UPSC Mains Answer PYQ 2019: Economics Optional Paper 1 (Part - 2) | Economics Optional Notes for UPSC PDF Download

Q5(a): Explain how money multiplier will be affected if there happens to be partial hoarding by public in each round as well as excess cash reserve holding by banks over the minimum required.
Ans: Money multiplier (m) is ratio of commercial bank money (M) with high power money (H).
m = M/H
M = Currency (C) + Demand deposit (D)
C = k*D where k is currency deposit ratio.
Hence M = (k + 1)D
H = Currency (C) + Cash reserve with banks (R)
R = r*D where r is cash reserve ratio.
Hence H = (k+r)D
Thus money multiplier (m) = [(k + 1) / (k+r)]
Now there is partial hoarding by public. Hence k will increase. And as banks are holding excess cash, r will also increase. Hence money multiplier in the economy will decrease. Decrease in money multiplier will reduce money supply in the economy.

Q5(b): In what sense is Friedman’s quantity theory said to be a ‘restatement’ of Fisher’s theory? Explain. (10 Marks)
Ans: Friedan reformulated Fisher’s quantity theory of money. Friedman assumed role of money for transaction as well as asset holding purpose. According to Freidman total wealth to be held in various forms.  Wealth composition is influenced by return on this assets.
On the basis of above assumption Friedman’s money demand function can be written as
Md = F(P, Y, rb, re, rd)
where P = price level
Y = real income
rb = nominal interest rate on bonds
re = nominal return on equities
rd = nominal return on durable goods
It can be restate as
Md = K( rb, re, rd)PY
In Equilibrium Money supply is equal to money demand thus
Ms = Md =  K( rb, re, rd)PY
Here K( rb, re, rd) is constant thus reformulating it we get
Ms/k = PY
Above equation is similar to Fisher’s equation : MV = PT
Quantity theory of money takes velocity of money is constant, Friedman made it function of interest rate. Through his portfolio approach he explained constancy of  velocity of money. Similar to Fisher equation it explained that, rise in money supply leads to rise in prices in long run.
Thus it is said that Friedman’s quantity theory is restatement of Fisher’s theory. Which made Fisher’s theory more comprehensive.

Q5(c): What criteria will have to be satisfied to obtain a Pareto efficient allocation? (10 Marks)
Ans: Pareto efficiency is said to occur when it is impossible to make one party better off without making someone worse off.

Conditions for Pareto optimality
Efficiency in consumption:

The required condition is that the marginal rate of substitution between any two products must be the same for every individual who consumes it.

At point E MRSxy for consumer a and consumer b is different. Thus both will exchange goods such that they move to either of point P, Q or R where (MRSxy)a = (MRSxy)b.

Efficiency in production
The required condition is that the marginal rate of technical substitution between labor and capital should be equal for both the producer. It can be given as (MRTSLK)a = (MRTSLK)b

Efficiency in product-mix
For equilibrium both product and consumption market should be simultaneously in equilibrium. It happens when marginal rate of substitution (MRS) between two products must equal the marginal rate of transformation (MRT) between them.  I

In the above diagram only at point E market will be in equilibrium where (MRSxy)a = (MRSxy)b = (MRTxy)a = (MRTxy)b

Q5(d): Automatic stabilizers are supposed to mitigate cyclical fluctuations, but there exist limitations which dampen the effect of these stabilizers. Analyze. 
Ans: Automatic stabilizers offset fluctuations in economic activity without direct intervention by policymakers. The well known automatic stabilizer is progressive taxation. As income increases it automatically increases taxes and thus reduces purchasing capacity. As income decreases it automatically reduces taxes and increases purchasing capacity thus boosting economy.

Limitations of automatic stabilizers

• It works only in demand side fluctuations. It has no capacity to handle supply side shocks.
• Sometime crisis can be large which requires more fiscal stimulus. For example 2009 global financial crisis.
• In some countries tax avoidance could be large. It reduces efficacy of automatic stabilizers.
• With the increased tax, tax compliance could reduce. It affects automatic stabilization.
• To ensure automatic stabilization government has to ensure efficient working of those stabilizers. For example in the tax as stabilizer, tax system should be efficient.

Q5(e): What are the obstacles to international macro-economic policy coordination? Discuss.
Ans: Since last few decades world is economically integrating. In the integrated economic world macro economic policy co ordination ensures mutual gains for all. However this policy co ordination is not seen in the world.
Obstacles in policy co ordination

1. Every nation want to maximize its own country’s welfare. Thus it ignores spill over effect of policy co ordination.
2. Initial situation of every country is different. It makes policy co ordination difficult. In the developing countries government may focus on increasing fiscal deficit to increase its productive capacity.
3. Some countries deliberately manipulate monetary policies to increase gain from trade. For example depreciation of currency.
4. Monetary system of every country is different.
5. Begar thy neighbor policies creates trust issues.
6. There is uncertainty regarding efficacy of policy co ordination.

To ensure policy co ordination most important is creating trust among nations. In addition to that there is need to have special support to underdeveloped and developing countries.

Q6(a) How is the Marshallian equilibrium different from Walrasian equilibrium? (15 Marks)
Ans:

Q6(b): Discuss the essential features of the growth models which incorporate research and development. 
Ans: From neo classical growth model to new growth models various growth models took R&D as important factor of growth.
Solow growth model 
Equation of solow growth model is given as
Y = AF(K,L)
where Y is income, K is capital, L is labor
Here A measures technological factor and is known as Solow residual. It measure rate of technological progress that increases output without increasing labor and capital.
As R&D increases, A increases. It tend to increase income in the economy.

Romer’s model of technological Change 
In Romer’s model technology is taken as endogenous factor. Its equation is given as.
ΔA = F(Ka, Ha, A)
where
ΔA  is change in technology
Ka is amount of capital invested in new technology
Ha is amount of human capital invested in new technology
A is existing technology
When more human capital is employed for R&D, change in technology (ΔA) will be more. Also technology is non rival and thus will have positive impact on other sectors as well. Thus investment in R&D leads to increase in economic development.
In the new growth model R&D is important factor of production. Government and private sector should focus on investment in R&D to increase the economic development.

Q6(c): In the contemporary world, many countries are not following Kuznets’ pattern of structural change. Give reasons.  (20 Marks)
Ans: Kuznet structural change hypothesis suggest that, as economic developed it transforms from agriculture to industry and then industry to service sector.
Kuznet N Curve

First economy transforms from agriculture to industry. It increases income in modern industry sector than agriculture sector. Urban income increases more than rural. It increases inequalities. But over the time spread effect works and rural income also increases. Due to decrease in disguised unemployment in agriculture, productivity of agriculture increases. It leads to increase in agricultural income.
Then economy transforms from industry to service sector. It increases income in modern service sector than industry and agriculture sector. It increases inequalities again.

Why many countries are not following this pattern?
According to Kongsamut’s empirical study, the rise in services sector is more than what Kuznets Predicted. Initially, as Agriculture declines, share of both Industry and Services increase. Over the time agriculture and industry declines and service sector share rises. Similar condition is seen in India. In India service sector share in GDP is 60%. As service sector is less employment elastic it increases inequality.
In some countries labor laws, land acquisition laws, environmental laws could be strict. It inhibits growth of industry and promotes employment in service sector. It happens because service sector requires less labor and land.
In country like India, manufacturing is seen as low occupation. It affects growth of manufacturing sector. It promotes tertiarization of  economy.
In ASEAN countries, with the growth government focused on distribution. Active government involvement reduced inequalities. Thus ASEAN countries did not saw Kuznet pattern of development.
However there are countries like China where Kuznet structural pattern is seen. But in most of the countries it does not follow.

