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Economics Question Bank Q1) Psychological law of consumption

Generally it is observed that when income increases, consumption also increases but by aless proportion than the increase in income. Suppose the total income of the community is 10crore and the consumption expenditure is also Rs 10 crore. In that case, there is no saving andinvestment. Further the income increases to Rs.15 crore. Then, consumption also increases, but not tothe extent of Rs15 crore. It may increase to Rs14 crore and Rs 1 crore constitutes the savings. Thissavings create a gap between Income and Consumption. This gap is in conformity with KeynesPsychological law of consumption, which states that, when aggregate income increases,consumption expenditure shall also increase but by a somewhat smaller amount". This lawtells us that people fail to spend on consumption the full amount of increment in income. As incomeincreases, the wants of the people get satisfied and as such when income increases they save morethan what they spend. This law may be considered as a rough indication of the actual macro -behaviour of consumers in the short run.This is the fundamental principle upon which the Keynesian consumption function is based. It is basedupon his observations and conclusion derived from the study of consumption function. This law is alsocalled the fundamental law of consumption. It consists of three inter related propositions:

1.When the aggregate income increases, expenditure on consumption will also increase but by asmaller amount.

2. The increased income is distributed over both spending and saving.

3. As income increases, both consumption spending and saving will go up.These three prepositions form Keynes psychological law of consumption. As consumption expenditureprogressively diminishes when income increases, a gap between income and expenditure arises. Thistendency is so deep rooted in people's habits, customs, and the psychological set up that it is difficultto change in the short run. Hence, it is impossible to raise the propensity to consume of the people soas to increase the national output, income and employment. Increasing the volume of investment inan economy can only fill up the gap between income and Consumption.

Q2) Circular flows in closed (GDP) and open economy (GNP)

In economics , the terms circular flow of income or circular flow refer to a simple economic model

which describes the reciprocal circulation of income between producers and consumers. [1][2] In the circular

flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and

"households" respectively and provide each other with factors in order to facilitate the flow of income [1].

Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. More complete and realistic circular flow models are more complex. They

would explicitly include the roles of government and financial markets, along with imports and exports.



Two sector model

In the simple two sec tor circular flow of income model the state of equilibrium is defined as a situation

in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that

is:

Y = E = O

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms

then spend this income on factors of production such as labour, capital and raw materials, "transferring"

their income to the factor owners. The factor owners spend this income on goods which leads to a circular

flow of income.

5 sector model

LEAKAGES INJECTION



Saving (S) Investment (I)

Taxes (T) Government Spending (G)

Imports (M) Exports (X)

The five sector model of the circular flow of income is a more realistic representation of the economy.

Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six

assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is

the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing

(savings from households) and lending of money. In terms of the circular flow of income model the

leakage that financial institutions provide in the economy is the option for households to save their

money. This is a leakage because the saved money can not be spent in the economy and thus is an idle

asset that means not all output will be purchased. The injection that the financial sector provides into the

economy is investment (I) into the business/firms sector. An example of a group in the finance sector

includes banks such as Westpac or financial institutions such as Suncorp.

The next sector introduced into the circular flow of income is the Government Sector that consists of the

economic activities of local, state and federal governments. The leakage that the Government sector

provides is through the collection of revenue through Taxes (T) that is provided by households and firms

to the government. For this reason they are a leakage because it is a leakage out of the current income

thus reducing the expenditure on current goods and services. The injection provided by the government

sector is Government spending (G) that provides collective services and welfare payments to the

community. An example of a tax collected by the government as a leakage is income tax and an injection

into the economy can be when the government redistributes this income in the form of welfare payments,

that is a form of government spending back into the economy.

The final sector in the circular flow of income model is the overseas sector which transforms the model

from a closed economy to an open economy. The main leakage from this sector are imports (M), which

represent spending by residents into the rest of the world. The main injection provided by this sector is

the exports of goods and services which generate income for the exporters from overseas residents. An

example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of

the wool (the farmer) therefore more money enters the economy thus making it an injection. Another

example is China processing the wool into items such as coats and Australia importing the product by

paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

In terms of the five sec tor circular flow of income model the state of equilibrium occurs when the total

leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports



OR

S + T + M = I + G + X.

