Topic wise Previous Year Questions (Solved) : Advanced Macro Economics | Economics Optional for UPSC PDF Download

Q1: Discuss critically the phenomenon of classical dichotomy. (2024)
Ans: The classical dichotomy, a key feature of classical economics, posits that real variables (output, employment, real interest rates) and nominal variables (money supply, price level) are separate and independently determined.
Critical Discussion
Positive Aspect:

• Simplifies macroeconomic analysis by allowing real sector analysis without involving monetary variables.
• Supported by neutrality of money in the long run — monetary changes only affect prices, not output.

Limitations:

• In the short run, changes in money supply can impact real variables through price stickiness and wage rigidity (as argued by Keynesians).
• Financial frictions and inflation expectations show real and nominal variables interact dynamically.

Recent View: Modern theories like New Keynesian Economics reject strict dichotomy, emphasizing monetary influence on real output at least temporarily.
Conclusion:
While classical dichotomy simplifies theoretical models, it fails to explain short-run macroeconomic fluctuations and modern monetary policy impacts.

Q2: Write down the major assumptions behind Neoclassical Loanable Funds Theory of Interest. (2024)
Ans: The Neoclassical Loanable Funds Theory explains the determination of the interest rate through the interaction of savings and investment in the financial market.
Major Assumptions

1. Savings Depend on Interest Rates: Higher interest rates encourage more savings.
2. Investment Depends on Interest Rates: Lower interest rates stimulate more investment by firms.
3. Flexible Interest Rate: Interest rate adjusts freely to equate saving and investment.
4. Perfect Competition in Capital Market: No individual can influence the interest rate.
5. Neutrality of Money: Money only facilitates transactions, does not affect real factors.
6. Rational Behavior: Households maximize utility (saving decisions); firms maximize profits (investment decisions).
7. Full Employment: The economy operates close to full employment, consistent with classical views.

Conclusion:
The Loanable Funds Theory, by emphasizing real forces of saving and investment, provides a foundational explanation for interest rate determination in classical and neoclassical thought.

Q3: Explain the concept of underemployment equilibrium with graphical illustration. Why full employment cannot be reached automatically in Keynes' approach? Analyse. 2024

Ans: The concept of underemployment equilibrium, a cornerstone of Keynesian economics, refers to an economy stabilizing at a level of output and employment below its full potential, resulting in persistent unemployment. John Maynard Keynes argued that, unlike classical economics’ assumption of automatic full employment, economies could remain stuck in this state without government intervention, a scenario relevant to India’s economic challenges like post-COVID recovery.

• Underemployment Equilibrium: This occurs when aggregate demand (AD) equals aggregate supply (AS) at an output level below full employment. For instance, in India’s 2023 rural demand slump, low consumer spending reduced production and sustained joblessness.
• Reasons for Non-Automatic Full Employment: Keynes highlighted sticky wages and prices, as seen in India’s labor laws preventing wage cuts, maintaining unemployment. Insufficient AD, like during India’s 2021 lockdown, fails to stimulate full-capacity production. Low business confidence further reduces investment, as observed in India’s private sector hesitancy post-2020.
• Policy Implications: Government intervention, such as India’s 2023 infrastructure spending, can boost AD to approach full employment. Without it, the economy remains trapped at a lower equilibrium.

Critics argue Keynes overlooks supply-side issues, like India’s skill mismatches, but his focus on demand-driven solutions remains vital. For example, India’s MGNREGA scheme counters underemployment by boosting rural demand. Keynes’ approach underscores the need for active fiscal policies to achieve full employment.

Underemployment equilibrium highlights the economy’s tendency to stabilize below full potential, necessitating government action to ensure inclusive growth in India. 

​Suggested Diagram: To illustrate underemployment equilibrium, use a Keynesian AD-AS model.

- Axes: X-axis represents output/employment (Y), and Y-axis represents price level (P).

- Curves: Plot the AD curve (downward sloping), AS curve (upward sloping in the short run), and a vertical line at full employment output (Yf).

- Equilibrium: Mark the intersection of AD and AS at equilibrium output (Ye), where Ye < Yf, showing underemployment equilibrium.

- Shift for Policy: Optionally, show a rightward AD shift (e.g., due to government spending) moving equilibrium closer to Yf.

