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GROUP 2
ECONOMICS FOR FINANCE

PAPER 8B - 40 MARKS
S.NO CHAPTER NAME UNIT NAME PAGE NO
1 NATIONAL INCOME ACCOUNTING 03
DETERMINATION OF
NATIONAL INCOME KEYNESIAN THEORY OF DETERIMNATION OF
2 34
NATIONAL INCOME
3 FISCAL FUNCTIONS AN OVERVIEW 68
4 MARKET FAILURE 78
GOVERNMENT INTERVENTIONS TO CORRECT
5 95
PUBLIC FINANCE MARKET FAILURE
6 FISCAL POLICY 112
7 THE CONCEPT OF MONEY DEMAND 130
8 THE CONCEPT OF MONEY SUPPLY 143
MONEY MARKET
9 MONETARY POLICY 157
10 THEORIES OF INTERNATIONAL TRADE 170
11 THE INSTRUMENTS OF TRADE POLICY 184
12 TRADE NEGOTIATIONS 197
INTERNATIONAL TRADE EXCHANGE RATE AND ITS ECONOMIC
13 211
EFFECTS
14 INTERNATIONAL CAPITAL MOVEMENTS 228
*Applicable for November 2023 Exams Onwards

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SHRESHTA For CA and CMA | SHRESHTA Professional Courses | CA Inter | P8B Economics For Finance
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1. NATIONAL INCOME
Q.NO.1 BREIFLY DISCUSS THE USEFULNESS AND SIGNIFICANCE OF NATIONAL INCOME

ESTIMATES?
ANSWER:
USEFULNESS AND SIGNIFICANCE OF NATIONAL INCOME ESTIMATES
National income accounts are fundamental aggregate statistics in macroeconomic analysis and are
extremely useful, especially for the emerging and transition economies.
1. National income accounts provide a comprehensive, conceptual and accounting framework for
analyzing and evaluating the short-run performance of an economy. The level of national income
indicates the level of economic activity and economic development as well as aggregate demand
for goods and services of a country.
2. The distribution pattern of national income determines the pattern of demand for goods and
services and enables businesses to forecast the future demand for their products.
3. Economic welfare depends to a considerable extent on the magnitude and distribution of
national income, size of per capita income and the growth of these over time.
4. The estimates of national income show the composition and structure of national income in
terms of different sectors of the economy, the periodical variations in them and the broad
sectoral shifts in an economy over time. It is also possible to make temporal and spatial
comparisons of the trend and speed of economic progress and development. Using this
information, the government can fix various sector-specific development targets for different
sectors of the economy and formulate suitable development plans and policies to increase
growth rates.
5. National income statistics also provide a quantitative basis for macroeconomic modelling and
analysis, for assessing and choosing economic policies and for objective statement as well as
evaluation of governments’ economic policies. These figures often influence popular and
political judgments about the relative success of economic programmes.
6. National income estimates throw light on income distribution and the possible inequality in the
distribution among different categories of income earners. It is also possible to make
comparisons of structural statistics, such as ratios of investment, taxes, or government
expenditures to GDP.
7. International comparisons in respect of incomes and living standards assist in determining
eligibility for loans, and/or other funds or conditions under which such loans, and/ or funds are
made available. The national income data are also useful to determine the share of nation’s
contributions to various international bodies.
8. Combined with financial and monetary data, national income data provides a guide to make
policies for growth and inflation.
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9. National income or a relevant component of it is an indispensable variable considered in
economic forecasting and to make projections about the future development trends of the
economy.
Q.NO.2 BREIFLY DISCUSS DIFFERENT CONCEPTS OF NATIONAL INCOME?
ANSWER:
1. The basic concepts and definitions of the terms used in national accounts largely follow those
given in the UN System of National Accounts (SNA) developed by United Nations to provide a
comprehensive, conceptual and accounting framework for compiling and reporting
macroeconomic statistics for analysing and evaluating the performance of an economy.
2. Each of these concepts has a specific meaning, use and method of measurement.
3. National income accounts have three sides: a product side, an expenditure side and an income
side.
a. The product side measures production based on concept of value added.
b. The expenditure side looks at the final sales of goods and services,
c. whereas the income side measures the distribution of the proceeds from sales to different
factors of production.
4. Accordingly, national income is a measure of the total flow of ‘earnings of the factor-owners’
which they receive through the production of goods and services. Thus, national income is the
sum total of all the incomes accruing over a specified period to the residents of a country and
consists of wages, salaries, profits, rent and interest.
5. On the product side there are two widely reported measures of overall production namely,
Gross Domestic Product (GDP) and Gross National Product (GNP).
6. CONCEPTS OF NATIONAL INCOME
A. Gross Domestic Product (GDP MP)
a. Gross domestic product (GDP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country during a given time period.
b. It is the sum total of ‘value added’ by all producing units in the domestic territory and
includes value added by current production by foreign residents or foreign-owned firms.
c. The term ‘gross’ implies that GDP is measured ‘gross’ of depreciation.’ Domestic’ refers
to ‘the geographic confines’ of a country.
i. if a Chinese citizen works temporarily in India, her production is part of the Indian
GDP.
ii. If an Indian citizen owns a factory in another country, for e.g. Germany, the
production at her factory is not part of India’s GDP.
d. However, GDP excludes transfer payments, financial transactions and non-reported
output generated through illegal transactions such as narcotics and gambling.
e. Gross Domestic Product (GDP) is in fact Gross Domestic Product at market prices (GDP
MP) because the value of goods and services is determined by the common measuring
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unit of money or it is evaluated at market prices.
f. Money enables us to measure and find the aggregate of different types of products
expressed in different units of measurement by converting them in terms of Rupees, say
tonnes of wheat may, thus, be added with millions of apples and with value of services
such as airplane journeys.
GDPMP = Value of Output in the Domestic Territory – Value of Intermediate Consumption
GDP MP = Σ Value Added
NOTE
a. FINAL GOODS AND SERVICES:
i. The value of only final goods and services or only the value added by the production
process would be included in GDP.
ii. Final goods refer to those goods which are used either for consumption or for
investment.
iii. They are neither resold nor undergo further transformation in the process of
production.
iv. The distinction between intermediate goods and final goods is made on the basis of
end use: if the good is for consumption or investment, then it is a final good.
v. By ‘value added’ we mean the difference between value of output and purchase of
intermediate goods. Value added represents the contribution of labour and capital to
the production process.
b. INTERMEDIATE GOODS
i. Intermediate goods refer to those goods which are used either for resale or for
further production in the same year.
ii. They do not end up in final consumption, and are not capital goods either. The
intermediate goods or services may be either transformed or used up by the
production process. They have derived demand.
iii. Intermediate goods are used up in the same year; if they remain for more than one
year, then they are treated as final goods.
iv. Intermediate consumption consists of the value of the goods and services consumed
as inputs by a process of production, excluding fixed assets whose consumption is
recorded as consumption of fixed capital.
v. Intermediate goods used to produce other goods rather than being sold to final
purchasers are not counted as it would involve double counting. The intermediate
goods or services may be either transformed or used up by the production process.
Ex: The value of flour used in making bread would not be counted as it will be included
while bread is counted. This is because flour is an intermediate good in bread making
process. Similarly, if we include the value of an automobile in GDP, we should not be
including the value of the tyres separately.
c. Gross Domestic Product (GDP) is a measure of production activity.
i. GDP covers all production activities recognized by SNA called the ‘production
boundary’. The production boundary covers production of almost all goods and
services classified in the National Industrial Classification (NIC).
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ii. Production of agriculture, forestry and fishing which are used for own consumption
of producers is also included in the production boundary.
iii. Thus, Gross Domestic Product (GDP) of any nation represents the sum total of gross
value added (GVA) (i.e, without discounting for capital consumption or depreciation)
in all the sectors of that economy during the said year.
d. Economic activities, as distinguished from non-economic activities, include all human
activities which create goods and services that are exchanged in a market and valued at
market price. Non-economic activities are those which produce goods and services, but
since these are not exchanged in a market transaction, they do not command any market
value.
Ex: hobbies, housekeeping and child rearing services of home makers and services of
family members that are done out of love and affection.
e. National income is a ‘flow’ measure of output per time period—for example, per year—
and includes only those goods and services produced in the current period i.e. produced
during the time interval under consideration.
i. The value of market transactions such as exchange of goods which already exist or
are previously produced, do not enter into the calculation of national income.
ii. Therefore, the value of assets such as stocks and bonds which are exchanged during
the pertinent period are not included in national income as these do not directly
involve current production of goods and services.
iii. However, the value of services that accompany the sale and purchase (e.g. fees paid
to real estate agents and lawyers) represent current production and, therefore, is
included in national income.
f. An important point to remember is that two types of goods used in the production process
are counted in GDP namely, capital goods (business plant and equipment purchases) and
inventory investment—the net change in inventories of final goods awaiting sale or of
materials used in the production which may be positive or negative.
i. Inventories are treated as capital.
ii. Additions to inventory stocks of final goods and materials belong to GDP because
they are currently produced output.
The national income in real terms when available by industry of origin, give a measure of
the structural changes in the pattern of production in the country which is vital for
economic analysis.
B. Nominal GDP verses Real GDP: GDP at Current and Constant prices
1. When GDP is estimated on the basis of current year’s market prices, it is called ‘nominal
GDP’ or ‘GDP at current prices’.
For example, GDP of year 2020-21 may be measured using prices of 2020-21.
2. Nominal GDP changes from year to year for two reasons.
a. First, the amount of goods and services produced changes, and
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b. second, market prices change.
3. Changes in GDP due to changes in prices fail to correctly explain the performance of the
economy in producing goods and services.
4. Therefore, for making comparisons of GDP at different points of time, we need to
compute real GDP. Real GDP is calculated in such a way that the goods and services
produced in a particular year are evaluated at some constant set of prices or constant
prices. In other words, it is calculated using the prices of a selected ‘base year’.
For example, if 2011-12 is selected as the base year, then real GDP for 2020-21 will be
calculated by taking the quantities of all goods and services produced in 2020-21 and
multiplying them by their 2011-12 prices.
5. Thus, real GDP or GDP at constant prices refers to the total money value of the final
goods and services produced within the domestic territory of a country during an
accounting year, estimated using base year prices.
6. Real GDP is an inflation-adjusted measure and is not affected by changes in prices; it
changes only when there is change in the amount of output produced in the economy.
7. Real GDP is a better measure of economic well being as it shows the true picture of the
change in production of an economy.
8. GDP DEFLATOR
a. The calculation of real GDP gives us a useful measure of inflation known as GDP
deflator. The GDP deflator is the ratio of nominal GDP in a given year to real GDP of
that year.
GDP Deflator = Nominal GDP/Real GDP X100
b. The GDP deflator, as the name implies, can be used to ‘deflate’ or take inflation out
of GDP. In other words, the GDP deflator is a price index used to convert nominal
GDP to real GDP
Real GDP = Nominal GDP/GDP Deflator x100
c. The deflator measures the change in prices that has occurred between the base year
and the current year.
d. In other words, it measures the current level of prices relative to the level of prices in
the base year.
For example, in 2019 if the nominal GDP is 6,000 billion and real GDP is 3,500 billion,
the GDP deflator is 171.43. Since nominal GDP and real GDP must be the same in the
base year, the deflator for the base year is always 100.
e. Inflation is a closely monitored aspect of macroeconomic performance and a
significant variable guiding macroeconomic policy. Using the GDP deflator, the
inflation rate between two consecutive years can be compute using the following
procedure:
Inflation rate in year 2 = (GDP deflator in year 2 - GDP deflator in year 1) / GDP
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deflator in year 1 x 100

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For example, if the GDP deflator in 2020 increased to 240 from 171 in 2019,
Inflation rate in year 2 = (240 -171)/171 *100
= 40.35 percent
(REFER ILLUSTRRATIONS 1-4)
C. Gross National Product (GNP)
1. Gross National Product (GNP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country by normal residents during an accounting year including net factor incomes from
abroad.
2. It is the total income earned by a nation’s permanent residents (called nationals). It
differs from GDP by including income that our citizens earn abroad and excluding income
that foreigners earn here.
3. Gross National Product (GNP) is evaluated at market prices and therefore it is in fact
Gross National Product at market prices (GNP MP).
GNP MP = GDP MP +Factor income earned by the domestic factors of production
employed in the rest of the world - Factor income earned by the factors of production of
the rest of the world employed in the domestic territory.
GNP MP = GDP MP + Net Factor Income from Abroad
GDP MP = GNP MP – Net Factor Income from Abroad (NFIA)
4. NFIA is the difference between the aggregate amount that a country's citizens and
companies earn abroad, and the aggregate amount that foreign citizens and overseas
companies earn in that country.
NFIA =Net compensation of employees + Net income from property and
entrepreneurship + Net retained earnings
5. If Net Factor Income from Abroad is positive, then GNPMP would be greater than
GDPMP.
6. You might have noticed that the distinction between ‘national’ and ‘domestic’ is net
factor income from abroad.
National = Domestic + Net Factor Income from Abroad
7. The two concepts GDP and GNP differ in their treatment of international transactions.
The term ‘national’ refers to normal residents of a country who may be within or outside
the domestic territory of a country and is a broader concept compared to the term
‘domestic’. For example, GNP includes earnings of Indian corporations overseas and
Indian residents working overseas; but GDP does not include these.
8. In other words, GDP excludes net factor income from abroad. Conversely, GDP includes
earnings from current production in India that accrue to foreign residents or foreign-
owned firms; GNP excludes those items.
For instance, profits earned in India by X Company, a foreign-owned firm, would be
included in GDP but not in GNP. Similarly, profits earned by Company Y, an Indian
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company in UK would be excluded from GDP, but included in GNP.
D. Net Domestic Product at Market Prices (NDPMP)
1. Net domestic product at market prices (NDPMP) is a measure of the market value of all
final economic goods and services, produced within the domestic territory of a country
by its normal residents and non-residents during an accounting year less depreciation.
2. The portion of the capital stock used up in the process of production or depreciation
must be subtracted from final sales because depreciation represents capital consumption
and therefore a cost of production.
NDP MP = GDP MP – Depreciation
3. As you are aware, the basis of distinction between ‘gross’ and ‘net’ is depreciation or
consumption of fixed capital.
Gross = Net + Depreciation or Net = Gross – Depreciation
E. Net National Product at Market Prices (NNPMP)
Net National Product at Market Prices (NNPMP) is a measure of the market value of all final
economic goods and services, produced by normal residents within the domestic territory of
a country including Net Factor Income from Abroad during an accounting year excluding
depreciation.
NNP MP = GNP MP – Depreciation
NNP MP = NDP MP + Net Factor Income from Abroad
NNP MP = GDP MP + Net Factor Income from Abroad – Depreciation
F. Gross Domestic Product at Factor Cost (GDPFC)
1. The production and income approach (which we will discuss later in this unit) measure
the domestic product as the cost paid to the factors of production. Therefore, it is known
as ‘domestic product at factor cost’.
2. GDP at factor cost is called so because it represents the total cost of factors viz. labour
capital, land and entrepreneurship.
3. At this stage, we need to clearly understand the difference between the concepts:
‘market price’ and ‘factor cost.’ In addition to factor cost, the market value of the goods
and services will include indirect taxes and subsidies such as:
i. Production taxes or subsidies that are paid or received in relation to production and
are independent of the volume of actual production.
Examples of production taxes are land revenues, stamps and registration fees and tax
on profession, factory license fee, taxes to be paid to the local authorities, pollution
tax etc.
Examples of production subsidies are subsidies to railways, subsidies to village and
small industries.
ii. Product taxes or subsidies that are paid or received on per unit of product.
Examples of product taxes are excise duties, sales tax, service tax and import export
duties.
Examples of product subsidies are food, petroleum and fertilizer subsidies.
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4. The market price will be lower by the amount of subsidies on products and production
which the government pays to the producer.
5. Hence, the market value of final expenditure would exceed the total obtained at factor
cost by the amount of product and production taxes reduced by the value of similar
kinds of subsidies. Direct taxes do not have the same effect since they do not impinge
directly on transactions but are levied directly on the incomes.
For example, if the factor cost of a unit of good X is Rs..50/, indirect taxes amount to
Rs.15/per unit and the government gives a subsidy of Rs..10/per unit, then market price
will be Rs.55/-
6. Thus, we find that the basis of distinction between market price and factor cost is net
indirect taxes (i.e., Indirect taxes - Subsidies).
Market Price = Factor Cost + Net Indirect Taxes
= Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price - Net Indirect Taxes
= Market Price - Indirect Taxes + Subsidies
Gross Domestic Product at Factor Cost (GDPFC)
= GDP MP – Indirect Taxes + Subsidies
= Compensation of employees
+ Operating Surplus (rent + interest+ profit)
+ Mixed Income of Self- employed
+ Depreciation
G. Net Domestic Product at Factor Cost (NDPFC)
1. Net Domestic Product at Factor Cost (NDPFC)is defined as the total factor incomes
earned by the factors of production. In other words, it is sum of domestic factor incomes
or domestic income net of depreciation.
2. As mentioned above, market price includes indirect taxes imposed by government. We
have to deduct indirect taxes and add the subsidies in order to calculate that part of
domestic product which actually accrues to the factors of production. The measure that
we obtain so is called Net Domestic Product at factor cost.
NDPFC = NDP MP – Net Indirect Taxes
= Compensation of employees + Operating Surplus (rent + interest+ profit) + Mixed
Income of Self- employed
H. Net National Product at Factor Cost (NNPFC)or National Income
1. National Income is defined as the factor income accruing to the normal residents of the
country during a year. It is the sum of domestic factor income and net factor income
from abroad.
2. In other words, national income is the value of factor income generated within the
country plus factor income from abroad in an accounting year.
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NNPFC = National Income = FID (factor income earned in domestic territory) + NFIA.
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If NFIA is positive, then national income will be greater than domestic factor incomes.
I. Per Capita Income
The GDP per capita is a measure of a country's economic output per person. It is obtained by
dividing the country’s gross domestic product, adjusted by inflation, by the total population.
It serves as an indicator of the standard of living of a country.
J. Personal Income
1. While national income is income earned by factors of production, Personal Income is the
income received by the household sector including Non-Profit Institutions Serving
Households.
2. Thus, national income is a measure of income earned and personal income is a measure
of actual current income receipts of persons from all sources which may or may not be
earned from productive activities during a given period of time.
3. In other words, it is the income ‘actually paid out’ to the household sector, but not
necessarily earned.
Examples of this include transfer payments such as social security benefits,
unemployment compensation, welfare payments etc.
4. Individuals also contribute income which they do not actually receive;
Example, undistributed corporate profits and the contribution of employers to social
security.
5. Personal income excludes retained earnings, indirect business taxes, corporate income
taxes and contributions towards social security.
6. Households receive interest payments from the firms and governments; they also make
interest payments to firms and governments.
7. As such, the net interest paid by households to firms and government is also deducted
from national income. Personal income forms the basis for consumption expenditures
and is derived from national income as follows:
PI = NI + income received but not earned – income earned but not received.
PI = NI - Undistributed profits – Net interest payments made by households –
Corporate Tax +Transfer Payments to the households from firms and government.
Note: An important point to remember is that national income is not the sum of personal
incomes because personal income includes transfer payments (eg. pension) which are
excluded from national income. Further, not all national income accrues to individuals as
their personal income.
K. Disposable Personal Income (DI)
1. Disposable personal income is a measure of amount of the money in the hands of the
individuals that is available for their consumption or savings.
2. Disposable personal income is derived from personal income by subtracting the direct
taxes paid by individuals and other compulsory payments made to the government.
DI = PI - Personal Income Taxes – Non tax payments
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3. Apart from the above aggregates, a few other aggregates are reported in India. These
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reflect the amount of goods and services the domestic economy has at its disposal.
4. Two more concepts need to be understood, namely:
a. Net National Disposable Income
Net National Disposable Income (NNDI) = Net National Income + other net current
transfers from the rest of the world (Receipts less payments)
Net National Disposable Income (NNDI) = NNI + net taxes on income and wealth
receivable from abroad + net social contributions and benefits receivable from
abroad.
b. Gross National Disposable Income (GNDI) = NNDI + CFC = GNI + other net current
transfers from the rest of the world (Receipts less payments)
(Other Current Transfers refer to current transfers other than the primary incomes)
c. Domestic Income may be categorized into:
1. Income from domestic product accruing to the public sector which includes
income from property and entrepreneurship accruing to government
administrative departments and savings of non-departmental enterprises.
2. Income from domestic product accruing to private sector = NDPFC - Income from
property and entrepreneurship accruing to government administrative
departments - Savings of non-departmental enterprises.
L. Private Income
Private income is a measure of the income (both factor income and transfer income) which
accrues to private sector from all sources within and outside the country.
Private Income = Factor income from net domestic product accruing to the private sector +
Net factor income from abroad + National debt interest + Current transfers from
government + Other net transfers from the rest of the world.
(REFER ILLUSTRRATIONS 5-8)
Q.NO.3 HOW THE MEASUREMENT OF NATIONAL INCOME IN INDIA TAKES PLACE?
ANSWER:
1. National Accounts Statistics (NAS) in India are compiled by National Accounts Division in the
Central Statistics Office, Ministry of Statistics and Programme Implementation (MOSPI).
2. Annual as well as quarterly estimates are published. This publication is the key source-material
for all macroeconomic data of the country.
3. As per the mandate of the Fiscal Responsibility and Budget Management Act 2003, the Ministry
of Finance uses the GDP numbers (at current prices) to determine the fiscal targets.
4. The Ministry of Statistics and Programme Implementation has released the new series of
national accounts, revising the base year from 2004-05 to 2011-12.
5. In the revision of National Accounts statistics done by Central Statistical Organization (CSO) in
January 2015, it was decided that sector-wise estimates of Gross Value Added (GVA) will now be
given at basic prices instead of at factor cost.
6. In simple terms, for any commodity the ‘basic price’ is the amount receivable by the producer
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from the purchaser for a unit of a product minus any tax on the product plus any subsidy on
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the product
Q.NO.4 EXPLAIN THE CIRCULAR FLOW OF INCOME AND DESCRIBE ITS RELEVANCE IN
MEASUREMENT OF NATIONAL INCOME?
ANSWER:
Circular flow of income refers to the continuous circulation of production, income generation and
expenditure involving different sectors of the economy. There are three different interlinked phases
in a circular flow of income, namely: production, distribution and disposition as can be seen from
the following figure.
(i) In the production phase, firms produce goods and services with the help of factor services.
(ii) In the income or distribution phase, the flow of factor incomes in the form of rent, wages,
interest and profits from firms to the households occurs
(iii) In the expenditure or disposition phase, the income received by different factors of
production is spent on consumption goods and services and investment goods. This
expenditure leads to further production of goods and services and sustains the circular flow.
These processes of production, distribution and disposition keep going on simultaneously and
enable us to look at national income from three different angles namely:
as a flow of production or value added,
as a flow of income and
as a flow of expenditure.
Each of these different ways of looking at national income suggests a different method of
calculation and requires a different set of data.
The details in respect of what is measured and what data are required for all three methods
mentioned above are given in the following table.
Data requirements and Outcomes of Different Methods of National Income Calculation

Method Data required What is measured
Phase of Output: Value added The sum of net values added Contribution of production
method (Product Method) by all the producing units
enterprises of the country
Phase of income: Income Total factor incomes Relative contribution of
Method generated in the production factor owners
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of goods and services

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Phase of disposition: Sum of expenditures of the Flow of consumption and
Expenditure method three spending units in the investment expenditures
economy, namely,
government, consumer
households, and producing
enterprises
Corresponding to the three phases, there are three methods of measuring national income.
They are:
Value Added Method (alternatively known as Product Method);
Income Method; and
Expenditure Method.
Q.NO.5 EXPLAIN VALUE ADDED METHOD OR PRODUCT METHOD IN CALCULATING NATIONAL

INCOME?
ANSWER:
Product Method or Value-Added Method is also called Industrial Origin Method or Net Output
Method.
1. National income by value added method is the sum total of net value added at factor cost across
all producing units of the economy.
2. The value-added method measures the contribution of each producing enterprise in the
domestic territory of the country in an accounting year and entails consolidation of production
of each industry less intermediate purchases from all other industries.
3. This method of measurement shows the unduplicated contribution by each industry to the total
output. This method involves the following steps:
Step1. Identifying the producing enterprises and classifying them into different sectors
according to the nature of their activities
All the producing enterprises are broadly classified into three main sectors namely:
(i) Primary sector,
(ii) Secondary sector, and
(iii) Tertiary sector or service sector
These sectors are further divided into sub-sectors and each sub-sector is further divided into
commodity group or service-group.
Step 2. Estimating the gross value added (GVAMP) by each producing enterprise (This is the
same as GDPMP)
Gross value added (GVA MP) = Value of output – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption
While calculating the value added, we are actually finding value of production of the firm.
Production of the firm = Value added + intermediate consumption.
(Note that imports are included in the value of intermediate consumption if total purchases
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are given. If domestic purchases are specifically mentioned, then imports will also be added.
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Also, sales include exports, if domestic sales are separately mentioned, exports need to be
added)
Step 3. Estimation of National income
For each individual unit, Net value added is found out.
∑ (GVA MP) – Depreciation = Net value added (NVA MP)
Adding the net value-added by all the units in one sub-sector, we get the net value-added by
the sub-sector.
By adding net value-added or net products of all the sub-sectors of a sector, we get the
value-added or net product of that sector.
For the economy as a whole, we add the net products contributed by each sector to get Net
Domestic Product. We subtract net indirect taxes and add net factor income from abroad to
get national income.
Net value added (NVA MP) – Net Indirect taxes = Net Domestic Product (NVA FC)
Net Domestic Product (NVA FC) + (NFIA) = National Income (NNP FC)
4. The values of the following items are also included:
i) Own account production of fixed assets by government, enterprises and households.
ii) Imputed value of production of goods for self- consumption, and
iii) Imputed rent of owner occupied houses.
iv) Change in stock(inventory)
Q.NO.6 EXPLAIN INCOME METHOD IN CALCULATING NATIONAL INCOME?

ANSWER:
1. Production is carried out by the combined effort of all factors of production. The factors are paid
factor incomes for the services rendered. In other words, whatever is produced by a producing
unit is distributed among the factors of production for their services.
2. Under Factor Income Method, also called Factor Payment Method or Distributed Share Method,
national income is calculated by summation of factor incomes paid out by all production units
within the domestic territory of a country as wages and salaries, rent, interest, and profit. By
definition, it includes factor payments to both residents and non- residents.
Thus,
NDP FC = Sum of factor incomes paid out by all production units within the domestic territory
of a country
NNP FC or National Income= Compensation of employees + Operating Surplus (rent +
interest+ profit) + Mixed Income of Self- employed + Net Factor Income from Abroad
3. ITEMS TO BE INCLUDED AND EXLUDED:

a. Only incomes earned by owners of primary factors of production are included in national
income. Thus, while wages of labourers will be included, pensions of retired workers will be
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excluded from national income.

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b. Compensation of employees includes, apart from wages and salaries, bonus, dearness
allowance, commission, employers’ contribution to provident fund and imputed value of
compensation in kind. Non-labour income includes rent (actual and imputed), royalty,
interest on loans availed for productive services, dividends, undistributed profits of
corporations before taxes, and profits of unincorporated enterprises and of government
enterprises.
(Note: Interest paid by government on public debt, interest on consumption loans and
interest paid by one firm to another are excluded.
Profit =Corporate taxes+ dividend retained+ earnings)
c. While using income method, capital gains, windfall profits, transfer incomes and income
from sale of second-hand goods and financial assets and payments out of past savings are
not included. However, commissions, brokerages and imputed value of services provided by
owners of production units will be included as these add to the current flow of goods and
services.
d. Usually it is difficult to separate labour income from capital income because in many
instances people provide both labour and capital services. Such is the case with self-
employed people like lawyers, engineers, traders, proprietors etc. In economies where
subsistence production and small commodity production is dominant, most of the incomes
of people would be of mixed type. In sectors such as agriculture, trade, transport etc. in
underdeveloped countries (including India), it is difficult to differentiate between the labour
element and the capital element of incomes of the people. In order to overcome this
difficulty a new category of incomes, called ‘mixed income’ is introduced which includes all
those incomes which are difficult to separate.
Q.NO.7 EXPLAIN EPENDITURE METHOD IN CALCULATING NATIONAL INCOME?

ANSWER:
EXPENDITURE METHOD
1. In the expenditure approach, also called Income Disposal Approach, national income is the
aggregate final expenditure in an economy during an accounting year.
GDPMP = ∑ Final Expenditure
2. In this approach to measuring GDP which considers the demand side of the products, we add up
the value of the goods and services purchased by each type of final user mentioned below.
A. Final Consumption Expenditure
a. Private Final Consumption Expenditure (PFCE)
i) To measure this, the volume of final sales of goods and services to consumer
households and non-profit institutions serving households acquired for consumption
(not for use in production) are multiplied by market prices and then summation is
done.
16
ii) It also includes the value of primary products which are produced for own
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consumption by the households, payments for domestic services which one
household renders to another, the net expenditure on foreign financial assets or net
foreign investment.
iii) Land and residential buildings purchased or constructed by households are not part
of PFCE. They are included in gross capital formation.
iv) Thus, only expenditure on final goods and services produced in the period for which
national income is to be measured and net foreign investment are included in the
expenditure method of calculating national income.
b. Government Final Consumption Expenditure
i) Since the collective services provided by the governments such as defence,
education, healthcare etc. are not sold in the market, the only way they can be
valued in money terms is by adding up the money spent by the government in the
production of these services.
ii) This total expenditure is treated as consumption expenditure of the government.
Government expenditure on pensions, scholarships, unemployment allowance etc.
should be excluded because these are transfer payments.
B. Gross Domestic Capital formation
a. Gross domestic fixed capital formation (Gross Investment) is that part of country's total
expenditure which is not consumed but added to the nation's fixed tangible assets and
stocks.
b. It consists of the acquisition of fixed assets and the accumulation of stocks. The stock
accumulation is in the form of changes in stock of raw materials, fuels, finished goods
and semi-finished goods awaiting completion.
c. Thus, gross investment includes final expenditure on machinery and equipment and own
account production of machinery and equipment, expenditure on construction,
expenditure on changes in inventories, and expenditure on the acquisition of valuables
such as, jewellery and works of art.
C. Net Exports
a. Net exports are the difference between exports and imports of a country during the
accounting year. It can be positive or negative.
b. How do we arrive at national income or NNPFC using expenditure method?
i) We first find the sum of final consumption expenditure, gross domestic capital
formation and net exports.
ii) The resulting figure is gross domestic product at market price (GDPMP).
iii) To this, we add the net factor income from abroad and obtain Gross National Product
at market price (GNPMP).
iv) Subtracting net indirect taxes from GNPMP, we get Gross National Product at factor
cost (GNPFC).
v) National income or NNPFC is obtained by subtracting depreciation from Gross
17
national product at factor cost (GNPFC).

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NOTE:
1. Ideally, all the three methods of national income computation should arrive at the same
figure. When national income of a country is measured separately using these methods, we
get a three-dimensional view of the economy.
2. Each method of measuring GDP is subject to measurement errors and each method provides
a check on the accuracy of the other methods. By calculating total output in several different
ways and then trying to resolve the differences, we will be able to arrive at a more accurate
measure than would be possible with one method alone.
3. Moreover, different ways of measuring total output give us different insights into the
structure of our economy.
4. Income method may be most suitable for developed economies where people properly file
their income tax returns. With the growing facility in the use of the commodity flow method
of estimating expenditures, an increasing proportion of the national income is being
estimated by expenditure method.
5. As a matter of fact, countries like India are unable to estimate their national income wholly
by one method. Thus, in agricultural sector, net value added is estimated by the production
method, in small scale sector net value added is estimated by the income method and in the
construction sector net value added is estimated by the expenditure method.
(REFER ILLUSTRATIONS 9-15)
Q.NO.8 EXPLAIN THE SYSTEM OF REGIONAL ACCOUNTS IN INDIA?

ANSWER:
THE SYSTEM OF REGIONAL ACCOUNTS IN INDIA
1. Regional accounts provide an integrated database on the innumerable transactions taking place
in the regional economy and help decision making at the regional level. At present, practically all
the states and union territories of India compute state income estimates and district level
estimates.
2. State Income or Net State Domestic Product (NSDP) is a measure in monetary terms of the
volume of all goods and services produced in the state within a given period of time (generally a
year) accounted without duplication.
3. Per Capita State Income is obtained by dividing the NSDP (State Income) by the midyear
projected population of the state.
4. The state level estimates are prepared by the State Income Units of the respective State
Directorates of Economics and Statistics (DESs). The Central Statistical Organisation assists the
States in the preparation of these estimates by rendering advice on conceptual and
methodological problems.
5. In the preparation of state income estimates, certain activities such as railways,
communications, banking and insurance and central government administration, that cut across
18
state boundaries, and thus their economic contribution cannot be assigned to any one state
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directly are known as the ‘Supra-regional sectors’ of the economy.
6. The estimates for these supra regional activities are compiled for the economy as a whole and
allocated to the states on the basis of relevant indicators.
Q.NO.9 CAN THE GDP OF A COUNTRY BE TAKEN AS AN INDEX OF WELFARE OF PEOPLE IN THAT
COUNTRY?
ANSWER:
There are many reasons to dispute the validity of GDP as a perfect measure of well- being. In fact,
GDP measures our ability to obtain many requirements to make our life better; yet leave out many
important aspects which ensure good quality of life for all. GDP measures exclude the following
which are critical for the overall wellbeing of citizens.
a. Income distributions and, therefore, GDP per capita is a completely inadequate measure of
welfare. Countries may have significantly different income distributions and, consequently,
different levels of overall well-being for the same level of per capita income.
b. Quality improvements in systems and processes due to technological as well as managerial
innovations which reflect true growth in output from year to year.
c. Productions hidden from government authorities, either because those engaged in it are
evading taxes or because it is illegal (drugs, gambling etc.).
d. Non market production (with a few exceptions) and Non-economic contributors to well-being
for example: health of a country’s citizens, education levels, political participation, or other social
and political factors that may significantly affect well-being levels.
e. The disutility of loss of leisure time. We know that, other things remaining the same, a country’s
GDP rises if the total hours of work increase.
f. Economic ’bads’ for example: crime, pollution, traffic congestion etc which make us worse off.
g. The volunteer work and services rendered without remuneration undertaken in the economy,
even though such work can contribute to social well-being as much as paid work.
h. Many things that contribute to our economic welfare such as, leisure time, fairness, gender
equality, security of community feeling etc.,
i. Both positive and negative externalities which are external effects that do not form part of
market transactions
j. The distinction between production that makes us better off and production that only prevents
us from becoming worse off,
for e.g. defence expenditures such as on police protection. Increased expenditure on police due to
increase in crimes may increase GDP but these expenses only prevent us from becoming worse
off. However, no reflection is made in national income of the negative impacts of higher crime
rates. As another example, automobile accidents result in production of repairs, output of
medical services, insurance, and legal services all of which are production included in GDP just as
any other production.
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Q.NO.10 DISCUSS THE LIMITATIONS AND CHALLENGESOF NATIONAL INCOME COMPUTATION?
ANSWER:
LIMITATIONS AND CHALLENGESOF NATIONAL INCOME COMPUTATION
There are innumerable limitations and challenges in the computation of national income. The task is
more complex in underdeveloped and developing countries. Following are the general dilemmas in
measurement of national income.
1. There are many conceptual difficulties related to measurement which are difficult to resolve,
such as:
a. lack of an agreed definition of national income,
b. accurate distinction between final goods and intermediate goods,
c. issue of transfer payments,
d. services of durable goods,
e. difficulty of incorporating distribution of income,
f. valuation of a new good at constant prices, and
g. valuation of government services
2. Other challenges relate to:
a. Inadequacy of data and lack of reliability of available data,
b. presence of non-monetised sector,
c. production for self-consumption,
d. absence of recording of incomes due to illiteracy and ignorance,
e. lack of proper occupational classification, and
f. accurate estimation of consumption of fixed capital
20
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Numerical Illustrations
Illustration 1
Find out GDP deflator? Interpret it
(In Billion Rs.)
Years Nominal GDP Real GDP GDP Deflator

2014 500 500 100
2015 800 650 123.08
2016 1150 800 143.75
2017 1300 950 136.84
2018 1550 1190 130.25
Solution
Notice that we use 2014 (base year) prices to compute real GDP of subsequent years. Real GDP
has risen over the years from 500 billion in 2014 to 1240 billion in 2019.
This indicates that the increase is attributable to an increase in quantities produced because the
prices are held constant at base year. A deflator above 100 is an indication of price levels being
higher as compared to the base year.
From years 2015 through 2019, we find that price levels are higher than that of the base year,
the highest being in the year 2016.If the GDP deflator is greater than 100, then nominal GDP is
greater than real GDP.
If the GDP deflator next year is less than the GDP deflator this year, then the price level has
fallen; if it is greater, price levels have increased.
Illustration 2
The nominal and real GDP respectively of a country in a particular year are Rs.3000 Crores and
Rs.4700 Crores respectively. Calculate GDP deflator and comment on the level of prices of the
year in comparison with the base year.
Solution
Nominal GDP = Rs.3000 Crores
Real GDP = Rs.4700 Crores
GDP Deflator = Nominal GDP/Real GDP X100
3000 /4700*100 =63.83
The price level has fallen since GDP deflator is less than 100 at 63.83.
Illustration 3
Find nominal GDP if real GDP = 450 and price index = 120
Solution
21
Nominal GDP =Real GDP × Price Index/100

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Nominal GDP = 450 *120/100 = 540
Illustration 4
Suppose nominal GNP of a country in year 2010 is given at Rs.600 Crores and price index is given
as base year 2010 is 100. Now let the nominal GDP increases toRs.1200 Crores in year 2018 and
price index rises to 110, find out real GDP?
Solution
Real GDP =Nominal GDP ×100/Price index
=1200 *100/110 = 1090.9 Crores
Illustration 5
From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.
Items Rs.in Crores
Operating surplus 2000
Mixed income of self-employed 1100
Rent 550
Profit 800
Net indirect tax 450
Consumption of fixed capital 400
Net factor income from abroad -50
Compensation of employees 1000
Solution
GDPMP = Compensation of employees + mixed income of self-employed +
operating surplus + depreciation + net indirect taxes
(Note: operating surplus = rent+ profit + interest)
=1000 + 1100 + 2000 + 400 + 450 =4950
GNPMP = GDPMP + NFIA = 4950 + (-50) = 4900
NNPMP = GNPMP – consumption of fixed capital = 4900 – 400 = 4500
NNPFC or NI = NNPMP – NIT = 4500 – 450 = 4050 Crores
Illustration 6
From the following data, estimate National Income and Personal Income.
Items Rs.. in Crores
Net national product at market price
1,891 Income from property and entrepreneurship accruing
to government administrative departments 45
Indirect taxes 175
Subsidies 30
22
Saving of non-departmental enterprises 10

Interest on National debt 15
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Current transfers from government 35

Current transfers from rest of the world 20
Saving of private corporate sector 25
Corporate profit tax 25
Solution
National Income = Net national product at market price – Indirect taxes +
Subsidies
= 1,891 – 175 + 30 = 1746crores
Personal Income = National income – Income from property and
entrepreneurship accruing to government administrative
departments – Saving of non-departmental enterprises +
National debt interest + Current transfers from government
+ Current transfers from rest of the world – Saving of private
corporate sector – Corporate profit tax
=1746 – 45 –10+ 15 + 35 + 20 – 25 – 25
=1711 Crores
Illustration 7
Calculate the aggregate value of depreciation when the GDP at market price of a country in a
particular year was Rs.1,100 Crores. Net Factor Income from Abroad was Rs.100 Crores. The value of
Indirect taxes – Subsidies was Rs.150 Crores and National Income was Rs.850 Crores.
Solution
Given
GDPMP = 1100 Crores, NFIA = 100 Crores, NIT =150 Crores, NNPFC = 850 Crores
∴ GDPFC = GDPMP- NIT = 1100 – 150 = 950
GNPFC= GDPFC+ NFIA = 950 + 100 = 1050
NNPFC= GNPFC- Depreciation
850= 1050- Depreciation
Depreciation = 1050 – 850 = 200 Crores.
Illustration 8
On basis of following information, calculate NNP at market price and Disposable personal
income
Items Rs.in Crores
NDP at factor cost 14900
Income from domestic product accruing to government 150
Interest on National debt 170
Transfer payment by government 60
Net private donation from abroad 30
23
Net factor income from abroad 80

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Indirect taxes 335

Direct taxes 100
Subsidies 262
Taxes on corporate profits 222
Undistributed profits of corporations 105
SOLUTION
NNP at Market price = NNP at factor cost +indirect tax-subsidies Where NNP at factor cost =
NDPFC + NFIA
= 14900 + 80=14980
Therefore, NNP MP = Therefore, NNP MP = 14980 + 335 – 262 = 15053
Disposable personal income (DI) = PI- Personal income tax
PI = NI + income received but not earned – income earned but not received
= 14980+ 170+60 +30 -150 -222- 105 = 14763
Therefore, DI= 14763- 100 = 14663 Crores
Illustration 9
Calculate National Income by Value Added Method with the help of following data-
Particulars Rs.(in Crores)
Sales 700
Opening stock 500
Intermediate Consumption 350
Closing Stock 400
Net Factor Income from Abroad 30
Depreciation 150
Excise Tax 110
Subsidies 50
Solution
NVA(FC) = GDP (MP) –Depreciation +NFIA- Net Indirect Tax Where
GVA(MP) = Value of output- intermediate consumption Value
of Output = Sales+ change in stock
= 700+ (400 - 500) = 600
GVA(MP) = 600 – 350= 250
Therefore NI = 250-150 +30-(110-50)
= 70 Crores
Illustration 10
Calculate the Operating Surplus with the help of following data-
Particulars Rs.in
Sales Crores
4000
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Intermediate consumption 600
Rent 400
Interest 300
Net indirect tax 500
Consumption of Fixed Capital 200
Mixed Income 400
Solution
GVAMP = Gross Value OutputMP – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption
= 4000-600 = 3400
GDPMP= GVAMP = 3400 Crores
NDPMP = GDPMP – consumption of fixed capital
= 3400 – 200
= 3200 Crores
NDP FC= NDPMP – NIT
= 3200 – 500 = 2700 Crores
NDPFC= Compensation of employees + Operating surplus + Mixed income 2700 = 800 +
Operating Surplus + 400
Operating surplus = 1500 Crores
Illustration 11
Calculate national income by value added method.
Particulars (Rs.in crores)
Value of output in primary sector 2000
Intermediate consumption of primary sector 200
Value of output of secondary sector 2800
Intermediate consumption of secondary sector 800
Value of output of tertiary sector 1600
Intermediate consumption of tertiary sector 600
Net indirect taxes 300
Depreciation 470
Solution
GDPMP= (Value of output in primary sector - intermediate consumption of primary sector) +
(value of output in secondary sector - intermediate consumption of secondary
sector) + (value of output in tertiary sector- intermediate consumption of tertiary
25
sector)
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Value of output in primary sector = 2000
- Intermediate consumption of primary sector = 200
+ Value of output in secondary sector = 2800
- Intermediate consumption in secondary sector = 800
+ Value of output in tertiary sector = 1600
- Intermediate consumption of tertiary sector = 600
GDP MP = Rs.4800 Crores
NNPFC = GDPMP + NFIA -NIT-Depreciation
NNPFC =National income= 4800+(-30)-300-470= 4000 Crores
Illustration 12
Calculate Net Value Added by Factor Cost from the following data
Items Rs.in Crores
Purchase of materials 85
Sales 450
Depreciation 30
Opening stock 40
Closing stock 30
Excise tax 45
Intermediate consumption 200
Subsidies 15
Solution
GVA MP = Sales+ change in stock - Intermediate consumption
= 450+ (30-40) -200
= 240Crores
NVAMP = GVAMP – Depreciation
NVAMP = 240-30 = 210 Crores
NVAFC = NVAMP – (indirect tax - subsidies)
= 210 – (45 -15) = 180Crores
Illustration 13
Calculate NI with the help of Expenditure method and income method with the
help of following data:
Items Rs.in Crores
Compensation of employees
1,200 Net factor income from Abroad 20
26
Profit 800
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Private final consumption expenditure 2,000
Net domestic capital formation 770
Rent 400
Interest 620
Mixed income of self-employed 700
Net export 30
Govt. final consumption expenditure 1100
Operating surplus 1820
Employer’s contribution to social security scheme 300
Solution
By Expenditure method
GDPMP = Private final consumption expenditure + Government final consumption
expenditure + Gross domestic capital formation (Net domestic capital
formation+ depreciation) + Net export
= 2000 + 1100 + (770+ 130) + 30= 4030Crores
NNPFC or NI = GDPMP- depreciation + NFIA – NIT
= 4030 – 130 + 20 – 120= 3800 Crores
By Income method
NNPFC or NI= compensation of employees+ operating surplus+ Mixed income of self-
employed + NFIA
= 1200+ 1820+ 700+ 20 = 3740Crores
Illustration 14
From the following data calculate
(a) Gross Domestic Product at Factor Cost, and
(b) Gross Domestic Product at Market price
Items Rs.in Crores
Gross national product at factor cost 61,500
Net exports (-) 50
Rent 800
Interest 900
Profit 1,300
Net domestic capital formation 800
Gross domestic capital formation 900
27
Factor income to abroad 80

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Solution
(a) GDP at factor cost = NDP at factor cost + Depreciation
= Compensation of employees+ Rent+ Interest+
Profit +Mixed income+ (Gross domestic capital
formation - Net domestic capital formation)
= Rs.3,000 + Rs.800 + Rs.900 + Rs.1,300 + (Rs.900
- Rs.800)
= Rs.6100 Crores
(b) Gross Domestic Product at Market Price
= GDP at factor cost + Net Indirect taxes =Rs.6100 + Rs.300
= 6400 Crores
Illustration 15
Calculate NNPFC. By expenditure method with the help of following information-
Items Rs.in Crores
Private final consumption expenditure 10
Net Import 20
Public final consumption expenditure 05
Gross domestic fixed capital formation 350
Depreciation 30
Subsidy 100
Income paid to abroad 20
Change in stock 30
Net acquisition of valuables 10
Solution
Calculation of national income by expenditure method:
GDPMP = Government final consumption expenditure (Public final consumption expenditure) +
Private final consumption expenditure + Gross domestic capital formation (Gross
domestic fixed capital formation + change stock + Net acquisition of valuables) + Net
export (Note: As net import is 20, hence, net export is -20)
= 5 +10 + [350 + 30 +10] + (- 20) = 5+10+390-20 = 385 Crores
NNPFC = GDPMP – Depreciation + Net factor income from abroad (Income from abroad –
Income paid to abroad) – Net Indirect tax (Indirect tax – subsidies)
= 385 – 30 + [0 – 20] – [0-100] = 385 – 30 – 20 + 100 = 435 Crores.
Illustration 16
Compute National income
Consumption 750
Investment 250
28
Government Purchases 100

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Exports 100
Imports 200
Solution
Expenditure Method: National income equals domestic spending
Y = C + I + G + (X – M)
(C + I + G = 1100) plus exports (X = 100) less imports (M = 200). Y =1000
Illustration 17
Calculate Gross Domestic Product at market Prices (GDPMP) and derive national income from
the following data (in Crores of Rs.)
Inventory Investment 100
Exports 200
Indirect taxes 100
Net factor income from abroad - 50
Personal consumption expenditure 3500
Gross residential construction investment 300
Depreciation 50
Imports 100
Government purchases of goods and services 1000
Gross public investment 200
Gross business fixed investment 300
Solution
Expenditure Method
GDPMP = Personal consumption expenditure + Gross Investment (Gross business fixed
investment + inventory investment) + Gross residential construction investment + Gross
public investment + Government purchases of goods and services + Net Exports (Exports-
imports)
GNPMP = GDPMP +Net factor income from abroad GNPMP - Indirect Taxes = GNP FC
GNP FC – Depreciation = NNP FC (National Income)
GDP Mp= Rs.
Personal consumption expenditure = 3500
+ Gross Investment = 900
which include(Gross Business fixed investment = 300 Gross residential construction investment
= 300
Gross public investment = 200
29
Inventory investment = 100)

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+ Government purchases of goods arid services = 1000
+ Net exports which include: = 100
(Exports = 200
Imports = 100)
GDP Mp = 5500 Crores
+Net Factor Income From Abroad = -50
GNP MP = 5450 Crores
-Indirect Taxes = 100
GNP FC = 5350 Crores
Illustration 18
Find GDPMP and GNPMP from the following data (in Crores of Rs.) using income method. Show
that it is the same as that obtained by expenditure method.
Personal Consumption 7,314
Depreciation 800
Wages 6,508
Indirect Business Taxes 1,000
Interest 1,060
Domestic Investment 1,442
Government Expenditures 2,196
Rental Income 34
Corporate Profits 682
Exports 1,346
Net Factor Income from Abroad 40
Mixed Income 806
Imports 1,408
Solution
Income Method
GDPMP = Employee compensation (wages and salaries + employers' contribution towards
social security schemes) + profits + rent + interest + mixed income + depreciation + net indirect
taxes (Indirect taxes - subsidies) GDPMP = 6,508+ 34 + 1060 + 806+ 682 + 1,000 + 800 = 10,890
GNP MP = GDPMP + NFIA =10,890+ 40 =10,930 Crores.
Expenditure Method
Y = C + I + G + (X – M)
Y = 7314 + 1442 + 2196+ (1346 –1408)
Y = (7314 + 1442 + 2196) – 62
GDPMP = Y = 10890
GNP MP = GDPMP + NFIA =10,890+ 40 =10,930 Crores
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Illustration 19
From, the following data calculate the Gross National Product at Market Price using Value
Added method
(Rs.in Crores)
Value of output in primary sector 500
Value of output in tertiary sector 700
Intermediate consumption in secondary sector 400
Value of output in secondary sector 900
Government Transfer Payments 600
Intermediate consumption in tertiary sector 300
Intermediate consumption in primary sector 250
Solution
GDPMP = (Value of output in primary sector - intermediate consumption of primary sector) +
(value of output in secondary sector - intermediate consumption of secondary sector) +
(value of output in tertiary sector - intermediate consumption of tertiary sector)
Value of output in primary sector = 500

- Intermediate consumption of primary sector = 250
+ Value of output in secondary sector = 900
- Intermediate consumption in secondary sector = 400
+ Value of output in tertiary sector = 700
- Intermediate consumption of tertiary sector = 300
GDP MP = Rs.1150 Crores
GNPMP = GDPMP + NFIA
GNPMP = 1150 – 20 = Rs.1130 Crores
Illustration 20
Calculate ‘Sales’ from the following data:
Particulars Rs.in Lakhs
Subsidies 200
Opening stock 100
Closing stock 600
Intermediate consumption 3,000
31
Profit 750
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Net value added at factor cost 2,000
SOLUTION: Net Value Added at factor cost = Sales + change in stocks - intermediate consumption-
depreciation – NIT
2000 = Sales + 500 – 3000 – 700 –(-200)
Sales= 2000- 500 +3000 + 700 – 200= 5000 lakhs
Illustration 21
Given the following data, determine the National Income of a country using expenditure
method and income method:
Particulars Rs.in Crores
Private Final Consumption Expenditure 1000
Government Final Consumption Expenditure 550
Compensation of Employees 600
Net Exports -15
Net Indirect Taxes 60
Net Domestic Fixed Investment 385
Consumption of Fixed Capital Formation 65
Net Factor Income from Abroad -10
Interest 310
Rent 200
Mixed Income of Self-Employed 350
Profit 400
Solution
Expenditure Method formula:
NDPMP = Private Final Consumption Expenditure + Net Domestic Fixed Investment +
Government final consumption expenditure + Net Exports (Exports-imports)
NNPMP = NDPMP + Net factor income from abroad NNPMP – Indirect Taxes = NNP FC =
National Income
Income Method Formula:
NDPFC = Employee compensation + profits + rent + interest + mixed income
NNPFC = NDPFC + NFIA = National Income
Particulars Rs.in crores
Expenditure Method
Private Final Consumption Expenditure 1000
32
+Government Final Consumption Expenditure +550

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+Net Domestic fixed Investment +385
+Net Exports +(-15)
NDP@MP =1920
+Net Factor Income from Abroad +(-10)
NNP@MP =1910
-Net Indirect Taxes -60
NNP@FC = 1850
Consumption of Fixed Capital 65
Income Method
Compensation of Employees 600
Interest +310
Rent +200
Mixed Income of Self-Employed +350
Profit +400
NDP@FC =1860
+Net Factor Income from Abroad +(-10)
NNP@FC = 1850
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1.2. THE KEYNESIAN THEORY OF
DETERMINATION OF NATIONAL INCOME
Q.NO.1 DISCUSS THE IMPORTANCE OF KEYNESIAN THEORY IN DETERMINATION OF NATIONAL
INCOME?
ANSWER
1. Keynes argued that markets would not automatically lead to full-employment equilibrium and
the resulting natural level of real GDP. The economy could settle in equilibrium at any level of
unemployment.
2. Keynesians believe that prices and wages are not so flexible; they are sticky, especially
downward.
3. The stickiness of prices and wages in the downward direction prevents the economy's resources
from being fully employed and thereby prevents the economy from returning to the natural
level of real GDP.
4. Output will remain at less than the full employment level as long as there is insufficient spending
in the economy. This was precisely what was happening during the great depression.
5. The Keynesian theory of income determination is presented in three models:
a. The two-sector model consisting of the household and the business sectors,
b. The three-sector model consisting of household, business and government sectors, and
c. The four-sector model consisting of household, business, government and foreign sectors
Q.NO.2 EXPLAIN CIRCULAR FLOW IN A SIMPLE TWO-SECTOR MODEL STATED BY KEYNESIAN?

ANSWER
CIRCULAR FLOW IN A SIMPLE TWO-SECTOR MODEL
3. CIRCULAR FLOW:
a. The circular flow of income is a process where the national income and expenditure of an
economy flow in a circular manner continuously through time.
b. Savings, expenditures, exports and imports are various components of circular flow of
income which are shown in the figure in the form of currents and cross currents in such a
manner that national income equals national expenditure.
4. Initially, we consider a hypothetical simple two-sector economy. Even though an economy of
this kind does not exist in reality, it provides a simple and convenient basis for understanding the
Keynesian theory of income determination. The simple two sector economy model assumes
that
a. There are only two sectors in the economy viz., households and firms, with only
consumption and investment outlays.
b. Households own all factors of production and they sell their factor services to earn factor
34
incomes which are entirely spent to consume all final goods and services produced by
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business firms.
c. The business firms hire factors of production from the households; they produce and sell
goods and services to the households and they do not save.
d. There are no corporations, corporate savings or retained earnings. The total income
produced, Y, accrues to the households and equals their disposable personal income Yd i.e.,
Y = Yd.
e. All prices (including factor prices), supply of capital and technology remain constant.
f. The government sector does not exist and therefore, there are no taxes, government
expenditure or transfer payments.
g. The economy is a closed economy, i.e., foreign trade does not exist; there are no exports and
imports and external inflows and outflows.
h. All investment outlay is autonomous (not determined either by the level of income or the
rate of interest);
i. All investment is net and, therefore, national income equals the net national product.
CIRCULAR FLOW OF INCOME AND EXPENDITURE WHICH PRESENTS THE WORKING OF THE TWO-
SECTOR ECONOMY
5. CIRCULAR FLOW IN A TWO SECTOR ECONOMY

a. The circular broken lines with arrows show factor and product flows and present ‘real flows’
and the continuous line with arrows show ‘money flows’ which are generated by real flows.
b. These two circular flows-real flows and money flows-are in opposite directions and the value
of real flows equal the money flows because the factor payments are equal to household
incomes.
c. There are no injections into or leakages from the system. Since the whole of household
income is spent on goods and services produced by firms, household expenditures equal the
total receipts of firms which equal the value of output.
Factor Payments = Household Income = Household Expenditure = Total Receipts of Firms = Value of
Output.
Note:
a. Equilibrium is defined as a state in which there is no tendency to change; or a position of rest.
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Equilibrium output occurs when the desired amount of output demanded by all the agents in the
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economy exactly equals the amount produced in a given time period.
b. An economy can be said to be in equilibrium when the production plans of the firms and the
expenditure plans of the households match.
Q.NO.3 EXPLAIN THE CONCEPTS OF AGGREGATE DEMAND FUNCTION; AGGREGATE SUPPLY;

CONSUMPTION FUNCTION?
ANSWER
1. AGGREGATE DEMAND FUNCTION
Aggregate demand (AD) is total planned expenditure. In a simple two-sector economy, the ex
ante aggregate demand (AD) for final goods or aggregate expenditure consists of only two
components:
a. Ex ante aggregate demand for consumer goods (C), and
b. Ex ante aggregate demand for investment goods (I)
AD = C + I
Of the two components, consumption expenditure accounts for the highest proportion of the
GDP. In a simple economy, the variable I is assumed to be determined exogenously and constant
in the short run. Therefore, the short-run aggregate demand function can be written as:
AD = C + I̅
Where = constant investment.
In the short run, AD depends largely on the aggregate consumption expenditure.
2. AGGREGATE SUPPLY:
Ex ante or planned aggregate supply is the total supply of goods and services which firms in a
national economy plan on selling during a specific time period. It is equal to national income of
the economy, which is either consumed or saved.
AS = C + S
3. THE CONSUMPTION FUNCTION

Consumption function expresses the functional relationship between aggregate consumption
expenditure and aggregate disposable income, expressed as:
C = f (Y)
The specific form of consumption–income relationship termed the consumption function,

proposed by Keynes is as follows:
C = a + bY
where C = aggregate consumption expenditure; Y= total disposable income; a is a constant term

which denotes the (positive) value of consumption at zero level of disposable income; and the
parameter b, the slope of the function, (∆C /∆Y) is the marginal propensity to consume (MPC)
36
i.e. the increase in consumption per unit increase in disposable income.

