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GNDU Question Paper-2024

B.A 2

Semester

ECONOMICS

(Macro Economics)

Time Allowed: 3 Hours Maximum Marks: 100

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

questions.

SECTION-A

1. Discuss the general equilibrium of the economy in classical framework. What are its

limitations?

2. What do you mean by Consumption Function? Diagrammatically explain the short run and long

run consumption functions.

SECTION-B

3. Define marginal efficiency of capital. Discuss various factors affecting the marginal efficiency of

capital.

4. Critically examine the Hicksian model of trade cycles.

SECTION-C

5. Discuss the roles and functions of the money as well as capital markets.

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6. What are the main functions of Bank? How it creates credit?

SECTION-D

7. Define Inflation. Why there is a trade-off between inflation and unemployment?

8. Discuss the role of fiscal policy during the periods of deflation.

GNDU Answer Paper-2024

B.A 2

Semester

ECONOMICS

(Macro Economics)

Time Allowed: 3 Hours Maximum Marks: 100

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

questions.

SECTION-A

1. Discuss the general equilibrium of the economy in classical framework. What are its

limitations?

Ans: Introduction

The classical economic framework, developed by economists such as Adam Smith, David Ricardo,

and John Stuart Mill, provides a traditional view of how an economy functions. It is based on the

idea that markets are self-regulating and that supply and demand naturally lead to an optimal

allocation of resources. In this framework, the concept of general equilibrium plays a crucial role in

explaining how different parts of the economy interact to achieve stability.

General equilibrium refers to a situation where all markets in the economy—such as the goods

market, labor market, and money market—are in balance simultaneously. This means that supply

equals demand in all these markets, and there are no shortages or surpluses.

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Assumptions of Classical General Equilibrium

The classical economists believed in certain assumptions that helped establish the concept of

general equilibrium:

1. Perfect Competition: It is assumed that markets are highly competitive, meaning that many

buyers and sellers exist, and no single entity can influence prices.

2. Say’s Law: This principle states that "supply creates its own demand," meaning that

whatever is produced in an economy will eventually be consumed.

3. Flexible Wages and Prices: Wages (payments to workers) and prices of goods are assumed

to be flexible. If there is unemployment, wages will fall, encouraging firms to hire more

workers. Similarly, if there is excess supply of goods, prices will decrease to balance the

market.

4. Rational Behavior: Consumers and producers are assumed to make decisions based on

rational thinking, aiming to maximize their utility and profits, respectively.

5. Full Employment: The economy is always operating at full employment, meaning that all

available workers who are willing to work at the prevailing wage rate can find jobs.

Working of General Equilibrium in the Classical Framework

The general equilibrium in the classical model can be understood by looking at three main markets:

1. Goods Market Equilibrium

• In the goods market, total production (supply) should match total spending (demand).

• Say’s Law ensures that all output produced by firms will be purchased by consumers,

businesses, or the government.

• If firms produce too much, prices will fall, encouraging consumers to buy more, restoring

equilibrium.

2. Labor Market Equilibrium

• The labor market follows the principle of demand and supply.

• If there is unemployment, wages will fall, making it cheaper for firms to hire more workers.

• As wages fall, businesses will increase employment until the labor market reaches

equilibrium at full employment.

3. Money Market Equilibrium

• Classical economists believed that money is only a medium of exchange and does not affect

real variables like output or employment (this is known as the neutrality of money).

• The money market reaches equilibrium when the supply of money, controlled by the central

bank, matches the demand for money by individuals and businesses.

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When all three markets—goods, labor, and money—are in balance, the economy is said to be in

general equilibrium. This means resources are fully utilized, and economic stability is achieved.

Limitations of the Classical General Equilibrium

While the classical framework provides a structured way to understand how markets function, it has

several limitations, particularly in explaining real-world economic fluctuations. Here are some major

criticisms:

1. Say’s Law Does Not Always Hold

• The assumption that "supply creates its own demand" does not always work in reality.

• During economic downturns, consumers may reduce spending due to uncertainty, leading to

excess supply and unemployment.

• Example: The Great Depression of the 1930s saw high unemployment and low demand,

contradicting Say’s Law.

2. Wages and Prices Are Not Always Flexible

• The classical model assumes that wages and prices adjust quickly to restore equilibrium.

However, in reality, wages are often sticky, meaning they do not fall easily due to labor

contracts, minimum wage laws, and worker resistance.

• Firms also hesitate to reduce prices significantly because it can reduce their profits.

• Example: Even during recessions, many companies avoid cutting wages to maintain

employee morale, leading to prolonged unemployment.

3. No Explanation for Business Cycles

• The classical model assumes a stable economy with full employment, but economies often

go through booms and recessions.

• Factors like financial crises, speculation, and changes in consumer confidence can cause

business cycles, which the classical model does not account for.

• Example: The 2008 Global Financial Crisis led to a deep recession, showing that markets do

not always self-correct immediately.

4. Neglects the Role of Government

• The classical model assumes that government intervention is unnecessary because the

economy will naturally reach equilibrium.

• However, during economic crises, government spending and policies (such as stimulus

packages) have been crucial in restoring economic stability.

• Example: During the COVID-19 pandemic, governments worldwide provided financial aid to

businesses and individuals to prevent economic collapse.

