SOLVED PREVIOUS QUESTION PAPERS: APRIL 2018

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Q1. (a)
Managerial economics has been generally defined as the study of economic theories, logic and tools
of economic analysis, used in the process of business decision making. It involves the understanding and
use of economic theories and techniques of economic analysis in analyzing and solving business problems.
Economic principles contribute significantly towards the performance of managerial duties as well as
responsibilities. Managers with some working knowledge of economics can perform their functions more
effectively and efficiently than those without such knowledge. Taking appropriate business decisions
requires a good understanding of the technical and environmental conditions under which business
decisions are taken. Application of economic theories and logic to explain and analyse these technical
conditions and business environment can contribute significantly to the rational decision-making process.
According to McNair and Meriam, "Managerial Economics consists of the use of economic modes of thought to
analyse business situation."
Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by management."
SCOPE OF MANAGERIAL ECONOMICS
Managerial economics comprises both micro- and macro-economic theories. Generally, the scope
of managerial economics extends to those economic concepts, theories, and tools of analysis used in
analysing the business environment, and to find solutions to practical business problems. In broad terms,
managerial economics is applied economics. The areas of business issues to which economic theories can
be directly applied are divided into two broad categories: 1. Operational or internal issues; and, 2.
Environment or external issues.
Operational problems are of internal nature. These problems include all those problems which
arise within the business organization and fall within the control of management. Some of the basic
internal issues include: choice of business and the nature of product (what to produce); choice of size of the
firm (how much to produce); choice of technology (choosing the factor combination); choice of price
(product pricing); how to promote sales; how to face price competition; how to decide on new investments;
how to manage profit and capital; and, how to manage inventory.
The microeconomic theories dealing with most of these internal issues include, among others:
 The theory of demand, which explains the consumer behaviour in terms of decisions on whether or
not to buy a commodity and the quantity to be purchased.
 Theory of Production and production decisions. The theory of production or theory of the firm
explains the relationship between inputs and output.
 Analysis of Market structure and Pricing theory. Price theory explains how prices are determined
under different market conditions.
 Profit analysis and profit management. Profit making is the most common business objective.
However, making a satisfactory profit is not always guaranteed due to business uncertainties. Profit
theory guides firms in the measurement and management of profits, in making allowances for the
risk premium, in calculating the pure return on capital and pure profit, and for future profit
planning.
 Theory of capital and investment decisions. Capital is the foundation of any business. It efficient
allocation and management is one of the most important tasks of the managers, as well as the
determinant of the firm’s success level. Some of the important issues related to capital include:
choice of investment project; assessing the efficiency of capital; and, the most efficient allocation of
capital.
ENVIRONMENTAL ISSUES are issues related to the general business environment. These are issues
related to the overall economic, social, and political atmosphere of the country in which the business is
situated. The factors constituting economic environment of a country include:
1. The existing economic system

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 2. General trends in production, income, employment, prices, savings and investment
3. Structure of the financial institutions.
4. Magnitude of and trends in foreign trade.
5. Trends in labour and capital markets.
6. Governments economic policies.
7. Social organizations, such as trade unions, consumers’ cooperatives, and producer unions. 8.
The political environment.
9. The degree of openness of the economy.
Managerial economics is particularly concerned with those economic factors that form the business
climate. In macroeconomic terms, managerial economics focus on business cycles, economic growth, and
content and logic of some relevant government activities and policies which form the business
environment.
IMPORTANCE OF MANAGERIAL ECONOMICS
In a nutshell, three major contributions of economic theory to business economics have been
enumerated:
1. Building of analytical models that help to recognize the structure of managerial problems, eliminate the
minor details that can obstruct decision making, and help to concentrate on the main problem area.
2. Making available a set of analytical methods for business analyses thereby, enhancing the analytical
capabilities of the business analyst.
3. Clarification of the various concepts used in business analysis, enabling the managers avoids conceptual
pitfalls.

Q1 (b)
Firm:- Firm is a business organisation that buys or hires factors of production in order to produce
goods and services that can be sold at a profit. We can define a firm (company, enterprise) as an
organization that employs productive resources to obtain products and/or services which are offered in the
market with the aim of making a profit. A few keywords in this definition deserve further attention. First,
firms are organizations, but not all organizations are firms. An organization is a complex social system
created by people to cooperate in the achievement of some goal. For instance, a political party is an
organization, but its goal is to contribute to positively transform society by means of collectively exerting
political power. What distinguishes firms from other organizations is the aim of obtaining a profit through
selling products and services in the market.
Second, firms fulfill the social role of production, transforming resources into finished goods and
services. Typically, firms use four different basic types of resources in productive activities:
Natural resources: taken directly from nature without previous transformation (land, air, water, wood,
etc.).
Capital: funds needed to invest in tools, machinery, equipment, technology.
Human resources: physical and intellectual capabilities of the workers.
Entrepreneurship: the innovative ideas that shape the business model.
Third, resources are combined and transformed into final products or services which are, in turn,
commercialized in markets to customers who are willing to pay for them. If the firm produces something
that customers like, it will certainly be able to set prices that can cover production costs and more. If not,
covering costs will be difficult and firm survival will be threatened.
The difference between the revenue raised from selling goods and services and the costs incurred in
delivering them is the firms’ profit. If it is positive, it means that the production of the firm is more valuable
than the resources employed. In that case, the firm is adding value to those resources. Alternatively, if
profit is negative (i.e., a loss) then the firm would be destroying value, since the resources are worth more
than the products and services obtained from them.
Value creation is a continuous process in which a large number of interrelated firms take part. We can

