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CONSTRUCTION

ECONOMICS AND
FINANCIAL
MANAGEMENT IN
CONSTRUCTION
CONTRACTING

S. Vindya Herath
NG/HNDQS/09/49
CONSTRUCTION ECONOMICS ANDFINANCIAL MANAGEMENT INCONSTRUCTION CONTRACTING

Programme HND in Quantity Surveying Unit 04 JACS Code K240

Module Number BE-QS-C-02 Module Title Construction Economics and


Financial Management in
Construction Contracting

Credit Value 20 Module Level H1 Module Value 1.0

Assessment Final Assessment Assessment Weighting 100%

Cost information to the internal management for the planning, controlling,


Assignment Title
economising and decision making.

Lecturer Mr.S.Kalananthan

Student Name S. Vindya Herath Student Number NG/HND/QS/09/49

Handed Over on 15/07/2016 Due Date 17/08/2016

Date Submitted Pass/ Re-Submission

Course Leader Mr. Geeth

Module Leader Mr. Kalananthan

Internal Verifier Date Verified

Developed by The Department of Engineering and Construction of ICBT Campus

Final Grade Fail Pass Merit Distinction

Initial Assessor

Assessor’s Signature Date Assessed

2nd Assessor

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ACKNOWLEDGEMENT

I would like to express my special gratitude and deepest appreciation to The International
College of Business and Technology and most of all, our lecturer, Mr. Kalananthan, for a
successful report on CEFMIC and Its Application and giving all the required encouragements and
unerring guidance.

Furthermore, it is my great pleasure to bestow my sincere thanks to my parents and my


friends specially for encouraging me and the support and knowledge we shared.

Finally, I would like to thank everyone who helped me in various ways to convert this is
into a successful one.

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TABLE OF CONTENT

ACKNOWLEDGEMENT ............................................................................................................ 2
TABLE OF CONTENT................................................................................................................ 3
TABLE OF FIGURES .................................................................................................................. 4
INTRODUCTION......................................................................................................................... 5
TASK 01 ..................................................................................................................................... 6
1.1 Identify the determinants of construction demand & supply. ......................................................... 6
1.2 Explain how the change in each determinant and effects the supply & demand. ........................... 6
TASK 02 ................................................................................................................................... 12
2.1 Market Changes to fluctuations in supply and demand and the market equilibrium. ................... 12
2.2 The Project Management Life Cycle. ........................................................................................... 14
TASK 03 ................................................................................................................................... 16
3.1 Various methods financial appraisal of various types of construction contracts. ......................... 16
TASK 04 ................................................................................................................................... 19
4.1 Fundamentals of finance management and the important in the construction. ............................. 19
4.2 Evaluate the significance of effective finance management in construction. ............................... 22
TASK 05 ................................................................................................................................... 23
5.2 Identify the 2 major kinds of policies which a government uses to control its economy. ............ 23
5.3 Effect of Fiscal Policy changes on construction economics and effective finance management. 25
CONCLUSION ........................................................................................................................... 26
REFERENCES ............................................................................................................................ 27

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TABLE OF FIGURES

Figure 1. Demand Curve ................................................................................................................. 7


Figure 2. Law of Demand ............................................................................................................... 8
Figure 3. Supply Curve ................................................................................................................... 9
Figure 4. Market Equilibrium ....................................................................................................... 12
Figure 5. Market Equilibrium Curve ............................................................................................ 13
Figure 6. Project Life Cycle .......................................................................................................... 14
Figure 7. Breakeven Point Chart ................................................................................................... 20
Figure 8. EVM Chart .................................................................................................................... 21
Figure 9. Fiscal Policy vs Monetary Policy .................................................................................. 24

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INTRODUCTION

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TASK 01

1.1 Identify the determinants of construction demand & supply.

A market facilitates the interaction of a buyer and a seller as they complete a transaction
furthermore Buyers, as a group, determine the demand and Sellers, as a group, determine the
supply. Markets exists in many forms. They determine the price and quantity of a good or service
transacted. The supply and the demand of a particular item differ from an item to item according
to the 02 main factors. According to their behavior the curves will shift and fluctuate
accordingly. Those are;
— Price
— Quantity
The inverse relationship between the price and the quantity demanded of a good or service
during some period of time. These main factors contribute for the change in supply and demand
where the slight variations results in fluctuations in the supply and demand.
Furthermore the supply and demand depends on some unique aspects such as Income, Taste, and
Prices of related goods, Aggregate demand, Expectations and number of buyers. For the demand
and Factors of production, Expectation of supply, more efficiency labor, No of suppliers. And
also quantity demand caused by changes in price only. It represented as movement along a
demand curve and the other factors determining demand are held constant.

