Class 12 Economics Long Questions With Answers - Determination Of Income And Employment

Q.1. Explain monetary measures for correcting inflationary and deflationary gap.
Ans. Following are the monetary measures for correcting inflationary and deflationary gap:
(i) Open Market Operation: Open market operation is the policy of the central monetary authority to sell and buy the government securities in the market. RBI purchases or sells government securities to the general public in a bid to correct deficient or excess demand in the economy.
(ii) Bank Rate Policy: Bank rate is the minimum rate at which the central bank discounts the first class bills of exchange and provides credit to the commercial banks. Higher bank rate reduces the lending capacity of the commercial banks as they get funds at a higher interest rate from RBI. Consequently, credit contracts in the economy as public borrows less at high rate of interest. It reduces excess demand. Similarly, lower bank rate increases the lending capacity of the commercial banks as they get funds at a lower interest rate from RBI. Consequently, credit expands in the economy as public borrows more at low rate of interest. It solves the problem of deficient demand.
(iii) Varying Reserve Requirements: Cash Reserve Ratio (CRR) is the minimum fraction of the total deposits with the commercial banks, which they are required to keep with the central bank. Statutory Liquidity Ratio (SLR), on the other hand, is the minimum fraction of the total deposits with the commercial bank, which they are required to maintain in the form of specified liquid assets. A high (low) value of CRR or SLR helps increase (decrease) the value of reserve deposit ratio, thus diminishing (increasing) the value of the money multiplier and money supply in the economy.
(iv) Rationing of the Credit: Rationing of the credit implies controlling the quantity in the form of loan. Here, amount of loan is determined for speculative purpose. Hence, total demand can be increased by rationing of credit. It will increase the purchasing power of people and hence, deficient demand will be corrected. Rationing of credit should be increased by central bank for correcting the excess demand or inflationary gap.

Q.2. Explain the role of the following in correcting‘deficit demand’ in an economy.
(i) Open market operations
(ii) Bank rate
Ans. (i) Open Market Operations: Open market operation is the policy of the central monetary authority to sell and buy the government securities in the market. The central bank purchases government securities from commercial banks and general public in a bid to correct the situation of deficient demand. This increases the stock of high powered money in the economy. As a result, the purchasing power of the people increases, which increases the Aggregate Demand in the economy.
(ii) Bank Rate: Bank rate is the minimum rate at which the central bank discounts the first class bills of exchange and provides credit to the commercial banks. The central bank decreases the bank rate to correct the situation of deficient demand in the economy. Lower bank rate increases the lending capacity of the commercial banks as they get funds at a lower interest rate from the central bank. Consequently, money supply expands in the economy as public borrows more at low rate of interest and Aggregate Demand rises.

Q.3. Explain the role of the following in correcting ‘excess demand’ in an economy:
(i) Bank rate
(ii) Open market operations
Ans. (i) Bank Rate: Bank rate is the minimum rate at which the central bank discounts the first class bills of exchange and provides credit to the commercial banks. The central bank increases the bank rate to correct the situation of excess demand in the economy. Higher bank rate reduces the lending capacity of the commercial banks as they get funds at a higher interest rate from the central bank. Consequently, money supply contracts in the economy as the public borrows less at high rate of interest and Aggregate Demand falls.
(ii) Open Market Operations: Open market operation is the policy of the central monetary authority to sell and buy the government securities in the market. The central bank sells government securities to commercial banks and general public in a bid to correct the situation of excess demand. This decreases the stock of high powered money in the economy. As a result, the purchasing power of the people declines, which decreases the Aggregate Demand in the economy.

Q.4. Explain the role of the following in correcting the deflationary gap in an economy:
(i) Open market operations
(ii) Margin requirements
Ans. The problem of deficient demand or deflationary gap can be corrected by adopting following monetary measures:
(i) Open Market Operations: Open market operation is the policy of the central monetary authority to sell and buy the government securities in the market. The central bank purchases government securities from commercial banks and general public in a bid to correct the situation of deficient demand. This increases the stock of high powered money in the economy. As a result, the purchasing power of the people increases, which increases the Aggregate Demand in the economy.
(ii) Margin Requirement: Margin requirement of loan is the minimum security price charged by the commercial bank for granting loans. A decrease in margin requirement will correct the situation of deficient demand in the economy. Lower margin requirement implies lower security price for a loan. Thus, people will borrow more loans from the banks and the Aggregate Demand will increase.

Q.5. Explain the concept of excess demand in macroeconomics. Also explain the role of ‘open market’ operation in correcting it.
Or
What is 'excess demand'? Explain the role of 'reverse repo rate' in removing it
Ans. Excess demand refers to a situation in which Aggregate Demand in the economy is greater than the Aggregate Supply (AD > AS) at full employment level.
Excess demand is also known as inflationary gap. It measures the gap between AD and AS at full employment level of output. Since Aggregate Demand remains more than essential demand at full employment level, there is a significant increment in monetary income. Thus, there is an over employment equilibrium. This increases the Aggregate Demand but production cannot be increased as Aggregate Supply is perfectly inelastic. The problem of excess demand can be explained with the help of a diagram.
In the diagram, point E represents the state of over employment equilibrium in the economy. At E, the gap between Aggregate Demand and Aggregate Supply is AE . That is, AE is the excess demand. The problem of excess demand can be corrected only by the interference of the government (increasing taxes and reducing public expenditure).
Open market operation is the policy of the central monetary authority to sell and buy the government securities in the market. The central bank sells government securities from commercial banks and general public in a bid to correct the situation of excess demand. This decreases the stock of high powered money in the economy. As a result, the purchasing power of the people decreases, which decreases the Aggregate Demand in the economy.
Reverse repo rate refers to the rate at which central bank borrows from the commercial banks. The central bank increases the reverse repo rate to correct the situation of excess demand. Higher reverse repo rate would induce commercial banks to lend more to the central bank and hence, would reduce the supply of money in the economy. As a consequence, Aggregate Demand would fall.

Q.6. Explain the meaning of underemployment equilibrium. Explain two measures by which full employment equilibrium can be reached.
Ans. Equilibrium is attained when planned expenditure is equal to the planned output in the economy. If this equality is achieved at a level less than full employment level of output then the economy will be in a situation of under employment equilibrium.
The two policy measures that the government can take are:
(i) Increase in Public Expenditure: Government can correct the situation of underemployment by increasing public expenditure on goods and services such as transportation, dams, electricity industry development expenditure, education, health etc. This increases the purchasing power of the public which, in turn, increases the demand for goods and corrects deficient demand. Moreover, increase in public expenditure also helps in eradicating poverty.
(ii) Open Market Operations: Open market operation is the policy of the central monetary authority to sell and buy the government securities in the market. The central bank purchases government securities from commercial banks and general public in a bid to correct the situation of deficient demand. This increases the stock of high powered money in the economy. As a result, the purchasing power of the people increases, which increases the Aggregate Demand in the economy.