Class 12 CBSE Economics: Introductory Macroeconomics - Exam Focused Questions
I. National Income and Related Aggregates
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is a stock variable? (a) Income (b) Consumption (c) Wealth (d) Investment
Net National Product at Factor Cost (NNPfc) is also known as: (a) Gross Domestic Product (GDP) (b) National Income (c) Personal Income (d) Disposable Income
Which of the following is NOT included in the estimation of National Income? (a) Transfer payments (b) Imputed rent of owner-occupied houses (c) Services rendered by a doctor (d) Production for self-consumption
Depreciation is also known as: (a) Capital loss (b) Capital consumption allowance (c) Capital gains (d) Capital formation
GDP at Market Price (GDPmp) - Net Indirect Taxes = ? (a) GDP at Factor Cost (GDPfc) (b) NNP at Market Price (NNPmp) (c) NDP at Market Price (NDPmp) (d) GNP at Factor Cost (GNPfc)
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Distinguish between 'stock' and 'flow' variables with suitable examples.
Explain the concept of 'Net Factor Income from Abroad (NFIA)' and its significance in national income accounting.
Differentiate between 'Intermediate Goods' and 'Final Goods' with examples.
What is the problem of 'Double Counting' in national income estimation? How can it be avoided?
Define 'Gross Domestic Product (GDP) at Market Price'. State its limitations as a measure of welfare.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the 'Income Method' of calculating National Income. What precautions should be taken while using this method?
Discuss the 'Product Method' (or Value Added Method) of calculating National Income. Illustrate with a hypothetical example.
Explain the 'Expenditure Method' of calculating National Income. What are its main components?
Define and explain the following aggregates: (a) GDP at Factor Cost (b) NNP at Market Price (c) Personal Disposable Income (d) Private Income
Critically examine GDP as a measure of economic welfare.
D. Numerical Problems (4-6 Marks Each)
Calculate National Income (NNPfc) from the following data:
GDPmp = ₹ 5,000 crores
Consumption of Fixed Capital = ₹ 500 crores
Net Indirect Taxes = ₹ 300 crores
Net Factor Income from Abroad = ₹ (-) 100 crores
From the following data, calculate: (a) GDPmp and (b) NNPfc.
Private Final Consumption Expenditure = ₹ 800 crores
Government Final Consumption Expenditure = ₹ 250 crores
Gross Domestic Capital Formation = ₹ 200 crores
Net Exports = ₹ (-) 30 crores
Consumption of Fixed Capital = ₹ 40 crores
Net Indirect Taxes = ₹ 60 crores
Net Factor Income from Abroad = ₹ 20 crores
Given the following data, calculate Gross National Product at Market Price (GNPmp) and Net Domestic Product at Factor Cost (NDPfc):
Compensation of Employees = ₹ 1,500 crores
Rent = ₹ 300 crores
Interest = ₹ 200 crores
Profits = ₹ 500 crores
Mixed Income of Self-Employed = ₹ 800 crores
Net Indirect Taxes = ₹ 180 crores
Consumption of Fixed Capital = ₹ 100 crores
Net Factor Income from Abroad = ₹ (-) 50 crores
E. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Circular flow of income in a two-sector economy is based on the principle of equality of income and expenditure." Elaborate.
How would the following be treated while estimating National Income? Give reasons. (a) Scholarship given to students by government. (b) Sale of second-hand car. (c) Interest paid by a bank on deposits. (d) Money received by a family in India from relatives working abroad.
Discuss the difficulties involved in measuring national income in a developing country like India.
II. Money and Banking
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is NOT a function of money? (a) Medium of exchange (b) Store of value (c) Price stability (d) Unit of account
The central bank of India is: (a) SBI (b) RBI (c) PNB (d) HDFC Bank
Which of the following is a quantitative method of credit control by the central bank? (a) Moral Suasion (b) Selective Credit Controls (c) Bank Rate (d) Margin Requirements
If Legal Reserve Ratio (LRR) is 20%, the money multiplier will be: (a) 2 (b) 5 (c) 10 (d) 20
Commercial banks create money by: (a) Printing currency notes (b) Accepting deposits (c) Advancing loans (d) Selling securities
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Explain the 'store of value' function of money. Why is it essential for economic transactions?
Differentiate between 'Central Bank' and 'Commercial Bank'.
Explain the concept of 'Money Multiplier'. How does it work?
What are 'Demand Deposits'? How do they differ from 'Time Deposits'?
Briefly explain 'Bank Rate' and its role in controlling credit.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Discuss the various functions of a Central Bank.
Explain the process of credit creation by commercial banks. Use a numerical example to illustrate.
Elaborate on the various quantitative measures used by the Central Bank to control the money supply in an economy.
What are the limitations of the Barter system? How does money overcome these limitations?
Explain the role of the Reserve Bank of India as 'Lender of Last Resort' and 'Banker to the Government'.
D. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Demonetisation was a step towards a cashless economy." Do you agree? Discuss the advantages and disadvantages of a cashless economy.
How would an increase in the Cash Reserve Ratio (CRR) affect the lending capacity of commercial banks? Explain the chain of effects.
Why is the control of money supply essential for the stability of an economy?
III. Determination of Income and Employment
A. Multiple Choice Questions (MCQ - 1 Mark Each)
In a two-sector economy, aggregate demand is given by: (a) C + I (b) C + S (c) C + I + G (d) C + I + G + (X-M)
If Marginal Propensity to Consume (MPC) is 0.8, then Marginal Propensity to Save (MPS) will be: (a) 0.2 (b) 0.8 (c) 1 (d) 0
The relationship between consumption and income is called: (a) Investment function (b) Savings function (c) Consumption function (d) Aggregate supply function
At equilibrium, in a two-sector economy: (a) AD > AS (b) AD < AS (c) AD = AS (d) All of the above
If investment increases by ₹ 100 crores and MPC is 0.75, the increase in income will be: (a) ₹ 400 crores (b) ₹ 100 crores (c) ₹ 75 crores (d) ₹ 125 crores
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Distinguish between 'Autonomous Consumption' and 'Induced Consumption'.
Explain the concept of 'Marginal Propensity to Consume (MPC)'. What is its range?
What is 'Ex-ante Investment' and 'Ex-post Investment'?
Define 'Full Employment' and 'Voluntary Unemployment'.
Explain the meaning of 'Investment Multiplier'.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the determination of equilibrium level of income and employment using the Aggregate Demand and Aggregate Supply approach. Use a diagram.
Explain the determination of equilibrium level of income and employment using the Savings and Investment approach. Use a diagram.
Discuss the concept of 'Inflationary Gap'. Explain its causes and measures to correct it.
Discuss the concept of 'Deflationary Gap'. Explain its causes and measures to correct it.
Derive the relationship between MPC and MPS. Explain how the value of the investment multiplier is related to MPC.
D. Numerical Problems (4-6 Marks Each)
Given a consumption function C = 100 + 0.75Y and autonomous investment I = 50. Calculate: (a) Equilibrium level of income (b) Consumption expenditure at equilibrium income (c) Savings at equilibrium income
If in an economy, the Marginal Propensity to Save (MPS) is 0.2 and an increase in investment of ₹ 500 crores takes place, calculate the total increase in income.
Suppose in a hypothetical economy, the income is ₹ 500 crores and the consumption expenditure is ₹ 300 crores. If the income increases to ₹ 600 crores and consumption expenditure increases to ₹ 380 crores, calculate: (a) Marginal Propensity to Consume (MPC) (b) Marginal Propensity to Save (MPS) (c) Autonomous Consumption if the initial consumption function was C = a + bY.
E. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Keynesian theory suggests that aggregate demand plays a crucial role in determining the level of income and employment." Elaborate on this statement.
Distinguish between 'deficient demand' and 'excess demand'. Explain the role of fiscal and monetary policy in correcting them.
Why is it that in a two-sector economy, income is either consumed or saved? Explain the implications of this assumption.
IV. Government Budget and the Economy
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is a non-tax revenue? (a) Income tax (b) Corporation tax (c) Fees and fines (d) GST
A budget is said to be balanced when: (a) Revenue Receipts = Revenue Expenditure (b) Capital Receipts = Capital Expenditure (c) Total Receipts = Total Expenditure (d) Revenue Receipts > Revenue Expenditure
Which of the following is a capital expenditure? (a) Salaries of government employees (b) Interest payments (c) Construction of a bridge (d) Subsidies
Fiscal deficit refers to: (a) Total expenditure - Total receipts (b) Revenue expenditure - Revenue receipts (c) Total expenditure - (Revenue receipts + Recovery of loans + Disinvestment) (d) Primary deficit - Interest payments
Borrowings by the government are a part of: (a) Revenue receipts (b) Capital receipts (c) Revenue expenditure (d) Capital expenditure
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Distinguish between 'Revenue Receipts' and 'Capital Receipts'. Give two examples of each.
Differentiate between 'Revenue Expenditure' and 'Capital Expenditure'. Give two examples of each.
What are the main objectives of a government budget?
Define 'Fiscal Deficit'. What are its implications?
Explain 'Primary Deficit'. How is it different from Fiscal Deficit?
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the various components of a government budget.
Discuss the different types of budget deficits and their implications for the economy.
Explain the budgetary policy as a tool for achieving the objective of 'economic stability'.
How does the government budget help in 'redistribution of income and wealth'?
Distinguish between 'Direct Tax' and 'Indirect Tax' with examples. Explain their merits and demerits.
D. Numerical Problems (4-6 Marks Each)
From the following data, calculate: (a) Revenue Deficit (b) Fiscal Deficit (c) Primary Deficit.
Revenue Receipts = ₹ 1000 crores
Revenue Expenditure = ₹ 1200 crores
Borrowings = ₹ 300 crores
Interest Payments = ₹ 80 crores
Capital Receipts (Non-debt creating) = ₹ 200 crores
Capital Expenditure = ₹ 400 crores
Given the following information, find the Budget Deficit and Primary Deficit.
Tax Revenue = ₹ 1500 crores
Non-tax Revenue = ₹ 500 crores
Borrowings = ₹ 600 crores
Revenue Expenditure = ₹ 2200 crores
Capital Expenditure = ₹ 300 crores
Interest Payments = ₹ 100 crores
E. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Borrowing by the government is a necessary evil." Comment on this statement.
Discuss the role of the government budget in managing inflation and deflation in an economy.
"A high fiscal deficit is always a matter of concern for an economy." Do you agree? Give reasons.
V. Balance of Payments
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is recorded in the current account of BOP? (a) Foreign direct investment (b) Portfolio investment (c) Exports of goods and services (d) External commercial borrowings
Balance of Payments (BOP) is a systematic record of: (a) All economic transactions between residents of a country and the rest of the world during a given period. (b) Only trade in goods between two countries. (c) Government's financial transactions with foreign countries. (d) Foreign exchange reserves of a country.
Unilateral transfers are also known as: (a) Exports (b) Imports (c) Gifts and remittances (d) Capital transfers
An increase in the value of domestic currency in relation to foreign currency is called: (a) Depreciation (b) Appreciation (c) Devaluation (d) Revaluation
Which of the following is a component of the capital account of BOP? (a) Merchandise exports (b) Income from investments (c) Loans from abroad (d) Services exports
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Define 'Balance of Payments (BOP)'. Why is it always in balance in accounting sense?
Distinguish between 'Current Account' and 'Capital Account' of BOP.
