Economics 2021 Paper I 50 marks Derive

Q4

(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) 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: (i) 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) 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 : (i) 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)

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Directive word: Derive

This question asks you to derive. The directive word signals the depth of analysis expected, the structure of your answer, and the weight of evidence you must bring.

See our UPSC directive words guide for a full breakdown of how to respond to each command word.

How this answer will be evaluated

Approach

The directive 'derive' in part (a) demands rigorous mathematical derivation as the core task, with 'describe' and 'illustrate' in other parts requiring explanatory and diagrammatic support. Allocate approximately 35% of time/words to part (a) given its 15 marks and technical derivation requirement; 25% to part (b) for its 15 marks covering monetary theory; and 40% to part (c) for its 20 marks involving complex IS-LM-BP analysis in two scenarios. Structure as: brief intro stating Lucas's rational expectations framework → systematic derivation in (a) with dual diagrams → concise exposition of money multiplier in (b) → comparative policy analysis in (c) with separate diagrams for closed and open economy cases → concluding synthesis on policy effectiveness under different regimes.

Key points expected

  • Part (a): Mathematical derivation of Lucas supply curve showing output deviation from natural rate as function of price surprise (P-P^e), with labour market clearing via nominal wage confusion; upward sloping SRAS when expectations fail, vertical LRAS at Yn when expectations fulfilled
  • Part (b): Definition of high-powered money (H = C + R) and money supply (M = m × H); derivation of money multiplier m = (1+c)/(c+r) where c=currency ratio, r=reserve ratio; assumptions including no currency drain, no excess reserves, stable ratios, immediate credit creation
  • Part (c)(i): IS-LM analysis for closed economy fixed exchange rate—expansionary fiscal shifts IS right, monetary expansion (lower r) shifts LM right; net effect typically expansionary not recessionary, though crowding-out possible
  • Part (c)(ii): IS-LM-BP with fixed exchange rate and zero capital mobility—monetary policy ineffective due to BoP disequilibrium requiring sterilization; fiscal policy effective; combined policy analysis showing recession unlikely under standard assumptions
  • Critical evaluation: Recognition that recession outcome requires specific conditions—complete crowding-out, liquidity trap, or perverse expectations—not generic result of the stated policy mix

Evaluation rubric

DimensionWeightMax marksExcellentAveragePoor
Concept correctness25%12.5Precise mathematical derivation in (a) with correct Lucas supply function Y = Yn + α(P-P^e); accurate money multiplier formula in (b); correct IS-LM-BP mechanics in (c) distinguishing policy effectiveness under zero capital mobility; no conceptual conflation between adaptive and rational expectationsCorrect verbal statements of Lucas supply curve slope and money multiplier concept but missing or flawed derivation steps; partial understanding of BP curve verticality under zero capital mobility; some confusion about monetary policy ineffectiveness conditionsFundamental errors such as deriving Keynesian rather than Lucas supply curve; confusing reserve ratio with currency ratio in multiplier; claiming monetary policy effective under fixed exchange rate with zero capital mobility; asserting recession without theoretical justification
Diagram / model25%12.5Clear diagrams for (a) showing both upward-sloping SRAS (expectations unfulfilled) and vertical LRAS (expectations fulfilled) with 45-degree line or labour market sub-diagrams; standard IS-LM diagrams for (c)(i); IS-LM-BP with vertical BP for (c)(ii); all properly labeled with equilibrium shiftsDiagrams present but missing key elements—no distinction between SRAS and LRAS in (a), or missing BP curve in (c)(ii); correct basic IS-LM shifts but unclear on final equilibrium outcomes; labels incomplete or axes unmarkedMissing diagrams for derivation-heavy parts; incorrect diagram types (AD-AS instead of Lucas framework); diagrams contradict verbal analysis; no graphical treatment of open economy case
Quantitative reasoning15%7.5Explicit derivation steps with proper notation in (a): production function, labour demand/supply with nominal wage confusion, market clearing; algebraic manipulation of money multiplier in (b); comparative statics in (c) showing directional effects on Y, r, and BoPSome mathematical steps shown but gaps in derivation; correct final formulas without intermediate working; qualitative rather than quantitative treatment of policy multipliers in (c)Purely verbal treatment where mathematics required; incorrect algebraic manipulation; no attempt to show how parameter changes (c, r) affect money supply; confusion between levels and changes in variables
Indian / empirical examples15%7.5Relevant Indian context where applicable—RBI's monetary policy framework and CRR adjustments (part b/c); India's managed float with elements of fixed rate management; 1991 balance of payments crisis illustrating capital mobility importance; avoid forced examples in purely theoretical (a)Generic mention of RBI or CRR without specific application to question; dated or irrelevant examples (e.g., 1970s oil shock for Lucas supply); missing opportunity to connect high-powered money to RBI's monetary base dataNo Indian examples where clearly relevant; incorrect factual claims about Indian monetary policy; examples from (a) that confuse Indian institutional context with theoretical model requirements
Policy implication20%10Clear synthesis: policy ineffectiveness proposition in (a) under rational expectations; trade-off between fiscal dominance and monetary control in (b); nuanced conclusion in (c) that recession is not inevitable—depends on relative magnitudes, crowding-out degree, and BoP constraints; recognition of Tinbergen instrument-target problemSeparate policy points per part without integration; correct but generic statements about monetary-fiscal mix; uncritical acceptance of recession conclusion without examining conditionsContradictory policy conclusions across parts; failure to address the specific recession question in (c); irrelevant policy recommendations (e.g., suggesting floating exchange rate when question specifies fixed); no recognition of Lucas critique implications for policy evaluation

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