5th Semester Economics Seleted Questions PDF

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Unit – I [2 marks]:
Macroeconomics: Basic concepts
5. Difference between micro & macro economics ************
Microeconomics Macroeconomics
1. It is that branch of economics which 1. It is that branch of economics which deals with
deals with the economic decision making aggregates and averages of the economy, e.g. aggregate
of individual economic agents such as output, national income, aggregate savings and
the producer, the consumer, etc. investment, etc.
2. In microeconomics, the economic 2. In macroeconomics, the decision making units (or the
decision making units (or the economics player) are the Central Planning Authority, the Central
agents) are individual consumers, Bank (e.g. the Reserve Bank of India) etc.
individual producers etc.
3. It takes into account small components of 3. It takes into consideration the economy of any county
the whole economic. as a whole.
4. It deals with the process of price 4. It deals with the general price level in any economy.
determination in case of individual
products and factors of production.
6. Distinguish between concepts of ‘stock’ and ‘flow’.********

Difference between Stock and flows:
Stock Flow
A stock has no time dimension. A flow has a time dimension.
A stock is measured at a point of time (say, A flow is measured per time period (say, per
as on 31st, March, 2010) month, per week etc)
A stock indicates the static aspects of an A flow variable indicates the dynamic aspects of
economy. an economy.
A stock often influence a flow, e.g. higher A flow variable also influence a stock e.g.
stock of capital would lead to higher flow of greater flow of saving per year would result in
goods & services in an economy. higher investment and greater capital stock in a
country.
8. What is capital good? Can any final good be capital good?**

(a) Capital Goods: Capital goods are man-made, durable items businesses use to produce goods
and services. They include tools, buildings, vehicles, machinery, and equipment. Capital goods
are also called durable goods, real capital, and economic capital. In accounting, capital goods
are treated as fixed assets. They’re also known as “plant, property, and equipment.”
(b) Final Goods: Final goods refer to those goods which are used either for consumption or for
investment.
Capital goods are not considered as final goods but they are used to make the final goods and services in
the market.

Unit – 2: National Income [6 Marks]

20. What is meant by circular flow of income?***************
Two sector economy
In simple economy if there is two sector i.e. household and firm, then transaction between these two
sector will lead to a circular flow of income. The real flow implies the flow of goods and services across
different sector of economy and money flow implies flow of money in the form of expenditure on various
goods and services. The circular flow of income is based on following assumption –
(a) All economic decisions are taken by Households and firms.
(b) Production takes place in firms and sold to households.
(c) Households are the suppliers of factor of production.
(d) Households spend money to purchase goods produced by a firms.
The concept of circular flow can be explained with the help of following diagram.
In the upper part of this diagram

Households supply different factors to firm
as shown by real flow (A) and in return
household received factors income from
firms as shown by money flow (B). In
factor market households are sellers and
firms are buyers. The expenses of firms is
the income of households. In lower part of
diagram firms supply goods and services to
households as shown by real flow (C). In
return households payments for goods and
services to firms as shown by money flow
(D). In product market households are
buyer and firms are sellers. The money
flows from households to firm. In others
words the expenditure of households is the
income of the firm. since the starting point
and the final point are the same therefore
this is called circular flow.
Three Sector Economy:

In our above analysis of money flow, we have ignored the existence of government for the sake
of making our circular flow model simple. This is quite unrealistic because government absorbs
a good part of the incomes earned by households. Government affects the economy in a number
of ways. Here we will concentrate on its taxing, spending and borrowing roles. When part of
income is spent on tax payment then that part of spending by any household or a firm can not
arise as income of another firm or household. So this tax payment is considered as the Leakage
or Withdrawal from the circular flow of income. When government purchase goods and services
produced by any sector ( says firm sector) then income earned by the firm sector does not
depend on expenditure made by the household sector. So the government expenditure
considered as Injection into the circular flow of income. It should be noted that in any economy
injection must be equal to withdrawal.
On left part of diagram shows the flow of income and expenditure between
household sector and the government. Household sector pays net tax (tax –transfer
payment). On the other hand, the government also purchase goods and services
from the household in form of wages and salaries or also makes transfer payments
in the form pension funds, relief, sickness benefits, health, education etc. On the
right side of the diagram shows flow of income and expenditure between business
sector and the government. Business firms pay net taxes (tax-subsidies) to the
government. On the other hand the government provides subsidies and purchase
goods and services from the business sector.
8. What do you mean by Real GDP & Nominal GDP?

Due to price level changes (that is, inflation or deflation) it becomes necessary to draw a distinction between
money income and real income. The reason is simple. GDP is expressed in money terms. Price level changes
can affect one measure of the total output of the economy. In general, the formula for converting GDP to real
𝐺𝐷𝑃
GDP is Real GDP = 𝑃 * 100
Where P is the price index (that is, the weighted average of all prices).
9. What do you mean by implicit deflator?

From nominal GDP and real GDP we can get the concept of GDP deflator also called implicit price deflator
for GDP. It is defined as the ratio of nominal GDP to real GDP. Thus
Nominal GDP
GDP deflator = Real GDP .
The GDP deflator shows what happens to the overall level of prices in the economy.

