Macro Economics 10 Years

UNIT 1
INTRODUCTION
7322
,4.What is macroeconomics ? How does it differ from microeconomics?

Ans. Macroeconomics is the study of how the economy behaves in broad
outline. It is largely concerned with the behaviour of economic aggregates, such
as total nationalproduct, total investment, and exports for the entire economy
It is also concerned with the average price of all goods and services, rather
than the prices of specific products. These aggregates follows from activities in
many different markets and from the behaviour of different decision-makers
such as consumers, governments and firms.
In contrast, microeconomics deals with the behaviour of individual markets,
such as those for wheat, vegetable, computer or apples, and with the detailed
behaviour of individual agents, such as firms and consumers.
In macroeconomics we add together the value of all goods and services
produced and we study the aggregate national product. We also average the
prices of all goods and services consumed and find out the general price level
for the entire economy. Several price indices are calculated to show different
sections of the economy. In particular, we have three prices indices namely
Wholesale Price Index (WPI), Retail Price Index (RPI), and Implicit Price Deflator
(IPD). In general, Macroeconomics is about the aggregate phenomena such as
growth, business cycles, inflation, unemployment and the balance of payment,
Q. 2. What are the macroeconom s issues in an economy ?

Ans. Macroeconomics as a separate subject is required to study various
forces that affect the economy as a whole and that cannot be fully or partially
understood by analysing individual markets and individual products. The major
macroeconomic issues in an economy are summarised as follows:
1. Economic Growth: Economic growth is the predominant determinant of
living standards in an economy. It is measured with the help of rise in both
totaland per capita output over time. These long term rising trends provides
us with an indicator of rising average living standards and serves as a major
economic policy issue. It has been among the most important issue in
macroeconomics to identify policies that increase the chances that world-wide
growth will continue without serious recessions or slowdowns as happened in
1970s and 1980s.
2. Business Cycles: Most developing economies have overtime grown and
are moving towards relative prosperity. At the same time we find that economies
experience shorter episodes of what we call recessions Macroeconomics tries
to give an explanation for both i.e., how is it p0ssiblelfor an economy growing
steadily overtime to experience bouts of recession?The economy ternds to move
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in a series of ups and downs, called business cycles, rather than in a steady patter
and an understanding of business cycles and providing policies that coul
ld
reduce economic fluctuations is a subject matter of macroeconomics.
3 Jnfiation Rise in the level of economic activity have usually bee
peen
accompanied by a rise in inflation. During inílation the purchasing power of
money is eroded drastically, which requires government intervention. Generally
attempts by governments to control high inflation have tended to bring about
recessions. Therefore, an important policy problem for governments, which
forms a major issue of macroeconomics, is how to stimulate economic activity
without causing inflation. A balance between stimulus and contraction can be
achieved by an appropriate timing of policy interventions.
4 Lemployment : A decline in the level of economic activity causes an
increase in unemployment. During the great depression of 1930s there was a
widespread massive problem of unemeployment which characterized the whole
of world economy. Since then unemployment was
perceived as a central concern
of economics in general and a major issue in macroeconomics in
particular. The
primary method of reducing unemployment that economists devised early in
twentieth century was for governments to increase their
trends to obtain the desired outcomes in the
spending and reduce
economy. Such deliberate use of
government spending and taxes to influence the economy is known as fiscal
policy.
5. Government Budget Deficits : At one time it was perceived that budget
deficits have a positive impact on the
economy because government spending
created jobs and raises the level of economic
activity. But recently, there is a
concern about the
potential burden of the debt, the form of interest payments.
in
This also forms a major issue
whereby the conflict over the role of the
government budget is discussed as a policy issue.
6. Interest Rates: In addition to fiscal
to the government.
policy, monetary policy is also available
Monetary policy involves changing interest rates, or the
money supply, in order to influence the economy. High interest rates reduce
the demand in the economy and low interest rates tend to
stimulate demand.
Another important channel of
monetary policy through the exchange
is
rates, especially flexible exchange rates.
Exchange rate changes affect the relative
prices and thereby the competitiveness, of domestic and
foreign producers.
UNIT 2
NATIONAL INCOME ACCOUNTING
QA. How is GDP computed using the method of Value added?

Or
What is the problem of double counting and how can it be avoided?
Ans. Value added: Production occurs in various stages : some firms produce
outputs that are used as inputs by the other firms, and these other firms in turn
produce outputs that are used as inputs by yet other firms. For example-A
maker of shirts buys cloth from a textile manufacturer and buttons, zips, thread,
pins, hangers etc. from a range of other producers.
If we merely add up the market value of all outputs of all firms, we would
obtain a total that was greatly in excess of the value of the economy's actual
output. The error that would arise in estimating the nation's output by adding
all sales of all firms is called double counting
The problem of double counting is solved by distinguishing between two
types of goods:
(a) ntermediate goods and services: Which are the outputs of some firms
that are in turn inputs for other firms.
(b)-Final goods and services: Which are the goods that are not used as inputs
by other firms in the period under consideration. These are the commodities
which are needed for its own sake for consumption or investment and satisfy
the final demand.
Now, if we take the total output as the value of all final goods and services
produced by firms, excluding all intermediate goods and services, then we can
avoid the problem of double counting. To do this more precisely, we use the
concept of value added. The total value of a firm's output is the gross value of its
output. The firm's value added is the net value of its output which is gross
value of its output minus the value of intermediate goods and services; and it
gives the firm's contribution to the nation's total output.
Thus, value added measures each firm's own contribution to the total output,
the amount of market value that is produced by that firm. Its use avoids the
statistical problem of double counting. In terms of formula, we may define
Gross Valueadded=Sum of allvalueadded inan.econonmy, which is a measure
of the economy's total output. Also, it is a measure of all final output that is
produced by allproductive activity in the economy.
Q2. How is GDP computed using the spending method?

Ans. Spending method: According to this method, GDP is calculated by
adding up the spending/expenditure going to purchase the final output
produced in a given year. Total spending is taken as the sum of Consumption
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(C), Investment (I) and net exports (X - M), i.c. GDP = C+I+X-
M. Her
lere,
consumption is further divided into two parts -Consumption spending of
government (Cg) and that of private individuals (Cp) so that we have, C=Co+
Cg. Broadly speaking, there are four important categories of GDP based on
spending method. We may explain them as follows:

(i)Private Consumption Spending (Cp) :This is spending by private
individuals, on goods and services (such as fruits, vegetables, clothes, medical
services etc.) produced and sold to their final users during the year. In addition
to individuals, it also includes final consumption expenditure of non-profit
making institutions serving households such as charities. However, it excludes
purchases of newly built houses as these are counted as part of investment and
not as consumption.
(ii) Goverument Consumption Spending (Cg): This includes the government
spending in providing goods and services that the public in general want, such
as health care, roads, and street lighting. Here we consider the individual
government final consumption and collective government final consumption
together as one term i.e., government consumption, sometimes just called
government spending.
(iii) Investment Spending (I): Investment spending is defined as spending
on the production of goods not for present use but rather for future
The goods created by the investment
consumption.
spending are called investment or capital
goods. Investment spending can be divided into three categories
(a) changes in stocks and inventories
(6) gross fixed capital formation and
(c) the net acquisition of valuables.
iv) Net Exports (X M) : This fourth is defined
category as
-
exports
minus imports (M) and arises from foreign trade of the economy with (X)
the rest
of the world. When the value of
exports exceeds the value of imports, the net
export term is positive. When the value of imports exceeds the value of
the net export term becomes exports,
negative.
Thus, GDP =Cp +Cg +I+ X- M
GDP spending-based is the sum of private consumption, government
consumption, investment and net export spending on currently produced
and services. It is GDP at market goods
tax and
prices which means it is including the indirect
excluding subsidies on products.
Q.3. How is GDP calculated using the income
Ans. GDP based on Income method In order
approach?
: to calculate GDP from the
income
side, incomes of owners of resource
inputs (land, labour, capital etc.) are added
up, so that the value or contribution of each one of
are three main
them is accounted for. There
categories of income acording to this method:
mixed income and the
compensation of employees. operating surplus,
(i) Operating surplus: This involves the
net business incomes after
for material inputs, but before payments
has been made to the hired labour and
taxes (such as
corporation tax) have been paid. By direct taxes we the direct
mean tne
taxes levied on individuals or
firms, usually in relation to their income.
Operating
NATIONAL INCOME ACCOUNTING
surpluses constitute large part of the profits and surpluses of the firms. Some
profits that are paid out as dividends to owners of firms, are called distributed
profits while the rest are retained by the firm for future use and are called
undistributed profits or retained earnings. Both these distributed and
undistributed profits are included in the calculation of GDP.
i) Mixed Incomes: This category includes the incomes of the self-employed
individuals who are not employed by any organization. These people sell their
services or output while running their sole-trader business. Part of their earnings
is equivalent to wage or salary and the rest may accrue as profits or surplus of
the business. That is why their incomes are called mixed incomes as they are a
mixture of two parts namely wage income and profit.
(i) Compensation ofemployees: This part comprises wages and salaries which
is a payment for the services of labour. This is also referred to as labour income.
Wages include total earnings of the hired labour gross of pension fund
contributions, insurance contributions and other benefits.
Thus, if we add these three categories, we get net domestic product at factor
cost prices, i.e., NDP = operating surplus+ mixed incomes + compensation of
employees.
It is net of indirect taxes and inclusive of the subsidies. Hence to obtain
Gross Domestic Product (GDP), we need to add depreciation to the above
calculated NDP measure. Further, the total output produced in the economy,
measured by GDP, differs from total income received, measured by the gross
national income, owing to net income from abroad.
Q.4. What is depreciation ? Why is it importantto compute depreciation?

Ans. Depreciation: Depreciation is the amount by which the capital stock
has been used up during a given period-as a result of the normal wear and tear
of machinery, normal accidental damage during production and foreseen
obsolescence (when the machines cannot be used efficiently and competitively
any more). It is also called the Capital Consumption expenditure. It refers to the
decline in the value of reproducible fixed assets in the production process only.
Depreciation represents a charge against the currents year's production and is
generally calculated on the basis of the expected life of the capital goods and
the interest rate, rather than on the actual current capital consumption itself.
It is important to compute the depreciationfor the following reasons
(i) These estimates tell us how much of the capital stock has been used up
and hence how much is left and how long it will last.
(ii) The corporate sector measures profits before depreciation (since it is a
charge against profits which arises from the current year's production). An
overestimation of depreciation is made by some firms to avoid paying high
dividends and taxes. This is why depreciation laws are linked with tax laws.
(iii) It is important to know depreciation to make distinction between gross
and net measures. Gross investment minus depreciation (or replacement
investment) is net investment. Positive net investment increases the economy's
total stock of capital, while replacement investment keeps the existing stock
intact by replacing what has been used up or worn out.
10 SATISH:B.A./B.Com. (Prog.) /l1IYEARECONOMICS |CBCs
between real GDP and nominal GDP.
Q.5. Explain the difference
Ans. GDP valued at current prices (i.e., prevailing market prices) is referre
to as nominal GDP or money GDP and GDP valued at the base-year (constant
at both current and base year prices
prices is called real GDP. GDP is computed
because prices keep rising as a result of inflation. For instance, if the outputof
goods and services produced by an economy during vear
remains the same a
and prices rise, then there will be an increase in GDP. However, this an increase
in money GDP and not in real GDP. Conversely, if prices remained constant
and there is an increase in production, real GDP will increase. This means that
there is economic growth in the economy. Economic growth is thus associated
with the growth of GDP in real termns.
In general, any change in nominal income reflects the combined effects of
changes in quantities and changes in prices. However, when real income is
measured over different periods by usinga common set of base-period prices,
changes in real income reflects only changes in real output.
If nominal and real GDP change by different amounts over same time period,
this implies change in prices over that period. Comparing the nominal and real
GDP over the same period gives us a price index which is called an implicit
price deflator. It is defined as follows
NominalGDP
Implicit deflator =
x100%
Real GDP
Otherwise, we can compute the real GDP, given the base year prices and
suitable price index from the nominal GDP as
NominalGDP
Real GDP =
Price Index
Q6. Differentiate between real national income and nominal national
inome.
Ans. National Income calculated at current prices is called Nominal
National Income. It's not considered to be a good measure of economic welfare
Whereas, National Income at constant prices is a true measure of the purchas-ing
power of the people. It is also called Real National Income. In case, national
income at constant prices rises, it means purchasing power of the people has
gone up. They, now can buy more goods and services with better standard of
living, as a result, economic welfare also rises. Thus, national income at constant
prices is a better index of economic welfare as compared with national income
at current prices.
Q. 7. Explain the income method of estimating national income. What
are the difficulties involved in this method?
Ans. GDP using income method: National income is calculated as
the
sum total of factor payments made by the producers or the sum received by
various factor of production. It is called income paid and income received
method respecti vely but both involve flow of income. Income method estimates
NATIONAL INCOME ACCOUNTING 11
national income from the side of paynments in the form of wages, rent, interest
and profit to factors of production. The steps involved are:
1. Identification of producing enterprises.
2. Classification of factor incomes into domestic factor income and net factor
income from abroad Domestic factor income is the income generated within
the domestic territory of the national by all
prod ce. It includes compensation
of employees (wages and salaries, retirement pensions, social security
contribution by employers), operating surplus (total income earned by a firm
during thie process of production from property and enterprises in the form
rent, interest and profit) and mixed income of self employed. Net factor income
from abroad is the income attributatble to factor services rendered by normal
residents of a nation to the rest of the world less factor services rendered to
them by rest of the world.
3. Estimation of National Income, which is done as follows
Income paid out by each firm involved in produced can be ascertained
by multiplying number of units of each input consume by price paid to
each unit. It gives income generated by each firm.
Income generated by all the firms in a particular sector can be calculated
by adding the income paid out by each firm.
By adding income paid out by all sectors, we can calculate net domestic
income or NDPMP
Difficulties in Income Method : Few precautions must be undertaken to
have correct estinmates.
1. Transfer payment should be excluded.
2. Whether services should be a part of national income or not is a mater
of argunment.
3. Confusion regarding addition of illegal incomes e.g., income of
smugglers, black-nmarketers etc.
al 4. As wealth tax, death duties, gift tax are paid out of current income,
these should not be included in the national income.
al 5. Windfall gains should not be included.
e.
6. Imputed rent of self-occupied accommodation should be included or
not.
o 7. Corporate tax should be included or not.
as 8. Income from sales proceeds of second hand goods should be excluded.
of Q.8. What are the activities that are not included in GDP ?
nt
ne Ans. Activities that are not included in GDP-GDP is only concerned
with new, or current, production. Old output is not counted in current GDP
because it was already counted back at the time it was produced. If some one
at sells a used car to you, the transaction is not counted in GDP only at the time it
is built, not each time, it is resold-thus, GDP ignores all transactions in which
he money or goods changes lands but in which no new goods and services are
by produced.
Sale of stocks and bonds are not counted in GDP. These exchanges are
ed transfers of ownership of assets, either electronically or
tes through paper
SATISH: B.A./B.Com. (Prog-)/I YEAR ECONOMICS [CBCS]
10
difference between real GDP and nominal GDP.

Q.5. Explain the
Ans. GDP valued at current prices (i.e., prevailing market prices) is referred
to as nominal GDP or money GDP and GDP valued at the base-year (constans
prices is called real GDP. GDP is computed at both current and base year pricee
because prices keep rising as a result of inflation. For instance, if the output o
remains the Same during a year
goods and services produced by an economy
and prices rise, then there will be an increase in GDP. However, this an increase
in money GDP and not in real GDP. Conversely, if prices remained constant
and there is an increase in production, real GDP will increase. This means that
there is economic growth in the economy. Economic growth is thus associated
with the growth of GDP in real terms.
In general, any change in nominal income reflects the combined effects of
changes in quantities and changes in prices. However, when real income is
measured over different periods by using a common set of base-period prices,
changes in real income reflects only changes in real output.
Ifnominal and real GDP change by different amounts over same time period,
this implies change in prices over that period. Comparing the nominal and real
GDP over the same period gives us a price index which is called an implicit
price deflator. It is defined as follows:
Nominal GDP
Implicit deflator = x100%
Real GDP
Otherwise, we can compute the real GDP, given the base year prices and
suitable price index from the nominal GDP as:
Nominal GDP
Real GDP=
Real GDP Price Index
Q.6. Differentiate between real national income and nominal national

income.
Ans. National Income calculated at current prices is called Nominal
National Income. It's not considered to be a good measure of economic welfare.
Whereas, National Income at constant prices is a true measure of the purchas-ing
power of the people. It is also called Real National Income. In case, national
income at constant prices rises, it means purchasing power of the people has
of
gone up. They, now can buy more goods and services with better standard
living, as a result, economic welfare also rises. Thus, national income at constant
prices is a better index of economic welfare as compared with national income
at current prices.
Q.7. Explain the income method of estimating national income. wna"

are the difficulties involved in this method?
Ans. GDP using income method: National income is calculated as
sum total of factor payments made by the producers or the sum received
various factor of production. It is called income paid and income receiv
method respectively but both involve flow of income. Income method estima
national income from the side of payments in the form of wages, rent, interest
and profit to factors of production. The steps involved are:
1. Identification of producing enterprises.
2. Classification of factor incomes into domestic factor income and net factor
income from abroad Domestic factor income is the income generated within
the domestic territory of the national by all produce. It includes conmpensation
of employees (wages and salaries, retirement pensions, social security
contribution by employers), operating surplus (total income earned by a firm
during thie process of production from property and enterprises in the form
rent, interest and profit) and mixed income of self employed. Net factor income
from abroad is the income attributatble to factor services rendered by normal
residents of a nation to the rest of the world less factor services rendered to
them by rest of the world.
3. Estimation of National Income, which is done as follows:
Income paid out by each firm involved in produced can be ascertained
by multiplying number of units of each input consume by price paid to
each unit. It gives income generated by each firm.
Income generated by all the firnms in a particular sector can be calculated
by adding the income paid out by each firm.
By adding income paid out by all sectors, we can calculate net domestic
income or NDPMP
Difficulties in Income Method: Few precautions must be undertaken to
have correct estimates.
Transfer payment should be excluded.
2. Whether services should be a part of national income or not is a matter
of argument.
3. Confusion regarding addition of illegal incomes e.g., income of
smugglers, black-marketers etc.
4. As wealth tax, death duties, gift tax are paid out of current income,
these should not be included in the national income.
5. Windfall gains should not be included.
6. Imputed rent of self-occupied accommodation should be included or
not.
7. Corporate tax should be included or not.
8. Income from sales proceeds of second hand goods should be excluded.
Q.8. What are the activities that are not included in GDP?
Ans. Activities that are not included in GDP-GDP is only concerned
with new, or current, production. Old output is not counted in current GDP
because it was already counted back at the time it was produced. If some one
sells a used car to you, the transaction is not counted in GDP only at the time it
is built, not each time, it is resold-thus, GDP ignores all transactions in which
money or goods changes lands but in which no new goods and services are
produced.
Sale of stocks and bonds are not counted in GDP. These exchanges are
transfers of ownership of assets, either electronically or through paper
12 SATISH: B.A./B.Com. (Prog.)/II YEAR ECONOMICS [CBCSI
exchanges and do not correspond to current production.
The part of the economy in which transactions take place and in which
income is generated that is unreported and therefore, not counted in GDP.
Q.9. Distinguish between actual GDP and potential GDP?

Ans. Economic growth is about the long-term trend in GDP and in order to
infer about this, the concepts of actual and potential GDP are being used and
the different between actual and potential GDP is called GDP gap.
Actual GDP refers to what the economy does in fact produce, whereas
Potential GDP measures what the economy could produce if all resources
land, labour and capital were fully employed at their normal level of utilization.
That level of employment is referred as the full employment income or potential
level of employment denoted as y,. Now GDP gap or output gap is defined to
measure the difference between what would have been produced if potential,
or full employment, GDP had been produced and what is actually produced,
as measured by current GDP.
GDP gap = Potential GDP - Actual GDP
1.e
Y-Y
Now if potential GDP (y,) > actual GDP (y), this gap measures the market
value of goods and services that could have been produced if the economy's
resources had been fully employed but actually went unproduced and output
gap is called deflationary gap.
On the other hand, if, potential GDP 0) < actual GDP (U), this gap measures
the market value of goods and services that were produced beyond the
economy's possible resources, because of various external factors and the output
gap is called inflationary gap.
Q.10. Discuss the product method of calculating gross domestic product/
national income. What are the problems faced in calculating the same?
Ans. GDP using product/output method:It is also known as value-added
or output method. It measures national income by estimating the contribution
by each enterprise producing in the domestic territory of the country in a period.
income.
The steps are followed to compute national
I. Identification and classification of enterprises into primary, secondary
and tertiary section. Goods and services that are a part of production are those
sold in the market earn profits, or supplied free or at nominal rate but not sola
in the market, imputed rent of owner-occupies houses and goods which dont
reach market like 'own-use-production'. But the activities excluded are illega"
leisure time and services rendered within the household by its members.
II. It involves measurement of value of output and double counting mus
be avoided.
One can find out the net value added at different stages of production o
commodity. The sum of net value added at different stage of production
in the economy will give the estimate of donmestic factor incone
commodity
the economy.
GDP Value of consumers, goods and services +Gross private domestic

investment+ Value of output of government sector.
Or
Gross value added = Value added in primary sector at market price+ value
added in secondary sector + Value added in tertiary sector
Difficulties in Product Method:

(a) It's difficult to determine price of goods retained for self-consumption
and don't reach market.
(b) It's difficult to decide whether the value of goods and services to be
measured at manufacturer's cost, wholesaler's price or at retail price.
(c)Whether services should be included in national income or not is a
matter of dispute.
(a) Reliable and accurate database not available about production in
unorganised sector.
(e)It's not possible to have a clear distinction between intermediate and
final goods as it depends on its use.
(Difficult to calculate depreciation when the value of capital good
increases or decreases due to changes in market conditions.
UNIT 3
DETERMINATION OF GDP
Q.1. Critically explain Say's Law of markets.

Ans. According to Say's law, "Supply always creates its own demand". In
general, it implies that overproduction and hence general unemployment are
not possible. Prof. J. B. Say did not agree with other views which believed that
overproduction and unemployment were common occurrences. According to
Prof. Say the main sources of demand is the flow of factor incomes generated
from the process of production itself whenever any new production process is
initiated and a certain outputs results, the demand for that output is also
simultaneously generated on account of the payment of remuneration to the
factor
of production. In other words, every output brought to existence injects
an equivalent amount of purchasing power in circulation which ultimately leads
to its sales so that there is no possibility of overproduction. This is the essence
of Say's law. If general overproduction is impossible, there is no possibility of
general unemployment.
Assumptions of the laio : Say's law of market is based on the following
assumptions
1. The law can operate only in a free exchange economy where there is
perfect/full freedom for the buyers to buy and sellers to sell.
2. There is free flow of money income.
3. Saving is equal to investment and this equality is brought about by
flexible interest rate.
4. There is no necessity on the part of the government to intervene in the
business matters so that the automatic adjustment is facilitated.
5. The size of the market is limited
by the volume of production, only
then will demand equal supply or supply creates its own demand.
Criticism of Say's Law : Say's Law has been criticised on two basis:
(i) Supply does not itself creates its own demand. According to Say's law
every supply creates its own demand. As such, general overproduction is not
possible. Now, this law is based on the assumption that the people spend their
entire income on
consumption and that they do not save anything out of thelr
income with the result that whatever is produced, is ultimately sold off in the
market. But in real life, people do not
spend their entire income. They do
a
part of their income for future use. This saving naturally reduces the save
demand for goods with the result that some presert
part of the present productio
remain unsold. This saving constitutes a
source of
the leakage and ultimately retar
income-expenditure flow in the economy. It also reduces the
aggreg
demand and reduction in aggregate demand leads to overproduction in
economy. Thus, Say's Law is very unrealistic.
(14)
DETERMINATION OF GDP 15
(ii) The supply of labour does not automatically adjust itself to its demand.
According to Say's Law, since general overproduction was impossible, general
unemployment was not of question. The eritics point out that this viewcannot
be accepted because employment is found in all the capitalist economies.
Q.2. What do you understand by the term GDP gap ?

Or
Distinguish between Actual GDP and potential GDP?
Ans. Economic growth is about the long-term trend in GDP and in order to
infer about this, we use the concepts of actual and potential GDP and we call
the difference between them as the GDP gap.
Potential GDP measures what the 'economy could produce if all resources
level of employment denoted as Y,. Now GDP gap or output gap is defined to
or full employment, GDP had been produced and what is actually produced,
as measured by current GDP.
i.e GDP gap Potential GDP - Actual GDP
Y-Y
Now if potential GDP (Y; )> actual GDP (Y) this gap measures themarket
value of goods and services'that could have been produced if the economy's
resources had been fully employed but actually went unproduced and output
gap is called recessionary gap. On the other hand, if Y> Y,, the output gap is
called inflationary gap.
Q. 3. What is the relationship between consumption expenditure and

personal disposable income ?
Or
What is the consumption function and what does it depend upon?
Ans. The consumption function provides description of how total desired
consumption expenditure change with changes in the level of income that the
consumers actually have to spend-their disposable income. According to
Keynes, current consumption expenditure depended only on tlhe current
income. When income is zero, a typical individual will still (via borrowing, or
drawing down his savings) consume some minimal amount. This level of
consumption spending isautonomousconsumptionspending because it persists
even when there is no income now. When income increases, the individual wil
want to consume more and more. This part of consumption is called induced
consumption because it varies directly with the disposable income. It can be
written in a general form,
C f (Y); where C = Consumption spending,
and Y Disposable income
16 Semester-VI [CBCcS
B.A. (Prog.)/B.Com. (Prog.) III Year
Generic Elective Course 2(a)
PRINCIPLES OF MACROECONOMICS
Keynes Fundamental Psychological Law of Consumption : It states that ther

ere is
a non-proportional relationship between income and consumption. Asincom
increases, consumption increases but not in the same proportion as incom
does. For example, if income of the consumer increases by 10% the
consumption will increase by 4% or 5% but certainly by less than 10%. Thi
psychological law is based on casual observation and introspection. We ca
specify the straight line consumption function based on this hypothesis,C=a
bY, where a and b are two positive parameters. This consumption function ha
two parts.
(a) Autonomous Consumption Expenditure : Which does not depend on leve
ofincome and is given by 'a'. Clearly when Y=0»C=a and a > 0. By introducin
'a', it becomes a non-proportional function. This part depends on past savings
wealth or borrowings of the consumer.
(b) Induced Consumption Function: Which depends on level of income andi
nothing but the slope of the consumption function.
C -b
aY
According to Keynes' fundamental psychological law of consumption
must lie between 0 and 1 as there is non-proportional relationship betwe
consumption and income. So when the income of the consumer doubles, h
consumption expenditure doesn't get doubled but increases by less than doubl
The positive linear Consumption function specified above can b
represented as follows with the help of a diagram--
ConsumptionC C a + bY
expenditure
a> 0
0 <b<1
Ay
O Y
Here we can easily infer that the slope of the consumption function
is less than one, i.e., 0<b<1.

