Worked Solutions
Topics 5–6: Financial Markets & Government — Worked Solutions (Preliminary Economics)
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Worked examples for Topics 5 and 6 of Preliminary Economics. Each shows where the marks are awarded, the key idea, and the full solution explained by your choice of tutor — Stella, Ella or Cassie.
How to use these
Try each question first, then check your working. Use the tutor tabs to read the full solution in the style that suits you: Stella is direct and challenging, Ella is warm and explains the why, and Cassie is concise and analytical.
Example 1 — Simple interest on a financial product
Question
A saver deposits \$5 000 in an account paying 4% per annum simple interest and leaves it for 3 years.
(a) Calculate the total interest earned over the 3 years. (1 mark)
(b) Explain one way the Reserve Bank of Australia raising the cash rate would be expected to affect borrowing and saving behaviour in the economy. (2 marks)
Solution
(a) Simple interest is $I = P × r × t = 5000 × 0.04 × 3 = \mathbf{\$600}$.
(b) When the RBA raises the cash rate, banks' funding costs rise and they pass this on as higher lending and deposit rates. The effects:
- Borrowing falls — loans (mortgages, business finance) cost more, so households and firms borrow and spend less.
- Saving rises — higher deposit rates make saving more rewarding, so people save more and consume less.
Either direction earns the marks — the point is that higher interest rates discourage borrowing/spending and encourage saving, which slows economic activity.
(a) Simple interest is worked out only on the original amount deposited, using $I = P × r × t$. Here $P = 5000$, $r = 0.04$ (that's 4%), and $t = 3$ years, so $I = 5000 × 0.04 × 3 = \mathbf{\$600}$ over the three years.
(b) The cash rate is the interest rate the RBA targets in the overnight money market, and it flows through to the rates banks charge and pay. When the RBA raises it:
- Borrowing tends to fall — because loans become more expensive, households think twice about a new mortgage or car loan and firms delay investment, so borrowing and spending ease off.
- Saving tends to rise — because banks offer better returns on deposits, holding money in savings becomes more attractive, so people are encouraged to save rather than spend.
You only need one of these, but both illustrate the same idea: dearer money discourages borrowing and rewards saving, which is how the RBA can cool down an overheating economy.
(a) $I = P × r × t = 5000 × 0.04 × 3 = \mathbf{\$600}$.
(b) RBA raises cash rate → higher lending and deposit rates.
- Borrowing ↓ — loans dearer → less borrowing/spending by households and firms.
- Saving ↑ — higher deposit returns → saving more attractive.
- Net effect: dampens economic activity (need only one direction for marks).
Where the marks go
- 1 mark: Correctly calculates simple interest of \$600
- 1 mark: Links a higher cash rate to higher borrowing/deposit interest rates
- 1 mark: Explains the effect on either borrowing (falls) or saving (rises)
Key idea
Simple interest is P × r × t; when the RBA raises the cash rate, higher interest rates discourage borrowing and spending while encouraging saving.
Example 2 — The role of government in the economy
Question
(a) Explain why public goods such as street lighting are unlikely to be provided by private markets. (2 marks)
(b) Outline one other way, apart from providing public goods, that government intervenes to address market failure. (2 marks)
Solution
(a) Public goods have two features: they're non-excludable (you can't stop non-payers from using them) and non-rival (one person's use doesn't reduce what's left for others). Street lighting fits both — it lights the street for everyone passing, and you can't switch it off for someone who didn't pay. That creates the free-rider problem: with no way to charge users, private firms can't earn a return, so they won't supply it. Government steps in and funds it through taxation.
(b) Another intervention is using taxes and subsidies to correct externalities. For a negative externality like pollution, government taxes the activity (e.g. a pollution tax) so producers face the true social cost and cut output toward the efficient level. For a positive externality like vaccination, a subsidy encourages more of the beneficial activity.
(a) Public goods have two special characteristics. First they're non-excludable — once provided, you can't realistically stop people who haven't paid from benefiting. Second they're non-rival — one person enjoying them doesn't use them up for anyone else. Street lighting shows both: it shines on everyone who walks past, and you can't bill individuals for it. The trouble for a private firm is the free-rider problem — if people can enjoy the good without paying, no one will pay, so the firm can't cover its costs and simply won't provide it. That's why government funds these goods through taxation instead.
(b) Beyond providing public goods, a major way government addresses market failure is through taxes and subsidies to deal with externalities. When an activity harms third parties — say, pollution — a tax raises the producer's costs so they take that harm into account and produce less. When an activity benefits others — like education or vaccination — a subsidy lowers the cost and encourages more of it. In both cases the government nudges the market toward the outcome that's better for society as a whole.
(a) Public goods are:
- Non-excludable — can't exclude non-payers.
- Non-rival — one person's use doesn't reduce others'.
- Street lighting fits both → free-rider problem → no private revenue → not supplied privately.
- Government funds via taxation.
(b) Other intervention: taxes and subsidies for externalities.
- Negative externality (pollution) → tax → less produced, social cost internalised.
- Positive externality (vaccination) → subsidy → more produced.
Where the marks go
- 1 mark: Identifies public goods as non-excludable and non-rival (street lighting example)
- 1 mark: Explains the free-rider problem prevents private provision
- 1 mark: Identifies another form of government intervention (e.g. taxes/subsidies, regulation)
- 1 mark: Outlines how that intervention addresses a market failure
Key idea
Public goods are non-excludable and non-rival, so the free-rider problem means private markets won't supply them; government also corrects market failure through tools such as taxes and subsidies.