Question Paper Economics-II (122) : July 2002

Part A : Basic Concepts (30 Points)

1. This part consists of questions with serial number 1 - 30. Answer all questions. Each question carries one point. Maximum time for answering Part A is 30 Minutes.

Total market value of all the final goods and services produced in a given period by factors of production located within a country is a. b. c. d. e. Gross National Product at market prices Gross Domestic Product at market prices Net National Product at market prices Gross National Product at factor cost Gross Domestic Product at factor cost.

2.

The quantity theory of money implies that a given percentage change in the money supply will cause a. b. c. d. e. An equal percentage change in nominal GDP A smaller percentage change in nominal GDP A larger percentage change in nominal GDP An equal percentage change in real GDP A smaller percentage change in real GDP.

3.

In an economy Marginal Propensity to Save (MPS) is estimated to be 0.25 and the proportional tax rate is 0.20. Multiplier for the economy is a. b. c. d. e. 2.0 2.5 4.0 5.0 None of the above.

4.

If the anticipated rate of inflation rises, other things remaining constant, we would expect the nominal interest rate to a. b. c. d. e. Remain unchanged Rise by the same percentage as the increase in the anticipated rate of inflation Fall by the same percentage as the increase in the anticipated rate of inflation Rise, but by less than the anticipated increase in the rate of inflation Fall, but by less than the anticipated increase in the rate of inflation.

5.

A current account deficit implies that a. b. c. d. e. Domestic spending exceeds domestic income Domestic income exceeds domestic spending Exports exceeds imports Domestic savings exceed domestic investment None of the above.

6.

An increase in government expenditure will a. b. c. d. e. Shift both IS and LM curves to the right Shift both IS and LM curves to the left Not affect the position of LM curve but shift the IS curve to left Not affect the position of IS curve but shift the LM curve to right Not affect the position of LM curve but shift the IS curve to right.

7.

In an economy Marginal Propensity to Consume is 0.75 and proportional tax rate is 0.20. If government expenditure increases by 100, change in budget surplus will be a. b. c. d. e. 100 50 0 50 100.

8.

In an economy Marginal Propensity to Consume is estimated to be 0.75. If investment in the economy increases by 50, equilibrium savings in the economy a. b. c. d. e. Remain unchanged Increase by 50 Increase by 150 Increase by 150 Increase by 200.

9.

Which of the following variables will be at low levels during boom phase of a business cycle? a. b. c. d. e. Bank reserves Wage rates Bank credit Inventory Cost of production.

10. Financial Inter-relations ratio is a. b. c. d. e. The ratio of total financial claims issued during a year to the national income for the year The ratio of primary issues by the non-financial sector to total physical asset formation The ratio of volume of financial instruments issued by financial intermediaries during a period to the volume of primary issues by the non-financial sector. The ratio of the total stock of financial assets at a point of time to the stock of physical assets Ratio of total financial claims to total physical asset formation.

11. A car produced in 2001 is held in inventory until it is sold in the year 2002. In which year the value of the car will be considered for computing GDP? a. b. c. d. e. 2001 2002 Both in 2001 & 2002 Half the value in 2001 and half the value in 2002 Depends on the accounting policies adopted by the company.

12. An important difference between the approaches of the Classical economists and Keynesian economists to achieve a macroeconomic equilibrium is that a. b. c. d. e. Keynesian economists actively promote the use of fiscal policy while the classical economists do not Keynesian economists actively promote the use of monetary policy to improve aggregate economic performance while classical economists do not Classical economists believe that monetary policy will certainly affect the level of output while Keynesians believe that money growth affects only prices Classical economists believe that fiscal policy is an effective tool for achieving economic stability while Keynesians do not None of the above.

13. If interest elasticity of demand for investment and consumption is zero a. b. c. d. e. Equilibrium income depends solely on the position of LM curve Equilibrium income depends solely on the position of IS curve There is no speculative demand for money Speculative demand for money is infinity Fiscal policy is totally ineffective in changing any of the real variables.

14. Which of the following variables is a flow variable? a. b. c. d. e. Capital stock A firms assets Gross fixed investment Price index Public debt.