Semester-VI |CBCS
B.A. 17
(Prog./B.Conn. (Prog.) III Year
Q. 4.
What is saving function ? Given a linear
the effect ofa decrease in
saving function, what is
level of income.
marginal propensity to save on the
equilibrium
Explain with the help of a suitable diagram.
Ans. Saving is that part of the
disposable income which is not on the
consumption. The disposable income (Y) is partly disposedspent
Consumption (C) and partly on Saving (S). Hence, we may say that Sof Yon-C.theIt =
follows that, once we take the

this will consumption dependent on disposable income,
automatically follow that saving also
The relationship between desired depend on disposable inconme.
saving and the
disposable income is described
by the saving function. Now if we consider linear
by:C a+bY, it will follow that consumption function given
a
incomne.
saving function will also be linear function of
S
S Y- C
S Y (a -
+
bY)
S Y - a - bY
S a + (1 - b) Y
or
S=-a +sY;| where s = 1 - b
or s =
1
mpc.
-
Next, we define average

propensity to save
(aps) which refers to the total
saving out of given total income and is given by aps =
While the marginal propensity to save

(mps) refers to the amount of
additional saving of
additional income. i.c., mps-
out an
the slope of the saving function. In the linear

OY
It is
nothing but .
and is equal to 1 mpc, where saving function, it is given by s

mpc (= b) is the marginal propensity to consume.
-
S
S = - a +sY
Here, a>0
As
As
s
Ay AY
OF
SATISH: B.A/BCom (Prog )/ ll YEAR ECONOMICS ICBCS
The equilibrium level ot income is determined by the equality of inv
in the economy. Flere we have to make a distinction betvweeen en

and saving
nvestoent and saving on one hand and exp0st investment and expost
exante
savine
on the other.
Exante position reters to what is intended, planned or desiredin s
beginning of the time period, while expost reters t0 actual saving and investme
what is being realized by the economy in the end.

According to Keynes, exante saving and investment may not be equal
the savers and investors are different groups of person and so long as saving
and investment decisions are
influenced by different motives, there S
is no reason why exante saving and S'-a+sY
exante investment need be equal, there
can be a divergence. On the other hand S-aSY
expost saving and expost investment
are always equal by definition as it is
an identity. Hence, at equilibrium we F
have expost investment =exante (Investment Functon)

investment = saving (exante) as shown
below
Here YY
a
I=I : Autonomous investment Diagram. Equilibrium determination by
function Saving-investment approach
S-a+sY :linear saving function.
Equality of two I = S determines S
S - 8 + sY
the equilibrium at point E and Y, is the
equilibrium level of income.
S -a+s
Effect of in mps
Now if MPS ***
decreases, then the slope of saving

function will change. It would become
flatter.
Original Saving Function :S = - a
****
**
+sY where s =
mpS
when mps, witha constant, O
we
Y.Y,
will have new saving function
S'= -a +s'Y; s '<s
The equilibrium point will shift to E' and there would be an increase in the
equilibrium of income from Y, to Y,'.
Q.5. Define investment multiplier. Show that it is directly related to

mpc and inversely related to mps.
Ans. The multiplier provides a measure of the magnitude of the changes
income or GDP. In case of investment multiplier it measures the change in

income due to one unit change in investment. It may be defined as a ratio of
change in GDP to the change in autonomous expenditure that brought it about.
The investment multiplier is denoted by k and is given by the following formula:
k 1
AI
1-mpc mps
Value of multiplier depends directly on the mpe and inversely on mps.
Let the original equilibrium level of income be given by,
Y a (1)
Let investment (1) be increased by AI so that new level of investment (1) =
+AL. This will give use new equilibrium level of income as
(2)
Subtracting (2) from (1), we get,
1
AY - where AY= Y1 -Y%
andAI I,-o
AY 1
AT
kask= is
the investment multiplier.
Next we can show relationship between k, mpc and mps using some
hypothetical values.
mpc nips k 1
1-mpc nips
0.5 0.5 2
0.75 0.25 4
0.8 0.2 5
0.9 0.1 10
1 0 00
SATISH: B.A./B.Com. (Prog.,)/IlI YEAR ECONOMICS [CBCS|
20
Since 0< mpc < 1, there 1 < k << o.
directly or positively related to mpc and inverselyv

Hence multiplier is
related to mps.
Q.6. What is effective

demand ? Will the level of effective demand be
always associated with full employment.
Ans. Effective demand implies
the expenditure which people are willing to
investment goods. At various levels
of income, there
incur on consumption and demand
demand but all the levels of not
are
are corresponding levels of met with the
these that level is effective which is fully
only
effective. Among to reduce nor
firms neither have a tendency
corresponding supply so that the
effective demand is aggregate demand
to expand production. In other words,
the aggregate
at that point it is intersected by
at the point of equilibrium and
supply curve.
is determined at the point where

The level of income and employment
to aggregate supply. Between
the two, aggregate
aggregate demand is equal
demand is dynamic and aggregate
demand at the point of equilibrium is
economic variable affecting level of
effective demand. Therefore, the basic
demand. The point of effective demand
income and employment is effective
terms.
and the equilibrium in the economy, can be represented in graphical
Income
45
Aggregate
demand
Level of employment/output
Y
intersection the aggregate demand curve

The equilibrium E is given by the the
with the 45° guide line. E is the point
of effective demand. At this point,
that
determined. However, it does not imply
actual level of employment (Y) is to
at this point. According
the economy has reached full employment (Y,) the
between the aggregáte demand function and
Keynes, the equilibrium at a point of less than
can and oftern does, take place
aggregate supply function
full employment. Aggregate demand equals aggregate supply
only if investment
between income and consumption
spending is sufficient to fill the gap emerging
so that Y, can be attained.
Q.7. Given the data on income and saving answer the following:
Income Saviug
0 - 50
400 50
(i) Calculate the consumption function and the value of multiplier.
(ii) Calculate the equilibrium level of income when autonomous
investment is equal to 100.
Ans. Using the given data on income and saving, we can find out marginal
propensity to save (mps) and marginal propensity to consume (mpc) as follows:
50+50 100
= 0.25
mps AY Y1-Yo 400-0 400
mpc= 1
-
mps
=
1 -
0.25 0.75
Value of 1
multiplier =1-mpc
= 4.
0.25
The consumption function will be given as-
C a + bY, where a = autonomous consumption expenditure
C 50+0.75Y and b = mpc.
Also, a> 0 and 0 < b< 1.

(ii) Equilibrium level of income is determined at the point where Aggregate
Expenditure (AE) equals aggregate supply (Y) and is given by the following
equation-
Y= AE
Y = C+I (ln a two sector model AD equals C + I)
Y= 50+0.75 Y + 100
or Y 150 +0.75 Y
(1 0.75) Y = 150
0.25 Y = 150
150
i.e., Y= 600.
Where Y, denotes the equilibrium level of income determined by solving
the above equation.
Q. 8. Discuss the significance of marginal efficiency of capital and rate
of interest as determinants of investment.
22 SATISH: B.A./B.Com.
(Prog-)/III YEAR ECONOMICS ICBCS
Or
Write a short note on determinants of inves tment.
Ans. The level of investment is determined at a point where the
rate of
interest and the marginal efficiency of capital (mec) are equal. These
of rate of interest (r) and mec are taken from
concepts
Keyrnes general theory of
employment. According to Keynes, r is the price which is paid for parting with
liquidity preference. It is determined at a point where liquidity preference and
the money supply are
equal.
The marginal efficiency of
capital in ordinary sense means the expected rate
of profit. It refers to the expected rate of return over cost, or the
expected
profitability of a capital asset. Mec depends on two variables
(a) prospective/expected yield and
(b) supply price of the capital asset.
The term prospective yield refers to the amount of annual incomes
over
years which an investor expects after meeting the running cost. In other words,
the prospective yield is the net aggregate return
expected from the capital asset
during its life time. For obtaining net expected rate of profit, supply price of
the capital has to be deducted from it. Keynes has defined mec as
"being equal
to that rate of discount which would make the present value of the series of
annuities given by the returns expected from the capital asset during its life
just equal to its price".
Marginal efficiency of capital and the level of investment are inversely
related i.e., mec would be higher, when investment is low and vice-versa.
Investment depends upon mec and the interest rate. A firm shall go on
investing more and more so long as mec is higher than the rate of interest. I
will stop at a point where mec equals rate of interest; beyond this it will not be
profitable as mec will be less than the rate of interest. This can be explained
with the following schedule
Volume of Investment inec Interest rate

(T Crores)
100 10% 8%
150 8% 8%
200 6% 8%
Two things can be observed from this table:
) mec goes on declining with the increase in investment.
(i) rate of interest is constant and
given.
Thus, the of investment would be 150 crores as at this level the mes
level
and the rate of interest are equal to each other.
However, if due to decline in
oes
money the rat of interest

supply (say) g
upto 10% in the nmarket, then in that case, level of investment shall decline to
100 crores. This, with the increase in the rate of interest, the level of investment
goes down and vice-versa.
Q.9. What is consumption function? Explain the relationship between

APC and MPC in case of linear consumption function.
Ans. Consumption Function: The consumption function isa mathematical
formula laid out by famed economist John Maynard Keynes. The formula
was designed to show the relationship between real disposable income and
consumer spending, the latter variable being what Keynes considered the most
important determinant of short-term demand in an economy. The consumption
function is represented as:
C A+MD
Where:
C Consumer spending
A = Autonomous consumption, or the level of consumption that would
still exist even if income was $ 0

M= Marginal propensity to consume, which is the ratio of consumption
changes to income changes
D Real disposable income
The consumption function is shown here to be linear, but that is
dependent
on the variable "M" (marginal propensity to consume) staying the same. In
fact, consumers tend to spend a smaller percentage of their disposable income
as it rises, creating a curved effect at higher income levels.
Relation b/w APC and APS
APC+APS =1
As we know Y =C+S
Dividing both sides of the equation by 4
APC+APS = 1
APC = 1 -APS
Relations b/w MPC and MPS

. Y C+S
AY = AC+AS
Dividing both sides of the equation by AY
AY ACAS
AY AY AY
1 MPC+ MPS
MPS = 1 -MPC
Q.10 Explain Consumption Funtion and saving Function.

SATISH: B.A./B.Com. (Prog.)/ IIIYEAR ECONOMICS |CBCS|
24
Ans. Consumption Function: The relationship between private
consumption expenditure and personal disposable income is called
consumption function.
C f(Y)
Where C= consumption expenditure
Y= personal disposable income
It means thatthe consumption expenditure depends on the level of persona
disposable income. Consumption is directly related to money income. A
income increases, the consumption expenditure also increases.
Saving Function: The relationship between income and consumption helps
to determine the relation between income and saving. Saving function expresses
the relationship between the level of disposable income and the amount oi
desired saving in an economy.
The Relationship: The linear consumption function can be expressed as
C a+bY
Where C =
consumption expenditure
a = consumption at zero level of income and it remains constan
b marginal propensity to consume
Y = any given level of income.
Deviation of Saving Function : In a simple two-sector economy mode

with no government and no
foreign trade, income equals
Y C
consumption plus savings.
Y = C+S
and C a+bY
C a+b
E
Y =a +bY +S
-S = a - Y + bY
-S =-a + (1-b) Y Co
Y <C
-S-S -a+(1-b) Y 45
Where -a is the Y
O X
intercept and (1-b) is the slope Y (Income)
of saving function. Whereas a
Y
is the Y-intercept and b is
slope of consumption
function.
Given 45° line and the
consumption function, saving
Curve can be derived. 0 *********************************************************
S=-G+ (1-b) Y
Graphically, saving is the
vertical distance between the
45° line and the consumption Y, Y
function. (Income)
Saving is positive when Y
>Cwhereas saving is negative when Y < C. Consider income Y, in the figure,
consumption is C,. So is obtained by subtracting C, from Y, One point on the
saving function is the point Y = Y, and S = S,
At income Y,, consumption intersects 45° line at E. At this point C = Y,
therefore, saving = 0. If income is zero, consumption is equal to a. Hence saving
equals-a. A third point on the saving function may be obtained by considering
other income levels.
Q. 11. Explain the relationship between consumption expenditure and

disposable income using psychological law of consumption.
Ans. Psychological Laws of Consumption: Keynes explain that
consumption depends on disposable income consumption increases as income
increases but by an amount less than increase in income. Consumption increases
is a lesser proportion than increase in disposable income. This is called
psychological law of consumption.
Propositions of Law:
1. When income increases, consumption also increases but by a smaller
amount.,
2. When income increases, increased income will be divided between
consumption and savings in a certain proportion.
3. As income increases, both consumption and savings will rise.
Assumptions:
1. Economy works under normal conditions i.e. neither inflation nor
deflation.
2. Law operates under market-oriented economy i.c., no, state intervention.
3. Propensity to consume remains unchanged. Only income changes &
other factors like price, population, distribution of income does not
change.
The consumption function provides description of how total desired
consumption expenditure change with changes in the level of income that the
consumers actually have to spend-their disposable income. According to
Keynes, current consumption expenditure depended only on the current income.
When income is zero, a typical individual will still (via borrowing, or drawing
down his savings) consume some minimal amount. This level of consumption
spending is autonomous consumption spending because it persist even when
there is no income now. When income increases, the individual will want to
consume more and more. This part of consumption is called induced
consumption because it varies directly with the disposable income. It can be
written in a general form,
C f (Y);
where C Consumption spending,
and Y Disposable income
26 SATISH:B.A./B.Com. (Prog.) /1IIYEAR HCONOMICS |CH
Kenynes Fundamental law of Consumption
It states that there is a
non-proportional relationship between
and inome
consumption. As income increases, consumption increases but not in the same
proportion as income does. For example, if income of the consumer increases
by 10% then consumption will increase by 4% or 5% but certainly by less than
10%. This psychological law is based on casual observation and
We can specify the straight line introspection
consumption function based on this hypothesis,
C-a+bY, where a and b are two positive parameters. This consumption
has two parts. function
(a) Autonomous Consumption Expenditure : Which does not depend on leve
ofincome and is given by'a'. Clearly when Y =0=C=aand a>0. By introducing
'a, it becomes a non-proportional function. This part depends on past
wealth or borrowing of the consunmer.
savíngs.
(b) Induced Consumption Function: Which depends on level of income and it
nothing but the slope of the consumption function
According to Keynes' fundamental psychological law of consumption

must lie between 0 and 1 as there is non-proportional relationship betweer
consumption and income. So when the income of the consumer doubles, hi
consumption expenditure doesn't get doubled but increases by less than double
The positive linear Consumption function specified above can b
represented as follows with the help of a diagram:
ConsumptionC
expenditure C a +bY
a> 0
0<b<1
Ay
A
Here we can easily infer that the slope of the consunmption function=
less than one, i.e. 0 <b<1.
Q. 12. Explain the determination of equilibrium level of GDP usi n

aggregate expenditure approach and the savings investment approa
two sector model.
DETERMINATION OF GDP
27
Ans. Aggregate Expenditure Approach- According of the economy
to this
approach,is
equilibrium GDP is determined where desired expenditure
equal to aggregate national output i.e., equilibrium between aggregate
expenditure and aggregate output brings equilibrium in the economy.
Aggregate expenditure is the summation of desired
expenditure (c) and investment (1) i.e., AE =C +I. consumption
It is upward sloping and starts from a
point above the origin indicating
autonomous consumption and tends to rise as the level of income
rises. Upward
sloping AE is due to upward sloping consumption function. Investment is
assumed to be autonomous of income, indicated
and has no impact on the
by a horizontal straight line
slope of AE function.
Aggregate Output is a planned output in a given period of time, Greater
output mean greater use of the factors of production. Inputs are
in response to higher levels of always available
planed output. Thus, output adjusts itself to
changes in the level of aggregate expenditure.
Y AE = Y
Y >AE
AE C+1
AEsY
45
Y, X
Income
(GDP)
Equilibrium will occur when income or output level is Y At this level of
GDP, aggregate expenditure of the
is there is economy is also Y,. Disequilibrium will occur
discrepancy between aggregate output and
45° line is the line of reference. It a8gregate expenditure
shows the equality between AD and Y (AS).
IfAE> Y, it will cause expansionary pressure on
from OY, to output and income rises
OY Whereas if AE<Y,
on output and income falls it will result in contradictonary pressure
from OY, to OY
level OY, Point E is the Equilibrium is achieved at GDP
equilibrium
intersects the 45° 1line. At this level point
where aggregate expenditure line
of GDP, aggregate output is
aggregate expenditure. Any level of GDP more than or less than OY,equal
to
leads to
disequilibrium.
AE= C+IVC=
Consumption Expenditure »C=Ca+ XY
Ca Autonomous expenditure
C Marginal propensity to consume
Y= Disposable Income
I= I, (Autonomous Investment)
At
equilibrium, Aggregate Output= Aggregate Expenditure
ICS [CBCS]
28 SATISH: 8.A./8.Com. (Prog.) / Ill YEAR ECONOM
Y= C+I ⇒ Y= Ca+ CY+ l0

Y-c Y =Ca + 10
1
⇒ y = (1- c) (Ca+ lo)
function I I0 intersect at P<r
Saving function SS1 and autonomous investment
OY0 leve l of GDP, saving ~
E whic h dete rmin es equi libri um GDP = Y0 • At
break-even poin t is at poin
investment are equal and happ en to be = Y0E. The
l to cons ump tion (Y = C, :::);
whe re saving is equal to zero. Hence income is equa
0). Any income level below or above OY0 caus
es imbalances between saving ar1
y
cc
to
Y'
OS, inve stme nt exceeds saVi
investment, hence dise quili briu m. At income level
equi libri um is attai ned at OY
by RS. It wou ld trigg er expa nsio n in income till
stment by ·vT. It wou ld ca~
income is above OY0 i.e., OY1 savi ng exceeds inve
• Thus , imba lanc e betw een sayj
contraction of inco me till it finally settles at OY0
cont racti on of inco me such u
and inve stme nt wou ld resu lt in expa nsio n or !I·
d I is achieved.
equilibrium is resto red and equa lity betw een San
C=C a+C Y ,13,
Y= C+S
d.
Y= Ca+ cY+ S te
S= -Ca + Y - cY
fE
S = - Ca+ (1 - c)Y I
C<
s = 1 - c ⇒ _m argin al prop ensi ty to save p
At equi libri um
S= I or
⇒ - Ca + (1 - c) Y = I0
⇒ (1 - c) Y = I0 + Ca e
Io +Ca Io +Ca
⇒ Y- (l-c ) orY = 5 C
j
/
. How are th1
,tfl: 13 Explain the concepts of APC, APS, MPC and MPS
"ratio mter-related?
ratio between desi
Average Propensity to Consume (APC) : It refers to the
DETrmMtNI\TION ( )II ( :t>I' ?')
y
C - LA
OL
0'----------1--➔ x
L
Personal Disposable
Income (Yd)
consumption expenditure (C) and personal disposable income (Yd), corresponding

to a given level of Yd.
C
c=-
Yd
where
c = average propensity to consume
C = Desired Consumption Expenditure
Yd = Personal Disposable Income.
. LA l
Average propensity to consume = OL w 1en
C
0 C
!he level of personal disposable income = OL. 'E.u
E~
Because, corresponding to OL level of personal :,
IJ)
Cl)
...
C :,
disposable income, individuals and households 0~
u'g
tend to support LA. Cl)
Cl)
C.
Marginal Propensity to Consume (MPC); It -x
-~w X
refers to the ratio between change in desired a. 0 A A.
consumption (LiC) corresponding to a change in Personal Disposable Income
personal disposable income (LiYd) (Yd)
b= 11C
11Yd
where b=Marginal propensity to consume 8.C =Change in desired runsumption
expenditure
LiYd= Change in personal disposable income.
In the figure, Yd changes from OP to OA, corrc:;ponding to it, desired
consumption expenditure changes from AD lo A, B. Thus, AC "' B1B2 when
tiYd= AA 1 = B82
Thus, marginal propensity to consume
IC:, fCBCSJ
) Ill\ 1:.,\1\ [(0\cL""l~!
S..\rt :,tl : I> \ IJ ( ,,m l P r,'~ DET£ RMl'\ ATIO '\. Of 1...,\1
\ AI'C • 1-APS
R1Il: ::. ... APS • 1- APC
~ or
BB, s> ~ MPC & \!PS
Rilib on bdw
An,r.>gt' Propt'.Itiit) to 5-1, ,. : It ro!frr.; 'J ~!PC • MPS • I
tt, th,' !JI>" r,.•t" '°""dnin.-d >-l\ ,ng Jnd
,ncom r "::-; ) • C• 5
p,·r, onJI d,spo sJbk
:.Y • :.C • ~
rom-,--pondini; to d S" t>n lt'1 d of Yd "
.::i
b, :.'\'
01' 1dmi; both >1dcs oJ the <'q.wlt on
aps= ~'\ d
0 6Y 6C ~
"h""-"
:rp: = J\ er:ig<' propensity to sa, e s :.v · sv· :.\
S = rk5,re d s.:i, mg y
~ I • M.PC - ~!PS
Yd= Pt>rsonal D,spo sabk Incom,•
A s f)<'r figure, awrag<' propt>nsil) to or \IPC • l - \ 11'5
s:i, <' = ABtO r\ when the lewl of
f'<'!'SOnll £ or \ !PS• I - \ ll'('
dtspoS-lble income = OA ;ind de,1red f
> s = 65
savm g= AB
Marg inal Prope nsity to Savl' : It
!JS .lrd •••
refers to l ratio betwe en chJng,· in
f
destred s.ivrngs (<lS) corr<'Spond1ng to a ~
changt> in perso nal d1,po sll 111conw 0 A \
(ti.Yd)
(mps) s = t,5/t,. Yd 5
where
y
s = mJrginal prop,.>ns,ty to sa, <!
1\..5 = ch.mge 111 d,-s,r,>d s.w, ng dt> ~bl,·
.lYd = dtJnge in pcr.,orul
incom e
Corre spond ing I ll 11 , d,-,u, -J -..., ""t
In the figure, Yd dung ~ from OA to OA 1. rul prup.'fu.?J
c AA • TI1u,. mJri;1
changes from AQ to Al n,u,, .lS= PR when ti. Yd 1
PR
tos.:ive= -
QR
:
Relati ons hip between APC, APS, MPC. MI'S
Relation betw,'t:11 APC and Al'S
Al'C• Af'S s J
As we know Ya C • S
D1v1ding both s1de:s of 1h,· 1'ij11~1, un hy Y
C S
J• - t -
y y
~ APC+ APS • 1
S em t•~k1-\ 1 ll lH 'SI
13.A. (l'rog.)/13.Co m. {Pro g. ) Il l Ye,ir
Generic Elec tive Cou rse 2(a )
PRINCIPLES or MACROECONOMICS
4 UNIT
NATIONAL INCOME DETERMI NATION IN
AN OPEN ECONOMY
Q. 1. Compute the equilibrium level of real GDP w h en :

C= <150 crorcs + 0.75 ly - T)
I= <100 crorcs
G= <150 crores
T= <2.00 crorcs
Ans. Thi:. is J three sector dosed economy model wi th the prc:-.cnce of house-
ho ld , firm ,rnd government sector in the economy. The equilibrium lc,·cl of income
(CDP) \Nill be determined at the p oint where aggrega te demand (A D ) eqtlJls
<1ggregate s upply as given by the follo w ing equation,
y= AD
1.e., y = C + I+G
substituting the values of C, I and G
WC get,
y= 150+0.75(y-T)+100+ 150
⇒ y= 150 + 0.75 (t/ - 200) + 100 + 150
⇒ y= 400 + 0.75y - 150
⇒ y= 250 + 0.75y
⇒ (1 - 0.75 )y = 250
⇒ 0.25y = 250
250
Ye= _ = <1000 crores.
0 25
Hence equilibriu m level o f CO i' (yr) Id be ckk r1ntt1L'd ,11<100() ( rot\'~
\\'Ott
Q. 2. What is the net expo rts functi on ? Wh.1t f.1clors m.1y c.1usc J shi ft in the
net exports function?
Ans. Net Export F1111rt io11 : In ,1n ()~wn e(orll1111 y lht· li.1 IJ11 cc ot tr.,ci L' l~i, t>n l11
the difference between exports .1nd im ports uf goods only) rL', ponJ ~ to c h,111 ~1''11
the CDP. In case of exports, they dl'pl'tld 011 the spend mg d cl'i~i11n 111,hk by th,
fo reign consumers wh o purch,1sc domestic goods J11d scrviCl'S. Tlwrl'll)t\', ~, \' .1~~uir,
th,1t the expo rts ore determ ined by inll ucnccs ou lsilk thr d\ll\\l'~ta· c ,'\ l1Wl1 l \ ,r
exports (X) ore ,1ssumed to be exogcnr ous.
Howeve r, imports (M ) depend un th e spending J L'Cis1rn,~ <1I Jn11H '"l1, 1,,, ,dc1' •
so when the incomes of domestic rnn~umcr" rise, tht· 111q1\11 t, , ,,,1' \\ \' t.1~c "'
ex po rts ilS the di ff l'rcncc between export!'- ,rnJ iinp1irts ,111d I li1·y .,11, th l ~.111\ 1'h n'l.1i;. ,
to the CDP beca use of the positive rcl.1lion~hi 11 lid ,,, l'l'I\ d1•~111',l 11np111 t~ ,11hl l·'
Semes ter-VI [CBCS]
B.A (Prog.)/B Com. (Prog.) III Year
Tl11S negative rela tionship between net exports aJ1d GDP rs called the net exports ftmct1011
Shifts 111 the 11et export fu 11ctio11 :The net export function which rela tes net exports
(X - M), denoted as NX, to GDP; is drawn on the assumption that everything that
affects net exports, except domestic GDP, remains constant. The major factors that
must.be held constant are
(a) foreign GDP,
(b) relative international price levels and (c) the exchange rate.
A change in any of these factors will affect the amount of net expor ts that will
occur at each level of GDP and hence will shift the net export function.
The net export function can be represent by the following diagram :
X, M
M (Imports) = mY
X
1-------~ - - - - - X = x(Exports)
{
o " " ' - - - - - ~ - - - --p- Real GDP
Diagram : (1) /Export and Import Function
Net Exports (X - M)
/ (X-M)I(Net exports functions)
Q,1 - - - - - -~ - - - - - -- Real GDP
Diagram : (it) Net Export Function
Increase in foreign GDP :Now suppos_e there is _an increase i~ foreign GDP. Oth~r
things being equal, it will lead to an mcrease m
the qu~n~1ty of our domesllc
prod uced goods demanded by foreign consumers 1.e.: It will increase our exports.
This causes the upward parallel shift of exports function (X) _and ~o~seque~t~y the
net export function (NX) would also shift upward parallel to its ongmal pos11Ion as
shown in the following diagram :
. BA /B Co m. (Prog.) / Ill YEAR ECONO MICS lC BCS]
34 SATISH , · · ·
X. M
M == mY
X .............................................................. 1.... . .................... x == X'

i X:: X X' > X
L--~,c-- +--
ix IL..- ---+,--+-,---➔ Diagram : (i)jExport land Import Function

