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X II
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factors of production namely, land, labour, capital and entrepreneur. The output
emerging from production is distributed in the form of money income i.e. rent,
wages, interest and profit, on the basis of contribution of each individual factor of
production. The economy needs to decide the best suitable mechanism for
distribution - to reduce inequality of income, to reduce poverty , to add to the
social welfare and standard of living of people.
Marginal opportunity cost - The amount of other good which has been given up
(scarified) in order to produce an additional unit of a good is called marginal
opportunity cost.
Economy is a system in which and by which people get their living. In other
words it’s a framework within which all the economic activities of a country take
place.
Commodity A
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Characteristics of PPC-
i) PPC is downward sloping- PPC assume that all the resources in the economy
are fully and efficiently utilized so in order to increase the production of one
good economy has to decrease the production of other good. Thus it is
downward sloping.
ii) PPC is concave to origin –PPC is concave to origin because of increasing
Marginal rate of transformation (MRT) / Marginal opportunity cost (MOC).
Marginal rate of transformation (MRT) increases because it assumes that all the
resources are not equally efficient to produce all the goods. Therefore, as
resources are transferred from one good to another good, less and less efficient
resources are transferred it increases the cost and MRT.
10.What do you mean by Utility? Briefly explain the concept of Total utility,
Marginal Utility and Average Utility with the help of an examples.
Ans: - Utility - The want satisfying power of a commodity is called utility.
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Average Utility- It is the utility per unit of a commodity consumed which can be
obtained by dividing total utility by number of units of commodity consumed.
TU
AU
Q
E.g.- Suppose by consuming 10 units of a commodity total amount of satisfaction
derive is 50. Then AU will be as follows-
TU
AU
Q
50
10
=5
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In above table and diagram, when consumer will purchase 3 units of commodity X
he will reach an equilibrium position because the condition of consumer’s
equilibrium MUX (in ) = PX is satisfied. At this level of consumption, the
marginal utility of X is equal to the price of commodity X i.e. 4.
If he purchases less than 3 units say 2 units then the marginal utility derived from
2 units is 6 and the price which he pays is 4.Since his MUX > PX .Therefore he
will purchase more quantity of commodity X and vice versa.
Hence consumer will be in equilibrium only at that point where MUX = PX.
16. Briefly explain the concept of Budget Set. Write the equation of budget
set.
Ans: - Budget Set- It refers to all the bundles or set of bundles available to the
consumer with given price and given income.
In other words, it is the collection of all the bundles that consumer can purchase
with his given income at the prevailing market prices.
Budget constraint- It shows that a consumer can choose any bundle as long as it
costs less or equal to income.
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Let
X1 be the amount of good 1. X2 be the amount of good 2.
P1 be the price of good 1. P2 be the price of good 2.
P1X1 = Total money spent on good 1 P1X2 = Total money spent on good 2
M is total income
Thus P1X1 + P2X2 ≤ M will be the equation of budget set.
17. Define Budget line. Give the formula for calculating the slope of the
budget line. Briefly explain the factors that cause changes in the Budget line.
Ans: - Budget line - It’s a line which shows various combinations of two goods
which a consumer can purchase with his given income and given prices of the
goods.
The equation of budget line is P1X1 + P2X2 = M
We can derive budget line with help of an example as under-
Suppose consumer income is 20 and price of good X is 4 and price of good Y is
2. Then the different combinations of two goods which consumer will be able to
purchase by spending his entire income will be as follows-
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The budget line has negative slope or it is downward sloping which indicates that
the consumer can purchase extra units of one commodity only by sacrificing some
units of other good
Changes in the Budget line - The factors which cause change in budget line are-
a) Change in consumer Income - If consumer income increases, then he can
purchase more quantities of both the goods. Therefore, budget line of consumer
shifts rightward and vice versa.
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19. What do you mean by demand and Market Demand? Explain the
determinants of demand for a commodity.
Ans: - Demand - The quantity of a commodity which a consumer wish to
purchase at given price and given period of time is called demand.
Market demand- The quantity of a commodity which all the consumers in the
market wish to purchase at a given price and given period of time is called market
demand.
Determinants of demand- The main determinants of demand for a commodity
are as follows-
i) Price of the commodity- When the price of a commodity increases the demand
for that commodity decreases and vice versa. It means there is inverse relationship
between price of commodity and quantity demanded.
ii) Income of the consumer - The income of consumer affects the demand of
commodity as follows-
The demand for normal goods tends to increase with increase in consumer income
and vice-versa. On the other hand, the demand for inferior goods tends to decrease
with increase in consumer income and vice-versa.
iii) Taste and preferences- When taste and preferences are in favour of the
commodity demand for commodity increases and vice versa.
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20. Explain the law of demand with the help of a demand schedule and
demand curve.
Ans: - Law of demand- This law states that other things remain constant a
consumer purchases more quantity of a commodity at lesser price and less quantity
at higher prices. It means there is inverse relationship between price of commodity
and quantity demanded.
Assumptions of law of demand - (Other things remain constant)
No change in consumer’s income.
No change in prices of other related goods.
No change in taste and fashion.
No change in future expectation regarding change in price of commodity
Explanation of law-
We can explain it with the help of following schedule and diagram:
The above schedule and diagram show that as price falls quantity demanded rises.
Hence prove the law of demand.
