General Instructions: (i) All questions in both sections are compulsory. However, there is internal choice in some questions. (ii) Marks for questions are indicated against each question. (iii) Question No.1-3 and 15-19 are very short answer questions carrying 1 mark each. They are required to be answered in one sentence. (iv) Question No.4-8 and 20-22 are short answer questions carrying 3 marks each. Answers to them should not normally exceed 60 words each. (v) Question No.9-10 and 23-25 are also short answer questions carrying 4 marks each. Answers to them should not normally exceed 70 words each. (vi) Question No.11-14 and 26-29 are long answer questions carrying 6 marks each. Answers to them should not normally exceed 100 words each. (vii) Answers should be brief and to the point and the above word limit be adhered to as far as possible. SECTION - A Q 1: Give equation of Budget Line. The budget line can be expressed as an equation: M = (PA x QA) + (PB x QB) Where: M = Money income; QA = Quantity of good 1 QB = Quantity of good 2 PA = Price of good 1 PB = Price of good 2 Q 2: When income of the consumer falls, the impact on price-demand curve of an inferior good is: (choose the correct alternative) P age 1 of 22
(a) Shifts to the right. (b) Shifts of the left. (c) There is upward movement along the curve. (d) There is downward movement along the curve. (a) Shifts to the right. Reason: Demand for inferior goods share a negative relationship with consumer's income. Hence, when the income of the consumer falls, the demand for inferior good increases leading to the rightward shift of the demand curve. Q 3: If Marginal Rate of Substitution is constant throughout, the Indifference curve will be: (choose the correct alternative) (a) Parallel to the x-axis. (b) Downward sloping concave. (c) Downward sloping convex. (d) Downward sloping straight line. (d) Downward sloping straight line. Reason: If Marginal Rate of Substitution is constant throughout, the Indifference curve will be downward sloping straight line. Q 4: Giving reason comment on the shape of Production Possibilities curve based on the following schedule: Good X (units) 0 10 1 9 2 7 3 4 4 0 Good Y (units) P age 2 of 22
Production Possibility Curve (PPC) will be concave to the origin because of the increasing opportunity cost. As we move down along the PPC, to produce each additional unit of Good X, more and more units of Good Y needs to be sacrificed. That is, as we move down along the PPC, the opportunity cost increases. And this causes the concave shape of PPC. Q 5: What will be the impact of recently launched 'Clean India Mission' (Swachh Bharat Mission) on the Production Possibilities curve of the economy and why? Production possibility curve is a graphical representation of the maximal mix of outputs that an economy can achieve using its existing resources to full extent and in the most efficient way. The mission of 'Clean India Mission' (Swachh Bharat Mission) will lead to better waste-management technique. Consequently it leads to healthy India and increased individual productivity. Both these factors will lead to better and efficient utilisation of existing resources of an economy. Accordingly, the economy will move higher and closer to initial PPC. This movement is being depicted in the below graph with the help of the arrow from point P. OR What will likely be the impact of large scale outflow of foreign capital on Production Possibilities curve of the economy and why? The large scale outflow of foreign capital will lead to a decrease in the availability of resources, thereby shifting the Production Possibility Curve (PPC) from right to left that is from AB to CD as shown in the following diagram. Hence, we can say that leftward shift of PPC results in fall in output and resources. P age 3 of 22
Q 6: The measure of price elasticity of demand of a normal good carries minus sign while price elasticity of supply carries plus sign. Explain why? The first law of demand states that as price increases, less quantity is demanded. This is why the demand curve slopes down to the right. Because price and quantity move in opposite directions on the demand curve, the price elasticity of demand is always negative. Hence the measure of price elasticity of demand of a normal good carries minus sign as there exists an inverse relationship between demand and price of the good. On the other hand, a supply curve is characterized by a line that slopes up to the right. Thus, as the price increases, more quantity is supplied. Because price and quantity move in the same directions on the supply curve, the price elasticity of supply is usually positive. Thus the price elasticity of supply always carries a plus sign. Q 7: There are large numbers