(1). Explain how can interest rate & income be determined thought the IS-LM framework?

Ans : The equilibrium level of income is determined by the equality of planned savings &
planned investment. Thus in the goods market we get these following equations :
1. S = S(Y)
2. I = I(r)
3. S = I
When Savings equals investment we achieve Equilibrium in the product market. From this we
obtain the IS curve which is locus of various combinations of real interest rate & real national
income for which the goods market is in equilibrium.

Now , from the money market we get the following equations :

4.M^D = L¹(Y) + L²(r)

5.M^S = M(bar) / P(bar)
6.M(bar)/P(bar) = L¹(Y) + L²(r)
When money supply equals money demand the money market achieve Equilibrium. From this
we obtain the LM curve which is the locus of various companies of real interest rate & real
national income for which the money market is in equilibrium.

However we cannot determine the equilibrium level of income from the goods market alone &
similarly we cannot also determine the real rate of interest from the money market alone. There
is interdependency on both the markets & Equilibrium in both the markets have to be achieved
simultaneously. Now there can be several equilibrium pairs of Y and r for both money and
product market. But there is single pair of Y and r which emerges from the intersection of IS and
LM curves that ensures equilibrium in both money and product markets.

Equilibrium attained like this is also known as general equilibrium, since it establishes
equilibrium in the money market, bonds market and the product market.

Adjustment towards equilibrium assumes two things:

1. Interest rate changes according to the position of demand for and supply of money,
2. Income level changes according to the position of demand for output.
Edward Shapiro believes that in case of disequilibrium both the markets adjust simultaneously.
Whereas, William H. Branson is of the opinion that money markets adjust much faster than the
product market. The question how does an economy attain general equilibrium can be
examined with the help of following diagrams -
Point E shows general equilibrium. All the points left of LM curve take A, L & B indicate that at
their respective levels of income, rates of interest are higher than the rates required to establish
equilibrium in the money market. For instance, at A which has a pair of r0 and Y0, where r0 is
too high a rate of interest to establish equilibrium in the money market.

This is a situation of excess money supply over money demand. Rate of interest must fall to r1
to bring equilibrium in the money market. But at r1 (I + G) is so high that through multiplier
income would start rising beyond Y0. This rise in Y will increase the transaction demand for
money which would be shifted from speculative demand for money raising the interest rate. This
rise in r would reduce the private business investment, known as crowding out of investment,
lowering the income from Y1 level. Ultimately r2, and Y2 levels would settle and both the
markets would be in equilibrium at E. Similarly, at all points beyond IS curve output is more than
the aggregate demand I + G. Output will adjust according to demand. Thus a change in output
or income would change the transaction and speculative demand for money bringing thereby, a
change in the rate of interest. These changes will continue till r2 and Y2 levels are reached
establishing equilibrium in money, bond and product market. Naturally, a shift in either IS or LM
curve will bring a change in general equilibrium condition and will settle where the new IS and
LM curves are intersecting each other.

Initially the economy is in general equilibrium at E0 where LM0 and IS0 intersect each other
establishing r0K0 pair of interest rate and income level. Increase in money supply shifts the LM
curve to LM1 establishing r1 rate of interest at K0. As r falls to r1 investment will increase and
raise the multiplied income to Y1 in a static model where all changes are instant.

Increased Y will demand more money for transaction purposes which shall flow out of
speculative balances, r will rise and it will result into crowding out of private investment.
Ultimately, E1 point, the point of general equilibrium will be attained establishing r11 and Y11
levels or r and Y.

(2). What do you mean by inflation? What are the various types of inflation? What are the
causes of inflation? How can inflation be controlled?

Ans : Inflation may be defined as persistent rise in the general price level rather than once for all
increase in it.
The various types of inflation on the basis of rate or speed is as follows :

1. Creeping Inflation:
It is the mildest form of inflation. It is generally regarded as conducive to economic development
because it keeps the economy away from stagnation. But, some economists consider creeping
inflation as potentially dangerous. They are of the view that, if not properly controlled in time,
creeping inflation may assume alarming proportions. Under creep­ing inflation, prices rise about
2 per cent annually.