Substitute goods are those goods, which can be used in place of each other. E.g.
coffee and tea. An increase in the price of a substitute good (Coffee) causes an
increase in the demand for the commodity (Tea). This will cause rightward shift of
demand curve and vice versa.
Complementary goods are those goods, which are used with each other. E.g. car
and petrol etc. In case of complementary goods, the demand for a commodity
raises with the fall in the price of other commodity. If the price of the car falls its
demand will rise, then the demand for petrol will also rise. This will cause a
rightward shift of demand curve of given commodity and vice versa.
Y Y
D1 D1
Price D Price D
Rise in price of Fall in price of
D2 substitute good D2 complementary good
Fall in price of
Rise in price of
su bstitute good D1 D1
complementary
D good D
D2 D2
O X O X
Demand Demand
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Demand curves are of two types - individual demand curve and Market demand
curve. The market demand curve can be obtained by horizontal summation of
individual demand curves.
Slope of the Demand Curve - The slope of the demand curve equals to the
change in price divided by the change in quantity. It is because the slope of a curve
is defined as the change in the variable on the Y-axis divided by the change in the
variable on the X-axis.
Ans:-
a) Difference between change in demand and change in quantity demanded
Sl.
Movement along a demand curve Shift of demand curve
No.
i Other things remain constant, if Keeping price constant, if demand of
demand for a commodity changes the commodity changes due to
(rises or falls) due to change in its change in some other factors, such as
price, is called. As in this case due change in consumer income, change
to change (rises or falls) in price of in prices of substitute goods etc. is
commodity, a consumer moves called change in demand. As in this
leftward or rightward on same case consumer shifts on a new
demand curve so it is also called demand curve so it is also called
movement along a demand curve. movement along a demand curve
ii The main cause is change in price The main causes are- change in
of commodity. consumer income, change in prices
of substitute goods, change in taste
and preferences etc.
iii Demand Schedule - Demand Schedule -
Price Demand Price Demand
( ) (Units) ( ) (Units)
3 10 2 10
2 20 2 20
1 30 2 30
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24.What do you mean by increase in demand? Name any five factors that
shift the demand curve to the right.
Ans:- Increase in demand - Keeping price constant, if demand of a commodity
increases due to some other factors affecting demand, such as increase in
consumer income for normal goods, decrease in price of complementary good,
change in taste and fashion in favour of a commodity etc. is called increase in
demand.
In this case a consumer shifts rightward on a new demand curve so also called
rightward shift of demand curve.
We can express it with the help of schedule and diagram as under-
Price Demand
( ) (Units)
5 100
5 200
The Factors those shift the demand curve to the right or responsible for increases
in demand are -
Increase in income of consumer in case of normal good.
Rise in price of substitute goods.
Fall in price of complementary goods.
Favorable change in taste etc.
Future expectation to increase the price of commodity.
25. Define price elasticity of demand. Briefly explain the factors affecting
price elasticity of demand.
Ans: - Price elasticity of demand – It measures the degree of responsiveness of
the quantity demanded of a good to a change in its price.
Let
Initial price = P Final price = P1
Initial quantity = Q Final quantity = Q1
Change in quantity (ΔQ) = Final quantity - Initial quantity
= Q1 – Q
Change in price (ΔP) = Final price - Initial price
= P1 - P
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Q
100
= () Q
P
100
P
ΔQ P
= ()
Q P
ΔQ P
Ed ()
Δp Q
Price elasticity of demand has negative sign as it shows inverse relationship
between price and quantity demanded. Elasticity of demand has no unit as it’s a
coefficient.
Factors affecting Price Elasticity of demand
i) Number of Substitutes - A commodity will have elastic demand if there are
more number of substitutes available. E.g.- Pepsi, Coca-Cola, and Frooti etc. A
commodity having less number of substitutes, such as salt will have inelastic
demand.
ii) Nature of the Commodity- Generally, the demand for necessities is inelastic
(less elastic) and demand for luxuries is elastic (more elastic). This is so because
certain goods which are essential to life will be demanded at any price, whereas
goods meant for luxuries can be disposed off easily if they appear.
iii) Different uses of commodity- If the commodity has different uses its demand
will be elastic.
iv) Habits- Commodities in habit of the consumers have less price elasticity.
v) Level of income - If consumer belongs to richer section then his demand will
not be affected by change in price, hence demand will be inelastic.
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% change in demand
Ed
% change in price
8
5
1.5
ii) Unitary elastic demand(Ed =1) - When percentage change in demand of a
commodity is equal to the percentage change in its price, such demand is called
unitary elastic demand.
Suppose due to 5% increase in price of a commodity, demand of commodity
decreases by 5% then elasticity of demand will be equal to 1.
% change in demand
Ed
% change in price
5
5
1
iii) Less than unitary elastic demand(Ed< 1) - When percentage change in
demand of a commodity is less than the percentage change in its price, such
demand is called less than unitary elastic demand.
Suppose due to 5% increase in price of a commodity, demand of commodity
decreases by 4% then elasticity of demand will be equal to 1.
% change in demand
Ed
% change in price
4
5
0.8
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28. Define MPP and APP. Is it possible MPP decrease but APP increase?
Give reasons to support your answer.
