Explain the components of Legal reserve Ratio.
LRR (Legal Reserve Ratio) refers to that legal minimum fraction of deposits which the banks are mandate to keep as cash with themselves. The LRR is fixed by the Central Bank. It has two components:
1. Cash Reserve Ratio
2. Statutory Liquidity Ratio
Cash Reserve Ratio (CRR): It refers to the minimum amount of funds that a commercial bank has to maintain with the Reserve Bank of India, in the form of deposits. For example, suppose the total assets of a bank are worth Rs 200 crore and the minimum cash reserve ratio is 10%. Then the amount that the commercial bank has to maintain with RBI is Rs 20 crore. If this ratio rises to 20%, then the reserve with RBI increases to Rs 40 crore. Thus, less money will be left with the commercial bank for lending. This will eventually lead to considerable decrease in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.
Statuary Liquidity Ratio (SLR): SLR is concerned with maintaining the minimum reserve of assets with RBI, whereas the cash reserve ratio is concerned with maintaining cash balance (reserve) with RBI. So, SLR is defined as the minimum percentage of assets to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit is reduced by increasing this liquidity ratio and vice-versa. In the previous example, this can be understood as rise in SLR will restrict the banks to pump money in the economy, thereby contributing towards decrease in money supply. The reverse case happens if there is a fall in SLR, as it increases the money supply in the economy.
Explain the distinction between autonomous and accommodating transactions in balance of payments. Also explain the concept of balance of payments deficit in this context.
Autonomous Items in BOP- Autonomous items refer to international economic transactions that take place due to some economic motives like earning income and profit maximisation. Such transactions are independent of the state of country’s balance of payment. These items are generally called ‘above the line items’ in BOP again, it is autonomous transactions which make deficit or surplus in BOP. BOP is in deficit if the autonomous receipts are less than autonomous payments. BOP is in surplus if the autonomous receipts are greater than autonomous payments.
Accommodating Items in BOP- Accommodating items refers to those international economic transactions that are not undertaken with the motive of earning profit such as government financing, injection or withdrawal from the official reserves. Such transactions are undertaken as a consequence of the autonomous transactions. In other words, they are compensating short-term capital transactions that are undertaken to correct the disequilibrium in the autonomous items.
The deficit in the BOP is governed by the balance of autonomous transactions in the BOP. The BOP would show a deficit if the autonomous receipts are lesser than the autonomous payments. As autonomous receipts implies a receipt of foreign exchange and autonomous payments implies a payment of foreign exchange, so, it can be said that BOP would show a deficit if the foreign exchange receipts are less than foreign exchange payments. In other words, the BOP deficit would be reflected in a depletion of foreign exchange reserves of the country.
Explain the concept of ‘deficient demand’ in macroeconomics. Also explain the role of Bank Rate in correcting it.
Deficient demand refers to the situation when aggregate demand (AD) is less than the aggregate supply (AS) corresponding to full employment level of output in the economy.
The situation of deficient demand arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap. Deflationary gap is the gap by which actual aggregate demand falls short of aggregate demand required to establish full employment equilibrium.
Reasons for deficient demand:
1. Decrease in Propensity to consume: A decrease in consumption expenditure, due to fall in the propensity to consume, leads to deficient demand in the economy.
2. Increase in taxes: AD may also fall due to imposition of higher taxes. It leads to decrease in disposable income and, as a result, the economy suffers from deficient demand.
3. Decrease in Government Expenditure: When government reduces its demand for goods and services due to fall in public expenditure, it leads to deficient demand.
4. Fall in Investment expenditure: Increase in the rate of interest or fall in the expected returns lead to decrease in the investment expenditure. It reduces the AD and gives rise to deficient demand.
5. Rise in Imports: When international prices are comparatively less than the domestic prices, then it may lead to a rise in imports, implying a cut in the aggregate demand.
6. Fall in Exports: Exports may fall due to comparatively higher prices of domestic goods or due to increase in the exchange rate for domestic currency. This will lead to deficient demand.
Role of Bank Rate in Correcting Deficit Demand:
The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks as the lender of last resort. During deficient demand, the central bank reduces the bank rate in order to expand credit. It leads to fall in the market rate of interest which induces people to borrow more funds. It ultimately leads to increase in the aggregate demand.
Explain the concept of ‘excess demand’ in macroeconomics. Also explain the role of ‘open market operation’ in correcting it.
Excess demand refers to the situation when aggregate demand (AD) is more than the aggregate supply (AS) corresponding to full employment level of output in the economy. It is the excess of anticipated expenditure over the value of full employment output.
Due to the excess of aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as inflationary gap. This gap measures the amount of surplus in the level of aggregate demand. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF). In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap.
