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Question Paper Economics – II : April 2002

Part A : Basic Concepts (30 Points)

• This part consists of questions with serial number 1 - 30.

• Answer all questions.

• Each question carries one point.

• Maximum time for answering Part A is 30 Minutes.

1. The IS curve shows

a. A positive relationship between rate of interest and level of income b. A negative relationship between rate of interest and level of income c. A positive relationship between rate of interest and level of investment d. A negative relationship between rate of interest and level of investment e. A positive relationship between level of income and level of investment.

2. Laffer curve shows the relationship between

a. Price level and unemployment b. Tax rates and tax revenue c. Interest rate and income level d. Income and money supply e. Demand for money and supply of money.

3. The LM function is Y = 500 + 20i. Which of the following combinations of interest and income does not represent a point on the LM curve?

a. i = 2% and Y = 460 b. i = 5% and Y = 600 c. i = 7% and Y = 640 d. i = 10% and Y = 700 e. i = 4% and Y = 580.

4. Money earned abroad and remitted to home country is

a. Included in home country GDP b. Included in home country GNP c. Included in both home country GDP and GNP d. Excluded from both home country GDP and GNP e. Included in home country GDP but excluded from home country GNP.

5. The basic difference between money stock measures M3 and M4 is that

a. M3 is more than M4 b. M2 is part of M3 where as M2 is not part of M4 c. M3 is part of M1 and M4 is not part of M1 d. M4 includes all post office deposits, where as in M3 these are not included e. M1 is part of M4 where as M1 is not part of M3.

6. GDP at factor cost exceeds GDP at market price

a. When the net factor income from abroad is negative b. When the net factor income from abroad is positive c. When depreciation of fixed capital exceeds gross investment d. When direct taxes exceed indirect taxes e. When subsidies exceed indirect taxes.

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7. National Income is

a. NDP at market prices b. NNP at market prices c. NDP at factor cost d. NNP at factor cost e. GNP at market price.

8. Which of the following is not a stock variable?

a. Foreign exchange reserves b. Public debt c. Wealth of a country d. Inflation e. Money supply.

9. If interest elasticity of demand for investment and consumption is zero

a. Equilibrium income depends solely on the position of LM curve b. Equilibrium income depends solely on the position of IS curve c. There is no speculative demand for money d. Speculative demand for money is infinity e. Fiscal policy is totally ineffective in changing any of the real variables.

10. ‘Liquidity trap’ refers to a situation wherein

a. There is too much liquidity in the economy b. The firms in the economy are facing credit crunch c. Interest rates does not decrease, no matter how much the money supply is expanded d. The country faces severe shortage of foreign exchange e. Excessive government borrowing reduces the availability of credit in the market.

11. Which of the following is an example of a government transfer payment?

a. Salary paid to a soldier b. Purchase of a new car for the Ministry of Finance c. Funding of a clinic to provide free vaccinations d. Free food coupons issued to persons in an antipoverty program e. Funding of a new bridge in an urban area.

12. Which of the following is true if the Central Bank reduces the Reserve Ratio?

a. Money supply and loans given by commercial banks will decrease b. Money supply will decrease while loans given by commercial banks will increase c. Money supply and loans given by commercial banks will increase d. Money supply will increase while loans given by commercial banks will decrease e. Money supply will remain unaffected while the loans given by the commercial banks

will decrease.

13. Personal income includes all of the following except

a. Transfer payments b. Undistributed corporate profits c. Personal income taxes d. Dividend payments e. Personal savings.

14. Transaction demand for money

a. Varies positively with income and rate of interest. b. Varies positively with income and inversely with rate of interest. c. Varies inversely with income and positively with rate of interest. d. Varies inversely with income and rate of interest. e. Varies inversely with income but less than proportionately with rate of interest.

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15. Which of the following transactions is included in the current account balance of the balance of payments statement?

a. Foreign direct investments b. Portfolio investments c. External commercial borrowings d. Dividends earned on portfolio investments e. External assistance.

16. In an economy, transaction demand for money is 500. The speculative demand for money is estimated to be 250-5i. If Central Bank of the country aims at an interest rate (i) of 10 percent, money supply should be

a. 200 b. 550 c. 700 d. 750 e. 800.