Ans : - Marginal Product: The change in total product by employing an
additional unit of a variable factor is called marginal product. It can be obtained by
two ways:
MPP = TPPn - TPPn-1
E.g. Suppose by employing 10 units of variable factor 50 units of a good are
produced and by employing 11 units, total 54 units are produced .Then MPP will
be as follows-
MPP = TPPn - TPPn-1
=TPP11 – TPP11-1
=TPP11 – TPP10
= 54 - 50
= 4 units
Average Product: It is the product per unit of a variable factor. This can be
obtained by dividing total physical product by number of units of variable factor
employed.
TPP
APP
N
Yes, it’s possible MPP decrease but APP increase. It happens only when MPP
is decreasing but more than APP.
In above diagram shaded areas shows that MPP decreasing but APP increasing as
MPP > APP.
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Ans: - Law of variable proportion or returns to variable factor - This law state
that keeping other factors of production constant, when only one variable factor is
increased, in the beginning total physical product increases at an increasing rate,
then increases at a decreasing rate and ultimately decline.
Explanation: The law of variable proportion can be explained with the help of a
schedule and a diagram as follows.
1 2 20 30
1 3 30 60
1 4 20 80
II
1 5 10 90
1 6 0 90
1 7 -10 80 III
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31. What do you mean by Total Fixed Cost (TFC), Total Variable Cost (TVC)
and Total Cost (TC) of a firm? How they are related?
Ans – Total Fixed Cost (TFC):- The total amount of money spends on fixed
factors of production is called fixed cost.
It can be obtained by subtracting, total variable cost from total cost
TFC = TC - TVC
Total Variable Cost (TVC):- The total amount of money spends on variable
factors of production is called total variable cost.
It can be obtained by subtracting, total fixed cost from total cost
TVC = TC - TFC
Total (TC):- The total amount of money spends on all the factors (fixed and
variable) of production is called total cost.
It can be obtained by summing up, total fixed cost and total variable cost
TC = TFC + TVC
33. Why does the difference between Average Total Cost (ATC) and Average
Variable Cost (AVC) decrease with increase in the level of output? Can these
two be equal at some level of output? Explain.
Ans :- Average cost is the sum of average fixed cost and average variable cost.
Hence
ATC (AC) = AFC + AVC
So, ATC - AVC = AFC
This shows that difference between ATC and AVC is equal to AFC.
AFC is obtained by dividing total fixed cost by output, i.e. AFC TFC
Q
And total fixed cost (TFC) is constant.
Therefore, with the increase in the level of output, AFC falls.
Thus, the difference between ATC and AVC decreases with increase in output.
No, ATC and AVC cannot be equal at any level of output as gap between them i.e.
AFC can never be zero because TFC is constant and positive.
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34. Define Average cost and Marginal cost. Briefly explain the relationship
between average cost and marginal cost?
Ans: - Average Cost: It is the “cost per unit” of output produced. This can be
obtained by dividing total costs (TC) by the units of output (Q).
TC
AC
Q
Marginal Cost: - It is the change in total costs resulting from a unit increase in
output.
MC = TCn –TCn-1
Relationship between marginal cost and average cost
(i)When marginal cost is less than average cost,
average cost falls. Y
MC
(ii) When marginal cost is equal to average cost, AC
average cost is minimum.
Cost
(iii) When marginal cost is greater than average
cost, average cost rises. X
O
Output
35. Define Total Revenue, Average Revenue and Marginal Revenue with the
help of examples. Explain the relationship between total revenue and
marginal revenue with diagram.
Ans: - Total Revenue: The total amount of money which a seller receives by
selling given units of a commodity is called total revenue.
It can be obtained by two ways:
By summing up the marginal revenue receive by selling different units of
commodity. TR = MR1+ MR2 + MR3 + MR4…… + MRn = ΣMR
By multiplying average revenue (price) by number of units of commodity
sold. TR = AR (P) × Q
E.g. suppose by selling 10 units of a commodity money received by seller is
50.Then his total revenue is 50.
Average Revenue: It is the revenue per unit of a commodity sold. This can be
obtained by dividing total revenue by number of units of commodity sold.
TR
AR
Q
E.g. suppose by selling 10 units of a commodity money received by seller is 50.
Then AR will be as follows-
TR
AR
Q
50
10
= 5
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In above diagram AR/MR line shows average revenue –marginal revenue curve.
(i) MR=MC,
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E E1
P AR/MR firm produces less than OQ2 then profit are not
maximise. On the other hand, if firm produces more
38. Define Supply and Market Supply. Explain any four determinants of
supply of a commodity.
Ans: - Supply- The quantity of a commodity that the producer is willing to sell at
a given price during a given period of time is called supply.
Market Supply -The quantity of a commodity which all the sellers in the market
wish to sale at a given price and given period of time is called market supply.
iii) Change in input price - If the price of factor inputs decreases it decreases the
cost of production and increase the production & supply of good. The supply curve
shifts to the right and vice versa.
iv) Change in the excise tax rate - If the excise duty decreases, it decreases the
production cost and increases the production & supply of good. The supply curve
shifts to the right and vice versa.
Ans-
a) Supply Schedule:-Supply schedule is a table which shows various quantities
of a commodity which a seller wishes to sale at different alternative prices in a
given period of time.
Supply schedule is of two types:-
Individual supply schedule –It’s a table which shows various quantities of a
commodity which an individual seller wishes to sale at different alternative
prices in a given period of time.
We can show it as follows-
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c) Slope of supply curve- The slope of the supply curve equals to the change in
price divided by the change in quantity supplied. It is because the slope of a
curve is defined as the change in the variable on the Y-axis divided by the
change in the variable on the X-axis.
