2

III Answer the following questions in a sentence or word.

1. Who are economic agents?
Ans: Economic agents are those individuals or institutions which take economic
decisions. They can be consumers, producers, Government, Corporation, Banks etc.
2. What does classical school of thought say?
Ans: The classical school of thought says that all the labourers who are ready to work
will find employment and all the factories will be working at their full capacity.
3. Give the meaning of imports.
Ans: When the economy buys goods from the rest of the world, they are called imports.
4. Name the well known work of Adam Smith.
Ans: An Enquiry into the Nature and Cause of the Wealth of Nations.
5. What do you mean by wage rate?
Ans: The price paid for purchase of labour services is called wage rate.

IV Answer the following questions in 4 sentences.

1. What are the features of capitalistic economy?

Ans: The important features of a capitalist of economy are as follows:
 There is private ownership of means of productions.
 Production takes place for selling the output in the market.
 There is sale and purchase of labour services at a price which is called wage rate.
 A typical capitalist enterprise has one or several entrepreneurs and exercise
control over major decisions.
 The entrepreneurs may themselves supply the capital needed or they may borrow
the capital.
2. Name and write the meaning of two kinds of trade in external sector.
Ans: The two kinds of Trade in external sector are exports and imports.
 A country may sell goods to the rest of the world – Exports.
 A country may buy goods from other countries – Imports.
3. Who are the macroeconomic decision makers?
Ans: The macroeconomic decisions makers are State itself or statutory bodies like the
Reserve Bank of India, Securities and Exchange Board of India and similar
institutions. Each such statutory body will have one or more public goals to pursue as
defined by law or the constitution of India itself.

V Answer the following questions in 12 sentences.

1. Briefly explain in what way Macro Economics is different from Micro
Economics.
Ans: The micro and macro economics are distinguished on the following grounds:

Scope:
 Micro Economics study in individual units so its scope is narrow.
 3

 Macro Economics study in aggregates, so its scope is wider.

Method of study:
 The Micro Economics follows slicing method as it studies individual unit.
 The Macro Economics follows lumping method as it studies in aggregates.

Economic Agents:
 In Micro Economics, each individual economic agent thinks about its owninterest and
welfare.
 In Macro Economics, economic agents are different among individual
economic agents and their goal is to get maximum welfare of a country.

Equilibrium:
 Micro economics studies the partial equilibrium in the country.
 Macro Economics studies the general equilibrium in the economy.

Domain:
 Micro economics consists of theories like consumer’s behaviour, production and cost,
Rent, Wages, Interest, etc.
 Macro economics comprises of theory of income, output and employment,
Consumption Function, Investment function, Inflation, etc.

2. Explain the working of the economy of a capitalist country.

Ans: Capitalist economy can be defined as an economy in which most of the
economic activities have the following characteristics:
a) There is private ownership of means of production.
b) Production takes place for selling the output.
c) There is sale and purchase of labour service at a price called wage rate.

In a capitalist country production activities are mainly carried out by capitalist

enterprises. A typical capitalist enterprise has one or several entrepreneurs. Entrepreneurs are
those who exercise control over major decisions and bear a large part of the risk associated with
the firm. They may themselves supply the capital needed to run the enterprise or they may
borrow the capital.

To carry out the production they also need natural resources. They need the most
important element of human labour to carry out production. This is called as labour. After
producing output with the help of land, labour and capital, the entrepreneur sells the product in
the market to earn money called revenue. Part of the revenue is paid out as rent for land, interest
for capital and wage for labour and keeps the rest of the revenue as profit.

Profits are often used by the producers in the next period to buy new machinery or to
build new factories, so that production can be expanded. These expenses which raise productive
capacity are examples of investment expenditure.
 4

3. Explain the role of the Government (State) and household sector in both
developed and developing countries.
Ans:
Role of Government: In both the developed and developing countries, apart from
capitalist sector, there is the institution of State. The role of the state includes framing
laws, enforcing them and delivering justice. The State here refers to the Government
which performs various developmental functions for the society as whole. It
undertakes production, apart from imposing taxes and spending money on building
public infrastructure, running schools, providing health services etc. These economic
functions of the state have to be taken into account when we want to describe the
economy of the country.
Role of Household sector: By household we mean a single individual who takes
decisions relating to her own consumption or a group of individuals for whom the
decisions relating to consumption are jointly determined. Households consist of
people. These people work in firms as workers and earn wages. They are the ones
who work in government departments and earn salaries or they are the owners of
firms and earn profits. Therefore, the market in which the firms sell their products
could not have been functioning without the demand coming from the households.
Further, they also earn rent by leasing land or earn interest by lending capital.

****
 8

GDPMP = C + I + G + X – M. where, C-Consumption Expenditure, I-Investment

Expenditure; G – Government’s Consumption and Investment Expenditure; X – Exports
and M- Imports.
GDPFC = GDPMP – NIT. ( NIT is Net Indirect Taxes).
7. Write the difference between nominal and real GDP.
Ans:
Nominal GDP Real GDP
 It is the value of GDP at current  It is evaluated at constant set of prices
prevailing prices. i.e., by keeping base year’s price index.
 It is not reliable  It is reliable.
 It does not give real picture of  It gives real picture of economic
economic development of a country. development of a country.

VI Answer the following questions in 12 sentences.

1. Write a short note on the concept of final good.
Ans: The final goods are those goods which are meant for final use and will not pass through any
more stages of production or transformations. They are called final goods because, once they
have been sold they pass out of the active economic flow. However, they may undergo
transformation by the action of the ultimate purchaser.
In fact, many final goods are transformed during their consumption. For instance, Tea leaves
purchased by the consumer are not consumed in that form – they are used to make drinkable tea,
which is consumed. Similarly most of the items that enter our kitchen are transformed through
the process of cooking. But cooking at home is not an economic activity, even though the
product involved undergoes transformation. Home cooked food is not sold to the market.
However, if the same cooking or tea was done in hotel where the cooked product would be sold
to customers, then the same items are not considered as final goods and would be counted as
inputs to which economic value addition can take place.
Thus, it is not in the nature of the good but in the economic nature of its usage that a good
becomes a final good.