17. In a two-sector economy, the marginal propensity to consume (MPC) is estimated to be 0.6. To bring about a 500 billion change in equilibrium national income (Y), the required increase in corporate investment (I) is

a. 125 billion b. 200 billion c. 240 billion d. 300 billion e. 360 billion.

18. The following information is extracted from National Income Accounts of an economy:

Investment by business sector = 100 Corporate profit tax = 50 Dividends paid by the business sector = 15 Retained earnings = 20

Corporate profits for the economy is

a. 20 b. 35 c. 85 d. 150 e. 185.

19. Savings function of an economy is S = – 300 + 0.25 Yd. Break-even disposable income for the economy is

a. 75 b. 300 c. 900 d. 1200 e. 1500.

20. The following data is available for an economy for the year 2000-01:

Rs. crore Primary issues 50,000 Secondary issues 30,000 Net physical capital formation 1,50,000 National income 3,00,000

Finance ratio for the economy is

a. 0.27 b. 0.53 c. 1.67 d. 3.00 e. 5.00

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21. Financial Inter-relations ratio is

a. The ratio of total financial claims issued during a year to the national income for the year

b. The ratio of primary issues by the non-financial sector to total physical asset formation c. The ratio of volume of financial instruments issued by financial intermediaries during a

period to the volume of primary issues by the non-financial sector d. The ratio of the total stock of financial assets at a point of time to the stock of physical

assets e. Ratio of total financial claims to total physical asset formation.

22. The real rate of interest

a. Equals the nominal rate plus the rate of inflation b. Equals the rate of inflation minus the nominal rate c. Equals the nominal rate minus the rate of inflation d. Tends to increase when inflation rises e. Is more relevant to investors than consumers.

23. A current account deficit implies that

a. There is net debit balance in the merchandise account. b. There is net credit balance in the merchandise account. c. Foreign exchange outflows on account of imports of goods and services and gifts made

exceed inflows on account of exports of goods and services received. d. Decrease in Foreign Exchange Reserves. e. Increase in Foreign Exchange Reserves.

24. Assume that the average MPC for a community is 2/3. If reducing the tax burden of the poorest 10% of the population were to increase the community’s disposable income by Rs.100,000, then you would expect to see

a. An increase in spending of less than Rs.66,667. b. An increase in spending of Rs.66,667. c. An increase in spending of more than Rs.66,667. d. An increase in spending of Rs.33,333. e. An increase in spending of more than Rs.33,000 but less than Rs.66,667.

25. If transfer payments are increased, which of the following is true of I-S curve?

a. I-S curve will shift to the left b. Slope of the I-S curve will increase c. I-S curve will shift to the right d. Slope of the I-S curve will decrease e. I-S curve will not be affected.

26. The current level of income is 200. Full employment income level is 225. If the marginal propensity to consume is 0.75 and there is a proportional income tax of 20%, to bring about full employment, the government spending

a. Should be increased by 10 b. Should be decreased by 10 c. Should be increased by 25 d. Should be decreased by 25 e. None of the above.

27. Which of the following is not correct?

a. NNP + Indirect taxes = National Income b. GNP = NNP + Depreciation c. Saving + Taxes = Investment + Government spending d. Personal income = Disposable income + Personal taxes e. Gross investment = Net Investment + Depreciation.

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28. In an inflationary period, the appropriate policy for the RBI would be to a. Sell government securities in the open market b. Encourage commercial banks to increase their loans c. Reduce Cash Reserve Ratio d. Reduce bank rate e. Extend credit to government.

29. From the following information, compute personal savings:

Personal income = Rs.10,000 Personal taxes = Rs. 3,000 Dividends = Rs. 200 Depreciation = Rs. 1,250 Consumption = Rs. 6,000

a. Rs. 4,000 b. Rs. 4,200 c. Rs. 7,000 d. Rs. 7,200 e. None of the above.

30. The following information relates a hypothetical economy:

Rs. in crore Consumption 500 Investment 170 Government expenditure 140 Money supply 162

The velocity of money in the economy is

a. 2.0 b. 3.0 c. 3.3 d. 5.0 e. 6.0

END OF PART A

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Part B : Problems (50 Points)

• This part consists of questions with serial number 1 – 5.

• Answer all questions.

• Points are indicated against each question.

• Detailed workings should form part of your answer.

• Do not spend more than 110 - 120 minutes on Part B.