Real GDP
i l
Il Il
i I
. . . . . . . ..... l i
I
····-..................... !
. .J:~-_.. ._. ,. : .·,
oL------=··,·~ 1::--_ _
,. -+ Real GDP
··•...........
'·,
NX= X'-M
NX = X'-M
Diagram : (it) Net Export (NX) Function
An upward shift in exports shifts the net export function upward. Simi!,
other influences can be worked out.
Q. 3. What do you mean by the Fiscal Policy. Also explain the Balanced Bud
multiplier in this context.
Ans. Fiscal Policy: Fiscal Policy involves the use of governm ent spending and
policies to influence the total aggregat e demand in order to achieve any spt'r
goal set by the governm ent. Fiscal policy basically is concerne d with the seltin:
the directions of required changes in aggregat e demand or spending . For in::.tni
government spending increases aggregate d esired spending and taxation dl'l.."1'~:tSl'
Any policy of the governm ent that attempts to stabilize GOP ;11 or 1h'.1r
desired level (usually potential GDP) is' called its Stabilizat io11 Pv/ic1;. Wlwncw1
economy is operatin g below the full employm ent level of oulpui or it:- C111'
stuck below the full potential, then the Fiscal Policy might be usl'd w n• tu 11
economy to its potential level of GDP. The Governm ent can simply, USl' nppt'Of 1
1
fisca l tools such as to raise its spending and/or to lower tax rates. ·nwy wt)uld :
the aggrega te demand curve upwards , causing an increase in tlw equil ibriu111 l
pushing the economy towards the target.
NATIONAL INCOME DETERMINATION lN AN OPEN ECONOMY 35
Bn/n11ccd Budget Multiplier : The budget balance is defined as the government

reven11es minus government spending. When this difference is positive the budget
is in surplus; when it is negative the budget is in deficit. When the budget is in
surplus, there is positive public saving, because the government is spending less on
the national product than the amount of income that it is withdrawing from the
circular flow of income and spending. When thew government budget is in deficit,
public saving is negative.
Next, we consider balanced budget changes. A balanced budget increase in the
govemment spending will have a mild expansionary effect of GDP, and a balanced budget
decrease will have a mild co11tractio11an1 effect.
The balanced budget multiplier (BBM) measures these effects. 813M is defined as
the change in GDP divided by the balanced budget change in government spending/
expenditure that brought it about for example, if there is extra ~ 100 crores of
government spending (combined with the tax increases to finance it), and this causes
GDP to rise by~ 60 Cr., then the BBM is 0.6; if, however GDP rises to~ 100 crores
then BBM is 1.0. ·
tiY tiY
i.e., BBM = tiG = tiT .
Q. 4. (a) Explain the working of multiplier when change in investment

in the economy is f 1,000 crore and the MPC is 0.5. Also estimate the total
change in income and value of multiplier.
(b) Give the following data for an economy:
C = 250 + 0.8Yd
I = ~ 100 crore
G = ~ 100 crore = T
Calculate the following :
(i) Saving at equilibrium level of income
(ii) The value of multiplier and the change in income, if investment
decrease by t 20 crore.
Ans. (a) tiI = ~ 1,000 crore
MPC = C=0.5
1 1 1
Multiplier, m = l-C = l-0.5 = 0.5 = 2
(Change in income) t,.y = m x t,.l
= 2 X 1000
IChange in Income = ~ 2,000 crore

(b) C = 250+0.SYd
I = 100
G = T = f 100 crore
At equilibrium level of income,
J
36 SATIS H : B.A ./B.Co m. (Prog. ) I III YEAR ECON OMIC S [CBCS
Y =C+ I+G
Y = 250 + 0.8 (Y-T) + 100 + 100
Y = 250 + 0.8 (Y-10 0) + 200
Y = 250 + 0.8Y - 80 + 200
Y. = 0.8Y + 370
Y -0.8Y = 370
0.2Y = 370
370
Y = - = t 1 850 crore
02 '
(i) Savin gs at equili brium level
S =-250 +0.2Y d
= _,, 250 + 0.2 (1,850 -100)
= - 250 + 0.2 (1,750)
= - 250 + 350
= t 100 crore.
(ii) Value of Multi plier
~I = 20
-1 1
rn = =--
1-MP C 1-0.8
=-1- =5
0.2
~y = M X ~I
~ Y = 5 x 20 = t 100 crore
Q. 5. Calculate equilibrium level of income from the follow

ing data :
C = 150 + 0.75 yd
I = f 100 crores
G = f 150 crores
T = t 200 crores
Ans. Y =C+I+G
= 150 + 0.75 (Y- T) + 100 + 150
= 400 + 0.75 (Y-20 0)
Y = 400 + 0.75Y -150
Y = 250 + 0.75Y
Y-0.7 5Y = 250
0.25Y = 250
250
Y= _ = t 1,000 crores.
0 25
Calculnl
Q. 6. Explain the relati onshi p betw een MPC and multi plier.
the value of multi plier when MPC is equal to 0.9, 0.8 and 0.5.
NATIONAL INCOME DETERMINATION IN AN OPEN ECONOMY 37
~y
Ans. Multiplier, K = -
Af
~y ~Y/t::,.Y 1
K = =
t::,.y t::,.C =--
t::,.Y-t::,.C 1-C
- --
t::,.y t::,.Y
C = mpc
As mpc increases, value of multiplier increases
mpc = 0.9
1 1
K = 1-0.9 = 0.1 =
10
rnpc = 0.8
K = ,_l_ = ....!_ = 5
1-0.8 0.5
rnpc = 0.5
1
K = - - = 1 =2
1-0.5 0.5
Q. 7. Calculate equilibrium level of income from tlte following data :

C =· 150 + 0.60 (Y-T)
I = f 120 crore
G = f 100 crore
T = f 50 crore
Also find change in equilibrium level of income if government
expenditure rises by f SO Crores.
Ans. Y = C+I+G
Y = 150 + 0.60 (Y-T) + 120 + 100
= 150 + 0.60 (Y-50) + 120 + 100 = 370 + 0.6Y -30
0.4Y = 340
340
Y = 0.4 = 850 crores
if, G = 150 crores ·
Y = C+l+G
= 150 + 0.60 (Y-50) + 120 150 = 420 + 0.6Y - 30
0.4Y = 390
390
Y = - = 975 crores
0.4
Q. 8. (a) Explain the working of multiplier when change in investment

in the economy is ~ 1,000 crores and the MPC is 0.05. Also estimate the total
change in income and value of multiplier.
38 SATISH: B.A./B.Com. (Prog.) / III YEA
R ECONOMICS [CBCS]
An s. Inv estm ent Cha nge (ill) :::: ~ 1000 cro res
mpc :::: 0.50
Cha nge in Inc om e (AY) = ?
As Per Inv estm ent Mu ltip lier
AY
(Ki) = -
ill
1 1
Ki = --=
1-C 1-0 .50
1
= 2
0.50 =
Thu s, usi ng e.g. (1), we get
AY
2 =
1000
AY :::: 2000 cro res.
(b) Giv en the foll ow ing dat a for an
eco nom y:
Co nsu mp tion fun ctio n C = 150 + 0.60 Yd
Inv est me nt I = t 120 crores
Go ver nm ent Exp end itur e G = ~ 100
crores
Taxes T = t 50 crores
Cal cul ate the fol low ing :
(i) Equ ilib riu m lev el of inc om e.
(ii) Ch ang e in equ ilib riu m lev
el of inc om e
if gov ern me nt exp end itur e inc rea
ses by t 50 crores .
An s. (i) Equ ilib rium lev el of inc om e
(Y) :::: C +I:::: G
Y = 150 + 0.60 yd + 120 + 100
= 150 + 0.60 (y-T ) + 120 + 100
= 150 + 0.60 (y-50) + 120 + 100
= 370 -30 + 0.60y
y = 340 + 0.60y
340
y = - - = -850 cro res
0.40
Ne w Go ver nm ent Exp end itur e= 100
+ 50 = 150 cro res
No w,
y = 150 + 0.60 (y- 50) + 120 + 15
y = 420 -30 + 0.60 y
0.40y = 390
y = 975 cro res .
Q. 9. For Saving funciion S = -500+0
.20Y, at wh at lev el of inc om e-
NATIO NAi. INC OMI-: D l•:TlmMtNA'J'ION IN AN O l'l~N l !C(JN O M Y 39
(i) will saving be equal lo :.r,ca·o?

(ii) will savings be equal to inves tment, if autonomous inve s tment ia
~100 Cl'Ol'CS ?
How much will the equilibrium level of income change, if autonomou s
investment increases lo ~ 150 crnrcs?
Ans. Sa ving Funclion S ., - 500 + 0.20 Y
(i) will saving be equal to zero
He nce, S 0, Then
c:i
s - 500 + 0,20 y
Cl
0 = - 500 + 0.20 y
500 == 0.20 y
500
= y
0.20
y ~ 2500 (crorcs)
:::i
(ii)(a) Saving == Investment

1 = s
100 = - 500 + 0.20 y
y = ~ 3000 (crorcs)
(b) When 1 = ~ 150 (crores)
150 = - 500 + 0.20 y
650 == 0.20 y
y = ~ 3250 (crores)
Q. 10. If C = 50 cro res + 0.6Y I = 20 crorcs

Find the value of the multiplier.
Ans. C = 50 crores + 0.6Y
I = 20
Y =C+I
Y = 50 crores + 0.6Y + 20 crores
Y -0.6Y = 50 crores + 20 crores
0.4Y = 70 crores
70
y
0.4
Y = 175 crores.
· l -l b w h'IC l1 IS
1 1
Here, multip l ier IS . - - -
1 - 0.6 0.4
or, C = a+ by
Y =A+ by+ I
Y - by = a+ I
(1 - b) Y = (a + I)
y _ (a+ I)
- (1 - b)
H1 sl'l\\ l'Sll' r-Vl lCH l'Sl
H. :\ . (l'ro g.)/ H.Cm n. (Pro h.) 111 Y~ ..1r
l:l'\\l-'l'l\' Ekd iVl' Com·sc 2 (.1)
l'RlN ClPl .ES Ol; l\tr\C ROl ~CON Ol\'t l CS
\ /1 .
liO Uy hnw mud , l',msu mpli, >n .rnd inl.'o mc will in

.\\\~l'l' .lSl' \l\
. ,\\\\'l' Sll\\c nt b " O crc.1s c as a r~s u1t
)' ·' (Hll'C S ? 01
Ans. lt 11\\' l's lnwn t i1h'l'l' s,•s by 30 crnn· s
'l\.,t.,l inYl' stnwn t will t,,, .. 5l1 ,-r,w1.•s
\ +I
1...'
\ .. !°1ll l.·r,H','S + lll>Y + SO cror,•s
\ IOL) l'l'l)l'l'S + l) ,t,Y
\ - l) .t, \ - tl)L) ('\'\)\'l 'S
( l- l1 .l~) \ • ll)l) l'l'lH'l' S
t()l)
y c - ('1'0l'l'S
OA
m 25() ('l'Ol'CS
(i) lncrl' ,lS,' in inc,m11..' == 250 cror~ s- 175 crorl 's
== 25 crore s
(ii) lnn~ as,' in l.'ons umpl ion
Cons umpt i,H, ⇒
C ::: 50 crorl' s + 0.6 (Y)
\ Vht~ll Y = l 75 cro res
C ::: 50 crorc s + 0.6 (175 er.)
= 50 crore s + 105 crore s
= 155 crore s
When Y ::: 250 crore s
C = 50 er. + 0.6 (250 e r.)
C = 500 er. + 150 er.
C = 200cr.
Incre ase in consu mpti o n = 200 er. - 155 er.
= 45 crore s.
ax
Q. 11. Give n, cc
NOP at mark et price = ~ 25,000 crore s
Depr -ccia tion = ~ 500 crore s
Net facto r incom e from abroa d= t 1000 crore s
Net indir ect taxes = t 300 crore s
Find out
(i) NNP at facto r cost
(ii) NOP at facto r cost
(iii) GNP at facto r cost
(iv) GDP at mark et price
(v) GDP at facto r cost
Se mes ter-VI lC BCS J '1 J
B.A. (Prog.) /B.Com . (Prog.) Ill Ycnr
Generi c Electiv e Course 2( a)
PRINC IPLES OF MACR OECO N O MI CS
(v i) GNP at market price
(v ii) NNP at market price
Ans. NOP ,.,11 , = 25000 cro res
D e prec iatio n = 500 c rores
NFIA = 1000 crores
NIT = 300 cro rcs
(i) NNPFC = NDP,., 11, + NFIA- NIT
= 25000 + 1000 - 300
= 25,700 crores
(ii) NDP,,c = NDPMl' -NIT
= 25000-3 00
24,700 crores
(iii) GNPFC = NNP Fe + Deprecia tio n
= 25,700 + 500
= 26,200 crores
(iv) GDP,.,11, = NOP MP+ Depreci ation
= 25,000 + 500
= 25,000 crores
(v) GDP rc = GDP ,., 11, -NIT
= 25,500-3 00
= 25,200 crores
(vi) GNP,., 11, = GNPFC + NIT

= 26,200 + 300
= 26,500 crores
(vii) NNPt.11, = NNPrc + NIT
= 25,700 + 300
= 26,000 crores
Q. 12. (a) Explain the working of multipli er when increase in investm ent in
an econom y is f 1,000 crores and the MPC is 0.50. Also estimate change in
equilibr ium level of income and value of multipli er.
Ans. I),, I = 1000 crores c = 0.5
pd Increase in iin in Income Incom e level

Investm ent consump tion
1 1000 1000 1000
2 1000 500 l 500 1500
3 1000 750 17SO 175()
4 1000 875 1875 1~7:-
5 1000 937.5 11n 7.s 19.•7.5
n 1000 2000 2 ll()ll '20(lll
42 SATISH: B.A./B.Com. (Prog.) / III YEAR ECONOMICS [CBCS]
1 1 1
(k) Value of multiplier= l-C = l-0.5 = 0.5 = 2 times
1
Change is equilibrium income (.1 Y) = l-C Cl I
= Z (1000) = 2000 crores

(b) Given the following data for an economy:
Consumptio n function C= 150 + 0.60 Yd
Investment I= f 120 crores
Government E~penditure G= f 100 crores
Taxes T= f 50 crores
Disposable income Vd = Y - T
Ans. C = 150 + 0.60 yd I= 120 crores G = 100 crores T = 50 crores
Calculate the following :
(i) Equilibrium level of income.
(ii) Change in equilibrium level of income if government expendi
increases by f 50 crores.
Ans. (1) Equilibrium Income (Y) C +I+ G
Y = 150 + 0.6 (Y - 50) + 120 + 100
Y = 370 + 0.6Y-30
Y= 340 + 0.6Y
Y-0.6Y= 340
0.4Y= 340
⇒ I Y= f 850 crores I
(ii) .1G = 50 New G = 150
1
.1 Y= - . 1 G
1-C
1
d y = 1-0.6 (50)
1
d Y= -(SO)
0.4
d Y= 2.5 (50)
I d Y = 125 crores I
UN ITS
MONEY IN A MODERN ECONOMY
Q. 1. Wha t is mon ey ? Des crib e vari ous func

tion s of mon ey.
Ans . Money is anyt hing th_at is gene rally acce
ptab le as a mea ns of paym ent
in the settl eme nt of all tran sact ions . It is the
mos t com mon ly used med ium of
exch ange or mea ns of tran sferr ing purc hasi
ng pow er. Gen eral acce ptab ility as
a mea ns of paym ent is the uniq ue featu re
of mon ey and this mak es mon ey
alon e the gene ral purc hasi ng pow er i.e., the
pow er to buy thin gs direc t! y in all
the mark ets.
The mos t fund ame ntal func tion of mon ey is
to facil itate the exch ange of
good s and serv ices in an econ omy and to lesse
n the wast e of time and scar ce
reso urce s to carr y out trade . The four basic ftmct
io11s of mo11 ey are sum mar ised
iitu1 as follo ws :
7 (1) Money as a medium of excha11ge: In the abse
nce of mon ey, good s w ould
1
have to be exch ange d by bart er (whi ch mea
ns dire ct exch ange of good s and
serv ices for good s and serv ices) . The majo r
diffi culty with bart er is that each
tran sact ion requ ires a doub le coin cide nce
of wan ts i.e., each part y to the
exch ange mus t have prec isely wha t the othe r
part y requ ires, and in appr opri ate
quan tity and at the time requ ired . This wou
ld invo lve a trem endo us wast e of
time and reso urce s in sear ch effo rt and in mak
ing barg ains . The use of mon ey
as med ium of exch ange avoi ds muc h of this
wast e by econ omis ing on the use
of scar ce real reso urce s in carry ing out exch ange
s. By facil itatin g trans actio ns,
mon ey mak es poss ible the bene fits of spec ializ
ation and the divi sion of labo ur,
whic h in turn cont ribu te to the efficiency of
the econ omic syst em .
(2) Money as a unit of account : Mon ey cust oma
rily serv es as a com mon unit
of acco unt or a mea sure of valu e in term s of
whic h the va lues of all good s and
serv ices are expr esse d. This is imp orta nt
to have mea ning ful acco unti ng
syste ms. So that a wide varie ty of good s and serv
ices who se phys ical quan titie s
are mea sure d in diffe rent unit s can be adde d
up.
(3) Money as sta11dard of deferred pay111e11 t: Mon
ey also serv e as a stan dard on
unit in term s of whic h defe rred or futu re paym
ents are state d. This appl ies to
the paym ents of inter est, rent, wag es, salar ies
etc.
(4) Money as a store of value: Mon ey is a conv enie
nt way to store purc hasi ng
pow er i.e., the mem bers of the publ ic can hold
their weal th in the form of money.
The use of mon ey as a med ium of exch ange
deco mpo ses a sing le bart er
trans actio n into two sepa rate trans actio ns of purc
hase and sale. This will requ ire
that the med ium of exch ange also serv e as
a store of valu e. Ther e are othe r
asse ts of all kind s whic h also serv e as store
s of valu e but mon ey is the only
; store of valu e th at is perf ectly liqui d.
( 43)
·I l S AT IS l l : 1\ .,\ / 11 .l \1111. (1 ' 111)', ,) / Ill Yl-. /\ 1{ l•l 'l iNl
>M l ( ' , i< IH , •I
Q . 2 . \Vh,1t ,H e di ffc rl.'nl mo11 c l .HY ,,gi;i•c1•o ' 1t ci; '·,i; u1:,c d l11 ln d i.1 ,,t pr.•11 1
· 111
Or
~
Sl,1lc tile nll!,1 s urcs o f mu1w y s,upp ly •as u sc<l by th e HUI.
Ans. 1V l1 ·11;; 11r1•,-; of t\lltll/1 ' /llrl/ /\ssn·snt,·s : /\t p n:Sl'
lll tl H" f'l' :an · four 1111!111'\ -11
.,~grc h,\ks .,1 c Cl1111 p1kd · b y t Ill'· 1,es
1 • • B k r1,,d iawi lhthc 11o n nof1 Jni•,r
l'1 vc ,111 u ' • . 1, , ..., .,1·v,,
in term s o f liqui dity : ~\, (Mun et ~1ry bi:lse), M (narr o
1 w lll Cllll'Y), M::, · c.l M.l (br<J~
11 1
mo111._•y). Tlws e nre defir wd as follow s :
(i) M == C urren cy in circu latio n + IJnnkers' Depo
11 sits with lil t· 1<.BI 1 'oth.1:s
Depo sits with thl-' RIJI.
(ii) M = C urren cy with the publi c+ Dem.:ind
1 Depo sit~ w ith the IJanki r
Syste m + 'olhe r' Depos its wilh the RBI.
(iii) M = M + Tinw linbililics porti on of Savin
2 gs De pos its w ith the Uanki ~
sy~le m + certif icate s of Depo sits issu ed by Ba nks + Te
rm -Dcposr
(excl udin g FCN R (B) d e posits) wilh a co ntrnc lu a l m
aturi ty of llj
lo and inclu ding one year with the Bank ing
Sys tem.
(iv ) M = M 2 + Term s De posit s (exc ludin g FCN R (B) d e pos its)
3 w ith
contr nctun l matu rity of over one year with the Bank
ing system
Call bo rrow ings from 'Non -Dep osito ry' finan cial Corp
orati ons h
the Bank ing Syste m.
Q. 3. Disc uss the Keyn esian appr oach to the dem and
for mon ey.
Ans. De111m1d for 111011ey : Mon ey for the sake of mon
ey is want ed only by,
miser . Peop le want mone y beca use it has got hold over
good s and servi ces. Peopl
want mone y beca use throu gh it they can purc hase
anyt hing they like. Money l
dema nded beca use it can be used as a medi um of exch
ange and store of value .~
other word s, thing s can be boug ht and sold throu gh
1noney. Thus , if one want s t
buy some thing, he need s.mo ney to pay for that. And
if one want s to store somethinl
he will store mone y value of that con1 modi ty for one
can buy that comm odity lat~
on throu g h mon ey. Thus the dc11rn11d for 111011cy mea11 s
:
(i) the amo unt of m o ney whic h buye rs are willi ng
to offer in lieu of dernan
for any comm odity , or
(ii) the volu me of good s and servi ces that se
llers will offer in exch ange fo
money.
Th~r e are num be r of trans actio ns whic h take place
in our day- to-da y life, fu
whic h mon ey is nee ded as a medi um of exch ange .
Thus , the dem and for mone yt
d e term ined by su ch objec tive facto rs as the volu me
of trans actio ns and the facto~
deter mini ng the amo unt of good s and servi ces prod
uced and trans acted . How eve.
there Jre some econ omis ts who poin t out that mon
ey is dem ande d as a store (
va lue o r as cc1sh ba lt1nce . Keyn es has listed three moti
ves due to whic h peop le wis'
to h o ld m o n ey in cash these are :
(i) Trn11snctio11s Moti ve: Indiv idua ls, finT\S and insti
tuti? ns dem and mon ey fo
the cond u c t o f d ay- to-d a y trc1ns actio ns . lncomes by
indiv idua ls and busi ness fir~'
a re receivt:>d a fte r s p ecifi ed p e rio d , but e xpen ditur
e is regu lar. Thus , the cash whiC
MON EY lN A M ODL:: l{N 1·'.CO NOM Y
in t!) qf lit JH' o f iJ1 n 11l ll' p .iy 1rwn l•,

is kept for m eetin g exp e nses be twee n two po
ich i-.. w il l,--h<'ld 0 11 .i c<'!ILtn l <,( fh j ,,
cons titu tes tran sact ions moti ve. The c.:ish , w h
motive is inter es t-in elas tic.
-day lrr1 ns.:1<· ti un!-. /Jl'opl c ulso
(ii) Preca utiou nry M otive : Besi des mee ting d ay-to
s of li fe wh ich con not be a n lidp nlcd .
with hold som e cash fo r mee ting som e excg cncie
by way of r nx a u lion.
The mon ey w ith h eld on acco unt of this is kep t
(iii ) Spec ulative Moti ve : The third mo ti ve fo r
ho ld ing ca!>h b th e d l·Sir<..: to earn
rnle of in teres t in the futu re wi /J be
p rofit s. Man y p eopl e m ay h ave a belie f tha t the
ture incre ase in the ra te: o f in te res t,
high er and in orde r to ta ke adva n tage of th is fu
lo be len t or inve s ted whe n th e ra tes
they may like to keep m oney in the liqui d for m
exer cises profo u nd in flu en ce on
of inter est actu ally rise. The spec ulative m o ti ve
the rate of inte rest.
d ema nd fo r n10n ey, indi cates
The liq uidi ty p refer en ce, which is also know n as
to keep in li q u id fo rm at diffe ren t
the amo u nt of money tha t peop le w oul d like
inter est and the liqui d ity pref eren ce
rates of inter est. The relat ions hip betw een rate of
.tlwa ys slop es dow nwa rd s to the
is inve rse. As such the liqu idity pref eren ce cu rve
right .
ing m oney in cash , ther e are
Besi des the thre e moti ves disc ussed abov e for hold
ct the price s to fall in fu ture, they
some other moti ves also . Firstly, if people expe
and serv ices. Seco ndly, peop le a lso
wou ld keep , mon ey rath er than keep ing good s
for the sake of con veni ence, p eop le
hold mon ey for expa ndin g their busi ness . Thir dly,
than in vesti ng th~m in bond s and
keep thei r sav ings in the form of cash rathe r
various moti ves discu ssed for w hich
secu ritie s. Thus the dema nd for mo11ey consists of
people hold or dema nd moJLey.
of mon ey.
Q. 4. Exa min e criti cally the Qua ntity theo ry
Or
tity of mon ey and price leve l
Crit icall y disc uss the relat ions hip b etw een quan
usin g Fish ers' quan tity theo ry of mon ey.
hip betw een quan tity of m oney
Ans . The expl anat ion with rega rd to the relat ions
tity theo ry of m on ey. Th e quan ti ty
and the general price level is prov id ed by the quan
theo ry of mon ey is the o ld es t
theo ry of mon ey pop u larly know n as class ical
of mon ey or gen eral pric e level.
expl anat ion of the dete rmin ation of the valu e
or the valu e of m on ey is gove rned
Acc ordi ng to this theo ry the general price level
ey is incre ased , the price leve l is
by quan tity of mon ey. Whe n ther quan tity of mon
mon ey. On th e othe r hand w h en
also incre ased and ther e is a fall in the valu e of
level fa lls dow n a nd the value
there is redu ction in the q uant ity of mon ey, th e price
hip betw een th e qua ntity o f mon ey
of m oney goes up. Thus , there is a direc t relat ions
g the same, the chan ges in the
and the gene ral pric e level. Othe r thing s rem ainin
chan ges is the gen er:tl pric e le vel
quan tity of money will brin g abou t prop ort ion ate
of mon ey is dou b led, th e gen eral
in th e sam e direc tion . For exam p le, if the quc1n tity
price level w ould also be d oubl ed and vice-ve rsa.
mon ey <1 nd the va lue of rnon ey
H owe ver, the relat ions h ip be tween quan tity o f
ean its purc h.:isi ng pow er. Wh en
is of a d iffer ent kind . By valu e of mon ey we m
(Pro ,. )/ Ill YEAR ECONOMICS [CBCS]
46 SATISH : B.A./B.Com. g. .
hasi ng pow er of mon ey 1s redu ced and
aene ral price level goes up, the pu~c vel and valu
o e of mon ey are inve rsely r " 1~ ·
versa . In othe r wor d s gene ral pnce e
. . 1 vel is directly re1ate d tot h e quan tity of , e1a~
But as seen above, the general pnce :.ty of mon rn ~
As s~ch, value of mon ey a nd q~an 1f mon ey and
ey are also inve rsely related ~~
. the gene ral pric e level i; d' li\,
the relat10nsl:u.p be twee.
n quan tity o l f
whe reas the relat ions hip between qua ntity of mon ey and va ue o mon ey·is inv ireo
. er54! th
Tl 1 f10nshi p betw een quan t1.ty of mon ey and gene ral pnc e level has h.._
1e re a f f on The equa • ~
explained with the help O an e~ua ~- · The tion in its mos t scientific forrn ~
been prov ided by Professor Irvm g is11 er. equa tion is give n belo w : ar
st
MV +M 'V' tr
p ---- H
= T b
p = Gen eral price level.
M = Mon ey in circulation. 1-
V = Velocity of mon ey in circu latio n. tl
\
M' = Volume of cred it in circulation. r
V' = Velecity of cred it in circulation. C
, T = Total num ber of transactions.

