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GNDU Question Paper-2022

B.A 2

Semester

ECONOMICS

(Micro Economics)

Time Allowed: Two Hours Maximum Marks: 100

Note: There are Eight questions of equal marks. Candidates are required to attempt any

Four questions

SECTION-A

1. Critically examine the classical theory of employment.

2. What do you mean by a multiplier ? Discuss their static and dynamic nature.

SECTION-B

3. Define investment function. Discuss the factors affecting investment decisions.

4. Critically evaluate the Samuelson's model of trade cycles.

SECTION-C

5. Give various types of money. What are the functions and roles of the money? 20

6. What do you mean by a bank? How the credit is controlled and what are its effects ? 20

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SECTION-D

7. Discuss the causes and effects of inflation. How it can be cured?

8. What is a fiscal policy? Discuss its objectives and the instruments.

GNDU Answer Paper-2022

B.A 2

Semester

ECONOMICS

(Micro Economics)

Time Allowed: Two Hours Maximum Marks: 100

Note: There are Eight questions of equal marks. Candidates are required to attempt any

Four questions

SECTION-A

1. Critically examine the classical theory of employment.

Ans: The Classical Theory of Employment: A Detailed Examination

The classical theory of employment is one of the earliest and most influential theories in

economics. Proposed by classical economists such as Adam Smith, David Ricardo, and John

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Stuart Mill, this theory seeks to explain how employment, wages, and output are

determined in an economy. It relies on the idea that free markets and competition naturally

lead to full employment, provided there are no external interventions or disruptions.

To better understand this theory, let us examine its main principles, assumptions, criticisms,

and practical implications in detail.

Key Principles of the Classical Theory of Employment

The classical theory revolves around the following principles:

1. Say’s Law of Markets

At the core of the classical theory lies Say’s Law, named after the French economist Jean-

Baptiste Say. It states:

“Supply creates its own demand.”

This means that whatever goods and services are produced in an economy will

automatically find buyers. In simpler terms, if a worker produces something, they will earn

wages, which they will then spend on other goods and services. This continuous cycle

ensures that everything produced is consumed, leaving no possibility of an overall shortage

of demand.

Example:

Imagine a village where farmers produce rice, potters make pots, and carpenters build

furniture. According to Say’s Law, the rice will be exchanged for pots and furniture, and so

on. Everyone’s production (supply) will create income, which will, in turn, create demand for

others' goods.

2. Wage-Price Flexibility

Classical economists believed that wages (what workers earn) and prices (the cost of goods

and services) are flexible and adjust according to market conditions. If there is

unemployment, wages will decrease, making it cheaper for businesses to hire workers.

Similarly, if there is an oversupply of goods, prices will fall, encouraging consumers to buy

more. These adjustments, they argued, ensure that markets always return to equilibrium,

where supply equals demand.

Example:

If a factory lays off workers due to high production costs, those workers may accept lower

wages to get rehired. With reduced wages, the factory can afford to employ them again,

restoring full employment.

3. Self-Regulating Markets

The classical theory emphasizes that markets are self-regulating. If there are imbalances,

such as unemployment or overproduction, the market forces of supply and demand will

automatically correct them without the need for government intervention.

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Analogy:

Think of the economy as a seesaw. If one side (supply) goes up too high, the other side

(demand) naturally adjusts to bring it back into balance. This self-correcting mechanism,

according to classical economists, ensures stability.

4. Savings-Investment Equality

The classical theory argues that savings (money set aside by people) will always equal

investment (money spent on businesses and projects). If people save more, interest rates

will fall, encouraging businesses to borrow and invest more. This maintains a balance

between savings and investment, which in turn ensures full employment.

Assumptions of the Classical Theory

The classical theory of employment is based on several key assumptions. These are

necessary for the theory to work as described:

1. Full Employment is the Norm: The classical economists assumed that the economy

naturally operates at full employment. Any unemployment is seen as temporary and

voluntary.

2. Perfect Competition: Markets are assumed to be perfectly competitive, meaning

that no single buyer or seller can influence prices or wages.

3. No Government Intervention: The theory assumes a laissez-faire approach, where

the government does not interfere in the economy.

4. Rational Behavior: Individuals and businesses are assumed to act rationally, making

decisions to maximize their own benefits.

5. Flexibility in Wages and Prices: Wages and prices can adjust freely without any

restrictions, such as labor unions or price controls.

Criticisms of the Classical Theory

While the classical theory was groundbreaking in its time, it has been widely criticized for its

unrealistic assumptions and failure to explain economic downturns, such as the Great

Depression of the 1930s. Let’s look at some of the key criticisms:

1. Unrealistic Assumption of Full Employment

The classical theory assumes that full employment is the natural state of the economy.

However, in reality, unemployment often persists due to structural issues (e.g., outdated

skills) or cyclical factors (e.g., economic recessions).

Example:

During the Great Depression, millions of people were unemployed despite being willing to

work for lower wages. The classical theory could not explain this prolonged period of

unemployment.

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2. Inflexibility of Wages and Prices

In the real world, wages and prices are not as flexible as the theory assumes. Labor unions,

minimum wage laws, and contracts often prevent wages from falling, even during periods of

high unemployment. Similarly, businesses may hesitate to reduce prices due to concerns

about profitability.

Example:

If a factory tries to cut wages during a recession, workers may strike or leave the job, further

worsening unemployment.

3. Neglect of Aggregate Demand

The classical theory focuses entirely on supply and neglects the importance of demand. If

people stop spending due to fear or uncertainty (as seen during economic recessions),

businesses cannot sell their goods, even if they lower prices. This leads to reduced

production and more unemployment.

4. Overemphasis on Self-Regulation

The idea that markets always self-correct is overly optimistic. Economic crises often require

government intervention, such as fiscal policies (e.g., government spending) or monetary

policies (e.g., adjusting interest rates), to restore stability.

