CFA Level 2 - Economics Session 4 - Reading 14

CFA Level 2 - Economics Session 4 - Reading 14 (Practice Questions, Sample Questions) 1. Which of the following most completely identifies the institutions in an economy that are necessary for markets to be effective? A) Property rights and a supporting legal system. B) Property rights and monetary exchange. C) A legal system and a central banking system. Explanation: For markets to be effective, property rights and monetary exchange are required. If property rights are properly established and enforced, people will be assured that government will not confiscate their savings and investments. Monetary exchange provides for the efficient exchange of goods and services. 2. Which of the following is least likely to be considered as one of the three social institutions that are critical to the development of an incentive system? A) A specific form of political organization. B) Markets. C) Property rights. Explanation: The three social institutions that are critical to the development of incentives are markets, property rights, and monetary exchange. Collectively, these three social institutions create incentives for people to specialize and trade, save and invest, and discover new technologies. A specific form of political organization is not necessary for economic growth as communist and authoritarian countries have experienced economic growth. 3. Which of the following is least likely to be considered as one of the three social institutions that are critical to the development of an incentive system? A) A specific form of political organization. B) Markets. C) Property rights. The three social institutions that are critical to the development of incentives are markets, property rights, and monetary exchange. Collectively, these three social institutions create incentives for people to specialize and trade, save and invest, and discover new technologies. A specific form of political organization is not necessary for economic growth as communist and authoritarian countries have experienced economic growth. Which of the following is least likely to be considered as one of the three social institutions that are critical to the development of an incentive system? A) A specific form of political organization. B) Markets. C) Property rights. Explanation: The three social institutions that are critical to the development of incentives are markets, property rights, and monetary exchange. Collectively, these three social institutions create incentives for people to specialize and trade, save and invest, and discover new technologies. A specific form of political organization is not necessary for economic growth as communist and authoritarian countries have experienced economic growth. 4. Economist Davey Jarvis is studying time series data from the nation-state of Northwestern Island. He has created the following summary chart on the average annual change in real GDP per capita: 1886-1905 estimated <1% 1906-1925 unknown 1926-1945 +0.9% 1946-1965 +1.1% 1966-1985 +4.2% 1986-2005 +2.3% Which of the following is most likely the source of the growth spurt between 1966 and 1985? A) Reduction in the federal budget deficit. B) Growth in physical capital. C) Trade policy shift from import restrictions to tariffs. Explanation: The sources of economic growth are Aggregate Hours, Labor Productivity, Physical Capital Growth, Human Capital Growth, and Technological Advance. A trade policy shift to tariffs or a reduction in the federal budget deficit may or may not help real GDP growth. 5. Which of the following is a source of economic growth? A) Property Rights. B) Capricious Government. C) Technological Advance. Explanation: The sources of economic growth are Aggregate Hours, Labor Productivity, Physical Capital Growth, Human Capital Growth, and Technological Advance. Property Rights are a precondition, but not a source. 6. Bond analyst Davey Jarvis is writing an article on sources of economic growth for a monthly investment newsletter. He is least likely to include a discussion of: A) human capital growth. B) monetary exchange. C) aggregate hours. Explanation: The sources of economic growth are Aggregate Hours, Labor Productivity, Physical Capital Growth, Human Capital Growth, and Technological Advance. Monetary exchange is a precondition, but not a source. 7. Consider the following three statements. Statement 1 Statement 2 Statement 3 A) Correct Incorrect Incorrect B) Correct Correct Correct C) Correct Correct Incorrect Explanation: Statement 3 is incorrect. It is the neoclassical theory of economic growth (not the classical theory) that contends that population growth is a direct function of the opportunity cost for women entering the workplace. The other statements are correct. 8. Which of the following is the most basic precondition to economic growth? A) Property rights. B) Markets. C) An incentive system. Explanation: A suitable incentive system is the most basic precondition that must exist in order for a society to realize economic growth. The three social institutions that are critical to the development of incentives are markets, property rights, and monetary exchange. Collectively, these three social institutions create incentives for people to specialize and trade, save and invest, and discover new technologies. 