2. Explain the circular flow of income of an economy.

Ans: The circular flow of income of an economy can be explained with the help of
following assumptions:
a) Existence of two sectors viz., household sector and producers.
b) Households are the owners of the factors of production.
c) Households receive income by selling the factor services.
d) There are no savings.
e) The firms produce goods to the households.
f) The economy is a closed economic system( where no Government or external trade or
savings)
The circular flow of income in a simple economy can be illustrated with the help of
following chart.
 9

Spending

Goods & Services

Firms Households

Factor Payments

Factor

In the above chart, the uppermost arrow, going from the households to the firms, represents the
spending by the households to buy goods and services produced by the firms. The second arrow
going from the firms to the households is the counterpart of the arrow above. It stands for the
goods and services which are flowing from the firms to the households. Thus the two arrows on
the top represent the goods and services market – the arrow above represents the flow of
payments for the goods and services, the arrow below represents the flow of goods and services.
The two arrows at the bottom of the diagram similarly represent the factors of the
production market. The lower most arrow going from the households to the firms symbolizes the
services that the households re rendering to the firms. Using these services the firms are
producing the output. The arrow above this, going from the firms to the households, represents
the payments made by the firms to the households for the services provided by the households.
Thus, When the income is spent on the goods and services produced by the firms, it takes
the form of aggregate expenditure received by the firms. Since the value of expenditure must be
equal to the value of goods and services, we can measure the aggregate income by calculating
the aggregate value of goods and services produced by the firms. This is clearly shown above in
the form of circular flow of income.

3. Write a note on externalities.

Ans: An externality is a cost or benefit conferred upon second or third parties as a result of
acts of individual production and consumption. But the cost or benefit of an externality
cannot be measured in money terms because it is not included in market activities.
In other words, Externalities refer to the benefits or harms a firm or an individual causes to
another for which they are not paid or penalized. They do not have any market in which they can
be bought and sold.
 10

There are two types of externalities viz.,

 Positive Externalities and
 Negative Externalities.
For example, let us imagine that there is chemical fertilizer industry. It produces the chemical
fertilizers required for agriculture. The output of the industry is taken for counting GDP of an
economy. This is positive externality.
While carrying out the production the chemical fertilizer industry may also be polluting
the nearby river. This may cause harm to the people who use the water of the river. Hence their
health will be affected. Pollution also may kill fish and other organisms of the river. As a result,
the fishermen of the river may lose their livelihood. Such harmful effects that the industry is
inflicting on others, for which it will not bear any cost are called negative externalities.

4. Illustrate unplanned accumulation and decumulation with an example

Ans: Change in inventories may be planned or unplanned. In case of unexpected fall in sales, the
firm will have unsold stock of goods which it had not anticipated. Hence there will be unplanned
accumulation of inventories. If there is unexpected increase in the sales there will be unplanned
decumulation of inventories.
This can be explained with the help of following illustration:
Suppose a firm produces T Shirts. It starts the production year with an inventory of 200 T
Shirts. During the coming year it expects to sell 2000 T shirts. Hence, it produces 2000 T shirts,
expecting to keep an inventory of 200 T Shirts at the end of the year. However, during the year,
the sales of T Shirts became low unexpectedly. The firm is able to sell only 1200 T Shirts. This
means that the firm is left with 800 unsold T Shirts. The firm ends the production year with 800
+ 200=1000 T shirts. The unexpected increase of inventories by 800 T shirts is an example for
unplanned accumulation of inventories.
On the other hand, if the sales had been more than 2000 we would have unplanned
decumulation of inventories. For instance, if the sales had been 2100, then not only the
production of 2000 T shirts will be sold, the firm will have to sell 100 T shirts out of the
inventory. This 100 (T shirts) unexpected reduction in inventories is an example of unexpected
decumulation of inventories.

5. Explain the examples of planned accumulation and decumulation of inventories.

Ans: Inventories are the unsold goods, unused raw materials or semi-finished goods which a firm
a firm carries from a year to the next year. Change in inventories may be planned or unplanned.
A planned change in inventories is the change in the stock of inventories which has occurred in a
planned way. The planned accumulation and decumulation of inventories are explained with
example as follows:
Suppose a firm wants to increase the inventories from 200 T shirts to 400 T shirts during
the year. Expecting sales of 2000 T shirts during the year, the firm produces 2000 + 200 = 2200
T shirts. If the sales are actually 2000 T shirts, the firm ends up with a rise of inventories. The
 11

new stock of inventories is 400 T shirts, which was planned by the firm. This is planned
accumulation of inventories.
On the other hand, if the firm had wanted to reduce the inventories from 200 to 50, the it
would produce 2000 – 150 = 1850 T shirts. This is because it plans to sell 150 T shirts out of the
inventory of 200 T shirts it started with. Then the inventory at the end of the year becomes 200 –
150 = 50 T shirts, which the firm wants. If the sales turn out to be 2000 T shirts as expected by
the firm, the firm will be left with the planned reduced inventory (decumulation) of 50 T Shirts.
These are the two instances of planned accumulation and planned decumulation of
inventories.

VII Answer the following questions in 20 sentences.

