Part – A

1.

(a) The above statement is false.

This is because in a 100% Reserve Banking System, there is no cash holding in the economy.
In such a case, we will assume that the bank can only accept deposits and not grant loans. It is
assumed that the entire money of the economy is deposited in the bank. Further, since it’s a
100% reserved banking system, whatever is deposited in the bank is kept aside as reserves
with the Central Bank, i.e., the CRR is also 100%. In other words, Rs. 1,00,000 cash that
I’ve deposited in a Demand Deposit Account in my bank is entirely kept aside with the
Reserve Bank of India as reserves. The Balance Sheet of such a bank can be seen as under:

Assets (in Rs.) Liabilities (in Rs.)

Reserves 1,00,000 Deposits 1,00,000
Total 1,00,000 Total 1,00,000

Now, we can see that since everything is in reserves, there is no money left for lending out
loans and hence banks won’t be able to influence the money supply at all. Due to non-
availability of loans, further deposits from the initial amount cannot be made. As a result,
there is no resultant effect on money supply, i.e., the money supply will continue to remain
Rs. 1,00,000. Therefore, it can be concluded that the money supply remains constant, i.e.,
neither increases, nor decreases.

(b) The given statement is true.

Propensity to save basically refers to the proportion of the total income or increase in income
that the consumers save rather than spending on goods and services for consumption. It can
be thus inferred that the propensity to save is directly proportional/related to savings. In other
words, a higher propensity to save points towards higher savings and vice-versa. Hence,
when there is an increase in the propensity to save, there is also an increase in the total
savings. It is assumed that a consumer divides his entire income into consumption and
savings (Propensity to save + Propensity to consume = 1). So, when a consumer saves more,
spending is reduced. It can be said that when savings increase, propensity to save increases
and resultantly, propensity to consume decreases. Thus, this implies that if the value of
propensity to save increases, consumers have saved more of their income and spent less on
consumption, leading to an overall increase in total savings.

(c) The given statement is false.

Measurement of stock of money supply is done with 4 measures, namely M 1, M2, M3, M4.
However, none of these measures include credit cards or debit cards as measures of stock of
money supply in the economy. Our economy considers “checkable deposits” as money.
Although credit cards come under the category of “plastic money”, they cannot be considered
as part of the economy’s measure of stock of money supply as they cannot be considered as a
method of “payment”, rather they’re “deferring payment”. While such cards can be used to
make purchases, such purchases are not “money”, rather they are termed as short-term loans
from the credit card company, wherein the latter immediately transfer money from their
checking account to the seller, which is to be returned to them by the end of the month. So,
effectively it can be said that a “money” transaction happens only when the consumer who
has borrowed money from the company pays back the loan. All in all, it can be summed up
that credit cards maybe one of the ways to move money from one person to another when
purchases are made, however, they do not change the quantity of money in the economy.
Hence, they cannot be considered as a measure of money supply.

(d) The given statement can be considered as both true and uncertain.

It is true that majority women in India tend to drop out of the labour force to indulge in
unpaid care work. So, if they spend less time on unpaid care work, they might actually take
up some productive work such as joining the labour force, etc., which in turn, would actually
add a lot of value to the GDP of the economy. Such value addition can be calculated with the
help of the opportunity-cost method. It can be assumed that had the woman not reduced her
paid work hours, she would have contributed value to the economy’s GDP equivalent to the
lost hours at the wage rate that she could have earned by doing paid work for those extra
hours. In other words, had she decided to indulge in paid work of Rs. 10,000 per extra hour,
instead of unpaid work, she would have contributed Rs. 10,000 to the economy’s GDP. So,
her contribution to economy’s GDP would have risen considerably.
There can be another aspect to this scenario where women focus less on unpaid work and
decide to take up paid employment, but due to a lot of work-force, there actually might arise
an issue of disguised unemployment. This in turn, would also not add to the economy’s GDP.
However, the contrary can also be true. If they were to spend less time on unpaid care work,
this does not necessarily imply that they would add billions to the country’s GDP. This is
because, even if they spent less time on unpaid care work, they might or might not indulge in
productive work for the economy, such as labour. They might just prefer to sit at their homes
and relax, or might just be uninterested in doing any productive paid work which would
contribute towards GDP growth. Hence, it can be concluded that the above statement is
uncertain as it can work both ways.

(e) The given statement is false.