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imagine the vertical chain of an industry as the sequence of stages that must be accomplished from raw
materials to product delivery to end customers
OBJECTIVE OF FIRM:-
The standard economic assumption underlying the analysis of firms is profit maximization. Firms are
assumed to make decisions that will increase profit. Generally speaking, profit maximization is the process
of obtaining the highest possible level of economic profit through the production and sales of goods and
services. The main objectives of firms are:
1. Profit maximization
2. Sales maximization
3. Increased market share/market dominance
4. Social/environmental concerns
5. Profit satisficing
6. Co-operatives/
Sometimes there is an overlap of objectives. For example, seeking to increase market share, may lead to
lower profits in the short-term, but enable profit maximisation in the long run.
Profit maximization : Usually, in economics, we assume firms are concerned with maximising profit.
Higher profit means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers
Alternative aims of firms: However, in the real world, firms may pursue other objectives apart from profit
maximisation.
1. Profit Satisficing
 In many firms, there is a separation of ownership and control. Those who own the company
(shareholders) often do not get involved in the day to day running of the company.
 This is a problem because although the owners may want to maximise profits, the managers have
much less incentive to maximise profits because they do not get the same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the shareholders happy, but then
maximise other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking
them) This is the problem of separation between owners and managers.
 This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers share options
and performance related pay although in some industries it is difficult to measure performance.
2. Sales maximization
Firms often seek to increase their market share – even if it means less profit. This could occur for various
reasons:
 Increased market share increases monopoly power and may enable the firm to put up prices and
make more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of supermarkets have lead
to the demise of many local shops. Some firms may actually engage in predatory pricing which
involves making a loss to force a rival out of business.
3. Growth maximisation : This is similar to sales maximisation and may involve mergers and takeovers.
With this objective, the firm may be willing to make lower levels of profit in order to increase in size and
gain more market share. More market share increases their monopoly power and ability to be a price setter.
4. Long run profit maximization : In some cases, firms may sacrifice profits in the short term to increase
profits in the long run. For example, by investing heavily in new capacity, firms may make a loss in the
short run but enable higher profits in the future.
5. Social/environmental concerns : A firm may incur extra expense to choose products which don’t harm
the environment or products not tested on animals. Alternatively, firms may be concerned about local
community / charitable concerns.
 Some firms may adopt social/environmental concerns as part of its branding. This can ultimately
help profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it does little to
improve sales/brand image.

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6. Co-operatives: Co-operatives may have completely different objectives to a typical PLC. A co-operative
is run to maximise the welfare of all stakeholders – especially workers. Any profit the co-operative makes
will be shared amongst all members.

Diagram showing different objectives of firms

Q1 = Profit maximisation (MR=MC)

Q2 = Revenue Maximisation (MR=0)

Q3 = Marginal cost pricing (P=MC) – allocative

efficiency

Q4 = Sales maximisation – maximum sales

while still making normal profit (AR=ATC)

Q2. (a)
Market structure refers to the nature and degree of competition in the market for goods and services. The
structures of market both for goods market and service (factor) market are determined by the nature of
competition prevailing in a particular market. Ordinarily, the term “market” refers to a particular place
where goods are purchased and sold. But, in economics, market is used in a wide perspective.
According to Prof. R. Chapman, “The term market refers not necessarily to a place but always to a
commodity and the buyers and sellers who are in direct competition with one another.”
In Economics however, the term “Market” does not refer to a particular place as such but it refers to a
market for a commodity or commodities. It refers to an arrangement whereby buyers and sellers come in
close contact with each other directly or indirectly to sell and buy goods.
Further, it follows that for the existence of a market, buyers and sellers need not personally meet each other
at a particular place. They may contact each other by any means such as a telephone or telex. Thus, the
term “Market” is used in economics in a typical and specialised sense. It does not refer only to a fixed
location.
It refers to the whole area of operation of demand and supply. Further, it refers to the conditions and
commercial relationships facilitating transactions between buyers and sellers. Therefore, a market signifies
any arrangement in which the sale and purchase of goods take place.
Market can be classified on different basis: There are different types of markets on the basis of
geographical area, time, business volume, nature of products, consumption, competition, seller's situation,
nature of transaction etc. as follows:
A) Market according to Area
Based on the extent of the market for any product, markets can be classified into local regional, national
and international markets.
 Local Market: A local market for a product exists when buyers and sellers of commodity carry on
business in a particular locality or village or area where the demand and supply conditions are
influenced by local conditions only. E.g. Perishable goods like milk and vegetables and bulky
articles like bricks and stones.
 National Market: When commodities are demanded and supplied throughout the country, there is
national market e.g. wheat, rice or cotton
 Regional Market: Commodities that are demanded and supplied over a region have regional market.

