Solutions Of BECC-103 TEE Questions (June 2024)

Section—A

1. Explain how real and money flows take place in an open economy. Use appropriate diagram to illustrate your answer.

In an open economy, the circular flow of income includes interactions with the foreign sector, alongside households, firms, government, and financial sectors. The model shows two types of flows: real flows (goods, services, and resources) and money flows (payments, income, and expenditures).

Real flows involve the movement of economic resources and outputs. Households provide factors of production (labor, land, capital) to firms (real flow clockwise). Firms produce goods and services, which flow to households (consumption), government (public goods), and abroad (exports). In return, imports bring foreign goods and services into the domestic economy.

Money flows move in the opposite direction (counterclockwise). Households receive income (wages, rent, interest, profit) from firms. This income is spent on consumption (to firms), taxes (to government), savings (to financial sector), and imports (to foreign sector). Firms receive revenue from sales, pay for imports, receive investment from financial sector, and subsidies/transfers from government. Exports bring money inflows from abroad, while imports cause outflows.In an open economy, key additions are:

• Exports (X): Goods/services flow out, money flows in.
• Imports (M): Goods/services flow in, money flows out.
• Net exports (X – M) affect the flow; if X > M, net inflow boosts domestic income.

Withdrawals (leakages) include savings (S), taxes (T), and imports (M). Injections include investment (I), government spending (G), and exports (X). Equilibrium occurs when injections = withdrawals.

Diagram description (imagine a circular flow diagram for open economy):

• Central circle with households and firms.
• Arrows: Real flows (resources to firms, goods to households/government/exports).
• Money flows opposite: Income to households, expenditure to firms.
• Government sector: Taxes out, G and transfers in.
• Financial sector: S out, I in.
• Foreign sector: Exports (goods out, money in), imports (goods in, money out).

This model illustrates how an open economy is influenced by international trade, with trade balance affecting overall income and output. For example, a trade surplus increases money inflows, boosting aggregate demand.

4. By using IS-LM curves, explain how simultaneous equilibrium in goods and money markets takes place. Explain how the adjustment process in the economy leads automatically to equilibrium.

The IS-LM model (developed by Hicks based on Keynes) shows simultaneous equilibrium in the goods market (IS curve) and money market (LM curve).The IS curve represents goods market equilibrium: points where planned investment (I) equals planned saving (S), or aggregate demand equals output (Y = C + I + G). It slopes downward because higher interest rates (r) reduce investment, lowering output (Y).

The LM curve represents money market equilibrium: money demand (liquidity preference) equals fixed money supply. It slopes upward because higher income (Y) increases transaction demand for money, requiring higher interest rates (r) to equilibrate.Simultaneous equilibrium occurs at the intersection of IS and LM curves, determining equilibrium interest rate (r*) and output/income (Y*). At this point, both markets clear: goods demand = supply, and money demand = supply.Adjustment process (automatic stabilization): Suppose the economy is above the intersection (e.g., higher Y, lower r than equilibrium). Goods market has excess demand (Y too high for given r), but money market has excess money supply (r too low). Interest rates rise to reduce investment and aggregate demand, shifting along IS leftward. Higher r reduces money demand, moving along LM. This continues until r and Y adjust to the intersection.If below equilibrium (lower Y, higher r): Excess supply in goods market (saving > investment) lowers r, increasing investment and Y (along IS rightward). Lower r increases money demand, moving along LM until balance.The process relies on flexible interest rates and responsiveness of investment/money demand. It shows automatic tendency toward equilibrium without policy, though Keynesians note rigidities may slow it.

Section—B

5. Explain the concept of investment multiplier. What are its limitations?

The investment multiplier (Keynesian) shows how an initial change in investment (ΔI) leads to a larger change in income/output (ΔY). Formula: Multiplier (k) = 1 / (1 – MPC), where MPC is marginal propensity to consume (change in consumption/change in income). Process: Initial ΔI increases income by the same amount. Recipients spend MPC fraction, creating new income. This rounds continue, total ΔY = k × ΔI. E.g., MPC = 0.8, k = 5; ₹100 investment raises income by ₹500.Limitations:

• Assumes constant MPC; in reality, it varies with income distribution.
• Ignores time lags; effects are not instantaneous.
• Leakages like imports, taxes, savings reduce multiplier (open economy: k = 1/(1 – MPC + MPM)).
• Assumes spare capacity; at full employment, it causes inflation, not output rise.
• Crowding out: Higher demand may raise interest rates, reducing private investment.
• Doesn’t account for expectations or monetary factors.