ΔY Change in price
Slope of supply curve
Δ X Change in quantity supplied
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40.Distinguish between
a) Extension of supply and Contraction of supply
b) Change in supply' and 'Change in quantity supplied' of a commodity.
Ans:-
a) Difference between Extension of supply and Contraction of supply
Sl.
No Extension of Supply Contraction of Supply
i Other things remain constant, if Other things remain constant, if
supply of commodity increases due to supply of commodity decrease due to
increase in its price, is called decrease in its price, is called
extension of supply. contraction of supply.
ii The main cause is increase in price of The main cause is decrease in price of
commodity. commodity.
iii It results rightward movement along a It results leftward movement along a
supply curve. supply curve.
iv Supply Schedule - Supply Schedule -
Price Supply Price Supply
( ) (Units) ( ) (Units)
5 100 10 200
10 200 5 100
v Supply curve- Supply curve-
10 100 5 100
10 200 10 200
S2 .
S
S
S1
Price
S2
Price
S S
S1
X X
O O
Supply Supply
vi) Less than unitary elastic supply (Es< 1):- When percentage change in supply
of a commodity is less than the percentage change in its price, such supply is
called less than unitary elastic supply.
42. What do you mean by perfect competition? State its main features?
Ans :- Perfect competition is a market where there are large numbers of buyers
and sellers and sellers sell homogeneous commodity at uniform price.
Under Perfect Competition a firm is only price taker.
Main features of perfect competition are as under -
(i) Large number of buyers and sellers - Under perfect competition buyers and
sellers are in such a large number so that neither a single buyer nor a single seller
can influence the market. It is because each seller sells a very small portion of the
market supply, similarly the demand of each buyer is also very small in the
market.
(ii) Homogeneous product - The product sold in the market is homogeneous or
identical in all respect i.e. shape, size, colour, composition, etc.
(iii) Free entry and exit of firms - Under perfect competition there are no barrier
to entry and exit of firms in industry. But entry and exit may take time so it
happens only in long runs.
(iv)Perfect knowledge of market- In this market all the sellers as well as buyers
have the complete information about the market situation. It means they are well
aware about the product and its price.
(v) Perfect mobility – The factors of production i.e. land, labour, capital and
entrepreneur are perfectly mobile. There is no geographical and occupational
restriction on their movement. It means factors of production are free to move
from one place to another place and one job to another job in which they get better
price.
Free entry and exit of firms under perfect competition - It means that there is
no barrier for entry and exit of firms in the industry. This freedom ensures that
firms earn just the normal profits in the long run.
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If the existing firms earn above-normal profits, new firms enter in the industry,
raise supply, which brings down the price. The profits fall till each firm is once
again earning only the normal profits.
If the existing firms are having losses, the firms start leaving, supply falls and
price goes up. The price continues to rise till the losses are wiped out and firms are
just earning normal profits.
In this case the buyers will not be able to buy all what they want to buy. The
pressure of excess demand will push the market price up. This will have two
effects - Extension of supply and contraction of demand. The tendency of supply
going up and demand going down will continue till market demand and supply
become equal. This is achieved at price 3 per unit where equilibrium is restored
and vice versa.
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In the diagram, demand and supply of good
Y D1 are equal at point E. So E is equilibrium
Price D
S point. At this point OP is equilibrium price
and OQ is equilibrium quantity. When
E1 demand increases, demand curve shifts to
P1
P
E F right i.e. D1 D1, then at OP price there is EF
excess demand. This results competition
among buyers which will raise the price. At
D1
a higher price, quantity demanded will fall
S D and quantity supplied will increase, resulting
O X in upward movement along new demand
Q Q1 Q2 Quantity
curve and given supply curve.
This reduces the gap between quantity demanded and quantity supplied. These
changes will continue till we reach the new equilibrium point E1 where quantity
demanded is equal to quantity supplied.
Now OP1 is new equilibrium price. Since new equilibrium price [OP1] is higher
than the old equilibrium price [OP] which shows that equilibrium price has
increased.
Y
In diagram, demand and supply of good
Price
D
S are equal at point E. So E is equilibrium
S point. At this point OP is equilibrium
1
P
E E 2 price and OQ is equilibrium quantity.
P 1
E 1 When supply increases new supply curve
S
S1S1 shifts to right, it shows that at OP
D
S 1
X
price, there is EE2 excess supply. This
O
Q Q Q Quantity
1
excess supply results competition among
2
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II) Control Price (Price Ceiling):- When government fixes price of a product at a
level lower than the equilibrium price, the price is called control price (or price
ceiling). Ceiling means the maximum limit. Producers cannot sell their products
above this price.
Control price or ceiling price is the maximum price that can be charged for a
commodity. This is done so that necessary goods become available to common
people.
Since control price is lower than the equilibrium price, it leads to excess demand
and short supply. Suppose, the equilibrium price of sugar in a free market is 40
per kg at which both demand and supply of sugar are equal, i.e., 50 tones. When
government fixes price at 35 per kg, the demand for sugar rises to 60 tones and
supply falls to 40 tones, this create disequilibrium.
The implication or consequence of price control can be any of the following:
a) Rationing: It is a system of distributing essential goods in limited quantities
at control prices.
b) Black market: It is a market in which controlled goods are sold unlawfully at
prices higher than the price fixed by the government.
c) Dual marketing: It is a system of having two prices for the same commodity
at the same time.