What are 'Visible Items' and 'Invisible Items' in the context of Balance of Trade?
Differentiate between 'Autonomus Items' and 'Accommodating Items' in BOP.
Explain the concept of 'Balance of Trade' and 'Balance on Current Account'.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the components of the 'Current Account' of the Balance of Payments.
Explain the various components of the 'Capital Account' of the Balance of Payments.
Distinguish between 'Balance of Payments Deficit' and 'Balance of Payments Surplus'. What are their implications?
Discuss the causes of disequilibrium in the Balance of Payments.
Explain the difference between 'Fixed Exchange Rate System' and 'Flexible Exchange Rate System'. Discuss their merits and demerits.
D. Numerical Problems (4-6 Marks Each)
Calculate 'Balance of Trade' from the following:
Exports of goods = ₹ 800 crores
Imports of goods = ₹ 1000 crores
Exports of services = ₹ 300 crores
Imports of services = ₹ 200 crores
From the following data, calculate the 'Balance on Current Account':
Exports of goods = ₹ 700 crores
Imports of goods = ₹ 900 crores
Net services = ₹ 150 crores
Net unilateral transfers = ₹ 50 crores
Net income from abroad = ₹ (-) 20 crores
E. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"A deficit in the Current Account is always a cause for concern." Do you agree? Justify your answer.
How would 'Foreign Direct Investment (FDI)' affect the Balance of Payments of a country? Explain.
Discuss the various policy measures that can be adopted to correct a persistent deficit in the Balance of Payments.
General Tips for Students:
Understand Concepts Thoroughly:
Don't just memorize definitions. Understand the logic behind each concept.
Practice Numerical Problems:
National Income, Income & Employment, and Government Budget sections frequently feature numerical questions.
Draw Diagrams:
For topics like Determination of Income and Employment, diagrams are crucial for illustrating concepts.
Case Studies/Application Based Questions:
Be prepared for questions that apply concepts to real-world scenarios.
Distinguish Key Terms:
Pay attention to differentiating between similar-sounding terms (e.g., GDP vs. GNP, Revenue vs. Capital, etc.).
Previous Year Papers:
Solve previous years' CBSE question papers to understand the pattern and types of questions asked.
Time Management:
Practice answering questions within the stipulated time.
This comprehensive set of questions should adequately prepare Class 12 CBSE students for their Economics exam focusing on Introductory Macroeconomics. Good luck!
prepare prepare all types of questions with answers on economic for Class 12 CBSE students For the exam point of views on the following topics. Introductory Macroeconomics
National Income and Related Aggregates 10 30
Money and Banking 06 15
Determination of Income and Employment 12 30
Government Budget and the Economy 06 17
Balance of Payments
Here's a comprehensive set of questions with answers on Introductory Macroeconomics for Class 12 CBSE students, covering all specified topics from an exam perspective. The questions include various types: Multiple Choice Questions (MCQ), Short Answer Questions (SAQ), Long Answer Questions (LAQ), and Higher Order Thinking Skills (HOTS) questions, along with numerical problems where applicable.
Class 12 CBSE Economics: Introductory Macroeconomics - Exam Focused Questions with Answers
Marks Distribution Reminder:
National Income and Related Aggregates:
10-30 Marks
Money and Banking:
06-15 Marks
Determination of Income and Employment:
12-30 Marks
Government Budget and the Economy:
06-17 Marks
Balance of Payments:
(Typically combined with others or asked as stand-alone SAQ/LAQ)
I. National Income and Related Aggregates
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is a stock variable? (a) Income (b) Consumption (c) Wealth (d) Investment
Answer: (c) Wealth
Net National Product at Factor Cost (NNPfc) is also known as: (a) Gross Domestic Product (GDP) (b) National Income (c) Personal Income (d) Disposable Income
Answer: (b) National Income
Which of the following is NOT included in the estimation of National Income? (a) Transfer payments (b) Imputed rent of owner-occupied houses (c) Services rendered by a doctor (d) Production for self-consumption
Answer: (a) Transfer payments
Depreciation is also known as: (a) Capital loss (b) Capital consumption allowance (c) Capital gains (d) Capital formation
Answer: (b) Capital consumption allowance
GDP at Market Price (GDPmp) - Net Indirect Taxes = ? (a) GDP at Factor Cost (GDPfc) (b) NNP at Market Price (NNPmp) (c) NDP at Market Price (NDPmp) (d) GNP at Factor Cost (GNPfc)
Answer: (a) GDP at Factor Cost (GDPfc)
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Distinguish between 'stock' and 'flow' variables with suitable examples.Answer:
Stock Variable:
A quantity measured at a specific point in time. It has no time dimension.
Examples:
Wealth, Capital, Money Supply, Inventory, Population.
Flow Variable:
A quantity measured over a period of time. It has a time dimension (e.g., per hour, per day, per year).
Examples:
Income, Consumption, Investment, Production, Profits, Interest.
Explain the concept of 'Net Factor Income from Abroad (NFIA)' and its significance in national income accounting.Answer:
NFIA
is the difference between factor income (like wages, rent, interest, profits) earned by normal residents of a country from the rest of the world and factor income paid to non-residents within the domestic territory of that country.
Significance:
NFIA bridges the gap between 'Domestic Income' (income generated within the domestic territory) and 'National Income' (income accruing to normal residents).
National Income = Domestic Income + NFIA
If NFIA is positive, National Income > Domestic Income.
If NFIA is negative, National Income < Domestic Income.
Differentiate between 'Intermediate Goods' and 'Final Goods' with examples.Answer:
Intermediate Goods:
Goods that are used as raw materials or for resale by producers during the same accounting year. They are not meant for final consumption or investment. Their value is merged with the value of final goods.
Examples:
Flour used by a baker to make bread, wood used by a furniture maker, electricity consumed by a factory.
Final Goods:
Goods that are meant for final consumption by households or for investment by firms. They are ready for use and will not undergo any further transformation in the current accounting year.
Examples:
Bread bought by a household, machinery purchased by a factory, milk bought by a household.
What is the problem of 'Double Counting' in national income estimation? How can it be avoided?Answer:
Double Counting:
It refers to the error of estimating the value of goods and services more than once while calculating national income. This happens when the value of intermediate goods is included along with the value of final goods, leading to overestimation of national income.
How to avoid:
Value Added Method:
Summing up the value added at each stage of production. Value Added = Value of Output - Intermediate Consumption.
Final Output Method:
Including only the value of final goods and services, excluding intermediate goods.
Define 'Gross Domestic Product (GDP) at Market Price'. State its limitations as a measure of welfare.Answer:
GDP at Market Price (GDPmp):
It is the market value of all final goods and services produced within the domestic territory of a country during an accounting year.
Limitations as a measure of welfare:
Non-monetary Exchanges:
Many activities (e.g., household work, self-consumption) are not exchanged for money and thus not included in GDP, understating welfare.
Externalities:
GDP does not account for positive (e.g., creation of parks) or negative (e.g., pollution) externalities, which impact welfare.
Distribution of Income:
A high GDP might hide income inequality. If wealth is concentrated, overall welfare might be low.
Composition of Output:
GDP doesn't differentiate between goods and services that enhance welfare (e.g., food, education) and those that do not (e.g., arms and ammunition).
Per capita GDP:
A high GDP might not translate into high per capita availability of goods and services if population is high.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the 'Income Method' of calculating National Income. What precautions should be taken while using this method?Answer:
Income Method:
This method measures National Income by summing up all factor incomes (wages and salaries, rent, interest, and profit) accrued to the normal residents of a country during an accounting year.
Steps:
Identify factor incomes:
Compensation of Employees (wages, salaries, social security contributions), Rent, Interest, Profits (dividends, undistributed profits, corporate tax), and Mixed Income of Self-Employed.
Sum up Domestic Factor Income:
Summing these components gives Net Domestic Product at Factor Cost (NDPfc).
Adjust for NFIA:
Add Net Factor Income from Abroad (NFIA) to NDPfc to get Net National Product at Factor Cost (NNPfc), which is National Income.
Precautions:
Transfer Payments:
Do not include transfer payments (e.g., old-age pensions, unemployment allowances, scholarships) as they are not payments for factor services.
Income from Illegal Activities:
Income from illegal activities (e.g., smuggling, gambling) should not be included.
Windfall Gains:
Income from speculation, lottery, etc., is excluded as it does not involve production of goods/services.
Second-hand Goods:
Income from the sale of second-hand goods is not included as it relates to past production. However, commission earned by brokers on such sales is included.
Imputed Rent:
Imputed rent of owner-occupied houses should be included.
Corporate Profit Distribution:
Ensure that corporate tax, dividends, and undistributed profits are taken as components of profit, avoiding double counting or omission.
Discuss the 'Product Method' (or Value Added Method) of calculating National Income. Illustrate with a hypothetical example.Answer:
Product Method (Value Added Method):
This method measures National Income by summing up the net value added by all producing units (firms and government) in the domestic territory of a country during an accounting year. It avoids double counting by focusing on the value added at each stage of production.
Steps:
Estimate Gross Value Added at Market Price (GVAmp) for each sector:
GVAmp = Value of Output - Intermediate Consumption.
Sum up GVAmp for all sectors:
This gives Gross Domestic Product at Market Price (GDPmp).
Adjust for Depreciation, NIT, and NFIA:
NDPmp = GDPmp - Depreciation
NDPfc = NDPmp - Net Indirect Taxes (NIT)
NNPfc (National Income) = NDPfc + Net Factor Income from Abroad (NFIA)
Hypothetical Example:
Farmer:
Produces wheat worth ₹1000. Sells to Miller. (Value of Output = ₹1000, Intermediate Consumption = ₹0, Value Added = ₹1000)
Miller:
Buys wheat for ₹1000, converts it into flour. Sells flour for ₹1500 to Baker. (Value of Output = ₹1500, Intermediate Consumption = ₹1000, Value Added = ₹500)
Baker:
Buys flour for ₹1500, converts it into bread. Sells bread for ₹2500 to Consumers. (Value of Output = ₹2500, Intermediate Consumption = ₹1500, Value Added = ₹1000)
Total Value Added =
₹1000 (Farmer) + ₹500 (Miller) + ₹1000 (Baker) =
₹2500
This ₹2500 represents the total value of final goods produced (bread), avoiding counting the wheat and flour multiple times.
Explain the 'Expenditure Method' of calculating National Income. What are its main components?Answer:
Expenditure Method:
This method measures National Income by summing up all final expenditures on goods and services produced within the domestic territory of a country during an accounting year. It focuses on the demand side of the economy.
Steps:
Identify Components of Final Expenditure:
Private Final Consumption Expenditure (C):
Expenditure by households on consumption of goods and services.
Government Final Consumption Expenditure (G):
Expenditure by government on goods and services for
collective consumption (e.g., defense, law and order, administration).
Gross Domestic Capital Formation (I):
Investment expenditure by firms and government on capital goods (e.g., machinery, buildings, changes in stock). This includes Gross Fixed Capital Formation and Change in Stocks.
Net Exports (X-M):
Difference between exports (expenditure by foreigners on domestic goods) and imports (expenditure by domestic residents on foreign goods).
Sum up these components:
This gives Gross Domestic Product at Market Price (GDPmp).