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  Global Market: When demand and supply conditions are influenced at the global level, we have
international market. e.g. gold, silver, cell phone etc.
On the basis of demand and supply, this geographical classification is made. With improved transport
facilities and communications, even goods of local markets can become international goods.
B) Market according to time: Marshall classified market based on the time element. In economics 'time'
does not mean clock time. It means only the division of time based on extent of adjustability of supply of a
commodity for a given change in its demand. The major divisions are very short period, short period and
long period.
 Very Short Period: Very short period refers to the type of competitive market in which the supply of
commodities cannot be changed at all. So in a very short period, the market supply is perfectly
inelastic. The price of the commodity depends on the demand for the product alone. The perishable
commodities like flowers are the best example.
 Short-period: Short period refers to that period in which supply can be adjusted to a limited extent
by varying the variable factors alone. The short period supply curve is relatively elastic. The short
period price is determined by the interaction of the short-run supply and demand curves.
 Long Period: Long period is the time period during which the supply conditions are fully able to
meet the new demand conditions. In the long run, all (both fixed as well as variable) factors are
variable. Thus the supply curve in the long run is perfectly elastic. Therefore, it is the demand that
influences price in the long period.
ESSENTIAL CHARACTERISTICS OF A MARKET ARE AS FOLLOWS:
1. One commodity: In practical life, a market is understood as a place where commodities are
bought and sold at retail or wholesale price, but in economics “Market” does not refer to a particular
place as such but it refers to a market for a commodity or commodities i.e., a wheat market, a tea
market or a gold market and so on.
2. Area: In economics, market does not refer only to a fixed location. It refers to the whole area or
region of operation of demand and supply
3. Buyers and Sellers: To create a market for a commodity what we need is only a group of potential
sellers and potential buyers. They must be present in the market of course at different places.
4. Perfect Competition: In the market there must be the existence of perfect competition between
buyers and sellers. But the opinion of modern economist is that in the market the situation of
imperfect competition also exists, therefore, the existence of both is found.
5. Business relationship between Buyers and Sellers: For a market, there must exist perfect business
relationship between buyers and sellers. They may not be physically present in the market, but the
business relationship must be carried on.
6. Perfect Knowledge of the Market: Buyers and sellers must have perfect knowledge of the market
regarding the demand of the customers, regarding their habits, tastes, fashions etc.
7. One Price: One and only one price be in existence in the market which is possible only through
perfect competition and not otherwise.
8. Sound Monetary System: Sound monetary system should be prevalent in the market, it means
money exchange system, if possible, be prevalent in the market.
9. Presence of Speculators: Presence of seculars is essential just to supply business information’s and
prices prevalent in the market.

MARKET ACCORDING TO COMPETITION

These markets are classified according to the number of sellers in the market and the nature of the
commodity. On the basis of competition, market can be classified into monopoly market, perfect market
and imperfect market.
i. Monopoly Market: If there is full control of producer over market, then such market is called

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 monopoly market. In such market, the producer determines price of his products in his own will. In
such market, only one producer or seller controls market. In practice, the producer or seller can
supply products or achieve monopoly on price only in small or limited area, but in wide area it
becomes impossible.
ii. Perfect Market: The market where the number of buyers and sellers is large, homogeneous of
products are bought and sold, same price of similar type products is determined from free
interaction between demand and supply is called perfect market. Perfect competition takes between
consumers and producers or buyers and sellers, but in practice perfect market can be rarely found.
iii. Imperfect Market: The market where there is no perfect competition between buyers and seller
is called imperfect market. In this type of market, customers are affected by product discrimination.
Post-sale services, packaging, price, nearness of market, credit facility, discount etc make product
discrimination. Customers can buy same types of products from different sellers according to their
desires and comfort. In practice, mostly products are bought and sold in imperfect market.

Q 2. (b)
According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process of
finding values for demand in future time periods.”
In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a specified
future period based on proposed marketing plan and a set of particular uncontrollable and competitive
forces.”
Demand forecasting enables an organization to take various business decisions, such as planning
the production process, purchasing raw materials, managing funds, and deciding the price of the product.
An organization can forecast demand by making own estimates called guess estimate or taking the help of
specialized consultants or market research agencies.
SIGNIFICANCE of Demand Forecasting: Demand plays a crucial role in the management of every

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business. It helps an organization to reduce risks involved in business activities and make important
business decisions. Apart from this, demand forecasting provides an insight into the organization’s capital
investment and expansion decisions.
i. Fulfilling objectives: Implies that every business unit starts with certain pre-decided objectives.
Demand forecasting helps in fulfilling these objectives. An organization estimates the current
demand for its products and services in the market and move forward to achieve the set goals.
ii. Preparing the budget: Plays a crucial role in making budget by estimating costs and expected
revenues.
iii. Stabilizing employment and production: Helps an organization to control its production and
recruitment activities. Producing according to the forecasted demand of products helps in avoiding
the wastage of the resources of an organization. This further helps an organization to hire human
resource according to requirement. For example, if an organization expects a rise in the demand for
its products, it may opt for extra labor to fulfill the increased demand.
iv. Expanding organizations: Implies that demand forecasting helps in deciding about the
expansion of the business of the organization. If the expected demand for products is higher, then
the organization may plan to expand further. On the other hand, if the demand for products is
expected to fall, the organization may cut down the investment in the business.
v. Taking Management Decisions: Helps in making critical decisions, such as deciding the plant
capacity, determining the requirement of raw material, and ensuring the availability of labor and
capital.
vi. Evaluating Performance: Helps in making corrections. For example, if the demand for an
organization’s products is less, it may take corrective actions and improve the level of demand by
enhancing the quality of its products or spending more on advertisements.
vii. Helping Government: Enables the government to coordinate import and export activities and
plan international trade.

LIMITATIONS of Demand Forecasting:

Demand forecasting is not a perfect science and we can rarely predict future needs with 100%
accuracy. The reasons for this are that past patterns don’t always continue into the future, past pattern are
not understood correctly and that random fluctuations in demand and the market prevent patterns from
being recognized. Therefore, it is usual to accept a margin of error, such as plus or minus 10% in your
forecasting.

