Posted by Anjali Kaur on Nov 28, 2021

Practice Test 7 – Macroeconomics

Practice Test 7 – Macroeconomics, covers topics of money and banking, national income.

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1. Define money supply.

The money supply and supply of money are the same. It refers to the total volume of money held by the public at a particular point in time in an economy. It is a stock concept.

The money supply is denoted by M1.

M1 = CURRENCY HELD BY THE PEOPLE + NET DEMAND DEPOSITS HELD BY COMMERCIAL BANKS + OTHER DEPOSITS WITH RBI

M1 is the most liquid form of money. It includes cash at the bank and cash in hand.

2. Define credit multiplier.

The money multiplier or deposit multiplier or credit multiplier is the same. It measures the amount of money that the banks are able to create in the form of deposits with every unit of money that it keeps as a reserve.

It is calculated as

Money Multiplier (MM or K) = 1/ CRR times

The formula for total deposit creation = Initial Deposit x Money Multiplier

3. What is repo rate and how does it affect money supply?

The rate at which the central bank of a country lends money to the commercial bank to meet their short-term need.

Let’s discuss the two cases to control credit in the economy:

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the central bank will increase the repo rate which will make borrowing by commercial banks costly. So, when the repo rate is increased, banks are also forced to raise their lending rate. It made the credit costlier, demand for credit reduces, less money goes to the economy. The purchasing power is reduced, aggregate demand falls and excess demand is corrected.

If there is deflation in the economy or less money supply, it implies deficient demand for money in the economy. In such a case, the repo rate is reduced, which makes credit cheaper for commercial banks. In turn, commercial banks reduced lending rates for the borrowers, demand for credit increased. More money flows to the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

4. What are demand deposits?

Answer. Deposits that are available on-demand, like fixed deposits.

5. What is the role of CRR in controlling credit creation?

It is also known by the minimum reserve ratio. CRR is the minimum percentage of deposits of commercial banks (Net demand and time liabilities) which is kept in the form of cash with the central bank.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, CRR is increased to control excess demand. The central banks withdraw additional purchasing power, there will be a contraction of credit, less money will flow into the economy. The purchasing power in the economy reduces, aggregate demand falls and the excess demand is corrected.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, CRR is decreased to control the deficient demand. The central banks inject additional purchasing power in the economy which expands credit demand. Money flows in the economy, purchasing power increases, aggregate demand rises and deficient demand is corrected.

6. Currency is issued by the central bank, yet we say that commercial banks create money. Explain. How is this money creation by commercial banks likely to affect the national income?

Commercial banks create money even though they cannot print money. Bank deposits form the basis for credit creation. They accept deposits from the public by opening a deposit account known as the primary deposit. Banks do not hold the money in the account itself, and the entire amount is not withdrawn from the account at the same time. So, they advance loans to business persons and retain only a small portion of the total deposits in the bank. The Central Bank decides the amount be held in the form of cash and the remaining amount is advanced as loans to business persons only against collateral securities. The bank will not give cash but open a derivative account in the name of the individual or institution. Here, the loans create a derivative deposit which is called a secondary deposit or derivative deposit. This secondary deposit is called the creation of credit. Hence, the banks are able to provide financial assistance to traders and industrialists. Their cheques and drafts are useful for trading on a large scale. It also provides concessional loans to the priority sectors such as agriculture, smallscale industry, retail trade, and export. Thus, the production activity increases the overall development of the nation.

7. Explain ‘Banker to the government’ and ‘Bankers’ bank’ functions of the central bank.

Banker to the government

The Central bank acts as a banker agent and a financial advisor to the Central Government and all the State governments.

As a banker, it carries out all banking business of the Government like maintaining Current Account, accepting receipts and making payments, also giving out loans for managing public debts.

As a financial advisor, the Central Bank advises the Government from time to time, economic, financial, and money matters.