Q7(a): In what way does the concept of a positive optimal tariff apply to only large countries and not to small countries? Explain. (15 Marks)
Ans: The optimum tariff is that rate of tariff that maximizes the net benefit resulting from the improvement in the nation’s terms of trade against the negative effect resulting from reduction in the volume of trade due to tariff.
The optimum tariffs is determined where the trade indifference curve of the tariff-imposing home country becomes tangent to the offer curve of the foreign country.
Small country case
The optimal tariff for a small country is zero because it cannot impact world prices. As it can not affect world prices Term of Trade will remain unchanged, but there will be significant reduction in volume of trade due to tariff.

Large country case
Optimum tariff is high for a large country which can significantly affect term of trade such that reduction in volume of trade due to tariff is compensated by increase in term of trade.
Thus the concept of a positive optimal tariff apply to only large countries and not to small countries.

Q7(b): Keynesian demand for money is one of the key concepts of Keynesian theory of unemployment. Illustrate.
Ans: Keynes theory of money demand recognized money as an asset. Keynes said that there are two motives to hold money. One for transaction purpose and other for speculation of future interest.
Bond prices are inversely proportional to the interest rate. When interest rate are above normal they are suppose to fall and when interest rate are below normal they are suppose to increase.  At low interest rate interest rate might increase. If capital loss outweighs interest rate earned investor will prefer to hold money. It is called as speculative demand.
At low interest rate there will be high speculative demand.  Any rise in money supply will be held as cash. Thus money demand will be highly elastic to the interest rate. It makes LM curve horizontal. In that case any demand side shock (Say fall in investment) will lead to fall in equilibrium output and unemployment.

In the absence of liquidity trap, money demand will be inelastic to interest rate. It makes LM curve vertical. Thus any demand side shock will not decrease output. Instead through interest rate adjustment output will remain stable at full employment.
Hence Keynes theory of money demand is one of the reason for involuntary unemployment.  However liquidity trap is only one of the factor major factor for involuntary unemployment is wage rigidity.

Q7(c): Can multinational investment defeat the objective of inclusive growth? Give reasons for your answer.  (20 Marks)
Ans: Multinational companies are companies with presence in more than two countries. Investment by these MNC are known as multinational investment.

Multinational investment and inclusive growth
Without the capital flow country A is earning OM and country B is earning O’N

Now earning in national B is greater than earning in nation A. Thus there will be capital inflow from country A to country B. It reduces capital earning in nation A and increases labor earning. Thus multinational companies promotes job in country B and promotes inclusive growth.

Multinational investment defeating objective inclusive growth
Multinational companies attracts talent from domestic firms. It affects viability of domestic firms. It destroys small firms and thus affects inclusive growth.
Multinational investment has low elasticity of employment compared to MSME. However multinational investment pays higher than MSME. It increases inequality and thus defeats objective of inclusive growth.
Presence of multinational investment creates strong competition for domestic products especially products of MSME. It may lead to closure of  MSME which might affect job of many people.
Not all the time multinational investment promotes inclusive growth. As multinational investment increases it hurts economic sovereignty of country. Under such condition government may act against the welfare of people. For example allowing mineral exploitation in tribal area will affect rights of tribal people.
Multinational investment might get involved in over exploitation of natural resources. It affects right of domestic people on natural resources. Also environmental degradation reduces growth in longer term. It affects inclusive growth scenario.
Multinational investment often get involved in tax avoidance. Major tools for tax abidance are transfer pricing and round tripping. It deprives government of resources which affects welfare schemes for vulnerable.

Q8(a): What makes monetary policy ineffective even in the short run? Explain.
Ans: Monetary policy involves change in money supply. Under following conditions monetary policy will not work.
Liquidity Trap Condition
In the liquidity trap condition, money demand is highly elastic with interest rate. It makes LM curve flat. Lets say there is rise in money supply. It will shidt LM curve downward. In this condition small change in interest rate is required for absorbing increased money supply. Thus only small rise in investment and output. Hence monetary policy would be ineffective under liquidity trap condition.