15. GDP of a country is 8000. Value of output produced in domestic country by foreign factors of production is 200 and value of the output produced by domestic factors of production in foreign countries is 100. GNP of the country is a. b. c. d. e. 7700 7800 7900 8100 8200 C = 1,500 + 0.75 Yd Which of the following is true if Yd is zero? a. b. c. d. e. Consumption is zero Savings are 1,500 Income must be greater than taxes Dissavings are 1,500 Savings are zero.

16. Consumption function for an economy is estimated to be

17. Suppose that people hold 50% of their money in currency. If the reserve ratio is 10% and total demand for money is Rs.5,000, then the amount required by banks to meet the reserve requirement is equal to a. b. c. d. e. Rs.250 Rs.2,250 Rs.2,500 Rs.5,000 None of the above.

18. Per capita output is a better indicator of economic performance of different countries than total output because a. b. c. d. e. Per capita output is easier to estimate Total output cannot be used to calculate economic growth Per capita output gives a better indication of the standard of living Total output does not take into account changes in prices None of the above.

19. For an economy GDP deflator for the year 2001 is 175 and the base year is 1990. If real GDP (in 1990 prices) for the year is 1000, nominal GDP for the year 2001 is a. b. c. d. e. 71 825 1000 1175 1750.

20. Which of the following is not advocated by supply-side economics? a. b. c. d. e. Promote competition Reduce government controls Increase corporate tax rate Reduce the role of government Remove institutional barriers.

21. In an economy demand for money is Md = 500 + 0.2Y 20i If money supply in the economy is 2340 and equilibrium rate of interest is 8 percent, national income is a. b. c. d. e. 340 500 1000 2000 None of the above.

22. GDP for the current year is 2500 and is expected to increase to 3000 during the next year. If accelerator coefficient is 4, investment during the next year will be a. b. c. d. e. 125 625 750 500 2000.

23. Which of the following would you suggest to counter a recession? a. b. c. d. e. Decrease in government expenditure Decrease in transfer payments Decrease in the discount rate Decrease in the money supply Increase in the tax rate.

24. The following information is available from the consolidated balance sheet of the banking sector: Item Net Bank Credit to the Government Bank Credit to the Commercial Sector Net Foreign Exchange Assets of the Banking Sector Net Non-Monetary Liabilities of the Banking Sector Government Currency Liabilities to the Public Money supply in the economy is a. b. c. d. e. Rs. 200 billion Rs.6000 billion Rs.6200 billion Rs.7400 billion Rs.7600 billion. Rs. Billion 2000 3000 2200 1200 200

25. If the economy is expected to grow at 8 percent and the population grows at 2 percent, expected growth rate in per capita income is a. b. c. d. e. 2% 4% 6% 10% 16%.

26. Net domestic capital formation in a country is 2000. Savings by private and public sectors in the economy are 1800 and 100 respectively. Current account deficit for the economy is a. b. c. d. e. 100 200 300 400 500.

27. Which of the following statements is true? a. b. c. d. e. GDP takes into account both transfer payments and leisure time GDP takes into account transfer payments, but not leisure time GDP takes into account leisure time, but not transfer payments GDP takes into account neither transfer payments nor leisure time GDP takes into account both the services of a housewife and services of a driver engaged by a company.

28. If the Average Propensity to Save (APS) is negative, then the Average Propensity to Consume (APC) is a. b. c. d. e. Negative Zero Positive but less than one One Greater than one.

29. Which of the following components of Investment can be negative? a. b. c. d. e. Plant and machinery Residential construction Inventory Non-residential construction None of the above.

30. In the long run the aggregate supply curve is a. b. c. d. e. Upward sloping Downward sloping Vertical Horizontal Horizontal until full employment is reached and vertical then after. END OF PART A

Part B : Problems (50 Points)

1. This part consists of questions with serial number 1 5. Answer all questions. Points are indicated against each question. Detailed workings should form part of your answer. Do not spend more than 110 - 120 minutes on Part B.

The following information is extracted from the National Income Accounts of an economy: Million units of currency (MUC) 16000 21600 2000 30000 1500 500 5000 8000 4200 11000 6500 7000 700 Nil 1200

Government expenditure Consumption expenditure Factor incomes received by domestic residents Rent Wages and salaries Interest income Dividends Direct taxes Corporate Profit taxes Personal Income taxes Indirect taxes Gross Investment Corporate Profits (Profit Before Tax) Net Investment Subsidies Net factor income from abroad (NFIA) Transfers to household sector (from government) You are required to find: a. National income b. Gross Domestic Product at market prices c. Personal Income d. Personal Savings e. Net Domestic Savings 2.