METHODS of demand forecasting

(A)Survey Methods :- Survey methods are generally used where purpose ultimate short run
forecast of demand. Under these methods servings are conducted to correct information about consumer
intentions and their future purchase planes further survey and end use method.
In complete enumeration methods these are some limitations- It can be successfully used in case of
their products whose consumers are concentrated in certain region or locality (ii) This method can't be used
in wide spread markets sample. survey method has also disadvantages such (i) sometime, reliability of data
is missing. (ii) It can be of greater use in forecasting where quantifications of variables is not possible and
behaviour is subject to change.
In opinion polls methods, there are three methods more
(a) Expert opinion methods :- Expert opinion method is simple and inexpensive but has some
limitations (i) estimates provided by sales representatives are reliable only to extent of cheers skill to
analyze the market (ii) Demand estimates may more the subjective judgment of the assessor which may
lead to over or under estimation (iii) The assessment of market demand based on inadequate information
available to sales representations.
(b) Delphos method :- This technique is an extension of simple expert opinion pole method there
experts may revise estimates of forecast of other experts along with other assumptions. Here, the
unconstructed opinions of the experts may conceal the fact that information used by experts in expressing
their forecasts may be based on sophisticated techniques.

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 (c) Market Studies and Experiments :- Here, firms select some areas of the representative markets
having similar features population income levels etc. Then market experiments are carriedout. But this
method had few disadvantages (i) Experimental methods are very expensive and cannot be carried by small
firms (ii) These methods are based on short term and controlled conditions markets and results may not be
applicable (iii) Tinkering with price increases may cause a permanent loss of customers to competitive
brands that might have been tried.
(B) Statistical Methods :- Statistical methods are considered to be superior techniques of
estimation of demand due to reasons as (i) method of estimation is scientific (ii) estimates are relatively
reliable (iii) the element of subjectivity is minimum (iv) estimation involves smaller costs statistical methods
of demand projection include the following techniques
Trend Projection methods: It is classical method of forecasting which is concerned with the study
of movements of variables through time or cause and effect relationship is not revealed by this method, the
projections made on trend basis are considered by many as mechanical approach
Trend method can be projected by three techniques based on time series data- Graphical method,
lease square method and box tanking method. Exponential trend is technique used in Graphical method. It
is represented as Y = a + bT + cT2

Q3. (a)
Cost volume profit analysis is a powerful tool for planning and decision making. Cost-Volume-
Profit Analysis (CVP), in managerial economics is a form of cost accounting. It is a simplified model,
useful for elementary instruction and for short-run decisions.
Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis.
A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable
costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an
initial examination that precedes more detailed CVP analysis.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The
assumptions underlying CVP analysis are: The behavior of both costs and revenues is linear throughout the
relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased
materials or sales.) Costs can be classified accurately as either fixed or variable. Changes in activity are the
only factors that affect costs. All units produced are sold (there is no ending finished goods inventory).
When a company sells more than one type of product, the sales mix (the ratio of each product to total sales)
will remain constant.
The components of Cost-Volume-Profit Analysis are:
 Level or volume of activity
 Unit Selling Prices
 Variable cost per unit
 Total fixed costs
 Profit
Managerial uses of CVP analysis to :
1. To determine the BEP(break even point)
2. To determine the targeted profit before tax and after tax
3. Engineering the CVP analysis
Technique of Cost-Volume-Profit Analysis:
The amount per unit is constant with output; under normal circumstances cost-volume-profit analysis
uses the technique of:
(i) Break-even analysis, and
(ii) Profit-Volume (P/V) analysis.
(i) Break-even analysis can be approached in
two ways:
1. Equation method: The equation method is
based on the contribution approach
income statement. The equation can be

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 stated in one of two ways: Profits equal Sales less Variable expenses, less Fixed Expenses, or Sales
equal Variable expenses plus Fixed expenses plus Profits. Remember that at the break-even point,
profits are equal to zero.

1. Contribution margin method: The Contribution Margin is the difference between selling
price and variable cost per unit. It measures the amount each unit sold contributes to
covering fixed cost (first) and increasing profit (once fixed costs are covered). The
contribution margin method has two key equations:
Break-even point in units sold equals Fixed expenses divided by CM (Contribution
margin )per unit, and Break-even point in sales rupee equals Fixed expenses divided by CM
(Contribution margin) ratio.

(ii) Profit-Volume (P/V) analysis:

A P/V graph is sometimes used in place of or along with a break-even chart. Profits and
losses are given on a vertical scale, and units of products, sales revenue or percentage of activity are
given on a horizontal line. The horizontal line is drawn on the graph to separate profits from losses.
The profits and losses at various
sales levels are plotted and connected by the
profit line. The break-even point is measured
at the point where the profit line intersects
the horizontal line. The PV graph may be
preferred to the break-even chart because
profit and losses at any point can be read
directly from the vertical scale, but the P/V
graph does not clearly show how costs vary
with activity.

Q3 (b)
The “no free lunch” mantra has a logical extension. Those who desire large rewards have to be
willing to expose themselves to considerable risk. The link between risk and return is most visible when
making investment choices; stocks are riskier than bonds, but generate higher returns over long periods.
Risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk
measures the uncertainty that an investor is willing to take to realize a gain from an investment. Risk is the
probability that an investment will not perform as expected and the investor will lose the money invested in
the project.
All business decisions and opportunities are based on this concept that future performance and
returns are uncertain and rely on many uncontrollable variables. This is the reason why the concept of risk
is tied so closely with the concept return. As risk increases, the required level of return also must increase in
order to sway the decision maker’s judgment. For example, a business owner wouldn’t make an invest that
has a high probability of losing all of his or her money without the chance of making a healthy return. The
reward is what entices people to make risky decisions, thus, the old saying—no risk, no reward.
Risks are of different types and originate from different situations. We have liquidity risk, sovereign
risk, insurance risk, business risk, default risk, etc. Various risks originate due to the uncertainty arising out
of various factors that influence an investment or a situation.