GDPmp = C + G + I + (X - M)
Adjust for Depreciation, NIT, and NFIA:
NDPmp = GDPmp - Depreciation
NDPfc = NDPmp - Net Indirect Taxes (NIT)
NNPfc (National Income) = NDPfc + Net Factor Income from Abroad (NFIA)
Main Components:
Private Final Consumption Expenditure (C)
Government Final Consumption Expenditure (G)
Gross Domestic Capital Formation (I)
Net Exports (X - M)
Define and explain the following aggregates:(a) GDP at Factor Cost(b) NNP at Market Price(c) Personal Disposable Income(d) Private IncomeAnswer:
(a) GDP at Factor Cost (GDPfc):
It is the money value of all final goods and services produced within the domestic territory of a country during an accounting year, valued at factor cost (i.e., excluding net indirect taxes).
GDPfc = GDPmp - Net Indirect Taxes
(b) NNP at Market Price (NNPmp):
It is the market value of net output of final goods and services produced by the normal residents of a country during an accounting year. 'Net' implies depreciation is excluded, and 'National' implies NFIA is included.
NNPmp = GDPmp - Depreciation + Net Factor Income from Abroad (NFIA)
(c) Personal Disposable Income (PDI):
It is that part of personal income which is actually available to households for their consumption and saving. It is personal income minus direct taxes paid by households and miscellaneous receipts of the government from households.
PDI = Personal Income - Direct Taxes paid by Households - Miscellaneous Receipts of Govt. Administrative Departments (fines, fees, etc.)
(d) Private Income:
It is the factor income accruing to the private sector from all sources (domestic and abroad) and current transfers from the government and rest of the world. It includes income from productive activities and transfer payments.
Private Income = Factor income from net domestic product accruing to private sector + NFIA + National debt interest + Current transfers from government + Net current transfers from rest of the world.
Critically examine GDP as a measure of economic welfare.Answer:
GDP as a Measure of Welfare:
GDP is often used as a rough indicator of economic welfare because a higher GDP generally implies a higher level of production, more goods and services available for consumption, and potentially a higher standard of living.
Criticisms/Limitations:
Non-monetary exchanges:
Many goods and services are not exchanged in the market (e.g., household services, volunteer work, production for self-consumption). These contribute to welfare but are not included in GDP, understating it.
Externalities:
GDP does not account for the positive or negative impacts of production activities on people's welfare. For example, pollution from industrial growth (negative externality) reduces welfare but is not subtracted from GDP. Building a public park (positive externality) increases welfare but is not fully reflected.
Distribution of Income:
GDP per capita might be high, but if the income is highly unequal, a large portion of the population might have a low standard of living. GDP does not reflect income distribution.
Composition of Output:
GDP doesn't distinguish between the type of goods produced. Production of necessities (food, education) or luxury goods, or even harmful goods (weapons, drugs), all increase GDP. Welfare is more impacted by the composition of output.
Leisure:
Increased leisure time, which enhances welfare, is not reflected in GDP. Conversely, working longer hours might increase GDP but reduce leisure.
Population changes:
GDP growth alone doesn't reflect welfare if population grows at a faster rate. Per capita GDP is a better measure, but still has the above limitations.
Quality of Life:
Factors like peace, safety, environment quality, health, and education are crucial for welfare but are not directly captured by GDP.
Conclusion:
While GDP is a useful indicator of economic activity and growth, it is an incomplete and often misleading measure of overall societal welfare. For a more holistic view, other indicators like Human Development Index (HDI), Green GDP, etc., are considered.
D. Numerical Problems (4-6 Marks Each)
Calculate National Income (NNPfc) from the following data:
GDPmp = ₹ 5,000 crores
Consumption of Fixed Capital = ₹ 500 crores
Net Indirect Taxes = ₹ 300 crores
Net Factor Income from Abroad = ₹ (-) 100 crores
Answer:
NNPfc = GDPmp - Consumption of Fixed Capital - Net Indirect Taxes + Net Factor Income from Abroad
NNPfc = ₹ 5,000 crores - ₹ 500 crores - ₹ 300 crores + (-) ₹ 100 crores
NNPfc = ₹ 4,500 crores - ₹ 300 crores - ₹ 100 crores
NNPfc = ₹ 4,200 crores - ₹ 100 crores
NNPfc = ₹ 4,100 crores
From the following data, calculate: (a) GDPmp and (b) NNPfc.
Private Final Consumption Expenditure = ₹ 800 crores
Government Final Consumption Expenditure = ₹ 250 crores
Gross Domestic Capital Formation = ₹ 200 crores
Net Exports = ₹ (-) 30 crores
Consumption of Fixed Capital = ₹ 40 crores
Net Indirect Taxes = ₹ 60 crores
Net Factor Income from Abroad = ₹ 20 crores
Answer:
(a) GDPmp (using Expenditure Method):
GDPmp = Private Final Consumption Expenditure + Government Final Consumption Expenditure + Gross Domestic Capital Formation + Net Exports
GDPmp = ₹ 800 + ₹ 250 + ₹ 200 + (-) ₹ 30
GDPmp = ₹ 1,250 - ₹ 30
GDPmp = ₹ 1,220 crores
(b) NNPfc:
NNPfc = GDPmp - Consumption of Fixed Capital - Net Indirect Taxes + Net Factor Income from Abroad
NNPfc = ₹ 1,220 - ₹ 40 - ₹ 60 + ₹ 20
NNPfc = ₹ 1,180 - ₹ 60 + ₹ 20
NNPfc = ₹ 1,120 + ₹ 20
NNPfc = ₹ 1,140 crores
Given the following data, calculate Gross National Product at Market Price (GNPmp) and Net Domestic Product at Factor Cost (NDPfc):
Compensation of Employees = ₹ 1,500 crores
Rent = ₹ 300 crores
Interest = ₹ 200 crores
Profits = ₹ 500 crores
Mixed Income of Self-Employed = ₹ 800 crores
Net Indirect Taxes = ₹ 180 crores
Consumption of Fixed Capital = ₹ 100 crores
Net Factor Income from Abroad = ₹ (-) 50 crores
Answer:
First, calculate NDPfc (Domestic Income) using Income Method:
NDPfc = Compensation of Employees + Rent + Interest + Profits + Mixed Income of Self-Employed
NDPfc = ₹ 1,500 + ₹ 300 + ₹ 200 + ₹ 500 + ₹ 800
NDPfc = ₹ 3,300 crores
Now, calculate GNPmp:
GNPmp = NDPfc + Consumption of Fixed Capital + Net Indirect Taxes + Net Factor Income from Abroad
GNPmp = ₹ 3,300 + ₹ 100 + ₹ 180 + (-) ₹ 50
GNPmp = ₹ 3,400 + ₹ 180 - ₹ 50
GNPmp = ₹ 3,580 - ₹ 50
GNPmp = ₹ 3,530 crores
E. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Circular flow of income in a two-sector economy is based on the principle of equality of income and expenditure." Elaborate.Answer:
In a two-sector economy, there are only two sectors: households and firms.
Households
are owners of factors of production and consumers of goods and services. They provide factor services (land, labour, capital, entrepreneurship) to firms and receive factor incomes (rent, wages, interest, profit). They spend this income on goods and services produced by firms.
Firms
produce goods and services using factor services from households. They make factor payments to households and receive revenue from the sale of goods and services.
Flows:
Real Flow:
Firms provide goods and services to households, and households provide factor services to firms.
Money Flow:
Firms pay factor incomes to households, and households make consumption expenditure to firms.
Equality:
The essence of the circular flow is that the total income generated in the economy (factor payments made by firms to households) must equal the total expenditure incurred in the economy (consumption expenditure made by households on goods and services produced by firms).
Income = Consumption Expenditure
Also, the value of production by firms must equal the value of factor incomes paid out.
This equality ensures that there is no leakage or injection in this simple model, maintaining a continuous flow. Any income earned by households is spent, and any output produced by firms is consumed. This concept is fundamental to understanding macroeconomic equilibrium.
How would the following be treated while estimating National Income? Give reasons.(a) Scholarship given to students by government.(b) Sale of second-hand car.(c) Interest paid by a bank on deposits.(d) Money received by a family in India from relatives working abroad.Answer:
(a) Scholarship given to students by government:
Not included.
Reason:
It is a 'transfer payment' or 'unilateral payment'. It is a payment made without any corresponding production of goods or services in the current accounting period. National income includes only factor incomes (payments for productive services).
(b) Sale of second-hand car:
Not included.
Reason:
The car was produced and its value was included in national income when it was first sold. Its resale does not represent new production in the current year. However, any commission earned by a broker on the sale of the second-hand car
would be included
as it represents payment for a fresh service rendered in the current year.
(c) Interest paid by a bank on deposits:
Included.
Reason:
This is a factor income (return on capital) earned by the depositors who provide financial capital to the bank. It represents payment for a productive service (lending money).
(d) Money received by a family in India from relatives working abroad:
Not included in National Income (NNPfc), but included in Private Income.
Reason:
This is a 'current transfer from the rest of the world' or a 'unilateral transfer'. It does not involve any factor service rendered by the receiving family in India in return for the money. However, such remittances are included in the
Private Income
of the residents, and in
the
Current Account of Balance of Payments
. For National Income (NNPfc), only factor income from abroad (part of NFIA) is included.
Discuss the difficulties involved in measuring national income in a developing country like India.Answer:
Measuring national income accurately in a developing country like India faces several challenges:
Non-monetized Transactions:
A significant portion of economic activity in India (especially in rural areas) is non-monetized, involving barter or production for self-consumption (e.g., subsistence farming). It's difficult to impute a value to these activities.
Unorganized Sector:
A large part of the economy is unorganized (small businesses, street vendors, daily wage earners) where proper accounts are not maintained. This makes data collection and estimation extremely challenging.
Illiteracy and Lack of Accounting Skills:
Many producers, especially in the agricultural and unorganized sectors, are illiterate and do not maintain proper records, leading to unreliable data.
Double Counting:
Due to the complex structure of production and lack of clear distinction between intermediate and final goods, there's a high possibility of double counting, leading to overestimation.
Lack of Occupational Specialization:
In many households, individuals might engage in multiple occupations (e.g., farming and handicrafts). This makes it difficult to classify their economic activities and attribute income.
Existence of Black Money/Underground Economy:
A substantial part of transactions occurs outside the formal economy to avoid taxes. This 'black money' is not recorded and thus not included in national income estimates, leading to underestimation.
Data Collection Issues:
Inadequate statistical machinery, lack of trained personnel, and vast geographical area make accurate data collection difficult and expensive.
Depreciation Estimation:
Accurately estimating depreciation for various assets, especially in traditional and informal sectors, is problematic due to diverse life spans and usage patterns.
Valuation of Government Services:
Services provided by the government (e.g., defense, public administration) are difficult to value as they are not sold in the market. They are generally valued at their cost of production.
