CA - Inter ECO (EFF) Top 120 Important Questions Nov2023

INDEX
EFF Important Questions
Chp No. of Approx.

Chapter Name Page No.
No. Questions Marks
Determination of National 8 to 12
1 30 1 – 20
Income Marks
8 to 12
2 Public Finance 26 21 – 35
Marks
8 to 12
3 The Money Market 27 36 – 53
Marks
8 to 12
4 International Trade 37 54 - 75
Marks
120
Total 40 Marks
Questions
Note-
1) Above questions are for revision purpose, for last minute preparation of EFF
Exam. The questions will help in covering the most important concepts of
whole syllabus.
2) For more practice and full coverage of questions from ICAI

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CHAPTER 1 - DETERMINATION OF NATIONAL INCOME
1. Compiler Q.3 MTP Mar 19, Apr 19

What do you understand by the term ‘final good”?
Ans. Final good is a good sold to final purchasers and is consumed by the end user in its
present state. It does not require any further processing and therefore will not undergo
any further transformation at the hands of producer.
Once a final good has been sold, it passes out of the active economic flow.
The value of the final goods already includes the value of the intermediate goods that
have entered into their production as inputs.
2. Compiler Q.6 PYQ Nov 18

Explain the Concept of Gross National Product at market price (GNPMP).
Ans. Gross National Product (GNP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country by normal residents during an accounting year plus net factor incomes from
abroad. Thus, GNP includes earnings of Indian corporations overseas and Indian residents
working overseas.
GNPMP = GDPMP + Net Factor Income from Abroad
Net factor income from abroad is the difference between

➢ the income received from abroad for rendering factor services by the normal
residents of the country to the rest of the world, and
income paid for the factor services rendered by non- residents in the domestic territory
of a country
3. Compiler Q.8 MTP Mar 22

How GDP and GNP differ in their treatment of international transaction?
Ans. The two concepts GDP and GNP differ in their treatment of international transactions.
The term ‘national’ refers to normal residents of a country who may be within or outside
the domestic territory of a country and is a broader concept compared to the term
‘domestic’.
For example, GNP includes earnings of Indian corporations overseas and Indian residents
working overseas; but GDP does not include these.
In other words, GDP excludes net factor income from abroad.
Conversely, GDP includes earnings from current production in India that accrue to foreign
residents or foreign-owned firms; GNP excludes those items.
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For instance, profits earned in India by X Company, a foreign-owned firm, would be

included in GDP but not in GNP. Similarly, profits earned by Company Y, an Indian
company in UK would be excluded from GDP but included in GNP.
4. Compiler Q.13 RTP May 22

Can the GDP of a country be taken as an Index of welfare of people in the country?
Ans. There are many reasons to dispute the validity of GDP as a perfect measure of wellbeing.
In fact, GDP measures our ability to obtain many requirements to make our life better;
yet leave out many important aspects which ensure good quality of life for all.
GDP measures exclude the following which are critical for the overall wellbeing of citizens
➢ Countries may have significantly different income distributions and, consequently,
different levels of overall well-being for the same level of per capita income.
➢ Quality improvements in systems and processes due to technological as well as

managerial innovations which reflect true growth in output from year to year.
➢ Productions hidden from government authorities, either because those engaged in it

are evading taxes or because it is illegal.
➢ Non-market production (with a few exceptions) and non-economic contributors to

well-being for example: health of a country’s citizens, education levels, political
participation, or other social and political factors that may significantly affect well-
being levels.
➢ The disutility of loss of leisure time. We know that other things remaining the same,
a country’s GDP rises if the total hours of work increase.
➢ The volunteer work and services rendered without remuneration undertaken in the
economy, even though such work can contribute to social well-being as much as paid
work.
➢ Many things that contribute to our economic welfare such as, leisure time, fairness,
gender equality, security of community feeling etc.,
Both positive and negative externalities which are external effects that do not form
part of market transactions.
5. Compiler Q.15 RTP Nov 22

What are the Challenges in compilation of in National Income Accounting?
Ans. The Challenges in compiling in National Income Accounting is as under:
a) production for self-consumption,
b) absence of recording of incomes due to illiteracy and ignorance,
c) lack of proper occupational classification, and
d) accurate estimation of consumption of fixed capital
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e) Inadequacy of data and lack of reliability of available data,

presence of non-monetized sector
6. Compiler Q.17 RTP May 20 & MTP May 20

How are the following transactions treated in national income calculation? What is
the rationale in each case?
i. Electricity sold to a steel plant
ii. Electric power sold to a consumer household
iii. A car manufacturer procuring parts and components from the market
A computer producer buys a robot produced in the same country and uses it in
production of computers.
Ans. i. Being an intermediate good, electricity sold to a steel plant will not be included in
national income calculation. The underlying principle is that only finished goods
and services which are directly sold to consumer for final consumption would be
included. Value of final output, namely steel, includes the value of electricity used
up in the production process. Counting electricity sold to a steel plant separately
will lead to the error of double counting and exaggerate the value of steel
production.
ii. Electric power sold to a consumer household would be included in the calculation
of GDP since it is a final good consumed by the end user. Electric power sold to a
consumer does not require any further processing and does not undergo any
further transformation before use. Once a final good has been sold, it passes out
of the active economic flow.
iii. The value of parts and components procured from market by a car manufacturer
will not be included in national income calculation because these are intermediate
goods used in car production. Value is added to parts and components through
process of production and the same is resold. Value of final output, namely car,
includes the value of the parts and components. Counting parts and components
separately will lead to the error of double counting and exaggerate the value of
car production.
The value of the robot bought by a computer producer for use in the production of
computers would be included in national income calculation because the computer
producer is the "final consumer" of the robot and the robot is not resold in the market
after value addition.
7. Compiler Q.19 PYQ July 21, MTP Sep 22

What do you mean about gross investment of a country?
Ans. Gross Investment is that part of country's total expenditure which is not consumed
but added to the nation's fixed tangible assets and stocks. It consists of the
acquisition of fixed assets and the accumulation of stocks. The stock accumulation is in
the form of changes in stock of raw materials, fuels, finished goods and semi -finished
goods awaiting completion.

Thus, gross investment includes:

➢ final expenditure on machinery and equipment,
➢ own account production of machinery and equipment,
➢ expenditure on construction,
➢ expenditure on changes in inventories, and
expenditure on the acquisition of valuables such as, jewellery, works of art.
8. Compiler Q.22 PYQ Nov 20, MTP Oct 19, RTP May 22
Which is the most appropriate method for calculation of National Income in developed
countries?
OR
Is country like India unable to estimate their National Income wholly by one method?
Give comments
Ans. Ideally, all three methods of national income computation should arrive at the same
figure. Moreover, different ways of measuring total output give us different insights
into the structure of our economy.
Income method may be most suitable for developed economies where people properly
file their income tax returns.
With growing facility in use of commodity flow method of estimating expenditures, an

increasing proportion of national income is being estimated by expenditure method.
As a matter of fact, countries like India are unable to estimate their national income
wholly by one method. Thus –
➢ in agricultural sector, net value added is estimated by production method,
➢ in small scale sector net value added is estimated by income method &
in construction sector net value added is estimated by expenditure method.
9. Compiler Q.27 MTP Oct 21

What is supra regional sector in an economy?
Ans. In the preparation of State income estimates, certain activities such as railways,
communications, banking. and insurance and central government administration, that cut
across state boundaries, and thus their economic contribution cannot be assigned to
any one state directly are known as the supra-regional sectors of the economy.
The estimates for the supra regional activities are compiled for the economy as a whole
and allocated to the states based on relevant indicators.
10. Compiler Q.34 PYQ Dec 21

The Nominal GDP and Real GDP of a country in the financial year 2018-19 were Rs
1,500 crore and Rs 1,200 crore respectively, you are required to calculate:
i. GDP deflator in the financial year 2018-19 and comment.
Inflation rate in the financial year 2019-20 assuming. GDP deflator rate in this year
is 140 as compared to the year 2018-19.

Ans.
Nominal GDP 1,500
i. GDP Deflator = × 100 = ×10 = 125
Real GDP 1,200
0
GDP deflator for 2018-19 = 125
Comment: A deflator above 100 is an indication of price levels being higher as compared
to base year.
ii. Inflation rate in year 2 = GDP deflater in year 2 - GDP deflater in year 1
× 100
GDP deflater in year 1
140 - 125 × 100 = 12%
=
125
Inflation Rate = 12%
Note: Year 2 refers to 2019-20 and year 1 refer to 2018-19.

You are given the following data on an economy in millions
Consumer Expenditure (inclusive of indirect taxes) 110
Investment 20
Government Expenditure (inclusive of transfer payments) 70
Exports 20
Imports 50
Net Property Income from abroad 10
Transfer payments 20
Indirect taxes 30
Population 0.5
i. Calculate the Gross Domestic Product at market prices.
ii. Calculate the Gross National Income at market prices.
iii. Calculate the Gross Domestic Product at factor cost.
Calculate the per capita Gross National Income at factor cost.
Ans. i. GDPMP = C + I + G + (X – Z)
= 110 + 20 + (70 – 20) + (20 – 50) = 150 million
ii. GNPMP = GDP at market prices + net property income from abroad
= 150 + 10 = 160 million
iii. GDPFC = GDP market prices – indirect taxes 150 – 30 = 120 million

iv. Per Capita Income = GNP at Factor Cost = 160 – 30 = 260 (in millions)
Population 0.5
12. Compiler Q.38 PYQ July 21

The following information is related to an economy:
Particulars (Rs.) In Crore
Domestic Sales 3600
Opening Stock 800
Exports 1000
Depreciation 300
Closing Stock 200
Net indirect tax 400
Intermediate consumption 600
Net factor income from abroad 10
Calculate the followings:

i. Gross Value of Output (GVOMP)
ii. Gross Value Added (GVAMP)
iii. Net Value Added (NVAMP)
iv. Net Domestic Product (NDPFC)
Net National Product (NNPFC)
Ans. Particulars (Rs.) In Crore
Domestic Sales 3600
+ Exports 1000
+ Change in stock (600)
Gross Value of Output (GVOMP) 4000
- Intermediate Consumption (600)
Gross Value Added (GVAMP) 3400
- Depreciation (300)
Net Value Added (NVAMP) 3100
- Net Indirect Taxes (400)
Net Domestic Product (NDPFC) 2700

+ Net Factor Income from Abroad (NFIA) 10
Net National Product (NNPFC) 2710

Using the information given in the following table calculate,
Particulars Amount
Sales by firm B to general government 300
Sales by firm A 1500
Sales by firm B to households 1350
Change in stock of firm A 200
Closing stock of firm B 140
Opening stock of firm B 130
Purchases by firm A 270
Indirect taxes paid by both the firms 375
Consumption of fixed capital 720
Sales by firm A to B 300

i. Value added by firm A and firm B
ii. Gross Domestic Product at Market Price
iii. Net Domestic Product at Factor Cost.
Ans. i. Value added by Firm A and Firm B, Gross Value Added (GVAMP) of Firm A Gross Value
Added (GVAMP) of Firm B
Particulars Amount (in Cr.)
Sales by firm A 1500
+ Change in stock of firm A 200
- Purchases by firm A (270)
Gross Value Added (GVAMP) of Firm A 1430
Sales by firm B to general government 300
+ Sales by firm B to households 1350
+ Closing stock of firm B 140

- Opening stock of firm B (130)
- Purchases by firm B (300)
Gross Value Added (GVAMP) of Firm B 1360
ii. Gross Domestic product at Market Price:
Value added by firm A 1430
+ Value added by firm B 1360
Gross Domestic Product at Market Price (GDPMP) 2790
iii. Net Domestic Price at Factor Cost:
Gross Domestic product at market price 2790
- Consumption of fixed capital 720
- Indirect taxes paid by both the firms [375 – 0] 375
NDPFC 1695
14. Compiler Q.52 ICAI SM, RTP May 20, MTP Oct 22
Calculate the Operating Surplus with the help of following data
Particulars Rs. in Crores
Sales 4000
Compensation of employees 800
Intermediate consumption 600
Rent 400
Interest 300
Net indirect tax 500
Consumption of Fixed Capital 200
Mixed Income 400

Ans. Particulars Rs. (In Crores)
Gross Value Output at MP…………….(Sales + change in stock) 4000

- Intermediate consumption 600
GVAMP = GDPMP 3400
- consumption of fixed capital 200
NDPMP 3200
- NIT 500
NDPFC 2700
Particulars Rs. (In Crores)
+ Operating surplus (Balancing Figure) 1500
+ Mixed income 400
NDPFC 2700
15. Compiler Q.59 ICAI SM

Calculate Gross Domestic Product at market Prices (GDPMP) and derive national income
from the following data (in Crores of Rs.)
Particulars Amount
Inventory Investment 100
Exports 200
Indirect taxes 100
Net factor income from abroad - 50
Personal consumption expenditure 3,500
Gross residential construction investment 300
Depreciation 50
Imports 100
Government purchases of goods and services 1000
Gross public investment 200
Gross business fixed investment 300

Ans.
Personal consumption expenditure 3500

+ Gross Investment which include-

➢ Gross Business fixed investment 300
➢ Gross residential construction investment 300
➢ Gross public investment 200
➢ Inventory investment 100 900
+ Government purchases of goods and services 1000
+ Net exports which include-

➢ Exports 200
➢ Imports (100) 100
GDPMP 5500
+ Net Factor Income from Abroad -50
GNPMP 5450
GNPMP 5450
- Indirect Taxes 100
GNPFC 5350
- Depreciation 50
NNPFC (National Income) 5300

Calculate National Income with the help of Expenditure Method and Income Method:
Particulars In Crore
Profit 700
Net factor Income from above abroad 40
Indirect Taxes 200
Subsidies 80
Private Final Consumption Expenditure 1800
Net domestic capital formation 900
Depreciation 150
Interest 600

Rent 400
Mixed Income of self employed 800
Export 50
Import 30
Government Final consumption expenditure 1,100
Employees contribution to social security scheme 400

Ans. Income Method
Particulars Amount (In Crores)
Compensation of employees 1,,600
+ Operating surplus
➢ Rent 400
➢ Interest 600
➢ Profit 700
+ Mixed Income of Self-Employed 800
+ Net Factor Income from Abroad. 40
NNPFC 4140
Private final consumption expenditure 1,800
+ Government final Consumption expenditure 1,100
+ Gross domestic Capital formation

➢ Net domestic Capital formation 900
➢ Depreciation 150
+ Net export [50-30] 20
GDPMP 3,970
- depreciation (150)
+ Net factor income from abroad 40
- Net Indirect taxes (120)
NNPFC or NI 3,740


Calculate Personal Income from the following data:
Undistributed profits of corporation 50
Net domestic product accruing to private sector 700
Corporation tax 65
Net current transfer from rest of the world 20
Net current transfer from the government 25
Interest on national debt 40

Ans.
Net domestic product accruing to private sector 700
+ Net factor income from abroad 10
+ Net current transfers from government 25
+ Net current transfers from rest of the world 20
+ interest on National debt 40
- Corporation tax (65)
- Undistributed profits of corporations (50)
Personal Income 680

On basis of following information, calculate NNP at market price and Disposable
personal income
Items Rs. in Crores
NDP at factor cost 14,900
Income from domestic product accruing to government 150
Interest on National debt 170
Transfer payment by government 60
Net private donation from abroad 30

Indirect taxes 335
Direct taxes 100
Subsidies 262
Taxes on corporate profits 222
Undistributed profits of corporations 105

Ans. Particulars Rs. (In Crores)
NDPFC 14,900
+ NFIA 80
NNP at factor cost 14,980
+ indirect tax 335
- subsidies 262
NNP at Market price 15,053
NI 14,980
+ Income received but not earned

➢ Interest on National debt 170
➢ Transfer payment by government 60
➢ Net private donation from abroad 30
- Income earned but not received

➢ Income from domestic product accruing to government 150
➢ Taxes on corporate profits 222
➢ Undistributed profits of corporations 105
PI 14,763
- Personal income tax 100
Disposable personal income (DI) 14,663

Calculate from the following data:
a) Private Income
b) Personal Income
Savings of non-department private enterprises 5,000

Income from domestic product accruing to private sector 450
Saving of private corporate sector 250
Current Transfer from government administrative