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The Keynesian Consumption Function
ANALYSIS FROM ABOVE GRAPH:

a. The consumption function shows the level of consumption (C) corresponding to each level of
disposable income (Y) and is expressed through a linear consumption function, as shown by
the line marked C = f(Y)
b. When income is low, consumption expenditures of households will exceed their disposable
income and households dissave i.e. they either borrow money or draw from their past
savings to purchase consumption goods.
c. If the disposable income increases, consumers will increase their planned expenditures and
current consumption expenditures rise, but only by less than the increase in income.
d. The intercept for the consumption function, a, can be thought of as a measure of the effect
on consumption of variables other than income, variables not explicitly included in this
simple model.
e. The Keynesian assumption is that consumption increases with an increase in disposable
income, but that the increase in consumption will be less than the increase in disposable
income (b <1). i.e. 0 < b < 1. This fundamental relationship between income and
consumption plays a crucial role in the Keynesian theory of income determination.
Q.NO.4 EXPLAIN THE CONCEPTS OF MARGINAL PROPENSITY TO CONSUME; AVERAGE PROPENSITY

TO CONSUME; SAVING FUNCTION; MARGINAL PROPENSITY TO SAVE; AVERAGE PROPENSITY TO
SAVE?
ANSWER
A. MARGINAL PROPENSITY TO CONSUME (MPC)
1. The consumption function is based on the assumption that there is a constant relationship
between consumption and income, as denoted by constant b which is marginal propensity to
consume.
2. The concept of MPC describes the relationship between change in consumption (∆C) and the
change in income (∆Y).
3. The value of the increment to consumer expenditure per unit of increment to income is
termed the Marginal Propensity to Consume (MPC).
MPC = ∆C/∆Y = b
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4. Although the MPC is not necessarily constant for all changes in income (in fact, the MPC
tends to decline at higher income levels), most analysis of consumption generally works with
a constant MPC.
B. AVERAGE PROPENSITY TO CONSUME (APC)

The average propensity to consume is a ratio of consumption defining income consumption
relationship. The ratio of total consumption to total income is known as the average propensity
to consume (APC).
APC = TOTAL CONSUMPTION/TOTAL INCOME= C/Y
The table below shows the relationship between income and consumption
Relationship between Income and Consumption
Income (Y) Consumption (C Saving APC (C/Y) MPC (∆C
(Rs.Crores) )(Rs.Crores) (Rs.Crores) /∆Y)
0 50 -50 ∞ -
100 125 -25 125/100 = 1.25 75/100 =
200 200 0 200/200 = 1.00 0.75 =
75/100
300 275 25 275/300 = 0.92 0.75 =
75/100
400 350 50 350/400=0.88 0.75 =
75/100
500 425 75 425/500=0.85 0.75
75/100 =
0.75 1.00
Note: The conventional Keynesian MPC is assumed to have a constant value less than
and usually greater than 0.50.
C. The Saving Function
Saving is also a function of disposable income. The saving function shows the function shows the
functional relationship between national income (= disposable income in two sector model) and
saving.
S = f(Y)
This can be illustrated with the following table and diagram.
Relationship between Income, Consumption and Saving
Disposable Income (Yd ) Consumption (C) (Rs.Crores) Saving (S) (Rs.Crores)
(Rs.Crores)
0 20 -20
60 70 -10
120 120 0
180 170 10
240 220 20
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The Consumption and Saving Function
Analysis:
a. The consumption and saving functions are graphed. The saving function shows the level of
saving (S) at each level of disposable income (Y).
b. The saving curve has a negative intercept (-a) on Y axis and its magnitude is the same as the
positive intercept of the consumption curve.
c. We know that consumption at zero level of income is positive (equal to a), and as such there
should be dissaving also of the same magnitude. By definition, national income Y = C + S,
which shows that disposable income is, by definition, consumption plus saving.
d. Therefore, S = Y – C. When national income is equal to Y1, C=Y and saving curve crosses X
axis. Thus, when we represent the theory of the consumption-income relationship, it also
implicitly establishes the saving-income relationship.
D. THE MARGINAL PROPENSITY TO SAVE (MPS)

1. The slope of the saving function is the marginal propensity to save.
2. If one-unit increase in disposable income leads to an increase of ‘b’ units in consumption, the
remainder (1 - b) is the increase in saving.
3. This increment to saving per unit increase in disposable income (1 - b) is called the marginal
propensity to save (MPS). The marginal propensity to save is the increase in saving per unit
increase in disposable income.
4. Saving is an increasing function of the level of income. In other words, saving increases as
39
income rises.
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MPS = ∆S/∆Y = 1-b
5. Marginal Propensity to Consume (MPC) is always less than unity, but greater than zero, i.e., 0
< b < 1 Also, MPC + MPS = 1; we have MPS 0 < b < 1.
6. Thus, saving is an increasing function of the level of income because the marginal propensity
to save (MPS) = 1- b is positive, i.e. saving increase as income increases.
E. AVERAGE PROPENSITY TO SAVE (APS)

The ratio of total saving to total income is called average propensity to save (APS). Alternatively,
it is that part of total income which is saved.
APS = Total Saving/Total Income = S/Y
Q.NO.5 EXPLAIN THE DETERMINATION OF NATIONAL INCOME IN A TWO SECTOR MODEL?

ANSWER
THE TWO-SECTOR MODEL OF NATIONAL INCOME DETERMINATION
1. Injections model is alternatively known as the saving-investment model. The equilibrium level of
income and output in the Keynesian framework is that level at which aggregate demand (C+ I)
and aggregate supply (C + S) or output are equal. i.e.
C + I = C + S (or) I = S
2. In a two sector economy,
a. The aggregate demand (C+ I) refers to the total spending in the economy i.e. it is the sum of
demand for the consumer goods (C) and investment goods (I) by households and firms
respectively.
b. The aggregate demand curve is linear and positively sloped indicating that as the level of
national income rises, the aggregate demand (or aggregate spending) in the economy also
rises.
c. The aggregate expenditure line is flatter than the 45- degree line because, as income rises,
consumption also increases, but by less than the increase in income.
d. The 45-degree line illustrates every single point at which planned aggregate expenditure,
measured on the Y, or vertical axis, is equal to planned aggregate production, which is
measured on the X, or horizontal axis.
e. All points on the 45° line indicate that aggregate expenditure equal aggregate output; i.e.
(C+I) is equal to Y or (C+S). Therefore, the line maps out all possible equilibrium income
levels.
f. For all points below the 45-degree line, planned aggregate expenditure is lesser than GDP
and for all points above the 45-degree line; planned aggregate expenditure is greater than
GDP.
g. If an economy is operating on the 45-degree line, then the aggregate product market is in
equilibrium. Ideally, we would like equilibrium to occur at potential GDP i.e., at the level of
40
full employment.
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h. Only at point E and at the corresponding equilibrium levels of income and output YO does
aggregate demand exactly equals output. At that level of output and income, planned
spending precisely matches production.
Determination of Equilibrium Income: Two Sector Model
i. Aggregate demand will not always be equal to aggregate supply. Aggregate demand
depends on the households’ plan to consume and to save. Aggregate supply depends on the
producers’ plan to produce goods and services.
j. Aggregate supply represents aggregate value expected by business firms and aggregate
demand represents their realized value. The expectations of businessmen are realized only
when aggregate expenditure equals aggregate income.
k. For the aggregate demand and the aggregate supply to be equal so that equilibrium is
established, the households’ plan must coincide with producers’ plan.
l. At equilibrium, expected value equals realized value. However, Keynes held the view that
that there is no reason to believe that:
i. Consumers’ consumption plan always coincides with producers’ production plan, and
ii. That producers’ plan to invest matches always with households plan to save. Putting it
differently, there is no reason for C + I and C + S to be always equal.
m. The figure above depicts the determination of equilibrium income. Income is measured
along the horizontal axis and the components of aggregate demand, C and I, are measured
along the vertical axis.
n. The investment function (I) is shown in panel B of the figure, the (C + I) or aggregate
41
expenditure schedule which is obtained by adding the autonomous expenditure component

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namely investment to consumption spending at each level of income. Since the autonomous
expenditure component (I) does not depend directly on income, the (C + I) schedule lies
above the consumption function by a constant amount.
o. Equilibrium level of income is such that aggregate demand equals output (which in turn
equals income). Only at point E and at the corresponding equilibrium levels of income and
output (Y0), does aggregate demand exactly equals output.
p. At that level of output and income, planned spending precisely matches production. Once
national income is determined, it will remain stable in the short run.
q. As long as the economy is operating at less than its full-employment capacity, producers will
produce any output along the 45-degree line that they believe purchasers will buy.
3. ANALYSIS WHY THE OTHER POINTS ON THE GRAPH ARE NOT POINTS OF EQUILIBRIUM.
1. Consider a level of income below Y0, for example Y1, generates consumption as shown along
the consumption function.
i) When this level of consumption is added to the autonomous investment expenditure (I),
the aggregate demand exceeds income; i.e., the (C + I) schedule is above the 45° line.
ii) Equivalently, at all those levels, ‘I’ is greater than S, as can be seen in panel (B). The
aggregate expenditures exceed aggregate output. Excess demand makes businesses to
sell more than what they currently produce.
iii) The unexpected sales would draw down inventories and result in less inventory
investment than business firms planned.
iv) They will react by hiring more workers and expanding production. This will increase the
nation’s aggregate income.
v) It also follows that with demand outstripping production, desired investment will exceed
actual investment.
2. Conversely, at levels of income above Y0, for example at Y2, output exceeds demand (the 45°
line is above the C +I schedule).
i) The planned expenditures on goods and services are less than what business firms
thought they would be; business firms would be unable to sell as much of their current
output as they had expected.
ii) They have unintentionally made larger inventory investments than what they planned
and their actual inventories would increase. Therefore, there will be a tendency for
output to fall.
iii) This process continues till output reaches Y0, at which current production exactly
matches planned aggregate spending and unintended inventory shortfall or
accumulation are therefore equal to zero.
iv) At this point, consumers’ plan matches with producers’ plan and savers’ plan matches
with investors’ plan. Consequently, there is no tendency for output to change.
3. Since C + S = Y, the national income equilibrium can be written as:
Y=C+I
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4. Since at equilibrium C = a+ b Y, and I is constant at I. By substituting a+ bY for C and I for I in
Y= C + I, the equilibrium level of national income can be expressed as:
Y = C+I
Y = a + bY+ I
Y-bY = a+ I
Y(1-b)= a+ I
Y = (a+ I)/(1-bY)
Y = 1/(1-bY)*(a+ I)
C=a+bY
C=a+b[1/(1-bY)*(a+ I)]
C=a+b/(1-b)*(a+ I)
4. Equilibrium with Unemployment or Inflation

a. At equilibrium, the equality of planned aggregate expenditures and output need not take
place at full employment.
b. If the aggregate expenditure line intersects the 45-degree line at the level of potential GDP,
then there is full employment equilibrium.
c. There is no recession, and unemployment is at the natural rate. But there is no guarantee
that the equilibrium will occur at the potential GDP level of output.
d. The economy can settle at any equilibrium which might be higher or lower than the full
employment equilibrium.
NOTE:
i) The equality between saving and investment can be seen directly from the identities in national
income accounting. Since income is either spent or saved, Y = C + S.
ii) Without government and foreign trade, aggregate demand equals consumption plus investment,
Y = C + I. Putting the two together, we have C + S = C + I, or S = I. This last equation indicates that
equilibrium can be achieved by equating injections I with leakages S.
iii) The saving schedule S slopes upward because saving varies positively with income. In equilibrium,
planned investment equals saving. Therefore, corresponding to this income, the saving schedule
(S) intersects the horizontal investment schedule (I). This intersection is shown in panel (B).
iv) Without government and foreign trade, the vertical distance between the aggregate demand
(C+I) and consumption line (C) in the figure is equal to planned investment spending, I. You may
also find that the vertical distance between the consumption schedule and the 45° line also
measures saving (S = Y - C) at each level of income.
v) Equilibrium is found at the intersection of the saving line and the investment line. At the
equilibrium level of income (at point E in panel B), the two vertical distances are equal. Thus, at
the equilibrium level of income, ex ante saving equals ex ante investment.
vi) By contrast, above the equilibrium level of income, Yo, saving (the distance between 45° line and
43
the consumption schedule) exceeds planned investment, while below Yo level of income,
planned investment exceeds saving.
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vii) If there is any deviation from equilibrium, i.e. planned saving is not equal to planned investment,
the process of readjustment will bring the economy back to equilibrium.
Q.NO.6 EXPLAIN LEAKAGES AND INJECTIONS IN A CIRCULAR FLOW OF INCOME STATED BY

KENESIAN?
ANSWER
1. LEAKAGE:
a. A leakage is referred to as an outflow of income from the circular flow model.
b. Leakages are that part of the income which is not used to purchase goods and services or
what households withdraw from the circular flow.
c. The act of saving by households is called a leakage from the circular flow model because the
income is not spent on goods and services produced by firms, and it will reduce the velocity
of the circular flow.
2. INJECTION:
a. An injection is an inflow of income to the circular flow. Due to an injection of income in the
circular flow, the volume of income increases.
b. Investment is an injection into the circular flow.
3. The circular flow will be balanced and therefore in equilibrium when the injections are equal
to the leakages.
a. If at any time, intended saving is greater than intended investment, this would mean that
people are spending lesser volume of money on consumption.
b. As a result, the inventories of goods will pile up. Consequently, the firms would decrease
their production which would lead to a fall in output and income of the household.
c. If the leakages are greater than the injections, then national income will fall, while if
injections are greater than leakages, national income will rise.
d. The national income will be in equilibrium only when intended saving is equal to intended
investment.
Q.NO.7 EXPLAIN DEFLATIONARY GAP IN A KEYNESIAN TWO SECTOR MODEL?

ANSWER
DEFLATIONARY GAP
1. If the aggregate demand for an amount of output is less than the full employment level of
output, then there is deficient demand. Deficient demand gives rise to a ‘deflationary gap’ or
‘recessionary gap’.
2. Recessionary gap also known as ‘contractionary gap’ arises in the Keynesian model of the macro
economy when the equilibrium level of aggregate production achieved in the short-run falls
short of what could be produced at full employment.
3. Recessionary gap occurs when the economy is in a business-cycle contraction or recession.
44
Deficient Demand - Deflationary Gap

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(C+I)
4. ANALYSIS:
a. OQ* is the full employment level of output. For the economy to be at full employment
equilibrium, aggregate demand should be Q*F.
b. If the aggregate demand is Q*G, it represents a situation of deficient demand. The resulting
deflationary gap is FG.
c. Firms will experience unplanned build-up of inventories of unsold goods and they will
respond by cutting production and employment leading to decrease in output and income
until the under- employment equilibrium is reached at E.
d. Deflationary gap is thus a measure of the extent of deficiency of aggregate demand and it
causes the economy’s income, output and employment to decline, thus pushing the
economy to under- employment equilibrium.
e. The macro- equilibrium occurs at a level of GDP less than potential GDP; thus, there is
cyclical unemployment i.e., rate of unemployment is higher than the natural rate. (Demand
deficient unemployment is the same as cyclical unemployment)
Q.NO.8 EXPLAIN INFLATIONARY GAP IN A KEYNESIAN TWO SECTOR MODEL?

ANSWER
INFLATIONARY GAP
1. If the aggregate demand for an amount of output is greater than the full employment level of
output, then there is excess demand.
2. Excess demand gives rise to ‘inflationary gap’ which is the amount by which actual aggregate
demand exceeds the level of aggregate demand required to establish the full employment
equilibrium.
3. This is the sort of gap that tends to occur during a business-cycle expansion and sets in motion
forces that will cause demand pull inflation.
Excess Demand - Inflationary Gap
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(C+I)0
(C+I)1
4. ANALYSIS:
a. The economy will be at full employment equilibrium at F with OQ* full employment level of
output and income.
b. Suppose the aggregate demand is for Q*G, there is excess demand and the resulting
inflationary gap FG.
c. The real output will be constant, but the rise in the price level will cause an increase in the
nominal output until the new equilibrium is reached at point E.
d. Point E is an equilibrium point because the aggregate demand ME is equal to output OM.
e. At the new equilibrium, real output, real income and employment will be the same; nominal
output and income has increased due to inflation.
5. In the Keynesian model, neither wages nor interest rates will decline in the face of abnormally
high unemployment and excess capacity. Output will remain at less than the full employment
rate as long as there is insufficient spending in the economy. Keynes argued that this was
precisely what was happening during the Great Depression.
Q.NO.9 DEFINE THE TERM INVESTMENT MULTIPLIER?

ANSWER
THE INVESTMENT MULTIPLIER
1. It is a process of multiple increases in equilibrium income due to increase in investment and how
much increase occurs depends upon the marginal propensity to consume. The process of
increase in national income due to increase in investment is illustrated below.
Effect of Changes in Autonomous Investment 46
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2. ANALYSIS:
a. An increase in autonomous investment by ∆I shifts the aggregate demand schedule from C+I
to C+I+∆I.
b. Correspondingly, the equilibrium shifts from E to E1and the equilibrium income increases
more than proportionately from Yo to Y1. This occurs due to the operation of the investment
multiplier.
3. Multiplier refers to the phenomenon whereby a change in an injection of expenditure will lead
to a proportionately larger change (or multiple changes) in the equilibrium level of national
income.
4. The investment multiplier explains how many times the equilibrium aggregate income increases
as a result of an increase in autonomous investment.
5. When the level of investment increases by an amount say ∆I, the equilibrium level of income will
increase by some multiple amounts, ∆Y. The ratio of ∆Y to ∆I is called the investment multiplier,
k.
K = ∆Y/∆I
The size of the multiplier effect is given by ∆ Y = k ∆I.
Illustration: if a change in investment of Rs.2000 million causes a change in national income of
Rs.6000 million, then the multiplier is 6000/2000 =3. Thus multiplier indicates the change in
equilibrium national income for each rupee change in the desired autonomous investment. The
value 3 in the above example tells us that for every Rs.1 increase in desired autonomous
investment expenditure, there will be Rs.3 increase in equilibrium national income.
6. Multiplier, therefore, expresses the relationship between an initial increment in autonomous
investment and the resulting increase in equilibrium aggregate income.
7. Since the increase in national income (∆Y) is the result of increase in investment (∆I), the
multiplier is called ‘investment multiplier.’
8. The process behind the multiplier can be compared to the ‘ripple effect’ of water. The process
does not stop here; it will generate a second-round of increase in income. The process further
continues as an autonomous rise in investment leads to induced increases in consumer demand
as income increases.
Let us assume that the initial disturbance comes from a change in autonomous investment (∆I) of
500 units. The economy being in equilibrium, an upward shift in aggregate demand leads to an
increase in national income which in a two sector economy will be, by definition, distributed as
factor incomes. There will be an equal increase in disposable income. Firms experience increased
demand and as a response, their output increases. Assuming that MPC is 0.80, consumption
expenditure increases by 400, resulting in increase in production.
9. The increase in equilibrium income per rupee increase in investment is:
∆Y/∆I = 1/(1-MPC) = 1/MPS
a. The marginal propensity to consume (MPC) is the determinant of the value of the multiplier
47
and that there exists a direct relationship between MPC and the value of multiplier.
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b. Higher the MPC more will be the value of the multiplier, and vice-versa. On the contrary,
higher the MPS, lower will be the value of multiplier and vice-versa.
c. The maximum value of multiplier is infinity when the value of MPC is 1 i.e., the economy
decides to consume the whole of its additional income. We conclude that the value of the
multiplier is the reciprocal of MPS.
For example, if the value of MPC is 0.75, then the value of the multiplier is:
Q.NO.10 DISCUSS THE IMPACT OF INCOME LEAKAGES ON MULTIPLIER?

ANSWER
LEAKAGES:
1. Increase in income due to increase in initial investment, does not go on endlessly. The process of
income propagation slows down and ultimately comes to a halt. Causes responsible for the
decline in income are called leakages.
2. Income that is not spent on currently produced consumption goods and services may be
regarded as having leaked out of income stream.
3. If the increased income goes out of the cycle of consumption expenditure, there is a leakage
from income stream which reduces the effect of multiplier. The more powerful these leakages
are the smaller will be the value of multiplier. The leakages are caused due to:
a. Progressive rates of taxation which result in no appreciable increase in consumption despite
increase in income
b. High liquidity preference and idle saving or holding of cash balances and an equivalent fall in
marginal propensity to consume
c. Increased demand for consumer goods being met out of the existing stocks or through
imports
d. Additional income spent on purchasing existing wealth or purchase of government securities
and shares from shareholders or bond holders
e. Undistributed profits of corporations
f. Part of increment in income used for payment of debts
g. Case of full employment additional investment will only lead to inflation, and
h. Scarcity of goods and services despite having high MPC
4. The MPC, on which the multiplier effect of increase in income depends, is high in under
developed countries; but ironically the value of multiplier is low. Due to structural inadequacies,
increase in consumption expenditure is not generally accompanied by increase in production.
E.g., increased demand for industrial goods consequent on increased income does not lead to
increase in their real output; rather prices tend to rise.
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Q.NO.11 DISCUSS HOW TO DETERMINE EQUILIBRIUM INCOME UNDER THREE SECTOR MODEL?
ANSWER
DETERMINATION OF EQUILIBRIUM INCOME: THREE SECTOR MODEL
1. Aggregate demand in the three sector model of closed economy (neglecting foreign trade)
consists of three components namely, household consumption(C), desired business investment
demand(I) and the government sector’s demand for goods and services(G). Thus in equilibrium,
we have
Y = C+I+G
2. Since there is no foreign sector, GDP and national income are equal. As prices are assumed to be
fixed, all variables are real variables and all changes are in real terms. Each of the variables in the
model is a flow variable.
3. CIRCULAR FLOW IN A THREE SECTOR ECONOMY
a. The three-sector, three-market circular flow model which accounts for government
intervention highlights the role played by the government sector. From the above flow chart,
we can find that the government sector adds the following key flows to the model:
i) Taxes on households and business sector to fund government purchases
ii) Transfer payments to household sector and subsidy payments to the business sector
iii) Government purchases goods and services from business sector and factors of
production from household sector, and
iv) Government borrowing in financial markets to finance the deficits occurring when
taxes fall short of government purchases
b. There are two flows out of the household sector in addition to consumption expenditure
namely, saving flow and the flow of tax payments to the government. These are actually
leakages.
c. The saving leakage flows into financial markets, which means that the part of that is saved is
49
held in the form of some financial asset (currency, bank deposits, bonds, equities, etc.). The
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tax flow goes to the government sector.

d. The leakages which occur in household sector do not necessarily mean that the total
demand must fall short of output. There are additional demands for output on the part of
the business sector itself for investment and from the government sector.
e. In terms of the circular flow, these are injections. The investment injection is shown as a flow
from financial markets to the business sector. The purchasers of the investment goods,
typically financed by borrowing, are actually the firms in the business sector themselves.
Thus, the amount of investment in terms of money represents an equivalent flow of funds
lent to the business sector.
f. The three-sector Keynesian model is commonly constructed assuming that government
purchases are autonomous. This is not a realistic assumption, but it will simplify our analysis.
4. Determination of income can also be explained with the help of aggregate demand and
aggregate supply
AD = C + I+ G
AS = C + S+ T
a. The equilibrium national income is determined at a point where both aggregate demand and
aggregate supply are equal, that is,
AD = Y = AS
C + I+ G =Y= C + S+ T
Determination of Equilibrium Income: Three Sector Model
50
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b. AGGREGATE EXPENDITURE AND AGGREGATE SUPPLY (PANEL A):
i) The variables measured on the vertical axis are C, I and G.
ii) The autonomous expenditure components namely, investment and government
spending do not directly depend on income and are exogenous variables determined by
factors outside the model.
iii) The equilibrium level of income is shown at the point E 1where the (C + l + G) schedule
crosses the 45° line, and aggregate demand is therefore equal to income (Y).
c. LEAKAGES AND INJECTIONS (PANEL B):
i) In panel B, the lines that plot these autonomous expenditure components are horizontal
as their level does not depend on Y. Therefore, C + I + G schedule lies above the
consumption function by a constant amount.
ii) The line S + T in the graph plots the value of savings plus taxes. This schedule slopes
upwards because saving varies positively with income. Just as government spending,
level of tax receipts (T) is decided by policy makers.
iii) In equilibrium, it is also true that the (S + T) schedule intersects the (I + G) horizontal
schedule.
d. Reasons why other points on the graph are not points of equilibrium.
i) Consider a level of income below Y.
a) We find that it generates consumption as shown along the consumption function.
When this level of consumption is added to the autonomous expenditures (I + G),
b) Aggregate demand exceeds income; the (C + I + G) schedule is above the 45° line.
Equivalently at this point I + G is greater than S + T, as can be seen in panel B.
c) With demand outstripping production, desired investments will exceed actual
investment and there will be an unintended inventory shortfall and therefore a
tendency for output to rise.
ii) Conversely, at levels of income above Y1,
a) Output will exceed demand; people are not willing to buy all that is produced.
b) Excess inventories will accumulate, leading businesses to reduce their future
production.
c) Employment will subsequently decline and output will fall back to the equilibrium
level.
iii) It is only at Y that output is equal to aggregate demand; there is no unintended inventory
shortfall or accumulation and, consequently, no tendency for output to change.
iv) The change in total spending, followed by changes in output and employment, is what
will restore equilibrium in the Keynesian model, not changes in prices.
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Q.NO.12 DISCUSS THE ROLE OF GOVERNMENT SECTOR IN DETERMINATION OF NATIONAL
INCOME UNDER THREE SECTOR MODEL?
ANSWER
THE GOVERNMENT SECTOR AND INCOME DETERMINATION: Government influences the level of
income through taxes, transfer payments, government purchases and government borrowing.
1. INCOME DETERMINATION WITH LUMP SUM TAX
We assume that the
a. Government imposes lump sum tax, i.e., taxes that do not depend on income,
b. Government has a balanced budget (G=T) and
c. there are no transfer payments.
The consumption function is defined as – C = a + b Yd
Where Yd = Y –T (disposable income), T = lump sum tax
Y= a + b (Y - T) + I + G
2. INCOME DETERMINATION WITH LUMP SUM TAX AND TRANSFER PAYMENTS

The consumption function is defined as – C = a + b Yd
Where Yd= Y- T+ TR where T is a lump sum tax and TR is autonomous transfer payments
C = a+ b (Y - T + TR)
Y= C+ I+ G
Y= a+ b (Y - T + TR) + I + G
Y= a +bY – bT +bTR + I + G
Y – by = a – bT +bTR + I + G
Y(1-b) = a – bT +bTR + I + G
3. INCOME DETERMINATION WITH TAX AS A FUNCTION OF INCOME

In (i) and (ii) above, we have analysed the effect of balanced budget with an autonomous lump
sum tax. In reality, the tax system consists of both lump sum tax and proportional taxes. The tax
function is defined as;
Tax function T = T + t Y
Where T = autonomous constant tax
t = income tax rate
T = total tax
The consumption function is C = a + b Yd
Where Yd = Y- T or Y -T - t Y
C= a+ b (Y- T - t Y)
Therefore, the equilibrium level of national income can be measured as-
Y= C + I+ G
Y=a+bYd+I+G
Y=a+b(Y-T -tY)+I+G
Y = a +bY - bT - b t Y + I + G
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Y- bY + btY = a -bT + I +G
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Y (1- b+ bt) = a -bT + I +G
4. INCOME DETERMINATION WITH TAX (AS A FUNCTION OF INCOME), GOVERNMENT
EXPENDITURE AND TRANSFER PAYMENTS
Here consumption function is written as C= a + b (Y- T -tY + TR)
Y= a + b (Y- T -tY + TR) + I + G
Q.NO.13 EXPLAIN THE DETERMINATION OF NATIONAL INCOME UNDER FOUR SECTOR MODEL?
ANSWER
DETERMINATION OF EQUILIBRIUM INCOME: FOUR SECTOR MODEL
1. The four sector model includes all four macroeconomic sectors, the household sector, the
business sector, the government sector, and the foreign sector.
2. The foreign sector includes households, businesses, and governments that reside in other
countries.
3. In the four sector model, there are three additional flows namely: exports, imports and net
capital inflow which is the difference between capital outflow and capital inflow.
4. The C+I+G+(X-M) line indicates the aggregate demand or the total planned expenditures of
consumers, investors, governments and foreigners (net exports) at each income level.
CIRCULAR FLOW IN A FOUR SECTOR ECONOMY
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In equilibrium, we have
Y = C + I + G + (X-M)
Q.NO.14 DISCUSS HOW EXPORTS, IMPORTS, NET EXPORTS ARE USEFUL IN DETERMINATION OF
EQULIBRIUM INCOME UNDER FOUR SECTOR MODEL?
ANSWER
1. The domestic economy trades goods with the foreign sector through exports and imports.
2. Exports are the injections in the national income, while imports act as leakages or outflows of
national income.
3. Exports represent foreign demand for domestic output and therefore, are part of aggregate
demand. Since imports are not demands for domestic goods, we must subtract them from
aggregate demand.
4. The demand for imports has an autonomous component and is assumed to depend on income.
Imports depend upon marginal propensity to import which is the increase in import demand per
unit increase in GDP.
5. The demand for exports depends on foreign income and is therefore exogenously determined
and is autonomous.
6. Imports are subtracted from exports to derive net exports, which is the foreign sector's
contribution to aggregate expenditures.
7. Since import has an autonomous component (M) and is assumed to depend on income(Y) and
marginal propensity to import (m), the import function is expressed as M= M + mY. Marginal
propensity to import m = ∆ M/∆ Y is assumed to be constant.
8. The equilibrium level of national income is determined at the level at which the aggregate
demand is equal to aggregate supply. The equilibrium condition is expressed as follows-
Y = C + I+ G + (X – M)
Where C = a + b(Y-T) M= M + mY
The equilibrium level of National Income can now be expressed by –
Y = C + I+ G + (X – M)
Y = a+ b (Y- T) + I + G + X-M - mY
Y – bY + mY = a- bT + I + G + X - M
9. The economy being in equilibrium, suppose export of country increases by ∆ X autonomously, all
other factors remaining constant. By incorporating the increase in exports by ∆ X, the
equilibrium equation of the country can be expressed as
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Or alternatively written as
The term 1/1 – b + m is known as foreign trade multiplier whose value is determined by marginal
propensity to consume (b) and marginal propensity to import (m).
10. If in the model proportional income tax and government transfer payments are incorporated,
then only the denominator of multiplier will change. If income tax is of form T= T + t Y where T is
constant lump-sum, t is the proportion of income tax and TR > 0 and autonomous, then the four
sector model can be expressed as:
Y = C + I+ G + (X – M)
Where C = a + b (Y- T - t Y + TR)
M= M + mY.
The equilibrium level of National Income can now be expressed as:
Q.NO.15 EXPLAIN DETERMINATION OF EQUILIBRIUM INCOME UNDER FOUR SECTOR MODEL

GRAPHICALLY?
ANSWER
1. Equilibrium is identified as the intersection between the C + I + G + (X - M) line and the 45-
55
degree line. The equilibrium income is Y. From panel B, we find that the leakages(S+T+M) are
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equal to injections (I+G+X) only at equilibrium level of income.

2. Only net exports(X-M) are incorporated into the four sector model of income determination.
3. Injections increase the level of income and leakages decrease it.
4. If net exports are positive (X > M), there is net injection and national income increases.
Conversely, if X<M, there is net withdrawal and national income decreases. In above graph
depicts a case of X<M.
5. When the foreign sector is included in the model (assuming M > X), the aggregate demand
schedule C+I+G shifts downward with equilibrium point shifting from F to E.
6. The inclusion of foreign sector (with M > X) causes a reduction in national income from Y0to Y1.
7. When X > M, the aggregate demand schedule C+I+G shifts upward causing an increase in
national income. Learners may infer diagrammatic expressions for possible changes in
equilibrium income for X>M and X = M. The greater the value of ‘m’, the lower will be the
autonomous expenditure multiplier.
Effects on Income When Imports are Greater than Exports
Q.NO.16 EXPLAIN THE EFFECTS OF COUNRY’S IMPORTS AND EXPORTS ON EQUILIBRIUM INCOME?
ANSWER
1. The more open an economy is to foreign trade, (the higher m is) the smaller will be the response
of income to aggregate demand shocks, such as changes in government spending or
autonomous changes in investment demand.
2. A change in autonomous expenditures will have a direct effect on income and an induced effect
on consumption with a further effect on income.
3. The higher the value of m, larger the proportion of this induced effect on demand for foreign,
not domestic, consumer goods.
4. Consequently, the induced effect on demand for domestic goods and, hence on domestic
income will be smaller.
5. The increase in imports per unit of income constitutes an additional leakage from the circular
flow of (domestic) income at each round of the multiplier process and reduces the value of the
autonomous expenditure multiplier.
6. An increase in demand for exports of a country is an increase in aggregate demand for
domestically produced output and will increase equilibrium income just as an increase in
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government spending or an autonomous increase in investment.

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7. An increase in the demand for a country’s exports has an expansionary effect on equilibrium
income, whereas an autonomous increase in imports has a contractionary effect on equilibrium
income.
8. However, this should not be interpreted to mean that exports are good and imports are harmful
in their economic effects.
9. Countries import goods that can be more efficiently produced abroad, and trade increases the
overall efficiency of the worldwide allocation of resources.
10. This forms the rationale for attempts to stimulate the domestic economy by promoting exports
and restricting imports.
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APPLICATION ORIENTED QUESTIONS
Q.NO.1
In a two sector economy, the business sector produces 7000 units at an average price of Rs.5.
a. What is the money value of output?
b. What is the money income of households?
c. If households spend 80 percent of their income, what is the total consumer expenditure?
d. What are the total money revenues received by the business sector?
e. What should happen to the level of output?
ANSWER:
a. The money value of output equals total output times the average price per unit. The money
value of output is (7,000 x 5) = Rs.35,000.
b. In a two sector economy, households receive an amount equal to the money value of output.
Therefore, the money income of households is the same as the money value of output i.eRs.
35,000.
c. Total spending by households (Rs.35,000 x 0.8) i.e., Rs.28,000.
d. The total money revenues received by the business sector is equal to aggregate spending by
households i.e., Rs.28, 000.
e. The business sector makes payments of Rs.35000 to produce output, whereas the households
purchase only output worth Rs.28,000 of what is produced. Therefore, the business sector has
unsold inventories valued at Rs.7000. They should be expected to decrease output.
Q.NO.2 Assume that an economy’s consumption function is specified by the equation C = 500 +
0.80Y.
a. What will be the consumption when disposable income (Y) is Rs.4,000, Rs.5,000, and Rs.6,000?
b. Find saving when disposable income is Rs.4,000, Rs.5,000, and Rs.6,000.
c. What amount of consumption for consumption function C is autonomous?
d. What amount is induced when disposable income isRs.4,000? Rs.5,000? Rs.6,000?
ANSWER:
a. Consumption for each level of disposable income is found by substituting the specified
disposable income level into the consumption equation.
a. Thus, for Y = Rs.4,000, C = Rs.500 + 0.80(Rs.4,000) = Rs.500 + Rs.3,200 = Rs.3,700.
b. Likewise C is Rs.4,500 when Y = Rs.5,000, and Rs.5,300 when Y = Rs.6,000.
b. Saving is the difference between disposable income and consumption. It is the difference
between the consumption line and the 45 line at each level of disposable income
a. Using the calculation from part a) above, we find that saving is Rs.300 when Y is Rs.4,000;
Rs.500 when Y is Rs.5,000 and Rs.700 when Y is Rs.6,000.
c. Autonomous consumption is the amount consumed when disposable income is zero;
autonomous consumption is Rs.500, i.e the consumption expenditure when the consumption
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line C intersects the vertical axis and disposable income is 0. Since autonomous consumption is
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unrelated to income, autonomous consumption is Rs.500 for all levels of income.

d. Induced consumption is the amount of consumption that depends upon the level of income.
Consumption is Rs.3,700 when disposable income is Rs.4,000. Since Rs.500 is autonomous (i.e
consumed regardless of the income level), Rs.3,200 out of the Rs.3,700 level of consumption is
induced by disposable income. Similarly, Induced consumption is Rs.4,000 when disposable
income is Rs.5,000, and Rs.4,800 when disposable income is Rs.6,000.
Q.NO.3 Find the value of the multiplier when

a. MPC is 0.2
b. MPC is 0.5
c. MPC is 0.8
ANSWER:
The value of the multiplier (k) is found by relating the change in output (∆Y) to the initial change in
aggregate spending. The value of the multiplier is directly related to the level of MPC, i.e., the
greater the MPC, the larger the value of the multiplier. The value of the multiplier is found from the
equation k = 1/ (1 − MPC).
a. Thus, when MPC is 0.2, the multiplier is 1.25
b. When MPC is 0.5, the multiplier is 2
c. When MPC = 0.80, the multiplier is 5
Q.NO.4 For the linear consumption function is C = 700 + 0.8Y; I is Rs.1200 and Net exports X-M =
100. Find equilibrium output?
ANSWER:
The equilibrium level of output can be found by equating output and aggregate spending i.e. by
solving Y = C + I + X-M for Y
Y = C + I + X- M
Y = 700 + 0.8Y + 1200 + 100
Y − 0.8Y = 700 + 1200 + 100
0.2Y = 2000
Y =2000/.2 = 10,000
Q.NO.5 Suppose in an economy

C = 100 + b(Y – 50 –t Y) ;
I = 50; G = 50 ;X = 10; M = 5 + 0.1Y;
MPC (b) = 0.8;
Proportional income tax rate (t) = 0.25
a. Find the equilibrium national income, foreign trade multiplier, equilibrium value of
imports.
b. If equilibrium national income falls short of full employment income by Rs.50, how much
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government should increase its expenditure to attain full – employment?

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ANSWER:
a. Y = C + I + G+X- M
Y= 100 + b (Y – 50 –t Y) +50+50 +10-5-0.1Y
Y= 100+ 0.8 (Y-50-0.25Y) +105 -0.1Y
Y= 100+0.8Y-40-0.2Y +105-0.1Y
Y= 165 +0.8Y-0.2Y-0.1Y
Y=165+ 0.5Y
Y-0.5Y=165
Y=165/0.5
Y= 330
OR
EQUILIBRIUM VALUE OF IMPORTS can be obtained by substituting the equilibrium income in the
import function. Thus M = 5+0.1 Y = 38
b. Required increase in government expenditure to attain Rs. 50 increase in Income can be

obtained as under
Q.NO.6 Suppose the consumption function is C=50+0.8Yd, I=180 crores, G=190, crores, T=0.20Y
a. Find the equilibrium level of income.
b. Find the revenue from taxes at equilibrium. Is the government budget balanced?
c. Find the equilibrium level of income when investment increases by 120 crores.
ANSWER:
a. Y = 50 + 0.8(Y-.20Y) + 180 + 190,
Ye = 420/.36 = 1166.66 Crores
b. T=0.2 (1166.66) = 233.332 Crores
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G=190< T= 233.332, thus, budget is not in balance. There exists a budget Surplus
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c. Change in Y= Change in I/ (1-b+bt) = 120/ (1-.8+.16) = 120/.36= 333.33Crores,

So new Y equilibrium:
Y new= 1166.66+333.33 = 1499.99 Crores
Q.NO.7 Given the following equations:

C=50+0.6Yd, I= 160, T =30, G =28, X-M = 20 -0.05 Y
a. Find the equilibrium level of income.
b. Find the net exports at equilibrium.
c. Find the income and net exports when investment increases to 195.
ANSWER:
a. Y = AE
Y= C + I + G + (X – M)
Y= 50+0.6(Y-T) + I + G + (X – M)
240+.55Y=Y
Ye= 533.33 Crores
b. X – M = 20 - .05 (533.33) = -6.66 Crores
c. Change in I= 35
Change in Y= 35/(1-b+m) =35/ (1-.6+.05) = 77.77 Crores
Thus, Ye= 533.33+77.77 =611.1 Crores
X-M @ Ye= 611.1= 20-.05(611.1) =10.555 Crores
Q.NO.8 What will be the value of average propensity to save when –

a. C = 200 at Y = 1,000
b. S = 450 at Y = 1,200
ANSWER:
a. APS = S/Y
S = Y – C = 1,000 – 200 = 800
Therefore, APS = S/Y = 800/1000 = 0.8
b. When S = 450 and Y = 1,200;
APS = S/Y = 450/1200 = 0.375
Q.NO.9 Calculate marginal propensity to consume and marginal propensity to save from the
following data about an economy which is in equilibrium:
National income = 2500,
Autonomous consumption expenditure = 300,
Investment expenditure = 100
ANSWER:
Y=C+I
By putting the value we get, 2500 = C + 100
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C = 2500 -100 = 2400

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C = C + bY
2400 = 300 + 2500 b
2400-300= 2500b
b = 0.84; MPS= 1- MPC = 1- 0.84 = 0.16
Q.NO.10 An economy is in equilibrium. Calculate national income from the following-

Autonomous consumption = 100;
Marginal propensity to save= 0.2;
Investment expenditure= 200
ANSWER:
Y= C + I
Y= C + MPC (Y) + I where MPC = 1-MPS
Y = 100 + 0.8Y + 200= 300 + 0.8Y
Y- 0.8Y = 300 0.2Y=300,
Y= 1500
Q.NO.11 Suppose the consumption of an economy is given by C = 20+ 0.6 Y and investment I= 10+
0.2 Y. What will be the equilibrium level of National Income?
ANSWER:
Y= C + I= 20+ 0.6 Y + 10+ 0.2 Y
Y = 30+ 0.8 Y
Y- 0.8 Y = 30
Y= 150
Q.NO.12 Suppose the consumption function C= 7+ 0.5Y, Investment is Rs.100, Find out equilibrium
level of Income, consumption and saving?
ANSWER:
Equilibrium Condition–
Y= C +I, Given C= 7+0.5Y and I= 100
Therefore Y= 7+0.5Y+ 100
Y- 0.5Y= 107
Y = 107/0.5 = 214
Y= C+I
214= C+100
C=114
S= Y- C =100
Q.NO.13 If the consumption function is C= 250 + 0.80 Y and I = 300. Find out equilibrium level of Y,
C and S?
ANSWER:
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C = 250+0.8(2750)
C = 2450
S = Y-C where C=a+bY
S = Y-(a+bY)
S = -a+(1-b)Y
= -250+(1-0.8)2750)
= 300
Or directly
S = Y-C
S=2750-2450=300
Q.NO.14 If saving function S = -10 + 0.2Y and autonomous investment I = 50 Crores. Find out the
equilibrium level of income, consumption and if investment increases permanently by Rs.5 Crores,
what will be the new level of income and consumption?
ANSWER:
S= I
-10 + 0.2Y = 50
0.2Y = 50 + 10
Y = 300 Crores
C= Y- S
Where S= -10 + 0.2 (300) = 50
C= 300-50 = 250 Crores
With the increase in investment by Rs.5 Crores, the new investment will become equal to Rs. 55
Crores.
S= I
-10 + 0.2Y = 55
Y= 325 Crores
C= 270 Crores
Q.NO.15 Given the empirical consumption function C= 100+0.75Y and I = 1000, calculate
equilibrium level of national income. What would be the consumption expenditure at equilibrium
level national income?
ANSWER:
C= 100+0.75Y and I = 1000,
Y=C+I in equilibrium
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Q.NO.16 In an economy investment expenditure is increased by Rs.400 Crores and marginal
propensity to consume is 0.8. Calculate the total increase in income and saving.
ANSWER:
MPC = 0.8; ∆I = 400 Crores
Multiplier (K)= 1 /1- MPC = 1 /1- 0.8 =1/ 0.2= 5
MPS= 1 - MPC = 1 – 0.8 = 0.2
Increase in income (∆Y) = K ×∆I = 5 × 400=2,000 Crores
Increase in saving= ∆Y × MPS = 2,000 × 0.2 = 400Crores
Q.NO.17 An increase in investment by 400 Crores leads to increase in national income by 1,600
Crores. Calculate marginal propensity to consume.
ANSWER:
Increase in investment (∆I) = 400 Crores
Increase in national income (∆ Y) = 1,600 Crores
Multiplier (K) =∆Y/∆I = K= 1,600/ 400 = 4
We know, K= 1 /1 –MPC
4= 1 /1 - MPC
MPC= 0.75
Q.NO.18 In an economy, investment is increased by Rs 600 Crores. If the marginal propensity to

consume is 0.6, calculate the total increase in income and consumption expenditure.
ANSWER:
MPC = 0.6; ∆I = Rs.600 Crores
Multiplier (K) = 1/ 1- MPC = 1/ 1 – 0.6 = 1/ 0.4 =25.
Increase in income (∆Y) = K × ∆I = 2.5 × Rs 600 Crores= Rs1,500 Crores
Increase in consumption (∆C) =∆Y × MPC = Rs1, 500Crores × 0.6 = Rs.900 Crores.
Q.NO.19 Suppose in a country investment increases by Rs.100 Crores and consumption is given by
C = 10 + 0.6Y (where C = consumption and Y = income). How much increases will there take place
in income?
ANSWER:
Multiplier = k = 1/1 – MPC = 1/1 – 0.6 = 2.5
Substituting the value of k and ∆I value in ∆Y= k∆I
∆Y= 2.5 X 100= Rs.250Crores
64
Thus, increase in investment by Rs 100 Crores will cause equilibrium income to rise by Rs.250
Crores
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Q.NO.20 Suppose we have the following data about a simple economy:
C = 10 + 0.75Yd,
I = 50, G = T = 20
where C is consumption, I is investment, Yd is disposable income, G is government
expenditure and T is tax.
a. Find out the equilibrium level of national income.
b. What is the size of the multiplier?
ANSWER:
a. Since G = T, budget of the government is balanced
Substituting the values of C, I and G in Y we have
Y = C+I+G
Y = a + bYd + I + G
Y= 10 + 0.75 (Y – 20) + 50 + 20
Y= 10 + 0.75 Y- 15 + 50 + 20 or, Y – 0.75 Y = 65
or, Y (1 – 0.75) = 65
or, 0.25 Y = 65
or, Y = 65 /.25 = 260
The equilibrium value of Y = 260
b. The value of the multiplier is = 1/ (1 – MPC) = 1/ (1 – b) = 1/ (1 – 0.75) = 1/0.25 = 4
Q.NO.21 Suppose the structural model of an economy is given –

C = 100+ 0.75 Yd; I = 200, G = T = 100; TR= 50,
find the equilibrium level of income?
ANSWER:
Y= C+ I+ G
Y = 100+ 0.75 Yd + 200 + 100
Y= 100 + 0.75(Y– 100 + 50) + 200 + 100
Y = 100 + 0.75Y -75 + 37.5 +200 +100
Y = 1450
Q.NO.22 For a closed economy, the following data is given –

Consumption C = 75 + 0.5 (Y-T); Investment I = 80; Total tax T = 25 + 0.1Y; Government
expenditure G = 100.
a. Find out equilibrium income?
b. What is the value of multiplier?
ANSWER:
65
a. Y = C+ I+G
Y= 75+ 0.5(Y- 25- 0.1Y) + 80+ 100
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Y(1-0.5+0.05)= 75-12.5+80+100
b.
Q.NO.23 Suppose C= 100 + 0.80 (Y- T + TR); I = 200; T= 25+0.1Y; TR= 50; G = 100
Find out equilibrium level of Income?
ANSWER:
Y=C+I+G
Y= 100 + 0.80 (Y- T + TR) + I+ G
Y=100 +0.80(Y – 25 - 0.1Y + 50) + 200 + 100
Y – 0.80 Y +0.08 Y = 420
Y(1-0.8+0.08) =420
Y= 1500
Q.NO.24 The consumption function is C = 40 + 0.8Yd,T= 0.1Y, I = 60 Crores G = 40 Crores, X = 58

and M = 0.05 Y. Find out equilibrium level of income, Net Export, net export if export were to
increase by 6.25.
ANSWER:
C= 40+ 0.8Yd
C= 40 + 0.8 (Y- 0.1Y)
Y= C + I+ G + (X – M)
Y= 40+0.8 (Y-0.1Y) + 60+40+(58-0.05Y)
Y= 40 + 0.8(0.9Y) + 60 + 40 + 58 - 0.05Y
Y-0.72Y+0.05Y = 198
Y (1-0.72+0.05) =198
Y (0.33) =198
Y= 198/0.33 = 600 Crores
Net Export= X-M = 58 – 0.05Y
58 – 0.05 (600) =58- 30= 28
If exports increase by 6.25, then exports = 64.25
Then, Y = 40+ 0.8 (Y- 0.1Y) + 60 + 40 + (64.25- 0.05Y)
Y (1-0.72+0.05) = 204.5
Y (0.33) = 204.5
Y=204.5/0.33 = 619.697
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Then import = .05 × 619.697 = 30.98

Net Export = 64.25- 30.98 = 33.27 Crores
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Thus, there is surplus in balance of trade as Net Exports are positive.
Q.NO.25 An economy is characterised by the following equation- Consumption C = 60+0.9Yd

Investment I = 10
Government expenditure G = 10 Tax T = 0
Exports X = 20
Imports M = 10 +0.05 Y What is the equilibrium income?
Calculate trade balance and foreign trade multiplier.
ANSWER:
Y = C + I+ G + (X – M)
= 60+0.9(Y – 0) + 10 +10 + (20- 10 -0.05Y)
= 60+ 0.9 Y +30 -0.05 Y
Y= 600
Trade Balance = X – M = 20-10-0.05(600) =- 20
Thus, trade balance in deficit.
Foreign trade multiplier = 1/1-b-m = 1/1-0.9+0.05 = 6.66
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2.1. FISCAL FUNCTIONS
Q.NO.11 WHAT IS THE PROBLEM FACED BY ECONOMIC SYSTEM AND EXPLAIN THE ROLE OF
GOVERNMENT IN AN ECONOMIC SYSTEM?
ANSWER:
A. PROBLEM FACED BY ECONOMIC SYSTEM
1. The basic economic problem of scarcity arises on account of qualitative as well as
quantitative constraints, the resources available to any society cannot produce all economic
goods and services that its members desire to have. Therefore, an economic system should
exist to answer the basic questions such as what, how and for whom to produce and how
much resources should be set apart to ensure growth of productive capacity.
2. The modern society offers three alternate economic systems through which the decisions of
resource reallocation may be made namely, the market, the government and a mixed system
where both markets and governments simultaneously determine resource allocation.
3. Correspondingly, we have three economic systems namely, capitalism, socialism and mixed
economy, each with varying degrees of state intervention in economic activities.
B. ROLE OF GOVERNMENT IN A MARKET ECONOMY IN THE WORDS OF ADAM SMITH

1. Adam Smith is often described as a bold advocate of free markets and minimal governmental
activity.
2. However, Smith saw an important resource allocation role for government when he
underlined the role of government in national defence, maintenance of justice and the rule
of law, establishment and maintenance of highly beneficial public institutions and public
works which the market may fail to produce on account of lack of sufficient profits.
3. Since the 1930s, more specifically as a consequence of the great depression, the state’s role
in the economy has been distinctly gaining in importance, and therefore, the traditional
functions of the state as described above, have been supplemented with what is referred to
as economic functions (also called fiscal functions or public finance function).
4. While there are differences among different countries in respect of the nature and extent of
government intervention in economies, all of them agree on one point that the governments
are expected to play a major role in the economy. This comes out of the belief that
government intervention will invariably influence the performance of the economy in a
positive way.
C. ROLE OF GOVERNMENT IN A MARKET ECONOMY IN THE WORDS OF RICHARD MUSGRAVE

1. Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the
three-branch taxonomy of the role of government in a market economy.
2. Musgrave believed that, for conceptual purposes, the functions of the government are to be
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separated into three, namely, resource allocation, (efficiency), income redistribution

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(fairness) and macroeconomic stabilization.

3. The allocation and distribution functions are primarily microeconomic functions, while
stabilization is a macroeconomic function.
4. The allocation function aims to correct the sources of inefficiency in the economic system,
while the distribution role ensures that the distribution of wealth and income is fair.
5. Monetary and fiscal policies, the problems of macroeconomic stability, maintenance of high
levels of employment and price stability etc fall under the stabilization function.
Q.NO.12 WHAT IS MEANY BY RESOURCE ALLOCATION, PRIVATE SECTOR RESOURCE ALLOCATION

AND STATE RESOURCE ALLOCATION?
ANSWER:
THE ALLOCATION FUNCTION
1. Resource allocation refers to the way in which the available resources or factors of production
are allocated among the various uses to which they might be put. It determines how much of
the various kinds of goods and services will actually be produced in an economy.
2. Resource allocation is a critical problem because the resources of a society are limited in supply,
while human wants are unlimited. Moreover, any given resource can have many alternative
uses.
3. One of the most important functions of an economic system is the optimal or efficient allocation
of scarce resources so that the available resources are put to their best use and no wastages are
there.
4. Efficient allocation of available resources in an economy takes place only when free and
competitive market structure exists and economic agents make rational choices and decisions.
5. The private sector resource allocation is characterized by market supply and demand and price
mechanism as determined by consumer sovereignty and producer profit motives.
6. The state’s allocation is accomplished through the revenue and expenditure activities of
governmental budgeting. In the real world, resource allocation is both market- determined and
government-determined.
Q.NO.13 BRIEFLY DISCUSS THE REASONS FOR MISALLOCATION OF RESOURCES?

