BECC 109 Solved Guess Paper 2026 for Intermediate Macroeconomics-II (IGNOU BA Honours Economics, BAECH)

Solow model features and steady-state growth

Question: Bring out the salient features of the Solow model. According to the Solow model, what are the factors that determine the steady-state growth of an economy?

Meaning: Robert M. Solow's neoclassical growth model (1956) extends the Harrod-Domar model by adding labour as a factor of production and by dropping the assumption of a constant capital-output ratio.

Salient features

1. The model assumes full employment of inputs in a market economy with no government interference.
2. It is a closed economy with no external trade.
3. It uses a neoclassical production function Y = EF(K, L) with constant returns to scale, where E is the level of technology.
4. The per-worker function satisfies f(0) = 0, f'(k) > 0 and f''(k) < 0, so output per worker rises with capital per worker at a diminishing rate.
5. Labour grows at an exogenous constant rate n, the saving rate s is fixed, and capital depreciates at a constant rate δ.
6. It shows how saving, population growth and technological progress affect the level and growth of output over time.

Factors determining steady-state growth

1. A steady state is where output per worker y, consumption per worker c and capital per worker k stay constant; at k*, actual investment equals break-even investment.
2. Break-even investment (δ + n)k must cover depreciation (δk) and equip new workers (nk), so population growth drags on capital accumulation just like depreciation.
3. Saving rate (s): a higher saving rate raises steady-state capital and output per worker, but only until the new steady state is reached.
4. Population growth (n) and depreciation (δ): higher values lower steady-state capital per worker.
5. Technological progress (g): on the balanced growth path, output per worker grows only at the rate of technological progress.
6. The Golden Rule level of capital maximises consumption per worker, where f'(k*) = δ + n + g.

Conclusion: A higher saving rate lifts living standards once, but only sustained technological progress explains output per worker rising year after year.

Fisher's two-period model and the interest rate effect

Question: Describe the consumer's optimisation problem in Fisher's two-period framework. What is the effect of an increase in the rate of interest on optimum consumption?

Meaning: Irving Fisher's intertemporal model shows a consumer choosing the affordable combination of present and future consumption that gives the highest satisfaction over time.

The consumer's optimisation problem

1. The intertemporal budget constraint is C1 + C2/(1 + r) = Y1 + Y2/(1 + r): the present value of consumption equals the present value of income.
2. The budget line has a slope of (1 + r), which is the opportunity cost of consuming today.
3. Intertemporal indifference curves are convex to the origin; their slope reflects the rate of time preference.
4. The consumer is in equilibrium where the highest attainable indifference curve touches the budget line.
5. A net borrower consumes more than current income in period 1, while a net lender (saver) consumes less.

Effect of a rise in the interest rate

1. A higher r makes the budget line steeper, rotating it clockwise through the income point.
2. The total effect splits into a substitution effect and an income effect.
3. Substitution effect: present consumption becomes costlier, so the consumer cuts C1 and raises C2.
4. Income effect for a net lender: higher interest earnings raise lifetime income, so consumption rises in both periods.
5. Future consumption rises without doubt because both effects push it the same way; the effect on present consumption is ambiguous.
6. If the substitution effect outweighs the income effect, the lender's current consumption falls.

Conclusion: Whether a higher interest rate cuts today's spending depends on preferences and on which of the two effects is stronger.

Central ideas of the real business cycle model

Question: Write a short note on the central ideas of the Real Business Cycle (RBC) model and explain its basic tenets.

Meaning: Real business cycle models, associated with Kydland and Prescott, explain output fluctuations as responses to real (supply) shocks rather than monetary (demand) shocks.

Central ideas and tenets

1. Fluctuations in output are treated as fluctuations in the natural rate of output itself.
2. Prices and wages are fully flexible, as in classical theory, so a shift in aggregate supply changes potential output.
3. Supply shocks include changes in technology, weather, new sources of raw materials and raw-material prices.
4. Shocks are assumed to be highly persistent, which explains why cycles last as long as they do.
5. An adverse shock such as a drought shifts the production function down and labour demand to the left, cutting employment and output, which is a recession.

Conclusion: The RBC model reads business cycles as the economy's optimal response to persistent real shocks, not as a failure of markets.

Ricardian equivalence and debt stabilisation

Question: Explain the concept of Ricardian equivalence. Using the government budget constraint, explain why debt stabilisation is necessary for the government.

Meaning: Ricardian equivalence, revived by Robert Barro (1974), holds that neither fiscal deficits nor public debt change aggregate output, so counter-cyclical fiscal measures may be ineffective.

The Ricardian equivalence proposition

1. A deficit lets the government spend more than its revenue, building debt that must be repaid through higher future taxes.
2. For rational, forward-looking households, a deficit is a trade-off between present and future consumption.
3. If a tax cut today signals higher taxes tomorrow, households save the windfall instead of spending it.
4. So Keynesian fiscal stimulus may fail to raise aggregate demand and output.

Why debt stabilisation matters

1. Three factors drive the debt-to-GDP ratio: the interest rate, the growth rate and the primary balance.
2. Stability needs a primary surplus that offsets (r − g) multiplied by the existing debt ratio.
3. When the real interest rate exceeds the growth rate, a primary surplus is required to stop the debt ratio rising.
4. A high debt ratio means larger interest payments and more borrowing, which squeezes fiscal space.

Conclusion: Ricardian equivalence questions debt-financed stimulus, while the budget constraint shows why a stable debt ratio is essential for fiscal sustainability.

Tobin's q theory and strategy when q is below 1

Question: Discuss Tobin's 'q' theory on the optimum investment level by firms. In this context, if 'q' is less than unity, suggest an investment strategy for the firm.

Meaning: James Tobin linked investment to the stock market: investment depends on the ratio of the market value of a firm's capital to the replacement cost of that capital.

The q-theory of investment

1. q = market value of the firm's installed capital ÷ replacement cost of that capital.
2. When market value is well above replacement cost (q well above 1), the firm has a strong incentive to invest.
3. With q > 1, each unit of new capital can be financed by selling shares worth q, earning (q − 1), so the firm floats shares and investment rises.
4. Equity is a third source of funds besides borrowing and retained earnings.

Strategy when q < 1

1. The market values the firm below the cost of replacing its capital.
2. The firm should avoid buying new capital, because new capital costs more than the market thinks it is worth.
3. In such a bearish phase, firms consolidate through mergers and acquisitions, buying existing capital cheaply rather than building new capacity.

Conclusion: Tobin's q ties investment to share prices, though volatile markets and adjustment costs weaken the link in practice.