1. The following information is extracted from the National Income Accounts of an economy:

Million units of currency (MUC)

Factor incomes received by domestic residents from Business sector 500 Foreigners 20 Gross Investment 200 Business Savings 25 Net Investment 150 Subsidies 10 Corporate Profit taxes 15 Personal Income taxes 100 Net factor income from abroad –5 Budget Deficit 10 Net transfer to household sector 7 Consumption Expenditure 319 Indirect taxes 70

You are required to find:

a. Gross Domestic Product at Market Prices.

b. National Income.

c. Current Account Balance.

(4 + 3 + 4 = 11 points)

2. The following information is taken from Union Budget for the year 2002 – 03: (Rs. crore)

Revenue Receipts Tax Revenue (Net) 1,72,965 Non-tax Revenue 72,140 Capital Receipts Recoveries of Loans 17,680 Other Receipts 12,000 Borrowings & Other Liabilities 1,35,524 Non-plan Expenditure On Revenue Account 2,70,169 (Of which, interest payments is Rs.1,17,390 crore) On Capital Account 26,640 Plan Expenditure On Revenue Account 70,313 On Capital Account 43,187

Required: a. Find the Fiscal Deficit, Revenue Deficit and Primary Deficit b. Comment on the significance of these deficits. c. For the economy money multiplier is estimated to be 3. If government plans to monetize 10% of the

fiscal deficit, what would be the impact on money supply?

(6 + 3 + 3 = 12 points)

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3. The consumption function estimated for an economy is

Ct = 80 + 0.6 dtY + 0.2 Ct – 1

If dtY increase by 100 and remains at that level, find the change in steady state level of consumption.

(4 points) 4. The following relations are estimated for an economy:

Savings function (S) = – 380 + 0.35 Yd + 10i

Tax function (T) = 0.30Y

Investment function (I) = 300 + 0.15Y – 50i

Transfer payments (R) = 200

Government Expenditure (G) = 1200

Exports (E) = 900

Import function (M) = 50 + 0.105Y

Money Supply (Ms) = 1000

Transaction Demand for Money (Mt) = 0.25Y

Speculative Demand for Money (Ma) = 350 – 100i

(All macroeconomic aggregates are in million units of currency (MUC) and the rate of interest is in percentage.)

Required: a. Compute the equilibrium level of income and rate of interest

b. The government desires to have an increase in the equilibrium output by 10% in the next period and for this purpose, the following alternatives are under consideration

i. Increase in government expenditure (G)

ii. Increase in money supply (Ms)

Compute the required increase in G and Ms to achieve the objective of the government.

c. Compute the impact of the two alternative measures in (b) above on private investment.

(6 + 5 + 3 = 14 points) 5. The following balances are taken from balance sheet of the Central Bank of a country.

Particulars Million units of currency (MUC) Credit to Government 7,000 Credit to Banks 4,000 Government Deposits 500 Other non-monetary liabilities 25 Net worth 1,000 Credit to commercial sector 2,000 Net foreign exchange assets 11,000 Other assets 100 Deposits of banks 6,000 Other Deposits 600

The currency/deposit ratio has been ascertained as 0.24. Reserve ratio imposed by the central bank is 7%. The amount of Government money is 25 million units of currency. Required: a. Find the money supply in the economy b. Because of intervention in the foreign exchange market, net worth of the central bank is expected to

erode by 50% in the next period. If the Central bank desires to maintain the current level of money supply by changing the reserve ratio, what should be the new reserve ratio?

(6 + 3 = 9 points)

END OF PART B

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Part C : Applied Theory (20 Points)

• This part consists of questions with serial number 6 - 8.

• Answer all questions.

• Points are indicated against each question.

• Do not spend more than 25 -30 minutes on Part C.

6. Discuss the Keynesian approach to demand for money.

(6 points)

7. Briefly discuss the ratios used to measure the financial development of an economy.

(6 points)

8. Write short notes on the following:

a. Demand-Pull Inflation

b. Current Account.

(4 + 4 = 8 points)

END OF PART C

END OF QUESTION PAPER

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Suggested Answers Economics – II : April 2002

Part A : Basic Concepts

1. Answer : (b)

Reason : IS curve shows various combinations of rate of interest and level of income where the goods market is in equilibrium. There is a negative relation between rate of interest and level of income because of negative relation between rate of interest and consumption and investment expenditure.