II. Money and Banking
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is NOT a function of money? (a) Medium of exchange (b) Store of value (c) Price stability (d) Unit of account
Answer: (c) Price stability
(Price stability is an objective of monetary policy, not a function of money itself)
The central bank of India is: (a) SBI (b) RBI (c) PNB (d) HDFC Bank
Answer: (b) RBI
Which of the following is a quantitative method of credit control by the central bank? (a) Moral Suasion (b) Selective Credit Controls (c) Bank Rate (d) Margin Requirements
Answer: (c) Bank Rate
If Legal Reserve Ratio (LRR) is 20%, the money multiplier will be: (a) 2 (b) 5 (c) 10 (d) 20
Answer: (b) 5
(Money Multiplier = 1/LRR = 1/0.2 = 5)
Commercial banks create money by: (a) Printing currency notes (b) Accepting deposits (c) Advancing loans (d) Selling securities
Answer: (c) Advancing loans
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Explain the 'store of value' function of money. Why is it essential for economic transactions?Answer:
Store of Value:
Money acts as a store of value, meaning it can be held and accumulated over time to be used for future transactions. It allows individuals to save their purchasing power.
Essential because:
Separation of Sale and Purchase:
It enables individuals to sell their goods/services today and purchase other goods/services at a later date, without the immediate need for a reciprocal transaction.
Savings and Investment:
It facilitates savings and investment, as people can save money and accumulate wealth, which can then be used for future investment.
Durability:
Money generally does not deteriorate quickly (unlike perishable goods in a barter system), making it a suitable means to store wealth.
Differentiate between 'Central Bank' and 'Commercial Bank'.Answer:
| Feature | Central Bank (e.g., RBI) | Commercial Bank (e.g., SBI, HDFC) | | :-------------- | :------------------------------------------------ | :------------------------------------------------ | |
Objective
| Monetary stability, economic growth, public welfare | Profit maximization | |
Ownership
| Government-owned | Can be public or private sector | |
Status
| Apex body, Banker's Bank, Government's Bank | Unit in the banking system, ordinary bank | |
Currency
| Issuer of currency (except 1 Re note/coin) | Cannot issue currency | |
Credit
| Controls credit supply | Creates credit (through loans) | |
Public dealing
| Generally does not deal directly with the public | Deals directly with the public (deposits, loans) |
Explain the concept of 'Money Multiplier'. How does it work?Answer:
Money Multiplier:
It refers to the multiple by which the total money supply in an economy can expand for each unit increase in the monetary base (initial deposit). It indicates how many times the commercial banks can create credit for an initial deposit.
Formula: Money Multiplier = 1 / Legal Reserve Ratio (LRR)
How it works:
When an initial deposit is made in a commercial bank (e.g., ₹1000).
The bank is required to keep a certain percentage (LRR) as reserves (e.g., if LRR is 20%, ₹200 is kept as reserve).
The remaining amount (e.g., ₹800) is lent out.
This ₹800 is again deposited in some other bank (or the same bank).
This second bank again keeps 20% (₹160) as reserve and lends out ₹640.
This process continues, with each subsequent loan becoming a deposit and a portion being lent out, creating new deposits.
The total money created (initial deposit + all subsequent deposits) will be a multiple of the initial deposit, determined by the money multiplier. The higher the LRR, the lower the money multiplier, and vice-versa.
What are 'Demand Deposits'? How do they differ from 'Time Deposits'?Answer:
Demand Deposits:
These are deposits that can be withdrawn by the depositor on demand, without any prior notice to the bank. They are typically held in current accounts or savings accounts and can be withdrawn through cheques, ATM cards, or online transfers. They are highly liquid.
Time Deposits (or Term Deposits):
These are deposits made for a fixed period of time (e.g., 6 months, 1 year, 5 years). They cannot be withdrawn before the expiry of the specified period without incurring a penalty. They are typically held in Fixed Deposit (FD) or Recurring Deposit (RD) accounts. They offer a higher interest rate than demand deposits but are less liquid.
Key Difference:
The primary difference lies in their
liquidity
and
withdrawal conditions
. Demand deposits are highly liquid and can be withdrawn anytime, while time deposits are less liquid and have a fixed maturity period.
Briefly explain 'Bank Rate' and its role in controlling credit.Answer:
Bank Rate:
It is the interest rate at which the central bank (RBI in India) lends money to commercial banks without any collateral (i.e., for long-term loans). It is also known as the discount rate.
Role in controlling credit:
It is a quantitative tool of credit control:
During Inflation (Excess Demand/Credit):
Central bank
increases
the bank rate. This makes borrowing by commercial banks more expensive. Consequently, commercial banks increase their lending rates for loans to the public. This discourages borrowing by individuals and firms, reducing the availability of credit and curbing inflation.
During Deflation (Deficient Demand/Credit):
Central bank
decreases
the bank rate. This makes borrowing cheaper for commercial banks, allowing them to lower their lending rates. This encourages borrowing and investment, thereby increasing credit availability and boosting aggregate demand.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Discuss the various functions of a Central Bank.Answer:
The Central Bank (e.g., RBI in India) is the apex financial institution in a country, playing a crucial role in regulating and controlling the banking system and money supply. Its main functions include:
Bank of Issue (Currency Authority):
It has the sole authority to issue currency notes (except one-rupee notes and coins, which are issued by the Ministry of Finance, GoI). This ensures uniformity, public faith in the currency, and control over money supply.
Banker to the Government:
It acts as a banker, agent, and financial advisor to the government (both central and state). It manages government accounts, collects and makes payments on behalf of the government, provides short-term loans (Ways and Means Advances), and manages public debt.
Banker's Bank and Supervisor:
It acts as a bank for commercial banks.
Custodian of Cash Reserves:
Commercial banks are required to keep a certain portion of their deposits as reserves with the central bank (CRR).
Lender of Last Resort:
It provides financial assistance to commercial banks during times of liquidity crisis or financial difficulty, preventing bank failures and ensuring financial stability.
Clearing House:
It facilitates the clearing and settlement of inter-bank transactions (e.g., cheque clearing).
Supervisor:
It regulates and supervises commercial banks through licensing, inspections, and monitoring.
Controller of Money Supply and Credit:
This is its most important function, aimed at achieving macroeconomic objectives like price stability, full employment, and economic growth. It uses various quantitative (Bank Rate, Repo Rate, Reverse Repo Rate, CRR, SLR, Open Market Operations) and qualitative tools (Margin Requirements, Moral Suasion, Selective Credit Controls).
Custodian of Foreign Exchange Reserves:
It manages the foreign exchange reserves of the country, ensuring exchange rate stability and facilitating international trade. It also handles foreign exchange transactions.
Collection and Publication of Data:
It collects, compiles, and publishes statistical data on banking, finance, and other economic sectors, which is vital for policy formulation.
Explain the process of credit creation by commercial banks. Use a numerical example to illustrate.Answer:
Credit Creation:
Commercial banks create credit (money) by advancing loans against deposits. This process is based on the fractional reserve system, where banks are required to keep only a fraction of their deposits as reserves and can lend out the rest.
Assumptions:
The entire banking system is considered as one unit.
All transactions are routed through banks.
Legal Reserve Ratio (LRR) is constant.
Process:
Initial Deposit:
When a person deposits cash (e.g., ₹1000) in a bank, this becomes the primary deposit.
Reserve Requirement:
The bank is legally required to keep a certain percentage of this deposit as reserves (Cash Reserve Ratio - CRR and Statutory Liquidity Ratio - SLR). Let's assume LRR = 20%. So, the bank keeps ₹200 as reserves and has ₹800 as excess reserves to lend.
Loan Granting:
The bank lends out ₹800 to a borrower. The loan is not given in cash but is credited to the borrower's demand deposit account with the same or another bank. This is where money is created.
Second Round Deposit:
When the borrower uses this ₹800 (e.g., to pay someone), the recipient deposits this amount into their bank account. This becomes a fresh deposit in the banking system.
Continuation:
The second bank (or the same bank) again keeps 20% (₹160) as reserve and lends out the remaining ₹640. This process continues in rounds.
Total Money Creation:
Each time a loan is made, it eventually returns as a deposit, leading to a multiple expansion of the initial deposit. The total money created is determined by the Money Multiplier (1/LRR).
Numerical Example:
Initial Deposit = ₹1000
LRR = 20% | Round | Deposit (₹) | Reserves (20%) (₹) | Loans (₹) | | :---- | :---------- | :----------------- | :-------- | | 1 | 1000 | 200 | 800 | | 2 | 800 | 160 | 640 | | 3 | 640 | 128 | 512 | | ... | ... | ... | ... | |
Total
|
5000
|
1000
|
4000
|
Total Money Created = Initial Deposit * Money Multiplier
Money Multiplier = 1 / 0.20 = 5
Total Money Created = ₹1000 * 5 = ₹5000
Thus, an initial deposit of ₹1000 led to a total money supply of ₹5000, out of which ₹1000 is the initial deposit and ₹4000 is created as credit (loans).
Elaborate on the various quantitative measures used by the Central Bank to control the money supply in an economy.Answer:
Quantitative measures (or general credit control measures) affect the overall volume of credit available in the economy.
Bank Rate Policy:
The rate at which the central bank lends to commercial banks without collateral.
Increase in Bank Rate:
Makes borrowing costly for commercial banks → commercial banks increase their lending rates → reduces demand for loans → contracts credit. (Used during inflation)
Decrease in Bank Rate:
Makes borrowing cheaper → commercial banks lower lending rates → increases demand for loans → expands credit. (Used during deflation)
Repo Rate (Repurchase Rate):
The rate at which commercial banks borrow short-term funds from the central bank against government securities.
Increase in Repo Rate:
Increases cost of borrowing for banks → similar effect to increase in Bank Rate, reduces credit.
Decrease in Repo Rate:
Reduces cost of borrowing → similar effect to decrease in Bank Rate, expands credit.
Reverse Repo Rate:
The rate at which the central bank borrows money from commercial banks against government securities.
Increase in Reverse Repo Rate:
Encourages commercial banks to deposit their surplus funds with the central bank → reduces their lending capacity → contracts credit.
Decrease in Reverse Repo Rate:
Discourages depositing funds with central bank → increases their lending capacity → expands credit.
Cash Reserve Ratio (CRR):
The percentage of commercial banks' Net Demand and Time Liabilities (NDTL) that they must keep as cash reserves with the central bank.
Increase in CRR:
Banks have to keep more reserves → less money available for lending → contracts credit.
Decrease in CRR:
Banks have more money for lending → expands credit.
Statutory Liquidity Ratio (SLR):
The percentage of NDTL that commercial banks must maintain in liquid assets (cash, gold, approved securities) with themselves.
Increase in SLR:
Banks have to hold more liquid assets → less money available for lending → contracts credit.
Decrease in SLR:
Banks have more money for lending → expands credit.
Open Market Operations (OMO):
Buying and selling of government securities by the central bank in the open market.
Sale of Securities (by CB):
Commercial banks buy securities from CB → their cash reserves with CB decrease → reduces lending capacity → contracts credit. (Used during inflation)
Purchase of Securities (by CB):
CB buys securities from commercial banks → banks receive cash from CB → increases their reserves → expands lending capacity → expands credit. (Used during deflation)
What are the limitations of the Barter system? How does money overcome these limitations?Answer:
Limitations of Barter System:
Lack of Double Coincidence of Wants:
This is the biggest hurdle. For an exchange to occur, both parties must simultaneously desire what the other possesses. (e.g., person A has shoes and wants rice, person B has rice and wants shoes).
Lack of Common Measure of Value:
There is no common unit to measure the value of goods and services. It's difficult to compare the value of shoes to rice, or a cow to a house, leading to arbitrary exchange ratios.
Difficulty of Future Payments/Contractual Payments:
It is difficult to make payments for future transactions or to specify contractual payments (e.g., rent, wages) as goods may vary in quality or quantity over time.