There are three kinds of methods used for determining the level of risk of our business. The methods can
be: Qualitative Methods – Quantitative Methods – Semi-quantitative Methods.

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(i) Qualitative Methods:
This is the kind of risk analysis method most often used for decision making in business projects;
entrepreneurs base themselves on their judgment, experience and intuition for decision making.
These methods can be used when the level of risk is low and does not warrant the time and resources
necessary for making a full analysis.
These methods are also used when the numerical data available are not adequate for a more quantitative
analysis that would serve as the basis for a subsequent and more detailed analysis of the entrepreneur’s
global risk.
The qualitative methods include:
 Brainstorming
 Questionnaire and structured interviews
 Evaluation for multidisciplinary groups
 Judgment of specialists and experts (Delphi Technique)
(ii)Semi-Quantitative Methods:
Word classifications are used, such as high, medium or low, or more detailed descriptions of likelihood
and consequences.
These classifications are shown in relation to an appropriate scale for calculating the level of risk. We need
to give careful attention to the scale used in order to avoid misunderstandings or misinterpretations of the
results of the calculation.

(iii)Quantitative Methods:
Quantitative methods are considered to be those that enable us to assign values of occurrence to the
various risks identified, that is, to calculate the level of risk of the project.
Los quantitative methods include:
 Analysis of likelihood
 Analysis of consequences
 Computer simulation
The development of these measurements can be effected by means of different mechanisms, among which
we note particularly the Monte Carlo Method, which is characterized by:
 A broad vision in order to show a range of possible scenarios
 Simplicity in putting it into practice
 Suitable for performing computer simulations

Q4 (a)
Reserve Bank of India (RBI) is the Central Bank of the country. Role of RBI differs from other
banks since it does not get engaged in day to day retail banking; does not do micro or macro regular
financing. On the contrary, it is the Bankers’ Bank and formulates monetary guidelines and policies which
are to be followed by all the banks operating in the country.
The Reserve Bank of India was established in 1935 with the provision of Reserve Bank of India
Act, 1934. Till 1949 RBI was privately owned and was nationalised in 1949. Since then RBI is fully owned
by the Government of India. It plays multi-facet role by executing multiple functions such as overseeing
monetary policy, issuing currency, managing foreign exchange, working as a bank of government and as
banker of scheduled commercial banks, among others. It also works for overall economic growth of the
country.

Role of RBI in Money Market:

 Firstly the central bank(RBI) could do this by setting a necessary reserve ratio, which would restrict
the ability of the commercial banks to increase the money supply by loaning out money. If this
condition were above the ratio the commercial banks would have wished to have then the banks
will have to create fewer deposits and make fewer loans then they could otherwise have profitably
done. If the central bank imposed this requirement in order to reduce the money supply, the
commercial banks will probably be unable to borrow from the central bank in order to increase their
cash reserves if they wished to make further loans. They might try to attract further deposits from
customers by raising their interest rates but the central bank may retaliate by increasing the

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 necessary reserve ratio.
 The central bank(RBI) can influence the supply of money through special deposits. These are
deposits at the central bank which the banking sector is required to lodge. These are then frozen,
thus preventing the sector from accessing them even though interest is paid at the average Treasury
bill rate. Making these special deposits reduces the level of the 'commercial banks' operational
deposits which forces them to cut back on lending.

 The supply of money can also be prohibited by the central bank(RBI) by adjusting its interest rate
which it charges when the commercial banks wish to borrow money (the discount rate). Banks
generally have a ratio of cash to deposits which they consider to be the minimum safe level. If
command for cash is such that their reserves fall below this level they will able to borrow money
from the central bank at its discount rate. If market rates were 8% and the discount rate were also
8%, then the banks might decrease their cash reserves to their minimum ratio knowing that if
demand exceeds supply they will be able to borrow at 8%. The central bank, even if, may raise its
discount rate to a value above the market level, in order to encourage banks not to reduce their cash
reserves to the minimum during excess loans. By raising the discount value to such a level, the
commercial banks are given an incentive to hold more reserves thus reducing the money multiplier
and the money supply.
 Another way the money supply can be affected by the central bank is through its operation of the
interest rate. By raising or lowering interest rates the demand for money is respectively reduced or
increased. If it sets them at a certain level it can clear the market at level by supplying sufficient
money to match the demand. Alternatively it could fix the money supply at a convinced rate and let
the market clear the interest rates at the balance. Trying to fix the money supply is not easy so
central banks regularly set the interest rate and provide the amount of money the market demands.
 The central bank(RBI) may also involve the money supply through operating on the open market.
This allows it to influence the money supply through the financial base. It may choose to either buy
or sell securities in the marketplace which will either inject or remove money respectively. Thus the
monetary base will be affected causing the money supply to modify.

