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Cambridge IAL Economics study materials
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Cambridge IAL Economics practice questions

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Question 1Introduction to the price system and government intervention

A government sets a maximum price for bread below the free-market equilibrium price. What is the most likely immediate result?

  1. A fall in demand because consumers expect lower prices in future
  2. A surplus of bread as quantity supplied exceeds quantity demanded
  3. A shortage of bread as quantity demanded exceeds quantity supplied Correct answer.
  4. No change in the market because price controls do not affect quantities

Explanation

A binding maximum price sits below equilibrium, so the quantity demanded rises along the demand curve while the quantity supplied falls along the supply curve. The gap between them is a shortage. Only a price ceiling set below equilibrium bites; at or above equilibrium it has no effect.

Question 2Introduction to the price system and government intervention

Which statement correctly describes the effect of a minimum price set above the equilibrium wage in a labour market?

  1. The demand for labour rises because firms can attract more workers
  2. The quantity of labour supplied exceeds the quantity demanded, creating unemployment Correct answer.
  3. Employment rises because workers supply more labour
  4. The market clears at the new higher wage

Explanation

A minimum wage above equilibrium is a binding price floor. At the higher wage, more workers offer themselves for work while firms demand fewer workers, so excess supply of labour appears as unemployment. The market cannot clear because the wage cannot fall to equilibrium.

Question 3Introduction to the price system and government intervention

The price elasticity of demand for a product is 0.4. How should this value be interpreted?

  1. Demand is price elastic, so a price rise increases total revenue
  2. Demand is unit elastic, so total revenue is unchanged by a price change
  3. Demand is price inelastic, so a price rise increases total revenue Correct answer.
  4. Demand is perfectly elastic, so any price rise reduces quantity to zero

Explanation

An elasticity of 0.4 means the percentage fall in quantity demanded is smaller than the percentage rise in price. Because the price effect dominates, total revenue rises when price rises. Values below one in absolute terms describe inelastic demand.

Question 4Introduction to the price system and government intervention

What happens to the production possibility frontier of an economy when it experiences an increase in the size of its labour force?

  1. The frontier becomes steeper but does not move
  2. The economy moves along a fixed frontier towards more capital goods
  3. The frontier shifts inward because more workers must be paid
  4. The frontier shifts outward, allowing more of both goods to be produced Correct answer.

Explanation

The production possibility frontier shows the maximum combinations of two goods producible with given resources and technology. An increase in the labour force is a rise in the quantity of a factor of production, so the capacity of the economy grows and the frontier shifts outward. Movement along a fixed frontier reflects reallocation, not growth.

Question 5Introduction to the price system and government intervention

A consumer's demand curve for a normal good slopes downward mainly because of which pair of effects?

  1. The law of diminishing returns and economies of scale
  2. The income effect and the elasticity effect
  3. The price effect and the output effect
  4. The income effect and the substitution effect Correct answer.

Explanation

When the price of a good falls, it becomes cheaper relative to substitutes, so consumers switch towards it, which is the substitution effect. The fall in price also raises real purchasing power, so consumers buy more of a normal good, which is the income effect. Together these explain the downward slope.

Question 6Introduction to the price system and government intervention

Which of the following is most likely to shift the market supply curve for coffee to the left?

  1. A fall in the wage paid to coffee pickers
  2. An increase in the price of coffee beans used in production Correct answer.
  3. A successful advertising campaign by coffee retailers
  4. A rise in consumer incomes, assuming coffee is a normal good

Explanation

A rise in the price of an input raises costs of production at every output level, so producers supply less at each price and the supply curve shifts left. Changes in consumer incomes or advertising affect demand, not supply. A fall in wages would shift supply to the right.

Question 7Introduction to the price system and government intervention

What is the defining feature of a free good in economics?

  1. A good whose price is set at zero by government regulation
  2. A good provided without charge by the public sector
  3. A good for which demand exceeds supply at any positive price
  4. A good that is unlimited in supply and has no opportunity cost Correct answer.

Explanation

A free good is available in sufficient quantity to satisfy all wants at zero price, so using it involves no sacrifice of alternatives and therefore no opportunity cost. Most goods are economic goods because they are scarce relative to wants. A zero price set by policy does not make a good free in this technical sense.