2. Walking Inflation:
Walking inflation occurs when the price rise becomes more marked as compared to creeping
inflation. Under walking inflation, prices rise approximately by 5 per cent annually.

3. Running Inflation :
Under running inflation, the prices increase at a still faster rate. The price rise may be about 10
per cent per annum.

4. Galloping inflation :
Under galloping inflation the prices rise by two or three digit rate per annum. A classical
example of galloping inflation is the post WW1 Germany where the price level shot over 200%
in the early 1920s.

5. Hyper inflation :
Hyper inflation is said to persist when the general price level increase at over three digit rate per
annum. Such inflation rate is extremely devastating for the country. Recent example of such
hyper inflation is Zimbabwe.
(or)
There are mainly two types of inflation on the basis of causes - Demand pull inflation (DPI) &
Cost push inflation (CPI). These are explained as follows :
(Sumon dadar notes chaipe dis)

The various causes of inflation are explained as follows :

1. Increase in Money Supply:

Inflation is caused by an increase in the supply of money which leads to increase in aggregate
demand. The higher the growth rate of the nominal money supply, the higher is the rate of
inflation. Modern quantity theorists do not believe that true inflation starts after the full
employment level. This view is realistic because all advanced countries are faced with high
levels of unemployment and high rates of inflation.

2. Increase in Public Expenditure:

Government activities have been expanding much with the result that government expenditure
has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods
and services. Governments of both developed and developing countries are providing more
facilities under public utilities and social services, and also nationalising industries and starting
public enterprises with the result that they help in increasing aggregate demand.

3. Increase in Consumer Spending:

The demand for goods and services increases when consumer expenditure increases.
Consumers may spend more due to conspicuous consumption or demonstration effect. They
may also spend more when they are given credit facilities to buy goods on hirepurchase and
instalment basis.

4. Deficit Financing:
In order to meet its mounting expenses, the government resorts to deficit financing by borrowing
from the public and even by printing more notes. This raises aggregate demand in relation to
aggregate supply, thereby leading to inflationary rise in prices. This is also known as
deficit-induced inflation.

5. Repayment of Public Debt:

Whenever the government repays its past internal debt to the public, it leads to increase in the
money supply with the public. This tends to raise the aggregate demand for goods and services
and to rise in prices.

6. Increase in Exports:
When the demand for domestically produced goods increases in foreign countries, this raises
the earnings of industries producing export commodities. These, in turn, create more demand
for goods and services within the economy, thereby leading to rise in the price level.

7. Natural Calamities :
Drought or floods is a factor which adversely affects the supplies of agricultural products. The
latter, in turn, create shortages of food products and raw materials, thereby helping inflationary
pressures.

8. Artificial Scarcities :
Artificial scarcities are created by hoarders and speculators who indulge in black marketing.
Thus they are instrumental in reducing supplies of goods and raising their prices.

9. Increase in Exports:
When the country produces more goods for export than for domestic consumption, this creates
shortages of goods in the domestic market. This leads to inflation in the economy.
10. International Factors:
In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial
countries, their effects spread to almost all countries with which they have trade relations. Often
the rise in the price of a basic raw material like petrol in the international market leads to rise in
the prices of all related commodities in a country.

Inflation is usually controlled by monetary & fiscal policy but sometimes other measures are also
used. This is explained as follows :

A. Monetary Measure : Monetary measure aim at reducing money incomes. Various tools of
monetary policy are as follows -

1. Credit Control :
One of the important monetary measures is monetary policy. The central bank of the country
adopts a number of methods to control the quantity and quality of credit. For this purpose, it
raises the bank rates, sells securities in the open market, raises the reserve ratio, and adopts a
number of selective credit control measures, such as raising margin requirements and
regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push
factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.

2. Demonetisation of Currency :
However, one of the monetary measures is to demonetise currency of higher denominations.
Such a measures is usually adopted when there is abundance of black money in the country.

3. Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old currency.
Under this system, one new note is exchanged for a number of notes of the old currency. The
value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an
excessive issue of notes and there is hyperinflation in the country. It is a very effective measure.
But is inequitable for its hurts the small depositors the most.