1.2 Explain how the change in each determinant and effects the supply & demand.

Demand
The various amounts of a product that consumers are willing and able to purchase at various
prices during some specific period and demonstrated by demand schedule and demand curve.
The inverse relationship between the price and the quantity demanded of a good or service
during some period of time.
Basically DEMAND occurs;
— Income.
— Substitution.
— Quality.
— Advertising.
— Complements.
— Weather.
— Expectations.
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Demand curve shows the inverse relationship between price and quantity demanded for a good
or service. And derived from a demand schedule showing the quantity demanded at various
prices.

Figure 1. Demand Curve

Some factors which affects the Demand are discussed below in detail.
— Income
When the income of the public increases the demand for plywood increases as the
potential of the buyers to buy increases.

— Prices of other goods


When the prices of the alternate goods for plywood increases, the demand for the
plywood increases too, while the price for the alternates decreases the demand decreases.

— Change in taste & preference


When the taste and the preference for Plywood increases the demand increases.

— Aggregate demand
In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total
demand for final goods and services in an economy at a given time. So the aggregate
demand for plywood increases the demand too will increase.

— Govt. Policies
When the government policies are favorable for Plywood the demand increases as the
customers can get the services and the goods with ease.

— Expectations
When the customers’ expectations are met the demand for Plywood or a service increase
eventually.
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— Information
When the information regarding Plywood or the services are elaborated profoundly the
demand will increase as the buyer will have good understanding about the plywood types
and the use of each type for his or her work..

Figure 2. Law of Demand

Supply
The various amounts of a product that producers are willing and able to supply at various prices
during some specific period. This method demonstrated by the supply schedule and supply
curve. Supply is the quantity of a good or resource that sellers (or suppliers) are willing and able
to offer to the market for sale under a given set of conditions over a specific period of time.
Mainly;
— Direct relationship between the price and quantity supplied.
— Increased price causes increased quantity supplied.
— Decreased price causes decreased quantity supplied.
— Related to cost-plus pricing model.
Determinants of Supply factors affecting supply of a good include price, prices of inputs,
technology, prices of related goods, taxes, expectations, number of firms, etc. Other things
remaining constant, as the price of a good rises, the corresponding quantity supplied increases,

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and as the price falls the quantity supplied decreases; the relationship between price and the
quantity supplied is positive.

Figure 3. Supply Curve

Supply depends on;


— Factors of production
When the factors which affects the production of Plywood item becomes favorable for
the industry the supply of that item increases eventually.

— Price of other goods


When the price of the other goods produced by the same supplier increases the supply of
Plywood good decreases.

— Changing technology
When the used technology for Plywood production changes with the time the supply of
the goods also changes accordingly.

— More efficiency labor


When the labor efficiency increases the supply of the goods will increase proportionally.
And as the labor efficiency for plywood increases the supply too will increase.

— Expectation of supply
When the expected supply of plywood increases the supply for that good will also
increases targeting a higher expectation.

— No of suppliers
When the number of suppliers for an item increases the supply will also increase to keep
up the previous market of the product.

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— Govt. Regulations
When the regulations regarding plywood production becomes favorable the supply too
will eventually increase.

Determinants & effects of Supply and Demand.


There are numerous economic factors that determine the supply and demand for different
currencies. Economic changes that alter the relative strength of different countries are major
factors. The economic strength of the Japanese and German economies following World War II,
for example, was behind the appreciation of those currencies. Government debt is also a
contributing factor. If investors fear a country may default on its debt, they will drop their
investments and switch them to another currency. Interest rates also cause shifts in capital
accounts as investors move their assets from one currency to another, seeking higher returns.
Speculators look for opportunities in foreign exchange markets and can sometimes influence
price changes.

A demand increase will cause a shift to the right in the demand curve, causing both price and
quantity to increase. A demand decrease will cause a shift to the left in the demand curve,
causing both price and quantity to decrease.