This diagram visually captures the gap between actual and potential output, emphasizing Keynes’ argument for intervention.

Q4: Calculate the equilibrium national income (Y) and interest rate (r) by using an appropriate macroeconomic model from the information given below: (10 + 5 =15 marks)
Aggregate saving function: s = -40 + 0.5(Y-T) + 0.25r
Tax function: T = 20 + 0.2Y
Investment function: I = 20 - 0.25r
Money demand function: L = 0.4Y - 0.5r
Aggregate money supply: M = 40 (rupees in crore)
 How will the equilibrium values change when money supply is increased by ₹ 20 crore? (2024) 
Ans:  Give:
Saving function: s = -40 + 0.5 (Y - T) + 0.25r
Tax function: T = 20 + 0.2Y
Investment function: I = 20 - 0.25r
Money demand function: L = 0.4Y - 0.5r
Money supply: M = 40
Step 1: Equilibrium Conditions

• Goods market equilibrium (IS curve): S = I
• Money market equilibrium (LM curve): L=M

Step 2: Solve IS Curve
Substitute T into S:

• T = 20 + 0.2Y
• Y - T = Y - (20 + 0.2Y) = 0.8Y - 20

Thus: s = -40 + 0.5(0.8Y - 20) + 0.25r
Simplifying:

• s = -40 + 0.4Y - 10 + 0.25r
• s = -50 + 0.4Y + 0.25r

Setting S = I: -50 + 0.4Y + 0.25r = 20 - 0.25r
Group r terms: 0.4Y + 0.5r = 70
(= Equation 1)
Step 3: Solve LM Curve
0.4Y−0.5r=40
— (Equation 2)
Step 4: Solve Equations 1 and 2
Add (1) and (2):

• (0.4Y + 0.5r) + (0.4Y− 0.5r) =70 + 40
• 0.8Y=110
• Y=137.5

Substitute ( Y =137.5 into Equation 2:
0.4(137.5) − 0.5r = 40
55 - 0.5r = 40
0.5r = 15
r = 30
Thus, equilibrium values are:

• Y = 137.5 crore rupees
• r = 30%

Step 5: Effect of Increase in Money Supply
When money supply 
M increases by ₹20 crore, new M = 60
Thus, the new LM curve becomes: 0.4Y−0.5r=60 (New Equation 2)
Again solving:
From Equation 1 (same as before): 
4Y+0.5r=70
From new LM curve:
0.4Y−0.5r=60
Add both equations: 
(0.4Y + 0.5r) + (0.4Y - 0.5r) = 70 + 60
0.8Y = 130
Y = 162.5
Substituting Y = 162.5 into the new LM curve:
0.4(162.5) - 0.5r = 60
65 - 0.5r = 60
0.5r = 5
r = 10
Thus, new equilibrium values are:

• Y = 162.5 crore rupees
• r = 10%

In the IS-LM framework, an increase in money supply shifts the LM curve to the right, leading to a higher national income (Y) and a lower interest rate (r).
This highlights the critical role of monetary policy in stimulating economic growth, as also reflected in recent RBI monetary policy measures post-COVID-19, where liquidity infusions led to lower interest rates and recovery in economic activity.

Q5: Critically analyse classical theory of interest. (2024)

Ans: The classical theory of interest, developed by economists like Irving Fisher and Alfred Marshall, posits that the interest rate is determined by the interaction of savings (supply of loanable funds) and investment (demand for loanable funds) in a free market. It assumes full employment and automatic market adjustments, a framework relevant to understanding India’s financial markets but subject to significant critiques.

• Savings-Driven Supply: The theory suggests that higher interest rates encourage savings, as seen in India’s high fixed deposit rates attracting household savings. Savings supply loanable funds for investment.
• Investment-Driven Demand: Firms borrow for investment when interest rates are low, evident in India’s infrastructure projects funded by bank loans during low-rate periods like 2021.
• Market Equilibrium: Interest rates adjust to balance savings and investment. For example, India’s RBI rate hikes in 2023 reduced borrowing, stabilizing the market.
• Criticisms: The theory assumes full employment, unrealistic in India with persistent underemployment. It ignores liquidity preference, as Keynes argued, where people hoard money, affecting rates, as seen in India’s cash-heavy rural economy. Additionally, it overlooks institutional factors like India’s regulated banking sector, which distorts free-market dynamics.