of buyers in a perfectly competitive market. Explain the significance of this feature. The number of buyers and sellers operating under perfect competition is very high. As the number of individual sellers very large, an individual seller cannot fix the price. Similarly no single buyer can fix the price or change it by his action. Even if he increases or reduces demand, it does not make any effect on the total demand in the market. Price of a product is determined by the interaction of total demand and total supply in the market. Hence every seller and buyer under perfect competition is a price taker and not a price maker. Q 8: Explain the effects of 'maximum price ceiling' on the market of a good'? Use diagram. P age 4 of 22
A price ceiling is a government-imposed price control or limit on how high a price is charged for a product. Governments intend price ceilings to protect consumers from conditions that could make necessary commodities unattainable. It is the legislated or government imposed maximum level of price that can be charged by the seller. Since price ceiling is lower than the equilibrium price thus the imposition of the price ceiling leads to excess demand as shown in the diagram below. The following are the consequences and effects of price ceiling. 1) An effective price ceiling will lower the price of a good, which decreases the producer surplus. The effective price ceiling will also decrease the price for consumers, but any benefit gained from that will be minimized by the decreased sales due to the drop in supply caused by the lower price. 2) If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the greatest number of consumers. 3) Prolonged shortages caused by price ceilings can create black markets for that good. 4) Due to artificially lowering the price, the demand becomes comparatively higher than the supply. This leads to the emergence of the problem of excess demand. 5) The imposition of the price ceiling ensures the access of the necessity goods within the reach of the poor people. This safeguards and enhances the welfare of the poor and vulnerable sections of the society. 6) Each consumer gets a fixed quantity of good (as per the quota). The quantity often falls short of meeting the individual s requirements. This further leads to the problem of shortage and the consumer remains unsatisfied. 7) Often it has been found that the goods that are available at the ration shops are usually inferior goods and are adulterated and infiltrated. Q 9: A consumer spends Rs. 1000 on a good priced at Rs. 8 per unit. When price rises by 25 per cent, the consumer continues to spend Rs. 1000 on the good. Calculate price elasticity of demand by percentage method. P age 5 of 22
Elasticity of Demand by Percentage method: E = % change in quantity demanded / % change in price. Price (Rs) Quantity (units) 8 125 1000 10 100 1000 Total Expenditure (Rs) % change in quantity demanded = (New quantity demanded - old quantity demanded)/ initial quantity*100 (100-125)/125 = -0.2*100 = -20 % in price = (New price old price)/ Initial price*100 (10-8)/8 = 0.25 *100 = 25 Price elasticity of demand = -20/25 = -0.8 Q 10: Define cost. State the relation between marginal cost and average variable cost. Cost or cost of production is the price paid to acquire, produce, accomplish, or maintain anything It refers to the expenditures incurred or payments made by a firm to various factors of production (such as, land, labour, capital and entrepreneur) and also non-factors of production (such as, raw materials, etc.) Average Variable Cost (AVC) is defined as the total variable cost per unit of output. We calculate it as: AVC = TVC/q Marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit, that is, it is the cost of producing one more unit of a good. Relationship between AVC and MC: i. Both AVC and MC are derived from total variable cost (TVC). AVC refers to TVC per unit of output and MC is the addition to TVC, when one more unit of output is produced. ii. Both AVC and MC curves are U-shaped due to the Law of Variable Proportions. P age 6 of 22
1) When AVC is falling, MC falls at a faster rate and stays below AVC curve. 2) When AVC is rising, MC rises at a faster rate and remains above AVC curve. 3) When AVC is at minimum point (y), MC is equal to AVC. 4) MC curve cuts AVC curve at its minimum point. 5) The minimum point of MC curve (x) will always lie left to the minimum point of AVC curve (y). Or Define revenue. State the relation between marginal revenue and average revenue. Revenue is the amount of money that a company actually receives during a specific period. In other words, revenue refers to the sale proceeds or sales receipts. Relationship between MR and AR The relationship between AR and MR can be studied under two forms of market- under Perfect Competition market and under Imperfect Competition market. 1. Under Perfect Competition market, AR equals MR throughout all output levels. Graphically, MR curve is a straight horizontal line parallel to the x-axis and coincides with the AR curve. P age 7 of 22