Difficulty of Storage of Value/Wealth:
Perishable goods (like fruits, vegetables, livestock) cannot be stored for long periods without losing value. This makes saving wealth difficult.
Indivisibility of Certain Goods:
Some goods are indivisible (e.g., a cow, a car). It's hard to exchange them for smaller units of other goods without losing their utility.
How Money Overcomes Limitations:
Medium of Exchange:
Money acts as a common medium of exchange, eliminating the need for double coincidence of wants. Person A sells shoes for money, and then uses that money to buy rice from person B.
Common Measure of Value (Unit of Account):
Money provides a common unit of account, allowing the value of all goods and services to be expressed in monetary terms. This simplifies comparison and accounting.
Standard of Deferred Payments:
Money serves as a standard for future payments and contractual obligations (like loans, salaries, rent). Its value is relatively stable, making it suitable for future transactions.
Store of Value:
Money is generally durable, non-perishable, and easy to store, allowing individuals to save their purchasing power for future use without fear of spoilage or degradation.
Transfer of Value:
Money facilitates the easy transfer of value from one person to another, or one place to another.
Explain the role of the Reserve Bank of India as 'Lender of Last Resort' and 'Banker to the Government'.Answer:
Lender of Last Resort:
Meaning:
As the central bank, RBI provides financial assistance to commercial banks when they face a liquidity crisis or severe financial difficulties and cannot obtain funds from any other source (e.g., inter-bank market).
Role/Significance:
Prevents Financial Crisis:
By providing emergency liquidity, RBI prevents a single bank's failure from cascading into a systemic banking crisis or a 'bank run' (where depositors rush to withdraw money due to fear).
Ensures Stability:
It instills confidence in the banking system, ensuring its stability and smooth functioning.
Protects Depositors' Interests:
It protects the interests of depositors by ensuring their funds are safe and accessible.
Promotes Monetary Stability:
It helps maintain confidence in the financial system, which is crucial for monetary stability.
Banker to the Government:
Meaning:
RBI acts as a banker, agent, and financial advisor to the Central and State Governments.
Role/Significance:
Manages Accounts:
It maintains the current accounts of government departments, facilitating receipt and payment transactions.
Accepts Deposits and Makes Payments:
It accepts deposits on behalf of the government and makes payments as authorized.
Manages Public Debt:
It manages the public debt of the government, issuing new loans and repaying old ones.
Provides Loans:
It provides short-term loans (Ways and Means Advances) to the government to bridge temporary gaps between receipts and expenditures.
Financial Advisor:
It advises the government on financial matters, including monetary policy, fiscal policy, public debt, and foreign exchange management.
Facilitates Remittances:
It facilitates domestic and international remittances for the government.
This function centralizes government banking, making it efficient and transparent, and provides the government with expert financial advice.
D. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Demonetisation was a step towards a cashless economy." Do you agree? Discuss the advantages and disadvantages of a cashless economy.Answer:
Demonetisation and Cashless Economy:
Yes, demonetisation (of ₹500 and ₹1000 notes in India in 2016) was indeed intended, among other objectives, to push India towards a cashless or less-cash economy. By removing a large portion of physical currency from circulation, it forced people to adopt digital payment methods, leading to a surge in UPI, mobile wallets, and card transactions.
Advantages of a Cashless Economy:
Increased Transparency and Reduced Corruption:
Digital transactions leave an audit trail, making it harder to evade taxes, conduct illegal activities, or hide black money.
Reduced Cost of Managing Currency:
Printing, transporting, securing, and destroying currency notes is expensive. A cashless system reduces these costs.
Financial Inclusion:
Digital payments can bring more people into the formal financial system, especially those without access to traditional banking services.
Convenience:
Digital transactions are faster, easier, and accessible 24/7 from anywhere with internet access. No need to carry physical cash or worry about change.
Improved Macroeconomic Data:
More digital transactions lead to better data collection, aiding policymakers in making informed decisions.
Better Security:
Reduced risk of theft or loss of physical cash.
Disadvantages of a Cashless Economy:
Digital Divide:
A significant portion of the population, especially in rural areas, lacks access to smartphones, internet, or digital literacy, excluding them from the system.
Cyber Security Risks:
Increased reliance on digital systems makes the economy vulnerable to cyber attacks, data breaches, and fraud.
Privacy Concerns:
Every transaction leaves a digital footprint, raising concerns about individual privacy and potential surveillance.
Transaction Costs:
Digital transactions often involve fees (though these are often absorbed or subsidized, particularly for small merchants).
Dependence on Technology:
A cashless economy is highly dependent on electricity and internet connectivity. Disruptions can bring economic activity to a halt.
Exclusion of Informal Sector:
A large informal sector might struggle to adapt, leading to economic disruption for daily wage earners and small businesses.
Loss of Anonymity:
Some individuals prefer cash for legitimate privacy reasons.
How would an increase in the Cash Reserve Ratio (CRR) affect the lending capacity of commercial banks? Explain the chain of effects.Answer:
CRR:
The percentage of commercial banks' Net Demand and Time Liabilities (NDTL) that they must keep as cash reserves with the central bank (RBI).
Impact of Increase in CRR:
Increased Reserve Requirement:
When the RBI increases CRR, commercial banks are legally required to hold a larger portion of their deposits as reserves with the central bank.
Reduced Excess Reserves:
This directly reduces the amount of 'excess reserves' (funds available for lending) that commercial banks have.
Decreased Lending Capacity:
With fewer excess reserves, the capacity of commercial banks to grant new loans decreases.
Higher Lending Rates (Potentially):
To compensate for reduced loanable funds and maintain profitability, banks may increase their interest rates on loans, making borrowing more expensive.
Contraction of Credit:
Higher interest rates and reduced availability of loans discourage individuals and businesses from borrowing, leading to an overall contraction of credit in the economy.
Reduced Money Supply:
As credit contracts, the money creation process (money multiplier effect) works in reverse, leading to a reduction in the overall money supply in the economy.
Impact on Economy:
This typically aims to curb inflation by reducing aggregate demand.
Chain of Effects:
CRR ↑
⇒
Banks' Required Reserves ↑
⇒
Banks' Excess Reserves ↓
⇒
Lending Capacity of Banks ↓
⇒
Loans & Advances ↓
⇒
Credit Creation ↓
⇒
Money Supply ↓
⇒
Aggregate Demand ↓
⇒
Inflation ↓.
Why is the control of money supply essential for the stability of an economy?Answer:
Control of money supply is essential for economic stability because it directly impacts key macroeconomic variables:
Price Stability (Controlling Inflation/Deflation):
Inflation:
If money supply grows excessively faster than the supply of goods and services, it leads to 'too much money chasing too few goods', resulting in inflation (general rise in prices). Controlling money supply helps to rein in inflationary pressures.
Deflation:
Conversely, if money supply is too low, it can lead to deficient demand and deflation (general fall in prices), which can cause economic slowdown and unemployment. An appropriate money supply prevents deflationary spirals.
Economic Growth:
An adequate and stable money supply supports productive activities.
Too much money:
Can lead to speculative bubbles and misallocation of resources.
Too little money:
Can stifle investment and consumption, hindering economic growth due to lack of liquidity.
Employment Generation:
Money supply influences investment and consumption. A controlled money supply helps create an environment conducive to investment, leading to higher production and employment.
Exchange Rate Stability:
Money supply affects domestic interest rates and inflation, which in turn influence capital flows and the exchange rate. Managing money supply helps in maintaining a stable exchange rate, crucial for international trade and investment.
Financial System Stability:
The central bank, by controlling money supply and acting as a lender of last resort, ensures the stability of the banking and financial system, preventing crises.
Interest Rate Management:
Control over money supply allows the central bank to influence interest rates, which are critical for borrowing, lending, and investment decisions across the economy.
In essence, the central bank uses monetary policy (through control of money supply) to achieve a balance between inflation and growth, ensuring overall macroeconomic stability.
III. Determination of Income and Employment
A. Multiple Choice Questions (MCQ - 1 Mark Each)
In a two-sector economy, aggregate demand is given by: (a) C + I (b) C + S (c) C + I + G (d) C + I + G + (X-M)
Answer: (a) C + I
If Marginal Propensity to Consume (MPC) is 0.8, then Marginal Propensity to Save (MPS) will be: (a) 0.2 (b) 0.8 (c) 1 (d) 0
Answer: (a) 0.2
(MPC + MPS = 1)
The relationship between consumption and income is called: (a) Investment function (b) Savings function (c) Consumption function (d) Aggregate supply function
Answer: (c) Consumption function
At equilibrium, in a two-sector economy: (a) AD > AS (b) AD < AS (c) AD = AS (d) All of the above
Answer: (c) AD = AS
If investment increases by ₹ 100 crores and MPC is 0.75, the increase in income will be: (a) ₹ 400 crores (b) ₹ 100 crores (c) ₹ 75 crores (d) ₹ 125 crores
Answer: (a) ₹ 400 crores
(Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1 / 0.25 = 4. Change in Income = Multiplier * Change in Investment = 4 * 100 = 400)
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Distinguish between 'Autonomous Consumption' and 'Induced Consumption'.Answer:
Autonomous Consumption (Cˉ):
The minimum level of consumption that occurs even when income is zero. It is independent of the level of income and is financed by past savings or borrowings. It is represented by the intercept on the Y-axis of the consumption function.
Induced Consumption (bY):
The part of consumption that varies directly with the level of income. As income rises, induced consumption rises. It is represented by the slope of the consumption function (MPC multiplied by income).
Consumption Function: C = Cˉ + bY (where b = MPC)
Explain the concept of 'Marginal Propensity to Consume (MPC)'. What is its range?Answer:
MPC:
It is the ratio of change in consumption (ΔC) to the change in income (ΔY). It indicates the proportion of additional income that is spent on consumption.
MPC = ΔC / ΔY
Range:
The value of MPC lies between 0 and 1 (0 < MPC < 1).
MPC = 0 means that the entire additional income is saved.
MPC = 1 means that the entire additional income is consumed.
In reality, MPC is usually between 0 and 1, as people typically consume a part of their additional income and save the rest.
What is 'Ex-ante Investment' and 'Ex-post Investment'?Answer:
Ex-ante Investment (Planned Investment):
It refers to the amount of investment that investors (firms) plan to undertake in the economy during a specific period. It is the planned or desired investment. In Keynesian theory, autonomous investment is usually considered ex-ante.
Ex-post Investment (Actual Investment):
It refers to the actual investment that has occurred in the economy during a specific period. It includes both planned investment and unplanned investment (e.g., unplanned changes in inventory).
In equilibrium, ex-ante savings equal ex-ante investment. However, ex-post savings are always equal to ex-post investment by definition (as what is not consumed is saved, and what is not consumed is production, which is either consumed or invested).
Define 'Full Employment' and 'Voluntary Unemployment'.Answer:
Full Employment:
A situation in an economy where all those who are willing and able to work at the existing wage rate are getting work. It does not mean zero unemployment; rather, it implies that only 'natural' unemployment (frictional and structural unemployment) exists. There is no involuntary unemployment.
Voluntary Unemployment:
A situation where a person is unemployed by choice. They are willing and able to work but are not willing to work at the existing wage rate, perhaps waiting for a higher wage or a better job opportunity. This type of unemployment is not considered a problem in macroeconomic terms.
