Paper I — Q4
(a) (i) Explain the effects of public spending on national income, if it is financed through government borrowings. (ii) Why do…
Explain the effects of public spending on national income, if it is financed through government borrowings.
Why do some believe that it is important to restrict the growth of public expenditure ? Suggest how public expenditure might be controlled.
10+(5+5)=20
Suppose that the market demand and supply functions are given by :
Qd = – 500P + 5000
and Qs = 400P – 400
Find out the effects of imposition of specific sales tax of 18% on equilibrium price and quantity.
In a monopoly market, the demand and cost curves are given by : p = 200 – 8q and c = 25 + 10q Suppose that the government imposes a tax of ₹ 10 per unit. How will equilibrium price and quantity be affected ? 8+7=15
Define money multiplier and discuss its determinants. Explain in terms of money multiplier, how the banking system of an economy can control money supply. 15 marks
हिंदी में प्रश्न पढ़ें
राष्ट्रीय आय पर सार्वजनिक व्यय के प्रभावों की व्याख्या कीजिए, यदि इसे सरकारी उधार के माध्यम से वित्तपोषित किया जाता है।
कुछ लोग क्यों मानते हैं कि सार्वजनिक व्यय की वृद्धि को सीमित करना महत्वपूर्ण है? सुझाव दीजिए कि सार्वजनिक व्यय को कैसे नियंत्रित किया जा सकता है।
10+(5+5)=20
मान लीजिए कि बाजार की मांग और आपूर्ति फलन इस प्रकार दिए गए हैं :
Qd = – 500P + 5000
एवं Qs = 400P – 400
18% के विशिष्ट बिक्री कर के लागू होने से, संतुलन मूल्य एवं मात्रा पर पड़ने वाले प्रभावों का पता लगाइए।
एकाधिकार बाजार में, मांग और लागत वक्र इस प्रकार दिए गए हैं : p = 200 – 8q एवं c = 25 + 10q मान लीजिए कि सरकार ₹ 10 प्रति इकाई का कर लगाती है। संतुलन मूल्य एवं मात्रा पर इसका क्या प्रभाव पड़ेगा?
8+7=15
मुद्रा गुणक को परिभाषित कीजिए एवं इसके निर्धारकों की विवेचना कीजिए । मुद्रा गुणक के संदर्भ में समझाइए कि अर्थव्यवस्था की बैंकिंग व्यवस्था मुद्रा आपूर्ति को कैसे नियंत्रित कर सकती है । 15
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) Effects of debt-financed public spending on national income
Debt-financed public spending raises national income through the Keynesian multiplier: an initial increase in government expenditure raises income, consumption and further demand, so ΔY = ΔG/(1-MPC(1-t)). But if borrowing is from domestic savers, it competes for loanable funds, raises interest rates and crowds out private investment, reducing the multiplier. If the RBI accommodates by monetising debt, crowding out falls but inflation and fiscal dominance risk rise. Under Ricardian equivalence, forward-looking households expect future taxes to repay debt, save more and offset the demand effect, so income may not rise. The net effect depends on slack, expectations and debt sustainability. Productive borrowing for infrastructure can raise potential output; unproductive borrowing increases debt servicing, intergenerational burden and fiscal risk, as seen in India’s market borrowings and the Fiscal Responsibility and Budget Management Act, 2003.
(a)(ii) Restricting and controlling public expenditure
Restricting public expenditure is important because unchecked growth can crowd out private activity, create inflationary pressure, raise debt, distort resource allocation, erode fiscal space and create fiscal dominance. Wagner’s Law and Peacock-Wiseman displacement effect explain why the state tends to expand, especially after crises. Control requires fiscal rules, zero-based and outcome-based budgeting, expenditure ceilings, performance audits by the CAG, user charges, public-private partnerships and disinvestment, and prioritising capital over recurrent spending.