Example:

During the 2008 financial crisis, governments around the world implemented stimulus

packages to prevent economies from collapsing. Without such intervention, unemployment

would have soared.

Modern Relevance and Keynesian Critique

The most notable critique of the classical theory came from the economist John Maynard

Keynes during the Great Depression. In his revolutionary book, The General Theory of

Employment, Interest, and Money (1936), Keynes argued that demand, not supply, is the key

driver of economic activity. He rejected the idea that markets always self-correct and

advocated for active government intervention to manage unemployment and stabilize the

economy.

Keynesian Counterpoints:

1. Demand drives production, not the other way around.

2. Governments should increase spending during recessions to create jobs and boost

demand.

3. Unemployment can persist even in the absence of wage rigidity.

Conclusion

The classical theory of employment played a foundational role in the development of

economic thought, emphasizing the importance of markets, competition, and self-

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regulation. However, its assumptions of full employment, wage-price flexibility, and self-

correcting markets have been challenged by real-world evidence and alternative theories

like Keynesian economics.

While the classical theory provides valuable insights into how markets can function under

ideal conditions, it fails to address the complexities and imperfections of modern

economies. Thus, while it remains an important historical framework, policymakers and

economists today rely on more comprehensive approaches to tackle issues like

unemployment and economic instability.

Analogy to Sum Up:

Think of the classical theory as an old map of a city. It gives you a general idea of how things

are organized but lacks the details to navigate the complexities of modern streets, traffic,

and buildings. For real-world navigation, you need a more detailed and updated guide—just

like today’s economies require more nuanced theories to address their challenges.

2. What do you mean by a multiplier ? Discuss their static and dynamic nature.

Ans: What is a Multiplier?

The concept of a multiplier comes from economics and was introduced by economist John

Maynard Keynes. The idea is simple: when there is an increase in spending in the economy,

it leads to a chain reaction of further spending, which ultimately results in a larger overall

increase in income and output. In other words, the multiplier measures how much total

income (or output) changes as a result of an initial change in spending.

Think of it like throwing a pebble into a still pond. That one small action creates ripples that

grow outward. Similarly, in an economy, when money is spent, it doesn't just stop at one

point. Instead, it keeps circulating, creating a ripple effect.

Understanding with an Example

Imagine the government decides to build a new bridge, and they spend ₹100 crore on it.

This money is paid to construction workers, engineers, and suppliers. Now, these workers

and suppliers have more income, and they will spend some of it on goods and services like

food, clothes, or transportation. The shopkeepers and service providers who receive this

money will also spend some of it. This process continues, causing the initial ₹100 crore to

multiply as it moves through the economy.

Here’s how it works step-by-step:

1. Initial Spending (Injection): The government spends ₹100 crore on the bridge

project.

2. First Round: Workers and suppliers receive the ₹100 crore and spend 80% of it (₹80

crore) on other goods and services.

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3. Second Round: The people who receive the ₹80 crore spend 80% of it (₹64 crore).

4. Third Round: The next group spends 80% of ₹64 crore, which is ₹51.2 crore.

This process keeps going, but the amount spent decreases in each round. The total increase

in income is much larger than the original ₹100 crore. This is the multiplier effect.

Formula for the Multiplier

The size of the multiplier depends on the Marginal Propensity to Consume (MPC), which is

the portion of additional income that people spend rather than save.

The formula is:

Multiplier=11−MPC\text{Multiplier} = \frac{1}{1 - \text{MPC}}Multiplier=1−MPC1

For example:

• If MPC = 0.8 (people spend 80% of their income),

Multiplier=11−0.8=5\text{Multiplier} = \frac{1}{1 - 0.8} = 5Multiplier=1−0.81=5

This means that if ₹1 is initially spent, the total impact on income will be ₹5.

Static Nature of the Multiplier

The static multiplier focuses on a one-time change in spending. It assumes that:

• The economy is not growing or shrinking.

• There are no time delays; the effect happens all at once.

• All other factors (like technology, population, or government policies) remain

constant.

This is like taking a snapshot of the economy. In this case:

• An initial increase in spending leads to an immediate and proportional increase in

income and output.

Example: Suppose the government gives every citizen ₹1000 to boost spending. If the

multiplier is 2, then the total increase in income will be ₹2000 (₹1000 × 2). This is a static

multiplier because it assumes the process stops after one round of adjustments.

However, real-world economies are more complex, and spending happens over time,

leading to a dynamic multiplier.

Dynamic Nature of the Multiplier

The dynamic multiplier considers that the multiplier effect unfolds over time. It

acknowledges that:

• Economic changes take time to spread.

• People might not spend their income immediately. They could save, invest, or delay

spending.

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• Factors like business cycles, inflation, and government policies influence the effect.

This is like watching a movie instead of taking a snapshot. The dynamic multiplier tracks how

the effect of spending builds up gradually before leveling off.

Example: Let’s say the government spends ₹100 crore on infrastructure. In the first year,

workers might spend ₹50 crore of it. Over the next few years, they and others will continue

to spend, invest, and re-spend portions of that money, causing the effect to spread over

time. It might take several years for the full multiplier effect to be realized.

Differences Between Static and Dynamic Multiplier

Aspect

Static Multiplier

Dynamic Multiplier

Time Frame

Immediate or one-time impact

Gradual effect over time

Assumptions

Simplifies by ignoring time delays and

external factors

Considers time, delays, and real-

world factors

Realism

More theoretical

Closer to real-world scenarios

Factors That Affect the Multiplier

1. Marginal Propensity to Consume (MPC):

A higher MPC leads to a larger multiplier because people spend more and save less.

Example: If people spend 90% of their income, the multiplier will be larger compared to

when they spend only 50%.