B. Fiscal measures : Monetary policy alone is incapable of controlling inflation. It should,

therefore, be supplemented by fiscal measures. Fiscal measures are highly effective for
controlling government expenditure, personal consumption expenditure, and private and public
investment. The principal fiscal measures are the following :

1.Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development activities in order
to curb inflation. This will also put a check on private expenditure which is dependent upon
government demand for goods and services. But it is not easy to cut government expenditure.
Though this measure is always welcome but it becomes difficult to distinguish between essential
and nonessential expenditure. Therefore, this measure should be supplemented by taxation.

2.Increase in Taxes:
To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so
high as to discourage saving, investment and production. Rather, the tax system should provide
larger incentives to those who save, invest and produce more. Further, to bring more revenue
into the tax-net, the government should penalise the tax evaders by imposing heavy fines. Such
measures are bound to be effective in controlling inflation. To increase the supply of goods
within the country, the government should reduce import duties and increase export duties.

3. Increase in Savings:
Another measure is to increase savings on the part of the people. This will tend to reduce
disposable income with the people, and hence personal consumption expenditure. But due to
the rising cost of living, people are not in a position to save much voluntarily. Keynes, therefore,
advocated compulsory savings or what he called ‘deferred payment’ where the saver gets his
money back after some years. For this purpose, the government should float public loans
carrying high rates of interest, start saving schemes with prize money, or lottery for long periods,
etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes,
etc. All such measures increase savings and are likely to be effective in controlling inflation.

C. Other Measures : The other types of measures are those which aim at increasing aggregate
supply and reducing aggregate demand directly these are :

1. Increasing production
2. Rational wage policy
3. Pice control
5. Rationing

(3). Explain the social cost of inflation.

Ans : Social cost of inflation may be understood under Anticipated inflation & Unanticipated
inflation.
(A)Cost of Anticipated are as follows -

1. Shoe-leather Costs :
This type of cost occurs because on account of inflation cost of holding money in the form of
currency (i.e., notes and coins) rises with the increase in inflation rate. Such cost arises
because no interest is paid on holding currency, while money kept in deposits with the bank or
used for keeping bonds earns interest. When inflation rate rises, the nominal interest rate on
bank deposits rises, the interest lost by holding currency by the people therefore increases. In
order to reduce the cost of holding currency people will tend to reduce their holdings of currency
for transaction purposes. Accordingly, at a time people will hold less currency with them and
keep as long as possible greater amount of money in bank deposits that yield interest.
Therefore, rather than withdrawing a large amount of currency from banks at a time, they will
withdraw less money which is sufficient for meeting daily expenses for a few days, say for a
week. But for doing so the people will make more trips to withdraw cash. More trips to a bank in
a month involves greater cost to the people. These costs have to be incurred on spending on
petrol if car is used for making trips, more wear and tear of car, the time spent for making a trip.
These costs of making more trips to the bank for withdrawing currency is metaphorically called
shoe-leather costs of inflation, as walking to banks more often one’s shoes wear out more
rapidly and one has to spend money on new shoes more often.

2. Menu Costs :
 The second type of anticipated inflation is menu costs, a term derived from a restaurant’s cost
of printing a new menu. Menu costs arise because high inflation requires them to change their
listed prices more often. Changing prices is somewhat more expensive because the firms have
to print new catalogues listing new prices and distribute them among their customers. They
have even to incur expenditure on advertisements to inform the public about their new prices.

3. Macroeconomic Inefficiency in Resource Allocation :

A third cost of inflation arises because firms having menu costs change their prices quite
infrequently. Given the reluctance to change prices frequently, the higher the rate of inflation, the
greater the variability in relative prices of a firm. Suppose a firm issues a new catalogue listing
prices of its products once in a year, say in the month of January of every year. If during the
year inflation occurs, there will be change in the relative prices of a firm to the general price
level. If inflation rate of one per cent per month takes place in a year the firm’s relative prices to
the general price level will fall by 12 per cent by the end of the year. As a result, his sales will
tend to be lower in the early part of the year (when its prices are relatively high) and higher in
the later part of the year (when its prices are relatively low). Thus when due to inflation relative
prices of a firm vary during a year as compared to the overall price level, it causes distortion in
production and therefore leads to microeconomic inefficiencies in resource allocation.

