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Disclaimer
The answers given below reflect just my understanding and what I may have written. They may not
be accurate so please exercise discretion. Your comments on the accuracy of these answers
welcome. :-)
Instructions
There are 8 questions divided into 2 sections. Question no. 1 and 5 are compulsory and out of the
remaining 3 are to be attempted with at least 1 from each section.
SECTION - A
Q 1. Answer the following in about 150 words each:- (10 x 5 = 50 marks)
Q 1.a Consider a perfectly competitive exchange economy with no production, and two
different goods 1 and 2. Let p1 and p2 be prices of the goods. The economy is populated by 2
people A and B. A's initial endowment of the two goods is given by (wa1, wa2) and B's initial
endowment is (wb1, wb2). A can choose any bundle (xa1, xa2) and B can choose any bundle
(xb1, xb2). In this pure exchange economy write out the conditions for a Walrasian equilibrium.
Show that for such an economy for any equilibrium set of prices that the absolute price level
is indeterminate.
Ans.

Initial equilibrium
Let us draw the edgeworth diagram.
Let initially A and B be at e0. Here A's endowment is (wa1, W a2) and B's endowment be (wb1, wb2).
They are at indifference curves ICa and ICb respectively.
Condition for Walrasian equilibrium
For Walrasian equilibrium, A and B will have to reach a pareto optimum point via exchange. The
pareto optimum point will lie on the contract curve. The conditions needed for such an equilibrium
are: (MRS1,2)a = (MRS1,2)b = P1/P2.
Absolute price indeterminacy
As we can see in the diagram, depending upon their relative bargaining strengths, A and B can
reach any point between e1 and e2. Let this be e3. But at e3 also, the Walrasian equilibrium condition
will only tells us the relative prices i.e. P1/P2 and not the absolute price level because we will only
know the slop of the price line. So absolute price level will be indeterminate. (Unfortunately in the
exam, I merely showed that multiple points are possible between e1 and e2. So will lose marks on
the absolute price section here.)

Q 1.b Kaldor in his theory of distribution argues, unlike Kalecki, that it is not reasonable to
neglect the constraint of labor shortage, and analyse a situation of full employment. Show
how investment and savings propensities determine distributive shares in the Kaldor
approach. Suppose that investment is not exogenous as in Kaldor's original model but that it
varies with profits. What does this mean for the stability of Kaldor model of distribution?
Ans.
Assumptions of Kaldor
1. Marginal propensities to save out of wages and profits remain constant. So average
propensities to save = savings rate = marginal propensities to save = sw for wages and sp for
profits.
2. sp > sw.
3. Investment (I) is exogenously given.
4. Full employment assumption.
Model
We know that in full employment, planned savings = planned investment.
Planned savings = savings from wages + savings from profits = sw*W + sp*P. This is equal to
planned investment. So I = sw*W + sp*P.
Now in economy, let Y be total income. Income = wages + profits. So Y = W + P or W = Y - P.
Substituting W in 1st equation, I = Sw*(Y-P) + sp*P. A bit of algebra and we will get, P/Y = (1/sp-sw) *
I/Y - (sw/sp-sw).
Investment not exogenous
If investment varies positively with profit, then we see that as investment rises, profits rise which
fuels investment further which raises demand further and hence inflation. So economy is not stable.
Similarly in such a case, demand depression too would spiral down. (I am not sure about this
reasoning though and may lose marks in the exam if wrong.)
Q 1.c Explain the determination of output and employment in a macroeconomy under the
conditions when individuals are subject to (i) no money illusion, (ii) money illusion).
Ans.

Case 1: No money illusion

Let initial equilibrium be at E. Let the prices fall. This leads to a situation where real wages rise from
w0/p0 to w1/p1. Demand for labor is less than supply of labor, so unemployment appears. But workers
are under no money illusion, they realise their real wages have gone up. They are open to nominal
wage cuts and unemployment pressure will now act to cut the nominal wages. Soon full employment
returns where real wages are same as before (w1/p2 = w0/p0). So output too remains at full
employment.
Case 2: Money illusion

Here give the above reasoning, but only say that workers are under money illusion, so resistant to
nominal wage cuts. So involuntary unemployment prevails.
Note: The above reasoning is when prices fall. Similar reasoning can be given when prices rise and
it would be equally correct. When prices rise, in money illusion, firms will produce and employ more
thinking their profits have gone up and workers will not reduce their labor thinking their wages have
not gone down.
Q 1.d An individual finds that all his receipts (including income) and payment transactions
are in the form of money that bears no interest. However, he can convert money into bonds
and earn interest income but that involves a fixed cost of each conversion transaction. What
are the determinants of the individual's demand for holding money?
Ans.
This is the Baumol Inventory Model for transaction demand of money.