Numerical Problems on
national income
Question 4:*********
From the following data calculate National Income:
Items (₹ in crore)
(a) Private income 1,200
(b) National debt interest 40
(c) Current transfers from the government administrative departments 40
(d) Other current transfers from rest of the world 12
(e) Income from property and entrepreneurship accruing to govt. departments 16
(f) Savings of government departmental enterprises 8
Solution:
National Income = Private income – National debt interest – Current transfers from the government
administrative departments – Other current transfers from rest of the world + Income from property
and entrepreneurship accruing to government departments + Savings of government departmental
enterprises = ₹ 1,200 crore – ₹ 40 crore – ₹ 40 crore – ₹ 12 crore + ₹ 16 crore + ₹ 8 crore =₹ 1,132 crore
Question 8:***********
From the following data calculate National Income:
Items (₹ in crore)
(a) Compensation of employees 800
(b) Rent 200
(c) Wages and salaries 750
(d) Net exports (–)30
(e) Net factor income from abroad (–)20
(f) Profit 300
(g) Interest 100
(h) Depreciation 50
(i) Remittances from abroad 80
(j) Taxes on profits 60
Solution:
National Income = Compensation of employees + Rent + Profit + Interest + Net factor income from
abroad *Income method+ = ₹ 800 crore + ₹ 200 crore + ₹ 300 crore + ₹ 100 crore + (–) ₹ 20 crore = ₹
1,380 crore.

Unit – 3: Determination of Equilibrium Level [Marks:10]
5. Discuss briefly the simple Keynesian model of income

determination. [2012]***
According to Keynes, there can be different sources of national income, such as government, foreign
trade, individuals, businesses and trusts.
For determining national income, Keynes had divided the different sources of income into four sectors
namely’ household sector, business sector, government sector, and foreign sector.
He prepared three models for the determination of national income, which are shown in Figure-1:
The two-sector model of economy involves households and businesses only, while three-sector model
represents households businesses, and government. On the other hand, the four-sector model contains
households, businesses, government, and foreign sector.
Determination of National Income in Two-Sector Economy:
The determination of level of national income in the two-sector economy is based on an assumption
that two-sector economy is an economy where there is no intervention of the government and foreign
trade. Apart from this, an economy can be a two-sector economy if it satisfies the following
assumptions:
(a) Comprises only two sectors, namely, households and businesses. The households are the owners of
factors of production and provide factor services to businesses to earn their livelihood in the form
of wages, rents, interest, and profits. In addition the households are the consumers of final goods
and services produced by businesses. On the other hand, businesses purchase factor services from
households to produce goods and services and sell it to households.
(b) Does not have government interference.
(c) Comprises a closed economy in which the foreign trade does not exist. In other words, import and
export services are absent in such an economy.
(d) The profit earned by an organization is completely distributed in the form of dividends among
shareholders.
(e) Keeps the prices of goods and services, supply of factors of production, and production technique
constant throughout the life cycle of organization.
Keynes believed that there are two major factors that determine the national income of a country.
These two factors are Aggregate Supply (AS) and Aggregate Demand (AD) of goods and services.
In addition, he believed that the equilibrium level of national income can be estimated when AD=AS.

Aggregate Supply:
AS can be defined as total value of goods and services produced and supplied at a particular point of
time. It comprises consumer goods as well as producer goods. When goods and services produced at a
particular point of time is multiplied by the respective prices of goods and services, it provides the total
value of the national output. The national output is the aggregate supply in the form of money value.
The Keynesian AS curve is drawn based on an assumption that total income is equal to total
expenditure. In other words, the total income earned is fully spent on different types of goods and
services.
According to Keynes theory of national income determination, the aggregate income is always equal to
consumption and savings.
Aggregate Income = Consumption(C) + Saving (S)
Therefore, the AS schedule is usually called C + S schedule. The AS curve is also named as Aggregate
Expenditure (AE) curve.
Aggregate Demand:
AD refers to the effective demand that is equal to the actual expenditure. Aggregate effective demand
refers to the aggregate expenditure of an economy in a specific time frame. AD involves two concepts,
namely, AD for consumer goods or consumption (C) and aggregate demand for capital goods or
investment (I).
Therefore, the AD can be represented by the following formula:
AD = C + I
Therefore, AD schedule is also termed as C + I schedule. According to Keynes theory of national income
determination in short-run investment (I) remains constant throughout the AD schedule, while
consumption (C) keeps on changing. Therefore, consumption (C) acts as the major determinant or
function of income (Y).
Figure-3 represents the graphical representation of national income determination in the two-sector
economy:

In Figure-3, while drawing AS schedule it is assumed that the total income and total expenditure are
equal. Therefore, the numerical value of AS schedule is one. AD schedule is prepared by adding the
schedule of C and I. The aggregate demand and aggregate supply intersect each other at point E, which
is termed as equilibrium point.
6. What is Keynesian consumption function? What are its

characteristics? Show that MPC+MPS=1. [2013]*********
The Concept of Consumption Function:
As the demand for a good depends upon its price, similarly consumption of a community depends upon the
level of income. In other words, consumption is a function of income. The consumption function relates the
amount of consumption to the level of income. When the income of a community rises, consumption also
rises.
How much consumption rises in response to a given increase in income depends upon the marginal
propensity to consume. It should be borne in mind that the consumption function is the whole schedule
which describes the amounts of consumption at various levels of income.
The consumption function or propensity to consume refers to income consumption relationship. It is a
“functional relationship between two aggregates, i.e., total consumption and gross national income.”
Keynesian Consumption Function:
The consumption function states that aggregate real consumption expenditure of an economy is a
function of real national income. This is called the Keynesian Consumption Function.
The consumption function has two technical attributes or properties:
(i) The average propensity to consume, and
(ii) The marginal propensity to consume.
(1) The Average Propensity to Consume:
“The average propensity to consume may be defined as the ratio of consumption expenditure to any
particular level of income.” It is found by dividing consumption expenditure by income, or APC = C/Y. It is
expressed as the percentage or proportion of income consumed.
The APC declines as income increases because the proportion of income spent on consumption
decreases.
But reverse is the case with APS (average propensity to save) which increases with increase in income.
Thus the APC also tells us about the APS, APS=1-APC.

