Principles of Macroeconomics

Inzamul Sepoy
Medium: English

Edition: 2019

ISBN: 978-93-5311-951-5

©Inzamul Sepoy

All rights reserved. No Part of this work may be copied, adapted

Abridged or translated, stored in any retrieval system, computer

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By any means without a prior written permission of the publishers.

Jurisdiction: All disputes with respect to this publication shall be

Subject to the jurisdictions of the courts, tribunals and forums of

New Delhi, India only.

Preface
No one is permitted to publish a key to this book without the

Written permission of the Author.

 Dear Readers,
I earnestly hope that the book will fully meet the
requirements of the students. It gives me immense pleasure to present
before you this book of Introductory Macroeconomics It is designed to be
used along with any reasonable Economics textbook. It is prepared in a
very precise language by which students can understand this subject in
a very easy way. The objective of this material is impart sufficient
practice to the students and to enable them to think analytically and
rationally. This manuscript should be useful for economics and business
students and, as well, for people who have studied Economics some time
ago and need a review of what they are supposed to have learned. Indeed,
one could learn Macroeconomics from scratch using this material alone,
although those trying to do so may find the presentation somewhat
compact, requiring slow and careful reading and thought as one goes
along.
I hope that students will find this book useful and will help them to
achieve academic excellence.

Inzamul Sepoy
Those who don't study economics will say that it's boring. Those who do will say that it's
dismal. The former say it's boring because they can't see the relationships so crucial to the
discipline. The latter say it's dismal because many of the conclusions reached reveal
saddening facts. It's not knowledge that's easy to show off, either, nor is it particularly
useful in day-to-day interactions.

So why would you ever want to study economics?

Study it because it interests you. Study it because monetary policy intrigues you, because
you want to know the causes of inflation, because you wonder how the market works so
flawlessly (or not), because you wish to comprehend socially applied concepts of efficiency,
because the concepts of supply and demand are beautiful to you, because you find the
analytical tools and theories of economics graceful, because you hope to learn more about the
market and the "invisible hand", because...

Why economics?
The world is made up of billions of people, each with their own motivations and beliefs. To try
to fully understand each individual would be a hopeless exercise in futility. Instead, the job of
the economist is to simplify the world to the point where we can say something interesting
about it. When building a model, it is always my hope that the interesting bit of information
I walk away with will, by some miracle, still be useful when applied to the real world, which is
anything but simple.
Note that I haven't said anything about an economy, money, or trade yet. You'll read quite a
bit about those topics in this book, but they are not as essential to economics as you might
think. Economics is the study of people and choice. It's a methodology. It's a way of thinking
about the world. If the authors have done their job, you'll walk away from this text with a new
perspective on the world and a deeper understanding of how choices are made.
Good luck!
 Principles of Macroeconomics

Content Page No.

1. National Income…………………………………………………………………..1

2. Money and Banking……………………………………………………………55

3. Determination of Income and Employment………………………..82

4. Government Budget………………………………………………………….120

5. Balance of payments…………………………………………………………146

Important Questions……………..…………………………..……….…..170
Guidelines for Project Work in Economics…………….………….179
Formulae (Aggregated)……………………………………………...…….184
 Syllabus
Unit 1: National Income and related aggregates

Some basic concepts: consumption goods, capital goods, final goods, intermediate goods; stocks
and flows; gross investment and depreciation.

Circular flow of income; Methods of calculating National Income – Value Added or Product
method, Expenditure method, Income method.

Aggregates related to National Income: Gross National Product (GNP), Net National Product
(NNP), Gross and Net Domestic Product (GDP and NDP) - at market price, at factor cost; Real and
Nominal GDP. GDP and Welfare

Unit 2: Money and Banking

Money - its meaning and functions.

Supply of money - Currency held by the public and net demand deposits held by
commercial banks.

Money creation by the commercial banking system.

Central bank and its functions (example of the Federal Reserve Bank): Bank of issue, Govt. Bank,
Banker's Bank, Controller of Credit through Bank Rate, CRR, SLR, Repo Rate and Reverse Repo
Rate, Open Market Operations, Margin requirement.

Unit 3: Determination of Income and Employment

Aggregate demand and its components. Propensity to consume and propensity to save (average
and marginal).

Short–run equilibrium output; investment multiplier and its mechanism.

Meaning of full employment and involuntary unemployment.

Problems of excess demand and deficient demand; measures to correct them - change in
government spending, taxes and money supply.

Unit 4: Government Budget and the Economy

Government budget - meaning, objectives and components.

Classification of receipts - revenue receipts and capital receipts; classification of expenditure -
revenue expenditure and capital expenditure.

Measures of government deficit - revenue deficit, fiscal deficit, primary deficit their meaning.

Unit 5: Balance of Payments

Balance of payments account - meaning and components; balance of payments deficit-meaning.

Foreign exchange rate - meaning of fixed and flexible rates and managed floating.

Determination of exchange rate in a free market.

Principles of Macroeconomics
 Principles of Macroeconomics

1 National Income and Related Aggregates

Learning Objectives

1. Introduction
2. Importance of Macroeconomics
3. Capital Goods and Consumer Goods
4. Investment
5. Depreciation
6. Stock and Flow
7. Economic Territory
8. Various Models of Circular Flow of Income
9. Aggregates related to national Income
10. Methods of Measurement of national Income
11. Value Added(Production) Method
12. Problem of Double Counting
13. Income Method
14. Domestic Income v/s National Income
15. Expenditure Method
16. GDP and Welfare
 Principles of Macroeconomics

It is that part of economic theory which studies the economy in its aggregate level or as a
whole. It is also known as theory of Income and Employment.

Importance of Macroeconomics
(i) It describes the how the economy as a whole functions and how the level of national
income and employment is determined on the basis of aggregate demand and
aggregate supply.
(ii) It helps to achieve the goal of economic growth, higher level of GDP and higher level
of employment.
(iii) It helps to bring stability in price level and analyses fluctuations in business activities.
You are about to enter the world of national income, the most important concept of
macroeconomics. Increasing national income is the ultimate goal of all planning, government
budgeting, government policies and development studies. Income is the most attractive world
among people, and probably the ultimate goal of all activities carried out by them. You, as a
student, must also be having the goal of earning good income, besides the desire for acquiring
knowledge. The income earning activity by an individual is a micro activity. The income earning
activity of all the individuals of a nation taken together is a macro activity. Our attention, in the
next few chapters, will mainly be on measurement of this activity.
In this chapter, we will study a number of concepts essential for estimating the national income
of a country.
Macroeconomics is the study of economic aspects of the country as a whole. The studies
concerning national income, employment, inflation, government budget, balance of
payments, are all macroeconomic studies.

In economics, a good is defined as any physical object, natural or man-made, or service

rendered, that could command a price in the market. Note two things. First, good includes both
physical objects and services. Second, it commands a price in the market. A good with the
second characteristics is called an ‘economic good’.
The term ‘goods’ is used to cover both goods and services throughout the study. Sometimes, to
distinguish between physical object and services, the term ‘goods’ is used for physical objects
only. This point must be kept in mind.
 Principles of Macroeconomics
Goods purchased, or own produced, for satisfaction of wants are called consumption goods.
Purchases of food, clothes, vehicles, furniture, etc. by families, called households in economics,
are consumption goods. Such goods, own-produced by families by commanding a price in the
market, are also consumer goods. Also, included are the services provided by the government
to the households free of cost.

Classification

Consumption goods are further classified into durables and non-durables. Goods which yield
services overtime are durable consumer goods. Washing machines, TV sets, cars, etc. in
households are some examples. Goods completely used up at the moment of use are non-
durable consumer goods. Food items, electricity, domestic services, etc. are some examples.
These are also called singles-use consumer goods.

CAPITAL GOODS
Goods capable of being used for producing other goods are called capital goods. These goods
are used for generating income. All purchases by production units, i.e. by factories, shops,
commercial institutions, etc. used for producing other goods are some examples. Such goods,
when self-produced, are also capital goods.

Classification

Capital goods are also classified into durables and non-durables. Buildings, machinery, vehicles,
etc. providing services overtime to the production units are some examples of durable capital
goods. Stocks of raw materials and goods are examples of non-durables. These are also called
singles-use capital goods.

INVESTMENT
Addition made to the stock of capital during a period is called investment. It is also called
capital formation.

Capital vs. Investment

Capital and investment both compose of capital goods but are different in the accounting
sense. Production units purchase new capital goods every year. These go on accumulating
year after year. The accumulated stock of capital goods at the beginning of the year is called
capital. But the capital goods added to this ‘capital’ during the year, is called investment.

Suppose, capital of a firm at the beginning of the financial year is $ 10 millions and at the end of
the year $ 11 millions. This addition of $ 1 millions during the year is investment. The beginning
of the year capital is $ 10 millions and the end of the year capital is $ 11 millions.
 Principles of Macroeconomics

Fixed and stock Investment

There are two components of investment: (i) investment in fixed capital, (i.e. durable) called
fixed investment and (ii) investment in stock of raw materials, semi-finished goods and finished
goods called stock investment.

Gross vs. Net Investment

A distinction is made between gross investment and net investment. It is based on the concept
of depreciation as explained below.

Depreciation
The term ‘depreciation’ is also known by an alternative name, ‘Consumption of fixed capital’.
This alternative name indicates clearly the meaning of depreciation. It refers to the fall in the
value of fixed capital goods due to normal wear and tear and foreseen obsolescence. By
normal wear and tear, we men the fall in value due to normal use in production. Foreseen
obsolescence means fall in value due to expected changes in technology, market demand,
government’s policy, etc. Continuous changes in technology make the machines used in
previous technology obsolete and may have to be abandoned even when they are still in
working condition and their technical lives are still not over. The same may happen if changes in
market demand or government policies are expected after some time. However, if the value of
an assets falls due to unforeseen obsolescence, or due to natural calamities like floods,
earthquakes, etc., or due to thefts, etc., it is called capital loss and not depreciation.
Unforeseen obsolescence may be due to unexpected changes in technology, market conditions,
government policies, etc.

Gross vs. Net Investment: The distinction

Total addition of capital goods to the existing stock of capital during a time period is gross
investment. But during the same time period a part of the existing stock of capital wears out
due to its use in production. This is, what is termed as depreciation, or consumption of fixed
capital. In this way, gross investment is addition to the capital stock, while depreciation is the
deduction from this capital stock. By subtracting depreciation from gross investment, we get
net investment.
Gross investment – depreciation =Net investment
 Principles of Macroeconomics
Net investment is a measure of the net availability of new capital after taking into account the
wear and tear and foreseen obsolescence of the existing capital.
Intermediate products refer to those goods and services which are purchased during the year
by one production unit from other production units and completely used up, or resold, during
the same year. This definition indicates two characteristics of intermediate product. (1)
Purchased by one production unit from another production unit, and (2) used up or resold,
during the same year, i.e., the year of purchase.
Let us explain the meaning of second characteristic. ‘Used up’ means transformed into other
products, or added to stocks. For example, suppose a printer buys paper suppose that only
paper worth $ 40000 is actually used up during the year. Now, in the accounting sense, the
remaining $ 10000 worth of paper is added to the closing stock. This addition to the closing
stock is an investment, called ‘investment in stock’. In this sense, the entire $ 50000 worth of
paper is completely used up in the process of production in the year 2009-10. Out of this $
40000 worth of paper is transformed into books and the remainder worth $ 10000 is
automatically added to stocks and so used up for investment. So, this purchase of $ 50000
worth of paper during 2009-10 is one of the intermediate cost of the printer.
What is the meaning of ‘resold’?
Take the case of a trader. Generally, traders buy goods and sell them without making any
alteration. This is what your grocery shop does in your area. This type of activity is nothing but
reselling activity. As such, the goods like bread, butter, cold drinks, etc. purchased by the grocer
are all intermediate products. All these purchases are either resold, or added to the closing
stock, i.e. used for investment.
Here, it is necessary to point out that not all purchases by a production unit from other
production units are intermediate products, because not all of them are necessarily or
completely used up or resold in the process of production during the year in the sense
described above. For example, machines, tools, vehicles, etc., called as fixed capital goods,
purchased by production units for own use are not completely used up during the year. Their
life is generally more than one year. These are not intermediate products but final products.
Conceptually, only non-durable capital goods are treated as intermediate products. However, in
defense services there are some exceptions. In defence service services, some durable capital
goods are also treated as intermediate products. These include (i) the weapons of destruction
such as missiles, rockets, bombs, etc., and (ii) equipments needed to deliver them such as
vehicles, tanks, missile carriers and launchers, etc. These are treated as raw materials needed
for producing defence services.
Now, we can define ‘intermediate consumption’ in a more concrete manner:
 Principles of Macroeconomics
Intermediate consumption refers to the expenditure incurred by a production unit on
purchasing those goods and services from other production units, which are meant for resale
or for completely using up during the same year.

Goods and services purchased, or own produced, for the purpose of consumption and
investment are final goods or products. By consumption, we mean purchases for satisfaction of
human wants of both durable and non-durable producer goods and net addition to stocks.
The essential characteristic of final products is that these are acquired for own use and not for
resale. All goods and services acquired by consumers are treated as for their own use and not
for resale. All durable goods acquired by the producers are for their own use, I.e. Capital
formation and, therefore, are final products. In comparison, the intermediate products are
acquired for reselling either directly (as done by traders) or indirectly (by completely using
them in the process of production). When a product is not to be resold it reaches its final use
and, therefore, is called a final product.
Final expenditure refers to the expenditure on goods and services meant for final
consumption and investment.

It will be useful to note one aspect of intermediate and final products. It will help in the
identification of the two types of products. The aspect is that no good or service is either always
intermediate or always final. A good or a service may be intermediate for one purchaser and
final for another purchaser. Take, for example, purchase of milk. When purchased by a
household, it is a final product, and when purchased by a restaurant, it is an intermediate
product. The services of a self-employed mechanic when purchased by a household it is a final
product, but when purchased by a factory, it is an intermediate product. A cycle when
purchased by an individual it is a final product, and when purchased by a cycle dealer it is an
intermediate product. Services of a taxi when purchased by a household, is a final product, but
when purchased by a production unit, it is an intermediate product. The essential point to be
noted is that no good or service is final or intermediate in itself. It all depends on whether it is
purchased or own use or for resale.

Examples
Q. Which among the following are following are final and which are intermediate products?

i. A machine purchased for installation in a factory

ii. Fees paid to the lawyer by a producer
iii. Milk purchased by a hotel.
Answers
 Principles of Macroeconomics
i. A machine purchased for installation in a factory is a final product because
expenditure on machine is investment expenditure.
ii. Fees paid to the lawyer by a producer is an intermediate expenditure to the
producer. It is because the producer buys the services of a lawyer (another
producer) for completely using as in production during the year.
iii. Milk purchased by a hotel is intermediate product to the hotel because it is
purchased from another production unit for resale indirectly.

Stocks and Flows

In macroeconomics, we come across many variables like income, wealth, capital,
investment, etc. These can be classified into stocks and flows on the basis of the time
dimension attached to the value.

Stocks
Variables whose magnitude is measured at a particular point of time are called stock
variables.

For example, in business accounts, magnitude of capital employed by a firm is measured on the
last day of the financial year, say, and capital as on 31st March, 2008. This is the position of all
the variables entering into the balance sheet, i.e. all assets and liabilities. By this criterion,
capital, wealth, inventory, etc. are all stock variables.

Flows
Variables whose magnitude is measured over a period of time are called flow variables.

For example, when we talk of income, we say income during the month, or during the year.
Similarly, we describe the magnitudes of the variables like output, expenditure, investment,
intermediate costs, net change in stocks, etc.
The distinction between stocks and flows can be compared to still camera and video camera.
Like in case of stocks, still camera records the position of an object at a particular moment. Like
flows, video camera records position of an object during a period of time.

Relation between stocks and flows

Stocks and flows are interrelated. For example, capital is a stock variable and use of capital
gives rise to the output, which is a flow variable. The use of stocks gives rise to flow. It is not a
one-way relationship. Output is a flow and is partly used for consumption and partly for
investment. Investment gets added to the capital and capital is a stock. Thus flows affect stocks.
 Principles of Macroeconomics

ECONOMIC TERRITORY
The United Nations System of National Accounts, briefly called SNA, defines economic
(or domestic) territory as that geographic territory administered by a government within
which persons, goods and capital circulate freely.

Accordingly, the scope of economic territory of a country is defined to include and exclude the
following:
a) Political frontiers including territorial waters and airspace.
b) Embassies, consulates, military bases, etc. located abroad (but excluding the foreign
ones located within its own political frontiers).
c) Ships, aircrafts, etc. operated by the residents between two or more countries.
d) Fishing vessels, oil and natural gas rigs etc. operated by residents in the international
waters or other areas over which country enjoys exclusive rights or jurisdiction.
Economic territory of a country is different from its political frontiers, i.e. geographic territory.
As we have seen, it excludes some areas political frontier of the country in question and
includes certain areas outside its own political frontier. The scope of economic territory is based
on economic criterion.

RESIDENT
National income measure the value of economic activities carried out by the residents of a
country. It is, therefore, first necessary to understand the meaning of the term ‘resident’ of a
country. A resident is defined as follows:

A resident, whether a person or an institution, is one whose Centre of economic interest lies in
the economic territory of the country in which he lives or is located.
By Centre of economics interest it is meant that (a) the resident lives or is located within the
economic territory and (b) the resident carries out the basic economic activities from that
location.
Resident vs. Citizen: There is a difference between the terms resident and citizen (or national).
A person becomes a national of a country because he was born in the county or on the basis of
some other legal criterion. A person is treated resident of a country on the basis of economic
criterion stated above. It is not necessary that a resident must also be the national of that
country. Even foreigners can be the residents if they pass the above stated economic test. For
 Principles of Macroeconomics
example, a large number of Indian nationals have settled in U.S.A countries. For India, they are
Non-Resident Indians (NRI) but continue to remain Indian nationals.
Examples of non-residents: The following categories of institutions and persons are not treated
as residents of the country in which they are situated or living. It is because they do not fulfil
the criterion of ‘Centre of economic interest’.
1) International organisations like the World Bank, World Health Organisaiton, I.M.F., I.L.O.
etc., are not treated residents of any country but of “international area”. For the
country in which these are situated, are non-resident organisaions.
2) Employees of international organisations are considered residents of the countries to
which they belong and not of the ‘international area’.
3) Workers from across the border who cross borders regularly to work in the given
country are treated as residents of the country where they live and not the resident of
the country where they work.
4) Foreign visitors or travelers visiting the given country for studies, medical treatment,
recreation, to take part in sports, cultural events, etc. are non-residents for the country
they are visiting.
5) Foreign staff of embassies and members of foreign armed forces located in the given
country are treated as non-residents.
6) The crews of foreign ships, aircrafts etc. are treated as non-residents.

Examples
Q.1. Are the following normal residents of US economy?

(i) Americans employed in the World Health Organisation located in USA.

Final Goods and Intermediate Goods

Final Goods:
Final goods refer to those goods which are used either for consumption or for investment.

Final Goods include:

(i) Goods purchased by consumer households as they are meant for final consumption (like milk
purchased by households).
 Principles of Macroeconomics

(ii) Goods purchased by firms for capital formation or investment (like machinery purchased by
a firm).

It must be noted that final goods are neither resold nor used for any further transformation in
the process of production.

Intermediate Goods:
Intermediate goods refer to those goods which are used either for resale or for further
production in the same year.

Factor Payment and Transfer Payment

The difference between the two is whether or not the income (payment) received is for
rendering productive service.

Payment received in exchange for rendering productive service is factor income whereas the
one received without providing any service (or good) in return is transfer income. Mind national
income includes only factor incomes and not transfer incomes.

For further clarification, the two concepts are compared below:

Factor Payment (Income):
1. It comprises rent, wages, interest and profit.

2. It is received in return for rendering productive service.

3. It is an earned income (earning concept).

4. It is bilateral payment.

5. It is included in national income.

Transfer Payment (Income):

1. It comprises gifts, subsidies, donations, scholarships, etc.

2. It is received without providing any good or service in return.

 Principles of Macroeconomics

3. It is an unearned income (receipt concept).

4. It is unilateral payment.

5. It is not included in national income.

Circular flow of income

It refers to the continuous flow of goods and services and money income among different
sectors in the economy. It is circular in nature. It has neither any end and nor any
beginning point.

Various Models of Circular Flow of Income

Circular flow of income in a Two Sector Economy: In This sector the money income flows
from firm sector to the household sector. With this money, the households purchase from the
firms, manufactured goods and services to satisfy their wants with the result that the same
money flows back from households to the firm sector.

