1. What are the basic key problems of an economy?

A1. Basic Problems Of An Economy

If there is a central economic problem that is present across all
countries, without any exception, then it is the problem of scarcity. This
problem arises because the resources of all types are limited and have
alternative uses. If the resources were unlimited or if a resource only
had one single use, then the economic problem would probably not
arise. However, be it natural productive resources or man-
made capital/consumer goods or money or time, scarcity of resources is
the central problem. This central problem gives rise to four basic
problems of an economy. In this article, we will look at these basic
problems in detail.

The Four Basic Problems of an Economy

As discussed in the paragraph above, the central economic problem of

scarcity of resources is broken down into four basic problems of an
economy. Let’s look at each of them separately.

Basic Problems of an Economy – #1 – What to Produce?

What does a society do when the resources are limited? It decides

which goods/service it wants to produce. Further, it also determines
the quantity required. For example, should we produce more guns or
more butter? Do we opt for capital goods like machines, equipment,
etc. or consumer goods like cell phones, etc.? While it sounds
elementary, society must decide the type and quantity of every single
good/service to be produced.

Basic Problems of an Economy – #2 – How to Produce?

The production of a good is possible by various methods. For example,

you can produce cotton cloth using handlooms, power looms or
automatic looms. While handlooms require more labour, automatic
looms need higher power and capital investment.

Hence, society must choose between the techniques to produce the

commodity. Similarly, for all goods and/or services, similar decisions
are necessary. Further, the choice depends on the availability of
different factors of production and their prices. Usually, a society opts
for a technique that optimally utilizes its available resources.

Basic Problems of an Economy – #3 – For whom to Produce?

Think about it – can a society satisfy each and every human wants?

Certainly not. Therefore, it has to decide on who gets what share of the
total output of goods and services produced. In other words, society
decides on the distribution of the goods and services among the
members of society.

Basic Problems of an Economy – #4 – What provision should be

made for economic growth?

Can a society use all its resources for current consumption? Yes, it can.
However, it is not likely to do so. The reason is simple. If a society uses
all its resources for current consumption, then its production capacity
would never increase.

Therefore, the standard of living and the income of a member of the

society will remain constant. Subsequently, in the future, the standard
of living will decline. Hence, society must decide on the part of
the resources that it wants to save for future progress.

http://www.economicsdiscussion.net/economic-problems/5-basic-
problems-of-an-economy-with-diagram/18173

2. Define Circular flow. Explain it for two/three/five sector economy

A2. The circular flow model demonstrates how money moves through
society. Money flows from producers to workers as wages and flows
back to producers as payment for products. In short, an economy is an
endless circular flow of money.
Circular Income Flow in a Two Sector Economy:
Real flows of resources, goods and services have been shown in Fig.
6.1. In the upper loop of this figure, the resources such as land, capital
and entrepreneurial ability flow from households to business firms as
indicated by the arrow mark.

In opposite direction to this, money flows from business firms to the

households as factor payments such as wages, rent, interest and
profits.

In the lower part of

the figure, money flows from households to firms as consumption
expenditure made by the households on the goods and services
produced by the firms, while the flow of goods and services is in
opposite direction from business firms to households.
Thus we see that money flows from business firms to households as
factor payments and then it flows from households to firms. Thus
there is, in fact, a circular flow of money or income. This circular
flow of money will continue indefinitely week by week and year by
year. This is how the economy functions. It may, however, be pointed
out that this flow of money income will not always remain the same
in volume.
In other words, the flow of money income will not always continue at
a constant level. In year of depression, the circular flow of money
income will contract, i.e., will become lesser in volume, and in years
of prosperity it will expand, i.e., will become greater in volume.

Circular Income Flow in a Three Sector Economy with Government:

In our above analysis of money flow, we have ignored the existence
of government for the sake of making our circular flow model simple.
This is quite unrealistic because government absorbs a good part of
the incomes earned by households. Government affects the economy
in a number of ways.

Here we will concentrate on its taxing, spending and borrowing roles.

Government purchases goods and services just as households and
firms do. Government expenditure takes many forms including
spending on capital goods and infrastructure (highways, power,
communication), on defence goods, and on education and public
health and so on. These add to the money flows which are shown in
Fig. 6.3 where a box representing Government has been drawn. It will
be seen that government purchases of goods and services from firms
and households are shown as flow of money spending on goods and
services.

Government expenditure may be financed through taxes, out of assets

or by borrowing. The money flow from households and business
firms to the government is labelled as tax payments in Fig. 6.3 This
money flow includes all the tax payments made by households less
transfer payments received from the Government. Transfer payments
are treated as negative tax payments.

3. The production possibility curve shows increasing opportunity cost.

Justify with an example and corresponding graph.
A3. Production possibility frontiers
An opportunity cost will usually arise whenever an economic agent
chooses between alternative ways of allocating scarce resources. The
opportunity cost of such a decision is the value of the next best
alternative use of scarce resources

Increasing opportunity cost

Opportunity cost can be thought of in terms of how decisions to
increase the production of an extra, marginal, unit of one good leads
to a decrease in the production of another good.

According to economic theory, successive increases in the production

of one good will lead to an increasing sacrifice in terms of a reduction
in the other good. For example, as an economy tries to increase the
production of good X , such as cameras, it must sacrifice more of the
other good, Y, such as mobile phones.
This explains why the PPF is concave to the origin, meaning its
is bowed outwards. For example, if an economy initially produces at
A, with 8m phones and 10m cameras (to 20m), and then increases
output of cameras by 10m, it must sacrifice 1m phones, and it moves
to point B.

If it now wishes to increase output of cameras by a further 10m (to

30m) it must sacrifice 2m phones, rather than 1m, and it moves to
point C; hence, opportunity cost increases the more a good is
produced.