Let the income be Y. Let he withdraws cash C at a time. Let the transaction cost per transaction be
fixed b. Let interest rate be r.

The individual will now look to minimise his overall costs which is transactions cost + opportunity
cost of lost interest.
transaction cost = (Y/C) * b because Y/C gives us the number of times he converts into bonds.
opportunity cost of lost interest = (C/2) * r where C/2 gives us his average cash holding for the period
and r is the interest rate on bonds.
So we have to minimise Total Cost = (Y/C) * b + (C/2) * r. Differentiating wrt C and equating to zero,
we get C = square root of (2Yb/r).
So the individual's demand for holding money will increase with the square root of his income,
transaction cost. And will decrease with the square root of the interest on bonds.
Q 1.e Suppose an industry is characterised by the following 3 conditions: (i) there area a
large number of small firms, each producing a differentiated product and facing a downward
sloping demand curve; (ii) each firm ignores the effects of its actions on the decisions taken
by other firms; and (iii) new firms producing close substitutes for the product of the existing
firms can enter the industry. Then derive the equilibrium conditions of an individual firm and
of the industry.
Ans.
This is the Chamberlin's Monopolistic Competition Model.
Additional Assumptions
1. Firms show myopic behavior i.e. don't learn from past mistakes.
Model / Equilibrium conditions
Due to the presence of large number of firms, it is expected that the decisions of a firm on changing
its strategy will have negligible effect on each of the other firms so as not to induce any reaction from
them. Thus a firm can plan its strategy drawing a demand curve independent of the reactions of
other firms. This can give us the firm's planned demand curve (dd curve). But while a firm plans its
actions on dd curve assuming other firms won't react to its decisions, in reality other firms may also
change their strategies (either the same factors which induce this firm to change also induced others
to change in order to maximize their own or some other factors). The market share demand curve

(DD) gives the actual demand curve of the firm after incorporating the effects of the changes made
by the other firms.

1. A movement along the DD curve indicates a price competition among the incumbent firms
whereas a shift in DD curve indicates free entry / exit. Initially let the firm is @ e1.
2. But it is earning supernormal profits. So new entrants will come and DD curve will shift to left
(from DD1 to DD2) and the new equilibrium will be @ e2. At this point the DD curve is a tangent
to the LAC curve. So all supernormal profits vanish and we would expect this to be the
equilibrium. But it is not.
3. The dd curve of the firm is not a tangent to the LAC curve but lies above it. So the firm would
think if it reduces the price further, it would move on the dd2 curve and earn supernormal
profits. So it reduces the prices. But all firms think the same and all of them reduce the prices.
So instead of moving on dd2 curve the movement is on DD2 curve. The firm moves to e2' but at
this point there is a loss. So firms would begin to exit and the DD curve will shift from DD 2 to
DD3 such that the new dd3 curve is a tangent to the LAC curve. This is the point of equilibrium.
Q 2.a Under the Bertrand price competition with homogenous products in an oligopoly
demonstrate how is the equilibrium price that will prevail is arrived at? (25 marks)
Ans.

Assumptions
1. 2 maximizing firms only and they face same demand and cost curves. Product is absolutely
homogenous. Entry is restricted. MC = AC = constant.
2. Both firms have large number of small buyers.
3. There is no capacity constraint and any firm can meet the entire market demand at any price
level.
4. No state interference and no externalities.
5. At the beginning of each period, each firm will assume that the other firm will keep its price
same as that in last period.
Model
1. Let initially firms divide the market among themselves. They will assume monopoly power
within their market and act like a monopolist.
2. But in the next round, the rival firm will realise that if it prices its product just below the other
firm, it can capture the entire market share. It does that and captures whole market. In the next
round, the other firm will do the same.
3. It is clear there will be a price war (since by undercutting the price of the rival under the
assumption that it will not change its price) any firm can capture the whole market. The price
war will continue until the price becomes equal to the unit cost of production below which no
firm will have the incentive to cut.
4. If at such a situation a firm raises the price to the monopoly price level again, it will face the risk
of losing its entire market share and selling zero. This is because the firms are assumed to
have infinite capacity and the product is supposed to be homogenous. So it will not raise its
prices and the Bertrand equilibrium is when no firm earns a supernormal profit where price =
average cost and there is no incentive to either cut the price or raise it.
Q 2.b Let the market demand curve for carbonated water be given by P = 20 - 9Q/2 where P is
the price and Q is the market output. Let there be 2 firms producing carbonated water, each
with a constant marginal cost of INR 2 or c1 = c2 = 2.