2. Answer : (b)

Reason : Laffer curve shows the relationship between tax rates and tax revenue.

3. Answer : (a)

Reason : LM function Y = 500 + 20i

If, i = 10%, Y = 500 + (20 × 10) = 700

i = 7%, Y = 500 + (20 × 7) = 640

i = 5%, Y = 500 + (20 × 5) = 600

i = 4%, Y = 500 + (20 × 4) = 580

i = 2%, Y = 500 + (20 × 2) = 540

Hence, (a) does not fall on the IS curve.

4. Answer : (b)

Reason : Money earned abroad and remitted to home country is factor income received from abroad, which is included in GNP of the home country and GDP of the host country.

5. Answer : (d)

Reason : M2 = M1 + Post office savings Bank Deposits

M3 = M1 + Time Deposits

M4 = M3 + All post office deposits.

∴ The answer is (d).

6. Answer : (e)

Reason : GDPFC = GDPMP – Indirect taxes + Subsidies

∴ If GDPFC > GDPMP, Subsidies > Indirect taxes

7. Answer : (d)

Reason : NNPFC is also called a National Income.

8. Answer : (d)

Reason : A variable is defined as a stock variable if it is measured at a point of time and as a flow variable if it is measured over a period of time. Of all the variables listed, only inflation is measured over a period of time and hence is a flow variable.

9. Answer : (b)

Reason : If interest elasticity of demand for investment and consumption is zero, IS curve is

Y = )t1(b1

A

−−

Hence, equilibrium income depends on the position of IS curve only.

Y

IS LM

i LM1

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10. Answer : (c)

Reason : Liquidity trap is a situation where the demand for money is infinitely elastic. At the current interest rate the public is willing to absorb any amount of money. Hence, increase in money supply will not decrease the rates of interest. Other options are not correct.

11. Answer : (d)

Reason : Transfer payments are payments which do not have any production activity associated with the payment and are not considered as income in National income accounting. In the given examples food coupons are issued free of cost and hence a transfer payment. All other payments involve some production activity for the period under consideration.

12. Answer : (c)

Reason : As reserve ratio (r) is reduced banks will be left with more reserves on the basis of which they can lend more thereby creating additional demand deposits (DD). As demand deposits increase money supply also increase as DD is a significant component of the money supply

13. Answer : (b)

Reason : Undistributed corporate profits are retained earnings (RE) by the business sector. Even though RE are part of national income, this does not go into the hands of household sector. Hence personal income does not include undistributed corporate profits. All other items are part of personal income.

14. Answer : (b)

Reason : Money demanded to settle transactions is called transaction demand for money (Mt). One of the important determinants of Mt is level of income. As income increases the consumption expenditure increases and the amount of money demanded to settle transactions also increase. Another variable influencing Mt is rate of interest. Since rate of interest is also cost of holding money people tend to economize on their holdings of money as rate of interest increase.

15. Answer : (d)

Reason : Dividends on portfolio investments is an income earned by a factor of production (capital). This is included in Income under Invisibles in Current Account. All other items are part of capital account.

16. Answer : (c)

Reason : Transaction demand for money = 500

Speculation demand for money = 250 – (5 × 10) = 200

Demand for money = 500 + 200 = 700

∴ Money supply = 700.

17. Answer : (b)

Reason : MPC = 0.6

Multiplier (m) = 5.24.0

1

6.01

1

MPC1

1==

−=

−

∆Y = m . ∆I

∴ ∆I = 5.2

500

m

Y=

∆ = 200

18. Answer : (c)

Reason : Corporate profits = Corporate profit tax + Dividends + Retained earnings

= 50 + 15 + 20 = 85

19. Answer : (d)

Reason : At break-even level of disposable income, savings are zero.

∴ S = –300 + 0.25Yd = 0

0.25 Yd = 300

Yd = 25.0

300 = 1200.

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20. Answer : (a)

Reason : Finance ratio (FR) = incomeNational

issuesTotal

Total issues = Primary issues + Secondary issues

= 50,000 + 30,000 = 80,000

∴ FR = 000,00,3

000,80 = 0.27

21. Answer : (d)

Reason : FIR = Financial assets / Physical assets (or) Total Issues / Net physical capital formation

22. Answer : (c)

Reason : Nominal rate of interest = real rate of interest + inflation. Therefore the answer is (c).