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A supply increase will cause a shift to the right in the supply curve, causing price to decrease and
quantity to increase. A supply decrease will cause a shift to the left in the supply curve, causing
price to increase and quantity to decrease.

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TASK 02

2.1 Market Changes to fluctuations in supply and demand and the market equilibrium.

Market equilibrium is a condition under which the quantity supplied is equal to the quantity
demanded; when a market is in equilibrium, there is no tendency for change. Occurs when the
buying decisions of households and the selling decisions of producers are equated.
A situation in which the supply of an item is exactly equal to its demand. Since there is neither
surplus nor shortage in the market, price tends to remain stable in this situation. Determines the
equilibrium price and equilibrium quantity bought and sold in the market. The equilibrium price
is the price at which the quantity demanded is equal to the quantity supplied.
 Shortages occur when price is below the equilibrium price; shortages cause the price to
rise.
 Surpluses occur when price is above the equilibrium price; surpluses cause the price to
fall.

Surplus
• Quantity demanded is less than quantity supplied Q d < Qs

Equilibrium
• Quantity demanded is equal to quantity supplied Qd = Qs

Shortage
• Quantity demanded is greater than quantity supplied Q d > Qs

Figure 4. Market Equilibrium

The operation of the market depends on the interaction between buyers and sellers. An
equilibrium is the condition that exists when quantity supplied and quantity demanded are equal.
At equilibrium, there is no tendency for the market price to change.
— Only in equilibrium is quantity supplied equal to quantity demanded.
— At any price level other than P0, the wishes of buyers and sellers do not coincide.

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Figure 5. Market Equilibrium Curve

If a market is not at equilibrium, market forces tend to move it to equilibrium. Let's break this
concept down.

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2.2 The Project Management Life Cycle.

No matter what project it is that you’re preparing for, the project management life cycle can
assist you and your team in narrowing the project's focus, keeping its objectives in order and
finishing the project on time, on budget and with a minimum of headaches. The Project
Management Life Cycle is the Initiation, Planning, Execution and Closure.

Figure 6. Project Life Cycle

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TASK 03
3.1 Various methods financial appraisal of various types of construction contracts.

Financial appraisal views investment decisions from the perspective of the organization. It
assesses the viability of a project based on the direct effects on the cash flow of the organization.
It considers whether the projected revenues will be sufficient to cover expenditures and whether
the financial return is sufficient to make the investment commercially viable.
Through the financial appraisal and the financial statement analysis we can answer some major
questions which may arise in the industry;
 Is the company in a state to fulfill their obligations in time by converting their assets?
 Can the company earn adequate profit?
 Is investment in the company safe?
 Is the company properly capitalized?
 Does the company earn enough to build reserves for future growth?
Appraisal helps to evaluate the past performance of a company. The Management Information
System is meant to ensure adequate profitability, to have an early warning of something going
wrong, to have basis for allocation of resources, to evaluate managers. Moreover there are some
types of financial appraisal. Those are;
 Net Present Value.
 Payback Method.
 Internal Rate of Return.
 Profitability Index.
 Average Rate of Return.

Net Present Value.


The net present value technique (NPV) involves discounting all future cash flows to a
common base year. And also this type consider time value of money, it compare rupee value of
today and after a year. This is determined by summing the net annual cash flow, discounted at
the project’s cost of capital and deducting the initial outlay. Advantages of this method are that it
reflects the time value of money and maximizes shareholder's wealth. Its weakness is that its
rankings depend on the cost of capital; present value will decline as the discount rate increases.
𝟏
𝑵𝒆𝒕 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 = 𝑺 +
(𝟏 + 𝒓)𝑵
If, S = Cash Flow
N = NO. Of years
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R = Interest Rate

Payback Method.
A company or a construction contract chooses the expected number of years required to recover
an original investment. Projects will only be selected if initial outlay can be recovered within a
predetermined period and time required to recover original investment. This method is relatively
easy since the cash flow doesn't need to be discounted. Here the weakness is that it ignores the
cash inflows after the payback period, and does not consider the timing of cash flows.
𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
Merits:
— More on liquidity then profitability.
— Ignores cost of capital.
— Not cover the earning beyond payback period.
— Suitable for small projects.
— Best when project have shorter period and less cost.
— Helps to entrepreneur to invest in quick return funds.
— Easy to operate and simple to understand.