What is the market equilibrium price and quantity when each firm behaves as a Cournot
duopolist? What are the firms' profits?
What is the marekt equilibrium price and quantity when each firm behaves as a Bertrand
duopolist? What are the firms' profits? (25 marks)
Ans.
Cournot equilibrium

1. Production on reaction curve: A firm will always produce on its reaction curve. This is because
it wants to make the highest possible profit for any given production by the rival. We know that
isoprofit lines closest to the axis gives the highest profit. So for any given production by B, A
would like to chose an isoprofit line which just touches B i.e. for which B is the highest point.
This is nothing but A's reaction curve so A will always produce on its reaction curve. Similar
argument can be run for B.
2. Thus any equilibrium can be reached only where both reaction curves intersect i.e. point e. But
@ e the industry profits are not maximized and pareto improvement is possible. Point p which
is the point of tangency can be one pareto optimal point.
Total revenue of Firm A = P * Q1 = (20 - 4.5Q1 - 4.5Q2) * Q1. Marginal revenue MR = 20 - 9Q1 - 4.5
Q2 (by simple differentiation of total revenue wrt Q1). A reaction curve maximises profit, so on the
reaction curve MC = MR. In our case, 20 - 9Q1 - 4.5 Q2 = 2 or 2Q1 + Q2 = 4.
Since both firms have identical costs, reaction curve of firm B will be, 2Q2 + Q1 = 4. Solving these 2
together, we get, Q1 = Q2 = 1.33333. P = 8. Profit of each firm = (8-2) * 1.3333 = 6 * 1.3333 = Rs. 8

Bertrand equilibrium
In Bertrand, Price = unit cost. In our case, unit cost = Rs. 2. So price = 2. This gives Q = 4. Since
both firms are identical, Q1 = Q2 = Q/2 = 4/2 = 2. Profit of each firm = (2-2) * 2 = 0.
Q 3.a If workers supply labor on the basis of an expected real wage, how is the aggregate
supply of output determined in the economy? Suppose aggregate demand and supply are
below the natural rate of unemployment and output. Would the New Classical economists
advocate any particular policy intervention when the economy is in such a situation? (25
marks)
Ans.
Note: I didn't attempt this question.
Determination of AS and output

First part is the standard New Classical Model. Here one has to define Rational Expectations
hypothesis and first i.e. workers would make 'best' use of all available information and won't make
any systematic mistakes while forming their expectations. They behave as predicted by the relevant
economic model. Then one has to give the Continuous Market Clearing hypothesis that markets
clear quickly so that full employment is maintained. So if suppose the government tries to lift demand
by monetary expansion, AD curve will shift from AD0 to AD1. But economy is already at full
employment, so output can't increase and monetary expansion will only cause more inflation. So
workers won't get fooled and will not offer additional labor. Economy will move from a to b and SAS
is vertical as well.

Policy intervention
Here draw a nice Philips curve and also the above diagram, but showing the equilibrium point to the
left of full employment. Then say New Classical will suggest no intervention because they believe in
policy inefficacy. Wages will quickly fall and full employment restored in such a situation on its own.
Q 3.b What are the main goals of a central bank? What are the instruments by which the
central bank manages the liquidity in the financial system and how does it use these
instruments to achieve its goals? (25 marks)
Ans.
Note: I didn't attempt this question.
Main goals (In India)
1. Price stability.
2. Maintaining reasonable rate of growth.
3. Maintaining external balance.
4. Promoting financial inclusion.
5. Financial stability of the economy.
Instruments to manage liquidity
1. LAF - Repo rate, reverse repo, MSF.
2. Open market operations.
3. Bank rate (although no more used).
4. CRR.
5. SLR.
6. Direct credit controls.
7. Prescription of CAR for banks and NBFCs.
Just put 1 line each on how they are used to amnage liquidity.
Q 4.a Macroeconomics is usually approached via the outcomes of economic interaction in
the following 4 markets - commodities, money, bonds, and labor markets. The Classical
economists focused on which 3 of these 4 markets? In which market does the loanable fund
theory of interest rate determination of the Classical economists focus and how is the
interest rate determined? The Neo Classical synthesis focuses on which 3 markets? In which
market is the interest rate primarily determined in the liquidity preference theory? (25 marks)

Ans.
Note: I didn't attempt this question as not sure about some parts.
Classical economists
Focused on commodities, money and labor markets.