Aggregates related to National Income

Domestic Aggregates
 Principles of Macroeconomics

 Gross Domestic Product at Market Price (GDPMP) is the market value of

all the final goods and services produced by all producing units located in the domestic
territory of a country during an accounting year.
 Net Domestic Product (NDPMP): NDPMP = GDPMP – Depreciation (Consumption
of Fixed Capital.
 Domestic Income (NDPFC): It is the factor income accruing to owners of the
factors of production for supplying factor services within domestic territory during an
accounting year.

National Aggregates

 Gross national Product at Market Price (GNPMP): is the market value

of all the final goods and services produced by normal residents (in the domestic
territory and abroad) of a country during an accounting year.

GDPMP + NFIA = GNPMP

 National Income (NNPFC) : It is the sum total of all factor income which are
earned by normal residents of a country in the form of wages, rent, interest and
profit during an accounting year.

Methods of Measurement of National Income

Income Method Expenditure Method Value Added Method

Formulae of National Income

National Income (NNPFC)

Conversion
Gross = Net + Dep. MP = FC + NIT
Net = Gross – Dep. FC = MP – NIT
Dep. = Gross – Net NIT = IT – Subsidies
 Principles of Macroeconomics

Dep. / Consumption of Fixed Capital

Dep. = Gross Capital Formation – Net Capital Formation
National = Domestic + NFIA
Domestic = National – NFIA

NFIA = Factor Income from Abroad – Factor Income to Abroad

Abbreviations
Dep. = Depreciation
MP = Market Price
FC = Factor Cost
NIT = Net Indirect Taxes
IT = Indirect Taxes
NFIA = Net Factor Income from abroad
NNPFC = Net National Product at Factor Cost

Value Added or Production Method (GVAMP)

(GVAMP) = Sales + Change in Stock – Intermediate Consumption

Value of Output = Sales + Change in Stock (Closing Stock –

Opening Stock)
 Principles of Macroeconomics

(GVAMP) = Value of Output – Intermediate Consumption/Cost

Value of Output = Production of Three Sectors

(Primary + Secondary + Tertiary)

{GVAMP = Gross Value Added at Market Price}

Intermediate Consumption = Intermediate Consumption of

Three Sectors (Primary + Secondary + Tertiary)

Problem of Double Counting

Counting the value of a commodity more than once while estimating national income is
called double counting. It leads to overestimation of national income. So, it is called problem
of double counting.

Domestic Income or Income Method (NDPFC)

(A) Compensation of Employees

Wages/Salary Social Securities Schemes by Employers

(B) Operating Surplus

Rent Interest Profit Royalty

 Principles of Macroeconomics

Dividend Corporate Undistributed

Tax Profit

(C) Mixed Income

NDPFC = (A) + (B) + (C)

NDPFC = Net Domestic Product at Factor Cost

Domestic Income v/s National Income

GDP and Welfare

In general GDP and welfare are directly related with each other. A higher GDP implies that
more production of goods and services. It means more availability of goods and services. But
more goods and services may not necessarily indicate that the people were better off during
the year. In other words, a higher GDP may not necessarily mean higher welfare of the people.
There are two types of GDP, (1) Nominal GDP and (2) Real GDP.

Real GDP
When the goods and services are produced by all producing units in the domestic territory of
a country during an accounting year and valued at base year’s price or constant price, it is
called real GDP or GDP at constant prices. It changes only by change in physical output not by
change in price level. It is called a true indicator of development.

Nominal GDP
When the goods and services are produced by all producing units in the domestic territory of
a country during an accounting year and valued these at current year’s price or current
 Principles of Macroeconomics
prices, it is called Nominal GDP or GDP at current prices. It is influenced by change in both
physical output and price level. It does not consider a true indicator of economic development.
Conversion of Nominal GDP into Real GDP
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
Real GDP = x 100
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥

Price Index plays the role of deflator deflating current price estimates into constant price
estimates. In this way it is called GDP Deflator.

Welfare
Welfare means material wellbeing of the people. It depends on many economic factors like
national income, consumption level quality goods etc. and non-economic factor like
environmental pollution, law and order etc. The welfare depends on economic factors is called
economic welfare and the welfare which depends on non-economic welfare is called social
welfare. Thus GDP and welfare directly related each other.

Expenditure Method (GDPMP)

(A) Government Final Consumption Expenditure

(B) Private Final Consumption Expenditure

(C) Gross Domestic Fixed Capital Formation

(Gross Fixed Capital Formation +Change in Stock)

(D) Net Export (Export – Import)

Note: Change in Stock = Closing Stock – Opening Stock

 Principles of Macroeconomics

GDPMP = (A) + (B) + (C) + (D)

GDPMP = Gross Domestic Product at Market Price

Treatment of Different Items in National Income and Domestic Income

Some of the major items whether included or excluded in national income are as follows:

1. Construction of a new house.

Ans: Yes, it will be included in the national income as it is a part of capital formation and leads
to production of goods and services in the economy.

2. Winning of a lottery prize.

Ans: No, it will not be included in the national income as it does not add to the flow of goods
and services in the economy.

3. Increase in the prices of stocks lying with a trader.

No, it will not be included in the national income as it does not amount to any flow of goods.

4. National debt interest or Interest on public debt.

Ans: No, it is not included in the national income as it is the interest paid on loans taken by
government to meet its consumption purposes.

5. Rent-free house given to an employee by an employer.

Ans: Yes, it is included in the national income by Income Method since it is a part of ‘wages in
kind’ paid to employees.
 Principles of Macroeconomics

6. Profit earned by foreign banks in India.

Ans: No, it is not included in the national income as it is a part of the factor income paid abroad.
It is subtracted from domestic income to get national income.

7. Purchases by foreign tourists or Food purchased by a foreign tourist at a hotel

in New Delhi.

Ans: Yes, purchases by foreign tourists are ‘exports’ and, therefore, they are included in the
national income through the Expenditure Method.

8. Rent received by Indian residents on their buildings rented out to foreigners in

India.

Ans: Yes, it will be included in the national income as it is a part of the factor income from
abroad.

9. Payment of fees to a lawyer engaged by a firm.

Ans: It is an intermediate expenditure for the firm because it involves purchase of services by

one production unit (firm) from another production unit (lawyer). So, it is deducted from the
value of output of the firm to arrive at the value added. So, it is not included in national income.

10. Free medical facilities by the employer or free boarding and lodging provided to
a domestic servant.

Ans: Yes. It will be included in national income as these free services are part of compensation
to employees.

11. Gifts received from abroad or Gift received from employer.

 Principles of Macroeconomics

Ans: National income as gifts received are transfer incomes.

12. Profits of Reliance Industries from its chemicals business in Australia.

Ans: Yes, it will be included in the national income as it is a part of the factor income from
abroad.

13. Salaries received by US residents working in Russian Embassy in USA.

Ans: Yes, it will be included in the national income as it is a pan of factor income from abroad.

14. Subsidized lunch served to workers in a factory or Firm incurred expenditure

on medical treatment of employee’s family.

Ans: Yes, it is a part of the compensation of employees and, therefore, it will be included in the
national income.

15. Old age pension

Ans: No, it will not be included in the national income as it is a transfer payment made by the
government and a transfer income for the receiver.

Old age pension must not be confused with retirement pension. Old age pension is not included

in national income as it is a transfer payment. On the other hand, retirement pension is

included in national income as it is a part of COE.

16. Durable goods purchased by a household or Purchase of car by a household.

Ans: Yes, it will be included in the national income as it is a part of the private final consumption
expenditure.
 Principles of Macroeconomics

17. Profits earned by an US bank from its branches abroad.

Ans: Yes, they will be included in the national income as they are a part of the factor income
from abroad.

18. Earnings of shareholders from the sale of shares.

Ans: No, it will not be included in the national income as it is a financial claim and does not
contribute to any productive activity.

19. Expenditure on advertisement by a firm or Commodities used in scientific

research.

Ans: No, it will not be included in the national income as it is a part of intermediate
consumption expenditure.

20. Petrol used in police vehicles.

Ans: No, it will not be included in national income as petrol is an intermediate good in this case.
It is used for the provision of the final product (maintenance of law and order by the police).

21. Financial help received by flood victims.

Ans: No, it will not be included in the national income as it is a transfer income.

22. Purchase of a machine by a factory or Purchase of a new taxi by a taxi-driver.

Yes, it will be included in the national income as it is a part of the gross domestic capital
formation.

23. Royalty
 Principles of Macroeconomics

Ans: Yes, it will be included in the national income as royalty is a productive income.

24. Commission on sale of second-hand goods or Brokerage payment on sale of

shares.

Ans: Yes, it will be included in the national income as it is the income of a middleman for his
productive services to various parties.

25. Dividend received by an American from his investment in shares of a foreign

company.

Ans: Yes, it will be included in the national income as it is factor income from abroad.

26. Purchase of raw materials by a production unit or Milk purchased by a Sweet

shop to make milk-cake.

Ans: No, it will not be included in the national income as it is a part of the intermediate
consumption expenditure.

27. Earnings of a self-employed doctor having a clinic at his own residence.

Ans: Yes, it will be included in the national income as it is a mixed income.

28. Money received from sale of second-hand goods or Money received by

government from sale of a public sector firm to a private owner.

Ans: hand goods are by virtue of transfer of an already existing object.

29. Imputed rent of self-occupied houses.

 Principles of Macroeconomics

Yes, it will be included in the national income as people living in such houses enjoy housing
services similar to those in rented houses.

30. Contribution to provident fund by employer or Value of interest foregone on

loans provided by employer to employee.

Yes, it will be included in the national income as it is a part of the compensation to employees.

31. Wheat grown by a farmer but used entirely for family’s consumption.

Ans: Yes, it is included in the national income because it adds to the current flow of goods and
services. Therefore, its imputed value should be included.

32. Expenditure on the construction of a flyover by the government.

Ans: Yes, it will be included in the national income as it is a part of gross domestic capital
formation.

33. Commission received by a dealer from the buyer and seller of a house.

Ans: Yes, it will be included in the national income as it is the income of the dealer for his
productive services.

34. Growing vegetables in a kitchen garden of the house.

Ans: No, it will not be included in the national income as it is difficult to estimate the value of
production (It is a non-market transaction).

35. Services rendered by family members to each other

 Principles of Macroeconomics

Ans: No, it will not be included in the national income as it is difficult to determine the value of
services provided by family members to each other.

36. Expenditure by government in providing free education or Expenditure on free

services provided by government.

Ans: Yes, it will be included in the national income as it is a part of the government final
consumption expenditure.

37. Insurance premium paid by employees or Fees received from student.

Ans: Yes, it is included in the national income as it is a part of the private final consumption
expenditure.

38. Mineral wealth of a nation.

Ans: It is a part of National wealth and is not included in national income. However, that part of

mineral wealth which has been extracted during the current year will be included in national
income under the product method.

39. Value of wood purchased for manufacturing a table or Expenditures on the

purchase of cold drinks by a school canteen from the manufacturer or Transport

expenses by a firm.

Ans: No, it will not be included in the national income as it is a part of intermediate
consumption expenditure.

40. Purchase of equipment’s for installation in a factory.

Ans: Yes, it will be included in the national income as it is a part of capital formation.
 Principles of Macroeconomics

41. Payment of wealth tax or Payment of Death duty.

Ans: No, it will not be included in the national income as it is a compulsory transfer payment to
the government.

42. Entertainment tax received by the government.

Ans: No, it will not be included in the national income as it is an indirect tax and a compulsory
transfer payment received by the government.

43. Salaries paid to Russians working in American Embassy in Russia.

Ans: No, it is not included in the national income as it is a part of the factor income paid abroad.
It is subtracted from domestic income to get national income.

44. Capital gains to US residents from sale of shares of a foreign company.

Ans: No, capital gains will not be included in the national income as they do not add to the
current flow of goods and services in the economy.

45. Harish works in India and sends money to his family in USA.

Ans: No, it will not be included in the national income as it is a transfer payment.

46. Destruction of building due to an earthquake.

Ans: No, it will not be included in the national income as it will not affect national product
directly.

47. HP uses its own new Laptops in its office for self-consumption.
 Principles of Macroeconomics

Ans: Yes, it is included in the national income as it adds to current flow of goods and services.
Therefore, imputed value of laptops should be included.

48. Purchase of a truck to carry goods by a production unit.

Ans: Yes, it will be included in the national income as it is a part of the gross domestic capital
formation.

49. Direct purchase made abroad by government.

Ans: Yes, it will be included in the national income as it is a part of the government final
consumption expenditure.

50. Earning from a part time job in McDonalds by a student.

Ans: Yes, it is included in the national income as it is an income received for productive services.

Exercise

Multiple Choice Questions

Q.1. which one of the following is a final expenditure:

(a) Purchased computer by school.

(b) Purchased scooter by scooter dealer.
(c) Purchased vegetable by restaurant.
(d) Purchased milk by tea shop

Q.2. which one of the following is a flow variable.

 Principles of Macroeconomics
(a) Capital formation (b) Change in inventory
(c) GDPMP (d) All the above

Q.3. When goods and services are produced in a year valued at current prices
years prices is called

(a) Real GDP (b) GDP at constant prices

(c) National product (d) GDP at current prices

Q.4. Which is not a component of NFIA?

(a) Net compensation of employees

(b) Net income from property and entrepreneurship
(c) Net retained earnings of resident companies abroad
(d) Net export

Short Questions
1. What is the difference between intermediate goods & final goods?
2. Why are the imports subtracted when GDP is calculated in expenditure approach?
3. If you woke up in the working & found that nominal GDP has doubled overnight, what
statistic would you need to check before you began to celebrate. Why?
4. What does the consumer price index measure?
5. What are the principal difference between government purchases of goods & service and
transfer payments?
6. Define production as an income generating activity.
7. What do you mean by inventory investment?
8. Why the national income is measured at factor prices and not at market prices?
9. Define GDP deflator as a measure of inflation.
10. Explain why we cannot calculate the national product simply by adding up the production of
all firms.
11. Why do the economists use real GDP rather than nominal GDP to gauge economic well-
being?
12. Why do you think households’ purchase of new housing is included in the investment
components of GDP rather than the consumption component?

Long Questions
1. What is the difference between GDP & GNP? Which one is the better measure of income?
Why?
 Principles of Macroeconomics
2. What is GDP deflator and how does it differ from the consumer price index?
3. Discuss the three approaches of measuring national income? Show that these three
approaches give identical result.
4. Discuss critically GDP as a measure of economic welfare.
5. Derive saving- investment identify in the context of an open economy.
6. From national income accounting show that an increase in taxes (while transfer unchanged)
must imply a change in net exports, government purchases or the saving investment balance.

Numerical Questions

Value Added or Production Method

1. Calculate net value added at market price of a firm.

ITEMS ($ in millions)
i. Sale 700
ii. Change in stock 40
iii. Depriciation 80
iv. Net in direct taxes 100
v. Purchasse of machinery 250
vi. Purchase of intermediate product. 400

Value of Output = Sale + change in stock

( 700 + 40=740)
NVA at mp = Value of output - purchase of intermediate product - depreciation

740 - 400 - 80 = $ 260 millions

2. Calculate net value added at market price of a firm.

ITEMS ($ in millions)
i. Sale 300
ii. Change in stock -10
iii. Depreciation 20
iv. Net in direct taxes 30
v. Purchase of machinery 100
vi. Purchase of intermediate product. 150

Value of output : - Sale + Change in stock ( 300+(-)10 = $ 290 in miilions)

Gross Value added at mp = Value of output - Purchase of intermediate product.
290 - 150 = $ 140 millions
 Principles of Macroeconomics
Net Value added at mp = Gross Value added at mp - Depreciation

140 - 20 = $ 120 thousands

3. Calculate net value added at market price of a firm.

ITEMS ($ in millions)
i. Sale 800
ii. Change in stock -30
iii. Depreciation 70
iv. Net in direct taxes 80
v. Purchase of machinery 150
vi. Purchase of intermediate product. 450

Value of output = Sale + Change in stock

800 + (-) 30 = $ 770/-
Gross Value added at mp = Value of Output - Purchase of intermediate product.
770 - 450 = $ 320/-
Net Value added at mp = Gross Value added at mp - Depreciation

Ans. 320 - 70 = $ 250/- thousand.

4. Calculate net value added at market price of a firm.

ITEMS ($ IN MILLIONS)
i. Value of output 400
ii. Change in stock 50
iii. Depreciation 20
iv. Net in direct taxes 25
v. Intermediate cost 200
vi. Export 10

Ans. $ 180 Millions.

5. Calculate Gross value added at factor cost of a firm.

ITEMS ($ IN MILLIONS)
i. Value of output 300
ii. Change in stock 30
iii. Depreciation 20
iv. Net in direct taxes 30
v. Intermediate cost 200
vi. Export 15

Ans. $ 70 Millions.
 Principles of Macroeconomics

6.Calculate net value added at market price of a firm.

ITEMS ($ IN MILLIONS)
i. Value of output 200
ii. Change in stock 30
iii. Depreciation 25
iv. Net in direct taxes 20
v. Intermediate cost 100
vi. Export 15

Ans. $ 55 Millions.

5. Calculate net value added at market price of a firm.

ITEMS ($ IN MILLIONS)
i. Sale 250
ii. Change in stock 30
iii. Depreciation 20
iv. Net in direct taxes 20
v. Purchase of Intermediate mediates product. 120
vi. Purchase of machines 300

Ans. $ 140 Millions.

8 . Calculate net value added at factor cost of a firm.

ITEMS ($ IN MILLIONS)
i. Sale 140
ii. Change in stock (-)10
iii. Depreciation 20
iv. Export 7
v. Intermediate cost 90
vi. Subsidies 5
vii. Import of raw material 3

Ans. $ 25 Millions

9. Calculate net value added at market price of a firm.

ITEMS ($ IN MILLIONS)
i. Sale in domestic market. 250
ii. Opening stock. 20
ii. Closing in stock 50
 Principles of Macroeconomics
iii. Depreciation 15
iv. Net in direct taxes 25
v. Intermediate cost 200
vi. Export 10

Ans. $ 160 Millions

10. Calculate ' net value added at factor cost' from the following data.
ITEMS ($ IN MILLIONS)
i. Sale 700
ii. Purchase of machine for installation in the 100
factory
iii. Subsidies 50
iv. Change in stock. (-) 30
v. Purchase of raw material 400
vi. rent 60
vii. Consumption of fixed capital 20

Ans. $ 300 Millions.

11. Calculate ' net value added at factor cost' from the following data.
ITEMS ($ IN MILLIONS)
i. Sale 800
ii. import of material. 500
iii. Subsidies 50
iv. Change in stock. 40
v. Purchase of raw material from domestic 450
market.
vi. Wages and salaries 200
vii. Consumption of fixed capital 60

Ans. $ 380 Millions.

12. Calculate net value added at market price.

ITEMS ($ in millions)
i. Deprecation 700
ii. Output sold 900
iii. Price per unit of output 40
iv. Closing stock 1,000
v. Opening stock 800
vi. Sale tax 3,000
 Principles of Macroeconomics
vii. intermediate cost. 20,000

Ans. $ 15,500 millions

13.Calculate ' gross value added at factor cost' from the following data: -

ITEMS ($ IN MILLIONS)
i. Unit of output sold. 2000
ii. Price per unit of output 20
iii. Subsidies 3000
iv. Change in stock. (-) 500
v. Intermediate cost. 15,000
vi. Consumption of fixed capital 2,000

Ans. $ 27,50 Millions

14.Calculate ' Net value added at factor cost' from the following data.

ITEMS ($ IN MILLIONS)
i. Price per unit of output, 25
ii. Output sold. 1,000
iii. Excise duty 5,000
iv. Depreciation 1,000
v. Change in stock (-) 500
vi. Intermediate cost 7,000

Ans. $ 300 Millions.

15. Calculate net value added at FC from the following.

ITEMS ($ in millions)
i.Purchase of material 30
ii.Depreciation 12
iii.Sales 200
iv.Excise tax 20
v.Opening stock 15
vi.Intermediate consumption 48
vii.Closing stock 10

Ans. NVA at FC =200 + 10 – 12 -15 -48 = $ 115 millions.

16. From the following data about firm ‘x’, calculate gross value added at FC by it.
 Principles of Macroeconomics
ITEMS ($ in thousands)
i.Sales 500
ii.Opening Stock 30
iii.Closing stock 20
iv.Purchase of intermediate products 300
v.Purchase of machinery 150
vi.Subsidey 40

Ans. Gross value added = (i) + (iii – ii) – (iv)

=500 + (20 – 30) – 300 = $ 190
Gross value added at FC = 190 + 40 subsidy = $ 230 thousands.