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5. Unrealistic Assumption of Full Employment

• The classical model assumes that everyone who wants to work can find a job at the right

wage.

• However, real-world factors like automation, outsourcing, and mismatched skills often lead

to persistent unemployment.

• Example: Many workers lost jobs in traditional industries (e.g., coal mining) due to

technological advancements, and they could not easily transition to new industries.

Conclusion

The classical theory of general equilibrium provides an idealized view of how economies function

under perfect conditions. It highlights the importance of market forces in determining wages,

prices, and production levels. However, its assumptions—such as flexible wages, Say’s Law, and full

employment—often do not hold in the real world.

Due to these limitations, later economists, such as John Maynard Keynes, introduced alternative

theories that emphasized the role of government intervention in stabilizing the economy. Keynesian

economics challenged the classical model, arguing that demand fluctuations can lead to prolonged

periods of unemployment and that government policies are necessary to stimulate demand during

downturns.

While the classical general equilibrium model provides a foundation for understanding economic

interactions, modern economists combine classical and Keynesian ideas to create more

comprehensive models that better reflect the complexities of real-world economies.

2. What do you mean by Consumption Function? Diagrammatically explain the short run and long

run consumption functions.

Ans: What is the Consumption Function?

The consumption function is a concept in macroeconomics that explains the relationship between

income and consumption. It tells us how much people spend on goods and services when their

income changes.

The idea behind the consumption function is simple:

• When people earn more money, they tend to spend more.

• When their income is low, they spend less because they have less money available.

This relationship between income and consumption is one of the key ideas in Keynesian economics,

named after the famous economist John Maynard Keynes. He argued that consumer spending is a

major driver of economic growth.

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Understanding the Consumption Function with an Example

Imagine a person named Ravi who earns ₹10,000 per month.

• He spends ₹8,000 on food, rent, transport, and other expenses.

• He saves ₹2,000.

Now, if Ravi’s income increases to ₹15,000 per month, he might:

• Spend ₹11,500 on his needs and wants.

• Save ₹3,500.

This pattern shows that as Ravi’s income increases, his spending also increases but not in the same

proportion. He spends more, but also saves a part of his income.

This is exactly what the consumption function explains!

Formula for the Consumption Function

A simple way to express the consumption function mathematically is:

C=C0+cY

Where:

• C = Total Consumption

• C₀ = Autonomous Consumption (minimum spending even when income is zero)

• c = Marginal Propensity to Consume (MPC) (how much consumption increases when income

increases)

• Y = Income

Breaking it Down

1. Autonomous Consumption (C₀)

o This is the money people spend even if they have no income.

o Example: If Ravi loses his job, he will still spend some money on food and rent using

his savings or borrowing from others.

2. Marginal Propensity to Consume (MPC)

o This tells us how much extra money people spend when their income increases.

o If MPC = 0.8, it means that for every ₹100 increase in income, ₹80 is spent and ₹20 is

saved.

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Short-Run and Long-Run Consumption Function

The consumption function behaves differently in the short run and the long run. Let’s understand

both with diagrams.

Short-Run Consumption Function

In the short run, people’s consumption depends mainly on their current income. Most people adjust

their spending based on how much they are earning right now.

Characteristics of the Short-Run Consumption Function

1. Consumption increases with income but at a decreasing rate (because some part is saved).

2. MPC is high (people spend most of what they earn).

3. Savings are low because people are mostly spending what they earn.

Diagram of the Short-Run Consumption Function

Below is a simple graphical representation of the short-run consumption function:

Explanation of the Graph:

• The line starts above zero because even if income is zero, people still need to spend on

necessities (autonomous consumption).

• As income increases, consumption also increases, but the slope is less than 1 (meaning not

all additional income is spent).

Example of Short-Run Consumption

• A daily wage worker earns ₹500 per day and spends ₹450 on food, transport, and rent.

• If his wage increases to ₹700 per day, he may now spend ₹600 while saving ₹100.

This shows that in the short run, consumption increases quickly when income rises, but some part is

saved.

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Long-Run Consumption Function

In the long run, people adjust their consumption based on their expected lifetime income rather

than just their current income.

Characteristics of the Long-Run Consumption Function

1. Consumption is smoother over time because people plan for the future.

2. MPC is lower compared to the short run because as people earn more, they save a larger

portion.

3. Wealth and past savings influence long-term consumption.

Diagram of the Long-Run Consumption Function

Explanation of the Graph:

• The curve is flatter in the long run because as people earn more, they save more instead of

spending everything.

• Unlike the short-run consumption function, which is steeper, the long-run function reflects

better financial planning.

Example of Long-Run Consumption

Consider a person who starts working at age 25 and plans to retire at age 60.

• He knows his income will increase over time, so he starts saving early to maintain his

standard of living after retirement.

• Even if he gets a big salary hike, he won’t spend all of it. Instead, he will invest and save for

the future.

This is why in the long run, consumption depends on both income and savings behaviour.

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Key Differences Between Short-Run and Long-Run Consumption

Aspect

Short-Run Consumption

Long-Run Consumption

Basis

Current Income

Expected Lifetime Income

MPC

High (People spend most of what they earn)

Lower (People save more for the future)

Savings

Low

High

Behavior

People adjust spending quickly

People plan consumption for the future

Graph

Steeper Curve

Flatter Curve

Final Thoughts

The consumption function is one of the most important concepts in economics because it explains

how people spend and save their income.