Explain the above diagram briefly how labor market determines output (Y = f(L) in short run).

They also followed Classical dichotomy i.e. money is neutral and just determines the price level.
Give Fisher's QTM equation, MV = PY.
Loanable Funds
Focused on the commodities market. It basically said as people decide to save more, interest rates
will fall and investment would increase. Like Say's law. Draw the diagram here.
Neo-classical synthesis
I thought it focuses on all 4. But anyways, if one has to choose only 3, IS curve focuses on goods
market. LM curve focuses on money market. Labor market determines the equilibrium in IS as well.
Draw neat diagrams.
Liquidity preference
I thought it focuses on bond and money markets. But if one has to choose only 1, it has to be bonds.
Talk about Keynes' speculative demand of money here mainly.
Q 4.b After 2003 till 2008 many emerging economies including India received huge capital
inflows. To contain the effect of these flows, the central bank sterilized the inflows. What is
sterilization and how does it affect the supply of money in the economy? (25 marks)
Ans.
When foreign funds flow in, people sell $ and buy INR. This will put appreciation pressures on INR
which may be bad for our exports. So the central bank may decide to intervene to stabilize INR and

sell INR and buy $ in the fx market. But this will increase INR money supply domestically. This
increase money supply may stroke inflationary pressures. So to contain these pressures, RBI may
conduct sterilization operations where RBI will issue short term bonds to mop up excess INR
liquidity. It may also buy INR in spot market and sell in forwards. This is sterilization.
It will reduce the money supply in the economy and push short term interest rates higher.
Now just draw a couple of neat diagrams: One showing IS-LM-BP curve with equilibrium point if ISLM above BP curve indicating external surplus. Show a dotted LM line to right indicating increased
liquidity due to RBI interventions. Then in next figure show the dotted line shifting back up indicating
sterilization.
SECTION - B
Q 5 Answer the following in about 150 words each:- (10 x 5 = 50 marks)
Q 5.a What are the 3 basic goals of public finance? Can these goals be coordinated into an
overall pattern of policy or they are always in conflict? (10 marks)
Ans.
Basic goals
1. Equity: People with higher ability to pay should pay more (vertical equity) and those with equal
ability to pay should pay equal (horizontal equity). Expenditure should also promote equity.
2. Development: Tax revenues should be sufficient to finance the development expenditure of the
government.
3. Efficiency: Public finance should increase the efficiency of the economy, make it more
competitive, encourage people to work more.
Conflicts
1. However, these objectives may be conflicting. Eg. a highly progressive may increase equity
and satisfy development objective, but hampers economic efficiency. It discourages people with
higher income from working.
2. A general consumption tax may be efficient but violates equity principle since consumption
forms a higher part of poors' incomes.
3. On specific commodity tax, Ramsey's rule advocates higher taxes on inelastic items like
necessities and lower taxes on elastic items like luxuries. But this violates the equity principle.
4. Income tax may violate the horizontal equity principle.

5. Lump sum tax doesn't cause any efficiency loss but is highly inequitable.
Harmony
1. A balance among the tradeoffs has to be achieved.
2. Taxes on leisure luxury items may encourage people to work more thus increasing efficiency as
well as promoting equity and development.
3. Wealth tax again can promote equity, development and efficiency.
4. Tax on inelastic land supply also doesn't compromise on efficiency.
Q 5.b What is an offer curve in international trade? For 2 countries engaged in trade in 2
goods, draw the offer curves such that the offer curve of the home country has a section
reflecting inelastic import demand and the foreign country's offer cure is elastic throughout.
Indicate in your diagram which part of the home country's offer curve is inelastic. What is the
reason for this shape of the offer curve? Suppose the home country imposes a tariff on
imports. Demonstrate the implications for trade. (10 marks)
Ans.
What is an offer curve

It determines the relative price of commodities at which trade can take place. For any given quantity
of a commodity, it shows the amount of the other commodity the country is willing to exchange. Offer
curves can be derived from the PPF analysis. In the PPF as can be seen @ price P3, the country is
willing to export DE3 amount of Y in exchange of DC3 amount of X. Thus plotting all such points we
can get the offer curve.
Inelastic offer curve

Reason for this shape

Elasticity: oc = % change in imports / % change in exports

= (MM) / (X/X). @ E1, (M/X) =

E1N/MN. and (X/M) = ON/E1N. So oc = ON/MN. So flatter the offer curve, the more inelastic it is.
This also shows that the country's import demand is so inelastic that it is willing to offer any amount
of exports for it.
Imposition of tariff