ANSWER:
MISALLOCATION OF RESOURCES:
1. A market economy is subject to serious malfunctioning in several basic respects. There is also
the problem of nonexistence of markets in a variety of situations.
2. While private goods will be sufficiently provided by the market, public goods will not be
produced in sufficient quantities by the market.
3. Efficient allocation of available resources in an economy takes place only when free and
competitive market structure exists and economic agents make rational choices and decisions.
4. Such efficient allocation of resources is assumed to take place only in perfectly competitive
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markets. In reality, markets are never perfectly competitive. Market failures which hold back the
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efficient allocation of resources occur mainly due to the following reasons:
a. Imperfect competition and presence of monopoly power in different degrees leading to
under-production and higher prices than would exist under conditions of competition. These
distort the choices available to consumers and reduce their welfare.
b. Markets typically fail to provide collective goods which are, by their very nature, consumed
in common by all people.
c. Markets fail to provide the right quantity of merit goods.
d. Common property resources are overused and exhausted in individual pursuit of self-
interest.
e. Externalities which arise when the production and consumption of a good or service affect
people and they cannot influence through markets the decision about how much of the good
or service should be produced e.g. pollution.
f. Factor immobility which causes unemployment and inefficiency.
g. Imperfect information, and
h. Inequalities in the distribution of income and wealth.
Q.NO.14 DISCUSS WHY GOVERNMENT INTERVENTION IN ALLOCATION OF RESOURCES IS

REQUIRED AND NAME THE INSTRUMENTS OF GOVERNMENT THAT CAN INFLUENCE THE
RESOURCE ALLOCATION? ILLUSTRATE FOUR CASES WHICH PROVIDE JUSTIFICATION FOR
GOVERNMENT INTERVENTION IN MARKETS. WHAT ARE THE DIFFERENT INSTRUMENTS AVAILABLE
TO THE GOVERNMENT TO IMPROVE ALLOCATION EFFICIENCY IN AN ECONOMY?
ANSWER:
1. According to Musgrave, the state is the instrument by which the needs and concerns of the
citizens are fulfilled and therefore, public finance is connected with economic mechanisms that
should ideally lead to the effective and optimal allocation of limited resources.
2. In the absence of appropriate government intervention, market failures may occur and the
resources are likely to be misallocated with too much production of certain goods or too little
production of certain other goods.
3. The allocation responsibility of the governments involves suitable corrective action when private
markets fail to provide the right and desirable combination of goods and services.
4. The government can provide us with goods and services that we cannot produce on our own or
buy at a price from the market.
For example, the government establishes property rights and makes the necessary arrangements
for enforcing contracts through provision of law enforcement and courts.
5. Goods which involve externalities that are not appropriately accounted for by price mechanism
in the market system require intervention by the government for corrective measures.
6. Merit goods which are greatly beneficial to the society also fall under the purview of provision
by the government. Demerit goods are controlled with appropriate legislations.
7. These interventions do not imply that markets are replaced by government action. In its
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allocation role, the government acts as a complement rather than as a substitute to the market
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system in an economy.
8. The resource allocation role of government’s fiscal policy focuses on the potential for the
government to improve economic performance through its expenditure and tax policies.
9. The allocative function in budgeting determines who and what will be taxed as well as how and
on what the government revenue will be spent. It is concerned with the provision of public
goods and the process by which the total resources of the economy are divided among various
uses and an optimum mix of various social goods (both public goods and merit goods).
10. The allocation function also involves the reallocation of society’s resources from private use to
public use.
11. A variety of allocation instruments are available by which governments can influence resource
allocation in the economy. For example,
a. Government may directly produce an economic good (for example, electricity and public
transportation services)
b. Government may influence private allocation through incentives and disincentives (for
example, tax concessions and subsidies may be given for the production of goods that
promote social welfare and higher taxes may be imposed on goods such as cigarettes and
alcohol)
c. Government may influence allocation through its competition policies, merger policies etc.
which affect the structure of industry and commerce (for example, the Competition Act in
India promotes competition and prevents anti-competitive activities)
d. Governments’ regulatory activities such as licensing, controls, minimum wages, and
directives on location of industry influence resource allocation.
e. Government sets legal and administrative frameworks, and
f. Any mixture of intermediate methods may be adopted by governments
g. Maximizing social welfare is one of the primary and most commonly manifest reasons for
government intervention in the market.
12. GOVERNMENT FAILURE AS A PART OF MISALLOCATION OF SOCIETY SCARCE RESOURCES
a. It is also possible that instead of eliminating market distortions, sometimes government
intervention may contribute to generate them.
b. Such instances are referred to as government failure. A government failure is said to occur
when government intervention in the market creates inefficiency and leads to misallocation
of society’s scarce resources.
c. The possible sources of this type of government failures are inadequate information, political
self-interest, conflicting objectives, bureaucracy, corruption and red tape, and high
administrative costs involved in government intervention.
d. Government failure may be relatively inconsequential if it gets restricted to being simply
ineffective and therefore the costs of such intervention are limited to the resources wasted
for such intervention.
e. Government failure is more serious when such intervention has generated new and serious
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problems which will have far reaching adverse consequences on the welfare of citizens.
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f. Governments should identify and evaluate the inefficiencies that may result from market
failure and the potential inefficiencies associated with deliberate government policies
framed to redress market failure.
Q.NO.15 DISCUSS ABOUT DISTRIBUTIVE FUNCTION OF GOVERNMENT? STATE THE AIMS OF

DISTRIBUTIVE FUNCTION OF THE GOVERNMENT?
ANSWER:
DISTRIBUTION FUNCTION
1. The distributive function of budget is related to the basic question of for whom should an
economy produce goods and services. It is concerned with the adjustment of the distribution of
income and wealth so as to ensure distributive justice namely, equity and fairness.
2. Governments can redistribute either through the expenditure side or through the revenue side
of the budget.
a. On the expenditure side, governments may provide free or subsidised education, healthcare,
housing, food and basic goods etc to deserving people.
b. On the revenue side, redistribution is done through progressive taxation.
3. Effective demand is determined by the level of income of the households and this in turn
determines the distribution of real output among people.
4. Therefore, the distribution function also relates to the manner in which the effective demand
over the economic goods is divided among the various individual and family spending units of
the society.
5. The present-day governments therefore involves changing the pattern of distribution of income,
wealth and opportunities from what the market would put forward to a more socially optimal
and egalitarian one.
6. The distribution function of the government aims at:
a. redistribution of income to achieve an equitable distribution of societal output among
households
b. advancing the well-being of those members of the society who suffer from deprivations of
different types
c. providing equality in income, wealth and opportunities
d. providing security (in terms of fulfilment of basic needs) for people who have hardships, and
e. ensuring that everyone enjoys a minimal standard of living
7. Redistribution of Income is essential to achieve an equitable distribution of societal output
among households. A few examples of the redistribution function (or market intervention for
economic reasons) performed by governments are:
a. Taxation policies of the government whereby progressive taxation of the rich is combined
with provision of subsidy to the poor households
b. Proceeds from progressive taxes used for financing public services, especially those that
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benefit low-income households (for example, supply of essential food grains at highly
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subsidized prices to BPL households)
c. Employment reservations and preferences to protect certain segments of the population,
d. Unemployment benefits and transfer payments to provide support to the underprivileged,
dependent, and physically handicapped,
e. Families below the poverty line are provided with monetary aid and aid in kind
f. Regulation of manufacture and sale of certain products to ensure health and well-being of
consumers, and
g. Special schemes for backward regions and for the vulnerable sections of the population
h. In modern times, most of the egalitarian welfare states provide free or subsidized education
and health-care system, unemployment benefits, pensions and such other social security
measures.
8. In exercising the redistributive function, there would be a conflict between efficiency and equity.
In other words, governments’ redistribution policies which interfere with producer choices or
consumer choices are likely to have efficiency costs or deadweight losses.
Greater equity can be achieved through high rates of taxes on the rich;
a. High rates of taxes could also act as a disincentive to entrepreneurship and work, and
discourage people from making savings and investments and taking risks.
b. This in turn will have negative consequences for economic output, productivity and growth
of the economy.
c. Consequently, the potential tax revenue may be reduced in future and the scope for
government’s welfare activities would get seriously limited.
d. An optimal budgetary policy towards any distributional change should reconcile the
conflicting goals of efficiency and equity by exercising an appropriate trade-off between
them.
Q.NO.16 DISCUSS THE BASIS FOR STABILIZATION FUNCTION OF GOVERNMENT? EXPLAIN HOW
ECONOMIC STABILITY CAN BE ACHIEVED THROUGH FISCAL POLICY?
ANSWER:
STABILIZATION FUNCTION
1. The theoretical rationale for the stabilization function of the government is derived from the
Keynesian proposition that a market economy does not automatically generate full employment
and price stability and therefore, the governments should pursue deliberate stabilization
policies.
2. Business cycles are natural phenomena in any economy and they tend to occur periodically.
3. The market system has inherent tendencies to create business cycles. The market mechanism is
limited in its capacity to prevent or to resolve the disruptions caused by the fluctuations in
economic activity.
4. In the absence of appropriate corrective intervention by government, the instabilities that occur
in the economy in the form of recessions, inflation etc., may be prolonged for longer periods
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causing enormous hardships to people, especially the poorer sections of the society.
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5. It is also possible that a situation of stagflation (a state of affairs in which inflation and
unemployment exist side by side) may set in and make the problem more intricate.
6. The stabilization issue also becomes more complex due to ‘contagion effect’ whereby the
increased international interdependence and financial integration causes forces of instability to
get easily transmitted from one country to other countries.
7. The stabilization function is one of the key functions of fiscal policy and aims at eliminating
macroeconomic fluctuations arising from suboptimal allocation of resources.
8. The stabilization function is concerned with the performance of the aggregate economy in terms
of:
a. Labour employment and capital utilization,
b. Overall output and income,
c. General price levels,
d. Balance of international payments, and
e. The rate of economic growth.
9. Government’s fiscal policy has two major components which are important in stabilizing the
economy:
a. An overall effect generated by the balance between the resources the government puts into
the economy through expenditures and the resources it takes out through taxation, charges,
borrowing etc.
b. A microeconomic effect generated by the specific policies it adopts.
Q.NO.17 DISCUSS HOW ECONOMIC STABILITY IS ACHEIVED THROUGH FISCAL POLICY?

ANSWER:
Government’s stabilization intervention may be through monetary policy as well as fiscal policy.
1. Monetary policy works through controlling the size of money supply and interest rate in the
economy which in turn would affect consumption, investment and prices.
2. Fiscal policy for stabilization purposes attempts to direct the actions of individuals and
organizations by means of its expenditure and taxation decisions.
a. On the expenditure side, Government can choose to spend in such a way that it stimulates
other economic activities. For example, government expenditure on building infrastructure
may initiate a series of productive activities. Production decisions, investments, savings etc
can be influenced by its tax policies.
b. On the other hand, taxes reduce the disposable income of people and therefore, reduce
effective demand.
c. During recession, in order to ensure income protection, the government increases its
expenditure or cuts down taxes or adopts a combination of both so that aggregate demand
is kept stable or even boosted up with more money put into the hands of the people.
d. On the other hand, to control high inflation the government cuts down its expenditure or
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raises taxes.
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e. The nature of the budget (surplus or deficit) also has important implications on a country’s
economic activity. While deficit budgets are expected to stimulate economic activity, surplus
budgets tend to slow down economic activity.
f. Generally government’s fiscal policy has a strong influence on the performance of the macro
economy in terms of employment, price stability, economic growth and external balance.
3. There is often a conflict between the different goals and functions of budgetary policy. Effective
policy design to meet the diverse goals of government is very difficult to conceive and to
implement. The challenge before any government is how to design its budgetary policy so that
the pursuit of one goal does not jeopardize the other.
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Q.NO.1 ELUCIDATE THE NATURE OF ECONOMIC FUNCTION PERFORMED BY THE GOVERNMENT IN
THE FOLLOWING CASES:-
a. THE GOVERNMENT INITIATES A MASSIVE PROGRAMME FOR ERADICATION OF MOSQUITO-
BORNE DISEASES IN COASTAL AREAS.
b. THE GOVERNMENT FIXES THE PRICES OF 377 ESSENTIAL MEDICINES LISTED IN THE NATIONAL
LIST OF ESSENTIAL MEDICINE, 2015.
ANSWER:
a.
i) Public good – Merit good- Positive externalities – Inefficient market outcomes - Possible
market failure – scope for market intervention to improve social welfare - Adam Smith’s
proposition of resource allocation role of government i.e., establishment and maintenance
of highly beneficial public institutions and public works which the market may fail to produce
on account of lack of sufficient profits. Define the resource allocation role of government’s
policy - the potential for the government to improve economic performance through its
expenditure to provide an optimum mix of various social goods.
ii) Nature and characteristics of the programme of government action – Policy of Expenditure -
Purpose- Welfare outcomes of programmes for eradication of mosquito-borne diseases –
Possibility of government failure.
iii) Substantiate with examples from recent policy propositions of government.
b.
i. The distributive function of budget related to the basic question of for whom should an
economy produce goods and services. Left to the market, only private benefits and private
costs would be reflected in the price paid by consumers. This means, through the market
mechanism, people would consume inadequate quantities compared to what is socially
desirable. Outcome: social welfare will not be maximized. Therefore - Government
Intervention in the case of Merit Goods eg. Healthcare - government deems that its
consumption should be encouraged
- Price intervention- setting price ceilings - to influence the outcomes of a market on
grounds of fairness and equity – price floor for ensuring minimum price and price ceiling for
making a resource or commodity available to all at reasonable prices - May illustrate with
diagram.
ii. Nature and characteristics of the programme of government action - Purpose- Welfare
outcomes of the policy – Negative outcomes - Possible disincentives to producers- diversion
of resources away from regulated products- black marketing- etc.
iii. Substantiate with examples
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Q.NO.2 THE GOVERNMENT DECIDES TO LEVY UP TO Rs.20,500/ PER FLIGHT FROM PRIVATE
AIRLINES ON MAJOR ROUTES IN ORDER TO FUND AN AMBITIOUS REGIONAL CONNECTIVITY
SCHEME WHICH SEEKS TO CONNECT SMALL CITIES BY AIR AND TO MAKE FLYING MORE
AFFORDABLE FOR THE MASSES. CRITICALLY EXAMINE THE IMPLICATIONS OF THIS POLICY ON THE
AIRLINES MARKET.
ANSWER:
Theory of Government intervention for redistribution to ensure fairness and equity
a. Price intervention - a market-based policy - contributing airlines may experience cost escalation
– possible fare hikes – changes in equilibrium quantities – disincentives to fly aircrafts in taxed
routes - possible exit from market by low profit margin airlines- Regional connectivity and other
welfare outcomes as subsidies to producers would lower their cost of production increase
output- substantial positive externalities.
b. Another possibility: government intervention in the economy to correct a market failure creates
inefficiency and leads to a misallocation of scarce resources - social welfare will not be
maximized – uncertainty as to the need for merit goods – disincentives to existing players -
cannot be sure that the government interventions would be effective – possibility of
government failure.
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2.2. MARKET FAILURE
Q.NO.1 DEFINE MARKET FAILURE. WHAT ARE THE ASPECTS OF MARKET FAILURE?
ANSWER:
MARKET FAILURE:
1. Market failure is a situation in which the free market leads to misallocation of society's scarce
resources in the sense that there is either overproduction or underproduction of particular
goods and services leading to a less than optimal outcome.
2. The reason for market failure lies in the fact that though perfectly competitive markets work
efficiently, most often the prerequisites of competition are unlikely to be present in an
economy.
3. There are two aspects of market failures namely, demand-side market failures and supply side
market failures.
a. Demand- side market failures are said to occur when the demand curves do not take into
account the full willingness of consumers to pay for a product.
For example, none of us will be willing to pay to view a wayside fountain because we can
view it without paying.
b. Supply-side market failures happen when supply curves do not incorporate the full cost of
producing the product.
For example, a thermal power plant that uses coal may not have to include or pay completely
for the costs to the society caused by fumes it discharges into the atmosphere as part of the
cost of producing electricity.
Q.NO.2 WHY DO MARKETS FAIL? WHAT ARE THE REASONS OF MARKET FAILURE?
ANSWER:
There are four major reasons for market failure. They are:
a. Market power,
b. Externalities,
c. Public goods, and
d. Incomplete information
Q.NO.3 DEFINE MARKET POWER? DISCUSS HOW THE MARKET POWER LEADS TO MARKET
POWER?
ANSWER:
1. Market power or monopoly power is the ability of a firm to profitably raise the market price of a
good or service over its marginal cost.
2. Firms that have market power are price makers and therefore, can charge a price that gives
them positive economic profits.
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3. Excessive market power causes the single producer or a small number of producers to produce
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and sell less output than would be produced in a competitive market.
4. Market power can cause markets to be inefficient because it keeps price higher and output
lower than the outcome of equilibrium of supply and demand.
5. In the extreme case, there is the problem of non-existence of markets or missing markets
resulting in failure to produce various goods and services, despite the fact that such products
and services are wanted by people.
For example: The markets for pure public goods do not exist.
Q.NO.4 DEFINE EXTERNALITIES? DISCUSS HOW THE EXTERNALITIES LEADS TO MARKET POWER?
ANSWER:
1. The actions of either consumers or producers result in costs or benefits that do not reflect as
part of the market price. Such costs or benefits which are not accounted for by the market price
are called externalities because they are “external” to the market.
2. In other words, there is an externality when a consumption or production activity has an indirect
effect on other’s consumption or production activities and such effects are not reflected directly
in market prices.
3. The unique feature of an externality is that it is initiated and experienced not through the
operation of the price system, but outside the market.
4. Since it occurs outside the price mechanism, it has not been compensated for, or in other words
it is uninternalized or the cost (benefit) of it is not borne (paid) by the parties.
5. Externalities are also referred to as 'spill over effects', 'neighbourhood effects' 'third-party
effects' or 'side-effects', as the originator of the externality imposes costs or benefits on others
who are not responsible for initiating the effect.
6. Externalities may be unidirectional or reciprocal.
E.g., Suppose a workshop creates ear- splitting noise and imposes an externality on a baker who
produces smoke and disturbs the workers in the workshop, then this is a case of reciprocal
externality.
If an accountant who is disturbed by loud music but has not imposed any externality on the
singers, then the externality is unidirectional.
7. Externalities can be positive or negative.
a. Negative externalities occur when the action of one party imposes costs on another party.
b. Positive externalities occur when the action of one party confers benefits on another party.
Q.NO.5 EXTERNALITIES CAN BE POSITIVE OR NEGATIVE. DISCUSS THE STATEMENT WITH SUITABLE
EXAMPLES?
ANSWER:
1. Externalities can be positive or negative.
a. Negative externalities occur when the action of one party imposes costs on another party.
b. Positive externalities occur when the action of one party confers benefits on another party.
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2. The four possible types of externalities are:

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a. Negative production externalities:
i) A negative externality initiated in production which imposes an external cost on others
may be received by another in consumption or in production.
Example: A negative production externality occurs when a factory which produces
aluminium discharges untreated waste water into a nearby river and pollutes the water
causing health hazards for people who use the water for drinking and bathing. Pollution of
river also affects fish output as there will be less catch for fishermen due to loss of fish
resources. The former is a case where a negative production externality is received in
consumption and the latter presents a case of a negative production externality received in
production.
ii) The firm has no incentive to account for the external costs that it imposes on consumers
of river water or fishermen when making its production decision. Additionally, there is no
market in which these external costs can be reflected in the price of aluminium.
b. Positive production externalities:
i) A positive production externality initiated in production that confers external benefits on
others may be received in production or in consumption.
ii) Compared to negative production externalities, positive production externalities are less
common.
Examples
A firm which offers training to its employees for increasing their skills. The firm generates
positive benefits on other firms when they hire such workers as they change their jobs.
In the case of a beekeeper who locates beehives in an orange growing area enhancing the
chances of greater production of oranges through increased pollination.
A positive production externality is received in consumption when an individual raises an
attractive garden and the persons walking by enjoy the garden.
iii) These external effects were not in fact taken into account when the production decisions
were made.
c. Negative consumption externalities
i) Negative consumption externalities are extensively experienced by us in our day to day life.
ii) Such negative consumption externalities initiated in consumption which produce
external costs on others may be received in consumption or in production.
Examples to cite where they affect consumption of others are
 Smoking cigarettes in public place causing passive smoking by others,
 Creating litter and diminishing the aesthetic value of the room
 Playing the radio loudly obstructing one from enjoying a concert.
Examples of negative consumption externalities affecting production
 The act of undisciplined students talking and creating disturbance in a class
preventing teachers from making effective instruction
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 The case of excessive consumption of alcohol causing impairment in efficiency for work
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and production
d. Positive consumption externalities:
i) A positive consumption externality initiated in consumption that confers external benefits
on others may be received in consumption or in production.
Example:
If people get immunized against contagious diseases, they would confer a social benefit to
others as well by preventing others from getting infected.
Consumption of the services of a health club by the employees of a firm would result in an
external benefit to the firm in the form of increased efficiency and productivity. When there are
externalities and the costs or benefits are experienced by people outside a transaction, the
actors in the transaction (consumers or producers) tend to ignore those external costs or
benefits.
Q.NO.6 DEFINE SOCIAL COST? EXPLAIN THE DIVERGENCE BETWEEN PRIVATE COST AND SOCIAL COST
ANSWER:
The presence of externalities creates a divergence between private and social costs of production.
When negative production externalities exist, social costs exceed private cost because the true
social cost of production would be private cost plus the cost of the damage from externalities.
Negative externalities impose costs on society that extend beyond the cost of production as
originally intended and actually borne by the producer. If producers do not take into account the
externalities, there will be over-production and market failure.
Social Cost = Private Cost + External Cost
1. PRIVATE COST
a. Private cost is the cost faced by the producer or consumer directly involved in a transaction.
b. If we take the case of a producer, his private cost includes direct cost of labour, materials,
energy and other indirect overheads.
2. SOCIAL COSTS:
a. Social costs refer to the total costs to the society on account of a production or consumption
activity.
b. Social costs are private costs borne by individuals directly involved in a transaction together
with the external costs borne by third parties not directly involved in the transaction.
c. In other words, social costs are the total costs incurred by the society when a good is
consumed or produced. It is thus private costs plus costs to third parties (i.e. private costs +
total negative externalities).
Q.NO.7 DEFINE MARGINAL PRIVATE COST, MARGINAL EXTERNAL COST, MARGINAL SOCIAL COST,
MARGINAL PRIVATE BENEFIT, MARGINAL EXTERNAL BENEFIT, MARGINAL SOCIAL BENEFIT?
ANSWER:
1. MARGINAL PRIVATE COST (MPC) is the change in the producer's total cost brought about by the
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production of an additional unit of a good or service. It is also known as marginal cost of

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production. (represented by the supply curve)
2. MARGINAL EXTERNAL COST (MEC) is the change in the cost to parties other than the producer
or buyer of a good or service due to an additional unit of the good or service.
3. MARGINAL SOCIAL COST (MSC) is the change in society's total cost brought about by an
additional unit of a good or service. (=MPC+MEC)
4. MARGINAL PRIVATE BENEFIT (MPB) is the marginal willingness to pay (represented by the
demand curve)
5. MARGINAL EXTERNAL BENEFIT (MEB) is the change in the benefit to parties other than the
producer or buyer of a good or service due to an additional unit of the good or service.
6. MARGINAL SOCIAL BENEFIT (MSB) is the change society’s total benefits associated with an
additional unit of a good or service. (MPB+MEB)
Note:
a. When no externality is present, there are no external costs and marginal social cost is the
same as marginal private cost; and marginal social benefit is the same as marginal private
benefit. Therefore, MPC=MSC and MPB=MSB.
b. If an externality is present, then either MSC≠MPC or MSB≠MPB (or both); and hence
equilibrium (where MPC=MPB) is unlikely to be efficient.
Q.NO.8 EXPLAIN THE IMPACT OF NEGATIVE EXTERNALITIES ON PRODUCTION AND LOSS OF

SOCIAL WELFARE?
ANSWER:
1. SOCIALLY OPTIMAL OUTPUT: It is that amount of output which takes into account all benefits
(private as well as external) and all costs (private as well as external).
2. When we want to find out whether social efficiency is achieved or not (i.e. highest possible
social benefits, given the constraint of costs), we need to compare marginal social benefits to
marginal social costs.
3. The condition for efficiency and optimum output is MSB=MSC i.e., (Marginal Social Benefit =
Marginal Social Cost). It means ‘the last unit produced should yield benefits to society that
exactly equals the costs to society for producing the last unit’.
4. Negative Production Externalities and Loss of Social welfare

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a. The equilibrium level of output that would be produced by a free market is Q1 at which
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marginal private benefit (MPB) is equal to marginal private cost (MPC).

b. Marginal social cost (MSC) represents the full or true cost to the society of producing
another unit of a good. It includes marginal private cost (MPC) and marginal external cost
(MEC).
c. Assuming that there are no externalities arising from consumption (so that MPB= MSB), we
can see that marginal social cost (Q1S) is higher than marginal private cost (Q1E).
d. Social efficiency occurs at Q2 level of output where MSC is equal to MSB.
e. Output Q1 is socially inefficient because at Q1, the MSC is greater than the MSB and
represents over production.
f. The shaded triangle represents the area of dead weight welfare loss. It indicates the area of
overconsumption.
g. Thus, we conclude that when there is negative externality, a competitive market will
produce too much output relative to the social optimum. This is a clear case of market failure
where prices are lower than optimum and fail to provide the correct signals.
Q.NO.9 DEFINE PUBLIC GOODS? STATE THE CHARACTERISTICS OF PUBLIC GOODS?

ANSWER:
PUBLIC GOODS
1. Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path-
breaking 1954 paper ‘The Pure Theory of Public Expenditure’ is usually recognized as the first
economist to develop the theory of public goods.
2. A public good (also referred to as collective consumption good or social good) is defined as one
which all enjoy in common in the sense that each individual’s consumption of such a good leads
to no subtraction from any other individuals’ consumption of that good.
3. CHARACTERISTICS OF PUBLIC GOODS
a. Public goods yield utility to people and are products (goods or services) whose consumption
is essentially collective in nature. No direct payment by the consumer is involved in the case
of pure public goods.
b. Public good is non-rival in consumption. It means that consumption of a public good by one
individual does not reduce the quality or quantity available for all other individuals.
For example, if, you eat your apple, another person too cannot eat it. But, if you walk in
street light, other persons too can walk without any reduced benefit from the street light.
c. Public goods are non-excludable. If the good is provided, one individual cannot deny other
individuals’ consumption.
d. Provision of a public good by government means provision for all.
For example, national defence once provided, it is impossible to exclude anyone within the
country from consuming and benefiting from it.
e. Public goods are characterized by indivisibility. For example, you can buy chocolates or ice
cream as separate units, but a lighthouse, a highway, an airport, defence, clean air etc
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cannot be consumed in separate units. In the case of public goods, each individual may
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consume all of the good i.e. the total amount consumed is the same for each individual.
f. Public goods are generally more vulnerable to issues such as externalities, inadequate
property rights, and free rider problems.
g. Once a public good is provided, the additional resource cost of another person consuming
the goods is ‘zero’. A good example is a lighthouse near a sea shore to guide the ships. Once
the beacon is lit, an additional ship can use it without any additional cost of provision.
h. Public goods are generally divided into two categories namely, public consumption goods
and public factors of production. A few examples of public goods are: national defence,
highways, public education, scientific research which benefits everyone, law enforcement,
lighthouses, fire protection, disease prevention and public sanitation.
i. A unique feature of public goods is that they do not conform to the settings of market
exchange.
j. The property rights of public goods with extensive indivisibility and nonexclusive properties
cannot be determined with certainty. Therefore, the owners of such products cannot
exercise sufficient control over their assets.
For example, if you maintain a beautiful garden, you cannot exercise full control over it so as
to charge your neighbours for the enjoyment which they get from your garden.
Note: As a consequence of their peculiar characteristics, public goods do not provide incentives
that will generate optimal market reaction. Producers are not motivated to produce a socially-
optimal amount of products if they cannot charge a positive price for them or make profits from
them. As such, though public goods are extremely valuable for the well-being of the society, left
to the market, they will not be produced at all or will be grossly under-produced.
Q.NO.10 DEFINE PRIVATE GOODS? STATE THE CHARACTERISTICS OF PRIVATE GOODS?

ANSWER:
1. PRIVATE GOODS: Private goods refer to those goods that yield utility to people. Since they are
scarce anyone who wants to consume them must purchase them. Most of the goods produced
and consumed in an economy are private goods. A few examples are: food items, clothing, movie
ticket, television, cars, houses etc.
2. CHARACTERISTICS OF PRIVATE GOODS
a. Owners of private goods can exercise private property rights and can prevent others from
using the good or consuming their benefits.
b. Consumption of private goods is ‘rivalrous’ that is the purchase and consumption of a private
good by one individual prevents another individual from consuming it.
c. Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers who have
not paid for them from consuming them or having access to them.
Note: Excludability necessitates that consumers of private goods send the right signals in the
market. A buyer of a private good is forced in a transaction to reveal what he or she is willing
to pay for a good or a service.
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d. Private goods do not have the free-rider problem. This means that private goods will be
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available to only those persons who are willing to pay for them.
e. Private goods can be parcelled out among different individuals. The market demand curve
for a private good is obtained by horizontal summation of individual demand curves.
f. All private goods and services can be rejected by the consumers if their needs, preferences
or budgets change.
g. Additional resource costs are involved for producing and supplying additional quantities of
private goods.
h. Whenever there is inequality in income distribution in an economy, issues of fairness and
justice tend to arise with respect to private goods.
i. Normally, the market will efficiently allocate resources for the production of private goods.
Q.NO.11 BREIFLY EXPLAIN THE CLASIFICATION OF PUBLIC GOODS?

ANSWER:
CLASSIFICATION OF PUBLIC GOODS: One approach to classify goods so as to establish taxonomy of
different types of goods is to concentrate on the non-rival and non-excludable characteristics of
public goods. The following table presenting the taxonomy of goods will help us understand the
classification of goods.
Excludable Non-excludable
Rivalrous A B
Private goods food, clothing, cars Common resources such as fish stocks, forest
resources, coal
Non- C D
rivalrous Club goods, cinemas, private parks, Pure public goods such as national defence
satellite television
1. Goods in category A are rival in consumption and are excludable. These are also known as pure
private goods.
2. Goods in category D which are characterized by both non-excludability and non-rivalry
properties are called pure public goods. A pure public good is non-rival as well as non-
excludable. The benefit that an individual gets from a pure public good does not depend on the
number of users.
The clarity of your radio reception is generally independent of the number of other listeners.
Knowledge is another non-rivalrous good. Once something has been discovered, one person's use
of that knowledge does not preclude others from applying the same knowledge. But, this is not
the case with most private goods.
3. Consumption goods that fall in category B are rival but not excludable. Common resources
would come under this category.
Bees from the hives of different bee keepers collect nectar from the nearby orange garden. The
blossom is rival as the nectar collected for one hive is unavailable to another. Even so, it may be
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inconceivable to try to deny any particular honey bee access i.e. the situation is non-excludable.
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The examples include public parks, public roads in a city etc.
4. Goods in category C are non-rival in consumption but are excludable.
A toll booth may exclude vehicles unless payment is made. Yet, if the road is not congested, one
car may utilize it with no loss of benefit even though the other cars are also consuming the road
service. Similarly, admission to a cinema, swimming pool, music concert etc. has potential for
exclusion, but if there is no congestion, each individual admitted may consume the services
without subtracting from the benefit of others.
The consumption of these is non- rival in nature but exclusion of households who do not pay is
feasible. A good example of this is DTH cable TV service or Digital goods.
Q.NO.12 DEFINE PURE AND IMPURE PUBLIC GOODS?

ANSWER:
1. PURE PUBLIC GOOD: A pure public good is nonrival as well as non-excludable. The concept of
pure public good is often criticized by many who point out that such goods are not in fact
observable in the real world.
For example, if the government provides law and order or medical care, the use of law courts or
medical care by some individuals subtracts the consumption of others if they need to wait. As
another example, we may take defence. If armies are mostly deployed in the northern borders, it
may not result in the same amount of protection to people in the south.
2. IMPURE PUBLIC GOODS: There are many hybrid goods that possess some features of both
public and private goods. These goods are called impure public goods and are partially rivalrous
or congestible.
a. Due to congestion, the benefit that an individual gets from an impure public good depends
on the number of users.
b. Consumption of these goods by another person reduces, but does not eliminate, the benefits
that other people receive from their consumption of the same good.
For example, open-access Wi-Fi networks become crowded when more people access it.
Impure public goods also differ from pure public goods in that they are often excludable.
An example of an impure public good would be cable television. It is non- rivalrous because
the use of cable television by other individuals will in no way reduce your enjoyment of it. The
good is excludable since the cable TV service providers can refuse connection if you do not
pay for set top box and recharge it regularly..
c. Impure public goods partially satisfy the two public good characteristics of non-rivalry in
consumption and non-excludability.
d. The possibility of exclusion from the use of an impure public good has two implications.
i) Since free riding can be eliminated, the impure public good may be provided either by
the market or by the government at a price or fee. If the consumption of a good can be
excluded, then, the market would provide a price mechanism for it.
ii) The provider of an impure public good may be able to control the degree of congestion
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either by regulating the number of people who may use it , or the frequency with which
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it may be used or both.
e. Two broad classes of goods have been included in the studies related to impure public
goods.
i) Club goods; first studied by Buchanan
Examples of club goods are: facilities such as swimming pools, fitness centres etc. These
goods are replicable and, therefore, individuals who are excluded from one facility may
get similar services from an equivalent provider.
ii) Variable use public goods; first analyzed by Oakland and Sandmo
Examples of Variable use public goods include facilities such as roads, bridges etc.
They can be excludable or non excludable.
If they are excludable, some people can be discouraged from using it frequently by
making them pay for its consumption. In doing so, the frequency of usage of the public
good can be controlled. Since they are not replicable, the facility should be accessible to
all potential users.
Q.NO.13 EXPLAIN THE TERM QUASI PUBLIC GOODS (MIXED GOODS)?

ANSWER:
1. QUASI-PUBLIC GOODS (MIXED GOODS): The quasi-public goods or services, also called a near
public good (for e.g. education, health services) possess nearly all of the qualities of the private
goods and some of the benefits of public good.
For example,
 If one gets inoculated against measles, it confers not only a private benefit to the individual,
but also an external benefit because it reduces the chances getting infected of other persons
who are in contact with him.
 Education will improve the individual’s earning potential and at the same time, it may
facilitate basic research creating non-rival, non-excludable knowledge and information which
are public goods. Other examples of benefits to the society through education are
improvement in decision making behaviour, provision of a screening device for the labour
market to determine the quality of labour and better cultural environment and heritage for
future generations.
 Students pursuing the chartered accountancy programme will have a demand curve for the
programme at various prices. This reflects the private benefits which the students believe
they would enjoy as a result of this education. However, there are likely other benefits such
as, the possible addition which you may make to accounting knowledge and practices, the
consultancy services you give to others, the policy recommendations that you may be able to
put forth for a better tax or budgeting system etc.
2. CHARACTERISTICS OF QUASI PUBLIC GOODS:
a. It is easy to keep people away from them by charging a price or fee. However, it is
undesirable to keep people away from such goods because the society would be better off if
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more people consume them.

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b. The combination of virtually infinite benefits and the ability to charge a price results in some
quasi-public goods being sold through markets and others being provided by government.
c. Markets for the quasi-public goods are considered to be incomplete markets and their lack
of provision by free markets would be considered as inefficiency and market failure.
Q.NO.14 WHAT DO YOU MEAN BY COMMON POOL RESOURCES AND WHY PRODUCERS AND
CONSUMERS DO NOT PAY FOR THESE RESOURCES?
ANSWER:
1. COMMON ACCESS RESOURCES
a. Common access resources or common pool resources are a special class of impure public
goods which are non-excludable as people cannot be excluded from using them.
b. These are rival in nature and their consumption lessens the benefits available for others. This
rival nature of common resources is what distinguishes them from pure public goods, which
exhibit both non-excludability and non-rivalry in consumption.
c. They are generally available free of charge. Some important natural resources fall into this
category.
Examples of common access resources are fisheries, forests, backwaters, common pastures,
rivers, sea, backwaters biodiversity etc. The earth’s atmosphere is perhaps the best example.
2. EFFECT OF ABSENCE OF PRICE MECHANISM:
a. Emissions of carbon dioxide and other greenhouse gases have led to the depletion of the
ozone layer endangering environmental sustainability.
b. Although nations are aware of the fact that reduced global warming would benefit everyone,
they have an incentive to free ride, with the result that nothing positive is likely to be done
to correct the problem.
c. Since price mechanism does not apply to common resources, producers and consumers do
not pay for these resources and therefore, they overuse them and cause their depletion and
degradation.
d. This creates threat to the sustainability of these resources and, therefore, the availability of
common access resources for future generations.
3. TRAGEDY OF THE COMMONS:
a. The problem of the ‘tragedy of the commons’ was first described and analysed by Garrett
Hardin in his article 'The Tragedy of the Commons' (1968).
b. Economists use the term to describe the problem which occurs when rivalrous but non
excludable goods are overused to the disadvantage of the entire world.
c. The term “commons” is derived from the traditional English legal term of “common land”
where farmers/peasants would graze their livestock, hunt and collect wild plants and other
produce.
d. Everyone has access to a commonly held pasture; there are no rules about sustainable
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numbers for grazing. The outcome of the individual rational economic decisions of cattle
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owners was market failure, because these actions resulted in degradation, depletion or even
destruction of the resource leading to welfare loss for the entire society.
Q.NO.15 WHAT DO YOU MEAN BY GLOBAL PUBLIC GOODS?
ANSWER:
1. GLOBAL PUBLIC GOODS: Global public goods are those public goods with benefits /costs that
potentially extend to everyone in the world. These goods have widespread impact on different
countries and regions, population groups and generations throughout the entire globe.
2. Global Public goods may be:
a. final public goods which are ‘outcomes’ such as ozone layer preservation or climate change
prevention, or
b. Intermediate public goods, which contribute to the provision of final public goods. e.g.
International health regulations
3. The World Bank identifies five areas of global public goods which it seeks to address: namely,
a. The environmental commons (including the prevention of climate change and biodiversity),
b. Communicable diseases (including HIV/AIDS, tuberculosis, malaria, and avian influenza),
c. International trade,
d. International financial architecture, and
e. Global knowledge for development.
4. The distinctive characteristic of global public goods is that there is no mechanism (either market
or government) to ensure an efficient outcome.
Q.NO.16 DESCRIBE FREE RIDER PROBLEM ASSOCIATED WITH PUBLIC GOODS?

ANSWER:
1. THE FREE-RIDER PROBLEM: A free rider is a person who benefits from something without
expending effort or paying for it. In other words, free riders are those who utilize goods without
paying for their use.
Example is Wikipedia, a free encyclopaedia which faces a free rider problem. Hundreds of
millions of people use Wikipedia every month but only a small part of users pay to use it. A large
majority of Wikipedia users do not pay to use the site but are able to benefit from the
information provided by the website.
2. The free-rider problem occurs when everyone enjoys the benefits of a good without paying for
it. Since private goods are excludable, free-riding mostly occurs in the case of public goods. The
free-rider problem leads to under- provision of a good or service and thus causes market failure.
3. FREE RIDING ON PUBLIC GOODS:
a. The absence of excludability in the case of public goods and the tendency of people to act in
their own self-interest will lead to the problem of free-riding. If individuals cannot be
excluded from the benefit of a public good, then they are not likely to express the value of
the benefits which they receive as an offer to pay.
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b. There is no incentive for people to pay for the good because they can consume it without
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paying for it.
c. The problem occurs because of the failure of individuals to reveal their real or true
preferences for the public good through their willingness to pay.
d. On account of the free- rider problem, there is no meaningful demand curve for public
goods. If individuals make no offer to pay for public goods, there is a market failure in the
case of theses goods and the profit-maximizing firms will not produce them.
e. There is an important implication for the behaviour of free-riding. If every individual plays
the same strategy of free-riding, the strategy will fail because nobody is willing to pay and
therefore, nothing will be provided by the market. Then, a free ride for any one becomes
impossible.
f. In fact, the public goods are valuable for people. If there is no free-rider problem, people
would be willing to pay for them and they will be produced by the market. As such, if the
free-rider problem cannot be solved, the following two outcomes are possible:
i) No public good will be provided in private markets
ii) Private markets will seriously under produce public goods even though these goods
provide valuable service to the society.
Q.NO.17 DEFINE INFORMATION FAILURE?

ANSWER:
INCOMPLETE INFORMATION: Complete information is an important element of competitive
market. Perfect information implies that both buyers and sellers have complete information about
anything that may influence their decision making. However, this assumption is not fully satisfied in
real markets due to the following reasons.
a. The nature of products and services tends to be highly complex e.g. cardiac surgery, financial
products (such as pension products, mutual funds etc).
b. In many cases consumers are unable to quickly / cheaply find sufficient information on the best
prices as well as quality for different products. Sometimes they misunderstand the true costs or
benefits of a product or are uncertain about the true costs and benefits.
c. People are ignorant or not aware of many matters in the market.
d. Generally they have inaccurate or incomplete data and consequently make potentially ‘wrong’
choices / decisions.
Information failure is widespread in numerous market exchanges. When this happens misallocation
of scarce resources takes place and equilibrium price and quantity is not established through price
mechanism. This results in market failure.
Q.NO.18 DEFINE ASYMMETRIC INFORMATION?

ANSWER:
ASYMMETRIC INFORMATION:
1. Asymmetric information occurs when there is an imbalance in information between the buyer
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and the seller i.e. when the buyer knows more than the seller or the seller knows more than the
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buyer. This can distort choices.
2. These are situations in which one party to a transaction knows a material fact that the other
party does not. This phenomenon, which is sometimes referred to as the ‘lemons problem’, is an
important source of market failure.
For example,
 The landlords know more about their properties than tenants,
 A borrower knows more about their ability to repay a loan than the lender,
 A used-car seller knows more about vehicle quality than a buyer,
 Health insurance buyers know more about the state of health than the insurance companies
 Some traders may possess insider information in financial markets.
Q.NO.19 DEFINE ADVERSE SELECTION?

ANSWER:
ADVERSE SELECTION
1. Asymmetric information generates adverse selection which results from hidden attributes that
can distort the usual market process and affect a transaction before it occurs.
2. Adverse selection generally refers to any situation in which one party to a contract or
negotiation possesses information relevant to the contract or negotiation that the
corresponding party does not have;
3. This asymmetric information leads the party lacking relevant knowledge to make suboptimal
decisions and suffer adverse effects. In such a situation, asymmetric information about quality
eliminates high-quality goods from a market.
4. Economic agents end up either selecting a sub-standard product or leaving the market
altogether. It can also lead to missing markets.
For example,
Insurance Market: If the health insurance companies could costlessly identify the health risks of
buyers, then there is no asymmetric information and therefore, insurers could offer low premiums to
the low-risk buyers and high premiums to the high-risks buyers. As a matter of fact, compared to
insurance buyers, insurers know less about the health conditions of buyers and are therefore unable
to differentiate between high-risk and low-risk persons. Due to the tendency of people with higher
health risks to obtain insurance coverage to a greater extent than persons with lesser risk, the
proportion of unhealthy people in the pool of insured people increases. In such situations, an
insurance company extends insurance coverage to an applicant whose actual risk is substantially
higher than the risk known by the insurance company. By not revealing the actual state of health, an
applicant is leading the insurance company to make decisions on coverage or premium costs that are
adverse to the insurance company's management of financial risk. This forces the price of insurance
to rise, so that more healthy people, aware of their low risks, choose not to be insured. This further
increases the proportion of unhealthy people among the insured, thus raising the price of insurance
up more. The process continues until most people who want to buy insurance are unhealthy. At that
point, insurance becomes very expensive, or—in the extreme—insurance companies stop selling the
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insurance leading to missing markets. If the sellers wish to do business profitably, they may have to
incur considerable costs in terms of time and money for identifying the extent of risk for different
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buyers which in turn would increase insurance premium.

MARKET FOR LEMONS:
a. It is the one developed by George Akerlof in relation to the used car market, which distinguishes
cars classified as good from those defined as “lemons” (poor quality vehicles).
b. The owner of a car knows much more about its quality than anyone else. While placing it for
sale, he may not disclose all that he knows about the mechanical defects of the vehicle.
c. Based on the probability that the car on sale is a ‘lemon’, the buyers’ willingness to pay for any
particular car will be based on the ‘average quality’ of used cars.
d. Not knowing the honesty of the seller means, the price offered for the vehicle is likely to be less
than that of a good car, to account for this risk. However, anyone who sells a ‘lemon’ (an
unusually poor car) stands to gain.
e. If buyers were aware as to which car is good, they would pay the price they feel reasonable for a
good car. Since the price offered in the market is lower than the acceptable one, good car sellers
will not be inclined to sell.
f. The market becomes flooded with ‘lemons’ and eventually the market may offer nothing but
‘lemons’. The good-quality cars disappear because they are kept by their owners or sold only to
friends.
g. The result is market distortion with lower prices and lower average quality of cars. With
asymmetric information, just as low quality high risk buyers drive out high quality low risk buyers
of insurance, low-quality cars can drive high-quality cars out of the market.
Q.NO.20 DEFINE MORAL HAZARD?

ANSWER:
1. MORAL HAZARD arises whenever there is an externality (i.e., whenever an economic agent can
shift some of its costs to others). It is about the opportunism characterized by an informed
person’s taking advantage of a less-informed person through an unobserved action.
2. It arises from lack of information about someone’s future behaviour. It occurs when one party to
an agreement knows that he need not bear the consequences of his bad behaviour or poor
decision making and that the consequence, if any, would be borne by the other party.
3. Therefore, he engages in risky behaviour or fails to act in good faith or acts in a different way
than if he had to bear those consequences himself.
In the insurance market, moral hazard refers to a situation that increases the probability of
occurrence of a loss or a larger than normal loss because of a change in the insurance policy
holders’ behaviour after the issuance of policy. For example, a driver who has a comprehensive
insurance tends to exhibit greater taste for risk-taking in getting to his destination quickly and
hence his interests contradict with those of the insurer. The more of one’s costs that are covered
by the insurance company, the less he cares whether the doctor charges excessive fees or uses
inefficient and costly procedures as part of his health care. This causes insurance premiums to
rise for everyone, driving many potential customers out of the market. In short, when someone is
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protected from paying the full costs of their harmful actions, they tend to act irresponsibly,
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making the harmful consequences more likely.
If the company could costlessly monitor the behaviour of the insured, it can charge higher fees
for those who make more claims. The problem lies in the fact that the insurance company cannot
observe people’s actions post-sale and therefore cannot judge without costly monitoring whether
occurrence of an event is genuine or the outcome of lack of effort on the part of the insured.
Therefore the expected outflow is higher and the insurance companies may be forced to increase
premiums for everyone or may even refuse to sell insurance at all in which case it is a case of
missing markets.
4. Asymmetric information, adverse selection and moral hazard affect the ability of markets to
efficiently allocate resources and therefore lead to market failure because the party with better
information has a competitive advantage.
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Q.NO.1 Identify the market outcomes for each of the following situations
(a) A few youngsters play loud music at night. Neighbours may not be able to sleep.
(b) Ram buys a large SUV which is very heavy
(c) X smokes in a public place
(d) Rural school students are given vaccination against measles
(e) Traffic congestion making travel very uncomfortable
(f) Piracy of computer programs
(g) Some species of fish are now getting extinct because they have been caught
indiscriminately.
(h) The municipality provides sirens four times a day
(i) Burglar alarms are installed by many in your locality
(j) Global warming increases due to emissions of fossil fuels
ANSWER:
(a) Negative externality, overproduction
(b) Negative externality, environmental externality, wear and tear of roads, increased fuel
consumption, added insecurity imposed on others
(c) Negative externality, overproduction
(d) Public good, positive externality
(e) Negative externality
(f) Unpatented computer programs have characteristics very much like a public good and
therefore market failure.
(g) The problem of the commons –The tragedy of commons
(h) Sirens have all characteristics of public goods. People will free ride – market failure.
(i) Positive externality, free riding.
(j) Negative externality.
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2.3. GOVERNMENT INTERVENTIONS TO CORRECT
MARKET FAILURE
Q.NO.1 WHAT IS THE ROLE OF GOVERNMENT IN MINIMISING THE MARKET POWER?
ANSWER:
GOVERNMENT INTERVENTION TO MINIMIZE MARKET POWER
1. RESTRAIN COMPETITION:
a. Because of the social costs imposed by monopoly, Governments intervene by establishing
rules and regulations designed to promote competition and prohibit actions that are likely to
restrain competition.
b. These legislations differ from country to country.
In India, we have the Competition Act, 2002(as amended by the Competition (Amendment)
Act, 2007) to promote and sustain competition in markets. The Antitrust laws in the US and
the Competition Act, 1998 of UK etc are designed to promote competitive economy by
prohibiting actions that are likely to restrain competition.
c. Such legislations generally aim at prohibiting contracts, combinations and collusions among
producers or traders which are in restraint of trade and other anticompetitive actions such
as predatory pricing.
2. Other measures include:
a. Market liberalisation by introducing competition in previously monopolistic sectors such as
energy, telecommunication etc
b. Controls on mergers and acquisitions if there is possible market domination
c. Price capping and price regulation based on the firm’s marginal costs, average costs,
past prices, or possible inflation and productivity growth
d. Profit or rate of return regulation
e. Performance targets and performance standards
f. Patronage to consumer associations
g. Tough investigations into cartelisation and unfair practices such as collusion and predatory
pricing
h. Restrictions on monopsony power of firms
i. Reduction in import controls and
j. Nationalisation
Note:
1. It is common that some of the regulatory responses of government to incentive failure tend to
create and protect monopoly positions of firms that have developed unique innovations.
For example, patent and copyright laws grant exclusive rights of products or processes to provide
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Another example is that of permitted natural monopoly.
2. Natural monopolies can produce the entire output of the market at a cost that is lower than
what it would be if there were several firms. If a firm is a natural monopoly, it is more efficient
to permit it to serve the entire market rather than have several firms compete each other.
Examples of such natural monopoly are electricity, gas and water supplies.
3. The Policy options for limiting market power in case of natural monopolies include price
regulation in the form of setting maximum prices that firms can charge.
4. In some cases, the government‘s regulatory agency determines an acceptable price, so as to
ensure a competitive or fair rate of return. This practice is called rate-of-return regulation.
Q.NO.2 WHAT IS THE ROLE OF GOVERNMENT TO CORRECT EXTERNALITIES?

ANSWER:
A. GOVERNMENT INTERVENTION TO CORRECT EXTERNALITIES
1. Freely functioning markets produce externalities because producers and consumers need to
consider only their private costs and benefits and not the costs imposed on or benefits
accrued to others.
2. To promote the overall welfare of all members of society, social returns should be
maximized and social costs minimized.
3. This implies that all costs and benefits need to be internalized by consumers and producers
while making buying and production decisions. Otherwise, market outcomes involve
underproduction of goods or services that entail positive externalities or overproduction in
the case of negative externalities.
4. Governments have numerous methods to reduce the effects of negative externalities and to
promote positive externalities.
B. GOVERNMENT INITIATIVES TOWARDS NEGATIVE EXTERNALITIES MAY BE CLASSIFIED AS:
1. Direct controls or regulations that openly regulate the actions of those involved in
generating negative externalities.
a. Direct controls, also known as command solutions, prohibit specific activities that
explicitly create negative externalities or require that the negative externality be limited
to a certain level.
For example
i) Government may limit the amounts of certain pollutants released into water and air
by individual firms or make it mandatory to use pollution control devices.
ii) Licensing, production quotas and mandates regarding acceptable production
processes are other examples of direct intervention by governments.
iii) Production, use and sale of many commodities and services are prohibited in our
country.
iv) Smoking is completely banned in many public places. Stringent rules are in place in
respect of tobacco advertising, packaging and labelling etc.
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b. Governments may pass laws to alleviate the effects of negative externalities.
Government stipulated environmental standards are rules that protect the environment
by specifying actions by producers and consumers.
For example, India has enacted the Environment (Protection) Act, 1986.
i) The government may, through legislation, fix emissions standard which is a legal limit
on how much pollutant a firm can emit.
ii) The set standard ensures that the firm produces efficiently. If the firm exceeds the
limit, it can invite monetary penalties or/and criminal liabilities.
iii) The firms have to install pollution-abatement mechanisms to ensure adherence to the
emission standards.
iv) This means additional expenditure to the firm leading to rise in the firm’s average
cost.
v) New firms will find it profitable to enter the industry only if the price of the product is
greater than the average cost of production plus abatement expenditure.
c. Another method is to charge an emissions fee which is levied on each unit of a firm’s
emissions. The firms can minimize costs and enhance their profitability by reducing
emissions. Governments may also form special bodies/ boards to specifically address the
problem:
For instance the Ministry of Environment & Forest, the Pollution Control Board of India
and the State Pollution Control Boards.
2. Market-based policies that would provide economic incentives so that the self-interest of the
market participants would achieve the socially optimal solution: The market based approaches
focus on generation of a market price for pollution. This is achieved by:
i) Setting the price directly through a pollution tax
ii) Setting the price indirectly through the establishment of a cap-and-trade system.
Q.NO.3 EXPLAIN PIGOUVIAN TAXES OR DISCUSS GOVERNMENT ACTIONS TO SOLVE NEGATIVE

EXTERNALITIES THROUGH TAXES?
ANSWER:
1. The key to internalizing an externality (both external costs and benefits) is to ensure that those
who create the externalities include them while making decisions.
2. One method of ensuring internalization of negative externalities is imposing pollution taxes. The
size of the tax depends on the amount of pollution a firm produces.
3. These taxes are named Pigouvian taxes after A.C. Pigou who argued that an externality cannot
be alleviated by contractual negotiation between the affected parties and therefore taxation
should be resorted to.
4. These taxes, by ‘making the polluter pay’, seek to internalize the external costs into the price of
a product or activity. More precisely, the tax is placed on the externality itself (the amount of
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pollution emissions) rather than on output (say, amount of steel).

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5. For each unit of pollution, the polluter must choose either to pay the tax or to reduce pollution
through any means at its disposal. Tax increases the private cost of production or consumption
as the case may be, and would decrease the quantity demanded and therefore the output of the
good which creates negative externality. The proceeds from the tax, some argue, can be
specifically earmarked for projects that protect or enhance environment.
6. Market outcomes of pollution tax.
ANALYSIS:
a. The free market outcome would be to produce a socially non optimal output level Q at the
level of equality between marginal private cost and marginal private benefit.
b. Since externalities are not taken into account, marginal private benefit would be
contemplated as marginal social benefit.
c. When negative externalities are present, the welfare loss to the society or dead weight loss
would be the shaded area ABC.
d. The tax imposed by government (equivalent to the vertical distance AA1) would shift the
cost curve up by the amount of tax, prices will rise to P1 and a new equilibrium is established
at point B, where the marginal social cost is equal to marginal social benefit.
e. Output level Q1 is socially optimal and eliminates the welfare loss on account of
overproduction.
f. The ideal corrective tax is equal to the negative externality. A tax on each unit of a good
equal to the external harm it causes can correct a negative externality, and bring the market
to the efficient quantity of the good. Thus the tax internalises the externality by making
pollution an accounting cost.
7. PROBLEMS IN ADMINISTERING AN EFFICIENT POLLUTION TAX. ARGUMENTS AGAINST

POLLUTION TAXES
a. Pollution taxes are difficult to determine and administer because it is difficult to discover the
right level of taxation that would ensure that the private cost plus taxes will exactly equate
with the social cost.
b. If the demand for the good is inelastic, the tax may only have an insignificant effect in
reducing demand. In such cases, the producers will be able to easily shift the tax burden in
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the form of higher product prices. This will have an inflationary effect with little effect on the
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level of production and may reduce consumer welfare.
c. The method of taxing the polluters has many limitations because it involves the use of
complex and costly administrative procedures for monitoring the polluters.
d. This method does not provide any genuine solutions to the problem. It only establishes an
incentive system for use of methods which are less polluting.
e. Pollution taxes also have potential negative consequences on employment and investments
because high pollution taxes in one country may encourage producers to shift their
production facilities to those countries with lower taxes.
Q.NO.4 EXPLAIN ‘CAP AND TRADE SYSTEM’ IN GENERATING A MARKET PRICE FOR POLLUTION?
ANSWER:
A. CAP AND TRADE SYSTEM: The second approach to establishing prices indirectly is ‘tradable
emissions permits’. The use of tradable permits to limit emissions is often called ‘cap and trade’.
A tradable permit is a license that allows a company to release a unit of pollution into the
environment over some period of time. By issuing a fixed number of permits, the government
determines the total level of pollution that can be legally emitted during each period (the “cap”).
1. Each firm has permits specifying the number of units of emissions that the firm is allowed to
generate.
2. A firm that generates emissions above what is allowed by the permit is penalized with
substantial monetary sanctions.
3. By allocating fewer permits than the free pollution level, the regulatory agency creates a
shortage of permits which then leads to a positive price for pollution, just as in the tax case.
4. The firms can sell their government-issued permits to other firms in an organized market.
5. Since the permits are tradable (the firm can sell for a price), a polluting firm faces an
opportunity cost i.e. for each unit of pollution that it creates, it must either buy a permit, or
it must forgo the revenue it could earn by selling the permit to some other firm.
6. A firm whose technology would make it very costly to reduce pollution generally buys
permits in the market. At the same time, a firm whose technology enables it to reduce
pollution rather cheaply will sell permits.
7. Since these permits are transferable different pollution levels are possible across the
regulated entities.
8. Under this system, a market in permits to pollute will emerge.
a. The high polluters have to buy more permits, which increases their costs, and makes
them less competitive and less profitable.
b. The low polluters receive extra revenue from selling their surplus permits, which makes
them more competitive and more profitable. Therefore, firms will have an incentive not
to pollute.
B. EFFECT OF CAP AND TRADE SYSTEM ON THE GENERAL PUBLIC:
1. The general public is not affected by the trade because total emissions remain unchanged.
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Thus, the price of the permit becomes part of the marginal cost of producing the polluting
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good.
2. With higher marginal cost, the market supply curve shifts upward, and the market
equilibrium price of the polluting good rises as well. This can move the quantity of a polluting
good toward its efficient level, similar to the effects of a tax.
3. Tradable permits allow consumers and firms to respond to prices when determining how
much of the negative externality to create. Tradable permits have been used since the early
1980s to reduce several types of pollution in the United States.
4. In 1994 the United States began a cap and trade system for the sulphur dioxide emissions
that cause acid rain by issuing permits to power plants based on their historical consumption
of coal. India is experimenting with cap-and-trade in the form of Perform, Achieve & Trade
(PAT) scheme and carbon tax in the form of a cess on coal.
C. Following are some advantages claimed for tradable permits:
1. The system allows flexibility and rewards efficiency.
2. The ‘cap’ puts a clear upper limit on the quantity of pollution that may be generated in each
period
3. The market for permits enables a clear price for pollution and helps in internalizing the costs.
The price of permits can be increased over time by reducing the number of permits available.
4. It is administratively cheap and simple to implement and ensures that pollution is minimised
in the most cost-effective way.
5. It also provides strong incentives for innovation to combat pollution.
6. Consumers may benefit if the extra profits made by low pollution firms are passed on to
them in the form of lower prices.
D. ARGUMENTS:
1. The main argument in opposition to the employment of tradable emission permits is that
they do not, in reality, stop firms from polluting the environment; They only provide an
incentive to them to do so.
2. If firms have monopoly power of some degree along with a relatively inelastic demand for its
product.
3. The extra cost incurred for procuring additional permits so as to further pollute the
atmosphere, could easily be compensated by charging higher prices to consumers.
NOTE: The two interventions mentioned above i.e. permits and taxes make use of market forces to
encourage consumers and producers to take externalities into account when planning their
consumption and production. In other words, the polluters are forced to consider pollution as a private
cost.
Q.NO.5 EXPLAIN POSITIVE EXTERNALITIES AND ROLE OF GOVERNMENT IN THE ASPECT OF

SUBSIDY?
ANSWER:
A. POSITIVE EXTERNALITIES:
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1. A positive consumption (production) externality occurs when consumption (production) of a

good cause positive benefits to a third party. This means that the social benefits of
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consumption or production exceed the private benefits.
2. In the case of positive consumption externality, the social marginal benefit (SMB) is higher
than private marginal benefit (PMB).
Education, preventive vaccination etc are examples of consumption having positive
externality.
3. In the case of positive production externality, the marginal social cost (MSC) is less than
private marginal cost.
Research and development, production of education, healthcare and similar merit goods fall
under this.
4. The intersection of the marginal social cost (MSC) and the social value curve (MSB curve)
determines the optimal level of output.
5. In case of goods with positive production externality, the market will produce less than the
efficient quantity.
B. GOVERNMENT INTERVENTION: Since positive externalities promote welfare, governments
implement policies that promote positive externalities. When positive externalities are present,
government may attempt to solve the problem through corrective subsidies to the producers
aimed at either increasing the supply of the good or through corrective subsidies to consumers
aimed at increasing the demand for the good.
C. Consumption externalities with the classic example of education. A competitive market in
education with no government interference would be inefficient.
A government subsidy is a market-based approach that changes the price of the product and
allows individual consumers to respond to those prices and make their own decisions. Subsidies
to consumers of a good with positive externality will increase the marginal private benefit of
consumption (since individuals now get paid to buy a good) and increase the demand for the
good.
In panel A,
1. The horizontal axis measures the quantity of education and the vertical axis measures the
price of education.
2. The demand curve (MPB) for education does not reflect positive externalities of education
consumption.
3. Without government intervention, the market reaches inefficient equilibrium at point ‘a
‘with Qe amount of education at Pe prices.
4. The distance ‘a b’ (marked by arrow) is the value of the positive externality.
5. The efficient level of output is Q* corresponding to point ‘c ‘where the MSB curve intersects
the supply curve.
6. The total deadweight loss (welfare loss) from all the education not provided is the shaded
triangle ‘b a c’.
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Effect of Government Subsidy
In panel B,
1. Subsidy equal to the value of the positive externality (marked by arrow) is paid to each
student.
2. The subsidy causes each student to add the same amount to the value that he or she places
on education and shifts up the demand curve by that amount.
3. The demand curve now rises to the level of the MSB curve, and the market equilibrium
moves to Q* -the efficient number.
4. In the new equilibrium, the price of education rises from Pe to P; however the students, after
accounting for the subsidy, pay only P* so that more of them choose to acquire education.
5. Thus, a subsidy on each unit of a good, equal to the external benefits it creates can correct a
positive externality and bring the market to an efficient output level.
D. EFFECT OF GOVERNMENT SUBSIDY ON OUTPUT:

1. A corrective production subsidy involves government paying part of the cost to the firms in
order to promote the production of goods having positive externalities.
2. This is in fact a market-based policy as subsidies to producers would lower their cost of
production.
a. What would be the outcome of government intervention through subsidy?
b. A subsidy on a good which has substantial positive externalities would reduce the
marginal private costs of production, increase the supply, shift the supply curve to the
right, reduce the price and increase the quantity demanded of the subsidised good.
3. A higher output that would equate marginal social benefit and marginal social cost is socially
optimal.
4. In the case of products and services whose externalities are vastly positive and pervasive,
government enters the market directly as an entrepreneur to produce and provide them.
Public education and health care are the obvious examples. Another example, fundamental
research to protect the futuristic technology interest of the society is, in most cases, funded
by government as the market may not be willing to provide them.
5. Governments also engage in direct production of environmental quality. Examples are:
aforestation, reforestation, protection of water bodies, treatment of sewage and cleaning of
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toxic waste sites.