III) Support price (Floor Price):- When government fixes price of a product at a
level higher than equilibrium price, it is called support price (or floor price). Floor
means the lowest limit. Support price or floor price is the minimum price at which
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Capital goods - The goods which help in production of other goods and services
and added in the capital stock of a country at the end of an accounting year are
called capital goods. It includes durable goods like car, fridge, road etc. Stock of
semi finished, finished goods and raw material are also part of it.
Flow-The economic variables that are measured during a period of time are called
flow variables. Flow is a dynamic concept. It has time dimensions. E.g. Interest
earned on bank deposits for 1 year, i.e. from 1st April 2011 to 31st March 2012.
Household Firms
Household Firms
Factor services
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v) Estimation of NNPFC- Add net factor income from abroad (NFIA) to NDPFC
to get NNPFC or National Income.
NNPFC (National Income) =NDPFC + NFIA
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65. Will the following factor incomes be included in domestic factor income of
India? Give reasons for your answer.
(i) Compensation of employees to the residents of Japan working in Indian
embassy in Japan.
(ii) Profits earned by a branch of foreign bank in India.
(iii) Rent received by an Indian resident from Russian embassy in India.
(iv) Profits earned by a branch of State Bank of India in England.
Ans : - (i) Yes, It will be included in domestic factor income of India because the
Indian embassy in Japan is a part of domestic territory of India.
(ii) Yes, It will be included in domestic factor income of India because the foreign
bank is located in the domestic territory of India.
(iii) No, It will not be included in domestic factor income of India because Russian
embassy in India is not a part of domestic territory of India.
(iv) No, It will not be included in domestic factor income of India because branch
of State Bank of India which is earning profit is in England which is not a part of
domestic territory of India.
66. What is meant by gross domestic product? Explain any three limitations
of gross domestic product as a measure of economic welfare.
Ans :- Gross domestic product (GDP) refers to the money value of all the
final goods and services produced with in domestic territory of a country during
a financial year inclusive of consumption of fixed capital or depreciation.
Welfare means sense of material well being among the people. This depends upon
greater availability of goods and services. So it may be concluded that higher level
of GDP is an index of greater well being of people. But this generalisation is not
correct due to some limitations.
Limitations of GDP as a measure of economic welfare-
i) Distribution of GDP- If with increase in GDP inequality of income increase,
poor become poorer while rich become richer. This may lead to decline in
welfare even though GDP has increased.
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67.What do you mean by barter system? What are its main difficulties? How
money overcome the problem of barter system? Explain
Ans: - Barter System implies direct exchange of goods against goods without the
use of money. It is also called C-C economy, i.e. Commodity-for-Commodity
exchange economy. E.g. When a weaver gives cloth to the farmer in return for
getting wheat from him, it is called barter exchange.
Money has solved the problem of barter exchange in the following ways:
a) Money as a medium of exchange solves the problem of lack of double
coincidence of wants.
b) In terms of money the value of other goods can be expressed.
c) Money is of a manageable size and shape, unlike some barter standards, such
as cattle.
d) The value of money changes less where as bartered goods may lose their value
after some time.
e) In term of money future payments can be easily made as value of money
changes less.
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71. What do you mean by money /credit creation? Explain the process of
Credit (deposit) creation by the commercial banks with the help of
numerical example. Also explain its Limitations.
Ans: - Money/Credit creation - The Process of multiplying the deposits by
commercial bank is called credit creation.
Money creation or deposit creation or credit creation by the bank is determine by –
(i) The amount of the initial fresh deposits and
(ii) The Legal Reserve Ratio (LRR) i.e. the minimum ratio of deposit legally
required to be kept as cash by banks.
It is assumed that all the money that goes out of bank is re-deposited in to the
banks.
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Let the LRR be 20% and there is a fresh deposit of 10,000. As required, the
banks keep 20% i.e. 2,000 as cash. Suppose the bank lend the remaining 8000.
Those who borrow use this money for making payments. As assumed who receive
payments put the money back in to the bank. In this way bank receive fresh
deposit of 8,000.
The bank again keeps the 20% i.e. 1,600 as cash and lends 6,400 which is also
80% of the last deposit. The money again comes back to the banks leading to a
fresh deposit of 6,400. The money goes on in multiplying in this way, and
ultimately total money creation is 50,000.
Given the amount of fresh deposit and the LRR, the total money creation formula
is:
1
Money creation Initial deposit
LRR
1
Money creation 10000
20%
1
10000 100
20
= 50,000
Limitations to credit creation - There are following limitations to credit creation
by banks:
1. The total amount of cash reserves in the banking system. Larger the cash
reserves more will be the credit creation.
2. Cash reserve ratio fixed by the central bank. More is the ratio, less is the power
to create credit and vice versa.
3. Banking habits of the people of the country- It means banking transactions
through cheques, drafts, bills etc. Good banking habit results in keeping smaller
amount of cash with the banks and therefore, more can be lent. This will create
large credit.
72. Define Central bank. What are the main functions of central Bank?
Explain.
Ans: - Central bank: A central bank is an apex institution of a country that
controls and regulates the monetary and financial systems of a country.
In India Reserve Bank of India (RBI) is the central bank.