2. Savings:

If people save a large portion of their income, the multiplier effect will be smaller

because less money is circulating.

3. Taxes:

Taxes reduce the amount people can spend, which decreases the multiplier.

4. Imports:

If people spend money on imported goods, the multiplier effect weakens because

that money leaves the domestic economy.

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Importance of the Multiplier in Economics

The multiplier is a crucial concept because it explains:

• How government spending can stimulate economic growth.

• Why investment in infrastructure, education, or health care can have far-reaching

effects.

• How recessions can be addressed by increasing spending to create jobs and income.

Example: During a recession, governments often use policies like increasing spending on

public works (roads, schools, etc.) to boost employment and income. The multiplier ensures

that the benefits of this spending are much larger than the initial investment.

Everyday Analogy to Understand the Multiplier

Think of the economy as a garden and spending as water. When you pour water (spending)

onto the soil, it doesn’t just help one plant (person or business). The water spreads,

nourishing many plants, and the garden flourishes. Similarly, money spent in the economy

doesn’t stay in one place; it moves around, benefiting many people and businesses.

Conclusion

The multiplier is a powerful economic tool that explains how spending ripples through an

economy, leading to a larger total impact. The static multiplier provides a simplified view of

this process, while the dynamic multiplier captures its gradual and time-dependent nature.

By understanding the multiplier, we can better appreciate how economic policies and

spending decisions affect growth and prosperity.

SECTION-B

3. Define investment function. Discuss the factors affecting investment decisions.

Ans: Investment Function: Definition and Factors Affecting Investment Decisions

Investment is an essential concept in economics that plays a significant role in shaping the

growth and development of any economy. Simply put, investment refers to the act of

putting money, resources, or time into something with the expectation of getting some

benefit or return in the future. In economics, investment specifically refers to the

expenditure by businesses or individuals on goods and services that will help produce more

goods or services in the future, such as machinery, buildings, or technology.

The "investment function" in economics describes the relationship between investment and

the factors that influence it. It is essentially a formula or a concept used to understand what

drives businesses and individuals to invest. In simple terms, the investment function

answers questions like: "Why do businesses decide to build more factories?" or "Why do

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individuals buy more equipment for their businesses?" Let’s delve deeper into this and

explore the factors affecting investment decisions.

Factors Affecting Investment Decisions

Investment decisions are not random; they are influenced by several economic and non-

economic factors. Below, we discuss these factors in detail to help understand how

businesses and individuals make such decisions.

1. Rate of Interest

The rate of interest is one of the most critical factors affecting investment decisions. When

businesses borrow money to invest, they have to pay interest on the loans. If the interest

rate is high, the cost of borrowing becomes expensive, and businesses may decide not to

invest as much. On the other hand, when interest rates are low, borrowing is cheaper,

encouraging more investment.

Example: Imagine you run a small bakery and want to buy a new oven. If the bank offers

you a loan at a low interest rate, it becomes affordable for you to invest in the oven.

However, if the interest rate is too high, you might postpone your investment or decide not

to buy the oven at all.

2. Expected Returns

Businesses invest with the hope of earning profits in the future. If they expect that an

investment will yield high returns, they are more likely to invest. On the contrary, if they

think the returns will be low or uncertain, they may hesitate to invest.

Example: A farmer considering buying a new tractor will first evaluate if the tractor can help

increase crop production and profits. If the farmer expects higher profits, they are likely to

go ahead with the investment.

3. Business Confidence and Economic Stability

Confidence plays a huge role in investment decisions. When businesses feel confident about

the economy’s future, they are more willing to invest. However, during times of economic

uncertainty, such as recessions, businesses tend to hold back on investments.

Example: During a booming economy, a clothing company may decide to open new stores,

expecting higher sales. But during a slowdown, the same company may delay its plans due

to fear of low demand.

4. Government Policies

Government policies such as tax rates, subsidies, and regulations significantly impact

investment decisions. If the government offers tax breaks or financial incentives for certain

types of investments, businesses are more likely to invest in those areas.

Example: If the government provides subsidies for installing solar panels, many businesses

may choose to invest in renewable energy projects to save money and benefit from the

incentives.

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5. Technological Advancements

The availability of new and advanced technology encourages businesses to invest in

upgrading their equipment and processes. Investing in technology often helps businesses

increase efficiency, reduce costs, and stay competitive in the market.

Example: A smartphone manufacturer may invest in advanced machinery to produce better-

quality phones faster and at a lower cost.

6. Cost of Capital Goods

The cost of machinery, tools, and other capital goods directly impacts investment decisions.

If these goods are affordable, businesses are more likely to invest in them. Conversely, if the

costs are too high, businesses may delay or avoid investment.

Example: If the price of a new printing machine is reduced due to technological

advancements, a publishing company might invest in it to improve production capacity.

7. Demand for Goods and Services

The demand for a company’s products or services influences its investment decisions. When

demand is high, businesses are motivated to expand production by investing in more

resources. However, if demand is low, they may hold back on investments.

Example: A car manufacturer may build a new factory if the demand for cars is increasing.

But if car sales are declining, the company might decide against such an investment.

8. Level of Savings in the Economy

Savings play a crucial role in providing funds for investment. Higher savings in an economy

mean more funds are available for businesses to borrow and invest. Low savings, on the

other hand, can limit the funds available for investment.

Example: If people in a country save more money in banks, those savings can be used by

businesses as loans for their investment needs.

9. Inflation

Inflation affects the purchasing power of money. High inflation may discourage investment

because it increases costs and reduces the real value of returns. On the other hand,

moderate inflation might encourage investment as businesses anticipate higher future

prices.

Example: If a construction company expects that the cost of materials will rise due to

inflation, it might decide to invest in purchasing materials now rather than later.