Assumptions

The basic circular flow of income model consists of seven assumptions:

1. The economy consists of two sectors: households and firms .



2 . Households spend all of their income (Y) on goods and services or consumption (C). There is no

saving (S).

3. All output (O) produced by firms is purchased by households through their expenditure (E).

4. There is no financial sector.

5. There is no government sector.

6. There is no overseas sector.

7. It is a closed economy with no exports or imports.

[edit ]

Q3) Compare MPC and MPS

MPC

In economics , the marginal propensi ty to consume (MPC) is an empirical metric that quantifies induced

consumption , the concept that the increase in personal consumer spending ( consumption ) that occurs

with an increase in disposable income (income after taxes and transfers). For example, if a household

earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that

dollar, the household will spend 65 cents and save 35 cents.

Mathematically, the marginal propensity to consume (MPC) function is expressed as the derivative of the

consumption (C) function with respect to disposable income (Y).

OR

, where C is the change in consumption, and Y is the change in disposable

income that produced the consumption.

For example, suppose you receive a bonus with your paycheck, and it's $500 on top of your

normal annual earnings. You suddenly have $500 more in income than you did before. If you

decide to spend $400 of this marginal increase in income on a new business suit, your

marginal propensity to consume will be 0.8 ( $400 / $500 ).



The marginal propensity to consume is measured as the ratio of the change in consumption to

the change in income, thus giving us a figure between 0 and 1. The MPC can be more than

one if the subject borrowed money to finance expenditures higher than their income. One

minus the MPC equals the marginal propensity to save (in a two sector closed economy), both

of which are crucial to Keynesian economics and are key variables in determining the value of

the multiplier .

MPS

The marginal propensi ty to save (MPS) refers to the increase in saving (non-purchase of current goods

and services) that results from an increase in income. For example, if a household earns one extra dollar,

and the marginal propensity to save is 0.35, then of that dollar, the household will spend 65 cents and

save 35 cents. It can also go the other way, referring to the decrease in saving that results from a

decrease in income. It is crucial to Keynesian economics and is the key variable in determining the valueof the multiplier .

Mathematically, the marginal propensity to save (MPS) function is expressed as the derivative of the

savings (S) function with respect to disposable income (Y).

In other words, the marginal propensity to save is measured as the ratio of the change in saving to the

change in income, thus giving us a figure between 0 and 1. It is the opposite of the marginal propensity to

consume (MPC). In a two sector closed economy MPS = 1 - MPC. Then for the example above, the

marginal propensity to consume would be 0.65.

Q4) Savings is a priva te vir tue and a public vice. Discuss

Q5) Crowding ou t effec t. Wha t it is, impac t on s ys tem and solu tion.

Wha t Does Crowding Out Effect Mean? An economic theory explaining an increase in interest rates due to rising government borrowing in themoney market.

Inves topedia explains Crowding Out Effect Governments often borrow money (by issuing bonds) to fund additional spending. The problem occurswhen government debt 'crowds out' private companies and individuals from the lending market.



Increased government borrowing tends to increase market interest rates. The problem is that thegovernment can always pay the market interest rate, but there comes a point when corporations andindividuals can no longer afford to borrow.

CROWDING OUT RESOURCESIf increased borrowing leads to higher interest rates by creating a greater demand for money and

loanable funds and hence a higher "price" ( ceteris paribus ), the private sector , which is sensitive to

interest rates will likely reduce investment due to a lower rate of return. This is the investment that is

crowded out. The weakening of fixed investment and other interest-sensitive expenditure counteracts to

varying extents the expansionary effect of government deficits. More importantly, a fall in fixed investment

by business can hurt long-term economic growth of the supply side, i.e., the growth of potential output .

CROWDING OUT DEMAND

Q6) Explain mul tiplier effec t and commen t on reverse mul tiplier effec t

in some economies over the las t 25 years

MULT IPL IER EFFECT

Wha t Does M ultiplier Effect Mean? The expansion of a country's money supply that results from banks being able to lend. The size of themultiplier effect depends on the percentage of deposits that banks are required to hold as reserves. Inother words, it is money used to create more money and is calculated by dividing total bank deposits bythe reserve requirement.