Question 8Introduction to the price system and government intervention

The cross elasticity of demand between two goods is negative. What does this indicate about the relationship between the goods?

  1. They are normal goods, because negative values indicate rising incomes
  2. They are substitutes, because a rise in the price of one raises demand for the other
  3. They are unrelated, because cross elasticity measures income effects
  4. They are complements, because a rise in the price of one reduces demand for the other Correct answer.

Explanation

Cross elasticity measures the responsiveness of demand for one good to a change in the price of another. A negative value means a price rise for one good reduces demand for the other, which is the pattern for complementary goods used together. Substitutes have positive cross elasticity.

Question 9Introduction to the price system and government intervention

A firm faces demand that is price inelastic over the current range of output. Which pricing decision would raise its total revenue?

  1. Reduce price, because quantity demanded will rise proportionately more
  2. Raise price, because the percentage fall in quantity demanded will be smaller Correct answer.
  3. Reduce price to the level where elasticity equals one, then raise it again
  4. Keep price unchanged, because revenue is maximised where demand is inelastic

Explanation

With inelastic demand, a given percentage rise in price produces a smaller percentage fall in quantity demanded, so total revenue increases. Revenue is maximised where elasticity equals one, which lies above the inelastic range. Cutting price when demand is inelastic would reduce revenue.

Question 10Introduction to the price system and government intervention

A government imposes a specific (per-unit) indirect tax on a good whose demand is perfectly inelastic. Who bears the full burden of the tax?

  1. Neither party, because the tax is absorbed by a fall in the quantity traded
  2. The burden is shared equally between consumers and producers
  3. Consumers, because the quantity demanded does not change so the price rises by the full tax Correct answer.
  4. Producers, because they are legally required to pay the tax to the authorities

Explanation

Tax incidence depends on the relative elasticities of demand and supply, not on who legally pays. With perfectly inelastic demand, buyers continue to purchase the same quantity, so the market price rises by the full amount of the tax and consumers bear the entire burden. Producers' net receipts are unchanged.

Question 11Introduction to the price system and government intervention

A consumer surplus is best defined as which of the following?

  1. The difference between what consumers are willing to pay and what they actually pay Correct answer.
  2. The extra revenue a firm earns when it raises its price
  3. The total amount spent by consumers on a good in a period
  4. The fall in consumer spending caused by a price rise

Explanation

Consumer surplus measures the benefit buyers receive beyond the price paid. On a demand and supply diagram it is the area below the demand curve and above the market price, up to the quantity purchased. It is not the same as total expenditure.

Question 12Introduction to the price system and government intervention

The government introduces a subsidy paid to producers of a merit good. What is the most likely effect on the market?

  1. The equilibrium stays the same because subsidies are transfers between firms and government
  2. The demand curve shifts right, raising both price and quantity
  3. The supply curve shifts left, raising price and reducing quantity
  4. The supply curve shifts right, lowering the equilibrium price and raising the quantity traded Correct answer.

Explanation

A subsidy reduces producers' costs per unit, so more is supplied at each price and the supply curve shifts right. The new equilibrium has a lower price to consumers and a larger quantity traded, with the government bearing the cost of the subsidy.

Question 13Introduction to the price system and government intervention

A firm's production creates a negative externality. In a free market with no intervention, which outcome is expected?

  1. Output equals the socially optimal level because firms internalise all costs
  2. Output is above the socially optimal level because private costs are below social costs Correct answer.
  3. Output is zero because the externality makes production unprofitable
  4. Output is below the socially optimal level and price is above it

Explanation

When production imposes external costs, social marginal cost exceeds private marginal cost. Firms base decisions on private costs, so the free-market quantity exceeds the socially optimal quantity, where marginal social cost equals marginal social benefit. This overproduction is the basis for intervention such as taxes.

Question 14Introduction to the price system and government intervention

A good is non-rival in consumption and non-excludable. Which type of good does it describe?

  1. A private good
  2. A public good Correct answer.
  3. A merit good
  4. A demerit good

Explanation

Non-rivalry means one person's consumption does not reduce the amount available to others, and non-excludability means non-payers cannot easily be prevented from consuming it. These two properties define a public good such as national defence, which markets tend to underprovide because of free riding.