The gradient of the PPF gets steeper as more cameras are produced,
indicating a greater sacrifice in terms of mobile phones foregone.

https://www.economicsonline.co.uk/Competitive_markets/Production
_possibility_frontiers.html

4. What are the approaches of GDP measurement?

A4. There are three ways to measure GDP. Each definition is
conceptually identical.
I. GDP is equal to the total expenditures for all final goods and
services produced within the country in a stipulated period of
time (usually a 365-day year).
 II. GDP is equal to the sum of the value added at every stage of
production (the intermediate stages) by all the industries within
a country, plus taxes less subsidies on products, in the period.
III. GDP is equal to the sum of the income generated by production
in the country in the period—that is, compensation of
employees, taxes on production and imports less subsidies, and
gross operating surplus (or profits)

5. Differentiate between GDP at factor cost and GDP at market prices

A5. There is one important difference that arises when calculating the
level of GDP from the spending side of the economy rather than
summing the values added in production. This difference arises
because the price paid by consumers for many goods and services is
not the same as the sales revenue received by the producer. There are
taxes that have to be paid, which place a wedge between what
consumers pay and producers receive.

Taxes attached to the transactions are known as indirect taxes. Thus,

if a consumer pays 100 for a meal in a restaurant the owner may
receive only 86, the remaining 14 will go to the government in the
form of VAT. The term factor cost or basic price is used in the
national accounts to refer to the prices of products as received by
producers. Market prices are the prices as paid by consumers.
Thus, factor cost or basic prices are equal to market prices minus
taxes on products plus subsidies on products.
http://www.preservearticles.com/economics/what-is-the-difference-
between-gdp-at-market-price-and-gdp-at-factor-cost/6482
6. Differentiate between GNP at factor cost and GDP at market prices
A6.
7. Explain with an example what is GDP deflator (explain real and
nominal gdp too)
A7. The GDP deflator is a measure of the price level of all
domestically produced final goods and services in an economy. It is
sometimes also referred to as the GDP Price Deflator or the Implicit
Price Deflator. It reflects changes in the average price level within the
economy. Therefore, it is commonly used by economists and
policymakers as a measure of inflation, together with the Consumer
Price Index (see also GDP deflator vs. CPI). Specifically, the GDP
deflator measures the current price level of domestically produced
goods relative to the price level in a specific base year. Thus, to
calculate the GDP deflator, we can follow a three-step process: (1)
calculate nominal GDP, (2) calculate real GDP, and (3) calculate the
GDP deflator.

1. Calculate Nominal GDP

Nominal GDP is defined as the monetary value of all finished goods

and services within an economy valued at current prices (see
also GDP). So this part is pretty easy. All we have to do is multiply
the quantity of all goods and services produced with their respective
prices and add them all up (see also How to Calculate GDP using the
Expenditure Approach).

To give an example, think of an economy that only produces ice

cream and candy bars. The table below shows the quantity produced
and prices of both goods for three consecutive years (2015, 2016, and
2017). If we calculate nominal GDP as described above, we find that
for the year 2015, it amounts to USD 400,000 (100,000*2 +
200,000*1). Meanwhile for 2016 nominal GDP is USD 740,000
(120,000*2.5 + 220,000*2) and for 2017 nominal GDP amounts to
USD 1,290,000 (150’000*4 + 230,000*3).
2. Calculate Real GDP

In a second step, we can now calculate real GDP. Unlike nominal

GDP, real GDP shows the monetary value of all finished goods and
services within an economy valued at constant prices. That means,
we choose a base year and use the prices of that year to calculate the
values of all goods and services for all the other years as well. This
allows us to eliminate the effects of inflation.

In our example, we’ll pick 2015 as our base year. Thus, the reference
prices of ice cream and candy bars are USD 2.00 and USD 1.00,
respectively. Starting from there, we can now calculate real GDP for
all three years. In 2015 real GDP amounts to USD 400,000
(100,000*2 + 200,000*1). Note that in the base year, real and nominal
GDP are always the same because we use the same prices when
calculating them. Meanwhile, for 2016 real GDP is USD 460’000
(120,000*2 + 220,000*1) and for 2017 it amounts to USD 530,000
(150,000*2 + 230,000*1). If you compare these numbers to the
numbers we calculated above, you can already see that real GDP
doesn’t grow quite as much as nominal GDP.
3. Calculate the GDP Deflator

Now that we know both nominal and real GDP, we can compute the
actual GDP deflator. To do this, we divide nominal GDP by real GDP
and multiply the result with 100. This gives us the change in nominal
GDP (from the base year) that cannot be attributed to changes in real
GDP. Check out the formula below:

Going back to our example, we can quickly see that the GDP deflator
for 2015 is 100 ([400,000/400,000]*100). The GDP deflator for the
base year will always be 100 because nominal and real GDP have to
be equal. However, things become more interesting when we look at
the following years. For the year 2016, the GDP deflator is7 160.9
([740,000/460,000]*100). That means, from 2015 to 2016, the price
level has increased by 60.9% (160.9 – 100). Similarly, the GDP
deflator for 2017 is 243.4, which reflects a price level increase of
143.4% compared to the base year.

In a Nutshell

The GDP deflator is a measure of the price level of all domestically

produced final goods and services in an economy. It is sometimes also
referred to as the GDP Price Deflator or the Implicit Price Deflator. It
can be calculated as the ratio of nominal GDP to real GDP times 100
([nominal GDP/real GDP]*100). This formula shows changes in
nominal GDP that cannot be attributed to changes in real GDP.
Hence, the GDP deflator is often used by economists to measure
inflation, together with the Consumer Price Index (CPI).

8. How growth and inflation is measured through GDP?

A8. The GDP deflator, also called implicit price deflator, is a measure of
inflation. It is the ratio of the value of goods and services an economy
 produces in a particular year at current prices to that of prices that
prevailed during the base year.