This equa tion , expl ainin g the relat ions hip betw
een gene ral pric e level and
quan tity of money,' hold s good only whe n certa
in assu mpt ions are mad e. They are
as follo ws:
(1) Mon ey in circulation (M) and credit in circu
latio n (M') chan ge prop ortio nately
in the sam e direc tion. For example, if M is doub
led the M' wou ld also be doubled.
(2) T, i.e., num ber of trans actio ns for whic h
mon ey is dem and ed, remains
unch ange d. In othe r word s, there is no chan ge
in the dem and for mon ey.
(3) V and V' i.e., velocities of mon ey and cred it
do not chan ge.
(4) Num ber of bart er trans actio ns cont inue to be
the sam e. In othe r wor ds, th~
num ber of such trans actio ns for whic h mon ey
is not need ed is the sam e.
Now we know that gene ral price level depe nds
upo n quan tity of mon ey (MV+
M'V ') and if a chan ge is brou ght abou t in the
gene ral pric e leve l, shal l be due to a
chan ge in the quan tity of money. For exam ple,
if M = 100, V = 5, M' = 50, V' = 5 and
T is 100; then Gen eral pric e level is
100 X 5 + 50 X
5 500 + 250 750
=-----
100 100 = 100 = 7·5
But if due to chan ges in the supp ly of mon
ey, the vari able s of the equa tion
chan ge in the follo wing way
M = 200, V = 5, M' =100, V' =5 and T = 100, then
200 X 5 + 100 X 5
Gen eral Pric e Leve l =
100
MONEY IN A MODERN ECONOM Y 47
1,000+500 1,500
= = - - =15
100 100
Thus we notice that general price has doubled because other things remaining
the same, quantity of money has doubled.
Evaluation: _It has ~n o~served that the relationshi p between·q uantity of money
and general price level 1s direct and hence changes in the quantity of money are
supposed to generate changes in the general price level in the same direction. For
this, we have to consider the explanatio n provided by the quantity theory of money.
However, there are many weak points in the theory. Some of them may be considere d
below: ·
(1) This theory is based on some assumptio ns which are untrue and unrealistic .
Hence, a theory based on unfounded assumptio ns can not be true. The theory regards
the demand for money fixed which is absolutely unreal. Further it assumes V and
V' constant. This also is untrue. Similarly, the relationsh ip between Mand M' can
not be exact. It is not necessary that M and M' vary proportion ately in the same
direction.
(2) According to this explanatio n, changes in the general price level are brm~ght
about only due to changes in quantity of money. However, in practical world we
find the quantity of money is a very fundament al factor but to suggest that it is the
only factor which brings about changes in the general price level is not true.
(3) The quantity equation is static. It applies to a world where other things
remain constant. But ours is a dynamic world where other things are constantly
changing. In reai life other things do not remain unchanged. In real world population ,
human behaviour , business cycle and technolog y-all change and changes in these
generate further changes. Dynamic forces form the essential basis of our society.
The theory may at best be of some help in explaining normal long run tendencies ,
but for short run cyclical fluctuation s it is of no avail. For the study of business
phenomen on the quantity equation is, therefore, utterly inadequate .
(4) Further the quantity equation does not provide the entire mechanism through
which changes in quantity of money finally bring about changes in the general
price level.
(5) Further, some noted economist s from Cambridg e University have provided
an alternate approach to the quantity theory and their approach is known as cash
balance approach. Their interpretat ion of the demand for money is different.
Inspite of all the shortcomi ngs mentioned above, the theory of money i.e.,
quantity theory of money provides us a very useful explanatio n with regard to the
determin_a tion of value of money and the relationshi p between quantity of money
and general price level. Changes in quantity of mo1~ey do bri_ng about changes in
price level. For substantia ting this point recent Indian experience of 1970-80 is a
point of utmost importanc e in view. The wl~olesale price i~dex in Indi_a i~ this year
registered a rise of 21 per cent and the basic cause for this was the nse m money
supply without being correspon ded' by similar rise in the volume of goods and
services.
SATISH: O.AJB.Coni. (Prog.) / l1l YE
48 AR ECON OMICS [CBC:SJ
. . th at inc rcnse in mo ney
. Keynes als? n~a111~a11; cco:·di ng s upp ly lea ds to i
to him inc rea se in mo ney sup ply
price-le vel but md irec t Y: t . ~t w ; 0ere~ ~
hic h in tur n wo uld inc rea se inv
to decline in the rate o_r mde re estrne Uld I~
th leve l of effe ctive em an d w oul d be up fina lly lea din g to inc nt. rn
wa~ e . rease in tv<
nat ional 111com e. 1-{oweve r, if the level of full em plo ym en t h as been achi
. . ld be •
onl y in the mo ney inc om e 1ea d' eved
¾
tha t case this incr eas e wo u mg to inc ,,
c ci
th
the- rice-level. Thu s, acc ord ing to .. • th t't f reaSe
Key ne5, mc rea se m e quan 1 YO
to it~r eas e in the price-level but moneylea~
onl y afte r the stage of full em plo
yment has ~ h<
ach ieve d. .
Q. s. (a) Explain the ratios approach Ol
to the creation of deposits.
(b) How is this diff ere nt from the cre
atio n of dep osi ts wh en ban ks workini
ol
competitive environment?
Ans. (a) There are two models of the cren
tiolldeposit money : The first shows how
ban ks can cre ate a larg e vol um e-of
d epo sit mo ney on the basis of a giv
rese rves. It is call ed the rati os app roa en amo untot
ch to the cre a tion of mo ney. The sec
how ban ks wo rk in a com pet itiv e ond shows
enviro nm ent to attr act the res erv
es they need in
ord er to cre ate dep osit money.
The rati os app roa ch :
Let R be the cas h hel d in ban k rese
rves,
C be the cas h hel d by the pub lic,
H (High- pow ere d mo ney ) be the
tota l cas h in the eco nomy; and
D be the size of dep osit s
We def ine H = C + R- (1), wh ich imp
lies tha t tota l cas h in the eco nom
eith er by the ban ks (R) or by the pub y is held i~
lic (C).
Cl
Let the des ired rese rve rati o of the
ban k be x. Thi s sho ws the pro por 0
dep osi t liabilities (D) tha t is to be tion of total
hel d as cash rese rve s (R) wit h the p
Thi s imp lies tha t R = xD. Cen tral bank.
n
...(2) ir
Finally, let the pub lic hol d a fraction
, b of its ban k dep osi ts in cas h : sl
C = bD
...(3) n
Sub stit utin g the sec ond and thir d e
equ atio ns into the first giv es,
H= C+ R
1,
or H= bD +x D
a
No w sol vin g for D yie lds, t'.
D = H/(b + x) i
... (4) '
Equ atio n (4) sho ws that, if the pub
lic des ired cas h rati o is zero, dep osit
rec ipro cal of the cas h res erv e rati s rise by
o, i.e.,
ti
H C
If b=O ⇒ D=-
x
M ON EY IN A M ODERN ECONOMY 49
If the bank's reserve ratio is 5 · ·
. th h . h per cent z.e., x = 0.05, then d eposits would be
twenty ti mes e cas m
. .
t e econ s h
omy. o t e value of the deposit multiplier is
calcu latedb y ta k m g reciprocal of c l • .
. . as 1 reserve r;:,tio. This shows the general case of
the deposit creation.
(b) A competitive banking syste1n ·· The ratios
· approach to bank behaviour tells us
· does
· powered money, b ut 1t
· le o f high
. t m oney is created assome mu l hp
how deposi
not provid e an accurate picture of how modern banks work.
The volume of bank loans is determined by the intersecti~n of the supply curve
of loans and the demand curve for loans as shown in the following diagram.
Interest
rate
.•...\ ...
••···
Supply of loans
Supply of deposits
i:· 1· .
l · ·•. ~emand to, loans
If" Output i
.___ _ _ _..,__ _ _ _ Volume of loans
0 A and deposits
The supply curve of loans is positively sloped and the demand curve for loans
is negatively sloped. The supply curve of loans is determined by (a) th e supply
curve of deposits and (b) the spread or the interest margin that banks require to
cover costs and risk. The spread is the difference between what the banks have to
pay to borrow money and what they get by lending it (which has to provide a
margin to cover staff costs,_return on capital employed and default risk). For given
interest rates elsewhere in the economy, the supply curve of deposits is positively
sloped because higher interest will attract more savings. The demand curve is
negatively sloped-high interest rates discourage borrowing and low rates
encourage borrowing.
Competition in banking drives the margin between deposits and loan rates to a
level such as i - i , where the spread is just enough to allow banks to cover costs
and make a n~rm~l return on capital. With the demand and supply curve shown,
these will be OA deposits and loans, and depositors will receive an interest rate of
id while borrowers pay the loan rate ii"
Q. 6. What is fiat money? What are limitation of barter system?

Ans. Fiat money is any money backed by the order of the government to
act as m oney. People have to accept it is exchange f? r goods and services and in
discharge of d ebt as the government has ordered 1t to be m on ey.
Limitations of barter system are :
(Prog.) / Ill YEAR ECONOMICS
SATISH : B.A.fB.Con1: [CBCS]
50
. . den ce of wa nts : Wh
at on e per son want
(i) Lack of d~u ~le c-0!~c~ha
t some oth er per son wa nts to
and buy must comcide wit asure buy an ; to s~1
of val ue: Ab sen ce of a com mo
(ii) Lack of common me n denons_elt, at
f s creates ma ny dif fic ult ies . 1
in ord er to express exc ha~ ge/ ' na101 w
~;; err ed pay me nt : It is dif fic
(iii ) Lack of sta nda r O ult to en ac
ments du e to lac k of any un it.
contracts which involvr fu!ure p:~ gage ~
lth . It is dif fic ult for the peo ple
(iv) Dif fic ult y in sto rin g ~ t m
ow.e r for fut ure use in the for
wealth or generalised pur si~ m ot stor, g<
like cattle, wheat, potatoes,ch;
storage and deterioration.
e c.
~l~ ing of stocks of suc h go od s
involves ~0%
0st1t
!;
fo
(v) Lack of divisibility: Lack of . . . . f
divis1bihty o som e go o d s to ma k
values equal 'makes barter system e exchange
(b) Money is any thi ng wh ichdifficult.
is gen era lly acc ept abl e by the
exchange of goods and services people in
or in rep aym ent of deb ts.
Functions of mo ney are :
(i) Medium of exchange : It is the . .
basic or pri ma ry fun cti on of mo
use of mo ney fac ilit ate s exc ney. The
han ge, exc han ge pro mo tes
specialisation increases produc spe cia lisa tion,
tivity and efficiency. .
(ii) Un it of account or measu . . .
re of value : Mo ney is the um
value of other goo ds and servic ts m which the
es are me asu red in mo ney ter ms
accordingly. an d expressed w
(iii ) Standard of deferred pa h<
ym ent s: Loans are tak en an d In
of money. The use of money ma rep aid in terms
intains a con sta nt va·l ue thr ou gh gc
(iv) Store of val ue : It serves as time.
a sto re of val ue of go od s in liq cc
People, wis h to keep a par t of the uid form.
ir we alt h in the form of mo ney fo
.
Q. 7. Explain bri efl y: (a) Transa dE
ction demand for mo ne y (b) Spe
dem and for money. culative
is:
Ans. (a) Transaction demand for
money : Individuals, firms and in
dem and money for the conduct institutions
of day-to-day transactions. Incom ar
after specific per iod s bu t exp end es are received
itu res are regular/Thus, the cas
h wh ich is kept
w
for meeting expenses between two be
points of time of income pay me
tra nsa ctio n dem and . This dem nts cpnstitute is
and is interest-inelastic.
(b) Sp ecu lat ive demand for mo
ney : This dem and is for the des
profits. Ma ny peo ple ma y hav ire of earning
e a belief tha t the rat e of int ere
will . be hig her and in ord er to st in the future is
take adv ant age of this fut ure inc
rates, the y ma y lik e to kee p mo rea se in interest
ney in the liq uid form to be len
wh en the rat es of int ere st act t or invested CL
ual ly rise. The spe cul ati ve dem
pro fou nd inf lue nce on the rat and exercises CL
e of interest.
h1
(b) Di sti ng uis h be tw een Me re
tal lic mo ney an d Paper money
An s. Me tal lic mo ne y : With . d,
the spr ead of civilization and h<
by lan d and sea , me tal lic mo trade relations
ney too k the place of com mo dit ol
na tio ns sta rte d usi ng silver, go y mo ney. Many
ld, copper, tin, etc. as mo ney. Bu
incon ven ien t thi ng to accept, t me tal wa s an
we igh , div ide and assess in qua
me tal wa s ma de int o coi ns lity. Accordingly,
of pre det erm ine d ~e igh t. Th
is inn ov ati on is
MONEY IN A MODERN ECONOMY
51
'b ted to King Midas of Lydi · h . .
attn u . d' . a m t e eighth century B.C. But gold cams
used m 1n 1a many centunes e l' h .
were . ar ier t an in Lydia. Thus coins came to be
accepted as c~nvete nt method of exchange .
As the p~ice oh gold began to rise, gold coins were melted in order to earn
mor e by. selling . .' Th'is 1ed governme nts to mix
. t em. as. metal . ·
copper or silver ·
m
th
gold coms smce eu mtnnsic value might be more than their face value. As
gold became d~arer a_nd scarce, silver coins were used, first in their pure form
and later 0 ~ n:ixe~ wi th alloy or some other metal. But metallic money had the
following hm1tahon s.
(i) It was not _possible to change its supply according to the requirem ents
of the nation both for internal and external use.
(ii) Being heavy, it was not possible to carry large sums of money in the
form of coins from one place to another by merchant s.
(iii) It was unsafe and inconvenient to carry precious metals for trade
purposes over long distances.
(iv) Metallic money was very expensive because the use of coins led to
their debaseme nt and their minting and exchange at the mint cost a
lot to the government.
Paper money : The development of paper money started with goldsmith s
who kept strong safes to store their gold. As goldsmith s were thought to be
honest merchants, people started keeping their gold with them for safe custody.
tn return, the goldsmith s gave the depositors a receipt promising to return the
gold on demand. These receipts of the goldsmiths were given to the sellers of
commodities by the buyers. Thus receipts of the goldsmith were a substitute
for money. Such paper money was backed by gold and was convertib le on
demand into gold.
This ultimately led to the development of bank notes. The bank notes are
issued by the central bank of the country. As the demand for gold and silver
increased with the rise in their prices, the convertibility of bank notes into gold
and silver was gradually given up during the beginning and after the First World
War in all the countries of the world. Since. then the bank money has ceased to
be representative money and is simply 'fiat money' which is inconvertible and
is accepted as money because it is backed by law.
Q. 8. What is high-pow ered money? How does it influe_nce money supply

is an economy ?
Ans. High Powered money: The high-pow ered money consists of the
currency (notes and coins) issued by the government and the RBI. 'A part of the
currency issued is held by the public, which we designate as Cp and a part is
held by the banks, as reserves which we designate as R. ·A part of these currency
·reserves of the bank is held by them in their own cash vaults and a part is
deposited in the Reserve Bank of India in .the reserve accounts which banks
hold with RBI. Accordingly, the high-powered money can be obtained as sum
of currency held by the public and the part held by the banks as reserves. Thus,
H = Cp + R ... (2)
protT) / HJ YBAR ECONOMICS ICBCSj
(
SAT16H : B.A,/0 ,C()fl'\ • If
52
Where ti • th• amount of hig/l•l'owcr! d money
Cp • c urrency held by th• public_
R • Cash reserves of currency with the banks
It i, to be noted that RBI and Governmen t are the producer~ of the hi
powered money and the commercial bank• do not have any role m produ,)'
this high-powered moncY(H). However, th• commerci~l ba,:,ks are p rodu,~
1
of demand deposits which are also used as money hke_ currency. Bui n
producing demand deposits or credit, ban ks have to keep with themselves ~
reserves of currency which have been denoted by R in equation - (2) ab'"h
Since these cash reserves with the ban ks serve as a basis /or the mu Itip le cre,:-••
of demand deposits which constitute an important part of total money su •~
in the economy. Jt provides high poweredness to the currency issued b PPIJ th
Reserve Bank and the Government. The theory of determination of rny 50 '
supply is based on the supply of and demand for high powered money. ••~
economists call it 'The H Theory of Money Supply'. However, it is "'
popu larly called 'Money Multiplier Theory of Money Supply' becau:;•.11•
1
explams the determ1nat1on of money supply as a certain multiple of th h"
powered money. How th• high powered money is related to the total e ~
supply ,s graphically depicted in the following figure. mone1
Money Supply
I I
Demand Deposit (D)
Currency (Cp)
i----.-----
Reserve
(A)
Currency
(Cp)
Theof
the top base
th of
f the figure shows the supply of hi l
the total sloe~ 'f"'e shows the total stock of mon~; powered money (H) whil•
o money supply is determined by a muslupply.
hple _0 fItthwill .be seen thatd
e high powere
MONEY IN A MODERN ECONOMY 53
ney. It will be fur th er seen that where as currency held the public(Cp) uses
mo f h' h . h' !P
the same amount O ig powered money, i.e., there is one-to-one relations
between currency held by the public and the money supply. In contrast to this,
bank deposits are a multiple of the cash reserves of the banks {R) which are
part of supply of high powered money. That is, one rupee of high powered
nd
money kept as bank reserves give rise to much more amount of dema
deposits. Thus the relationshi p between money supply and the high powered
money is determined by the money multiplier.
The money multiplier which we denote by 'm' is the ratio of total money
supply (M) to the stock of high powered money. That is; m The size of ~oney
multiplier depends on the preference of the public to hold currency relative to
deposits (i.e. ratio of currency to deposits which we denote by K) and bank's
desired cash reserves ratio to deposits (which we call r) It follows from above
that if there is increase in currency held-by the public whi.ch is a part of t~e
high powered money, with demand deposits remaining unchanged, there will
be direct increase in the money supply in the economy. If currency reserves
held by the banks increase, this will not change the money supply immediate ly
but will set in motion a process of multiple creation of demand deposits of the
public in the banks. Although banks use these currency reserves held by them,
which constitute a part of the high powered money, to give more loans to the
businessmen and thus create demand deposits, they do not affect either the
amount of currency held by the public or the compositio n of high powered
money. The amount of high powered money is fixed by the RBI by its past
actions.
Money Multiplier
As we stated above, money multiplier is the degree to which money supply
is expanded as a result of the increase in high powered money. Thus Rearrangin g
this we have
M=H.m
Thus money supply is determined by the size of money multiplier( m) and
the amount ~f high powered money (H).
Q. 9. What are the objectives of monetary policy?

Ans. Monetary policy refers to that policy through which the Central Bank
of the c~untry controls the supply of money, availability of money, the cost of
money or the rate of interest in order to attain a set of objectives focussing on
the growth and stability of the economy.
Objectives of Monetary Policy

(i) Full employme nt-It is that situation wherein all persons who are able
to work and willing to work at the prevailing wage rate, get work. For this, RBI
adopts cheap money policy, where rate of interest is lowered to expand the
availability of credit.
(ii) Price Stability-:-Mo~etary policy seeks to eradicate both inflationar y
54 SATISH: B.A.fB .Com . ) Im YEA R ECON
. (Piog. OMICS [C Bcs1
•es th e econ om y. \
as w ell as defla tio na
ry ~e!1denci_ inke r d w ith th e st ab ili ty
(ii i) Exchange Stab of BOP an d rnon '
1hty-_lt ise: ha ng e
po lic y seeks to re gu re se rv es th at im pa
la te foreign,, in th e rt s stab ili tye t;i~i
su pp ly an d de m an in te rn at io na l m on ey
d pa ra meter~ m ar ke t. to1
(iv) Reduction in 1f~ al it y- M P serv es as
Ec on on uc equ an in st ru rne
ac hi ev in g eq ui ta bl e an d w ea ltl i th ro ug
di st ri bu tio n° in co h fa st er de tt Oi
.
to w ea ke r sections f · ty m e f . teres.t
o soci at a lo w er ra te o ive~
(v) Economic G ro e th usm ta in ed ·ris e in re al
ca pi ta Th e go ve rn w th -I t refers in co rn
· m en t ad op ts su ch ato e \ r ol ic y as m ay acceler
ra te of ca pi ta l fo rm . m on e a Y P_ : P~1
be ca us e of low ra te at io n m t11e co un try· Pr od uc tio n capac1•ty 1s .
1 a e th,
ow rna1·
of ca pi ta l formation,
na tu ra l an d hu m an th us thes e ec on om . f .1 nl)
re so ur ce s fully. ie s ai to use theh
Q. 10. Ex pl ai n th e al
te rn at iv e m ea su re s
Ans. A lte rn at iv e M of m on ey su pp ly
ea su re s of M on ey gi ve n by RRt
measures given by RB Su pp ly : Th er e ar e
I. They are as follow tw o alternative
1. N ar ro w M ea su s:
re of M on ey su pp
deposits (deposits w ly : It in cl ud es cu rr
ithdrawable or trans en cy an d demand
in th e country. Pu fe ra ble throug~ cheques)
bl ic in cl ud es in di vi he ld by the public
Government, centra du al s an d fir m s bu
l an d commercial ba t ex cl ud es Cent ral
nks.
M = Currency + D em
1 an d Deposits
M l= C +D D
It is the most accept
ed measure of m on
assets that are genera ey su pp ly as it in cl
lly accepted as a mea ud es only those
are not money. ~ ns of pa ym en t. Savi
ng an d tim e deposits
2. Broader M ea su re
of M on ey su pp ly : It
money. stresses the st or e of
va lu e func tiono!
M2 = M + Time Dep
1 osits
~ = Currency+
Demand Deposits + Ti
(Includes savings de me Deposits
posits)
M2 = C + D D +T D
or M = C + DD
2 + Savings + Time Dep
Its ar gu ed that saving osits
s an d time deposits
de m an d deposits. A ar e close su bs tit ut es
ccording to Milton Fr of currency and
supply. iedan, M is th e be st
2 m ea su re of money
3. Generally accept
ed Measure of Mon
to in cl ud e currency ey Su pp ly : M on ey
an d de m an d deposi is or di na ril y defined
ts, bu t no t tim e an d
sa vi ng deposits.
Q. 11. D is cu ss th e
importance of m on
A ns . Importance of ey in a m od er n ec
Money in a Modern on om y.
pa rt in all societies. Economy: M on ey en
It pr ov id es in valuab acts on im portant
de ve lo pm en t w ou le economic services
ld no t be possible. w ith out w hi ch the
co ns um pt io n, pr od It in flu en ce s all ec
uc tio n, exchange, di on om ic activiti es lik
st rib ut io n an d pu bl e
ic finance.
MONEY IN A MODERN ECONOMY 55
1• The producer , -. prod uced or

gets money as a payment for goods or services
.
rendered by hnn._ Cons~mer never spends his entire income on consumption rather
he saves for contingencies and for future consumption needs.
2. _Mo~ey is ind ispen~able for a producer. He ·can purchase raw materials,
advertise his goods or services, borrow capital etc. Without money, all this activities
can't be done.
3. Money helps in the process of exchange and money has removed all barriers
of barter exchange. It has helped in the economic integration of several economies
of the world.
4. Money helps in the operations of government i.e., financing of public
expenditure. Both tax and government expenditure have an impact on the working
of modern economy. Tax are collected in terms of money and are spent on thlngs
ensuring maximum social advantage. Disqepancy between revenue and expenditure
of the government results in either surplus or deficit in the government budget.
5. Money helps in the equitable distribution of national income among various
factors of production, like wages, rent, interest profit etc.
Q 12. Explain the various functions of money.