Question 15Introduction to the price system and government intervention

Which of the following best explains why a government might impose a maximum price on rented housing?

  1. To reduce the quantity of housing demanded to match supply
  2. To increase landlords' rental income and encourage new building
  3. To raise the equilibrium rent to reflect rising construction costs
  4. To make housing more affordable for tenants, at the risk of creating a shortage Correct answer.

Explanation

A rent ceiling is intended to protect tenants by keeping rents below the free-market level. The predictable side effect is excess demand, because quantity demanded rises while landlords supply fewer rental units. The policy trades affordability for a shortage and possible queuing or black markets.

Question 16Introduction to the price system and government intervention

The income elasticity of demand for a good is -0.6. What does this imply?

  1. The good is a complement to most other goods
  2. The good is an inferior good and demand falls as income rises Correct answer.
  3. The good is a luxury good with highly elastic demand
  4. The good is a normal good and demand rises as income rises

Explanation

Income elasticity measures how demand responds to a change in income. A negative value means demand falls when income rises, which is the defining characteristic of an inferior good. Normal goods have positive income elasticity, and luxuries have values above one.

Question 17Introduction to the price system and government intervention

A market is in equilibrium at a price of 10 units of currency with 500 units traded. The government then fixes a minimum price of 12. Which statement is correct?

  1. The minimum price creates excess demand because buyers expect further rises
  2. The minimum price shifts the demand curve to the left
  3. The minimum price has no effect because it is above the equilibrium price only slightly
  4. The minimum price is binding and creates excess supply at 12 Correct answer.

Explanation

A minimum price takes effect only when it is set above the equilibrium price. At 12, the quantity supplied exceeds the quantity demanded, so excess supply appears and the market cannot clear downward because the legal price cannot fall. This is the standard analysis of a binding price floor.

Question 18Introduction to the price system and government intervention

A firm's demand curve becomes more elastic after several close substitutes enter the market. What is the likely effect on the firm's ability to raise price profitably?

  1. Its ability to raise price increases because total market demand is fixed
  2. Its ability to raise price falls because consumers can switch easily Correct answer.
  3. Its ability to raise price is unchanged because elasticity affects only quantity
  4. Its ability to raise price increases because consumers have more choice

Explanation

Elasticity of demand for a firm's product measures how easily buyers can switch to alternatives. More close substitutes make demand more elastic, so a price rise causes a proportionately larger loss of sales, reducing the firm's pricing power. This is why competition constrains price increases.

Question 19Introduction to the price system and government intervention

Which change would cause a movement along the demand curve for a good rather than a shift of the curve?

  1. A rise in consumers' incomes
  2. A fall in the price of a complementary good
  3. A rise in the price of the good itself Correct answer.
  4. A change in consumer tastes in favour of the good

Explanation

A change in the good's own price alters the quantity demanded and is shown as a movement along a given demand curve. Shifts of the curve are caused by changes in the non-price determinants of demand, such as income, tastes, or the prices of related goods.

Question 20Introduction to the price system and government intervention

The supply of a good is perfectly inelastic. What does this mean for the effect of an increase in demand on price and quantity?

  1. Price rises but quantity traded does not change Correct answer.
  2. Price rises and quantity rises proportionally
  3. Both price and quantity stay the same
  4. Price stays the same and quantity rises

Explanation

Perfectly inelastic supply means the quantity supplied is fixed regardless of price, shown as a vertical supply curve. An increase in demand then raises the equilibrium price only, since the quantity traded is limited to the fixed amount available.

Question 21Introduction to the price system and government intervention

A government wants to reduce the consumption of a demerit good with inelastic demand. Which combination of policies is most likely to succeed?

  1. Price controls set below equilibrium, because shortages reduce consumption
  2. A small tax alone, because inelastic demand means quantity falls sharply
  3. A tax combined with regulation and information campaigns, because price signals alone change quantity little Correct answer.
  4. A subsidy to producers, because lower costs reduce consumption

Explanation

When demand is inelastic, a tax raises price but reduces quantity only slightly, so it is a weak instrument on its own. Combining the tax with regulation and information campaigns attacks consumption through several channels at once. This multi-policy approach is more effective than relying on price alone.