This ratio helps show the extent to which the increase in gross domestic
product has happened on account of higher prices rather than increase in
output. 

Since the deflator covers the entire range of goods and services produced
in the economy — as against the limited commodity baskets for the
wholesale or consumer price indices — it is seen as a more comprehensive
measure of inflation.

9. Why does Aggregate demand slope downward?

A9. The aggregate demand curve (AD) is the total demand in the
economy for goods at different price levels. AD = C + I + G + X – M

If there is a fall in the price level, there is a movement along the AD

curve because with goods cheaper – effectively, consumers have more
spending power.

 
Why is AD curve downwardly sloping?
Responses to price level:
• Price level increases, real income declines-> reduced ability to
pay- known as wealth effect – demand of good & services fall
• The Saving effect / interest rate effect- price level goes up, less
money to save after consumption – leading to higher interest
rate – leads to less investment and less output. Rate of interest
remains high for govt too.
• At high price level govt stops its expenditure so that the
additional income generated does not trigger inflation further
The foreign-sector substitution effect- with price level going up,
exports will be costlier and there will be less demand for our exported
goods & vice -versa

10. How does the price and output get decided in in economy?
(AD&AS equilibrium)
Aggregate supply is the total supply of goods and services that firms in a national
economy plan on selling during a specific time period. It is the total amount of goods
and services that firms are willing to sell at a specific price level in an economy.
Aggregate demand is the total demand for final goods and services in an economy at
a given time and price level. It is the demand for the gross domestic product (GDP)
of a country.

Equilibrium is the price-quantity pair where the quantity demanded is equal to the
quantity supplied. It is represented on the AS-AD model where the demand and
supply curves intersect. In the long-run, increases in aggregate demand cause the
price of a good or service to increase. When the demand increases the aggregate
demand curve shifts to the right. In the long-run, the aggregate supply is affected
only by capital, labour, and technology. Examples of events that would increase
aggregate supply include an increase in population, increased physical capital stock,
and technological progress. The aggregate supply determines the extent to which
the aggregate demand increases the output and prices of a good or service.

When the aggregate supply and aggregate demand shift, so does the point of
equilibrium. The aggregate demand curve shifts and the equilibrium point moves
horizontally along the aggregate supply curve until it reaches the new aggregate
demand point.

A10.
11. What do mean by Psychological law of consumption?

A11. Psychological Law of Consumption: (Assumptions and and

Implication)!
The Keynesian concept of consumption function stems from the
fundamental psychological law of consumption which states that there
is a common tendency for people to spend more on consumption
when income increases, but not to the same extent as the rise in
income because a part of the income is also saved. The community, as
a rule, consumes as well as saves a larger amount with a rise in
income.

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Thus, Keynes’ psychological law of consumption is based on the
following propositions:
i. When the total income of a community increases, the consumption
expenditure of the community will also increase, but less
proportionately.

ii. It follows from this that an increase in income is always bifurcated

into spending and saving.

iii. An increase in income will, thus, lead to an increase in both

consumption and savings. This means that with an increase in income
in the community, we cannot normally expect a reduction in total
consumption or a reduction in total savings. A rising income will
often be accompanied by increased savings and a falling income by
decreased savings. The rate of increase or decrease in savings will be
greater in the initial stages of increase or decrease of income than in
the later stages.

The gist of Keynes’ law is that consumption mainly depends on

income and that income recipients always do not tend to spend all of
the increased income on consumption. This is the fundamental maxim
upon which Keynes’ concept of consumption function is based.

12. Explain MPC and APC with example and Graph

A12. APC is the ratio of consumption to income. It is the proportion

of income that is consumed. It is worked out by dividing total
consumption expenditure (C) by total income (Y).

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Symbolically,
APC = C/Y

MPC measures the response of consumption spending to a change in

income. It is the ratio of change in consumption to a change in
income. It is worked out by dividing the change in consumption by
the change in income.

Symbolically,

MPC = ∆C/∆Y

Suppose, disposable national income rises from Rs. 100 crore to Rs.
200 crore. As a result, consumption spending rises from Rs. 125 crore
to Rs. 200 crore.

Thus,

MPC = 200-125/200-100

= 75/100 = 0.75 = 3/4

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In this example, MPC = 3/4. The economic meaning is that if national

income rises by four rupees, consumption spending would increase by
three rupees and the remainder one rupee would be saved. Note that,
in this example, the value of MPC is positive but less than one (0 >
MPC < 1).

Since at zero level of income, consumption is positive, so MPC must

always be positive. Further, since increase in consumption is less than
that of increase in income, the value of MPC must be less than one.

The relationship between planned consumption expenditure and

disposable income is presented in Table 10.1 in terms of a
hypothetical data.
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Table 10.1 tells us that when income is zero, consumption is positive

(Rs. 50 crore). But as income increases, consumption rises. Further, as
the rise in consumption is less than the rise in income, APC declines.

However, since the rate of increase in consumption is less than the

rate of increase in income, the value of MPC is always less than one
(here 0.75). At the same time, MPC is always positive because
consumption is positive even if income is zero. Finally, the table
suggests that MPC < APC.

Consumption function equation:

The relationship between consumption spending and income is
usually explained in an equation form:
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C = a + bY (a > 0; 0 < b < 1)

Here C and Y represent consumption and national income,

respectively. This equation indicates that consumption is a linear
function of income since it is the equation of a straight line. In the
equation, ‘a’ stands for autonomous consumption—consumption that
does not vary with the changes in national income. This part of
consumption spending is independent of the level of income.
Its value is positive in the sense that consumption is always positive,
even if income is zero, ‘b’ is the behavioural coefficient or the MPC.
This part of consumption is called ‘induced’ consumption. According
to Keynes, MPC is always positive but less than one. Here ‘b’ is the
slope of the consumption function. Thus, MPC is the slope of the
consumption line.
(b) Consumption Function in a Graphical Form:
The consumption function equation can be represented in terms of
Fig. 10.6 where we measure income on the horizontal axis and
planned consumption expenditure on the vertical axis. All points on
the 45° line show that the values measured on the two axes are equal
(i.e., Y = C).