Explain the meaning of 'Investment Multiplier'.Answer:
Investment Multiplier (k):
It is the ratio of the change in national income (ΔY) to the initial change in investment (ΔI) that brought about the change in income. It shows how many times the income expands due to an initial change in investment.
k = ΔY / ΔI
Relationship with MPC/MPS:
The value of the multiplier is directly related to MPC and inversely related to MPS.
k = 1 / (1 - MPC)
k = 1 / MPS
A higher MPC implies a higher multiplier, meaning a small initial investment leads to a larger increase in income. This is because a larger proportion of additional income is re-spent on consumption in each round of the circular flow.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the determination of equilibrium level of income and employment using the Aggregate Demand and Aggregate Supply approach. Use a diagram.Answer:
Aggregate Demand (AD):
Total demand for final goods and services in an economy during an accounting year. In a two-sector economy, AD = C + I.
Aggregate Supply (AS):
Total output of final goods and services planned to be produced in an economy during an accounting year. In the Keynesian framework, AS is equivalent to National Income (Y) as it represents the value of total output produced, which generates equivalent income. So, AS = Y (or AS = C + S).
Equilibrium Condition:
Equilibrium level of income and employment is determined where Aggregate Demand (AD) equals Aggregate Supply (AS).
AD = AS
C + I = C + S
(which implies I = S, the alternative approach)
Explanation:
If AD > AS:
This means planned expenditure is greater than planned output. Producers face unplanned depletion of inventories. To meet the higher demand, producers will increase production, leading to an increase in income and employment until AD = AS.
If AD < AS:
This means planned expenditure is less than planned output. Producers face unplanned accumulation of inventories. To clear the excess stock, producers will reduce production, leading to a decrease in income and employment until AD = AS.
Diagram:
Y-axis: AD, AS
X-axis: Income/Output (Y)
AS Curve:
A 45-degree line from the origin, representing AS = Y.
Consumption Function (C):
Upward sloping, starting from autonomous consumption (Cˉ) on the Y-axis.
Investment Curve (I):
Horizontal line, as autonomous investment is assumed.
AD Curve:
Parallel to the C curve, but shifted upwards by the amount of autonomous investment (I), i.e., AD = C + I.
Equilibrium (E):
The point where the AD curve intersects the AS (45-degree) curve. The corresponding income level on the X-axis is the equilibrium income (YE).
[Diagram Sketch: A graph with Income/Output on the X-axis and Aggregate Demand/Aggregate Supply on the Y-axis. A 45-degree line from the origin (AS curve). An upward-sloping AD curve starting from above the origin and intersecting the AS curve at point E. Indicate YE on the X-axis and ADE/ASE on the Y-axis.]
Explain the determination of equilibrium level of income and employment using the Savings and Investment approach. Use a diagram.Answer:
Savings (S):
That part of income which is not consumed. S = Y - C.
Investment (I):
Autonomous investment is assumed to be constant (fixed).
Equilibrium Condition:
Equilibrium level of income and employment is determined where planned Savings (S) equals planned Investment (I).
S = I
This condition is derived from AD = AS (C + I = C + S → I = S).
Explanation:
If S > I:
This means that planned savings are greater than planned investment. This implies that consumption is less than what is required to purchase the entire output. This leads to an unplanned accumulation of inventories for producers. To reduce inventories, producers will cut down production, leading to a fall in income and employment until S = I.
If S < I:
This means that planned savings are less than planned investment. This implies that consumption is more than what is required to purchase the entire output. This leads to an unplanned depletion of inventories for producers. To replenish inventories and meet higher demand, producers will increase production, leading to a rise in income and employment until S = I.
Diagram:
Y-axis: Savings, Investment
X-axis: Income/Output (Y)
Investment Curve (I):
A horizontal line parallel to the X-axis (assuming autonomous investment).
Savings Curve (S):
Upward sloping curve, starting from a negative intercept on the Y-axis (representing dissavings at zero income) and intersecting the X-axis where savings are zero.
Equilibrium (E):
The point where the Savings curve intersects the Investment curve. The corresponding income level on the X-axis is the equilibrium income (YE).
[Diagram Sketch: A graph with Income/Output on the X-axis and Savings/Investment on the Y-axis. A horizontal line for Investment (I). An upward-sloping Savings curve (S) starting from below the origin and intersecting the Investment line at point E. Indicate YE on the X-axis and SE/IE on the Y-axis.]
Discuss the concept of 'Inflationary Gap'. Explain its causes and measures to correct it.Answer:
Inflationary Gap:
It refers to the situation where Aggregate Demand (AD) is greater than Aggregate Supply (AS) at the full employment level of output. It represents the excess of AD over AS at the full employment level. This gap leads to inflationary pressures as producers cannot increase real output beyond full employment.
Inflationary Gap = AD (at full employment) - AS (at full employment)
Causes of Inflationary Gap (or Excess Demand):
Increase in Private Consumption Expenditure:
Due to rise in disposable income, expectations, or lower interest rates.
Increase in Investment Expenditure:
Due to lower interest rates, higher expected profits, or increased availability of credit.
Increase in Government Expenditure:
Due to higher government spending on public goods and services.
Increase in Exports/Decrease in Imports:
Due to favorable exchange rates or global demand.
Reduction in Taxes:
Increases disposable income, leading to more consumption and investment.
Increase in Money Supply:
Leads to higher liquidity and lower interest rates, boosting AD.
Measures to Correct Inflationary Gap:
Fiscal Measures (by Government):
Decrease Government Expenditure:
Reduce spending on public works, administration, etc.
Increase Taxes:
Increase direct taxes (income tax, corporate tax) and indirect taxes (GST), reducing disposable income and consumption/investment.
Reduce Public Borrowings:
Less borrowing by government leaves more funds for private sector.
Monetary Measures (by Central Bank):
Increase Bank Rate/Repo Rate:
Makes borrowing more expensive for commercial banks, leading to higher lending rates and reduced credit availability.
Increase CRR/SLR:
Reduces the lending capacity of commercial banks.
Sale of Government Securities (Open Market Operations):
Absorbs liquidity from the economy, reducing money supply.
Increase Margin Requirements:
Reduces the amount of loan provided against collateral, curbing speculative activities.
Selective Credit Controls:
Discourages credit for specific purposes deemed undesirable.
Discuss the concept of 'Deflationary Gap'. Explain its causes and measures to correct it.Answer:
Deflationary Gap:
It refers to the situation where Aggregate Demand (AD) is less than Aggregate Supply (AS) at the full employment level of output. It represents the deficiency of AD below AS at the full employment level. This gap leads to deflationary pressures, accumulation of unsold stock, and involuntary unemployment.
Deflationary Gap = AS (at full employment) - AD (at full employment)
Causes of Deflationary Gap (or Deficient Demand):
Decrease in Private Consumption Expenditure:
Due to fall in disposable income, negative expectations, or higher interest rates.
Decrease in Investment Expenditure:
Due to higher interest rates, lower expected profits, or reduced availability of credit.
Decrease in Government Expenditure:
Due to austerity measures or reduced public spending.
Decrease in Exports/Increase in Imports:
Due to unfavorable exchange rates or global economic slowdown.
Increase in Taxes:
Reduces disposable income, leading to less consumption and investment.
Decrease in Money Supply:
Leads to lower liquidity and higher interest rates, dampening AD.
Measures to Correct Deflationary Gap:
Fiscal Measures (by Government):
Increase Government Expenditure:
Increase spending on infrastructure, social programs, etc., directly boosting AD.
Decrease Taxes:
Reduce direct taxes (income tax, corporate tax) and indirect taxes (GST), increasing disposable income and consumption/investment.
Increase Public Borrowings:
Government borrows from public, putting money into circulation (though this needs careful balancing).
Monetary Measures (by Central Bank):
Decrease Bank Rate/Repo Rate:
Makes borrowing cheaper for commercial banks, leading to lower lending rates and increased credit availability.
Decrease CRR/SLR:
Increases the lending capacity of commercial banks.
Purchase of Government Securities (Open Market Operations):
Injects liquidity into the economy, increasing money supply.
Decrease Margin Requirements:
Encourages borrowing by making more loanable funds available against collateral.
Selective Credit Controls:
Encourages credit for specific productive purposes.
Derive the relationship between MPC and MPS. Explain how the value of the investment multiplier is related to MPC.Answer:
Relationship between MPC and MPS:
We know that income (Y) is either consumed (C) or saved (S).
Y = C + S
If there is a change in income (ΔY), it will lead to a change in consumption (ΔC) and a change in saving (ΔS).
ΔY = ΔC + ΔS
Divide the entire equation by ΔY:
ΔY/ΔY = ΔC/ΔY + ΔS/ΔY
1 = MPC + MPS
Therefore,
MPC + MPS = 1
. This implies that the sum of marginal propensity to consume and marginal propensity to save is always equal to one. If we know one, we can find the other (e.g., MPS = 1 - MPC or MPC = 1 - MPS).
Relationship between Investment Multiplier (k) and MPC:
The investment multiplier (k) is defined as: k = ΔY / ΔI
We know that at equilibrium, Savings (S) = Investment (I).
When there is a change in investment (ΔI), it leads to a change in savings (ΔS) in equilibrium. So, ΔI = ΔS.
Substitute ΔI with ΔS in the multiplier formula:
k = ΔY / ΔS
We also know that MPS = ΔS / ΔY. Therefore, 1/MPS = ΔY / ΔS.
So,
k = 1 / MPS
.
Since MPS = (1 - MPC), we can substitute this into the multiplier formula:
k = 1 / (1 - MPC)
Explanation of the relationship:
A higher MPC means that a larger proportion of any additional income is consumed. This consumption expenditure of one person becomes the income of another, which then gets partially consumed again, and so on. This leads to a larger cumulative increase in income for a given initial investment, hence a higher multiplier.
Conversely, a lower MPC (and thus a higher MPS) means that more of the additional income is saved, leading to less re-spending in the economy. This results in a smaller cumulative increase in income and a lower multiplier.
D. Numerical Problems (4-6 Marks Each)
Given a consumption function C = 100 + 0.75Y and autonomous investment I = 50. Calculate:(a) Equilibrium level of income(b) Consumption expenditure at equilibrium income(c) Savings at equilibrium incomeAnswer:
(a) Equilibrium level of income:
At equilibrium, Y = AD
AD = C + I
Y = (100 + 0.75Y) + 50
Y = 150 + 0.75Y
Y - 0.75Y = 150
0.25Y = 150
Y = 150 / 0.25
Y = 600
(Equilibrium Income = ₹600)
(b) Consumption expenditure at equilibrium income:
C = 100 + 0.75Y
C = 100 + 0.75 * (600)
C = 100 + 450
C = 550
(Consumption Expenditure = ₹550)
(c) Savings at equilibrium income:
Savings (S) = Y - C
S = 600 - 550
S = 50
(Savings = ₹50)
Alternatively, at equilibrium, S = I. Since I = 50, S must also be 50.