Question 22Introduction to the price system and government intervention

A price ceiling is set below equilibrium in a competitive market. Which consequence is most consistent with economic analysis?

  1. The market automatically returns to equilibrium because demand falls
  2. Producers compete for buyers by raising quality, eliminating the shortage
  3. Total consumer surplus necessarily rises because the price is lower
  4. Non-price rationing such as queues or black markets may develop Correct answer.

Explanation

A binding price ceiling prevents price from allocating the good, so excess demand persists and allocation occurs through non-price means such as queues, rationing, or illegal resale. Consumer surplus may rise or fall depending on how much quantity is lost, so it does not necessarily increase.

Question 23Introduction to the price system and government intervention

The marginal social benefit of a good equals the marginal private benefit plus the external benefit. Where the external benefit is positive and ignored by the market, which outcome results?

  1. The free market produces exactly the socially optimal quantity
  2. The free market produces less than the socially optimal quantity Correct answer.
  3. The free market produces more than the socially optimal quantity
  4. The free market produces nothing because the good is unprofitable

Explanation

With a positive externality, marginal social benefit exceeds marginal private benefit, so the demand curve understates the true social value of the good. The market equates private benefit with cost and therefore produces less than the socially optimal quantity. A subsidy can move output towards the social optimum.

Question 24Introduction to the price system and government intervention

A government removes a binding price floor on an agricultural product. Assuming competitive markets and no other changes, what is the expected effect?

  1. The price rises to the former floor level and the surplus persists
  2. The price falls to the equilibrium level and the surplus is eliminated Correct answer.
  3. The price falls and a shortage develops at the new equilibrium
  4. The quantity traded falls because producers leave the market

Explanation

A binding price floor holds the price above equilibrium and creates persistent excess supply. Removing it allows the price to fall to the market-clearing level, where quantity supplied equals quantity demanded, eliminating the surplus. The quantity traded rises as the price falls towards equilibrium.

Question 25Introduction to the price system and government intervention

Which statement about the relationship between total, average and marginal values is correct?

  1. Total value is maximised where marginal value is at its highest
  2. When marginal value is positive, average value must be rising
  3. When marginal value is below average value, average value is falling Correct answer.
  4. Marginal value equals total value divided by quantity at every level of output

Explanation

The marginal value pulls the average towards it. If the marginal value lies below the average, adding another unit lowers the average, so average value falls. Total value is maximised where marginal value is zero, not where it is highest.

Question 26Introduction to the price system and government intervention

Which of the following best describes the rationing function of the price mechanism in a free market?

  1. Prices provide an incentive for firms to reduce costs and adopt more efficient production methods.
  2. Prices signal to producers where consumer demand is strongest, guiding the allocation of resources.
  3. Prices adjust to equalise the marginal utility obtained from the last unit of each good consumed.
  4. Prices rise when demand exceeds supply, so only those willing and able to pay the higher price obtain the good. Correct answer.

Explanation

The rationing function occurs when price changes eliminate excess demand or excess supply by determining who gets the scarce good. When demand exceeds supply, the price is bid up, and only consumers willing and able to pay the higher price will purchase the good. This rations the limited quantity among competing buyers.

Question 27Introduction to the price system and government intervention

A consumer's demand for a good is price elastic. If the price of the good falls by 5%, which outcome is most consistent with this information?

  1. Quantity demanded will remain unchanged.
  2. Total expenditure on the good will rise. Correct answer.
  3. Quantity demanded will rise by less than 5%.
  4. Total expenditure on the good will fall.

Explanation

When demand is price elastic, the percentage increase in quantity demanded exceeds the percentage fall in price. Therefore total expenditure, which equals price times quantity, rises when price falls. This is a key application of the relationship between elasticity and total revenue.

Question 28Introduction to the price system and government intervention

In a market with no government intervention, a positive externality in consumption exists. Which statement about the free-market equilibrium is correct?

  1. Marginal social benefit equals marginal private benefit, so the market achieves allocative efficiency.
  2. Marginal social benefit is less than marginal private benefit, so the good is overconsumed relative to the social optimum.
  3. Marginal social cost exceeds marginal private cost, so the good is overproduced relative to the social optimum.
  4. Marginal social benefit exceeds marginal private benefit, so the good is underconsumed relative to the social optimum. Correct answer.