23. Answer : (c)

Reason : Current account captures the transactions related to trade in goods and services, transfer payments and factor incomes. If foreign exchange out flow on account of these is more than inflows, the current account is in deficit.

24. Answer : (c)

Reason : Average MPC = 2/3. For poorest 10% if the population MPC > 2/3.

∴ If Yd of this segment increase by Rs.1,00,000, consumption expenditure would increase by > 2/3 × 1,00,000, i.e. > Rs.66,667.

25. Answer : (c)

Reason : If transfer payments are increased IS curve will shift to the right as autonomous expenditure in the economy increase.

26. Answer : (a)

Reason : Multiplier (m) = 5.240.0

1

)20.01(75.01

1

)t1(MPC1

1==

−−=

−−

∆Y = 25

∆G = 5.2

25

m

Y=

∆ = 10.

27. Answer : (a)

Reason : National income = NNPMP – indirect taxes + subsidies. Therefore, answer is (a). All other relations are correct.

28. Answer : (a)

Reason : It would be appropriate for the RBI to pursue a contractionary monetary policy during a period of inflation. Through contractionary monetary policy RBI would like to moderate the aggregate demand in the economy thereby causing the prices to fall. Of all the options, only open market sale of government securities is a contractionary monetary policy. All other options are expansionary monetary policies.

29. Answer : (e)

Reason : Personal savings = Personal income – Personal tax – Personal consumption

= 10,000 – 3,000 – 6,000 = Rs.1,000.

30. Answer : (d)

Reason : Velocity of money = (M)supplyMoney

e(PY)expenditurTotal

Total expenditure = C + I + G = 500 + 170 + 140 = 810

∴ Velocity of money = 162

80 = 5.

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Part B : Problems

1. a. GDPMP = Factor income paid to domestic residents by the production sector + Factor income paid to foreign residents by the production sector + Business savings + corporate profit tax + Depreciation + Indirect taxes – subsidies.

Depreciation = (Gross investment – Net investment)

= 200 – 150 = 50

Factor income paid abroad = Factor income received from abroad – NFIA

= 20 – (– 5) = 25

∴ GDPMP = 500 + 25 + 25 + 15 + 50 + 70 – 10 = 675

b. NI = GDPMP – Indirect taxes + subsidies – Depreciation + NFIA

= 675 – 70 + 10 – 50 + (–5)

= 560

c. CAB = Domestic savings (DS) – Domestic Investment (DI)

DS = Business savings + Government savings + Household savings.

Household savings = Personal Disposable income – Personal consumption

PDI = NI – Business savings – corporate profit tax + net transfers – Personal income tax

PDI = 560 – 25 – 15 + 7 – 100

= 427

∴ PS = 427 – 319

= 108

∴ CAB = (25 – 10 + 108) – 150

= – 27

∴ Current account deficit = 27.

2. a. Fiscal Deficit = Borrowings and other liabilities

= Rs.1,35,524 Cr

Revenue Deficit = Revenue expenditure – Revenue Receipts

Revenue Expenditure = Non-plan revenue expenditure + plan revenue expenditure

= 2,70,169 + 70313

= Rs.3,40,482 Cr

∴ Revenue Deficit = 3,40,482 – (1,72,965 + 72,140)

= Rs.95,377 Cr.

Primary Deficit = Fiscal Deficit – Interest payments

= 135,524 – 117,390 = Rs.18,134 Cr.

b. Fiscal deficit signifies the net addition to the public debt for the current year.

Revenue deficit signifies the amount of borrowings required to finance current consumption expenditure of the government.

Primary deficit indicates the discretionary component of fiscal deficit. This is because of committed nature of interest payments.

c. Fiscal Deficit = Rs.1,35,524 Cr. 10% of fiscal deficit = Rs.13552.4 Cr. Monetization of deficit directly increase the high powered money in the economy ∴∆H = Rs.13552.4 Cr. ∆Ms = m. ∆H = 3 × 13552.4 = Rs.40657.2

∴ Monetization of 10% of the fiscal deficit would increase the money supply by Rs.40657.2 Cr.