• In the short run, consumption increases quickly with income, but some part is saved.

• In the long run, people plan their consumption and save more to maintain a stable lifestyle.

Understanding this concept helps economists and policymakers make decisions about taxation,

interest rates, and economic policies to promote growth and stability.

Conclusion

The consumption function is a powerful tool in macroeconomics. It helps us understand how people

decide to spend and save their income in both the short and long run. By analyzing this function,

economists can predict economic trends, and governments can design policies to improve people’s

financial well-being.

SECTION-B

3. Define marginal efficiency of capital. Discuss various factors affecting the marginal efficiency of

capital.

Ans: Marginal Efficiency of Capital (MEC) – Meaning and Explanation

Marginal Efficiency of Capital (MEC) is a concept in macroeconomics that explains the expected

profitability of investing in new capital assets, such as machinery, buildings, or technology. In simple

words, it refers to the rate of return a business expects to earn from an additional unit of capital

investment.

For example, suppose a company invests in a new machine. If the company expects that the

machine will help produce more goods and generate higher profits, the marginal efficiency of

capital for that machine is high. If the expected profits are low, the MEC is low.

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The MEC concept was introduced by the famous economist John Maynard Keynes. It plays a crucial

role in determining investment levels in an economy. Businesses make investment decisions based

on the expected return from their investments. If the MEC is high, businesses are more likely to

invest, leading to economic growth.

Formula for Marginal Efficiency of Capital

Mathematically, MEC is calculated as:

For example, if a company spends ₹1,00,000 on a new machine and expects an annual return of

₹10,000, then:

This means the company expects a 10% return on its investment in the machine. If this return is

higher than the prevailing interest rate in the market, the company will likely proceed with the

investment.

Factors Affecting the Marginal Efficiency of Capital

Several factors influence MEC, and understanding them helps in analyzing why businesses invest

more in some situations and less in others.

1. Demand for Goods and Services

When the demand for goods and services increases, businesses expect higher sales and profits. This

raises the MEC because firms anticipate greater returns on their investments.

Example:

If there is a sudden increase in demand for electric cars, companies like Tesla and Tata Motors will

find it profitable to invest in new factories and technology. The expected return on such

investments would be high, increasing the MEC.

Conversely, if demand for a product falls, the expected profit from new investments also decreases,

leading to a lower MEC.

2. Cost of Capital Goods

The price of machines, tools, equipment, and other capital goods also impacts MEC. If capital goods

are expensive, the cost of investment increases, making it less attractive for firms to invest. This

lowers MEC.

Example:

If a company needs a new printing press that costs ₹50 lakhs, but a newer model with similar

efficiency becomes available for ₹30 lakhs, the lower cost would increase the MEC and encourage

investment.

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On the other hand, if raw materials and machines become costly due to inflation, businesses may

hesitate to invest, leading to a decline in MEC.

3. Rate of Interest

Interest rates play a crucial role in investment decisions. If the interest rate is lower than the MEC,

businesses will find it profitable to borrow money and invest in capital goods.

Example:

If a company expects a 12% return on investment but the bank’s loan interest rate is only 8%, it

makes sense for the company to take a loan and invest, as it will still make a 4% profit. However, if

the loan interest rate rises to 15%, the company will avoid investing because the cost of borrowing

is higher than the expected return.

Thus, higher interest rates lower MEC, while lower interest rates increase MEC.

4. Technological Advancements

When new technologies are introduced, they make production more efficient and increase the

expected return on investment, leading to a rise in MEC.

Example:

A textile factory that adopts automated weaving machines can produce clothes faster and at a

lower cost. This increases the factory’s expected profits, thereby raising MEC.

If businesses do not upgrade to newer, more efficient technologies, their MEC will remain low

compared to competitors who adopt innovations.

5. Business Confidence and Future Expectations

Investment decisions depend on how confident businesses feel about future economic conditions. If

companies expect strong economic growth, rising incomes, and stable policies, they will invest

more, leading to a higher MEC.

Example:

If a government announces tax reductions and business-friendly policies, companies will feel

confident about expanding their operations. This increases MEC because businesses expect better

future profits.

However, if businesses fear a recession, economic slowdown, or political instability, they will delay

investments, causing MEC to decline.

6. Level of Existing Capital Stock

If businesses already have enough capital goods, they may not need to invest in more machinery or

buildings. This leads to a lower MEC.

Example:

If a factory has 10 machines and they are running efficiently, the business may not find it necessary

to buy more machines unless demand increases significantly. As a result, the MEC for additional

machines is low.

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On the other hand, if the existing machinery is outdated or insufficient, businesses will invest in new

equipment, leading to a higher MEC.

7. Political and Economic Stability

Stable political conditions and sound economic policies encourage businesses to invest, increasing

MEC. However, uncertainty or frequent policy changes can discourage investment.

Example:

If a country faces political turmoil or frequent policy reversals, businesses hesitate to make long-

term investments. On the other hand, in politically stable nations with clear economic policies,

businesses invest more, leading to higher MEC.

8. Inflation and Price Stability

Mild inflation can sometimes encourage investment because businesses expect higher revenues in

the future. However, excessive inflation can increase production costs and reduce profitability,

leading to a lower MEC.