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Q.NO.6 DEFINE MERIT GOODS. EXPLAIN HOW GOVERNMENT INTERVENES IN MERIT GOODS TO
OVERCOME MARKET FAILURE?
ANSWER
A. MERIT GOODS:
1. Merit goods are goods which are deemed to be socially desirable and therefore the
government deems that its consumption should be encouraged. Substantial positive
externalities are involved in the consumption of merit goods.
Examples of merit goods include education, health care, welfare services, housing, fire
protection, waste management, public libraries, museum and public parks.
2. In contrast to pure public goods, merit goods are rival, excludable, limited in supply,
rejectable by those unwilling to pay, and involve positive marginal cost for supplying to extra
users.
3. Merit goods can be provided through the market, but are likely to be under-produced and
under-consumed through the market mechanism so that social welfare will not be
maximized.
B. ADDITIONAL REASONS FOR GOVERNMENT PROVISION OF MERIT GOODS ARE:
1. Information failure is widely prevalent with merit goods and therefore individuals may not
act in their best interest because of imperfect information.
2. Equity considerations demand that merit goods such as health and education should be
provided free on the basis of need rather than on the basis of individual’s ability to pay.
3. There is a lot of uncertainty as to the need for merit goods E.g. health care. Due to
uncertainty about the nature and timing of healthcare required in future, individuals may be
unable to plan their expenditure and save for their future medical requirements. The market
is unlikely to provide the optimal quantity of health care when consumers actually need it,
because they may be short of the necessary finances to pay the market price.
C. GOVERNMENT INTERVENTION INCASE OF MERIT GOODS:
1. The possible government responses to under-provision of merit goods are regulation,
subsidies, direct government provision and a combination of government provision and
market provision. Regulation determines how a private activity may be conducted.
For example, the way in which education is to be imparted is government regulated.
2. Governments can prohibit some type of goods and activities, set standards and issue
mandates making others oblige.
For example, government may make it compulsory to avail insurance protection.
Compulsory immunization may be insisted upon as it helps not only the individual but also
the society at large.
3. Government could also use legislation to enforce the consumption of a good which
generates positive externalities.
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E.g. use of helmets, seat belts etc. The Right of Children to Free and Compulsory Education
Act, 2009 which mandates free and compulsory education for every child of the age of six to
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fourteen years is another example.
4. A variety of regulatory mechanisms may also be set up by government to enhance
consumption of merit goods and to ensure their quality.
5. Government can also provide free information to consumers, to compensate for the
information failure that discourages consumption.
6. An additional option is to compel individuals to consume the good or service that generates
the external benefit.
For example, if suspected of having a contagious disease such as COVID, an individual may be
forced to get medical treatment. Universal compulsory schooling for children upto 14 years.
7. When governments provide merit goods, it may give rise to large economies of scale and
productive efficiency apart from generating substantial positive externalities and overcoming
the problems mentioned above.
8. The ultimate encouragement to consume is to make the good completely free at the point of
consumption, such as with freely available hospital treatment for contagious diseases.
9. When merit goods are directly provided free of cost by government, there will be substantial
demand for the same.
10. As can be seen from the following diagram, when people are required to pay the free market
price, people would consume only OQ quantity of healthcare. If provided free at zero prices,
the demand OD far exceeds supply.
Consumption of Merit Goods at Zero Price
Q.NO.7 DEFINE DEMERIT GOODS. EXPLAIN HOW GOVERNMENT INTERVENES IN DEMERIT GOODS
TO OVERCOME MARKET FAILURE?
ANSWER:
A. Demerit goods
1. Demerit goods are goods which are believed to be socially undesirable.
Examples of demerit goods are cigarettes, alcohol, intoxicating drugs etc.
2. The consumption of demerit goods imposes significant negative externalities on the society
as a whole and therefore the private costs incurred by individual consumers are less than the
social costs experienced by the society.
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3. The production and consumption of demerit goods are likely to be more than optimal under
free markets.
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4. The price that consumers pay for a packet of cigarettes is market determined and does not
account for the social costs that arise due to externalities.
5. However, all goods with negative externalities are not essentially demerit goods;
E.g. Production of steel causes pollution, but steel is not a socially undesirable good.
B. GOVERNMENT INTERVENTION IN THE CASE OF DEMERIT GOODS
Consumers overvalue demerit goods because of imperfect information and they are not the best
judges of welfare with respect to such goods. The government should therefore intervene in the
marketplace to discourage their production and consumption.
1. At the extreme, government may enforce complete ban on a demerit good.
E.g. Intoxicating drugs. In such cases, the possession, trading or consumption of the good is
made illegal.
2. Through persuasion which is mainly intended to be achieved by negative advertising
campaigns which emphasize the dangers associated with consumption of demerit goods.
3. Through legislations that prohibit the advertising or promotion of demerit goods in
whatsoever manner.
4. Strict regulations of the market for the good may be put in place so as to limit access to the
good, especially by vulnerable groups such as children and adolescents.
5. Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale of
tobacco to be away from schools, and time restrictions under which sale at particular times
during the day is banned.
6. Imposing unusually high taxes on producing or purchasing the good making them very costly
and unaffordable to many is perhaps the most commonly used method for reducing the
consumption of a demerit good.
For example, the GST Council has bracketed four items namely, high end cars, pan masala,
aerated drinks and tobacco products into demerit goods category and therefore these would
be taxed (with a cess being added on to the basic tax) at much higher rates than the top GST
slab of 28 per cent.
C. OUTCOMES OF MINIMUM PRICE FOR A DEMERIT GOOD:
1. The government can fix a minimum price below which the demerit good should not be
exchanged. The effect of such minimum price fixation above equilibrium price is shown in
the figure below:
Outcomes of Minimum Price for a Demerit Good
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ANALYSIS
i) Free market equates marginal private cost with marginal private benefit (point B) and
produces an output of a demerit good Q at which marginal social benefit (MSB) is much
less than marginal private benefit (MPB).
ii) At this level of output, there is a divergence (BC) between marginal private benefit (MPB)
and marginal social benefit (MSB).
iii) The shaded area represents loss of social welfare. If the government determined
minimum price is P1, demand contracts and the quantity of alcohol consumed would be
reduced to Q1. At Q1level of output, marginal social benefit (MSB) is equal to marginal
social cost (MSC) and the quantity of alcohol consumed is optimal from the society’s
point of view.
2. The demand for demerit goods such as, cigarettes and alcohol is often highly inelastic, so
that any increase in price resulting from additional taxation causes a less than proportionate
decrease in demand. Also, sellers can always shift the taxes to consumers without losing
customers.
3. The effect of stringent regulation such as total ban is seldom realized in the form of
complete elimination of the demerit good; conversely such goods are secretly driven
underground and traded in a hidden market.
Q.NO.8 EXPLAIN HOW GOVERNMENT INTERVENES IN PUBLIC GOODS TO OVERCOME MARKET

FAILURE?
ANSWER:
GOVERNMENT INTERVENTION IN THE CASE OF PUBLIC GOODS
1. All public goods which are non excludable are highly prone to free rider problem and therefore
markets are unlikely to get established.
2. Direct provision of a public good by government can help overcome free-rider problem which
leads to market failure.
3. The non-rival nature of consumption provides a strong argument for the government rather
than the market to provide and pay for public goods.
4. In the case of such pure public goods where entry fees cannot be charged, direct provision by
governments through the use of general government tax revenues is the only option.
5. Excludable public goods can be provided by government and the same can be financed through
entry fees. A very commonly followed method is to grant licenses to private firms to build a
public good facility.
6. Under this method, the goods are provided to the public on payment of an entry fee. In such
cases, the government regulates the level of the entry fee chargeable from the public and keeps
strict watch on the functioning of the licensee to guarantee equitable distribution of welfare.
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7. Some public goods are provided by voluntary contributions and private donations by corporate
entities and nongovernmental organisations.
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8. Self-interested firms or individuals sometimes provide public goods because they can indirectly
make money out of them.
9. The most important public goods like defence, establishment and maintenance of legal system,
fire protection, disease prevention etc are invariably provided by the government.
10. Certain goods are produced and consumed as public goods and services despite the fact that
they can be produced or consumed as private goods. This is because, left to the markets and
profit motives, these may prove dangerous to the society.
Examples are scientific approval of drugs, production of strategic products such as atomic
energy, provision of security at airports etc.
Q.NO.9 WHAT DO YOU MEAN BY PRICE CEILING? EXPLAIN IT WITH EXAMPLES?

ANSWER:
PRICE INTERVENTION: NON MARKET PRICING
1. Price intervention generally takes the form of price controls which are legal restrictions on price.
2. Price controls may take the form of either a price floor (a minimum price buyers are required to
pay) or a price ceiling (a maximum price sellers are allowed to charge for a good or service).
Fixing of minimum wages and rent controls are examples of such market intervention.
3. Government usually intervenes in many primary markets which are subject to extreme as well as
unpredictable fluctuations in price.
For example in India, in the case of many crops the government has initiated the Minimum
Support Price (MSP) programme as well as procurement by government agencies at the set
support prices.
4. The objective is to guarantee steady and assured incomes to farmers. In case the market price
falls below the MSP, then the guaranteed MSP will prevail.
Market Outcome of Minimum Support Price
ANALYSIS:
a. When price floors are set above market clearing price, suppliers are encouraged to over-
supply and there would be an excess of supply over demand.
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b. At price Rs.150/ which is much above the market determined equilibrium price of Rs. 75/,
the market demand is only Q1, but the market supply is Q2.
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5. When prices of certain essential commodities rise excessively, government may resort to
controls in the form of price ceilings (also called maximum price) for making a resource or
commodity available to all at reasonable prices.
For example: maximum prices of food grains and essential items are set by government during
times of scarcity.
ANALYSIS:
a. A price ceiling which is set below the prevailing market clearing price will generate excess
demand over supply.
b. As can be seen in the following figure, the price ceiling of Rs.75/ which is below the market-
determined price of Rs.150/leads to generation of excess demand over supply equal to Q1-
Q2.
Market Outcome of Price Ceiling
6. With the objective of ensuring stability in prices and distribution, governments often intervene
in grain markets through building and maintenance of buffer stocks. It involves purchases from
the market during good harvest and releasing stocks during periods when production is below
average.
Q.NO.10 INFORMATION FAILURE IS ALSO A REASON FOR MARKET FAILURE. WITH THE
INTERVANTION OF GOVERNMENT HOW THIS IS CORRECTED EXPLAIN?
ANSWER:
GOVERNMENT INTERVENTION FOR CORRECTING INFORMATION FAILURE
For combating the problem of market failure due to information problems and considering the
importance of information in making rational choices, the following interventions are resorted to:
1. Government makes it mandatory to have accurate labelling and content disclosures by
producers. Eg. Labelling on cigarette packets and nutritional information in food packages.
2. Mandatory disclosure of information For example: SEBI requires that accurate information be
provided to prospective buyers of new stocks.
3. Public dissemination of information to improve knowledge and subsidizing of initiatives in that
direction.
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4. Regulation of advertising and setting of advertising standards to make advertising more

responsible, informative and less persuasive.
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Q.NO.11 EXPLAIN WHAT TYPES OF FISCAL POLICY MEASURES ARE USEFUL FOR REDISTRIBUTION
OF INCOME IN AN ECONOMY?
ANSWER:
GOVERNMENT INTERVENTION FOR EQUITABLE DISTRIBUTION
1. One of the most important activities of the government is to redistribute incomes so that there
is equity and fairness in the society. Equity can be brought about by redistribution of
endowments with which the economic agents enter the market.
2. Some common policy interventions include: progressive income tax, targeted budgetary
allocations, unemployment compensation, transfer payments, subsidies, social security
schemes, job reservations, land reforms, gender sensitive budgeting etc.
3. Government also intervenes to combat black economy and market distortions associated with a
parallel black economy.
4. Government intervention in a market that reduces efficiency while increasing equity is often
justified because equity is greatly appreciated by society.
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Q.NO.1 The pharmaceutical industry is involved in innovation, development, production, and
marketing of medicines in India. Ensuring the availability of lifesaving drugs at reasonable prices is
the duty of the government. The National Pharmaceutical Pricing Authority (NPPA) is the
watchdog in India, which controls the prices of drugs. Government has to consider the interest of
both the producers and the buyers.
i) Elucidate the market outcomes if matters relating to drugs are entirely left to the
pharmaceutical industry.
ii) Appraise the need for government action in the above case. Do you consider government
action necessary in the case of medicines? Why?
iii) What are the different policy options available to government to meet its public health
objectives?
ANSWER:
(i) Essential commodity – Left to market there may be inefficiency and possible market power –
likely to charge higher prices than competitive prices- Price controls are put in place by
governments to influence the outcomes of a market- Policy options for limiting market power
also include price regulation in the form of setting maximum prices that firms can charge- In
some cases, the government‘s regulatory agency determines an acceptable rate-of return -
setting price-caps based on the firm’s variable costs, past prices, and possible inflation and
productivity growth regulation price, so as to ensure a competitive or fair rate of return.
Legislation, regulation in terms of price controls, selection and listing of items to be included in
price control, care to be taken not to damage the incentives of producers.
(ii) Merit good- merit goods are rival, excludable, limited in supply, rejectable by those unwilling to
pay, and involve positive marginal cost for supplying to extra users. Positive externalities- Left
to the market, only private benefits and private costs would be reflected in the price paid by
consumers. This means, compared to what is socially desirable, people would consume
inadequate quantities.
(iii) Merit goods can be provided through the market, but are likely to be under produced and
under-consumed through the market mechanism so that social welfare will not be maximized -
This is a strong case for government intervention. Government intervention in the form of direct
provision, regulation, licensing and controls. Illustrate with figure: Market outcome for merit
goods.
Q.NO.2 The Commission for Agricultural Costs and Prices (CACP) advises the government on
minimum support prices of 23 agricultural commodities which comprise 7 cereals, 5 pulses, 7
oilseeds, and 4 commercial crops.
(i) What is the underlying principle of minimum support prices? Do you think MSP is a form of
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market intervention? Why?

(ii) Why do you consider free markets undesirable for the above mentioned agricultural
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commodities?
ANSWER:
(i) Influence the outcomes of a market on grounds of fairness and equity- strong political demand
for government intervention - Price intervention for ensuring stable prices and stable incomes to
producers - market-based incentives to ensure steady output, outcomes of higher than
equilibrium price. Illustrate with figures
(ii) Markets for primary products are subject to extreme as well as unpredictable fluctuations in
price – Income elasticity of demand for primary products is less than one – need to guarantee
steady and assured incomes to farmers - Minimum Support Price (MSP) programme as well as
procurement by government agencies at the set support prices - Illustrate with figure : Market
outcome of minimum support price- When price floors are set above market clearing price,
suppliers are encouraged to over-supply and there would be an excess of supply over demand –
limitations -possible government failure
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2.4. FISCAL POLICY
Q.NO.1 DEFINE FISCAL POLICY? HOW FISCAL POLICY HAD A STRONG INFLUENCE ON THE
PERFORMANCE OF MACRO ECONOMY?
ANSWER:
A. FISCAL POLICY:
1. Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and level of growth of aggregate demand, output and
employment.
2. It includes any design on the part of the government to change the price level, composition
or timing of government expenditure or to alter the burden, structure or frequency of tax
payment.
3. Fiscal policy is in the nature of a demand-side policy. An economy which is producing at full-
employment level does not require government action in the form of fiscal policy.
B. OBJECTIVES OF FISCAL POLICY

The objectives of fiscal policy, like those of other economic policies of the government, are
derived from the aspirations and goals of the society. Since nations differ in numerous aspects,
the objectives of fiscal policy also may vary from country to country. However, the most
common objectives of fiscal policy are:
1. Achievement and maintenance of full employment,
2. Maintenance of price stability,
3. Acceleration of the rate of economic development, and
4. Equitable distribution of income and wealth.
The importance as well as order of priority of these objectives may vary from country to country
and from time to time. For instance, while stability and equality may be the priorities of
developed nations, economic growth, employment and equity may get higher priority in
developing countries.
These objectives are not always compatible; for instance the objective of achieving equitable
distribution of income may conflict with the objective of economic growth and efficiency.
Q.NO.2 WHAT IS NON-DISCRETIONARY FISCAL POLICY AND HOW IT OCCURS?

ANSWER:
AUTOMATIC STABILIZERS / NON-DISCRETIONARY FISCAL POLICY
1. Non-discretionary fiscal policy or automatic stabilizers are part of the structure of the economy
and are ‘built-in’ fiscal mechanisms that operate automatically to reduce the expansions and
contractions of the business cycle.
2. Changes in fiscal policy do not always require explicit action by government. In most economies,
changes in the level of taxation and level of government spending tend to occur automatically.
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These are dependent on and are determined by the level of aggregate production and income,
such that the instability caused by business cycle is automatically dampened without any need
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for discretionary policy action.

3. Any government programme that automatically tends to reduce fluctuations in GDP is called an
automatic stabilizer. Automatic stabilizers have a tendency for increasing GDP when it is falling
and reducing GDP when it is rising.
4. In automatic or non-discretionary fiscal policy, the tax policy and expenditure pattern are so
framed that taxes and government expenditure automatically change with the change in
national income.
5. It involves built-in tax or expenditure mechanism that automatically increases aggregate
demand when recession is there and reduces aggregate demand when there is inflation in the
economy. Personal income taxes, corporate income taxes and transfer payments
(unemployment compensation, welfare benefits) are prominent automatic stabilizers.
6. Automatic stabilisation occurs through automatic adjustments in government expenditures and
taxes without any deliberate governmental action. These automatic adjustments work towards
stimulating aggregate spending during the recessionary phase and reducing aggregate spending
during economic expansion.
7. RECESSION:
a. During recession incomes are reduced; with progressive tax structure, there will be a decline
in the proportion of income that is taxed. This would result in lower tax payments as well as
some tax refunds.
b. Simultaneously, government expenditures increase due to increased transfer payments like
unemployment benefits. These two together provide proportionately more disposable
income available for consumption spending to households.
c. In the absence of such automatic responses, household spending would tend to decrease
more sharply and the economy would in all probability fall into a deeper recession.
8. EXPANSION:
a. When an economy expands, employment increases, with progressive system of taxes people
have to pay higher taxes as their income rises.
b. This leaves them with lower disposable income and thus causes a decline in their
consumption and therefore aggregate demand.
c. Similarly, corporate profits tend to be higher during an expansionary phase attracting higher
corporate tax payments. With higher income taxes, firms are left with lower surplus causing
a decline in their investments and thus in the aggregate demand.
d. Again, during expansion unemployment falls, therefore government expenditure by way of
transfer payments falls and with lower government expenditure inflation gets
controlled to a certain extent.
e. During an expansionary phase, all types of incomes rise and the amount of transfer
payments decline resulting in proportionately less disposable income available for
consumption expenditure. The built-in stabilisers automatically remove spending from the
economy to reduce demand-pull inflationary pressures and further expansionary
stimulation.
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f. Automatic stabilizers work through limiting the increase in disposable income during an
expansionary phase and limiting the decrease in disposable income during the contraction
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phase of the business cycle.

9. EFFECT OF AUTOMATIC STABILIZER ON MULTIPLIER WHEN GDP INCREASES:
a. Since automatic stabilizers affect disposable personal income directly, and because changes
in disposable personal income are closely linked to changes in consumption, these stabilizers
act swiftly to reduce the extent of changes in real GDP.
b. However, automatic stabilizers that depend on the level of economic activity alone would
not be sufficient to correct instabilities. The government needs to resort to discretionary
fiscal policies.
c. Discretionary fiscal policy for stabilization refers to deliberate policy actions on the part of
government to change the levels of expenditure, taxes to influence the level of national
output, employment and prices.
d. Governments influence the economy by changing the level and types of taxes, the extent
and composition of spending, and the quantity and form of borrowing.
e. Governments may directly as well as indirectly influence the way resources are used in an
economy. The fundamental equation of national income accounting that measures the
output of an economy, or gross domestic product (GDP), according to expenditures.
GDP = C + I + G + NX.
GDP is the value of all final goods and services produced in an economy during a given period
of time. The right side of the equation shows the different sources of aggregate spending or
demand namely, private consumption (C), private investment (I), government expenditure i.e.
purchases of goods and services by the government (G), and net exports, (exports minus
imports) (NX). It is evident from the equation that governments can influence economic
activity (GDP) by controlling G directly and influencing C, I, and NX indirectly, through
changes in taxes, transfer payments and expenditure.
Q.NO.3 EXPLAIN KEYNESIAN SCHOOL OPINION FOR STABILIZING THE ECONOMY?

ANSWER:
1. Fiscal policy is a vital component of the general economic framework of a country and is
therefore closely connected with its overall economic policy strategy.
2. The ability of fiscal policy to influence output by affecting aggregate demand makes it a potential
instrument for stabilization of the economy.
3. The Keynesian school is of the opinion that fiscal policy can have very powerful effects in altering
aggregate demand, employment and output in an economy when the economy is operating at
less than full employment levels and when there is need to offer stimulus to demand.
4. There is a significant and justifiable role for the government to institute relevant fiscal policy
measures. In fact the global financial crisis around the year 2008 has caused fiscal policy to be at
centre of the public policy debate.
5. The tools of fiscal policy are taxes, government expenditure, public debt and the government
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budget.
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Q.NO.4 EXPLAIN HOW GOVERNMENT EXPENDITURE ACTS AS AN INSTRUMENT OF FINACIAL
POLICY?
ANSWER:
GOVERNMENT EXPENDITURE AS AN INSTRUMENT OF FISCAL POLICY
1. Public expenditures are income-generating and include all types of government expenditure
such as capital expenditure on public works, relief expenditures, subsidy payments of various
types, transfer payments and other social security benefits.
2. Government expenditure is an important instrument of fiscal policy. It includes governments’
expenditure towards consumption, investment and transfer payments. Government
expenditures include:
a. Current expenditures to meet the day-to-day running of the government,
b. Capital expenditures which are in the form of investments made by the government in
capital equipments and infrastructure, and
c. Transfer payments i.e. government spending which does not contribute to GDP because
income is only transferred from one group of people to another without any direct
contribution from the receivers.
3. Government may spend money on performance of its large and ever-growing functions and also
for deliberately bringing in stabilization.
4. During a recession, it may initiate a fresh wave of public works, such as construction of roads,
irrigation facilities, sanitary works, ports, electrification of new areas etc.
5. Government expenditure involves employment of labour as well as purchase of multitude of
goods and services. These expenditures directly generate incomes to labour and suppliers of
materials and services.
6. A part from the direct effect, there is also indirect effect in the form of working of multiplier. The
incomes generated are spent on purchase of consumer goods. The extent of spending by people
depends on their marginal propensity to consume (MPC).
7. There is generally surplus capacity in consumer goods industries during recession and an
increase in demand for various goods leads to expansion in production in those industries as
well.
8. Additionally, a programme of public investment will strengthen the general confidence of
businessmen and consequently their willingness to invest. Primary employment in public works
programmes will induce secondary and tertiary employment, and before long the economy is
put on an expansion track.
9. A distinction is made between the two concepts of public spending during depression, namely,
the concept of ‘pump priming’ and the concept of 'compensatory spending'.
a. Pump priming
i) It involves a one-shot injection of government expenditure into a depressed economy
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with the aim of boosting business confidence and encouraging larger private investment.
It is a temporary fiscal stimulus in order to set off the multiplier process.
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ii) The argument is that with a temporary injection of purchasing power into the economy
through a rise in government spending financed by borrowing rather than taxes, it is
possible for government to bring about permanent recovery from a slump.
iii) Pump priming was widely used by governments in the post-war era in order to maintain
full employment; It became discredited later when it failed to halt rising unemployment
and was held responsible for inflation.
b. Compensatory spending
i) It is said to be resorted to when the government spending is deliberately carried out with
the obvious intention to compensate for the deficiency in private investment.
ii) Public expenditure is also used as a policy instrument to reduce the severity of inflation
and to bring down the prices. This is done by reducing government expenditure when
there is a fear of inflationary rise in prices.
iii) Reduced incomes on account of decreased public spending, helps to eliminate excess
aggregate demand.
Q.NO.5 DEFINE THE TERM “GOVERNMENT SPENDING MULTIPLIER”?

ANSWER:
THE GOVERNMENT SPENDING MULTIPLIER
Spending multiplier (also known as Keynesian or fiscal policy multiplier) represents the multiple by
which GDP increases or decreases in response to an increase and decrease in government
expenditures and investment, holding the real money supply constant.
Quantitatively, the government spending multiplier is the same as the investment multiplier. It is
the reciprocal of the marginal propensity to save (MPS). Higher the MPS, lower the multiplier, and
lower the MPS, higher the multiplier.
∆Y/∆G = 1/MPS = 1/1-MPC= 1/1-b
Where,
MPS stands for marginal propensity to save (MPS); and
MPC is marginal propensity to consume
MPS equals 1 – MPC
MPC = Increase in Consumption / Increase in Income
Q.NO.6 SUPPOSE COUNTRY X IS PASSING THROUGH RECESSION, WHAT TYPE OF TAX POLICY
SHOULD BE FRAMED DURING RECESSION PHASE?
ANSWER:
TAXES AS AN INSTRUMENT OF FISCAL POLICY
1. Taxes form the most important source of revenue for governments. Taxation policies are
effectively used for establishing stability in an economy.
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2. Tax as an instrument of fiscal policy consists of changes in government revenues or in rates of

taxes aimed at encouraging or restricting private expenditures on consumption and investment.
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3. Taxes determine the size of disposable income in the hands of the general public which in turn
determines aggregate demand and possible inflationary and deflationary gaps.
4. The structure of tax rates is varied in the context of the overall economic conditions prevailing in
an economy.
5. During recession and depression
a. The tax policy is framed to encourage private consumption and investment. A general
reduction in income taxes leaves higher disposable incomes with people inducing higher
consumption.
b. Low corporate taxes increase the prospects of profits for business and promote further
investment. The extent of tax reduction and /or increase in government spending required
depends on the size of the recessionary gap and the magnitude of the multiplier.
6. During inflation
a. New taxes can be levied and the rates of existing taxes are raised to reduce disposable
incomes and to wipe off the surplus purchasing power.
b. However, excessive taxation usually stifles new investments and therefore the government
has to be cautious about a policy of tax increase.
7. Income taxes lower consumption spending at each level of income because such taxes reduce
disposable income which is a major determinant of households’ consumption. This is because
the marginal propensity to consume out of income after paying taxes is c (1- t) where (1- t) is the
fraction of income left after taxes.
Q.NO.7 DEFINE THE TERM “TAX MULTIPLIER”?

ANSWER:
The tax multiplier represents the multiple by which GDP increases (decreases) in response to a
decrease (increase) in taxes charged by governments.
It is assumed that any increase or decrease in tax affects consumption only (and has no effect on
investment, government expenditures etc.)
Simple Tax multiplier =
This can be understood in the following manner: since 𝐶 = 𝑐(𝑌 − 𝑇), a rise in tax by an amount ∆𝑇
leads to a change in consumption by −𝑏∆𝑇 which, through multiplier leads to a total change equal
to −𝑏∆𝑇/1− b in equilibrium income.
The tax multiplier has a negative sign. It means that tax and increase in tax have negative impact on
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national income.
Given the same value of marginal propensity to consume, simple tax multiplier will be lower than the
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spending multiplier. This is because in the first round of increase in business or government
expenditures, they inject the initial amount of that spending into the income stream and then it
multiples through the economy, while in case of a decrease in taxes of the same amount,
consumption increase by a factor of MPC. So, if the government increases spending by 10 billion, the
entire 10 billion is injected into the income stream. On the other hand, if taxes are reduced by 10
billion, only the MPC x 10 billion is injected into the expenditure stream. For example when the MPC
is 0.9, the spending multiplier is 10; but the tax multiplier is -9 and when the MPC is 0.6, the spending
multiplier is 2.5; but the tax multiplier is -1.5.
The method of analysing the impact of a change in lump-sum taxes on the level of income is the
same as that of change in government expenditure.
Q.NO.8 DEFINE THE TERM “BALANCED BUDGET MULTIPLIER”?

ANSWER:
BALANCED BUDGET MULTIPLIER
The government budget is said to be in balance when ∆G = ∆ T. The balanced budget multiplier is
always equal to 1.
The balanced budget multiplier is obtained by adding up the government spending multiplier (fiscal
multiplier) and the tax multiplier.
Q.NO.9 EXPLAIN HOW PUBLIC DEBT ACTS AS INSTRUMENT OF FISCAL POLICY?

ANSWER:
PUBLIC DEBT AS AN INSTRUMENT OF FISCAL POLICY
1. A rational policy of public borrowing and debt repayment is a potent weapon to fight inflation
and deflation.
2. Public debt may be internal or external;
a. When the government borrows from its own people in the country, it is called internal debt.
b. When the government borrows from outside sources, the debt is called external debt.
3. Public debt takes two forms namely, market loans and small savings.
a. In the case of market loans, the government issues treasury bills and government securities
of varying denominations and duration which are traded in debt markets.
b. For financing capital projects, long-term capital bonds are floated and for meeting short-
term government expenditure, treasury bills are issued.
c. The small savings represent public borrowings, which are not negotiable and are not bought
and sold in the market. In India, various types of schemes are introduced for mobilising small
savings e.g., National Savings Certificates, National Development Certificates, etc.
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4. Borrowing from the public through the sale of bonds and securities curtails the aggregate
demand in the economy. Repayments of debt by governments increase the availability of money
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in the economy and increase aggregate demand.

Q.NO.10 EXPLAIN HOW BUDGET ACTS AS INSTRUMENT OF FISCAL POLICY?
ANSWER:
BUDGET AS AN INSTRUMENT OF FISCAL POLICY
1. Government’s budget is widely used as a policy tool to stimulate or contract aggregate demand
as required. The budget is simply a statement of revenues earned from taxes and other sources
and expenditures made by a nation’s government in a year.
2. The net effect of a budget on aggregate demand depends on the government’s budget balance.
3. A government’s budget can either be balanced, surplus or deficit.
a. A balanced budget results when expenditures in a year equal its revenues for that year. Such
a budget will have no net effect on aggregate demand since the leakages from the system in
the form of taxes collected are equal to the injections in the form of expenditures made.
b. A budget surplus that occurs when the government collects more than what it spends,
though sounds like a highly attractive one, has in fact a negative net effect on aggregate
demand since leakages exceed injections.
c. A budget deficit wherein the government expenditure in a year is greater than the tax
revenue it collects has a positive net effect on aggregate demand since total injections
exceed leakages from the government sector.
4. While a budget surplus reduces national debt, a budget deficit will add to the national debt. A
nation’s debt is the difference between its total past deficits and its total past surpluses. If a
government has borrowed money over the years to finance its deficits and has not paid it back
through accumulated surpluses, then it is said to be in debt.
5. Deliberate changes to the composition of revenue and expenditure components of the budget
are extensively used to change macro economic variables such as level of economic growth,
inflation, unemployment and external stability.
For instance, a budget surplus reduces government debt, increases savings and reduces interest
rates.
6. Higher levels of domestic savings decrease international borrowings and lessen the current
account deficit.
Q.NO.11 EXPLAIN THE TYPES OF DISCRETIONARY FISCAL POLICY?

ANSWER:
TYPES OF FISCAL POLICY
1. Fiscal policy measures to correct different problems created by business-cycle instability are of
two basic types namely, expansionary and contractionary.
2. EXPANSIONARY FISCAL POLICY
a. It is designed to stimulate the economy during the contractionary phase of a business cycle
or when there is an anticipation of a business cycle contraction.
b. This is accomplished by increasing aggregate expenditures and aggregate demand through
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an increase in all types of government spending and / or a decrease in taxes.

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3. CONTRACTIONARY FISCAL POLICY
a. It is basically the opposite of expansionary fiscal policy. It is designed to restrain the levels of
economic activity of the economy during an inflationary phase or when there is anticipation
of a business-cycle expansion which is likely to induce inflation.
b. This is carried out by decreasing the aggregate expenditures and aggregate demand through
a decrease in all types of government spending and/ or an increase in taxes.
c. It should ideally lead to a smaller government budget deficit or a larger budget surplus.
Note:
i) During inflation or when there is excessive levels of utilization of resources, fiscal policy aims at
controlling excessive aggregate spending, and
ii) During deflation or during a period of sluggish economic activity when the rate of utilization of
resources is less, fiscal policy aims to compensate the deficiency in effective demand by boosting
aggregate spending.
Q.NO.12 EXPLAIN RECESSIONARY GAP? WHAT ARE THE INSTRUMENTS FOR EXPANSIONARY
FISCAL POLICY?
ANSWER:
A. RECESSION:
1. A recession is said to occur when overall economic activity declines, or in other words, when
the economy ‘contracts’.
2. A recession sets in with a period of declining real income, as measured by real GDP
simultaneously with a situation of rising unemployment.
3. If an economy experiences a fall in aggregate demand during a recession, it is said to be in a
demand-deficient recession. Due to decline in real GDP, the aggregate demand falls and
therefore, lesser quantity of goods and services will be produced.
B. A RECESSIONARY GAP:
1. It is also known as a contractionary gap, is said to exist if the existing levels of aggregate
production is less than what would be produced with full employment of resources.
2. It is a measure of output that is lost when actual national income falls short of potential
income, and represents the difference between the actual aggregate demand and the
aggregate demand which is required to establish the equilibrium at full employment level of
income.
3. This gap occurs during the contractionary phase of business-cycle and results in higher rates
of unemployment.
C. According to Keynes, when the aggregate demand (i.e. economy’s appetite for buying goods and
services) falls short of aggregate supply (the economy’s capacity to produce goods and services),
it results in unemployment of resources, especially labour. In that case, the government
intervenes through an expansionary fiscal policy.
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Expansionary Fiscal policy for Combating Recession
ANASLYSIS:
a. Real GDP at Y1 level lies below the natural level, Y 2. This represents a situation where the
economy is initially in a recession. There is less than full employment of the resources in the
economy.
b. The classical economists held the view that in such a condition flexibility of wages would
cause wages to fall resulting in reduction in costs. Consequently, suppliers would increase
supply and the short run aggregate supply curve SAS1 will shift to the right say SAS2 and
bring the economy back to the level of full employment at Y2.
c. According to Keynes, wages are not as flexible as what the classical economists believed and
are ‘sticky downward,’ meaning wages will not adjust rapidly to accommodate the
unemployed.
d. The government responds by increasing government expenditures in adequate quantities so
as to cause a shift in the aggregate demand curve to the right from AD1 to AD2.
e. In doing so, the government may have to incur a budget deficit by spending more than its
current receipts.
f. As a response to the shift in AD, output increases as the total demand in the economy
increases.
g. Firms respond to growing demand by producing more output. In order to increase their
output in the short-run, firms must hire more workers. This has the effect of reducing
unemployment in the economy.
h. The increase in government expenditures need not be equal to the difference between Y2
and 𝑌𝑌1, it can be much less. The concept of ‘fiscal multiplier,’ i.e. the response of gross
domestic product to an exogenous change in government expenditures is of use to
determine the required level of government expenditure.
Q.NO.13 DEFINE CONTRACTIONARY FISCAL POLICY. WHAT MEASURES UNDER THIS POLICY ARE TO
BE ADOPTED TO ELIMINATE THE INFLATIONARY GAP?
ANSWER:
A. INFLATION:
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1. When aggregate demand rises beyond what the economy can potentially produce by fully
employing it’s given resources, it gives rise to inflationary pressures in the economy.
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2. The aggregate demand may rise due to large increase in consumption demand by
households or investment expenditure by entrepreneurs, or government expenditure.
3. In these circumstances inflationary gap occurs which tends to bring about rise in prices.
Under such circumstances, a contractionary fiscal policy will have to be used.
B. Contractionary fiscal policy
6. It refers to the deliberate policy of government applied to curtail aggregate demand and
consequently the level of economic activity. In other words, it is fiscal policy aimed at
eliminating an inflationary gap.
7. This is achieved by adopting policy measures that would result in the aggregate demand
curve (AD) shifting to the left so the equilibrium may be established at the full employment
level of real GDP. This can be achieved either by:
a. Decrease in government spending: With decrease in government spending, the total
amount of money available in the economy is reduced which in turn trim down the
aggregate demand.
b. Increase in personal income taxes and/or business taxes:
i) An increase in personal income taxes reduces disposable incomes leading to fall in
consumption spending and aggregate demand.
ii) An increase in taxes on business profits reduces the surpluses available to businesses,
and as a result, firms’ investments shrink causing aggregate demand to fall.
iii) Increased taxes also dampen the prospects of profits of potential entrants who will
respond by holding back fresh investments.
c. A combination of decrease in government spending and increase in personal income
taxes and/or business taxes
Contractionary Fiscal policy for Combating Inflation
ANALYSIS:
a. As real GDP rises above its natural level, (Y in the above figure), prices also rise,
prompting an increase in wages and other resource prices. This causes the SAS curve to
shift from SAS 1 to SAS 2. As a result, the price level goes up from P1 to P3.
b. Nevertheless, the real GDP remains the same at Y. The government now needs to
intervene to control inflation by engaging in a contractionary fiscal policy designed to
reduce aggregate demand so that the aggregate demand curve (AD1) does not shift to
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AD2.
c. The government needs to reduce expenditures or raise taxes only by a small amount
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because of the multiplier effects that such actions may have.

d. Even as expenditures are reduced, the government may attempt to enhance public
revenues in order to generate a budget surplus. In any economy, on account of political,
social and defence considerations government spending cannot be reduced beyond a
particular limit. However, the government can change its expenditure in response to
inflationary pressures.
Q.NO.14 EXPLAIN THE USE OF FISCAL POLICY IN ECONOMIC GROWTH?

ANSWER:
FISCAL POLICY FOR LONG-RUN ECONOMIC GROWTH
1. Fiscal policy acts as an effective tool for managing aggregate demand in the short-run to help
maintain price stability and employment levels. However, demand-side policies unaccompanied
by policies to stimulate aggregate supply cannot produce long-run economic growth.
2. Fiscal policies such as those involving infrastructure spending generally have positive supply-side
effects. When government supports building a modern infrastructure, the private sector is
provided with the requisite overheads it needs.
3. Government provision of public goods such as education, research and development etc.
provide momentum for long-run economic growth.
4. A well designed tax policy that rewards innovation and entrepreneurship, without discouraging
incentives will promote private businesses who wish to invest and thereby help the economy grow.
Q.NO.15 EXPLAIN HOW FISCAL POLICY HELPS IN REDUCING INEQUALITIES OF INCOME AND
WEALTH?
ANSWER:
FISCAL POLICY FOR REDUCTION IN INEQUALITIES OF INCOME AND WEALTH
1. Many developed and developing economies are facing the challenge of rising inequality in
incomes and opportunities. Fiscal policy is a chief instrument available for governments to
influence income distribution and plays a significant role in reducing inequality and achieving
equity and social justice.
2. The distribution of income in the society is influenced by fiscal policy both directly and indirectly.
While current disposable incomes of individuals and corporates are dependent on direct taxes,
the potential for future earnings is indirectly influenced by the nation’s fiscal policy choices.
3. Government revenues and expenditure have traditionally been regarded as important
instruments for carrying out desired redistribution of income.
4. Measures to reduce inequalities of income and wealth.
a. A progressive direct tax system ensures that those who have greater ability to pay contribute
more towards defraying the expenses of government and that the tax burden is distributed
fairly among the population.
b. Indirect taxes can be differential: for example, the commodities which are primarily
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consumed by the richer income group, such as luxuries, are taxed heavily and the
commodities the expenditure on which form a larger proportion of the income of the lower
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income group, such as necessities, are taxed light.

c. A carefully planned policy of public expenditure helps in redistributing income from the rich
to the poorer sections of the society. This is done through spending programmes targeted on
welfare measures for the disadvantaged, such as
i) Poverty alleviation programmes
ii) Free or subsidized medical care, education, housing, essential commodities etc. to
improve the quality of living of poor
iii) Infrastructure provision on a selective basis
iv) Various social security schemes under which people are entitled to old-age pensions,
unemployment relief, sickness allowance etc.
v) Subsidized production of products of mass consumption
vi) Public production and/ or grant of subsidies to ensure sufficient supply of essential
goods, and
vii) Strengthening of human capital for enhancing employability etc.
Note: Choice of a progressive tax system with high marginal taxes may act as a strong deterrent
to work, save and invest. Therefore, the tax structure has to be carefully framed to mitigate
possible adverse impacts on production and efficiency. Additionally, the redistributive fiscal
policy and the extent of spending on redistribution should be consistent with the
macroeconomic policy objectives of the nation.
Q.NO.16 WHAT ARE THE LIMITATIONS OF FISCAL POLICY?

ANSWER:
LIMITATIONS OF FISCAL POLICY
Discretionary fiscal policy is the conscious manipulation of government spending and taxes to
influence the economy.
Some significant limitations in respect of choice and implementation of fiscal policy:
1. One of the biggest problems with using discretionary fiscal policy to counteract fluctuations is
the different types of lags involved in fiscal-policy action. There are significant lags are:
a. Recognition lag: The economy is a complex phenomenon and the state of the macro
economic variables is usually not easily comprehensible. Just as in the case of any other
policy, the government must first recognize the need for a policy change.
b. Decision lag: Once the need for intervention is recognized, the government has to evaluate
the possible alternative policies. Delays are likely to occur to decide on the most appropriate
policy.
c. Implementation lag: Even when appropriate policy measures are decided on, there are
possible delays in bringing in legislation and implementing them.
d. Impact lag: Impact lag occurs when the outcomes of a policy are not visible for some time.
2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly
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possible that an expansionary policy is initiated when the economy is already on a path of
recovery and vice versa.
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3. There are difficulties in instantaneously changing governments’ spending and taxation policies.
4. It is practically difficult to reduce government spending on various items such as defence and
social security as well as on huge capital projects which are already midway.
5. Public works cannot be adjusted easily along with movements of the trade cycle because many
huge projects such as highways and dams have long gestation period.
6. Besides, some urgent public projects cannot be postponed for reasons of expenditure cut to
correct fluctuations caused by business cycles.
7. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation
may set in and also promptly determining the accurate policy to be undertaken.
8. There are possible conflicts between different objectives of fiscal policy such that a policy
designed to achieve one goal may adversely affect another.
For example, an expansionary fiscal policy may worsen inflation in an economy
9. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives.
For example, increase in profits tax may adversely affect the incentives of firms to invest and an
increase in social security benefits may adversely affect incentives to work and save.
10. Deficit financing increases the purchasing power of people. The production of goods and
services, especially in underdeveloped countries may not catch up simultaneously to meet the
increased demand. This will result in prices spiralling beyond control.
11. Increase is government borrowing creates perpetual burden on even future generations as debts
have to be repaid. If the economy lags behind in productive utilization of borrowed money,
sufficient surpluses will not be generated for servicing debts. External debt burden has been a
constant problem for India and many developing countries.
Q.NO.17 WHAT DO YOU MEAN BY CROWDING OUT IN RELATION TO FISCAL POLICY?

ANSWER:
CROWDING OUT
1. Crowding out effect is the negative effect fiscal policy may generate when money from the
private sector is ‘crowded out’ to the public sector. In other words, when spending by
government in an economy replaces private spending, the latter is said to be crowded out.
2. When the government increases it’s spending by borrowing from the loanable funds from the
market the demand for loans increases and this pushes the interest rates up.
3. Private investments are sensitive to interest rates and therefore some private investment
spending is discouraged.
4. Similarly, when government increases the budget deficit by selling bonds or treasury bills, the
amount of money with the private sector decreases and consequently interest rates will be
pushed up. As a result, private investments, especially the ones which are interest –sensitive,
will be reduced.
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5. Fiscal policy becomes ineffective as the decline in private spending partially or completely offset
the expansion in demand resulting from an increase in government expenditure.
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6. Nevertheless, during deep recessions, crowding-out is less likely to happen as private sector
investment is already minimal and therefore there is only insignificant private spending to crowd
out.
7. Moreover, during a recession phase the government would be able to borrow from the market
without increasing interest rates.
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Q.NO.1 The government of Country X, an underdeveloped country, having a severe problem of
unemployment of labour embarks on a massive development programme. It has recognized the
imminent need for boosting up investments to take the country to a higher than average growth
trajectory. The following steps were taken by the government:
i) Invited tenders for a huge network of highways, solar energy generation, communication
systems and computerized systems
ii) Large number of schools throughout the country
iii) Research grants for universities and private research institutes
iv) Announced a number of free healthcare programmes for all
v) All citizens assured of social security
vi) Increase in payments under existing social security schemes
vii) Tax exemption limit raised for individuals, instituted progressive taxes with high marginal
rates - increased corporate taxes
Very soon prices started spiralling and there was general unrest among people especially the
poor.
i) Analyze each of the above measures from a fiscal policy perspective.
ii) Why did overall prices increase?
iii) What policies do you suggest to solve the problem of price rise?
iv) What are the limitations of such policies?
ANSWER:
i) Fiscal policy aimed at economic growth and desired redistribution of income - This is done
through spending programmes targeted on welfare measures for the disadvantaged for e.g.
poverty alleviation programmes, free or subsidized amenities to improve the quality of living of
poor, infrastructure provision on a selective basis, strengthening of human capital for enhancing
employability, Government provision of public goods such as education, research and
development etc. provide momentum for long-run economic growth - A well designed tax policy
that rewards innovation and entrepreneurship, without discouraging incentives will promote
private businesses who wish to invest and thereby help the economy grow- A progressive direct
tax system ensures that those who have greater ability to pay contribute more towards
defraying the expenses of government and that the tax burden is distributed fairly among the
population- carefully planned policy of public expenditure helps in redistributing income from
the rich to the poorer sections of the society-
ii) Conflict with stabilization functions of state policy - Government expenditure injects more
money into the economy and stimulates demand in each case, disposable incomes increase-
aggregate demand increases – illustrate with shift in AD curve- No corresponding increase in
output- inflation sets in
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iii) Remedy through fiscal policy- reduce aggregate demand – contractionary fiscal policy–increase
aggregate supply - illustrate using figure
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iv) Conflict of objectives -Possible lags - long gestation periods - politically unviable to reduce
expenditure-high taxes lead to disincentives to invest.
Q.NO.2 In the above example, suppose that the increase in government spending has been 5
billion. Assume that the marginal propensity to consume of people is equal to 0.6.
i) What will be the government spending multiplier?
ii) What impact would a 5 billion increase in government expenditure have on equilibrium GDP?
ANSWER:
(i) The government spending multiplier when the MPC is 0.6, is 1/1- MPC) = 2.5.
(ii) A 5 billion increase in government expenditure will change the GDP by 5*2.5=12.5 billion if the
MPC = 0.6.
Q.NO.3 For an Economy with the following specifications

Consumption, C = 50+0.75 Yd
Investment, I = 100
Government Expenditure, G = 200
Transfer Payments, R= 110
Income Tax = 0.2Y
Calculate the equilibrium of income and the value of expenditure multiplier.
ANSWER:
The level of disposable income Yd is given by
Yd = Y-Tax + Transfer Payments, Where, Transfer Payment = 110
= Y -0.2 Y +110 = 0.8Y +110, and C = 50+0.75 Yd
= 50+0.75(0.8Y +110) (where Yd = 0.8Y +110)
= 50+(0.75×0.8Y) + (0.75X110) =132.50+0.6Y C = 132.50+0.6 Y
Now Y = C+I+G, Where C = 132.50+0.6Y, I = 100, G = 200 (Given) Y = (132.50+0.6Y) +100+200
= 432.50+0.6Y
Y-0.6Y= 0.4Y = 432.50
or Y = 432.50/0.4 = 1,081.25 Crores
Q.NO.4 Assume that the MPC is equal to 0.6.

(a) What is the value of government spending multiplier?
(b) What impact would a 50 billion increase in government spending have on equilibrium GDP?
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(c) What about a 50 billion decrease in government spending?

ANSWER:
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(a) Government Spending Multiplier = 1/1-MPC
=1/(1-0.6) = 1/0.4 = 2.5
(b) & (c) Change in GDP=Initial Change in Spending x (1−MPC) 50x 2.5 = 125 billion
Q.NO.5 If country X has a marginal propensity to consume of 0, what is the value of fiscal
multiplier?
ANSWER:
Given MPC=0; MPS = (1-0) = 1
The spending multiplier =1. There is no multiplier effect
Q.NO.6 Average per capita income of country Y rose from 42,300 to 50,000 and the corresponding
figures for per capita consumption rose from 35,400 to 42,500. Find the spending multiplier for
this economy.
ANSWER:
Spending multiplier = 1/(1-MPC).
MPC = Increase in Consumption/ Increase in Income
= (42,500−35,400)/ (50,000 − 42,300)
= 0 .922
Multiplier = 1/(1-0.922) = 1/(0.078) = 12.83
Q.NO.7 What would be the impact on GDP if both government spending and taxes are increased
by 5 billion when the MPC is 0.9?
ANSWER:
MPC= 0.9; MPS=0.1. Therefore, spending Multiplier = 1/1-b = 10
Change in GDP=Initial Change in Spending x 10 = 5 x 10 = 50 billion
Tax multiplier = -b/1-b = -9
Decrease in GDP = Initial Change in Tax x 9 = 45 billion
The net result is that output increases by 5 billion.
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3.1. CONCEPT OF MONEY DEMAND
Q.NO.1 DEFINE THE TERM MONEY? EXPLAIN THE CHARACTERISTICS OF MONEY?
ANSWER:
A. MONEY:
1. Money is at the centre of every economic transaction and plays a significant role in all
economies. In simple terms money refers to assets which are commonly used and accepted
as a means of payment or as a medium of exchange or for transferring purchasing power.
2. For policy purposes, money may be defined as the set of liquid financial assets, the variation
in the stock of which will have impact on aggregate economic activity.
3. As a statistical concept, money could include certain liquid liabilities of a particular set of
financial intermediaries or other issuers (RBI, 2007).
4. Money has generalized purchasing power and is generally acceptable in settlement of all
transactions and in discharge of other kinds of business obligations including future
payments.
5. Money is a totally liquid asset as it can be used directly, instantly, conveniently and without
any costs or restrictions to make payments.
6. Money represents a certain value, but currency which represents money does not
necessarily have intrinsic value. When money takes the form of a commodity with intrinsic
value, it is called commodity money.
For e.g. gold, silver or any other such elements may be used as money. As you know, fiat
money (also known as token money) has no intrinsic value, that is, it has no value if it were
not used as money.
7. Fiat money is used as a medium of exchange because the government has, by law, made
them “legal tender,” which means, they serve, by law, as means of payment.
8. In modern days, money is not necessarily a physical item; it may also constitute electronic
records. Money is, in fact, only one among many kinds of financial assets which households,
firms, governments and other economic units hold in their asset portfolios.
9. Unlike other financial assets, money is an essential element in conducting most of the
economic transactions in an economy.
Q.NO.2 EXPLAIN THE FUNCTIONS OF MONEY?

ANSWER:
FUNCTIONS OF MONEY
Money performs many important functions in an economy which not only remove the difficulties of
barter but also support trade and industry. These functions are as follows-
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1. MEDIUM OF EXCHANGE:
a. Money is a convenient medium of exchange or it is an instrument that facilitates easy
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exchange of goods and services.
b. Money, though not having any inherent power to directly satisfy human wants, by acting as a
medium of exchange, it commands purchasing power and its possession enables us to
purchase goods and services to satisfy our wants.
c. By acting as an intermediary, money increases the ease of trade and reduces the inefficiency
and transaction costs involved in a barter exchange. In a barter economy every transaction
has to involve an exchange of goods (and /or services) on both sides of the transaction.
d. By decomposing the single barter transaction into two separate transactions of sale and
purchase, money eliminates the need for double coincidence of wants.
e. Money also facilitates separation of transactions both in time and place and this in turn
enables us to economize on time and efforts involved in transactions.
2. MEASURE OF VALUE:
a. Money is an explicitly defined unit of value or unit of account. A unit of account is the
yardstick people use to post prices and record debts. All economic values are measured and
recorded in terms of money.
b. As a measure of value, money works as a common denominator, as a unit of account.
c. The monetary unit measures and express the value of all goods and services.
d. Money helps in expressing the value of each good or service in terms of price, which is
nothing but the number of monetary units for which the good or service can be exchanged.
It is convenient to trade all commodities in exchange for a single commodity.
e. Money is convenient to measure the prices of all commodities in terms of a single unit,
rather than record the relative price of every good in terms of every other good.
f. An obvious advantage of having a single unit of account is that it greatly reduces the number
of exchange ratios between goods and services.
g. Use of money as a unit of account can encourage trade by making it easier for individuals to
know how much one good is worth in terms of another.
h. A common unit of account facilitates a system of orderly pricing which is crucial for rational
economic choices. Goods and services which are otherwise not comparable are made
comparable through expressing the worth of each in terms of money.
i. Money is a useful measuring rod of value only if the value of money remains constant. The
value of money is linked to its purchasing power, i.e., the quantity of goods and services that
can be bought with a unit of money.
j. Purchasing power of money is the inverse of the average or general level of prices as
measured by the consumer price index. As such the value of money decreases when prices
rise and increase when prices fall.
3. STANDARD OF DEFERRED PAYMENT:
a. Money serves as a unit or standard of deferred payment i.e., money facilitates recording of
deferred promises to pay. Money is the unit in terms of which future payments are
contracted or stated. It simplifies credit transactions.
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b. By acting as a standard of deferred payments, money helps in capital formation both by the
government and business enterprises. This function of money enables the growth of
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financial and capital markets and helps in the growth of the economy.
c. Variations in the purchasing power of money due to inflation or deflation reduce the efficacy
of money in this function.
4. STORE OF VALUE:
a. A store of value is an item that people can use to transfer purchasing power from the preset
to the future.
b. The splitting of purchases and sale into two transactions involves a separation in both time
and space.
c. This separation is possible because money can be used as a store of value or store of means
of payment during the intervening time.
i) Rather than spending one’s money at present, one can store it for use at some future
time. Thus, money functions as a temporary abode of purchasing power in order to
efficiently perform its medium of exchange function.
ii) Money also functions as a permanent store of value. There are many other assets such as
government bonds, deposits and other securities, land, houses etc. which also store
value.
d. The effectiveness of an asset as a store of value depends on the degree and certainty with
which the asset maintains its value over time. Hence, in order to serve as a permanent store
of value in the economy, the purchasing power or the value of money should either remain
stable or should monotonically rise over time.
Note: Despite having the advantages of potential income yield and appreciation in value over
time, these other assets are subject to limitations such as storage costs, lack of liquidity and
possibility of depreciation in value. Financial assets like the riskless government bonds do not
command perfect reversibility as their purchase and sale are subject to certain brokerage costs
although this may be quite small.
Q.NO.3 STATE THE GENERAL CHARACTERISTICS OF MONEY?

