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Note Answer all questions. Kindly note that answers for 10 marks questions should be
approximately of 400 words. Each question is followed by evaluation scheme
Q1. Economic stability implies avoiding fluctuations in economic activities. It is important to avoid
the economic and financial crisis. The challenge is to minimize the instability without affecting
productivity, efficiency, employment. Find out the instruments to face the challenges and to
maintain an economic stability. (Explanation of economic stability, Instruments) 2, 8
Economic Stability
Promoting economic stability is partly a matter of avoiding economic and financial crisis. A dynamic
market economy necessarily involves some degree of instability, as well as gradual structural change. The
challenge for policy makers is to minimize this instability without reducing the ability of the economic
system to raise living standards through increasing productivity, efficiency and employment. Economic
stability is fostered by robust economic and financial institutions and regulatory frameworks.
Economic stability implies avoiding fluctuations in the level of economic activities as 100% stability is
neither possible nor desirable. It implies only relative stability in the overall level of economic activities.
A stabilization policy is a set of measures introduced to stabilize a financial system or economy. It can
refer to correcting the normal behavior of business cycles. In this case, the term generally refers to
demand management by monetary and fiscal policy to reduce normal fluctuations in output, sometimes
referred to as keeping the economy on an even keel. The policy changes in these circumstances are
usually countercyclical, compensating for the predicted changes in employment and output to increase
short run and medium run welfare. It can also refer to measures taken to resolve a specific economic
crisis, for instance, an exchange rate crisis or stock market crash, in order to prevent the economy
developing recession or inflation. The initiative is taken by the government or the central bank or both.
Depending on the goal to be achieved, it involves some combination of restrictive fiscal measures and
monetary tightening. Such stabilization policies can be painful, in the short run, for the economy because
of lower output and higher unemployment. They are designed to be a platform for successful long run
growth and reform.
Instruments of Economic Stability:
Following are the instruments of economic stability:
1. Monetary Policy. 2. Fiscal Policy 3. Physical policy or Direct Controls.
The central bank and the government have developed these instruments to correct the discrepancies that
occur in the process of economic growth.
Monetary Policy
Monetary policy is a part of the overall economic policy of a country. It is employed by the government
as an effective tool to promote economic stability and achieve certain predetermined objectives.

Meaning and definition:

Monetary policy deals with the total money supply and its management in an economy. It is essentially a
programme of action undertaken by the monetary authorities, generally the central bank, to control and
regulate the supply of money with the public, and the flow of credit with a view to achieving economic
stability and certain predetermined macroeconomic goals. Monetary policy can be explained in two
different ways. In a narrow sense, it is concerned with administering and controlling a countrys money
supply including currency notes and coins, credit money, level of interest rates and managing the
exchange rates. In a broader sense, monetary policy deals with all those monetary and non-monetary
measures and decisions that affect the total money supply and its circulation in an economy. It also
includes several non-monetary measures like wages and price control, income policy, budgetary
operations taken by the Government which indirectly influence the monetary situations in an economy.
Fiscal Policy
Fiscal policy is an important part of the overall economic policy of a nation. It is being increasingly used
in modern times to achieve economic stability and growth throughout the world. Lord Keynes, for the
first time, emphasized the significance of fiscal policy as an instrument of economic control. It exerts
deep impact on the level of economic activity of a nation.
The term fisc in English language means treasury, and the policy related to treasury or government
exchequer is known as fiscal policy. Fiscal policy is a package of economic measures of the Government
regarding public expenditure, public revenue, public debt or public borrowings. It concerns itself with the
aggregate effects of government expenditure and taxation on income, production and employment. In
short, it refers to the budgetary policy of the government. Fiscal policy is concerned with the manner in
which all the different elements of public finance, while still primarily concerned with carrying out their
own duties (as the first duty of a tax is to raise revenue), may collectively be geared to forward the aims
of economic policy. It involves alterations in government expenditures for goods and services or the
level of tax rates. Unlike monetary policy, these measures involve direct government interference in the
market for goods and services (in case of public expenditure) and direct impact on private demand (in
case of taxes).
Physical Policy or Direct Controls
Government interference with the forces of demand and supply in the market, and state regulation of
prices of commodities are common features in these days. Thus, when monetary and fiscal measures are
inadequate to control prices, government resorts to direct control. During wars, when inflationary forces
are strong, price control involves imposing ceilings in respect of certain prices and prices are to be
stopped from rising too high. In a planned economy, the objective of price control is to bring about
allocation of resources in accordance with the objects of plan. Price control normally involves some
control of supply or demand or both. These are done by control of distribution of commodities through
rationing. Rationing is, therefore, an essential part of the price control policy. In the U.S., price control
takes the form of price support programme in which prices are prevented from falling below certain
levels considered fair. Under certain circumstances, government may resort to dual pricing which is yet
another form of price control by the government.