1. Explain the macro economic identities.
Ans: The macroeconomic identities are as follows:
a) Gross Domestic Product (GDP): Gross Domestic Product measures the aggregate
production of final goods and services taking place within the domestic economy during a
year. But the whole of it may not accrue to the citizens of the country. It includes GDP at
Market prices and GDP at Factor cost.
GDP at market price is the market value of all final goods and services produced within a
domestic territory of a country measured in a year. Here everything is valued at market
prices. It is obtained as follows:
GDPMP = C + I + G + X – M
GDP at factor cost is gross domestic product at market prices minus net indirect taxes. It
measures money value of output produced by the firms within the domestic boundaries of a
country in a year.
GDPFC = GDPMP – NIT.
b) Gross National Product: It refers to all the economic output produced by a nation’s normal
residents, whether they are located within the national boundary or abroad. It is defined as
GDP plus factor income earned by the domestic factors of production employed in the rest of
the world minus factor income earned by the factors of production of the rest of the world
employed in the domestic economy. Therefore,
GNP = GDP + Net factor income from abroad
c) Net National Product (NNP): A part of the capital gets consumed during the year due to
wear and tear. This wear and tear is called depreciation. If we deduct depreciation from GNP
the measure of aggregate income that we obtain is called Net National Product. We get the
value of NNP evaluated at market prices. So,
NNP = GNP – Depreciation
d) Net National Product (NNP) at factor cost: The NNP at factor is the sum of income earned
by all factors in the production in the form of wages, profits, rent and interest etc., belong to a
country during a year. It is also known as National income. We need to add subsidies to NNP
and deduct indirect taxes from NNP to obtain NNP at factor cost.
 12

NNPFC = NNP at market prices – indirect taxes + subsidies.

e) Personal Income (PI): It refers to the part of National income (NI) which is received by
households. It is obtained as follows:
PI = NI – Undistributed Profits – Net interest payments made by the households – Corporate
tax + Transfer payments to the households from the Government and firms.
f) Personal Disposable Income (PDI): If we deduct the personal tax payments (income tax)
and Non-tax payments (fines, fees) from Personal Income, we get PDI. Therefore,
PDI = PI – Personal tax payments – Non-tax payments.
2. Briefly explain the expenditure method of measuring GDP.
Ans: Expenditure method is the alternative way to calculate the GDP by looking at the demand
side of the products. Here the aggregate value of the output in the economy by expenditure
method will be calculated in the following way.
In this method we add the final expenditures that each firm makes. Final expenditure is
that part of expenditure which is undertaken not for intermediate purposes. If the baker buys
Rs.50 worth of wheat from the farmers is considered as intermediate good and the final
expenditure received by the baker is 200. Then the aggregate value of output of the economy is
Rs.200 + Rs.50 = Rs.250.
Let us assume that firm i makes the final expenditure on the following accounts:
 Final consumption expenditures on the goods and services by households, denoted as Ci
 Final investment expenditure incurred by the firms on capital goods, denoted as Ii
 The expenditure that the Government makes on the final goods and services produced by
the firm, denoted as Gi
 The export revenues that firm i earns by selling its goods and services abroad, denoted as
Xi.
Now the total final consumption, investment, government and export expenditures
received by the firm i. Now GDP according to the expenditure method is expressed as
follows:
GDP = ∑Ni-1 RVi= C + I + G + X – M
∑Ni-1 RVi is the sum of final consumption -C, investment -I, government - G and exports -X expenditures
(M-imports) received by all the firms in the economy.

3. Explain a numerical example to show that all the three methods of estimating GDP
gives us the same answer.
Ans: The three methods of calculating GDP viz., Product or Value Added Method, Expenditure
method and Income Method, give us the same answer. This can be explained with the help of
numerical example as follows:
Let us imagine, there are two firms X and Y. Suppose X use no raw material and
produces cotton worth Rs.50. X sell its cotton to firm Y, who uses it to produce cloth. Y sells the
cloth produced to consumers for Rs.200.
 GDP in the phase of product or the value added method: Here the value added =
Sales – Intermediate goods.
 13

Thus VA X = 50 – 0
VA Y = 200 – 50 = 150.
Thus GDP = VAX + VA Y = 50 + 150 = 200 .
GDP distribution for firms X and Y
Particulars Firm X Firm Y
Sales 50 200
Intermediate consumption 0 50
Value added 50 150
 GDP in the phase of Expenditure Method: Under this method, GDP is the sum of final
expenditure/s on goods and services for end use. In the above case, final expenditure is
expenditure by consumers on cloth. Therefore, GDP = 200.
 GDP in the phase of Income Method: Under this method, GDP is obtained by adding
factor payments. Let us imagine firm X, from Rs.50 received gives Rs.30 as wages and
keeps the remaining Rs.20 as its profits. Similarly, firm Y gives Rs.100 as wages and
keeps Rs.50 as profits. It can be stated in the following table:
Particulars Firm X Firm Y Total
Wages 30 100 130
profits 20 50 70
Now the GDP by income method = total of factor payments (incomes) which is equal to
total wages received (workers of Firms X and Y) and total profits earned (by Firms X and
Y). Thus GDP = Wages + Profits i.e., GDP = 130 + 70 = 200.
Thus all the three methods of estimating GDP give us the same answer.