Expansionary fiscal policies of the government are basically aimed at stimulating a higher
level of economic activity, that include the use of government spending, transfer payments,
tax cuts, etc. When the government plans on introducing expansionary fiscal policies, it
basically increases its government spending to boost the aggregate demand. However, for
increasing the spending, it needs money. In such a situation, it either increases taxes or more
preferably, borrows money, to decreases their deficits. To finance such budget deficits, the
government borrows such money from the capital markets, i.e., the markets for loanable
funds, thereby reducing the quantity of money available to the private investors for
investment. Such a situation is referred to as “crowding out” of private investment. This in
turn, leads to a rise in interest rates, thereby raising the cost of borrowing. As a result,
investment by firms decreases as they turn out to be very expensive. Firms refrain from
borrowing as it would prove to be detrimental for them and resort to increasing their savings
due to high rates of interest. In such cases, government’s expansionary fiscal policies prove to
be counterproductive for the goal of increasing private investment.

However, the case is different in a small economy where firms depend only on their own
funds, such as inherited wealth or by taking help from relatives and friends, to finance their
investment projects. In such an economy, since the firms do not depend on the market for
loanable funds in the first place, the issue of crowding out is avoided. Rise in interest rates
have no effect on the firms. Hence, it can be said that an expansionary fiscal policy will not
be detrimental to their investment plans.
 Part - B

2.

(a) No, I do not agree with the inclusion of ‘GDP’ as one of the indicators to arrive at the
composite level of happiness, as per this index/report.

While GDP refers to the market value of all final goods and services produced in an
economy, in a given period of time, happiness refers to a state of subjective well-being of an
individual. So, GDP and happiness cannot be said to be related because as is evident from the
report, the country with the highest GDP does not top the happiest countries index and vice
versa. GDP can never be used as an indicator to measure welfare or happiness. Even if the
happiness index is high for a country wherein increase in the GDP is one of the factors, there
might be many other factors which would be equally contributing or more essential in
determining the composite level of happiness. Although it might seem that higher GDP
leading to higher income levels makes people happier, in reality, the case is not so. For
example, even if the GDP of a country is lesser than the GDP of another country, but the
people of the former despite lower income levels, are able to meet their basic needs like food,
health and shelter, their happiness increases. On the other hand, people of a high GDP
country might not be as happy, despite higher income levels, if the standard of their basic
demands is higher and it remains unfulfilled. Another example can be the products or
production methods that add value to the GDP. Suppose people are miserable in their jobs
and have a toxic work culture, they might undoubtedly contribute towards the output or the
value of goods and services. However, in such a case, their happiness levels decrease as they
have threats to their physical and mental health. Hence, even if GDP is relevant to happiness,
it cannot be concluded that GDP is an indicator of the composite level of happiness because it
lacks the existence of a clear, linear relationship.

(b) Based on the above report, out of the South Asian nations, we can see that Nepal is the
happiest country at a rank of 84, followed by Bangladesh at the 94 th position, Pakistan at the
121st position, Sri Lanka at the 127th and India at the last. However, as per the World Bank
statistics, the GDP growth rates of the countries were in the following order; Bangladesh
(7.9%), Nepal (7.6%), India (6.5%), Pakistan (5.8%) and Sri Lanka (3.3%). This shows that
there is no direct relation between GDP and happiness. Had there been any such direct
relationship, then Nepal, being the happiest country among the above lot would have had a
higher GDP growth rate than all the other South Asian nations. But, we can clearly see that
the case is not so. Nepal stands second in the list of GDP growth rates, below Bangladesh. It
can be thus implied that happiness is a result of a variety of factors. For example, although
Nepal might not be as well off than Bangladesh in terms of GDP, it definitely topping the
happiness index, suggest that the country might have improved the working conditions of its
people or increased their quality of life in some manner. On the other hand, it can be assumed
that while Bangladesh is higher than Nepal in terms of GDP, it definitely contributes more in
terms of goods and services. It also indicates that the average income levels in the economy
and average living standards of the people of Bangladesh are comparatively high. Still, the
people there aren’t as happy maybe due to toxic working conditions or lower quality of life.

Similarly, if we compare India and Sri Lanka, we can see that while Sri Lanka is above India
in terms of happiness, it holds the lowest rank among the above countries in terms of GDP.
So, it can be concluded that although the value added by the Sri Lankan people to their
economy is not as high as compared to the Indians, they still have a higher level of happiness
and wellbeing. Indians, despite contributing more to the GDP in comparison to Pakistan and
Sri Lanka, have low levels of happiness. This might be a result of variety of factors such as
poverty, lack of basic necessities of life, insufficient wages, etc. Hence, while GDP just refers
to value addition to the goods and services of an economy, without taking the conditions of
people into consideration, there are various other factors taken into consideration while
depicting happiness, which is a subjective well-being. It can thus be concluded from the
above report that although GDP is a very important macroeconomic variable, it is not an
indicator or is an incomplete measure of happiness.