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3. Ct = 80 + 0.6 Y dt + 0.2 Ct – 1

At steady state, tC = Ct – 1

∴ Ct = 80 + 0.6 Y dt + 0.2Ct

0.8 Ct = 80 + 0.6 Y dt

Ct = 100 + 0.75 Y dt

∆Ct = 0.75 × ∆ Y dt

= 0.75 × 100

= 75

∴ If Y dt increase by 100, steady state level of consumption increase by 75.

4. a. S = – 380 + 0.35 Yd + 10i

C = 380 + 0.65Yd – 10i

Yd = (Y – tY + R)

= (Y – 0.3Y + 200)

∴ C = 380+ 0.65 (Y – 0.3Y + 200) – 10i

= 510 + 0.455Y – 10i

IS function Y = C + I + G + (E – M)

= 510 + 0.455Y – 10i + 300 + 0.15Y – 50i + 1200 + 900 – 50 – 0.105Y

Y = 2860 + 0.5Y – 60i

Y = 5.0

i602860 − = 5720 – 120i IS functions

LM function Ms = Md

Md = Mt + Ma

= 0.25Y + 350 – 100i

∴ 1000 = 0.25Y + 350 – 100i

Y = 25.0

i100650 + = 2600 + 400i LM function

At equilibrium LM = IS

2600 + 400i = 5720 – 120i

520i = 3120

i = 6%

Y = 5000.

b. If Y is to increase by 10% new equilibrium income is 5000 (1 + 0.10) = 5500

Option I: Increase in G Y = 2600 + 400i LM function

If Y = 5500

400i = 5500 – 2600

i = 400

2900 = 7.25%

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IS function with G as a variable is

Y = (2860 – 1200 + G) + 0.5Y –60i

Y = 5.0

)i60G1660( −+

Y = 3320 + 2G – (120 × 7.25)

2G = 3050

G = 1525.

∴ Increase in G = 1525 – 1200 = 325.

Option II: Increase in Money Supply Y = 5720 – 120i IS function

If Y = 5500,

120i = 5720 – 5500

i = 1.83%

Ms = 0.25Y + 350 – 100i LM function

If Y = 5500 and i = 1.83%

Ms = (0.25 × 5500) + 350 – (100 × 1.83)

= 1542

c. Increase in G:

Change in Investment (∆I) = I1 – I0

I1 = 300 + (0.15 × 5500) – (50 × 7.25)

= 762.50

I0 = 300 + (0.15 × 5000) – (50 × 6.0)

= 750

∴∆I= 762.50 –750

= 12.50

Increase in Money Supply

∆I = I1 – I0

I1 = 300 + (0.15 × 5500) – (50 × 1.83)

= 1033.50

I0 = 750

∆I = 1033.50 –750

= 283.50

5. a. High powered money = Monetary Liabilities of RBI + Government Money

Monetary liabilities of RBI = Financial Assets + Other Assets – Non-monetary liabilities

Financial Assets = Credit to Government + Credit to Banks + Credit to commercial sector + Net Foreign exchange assets

= 7000 + 4000 + 2000 + 11000

= 24000

Other Assets = 100

Non-monetary liabilities = Government deposits + other non-monetary liabilities + Net worth

= 500 + 25 + 1000 = 1525

∴ Monetary liabilities = 24000 + 100 – 1525 = 22575

Government money = 25

∴ High powered money (H) = 22575 + 25 = 22600

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Money Supply = H × m

Money multiplier (m) = rC

C1

u

u

++

= 07.024.0

24.01

++

= 31.0

24.1 = 4

∴ Money Supply in the economy = 22600 × 4

= 90400 MUC

b. If networth is eroded by 50%, Net worth = 500 MUC.

∴ Monetary liabilities = 22575 + 500 = 23075

H = 23100.

If money supply is held constant,

90400 = 23100

+ r24.0

24.1

r = 24.024.190400

23100−

×

= 0.0769

= 7.69%

∴ The central bank should increase the reserve ratio to 7.69%.

Part C: Applied Theory

6. THE KEYNESIAN APPROACH TO DEMAND FOR MONEY

According to the classical view, transaction is the only motive for holding money. It held that money is demanded only for spending purposes. Keynes recognized that money was held for other reasons too. In his view, money would be held as an asset, a non-interest-paying asset, whereby velocity is affected and tends to change. According to him the three motives for holding money are transactions, precaution and liquidity or speculation.