(b)(i) Effects of the 18% sales tax
For the competitive market, pre-tax equilibrium is found by equating demand and supply: -500P + 5000 = 400P - 400, so P = 6 and Q = 2000. Interpreting the 18% sales tax as an ad valorem tax on the consumer price, sellers receive 0.82P, so the supply function becomes Qs = 400(0.82P) - 400 = 328P - 400. Equating with demand gives 828P = 5400, so P = 6.52 and Q = 1739. The tax per unit is 0.18 × 6.52 = 1.17. Consumers pay 0.52 more and producers receive 0.65 less; consumer incidence is 0.52/1.17 = 44.4%, and producer incidence is 55.6%. (If the 18% is instead levied on the seller's price, so that the consumer price is 1.18 times the seller's price, equilibrium is about P ≈ 6.44 and Q ≈ 1782.)
(b)(ii) Monopoly with a ₹10 per-unit tax
In monopoly, TR = 200q - 8q², MR = 200 - 16q, MC = 10. Pre-tax: 200 - 16q = 10, q = 11.875, p = 105. With a ₹10 per unit tax, MC becomes 20, so 200 - 16q = 20, q = 11.25, p = 110. Price rises by 5 and output falls by 0.625. The consumer bears 5 of the tax and the producer’s net price falls from 105 to 100, so pass-through is 50%. This is higher than the 44.4% consumer pass-through in the competitive example, but competitive pass-through depends on demand and supply elasticities and can be above or below 50%, so no general ranking exists.
(c) Money multiplier and control of money supply
The money multiplier is m = broad money/monetary base (M3/M0 in India). With M = C + D and H = C + R, and writing c = C/D (currency-deposit ratio) and r = R/D (reserve ratio, the CRR plus banks' excess reserves), m = (1 + c)/(c + r); if the public holds no currency, this reduces to the simple deposit multiplier 1/r. Determinants are the CRR, banks' excess reserves, the currency-deposit ratio (the public's preference for cash), and indirectly the SLR and credit demand, since SLR holdings of government securities limit the funds banks can lend even though they are not reserves with the RBI. The banking system, guided by the RBI, controls money supply because credit creation is limited by reserve ratios. If the RBI raises the CRR the multiplier falls directly, and a higher SLR restrains lending, and deposit expansion slows; if it raises the repo rate, borrowing cost rises, lending falls and excess reserves may increase, also reducing the multiplier. Open market operations change the monetary base: selling government securities drains base money, while buying injects it. Since money supply equals multiplier times base, the RBI can tighten or ease liquidity by combining base changes with multiplier-affecting instruments.
How this answer will be evaluated
Framework: Keynesian multiplier with IS–LM crowding out; tax incidence; monopoly with a specific tax; money multiplier
What earns full marks: All four numericals exact with working; theory parts model-based with a verdict; multiplier derived.
Evaluation rubric
Each sub-part is marked on its own, against the marks and word limit printed on the paper.
- (a)(i) Effects on national income of public spending financed by government borrowing. 10 marks
explain— definition/context → points in order → small example → short close
Must cover
- Debt-financed ΔG raises Y by the multiplier; domestic borrowing raises r and crowds out investment
- Monetisation reduces crowding out but raises inflation/fiscal dominance; Ricardian equivalence offsets
- Net effect depends on slack, expectations, debt sustainability; productive vs unproductive borrowing
- FRBM/India reference and the intergenerational burden
Loses marks
- Multiplier stated without the interest-rate channel
- Confuses borrowing with money creation
- No diagram or model
Earns more
- Contrast with tax finance: balanced-budget multiplier of one
- Liquidity trap or slack economy: no crowding out
- Diagram: IS shifts right along LM
- Money-financed spending compared in a line
Extra mark
- Debt-servicing burden on future budgets
- An Indian episode: the 2008–09 stimulus or 2020 borrowing
- (a)(ii) Why some hold that the growth of public expenditure must be restrained. 5 marks
explain— definition/context → points in order → small example → short close
Must cover
- Why restrict: crowding out, inflation, debt/interest burden, fiscal space erosion, fiscal dominance
- Wagner's Law and Peacock–Wiseman displacement explain expenditure growth
- Controls: fiscal rules (FRBM-type), ZBB/outcome budgeting, ceilings, CAG audits, subsidies rationalisation/DBT, PPPs/disinvestment
- Capital vs recurrent prioritisation
Loses marks
- Lists deficits without why growth itself matters
- Anti-government polemic without economics
- Restates Wagner's law only
Earns more