(3 + 2 + 2 + 2 + 3 = 12 points) The following information is available from balance sheet of the Reserve Bank of India: Particulars Rs. million Credit to Banking Sector 12000 Credit to Government 18000 Government Deposits 600 Other deposits with the RBI 100 Other non-monetary liabilities 400 Net worth 10000 Credit to commercial sector 7000 Net foreign exchange assets 21000 Other assets 250 Government money in the economy is Rs.750m. Currency deposit ratio for the economy is estimated to be 0.30. Cash reserve ratio (CRR) imposed by the RBI is 7.5 percent. Required: a. Calculate the money supply in the economy. b. If foreign exchange reserves of India decline by Rs.600m, what would happen to the money supply? (show all your computations) c. If the RBI would like to sterilize the impact of change in foreign exchange reserves on the money supply by adjusting the CRR, what should be the new CRR. (5 + 2 + 3 = 10 points) 6

3.

4.

5.

The following information pertains to the balance of payments of India for the period AprilDecember 2001. Particulars US $ million Merchandise imports 42121 Merchandise exports 32639 Export of services, including travel and transportation 15316 Import of services, including travel and transportation 13677 Factor income received from abroad 1912 Factor income paid abroad 3931 Private remittances to abroad 49 Private remittances from abroad 9185 Net foreign investments in India 4055 Net foreign investments by India 555 Net external assistance to India 130 Net Commercial Borrowings (MT & LT) by India -471 Net short-term borrowings by India -835 Other capital inflows 12646 Other capital outflows 10724 Errors & Omissions 2049 Required: a. Prepare a balance of payments statement for the period Apr-Dec 2001. b. If money multiplier is estimated to be 4, what is the impact of balance of payments position on the money supply in the economy? (Exchange rate is Rs.50/US$) (8 + 2 = 10 points) The following relations are derived for an economy. Saving function (S) 1140 + 0.5Yd + 12i Investment function (I) 900 + 0.1 Y 100i Tax function (T) 0.30 Y Transfer payments (R) 600 Government expenditure (G) 3440 Transaction demand for money (Mt) 0.25Y Speculative demand for money (Ma) 1050 150i Exports (E) 1636 Import function (M) 150 + 0.15Y Required: a. If the equilibrium output (Y) is 9580, find the money supply in the economy. b. If the money supply is expected to increase by 190, what is the impact on trade balance and budget deficit. (5 + 7 = 12 points) For an economy the following indicators of financial development are available: Year 2000 Year 2001 Finance Ratio 0.25 0.32 Financial Intermediation Ratio 1.25 1.50 Intermediation Ratio 0.60 0.70 Primary Issues 1,00,000 1,50,000 Required: a. Compute the following for the years 2000 and 2001. i. Total issues ii. National income b. Comment on the trend in the Finance Ratio and the Intermediation Ratio. (4 + 2 = 6 points)

END OF PART B

Part C : Applied Theory (20 Points)

This part consists of questions with serial number 6 8.. Answer all questions. Points are indicated against each question. Do not spend more than 25 -30 minutes on Part C.

6.

Write short notes on the following: a. Automatic stabilizers b. Open Market Operations (4 + 4 = 8 points) Discuss the implications of higher level of fiscal deficits. (5 points)

7.

8.

Using aggregate demand (AD) aggregate supply (AS) framework; explain the sources of inflation originating on demand and supply sides. (7 points)

END OF PART C END OF QUESTION PAPER

Suggested Answers Economics-II (122) : July 2002

Part A : Basic Concepts
1. Answer : (b) Reason : a. GNPMP is the total market value of the final goods and services produced in a given period by factors of production owned by the citizens of a country. b. GDPMP is defined as the total market value of all the final goods and services produced in a given period by factors of production located within a country c. NNPMP is GNPMP depreciation d. GNPFC is the total value of the final goods and services produced in a given period by factors of production owned by the citizens of a country and valued at factor cost. e. GDPFC is the total market value of the final goods and services produced in a given period by factors of production located within a country and valued at factor cost. Answer : (a) Reason : Quantity theory of money (QTM) says MV = PY Where, M = money supply V = velocity of money P = price level Y = real GDP PY = nominal GDP Assuming V is a constant, a change in M leads to an equal percentage change in PY. Answer : (b) 1 Reason : Multiplier = 1 (1 t ) Where
= MPC = 1 MPS = 1 0.25 = 0.75

2.