9. Assume that real GDP per labor hour grew by 6 percent over the past 5 years while capital per labor hour grew by 5.25 percent. Based on the one third rule, the amount of real GDP growth attributable to the increase in capital per labor hour and the amount attributable to technological change are closest to: Increase in Capital Technological Change A) 2.00% 4.00% B) 0.75% 5.25% C) 1.75% 4.25% Explanation: According to the one third rule, capital has contributed one third of 5.25% toward the increase in real GDP per labor hour. So, the capital growth contribution to the increase in GDP is 1/3 × 5.25% = 1.75%. The remaining 4.25% (= 6% – 1.75%) growth in real GDP per labor hour is attributable to technological change. 10. Which of the following is the most accurate description of the one third rule? A) One third of real GDP per labor hour is attributable to the level of new capital per labor, holding technology constant. B) A 1% increase in technology results in a one third of 1% increase in real GDP per labor hour, holding capital per labor hour constant. C) A 1% increase in capital per labor hour results in a one third of 1% increase in real GDP per labor hour, holding technology constant. Explanation: The one third rule states that at a given level of technology, on average, a 1% increase in capital per labor hour results in a one third of 1% increase in real GDP per labor hour. 11. Assume that real GDP per labor hour grew by 7% over the past 5 years while capital per labor hour grew by 4.5%. Using the one-third rule, an estimate of the amount of real GDP growth attributable to technological change is closest to: A) 1.5% B) 2.33% C) 5.5% Explanation: Growth in real GDP = technology contribution + new capital contribution. 1/3 Rule: New capital contribution to real GDP growth = 1/3(% change in new capital) Technology contribution = real GDP growth – new capital contribution = real GDP growth - 1/3(% change in new capital) = 7% - 1/3(4.5%) = 5.5% 12. Over a 10 year period, labor productivity increased from $10 per labor hour to $10.60 per labor hour. Over the same period, the investment in new capital increased from $25 per labor hour to $25.50 per labor hour. The contribution of technological advancement to economic growth over this period is closest to: A) 5.33%. B) 4.11%. C) 3.00%. Explanation: According to the one third rule, at a given level of technology, a 1% increase in capital per labor hour results in a 1/3% increase in real GDP per labor hour. The percent change in capital per labor hour is 2% = (25.50/25) – 1. The increase in productivity due to the increase in capital per labor hour is 1/3 x 2.0% = 0.67%. The change in economic growth (GDP per labor hour) is 6% = (10.6/10) – 1. The remainder of the increase in GDP per labor hour, 6% – 0.67% = 5.33%, is due to technology change. 13. Assume that real gross domestic product (GDP) per labor hour grew 7% over the past three years. Based on the one third rule, the amount of real GDP growth attributable to the change in new capital is 1.5%. Over this period, the contribution of technological change to real GDP growth and the growth rate in new capital is closest to: Technology contribution Growth of new capital A) 6.5% 0.5% B) 5.5% 4.5% C) 1.8% 4.5% Explanation: Growth in real GDP = technology contribution + new capital contribution. One Third Rule: New capital contribution to real GDP growth = (1/3)(% growth in new capital) So, 1.5% = (1/3)(growth in new capital), or new capital growth = 4.5% = 1.5% / (1/3) Technology contribution = real GDP growth – new capital contribution = real GDP growth – 1.5% = 7% - 1.5 = 5.5% 14. Which of the following is NOT a typical property of productivity curves? A) Growth in capital per labor hour causes an upward movement along productivity curves. B) Technological growth causes productivity curves to shift upward. C) The shape of productivity curves is affected by changes in population growth. Explanation: Productivity curves are a plot of labor productivity (y-axis) against capital per labor hour (x-axis) at a given state of technology. Properties of productivity curves include: -Productivity increases as capital per labor hour increases, at a given state of technology. Growth in capital per labor hour causes movements along a productivity curve. -Productivity increases as the state of technology increases at any given level of capital per labor hour. Technological growth causes the productivity curve to shift upward. -Productivity curves exhibit the law of diminishing returns 15. Brent Bates, CFA, is a portfolio manager for a large money management firm located in New York. Analysts at the firm, led by Bates, have been following the development of the economic situation in Mexico after the signing of NAFTA in 1994, which lifted certain restrictions on investment in Mexico commerce by foreign firms. After a period of adjustment, the firm believed the Mexican market presented opportunity for attractive investment returns. The firm has recently purchased a controlling interest in a commercial bank based in Mexico City. One of the first measures to be taken by the firm is to diversify the bank’s portfolio through investments in Central and South America. The firm believes that Bates’ expertise in the analysis of the Mexican economy will be beneficial is pursuing other Latin American investment opportunities. Bates has identified two potential investments, both of which he believes will be in alignment with his firm’s investment criteria, and is ready to present his recommendations to the firm’s managing directors. One of Bates’ recommended investment opportunities is a company located in Country A, the largest country in South America, while the other is headquartered in Country B, a smaller Central American nation. Knowing that the firm’s partners have limited knowledge of the nuances of the Latin American economies, Bates decides to take a “macro” approach to his presentation by providing