4. Write down some of the limitations of using GDP as an index of welfare of a

country.
Ans: Gross Domestic Product (GDP) is the sum total of value of goods and services created
within the geographical boundary of a country in a particular year. It gets distributed among the
people as incomes except retained earnings. So we consider that higher level of GDP of a
country is an index of greater well being of the people of that country. Welfare of a country
means well being of entire population of the country. But there are certain limitations of suing
GDP as an index of welfare of a country. They are as follows:
a) Distribution of Gross Domestic Product (GDP): Generally, the rise in GDP will not represent
increase in the welfare of the country. If the GDP of the country is rising, the welfare may not
rise as a consequence. This is because the rise in Gross Domestic Product may be concentrated in
the hands of very few individuals or firms. For the remaining, the income may in fact might have
decreased. In such a situation the welfare of the entire country cannot be said to have improved.
b) Non-monetary exchanges: Some of the activities in a country are not evaluated in terms of
money. For instance, the domestic services of housewife are not paid for. The exchanges which
take place in the informal sector without the help of money are called barter exchanges. In barter
exchanges goods are directly exchanged against each other. As money is not used here, these
exchanges are not registered as part of economic activity. In India, because of many remote
 14

areas, these kinds of exchanges still take place and they are generally not counted in the GDP.
Therefore, Gross Domestic Product calculated in the standard manner may not give us a clear
indication of welfare of a country.
c) Externalities: An externality is a cost or benefit conferred upon second or third parties as a
result of acts of individual production and consumption. In other words, externalities refer to the
benefits or harms, a firm or an individual causes to another for which they are not paid or
penalized. These do not have any market in which they can be bought and sold. But the cost or
benefit of an externality cannot be measured in money terms because it is not included in market
activities. For example, the pleasure one gets from his neighbour’s garden is an external benefit
and external cost is environmental pollution caused by industries. Both are excluded from
national income estimates.

*****
 17

3. State the credit control instruments of RBI.

Ans: There are two instruments of RBI to control credit viz., Quantitative techniques and
Qualitative techniques.
The quantitative techniques include Bank rate, Open market operations, CRR and SLR.
The qualitative techniques include Credit rationing, margin requirements, moral suasion,
publicity, direct action and issue of directives.
4. Mention the two motives of demand for money.
Ans: The two motives of demand for money are as follows:
 The transaction Motive
 The Speculative Motive.
5. How does bank rate influence money supply?
Ans: The RBI can influence money supply by changing the rate at which it gives loans to
the commercial banks. This rate is called as Bank Rate. By increasing the bank rate, loans
taken by commercial banks become more expensive which reduces the reserves held by
the commercial bank and hence decreases money supply. A fall in the bank rate can
increase the money supply.
6. What role of RBI is known as ‘Lender of Last Resort’?
Ans: When commercial banks need more funds in order to be able to create more credit,
they may go to market for raising such funds or go to the RBI. The RBI provides them
funds through various instruments. This role of RBI, that of being ready to lend to banks
at all times is said to be the lender of last resort.

VI Answer the following questions in 12 sentences.

1. Money acts as a convenient unit of account. Explain this statement with example.
Ans:The money acts as a common measure of value. The values of all goods and services
can be expressed in terms of money. As a measure of value, money performs following
functions:
 The value of all goods and services measured and expressed in terms of the
money.
 Rate of exchange of goods and services expressed in money.
 Facilitates the maintenance of accounts.
 It facilitates price mechanism.
 It makes goods and services comparable in terms of price.
For instance, when we say that the value of a book is Rs.500 we mean that the book can
be exchanged for 500 units of money where a unit of money is rupee in this case. If the price of a
pencil is Rs.5 and that of a pen is Rs.10 we can calculate the relative price of a pen with respect
to a pencil i.e., a pen is worth 10/5=2 pencils.

2. Briefly explain the functions of RBI.

Ans: The main functions of RBI are as follows:
a) Printing and issuing currency notes-It has complete authority of printing and issuing
currency notes in the country. RBI issue all denominations of currency notes (Rs.2, Rs.10,
 18

Rs.20, Rs.50, Rs.100, Rs.500 and Rs.2000) except one rupee note, which is issued by finance
ministry, Government of India. The minimum reserve system of note issue was followed by
RBI after 1956.
b) Banker to Government.- RBI works as banker to the Government. It does all activities of
banking on behalf of govt. activities like opening account, receiving money, making
payments, transfer govt. funds, manages public debt and also maintains accounts of
expenditure of govt. it also gives credit to govt. relating to financial matters RBI gives advice
to Government.
RBI also acts as agent to the Government through performing the transfer of
funds from Government to beneficiaries. RBI also advises the Government during
some circumstances like not to go for over expenditure during inflation.

c) Act as Bankers’ bank- All banks and financial institutions in India are under the control of
RBI. It advices and gives direction on all transactions of commercial banks. All commercial
banks in India have to keep certain portion of its deposits as cash reserves with RBI. All
commercial banks have to submit a detailed document and report about its transactions to
RBI.
As a banker’s bank RBI functions as follows:

i. Lender of last resort: RBI provides financial assistance to commercial banks like
giving credit, discounting bills, giving advances, etc during their financial crisis and
helps the banks as a lender of last resort.
ii. Clearing House: Commercial Banks in crisis can approach RBI for loans and
advances. RBI re-discounts bills and lends money to commercial banks. It also
advances money on other securities.
d) Controls credit creation activities of commercial banks-The credit provided by all
commercial banks is controlled by RBI. RBI implements both Quantitative and qualitative
techniques to control the credit generated by commercial banks. The quantitative measures to
control credit are Bank rate policy, Open market operation, Cash reserve ratio and Statutory
liquidity ratio. The qualitative techniques of credit control include fixation of margin
requirements for loans, introduction of a system of credit rationing, moral suasion and Direct
action.
e) Controls money market- RBI is the leader of money market. All the activities and
components of money market like commercial banks and financial institutions are controlled
and directed by RBI.
f) Custodian of foreign exchange reserves- RBI has regular and continuous contacts with
international monetary institutions relating to foreign exchange reserves. Precious foreign
exchanges is preserved and protected by it.
3. Write a note on legal definitions of money.
Ans: The total stock of money in circulation among the public at a particular point of
time is called money supply. The legal definitions of money are defined as follows:
 M1 = CU + DD (CU currency notes held by the public; DD is net demand of the
public held by the banks.
 M2 = M1 + Savings deposits with Post office savings banks
 M3 = M1 + Net time deposits of commercial Banks
 19

 M4 = M3 + Total deposits with post office savings organizations.