17. From the following data about firm ‘A’, calculate net value added at market price by it.

ITEMS ($ in thousands)
i.Sales 700
ii. Change in stock 40
iii. Depreciation 80
iv. Net indirect taxes 100
v. Purchase of machinery 250
vi. Purchase of intermediate products 400

Ans. NVA at MP = (700 + 40) – 400 – 80 = $ 260 thousands.

18.Calculate gross value added at FC from the following data.

ITEMS ($ in millions)
i. Consumption of fixed capital 5
ii. Sales 100
iii. Subsidies 2
iv. Closing stock 10
v. Purchase of row materials 50
vi. Opening stock 15
vii. Indirect taxes 10

Ans. GVA at MP = 100 + 10 -15 - 50 = $ 45

GVA at FC = 45 + 2 – 10 = $ 37 millions.

19.From the following data, calculate gross value added at FC.

ITEMS ($ in millions)
i. Sales 180
 Principles of Macroeconomics
ii. Rent 5
iii. Subsidies 10
iv. Change in stock 15
v. Purchase of row materials 100
vi. Profits 25

Ans. GVA at FC = 180 + 15 -100 + 10 = $ 105 millions.

20.From the following data, calculate gross value added at FC.

ITEMS ($ in millions)
i. Net indirect taxes 20
ii. Purchase of intermediate products 120
iii. Purchase of machines 300
iv. Sales 250
v. Consumption of fixed capital 20
vi. Change in stock 30

Ans. GVA at FC = 250 + 30 – 120 – 20 = $ 140 millions.

21.Calculate net value added at MP from the following data.

ITEMS ($ in millions)
i. Depreciation 5
ii. Sales 100
iii. Opening stock 20
iv. Intermediate consumption 70
v. Excise duty 10
vi. Change in stock -10

Ans. NVA at MP = 100 + (-10) – 70 – 5 = $ 15 millions

22.From the following data relating to a firm, calculate net value added at FC.

ITEMS ($ in millions)
i. Subsidy 40
ii. Sales 800
iii. Depreciation 30
iv. Exports 100
v. Closing stock 20
vi. Opening stock 50
vii. Intermediate purchases 500

Ans. NVA at FC = 800 + 20 – 50 – 500 + 40 – 30

= $ 280 millions. (Exports are a part of sale.)
 Principles of Macroeconomics

23.Calculate value of output from the following data.

ITEMS ($ in millions)
i. Net value added at FC 100
ii. Intermediate consumption 75
iii. Excise duty 20
iv. Subsidy 5
v. Depreciation 10

Ans. Value of output = 100 + 75 + 20 – 5 + 10 = $ 200 millions.

24.Calculate intermediate consumption from the following data.

ITEMS ($ in millions)
i. Value of output 200
ii. Net value added at FC 80
iii. Sale tax 15
iv. Subsidy 5
v. Depreciation 20

Ans. Gross value added = Value of output – Intermediate consumption

Intermediate consumption = Value of output (at MP) – Gross value added at MP
=200 – (80 + 20 + 15 – 5) = $ 90 millions.

25.Calculate sales from the following data.

ITEMS ($ in millions)
i. Net value added at FC 300
ii. Intermediate consumption 200
iii. Indirect tax 20
iv. Depreciation 30
v. Change in stocks (-) 50

Ans. Gross value added at MP = Sales + Changes in stocks – Intermediate consumption

Sale = (NVA at FC + Depreciation + Indirect tax) – Change in stocks
+ Intermediate consumption
=(300 + 30 + 20) – (-50) + 200
= $ 600 millions.

26.Calculate Net Value Added at FC from the following data.

ITEMS ($ in millions)
 Principles of Macroeconomics
i. Depreciation 20
ii. Intermediate cost 90
iii. Subsidy 5
iv. Sales 140
v. Exports 7
vi. Change in stock (-) 10
vii. Import of raw material 3

Ans. NVA at FC = 140 + (-10) – 90 + 5 – 20 = $ 25 millions.

(Note: Sales include exports also and Intermediate cost includes import of raw material.)

27.From the following about firm x, calculate NVA at FC.

ITEMS ($in millions)

i. Purchase of raw material 500
ii. Gross capital formation 200
iii. Subsidies 60
iv. Opening stock 50
v. Sales 800
vi. Net capital formation 180
vii. Closing stock 40

Ans. NVA at FC = 800 + (40 – 50) – 500 – dep. (200 – 180) + 60

= $ 330 millions

28.From the following information about firm ‘x’, calculate value added at factor cost.

ITEMS ($ in millions)
i. Purchase of raw material 500
ii. Gross capital formation 200
iii. Subsidies 60
iv. Opening stock 50
v. Sales 800
vi. Net capital formation 180
vii. Closing stock 40

Ans. NVA at FC = 800 + (40 – 50) – 500 – DEP. (200 – 180)

= $ 330 millions.

29.From the following data, calculate gross value added at FC.

 Principles of Macroeconomics

ITEMS ($ in millions)
i. Sales 180
ii. Rent 5
iii. Subsidies 10
iv. Change in stock 15
v. Purchase of raw material 100
vi. Profits 25

Ans. Gross VA at FC = 180 + 15 – 100 + 10 = $ 105 millions

30. From the following data , calculate gross value added at FC.

ITEMS ($ in millions)
i. Net indirect taxes 20
ii. Purchase of intermediate products 120
iii. Purchase of machines 300
iv. Sales 250
v. Consumption of fixed capital 20
vi. Change in stock 30

Ans. Gross VA at FC = 250 + 30 – 120 – 20 = $ 140 millions

31.Calculate Net Value Added at MP from the following data.

ITEMS ($ in millions)
i. Depreciation 5
ii. Sales 100
iii.Opening stock 20
iv.Intermediate consumption 70
v. Excise duty 10
vi. Change in stocks 10

Ans. Net VA at MP = 100 + (-10) – 70 -5 =15 millions

32.From the following data relating to a firm, calculate net value added at FC.
 Principles of Macroeconomics

ITEMS ($ in millions)
i. Subsidy 40
ii. Sales 800
iii. Depreciation 30
iv. Exports 100
v. Closing stock 20
vi. Opening stock 50
vii. Intermediate purchase 500

Ans. NVA at FC = 800 + 20 – 50 – 500 + 40 – 30

= $ 280 millions ( Exports are a part of sale.)

33.Calculate value of output from the following data.

ITEMS (Rs. in millions)

i. Net value added at FC 100
ii. Intermediate consumption 75
iii. Excise duty 20
iv. Subsidy 5
v. Depreciation 10

Ans. Value of output = 100 + 75 + 20 – 5 + 10 = 200 millions

(Note: value of output always means value of gross output at MP unless stated otherwise.)

34.Calculate intermediate consumption from the following data.

ITEMS ($ in millions)
i. Value of output 200
ii. Net value added at FC 80
iii. Sale tax 15
iv. Subsidy 5
v. Depreciation 20

Ans. Gross value added = Value of output – Intermediate consumption

Intermediate consumption = Value of output (at MP) – Gross value added at MP
= 200 – (80 + 20 + 15 – 5)
= $ 90 millions.

35.Calculate sales from the following data.

ITEMS ($ in millions)
i. Net value added at FC 300
ii. Intermediate consumption 200
 Principles of Macroeconomics
iii. indirect tax 20
iv. Depreciation 30
v. Change in stocks (-) 50

Ans. Gross value added at MP = sales + Change in stocks – Intermediate consumption

Sales = (NVA of FC + depreciation + indirect tax) – Change in stocks + Intermediate
consumption
= (300 + 30 + 20) – (-50) + 200
= $ 600 millions

36.Calculate Net Value Added at FC from the following data.

ITEMS ($ in millions)
i. Depreciation 20
ii. Intermediate cost 90
iii. Subsidy 5
iv. Sales 140
v. Exports 7
vi. Change in stock (-) 10
vii. Import of raw material 3

Ans. NVA of FC = 140 + (-10) -90 + 5 – 20 = $ 25 millions

(Note: Sales include exports also and intermediate cost includes import of raw materials.)

37.Calculate value of output from the following.

ITEMS ($ in millions)
i. Net value added at FC 200
ii. Intermediate consumption 150
iii. Excise duty 40
iv. Subsidy 10
v. Depreciation 20

Ans. Value of output = 200 + 150 + 40 – 10 +20 = $ 400 millions

(Value of output means value of gross output at MP)

38.Calculate intermediate consumption from the following data.

ITEMS ($ in millions)
i. Value of output 400
ii. Net value added at FC 160
iii. Depreciation 40
iv. Subsidy 10
v. Sale tax 30
 Principles of Macroeconomics
Ans. Intermediate consumption
= Value of output (at MP) – gross value added (at MP)
= 400 – (160 + 40 + 30 – 10) = $ 180 millions.
39.Calculate sales from the following data.

ITEMS ($ in millions)
i. Net value added at FC 600
ii. Intermediate Consumption 400
iii. Indirect tax 40
iv. Change in stocks -100
v. Depreciation 60

Hint. Gross value added at MP = Sales + Change in stock – intermediate consumption

Sales = Gross value added at MP – change in stock + intermediate consumption
= (600 + 60 + 40) – (-100) + 400
= 700 + 100 + 400 = $ 1200 millions

40.Calculate value of output from the following.

ITEMS ($ In millions)
Net value added at FC 200
Intermediate consumption 150
Excise duty 40
Subsidy 10
Depreciation 20

Ans. Value of output = 200 + 150 + 40 – 10 + 20 = $ 400 millions

Income Method
1. From the following data calculate national income, domestic income.

ITEMS ($ In Millions)
i.Rent 5,000
ii.Wages 30,000
iii.Interest 8,000
iv.Surplus of public sector 15,000
v.Profit tax 2,000
vi.Personal tax 1,500
vii.Mixed income 4,000
viii.Undistributed profit 3,000
ix.Transfer payment by government 10,00
x.Dividend 12,000
 Principles of Macroeconomics
xi.Net assets income from abroad 7,000
xii.Transfer from abroad 2,500

Ans. National Income = Rent + Wages + interest + mixed income + profit tax + dividend + undistributed
profit + surplus of public sector + net assets income from abroad.
= 5,000 + 30,000 + 4,000 + 2,000 + 12,000 + 3,000 +15,000 + 7,000
= $ 86,000 millions
Domestic Income = National Income – net assets income from abroad
= 86,000 – 7,000 = $ 79,000 millions

2. From the following data find out (a) NNP at MP.

ITEMS ($ In millions)
GDP at FC 2,570
Indirect taxes 850
Subsidies 125
Net factor income from abroad -5
Savings of non-departmental enterprises 15
Income from property and entrepreneurship 10
accruing
to Govt. administrative departments 100
Consumption of fixed capital 290
Interest on public debt 60
Current transfer from government 245
Other current transfers from the rest of the world 310
Corporation tax 190
Savings of private corporate sector 85
Direct taxes paid by households 500

Ans. NNP at MP = 2,570 + 850 – 125 – 5 – 290 = $ 3,000 millions

3. Calculate national income from the following.

ITEMS ($ in millions)
i Rent 80
ii. Interest 100
iii.Profits 210
iv.Tax on profits 30
v.Employees contribution to S.S. schemes 25
vi.Mixed income of self-employees 250
vii.Net indirect taxes 60
viii.Employer’s contribution to S.S. schemes 50
 Principles of Macroeconomics
ix.Comprensation of employees 500
X.Net factor income from abroad (-) 20

Ans. Domestic income = 80 + 100 + 210 + 250 + 500 = $ 1,140

National income = 1,140 + (-20) = $ 1,120 millions

4. From the following data calculate GNP at MP via the income method.

ITEMS ($ in millions)
i. Wages and salaries 700
ii.Rent 100
iii.Depreciation 50
Iv.Net factor income from abroad -10
v.Mixed income 400
vi.Subsidies 100
vii.Profits 400
viii.Indirect taxes 300
ix.Employers contribution to S.S. Schemes 50
x.Interest 40

Ans. NDPFC = 700 + 100 + 400 + 50 + 40 = $ 1,690

GDPMP =1,690+ 50 – 100 + 300 = $ 1,940
GNPMP = 1,940 +(-) 10 = $ 1,930 millions

5. Calculate ‘Net Domestic Product at Market Price’.

ITEMS ($ in millions)
i.Income from domestic product accruing to 120
government
ii.Wages and Salaries 400
iii.National debt Interest 60
iv.Profit 200
v.Net factor income to abroad (-) 20
vi.Rent 100
vii.Current transfers from government 30
viii.Interest 150
ix.Social security contribution by employers 50
x.Net indirect tax 70
xi.Net current transfer to abroad (-) 10

6. From the following data, Calculate National Income.

ITEMS ($ IN Millions)
i. Compensation of employee 1200
 Principles of Macroeconomics
ii. Rent. 400
iii. Profit 800
iv. CFC 300
v. M I 1000
Vi. Private income 3600
vii. NFIA -50
viii. Net retained earnings of private enterprises. 200
ix. Interest 250
x. N I T 350
xi. Net Export. -60
xii. Direct txes 150
Xiii. Corporation tax. 100

Ans. $ 3600 Millions.

7. From the following data, Calculate National Income.

ITEMS ($IN Millions)

i. Compensation of employee 800
ii. Rent. 300
iii. Profit 700
iv. C F C 80
v. M I 600
Vi. Private income 2500
vii. NFIA -50
viii. Net retained earnings of private enterprises. 50
ix. Interest 500
x. N I T 150
xi. Net Export. -40
xii. Direct taxes paid by household 70
Xiii. Corporation tax. 100

Ans. $ 2850 Millions.

8. From the following data, Calculate National Income.

ITEMS ($ IN Millions)
i. Compensation of employee 1000
ii. Rent. 200
iii. Profit 500
iv. C F C 100
v. M I 800
Vi. Private income 2000
 Principles of Macroeconomics
vii. NFIA -50
viii. Net retained earnings of private enterprises. 150
ix. Interest 250
x. N I T 160
xi. Net Export. -40
xii. Direct taxes paid by household 120
Xiii. Corporation tax. 200

Ans. National Income $ 2700 Millions

9. From the following data, Calculate National Income.

ITEMS ($ IN Millions)
i. Compensation of employee 600
ii. Rent. 100
iii. Profit 80
iv. C F C 50
v. M I 200
Vi. Current transfer from government 25
vii. NFIA (-) 10
Viii . Interest 120
ix. N C T from ROW 20
x. N I T 110

10. Calculate "Gross national product at market price from the following data.

ITEMS ($ IN Millions)
i. Corporation tax 35
ii. Wages and salaries. 200
iii. National debt interest 25
iv. Operating surplus. 400
v. N C T from abroad. 15
vi. Net factor income from abroad. (-) 10
vii. C F C 20
viii. Social security contribution by employers 30
ix. Net indirect taxes 40
x. C T from Govt. 5
xi. Net domestic product at factor at cost 500
accruing to private sector.
 Principles of Macroeconomics

11. Find Gross National Product at market price.

ITEMS ($ IN Millions)
i. Compensation of employee 4,000
ii. Rent 800
iii. Profit 1,500
iv. Undistributed profit 400
v. M I 1,800
Vi. Net export - 30
Vii. Net domestic capital formation. 900
viii. Gross domestic capital formation 1,000
IX. Change in stock 50
x. Interest 900
xi. N I T 500
xii. NCT from ROW 60
xiii. N F I A - 80

12. Calculate National Income from the following data by Income and Expenditure method.

ITEMS ($ IN Millions)
i. Interest 150
ii. Rent 250
iii. G F C E 600
iv. P F C E 1200
v. Profit 640
vi. C Employee 1000
vii. N F I A 30
Viii. N I T 60
IX. N C T from R O W -40
X. C F C 50
xi. Net domestic capital formation. 340

13. Calculate gross domestic product at MP and Factor income from abroad.

ITEMS ($ IN Millions)
i. Profit 500
ii. Export. 40
iii. Compensation of employee 1500
iv. Gross National product at factor cost. 2800
v. N C T from ROW 90
vi. rent 300
vii. Interest 400
 Principles of Macroeconomics
viii. Factor Income from Abroad 120
ix. N I T 250
x. Net domestic capital formation. 650
xi. Gross fixed capital formation. 700
Xii. Change in stock. 50

14. Calculate gross domestic product at MP and Factor income from abroad.

ITEMS ($ IN Millions)
i. Compensation of employee 1,000
ii. Net Export. -50
iii. Profit, 400
iv. Interest 250
v. Rent 150
vi. Gross National product at factor cost. 1850
vii. Gross domestic capital formation. 220
viii. net fixed capital formation 150
ix. Change in stock. 20
x. Factor Income from Abroad 30
Xi. N I T 100

15. From the following data calculate (a) Gross domestic product at MP and Factor income
from abroad.

ITEMS ($ in Millions)
i. Gross National product at factor cost. 6150
ii. Net Export. -50
iii. Compensation of employee 3000
iv.Rent , 800
v. Interest, 900
vi. Profit, 1300
vii. N I T 300
viii. Net domestic capital formation. 800
ix. Gross fixed capital formation 850
x. Change in stock. 50
Xi. dividend 300
xii. Factor Income from Abroad 80

Ans. $ 6400 millions (b) $ 130 Millions.

16. Calculate (a) Net domestic product at factor Cost.

ITEMS ($ in Millions)
i. Domestic product accruing to govt. sector 300
 Principles of Macroeconomics
ii. Wages and Salaries 1000
Iii Net current transfer to abroad. - 20
iv. Rent 100
v. Interest paid by the production unit 130
Vi. National debt interest 30
vii. Corporation tax 50
viii. Current transfer by government. 40
ix. Contribution to social security scheme by 200
employers
x. Dividends 100
xi. Undistributed profit 20
xii. Net factor income to abroad. 0

Ans. $ 1600 millions

17. Calculate (a) Net National product at MP from the following data.

ITEMS ($ in Millions)
i. N C T to abroad. 30
ii. M I 600
iii. Subsidies 20
iv. Operating surplus 200
v. National debt interest. 70
vi. Net factor income to abroad. 10
vii. Compensation of employee. 1400
viii. Indirect taxes 100
ix. Domestic product accruing to government. 350
x. Current transfers by government. 50

Ans. $ 2270 millions

18. Calculate: (a) 𝐆𝐃𝐏𝐌𝐏 and (b) 𝐍𝐍𝐏𝐅𝐂 from the following data.
ITEMS ($ in millions)
Net indirect taxes 38
Consumption of Fixed Capital 34
Net factor income from abroad (-)3
Rent 10
Profits 25
Interest 20
Royalty 5
Wages and salaries 170
Employer’s contribution to S.S. schemes 30
 Principles of Macroeconomics
Ans. (a) NNPFC = (-3) + 10 + 25 + 20 + 5 + 170 + 30 = $ 257 millions

(b) GDPMP = 257 + 38 + 34 – (-3) = $ 332 millions

19. Calculate National Income from the following.

ITEMS ($ in millions)
Mixed Income of self-employed 200
Old-age pension 20
Dividends 100
Operating surplus 900
Wages and salaries 500
Profits 400
Employer’s contribution to S.S Schemes 50
Net factor Income from abroad (-)10
Consumption of Fixed Capital 50
Net indirect taxes 50

Ans. Domestic Income = 200 + 900 + 500 + 50 = $ 1,650 millions

National Income = 1, 650 + (-10) = $ 1,640 millions

20.Calculate National Income from the following.

ITEMS ($ in millions)
Rent 80
Interest 100
Profits 210
Tax on profits 30
Employees contribution to S.S Schemes 25
Mixed Income of self-employed 250
Net indirect taxes 60
Employer’s contribution to S.S schemes 50
Compensation of employees 500
Net factor Income from abroad (-)20

Ans. Domestic Income = 80 + 100 + 210 + 250 + 500 = $ 1,140 millions

National Income = 1,140 + (-20) = $ 1,120 millions

21. Calculate' Gross National product at Market Price' by the production method and Income
method.

ITEMS ($ in Millions)
i. Value of output of the primary sector 1000
 Principles of Macroeconomics
ii. Indirect taxes 200
Iii Compensation of employee 780
iv. Net factor income from abroad. 100
v. Intermediate purchase by all the sector 2900
Vi. Rent 300
vii. Value of output by secondary sector 2000
viii. Subsidies 50
ix. Interest 600
x. Consumption of fixed capital. 120
xi. Value of output of the secondary sector 3000
xii. Profit 320
xiii. Mixed income of self employed 830
Ans. $ 3000 millions.