Example:

If raw material prices keep rising unpredictably, businesses may avoid investment, fearing uncertain

returns. But if inflation remains moderate and predictable, firms can plan better, increasing MEC.

Conclusion

The marginal efficiency of capital (MEC) is a key determinant of investment in an economy. It

represents the expected profitability of new investments and influences how much businesses are

willing to invest in capital goods.

Several factors affect MEC, including:

• Demand for goods and services

• Cost of capital goods

• Rate of interest

• Technological advancements

• Business confidence and expectations

• Level of existing capital stock

• Political and economic stability

• Inflation and price stability

When MEC is high, businesses invest more, leading to economic growth, job creation, and higher

production. When MEC is low, investments decline, slowing down economic progress.

Understanding MEC helps policymakers and economists design strategies to boost investment and

economic growth by ensuring stable economic conditions, favorable interest rates, and investment-

friendly policies.

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4. Critically examine the Hicksian model of trade cycles.

Ans: Introduction

Trade cycles, also known as business cycles, refer to the periodic fluctuations in economic activity,

characterized by phases of expansion and contraction. Several economists have attempted to

explain why economies experience these ups and downs. One of the well-known theories of trade

cycles is the Hicksian Model of Trade Cycles, proposed by British economist John R. Hicks in his

book A Contribution to the Theory of the Trade Cycle (1950). Hicks' model builds upon Keynesian

principles and introduces the concept of the multiplier-accelerator interaction to explain business

cycles.

Key Features of the Hicksian Model

The Hicksian model primarily explains economic fluctuations through two main forces:

1. The Multiplier Effect: This concept, derived from Keynesian economics, suggests that an

initial increase in investment or spending leads to a greater overall increase in income and

output. For example, if the government invests in building roads, the workers employed in

the project will have more money to spend, which will further boost demand in other

industries.

2. The Accelerator Effect: This principle suggests that an increase in income and output leads

to higher investments. Businesses, seeing a rise in demand for their goods and services,

invest in new machinery and factories to expand production. Conversely, when demand

falls, businesses cut back on investments, leading to a downward economic trend.

How the Hicksian Model Explains Trade Cycles

Hicks argued that trade cycles occur due to the interaction between the multiplier and

the accelerator. His model suggests that when the economy is expanding, the multiplier

effect stimulates economic growth, and the accelerator effect further amplifies it. However,

economic expansion cannot continue indefinitely due to ceiling and floor constraints, which lead to

fluctuations.

1. The Ceiling Constraint (Upper Limit)

The economy cannot grow indefinitely because of physical and financial limitations. Some of the

major constraints that prevent continuous economic expansion include:

• Full Employment: When all available workers are employed, businesses cannot hire more

workers to expand production.

• Limited Resources: Shortages of raw materials, machinery, or energy sources can slow down

production.

• Inflation: When demand exceeds supply, prices rise, reducing the purchasing power of

consumers and slowing down further spending.

When these constraints are reached, economic growth slows down, leading to a turning

point where expansion shifts to contraction.

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2. The Floor Constraint (Lower Limit)

Just as there is a ceiling to growth, there is also a lower limit, or floor, to economic decline. Hicks

introduced the concept of an autonomous investment floor, which prevents the economy from

falling indefinitely.

Autonomous investments refer to investments that occur regardless of economic conditions, such

as government spending on public infrastructure, military projects, or essential industries. These

investments provide a safety net, ensuring that the economy does not completely collapse. When

economic contraction slows down due to these investments, a new cycle of expansion begins.

The Cycle in Action

1. Boom Phase: The economy experiences rapid growth due to increased investments and

consumption. The multiplier and accelerator work together to drive expansion.

2. Peak Phase: The economy reaches its upper limit due to full employment, rising inflation,

and resource constraints.

3. Recession Phase: Economic growth slows down as demand decreases, leading to lower

investment and production.

4. Depression Phase: The economy hits its lowest point, but government spending and other

autonomous investments provide a floor to prevent further decline.

5. Recovery Phase: The economy starts growing again due to new investments and rising

demand, leading to the next cycle.

Strengths of the Hicksian Model

The Hicksian model provides several key insights into the causes of trade cycles:

1. Explains Regular Fluctuations: The model successfully explains why economies experience

regular booms and recessions due to the interaction of the multiplier and accelerator.

2. Incorporates Real-World Constraints: By introducing the concepts of ceiling and floor, the

model provides a realistic explanation of why economies do not grow indefinitely or collapse

entirely.

3. Emphasizes Investment’s Role: The model highlights the importance of investment in

driving economic cycles, making it useful for policymakers in designing economic strategies.

Criticism of the Hicksian Model

Despite its strengths, the Hicksian model has some limitations:

1. Simplistic Assumptions: The model assumes that the economy behaves in a predictable

manner, which is not always the case in real life.

2. Ignores External Factors: It does not consider external shocks such as wars, pandemics, or

financial crises, which can disrupt economic cycles.

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3. Rigid Ceiling and Floor: In reality, the ceiling and floor constraints are not always fixed.

Technological advancements, policy changes, or shifts in consumer behavior can alter these

limits.

4. Overdependence on Investment: The model assumes that investment is the main driver of

trade cycles, ignoring other factors such as government policies, consumer behavior, and

international trade.