Following are the reasons for Excess Demand:
1. Rise in the Propensity to consume: Excess demand may arise because of increase in consumption expenditure due to rise in the propensity to consume or fall in propensity to save.
2. Reduction in taxes: It may also occur due to increase in disposable income and consumption demand because of decrease in taxes.
3. Increase in Government Expenditure: Rise in government demand for goods and services due to increase in public expenditure will also result in excess demand.
4. Increase in Investment. Excess demand can also arise when there is increase in investment due to decrease in rate of interest or increase in expected returns.
5. Fall in Imports: Decrease in imports due to higher international prices in comparison to domestic prices may also lead to excess demand.
6. Rise in Exports: Excess demand may also arise when demand for exports increases due to comparatively lower prices of domestic goods or due to decrease in the exchange rate for domestic currency.
Role of Open Market Operation in curbing the Excess Demand:
In order to curb the problem of excess demand, the government can opt for open market operations (OMO). Open market operations refer to sale and purchase of securities in the open market by the central bank. It directly influences the level of money supply in the economy. During excess demand, central bank offers securities for sale. Sale of securities reduces the reserves of commercial banks. It adversely affects the bank’s ability to create credit and decreases the level of aggregate demand in the economy.
Giving reason, explain how the following should be treated in estimating national income:
Expenditure on fertilizers by a farmer.
Expenditure on fertilizers by a farmer should not be included in the estimation of National Income. This is because it is an intermediate consumption that a farmer purchases in order to enhance the crop productivity, so that he can sell more output.
Giving reason, explain how the following should be treated in estimating national income:
Purchase of tractor by a farmer
Purchase of tractor by a farmer should be included in the estimation of National Income. This is because it is a part of Gross Domestic Capital Formation.
|(i)||Factor income from abroad||15|
|(ii)||Private final consumption expenditure||600|
|(iii)||Consumption of fixed captial||50|
|(iv)||Government final consumption expenditure||200|
|(v)||Net current transfers to abroad||(-)5|
|(vi)||Net domestic fixed capital formation||110|
|(vii)||Net factor income to abroad||10|
|(ix)||Net indirect tax||70|
|(x)||Change in stocks||(-)10|
NDPMP = Private Final Consumption Expenditure + Government Final Consumption Expenditure + Net Domestic Fixed Capital Formation + Change in Stock - Net Imports
= 600 + 200 + 110 + (-10) - (-20)
= Rs 920 Cr.
NNPFC = NDPMP+ NFIA -Net Indirect Taxes
= 920 + (-10) - 70
= Rs 840 Cr.
Net National Disposable Income
= NDPMP + NFIA - Net Current Transfers to Abroad
= 920 + (-10) - (-5) Cr.
= Rs 915 Cr.
Explain bankers bank, function of Central bank.
The central bank being the apex bank of a country, serve as a banker to all the commercial banks in the country. The reserves of the commercial banks are held by the central bank. These reserves serve as a pool from which the central bank advances money to the commercial banks in times of financial crisis. The central bank supervises, regulates the commercial banks and helps them in case of any financial exigencies.
Explain the role of Government budget in allocation of resources.
Through the budgetary policy, Government aims to allocate resources in accordance with the economic (profit maximisation) and social (public welfare) priorities of the country. Government can influence allocation of resources through:
(i) Tax concessions or subsidies:
To encourage investment, government can give tax concession, subsidies etc. to the producers. For example, Government discourages the production of harmful consumption goods (like liquor, cigarettes etc.) through heavy taxes and encourages the use of ‘Khaki products’ by providing subsidies.
(ii) Directly producing goods and services:
If private sector does not take interest, government can directly undertake the production.
Explain ‘Revenue Deficit’ in a Government budget? What does it indicate?
Revenue deficit is the gap between the consumption expenditure (revenue expenditure) of the Government and its current revenues (revenue receipts). It also indicates the extent to which the government has borrowed to finance the current expenditure. Revenue receipts consist of tax revenues and non-tax revenues. Tax revenues comprise proceeds of taxes and other duties levied. The expenditure incurred for normal running of government functionaries, which otherwise does not result in the creation of assets is called revenue expenditure.
Revenue Deficit = Revenue Expenditure - Revenue Receipts
Indications of Revenue Deficit:
The revenue deficit indicates the following points.
i. It reflects the government fiscal policy.
ii. It indicates the need for government’s borrowings to finance its consumption expenditures and revenue expenditures such as payments to government employees, etc.
iii. Revenue deficit implies unsoundness of the financial system of an economy.
An increase in revenue deficit implies a proportional increase in the fiscal deficit.