Expenditure Method
1.Calculate (a) GDP at MP (b) GNP at MP from the following data.
ITEMS ($ in millions)
Personal consumption expenditure 27,500
Government consumption expenditure 3,000
Gross domestic fixed capital formation 2,500
Import of goods and services 500
Net factor income from abroad (-)250
Subsidy 250
Fall in stock 300
Export of goods and services 450
Depreciation 1,000
Net indirect taxes 1,000

Ans. (a) GDP at MP = $ 32,650 millions

(b) GNP at MP = $ 32,400 millions

2. Calculate GDP on the basis of the following data.

ITEMS ($ in millions)
Governmental final consumption expenditure 43,201
Private final consumption expenditure 52,302
Gross fixed capital formation 5,109
Change in stocks 2,055
Exports of goods and services 1,861
Imports of goods and services 1,920
 Principles of Macroeconomics
Ans. GDP = $ 1,02,608 millions

3. From the following data, calculate: (i) 𝐆𝐃𝐏𝐌𝐏 (ii) 𝐆𝐃𝐏𝐅𝐂 (iii) 𝐍𝐃𝐏𝐅𝐂 and (iv) 𝐍𝐍𝐏𝐅𝐂 .
ITEMS ($ in millions)
Personal consumption expenditure 45,000
Government consumption expenditure 5,000
Gross domestic fixed capital formation 1,000
Exports 6,000
Imports 3,000
Net indirect taxes 3,500
Consumption of Fixed Capital 4,500
Change in stocks 1,000
Net factor income from abroad (-)2,000
Ans. (i) GDPMP = $ 55,000 millions (ii) GDPFC = $ 51,500 millions

(iii) NDPFC = $ 47,000 millions (iv) NNPFC = $ 45,000 millions

4.Calculate NDP at MP.

ITEMS ($ in millions)
Government consumption expenditure 250
Private consumption expenditure 350
Change in stocks 40
Gross fixed investment 200
Depreciation 60
Net exports 70
Net indirect taxes 50
Income from domestic product to government 20
sector
Corporate tax 60
Undistributed profit 30
Current transfer from abroad (net) 20
Personal taxes 60

Ans. (i) NDP at MP = $ 850 millions

5.Calculate (a) GNP at MP and (b) NNP at Fc from the following data.
ITEMS ($ in millions)
Gross domestic capital formation 94
Net exports (- )6
Private final consumption expenditure 260
Net factor income from abroad (-) 3
Consumption of fixed capital 39
Net change in stocks 11
 Principles of Macroeconomics
Net indirect taxes 43
Government final consumption expenditure 47

Ans. (a) GNP at MP = $ 392 millions

(b) NNP at FC = $ 310 millions

6. Calculate (a) GNP at MP and (b) NNP at FC from the following data.
ITEMS ($ in millions)
Government final consumption expenditure 24
Net indirect taxes 23
Consumption of fixed capital 22
Gross domestic capital formation 24
Net exports (-)4
Private final consumption expenditure 161
Net factor income from abroad (-)1
Net change in stocks 3

Ans. (a) GNP at MP = (i) + (iv) + (v) + (vi) + (vii)

= 24 + 24 + (-4) + 161 + (-1) = $ 204 millions

(b) NNP at FC = GNP at MP – (ii) – (iii)

= 204 – 23 – 22 = $ 159 millions

7. Calculate (a) GNP at MP and (b) NNP at FC from the following data.
ITEMS ($ in millions)
Government final consumption expenditure 50
Net exports (-)7
Gross domestic capital formation 100
Net indirect taxes 47
Private final consumption expenditure 265
Net change in stocks 13
Net factor income from abroad (-)5
Consumption of fixed capital 45

Ans. (a) GNP at MP = (i) + (ii) + (iii) + (v) + (vii)

= 50 + (-7) + 100 + 265 + (-5) = $ 403 millions

(b) NNP at FC = GNP at MP – (viii) – (iv)

= 403 – 45 – 47 = $ 311 millions

 Principles of Macroeconomics
8. Calculate GNP at Fc from the following data.
ITEMS ($ in millions)
Net domestic capital formation 350
Closing stock 100
Government final consumption expenditure 200
Net indirect taxes 50
Opening stock 60
Consumption of fixed capital 50
Net exports (-)10
Private final consumption expenditure 1,500
Imports 20
Net factor income from abroad (-)10

Ans. GDP at MP = 350 + 200 + 50 + (-10) + 1,500 = $ 2,090 millions

GNP at FC = 2,090 – 50 + (-10) = $ 2,030 millions

9. Calculation NDP at FC from the following data:

ITEMS ($ in millions)
Private final consumption expenditure 400
Gross domestic capital formation 100
Change in stocks 20
Direct purchases from abroad by resident 50
households
Net indirect taxes 60
Net factor income from abroad 10
Direct purchases by non-residents in domestic 150
market
Net exports (-)20
Consumption of fixed capital 20
Government final consumption expenditure 100

Ans. GDP at MP = 400 + 100 + 50 – 150 – 20 + 100 = $ 480 millions

NDP at FC = 480 – 60 – 20 = $ 400 millions

10. From the following data, Calculate National Income.

ITEMS ($ IN Millions)
i. N C T from ROW 10
 Principles of Macroeconomics
ii. Private final consumption expenditure 600
iii. National debt interest 15
Iv. Net export (-) 20
v. C T from government. 5
Vi. Net domestic product at factor cost accruing 25
to government.
Vii. Government final consumption expenditure 100
viii. Net indirect taxes, 30
ix. Net domestic capital formation, 70
x. Net factor income from abroad. 10

11. From the following data, Calculate National Income.

ITEMS ($ IN Millions)
1. N C T from ROW 5
2. Private final consumption expenditure 300
3. N F income to abroad. 10
4. Govt. final consumption expenditure 100
5. Subsidies 20
6. Net domestic fixed capital formation. 80
7. Indirect taxes 70
8. Net export -40
9. Change in stocks 20
10. Current transfer from govt. 15

12. From the following data, calculate ' National income' by (a) Income method (b)
Expenditure method.
ITEMS ($ IN Millions)
1. Interest 150
2. Rent. 250
3. Government final consumption expenditure 600
4. Private final consumption expenditure 1200
5. Profit 640
6. Compensation of employees 1000
7. Net factor income from abroad. 30
8. N I T 60
9. Net export. (-) 40
10. CFC 50
11. Net domestic capital formation. 340

13. Calculate National Income by Income method and Expenditure method.

ITEMS ($ in Millions)
 Principles of Macroeconomics
i. Profit 200
ii. Private final consumption expenditure 440
iii. Govt. final consumption expenditure. 250
iv. Compensation of employee. 350
v. Gross domestic capital formation. 90
vi. Interest , 20
vii. Net Export -20
viii. Interest 60
ix. Rent 70
x. Net factor income to abroad. 50
xi. N I T, 60

Ans. (a) $ 630 Millions

(b) $ 630 Millions.

14. Calculate National income by Income method and Expenditure method.

ITEMS ($ in Millions)
i. Government final consumption expenditure, 2000
ii. Net domestic capital formation 600
iii. Consumption of fixed capital 70
iv., Net export 60
v. Net indirect taxes, 200
vi. Private final consumption expenditure, 4000
vii. Net factor income to abroad. 60
viii. Compensation of employee, 3660
ix. Profit, 1500
x. Rent, 500

xi. Interest, 800

xii. divident 300

(a) $ 6400 Millions (b) $ 6400 Millions.

15. From the following data calculate Gross National Product at factor cost by (a) Income
method and (b) Expenditure method.

ITEMS (Rs. in Millions)

i. Government final consumption expenditure 200
ii. Private final consumption expenditure 400
iii. Profit 160
iv.Net indirect taxes 60
v. Rent 70
vi.Interest 50
 Principles of Macroeconomics
vii. Compensation of employee 300
viii. Export 65
ix.Import 95
x. Gross domestic capital formation 80

xi. Consumption of fixed capital 10

xi. Net factor income from abroad 50

16. Calculate National income by Income method and Expenditure method.

ITEMS ($ in Millions)
i. Profit, 200
ii. Private final consumption expenditure, 440
iii. Government final consumption expenditure, 250
iv., Compensation of employee, 350
v. Gross domestic capital formation, 90
vi. Consumption of fixed capital, 20
vii. Net export - 20
viii. Interest, 60
ix. Rent, 70
x. Net factor income from abroad, 50

xi. Net indirect taxes, 60

(a) $ 630 Millions (b) $ 630 Millions.

17. Calculate ' Net domestic product at factor cost' by the expenditure method and Product
method.

ITEMS ($ in Millions)
i. Value of output in the economic territory 4100
ii. Net export. -50
iii. Intermediate purchase by the primary sector. 600
iv. Private final consumption expenditure 1450
v. Intermediate purchase by the secondary sector 700
Vi. Government final consumption expenditure 400
vii. Net domestic capital formation 200
viii. Intermediate purchase by the territory 700
sector.
ix. Net change in stock -50
X. Indirect taxes 100
xi. Consumption of fixed capital. 50
 Principles of Macroeconomics

18. Calculate' National income' by the expenditure method and Income method.

ITEMS ($ in Millions)
i. Net Indirect taxes 120
ii. Net factor income to abroad. 10
Iii Wages salaries 320
iv. Rent 35
v. Wages and Salaries 40
Vi. Rent 15
vii. Private final consumption expenditure 500
viii. Interest 60
ix. Change in stock -10
x. Social security contribution by employers 30
xi. Government final consumption expenditure. 100
xii. Profit 50
xiii. Net Export. 0

Ans. $ 500 millions

Value based Questions
Q.1. A doctor treats his own son who is not well. Does this service have a value? Should it be included
in National Income?

This service does have a value but we do not include it in National Income because it is a unilateral
transaction or a transfer payment. *

Value: care & concern/empathy

Q.2. Production in an industry results in pollution around that locality. In such a situation, what
should the industry do?

Industries which create pollution should be situated outside city limits or should install pollution control
measures but it will increase the cost of production. *

Value: environmental awareness/social responsibility.

Q.3. The Govt. provides old age pension to people who have no source of income and are the
responsibility of the Govt. How is this justified?

Old age pension increases the expenditure of the Govt. resulting in a higher deficit in the budget. This is
a compulsory expenditure and cannot be avoided by the Govt. *

Value: social welfare.

 Principles of Macroeconomics
Q.4. Non Resident Indians send a lot of money to their families in India and it increases the foreign
exchange reserves of the country. Should this income be considered while calculating National
Income?

Only bilateral transactions or earned income is considered for national income. Hence remittances of
non-resident Indians are not considered.

Value: social responsibility/care & concern

Q.5. Govt. expenditure on maintaining the defence sector is large although we do not have a war
threat often. At the same time we have a large number of people below the poverty line. Is this
expenditure justified?

Govt. has to spend on both defence and in reducing poverty in the economy. Both are important areas
of expenditure and the Govt. has to balance between the two. *

Value: social welfare/national integrity & security

 Principles of Macroeconomics

2 Money & Banking

Learning Objectives

1. Definition
2. Evolution of Money
3. Barter System
4. Money and its Functions
5. Importance of Money and it’s Classification
6. Qualities of Good Money
7. Speculative Demand For Money
8. Money Supply
9. Determinants of Money Supply
10. Banking
11. Commercial Bank and its Functions
12. Credit creation or money creation by Commercial banks
13. Central Bank and its Functions

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 Principles of Macroeconomics

Money is defined as anything which is generally acceptable by the people in exchange of

goods and services or in repayments of debts.

Money is anything which is commonly accepted as a medium of exchange and in

discharge of debts. Money occupies a unique position in a modern economy. In its absence the
whole prosperous economic life would collapse like a pack of cards. Money is the most
important invention of modern times.

Money is the commonly accepted medium of exchange. Most definitions of money take
‘functions of money’ as their starting point. ‘Money is that which money does’. According to Prof.
Walker, ‘Money is as money does.’ This means that the term money should be used to include anything
which performs the functions of money, viz., medium of exchange, measure of value, unit of account
etc. Since general acceptability is the fundamental characteristic of money, therefore, money may be
defined as ‘anything which is generally accepted the people in exchange of goods and services or in
repayment of debts.’

EVOLUTION OF MONEY

Evolution of money was mainly through commodity money, metallic money, paper money and bank
money. Money is the most important invention of all in modern times. In earlier days human beings do
not exchange goods with the help of money rather than they exchange goods against goods called
Barter Exchange. The various types off commodities exchanged are called commodity Money. The
problem of uniformity of weight and purity of precious metals leads to evolution of paper money called
Currency Notes. Even paper money started becoming inconvenient because of time involved in counting
and space required for its safe keeping. This led to introduction of Bank Money (or credit money) in the
form of cheques, drafts, bill of exchange, credit cards, etc.

Briefly evolution of money was mainly through commodity money, metallic money, paper
money and bank money as explained below. In primitive age, goods were exchanged directly
for one another. Such exchange of goods for goods was called Barter Exchange. As transactions
increased the inconveniences and drawbacks of barter led to the gradual use of a medium of
exchange.
If we study history of money, we shall find that all sorts of commodities like seashells, pearls,
precious stones, tea, tobacco, cow, leather, cloth, salt, wine etc. have been used as a medium
of exchange (i.e, money) at different times. It is called Commodity Money. But in course of time
all other commodities were discarded in favour of gold and silver (i.e., metallic money). This
process was finally taken over by the state as one of its essential features and ultimately in 20 th
century commodity and metallic money gave way to Paper Money which means currency
notes. Nowadays use of paper money has almost become universal along with coins made of
copper, bronze or nickel etc. The process of evolution of some better medium of exchange still
continues. As the volume of transactions increased, even paper money started becoming

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 Principles of Macroeconomics

inconvenient because of time involved in its counting and space required for its safe keeping.
This led to introduction of Bank Money (or credit money) in the form of cheques, drafts, bill of
exchange, credit cards etc. These days plastic money in the form of debit cards is becoming
popular. Thus bank money has become most important form of money in modern times
because it is not only very convenient form of money for large payments but also eliminates
risks and is durable.

Inconveniences (problems) of barter exchange.

(i) Lack of double coincidence of wants. ‘Simultaneous fulfilment of mutual wants by buyers
and sellers’ is known as double coincidence of wants. There is lack of double coincidence in the
wants of buyers and sellers in barter exchange. The producer of jute may want shoes in
exchange for his jute. But he may find it difficult to get a shoemaker who is also willing to
exchange his shoes for jute. Thus a seller has to find out a person who wants to buy seller’s
goods and at the same time who must have what the seller wants. This is called double
coincidence of wants which is the main drawback of barter exchange.
(ii) Lack of common measure of value. In barter, there is no common measure (unit) of value.
Even if buyer and seller of each other commodity happen to meet, the problem arises in what
proportion the two goods are to be exchanged. Each article must have as many different values
as there are other articles for which it is to be exchanged. When thousands of articles are
produced and exchanged, there will be unlimited number of exchange ratios. Absence of a
common denominator in order to express exchange ratios create many difficulties. Money
obviates these difficulties and acts as a convenient unit of value and account.
(iii) Lack of standard of deferred payment. There is problem of future (or deferred) payments.
It is difficult to engage in contracts which involve future payments due to lack of any
satisfactory unit. As a result future payments are to be stated in term of specific goods or
services. But there could be disagreement about quality of the goods, specific type of the goods
and change in the value of the goods.
(iv) Difficulty in storing wealth (or generalised purchasing power). It is difficult for the people
to store wealth or generalise purchasing power for future use in the form of goods like cattle,
wheat, potatoes etc. Holding of stocks of such goods involve costly storage and deterioration.
(v)Lack of divisibility. How to exchange goods of equal value? The shoemaker wants a loaf in
exchange of his shoes but exchange value of a piece of loaf is but a fraction of a pair of shoes.
Shoes cannot be sub-divided without destroying their values. Similarly if a person cannot do so
without killing his cow. Thus lack of divisibility makes barter exchange impossible.
In order to overcome the above disadvantages of the barter system money was invented by the
society.

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 Principles of Macroeconomics

Functions of money
In general terms, main function of money in an economic system is “to facilitate the exchange
of goods and services and help in carrying out trade smoothly.” Its basic characteristic is general
acceptability. Functions of money are reflected in the well-known following couplet:

Functions of money

Primary functions Secondary functions

Medium Measure Standard of Store

Of exchange of value deferred of value
Payment

Thus conventionally money performs the following four functions (primary and secondary) each of
which overcomes one or the other difficulty of barter as explained below.

1. Money as the Medium of Exchange. Money came into use to remove the inconveniences of barter.
Medium of exchange is the basic or primary function of money. People exchange goods and services
through the medium of money. Money acts as a medium of exchange or as a medium of payments.
Money by itself has no utility (except perhaps to the miser). It is only an intermediary. The use of
money facilitates exchange, exchange promotes specialisation, specialisation increases productivity
and efficiency. A good monetary system is, therefore, of immense utility to human society. Money is
also called a bearer of options or generalised purchasing power because it provides freedom of
choice to buy things he wants most from those who offer best bargain.
2. Money as a Unit of Account or Measure of Value. Money serves as unit of account or a measure of
value. Money is the measuring rod, i.e., it is the unit in terms of which the values of other
commodities and services are measured, compared and expressed. Different goods produced in the
country are measured in different units, e.g., cloth in meters, milk in litres, and sugar in kilograms.
Without a common unit of measure, exchange of goods and services becomes very difficult. Values
of all goods and services can be expressed in a single common unit called money. Again without a
measure of value, there can be no pricing process. Without a pricing process, organised marketing
and production is not possible. Thus, the use of money as a measure of value is the basis of
specialised production. The measuring rod of money is also indispensable to all forms of economic
planning. Consumer compare the values of alternative purchases in terms of money. Producers
compare the relative costliness of the factors of production in terms of money and also plan their

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 Principles of Macroeconomics

output on the basis of the money yield. It is, Therefore, highly important that the value of money
should be stable.
3. Money as the standard of Deferred Payments. Debts are usually expressed in terms of the money
of account. Loans are taken and repaid in terms of money. The use of money as the standard of
deferred or delayed payments immensely simplifies borrowing and lending operations because
money maintains a constant value through time. Thus money facilitates the formation of capital
markets and the work of financial intermediaries like Stock Exchange, Investment Trust and Banks.
Money is the link which connects the values of today with those of the future. It has become
possible because value of money is stable and it has general acceptability and durability.
4. Money as a Store of Value. Wealth can be stored in terms of money for future. It serves as a store
value of goods in liquid form. Bu spending it we can get any commodity in future. Keynes places
great emphasis on this function of money. Holding money is equivalent to keeping a reserve of
liquid assets because it can be easily converted into other things. People, therefore, normally wish
to keep a part of their wealth in the form of money because savings (storing of value) in terms of
goods is very difficult. Wheat or any other product which will command a value cannot be stored for
a long period. The desire for money (cash) is known as liquidity preference. Clearly money is the
best form of store of value.

Importance of money in a modern economy

Importance (significance) of money. Money occupies a unique position in a modern capitalist
economy. In its absence, the whole prosperous economic life would collapse like a pack of cards. The
advantages or uses of money can be best understood by considering the system in which money is
absent. Although uses of money are manifold but a few of its important advantages are given below:
It helps in removing drawbacks of barter.

1. Money as medium of exchange solves the barter’s problem of lack of double coincidence of wants.
Money is accepted as medium of exchange. People exchange goods and services through medium of
money when they buy goods or sell products. Thus money acts as intermediary which solves barter’s
problem of lack of double coincidence of wants.
2. Money as measure (unit) of value or a unit of account solves the barter problem of lack of common
measure (unit) of value. Money measures exchange value of commodities and makes keeping of
business accounts possible.
3. Money as standard of deferred payments helps to solve the barter problem of lack of standard of
deferred payment. Again it helps to make contracts which involve future payments.
4. Money as store of value solves the barter problem of lack of storing wealth (or generalised
purchasing power).

Doubtlessly money helps in removing the difficulties of barter system

(i) It facilitates exchange of goods and services and helps in carrying on trade smoothly. The
present highly complicated economic system will not exist without money.

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(ii) Money helps in maximising consumers’ satisfaction and producers’ profits. It helps and
promotes saving.
(iii) Money promotes specialisation which increases productivity and efficiency.
(iv) It facilitates planning of both production and consumption.
(v) Money can be utilised in reviving the economy from depression.
(vi) Money enables production to take place in advance of consumption.
(vii) It is the institution of money which has proved a valuable social instruments of promoting
economic welfare. The whole economic science is based on money; economic motives and
activities are measured by money. In fact money makes its appearance in every phase of
economics.