If in an economy, the Marginal Propensity to Save (MPS) is 0.2 and an increase in investment of ₹ 500 crores takes place, calculate the total increase in income.Answer:
Given: MPS = 0.2, ΔI = ₹ 500 crores
Investment Multiplier (k) = 1 / MPS
k = 1 / 0.2 = 5
We know that k = ΔY / ΔI
5 = ΔY / 500
ΔY = 5 * 500
ΔY = ₹ 2,500 crores
(Total increase in income = ₹2,500 crores)
Suppose in a hypothetical economy, the income is ₹ 500 crores and the consumption expenditure is ₹ 300 crores. If the income increases to ₹ 600 crores and consumption expenditure increases to ₹ 380 crores, calculate:(a) Marginal Propensity to Consume (MPC)(b) Marginal Propensity to Save (MPS)(c) Autonomous Consumption if the initial consumption function was C = a + bY.Answer:
Initial Income (Y1) = ₹ 500 crores, Initial Consumption (C1) = ₹ 300 crores
New Income (Y2) = ₹ 600 crores, New Consumption (C2) = ₹ 380 crores
Change in Income (ΔY) = Y2−Y1 = 600 - 500 = ₹ 100 crores
Change in Consumption (ΔC) = C2−C1 = 380 - 300 = ₹ 80 crores
(a) Marginal Propensity to Consume (MPC):
MPC = ΔC / ΔY
MPC = 80 / 100
MPC = 0.8
(b) Marginal Propensity to Save (MPS):
MPS = 1 - MPC
MPS = 1 - 0.8
MPS = 0.2
(c) Autonomous Consumption (a):
The consumption function is C = a + bY, where 'b' is MPC.
So, C = a + 0.8Y
Using the initial values (or new values):
300 = a + 0.8 * 500
300 = a + 400
a = 300 - 400
a = -100
(Autonomous Consumption = ₹ (-) 100 crores. This indicates that at zero income, there would be dissavings of ₹100 crores to finance basic consumption.)
E. Higher Order Thinking Skills (HOTS - 3-6 Marks Each)
"Keynesian theory suggests that aggregate demand plays a crucial role in determining the level of income and employment." Elaborate on this statement.Answer:
Keynesian Focus on AD:
John Maynard Keynes, in his 'General Theory', challenged classical economics, which believed that supply creates its own demand (Say's Law) and that the economy naturally tends towards full employment. Keynes argued that in a capitalist economy, the equilibrium level of income and employment is not necessarily at full employment but is determined by the level of
Aggregate Demand (AD)
.
Role of AD:
Insufficient AD leads to Underemployment Equilibrium:
If the total demand for goods and services (AD) is less than the full employment level of output, then producers will reduce production, leading to involuntary unemployment and an equilibrium at a level below full employment. Keynes called this 'deficient demand'.
AD drives Production:
Producers decide how much to produce based on their expectations of aggregate demand. If they anticipate low demand, they will produce less, employ fewer resources, and thus generate less income. Conversely, higher anticipated demand leads to higher production, employment, and income.
Effective Demand:
Keynes introduced the concept of 'Effective Demand', which is the level of AD that equals AS. It is this effective demand that determines the actual level of income and employment. If AD is too low, the economy can get stuck in a low-level equilibrium trap.
Multiplier Effect:
Any change in autonomous components of AD (like investment or government spending) has a magnified effect on total income and employment due to the multiplier mechanism. This highlights the power of influencing AD.
Policy Implications:
Since AD is the primary determinant, Keynes advocated for active government intervention (fiscal policy) and central bank intervention (monetary policy) to manage AD and move the economy towards full employment, especially during recessions.
Conclusion:
For Keynes, it's not the productive capacity (AS) that is the problem, but rather the insufficient spending (AD) that prevents the economy from reaching its full potential. Therefore, boosting or moderating aggregate demand is crucial for managing income and employment.
Distinguish between 'deficient demand' and 'excess demand'. Explain the role of fiscal and monetary policy in correcting them.Answer:
Deficient Demand (Deflationary Gap):
Meaning:
A situation where aggregate demand (AD) falls short of the aggregate supply (AS) required to achieve full employment equilibrium. It leads to deflationary pressures, involuntary unemployment, and accumulation of unsold stock.
Role of Policies to Correct (to increase AD):
Fiscal Policy (Government):
Increase Government Expenditure:
Boosts AD directly (e.g., infrastructure projects, public welfare schemes).
Decrease Taxes:
Increases disposable income, leading to more consumption and investment.
Increased Public Borrowing (from public/RBI):
Can inject money into the economy.
Monetary Policy (Central Bank):
Decrease Repo/Bank Rate:
Makes borrowing cheaper for banks, who then lower lending rates, encouraging investment and consumption.
Decrease CRR/SLR:
Increases banks' lending capacity, boosting credit availability.
Open Market Purchases of Securities:
Injects liquidity into the banking system, increasing money supply.
Decrease Margin Requirements:
Makes loans more accessible.
Excess Demand (Inflationary Gap):
Meaning:
A situation where aggregate demand (AD) exceeds the aggregate supply (AS) at the full employment level of output. It leads to inflationary pressures as the economy cannot produce more beyond full capacity.
Role of Policies to Correct (to decrease AD):
Fiscal Policy (Government):
Decrease Government Expenditure:
Reduces AD directly.
Increase Taxes:
Reduces disposable income, curbing consumption and investment.
Reduce Public Borrowing:
Less borrowing by government frees up funds for the private sector and reduces liquidity.
Monetary Policy (Central Bank):
Increase Repo/Bank Rate:
Makes borrowing more expensive for banks, who then raise lending rates, discouraging investment and consumption.
Increase CRR/SLR:
Reduces banks' lending capacity, curbing credit expansion.
Open Market Sale of Securities:
Absorbs liquidity from the banking system, reducing money supply.
Increase Margin Requirements:
Curbs speculative lending.
Conclusion:
Both fiscal and monetary policies are crucial tools that governments and central banks use to manage aggregate demand and maintain macroeconomic stability by countering deficient or excess demand.
Why is it that in a two-sector economy, income is either consumed or saved? Explain the implications of this assumption.Answer:
Assumption: Y = C + S:
In a two-sector economy (Households and Firms), it is assumed that all income generated (Y) is either spent on consumption (C) or saved (S). This is a simplified model, excluding government (taxes, government spending) and the foreign sector (exports, imports).
Households:
Receive factor income from firms. They have two choices: spend it on goods and services (consumption) or not spend it (saving).
Firms:
Use the income from sales for consumption and to pay factor incomes. What is not consumed by households becomes savings which can be channelled to investment by firms.
Implications of this assumption:
Closed Economy:
There are no international transactions (exports or imports). The economy is self-contained.
No Government Intervention:
There are no taxes, subsidies, or government expenditure. The government sector is absent.
Investment = Saving (Equilibrium Condition):
This fundamental identity arises from the model. Since AD = C + I and AS = C + S, at equilibrium (AD = AS), it means C + I = C + S, which implies I = S. This is a crucial condition for macroeconomic equilibrium in this model.
Leakages = Injections (in a broader context):
In this specific model, saving is the only leakage (withdrawal from the circular flow), and investment is the only injection (addition to the circular flow). The equilibrium condition S = I then means that leakages equal injections.
Simplicity for Analysis:
This simplified model allows for a clear understanding of the basic relationships between income, consumption, saving, and investment without the complexities introduced by government and foreign trade. It forms the foundation for understanding more complex macroeconomic models.
IV. Government Budget and the Economy
A. Multiple Choice Questions (MCQ - 1 Mark Each)
Which of the following is a non-tax revenue? (a) Income tax (b) Corporation tax (c) Fees and fines (d) GST
Answer: (c) Fees and fines
A budget is said to be balanced when: (a) Revenue Receipts = Revenue Expenditure (b) Capital Receipts = Capital Expenditure (c) Total Receipts = Total Expenditure (d) Revenue Receipts > Revenue Expenditure
Answer: (c) Total Receipts = Total Expenditure
Which of the following is a capital expenditure? (a) Salaries of government employees (b) Interest payments (c) Construction of a bridge (d) Subsidies
Answer: (c) Construction of a bridge
Fiscal deficit refers to: (a) Total expenditure - Total receipts (b) Revenue expenditure - Revenue receipts (c) Total expenditure - (Revenue receipts + Recovery of loans + Disinvestment) (d) Primary deficit - Interest payments
Answer: (c) Total expenditure - (Revenue receipts + Recovery of loans + Disinvestment)
Borrowings by the government are a part of: (a) Revenue receipts (b) Capital receipts (c) Revenue expenditure (d) Capital expenditure
Answer: (b) Capital receipts
(Specifically, debt-creating capital receipts)
B. Short Answer Questions (SAQ - 3-4 Marks Each)
Distinguish between 'Revenue Receipts' and 'Capital Receipts'. Give two examples of each.Answer:
Revenue Receipts:
Government receipts that neither create a liability nor lead to a reduction in assets. They are regular and recurring in nature.
Examples:
Income tax, Corporation tax, GST, Fees, Fines, Dividends from PSUs.
Capital Receipts:
Government receipts that either create a liability or lead to a reduction in assets. They are non-recurring in nature and represent the government's borrowings or disinvestment.
Examples:
Borrowings (from market, RBI, abroad), Disinvestment proceeds, Recovery of loans, Small savings.
Differentiate between 'Revenue Expenditure' and 'Capital Expenditure'. Give two examples of each.Answer:
Revenue Expenditure:
Government expenditure that neither creates assets nor reduces liabilities. It is incurred for the day-to-day running of government departments and provision of services. It is recurring in nature.
Examples:
Salaries of government employees, Interest payments, Subsidies, Pensions.
Capital Expenditure:
Government expenditure that either creates assets (e.g., building roads, schools) or reduces liabilities (e.g., repayment of loans). It adds to the productive capacity of the economy or reduces financial burdens. It is non-recurring in nature.
Examples:
Construction of roads, bridges, schools, Repayment of loans, Purchase of machinery, Investment in shares of companies.
What are the main objectives of a government budget?Answer:
The main objectives of a government budget are:
Reallocation of Resources:
To allocate resources in accordance with the economic and social priorities of the country (e.g., discourage harmful goods through taxes, encourage socially desirable goods through subsidies).
Redistribution of Income and Wealth:
To reduce inequalities in income and wealth through progressive taxation (higher income, higher tax) and public expenditure (providing benefits to the poor).
Economic Stability:
To control fluctuations in the economy (inflation or deflation) through fiscal measures (adjusting taxes and government spending).
Managing Public Enterprises:
To manage and finance public sector enterprises (PSUs) that operate for social welfare rather than just profit.
Economic Growth:
To promote economic growth by making public investments in infrastructure, education, health, and by providing incentives for private investment.
Reducing Regional Disparities:
To promote balanced regional growth by encouraging setting up of production units in backward regions through tax concessions and subsidies.
Define 'Fiscal Deficit'. What are its implications?Answer:
Fiscal Deficit:
It is the difference between the government's total expenditure (revenue + capital) and its total receipts (revenue receipts + non-debt creating capital receipts like recovery of loans and disinvestment proceeds). It indicates the total borrowing requirements of the government.
Fiscal Deficit = Total Expenditure - (Revenue Receipts + Recovery of Loans + Disinvestment)
Alternatively, Fiscal Deficit = Total Borrowings (as borrowings cover the deficit)
Implications of High Fiscal Deficit:
Debt Trap:
High fiscal deficit implies high borrowings, leading to higher interest payments in the future, which further increases expenditure and potentially more borrowing, creating a debt trap.
Inflationary Pressure:
Government borrowing from RBI (printing new currency) or from the public can increase money supply, leading to inflation.
