CIMA BA1 Macroeconomic and institutional context of business: practice questions with answers

Question 1

In the economy of Veloria, out of each extra $1 of national income households save $0.15, pay $0.20 in taxes and spend $0.15 on imports. The government increases its spending by $40 billion. Assuming no other changes, by how much will equilibrium national income rise?

1. A $80 billion
2. B $266.67 billion
3. C $114.29 billion
4. D $20 billion

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Answer: A. In an open economy with a government, the multiplier = 1 / marginal propensity to withdraw, where withdrawals are savings, taxes and imports.

- MPW = MPS + MPT + MPM = 0.15 + 0.20 + 0.15 = 0.50
- Multiplier = 1 / 0.50 = 2
- Change in national income = $40bn x 2 = $80bn

Each round of spending leaks out of the circular flow through all three withdrawals, so ignoring any of them overstates the multiplier.

Question 2

Belmora's currency depreciates by 10% against the currencies of all its main trading partners. Assuming that firms do not change their prices in their own currencies, which of the following is the most likely immediate effect?

1. A Belmora's exports become more expensive in foreign currency terms and its imports become cheaper in Belmoran currency
2. B Belmora's exports and imports both become cheaper to the buyers
3. C Prices of traded goods are unaffected because the depreciation is the same against all currencies
4. D Belmora's exports become cheaper in foreign currency terms and its imports become more expensive in Belmoran currency

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Answer: D. A depreciation (fall in the external value of a currency) makes a country's exports cheaper in foreign markets and its imports dearer at home. This tends to help exporters and domestic producers competing with imports, but raises the cost of imported raw materials and can add to inflation. Whether the trade balance improves depends on the price elasticities of demand for exports and imports.

Question 3

The government of Corvenna charges a duty of $0.60 on every litre of road fuel sold, whatever its selling price. Households on low incomes spend a larger proportion of their income on fuel than households on high incomes. How is this duty best described?

1. A An indirect, ad valorem tax that is progressive in relation to income
2. B An indirect, specific tax that is regressive in relation to income
3. C A direct, specific tax that is proportional to income
4. D An indirect, specific tax that is progressive in relation to income

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Answer: B. - Direct taxes are levied on income, profits or wealth (income tax, corporation tax). Indirect taxes are levied on spending (sales tax, excise duties).
- A specific tax is a fixed amount per unit ($0.60 per litre); an ad valorem tax is a percentage of value (e.g. 20% sales tax).
- A tax is progressive if it takes a rising proportion of income as income rises, proportional if the proportion is constant and regressive if the proportion falls as income rises.

Because low-income households spend a larger share of their income on fuel, the fuel duty takes a larger share of their income: it is regressive.

Question 4

Tarrow Ltd is based in Ostland, whose currency is the ost (O). It sells 10,000 units a year in the United States at $80 per unit and its costs are O50 per unit, all incurred in Ostland. Over the year the exchange rate moves from O1 = $1.25 to O1 = $1.40. If Tarrow keeps its US dollar price unchanged, what will its annual profit be in osts after the change?

1. A O71,429
2. B O140,000
3. C O620,000
4. D O125,000

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Answer: A. Tarrow earns revenue in dollars but pays costs in osts, so an appreciation of the ost reduces its profit if it holds its dollar price.

| | O1 = $1.25 | O1 = $1.40 |
|---|---|---|
| Revenue ($800,000 / rate) | O640,000 | O571,429 |
| Costs (10,000 x O50) | O500,000 | O500,000 |
| Profit | O140,000 | O71,429 |

Revenue in osts falls by 10.7% but profit falls by 49.0%, because costs are fixed in osts. Alternatively Tarrow could raise its dollar price to protect its margin, but it would then lose price competitiveness in the US market. Either way, a stronger home currency harms exporters.

Question 5

Kesmore imposes a 25% tariff on imported bicycles from all countries. Bicycles cost $80 each from Westland, the lowest-cost producer in the world, and $90 each from Tervia. Kesmore then forms a customs union with Tervia, so imports from Tervia become tariff-free while the 25% tariff still applies to Westland. Which of the following correctly describes the effect on Kesmore's bicycle imports?

1. A Trade creation: imports switch to a lower-cost producer, so consumers save $10 per bicycle
2. B Trade diversion: imports switch to a higher-cost producer, costing $10 more per bicycle than the lowest world price
3. C Trade diversion: imports switch to a lower-cost producer, saving $10 per bicycle in resources
4. D Trade creation: imports from Westland rise because Kesmore's tariff on Westland's bicycles is removed

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Answer: B. | Source | Before the customs union | After the customs union |
|---|---|---|
| Westland (non-member) | $80 + 25% = $100 | $80 + 25% = $100 |
| Tervia (member) | $90 + 25% = $112.50 | $90 (no tariff) |

Before the union Kesmore imports from Westland; afterwards it imports from Tervia. This is trade diversion: trade moves from a more efficient non-member to a less efficient member because of the common external tariff. The resource cost to the world rises by $10 per bicycle ($90 - $80), and Kesmore's government loses $20 of tariff revenue per bicycle, although consumers pay $10 less.

Trade creation, by contrast, occurs when a customs union replaces higher-cost domestic production with lower-cost imports from a member.

Question 6

Corland enters a recession. Without any new decisions by the government, income tax and sales tax receipts fall and spending on unemployment benefits rises, so the budget deficit widens. What is this effect called and what is its impact?

1. A Automatic stabilisers; they reduce the size of the fall in aggregate demand
2. B Discretionary fiscal policy; it deliberately increases aggregate demand
3. C Fiscal drag; it increases the tax burden on households and deepens the recession
4. D Crowding out; it reduces private sector investment and deepens the recession

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Answer: A. Automatic (built-in) stabilisers are features of the tax and benefit system that move the budget balance in a counter-cyclical direction without any policy decision:

- In a recession, incomes and spending fall, so tax receipts fall, and unemployment benefit payments rise. The deficit widens, supporting disposable income and limiting the fall in aggregate demand.
- In a boom, the opposite happens and demand is restrained.

Progressive income taxes make the stabilising effect stronger.