2. Under Imperfect Competition market, as output increases both AR and MR fall. However, AR remains greater than MR at all levels of output. Also, when AR curve becomes zero, then the MR curve is negative. Graphically, both AR curve and MR curve are downward sloping but the AR curve remains above the MR curve. Q 11: A consumer consumes only two goods X and Y both priced at Rs. 3 per unit. If the consumer chooses a combination of these two goods with Marginal Rate of Substitution equal to 3, is the consumer in equilibrium? Give reasons. What will a rational consumer do in this situation? Explain. At the point of consumer equilibrium, the following equality should be met: MRS = Px/Py MRS = 3 (given) Px/Py= 3/3 = 1 Thus, MRS is greater than the price ratio. P age 8 of 22
In order to reach the equilibrium point, a rational consumer would increase the consumption of good X and decrease that of good Y. Or A consumer consumes only two goods X and Y whose prices are Rs. 4 and Rs. 5 per unit respectively. If the consumer chooses a combination of the two goods with marginal utility of X equal to 5 and that of Y equal to 4, is the consumer in equilibrium? Give reason. What will a rational consumer do in this situation? Use utility analysis. According to the utility approach, a consumer reaches equilibrium where the following equality is met. MUx/Px = MUY/Py MUx/Px =5/4 (given) MUY/Py = 4/5 So MUx/Px is greater than MUY/Py. Thus a rational consumer has to increase the consumption of good X and decrease that of good Y in order to reach equilibrium. Q 12: State the different phases of changes in Total Product and Marginal Product in the Law of Variable Proportions. Also show the same in a single diagram. The law of variable proportions state that as the quantity of one factor is increased, keeping the other factors fixed, the marginal product of that factor will eventually decline. This means that up to the use of a certain amount of variable factor, marginal product of the factor may increase and after a certain stage it starts diminishing. Assumptions of Law of Variable Proportions: 1. Constant State of Technology: First, the state of technology is assumed to be given and unchanged. If there is improvement in the technology, then the marginal product may rise instead of diminishing. 2. Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity is kept fixed. It is only in this way that we can alter the factor proportions and know its effects on output. The law does not apply if all factors are proportionately varied. 3. Possibility of Varying the Factor proportions: Thirdly, the law is based upon the possibility of varying the proportions in which the various factors can be combined to produce a product. The law does not apply if the factors must be used in fixed proportions to yield a product. P age 9 of 22
Behaviour of TP Stages Stage Name TP Range I Stage of increasing return TP increases at an From 0 to point F increasing rate till F Stage of diminishing return Increases at a decreasing From F to point H II rate and attains maximum at H III Stage of negative return. TP starts to fall From H onwards The whole production phase can be distinguished into three different production stages. I st Stage: Increasing Returns to a Factor This stages starts from the origin point O and continues till the point of inflexion (F) on the TP curve. During this phase, TP increases at an increasing rate and is also accompanied by rising MP curve. The MP curve attains its maximum point corresponding to the point of inflexion. Throughout this stage, AP continues to rise II nd Stage: Diminishing Returns to a Factor This stage starts from point F and continues till point H on the TP curve. During this stage, the TP increases but at a decreasing rate and attains its maximum point at H, where it remains constant. On the other hand, the MP curve continues to fall and cuts AP from its maximum point S, where MP equals AP. When TP attains its maximum point, corresponding to it, MP becomes zero. AP, in this stage initially rises, attains its maximum point at S and thereafter starts falling III rd Stage: Negative Returns to a Factor This stage begins from the point H on the TP curve. Throughout this point, TP curve is falling and MP curve is negative. Simultaneously, the AP curve continues to fall and approaches the x-axis (but does not touch it). P age 10 of 22