Systematic monetary policy under rational Expectation Hypothesis
Lucas  said that economic agent will form expectation on the basis of all available information.

Let say there is rise in money supply. It will increase price level. Increase in price level will increase value of marginal product. It will sift labor demand outward.  It will lead to rise in employment. This change will be anticipated & economic agent react to it to adjust accordingly. It results into shift of labor supply and hence output to leftward. Hence systematic monetary policy will be ineffective even in short run.
Open economy with perfect capital mobility and fixed exchange rate

With increase in money supply, LM curve will shift rightward. It will reduce equilibrium interest rate. But under perfect capital mobility, capital will start flowing outward. With fixed exchange rate central bank will intervene to keep exchange rate stable. It will reduce money supply and shift LM curve back to leftward. Thus monetary policy will be ineffective in short run.

Q8(b): Trade can be growth-promoting or growth-inhibiting. Argue in terms of the established theories.
Ans: International trade can be growth promoting as well as growth inhabiting. Proponent of each argument had proposed different models.

Trade as growth promoter 
Comparative advantage theory:
Even if one country has absolute advantage in all goods than the other, both countries will still gain by trading with each other, as long as they specialized in the commodity with relative advantage.

In the above case country A has advantage in both commodity X and Y. But in above case country A has comparative cost advantage in the production of X and B has comparative advantage in Y. If A specialize in X & B in Y then overall output will increase.
On the similar line Heckscher-Ohlin theory says country will gain from trade if they specialized in the commodity intensive in the factor in which country is abundant.

Trade as engine of growth
According to Haberler trade can lead to full utilization of unemployed source. By expanding market trade makes division of labor possible & promotes economies of scale. It is excellent anti monopoly weapon and this promotes growth.

Trade as growth inhibitor
Bhagwati’s immiserizing growth

The growth can increase export to the extent that it deteriorates Term of Trade of country. The welfare loss due to deteriorated term of trade can be more than gain due to increased export.

I the above figure country is on welfare curve E, but with growth its welfare decreases to G.  Loss of welfare impacts  countries growth in longer run.

Trade as inhibitor of growth 
Demand for raw material grows less rapidly than finished goods. Thus with the trade developed countries will gain at the cost of developing countries.
In certain industry country could have comparative advantage but cost of set up is high. In such case if other country has already built plant then growth of industry in first country may not happen.
Trade can exploit environmental resources beyond limit. It impacts long run growth potential of country.
Trade has potential to increase growth. But to reduce its negative effect there is need to have rule based order which protects interest of developing countries.

Q8(c): What are the causes of market failure in agriculture? How may government intervention mitigate this?
Ans: Agriculture is one of the most volatile industry. Market failure in agriculture is often seen. Below are some reasons for market failure.

Cobb Web Model 
Agricultural supply is significantly affected by past prices. Due to perishability of goods, supply is elastic to price & demand is inelastic to the price. Thus elasticity of demand < elasticity of supply.

Under this condition Cobb Web model will be in the divergent position. With change in prices there will be sharp change in supply compared change in demand. Hence once market distributed it won’t return to previous position.

Import surge 
When the import surges, domestic prices fall. It affects farmer welfare.

Environmental aspects
Agriculture is highly dependent on monsoon. Excess rainfall, drought, hail storm destroys crops. It affects supply side of agriculture.

Monopsony in market
In India farmers can only sell in APMC. It creates monopsony of few trades traders. It affects farmers welfare.

Government Intervention to mitigate this

1. Government provides minimum support price. It reduces volatality in the agricultural market.
2. In case of heavy import, government can increase import duty. It reduces import.
3. Government can provide insurance against crop failure due to natural factors. India has Pradahn Mantri Fasal Bima Scheme for that.
4. Government can create storage capacities. It will help farmer to store grains and sell when prices are high.
5. Government can strengthen forward markets. It will reduce monopsony in the agricultural market.

Due to volatile nature of agriculture state support is essential for agricultural sector. Government India is also providing similar support to the agricultural sector.