On trade, tariff imposition will reduce trade volume (offer curve shifts from Oa to Ob) and also
increases the terms of trade of the tariff imposing country (if it is a large country).
Q 5.c Summarize the main arguments of the trade optimists and trade pessimists with regard
to trade policy for developing countries. Which argument does data tend to support? (10
marks)
Ans.
Arguments for and against
Pretty standard, don't need to reproduce here.
Data
1. East Asian economies' experience is pro trade.
2. Our own experience post and pre liberalization is pro trade.
Q 5.d State 5 reasons that support government intervention in agricultural markets. (10
marks)
Ans.
1. Poor and marginal farmers: Hence the need for subsidies and MSPs.
2. Food security: Due to large poor population, hence need of MSPs and PDS.
3. Hoarding and inefficiency supply chain.
4. Encourage cultivation of desired crops: Like pulses, oil seeds etc.

5. Crowding in: Govt. intervention leaves more money in farmers' hands who can invest. Govt.
investment too crowds in private investment.
Q 5.e Expand on the following explanations for the Kuznets hypothesis bout inequality and
development -- (i) the cohort size hypothesis, (ii) the effect of openness on inequality, and (iii)
the strong versus the weak version of the hypothesis. (10 marks)
Ans.
Note: I didn't know (i) and (iii) so couldn't attempt these. Attempted only (ii)
(ii) Effect of openness on inequality:
1. A trade liberalization-versus-inequality graph has a measures trade openness along the x-axis and
inequality along the y-axis. By studying data from several Latin American countries that have
implemented trade liberalization policies in the past 30 years, the Kuznets curve seems to apply to
the relationship between trade liberalization and inequality (measured by the GINI coefficient).

Q 6.a Suppose a given yield of tax is to be obtained from an excise on a particular product in
a perfectly competitive economy. If the objective is economic efficiency the government
would prefer that tax which obtains the desired yield with a lesser increase in the price.
Should the government impose a unit tax or an ad valorem tax if the objective is that they
should both impose the same burden at the initial price before the imposition of the tax?
Demonstrate your answer with a diagram. (25 marks)
Ans.
No idea whatsoever. Did not attempt.
Q 6.b What is rent seeking? Consider a proposal by a government to levy a proportional tax
on income so as to subsidize the consumption of a good. The proportional tax at a rate t
reduces the wage received to w*(1-t) which with a standard upward sloping supply of labor
curve will reduce the hours of labor worked from say L2 to L1. The net income of the person
falls and tax revenue will be twL1. This is transferred as a subsidy which reduces the price of
a subsidized good from P to P-S and increases the quantity demanded from Q1 to Q2. What is
the valuation of the subsidy by the recipient? Is it equal to the value of taxes paid to finance
the subsidy? If the tax payer decides to devote resources to rent seeking to forestall the
policy to subsidize the good and the subsidy recipient is also willing to devote resources to

encourage the adoption of policy, who will have the advantage in the rent seeking context?
(25 marks)
Ans.
Don't know apart from drawing one or two figures. Did not attempt.
Q 7.a Suppose the goods, financial, current account and foreign exchange markets are
initially in equilibrium. The economy has low or imperfect capital mobility and operates at a
fixed exchange rate. The economy is subject to a favorable demand shock that raises
expenditure. What is the outcome of the shock on aggregate income and interest rate in the
short run? How is the balance of payments equilibrium achieved? Draw a diagram to support
your answer. (25 marks)
Ans.

Assumption
1. Economy has slack i.e. below full employment.
2. No sterilization by central bank.
Initial equilibrium
@ E, IS (goods market), LM (financial market) and BP (external market) are in equilibrium. BP curve
is steeper than LM curve to show imperfect capital mobility.
Favorable demand shock
1. The IS curve will shift to right (IS --> IS'). It will intersect LM curve at Z'.
2. So in short run, aggregate income will rise and interest rate will rise.
BoP equilibrium re-establishment

1. @ Z', economy faces BoP deficit. This is because the increase in income has increased the
imports more than the additional capital inflows caused by the rise in interest rates. So there
will be a BoP deficit, people will buy $, sell INR. But due to its commitment to maintain fixed
exchange rate, central bank will have to intervene and sell $, buy INR. This will reduce
domestic INR liquidity and make LM curve shift left (LM --> LM').
2. We will reach a new equilibrium on BP curve @ F where IS', LM' and BP intersect. Thus
external equilibrium is re-established.
Q 7.b What is a speculative attack on a currency? Suppose the economy has a fixed
exchange rate and the government is following an expansionary macroeconomic policy. The
government increases the budget deficit which it finances through a monetary expansion.
How does this lead to a crisis? What is the timing of the speculative attack? (25 marks)
Ans.