Q 13: Why is the equality between marginal cost and marginal revenue necessary for a firm to be in equilibrium? Is it sufficient to ensure equilibrium? Explain. Equilibrium refers to a state of rest when no change is required. A firm (producer) is said to be in equilibrium when it has no inclination to expand or to contract its output. This state either reflects maximum profits or minimum losses. According to MC=MR approach, As long as MC is less than MR, it is profitable for the producer to go on producing more because it adds to its profits. He stops producing more only when MC becomes equal to MR. When MC is greater than MR after equilibrium, it means producing more will lead to decline in profits. Both the conditions are needed for Firm s Equilibrium: 1. MC = MR: MR is the addition to TR from sale of one more unit of output and MC is addition to TC for increasing production by one unit. Every producer aims to maximize the total profits. For this, a firm compares it s MR with its MC. Profits will increase as long as MR exceeds MC and profits will fall if MR is less than MC. So, equilibrium is not achieved when MC < MR as it is possible to add to profits by producing more. Producer is also not in equilibrium when MC > MR because benefit is less than the cost. It means, the firm will be at equilibrium when MC = MR. 2. MC is greater than MR after MC = MR output level: MC = MR is a necessary condition, but not sufficient enough to ensure equilibrium. Only that output level is the equilibrium output when MC becomes greater than MR after the equilibrium. It is because if MC is greater than MR, then producing beyond MC = MR output will reduce profits. On the other hand, if MC is less than MR beyond MC = MR output, it is possible to add to profits by producing more. So, first condition must be supplemented with the second condition to attain the producer s equilibrium. P age 11 of 22
Q 14: Market for a good is in equilibrium. The demand for the good 'increases'. Explain the chain of effects of this change. Equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. When the supply and demand curves intersect, the market is in equilibrium. This is where the quantity demanded and quantity supplied are equal. The corresponding price is the equilibrium price or market-clearing price, the quantity is the equilibrium quantity. Suppose D1 and S1Sare the initial market demand curve and the initial market supply curve, respectively. The initial equilibrium is established at point E1, where the market demand curve and the market supply curve intersects each other. Accordingly, the equilibrium price is OP1 and the equilibrium quantity demanded is Oq1. Now, if there is an increase in the market demand, the market demand curve shifts parallely rightwards to D2 from D1, while the market supply curve remains unchanged at S1.. This implies that at the initial price OP1, there exist excess demand equivalent to (Oq'1 - Oq1) units. This excess demand will increase competition among the buyers and they will now be ready to pay a higher price to acquire more units of the good. This will further raise the market price. The price will continue to rise till it reaches OP2. The new equilibrium is established at point E2, where the new demand curve D2intersects the supply curve S1 Hence, an increase in demand with supply remaining constant, results in rise in the equilibrium price as well as the equilibrium quantity. SECTION - B Q 15: What is 'aggregate supply' in macroeconomics? P age 12 of 22
Aggregate supply is the total supply of goods and services produced within an economy at a given overall price level in a given time period. In other words supply refers to the total output produced in the country or the total national product of the country at a given level of employment. Q 16: The value of multiplier is: (choose the correct alternative) (a) 1/MPC (b) 1/MPS (c) 1/(1-MPS) (d) 1/(MPC-1) (b) 1/MPS Or, 1/(1-MPC) Q 17: Borrowing in government budget is: (choose the correct alternative) (a) Revenue deficit (b) Fiscal deficit (c) Primary deficit (d) Deficit in taxes (b) Fiscal deficit: The fiscal deficit is defined as the excess of government revenue over government expenditure. Hence borrowing in government budget is a fiscal deficit. Q 18: The non-tax revenue in the following is: (choose the correct alternative) (a) Export duty (b) Import duty (c) Dividends (d) Excise (c) Dividend: The non-tax revenue is dividends as the import duty, export duty and excise are different kinds of tax revenue for the government. P age 13 of 22