Internal Rate of Return. (IRR)


IRR is use time value of money and this type consider the Cash Flow for the whole life of
project. This method equates the net present value of the project to zero. The project is evaluated
by comparing the calculated internal rate of return to the predetermined required rate of return.
Projects with Internal rate of return that exceed the predetermined rate are accepted. The major
weakness is that when evaluating mutually exclusive projects, use of internal rate of return may
lead to selecting a project that does not maximize the shareholders' wealth.
Merits:
— Decision making is depends on the future financial projection.
— It assumes that re-investment rate of cash flow is at IIR
— Difficult to understand and use.
— Recognized time value of money.
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— Objective of maximizing owner’s welfare.


— Consider cash flow for whole life.

Profitability Index.
This method mainly talk about ratio of present value of inflow and outflow. And Profitability
ratio of project more than 01 is to be selected. This is the ratio of the present value of project
cash inflow to the present value of initial cost. Projects with a Profitability Index of greater than
1.0 are acceptable. The major disadvantage in this method is that it requires cost of capital to
calculate and it cannot be used when there are unequal cash flows. The advantage of this method
is that it considers all cash flows of the project.
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘
𝑷𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑰𝒏𝒅𝒆𝒙 =
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘

Merits:
— Conceptually sound.
— Consider time value of money.
— Facilitates ranking of project.

Average Rate of Return. (ARR)


ARR method is better than Pay Back Period method. This considers earnings of full project
during its economic time. Average Rate of Return also known as Return on Investment (ROI).
This method ignores time value of money and more focus on profit and loss. ARR isn’t consider
re-investment of profit over years and moreover ARR isn’t compare between sizes of investment.
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

Merits:
— Consider earning of full life.
— Helps to comparing with other projects.
— Simple to calculate and easy to understand.
— Consider net earnings after depreciation and taxes.

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TASK 04
4.1 Fundamentals of finance management and the important in the construction.

A construction company may be rich on paper & yet go bankrupt if it doesn’t have enough
liquidity to pay for its financial obligations. More companies fail for lack of liquidity than for
any other reason. It can be argued that cash is the most important resource that any contractor
can manage.

Breakeven Point
The breakeven point is the sales value at which a business neither makes profit nor loss. This will
assist organizations to setting both revenue and profitability targets & this is the relationship
between cost volume and profits at various levels of activity, with an emphasis placed on the
break-even point. If output of any product falls below that point there is loss; and if output
exceeds that point there is profit.
To find the breakeven point, you need to know your variable and fixed costs. Within a
reasonable sales range, fixed costs do not vary with sales or production volume. Variable costs
are directly proportional to the sales volume. Think of variable costs this way: sales cause
variable costs. If sales don't cause the cost, then the cost is fixed.
Thus, it is the minimum point of production where total costs are recovered. Therefore, at break-
even point.
 Sales Revenue – Total Cost
 or, Sales – Variable Cost = Contribution = Fixed Cost
It can be concluded that at break-even point the contribution earned just covers the fixed cost
and, at levels below the point, contribution earned is not sufficient to match the fixed cost and, at
levels above the point, contribution earned more than recovers the fixed cost.
Construction industry is constantly keep evolving and changing and margins and overhead costs
are always changing. To keep organization’s break even amount relevant firm need to constantly
recalculate it to reflect the changes occurring in business.

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Figure 7. Breakeven Point Chart

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Earned Value Management (EVM)


EVM is a technique that is used to track the progress and status of a project and forecast its likely
future performance. Furthermore a systematic approach to the integration and measurement of
cost, schedule, and technical (scope) accomplishments on a project. Provides the ability to
examine detailed schedule information, critical program and technical milestones, and cost data.
EVM;
— Provides info about the project in terms of accomplishment as well as how much has
been spent to date.
— Helps to make critical project decision based on actual vs. budget cost, variance, and
trends & to predict future performance.
— Useful to make prediction based on comparative analysis.
— Improves project performance.
— Identifies the problems by analyzing the data captured.
— Value for money & project’s final cost / delivery date with certainly.
EVM helps project managers to measure project performance. It is a systematic project
management process used to find variances in projects based on the comparison of worked
performed and work planned. EVM is used on the cost and schedule control and can be very
useful in project forecasting. The project baseline is an essential component of EVM and serves
as a reference point for all EVM related activities. EVM provides quantitative data for project
decision making.

