Test: Class 12 (Macroeconomics) Economy NCERT Based - 2 - UPSC MCQ

GDP at factor cost is gross domestic product at market prices, less net product taxes. Market prices are the prices as paid by the consumers. Market prices also include product taxes and subsidies.

The term factor cost refers to the prices of products as received by the producers. Thus, factor cost is equal to market prices, minus net indirect taxes. GDP at factor cost measures money value of output produced by the firms within the domestic boundaries of a country in a year.

In order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices.

For comparison we take the help of real GDP. Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices).

Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes. Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices.

Reserve Bank is the only institution which can issue currency. When commercial banks need more funds in order to be able to create more credit, they may go to market for such funds or go to the Central Bank.

Central bank provides them funds through various instruments. This role of RBI, that of being ready to lend to banks at all times is another important function of the central bank, and due to this central bank is said to be the lender of last resort. The RBI controls the money supply in the economy in various ways.

The tools used by the Central bank to control money supply can be quantitative or qualitative. Quantitative tools control the extent of money supply by changing the CRR, or bank rate or open market operations.

Qualitative tools include persuasion by the Central bank in order to make commercial banks discourage or encourage lending which is done through moral suasion, margin requirement, etc

Open Market Operations refers to buying and selling of bonds issued by the Government in the open market. This purchase and sale is entrusted to the Central bank on behalf of the Government.

When RBI buys a Government bond in the open market, it pays for it by giving a cheque. This cheque increases the total amount of reserves in the economy and thus increases the money supply. Selling of a bond by RBI (to private individuals or institutions) leads to reduction in quantity of reserves and hence the money supply.

The RBI can influence money supply by changing the rate at which it gives loans to the commercial banks.

This rate is called the Bank Rate in India. By increasing the bank rate, loans taken by commercial banks become more expensive; this reduces the reserves held by the commercial bank and hence decreases money supply. A fall in the bank rate can increase the money supply.

The most important determinant of consumption demand is household income. A consumption function describes the relation between consumption and income. The simplest consumption function assumes that consumption changes at a constant rate as income changes.

Of course, even if income is zero, some consumption still takes place. Since this level of consumption is independent of income it is called autonomous consumption. We can describe this function as: C C cY = + (4.1) The above equation is called the consumption function. households.

When income changes, change in consumption ∆C can never exceed the change in income (Y) ∆. The maximum value which c can take is 1.

On the other hand, consumers may choose not to change consumption even when income has changed. In this case MPC = 0. Generally, MPC lies between 0 and 1 (inclusive of both values).

This means that as income increases either the consumers does not increase consumption at all (MPC = 0) or use entire change in income on consumption (MPC = 1) or use part of the change in income for changing consumption (0 < MPC < 1)

Investment is defined as addition to the stock of physical capital (such as machines, buildings, roads etc., i.e. anything that adds to the future productive capacity of the economy) and changes in the inventory (or the stock of finished goods) of a producer.

Note that ‘investment goods’ (such as machines) are also part of the final goods – they are not intermediate goods like raw materials. Machines produced in an economy in a given year are not ‘used up’ to produce other goods but yield their services over a number of years.

Investment decisions by producers, such as whether to buy a new machine, depend, to a large extent, on the market rate of interest. However, for simplicity, we assume here that firms plan to invest the same amount every year.

When GDP rises, disposable income also rises but by less than the rise in GDP because a part of it is siphoned off as taxes. This helps limit the upward fluctuation in consumption spending.

During a recession when GDP falls, disposable income falls less sharply, and consumption does not drop as much as it otherwise would have fallen had the tax liability been fixed. This reduces the fall in aggregate demand and stabilises the economy.

Budgetary deficits must be financed by either taxation, borrowing or printing money. Governments have mostly relied on borrowing, giving rise to what is called government debt.

The concepts of deficits and debt are closely related. Deficits can be thought of as a flow which adds to the stock of debt. If the government continues to borrow year after year, it leads to the accumulation of debt and the government has to pay more and more by way of interest These interest payments themselves contribute to the debt.

We must note that larger deficits do not always signify a more expansionary fiscal policy. The same fiscal measures can give rise to a large or small deficit, depending on the state of the economy.

For example, if an economy experiences a recession and GDP falls, tax revenues fall because firms and households pay lower taxes when they earn less. This means that the deficit increases in a recession and falls in a boom, even with no change in fiscal policy.

Output Market: An economy can trade in goods and services with other countries. This widens choice in the sense that consumers and producers can choose between domestic and foreign goods.

Financial Market: Most often an economy can buy financial assets from other countries. This gives investors the opportunity to choose between domestic and foreign assets.

Labour Market: Firms can choose where to locate production and workers to choose where to work. There are various immigration laws which restrict the movement of labour between countries.

Trade in services includes factor income and non-factor income transactions. Transfer payments are the receipts which the residents of a country get for ‘free’, without having to provide any goods or services in return. They consist of gifts, remittances and grants. They could be given by the government or by private citizens living abroad.

Balance of Trade (BOT) is the difference between the value of exports and value of imports of goods of a country in a given period of time.

Export of goods is entered as a credit item in BOT, whereas import of goods is entered as a debit item in BOT. It is also known as Trade Balance.

BOT is said to be in balance when exports of goods are equal to the imports of goods. Surplus BOT or Trade surplus will arise if a country exports more goods than what it imports. Whereas, Deficit BOT or Trade deficit will arise if a country imports more goods than what it exports.

When income increases, consumer spending increases. Spending on imports is also likely to increase.

When imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency. If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward.

On balance, then domestic currency may or may not depreciate. What happens will depend on whether exports are growing faster than imports. In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world normally finds its currency depreciating because its imports grow faster than its exports. Its demand curve for foreign currency shifts faster than its supply curve.