CEA Economic Theory & Principles 4 — Questions and Answers
Question 1: According to the theory of comparative advantage, trade between two countries is beneficial when:
- One country has an absolute advantage in all goods
- Each country specializes in goods with lower opportunity costs (Correct answer)
- Both countries produce identical goods
- Trade is balanced with no deficits or surpluses
Correct answer: Each country specializes in goods with lower opportunity costs
Comparative advantage holds that countries gain from trade by specializing in goods they produce at relatively lower opportunity cost.
Question 2: The velocity of money (V) in the Quantity Theory of Money equation MV = PQ represents:
- The rate at which the central bank prints money
- The average number of times a unit of currency is spent in a period (Correct answer)
- The speed of inflation
- The ratio of nominal to real GDP
Correct answer: The average number of times a unit of currency is spent in a period
Velocity measures how frequently money circulates through the economy to facilitate transactions.
Question 3: Which of the following best describes 'moral hazard' in economics?
- The tendency of markets to underproduce public goods
- Risk-taking behavior that increases when one party is insulated from consequences (Correct answer)
- The cost of enforcing contracts
- Adverse selection in insurance markets
Correct answer: Risk-taking behavior that increases when one party is insulated from consequences
Moral hazard arises when insulation from risk (e.g., through insurance) leads to riskier behavior.
Question 4: A rightward shift in the aggregate supply curve most likely results in:
- Higher price levels and lower output
- Lower price levels and higher output (Correct answer)
- Higher inflation with no output change
- Lower output with unchanged prices
Correct answer: Lower price levels and higher output
An increase in aggregate supply shifts the AS curve right, reducing the price level and increasing real GDP output.
Question 5: The 'crowding out' effect refers to:
- Government spending reducing private investment by raising interest rates (Correct answer)
- Immigration reducing wages for native workers
- Monopolies displacing competitive firms
- Exports falling as domestic consumption rises
Correct answer: Government spending reducing private investment by raising interest rates
When government borrows to fund spending, it competes for loanable funds, pushing up interest rates and reducing private investment.
Question 6: In the context of monetary policy, 'open market operations' involve:
- Setting reserve requirements for commercial banks
- Buying or selling government securities to influence the money supply (Correct answer)
- Adjusting the discount rate for bank lending
- Regulating foreign currency exchange rates
Correct answer: Buying or selling government securities to influence the money supply
The Fed buys or sells Treasury securities to inject or withdraw reserves from the banking system, altering the money supply.
Question 7: The concept of 'economies of scale' means that as output increases:
- Average total costs rise proportionally
- Marginal costs always decline
- Long-run average costs fall (Correct answer)
- Fixed costs increase
Correct answer: Long-run average costs fall
Economies of scale exist when expanding production causes long-run average costs to decrease.
CEA Economic Theory & Principles 4
According to the theory of comparative advantage, trade between two countries is beneficial when: