UPSC Mains Answer PYQ 2021: Economics Optional Paper 1 (Part - 2) | Economics Optional Notes for UPSC PDF Download

Q4(c): Do you think that increase in Government spending through borrowing from public accompanied by fall in required reserve ratio generates recession in the economy ? Illustrate your answer : 
(i) in a closed economy with fixed exchange rate. 
(ii) in an open economy with fixed exchange rate and without any capital mobility.
Ans: Government spending is expansionary fiscal policy thus will lead to outward shift in IS curve. Decrease in required reserve ration is expansionary monetary policy leading to outward shift in LM curve.
Closed Economy With Fixed Exchange Rate:
In closed economy there will not be any trade nor any capital exchange.

Expansionary fiscal policy will increase income. However it will also increase transaction demand of money. To compensate it speculative demand of money should decrease by increase in interest rate.
This rise in interest rate can crowd out private investment. But there is also expansionary monetary policy which will prevent crowding out (by downward revision of interest rate). Thus, there will not be recession instead output will increase in this case.
Open Economy With Fixed Exchange Rate & Without Any Capital Mobility:
In the economy without any capital mobility expansionary monetary policy will not affect external balance. With perfect capital immobility the BP curve is vertical at the income level at which imports equal exports.
Expansionary fiscal policy will increase income and thus import. On other hand expansionary monetary policy will not affect capital outflow. Here exchange rate is also fixed. Thus here there will not be recession but external balance of economy will be in the disequilibrium.

Q5(a): Explain Rosenstein-Rodan’s view that economic underdevelopment is the outcome of a massive coordination failure.
Ans: Rosenstien-Rodan model is a big push Model.  In subsistence economies, people don’t have the purchasing power to buy new products. Thus the first factory will not be able to sell all its produce. Its own workers will consume only a part of the produce. Hence simultaneously multiple factories are needed. Thus there exist positive externalities which in absence of a coordinated approach may lead to a failure to achieve an optimal state.

If the wage rate is w₁ and if the firm estimates that by switching alone it would be above point A, it will switch. Since this decision will be made by firms in all industries, entire economy will switch to modern sector and the overall production will be much higher.
But if the wage rate is w₂ and if the firm estimates that by switching alone it would be below point B, it will not switch. This is despite the fact that if all firms switch simultaneously, the economy may reach much above B but still a coordination failure will happen in the absence of state planning.

Q5(b): Explain how gender sensitive human development index can be constructed.
Ans: Gender sensitive human development index measures the gender gap. It can be constructed as follow.
Gender Development Index (GDI)

The gender sensitive human development index is the ratio of the HDIs calculated separately for females and males using the same methodology as in the HDI. It is a direct measure of gender gap showing the female HDI as a percentage of the male HDI.
The GDI shows how much women are lagging behind their male counterparts and how much women need to catch up within each dimension of human development. It is useful for understanding the real gender gap in human development achievements and is informative to design policy tools to close the gap.

Q5(c): Show that the economic integration is the pre-requisite to establish covered interest rate parity.
Ans: Covered interest arbitrage refers to the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale (swap) of the foreign currency to cover the foreign exchange risk.
To do this, the investor exchanges the domestic currency for the foreign currency at the current spot rate and at the same time the investor sells forward the amount of the foreign currency he or she is investing plus the interest he or she will earn so as to coincide with the maturity of the foreign investment.

If economic integration is not there neither interest arbitrage will work nor exchange rate arbitrage. It will lead to failure of covered interest rate parity. Thus for establishing covered interest rate parity economic integration is pre requisit.Q5(d): Under what condition Real Exchange Rate is synonymous to ‘terms of trade’ ? Discuss.
Ans: The real exchange rate (RER) between two currencies is the nominal exchange rate (e) multiplied by the ratio of prices between the two countries, P/P*. On other hand Term of Trade is ratio between prices of two countries.
RER = E*(P/P*)
Thus RER is synonumous to term of trade when nominal exchange rate is 1.
Factors That Will Lead to Unit Nominal ER

1. Full economic integration
2. There is free trade without any obstacles
3. All goods and commodities are traded
4. Both the countries have same currency denomination

Q5(e): Do you agree whether sustainable use of energy ensures economic sustainability ? Explain.
Ans: It is usually said that with increase in economic development energy use also increases. Hence for ensuring long term economic sustainability sustainable use of energy becomes important.

Sustainable Use of Energy & Economic Sustainability:

1. Improving energy efficiencies improves production capcities.
2. Sustainable energy resources like solar energy can provided energy to remote locations. Eg. North East India.
3. Schemes like PM-KUSUM provided additional income to farmers by production of renewable solar energy.
4. It promotes economic development through research.
5. It will also help in job creations. Eg. Job created in solar panel production and maintainance of renewable energy plants

Sustainable use of energy will help us to fulfill SDG 7 related to clean and affordable energy. It can ensure economic development. Thus, future economies should focus on sustainable use of energy.

Q6(a): Evaluate Kuznets’ inverted U shaped curve hypothesis of income distribution. Does it hold good for less developed countries as well ?
Ans: Kuznets hypothesis analyzed effect of growth on distribution of income. According to Kuznet as income increases inequalities first increase and then decrease.

Causes for increase in inequalities:
In the first part, industrial income rises and agricultural income falls. It also creates disparity between urban and rural area. It is because backwash effect is working for rural and agricultural sector.

Causes for decreased inequalities:
Over the period spread effect starts working in rural area. It raises income in rural area. Also because of political pressure government might take actions to reduce inequalities. It together helps in reducing inequalities.

Trend in in income inequalities in developing and developed economies:
East Asian economies invalidated Kuznets hypothesis. There inequalities are decreasing with rising income. Increase in income was well distributed thus it reduced inequalities. It might be because of active government intervention for redistribution.
In developed countries after fall in inequalities it started rising again. It might be because of growth in service sector. Service sector has high income generation capacity but low employment elasticity. Thus inequalities are increasing with growth of service sector.
In countries like India and Brazil inequalities have not shown downward trend with growth. Inequalities kept rising with growth. It might be because of weak manufacturing sector and strong service sector. Another reason could be high income inequalities in initial phases. Thus India and Brazil might be taking time to go on downward path of Kuznet curve.

Q6(b): Does human capital cause economic growth ? Explain how human capital formation can be enhanced.
Ans: Human capital have played important role in economic growth. It can be seen in the Japan, South Korea and South East Asian Countries. Endogenous growth models also prdicts that human capital can cause economic growth. Romer’s model also predicts that investment in human capital can lead to growth for longer time.
Human Capital and Economic Growth:
The production function with constant returns can be expressed as follow
Y = AK
Where A is a positive constant it represents the level of technology. Here K  is treated in a broad sense to include both physical and human capital so as to assume away the absence of diminishing returns to capital in the AK production function.
Output per capita is y = Y/L = A*(K/L)= Ak
where k is per capital capital K/L
Now ∆k = I = Saving (S) – Depreciation (D)
We know that S = sY & D = dK
∆K = I = sY – dK
We can rewrite this as
sY = K(∆K/K) + dK
At steady stage ∆K/K = ∆Y/Y  = n
Thus sY = (n+d)K
but Y/K = A
Hence  sA = (n + d)

With AK model increase in capital increases income with constant proportion. Now if sA > n + d then k grows in perpetuity. Thus technological progress, driven by investment in human capital formation and R & D, offsets diminishing returns to physical capital

Enhancing Human Capital Formation:

1. Amartya Sen’s capability development approach could be suitable for the enhancing human capitla formation.
2. Education playes important role in human capital formation. Government should focus on ensuring accessibility to quality education at affordable rate.
3. Health ensures that human capital is available for longer time without any disruption. Thus, government should focus on ensuring accessibility to quality health at affordable rate.
4. Skilling of population can increase quality of human resource.
5. R&D spending playes important role in enhancement of human capital. Both private companies and government companies should focus on it.
6. Nutrition ensures the availibility of healthy human capital.

Thus by focusing on health, education and skilling human capital can be enhanced in the country.

