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Economics 2021 Paper I 50 marks Derive

Paper I — Q4

(a) Derive short-run aggregate supply curve following Lucas, when expectations are not realised, assuming that labour market…

(a)

Derive short-run aggregate supply curve following Lucas, when expectations are not realised, assuming that labour market clears. What will be its shape when expectations are fulfilled ? (10+5 marks)

(b)

Describe high powered theory of money supply in brief. State the assumptions made in its construction. (8+7 marks)

(c)
(i)

Do you think that increase in Government spending through borrowing from public accompanied by fall in required reserve ratio generates recession in the economy ? Illustrate your answer: in a closed economy with fixed exchange rate.

(ii)

in an open economy with fixed exchange rate and without any capital mobility. 20 marks

हिंदी में प्रश्न पढ़ें
(a)

श्रम-बाजार को संतुलित मानते हुए, प्रत्याशाएं पूर्ण न होने की दशा में, लुकास का अल्पकाल समग्र-पूर्ति वक्र व्युत्पन्न कीजिए । प्रत्याशाएं पूर्ण होने पर इस वक्र का स्वरूप क्या होगा ? (10+5 अंक)

(b)

उच्च-शक्ति मुद्रा-पूर्ति सिद्धांत का संक्षेप में वर्णन कीजिए । इस सिद्धांत के निर्माण में प्रयुक्त मान्यताओं को बताइए । (8+7 अंक)

(c)
(i)

आपके विचार से क्या सार्वजनिक उधार द्वारा सरकारी व्यय में वृद्धि एवं साथ ही वांछित-आरक्षण-अनुपात कम होने से अर्थव्यवस्था में मंदी की स्थिति उत्पन्न होती है ? निम्न परिस्थितियों में समझाइए : एक बंद अर्थव्यवस्था में स्थिर विनिमय दर के साथ ।

(ii)

एक खुली अर्थव्यवस्था में स्थिर विनिमय दर एवं बिना किसी पूंजी-गतिशीलता के साथ । (20 अंक)

Q4 of the 2021 UPSC Mains Economics Paper I, as printed
The question as printed in the 2021 Economics paper
Evaluate your answer to this question → See all 2021 Economics questions

Model answer

Drafted with AI by UPSC Answer Check against this question's marking rubric, to the expected length. UPSC does not publish answers for Mains — this is one way to score well, not an official key. How we build rubrics and answers.

(a)(i) Lucas supply curve when expectations are not realised. Let Y = F(L), F′ > 0, F″ < 0. Firms demand labour on the actual real wage, W/P = F′(L); workers supply labour on the expected real wage, W/Pᵉ = ψ(L), ψ′ > 0. Clearing of the labour market gives P F′(L) = Pᵉ ψ(L). Log-linearising around the full-information point (P = Pᵉ, L = L*, F′(L*) = ψ(L*)), with λ = −L*F″/F′ > 0 and δ = L*ψ′/ψ > 0, gives ln P − ln Pᵉ = (λ + δ)(ln L − ln L*). With ln Y = ln Y* + ε_L(ln L − ln L*) and ε_L = L*F′(L*)/Y*, the Lucas curve is ln Y = ln Y* + α(ln P − ln Pᵉ), where α = ε_L/(λ + δ) > 0. It slopes upward: when P > Pᵉ, workers mistake the rise in the price level for a higher real wage and supply more labour, while firms hire more at the lower actual real wage.

(a)(ii) Shape when expectations are fulfilled. When P = Pᵉ the bracket vanishes and Y = Y*. The supply curve is vertical at the natural level of output, money is neutral, and only unanticipated price changes move output.

Diagram: Lucas aggregate supply: short run and full information

(b)(i) High-powered money theory. High-powered money (the monetary base) is H = C + R, currency with the public plus bank reserves. The money supply is M = C + D. With currency–deposit ratio c = C/D and reserve–deposit ratio r = R/D, M/H = (C + D)/(C + R) = (1 + c)/(c + r), so M = mH, where m = (1 + c)/(c + r) is the money multiplier. If r = r_r + e (required plus excess reserve ratio), m = (1 + c)/(c + r_r + e). The central bank controls H through open-market operations, the repo rate and foreign-exchange operations, and sets r_r; the public determines c; banks determine e. The central bank thus influences M by changing H, as long as m is stable.

(b)(ii) Assumptions. (i) The central bank controls H exogenously. (ii) The currency–deposit ratio c is stable, set by public habits. (iii) The required reserve ratio r_r is stable or policy-determined. (iv) The excess reserve ratio e is stable or negligible. (v) The multiplier m is therefore stable and predictable. (vi) Interest rates do not materially alter c, r_r or e. (vii) No external or other leakages disturb H.