Qualities of a Good Money

(i) General Acceptability: It is the very essence of money. Unless a person
knows that the money which he accepts in exchange for his goods or services, will
be taken without any objection by others.
(ii) Portability: A commodity fit to be used as money must be such that it can be
easily and economically transported from one place to another.
(iii) Durability: As money is passed from one hand to another hand and is kept in
reserve, it must not easily deteriorate, either in itself or as a result of wear and tear.
For example Indian currency notes is made up of Paper with cotton blend.
(iv) Divisibility: The money material should be capable of division and aggregate
value of the mass after division should be almost exactly the same as before.
(v) Stability of value: Money should not be subject to fluctuations in value.

Classification of Money
Money can be classified on different bases but we discuss below classification on the basis of
Relationship between (i) the value of money as money, and (ii) value of money as commodity.
1. Full bodied Money. It is the money whose value as a commodity (of which it is made of)
for non-monetary purposes is as great as its value as money. In other words, it is the
money whose face value is equal to its intrinsic value. We see that most of the earlier
commodity moneys like gold, silver, cattle etc. were as valuable for non-monetary
purposes as they were for monetary purposes. Another example of full-bodied money is
standard coins when the economy was on a metallic standard, i.e., gold coins in a gold
standard and silver coins in a silver standard. Standard coins refer to those coins whose
real or intrinsic value (i.e., value of the metal) is equal to the face (printed) value. For
instance, if value of metal used in a five rupee coin is equal to five USD, it will be called

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standard coin and recognised as full-bodied money is either metallic money or

representative money.
2. Representative Full-bodied Money. It is generally made of paper money. Although
paper money has no value as commodity but represents in circulation an amount of
money with a commodity value equal to the value of money. It is hundred per cent
backed up by a metallic reserve and is fully redeemable in some precious metal. It is
equivalent to a circulating warehouse receipt for full-bodied coins or their equivalent in
bullion. In other words, it is equivalent to the reserve kept in the form of gold and silver
and foreign currencies against the amount of notes circulated. This type of paper money
is called representative paper money, because it represents in circulation an amount of
money with commodity (gold, silver etc.) value equal to the value of money (otherwise
paper money itself has no value as a commodity). The benefit of representative paper
money is that it can be conveniently used in trade in which large sums of money are
required.
3. Credit Money. Credit money refers to money whose value as money is greater than the
commodity value of the material from which the money is made, e.g., token coins,
currency notes, cheques etc. Since it is made of cheap metal or paper, its official
purchasing power is higher than the value of metal or paper content. In day-to-day
language, bank money is called credit money which refers to bank deposits of the
people and which are payable on demand through cheque, bank drafts etc. Credit
money is of various forms as shown below.
(i) Token coins. Token money (or coins) refers to money whose face value is much
greater than its intrinsic value.
(ii) Representative token money. It is generally in the form of paper issued by
Government with the backing of an equivalent amount of bullion or token money.
This is, in effect, a circulating warehouse receipt for token coins or the bullion that is
backing it.
(iii) Circulating promissory notes issued by Central Bank.
(iv) Deposits in Bank. These deposits like savings deposits are claims of creditors against
banks which can be transferred from one person to another by means of cheques.
These chequable deposits are credit money because the bank does not back the
chequable deposits it has with an equal amount of financial assets or money. A
cheque is an instrument that instructs the bank to transfer funds from the cheque
issuer’s account to the cheque receiver. At the same time credit instruments are very
convenient for making payments. The risk of carrying large amounts of cash is
eliminated.
4. Fiat Money. Fiat money is any money backed by the order (fiat) of the government to
act as money. It is money with no intrinsic value. It is that type of paper money which is
inconvertible. It circulates in the country on the fiat (I.e. Command) of the state. Fiat

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money is generally created and issued by the government at the time of crisis like war or
emergency. Since it is issued, without any backing of gold, silver or other reserves,
therefore, it is inconvertible (not convertible) into anything than itself. It has no fixed
value in terms of nay objective standard leading sometimes to doubts about its
acceptability. For instance Mark issued in Germany just after First World War lost its
value so rapidly that it ceased to be generally acceptable. Fiat money is different from
Fiduciary money. Fiduciary money is the money which is accepted as money on the basis
of trust that the issuer commands, e.g., demand deposits of banks.
5. High Powered Money. High powered money or monetary base refers to the money
produced by Central Bank. Alternatively total liability of monetary authority of the
country and R.B.I. is called monetary base or high powered money (H). It consists of (i)
currency (notes and coins) in the hands of public (C), (ii) Cash reserve of commercial
banks (R) and (iii) Other deposits with R.B.I. (OD). Symbolically:
H=C + R= OD
High powered money is different from ordinary money (M1) which consists of (i) currency held
by public (C) , (ii) Demand deposits in banks (DD) and (iii) Other deposits with R.B.I. (OD) i.e.
M1=C +DD +OD. The only difference between the two (H and M1) pertains to their one
component. It is currency in circulation with the public (C) for high powered money but demand
deposits in banks (DD) for ordinary money. In high powered money if any person produces a
currency note to R.B.I., the latter must pay him value equal to the figure printed on the note.

Speculative demand for money

Speculative demand for money (𝐌𝐬𝐝 ). It is demand for money as ‘store of wealth’. Wealth can be held
(stored) in the form of landed property, bonds, money, bullion etc. For sake of simplicity all forms of
assets except money may be clubbed in a single category called bonds. Thus according to Keynes
there are two types of assets i.e. money and bonds. How to make best use of both considering if we
deposit cash in saving bank account, we earn interest and if we purchase bonds, we get monetary
return on it. People compare rate of return on bond with rate of interest on band deposits. It is
speculation about future changes (rise/fall) in interest rate and bond prices that the resulting
demand for money is called ‘speculative demand for money’. Clearly aim is to make money
(monetary gain) out of money.

Relationship between bond price and interest rate. Price of a bond is inversely related to market rate of
interest. How? Suppose $ 1000 bond yields fixed return of 10% per annum which means the bond has
fixed annual income of $ 100. Let us assume that rate of interest in saving bank account falls from 10%
to 8%. The question is how much money kept in bank will fetch interest of $ 100 (equal to return from
8
bond) after one year. Suppose x is the amount, then the amount will be 𝑥 X 100
=100 or x=1250. Clearly
Rs. 1250 kept in saving bank account will give the same return. (i.e. $ 100) as $ 1000 invested in bond.

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Naturally people will prefer to buy bond than to deposit cash in bank. Competition among buyers will
push up the price of $ 1000 bond (face value) to $ 1250. Hence conclusion is obvious. With fall in market
rate of interest (i.e. bank deposit interest), price of bond rises and vice versa. In other words price of
bond is inversely related to market rate of interest. Mind. Speculation about changes (rise/fall) in
interest rate and bond prices give rise to speculative demand for money.

(b)Relationship between speculative demand for money and rate of interest. Speculative demand for
money is inversely related to rate of interest i.e. higher the rate of interest, smaller will be speculative
demand for money and vice versa as proved above. Therefor curve of speculative demand for money is
downward sloping to right. There are two situations.

(i) If market rate of interest is very high and every one expects it to fall in future (i.e. rise in price of
bond) thereby anticipating capital gain from bond-holding, people will convert their money into bonds.
Thus speculative demand for money is low.

(ii) On the contrary if rate of interest is low and people expect it to rise in future (i.e. fall in price of
bond) anticipating capital loss from bond-holding, people convert their bonds into money in order ot
avoid future capital loss. They hold up money balance thinking that income from non-monetary assets
like bond will be low and so the cost of money holding will also be low. Thus speculative demand for
money becomes very high so much so that when rate of interest declines to minimum, say 3% as,
speculative demand for money becomes infinite (perfectly elastic). This pushes the economy into
liquidity trap and the speculative demand curve becomes flat.

Total demand for money (M𝑡d ) consists of transaction demand (including precautionary
demand) for money ((Mtd ) as a function of income and speculative (or assets) demand for money (Msd )
as a function of rate of interest. Symbolically:

M𝑡d = Mtd + Msd

Situation of liquidity trap

It is a situation of very low rate of interest where people expect the interest rate to rise in future and
bond prices to fall. Consequently it becomes totally un-attractive to invest money in bonds causing
capital loss. People withhold, as inactive balance, all money and nothing is invested. In such a
situation speculative demand for money is infinite making the demand curve a horizontal straight line
curve parallel to x-axis beyond point call it a situation of liquidity trap because expansion in money
supply gets trapped in the sphere of liquidity trap.

Money supply
The supply of money means the total stock of all the forms of money (paper money, coins and
demand deposits of banks) which are held by the public at any particular point of time. Two points
need to be noted in this connection: (i) Supply of money is a stock variable (not flow variable) because it

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is related to a point of time (not to period of time). (ii) Stock of money always refers to the stock of
money held by the public. Here the term public includes all economic units like households, firms, local
authorities, and non-departmental enterprises of government. The government and banking system are
not included in public as they are producers of money.

Remember, sources of money supply are (i) governments (which issues one Rupee note and all other
coins), (ii) Fed (which issues currency), and (iii) Commercial banks (which create credit on the basis of
demand deposits).

Measure of money supply (money stock)

Central Bank uses four alternative measures of money supply called as M1, M2, M3, and M4. Each
measure is briefly explained below. Among these measures, M1 is the most commonly used measure
of money supply because its components are regarded as most liquid assets.

(i) M1 = C + DD + OD. Here C denotes currency held by public, DD stands for demand deposits in bank
(interbank deposits are not included) and OD stands for other deposits with Central bank. Demand
deposits are deposits which can be withdrawn at any time on demand by account holders. Current
account deposits are included in demand deposits. But savings account deposits are not included in DD
because certain conditions are imposed on amount of withdrawal and number of withdrawals. OD
stands for other deposits with Central bank which includes demand deposits of Public Financial
Institutions (like Industrial Finance Corporation), demand deposits of foreign central banks and
international financial institutions (like IMF).

(ii) M2 = M1 (detailed above) + saving deposits with Post Office Saving Banks. (This is a broader concept
of money supply as compared to M1)

(iii)M3 = M1 + net Time-deposits with Commercial Banks (Data of 2003-2004 is shown below). (This is
also a broader concept of money supply as compared to M1)

(iv)M4 = M3 + total deposits with Post Office Saving Organisation (excluding NSC) (This is still broader –
broader than even M3)

In fact a great deal of debate is still going on as to what constitutes money supply. Savings deposits of
post offices are not a part of money supply because they do not serve as medium of exchange due to
lack of cheque facility. Similarly, fixed deposits in commercial banks is not counted as money. M1 and
M2 are known as narrow money whereas M3 and M4 are known as broad money. In practice, M3 is
widely used as measure of money supply which is also called aggregate monetary resources of the
society. All the above four measures represent different degrees of liquidity, with M1 being the most
liquid and M4 being the least liquid of all. It may be noted that liquidity means ability to convert an asset
into money quickly and without loss of value

Constituents (determinants) of money supply

We have read above alternative measures of money supply and its constituents. Let us for simplicity us
most liquid definition of money, viz., M1=C+DD+OD. Clearly money supply will change when magnitude
of its constituents (Such as C, DD or time deposit) changes. For instance changes in C (currency held by

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public), DD(net demand deposits in banks) and net time deposits of banks will cause changes in money
stock. In addition, various actions of Fed and commercial banks as well as ‘preference of the public for
holding cash balance vis-à-vis deposits in banks’ affect money supply. These are summarised in the form
of following key ratios.

Currency Deposit Ratio (Cdr). It is ratio of currency held by public to their holding of bank deposits.
Symbolically :
𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑤𝑖𝑡ℎ 𝑝𝑢𝑏𝑙𝑖𝑐
Cdr = 𝐵𝑎𝑛𝑘 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠

1 𝐶𝑑𝑟
For instance if a person gets Re. 1, he will put 1+𝐶𝑑𝑟 in bank account and keep Rs. 1+𝐶𝑑𝑟 in cash.
1 1 1
(1+c dr + 1+c dr + 1+c dr).

It shows people’s preference for liquidity (cash) which influences money supply.

Reserve Deposit Ratio (rdr). It is proportion (ratio) of total deposits which commercial banks keep as
reserves. Banks hold a part of money from peoples’ deposits as reserve money consists of (i) Vault cash
in banks and (ii) deposits of commercial banks in Fed. For convenience sake, suppose a bank has deposit
of $ 100 out of which it keep
$ 20 as reserve money (vault cash $ 15 + deposit with Fed $5) and loan out $ 80 (loan $ 30 + investment
$ 50). In this case rdr =20/100 =0.2. It may be added that in order to control and regulate money supply,
Fed uses various policy instruments such as Cash Reserve Ratio (CCR) and Statutory Liquid Ratio (SLR). In
addition to these ratios, Fed uses instrument of Bank Rate to control the value of rdr.

High Powered Money. The Total liability of the monetary authority of the country, Fed, is called the high
powered money or monetary base. It is the money created/produced by Central Bank. It consists of
currency (notes and coins) in circulation with the public and vault cash of commercial banks and
deposits held by government and commercial banks with Fed. It is high powered money because these
are liability of Fed to refund deposits on demand from the deposit holders. Again if a person presents a
currency note to Fed, the latter has to pay him value equal to the amount printed on the note.
Remember, Fed acquires assets against these liabilities.

In short, Fed regulates money supply by controlling stock of high powered money, bank rate and reserve
requirements of commercial banks.

Money creation by Fed. Suppose Fed wishes to increase money supply. For this it will inject
additional high powered money into the economy. Let us assume that Fed purchase gold. This results in
an increase in currency in circulation equal to $ 100 millions. Further suppose that Fed purchases
securities worth $ 400 millions in the open market. It will issue a cheque of at his account in, say, First
Century Bank which receives this amount. Clearly currency held by the public thus goes up. Here comes
the part played by money multiplier.

Money Multiplier. Money multiplier (m) is the ratio of total money supply (M) to the stock of high
powered money in the economy.

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Banking
Banking means the accepting, for the purpose of lending or investments, of deposits of
money from the public repayable on demand or otherwise, and withdrawable by cheques,
draft, order, etc.

Commercial Banks
A commercial bank is a financial institution which performs the function of accepting
deposits from the general public and giving loans for investment which the aim of earning
profit.

Example of Commercial banks in USA are: HSBC, Bank of America, First Century Bank etc.

Functions of Commercial Banks

(i) It accepts deposits
(ii) It gives loans and advances
(iii) Overdraft Facilities
(iv) Discounting bill of exchanges

LRR (Legal Reserve Ratio)

CRR (Cash Reserve Ratio) SLR (Statutory Liquidity Ratio)

BASIS FOR CRR SLR

COMPARISON
Meaning CRR is the percentage of money The bank has to keep a certain percentage of
which the bank has to keep with the their Net Time and Demand Liabilities in the
Central Bank in the form of cash. form of liquid assets as specified by Fed.

Form Cash Cash and other assets like gold and

government securities viz. Central and State
government securities.

Effect It controls excess money flow in the It helps in meeting out the unexpected
economy. demand of any depositor by selling the bonds.

Maintenance Central Bank of USA i.e. Fed Bank itself.

with

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Regulates Liquidity in the economy. Credit growth in the economy.

Credit creation or money creation by Commercial

Banks
Suppose a man, say X, deposits 2,000 with a bank and the LRR is 10%,which means the
bank keeps only the minimum required 200 as cash reserve (LRR).The bank can use the
remaining amount of 1800 (2000-200) for giving loan to someone. The bank lends 1800 to, say
Y who is actually not given loan but only demand deposit account is opened in his name and the
amount is credited to his account. This is the first round of credit creation in the form of
secondary deposit ($ 1800), which equals 90% of primary (initial) deposit. Again 10% of Y's
deposit (1800 - 180) is kept by - e bank as cash reserve (LRR) and the balance $ 1620 (1800 -
180) is advanced to, say, Z. The bank gets new demand deposit of $ 1620. This is second round
of credit creation which is 90% of first round of increase of $ 1800. The third round of credit
creation will be 90% of second round of $ 1620. This is not the end of story. The process of
credit creation goes on continuously till derivative deposit (secondary deposit) becomes zero. In
the end, volume of total credit created in this way becomes multiple of initial (primary) deposit.
The quantitative outcome is called money multiplier. If the bank succeeds in creating total
credit of, say, z $ 18000, it means bank has created 9 times of primary (initial) deposit of $
2000. This is what - meant by credit creation. In short, money (or credit) creation by commercial
banks is determined by (i) amount of initial (primary) deposits and (ii) LRR. The multiple is called
credit creation or money multiplier.

𝟏
Money Multiplier =
𝐋𝐑𝐑

Money Multiplier means the multiple by which total deposits increases due to initial deposit.

Central Bank

The Central Bank is the apex bank of monetary system of a country.

A central bank, reserve bank, or monetary authority is an institution that manages
a state's currency, money supply, and interest rates. Central banks also usually oversee
the commercial banking system of their respective countries. In contrast to a commercial
bank, a central bank possesses a monopoly on increasing the monetary base in the state, and
usually also prints the national currency, which usually serves as the state's legal tender.
Central banks also act as a "lender of last resort" to the banking sector during times of financial
crisis. Most central banks usually also have supervisory and regulatory powers to ensure the

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solvency of member institutions, prevent bank runs, and prevent reckless or fraudulent
behavior by member banks.
Central banks in most developed nations are institutionally designed to be independent from
political interference. Still, limited control by the executive and legislative bodies usually exists.

Difference between Repo Rate and Reverse Repo Rate

BASIS FOR REPO RATE REVERSE REPO RATE
COMPARISON
Meaning Repo rate is the rate at which the Central Reverse repo rate is the rate at
bank grants loan to the commercial which the commercial banks
banks for a short period against grant loan to the Central Bank.
government securities.
Purpose To fulfill the deficiency of funds. To ensure liquidity in the
economy.
Rate High Comparatively less.
Controls Inflation Money supply in the economy.
Charged on Repurchase Agreement Reverse Repurchase Agreement

Functions of Central bank

(i) Issue of currency: The central bank is given the sole monopoly of issuing currency
in order to secure control over volume of currency and credit. These notes circulate
throughout the country as legal tender money. Central Bank has to keep a reserve in the
form of gold and foreign securities as per statutory rules against the notes issued by it. It
may be noted that Central bank issues all currency notes.
(ii) Banker to the government: Central Bank functions as a banker to the
government. It means the central bank provides some banking facilities to the
government which commercial banks give to the public. It accepts deposits from the
government and gives loans to the government.
(iii) Banker’s bank & supervisor: There are usually hundreds of bank in our
country. There should be some agency to regulate and supervising their proper
functioning. This duty is discharged by the central bank. Central bank acts as banker’s
bank.
(iv) Controller of credit and money supply: Central bank controls credit and
money supply through its monetary policy which consists of two parts – Currency and
credit. The main objective of credit control function of central bank is price stability

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along with full employment. It control credit and money supply by adopting quantitative
and qualitative measures.
(v) Lender of Last Resort: A lender of last resort is an institution, usually a
country's central bank that offers loans to banks or other eligible institutions that are
experiencing financial difficulty or are considered highly risky or near collapse.

The Federal Reserve

The Federal Reserve System, also known as "The Fed," is America's central bank. That makes it
the most powerful single actor in the U.S. economy and thus the world. It is so complicated that
some consider it a "secret society" that controls the world's money. They’re right. Central banks
do manage the money supply around the globe. But there is nothing secret about it.

System Structure

To understand how the Fed works, you must know its structure. The Federal Reserve System
has three components. The Board of Governors directs monetary policy. Its seven members are
responsible for setting the discount rate and the reserve requirement for member banks. Staff
economists provide all analyses. They include the monthly Beige Book and the semi-
annual Monetary Report to Congress.

The Federal Open Market Committee (FOMC) oversees open market operations. That includes
setting the target for the fed funds rate, which guides interest rates. The seven board members,
the president of the Federal Reserve Bank of New York, and four of the remaining 11 bank
presidents are members. The FOMC meets eight times a year.

The Federal Reserve Banks supervise commercial banks and implement policy. They work with
the board to supervise commercial banks. There is one located in each of their 12 districts.

What the Federal Reserve Does?

The Federal Reserve has four functions. Its most critical and visible function is to
manage inflation and maintain stable prices. It sets a 2 percent inflation target for the core
inflation rate. Why is managing inflation so important? Ongoing inflation is like a cancer that
destroys any benefits of growth.

Second, the Fed supervises and regulates many of the nation’s banks to protect consumers.
Third, it maintains the stability of the financial markets and constrains potential crises. Fourth,
it provides banking services to other banks, the U.S. government, and foreign banks.