M1 and M2 are narrow money. M3 and M4 are broad money.

4. Write a brief note on transaction motive and speculative motives of demand for
money.
Ans:
 Transaction Motive: Transaction motive demand for money refers to holding money
to carry out transactions. If we receive our income weekly and make payments on the
first day of every week, we need not hold any cash balance throughout the rest of the
week. But our expenditure patterns do not normally match our receipts. People earn
incomes at discrete points in time and spend it continuously throughout the interval.
The Transaction demand for money is represented as follows:
MdT = k. T
Where, T is the total value of transactions in the economy ovr unit period
and k is a position fraction.

 Speculative Motive: Some people hold cash to invest on shares, debentures, gold,
immovable properties etc. The speculative demand for money refers to the demand
for money that people hold as idle cash to speculate with the aim of earning capital
gains and profits. The speculative demand for money can be written as follows:
Mds= rmax- r
r - rmin
Where, r is the market rate of interest and rmax and rmin are the upper and lower
limits of r, both positive constants. It clearly states that as r decreases from rmax to rmin, the
value of speculative demand for money decreases from zero to infinity.

VII Answer the following questions in 20 sentences

1. Explain the functions of money?. How does money overcome the short comings of a
barter system?
Ans: The functions of Money are broadly classified as follows:
 Primary Functions
 Secondary Functions
 Contingent Functions

I Primary Functions:
The primary functions of money are as follows:
a) Medium of Exchange: Money plays an important role as a medium of exchange. It
facilitates exchange of goods for money. It has solved the problems of barter system. Barter
exchanges become extremely difficult in a large economy because of the high costs people
would have to incur looking for suitable persons to exchange their surpluses. It helps the
people to sell in one place and buy in another place. Money has widened the scope of market
transactions. Money has become a circulating material between buyers and sellers.
 20

b) Measure of Value/Unit of account: The money acts as a common measure of value. The
values of all goods and services can be expressed in terms of money. As a measure of value,
money performs following functions:
 The value of all goods and services measured and expressed in terms of the
money.
 Rate of exchange of goods and services expressed in money.
 Facilitates the maintenance of accounts.
 It facilitates price mechanism.
 It makes goods and services comparable in terms of price.
For instance, when we say that the value of a book is Rs.500 we mean that the book can
be exchanged for 500 units of money where a unit of money is rupee in this case. If the price of a
pencil is Rs.5 and that of a pen is Rs.10 we can calculate the relative price of a pen with respect
to a pencil i.e., a pen is worth 10/5=2 pencils.
II Secondary Functions: The secondary functions of money are as follows:
a) Store of value: People can save part of their present income and hold the same for future.
Money can be stored for precautionary motives needed to overcome financial stringencies.
Money solves one of the deficiencies of barter system i.e., difficulty to carry forward one’s
wealth under the barter system.
For instance, we have an endowment of wheat which we do not wish to consume
today entirely. We may regard this stock of surplus wheat as an asset which we may wish
to consume or even sell off, for acquiring other commodities at some future date. But
wheat is a perishable item and cannot be stored beyond a certain period. Also, holding the
stock of rice required a lot of space. We may have to spend considerable time and
resources looking for people with a demand for wheat when we wish to exchange our
stock for buying other commodities. This problem can be solved if we sell our wheat for
money. Money is not perishable land its storage costs are also less.
b) Standard of deferred payments: All the credit transactions are expressed in terms of
money. The payment can be delayed or postponed. So, money can be used for delayed
settlement of dues or financial commitments.
c) Transfer of value: Money acts as a transfer of value from person to person and from place
to place. As a transfer of value, money helps us to buy goods, properties or anything from
any part of the country or the world. Further, money earned in different places can be brought
or transferred to anywhere in the world.

III Contingent Functions of Money: Other than Primary and Secondary functions,
money also performs other functions which are as follows:
a) Basis of Credit: Money serves as a basis of the credit. The modern credit system
exists only because of existence of money.
b) Distribution of National Income: Money helps in distribution of national income.
The reward paid to factors of production in the form of rent, wages, interest and profit
are nothing but the distribution of National Income at factor prices.
c) Provides Liquidity and Uniformity: Money provides liquidity to all kinds of assets
both moveable and immovable. Money can be converted into any type of asset and all
assets can be converted into money.
 21

d) Helps in consumers’ and producers’ equilibrium: All goods and services are
expressed in terms of money. The consumer attains equilibrium when the price of a
product is equal to his marginal utility. Similarly, the producers reach equilibrium if
they get maximum satisfaction. Both consumers and producers try to achieve
equilibrium with the help of money.
2. Write the story of gold smith Lala on the process of deposit and loan (credit) creation
by commercial banks.
Ans: Once there was a goldsmith named Lala in a village. In this village, people used
gold and other precious metals in order to buy goods and services. These metals were
acting as money. People in the village started keeping their gold with Lala for safe
keeping. In return for keeping their gold, Lala issued paper receipts to people of the
village and charged a small fee from them. Slowly, over time, the paper receipts issued
by Lala began to circulate as money. This means that instead of giving gold for
purchasing wheat, some would pay for wheat or shoes or any other good by giving the
paper receipts issued by Lala. Thus, the paper receipts started acting as money since
everyone in the village accepted these as a medium of exchange.
Let us imagine that Lala had 100 kgs of gold, deposited by different people and he
had issued receipts corresponding to 100 kgs of gold. At this time Ramu comes to Lala
and asks for a loan of 25 kgs of gold. Now Lala can decide that everyone with gold
deposits will not come to withdraw their deposits at the same time and so he may as well
give the loan to Mr.Ramu and charge ;him for it. If Lala gives the loan of 25 kgs of gold,
Ramu could also pay Mr.Ali with these 25 kgs of gold and Ali could keep the 25 kgs of
gold with Lala in return for a paper receipt. In effect, the paper receipts, acting as money,
would have increased to 125 kgs now. It seems that Lala has created money out of thin
air. The modern banking system works precisely the way Lala behaves in this example.