600
departments
Current Transfer from of the world 200
Corporative Tax 80
Direct personal tax 160
Net factor Income from abroad (70)

Ans.
Factor Income from domestic product accruing to the 400

private sector
+ Net factor Income from abroad (70)
+ Current Transfers from government 600
+ Other net transfer from the rest of the world. 200
Private Income 1,130
National Income 5,000
- Undistributed Profits -
- Net interest payment made by households -
- Corporate Tax (80)
+ Transfer payments to the households from firms and -

government
Personal Income 4,920

Calculate Gross National Disposable income from the following data (in Rs. Crores)
NDP at factor cost 6000
Net factor income to abroad -300
Consumption of fixed capital 400
Current transfers from government 200

Net current transfers from rest of the world 500
Indirect taxes 700
Subsidies 600
Ans.
Particulars Amount
NDP at factor cost 6,000
+ Consumption of fixed capital 400
GDP at factor cost 6,400
+ Net factor income to abroad -300
GNP at factor cost 6,100
+ indirect taxes 700
- Subsidies (600)
GNP at market prices 6,200
+ Net current transfers from rest of the world 500
Gross National Disposable income 6,700

What are the factors that causes leakages in the multiplier?
Ans. Multiplier refers to the phenomenon whereby a change in an injection of expenditure will
lead to a proportionately larger change (or multiple changes) in the equilibrium level of
national income. The investment multiplier explains how many times the equilibrium aggregate
income increases as a result of an increase in autonomous investment.
1) progressive rates of taxation which result in no appreciable increase in consumption
despite increase in income
2) high liquidity preference and idle saving or holding of cash balances and an equivalent fall
in marginal propensity to consume
3) increased demand for consumer goods being met out of the existing stocks or through
imports
4) additional income spent on purchasing existing wealth or purchase of government
securities and shares from shareholders or bond holders
5) undistributed profits of corporations
6) part of increment in income used for payment of debts
7) case of full employment additional investment will only lead to inflation,
scarcity of goods and services despite having high MPC

22. Compiler Q.86 RTP Nov 21, MTP Sep 22

How deflationary gap arises in an economy?
Ans. Deflationary gap is thus a measure of the extent of deficiency of aggregate demand, and
it causes the economy’s income, output, and employment to decline, thus pushing the
economy to under- employment equilibrium. The macro- equilibrium occurs at a level of
GDP less than potential GDP; thus, there is cyclical unemployment i.e., rate of
unemployment is higher than the natural rate.
In the figure given here, OQ* is the full

employment level of output. For the
economy to be at full employment
equilibrium, aggregate demand should
be Q*F. If actual aggregate demand is
Q*G, it represents a situation of
deficient demand. The resulting
deflationary gap is FG. It will lead to
under-employment equilibrium is
reached at E.
23. Compiler Q.88 MTP May 20, Mar 22, RTP May 18, Nov 18
What would happen if aggregate expenditures were to exceed the country’s economy’s
production capacity?
Ans. Aggregate demand (AD) is the sum of all planned expenditures for the entire economy. When
aggregate expenditures exceed an economy’s production capacity at full employment level;
the resulting strain on resources creates “demand-pull” inflation or higher price level.
Nominal output will increase, but it merely reflects higher prices, rather than additional
real output.

How is aggregate consumption function affected, if:
i. An impending war is expected to result in shortage of goods and an adoption of
a rationing system,
ii. Increased cost for steel, oil etc. are expected to result in higher prices for
consumer goods, or
The leadership assures that economic policy is bringing the recession to an end.
Ans. Effect on Aggregate Consumption Function:
i. If an impending war is expected, it will result in shortage of goods and an adoption of
a rationing system is essential. As war happens supply will be less, and demand will
be high which will lead to increase in prices thereby reducing the disposable income
causing reduction in the aggregate consumption. This will shift the aggregate
consumption function downwards.
ii. The price of goods and services is determined by the interaction of supply and demand
of goods and services. If cost of steel and oil prices go up, naturally the producer

is not having any incentive to produce at the earlier levels. This reduces the supply
in the economy resulting in increased demand and prices will go up causing the
aggregate consumption function to decline.
The leadership is assuring that economic policy is bringing the recession to an end. But
economic policies carry a gestation period to become effective and giving both short-term
and long-term result. So mere assurance will not increase the aggregate consumption
function till the effect is realised by both the producer and consumer and the price level
is maintained at an equilibrium level where the consumer can consume at the pre-recession
stage and producer too.
25. Compiler Q.99 MTP Nov 21, Mar 22, Apr 22, RTP May 22
How is multiplier useful in of functioning of Keynesian theory of determination of
National Income?
OR
What are the factors behind the concept of multiplier?
Ans. The multiplier concept is central to Keynes's theory because it explains how shifts in
investment caused by changes in business expectations set off a process that causes not
only investment but also consumption to vary. The multiplier shows how shocks to one sector
are transmitted throughout the economy.
The MPC, on which the multiplier effect of increase in income depends, is high in
underdeveloped countries, but ironically the value of multiplier is low. Due to structural
inadequacies, increase in consumption expenditure is not generally accompanied by increase
in production.
Example, increased demand for industrial goods consequent on increased income does not
lead to increase in their real output, rather prices tend to rise.
26. Compiler Q.102 MTP Aug 18

If an economy has a flat aggregate expenditure function, what would be the nature of
the multiplier?
Ans. The marginal propensity to consume (MPC) is the determinant of the value of the multiplier
and that there exists a direct relationship between MPC and the value of multiplier. Higher
the MPC, more will be the value of the multiplier and vice-versa.
A flat aggregate expenditure function implies lower MPC and higher MPS for all levels of
income. Therefore, the value of multiplier will be small.

The equilibrium level of income of an economy is Rs. 2,000 crores. The autonomous
consumption expenditure is equal to Rs.100 crores and investment expenditure is Rs.500
crores. Calculate.
i. Consumption expenditure level of National Income.
ii. Marginal propensity to save and Marginal propensity to consume

iii. Break-even level of Income.

Ans. i. Consumption expenditure at equilibrium level of National Income
Y = C + I [ AD = C + I]
Putting the value of Investment Expenditure (I) = Rs.500 Crores and
Income (Y) = Rs. 2000 crores,
we get C = 2,000 – 500
C = Rs 1500 Crores
ii. Marginal Propensity to Save (MPS)

Consumption function is given by
C = a + bY
1500 = 100 + 2000 b
2000 b = 1400
MPC = 0.7
MPS = 1-MPC = 1-0.7 = 0.3
iii. Break-even level of Income attained at break-even point = C = Y Putting Y = C

Y = 100 + 0.7 Y
0.3Y = 100
Y = 333.33

If saving function S = -10 + 0.2Y and autonomous investment I = 50 Crores. Find out
the equilibrium level of income, consumption and if investment increases permanently by
Rs. 5 Crores, what will be the new level of income and consumption?
At equilibrium, AS = AD
or S = I
Ans. -10 + 0.2Y = 50
0.2Y = 50+ 10
Y = 300 Crores
C= Y- S
Where S= -10 + 0.2 (300) = 50
C= 300-50 = 250 Crores
With the increase in investment by Rs. 5 Crores, the new investment will become equal to
Rs. 55 Crores.
S=I
-10 + 0.2Y = 55
Y= 325 Crores
C= 270 Crores


The consumption function is C = 40 + 0.8Yd,T= 0.1Y, I = 60 Crores G = 40 Crores, X
= 58 and M = 0.05 Y. Find out equilibrium level of income, Net Export, net export if
export were to increase by 6.25.
Ans. C= 40+ 0.8Yd
C= 40 + 0.8 (Y- 0.1Y)
Y= C + I+ G + (X – M)Y = 40 + 0.8 (Y - 0.1Y) + 60 + 40 + (58 - 0.05Y)

Y= 40 + 0.8(0.9Y) + 60 + 40 + 58 - 0.05Y
Y-0.72Y+0.05Y =198
Y(1-0.72+0.05) =198
Y (0.33) =198
Y= 198/0.33 = 600 Crores
Net Export = X-M = 58 – 0.05Y

58 – 0.05 (600) =58- 30= 28
If exports increase by 6.25,

then exports = 64.25
Then, Y = 40+ 0.8 (Y- 0.1Y) + 60 + 40 + (64.25- 0.05Y)

Y(1-0.72+0.05) = 204.5
Y (0.33) = 204.5
Y=204.5/0.33 = 619.697
Then import = .05 × 619.697= 30.98

Net Export= 64.25- 30.98= 33.27 Crores
Thus, there is surplus in balance of trade as Net Exports are positive

For an Economy with the following specifications Consumption,
C = 50 + 0.75 Yd
Investment, I = 100
Government Expenditure, G = 200
Transfer Payments, R= 110
Income Tax = 0.2Y
i. Find out the equilibrium of income and the value of expenditure multiplier.
ii. If autonomous taxes worth Rs. 25 Crores are added. Find out equilibrium level of
Income.
If the economy is opened up with exports X = 25 and imports M = 5 + 0.25Y Calculate
the new level of Income and balance of Trade (Assume that there are no autonomous
Taxes.

Ans. i. Level of Disposable income Yd is given by Yd = Y-Tax + Transfer Payments, Where,

Transfer Payment = 110
= Y - 0.2 Y + 110 = 0.8Y + 110, and C = 50 + 0.75 Yd = 50 + 0.75 (0.8Y + 110)
(where Yd = 0.8Y +110)
= 50 + (0.75 × 0.8Y) + (0.75 X 110) = 132.50 + 0.6Y
C = 132.50 + 0.6 Y
Now Y = C + I + G, Where C = 132.50 + 0.6Y, I = 100, G = 200(Given)
Y= (132.50 + 0.6Y) + 100 + 200 = 432.50 + 0.6Y
Y - 0.6Y = 0.4Y = 432.50 or
Y = 432.50/0.4 = Rs. 1,081.25 Crores
Expenditure Multiplier = 1 = 1 = 2.5,

1-b 1 – 0.60
ii. If autonomous taxes worth of Rs. 25 Crores added, this will reduce disposable income
by Rs. 25 crores
Level of Disposable income Yd is given by Yd = Y – Tax + Transfer payments
Thus Yd = Y - 0.2Y + (110-25) = 0.8Y +85 ( Income Tax Given = 0.2Y , Transfer
Payments = 110)
C = 50 + 0.75 (0.8Y + 85) (Given C = 50 + 0.75 Yd)
C = 50 + (0.75 × 0.8Y) + (0.75 × 85) = 50 + 0.6Y + 63.75 = 113.75 + 0.6Y
Y = C + I + G = (113.75 + 0.6Y) + 100 + 200 = 413.75 + 0.6Y (C= 113.75 + 0.6Y ,
I = 100, G = 200)
Y - 0.6Y = 413.75 0.4Y = 413.75
Y = 413.75 = Rs. 1034.375 Crores

0.4
iii. Y = C + I + G + (X - M), Where Consumption, (C) = 132.50 + 0.6 Y, Investment(I) =
100, Government Expenditure (G) = 200
Since X = 25, M = 5 + 0.25 Y
Y = (132.50 + 0.6Y) + 100 + 200 + {25 - (5 + 0.25Y )}
(Given X = 25 cr and M= 5 + 0.25Y)
Y = (132.50 + 0.6Y) + 100 + 200 + (25 – 5 - 0.25Y) = (1 - 0.6 + 0.25)
Y = 452.50
452.50
Y= = Rs. 696.15 Crores
0.65
Imports = 5 + 0.25Y = 5 + (0.25 × 696.15) = Rs.179.04 Crores

Balance of trade = Exports – Imports
Balance of Trade = 25 - M = 25 - 179.04 = -Rs.154.04 crores.
Thus, there is adverse balance in Trade of Rs. 154.04 crores

CHAPTER 2 - PUBLIC FINANCE
1. Compiler Q.2 MTP SEP 22

Describe the various interventionist measures adopted by the government?
Ans. Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. However, Smith saw an important resource allocation role for
government when he underlined the role of government in-
➢ national defence,
➢ maintenance of justice and the rule of law,
➢ establishment and maintenance of highly beneficial public institutions and public
works which the market may fail to produce on account of lack of sufficient profits.
Since the 1930s, more specifically as a consequence of the great depression been
distinctly gaining importance, and therefore, the traditional functions of the state as
described above, have been supplemented with what is referred to as economic functions
(also called fiscal functions or public finance function).
While there are differences among different countries in respect of the nature and
extent of government intervention in economies, all of them agree on one point that the
governments are expected to play a major role in the economy. This comes out of the
belief that government intervention will invariably influence the performance of the
economy in a positive way.

Explain how the role of State is pivotal in Public Finance?
Ans. According to Musgrave, the state is the instrument by which the needs and concerns
of the citizens are fulfilled and therefore, public finance is connected with economic
mechanisms that should ideally lead to the effective and optimal allocation of limited
resources. This logic, in effect, makes it necessary for the government to intervene in
the market to bring about improvement in social welfare.
In the absence of appropriate government intervention, market failures may occur and
the resources are likely to be misallocated with too much production of certain goods or
too little production of certain other goods.
The allocation responsibility of the governments involves suitable corrective action when
private markets fail to provide the right and desirable combination of goods and
services. Briefly put, market failures provide the rationale for government’s allocative
function.
3. Compiler Q.6 PYQ Jan 21, RTP Nov 19, May 22

How can the government influence the resource allocation in an economy?

Ans. A variety of allocation instruments are available by which governments can influence
resource allocation in the economy. They are
i. government may directly produce the economic good (for example, electricity and
public transportation services)
ii. government may influence private allocation through incentives and disincentives
(for example, tax concessions and subsidies may be given for the production of
goods that promote social welfare and higher taxes may be imposed on goods such
as cigarettes and alcohol)
iii. government may influence allocation through its competition policies, merger
policies etc. which will affect the structure of industry and commerce (for
example, the Competition Act in India promotes competition and prevents anti-
competitive activities).
iv. governments’ regulatory activities such as licensing, controls, minimum wages, and
directives on location of industry influence resource allocation.
v. government sets legal and administrative frameworks, and
any of a mixture of intermediate techniques may be adopted by governments.
4. Compiler Q.15 MTP Mar 19, Mar 21, ICAI SM

Describe rationale for the stabilisation function of government policy.
Ans. Stabilization function is one of the key functions of fiscal policy and aims at eliminating
macroeconomic fluctuations arising from sub-optimal allocation. The stabilization
function is concerned with the performance of the aggregate economy in terms of labour
employment and capital utilization, overall output and income, general price levels,
economic growth and balance of international payments.
The rationale for the stabilization function of the government is derived from the
Keynesian proposition that a market economy does not automatically generate full
employment and price stability and therefore the governments should pursue
deliberate stabilization policies.
Government’s stabilization intervention may be through monetary policy as well as fiscal

policy. Monetary policy has a singular objective of controlling the size of money supply
and interest rate in the economy, while fiscal policy aims at changing aggregate demand
by suitable changes in government spending and taxes.

Does government intervention always result in correcting market failure?
Ans. We cannot be sure whether the government interventions would be effective or whether
it would make the functioning of the economy less efficient.
When government intervention in the economy to correct a market failure creates

inefficiency and leads to a misallocation of scarce resources, it is called government
failure.
Government failure occurs when intervention:

➢ is ineffective causing wastage of resources expended for the intervention

➢ produces fresh and more serious problems
It is important that policy makers consider all of costs and benefits associated with any
type of government intervention.
6. Compiler Q.20 MTP May 20, Apr 22

How do the markets fail in an economy? What are the main reasons behind this
market failure and economic inefficiency?
Ans. Market fails in an economy when the free market leads to misallocation of society's
scarce resources or in other words, there is either overproduction or underproduction of
particular goods and services leading to a less than optimal outcome.
The four main reasons for market failure are:

i. Market power - Excessive market power causes single producer or small number of
producers to produce and sell less output than would be produced and charge a
higher price.
ii. Externalities- Externalities hinder the ability of market prices to convey
accurate information about how much to produce and how much to buy.
iii. Public goods- Due to their special characteristics such as non-excludability and
non-rivalry, are not produced at all or produced less than optimal quantities.
These have Free rider problem causing over-use, degradation and depletion of
common resources resulting in market failure.
Incomplete information - Information failure manifests in asymmetric information
causing adverse selection and moral hazard.
7. Compiler Q.23 PYQ Nov 20, July 21, Dec 21 MTP Apr
19, RTP Nov 18
Explain the different types of externalities? How do externalities lead to welfare
loss of markets?
Ans. Negative externalities occur when the action of one party imposes costs on another
party. Positive externalities occur when the action of one party confers benefits on
another party.
The four possible types of externalities are

i. negative production externality initiated in production which imposes an external
cost on others,
ii. positive production externality, less commonly seen, initiated in production that
confers external benefits on others,
iii. negative consumption externalities initiated in consumption which produce
external costs on others,
iv. positive consumption externality initiated in consumption that confers external
benefits on others.

Each of the above may be received by another in consumption or in production. The

firm or the consumer as the case may be, however, has no incentive to account for the
external costs that it imposes on consumers.
How negative externalities lead to welfare loss of markets may be explained with the
help of the following diagram
(Can explain the chart in own words)

➢ The equilibrium level of output that would be produced by a free market is Q1 at which
marginal private benefit (MPB) is equal to marginal private cost (MPC). Marginal social
cost (MSC) represents the full or true cost to the society of producing another unit
of a good.
➢ It includes marginal private cost (MPC) and marginal social cost (MSC). Assuming that
there are no externalities arising from consumption, we can see that marginal social
cost (Q1S) is higher than marginal private cost (Q1E). Social efficiency occurs at Q2
level of output where marginal social cost is equal to marginal social benefit.
➢ Output Q1 is socially inefficient because at Q1, the marginal social cost is greater
than the marginal social benefit and represents over production. The shaded triangle
represents the area of dead weight welfare loss. It indicates the area of
overconsumption.
➢ Thus, we conclude that when there is negative externality, a competitive market will
produce too much output relative to the social optimum. This is a clear case of market
failure where prices fail to provide the correct signals. When there is a positive
externality, the actual output is lower than the optimal one at which marginal social
(MSC) cost is equal to marginal social benefit (MSB).
There is a welfare loss to the society due to under production and under consumption.
This is a strong case for government intervention in the case of such goods.

Identify the market outcomes for each of the following situations
i. A few youngsters play loud music at night. Neighbours may not be able to
sleep.
ii. Ram buys a large SUV which is very heavy

iii. X smokes in a public place.

iv. Rural school students are given vaccination against measles
Traffic congestion making travel very uncomfortable.
Ans. i. Negative consumption externality; social cost not accounted for; market failure;
overproduction
ii. Negative consumption externality; environmental externality; wear and tear of
roads; increased fuel consumption; added insecurity imposed on others; social cost
not accounted for; overproduction.
iii. Negative consumption externality; overproduction.
iv. Public good, merit good; positive consumption externality; under production; scope
for government intervention.
negative consumption externalities – as individuals consume road space they reduce
available road space and deny this space to others.

Identify the market outcomes for each of the following situations
a) Piracy of computer programs
b) Some species of fish are now getting extinct because they have been caught
indiscriminately.
c) The municipality provides sirens four times a day
d) Burglar alarms are installed by many in your locality
e) Global warming increases due to emissions of fossil fuels
Ans. a) Unpatented computer programs have characteristics very much like a public good
and therefore market failure.
b) The problem of the commons –The tragedy of commons
c) Sirens have all characteristics of public goods. People will free ride – market failure.
d) Positive externality, free riding.
Negative externality.
10. Compiler Q.34 PYQ Jan 21, MTP Aug 18, RTP May 19
Distinguish between private cost and social cost
Ans. Private cost is the cost faced by the producer or consumer directly involved in a
transaction. If we take the case of a producer, his private cost includes direct cost of
labour, materials, energy and other indirect overheads. These are usually added up to
determine market price.
The actions of consumers or producers result in costs or benefits to others and the
relevant costs and benefits are not reflected as part of market prices. In other words,
market prices do not incorporate externalities.
Social costs refer to the total costs to the society on account of a production or
consumption activity.
Social costs are private costs borne by individuals directly involved in a transaction
together with the external costs borne by third parties not directly involved in the
transaction.

Social costs represent the true burdens carried by society in monetary and non-
monetary terms.
11. Compiler Q.40 PYQ May 18, PYQ Nov 20

What are the Features of Public Goods?
Ans. 1) Public goods yield utility and their consumption is essentially collective in nature.
2) Public goods are non-rival in consumption i.e. consumption of a public good by one
individual does not reduce the quality or quantity available for all other individuals
3) Public goods are non-excludable i.e. consumers cannot (at least at less than
prohibitive cost) be excluded from consumption benefits
4) Public goods are characterized by indivisibility, each individual may consume all of the
good i.e. the total amount consumed is the same for each individual.
5) Once a public good is provided, the additional resource cost of another person
consuming the good is zero.
6) No direct payment by the consumer is involved in the case of pure public goods.
7) These goods are generally more vulnerable to issues such as externalities,
inadequate property rights, and free rider problems.
Competitive private markets will fail to generate economically efficient outputs of
public goods. E.g. national defence.

Define near public goods. Is it desirable to keep people away from such goods? Give
comments.
Ans. Near public good (for e.g. education, health services) possess nearly all of the qualities
of the private goods and some of the benefits of public good. It is easy to keep people
away from them by charging a price or fee.
However, it is undesirable to keep people away from such goods because the society
would be better off if more people consume them. This particular characteristic
namely, the combination of virtually infinite benefits and the ability to charge a price
result in some near public goods being sold through markets and others being provided
by government.
As such, people argue that these should not be left to the market alone
13. Compiler Q.51 PYQ July 21, MTP Mar 19, May 20,
Oct 20, ICAI SM
Define common access resources? Why are they over used?
Ans. Common access resources or common pool resources are a special class of impure
public goods which are non-excludable as people cannot be excluded from using them.
These are rival in nature & their consumption lessens benefits available for others.

They are generally available free of charge. Some important natural resources fall into
this category. Examples of common access resources are fisheries, common pastures,
rivers, sea, backwaters biodiversity etc.
The earth’s atmosphere is perhaps the best example. Emissions of carbon dioxide and
other greenhouse gases have led to the depletion of the ozone layer endangering
environmental sustainability. Although nations are aware of the fact that reduced global
warming would benefit everyone, they have an incentive to free ride, with result that
nothing positive is likely to be done to correct the problem. (Not necessary to write this
para)
Since price mechanism does not apply to ‘common resources’, producers and consumers
do not pay for these resources and therefore, they overuse them and cause their
depletion and degradation.
14. Compiler Q.59 PYQ Nov 20, RTP May 22

Explain the situation “where a pharmaceutical Company has full information regarding
the risks of a product, but it continues to sell”?
Ans. This is a case of Asymmetric Information. Asymmetric information occurs when there
is an imbalance in information between buyer and seller i.e. when the buyer knows more
than the seller or the seller knows more than the buyer. This can distort choices.
With asymmetric information, low-quality goods can drive high-quality goods out of
the market.
These are situations in which one party to a transaction knows a material fact that the
other party does not. This phenomenon, which is sometimes referred to as the ‘lemons
problem’, is an important source of market failure.
15. Compiler Q.62 PYQ Dec 21, MTP Oct 19, ICAI SM
How does the government intervene to minimize market power?
Or
How do governments ensure that market power does not create distortions in the
market?
Ans. Market power is an important factor that contributes to inefficiency because it results
in higher prices than competitive prices. In addition, market power also tends to restrict
output and leads to deadweight loss. Because of the social costs imposed by monopoly,
governments intervene by establishing rules and regulations designed to promote
competition and prohibit actions that are likely to restrain competition.
These legislations differ from country to country. For example, in India, we have the
Competition Act, 2002 to promote and sustain competition in markets. Such legislations
generally aim at prohibiting contracts, combinations and collusions among producers or
traders which are in restraint of trade and other anti-competitive actions such as
predatory pricing.

On the contrary, some of the regulatory responses of government to incentive failure

tend to create and protect monopoly positions of firms that have developed unique
innovations. For example, patent and copyright laws grant exclusive rights of products
or processes to provide incentives for invention and innovation.
Policy options for limiting market power also include price regulation in the form of
setting maximum prices that firms can charge. Price regulation is most often used for
natural monopolies that can produce the entire output of the market at a cost that is
lower than what it would be if there were several firms. If a firm is a natural monopoly,
it is more efficient to permit it serve the entire market rather than have several
firms who compete each other. Examples of such natural monopoly are electricity, gas
and water supplies.
In some cases, the government‘s regulatory agency determines an acceptable price, so

as to ensure a competitive or fair rate of return. This practice is called rate-of return
regulation.
Another approach to regulation is setting price-caps based on the firm’s variable costs,
past prices, and possible inflation and productivity growth.
ALTERNATIVELY Short Answer (if 2 marks question is asked)

Market power is an important factor that contributes to inefficiency due to higher
prices than competitive prices.
Because of the social costs imposed by monopoly, governments intervene by establishing

rules and regulations designed to promote competition and prohibit actions that are
likely to restrain competition.
Policy options also include price regulation in the form of setting maximum prices that
firms can charge based on the firm’s variable costs, past prices, and possible inflation
and productivity growth. These are some methods by which the government ensures
that market does not create distortions

Describe the problems in administering an efficient pollution tax.
Ans. Pollution tax is imposed on the polluting firms in proportion to their pollution output to
ensure internalization of externalities. Following are the problems in administering an
efficient pollution tax:
1) Pollution taxes are complex to determine and administer because it is difficult to

discover the right level of taxation that would ensure that the private cost plus
taxes will exactly equate with the social cost.
2) If the demand for the good on which pollution tax is imposed is inelastic, the tax may
only have an insignificant effect in reducing demand. The producers will be able to

easily shift the tax burden in the form of higher product prices. This will have an
inflationary effect and may reduce consumer welfare.
3) Imposition of pollution tax involves the use of complex and costly administrative
procedures for monitoring the polluters.
4) Pollution tax does not provide any genuine solutions to the problem. It only
establishes an incentive system for use of methods which are less polluting.
Pollution taxes also have potential negative consequences on employment and
investments because high pollution taxes in one country may encourage producers to
shift their production facilities to those countries with lower pollution taxes.
17. Compiler Q.70 PYQ Nov 18, MTP Nov 21, RTP May 20
How do government correct market failure resulting from demerits goods?
Or
Why is government intervention required in case of demerit good?
Ans. Demerit goods are goods which impose significant negative externalities on the society
as a whole and are believed to be socially undesirable. The production and consumption
of demerit goods are likely to be more than optimal under free markets. The government
should therefore intervene in the marketplace to discourage their production and
consumption.
The Governments correct market failure resulting from demerit goods in the following
way-
1) At the extreme, government may enforce complete ban on a demerit good. e.g.
Intoxicating drugs. In such cases, the possession, trading or consumption of the
good is made illegal.
2) Through persuasion which is mainly intended to be achieved by negative advertising
campaigns which emphasize the dangers associated with consumption of demerit
goods.
3) Through legislations that prohibit the advertising or promotion of demerit goods in
whatsoever manner.
4) Strict regulations of the market for the good may be put in place so as to limit
access to the good, especially by vulnerable groups such as children and
adolescents.
Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale
of tobacco to be away from schools, and time restrictions under which sale at
particular times during the day is banned.
18. Compiler Q.74 PYQ Nov 20, MTP Mar 19, Apr 19, May 20, Sep 22,
RTP Nov 18, Nov 19, Nov 21, ICAI SM
Describe price ceilings with examples.
Or
Explain why government imposes price ceilings, Explain market outcome of price
ceiling through diagram
Or
What is the market outcome of price ceiling explain with a help of a diagram?

Or
When price of certain essential goods rises excessively, how does the government
intervene to control the price? Explain with the help of an example and with suitable
diagram
Ans. Price ceiling is a government intervention in regulated market economies wherein an
upper limit is set on the price charged for a product or service and the sellers are bound
to abide by such limits. The objective is to influence the outcomes of a market on
grounds of fairness and equity.
The market outcome of price ceiling through diagram

When prices of certain essential commodities rise excessively, government may resort
to controls in the form of price ceilings (also called maximum price) for making a
resource or commodity available to all at reasonable prices. Rent controls, setting of
maximum prices of food grains and essential items during times of scarcity etc are
examples of price ceiling.
A price ceiling which is set below the prevailing market clearing price will generate
excess demand over supply and shortages will result.
Market Outcome of Price Ceiling
The intersection of demand and supply curves set the market price of the commodity in
question at Rs. 150. Since the market determined equilibrium price is considered high
considering the welfare of people, the government intervenes in the market and a price
ceiling is set at Rs. 75 which is below the prevailing market clearing price. At price
Rs. 75, the quantity demanded is Q2 and the quantity supplied is only Q1. In other words,
there is excess demand equal to Q1-Q2.
Thus the market outcome a price ceiling which is below the market-determined price
leads to generation of excess demand over supply.

19. Compiler Q.79 RTP Nov 20, MTP Sep 22, Oct 21,
ICAI SM
Explain why do governments provide subsidies? Illustrate a few examples of
subsidies.
Or
What are the role of subsidy as part of government intervention in public finance?
Or
What is the objective of government subsidy?
Ans. Subsidy is a form of market intervention by government. It involves the government
directly paying part of cost to the producers or consumers in order to promote the
production (consumption) of goods and services.
In other words, a subsidy on a good which has substantial positive externalities would
reduce its cost and consequently price, shift the supply curve to the right and increase
its output. Thus, encouraging increased production and consumption.
A higher output that would equate marginal social benefit and marginal social cost is
socially optimal.
There are many forms of subsidies given out by the government.

➢ Welfare payments and unemployment benefits- The objective of these types of
subsidies is to help people who are temporarily suffering economically.
➢ Subsidized interest rates (interest subsidy) on student loans- given to encourage
people to further their education.
Fertiliser subsidy, food subsidy etc
20. Compiler Q.83 PYQ Nov 19, MTP Oct 19, RTP May 22,
ICAI SM
What is the distinction between discretionary and non-discretionary fiscal policy?
Ans. 1) Discretionary fiscal policy refers to deliberate policy actions on the part of the
government to change the levels of expenditure and taxes to influence the level of
national output, employment, and prices.
Whereas non-discretionary fiscal policy or automatic stabilizers are part of the
structure of the economy and are ‘built -in’ fiscal mechanisms that operate
automatically to reduce the expansions and contractions of the business cycle.
2) Specific export subsidies & concessions are examples of discretionary fiscal policy.
Whereas personal & corporate income tax and transfer payments by government
are examples of non-discretionary fiscal policy
3) Discretionary fiscal policy consists of actions taken at the time of a problem to

alter the economy of the moment. Thus, the aim can be anti-cyclical (decrease) or
pro cyclical (increase).
Whereas non-discretionary fiscal policy is that set of policies that are built into the
system to stabilize the economy when growth is either too fast or too slow.

4) Discretionary policy usually implies implementation lags and is not automatically

reversed when economic conditions change.
Whereas non-discretionary fiscal policy ensures self-correcting fiscal response.
21. Compiler Q.85 PYQ Nov 20, MTP May 20, Apr 22, RTP
May 18, Nov 18
Examine what types of fiscal policy measures are useful for redistribution of income
in an economy?
Or
Fiscal policy plays a significant role in reducing inequality and achieving equity and
social justice. Do you agree? Substantiate your answer with examples.
Ans. Many developed and developing economies are facing the challenge of rising inequality in
incomes and opportunities. Redistribution of income to ensure distributive justice is
essentially a fiscal function. Fiscal policy is a chief instrument available for governments
to influence income distribution and plays a significant role in reducing inequality and
achieving equity and social justice.
The distribution of income in the society is influenced by fiscal policy both directly and
indirectly. While current disposable incomes of individuals and corporates are
dependent on direct taxes, the potential for future earnings is indirectly influenced
by the nation’s fiscal policy choices.
Government revenues and expenditure have traditionally been regarded as important

instruments for carrying out desired redistribution of income. Each of these can be
manipulated to achieve desired distributional effects
➢ A progressive direct tax system appropriately designed to protect incentives
ensures that those who have greater ability to pay contribute more towards
incurring the expenses of government and that the tax burden is distributed fairly
among the population.
➢ Indirect taxes can be differential: For example, commodities which are primarily
consumed by the richer income group, such as luxuries, are taxed heavily and the
commodities the expenditure on which form a larger proportion of the income of the
lower income group, such as necessities, are taxed light. Property taxes act both as
a source of revenue and as an efficient redistributive instrument.
A carefully planned policy of public expenditure helps in redistributing income from the
rich to the poorer sections of the society. This is done through spending programmes
targeted on welfare measures for the disadvantaged, such as (write any 4)
i. poverty alleviation programmes
ii. free or subsidized medical care, education, housing, essential commodities etc. to
improve the quality of living of poor
iii. infrastructure provision on a selective basis

iv. various social security schemes and more efficient social transfers under which
people are entitled to pensions, conditional cash transfer programs,
unemployment relief, sickness allowance etc.
v. subsidized production of products of mass consumption
vi. public production and/ or grant of subsidies to ensure sufficient supply of
essential goods, and
vii. strengthening of human capital for enhancing employability etc.
The design of redistribution policies should justify both redistributive and efficiency
objectives. Choice of a progressive tax system with high marginal taxes may act as a
strong deterrent to work, save and invest. Therefore, tax structure has to be carefully
framed to mitigate possible adverse impacts on production and efficiency. Additionally,
redistributive fiscal policy and extent of spending on redistribution should be consistent
with macroeconomic policy objectives of nation.
22. Compiler Q.86 PYQ Nov 18, Nov 19, Dec 21, MTP Mar
19, Oct 20
Explain the term Contractionary Fiscal Policy. What are the measures undertaken
in a contractionary fiscal policy?
Ans. When aggregate demand rises beyond what the economy can potentially produce by
fully employing its given resources; it gives rise to inflationary pressures in the
economy. The aggregate demand may rise due to large increase in consumption demand
by households or investment expenditure by entrepreneurs, or government expenditure.
In these circumstances inflationary gap occurs which tends to bring about rise in
prices. Under such circumstances, a contractionary fiscal policy will have to be used.
Contractionary fiscal policy refers to the deliberate policy of government applied to

curtail aggregate demand and consequently the level of economic activity. In other
words, it is fiscal policy aimed at eliminating an inflationary gap. This is achieved by
adopting policy measures that would result in the aggregate demand curve (AD) shift
to the left so the equilibrium may be established at the full employment level of real
GDP.
This can be achieved either by:

➢ Decrease in government spending.
➢ Increase in personal income taxes and/or business taxes.
A combination of decrease in government spending and increase in personal income taxes
and/or business taxes.
23. Compiler Q.88 RTP May 18, May 20

Analyse what should be the tax policy during recession and depression?
Or
Suppose country X is passing through recession, what type of tax policy should be
framed during this period?

Ans. A recession is said to occur when overall economic activity declines, or in other words,
when the economy ‘contracts’. A recession sets in with a period of declining real income,
as measured by real GDP, simultaneously with a situation of rising unemployment.
If an economy experiences a fall in aggregate demand during a recession, it is said to be

in a demand-deficient recession. Economic depression is a condition of the economy
resulting from an extended period of negative economic activity as measured by GDP.
It is an extremely severe form of recession that leads to extended unemployment,

increased credit defaults, extensive decline in output and income and a deflationary
economy
Taxation, though less effective compared to public expenditure, is a powerful instrument

of fiscal policy in the hands of governments to combat recession and depression.
➢ Reduction in corporate and personal income taxation is a useful measure to
overcome contractionary tendencies in the economy. A tax cut increases disposable
incomes of households. Their inclination to spend a portion of the additional
disposable income determined by their marginal propensity to consume and the
multiplier effect of spending would set out a chain reaction of spending, increased
incomes, and consequent increased output.
➢ Reduction in the rates of commodity taxes like goods & service tax (GST) and
import duty promote consumption and ultimately boost investments.
Moreover, tax measures can provide incentives, or reduce disincentives, for firms and
households to engage in investment and consumer spending.
24. Compiler Q.95 PYQ May 18, Jan 21, MTP Mar 19, Nov
21, RTP Nov 22, ICAI SM
What is meant by Crowding out?
Or
How is economy effected by crowding out effect?
Ans. The crowding out view is that a rapid growth of government spending leads to a transfer
of scarce productive resources from the private sector to the public sector where
productivity might be lower.
An increase in the size of government spending during recessions will ‘crowd-out’

private spending in an economy and lead to reduction in an economy’s ability to self-
correct from the recession, and possibly also reduce the economy’s prospects of long-
run economic growth.
Crowding out effect is the negative effect fiscal policy may generate when money from
the private sector is ‘crowded out’ to the public sector.

During deep recessions, crowding-out is less likely to happen as private sector

investment is already minimal and therefore there is only insignificant private spending
to crowd out. Moreover, during a recession phase the government would be able to
borrow from the market without increasing interest rates.
25. Compiler Q.96 PYQ Jan 21

Calculate the Fiscal Deficit and Primary Deficit from the data given below:
Total Expenditure on Revenue Account and Capital Account 547.62
Revenue Receipts 226.82
Non-debt Capital Receipts 103.00
Interest Payments 84.00

Ans. Fiscal Deficit = Total Expenditure on Revenue Account and Capital Account – Revenue
receipts- Non debt Capital Receipts
= 547.62 – 226.82 - 103.00
= 217.80 Cr
Primary Deficit = Fiscal Deficit – Interest Payments

= 217.80 cr – 84.00cr
= 133.80 Cr
26. Compiler Q.99 MTP Aug 18

The equilibrium level of real GDP is Rs 1,000 billion, the full employment level of real
GDP is Rs 1,250 billion, and the marginal propensity to consume (MPC) is 0.60. How
much government spending (∆G) would be needed to raise income to full-employment
level?
Ans. k. ∆G = ∆ Y; k = 1/0.4 = 2.5
∆G = (1250 -1000) / 2.50

∆G = 100 billion

CHAPTER 3 - Money Market
1. Compiler Q.3 PYQ Nov 18, ICAI SM

Mention the general characteristics of Money.
Ans. There are some general characteristics that money should possess in order to make it
serve its functions as money. Money should be:
➢ Generally acceptable
➢ Durable or long-lasting
➢ Effortlessly recognizable
➢ Difficult to counterfeit i.e. not easily reproducible by people
➢ Relatively scarce, but has elasticity of supply
➢ Portable or easily transported
➢ Possessing uniformity; and
Divisible into smaller parts in usable quantities or fractions without losing value

Do you think money is a unique store of value?
Ans. Financial assets other than money are also performing the function of store of value. Just
as money has, the financial assets have fixed nominal value over time and represent
generalized purchasing power. Therefore, money is not a unique store of value.

Which of the functions of money do the following items satisfy?
i. A credit card.
ii. A token of specified amount of money which can be used for shopping
Ans. i. A credit card is a medium of exchange
A token of specified amount of money which can be used for shopping satisfies all 3
functions of money, which are store of value, unit of account, and medium of exchange.
4. Compiler Q.12 PYQ May 18, MTP Oct 20, RTP Nov 19
Explain the classical version of quantity theory of demand for money
OR
Explain the Fisher’s Quantity theory of demand for money?
OR
Explain the following modified equation of exchange as given by Irving Fisher: MV
+M'V’=PT
Ans. According to Fisher, quantity theory of money demonstrates that there is strong
relationship between money and price level and the quantity of money is the main
determinant of the price level or the value of money. In other words, changes in the
general level of commodity prices or changes in the value or purchasing power of money
are determined first and foremost by changes in the quantity of money in circulation.

Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is

formally stated as follows: MV = PT
Where, M = the total amount of money in circulation (on an average) in an economy
V = transactions velocity of circulation i.e. the average number of times across all
transactions a unit of money (say Rupee) is spent in purchasing goods and services
P = average price level (P= MV/T)
T = the total number of transactions.
Later, Fisher extended the equation of exchange to include demand (bank) deposits
(M’) and their velocity (V’) in the total supply of money. Thus, the expanded form of the
equation of exchange becomes: MV + M'V' = PT
Where, M’ = the total quantity of credit money
V' = velocity of circulation of credit money
The total supply of money in the community consists of the quantity of actual money (M)
and its velocity of circulation (V).
Velocity of money in circulation (V) and the velocity of credit money (V') remain constant.
T is a function of national income.
Since full employment prevails, the volume of transactions (T) is fixed in the short run.
Briefly put, the total volume of transactions (T) multiplied by the price level (P)
represents the demand for money. The demand for money (PT) is equal to the supply of
money (MV + M'V'). In any given period, the total value of transactions made is equal to
PT and the value of money flow is equal to MV+ M'V’.
Fisher did not specifically mention anything about the demand for money; but the same
is embedded in his theory as dependent on the total value of transactions undertaken
in the economy.
Thus, there is an aggregate demand for money for transactions purpose and more the
number of transactions people want, greater will be the demand for money. The total
volume of transactions multiplied by the price level (PT) represents the demand for
money.

Fisher's equation of exchange is: MV =PT. If velocity (V) = 25, Price (P) 110.5 and
volume of transaction (T) = 200 billion.
Calculate:
1. Total money supply (m)
2. Effect on M when velocity (V) increases to 75
Velocity (V) when the volume of transactions increases to 325 billion.
Ans. 1. MV = PT
M× 25 = 110.5 × 200
Therefore,25 M = 22100
Then M = 22100 ÷ 25 = 884 bn
Total supply supply (m) = 884 bn

2. M × 75 = 110.5 × 200
M = 110.5 × 200÷ 75 = 294.66 bn
Hence supply of money will reduce from 884bn to 294.66 bn
3. MV = PT
884 × V = 110.5 × 325 V = 40.62 bn
When Volume of transaction increases to 325 bn velocity (v) will be 40.62 bn
6. Compiler Q.18 PYQ Nov 19, MTP Aug 18

Explain the Cambridge Version of Cash Balance Approach, Md = k P Y
Or
Explain the neo-classical approach to demand for money
Ans. In the early 1900s, Cambridge Economists- Alfred Marshall, A.C. Pigou, D.H. Robertson
and John Maynard Keynes (then associated with Cambridge) put forward a fundamentally
different approach to quantity theory, known neo-classical theory or cash balance
approach.
The Cambridge version holds that money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points of
time rather than being simultaneous, and
2. being a hedge against uncertainty.
While the first above represents transaction motive, just as Fisher envisaged, the
second points to money’s role as a temporary store of wealth. Since sale and purchase
of commodities by individuals do not take place simultaneously, they need a ‘temporary
abode’ of purchasing power as a hedge against uncertainty. As such, demand for money
also involves a precautionary motive in Cambridge approach.
Since money gives utility in its store of wealth and precautionary modes, one can say that
money is demanded for itself.
Now, the quantity of money demanded will depend partly on income and partly on other
factors of which important ones are wealth and interest rates. The former determinant
of demand i.e. income, points to transactions demand such that higher the income, the
greater the quantity of purchases and as a consequence greater will be the need for
money as a temporary abode of value to overcome transactions costs.
The Cambridge equation is stated as:

Md = k PY,
Where Md = is the demand for money

Y = real national income
P = average price level of currently produced goods and services
PY = nominal income

k = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains
that the demand for money (M) equals k proportion of the total money income.
Thus, we see that the neoclassical theory changed the focus of the quantity theory of
money to money demand and hypothesized that demand for money is a function of money
income.
7. Compiler Q.20 PYQ May 18, Dec 21, MTP Oct 21, Sep 22
Why do people hold money balances?
Or
Explain why people hold money according to Liquidity Preference Theory
Or
What are the different motive for holding cash according to Keynes?
Ans. According to Keynes’ Liquidity Preference Theory’, people hold money (M) in cash for
three motives:
i. Transactions motive: People hold cash for current transactions for personal and
business exchanges i.e. to bridge the time gap between receipt of income and
planned expenditures.
ii. Precautionary motive: People hold cash to make unanticipated expenditures that
may occur due to unforeseen and unpredictable contingencies.
iii. Speculative motive: This motive reflects people’s desire to hold cash in order to be
equipped to exploit any attractive investment opportunity requiring cash
expenditure. According to Keynes, people demand to hold money balances to take
advantage of the future changes in the rate of interest, which is the same as
future changes in bond prices.
The sum of the transaction and precautionary demand, and the speculative demand, is
the total demand for money.
8. Compiler Q.23 PYQ Dec 21 RTP May 18

Explain how speculative motive for holding cash is related to market interest rate
Ans. According to Keynes’ theory of liquidity preference, speculative motive for holding cash
is related to market interest. The market value of bonds and the market rate of
interest are inversely related. A rise in the market rate of interest leads to a decrease
in the market value of the bond, and vice versa.
Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate
and compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
If wealth-holders consider that the current rate of interest is high compared to the
‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond
prices). At the high current rate of interest, they will convert their cash balances into
bonds because:

i. they can earn high rate of return on bonds

ii. hey expect capital gains resulting from a rise in bond prices consequent upon an
expected fall in the market rate of interest in future.
Conversely, if the wealth-holders consider the current interest rate as low, compared to
the ‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise
in future (fall in bond prices), they would have an incentive to hold their wealth in the
form of liquid cash rather than bonds because:
i. the loss suffered by way of interest income forgone is small,
ii. they can avoid the capital losses that would result from the anticipated increase
in interest rates, and
iii. the return on money balances will be greater than the return on alternative
assets
iv. If the interest rate does increase in future, the bond prices will fall and the
idle cash balances held can be used to buy bonds at lower price and can thereby
make a capital-gain.
Summing up,
➢ If current rate of interest is higher than the critical rate of interest, a typical
wealth-holder would hold in his asset portfolio only government bonds, while
➢ If current rate of interest is lower than the critical rate of interest, his asset
portfolio would consist wholly of cash.
➢ If current rate of interest is equal to the critical rate of interest, a wealth-holder
is indifferent to holding either cash or bonds.
The inference from the above is that the speculative demand for money and interest are
inversely related.

Justify the following statements in the light of holding cash balance.
1) For investment in interest bearing assets
2) In the prevailing scenario, usually all transactions are made through online or E-
banking.
Money is a unique store of value
Ans. 1) For Investment in interest bearing assets: The speculative motive reflects people’s
desire to hold cash in order to be equipped to exploit any attractive investment
opportunity requiring cash expenditure. According to Keynes, people demand to hold
money balances to take advantage of the future changes in the rate of interest,
which is the same as future changes in bond prices.
2) In the prevailing scenario, usually all transactions are made through online or E
banking: The transactions motive for holding cash relates to ‘the need for cash for
current transactions for personal and business exchange.’ The need for holding
money arises because there is lack of synchronization between receipts and
expenditures.
Money is a unique store of value: Many unforeseen and unpredictable contingencies
involving money payments occur in our day-to-day life. Individuals as well as businesses

keep a portion of their income to finance such unanticipated expenditures. The amount
of money demanded under the precautionary motive depends on the size of income,
prevailing economic as well as political conditions and personal characteristics of the
individual such as optimism/ pessimism, farsightedness etc.
10. Compiler Q.29 MTP Oct 21, Mar 22, RTP May 21
Explain the concept of Liquidity Trap.
Or
What are the impact of liquidity trap on the economy?
Ans. Liquidity trap is a situation where the desire to hold bonds is very low and approaches
zero, and the demand to hold money in liquid form as an alternative approaches infinity.
People expect a rise in interest rate and the consequent fall in bond prices and the
resulting capital loss. The speculative demand becomes perfectly elastic with respect
to interest rate and the speculative money demand curve becomes parallel to the X
axis.
Empirical evidence of liquidity trap is found during the global financial crisis of 2008 in
the United States and Europe. Short-term interest rates moved close to zero. Some
economists argued that these developed economies were in a liquidity trap. Even tripling
of the monetary base in the US between 2008 and 2011 failed to produce significant
effect on the domestic prices.
When interest rates fall to very low levels, the expectation is that since the interest
rate is very low it cannot go further lower and that in all possibility it will move
upwards. When interest rates rise, the bond prices will fall. To hold bonds at this low
interest rate is to take the almost certain risk of a capital loss.
Therefore, the desire to hold bonds is very low and approaches zero, and the demand
to hold money in liquid form as alternative to bond holding approaches infinity. In other
words, investors would maintain cash savings rather than hold bonds.
The speculative demand becomes perfectly elastic with respect to interest rate and
the speculative money demand curve becomes parallel to the X axis. This situation is
called a ‘Liquidity trap’.
11. Compiler Q.30 PYQ Dec 21, RTP Nov 18