Speculative attack
This means when speculators and traders start taking big bets against the central bank on a
currency for either its massive devaluation or revaluation (devaluation mostly). The bets become so
huge that they put so much pressure on the central bank and forces it to devaluate (or revaluate) the
currency.
Crisis development
1. Assumptions
1. Y < full employment output.
2. No sterilization by central bank.

Let the economy initially be at E0 where IS, LM, BP curves intersect. Now expansionary fiscal policy
takes IS curve to IS' from IS. We go to E1. Now expansionary monetary policy takes LM curve to LM'
from LM. We go to E2. But at this point, our imports have gone up too much (due to rise in income)
but our capital flows are insufficient to cover them. So we have a BoP deficit. The central bank will
intervene, sell $< buy INR. But its fx reserves will start to run down and soon speculative attacks will
start.
Timing
When the reserves of central bank start to run down or it seems central bank will no longer be able
to sustain its current policy.
Q 8.a Explain the Lewis model of structural change from an agricultural economy to a modern
industrial economy. State 3 major criticisms of Lewis model. (20 marks)
Ans.

Assumptions
1. 2 sector dual economy. Agriculture which is primitive, suffers from disguised unemployment
and industry which is modern. Disguised unemployment is the employment of labor which has
got 0 or at least < subsistence wage MPPL. This means that a release of labor from
agriculture will not reduce the APPL and may even raise it.
2. Agriculture is a sector which suffers from diminishing returns (because the total quantity of land
is fixed). Thus huge amount of surplus labor exists in the agriculture in the form of disguised
unemployment and which is willing to find employment in the higher paying industrial sector in
want of higher wages. Thus there is a markup of wages in the industrial sector (Lewis took it @
30%). The huge surplus labor from agriculture ensures that even when employment in
industrial sector goes up, the wages don't go up.

3. All wages are consumed and all profits are saved and invested.
4. There is sufficient demand always to absorb all the additional production without any fall in
prices.
5. Static technology.
Model
1. The model shows how the process of industrial expansion or capital accumulation is self
sustaining and will absorb all the surplus labor from agriculture.
2. Let wm be the wages in manufacturing (industrial) sector and wa be the wages in agriculture. In
period 1, with some initial investment total production will be the area under the marginal
product curve (MP1). Out of this only wm has to be paid out as wages and rest is the surplus
which is saved and all of it is reinvested in the economy. Labor employed in period 1 is L1.
3. In the next period, the profit from period 1 will be reinvested, new capacity would be setup. As a
result the marginal product will go up (from MP1 to MP2) and hence the demand for labor would
increase. But the new labor can be hired at the same wage rate (surplus labor assumption). So
L2 amount of labor (> L1) would be hired and new surplus would also be higher which would get
reinvested in next period and so on. Thus this cycle continues at an increasing rate until all
surplus labor is absorbed.
4. According to Lewis as industry expands, the share of profits in the national income will also
rise. This is because - (a) Share of profits in industrial sector will rise (such is the case when
successive MPPL curves are drawn parallel to each other). (b) Share of industrial sector in GDP
itself will rise. The increasing profits serve as an incentive to reinvest them in building new
capacity as well as the source to finance it. The increasing profits are guaranteed by constant
wages and sufficient demand which will prevent a fall in prices.
5. When the modern sector expands and workers earn higher wages there will be a rise in prices
as the workers are paid out of the new money created. But when the formed capital is put to
use output of consumer goods will also increase leading to a stabilization in prices. Further with
the expansion of modern sector, not only do output and employment increase but also profits.
As the share of profits increase the amount of investment being financed out of the created
money diminishes and ultimately the increase in voluntary savings kills inflation.
6. The expansion stage comes to an end when there is no surplus labor left in the agriculture and
now both industry and agriculture begin to compete for labor. @ this point agriculture is said to
be commercialized and end of take off stage is defined.
Limitations
1. Technological changes: Lewis assumes that the surplus will not be invested in labor saving
technologies or management techniques and thus increased surplus and investment will
necessarily mean increased employment. This has not been the case empirically as is evident
from the Indian experience. Since 1993-94, the output growth rate has been very high