3.

t = tax rate Multiplier = 1 1 0.75 (1 0.20) 1 0.40 = 2.5

= 4.

5.

Answer : (b) Reason : Expected nominal interest rate = real interest rate + expected rate of inflation. Therefore, if the expected inflation goes up, expected nominal rate of interest also goes up by the same amount. Hence the answer is (b) Answer : (a) Reason : Y= C + 1 + G + Net Exports Where Y = Domestic income C + 1 + G = Domestic spending. Y (C + 1 + G) = Net Exports (Current Account Balance) If Current Account Balance is negative, then domestic spending is greater than domestic income The answer is (a). (b) If domestic income exceeds domestic spending, there is current account surplus. (c) Current account balance is equal to exports imports. If exports exceed imports, there is current account surplus. (d) If domestic savings exceed domestic investment, domestic income exceeds domestic spending and there is current account surplus. 9

6.

Answer : (e) Reason : Expansionary monetary policy will shift the LM curve to the right and contractionary monetary policy will shift the LM curve to the left. Expansionary fiscal policies will shift the IS curve towards right but will not affect LM curve. Answer : (b) Reason : BS = Where (1 b) (1 t ) . G 1 b (1 t )

7.

b = Marginal Propensity to Consume = 0.75 T = tax rate = 0.20 G = 100 (1 0.75) (1 0.20) BS = 100 = 50. 1 0.75 (1 0.20) 8. Answer : (b) Reason : Y = 1 . I 1 1 .50 = 200 0.25 1 MPC = MPS Y 0.25 200 50

= MPS = S = = = 9.

Savings increase by 50

Answer : (d) Reason : a. During a boom bank reserves will be high as the bank credit is high to support the increased economic activity b. Wage rate will be high as demand for labor increase during the boom phase c. As the economic activity increase during the boom phase bank credit also increases d. During a boom demand increased at a faster rate and inventories tend to be low. All other variables tend to increase during a boom. e. Cost of production will be high as demand for factors of production will be relatively high during the boom phase. 10. Answer : (d) Total Stock of Financial Assets Reason : Financial Inter-relations ratio = Total Stock of Physical Assets Or = Therefore, the Answer is (d) Total Financial Claims issued Net Physical Capital Formation

11. Answer : (a) Reason : Value of the car will be included in GDP for the year 2001 because the production has taken place during this period. As we already know, GDP is the value of final goods and services produced during the period. 12. Answer : (a) Reason : An important difference between the approaches of the classical and Keynesian economists use to achieve a macroeconomic equilibrium is that Keynesian economists actively promote the use of fiscal policy; the classical economists do not. Classical economists believe intervention can be de-stabilizing and advocate laissez- faire economy. Therefore the answer is (a).

10

13. Answer : (e) Reason : IS Functions is Y = A i 1 b (1 t ) A b t = = = = Autonomous expenditure Coefficient indicating interest rate sensitivity of investment and consumption MPC tax rate

Where

If interest elasticity of demand for investment and consumption is zero, = 0. Y = A . That is, equilibrium income depends only on the IS curve. 1 b (1 t )

When plotted, the IS curve is r IS LM

Y 14. Answer : (c) Reason : A variable is a stock if it is measured at a particular point of time. It is a flow variable if it is measured over a period of time. a. Capital stock is measured at a particular point of time, hence is a stock variable b. A firms assets are measured at a particular point of time, hence is a stock variable c. Investment is measured over a period of time hence is a flow variable. d. Price index is measured at a particular point of time, hence is a stock variable e. Public debt is measured at a particular point of time, hence is a stock variable 15. Answer : (c) Reason : GNP = GDP + NFIA NFIA = = = GNP = = Factor income received from abroad Factor income paid abroad. 100 200 100 8000 100 7900.

16. Answer : (d) Reason : If Yd is zero, consumption is 1500, which is autonomous consumption. This consumption is financed by dissavings or borrowing. Hence dissavings are 1500. 17. Answer : (a) Reason : Total money = Rs.5,000. 50% of total money which is held in the form of currency is Rs.2,500. Demand deposit component of money supply is Rs.2,500. Given the reserve ratio of 10%, required reserves are 2,500 0.10 = Rs.250.