3. Explain the open market operation.

Ans: The open market operations as one of the tools of RBI to control money supply,
refers to buying and selling of bonds issued by the Government in the open market. This
purchase and sale is entrusted to the RBI on behalf of the Government.
When RBI buys a Government bond in the open market, it pays for it by giving a
cheque. This cheque increases the total amount of reserves in the economy and thus
increases the money supply. Similarly, selling of a bond by RBI to private individuals or
institutions leads to reduction in quantity of reserves and money supply.
There are two types of open market operations. They are as follows:
a) Outright: Outright open market operations are permanent in nature. When the RBI
buys the securities, it is without any promise to sell them later. Similarly, when the
RBI sells these securities, it is without any promise to buy them later. As a result, the
injection/absorption of the money is of permanent nature.
b) Repo: This is another type of operation in which the RBI buys the security with
agreement of purchase on particular date and price. This is called repo. The interest
rate at which the money is lent in this way is called repo rate.
 22

Similarly, instead of outright sale of securities the RBI may sell the securities
through an agreement which as a specification about the date and price at which it will be
repurchased. This type of agreement is called reverse repo. The rate at which the money
is withdrawn in this manner is called the reverse repo rate.
The RBI conducts repo and reverse repo operations at various maturities like
overnight, 7 days, 14 days etc. These types of operations have now become the main
tool of monetary policy of the RBI.
4. Requirement of reserves acts as a limit to money (credit) creation. Explain.
Ans: The RBI decides a certain percentage of deposits which every bank must keep as
reserves. This is done to ensure that no bank is over lending. This is a legal requirement
and is binding on the banks. This is called the CRR (Cash Reserve Ratio).
Apart from the CRR, banks are also required to keep some reserves in liquid form
in the short term. This ratio is called SLR (Statutory Liquidity Ratio). The statutory
requirement of the reserve ratio acts as a limit to the amount of credit that banks can
create.
For example, let us assume that Canara Bank starts with a deposit of Rs.1000
made by Mr.X. The reserve ratio is 20%. Thus Canara Bank has Rs.800 (1000 –
200=800.i.e.,20% of 1000 is deducted) to lend and the bank lends out of Rs.800 to Mr.Y,
which is shown in the bank’s deposits in the next round as liabilities, making a total of
Rs.1800 as deposits. Now Canara bank is required to keep 20% of 1800 i.e., 360 as cash
reserves. The bank had started with Rs.1000 as cash. Since it is required to keep only
Rs.360 as reserves it lends Rs.640 (1000-360=640). The bank lends out Rs.640 to Mr.Z.
This in turn shows up in the bank, as deposits. The process keeps repeating itself till all
the required reserves become Rs.1000. The required reserves will be Rs.1000 only when
the total deposits become Rs.5000. This is because, for deposits of Rs.5000, cash reserves
would have to be Rs.1000 (20% of 5000 = 1000)
The process is illustrated in the following table:
Round Deposit in Bank Required Reserve Loan made by Bank
1 1000 200 800
2 1800 360 640
- - - -
- - - -
- - - -
- - - -
Last 5000 1000 4000
In the above table, the first column lists each round. The second column depicts the
total deposits with the bank at the beginning of each round. 20% of these deposits
need to be deposited with the RBI as required reserves ( 3rd column). What the bank
lends in each round gets added to the deposits with the bank in the 2nd round. 4th
column indicates the loans made by the banks.

VII Assignment and project oriented questions

 23

1. Write a note on Demonetisation.

Ans: Demonetisation was a new step taken by the Government of India on 8th
November, 2016. It was introduced to tackle the problem of corruption, black
money, terrorism and circulation of fake currency in the economy. Old currency
notes of Rs.500 and Rs.1000 were no longer legal tender. New currency notes in
denomination of Rs.500 and Rs.2000 were introduced. The public were advised to
deposit old currency notes in their bank account till 31st of March 2016 without
any declaration and upto 31st March 2017 with the RBI with declaration.
In order to avoid a complete breakdown and scarcity of cash, Government
allowed exchange of Rs.4000 old currency notes with new currency restricting to a
person per day. Further till 12th December 2016, old currency notes were acceptable
as legal tender at petrol pumps, Government hospitals and for payment of
Government dues like taxes, power bills etc.
This initiative had both appreciation and criticism. There were long queues
outside banks and ATM centres. There was acute shortage of currency notes and had
adverse effect on economic activities. But now, normalcy has returned.
The demonetization also has positive effects. It improved tax compliance as a
large number of people were bought in the tax ambit. The savings of individual were
channelized into the formal financial system. As a result, banks have more resources
at their disposal which can be used to provide more loans at low rate of interest.
Demonetisation helps in curbing black money, reducing tax evasion and
corruption will decrease. It also help in tax administration in another way, by shifting
transaction out of the cash economy into the formal payment system. Now a days,
households and firms have started to shift from cash payment to electronic payments.
****
 26

1. Write the meaning of excess demand and deficient demand.

Ans: If the equilibrium level of output is more than the full employment level, it is due to
the fact that the demand is more than the level of output produced at full employment
level. This situation is called excess demand.
If the equilibrium level of output is less than the full employment of output, it is
due to fact that demand is not enough to employ all factors of production. This situation
is called deficient demand.
2. Give the meaning of investment multiplier. Write its formula.
Ans: Investment multiplier is the ratio of the total increment in equilibrium value of final
goods output to the initial increment in autonomous expenditure. Its formula is
Investment Multiplier = ∆Y/∆A = 1/1-c.
Where ∆Y is the total increment in final goods output, ∆A is initial increment in
autonomous expenditure; c is size of the multiplier
3. Give the meaning of paradox of thrift.
Ans: As people become more thrifty, they end up saving less or same as before in
aggregate, known as Paradox of thrift.
In other words, If all the people of the economy increase the proportion of income
they save, total value of savings in the economy will not increase – it will either decrease
or remain unchanged. This result is known as the Paradox of Thrift.