4. Inconvenience of Living :
Lastly, another social cost of inflation is the inconvenience of living in a world with a changing
price level. Money is the yardstick with which we measure the value of transactions. When
inflation is taking place the value of money changes and as a result it becomes difficult to
correctly estimate the value of transactions in real terms every time a transaction is made during
a year. The rising price level makes it difficult to make optimal decisions about saving and
investment and thus do the rational financial planning covering a long period of time. To quote
Mankiw, “A dollar saved today and invested at a fixed nominal interest rate will yield a fixed
dollar amount in the future. Yet the real value of that dollar amount – which will determine the
retiree’s living standard – depends on the future price level. Deciding how much to save would
be much simpler if people could count on the price level in 30 years being similar to its level
today.

(B)Cost of unanticipated inflation are as follows -

1. Redistribution of Wealth :
Unexpected inflation arbitrarily redistributes wealth from one group to another group, such as
from borrowers to lenders. When people decide to borrow money or lend money, they often
consider what they think the rate of inflation will be. When the rate of inflation is different than
anticipated, the amount of interest repaid or earned will also be different than what they
expected.
Lenders are hurt by unanticipated inflation because the money they get paid back has less
purchasing power than the money they loaned out.
Borrowers benefit from unanticipated inflation because the money they pay back is worth less
than the money they borrowed.
Similarly, unanticipated inflation harms the individuals, who retire on pensions fixed in rupee
terms. After some years of inflation, the real value or purchasing power of the fixed nominal
pension will greatly decline and will therefore reduce his standard of living in his old age.
(4). Explain the concept of Frictional unemployment , Structural unemployment & Cyclical
unemployment.

Ans :

1. Frictional Unemployment :
Frictional unemployment exists when there is lack of adjustment between demand for and
supply of labour. This may be due to lack of knowledge on the part of employers about the
availability of workers or on the part of workers that employment is available at a particular
place. It is also caused by lack of necessary skills for a particular job, labour immobility,
breakdowns of machinery, shortages of raw materials, etc. The period of unemployment
between losing one job and finding another is also included under frictional unemployment.

2. Structural unemployment :
Structural unemployment results from a variety of causes. It may be due to lack of the
co-operant factors of production, or chages in the economic structure of the society. The word
structural implies that “the economic changes are massive, extensive, deep-seated, amounting
to transformation of an economic structure, i.e., the production functions or labour supply
distribution. More specifically, it refers to changes which are large in the particular area, industry
or occupation.” Shifting patterns in the demand for the products of various industries have also
been responsible for this type of unemployment. There are, however, economists who argue
that the higher unemployment in America since 1957 has been due to causes other than
inadequae demand: (1) A faster rate of technological change; (2) a displaced worker remains
unemployed for a number of days in finding a new job; and (3) most of the unemployed workers
belong to blue-collar groups. The supporters of the structural transformation thesis hold that the
number of vacancies is greater than or equal to the number of displaced workers due to
structural changes in a particular area, industry or occupation, and that unemployment is not
due to inadequacy of demand.

3. Cyclical unemployment :
Cyclical unemployment arises due to cyclical fluctuations in the economy. They may also be
generated by international forces. A business cycle consists of alternating periods of booms and
depressions. It is during the downswing of the business cycle that income and output fall leading
to widespread unemployment.

(5). Explain the Aggregate Demand & it's components.

Ans : Aggregate demand is total demand by all the sectors of an economy for all final goods &
service at each prices. The components of aggregate demand are as follows :

1. Consumption spending (C) :

It is the largest component of an economy’s aggregate demand, and it refers to the total
spending of individuals and households on goods and services in the economy. Consumption
spending depends on disposable income.

2. Investment spending (I) :

It is the total expenditure on new capital goods and services such as machinery, equipment,
changes in inventories, investments in nonresidential structures, and residential structures.
Investment spending usually depends of interest rate.

3. Government Spending (G) :

It is the total amount of expenditure by the government on infrastructure, investments, defense
and military equipment, public sector facilities, healthcare services, and government employees.
It excludes the spending on transfer payments, such as pension plans, subsidies, and aid
transfers to other countries that are in need.

4. Net export (NX) :

It is different between exports of domestically produced goods & servics and imports of foreign
produced goods & services.