Bankers bank

Being the apex (prime) bank, the Central Bank acts as a banker to other banks.

a. Custodian of cash reserve

As a custodian of cash reserve, commercial banks are required to give a certain portion of their deposits with Central Bank, in this way, the Central bank acts as a custodian of cash reserve because commercial banks deposits CRR with the Central Bank.

b. Lender of last resort

As a lender of last resort it makes short-term credit available to them, that is, it gives financial loans to commercial banks against approved securities.

c. Clearing house function

Under this, the Central bank holds the cash reserve of all the commercial banks and it becomes easier for the Central Bank to act as their clearinghouse. All commercial banks have their account with the central bank and therefore the central bank can easily settle claims of various commercial banks against each other by making debit and credit entries in their account.

d. As a supervisor

The central bank supervises, regulates, and controls commercial banks. The regulation may be related to their licensing, branch expansion, liquidity of assets, etc. It also includes periodic inspection of banks.

8. Distinguish between final and intermediate goods. Give examples.

Final Goods

• These are those goods which are used either for consumption or for investment.
• They are included in both national and domestic income.
• They are considered to have crossed the production boundary because they are ready for consumption.
• Examples; Milk purchased by the household for consumption, a car purchased as an investment.
• Final goods are further sub-divided into ‘Consumption Goods’ and ‘Capital Goods’.

Intermediate Goods

• These are those goods which are used either for resale or for further production in the same year.
• These goods are not durable in nature.
• They are neither included in national income nor in domestic income.
• They are still within the production boundary as they are not completed.
• Example; Milk used in dairy shops for resale, coal used in the factory for further production, etc.

9. Is GDP considered to be a good measure of welfare? Discuss.

GDP is considered as an index of the welfare of the people. Welfare means the sense of material well being among the people. So, higher GDP indicates the greater welfare of the people. However, this generalization may not be correct due to some limitations. 

Limitations of GDP as a welfare measure

1. Distribution of GDP

It is possible that with the rise in GDP, inequalities in the distribution of income may also increase, that is, the gap between rich and poor will increase.

GDP does not take into account, change in inequalities in the distribution of income.

So, the welfare of the people may not increase with the rise in GDP.

2. Change in Price

If the increase in the GDP is due to a rise in prices and not due to an increase in physical output then, it will not be a reliable index of economic welfare.

3. Non-Monetary Changes

Many activities in an economy are evaluated in monetary terms.

For example, non-monetary transactions like the services of the housewife are not included in the GDP. However, they influence economic welfare.

4. Rate of Population Growth

GDP does not consider the changes in the population of the country.

If the rate of population growth is higher than the rate of growth of GDP, then it decreases the per capita availability of goods and services, which negatively affects economic welfare.

Therefore, GDP may not be taken as a satisfactory measure of economic welfare. But still, it reflects some index of economic welfare.

5. Externalities

Externalities refer to the benefits and harms of an activity caused by a firm or individual for which they are not paid or penalized. Externalities are of two types:

a. Positive Externalities

Activities that result in benefits to others are called positive externalities.

For example, Use of public parks by the people for pleasure.

b. Negative Externalities

Activities for which no payments are made by the people activities which result in harm to others are called negative externalities.

For example, the Environmental population is caused by the industry.

10. Calculate GVA at FC:

Answer:

Sales = Units of output sold X Price per unit of output = 1000 x 30 = 30000

Value of Output = Sales + Change in stock = 30000 + ( 3000-2000) = 31000

GVAmp = Value of Output – Intermediate Cost = 31000 – 12000 = 19000

GVAfc = GVAmp – NIT = 19000 – (2500+3500) = 19000- 6000 = 13000

11. From the following data calculate NNP at fc by Income method and expenditure method:

Answer. Income method

NDPfc = COE + OS + MI

COE = 3800+200 = 4000

OS = 200+150+800 = 1150

NDPfc = 4000+1150 = 5150

NNPfc = NDPfc + NFIA = 5150 + (-30) = 5120

Expenditure method

GDPmp = P + G + GDCF + NX

GDPmp = 4000+ 1000+ (500+ 40) + (-50)

GDPmp = 5540-50 = 5490

NNPfc = GDPmp – NIT + NFIA – Depreciation

NNPfc = 5490 – 300 + (-30) – 40 = 5120

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