The Fed performs its functions by conducting monetary policy. The goal of monetary policy
is healthy economic growth. That target is a 2 to 3 percent gross domestic product growth rate.

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It also pursues maximum employment. The goal is the natural rate of unemployment of 4.7 to
5.8 percent.

Manages Inflation

The Federal Reserve controls inflation by managing credit, the largest component of the money
supply. This is why people say the Fed prints money. The Fed moderates long-term interest
rates through open market operations and the fed funds rate.

When there is no risk of inflation, the Fed makes credit cheap by lowering interest rates. This
increases liquidity and spurs business growth. That ultimately reduces unemployment. The Fed
monitors inflation through the core inflation rate, as measured by the Personal Consumption
Expenditures Price Index. It strips out volatile food and gas prices from the regular inflation
rate. Food and gas prices rise in the summer and fall in the winter. That's too fast for the Fed to
manage.

The Federal Reserve uses expansionary monetary policy when it lowers interest rates. That
expands credit and liquidity. These make the economy grow faster and create jobs. If the
economy grows too much, it triggers inflation. At this point, the Federal Reserve
uses contractionary monetary policy and raises interest rates. High-interest rates make
borrowing expensive. Increased loan costs slow growth and decrease the likelihood of
businesses raising prices. The major players in the fight against inflation are the Federal Reserve
chairs.

These are the heads who manage the Fed’s interest rates.

The Fed has many powerful tools. It sets the reserve requirement for the nation's banks. It
states that banks must hold at least 10 percent of their deposits on hand each night. This
percentage is less for smaller banks. The rest can be lent out.

If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs
from other banks. The funds it borrows is known as the fed funds. Banks charge each other
the fed funds rate on these loans.

The FOMC sets the target for the fed funds rate at its monthly meetings. To keep it near its
target, the Fed uses open market operations to buy or sell securities from its member banks. It
creates the credit out of thin air to buy these securities. This has the same effect as printing
money. That adds to the reserves the banks can lend and results in the lowering of the fed
funds rate. Knowledge of the current fed funds rate is important because this rate is a
benchmark in financial markets.

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Supervises the Banking System

The Federal Reserve oversees roughly 5,000 bank holding companies, 850 state bank members
of the Federal Reserve Banking System, and any foreign banks operating in the United States.
The Federal Reserve Banking System is a network of 12 Federal Reserve banks that both
supervise and serve as banks for all the commercial banks in their region.

The 12 banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta,
Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The Reserve Banks serve
the U.S. Treasury by handling its payments, selling government securities, and assisting with its
cash management and investment activities. Reserve banks also conduct valuable research on
economic issues.

The Dodd-Frank Wall Street Reform Act strengthened the Fed's power over banks. If any bank
becomes too big to fail, it can be turned over to Federal Reserve supervision. It will require a
higher reserve requirement to protect against any losses.

Dodd-Frank also gave the Fed the mandate to supervise "systematically important institutions."
In 2015, the Fed created the Large Institution Supervision Coordinating Committee. It regulates
the 16 largest banks. Most important, it is responsible for the annual stress test of 31 banks.
These tests determine whether the banks have enough capital to continue making loans even if
the system falls apart as it did in October 2008.

On February 3, 2017, President Trump attempted to weaken Dodd-Frank. He signed

an executive order that instructed the Treasury secretary to review areas that need to be
amended. But many of Dodd-Frank's regulations had already been incorporated into
international banking agreements.

Maintains the Stability of the Financial System

The Federal Reserve worked closely with the Treasury Department to prevent global financial
collapse during the financial crisis of 2008. It created many new tools, including the Term
Auction Facility, the Money Market Investor Funding Facility, and Quantitative Easing. For a
blow-by-blow description of everything that happened while it was going on, the article
discussing federal intervention in the 2007 banking crisis gives a clear account.

Two decades earlier, the Federal Reserve intervened in the Long Term Capital Management
Crisis. Federal Reserve actions worsened the Great Depression of 1929 by tightening the money
supply to defend the gold standard.

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Provides Banking Services

The Fed buys U.S. Treasurys from the federal government. That's called monetizing the debt.
The Fed creates the money it uses to buy the Treasurys. It adds that much money to the money
supply. Over the past 10 years, the Fed has acquired $4 trillion in Treasurys.

The Fed is called the "bankers' bank." That is because each Reserve bank stores currency,
processes checks, and makes loans for its members to meet their reserve requirements when
needed. These loans are made through the discount window and are charged the discount rate,
one that is set at the FOMC meeting. This rate is lower than the fed funds rate and Libor. Most
banks avoid using the discount window because there is a stigma attached. It is assumed the
bank can't get loans from other banks. That's why the Federal Reserve is known as the bank of
last resort.

History

The Panic of 1907 spurred Congress to create the Federal Reserve System. It established a
National Monetary Commission to evaluate the best response to prevent ongoing financial
panics, bank failures, and business bankruptcies. Congress passed the Federal Reserve Act of
1913 on December 23 of that year.

Congress originally designed the Fed to "provide for the establishment of Federal Reserve
banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to
establish a more effective supervision of banking in the United States, and for other
purposes." Since then, Congress has enacted legislation to amend the Fed's powers and
purpose.

Congress created the Fed's board structure to ensure its independence from politics. Board
members serve staggered terms of 14 years each. The president appoints a new one every two
years. The U.S. Senate confirms them. If the staggered schedule is followed, then no president
or congressional party majority can control the board.

This independence is critical. It allows the Fed to focus on long-term economic goals. It can
make all decisions based solely on economic indicators. No president can pressure members to
keep interest rates low and overstimulate the economy.

President Trump is the first president in history to question that independence. In 2018, he
publicly criticized the Fed for raising interest rates. He said higher rates slow growth and offset
his attempts to spur the economy. When asked to name the single greatest threat to growth,
he blamed the Fed.

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This is despite the fact that Trump nominated six of the seven members. The Senate has
confirmed three of them. Trump inherited this rare opportunity to stack the Fed board in his
favor. The chair position came up for reappointment during his term. Three board positions
were already vacant, including the vice-chair position. Two of them have been vacant since the
financial crisis.

Who Owns the Fed?

Technically, member commercial banks own the Federal Reserve. They hold shares of the 12
Federal Reserve banks. But that doesn't give them any power because they don't vote. Instead,
the Board and FOMC make the Fed's decisions. The Fed is independent because those decisions
are based on research. The president, U.S. Treasury Department, and Congress don't ratify its
decisions. But, the board members are selected by the president and approved by Congress.
That gives elected officials control over the Fed's long-term direction but not its day-to-day
operations.

Some elected officials are still suspicious of the Fed and its ownership. They want to abolish it
altogether. Senator Rand Paul wants to control it by auditing it more thoroughly. His father,
former Congressman Ron Paul, wanted to end the Fed.

Role of the Fed Chair

The Federal Reserve Chair sets the direction and tone of both the Federal Reserve Board and
the FOMC. President Trump appointed Board member Jerome Powell to be the chair from
February 5, 2018, to February 5, 2022. He is continuing the Fed's normalizing policies.

The former chair is Janet Yellen. Her term began on February 3, 2014, and ended on February 3,
2018. Her biggest concern had been unemployment, which is also her academic specialty. That
made her "dovish" rather than “hawkish.” That meant she was more likely to want to lower
interest rates. Ironically, she was the chair when the economy required contractionary
monetary policy.

Ben Bernanke was the chair from 2006 to 2014. He was an expert on the Fed's role during the
Great Depression. That was very fortunate. He knew the steps to take to end the Great
Recession. He kept the economic situation from turning into a depression.

How the Fed Affects You

The press scrutinizes the Federal Reserve for clues on how the economy is performing and what
the FOMC and Board of Governors plan to do about it. The Fed directly affects your stock and
bond mutual funds and your loan rates. By having such an influence on the economy, the Fed
also indirectly affects your home's value and even your chances of being laid off or rehired.

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Exercise

Multiple Choice Questions

Q.1. The merit of issuing notes with Central Bank can be seen in

(a) Uniformity in note issue (b) Stability in currency

(c) control of credit (d) All the above

Q.2. Money supply consists of

(a) Currency (b) Deposits

(c) both currency & deposits (d) None of the above

Q.3. Which are is a qualitative instrument of Central Bank?

(a) Cash Reserve Ratio (b) Repo rate

(c) Moral Suasion (d) Open market operation

Q.4. Which is the legal tender money?

(a) Cheque (b) Credit Card

(c) USD (d) demand Draft

Q.5. there is inflationary situation in US, what step Fed should take?

(a) Issuing more currency (b) Increase in bank rate

(c) Decrease in CRR (d) Decrease in SLR

Short Questions
Q. 1. What are the primary functions of money?
Ans. Medium of exchange and measure of value are primary functions of money.
Q. 2. What is barter?
Ans. The direct exchange of goods for goods is called barter.
Q. 3. Define money supply.
Ans. Stock of money in the country on a specific day.
Q. 4. What is included in money supply?
Ans. (i) Currency with public.
(ii) Demand deposits.

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Q. 5. State the components of money supply.

Ans. (i) Currency and coins with public

(ii) Demand deposits of commercial banks.

Q. 6. Define a central bank.

Ans. Central bank is the bank which has monopoly of issuing currency and which is the apex
monetary authority of the country
Q. 7. What is the name of Central Bank in USA?
Ans. Reserve Bank of USA is the Federal Reserve Bank.
Q. 8. Define Cash Reserve Ratio (CRR)?
Ans. CRR refers to that minimum percentage of deposits with the commercial banks which the
commercial banks must keep with the central bank.
Q. 9. What is a scheduled bank?
Ans. A bank whose name is included in 2nd Schedule of Federal Reserve Bank is called a
scheduled bank.
Q. 10. Define banking.
Ans. Accepting deposits from public and lending funds to them is called banking.
Q. 11. What is meant by double coincidence of wants?
Ans. Double coincidence means that an exchange of goods between two persons is possible
only when both parties require goods of each other.
Q. 12. What is fiat money?
Ans. Money issued by the government under emergency conditions.
Q. 13. ‘Legal tender money is also known as fiat money.’ Why?
Ans. Legal tender money is also called fiat money because it has to be accepted as money as
per the orders of the government.
Q. 14. What is fiduciary money?
Ans. It is voluntary money generally accepted on the basis of trust by acceptor e.g. drafts,
cheques, bills of exchange etc.
Q. 15. What is legal tender money?
Ans. Money declared under the law of the country is called legal tender money. For example,
currency notes and coins have been declared as legal tender money by the order of the
government.
Q. 16 .What are the secondary functions of money?
Ans. Store of value, standard of deferred payments and transfer of value are the secondary
functions of money.

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Q. 17. What are the two essential functions of a bank?

Ans. Accepting deposits from the people, and giving loans and advances to them are the two
essential functions of banks.
Q. 18. What are demand deposits?
Ans. Deposits that are payable on demand are called demand deposits.
Q. 19. What are the different types of deposits accepted by banks?
Bank accepts mainly three types of deposits:
Ans. (i) Current Account Deposits
(ii) Fixed Term Deposits

(iii) Savings Account Deposits

Q. 20. What is meant by overdraft facility?

Ans. In overdraft facility, a current account holder is allowed to withdraw more than his
balance in the account up to an agreed limit.
Q. 21. Define a bank.
Ans. Bank is an institution which accepts deposits from the people and gives loans and
advances to them.
Q. 22. What is a commercial bank?
Ans. A commercial bank is an institution that accepts deposits from the people and extends
loans and advances to them to earn profit.
Q. 23. Define statutory liquidity ratio (SLR).
Ans. SLR is the ratio of deposits which commercial banks are required to keep with themselves.
OR

It is a percentage fixed by Central bank, of net deposits of the banks which they must maintain
in the form of liquid assets specified by Central Bank.

Q. 24. Define Legal Reserve Ratio.

Ans. It is that fraction of deposits which is legally compulsory for the commercial banks to keep
with themselves in the form of cash.
Q. 25. What are open market operations?
Ans. Buying and selling of government securities by the central bank from/to banks is called
open market operations.
Q. 26. What is margin requirement?

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Ans. It is the difference between the value of security and the amount of money given against
that.
Q. 28. What is central bank?
Ans. Central bank is an apex institution which controls and regulates the banking and monetary
system of a country and has the sole authority for the issue of currency of that country.
Q. 29. Which are the qualitative monetary measures?
Ans. Qualitative monetary measures available to central bank are margin requirements, moral
suasion, selective credit controls etc.
Q. 30. Mention the quantitative monetary measures available to the central bank.
Quantitative monetary measures available to central bank are:
Ans. (i) Bank Rate Policy
(ii) Open market operations and

(iii) Varying Reserve Ratios

Q. 31. How are short term borrowings made by the government from the central bank?
Ans. The Government sells treasury bills to central bank for short term borrowings.
Q. 32. Define ‘bank rate’.
OR
What is bank rate?
Ans. The rate at which central bank lends to commercial banks by rediscounting their bills is
called bank rate.
Q. 33. What is full bodied money?
Ans. Full bodied money is that money whose value as a commodity is equal to its value as
money.
Q. 34. Which system is followed in USA for issuing notes?
Ans. For issue of notes, minimum reserve system is followed in USA.
Q. 35. What are the various measures of money supply in USA?
Ans. Central bank has presented four measures of money supply which are M 1, M2, M3 and M4.

Long Questions

1. What do you mean by industrial banks?

Industrial Banks are corporate organisations which specialise in providing industrial capital by
subscribing to the share and debenture issues of public companies. Industrial banks normally

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meet the long term requirements of funds for purchase of land, plant and machinery, and
financing of expansion and diversification activities of industrial companies

2. State briefly the function of foreign exchange banks.

Business firms engaged in foreign trade receive and make payment through foreign currency. In
order to facilitate such transactions and also help exporters and importers, there are banking
institutions which primarily engage in transactions involving foreign exchange. These are known
as Foreign Exchange Banks. Besides financing foreign trade, the exchange banks also render
services such as acting as referees, collecting and supplying information about the foreign
customers, providing remittance facilities.

3. What commercial banks? What type of services do banks provide as agent of their
customers?
Commercial banks are banking institutions which accept deposits from the public and grant
short term loans and advances to their customers.

Banks provide agency services, such as collection of bills, payment of insurance premium,
purchase and sale of securities, etc. to the customers.

5. Describe the services of a commercial bank to the business community.

A commercial bank performs the following services to business community.

(a) Issue of letter of credit, traveller’s cheque and circular notes.

(b) Supply of trade information.

(c) Acting as a reformer as regards financial status of customers.

(d) Safe custody of important documents in safe deposits vaults (lockers) available on hire.

6. Explain the role of banking in modern society

Following are the advantages of banks in a modern society:
1. Money deposited in commercial banks can be withdrawn on demand by cheque. Payments
can also be made by cheque. Thus, business firms are not required to make large payments in
cash and also not required to maintain large cash balances with them.

2. Financial assistance is provided by banks by way of cash credit, overdraft, loans and advances
on discounting of bills of exchange.

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3. Various agency services provided by commercial banks are prompt and reliable, for all these
services bank charge only a nominal fee or commission.

7. Do banks provide services other than accepting deposits and lending money? Discuss.
Banks provide many services other than accepting deposits and lending money. The various
other services of banks are:
1. Promoting and mobilising savings of the public.

2. Providing funds to trade and industry by way of discounting bills, overdraft, cash credit
facility and transfer of funds from one place to another.

3. Providing agency services to customers, such as collection of bills, payments of insurance

premium, purchase and sale of securities, etc. and other general services, such as issue of
traveller’s cheques, credit cards, locker facility, etc.

8. Write a short note on Federal Reserve Bank.

The Federal Reserve System, also known as "The Fed," is America's central bank. That makes it
the most powerful single actor in the U.S. economy and thus the world. It is so complicated that
some consider it a "secret society" that controls the world's money. They’re right. Central banks
do manage the money supply around the globe. But there is nothing secret about it.
10. What do you understand by development banks?
Development banks are special financial institutions which provide long-term capital to
industry. These banks assist the promotion, expansion and modernisation of industries. They
act as underwriters also.

11. Write a short note on the functions of commercial banks.

The functions of commercial banks are divided into two categories.

(i) Primary functions,

(ii) Secondary function.

Primary functions include accepting deposits and lending money. Loans given by banks are:
Short- term loans and long-term loans. Banks grant short-term loan to its customers by way of
cash credit, overdraft discounting of bills.

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Bank accepts deposits from the public and their customers in the form of current deposit,
saving deposit, fixed deposit and under other deposit scheme. Bank grant loans to customers as
demand loans and term loan.

The auxiliary services of banks are agency services and general utility services. Agency services
are rendered as agent of customers whereas general utility services are rendered to the general
public.

12. What type of services do banks provide as ‘Agent’ of customers? Mention any five
services.
Services of bank to its customers as agent’s are:
1. Dealing in Bills of Exchange, Promissory Notes, Hundies and Drafts.

2. Issuing letter of credit, Travellers cheques and circular notes.

3. Buying, selling and dealing in bullion as well as foreign exchange and foreign bank notes.

4. Acting as ‘agent’ for clients, buying and selling shares and debentures and acting as
underwriter.

5. Collection and remittance of money and extending guarantee against loans raised by
customers.

(c) A Housewife:
Safe custody of valuable articles can be arranged by hiring lockers in banks, etc.

13. How do commercial banks serve the business community in our country? Briefly explain.
(i) Banks undertake collection of book debts, bills of exchange promissory notes dividend
warrants, etc., which greatly facilitate business activities.

(ii) Foreign trade activities are also greatly facilitated by banks undertaking issue of letter of
credit; acceptance and payment of documentary bills, and providing financial assistance by way
of pre-shipment and post-shipment credit, etc.

(iii) An important service provided by banks to individuals and business firms is that of acting as
a reference.

14. Explain the methods of granting loan by bank.

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The loan can be granted as:

(a) Demand loan,

(b) Term loan.

(a) Demand Loan:

Demand loan is repayable on demand. The entire amount of demand loan is disbursed at one
time and the borrower has to pay interest on it. The borrower can repay the loan either in
lumpsum or as agreed with the bank.

(b) Term Loans:

Medium and long term loans are called, Term loans’. Term loans are granted for more than one
year and repayment of such loans is spread over a longer period the repayment is generally
made in suitable instalments of fixed amount. These loans are repayable over a period of 5
years and maximum upto 15 years.

15. What do you mean by bank overdraft? Explain the procedure for granting overdraft by
bank.
Overdraft facility is the result of an agreement with the bank by which a current account holder
is allowed to withdraw a specified amount over and above the credit balance in his/her
account. It is a short term facility. This facility is made available to current account holders only
who operate their account through cheques. Overdraft facility is generally granted by bank on
the basis of a written request by the customer.

16. Differentiate between loans and advances.

A loan is granted for a specific time period. Generally commercial banks grant short-term loans.
But term loans, that are loan for more than a year, may also be granted. Loans are generally
granted against the security of certain assets. An advance is a credit facility provided by the
bank to its customers.

It differs from loan in the sense that loans may be granted for a longer period but advances are
normally granted for a short period of time. The rate of interest charged on advance varies
from bank to bank.

17. Explain cash credit facility allowed by banks to customers.

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A cash credit facility is an arrangement whereby the bank agrees to lend money to the
borrower upto a certain limit. The bank put this amount of money to the credit of the
borrower.

The borrower draws the money as and when he needs. Interest is charged only on the amount
actually drawn and not on the amount placed to the credit of borrower’s account. Cash credit is
generally granted on a bond of credit or certain other securities.

18. What do you mean by discounting of bills by bank?

Banks purchase the bills at face value minus interest at current rate of interest for the period of
the bill. This is known as ‘Discounting of bills’. Bills of exchange are negotiable instruments and
enable the debtors to discharge their obligations towards their creditors, such bills of exchange
arise out of commercial transactions both in internal trade and external trade. By discounting
these bills before they are due for a nominal amount, the banks help the business community.

19. Explain in brief the agency functions of a commercial bank.

The agency functions of a commercial bank are as follows:

(a) Collection and payment of cheques and bills on behalf of the customers.

(b) Collection of dividends, interest and rent, etc on behalf of customers, if so instructed by
them.

(c) Purchase and sale of shares and securities on behalf of customers.

(d) Payment of rent, interest, insurance premium subscription etc. on behalf of customers, if so
instructed.

(e) Acting as a trustee or executor.

20. Differentiate between primary and secondary functions rendered by bank.

Primary functions of a commercial bank include:
(a) Accepting deposits: and

(b) Granting loans and advances. Secondary functions of a commercial bank include as follows:

(i) Issuing letters of credit traveller’s cheques, circular notes, etc.