(2) The Marginal Propensity to Consume:
“The marginal propensity to consume may be defined as the ratio of the change in consumption to the
change in income or as the rate of change in the average propensity to consume as income changes.” It
can be found by dividing change in consumption by a change in income, or MPC = ∆C/∆Y
Characteristics of Keynesian consumption function
According to Keynes the consumption function must possess the following characteristics:
(a) Aggregate real consumption expenditure is a stable function of real income.
(b) The marginal propensity to consume (MPC) or the slope of the consumption function defined as
dc/dY must lie between zero and one i.e. 0 < MPC < 1.
(c) The average propensity to consume (APC) or the proportion of income spent on consumption
defined as C/Y should be decreasing as income increases. From the relation between marginal and
average we know that, when average falls, marginal is below average. Thus, when the average
propensity to consume (APC) falls, the marginal propensity to consume (MPC) must be lower than
the APC.
(d) The marginal propensity to consume (MPC) itself probably decreases or remains constant as
income increases.
These four characteristics specify the shape of the consumption function. It can be seen clearly that, if
we draw a straight line consumption function with a positive intercept with the vertical axis, and
intersecting the 45° line from above, it will satisfy all the four characteristics.
Mathematical Relationship between MPC and MPS!
The sum of MPC and MPS is equal to unity (i.e., MPC + MPS = 1).
For sake of convenience, suppose a man’s income Increases by Rs 1. If out of it, he spends 70 paise on
consumption (i.e., MPC = 0.7) and saves 30 paise (i.e., MPS = 0 3) then MPC + MPS = 0.7 + 0.3 = 1.
MPC + MPS = I as proved below.
We know that income (Y) is either spent on consumption (C) or saved (S).
Symbolically:
Y =C + S
or
∆Y = ∆C + ∆S
By dividing both sides by AY, we get:
∆Y/∆Y = ∆C/∆Y + ∆S/∆Y
or
1 = MPC + MPS
MPC + MPS = 1.

8. How does the Keynesian consumption function determine

the concerned saving function? [2012]
OR
What is Keynesian consumption function? How would you
derive the saving function from the Keynesian consumption
function? Explain your answers diagrammatically. [2016]
Keynesian consumption function
The consumption function states that aggregate real consumption expenditure of an economy is a function
of real national income. This is called the Keynesian Consumption Function.
The consumption function shows what consumption expenditure would be at different levels of income. The
aggregate consumption in the economy can be found out from the consumption expenditure of different
individuals purchasing commodities.
When all prices and the level of income change in the same proportion, the consumption expenditure will
also change in the same proportion.
Thus, the aggregate consumption function states that real consumption is a function of real income and then
the consumption function can be written as C = C(Y) where C is real consumption expenditure and Y is real
national income. This is the Keynesian Consumption Function. The straight line consumption function has a
constant slope at all points. The (MFC) marginal propensity to consume decreases as income increases.
The Saving Function:
The saving function can be deduced from the consumption function. Saving (S) is defined as the difference
between income and consumption, i.e. S = Y – C = Y – C(Y). It means that saving (S) is a function of income,
i.e. S = S(Y). The saving function can be known from the consumption function. The average propensity to
consume is S/Y and the marginal propensity to consume is dS/dY, change in saving when income changes.
Diagrammatic Derivation of Saving Curve from Consumption Curve!
We know that consumption + saving is always equal to Income because income is either consumed or saved.
Therefore, we can derive saving function or curve directly from consumption function or curve. This has
been depicted in the adjoining Fig. 8.7 comprising Part-A showing consumption function and Part-B showing
saving function.

In Part-A of this Figure, CC curve shows consumption function corresponding to each level of income
whereas 45° line represents income. Recall that each point on 45° line is equidistant from X-axis and Y-axis. C
curve intersects 45° line at point B at which BR = OR, i.e., consumption = Income. Therefore, point B is called
Break-even point showing zero saving.
It emphasises that saving curve must intersect x-axis at the same income level where consumption curve and
45° line intersect. Further, it will be seen that to the left of point B, consumption function lies above 45° line
showing that consumption is more than income, i.e., negative saving and to the right of point B,
consumption function lies below 45° line showing positive saving.
Now, in Part-B we derive saving function in the form of saving curve. Remember, in Part-A, the amount of
saving (or dissaving) is the vertical distance between C curve and 45° line. By plotting in Part-B of the Fig.
8.7, the vertical distances of Part-A representing saving/dissaving and by joining them, we derive a saving
curve. For instance, at 0 (zero) level of income in Part-A, vertical distance OC (representing dissaving) is
plotted as OS1 below X-axis in Part-B.
Similarly, at OR level of income in Part-A, vertical distance at point B being nil is shown as point B1 on X-
axis in lower part of the Fig. Likewise, LM vertical distance of Part-A is shown as L1M1 in Part-B. By joining
points S, B1 and L1 in lower segment, we get saving curve. Thus, saving curve/function is diagrammatically
derived from consumption curve/function.