VI Answer the following questions in 12 sentences.

1. Give the meaning of Aggregate demand function. How can it be obtained
graphically?
Ans: The aggregate demand function shows the total demand at each level of income.
Graphically it means the aggregate demand function can be obtained by vertically adding
the consumption and investment function.
Y

Consumption Aggregate demand = C+I+cY

& Investment
L C=c+cY

J i=I

O Output X

Here, OM = Consumption, OJ = Investment, OL = Consumption + Investment

 27

The aggregate demand is obtained by vertically adding the consumption and investment
functions. The aggregate demand function is parallel to the consumption i.e., they have the same
slope of ‘c’

2. Briefly explain consumption function.

Ans: The consumers demand can be expressed by the equation C = Ĉ + cY, where Ĉ is
autonomous expenditure and c is the marginal propensity to consume. The consumption
function can be shown as follows:
The consumption function can be graphically expressed as follows:

C=c+cy

α I

O Y
In the above diagram Ĉ is the intercept of the consumption. ‘c’ is slope of consumption
function equals α.
3. Explain the investment function with the help of graphs.
Ans: In a two sector model, there are two sources of final demand. The first is
consumption and the second is investment. The investment function was shown as I = Ї.
Graphically, this is shown as a horizontal line at a height equal to Ї above the
horizontal axis.

C, I

I= Ї

O Y (income)
 38

David Ricardo said that in the face of high deficits, people save more. It is called
equivalence because, the taxation and borrowing are equivalent means of financing
expenditure. When the government increases spending by borrowing today, which will be
repaid by taxes in the future, it will have the same impact on the economy as an increase in
government expenditure that is financed by a tax increase today.

VI Answer the following questions in 20 sentences.

1. Explain the classification of receipts.
Ans: The government budget consists of Revenue Budget and Capital Budget. Both the
budgets have receipts viz., Revenue Receipts and Capital receipts.
Revenue Receipts: Revenue receipts are those receipts which do not lead to a claim on
the government. They include the following:
 Tax Revenue
 Non Tax Revenue

Tax Revenues are the important component of revenue receipts. Tax revenue consists of
Direct tax and indirect taxes. The direct tax includes income tax, corporate tax and indirect tax
includes excise duty (tax on production of goods in the country), customs duties (tax on exports
and imports) and service tax (GST-Goods and Services Tax has been introduced in place of
indirect taxes from 1stjuly 2017). Other direct taxes like wealth tax and gift tax have never
brought in large amount of revenue and thus they are called as paper taxes.

The non tax revenue of the central government consists of the following:

 Interest receipts on account of loans by the central government.

 Dividends and profits on investments made by the government.
 Fees and other receipts for services rendered by the government.
 Grants-in-aid from foreign countries and international organizations.

Capital Receipts: All those receipts of the government which create liability or reduce financial
assets are termed as capital receipts. The government receives money by way of loan or from the
sale of its assets. Loans have to be repaid to the agencies from whom the government has
borrowed. Thus it creates liability. Sale of government assets like sale of shares in Public Sector
Undertakings (disinvestment), reduces the total amount of financial assets of the government.

When government takes fresh loans it means that it has to be returned with interest.
Similarly, when government sells an asset it means that in future its earnings from that asset will
disappear. Thus, these receipts can be debt creating or non-debt creating.

2. Explain the classification of expenditure.

Ans: The public expenditure can be classified as follows:
 Revenue Expenditure
 39

 Capital Expenditure
Revenue Expenditure: It is the expenditure of government spent on the purposes other than the
creation of physical or financial assets. It is incurred for the normal functioning of the
government departments and various services, interest payments, grants given to state
governments and other parties. The revenue expenditure consists of the following:
 Plan Revenue expenditure; and
 Non-plan revenue expenditure.

The plan revenue expenditure is related to central plans and central assistance for state
and union territory plans.

The non plan revenue expenditure is the more important component of revenue
expenditure. It covers a vast range of general, economic and social services of the government.
The main items of non-plan expenditure are interest payments, defence services, subsidies,
salaries and pensions.

Capital Expenditure: The capital expenditure of the government includes the

expenditures which result in creation of physical or financial assets or reduction in financial
liabilities. This includes expenditure on the acquisition of land, building, machinery, equipment,
investment in shares, and loans and advances by the central government to state and union
territory governments, public sector undertakings (PSUs) and other parties.

The capital expenditure is categorized as follows:

 Plan capital expenditure and

 Non-plan capital expenditure

The plan capital expenditure is related to central plan and central assistance for state and
union territory plans.

The non-plan capital expenditure covers various general, social and economic services
provided by the government.

3. ‘The fiscal deficit gives borrowing requirements of the government’. Elucidate.