Thus, actual multiplier is smaller than theoretical.

6. Distinguish between demand-pull and cost-push inflation.

Demand-pull inflation occurs when aggregate demand (AD) exceeds aggregate supply (AS), often “too much money chasing too few goods.” Causes: Expansionary fiscal/monetary policy, increased consumption/investment, export boom. AD shifts right, raising prices and output (if below full employment). Typical in booming economies; “demand-pull” as excess demand pulls prices up.Cost-push inflation arises from rising production costs, reducing AS (leftward shift). Causes: Higher wages (trade unions), raw material prices (oil shocks), taxes, supply disruptions. Prices rise even if AD unchanged or falling, often causing stagflation (inflation + stagnation). Output falls, unemployment rises.Key differences:

• Origin: Demand-pull from excess AD; cost-push from reduced AS/higher costs.
• Output effect: Demand-pull increases output; cost-push decreases.
• Policy: Demand-pull eased by contractionary policy; cost-push harder (tight policy worsens unemployment).
• Examples: Demand-pull post-COVID stimulus; cost-push 1970s oil crisis.

Both raise prices but differ in causes and effects.

8. Explain how national income can be measured by the value-added method.

The value-added method (production approach) measures national income by summing value added at each production stage, avoiding double-counting.Value added = Value of output – Intermediate consumption (cost of inputs from other firms).Steps:

1. Calculate gross value added (GVA) for each sector (agriculture, industry, services): Output value minus intermediate inputs.
2. Sum sectoral GVAs to get GDP at basic prices.
3. Add taxes on products minus subsidies to get GDP at market prices.
4. National income (Net National Income at factor cost) = GDP at market prices – depreciation + net factor income from abroad – indirect taxes + subsidies (adjustments vary).

Advantages: Captures contribution at each stage; useful for sectoral analysis.E.g., Farmer sells wheat ₹100 (value added ₹100). Miller buys wheat ₹100, sells flour ₹200 (value added ₹100). Baker buys flour ₹200, sells bread ₹300 (value added ₹100). Total value added = ₹300 = national income contribution.This equals income/expenditure methods in theory.

9. Define various macro aggregates in an economy. How would you obtain national income from gross domestic product at market price?

Key macro aggregates:

• GDP at market price (GDPmp): Total monetary value of final goods/services produced within borders in a year, at current prices (includes indirect taxes minus subsidies).
• GDP at factor cost: GDPmp minus net indirect taxes.
• GNP (Gross National Product): GDP + net factor income from abroad (NFIA).
• NDP (Net Domestic Product): GDP – depreciation.
• NNP (Net National Product): GNP – depreciation.
• National Income (NI) or NNP at factor cost: NNP at market price minus net indirect taxes (or GNP at factor cost – depreciation).

To obtain national income from GDP at market price: National Income = GDPmp – Depreciation + NFIA – Net indirect taxes (indirect taxes – subsidies).This adjusts for capital consumption, international income flows, and indirect taxes (not part of factor incomes).

Section—C

(a) Stagflation

Stagflation combines stagnation (low/negative growth, high unemployment) with high inflation. It challenges Keynesian theory (inflation and unemployment inversely related via Phillips curve). Causes: Supply shocks (e.g., 1970s oil crises raising costs → cost-push inflation, reduced output). Adverse supply shifts cause prices to rise while output falls.Effects: Erodes purchasing power, increases unemployment, reduces investment. Policy dilemma: Expansionary policy worsens inflation; contractionary worsens unemployment.Example: 1973-75 oil shock led to stagflation in many economies.

(c) Speculative demand for money

Speculative demand (Keynes) is money held to take advantage of future interest rate changes (bond price inverse to rates). People hold cash if they expect bond prices to fall (interest rates rise), avoiding capital losses.

It varies inversely with interest rates: High rates → low speculative demand (prefer bonds); low rates → high (expect rates to rise, bond prices fall). Total money demand = transaction + precautionary + speculative. Speculative part makes LM curve upward-sloping and explains liquidity trap (at very low rates, infinite speculative demand).