ANSWER:
There are some general characteristics that money should possess in order to make it serve its
functions as money. Money should be:
1. Generally acceptable
2. Durable or long-lasting
3. Effortlessly recognizable.
4. Difficult to counterfeit i.e. not easily reproducible by people
5. Relatively scarce, but has elasticity of supply
6. Portable or easily transported
7. Possessing uniformity; and
8. Divisible into smaller parts in usable quantities or fractions without losing value
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Q.NO.4 WRITE ABOUT DEMAND FOR MONEY?
ANSWER:
THE DEMAND FOR MONEY
1. If people desire to hold money, we say there is demand for money. The demand for money is in
the nature of derived demand; it is demanded for its purchasing power.
2. The demand for money is a demand for real balances. People demand money because they wish
to have command over real goods and services with the use of money.
3. Demand for money is actually demand for liquidity and demand to store value.
4. The demand for money is a decision about how much of one’s given stock of wealth should be
held in the form of money rather than as other assets such as bonds. Although it gives little or
no return, individuals, households as well as firms hold money because it is liquid and offers the
most convenient way to accomplish their day to day transactions.
5. Demand for money has an important role in the determination of interest, prices and income in
an economy.
Q.NO.5 DISCUSS THE DETERMINANTS OF DEMAND FOR MONEY?

ANSWER:
1. The quantity of nominal money or how much money people would like to hold in liquid form
depends on many factors, such as income, general level of prices, rate of interest, real GDP, and
the degree of financial innovation etc.
2. Higher the income of individuals, higher the expenditure; richer people hold more money to
finance their expenditure.
3. The quantity which people desire to hold is directly proportional to the prevailing price level;
higher the prices, higher should be the holding of money.
4. The opportunity cost of holding money is the interest rate a person could earn on other assets.
Therefore, higher the interest rate, higher would be opportunity cost of holding cash and lower
the demand for money.
5. Innovations such as internet banking, application based transfers and automated teller machines
reduce the need for holding liquid money. Just as households do, firms also hold money
essentially for the same basic reasons.
Q.NO.6 EXPLAIN THE CLASSICAL VERSION OF QUANTITY THEORY FOR MONEY?

ANSWER:
CLASSICAL APPROACH: THE QUANTITY THEORY OF MONEY (QTM)
1. The quantity theory of money, one of the oldest theories in Economics, was first propounded by
Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published in 1911
and later by the neoclassical economists.
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2. Both versions of the QTM demonstrate that there is strong relationship between money and
price level and the quantity of money is the main determinant of the price level or the value of
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money.
3. Changes in the general level of commodity prices or changes in the value or purchasing power of
money are determined first and foremost by changes in the quantity of money in circulation.
4. Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally
stated as follows:
MV = PT
Where, M = the total amount of money in circulation (on an average) in an economy
V = transactions velocity of circulation i.e. the average number of times across all
transactions a unit of money(say Rupee) is spent in purchasing goods and services
P = average price level (P= MV/T)
T = the total number of transactions.
(Later economists replaced T by the real output Y).
5. Subsequently, Fisher extended the equation of exchange to include demand (bank) deposits (M’)
and their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of
exchange becomes:
MV + M'V' = PT
Where M' = the total quantity of credit money

V'= velocity of circulation of credit money
a. The total supply of money in the community consists of the quantity of actual money (M)
and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of
credit money (V') remain constant. T is a function of national income.
b. Since full employment prevails, the volume of transactions T is fixed in the short run.
c. The total volume of transactions (T) multiplied by the price level (P) represents the demand
for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any
given period, the total value of transactions made is equal to PT and the value of money flow
is equal to MV+ M'V'.
Note: Fisher did not specifically mention anything about the demand for money; but the same is
embedded in his theory as dependent on the total value of transactions undertaken in the
economy. That is people would hold money in a quantity proportional to total transactions
irrespective of interest rate. Thus, there is an aggregate demand for money for transactions
purpose and more the number of transactions people want, greater will be the demand for
money.
Q.NO.7 EXPLAIN THE CAMBRIDGE VERSION OF CASH BALANCE APPROACH?

ANSWER:
THE CAMBRIDGE APPROACH
1. In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John
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Maynard Keynes (then associated with Cambridge) put forward a fundamentally different
approach to quantity theory, known as cash balance approach.
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2. The Cambridge version holds that money increases utility in the following two ways:
a. TRANSACTION MOTIVE: It enabling the possibility of split-up of sale and purchase to two
different points of time rather than being simultaneous, and
b. PRECAUTIONARY MODES: being a hedge against uncertainty.
3. Transaction motive, just as Fisher envisaged, the second points to money’s role as a temporary
store of wealth. Since sale and purchase of commodities by individuals do not take place
simultaneously, they need a ‘temporary abode’ of purchasing power as a hedge against
uncertainty.
4. Demand for money also involves a precautionary motive in Cambridge approach. Since money
gives utility in its store of wealth and precautionary modes, one can say that money is
demanded for itself.
5. It depends partly on income and partly on other factors of which important ones are wealth and
interest rates. The former determinant of demand i.e. income, points to transactions demand
such that higher the income, the greater the quantity of purchases and as a consequence
greater will be the need for money as a temporary abode of value to overcome transactions
costs.
6. The demand for money was primarily determined by the need to conduct transactions which will
have a positive relationship to the money value of aggregate expenditure. Since the latter is
equal to money national income, the Cambridge money demand function is stated as:
Md = k PY
Where
Md = is the demand for money balances,
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’ is a parameter reflecting economic
structure and monetary habits, namely the ratio of total transactions to income and the ratio of
desired money balances to total transactions. The equation above explains that the demand for
money (M) equals k proportion of the total money income.
7. The neoclassical theory changed the focus of the quantity theory of money to money demand
and hypothesized that demand for money is a function of only money income.
Q.NO.8 EXPLAIN THE KEYNESIAN THEORY OF DEMAND FOR MONEY?

ANSWER:
THE KEYNESIAN THEORY OF DEMAND FOR MONEY
1. Keynes’ theory of demand for money is known as Liquidity Preference Theory. Liquidity
preference, a term that was coined by John Maynard Keynes in his masterpiece
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2. ‘The General Theory of Employment, Interest and Money’ (1936), denotes people’s desire to
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hold money rather than securities or long-term interest-bearing investments.
3. According to Keynes, people hold money (M) in cash for three motives:
a. Transactions motive,
b. Precautionary motive, and
c. Speculative motive.
A. The Transactions Motive

i) The transactions motive for holding cash relates to ‘the need for cash for current
transactions for personal and business exchange.’
ii) The need for holding money arises because there is lack of synchronization between
receipts and expenditures. The transaction motive is further classified into income motive
and business (trade) motive.
iii) Keynes did not consider the transaction balances as being affected by interest rates.
iv) The transaction demand for money is directly related to the level of income. The
transactions demand for money is a direct proportional and positive function of the level
of income and is stated as follows:
Lr = kY
Where
Lr is the transactions demand for money,
k is the ratio of earnings which is kept for transactions purposes
Y is the earnings.
v) Keynes considered the aggregate demand for money for transaction purposes as the sum
of individual demand and therefore, the aggregate transaction demand for money is a
function of national income.
B. The Precautionary Motive
i) Individuals as well as businesses keep a portion of their income to finance such
unanticipated expenditures.
ii) The amount of money demanded under the precautionary motive depends on the
size of income, prevailing economic as well as political conditions and personal
characteristics of the individual such as optimism/ pessimism, farsightedness etc.
iii) Keynes regarded the precautionary balances just as balances under transactions motive
as income elastic and by itself not very sensitive to rate of interest.
C. The Speculative Demand for Money
i) The speculative motive reflects people’s desire to hold cash in order to be equipped to
exploit any attractive investment opportunity requiring cash expenditure.
ii) According to Keynes, people demand to hold money balances to take advantage of the
future changes in the rate of interest, which is the same as future changes in bond prices.
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iii) It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the return on bonds.
4. ASSUMPTIONS: Keynes assumed that that the expected return on money is zero, while the
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expected returns on bonds are of two types, namely:
a. The interest payment
b. The expected rate of capital gain.
5. The market value of bonds and the market rate of interest are inversely related.
a. A rise in the market rate of interest leads to a decrease in the market value of the bond, and
vice versa.
b. Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate and
compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
c. If wealth-holders consider that the current rate of interest is high compared to the ‘normal
or critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the
high current rate of interest, they will convert their cash balances into bonds because:
i) they can earn high rate of return on bonds
ii) they expect capital gains resulting from a rise in bond prices consequent upon an
expected fall in the market rate of interest in future.
d. Conversely, if the wealth-holders consider the current interest rate as low, compared to the
‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise in future (fall
in bond prices), they would have an incentive to hold their wealth in the form of liquid cash
rather than bonds because:
i) the loss suffered by way of interest income forgone is small,
ii) they can avoid the capital losses that would result from the anticipated increase in
interest rates, and
iii) the return on money balances will be greater than the return on alternative assets
iv) If the interest rate does increase in future, the bond prices will fall and the idle cash
balances held can be used to buy bonds at lower price and can thereby make a capital-
gain.
Individual’s Speculative Demand for Money
Analysis:
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a. The discontinuous portfolio decision of a typical individual investor is shown in the figure above.
When the current rate of interest r n is higher than the critical rate of interest r c, the entire
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wealth is held by the individual wealth-holder in the form of government bonds.

b. If the rate of interest falls below the critical rate of interest rc, the individual will hold his entire
wealth in the form of speculative cash balances.
c. The discontinuity of the individual wealth-holder's demand curve for the speculative cash
balances disappears and we obtain a continuous downward sloping demand function showing
the inverse relationship between the current rate of interest and the speculative demand for
money
d. According to Keynes, higher the rates of interest, lower the speculative demand for money, and
lower the rate of interest, higher the speculative demand for money.
Aggregate Speculative Demand for Money
Q.NO.9 WHAT ARE THE IMPACTS OF LIQUIDITY TRAP ON THE ECONOMY?

ANSWER:
LIQUIDITY TRAP
1. At a very high interest rate, say r*, the opportunity cost of holding money (in terms of foregone
interest) is high and therefore, people will hold no money in speculative balances.
2. When interest rates fall to very low levels, the expectation is that since the interest rate is very
low it cannot go further lower and that in all possibility it will move upwards.
3. When interest rates rise, the bond prices will fall (interest rates and bond prices are inversely
related).
4. To hold bonds at this low interest rate is to take the almost certain risk of a capital loss (as the
interest rate rises and bond prices fall).
5. The desire to hold bonds is very low and approaches zero, and the demand to hold money in
liquid form as alternative to bond holding approaches infinity.
6. Investors would maintain cash savings rather than hold bonds. The speculative demand
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becomes perfectly elastic with respect to interest rate and the speculative money demand curve
becomes parallel to the X axis. This situation is called a ‘Liquidity trap’.
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7. In such a situation, the monetary authority is unable to stimulate the economy with monetary
policy. Since the opportunity cost of holding money is zero, even if the monetary authority
increases money supply to stimulate the economy, people would prefer to hoard money.
Consequently, excess funds may not be converted into new investment. The liquidity trap is
synonymous with ineffective monetary policy.
8. Empirical evidence of liquidity trap is found during the global financial crisis of 2008 in the
United States and Europe. Short-term interest rates moved close to zero. Some economists
argued that these developed economies were in a liquidity trap.
9. Even tripling of the monetary base in the US between 2008 and 2011 failed to produce
significant effect on the domestic prices.
10. The sum of the transaction and precautionary demand, and the speculative demand, is the total
demand for money.
11. An increase in income increases the transaction and precautionary demand for money and a rise
in the rate of interest decreases the demand for speculative demand money.
Q.NO.10 DEFINE THE TERM REAL CASH BALANCE. DISCUSS THE INVENTORY APPROACH TO
DEMAND FOR MONEY?
ANSWER:
A. INVENTORY APPROACH TO TRANSACTION BALANCES
1. Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for
money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’ was
essentially viewed as an inventory held for transaction purposes.
2. Inventory models assume that there are two media for storing value:
a. Money and
b. An interest-bearing alternative financial asset.
3. There is a fixed cost of making transfers between money and the alternative assets e.g.
broker charges. While relatively liquid financial assets other than money (such as, bank
deposits) offer a positive return, the above said transaction cost of going between money
and these assets justifies holding money.
B. Baumol used business inventory approach to analyze the behaviour of individuals. People hold
an optimum combination of bonds and cash balance, i.e., an amount that minimizes the
opportunity cost.
C. BAUMOL’S PROPOSITIONS
1. Baumol’s Propositions in his theory of transaction demand for money hold that receipt of
income, say Y takes place once per unit of time, but expenditure is spread at a constant rate
over the entire period of time.
2. Excess cash over and above what is required for transactions during the period under
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consideration will be invested in bonds or put in an interest-bearing account.

3. Money holdings on an average will be lower if people hold bonds or other interest yielding
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assets.
4. The higher the income, the higher is the average level or inventory of money holdings.
5. The level of inventory holding also depends upon the carrying cost, which is the interest
forgone by holding money and not bonds, net of the cost to the individual of making a
transfer between money and bonds, say for example brokerage fee.
6. The individual will choose the number of times the transfer between money and bonds takes
place in such a way that the net profits from bond transactions are maximized.
7. The average transaction balance (money) holding is a function of the number of times the
transfer between money and bonds takes place. The choice of the number of times the bond
transaction is made determines the split of money and bond holdings for a given income.
D. THE BROKERAGE FEE EFFECT.
1. An increase the brokerage fee raises the marginal cost of bond market transactions and
consequently lowers the number of such transactions.
2. The increase in the brokerage fee raises the transactions demand for money and lowers the
average bond holding over the period.
3. This result follows because an increase in the brokerage fee makes it more costly to switch
funds temporarily into bond holdings.
4. An individual combines his asset portfolio of cash and bond in such proportions that his
overall cost of holding the assets is minimized.
Q.NO.11 EXPLAIN FRIEDMAN'S RESTATEMENT OF THE QUANTITY THEORY?

ANSWER:
FRIEDMAN'S RESTATEMENT OF THE QUANTITY THEORY
1. Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of
asset price theory. Friedman treats the demand for money as nothing more than the application
of a more general theory of demand for capital assets.
2. Demand for money is affected by the same factors as demand for any other asset, namely
a. Permanent income.
b. Relative returns on assets. (which incorporate risk)
3. Friedman maintains that it is permanent income and not current income as in the Keynesian
theory that determines the demand for money.
a. Permanent income which is Friedman’s measure of wealth is the present expected value of
all future income.
b. To Friedman, money is a good as any other durable consumption good and its demand is a
function of a great number of factors.
4. Friedman identifies the following four determinants of the demand for money. The nominal
demand for money:
a. Is a function of total wealth, which is represented by permanent income divided by the
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discount rate, defined as the average return on the five asset classes in the monetarist
theory world, namely money, bonds, equity, physical capital and human capital.
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b. Is positively related to the price level, P. If the price level rises the demand for money
increases and vice versa.
c. Rises if the opportunity costs of money holdings (i.e. returns on bonds and stock) decline and
vice versa.
d. Is influenced by inflation, a positive inflation rate reduces the real value of money balances,
thereby increasing the opportunity costs of money holdings.
Q.NO.12 EXPLAIN THE DEMAND FOR MONEY AS BEHAVIOUR TOWARD RISK AS PER TOBIN?
ANSWER:
THE DEMAND FOR MONEY AS BEHAVIOUR TOWARD RISK: In his classic article, ‘Liquidity
Preference as Behaviour towards Risk’ (1958), Tobin established that the risk-avoiding behaviour of
individuals provided the foundation for the liquidity preference and for a negative relationship
between the demand for money and the interest rate. The risk-aversion theory is based on the
principles of portfolio management.
1. According to Tobin, the optimal portfolio structure is determined by
a. the risk/reward characteristics of different assets
b. the taste of the individual in maximizing his utility consistent with the existing opportunities
2. An individual would hold a portion of his wealth in the form of money in the portfolio because
the rate of return on holding money was more certain than the rate of return on holding interest
earning assets and entails no capital gains or losses.
3. The individual will be willing to face this risk because the expected rate of return from the
alternative financial assets exceeds that of money.
4. According to Tobin, the rational behaviour of a risk-averse economic agent induces him to hold
an optimally structured wealth portfolio which is comprised of both bonds and money.
5. The overall expected return on the portfolio would be higher if the portfolio were all bonds, but
an investor who is ‘risk-averse’ will be willing to exercise a trade- off and sacrifice to some extent
the higher return for a reduction in risk.
6. Tobin's theory implies that the amount of money held as an asset depends on the level of
interest rate.
a. An increase in the interest rate will improve the terms on which the expected return on the
portfolio can be increased by accepting greater risk.
b. In response to the increase in the interest rate , the individual will increase the proportion of
wealth held in the interest-bearing asset, say bonds, and will decrease the holding of money.
c. Within Tobin's framework, an increase in the rate of interest can be considered as an
increase in the payment received for undertaking risk.
d. When this payment is increased, the individual investor is willing to put a greater proportion
of the portfolio into the risky asset, (bonds) and thus a smaller proportion into the safe
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asset, money.
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Q.NO.1
(a) Why should you hold money balances?
(b) Will you choose to hold only interest bearing assets?
(c) What would your choice be if you can pay for nearly all transactions through online transfers?
(d) Do you think money is a unique store of value?
ANSWER:
(a) Transaction, precautionary and speculative demand – depends on the nature of the holder-
institutional payments mechanisms and the gap between receipt and use of money, amount of
income and changes in incomes, general level of prices, cost of conversion from near money to
money etc.
(b) Not always- Partly held in assets- Depends on costs in terms of time and resources to keep
moving in and out of bonds or other assets, the levels of interest payments, expectations about
bond prices, future price levels- concept of speculative demand for money.
(c) Depends on financial infrastructure, how costless and immediate are transfers, preferences,
attitude towards risks and the opportunity costs.
(d) Financial assets other than money are also performing the function of store of value. Just as
money has, the financial assets have fixed nominal value over time and represent generalized
purchasing power. Therefore, money is not a unique store of value.
Q.NO.2
(a) Calculate M
Velocity 19
Price 108.5
Volume of transactions 120 billion
(b) What will be the effect on money supply if velocity is 25?
ANSWER:
(a) MV = PT,
M x 19 = 108.5 x 120; Therefore M 685.26
(b) For V =25, with given p and T, M will be 520.8
Q.NO.3
(a) Calculate velocity of money
Money Supply 5000 billion
Price 110
Volume of transaction 200
(b) What will be the outcome if volume of transaction increases to225?
ANSWER:
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(a) MV=PT;
5000 x V = 110x200, Therefore V = 4.4
(b) If Volume of transaction 225, then V= 4.95
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3.2. CONCEPT OF MONEY SUPPLY
Q.NO.1 DEFINE THE TERM MONEY SUPPLY?
ANSWER:
MONEY SUPPLY: The term money supply denotes the total quantity of money available to the
people in an economy. The quantity of money at any point of time is a measurable concept. It is
important to note two things about any measure of money supply:
1. The supply of money is a stock variable i.e. it refers to the total amount of money at any
particular point of time. It is the change in the stock of money (say, increase or decrease per
month or year), which is a flow.
2. The stock of money always refers to the stock of money available to the ‘public’ as a means of
payments and store of value. This is always smaller than the total stock of money that really
exists in an economy.
Q.NO.2 DEFINE THE TERM PUBLIC AS PER MONEY SUPPLY?

ANSWER:
PUBLIC: The term ‘public’ is defined to include all economic units (households, firms and
institutions) except the producers of money (i.e. the government and the banking system).
a. The word ‘public’ is inclusive of all local authorities, non-banking financial institutions, and non-
departmental public-sector undertakings, foreign central banks and governments and the
International Monetary Fund which holds a part of Indian money in India in the form of deposits
with the RBI.
b. The standard measures of money, interbank deposits and money held by the government and
the banking system are not included.
Q.NO.3 DISCUSS THE RATIONALE OF MEASURING MONEY SUPPLY?

ANSWER:
RATIONALE OF MEASURING MONEY SUPPLY: The empirical analysis of money supply is important
for two reasons:
1. It facilitates analysis of monetary developments in order to provide a deeper understanding of
the causes of money growth.
2. It is essential from a monetary policy perspective as it provides a framework to evaluate
whether the stock of money in the economy is consistent with the standards for price stability
and to understand the nature of deviations from this standard.
The central banks all over the world adopt monetary policy to stabilise price level and GDP growth
by directly controlling the supply of money. This is achieved mainly by managing the quantity of
monetary base. The success of monetary policy depends to a large extent on the controllability of
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the monetary base and the money supply.

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Q.NO.4 DISCUSS THE SOURCES OF MONEY SUPPLY IN AN ECONOMY?
ANSWER:
1. The supply of money in the economy depends on:
a. The decision of the central bank based on the authority conferred on it , and
b. The supply responses of the commercial banking system of the country to the changes in
policy variables initiated by the central bank to influence the total money supply in the
economy.
2. MONETORY AUTHORITY:
a. The central banks of all countries are empowered to issue currency and, therefore, the
central bank is the primary source of money supply in all countries.
b. High powered money issued by monetary authorities is the source of all other forms of
money.
c. The currency issued by the central bank is ‘fiat money’ and is backed by supporting reserves
and its value is guaranteed by the government.
d. The currency issued by the central bank is a liability of the central bank and the government.
e. Therefore, in principle, it must be backed by an equal value of assets mainly consisting of
gold and foreign exchange reserves.
f. In practice most countries have adopted a ‘minimum reserve system’ wherein the central
bank is empowered to issue currency to any extent by keeping only a certain minimum
reserve of gold and foreign securities.
3. BANKING SYSTEM:
a. The second major source of money supply is the banking system of the country.
b. The total supply of money in the economy is also determined by the extent of credit created
by the commercial banks in the country.
c. Banks create money supply in the process of borrowing and lending transactions with the
public. Money so created by the commercial banks is called 'credit money’.
d. The high powered money and the credit money broadly constitute the most common
measure of money supply, or the total money stock of a country.
e. The Crypto currencies face significant legislative uncertainties and are not legally recognized
in India as currency. Hence, these are not categorized as money.
Q.NO.5 DISCUSS THE MEASUREMENT OF MONEY SUPPLY?

ANSWER:
MEASUREMENT OF MONEY SUPPLY
1. Since July 1935, the Reserve Bank of India has been compiling and disseminating monetary
statistics. Till 1967-68, the RBI used to publish only a single ‘narrow measure of money supply’
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(M1) defined as the sum of currency and demand deposits held by the public.
2. From 1967-68, a 'broader' measure of money supply, called 'aggregate monetary resources'
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(AMR) was additionally published by the RBI.
3. From April 1977, following the recommendations of the Second Working Group on Money
Supply (SWG), the RBI has been publishing data on four alternative measures of money supply
denoted by M1, M2, M3 and M4 besides the reserve money.
4. The respective empirical definitions of these measures are given below:
M1 = Currency notes and coins with the people + demand deposits with the banking system
(Current and Saving deposit accounts) + other deposits with the RBI.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + time deposits with the banking system.
M4 = M3 + total deposits with the Post Office Savings Organization (excluding National Savings
Certificates)
Note: The RBI regards these four measures of money stock as representing different degrees of
liquidity. It has specified them in the descending order of liquidity, M1 being the most liquid and
M4 the least liquid of the four measures.
5. Following the recommendations of the Working Group on Money (1998), the RBI has started
publishing a set of four new monetary aggregates on the basis of the balance sheet of the
banking sector in conformity with the norms of progressive liquidity. The new monetary
aggregates are:
Reserve Money
=Currency in circulation + Bankers’ deposits with the RBI + Other Deposits with the RBI
= Net RBI credit to the Government + RBI credit to the Commercial Sector + RBI’s Claims on
Banks + RBI’s net Foreign assets + Government’s Currency liabilities to the public – RBI’s net non
– monetary Liabilities
NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’ deposits
with the RBI
NM2 = NM1 + Short term time deposits of Residents (including and upto contractual maturity of
one year).
NM3 = NM2 + Long term time deposits of residents + Call/Term funding from financial
institutions
Q.NO.6 DISCUSS THE COMPONENTS OF NARROW MONEY?

ANSWER:
M1 = Currency notes and coins with the people + demand deposits with the banking system
(Current and Saving deposit accounts) + other deposits with the RBI.
1. Currency consists of paper currency as well as coins.
2. Demand deposits comprise the current-account deposits and the demand deposit portion of
savings deposits, all held by the public. These are also called CASA deposits and these are
cheapest sources of finance for a commercial bank.
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a. The total deposits include both deposits from the public as well as inter- bank deposits.
Money is deemed as something held by the ‘public’.
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b. Since inter-bank deposits are not held by the public, they are netted out of the total demand
deposits to arrive at net demand deposits.
3. 'Other deposits’ with the RBI are its deposits other than those held by the government (the
Central and state governments), and include
a. Demand deposits of quasi-government institutions, other financial institutions,
b. Balances in the accounts of foreign central banks and governments, and
c. Accounts of international agencies such as IMF and the World Bank.
Note: Empirically the 'other deposits' of the RBI constitute a very small proportion (less than one per
cent) of the total money supply.
Q.NO.7 DISTINGUISH NARROW MONEY AND RESERVE MONEY?

ANSWER:
1. M1 (narrow money) is defined as the sum of currency held by the public, demand deposits of
the banks and other deposits with the RBI. Banks include commercial and co-operative banks.
2. Reserve money is comprised of the currency held by the public, cash reserves of banks and
other deposits of the RBI.
a. It is also known as central bank money, base money or high-powered money, needs a special
mention as it plays a critical role in the determination of the total supply of money.
b. It determines the level of liquidity and price level in the economy and its management is of
crucial importance to stabilize liquidity, economic growth, and price level in an economy.
3. On comparison, we find that there is difference between M1 and reserve money.
a. Bank reserves, which are a component of the monetary base, are not included in M1. In
addition, bank deposits, which are a component of M1, are not a part of the monetary base.
b. Reserves are commercial banks’ deposits with the central bank for maintaining cash reserve
ratio (CRR) and as working funds for clearing adjustments.
Q.NO.8 WRITE A SHORT NOTE ON LIQUIDITY AGGREGATES MEASURED BY CENTRAL BANK?

ANSWER:
The central bank also measures macroeconomic liquidity by formulating various ‘liquidity’
aggregates in addition to the monetary aggregates. While the instruments issued by the banking
system are included in ‘money’, instruments, those which are close substitutes of money but are
issued by the non-banking financial institutions are also included in liquidity aggregates.
L1 = NM3 + All deposits with the post office savings banks (excluding National Savings
Certificates).
L2 = L1 +Term deposits with term lending institutions and refinancing institutions (FIs) + Term
borrowing by FIs + Certificates of deposit issued by FIs.
L3 = L2+ Public deposits of non-banking financial companies
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Q.NO.9 EXPLAIN THE CONCEPT OF MONEY MULTIPLIER?
ANSWER:
1. The money supply is defined as
M = m X MB
Where M is the money supply, m is money multiplier and MB is the monetary base or high powered
money.
2. From the above equation we can derive the money multiplier (m) as
Money Multiplier(m) = Money Supply/Monetary Base
3. MONEY MULTIPLIER IN TERMS OF MONEY SUPPLY:

a. Money multiplier m is defined as a ratio that relates the changes in the money supply to a
given change in the monetary base.
b. It is the ratio of the stock of money to the stock of high powered money.
c. It denotes by how much the money supply will change for a given change in high-powered
money.
d. The money- multiplier process explains how an increase in the monetary base causes the
money supply to increase by a multiplied amount.
For instance, if there is an injection of Rs.100 Cr through an open market operation by the
central bank of the country and if it leads to an increment of Rs.500 Cr. of final money supply,
then the money multiplier is said to be 5. Hence, the multiplier indicates the change in
monetary base which is transformed into money supply.
e. The multiplier indicates what multiple of the monetary base is transformed into money
supply. In other words, money and high powered money are related by the money
multiplier. We make two simplifying assumptions as follows;
i) Banks never hold excess reserves.
ii) Individuals and non-bank corporations never hold currency.
4. MONEY MULTIPLIER IN RESERVE RATIO:
a. The money multiplier is the reciprocal of the reserve ratio. Deposits, unlike currency held by
people, keep only a fraction of the high-powered money in reserves and the rest is lent out
and culminate in money creation.
b. If R is the reserve ratio in a country for all commercial banks, then each unit of (say Rupee)
money reserves generates 1/R money.
Therefore, for any value of R, the Money Multiplier is 1/R
For example, if R =10%, the value of money multiplier will be 10. If the reserve ratio is only 5
%, then money multiplier is 20. Thus, the higher the reserve ratio, the less of each deposit
banks loan out, and the smaller the money multiplier.
c. An increase in the monetary base that goes into currency is not multiplied, whereas an
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increase in monetary base that goes into supporting deposits is multiplied.

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Q.NO.10 EXPLAIN THE CONCEPT OF THE MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY?
ANSWER:
THE MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY
The money multiplier approach to money supply propounded by Milton Friedman and Anna
Schwartz, (1963) considers three factors as immediate determinants of money supply, namely:
a. the stock of high-powered money (H)
b. the ratio of reserves to deposits or reserve-ratio r = {Reserves/Deposits R/D} and
c. the ratio of currency to deposits, or currency-deposit ratio c={C/D}
1. THE BEHAVIOUR OF THE CENTRAL BANK

a. The behaviour of the central bank which controls the issue of currency is reflected in the
supply of the nominal high-powered money.
b. Money stock is determined by the money multiplier and the monetary base (H) is controlled
by the monetary authority.
c. If the behaviour of the public and the commercial banks remains unchanged over time, the
total supply of nominal money in the economy will vary directly with the supply of the
nominal high-powered money issued by the central bank.
2. THE BEHAVIOUR OF COMMERCIAL BANKS
a. By creating credit, the commercial banks determine the total amount of nominal demand
deposits.
b. The behaviour of the commercial banks in the economy is reflected in the ratio of their cash
reserves to deposits known as the ‘reserve ratio’.
c. If the required reserve ratio on demand deposits increases while all the other variables
remain the same, more reserves would be needed. This implies that banks must contract
their loans, causing a decline in deposits and hence in the money supply.
d. If the required reserve ratio falls, there will be greater expansions of deposits because the
same level of reserves can now support more deposits and the money supply will increase.
To sum up, smaller the reserve ratio larger will be the money multiplier.
e. The commercial banks keep only the required fraction of their total deposits in the form of
cash reserves. However, for the commercial banking system as a whole, the actual reserves
ratio may be greater than the required reserve ratio since the banks keep a higher than the
statutorily required percentage of their deposits in the form of cash reserves as a buffer
against unexpected events requiring cash.
3. The Behaviour of the Public
a. The behaviour of the public influences bank credit through the decision on ratio of currency
to the money supply designated as the ‘currency ratio’.
b. If many people like you do so, technically we say there is an increase in currency ratio.
148
c. When bank deposits are being converted into currency, banks can create only less credit
money.
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d. The overall level of multiple expansion declines money multiplier also falls.
e. Money multiplier and the money supply are negatively related to the currency ratio c.
f. The currency-deposit ratio (c) represents the degree of adoption of banking habits by the
people. This is related to the level of economic activities or the GDP growth and is influenced
by the degree of financial sophistication in terms of ease and access to financial services,
availability of a richer array of liquid financial assets, financial innovations, institutional
changes etc.
g. The smaller the currency-deposit ratio, the larger would be the money multiplier. This is
because a smaller proportion of high powered money is being used as currency and
therefore, a larger proportion is available to be reserves which get transformed into money.
h. An increase in TD/DD ratio means that greater availability of free reserves and consequent
enlargement of volume of multiple deposit expansion and monetary expansion.
i. The money supply is determined by high powered money (H) and the money multiplier (m)
and varies directly with changes in the monetary base, and inversely with the currency and
reserve ratios.
M = C+D (1)
H = C + reserves (2)
Where C is currency and D is deposits which are assumed to be demand deposits. We
summarise the behaviour of the public, banks and the central bank by three variables
namely, currency-deposit ratio c= C/D, reserve-ratio r= Reserves/D, and the stock of high-
powered money (H)
Rewriting equation (1) and (2) above as
M = (c+1) D,
H = (c+ r) D
When there are excess reserves, the money multiplier m is expressed as
4. The money multiplier is a function of:

a. The currency ratio set by depositors c which depends on the behaviour of the public
b. Excess reserves ratio set by banks e, and
c. The required reserve ratio set by the central bank r, which depends on prescribed CRR and
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the balances necessary to meet settlement obligations.

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Numerical Illustration
(a) In Gladys land,
r = 10%= 0.10
Currency = 400 billion
Deposits = 800 billion
Excess Reserves = 0.8 billion = 800 million
Money Supply is M = Currency + Deposits = 1200 billion
c = C/D = 400 billion/800 billion = 0.5 or depositors hold 50 percent of their money as
currency
e= 0.8 billion /800 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves.
Multiplier
= 1+0.5/ 0.1+0.001+0.5 = 1.5/ 0. 601 =2.5
Therefore, a 1 unit increase in H leads to a 2.50 units increase in M. The simple deposit
multiplier in this example would be 1/r= 1/0.1=10
The difference is due to inclusion of currency and excess reserves in calculating the multiplier.
(b) If the reserve ratio is increased to 15 percent, the value of the money multiplier will be,
= 1+0.5/ 0.15+0.001+0.5 = 1.5/ 0. 651 =2.3
Obviously, r and m are negatively related: m falls when r rises, and m rises when r falls. The
reason is that less multiple deposit creation can occur when r rises, while more multiple
deposit creation can occur when r falls.
Q.NO.11 DISCUSS ABOUT EXCESS RESERVES AND ITS IMPACT ON ECONOMY?

ANSWER:
EXCESS RESERVES (ER)
1. The Excess Reserves (ER) are funds that a bank keeps back beyond what is required by regulation
form a very important determinant of money supply.
2. ‘Excess reserves’ are the difference between total reserves (TR) and required reserves (RR).
Therefore, ER=TR-RR.
If total reserves are Rs 800 billion, whereas the required reserves are Rs 600billion, then the
excess reserves are Rs 200 billion.
3. The additional units of high-powered money that goes into ‘excess reserves’ of the commercial
banks do not lead to any additional loans, and therefore, these excess reserves do not lead to
creation of money. If the central bank injects money into the banking system and these are held
as excess reserves by the banking system, there will be no effect on deposits or currency and
hence no effect on money supply.
4. Two primary factors namely market interest rates and expected deposit outflows affect these
costs and benefits and hence in turn affect the excess reserves ratio.
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a. If interest rate increases, it means that the opportunity cost of holding excess reserves rises
because the banks have to sacrifice possible higher earnings and hence the desired ratio of
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excess reserves to deposits falls.
b. Conversely, a decrease in interest rate will reduce the opportunity cost of excess reserves,
and excess reserves will rise. Therefore, we conclude that the banking system's excess
reserves ratio r is negatively related to the market interest rate.
c. If banks fear that deposit outflows are likely to increase (that is, if expected deposit outflows
increase), they will want more assurance against this possibility and will increase the excess
reserves ratio. Conversely, a decline in expected deposit outflows will reduce the benefit of
holding excess reserves and excess reserves will fall.
Q.NO.12 EXPLAIN THE EFFECT OF MONETORY POLICY ON MONEY SUPPLY?

ANSWER:
EFFECT OF MONETARY POLICY ON MONEY SUPPLY
If the central bank wants to stimulate economic activity it does so by infusing liquidity into the
system.
E.g., Open market operations (OMO) by central banks. Purchase of government securities injects
high powered money (monetary base) into the system. Assuming that banks do not hold excess
reserves and people do not hold more currency than before, and also that there is demand for loans
from businesses, the credit creation process by the banking system in the country will create money
The effect of an open market sale is very similar to that of open market purchase, but in the
opposite direction. In other words, an open market purchase by central bank will reduce the
reserves and thereby reduce the money supply.
Q.NO.13 EXPLAIN THE EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY?

ANSWER:
EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY
1. Whenever the central and the state governments’ cash balances fall short of the minimum
requirement, they are eligible to avail of a facility called Ways and Means Advances
(WMA)/overdraft (OD) facility.
2. When the Reserve Bank of India lends to the governments under WMA /OD, it results in the
generation of excess reserves (i.e., excess balances of commercial banks with the Reserve Bank).
3. This happens because when government incurs expenditure, it involves debiting the government
balances with the Reserve Bank and crediting the receiver (for e.g., salary account of
government employee) account with the commercial bank.
4. The excess reserves created can potentially lead to an increase in money supply through the
money multiplier process.
Q.NO.14 EXPLAIN CREDIT MULTIPLIER?

ANSWER:
THE CREDIT MULTIPLIER
1. The Credit Multiplier also referred to as the deposit multiplier or the deposit expansion
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multiplier, describes the amount of additional money created by commercial bank through the
process of lending the available money it has in excess of the central bank's reserve
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requirements.
2. The deposit multiplier is tied to the bank's reserve requirement. This measure tells us how much
new money will be created by the banking system for a given increase in the high-powered
money. It reflects a bank's ability to increase the money supply.
3. The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio is 20%, then
credit multiplier = 1/0.20 = 5.
Credit Multiplier = 1/Required Reserve Ratio
4. The existence of the credit multiplier is the outcome of fractional reserve banking. It explains
how increase in money supply is caused by the commercial banks’ use of depositors’ funds to
lend money. When a bank uses the deposited money for lending, the bank generates another
claim on a given amount of deposited money.
For example, if A deposits Rs. 1000/ in cash at a bank (Bank X), this constitutes the bank's current
total cash deposits. If the required reserve is 10 percent, the bank would lend Rs. 900/ to B. By
lending B Rs. 900/, the bank creates a deposit for Rs. 900/ that B can now use. It is as though B
owns Rs. 900/. This in turn means that A will continue to have a claim against Rs. 1000/ while B
will have a claim against Rs. 900/. The bank has Rs. 1000/ in cash against claims of Rs. 1900/. In
short, the bank has created Rs. 900/ out of "thin air" since these Rs. 900/ are not supported by
any genuine money. At any time, the fractional reserve commercial banks have more cash
liabilities than cash in their vaults.
Now suppose B buys goods worth Rs. 900/ from C and pays C by cheque. C places the cheque
with his bank, Bank Y. After clearing the cheque, Bank Y will have an increase in cash of Rs. 900/,
which it may take advantage of and use to lend out Rs. 810/ to D which may again be deposited
in another bank, say Bank Z. Again 10 per cent of Rs. 810 (Rs. 81) has to be kept as required
reserves and the remaining Rs. 719/ can be lent out, say to E.
This sequence keeps on continuing until the initial deposit amount Rs. 1,000 grows exactly by the
multiple of required reserves (in this case, 10%). Ultimately, the expanded credit availability
would be 1000 + 900 (90% of 1000) + 810 (90% of 900) + 729 (90% of 810) + (90% of 719)
+……. This summation would end with an amount which is equivalent to 1/10% of 1000, which is
Rs. 10,000. Thus, in our example, the initial deposit is capable of multiplying itself out 10 times. In
short, we find that the fact that banks make use of demand deposits for lending it sets in motion
a series of activities leading to expansion of money that is not backed by money proper. It is
interesting to know that there is no difference between the type of money created by commercial
banks and that which are issued by the central bank.
Q.NO.15 THE DEPOSIT MULTIPLIER AND THE MONEY MULTIPLIER THOUGH CLOSELY RELATED ARE
NOT IDENTICAL. EXPLAIN BREIFLY?
ANSWER:
The deposit multiplier and the money multiplier though closely related are not identical because:
a. Generally banks do not lend out all of their available money but instead maintain reserves at a
level above the minimum required reserve.
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b. All borrowers do not spend every Rupee they have borrowed. They are likely to convert some
portion of it to cash.
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Q.NO.1 Calculate Narrow Money (M1) from the following data
Currency with public Rs. 90000 crore
Demand Deposits with Banking System Rs. 200000 crore
Time Deposits with Banking System Rs. 220000 crore
Other Deposits with RBI Rs. 280000 crore
Saving Deposits of Post office saving banks Rs. 60000 crore
ANSWER:
M1 = Currency with public + Demand Deposits with Banking System + Other Deposits with the RBI
= 90000 crore + 200000 crore + 280000 crore = 570000crore
Q.NO.2 Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every Rs.
1,00,000 deposited in the banking system. What will be the total credit money created by the
banking system in each case?
ANSWER:
Credit Multiplier is the reciprocal of required reserved ratio.
Credit Multiplier = 1/Required Reserve Ratio
For RRR = 0.10 i.e., 10% the credit multiplier = 1/0.10 = 10
For RRR = 0.125i.e. 12.5% the credit multiplier = 1/0.125 = 8
Credit Creation = Initial deposits x 1/RRR
For RRR 0.10 credit creation will be 1, 00,000× 1/0.10 = Rs, 10, 00,000
For RRR 0.125 credit creation will be 1, 00,000× 1/0.125= Rs, 8, 00,000
Q.NO.3 Calculate currency with the Public from the following data (Rs. Crore)
1.1 Notes in Circulation 2496611
1.2 Circulation of Rupee Coin 25572
1.3 Circulation of Small Coins 743
1.4 Cash on Hand with Banks 98305
ANSWER:
Currency with the Public (1.1 + 1.2 + 1.3 – 1.4) = (2496611+25572+743) – 98305 = 2424621 crores
Q.NO.4 Calculate M2 from the following data

(Rs. crore)
Notes in Circulation 2420964
Circulation of Rupee Coin 25572
Circulation of Small Coins 743
Post Office Saving Bank Deposits 141786
Cash on Hand with Banks 97563
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Deposit Money of the Public 1776199

Demand Deposits with Banks 1737692
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‘Other’ Deposits with Reserve Bank 38507
Total Post Office Deposits 14896
Time Deposits with Banks 178694
ANSWER:
M2 = M1+ Post Office Saving Bank Deposits
where M1 = (Notes in Circulation + Circulation of Rupee Coin + Circulation of Small Coins - Cash on
Hand with Banks) + Deposit Money of the Public
= (2420964+25572+743+97563- 97563) +1776199 =4125915
M2 = M1+ Post Office Saving Bank Deposits = 4125915 +141786= 4267701
Q.NO.5 If the required reserve ratio is 10 percent, currency in circulation is Rs.400 billion, demand
deposits are Rs.1000 billion, and excess reserves total Rs.1 billion, find the value of money
multiplier
ANSWER:
r = 10% = 0.10
Currency = 400 billion
Deposits = 1000 billion
Excess Reserves = 1 billion
Money Supply is M = Currency + Deposits = 1400 billion
c = C/D = 400 billion/1000 billion = 0. 4 or depositors hold 40 percent of their money as currency
e= 1billion /1000 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves.
Multiplier = 1+0.4/ 0.1+0.001+0.4 = 1.5/ 0. 501 =2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.
Q.NO.6 Prepare separate graphs using excel on ‘Money Stock: Components and Sources’ and
‘Reserve Money: Components and Sources’ for four previous months from the weekly
statistical supplements published by Reserve Bank of India. Identify the trends in each.
ANSWER:
From the RBI website, collect the relevant information from the ‘publications (weekly) page.
Q.NO.7 Compute Reserve Money from the following data published by RBI
Components (In billions of Rs.) As on 7 July 2017
Currency in Circulation 15428.40
Bankers’ Deposits with RBI 4596.18
’Other’ Deposits with RBI 183.30
ANSWER:
Reserve Money = Currency in Circulation + Bankers’ Deposits with RBI + ’Other’ Deposits with RBI
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= 15428.40+4596.18+183.30= 20207.88
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Q.NO.8 Compute M3 from the following data published by RBI
Components (In billions of Rs.) As on 31 March, 2017
Currency with the Public 12637.1
Demand Deposits with Banks 14,106.3
Time Deposits with Banks 101,489.5
‘Other’ Deposits with Reserve Bank 210.9
ANSWER:
M3 = Currency with the Public + Demand Deposits with Banks+ Time Deposits with Banks+ ‘Other’
Deposits with Reserve Bank
=12637.1+14,106.3+101,489.5+210.9
= 128,443.8
Q.NO.9 What will be the total credit created by the commercial banking system for an initial
deposit of Rs.1000/ for required reserve ratio 0.02, 0.05 and 0.10 percent respectively?
Compute credit multiplier.
ANSWER:
Credit Multiplier =1/ Required Reserve Ratio
1000 x 1/0.02= 50,000
1000x 1/0.05 – 20,000
1000x1/0.10= 10,000
Q.NO.10 How would each of the following affect money multiplier and money supply?
(i) Commercial banks in India decide to hold more excess reserves
(ii) Fearing shortage of money in ATMs, people decide to hoard money
(iii) Banks open large number ATMs all over the country
(iv) E banking becomes very common and nearly all people use them
(v) During festival season, people decide to use ATMs very often
(vi) If banks decide to keep 100% reserves. What would be the effect on money multiplier and
money supply?
(vii) Suppose banks need to keep no reserves only 0% reserves are there.
ANSWER:
(i) Excess reserves are those reserves that the commercial banks hold with the central bank in
addition to the mandatory reserve requirements. Excess reserves result in an increase in
reserve-deposit ratio of banks; less money for lending reduces money multiplier; money supply
declines.
(ii) When people hold more money, it increases the currency-deposit ratio; reduces money
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multiplier; money supply declines.

(iii) ATMs let people to withdraw cash from the bank as and when needed, reduces cost of
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conversion of deposits to cash and makes deposits relatively more convenient. People hold less
cash and more deposits, thus reducing the currency-deposit ratio; increasing the money
multiplier causing the money supply to increase
(iv) See (iii) above
(v) If people, for any reason, are expected to withdraw money from ATMs with more frequency,
then banks will want to keep more reserves. This will raise the reserve ratio, and lower the
money multiplier. As a result money supply will decline
(vi) If banks decides to keep 100% reserves, then the Money multiplier = 1/required reserve ratio =
1/100% = 1. No additional money supply as there is no credit creation
(vii) If the required reserve ratio is 0 %, then money multiplier is infinite and there will be
unlimited money creation. There will be chaos with spiraling prices as money supply is too much
and real output cannot increase.
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3.3. MONETARY POLICY
Q.NO.1 DEFINE MONITORY POLICY? WHAT ARE THE COMPONENTS OF MONITORY POLICY?
ANSWER:
A. MONETARY POLICY
1. Monetary policy refers to the use of monetary policy instruments which are at the disposal
of the central bank to regulate the availability, cost and use of money and credit to promote
economic growth, price stability, optimum levels of output and employment, balance of
payments equilibrium, stable currency or any other goal of government's economic policy.
2. Monetary policy is essentially a programme of action undertaken by the monetary
authorities, normally the central bank, to control and regulate the demand for and supply of
money with the public and the flow of credit with a view to achieving predetermined
macroeconomic goals.
3. Monetary policy encompasses all actions of the central bank which are aimed at directly
controlling the money supply and indirectly at regulating the demand for money. Monetary
policy is in the nature of ‘demand-side’ macroeconomic policy and works by stimulating or
discouraging investment and consumption spending on goods and services. It is no surprise
that monetary policy is regarded as an indispensable policy instrument in an economy.
B. The central bank, in its execution of monetary policy, functions within an articulated monetary
policy framework which has three basic components
1. The objectives of monetary policy
2. The analytics of monetary policy which focus onthe transmission mechanisms, and
3. The operating procedure which focuses on the operating targets and instruments.
Q.NO.2 STATE THE OBJECTIVES OF MONITORY POLICY?

ANSWER:
THE OBJECTIVES OF MONETARY POLICY
1. The objectives set for monetary policy are important because they provide explicit guidance to
policy makers. Monetary policy of a country is in fact a reflection of its economic policy and the
objectives of monetary policy generally coincide with the overall objectives of economic policy.
2. The Reserve Bank of India Act, 1934, in its preamble sets out the objectives of the Bank as ‘to
regulate the issue of bank notes and the keeping of reserves with a view to securing monetary
stability in India and generally to operate the currency and credit system of the country to its
advantage’.
3. Multiple objectives, all of which are equally desirable, such as
a. Rapid economic growth,
b. Debt management,
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c. Moderate long-term interest rates,

d. Exchange rate stability and
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e. External balance of payments equilibrium
were incorporated as objectives of monetary policy by policy makers in later years.
4. In developing countries, the monetary policy of such countries also incorporate explicit
objectives such as:
a. Maintenance the economic growth,
b. Ensuring an adequate flow of credit to the productive sectors,
c. Sustaining - a moderate structure of interest rates to encourage investments, and
d. Creation of an efficient market for government securities.
5. Considerations of financial and exchange rate stability have assumed greater importance in India
recently on account of increasing openness of the economy and the progressive economic and
financial sector reforms.
Q.NO.3 STATE THE ANALYTICES OF MONITORY POLICY?

ANSWER:
ANALYTICS OF MONETARY POLICY
1. Same like fiscal policy, monetary policy is intended to influence macroeconomic variables such
as aggregate demand, quantity of money and credit, interest rates etc, so as to influence overall
economic performance.
2. The process or channels through which the change of monetary aggregates affects the level of
product and prices is known as ‘monetary transmission mechanism’.
3. It describes how policy-induced changes in the nominal money stock or in the short-term
nominal interest rates impact real variables such as aggregate output and employment.
4. Monetary policy transmission is the process through which a change in the policy rate gets
transmitted primarily to the short-term money market rate and subsequently to the entire range
of interest rates namely, banks’ deposit and lending rates and interest rates in bond markets.
These interest rate changes affect macro-economic variables such as consumption, investment
and exports which in turn influence aggregate demand, output and employment.
5. There are mainly five different mechanisms through which monetary policy influences the price
level and the national income. These are:
a. The interest rate channel,
b. The exchange rate channel,
c. The quantum channel (e.g., relating to money supply and credit),
d. The asset price channel i.e. via equity and real estate prices. and
e. The expectations channel
6. According to the traditional Keynesian interest rate channel,
a. Contractionary monetary policy‐induced increase in interest rates increases the cost of
capital and the real cost of borrowing for firms with the result that they cut back on their
investment expenditures. Similarly, households facing higher real borrowing costs, cut back
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on their purchases of homes, automobiles, and all types of durable goods. A decline in
aggregate demand results in a fall in aggregate output and employment.
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b. Conversely, an expansionary monetary policy induced decrease in interest rates will have the
opposite effect through decreases in cost of capital for firms and cost of borrowing for
households.
Q.NO.4 EXPLAIN THE EXCHANGE RATE CHANNEL OF MONETORY TRANSMISSION MECHANISMS?

ANSWER:
1. Changes in monetary policy cause differences between domestic and foreign interest rates
leading to capital flows (inflow or outflow) and exchange rate. The exchange rate channel works
through expenditure switching between domestic and foreign goods.
2. Appreciation of the domestic currency makes domestically produced goods more expensive
compared to foreign‐produced goods. This causes net exports to fall; correspondingly domestic
output and employment also fall.
3. Depreciation of the domestic currency makes domestically produced goods more cheaper
compared to foreign‐produced goods. This causes net exports to rise; correspondingly domestic
output and employment also rise.
Q.NO.5 DISCUSS ABOUT CREDIT CHANNEL OF MONETORY TRANSMISSION MECHANISMS?

ANSWER:
1. Credit channel operates by altering access of firms and households to bank credit. Most
businesses and people mostly depend on bank for borrowing money.
2. An open market operation that leads first to a contraction in the supply of bank reserves and
then to a contraction in bank credit requires banks to cut back on their lending.
3. This, in turn makes the firms that are especially dependent on banks loans to cut back on their
investment spending. Thus, there is decline in the aggregate output and employment following a
monetary contraction.
4. BALANCE SHEET CHANNEL: As a firm’s cost of credit rises, the strength of its balance sheet
deteriorates.
a. A direct effect of monetary policy on the firm’s balance sheet comes through an increase in
interest rates leading to an increase in the payments that the firm must make to repay its
floating rate debts.
b. An indirect effect occurs when the same increase in interest rates works to reduce the
capitalized value of the firm’s long‐lived assets.
c. Hence, a policy‐induced increase in the short‐term interest rate not only acts immediately to
depress spending through the traditional interest rate channel, it also acts, possibly with a
time-lag, to raise each firm’s cost of capital through the balance sheet channel.
d. These together aggravate the decline in output and employment.
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5. STANDARD ASSET PRICE CHANNEL:

a. The standard asset price channel suggests that asset prices respond to monetary policy
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changes and consequently affect output, employment and inflation.
b. A policy‐induced increase in the short‐term nominal interest rates makes debt instruments
more attractive than equities in the eyes of investors leading to a fall in equity prices.
c. If stock prices fall after a monetary tightening, it leads to reduction in household financial
wealth, leading to fall in consumption, output, and employment.
6. Changes in monetary policy may have impact on people’s expectations about inflation and
therefore on aggregate demand. This in turn affects employment and output in the economy.
7. The manner in which these different channels function in a given economy depends on:
a. the stage of development of the economy, and
b. the underlying financial structure of the economy
Q.NO.6 EXPLAIN HOW THE OPERATING FRAMEWORK IS USEFUL IN IMPLEMENTATION OF

MONETORY POLICY?
ANSWER:
A. The operating framework relates to all aspects of implementation of monetary policy. It
primarily involves three major aspects, namely,
a. Choosing the operating targets,
b. Choosing the intermediate targets, and
c. Choosing the policy instruments.
1. CHOOSING THE OPERATING TARGETS: The operating targets refer to the financial variables
that can be controlled by the central bank to a large extent through the monetary policy
instruments (reserve money and short-term money market interest rates or weighted
average call rate (WACR)).
2. CHOOSING THE INTERMEDIATE TARGETS: The intermediate targets (e.g. monetary
aggregates and short-term and long- term interest rates) are variables which the central
bank can hope to influence to a reasonable degree through the operating targets. The
intermediate targets display a predictable and stable relationship with the goal variables
(e.g. stability, growth etc.)
3. CHOOSING THE POLICY INSTRUMENTS: The monetary policy instruments are the various
tools that a central bank can use to influence money market and credit conditions and
pursue its monetary policy objectives.
B. OPERATING PROCEDURES AND INSTRUMENTS:
1. The day-to-day implementation of monetary policy by central banks through various
instruments is referred to as ‘operating procedures’. For example, liquidity management is
the operating procedure of the Reserve Bank of India
2. For implementing monetary policy, a central bank can act directly, using its regulatory
160
powers, or indirectly, using its influence on money market conditions as the issuer of reserve
money (currency in circulation and deposit balances with the central bank).
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3. The direct instruments comprise of:
a. The required cash reserve ratios and liquidity reserve ratios prescribed from time to
time.
b. Directed credit which takes the form of prescribed targets for allocation of credit to
preferred sectors (for e.g. Credit to priority sectors), and
c. Administered interest rates wherein the deposit and lending rates are prescribed by the
central bank.
4. The indirect instruments mainly consist of:
a. Repos
b. Open market operations
c. Standing facilities, and
d. Market-based discount window.
Q.NO.7 DEFINE THE TERMS CASH RESERVE RATIO, STATUTORY LIQUIDITY RESERVE AND LIQUIDITY
ADJUSTMENT FACILITY?
ANSWER:
A. CASH RESERVE RATIO (CRR)
1. CRR refers to the average daily balance that a bank is required to maintain with the Reserve
Bank of India as a share of its total net demand and time liabilities (NDTL). This percentage
will be notified from time to time by the Reserve Bank.
2. The RBI may set the ratio in keeping with the broad objective of maintaining monetary
stability in the economy.
3. This requirement applies uniformly to all scheduled banks in the country irrespective of its
size or financial position.
4. Non-Bank Financial Institution (NBFIs) are outside the purview of this reserve requirement.
5. The Reserve Bank does not pay any interest on the CRR balances maintained by the
scheduled commercial banks (SCBs) with effect from the fortnight beginning March 31, 2007;
6. The failure of a bank to meet its required reserve requirements would attract penalty in the
form of penal interest charged by the RBI.
7. CRR acts as one of the important quantitative tools aiding in liquidity management.
a. Higher the CRR with the RBI, lower will be the liquidity in the system and vice versa.
b. During slowdown in the economy, the RBI reduces the CRR in order to enable the banks
to expand credit and increases the supply of money available in the economy.
c. In order to contain credit expansion during period’s high inflation, the RBI increases the
CRR.
Note: The cash reserve ratio as on 20th September, 2020 was 4.00 percent
B. STATUTORY LIQUIDITY RATIO (SLR)
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1. As per the Banking Regulations Act 1949, all scheduled commercial banks in India are
required to maintain a stipulated percentage of their total Demand and Time Liabilities (DTL)
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/ Net DTL (NDTL) in one of the following forms:
a. Cash
b. Gold, or
c. Investments in un-encumbered Instruments that include:
i) Treasury-bills of the Government of India.
ii) Dated securities including those issued by the Government of India from time to time
under the market borrowings programme and the Market Stabilization Scheme
(MSS).
iii) State Development Loans (SDLs) issued by State Governments under their market
borrowings programme.
iv) Other instruments as notified by the RBI. These include mainly the securities issued
by PSEs.
2. The SLR requires holding of assets in one of the above three categories by the bank itself.
3. The banks which fail to meet its SLR obligations are liable to be imposed penalty in the form
of a penal interest payable to RBI. As on 20th September, 2020, the SLR was 18 per cent.
4. The SLR is also a powerful tool for controlling liquidity in the domestic market by means of
manipulating bank credit.
a. Changes in the SLR chiefly influence the availability of resources in the banking system
for lending.
b. A rise in the SLR which is resorted to during periods of high liquidity, tends to lock up a
rising fraction of a bank’s assets in the form of eligible instruments, and this reduces the
credit creation capacity of banks.
c. A reduction in the SLR during periods of economic downturn has the opposite effect. The
SLR requirement also facilitates a captive market for government securities.
C. LIQUIDITY ADJUSTMENT FACILITY (LAF) (RBI has introduced Liquidity Adjustment Facility (LAF)
w.e.f. June 2000).
1. The Liquidity Adjustment Facility (LAF) enables the RBI to modulate short-term liquidity
under varied financial market conditions to ensure stable conditions in the overnight (call)
money market.
2. It is extended by the Reserve Bank of India to the scheduled commercial banks (excluding
RRBs) and primary dealers to avail of liquidity in case of requirement (or park excess funds
with the RBI in case of excess liquidity) on an overnight basis against the collateral of
government securities including state government securities.
3. The LAF consists of overnight as well as term repo auctions. The aim of term repo is to help
develop the inter-bank term money market. This move is expected to set market based
benchmarks for pricing of loans and deposits, and hence improve transmission of monetary
policy.
4. The introduction of LAF is an important landmark since it triggered a rapid transformation in
162
the monetary policy operating environment in India. Its objective is to assist banks to adjust
their day-to-day mismatches in liquidity.
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5. Currently, the RBI provides financial accommodation to the commercial banks through
repos/reverse repos under the Liquidity Adjustment Facility (LAF).
Q.NO.8 EXPLAIN HOW REPO ACTS AS AN INSTRUMENT IN MONETORY POLICY?