Q2. Explain any eight macroeconomic ratios. (Definition of Macroeconomics, Macroeconomics

ratios) 2, 8
Definition of Macroeconomics
Macroeconomics is the branch of economics that studies the behavior and performance of an economy as
a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate, gross
domestic product and inflation.
Macroeconomic Ratios
There are several macroeconomic ratios and an attempt is made to explain eight such macroeconomic
ratios. For a business firm, the knowledge of these macroeconomic ratios is indispensable for taking
microeconomic decisions.
1. In other words, it tells us about the percentage of consumption out of a given level of income.
This can be expressed as C = f [Y] where C = consumption, Y = income and f = function. Consumption is
an increasing function of income. Higher the income, higher would be the consumption and vice-versa.
There is a direct relationship between the two. For example, out of Rs. 100, a person can consume Rs. 80,
and save Rs 20. In this case, the consumption income ratio is 1:0.8. This ratio helps business personnel to
forecast his/her sales in the market.
2. Saving income ratio
Excess of income over expenditure is saving. The saving function can be easily derived by subtracting
spending from income. Hence, S = Y C where S = saving, Y = income and C = consumption. It is a
function of income. S = f [Y]. It implies that there is a direct relationship between the two. Higher the
income, higher would be the savings and vice-versa. The saving-income ratio indicates the amount of
savings made out of a given level of income. In the above example, saving income ratio is 1:0.2. The
consumption income ratio and saving income ratio enable a business to plan its production schedule and
derive sales forecasts.
3. Capital output ratio
There is a close relationship between capital investment and income-growth in any economy. Capital is
regarded as the lifeblood of all economic activities and as such, it constitutes a major determinant of
economic growth rate in an economy. The volume of investment generally determines the rate of growth
in the real income of the people in an economy.
4. Capital labour ratio
This ratio indicates the proportion of two factor inputs. It tells us the ratio between the numbers of
laborers required for a given amount of capital invested in any business. This ratio is useful to work out
the least cost combination by substituting one factor input to another. This ratio can be expressed as K/L
5. Output-labour ratio

The term productivity in general is defined as a ratio of what comes out of a business to what goes in to
the business, i.e., it is the ratio of outcome to the efforts of the business. Hence, productivity would
mean the value of output divided by the value of inputs employed. There are different kinds of
productivity ratios.

6. Input- output ratio

This ratio explains the relationship between two variables of inputs and outputs. Input-output ratio
indicates the quantity of inputs employed and the quantity of outputs obtained. It is also called as
production function in economics. Production is purely physical in nature and as such, the ratio between
inputs and outputs is determined by technology, availability of equipments, labour, materials, etc. It can
be expressed in the form of a mathematical equation.
7. Value added output ratio
Value added output is the difference between the value of output produced and the value of inputs
employed. In other words, it is a ratio of increase in the quantity of inputs employed and the
corresponding increase in the output obtained. It is very much necessary to find out the difference
between the value of inputs used and the output obtained. This will help in deciding whether to increase
the employment of additional factor input units in the production process.
8. Cash reserve ratio
A commercial bank mobilizes deposits from the general public and the entire amount of deposits is not
kept in the form of cash. An experienced banker knows that all depositors will not withdraw their entire
deposits on the same day at the same time. Hence, only a fraction of total deposits is kept in the form of
liquid cash to honor the cheques drawn on demand deposit by the customers. The remaining excess
deposits are used for lending and investment purposes by the bank.
Q3. Define Inflation and explain the types of inflation. (Definition of Inflation, types of inflation)
Inflation has become a global phenomenon in recent years. Development economics is very much
associated with inflation. An in-depth study of inflation is of paramount importance to a student of
managerial economics. The term inflation is used in many senses and hence it is very difficult to give a
generally accepted, universally agreeable, and precise definition to the term inflation. Popularly, inflation
is associated with high prices, which causes a decline in the value of money. Inflation is commonly
understood as a situation of substantial and rapid increase in the level of prices and consequent
deterioration in the value of money over a period of time. It refers to the average rise in the general level
of prices and fall in the value of money. Inflation is an upward movement in the average level of prices.
The opposite of inflation is deflation, a downward movement in the average level of prices. The common
feature of inflation is rise in prices and the degree of inflation may be measured by price indices.
Types of inflation
Depending upon the rate of rise in prices and the prevailing situation, inflation has been classified into the
following six types:
Creeping inflation When the rise in prices is very slow (less than 3%) like that of a snail or creeper it is
called creeping inflation.