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(ii) Undertaking safe custody of valuables, important documents and securities by providing
safe deposit vaults or lockers.

(iii) Providing customers with facilities of foreign exchange.

(iv) Collecting and supplying business information, etc.

21. Describe briefly the various modes of acceptance of deposits by banks.

The various modes of acceptance of deposits by bank:
(i) Current Deposit:
Current deposit can be withdrawn by the depositor at any time by cheques. Current accounts
do not carry any interest as the amount deposited in these accounts is repayable on demand
without any restriction

(ii) Saving Deposit:

Saving deposit accounts meant for individuals who wish to deposit small amounts out of their
current income. It helps in safeguarding their future and also earning interest on the savings

(iii) Fixed Deposit:

The term ‘fixed deposit’ means deposit repayable after the expiry of a specified period. Fixed
deposits are most useful for a commercial bank.

(iv) Recurring Deposit:

Under this type of deposit, the depositor is required to deposit a fixed amount of money every
month for a specified period of time

(v) Miscellaneous Deposits:

Bank have introduced several deposit schemes to attract deposits from different types of
people, like home construction deposit scheme, sickness benefit deposit scheme, children gift
plan, old age pension scheme, mini deposit scheme, etc.

22. Can a customer encash a fixed deposit receipt before the due date? Discuss.
In case a depositor requires the money before the due date, he or she makes a request to the
bank for its payment. When the payment of fixed deposit is made before the due date, the
depositor loses interest which is normally 1 % less compared to the rate applicable for the
period.

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23. Write short note on recurring deposit account.

It is one form of saving deposits. Depositors save and deposit regularly every month a fixed
instalment so that they are assured of sizeable amount at a later period. This will enable the
depositors to meet contingent expenses. The interest earned on recurring account is higher
than on the saving account.

24. Describe the Reserve Bank’s regulatory and supervisory functions relating to commercial
banks.
The Reserve Bank’s regulatory and supervisory functions relating to commercial banks cover
their establishment {i.e., licensing), branch expansion, liquidity of their assets management and
methods of working, amalgamation, reconstruction and liquidation.

The control is exercised by the bank through periodic inspections conducted by its own staff
and follow-up action after the inspections, as also by calling for returns and necessary
information from banks

Value Based Questions

Q.1. USA at times has high levels of inflation. What should the Govt. do? What is the impact on the
people?

Govt. has to implement monetary and fiscal measures to control inflation and bring it within feasible
limits. Inflation affects the standard of living of the people and results in more people below the poverty
line.

Value: problem solving/economic equality

Q.2. Is money economy better than barter economy?

Money as a medium of exchange helps increase economic transactions and increase the flow of money
in the economy. (Maximum liquidity convenient)

Value: empathy

Q.3. Some commercial banks at times have less than the prescribed SLR reserve. Are they right in their
decision?

The right amount of SLR is required to maintain the liquidity of the bank. Whenever customers approach
the bank for money, this need has to be satisfied. It is a violation of norms.

Value: critical thinking.

Q.4. Commercial banks have increased the credit creating activities in the economy and it is beneficial
for them. Will it be beneficial for the economy as well?

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It may be beneficial for the banks, but it may harm the economy during Inflation. But it is beneficial
during deflation to bring more money into Circulation.

Value: Analytical thinking.

Q.5. Do you think poverty can be eradicated by increasing the money supply through printing of more
currency by Central Bank?

It will increase money supply and lead to inflation. Increase in money Supply will not solve poverty.
Employment through productive activity, Will help to solve the poverty

Value: critical thinking

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3 Determination of Income & Employment

Learning Objectives

1. Introduction
2. Aggregate Demand and its components
3. Aggregate Supply
4. Consumption Function
5. Propensity to Consume
6. Saving Function
7. Propensity to Save
8. Invest function, induced and Autonomous Investment
9. Ex-Ante Saving and Invest Ex-Post saving
10. Investment Multiplier
11. Paradox of Thrift
12. Parametric Shift
13. Excess Demand and Its Impact
14. Inflationary Gap
15. Measures to Control The Excess Demand
16. Deficient Demand and Its Impact
17. Deflationary Gap
18. Measures to Control the Deficient Demand

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Aggregate Demand and Its components

Aggregate demand refers to the total value of all final goods and services that are planned to
buy by all the sectors of the economy at a given level of income during a period of time. AD
represents the total expenditure on goods and services in an economy during a period of time.

Components of Aggregate demand:

(i) Household consumption expenditure (C).
(ii) Investment Expenditure (I).
(iii) Government Consumption Expenditure (G).
(iv) Net Export (Export – Import)(X – M)

Thus, AD = C + I + G + (X –M)

Aggregate Supply
Aggregate supply refers to total value of all final goods and services that are planned to be
produced by all the producing units in the economy during a given period of time. It is also
the value of total output available in an economy during a given period of time.

Aggregate Supply (AS) = C + S

Aggregate supply refers to the national income of the country.

AS = Y (National Income)

Consumption function
The consumption function, or Keynesian consumption function, is an economic formula
that represents the functional relationship between total consumption and gross national
income. It was introduced by British economist John Maynard Keynes, who argued the
function could be used to track and predict total aggregate consumption expenditures.

Consumption Function Curve

A consumption function curve indicating C = C + bY is drawn in the below figure

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(i) Consumption can never be zero even if income is zero because some minimum level of
consumption has to be maintained for survival. Such subsistence consumption is called
autonomous consumption. That is why consumption curve starts from positive point C on Y-
axis. In the above Figure, consumption expenditure equal to OC is the minimum level of
consumption which represents autonomous consumption.

(ii) Slope of consumption curve slopes upward which shows direct relationship, i.e., when
income rises, consumption expenditure also rises but in a lesser proportion.

(ii) The rising slope of consumption curve is b (i.e., MPC = AC/AY).

(iv) Since slope of curve is constant, we get a straight line consumption curve.

Relationship between Income and Consumption expenditure:

Remember, consumption expenditure is the function of income, i.e., it depends upon income
as shown below:
(i) According to Keynes, as income increases, consumption expenditure also increases but by
less than the increase in income. In other words, when income increases, consumption
expenditure does not increase at the same rate as income. This is called Keynesian
Psychological law of consumption. There is tendency of people not to spend on consumption
the whole of incremental income, i.e., additional consumption is less than additional income. In
other words, MPC is less than 1 (MPC< 1).

For instance, if income increases by Rs 100, the tendency is to spend a part, say, Rs 75, on
consumption and save the remaining part, i.e., Rs 25. This is known as induced consumption. It
should be kept in mind that when income is zero, consumption is still positive (+) because a
person has to spend a minimum amount to keep his body and soul together. This is called
autonomous consumption.

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(ii) When income is very low, consumption expenditure is higher than income. Its reason is that
some minimum level of consumption has to be maintained irrespective of low level of income.
In such a situation, value of APC (i.e., relationship between income and consumption C/Y)
becomes higher than 1.

For example, if at the income level of Rs 2000, consumption expenditure is Rs 2400, then APC =
24000/2000 = 12, i.e., higher than 1. When current consumption exceeds current Income,
people draw upon their past saving, i.e., there is dissaving.

Break-even point:
When consumption expenditure becomes equal to income and there is no saving, it is called
break-even point.

Propensity to consume is of two types—Average Propensity to Consume (APC) and Marginal

Propensity to Consume (MFC).

Calculations in Consumption Function

C = f(Y)

Where C = Consumption
Y = national Income
F = Functional Relationship
Equation of consumption function

C = C + MPC. Y

C = Autonomous Consumption

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Properties or Technical Attributes of the Consumption Function:

The consumption function has two technical attributes or properties:

(i) The average propensity to consume, and

(ii) The marginal propensity to consume.

Propensity to Consume

Average Propensity to Consume Marginal Propensity to Consume

(1) The Average Propensity to Consume:

“The average propensity to consume may be defined as the ratio of consumption expenditure

to any particular level of income.” It is found by dividing consumption expenditure by income,

or APC = C/Y.

(2) The Marginal Propensity to Consume:

“The marginal propensity to consume may be de- fined as the ratio of the change in

consumption to the change in income or as the rate of change in the average propensity to

consume as income changes.”

Significance of MPC

The MPC is the rate of change in the APC. When income increases, the MPC falls but more than

the APC. Contrariwise, when income falls, the MPC rises and the APC also rises but at a slower

rate than the former. Such changes are only possible during cyclical fluctuations whereas in the
short-run there is change in the MPC and MPC<APC.

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Keynes’s Psychological Law of Consumption

Keynes propounded the fundamental Psychological Law of Consumption which forms the basis

of the consumption function. He wrote, “The fundamental psychological law upon which we are

entitled to depend with great confidence both a prior from our knowledge of human nature

and from the detailed facts of experience, is that men are disposed as a rule and on the average

to increase their consumption as their income increases but not by as much as the increase in

their income.” The law implies that there is a tendency on the part of the people to spend on
consumption less than the full increment of income.

Saving Function
Saving function refers to the functional relationship between consumption and saving.

S = f(Y)

Saving is that part of income which is not spent on current consumption. The relationship
between saving and income is called saving function.

Simply put, saving function (or propensity to save) relates the level of saving to the level of
income. It is the desire or tendency of the households to save at a given level of income. Thus,
saving (S) is a function (f) of income (Y).

Symbolically,

S = f (Y)

Two noteworthy features of saving function are:

(i) Saving can be negative (-) at zero or low level of income and (ii) As Income increases, savings
also increase but more than the increase in income

Remember, saving is residual income of households that is left after consumption.

Algebraically:
S = Y-C

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Saving function equation:

As saving function is corollary of consumption function, we can derive the corresponding saving
function from consumption function equation C = C + bY by substituting it in the equation S = Y
– C as shown below.

Where C = Autonomous consumption (- C represents dissaving which is needed to finance

autonomous consumption. Clearly, at zero level of income, amount of autonomous
consumption = Amount of dissaving.), b = MPC (so that 1 – b represents MPS, i.e.. Marginal
propensity to save), Y = Income.

For example, the saving equation S = – 30 + (1- 0.75) Y means – 30 is dissaving (or autonomous
saving that needs to take place to finance autonomous consumption). As income increases,
0.25 (= 1 – 0.75) or 25% of additional income is saved.

Relationship between Income and Saving

(i) There is direct relationship between income and saving, i.e., if income increases, saving also
increases but by less than increase in income. It means as income increases, proportion of
income saved increases (because proportion of income consumed decreases).

(ii) At lower level of income, saving is negative. In the initial stages when there is very low level
of income, consumption expenditure is more than income leading to negative saving [i.e.,
dissaving). For instance, if income is, say, Rs 5,000 and consumption expenditure is, say 6,000,
then saving will be negative, i.e., -1000 (= 5000 – 6000). It is called dissaving. Here average
propensity to save is negative.

APS = -1000/5000 = -0.2.

Saving Function Curve

A diagrammatic representation of relationship between income and savings level gives the
saving function curve. In the below figure saving function curve is a straight line because
slope of saving is constant.

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The curve slopes upward which depicts direct relationship between income and saving. The
savings functions line SS cuts the income line at point B which is called Break-even point
because at this point consumption expenditure is equal to income (or savings are zero).

To the left of break-even point, savings are negative (-) indicating consumption being more than
income whereas to the right of break-even point, savings are positive (-K) indicating
consumption expenditure being less than income. The shaded area reflects dissaving which is
equal to the area of autonomous consumption shown as – C in the below figure

Relationship between MPC & MPS, APC & APS

MPC + MPS = 1 APC + APS = 1

∆C ∆S C S
+ =1 + =1
∆Y ∆Y Y Y
∆C+ ∆S C+S
=1 =1
∆Y Y
∆𝑌 𝑌
=1 =1
∆𝑌 𝑌

1 =1 1 =1

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Formulae of MPC, APC, MPS, APS, Multiplier (K), Autonomous

Consumption

Y=C+S Y=C+I ∆Y = ∆C + ∆S
S=Y–C (S = I) I=Y–C ∆S = ∆Y − ∆C
C=Y–S C=Y–I ∆C = ∆Y − ∆S

∆C C
MPC = APC =
∆Y Y
∆S S
MPS = APS =
∆Y Y

MPC + MPS = 1 APC + APS = 1

MPC = 1 – MPS APC = 1 APS
MPS = 1 – MPC APS = 1 APC

Autonomous Consumption(C)
Y=C+S
C = C + MPC . Y
Y = C + MPC . Y + S
or
Y = C + MPC . Y + I

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Investment function, Induced and Autonomous Investment

Functional relationship of investment with the different levels of income and employment in
an economy is called investment function.

Induced investment refers to the investment in by the private sectors for the motive of
earning profit.

Autonomous Investment refers to the investment which is made irrespective of level of

income as is genera generally done in government sector.

Ex-Ante savings and Ex-Post savings

The savings which are planned to be made by all the households in the economy during a
period in the beginning of the period is called ex-ante savings.

Ex- post savings are those which the households actually save from their income.

Ex-Ante Investment and Ex-Post Investment

The investments which are planned to be made by all the households in the economy during a
period in the beginning of the period is called ex-ante investments.

Ex- post investment are those which the households actually save from their income.

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Difference between ex ante investment and ex post

investment
S. No. Ex-ante Investment Ex-post Investment

1. It refers to the planned or intended investment It refers to the actual level of investment
during a particular period of time. during a particular period of time.

2. It is imaginary (intended), in which a firm It is factual or original that signifies the

assumes the level of investment on its own. existing investment of a particular time.

3. It is planned on the basis of future expectations. It is the actual result of variables.

Investment Multiplier (K)

An investment multiplier refers to the concept that any increase in public or private investment
spending has a more than proportionate positive impact on aggregate income and the general
economy. The multiplier attempts to quantify the additional effects of a policy beyond those
immediately measurable. The larger an investment's multiplier, the more efficient it is at creating
and distributing wealth throughout an economy.

Investment multiplier shows a relationship between the change in National Income and change
in Investments.
∆Y
K=
∆I
1
K=
MPS
1
K=
1−MPC

Paradox of Thrift
Paradox of thrift refers to a situation in which people tend to save more money, thereby
leading to a fall in the savings of the economy as a whole. In other words, when everyone
increases his/her saving-income proportion i.e. MPS (s), then, the aggregate demand will fall as
consumption decreases. This will further lead to a decrease in employment and income level
and finally this will reduce the total savings for the economy. This concept was suggested by

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Keynes wherein increased saving at individual levels will gradually lead to the slowdown of
economy in terms of circular flow of income.

Parametric Shift
A parametric shift is graph due to change in the value of parameter.

(i) A positively sloping straight line swings upwards at its slopes is decreases.
(ii) A positively sloping straight line shifts upwards in parallel as its intercept is
increased.

In the above diagram the line is swings upwards. This kind of shift is called parametric shift.

Involuntary Unemployment
An involuntary unemployment means a situation in which all bale persons who are willing
to work at the prevailing wage rate do not get work.

Meaning of Full Employment

Full employment refers to the situation in which every able bodied person who is willing to
work at the prevailing wage rate are engaged in some production activity or employment.

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Excess Demand and Its Impact

When in an economy, aggregate demand is in excess of aggregate supply at full
employment, the demand is called an excess demand.

When in an economy, aggregate demand is in excess of ‘aggregate supply at full employment’, the
demand is said to be an excess demand and the gap is called inflationary gap. In other words, excess
demand refers to the excess of aggregate demand over the available output (aggregate supply) at full
employment. The gap is called inflationary because it causes inflation (continuous rise in prices) in the
economy. According to Keynes, equilibrium level of income, output and employment is determined
solely by level of aggregate demand during short period.

Inflationary Gap
Inflationary gap is the amount by which the actual aggregate demand exceeds aggregate supply at
the level of full employment. For instance in the below figure is shown as inflationary gap. It is a
measure of amount of the excess of aggregate demand. It causes a rise in price level called inflation.

When aggregate demand is more than ‘level of output at full employment’ then the excess or gap is
called inflationary gap. Alternatively it is the amount by which actual aggregate demand exceeds the
level of aggregate demand required to establish full-employment equilibrium. Thus inflationary gap is a
measure of amount of the excess of aggregate demand over ‘aggregate supply at full employment’. It
indicates that the buyers intend to buy more than the maximum physical output the producers can
produce by employing all the maximum physical output the producers can produce by employing all the
available resources. In such a situation an increase in demand means only an increase in money
expenditure without any corresponding increase in output and employment because all the resources
have already been fully employed. A simple example will further clarify it. Let us suppose that an
imaginary economy by employing all its available resources can produce 10,000 qtls.l of rice. If actual
aggregate demand for rice is, say 12,000 qtls. This demand will be called an excess demand, because
output (aggregate supply) at excess of 2,000 (=12,000 – 10,000) qtls. Will be called an inflationary gap.

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In short inflationary gap is the amount by which aggregate demand exceeds the aggregate demand
required to establish the full employment equilibrium.

Impact of Excess Demand. Since there is already full capacity production, excess demand does not
cause any rise in output and employment but it leads to rise in prices. In such a situation when resources
have been fully employed, increase in demand implies pressure on existing supplies of goods causing
rise in prices and a situation of inflation. Clearly this is demand pull inflation, i.e., demand induced
increase in price level. A persisting rise in general level of prices after full employment is called inflation.

Inflation creates inequalities of distribution of wealth, loss to creditors and salaried people, social
unrest and revolt, loss of faith in government and morality. Remember, in such a situation real income
(i.e., in terms of physical output) cannot rise but money income (i.e., in terms of physical output) cannot
rise but money income (i.e., in terms of money value of physical output) will rise.

Measures to control situation of excess demand

Keeping in view the adverse effects as stated above, aggregate demand has to be reduced by an amount
equal to inflationary gap. Here we include Government sector which affects the economic activity
through its expenditure and tax programme. This inclusion of government sector means that aggregate
demand is now equal to sum of consumption, investment and Government expenditure, i.e., AD = C + I +
G. The three most important measures to control excess demand are fiscal policy, monetary policy and
foreign trade policy. Fiscal policy is used by the government whereas monetary policy is used by Central
Bank of the country. However, the following measures are suggested to rectify the situation of excess
demand.

Fiscal Policy
Fiscal policy is the expenditure and revenue (tax) policy of the government to accomplish the desired
objectives. In case of excess demand (i.e., when current demand is more than AS at full employment),
objective of fiscal policy is to reduce aggregate demand. Main tools of fiscal policy are:

(i) Expenditure policy (Reduce expenditure). In a situation like that of excess demand, government
should curtail its expenditure on public works such as roads, buildings, rural electrification, irrigation
works thereby reducing the money income of the people and their demand for goods and services. In
this way, government should reduce the budget deficit which shows excess of expenditure over
revenue. When government expenditure increases, AD of an economy increases by the same amount.

(ii) Revenue policy (Increase taxes). The other important part of fiscal policy is revenue policy which is
expressed I terms of taxes. During inflation, government should raise rates of all taxes especially on rich
people because taxation withdraws purchasing power from the tax payers and to that extent reduces
effective demand. Care should be taken that measures adopted to raise revenue should be
disinflationary and at the same time have no harmful effects on production and savings.

Here distinction is made between discretionary and non-discretionary measures used by the
government. The non-discretionary elements refer to inbuilt stabilizers of income which operate
automatically. Progressive income-tax, grants, subsidies, old age pension and other such like transfer
payments are non-discretionary measures which operate automatically in both the situations of excess

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demand and deficient demand. As against it, discretionary measures refer to reduction in expenditure
on public works, on public health and education, on defence and internal administration etc.

(iii) Public borrowing (Increases it). Additionally, government should resort to large scale public
borrowing to mop up excess money with the public.

(iv) Deficit financing (Reduce it). At the same time deficit financing (Printing of notes) should be cut
down drastically. Reducing deficit financing will reduce government ability to spend which in turn will
decrease AD in the economy. Deficit financing is a method adopted by the government for financing its
deficit through printing of more notes.