ANSWER:
REPO: Repurchase Options or in short ‘Repo’, is defined as ‘an instrument for borrowing funds by
selling securities with an agreement to repurchase the securities on a mutually agreed future date at
an agreed price which includes interest for the funds borrowed’.
1. The repo rate is the (fixed) interest rate at which the Reserve Bank provides overnight liquidity
to banks against the collateral of government and other approved securities under the liquidity
adjustment facility (LAF).
2. Repo is a money market instrument, which enables collateralised short-term borrowing and
lending through sale/purchase operations in debt instruments.
3. The Repo transaction in India has two elements: -
a. The seller sells securities and receives cash while the purchaser buys securities and parts
with cash.
b. The securities are repurchased by the original holder.
c. The user pays to the counter party the amount originally received, plus the return on the
money for the number of days for which the money was used, which is mutually agreed.
4. All these transactions are reported on the electronic platform called the Negotiated Dealing
System (NDS). The Clearing Corporation of India Ltd. (CCIL) has put in an anonymous online repo
dealing system in India, with an anonymous order matching electronic platform.
5. Repo or repurchase option is a collateralised lending. Repo operations thus inject liquidity into
the system.
6. There are three types of repo markets operating in India namely:
(i) Repo on sovereign securities
(ii) Repo on corporate debt securities, and
(iii) Other Repos
Q.NO.9 EXPLAIN ABOUT POLICY RATE?

ANSWER:
POLICY RATE:
1. In India, the fixed repo rate quoted for sovereign securities in the overnight segment of Liquidity
Adjustment Facility (LAF) is considered as the policy rate.
2. The RBI uses the single independent ‘policy rate’ which is the repo rate (in the LAF window) for
balancing liquidity. The policy rate is in fact, the key lending rate of the central bank in a country.
3. A change in the policy rate gets transmitted through the money market to the entire the
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financial system and alters all other short term interest rates in the economy, thereby
influencing aggregate demand.
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4. If the RBI wants to make it more expensive for banks to borrow money, it increases the repo
rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo
rate.
The Monetary Policy committee (MPC) at its meeting on August 4-6, 2020 decided to: has
decided to reduce the policy repo rate under the liquidity adjustment facility (LAF) by 40 bps to
4.0 per cent from 4.40 per cent with immediate effect; accordingly, the marginal standing facility
(MSF) rate and the Bank Rate stand reduced to 4.25 per cent from 4.65 per cent; and the reverse
repo rate under the LAF stands reduced to 3.35 per cent from 3.75 per cent.
Q.NO.10 EXPLAIN HOW REVERSE REPO ACTS AS AN INSTRUMENT IN MONETORY POLICY?

ANSWER:
REVERSE REPO RATE:
1. The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from
banks against the collateral of eligible government securities under the LAF.
2. It is a monetary policy instrument and in effect it absorbs the liquidity from the system.
3. This operation takes place when the RBI borrows money from commercial banks by selling them
securities (which RBI permits) with an agreement to repurchase the securities on a mutually
agreed future date at an agreed price which includes interest for the funds borrowed.
4. The interest rate paid by the RBI for such borrowings is called the "Reverse Repo Rate". Thus,
reverse repo rate is the rate of interest paid by the RBI on its borrowings from commercial
banks.
NOTE:
1. The ‘repo rate’ and the reverse repo rate’ are changed only through the announcements
made during the Monetary Policy Statements of the RBI. From May, 2011 onwards, the
reverse repo rate is not announced separately, it will be linked to repo rate. The Reserve Bank
also conducts variable interest rate reverse repo auctions, as necessitated under the market
conditions.
2. In addition to the existing overnight LAF (repo and reverse repo) and MSF, from October
2013, The Reserve Bank has introduced ‘Term Repo’ (repos of duration more than a day)
under the Liquidity Adjustment Facility (LAF) for 14 days and 7 days tenors. LAF is conducted
at a fixed time on a daily basis on all working days in Mumbai (excluding Saturdays).
Q.NO.11 EXPLAIN MARGINAL STANDING FACILITY AND HOW IT ACTS AS AN INSTRUMENT IN

MONETORY POLICY?
ANSWER:
MARGINAL STANDING FACILITY (MSF)
1. The Reserve Bank of India, being a bankers’ bank, acts as a lender of last resort. The Marginal
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Standing Facility (MSF) announced by the Reserve Bank of India (RBI) in its Monetary Policy,
2011-12 refers to the facility under which scheduled commercial banks can borrow additional
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amount of overnight money from the central bank over and above what is available to them
through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a
limit (a fixed per cent of their net demand and time liabilities deposits (NDTL) liable to change
every year ) at a penal rate of interest.
2. This provides a safety valve against unexpected liquidity shocks to the banking system.
3. The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight
lending rates in the inter-bank market and to enable smooth monetary transmission in the
financial system.
4. Banks can borrow through MSF on all working days except Saturdays, between 7.00 pm and 7.30
pm, in Mumbai. The minimum amount which can be accessed through MSF is Rs. 1 crore and
more will be available in multiples of Rs. 1 crore.
5. The MSF would be the last resort for banks once they exhaust all borrowing options including
the liquidity adjustment facility on which the rates are lower compared to the MSF.
6. The MSF rate being a penal rate automatically gets adjusted to a fixed per cent above the repo
rate. MSF is at present aligned with the Bank rate. Practically, MSF represents the upper band of
the interest corridor with repo rate at the middle and reverse repo at the lower band.
7. The MSF rate and reverse repo rate determine the corridor for the daily movement in the
weighted average call money rate.
Q.NO.12 EXPLAIN MARKET STABILISATION SCHEME AND HOW IT ACTS AS AN INSTRUMENT IN

MONETORY POLICY?
ANSWER:
MARKET STABILISATION SCHEME (MSS)
1. This instrument for monetary management was introduced in 2004 following a MoU between
the Reserve Bank of India (RBI) and the Government of India (GoI) with the primary aim of aiding
the sterilization operations of the RBI.
2. Sterilization is the process by which the monetary authority sterilizes the effects of significant
foreign capital inflows on domestic liquidity by off-loading parts of the stock of government
securities held by it).
3. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through
sale of short-dated government securities and treasury bills.
4. Under this scheme, the Government of India borrows from the RBI (such borrowing being
additional to its normal borrowing requirements) and issues treasury-bills/dated securities for
absorbing excess liquidity from the market arising from large capital inflows.
Q.NO.13 EXPLAIN THE TERM BANK RATE AND HOW IT ACTS AS AN INSTRUMENT IN MONETORY
POLICY?
ANSWER:
BANK RATE
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1. Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as ‘the
standard rate at which the Reserve Bank is prepared to buy or re- discount bills of exchange or
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other commercial paper eligible for purchase under the Act’.

2. The bank rate once used to be the policy rate in India i.e., the key interest rate based on which
all other short term interest rates moved.
3. Discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued on
introduction of Liquidity Adjustment Facility (LAF). As a result, the bank rate has become
dormant as an instrument of monetary management.
4. The bank rate has been aligned to the Marginal Standing Facility (MSF) rate and, therefore, as
and when the MSF rate changes alongside policy repo rate changes, the bank rate also changes
automatically.
5. MSF assumed the role of bank rate and currently the bank rate is purely a signalling rate and
most interest rates are delinked from the bank rate.
6. Now, bank rate is used only for calculating penalty on default in the maintenance of Cash
Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR).
Q.NO.14 EXPLAIN OPEN MARKET OPERATIONS AND HOW IT ACTS AS AN INSTRUMENT IN

MONETORY POLICY?
ANSWER:
OPEN MARKET OPERATIONS
1. Open Market Operations (OMO) is a general term used for market operations conducted by the
Reserve Bank of India by way of sale/ purchase of Government securities to/ from the market
with an objective to adjust the rupee liquidity conditions in the market on a durable basis.
2. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby
sucking out the rupee liquidity.
3. When the liquidity conditions are tight, the RBI will buy securities from the market, thereby
releasing liquidity into the market.
Q.NO.15 DISCUSS THE MONETARY POLICY FRAMEWORK AGREEMENT?

ANSWER:
THE MONETARY POLICY FRAMEWORK AGREEMENT
1. The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving a statutory
backing to the Monetary Policy Framework Agreement (MPFA) and for setting up a Monetary
Policy Committee (MPC).
2. The Monetary Policy Framework Agreement is an agreement reached between the Government
of India and the Reserve Bank of India (RBI) on the maximum tolerable inflation rate that the RBI
should target to achieve price stability.
3. The amended RBI Act (2016) provides for a statutory basis for the implementation of the
‘flexible inflation targeting framework’.
4. Announcement of an official target range for inflation is known as inflation targeting. The Expert
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Committee under Urijit Patel to revise the monetary policy framework, in its report in January,
2014 suggested that RBI abandon the ‘multiple indicator’ approach and make inflation targeting
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the primary objective of its monetary policy.
5. The inflation target is to be set by the Government of India, in consultation with the Reserve
Bank, once in every five years. Accordingly,
a. The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the
target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit
of 6 per cent and the lower tolerance limit of 2 per cent.
b. The RBI is mandated to publish a Monetary Policy Report every six months, explaining the
sources of inflation and the forecasts of inflation for the coming period of six to eighteen
months.
c. The following factors are notified by the central government as constituting a failure to
achieve the inflation target:
i) The average inflation is more than the upper tolerance level of the inflation target for
any three consecutive quarters; or
ii) The average inflation is less than the lower tolerance level for any three consecutive
quarters.
Q.NO.16 DISCUSS THE ROLE OF THE MONETARY POLICY COMMITTEE?

ANSWER:
THE MONETARY POLICY COMMITTEE (MPC)
1. An important landmark in India’s monetary history is the constitution of an empowered six-
member Monetary Policy Committee (MPC) in September, 2016 consisting of
a. The RBI Governor (Chairperson),
b. The RBI Deputy Governor in charge of monetary policy,
c. One official nominated by the RBI Board and
d. The remaining three central government nominees representing the Government of India
who are persons of ability, integrity and standing, having knowledge and experience in the
field of Economics or banking or finance or monetary policy.
2. The Committee is required to meet at least 4 times a year and the decisions adopted by the MPC
are published after conclusion of every meeting of the MPC.
3. Based on the review of the macroeconomic and monetary developments in the economy, the
MPC shall determine the policy rate required to achieve the inflation target.
4. The fixing of the benchmark policy interest rate (repo rate) is made through debate and majority
vote by this panel of experts.
5. With the introduction of the Monetary Policy Committee, the RBI will follow a system which is
more consultative and participative similar to the one followed by many of the central banks in
the world. The new system is intended to incorporate:
a. Diversity of views,
b. Specialized experience,
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c. Independence of opinion,
d. Representativeness, and
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e. Accountability.
6. The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the
monetary policy. The views of key stakeholders in the economy and analytical work of the
Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.
7. The Financial Markets Operations Department (FMOD) operationalises the monetary policy,
mainly through day-to-day liquidity management operations.
8. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to
ensure that the operating target of monetary policy (weighted average lending rate) is kept close
to the policy repo rate.
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Q.NO.1 What will be the nature of the monetary policy undertaken by RBI in the following?
(i) Increases repo rate by 50 basis points
(ii) Reduces the cash reserve ratio
(iii) Increases the supply of currency and coins
(iv) Terminates marginal standing facility
(v) Increases the interest rates chargeable by commercial banks
(vi) Sells securities in the open market
(vii) Initiates reverse repo operation
(viii) Changes in the SLR
ANSWER:
(i) Contractionary monetary policy
(ii) Expansionary monetary policy
(iii) Expansionary monetary policy
(iv) Contractionary monetary policy
(v) Contractionary monetary policy
(vi) Contractionary monetary policy
(vii) Absorbs the liquidity in the system
(viii) Influence the availability of resources in the banking system for lending
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4.1. THEORIES OF INTERNATIONAL TRADE
Q.NO.1 DEFINE INTERNATIONAL TRADE AND DESCRIBE HOW IT DIFFERS FROM INTERNAL TRADE?
ANSWER:
INTERNATIONAL TRADE
1. International trade is the exchange of goods and services as well as resources between countries. It
involves transactions between residents of different countries.
2. As distinguished from domestic trade or internal trade which involves exchange of goods and services
within the domestic territory of a country using domestic currency, international trade involves
transactions in multiple currencies.
3. Compared to internal trade, international trade has greater complexity as it involves
a. Heterogeneity of customers and currencies,
b. Differences in legal systems, business practices and political systems,
c. More elaborate documentation, exchange rate risks, complex procedures and formalities,
d. High operating costs, issues related to shipping, insurance and transportation
e. Diverse restrictions and interventions from governments in the form of taxes, regulations, duties,
tariffs, quotas, trade barriers, standards, and
f. Restraints to movement of specified goods and services.
Note: At present, liberal international trade is an integral part of international relations and has become
an important engine of growth in developed as well as developing countries.
Q.NO.2 CRITICALLY EXAMINE THE ARGUMENTS FOR AND AGAINST INTERNATIONAL TRADE?
ANSWER:
1. ARGUMENTS IN FAVOUR OR SUPPORT OF INTERNATIONAL TRADE
Some economists and policy makers argue that there are net benefits from keeping markets open to
international trade and investments, others feel that trade generates a number of adverse consequences
on the welfare of citizens.
A. Powerful stimulus to Economic Efficiency:
a. International trade is a powerful stimulus to economic efficiency and contributes to economic
growth and rising incomes. The wider market made possible owing to trade induces companies
to reap the quantitative and qualitative benefits of extended division of labour.
b. As a result, they would enlarge their manufacturing capabilities and benefit from economies of
large scale production. The gains from international trade are reinforced by the increased
competition that domestic producers are confronted with on account of globalization of
production and marketing, requiring businesses to compete against global businesses.
c. Competition from foreign goods compels manufacturers, especially in developing countries, to
enhance efficiency and profitability by adoption of cost reducing technology and business
practices.
d. Efficient deployment of productive resources to their best use is a direct economic advantage of
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foreign trade. Greater efficiency in the use of natural, human, industrial and financial resources
ensures productivity gains. Since international trade also tends to decrease the likelihood of
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domestic monopolies, it is always beneficial to the community.
B. Access To New Markets And New Materials
a. Trade provides access to new markets and new materials and enables sourcing of inputs and
components internationally at competitive prices. This reflects in innovative products at lower
prices and wider choice in products and services for consumers.
b. Also, international trade enables consumers to have access to wider variety of goods and services
that would not otherwise be available. It also enables nations to acquire foreign exchange
reserves necessary for imports which are crucial for sustaining their economies.
C. International trade enhances the extent of market and augments the scope for mechanization and
specialisation. Trade necessitates increased use of automation, supports technological change,
stimulates innovations, and facilitates greater investment in research and development and
productivity improvement in the economy.
D. Exports stimulate economic growth by creating jobs, which could potentially reduce poverty, and
augmenting factor incomes and in so doing raising standards of livelihood and overall demand for
goods and services. Trade also provides greater stimulus to innovative services in banking, insurance,
logistics, consultancy services etc.
E. Employment generating investments, including foreign direct investment, inevitably follow trade. For
emerging economies, improvement in the quality of output of goods and services, superior products,
finer labour and environmental standards etc. enhance the value of their products and enable them
to move up the global value chain.
F. Opening up of new markets results in broadening of productive base and facilitates export
diversification so that new production possibilities are opened up. Countries can gainfully dispose off
their surplus output and, thus, prevent undue fall in domestic prices caused by overproduction. Trade
also allows nations to maintain stability in prices and supply of goods during periods of natural
calamities like famine, flood, epidemic etc.
G. Trade can also contribute to human resource development, by facilitating fundamental and applied
research and exchange of know-how and best practices between trade partners.
H. Trade strengthens bonds between nations by bringing citizens of different countries together in
mutually beneficial exchanges and, thus, promotes harmony and cooperation among nations.
2. ARGUMENTS AGAINST TO INTERNATIONAL TRADE
Despite being a dynamic force, which has an enormous potential to generate overall economic gains,
liberal global trade and investments are often criticized as detrimental to national interests. The major
arguments put forth against trade openness are:
A. Possible negative labour market outcomes in terms of labour-saving technological change that
depress demand for unskilled workers, loss of labourers' bargaining power, downward pressure on
wages of semi-skilled and unskilled workers and forced work under unfair circumstances and
unhealthy occupational environments.
B. International trade is often not equally beneficial to all nations. Potential unequal market access
and disregard for the principles of fair trading system may even amplify the differences between
trading countries, especially if they differ in their wealth.
a. Economic exploitation is a likely outcome when underprivileged countries become vulnerable to
the growing political power of corporations operating globally.
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b. The domestic entities can be easily outperformed by financially stronger transnational

companies.
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C. International trade is often criticized for its excessive stress on exports and profit-driven
exhaustion of natural resources due to unsustainable production and consumption.
Substantial environmental damage and exhaustion of natural resources in a shorter span of
time could have serious negative consequences on the society at large.
D. Probable shift towards a consumer culture and change in patterns of demand in favour of
foreign goods, which are likely to occur in less developed countries, may have an adverse
effect on the development of domestic industries and may even threaten the survival of
infant industries. Trade cycles and the associated economic crises occurring in different
countries are also likely to get transmitted rapidly to other countries.
E. Risky dependence of underdeveloped countries on foreign nations impairs economic
autonomy and endangers their political sovereignty. Such reliance often leads to widespread
exploitation and loss of cultural identity. Substantial dependence may also have severe
adverse consequences in times of wars and other political disturbances.
F. Welfare of people may often be ignored or jeopardized for the sake of profit. Excessive
exports may cause shortages of many commodities in the exporting countries and lead to
high inflation (e.g. onion price rise in 2014; export ban on all non-basmati rice in an attempt
to reign in soaring prices and to ensure sufficient stocks for domestic consumption as global
reserve levels hit a 25-year low). Also, import of harmful products or international trade in
hazardous chemicals may cause health hazards and environmental damage in those
countries which do not have sufficient infrastructure or capacity to scrutinize such imports.
G. Too much export orientation may distort actual investments away from the genuine
investment needs of a country.
H. Instead of cooperation among nations, trade may breed rivalry on account of severe
competition
I. Finally, there is often lack of transparency and predictability in respect of many aspects
related to trade policies of trading partners. There are also many risks in trade which are
associated with changes in governments' policies of participating countries, such as
imposition of an import ban, high import tariffs or trade embargoes.
Q.NO.3 DISCUSS THE MERCANTILISTS' VIEW OF INTERNATIONAL TRADE?

ANSWER:
1. Mercantilism, which was the policy of Europe’s great powers, was based on the premise that
national wealth and power are best served by increasing exports and collecting precious metals
in return.
2. Mercantilists also believed that the more gold and silver a country accumulates, the richer it
becomes. Mercantilism advocated maximizing exports in order to bring in more “specie” (money
in the form of precious metals rather than notes) and minimizing imports through the state
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imposing very high tariffs on foreign goods.

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3. This view argues that trade is a ‘zero-sum game’, with winners who win, does so only at the
expense of losers and one country’s gain is equal to another country’s loss, so that the net
change in wealth or benefits among the participants is zero.
4. The arguments put forth by mercantilists were later proved to have many shortcomings by later
economists. Although it is still very important theory which explains policies followed by many
big and fast-growing economies in Asia.
Q.NO.4 DISCUSS THE THEORY OF ABSOLUTE ADVANTAGE?

ANSWER:
1. Adam Smith was the first to put across the possibility that international trade is not a zero-sum
game. According to Adam Smith who supported unrestricted trade and free international
competition, absolute cost advantage is the determinant of mutually beneficial international
trade.
2. The absolute cost advantage theory points out that a country will specialize in the production
and export of a commodity in which it has an absolute cost advantage. In other words, exchange
of goods between two countries will take place only if each of the two countries can produce
one commodity at an absolutely lower production cost than the other country.
3. Smith’s thoughts on the principle of division of labour constitute the basis for his theory of
international trade and therefore, the value of goods is determined by measuring the labour
incorporated in them.
4. The theory is generally presented with an example of a hypothetical two countries and two
commodities model (2x2 model).
a. Absolute advantage exists between nations when they differ in their ability to produce
goods. Each nation can produce one good with less expenditure of human labour or more
cheaply than the other.
b. As a result, each nation has an absolute advantage in the production of one good. Absolute
advantage can be explained with a simple numerical example given in table
Output per Hour of Labour
Commodity Country A Country B
Wheat (bushels/Hour) 6 1
Cloth (Yards/Hour) 4 5
Analysis:
(i) one hour of labour time produces 6 bushels and 1 bushel of wheat respectively in
country A and country B. On the other hand, one hour of labour time produces 4 yards of
cloth in country A and 5 in country B. Country A is more efficient than country B, or has
an absolute advantage over country B in production of wheat. Similarly, country B is
more efficient than country A, or has an absolute advantage over country A in the
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production of cloth.
(ii) If both nations can engage in trade with each other, each nation will specialize in the
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production of the good, it has an absolute advantage in and obtain the other commodity
through international trade. Therefore, country A would specialise completely in
production of wheat and country B in cloth.
(iii) If country A exchanges six bushels of wheat (6W) for six yards of country B’s cloth (6C),
then country A gains 2C or saves half an hour or 30 minutes of labour time (since the
country A can only exchange 6W for 4C domestically).
(iv) Similarly, the 6W that country B receives from country A is equivalent to or would
require six hours of labour time to produce in country B. These same six hours can
produce 30C in country B (6 hours x 5 yards of cloth per hour). By being able to exchange
6C (requiring a little over one hour to produce in the country B) for 6W, country B gains
24C, or saves nearly five hours of work.
(v) This example shows trade is advantageous, although gains may not be distributed
equally, because their given resources are utilised more efficiently, and, therefore, both
countries can produce larger quantities of commodities which they specialize in.
(vi) By specialising and trading freely, global output is, thus, maximized and more of both
goods are available to the consumers in both the countries. If they specialise but do not
trade freely, country A’s consumers would have no wheat, and country B’s consumers
would have no cloth. That is not a desirable situation.
(vii) The theory discussed above gives us the impression that mutually gainful trade is
possible only when one country has absolute advantage and the other has absolute
disadvantage in the production of at least one commodity.
(viii) Country A has absolute advantage in the production of both commodities and
country B has absolute disadvantage in the production of both commodities. This is the
question that Ricardo attempted to answer when he formalized the concept of
‘comparative advantage’ to espouse the argument that even when one country is
technologically superior in both goods, it could still be advantageous for them to trade.
Q.NO.5 DISCUSS THE THEORY OF COMPETITIVE ADVANTAGE? (OR) USING RICARDIAN MODEL,
EXPLAIN HOW TWO COUNTRIES CAN GAIN FROM TRADE? WHAT DOES THE RICARDIAN MODEL
SUGGEST REGARDING THE EFFECT OF TRADE?
ANSWER:
David Ricardo developed the classical theory of comparative advantage in his book ‘Principles of
Political Economy and Taxation’ published in 1817.
1. The law of comparative advantage states that even if one nation is less efficient than (has an
absolute disadvantage with respect to) the other nation in the production of all commodities,
there is still scope for mutually beneficial trade.
2. The first nation should specialize in the production and export of the commodity in which its
absolute disadvantage is smaller (this is the commodity of its comparative advantage) and
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import the commodity in which its absolute disadvantage is greater (this is the commodity of its
comparative disadvantage).
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3. Comparative advantage differences between nations are explained by exogenous factors which
could be due to the differences in national characteristics.
4. Analysis:
a. Labour differs in its productivity internationally and different goods have different labour
requirements, therefore comparative labour productivity advantage was Ricardo’s predictor
of trade.
b. Country B can produce only two yards of cloth per hour of labour. Country B has now
absolute disadvantage in the production of both wheat and cloth. However, since B’s labour
is only half as productive in cloth but six times less productive in wheat compared to country
A, country B has a comparative advantage in cloth. On the other hand, country A has an
absolute advantage in both wheat and cloth with respect to the country B, but since its
absolute advantage is greater in wheat (6:1) than in cloth (4:2), country A has a comparative
advantage in production and exporting wheat.
c. In a two-nation, two-commodity world, once it is established that one nation has a
comparative advantage in one commodity, then the other nation must necessarily have a
comparative advantage in the other commodity. In other words, country A’s absolute
advantage is greater in wheat, and so country A has a comparative advantage in producing
and exporting wheat. Country B’s absolute disadvantage is smaller in cloth, so its
comparative advantage lies in cloth production. According to the law of comparative
advantage, both nations can gain if country A specialises in the production of wheat and
exports some of it in exchange for country B’s cloth. Simultaneously, country B should
specialise in the production of cloth and export some of it in exchange for country A’s wheat.
d. Assume that country A could exchange 6W for 6C with country B. Then, country A would gain
2C (or save half an hour of labour time) since the country A could only exchange 6W for 4C
domestically. We need to show now that country B would also gain from trade. Country B
which receives 6W from the country A would require 6 hours of labour time to produce in
country B. With trade, country B can instead use these 6 hours to produce 12C and give up
only 6C for 6W from the country A. Thus, the country B would gain 6C or save 3 hours of
labour time and country A would gain 2C. However, the gains of both countries are not likely
to be equal.
e. However, we need to recognize that this is not the only rate of exchange at which mutually
beneficial trade can take place. Country A would gain if it could exchange 6W for more than
4C from country B; because 6W for 4C is what it can exchange domestically (both require the
same one-hour labour time). The more C it gets, the greater would be the gain from trade.
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f. Conversely, in country B, 6W = 12C (in the sense that both require 6 hours to produce).
Anything less than 12C that country B must give up to obtain 6W from country A represents
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a gain from trade for country B.
g. To summarize, country A gains to the extent that it can exchange 6W for more than 4C from
the country B. Country B gains to the extent that it can give up less than 12C for 6W from
country A. Thus, the range for mutually advantageous trade is 4C < 6W < 12C.
h. The spread between 12C and 4C (i.e., 8C) represents the total gains from trade available to
be shared by the two nations by trading 6W for 6C. The closer the rate of exchange is to 4C =
6W (the domestic or internal rate in country A), the smaller is the share of the gain going to
country A and the larger is the share of the gain going to country B.
i. Alternatively, the closer the rate of exchange is to 6W = 12C (the domestic or internal rate in
country B), the greater is the gain of country A relative to that of country B.
j. However, if the absolute disadvantage that one nation has with respect to another nation is
the same in both commodities, there will be no comparative advantage and no trade.
Q.NO.6 DISCUSS HOW HEBERLER RESOLVED RICARDO’S UNREALISTIC ASSUMPTION OF LAW OF

COMPARITIVE ADVANTAGE BASED ON THE ‘LABOUR THEORY OF VALUE’?
ANSWER:
PROBLEM: Ricardo based his law of comparative advantage on the ‘labour theory of value’, which
assumes that the value or price of a commodity depends exclusively on the amount of labour going
into its production. This is quite unrealistic because labour is not the only factor of production, nor is
it used in the same fixed proportion in the production of all commodities.
SOLUTION: In 1936, Haberler resolved this issue when he introduced the opportunity cost concept
from Microeconomic theory to explain the theory of comparative advantage in which no
assumption is made in respect of labour as the source of value.
1. Opportunity cost is basically the value of the forgone option. It is the ’real’ cost in
microeconomic terms, as opposed to cost given in monetary units.
2. According to the opportunity cost theory, the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to produce one extra unit of
the first commodity.
3. The opportunity cost of producing one unit of good X in terms of good Y may be computed as
the amount of labour required to produce one unit of good X divided by the amount of labour
required to produce one unit of good Y. That is, how much Y do we have to give up in order to
produce one more unit of good X.
4. Logically, the nation with a lower opportunity cost in the production of a commodity has a
comparative advantage in that commodity (and a comparative disadvantage in the second
commodity).
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5. ANALYSIS:
a. we find that country A must give up two-thirds of a unit of cloth to release just enough
resources to produce one additional unit of wheat domestically. Therefore, the opportunity
cost of wheat is two-thirds of a unit of cloth (i.e., 1W = 2/3C in country A).
b. Similarly, in country B, we find that 1W = 2C, and therefore, the opportunity cost of wheat
(in terms of the amount of cloth that must be given up) is lower in country A than in country
B, and country A would have a comparative (cost) advantage over country B in wheat.
c. In a two-nation, two-commodity world, if country A has a comparative advantage in wheat,
then country B will have a comparative advantage in cloth. Therefore, country A should
consider specializing in producing wheat and export some of it in exchange for cloth
produced in country B. By such specialization and trade, both nations will be able to
consume more of both commodities than what would have been possible without trade.
6. International differences in relative factor-productivity are the cause of comparative advantage
and a country exports goods that it produces relatively efficiently. This fact points to a tendency
towards complete specialization in production.
7. Ricardo demonstrated that for two nations without input factor mobility, specialization and
trade could result in increased total output and lower costs than if each nation tried to produce
in isolation. Trade generates welfare gains and both countries can potentially gain from trade.
Therefore, international trade need not be a zero-sum game.
8. However, the Ricardian theory of comparative advantage suffers from many limitations.
a. Its emphasis is on supply conditions and excludes demand patterns.
b. Moreover, the theory does not examine why countries have different costs.
c. The theory of comparative advantage also does not answer the important question: Why
does a nation have comparative advantage in the production of a commodity and
comparative disadvantage in the production of another?
Q.NO.7 DISCUSS THE HECKSCHER-OHLIN THEORY OF TRADE?

ANSWER:
The Heckscher-Ohlin theory of trade, (named after two Swedish economists, Eli Heckscher and his
student Bertil Ohlin), also referred to as Factor-Endowment Theory of Trade or Modern Theory of
Trade. This theory is considered as a very important theory of international trade. In view of the
contributions made by P. A. Samuelson, this theory is also sometimes referred to as Heckscher-
Ohlin- Samuelson theorem.
1. The Heckscher-Ohlin (H-O) model studies the case that two countries have different factor
endowments under identical production function and identical preferences. The difference in
factor endowment results in two countries having different factor prices in the beginning.
Consequently, H-O model implies that the two countries will have different cost functions.
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2. The Heckscher-Ohlin theory of trade states that comparative advantage in cost of production is
explained exclusively by the differences in factor endowments of the nations.
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3. In a general sense of the term, ‘factor endowment’ refers to the overall availability of usable
resources including both natural and man-made means of production.
4. Nevertheless, in the exposition of the modern theory, only the two most important factors—
labour and capital—are taken into account.
5. According to this theory, international trade is but a special case of inter-regional trade.
a. Different regions have different factor endowments, that is, some regions have abundance
of labour, but scarcity of capital; whereas other regions have abundance of capital, but
scarcity of labour.
b. Different goods have different production functions, that is, factors of production are
combined in different proportions to produce different commodities.
c. While some goods are produced by employing a relatively larger proportion of labour and
relatively small proportion of capital, other goods are produced by employing a relatively
small proportion of labour and relatively large proportion of capital.
d. Thus, each region is suitable for the production of those goods for whose production it has
relatively abundant supply of the requisite factors. A region is not suitable for production of
those goods for whose production it has relatively scarce or zero supply of essential factors.
e. Hence different regions have different capacity to produce different commodities.
Therefore, difference in factor endowments is the main cause of international trade as well
as inter-regional trade.
6. According to Ohlin, the immediate cause of inter-regional trade is that goods can be bought
cheaper in terms of money than they can be produced at home and this is the case of
international trade as well. The cause of difference in the relative prices of goods is the
difference the amount of factor endowments, like capital and labour, between two countries.
a. The theory states that a country’s exports depend on endowment of resources i.e. whether
the country is capital-abundant or labour-abundant. If a country is a capital abundant one, it
will produce and export capital-intensive goods relatively more cheaply than other countries.
b. Likewise, a labour-abundant country will produce and export labour-intensive goods
relatively more cheaply than another country.
c. The labour-abundant countries have comparative cost advantage in the production of goods
which require labour-intensive technology and by the same reasoning; capital-abundant
countries have comparative cost advantage in the production of goods that need capital-
intensive technology.
7. The Heckscher-Ohlin theory of foreign trade can be stated in the form of two theorems namely,
Heckscher-Ohlin Trade Theorem and Factor-Price Equalization Theorem.
a. The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in the
i) export of a commodity whose production requires intensive use of its abundant
resources and
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ii) imports a commodity whose production requires intensive use of its scarce resources.
b. The ‘Factor-Price Equalization’ Theorem states that international trade tends to equalize the
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factor prices between the trading nations.
i) In the absence of foreign trade, it is quite likely that factor prices are different in
different countries. International trade equalizes the absolute and relative returns to
homogenous factors of production and their prices.
ii) In other words, the wages of homogeneous labour and returns to homogeneous capital
will be the same in all those nations which engage in trading.
8. The factor price equalisation theorem postulates that if the prices of the output of goods are
equalised between countries engaged in free trade, then the price of the input factors will also
be equalised between countries. This implies that the wages and rents will converge across the
countries with free trade, or in other words, trade in goods is a perfect substitute for trade in
factors. The Heckscher- Ohlin theorem, thus, puts forth that foreign trade eliminates the factor
price differentials. The factor price equalization theorem is in fact a corollary to the Heckscher-
Ohlin trade theory. It holds true only as long as Heckcher-Ohlin Theorem holds true.
9. The basic assumption of the Heckscher-Ohlin theorem is that the two countries share the same
production technology and that markets are perfectly competitive.
a. The opening up to trade for a labour-abundant country, will increase the price of labour-
intensive goods, say clothes, and, thus, lead to an expansion of clothes production.
b. As there is demand for exports of clothes in foreign markets, the demand for factors of
production increases in the clothes sector. Because clothes are labour-intensive goods, an
increasing demand for labour in the factor market will attract labour from the capital-
intensive industry, within the country, say machine, tools.
c. The expanding clothes industry absorbs relatively more labour than the amount released by
the contracting machine tools industry. The price of labour goes up, and whilst its relative
price increases, the relative price of capital declines.
d. As a result, capital returns decreases in relation to wage rate and the factors of production
will become more capital-intensive in both sectors leading to a decline in the marginal
productivity of capital and an increase in that of labour in both sectors.
e. Similarly, when country B increases its specialization in the production of capital-intensive
commodity, its demand for capital increases causing capital returns to increase in relation to
wage rate. This means that specialization leads to change in relative factor prices.
f. When the prices of the output of goods are equalized between countries as they move to
free trade, then the prices of the factors (capital and labour) will also be equalized between
countries. It means that product mobility and factor mobility become perfect substitutes.
g. With trade, whichever factor receives the lowest price before two countries integrate
economically and effectively become one market, will therefore tend to become more
expensive relative to other factors in the economy, while those with the highest price will
tend to become cheaper. This process will continue till factor prices are equalised between
the trading nations.
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Q.NO.8 COMPARE THEORY OF COMPARATIVE COSTS AND MODERN THEORY?
ANSWER:
Comparison of Theory of Comparative Costs and Modern Theory
Theory of Comparative Costs Modern Theory
The basis is the difference between countries Explains the causes of differences in
is comparative costs comparative costs as differences in factor
endowments
Based on labour theory of value Based on money cost which is more realistic.
Considered labour as the sole factor of Widened the scope to include labour and
production and presents a one- factor capital as important factors of production.
(labour) model This is 2-factor model and can be extended
to more factors.
Treats international trade as quite distinct International trade is only a special case of
from domestic trade inter-regional trade.
Studies only comparative costs of the goods Considers the relative prices of the factors
concerned which influence the comparative costs of the
goods
Attributes the differences in comparative Attributes the differences in comparative
advantage to differences in productive advantage to the differences in factor
efficiency of workers endowments.
Does not take into account the factor price Considers factor price differences as the
differences main cause of commodity price differences
Does not provide the cause of differences in Explains the differences in comparative
comparative advantage. advantage in terms of differences in factor
endowments.
Normative; tries to demonstrate the gains Positive; concentrates on the basis of trade
from international trade
Q.NO.9 DISCUSS NEW TRADE THEORY AND ITS ARGUMENTS? OR EXPLAIN THE ADVANTAGES OF
TWO KEY CONCEPTS OF NEW TRADE THEORIES TO COUNTRIES WHEN IMPORTING GOODS TO
COMPETE WITH PRODUCTS FROM THE HOME COUNTRY.
ANSWER:
1. New Trade Theory (NTT) is an economic theory that was developed in the 1970s as a way to
understand international trade patterns.
2. NTT helps in understanding why developed and big countries are trade partners when they are
trading similar goods and services. These countries constitute more than 50% of world trade.
3. This is particularly true in key economic sectors such as electronics, IT, food, and automotive.
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We have cars made in the India, yet we purchase many cars made in other countries.
4. These are usually products that come from large, global industries that directly impact
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international economies.
The mobile phones that we use are a good example. India produces them and also imports them.
NTT argues that, because of substantial economies of scale and network effects, it pays to export
phones to sell in another country.
5. Those countries with the advantages will dominate the market, and the market takes the form
of monopolistic competition. Monopolistic competition tells us that the firms are producing a
similar product that isn't exactly the same, but awfully close.
6. According to NTT, two key concepts give advantages to countries that import goods to compete
with products from the home country:
a) Economies of Scale: As a firm produces more of a product, its cost per unit keeps going
down. So if the firm serves domestic as well as foreign market instead of just one, then it can
reap the benefit of large scale of production consequently the profits are likely to be higher.
b) Network effects refer to the way one person’s value for a good or service is affected by the
value of that good or service to others.
(i) The value of the product or service is enhanced as the number of individuals using it
increases. This is also referred to as the ‘bandwagon effect’.
(ii) Consumers like more choices, but they also want products and services with high utility,
and the network effect increases utility obtained from these products over others.
Example: Mobile App such as What’s App and software like Microsoft Windows.
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Q.NO.1 THE PRICE INDEX FOR EXPORTS OF COUNTRY A IN YEAR 2012 (2000 BASE-YEAR), WAS
116.1 AND THE PRICE INDEX FOR COUNTRY A’S IMPORTS WAS 120.2 (2000 BASE- YEAR)
(I) WHAT DO THESE FIGURES MEAN?
(II) CALCULATE THE INDEX OF TERMS OF TRADE FOR COUNTRY A
(III) HOW DO YOU INTERPRET THE INDEX OF TERMS OF TRADE FOR COUNTRY A?
ANSWER:
(i) The price index for exports of Country A in year 2012 (2000 base- year), was 116.1 means that
compared to year 2000, its export prices were 16.1 percent above the 2000 base year prices.
(ii) The price index for Country A’s imports was 120.2 in year 2012(2000 base-year), means that
compared to year 2000, its import prices were 20.2 percent above the 2000 base year prices.
(iii) The index of the terms of trade for Country A in 2012 would be calculated as follows:
Terms of Trade = Price index of exports/Price index of its imports x 100
= (116.1/120.2)x100 = 96.6
“Terms of trade” is ratio of the price of a country’s export commodity to the price of its import
commodity. The figure 96.6 means that each unit of country A’s exports in 2012 exchanged for
3.4 percent (3.4 = 100 – 96.6) fewer units of imports than in the base year.
Q.NO.2 THE TABLE BELOW SHOWS THE NUMBER OF LABOUR HOURS REQUIRED TO PRODUCE
WHEAT AND CLOTH IN TWO COUNTRIES X AND Y.
COMMODITY COUNTRY X COUNTRY Y
I UNIT OF CLOTH 4 1.0
I UNIT OF WHEAT 2 2.5
(i) COMPARE THE PRODUCTIVITY OF LABOUR IN BOTH COUNTRIES IN RESPECT OF BOTH
COMMODITIES
(ii) WHICH COUNTRY HAS ABSOLUTE ADVANTAGE IN THE PRODUCTION OF WHEAT?
(iii) WHICH COUNTRY HAS ABSOLUTE ADVANTAGE IN THE PRODUCTION OF CLOTH?
(iv) IF THERE IS TRADE, WHICH COMMODITY SHOULD THESE COUNTRIES PRODUCE?
(v) WHAT ARE THE OPPORTUNITY COSTS OF EACH COMMODITY?
ANSWER:
(i) Productivity of labour in both countries in respect of both commodities

Productivity of Labour Country X Country Y
Units of cloth per hour 0.25 1.0
Units of wheat per hour 0.5 0.4
(ii) Country X has absolute advantage in the production of wheat because productivity of wheat is
higher in country X , or conversely, the number of labour hours required to produce wheat in
country X is less compared to country Y
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(iii) Country Y has absolute advantage in the production of cloth because productivity of cloth is
higher in country Y , or conversely, the number of labour hours required to produce cloth in
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country Y is less compared to country X

(iv) In country X, the opportunity cost is 0.25 units of cloth for 0.5 unit of wheat.
(v) In country Y the opportunity cost is 0.4 units of wheat for 1 unit of cloth.
Q.NO.3 COUNTRIES ROSE LAND AND DAISY LAND HAVE A TOTAL OF 4000 HOURS EACH OF
LABOUR AVAILABLE EACH DAY TO PRODUCE SHIRTS AND TROUSERS. BOTH COUNTRIES USE
EQUAL NUMBER OF HOURS ON EACH GOOD EACH DAY. ROSE LAND PRODUCES 800 SHIRTS AND
500 TROUSERS PER DAY. DAISY LAND PRODUCES 500 SHIRTS AND 250 TROUSERS PER DAY.
IN THE ABSENCE OF TRADE:
I. WHICH COUNTRY HAS ABSOLUTE ADVANTAGE IN PRODUCING
A. SHIRTS
B. TROUSERS
II. WHICH COUNTRY HAS COMPARATIVE ADVANTAGE IN PRODUCING
A. SHIRTS
B. TROUSERS
ANSWER:
Goods produced by each country
Country Shirts Trousers
Rose Land 800 500
Daisy Land 500 250
Each country has 4000 hours of labour and uses 2000 hours each for both the goods. Therefore, the
number of hours spent per unit on each good
Country Shirts Trousers
Rose Land 2.5 4
Daisy Land 4 8
Since Rose Land produces both goods in less time, it has absolute advantage in both shirts and
trousers.
Comparative advantage; comparing the opportunity costs of both goods we have
Rose Land
Opportunity cost of Shirts =2.5/4 = 0.625 trousers
If 4 hours are used up in 1 trouser, trousers given up in 2.5 hours are (1/4)*2.5 = 0.625 trousers.
Similarly, Opportunity cost of Trousers = 4/2. 5 =1.6 shirts
Daisy Land
Opportunity cost of Shirts 4/8 = 0.5 trousers Opportunity cost of Trousers 8/4 =2 shirts
For producing shirts
Daisy Land has lower opportunity cost for producing shirts (0.5<0.625), therefore Daisy Land has
comparative advantage
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For producing Trousers

Rose Land has lower opportunity cost for producing Trousers (1.6<2), therefore Rose Land has
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comparative advantage
4.2. THE INSTRUMENTS OF TRADE POLICY
Q.NO.1 DEFINE TRADE POLICY?
ANSWER:
1. Trade policy encompasses all instruments that governments may use to promote or restrict
imports and exports. Trade policy also includes the approach taken by countries in trade
negotiations.
2. While participating in the multilateral trading system and/or while negotiating bilateral trade
agreements, countries assume obligations that shape their national trade policies.
3. The instruments of trade policy that countries typically use to restrict imports and/ or to
encourage exports can be broadly classified into
a. Price- related measures such as tariffs and
b. Non- price measures or non-tariff measures (NTMs).
Q.NO.2 DEFINE TARIFFS AND EXPLAIN THE VARIOUS TYPES OF TARIFFS?

ANSWER:
1. Tariffs, also known as customs duties, are basically taxes or duties imposed on goods and
services which are imported or exported. Different tariffs are generally applied to different
commodities.
2. It is defined as a financial charge in the form of a tax, imposed at the border on goods going
from one customs territory to another. They are the most visible and universally used trade
measures that determine market access for goods.
3. Instead of a single tariff rate, countries have a tariff schedule which specifies the tariff collected
on every particular good and service.
4. Import duties being pervasive than export duties, tariffs are often identified with import duties
and in this unit, the term ‘tariff’ would refer to import duties.
5. Tariffs are aimed at altering the relative prices of goods and services imported, so as to contract
the domestic demand and thus regulate the volume of their imports.
6. Tariffs leave the world market price of the goods unaffected; while raising their prices in the
domestic market.
7. The main goals of tariffs are to raise revenue for the government, and more importantly to
protect the domestic import-competing industries.
FORMS OF IMPORT TARIFFS
A. Specific Tariff:
1. Specific tariff is the fixed amount of money per physical unit or according to the weight or
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measurement of the commodity imported or exported.

2. This tariff can vary according to the type of good imported.
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Ex: a specific tariff of Rs. 1000 may be charged on each imported bicycle.
3. The disadvantage of specific tariff as an instrument for protection of domestic producers is
that its protective value varies inversely with the price of the import.
Ex: If the price of the imported cycle is Rs. 5,000/- and the rate of tariff is 20%; then, if due to
inflation, the price of bicycle rises to Rs.10,000, the specific tariff is still only 10% of the value
of the import.
4. Since the calculation of these duties does not involve the value of merchandise, customs
valuation is not applicable in this case.
B. Ad valorem tariff:
1. When the duty is levied as a fixed percentage of the value of the traded commodity, it is
called as valorem tariff.
2. An ad valorem tariff is levied as a constant percentage of the monetary value of one unit of
the imported good.
Ex: A 20% ad valorem tariff on any bicycle generates a Rs.1000 payment on each imported
bicycle priced at Rs. 5,000 in the world market; and if the price rises to Rs. 10,000, it
generates a payment of Rs. 2,000/.
3. While ad valorem tariff preserves the protective value of tariff on home producer, it gives
incentives to deliberately undervalue the good’s price on invoices and bills of lading to
reduce the tax burden. Nevertheless, ad valorem tariffs are widely used across the world.
C. There are many other variations of the above tariffs, such as:
1. Mixed Tariffs: Mixed tariffs are expressed either on the basis of
a. the value of the imported goods (an ad valorem rate) or
b. a unit of measure of the imported goods (a specific duty)
depending on which generates the most income (or least income at times) for the nation.
Ex: duty on cotton: 5 per cent ad valorem or Rs. 3000/per tonne, whichever is higher.
2. Compound Tariff or a Compound Duty is a combination of an ad valorem and a specific
tariff.
a. That is, the tariff is calculated on the basis of both the value of the imported goods (an ad
valorem duty) and a unit of measure of the imported goods (a specific duty).
b. It is generally calculated by adding up a specific duty to an ad valorem duty.
c. Thus, on an import with quantity q and price p, a compound tariff collects a revenue
equal to tsq + tapq, where ts is the specific tariff and ta is the ad valorem tariff.
Ex: duty on cheese at 5 per cent advalorem plus 100 per kilogram.
3. Technical/Other Tariff: These are calculated on the basis of the specific contents of the
imported goods i.e., the duties are payable by its components or related items.
Ex: Rs. 3000 on each solar panel plus Rs. 50/ per kg on the battery.
4. Tariff Rate Quotas: Tariff rate quotas (TRQs) combine two policy instruments: quotas and
tariffs.
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a. Imports entering under the specified quota portion are usually subject to a lower
(sometimes zero) tariff rate.
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b. Imports above the quantitative threshold of the quota face a much higher tariff.
5. Most-Favoured Nation Tariffs: MFN tariffs refer to import tariffs which countries promise to
impose on imports from other members of the WTO, unless the country is part of a
preferential trade agreement (such as a free trade area or customs union). This means that,
in practice,
a. MFN rates are the highest (most restrictive) that WTO members charge each other.
b. Some countries impose higher tariffs on countries that are not part of the WTO.
6. Variable Tariff: A duty typically fixed to bring the price of an imported commodity up to level
of the domestic support price for the commodity.
7. Preferential Tariff: Nearly all countries are part of at least one preferential trade agreement,
under which they promise to give another country's products lower tariffs than their MFN
rate. These agreements are reciprocal.
a. A lower tariff is charged from goods imported from a country which is given preferential
treatment.
Examples:
i) Preferential duties in the EU region under which a good coming from one EU country
to another is charged zero tariff rate.
ii) North American Free Trade Agreement (NAFTA) among Canada, Mexico and the USA
where the preferential tariff rate is zero on essentially all products.
b. Countries, especially the affluent ones also grant ‘unilateral preferential treatment’ to
select list of products from specified developing countries. The Generalized System of
Preferences (GSP) is one such system which is currently prevailing.
8. Bound Tariff:
a. Under this, a WTO member binds itself with a legal commitment not to raise tariff rate
above a certain level. By binding a tariff rate, often during negotiations, the members
agree to limit their right to set tariff levels beyond a certain level.
b. The bound rates are specific to individual products and represent the maximum level of
import duty that can be levied on a product imported by that member.
c. A member is always free to impose a tariff that is lower than the bound level. Once
bound, a tariff rate becomes permanent and a member can only increase its level after
negotiating with its trading partners and compensating them for possible losses of trade.
d. A bound tariff ensures transparency and predictability.
9. Applied Tariffs: An 'applied tariff' is the duty that is actually charged on imports on a Most-
Favoured Nation (MFN) basis. A WTO member can have an applied tariff for a product that
differs from the bound tariff for that product as long as the applied level is not higher than
the bound level.
10. Escalated Tariff
a. Escalated Tariff structure refers to the system wherein the nominal tariff rates on
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imports of manufactured goods are higher than the nominal tariff rates on intermediate
inputs and raw materials, i.e., the tariff on a product increases as that product moves
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through the value-added chain.
Ex: 4% tariff on iron ore or iron ingots and 12% tariff on steel pipes. This type of tariff is
discriminatory as it protects manufacturing industries in importing countries and
dampens the attempts of developing manufacturing industries of exporting countries.
b. This has special relevance to trade between developed countries and developing
countries. Developing countries are thus forced to continue to be suppliers of raw
materials without much value addition.
11. Prohibitive tariff: A prohibitive tariff is one that is set so high that no imports can enter.
12. Import subsidies: Import subsidies also exist in some countries. An import subsidy is simply a
payment per unit or as a percent of value for the importation of a good (i.e., a negative
import tariff).
13. Tariffs as Response to Trade Distortions:
a. Sometimes countries engage in 'unfair' foreign-trade practices which are trade distorting
in nature and adverse to the interests of the domestic firms.
b. The affected importing countries, upon confirmation of the distortion, respond quickly by
measures in the form of tariff responses to offset the distortion.
c. These policies are often referred to as "trigger-price" mechanisms. The following
sections relate to such tariff responses to distortions related to foreign dumping and
export subsidies.
14. Anti-dumping Duties:
a. An anti-dumping duty is a protectionist tariff that a domestic government imposes on
foreign imports that it believes are priced below fair market value.
b. Dumping occurs when manufacturers sell goods in a foreign country below the sales
prices in their domestic market or below their full average cost of the product.
c. Dumping may be persistent, seasonal, or cyclical. Dumping may also be resorted to as a
predatory pricing practice to drive out established domestic producers from the market
and to establish monopoly position.
d. Dumping is an international price discrimination favouring buyer of exports, but in fact,
the exporters deliberately forego money in order to harm the domestic producers of the
importing country.
e. Dumping is unfair and constitutes a threat to domestic producers and therefore when
dumping is found, anti-dumping measures may be initiated as a safeguard instrument by
imposing additional import duties/tariffs so as to offset the foreign firm's unfair price
advantage.
f. This is justified only if the domestic industry is seriously injured by import competition,
and protection is in the national interest (that is, the associated costs to consumers
would be less than the benefits that would accrue to producers).
Ex: In January 2017, India imposed anti-dumping duties on colour-coated or pre- painted
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flat steel products imported into the country from China and European nations for a
period not exceeding six months and for jute and jute products from Bangladesh and
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Nepal.
15. Countervailing Duties:
a. Countervailing duties are tariffs that aim to offset the artificially low prices charged by
exporters who enjoy export subsidies and tax concessions offered by the governments in
their home country.
b. If a foreign country does not have a comparative advantage in a particular good and a
government subsidy allows the foreign firm to be an exporter of the product, then the
subsidy generates a distortion from the free-trade allocation of resources.
c. In such cases, CVD is charged in an importing country to negate the advantage that
exporters get from subsidies to ensure fair and market-oriented pricing of imported
products and thereby protecting domestic industries and firms.
Ex: In 2016, In order to protect its domestic industry, India imposed 12.5% countervailing
duty on Gold jewellery imports from ASEAN.
Q.NO.3 STATE THE EFFECTS OF TARIFFSON INTERNATIONAL TRADE?

ANSWER:
1. A tariff levied on an imported product affects both the exporting country and the importing
country.
i) Tariff barriers create obstacles to trade, decrease the volume of imports and exports and
therefore of international trade. The prospect of market access of the exporting country is
worsened when an importing country imposes a tariff.
ii) By making imported goods more expensive, tariffs discourage domestic consumers from
consuming imported foreign goods. Domestic consumers suffer a loss in consumer surplus
because they must now pay a higher price for the good and also because compared to free
trade quantity, they now consume lesser quantity of the good.
iii) Tariffs encourage consumption and production of the domestically produced import
substitutes and thus protect domestic industries.
iv) Producers in the importing country experience an increase in well-being as a result of
imposition of tariff. The price increase of their product in the domestic market increases
producer surplus in the industry. They can also charge higher prices than would be possible
in the case of free trade because foreign competition has reduced.
v) The price increase also induces an increase in the output of the existing firms and possibly
addition of new firms due to entry into the industry to take advantage of the new high
profits and consequently an increase in employment in the industry.
vi) Tariffs create trade distortions by disregarding comparative advantage and prevent countries
from enjoying gains from trade arising from comparative advantage. Thus, tariffs discourage
efficient production in the rest of the world and encourage inefficient production in the
home country.
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vii) Tariffs increase government revenues of the importing country by the value of the total tariff
it charges.
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2. Trade liberalization in recent decades, either through government policy measures or through
negotiated reduction through the WTO or regional and bilateral free trade agreements, has
diminished the importance of tariff as a tool of protection.
3. Currently, trade policy is focusing increasingly on not so easily observable forms of trade barriers
usually called non-tariff measures (NTMs).
4. NTMs are thought to have important restrictive and distortionary effects on international trade.
They have become so invasive that the benefits due to tariff reduction are practically offset by
them.
Q.NO.4 DEFINE NON TARIFF MEASURES (NTMS)?