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The line CC’ is the consumption line which cuts the vertical axis at
some positive point. Positive vertical intercept (a > 0) of the
consumption function implies that planned consumption expenditure
exceeds income at very low levels of income. The line CC’ is upward
rising.

This means that, as income rises, consumption rises. Such

consumption is called induced consumption. At an income level of
OY0, CC’ line coincides with the 45° line. That is to say, at point E,
income equals consumption. Such equality of income and
consumption is called breakeven point.
To the left of point E, say at OY 1 income level, as consumption
exceeds income there occurs negative saving or dissaving. This means
that people consume more than their income, i.e. they spend their past
savings. Actually, to the left of point E, CC’ line lies above the 45°
line and to determine dissaving we have used -S sign in Fig. 10.6.
On the other hand, to the right of E, i.e., at an income level of OY 2,
income exceeds consumption (and, hence, CC’ line lies below the 45°
line) and positive saving occurs. As people do not spend their entire
income on consumption, the rest is saved.
One can determine APC and MPC from the position or the location of
CC’ line and slope of the CC’ line, respectively. At zero income, APC
= ∞. As income rises, APC declines but it never becomes zero. To
determine the value of MPC, we have chosen two points f and d on
the line CC’. As we move from f to d, income rises (A Y) by ft and
consumption rises (∆C) by dt.

Thus, MPC = ∆C/∆Y = dt/ft = slope of the line CC’. Its value is less
than unity since the rate of increase in consumption (dt) is less than
the rate of increase in income (ft). As CC’ is a straight line, MPC
remains constant at all levels of income.

Though MPC remains constant as income rises, APC continuously

declines on a straight line consumption function. This may be
explained by examining Fig. 10.7. Let us consider point H on the line
CC’. Corresponding to this point, income is OY and consumption is
OM.

Thus, APC at point H is:

APC= OM/OY

Now consider the dashed lines β and θ drawn from the origin. Lines
such as these are called rays. The slope of the ray β is equal to the
tangent of the angle β and is, therefore, equal to OM/OY. Thus, the
slope of the ray to point H is the APC at point H.

Similarly, the slope of the ray to point H 1 is the APC. In other words,
the slope of the dashed lines OH and OH1 represent APCs at points H
and H1, respectively. Since the slope of the ray OH 1 is less steep than
that of the slope of the ray OH, APC declines as income rises.
To calculate MPC, one must take into account the slope of the
consumption line CC’ between points, such as f and d, in Fig. 10.7.
By inspection, we can see that tan β or tan θ is greater than tan θ’.
This suggests that APC > MPC. So we can conclude that the
coordinates at any point on a consumption line give us the value of
APC and the slope between any two points gives us the value of
MPC.

Consider Fig. 10.6 again. At zero income APC = ∞; to the left of

point E, APC > 1; at point E, APC = 1; and to the right of point E,
APC < 1.

On the other hand, 0 < MPC < 1 (i.e., double inequality). On a straight
line consumption function, MPC remains constant at all levels of
income. Thus, the Keynesian consumption function of the short run
variety shows that APC > MPC. We can prove this in the following
way. The equation of the linear consumption line is C = a + bY.

From this equation, one obtains:

APC = C/Y = a/Y + b,

and MPC = b.

Thus, APC > MPC by the amount a/Y. Or MPC < APC implies b <
a/Y + b which implies 0 < a/Y

We have already said that Keynes’ consumption function is a short

run one and the relationship between consumption and income is a
non-proportional one in the sense that MPC < APC.

However, a long run consumption function shows a proportional

relationship between income and consumption. Because of this
proportional relationship, MPC = APC. The long run consumption
function starts from the origin. Its functional form is thus C = bY.

Saving Function or Saving Propensity:

As propensity to consume refers to willingness to consume so does
propensity to save refers to willingness to save. Saving is the
difference between income and planned consumption, i.e.,

S=Y–C

Saving function is derived from the consumption function. Planned

saving is a function of aggregate disposable income, i.e.,

S = f (Y)

Keynes’ saving function has the following characteristics:

i. Saving is a stable function of disposable income.

ii. Saving varies directly with disposable income.

iii. The rate of increase in saving is less than the rate of increase in
income. At very low levels of income as well as at zero income, since
consumption is positive, saving must be negative. As income
increases, dissaving vanishes and saving becomes positive. In
Keynes’ terminology, this feature suggests that the value of the
marginal propensity to save (MPS) is positive but less than one.

13. Explain spending multiplier

A13. What is the Spending Multiplier?

Definition: The spending multiplier refers to the effect that increased
government spending will have on a country’s economy. The term is
used to indicate the fact that a small increase in government spending
can result in a relatively large rise in a country’s gross domestic
product (GDP).

What does Spending Multiplier mean?

When the government incurs any expenditure, it puts money into the
hands of the country’s citizens. Consider a situation where the
government decides to spend $100 million on building a new road.
This money will be used for:
 Buying road construction equipment, engineering equipment,
and heavy vehicles.
 Paying wages to workers.
 Incurring other expenditure associated with the project.