9. Explain the Keynesian theory of investment multiplier. What

are the limitations of the theory?. [2013]***********
OR
Explain briefly the implication of various leakages in the
process of working of the Keynesian investment multiplier.
[2014]
What is an Investment Multiplier
An investment multiplier refers to the concept that any increase in public or private investment spending
has a more than proportionate positive impact on aggregate income and the general economy. The
multiplier attempts to quantify the additional effects of a policy beyond those immediately measurable. The
larger an investment's multiplier, the more efficient it is at creating and distributing wealth throughout an
economy.
What Is the Keynesian Multiplier?
The multiplier concept is central to Keynes’ theory because it tells us that an increase in investment by a
certain amount leads to an increase in income greater than the increase in investment. Thus, an investment
has a “multiplier effect” on aggregate demand. The concept of multiplier is a solution to the problem of
underemployment equilibrium.
While developing his theory of “investment multiplier”, Keynes borrowed the concept from R. F. Kahn’s
“employment multiplier.” A change in autonomous investment expenditure brings about a change in
income. However, the change in income is greater than or a multiple of the change in investment. Suppose,
an investment of Rs. 2,000 crore causes an increase in income by Rs. 6,000 crore, then the value of the
multiplier would be 3. Thus, the multiplier is the change in income consequent upon a change in investment.
Or the multiplier is the ratio of change in income (∆Y) to a planned change in investment (∆I). Let the
investment multiplier be denoted by KI. Multiplier is the number by which the change in investment has to
be multiplied to obtain the resulting change in income.
Thus, ∆Y = KI. ∆l
Or KI = ∆Y/∆I
Multiplier Process:
Why does income rise in a multiplied form following a rise in investment? From the circular flow of income,
we know that business firms earn when households spend, and households earn when firms spend on hiring
input services rendered. Thus, total income equals total expenditure.
However, a part of this total income is spent on consumption and the rest is saved. This induced
consumption of one individual becomes the income of another individual which again results in an increase
in consumption. This again creates income and the process goes on.
Thus, an initial autonomous investment expenditure leads to an increase in income via consumption
expenditure. However, the process of income generation must stop when the last consumption spending
fails to generate fresh income. Anyway, at the end, the total increase in income will be more than the initial
volume of investment. However, how much income will rise in response to an increase in investment
depends on the value of MPC or its complementary term, MPS.

Fig. 3.15 illustrates the graphical exposition of the multiplier process in an alternative way. To be in
equilibrium, leakage (here, saving only) must equal injection (here, investment only). Further, investment is
assumed to be autonomous, represented by the line I1. SS‘— the saving schedule— cuts the I1 line at E1.
Corresponding to this equilibrium point, equilibrium level of income, thus, determined is OY1 An increase in
investment by an amount AI causes the investment line to shift up to l 1 Equilibrium point shifts to E2 and
income rises from OY1to OY2 Anyway, the increase in income (AY) is bigger than the increase in investment
(A 1). The multiplier is now in action and the economy recovers from the ‗Great Depression‘.
Limitations:
(a) Firstly,Keynes assumed that consumption depends on income and MPC of the economy does not
change. But, experience and evidence suggest that consumption depends on other factors including
income. Keynes ignored other determinants of consumption function.
(b) Secondly, the multiplier analysis describes the effect of an increase in autonomous investment on
national income. But it neglects the effect of consumption on investment. Changes in consumption
result in a change in investment spending. This sort of investment is called induced investment.
Multiplier analysis neglects this aspect. If induced investment is taken into account the value of
multiplier will be larger than the simple multiplier presented by Keynes.
(c) Thirdly, multiplier analysis comes to a halt if the economy remains at the full employment level since
output or income cannot increase beyond this level even if investment spending increases. Only at the
underemployment situation does multiplier work.
(d) Fourthly, Keynesian multiplier is an instantaneous multiplier in the sense that as soon as investment
takes place income tends to rise. This is also called ‗static multiplier‘ as there is no lag between income
and investment expenditure. However, in reality, there exists a time lag between incomes received and
consumption spending. Greater the time lag, lower will be the value of the multiplier because now
change in income is not instantaneous.
(e) Finally, leakages or withdrawals result in a smaller value of multiplier. In other words, due to the
presence of leakages, process of income generation slows down. For instance, if people decide to save
more from their incomes the value of the multiplier will be weaker.

Unit – 4 [10 Marks]:

Commodity market and Money market equilibrium
4. Discuss Liquidity Preference theory of demand for money.

OR
Discuss the Keynesian theory of demand for money. [2013]****
Keynes’ Theory of Demand for Money:
In his well-known book, Keynes propounded a theory of demand for money which occupies an important
place in his monetary theory.
It is also worth noting that for demand for money to hold Keynes used the term what he called liquidity
preference. How much of his income or resources will a person hold in the form of ready money (cash or
non-interest-paying bank deposits) and how much will he part with or lend depends upon what Keynes
calls his ―liquidity preference.‖ Liquidity preference means the demand for money to hold or the desire of
the public to hold cash.
Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:
Liquidity preference of a particular individual depends upon several considerations. The question is: Why
should the people hold their resources liquid or in the form of ready money when he can get interest by
lending money or buying bonds?
The desire for liquidity arises because of three motives:
(a) The transactions motive,
(b) The precautionary motive, and
(c) The speculative motive.
(A) The Transactions Demand for Money:
The transactions motive relates to the demand for money or the need for money balances for the
current transactions of individuals and business firms. Individuals hold cash in order ―to bridge the
interval between the receipt of income and its expenditure‖.
The businessmen and the entrepreneurs also have to keep a proportion of their resources in money
form in order to meet daily needs of various kinds. They need money all the time in order to pay for
raw materials and transport, to pay wages and salaries and to meet all other current expenses incurred
by any business firm.
(B) Precautionary Demand for Money:
Precautionary motive for holding money refers to the desire of the people to hold cash balances for
unforeseen contingencies. People hold a certain amount of money to provide for the danger of
unemployment, sickness, accidents, and the other uncertain perils. The amount of money demanded
for this motive will depend on the psychology of the individual and the conditions in which he lives.
(C) Speculative Demand for Money:
The speculative motive of the people relates to the desire to hold one‘s resources in liquid form in
order to take advantage of market movements regarding the future changes in the rate of interest (or
bond prices). The notion of holding money for speculative motive was a new and revolutionary
Keynesian idea.
Money held under the speculative motive serves as a store of value as money held under the
precautionary motive does. But it is a store of money meant for a different purpose. The cash held
under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate.