3. Indie country’s government’s alternative plans can be explained as follows:

Plan A requires imposing a tax of 500 on that section of the population that lives above
poverty line and use the tax collection to provide as unemployment allowances to the
population living below poverty line. This is a form of using tax revenues for transfer
payment. Transfer payments are basically unilateral transfers or one-sided payments which
include government grants, subsidies or gifts to individuals and firms. They do not involve
exchange of goods and services. In this case, the government gains tax revenue by taxing
those above the poverty line. However, it uses such revenue as unemployment allowances to
the population living below the poverty line. Such increase in transfer payments will lead to
an increase in the disposable income. But transfer payments have an indirect effect on the
aggregate demand and GDP, i.e., it is based on their effect on consumption or investment.
However, due to the taxation, the people who have had to pay taxes of Rs. 500 would
consider cutting down their consumption by an equivalent amount since their disposable
income reduces. So, while increasing transfer payments for 50% people would have a
positive effect on the economy and stimulate economic growth, increasing taxes on the rest
50% would have a negative effect on the economic equilibrium. For example, let’s say
consumers receive a tax cut of 50. If they spent it all, that would add 50 to aggregate demand.
But according to the “marginal propensity to consume” (mpc) principle, consumers are likely
to use a portion of the tax cut to increase saving or reduce debt. With the mpc of 0.8, the
portion saved will be 0.2*50 = 10, leaving 40 for increased consumption. Thus, the effect on
aggregate demand would be only 40, not 50 (since saving is not part of aggregate demand).
The same logic would hold if consumers received extra transfer income of 50. They would
spend only 40, and save 10. Similarly, with a tax increase or benefit cut of 50, individuals
and families would have less to spend and would reduce their consumption by 40.

Plan B is to impose a tax of 500 on that section of the population that lives above poverty
line; and use the tax collection to finance its expenditure on an employment generation
scheme, which provides 100 days of promised employment to the population living below
poverty line. This is a form of government spending, that is basically government expenditure
on public goods and services. Since government spends on employment services to the
people below the poverty line, it helps in increasing their quality of life. This in turn,
increases their bargaining power, since they also have some source of income. Their
disposable income also decreases wherein they are able to buy goods and services. Thus, this
spending of the government has a direct effect on the aggregate demand and GDP. Further,
since the disposable income of the people above the poverty line decreases, their
consumption also decreases a bit. As a result, there is a decrease in the wealth gap.
Government spending also helps in stimulating economy in a better manner as it is a form of
investment. It invests in human resources and avails benefits from them. So, it is beneficial
for both the government and the people, as well as the economy as a whole.
For calculating the benefits of govt. spending, govt. multiplier can be used, while for
understanding impact of taxes, tax multiplier can be used. For example, suppose mpc is 0.8,
Govt multiplier will be (1/(1-mpc)) =5 and tax multiplier will be [-mpc/(1-mpc)] = -4. From
the above, it can be inferred that since the multiplier effect of taxes goes in the opposite
direction from that of government spending, it might appear that the effects would cancel
each other out. But this is not the case. As the tax multiplier is smaller than the government
spending multiplier, there is a net positive effect on aggregate demand and equilibrium.

It is a well-established fact that change in taxes or transfer payments, however, don’t have
exactly the same effect as changes in government spending on goods and services. Changes
in taxes or transfer payments directly affect disposable income but only indirectly affect
consumption and aggregate demand. Hence their impact on economic equilibrium is less than
that of government spending, which affects aggregate demand directly. For this reason, the
multiplier effects of changes in taxes and transfer payments are smaller than the multiplier
impacts of government spending. Thus, government spending has a better effect on the
economy as compared to taxes and transfer payments. Hence, it can be concluded that Plan B
is better than plan A for stimulating the economy.

5.

