Class XII – Equilibrium and Disequilibrium in the Economy – PYQs

Ans. Inflationary gap is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy. It causes excess demand in the economy. Owing to excess demand, price levels tend to rise without any rise in the level of income or employment in the economy.

Repo rate is the rate at which the central bank lends money to the commercial banks. To correct the situation of inflationary gap, repo rate is increased. As a follow-up action, the commercial banks raise the market rate of interest (the rate at which the commercial banks lend money to the consumers and the investors) which reduces demand for credit.

Consequently, consumption expenditure and investment expenditure are reduced implying a reduction in aggregate demand, as required to correct inflationary gap.

Ans. Deficient demand refers to a situation when Aggregate Demand (AD) is short of Aggregate Supply (AS) corresponding to full employment in an economy.

Bank rate is the rate at which the central bank lends money to the commercial banks. To correct the situation of deficient demand, bank rate is decreased. As a follow-up action, the commercial banks lower the market rate of interest (the rate at which the commercial banks lend money to the consumers and the investors). This increases demand for credit.

Consequently, consumption expenditure and investment expenditure are increased, implying an expansion in aggregate demand, as required to correct deficient demand.

Ans. Deflationary gap is the shortfall in aggregate demand from the level required to maintain full employment equilibrium in the economy. It causes deficient demand in the economy. Owing to deficient demand, planned level of output is reduced. Along with reduction in the level of output, level of income and employment also tend to reduce. The economy is driven into a state of low level equilibrium trap.

Open market operations is the policy that focuses on increasing and decreasing the stock of liquidity (or cash balances) with the people as well as with the commercial banks, through sale and purchase of securities by the central bank. During the situation of deflationary gap, when cash balances need to be increased (to stimulate the level of aggregate demand), the central banks starts buying securities. Purchase of securities injects purchasing power into the money market.

Cash balances of the commercial banks start picking up. This enhances their capacity to create credit. Flow of credit increases, leading to increase in AD and deflationary gap is corrected.

Ans. Deficient demand refers to a situation when Aggregate Demand (AD) is short of Aggregate Supply (AS) corresponding to full employment in an economy.

Margin requirements refer to minimum down payment that the borrowers have to make as a percentage of their total borrowing from the commercial banks. To correct the situation of deficient demand, margin requirement is reduced. Lower margin requirement acts as an incentive to borrow. This induces borrowers to raise more credit implying a rise in aggregate demand, as desired to correct deficient demand.

Ans. The given statement is true, an excess of aggregate demand over full employment level of aggregate supply represents the situation of inflationary gap because when economy is working at full employment level, there is no chance of increase in production and aggregate demand still increases then producers have to increase the general price level to control the situation.

Ans. The given statement is false.

Ratio of MPC and MPS is 4:1

MPC 4/5 = 0.8; MPS = 1/ 5 = 0.2 ⇒ K = 1/MPS

K = 1 /0.2 = 5

Thus, the value of multiplier is 5 not 4.

Ans. Excess demand refers to the situation when Aggregate Demand (AD) is in excess of Aggregate Supply (AS) corresponding to full employment in the economy

In a situation of excess demand, government raises the rates of all taxes.

This reduces the purchasing power of the people and reduces both consumption and investment expenditures. A fall in consumption and investment expenditures reduces the level of aggregate demand and helps to check the problem of excess demand.

Ans. The given statement is false, according to Keynesian theory of employment, a state of under-employment can exist. This may occur at that level of income where equilibrium between AD and AS happens at less than full employment level.

Ans. The given statement is false, because when income is zero, autonomous consumption may exist in economy for survival, thus APC(C/Y) will never be zero.

Ans. Inflationary gap occurs when AD>AS corresponding to full employment level. This inflationary gap, i.e, excess of Aggregate Demand causes inflation in the economy and price levels tend to rise.

In this figure,

AD_FE = AD at full employment level

AD_AE = AD above full employment level

The point E is the equilibrium point where AD = AS. But there is excess demand (current) at AD_AE, where Aggregate Demand FP is more than the Aggregate Supply in the economy. This difference of actual Aggregate Demand and Supply, i.e. EF is the inflationary gap.

Inflationary Gap = Excess Demand = AD_AE – AD_FE = EF

Role of Legal Reserves to Correct the Problem of Inflationary Gap

Legal reserves like Cash Reserve Ratio and Statutory Liquidity Ratio are the tools to correct the problem of inflationary gap.

(i) Cash Reserve Ratio (CRR) Each and every commercial bank has to keep a certain proportion of its demand and time deposits in the form of cash and other liquid assets with the Central Bank. This ratio is termed as Cash Reserve Ratio. To correct the problem of inflationary gap, the Central Bank increases the CRR. It reduces the supply of money and credit creation capabilities of commercial banks. Due to lesser supply of money, the Aggregate Demand comes down and the economy attains equilibrium situation.

(ii) Statutory Liquidity Ratio (SLR) It refers to a fixed percentage of the total assets of a bank in the form of cash or other liquid assets that is required to be maintained by the bank. During the situation of inflationary gap, SLR is increased. This reduces the credit creation capacity of commercial banks and reduces the flow of money in the economy. As a result of that, the Aggregate Demand comes down and ultimately, the economy attains equilibrium.

Ans. ‘KT’ represents inflationary gap which means aggregate demand is more than aggregate supply corresponding to full employment level. Two fiscal measures to correct the situation of inflationary gap are

(i) Revenue Policy: To correct the situation of inflationary gap, government raises the rate of all taxes. This reduces the purchasing power by reducing disposable income (i.e., after tax income) of the people which in turn will reduce the aggregate demand in the economy.

(ii) Expenditure Policy: To correct the situation of inflationary gap, government should reduce its public expenditure. This reduces the purchasing power by reducing total income of the people which in turn will reduce the aggregate demand in the economy.