1. 7. Define LM curve. Derive and explain the different slopes of the LM curve
in its different segments. [2015, 2018]**************
LM curve.
The LM curve, "L" denotes Liquidity and "M" denotes money, is a graph of combinations of
real income (Y), and the real interest rate (r), such that the money market is in equilibrium
(i.e. real money supply = real money demand).
In macroeconomics, the LM curve is the liquidity preference and money supply curve, and it
shows the relationship between real output and interest rates.
Derivation of the LM Curve:
The LM curve can be derived from the Keynesian theory from its analysis of money market
equilibrium. According to Keynes, demand for money to hold depends upon transactions
motive and speculative motive.
It is the money held for transactions motive which is a function of income. The greater the
level of income, the greater the amount of money held for transactions motive and therefore
higher the level of money demand curve.
The demand for money depends on the level of income because they have to finance their
expenditure, that is, their transactions of buying goods and services. The demand for money
also depends on the rate of interest which is the cost of holding money. This is because by
holding money rather than lending it and buying other financial assets, one has to forgo
interest.
Thus demand for money (Md) can be expressed as:
Md = L(Y, r)
Where Md stands for demand for money, Y for real income and r for rate of interest. Thus,
we can draw a family of money demand curves at various levels of income. Now, the
intersection of these various money demand curves corresponding to different income levels
with the supply curve of money fixed by the monetary authority would gives us the LM
curve.
In Fig. 24.2 (a) and (b) we have derived the LM curve from a family of demand curves for
money.

As income increases, money demand curve shifts outward and therefore the rate of interest which equates
supply of money, with demand for money rises. In Fig. 24.2 (b) we measure income on the X-axis and
plot the income level corresponding to the various interest rates determined at those income levels
through money market equilibrium by the equality of demand for and the supply of money in Fig. 24.2
(a).
Slope of LM Curve:
It will be noticed from Fig. 24.2 (b) that the LM curve slopes upward to the right. This is because with
higher levels of income, demand curve for money (Md) is higher and consequently the money- market
equilibrium, that is, the equality of the given money supply with money demand curve occurs at a higher
rate of interest. This implies that rate of interest varies directly with income.
14. Examine how far fiscal policy is more effective than monetary policy in combatting
a recessionary situation. [2016]*****
Fiscal policy
Fiscal policy determines the way in which the central government earns money through taxation and
how it spends money. To assist the economy, a government will cut tax rates while increasing its own
spending; to cool down an overheating economy, it will raise taxes and cut back on spending.
Monetary policy
Monetary policy involves the management of the money supply and interest rates by central banks. To
stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to
borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can
implement a tight monetary policy by raising interest rates and removing money from circulation.
How far fiscal policy is more effective than monetary policy
The aims of fiscal and monetary policy are similar. They could both be used to:
 Maintain positive economic growth
 Aim for full employment
 Keep inflation low
The principal aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic cycle. In
recent years, governments have often relied on monetary policy to target low inflation. However, in
recessions, there are strong arguments for also using fiscal policy to achieve economic recovery.
(a) Fiscal policy involves changing government spending and taxation. It involves a shift in the
government's budget position. e.g. Expansionary fiscal policy involves tax cuts, higher
government spending and a bigger budget deficit. Government spending is a component of AD.
(b) Expansionary fiscal policy can directly create jobs and economic activity by injecting demand
into the economy. Keynes argued expansionary fiscal policy is necessary in a recession because
of the excess private sector saving which arises due to the paradox of thrift. Expansionary fiscal
policy enables unused savings to be used and idle resources to be put into work.
(c) In a deep recession and liquidity trap, fiscal policy may be more effective than monetary policy
because the government can pay for new investment schemes, creating jobs directly – rather
than relying on monetary policy to indirectly encourage business to invest.
(d) Government spending directly creates demand in the economy and can provide a kick-start to
get the economy out of recession. Thus in a deep recession, relying on monetary policy alone,
may be insufficient to restore equilibrium in the economy.
(e) In a liquidity trap, expansionary fiscal policy will not cause crowding out because the
government is making use of surplus saving to inject demand into the economy.
(f) In a deep recession, expansionary fiscal policy may be important for confidence – if monetary
policy has proved to be a failure.