Transactions Demand for Money: The most obvious reason for holding money is to spend it. Money provides us with instant purchasing power. An individual needs to hold some money in order to carry out routine transactions such as paying for groceries, monthly house payments, bus fares, paying electricity bills and so on. Similarly firms hold transactions balances to meet routine payments such as wages, purchase supplies, and so on. The transactions demand for money arises because payments and receipts are not perfectly synchronized i.e. income is not received at the time purchases are to be made or purchases are not made at the same time of receipt of income. So, money balances are held or demanded to bridge the gap between everyday expenses and the pay day.

Precautionary Demand for Money: The demand for precautionary balances broadly represents money that is held as a precaution against some unforeseen events such as medical emergency, an accident, etc. Generally individuals and firms who are uncertain about the future hold additional cash as a precaution against such uncertain circumstances. However, precautionary balances are also held as a cushion against uncertainty about the amount and timing of the receipts. Firms, in particular, are not always certain when they will receive payment for sale of goods. Unexpected interruption in receiving payments makes it difficult for the firms to make purchases. To minimize such problems firms and individuals hold precautionary balances.

Speculative Demand for Money: The third motive for holding money is the speculative motive. Individuals and firms may want to maintain part of their wealth in the form of money to take advantage of price reduction. Speculation may also be on the price of stock and bonds. If the money holder feels the prices of the securities are too low, he may expect a rise in prices. In this case, our speculator would no longer hold money; the securities would be bought and held. On the other hand, if he expects a decline in the prices of securities, he prefers money to bonds. Thus, the speculative demand for money changes with the change in the prices of securities and earnings possible.

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As security prices are linked to interest rates and move inversely proportional to a change in interest rates, we can say that with a rise in interest rates, prices of securities fall and the speculative demand for money also comes down. On the other hand if interest rates fall, securities prices rise and demand for speculation purposes also rises. Thus, speculative demand is inversely proportional to the rate of interest as shown in the Figure 1.

Figure 1

The total demand for money is the sum of the transactions demand, precautionary demand and speculative demand. As money is held for transactions and precautionary purposes with the intention of spending as and when necessary, the demand for such money is referred to as demand for active balances. Money held for these purposes is not influenced by interest rates. Figure 2 shows demand for these active balances.

Figure 2

Speculative demand for money, on the other hand, is highly responsive to changes in interest rates. Money held for speculative demand is held as an asset rather than as something to spend and as such is referred to as the demand for idle balances.

Combining the demand for active balances and the demand for idle balances gives the overall demand for money as shown in Figure 3.

Figure 3

Thus, as per the Keynesian Approach, transactional and precautionary balances are greatly determined by income levels whereas speculative demand for money is highly influenced by interest rates.

7. Financial Development A well developed financial system is very essential for the smooth functioning of any economy. One set of important statistical indicators that is used to look at the financial development of a country is financial development ratios.

An economy can be broadly divided into financial and non-financial sectors. Financial sector consists of banks and other financial institutions. Business of the financial sector is financial intermediation, that is channeling resources from surplus sectors (savers) in the economy to the deficit sectors (borrowers) in the

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channeling resources from surplus sectors (savers) in the economy to the deficit sectors (borrowers) in the economy.

Non-financial sector consists of household sector, private corporate business, government and the rest of the world. In the non-financial sector there are surplus spenders (savers) and deficit spenders (borrowers). Within household sector some households may have savings and someone else may have to borrow. On the whole the household sector may have net savings which can be lent to others sectors like corporate or government which is in need of funds. This way there are intra and inter-sectoral flows of funds in an economy.

Flow of funds can take place in two forms. One is that the surplus and deficit spenders can interact directly. That is deficit spenders directly borrow from surplus spenders by issuing claims on themselves. The other form is through financial intermediation. Here financial intermediaries mobilize the funds from surplus spenders and lend them to deficit spenders.

The claims issued in an economy can be classified into primary or secondary issues. Primary issues are claims issued by deficit spenders directly to the surplus spenders. Primary issues are also called new issues. Secondary issues are claims issued by financial sector. Total issues in an economy consist of both primary and secondary issues.

Volumes of these financial flows can be used to define various ratios of financial development. These ratios are (i) Finance Ratio, (ii) Financial Interrelations Ratio, (iii) New Issue Ratio and (iv) Intermediation ratio.