The money that the government spends will be used by the people
who receive it, to buy various goods and services. The people who
supply these goods and services will, in turn, spend the amounts that
they receive.
In this manner, the total expenditure in the country’s economy will be
much greater than the government expenditure of $100 million on
building a road. That’s because each person who receives money will
spend a part of it.
How much greater will the expenditure be? That’s exactly what the
spending multiplier tells you.
When a person receives money, a part of it is spent and the remaining
is saved. Say, a person spends 75% of every dollar that is received. In
this situation:
 The marginal propensity to consume (MPC) is 0.75 and
 The marginal propensity to save (MPS) is 0.25.

Using this information, we can calculate the spending multiplier:

Spending multiplier = 1 / (1 – MPC)
Spending multiplier = 1 / (1 – 0.75)
Spending multiplier = 1 / 0.25
Spending multiplier = 4
So, if people spend 75% of every dollar that they earn, the spending
multiplier is 4. The government’s road project, which involves an
expenditure of $100 million will result in an increase in GDP of $400
million ($100 million X 4.)

Example of the Spending Multiplier

The year 1929 saw the US economy entering into a recession.
Unemployment soared, the economy contracted, and 10,000 of the
country’s banks failed.
What did the government do to overcome this situation? It introduced
the “New Deal,” a program launched by the Roosevelt administration.
The New Deal was a series of government initiatives that attempted to
boost demand and get the country’s economy back on track.
Some of the measures that were introduced were:
 Building a series of dams along the Tennessee River. This
created employment and helped to generate power for the people in
the region.
 Commodity farmers were paid to leave their fields fallow,
resulting in an end to agricultural surpluses and low prices.
 A number of new construction projects were launched. The
government paid for building new post offices, bridges, schools,
highways, and parks.

When the US entered World War II in 1941, there was a sharp rise in
industrial production. The New Deal and the increased economic
activity due to WW II finally ended the American recession.
In 1933, US GDP stood at $778 billion in real terms. By 1944, it had
almost trebled to $2.2 trillion. A large part of this increase was
because of government spending and the multiplier effect.

Summary
When the government makes an expenditure, the increase in a
country’s GDP is much larger than the amount spent because of the
effect of the spending multiplier.
14. Differentiate between real rate and nominal rate
A14. ominal vs Real Interest Rate Comparative Table
Basis Nominal Rate Real Rate
Nominal Rate = Real Rate +
Formula Real Rate = Nominal Rate
Inflation
Nominal Rate is the simplest form Real rates are interest r
Definition of the rate which does not take adjusted to take into ac
inflation into account ripples caused by inflation
When inflation is greate
They do not have any effect of rate the real rate will be
Inflation effect
inflation the inflation is less than
real rate will be positive.
Investors who want to s
Bonds usually quote nominal rates.
inflation invest in T
This type of rates is usually quoted
Protected Securities (TIP
as coupon rate for fixed income
Investment these securities is indexe
investments as this rate is the
Option are also mutual funds ava
interest rate promised by the issuer
bonds, mortgages, and loa
that is stamped on the coupon to be
the floating interest rate
redeemed by bondholders
with current rates
The rate of a Deposit is g
The rate of a Deposit is given as 2%
$1000 investment and th
p.a. on a $1000 investment. In
3%. The actual percentag
Example nominal terms, the investor thinks
is going to
that he is going to receive $200 as
2% – 3% = -1%. The retu
interest.
the rate of inflation is neg
 
Conclusion
Understanding interest rates are important as they will help evaluate
and compare different investments and loans over time. In economics,
nominal and real interest rates are two important concepts. GDP
(Gross domestic product) of a country is quoted in nominal as well as
real interest rate terms.

The Fisher equation as stated above helps in determining this rate

precisely. The nominal rate describes the interest rate without any
correction for the effects of inflation and the real interest rate refers to
the interest rate adjusted for the effects of inflation.

https://www.wallstreetmojo.com/nominal-vs-real-interest-rate/
15. Some countries have very low and some have very high interest
rates, why?
I’ll tell you a recent story about Japan. The country recently
introduced negative interest rates. Yes you read it correctly, you will
be charged to keep your money in your bank. Now let us understand
why Japan had to do this.
Japan has an ageing population whose population is not growing. This
has led to a plateau in the demand of product and services. This has
caused the inflation to come to near zero levels. Therefore the growth
of the economy has become stagnated. The negative/low interest rate
incentivises people and companies to spend their money in the banks
or take new loans. This will help in improving the demand and hence
grow the economy.
For a developing country, there is a huge demand of product and
services, and the inflation is high. Inflation is the increase in the
prices of goods and services with time. The inflation in a developing
economy is high due to the mismatch in the supply and demand of
products and services. The demand is high but supply is unable to
match the demand. The companies can make new factories and
increase the supply but that takes time and by that time inflation will
remain high. This is called heating of the economy.
Now a small inflation is good for the economy but high inflation
swiftly erodes the purchasing power of the currency. Since the
inflation is high, the banks have to charge an interest rate over and
above it so as to make profit in real terms. So in a developing
economy, the interest rates are kept high.

16. What are the basic differences between one rupee note and other
notes?
A16. Rupee is unit of currency in India. The one rupee note is signed
by Finance Secretary, Ministry of Finance.
Why RBI not allowed to print one rupee?
The legal tender of higher denomination notes says, I promise to pay
so and so rupees to the bearer of this note.
Now if you take 10 rupees note to RBI and tell, no one is accepting it,
please return me the value of this currency. Then, RBI will provide
you Ten, one rupee notes. Because that's what is promised on the
note.
The basic logic goes like this, Legal tender of the rupee is with
Government of India. On the basis of this legal tender, fiat currency
system works. If there would have been gold standard, then in above
case, RBI needed to return 10 rupees of worth gold to the bearer of
the note.
It (One rupee note) doesn't promise to pay, because it's the unit of
currency. There is no other medium of exchange legally allowed in
terms of currency in India. Thats why there is no need of promise. It's
the default standard in India.
• One rupee note has got the status of coin(coin picture on note)
but other denomination notes are notes only
• One rupee note, like coins, is an asset but others are a part of
Liability
• One rupee note along with coins are printed by GOI but other
are done by RBI- seal is there
• “I promise to pay” is not mentioned on one rupee note but its
mentioned on other notes
 • One rupee note is signed by Finance Secretary but other notes
are signed by RBI governor.