Critically examine the post Keynesian theories of demand for money?
Ans. The post-Keynesian economists developed a number of models to provide alternative
explanations to confirm the formulation relating real money balances with real income
and interest rates. Most post-Keynesian theories of demand for money emphasize the
store-of-value or the asset function of money.
Inventory Approach to Transaction Balances

Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand
for money, known as Inventory Theoretic Approach, in which money or ‘real cash
balance’ was essentially viewed as an inventory held for transaction purposes.
People hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost.
The optimal average money holding is-
➢ a positive function of
✓ income Y
✓ price level P,
✓ transactions costs c, and
➢ a negative function of nominal interest rate
Friedman's Restatement of the Quantity Theory

Milton Friedman (1956) extending Keynes’ speculative money demand within the
framework of asset price theory holds that demand for money is affected by the same
factors as demand for any other asset, namely, permanent income and relative returns
on assets.
The nominal demand for money-

➢ is positively related to the price level, P.
➢ rises if bonds and stock returns, rb and re, respectively decline and vice versa;
➢ is influenced by inflation; and
➢ is a function of total wealth.
The Demand for Money as Behaviour towards Risk
The Demand for Money as Behaviour toward as ‘aversion to risk’ propounded by Tobin
states that money is a safe asset but an investor will be willing to exercise a trade-
off and sacrifice to some extent the higher return from bonds for a reduction in risk.
According to Tobin, rational behaviour explained induces individuals to hold an optimally

structured wealth portfolio which is comprised of both bonds and money and the
demand for money as a store of wealth depends negatively on the interest rate.
These theories establish a positive relation of demand for money to real income and
an inverse relation to the rate of return on earning assets, i.e. the interest rate.
12. Compiler Q.37 MTP Nov 21, Mar 22, RTP Nov 19
Why empirical analysis of money supply is important?
OR
What is the rationale of measuring money supply?.
Ans. The term money supply denotes the total quantity of money available to the people in
an economy. The quantity of money at any point of time is a measurable concept.
Empirical analysis of money supply is important for two reasons:

i. It facilitates analysis of monetary developments in order to provide a deeper

understanding of the causes of money growth.
It is essential from a monetary policy perspective as it provides a framework to evaluate

whether the stock of money in the economy is consistent with the standards for price
stability and to understand the nature of deviations from this standard. The central
banks all over the world adopt monetary policy to stabilise price level and GDP growth
by directly controlling the supply of money. This is achieved mainly by managing the
quantity of monetary base. The success of monetary policy depends to a large extent
on the controllability of money supply and the monetary base.
13. Compiler Q.44 PYQ Nov 19 Jan 21 RTP Nov 19

What is high powered money? Calculate it from the following data:
Components in Million (Rs.)
Net RBI Credit to the Government 41,561.2
RBI credit to the Commercial sector 18,459.3
RBI’s net non-monetary liabilities 24,981.2
RBI’s claims on banks 31,456.2
RBI’s Net foreign assets 10,456.1
Government’s currency liabilities to the public 21,417.1

Ans. High powered money is also known as reserve money which determines the level of liquidity
and price level in the economy.
Components Amount (in Million Rs.)
Net RBI Credit to the Government 41,561.2
+ RBI credit to the Commercial sector 18,459.3
+ RBI’s claims on banks 31,456.2
+ RBI’s Net foreign assets 10,456.1
+ Government’s currency liabilities to the public 21,417.1
- RBI’s net non-monetary liabilities (24,981.2)
Reserve Money 98,368.7

The following information is given:
Components in Crores (Rs.)
Notes in Circulation 25,00,000

Circulation of Rupee Coins 26,000
Circulation of Small Coins 850
Cash on hand with Banks 95,000
Bankers' Deposits with RBI 4,500
Other Deposits with RBI 180
Total Post office Deposits 12,000
Time Deposits with Banks 15,000

You are required to compute:
i. Currency with the Public; and
Reserve Money.
Ans. Components in Crores (Rs.)
Notes in Circulation 25,00,000
+ Circulation of Rupee Coins 26,000
+ Circulation of Small Coins 850
- Cash on hand with Banks (95,000)
Currency with Public 24,31,850
Currency in Circulation
Currency with Public 24,31,850
+ Cash on Hand with Banks 95,000 25,26,850
+ Bankers' Deposits with RBI 4,500
+ Other Deposits with RBI 180
Reserve Money 25,31,530

Distinguish between M1 and M2. Find out M1 when a country has the following
monetary asset information as of Mar 20:
Components in Million (Rs.)
Cash in hands of the public 300
Demand Deposits 400
Savings Type accounts 2000

Money Market Mutual Funds 1000
Traveller’s checks 50
Small Time Deposits 500
Large Time Deposits 450
Other Checkable Deposits 150

Ans. M1 is composed of currency and coins with the people, demand deposits of banks (current
and saving accounts) and other deposits with the RBI whereas M2 includes M1 as well as
savings deposits with post office savings banks.
Particulars Amount (in Millions of Rs.)
Cash in hands of the public 300
+ Demand Deposits 400
+ Other Checkable Deposits 150
+ Traveller’s checks 50
M1 900
16. Compiler Q.56 PYQ Nov 20, Jan 21

Compute M3 from the following data
Currency with the public 2,25,432.6
Demand Deposits with Banks 3,40,242.4
Time Deposits with Banks 2,80,736.8
Post office savings Deposits

446.7
(Excluding National Saving Certificates)
Other Deposits with RBI

392.7
(Including Government Deposits)
Post Office National Saving Certificates 83.7
Government Deposits with RBI· 102.5

Ans.
Currency with the public 2,25,432.6
+ Demand Deposits with Banks 3,40,242.4
+ Time Deposits with Banks 2,80,736.8

Other Deposits with RBI

+ 392.7
(Including Government Deposits)
- Government Deposits with RBI· (102.5)
M3 8,46,702

Calculate liquidity aggregate L2 when the following information is given-
Particulars in Crores (Rs.)
Term deposits with term lending institutions 750
Term borrowing by refinancing institutions 450
All deposits with post office savings banks 1,320
Term deposits with refinancing institutions 590
Certificate of deposits issued by FIs 290
Public deposits of non-banking financial companies 450
NM3 2,650
National saving certificates 240

Ans.
Particulars Amount (in Crores of Rs.)
NM3 2,650
+ All deposits with post office savings banks 1,320
L1 3,970
+ Term deposits with term lending institutions 750
+ Term deposits with refinancing institutions 590
+ Term borrowing by refinancing institutions 450
+ Certificate of deposits issued by FIs 290
L2 6,050
18. Compiler Q.65 PYQ Jan 21, RTP Nov 18, Nov 21
What is money multiplier approach to supply of money?
Ans. The money multiplier approach to money supply propounded by Milton Friedman and Anna
Schwartz, considers three factors as immediate determinants of money supply, namely:
a) the stock of high-powered money (H)
b) the ratio of reserves to deposits

c) currency-deposit ratio
The above determinant represents the behaviour of the central bank, behaviour of the
commercial banks and the behaviour of the general public respectively.
The behaviour of the central bank which controls the issue of currency is reflected
in the supply of the nominal high-powered money.
Behaviour of the commercial banks- If the required reserve ratio on demand deposits
increases while all the other variables remain the same, more reserves would be needed.
This implies that banks must contract their loans, causing a decline in deposits and
hence in the money supply. If the required reserve ratio falls, there will be greater
expansions of deposits because the same level of reserves can now support more
deposits and the money supply will increase.
Behaviour of the general public- The currency-deposit ratio (c) represents the degree
of adoption of banking habits by the people.
19. Compiler Q.68 PYQ May 18, Nov 20, MTP Oct 18, RTP Nov 18
Explain how each of the following may affect money multiplier and money supply?
i. Fearing shortage of money in ATM’s, people decide to hoard money?
ii. During festival season, people decide to withdraw money through ATMs very
often
iii. Banks open large number of ATMs all over country
iv. E banking becomes very common and nearly all people use them
v. If Commercial banks decide to keep 100% reserves.
vi. If Commercial Banks do not keep reserves
vii. If Commercial Banks keep excess reserves.
viii. If Commercial Banks keep less reserves
Ans. i. The money multiplier is a function of the currency ratio set by depositors ‘c’,
which depends on the behaviour of the public in respect of holding money. The
public by their decisions in respect of the size of the nominal currency in hand
(designated as the currency ratio) is in a position to influence the amount of the
nominal demand deposits of the commercial banks. When people decide to hoard
to money fearing shortage of money in ATM’s, there is an increase in c because
depositors are converting some of their demand deposits into currency. Demand
deposits undergo multiple expansions while currency does not. Hence when
demand deposits are being converted into currency, there is a switch from a
component of the money supply that undergoes multiple expansions to one that
does not. The overall level of multiple expansion declines, and therefore, money
multiplier also falls.
ii. Demand deposits held by people are highly liquid as they can be easily withdrawn
and converted to cash. If people, for any reason, withdraw money from ATMs
with greater frequency, then banks will have to keep more cash reserves to

meet the obligations. This will raise the reserve ratio, and lower the money
multiplier. As a result, money supply will decline.
iii. ATMs let people to withdraw cash from the bank as and when needed, reduces
cost of conversion of deposits to cash and makes deposits relatively more
convenient. People hold less cash and more deposits, thus reducing the currency-
deposit ratio; increasing money multiplier causing the money supply to increase.
iv. If e-banking becomes very common and nearly all people use it, then it would make
deposits relatively more convenient and reduce cost of conversion of deposits to
cash. People hold less cash and more deposits, thus reducing the currency-deposit
ratio; increasing the money multiplier causing the money supply to increase.
v. If banks decide to keep 100% reserves, then the Money multiplier = 1/required
reserve ratio = 1/100% = 1. Deposits simply substitute for the currency that is
held by banks as reserves and therefore no new money is created by banks.
vi. If commercial banks do not keep reserves and lends the entire deposits, it is a
case of zero required reserve ratio and credit multiplier will be infinite and
therefore money creation will also be infinite.
vii. Excess reserves are reserves over and above what banks are legally required to
hold against deposits. The additional units of money that goes into ‘excess
reserves’ of the commercial banks do not lead to any additional loans, and
therefore, these excess reserves do not lead to creation of money. The increase
in banks’ excess reserves reduces the credit multiplier, causing the money supply
to decline.
The impact on credit multiplier and money supply, if commercial banks keep less reserve
then commercial banks can lend additional money, and therefore, these lead to creation
of more credit. If banks need to keep only less reserve, then the credit multiplier would
be high and therefore money supply would be higher

“The deposit multiplier and the money multiplier though closely related are not
identical". Explain briefly.
Ans. The money multiplier denotes by ‘how much the money supply will change for a given
change in high-powered money’.
The deposit multiplier describes the amount of additional money created by
commercial bank through the process of lending the available money it has in excess of
the central bank's reserve requirements.
Though closely related they are not identical because:

a) Generally banks do not lend out all of their available money, but instead maintain
reserves at a level above the minimum required reserve. In other words, banks
keep excess reserves.
The public prefers to hold some cash and therefore, some of the increase in loans will
not be deposited at the commercial banks, but will be kept cash. This means, that when
new reserves enter the banking system they will not be multiplied entirely by the
deposit multiplier into new demand deposits. Some money will leave the banking system
in the form of cash. Therefore, the money supply will be raised by less than the demand
deposits. If some portion of the increase in high-powered money finds its way into
currency, this portion does not undergo multiple deposit expansion. The size of the
money multiplier is reduced when funds are held as cash rather than as demand deposits.
21. Compiler Q.76 MTP May 20, Oct 22, ICAI SM

What effect does government expenditure have on money supply?
Ans. Whenever the central and the state governments’ cash balances fall short of the
minimum requirement, they are eligible to avail a facility called Ways and Means
Advances (WMA)/overdraft (OD) facility.
When the Reserve Bank lends to the governments under Ways and Means Advances
(WMA)/overdraft (OD), it results in the generation of excess reserves (i.e., excess
balances of commercial banks with the Reserve Bank).
This happens because when the government incurs expenditure, it involves debiting the
government balances with the Reserve Bank and crediting the receiver (for e.g., salary
account of government employee) account with the commercial bank.
The excess reserves thus created can potentially lead to an increase in money supply
through the money multiplier process.
22. Compiler Q.80 MTP Nov 21, Mar 22, RTP Nov 21
What are the operating procedures and instrument of monetary policy?
OR
Explain operating procedures in the context of monetary policy of India?
Ans. The day-to-day implementation of monetary policy by central banks through various
instruments is referred to as ‘operating procedures. For example, liquidity management
is the operating procedure of the Reserve Bank of India
The operating framework relates to all aspects of implementation of monetary policy. It
primarily involves three major aspects, namely,
➢ choosing the operating targets,
➢ choosing the intermediate targets, and
➢ choosing the policy instruments.
The operating targets refer to the financial variables that can be controlled by the
central bank to a large extent through the monetary policy instruments.

The intermediate targets are variables which the central bank can hope to influence to
a reasonable degree through the operating targets.
The monetary policy instruments are the various tools that a central bank can use to
influence money market and credit conditions and pursue its monetary policy objectives.
In general, the direct instruments comprise of:

a) the required cash reserve ratios and liquidity reserve ratios prescribed from time
to time.
b) directed credit which takes the form of prescribed targets for allocation of credit
to preferred sectors
c) administered interest rates wherein the deposit and lending rates are prescribed
by the central bank.
The indirect instruments mainly consist of:

a) Repos
b) Open market operations
c) Standing facilities, and
Market-based discount window.
23. Compiler Q.84 PYQ Nov 18, RTP May 20

How does the monetary policy influence the price level and the national income?
Ans. The process or channels through which the change of monetary aggregates affects
the level of product and prices is known as ‘monetary transmission mechanism’. There
are mainly four different mechanisms through which monetary policy influences the
price level and the national income.
These are:
a) the interest rate channel,
b) the exchange rate channel,
c) the quantum channel (e.g., relating to money supply and credit), and
d) the asset price channel i.e. via equity and real estate prices.
Under the interest rate channel, changes in monetary policy are eventually reflected in
the real long-term interest rates which influence aggregate demand by altering business
investment and durable consumption decisions. This, in turn, gets reflected in aggregate
output and prices.
The exchange rate channel works through expenditure switching between domestic and
foreign goods. Appreciation of the domestic currency makes domestically produced
goods more expensive compared to foreign‐produced goods. This causes net exports to
fall; correspondingly domestic output and employment also fall
The quantum channel (e.g., relating to money supply and credit)

Two distinct credit channels:

➢ Bank lending channel - Credit channel operates by altering access of firms and
households to bank credit.
➢ Balance sheet channel- A direct effect of monetary policy on the firm’s balance
sheet comes about when an increase in interest rates works to increase the
payments that the firm must make to service its floating rate debts. An indirect
effect sets in, when the same increase in interest rates works to reduce the
capitalized value of the firm’s long‐lived assets.
The asset price channel: Asset prices respond to monetary policy changes and
consequently impact output, employment and inflation. A policy‐induced increase in the
short‐term nominal interest rates makes debt instruments more attractive than
equities in the eyes of investors leading to a fall in equity prices, erosion in household
financial wealth, fall in consumption, output, and employment.
24. Compiler Q.90 PYQ Nov 20, Jan 21, MTP Mar 19,
Sep 22, RTP Nov 18
Explain the function of SLR? What are the eligible securities of SLR?
Or
What are the eligible securities for SLR?
Or
Explain the functioning of SLR?
Or
How do changes in Statutory liquidity ratio impact the economy?
Ans. The Statutory Liquidity ratio (SLR) is an instrument of monetary policy and aims to
control liquidity in the domestic market by means of manipulating bank credit.
Changes in the SLR chiefly influence the availability of resources in the banking system
for lending.
➢ A rise in the SLR which is resorted to during periods of high liquidity, tends to lock
up a rising fraction of a bank’s assets in the form of eligible instruments, and this
reduces the credit creation capacity of banks.
➢ A reduction in the SLR during periods of economic downturn has the opposite effect.
The SLR requirement also facilitates a captive market for government securities.
Following are the eligible securities of SLR;

a) Cash
b) Gold valued at a price not exceeding the current market price, or,
c) Investments in un-encumbered Instruments that include:
➢ Treasury-bills of the Government of India.
➢ Dated securities including those issued by the Government of India from time to
time under the market borrowings programme and the Market Stabilization
Scheme (MSS).