For instance, India’s 2023 monetary policy tightened interest rates, but investment didn’t rise proportionally due to global uncertainties, challenging classical assumptions. Critics also note the theory’s neglect of income distribution effects, as high rates burden India’s small borrowers. Despite this, its emphasis on savings-investment linkage informs India’s financial planning.

The classical theory of interest provides a foundational understanding of rate determination but falters in complex, non-ideal economies like India, requiring integration with Keynesian and modern perspectives.

Q6: Explain the major differences between classical and Keynesian macroeconomics. (2023)

Ans: Classical and Keynesian macroeconomics offer contrasting views on how economies function, particularly regarding employment, market adjustments, and government roles. These differences are crucial for understanding India’s economic policies, balancing market dynamics and state intervention.

• Classical View: Assumes full employment, with flexible wages and prices ensuring market equilibrium. In India’s pre-1991 era, classical ideas underpinned limited government roles.
• Keynesian View: Argues economies can stabilize at underemployment due to insufficient aggregate demand, as seen in India’s 2020 COVID-19 slowdown, necessitating government spending.
• Price and Wage Flexibility: Classical theory trusts market adjustments, like wage cuts, to restore jobs, while Keynes highlights sticky wages, evident in India’s labor market rigidities.
• Government Role: Classical advocates minimal intervention, whereas Keynes supports fiscal policies, like India’s 2023 infrastructure push, to boost demand.

For example, India’s MGNREGA reflects Keynesian demand stimulation, contrasting classical reliance on market forces. Critics argue Keynesian policies risk inflation, as seen in India’s post-2021 recovery, while classical assumptions ignore real-world frictions. Both perspectives inform India’s mixed economy.

Classical and Keynesian macroeconomics provide distinct frameworks, guiding India’s policy choices between market-driven and interventionist approaches for balanced growth. 
​Suggested Diagram: AD-AS model.

- X-axis: Output/employment (Y); Y-axis: Price level (P).

- Classical: Vertical AS at full employment (Yf), with AD shifts only affecting prices.

- Keynesian: Upward-sloping AS, with AD-AS intersection at Ye < Yf, showing underemployment.

Q7: "Under rational expectation hypothesis, systematic monetary policy is ineffective." Explain the above statement using a suitable model. (2023)

Ans: The rational expectations hypothesis (REH), developed by Robert Lucas, posits that agents use all available information to form expectations, rendering systematic monetary policy ineffective in influencing real output. This is relevant to India’s monetary policy challenges, like RBI’s inflation targeting.

• Rational Expectations: Agents anticipate policy effects, neutralizing outcomes. In India, expected RBI rate hikes in 2023 led firms to adjust prices, offsetting output gains.
• Policy Ineffectiveness: Systematic policies, like regular rate changes, are predicted, impacting only prices, not output, as per the Lucas critique.
• Model Explanation: In the Lucas aggregate supply model, output (Y) deviates from natural rate (Yn) only due to unexpected policy shocks. Expected policies shift prices (P), not Y.
• Limitations: REH assumes perfect information, unrealistic in India’s diverse economy with information asymmetries.

For instance, India’s 2023 inflation control measures were anticipated, limiting employment boosts. Critics argue REH overlooks adaptive expectations in India’s informal sector, yet it highlights policy predictability’s limits.

REH underscores that systematic monetary policy struggles to influence real variables, urging India to focus on structural reforms and surprise policies. 
​Suggested Diagram: Lucas Supply Curve.

- X-axis: Output (Y); Y-axis: Price level (P).

- Vertical line at Yn (natural output); upward-sloping AS for unexpected shocks.

- Show expected policy shifting P upward, leaving Y at Yn.

Q8: In the IS-LM framework, the effectiveness of monetary and fiscal policies depend on the interest elasticity of investment. (2023)

Ans: The IS-LM framework, developed by John Hicks, analyzes the interaction of goods (IS) and money markets (LM), showing how monetary and fiscal policy effectiveness hinges on investment’s interest elasticity. This is critical for India’s policy design amid economic fluctuations.