ANSWER:
1. Non-tariff measures (NTMs) are policy measures (other than ordinary customs tariffs) that can
potentially have an economic effect on international trade in goods, changing quantities traded,
or prices or both (UNCTAD, 2010).
2. Non-tariff measures comprise all types of measures which alter the conditions of international
trade, including policies and regulations that restrict trade and those that facilitate it. NTMs
consist of mandatory requirements, rules, or regulations that are legally set by the government
of the exporting, importing, or transit country.
3. NTMs are not the same as non-tariff barriers (NTBs).
a. NTMs are sometimes used as means to circumvent free-trade rules and favour domestic
industries at the expense of foreign competition. In this case they are called non-tariff
barriers (NTBs).
b. In other words, non-tariff barriers are discriminatory non-tariff measures imposed by
governments to favour domestic over foreign suppliers.
c. NTBs are thus a subset of NTMs that have a 'protectionist or discriminatory intent'.
Compared to NTBs, non-tariff measures encompass a broader set of measures.
4. According to WTO agreements, the use of NTMs is allowed under certain circumstances.
Ex: Technical Barriers to Trade (TBT) Agreement and the Sanitary and Phytosanitary Measures
(SPS) Agreement, both negotiated during the Uruguay Round.
5. It is very difficult, and sometimes impossible, to distinguish legitimate NTMs from protectionist
NTMs, especially because the same measure may be used for several reasons.
6. Depending on their scope and/or design NTMs are categorized as:
A. Technical Measures: Technical measures refer to product-specific properties such as
characteristics of the product, technical specifications and production processes. These
measures are intended for ensuring product quality, food safety, environmental protection,
national security and protection of animal and plant health.
B. Non-technical Measures: Non-technical measures relate to trade requirements; for
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example; shipping requirements, custom formalities, trade rules, taxation policies, etc.
C. These are further distinguished as:
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a) Hard measures (e.g. Price and quantity control measures),

b) Threat measures (e.g. Anti-dumping and safeguards) and
c) Other measures such as trade-related finance and investment measures. Furthermore,
the categorization also distinguishes between:
i) Import-related measures which relate to measures imposed by the importing
country, and
ii) Export-related measures which relate to measures imposed by the exporting country
itself.
iii) In addition, to these, there are procedural obstacles (PO) which are practical
problems in administration, transportation, delays in testing, certification etc which
may make it difficult for businesses to adhere to a given regulation.
Q.NO.5 STATE THE TECHNICAL MEASURES OF NON TARIFF MEASURES (NTMS)?

ANSWER:
A. Sanitary and Phytosanitary (SPS) Measures:
1. SPS measures are applied to protect human, animal or plant life from risks arising from
additives, pests, contaminants, toxins or disease-causing organisms and to protect
biodiversity.
2. These include ban or prohibition of import of certain goods, all measures governing quality
and hygienic requirements, production processes, and associated compliance assessments.
Ex: Prohibition of import of poultry from countries affected by avian flu, meat and poultry
processing standards to reduce pathogens, residue limits for pesticides in foods etc.
B. Technical Barriers To Trade (TBT):
1. Technical Barriers to Trade (TBT) which cover both food and non-food traded products refer
to mandatory ‘Standards and Technical Regulations’
2. Standards and Technical Regulations define the specific characteristics that a product should
have, such as its size, shape, design, labelling / marking / packaging, functionality or
performance and production methods, excluding measures covered by the SPS Agreement.
3. The specific procedures used to check whether a product is really conforming to these
requirements (conformity assessment procedures e.g. testing, inspection and certification)
are also covered in TBT.
4. This involves compulsory quality, quantity and price control of goods before shipment from
the exporting country.
5. Just as SPS, TBT measures are standards-based measures that countries use to protect their
consumers and preserve natural resources, but these can also be used effectively as
obstacles to imports or to discriminate against imports and protect domestic products.
6. Altering products and production processes to comply with the diverse requirements in
export markets may be either impossible for the exporting country or would obviously raise
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costs, hurting the competitiveness of the exporting country.

Examples for TBT are Food laws, quality standards, industrial standards, organic certification,
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eco-labelling, and marketing and label requirements.

Q.NO.6 STATE THE NON-TECHNICAL MEASURES OF NON-TARIFF MEASURES (NTMS)?
ANSWER:
NON-TECHNICAL MEASURES: These include different types of trade protective measures which are
put into operation to neutralize the possible adverse effects of imports in the market of the
importing country.
Following are the most commonly practiced measures in respect of imports:
A. IMPORT QUOTAS:
1. An import quota is a direct restriction which specifies that only a certain physical amount of
the good will be allowed into the country during a given time period, usually one year.
2. Import quotas are typically set below the free trade level of imports and are usually enforced
by issuing licenses. This is referred to as a binding quota; a non-binding quota is a quota that
is set at or above the free trade level of imports, thus having little effect on trade.
3. Import quotas are mainly of two types: absolute quotas and tariff-rate quotas.
a. Absolute quotas or quotas of a permanent nature: Absolute quotas or quotas of a
permanent nature limit the quantity of imports to a specified level during a specified
period of time and the imports can take place any time of the year.
i) No condition is attached to the country of origin of the product.
Ex: 1000 tonnes of fish import which can take place any time during the year from any
country.
ii) When country allocation is specified, a fixed volume or value of the product must
originate in one or more countries.
Ex: A quota of 1000 tonnes of fish that can be imported any time during the year, but
where 750 tonnes must originate in country A and 250 tonnes in country B.
iii) In addition, there are seasonal quotas and temporary quotas.
4. Quota Rents:
a. With a quota, the government, of course, receives no revenue. The profits received by
the holders of such import licenses are known as ‘quota rents’. While tariffs directly
interfere with prices that can be charged for an imported good in the domestic market,
import quota interferes with the market prices indirectly. Obviously, an import quota
always raises the domestic price of the imported good.
b. The license holders are able to buy imports and resell them at a higher price in the
domestic market and they will be able to earn a ‘rent’ on their operations over and above
the profit they would have made in a free market.
c. The welfare effects of quotas are similar to that of tariffs. If a quota is set below free
trade level, the amount of imports will be reduced. A reduction in imports will lower the
supply of the good in the domestic market and raise the domestic price. Consumers of
the product in the importing country will be worse-off because the increase in the
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domestic price of both imported goods and the domestic substitutes reduces consumer
surplus in the market.
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d. Producers in the importing country are better-off as a result of the quota. The increase in
the price of their product increases producer surplus in the industry. The price increase
also induces an increase in output of existing firms (and perhaps the addition of new
firms), an increase in employment, and hence an increase in profit.
B. PRICE CONTROL MEASURES:

1. Price control measures (including additional taxes and charges) are steps taken to control or
influence the prices of imported goods in order to support the domestic price of certain
products when the import prices of these goods are lower.
2. These are also known as 'para-tariff' measures and include measures, other than tariff
measures, that increase the cost of imports in a similar manner, i.e., by a fixed percentage or
by a fixed amount.
Example: A minimum import price established for sulphur.
C. NON-AUTOMATIC LICENSING AND PROHIBITIONS:

1. These measures are normally aimed at limiting the quantity of goods that can be imported,
regardless of whether they originate from different sources or from one particular supplier.
2. These measures may take the form of non-automatic licensing, or complete prohibitions.
Example: Textiles may be allowed only on a discretionary license by the importing country.
India prohibits import/export of arms and related material from/to Iraq. Further, India also
prohibits many items (mostly of animal origin) falling under 60 EXIM codes.
D. FINANCIAL MEASURES:
1. The objective of financial measures is to increase import costs by regulating the access to
and cost of foreign exchange for imports and to define the terms of payment.
2. It includes measures such as advance payment requirements and foreign exchange controls
denying the use of foreign exchange for certain types of imports or for goods imported from
certain countries.
Example: An importer may be required to pay a certain percentage of the value of goods
imported 3 months before the arrival of goods or foreign exchange may not be permitted for
import of newsprint.
E. MEASURES AFFECTING COMPETITION:

1. These measures are aimed at granting exclusive or special preferences or privileges to one or
a few limited group of economic operators.
2. It may include government imposed special import channels or enterprises, and compulsory
use of national services.
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Example: A statutory marketing board may be granted exclusive rights to import wheat: or a
canalizing agency (like State Trading Corporation) may be given monopoly right to distribute
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palm oil.
3. When a state agency or a monopoly import agency sells in the domestic market at prices
above those existing in the world market, the effect will be similar to an import tariff.
F. GOVERNMENT PROCUREMENT POLICIES:

1. Government procurement policies may interfere with trade if they involve mandates that
the whole of a specified percentage of government purchases should be from domestic firms
rather than foreign firms, despite higher prices than similar foreign suppliers.
2. In accepting public tenders, a government may give preference to the local tenders rather
than foreign tenders.
G. TRADE-RELATED INVESTMENT MEASURES: These measures include rules on local content

requirements that mandate a specified fraction of a final good should be produced domestically.
a. requirement to use certain minimum levels of locally made components, (25 percent of
components of automobiles to be sourced domestically)
b. restricting the level of imported components, and
c. limiting the purchase or use of imported products to an amount related to the quantity or
value of local products that it exports. (A firm may import only up to 75 % of its export
earnings of the previous year)
H. DISTRIBUTION RESTRICTIONS:
1. Distribution restrictions are limitations imposed on the distribution of goods in the importing
country involving additional license or certification requirements.
2. These may relate to geographical restrictions or restrictions as to the type of agents who
may resell.
Example: a restriction that imported fruits may be sold only through outlets having
refrigeration facilities.
I. RESTRICTION ON POST-SALES SERVICES: Producers may be restricted from providing after- sales
services for exported goods in the importing country. Such services may be reserved to local
service companies of the importing country.
J. ADMINISTRATIVE PROCEDURES:
1. Another potential obstruction to free trade is the costly and time-consuming administrative
procedures which are mandatory for import of foreign goods.
2. These will increase transaction costs and discourage imports. The domestic import-
competing industries gain by such non- tariff measures.
Examples include specifying particular procedures and formalities, requiring licenses,
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administrative delay, red-tape and corruption in customs clearing frustrating the potential
importers, procedural obstacles linked to prove compliance etc.
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K. RULES OF ORIGIN:
1. Country of origin means the country in which a good was produced, or in the case of a
traded service, the home country of the service provider.
2. Rules of origin are the criteria needed by governments of importing countries to determine
the national source of a product.
3. Their importance is derived from the fact that duties and restrictions in several cases depend
upon the source of imports.
4. Important procedural obstacles occur in the home countries for making available
certifications regarding origin of goods, especially when different components of the product
originate in different countries.
L. SAFEGUARD MEASURES: These are initiated by countries to restrict imports of a product

temporarily if its domestic industry is injured or threatened with serious injury caused by a surge
in imports. Restrictions must be for a limited time and non-discriminatory.
M. EMBARGOS:
1. An embargo is a total ban imposed by government on import or export of some or all
commodities to particular country or regions for a specified or indefinite period.
2. This may be done due to political reasons or for other reasons such as health, religious
sentiments. This is the most extreme form of trade barrier.
Q.NO.7 STATE THE EXPORT-RELATED MEASURES IMPOSED BY EXPORTING COUNTRY ITSELF?

ANSWER:
EXPORT-RELATED MEASURES
A. BAN ON EXPORTS:
1. Export-related measures refer to all measures applied by the government of the exporting
country including both technical and non- technical measures.
Example: During periods of shortages, export of agricultural products such as onion, wheat
etc. may be prohibited to make them available for domestic consumption.
2. Export restrictions have an important effect on international markets. By reducing
international supply, export restrictions have been effective in increasing international
prices.
B. EXPORT TAXES:
1. An export tax is a tax collected on exported goods and may be either specific or ad valorem.
The effect of an export tax is to raise the price of the good and to decrease exports.
2. Since an export tax reduces exports and increases domestic supply, it also reduces domestic
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prices and leads to higher domestic consumption.

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C. EXPORT SUBSIDIES AND INCENTIVES:
1. Exporting countries have developed compensatory measures of different types for exporters
like export subsidies, duty drawback, duty-free access to imported intermediates etc.
2. Governments or government bodies also usually provide financial contribution to domestic
producers in the form of grants, loans, equity infusions etc. or give some form of income or
price support.
3. If such policies on the part of governments are directed at encouraging domestic industries
to sell specified products or services abroad, they can be considered as trade policy tools.
D. VOLUNTARY EXPORT RESTRAINTS:

1. Voluntary Export Restraints (VERs) refer to a type of informal quota administered by an
exporting country voluntarily restraining the quantity of goods that can be exported out of
that country during a specified period of time.
2. Such restraints originate primarily from political considerations and are imposed based on
negotiations of the importer with the exporter.
3. The inducement for the exporter to agree to a VER is mostly to appease the importing
country and to avoid the effects of possible retaliatory trade restraints that may be imposed
by the importer.
4. VERs may arise when the import- competing industries seek protection from a surge of
imports from particular exporting countries. VERs cause, as do tariffs and quotas, domestic
prices to rise and cause loss of domestic consumer surplus.
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Q.NO.1
i) Which of the three exporters engage in anticompetitive act in the international market while
pricing its export of good X to country D?
ii) What would be the effect of such pricing on the domestic producers of good X? Advise remedy
available for country D?
Goods X Country Country B Country C
A (in $) (in $) (in$)
Average Cost 30.5 29.4 30.9
Price per Unit for domestic Sales 31.2 31.1 30.9
Price charged in country D 31.9 30.6 30.6
ANSWER:
i) Dumping by Country B and Country C. B, because it sells at a lower price than that in domestic
market; Country C because it is selling at a price which is less than the average cost of
production.
ii) Adverse effects on domestic industry as they will lose competitiveness in their markets due to
unfair practice of dumping. Country D may prove damage to domestic industries and charge
anti-dumping duties on goods imported from Country B and Country C so as to raise the price
and make it at par which similar goods produced by domestic firms.
Q.NO.2
i) What do you think the implications on trade will be if India pays an export subsidy of Rs. 400 /
on every pair of cotton trousers exported by it to Germany.
ii) Suppose Germany charged an equivalent countervailing duty on every pair of cotton trousers
imported from India. Do you think world welfare will be affected?
ANSWER:
i) Unfair and artificially created price advantage to trousers exporters of India – price does not
reflect costs- German trousers industry lose competitiveness and market share as trousers from
India are lower priced- Loss of world welfare. German industry can ask for protection by
introducing countervailing duties.
ii) An equivalent countervailing duty will push the prices of Indian trousers and afford protection to
domestic trousers industry. World welfare will be the same as before India introduced export
subsidy.
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4.3. TRADE NEGOTIATIONS
Q.NO.1 STATE THE RELEVANCE OF INTERNATIONAL TRADE NEGOTIATIONS?
ANSWER:
1. The recent years have seen intense bilateral and multilateral negotiations among different
nations in the international arena. India, for example, has already become part of 19 such
concluded agreements and is currently negotiating more than two dozens of such proposals.
2. Major events in the year 2020, such as
a. Britain’s exit from the European Union,
b. The new free trade agreement [which is a successor of the North American Free Trade
Agreement (NAFTA)] concluded between Canada, Mexico, and United States, namely United
States–Mexico–Canada Agreement (USMCA)
c. Many other unpredictable developments in the trade front due to trade war between the US
and China and the global pandemic
3. International trade negotiations, especially the ones aimed at formulation of international trade
rules, are complex interactive processes involving different countries having competing
objectives.
a. Trade negotiations are not just face to face discussions; rather they are multilevel or network
games and involve intricate and time-consuming processes. They usually involve many
parties who have conflicting interests and objectives.
b. National governments are not the sole stakeholders in a trade negotiation. Many interest
groups, lobbying groups, pressure groups and Non-Governmental Organizations (NGO) exert
their influence on the process. As anyone can guess, the positions taken by each of the
negotiating parties would represent their underlying agenda of interests.
For example, in trade negotiations, when one of the parties seems to be bargaining for
market access through reduction in tariffs, the other (s) may be clamouring on the issue of
possible grant of protection to domestic industries.
Q.NO.2 DEFINE REGIONAL TRADE AGREEMENTS AND EXPLAIN ITS TAXONOMY?

ANSWER:
REGIONAL TRADE AGREEMENTS (RTAS): Regional Trade Agreements are defined as groupings of
countries (not necessarily belonging to the same geographical region), which are formed with the
objective of reducing barriers to trade between member countries. In other words, a regional trade
agreement (RTA) is a treaty between two or more governments that define the rules of trade for all
signatories. As of 1 February 2021, 339 RTAs were in force.
TAXONOMY OF REGIONAL TRADE AGREEMENTS: Trade negotiations result in different types of
agreements -
1. Unilateral Trade Agreements under which an importing country offers trade incentives in order
to encourage the exporting country, to engage in international economic activities that will
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improve the exporting country’s economy.

E.g. Generalized System of Preferences.
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2. Bilateral Agreements are agreements which set rules of trade between two countries, two blocs
or a bloc and a country. These may be limited to certain goods and services or certain types of
market entry barriers.
E.g. EU-South Africa Free Trade Agreement; ASEAN–India Free Trade Area.
3. Regional Preferential Trade Agreements among a group of countries reduce trade barriers on a
reciprocal and preferential basis for only the members of the group.
E.g. Global System of Trade Preferences among Developing Countries (GSTP)
4. Trading Bloc has a group of countries that have a free trade agreement between themselves and
may apply a common external tariff to other countries.
E.g. Arab League (AL), European Free Trade Association (EFTA)
5. Free-trade area is a group of countries that eliminate all tariff and quota barriers on trade with
the objective of increasing exchange of goods with each other. The trade among the member
states flows tariff free, but the member states maintain their own distinct external tariff with
respect to imports from the rest of the world. In other words, the members retain independence
in determining their tariffs with non-members.
E.g. USMCA.
6. Customs union is a group of countries that eliminate all tariffs on trade among themselves but
maintain a common external tariff on trade with countries outside the union (thus, technically
violating MFN). The common external tariff which distinguishes a customs union from a free
trade area implies that, generally, the same tariff is charged wherever a member imports goods
from outside the customs union.
E.g. The EU is a Customs Union; its 27 member countries form a single territory for customs
purposes. Gulf Cooperation Council (GCC), Southern Common Market (MERCOSUR).
7. Common Market: A Common Market deepens a customs union by providing for the free flow of
output and of factors of production (labour, capital and other productive resources) by reducing
or eliminating internal tariffs on goods and by creating a common set of external tariffs. The
member countries attempt to harmonize some institutional arrangements and commercial and
financial laws and regulations among themselves. There are also common barriers against non-
members (e.g., EU, ASEAN)
8. Economic and Monetary Union: For a common market, the free transit of goods and services
through the borders increases the need for foreign exchange operations and results in higher
financial and administrative expenses of firms operating within the region. The next stage in the
integration sequence is formation of some form of monetary union. In an Economic and
Monetary Union, the members share a common currency. Adoption of common currency also
makes it necessary to have a strong convergence in macroeconomic policies.
For example, the European Union countries implement and adopt a single currency.
Conclusion: There has been significant growth in international trade since the end of the Second
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World War, mostly due to multilateral trade system which is both a political process and a set of
political institutions. It is a political process because it is based on negotiations and bargaining
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among sovereign governments based on which they arrive at rules governing trade between or
among themselves. The political institutions that facilitate trade negotiations, and support
international trade cooperation by providing the rules of the game have been the former General
Agreements on Tariffs and Trade (GATT) and the World Trade Organization (WTO).
Q.NO.3 DISCUSS THE HISTORY OF GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT)?
ANSWER:
GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT): The General Agreement on Tariffs and
Trade (GATT) provided the rules for much of world trade for 47 years, from 1948 to 1994; but it was
only a multilateral instrument governing international trade or a provisional agreement along with
the two full-fledged “Bretton Woods” institutions, the World Bank and the International Monetary
Fund.
1. The original intention to create an International Trade Organization (ITO) as a third institution to
handle the trade side of international economic cooperation did not succeed for want of
endorsement by some national legislatures, especially the US.
2. 8 rounds of multilateral negotiations known as “trade rounds” held under the auspices GATT
resulted in substantial international trade liberalization.
3. Though the GATT trade rounds in earlier years contemplated tariff reduction as their core issue,
later on the Kennedy Round in the mid-sixties, and the Tokyo Round in the 1970s led to massive
reductions in bilateral tariffs, establishment of negotiation rules and procedures on dispute
resolution, dumping and licensing.
4. The arrangements were informally referred to as ‘codes’ because they were not acknowledged
by the full GATT membership. A number of codes were ultimately amended in the Uruguay
Round and got converted into multilateral commitments accepted by all WTO members. The
eighth, the Uruguay Round of 1986-94, was the last and most consequential of all rounds and
culminated in the birth of WTO and a new set of agreements.
5. The GATT lost its relevance by 1980s because
a) It was obsolete to the fast-evolving contemporary complex world trade scenario
characterized by emerging globalisation
b) International investments had expanded substantially
c) Intellectual property rights and trade in services were not covered by GATT
d) World merchandise trade increased by leaps and bounds and was beyond its scope.
e) The ambiguities in the multilateral system could be heavily exploited
f) Efforts at liberalizing agricultural trade were not successful
g) There were inadequacies in institutional structure and dispute settlement system
h) It was not a treaty and therefore terms of GATT were binding only insofar as they are not
incoherent with a nation’s domestic rules.
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Q.NO.4 STATE THE OBJECTIVES AND FUNCTIONS OF WORLD TRADE ORGANISATION?
ANSWER:
1. The most important outcome of the Uruguay Round agreement was the replacement of the
General Agreement on Tariffs and Trade (GATT) secretariat with the World Trade Organization
(WTO) in Geneva with authority not only in trade in industrial products but also in agricultural
products and services.
2. The bulk of the WTO's present operations come from the 1986-94 negotiations called the
Uruguay Round and earlier negotiations under the General Agreement on Tariffs and Trade
(GATT).
3. The principal objective of the WTO is to facilitate the flow of international trade smoothly,
freely, fairly and predictably. The WTO has six key objectives:
a) To set and enforce rules for international trade,
b) To provide a forum for negotiating and monitoring further trade liberalization,
c) To resolve trade disputes,
d) To increase the transparency of decision-making processes,
e) To cooperate with other major international economic institutions involved in global
economic management, and
f) To help developing countries benefit fully from the global trading system.
4. The objectives of the WTO Agreements as acknowledged in the preamble of the Agreement
creating the World Trade Organization, include “raising standards of living, ensuring full
employment and a large and steadily growing volume of real income and effective demand, and
expanding the production of and trade in goods and services.
5. The WTO, whose primary purpose is to open trade for the benefit of all, does its functions by
acting as a forum for trade negotiations among member governments, administering trade
agreements, reviewing national trade policies, assisting developing countries in trade policy
issues, through technical assistance and training programmes and cooperating with other
international organizations.
Q.NO.5 EXPLAIN THE STRUCTURE OF WORLD TRADE ORGANISATION?

ANSWER:
STRUCTURE OF WORLD TRADE ORGANISATION:
1. The WTO activities are supported by a Secretariat located in Geneva, headed by a Director
General. It has a three-tier system of decision making.
a) The WTO’s top- level decision-making body is the Ministerial Conference which can take
decisions on all matters under any of the multilateral trade agreements. The Ministerial
Conference meets at least once every two years.
b) The next level is the General Council which meets several times a year at the Geneva
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headquarters. The General Council also meets as the Trade Policy Review Body and the
Dispute Settlement Body.
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c) At the next level, the Goods Council, Services Council and Intellectual Property (TRIPS)
Council report to the General Council. These councils are responsible for overseeing the
implementation of the WTO agreements in their respective areas of specialisation. The WTO
Secretariat maintains working relations with almost 200 international organisations in
activities ranging from statistics, research, standard-setting, and technical assistance and
training.
2. Numerous specialized committees, working groups and working parties deal with the individual
agreements and other areas such as the environment, development, membership applications
and regional trade agreements.
3. The WTO accounting for about 95% of world trade currently has 164 members, of which 117 are
developing countries or separate customs territories. Around 24 others are negotiating
membership. The WTO’s agreements have been ratified in all members’ parliaments.
Q.NO.6 STATE THE GUIDING PRINCIPLES OF WORLD TRADE ORGANIZATION?

ANSWER:
THE GUIDING PRINCIPLES OF WORLD TRADE ORGANIZATION (WTO)
1. TRADE WITHOUT DISCRIMINATION (It follows the principle of Most-favoured-nation):
a) Originally formulated as Article 1 of GATT, this principle states that any advantage, favour,
privilege or immunity granted by any contracting party to any product originating in or
destined for any other country shall be extended immediately and unconditionally to the like
product originating in or destined for the territories of all other contracting parties
b) Under the WTO agreements, countries cannot normally discriminate between their trading
partners.
c) If a country lowers a trade barrier or opens up a market, it has to do so for the same goods
or services from all other WTO members. Under strict conditions, various permitted
exceptions are allowed.
E.g.
Countries may enter into free trade agreements and trading may be done within the group
discriminating against goods from outside;
a country can raise barriers against products that are considered to be traded unfairly from
specific countries; or they may give special market access to developing countries.
2. THE NATIONAL TREATMENT PRINCIPLE (NTP):

a) The National Treatment Principle is complementary to the MFN principle.
b) GATT Article III requires that with respect to internal taxes, internal laws, etc. applied to
imports, treatment not less favourable than that which is accorded to like domestic products
must be accorded to all other members.
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c) In other words, a country should not discriminate between its own and foreign products,
services or nationals.
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For instance, once imported apples reach Indian market, they cannot be discriminated
against and should be treated at par in respect of marketing opportunities, product visibility
or any other aspect with locally produced apples.
3. FREE TRADE:
a) Lowering trade barriers for opening up markets is one of the most obvious means of
encouraging trade. But by the 1980s, the negotiations had expanded to cover non-tariff
barriers on goods, and to the new areas such as services and intellectual property.
b) Since these require adjustments, the WTO agreements permit countries to bring in changes
gradually, through "progressive liberalization". Developing countries are generally given
longer time to conform to their obligations.
4. PREDICTABILITY:
a) Investments will be encouraged only if the business environment is stable and predictable.
b) The foreign companies, investors and governments should be confident that the trade
barriers will not be raised arbitrarily. This is achieved through 'binding' tariff rates,
discouraging the use of quotas and other measures used to set limits on quantities of
imports, establishing market-opening commitments and other measures to ensure
transparency.
c) A country can change its bindings, but only after negotiating with its trading partners, which
could mean compensating them for loss of trade.
5. PRINCIPLE OF GENERAL PROHIBITION OF QUANTITATIVE RESTRICTIONS: One reason for this

prohibition is that quantitative restrictions are considered to have a greater protective effect
than tariff measures and are more likely to distort the free flow of trade
6. GREATER COMPETITIVENESS: This is to be achieved by discouraging "unfair" practices such as

export subsidies, dumping etc. The rules try to establish what is fair or unfair, and how
governments can take action, especially by charging additional import duties intended to
compensate for injury caused by unfair trade.
7. TARIFFS AS LEGITIMATE MEASURES FOR THE PROTECTION OF DOMESTIC INDUSTRIES:

a. The imposition of tariffs should be the only method of protection, and tariff rates for
individual items should be gradually reduced through negotiations 'on a reciprocal and
mutually advantageous' basis.
b. Member countries bind themselves to maximum rates and the imposition of tariffs beyond
such maximum rates (bound rates) or the unilateral raise in bound rates are banned.
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8. TRANSPARENCY IN DECISION MAKING:
a) The WTO insists that any decision by members in the sphere of trade or in respect of matters
affecting trade should be transparent and verifiable. Such changes in matters of trade or of
trade related rules have to be invariability and without delay be notified to all the trading
partners.
b) In case of any opposition to such changes, they should be appropriately addressed and any
loss occurring to the affected members should be suitably compensated for.
9. PROGRESSIVE LIBERALIZATION: Many trade issues of a controversial nature similar to labour

standards, non-agricultural market access, etc. on which there was general disagreement among
trading partners were left unsettled during the Uruguay Round. These are to be liberalized
during consecutive rounds of discussion.
10. MARKET ACCESS: The WTO aims to increase world trade by enhancing market access by
converting all non- tariff barriers into tariffs which are subject to country specific limits. Further,
in major multilateral agreements like the Agreement on Agriculture (AOA), specific targets have
been specified for ensuring market access.
11. SPECIAL PRIVILEGES TO LESS DEVELOPED COUNTRIES: With majority of WTO members being
developing countries and countries in transition to market economies, the WTO deliberations
favour less developed countries by giving them greater flexibility, special privileges and
permission to phase out the transition period. Also, these countries are granted transition
periods to make adjustments to the not so familiar and intricate WTO provisions.
12. PROTECTION OF HEALTH &ENVIRONMENT: The WTO's agreements support measures to

protect not only the environment but also human, animal as well as plant health with the
stipulation that such measures should be non- discriminatory and that members should not
employ environmental protection measures as a means of disguising protectionist policies.
13. A TRANSPARENT, EFFECTIVE AND VERIFIABLE DISPUTE SETTLEMENT MECHANISM:

a) Trade relations frequently involve conflicting interests. Any dispute arising out of violation of
trade rules leading to infringement of rights under the agreements or misunderstanding
arising as regards the interpretation of rules, are to be settled through consultation.
b) In case of failures, the dispute can be referred to the WTO and can pursue a carefully
mapped out, stage- by-stage procedure that includes the possibility of a judgment by a panel
of experts, and the opportunity to appeal the ruling on legal grounds. The decisions of the
dispute settlement body are final and binding.
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Q.NO.7 DISCUSS THE PROVISIONS OF WORLD TRADE ORGANIZATION AGREEMENTS?
ANSWER:
1. The WTO agreements cover goods, services and intellectual property and the permitted
exceptions. These agreements are often called the WTO’s trade rules, and the WTO is often
described as “rules-based”, a system based on rules. (The rules are actually agreements that the
governments negotiated).
2. The WTO agreements are voluminous and multifaceted. The ‘Legal Texts’ consist of a list of
about 60 agreements, annexes, decisions and understandings covering a wide range of activities.
3. The major provisions of WTO agreements are given below:
a) Agreement on Agriculture aims at strengthening GATT disciplines and improving agricultural trade. It
includes specific and binding commitments made by WTO Member governments in the three areas
of market access, domestic support and export subsidies.
b) Agreement on the Application of Sanitary and Phytosanitary (SPS) Measures establishes
multilateral frameworks for the planning, adoption and implementation of sanitary and
phytosanitary measures to prevent such measures from being used for arbitrary or unjustifiable
discrimination or for camouflaged restraint on international trade and to minimize their adverse
effects on trade.
c) Agreement on Textiles and Clothing replaced the Multi-Fibre Arrangement (MFA) which was
prevalent since 1974 and entailed import protection policies. ATC provides that textile trade should
be deregulated by gradually integrating it into GATT disciplines over a 10-year transition period.
d) Agreement on Technical Barriers to Trade (TBT) aims to prevent standards and conformity
assessment systems from becoming unnecessary trade barriers by securing their transparency and
harmonization with international standards. Often excessive standards or misuse of standards in
respect of manufactured goods, and safety/environment regulations act as trade barriers.
e) Agreement on Trade-Related Investment Measures (TRIMs) expands disciplines governing
investment measures in relation to cross-border investments. It stipulates that countries receiving
foreign investments shall not impose investment measures such as requirements, conditions and
restrictions inconsistent with the provisions of the principle of national treatment and general
elimination of quantitative restrictions. For example: measures such as local content requirements
and trade balancing requirements should not be applied on investing corporations.
f) Anti-Dumping Agreement seeks to tighten and codify disciplines for calculating dumping margins and
conducting dumping investigations, etc. in order to prevent anti-dumping measures from being
abused or misused to protect domestic industries.
g) Customs Valuation Agreement specifies rules for more consistent and reliable customs valuation and
aims to harmonize customs valuation systems on an international basis by eliminating arbitrary
valuation systems.
h) Agreement on Pre-shipment Inspection (PSI) intends to secure transparency of pre-shipment
inspection wherein a company designated by the importing country conducts inspection of the
quality, volume, price, tariff classification, customs valuation, etc. of merchandise in the territory of
the exporting country on behalf of the importing country’s custom office and issues certificates. The
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agreement also provides for a mechanism for the solution of disputes between PSI agencies and
exporters.
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i) Agreement on Rules of Origin provides for the harmonization of rules of origin for application to all
non-preferential commercial policy instruments. It also provides for dispute settlement procedures
and creates the rules of origin committee.
j) Agreement on Import Licensing Procedures relates to simplification of administrative procedures
and to ensure their fair operation so that import licensing procedures of different countries may not
act as trade barriers.
k) Agreement on Subsidies and Countervailing Measures aims to clarify definitions of subsidies,
strengthen disciplines by subsidy type and to strengthen and clarify procedures for adopting
countervailing tariffs.
l) Agreement on Safeguards clarify disciplines for requirements and procedures for imposing
safeguards and related measures which are emergency measures to restrict imports in the event of a
sudden surge in imports.
m) General Agreement on Trade in Services (GATS): This agreement provides the general obligations
regarding trade in services, such as most- favoured- nation treatment and transparency. In addition,
it enumerates service sectors and stipulates that in the service sectors for which it has made
commitments, a member country cannot maintain or introduce market access restriction measures
and discriminatory measures that are severer than those that were committed during the
negotiations.
n) Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS): This agreement
stipulates most-favoured-nation treatment and national treatment for intellectual properties, such as
copyright, trademarks, geographical indications, industrial designs, patents, IC layout designs and
undisclosed information. In addition, it requires member countries to maintain high levels of
intellectual property protection and to administer a system of enforcement of such rights. It also
stipulates procedures for the settlement of disputes related to the agreement.
o) Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU) provides the
common rules and procedures for the settlement of disputes related to the WTO agreements. It
aims to strengthen dispute settlement procedures by prohibiting unilateral measures, establishing
dispute settlement panels whose reports are automatically adopted, setting time frames for dispute
settlement, establishing the Appellate Body etc. (for details of India’s disputes at the WTO, refer box1
below)
p) Trade Policy Review Mechanism (TPRM) provides the procedures for the trade policy review
mechanism to conduct periodical reviews of members’ trade policies and practices conducted by the
Trade Policy Review Body (TPRB).
q) Plurilateral Trade Agreements: Multilateral negotiations are those negotiations involving the entire
WTO contracting parties. The Plurilateral trade agreements involve several countries with a common
interest but do not involve all WTO countries.
i) Agreement on Trade in Civil Aircraft: The Agreement on Trade in Civil Aircraft entered
into force on 1 January 1980. It now has 32 signatories. The agreement eliminates import
duties on all aircraft, other than military aircraft, as well as on all other products covered
by the agreement.
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ii) Agreement on Government Procurement: The fundamental aim of the GPA is to

mutually open government procurement markets among its parties. This agreement
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requires national treatment and non- discriminatory treatment in the area of
government procurement and calls for fair and transparent procurement procedures.
The agreement covers the procurement of services (in addition to goods) and the
procurement by sub-central government entities and government- related agencies (in
addition to central government).
Conclusion: All the above-mentioned agreements entered into by the members are not static;
they are renegotiated from time to time and new agreements evolve from negotiations.
Example: Many agreements were negotiated under the Doha Development Agenda, launched by
WTO trade ministers in Doha, Qatar, in November 2001.
Q.NO.8 WRITE ABOUT DOHA ROUND OF WTO?

ANSWER:
The Doha Round: The Doha Round formally the Doha Development Agenda, which is the 9th round
since the Second World War was officially launched at the WTO’s Fourth Ministerial Conference in
Doha, Qatar, in November 2001. The round seeks to accomplish major modifications of the
international trading system through lower trade barriers and revised trade rules. The negotiations
include 20 areas of trade, including agriculture, services trade, market access for non-agricultural
products (NAMA), trade in services, trade facilitation, environment, geographical indications and
certain intellectual property issues. The most controversial topic in the Doha Agenda was agriculture
trade.
Q.NO.9 DESCRIBE 25 YEARS OF THE WTO ACHEIVEMENTS AND CONCERNS?

ANSWER:
25 YEARS OF THE WTO ACHEIVEMENTS AND CONCERNS The WTO has helped transform
international economic relations to a great extent over the past 25 years of its existence.
1. There has been spectacular growth in world trade in goods and services. Since 1995, the dollar
value of world trade has increased nearly four-fold, while the real volume of world trade has
expanded by 2.7 times.
2. This is commendable as it outstrips the two-fold increase in world GDP over that period. The
average tariffs have almost halved, from 10.5% to 6.4% during this period.
3. The remarkable increase in global value chains (GVCs) has been made possible by the
predictable market conditions fostered by the WTO along with improved communication.
4. Businesses, being assured of the possibility of movement of components and associated services
across multiple locations, have been able to disaggregate manufacturing production across
countries and regions. At present, trade within these value chains accounts for almost 70% of
total merchandise trade.
5. The rise of global value chains has been a significant factor in enabling rapid catch-up growth in
developing economies. Also, these have resulted in increased purchasing power and consumer
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choice in all countries. For the economies that joined the WTO after its creation, accession
involved far-reaching reforms and market-opening commitments and research suggests that
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these have enabled a lasting boost to national income.
6. Over the past 25 years, there has been the fastest poverty reduction in history: in 1995, over
one in three people living around the world fell below the World Bank's $1.90 threshold for
extreme poverty. Today the extreme poverty rate is less than 10%, the lowest ever.
7. MAJOR ISSUES OF WTO: However, in recent years, apprehensions have been raised in respect of
the WTO and its ability to maintain and extend a system of liberal world trade. The major issues
are:
a) The progress of multilateral negotiations on trade liberalization is very slow and the
requirement of consensus among all members acts as a constraint and creates rigidity in the
system. As a result, countries find regionalism as a plausible alternative. Moreover,
contemporary trade barriers are much more complex and difficult to negotiate in a
multilateral forum. Logically, these issues are much easier if discussed on bilateral or regional
level.
b) The complex network of regional agreements introduces uncertainties and murkiness in the
global trade system.
c) While multilateral efforts have effectively reduced tariffs on industrial goods, the
achievement in liberalizing trade in agriculture, textiles, and apparel, and in many other
areas of international commerce has been negligible.
d) The negotiations, such as the Doha Development Round, have run into problems, and their
definitive success is doubtful.
e) Most countries, particularly developing countries are dissatisfied with the WTO because, in
practice, most of the promises of the Uruguay Round agreement to expand global trade has
not materialized.
f) The developing countries have raised a number of concerns and a few are presented here:
i) The developing countries contend that the real expansion of trade in the three key areas
of agriculture, textiles and services has been dismal.
ii) Protectionism and lack of willingness among developed countries to provide market
access on a multilateral basis has driven many developing countries to seek regional
alternatives.
iii) The developing countries have raised a number of issues in the Doha Agenda in respect
of the difficulties that they face in implementing the present agreements.
iv) The North-South divide apparent in the WTO ministerial meets has fuelled the
apprehension of developing countries about the prospect of trade expansion under the
WTO regime.
v) Developing countries complain that they face exceptionally high tariffs on selected
products in many markets and this obstructs their vital exports.
Examples are tariff peaks on textiles, clothing, and fish and fish products.
vi) Another major issue concerns ‘tariff escalation’ where an importing country protects its
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processing or manufacturing industry by setting lower duties on imports of raw materials

and components, and higher duties on finished products.
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vii) There is also possible erosion of preferences i.e., the special tariff concessions granted by
developed countries on imports from certain developing countries have become less
meaningful because of the narrowing of differences between the normal and preferential
rates.
viii) The least-developed countries find themselves disproportionately disadvantaged and
vulnerable with regard to adjustments due to lack of human as well as physical capital,
poor infrastructure, inadequate institutions, political instabilities etc.
ix) In recent times, the World Trade Organization and the global trading system are facing
serious challenges in terms of unilateral measures and counter measures by some
members. Over the past two years, governments have introduced trade restrictions and
protectionist actions covering a substantial amount of international trade, affecting $747
billion in global imports in 2019 alone.
x) The rising uncertainty about market conditions is causing businesses to postpone
investment, weighing on growth and the future potential of our economies. Many areas
of trade such as e-commerce are still outside the WTO.
xi) There are mounting trade tensions as some members do not adhere to the WTO’s
established procedures. The unilateral tariffs threatened by the U.S. and China are
examples. Countries are using the permissible clause of ‘national security’ as a
justification for tariffs.
xii) There is an ongoing stalemate in the appointment of members of the Appellate Body of
WTO’s dispute settlement mechanism. The appellate body is nearly paralyzed because it
does not have the three panellists required to sign rulings.
Q.NO.10 STATE THE LIST OF AGREEMENTS IN THE FINAL ACT OF THE URUGUAY ROUND?
ANSWER:
A Summary of Agreements in the Final Act of the Uruguay Round
1. Agreement Establishing the WTO
2. General Agreement on Tariffs and Trade 1994
3. Uruguay Round Protocol GATT 1994
4. Agreement on Agriculture
5. Agreement on Sanitary and Phytosanitary Measures
6. Decision on Measures Concerning the Possible Negative Effects of the Reform Programme on
Least-Developed and Net Food-Importing Developing Countries
7. Agreement on Textiles and Clothing (terminated on 1 January 2005)
8. Agreement on Technical Barriers to Trade
9. Agreement on Trade-Related Investment Measures
10. Agreement on Implementation of Article VI (Anti-dumping)
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11. Agreement on Implementation of Article VII (Customs Valuation)

12. Agreement on Pre shipment Inspection
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13. Agreement on Rules of Origin
14. Agreement on Import Licensing Procedures
15. Agreement on Subsidies and Countervailing Measures
16. Agreement on Safeguards
17. General Agreement on Trade in Services
18. Agreement on Trade-Related Aspects of Intellectual Property Rights, Including Trade in
Counterfeit Goods
19. Understanding on Rules and Procedures Governing the Settlement of Disputes
20. Decision of Achieving Greater Coherence in Global Economic Policy-Making
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Q.NO.1 India aims to become a global leader in solar energy and for achieving this, the Jawaharlal
Nehru National Solar Mission (JNNSM) was launched in 2010. To persuade and to promote
producers to participate in the national solar programme, the government planned long-term
power purchase agreements with solar power producers, thus effectively guaranteeing the sale of
the energy produced as well as the price that solar power producers would obtain. However,
there was a stipulation that the producers should use domestically sourced inputs, namely solar
cells and modules. India lost the case in DSB and WTO has ruled against the stipulation of local
content requirements by government of India.
Answer the following questions
i) How does the 'local content requirements' clause violate the WTO agreements?
ii) Do you think Indian domestic solar power industry will be affected when India scraps the
local-sourcing regulation as per the ruling of WTO?
ANSWER:
(i) Local-sourcing regulation is considered as a protectionist measure inconsistent with India’s
international obligations under WTO agreement. Discrimination on the basis of the national
‘origin’ of the cells and modules is a violation of its trade commitment for ‘national treatment
obligation’ under WTO. If the objective is cost reduction and efficiency, then the solar power
producers should be free to choose energy-generation equipment and components on the basis
of price and quality, irrespective of whether they are manufactured locally or not. By
mandatorily requiring solar power producers to buy locally, the government has, it is argued,
tried to distort competition. This imposes extra cost, and may possibly be passed on to the final
consumers. Therefore, the interests of the consumers will not be protected.
(ii) The market forces would prevail in respect of solar energy production. The import competing
domestic industry of solar panels and modules may face stiff competition from imported items,
especially those from China. Indian solar industry is in its infancy. Possibility of subsidized
imports and dumping from different countries. India can evoke anti-dumping duties,
countervailing duties and safe guards as provided for in WTO agreements. Need for innovation,
cost reduction and quality improvement of Indian solar industry to compete with global
manufacturers. Since clean energy is a merit good, government may produce and supply it
directly - economies of large-scale production can be reaped leading to cost and price reduction.
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4.4. EXCHANGE RATE AND ITS ECONOMIC
EFFECTS
Q.NO.1 DEFINE HOW EXCHANGE RATE IS DETERMINED?
ANSWER:
Households, businesses and governments in India, for example, buy different types of goods and
services produced in other countries. Similarly, residents of the rest of the world buy goods and
services from residents in India.
Foreign investors, businesses, and governments invest in our country, just as our nationals invest in
other countries. In the same way, lending, and borrowing also take place internationally. These and
similar other transactions give rise to an international dimension of money, which involves exchange
of one currency for another.
Q.NO.2 DEFINE THE EXCHANGE RATE? EXPLAIN THE WAYS TO EXPRESS NORMAL EXCHANGE RATE
BETWEEN TWO CURRENCIES?
ANSWER:
EXCHANGE RATE OR FOREIGN EXCHANGE RATE:
1. The term ‘Foreign Exchange’ refers to money denominated in a currency other than the
domestic currency. Similar to any other commodity, foreign exchange has a price.
2. The exchange rate, also known as a foreign exchange (FX) rate, is the price of one currency
expressed in terms of units of another currency and represents the number of units of one
currency that exchanges for a unit of another.
3. In other words, exchange rate is the rate at which the currency of one country is exchanged for
the currency of another country. It is the minimum number of units of one country’s currency
required to purchase one unit of the other country’s currency.
WAYS TO EXPRESS NOMINAL EXCHANGE RATE BETWEEN TWO CURRENCIES There are two ways to
express nominal exchange rate between two currencies (e.g. the US $ and Indian Rupee) namely
direct quote and indirect quote.
1. The direct form of quotation is also called European Currency Quotation whereas indirect form
is known as American Currency Quotation. A direct quote is the number of units of a local
currency exchangeable for one unit of a foreign currency. The price of 1 dollar may be quoted in
terms of how much rupees it takes to buy one dollar.
For example, Rs. 76/US$ means that an amount of Rs. 76 is needed to buy one US dollar or Rs. 76
will be received while selling one US dollar.
2. An indirect quote is the number of units of a foreign currency exchangeable for one unit of local
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currency;
For example: $ 0.0151 per rupee.
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3. A quotation in direct form can easily be converted into a quotation in indirect form and vice-
versa. This is done by taking the reciprocal of the given rate.
4. An exchange rate has two currency components; a ‘base currency’ and a ‘counter currency’.
5. In a direct quotation, the foreign currency is the base currency and the domestic currency is the
counter currency. In an indirect quotation, the domestic currency is the base currency and the
foreign currency is the counter currency. As the US dollar is the dominant currency in global
foreign exchange markets, the general convention is to apply direct quotes that have the US
dollar as the base currency and other currencies as the counter currency.
6. There may be two pairs of currencies with one currency being common between the two pairs.
For instance, exchange rates may be given between a pair, X and Y and another pair, X and Z.
The rate between Y and Z is derived from the given rates of the two pairs (X and Y, and, X and Z)
and is called ‘cross rate’. When there is no difference between the buying and the selling rate,
the rate is said to be ‘unique’ or ‘unified’. But it is rarely seen in practice.
7. There are generally two rates selling rate and buying rate for any currency when one goes to
exchange it in the market. Selling rate is generally higher than the buying rate for a currency.
This is the commission of the money exchanger (dealer) to run its operations.
Q.NO.3 DEFINE EXCHANGE RATE REGIME? EXPLAIN THE TYPES OF EXCHANGE RATE REGIMES?
ANSWER:
EXCHANGE RATE REGIME: An exchange rate regime is the system by which a country manages its
currency with respect to foreign currencies. It refers to the method by which the value of the
domestic currency in terms of foreign currencies is determined.
There are two major types of exchange rate regimes at the extreme ends; namely:
i) floating exchange rate regime (also called a flexible exchange rate), and
ii) fixed exchange rate regime
1. FLOATING EXCHANGE RATE REGIME:

a. Under floating exchange rate regime, the equilibrium value of the exchange rate of a
country’s currency is market-determined i.e., the demand for and supply of currency relative
to other currencies determine the exchange rate.
b. There is no predetermined target rate and the exchange rates are likely to change at every
moment in time depending on the changing demand for and supply of currency in the
market.
c. There is no interference on the part of the government or the central bank of the country in
the determination of exchange rate.
d. Any intervention by the central banks in the foreign exchange market (through purchases or
sales of foreign currency in exchange for local currency) is intended for only moderating the
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rate of change and preventing undue fluctuations in the exchange rate, rather than for
establishing a particular level for it (for example: India).
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e. Nevertheless, in a few countries (for example, New Zealand, Sweden, the United States), the
central banks almost never interfere to administer the exchange rates. Nearly all advanced
economies follow floating exchange rate regimes. Some large emerging market economies
also follow the system.
2. FIXED EXCHANGE RATE REGIME:

a. A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate
regime under which a country’s Central Bank and/ or government announces or decrees
what its currency will be worth in terms of either another country’s currency or a basket of
currencies or another measure of value, such as gold.
For example: a certain amount of rupees per dollar.
b. When a government intervenes in the foreign exchange market so that the exchange rate of
its currency is different from what the market forces of demand and supply would have
decided, it is said to have established a “peg” for its currency.
c. In order to sustain a fixed exchange rate, it is not enough that a country pronounces a fixed
parity: it must also make concentrated efforts to defend that parity by being willing to buy
(or sell) foreign reserves whenever the market demand for foreign currency is lesser (or
greater) than the supply of foreign currency. In other words, in order to maintain the
exchange rate at the predetermined level, the central bank intervenes in the foreign
exchange market.
Q.NO.4 DEFINE THE TERMS PEG, SOFT PEG AND HARD PEG?
ANSWER:
PEG: When a government intervenes in the foreign exchange market so that the exchange rate of its
currency is different from what the market forces of demand and supply would have decided, it is
said to have established a “peg” for its currency.
SOFT PEG: A soft peg refers to an exchange rate policy under which the exchange rate is generally
determined by the market, but in case the exchange rate tends to be move speedily in one
direction, the central bank will intervene in the market.
HARD PEG: With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value
for the exchange rate.
NOTE:
A. We are often misled to think that it is common for countries to adopt the flexible exchange rate
system.
B. In the real world, there is a spectrum of ‘intermediate exchange rate regimes’ which are either
inflexible or have varying degrees of flexibility that lie in between these two extremes (fixed and
flexible).
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For example, a central bank can implement soft peg and hard peg policies
C. Both soft peg and hard peg policy require that the central bank intervenes in the foreign
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exchange market.
Q.NO.5 DISCUSS THE ADVANTAGES OF FIXED RATE REGIME?
ANSWER:
In an open economy, the main advantages of a fixed rate regime are:
1. A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks and
transaction costs that can impede international flow of trade and investments. International
trade and investment are less risky under fixed rate regime as profits are not affected by the
exchange rate fluctuations.
2. A fixed exchange rate can thus, greatly enhance international trade and investment.
3. A reduction in speculation on exchange rate movements if everyone believes that exchange
rates will not change.
4. A fixed exchange rate system imposes discipline on a country's monetary authority and
therefore is more likely to generate lower levels of inflation.
5. The government can encourage greater trade and investment as stability encourages
investment.
6. Exchange rate peg can also enhance the credibility of the country's monetary-policy.
7. However, in the fixed or managed floating exchange rate regimes (where the market forces are
allowed to determine the exchange rate within a band), the central bank is required to stand
ready to intervene in the foreign exchange market and, also to maintain an adequate amount of
foreign exchange reserves for this purpose.
Q.NO.6 DISCUSS THE ADVANTAGES AND DISADVANTAGES OF FLAOTING RATE REGIME?

ANSWER:
A. A floating exchange rate has many advantages:
1. A floating exchange rate has the greatest advantage of allowing a Central bank and /or
government to pursue its own independent monetary policy.
2. Floating exchange rate regime allows exchange rate to be used as a policy tool
for example, policy-makers can adjust the nominal exchange rate to influence the
competitiveness of the tradable goods sector.
3. As there is no obligation or necessity to intervene in the currency markets, the central bank
is not required to maintain a huge foreign exchange reserves.
B. However, the greatest disadvantage of a flexible exchange rate regime is that volatile exchange
rates generate a lot of uncertainties in relation to international transactions and add a risk
premium to the costs of goods and assets traded across borders.
CONCLUSION: In short, a fixed rate brings in more currency and monetary stability and credibility;
but it lacks flexibility. On the contrary, a floating rate has greater policy flexibility; but less stability.
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Q.NO.7 DEFINE NOMINAL EXCHANGE RATE, REAL EXCHANGE RATE AND REAL EFFECTIVE
EXCHANGE RATE?
ANSWER:
A. Nominal Exchange Rate
1. It refers to the rate at which a person can trade the currency of one country for the currency
of another country. For any country, there are many nominal exchange rates because its
currency can be used to purchase many foreign currencies.
2. It can be used to find the domestic price of foreign goods. However, trade flows are affected
not by nominal exchange rates, but instead, by real exchange rates. The person or firm
buying another currency is interested in what can be bought with it.
B. REAL EXCHANGE RATE
1. The real exchange rate is the rate at which a person can trade the goods and services of one
country for the goods and services of another.
2. It describes ‘how many’ of a good or service in one country can be traded for ‘one’ of that
good or service in a foreign country. A country’s real exchange rate is a key determinant of
its net exports of goods and services. For real exchange rate, in the case of trade in a single
good, we must first use the nominal exchange rate to convert the prices into a common
currency.
3. The real exchange rate (RER) between two currencies is the product of the nominal exchange
rate and the ratio of prices between the two countries. It is calculated as:
Real exchange Rate = (Nominal exchange Rate) x Domestic price / Foreign price
Thus, real exchange rate depends on the nominal exchange rate and the prices of the good
in two countries measured in the local currencies.
When studying the economy as a whole, we use price indices which measure the price of a
basket of goods and services. Real exchange rate will then be:
Real exchange rate = Nominal exchange rate X Domestic price Index / Foreign price Index
C. REAL EFFECTIVE EXCHANGE RATE

1. It is the nominal effective exchange rate (a measure of the value of a domestic currency
against a weighted average of various foreign currencies) divided by a price deflator or index
of costs.
2. An increase in REER implies that exports become more expensive and imports become
cheaper; therefore, an increase in REER indicates a loss in trade competitiveness.
Q.NO.8 DISCUSS ABOUT FOREIGN EXCHANGE MARKET?

ANSWER:
THE FOREIGN EXCHANGE MARKET:
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1. The wide-reaching collection of markets and institutions that handle the exchange of foreign
currencies is known as the foreign exchange market. In this market, the participants use one
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currency to purchase another currency.
2. The foreign exchange market operates worldwide and is by far the largest market in the world in
terms of cash value traded. Being an over-the-counter market, it is not a physical place; rather, it
is an electronically linked network of big banks, dealers and foreign exchange brokers who bring
buyers and sellers together.
3. With no central trading location and no set hours of trading, the foreign exchange market
involves enormous volume of foreign exchange being traded worldwide. The participants such as
firms, households, and investors who demand and supply currencies represent themselves
through their banks and key foreign exchange dealers who respond to market signals
transmitted instantly across the world.
4. The foreign exchange markets operate on very narrow spreads between buying and selling
prices. But since the volumes traded are very large, the traders in foreign exchange markets
stand to make huge profits or losses.
5. ROLE OF PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET: The major participants in the
exchange market are central banks, commercial banks, governments, foreign exchange Dealers,
multinational corporations that engage in international trade and investments, non-bank
financial institutions such as asset-management firms, insurance companies, brokers,
arbitrageurs and speculators.
a. The central banks participate in the foreign exchange markets, not to make profit, but
essentially to contain the volatility of exchange rate to avoid sudden and large appreciation
or depreciation of domestic currency and to maintain stability in exchange rate in keeping
with the requirements of national economy. If the domestic currency fluctuates excessively,
it causes panic and uncertainty in the business world.
b. The commercial banks participate in the foreign exchange market either on their own
account or for their clients. When they trade on their own account, banks may operate
either as speculators or arbitrageurs/or both. The bulk of currency transactions occur in the
interbank market in which the banks trade with each other.
c. Foreign exchange brokers participate in the market as intermediaries between different
dealers or banks.
i) Arbitrageurs make profit by discovering price differences between pairs of currencies
with different dealers or banks.
ii) Speculators, who are bulls or bears, are deliberate risk-takers who participate in the
market to make gains which result from unanticipated changes in exchange rates.
iii) Other participants in the exchange market are individuals who form only a very
insignificant fraction in terms of volume and value of transactions.
Note:
i) Regardless of physical location, and given that the markets are highly integrated, at any
given moment, all markets tend to have the same exchange rate for a given currency.
This phenomenon occurs because of arbitrage.
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ii) Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price
differences of an asset at different dealing locations. There is potential for arbitrage in
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the forex market if exchange rates are not consistent between currencies.
iii) When price differences occur in different markets, participants purchase foreign
exchange in a low-priced market for resale in a high-priced market and makes profit in
this process. Due to the operation of price mechanism, the price is driven up in the low-
priced market and pushed down in the high-priced market.
iv) This activity will continue until the prices in the two markets are equalized, or until they
differ only by the amount of transaction costs involved in the operation. Since forex
markets are efficient, any profit spread on a given currency is quickly arbitraged away.
6. In the foreign exchange market, there are two types of transactions:
a. Current transactions which are carried out in the spot market and the exchange involves
immediate delivery, and
b. Future transactions wherein contracts are agreed upon to buy or sell currencies for future
delivery which are carried out in forward and/or futures markets
c. Exchange rates prevailing for spot trading (for which settlement by and large takes two days)
are called spot exchange rates. The exchange rates quoted in foreign exchange transactions
that specify a future date are called forward exchange rates. The currency forward contracts
are quoted just like spot rate; however, the actual delivery of currencies takes place at the
specified time in future.
d. When a party agrees to sell euro for dollars on a future date at a forward rate agreed upon,
he has ‘sold euros forward’ and ‘bought dollars forward’. A forward premium is said to occur
when the forward exchange rate is more than a spot exchange rates. On the contrary, if the
forward trade is quoted at a lower rate than the spot rate, then there is a forward discount.
e. Currency futures, though conceptually similar to currency forward and perform the same
function, they are distinct in their nature and details concerning settlement and delivery.
f. While a foreign exchange transaction can involve any two currencies, most transactions
involve exchanges of foreign currencies for the U.S. dollars even when it is not the national
currency of either the importer or the exporter. On account of its critical role in the forex
markets, the dollar is often called a ‘vehicle currency’.
Q.NO.9 HOW THE NOMINAL EXCHANGE RATE IS DETERMINED?