➢ State Development Loans (SDLs) issued by State Governments under their

market borrowings programme.
➢ Other instruments as notified by the RBI.
25. Compiler Q.95 PYQ May 18, July 21

Explain the difference between Liquidity Adjustment Facility (LAF) and Marginal
Standing Facility (MSF).
Ans. Liquidity Adjustment Facility (LAF) which was introduced by RBI in June, 2000, is a
facility extended to the scheduled commercial banks and primary dealers to avail of
liquidity in case of requirement on an overnight basis against the collateral of government
securities including state government securities.
Its objective is to assist banks to adjust their day to day mismatches in liquidity.
Currently, the RBI provides financial accommodation to the commercial banks through
repos / reverse repos under LAF.
Marginal Standing Facility (MSF) which was introduced by RBI in its monetary policy
statements 2011 -12, refers to the facility under which scheduled commercial banks can
borrow additional amount of overnight money from the central bank over and above what
is available to them through the LAF window by dipping into their Statutory Liquidity
Ratio (SLR) portfolio up to a limit at a penal rate of interest.
This provides a safety valve against unexpected liquidity shocks to the banking system.
The MSF would be the last resort for banks once they exhaust all borrowing options
including the liquidity adjustment facility.
26. Compiler Q.99 PYQ Jan 21, MTP May 20, Mar 22, Sep 22,
RTP May 18, May 19, ICAI SM
What role does Market Stabilization Scheme (MSS) play in our economy?
Ans. Market Stabilization scheme (MSS), introduced in 2004, is a monetary policy intervention
by the RBI primary aim of aiding the sterilization operations of RBI, i.e., to withdraw
excess liquidity (or money supply) by selling government securities in the economy.
Under the Market Stabilisation Scheme (MSS) the Government of India borrows from
the RBI (such borrowing being additional to its normal borrowing requirements) and issues
treasury-bills/dated securities that are utilized for absorbing from the market excess
liquidity of a more enduring nature arising from large capital inflows.
The bills/bonds issued under MSS would have all the attributes of the existing treasury
bills and dated securities. The bills and securities will be issued by way of auctions to
be conducted by the Reserve Bank.
These bonds are issued by RBI on the behalf of Government in order to mop out excess
liquidity from the market (Banks) and not for raising capital for government.

Below line is only for explanation, not to be written in exam-

(Sterilization is the process by which the monetary authority sterilizes the effects of
significant foreign capital inflows on domestic liquidity by off-loading parts of the stock
of government securities held by it)

Explain the role of Monetary Policy Committee (MPC) in India.
Ans. An important landmark in India’s monetary history is the constitution of an empowered
six-member Monetary Policy Committee (MPC) in September, 2016 consisting of-
➢ RBI Governor (Chairperson),
➢ RBI Deputy Governor - in charge of monetary policy,
➢ one official nominated by the RBI Board and
➢ remaining three central government nominees representing the Government of India
who are persons of ability, integrity and standing, having knowledge and experience in
the field of Economics or banking or finance or monetary policy.
The Committee is required to meet at least four times a year and the decisions adopted
by the MPC are published after conclusion of every meeting of the MPC.
Based on the review of the macroeconomic and monetary developments in the economy,
the MPC shall determine the policy rate required to achieve the inflation target. The
fixing of the benchmark policy interest rate (repo rate) is made through debate and
majority vote by this panel of experts.
With the introduction of the Monetary Policy Committee, the RBI will follow a system
which is more consultative and participative similar to the one followed by many of the
central banks in the world.
The new system is intended to incorporate:

➢ diversity of views,
➢ specialized experience,
➢ independence of opinion,
➢ representativeness, and
accountability.

CHAPTER 4 - International Trade
1. Compiler Q.2 PYQ May 19, MTP Oct 19, MTP May
20, ICAI SM
How does trade increase economic efficiency and which view argued that trade is a
zero- sum game and how?
Ans. Economic efficiency increases due to quantitative and qualitative benefits of-
➢ extended division of labour,
➢ economies of large scale production,
➢ betterment of manufacturing capabilities,
➢ increased competitiveness & profitability by using cost reducing technology and
business practices &
➢ decrease in the likelihood of domestic monopolies
Efficient deployment of productive resources - natural, human, industrial and financial

resources ensure productivity gains.
Mercantilist argued that trade is a zero sum game. Mercantilism advocated maximizing
exports in order to bring in more precious metals and minimizing imports through the
state imposing very high tariffs on foreign goods.
This view argues that trade is a ‘zero-sum game’, with winners who win does so only
at the expense of losers and one country’s gain is equal to another country’s loss,
so that the net change in wealth or benefits among the participants is zero.

The table below shows the number of labour hours required to produce wheat and cloth
in two countries X and Y.
Commodity Country X Country Y
1 unit of cloth 4 1.0
1 unit of wheat 2 2.5

1. Compare the productivity of labour in both countries in respect of both
commodities
2. Which country has absolute advantage in the production of wheat?
3. Which country has absolute advantage in the production of cloth?
4. If there is trade, which commodity should these countries produce?
What are the opportunity costs of each commodity?
Ans. 1) Productivity of labour in both countries in respect of both commodities
Productivity of labour Country X Country Y
Units of cloth per hour 0.25 1.0

Units of wheat per hour 0.5 0.4
2) Country X has absolute advantage in the production of wheat because productivity of

wheat is higher in country X , or conversely, the number of labour hours required to produce
wheat in country X is less compared to country Y
3) Country Y has absolute advantage in the production of cloth because productivity of

cloth is higher in country Y , or conversely, the number of labour hours required to produce
cloth in country Y is less compared to country X
4) In country X, the opportunity cost is 0.25 units of cloth for 0.5 unit of wheat
5) In country Y the opportunity cost is 0.4 units of wheat for 1 unit of cloth.

Countries China and India have a total of 6000 hours each of labour available each
day to produce shirts and trousers. Both countries use equal number of hours on
each good each day. China produces 1000 shirts and 300 trousers per day. India
produces 300 shirts and 200 trousers per day.
In the absence of trade:
i. Which country has absolute advantage in producing Shirts and Trousers?
ii. Which country has comparative advantage in producing Shirts and Trousers?
Ans. Goods produced by each country
Country Shirts Trousers
China 1000 300
India 300 200
Each country has 6000 hours of labour and uses 3000 hours each for both the goods.
Therefore, the number of hours spent per unit on each good
Country Shirts Trousers
China 3 10
India 10 15
Since China produces both goods in less time, it has absolute advantage in both shirts and
trousers.
Comparative advantage: Comparing the opportunity costs of both goods we have
China
Opportunity cost of Shirts 3/10 = 0.3
Opportunity cost of Trousers 10/3 =3.33

India
Opportunity cost of Shirts 10/15 = 0.67
Opportunity cost of Trousers 15/10 =1.5
For producing shirts

China has lower opportunity cost for producing shirts, therefore China has comparative
advantage
For producing Trousers

India has lower opportunity cost for producing Trousers, therefore India has
comparative advantage.
4. Compiler Q.12 PYQ Nov 19, Nov 20 MTP Mar 19 Oct

21, Apr 22
What are the reason for superiority of Hecksher Ohlin theory of International Trade
over the theory of comparative advantage?
OR
What is the crux of Heckscher-Ohlin theory of International Trade
OR
Explain the key features of modem theory of international trade
Ans. The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory of
Trade or Modern Theory of Trade, emphasises the role of a country's factor
endowments in explaining the basis for its trade. ‘Factor endowment’ refers to the overall
availability of usable resources including both natural and man-made means of
production.
If two countries have different factor endowments under identical production function
and identical preferences, then the difference in factor endowment results in two
countries having different factor prices and different cost functions. In this model a
country's advantage in production arises solely from its relative factor abundance. Thus,
comparative advantage in cost of production is explained exclusively by the differences
in factor endowments of the nations.
According to this theory, international trade is but a special case of inter-regional

trade. Different regions have different factor endowments, that is, some regions have
abundance of labour, but scarcity of capital; whereas other regions have abundance of
capital, but scarcity of labour. Thus, each region is suitable for the production of those
goods for whose production it has relatively plentiful supply of the requisite factors.
The theory states that a country’s exports depend on its resources endowment i.e.
whether the country is capital-abundant or labour abundant.
A country which is capital-abundant will export capital-intensive goods. Likewise, the

country which is labor-abundant will export labour-intensive goods.
The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in-

➢ export of a commodity whose production requires intensive use of its abundant

resources and
➢ imports a commodity whose production requires intensive use of its scarce
resources.
The Factor-Price Equalization Theorem which is a corollary to the Heckscher-Ohlin

trade theory states that in the absence of foreign trade, it is quite likely that factor
prices are different in different countries. International trade equalizes the absolute
and relative returns to homogenous factors of production and their prices. This implies
that the wages and rents will converge across the countries with free trade, or in other
words, trade in goods is a perfect substitute for trade in factors. The Heckscher-Ohlin
theorem thus postulates that foreign trade eliminates the factor price differentials.
5. Compiler Q.16 PYQ July 21, May 22, MTP Nov 21,
RTP May 21
Briefly explain the New Trade Theory and its importance.
Or
What is the effect of New Trade Policy on Industries?
Ans. New Trade Theory (NTT) is an economic theory that was developed in the 1970s as a way
to understand international trade patterns. NTT helps in understanding why developed
and big countries are trade partners when they are trading similar goods and services.
These countries constitute more than 50% of world trade.
This is particularly true in key economic sectors such as electronics, IT, food, and
automotive. We have cars made in the India, yet we purchase many cars made in other
countries. These are usually products that come from large, global industries that
directly impact international economies. The mobile phones that we use are a good
example. India produces them and also imports them.
NTT argues that, because of substantial economies of scale and network effects, it
pays to export phones to sell in another country. Those countries with the advantages
will dominate the market, and the market takes the form of monopolistic competition.
Monopolistic competition tells us that the firms are producing a similar product that is
not exactly the same, but awfully close.
According to NTT, two key concepts give advantages to countries that import goods to
compete with products from the home country. These are:
➢ Economies of Scale: As a firm produces more of a product, its cost per unit keeps
going down. So if the firm serves domestic as well as foreign market instead of just
one, then it can reap the benefit of large scale of production consequently the
profits are likely to be higher.
Network effects refer to the way one person’s value for a good or service is affected
by the value of that good or service to others. The value of the product or service is
enhanced as the number of individuals using it increases. This is also referred to as the
‘bandwagon effect’. Consumers like more choices, but they also want products and

services with high utility, and the network effect increases utility obtained from these
products over others. A good example will be Mobile App such as WhatsApp and software
like Microsoft Windows.

The price index for exports of Bangladesh in the year 18-19 (based on 2010-11)
was 233.73 and the price index for imports of it was 220.50 (based on 2010-11)
i. What do these figures mean?
ii. Calculate the index of terms of trade for Bangladesh.
iii. How would you interpret the index of terms of trade for Bangladesh?
Ans. i. The figures represent foreign trade price indices which are compiled using prices
of specified group of commodities exported from and imported by Bangladesh in
the year 18-19. Both indices have a base year of 2010 -11 (=100) and the price
changes are measured in relation to that figure. In the current year, the import
price index of 220.50 indicates that there has been a 120.50 percent increase in
price since 2010-11 and export price index shows that there is 133.73 percent
increase in export prices. These indices track the changes in the price which
firms and countries receive / pay for products they export/ import and can be
used for assessing the impact of international trade on the domestic economy.
ii. Terms of trade for Bangladesh (ToT) is given by
Terms of Trade = Price of index Bangladesh export 233.73

x 100 = x 100
Price of index Bangladesh import 220.50
= 106
‘Terms of trade’ is defined as the ratio between the index of export prices and the
index of import prices. It is the relative price of a country’s exports in terms of its
imports and can be interpreted as the amount of import goods an economy can purchase
per unit of export goods. If the export prices increase more than the import prices, a
country has positive terms of trade, because for the same amount of exports, it can
purchase more imports. In the given problem, with a ToT of 106, a unit of exports by
Bangladesh will buy six percent more of imports. In other words, from the sale of home
produced goods at higher export prices and the purchase of foreign produced goods at
lower prices, trade will result in Bangladesh obtaining a greater volume of imported
products for a given volume of the exported product. This indicates increased welfare
for Bangladesh.
7. Compiler Q.21 RTP NOV 22

How do trade Policy influence international trade?
Ans. Trade policy encompasses all instruments that governments may use to restrict imports
and promote exports. Trade policy also includes the approach taken by countries in trade
negotiations.
While participating in the multilateral trading system and/or while negotiating bilateral
trade agreements, countries assume obligations that shape their national trade policies.

The instruments of trade policy that countries typically use to restrict imports and/ or
to encourage exports can be broadly classified into-
➢ price- related measures such as tariffs and
non- price measures or non-tariff measures (NTMs).
8. Compiler Q.25 MTP Mar 22, RTP May 20, PYQ May
18, PYQ July 21, MTP May 20
Explain how a tariff levied on an imported product affects both the country exporting
a product and the country importing that product.
OR
What role tariff plays as response to trade distortions?
Ans. Tariff is defined as a financial charge in the form of a tax, imposed at the border on
goods going from one customs territory to another. Tariffs are the most visible and
universally used trade measures. Tariffs are aimed at altering the relative prices of
goods and services imported, so as to contract the domestic demand and thus regulate
the volume of their imports.
Tariffs leave the world market price of the goods unaffected; while raising their prices
in the domestic market. The main goals of tariffs are to raise revenue for the
government, and more importantly to protect the domestic import-competing industries.
A tariff levied on an imported product affects both the country exporting a product and
the country importing that product.
i. Tariff barriers create obstacles to trade, decrease the volume of imports and
exports and therefore of international trade. The prospect of market access of
the exporting country is worsened when an importing country imposes a tariff.
ii. By making imported goods more expensive, tariffs discourage domestic consumers
from consuming imported foreign goods. Domestic consumers suffer a loss in
consumer surplus because they must now pay a higher price for the good and also
because compared to free trade quantity, they now consume lesser quantity of the
good.
iii. Tariffs encourage consumption and production of the domestically produced
import substitutes and thus protect domestic industries.
iv. Producers in the importing country experience an increase in well -being as a
result of imposition of tariff. The price increase of their product in the domestic
market increases producer surplus in the industry. They can also charge higher
prices than would be possible in the case of free trade because foreign competition
has reduced.
v. The price increase also induces an increase in the output of the existing firms
and possibly addition of new firms due to entry into the industry to take advantage
of the new high profits and consequently an increase in employment in the industry.
vi. Tariffs create trade distortions by disregarding comparative advantage and
prevent countries from enjoying gains from trade arising from comparative
advantage. Thus, tariffs discourage efficient production in the rest of the world
and encourage inefficient production in the home country.

Tariffs increase government revenues of the importing country by the value of the total
tariff it charges
9. Compiler Q.28 PYQ May 19, RTP May 22

What is Compound tariff and how it is different from Mixed Tariff?
Ans. Compound Tariff or a Compound Duty is a combination of an ad valorem and a specific
tariff i.e., the tariff is calculated on the basis of both the value of the imported goods
(an ad valorem duty) and a unit of measure of the imported goods (a specific duty). It
is generally calculated by adding up a specific duty to an ad valorem duty.
Mixed Tariffs: Mixed tariffs are expressed either on the basis of the value of the
imported goods (an ad valorem rate) or on the basis of a unit of measure of the imported
goods (a specific duty) depending on which generates the most income (or least income
at times) for the nation.
10. Compiler Q.32 PYQ Dec 21, MTP May 20, Sep 22,
ICAI SM
How does Escalated tariff structure work and discriminated ?
Ans. Escalated Tariff structure refers to the system wherein the nominal tariff rates on
imports of manufactured goods are higher than the nominal tariff rates on
intermediate inputs and raw materials, i.e the tariff on a product increases as that
product moves
through the value-added chain.
For example a four percent tariff on iron ore or iron ingots and twelve percent tariff
on steel pipes. This type of tariff is discriminatory as it protects manufacturing
industries in importing countries and dampens the attempts of developing manufacturing
industries of exporting countries.
This has special relevance to trade between developed countries and developing
countries. Developing countries are thus forced to continue to be suppliers of raw
materials without much value addition.
11. Compiler Q.38 PYQ May 18, MTP Mar 19, Apr 22, RTP
May 18, ICAI SM
Define ‘dumping’? What is meant by an ‘Anti-dumping’ measure?
Ans. Dumping occurs when manufacturers sell goods in a foreign country below the sales
prices in their domestic market or below their full average cost of the product.
Dumping may be persistent, seasonal, or cyclical. Dumping may also be resorted to as a
predatory pricing practice to drive out established domestic producers from the
market and to establish monopoly position.
Dumping is international price discrimination favouring buyers of exports, but in fact,

the exporters deliberately forego money in order to harm the domestic producers of
the importing country and to gain market share. This is an unfair trade practice and
constitutes a threat to domestic producers.