(a) Keeping aside of requisite funds on a daily basis, against deposits, with the Central Bank
refers to cash reserve ratio (crr). In the present scenario, there is only one commercial bank,
the ABC Bank. The fact that it has been keeping aside higher funds (as per the statutory
requirement) with the Central Bank, to be able to honour its withdrawals implies that the
value of money multiplier reduces and the money supply in the economy is lesser than
expected. This is because since the bank keeps aside more money for withdrawals, the
quantity of loan which can be given out to the public decreases. This in order, reduces further
deposits to be made by the public. As a result, the entire money supply is affected, i.e., it
there is less money for circulation than what it actually should have been. Following this,
there is a recession due to which the central bank reduces the statutory reserve requirement.
However, maybe due to the fear of “bank-runs”, a situation wherein the banks are incapable
of paying back the money of customers, the ABC Bank keeps aside more funds to be able to
honour its withdrawals. This in turn, results in even lesser money for circulation in the
economy as a huge amount of money is kept aside as reserves. The fact that the central bank
reduced the statutory reserve requirement, was an indirect signal to the ABC Bank to increase
the money supply. The central bank wanted that due to their policy change, the commercial
bank would keep aside less money as reserves, and give out the rest amount as loans. This
would have helped to increase the circulation of money, thereby increasing the money
supply.

For example, suppose ABC Bank had Rs. 100 as initial deposits. Assuming the mandated crr
to be 8%, the value of money multiplier will be equal to (1/crr) = (1/ 0.08) = 12.5. We can
further calculate the Money Supply (MS) as follows:

MS = Money multiplier*initial deposits

= 12.5*100

= Rs. 1250

However, ABC Bank kept aside reserves equal to a crr value of 10%. So, money multiplier in
this case is equal to (1/crr) = (1/ 0.10) = 10. Money supply is as follows:

MS = Money multiplier*initial deposits

= 10*100

= Rs. 1000

Hence, we can clearly see that for even a small initial deposit of Rs. 100, if the crr is reduced
and the bank keeps more money aside as reserves, the total money supply of the economy
reduces (in this scenario, by Rs. 250). So, it can be clearly inferred that when the central bank
reduces the statutory reserve requirement and the bank does not abide by it, rather increases
the money kept aside as reserves, it will significantly decrease the money supply in the
economy and there will be a lot less money for circulation in the hands of the public.

(b) In the first scenario, we can assume that since country A has a very large economy, it is a
growing economy and since country B is the smaller one, it is the stagnant economy. So, in
such a case where both of them resort to using “paper” as a means of winning over the other
by printing the other’s currency and then dropping large quantities of it by airplane, it can be
said that country A will be in a better position over country B. This is because since A is a
larger, growing economy, it has the ability to absorb the extra money supply in circulation in
its economy, without much impact. However, in case of country B, it will prove to be highly
detrimental. This is because, it is a stagnant economy where the output is considered
constant. So, when country A prints large quantities of B’s currency and drops it in country
B, the money supply will increase a lot. Since there will be a lot of money in the hands of the
public with limited goods, the demand for goods and services will also increase. There will
be a lot of chaos and uncertainty in the economy. However, output being constant, it will not
be able to absorb the excess demand and put a lot of pressure on the prices, thereby giving
rise to inflation. Further, if this inflation takes place over a long period of time with
substantially high interest rates, it will lead to a situation of hyperinflation. As a result, the
value of money of country B will get eroded. The savers /debtors are the most hurt because
hyperinflation can wipe out their savings. People with fixed incomes are also badly affected.
In such a situation, it obviously becomes very difficult to run the economy due to
inconvenience of use of the currency. People resort to barter—exchanging goods, services, or
assets directly for other goods, services, or assets—to try to avoid having to deal with a
rapidly inflating currency. There is redistribution of wealth from creditors to debtors as
people now repay debts in money that is worth less than the money that they originally
borrowed. The process of normal patterns of lending and saving is also disrupted. As a result,
production reduces and unemployment rises, severely affecting the economy. Hence, in this
scenario, country A will be in a beneficial position, as compared to B, since the former won’t
be affected much but the latter’s economy will be in shambles. So, the above strategy can
work for A, but not B.

In the second scenario, we can assume that both the countries have a stagnant economy. In
such a case, both the countries will have a fixed output despite increasing demand. Although
this will give rise to a scenario of inflation for both the countries, similar to the above
scenario of stagnant economies, the outcome for both countries will be different. A, being a
larger economy, will take greater time to experience inflation, as compared to B, the smaller
economy. Although inflation will be disruptive for both, country B will experience the impact
much faster than country A. So, the above strategy of printing money would be detrimental
for both and is not feasible for both, however, A will have an advantage over B.