ANSWER:
NOMINAL EXCHANGE RATE: Usually, the supply of and demand for foreign exchange in the
domestic foreign exchange market determine the external value of the domestic currency, or in
other words, a country’s exchange rate.
Individuals, institutions and governments participate in the foreign exchange market for a number
of reasons.
1. On the demand side, people desire foreign currency to:
a. purchase goods and services from another country
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b. for unilateral transfers such as gifts, awards, grants, donations or endowments

c. to make investment income payments abroad
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d. to purchase financial assets, stocks or bonds abroad
e. to open a foreign bank account
f. to acquire direct ownership of real capital, and
g. for speculation and hedging activities related to risk-taking or risk- avoidance activity
2. The participants on the supply side operate for similar reasons. Thus, the supply of foreign
currency to the home country results from
a. purchases of home exports,
b. unilateral transfers to home country,
c. investment income payments,
d. foreign direct investments and portfolio investments,
e. placement of bank deposits and speculation.
3. Determination of Nominal Exchange Rate
a. The equilibrium rate of exchange is determined by the interaction of the supply and demand
for a particular foreign currency.
b. In the above graph, the demand curve (D$) and supply curve (S$) of dollars intersect to
determine equilibrium exchange rate eeq with Qe as the equilibrium quantity of dollars
exchanged.
Q.NO.10 HOW TO DETERMINE CHANGES IN EXCHANGE RATES?

ANSWER:
A. CHANGES IN EXCHANGE RATES:
Changes in Exchange Rates portray depreciation or appreciation of one currency. The terms,
Rs.currency appreciation’ and ‘currency depreciation’ describe the movements of the exchange
rate. Currency appreciates when its value increases with respect to the value of another
currency or a basket of other currencies. On the contrary, currency depreciates when its value
falls with respect to the value of another currency or a basket of other currencies.
For example, the Rupee dollar exchange rate in the month of January is $1 = Rs. 70. And, we find
that in the month of April it is $1 = Rs. 75.
In April, you will have to exchange a greater amount of Indian Rupees (Rs.75) to get the same 1
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unit of US dollar. As such, the value of the Indian Rupee has gone down or Indian Rupee has
depreciated in its value. Rupee depreciation here means that the rupee has become less valuable
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with respect to the U.S. dollar.
Simultaneously, if you look at the value of dollar in terms of Rupees, you find that the value of
the US dollar has increased in terms of the Indian Rupee. One dollar will now fetch Rs.75 instead
of Rs.70 earlier. This is called appreciation of the US dollar.
Note: When one currency depreciates against another, the second currency must
simultaneously appreciate against the first.
B. Home-currency depreciation (or foreign-currency appreciation) takes place when there is an
increase in the home currency price of the foreign currency (or, alternatively, a decrease in the
foreign currency price of the home currency). The home currency thus becomes relatively less
valuable.
C. Home-currency appreciation (or foreign-currency depreciation) takes place when there is a
decrease in the home currency price of foreign currency (or alternatively, an increase in the
foreign currency price of home currency). The home currency thus becomes relatively more
valuable.
D. Home-Currency Depreciation under Floating Exchange Rates: Under a floating rate system, if
for any reason, the demand curve for foreign currency shifts to the right representing increased
demand for foreign currency, and supply curve remains unchanged, then the exchange value of
foreign currency rises and the domestic currency depreciates in value.
Home-Currency Depreciation under Floating Exchange Rates
Analysis:
1. The market initially is in equilibrium at point E with equilibrium exchange rate e eq.
2. An increase in domestic demand for the foreign currency, with supply of dollars remaining
constant, is represented by a rightward shift of the demand curve to D1$.
3. The equilibrium exchange rate rises to e1. This indicates that more units of domestic
currency (here Indian Rupees) are required to buy one unit of foreign currency (here dollar)
and that the domestic currency (the Rupee) has depreciated.
E. Home-Currency Appreciation under Floating Exchange Rates
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Analysis
An increase in the supply of foreign exchange shifts the supply curve to the right to S1 $ and as a
consequence, the exchange rate declines to e1. It means, that lesser units of domestic currency
(here Indian Rupees) are required to buy one unit of foreign currency (dollar), and that the
domestic currency (the Rupee) has appreciated.
F. Conclusion: As we are aware, in an open economy, firms and households use exchange rates to
translate foreign prices in terms of domestic currency. Exchange rates also permit us to compare
the prices of goods and services produced in different countries. Furthermore, import or export
prices could be expressed in terms of the same currency in the trading contract. This is the
reason why exchange rate movements can affect intentional trade flows.
Q.NO.11 DIFFERENTIATE DEVALUATION AND DEPRECIATION, REVALUATION AND APPRECIATION?

ANSWER:
A. DEVALUATION VS DEPRECIATION
1. Devaluation is a deliberate downward adjustment in the value of a country's currency
relative to another country’s currency or group of currencies or standard.
2. It is a monetary policy tool used by countries that have a fixed exchange rate or nearly fixed
exchange rate regime and involves a discrete official reduction in the otherwise fixed par
value of a currency.
3. The monetary authority formally sets a new fixed rate with respect to a foreign reference
currency or currency basket.
4. In contrast, depreciation is a decrease in a currency's value (relative to other major currency
benchmarks) due to market forces of demand and supply under a floating exchange rate and
not due to any government or central bank policy actions.
B. REVALUATION VS APPRECIATION
1. Revaluation is the opposite of devaluation and the term refers to a discrete official increase
of the otherwise fixed par value of a nation’s currency.
2. Appreciation, on the other hand, is an increase in a currency's value (relative to other major
currencies) due to market forces of demand and supply under a floating exchange rate
and not due to any government or central bank policy interventions.
Q.NO.12 DISCUSS THE IMPACTS OF EXCHANGE RATE FLUCTUATIONS ON DOMESTIC ECONOMY?

ANSWER:
IMPACTS OF EXCHANGE RATE FLUCTUATIONS ON DOMESTIC ECONOMY
The developments in the foreign exchange markets affect the domestic economy both directly and
indirectly. The direct impact of fluctuations in rates is initially felt by economic agents who are
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directly involved in international trade or international finance. In judging the impacts of exchange
rate fluctuations, it becomes, therefore, necessary to evaluate their effects on trade, investments,
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consumption output, economic growth and inflation.
1. IMPACT ON TRADE: Exchange rates have a very significant role in determining the nature and
extent of a country's trade. Changes in import and export prices will lead to changes in import
and export volumes, causing changes in import spending and export revenue.
2. IMPACT OF FLUCTUATIONS IN THE EXCHANGE RATE AFFECT THE ECONOMY BY CHANGING THE
RELATIVE PRICES OF DOMESTICALLY-PRODUCED AND FOREIGN-PRODUCED GOODS AND
SERVICES.
a. All else equal (or other things remaining the same), an appreciation of a country’s currency
raises the relative price of its exports and lowers the relative price of its imports. Conversely,
depreciation lowers the relative price of a country’s exports and raises the relative price of
its imports.
b. When a country’s currency depreciates, foreigners find that its exports are cheaper and
domestic residents find that imports from abroad are more expensive. An appreciation has
opposite effects i.e., foreigners pay more for the country’s products and domestic
consumers pay less for foreign products.
For example; assume that there is devaluation or depreciation of Indian Rupee from
$1=Rs.65/ to $1=Rs.70/. A foreigner who spends ten dollars on buying Indian goods will, post
devaluation, get goods worth Rs..700/ instead of Rs.650/ prior to depreciation. An importer
has to pay for his purchases in foreign currency, and, therefore, a resident of India, who
wants to import goods worth $1 will have to pay Rs.70/ instead of Rs.65/ prior to
depreciation.
c. Importers will be affected most as they will have to pay more rupees on importing products.
On the contrary, exporters will be benefitted as goods exported abroad will fetch dollars
which can now be converted to more rupees.
3. EXCHANGE RATE CHANGES AFFECT ECONOMIC ACTIVITY IN THE DOMESTIC ECONOMY.

a. A depreciation of domestic currency primarily increases the price of foreign goods relative to
goods produced in the home country and diverts spending from foreign goods to domestic goods.
b. Increased demand, both for domestic import-competing goods and for exports, encourages
economic activity and creates output expansion.
c. Overall, the outcome of exchange rate depreciation is an expansionary impact on the
economy at an aggregate level.
d. The positive effect of currency depreciation, however, largely depends on whether the switching
of demand has taken place in the right direction and in the right amount, as well as on the
capacity of the home economy to meet that increased demand by supplying more goods.
4. IMPACT OF EXCHANGE RATES ON REAL INCOME:

a. By lowering export prices, currency depreciation increase the international competitiveness
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of domestic industries, the volume of exports and promotes trade balance. However, a point
to be noted is that the price changes in exports and imports may counterbalance or offset
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each other only if trade is in balance and terms of trade are not changed.
b. In case the country’s imports exceed exports, the net result is a reduction in real income
within the country.
5. IMPACT ON EMPLOYMENT: For an economy where exports are significantly high, a depreciated
currency would mean a lot of gain. In addition, if exports originate from labour- intensive
industries, increased export prices will have positive effect on employment and potentially on
wages.
6. IMPACT ON INFLATION:
a. Depreciation is also likely to add to consumer price inflation in the short run, directly through
its effect on prices of imported consumer goods and also due to increased demand for
domestic goods.
b. The impact will be greater if the composition of domestic consumption baskets consists
more of imported goods. Indirectly, cost push inflation may result through possible
escalation in the cost of imported inputs.
c. In such an inflationary situation, the central bank of the country will have no incentive to cut
policy rates as this is likely to increase the burden of all types of borrowers including
businesses.
7. IMPACT ON FACTORS OF PRODUCTION:
a. When a country’s currency depreciates, production for exports and of import substitutes
become more profitable. Therefore, factors of production will be induced to move into the
tradable goods sectors and out of the non- tradable goods sectors.
b. The reverse will be true when the currency appreciates. These types of resource movements
involve economic wastes.
8. IMPACT ON TERMS OF TRADE:
a. A depreciation or devaluation is also likely to affect a country’s terms of trade (Terms of
trade is the ratio of the price of a country’s export commodity to the price of its import
commodity).
b. Since the prices of both exports and imports rise in terms of the domestic currency as a
result of depreciation or devaluation, the terms of trade of the nation can rise, fall or remain
unchanged, depending on whether price of exports rises by more than, less than or same
percentage as the price of imports.
9. IMPACT ON CURRENT ACCOUNT BALANCE:
a. The fiscal health of a country whose currency depreciates is likely to be affected with rising
export earnings and import payments and consequent impact on current account balance.
b. A widening current account deficit is a danger signal as far as growth prospects of the overall
economy is concerned.
c. If export earnings rise faster than the imports spending then current account balance will
improve.
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10. IMPACT ON EXTERNAL COMMERCIAL BORROWINGS:

a. Companies that have borrowed in foreign exchange through external commercial
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borrowings (ECBs) but have been careless and did not sufficiently hedge these loans against
foreign exchange risks, would also be negatively impacted as they would require more
domestic currency to repay their loans.
b. A depreciated domestic currency would also increase their debt burden and lower their
profits and impact their balance sheets adversely. These would signal investors who will be
discouraged from investing in such companies.
11. IMPACT ON PUBLIC DEBT IN FOREIGN CURRENCY: Countries with foreign currency denominated
government debts, currency depreciation will increase the interest burden and cause strain to
the exchequer for repaying and servicing foreign debt. Fortunately, India’s has small proportion
of public debt in foreign currency.
12. IMPACT ON FINANCIAL FORECASTING: Exchange rate fluctuations make financial forecasting
more difficult for firms and larger amounts will have to be earmarked for insuring against
exchange rate risks through hedging.
13. IMPACT ON PATTERNS OF INTERNATIONAL CAPITAL FLOWS:
a. With growth of investments across international boundaries, exchange rates have assumed
special significance. Investors who have purchased a foreign asset, or the corporation which
floats a foreign debt, will find themselves facing foreign exchange risk.
b. Exchange rate movements have become the single most important factor affecting the value
of investments at international level. They are critical to business volumes, profit forecasts,
investment plans and investment outcomes.
c. Depreciating currency hits investor sentiments and has radical impact on patterns of
international capital flows.
14. IMPACT ON FOREIGN CAPITAL INFLOWS:
a. Foreign investors are likely to be indecisive or highly cautious before investing in a country
which has high exchange rate volatility.
b. Foreign capital inflows are characteristically vulnerable when local currency weakens.
Therefore, foreign portfolio investment flows into debt and equity as well as foreign direct
investment flows are likely to shrink.
c. This shoots up capital account deficits affecting the country’s fiscal health. If investor
sentiments are such that they anticipate further depreciation, there may be large scale
withdrawal of portfolio investments and huge redemptions through global exchange traded
funds leading to further depreciation of domestic currency.
d. This may result in a highly volatile domestic equity market affecting the confidence of
domestic investors. Reduced foreign investments also widen the gap between investments
required for growth and actual investments. Over a period of time, unemployment is likely to
mount in the economy.
15. OTHER IMPACTS: With increasing dependence on imports, Indian economy has always felt the
brunt of higher international prices of fuel impacting domestic transportation and overall cost of
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production which often triggered inflation, increase in oil and fertilizer subsidy bills, costly
foreign travel, escalated foreign debt service payments and higher outstanding external
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commercial borrowings (or ECB) and government’s foreign debt.
The other impacts of currency depreciation are:
a) Windfall gains for export-oriented sectors (such as IT sector, textile, pharmaceuticals, gems
and jewellery in the case of India) because depreciating currency fetches more domestic
currency per unit of foreign currency.
b) Remittances to homeland by non-residents and businesses abroad fetches more in terms of
domestic currency
c) Depreciation would enhance government revenues from import related taxes, especially if
the country imports more of essential goods
d) Depreciation would result in higher amount of local currency for a given amount of foreign
currency borrowings of government.
e) Depreciation also can have a positive impact on country’s trade deficit as it makes imports
more expensive for domestic consumers and exports cheaper for foreigners.
f) Depreciation also can have a positive impact on controlling spiralling gold imports (mostly
wasteful) and thereby improve trade balance.
Q.NO.13 DISCUSS THE IMPACTS OF EXCHANGE RATE FLUCTUATIONS WITH RESPECT TO

APPRECIATION OF CURRENCY ON DOMESTIC ECONOMY?
ANSWER:
An appreciation of currency or a strong currency (or possibly an overvalued currency) makes the
domestic currency more valuable and, therefore, can be exchanged for a larger amount of foreign
currency.
An appreciation will have the following consequences on real economy:
1. IMPACT ON EXPORTS AND IMPORTS:
a. An appreciation of currency raises the price of exports and, therefore, the quantity of
exports would fall. Since imports become cheaper, we may expect an increase in the
quantity of imports.
b. Combining these two effects together, the domestic aggregate demand falls and, therefore,
economic growth is likely to be negatively impacted.
2. IMPACT ON BUSINESS CYCLE: The outcome of appreciation also depends on the stage of the
business cycle as well.
a. If appreciation sets in during the recessionary phase, the result would be a further fall in
aggregate demand and higher levels of unemployment.
b. If the economy is facing a boom, an appreciation of domestic currency would trim down
inflationary pressures and soften the rate of growth of the economy.
3. IMPACT ON INFLATION:
a. An appreciation may cause reduction in the levels of inflation because imports are cheaper.
Lower price of imported capital goods, components and raw materials lead to decrease in
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cost of production which reflects on decrease in prices.

b. Additionally, decrease in aggregate demand tends to lower demand pull inflation. Living
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standards of people are likely to improve due to availability of cheaper consumer goods.
4. IMPACT ON TECHNOLOGICAL INNOVATIONS AND CAPITAL-INTENSIVE PRODUCTION: With
increasing export prices, the competitiveness of domestic industry is adversely affected and
therefore, firms have greater incentives to introduce technological innovations and capital-
intensive production to cut costs to remain competitive.
5. IMPACT ON CURRENT ACCOUNT:
a. Increasing imports and declining exports are liable to cause larger deficits and worsen the
current account. However, the impact of appreciation on current account depends upon the
elasticity of demand for exports and imports.
b. Relatively inelastic demand for imports and exports may lead to an improvement in the
current account position. Higher the price elasticity of demand for exports, greater would be
the fall in demand and higher will be the fall in the aggregate value of exports. This will
adversely affect the current account balance.
6. IMPACT ON COMPETITIVENESS: Loss of competitiveness will be insignificant if currency
appreciation is because of strong fundamentals of the economy.
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Q.NO.1 Explain the implications of the following on the demand and supply of foreign exchange
and the exchange rate in spot foreign exchange market.
i) Merry Land’s exports remained more or less stagnant in the years 2005-06 to 2016-17.
However, due to heavy thrust on industrialization, import of machinery, raw materials and
components as well as associated services of different types increased.
ii) The investors of Merry Land find investments in financial assets in UK highly attractive and the
government of Merry Land which has a liberal attitude on foreign investments permits such
investments.
iii) Many foreign investors who had previously acquired Roseland ’s financial assets sell them.
iv) Effect on Country Y if Country X borrows $ 100 billion from country Y
ANSWER:
i) Higher demand in Merry Land for foreign exchange (say $) to make development imports for
industrialization; coupled with no proportionate increase in supply on account of meagre inflow
of foreign exchange consequent on stagnant exports for more than a decade, lead to rise in
exchange rate and depreciation in the value of domestic currency.
ii) Increased demand for foreign exchange in Australia; the domestic currency depreciates.
iii) Increased demand for foreign exchange; Roseland’s domestic currency depreciates
iv) International capital outflow: demand for foreign currency-outflow of foreign exchange,
depreciation of domestic currency
Q.NO.2 Explain how the exchange rate value of Indian Rupee will be affected in each of the
following cases. What are the possible consequences on exports and imports?
i) The spot exchange rate changes from Rs.61/ 1$ toRs.64/1$
ii) The spot exchange rate changes from Rs.66/ 1$ toRs.63/1$
ANSWER:
i) The spot exchange rate changes from Rs.61/ 1$ to Rs.64/1$. It implies depreciation of Rupee and
appreciation of Dollar. Exports become cheaper and more attractive to foreigners; imports will
be discouraged as they become costlier to import.
ii) The spot exchange rate changes from Rs.66/ 1$ to Rs.63/1$. This means that Rupee has
appreciated in value and dollar has depreciated. Exports become costlier and so demand for
Indian exports may fall; imports become cheaper.
Q.NO.3 In 1983 Australia decided to float its dollar. Assuming free trade, explain the effects of
each of the following on the spot exchange rate between AUD and USD.
(i) There is a substantial increase demand in Australia for US exports of services. Since Australia
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manufactures were favoured over others, there is a proportionate increase in exports of

Australian products to the US.
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(ii) Investors in Australia perceive that the returns on investments in the US would be much more
lucrative than elsewhere. As a result there is a huge increase in demand for investments in US
dollar denominated financial investments
(iii) Political uncertainties in the US due to presidential elections caused large scale shift of
Australian financial investments back in to Australia
(iv) An epidemic in some parts of Australia made the US evoke SPS measures and ban the entry of
a number of food items to the US
ANSWER:
i) The spot exchange rate between AUD and USD will not be affected as increased demand for
foreign currency in each country will be matched by a proportionate increase in the supply of
foreign exchange.
ii) Investors in Australia would demand more USD for making dollar denominated financial
investments in the US. Supply of US dollars remaining the same, being in floating rate, AUD will
depreciate and USD will appreciate.
iii) Large scale shift of Australian financial investments back to home due to political uncertainties in
the US would result in large scale sale of financial assets and capital outflow from the US. This
will lead to more inflow of US dollars to Australia and demand remaining the same, depreciation
in the value of USD viz a viz AUD.
iv) Ban of exports to the US reduces USD inflows to Australia; Supply of USD decreases and demand
for USD remaining the same, AUD may depreciate.
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4.5. INTERNATIONAL CAPITAL MOVEMENTS
Q.NO.1 DEFINE FOREIGN CAPITAL? STATE THE COMPONENTS OF FOREIGN CAPITAL FLOWS?
ANSWER:
FOREIGN CAPITAL: The term 'foreign capital' is a comprehensive one and includes any inflow of
capital into the home country from abroad and therefore, we need to be clear about the distinction
between movement of capital and foreign investment. Foreign capital may flow into an economy in
different ways.
Some of the important components of foreign capital flows are:
1. Foreign aid or assistance which may be:
a. Bilateral or direct inter government grants.
b. Multilateral aid from many governments who pool funds with international organizations
like the World Bank.
c. Tied aid with strict mandates regarding the use of money or untied aid where there are no
such stipulations
d. Foreign grants which are voluntary transfer of resources by governments, institutions,
agencies or organizations.
2. Borrowings which may take different forms such as:
a. Direct inter government loans
b. Loans from international institutions (e.g. world bank, IMF, ADB)
c. Soft loans for e.g. from affiliates of World Bank such as IDA
d. External commercial borrowing, and
e. Trade credit facilities
3. Deposits from non-resident Indians (NRI)
4. Investments in the form of:
a. Foreign portfolio investment (FPI) in bonds, stocks and securities, and
b. Foreign direct investment (FDI) in industrial, commercial and similar other enterprises
Q.NO.2 EXPLAIN BREIFLY ABOUT FOREIGN DIRECT INVESTMENT?

ANSWER:
International investments are of two types namely, Foreign Direct Investment (FDI) and Foreign
Portfolio Investment (FPI).
A. FOREIGN DIRECT INVESTMENT (FDI)
1. Foreign direct investment (FDI) refers to the act of acquisition or construction of physical
capital by a firm from one (source) country in another (host) country. The term sometimes
refers to the flow per unit time, and sometimes to the accumulated stock of capital.
2. It is defined as a process whereby the resident of one country (i.e. home/source country)
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acquires ownership of an asset in another country (i.e. the host country) and such
movement of capital involves ownership, control as well as management of the asset in the
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host country.
B. Foreign direct investment (FDI), according to IMF manual on 'Balance of payments'
1. It is "all investments involving a long-term relationship and reflecting a lasting interest and
control of a resident entity in one economy in an enterprise resident in an economy other
than that of the direct investor”.
2. This typically occurs through acquisition of more than 10 percent of the shares of the target
asset.
3. Direct investment comprises not only the initial transaction establishing the relationship
between the investor and the enterprise, but also all subsequent transactions between them
and among affiliated enterprises, both incorporated and unincorporated.
C. According to the IMF and OECD definitions,
1. the acquisition of at least 10% of the ordinary shares or voting power in a public or private
enterprise by non- resident investors makes it eligible to be categorized as foreign direct
investment (FDI).
2. India also follows the same pattern of classification. FDI has three components, viz., equity
capital, reinvested earnings and other direct capital in the form of intra-company loans
between direct investors (parent enterprises) and affiliate enterprises.
D. FOREIGN DIRECT INVESTORS may be individuals, incorporated or unincorporated private or
public enterprises, associated groups of individuals or enterprises, governments or government
agencies, estates, trusts, or other organizations or any combination of the above-mentioned
entities.
E. The main forms of direct investments are:
1. The opening of overseas companies, including the establishment of subsidiaries or branches,
2. Creation of joint ventures on a contract basis,
3. Joint development of natural resources and
4. Purchase or annexation of companies in the country receiving foreign capital.
F. Direct investments are real investments in factories, assets, land, inventories etc. and involve
foreign ownership of production facilities. The investor retains control over the use of the
invested capital and also seeks the power to exercise control over decision making to the extent
of its equity participation. The lasting interest implies the existence of a long-term relationship
between the direct investor and the enterprise and a significant degree of influence by the
investor on the management of the enterprise.
G. CATEGORIES OF FDI: Based on the nature of foreign investments, FDI may be categorized as
horizontal, vertical or conglomerate.
1. A HORIZONTAL DIRECT INVESTMENT is said to take place when the investor establishes the
same type of business operation in a foreign country as it operates in its home country.
For example, a cell phone service provider based in the United States moving to India to
provide the same service.
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2. A VERTICAL INVESTMENT is one under which the investor establishes or acquires a business
activity in a foreign country which is different from the investor’s main business activity yet
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in some way supplements its major activity.
For example; an automobile manufacturing company may acquire an interest in a foreign
company that supplies parts or raw materials required for the company.
3. A CONGLOMERATE TYPE OF FOREIGN DIRECT INVESTMENT is one where an investor makes
a foreign investment in a business that is unrelated to its existing business in its home
country. This is often in the form of a joint venture with a foreign firm already operating in
the industry, as the investor has no previous experience.
4. Two- Way Direct Foreign Investments which are reciprocal investments between countries.
These investments occur when some industries are more advanced in one nation
For example, the computer industry in the United States), while other industries are more
efficient in other nations (such as the automobile industry in Japan).
Q.NO.3 EXPLAIN BREIFLY ABOUT FOREIGN PORTFOLIO INVESTMENT?

ANSWER:
A. FOREIGN PORTFOLIO INVESTMENT (FPI): Foreign portfolio investment is the flow of ‘financial
capital’ rather than ‘real capital’ and does not involve ownership or control on the part of the
investor.
Examples of foreign portfolio investment are
a. the deposit of funds in an Indian or a British bank by an Italian company,
b. the purchase of a bond (a certificate of indebtedness) of a Swiss company or the Swiss
government by a citizen or company based in France.
B. FEATURES OF FOREIGN PORTFOLIO INVESTMENT:
1. Unlike FDI, portfolio capital moves to investment in financial stocks, bonds and other
financial instruments and is effected largely by individuals and institutions through the
mechanism of capital market.
2. These flows of financial capital have their immediate effects on balance of payments or
exchange rates rather than on production or income generation.
3. Foreign portfolio investment (FPI) is not concerned with either manufacture of goods or with
provision of services. Such investors also do not have any intention of exercising voting
power or controlling or managing the affairs of the company in whose securities they invest.
4. The sole intention of a foreign portfolio investor is to earn a remunerative return through
investment in foreign securities and is primarily concerned about the safety of their capital,
the likelihood of appreciation in its value, and the return generated.
5. Logically, portfolio capital moves to a recipient country which has revealed its potential for
higher returns and profitability.
6. Following international standards, portfolio investments are characterised by lower stake in
companies with their total stake in a firm at below 10 percent. It is also noteworthy that
unlike the FDIs, these investments are typically of short-term nature, and therefore, are not
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intended to enhance the productive capacity of an economy by the creation of capital assets.
7. Portfolio investors will evaluate, on a separate basis, the prospects of each independent unit
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in which they might invest and may often shift their capital with changes in these prospects.
8. Therefore, portfolio investments are, to a large extent, expected to be speculative. Once
investor confidence is shaken, such capital has a tendency to speedily shift from one country
to another, occasionally creating financial crisis for the host country.
C. MODES OF FOREIGN DIRECT INVESTMENT (FDI): Foreign direct investments can be made in a
variety of ways, such as:
1. Opening of a subsidiary or associate company in a foreign country,
2. Equity injection into an overseas company,
3. Acquiring a controlling interest in an existing foreign company,
4. Mergers and acquisitions(M&A)
5. Joint venture with a foreign company.
6. Green field investment (establishment of a new overseas affiliate for freshly starting
production by a parent company).
7. Brownfield investments (a form of FDI which makes use of the existing infrastructure by
merging, acquiring or leasing, instead of developing a completely new one. For e.g. in India
100% FDI under automatic route is allowed in Brownfield Airport projects.
Q.NO.4 DIFFERENTIATE FOREIGN DIRECT INVESTMENT AND FOREIGN PORTFOLIO INVESTMENT?

ANSWER:
FOREIGN DIRECT INVESTMENT (FDI) VS FOREIGN PORTFOLIO INVESTMENT (FPI)
Foreign direct investment (FDI)Rs. Foreign portfolio investment (FPI)
Investment involves creation of physical assets Investment is only in financial assets
Has a long term interest and therefore remain Only short term interest and generally remain
invested for long invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology transfer Not accompanied by technology transfer
Direct impact on employment of labour and No direct impact on employment of labour and
wages wages
Enduring interest in management and control No abiding interest in management and control
Securities are held with significant degree of Securities are held purely as a financial
influence by the investor on the management investment and no significant degree of
of the enterprise influence on the management of the enterprise
Q.NO.5 STATE THE REASONS FOR FOREIGN DIRECT INVESTMENT?

ANSWER:
REASONS FOR FOREIGN DIRECT INVESTMENT
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Economic prosperity and the relative abundance of capital are necessary prerequisites for export of
capital to other countries. Many economies and organisations have accumulation of huge mass of
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reserve capital seeking profitable use. The primary aim of economic agents being maximisation of
their economic interests, the opportunity to generate profits available in other countries often
entices such entities to make investments in other countries.
The chief motive for shifting of capital between different regions or between different industries is
the expectation of higher rate of return than what is possible in the home country. Investment in a
host country may be considered as profitable by foreign firms because of some firm-specific
knowledge or assets (such as superior management skills or an important patent) that enable the
foreign firm to gainfully outperform the host country's domestic firms. There are many other
reasons (as listed below) for international capital movements which have found adequate empirical
support. Investments move across borders on account of:
1. The increasing interdependence of national economies and the consequent trade relations and
international industrial cooperation established among them
2. Internationalisation of production and investment of transnational corporations in their
subsidiaries and affiliates.
3. Desire to reap economies of large-scale operation arising from technological growth
4. Lack of feasibility of licensing agreements with foreign producers in view of the rapid rate of
technological innovations
5. Necessity to retain direct control of production knowledge or managerial skill (usually found in
monopolistic or oligopolistic markets) that could easily and profitably be utilized by corporations
6. Desire to procure a promising foreign firm to avoid future competition and the possible loss of
export markets
7. Risk diversification so that recessions or downturns may be experienced with reduced severity
8. Shared common language or common boundaries and possible saving in time and transport
costs because of geographical proximity
9. Necessity to retain complete control over its trade patents and to ensure consistent quality and
service or for creating monopolies in a global context
10. Promoting optimal utilization of physical, human, financial and other resources
11. Desire to capture large and rapidly growing high potential emerging markets with substantially
high and growing population
12. Ease of penetration into the markets of those countries that have established import restrictions
such as blanket bans, high customs duties or non-tariff barriers which make it difficult for the
foreign firm to sell in the host-country market by ‘getting behind the tariff wall’.
13. Lower environmental standards in the host country and the consequent relative savings in costs
14. Stable political environment and overall favourable investment climate in the host country
15. Higher degree of openness to foreign capital exhibited by the recipient country and the
prevalence of preferential investment systems such as special economic zones to encourage
direct foreign investments
16. The strategy to obtain control of strategic raw material or resource so as to ensure their
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uninterrupted supply at the lowest possible price; usually a form of vertical integration
17. Desire to secure access to minerals or raw material deposits located elsewhere and earn profits
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through processing them to finished form (Eg. FDI in petroleum)
18. The existence of low relative wages in the host country because of relative labour abundance
coupled with shortage and high cost of labour in capital exporting countries, especially when the
production process is labour intensive.
19. Lower level of economic efficiency in host countries and identifiable gaps in development
20. Tax differentials and tax policies of the host country which support foreign direct investment.
However, a low tax burden cannot compensate for a generally fragile and unattractive FDI
environment.
21. Inevitability of defensive investments in order to preserve a firm’s competitive position
22. High gross domestic product and high per capita income coupled with their high rate of growth.
There are also other philanthropic objectives such as strengthening of socio-economic infrastructure,
alleviation of poverty and maintenance of ecological balance of the host country, and prevalence of
high standards of social amenities and possibility of good quality of life in the host country
Q.NO.6 NAME THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT?

ANSWER:
HOST COUNTRY DETERMINANTS OF FOREIGN DIRECT INVESTMENT
Economic Determinants Policy Framework
Market -seeking FDI: a. Economic, political, and social stability Rules
a. Market size and per capita income regarding entry and operations
b. Market growth b. Standards of treatment of foreign affiliates
c. Access to regional and global markets c. Policies on functioning and structure of
d. Country-specific consumer preferences markets (e.g., regarding competition,
e. Structure of markets mergers)
Resource - or asset-seeking FDI: d. International agreements on FDI
a. Raw materials Privatization policy
b. Low -cost unskilled labor e. Trade policies and coherence of FDI and
c. Availability of skilled labor trade policies
d. Technological innovative, and other created f. Tax policy
assets (e.g., brand names) Business Facilitation
e. Physical infrastructure a. Investment promotion (including image
Efficiency -seeking FDI: building and investment- generating
a. Costs of above physical and human activities and investment- facilitation
resources and assets (including an services)
adjustment for productivity) b. Investment incentives
b. Other input costs (e.g., intermediate i) "Hassle costs" (related to corruption
products, transport costs) and administrative efficiency)
c. Membership of country in a regional ii) Social amenities (e.g., bilingual schools,
integration agreement, which could be quality of life)
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conducive to forming regional corporate iii) After-investment services

networks
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Q.NO.7 NAME THE FACTORS IN THE HOST COUNTRY DISCOURAGING INFLOW OF FOREIGN
INVESTMENTS?
ANSWER:
FACTORS IN THE HOST COUNTRY DISCOURAGING INFLOW OF FOREIGN INVESTMENTS ARE
a. Infrastructure lags
b. High rates of inflation
c. Balance of payment deficits
d. Poor literacy and low labour skills
e. Rigidity in the labour market
f. Bureaucracy and Corruption
g. Unfavourable tax regime
h. Cumbersome legal formalities and delays
i. Difficulties in contract enforcement
j. Land acquisition issues
k. Small size of market and lack of potential for its growth
l. Political instability
m. Absence of well-defined property rights
n. Exchange rate volatility
o. Poor track-record of investments
p. Prevalence of non-tariff barriers
q. Stringent regulations
r. Lack of openness
s. Language barriers
t. High rates of industrial disputes
u. Lack of security to life and property
v. Lack of facilities for immigration and employment of foreign technical and administrative
personnel
w. Double taxation
x. Lack of a general spirit of friendliness towards foreign investors.
Q.NO.8 WHAT ARE THE BENEFITS OF FOREIGN DIRECT INVESTMENTS?

ANSWER:
BENEFITS OF FOREIGN DIRECT INVESTMENT
1. COMPETITIVE ENVIRONMENT:
a. Entry of foreign enterprises usually fosters competition and generates a competitive
environment in the host country. The domestic enterprises are compelled to compete with
the foreign enterprises operating in the domestic market.
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b. This results in positive outcomes in the form of cost- reducing and quality-improving
innovations, higher efficiency and increasing variety of better products and services at lower
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prices ensuring wider choice and welfare for consumers.
2. EFFECT ON FACTORS OF PRODUCTION:
a. International capital allows countries to finance more investment than can be supported by
domestic savings.
b. The provision of increased capital to work with labour and other resources available in the
host country can enhance the total output/GDP (as well as output per unit of input) flowing
from the factors of production.
3. GROWTH AND ECONOMIC DEVELOPMENT:
a. From the perspective of emerging and developing countries, FDI can accelerate growth and
foster economic development by providing the much-needed capital, technological know-
how, management skills, marketing methods and critical human capital skills in the form of
managers and technicians.
b. The spill-over effects of the new technologies usually spread beyond the foreign
corporations. In addition, the new technology can clearly enhance the recipient country's
production possibilities.
4. POLITICAL AND STRUCTURAL REFORMS: Competition for FDI among national governments also
has helped to promote political and structural reforms important to attract foreign investors,
including legal systems and macroeconomic policies.
5. PRODUCTION BASE: Since FDI involves setting up of production base (in terms of factories,
power plants, etc.), it generates direct employment in the recipient country. Subsequent FDI as
well as domestic investments propelled in the downstream and upstream projects that come up
in multitude of other services, generate multiplier effects on employment and income/GDP.
6. EMPLOYMENT OPPURTUNITIES: FDI not only creates direct employment opportunities but also,
through backward and forward linkages, generate indirect employment opportunities. This
impact is particularly important if the recipient country is a developing country with an excess
supply of labour caused by population pressure.
7. WAGE LEVELS: Foreign direct investments also promote relatively higher wages for skilled jobs.
More indirect employment will be generated to people in the lower- end services sector
occupations thereby catering to an extent even to the less educated and unskilled persons
engaged in those units.
8. FOREIGN MARKETS: Foreign corporations provide better access to foreign markets. Unlike
portfolio investments, FDI generally entails people-to-people relations and is usually considered
as a promoter of bilateral and international relations. Greater openness to foreign capital leads
to higher national dependence on international investors, making the cost of discords higher.
9. PROMOTION OF ANCILLARY UNITS: There is also greater possibility for the promotion of
ancillary units resulting in job creation and skill development for workers.
10. PROMOTES EXPORTS: Foreign enterprises possessing marketing information with their global
network of marketing are in a unique position to utilize these strengths to promote the exports
235
of developing countries. If the foreign capital produces goods with export potential, the host
country is in a position to secure scarce foreign exchange needed to import capital equipments
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or materials to assist the country's development plans or to ease its external debt servicing.
11. IMPLEMENT EFFECTIVE TAX MEASURES: If the host country is in a position to implement
effective tax measures, the foreign investment projects also would act as a source of new tax
revenue which can be used for development projects.
12. ECONOMIES OF SCALE: It is likely that foreign investments enter into industries in which
economies of scale can be realized so that consumer prices may be reduced. Domestic firms
might not always be able to generate the necessary capital to achieve the cost reductions
associated with large-scale production.
13. MARKET POWER OF DOMESTIC MONOPOLIES: Increased competition resulting from the inflow
of foreign direct investments facilitates weakening of the market power of domestic monopolies
resulting in a possible increase in output and fall in prices.
14. BALANCE OF PAYMENT: Since FDI has a distinct advantage over the external borrowings, it is
considered to have a favourable impact on the host country’s balance of payment position, and
15. BETTER WORK CULTURE AND HIGHER PRODUCTIVITY: Better work culture and higher
productivity standards brought in by foreign firms may possibly induce productivity related
awareness and may also contribute to overall human resources development.
Q.NO.9 WHAT ARE THE POTENTIAL PROBLEMS ASSOCIATED WITH FOREIGN DIRECT INVESTMENT?
ANSWER:
Following are the general arguments put forth against the entry of foreign capital:
1. FDIs are likely to concentrate on capital-intensive methods of production and service so that
they need to hire only relatively few workers. Such technology is inappropriate for a labour-
abundant country as it does not support generation of jobs which is a crucial requirement to
address the two fundamental areas of concern for the less developed countries namely, poverty
and unemployment
2. The inherent tendency of FDI flows to move towards regions or states which are well endowed
in terms of natural resources and availability of infrastructure has the potential to accentuate
regional disparity. Foreign capital is also criticized for accentuating the already existing income
inequalities in the host country.
3. In the context of developing countries, it is usually alleged that the inflow of foreign capital may
cause the domestic governments to slow down its efforts to generate more domestic savings,
especially when tax mechanisms are difficult to implement. If the foreign corporations are able
to secure incentives in the form of tax holidays or similar provisions, the host country loses tax
revenues.
4. Foreign firms may partly finance their domestic investments by borrowing funds in the host
country's capital market. This action can raise interest rates in the host country and lead to a
decline in domestic investments through ‘crowding-out’ effect.
5. The expected benefits from easing of the balance of payments situation might remain unrealised
236
or narrowed down due to the likely instability in the balance of payments and the exchange rate.
a. FDI brings in more foreign exchange, improves the balance of payments and raises the value
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of the host country's currency in the exchange markets.
b. However, when imported inputs need to be obtained or when profits are repatriated, a
strain is placed on the host country's balance of payments and the home currency leading to
its depreciation.
c. Such instabilities jeopardize long-term economic planning. Foreign corporations also have a
tendency to use their usual input suppliers which can lead to increased imports.
d. Also, large scale repatriation of profits can be stressful on exchange rates and the balance of
payments.
6. Jobs that require expertise and entrepreneurial skills for creative decision making may generally
be retained in the home country and therefore the host country is left with routine management
jobs that demand only lower levels of skills and ability. The argument of possible human
resource development and acquisition of new innovative skills through FDI may not be realized
in reality.
7. High profit orientation of foreign direct investors tend to promote a distorted pattern of
production and investment such that production could get concentrated on items of elite and
popular consumption and on non- essential items.
8. Foreign entities are usually accused of being anti-ethical as they frequently resort to methods
like aggressive advertising and anticompetitive practices which would induce market distortions.
9. A large foreign firm with deep pockets may undercut a competitive local industry because of
various advantages (such as in technology) possessed by it and may even drive out domestic
firms from the industry resulting in serious problems of displacement of labour.
10. The foreign firms may also exercise a high degree of market power and exist as monopolists with
all the accompanying disadvantages of monopoly. The high growth of wages in foreign
corporations can influence a similar escalation in the domestic corporations which are not able
to cover this increase with growth of productivity. The result is decreasing competitiveness of
domestic companies which might prove detrimental to the long-term interests of industrial
development of the host country.
11. FDI usually involves domestic companies ‘off –shoring’, or shifting jobs and operations abroad in
pursuit of lower operating costs and consequent higher profits. This has deleterious effects on
employment potential of home country.
12. The continuance of lower labour or environmental standards in host countries is highly
appreciated by the profit seeking foreign enterprises. This is of great concern because efforts to
converge such standards often fail to receive support from interested parties.
13. At times, there is potential national security considerations involved when foreign firms function
in the territory of the host country, especially when acute hostilities prevail.
14. FDI may have adverse impact on the host country's commodity terms of trade (defined as the
price of a country's exports divided by the price of its imports). This could occur if the
investments go into production of export- oriented goods and the country is a large country in
237
the sale of its exports. Thus, increased exports drive down the price of exports relative to the
price of imports.
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15. FDI is also held responsible by many for ruthless exploitation of natural resources and the
possible environmental damage.
16. With substantial FDI in developing countries there is a strong possibility of emergence of a dual
economy with a developed foreign sector and an underdeveloped domestic sector.
17. Perhaps the most disturbing of the various charges levied against foreign direct investment is
that a large foreign investment sector can exert excessive amount of power in a variety of ways
so that there is potential loss of control by host country over domestic policies and therefore the
less developed host country’s sovereignty is put at risk. Mighty multinational firms are often
criticized of corruption issues, unduly influencing policy making and evasion of corporate social
responsibility.
Q.NO.10 EXPLAIN THE IMPACT OF FOREIGN DIRECT INVESTMENT IN INDIA?

ANSWER:
FOREIGN DIRECT INVESTMENT IN INDIA
1. FDI is an important monetary source for India's economic development. The import-substitution
strategy of industrialisation followed by India post- independence, stressed on an extremely
careful and selective approach while formulating FDI policy. Extensive controls imposed by the
government severely restricted the inflow of foreign capital to India.
2. The enactment of the Foreign Exchange Regulation Act (FERA), 1973 consolidated the regulatory
framework with stipulations of up to 40 % of foreign equity holding in a joint venture.
3. The Industrial Policy announcements of 1980 and 1982 and the Technology Policy Statement
(1983) provided for a moderately lenient attitude towards foreign investments by endorsement
of manufacturing exports as well as modernisation of industries through liberalised imports of
capital goods and technology.
4. This was supplemented by trade liberalisation measures in the form of tariff reduction and
shifting of large number of items from import licensing to Open General Licensing (OGL).
5. The most important shift in investment policy occurred when India embarked upon economic
liberalisation and reforms programme in 1991 to raise its growth potential and to integrate with
the world economy.
6. Further reforms in subsequent years put in place a series of measures directed towards
liberalizing foreign investments and for ensuring access to foreign technology and funding.
7. The government’s strategy favouring foreign investments and the prevalent robust business
environment have ensured that foreign capital keeps flowing into the country.
8. The government initiatives such as, automatic approval of FDI, simplification of procedures,
setting up of Foreign Investment Promotion Board (FIPB abolished w.e.f. May 2017), signing of
the Multilateral Investment Guarantee Agency Protocol for protection of foreign investments,
permitting use of foreign trade marks and brand names, 100% FDI in multitude of sectors ,
238
enactment of Foreign Exchange Management Act (FEMA)1999, passing of the SEZ Act in 2005,
Special Economic Zones (SEZ), support to mergers acquisitions, and green field investments,
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and encouragement to foreign technology collaboration agreements are a few such measures .
9. Apart from being a critical driver of economic growth, foreign direct investment (FDI) is a major
source of non-debt financial resource for the economic development of India. According to the
latest World Investment Report 2020 by UNCTAD, India jumped from 12th position in 2018 to
9th position in 2019 among the world’s largest FDI recipient.
10. According to the Reserve Bank of India Bulletin, July 2020,
a. The Gross Inflows/Gross Investments to India amounted to US$ 74390million.
b. The total direct investments India received during May 2020 is US$2535 million.
c. During the same period, the Foreign Direct Investment by India abroad amounted to US$ 519
million, making the Net Foreign Direct Investment US$ 2016 million.
d. During 2019- 20, India received the maximum FDI equity inflow from Singapore (US$ 14.67
billion), followed by Mauritius (US$ 8.24 billion), Netherlands (US$ 6.50 billion), USA (US$
4.22 billion) and Japan (US$ 3.22 billion).
e. The services sector (Finance, Banking, Insurance, Non-Finance/Business, Outsourcing, R&D,
Courier, Tech. Testing and Analysis, Other) attracted the highest amount of FDI with 17.45
percent of the total; followed by computer software & hardware (7.93%).
11. Currently, an Indian company may receive foreign direct investment either through ‘automatic
route’ without any prior approval either of the Government or the Reserve Bank of India or
through ‘government route’ with prior approval of the Government.
12. An Indian Company can receive foreign investment by issue of ‘FDI compliant instruments’
namely: equity shares, fully and mandatorily convertible preference shares and debentures,
partly paid equity shares and warrants. These have to be issued in accordance with the
provisions of the Companies Act, 2013 and the SEBI guidelines, as applicable.
13. All foreign investments are repatriable (net of applicable taxes) except in cases where the
investment is made or held on non-repatriation basis or where the sectoral condition specifically
mentions non-repatriation. Further, dividends/ profits (net of applicable taxes), on foreign
investments, being current income can be remitted outside India through an Authorised Dealer
bank. Only NRIs are allowed to set up partnership/ proprietorship concerns in India on non-
repatriation basis.
14. In India, foreign investment is prohibited in the following sectors:
a. Lottery business including Government / private lottery, online lotteries, etc.
b. Gambling and betting including casinos etc.
c. Chit funds
d. Nidhi company
e. Trading in Transferable Development Rights (TDRs)
f. Real Estate Business or Construction of Farm Houses
g. Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco
substitutes
239
h. Activities / sectors not open to private sector investment e.g. atomic energy and railway
operations (other than permitted activities).
Page
i. Foreign technology collaboration in any form including licensing for franchise, trademark,
brand name, management contract is also prohibited for lottery business and gambling and
betting activities.
15. CHANGES INTRODUCED IN THE FDI POLICY:
a. With the objective of making India the most open economy in the world for FDI and for
providing major impetus to employment and job creation, the FDI regime was radically
liberalized on 20-June-2016.
b. Changes introduced in the FDI policy include increase in sectoral caps, bringing more
activities under automatic route and easing of conditions for foreign investment. These
include easing of FDI in defence sector, e-commerce, in respect of food products
manufactured or produced in India, pharmaceuticals (Greenfield and Brownfield), airports
(both Greenfield and Brownfield), airport transport services, private security agencies,
animal husbandry, establishment of branch offices, liaison office or project office, teleports,
direct to home cable networks, mobile TV and head end-in-the sky broadcasting service and
single brand retail trading.
Q.NO.11 DISCUSS OVERSEAS DIRECT INVESTMENTBY INDIAN COMPANIES?

ANSWER:
OVERSEAS DIRECT INVESTMENTBY INDIAN COMPANIES
1. Integration of the Indian economy with the rest of the world is evident not only in terms of
higher level of FDI inflows but also in terms of increasing level of FDI outflows.
2. The overseas foreign direct investments by the Indian entrepreneurs are called Out-bound
investments.
3. Direct investment outside India means investments, either under the automatic route or the
government approval route, by way of contribution to the capital or subscription to the
memorandum of a foreign entity or by way of purchase of existing shares of a foreign entity
either by market purchase or private placement or through stock exchange, signifying a long-
term interest in the foreign entity (joint venture (JV) / wholly owned subsidiary (WOS).
a. Indian corporates can also invest overseas other than by way of direct investments. Listed
Indian companies can invest up to 50% of their net worth as on the date of the last audited
Balance Sheet in overseas companies, listed on a recognized stock exchange, or in the rated
debt securities issued by such companies.
b. Outbound investments from India have undergone substantial changes not only in terms of
size but also in terms of geographical spread and sectoral composition. The total financial
commitment (equity +loan+ guarantee issue) on outward Foreign Direct Investment
(OFDI) from India stood at US$ 805.86 million in the month of June, 2020.
c. The overseas investments have been primarily driven by resource seeking, market seeking or
technology seeking motives.
d. Many Indian IT firms like Tata Consultancy Services, Infosys, WIPRO, and Satyam acquired
240
global contracts and established overseas offices in developed economies to be close to their
key clients.
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e. Recently, there has been a surge in resource seeking overseas investments by Indian
companies, especially to acquire energy resources in Australia, Indonesia and Africa. Indian
entrepreneurs are also choosing investment destinations in countries such as Mauritius,
Singapore, British Virgin Islands, and the Netherlands on account of higher tax benefits they
provide.
f. At present, any Indian investor can make overseas direct investment in any bona- fide
activity except in certain real estate activities.
g. This has been made possible by progressive relaxation of the capital controls and
simplification of procedures for outbound investments from India.
For example, the annual overseas investment ceiling to establish joint ventures (JV) and
wholly owned subsidiaries has been raised to US$ 125,000 from US$ 75,000.
h. The RBI has also relaxed norms for foreign investment by Indian corporates by raising the
borrowing limit.
241
Page
Q.NO.1 Which of the following is FDI?
i) Claram Joe, a German investor buys 5000 shares of Ford, a US Automobile company.
ii) Annette D, the US Company acquires all the equity shares of Emeline & Co in Alice Land which
makes computer components.
iii) A Bulgarian investor Boryana Gergiev pays cash and buys 0.2 % of all outstanding equity
shares of Mariette company which makes computer peripherals
iv) Maansi Tech solutions purchase 52% stake in a Sarra, a Jamaican technology firm
v) Kora extends a loan to Christa Victorine, a power producing firm in which it holds 60 percent
of equity
vi) Augusta Corp lends pounds 10 million to Lee Sud, a Dutch parts making firm in which it holds
79 percent of equity
ANSWER:
i) Not FDI because less than 10 percent (which is the globally accepted criterion)
ii) FDI since 100 percent shares are bought
iii) Not FDI because an insignificant part of the total stake is acquired
iv) FDI because it involves more than 10 percent of the company’s shares.
v) FDI; lending to a company in which Kora has majority stake
vi) FDI refer (e)above
Q.NO.2
a. Labour group in your country oppose the flow of FDI into the country on grounds of perceived
inequities consequent on FDI. What are their arguments?
b. Beth & Sushil are members of the committee for resolution of the issue cited above. What
arguments would they put forth to convince the labour groups with respect to welfare
implications for labour that may arise from FDI?
ANSWER:
a) Foreign corporates concentrate on capital-intensive methods of production - so they need to
hire only relatively few workers, technology inappropriate for a labour-abundant country - does
not support generation of jobs or address poverty and unemployment- help accentuate the
already existing income inequalities- jobs that require expertise and entrepreneurial skills for
creative decision making may generally be retained in the home country and therefore the host
country is left with routine management jobs that demand only lower levels of skills and ability.
The argument of possible human resource development and acquisition of new innovative skills
through FDI may not be realized in reality- may resort to anti-ethical, and anticompetitive
practices- ‘off –shoring’, or shifting jobs – negative effects on employment potential of home
country- continuance of lower labour or environmental standards and ruthless labour and
242
natural resources exploitation.

Page
b) FDI will - accelerate growth and foster economic development – bring in technological know-
how, management skills and marketing methods- generate direct employment in the recipient
country- Subsequent FDI as well as domestic investments propelled in the downstream and
upstream projects that come up in multitude of other services generate multiplier effects on
employment and income- generate indirect employment opportunities-- promote relatively
higher wages for skilled jobs- more indirect employment will be generated to persons in the
lower-end services sector occupations thereby catering to an extent even to the less educated
and unskilled engaged in those units- Better work culture and higher productivity standards-
induce productivity related awareness and may also contribute to overall human resources
development.
THE END
243
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GROUP 2

ECONOMICS FOR FINANCE

*Applicable for November 2023 Exams Onwards

Q.NO.1 BREIFLY DISCUSS THE USEFULNESS AND SIGNIFICANCE OF NATIONAL INCOME

unit of money or it is evaluated at market prices.

b. second, market prices change.

deflator in year 1 x 100

company in UK would be excluded from GDP, but included in GNP.

Data requirements and Outcomes of Different Methods of National Income Calculation

of goods and services

Q.NO.5 EXPLAIN VALUE ADDED METHOD OR PRODUCT METHOD IN CALCULATING NATIONAL

Q.NO.6 EXPLAIN INCOME METHOD IN CALCULATING NATIONAL INCOME?

3. ITEMS TO BE INCLUDED AND EXLUDED:

excluded from national income.

Q.NO.7 EXPLAIN EPENDITURE METHOD IN CALCULATING NATIONAL INCOME?

consumption by the households, payments for domestic services which one

national product at factor cost (GNPFC).

Q.NO.8 EXPLAIN THE SYSTEM OF REGIONAL ACCOUNTS IN INDIA?

directly are known as the ‘Supra-regional sectors’ of the economy.

Years Nominal GDP Real GDP GDP Deflator

Nominal GDP =Real GDP × Price Index/100

Nominal GDP = 450 *120/100 = 540

Saving of non-departmental enterprises 10

Current transfers from government 35

Net factor income from abroad 80

Indirect taxes 335

Compensation of employees 800

Private final consumption expenditure 2,000

Factor income to abroad 80

Government Purchases 100

Inventory investment = 100)

+ Government purchases of goods arid services = 1000

Value of output in primary sector = 500

+Government Final Consumption Expenditure +550

+Net Domestic fixed Investment +385

Q.NO.2 EXPLAIN CIRCULAR FLOW IN A SIMPLE TWO-SECTOR MODEL STATED BY KEYNESIAN?

5. CIRCULAR FLOW IN A TWO SECTOR ECONOMY

economy exactly equals the amount produced in a given time period.

Q.NO.3 EXPLAIN THE CONCEPTS OF AGGREGATE DEMAND FUNCTION; AGGREGATE SUPPLY;

3. THE CONSUMPTION FUNCTION

The specific form of consumption–income relationship termed the consumption function,

where C = aggregate consumption expenditure; Y= total disposable income; a is a constant term

i.e. the increase in consumption per unit increase in disposable income.

ANALYSIS FROM ABOVE GRAPH:

Q.NO.4 EXPLAIN THE CONCEPTS OF MARGINAL PROPENSITY TO CONSUME; AVERAGE PROPENSITY

B. AVERAGE PROPENSITY TO CONSUME (APC)

APC = TOTAL CONSUMPTION/TOTAL INCOME= C/Y

D. THE MARGINAL PROPENSITY TO SAVE (MPS)

MPS = ∆S/∆Y = 1-b

E. AVERAGE PROPENSITY TO SAVE (APS)

APS = Total Saving/Total Income = S/Y

Q.NO.5 EXPLAIN THE DETERMINATION OF NATIONAL INCOME IN A TWO SECTOR MODEL?

expenditure schedule which is obtained by adding the autonomous expenditure component

4. Equilibrium with Unemployment or Inflation

Q.NO.6 EXPLAIN LEAKAGES AND INJECTIONS IN A CIRCULAR FLOW OF INCOME STATED BY

Q.NO.7 EXPLAIN DEFLATIONARY GAP IN A KEYNESIAN TWO SECTOR MODEL?

Deficient Demand - Deflationary Gap

Q.NO.8 EXPLAIN INFLATIONARY GAP IN A KEYNESIAN TWO SECTOR MODEL?

Q.NO.9 DEFINE THE TERM INVESTMENT MULTIPLIER?