Inves topedia explains M ultiplier Effect The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and dividethis by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn mustalso keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as morepeople deposit money and more banks continue lending it - until finally the $100 initially deposited createsa total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effectfor every dollar deposited. The lower the reserve requirement, the larger the money supply, which meansmore money is being created for every dollar deposited.



Q7) Discuss mone y as a medium of exchange bo th domes ticall y and

in terna tionall y

Q8) Credi t crea tion. Its impor tance, con trol and consequences of too

much or too li tt le credi t

One of the important functions of commercial bank is the creation of credit. Credit creation is the multiple expansions of

banks demand deposits. It is an open secret now that banks advance a major portion of their deposits to the borrowers

and keep smaller parts of deposits to the customers on demand. Even then the customers of the banks have full

confidence that the depositor's lying in the banks are quite safe and can be withdrawn ondemand. The banks exploit this

trust of their clients and expand loans by much more time than the amount of demand deposits possessed by them. This

tendency on the part of the commercial banks to expand their demand deposits as a multiple of their excess cash reserve

is called creation of credit.The single bank cannot create credit. It is the banking system as a whole which can expand loans by many times of its

excess cash reserves. Further, when a loan is advanced to an individuals or a business concern, it is not given in cash.

The bank opens a deposit account in the name of the borrower and allows him to draw upon the bank as and when

required. The loan advanced becomes the gain of deposit by some other bank. Loans thus make deposits and deposits

make loans.

In economics, mone y crea tion is the process by which the money supply of a country is expanded.

There are two principal stages of money creation. First, the central bank of a country can introduce or

issue new money into the economy (termed 'expansionary monetary policy '). A central bank usuallyinjects new money into the economy by purchasing financial assets . Second, the new money introduced

by the central bank is multiplied by commercial banks through fractional reserve banking , expanding the

amount of broad money (i.e. cash plus demand deposits ) in the economy.

Quan tita tive easingM ain article: Quantitative easing

Q uantitative easing involves the creation of a significant amount of new base money by a central bank by

the buying of assets that it usually does not buy. Usually, a central bank will conduct open market

operations by buying short-term government bonds or foreign currency. However, during a financial crisis ,

the central bank may buy other types of financial assets as well. The central bank may buy long-term

government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans.

The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when

interest rates cannot be pushed any lower.



Q uantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the

central bank), giving depository institutions the ability to make new loans. Q uantitative easing is usually

used when lowering the discount rate is no longer effective because they are already close to or at zero.

In such a case, normal monetary policy cannot further lower interest rates, and the economy is in

a liquidity trap .

[edit ]Ph ysical currenc y

In modern economies, relatively little of the money supply is in physical currency. For example, in

December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about

10%) consisted of physical coins and paper money. [2] The manufacturing of new physical money is

usually the responsibility of the central bank, or sometimes, the government's treasury .

Contrary to popular belief, money creation in a modern economy does not directly involve the

manufacturing of new physical money, such as paper currency or metal coins . Instead, when the central

bank expands the money supply through open market operations (e.g. by purchasing government bonds),

it credits the accounts that commercial banks hold at the central bank (termed high powered money ).

Commercial banks may draw on these accounts to withdraw physical money from the central bank.

Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new

currency. [3]

Q9) Narsimhan commi tt ee recommenda tion

N arasimham committee in 1991 sugessted following recommendation

1. Opening of More Pvt. sector banks

2. Motivation foreign banks to expand their network by opening new branches.

3. Deregulation of RBI and Finance ministry of India. Making RBI as a regulator of all Banks and let

Banks takes participation in equity market with govt. stake of 51%,

4. Regulation introduced by RBI include CAR, Asset classification , N PA ratio

5. Corporate Governance : promoting customer relations and office culture

6. Asset Reconstruction for bringing down N PA in future

7. Risk Management8. CDR

9. E-Banking and VRS

Q10) Wha t are the Basel norms?



W hat is Basel II?