Real-World Application of the Hicksian Model

Although the Hicksian model is theoretical, it has practical applications. For example:

• Great Depression (1929-1939): The economic collapse followed by government intervention

through public spending aligns with the model’s floor constraint.

• Post-World War II Boom: Massive investments in infrastructure and industrial development

led to economic expansion, demonstrating the multiplier-accelerator interaction.

• 2008 Financial Crisis: The crash led to a decline in investment, but government stimulus

packages acted as an autonomous investment floor, preventing total economic collapse.

Conclusion

The Hicksian model of trade cycles provides a valuable framework for understanding economic

fluctuations. By integrating the multiplier-accelerator interaction with ceiling and floor constraints,

it explains why economies experience regular booms and recessions. However, its reliance on

simplified assumptions and its inability to account for external shocks limit its accuracy in predicting

real-world economic conditions. Despite these shortcomings, the model remains an essential tool in

economic theory and policy-making.

SECTION-C

5. Discuss the roles and functions of the money as well as capital markets.

Ans: Introduction

Money and capital markets play a crucial role in the economy by facilitating the flow of funds

between individuals, businesses, and governments. These markets help in economic development

by ensuring that money is available where it is needed the most. In simple terms, the money market

deals with short-term borrowing and lending, while the capital market deals with long-term

investments.

Money Market

The money market is where short-term financial instruments are traded. These instruments usually

have a maturity period of one year or less. The money market provides liquidity to businesses and

governments, ensuring that they have access to funds for their day-to-day operations.

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Roles of the Money Market

1. Providing Short-Term Liquidity

o Businesses and governments often need money to cover short-term expenses like

paying salaries, buying raw materials, or handling unexpected costs.

o Example: A company needing funds to pay its employees before receiving payments

from customers can borrow from the money market.

2. Ensuring Financial Stability

o The money market helps stabilize the financial system by ensuring that there is

enough money available for short-term needs.

o Example: During an economic crisis, central banks inject money into the money

market to keep the financial system running smoothly.

3. Helping the Central Bank Implement Monetary Policy

o The central bank (like the Reserve Bank of India or the Federal Reserve) uses the

money market to control inflation and interest rates.

o Example: If inflation is high, the central bank may raise interest rates to reduce the

money supply, making borrowing more expensive and reducing excessive spending.

Functions of the Money Market

1. Facilitating Short-Term Borrowing and Lending

o Financial institutions, businesses, and governments borrow and lend money for short

periods to meet their cash flow needs.

o Example: A bank may lend money to a company for 6 months to help it manage

seasonal demand.

2. Providing Investment Opportunities

o Investors who want low-risk, short-term investment options use the money market.

o Example: People invest in fixed deposits, treasury bills, or certificates of deposit to

earn interest.

3. Reducing Business Risks

o Businesses can use the money market to manage risks associated with currency

fluctuations and interest rate changes.

o Example: A company importing goods can use foreign exchange markets within the

money market to stabilize costs.

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Instruments of the Money Market

Some key financial instruments in the money market include:

• Treasury Bills (T-Bills): Short-term government debt securities used to raise funds.

• Commercial Papers: Unsecured short-term loans issued by large companies.

• Certificates of Deposit (CDs): Fixed-term deposits issued by banks.

• Call Money Market: Banks lend and borrow funds for very short durations (sometimes

overnight).

Capital Market

The capital market is where long-term financial securities are bought and sold. It helps businesses

and governments raise funds for long-term investments like infrastructure projects, business

expansion, and technological development.

Roles of the Capital Market

1. Providing Long-Term Funds

o Companies and governments need funds for large projects that require long-term

financing.

o Example: A company planning to build a new factory can raise funds by issuing

shares or bonds in the capital market.

2. Encouraging Economic Growth

o By providing businesses with access to funds, the capital market helps create jobs

and boost economic development.

o Example: A tech startup raising money through the capital market can use it to

develop innovative products and hire more employees.

3. Facilitating Wealth Creation

o Individuals can invest in stocks and bonds to grow their wealth over time.

o Example: A person who buys shares in a successful company may earn dividends and

see the value of their investment increase.

4. Helping the Government Raise Funds

o Governments issue long-term bonds to finance projects like building highways,

railways, and schools.

o Example: A government might issue bonds to raise money for a new metro system.

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Functions of the Capital Market

1. Mobilizing Savings and Investments

o The capital market converts individual savings into productive investments by

providing opportunities to invest in shares, bonds, and mutual funds.

o Example: Instead of keeping money idle in a bank, individuals can invest in stocks to

earn better returns.

2. Providing a Platform for Buying and Selling Securities

o The capital market includes stock exchanges where shares and bonds are traded.

o Example: Companies like Tata, Reliance, or Infosys list their shares on stock

exchanges, allowing investors to buy and sell them.

3. Offering Liquidity to Investors

o Investors can sell their stocks or bonds whenever they need money, making

investments more flexible.

o Example: An investor who bought shares of a company can sell them on the stock

exchange if they need cash.

4. Determining the Value of Securities

o The prices of shares and bonds are determined in the capital market based on

demand and supply.

o Example: If many investors want to buy a particular company’s shares, the price of

those shares will increase.

Instruments of the Capital Market

Some important financial instruments in the capital market include:

• Stocks (Shares): Ownership stakes in companies.

