflicts with the normal delays in correcting the problems that develop.

3. Jack is a taxpayer who earns K300,000. Suppose income is taxed with a formula of 10% for K0-K49,999, 15% from K50,000 – K99,999 and 20% for over K100,000.

a) How much income tax does Jack have to pay? P90 (4 marks)

(((0.10*50000) + (0.15*50000) + (0.20*200,000)))

= 5000+7500+40,000

=K 52,500

b) Using a demand and supply diagram, analyse how an increase in tax on fuel can affect

the equilibrium price and equilibrium quantity of fuel. [6 marks] P 91

marks for the demand and supply diagram:

- axes correctly labelled (price and quantity)

- demand and supply curves correctly labelled

- shift of supply curve to the left

- rise in price/fall in quantity

marks for analysis:

- an increase in an indirect tax raises firms’ costs of production

- there will be a rise in the equilibrium price

- and a fall in the equilibrium quantity

c) Discuss the extent to which a direct tax, such as income tax, can affect the distribution of income in an economy. (10 marks) P90, 96

marks on how it can affect the distribution of income:

- a direct tax is a tax on the income of people and firms

- income tax is usually a progressive tax ,

- this takes not just more of the income of the rich

- but also an increasing proportion of their income ,

- reduces the gap between the income of the rich and the poor

- tax revenue raised may be used to help the poor e.g. spending on housing, education and health care

- this may increase the earning potential of the poor

marks for why the effect may be limited:

- will depend on how progressive the tax is , some countries operate flat taxes

- will be influenced by the extent of tax avoidance , some of the rich may find ways of not paying the tax

- a high rate may discourage effort and enterprise , leading to lower output, higher unemployment , greater poverty/more uneven distribution of income

- it may be offset by the regressive nature of other taxes

- other factors may change such as a lowering of the minimum wage , how this could affect the distribution of income

4. Some governments place great emphasis on the aims of economic growth and keeping the level of unemployment low. How far do you agree that these aims should be the most important of a government? (20 marks)

Discussion of the general macro aims of government policy with a comment on whether the two mentioned should be regarded as the most crucial. The effect on economic growth and low unemployment can be developed. Reasons should be given for either choosing or not choosing these aims as the most important.

END OF EXAMINATION PAPER

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Unemployment (μ)

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