Ans. Function of Money : Money is a medium, a measure, a standard and a
store. First two primary functions of money. There are secondary and contingent
functions of money.
1. Primary Functions :
(a) Medium of exchange-It is the most important function of money that it
serves as a medium of exchange or means of payment. Its use allows sale and
purchase to be conducted independently.
(b) Measure of Value: It acts as a common measure or standard of value of the
unit of goods and services. Money becomes a common denominator. Everything
and anything's value can be computed in terms of money.
2. Secondary Functions :
(a) Standard of deferred payn:1ents : Money serves as a standard of debt of
deferred payments. It's easier to measure debts or the promises of future payments
in terms of money.
(b) Store of Value : It is a way to store wealth. Holding wealth in the form of
money is better than all the other alternative forms of wealth because money is the
most liquid financial asset.
(c) Transfer of Value : Money helps to transfer value from one person or
place to another person or place. Money helps in easy1 quick and efficient
transfer.
56 Semester-VI [CBCS]
. B.A. (Prog.)/B.Com. (Prog.) III Year
3. Contingen t Functions :
(a) Distributi on of social income among factors of productio n has bee
facilitated by money. n
(b) Money is the basic strength of credit system.
(c) Liquidity Money is the most liquid asset and can be easily converted
into any other asset as per needs.
(d) Money helps in equalising marginal utilities as the prices of all
commoditi es are expressed·in terms of money.
•••
·r ·
Note: Publisher is not responsible for any omissions/errors , , d ·n-;
1 any, occurre 1
b00 k d · st
un e~ any Circum ances. Though every possible measures have been takeO
to make this book upto the mark · b ot
2018/Marc _
SEMESTER-VI [CBCSJ
8.A. (Prog.)/B.Com. (Prog.)/111 Year- 2018
Generic Elective- ECONOMICS
Principles of Macroeconomics
Llun1twn: 3 Hours
_::-- sr. n~,o, ,·'799· Ma:d1111m1M11 rk:, : 75
All questions carry equal marks .
.,,, AnSwer any five. Question No. 8 is comp11lsory.
_r.,_. (a) furplai~ the importance of avoicling double counting in the
6 umation of domestic product. Describe wit11 an example (9)
(b) Explain the difference between nominal National Income and real
National Income. (6)
Ans. (a) See Q. 1, Page 7.
(b) See Q. 5, Page 10.
..Qr--Z7'a) Explain the concepts of APC and APS, MPC and MPS. What
factors determine the marginal propensity to consume? (10)
(b) Given the following consumption function C = 100 + 0.6Y. Derive the
corresponding saving function and compute the value of saving when Y = 800.(5)
(b) C = 100 + 0.6Y
Y = C+ S
-S = C- Y
-S = 100 + 0.6Y - Y
I-S=100 - 0.4YI ⇒ I-S= - 100+(1 - 0.6)YI
Saving function
Value of saving when Y = 800
- 100 + 0.4 X 800
= - 100 + 320
Savings = 220.
Q. 3:" (a) Define Marginal Efficiency of Capital (MEC) and how it affects
the invesbnent decisions? (8)
(b) Explain the detem1ination of equilibrium level of income in an open
economy with a suitable diagram. (7)
Ans. (a) Marginal effici ency of capital (MEC)
It is the rate of discount which would equ.i te the price of a fixed capital asset
with its present discoun ted value of expected income. So, it is the net rate of
return that is expected from the purchase of additional capital. It is calculated as
the profi t that a fi rm is expected to earn considering the cost of inputs and the
depreciation of capital. It is influenced by expectation about future input costs
and demand. The MEC and capital outlays are U1e elements that a firm lakes into
.1ccount when deciding about an investment project.
(57)
58 SATISH: B.A./8.Com. (Prog.) /III Year Economics (SEMESTER-VI) [CBCS]
Th~ MEC needs to be higher than the rate of interest, r, for investment to take
place. This is because the present value (PV) of future return to capital needs to be
higher than the cost of capital, Ck. These variables can be expressed as follows :
Pv = f ~, where n ➔ no. of years during which capital ill be productive
i=I (t+r)
Ri ➔ net return in year i
Ck= L• R'1
; , where Ck ➔ upfront capital outlays
i=I (t+MEC)
Hence, for an investment t-0 take place, it is necessary that Pv > Ck; that is
MEC > r. As a consequence, an inverse relationship between the rate of interest
and investment is found.
(b) An open economy is in equilibrium when its national expenditure (E) is
equal to its national income Y.
This can be shown using the following equations :
E = C + I + G + (X - M)
Y = C +S +I
y = E
C + S + T = C + I + G + (X - M)
IS +T + M=l +G+ XI
I, G. X, S, T, M
t
I / S+T+M
I , +G+ X
'
I
o ~ mcome
where, S + T + M refe~s to total income and I+ G + X, the total expenditure.

When, S + T + M is equal to I + G + X, the equilibrium level of income is
determined.
Q. 4. (a) Suppose you have the following information about a closed
economy: (lO)
C = 50 + 0.80 (Y - T)
I = 200
G = 100
(i) Find out the equilibrium level of income.
. (ii) Suppose G increases to 125 what is the new equilibrium 1 1 f
income? eve o
I
(iii) What level of G is needed to achieve a target income of 200?

(b) What is net export function? (5)
Ans. (a)
Principles of M
acroeconomics-2018 59
C = 50 + 0.8 (Y -1)
I = 200
G = 100
(i) Equilibrium level of Income
Y= C+l+G
= 50 + 0.8 (Y -1) +200 + 100
Y = 50 +0.8 Yd +300
y = 3S0+0:8Ydwhere [Yd=Y-tj
Y = 350 +0.8 Yd
(ii) If Gincrease is to 125
y = 50 +0.8Yd +200 +125
Y = 375 + 0.8Yd
Suppos e T = 50
Y = 375 + 0.8 (Y - 50)
Y = 375 +0.SY-40
Y-0.8Y = 335
0.2Y = 335
Y = t 1,675.
(iii) If Y = 200
Y = C+I+G
200 = 50+0.8 Yd+200+ G
G = 200-50-0.BYd-200
G = -50-0.BYd
G = -C50+0.8YdAns.
Q. 5. (a) What is the relationship between marginal propensity to consum
e
(5)
and value of simple multiplier?
(b) Explain the process ·of credit creation in multiple banking system
. (10)
Ans. (a) The multiplier provides a measure of the magnitude of the changes
in
in income or GDP. In case of investment multiplier it measures the change
defined as a ratio of
income due to one unit change in investment. It may be
change in GDP to the change in autonomous expenditure that brough t it about.
a:
The investment multiplier is denoted by k and is given by the following f0rmul
k = 6.y = _1_ = _1_ _
6.1 1- mpc mpc
Value of multiplier depends directly on the mpc and iiwersely on mps. Let the
original equilibrium level of income be given by,
1 .
... (1)
Y0 = -(a+ I0 )
1-b
Let investment (I) be increased by 6.1 so that new level of investment (11) = Io +
6.1. This will give us new equilibrium level of income as
1 . .. (2)
Y1 = -(a+ l 1)
1-b
Substracting (2) from (1), we get,
60 SATISH: B.A./B.Com. (Prog.) /III Year Economics (SEM EST ER-V I) lCBCS}
_l j
(l Y1 - Yo
1-b-...:-...,-,
1 I
1 whe re ~y = Y1 - Yo,
--~ I;
1- b \
~y 1
⇒ - --
M 1- b
⇒ ~y = k as k = _l_ is the inve stme nt mult iplie

~I r.
1-b
(b) In a com petit ive bank ing syst em, the volu
me of ban k loan s is determined
by the inter sect ion of the supp ly Clfrv e of loan
s and dem and curv e for loans. 1
The supp ly curv e of loan s is dete rmin ed by (i)

supply curv e of depo sits and
(ii) the spre ad, i.e., the inte rest mar gins the bank
s requ ire to cove r cost s and risk.
For a give n inte rest rate, the supp ly curv e of depo
sits is posi tive ly slop ed because
high er inter est rates will attra ct mor e savi ngs.
The dem and curv e for loans is
nega tivel y slop ed-a s high er inter est rates disc
oura ge borr owi ng and vice versa.
y #-,,•;::~L=:~b
,. ,, - ·-/
!,. 1~/ -/' -
j / : -,
°' l__ _-· _\_ .•,_ Deman: fer L.oans
0 A X
Volume of bans
& depceib
Equ ilibr ium is the mar ket for bank loan s is
dete rmin ed whe re the demand
and supp ly of loan s are equa l.' Borr owe rs
will pay rb inte rest rate, while
depo sitor s will get rd rate of inter est. Diff
eren ce betw een the two (= rbrd)
repr esen ts the spre ad of the bank .
The cred it crea tion pow er of com mer cial bank
s is not abso lute , it is severely
limi ted by a num ber of facto rs and they are as
follo ws :
1. Ratio of cash reserves to dep osits : Ever
y com mer cial ban k is bou nd by
law to keep a cert ain prop ortio n of its depo sits
in the form of cash to mee t their
obli gati ons tow ards thei r depo sitor s. Ban ks'
abili ty to crea te cred it is inversely
rela ted to this ratio .
2. Total cash reserves in the country : Larg er
the cash rese rves avai lable in
the econ omy , mor e will be the cred it crea ted
by the com mer cial ban ks, and vice
vers a.
3. Monetary Policy : The cent ral bank can
restr ict or exp and the credit
crea tion pow er of the bank s by usin g vari ous
mea sure s of cred it cont rol.
4. Bus ines s Con ditio ns : Dur ing tJ:ie peri ods
of pros peri ty, ther e w ill be
freq uent dem and for loan s and adva nces by
the busi ness com modity; thus , the
pow er of bank s to crea te cred it will incr ease
and vice vers a.
Principles of Macroeconomics -2018
61
5
peJJland for cash-m~ney by the General Public : Banking habits of the
ie determine the credit_ creation power of banks. Economies where credit
pe~~ents, e.g . .che~ue s, bills etc. are frequPntly used by the people to fulfil
~ r business obligah~ns, the banks are required to keep smaller amount of cash
~ serves, therefore, then power to_create credit will be more than those countries
r e people use currency and corns to make payments
wher f h . .
6. Nature o t e security off_ered : Ban.ks do not create credit in the air but
ert the securities into money. The banks also offer credit facilities to the
coll V h th
borrow_ers only _w . en ey o~f~r ~o~d assets or securities. The credit creation
0
wer 1s not unlimited rather it 1s linuted by the risk and doubtful securities.
p Q. 6. What do you mean by liquidity preference? Explain the Keynesian
theory of demand for money. (15)
Ans. Demand for money : Money for the sake of money is wanted only by a
Jlliser. People wcµit money because it has got hold over goods and services.
people want money because through it they can purchase anything they like.
Money is demanded because it can be used as a medium of exchange and store
of value. In other words, things can be bought and sold through money. Thus, if
one wants to buy something, he needs money to pay for that. And if one wants to
store something, he will store money value of that commodity for one can buy
that commodity later on through money. Thus the demand for money means :
(i) the amount of money which buyers are willing to offer in lieu of demand
for any commodity, or ·
(ii) the volume of goods and services that sellers wm ·offer in exchange for
money.
There are number of transactions which ,take place in our day-to-day life, for
which money is needed as a medium of exchange. Thus, the demand for money
is determined by such objective factors as · the volume of transactio.ps and the
factors determining the amount of goods and services produced and transacted.
However, there are some economists who point out that µ10ney is demanded as a
store of value or as cash balance. Keynes has listed three motives due to which
people wish to hold money in cash. These are :
(i) Transactions Motive: Individuals, firms and institutions demand money
for the conduct of day-to-day transactions. Incomes by individuals and bui,iness
firms are received after specified period, but expenditure is reguJar. Thus, the
cash which is kept for meeting expenses between two points of time of income
payments constitutes transactions motive. The cash, which is with-held on
account of this motive is interest-inelastic.
(ii) Precautionary Motive: Besides meeting day-to-day transactions people
also withhold some cash for meeting some exegencies of life which can not be
anticipated. The money withheld on account of this is kept by way of precaution.
(iii) Speculative Motive : The third motive for holding cash is the desire to
earn profits. Many people may have a belief that the rate of interest in the future
will be higher and in order to take advantage of this future increase in the rate of
interest, they may like to keep money in the liquid form to be lent or invested
when the rates of interest actually rise. The speculative motive exercises
62 SATISH: B.A./8.C om. (Prog.) /III Year Economics (SEMESTER-VI) [CBCS]
profound influence on the rate of interest. .

The liquidity preference, which is also kno~n as de~~ f~r money,
indicates the amount of money that people would like to keep m liqwd form at
different rates of interest. The relations hip between rate of interest and the
liquidity preference is inverse. As such the liquidity preferen ce curve always
slopes downwa rds to the right. I
Besides the three motives discusse d above for holding money in cash, there
are some other motives also. Firstly, if people expect the prices to fall in future
I
they would keep, money rather than keeping goods and services. Secondly,
people also hold money for expandin g their business . Thirdly, for the sake of
convenience, people keep their savings in the form of cash rather ~han investing
them in bonds and securities. Thus, the demand for money consists of varioUs
motives discusse d for which people hold or demand money.
Q. 7. (a) What is open market operatio n and how monetar y authority uses
it to regulate money supply? (9)
(b) What is Balanced Budget Multiplier? (6)
Ans. (a) The qualitativ e methods are directed towards influenci ng the total
volume of credit in the banking system, without special regard for the use to
which it is put. The qualitativ e methods of credit control, on the other hand, are
directed towards particula r use of credit and not the total volume outstanding.
But here we are concerne d only with Bank Rate and Open Market Operations
which we discuss below :
1. Bank Rate: Bank rate is the most tradition al weapon of credit control used
by the central bank. The bank rate is the official minimum rate at which the
central bank of a country is prepared to rediscou nt approve d bills of exchange or
to lend on approved securities. The bank rate mechani sm seeks to influence iPP.
volume of credit through changes in the rate of interest. An increase in the ban·
rate brings about an increase in the rate of interest and this increase in the rate of
interest adversel y affects borrowin g. This is so because business men in view of
the ri~ing rates of interest will reduce their stocks, inventor ies etc. They would
liquidate their stocks to pay for the bank loans. On the ·other hand a decline in
the bank rate will be followed by a decline in the rate ~f interest. This decline
1
would stimulate borrowin g by business men and industria lists and increase
investme nt and producti on.
The success of bank rate policy mainly depends upon the changes in the
interest rate correspo nding to changes in the bank rate. In underdeveloped
countries interest rates do not change directly to the extent to which bank rate 1
changes and hence bank rate is not fully successful.
2. Open Market Operations : Open market operatio ns refer to sale and
purchase of governm ent bonds and securities. Such sales and purchase influence
liquidity position of banks. When the central bank wishes to increase baru<
advances , it starts purchasi ng governm ent bonds and securities. The sellers of
these bonds get payment s in cheques which they deposit with banks. 'fhi5
improve s the liquidity _a nd credit creating power of banks. On the other hand, il
the central bank sells such securities people buy them and for making payments,
-20 18
Pri nci ples of Ma croeco nom ics 63
. .
draW mo ney fro m ban ks. This ad verse} affe c . . cre dit
iith uriti y. ts liq wd ity and
d1eY ~ paw er of ban ks. Th e pu rchase of sec es and sale
es mcreases advanc
. d"" rea
ctfatirtg. ies ses ad.van ces •
securit .::~ · .
n rna rke t op era tio ns are ver y goo d to effect the sea son a1mo vem ent s rn
of ()np f
vr - · d t th sen ce o too mu ch money (dur ing the slack
season) or
the economf ue o e ~re
y season).
fillancial s~ ge n~ y (du rm g the ~us · t · tam·
ati ons m res erv e rat io : All ban ks are reqw·red t o marn am a cer
3. van . . reserves wit h
of the ir d~ m~ d an d tim e liabilities in the form of cash
percent age uirem ent or cash
15 d to as sta tut ory reserve req
the central ~ank. This refez:re the cen tral ban k
req uir em ent (CR R). Th is serves as a tool in the han ds of
reserve time depen din g on
io can be cha nge d from time to
for mon_et~ry cont~~l as thi s rat
nom y.
the liqwdity con ditions of any eco int ain a
Liq uid ity Ra tio (SL R): SLR requires the banks to ma
4. Statut ory be held in the for m
dem and and time liabilities to
certain percentag e of the ir tot al se of-
ets. These liquid assets com pri
of certain des ign ate d liq uid ass
(ER)
- Excess Reserves of the ban ks
the banks (CA) and
- Cu rre nt acc ount balances of
securities (I).
- Inv est me nt in Go ver nm ent
·
It can be def ine d as -
SLR = ER +C A+ I.
L
e and hence
s rat io can als o be var ied by the central bank from time to tim
Thi
ary control.
serves as an ins tru me nt of monet d as the
: The budget balance is define
(b) Balanced Budget Multiplier this dif fer ence is
nt rev enu es mi nus government spending. When
gov ern me in deficit.
bud get is in sur plu s; wh en it is negative the bud get is
positive the ing, because the
s, there is positive public sav
When the bud get is in sur plu am oun t of income
the national product than the
government is spe ndi ng less on nding. When the
t it is wit hdr aw ing fro m the circular flow of income and spe
tha
, public saving is negative.
government bud get is in deficit increa se in
we con sid er bal anc ed bud get changes. A balanced budget
Next, ct on GDP, and a
l have a mild expansion ary effe
the government spending wil ct.
have a mild contractionary effe
balanced bud get decrease will cts. BB M is de-
(BBM) measures these effe
The balanced bud get multiplier in govern-
as the cha nge in GD P div ide d by the balanced budget change
fined extra Rs. 100
nd ing / exp end itu re tha t bro ught it. For example, if there is
ment spe ses to finance it),
(combined with the tax increa
crores of government spending ; if, how ever GDP
Rs. 60 er., then the BBM is 0.6
and this causes GDP to rise by
is 1.0.
rises to Rs. 100 crores then BBM
BBM = L\Y = L\Y.
i.e., L\G L\T
(5, 5, 5)
ee:
Q. 8. Write short notes on any thr
(a) Objectives of Monetary policy
(b) GDP Deflator
(c) Autonomous Expend
iture
~I
64 SEMESTER-VI [CBCS] I
B.A. (Prog.)/B.Com. (Prog.)/111 Yea r-20 18
Generic Elec tive -EC ON OM ICS I
Principles of Macroeconomics
(d) Com pone nts of BoP
(b) GDP Defl ator - In economics, the GDP defla
tor is a meas ure of the level
of prices of all new, domestically produced,
final good s and services in an
economy. GDP stand s for gross domestic product,
the total mon etary value of all
final good s and services prod uced with in the
territory of a coun try over a
particular perio d of time (quarterly or annually)
.
Nom inal GDP
GDP deflator = - - - - - x 100
Real GDP
The norrtinal GDP of given year is comp uted using
that year's prices, while
the real GDP of that year is computed using the
base year's prices.
(c) Autonomous Expenditure -An auto nom ous
expe nditu re describes the
components of an economy's aggregate expenditu
re that are not impa cted by
that same economy's real level of income. This
type of spen ding is considered
automatic and necessary, whet her occurring
at the gove rnme nt level or the
individual level. Classical economic theory state
s that a rise in autonomous
expe nditu res will create at least an equivalent
rise in aggregate outp ut such as
GDP, if not a greater rise.
(d) eomp onen ts of Bop - The balance of paym
ent accounts measure the net
transactions between domestic residents and the
rest of the world over a specific
period. Each transaction is classified according
to the payments or receipts that
would typically arise from it. Balance of payments
accounts are divided into two
broad parts :
(i) Current account: The curre nt account deals
with paym ents for goods and
services, incomes and transfers.
(ii) Capital and financial acco unts : This part
records transactions related to
international movements of ownership of finan
cial assets, such as shares, bank
loans or government securities, and othe r assets.
TI1e current and capital account balances are
necessarily of equa l and
opposite size. Whe n adde d together, they equal
to zero.
The terms balan ce of payments deficit' and 'bala
nce of paym ents surplus
must refer to the balance on some part of the curre
nt account. The existence of a
current account balance of deficit tells us only that
an economy's total spending
exceeds its total income and that it has a capital
inflow. The existence of such a
deficit is consistent both with healthy, growing
economies anc\ with unhealthy,
inefficient economies. •
Note: Publisher is not responsible for any omissions/erro

rs, if any, occurred in
this book unde r any circumstances. Thou gh every
possible measures
have been taken to make this book upto the mark
. SG/2018_Oct_17
SEMESTER-VI [CBCS]
B.A. (Prog.)/B.Com. (Prog.)/III Year-2019
Generic Elective-ECONOMICS
[Principles of MacroeconomicsJ
vuratio11 : 3 Hours Sr. No. 9272 Maximum Marks : 75
Attempt any five questions.

All questions carry equal marks.
Q. 8. is compulsory.
nal Income
Q. 1. (a) Explain the steps involved in the estimation of Natio
approach. (9)
with the help of value added method or produ ction
(b) Explain the difference between Actual GDP
and Potential GDP. (6)
as value -adde d
Ans. (a) GDP using product/output method: It is also know n
ating the contr ibutio n by
or outpu t metho d. It measu res nation al income by estim
count ry in a perio d. The
each enterp rise produ cing in the domestic territo ry of the
steps are follow ed to comp ute national incom e-
ry, secon dary and
!. Identification and classification of enterprises into prima
ction are those sold in
tertiary sectors. Good s and services that are a part of produ
rate but not sold in the
the mark et earn profits, or suppl ied free or at nomi nal
which don't reach
market, impu ted rent of owner-occupies house s and goods
ded are illegal leisur e
market like 'own-use-p roduc tion'. But the activities exclu
ers.
time and services rende red withi n the household by its memb
e count ing must be
II. It involves measu remen t of value of outpu t and doubl
avoided.
of produ ction of a
One can find out the net value added at different stages
production of comm odity
commodity. The sum of net value added at different stages of
e in the economy.
in the economy will give the estimate of domestic factor incom
priva te dome stic
GDPMP = Value of consu mer goods and services + Gross
inves tment + Value of outpu t of government.sector.
Or
mark et price + Value
Gross value added = Value added in prima ry sector at
added in secon dary secto r+ Value added in tertiary sector
Difficulties in Val'qe Added or Product Method :

onsum ption and
(a) It's difficult to -petermine price of goods retained for self-c
don't reach market.
( 65)
SATISH : B.A./B.Com. (Prog.) / III Year Fn inomics (SB.MESTER-VI) [CBCsj \
66
(b) It's difficult to decide whether the value of go~ds-a~d services to be measured \
at manufacturer's cost, whqlesaler's price or at retail price. .
(c) Whether.services should be included in national income or not is a matter
of dispute. . .
(d) lleliable and accurate database not available about production in
unorgan iscd sector. . .
(e) It's not possible to have a clear distinction between mtermed1ate and finJI 1
goods as it depends on its use. . . I
(j) Difficult to calculate depreciation when the value of capital goods increases
or decreases 'Clue to changes in market conditions.
(Z,) Difference between Actual GDP and Potential GDP: Economic growth
is about the long-term trend in GDP and in order to infer about this, the concepts
of actual and potential CDP are being used and the different between actual and
potential GDP is called GDP gap. J
Potential GDP measures what the economy could produce if all resources-
level of employment denoted as y1 . Now GDP gap or outp~t gap i~ defined to
or-full employment GDP had been produced and what is actually produced, as
measured by curre·nt GDP.
z.e., CDP gap = Potential GDP -Actual GDP
= Y1 -Y
Now if potential CDP (y1) > actual GDP (y), this gap measures the market
value of goods and services that could have been produced if the economy's
resources had been ful\y employed but actually went unproduced and output
gap is called deflationary gap.
On the other hand, if potential CDP (y1) < actual GDP (y), this gap measures \
the market value of goods and services that were produced beyond the
economy's possible resources, because of various external factors and the output 1
gap is called inflationary gap.
Q. 2 . (a) Distinguish between marginal propensity to consume and

average propensity to consume. Explain the factors that determine the
marginal propensity to ~onsume in an economy. (10)
(b) If the consumption function is C = 50 + 0.75Y, write the corresponding
saving function. At what level of income saving becomes zero? (5)
Ans~ (a) The consumption function is a mathematical formula laid out by famed
economist John Maynard Keynes. The formula was designed to show the
rel~tionshi~ between real dispos_able income and consumer spending, the latter
variable being what Keynes considered the most important determinant of short·
term demand in an economy. The consumption function is rcprc>scnted as:
I
~-
Principles of Macroeconomics-2019 67
C = A+MD
where:
C ::: consumer spending
umption that would
A ::: Autonomous consumption, or the level of cons
still exist even if income was O
of consumption
M ::: Marginal propensity to consume, which is the ratio
changes to income changes
D ::: Real disposable income
but that is dependent on
The consumption function is shown here to be linear,
) staying the same. In fac~,
the variable "M" (marginal propensity to consume
disposable income as it
consumers tend to spend a smaller percentage of their
rises, creating a curved effect at higher income levels.
Relation between APC and APS
APC+APS = 1
As we know Y = C+S
Dividing both sides of the equation by 4
4 C S
= -+ -
y y y
C S
1 = -+ -
4 4
APC+APS = 1
APC = 1-A PS
Relation between MPC and MPS