Walking inflation When the rise in prices is moderate (in the range of 3 to 7%) and the annual inflation
rate is of single digit it is called walking inflation. It is a warning signal for the government to control it
before it turns into running inflation.
Running inflation When the prices rise rapidly at a rate of 10 to 20% per annum it is called running
inflation. Such inflation affects the poor and middle classes adversely. Its control requires strong
monetary and fiscal measures; otherwise, it can lead to hyperinflation.
Hyperinflation Hyperinflation is also called by various names like jumping, runaway, or galloping
inflation. During this period, prices rise very fast (double or triple digit rates) at a rate of more than 20 to
100% per annum and become absolutely uncontrollable. Such a situation brings a total collapse of the
monetary system because of the continuous fall in the purchasing power of money.
Demand-pull Inflation The total monetary demand persistently exceeds the total supply of goods and
services at current prices so that prices are pulled upwards by the continuous upward shift of the
aggregate demand function. It arises as a result of an excessive aggregate effective demand over
aggregate supply of goods and services in a slowly growing economy. Supply of goods and services will
not match the rising demand. The productive ability of the economy is so poor that it is difficult to
increase the supply at a quicker rate to match the increase in demand for goods and services. When
exports increase, the money income of people rises. With excess money income, purchasing power,
demand, and prices move in the upward direction.
Cost-push inflation Prices rise on account of increasing cost of production. Thus, in this case, rise in
price is initiated by growing factor costs. Hence, such a price rise is termed as cost-push inflation as
prices are being pushed up by rising factor costs. A number of factors contribute to the increase in cost of
production. They are:
Demand for higher wages by the labour class.
Fixing of higher profit margins by the manufacturers.
Introduction of new taxes and raising the level of old taxes.
Q4. Define Fiscal Policy and the instruments of Fiscal policy. (Explanation of Fiscal Policy,
Instruments) 2, 8
Fiscal Policy
Fiscal policy is an important part of the overall economic policy of a nation. It is being increasingly used
in modern times to achieve economic stability and growth throughout the world. Lord Keynes, for the
first time, emphasized the significance of fiscal policy as an instrument of economic control. It exerts
deep impact on the level of economic activity of a nation.
Instruments of fiscal policy
The instruments of fiscal policy include:
1. Public revenue: It refers to the income or receipts of public authorities. It is classified into two parts tax-revenue and non-tax revenue. Taxes are the main source of revenue to a government. There are two
types of taxes. They are direct taxes such as personal and corporate income tax, property tax, expenditure
tax, and indirect taxes such as customs duties, excise duties, sales tax (now called VAT). Administrative
revenues are the bi-products of administrate functions of the government. They include fees, licence fees,
price of public goods and services, fines, escheats and special assessment.

2. Public expenditure policy: It refers to the expenditure incurred by the public authorities like central,
state and local governments. It is of two kinds: development or plan expenditure and non-development or
non plan expenditure. Plan expenditure includes income-generating projects like development of basic
industries, generation of electricity, development of transport and communications and construction of
dams. Non-plan expenditure includes defense expenditure, subsidies, interest payments and debt
servicing changes.
3. Public debt or public borrowing policy: All loans taken by the government constitutes public debt. It
refers to the borrowings made by the government to meet the ever-rising expenditure. It is of two types,
internal borrowings and external borrowings.
4. Deficit financing: It is an extraordinary technique of financing the deficits in the budgets. It implies
printing of fresh and new currency notes by the government by running down the cash balances with the
central bank. The amount of new money printed by the government depends on the absorption capacity of
the economy.
5. Built in stabilizers or automatic stabilizers (BIS): The automatic or built-in stabilizers imply
automatic changes in tax collections and transfer payments or public expenditure programmes so that it
may reduce the destabilizing effect on aggregate effective demand. When income expands, automatic
increase in taxes or reduction in transfer payments or government expenditures will tend to moderate the
rise in income. On the contrary, when the income declines, tax falls automatically and transfers and
government expenditure will rise and thus built-in stabilizers cushion the fall in income.
Q5. Investment is a part of income which can be used for various purposes. It is necessary to create
employment in an economy and to increase national income. To understand the benefits of income,
study the various types of investment. (Explanation of investment, types of investment)
Investment Function
Investment is the second important component of effective demand. In Keynesian economics, the term
investment has a different meaning. In the ordinary language, it refers to financial investment. i.e.
purchase of stocks, shares, debentures, bonds, etc. In this case, there is only transfer of rights or titles
from one person to another. It is an investment by one and disinvestment by another and as such, the
value transaction mutually cancels out each other. They do not add anything to the total stock of capital of
the nation. Investment, according to Keynes, refers to real investment. It implies creation of new capital
assets or additions to the existing stock of productive assets. It refers to that part of the aggregate income,
which is used for the creation of new structures, new capital equipments, machines, etc that help in the
production of final goods and services in an economy. Creation of income earning assets is called
investment. Thus, investment must generate income in the economy. Investment also refers to an addition
to capital with such investment occurring when a new house is built or a new factory is built. Investment
means making an addition to the stock of goods in existence. These activities necessitate the employment
of more labour and thus result in an increase in national income and employment.
Types of investment
Keynes speaks of 5 types of investment. They are as follows:
1. Private investment
It is made by private entrepreneurs on the purchase of different capital assets like machinery, plants,
construction of houses and factories, offices, shops, etc. It is influenced by MEC and interest rate. It is
profit elastic. Profit motive is the basis for private investment. Private entrepreneurs would take up
only those projects which yield quick results and generally those that have a small gestation period.
2. Public investment