• Monetary Policy: High interest elasticity means lower rates significantly boost investment, shifting IS right, as in India’s 2021 rate cuts spurring infrastructure.
• Fiscal Policy: Low elasticity limits monetary policy’s impact, making fiscal expansion, like India’s 2023 budget spending, more effective in raising output.
• IS-LM Dynamics: Steep IS (low elasticity) reduces monetary policy’s effect, while flat LM (high money demand elasticity) weakens fiscal policy, as seen in India’s liquidity traps.
• Contextual Factors: India’s small firms, less sensitive to rate changes, reduce monetary policy efficacy, favoring fiscal measures.

The 2023 RBI rate hikes had limited investment impact due to low elasticity in India’s MSMEs. Critics note IS-LM oversimplifies, ignoring external trade, yet it guides policy balance.

Interest elasticity shapes policy effectiveness in IS-LM, informing India’s strategic use of monetary and fiscal tools for growth. Suggested Diagram: IS-LM Model.

- X-axis: Output (Y); Y-axis: Interest rate (r).

- Downward-sloping IS; upward-sloping LM.

- Show steep IS (low elasticity) with fiscal shift (larger Y increase) vs. monetary shift (smaller Y increase).

Q9: How important is speculative demand for money in achieving unemployment equilibrium in the Keynesian model? (2023)

Ans: In the Keynesian model, speculative demand for money, part of liquidity preference, plays a critical role in achieving unemployment equilibrium by influencing interest rates and aggregate demand. This is relevant to India’s economic challenges, like persistent underemployment.

• Speculative Demand: Individuals hold money anticipating bond price changes, as in India’s 2023 market volatility, keeping interest rates high.
• Impact on Investment: High speculative demand raises interest rates, reducing investment, as seen in India’s post-2021 recovery, lowering aggregate demand.
• Unemployment Equilibrium: Low demand leads to output below full employment, as in India’s 2020 slowdown, with firms cutting jobs.
• Liquidity Trap: Extreme speculative demand, like in India’s 2021 liquidity hoarding, renders monetary policy ineffective, sustaining unemployment.

The 2023 rural demand slump in India reflected speculative hoarding amid uncertainty, exacerbating unemployment. Critics argue Keynes overstates speculative demand’s role, neglecting supply-side factors like India’s skill gaps.

Speculative demand for money is pivotal in Keynesian unemployment equilibrium, highlighting the need for fiscal interventions in India’s economy. Suggested Diagram: Liquidity Preference.

- X-axis: Money demand; Y-axis: Interest rate (r).

- Plot speculative demand curve (downward sloping); high demand raises r, reducing investment.

- Link to AD-AS showing Ye < Yf.

Q10: Discuss Friedman’s restatement of Quantity Theory of Money... when does it reduce to Classical? (2023)

Ans: Milton Friedman’s restatement of the Quantity Theory of Money (QTM) modernizes the classical view, emphasizing money supply’s role in determining nominal income. Its relevance to India’s monetary policy, like RBI’s inflation control, lies in its nuanced approach.

• Friedman’s Restatement: Money demand is a stable function of income, wealth, and interest rates, with MV = PY holding in the long run. In India, 2023 money supply growth influenced inflation.
• Differences from Classical: Classical QTM assumes constant velocity (V) and full employment, while Friedman allows variable V and short-run output effects, as in India’s post-COVID recovery.
• Reduction to Classical: Friedman’s QTM becomes classical when V is stable, output is at full employment, and money only affects prices, as in stable economies unlike India’s fluctuating growth.
• Policy Implications: Friedman’s flexible V supports India’s cautious monetary tightening to curb inflation without assuming automatic full employment.

The 2023 RBI policy reflected Friedman’s view, targeting money supply to stabilize prices. Critics argue his theory underestimates demand-side shocks, yet it refines classical insights.

Friedman’s QTM offers a dynamic framework for monetary policy, reducing to classical under idealized conditions, guiding India’s economic stability efforts. Suggested Diagram: Quantity Theory Equation.

- Plot MV = PY with stable V (classical) vs. variable V (Friedman).

- X-axis: Money supply (M); Y-axis: Nominal income (PY).

- Show price (P) changes under classical vs. output (Y) changes under Friedman.