Main functions of a central bank are:
i) Issue of Currency - The central bank has monopoly of issuing currency in the
country. Currency issued by it, is its monetary liability so it has to keep a reserve
in the form of gold and foreign securities. It promotes efficiency in the financial
system. Firstly, because this leads to uniformity in the issue of currency. Secondly,
because it gives Central Bank a direct control over money supply.
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ii) Bankers to Government- Central bank acts as the bank of central and state
governments. It carries out all banking business of the govt. The govt. keeps its
cash balances on current a/c with the central bank. It gives loans to central
government for short period and manages the public debt of the country. It also
transfers government funds and buys and sells securities, treasury bills etc. on
behalf of the government.
iii) Bankers Bank & Supervisor- As the banker to banks the central bank holds a
part of cash reserve of banks, lends them short-term funds and provides them with
centralized clearing and remittance facilities.
The central bank supervises, regulates and controls the commercial banks. The
regulation of these banks may be related to their licensing, branch expansion,
liquidity of assets, management, merging of banks etc. The control is exercised by
periodic inspection of banks and the returns filed by them.
iv) Controller of Money Supply- The central bank of the country tries to control
the availability of credit in the market with its many tools like CRR, SLR, bank
rate, open market operation etc which are also called the instruments of Monetary
policy. Central bank regulates the money supply and credit in the best interest of
the country.
v) Lender of Last Resort- It helps the commercial banks in times of financial
difficulties. Scheduled banks can take the loans by rediscounting first class bills or
short term approved securities, whenever they do not get funds from any other
sources.
73.What is credit control? How central bank control the credit? Explain.
Ans :- Credit Control :- The Central Bank controls the money supply and credit
in the best interests of the economy. The bank does this by taking recourse to
various instruments. These are:
i) Bank Rate Policy: The bank rate is the rate at which the central bank lends
funds to banks. The effect of a change in the bank rate is to change the cost of
securing funds from the central bank.
A rise in the bank rate will increase the cost of borrowing from the central bank
then causes the commercial banks to increase the interest rates at which they lend.
This will discourage businessmen and others from taking loans. Thus reduces the
volume of credit and vice versa.
ii) Open Market Operations: The act of buying and selling of government
securities by the Central Bank from / to the public and banks is called open market
operations.
When the Central Bank buys securities from the banks and public it adds to cash
balances in the economy. If cash balances are increased in the economy there will
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be more deposits with the commercial banks which raise the banks’ ability to give
credit and thus increase the money supply.
When the Central Bank sells securities to the banks and public it withdraws cash
balances from the economy. If cash balances are decreased in the economy there
will be lesser deposits with the commercial banks which reduce the banks’ ability
to give credit and thus decrease the money supply.
iii) Legal Reserve Ratio (LRR) – LRR is the minimum ratio of deposits which
every bank legally is required to keep as liquefied reserve. There are two
components of LLR namely CRR and SLR.
Cash Reserve Ratio (CRR): The minimum percentage of their total deposits
which is to be kept by commercial banks with the Central Bank is called Cash
Reserve Ratio.
A change in CRR affects the power of commercial bank to create the credit. An
increase in the CRR reduces the lending capacity of commercial banks to grant
loan. Then the commercial banks will increase the interest rates at which they
lend. This will then discourage businessmen and others from taking loans. Thus
reduces the volume of credit and vice versa.
Thus the CRR should be increased when credit is to be contracted and it (CRR)
should be decreased when credit is to be increased.
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When this rate is raised, it encourages the commercial banks to keep their funds
with the central bank. This has the negative effect on the lending capability of the
commercial banks and vice versa.
vi) Margin Requirements: A margin is the difference between the amount of the
loan and market value of the security offered by the borrower against the loan.
If the margin imposed by the Central Bank is 20%, then the bank is allowed to
give a loan only up to 80% of the value of the security. By altering the margin
requirements, the Central Bank can alter the amount of loans made against
securities by the banks. So higher margin requirements decreases the demand for
credit and vice versa.
74.What is Aggregate Demand? What are its main components?
Ans: - Aggregate Demand is the total demand for all the final goods & services
by all the consumers in the economy during a year.
The main determinants of Aggregate demand are
i) Private final consumption demand (C) - It is the demand of household and
non-profit making institutions serving households for durable goods (T.V., Fan
etc.), semi-durable goods (clothes, shoes etc.) and non-durable goods (vegetable,
bread etc.).
ii) Government final consumption demand (G)- It is the expenditure incurred by
government on the purchase of goods and services which are needed to provide
facilities to the general public, such as, expenditure on road, school, bridge,
hospital etc. The level of government expenditure is determined by the
government policy.
iii) Private investment demand (I)- It refers to the expenditure incurred by the
private firm on the purchase of capital goods, such as plant , equipments,
buildings, machine etc. The investment is made in the economy in order to
increase the production capacity as well as to maintain the present level of
production. The rate of interest affects the investment demand inversely.
iv) Net exports (X-M) - It is the difference between exports of goods & services
and imports of goods & services during the given period of time. It refers to the
demand of foreigners for our goods & services over domestic demand for foreign
countries goods & services.
75. Define APC and APS. Derive the relationship between APC and APS.
Ans: - APC (Average Propensity to consume) is defined as the ratio of total
consumption to total income. Mathematically APC C
Y
Where, C= Consumption, Y= Income
APS (Average Propensity to Save) is defined as the ratio of total saving to total
income. Mathematically APS S
Y
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76. Explain the concept of MPC with the help of table and diagram. Why can
the value of MPC be not greater than 1?