It is undertaken by the public authorities like central, state and local authorities. It is made on building
infrastructure of the economy, public utilities and on social goods, for example, expenditure on basic
industries, defense industries, construction of multipurpose river valley projects, etc. In this case, the
basic criterion and motto is social net gain, social welfare and not profits. The principle of maximum
social advantage would govern public expenditure. It is also influenced by social and political
3. Foreign investment
It consists of excess of exports over the imports of a country. It depends on many factors such as
propensity to export of a given country, foreigners capacity to import, prices of exports and imports, state
trading and other factors.
4. Induced investment
Induced investment is another name for private investment. Investment, which varies with the changes in
the level of national income, is called induced investment. When national income increases, the aggregate
demand and level of consumption of the community also increases. In order to meet this increased
demand, investment has to be stepped up in capital goods sector which finally leads to increase in the
production of consumption goods Therefore, we can say that induced investment is income elastic i.e.,
it increases as income increases and vice-versa.
5. Autonomous investment
Autonomous investment is another name for public investment. The investment, which is independent
of the level of income, is called as autonomous investment. Such investments do not vary with the level
of income. Therefore it is called income-inelastic. It does not depend on changes in the level of income,
consumption, rate of interest or expected profit.
Q6. Discuss any two law of returns to scale with example. (Law of returns to scale, examples) 8, 2
Answer: Laws of returns to scale
The concept of returns to scale is a long run phenomenon. In this case, we study the change in output
when all factor inputs are changed or made available in required quantity. An increase in scale means that
all factor inputs are increased in the same proportion. In returns to scale, all the necessary factor inputs
are increased or decreased to the same extent so that whatever the scale of production, the proportion
among the factors remains the same.
Three phases of returns to scale
Generally speaking, we study the behaviour pattern of output when all factor inputs are increased in the
same proportion under returns to scale. Many economists have questioned the validity of returns to scale
on the ground that all factor inputs cannot be increased in the same proportion and the proportion between
the factor inputs cannot be kept uniform. But in some cases, it is possible that all factor inputs can be
changed in the same proportion and the output is studied when the input is doubled or tripled or increased
five-fold or ten-fold. An ordinary person may think that when the quantity of inputs is increased 10 times,
output will also go up by 10 times. But it may or may not happen as expected. It may be noted that when
the quantity of inputs are increased in the same proportion, the scale of output or returns to scale may be
either more than equal, equal or less than equal. Thus, when the scale of output is increased, we may get
increasing returns, constant returns or diminishing returns. When the quantity of all factor inputs are
increased in a given proportion and output increases more than proportionately, then the returns to scale
are said to be increasing; when the output increases in the same proportion, then the returns to scale are
said to be constant; when the output increases less than proportionately, then the returns to scale are said
to be diminishing.
Increasing returns to scale
Increasing returns to scale is said to operate when the producer is increasing the quantity of all factors
[scale] in a given proportion leading to a more than proportionate increase in output.

For example, when the quantity of all inputs are increased by 10%, and output increases by 15%, then
we say that increasing returns to scale is operating. In order to explain the operation of this law, an equal
product map has been drawn with the assumption that only two factors X and Y are required. Figure 5.9
depicts the operation of the law of increasing returns to scale. In the figure, Factor X is represented along
OX axis and factor Y is represented along OY axis. The scale line OP is a straight line passing through the
origin on the isoquant map indicating the increase in scale as we move upward. The scale line OP
represent different quantities of inputs where the proportion between factor X and factor Y is remains
constant. When the scale is increased from A to B, the return increases the output from 100 units to 200
units. The scale line OP passing through origin is called as the expansion path. Any line passing
through the origin will indicate the path of expansion or increase in scale with definite proportion
between the two factors. It is very clear that the increase in the quantities of factor X and Y [scale] is
small as we go up the scale and the output is larger. The distance between each isoquant curve is
progressively diminishing. It implies that in order to get an increase in output by another 100 units, a
producer is employing lesser quantities of inputs and his production cost is declining. Thus, the law of
increasing returns to scale is operating.