- Public-choice view: bureaucratic and electoral bias to spend
- Committed expenditure rigidities: salaries, pensions, interest
- Debt sustainability: interest rate against growth rate
- FRBM rationale in India
Extra mark
- Baumol's cost disease in public services
- Ratchet effect after crises
- (a)(ii) Implementable measures to control public expenditure, and who applies them. 5 marks
suggest— the problem in one line → implementable measures → who acts → conclusion
Must cover
- Controls by named actors: fiscal rules under FRBM enforced by Parliament and the Finance Ministry
- Budget tools: zero-based and outcome budgeting, expenditure ceilings, medium-term expenditure framework
- Oversight and efficiency: CAG performance audits, subsidy rationalisation through DBT, scheme evaluation and sunset clauses
- Resource side: user charges, PPPs/disinvestment; protect capital spending while curbing recurrent spending
Loses marks
- Wish-list without an actor
- Only 'cut spending'
- Measures that cut capital expenditure alone
Earns more
- Medium-term expenditure framework
- Public Financial Management System and cash management
- Sunset clauses and scheme evaluation
- Pension and wage-bill reform
Extra mark
- An independent fiscal council
- Expenditure Management Commission recommendations
- (b)(i) Equilibrium price and quantity before and after an 18% sales tax, from the given demand and supply. 8 marks
calculate— given → formula → substitution → result with units → interpretation
Must cover
- Pre-tax equilibrium P = 6, Q = 2000
- Ad valorem 18%: supply Qs = 328P − 400 → P = 6.52, Q ≈ 1739
- Consumer pays ≈0.52 (44.4%), producer bears ≈0.65 (55.6%); tax wedge 1.17
- Alternative interpretation (≈6.44/1782) noted
Loses marks
- Treats 18% as a rupee amount without saying so
- Wedge applied to both sides
- Final figures without substitution
Earns more
- Either wedge convention accepted if stated and used consistently
- Incidence split explained by relative elasticities
- Tax revenue and deadweight loss computed
- Diagram with the rotated supply curve
Extra mark
- Notes 18% makes the tax ad valorem, not specific, and says so
- Checks the answer in the demand function
- (b)(ii) Monopoly equilibrium price and quantity before and after a ₹10 per-unit tax. 7 marks
calculate— given → formula → substitution → result with units → interpretation
Must cover
- MR = 200 − 16q; MC = 10; pre-tax q = 11.875, p = 105
- Tax raises MC to 20 → q = 11.25, p = 110
- Price rises by 5 (50% pass-through); output falls 0.625; producer net price 100
- Comparison with competitive pass-through and the no-general-ranking point
Loses marks
- Sets price equal to MC
- Adds the tax to price directly
- Arithmetic without the equations
Earns more
- Notes a specific tax shifts MC, not demand
- Profit before and after computed
- Diagram: demand, MR, MC before and after
- Half-shifting explained by linear demand
Extra mark
- Compares incidence with the competitive case
- (c) Define the money multiplier, discuss its determinants, and explain through it how the banking system controls money supply. 15 marks
explain— definition/context → points in order → small example → short close
Must cover
- Money multiplier m = M/H (M3/M0); determinants CRR, excess reserves, currency-deposit ratio; SLR acts indirectly via lending
- m = (1 + c)/(c + r) form stated
- Credit creation constrained by reserve ratios; CRR/SLR/repo effects on the multiplier
- OMO changes the base; money supply = multiplier × base (RBI control framework)
Loses marks
- Definition without the formula
- Determinants listed without direction of effect
- Banks described as printing money
Earns more
- Derivation from M = C+D and H = C+R
- Leakages: cash drain, excess reserves, weak credit demand
- Cites RBI's current M3/M0 figure from the Bulletin
- Limits of banks' control: RBI's instruments and credit demand
Extra mark
- Endogenous-money critique of the mechanical multiplier
- A CRR change traced through to money supply
What "Explain" is asking you to do
Make the working of something clear — what sets it off, what follows from what, and what it produces. Explain is the Commission's mechanism word: it dominates the technical papers and the “explain why” stems, where the marks sit in the causal chain and not in the label.
Structure that answers it
State what it is → the initiating condition → the chain of cause, step by step → an instance where it plays out → what the chain produces
Where marks are lost
Describing what something looks like instead of why it works that way. Naming the stages without linking them reads as description too.
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