10. Social and Political Environment

A stable social and political environment encourages investment, while instability or political

unrest discourages it. Investors prefer to invest in regions where there is law and order, and

the risk of loss due to instability is minimal.

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Example: Businesses are more likely to invest in countries with stable governments and

clear economic policies compared to regions experiencing political unrest or frequent policy

changes.

11. Availability of Credit

The ease with which businesses can access loans or credit also impacts investment

decisions. If banks and financial institutions readily provide loans, businesses are more likely

to invest. However, if credit is difficult to obtain, investment levels may drop.

Example: A startup company might invest in a new project if it can easily secure a loan from

a bank. If banks are reluctant to lend, the company might have to put its plans on hold.

12. Competition in the Market

The level of competition in the market can also influence investment decisions. In highly

competitive markets, businesses may invest more in improving their products or services to

stay ahead of rivals. Conversely, in less competitive markets, businesses might invest less.

Example: An electronics company may invest heavily in research and development to launch

innovative products and stay ahead of competitors.

Conclusion

Investment decisions are influenced by a combination of economic, social, and psychological

factors. These factors are interconnected and often vary depending on the specific situation

of a business or economy. For instance, a company may decide to invest in new machinery

because of low interest rates, high demand for its products, and confidence in the

economy’s stability.

Understanding the investment function and the factors affecting it is crucial for

policymakers, businesses, and individuals. Governments can use this understanding to

create favorable conditions for investment by offering incentives, ensuring economic

stability, and maintaining a conducive business environment. Similarly, businesses can make

informed decisions by analyzing these factors to maximize their returns on investment. By

considering all these aspects, investments can drive economic growth, create jobs, and

improve overall living standards.

4. Critically evaluate the Samuelson's model of trade cycles.

Ans: Introduction to Trade Cycles

Trade cycles, also known as business cycles, are the periodic ups and downs in economic

activity that occur over time. These cycles consist of four main phases: expansion, peak,

contraction (or recession), and trough. Economists have proposed various theories to

explain why trade cycles occur, and one of the notable models is Paul Samuelson’s model of

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trade cycles. Samuelson developed his theory in 1939, combining ideas from Keynesian

economics and mathematical reasoning.

Samuelson’s model is based on two key concepts: the multiplier and the accelerator.

Together, these two factors create a dynamic relationship that explains how economies

move through cycles of boom and bust.

Multiplier and Accelerator: The Foundation of Samuelson’s Model

1. The Multiplier Effect

The multiplier refers to how an initial increase in investment leads to a larger overall

increase in national income. For example, if the government builds a new road, it

creates jobs for construction workers. These workers spend their wages on goods

and services, leading to more income for others. This ripple effect multiplies the

original investment's impact on the economy.

2. The Accelerator Effect

The accelerator focuses on how changes in demand affect investment. Businesses

invest in new machinery, factories, or technology to meet increasing demand for

their products. For example, if demand for cars rises, car manufacturers invest in

expanding production. However, if demand slows down, investment decreases,

which can lead to a downturn in economic activity.

Samuelson’s Model of Trade Cycles

Samuelson combined these two ideas in his mathematical model. He argued that the

interaction between the multiplier and the accelerator creates oscillations in economic

activity, leading to trade cycles. Let’s break this down step by step:

1. How Growth Begins

Imagine an economy in a stable state. Suddenly, an increase in government spending

or private investment boosts income and demand. The multiplier effect kicks in,

amplifying this increase in income. As income rises, businesses notice growing

demand and decide to invest more, triggering the accelerator effect. This leads to a

further increase in income and demand, causing the economy to expand.

2. The Boom Phase

As the multiplier and accelerator reinforce each other, the economy experiences

rapid growth. Businesses expand production, employment rises, and consumers

spend more. This is the boom phase of the trade cycle.

3. The Downturn

Eventually, the economy hits a peak. Demand may slow down due to saturation—

consumers have bought what they need and are no longer increasing their spending.

When demand slows, businesses reduce their investments. This causes income to

fall, and the multiplier effect now works in reverse, amplifying the decline.

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4. The Recession Phase

As income continues to fall, the accelerator effect further reduces investment. This

creates a downward spiral, leading to a recession or economic contraction.

5. The Recovery

After hitting a low point (the trough), the economy begins to recover. Factors like

government intervention, renewed consumer confidence, or external events may

stimulate new investment. The cycle starts again, moving back into expansion.

Strengths of Samuelson’s Model

1. Simplicity and Clarity

Samuelson’s model uses straightforward concepts to explain a complex

phenomenon. The interaction of the multiplier and accelerator provides a logical

explanation for the recurring nature of trade cycles.

2. Dynamic Nature

The model captures the economy's inherent instability and shows how small changes

in one factor (like investment) can lead to significant fluctuations over time.

3. Policy Implications

By understanding the multiplier-accelerator interaction, policymakers can take

measures to stabilize the economy. For example, during a downturn, governments

can increase public spending to counteract the decline in private investment.

Criticisms of Samuelson’s Model

Despite its strengths, Samuelson’s model has some limitations:

1. Over-Simplification

The model assumes that the economy relies only on the multiplier and accelerator to

generate trade cycles. In reality, many other factors—like international trade,

technological changes, and political events—also influence economic fluctuations.

2. Rigid Assumptions

Samuelson’s model assumes fixed relationships between income, consumption, and

investment. For example, it assumes that businesses will always respond to changes

in demand with proportional changes in investment. However, in real life, businesses

may delay investment decisions due to uncertainty or other constraints.

3. Lack of Real-World Complexity

The model does not account for factors like inflation, unemployment, or interest

rates, which play a significant role in real-world trade cycles. For instance, during a

boom, rising prices and wages can dampen demand, slowing down the economy.

4. No Explanation for External Shocks

Samuelson’s model focuses on internal dynamics of the economy but does not

explain how external shocks, such as natural disasters or global financial crises, can

disrupt trade cycles.