11

18. Answer : (c) Reason : Per capita output is total output / population. a. Estimation of per capita income is not easier. We need to estimate total output as well as size of the population. b. Growth rate of the economy can be computed using total output c. This is a better measure of economic performance because it takes into account changes in the size of the population. d. Total output (nominal) takes into account both real output as well as changes in the price level. Further, economic performance is better judged by real output rather than nominal output. 19. Answer : (e) Reason : Nominal GDP = = GDP deflator in the current year Re al GDP 100 GDP deflator in the base year

20. Answer : Reason :

21. Answer : Reason :

22. Answer : Reason :

175 1,000 100 100 = 1,750. Nominal GDP for the year 2001 = 1,750. (c) Supply side economics advocates promoting competition, decreasing role for the state, incentives to production sector like decreasing tax rates and reducing government controls and removing institutional barriers to increase efficiency. Supply-side economics do not advocate increase in the tax rate. Hence answer is (c). (e) Md = 500 + 0.2Y 20i At equilibrium Ms = Md. 2,340 = 500 + 0.2Y (20 8) 0.2Y = 2,340 500 + 160 = 2,000 Y = 10,000. Therefore the answer is (e). (e) Investment Acceleration Coefficient = Change in Income Investment 500 Investment for the next year 4 =

= =

4 500 2,000.

23. Answer : (c) Reason : To counter the recession the fiscal and monetary policies should be expansionary. a. Decrease in government expenditure is a contractionay fiscal policy. This measure will worsen the recessionary situation. b. Decrease in government expenditure is a contractionay fiscal policy. This measure will worsen the recessionary situation. c. Decrease in the discount rate increase money supply in the economy and is an expansionary monetary policy. This will counter the recession by increasing the aggregate demand in the economy. d. Decrease in money supply is a contractionay monetary policy. This measure will worsen the recessionary situation. e. Increase in the tax rate is a contractionay fiscal policy. This measure will worsen the recessionary situation. 24. Answer : (c) Reason : Money Supply = Net bank credit to Government + Bank credit to commercial sector + Net foreign exchange assets of the banking sector Net non-monetary liabilities of the banking sector +Government money = 2000+3000+2200-1200+200 = Rs.6200billion 12

25. Answer : (c) Reason : Growth in per capita income

= =

Growth in economy Growth rate of population 8 2 = 6%.

26. Answer : (c) Reason : S I = CAB S = 1800 100 = 1700 I = 2000 CAB = 1700 2000 = 300 Current Account Deficit = 300 27. Answer : (d) Reason : In computing GDP transfer payments, leisure time and non-marketable services are not taken into account. Therefore, the answer is (d) 28. Answer : (e) Reason : APS + APC = 1 If APS < 0 , APC > 1 29. Answer : (c) Reason : a. Investment in plant and machinery can at the most be zero and cannot be negative. If we do not undertake any investment in plant and machinery, the investment is zero. b. Investment in residential construction can at the most be zero and cannot be negative. If we do not undertake any investment in residential construction, the investment is zero. c. Change in inventory can be either positive or negative. Positive if there is accumulation of inventories and negative if there is decumulation of inventories. d. Investment in non-residential construction can at the most be zero and cannot be negative. If we do not undertake any investment in non-residential construction, the investment is zero. 30. Answer : (c) Reason : a. In the short run the AS curve may be upward sloping. This is because of the unanticipated rise in price level lead to higher profits to the business sector. b. AS curve cannot be downward sloping as downward AS curve indicates inverse relation between price level and aggregate output c. In the long run there will not be a discrepancy between the expected and realized price levels and the AS curve become vertical d. In the short run if the economy has lot of unemployed resources the AS may be horizontal, but not in the long run e. This shape of the AS curve may be possible in the short run but not I the long run.