Q4 (b)
Capital Market is one of the significant aspect of every financial market. Hence it is necessary to
study its correct meaning. Broadly speaking the capital market is a market for financial assets which have a
long or indefinite maturity. Unlike money market instruments the capital market instruments become
mature for the period above one year. It is an institutional arrangement to borrow and lend money for a
longer period of time. It consists of financial institutions like IDBI, ICICI, UTI, LIC, etc. These institutions
play the role of lenders in the capital market. Business units and corporate are the borrowers in the capital
market. Capital market involves various instruments which can be used for financial transactions.
Capital market provides long term debt and equity finance for the government and the corporate
sector. Capital market can be classified into primary and secondary markets. The primary market is a
market for new shares, where as in the secondary market the existing securities are traded. Capital market
institutions provide rupee loans, foreign exchange loans, consultancy services and underwriting.
H. T. Parikh states, ‘By capital market I mean the market for all financial instruments, short-term and long-
term as also commercial, industrial and government papers’.

Instruments in capital markets can be classified into three categories: Pure, Hybrid and Derivatives.

(1) Pure Instruments : Equity shares, preference shares, debentures and bonds which are issued with the
basic characteristics without mixing the features of other instruments are called pure instrument.

(2) Hybrid Instruments : Instruments which are created by combining the features of equity, preference,
bond are called as hybrid instruments.

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 Example: Hybrid instruments are:
- Convertible preference shares
- Non-convertible debentures with equity warrant
- Partly convertible debentures
- Secured premium notes
(3) Derivative Instrument : A derivative instrument is a financial instrument which derives its value
from the value of some other financial instrument or variable.
Example: Futures and Options belong to the categories of derivatives.

The Equity Capital refers to that portion of the organization’s capital, which is raised in exchange for the
share of ownership in the company. These shares are called the equity shares.
The equity shareholders are the owners of the company who have significant control over its management.
They enjoy the rewards and bear the risk of ownership. However, their liability is limited to the amount of
their capital contributions. The Equity Capital is also called as the share capital or equity financing.

Advantages of Equity Capital

It has several advantages:
 The firm has no obligation to redeem the equity shares since these have no maturity date.
 The equity capital act as a cushion for the lenders, as with more and more equity base, the
company can easily raise additional funds on favorable terms. Thus, it increases the
creditworthiness of the company.
 The firm is not bound to pay dividends, in case there is a cash deficit. The firm can skip the equity
dividends without any legal consequences.

Disadvantages of Equity Capital

There are several disadvantages of raising the finances through the issue of equity shares which are listed
below:
 With the more issue of equity shares, the ownership gets diluted along with the control over the
management of the company.
 The cost of equity capital is high since the equity shareholders expect a higher rate of return as
compared to other investors.
 The cost of issuing equity shares is usually costlier than the issue of other types of securities. Such
as underwriting commission, brokerage cost, etc. are high for the equity shares.
 The cost of equity is relatively more, since the dividends are paid out of profit after tax, but the
interest payments are tax-deductible.

MUTUAL FUNDS

The Mutual Funds are the professionally managed investment companies that pools the resources of
several investors who shares the common financial goal. The funds so collected is reinvested by the fund
manager into different types of securities ranging from shares to debentures to money market instruments
depending upon the objective as stated in the mutual fund scheme.
The mutual fund’s prime advantage is that it enables the investors to invest in the diversified asset portfolio
at a relatively lower cost. The fund manager attempts to structure the portfolio in such a way that it results
in the maximum yield for the investors.
The advantages and disadvantages of mutual funds depend on the type of scheme taken by the investors.
Hence, there are several mutual fund schemes, as listed below:
1. Balanced Funds
2. Equity-Diversified Funds
3. Equity Linked Savings Scheme
4. Sector Funds
5. Thematic Funds
6. Arbitrage Funds
7. Hedge Fund

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 8. Exchange Traded Funds

Advantages of Mutual Funds

 The investor is allowed to invest in the diversified portfolio in return for a mere management fee,
which he pays to the fund manager who buys the different types of securities Viz. Shares,
debentures and other money market instruments. Thus, the mutual funds allow the small investors
to invest their funds in the diversified portfolio at a relatively lower cost.
 The returns in the form of dividend or interest received from the investments can be further used to
purchase the additional shares in the mutual funds, thereby enabling the investors to grow their
investments.
 Mutual funds help in reducing the portfolio risk through diversification. Since the fund manager
invests in several securities of different companies or industries, an investor is protected against the
risk of a huge monetary loss due to the problem in any one security.
 The assets in the portfolio are liquid, which means the investor can anytime convert its securities
into cash by selling it to any other investor in the mutual fund.
 The inexperienced investors who do not know much about the securities and are looking for
maximizing their financial goals can invest in the mutual funds to get their resources managed
professionally.
 The investors can buy the mutual funds easily and with a minimum investment. These are traded
once in a day thereby eliminating the price fluctuations throughout the day and discouraging the
arbitrage opportunities that the day traders practice.

Disadvantages of Mutual Funds

 The cost associated with the mutual funds might be high as compared to the returns they produce.
This is because the investor has to pay the commission along with the price of the mutual fund to
the portfolio manager.
 The mutual fund returns like any other investments are uncertain and depends largely on the
expertise of the fund manager. Thus, the capital gains extensively rely on the skill sets of the fund
manager.
 Sometimes, the stock index outperforms the mutual funds and therefore, the investor must research
all the fund related facts before investing in the portfolio.
 The management fee that shall be charged depends on the type of fund purchased. In a case of the
riskier and aggressive funds, the management fee is considerably higher than the moderate risk
funds.
Thus, an individual selects the investment scheme with an objective to diversify their portfolio risk and
carefully study all the advantages and disadvantages associated with it in order to make an optimum
choice.