• Bonds: Long-term loans issued by companies or governments with a promise to repay with

interest.

• Debentures: A type of bond not secured by physical assets but based on the company’s

creditworthiness.

• Mutual Funds: A pool of money collected from multiple investors to invest in stocks, bonds,

or other assets.

Differences Between Money Market and Capital Market

Feature

Money Market

Capital Market

Time Duration

Short-term (up to 1 year)

Long-term (more than 1 year)

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Risk Level

Low risk

Higher risk but higher returns

Instruments

Treasury bills, Commercial papers, Call

money, Certificates of Deposit

Stocks, Bonds, Debentures, Mutual Funds

Purpose

Helps businesses and governments manage

short-term liquidity needs

Helps businesses and governments raise

long-term investment funds

Returns

Lower returns due to short duration

Higher returns due to longer duration

Conclusion

Both the money market and capital market play essential roles in the economy. The money market

ensures liquidity and financial stability by providing short-term funds, while the capital market

promotes economic growth by facilitating long-term investments. These markets work together to

create a balanced financial system, ensuring that businesses, individuals, and governments have

access to the funds they need at the right time. Understanding their roles and functions can help

individuals make informed financial decisions, whether they are looking for short-term security or

long-term investment growth.

6. What are the main functions of Bank? How it creates credit?

Ans: Functions of a Bank and How It Creates Credit

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

providing loans, and offering various financial services. Banks help individuals, businesses, and the

government manage money efficiently. They act as intermediaries between depositors (who save

money) and borrowers (who need money). Let’s discuss the main functions of a bank and

understand how it creates credit.

Main Functions of a Bank

1. Accepting Deposits

One of the primary functions of a bank is to accept deposits from the public. People keep their

money in banks for safety and also earn interest on their savings. Banks offer different types of

deposits:

• Saving Deposits: These accounts are for individuals who want to save money and earn

interest on their deposits.

• Current Deposits: These accounts are mainly used by businesses for daily transactions. They

do not earn interest.

• Fixed Deposits: Also called term deposits, these accounts offer higher interest rates as

money is locked for a specific period.

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• Recurring Deposits: Individuals deposit a fixed amount regularly and earn interest over time.

2. Providing Loans and Advances

Banks provide loans to individuals, businesses, and industries. The money deposited by the public is

used to lend money to those in need. The main types of loans and advances include:

• Personal Loans: Given to individuals for various personal needs.

• Business Loans: Provided to businesses for expansion and operational purposes.

• Home Loans: Given for purchasing or constructing houses.

• Agricultural Loans: Provided to farmers to support farming activities.

3. Credit Creation

Banks create credit by lending money to borrowers while keeping only a fraction of deposits as

reserves. This process increases the total money supply in the economy. (Detailed explanation is

given below.)

4. Facilitating Payments and Money Transfers

Banks provide payment and money transfer services such as:

• Issuing cheques and demand drafts.

• Providing online banking, mobile banking, and ATM services.

• Enabling fund transfers through NEFT, RTGS, and UPI.

5. Foreign Exchange Transactions

Banks help businesses and individuals exchange currencies for international trade, travel, and

investments.

6. Investment Services

Many banks offer services like mutual funds, insurance, and stock market investments to

customers.

7. Safe Deposit Lockers

Banks provide locker facilities where people can safely store valuables like jewelry and important

documents.

8. Issuing Credit and Debit Cards

Banks issue debit and credit cards that allow customers to make payments conveniently without

carrying cash.

9. Providing Financial Advice

Banks advise individuals and businesses on investments, savings, and financial planning.

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How Banks Create Credit?

One of the most important functions of a bank is credit creation. This process increases the total

money supply in an economy.

Understanding Credit Creation with an Example

Let’s assume there is a bank called XYZ Bank. Suppose Mr. A deposits ₹10,000 in his savings account.

The bank does not keep the entire amount idle; instead, it keeps a fraction of it as a reserve (as per

the Reserve Bank of India’s regulations) and lends out the rest.

Let’s assume the bank keeps 10% (₹1,000) as reserves and lends ₹9,000 to Mr. B. Mr. B deposits this

amount in another bank or spends it, and the receiver of this money again deposits it in a bank.

Now, the bank again keeps 10% of ₹9,000 (i.e., ₹900) and lends out the rest. This process continues,

creating a multiplier effect.

The Money Multiplier Effect

Each time the bank lends money, it generates deposits in another account, increasing the total

money supply. The formula to calculate the total credit created is:

If the initial deposit is ₹10,000 and the reserve ratio is 10%, the total credit created would be:

Thus, from an initial deposit of ₹10,000, the banking system can create credit of ₹1,00,000 in the

economy.

Importance of Credit Creation

1. Boosts Economic Growth: More credit means more investments, leading to economic

development.

2. Increases Purchasing Power: Businesses and individuals can borrow and spend more.

3. Encourages Entrepreneurship: Startups and businesses can take loans to grow.

4. Improves Living Standards: People can buy houses, cars, and other assets with loans.

Limitations of Credit Creation

1. Banking Regulations: The Reserve Bank of India (RBI) controls the reserve ratio, affecting

credit creation.