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Example to Illustrate Samuelson’s Model

Let’s take an example of a small town that relies on a car manufacturing plant as its main

economic driver:

• Initial Expansion: The plant receives a large order for cars. To meet the demand, it

hires more workers and increases production. Workers spend their wages locally,

boosting income for shops and services in the town. This is the multiplier effect.

• Investment Boom: As demand for cars grows, the plant decides to expand by

building a new factory. This triggers the accelerator effect, leading to even more jobs

and spending in the local economy.

• Peak and Decline: Eventually, the demand for cars slows down. The plant no longer

needs to expand and reduces production. This leads to layoffs, decreasing income

and spending in the town.

• Recession and Recovery: The town’s economy contracts until a new opportunity

(such as government funding for infrastructure) stimulates growth again.

Conclusion

Samuelson’s model of trade cycles offers a valuable framework for understanding economic

fluctuations. By focusing on the interplay between the multiplier and accelerator, the model

explains how economies move through phases of boom and bust. However, its simplicity

also limits its ability to capture the full complexity of real-world economies.

Despite these limitations, Samuelson’s model remains an essential starting point for

studying trade cycles and highlights the importance of investment and demand in shaping

economic activity. To make the most of this theory, it is essential to combine it with insights

from other models and real-world observations.

SECTION-C

5. Give various types of money. What are the functions and roles of the money?

Ans: Types of Money, Functions, and Roles of Money

Money is an essential part of our daily lives, influencing how we exchange goods and

services, save for the future, and measure the value of various things. To understand money

comprehensively, let us explore its types, functions, and roles in a simple and easy-to-

understand manner.

Types of Money

Money comes in various forms, each serving different purposes depending on the time

period, society, and economy. Here are the main types of money:

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1. Commodity Money

Commodity money is money that has intrinsic value. This means the material it is

made of holds value on its own, even if it isn’t used as money. Examples include

gold, silver, salt, or grain.

Example: In ancient times, gold coins were used for trading, and people valued the

gold itself for making jewelry or storing wealth.

2. Fiat Money

Fiat money has no intrinsic value but is recognized as legal tender because the

government declares it so. The paper currency and coins we use today are examples

of fiat money.

Example: A ₹100 note is valuable not because the paper itself is worth ₹100 but

because the government guarantees its value.

3. Representative Money

This type of money represents a claim on a commodity that can be redeemed later.

It has no inherent value but can be exchanged for something valuable.

Example: In earlier times, people used gold certificates that could be exchanged for

actual gold.

4. Digital Money

Digital money exists electronically and is used for online transactions. It doesn’t have

a physical form like cash.

Example: Bank transfers, credit cards, and payment apps like Paytm or Google Pay.

5. Cryptocurrency

Cryptocurrencies are decentralized digital currencies that use blockchain technology

to ensure secure transactions. They are not controlled by any government or

institution.

Example: Bitcoin, Ethereum.

6. Bank Money

Bank money refers to the money kept in bank accounts, which can be accessed

through cheques, debit cards, or online banking.

Example: The balance in your savings account is a form of bank money.

Functions of Money

Money performs several important functions that make economic transactions and daily life

smoother. These can be divided into four key functions:

1. Medium of Exchange

Money simplifies the exchange of goods and services by eliminating the need for

bartering, which requires a double coincidence of wants (both parties needing what

the other has).

Example: Instead of exchanging rice for clothes, you can simply pay money to buy

clothes and use the same money to buy rice from someone else.

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2. Measure of Value (Unit of Account)

Money provides a standard way to measure and compare the value of goods and

services. It allows us to express the price of something in terms that everyone

understands.

Example: A book costs ₹500, and a pair of shoes costs ₹1,000. You can compare their

values easily because both are expressed in terms of money.

3. Store of Value

Money allows you to save wealth for future use. Unlike perishable goods (like fruits

or vegetables), money doesn’t spoil and retains its value over time (assuming no

inflation).

Example: If you earn ₹10,000 this month, you can save it for future expenses instead

of spending it all immediately.

4. Standard of Deferred Payment

Money enables borrowing and lending by serving as a standard for future payments.

This makes it possible to take loans or agree on payments over time.

Example: If you take a loan to buy a car today, you agree to repay it in installments

with money over a few years.

Roles of Money

Money plays a critical role in shaping economies and societies. Here are the main roles it

performs:

1. Facilitates Trade

Money makes trade more efficient and less complicated compared to the barter

system. It eliminates the need to find someone who both has what you need and

needs what you have.

Example: A farmer can sell crops for money and use that money to buy tools or

seeds from different sellers.

2. Promotes Specialization

Money encourages specialization by allowing individuals and businesses to focus on

producing what they are best at and exchanging their output for other goods and

services.

Example: A carpenter specializes in making furniture, earns money by selling it, and

then uses that money to buy food, clothes, or other necessities.

3. Encourages Saving and Investment

Money allows people to save for the future, which can then be used for investments

like starting a business, buying property, or funding education.

Example: A family saving money over the years to buy a house is possible because of

money's role as a store of value.

4. Acts as a Tool for Economic Policy

Governments and central banks use money supply and interest rates to manage

economic growth, control inflation, and stabilize the currency.

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Example: During a recession, a government may lower interest rates to encourage

borrowing and spending.

5. Improves Economic Stability

Money provides a reliable and uniform way of conducting transactions, ensuring

stability and trust in the economy.

Example: In a well-functioning economy, people trust that the money they earn

today will have value tomorrow.

6. Facilitates Global Trade

With money, countries can engage in international trade by using a common

currency or exchange rates to settle payments.

Example: An Indian company can buy products from the US by paying in dollars,

thanks to foreign exchange markets.