Ans: - MPC (Marginal Propensity to consume) is defined as the ratio of change
in consumption to change in income. Mathematically MPC ΔC Where C =
ΔY
change in consumption, Y= change in income.
For example, if income increases from 200 crores to 250 crores and
consumption increases from 20 crores to 40 crores, it implies that 0.4 is the
MPC or 40% increase in the income is being consumed.
This can further be explained with the help of a table and a diagram. If income and
consumption are:
Income (Y) Consumption Marginal propensity to consume
Expenditure (C) ΔC
MPC
ΔY
200 20 ---
250 40 0.4
MPC can also be explained with the given diagram.
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78. Define:-
a) Psychological law of consumption
b) Ex-ante Investment
c) Ex-post investment.
d) Involuntary unemployment
e) Full employment
Ans: -
a) Psychological law of consumption: It state that as income in an economy
increases consumption also increases but less than increase in income.
b) Ex-ante Investment:- Ex-ante Investment refers to the planned or intended
investment during a particular period of time. It is planned on the basis of
future expectations. So it is imaginary (intended), in which a firm assumes
the level of investment on its own.
c) Ex-post Investment:- Ex-post Investment refers to the actual level of
investment during a particular period of time. It signifies the existing
investment of a particular time.
d) Involuntary Unemployment refers to a situation in which people are ready
to work at prevailing wage rate, but do not find work.
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79. Explain the meaning of equilibrium level of income with the help of a
diagram.
Ans: - The level of income and output in an economy is determined at that point
where; aggregate demand is equal to aggregate supply.
AD= C+I
AS=C+S
AS=Y (refers to countries national income)
At equilibrium point AD=AS.
Equilibrium can be achieved at full employment and even at under employment
situation. It may not be always at full employment condition in an economy.
We can explain it with the help of following schedule and diagram-
The above schedule shows equilibrium level of income is 300 where AD=AS
300=300.
We can explain it with the help of diagram as follows-
In diagram OY is the equilibrium level of
income because at E aggregate demand is
equal to aggregate supply.
Before this equilibrium level of income and
output, when income falls to OY0, AD is
D0Y0 against AS is S0Y0. This AD > AS
indicates planned spending > planned
output then there will be more demand for
goods and services so the firms will increase
the output .Consequently, employment
,output and income will be increased till the
equilibrium level of income and output OY
is reached where AD = AS.
On the other hand, when AD < AS it means planned spending < planned output,
then there will be unsold stock of goods with the firm so the firm will reduce the
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E
I I
X
O Y Y1 Inco m e
Working of the multiplier -The working of the multiplier is based on the fact that
one person's expenditure is other person's income. When investment increases, it
increases the income consequently consumption also increases. And increase in
consumption lead to increase in income.
Symbolically: ∆I→∆Y→∆C→∆Y
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83.Explain the meaning of inflationary gap with the help of diagram and also
write measures to correct it.
Ans: - Inflationary Gap- The excess of actual aggregate demand over aggregate
supply at full employment equilibrium point is called inflationary gap.
When AD > AS this lead to price rise or inflation so it’s called inflationary gap.
We can show it with the help of diagram as follows.
Impacts on the Economy: - As AD < AS, producers wish to produce less. The
level of output and income will reduce.
Impacts on output - Output will reduce.
Employment - Level of employment will decrease.
Price - Price will fall
Measures to correct deflationary gap-
• Increase in government expenditure
• Decrease in taxes
• Increase in availability of credit - by decrease in bank rate, decrease in CRR &
SLR, purchase of securities by central bank, decrease in margin requirement etc.
85.Define a government budget. State any four of its main objectives.
Ans: - Government Budget - It is an annual financial statement of estimated
receipts and expenditure of the government for coming financial year.
Objectives of a Government Budget -
(i) Reallocation of resources - The Government has to reallocate resources from
less priority areas to more priority areas, to achieve its social and economic
objectives.
(ii) Reduction of inequalities - Through the budget government can adopt
progressive taxation policy and spend more on requirement of the poor to reduce
the inequalities of income and wealth.
(iii) Economic growth- To promote rapid and balanced economic growth so as to
improve living standard of the people.
(iv) Economic stability- The Government tries to prevent business fluctuations
and maintain economic stability to maintain price stability and correct business
cycles.
(v) Reduction of poverty and unemployment- To eradicate (reduce) mass
poverty and unemployment by creating employment opportunities and providing
maximum social benefits to the poor.
(vi) Management of public enterprises - Government undertakes commercial
activities that are of the nature of natural Monopolies, heavy manufacturing etc.,
through its public enterprises.
Corporation tax neither reduces assets nor creates any liability for the
government. So treated as a revenue receipt.
Fee of Government College neither reduces assets nor creates any liability for the
government. So treated as a revenue receipt.
Grant and aid neither reduces assets nor creates any liability for the government.
So treated as a revenue receipt.
Profits of public sector undertakings neither reduce assets nor create any
liability for the government. So treated as a revenue receipt.
87.Define tax. What is direct and indirect taxes give some examples of each.
Ans: - Tax – Tax is a legally compulsory payment imposed by the government.
Direct tax- A tax in which liability to pay tax and actual burden of the tax falls on
the same person. The burden of these taxes cannot be shifted to other person.