Q5 (a)
(i) Gross Domestic Product (GDP) : Gross Domestic Product (GDP) is the broadest quantitative measure
of a nation's total economic activity. More specifically, GDP represents the monetary value of all goods
and services produced within a nation's geographic borders over a specified period of time. GDP is the final
value of the goods and services produced within the geographic boundaries of a country during a specified
period of time, normally a year. GDP growth rate is an important indicator of the economic performance
of a country. In the words of Campbell: "Gross Domestic Product is defined as the total value of all final
goods and services produced in a country in one year". According to Shapiro: "GDP is defined as a flow
variable, measuring the quantity of final good and services produced" during a year".
Description: It can be measured by three methods, namely,
1. Output Method: This measures the monetary or market value of all the goods and services
produced within the borders of the country. In order to avoid a distorted measure of GDP due to
price level changes, GDP at constant prices o real GDP is computed. GDP (as per output method)

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 = Real GDP (GDP at constant prices) – Taxes + Subsidies.
2. Expenditure Method: This measures the total expenditure incurred by all entities on goods and
services within the domestic boundaries of a country. GDP (as per expenditure method) = C + I +
G + (X-IM) C: Consumption expenditure, I: Investment expenditure, G: Government spending
and (X-IM): Exports minus imports, that is, net exports.
3. Income Method: It measures the total income earned by the factors of production, that is, labour
and capital within the domestic boundaries of a country. GDP (as per income method) = GDP at
factor cost + Taxes – Subsidies.
In India, contributions to GDP are mainly divided into 3 broad sectors – agriculture and allied
services, industry and service sector. In India, GDP is measured as market prices and the base year for
computation is 2011-12. GDP at market prices = GDP at factor cost + Indirect Taxes – Subsidies
When GDP declines for two consecutive quarters or more, by definition the economy is in a
recession. Meanwhile, when GDP grows too quickly and fears of inflation arise, the Federal Reserve often
attempts to stimulate the economy by raising interest rates.

(II) PUBLIC PRIVATE PARTNERSHIP

Public Private Partnership means an arrangement between a government/statutory
entity/government owned entity on one side and a private sector entity on the other. It is often done for
the provision of public assets or public services, through investments being made and/or management
being undertaken by the private sector entity, for a specified period of time. There is well defined allocation
of risk between the private sector and the public entity. The private entity who is chosen on the basis of
open competitive bidding, receives performance linked payments that conform (or are benchmarked) to
specified and pre-determined performance standards, measurable by the public entity or its representative.

Characteristics of PPP
 The private sector is responsible for carrying out or operating the project and takes on a substantial
portion of the associated project risks
 During the operational life of the project the public sector’s role is to monitor the performance of the
private partner and enforce the terms of the contract
 The private sector’s costs may be recovered in whole or in part from charges related to the use of the
services provided by the project, and may be recovered through payments from the public sector
 Public sector payments are based on performance standards set out in the contract
 Often the private sector will contribute the majority of the project’s capital costs, although this is not
always the case

Advantages of PPP
 Access to private sector finance
 Efficiency advantages from using private sector skills and from transferring risk to the private sector
 Potentially increased transparency
 Enlargement of focus from only creating an asset to delivery of a service, including maintenance of the
infrastructure asset during its operating lifetime
 This broadened focus creates incentives to reduce the full life-cycle costs (ie, construction costs and
operating costs)

Types of PPP modes

The four major “families” of PPP modes are:
 Management contracts - Contractual arrangement for the management of a part or whole of

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 a public facility or service by the private sector. Capital investment is typically not the
primary focus in such arrangements.
 Lease contracts
 Concessions and
 Build-operate-transfer (BOT) and its variants.

Various Government incentives for PPPs

The Government has facilitated the PPP sector by offering:
 Viability Gap Funding (VGF) subsidy - Viability Gap Funding of upto 40% of the cost of the
project can be accessed in the form of a capital grant.
 India Infrastructure Project Development Fund (IIPDF) - Scheme supports the Central and the
State Governments and local bodies through financial support for project development activities (,
feasibility reports, project structuring etc) for PPP projects
 IIFCL - long-term debt for financing infrastructure projects that typically involve long gestation
periods since debt finance for such projects should be of a sufficient.
 Foreign Direct Investment (FDI) - upto 100% FDI in equity of SPVs in the PPP sector is allowed
on the automatic route for most sectors.

(iii) GROWTH RATE : An economic growth rate is a measure of economic growth from one period to
another in percentage terms. This measure does not adjust for inflation; it is expressed in nominal terms.
In practice, it is a measure of the rate of change that a nation's gross domestic product (GDP) goes
through from one year to another, but gross national product (GNP) can also be used if a nation's economy
depends heavily on foreign earnings.
The economic growth rate demonstrates the change in a nation’s, or larger economy's, income over
a specified period of time. Most commonly, this is examined on a quarterly basis, but economic growth
rates can be observed across larger spans of time, such as year over year (YOY) or decade over decade.

Analyzing Economic Growth Rates

The economic growth rate provides insight into the general direction and magnitude of growth for
the overall economy. While economic growth is most often assumed to refer to positive movement,
economic changes can be positive or negative. If an economy experiences two consecutive quarters with
falling growth rates, it can be said that the associated economy is falling into a recession. If the economy
begins to shrink, the percentage rate can be expressed as a negative to demonstrate the income lost over the
time period being examined.