2. Public Demand for Cash: If people withdraw more money, banks have less to lend.

3. Economic Conditions: In times of recession, people borrow less, reducing credit creation.

4. Bad Loans (NPAs): If borrowers fail to repay, banks suffer losses, restricting further lending.

Conclusion

Banks play a crucial role in managing money in the economy through their functions like accepting

deposits, providing loans, facilitating payments, and creating credit. Credit creation helps in

economic growth, but it must be regulated to prevent inflation and financial crises. By maintaining a

balance, banks ensure a stable and growing economy

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SECTION-D

7. Define Inflation. Why there is a trade-off between inflation and unemployment?

Ans: Inflation and the Trade-off Between Inflation and Unemployment

Definition of Inflation

Inflation refers to the general increase in the prices of goods and services in an economy over a

period of time. When inflation occurs, the purchasing power of money decreases, meaning that

people need more money to buy the same things they used to afford with less money before.

For example, imagine that last year a loaf of bread cost 20 rupees, but this year it costs 25 rupees.

This price rise is an example of inflation. If the prices of most goods and services go up in a similar

way, the overall cost of living increases, and this is known as inflation.

Causes of Inflation

Inflation can occur due to several reasons, including:

1. Demand-Pull Inflation: This happens when the demand for goods and services exceeds the

available supply. When people have more money to spend, businesses may struggle to keep

up with the demand, leading to an increase in prices.

o Example: If everyone suddenly wants to buy cars but there are not enough cars

available, car prices will go up.

2. Cost-Push Inflation: This occurs when the production cost of goods and services increases,

and businesses pass these costs onto consumers by raising prices.

o Example: If the cost of petrol increases, transportation costs rise, leading to higher

prices for vegetables and other goods transported by vehicles.

3. Increase in Money Supply: If the government prints more money or provides easy access to

loans, more money enters the economy, increasing demand and leading to inflation.

o Example: If everyone in a town suddenly receives free money, they will buy more

things, causing shops to raise their prices.

4. Imported Inflation: When the prices of goods imported from other countries rise, domestic

prices also increase.

o Example: If India imports oil from another country and that country increases the

price of oil, petrol prices in India will rise, affecting transportation and other

industries.

Effects of Inflation

Inflation can have both positive and negative effects:

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Negative Effects:

• Decreased Purchasing Power: When prices rise, people can buy fewer things with the same

amount of money.

• Uncertainty in Business: Businesses may hesitate to invest in new projects if they are unsure

how inflation will affect costs and demand.

• Fixed-Income Sufferers: Retired people or workers with fixed salaries struggle as their

earnings do not increase with inflation.

• Savings Lose Value: If inflation is high, money kept in savings accounts loses its value over

time.

Positive Effects:

• Encourages Spending and Investment: Moderate inflation encourages people to spend

money rather than save it because the value of money decreases over time.

• Higher Profits for Businesses: Businesses can increase their prices and earn more revenue.

Trade-off Between Inflation and Unemployment

There is often a trade-off between inflation and unemployment, meaning that when inflation is

high, unemployment tends to be low, and when inflation is low, unemployment tends to be high.

This relationship is explained by the Phillips Curve.

Why Does This Trade-off Exist?

1. Higher Demand Creates More Jobs: When inflation occurs due to increased demand,

businesses need to produce more goods and services to meet the demand. This requires

hiring more workers, reducing unemployment.

o Example: If people start buying more mobile phones, companies like Samsung and

Apple will hire more workers to make and sell more phones.

2. Wage-Price Spiral: When businesses hire more workers, they must pay higher wages to

attract employees. Workers with more money spend more, increasing demand and pushing

prices up further, leading to more inflation.

o Example: A company raises salaries due to increased demand, but workers spend

more, leading to higher demand and further inflation.

3. Tight Monetary Policy Increases Unemployment: When inflation is too high, the

government may take steps to control it, such as increasing interest rates. Higher interest

rates make borrowing money more expensive, reducing business expansion and leading to

job losses.

o Example: If loan interest rates increase, fewer people will take home loans, reducing

demand in the housing sector, leading to job losses in construction.

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Is the Trade-off Always True?

While the trade-off between inflation and unemployment holds in many cases, it is not always true.

Some situations challenge this relationship:

• Stagflation: This is a situation where both high inflation and high unemployment exist at the

same time. This happened in the 1970s when oil prices rose sharply, causing economic

problems worldwide.

• Long-Term View: In the long run, if inflation keeps rising uncontrollably, it can cause

businesses to struggle, leading to higher unemployment.

• Structural Unemployment: Sometimes, even if inflation is high, unemployment may not

decrease if workers do not have the skills required for available jobs.

Conclusion

Inflation is a rise in the general price levels of goods and services, which affects the economy in both

positive and negative ways. There is often a trade-off between inflation and unemployment, where

reducing unemployment can lead to higher inflation and vice versa. However, this relationship is not

always consistent, and other factors like stagflation and structural issues can influence the

economy.

Governments and central banks, like the Reserve Bank of India (RBI), try to balance inflation and

unemployment by adjusting interest rates, controlling money supply, and implementing economic

policies. The goal is to keep inflation at a moderate level while ensuring enough job opportunities

for people.

Understanding this trade-off helps us see why economic policies often focus on striking a balance

between keeping prices stable and ensuring employment opportunities for everyone.