Y = C+S
!lY = !lC + !lS
Dividing both sides of the equation by !lY
!lY L'lC L'lS
- = -+-
!lY b..Y L'lY
1 = MPC+MPS
MPS= 1-M PC
C =SO+ 0.75y
(b)
s = y-C
Savings = Income - Consumption
S= Y-C
= Y- (50 + 0.75Y)
S= Y-0.75Y-SO
S= 0.25Y-50
I S= 0 l
68 SATISH : B.A./B.Com. (Prog.) ! llI Yea
r Eco nomics (SEMESTER-VI) lCBesl '
0.2 5Y- 50= 0
0.25Y = 50 I
Y=
50
Q.25 I
1Y= 200 1
So, whe n Y = 200, savi ngs will become
I
zero.
Q. 3 . (a) Dis ting uish bet wee n induced
and autono
mous investment. (S)
(b) Exp lain the det erm ina tion
of equ ilib riu m lev el of GD P usin
aggregate exp enditure approach and sav ing inv estm
sector mo del economy. ent approach in a tw!
(10)
Ans. (a) Induced investment is that inve
stm ent whi ch is gov erne d by income
arid amount of pro fit in retu rn i.e. high er
pro fit may lead to high er investment and
vice versa.
Autonomous investment is that inve stm
ent whi ch is ind epe nde nt of the level
of inco me or pro fit and is not indu ced
by any cha nge s in the income. It is base
social inve stm ent gain ing long term fina d on
ncial retu rn and social goo d, it includes
intr odu ctio n of new techniques of pro
duc tion and resources.
Ind uce d investment is highly volatile, but
its volality is redu ced by autonomous
inve stm ents, whi ch pro vide s stability to
the economy. The auto noq ,ous investme
can be incr ease d and dec reas ed any time nt
, notw iths tand ing the cha nge s in income
and profit. Since, the auto nom ous inve
stm ent _is not d eter min ed by consideratio
of pro fit and is dete rmi ned by con side n
rati on of the social wel fare earn ing long
term social goo d to people. So, dur ing
the times of economic dep ress ions, the
gov ernm ent try to boo st the autonomous
investment. Thus, auto nom ous investme
is one of the key concepts in welfare econ nt
omics.
(b) Agg reg ate Exp end itur e Ap pro
ach -Ac cor din g to this app roa c~,
equ ilib rium GDP is dete rmi ned whe re
desi red exp end itur e of the econom y is equa
to agg rega te nati ona l out put i.e., equ ilib l
rium betw een agg rega te exp end itur e and
agg rega te out put brin gs equ ilib rium in
the eco nom y.
Agg rega te exp end itur e is the sum mat ion
of des ired con sum ptio n expenditure
(C) and inve stm ent (I) i.e., AE = C + I.
It is upw ard slop ing and star ts from a
poi nt abo ve the orig in indicating
auto nom ous con sum ptio n and tend s
to rise as the level of inco me rises. Upw
slop ing AE is due to upw ard slop ing con ard
sum ptio n function . Inve stm ent is assumed
to be auto nom ous of income, indi cate
d by a hor izon tal stra ight line and has
imp act on the slop e of AE function. no
Agg rega te out put is a plan ned out put
in a given per iod of time. Greater output
mea ns grea ter use of the factors of
pro duc tion . Inp uts are alw ays ava ilab
resp ons e to high er levels of plan ed outp le in
ut. Thu s, out put adju sts itself to changes
in the level of agg rega te exp end itur e.
Principles of Macroeconomics - 2019 69
y
AE = Y
Q)
~
~
"O
C AE = C + I
Q)
Income
(GDP)
is Y0• At this level of GDP,

Equilibrium ':ill occur when income or output level
quilibrium will occur in there
aggregate expenditure of the economy is also Y0• Dise
egate expenditure. 45° line is
is discrepancy between aggregate output and aggr
AD and Y (AS).
the line of reference. It shows the equality between
ut and income rises from
If AE > Y, it will cause expansionary pressure on outp
onary pressure on outp ut
0¥ 1 to OY0• Whereas if AE < Y, it will result in contradict
ved at GDP level OY0• Point
and income falls from OY2 to OY0• Equilibrium is achie
re lineintersects the 45° line.
Eis the equilibrium point where aggregate expenditu
egate expenditure. Any level
At this level of GDP, aggregate output is equal to aggr
rium .
of GDP more than or less than OY0 leads to disequilib
AE = C + I 'if C =Consumption expenditure ⇒ C =
Ca+ XY
Ca= Autonomous expenditure

C = Marginal propensity to consume
Y = Disposable income
I = I 0 (Autonomous investment)
nditure
At equilibrium, Aggregate Output = Aggregate Expe
Y = C +I ⇒ Y = Ca + CY + I0
Y-cY = Ca+ I0
1
⇒ Y = (l - C) (C. + I0 )
ion I I0 intersect at point

Saving function SS1 and autonomo us investment funct
level of GDP, saving ai:td
E which determines equilibrium GDP = Y0• At OY0
-even point is at poirit s
inves tment are equal and happen to be = Y0E. The break
consumption (Y = C, ⇒ S =O).
where saving is equal to zero. Hence income is equal to
lances between saving and
Any income level below or above OY0 causes imba
inves tment exceeds saving
investment, hence disequilibrium. At income level OS,
ibrium is attained at OY0 • If
by RS. It would trigger expansion in income till equil
tment by VT. It would cause
income is above OY0 i.e., OY 1 saving exceeds inves
, iryibalance between saving
contraction of income till it finally settles at OY0• Thus
action of income such that
and investmen t would result in expansion or contr
I is achieved.
equilibrium is restored and equality between Sand
/ Ill Year Economics (SEMESTt:
/B Con1. (Prog.)
SATISI-l : B.A. .
a.
VI) l~ I
i
70 ·
~
y V SI
Equilibrium GDP
i i S> I
E l
Tl lo
l' X
Y,
GDP
Y'
y == C+ S C= Ca +c y
y == Ca+ cY + S
S == - Ca+ y - cY
s == - Ca+ (1 - c)Y
5 == 1 _ c ⇒ marginal pr op ensit
y to save
At equilibrium
s == I or
⇒ - Ca+ (1 - c) Y = 'Io
⇒ (1 - c) y == Io+ Co
I0 +C Io +Co
⇒
y
0
or Y= -"----'"-
= (1 -c ) s
Q. 4 . (a) Su pp os e an econ
omic mo de l is gi ve n a.s fo llo w s
:
C = 100 + 0.80Yd wh er e
(Y d= Y - T)
I= 150 G = 50
T = 20 + 0.25Y
Find
(i) Equilibrium level
of income, co ns um pt io n
an d sa vi ng s.
(ii) Change in eq uil ib!
100. ium income if G in cr ea se s to 100 an d·I
decreases lo
(10l
What do you mean by ba lan
(b)
ce d bu dg et mu lti pl ier ? (ll
Ans. (a) C = 100 + 0.80Yd
I= 150
G = 50
T = 20+ 0.25Y
(1) Equilibrium level of inc
ome
Y = C+ I+ G
.
Principles of Macroecon om1cs - 2019
71
y = 100 + 0.80(Yd) + 150 + 50
y = 100 + 0.8(Y - T) + 200
y = 300 + 0.8 [Y - (20 + 0.25Y)]
y= 3oo + 0.8 [Y - 20 - 0.25Y]
y = 300 + 0.8 [0.7SY - 20]
Y= 300 + 0.6Y - 16
Y= 284 + 0.6Y
Y -0.6Y = 284
0.4Y = 284
Y= 284/0.4
Y= 710.
(ii) If G increases to 100 and I decreases to 100, there will be no chanoe in the
0
equilibrium levPI of income.
(b) Balanced Budget Multiplier : The budget balance is defined as the
government revenues minus government spending. When this difference is positive
the budget is in surplus; when it is negative the budget is in deficit. When the
budget is in surplus, there is positive public saving, because the government is
spending less on the national product than the amoun t of income tha t it is
withdrawing from the cl!cular flow of income and spending. When the government
budget is in deficit, public saving is negative .
Next, we consider balanced budget ch,mges. A balanced budget increase in
the government spending will have a mild expansionary effect on GDP, and a
balanced budget decrease will have a mild contractionary effect.
The balanced budget multiplier (BBM) measures these effects. BBM is defined
as the change in GDP divided by the balanced budget change in government
spending/expenditure that brought it about. For example, if there is extra t 100
crores of government spending (combined wi th the tax increases to finance it),
and this causes GDP to rise by { 60 crore, then the BBM is 0.6; if, however GDP
rises to~ 100 crores then BBM is 1.0.
t::.Y t::.Y
i.e., BBM = - = -
t::.G t::.T
Q. 5.' What is net export function? How it affect equilibrium level of

income and GDP in an open economy? What.are the fac tors which affect net
export function? (15 )
Ans. Net Export Function: In an open economy the balance of trade (give n by
the difference between exports and imports of goods only) responds to changes j~
the GDP. In case of exports, they depend Qn the spending decision made by the
foreign consumers who purchase domestic goods and services. Therefore, we
assume that the exports are determined by influences outside the domestic economy
i.e., exports (X) are assumed to be exogeneous.
However, imports (M) depend on the spending decisions of domesti c residents
so when the incomes of domestic consu11wrs rise, the imports rise. We takt.> nf' t
72 SATISH: B.A./B.Com. (Prog.),: lJl Year Economics (SEMESTER-VI) [CBCs] \
exports as the difference between exports and imports and they are negat' \
related to the GDP because of the positive relationship between ~esired irn~:ely \
and GDP. This negative relationship between net exports and GDP 1s called the tts
exports function.
Shifts in the net export function : The net export function which relate
net
exp.orts (X- M), denoted as NX, to GDP; is drawn on the assumption that everyt:~et
that affects net exports, except domestic GDP, remains constant. The major fact:g
I
that must be held constant are s
(n) foreign GDP, \
(b) relative international price levels and (c) the exchange rate.
A change in any of these factors will affect the amount of net exports that .11
occur at each level of GDP and hence will shift the net export function. Wt
The net export function can be represent by the following diagram :
X,M
M (Imports) = mY
r
x r - - - - - - , . i , ~ - - - - X = x (Exports)
{
: Real GDP
Net Exports (X - M)
{ / (XI) (Net export function)
•!
or---~ '°"-----. Real GDP
Diagram : (ii) Net Export Function
.Increase in foreign GDP : Now su h . .

Other things being equal it will lead ..~ pp~se t ~re_ Is an increase in foreign GDP.
' cv an increase in the q t· f .
prod uced goods demanded by foreign .. uan 1ty o our domestic
Th" consumers 1 e it w·n •
1 increase our exports.
1s causes the upward parallel shift f f · ·,
net export function (NX) would also 8~. ;txport unction (X) and consequently the
1 rd
as shown in the following diagram: upwa parallel to its original position
Principles of Macro .
econom 1cs- 2019
73
X,M
M=mY
X ·-- ....-.. _ 1_··- ··-- X- x'
X=X X'>X
0
NX r --- -+-,- -;,L.__ _..,. Real GDP
Diagram: (i):Export r nd Import Function
i
0 1----- -.,..._ _..,.__ _ _ _ Real GDP

.............
·•... NX=X'- M
NX=X'- M
Diagram : (ii) Net Export (NX) Function
An upward shift in exports shifts the net export function upward. Similarly
other influences can be worked out.
Q. 6 . (a) Define high powered money. Explain Ml, M2 and M3. (7)
(b) What is liquidity trap? Explain the liquidity preference theory of
(8)
demand for money.
Ans. (a) High Powered Money : The high-powered money consists of the
the
currency (notes and coins) issued by the government and the RBI. A part of
and a part is held
currency issued is held by the public, which we designate as Cp
s
by the banks, as reserves which we designate as R. A part of these currency reserve
the
of the bank is held by them in their own cash vaults and a part is deposited in
Reserve Bank of India in the reserve accoun ts which banks hold with RBI.
by
Accordingly, the high-powered money can be obtained as sum of currency held
the public and the part held by the banks as reserves . Thus, ·
H =Cp+ R ... (1)
where H = the amount of high-po wered money
iG (SEM ESTER-VI)
fCetsl
g.) / III Year Econom
SATJSH : B.A./8 .Com. (P ra
74 ld by the pu bI ic
Cp = Currency he s
sh reserv es of cu rrency with th e bank
R = Ca
producers ofdthe hi gh~pow ered
ernm en t ar e th e ·
It is to be noted th at
RBI and G ov 1 · mg this h.
nk s do no t have any ro e m pr o uc of de 'gh,
m ercial ba od ucers
monev and th e com owever, the commercial ba nks are pr nd
powe;ed money (H
). H
e cu rr en cy . B ut for pr od ucing de :a
rves of curr an d [
lik
also used as money se
deposits which are ca sh re
:~~es
ith th em se lv es
nks ha ve to keep w th ese cash res ency
deposits on credit, ba d by R in equation - (1) above. Since ts
which have been de
note
m ul tip le cr ea tio n of deman d deposi h
economy. It prov1·~c
as a basis for th e
with the banks serve on ey su pp ly in th e
over nrn es
rtant part of total m erve Bank an d the G
constitute an impo issu ed by th e R es ent.
high poweredness to
the currency
pp ly is ba se d on th e supply of an d dern
ination of money su ey Sup ~ d
The theory of determ
for high powered m
oney. Some ec on
ll~ d
om
'M
is
on
ts ca
ey
ll it 'T he H Theory of Mon
Money Su
Multiplier Theory of ul tiple ~Phy
pr
re popula rly ca
_ a certain m
H ow ev e:, it is ~o
0
th e dete rm m at10 n of money supp ly as t e
because 1t explams su p 1 15 .
.
high powered money on ey is re la te d to the to ta l m oney p Y
ered m
H ?w the h!gh p_ow e following figure.
m th
graphically depicted
Money Supply
I
Currency (Cp)
Demand Deposit (D
)
Reserve
(A)
Currency
(Cp)
'
se of the figure shows the su 1y of h.igh powered money (H) while the
The ba ows the total sto /P
f at th e
top of the figure sh ; b m on ey ~u pp ly. It will be seen th
supply is dete . c ered money.
total stock of money e Y a ~ ul tiple of the high pow
en that w he re :: m th e public(Cp) uses the samne
It will be further se ;~en c~ t:'ld nship betwee
ou nt of high po wered money,' i .e.cu, ere 15 one-to-one re latio
am
Principles of Macroeconomics- 2019
75
/ ,peid bythe publicand the money supply. In contrast to this, bank deposits
cvrrenc~ltlPle of the ca~h I eserves of the _banks (R) which are part of supply of high
e~ oiedrn oney· That 1s, one rupee of high powered money kept as ban k reserves
J iJi fd
~01ve: to inuch more ~mount O emand deposits. Thus the relationship between
~j11ens:upplyand the high powered money is determined by the money multiplier.
0
10neY l . 1· h' h d
n fhe money mu h_P ier w IC we enote by'~' is the ratio of total money supply
the stock of high powered mon~y. That 1s; m, the size of money multiplier
10
WI) ds on the preference of the public to hold currency relative to deposits (i.e.
derenfcurrency to deposits which we denote by K) and bank's desired cash reserves
1
ra1°~ 0 deposits (which we call r). It follows
from above that if there is increase in
1311
:ency held by the public which is a part of the high powered money, with
cur . . . h
dernand deposits remaining unc anged, there will be direct increase in the money
upply in the economy. If currency reserves held by the banks increase, this will
~ot change the money supply immediately but will set in motion a process of
multiple creation of demand deposits of the public in the banks. Although' banks
use these currency reserves held by them, which constitute a part of the high
powered money, to gi~e mo~e loans to the businessmen and thus create ~emand
deposits, they do not atfect either the amount of currency held by the pub!Jc or the
composition of high powered money. The amount of high powered money is fixed
by the RBI by its past actions.
Money Multiplier
A$ we stated above, money multiplier is the degree to which money supply is
expanded as a result of the increase in high powered money. Thus, rearranging
this we have
M = H.rn
Thus, money supply is determined by the size of money multiplier(m) and the
amount of high powered money (H).
Q. 7. (a) How does an expansionary fiscal policy affect the equilibrium

level of income in an economy? (7)
(b) Critically examine the quantity theory money. (8)
Ans. (a) Expansionary fiscal policy occurs when the government cuts/decreases
or increase government spending, shifting the aggregate demand curve to the right.
It increases the level of aggregate demand, through either increase in government
spending or reduction in taxes.
This can be done by-
1. Increasing consumption by raising disposable income through cuts in
personal income taxes or pay roll taxes;
2. Increasing investment by raising after tax profits through cuts in business
taxes; and
3. lncreasi~g government purchases through increased spending by the govt
on final goods and services.
,. (P og) I III Year Economics (SEMESTER-VI) [C:a~
76 SATISH : B.A./B.Lom. r . I/
. LRAS
SRAS0
]
8
·;::
a. q
P,
Po
y0 Y1 Real GDP f
ll
ssion occurring at a quantJ
The original equilibrium (Eo) represents a rec~
r, a sh1f~ of aggr~gate demand fro~
of output (Yo) below potential GDP. Howev_e
onary fiscal policy, can move thrn
AD to AD enacted through an expansi poten~ial. GDP. s·1ncee
0 to ~ new equilibrium output
1 of E1 at the leve.l ofGDP
economy . 1 ' any inflationa
w potenha
the economy was originally producmg belo
~esult_s should be rela~ively srna~r
increase in the price level from po to pl that
ion with regard to the relation·shiphbetween quantity of .rno
The expl anat
(b)
l
· by the quantity t eory_o money. The quanney
·s provided f r~
and the gene ral price leve 1
sical theory of money is the olct~s
theory of money popularly known as clas
e of money or general _Price leve/
explanation of the determination of t~e valu
l or th~ ~alue of money is_ gove.rned
According to this theory the general pr~ce leve
money 1s mcreased, the price level is
by quantity of money. When the quantity of
of money. On the other hand when
also increased and there is a fall in the value
the price level falls down and the
there is reduction in the quantity of money,
ct relationship between the quantity
value of.money goes up. Thus, there is a dire
gs remaining the same, the changes
of money and the general price level. Other thin
ortionate changes in the general
in the quantity of money will bring about prop
if the quantity of money is doubled,
price level in the same direction. For example,
and vice-versa.
the general price level would also be doubled
of money and the value of nioneY.
However, the relationship between quantity
mean its purchasing power. Whe~
is of a different kind . By value of money we
er of money is reduced and vice-
general price level goes up, the purchasing pow
value of money are inversely related.
versa. In other words general price level and
ctly related to the quantity of money.
But as seen above, the general price level is dire
ey are also inversely related. Thus,
As such, value of money and quantity of mon
and _the general price revel is direct
the relationship between quantity of money
money and value of money is inverse.
whereas the relationship between quantity of
and general price level has been
The relationship between quantity of money
ation in its most scientific formhas
explained with the help of an equation. The equ
equation is given belo w :
been provided by Professor Irving Fjsher. The
MV+M'V'
P=----
T
where, P = General price level.
M = Money in circulation.
V = Velocity of money in circulation.
M' = Volume of credit in circulation.
Principles of Macroeconomics-lQJg
77
, ,.,, Velocity of <::redit in circulation.
~ "" Total numb_e~ of transactions.
. equation explammg th e relationship between general price level and
qo•
f~:
~~
of money, holds good only when certain assumptions are made:They are
s. '
follow . . . l t' {M)

is (l) Money_ in cucu a 1_0 n . and credit in circulation (M') change
ortionately m the same direction. For example, if Mis doubled the M' would
proPbe doubled.
50
il (Z) T i.e., number of transac~ions for which money is demanded, remains
i.anged. In other words, there 1s no change in the demand for money.
on"' ) V and V' 1.e.,
· ve Ioc1·t·1es of money and credit do not change.
13
(4) Number of bart~r transactions continue.to be the same. In other words, the
urnber of such transactions for which money is not needed is the same.
n Now we know that general price level depends upon quantity of money
(MV + M'V') and if a change is brought about in the general price level, shall be
due to a change in the quantity of money. For example, if M = 100, V =5, M' = 50, V'
~ 5and T is 100; then general price level is
100x5+50 x5 500+250 750

100 = 100 = 100 = 75 ·
But if due to changes in the supply of money, the variables of the equation
change in the following way
M = 200, V = 5, M' = 100, V' = 5 and T= 100, then
200x 5+ 100x5
General Price Level =
100
1,000 +500 1,500
= 100 = wo=15 ·
Thus, we notice that general price has doubled because other things remaining
the same, quantity of money has doubled.
Evaluation : It has been observed that the relationship bet"{een quantity of
money and general price level is direct and hence changes in the quantity of money
are supposed to generate changes in the general price level in the same direction.
For this, we have to consider the explanation provided by the quantity theory of
money. _However, there are many weak points in the theory. Some of them may be
considered below :
(1) This theory is based on some assumptions which are untrue and unrealistic.
Hence, a theory based on unfounded assumptions can not be true. The theory
regards the demand for money fixed which is absolutely unreal. Further it assumes
V and V' constant. This also is untrue. Similarly, the relationship between M and
M' can not be exact. It is not necessary that M and M' vary proportionately in the
same direction.
(2) According to this explanation, changes in the general price level are brought
about only due to changes in quantity of money. However, in practical world we
find the quantity of money is a very fundamental factor but to suggest that it is the
only factor which brings about changes in the general price level is not true.
78 SATISH: B.A./B.Com . (Prog.) i III Year Economics (SEMESTER-VI) [CBCsj
(3) The quantity equation is static. It applies to a world :Vhere other th·
0ther th mgs are consta~~gs
remain constant. But ours is ~ dynamic world wh~re
• In rea 1 1·f otl1er things. do not remain unchanged . In real Wor1ly
ch angmg. I e 1 _
nd techno ogy all change d
population human behaviour, business cycle a
changes in ;hese generate further changes. Dynamic forces form the essential ban_d
of our society. The theory may at be~t be of som~ help _in explaini~g normal l~~ts
run tendencies, but for short run cy~hcal fluc_tua~Ions It IS of no avail. ~or the snidi
of business phenomenon the quanti ty equat10n is, therefore, utterly inadequate
(4) Further the quantity equation does not provide the entire mechan·1 · 1
through which changes in quantity of money finally bring about changes in :~
general price level.
(5) Further, some noted economists from Cambri~ge Universi~y have provided
an alternate approach to the quantity theory and their approach 1s known as cash
balance approach. Their interpretation of the demand for money is different.
Inspite of all the shortcomings mentioned above, the theory of money i.e.
quantity theory of money provides us a very useful explanation with regard to th;
determination of value of money and the relationship between quantity of money
and general price level. Changes in quantity of money do bring about changes in
price level. For substantiating this point recent Indian experience of 1970-80 is a
point of utmost importance in view. The wholesale price index in India in this year
registered a rise of 21 per cent and the basic cause for this was the rise in money
supply without being corresponded by similar rise in the volume of goods and
services.
Keynes also maintains that increase in money supply leads to increase in price-
level but indirectly. According to him increase in money supply would lead to
decline in the rate of interest which in tum would increase investment. In this way
the level of effective demand would be up finally leading to increase in the national
income. However, if the level of full employment has been achieved, in that case
this increase would be only in the money income leading to increase in the price·
level. Thus, according to Keynes, increase in the quantity of money leads to increase
in the price-level but only after the stage of full employment has been achieved.
Q. 8. Write short notes on any three : (5, 5, 5)
(a) Difference between BoP and BoT