Anti-dumping measures consist of imposition of additional import duties to offset the

effects of dumping.
These measures are initiated as safeguards to offset the foreign firm's unfair price
advantage. This is justified only if the domestic industry is seriously injured by import
competition, and protection is in the national interest (that is, the associated costs to
consumers would be less than the benefits that would accrue to producers).
12. Compiler Q.41 PYQ Nov 20, MTP Nov 21, PYQ May 22,
ICAI SM
What is countervailing duty and how does it effect trade policy?
Ans. Countervailing duties are tariffs that aim to offset the artificially low prices charged
by exporters who enjoy export subsidies and tax concessions offered by the
governments in their home country.
If a foreign country does not have a comparative advantage in a particular good and a
government subsidy allows the foreign firm to be an exporter of the product, then the
subsidy generates a distortion from the free-trade allocation of resources.
In such cases, CVD is charged in an importing country to negate the advantage that
exporters get from subsidies to ensure fair and market oriented pricing of imported
products and thereby protecting domestic industries and firms.

You are given the following information:
Good M India Japan China
(Mobile Phones) (in $) (in $) (in $)
Average Cost 70.5 69.4 70.9
Price per unit for domestic sales 71.2 71.10 70.9
Price charged in Dubai 71.9 70.6 70.6

a) Which of the three exporters are engaged in anticompetitive act in the
international market while pricing its export of mobile phones to Dubai?
What would be the effect of such pricing on domestic producers of mobile phones?
Ans. China and Japan are engaged in anti-competitive act in the international market while
pricing its export of mobile phones to Dubai. Both China and Japan are selling at a price
which is less than price per unit for domestic sales.
The effect of such pricing will be having adverse effect on domestic industry as they will
lose competitiveness in their domestic market due to unfair practice of dumping. Dubai
may prove damage to domestic industries and charge anti-dumping duties on goods
imported from Japan and China so as to raise the price and making it at par with similar
goods produced by domestic firms.

14. Compiler Q.45 PYQ Jan 21, MTP Apr 22, RTP Nov 18
Nov 19 May 21
Explain how ‘technical barriers to trade’ (TBT) may operate as a protectionist
measure?
Or
Food Laws, Quality Standards and Industrial Standards are examples of which type
of non-tariff measures? Give Comments.
Or
Describe different technical barriers to trade (TBT) and their effects on trade?
Ans. The non-tariff measure ‘technical barriers to trade’ (TBT) which cover both food and
non-food traded products refers to mandatory standards and technical regulations
that define specific characteristics that a product should have, such as its size, shape,
design, labelling/marking/packaging, production methods, functionality or
performance.
The specific procedures used to check whether a product is really conforming to these
requirements (conformity assessment procedures e.g. testing, inspection and
certification) are also covered in TBT. This involves compulsory quality, quantity and
price control of goods before shipment from the exporting country.
TBT measures are standards-based measures that countries use to protect their
consumers and preserve natural resources, but these can also be used effectively as
obstacles to imports or to discriminate against imports and protect domestic products.
In actual practice, technical measures create trade barriers for existing and potential
exporters for the following reasons:
a) Altering products and production processes to comply with the diverse
requirements in export markets may be either impossible for the exporting country
or would obviously raise costs hurting the competitiveness of the exporting country.
b) Compliance with technical regulations needs to be established through testing,
certification or inspection by laboratories or certification bodies. These are usually
cumbersome and costly
c) The exporters also need to incur additional costs for consultation, acquisition of
expertise, training etc.
In effect technical measures, or the ways in which they are applied, discriminate against
foreign producers and turn out to be trade restrictive rather than being legitimate
implementation of social policy.
Some examples of TBT are: food laws, quality standards, industrial standards, organic
certification, eco-labelling, ingredient standards, shelf-life restrictions, marketing
and labelling requirements.

15. Compiler Q.52 MTP Oct 20, RTP Nov 19

Is prohibition of import of poultry from countries affected by avian flu, meat and
poultry processing standards to reduce pathogens, residue limits for pesticides in
foods etc. an example of Sanitary and Phytosanitary (SPS) measure? How?
Or
Which technical measures are applied to protect human, animal or plant life from
risks arising from additives, pests, contaminants, toxins or disease-causing
organisms. Explain with an example.
Ans. Yes, prohibition of import of poultry from countries affected by avian flu, meat and
poultry processing standards to reduce pathogens, residue limits for pesticides in foods
etc. are the examples of Sanitary and Phytosanitary (SPS) measures.
These measures are applied to protect human, animal or plant life from risks arising
from additives, pests, contaminants, toxins or disease-causing organisms and to
protect biodiversity.
These include ban or prohibition of import of certain goods, all measures governing
quality and hygienic requirements, production processes, and associated compliance
assessments.

Discuss the non-technical measures adopted by the countries with reference to
i. Trade related investment measures; and
ii. Price control measures
Ans. Non-technical measures relate to trade requirements, for example, shipping requirements,
custom formalities, trade rules, taxation policies, etc.
i. Trade-Related Investment Measures: These measures include rules on local content
requirements that mandate a specified fraction of a final good should be produced
domestically.
➢ requirement to use certain minimum levels of locally made components, (25
percent of components of automobiles to be sourced domestically)
➢ restricting the level of imported components, and
➢ limiting the purchase or use of imported products to an amount related to the
quantity or value of local products that it exports. (A firm may import only up to
75 % of its export earnings of the previous year)
Price Control Measures: Price control measures (including additional taxes and charges)
are steps taken to control or influence the prices of imported goods in order to support
the domestic price of certain products when the import prices of these goods are lower.
These are also known as 'para-tariff' measures and include measures, other than tariff
measures, that increase the cost of imports in a similar manner, i.e. by a fixed percentage
or by a fixed amount. Example: A minimum import price established for sulphur.

17. Compiler Q.57 PYQ July 21, MTP Oct 18, RTP May 22,
ICAI SM
What is Voluntary Export Restraints? Under which circumstances exporters commit to
voluntary export restraint? Discuss.
Ans. Voluntary Export Restraints (VERs) refer to a type of informal quota administered by an
exporting country voluntarily restraining the quantity of goods that can be exported out
of that country during a specified period of time. Such restraints originate primarily from
political considerations and are imposed based on negotiations of the importer with the
exporter.
The inducement for the exporter to agree to a VER is mostly to appease the importing
country and to avoid the effects of possible retaliatory trade restraints that may be
imposed by the importer. VERs may arise when the import - competing industries seek
protection from a surge of imports from particular exporting countries. VERs cause, as
do tariffs and quotas, domestic prices to rise and cause loss of domestic consumer surplus.
18. Compiler Q.61 PYQ Dec 21, RTP Nov 20

Describe the different types of agreements that take place during the negotiations
of trade?
Ans. Trade negotiations result in different types of agreements. These agreements are
➢ Unilateral trade agreements- under which an importing country offers trade
incentives in order to encourage the exporting country to engage in international
economic activities. E.g. Generalized System of Preferences.
➢ Bilateral agreements- agreements which set rules of trade between two

countries, two blocs or a bloc and a country. These may be limited to certain goods
and services or certain types of market entry barriers. E.g. EU-South Africa Free
Trade Agreement; ASEAN–India Free Trade Area.
➢ Regional Preferential Trade Agreements- agreements that reduce trade barriers
on a reciprocal and preferential basis for only the members of the group. E.g.
Global System of Trade Preferences among Developing Countries (GSTP).
➢ Trading bloc- A group of countries that have a free trade agreement between
themselves and may apply a common external tariff to other countries. Example:
Arab League (AL), European Free Trade Association (EFTA).
➢ Free-trade area- is a group of countries that eliminate all tariff barriers on

trade with each other and retains independence in determining their tariffs with
non-members. Example: NAFTA.
➢ Customs union -A group of countries that eliminate all tariffs on trade among
themselves but maintain a common external tariff on trade with countries outside
the union (thus technically violating MFN). E.g. EC, MERCOSUR.

➢ Common market- A common market deepens a customs union by providing for the
free flow of factors of production (labor and capital) in addition to the free flow
of outputs. The member countries attempt to harmonize some institutional
arrangements and commercial and financial laws and regulations among themselves.
There are also common barriers against non-members (E.g., EU, ASEAN).
Economic and Monetary Union- members share a common currency and macroeconomic
policies. For E.g., the European Union countries implement and adopt a single currency.
19. Compiler Q.65 PYQ May 18, Nov 19, Nov 20, July 21, Dec 21,
MTP Aug 18, May 20, RTP May 18, May 22
What are the major functions/objectives of the WTO? What do you understand by
the term ‘Most-favored-nation’ (MFN)?
Ans. The principal objective of the WTO is to facilitate the flow of international trade
smoothly, freely, fairly and predictably. To achieve this, the WTO endeavors:
i. to set and enforce rules for international trade,

ii. to provide a forum for negotiating and monitoring further trade liberalization
iii. to resolve trade disputes
iv. to increase the transparency of decision-making processes
v. to cooperate with other major international economic institutions involved in
global economic management, and
vi. to help developing countries benefit fully from the global trading system.
When a country enjoys the best trade terms given by its trading partner it is said to
enjoy the Most Favored Nation (MFN) status. Originally formulated as Article 1 of
GATT, this principle of non-discrimination states that any advantage, favour, privilege
or immunity granted by any contracting party to any product originating in or destined
for any other country shall be extended immediately and unconditionally to the like
product originating or destined for the territories of all other contracting parties .
Under the WTO agreements, countries cannot normally discriminate between their
trading partners. If a country improves the benefits that it gives to one trading
partner, (such as a lower a trade barrier, or opens up a market), it has to give the same
best treatment to all the other WTO members too in respect of the same goods or
services so that they all remain ‘most-favoured’.
As per the WTO agreements, each member treats all the other members equally as
“most-favoured” trading partners.

World Trade Organisation (WTO) has a three-tier system of decision making.“
Explain.
Ans. The World Trade Organization has a three- tier system of decision making.

The WTO’s top level decision-making body is the Ministerial Conference which can take
decisions on all matters under any of the multilateral trade agreements.
The Ministerial Conference meets at least once every two years.
The next level is the General Council which meets several times a year at the Geneva
headquarters. The General Council also meets as the Trade Policy Review Body and the
Dispute Settlement Body.
At the next level, the Goods Council, Services Council and Intellectual Property
(TRIPS) Council report to the General Council. These councils are responsible for
overseeing the implementation of the WTO agreements in their respective areas of
specialisation.
The three also have subsidiary bodies. Numerous specialized committees, working groups
and working parties deal with the individual agreements.
21. Compiler Q.72 MTP Aug 18, MTP Oct 18

What is meant by ‘safeguard measures’ under WTO?
Ans. A safeguard measures is an action taken to protect a specific domestic industry from an
unexpected build-up of imports. Safeguard measures are initiated by countries to
restrict imports of a product temporarily if its domestic industry is injured or
threatened with serious injury caused by a surge in imports.

Differentiate Trade- Related Investment Measures (TRIMS) and Trade-Related
Aspects of Intellectual Property Rights (TRIPS).
Ans. Trade-Related Investment Measures (TRIMs) is an agreement on trade related
investment measures which specifies the rule that are applicable to domestic regulation
a country applies to foreign investors.
The agreement is applicable to all the members of WTO. It expands disciplines

governing investment measures in relation to cross-border investments by stipulating
that countries receiving foreign investments shall not impose investment measures
such as requirements, conditions and restrictions inconsistent with the provisions of the
principle of national treatment and general elimination of quantitative restrictions.
On the other hand, Trade Related Aspects of Intellectual Property Rights (TRIPS) is an
international agreement among various members of WTO on intellectual property rights.
It is one of the most comprehensive multilateral agreements on intellectual rights.
It stipulates most -favoured-nation treatment and national treatment for intellectual

properties, such as copyright, trademarks, geographical indications, industrial designs,
patents, IC layout designs and undisclosed information.

23. Compiler Q.85 PYQ Dec 21, MTP Oct 18, RTP May 21,
ICAI SM
Mention the types of transactions in the forex market? Also distinguish between
forward premium and forward discount.
Ans. In the foreign exchange market, there are two types of transactions:
i. current transactions which are carried out in the spot market and the exchange
involves immediate delivery, and
ii. future transactions wherein contracts are agreed upon to buy or sell currencies
for future delivery which are carried out in forward and/or futures markets.
Forward Premium Vs. Forward Discount

A forward premium is said to occur when the forward exchange rate is more than a
spot exchange rates.
On the contrary, if the forward trade is quoted at a lower rate than the spot rate,
then there is a forward discount.
24. Compiler Q.88 PYQ July 21, MTP Oct 19, Oct 22
What are the main advantages of fixed rate regime in an open economy?
Ans. In an open economy, the main advantages of a fixed rate regime are, firstly, a fixed
exchange rate avoids currency fluctuations and eliminates exchange rate risks and
transaction costs that can impede international flow of trade and investments. A fixed
exchange rate can thus greatly enhance international trade and investment.
Secondly, a fixed exchange rate system imposes discipline on a country’s monetary

authority and therefore is more likely to generate lower levels of inflation.
Thirdly, the government can encourage greater trade and investment as stability
encourages investment.
Fourthly, exchange rate peg can also enhance the credibility of the country’s monetary
policy.
And lastly, in the fixed or managed floating (where the market forces are allowed to
determine the exchange rate within a band) exchange rate regimes, the central bank is
required to stand ready to intervene in the foreign exchange market and, also to
maintain an adequate amount of foreign exchange reserves for this purpose.
25. Compiler Q.90 PYQ Dec 21, RTP May 19

How is exchange rate determined under floating exchange rate regime?
OR
How is the nominal exchange rate determined? Explain.
Ans. Under floating exchange rate regime the equilibrium value of the exchange rate of a
country’s currency is market determined i.e. the demand for and supply of currency relative
to other currencies determines the exchange rate.

Determination of Nominal Exchange Rate: Usually, the supply of and demand for foreign
exchange in the domestic foreign exchange market determines the external value of the
domestic currency, or in other words, a country’s exchange rate.
Individuals, institutions and governments participate in the foreign exchange market for a
number of reasons.
On the demand side, people desire foreign exchange to:
• Purchase goods and services from another country
• for unilateral transfers such as gifts, awards, grants, donations or endowments
• to make investment income payments abroad
• to purchase financial assets, stock or bonds abroad
• to open a foreign bank account
• to acquire direct ownership of real capital and for speculative and hedging
activities related to risk taking or risk avoidance.
The participants on the supply side operate for similar reasons. Thus, the supply of foreign
currency to the home country results from:
• purchases of home exports;
• unilateral transfers to home country;
• investment income payments;
• foreign direct investments and portfolio investments;
• placement of bank deposits and speculation.
Similar to any standard market, the exchange market also faces a downward sloping
demand curve and an upward-sloping supply curve.
Determination of Nominal Exchange
The equilibrium rate of exchange is determined by
the interaction of the supply and demand for a
particular foreign currency.

Explain the concept of soft peg and hard peg exchange rate policies.
Ans. A currency peg is a policy in which a national government sets a specific fixed exchange
rate for its currency with a foreign currency or basket of currencies. Pegging a currency
stabilizes the exchange rate between countries.
A soft peg refers to an exchange rate policy under which the exchange rate is generally
determined by the market, but in case the exchange rate tends to move speedily in one
direction, the central bank will intervene in the market.
With a hard peg exchange rate policy, the central bank sets a fixed and unchanging
value for the exchange rate. Both soft peg and hard peg policy require that the central
bank intervenes in the foreign exchange market.