Examples and Analogies

1. Medium of Exchange:

Imagine you’re at a carnival. Instead of bartering toys for food, you use tickets

(money) to buy whatever you need from any stall. This simplifies the process.

2. Measure of Value:

Think of money as a scale. Just as a scale measures weight, money measures the

worth of goods and services, making it easy to compare.

3. Store of Value:

Picture saving water in a tank for future use. Similarly, money allows you to store

wealth to spend later.

4. Deferred Payment:

When you borrow a friend’s bicycle with a promise to return it later, that’s like

taking a loan. Money formalizes this concept by standardizing payments.

Conclusion

Money is more than just currency; it is the foundation of modern economies. It simplifies

trade, fosters growth, and promotes stability. By understanding its types, functions, and

roles, we can better appreciate its significance in our lives and the economy. Whether in the

form of coins, digital wallets, or even cryptocurrency, money remains an indispensable tool

for human progress.

6. What do you mean by a bank? How the credit is controlled and what are its effects ?

Ans: Understanding Banks and Credit Control

A bank is a financial institution that plays a critical role in the economy by accepting deposits

from individuals, businesses, and organizations, and using those funds to provide loans and

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other financial services. In simpler terms, a bank acts as a middleman between those who

have extra money (savers) and those who need money (borrowers).

Banks are not just limited to keeping money safe; they also help in making payments,

transferring funds, and even creating money in the form of credit. By doing so, they

contribute to the smooth functioning of the economy.

Functions of a Bank

1. Accepting Deposits:

Banks accept money from individuals and businesses in the form of savings accounts,

fixed deposits, or recurring deposits. This money is kept safe, and depositors may

earn interest on their savings.

2. Providing Loans:

Banks lend money to those who need it, like businesses looking to expand or

individuals wanting to buy a house or car. The interest charged on loans is a primary

source of income for banks.

3. Facilitating Payments:

Banks provide services like checks, debit and credit cards, and online payment

systems, making it easy for people to pay for goods and services.

4. Creating Credit:

Banks create credit by lending out a significant portion of the deposits they receive.

This process helps in increasing the money supply in the economy.

5. Providing Other Services:

Banks also offer services like foreign exchange, investment advice, and insurance.

Credit Control

Credit control refers to the measures taken by a central authority, usually the central bank

(like the Reserve Bank of India), to regulate and control the amount of credit in the

economy. The primary aim of credit control is to ensure economic stability, curb inflation,

encourage growth, and prevent financial crises.

Why Is Credit Control Necessary?

When too much credit is available, it may lead to inflation (a rise in prices), as people have

more money to spend. On the other hand, if credit is scarce, economic growth may slow

down because businesses and consumers cannot borrow money to invest or spend. Thus,

credit control ensures a balance in the economy.

Methods of Credit Control

There are two types of methods used for credit control: Quantitative Methods and

Qualitative Methods.

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1. Quantitative Methods

These methods focus on controlling the total quantity of credit in the economy.

• Bank Rate Policy:

The central bank influences credit by changing the bank rate (the interest rate at

which it lends money to commercial banks). If the rate is increased, borrowing

becomes expensive, reducing the money supply. Conversely, a lower rate

encourages borrowing and increases the money supply.

Example: Suppose the central bank increases the bank rate. Commercial banks, in turn, raise

their interest rates for loans. As a result, fewer businesses and individuals take loans,

reducing credit in the economy.

• Open Market Operations (OMO):

The central bank buys or sells government securities in the open market to regulate

the money supply. Selling securities reduces the money supply, while buying them

increases it.

Example: If the central bank sells government bonds, people and institutions buy them

using their money, reducing the amount of money available for lending.

• Cash Reserve Ratio (CRR):

Commercial banks are required to keep a certain percentage of their deposits as

reserves with the central bank. By increasing or decreasing the CRR, the central bank

controls the amount of money banks can lend.

Example: If the CRR is raised, banks must keep more money with the central bank, leaving

them with less money to give as loans.

• Statutory Liquidity Ratio (SLR):

Banks are required to keep a certain percentage of their net demand and time

liabilities (NDTL) in the form of gold, cash, or approved securities. Adjusting the SLR

helps control credit creation.

2. Qualitative Methods

These methods aim to control the direction or purpose of credit to ensure it is used

effectively.

• Selective Credit Controls:

The central bank may restrict loans for speculative activities like stock market

investments, which can lead to economic instability.

Example: The central bank may limit loans for buying luxury items during inflationary

periods.

• Moral Suasion:

The central bank persuades commercial banks to follow guidelines and act

responsibly in credit creation.

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Example: The central bank might request banks to lend more to the agriculture sector

during a drought.

• Direct Action:

The central bank can take direct action, like penalizing banks that do not follow its

guidelines.

Effects of Credit Control

Credit control significantly impacts the economy and society in various ways:

1. On Inflation

• Controlled Inflation:

Credit control helps reduce inflation by limiting the money supply, ensuring prices

remain stable.

Example: If people have less credit, their purchasing power decreases, leading to

lower demand and stabilizing prices.

• Preventing Deflation:

In cases of deflation (a drop in prices), increasing the money supply helps boost

demand and stabilize the economy.

2. On Economic Growth

By regulating credit, the central bank ensures that sufficient funds are available for

productive activities like infrastructure development and industrial growth.

Example: During a recession, the central bank may reduce interest rates to encourage

borrowing and investment.

3. On Employment

Adequate credit availability promotes business growth, which leads to job creation.

Conversely, strict credit control during inflationary periods may reduce employment

opportunities.

4. On Speculative Activities

Credit control minimizes speculative activities in areas like real estate and stock markets,

reducing the risk of economic instability.

5. On Savings and Investments

By influencing interest rates, credit control affects people's savings and investments. Higher

interest rates encourage savings, while lower rates promote borrowing and investment.