Q6(c): Explain how Harrod’s warranted rate of growth is similar to Domar’s required rate of growth. How has Solow improved upon Harrod-Domar’s growth model ?
Ans: Harrod – Domar model wanted to determine unique rate at which investment and income must grow such that full employment level is maintained for longer time.
In Harrod’s model warranted growth rate is growth rate which induces enough investment to match planned saving. It is given by
Warranted growth rate (gw) = s/Vr
where s is saving rate and Vr is warranted capital output ratio.
While in Domar model required rate of growth is given as follow
Gy (∆y/y) = (∆I/I) = s.σ
Where s is MPS and σ if output capital ratio.
So in the steady state or rate of growth of investment is equal to the rate of growth of GDP is equal to s.σ. It is same as the Harrod’s warranted growth rate.

Solow’s improvement upon Harrod Domar Model
Knife Edge Problem:
In Harrod’s model equilibrium is achieved when gn = gw = g. Any deviation from this will lead to either chronic depression or chronic inflation. It occurs because production function is assumed as fixed coefficients production. Because of it labor can not be substituted for capital. It brings rigidity to Vr. Also MPS is constant. Thus there is no way to achieve equilibrium but at gn = gw = g

Dropping assumption of fixed coefficients production function (Solow Swan Solution):
If capital grows faster than labor i.e. gw > gn, labor will become scarcer, wages will increase and technological innovations will take place in labor saving techniques. Thus Vr will increase (since now more capital is required to produce same output) and this will lower gw. If however, labor grows faster than capital then gw < gn, and labor redundancy will depress real wages and shift will be made towards labor intensive technologies. Thus Vr will fall and gw will increase.
Hence dropping assumption of fixed coefficient production function can solve problem of knife edge.

Q7(a): Discuss the theory of acquired advantage in international trade using suitable examples.
Ans: Acquired advantage means the ability of a country to produce a good or service with fewer resources using knowledge or skills that are acquired over time. Theory of acquired advantage can be explained using product cycle model.
Acquired Advantage & Product Cycle Model:
Product life cycle model explains that intially develope country innovates a product. Over the time developing country acquires comparative advantage in that product and starts dominating innovating country.

Stages of product life cycle model:

1. In stage I (time OA), the product is produced and consumed only in the innovating country.
2. In stage II (AB), production is perfected in the innovating country and increases rapidly to accommodate rising demand at home and abroad.
3. In stage III (BC), the product becomes standardized and the imitating country starts producing the product for domestic consumption.
4. In stage IV (CD), the imitating country starts underselling the innovating country in third markets, and in stage V (past point D) in the latter’s market as well.

Case Studies:

1. Japan acquired comparative advantage in autombiles.
2. South Korea and China acquired comparative advantage in electronics.

Q7(b): Do you think that movement of the nominal exchange rate of Rupee represents a corresponding movement of Indian goods vis-a-vis foreign goods ? Explain your position.
Ans: Since 2000 India have seen gradual depreciation of Indian currency. International trade theories suggests that depreciation of currency increases export of the currency and decreases import. In India this movement can be seen.
As currency depreciate export increased but however import have also shown increasing trend. Rise in import increased due to following reasons.

1. Import dependence on oil
2. Import of raw material from countries like China
3. Craze for imported goods.
4. Rise in income led to rise in import

Because of these factors despite of depreciation of currency India have trade deficit. In a country like India trade is not only factor which determines nominal exchange rate. India is one of the attractive destination for the foreign capital inflow. Foreign inflow also affects nominal exchange rate. Central bank of India (RBI) also intervenes in foreign exchange markets to ensure exchange rate stability.
Thus, it can be observed that nominal exchange rate of Rupee do represents a corresponding movement of Indian goods vis-a-vis foreign good but it is not complete due to other factors like RBI intervention, import dependence and foreign capital flow.

Q7(c):  What are the different categories of trade blocks ? Are trade blocks beneficial to less developed economies ? Justify your answer.
Ans: A trade bloc is a trade agreement among governments that are typically within a shared geographical region. The agreement is entered into as a means of protecting member nations from excessive imports of non-member nations. And to encourage trade among member states, tariffs, taxes, and other trade barriers among them are often reduced or abolished.