Q 19: Other things remaining unchanged, when in a country the price of foreign currency rises, national income is: (choose the correct alternative) (a) Likely to rise (b) Likely to fall (c) Likely to rise and fall both (d) Not affected (a) Likely to rise: As export is one of the main component of National Income, which increases as a result of rise in foreign currency price, there is likely an increase in the National income. Q 20: If Real GDP is Rs. 200 and Price Index (with base = 100) is 110, calculate Nominal GDP. Real GDP = (Nominal GDP/ Price Index of Current Year)*100 = Rs 200 (given) Price index = 110 Hence, 200 = (Nominal GDP/110)* 100 Therefore, Nominal GDP = (200*110)/100 = 220 Q 21: Name the broad categories of transactions recorded in the 'capital account' of the Balance of Payments Accounts. The Balance of Payments (Bop) records the transactions in goods, services and assets between residents of a country with the rest of the world for a specified time period typically a year. Capital account of BoP records public and private investment, and lending activities. It is the net change in foreign ownership of domestic assets. The following are the three broad categories of transactions recorded under capital account of BOP. 1. Foreign Investment Foreign investment is bifurcated into Foreign Direct Investment (FDI) and portfolio investment. FDI is the act of purchasing an asset and at the same time acquiring control on it. The FDI can be in the form of inflow of investment (credit) and outflow in the form of disinvestments (debit) or abroad in the reverse manner. P age 14 of 22
Portfolio investment is the acquisition of an asset, without control over it. Portfolio investment comes in the form of Foreign Institutional Investors (FIIs), offshore funds and Global Depository Receipts (GDRs) and American Depository Receipts (ADRs). 2. Loans and Borrowings - Loans are further classified into external assistance, medium and long-term commercial borrowings and short-term borrowings. Loans and borrowings by a country from the foreign countries or from the international money market are recorded in the Capital Account of the BOP. These borrowings can be in the form of commercial borrowings or in the form of assistance. When a country borrows with the consideration of assistance, the transaction would involve a lower rate of interest as compared to the prevailing market rate of interest. As against this, commercial borrowings involve open market rate of interest. Loans and borrowings result in inflow of foreign exchange into the country. Hence, they are recorded as positive items in the Capital Account of BOP. Unlike FDI and Portfolio Investments, loans and borrowings are debt creating capital transactions. 3. Banking Capital Transactions- Banking capital comprises external assets and liabilities of commercial and government banks authorized to deal in foreign exchange, and movement in balance of foreign central banks and international institutions like, World Bank, IDA, ADB and IFC maintained with RBI. Non-resident (NRI) deposits are an important component of banking capital. OR Name the broad categories of transactions recorded in the 'current account' of the Balance of Payments Accounts. Current account refers to an account which records all the transactions relating to export and import of goods and services and unilateral transfers during a given period of time. Current account contains the receipts and payments relating to all the transactions of visible items, invisible items and unilateral transfers. Components of Current Account: The main components of Current Account are: 1. Export and Import of Goods (Merchandise Transactions or Visible Trade): A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance). 2. Export and Import of Services (Invisible Trade): It includes a large variety of non- factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds: (a) Shipping, P age 15 of 22
(b) Banking, and (c) Insurance. Payments for these services are recorded on the negative side and receipts on the positive side. 3. Unilateral or Unrequited Transfers to and from abroad (One sided Transactions): Unilateral transfers include gifts, donations, personal remittances and other one-way transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side. 4. Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits. Q 22: Where will sale of machinery to abroad be recorded in the Balance of Payments Accounts? Give reasons. Sale of machinery to abroad (exports) will be recorded as positive item in the current account of BOP. Current account refers to an account which records all the transactions relating to export and import of goods and services and unilateral transfers during a given period of time. Current account contains the receipts and payments relating to all the transactions of visible items, invisible items and unilateral transfers. Those transactions that result in a inflow of foreign exchange in the country are recorded as positive items in the current account of BOP. On the other hand, those items that lead to an outflow of foreign exchange from the country are recorded as negative items in the current account of BOP. Therefore, as sale of machinery abroad leads to an inflow of foreign exchange in the country it will be recorded as a positive item in the current account of BOP. Q 23: Explain the 'bank of issue' function of the central bank. The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank. However, the currency issued by the central bank is its monetary liability. In other words, the central bank is obliged to back the currency issued by it by assets of equal value such as gold coins and bullions, foreign exchange. In addition to issuing currency to the general public, the central bank also issues currency to the central government of the country. P age 16 of 22
That is, the central government if required, can sell its securities to the central bank and in return gets the required cash currency. OR Explain 'Government's Bank' function of central bank. Central banks act as bankers, fiscal agents and advisers to their respective governments. As a banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government. It keeps the stock of gold of the government. Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt. The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc. Q 24: Government of India has recently launched 'Jan-Dhan Yojna' aimed at every household in the country to have at least one bank account. Explain how deposits made under the plan are going to affect national income of the country. With the Jan Dhan Yojna a greater number of individuals are brought under the ambit of banking system. Those individuals who earlier did not have savings account now have access to banking facilities and have opened savings account with the commercial banks. In this way, the commercial banks are able to tap greater savings which in turn can be used to lend loans for investment purposes. Thus, the yojna indirectly helps in increasing the investment and production in the economy which in turn would help in improving the national income. Q 25: An economy is in equilibrium. Calculate national income from the following: Autonomous consumption (C) = 100 Marginal propensity to save (S) = 0.2 Investment expenditure (I) = 200 Autonomous consumption (C) = 100 Marginal propensity to save (S) = 0.2 P age 17 of 22
Therefore MPC (c) = 1 - MPS = 1-0.2 = 0.8 Investment expenditure (I) = 200 Y = C+I at equilibrium = C+cY +I Y=100+0.8Y+200 Y=0.8Y+300 Hence, Y-0.8Y = 300 0.2Y = 300 So, Y = 300/.2 = 1,500 Q 26: Giving reason, explain how the following should be treated in estimation of national income: (i) Expenditure by a firm on payment of fees to a chartered accountant (ii) Payment of corporate tax by a firm (iii) Purchase of refrigerator by a firm for own use a) The services of chartered accountant hired by the firm should not be included in the estimation of national income. This is because it forms a part of the firm s intermediate consumption. b) Corporate profits already form part of national income. Hence Payment of corporate tax is not included in the national income as it is a mere transfer payment from the firm to the government. c) Purchase of refrigerator by a firm for own use will be included in the national income as it is regarded as final consumption expenditure. Q 27: Explain the concept of Inflationary Gap. Explain the role of Repo Rate in reducing this gap. Inflationary gap is also referred to as excess demand. When aggregate demand is greater than aggregate supply, at full employment level in the economy, it is referred to as inflationary gap or excess demand. This situation actually results in increase of prices, that is inflation. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF). P age 18 of 22
In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap. That is, FY EY = FE (Inflationary Gap) In the figure, AD1 and AS represents the aggregate demand curve and aggregate supply curve respectively. The economy is at full employment equilibrium at point E, where AD1 intersects AS curve. At this equilibrium point, OY represents full employment level and EY is aggregate demand at the full employment level of output. Suppose that the actual aggregate demand for output is FY, which is higher than EY. This implies that actual aggregate output demanded by the economy FY is more than the potential (full employment) aggregate output EY. Thus, the economy is facing surplus demand. This situation is termed as excess demand. As a result of the excess demand, inflationary gap arises. The inflationary gap is measured by the vertical distance between the actual aggregate demand for output and the potential (or full employment