Basel II is the second of the Basel Accords recommended on banking laws and regulationsissued by the Basel Committee on Banking Supervision. The purpose of Basel II is to createan international standard that banking regulators can use when creating regulations abouthow much capital banks need to put aside to guard against the types of financial and

operational risks (these terms are explained in later sections) banks face. Theseinternational standards can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

Basel II insists on setting up rigorous risk and capital management requirements designedto ensure that a bank holds capital reserves appropriate to the risk The underlyingassumption behind these rules is that the greater risk to which the bank is exposed, thegreater the amount of capital the bank needs to hold to safeguard its solvency and overalleconomic stability. It will also oblige banks to enhance disclosures.

A dvantages of Basel II over Basel I Basel 1 Proposed new A ccord or Basel II

Focus on a single risk measure,primarily on credit risk. Doesn'tcover operation risk

More emphasis on banks' own internalmethodologies, supervisory review,and market discipline

One size fits all Flexibility, menu of approaches,incentives for better risk management

Broad structure More risk sensitivity Uses arbitrary risk categories & risk weights

Risk weights linked to external ratingsassigned by ECAI or IRB by bank

C apital A dequacy Requirements

Capital adequacy requirements on the banks not only protect investors, but also safeguard

them against possibility of failure of a big-bank. It also strengthens market discipline. InBasel I Capital adequacy is given as a single number that was the ratio of a banks capital toits assets. The key requirement was that tier-I capital was at least 8% of assets

Three pillars of Basel II

Types of risks according to Basel II



M arket Risk C redit Risk Operational Risk The risk of losses in on- andoff-balance-sheet positionsarising from movements inmarket prices.

Main factors contributing tomarket risk are: equity,interest rate, foreign exchange,and commodity risk. The totalmarket risk is the aggregationof all risk factors.

The risk that a counterpartywill not settle an obligation forfull value, either when due orat any time thereafter.

In exchange for-value systems,the risk is generally defined toinclude replacement risk andprincipal risk.

(Internal controls & Corporategovernance):

The risk of loss resulting frominadequate or failed internalprocesses people and systemsor from external events

W hy Indian Banks need Basel II or new accord

India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendationsof Steering Committee established in February 2005 for the purpose, the RBI had issueddraft guidelines for implementing a N ew Capital Adequacy Framework, in line with Basel II.

The deadline for implementing Basel II, originally set for March 31, 2007, has now beenextended. Foreign banks in India and Indian banks operating abroad will have to adhere tothe guidelines by March 31, 2009. But the decision to implement the guidelines remainsunchanged.

Apart from the above mentioned advantages of Basel II vis-à-vis Basel 1, there are certainreasons which manifests why Indian Banks require Basel II compliance:-

y Basel II norms will facilitate introduction of new complex financial products in IndianBanking Sector

y Indian banks require a more risk sensitive framework. There is improvement in risk

management system by Indian banksy N ew rules will provide a range of options for estimating regulatory capital and will

reduce gap between regulatory capital & economic capital

Q11) Mone tar y polic y wr t quali ta tive and quan titave weapons

Q1 2) Types of in teres t ra tes in India.

Q13) Infla tion ± Causes and Con trol measures

Inflation: Inflation is an upward movement in the average level of prices. The boundary betweeninflation and deflation is price stability.Because inflation is a rise in the general level of prices, it is intrinsically linked to money, as Capturedby the often heard refrain "Inflation is too much money chasing too few goods".inflation is caused by a combination of four factors:1. The supply of money goes up.2. The supply of other goods goes down.



3. Demand for money goes down.4. Demand for other goods goes up.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

y Demand-pull inflation: inflation caused by increases in aggregate demand due to increased privateand government spending, etc.y Cost-push inflation: presently termed "supply shock inflation," caused by drops in aggregate supply

due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass thison to consumers in the form of increased prices.

y Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because itinvolves workers trying to keep their wages up (gross wages have to increase above the CPI rate tonet to CPI after-tax) with prices and then employers passing higher costs on to consumers as higherprices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen ashangover inflation.

Causes of Inflation:

1)Increase in the money supply in the economy or increase in the velocity of the circulation of money.