(b) Open Market Operations
(c) Paradox of thrift
(d) Objectives of Monetary Policy
Ans. (a) Difference between BoP and BoT:
Basis Balance of Trade (BoT) Balance of Payment (BoP)
1. Nature Transactions concerning All transaction s concerning
·t I
of transaction trade of goods only are goods, services and cap1 a
recorded. transfers are recorded.
2. Capital Transactions of capital Transactions of capital .
transactions nature are not included nature are also recorded !fl
in balance of trade. balance of payment.
Princ iples of M
acroe conom ics-20 19
79
3. Mutual relatio n Balan ce of trade 1s
·
a part
,y . of curren t accou nt of BoP. BoP is much larger as it
as it has curren t and capita1
d.
accounts which includes
d.
4. Net positi on BoP too.
IS It may be at favourable or
g unfav ourab le or in It always remain s balanced
y equili brium state. in the sense that receip t side
is made equal to payme nt
5. Economic side.
n It is not true indica tor of
e indica tor It is true indicator of
econo mic prospe rity of a
economic performance of an
count ry.
economy.
:i
(b) Open market operation: See Q. 7(a), Page 62.
:)
(c) T~e paradox of thrift states that an increase in autonomous saving

leads to
decrease m aggre gate deman d and thus a decrease in gross outpu t which
will in
turn lower total saving . The parado x is that total saving
may fall because of
{ individual's attem pts to increase their saving, and, broadly speaking, that
increase
in savings may be harmf ul to an economy. It's also called prisoner's
dilemma.
Prisoner's Dilem ma-It refers to two prisoners namely Molly and Knuck
les.
They were partne rs in crime and imprisoned together. Now for punish
ment, the
district attorn ey interv iews both of them and states it by saying that
(i) If one of
them alone confesses then that person would get off only with a three-
month
sentence while .the other partne r would serve for ten years and (ii) If both
confess
then both of them would get five years of imprisonment.
Now given this deal, the prisoners dilemma is to confess or not to confes
s and
this dilem ma can be repres ented by way of two-by-two matrix game as
follows :
Molly
r
Confess
- '
No confess
Confess A 5 years B lU years
5 years 3 months
C 3 months D 1 year
No confess 10 years 1 year
In this case, the most significant result is that when both prisoners act selfish
ly
by confessing, they both end u~ ~ith lon?er prison terms ~f five years_- Only
when
they both act collusively/altruistically will they end up with short pnson
terms.
(d) Monetary policy refers to that policy through which the Central Bank
of
the country controls the supply of money, availab~lit~ of money, _the cost
of money
or the rate of interest in order to attain a set of ob1ectives focussing on the
growth
and stability of the economy.
J
StMESTER--VI [CBCS
BO
. (Prog.)/B.Com. (Prog.)/III Year- 2019
B.A NOMICSO
Generic Elective-EC
omics]
lPrinciples of Macroecon
y Policy
Objectives of Monetar l persons Wh o are
t is th at si tuation wherein al
( ') FulI Empl
oy m en t-I
a1
· g wage ra t e, ge work. For thi R ab/i:~
·1 m t
, k at the pr ev a~ail!~;~tpi.'
work and willing to wor of in te re st is lo wered to expand the
here ra te '1fy~
cheap money policy, w
th i fl .
credit.
-M on et ar y po lic y seeks to eradicate bo n ati onaty ,
(ii ) Price Stability .es m . th e economy.. 3
ry ten d en c1
well as deflationa w ith the sta~ility of BO
P and
ili t~ -I t is lin ke d y In on~
(ii i) Exchange St ab re se rv es th at imparts Stabil't
foreign ex ch an ge 1
to as upr,;·
policy seeks to regulate · tI1e m · tern ah ·on a1 m on ey m ar ket. 1
an d pa ra m eter s m •
and dem serves as an
no m ic In eq ua li ty -M P
co through fas:-ns:u~ent 1
uc tio n in ,E o
(iv ) Red m e an d w ea lth
stribution of in co er elivery to
achieving equitable di at a l? w er ra te of in terest.
ty
weaker sections of socie alm· me pe .
G ro wt h - It re fe rs to the sustained rise in re co r capita
(v) Economic . y as may accelerat th
t adopts su ch a m on et ar y po lic e e rate of cap.1~
The govern·men . city is lo w m ai nly b lo
ecause of wrateo:
, rmat1· on m the country. Production capa
1o to us e th eir na t
. . these econom ie s fa il uraI and hu ma.1
capital format10n, thus
resources fully.
I
- ,din
Note: Publisher is ot responsible for . . if any, occurrc 1
this b00k under any cir any 0 m1~s1ons/errors' ,. /1J1J
cumstances · Tl1ough eve1y possible n,c .1Slll'l!~ 05
tak
been k
en to make this b cc. SG/2019~D
oo upto the mark.
SEMESTER-VI fCBCSJ
B.A. (Prog.)/B.Com. (Prog.)/111 Year-2020
Generic Elective-ECONOMICS
[Principles of Macroeconomics]
Unique Paper Code : 62275604 Maximum Marks: 75

v,antion : 2 Hours
l marks.
Attempt any four questions. All questions carry equa
ation of national incom e with
Q. 1. (a) Explain steps involved in the estim
the help of the income method.
(b) Differentiate between final and inte
rmediate goods.
Ans .. (a) National Income (Methods)
ed by all prod ucin g units is
1. Value Add ed Met hod (Ne t value add
mea sure d)
mes is mea sure d)
. 2. Inco me Met hod (Sum of all factor inco
items of final exp end itur e is
3. Exp end itur e Met hod (Sum of all
mea sure d)
National Income By Income Method
mea sure d from the side of pay men ts
The nati onal income in this method is it
form of rent, wages, inte rest and prof
made to the factors of prod ucti on in the me is calc ulat ed by
unting year. Thus, inco
for their prod ucti ve services in an acco the
rate d by all the prod ucin g unit s located with in
adding up factor incomes gene lting tota l is calle d
of account. The resu
domestic economy duri ng a period . By add ing net fact or
uct at FC (NDPFc)
Domestic Income or Net Domestic Prod
estic income, we get National Income (NNPFc).
income from abro ad to dom
Steps Involved
in estimating national income by
The following are the main steps involved
income met hod : ve
1. The first step in income met
hod is also to identify the prod ucti
various industria l sect ors such as
enterprises and then classify them into etc.
ing
agriculture, fishing, manufacturing, bank
step is to classify the facto r payments. Factor paym ents are as
2. The second
follow:
(a) Compensation to employees, inclu
ding wages and salaries.
(b) Rent and Royalty .
(c) Interest
(d) Prof its-D ivid end s, undistributed
profits, corporate income tax
(e) Mixed income of the self employed.
payments. Income paid out by eacl1
3. The third step is t<;> measure factor
ing price paid out to each facto r and
enterpris e can be estimated by multiply
num ber of units of each factor employed.
by all enterprises belonging to an
4. Add ing up of all factor payments
(NOP at FC).
indu stria l sector to get domestic income
from abroad to dom estic factor
5. Finally, by addi ng net factor income
prod uct at factor cost (NN Pr,c) which is
income or NDPFc , we get net national
(81)
)/Ill Year l•'.clmomi c~ (SE MP.STFR
SATISH: B.A.fB.Corl\, (Pro~.
82 , . VJ) 1<·11(\ \
nlso collcd nationo\ incuf\'\l:,

rrecnutions: . "are not included.
l . Trnnsfor poymei~;lf.occupied hou .
ses arc included. f-lJ
2. Imputed rent of ~ not included.
3. Illegal n,on ~y ar\ also not included.
4. Windfall gams ~rea~ ~ot separately incl
s. Corpora t~_profi_t/ t , wealth tax, tax onudelott d.
eries etc. arc not .
6. Death dutt~s, g1t ax,
tn<:1t1dQu c<
in natio~al m~o metl e sale of second-han
7. The receipts fr~m 11. con1e d goo ds sho uld not b
t of nationa m · e treated
as a par t .
8. Income equa1 O the valu• e ofdpro duction used for self cons
r
should be estimated and me1u ed. · umptio p,
en Final Goo ds and . n
(b) Difference betwe Inte rme dia te Goods
Final Goods . h
All goods which are meant eith er
(a) for consumption by consumers or .
(b) for investment by firms are calle? ir
fmal goods.
They are meant for final use and the fmal use
d d rs of a prod~ct ~re consumers
s They are neither used for further transfor C
ant pro lducelnr ·other words final goods are mation m product'
no reso . acq uire d for their own use i etobn
consumers for satisfaction of' theu .
wants and by pro ducers for capital · ·· Y
form ation .
Intermediate Goods
All goods which are used
(a) as a raw material for further product~ C
on of oth_er goods, or
(b) for -resale in the same year are called
mte
Intermediate goods are purchased by one firm rmed1ate goods.
material or for resale. e.g. raw material pur from the other for uses as raw
chased use in a factory. Alternatively
defined-
"Goods which are used up during the pro
are called intermediate goods". The expend cess of production of other goods
iture on them is called intermediate
costs or intermediate expenditure.
Difference between Final and Intermediat
e Goods
Basis Final Goods
Meaning Final goods refer to thos Intermediate Goods
e Intermediate goods refer to those
goods which are either for goods whi
ch are used either for
consumption or for investment. resale or for
Nature further production.
Th~y are included in both They neither included in national
national and domestic income. income nor
Demand They ha~e a direct demand as in domestic income.
They have a derived demand as
they satisfy the wants dire
ctly. their demand depends on the
dem
Value r-:ro value has to be added to the Someand for final goods.
value has to be added to
addition
Production Th fmal goods. intermediate goods.
e hav the
boundary prod fe cros b
sed the Th
ey are s 1 t'll with in
Example M"l k uc ion oundary.
1 purchas~ production boundary. ale
for consumptiodn.by households Milk used in dairy shop for res ·
nom ics- 202 0
Pap er BC 6.2 (a) : Principles of Macro eco 83
. th .
Exp• ) ain e con sum ptio n function in detail. Ho w can the sav ing
s
Q. 2. (,1)
fi!llction be der~ved fro m the con sum ptio
n function?
th e cha nge in income if the change in investm ent is Rs.
(b) What wil l b e
1000 crores and MPC = 0.75
? Also, find out the val ue of mu ltip lier .
Ans. (a) Con sum pti on Functio n ed
n con sum ption and inc om e is call
The fun c tion al rela tion ship bet wee
cons ump tion functio n.
Thi s is exp r ess ed a s C 2 F (Y).
Thu s con sum ptio n fun ctio n mea ns
Co~ sum p~i on is rela ted to inco me. goo ds.
ptio n
prop orti on of mc om e spe nt on con sum
Features : e is
1. A ver y zer o or ver y low leve
l of inco me, consum ptio n exp end itur
sur viva l.
min imu m con sum ptio n is nec essa ry for
high er tha n inc om e as e
exp end itur e also incr eas es but incr eas
2. As inc om e incr eas es, con sum ptio n
in con sum ptio n is less tha n the incr
ease in inco me.
ns pro por tion of inco me spe nt on
Sim ply , con sum ptio n fun ctio n mea
cons um ptio n. Thu s,
C = Con sum ptio n
F = Fun ctio n
Y = Inc ome
JC3 F(Y)
p!ay s imp o~t ant rol~ in Key ne's the ory

The con cep t of con sum ptio n fu~ ctio n him , as the mco me mcr ease s, a sma ller
to
of inc om e and emp loy men t. Acc ord mg pro por tio~ of con_sum ptio n to inco me
ed. The
pro por tion of inco me is con sum
(APC) falls as mco me mcr ease s.
call ed ave rag e pro pen sity to con sum e
be exp ress ed as
The con sum ptio n fun ctio n equ atio n can
C = a+ by
whe re, C = Con sum ptio n exp end itur e
a = Aut ono mou s con sum ptio n
. 1 prop ens1·ty t o con sum e
. M arg ma
-AC z.e.
b
AY
y = Inco me level.
Con sum ptio n Fun ctio n
1. Lin ear Con sum ptio n Fun ctio n
y
c,1 -- -- -- --- - - - -
Con sum ption --
C .___ _ ___ _,,_ '--~ ---
, (Prog )/lll Year Eronomics (SEMESTER-vr
84 SATISH: B.A./8.C0 tn• . J l(Bc_(
'!
t.on F1mction
2. Non-Linear Consump t
y
C=8 + by
alL_L_LJ_...1.-----~
0
x
Income
Derivation of saving function from the consumption function

We can derive the corresponding saving function from consumption function-
s = Y-C
= Y-(a+by) (:. C=a+by)
= Y-a-by
,-----------,
IS= -a+(l-b)Y
a = It represents dissaving which is needed to finance autonomous
consumption.
b = MPC
y = Income
(b) Investment Multiplier: It shows the change in income due to the chantt· 1
in level of investment. 1.l
1
K=
1-MPC
tiY 1
- =
!ii 1-MPC
According to question,
tiY 1
=
l000crores 1- 0.75
1000 •
tiY = 0.,.25 x JOO crores
ti Y = 4000 crores.
Therefore the change in inco . b
investment is Rs. 1000 crores. me WI 11 e Rs. 4000 crores, it' the ,·h:111t,1'
111
I
Value of multiplier = 1
=
1- MPC 1- 0.75
1
"' Q25 X lOQ •
4,
Q. 3. What is net export fun t. .
c ion? With the help of dla~1'1\m, l.,,,l,h ihc
1 1
Paper BC 6.2 (a): Princip
les of M
acroeconomics-2020
responsible for the shift in 85
!~ct.orsal income and output. the net .
110 export function and its impa
rJ n5 Net Export Functio ct on
t;r~
~k1 as NET EXPORT FUNC
n- The differ
t:vnorts of a country depe
b
TION or ~D t; 11 1~ ~; xp
or ts and imports
l,.;)'r d · d nd on the spending d .
co0ds an _services pr o uce • d .
0 m our country i.e. expo ecis10ns o·f fore1g
.
ners on the
!0. 1.,-es outside th e coun rts are determine d b the
h try an d the refore do not vary wi"th th
t\1- Thus, t e)~ are _the au
'
h •
e c ange m mc•y
determines national mc~m tonomous part of aggregate expenditu re
ome
(AE) that
e (GDP) of our country.
On the other hand, impo
our country on the good
rts depend on the decision
s and services produced of domestic residents of
101ports generally rise with the in foreign
rncome increases they spen increase in domestic incom countries. The
d more on foreign produc e. As consumer's
imports are a function of ed consumer goods. Thus
GDP. As the gross domesti
mcreases an d vice-versa. c income increases import
Being determined autonom
ously exports do not vary
the imports rise with the inc with income (Y), while
As a result, the net exporease in GDP. .
rt
exports and imports, decre function which r~presents the difference between
a~e wi~h the rise m GDP.
negatively related to gross Thus, net exports are
• national mcome (GDP).
D1agram •• Panel (a) : Exports and Im
y
lmp
ports
ort function
u,
t:
8.
§ • X(Autonomous export)
a!!
u,
t:
0
a.
~
0 1 L -- -- + -- -"7 X
y
I
Q) I
z I
I
I
I
I
O X
export function (NX)
. .Panel (b): Net ~xports

el of GDP, if, net expo rt
unction - At a particular
lev le
Shift in Ne t Ex po
increases or decreases ~~ to favourable or unfav~ura~ changes in the factors
ut line/curve shifts upwar ownward. F~ctors which
affecting it, the net expo: or .
causes shift in net expor a5 are as under :
/Ill Year Economics (SEMESTER.
. B.AfB•Com- (Prog. ) -VJ) [~e
86 SATISH. · a1 mcom · ~l
e in the natton e of
. Income- Any chang ·
ex orts of domestic economy. Bee e fotf th
1. _For~~~tly affects ~e ne!ma~d for goods increases due to Whtllse ¼h~
cou~tne~DP increases, foreign d Th's lead to parallel upwa rd shift in ch expo~
foreign t' c economy incr~as~\. t wth in GDP in the USA, it Will irnnet exp
of do_mes ~ g when there is h~g . Agroa result exports in India increase Port tts
function. • · . from India. s lll~t\
oods and services . also. s and te
. lvi\\
!Hect its net export functt_on al Prices-Relative pnce~ of domestic good
2• Relative .Intemation.
mpettt . ss of the domestic economy. Ch s and
services determine co . tvene .
l t1·on to the domestic pnce . 1
evel Will
ang
b es in
· level m re a
international price Inflation rate and Exch ange ra te cause net e thete
because of two reasons- export
function to shift. It 1.s the Diagra m -Shif t in net export functi
3. Exchange Rate- y ·
on
rate at which currency of ~ur
country is exchanged or
currency of other country. .Aft:r
keeping foreign and domestic
price level const_ant, the
depreciation of Indian rupee
will make Indian exports Q)
cheaper and imports expensive. z
This will increase our exports
and reduce our imports from pr
abroad. This will increases the o '--- --- -~-~x bl
NX, NX NX,
net export. ta
GDP (Real National Income) 11
Impact of Shift on National Income and Expor:t: If :xpor t is ~onstan th
autonomous while import inc:i:eases as level of real national mcome raises. t or af
As net export and GDP have negative relationship. Because decreasing value af
/ of net export from NX to NX2 the GDP will increase and vice-versa. aI
(a) It can be clearly seen that exports rises as GDP rises and imports
ille
constant.
(b) Export falls as GDP falls and imports rise as GDP falls.
(c) Exports and imports both fall when GDP rise.
ff
Obviously when increasing values of import are deducted from a constant
Cl
value of exports we will get decreasing value of net exports in relation
increasing level of income. to l
Q. 4. (a) Suppose you have following information about an economy:
C = 150 + 0.8 Yd, I= 100, G = 200, T = 50, NX = 20
Fiud the ~q.uil~brium level of incom
e and the value of multiplier. Calculate
the new equ1hbnum level of income if government expenditure increase
from Rs. 200 to Rs. 300. s
(b) Balance budget multiplier.
Ans. (a) C == 150 + 0.8 yd
.I == 100; G = 200; T = 50
NX = 20
y = C+I+ G+NX
\
l'.1rt'f 81..: h,: (a): Principlt•!:! of Mon ot•conornit ti - 2020 H7
'(,
)'-S l
J 1 • 150 + 0.8 {Y- I) + 100 + 200 + 20
Y .. 470 + 0.8 (Y - 50)
Y • 470 + 0.8Y - 40
\ (1-0.S) = 430
430 ~
y = -:t
0.
X )-0 = 2150
Q-t\(j
i. Level ofincome = l21so1
; in 1
2. \'alue of multiplier =
1ete 1-MPC
}O;t
= _1_=.2_=~
1- 0.8 0.2
3.~G = 300 - 200 =100
tiY
- = 5
tiG
0.Y = 5 x tiG
0.Y = 5 X 100 :: 500
New equilibrium level = 2150 + 500 = 126501 .
(b) Balance Budget Multiplier-A measure of the change in aggregate
production caused by equal changes in govt. purchases and taxes. The balanced
budget multiplier is equal to one, meaning that the multiplier effect of a d1ange in
taxes offsets all but the initial production cause by the change in govt. purchases.
This multiplier is the combination of the expenditure multiplier, ,-vhich measures
the change in aggregate production caused by changes in an autonomous
or
aggregate expenditure and the tax multiplier which measures the change in
aggregate production caused by changes in taxes. This multiplier is useful in the
ie
analysis of fiscal policy changes that involves both govt. purd,ases and taxes.
The balance budget mul tiplier is equal to one. The "positive" impact on
aggregate production caused by a change in government purchases is largely, but
not completely, offset by the "negative" impact of the change in taxes.
The balanced budget multi plier, like the expenditure multiplier and tax
multiplier can come in several different varieties based on the consutnption
1t conceiving the structure of the economy and its components.
)
Balance Budget Multiplier
· = Govt. Expenditure Multiplier+ Tax Multiplier
⇒ Govt. Expenditure Multiplier
Y = C+ I +G
Y = a+ by + I + G
Y (1- b) = a+ I + C
1
Y= - [a+ l+ G] ... ( l)
1- b
Now ~uppose change in income is due to change in govt. spending,
1
Y + !).y = - (a+ I + G + 6G) ... (2)
1- b
Subtracting (1) from (2)
~, l•l\ll ~Tl' f< VI IC'H< -~,I
H..\ . (1' 10H )/ U.{ \Hll, (Prog,)/Jll Yt',lr 2020
'- ;,•iwt ir H ,,~·tiv~ ECONOMH 'S
l l'rhwh, lt·~ o l 1\ifacroeconomicBJ
I
.\ 1I
I• II .
l I•
l I v.,hll' tl l M11llipller
, fa,~ lultirlit>r
\
y .. a
-
c..>1 I t· G
., t, (Y- 1 + TR) + I + G ,/1
Y • :\ + by - /JT + /t fR + I + G rr
,,
Y (1-b) = n - bT + IJTR ➔ l + G
y = _ l_ (a - /JT + blR + l + G)
1-IJ i-
.
• ;;
C
:
Suppose change in income is due to change in tax.

1
y + jj,_Y = - (a-bT-bM + blR+ I+ G) C.
1-b 12
Subtracting (1) from (2)
1
!).Y = - (-b!).T)
1-b
~ Value of multiplier
:. Balanced budget multiplier= Govt. expend. multiplier+ Tax multiplier
l -b
= --+ =
1-b 1-b
1-b
= [ll .
1-b
Q. 5. (a) What is open market operation and how monetary authority u~
it to regulate money supply?
(b) What are the components of money supply?
Ans. (a} See Q. 7(a) 2018, Page 62. (b) See Q . 2, Page 44, See Q . 10, Page 5-t
Q. 6. (a) Explain how do commercial banks create credit in multifk'
banking systems.
(b) Suppose there is a fresh deposit of 10,000 in banks and the Iegnl rcSt'f' ~
ratio is 0,5. How much is the total deposit creation?
Ans. (a) Sec Q. S(a), Pa~c _48.; (b) Q. S(u), Page 48. . . ,, th:
lf_ the legal reser ve ratio 1s 0.5 or 50% tlwn d eposits wou ld be two_ 111
ri:J·,h ,n the econom y. So, the v::il 11c• of the..~ dcpn:;11 1nu ll lpliN i::l ~.,kuJ,,t\
111
'\i
~:::ih n~ reciprocal of co<Jh rt•::,crv,' ra tio ,
I ,.
JJ u b, If,
.
. h. (•f h.. nol rr• ~1rl)l'l'l l IJI'
I ' 0 1' ·"'Y ' . ' '
n1nl ~111i on•1/t•J'1'()1'~ 11 .,n, ' I I I
' ..
I 111 \'1
'-1"'' '1 '
•
thJ ·j booJ, t1nd<·r any dr1 ·111 1111ta 11t ·l'n , T h, 11 11 i! 1 '--'VPry ,,1.1~~il 1k in( , \'
r, t , ll} I 11111.
ht1v,, bf'1 •t1 li.JY!'n lo rn ;1k1• th lu 1111,11• ,qn,, 1lw n H11 I, . S(,/'1
SEMES TER- VI lCBCSl
B.A. (Prog.)/13. (Com) (Prog ) /Eco
. \II
· nom1cs I Year- 2021
PRINCIPLES OF MACROECON OMI CS
-
,'n : ~ Hours
• ____ S Nc1·~u
:,•1
___ ____:_-~·= ·22756()4
~.~~ ::_ 1
M11x i111 11111 Mnrk~ 75
Atfrmpt anv four q1te•t · . All .- - - --
.1 .1' · ~ !Olis . questim1s cnrry equn/ mnrks
Q. 1. (a) Discuss the GDP deflator and the problems of fixed weights .
Ans. GDP deflator also known · 1· · · d
as imp 1c1t price efl ator 1·s an essentia
· l measure
. .,conomy that helps compar e th
• . . . . e n·se in
· pnce
· IevesI and of ·
goods and serv ices
t,etween years. lt is an indicato r of the impact of inflation on COP in an econom y. It
,,erely notes th~ price change in an economy in one year. The process of calculati ng
meva lue ~f price chang,~ as reflected in real and nominal GDP of the country is
tem~ed as CD~ De~ator . GDP Deflator is a price index (Pl) that focuses on showing
the impact of mflat1on or deflation on the current prices in the economy and by
dearly showing how price changes is dependent to relative GDP.
GDP Deflato r can be compare d between several priods ol time without use
of base year as it is constant, nor use a specific basket of goods. CDP Deflator is
nexible but like CP1 , GDP Deflator does not haw ba~e va lue and th at equals to 100.
Formula of calculating GDP Deflator is :
GDP Deflator = (Nominal GDP) -;- (Real GDP) x 100
Here, Normal GDP refers to the current prices in the market and Real GDP
measures the actual cost that went into producing the product. Nominal GDP is
calculated using that year's prices while Real GDP is calculated using that year's
prices while Real GDP is calculated using the base year's prices. When Nominal
GDP is divided .
Example Let us take an imaginary production table for India that only incluc!es
three goods Mobiles, Cakes and Pens. Between the years 2019 and 2020, the outpul
and prices of these goods produced by Indian economy changed yet by calculating
2020 output in 2019 prices we derive the Real CDP and therefor e the GDP Deflator
.
Indian Output in 2019
Goods Oty. Price (2019) Total value of output
--
Mobiles 10 5 10 X 5 = 50
Pens 5 20 5 X 20 =- 100
-- --- ·-
Cakes 4 3 4 x3 = 12
--- -
Nominal GDP 50 + 100 + 12 = 162
-
From the above table, the value of output for each goods in 2019 is deri ved by
mu ltiplying Lhe_quantity and price of goods. Nc..;or is simply the sum of these tota l
value of Mobiles, Pens and Cakes.
Between 201 9 and 2020 both the qu antity produced and the price of these goods
increased . This result in a higher Nc,1w for 2020. Yet only some of the incrl'a:,e cc1n
be attribute d to increases in outpu t or 'real' economic growth. As i~ni hc.rnl portion
(8!>)
90 SATIS H: B.A./B.Com. (Prag.) / Economics/ III Year [SEME STER- VI] [C::e,,..,
.
~~
of this increa se in nomin al GDP is the result of pure price increa ses which
make consum ers any better off.
do n()t
Indian Outpu t in 2020
Goods Qty. Price (2020) Total value of
Mobile s ,. · 12 5.5
22
10 X
~
5.5
6
6
Pens 6 6x22==~
Cakes 5 3.5 Sx3 .5== ~
Nomin al GDP 66+ 132 +17 ~
· - 55
The Real econom ic growth from 2019-2020 by re-calcul . . ~
ating the 2020 t _
2019 prices. This makes 2019 "Base Year", when calcul ating the
2020 GDP ct~ s. 1n
The 2020 GDP Deflat or is-the index by which 2020 Ncor can be conver ted
. inte ator.
0~
real GDP in 2019 prices
Proble ms of Fixed Weigh ts The use of fixed price weigh ts to estirnat
GDP leads to proble ms becaus e 1t . . . e real
ignore s the follow ing :
(a) Struct ural change s in the econom y.
(b) Suppl y shifts, which causes large decrea ses in price and large increase
s
in quanti ty suppli ed.
(c) The substit ution effect of price increas es.
(d) The exclus ion of non-m arket transac tions.
(e) The failure to accoun t for or repres ent the degree of incom
e in equality
in society .
({) Treatin g thP replac ement of deprec iated capita l the same as the creation
of new capital .
Now, the proble m arises becaus e the fixed weign ted system used to calculate
GDP is not capabl e of fully accoun ting for these structu ral change s. As
a result, the
· further the measu re of GDP gets from the base year, the less accura te the
calculation
of real GDP becom es. While the fixed weigh t metho dology has the advanta
ges of
simpli city and ease of interpr etation , it also has numbe r of undesi rable
feat_um.
Most impor tantly the growt h rate of a fixed-w eight measu re real GDP
depends on
the cho.ice of base year. The reason we get higher growt h rates for real
GbP when
using earlier base years is the well-k nown proble m of" substi tution bias"
associated
with fixed weigh t indexe s. Catego ries with declin ing relativ e prices tend
to have
faster growt h in quanti ties.
(b) Calcul ~te Nomin al GDP for the Both Years with the help of data
given
in below table
Goods Produ ction Price (per unit i ~
---
Yearl Year2 Year 1 Ye~
Ql Q2 Pl E---
Good X 12 22 1.00 o.so
Paper BC. 6.2 (a): Principles of Macroeconomics-2021
91
Goods Production Price (per unit in $)

Year 1 Year2 Year 1 Year 2
Ql Q2 Pl P2
GoodY 14 08 0.60 · 2.00
Good Z 20 24 1.40 1.80
(a) What are the limitations of using nominal GDP ?
Ans, Calculation of Nominal GDP
, Goods Production Price Nominal GDP

,...
Year 1 Year2 Yearl Year2 Yeatl Year2
Ql Q2 Pl P2
Good X 12 22 1.00 0.80 12.00 17.60
Good Y 14 08 0.60 2.00 8.40 16.00
Good Z 20 24 1.40 1.80 28.00 43.20
Total 48.40 76.80
Limitations of Nominal GDP