13

Part B : Problems
1. a. Sum of all factor incomes earned by domestic factors of production = Rent + Wages and salaries + Interest + Profits = 2,000 + 30,000 + 1,500 + 6,500 = 40,000 GDPMP = NNPFC + Depreciation + Indirect Taxes Subsidies NFIA Depreciation = Gross Investment Net investment = 11,000 7,000 = 4,000 GDPMP = 40,000 + 4,000 + 4,200 700 = 47,500 Personal Income (PI) = NI Corporate profits + Dividends + Transfer payments = 40,000 6,500 + 500 + 1,200 = 35,200 Personal Savings (PS) = PDI Personal consumption PDI = PI Personal income taxes = 35,200 8,000 = 27,200 PS = 27,200 21,600 = 5,600. Net Domestic Savings (NDS) = Personal Savings + Business Savings + Government Savings Business Savings (Retained earnings) = Corporate Profits Corporate Profit Tax Dividends = 6,500 5,000 500 = 1,000 Government Savings = Net Tax Collections Government Expenditure Transfer payments = (5,000 + 8,000 + 4,200 700) 16,000 1,200 = 700 NDS = 5,600 + 1,000 700 = 5,900. High powered money Monetary liabilities of RBI Financial Assets = Monetary Liabilities of RBI + Government Money = Financial Assets + Other Assets Non-monetary liabilities = Credit to Government + Credit to Banks + Credit to commercial sector + Net Foreign exchange assets = 18,000 + 12,000 + 7,000 + 21,000 = 58,000 = 250 = Government deposits + other non-monetary liabilities + Net worth = 600 + 400 + 10,000 = 11,000 = 58,000 + 250 11,000 = 47,250 = 750 = 47,250 + 750 = 48,000 = Hm 1+ C u = Cu + r = Money Supply in the economy b. 1 + 0.30 0.30 + 0.075 = 1.30 0.375 = 3.47 National Income (NNPFC) =

b.

c.

d.

e.

2.

a.

Other Assets Non-monetary liabilities Monetary liabilities Government money High powered money (H) Money supply (Ms) Money multiplier (m)

= 48,000 3.47 = Rs.166,560m. If foreign exchange reserves decline by Rs.600m High powered money decrease by Rs.600 m Ms = m H = 3.47 600 = 2082. Money supply decrease by 2082. 14

c.

If RBI would like to sterilize 1 + 0.30 166560 = 47400 0.30 + r 0.30 + r = 1.30 47,400 1,66,560

61620 = 0.3699 166560 r = 0.3699 0.30 = 0.0699 = 6.99% RBI should decrease the CRR to 6.99%. 3. a. Item Current Account I. Merchandise II. Invisible (a + b + c) a. b. c. A. Services Income Transfers Balance of payments for the period Apr-Dec 2001 Credit 32,639 26,413 15,316 1,912 9,185 59,052 4,055 130 12,646 16,831 2,049 77,932 Debit 42,121 17,657 13,677 3,931 49 59,778 555 471 835 10,724 12,585 72,363 5,569 (US $ million) Net (9,482) 8,756 1,639 (2019) 9,136 (726) 3,500 130 (471) (835) 1,922 4,246 2,049 5,569 (5,569)

Current account balance (I + II)

Capital Account I. Foreign investment II. Net external Assistance III. Net commercial Borrowings (MT & LT) IV. Net short term Borrowings V. B. C. D. E. b. Other Capital Capital account balance (I + II + III + IV + V) Errors & omissions Overall Balance (A + B + C) Change in forex reserves

Change in money supply (Ms) =

Money multiplier Change in high powered money (H)

Since the overall BoP position is a surplus of US $ 5,569m, forex reserves increase by the same amount, which leads to an increase in H by 5,569 50 = Rs.2,78,450 m Ms 4. a. = 4 2,78,450 = Rs.11,13,800 m.

S = 1140 + 0.5Yd + 12i Consumption (C) = 1140 + 0.5Yd 12i d Y = YT+R = (Y 0.3Y + 600) Goods Market At equilibrium in goods market Y = C+1+G+EM Y = 1140 + 0.5 (Y 0.3Y + 600) 12i + 900 + 0.1Y 100i + 3440 + 1636 150 0.15Y Y = 7266 + 0.3Y 112i 0.7Y = 7266 112i Y = 10380 160i IS function 15

b.