The Nominal Exchange rate of India is Rs. 56/1 $, Price Index in India is 116 and
Price Index in USA is 112. What will be the Real Exchange Rate of India?
Ans. The ‘real exchange rate' describes ‘how many’ of a good or service in one country can be
traded for ‘one’ of that good or service in a foreign country. Thus it incorporates
changes in prices
Domestic price index

Real Exchange rate = Nominal exchange rate ×
Foreign price index
= 56 x 116
= 58
112
28. Compiler Q.102 RTP NOV 22

How does appreciation and depreciation of currency affect real economy?
Ans. Currency appreciation –
➢ raises the price of exports, thus decrease exports;
➢ increase imports,
➢ adversely affect the competitiveness of domestic industry,
➢ cause larger deficits, and
➢ worsens the trade balance.
A depreciation of domestic currency primarily-

➢ increases price of foreign goods relative to goods produced in the home country and
diverts spending from foreign goods to domestic goods.
➢ production for exports and of import substitutes become more profitable.
➢ factors of production will be induced to move into the tradable goods sectors and
out of the non- tradable goods sectors.
The reverse will be true when the currency appreciates. These types of resource
movements involve economic wastes.

Compare and contrast between devaluation and depreciation in the context of
exchange rate.
Ans. ➢ Devaluation is a monetary policy tool used by countries that have a fixed exchange
rate or nearly fixed exchange rate regime and involves a discrete official reduction
in the otherwise fixed par value of a currency. The monetary authority formally sets
a new fixed rate with respect to a foreign reference currency or currency basket.
Depreciation lowers the relative price of a country’s exports, raises the relative
price of its imports, increases demand both for domestic import- competing goods
and for exports, leads to output expansion, encourages economic activity, increases
the international competitiveness of domestic industries, increases the volume of
exports, and improves trade balance.

➢ Devaluation is a deliberate downward adjustment in the value of a country's currency

relative to another country’s currency or group of currencies or standard,
In contrast depreciation is a decrease in a currency's value (relative to other major
currency benchmarks) due to market forces of demand and supply under a floating
exchange rate and not due to any government or central bank policy actions.
30. Compiler Q.108 PYQ Jan 21, PYQ Nov 20

Following exchange rate quotations are available for different periods:
1. The spot exchange rate changes from Rs. 65 per $ to Rs. 68 per $.
2. The spot exchange rate changes from $ 0.0125 per rupee to $ 0.01625 per rupee.
Answer the following:
A. Identify the nature of rate quotations in (1) and (2) above.
B. Identify the base currency and counter currency in (1) and (2) above.
What are possible consequences on exports and imports of (1) and (2) above.
Ans. A. The nature of rate quotations in (1) and (2)
In an exchange rate, two currencies are involved. There are two ways to express
nominal exchange rate between two currencies (here US $ and Indian Rupee) namely
direct quote and indirect quote.
The nature of rate quotation in [(1) Rs. 65/per $] is direct quote, (also called
European Currency Quotation).
The exchange rate is quoted in terms of the number of units of a local currency
exchangeable for one unit of a foreign currency. For example, 65/US$ means that
an amount of 65 is needed to buy one US dollar or 65 will be received while selling one
US dollar.
An indirect quote is presented in [(2) $ 0.0125 per Rupee] of the question. In an
indirect quote, (also known as American Currency Quotation), the exchange rate is
quoted in terms of the number of units of a foreign currency exchangeable for one
unit of local currency; for example: $ 0.0125 per rupee. In an indirect quote, domestic
currency is the commodity which is being bought and sold.
B. The base currency and counter currency in (1) and (2) An exchange rate has two
currency components; a ‘base currency’ and a ‘counter currency’. The currency in the
numerator always states ‘how much of that currency is required for one unit of the
base currency’.
➢ In a direct quotation [in (1) Rs. 65/per $], the foreign currency is the base
currency and the domestic currency is the counter currency. So in the given
question, US dollar is the base currency and Indian Rupee is the counter currency.
➢ In an indirect quotation, [in (2) $ 0.0125 per Rupee], the domestic currency is the
base currency and the foreign currency is the counter currency. So in the given
question, Indian Rupee is the base currency and US dollar is the counter currency.
C. The possible consequences on exports and imports of (1) and (2)

When the spot exchange rate changes from Rs. 65/per $ to Rs. 68/ per $, it
indicates that a person has to exchange a greater amount of Indian Rupees (68)
to get the same 1 unit of US dollar. The rupee has become less valuable with respect

to the U.S. dollar or Indian Rupee has depreciated in its value. Simultaneously, the
dollar has appreciated.
Consequence on exports and imports of (1)

Other things remaining the same, when a country’s currency depreciates, foreigners find
that its exports are cheaper and the quantity demanded of its export goods will increase.
For Eg- a foreigner who spends 10 dollars on buying Indian goods will, get goods worth Rs.
680 /- instead of Rs. 650/- prior to depreciation.
On other hand, domestic residents find that imports from abroad are more expensive.
A resident of India, who wants to import goods worth $1 will have to pay Rs. 68/- instead
of Rs. 65/- prior to depreciation. Imports will be discouraged as importers will have to
pay more rupees per dollar for importing products. In short, depreciation of domestic
currency lowers the relative price of a country’s exports and raises the relative price
of its imports.
Consequence on exports and imports of (2)

In this case, Rupee has appreciated and dollar has depreciated. Earlier, $ 1.25 would
fetch export goods worth Rs. 100/- from India; but after change $16.25 would be
necessary to buy same amount of goods.
Other things remaining the same, when a country’s currency appreciates, it raises
relative price of its exports and lowers relative price of its imports. In other words,
foreigners find their imports from that country (exports from India in above case)
costlier. Thus qty demanded of export goods would decrease.
On the other hand, the domestic residents find that imports from abroad are cheaper.
Therefore, we may expect an increase in the quantity of imports.
31. Compiler Q.110 MTP Aug 18, MTP Mar 19, RTP May 21,
RTP Nov 21, Nov 22, ICAI SM
What is Arbitrage? What is the outcome of Arbitrage?
Or
How does arbitrage prevents the risk arising out of the fluctuations in the exchange
rate?
Ans. Arbitrage refers to the practice of making risk-less profits by intelligently exploiting
price differences of an asset at different dealing places. On account of arbitrage,
regardless of physical location, at any given moment, all markets tend to have the same
exchange rate for a given currency.
When price differences occur in different markets, participants purchase foreign

exchange in a low-priced market for resale in a high-priced market and makes profit
in this process.
Due to the operation of price mechanism, the price is driven up in the low-priced market
and pushed down in the high-priced market.

This activity will continue until the prices in the two markets are equalized, or until they
differ only by the amount of transaction costs involved in the operation. Since forex
markets are efficient, any profit spread on a given currency is quickly arbitraged away.
32. Compiler Q.114 PYQ May 19, RTP Nov 18

Enumerate the bases of distinction between FDI and FPI
Ans. Foreign direct investment takes place when the resident of one country (i.e. home
country) acquires ownership of an asset in another country (i.e. the host country) and
such movement of capital involves ownership, control as well as management of the asset
in the host country.
Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather
than ‘real capital’ and does not involve ownership or control on the part of the investor.
Foreign direct investment (FDI) Foreign portfolio investment (FPI)
Investment involves creation of physical Investment is only in financial assets

assets
Has a long term interest and therefore Only short term interest and generally
remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology Not accompanied by technology transfer

transfer
Direct impact on employment of labour No direct impact on employment of

and wages labour and wages
Enduring interest in management and No abiding interest in management and

control control
Securities are held with significant Securities are held purely as a financial
degree of influence by the investor on investment and no significant degree of
the management of the enterprise influence on the management of the
enterprise
33. Compiler Q.119 PYQ Nov 18, MTP Oct 18, Oct 21, Apr 22,
ICAI SM
What are the different routes for securing FDI?
OR
What are the different modes of foreign Direct Investment?
Ans. FDI is an important monetary source for India's economic development. The import -
substitution strategy of industrialisation followed by India post-independence era,
stressed on an extremely careful and selective approach while formulating FDI policy. The

government’s strategy favouring foreign investments and the prevalent robust business
environment have ensured that foreign capital keeps flowing into the country.
Modes of FDI is as follows:

i. Opening of a subsidiary or associate company in a foreign country,
ii. Equity injection into an overseas company,
iii. Acquiring a controlling interest in an existing foreign company,
iv. Mergers and acquisitions(M&A)
v. Joint venture with a foreign company.
vi. Green field investment (establishment of a new overseas affiliate for freshly
starting production by a parent company).
Brownfield investments (a form of FDI which makes use of the existing infrastruc ture
by merging, acquiring, or leasing, instead of developing a completely new one. For e.g., in
India 100% FDI under automatic route is allowed in Brownfield Airport projects.
34. Compiler Q.121 PYQ July 21, RTP Nov 20, MTP Oct 22,
ICAI SM
Into how many parts are FDIs categorized according to the nature of foreign
investment? Describe them.
Or
Distinguish between horizontal, vertical and conglomerate type of foreign investments.
Ans. Based on the nature of foreign investments, FDI may be categorized into three parts as
horizontal, vertical or conglomerate.
i. A horizontal direct investment is said to take place when the investor establishes
the same type of business operation in a foreign country as it operates in its
home country, for example, a cell phone service provider based in the United
States moving to India to provide the same service.
ii. A vertical investment is one under which the investor establishes or acquires a
business activity in a foreign country which is different from the investor’s main
business activity yet in some way supplements its major activity. For example;
an automobile manufacturing company may acquire an interest in a foreign company
that supplies parts or raw materials required for the company.
A conglomerate type of foreign direct investment is one where an investor makes a
foreign investment in a business that is unrelated to its existing business in its home
country. This is often in the form of a joint venture with a foreign firm already operating
in the industry as the investor has no previous experience.
35. Compiler Q.125 PYQ Jan 21, MTP Mar 19, RTP May 18
Define foreign direct investment (FDI). Mention two arguments made in favour of
FDI to developing economies like India?
Ans. Foreign direct investment is defined as a process whereby the resident of one country
(i.e. home country) acquires ownership of an asset in another country (i.e. the host country)
and such movement of capital involves ownership, control as well as management of the
asset in the host country.

Direct investments are real investments in factories, assets, land, inventories etc. and
have three components, viz., equity capital, reinvested earnings and other direct capital
in the form of intra-company loans. Foreign direct investment also includes all subsequent
investment transactions between the investor and the enterprise and among affiliated
enterprises, both incorporated and unincorporated.
FDI involves long term relationship and reflects a lasting interest and control. According
to the IMF and OECD definitions, the acquisition of at least ten percent of the ordinary
shares or voting power in a public or private enterprise by non-resident investors makes
it eligible to be categorized as FDI.
FDI may be categorized as horizontal, vertical, conglomerate and two way direct foreign
investments which are reciprocal investments.
Following are the benefits ascribed to foreign investments:

i. Entry of foreign enterprises usually fosters competition and generates a competitive
environment in the host country. The domestic enterprises are compelled to compete
with the foreign enterprises operating in the domestic market. This results in positive
outcomes in the form of cost-reducing and quality-improving innovations, higher
efficiency and increasing variety of better products and services at lower prices
ensuring wider choice and welfare for consumers.
International capital allows countries to finance more investment than can be supported
by domestic savings resulting in higher productivity and enhanced output. From the
perspective of emerging and developing countries, FDI can accelerate growth and foster
economic development by providing the much needed capital, technological know-how,
management skills and marketing methods and critical human capital skills in the form of
managers and technicians. The spill -over effects as the new technologies usually spread
beyond the foreign corporations. In addition, the new technology can clearly enhance the
recipient country's production possibilities.
36. Compiler Q.126 MTP Apr 19, RTP May 19

How do foreign direct investments affect human capital in recipient countries?
or
Mention the effects of FDI on host country labour.
Ans. Since FDI involves setting up of production base (in terms of factories, power plants,
etc.) it generates direct employment in the recipient country. Subsequent FDI as well as
domestic investments propelled in the downstream and upstream projects that come up
in multitude of other services generate multiplier effects on employment and income.
FDI not only creates direct employment opportunities but also, through backward and
forward linkages, it is able to generate indirect employment opportunities as well. It is
also argued that more indirect employment will be generated to persons in the lower-
end services sector occupations thereby catering to an extent even to the less educated
and unskilled engaged in those units.

This impact is particularly important if the recipient country is a developing country with
an excess supply of labour caused by population pressure. Foreign direct investments
also promote relatively higher wages for skilled jobs.
However, jobs that require expertise and entrepreneurial skills for creative decision
making may generally be retained in the home country and therefore the host country is
left with routine management jobs that demand only lower levels of skills and ability. This
may result in ‘crowding in’ of people in jobs requiring low skills, perpetuation of low labour
standards and differential treatment.
FDIs are likely use labor-saving technology and capital-intensive methods in a labour
abundant country and cause labour displacement. Such technology is inappropriate for a
labour-abundant country as it does not support generation of jobs which is a crucial
requirement to address poverty and unemployment which are the two fundamental areas
of concern for the less developed countries.
Not only that foreign entities fail to support employment generation, but they may also
drive out domestic firms from the industry resulting in serious problems of displacement
of labour.
37. Compiler Q.133 PYQ May 18

Describe deterrents to Foreign Direct Investment (FDI) in the country.
Ans. i. Poor macro-economic environment, such as, infrastructure lags, high rates of
inflation and continuing instability, balance of payment deficits, exchange rate
volatility, unfavourable tax regime (including double taxation), small size of market
and lack of potential for its growth and poor track-record of investments.
ii. Unfavourable resource and labour market conditions such as poor natural and human
resources, rigidity in the labour market, low literacy, low labour skills, language
barriers and high rates of industrial disputes
iii. Unfavourable legal and regulatory framework such as absence of well-defined
property rights, lack of security to life and property, stringent regulations,
cumbersome legal formalities and delays, bureaucracy and corruption and political
instability.
Lack of host country trade openness viz. lack of openness, prevalence of nontariff
barriers, lack of a general spirit of friendliness towards foreign investors, lack of
facilities for immigration and employment of foreign technical and administrative
personnel.

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INDEX

EFF Important Questions

Chp No. of Approx.

2) For more practice and full coverage of questions from ICAI

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CHAPTER 1 - DETERMINATION OF NATIONAL INCOME

1. Compiler Q.3 MTP Mar 19, Apr 19

2. Compiler Q.6 PYQ Nov 18

GNPMP = GDPMP + Net Factor Income from Abroad

Net factor income from abroad is the difference between

3. Compiler Q.8 MTP Mar 22

CA Mohnish Vora mvsir.in 1

For instance, profits earned in India by X Company, a foreign-owned firm, would be

4. Compiler Q.13 RTP May 22

➢ Quality improvements in systems and processes due to technological as well as

➢ Productions hidden from government authorities, either because those engaged in it

➢ Non-market production (with a few exceptions) and non-economic contributors to

5. Compiler Q.15 RTP Nov 22

2 mvsir.in CA Mohnish Vora

e) Inadequacy of data and lack of reliability of available data,

6. Compiler Q.17 RTP May 20 & MTP May 20

7. Compiler Q.19 PYQ July 21, MTP Sep 22

CA Mohnish Vora mvsir.in 3

Thus, gross investment includes:

With growing facility in use of commodity flow method of estimating expenditures, an

9. Compiler Q.27 MTP Oct 21

10. Compiler Q.34 PYQ Dec 21

4 mvsir.in CA Mohnish Vora

Note: Year 2 refers to 2019-20 and year 1 refer to 2018-19.

11. Compiler Q.36 RTP May 18

Government Expenditure (inclusive of transfer payments) 70

Net Property Income from abroad 10

CA Mohnish Vora mvsir.in 5

12. Compiler Q.38 PYQ July 21

Domestic Sales 3600

Opening Stock 800

Closing Stock 200

Net indirect tax 400

Intermediate consumption 600

Net factor income from abroad 10

Calculate the followings:

Domestic Sales 3600

+ Change in stock (600)

Gross Value of Output (GVOMP) 4000

- Intermediate Consumption (600)

Gross Value Added (GVAMP) 3400

Net Value Added (NVAMP) 3100

- Net Indirect Taxes (400)

Net Domestic Product (NDPFC) 2700

6 mvsir.in CA Mohnish Vora

+ Net Factor Income from Abroad (NFIA) 10

Net National Product (NNPFC) 2710

13. Compiler Q.42 RTP May 19

Sales by firm B to general government 300

Sales by firm A 1500

Sales by firm B to households 1350

Change in stock of firm A 200