Unit – 5:
Money, Inflation and Unemployment [6 + 6 = 12 Marks]
4. What do you mean by supply of money? Discuss the different measures of supply of
money. [2013]
The supply of money:
The supply of money means the total stock of money (paper notes, coins and demand deposits of bank)
in circulation which is held by the public at any particular point of time.
Briefly money supply is the stock of money in circulation on a specific day. Thus two components of
money supply are
(i) currency (Paper notes and coins)
(ii) Demand deposits of commercial banks.
Again it needs to be noted that (like difference between stock and supply of a commodity) total stock of
money is different from total supply of money.
Supply of money is only that part of total stock of money which is held by the public at a particular point
of time. In other words, money held by its users (and not producers) in spendable form at a point of
time is termed as money supply.
The stock of money held by government and the banking system are not included because they are
suppliers or producers of money and cash balances held by them are not in actual circulation. In short,
money supply includes currency held by public and net demand deposits in banks.
Sources of Money Supply:
(a) Government (which Issues one-rupee notes and all other coins)
(b) RBI (which issues paper currency)
(c) commercial banks (which create credit on the basis of demand deposits).
Four Measures of Money Supply in India
There are four measures of money supply in India which are denoted by M1, M2, M3 and M4. This
classification was introduced by the Reserve Bank of India (RBI) in April 1977.
(A) M1
The first measure of money supply, M1 consists of:
(i) Currency with the public which includes notes and coins of all denominations in circulation excluding
cash on hand with banks:
(ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits; and
(iii) ‘Other deposits’ with RBI which include current deposits of foreign central banks, financial
institutions and quasi-financial institutions such as IDBI, IFCI, etc., other than of banks, IMF, IBRD, etc.
(B) M2
M2. The second measure of money supply is M2which consists of M1 plus post office savings bank
deposits. Since savings bank deposits of commercial and cooperative banks are included in the money
supply, it is essential to include post office savings bank deposits. The majority of people in rural and
urban India have preference for post office deposits from the safety viewpoint than bank deposits.
(C) M3
The third measure of money supply in India is M3, which consists of M1, plus time deposits with
commercial and cooperative banks, excluding interbank time deposits. The RBI calls M3 as broad money.
(D) M4
The fourth measure of money supply is M4 which consists of M3 plus total post office deposits
comprising time deposits and demand deposits as well. This is the broadest measure of money supply.

5. What is high-powered money? [2013]**********
High Powered Money:
High powered money or powerful money refers to that currency that has been issued by the
Government and Reserve Bank of India. Some portion of this currency is kept along with the public while
rest is kept as funds in Reserve Bank.
Thus, we get the equation as:
H=C+R
Where H = High Powered Money
C = Currency with the public (Paper money + coins)
R = Government and bank deposits with RBI
High powered money is also known as secured money (RM) because banks keep with them Reserve
Fund(R) and on the bases of this Demand deposits (DD) are created. Since the bases of creation of credit
is Reserve Fund (R) and R is obtained as a part of high powered money (H) Security fund so high
powered money is termed as Base money.
Components of High Powered Money:
The following are the important components which determine high power money:
1. Currency with the public
2. Other Deposits with RBI
3. Cash with Banks
4. Banker’s Deposits with RBI.
High powered Money (H) includes currency with Public (C), important reserves of Commercial banks and
other reserve (ER).
6. What are the Sources of High Powered Money:

Sources of High Powered Money:
The following are the sources of High Powered Money:
(1) Claims of Reserve Bank of India:
Reserve Bank also provides loans to the government. This loan is in the form of investment in
government securities by the Reserve Bank. After deducting the deposits of government from quantity
of loan of Reserve Bank quantity of net bank credit to government is calculated. It is also a source of
High Powered Money.
(2) Net Foreign Exchange Assets of Reserve Bank:
It is the work of Reserve Bank to make arrangement for foreign exchange funds. When, Reserve Bank
purchases foreign securities by paying the money of the country, then the quantity of foreign exchange
increases which increases high powered money. On the contrary, when Reserve Bank sells foreign
securities, then the quantity of foreign exchange with the central bank of the country decreases. It
results decrease in high powered money.
(3) Government’s Currency Liabilities to the Public:
Finance Ministry of the Indian Government is responsible for printing one rupee note and also for
coinage. This function is done through the government for completing money related responsibilities
towards the public. Thus with the increase in these liabilities, quantity of supply of money will increase
and the quantity of High Powered money will also increase.
(4) Net Non-Monetary Liabilities of Reserve Bank:

The non-monetary liability of Reserve Bank is in the form of capital introduced in national fund and
statutory fund. Its main items are-Paid-up Capital, Reserve Fund, Provided Fund and pension fund of the
employees of Reserve Bank of India.

Non-monetary liabilities of Reserve Bank are inversely proportional to high Powered Money i.e. with the
increase in non-monetary liabilities, there will be a decrease in the quantity of new high powered
money.
Thus, H = 1 + 2 + 3 – 4
7. Importance of High Powered Money:

Importance of High Powered Money:
The following are the importance of High Powered Money:
(1) Base Money:
Deposit of Public in a bank and expansion of credit is the base of supply of money. That is why some
economists considered it as base money.
(2) Source of Changes:
The direction in which change in the high power money takes place is powered to the direction of
change in the supply of money. Thus from this point of view High Powered Money is also important.
(3) Money Multiplier:
What will be money multiplier (M) is declared in economy on the bases of High Powered Money because
supply of money is far more than high power money.
(4) Monetary Control:
A Special attention is paid by the central bank of any country on High Powered Money at the time of
monetary control. Because, it is a big part of total supply of money in a country.
8. Discuss briefly the concept of money multiplier [2014]********

Money Multiplier
The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in the total
money supply.
For example, if the commercial banks gain deposits of ₹ 1 million and this leads to a final money supply
of ₹ 10 million. The money multiplier is 10.
The money multiplier is a key element of the fractional banking system.
(a) There is an initial increase in bank deposits (monetary base)
(b) The bank holds a fraction of this deposit in reserves and then lends out the rest.
(c) This bank loan will, in turn, be re-deposited in banks allowing a further increase in bank lending
and a further increase in the money supply.
The Reserve Ratio
The reserve ratio is the % of deposits that banks keep in liquid reserves.
For example 10% or 20%
Formula for money multiplier
In theory, we can predict the size of the money multiplier by knowing the reserve ratio.
 If you had a reserve ratio of 5 %. You would expect a money multiplier of 1/0.05 = 20
 This is because if you have deposits of a ₹ 1 million and a reserve ratio of 5 %. You can
effectively lend out ₹ 20 million