Explanation

A positive externality in consumption means that each unit consumed generates benefits to third parties, so marginal social benefit is greater than marginal private benefit. Consumers ignore these external benefits and base decisions on private benefit, leading to underconsumption compared with the social optimum where MSB equals MSC.

Question 29Introduction to the price system and government intervention

A government imposes a specific (per-unit) indirect tax on a good. Which factor would most increase the share of the tax burden borne by consumers?

  1. Demand for the good is price inelastic while supply is relatively elastic. Correct answer.
  2. Demand for the good becomes more price elastic.
  3. Supply of the good becomes more price elastic.
  4. The tax is levied as a percentage of the price rather than a fixed amount per unit.

Explanation

The incidence of an indirect tax depends on the relative elasticities of demand and supply. When demand is inelastic and supply is elastic, producers can pass most of the tax forward to consumers because consumers are less able to reduce quantity purchased. Thus consumers bear a larger share of the tax burden.

Question 30Introduction to the price system and government intervention

A government provides a subsidy to consumers of a good that generates a positive externality in consumption. Which outcome is most likely in a competitive market?

  1. The demand curve shifts to the right, increasing price and quantity traded. Correct answer.
  2. The supply curve shifts to the left, increasing price and reducing quantity traded.
  3. The demand curve shifts to the left, reducing price and quantity traded.
  4. The supply curve shifts to the right, reducing price and increasing quantity traded.

Explanation

A subsidy paid to consumers effectively increases their willingness and ability to pay, shifting the demand curve to the right. In a competitive market, this raises both the equilibrium price and quantity, helping to internalise the positive externality and move output closer to the social optimum.

Question 31Introduction to the price system and government intervention

Which of the following is an example of a government failure arising from the use of a maximum price?

  1. A maximum price set below equilibrium increases the quantity supplied and reduces the quantity demanded.
  2. A maximum price set above equilibrium has no effect on the market price or quantity.
  3. A maximum price set above equilibrium causes a surplus that the government must purchase.
  4. A maximum price set below equilibrium creates excess demand and may lead to rationing, queues or black markets. Correct answer.

Explanation

A binding maximum price (ceiling) set below equilibrium prevents the price from rising to clear the market. This creates excess demand, and the resulting shortage may force non-price rationing mechanisms such as queues, waiting lists or illegal black markets, which represent government failure because the intervention creates inefficiency.

Question 32Introduction to the price system and government intervention

Which of the following best explains why the supply curve for a good is upward sloping in the short run?

  1. Producers can easily substitute between inputs, allowing them to expand output without increasing costs.
  2. As output increases, firms experience diminishing marginal returns, so higher prices are needed to cover rising marginal costs. Correct answer.
  3. Consumers are willing to pay higher prices for larger quantities due to diminishing marginal utility.
  4. Technological progress lowers average costs as output expands, encouraging firms to supply more at higher prices.

Explanation

In the short run, at least one factor of production is fixed, so expanding output eventually leads to diminishing marginal returns. Marginal cost rises as more is produced, and firms require a higher price to cover these increasing costs, giving an upward-sloping supply curve.

Question 33International trade and exchange rates

A country's current account records a deficit of $40bn while its financial account shows a net inflow of $55bn. Assuming no errors and omissions, what is the balancing entry on the capital account and net errors and omissions combined?

  1. A net inflow of $95bn
  2. A net outflow of $95bn
  3. A net outflow of $15bn Correct answer.
  4. A net inflow of $15bn

Explanation

The balance of payments must sum to zero, so the current account deficit of $40bn must be financed by a combined surplus of $40bn across the other accounts. If the financial account already contributes a $55bn inflow, the remaining accounts must show a $15bn outflow to restore balance.

Question 34International trade and exchange rates

Which statement best describes the effect of a depreciation of a country's exchange rate on its balance of payments, according to the Marshall-Lerner condition?

  1. The trade balance worsens because imports become more expensive in domestic currency
  2. The trade balance is unaffected because volumes of trade do not respond to price changes
  3. The trade balance improves provided the sum of the price elasticities of demand for exports and imports exceeds one Correct answer.
  4. The trade balance always improves because exports become cheaper in foreign currency

Explanation

The Marshall-Lerner condition states that a depreciation improves the trade balance only if the combined price elasticities of demand for exports and imports exceed unity in absolute value. If elasticities are low, the value of imports may rise faster than export volumes, worsening the balance.