Types of Trade Blocks

1. Free-Trade Area: All barriers to import and export of goods and services among member countries are removed. For e.g. North American Free Trade Agreement (NAFTA).
2. Customs Union: Free-trade area + all member countries adopt a common set of trade restrictions with non-members.
3. Common Market: Customs union + all barriers to the movement of labor and capital goods among member countries are removed.
4. Economic Union: Common market + member countries establish common institutions and economic policy. For e.g. European Union (EU).
5. Monetary Union: Economic union + member countries adopt a single currency. For e.g. European Zone

Trade Block & Less Developed Countries

1. The ASEAN free trade aea have played important role in the development of ASEAN countries. It increased economic development, job creation & reduced poverty.
2. African free trade agreement is playing important role in the development of African continent. UNECA estimates that AfCFTA will boost intra-African trade by 52.3% once import duties and non-tariff barriers are eliminated.
3. However, usually less developed countries gains less in free trade agreement due to their low negotiation power and limited production capacities.
4. In South Asia, SAFTA have limited success.
5. However, ASEAN free trade area have also created problems like 1999 currency crisis which affected economies of ASEAN countries.

Thus it can be said that effect of trade blocks on less developed countries is mixed.

Q8(a): If the government raises taxes on labour income and interest income, explain how potential GDP and economic growth are affected.
Ans: Potential GDP is an estimate of the highest level of output an economy can sustain over a period of time. It assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply.

Determinants of Potential GDP:

1. Size of labor force
2. Productivity of labor force
3. Investment 
4. Infrastructure

Effect of Increased Labor Income Tax & Inerest Income Tax on Potential GDP:
Increase in labor income tax will reduce wages for the labor. This will discourage labor force participation. Thus, labor supply curve will shift inward. Thus labor supply will decrease and hence potential GDP.
Increase in tax on interest income will affect investor sentiments. It will discourage overall investment which will further affect potential GDP in the economy. 
If the government raises taxes on labour income and interest income, potential GDP and economic growth of the country will lower. 

Q8(b): Examine the effects of providing public service by a private agency at a lesser price than earlier one on
(i) a closed economy with fixed wages.
(ii) a closed economy with flexible wages.
Ans: When private agency provides public service at low price, value of marginal product for the labor will change. It will generate different effect in the economy in case of fixed wages and flexible wages .
(i) Fixed Wage Case
This is a Keynesian case. Fall in prices will increase real wages. As shown in below figure it will result into the involuntary unemployment RT. Labor market won’t be in equilibrium. Employment and output  will be less than natural level. 

(ii) Flexible Wage Case
This is a classical case. Now service is provided at lesser price. Lets assume that there is no government subsidies. So in such case value of marginal product of labor will decrease and real wages will increase. Thus labor demand curve will shift dowanward (Nd(P1) to Nd(P0)). Labor will get to know increase in real wages. As the wages are flexible there will be downward revision of nominal money wages. It will shift labor supply curve outward. Hence, equilibrium will be reestablish at the initial employment and output level.

Q8(c): What is Buchanan’s criticism of Arrow’s theorem ? Show how A. K. Sen proved Arrow’s theorem without the overall consistency of social choice to avoid the criticism.
Ans: Arrow’s impossibility theorem is a social-choice paradox illustrating the impossibility of having an ideal voting structure to translate individual preferences into social preferences without violating one of the following axioms : Nondictatorship, Pareto Efficiency, Independence of Irrelevant Alternatives, Unrestricted Domain and Social Ordering.
Buchanan’s Criticism of Arrow’s Theorem:

1. It argues that it is silly to think that there might be social preferences that are analogous to individual preferences
2. Social prefrences should not be used in social welfare theorem 
3. Arrow’s Theorem to emphasize the chaotic, untrustworthy nature of democracy. 

Sen’s Modification:
Amartya Sen extended Arrow’s framework to take into account not only ordinal information about people’s preferences among pairs of alternatives, but also cardinal information about the utility they derive from each one.
Another critical essay to Paretian optimum was provided by Indian Nobel laureate Amartya Sen, who demonstrated with a paradox the impossibility of Paretian liberal, in 1970. The logic scheme is based on Arrow's impossibility theorem. Sen considers two individuals, A and B, and three possible actions for each individual:

1. A reads a book
2. B reads a book
3. nobody reads a book.

A prefers action 3) over action 1) and action 2) (3>1>2), while B prefers action 1) over action 2) and action 3) (1>2>3). Therefore, the Paretian optimum solution is action 1) prevailing over action 2) (1>2). However, a liberal society shares two relevant values:
In this way he was able to investigate the consequences of other assumptions than Arrow’s about the measurability and interpersonal comparability of individual preferences.