Crowding Out:
Government borrowing from the market can reduce the availability of funds for the private sector, leading to higher interest rates and reduced private investment.
Loss of International Confidence:
A consistently high fiscal deficit can erode international investors' confidence in the economy.
Future Burden:
Future generations will have to bear the burden of repayment of past borrowings and interest.
Explain 'Primary Deficit'. How is it different from Fiscal Deficit?Answer:
Primary Deficit:
It is the difference between fiscal deficit and interest payments. It indicates the amount of borrowing needed to finance current expenditure excluding interest payments on past loans.
Primary Deficit = Fiscal Deficit - Interest Payments
Difference from Fiscal Deficit:
Fiscal Deficit
shows the total borrowing requirement of the government to cover all its expenditures.
Primary Deficit
shows the borrowing requirement
excluding
interest payments on past debts. It highlights the extent to which the government is borrowing to meet its current expenditure (excluding debt servicing costs).
If primary deficit is zero, it means the government is borrowing only to pay interest on past loans, and not for current expenditure. A reducing primary deficit indicates fiscal consolidation and a move towards sustainability.
C. Long Answer Questions (LAQ - 5-6 Marks Each)
Explain the various components of a government budget.Answer:
A government budget has two main components: the Revenue Budget and the Capital Budget.
I. Revenue Budget:
Deals with the revenue receipts and revenue expenditures of the government.
A. Revenue Receipts:
Receipts that neither create a liability nor reduce assets.
Tax Revenue:
Compulsory payments to the government.
Direct Taxes:
Imposed on income and wealth (e.g., Income Tax, Corporate Tax, Property Tax).
Indirect Taxes:
Imposed on goods and services (e.g., GST, Customs Duty, Excise Duty - pre-GST era).
Non-Tax Revenue:
Receipts other than taxes.
Fees and Fines:
Payments for services rendered or penalties for violations.
Interest Receipts:
From loans given by the government.
Dividends and Profits:
From public sector undertakings.
Grants and Donations:
Voluntary contributions.
Escheats:
Claim of government on property of a person who dies without legal heir.
B. Revenue Expenditure:
Expenditure that neither creates assets nor reduces liabilities.
Salaries and Wages:
Of government employees.
Interest Payments:
On government borrowings.
Subsidies:
Financial assistance to producers or consumers.
Pensions:
To retired government employees.
Defence Services:
Day-to-day expenses of defense.
Administrative Expenses:
General administration costs.
II. Capital Budget:
Deals with capital receipts and capital expenditures of the government.
A. Capital Receipts:
Receipts that either create a liability or reduce assets.
Borrowings:
From the public (market loans), RBI, foreign governments/institutions. (Creates liability)
Recovery of Loans:
Loans given by the government are repaid. (Reduces assets - loans extended)
Disinvestment:
Sale of government equity in Public Sector Undertakings (PSUs). (Reduces assets - ownership)
Small Savings:
Public deposits in post office savings schemes, etc.
B. Capital Expenditure:
Expenditure that either creates assets or reduces liabilities.
Construction of Infrastructure:
Roads, bridges, dams, schools, hospitals. (Creates assets)
Investment in Shares:
In PSUs or other companies. (Creates assets)
Loans to States/UTs/PSUs:
(Creates assets - loans extended)
Repayment of Loans:
Of government borrowings. (Reduces liabilities)
Acquisition of Land/Buildings:
(Creates assets)
These components are crucial for understanding the government's financial position and its impact on the economy.
Discuss the different types of budget deficits and their implications for the economy.Answer:
Budget deficits occur when government expenditure exceeds its receipts. The three main types are:
Revenue Deficit:
Definition:
Revenue Expenditure > Revenue Receipts.
Implications:
Indicates government's inability to meet its regular, recurring expenses from its regular income.
Implies dissavings by the government, as it's consuming more than it's earning.
Often leads to borrowing to finance day-to-day administration, which is unproductive and inflationary.
May force the government to sell assets (disinvestment) or borrow to meet consumption expenditure, weakening the financial position.
Fiscal Deficit:
Definition:
Total Expenditure > (Revenue Receipts + Non-debt Capital Receipts). It signifies the total borrowing requirement of the government.
Implications:
Debt Trap:
A persistent high fiscal deficit leads to accumulation of debt and rising interest payment burden, potentially pushing the government into a debt trap.
Inflationary Pressures:
If financed by borrowing from RBI (deficit financing/printing money), it increases money supply and can cause inflation.
Crowding Out:
If financed by borrowing from the domestic market, it can reduce the availability of funds for private investors, leading to higher interest rates and lower private investment. This 'crowds out' private sector investment.
Loss of Credibility:
High and persistent fiscal deficit can erode investor confidence, both domestic and foreign, affecting credit ratings and foreign investment.
Future Burden:
Transfers the burden of current consumption to future generations, who will have to repay the debt.
Primary Deficit:
Definition:
Fiscal Deficit - Interest Payments. It indicates the borrowing requirement of the government for current expenditure, excluding interest payments on past debt.
Implications:
Debt Sustainability:
A zero primary deficit implies that the government is borrowing only to repay past interest obligations, suggesting some level of fiscal sustainability if revenue deficits are also contained.
Fiscal Irresponsibility (if high):
A high primary deficit indicates that the government is borrowing heavily to meet its current consumption and investment needs, which is financially unsustainable in the long run.
True Reflection of Fiscal Stance:
It gives a clearer picture of the government's fiscal effort to control expenditure and raise revenue, as it removes the burden of inherited interest payments.
In summary, deficits indicate financial stress for the government and can have various adverse macroeconomic consequences, necessitating careful management through fiscal policy.
Explain the budgetary policy as a tool for achieving the objective of 'economic stability'.Answer:
Economic stability refers to the absence of large fluctuations in prices, employment, and output. Government budget (fiscal policy) is a powerful tool to achieve this by managing aggregate demand.
Addressing Inflation (Excess Demand):
Inflationary Situation:
When there is excess aggregate demand leading to rising prices.
Budgetary Response:
Increase Taxes:
Direct taxes (income tax, corporate tax) reduce disposable income and thus consumption and investment. Indirect taxes make goods more expensive, reducing demand.
Decrease Government Expenditure:
Reduces direct injection of demand into the economy. Government can cut spending on public works, subsidies, etc.
Reduce Public Borrowing:
Decreases money supply and prevents crowding out of private investment.
Overall Effect:
These measures reduce aggregate demand, thus curbing inflationary pressures and stabilizing prices.
Addressing Deflation (Deficient Demand):
Deflationary Situation:
When there is deficient aggregate demand leading to falling prices, accumulation of inventories, and unemployment.
Budgetary Response:
Decrease Taxes:
Reduces the tax burden, increasing disposable income and encouraging consumption and investment.
Increase Government Expenditure:
Directly boosts aggregate demand through spending on infrastructure, welfare programs, etc., creating jobs and income.
Increase Public Borrowing (from RBI/public):
Can inject money into the economy to stimulate demand.
Overall Effect:
These measures stimulate aggregate demand, helping to overcome deflationary pressures and promote economic growth and employment.
Automatic Stabilizers:
The budget also contains 'automatic stabilizers' like progressive income taxes and unemployment benefits.
During a boom, higher incomes mean higher tax collections (reducing AD) and lower unemployment benefits (reducing expenditure).
During a recession, lower incomes mean lower tax collections (increasing AD) and higher unemployment benefits (increasing expenditure).
These operate automatically without explicit policy decisions, helping to moderate economic fluctuations.
By strategically adjusting its revenue and expenditure policies, the government uses its budget to stabilize the economy and steer it towards desired macroeconomic goals.
How does the government budget help in 'redistribution of income and wealth'?Answer:
The government budget is a crucial instrument for promoting equity and social justice by redistributing income and wealth in an economy. This is achieved through two main channels:
Taxation Policy (Revenue Side):
Progressive Taxation:
The government imposes taxes in a progressive manner, meaning higher income groups pay a larger proportion of their income as tax (e.g., income tax, wealth tax). This reduces the disposable income of the rich more significantly than the poor.
Taxes on Luxuries:
Higher taxes on luxury goods (often consumed by the rich) can also contribute to redistribution.
By collecting more from those who have more, the government mobilizes resources that can then be used to benefit the less privileged.
Expenditure Policy (Expenditure Side):
Public Provision of Goods and Services:
The government provides essential goods and services (e.g., education, healthcare, public transport, housing) at free or subsidized rates, which disproportionately benefits the poor and vulnerable sections of society who cannot afford them at market prices.
Subsidies:
Providing subsidies on essential commodities (e.g., food, LPG, fertilizers) or on basic services helps reduce the burden on lower-income households.
Transfer Payments:
Direct cash transfers, old-age pensions, unemployment allowances, scholarships, and various welfare schemes (e.g., MGNREGA) directly transfer income to the poor and marginalized groups, increasing their purchasing power and improving their living standards.
Investment in Backward Regions:
Government expenditure on infrastructure and development projects in backward regions helps create employment opportunities and income for residents in those areas, reducing regional disparities.
By combining progressive taxation with targeted public expenditure and social welfare programs, the government uses its budget to narrow the gap between the rich and the poor, enhance the welfare of the underprivileged, and promote a more equitable distribution of income and wealth in society.
Distinguish between 'Direct Tax' and 'Indirect Tax' with examples. Explain their merits and demerits.Answer:
Direct Tax:
Meaning:
A tax whose incidence (burden) and impact (payer) fall on the same person. It cannot be shifted to others.
Examples:
Income Tax, Corporate Tax, Wealth Tax, Property Tax.
Merits:
Equity/Progressivity:
Generally progressive, meaning higher income earners pay a larger percentage of their income as tax, promoting income redistribution.
Certainty:
The taxpayer knows how much they have to pay, and the government knows how much it will collect.
Elasticity:
Tax revenue increases automatically with economic growth (income increases, tax collection increases).
Simplicity (for calculation):
Once income is determined, tax calculation is straightforward.
Demerits:
Disincentive to Work/Save:
High direct taxes can discourage work effort, savings, and investment.
Tax Evasion:
High direct taxes can lead to greater motivation for tax evasion, creating a black economy.
Narrow Base:
Often affects only a segment of the population (e.g., salaried individuals, large corporations).
Arbitrary Rates:
The determination of fair tax rates can be arbitrary and politically influenced.
Indirect Tax:
Meaning:
A tax whose incidence (burden) and impact (payer) fall on different persons. It can be shifted to others. The producer/seller pays the tax initially but recovers it from the consumer by charging a higher price.
Examples:
Goods and Services Tax (GST), Customs Duty, Excise Duty (pre-GST), Sales Tax (pre-GST), Service Tax (pre-GST).
Merits:
Wide Coverage:
Paid by almost everyone who consumes goods and services, so the tax base is wide.
Convenience:
Paid incrementally with consumption, so it feels less burdensome.
Check on Harmful Consumption:
Can be used to discourage consumption of harmful goods (e.g., sin taxes on tobacco, alcohol).
Less Tax Evasion (relatively):
As it's embedded in the price, it's harder to evade.
Demerits:
Regressive:
Often falls disproportionately on lower-income groups, as they spend a larger proportion of their income on goods and services, thus increasing inequality.
Inflationary:
Can lead to higher prices, contributing to inflation.
Uncertainty:
Tax revenue can fluctuate with consumption patterns.
Lack of Social Consciousness:
People are often unaware they are paying these