2)Increase in the government expenditure in the economy.

3)Increase in the investment expenditure in the economy.

4) Deficit financing is an important cause of inflationary rise in the prices.

5)Increase in the population growth of the economy.It is a very important cause of rise in the basic

food prices in a developing country like India.

6)Increase in the export of the economy.It creates a shortage of commodities in the domestic market.

7)Increase in indirect taxes like sales tax.It increases the cost of production for the producers.Hence

they raise the prices of their manufactured items.

8)Decrease in indirect taxes like income tax.

9)Increase in hoardings,profiteering and black marketing.When people are engaged in black and illegal

activities,demand for essential and luxury items rises.



10)Increase in wage rates.It causes the producers to raise the prices of their goods to balance their

profits.

Control of Inflation

1) Monetary Measures:

Monetary measures can help in reducing the pressure of demand.Monetary measures

to control inflation includes:

(i)Higher bank rate.

(ii)Sale of government securities in the open market.

(iii)Increase in reserve requirements.

(iv)Selective credit control measures like Consumer Credit Control,Rationing

All these measures lead to fall in money supply that takes away the extra purchasing power of the

people.Hence aggregate demand falls and prices of the commodities also falls.

2) Fiscal Measures:

Fiscal Measures also help in reducing the pressure of demand.These measures include:

(i)A reduction in government spending.

(ii)Increase in tax rates.

(iii)Increase in public borrowings.

3) Other M easures:

Other measures like expansion of output,wage policy,price control and rationing can be used tosupplement the monetary fiscal measures undertaken to combat inflationary measures.Moreover

suitable income policy can be adopted to control cost push inflation.

Q14) Forex marke t mechanisms

Foreign exchange market provides a forum or a meeting point where the currency of one country can be traded forthe currency of another country. This kind of market is essential because different countries around the globe have different currencies for trading and that import and export of goods and services between countries is inevitable. If the trading isonly within a country, local currency dealings are preferable. For example if Thailand imports aircrafts from the UnitedStates, it has to pay by U.S.Dollar currency and not by Thai bahts. From where will Thailand get U.S.Dollar currency unlessthere is a market for foreign exchange? So, the payment in a particular currency depends upon the exporting country or thecurrency preferred by the exporter. There are cases when the exporter also accepts payment in other currencies providedthey fall under the "major/hard currencies" being popularly and widely traded around the globe. Examples of suchcurrencies are U.S.Dollars, British Pounds, Euros, Japanese Yen, French Franc, Deutsche Mark and Swiss Franc. Foreigncurrencies are also used for direct investment in foreign countries investment options and lendings apart from export andimport. The world's largest financial markets can be traced to foreign currency markets. The major participants in a foreigncurrency market are large commercial banks and central banks of countries.



shortfall will have to be counter balanced in other ways ± such as by funds earned from its foreign

investments, by running down reserves or by receiving loans from other countries.

The Balance of Pa ymen ts Divided

The BOP is divided into three main categories: the current account , the capital account and the financial

account. Within these three categories are sub-divisions, each of which accounts for a different type of

international monetary transaction.

The Curren t Accoun t

The current account is used to mark the inflow and outflow of goods and services into a country. Earnings

on investments, both public and private, are also put into the current account.

The Capi tal Accoun t

The capital account is where all international capital transfers are recorded. This refers to the acquisition

or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets,which are needed for production but have not been produced, like a mine used for the extraction of

diamonds.

The Financial Accoun t

In the financial account, international monetary flows related to investment in business, real estate, bonds

and stocks are documented.

The Balancing Ac t

The current account should be balanced against the combined-capital and financial accounts. However,

as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, thechange in the value of money can add to BOP discrepancies. When there is a deficit in the current

account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital

account. If a country has a fixed asset abroad, this borrowed amount is marked as a capital account

outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings

from investments). The current account deficit would thus be funded.

When a country has a current account deficit that is financed by the capital account, the country is

actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its

current account deficit, this would appear as an inflow of foreign capital in the BOP.

Q17) Shor t no te on: Fiscal Polic y Developmen t

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