broad economic information about the current situations in the two countries. Bates begins with the company located in Country A, which is one of the largest manufacturers of women’s shoes in South America. The country’s economy has battled extremely high rates of inflation in the past. Over the past decade, tough policies enacted by its government appear to have controlled inflation while at the same time allowed measurable growth in real GDP. In the past ten years, Country A’s real GDP per labor hour has increased from $8.00 per labor hour to $8.64 in this time period. Over the same time period, investment in new capital increased from $18.00 per labor hour to $18.90 per labor hour. The company located in Country B has been operating in a much different economic climate than the first company. After a history of low productivity and a predominantly rural-based economy, the government of Country B has attempted to stimulate national productivity through a series of policies designed to promote more industrial commerce. Country B has established a multi-part system of incentives to encourage economic growth. Formerly state-run enterprises are increasingly being transferred into private ownership. The government of Country B has encouraged more foreign investment through less restrictive investment regulations. Also, interest rates are being carefully managed through accommodating fiscal and monetary policies to encourage growth.According to the classical growth theory, Country A’s recent growth in real GDP: A) is a result of the recent decrease in interest rates, which intensified incentives to discover new production methods that increase profitability. B) will lead to an explosion in population growth that will eventually erase any gains in GDP per labor hour. C) is directly attributable to a decreased opportunity cost for women to enter the workplace. Explanation: A key component of the classical growth theory is that growth in GDP is always temporary. When real GDP per capita rises above a subsistence level, the population will grow, driving GDP per capita back down to its original level. (Study Session 4, LOS 14.d) In general, which of the following factors is credited with being the largest contributor to a country’s sustained economic growth? A) Investment in new capital. B) Investment in human capital. C) Discovery of new technologies. Explanation: The discovery of new technologies has contributed more to sustained economic growth than investment in new capital or increased investment in human capital. (Study Session 4, LOS 14.c) The amount of Country A’s increase in GDP per labor hour that can be attributed to the change in capital per labor hour is closest to: A) 1.67%. B) 3.33%. C) 2.50%. Explanation: According to the “one-third” rule, at a given level of technology, a one percent increase in capital per labor hour results in a 1/3 of 1% increase in real GDP per labor hour. If capital labor per hour grew by 5%, then the capital growth contribution to the increase in GDP is 1.67% (= 1/3 × 5%). (Study Session 4, LOS 14.b) If in the next year, Country A’s investment in new capital increases by an additional $0.90 per labor hour, and the level of technology remains unchanged, GDP per labor hour will increase: A) by the same amount as from the previous decade’s $0.90 increase in investment in new capital. B) and the increase will be less than the increase resulting from the previous decade’s $0.90 increase in investment in new capital. C) and the increase will be greater than the increase resulting from the previous decade’s $0.90 increase in investment in new capital. Explanation: In accordance with the law of diminishing returns, at a given level of technology, the increase in GDP per labor hour will decrease as incremental capital per labor hour is added. (Study Session 4, LOS 14.b) Country B has implemented policies to ensure that an adequate incentive system is in place to foster economic development in the country. Which of the following are the three components necessary for a country to establish such a system? A) Markets, property rights, and monetary exchange. B) Property rights, monetary exchange, and investment in human capital. C) Markets, property rights, and investment in human capital. Explanation: The three most basic components necessary for a country’s economic growth are markets, property rights, and monetary exchange. Markets allow for the exchange of information among buyers and sellers. Property rights give assurance that no entity can confiscate savings and investments of a country’s citizens. Monetary exchange facilitates the efficient exchange of goods and services. (Study Session 4, LOS 14.a) According to the basic principles of the new growth theory, the government of Country B will succeed in fostering new economic development in their country through: A) an increase in capital accumulation. B) an increase in labor productivity. C) a decrease in real interest rates. Explanation: The new growth theory contends that the two main catalysts of growth are the creation of knowledge capital and lower real interest rates. (Study Session 4, LOS 14.d) 16. Which of the following is most accurate regarding labor productivity curves? Growth in capital per labor hour causes: A) productivity curves to shift; technological growth causes movement along productivity curves. B) movements along a productivity curve; technological growth causes productivity curves to shift. C) and technological growth cause productivity curves to shift. Explanation: The productivity curve results when labor productivity (real gross domestic product (GDP) per labor hour) is plotted against capital per labor hour at a given state of technology. A productivity curve shows how real GDP per labor hour changes as capital per labor hour changes. Growth in capital per labor hour causes movements along a productivity curve. Technological growth causes productivity curves to shift. 