At equilibrium Y = 9580 9580 = 10380 100i 160i = 800 i = 5% Money Market The money market is in equilibrium when Md = Ms Md = Mt + Ma Mt = 0.25 Y Ma = 1050 150i Md = 0.25Y + 1050 150i = (0.25 Y 9580) + 1050 (150 5) = 2695. The money supply is 2695 If the money supply increase by 190, new money supply is 2,695 + 190 = 2885 LM function Ms = Md 2855 = 0.25Y + 1050 150i 0.25Y = 1835 + 150i Y = 7340 + 600i LM Function At equilibrium, LM and IS functions are equal 10380 160i = 7340 + 600i 760i = 3040 i = 4% Y = 9740 Trade Balance (TB) = EM Before increase in MS, TB = 1636 150 0.15 9580 = 49 After increase in MS, TB = 1636 150 0.15 9740 = 25 Impact on TB = Decrease by 24 Budget deficit (BD) = G+RT Before increase in MS, (BD) = 3440 + 600 (0.3 9580) = 1166 After increase in MS = 3440 + 600 (0.3 9740) = 1118 Impact on Budget deficit = Decrease by 48

5.

a.

Total issues Secondary issues National Income

= = =

Primary issues + Secondary issues Primary issues Intermediation ratio Total issue Finance Ratio 2000 1,00,000 0.60 = 60,000 1,60,000 1,60,000 0.25 = 6,40,000 2001 1,50,000 0.70 = 1,05,000 2,55,000 2,55,000 0.32 = 7,96,875

Secondary issues Total issues National Income

16

b.

Increase in FR indicates increased financial deepening of the economy. That is, financial development of the country is more than the overall economic development of the country during the period. Increase in IR indicates increased financial intermediation in the economy. That is, ultimate users of funds access funds from ultimate savers through financial intermediaries like banks and financial institutions.

Part C: Applied Theory

6. a. Every economy suffers from cyclical fluctuations in output, employment and prices. The ups and downs of the economy have an automatic impact on certain government expenditures and revenues. For example, when the real GDP falls below its potential value, unemployment may increase. Due to an increase in the unemployment rate the overall tax collections of the government decreases along with certain additional government expenditures, like unemployment allowances, etc. It is to be noted that such changes in the government spending or tax collection does not involve any deliberate step undertaken and are beyond the discretion of the government. The changes in the government spending and revenues that results automatically as the economy fluctuates are called non-discretionary fiscal policies. Automatic stabilizers are features of the government budget that automatically adjust net taxes to stabilize aggregate demand as the economy expands or contracts. When the economy begins to contract, these stabilizers increase transfer payments and reduce tax collections in order to stimulate aggregate demand. When the economy begins to expand, the automatic stabilizers increase tax collections and reduce transfer payments in order to restrain growth in the aggregate demand. b. Open Market Operations: It involves purchase and sale of securities (generally government securities) by the Central Bank, to regulate the credit creating capacity of the commercial banks. When the Central Bank purchases securities it makes cheque payment to the sellers. The sellers deposit the cheques with the commercial banks, which automatically raise their reserve base. An increase in the reserve base of the banks provides a basis to multiple expansion of credit and deposits. Similarly, when the Central Bank performs open market sale of securities, it results in a decrease in the bank reserves. So it can be said that, an open market purchase is expansionary in its effect and an open market sale is contractionary in its effect from the point of view of credit creation. It is to be noted that if the OMO does not take place on a mass-scale, it is not possible for the Central Bank to regulate the deposit-creating power of the banking system. As the open market sale is contractionary in nature and restrains the credit creating capacity of the banking system, it exerts an upward thrust on the whole interest rate structure. Under open market sale, a fall in the prices of securities tend to raise the yield on these securities and similar securities of higher interest rates. Assuming that the demand for loans by the public is interest elastic, the aggregate demand for bank credit will fall.

7.

Large fiscal deficits have implications on money supply, growth, inflation and for the access to resources of private investment. Money Supply Growth: We expect the government to be able to finance this fiscal deficit with a remarkably small money creation component. When debt is monetized, net RBI credit to government increases which increases the high-powered money in the economy. With the introduction of WMA on April 1, 1997 the component of debt monetized is limited, providing greater autonomy to the RBI in its conduct of monetary policy. Inflation: Since the fiscal deficit is not monetized to a large extent, high fiscal deficit does not imply a high growth in money supply. But, a large part of the fiscal deficit is used to finance current government expenditure, which is unproductive by its nature. This expenditure instantaneously increases the aggregate demand in the economy without any increase in the production. This would finally lead to an inflationary situation in the longrun. Crowding-out of private investment: When Government borrows from the market, liquidity position in the market becomes tight leading to a higher rate of interest. This higher rate of interest is a higher cost of capital which discourages private investment. Crowding-out of essential public expenditure: Fiscal deficit is a net addition to public debt. Increased public debt necessitates more debt service in the form of interest and repayment of borrowings. This crowds-out essential public expenditure on health, education and other social and economic welfare. 17

8.