Conclusion

Banks are the backbone of the financial system, providing critical services to individuals,

businesses, and the government. However, the credit they create can have both positive

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and negative effects on the economy. To maintain economic stability, the central bank uses

credit control measures to regulate the money supply.

Through tools like the bank rate, CRR, and selective credit controls, the central bank ensures

that credit is neither excessive nor insufficient. This balanced approach helps curb inflation,

promote growth, and maintain economic stability. Understanding these concepts not only

helps us see the role of banks in our daily lives but also gives insight into how the economy

functions.

SECTION-D

7. Discuss the causes and effects of inflation. How it can be cured?

Ans: What is Inflation?

Inflation is the rise in the overall level of prices in an economy over a period of time. In

simple terms, it means things get more expensive, and the value of money decreases. For

example, if last year you could buy 10 apples for ₹100, but this year you can buy only 8

apples for the same amount, inflation has occurred.

Causes of Inflation

Inflation happens due to several reasons. These can be broadly divided into two types:

Demand-Pull Inflation and Cost-Push Inflation.

1. Demand-Pull Inflation

This occurs when there is too much demand for goods and services, but the supply cannot

keep up. Think of it like a festival sale where everyone wants the same products, but there

are only a limited number available. This creates competition among buyers, and sellers

raise the prices.

Reasons for Demand-Pull Inflation:

• Increased Money Supply: If people suddenly have more money to spend, they

demand more goods, pushing prices up. For example, if the government prints more

money and distributes it, people can spend more, causing inflation.

• Population Growth: A growing population means more people are buying the same

limited goods.

• Rising Income Levels: When people's incomes increase, they buy more, which can

drive prices higher.

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2. Cost-Push Inflation

This happens when the cost of producing goods increases, and businesses pass these costs

on to consumers by raising prices. Imagine a bakery that has to pay more for flour and

electricity. To maintain its profit, the bakery raises the price of bread.

Reasons for Cost-Push Inflation:

• Higher Production Costs: Increases in wages, raw material prices, or fuel costs lead

to higher production costs.

• Supply Chain Disruptions: Natural disasters, wars, or pandemics can disrupt the

supply of goods, leading to higher prices. For example, during the COVID-19

pandemic, the cost of some goods increased because factories were closed, and

transportation was disrupted.

• Import Dependence: If a country depends on imported goods, and the price of these

imports rises (due to currency depreciation or international factors), inflation can

occur.

Effects of Inflation

Inflation affects everyone differently, depending on their income, spending habits, and

financial situation. Some effects are positive, but most are harmful.

Positive Effects:

1. Encourages Spending: When prices rise, people tend to spend money quickly instead

of saving it, as saving would reduce their purchasing power. This can boost economic

activity.

2. Benefits Borrowers: If someone has taken a loan at a fixed interest rate, inflation

reduces the real value of the money they have to repay.

Negative Effects:

1. Reduced Purchasing Power: For most people, inflation means they can buy less with

the same amount of money. This hits poor and middle-class families the hardest.

o Example: If your salary is ₹10,000, and inflation increases the price of goods

by 10%, your salary will feel like ₹9,000 because everything costs more.

2. Savings Lose Value: If the interest earned on savings is lower than the inflation rate,

the real value of savings decreases.

o Example: If your bank gives 5% interest but inflation is 8%, your savings are

effectively losing value.

3. Uncertainty for Businesses: Businesses may hesitate to invest or expand if they are

unsure about future costs and prices.

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4. Fixed-Income Groups Suffer: Retirees or people living on fixed pensions struggle as

their incomes do not increase with rising prices.

5. Income Inequality: Inflation often widens the gap between the rich and the poor.

The wealthy can invest in assets like real estate or gold that grow in value, while the

poor struggle to afford basic needs.

How to Cure Inflation

Inflation can be controlled by using various policies and measures. These include monetary,

fiscal, and supply-side approaches.

1. Monetary Policy

The central bank (like the Reserve Bank of India) controls the money supply and interest

rates to manage inflation.

• Increasing Interest Rates: When interest rates rise, borrowing becomes expensive.

People and businesses borrow and spend less, reducing demand and slowing down

inflation.

o Example: If the bank increases loan rates, fewer people might buy cars or

homes, reducing the demand for these products.

• Reducing Money Supply: The central bank can take steps to reduce the amount of

money in circulation by selling government bonds or increasing reserve

requirements for banks.

2. Fiscal Policy

The government uses taxes and spending to control inflation.

• Reducing Government Spending: By cutting down on public projects or subsidies,

the government reduces the amount of money in the economy, which can lower

demand and control inflation.

• Increasing Taxes: Higher taxes leave people with less disposable income to spend,

reducing demand and curbing inflation.

3. Supply-Side Measures

These focus on increasing the supply of goods and services to match demand.

• Improving Production: Encouraging businesses to produce more goods through

subsidies or better infrastructure can help control inflation.

o Example: If there is a shortage of wheat, the government can provide

incentives for farmers to grow more.

• Importing Goods: If domestic supply cannot meet demand, importing goods can

stabilize prices. For example, India sometimes imports onions or pulses to reduce

their prices when there is a shortage.

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4. Controlling Expectations

If people believe that inflation will continue, they may start hoarding goods or demanding

higher wages, which can make inflation worse. Governments and central banks often use

communication to manage these expectations.

Examples from Real Life

• India (1970s): During the oil crisis, global oil prices rose sharply, causing cost-push

inflation in India. This led to high transportation and production costs, affecting all

sectors.

• Zimbabwe (2000s): Zimbabwe experienced hyperinflation when the government

printed excessive money. Prices rose so fast that a loaf of bread cost millions of

Zimbabwean dollars.

• COVID-19 Pandemic (2020): Disrupted supply chains and increased demand for

certain goods like masks and sanitizers caused inflation in many countries.