Question 35International trade and exchange rates

A government removes a quota on imported steel. Which outcome is most likely in the domestic steel market?

  1. The domestic current account moves into surplus
  2. Domestic steel output expands as firms gain scale
  3. Domestic steel prices rise and producer surplus rises
  4. Domestic steel prices fall and consumer surplus rises Correct answer.

Explanation

Removing a quantitative restriction increases the supply of imports, which lowers the domestic price toward the world price. Lower prices raise consumer surplus and typically reduce domestic producer surplus and output.

Question 36International trade and exchange rates

Under a system of floating exchange rates, which combination of changes would most likely cause a currency to depreciate?

  1. A rise in domestic interest rates combined with falling domestic inflation
  2. A rise in foreign interest rates combined with rising domestic interest rates
  3. A rise in export demand combined with falling domestic inflation
  4. A fall in domestic interest rates combined with rising domestic inflation Correct answer.

Explanation

Lower interest rates reduce the relative return on holding the currency, causing capital outflow and reduced demand. Higher domestic inflation erodes competitiveness and purchasing power, reinforcing downward pressure on the exchange rate.

Question 37International trade and exchange rates

Which of the following is recorded as a credit item in a country's balance of payments?

  1. A dividend paid to a foreign shareholder
  2. A purchase of foreign government bonds by domestic residents
  3. A gift sent abroad by domestic residents
  4. An export of services to a foreign resident Correct answer.

Explanation

Credit items are transactions that bring foreign currency into the country, such as exports of goods and services. Payments abroad, including income transfers and purchases of foreign assets, are recorded as debits.

Question 38International trade and exchange rates

A country joins a customs union with its trading partners. Which change is a direct consequence of this arrangement?

  1. Free movement of labour is automatically guaranteed among members
  2. Member countries adopt a single common currency
  3. Common external tariffs are applied to imports from non-members Correct answer.
  4. Member countries retain different tariffs against non-members

Explanation

A customs union involves free trade among members plus a common external tariff against non-members. It does not by itself create a single market for labour or a monetary union.

Question 39International trade and exchange rates

Which effect describes trade creation resulting from a customs union?

  1. Imports shift from a low-cost non-member to a higher-cost member country
  2. Consumers pay higher prices because external tariffs are removed
  3. High-cost domestic production is replaced by imports from a lower-cost member country Correct answer.
  4. Domestic firms expand output to replace imports from member countries

Explanation

Trade creation occurs when the removal of internal tariffs allows consumers to buy from a more efficient member producer, lowering costs and raising welfare. Trade diversion, by contrast, shifts purchases to a less efficient member because of the common external tariff.

Question 40International trade and exchange rates

A central bank intervenes in the foreign exchange market by selling its own currency and buying foreign currency reserves. What is the likely effect?

  1. The domestic currency depreciates and foreign reserves fall
  2. The domestic currency depreciates and foreign reserves rise Correct answer.
  3. The domestic currency appreciates and foreign reserves fall
  4. The domestic currency appreciates and foreign reserves rise

Explanation

Selling the domestic currency increases its supply on the foreign exchange market, pushing its price down, which is a depreciation. The foreign currency received in exchange is added to official reserves.

Question 41International trade and exchange rates

Which of the following is most likely to improve a country's current account balance in the short run?

  1. A rise in domestic absorption of imported goods
  2. A rise in domestic incomes triggering higher imports
  3. A rise in domestic saving relative to investment Correct answer.
  4. A fall in foreign demand for the country's exports

Explanation

A current account balance reflects the gap between national saving and investment, so higher saving relative to investment reduces the deficit or increases the surplus. The other options raise imports or reduce exports, worsening the balance.

Question 42International trade and exchange rates

A country with a fixed exchange rate faces persistent balance of payments deficits. Which policy response is consistent with maintaining the peg?

  1. Imposition of capital controls combined with lower interest rates
  2. Expansionary fiscal policy to stimulate domestic demand
  3. Devaluation of the currency against the peg
  4. Contractionary monetary policy to raise interest rates and attract capital inflows Correct answer.