10. Explain briefly the theory of demand-pull inflation [2015]. Explain the causes of a
demand-pull inflation. [2017]************
What is Demand-Pull Inflation ?
Demand-pull inflation is used by Keynesian economics to describe what happens when price levels rise
because of an imbalance in the aggregate supply and demand. When the aggregate demand in an
economy strongly outweighs the aggregate supply, prices go up. Economists describe demand-pull
inflation as a result of too many dollars chasing too few goods.
Demand-pull inflation results from strong consumer demand. Many individuals purchasing the same
good will cause the price to increase, and when such an event happens to a whole economy for all types
of goods, it is called demand-pull inflation.
Demand-Pull Inflation in Contrast With Cost-Push Inflation
Cost-push inflation is when price and wage go up and are transferred from one sector of the economy to
another. Though they move in practically the same manner, they work on a different aspect of the
whole inflationary system. Demand-pull inflation shows how price rise starts, while cost-push inflation
portrays why inflation is difficult to stop once it begins.
The main idea behind demand-pull inflation is that consumer demand that outweighs aggregate supply
greatly drives inflation. In a market where there are a particular number of goods and a huge demand
for those goods, the prices of those goods have to rise.
Example of Demand-Pull Inflation
When oil refineries work at full capacity, they cause demand-pull inflation. Environmental concerns
cause regulatory problems for refineries. Because of prohibitive factors by the government, supply
created by oil refineries is also limited. Rather than a lack of oil or the lack of companies to produce oil,
restrictive legislation prevents the market from providing optimum efficiency in producing goods with
high demand. The oil industry, then, is one of the biggest contributors of demand-supply inflation.
Causes of Demand-Pull Inflation
There are five causes for demand-pull inflation:
(a) A growing economy: When consumers feel confident, they will spend more, take on more debt
by borrowing more. This leads to a steady increase in demand, which means higher prices.
(b) Asset inflation: a sudden rise in exports, which translates to an undervaluation of the involved
currencies
(c) Government spending: When the government opens up its pocketbooks, it drives up prices.
Military spending prices may go up when the government starts to buy more military
equipment.
(d) Inflation expectations: forecasts and expectations of inflation, where companies increase their
prices to go with the flow of the expected rise
(e) More money in the system: demand-pull inflation is produced by an excess in monetary growth
or an expansion of the money supply. Too much money in an economic system with too few
goods makes prices increase.

12. What is cost – push inflation? Explain the causes of cost – push inflation.
[2016]*******
Definition:
Cost push inflation is inflation caused by an increase in prices of inputs like labour, raw material, etc. The
increased price of the factors of production leads to a decreased supply of these goods. While the
demand remains constant, the prices of commodities increase causing a rise in the overall price level.
This is in essence cost push inflation.
Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of wages
and raw materials. Higher costs of production can decrease the aggregate supply (the amount of total
production) in the economy. Since the demand for goods hasn't changed, the price increases from
production are passed onto consumers creating cost-push inflation.
Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher
costs of raw materials. Cost-push inflation is determined by supply-side factors (cost-push inflation is
different to demand-pull inflation which occurs due to aggregate demand growing faster than aggregate
supply)
Cost-Push vs. Demand-Pull
Rising prices caused by consumers is called demand-pull inflation. Demand-pull inflation includes times
when an increase in demand is so great that production can't keep up, which typically results in higher
prices. In short, cost-push inflation is driven by supply costs while demand-pull inflation is driven by
consumer demand—while both lead to higher prices passed onto consumers.
Causes of Cost-Push Inflation
(a) Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices and
higher transport costs. All firms would see some rise in costs. As the most important commodity,
higher oil prices often lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
(b) Imported Inflation. A devaluation will increase the domestic price of imports. Therefore, after a
devaluation, we often get an increase in inflation due to rising cost of imports.
(c) Higher Wages. Wages are one of the main costs facing firms. Rising wages will push up prices as
firms have to pay higher costs (higher wages may also cause rising demand)
(d) Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price increase
will be a temporary increase.
(e) Profit-push inflation. If firms gain increased monopoly power, they are in a position to push up
prices to make more profit
(f) Higher Food Prices. In western economies, food is a smaller % of overall spending, but in
developing countries, it plays a bigger role. (food inflation)
(g) Depreciation in the exchange: Imported inflation could occur after a depreciation in the exchange
rate which increases the price of imported goods.
(h) Rise in oil prices or other raw materials: Cost-push inflation could be caused by a rise in oil prices
or other raw materials.