That's why one rupee note is printed by Government of India and not
Reserve Bank Of India.

17. What do you mean by money supply by RBI?

A17. RBI controls money supply in the market through various tools and measures.

 CRR - Cash Reserve Ratio is the proportion of total deposits that the
banks are required to maintain with the RBI has reserves. By changing this
ratio RBI can influence the amount of cash that is available for the banks to
lend. A high CRR implies less money to lend, thus contraction in money
supply. A low CRR enables banks to hold more cash with them, which is
then available to lend. Thus, expanding the money supply.
 Open Market Operation - It is the sale/purchase of the government
bonds and securities in the market to adjust the rupee liquidity. For
example, when RBI sells government bonds/securities, people buy them
against money (say cash) this leads to a contraction in money supply as
money moves from public to RBI. In case of purchases, money supply
expands.
 Repo Rate - It is the rate at which the central bank (RBI) lends money to
commercial banks. If RBI increases this repo rate, it becomes costlier for the
commercial banks to borrow money from RBI. They are left with lesser
amount of money to lend to the general public. Thus the money supply
contracts. A low repo rate helps commercial bank avail loans at cheaper
prices, thus expanding the money supply.

18. State and explain 5 functions of RBI.

A18. This concentration of notes issue function with the Reserve

Bank has a number of advantages: (i) it brings uniformity in notes
issue; (ii) it makes possible effective state supervision; (iii) it is easier
to control and regulate credit in accordance with the requirements in
the economy; and (iv) it keeps faith of the public in the paper
currency.

2. Banker to Government:
As banker to the government the Reserve Bank manages the banking
needs of the government. It has to-maintain and operate the
government’s deposit accounts. It collects receipts of funds and
makes payments on behalf of the government. It represents the
Government of India as the member of the IMF and the World Bank.

ADVERTISEMENTS:

3. Custodian of Cash Reserves of Commercial Banks:

The commercial banks hold deposits in the Reserve Bank and the
latter has the custody of the cash reserves of the commercial banks.

4. Custodian of Country’s Foreign Currency Reserves:

The Reserve Bank has the custody of the country’s reserves of
international currency, and this enables the Reserve Bank to deal with
crisis connected with adverse balance of payments position.

ADVERTISEMENTS:

5. Lender of Last Resort:

The commercial banks approach the Reserve Bank in times of
emergency to tide over financial difficulties, and the Reserve bank
comes to their rescue though it might charge a higher rate of interest.

6. Central Clearance and Accounts Settlement:

Since commercial banks have their surplus cash reserves deposited in
the Reserve Bank, it is easier to deal with each other and settle the
claim of each on the other through book keeping entries in the books
of the Reserve Bank. The clearing of accounts has now become an
essential function of the Reserve Bank.

ADVERTISEMENTS:

7. Controller of Credit:
Since credit money forms the most important part of supply of
money, and since the supply of money has important implications for
economic stability, the importance of control of credit becomes
obvious. Credit is controlled by the Reserve Bank in accordance with
the economic priorities of the government.

19. Explain the liquidity preference theory of demand for money and
also the term "liquidity trap".
• A19. Liquidity preference means the demand for money to hold
cash. An investor demands a higher interest rate, or premium,
on securities with long-term maturities, which carry greater risk,
because all other factors being equal, investors prefer cash or
other highly liquid holdings.

• Investments that are more liquid are easier to sell fast for full
value.

• According to the liquidity preference theory, interest rates on

short-term securities are lower because investors are sacrificing
less liquidity than they do by investing in medium-term or long-
term securities.

• The desire for liquidity arises because of three motives

– Transaction motive
 – Precautionary motive

– Speculative motive

• Transaction Motive: Desire to hold money for the current

transactions by individuals and business firms.

b) Precautionary Motive: Desire to hold money for unforeseen

contingencies (Unemployment, sickness, accidents….) .

“The money held in both the motives are mainly the

function of

the size of Income but NOT rate of interest”. These are interest
rate insensitive.

c) Speculative Demand for money (Portfolio theory): Desire to hold

ones resources in liquid form in order to take advantage of the market
movements from the future changes in the rate of interest. The cash is
used to make speculative gains by investing in bonds and shares
whose price movement would help to make money

Speculative motive is a function of rate of interest. With higher

interest rate people opt to save i.e. prefer riskless return to risky ones.

a) Transaction Motive: Desire to hold money for the current

transactions by individuals and business firms.

b) Precautionary Motive: Desire to hold money for unforeseen

contingencies (Unemployment, sickness, accidents….) .

“The money held in both the motives are mainly the

function of

the size of Income but NOT rate of interest”. These are interest
rate insensitive.
c) Speculative Demand for money (Portfolio theory): Desire to hold
ones resources in liquid form in order to take advantage of the market
movements from the future changes in the rate of interest. The cash is
used to make speculative gains by investing in bonds and shares
whose price movement would help to make money

Speculative motive is a function of rate of interest. With higher

interest rate people opt to save i.e. prefer riskless return to risky ones.

• Transaction & precautionary demand is highly inelastic to

interest rate but speculative demand is elastic to money supply

• Keynes visualised conditions in which the speculative demand

for money would be highly or even totally elastic so that
changes in the quantity of money would be fully absorbed into
speculative balances.

• Higher the rate of interest lower the demand for money for
speculative motive and less money would be kept as inactive
balance and vice versa.

• The LP curve become perfectly elastic at very low rate of

interest

• i.e it indicates a absolute liquidity prefrences of the people.