Figure 8. EVM Chart

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4.2 Evaluate the significance of effective finance management in construction.

Financial management is part of the decision-making, planning and control subsystems of an


enterprise. Financial issues that engineering managers must understand and address through their
accounting staff to collaboratively provide for effective financial management of their consulting
engineering or design firm. Financial decisions which increase risks will decrease the value of
the firm and on the other hand, financial decisions which increase the profitability will increase
value of the firm.
Construction sector is vulnerable to economic changes, especially during recession periods due
to the high capital outlays, cost flexibility and high competition limiting the price. The changes
of the business environment, often associated with shortage of funds, exchange rate fluctuation
and political instability are increasing the construction projects financial risks. The actual
economical context in the Central and East European countries is characterized by an aggressive
competition and a lack of investments in construction area.
In today’s environment, the role of the financial manager in a construction organization is
essential to organizational success, and more importantly, is vital to avoiding failure. That may
sound extreme, but in many circumstances, competition is so fierce and margins are so thin,
reliable financial information and analysis certainly can make the difference between success and
failure.
Financial risk and construction goes hand-in-hand, and the further away a company is from the
project developer, the more risk it shoulders. The scope of financial risk on a construction project
is a huge topic contemplating under-funded or underbid projects, contractor default problems,
misappropriation of project funds and more.

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TASK 05
5.1 Classification of Taxes.
There are main two types of taxes:

5.2 Identify the 2 major kinds of policies which a government uses to control its economy.
Fiscal Policy
Fiscal policy is used to control the government’s revenue and expenditure & involves the
decisions that a government makes regarding collection of revenue, through taxation and about
spending that revenue. If the economy is growing fast, then the government may decrease the
spending.
Governments typically use fiscal policy to promote strong and sustainable growth and reduce
poverty. The role and objectives of fiscal policy gained prominence during the recent global
economic crisis, when governments stepped in to support financial systems, jump-start growth,
and mitigate the impact of the crisis on vulnerable groups.

Monetary Policy
Monetary policy refers to the attempts to manipulate either the rate of interest or the
money supply to bring about desired changes in the economy & this is how central banks
manage liquidity to create economic growth. Liquidity is how much there is in the money
supply. That includes credit, cash, checks, and money market mutual funds. The most important
of these is credit. That includes loans, bonds, and mortgages.

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Monetary policy involves altering base interest rates, which ultimately determine all other
interest rates in the economy, or altering the quantity of money in the economy. Many
economists argue that altering exchange rates is a form of monetary policy, given that interest
rates and exchange rates are closely related.
The core objective of the Central Bank of Sri Lanka is to maintain the economic and price
stability. Therefore, in order to achieve the objective, the Central Bank of Sri Lanka implements
the monetary policy which are the actions to influence costs and availability of money. Monetary
policy is used to control the inflation rates of the country.

Figure 9. Fiscal Policy vs Monetary Policy

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5.3 Effect of Fiscal Policy changes on construction economics and effective finance
management.

The fiscal policy is imposed by the government on the economy and related to the taxation
policy imposed by the government to control the overall spending within the economy.
The study finally recommended that there should be consistency in policy making by the
government in order to influence the level of aggregate demand in the economy in an effort to
achieve economic objectives of prices stability of building materials, full employment of labors
and economic growth. That taxes such as VAT, custom and exercise duties, road rolls, petrol
duties, wages tax, rent tax, interest tax, and profit tax should be reduced so that disposable
income of individual would be increased and stable in order to improve investment in
construction work.
When the government imposes taxes they receive a greater income which in turn will result in
the increase of government spending. Majority of the government spending will be on capital
infrastructure, in other words constructions. Therefore, the construction companies will be able
to obtain many contracts from the government. This will increase the demand for their products
and services. Also government sending includes providing subsidies to industries. When the
subsidies received by the construction industry increase it will directly benefit the business.
The government can influence the construction economy by reducing the taxes as well. Reducing
the taxes will lead to higher disposable income for the consumers. Once the consumers have a
higher income at their disposal then they will be prompted to invest in private capital expenditure
such houses. This will result in the increase in demand for constructions in the country. The
construction industry will be benefited by the changes in the fiscal policies by the government.

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CONCLUSION

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