Explanation

To defend a fixed parity, a central bank can raise interest rates, attracting capital inflows and reducing import demand through lower aggregate demand. This supports the currency without abandoning the peg.

Question 43International trade and exchange rates

Which statement about the terms of trade is correct?

  1. An improvement means export prices fall relative to import prices
  2. The terms of trade measure the volume of trade rather than prices
  3. An improvement means the price of exports rises relative to the price of imports Correct answer.
  4. A deterioration necessarily reduces a country's real income

Explanation

The terms of trade are the ratio of export prices to import prices, usually expressed as an index. An improvement occurs when export prices rise relative to import prices, allowing more imports per unit of exports.

Question 44International trade and exchange rates

Which factor would most likely cause a depreciation of a floating currency?

  1. A rise in export competitiveness following productivity gains
  2. A fall in the domestic money supply by the central bank
  3. A rise in foreign demand for the country's financial assets
  4. A speculative outflow of hot money from domestic financial assets Correct answer.

Explanation

Speculative capital outflow reduces demand for the currency and increases its supply as investors sell domestic assets, causing depreciation. The other options raise demand for the currency or tighten supply, tending to appreciate it.

Question 45International trade and exchange rates

Which of the following is an example of a non-tariff barrier to trade?

  1. A 20 per cent ad valorem tariff on imported textiles
  2. Strict product health and safety standards imposed on imports Correct answer.
  3. A subsidy paid to domestic farmers
  4. A quota limiting the volume of imported cars

Explanation

Non-tariff barriers are restrictions other than taxes on imports, such as technical, health and safety standards that raise compliance costs. Tariffs and quotas are distinct instruments, and subsidies are domestic support rather than a border barrier.

Question 46International trade and exchange rates

A depreciation of the exchange rate raises the domestic price of imports. Which term describes this effect on the domestic inflation rate?

  1. Monetary inflation
  2. Imported inflation Correct answer.
  3. Demand-pull inflation
  4. Cost-push inflation caused by wage rises

Explanation

A weaker currency raises the domestic currency price of imported goods, which feeds directly into the price level; this is called imported inflation. It is a specific channel distinct from wage-driven cost-push or demand-pull pressures.

Question 47International trade and exchange rates

Which of the following best explains why a country might adopt a fixed exchange rate?

  1. To permit automatic adjustment of the exchange rate to trade imbalances
  2. To provide certainty for exporters and importers when planning contracts Correct answer.
  3. To allow the central bank to set interest rates independently of other countries
  4. To eliminate the need to hold foreign exchange reserves

Explanation

A fixed rate removes exchange rate uncertainty, which reduces transaction costs and risk for firms engaged in international trade. However, it requires reserves and constrains independent monetary policy.

Question 48International trade and exchange rates

A country experiences a rise in its terms of trade index from 100 to 120. Assuming unchanged trade volumes, what is the most likely effect?

  1. The currency must have depreciated
  2. Real income rises because each unit of exports buys more imports Correct answer.
  3. The country's balance of trade necessarily deteriorates
  4. Export volumes must have risen to cause this change

Explanation

A higher terms of trade index means export prices have risen relative to import prices, so a given volume of exports finances more imports. With unchanged volumes, the country gains real income from the price effect.

Question 49International trade and exchange rates

Which policy is most likely to reduce a persistent current account deficit?

  1. A reduction in interest rates to stimulate consumption
  2. An increase in government spending on imported capital goods
  3. Expenditure-switching policies combined with a reflationary budget
  4. Expenditure-reducing policies that lower aggregate demand Correct answer.

Explanation

Expenditure-reducing policies cut aggregate demand and therefore the demand for imports, improving the current account. Expenditure-switching policies can also help but only if elasticities are sufficient.

Question 50International trade and exchange rates

Which of the following describes a free trade area rather than a customs union?

  1. Members adopt a common external tariff against non-members
  2. Members allow free movement of labour and capital
  3. Members share a single central bank and currency
  4. Members remove tariffs among themselves but set their own tariffs on non-members Correct answer.

Explanation

A free trade area eliminates internal barriers while each member keeps an independent external trade policy. A customs union goes further by harmonising external tariffs.