• At low rate of interest people will hold money as inactive

balance which is called as a liquidity trap.

• The expansion of money supply gets trapped and cannot effect

rate of interest and the level of investment.
 • However demand of money does not depend so much upon the
current rate of interest as on expectations about changes in the
rate on interest

20. Explain with an example - how goods and money market would
be in equilibrium.
• A20. Money market equilibrium occurs at the interest rate at
which the quantity of money demanded equals the quantity of
money supplied. All other things unchanged, a shift in money
demand or supply will lead to a change in the equilibrium
interest rate. Money supply is given as constant at one period of
time and so as the real money supply (adjusting for inflation)
too which is represented by M/P.

21. One numerical from goods and money market may come. (IS and
LM)
A21. Q: If, M=Rs.150, & L=0.20Y-4i, then find out the money
market equilibrium.
Ans: As we saw above, Money market will be in equilibrium when
Money demand= Money supply. So the equilibrium condition would
be
Rs.150=0.20Y-4i
 .2Y= 150+4i
Y = 750+20i , It is also called as LM
Whatever is earned, its either consumed or saved by the economy. So
Y= C+S
Again the total expenditure approach says that Y=C+I+G+(X-M)
In the equilibrium condition, when income is equal to planned
expenditure,
Y= C+I+G+(X-M)
FOR Example: C=50+0.80Y, I=140-6i, G= 10, X-M=-20,
Then goods market Equilibrium condition will be
Y= 50+0.80Y+140-6i+ 10-20
.2Y= 180-6i
Y= 900 – 30i, this is called the IS function.
Y = 750+20i , LM equation
Y= 900 – 30i, IS function.
750+20i= 900 – 30i
 50i= 150
 i= 3
 Y= 750+20*3= 810
Therefore economy will have an equilibrium when at 3% interest rate
and Rs. 810 of real output or Income.

22. Differentiate between cost push and demand pull inflation.

A22.

• INFLATION IS BETTER
Inflation, though it redistributes income and wealth in favour of
 the rich and causes economic inequalities, does not reduce
national income. Deflation, on the other hand, has the
undesirable effect of reducing national income.
It is easy to control inflation by adopting various monetary and
fiscal measures, but it is very difficult to recover the economy
from deflation.
Inflation is a post-full employment phenomenon, while deflation
is an under-employment phenomenon.
Inflation is a single evil because it redistributes wealth in favour
of the rich people arbitrarily. Deflation is a double evil because
it not only redistributes wealth in the same arbitrary manner,
though in favour of the poor people, but also, reduces output and
causes unemployment.
Once deflation starts, it gathers momentum and the cumulative
downward process ultimately takes the economy into severe
depression but in case of inflation it is not so. 
• Inflation is unjust but deflation is inexpedient
Inflation is caused by a combination of following factors:
• The supply of money goes up.
• The supply of other goods goes down.
• Demand for other goods goes up.
Its divided in two types
• Demand - Pull Inflation
• Cost- Push Inflation

23. Explain the types of unemployment. Is possible to have full-

employment with no one unemployed.
• A23. Disguised Unemployment- - it is a situation in which more
people are doing work than actually required like our
agricultural labourers.
• Disguised unemployment exists where part of the labor force is
either left without work or is working in a redundant manner
where worker productivity is essentially zero. It is
unemployment that does not affect aggregate output. An
economy demonstrates disguised unemployment
when productivity is low and too many workers are filling too
few jobs.
• Seasonal Unemployment – Seasonal cultivation stops to create
so.
• You might also hear of seasonal unemployment as another type
of unemployment. Like its name suggests seasonal
unemployment results from regular changes in the season.
Workers affected by seasonal unemployment include resort
workers, ski instructors, and ice cream vendors. It could also
include people who harvest crops. Construction workers are laid
off in the winter, in most parts of the country. School employees
can also be considered seasonal workers.
• Cyclical Unemployment -

It is caused by the contraction phase of the business cycle. That's

when demand for goods and services fall dramatically. It forces
businesses to lay off large numbers of workers to cut costs.

Cyclical unemployment creates more unemployment. The laid-

off workers have less money to buy the goods and services they
need. That further lowers demand.

• Structural Unemployment - caused by the skill gap.

• It exists when shifts occur in the economy that creates a

mismatch between the skills workers have and the skills needed
by employers.

• An example of this is an industry’s replacement of machinery

workers with robots. Workers now need to learn how to manage
the robots that replaced them. Those that don't learn need
 retraining for other jobs or face long-term structural
unemployment.

• Frictional Unemployment – It is due to immobility of labour,

lack of correct and timely information, seasonal nature of work.
etc.

• It occurs when workers leave their old jobs but haven't yet found
new ones. Most of the time workers leave voluntarily, either
because they need to move, or they've saved up enough money
to allow them to look for a better job.

• Frictional unemployment also occurs when students are looking

for that first job or when mothers are returning to the workforce.
It also happens when workers are fired or, in some cases, laid
off due to business-specific reasons, such as a plant closure.

The theories behind the Phillips curve pointed to the inflationary costs

of lowering the unemployment rate. That is, as unemployment rates
fell and the economy approached full employment, the inflation rate
would rise. But this theory also says that there is no single
unemployment number that one can point to as the "full employment"
rate. Instead, there is a trade-off between unemployment and inflation:
a government might choose to attain a lower unemployment rate but
would pay for it with higher inflation rates. In essence, in this view,
the meaning of “full employment” is really nothing but a matter of
opinion based on how the benefits of lowering the unemployment rate
compare to the costs of raising the inflation rate.