Ans: Fiscal deficit is the difference between the government’s total expenditure and its
total receipts excluding borrowing. It can be expressed as follows:
Gross fiscal deficit = Total expenditure – (Revenue receipts + non-debt creating
capital receipts).
The non-debt creating capital receipts are those receipts which are not borrowings
and do not give rise to debt. For example, recovery of loans and the proceeds from the
sale of Public sector undertakings. The fiscal deficit will have to be financed through
borrowing. Thus, it indicates the total borrowing requirements of the government from all
sources. From the financing side the fiscal deficit can be expressed as follows:
 45

Ans: Foreign exchange rate is the price of one currency in terms of another currency.
It links the currencies of different countries and enables comparison of international
costs and prices.
For example, if we need to pay Rs.68 for 1 dollar, then the exchange rate is Rs.68
per dollar.

VI Answer the following questions in 12 sentences.

1. Write a note on balance of trade.
Ans: Balance of trade is the difference between the value of exports and value of
imports of goods of a country in a given period of time. Export of goods is
entered as a credit item in balance of trade. Import of goods is entered as a debit
item in balance of trade. It is also called as Trade balance.
Balance of trade is said to be in balance when exports of goods are equal to the
imports of goods i.e., balanced balance of trade.
Surplus balance of trade arises if country’s exports of goods are more than its
imports.
Deficit balance of trade arises if a country’s imports of goods are more than its
exports.
Balance of trade is narrow concept and it may not show the international
economic position of an economy. It gives partial picture of international transactions and
it is less reliable. It does not include net invisibles i.e., the difference between the value of
exports and value of imports of invisibles (services) of a country in a given period of
time.
2. Write the chart of components of current account.
Ans: The chart which consists of different components of current account can be
drawn as follows
 46

Current Account

Trade in goods Trade in services Transfer Payments

Export of Import of Net factor Net non-factor Gifts, remittances

Goods Goods Income Income Grants

Net income
From Shipping, banking
Compensation insurance, tourism
of employees software service etc.

Net investment
income

3. Write the chart of components of capital account.

Ans: The chart which consists of different components of capital account can be
drawn as follows:
Capital Account

Investments External Borrowings External Assistance

Direct Portfolio External Govt. aid, Inter

Investment Investment commercial governmental, multi
Borrowings multilateral and
FDI, Equity FII, Offshor short term debt Bilateral loans
Reinvested funds
Earnings &
Other direct
Capital flows

FDI – Foreign Direct Investment; FII – Foreign Institutional Investments

4. Briefly explain the effect of an increase in demand for imports in the foreign
exchange market with the help of a diagram.
Ans: Foreign exchange market is the market in which national currencies are
traded for one another. The major participants in the foreign exchange market are
 47

commercial banks, foreign exchange brokers and other authorized dealers and
monetary authorities.
Foreign exchange rate is the price of one currency in terms of another currency.
Different countries have different methods of determining their currency’s
exchange rate. It can be determined through flexible exchange rate, fixed
exchange rate or managed floating exchange rate.
The flexible exchange rate is determined by the market forces of demand
and supply. Here, the exchange rate is determined at that point where the demand
curve intersects with the supply curve.
If the demand for foreign goods and services increases, the demand curve
shifts upward and right to the original demand curve. This can be graphically
represented as follows:

Rupees S
E2

E1
D’
S D
O Dollars
The increase in demand for imports, results in a change in the exchange rate. The
initial exchange rate is E1 = 60, which means that we need to exchange Rs.60 for
one dollar. At the new equilibrium, the exchange rate becomes E2=70, which
means that we need to pay more rupees for a dollar.
The increase in the price of dollars due to rise in demand for imports
indicates that the value of rupees in terms of dollars has fallen and the value of
dollar in terms of rupees has increased.
5. Explain the merits and demerits of flexible and fixed exchange rate system.
Ans:
Flexible exchange rate: The flexible exchange rate is determined by the market
forces of demand and supply. Here, the exchange rate is determined at that point
where the demand curve intersects with the supply curve.

Merits of Flexible exchange rate:

The flexible exchange rate system gives the government more flexibility
and they do not need to maintain large stocks of foreign exchange
reserves.
 The movements in the exchange rate automatically take care of the
surpluses and deficits in the Balance of payments.
Demerits of Flexible Exchange rate:
 48

 It is subject to international market fluctuations as the rate of exchange is

determined by market forces demand and supply.
 It may lead to uncertainties in foreign exchange market due speculations.

Fixed exchange rate: Under this exchange rate system, the Government fixes the
exchange rate at a particular level. Here, the central monetary authority or the
Government decides the exchange rate in accordance with the international
market requirements.
Merits of Fixed Exchange rate:
 There is more credibility that the government will be able to maintain the
exchange rate at the level specified.
 In case of deficit balance of payments, the governments will interfere to
take care of the gap by use of its official reserves.

Demerits of Fixed exchange rate:

 If the foreign exchange reserves are inadequate, people would begin to

doubt the ability of the government.
 There may be aggressive buying of one currency forcing the government
to devalue, so there may be speculative attack on a currency.

VII Answer the following questions in 20 sentences

1. Write a note on balance of payment.

Ans: The balance of payments is the record of the transactions in goods, services and
assets between residents of a country with the rest of the world for a specified time period
i.e., a year. The balance of payments consists of two accounts viz.,
 Current Account
 Capital Account.
Current Account: It is the record of trade in goods and services and transfer payments.
The main components of current account are trade in goods i.e., exports and imports of
goods. The Trade in services includes the factor income and non-factor income
transactions. Transfer payments are the receipts which the residents of a country get for
free without having to provide any goods or services in return. They consists of gifts,
remittances and grants. They could be given by the government or by private citizens
living abroad.
Current account is in balance when receipts on current account are equal to the
payments on the current account. A surplus current account means that the nation is a
lender to other countries and a deficit current account means that the nation is a borrower
from other countries.
Capital Account: It is the record of all international transactions of assets. An asset is
any one of the forms in which wealth can be held.