8. Discuss the role of fiscal policy during the periods of deflation.

Ans: The Role of Fiscal Policy During Deflation

Introduction

Deflation is a situation where the overall price levels in an economy decrease over time. While this

might seem like a good thing because goods and services become cheaper, it actually harms the

economy. Businesses earn less revenue, wages fall, unemployment rises, and economic growth

slows down. To counter deflation, the government uses fiscal policy, which involves changes in

government spending and taxation to influence economic activity. In this article, we will discuss

how fiscal policy can help during deflation and why it is important.

Understanding Deflation and Its Problems: Deflation occurs when there is a lack of demand in the

economy. People and businesses reduce spending, which leads to lower profits, job losses, and

reduced production. Some of the major problems caused by deflation include:

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1. Decrease in Consumer Spending: When prices fall, people expect them to fall even further

and delay their purchases. This reduces demand in the economy.

2. Lower Business Profits: Businesses earn less revenue, making it difficult for them to invest

and expand.

3. Increase in Unemployment: As businesses struggle to make profits, they cut down on their

workforce, leading to higher unemployment rates.

4. Debt Becomes Expensive: When prices fall, the real value of debt increases, making it

harder for borrowers to repay their loans.

5. Reduced Economic Growth: Overall, lower demand and investment slow down economic

growth, creating a vicious cycle of declining economic activity.

What is Fiscal Policy?

Fiscal policy refers to the use of government spending and taxation to influence economic

conditions. It is one of the main tools governments use to manage the economy. During deflation,

the government implements expansionary fiscal policy, which includes increasing government

spending and reducing taxes to boost demand and encourage economic activity.

How Fiscal Policy Helps During Deflation

During deflation, the government uses the following fiscal policy measures to stimulate economic

growth:

1. Increasing Government Spending

One of the most effective ways to counter deflation is by increasing government spending. The

government can spend more money on:

• Infrastructure Projects: Building roads, bridges, schools, and hospitals creates jobs and

increases demand for raw materials like cement and steel.

• Public Services: Expanding healthcare and education services provides employment and

improves the standard of living.

• Subsidies and Support for Businesses: The government can provide financial support to

struggling businesses to help them stay afloat and continue operations.

• Social Welfare Programs: Increasing unemployment benefits and pensions puts more

money into people's hands, encouraging them to spend more.

By increasing spending, the government injects more money into the economy, leading to higher

demand for goods and services, which helps stop the deflationary cycle.

2. Reducing Taxes

Lowering taxes allows people and businesses to have more disposable income. This can be done in

several ways:

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• Reducing Income Tax: When people pay less tax on their salaries, they have more money to

spend on goods and services.

• Lowering Corporate Tax: When businesses pay lower taxes, they can invest more in

expansion and job creation.

• Reducing Sales Tax (GST/VAT): Lowering taxes on goods and services makes them cheaper,

encouraging people to buy more.

When people and businesses have more money to spend, demand for goods and services increases,

which helps in controlling deflation.

3. Providing Direct Financial Support

Governments can also directly transfer money to individuals and businesses to boost spending.

Some examples include:

• Cash Transfers: Providing direct financial aid to low-income families helps them buy

essential goods, increasing overall demand.

• Small Business Grants: Offering financial assistance to small businesses helps them survive

during tough economic times and prevents mass layoffs.

• Debt Relief Programs: Helping individuals and businesses manage their debts ensures they

continue spending and investing instead of saving excessively.

Examples of Fiscal Policy in Action

To better understand how fiscal policy helps during deflation, let's look at some real-world

examples:

1. The Great Depression (1930s, USA):

o The U.S. faced severe deflation, high unemployment, and economic stagnation.

o The government, under President Franklin D. Roosevelt, launched the New Deal,

which included massive public works projects, financial aid programs, and subsidies

for businesses.

o This government spending helped in job creation and economic recovery.

2. Japan’s Deflation Crisis (1990s-2000s):

o Japan faced long-term deflation due to low consumer spending and business

investment.

o The government introduced fiscal policies like tax cuts and increased spending on

infrastructure projects to stimulate demand.

3. COVID-19 Pandemic (2020):

o The global economy faced a sharp decline in demand due to lockdowns and job

losses.

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o Governments around the world, including the USA, India, and European countries,

provided stimulus packages, cash transfers, and tax relief to boost economic activity

and prevent deflation.

Challenges of Using Fiscal Policy During Deflation

While fiscal policy is a powerful tool, it also has some challenges:

• Increasing Government Debt: More spending means the government borrows more money,

leading to higher national debt.

• Time Lag: Implementing fiscal policies takes time, and the effects may not be immediate.

• Inflationary Risks: If too much money is pumped into the economy, it may lead to inflation

(too much increase in prices).

• Political Constraints: Governments may face political opposition in increasing spending or

reducing taxes.

Conclusion

Deflation is harmful to an economy as it reduces demand, lowers wages, and increases

unemployment. Fiscal policy plays a crucial role in combating deflation by increasing government

spending, reducing taxes, and providing direct financial support. By implementing these measures,

the government can boost demand, encourage investment, and restore economic growth.

However, careful planning is needed to ensure that fiscal policies are effective without leading to

excessive debt or inflation. History has shown that well-designed fiscal policies can successfully pull

economies out of deflation and set them on a path to recovery.

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