(c) Government borrowing with a lower reserve ratio. Borrowing from the public leaves the money stock unchanged but raises G, so IS shifts right; a lower r_r raises m and so M = mH, shifting LM right. (i) Closed economy. The fixed exchange-rate condition is inoperative; in IS–LM, both shifts raise output and employment. The interest rate may rise or fall, depending on the relative shifts, and the crowding out from G is offset or reversed by the monetary expansion. No recession is generated. (ii) Open economy, fixed exchange rate, no capital mobility. The balance-of-payments condition is NX(Y, E) = 0, so BP is vertical at Y_BP; assume the economy starts at Y_BP. Both shifts push Y above Y_BP, imports exceed exports, and the BoP is in deficit. To defend the exchange rate the central bank sells foreign exchange, so H falls, and LM shifts back left. Because there is no capital inflow to finance the deficit, the adjustment continues until Y returns to Y_BP. In the final position, output is unchanged, the interest rate is higher, private investment is crowded out by G, and reserves have fallen; the lower r_r only hastens the loss of reserves. Thus the policy mix does not cause recession in either case; in (ii) it simply fails to raise output.

Diagram: IS-LM and IS-LM-BP with debt-financed G and a lower reserve ratio

How this answer will be evaluated

Framework: Lucas Supply Curve / IS-LM-IP Model

What earns full marks: Rigorous derivations with clear diagrams, precise assumptions, and correct application of IS-LM-IP model to both scenarios.

Evaluation rubric

Each sub-part is marked on its own, against the marks and word limit printed on the paper.

  1. (a)(i) Derive Lucas short-run aggregate supply curve with unfulfilled expectations. 10 marks

    derive— given → assumptions → stepwise derivation → result → check

    Must cover

    • State Lucas supply function with price expectations
    • Assume labour market clears (wage/price flexibility)
    • Show positive slope of SRAS curve
    • Derive relationship between actual and expected price level

    Loses marks

    • Verbal description without mathematical derivation
    • Confusing with Keynesian SRAS
    • Ignoring the 'unfulfilled expectations' condition

    Earns more

    • Mention rational expectations framework
    • Show diagram with P and Y axes
    • Explain role of monetary surprise

    Extra mark

    • Reference to Lucas 1972 paper
    • Mention of natural rate hypothesis
  2. (a)(ii) Describe shape of SRAS when expectations are fulfilled. 5 marks

    explain— definition/context → points in order → small example → short close

    Must cover

    • State that curve becomes vertical
    • Explain output equals natural level (Y=Y*)
    • Link to long-run neutrality of money

    Loses marks

    • Saying curve remains upward sloping
    • Failing to link to long-run equilibrium

    Earns more

    • Diagram showing vertical line at Y*
    • Mention of classical dichotomy

    Extra mark

    • Reference to Friedman's natural rate
  3. (b)(i) Describe high-powered theory of money supply. 8 marks

    describe— define → structure or process in order → labelled diagram → significance

    Must cover

    • Define high-powered money (monetary base)
    • Explain money multiplier mechanism
    • Show formula M = m * H
    • Describe central bank's role in controlling H

    Loses marks

    • Confusing with quantity theory of money
    • Ignoring the multiplier process

    Earns more

    • Diagram of money creation process
    • Mention of reserve requirements

    Extra mark

    • Friedman–Schwartz base-multiplier approach (M = mH)
  4. (b)(ii) State assumptions of high-powered money theory. 7 marks

    explain— definition/context → points in order → small example → short close

    Must cover

    • Assume fixed reserve ratio
    • Assume stable currency-deposit ratio
    • Assume a stable excess-reserve ratio
    • Assume central bank controls base

    Loses marks

    • Listing general assumptions not specific to this theory
    • Missing the key multiplier assumptions

    Earns more

    • Interest rates do not alter c, r_r or e
    • Multiplier stable and predictable

    Extra mark

    • Reference to specific central bank policy
  5. (c) Analyse if fiscal expansion with reserve cut causes recession in two scenarios. 20 marks

    analyse— intro → causes → effects → stakeholders/linkages → way forward

    Must cover

    • Use IS-LM for the closed economy and IS-LM-BP with a vertical BP for the open economy
    • Closed: IS right (G up), LM right (lower reserve ratio); output rises, no recession
    • Open: Y above Y_BP gives BoP deficit, reserve loss lowers H, LM shifts back; Y returns to Y_BP, r higher, no recession
    • Analyze both closed and open economy cases

    Loses marks

    • Verbal answer without IS-LM diagrams
    • Ignoring the fixed exchange rate condition
    • Not distinguishing between the two scenarios

    Earns more

    • Diagrams for both scenarios
    • Explain crowding out effect
    • Mention of Mundell-Fleming framework

    Extra mark

    • Reference to specific fiscal policy example
    • Mention of fiscal multiplier
What "Derive" is asking you to do

Reach the stated expression from a starting relation, justifying every step. The destination is printed in the question, so only the route earns marks, and the assumptions you work under are part of that route.

Structure that answers it

Assumptions and notation defined → starting relation or governing equation → each step with its justification → the required expression → limiting case or boundary check

Where marks are lost

Writing the standard result first and fitting three lines to it, which an examiner reads at a glance. Marks also go on assumptions left unstated — lossless medium, small amplitude, errors independent with zero mean — and on symbols used before they are defined, even when the question says usual notations.

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