ICAP PRC-3 Economic policies and trends: practice questions with answers

Answer: D. - Impact of a tax: the person legally liable to pay it to the government (here, the manufacturers).
- Incidence: the person who finally bears the money burden (here, consumers, because prices rise by the full tax).
- Direct tax: impact and incidence fall on the same person and cannot be shifted (income tax, wealth tax).
- Indirect tax: levied on goods and services and can be shifted to others (sales tax, excise, customs duty). In Pakistan, federal sales tax on goods is levied under the Sales Tax Act 1990.

Answer: B. Crowding out occurs when expansionary fiscal policy financed by borrowing raises interest rates (the government competes with the private sector for the same pool of savings and bank credit). Higher borrowing costs reduce private investment and interest-sensitive consumption, so part of the boost from government spending is offset. The effect is strongest when the economy is near full capacity and when government borrows heavily from the domestic banking system.

Answer: B. In Keynes's liquidity preference model, when the interest rate is very low and expected to rise, bond prices are expected to fall, so people prefer to hold money rather than bonds. The demand for money becomes almost perfectly elastic: any increase in the money supply is simply held idle and does not reduce the interest rate further. This is the liquidity trap, in which monetary policy becomes ineffective and fiscal policy is needed to raise demand.

Answer: A. Open market operations (OMOs) are the central bank's buying and selling of government securities to manage liquidity in the money market:

- Mop-up (sell securities): drains reserves when there is surplus liquidity, raising short-term rates towards the policy rate.
- Injection (buy securities): adds reserves when liquidity is short.

OMOs keep the overnight rate close to the policy rate, usually within an interest-rate corridor whose ceiling is the rate at which the central bank lends overnight and whose floor is the rate it pays on banks' overnight deposits.

Answer: D. Causes of inflation:

- Demand-pull: total spending grows faster than the economy's capacity to produce.
- Cost-push: rising costs of production (wages, raw materials, energy) are passed on in prices.
- Imported inflation: a form of cost-push inflation that arises when import prices rise, often because the home currency depreciates; it matters a great deal for economies that import much of their fuel and inputs.
- Built-in: a wage-price spiral driven by expectations.

Here the trigger is a currency depreciation raising import costs, so it is imported inflation.

Answer: B. Types of unemployment:

- Frictional: short-term, while workers search and move between jobs.
- Structural: a mismatch between workers' skills or location and the jobs available, caused by long-term changes in the economy's structure; technological unemployment (jobs replaced by automation) is a form of structural unemployment.
- Cyclical (demand-deficient): caused by a general fall in aggregate demand in a downturn.
- Seasonal: linked to the time of year.
- Disguised: more workers in an activity than are needed; their marginal product is near zero.

Ammar's skills have been made obsolete by technology while other vacancies go unfilled, so he is structurally unemployed; retraining is the usual remedy.