level) aggregate demand. In other words, the distance between FY and EY, i.e. FE represents the inflationary gap. Repo rate refers to the rate at which the central bank lends to the commercial bank. In case of inflationary gap, the central bank would increase repo rate. An increase in the repo rate increases the cost of borrowings for the commercial banks. This discourages the demand for loans and borrowings. Thereby, the consumption expenditure falls, and hence aggregate demand falls. OR Explain the concept of Deflationary Gap and the role of 'Open Market Operations' in reducing this gap. Deflationary gap is otherwise called as deficit demand. It is a situation where aggregate demand is less than aggregate supply at the level of full employment. Graphically, it is represented by the vertical distance between the aggregate demand at the full employment level of output (ADF) and the actual level of aggregate demand (ADE). In the figure below, EY denotes the aggregate demand at full employment level of P age 19 of 22
output and CY denotes the actual aggregate demand. The vertical distance between these two represents deflationary gap. EY CY = EC (Deflationary Gap) In the figure, AD1 and AS represents the aggregate demand curve and aggregate supply curve. The economy is at full employment equilibrium at point E, where AD1 intersects at AS curve. At this equilibrium point, OY represents the full employment level of output and EY is the aggregate demand at the full employment level of output. Let us suppose that the actual aggregate demand for output is only CY, which is lower than EY. This implies that actual aggregate output demanded by the economy CY falls short of the potential (full employment) aggregate output EY. Thus, the economy is facing a deficiency in demand. This situation is termed as deficit demand. As a result of the deficit demand, deflationary gap arises. The deflationary gap is measured by the vertical distance between the potential (or full employment level) aggregate demand and the actual aggregate demand for output. In other words, the distance between EY and CY, i.e. EC represents the deflationary gap. To correct deflationary gap, the central bank purchases the securities in the market through Open market operations (OMO). It refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Through OMO, the flow of money is increased and subsequently enhancing the purchasing power of the people. The higher purchasing power increases the aggregate demand. Q 28: Explain the role the government can play through the budget in influencing allocation of resources. Allocation of resources is one of the important objectives of government budget. In a mixed economy, the private producers aim towards profit maximisation, while, the government aims towards welfare maximisation. The private sector always tend to divert resources towards areas of high profit, while, ignoring areas of social welfare. In such a P age 20 of 22
situation, the government through the budgetary policy, aims to reallocate resources in accordance with the economic (profit maximisation) and social (public welfare) priorities of the country. Government can influence allocation of resources through: (i) Tax concessions or subsidies: To encourage investment, government can give tax concession, subsidies etc. to the producers. For example, Government discourages the production of harmful consumption goods (like liquor, cigarettes etc.) through heavy taxes and encourages the use of Khaki products by providing subsidies. (ii) Directly producing goods and services: If private sector does not take interest, government can directly undertake the production. Q 29: Calculate National Income and Personal Disposable Income: (Rs. crores) (i) Personal tax 80 (ii) Private final consumption expenditure 600 (iii) Undistributed profits 30 (iv) Private income 650 (v) Government final consumption expenditure 100 (vi) Corporate tax 50 (vii) Net domestic fixed capital formation 70 (viii) Net indirect tax 60 (ix) Depreciation 14 (x) Change in stocks ( ) 10 (xi) Net imports 20 (xii) Net factor income to abroad 10 Computation of National Income: National Income = Private final consumption expenditure + Government final consumption expenditure + (Net domestic fixed capital formation + depreciation + change in stock) - net imports - depreciation - Net Indirect Taxes - Net factor income to abroad National income = 600 + 100 + (70 + 14-10) - 20-14 - 60 10 P age 21 of 22
or, National income = Rs 670 crore Computation of Disposable income: Personal Disposable Income = Private income - Undistributed profits - Corporation tax Personal tax or, Personal Disposable Income = 650-30 - 50 80 or, Personal Disposable Income = Rs 490 crore P age 22 of 22