24. Differentiate between contractionary and expansionary fiscal

policy
A24. Contractionary fiscal policy happens when the government and its public
agencies lowers its expenditures, while also decreasing spending or increasing taxes at
the same time. When a  government reduces its spending and/or increases taxes, it
leaves a lower amount of capital available for private business, thus causing a
contraction of the economy and usually a degree of higher unemployment. This type
policy is typically used to control the growth of inflation. 
Expansionary fiscal policy is the flip side of this coin, in which the government raises
spending and lowers taxes to boost economic growth. Reduced taxes help private
enterprise to invest in major projects, employment, and physical expansion. In today's
world of 2016, the most appropriate action is a contractionary policy. The global
economy has recovered from the great recession of 2008 and it is important to prevent
the same type of economic bubbles that occurred in the past. 

25. Differentiate between capital and revenue expenditure and

receipts.
26. Give 5 point observation about our tax structure and collection

27. Explain the instruments of monetary policy

A27. Monetary policy is a way for the RBI to control the supply of
money in the economy. So these credit policies help control the
inflation and in turn help with the economic growth and development
of the country. So now let us take a look at the various instruments of
monetary policy that the RBI has at its disposal.

1] Open Market Operations

Open Market Operations is when the RBI involves itself directly and
buys or sells short-term securities in the open market. This is a direct
and effective way to increase or decrease the supply of money in the
market. It also has a direct effect on the ongoing rate of interest in the
market.

2] Bank Rate

One of the most effective instruments of monetary policy is the bank

rate. A bank rate is essentially the rate at which the RBI lends money
to commercial banks without any security or collateral. It is also the
standard rate at which the RBI will buy or discount bills of
exchange and other such commercial instruments.

So now if the RBI were to increase the bank rate, the commercial
banks would also have to increase their lending rates. And this will
help control the supply of money in the market. And the reverse will
obviously increase the supply of money in the market.

3] Variable Reserve Requirement

There are two components to this instrument of monetary policy,
namely – The Cash Reserve Ratio (CLR) and the Statutory Liquidity
Ratio (SLR). Let us understand them both.

Cash Reserve Ratio (CRR) is the portion of deposits with the

commercial banks that it has to deposit to the RBI. So CRR is the
percent of deposits the commercial banks have to keep with the RBI.
The RBI will adjust the said percentage to control the supply of
money available with the bank. And accordingly, the loans given by
the bank will either become cheaper or more expensive. The CRR is
a great tool to control inflation.

The Statutory Liquidity Ratio (SLR) is the percent of total deposits

that the commercial banks have to keep with themselves in form of
cash reserves or gold. So increasing the SLR will mean the banks
have fewer funds to give as loans thus controlling the supply of
money in the economy. And the opposite is true as well.

4] Liquidity Adjustment Facility

The Liquidity Adjustment Facility (LAF) is an indirect instrument for

monetary control. It controls the flow of money through repo rates
and reverse repo rates. The repo rate is actually the rate at which
commercial banks and other institutes obtain short-term loans from
the Central Bank.

And the reverse repo rate is the rate at which the RBI parks its funds
with the commercial banks for short time periods. So the RBI
constantly changes these rates to control the flow of money in the
market according to the economic situations.

5] Moral Suasion

This is an informal method of monetary control. The RBI is the

Central Bank of the country and thus enjoys a supervisory position in
the banking system. If there is a need it can urge the banks to exercise
 credit control at times to maintain the balance of funds in the market.
This method is actually quite effective since banks tend to follow the
policies set by the RBI.

28. Differentiate between current account and capital account in BOP

A28.
29. What do you mean by Twin Deficit?
A29. Twin Deficits Definition
In economics, a twin deficit occurs when a nation has both a current
account deficit and a fiscal deficit. You can also call twin deficits a
double deficit.
Current Account Deficit Definition
The current account is an account on the balance of payments. The
current account records a nation’s net imports and exports. If imports
exceed exports, then that nation has a current account deficit. If
exports exceed imports, then that nation has a current account surplus.
Define Fiscal Deficit
Government budgets consist of the following:

 Monetary inflows from tax revenue and borrowing

 Monetary outflows from expenditures and interest payments
Governments borrow money by issuing bonds, and then pay interest
on those issuances. A fiscal deficit occurs when government spending
exceeds government revenues. Whereas a fiscal surplus occurs when
government revenues exceed government spending. You can also call
a fiscal deficit a budget deficit or a budgetary deficit.
Current Account Deficit – Fiscal Deficit
The twin deficit, or double deficit, occurs when a nation has both a
current account deficit and a budget deficit. This means the
country’s economy is importing more than it is exporting, and the
country’s government is spending more money than it is generating.
When a country has a double deficit, it is a debtor to the rest of the
world. Over the long term, a double deficit may cause the
nation’s currency to devalue.
Why Does the Double Deficit Matter?
The budgetary deficit represents a significant portion of
federal spending that must be financed through the issuance of debt.
This is generally not viewed as favorable as such debt increases the
amount of high quality debt available for investors and negatively
impacts the supply of funds for private borrowers, thereby raising the
real interest rate for private loans. In addition, the future generations
who will have to pay for such borrowings through increased
tax collections will not enjoy the full benefit of the additional
government spending today.

30. When would devaluation/revaluation be profitable for a country?

 Currency devaluation involves taking measures to strategically lower
the purchasing power of a nation's own currency.
 Countries may pursue such a strategy to gain a competitive edge in
global trade and reduce sovereign debt burdens.
 Devaluation, however, can have unintended consequences that are
self-defeating.
 A revaluation is a calculated upward adjustment to a country's official
exchange rate relative to a chosen baseline, such as wage rates,
the price of gold, or a foreign currency.
 In a fixed exchange rate regime, only a country's government, such as
its central bank, can change the official value of the currency.
 In floating exchange rate systems, currency revaluation can be
triggered by a variety of events, including changes in the interest rates
between various countries or large-scale events that impact an
economy.