Institute of Rural Management Anand

Course Name: Macroeconomics Programme: PGDM-RM42 and FPM-RM20

Date: 30th January, 2022 Term – II Roll No._______________________

Mid Term Exam (Open Book)

Duration of Exam: 2 Hrs 00 Mins Weightage: 30 percent Total Marks: 50 Marks

1. The production function of an imaginary country Wattland is given by: 𝑌 = 𝐴𝐾 𝛼 𝑁1−𝛼 , where 𝐴 =
0.75 and 𝛼 = 0.4. 𝐾 denotes the value of capital and 𝑁 denotes the number of workers in the
economy. Based on this information, answer the following:
a) Is the production function of Wattland characterized by constant returns to scale? If yes,
explain. (2 points)
b) There increasing returns to either of capital or labor? True or False. In either case, explain.
. (3 points)
c) Derive an expression for the steady-state capital per worker and the consequent steady-state
output per worker in terms of 𝑠 and 𝛿 (savings rate and the rate of depreciation,
respectively). Solve for the steady-state output per worker when 𝑠 = 0.25 and 𝛿 = 0.10.
(5 points)
d) Suppose that in the year 2022, the people of Wattland start saving at a higher rate, i.e., 30%
of the output. What is the new steady-state output per worker? What is the capital per worker
in the year 2025 and the corresponding output per worker? (5 points)
e) Derive an expression for the steady state consumption per worker. State all the assumptions
clearly. (2 points)
f) What, in your understanding, is meant by Golden-Rule level of capital? Determine the
saving rate that would maximize steady-state consumption per worker. (3 points)

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2. Please refer to the Budget at a Glance for FY22.

2019-2020 2020-2021 2020-2021 2021-2022

Budget Revised Budget
Actuals Estimates Estimates Estimates
1. Revenue Receipts 1684059 2020926 1555153 1788424
2. Tax Revenue (Net to 1356902 1635909 1344501 1545396
Centre)
3. Non Tax Revenue 327157 385017 210652 243028

4. Capital Receipts 1002271 1021304 1895152 1694812

5. Recovery of Loans 18316 14967 14497 13000
6. Other Receipts 50304 210000 32000 175000
7. Borrowings and Other 933651 796337 1848655 1506812
Liabilities

8. Total Receipts (1+4) 2686330 3042230 3450305 3483236

9. Total Expenditure (10+13) 2686330 3042230 3450305 3483236

10. On Revenue Account 2350604 2630145 3011142 2929000
of which
11. Interest Payments 612070 708203 692900 809701
12. Grants in Aid for creation 185641 206500 230376 219112
of capital assets

13. On Capital Account 335726 412085 439163 554236

14. Revenue Deficit (10-1) 666545 609219 1455989 1140576

(3.3) (2.7) (7.5) (5.1)
15. Effective Revenue Deficit 480904 402719 1225613 921464
(14-12) (2.4) (1.8) (6.3) (4.1)
16. Fiscal Deficit 933651 796337 1848655 1506812
[9-(1+5+6)] (4.6) (3.5) (9.5) (6.8)
17. Primary Deficit (16-11) 321581 88134 1155755 697111
(1.6) (0.4) (5.9) (3.1)

a) Interpret the numbers in the last row (Primary Deficit) of the above table. Is there any
underlying trend? Are the revised numbers for FY21 a reason for worry? If yes, why?
(4 points)
b) Assume that you are the Union Finance Minister. Outline few of your strategies to meet the
primary deficit target of 3.1% for FY22. (3 points)

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 c) As per the requirements of the Fiscal Responsibility and Budget Management (FRBM) Act,
2003, the Centre needed to limit the fiscal deficit to 3% of GDP by March 31, 2021.
However, COVID-19 induced circumstances meant that the Centre missed out on the target.
That notwithstanding, what is the fundamental cause for worry with regards to the high
fiscal deficit figures laid down in the above table? (3 points)

3. New Zealand rewrote the charter of its central bank in the early 1990s to make low inflation its
only goal. Why would New Zealand want to do this? (5 points)

4. Let’s assume a fictional kingdom Gondor owns assets in oversea worth 10 per cent of its GDP. These
assets have an average rate of return of 20 per cent. Furthermore, foreign countries own assets in Gondor
worth 30 per cent of its GDP but the rate of return of these assets is only at 7 per cent. Which of GDP or
GNP is higher in Gondor? (3 points)

5. You are an international investor and have been following the government bond market of Watopia, a
small country. You see a zooming rise in the bong interest rates in just about a year. Would you be
inclined to invest in these bonds? Clearly justify your response. (3 points)

6. The Governor of the Central Bank of Arthnagar is trying to get his monetary policy right. More
specifically, he would like to target the overnight interest rates, also known as repo rates. Repo rate is the
interest rate at which the central banks give loans to the commercial banks against government securities.
While the Governor is concerned about controlling inflation, he has to take into consideration the
Arthnagar Government’s quest for high growth. On performing an internet search, he finds an interesting
result known as the Taylor’s rule. The Taylor’s rule, devised by an American economist, is supposed to
give an indicative guideline to set the interest rate based on the targeted long term real interest rate, the
targeted inflation rate, the prevailing interest rate and the gap between actual GDP and the potential GDP.
More specifically, the Taylor’s rule reads as follows:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝐴𝑐𝑡𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 + 0.5
∗ (𝐴𝑐𝑡𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 − 𝑇𝑎𝑟𝑔𝑒𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒) + 0.5
∗ 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑔𝑎𝑝 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑎𝑐𝑡𝑢𝑎𝑙 𝑎𝑛𝑑 𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝐺𝐷𝑃)

The gap between actual and targeted inflation, as also the gap between actual and potential GDP could

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be positive or negative. The Central Bank wants to target an inflation rate of 5%, while the actual
inflation rate is 6%. The long-term real interest rate is aimed at 4%.

Given that the Taylor’s rule has some credibility, the government decides to follow it. On the basis of
the information provided, answer the following.

a) Assuming that the country is operating at potential GDP, what is the interest rate the Bank must
set? (3 points)

b) Now consider a scenario where the economy is operating at a negative GDP gap of 2%. What
should be the targeted interest rate be now? (3 points)

c) Can the governor be assured that once he sets the overnight rates based on the Taylor’s rule, the
economy would automatically follow the suit? What else do you think he may have to do to
accomplish his and his country’s target? (3 points)

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