Conclusion

Inflation is a natural part of any economy, but it needs to be controlled to ensure stability

and fairness. While mild inflation can encourage economic growth, high inflation harms

everyone, especially the poor and those on fixed incomes. By using monetary and fiscal

policies and improving supply chains, inflation can be managed effectively.

Understanding inflation helps individuals and governments make better financial decisions.

For example, saving in inflation-proof assets like gold or real estate can protect against the

effects of rising prices. Similarly, governments can balance growth and stability by keeping

inflation under control.

8. What is a fiscal policy? Discuss its objectives and the instruments.

Ans: Fiscal Policy: Meaning, Objectives, and Instruments

What is Fiscal Policy?

Fiscal policy is the way a government manages its income and spending to influence the

economy. Think of it as the government's financial plan to ensure the country's economy

runs smoothly. Just like a family budgets its income to meet expenses and save for the

future, the government uses fiscal policy to manage national resources and economic

activities.

Fiscal policy primarily deals with two things:

1. Government Revenue: Money collected by the government, mainly through taxes.

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2. Government Expenditure: Money spent by the government on various activities,

such as building roads, running schools, or paying pensions.

By carefully balancing these two aspects, the government tries to achieve economic

stability, growth, and equality.

Objectives of Fiscal Policy

The main goals of fiscal policy are to ensure the overall well-being of the economy. Let’s

explore its objectives:

1. Economic Stability

The economy naturally goes through ups (booms) and downs (recessions). Fiscal

policy helps to smooth out these fluctuations.

o Example: During a recession, when people lose jobs and businesses close

down, the government spends more on public projects to create jobs and

boost demand.

2. Promoting Economic Growth

Fiscal policy is used to encourage the production of goods and services and ensure

sustainable economic growth.

o Example: The government might reduce taxes on businesses, making it easier

for them to invest in new factories or technologies.

3. Reducing Unemployment

By increasing public spending, the government can create job opportunities. For

instance, constructing highways or public hospitals requires workers, engineers, and

suppliers.

4. Reducing Income Inequality

Governments use fiscal policy to reduce the gap between the rich and the poor. This

is done by taxing the wealthy more and using that money to provide subsidies, free

education, or healthcare for the underprivileged.

o Example: Providing affordable housing for low-income groups is one way

fiscal policy addresses inequality.

5. Controlling Inflation and Deflation

Fiscal policy also helps in managing the prices of goods and services:

o During Inflation (when prices are too high): The government reduces

spending or increases taxes to decrease the amount of money people have to

spend.

o During Deflation (when prices are too low): The government spends more or

lowers taxes to encourage people to buy more goods.

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Instruments of Fiscal Policy

The government uses certain tools, called instruments, to implement fiscal policy

effectively. These instruments are broadly divided into two types:

1. Taxation

Taxes are the primary way governments collect money. There are two types of taxes:

• Direct Taxes: Taxes on income, such as income tax.

• Indirect Taxes: Taxes on goods and services, like GST (Goods and Services Tax).

How taxes are used in fiscal policy:

• To reduce inflation, the government might increase taxes, so people have less

money to spend.

• To fight recession, it might lower taxes, leaving more money in people's hands to

boost demand.

Example: During the COVID-19 pandemic, many countries reduced taxes on essential goods

to help people manage their expenses.

2. Government Spending

The government spends money on public services, infrastructure, defense, and welfare

schemes. This spending directly affects economic activity.

• During a Recession: The government increases spending on projects like building

schools, hospitals, and highways to create jobs and boost the economy.

• During Inflation: The government reduces spending to control excess demand and

bring prices down.

Example: In India, the Mahatma Gandhi National Rural Employment Guarantee Act

(MGNREGA) is a program where the government spends money to provide jobs in rural

areas.

3. Public Debt (Borrowing)

When the government’s spending exceeds its income, it borrows money, usually through

bonds. Borrowing can help fund development projects but needs to be managed carefully to

avoid long-term debt problems.

• Example: Governments often borrow to build critical infrastructure like dams, which

can boost economic growth over time.

4. Subsidies and Transfer Payments

Subsidies are financial help given by the government to make goods and services affordable

for specific groups. Transfer payments include pensions, unemployment benefits, and

scholarships.

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• Example: The government provides subsidies on fertilizers to help farmers reduce

costs and increase food production.

How Fiscal Policy Works in Real Life: A Simple Analogy

Imagine a school principal managing a big annual event.

• If there’s too much chaos (inflation), the principal might ask students to calm down

by enforcing strict rules (raising taxes or cutting spending).

• If the event feels dull (recession), the principal might introduce fun activities or

distribute goodies (spending more or cutting taxes).

Similarly, the government adjusts its spending and taxation policies depending on the

economic situation.

Challenges in Implementing Fiscal Policy

1. Delayed Impact: Changes in fiscal policy take time to show results. For instance,

building a highway might create jobs, but the effects will be gradual.

2. Political Pressure: Politicians may focus on short-term gains, such as reducing taxes

before elections, rather than long-term economic stability.

3. Debt Burden: Excessive government borrowing can lead to debt, which may become

a problem for future generations.

4. Inflationary Risks: Over-spending by the government can lead to inflation, where

prices rise too quickly.

Conclusion

Fiscal policy is a powerful tool for managing the economy. By adjusting taxes and

government spending, it aims to ensure economic stability, growth, and equality. Whether

it’s creating jobs during a recession, controlling inflation, or reducing income inequality,

fiscal policy plays a crucial role in shaping the nation’s economic future. However, careful

planning and execution are essential to avoid pitfalls like excessive debt or delayed results.

In short, fiscal policy is like a balancing act—a seesaw that the government uses to maintain

economic equilibrium for the benefit of its people.

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