Causes of Economic Growth

Economic growth can be spurred by a variety of factors or occurrences. Most commonly, increases
in aggregate demand encourage a corresponding increase in overall output that brings in a new source of
income. Technological advancements and new product developments can exert positive influences on
economic growth. Increases in demand or availability in foreign markets that result in higher exports can
also have positive influences. This can be due to the spread of previously unavailable products into a new
market or increases in the particular market are economic standing that raise the discretionary income of its
citizens. As demand rises, associated sales levels also rise. This influx of income causes an increase in the
economic growth rate.

(IV)DISPOSABLE PERSONAL INCOME:

Disposable personal income is the amount which is actually at the disposal of households to spend as they
like. It is the amount which is left with the households after paying personal taxes such as income tax,
property tax, national insurance contributions etc.
Formula for Disposable Personal Income:
Disposable personal income = Personal Income - Personal Taxes
DPI = PI - Personal Taxes
The concept of disposable personal income is very important for studying the consumption and saving

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behavior of the individuals. It is the amount which households can spend and save. Disposable Income =
Consumption + Saving DI = C + S

Q5 (b)
(i) REVENUE ACCOUNT: A revenue account is an account with a credit balance. It includes all the
revenue receipts also known as current receipts of the government. These receipts include tax revenues and
other revenues of the government.
Tax revenues include the revenue earned by the government authorities by levying direct and
indirect taxes and duties. Direct taxes include income tax, corporate tax and so on. Indirect taxes include
Excise duties, customs duties, and service tax.Other revenues include revenues from other sources of
investments like interest, dividends, profits from public sector units, fees, fines and so on.
Revenue expenditure includes expenses which are not used for the creation of assets or repayment
of liabilities. These basically include current expenses of the government. For example, paying salaries,
giving grants are instances of revenue expenditure. It can further be divided into plan and non-plan
expenditure. The current budget, however, has not used this classification.

(ii) CAPITAL ACCOUNT: A capital account is an account that includes the capital receipts and the
payments. It basically includes assets as well as liabilities of the government. Capital receipts comprise of
the loans or capital that are raised by governments by different means.
They can also raise money from the public, such loans are market loans. They could also borrow
from banks or other sources by means of Treasury Bills, also called T-Bills. Loans are also raised from
external sources like foreign governments or international institutions. Another way of raising capital is by
disinvestment in public sector units or other assets.

(iii)BUDGET DEFICIT : The Budget Deficit is the financial situation wherein the expenditures exceed
the revenues. The Budget Deficit generally relates to the government’s expenditure and not the business or
individual’s spending.
The government’s collective deficits are termed as “National Debt”. In the case of a budget deficit,
be it the Government or any business, it has to resort to the external borrowings in order to escape the
bankruptcy. The Investors or analyst study the budget deficit of the country or business to judge its
financial health.
There can be different types of budget deficits that can be classified on the basis of types of receipts
and expenditures taken into the consideration. These are: Revenue Deficit, Fiscal Deficit, Primary
Deficit, Monetized Deficit.
The major implications of a Government budget deficit are:
 Slower economic growth
 Increased tax revenue
 High unemployment rates
 High Government spending
 Investors expect high inflation rates due to which the real value of debt reduces and thus, the
investors expect higher interest rates for their future loans to the government.

(iv) CAPITAL DEFICIT: Two primary types of accounts are used in international finance. The current
account represents actual transactions, much like any other standard accounting ledger. The capital
account reflects the flow of money and assets in and out of the country. The capital account is somewhat
counter-intuitive, and a deficit in the capital account means that money is leaving the country. Money
leaving the country is not necessarily a bad thing as it can mean that the country is developing and
purchasing assets outside of the country. These assets can contribute positively to the net worth, despite the
use of the term deficit. A surplus in the capital account means that more money is flowing into the country
than out of the country. A surplus is great for job growth and immediate economic development. The flip

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side to a surplus is the interest and return that investors expect in the future.

(V) PLAN AND NON-PLAN EXPENDITURES

Government of India has now scrapped the plan and non-plan expenditures in budget exercise and their
place has been now taken by capital and revenue spending classifications. The classification of plan and
non-plan was a major exercise in India during planning era. Under this, all expenditures which were done
in the name of planning were called plan expenditures while all other expenditures were placed under non-
plan expenditures. Further, generally (not always), the plan expenditure produced some tangible assets
related to economic development. This was the reason that plan expenditures were also called
“development expenditures”.
This classification is not relevant now still for your examinations, kindly note that important non-plan
revenue expenditures included the following:
 Interest payments on the loans taken by Government of India
 Expenditure incurred on Defence Services (except Defence Equipment which is a capital
expenditure)
 Subsidies
 Grants to the states and UTs, including those from calamity fund
 Pensions, Social services such as healthcare, education, social security etc.
 Police
 Economic services by the government such as Agriculture, Industry, Power, Science & Technology
 Grants to foreign Governments
Non-Plan Capital Expenditure included the following:
 Defence Equipments and modernization
 Loans to Public sector companies
 Loans to states and union territories
One of the most important headings under the non plan revenue expenditures is “Interest payments on the
loans taken by Government of India”. The plan components were related to items dealing with long-term
socio-economic goals as determined by the ongoing plan process. They often relate to specific schemes and
projects. Furthermore, they are usually routed through central ministries to state governments for achieving
certain desired objectives. These funds are generally in addition to the assignment of central taxes as
determined by the Finance Commissions. In some cases, the state governments also contribute their own
funds to the schemes.

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