17. Labor productivity may be decomposed into which of the following two factors? A) Growth in physical capital per labor hour and technological change. B) Growth in both physical capital and human capital per labor hour. C) Growth in physical capital per labor hour and growth in real interest rates. Explanation: Changes in the growth rate of labor productivity may be decomposed into two components: (1) the growth in physical capital per labor hour, and (2) technological change. The one third rule is useful in this decomposition. 18. Which of the following is least likely to be observed when examining a labor productivity curve? A) The rate of change in technology as labor increases. B) The change in real GDP per labor hour as capital per hour changes, holding technology constant. C) The change in real GDP per labor hour as technology changes, holding capital per labor hour constant. Explanation: Labor productivity curves show: (1) the change if real GDP per labor hour as capital per labor hour changes, at a given state of technology, and (2) the change in real GDP per labor hour increases as the state of technology changes, at a given level of capital per labor hour. There is no way to directly observe the rate of change in technology from a labor productivity curve. 19. Which of the following is least likely to be considered necessary to sustain long-term economic growth? A) Investment in human capital. B) Positive population growth. C) Discovery of new technologies. Explanation: For economic growth to continue over the long term, societies must have incentives that encourage the pursuit of savings and investment in new capital, investment in human capital, and discovery of new technologies. 20. Technological progress is most extensively applied to which of the following? A) The developments in human capital. B) Improvements in the productivity of physical capital. C) The creation of investment opportunities and savings incentives. Explanation: While the most all-encompassing and powerful technologies are the development of human capital (written and spoken language, science, and mathematics) most technological progress involves improvements in the productivity of physical capital. 21. Which of the following activities provides the least significant contribution to economic growth? A) Discovery of new technologies. B) Increased consumer spending. C) Savings and investment in new capital. Explanation: Three activities are necessary to result in persistent economic growth: 1.Savings and investment in new capital increase labor productivity, which is defined as real GDP per labor hour. Saving and investment in new capital increases the level of capital per worker. 2.Investment in human capital is the investment in people’s skills and knowledge, leading to productivity improvements and technological advances. 3.Discovery of new technologies contributes to sustained economic growth by making human capital and physical capital more productive. 22. The new growth theory contends that economic growth is a function of which of the following two economic variables? A) The subsistence real wage and real interest rates. B) Real interest rates and technological change. C) The creation of knowledge capital and real interest rates. Explanation: The new growth theory holds that productivity growth is a function of society’s ability to discover new products and methods (i.e., the creation of knowledge capital), and real interest rates. 23. Which of the following concepts is uniquely associated with the new theory of economic growth? A) Increased spending on health care and population growth. B) Real gross domestic product (GDP) growth based on investment in new capital and technological change. C) No diminishing returns to knowledge capital. Explanation: Knowledge capital is a special type of public good because it is not subject to the law of diminishing returns. This is a key element of new growth theory. The implication is that, unlike the classical or neoclassical growth theories, economic growth is not limited. 24. Which of the following concepts is uniquely associated with the neoclassical theory of economic growth? A) Opportunity cost of having children. B) No diminishing returns to knowledge capital. C) Real GDP growth. Explanation: Neoclassical economists argue that the most important economic influence on population growth is the opportunity cost to women for entering the workplace. As real wages for women rise and their job opportunities expand, the opportunity cost of staying home and raising children increases. As the opportunity cost of having children increases, birth rates decline, and population growth slows. 25. While having lunch with a group of friends, Francine Lenser, CFA, was overheard saying the following: “The recent boom in technological advances should keep the economy growing. Whenever the economy slows, someone will come along with a bold new idea that kick-starts it.” Lenser’s statement most accurately reflects the: A) exogenous growth theory. B) new growth theory. C) neoclassical growth theory. Explanation: Lenser’s statement is a decent layman’s description of the new growth theory, also known as the endogenous growth theory. This theory argues that economic growth can continue indefinitely as long as technological advances are made.