These taxes can be made progressive easily. Examples- income tax, corporation
tax, wealth tax, gift tax etc.
Indirect tax- A tax in which liability to pay tax is of one person but actual burden
of the tax falls on the some other person. The burden of these taxes can be shifted
to some other person. These taxes cannot be made progressive easily. These can be
made progressive by imposing more taxes on luxury items which are mainly used
by the high income group people. Examples- sales tax, excise duty, service tax,
VAT etc.
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92.What are the various types of deficits in government budget? Also write
their implications.
Ans: - There are 3 types of deficits: -
Revenue Deficit- The excess of government revenue expenditure over revenue
receipts is called revenue deficit.
Revenue Deficit = Revenue Expenditure - Revenue Receipts
Implications
It implies dissavings of government.
It indicates the inability of the government to meet its regular and recurring
expenditure.
A high revenue deficit gives a warning signal to the government to either curtail
its expenditure or increase its revenue.
Revenue deficit is financed through capital receipts like borrowings and used to
meet the consumption expenditure of the government. It leads to inflationary
pressure in the economy.
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Fiscal Deficit- The excess of total expenditure of the government over its total
receipts excluding borrowing is called fiscal deficit.
Implications-
It indicates total borrowing requirements of the government. Borrowing create
problem of not only payment of interest but also repayment of loans.If it
continuously increases it means government takes more loans to repay the
previous loans. As a result country is caught in debt trap.
If government borrows from central bank, central bank issue new currency notes.
It increases money supply and generates inflationary pressure in the economy.
When government borrows from rest of the world, it raises the country’s
dependence on other countries.
Primary Deficit- the excess of fiscal deficit over interest payments is called
primary deficit.
Implications:
It indicates how much of the government borrowing are going to meet expenses
other than interest payments.
If it is zero, it indicates that government is only borrowing to repay the interest of
previous loans.
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94. What is meant by visible and invisible items in the Balance of payments
account? Give some examples of each.
Ans: - Visible items refer to items relating to trade of material goods with other
countries.
Examples - tea, clothes, machinery etc.
Invisible items refer to items relating to trade of services with other countries and
unilateral transfers.
Examples- Transport services, Insurance and banking services etc.
95. Differentiate between Current Account and Capital Account of BOP.
Ans:- Difference between current account and capital account of BOP-
Sl.
No. Current Account Capital Account
i It is the account which records It records capital transactions such as
exports and imports of goods, loan and investment between a
services and unilateral transfers. country and rest of the world.
ii Items of current account do not Items of capital account cause change
cause change in the assets and in the assets and liability status of the
liability status of the residents of a residents of a country & its
country & its government. government.
iii The main components of current The main components of capital
account are export and import of account are private capital transaction,
goods, services and unilateral official capital transaction and baking
transfers. capital transaction etc.
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iv These items are also called above the These items are also called below
line items because they are recorded the line items because they are
as first items before calculating recorded after calculating surplus
surplus or deficit in BOP. or deficit in BOP.
Supply of Foreign exchange comes from - The foreigner’s purchasing goods and
services (exports), the foreigners who invest in home country through joint
ventures, remittances from abroad, foreign tourists come to visit a country. There
is direct relationship between foreign exchange rate and supply of foreign
exchange. So supply curve of foreign exchange is upward sloping.
Y
Df In diagram, Df Df is demand and Sf Sf
Sf
FER
E is supply curve of foreign exchange
R
.They are equal at point E, so E is
equilibrium point. At this point OR is
Sf Df
determined as equilibrium foreign
X
O M
Foreign Exchange
exchange rate.
98.When exchange rate of foreign currency rise its supply rises? Explain.
Ans: - A rise in foreign exchange rate makes home country’s goods cheaper to
foreigners so they will purchase more goods and services, as a result demand for
country’s goods increases in foreign market which leads to increase in country’s
exports. At the same time foreigners who want to invest in home country will
invest more, more foreign tourists will come to visit home country. This brings a
greater supply of foreign exchange. Hence supply of foreign currency rises.
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Indian rupee because more rupees are required now to buy one US dollar. It
occurs in Flexible Exchange Rate System
100. Differentiate between fixed exchange rate and flexible exchange rate
system.
Ans: - Difference between fixed exchange rate and flexible exchange rate system
Sl.
Fixed Exchange Rate System Flexible Exchange Rate System
No.
i The system in which exchange rate is The system in which exchange rates
officially declared by government or are determined by the demand and
central bank of a country and only a supply forces of foreign exchange in
very small deviation from this fixed the market is called Flexible
value is possible is called Fixed Exchange Rate System.
Exchange Rate System.
ii Advantages (Merits) Advantages (Merits)
1-It ensures stability, in the exchange 1-This system does not require huge
rate which encourages international reserves of gold and international
trade. currencies.
2- It prevents speculations in foreign 2-This system does not require the
exchange market. huge back-up of international reserves
3- It helps co-ordination of so encourage the movement of capital
macroeconomics policies across across different parts of the world.
different countries of the world. 3-Deficit and surplus in BOP is
4- It implies low risk and low automatically corrected.
uncertainty of future payments so.
iii Disadvantages (Demerits) Disadvantages (Merits)
1-This system requires huge reserves 1-It encourages speculation leading to
of gold and international currencies. fluctuations in exchange rate.
2-In this system the benefits of free 2- It discourages investment and
markets are deprived. international trade.
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