Finance Ratio (FR): It is defined as the ratio of total financial claims issued during the year to national income of that year. This captures the relation between financial development and overall economic development and indicates the financial deepening.

Financial Interrelations Ratio (FIR): FIR is the ratio of financial claims issued to net physical capital formation. This captures the relation between financial development and the growth of physical investment. Sometimes it is calculated as the ratio of the total stock of financial assets to the stock of physical assets at a point of time.

New Issue Ratio (NIR): NIR is the ratio of primary (new) issues by the non-financial sector to the net physical capital formation. This is a measure of ‘financial disintermediation’. This indicates the extent to which non-financial sectors are financing their investment by borrowing directly from the ultimate savers rather than through the financial intermediaries.

Intermediation Ratio (IR): This is the ratio of secondary issues to primary issues i.e. claims issued by financial institutions to issues of non-financial sectors. This indicates the degree of financial intermediation.

8. a. Demand-Pull Inflation

One explanation for the inflation runs in terms of generalized excess demand, sometimes loosely and not very accurately described as “too much money chasing too few goods”. According to this explanation, the general rise in the price level is because the demand for goods and services exceeds the supply available at existing prices. In terms of AD-AS framework, the rightward shift in the AD curve means an excess demand for goods and services at existing prices.

In figure above, the AD increases to Y1 from Y0 because of the shift in the AD0 curve to AD1. But at

the price level P0, the AS is Y0. Therefore, the excess demand is Y1 – Y0. To eliminate the excess

demand, the price level increases to P1, where the AD and AS are equal at Y2.

The factors causing a shift in the AD can be classified into real and monetary factors. Among the real factors are fiscal actions like changes in the government spending and taxes. Among the monetary factors are changes in the money supply.

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The Real Factors: The real factors which can cause a rightward shift in the AD curve are – an increase in government expenditure with no change in the tax receipts, a decrease in the tax receipts with no change in the government spending, a rightward shift in the consumption function, investment function or export function.

The Monetary Factors: On the monetary side, demand-pull inflation may originate either through a decrease in the demand for money or an increase in the supply of money. As we discussed with IS-LM curves, a decrease in the demand for money or an increase in the money supply will shift the LM curve towards right causing a rightward shift in the AD curve. In reality a decrease in the demand for money is not likely to originate an inflation, but it is almost certain to intensify an ongoing inflation that has reached a rapid rate. The greater the rate of inflation, the costly it becomes to hold money, and the smaller the amount of real balances the public will want to hold at any level of real income and any interest rate. The velocity of money increases, which acts on the price level like an increase in the supply of money. But rapid increase in the money supply is a source of excess demand which can originate an inflation.

b. Current Account The Current Account records the transactions in merchandise and invisibles with the rest of the world. Merchandise covers exports and imports of all movable goods, where the ownership of goods changes from residents to non-residents and vice versa. Therefore Current Account captures the effect of trade link between the economy and rest of the world.

The merchandise trade values exports on f.o.b. (Free on Board) basis and are shown as credit items and the imports valued on c.i.f. (Cost Insurance and Freight) basis are the debit items. However, the IMF Balance of Payments manual provides guidelines for compilation of the BoP statistics prescribing the valuation of both exports and imports on f.o.b. basis.

The item Invisibles includes travel, transportation, insurance, investment income, and other miscellaneous items. The credit under the Invisibles comprises the value of services rendered by residents to non-residents. The income earned by residents on ownership of financial assets (investment income), use of non-financial assets (property income) and other receipts in cash or kind without a quid pro quo (transfer payments) are all recorded as credits. Similar remittances made by residents to non-residents are recorded as debits.

G.n.i.e. implies government not included elsewhere. A credit entry of the G.n.i.e. includes items like: funds received from a foreign government for the maintenance of their embassy, consulates, etc. in India. Under the heading ‘Miscellaneous’, payment to a foreign technical consultant for professional services rendered by him will appear as a debit item.

Transfers may be of two types: official and private. A debit entry under the heading Official Transfers constitute items like revenue contributions by the government of India to international institutions or any transfer (even in the form of gifts) of commodities by the government to non-residents. Private transfers include items like, cash remittances by non-resident Indians for their family maintenance in India.