In analyzing the causes of inflation, traditionally the approach has been to focus on the Aggregate Supply (AS) and Aggregate Demand (AD). In the AS-AD framework, price rise is caused by either a rightward shift in the AD curve or a leftward shift in the AS curve.

Figure 1 As shown in figure 1, an increase in the AD causes a shift in the AD curve towards right. Given the supply curve, this results in an increased price level from P0 to P1. The inflation caused by the shift in the AD curve is called Demand-pull Inflation. In figure 2, the shift in the supply curve towards left, signifying a decrease in the supply, causes the price rise to P1 from P0. The inflation caused by the shift in the AS curve is called Cost-push Inflation.
AS1 AS

Figure 2 Demand-Pull Inflation One explanation for the inflation runs in terms of generalized excess demand, sometimes loosely and not very accurately described as too much money chasing too few goods. According to this explanation, the general rise in the price level is because the demand for goods and services exceeds the supply available at existing prices. In terms of AD-AS framework, the rightward shift in the AD curve means an excess demand for goods and services at existing prices.

Figure 3 In figure 3, the AD increases to Y1 from Y0 because of the shift in the AD0 curve to AD1. But at the price level P0, the AS is Y0. Therefore, the excess demand is Y1 Y0. To eliminate the excess demand, the price level increases to P1, where the AD and AS are equal at Y2. The factors causing a shift in the AD can be classified into real and monetary factors. Among the real factors are fiscal actions like changes in the government spending and taxes. Among the monetary factors are changes in the money supply. 18

The Real Factors: The real factors which can cause a rightward shift in the AD curve are an increase in government expenditure with no change in the tax receipts, a decrease in the tax receipts with no change in the government spending, a rightward shift in the consumption function, investment function or export function. The Monetary Factors: On the monetary side, demand-pull inflation may originate either through a decrease in the demand for money or an increase in the supply of money. As we discussed with IS-LM curves, a decrease in the demand for money or an increase in the money supply will shift the LM curve towards right causing a rightward shift in the AD curve. In reality a decrease in the demand for money is not likely to originate an inflation, but it is almost certain to intensify an ongoing inflation that has reached a rapid rate. The greater the rate of inflation, the costly it becomes to hold money, and the smaller the amount of real balances the public will want to hold at any level of real income and any interest rate. The velocity of money increases, which acts on the price level like an increase in the supply of money. But rapid increase in the money supply is a source of excess demand which can originate an inflation. Cost-Push Inflation Cost-push theory of inflation explains the causes of inflation originating from supply side.

Figure 4 In figure 4, when AS curve shifts leftward from AS0 to AS1, the price level increases from P0 to P1. In costpush inflation theory, the causes for the leftward shift in the AS curve are identified as increase in the wage level unmatched by the increase in the labor productivity, increase in the profit margins by those who can exercise the market power and supply shocks. Depending on the cause of inflation, three types of inflation are identified under the cost-push inflation: Wage-push inflation, Profit-push inflation and Supply-shock inflation. Wage-Push inflation: Wage-push inflation is a result of labor extracting money-wage rate increases greater than the increase in the productivity of labor. This causes the labor cost per unit of output to rise forcing the producers to increase the prices. The increase in money-wages matched by increase in labor productivity are not inflationary since labor cost per unit of output does not increase. Wage-push inflation can only occur in imperfectly competitive labor markets. Strong labor unions are a source of imperfection in the labor markets. Profit-Push Inflation: Profit-push is another variant of supply inflation. Just as labor unions exercise their market power by forcing wage increases, so also oligopolists and monopolists may, in their drive toward greater profits, raise prices more than enough to offset any cost increases. This is also possible only with the existence of imperfectly competitive markets in the sale of goods and services. If the markets for goods and services are perfectly competitive, sellers can earn only normal profits. Supply-Shock Inflation: A third source of supply-side inflation is supply-shock. A supply-shock means a drastic reduction in the supply such as crop failure due to bad weather, ban on imports of a critical raw material, reduction in the supply of oil by the Organization of Petroleum Exporting Countries (OPEC), etc. Supply-shock also shifts the AS curve towards left causing inflation.

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