(specially from modern sectors) but organized employment has been falling at the rate of 0.33% p.a. On the other hand rural to urban migration has increased but this is merely shifting
the surplus labor situation from agriculture to unorganized sector.
2. Demand deficiency and declining terms of trade: Lewis assumes that there will be endless
demand for the produce which will prevent a fall in prices. This is clearly not the case in current
economy. agriculture's role as a market for industrial goods is neglected but agriculture
consumes a good part of the industrial output. If it doesn't grow then it will lower the growth in
aggregate demand.
3. Wage goods gap: It neglects the importance of agriculture in sustaining the capital formation in
industrial sector. It must be noted that as labor moves from agriculture to industry, their income
will rise and hence demand for food grains (wage goods). If the supply of these food grains is
not increased, their prices will rise which will lead to higher wages and hence a collapse of the
model itself on its own feet.
Q 8.b It is said that a characteristic of the Harrod-Domar model is that even for the long run
the economy is at best balanced on a knife edge of equilibrium growth. Explain the HarrodDomar model and the reason for this characteristic. (15 marks)
Ans.

Objective
1. He asks the question - if changes in income induce investment, what must be the rate of growth
of income for plans to invest to equal plans to save in order to ensure a moving equilibrium in a
growing economy through time? Moreover, is there any guarantee that the required rate of
growth will prevail? If not, what will happen? In static Keynes, if the equilibrium between S & I is
disturbed then the economy corrects itself to a new equilibrium level. However, if growth

equilibrium is disturbed then will it be self correcting or self aggravating? Also will this
equilibrium rate be equal to the maximum rate of growth that the economy is able to sustain
given the rate of growth of productive capacity? If not, what will happen?
2. Thus he wanted to determine that unique rate at which investment and income must grow so
that full employment level is maintained over a long period of time i.e. equilibrium growth is
achieved. This is only possible if the additional demand generated by the investment is equal to
the additional productive capacity created by it.
Assumptions
1. Economy starts from the full employment point.
2. Marginal capital - output ratio (v = K/Y) is same as average capital - output ratio (K/Y) and is
greater than 1.
3. Marginal propensity to save (s) is equal to savings rate in the economy (s) i.e. marginal
propensity to save remains constant at all levels of income and the intercept term is zero.
Model
Harrod's 1st Growth Equation
1. Increase in income (Y) depends on increase in stock of capital (K) during a period and the
actual capital - output ratio ( = K/Y). So Y = (K/v).
2. Now K = I i.e. change in capital stock is nothing but investment. Thus Y = (I/v). To express
as growth rate, we rewrite as (Y/Y) = (I/Y)/v or Gy = (I/Y)/v where Gy is the actual growth rate.
Thus it is clear that growth rate will be higher if investment as a proportion of GDP is higher or
capital - output ratio is lower.
3. In Keynesian framework, actual savings = actual investment. Thus Gy = (S/Y)/v or Gy = s/v.
Harrod's 2nd Growth Equation
1. The 1st equation is merely a definitional equation. We need more than a definitional equation to
know whether the actual growth rate will provide the basis for a dynamic equilibrium in the
sense it keeps the plans to save equal to the plans to invest @ full employment level. This is
the warranted growth rate (Gw) which is that growth rate which induces just enough investment
to match planned savings and thus keeps capital fully employed (and also labor since full
employment assumption) so that manufacturers are willing to carry on investment in the future
at the same rate as in past.
2. How is the Gw determined? Plans to save at any point in time are given by the Keynesian
function: S = sY and this gives us the potential supply of investment goods. The demand for
investment goods is given by the acceleration principle Ir = vr.Y where the vr is the warranted
capital-output ratio and is given by Kr/Y. This ratio is determined by technological conditions.
Thus we get, s.Y = vr.Y or Gw = (Y/Y) = s/vr. At this rate expenditure on consumption goods
will be equal to production of consumption goods as well.