• It can't compare the intricacies of price and quantity To understand the
productivity of the economy, one must compare the result of two years.
And it's not only the total output that matters because the price has always
been changing. What matters, rather, is the quantity produced in a year. If
we can compare that, then we would be able to understa.nd whether the
economy is growing or not. A nominal gross domestic product can't compare
the intricacies of price and quantity.
• It doesn't compare similar results Comparing the result of the previous
year at the previous year's market price with ~he result of this year with
this. yea_:'s market price ist)'t the right thing to do; because there are many
factors tharhave-changed or remained same. That's why we need to take
a base price/quantity to reach the right conclusion.
• One bf the limitations of usir:ig nominal GDP is-when an economy is mired
in recession or a period of negative GDP growth. Negative GDP gro_w th
.could be due to a decrease in prices:,called deflation. '
• It doesn't consider the effect of inflation' Tl:us is a big negative. Inflation affects
an economy so very intensely. And not considering the effect of inflation
in calculating GDP is a big no. Not, considering inflation for calculation 0 {
nominal gross domestic product may be easier, but not a '{a lid calculation
for experts in the field.
• The nominal GDP is a measure of a country's economic output for a calend~r
year, using curent prices, without adjusting those prices for inflation. The
nominal GDP figure can be misleading when considered by itself, since it
92 SATISH: B.A.fB .Com. (Pr ) / Economics/ Jll Yea r !SEMESTER- VI] I
og.
C:Bcsl
me tha t sig nif ica nt gro wt h
cou ld lea d a use~ to as_su has occur
ntr y' s inf lat ion rat e.
the re is sim ply a ium p 10 cou tect, \vh
. n Co nsu mp
. d S ·
tion an avmg Fu nct ion ~
Q. 2. (a) Discuss the Keynes1a
.
help of suitable diagram and equ s With th '
ations.
An s See Q 3 and Q. 4, Un it-3 e
, Pag e 15- 18.
· ' h h ve the
(b) Su pp ose t at we a fol low ing mo de l for the goo
. ds mark
c= 10 + 0.50 (Y - T) et:
I= 20 +0 .l Y
G = 10
T = 10
y = C+ l+ G
fin d ou t the rqu ilib riu m lev
el of inc om e inv es~ en l, con
sum pti on and saving. \
Ans. (i) Eq uil ibr ium inc om e (X)
y = C+ I+ G
= 10 + 0.50 (Y - 10) + (10
+ 0.1 Y) + 10
= 10 + 10 + 10 - 5 + 0.5
Y + 0.1 Y
= Y- 0.6 Y= 25
25
Y= - = 41.66
0.6
(ii) Inv est me nt (I) = 10 + 0.1 Y
I = 10 + (0.1 x 62.5)
I = 10 + 6.25
I = 16.25
(iii) Co nsu mp tio n (C) = 10 + 0.5
(Y - T)
C = 10 + 0.5 (62 .5- 10 )
C = 10 (0.5 x 52.5)
C = 10 + 26.25
C = 36.25
(iv) Eq uil ibr ium
Sav ing (S) = Inv est me nt (I)
as inv est me nt = 16.25 (I)
Sav ing (S) = 16.~5
Q. 3. (a) Discuss the Balaned-Bu
dget Multiplier and its value.
. Ans. Balanced-Budget Multip d
lier It is a cha ng e in Ag gre gat e
bro ug ht abo ut by a cha nge
io go ver nm ent exp end itu re, oeni~;d
by a cha ng e in rev enu es rec wh ich is exa ctly ~ate
eiv ed fro m tax ati on an4 oth
. er sou rces. c\
exp end itu re ha s an,im me dia , ff On aggreg31
Th e cha ng e m go ver nm ent
dem an.d an d gen era tes inc te e ect ge in 1
om e of an equ iva len t siz e.
tax ati on do es no t cha nge agg By con tra st, the chaf l
beca use \
reg ate dem and by an eq uiv
som e of the inc rea sed /re du ced ale nt arn oun t savi"~
Disposable l11con:ie w ill be o ffse t by
cha nges in. \
I
Paper BC. 6.2 {a) • p · · 1
· rincip es of Macroeconomics-2021 93
uently, an increase in govern .
conseq t . ment expenditure and taxation of equal amounts
. have a ne expansionary effect
111111 • • on aggregate demand and incomes while a
decrease m _government expenditure and taxation of equal amounts will have a
net contract1onary effect.
AE
AE
AE0
,,,,
,,'
,,,,
I
I
,, I
/ I
/ I
I
I
I
0 Y0 y 0 Y0 y
(i) Increase in G (i) Increase in T
Now from the above figure it shows a balanced budget increase in government
purchases will increase the equilibrium level of GDP.
Part (i) shows the effect of an increase in (autonomous) government purchases,
llG. Taken by itself, this policy would shift the AE function upward and lead to
an increase in equilibrium GDP above Y0• Part (ii) shows the effect of an increase
in autonomous taxes, ~T. Taken by itself, this policy would shift the AE function
downward and reduce equilibrium GDP below Y0•
The Balanced-Budget Multiplier has a value of 1. This value indicates that the
change in aggregate production is caused by the initial injection of government
purchases. The subsequent change in aggregate production that might result as
government purchases, trigger cumulative reinforcing included changes in factor
payments, income and consumption are cancelled out by an opposite impact from
the·change in taxes.
Example Suppose the government purchases are increased by t 100 crores
using fiscal policy designed to correct a business cycle contraction, by itself, this
t 100 crores government purchases increase would be expected a t 400 crores
increase in aggregate production. However further suppose that this t 100 crores
increase in government purchases is matched by and paid for an equal t 100 crores
increase in taxes. This t 100 crores increase in taxes is expected to trigger t 300
crores decrease in aggregate production. The net impact an aggregate production
of both changes is only t 100 crores, not t 400 crores. If a t 400 crores increase in
aggregate production is needed to achieve full employment, then this strategy falls
t 300 crores short.
Q. 3. (b) Derive the simple multi pier and wehat is the relationship between
marginal propensity to save and value of simple multiplier? What will happen
to Multiplier if MPC > 1 ? .
Ans. See Q. 5, Page 18-20.
If MPC > l, then the value of multiplier will become negative.
• l ) / t.: lllllltl l l'1/ Ill Y1 •,11 1:,1Ml h ll 1< Vq ,, I< '1 'I
94 SATl SH : B.A./H LOil\. ( I l"(I ~ l l
. .. ks crc.>,, tc morwy .md wh,1 1l11 n1urwy '" tJJh1i1

Q. 4. (a) How comm crc1a 18 J.n 111
Ans . See Q 5 (a) ,md (/J), P.igc

48--49
· ·
'
. . T , . 10 thl' µron •1,& of I n•d ll. 1 1.11•,111t ir , 1,y '"'

Money Mult1 pher t r~1a1t:~ . 11 ,,il•r,
. . . . .1Y
of comm ~rclol
.
bu11k11 .,b
.,
lo
.
now
. .
11 1o1 11y 111,
1t<t ••;t
1,
banks ind icating the Lapaci
. . k . n pnri son to p rttn i1 ry rJl' j10 tJl l~,. J Iii,, I <11 11,•p1 ' n, L,,
credi t 1s create d by ban s in COi ' · ' ,
. . an exa mp 1e, let F, rimary depos its be ~ I 00 i !'nrt• <1 nd tut.JI d1. P•,• 1
v,11th
exp lamed
. t 1·ve depos its be ~ 500 crores, here tolJ 1t 1l'ru '•11 l., .i,,. 'i ltr1111\ 1111, 1,'
1
' d enva
.me1u d mg
1 r , 1. '
an d there f ore, d epos1 . . pt bcrom
·t multiplier is S· Th is conce d 1•0 u rth,•1 1 1,,.i 11 11 ., (1r
,. ,,
at the follow ing tabl e where cash reserv e ratio is t1 ssu mc lo h,J I()'¼
- -
Balance (?J
Depos its((}
100 (Prima ry Deposit)
CRR (10%) Amount
10 90 - --,,
'
I
9 8]
90 (Derivative Deposit
~~
81 (Derivative Depos it) 8.1 72.9
~-..i
72.9 (Derivative Deposit) 7.29 64.71
I
---
'
I
1000.00 100.00 900.00

-
ts are ten
1n the above example, depos it multipli er is 10 becau se total deposi
times m·o re than the derivative depos its.
Depos it multip ler is estimated in the follow ing mann er:
1
OM = CRR
Therefore, if Cash Reserve Ratio (CRR) is 10%, then OM wi ll be:

1 1 1 1
OM CRR 10% 10 1 lO
- -
100 10
Th e higher is th e CRR, less would be the OM and vice-versa .

that ban~
In other words . "The money multip ler is the a moun t of money
its that Fedml
genera te with each dolfa r of reserves. Reserves is the amoun t of depos
is the rat1oo1
Reserve requir es banks to hold and not lend . The money multi p lier
be cakulatcd
depos its to reserv e in the bankin g system . A money multi p li er can
t it has '11
using the ratio of th e amoun t loa ned out by a bank by th e dollar amoun
reserv es.
ot the
Money Multiplier Formula The money multip lier is the reciprocal
reserve rati o:
Mone y mul tipler = 1/R,
wh ere I< is the reserv e ratio.
.
Pa p~r BC. 6.2 (n) : Princ iples of Macroe conom ~cs - 2021 95
(b) Discu ss open m arket opera tions and h

oiltrol mone y supp ly in econ omy ? ow mone tary autho rity use it to
ncing the total vol u me
c Ans. !he qualit at_ive meth ods a~e direc ted towar ds influe
th st the use to wh ich it is
of credit m ~ b~nk mg sy em, witho ut speci al regar d for
, are direc ted
pu t. The qua_h tative meth ods of credi t contr ol, on the other hand
e outst andin g. But here
to~vard s parti_ cular use of credi t and not the total volum
ation s wh ich we
we are conce rned only with Bank Rate and Open Mark et Oper
discuss below :
of credi t contr ol used
1. Bank Rate Bank rate is the most tradit ional weap on
rate at which the centr al
by the centr al bank . The bank rate is the official minim um
of excha nge or to lend
bank of a count i'y is prepa red to redisc ount appro ved bills
influe n ce the volum e of
on appro ved secur ities. The bank rate mech anism seeks to
in the bank rate bring s
credit throu gh chang es in the rate of intere st. An increa se
se in the rate of intere st
about an incre ase in the rate of intere st and this increa
n in view of the rising
adver sely affect s borro wing . This is so becau se busin essme
woul d liquid ate their
rates of intere st will reduc e their stock s, inven tories etc. They
e in the bank rate will be
stocks to pay for the bank loans . On the other hand a declin
--f stimu late borro wing
followed by a declin e in the rate of intere st. This declin e woul
and produ ction .
by busin essm en and indus trialis ts and increa se inves tment
es in the intere st'
The succe ss of bank rate policy mainl y depen ds upon the chang
oped count ries intere st
rate corre spond ing to chang es in the bank rate. In under devel
rate chang es and hence
rates do not chang e direct ly to the e::c tent to which bank
bank rate is not fully succe ssful.
refer to sale and
2. Open Mark et Oper ation s Open mark et opera tions
and purch ase influenct>
purch ase of gover nmen t bond s and secur ities. Such sales
increa se bank advan ces,
liquid ity positi on of banks . When the central bank wishe s to
seller s of these bond s get
it starts purch asing gover nmen t bonds and secur ities. The
impro ves the liquid ity
paym ents in chequ es which they depos it with banks . This
if the centr al bank se lls
and credit creati ng powe r of banks . On the other hand,
they withd raw mone y
such secur ities peopl e buy them and for.m aking paym ents,
creati ng powe r of banks . The
from banks . This adver sely affects liquid ity and credit
decre ases advan ces.
purch ase of secur ities increa ses advan ces and sale of secur ities
nal move ment s in
Open mark et opera tions are very good to effect the seaso
ng the slack seaso n) or
the econo my due to the prese nce of too much mone y (duri
financ ial string ency (durin g the busy seaso n).
main tain a certai n
3. Variations in reserve ratio All banks are requi red to
of cash reserv es with
perce ntage of their dema nd and time liabili ties in the form
reme nt or cash reserv e
the centra l bank. This is referr ed to as statut ory reserv e requi
l bank for mone tary
requi remen t (CRR). This serve s as a tool in the hands of the centra
ding on the liquid ity
contr ol as this ratio can be chang ed from time to time depen
condi tions of any econo my.
banks to main tain a
4. Statu tory liqui dity Ratio (SLR) SLR requi res the
to be held in the form
certai n perce ntage of their total dema nd and time liabilities
rise of-
of certai n desig nated liquid assets . These liquid assets comp
96 SATISH: B.A./B.Com. (Pwg.)/ Ewnomics/ Ill Yea r !SEMESTER- Vt] ICBcsl
Excess Reserves of thP banks (FR)

Current account balances of the banks (CA) and
Investment in Government securities (I).
It can be defined as -
ER + CA+ I
SLR =
L
This ratio can also be varied by the central bank from time to time and h
ence
serves as an instrument of monetary control.
Q. 5. Discuss the effect on Money Market using a suitable diagram f
following changes: or
(a) Increase in nominal Income
(b) Increase in Money supply.
Ans. (a)Increase in nominal Income Recall that an increase in nonf1
1
income will shift the money demand curve to the right. At the old interest rate (~;
the quantity of money demanded is now higher than the supply of money in th;
economy (money supply has not changed). Because of this the ihterest ate must
rise for people to be happy holding the old level of money. When the interest rate
rise the yield on bonds is higher, and the demand for bonds will increase.
The stock of money remaining fixed, the attempt by the people to hold mart>
money balances at a rate of interest lower tha'n the equilibrium level through sale of
bonds will only cause the bond prices to fall. The fall in bond prices implies the rise
in the rate of interest. Thus, their prices started as a reaction to the excess demand
for money at an interest rate below the equilibrium will end up with the rise in the
interest rate of the equili~rium level.
y
.... Ms, Ms2

rJ) I
I
ill
.... I
I
ill I
.s
,.... I
Or -------- ·_ i E
ill
.... I I
ro r ----------,-I
-
P:::
'II
0
I
I
I
~ ------'-'- -'----
N N"
---
'
LP
X
Quantity of Money
Effect of an Increase in the Money Supply Let us now examine' t11l' t•lt,•d
of increase in money supply on the rate of interest. In thf' fi~un· n b(1V1' I I' i., till'
demand for money for satisfying various motives, To begin with, ON i~ tlw qu,,n 111 1
1
of money available. Rate of interest will br dctcrmined wh('l'l' 1lw (h-m,111d 1i1r 11 1\' 11'·
P:iper BC. 6.2 (n) . Pnn .
. rt p1l''.. ot M,1c ru(• <nnom11 "
:Z!l2 I
ril,incc or equ ol to the fixed ::,up pl 'fl
,,11 · . . f
\ti~ cleat form Fig. tha t demand Yo mo nt•y ( )N .
fo _
rilt' of .mt ere~t. Hence O r i~ the r monl'y ,~ <'LIU;-i l t ( JN
.,t ,'r • . . .l · " u yu,mt1ty of monev
. 1I
Ass um ing no chan ge m exp-ectatiequi mu m rill1 · uf inl1 'r<', t ·
titY of mon ey (th rou gh b · ons and n . ,
,~.1n . , . . omina
, 1 the ope n ma rke t) wil l I uym g sec un t1C's by thf' cl il1 lt> rni·, an in<
l 111 1. f rca'> P 1n the
!f\10 ' ow er tI1e ra te of inlerc~t. rn ra ian r, o the rnun trv
\~ Fig . ~h ;n ~e~u ant ity of mo '
ney increa ses fro m ON to ( )N' , the
!a\\s ro;f r O r eca use the rate of intere~t
new quantity of money OU is in
,Jernan . or mo ney ar Or ' rate of bal anc e with the
Thus, giv e the mo ney dem and cur interest. In this case we move dow
v n on the cu rvc>
. e or curve o f 11qu
· · ·
1n the qua nti ty of mo ney bri.ngs 1d1ty preference, an increase
dow n the rate of inte rest .
Let us see ho w increase in money
sup ply leads to the fall in the rate
With initial equ ilib riu m at Or, wh of inte rest .
en the money supply is expanded
there em erg e excess sup ply of mo from ON to ON',
ney at the initial Or rate of interes
would react to this excess quanti t. Th e people
ty of money supplied by buying
the bon d pri ces will go up which bon ds. As a result,
implies that the rate of interest wil
is how the inc rea se in mo ney sup l decl ine . 1l1is
ply leads to the fall in rate of inte
(ii) Sh i~s in Mo ney De ma nd res t.
or liq uid ity Preference Cu rve
of money dem and curve dep end The posi tion
s upo n two fac tor s-
(1) Th e \eve\ of nominal
income, (2) the expect atio ns abo
bond prices in the future which ut the changes in
implies changes in rate of inte res
has bee n exp lain ed above, a mo t in future. As
ney demand curve is dravm by ass
\ev e\ of nominal income. With the uming a certain
increase in nominal income, money
transac tions and precaution ary dem and for
motives increase cau sin g an upw
money dem and curve. ard shift in the
Shift in money demand curve (or
what Key nes call ed liqu idity prefere
can also be cau sed by changes in nce curve)
the expectations of the people reg
in bon d prices or movement s in arding changes
the rate of interes t in the futu re.
MS
0 N X
Quant ity of Money
Eff ect of increase in Liquid ity
Preference on the Rate of Interest
· I Ill Year [SEMESTER-VI] [CBc
98 SATISH: B.A./B.Com. (Prog.) I Economics SJ
d h ople on balance to expect a higher
. If some changes in events lea t e pe. su osed, the mone de rate or
interest in the future then they had prevwuslyll . PP e which wi ll Yb . rnand or
. ·d · 1 t' motive w1 mcreas ring b
11qu1 1ty preference for specu a 1ve O
f I' •d I·t f a 01.1 1
an upward shift in the money demand curve iqui Y pre erence curve
and this will raise the rate of interest.
. · f mone)' remains unchanged at ON
In Fig. assuming that the quantity O , the
rise in the money demand or liquidity preference curve fro~ LP1 to LP2, the rate or
· · t Oh the new speculative demand for rnoney
interest nses from Or to Oh because a ,
is in equilibrium with the supply of money ON.
Itis worth noting that when the liqu•idity preferen_ce curve rises from LP 1 to LP1
the amount of money held does not increase; it iemams ON as before.
Only the rate of interest rises from Or to Oh to equilibrate the new liquid it,
preference or money demand with the avilable quantity of money ON. )
Thus we see that Keynes explained interest in terms of purely monetary forces
and not in terms of real forces like productivity of capital and thrift which forn,ect
thetoundation-Stones of both classical and. loanable fund. ~heories. According tu
him, demand for money for speculative motive together w1tn the supply of moiwv
determines the rate of interest. He agreed that the marginal revenue product of
<:apital tends to become equal to the rate of interest but the rate of interest is not
detern;ined by marginal revenue productivity of capital. Moreover, according to
him, interest is not a reward for saving or thriftiness or waiting but for parting with
liquidity. Keynes asserted that it is not the rate of interest which equalises saving
an investment. But this equality is brought through changes in the level of income.
Q. 6. How does an increase in Investment affect the equilibrium level of
income in an economy? Use suitable equation, multipliers and diagram for this
answer?
Ans. Investment influences the rate of economi c g rowth beca use it is a
compqnent of aggegate deri1and AD and top of it influ ences the poductive ca pacity
of the economy (LRAS). An increase in investment should be a boost to economic
growth. Investment means expenditu er on ca pital sending, exa mpl e buying a new
house, building bigger workshop.
Investment is a component of aggega te demand (AD), therefoe if there is Jn
increase in investment, it will boost AD and shot-run economic gow th.
· PL
LRAS
-------------
AD2
AD I
Paper BC 6 2 (a). p · •
· · · rmcip1es of Macro econom ics-202 1
99
If thee is spare capaci ty then in d·
the rate of econo mic gowth . crease investm ent and a rise in AD will increas e
Howev e, if the econo my is I t f .
. d . ose O u 11 capacit y, then ising AD will only cause
inflat10n an not an increa se in cReal GDP.
Howe ve there are other fa t
.. c ors th a t a ff ect A D apart from investm
·
ent. For
exampl e,1fth erewa safal1 1·11co s d '
. n umer spen mg or a fall in · · ·
export , then a rise 111
investm ent may no} achtall ~ increas e AD. Investm ent is not the bigges t
compo nent
of AD (appro x 16.5 Ya). The bigges t compo nent of AD is consum er spendi ng (appro
65.5%). x
~n~est ment and the multip lier effect If the econom y has spare capacit
y, a
rise m invest ment can also cause a multip lier effect. The initial rise in investm
ent
increases econo mic growth , but if firms gain more sales and profit, they
are willing
to reinve st this in furthe r investm ent. Also, househ olds who
gain emplo yment from
the invest ment, have more incom e to spend. Thus an investm ent of £2 billion
could
cause a final increa se in real GDP of £3 billion , (multip lier effect-of 1.5).
Invest ment and the supply -side of the economy If investm ent is effectiv
e
then it should also increa se the produc tive capaci ty of the econom y. For
examp le,
investi ng in skills and educat ion can _increas e labour produc tivity. Investm
ent in
new techno logy and capital can increas e produc tivity and the produc tive
capaci ty
of the econom y; this helps to shift long-r un aggreg ate supply (LRAS)
to the right.
An increa se in LRAS is essenti al for long-te rm econom ic growth ; it can
increas e
econom ic growt h withou t inflatio n. If investm ent leads to a signifi cant
incrL•ase in
produc tivity then - it can lead to an increas e in the long run trend rate
of econom ic
growth , (avera ge sustain able rate of growth . Investm ent can lead to
higher real
GDP withou t inflatio n.
AD/A S diagram showi ng increase in LRAS and AD
PL LRASl LRAS2
AD2
AD1
Real GOP (Y)
Evalu ation
• It d ds on the type of investm ent. For examp le, mispla ced govern ment
epen . . Id . ffi .
invest ment in impro ving indust rial capaci ty cou b e me . c1ent an a1 1
d f ·
·
to increa se pro duct 1·vity in the econom y. Privat e sector invest
·mvest men t f m overse as may be much more effectiv e m . . ment . or
ro actuall y mcreas mg
produ ctivity as private firms have more knowl edg_e about the most effectiv .
e
types of invest ment.
.,/ Il l Yrar IShM Uf/ J,R Vfj f< tu '•I
lOO SA.TISH : B.A./B.Cc,m. (Proi~-) / EronflmK
cont.lrni nl1i in p11 bJ1£

• Ho,,ve\'er, some coun tries mny hnve sup ply- 1
goud1, will not bt- pr:LV,rj i(J",.d t

· roads, brid gesI infrastructure. These pub lic • i,,
,re gov r rn m,•n t lnvti 1-1,
fully by the free -market; therefor e, 1t ,may rt'qu I . tni(•n
to overcome the supply botdcnecks. r·or examp e, rongc1,l,1C1n 1,n th,, 1
ic artiv ity. r,,d h
is a major cons traint for business and econom
for improv ing prc,du,
• In the long term , investm ent is important 11
omy. With out invi•f>t t,v /
and increasi ng the competitiven ess of an econ
um ptio n, but th is crea trn"ni,
an economy could enjoy high leve ls of cons
current account defi (J e.. dn
unbalan ced economy. There wi ll tend to be a I dflrj
.
. 1e inve
11tt stm ent in future growth pr~spects.

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UNIT 1

,4.What is macroeconomics ? How does it differ from microeconomics?

Q. 2. What are the macroeconom s issues in an economy ?

QA. How is GDP computed using the method of Value added?

Q2. How is GDP computed using the spending method?

spending method. We may explain them as follows:

Q.4. What is depreciation ? Why is it importantto compute depreciation?

difference between real GDP and nominal GDP.

price deflator. It is defined as follows:

Q.6. Differentiate between real national income and nominal national

Q.7. Explain the income method of estimating national income. wna"

Q.9. Distinguish between actual GDP and potential GDP?

GDP Value of consumers, goods and services +Gross private domestic

Difficulties in Product Method:

Q.1. Critically explain Say's Law of markets.

Q.2. What do you understand by the term GDP gap ?

Q. 3. What is the relationship between consumption expenditure and

Keynes Fundamental Psychological Law of Consumption : It states that ther

is less than one, i.e., 0<b<1.

follows that, once we take the

Next, we define average

While the marginal propensity to save

the slope of the saving function. In the linear

and is equal to 1 mpc, where saving function, it is given by s

The equilibrium level ot income is determined by the equality of inv

in the economy. Flere we have to make a distinction betvweeen en

what is being realized by the economy in the end.

have expost investment =exante (Investment Functon)

decreases, then the slope of saving

Q.5. Define investment multiplier. Show that it is directly related to

income or GDP. In case of investment multiplier it measures the change in

Since 0< mpc < 1, there 1 < k << o.

directly or positively related to mpc and inverselyv

Q.6. What is effective

is determined at the point where

intersection the aggregate demand curve

C 50+0.75Y and b = mpc.

Also, a> 0 and 0 < b< 1.

Volume of Investment inec Interest rate

money the rat of interest

Q.9. What is consumption function? Explain the relationship between

still exist even if income was $ 0

Relations b/w MPC and MPS

Q.10 Explain Consumption Funtion and saving Function.

Deviation of Saving Function : In a simple two-sector economy mode

Q. 11. Explain the relationship between consumption expenditure and

According to Keynes' fundamental psychological law of consumption

less than one, i.e. 0 <b<1.

Q. 12. Explain the determination of equilibrium level of GDP usi n

Y= C+I ⇒ Y= Ca+ CY+ l0

consumption expenditure (C) and personal disposable income (Yd), corresponding

Q. 1. Compute the equilibrium level of real GDP w h en :

Diagram : (1) /Export and Import Function

/ (X-M)I(Net exports functions)

Q,1 - - - - - -~ - - - - - -- Real GDP

Diagram : (it) Net Export Function

X .............................................................. 1.... . .................... x == X'

ix IL..- ---+,--+-,---➔ Diagram : (i)jExport land Import Function

Bn/n11ccd Budget Multiplier : The budget balance is defined as the government

Q. 4. (a) Explain the working of multiplier when change in investment