13. Differentiate Demand Pull Inflation & Cost-push Inflation [2012, 2014]************
From theoretical point of view differences between demand-pull inflation and cost-push inflation are
stated below –
DEMAND-PULL INFLATION DEMAND-PUSH INFLATION
(a) Considering aggregate supply of the (a) Increasing tendency in general price level due
commodities in the economy unchanged, to increase in cost of production (especially
Increase in aggregate demand in the economy wage cost) of the firms as a whole results in
creates excess demand that leads to a rising cost-push inflation.
price tendency generally called demand-pull
inflation.
(b) In case of demand-pull inflation producers are (b) But due to increase in cost of production,
encouraged to increase their production. In producers are highly discouraged to conduct
such a situation demand for the factors are their production process as usually due to low
increased which leads to increase in factor profitability. It leads to a reduction in total
prices. production and hence total supply of
commodities also reduced.
(c) Under demand-pull inflation existence of full (c) But in case of cost-push inflation existence of
employment of resources is an important full employment is not an important condition.
criterion.
(d) Under demand-pull inflation, it is assumed that (d) On the other hand, under cost-push inflation
cost of production remained unchanged. aggregate demand for the commodities in the
economy assumed to be fixed.
(e) Diagrammatically demand-pull inflation can be (e) On the other hand, cost-push inflation can be
explained with the help of rightward shift in the explained with the help of leftward shift in
aggregate demand curve keeping aggregate aggregate supply curve with unchanged
supply curve unchanged. aggregate demand schedule.
(f) Under demand-pull inflation excess demand for (f) On the other hand, in case of cost-push
commodities pulls up the price level from inflation higher cost of production pushes the
above. Due to this it is termed as demand-pull general price level up. Due to this such an
inflation. inflationary situation is termed as the cost-push
inflation.
(g) Demand-pull inflation may lead to galloping (g) On the other hand, cost-push inflation may lead
inflationary situation if not checked at the to economic stagflation in the economy if not
initial stage. properly controlled.
(h) In case of demand-pull inflation both fiscal and (h) But, in case of cost-push inflation neither fiscal
monetary measures are effective to check nor monetary measures but the other measures
inflationary pressure. are effective to check inflationary pressure.

18. Analyze the role of fiscal and monetary policies in controlling inflations.
[2013]*************
Inflation is considered to be a complex situation for an economy. If inflation goes beyond a moderate rate,
it can create disastrous situations for an economy; therefore is should be under control. It is not easy to
control inflation by using a particular measure or instrument. The main aim of every measure is to reduce
the inflow of cash in the economy or reduce the liquidity in the market.
The different measures used for controlling inflation are explained below.
1. Monetary Measures:
The government of a country takes several measures and formulates policies to control economic
activities. Monetary policy is one of the most commonly used measures taken by the government to
control inflation.
In monetary policy, the central bank increases rate of interest on borrowings for commercial banks. As a
result, commercial banks increase their rate of interests on credit for the public. In such a situation,
individuals prefer to save money instead of investing in new ventures.
This would reduce money supply in the market, which, in turn, controls inflation. Apart from this, the
central bank reduces the credit creation capacity of commercial banks to control inflation.
The monetary policy of a country involves the following:
(a) Rise in Bank Rate: It Refers to one of the most widely used measure taken by the central bank to
control inflation. The bank rate is the rate at which the commercial bank gets a rediscount on
loans and advances by the central bank. The increase in the bank rate results in the rise of rate of
interest on loans for the public. This leads to the reduction in total spending of individuals.
The main reasons for reduction in total expenditure of individuals are as follows;
(i) Making the borrowing of money costlier:
(ii) Creating adverse situations for businesses:
(iii) Increasing the propensity to save:
(b) Direct Control on Credit Creation: Constitutes the major part of monetary policy. The central
bank directly reduces the credit control capacity of commercial banks by using the following
methods:
 Performing Open Market Operations (OMO): Refers to one of the important method
used by the central bank to reduce the credit creation capacity of commercial banks. The
central bank issues government securities to commercial banks and certain private
businesses. In this way, the cash with commercial banks would be spent on purchasing
government securities. As a result, commercial bank would reduce credit supply for the
general public.
 Changing Reserve Ratios: Involves increase or decrease in reserve ratios by the central
bank to reduce the credit creation capacity of commercial banks. For example, when the
central bank needs to reduce the credit creation capacity of commercial banks, it increases
Cash Reserve Ratio (CRR). As a result, commercial banks need to keep a large amount of
cash as reserve from their total deposits with the central bank. This would further reduce
the lending capacity of commercial banks. Consequently, the investment by individuals in
an economy would also reduce

2. Fiscal Measures:
Apart from monetary policy, the government also uses fiscal measures to control inflation. The two main
components of fiscal policy are government revenue and government expenditure. In fiscal policy, the
government controls inflation either by reducing private spending or by decreasing government
expenditure, or by using both.
It reduces private spending by increasing taxes on private businesses. When private spending is more, the
government reduces its expenditure to control inflation. However, in present scenario, reducing
government expenditure is not possible because there may be certain on-going projects for social welfare
that cannot be postponed.
Besides this, the government expenditures are essential for other areas, such as defence, health, education,
and law and order. In such a case, reducing private spending is more preferable rather than decreasing
government expenditure. When the government reduces private spending by increasing taxes, individuals
decrease their total expenditure.
For example, if direct taxes on profits increase, the total disposable income would reduce. As a result, the
total spending of individuals decreases, which, in turn, reduces money supply in the market. Therefore, at
the time of inflation, the government reduces its expenditure and increases taxes for dropping private
spending.

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6. Distinguish between concepts of ‘stock’ and ‘flow’.********

8. What is capital good? Can any final good be capital good?**

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Unit – 2: National Income [6 Marks]

In the upper part of this diagram

Three Sector Economy:

8. What do you mean by Real GDP & Nominal GDP?

9. What do you mean by implicit deflator?

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Unit – 3: Determination of Equilibrium Level [Marks:10]

5. Discuss briefly the simple Keynesian model of income

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6. What is Keynesian consumption function? What are its

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8. How does the Keynesian consumption function determine

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9. Explain the Keynesian theory of investment multiplier. What

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Unit – 4 [10 Marks]:

4. Discuss Liquidity Preference theory of demand for money.

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6. What are the Sources of High Powered Money:

(4) Net Non-Monetary Liabilities of Reserve Bank:

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7. Importance of High Powered Money:

8. Discuss briefly the concept of money multiplier [2014]********

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