3. While vr is the desired capital - output ratio, v is the actual capital - output ratio. Let us consider
the case when there is a departure of actual growth rate from the warranted growth rate. If say
there are recessionary conditions (i.e. Gy < Gw), it means v > vr or the installed capital is not
fully utilized. This means there is a surplus of investment goods and this will depress further
investment. But if further investment falls down then the further growth rate will fall down as well
and there is no method to ensure Gy increases and becomes equal to Gw again. Similarly in
boom conditions (i.e. Gy > Gw), v < vr or the installed capital will be more than fully utilized. This
shortage of capital induces the producers to invest more which takes further Gy even higher
and away from Gw. Thus any deviation is self aggravating.
Harrod's 3rd Growth Equation
1. Now even if the economy grows at the rate required for full utilization of capital (i.e. G w) this still
doesn't guarantee the full employment of labor. This is because of 2 reasons - (a) Gw depends
on technical factors (say how many machines are required to build one unit of output) while full
employment of labor must necessarily depend on labor growth. (b) Harrod assumes labor and
capital are not substitutable. Thus he conceives the natural growth rate (Gn) which is equal to
the summation of labor growth rate and labor productivity growth rate (thus Gn = n + q where n
is the labor growth rate and q is growth rate in its productivity which is made possible by
technical considerations). Both n and q are thus exogenously determined.
2. This natural growth rate defines the equilibrium rate of growth in the long run (clearly in the long
run for the full employment equilibrium, Gy = Gn). Also if Gy > Gw then Gy will increase but this
expansion can't go on indefinitely (the availability of labor and natural resources will put a limit
to it) and the increase in Gy will stop once it hits Gn. The long run question for the economy,
thus, is the relation between Gw and Gn. For the full employment of both labor and capital, the
required condition is Gy = Gw = Gn. This is also called Harrod's golden age.
3. Knife edge problem: The equality of all growth rates is called the balanced growth equilibrium
or the growth rate. But it is seldom achievable. This is because they are determined by s, vr, n
and q which are determined quite independently of each other. Gw is determined by s and vr,
Gn by n and q. Thus if Gw > Gn there will be a tendency for chronic depression (since Gy = Gn in
LR) and the actual growth rate will never be sufficient to stimulate investment demand to match
the amount of planned savings. There will be too much of savings. If Gw < Gn then there will be
a tendency for chronic inflation because actual growth rate will tend to exceed the warranted
rate. There will be too little savings.
Reasons for Knife Edge Instability
1. Constant savings rate: In the LR, savings rate (s) may change so as to change Gw to bring it in
line with the Gn. If Gw > Gn then there will be tendency towards depression which will tend to
reduce the share of profits in the LR and hence savings will reduce, thereby lowering Gw.

Similarly in opposite condition, there will be boom and share of profits will rise and hence
savings and hence Gw.
2. Fixed coefficients or L shaped isoquants: If capital grows faster than labor i.e. Gw > Gn, labor
will become scarcer, wages will increase and technological innovations will take place in labor
saving techniques. Thus vr will increase (since now more capital is required to produce same
output) and this will lower Gw. If however, labor grows faster than capital then Gw < Gn, and
labor redundancy will depress real wages and shift will be made towards labor intensive
technologies. Thus vr will fall and Gw will increase.
Q 8.c What are the 2 key conclusions of the H-O model of international trade? Under what
assumptions are these conclusions arrived at? (15 marks)
Ans.
Key conclusions

1. International trade can happen on the basis of difference in factor endowments.

2. A country will export the good which uses its more abundant factor intensely.
In the figure, let autarky productions be at f and e respectively. Now due to trade, countries will
specilize in products which use their more abundant factor more intensely. So A moves from f to g
while B moves from e to h. A new price line in the world (Px/Py)w will be established and both
countries will trade and consume on a higher indifference curve (shown in brown line). Thus trade
becomes possible due to differences in factor endowments. Also A exports Y and B exports X commodities which use their more abundant factor more intesely.
Key assumptions

1. There are 2 nations (A and B) , 2 commodities (X and Y), 2 factors of production (labor and
capital).
2. Both nations have same technology in production. This means isoquants are identical in both
nations for each product and further if say factor prices are same in both nations then both will
use exactly the same amount of labor and capital in the production of each commodity. It is
another case though that because factor prices are different in both nations then they may use
more of the relatively cheaper factor in the production.
3. Commodity X is labor intensive while commodity Y is capital intensive in both nations. This
means that for a given (w/r), (K/L) ratio is higher for commodity Y in both nations than (K/L)
ratio for X. This must be true for all possible (w/r) i.e. @ no given w/r should K/L in Y become
less than K/L employed in X. It doesn't mean K/L is same in both nations for Y it just means K/L
is higher for Y than X in both nations.
4. Both commodities are produced under CRS in both countries. It doesn't mean DRS doesn't
prevail for any one factor. It simply means that taken both factors together CRS prevails.
5. There is incomplete specialization in both nations. This means none of the nations is very small
so as to exclude boundary solutions.
6. Tastes are equal in both nations. This means for a given commodity price ratio (P x/Py) both
nations will consume same proportion of X and Y. Note that this doesn't imply that they will be
on same indifference curve.
7. There is perfect competition in both commodity and factor markets in both nations. There is
perfect factor mobility within each nation but no international factor mobility. There are no
transport costs, tariffs or other obstructions to the free flow of trade. All resources are fully
employed in both nations.
8. International trade between the two is balanced.