Monetary Policy (Raise bank rate and cash reserve

ratio)
Monetary policy is the policy of the central bank of a country to regulate and control money supply and
credit in the economy. Money broadly refers to currency notes and coins whereas credit refers to loans.
Monetary measures (instruments) affect the cost of credit (i.e., rate of interest) and availability of credit.
Thus in helps in checking excess demand when credit availability is restricted and credit is made costlier.
Measures of monetary policy may be (a) quantitative (which influences volume of credit
indiscriminately), and (b) qualitative (which regulate flow of credit for specific uses)

(A) Quantitative Measures

(i) Bank rate (Increase bank rate). Bank rate is the rate of interest at which Central Bank lends to
commercial banks. Changing bank rate to influence credit availability is called Bank Rate Policy.
Mind, Central Bank lends to only commercial banks and not to general public. In a situation of
excess demand leading to inflation, Central Bank raises bank rate. This raises cost of borrowing
which discourages commercial banks in borrowing from Central Bank. Increase in bank rate
forces the commercial banks to increase their lending rate of interest which makes credit
costlier. As a result, demand for loans falls. Again high rate of interest slows down the demand
for goods and services and induces households to increase their savings by restricting
expenditure on consumption and discourages investment. Thus expenditure on investment and
consumption is reduced and this reduces credit creation by commercial banks. Remember rate
of interest represents cost of money.
(ii) Open Market Operation (Sell securities). It refers to buying and selling of government securities
and bonds in the open market by the Central Bank. This is done to influence the volume of cash
reserves with the commercial banks. Sale by Central Bank brings flow of money to Central Bank
from commercial banks thereby restricting their lending capacity. Such operations affects
amount of cash reserves with the commercial banks and their capacity to offer loans. During
inflation, Central Bank sells government securities to commercial banks which lose equivalent
amount of cash reserve thereby affecting their capacity to offer loans. This absorbs liquidity
from the system. As a result, there is fall in investment and aggregate demand. Thus it is an
effective measure to control credit.

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(iii) Cash-Reserve Ratio (Raise CCR). It is ratio (or fraction) of bank deposits that a commercial bank
is required to keep with the Central Bank. Every commercial bank is required under law to keep
with central bank a minimum percentage (say, 8 per cent) of its deposits or reserve in the form
of cash. This is called Cash Reserve Ratio. The bank is free to lend the remaining deposits. Higher
the CRR, lesser is bank’s lending capacity. When there is an inflationary situation, Central Bank
raises the rate of minimum cash-reserve ratio thereby curtailing the lending capacity of
commercial banks.

Statutory Liquidity Ratio (SLR). In additional to CRR, there is another measure called SLR
according to which every bank is required to hold a minimum proportion of its total demand and
time deposits in liquid form (e.g. government securities) as per regulation of Fed. When Fed
wants to contract credit or lending by banks, it raises SLR and thereby reduces credit availability.
(B) Qualitative Measures (The control purpose and
direction of credit).
(iv) Moral Suasion (Restrict credit). This refers to written or oral advice given by Central Bank to
commercial banks to restrict or expand credit. During inflation, the Central Bank of a country
employs selective credit control measures like moral suasion. For instance, it persuades its
member banks not to advance credit for speculation or prohibits banks from entering into
certain transactions. This advice is generally followed by member banks.
(v) Margin Requirements (Increase it). Margin requirement refers to the amount of security that
banks demand from borrower of loan. It is the difference between the amount of loan granted
and the current value of security offered for taking loan. In a situation of excess demand, Central
Bank raises the limit of margin requirements. This discourages borrowing because it makes
traders get less credit against their securities. On the other hand, in case of deficient demand,
margin requirements are lowered to encourage borrowing.

Foreign Trade Policy (Enlarge import surplus)

In a situation of excess demand, import surplus (excess of imports over exports) should be created and
enlarged because imports act a leakage from income stream. Thus the excess demand will be reduced to
the extent of import of goods produced by other countries. Hence, a liberal policy is very helpful.
However import surplus can be financed (i) by drawing upon foreign exchange reserve or gold reserves,
(ii) by taking loans from foreign governments or World Bank etc., and (iii) by taking aid from other
countries in the form of grants.

Excess demand and credit supply

In a situation of excess demand, credit supply should be curtailed/ contracted to control inflation.
When credit availability is restricted and credit is made costlier, the state of excess demand in the
economy is controlled to a great extent.

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Deficient demand
When in an economy aggregate demand falls short of aggregate supply at full employment, the
demand is said to be a deficient demand and the difference (gap) is called deflationary gap. Deficient
demand gives rise to deflationary gap which causes income, output and employment to full and thus
pushes the economy to an underemployment equilibrium. As a result resources remain partly
unutilised showing underemployment.

Deflationary gap
Deflationary gap is the amount by which the actual aggregate demand falls short of aggregate
supply at the level of full employment (i.e., falls short of full employment output). It is a measure of
amount of deficiency of aggregate demand which is required to establish full employment
equilibrium. It causes a decline in output, income and employment along with fall in prices.

Between inflationary gap (causing inflation) and deflationary gap (causing deflation or
depression), the latter is worse because of its serious economic consequences. Moreover deflation (fall
in price level) is difficult to control than inflation.

Deflationary gap and equilibrium level of income

Equilibrium level of income indicates mere equality between aggregate demand and aggregate supply
irrespective of whether it is a full employment equilibrium or under-employment equilibrium. If it is a
full employment equilibrium where all resources are employed to their full limit, deflationary gap cannot
exist at equilibrium level of income. On the other hand, if it is an under-employment equilibrium where
all resources are not fully employed, i.e., some resources are under-employed, then deflation gap can
exist at equilibrium level of income.

Conclusion. We may conclude our discussion in this way. Equilibrium level of national income is
determined by the equality between aggregate demand and aggregate supply (or between savings and
investment). An ideal situation for an economy is full employment equilibrium, i.e., when its aggregate
demand and aggregate supply are in equilibrium at such a point where all the resources of the economy
are employed fully. Every economy aspires for it. US Economy should put in all efforts to achieve and
stay at full employment equilibrium level of income.

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When aggregate demand is less than the level of output at full employment, then the deficiency or gap
is called deflationary gap. It is the difference between the actual level of aggregate demand and the
level of aggregate demand required to establish the full employment equilibrium. It is a measure of the
amount of deficiency in aggregate demand. Briefly deflationary gap is synonym of deficient demand. The
gap is called deflationary gap because it leads to deflation. For instance suppose an economy by fully
utilizing all its available resources can produce 10,000 qtls. Of rice. If the actual aggregate demand for
rice is, say 8,000 qtls. Keynes called it an under-employment equilibrium. Deflationary gap or deficient
demand causes low income, low output and low employment in the economy.

Impact of deficient demand

Deficient demand reduces economy’s output, income and employment. How? Due to deficient demand,
inventories (stock) of unsold goods will accumulate and therefore, the producers will cut down
production by reducing employment. Thus both output and employment will continue to fall until a new
equilibrium is reached at E1. In fact basic problem with deficient demand is lack of full utilisation of
available resources in the form of idle labour force, unutilised industrial capacity and uncultivated lands
i.e. involuntary unemployment. If deficiency in demand (or deflationary gap) is not bridged, it can lead
to fall in output, employment and prices and, therefore, to depression. Depression refers to a phase of
economic activity where falling production and incomes lead to fall in demand and therefore fall in
prices. Once started, the process of depression is self-generating. This is what happened during Great
Depression of 1929-33.

Measures to rectify the situation of deficient demand

In view of adverse effects as stated above, there is great need to close the deflationary gap. Aggregate
demand has to be increased by an amount equal to deflationary gap. The most important measures to
remedy such a situation are fiscal policy, monetary policy and foreign trade policy. Since deficient
demand is opposite of excess demand.

Fiscal policy
(Increase investment and reduce taxes). Fiscal policy comprises expenditure policy and taxation policy of
the government. Main tools of fiscal policy are (i) expenditure policy, (ii) revenue policy, (iii) deficit
financing, and (iv) public borrowing.

(i) Expenditure Policy (Increase expenditure). The objective of expenditure policy should be to pump
more money in the system that gives a fillip to the demand. During period of deficiency in demand, the
government should make large investments in public works like construction of roads, bridges, buildings,
railway lines, canals and provide free education and medical facilities although it may enlarge budget
deficit. The aim is to give more money in the hands of people so that they should also spend more.
Keynes in fact advocated deficit budget to step up aggregate demand.

(ii) Revenue Policy (Reduce tax rate). Taxes on personal incomes and taxes on expenditures on buildings
etc. should be reduced. If possible, tax on lower income groups be abolished. This will increase their

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disposable income for spending. In addition, subsidies, old age pension, unemployment allowance and
grants, interest free loans should be given.

(i) Deficit financing (Printing of notes) should be encouraged.

(ii) Government (public) borrowing should be discouraged.

Monetary Policy (Reduce bank rate and Cash-reserve

ratio)

Monetary policy is the policy of the Central Bank of a country to control credit and money supply.
Mind, credit generally refers to the finance provided to others at a certain rate of interest. The aim of
monetary policy in times of depression is to cause an increase in the investment expenditure by
firms. Thus credit is made cheap and easily available in the following ways:

(A) Quantitative Measures

(i) Bank rate (Reduce it). Bank Rate is the rate at which Central Bank lends to the commercial banks. The
banks in turn increase or decrease accordingly. To check depression, the Central Bank reduces bank rate
thereby enabling the commercial banks to take more loans from it and in turn give more loans to
produces at a lower rate of interest.

(ii) Open Market Operation (Buy securities). These refer to buying and selling of government securities
which influence money supply in the economy. During depression, Central Bank buys Government
bonds and securities from commercial banks by paying in cash to increase their cash stock and lending
capacity.

(iii) Cash-Reserve Ratio (Reduce CRR). Central bank lowers rate of cash-reserve ratio thereby increasing
bank’s capacity to give credit. Similarly Central Bank lowers Statutory Liquidity Ratio (SLR) to
increase availability of credit.

(B) Qualitative Measures

There are qualitative measures also which regulate credit for specific purposes. They channelize credit
into priority sectors and impede its use in undesirable sectors of economy as explained below.

(iv) Margin Requirement (Reduce it). To check depression, Central Bank reduces margin requirement
which encourages borrowing because it induces businessmen to get more credit against their
security.
(v) Moral Suasion. In a situation of deficient demand, Central Bank persuades, requests, appeals or
advises its member banks to expand credit facilities.
(vi) Rationing of credit and sometimes direct action are also resorted to promote social justice while
checking state of depression.

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Foreign trade policy (Enlarge export surplus)

In national accounting, it was made clear that exports are a part of domestic investment. So additional
exports, like domestic investment, increase income and spending. Exports constitute foreign demand for
domestic products. More exports have the effect of increasing aggregate demand. Therefore, when an
economy suffers from deficient demand, it can reduce its deflationary gap by creating and increasing
export surplus (excess of exports over imports). All efforts should be made to encourage export and
discourage imports for generating more employment and income. For this the country may set apart for
export a part of its domestic product which is in demand abroad.

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Exercise

Multiple Choice Questions

Q.1. When all the able and bodied people who are willing to work at prevailing
wage rate but not getting work then it is called

(a) Voluntary unemployment (b) Involuntary unemployment

(c) Under employment (d) none of the above

Q.2. Which of the following can become negative

(a) APC (b) APS

(c) MPC (d) MPS

Q.3. Consumption function is the functional relationship between

(a) Income and saving

(b) Price level and consumption
(c) Income and consumption
(d) Income, saving and consumption

Q.4. When value of MPC is 0.75 then the value of investment multiplier is

(a) K = 4 (b) K = 5
(c) K = 2 (d) K = 3

Q.5. When Ad falls short of AS at full employment level of output then it is

called

(a) Excess demand (b) deficient demand

(c) Inflationary gap (d) all the above

Short Questions
Q.1. If MPC is 0.9, what is the value of multiplier? How much investment is needed to
increase national income by Rs 5,000 Millions Calculate.
Ans. Here ΔY = 5,000 Cr., MPC = 0.9, K = ?, ΔI = ?
By formula K = 1/1-MPC

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K = -1/1-0-.9- = 1/0.1

K = 10

But K = ∆Y/∆I

10 = 5,000/∆I

∆I= 5000/10= 500Cr

So K = 10 and ΔI = 500Cr.

Q.2. Measure the level of ex-ante aggregate demand when autonomous investment and
consumption (A) is Rs 50 millions, and MPS is 0.2 and level of income Y is Rs 4,000 millions.
State whether the economy is in equilibrium or not (cite reasons).
Ans. MFC = 1-MPS
= 1-0.2 = 0.8

Y = Rs 4,000 millions

Now, Aggregate Demand,

AD = C + I

= a + by + I ̅ (where b = MPC)

= a + I ̅ + by

A + by (where A = a + I) a = autonomous consumption

I ̅ = autonomous investment

Now A is given as Rs 50 millions

AD = 50 + 0.8 (4,000)

= Rs 3,250 millions

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Aggregate demand (Rs 3,250 millions) being less than the aggregate supply (Rs 4,000 millions),
the economy is obviously not in equilibrium.

Q.3. In an economy, planned savings exceed planned investment. How will an equality
between the two be achieved? Explain.
Ans. The equilibrium level of National income can be established by the equality between
planned savings and planned investment. As this is derived by the AD – AS approach itself.
AD = AS

C+1 = C+S

(Planned) I = S (Planned)

The equilibrium can better be understood by the following diagram:

From the diagram above, if S > I i.e. National income ON2. But increase in savings as compared
to investment will result in decrease in production, income and employment in the economy.
This will bring the income at equilibrium level i.e. where S = I i.e. at ON level of income.
Moreover, if I > S i.e., level of National income is at ON1. This will result in increase in income,
output level is reached i.e. ON level of income where S = I.

Q.4. In an economy 75 percent of the increase in income is spent on consumption. Investment

is increased by Rs 1,000 millions. Calculate:
(a) Total increase in income.
(b) Total increase in consumption expenditure.
Ans. MPC = -3/4, MPS = -1/4 K= 4
(i) ∆Y = ∆I X K

= 1,000 x 4

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= Rs 4,000 Millions

(ii) Given that ∆Y = ∆C + ∆I

∆C = ∆Y – ∆I

= 4,000-1,000

= Rs 3,000 Millions

OR

∆C – AY X MFC

= 4,000X0.75

= Rs 3,000 Millions.

Q.5. In an economy the equilibrium level of income is Rs 12,000 millions. The ratio of
marginal propensity to consume and marginal propensity to save is 3: 1 Calculate the
additional investment needed to reach a new equilibrium level of income of Rs 20,000
millions.
Ans. MFC = 0.75; AY needed = 8,000 Millions.
K= 1/ 1-MFC =1/ 1-0.75 =4

∆Y = ∆I.K

8,000= ∆ I X 4

∆I= 2,000

Reasoning Questions

Q.6. Giving reasons, state whether the following statements are true or false:
(i) When marginal propensity to consume is zero, the value of investment multiplier will also
be zero.
(ii) Value of average propensity to save can never be less than zero.
Ans. (i) False. When MFC = 0, Multiplier 1/ 1-MPC = 1/1/0=1

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(ii) False. AFS or S/Y can be negative when S is negative at low level of income. At low level of
income consumption expenditure is more than income.

Q.7. Giving reasons, state whether the following statements are true or false:
(i) There is an inverse relationship between the value of marginal propensity to save and
investment multiplier.
(ii) When the value of average propensity to save is negative, the value of marginal
propensity to save will also be negative.
Ans. (i) True, because investment multiplier (K) = 1/(MPS)
(ii) False, the value of MPS can never be negative, value of MFS varies between 0 and l.

Q.8. Giving reasons, state whether the following statements are true or false:
(i) If the ratio of marginal propensity to consume and marginal propensity to save is 4:1, the
value of investment multiplier will be 4.
(ii) Sum of average propensity to consume and marginal propensity to consume is always
equal to 1.
Ans. (i) False, When MFC: MPS = 4:1
Then MPS = 1/ 5

Investment multiplier = 1/MPS= 1/0.2 = 5

(ii) False, there can be no such relationship between APC and MPC. APC is the ratio of C and Y
and MPC is the ratio of ∆C and ∆Y.

Q.9. State whether the following statements are true or false. Give reasons for your answer:
(a) When marginal propensity to consume is greater than marginal propensity to save, the
value of investment multiplier will be greater than 5.
(b) The value of marginal propensity to save can never be negative.
Ans. (a) True, if MPC is greater than 0.8.
OR

False, if MPC is greater than 0.5 but not greater than 0.8

(b) True, since MPS = ∆S/∆Y, The individual may at the most spend the entire ∆Y so that ∆S = 0.
So, MPS can at the most be zero.

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Q.10. Giving reasons, state whether the following statements are true or false:
(i) Average propensity to save is always greater than zero.
(ii) Value of investment multiplier varies between zero and infinity.
Ans. (i) False, it can be negative at low level of income when consumption expenditure is
greater than income.
(ii) False, it varies from 1 to infinity.

Long Questions

Q.1. Explain ‘Paradox of Thrift’.

Ans. If all the people in the economy increase the proportion of their savings, the total volume
of savings does not increase. It either decreases or remains unchanged. This is known as
paradox of thrift. It states that when people become more thrifty, they start saving less or the
same.
Q.2. Calculate consumption level for Y = Rs 1,000 millions if consumption function is C = 300 +
0.5Y.

Ans.
Consumption level C = = 300 + 5/10 x 1000 = 300 + 500 = Rs 800millions.

Q.3. Find out income level when consumption = Rs 1200 millions and consumption function is
C = 100 + 0.5Y.

Ans.
1200 = 100 +5/10 Y= 100 + 1/2 Y

= 1200 -100 = 1100

Y = 1100 x 2 = Rs 2200millions

Since for survival, there has to be autonomous consumption, therefore, C is greater than zero
(C > 0). According to Keynes, as income increases, it is human tendency to increase
consumption (0 < b) but increase in consumption is not as much as increase in income, i.e., b is
less than 1 (b < 1). Thus, we can show the interrelationship in this way.

C > 0, 0 < b < l

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Q.4. If MPC is 0.9, what is the value of multiplier? How much investment is needed to
increase national income by Rs 5,000 Millions Calculate.
Ans. Here ΔY = 5,000 Cr., MPC = 0.9, K = ?, ΔI = ?
By formula K = 1/1-MPC

K = -1/1-0-.9- = 1/0.1

K = 10

But K = ∆Y/∆I

10 = 5,000/∆I

∆I= 5000/10= 500Cr

So K = 10 and ΔI = 500Cr.

Q.5. Measure the level of ex-ante aggregate demand when autonomous investment and
consumption (A) is Rs 50 millions, and MPS is 0.2 and level of income Y is Rs 4,000 millions.
State whether the economy is in equilibrium or not (cite reasons).
Ans. MFC = 1-MPS
= 1-0.2 = 0.8

Y = Rs 4,000 millions

Now, Aggregate Demand,

AD = C + I

= a + by + I ̅ (where b = MPC)

= a + I ̅ + by

A + by (where A = a + I) a = autonomous consumption

I ̅ = autonomous investment

Now A is given as Rs 50 millions

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AD = 50 + 0.8 (4,000)

= Rs 3,250 millions

Aggregate demand (Rs 3,250 millions) being less than the aggregate supply (Rs 4,000 millions),
the economy is obviously not in equilibrium.

Q.6. In an economy, planned savings exceed planned investment. How will an equality
between the two be achieved? Explain.
Ans. The equilibrium level of National income can be established by the equality between
planned savings and planned investment. As this is derived by the AD – AS approach itself.
AD = AS

C+1 = C+S

(Planned) I = S (Planned)

The equilibrium can better be understood by the following diagram:

From the diagram above, if S > I i.e. National income ON2. But increase in savings as compared
to investment will result in decrease in production, income and employment in the economy.
This will bring the income at equilibrium level i.e. where S = I i.e. at ON level of income.
Moreover, if I > S i.e., level of National income is at ON1. This will result in increase in income,
output level is reached i.e. ON level of income where S = I.

Q.7. In an economy 75 percent of the increase in income is spent on consumption. Investment

is increased by Rs 1,000 millions. Calculate:
(a) Total increase in income.
(b) Total increase in consumption expenditure.
Ans. MPC = -3/4, MPS = -1/4 K= 4

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(i) ∆Y = ∆I X K

= 1,000 x 4

= Rs 4,000 Millions

(ii) Given that ∆Y = ∆C + ∆I

∆C = ∆Y – ∆I

= 4,000-1,000

= Rs 3,000 Millions

OR

∆C – AY X MFC

= 4,000X0.75

= Rs 3,000 Millions.

Q.10. In an economy the equilibrium level of income is Rs 12,000 millions. The ratio of
marginal propensity to consume and marginal propensity to save is 3: 1 Calculate the
additional investment needed to reach a new equilibrium level of income of Rs 20,000
millions.
Ans. MFC = 0.75; AY needed = 8,000 Millions.
K= 1/ 1-MFC =1/ 1-0.75 =4

∆Y = ∆I.K

8,000= ∆ I X 4

∆I= 2,000

Q.11. Giving reasons, state whether the following statements are true or false:
(i) When marginal propensity to consume is zero, the value of investment multiplier will also
be zero.
(ii) Value of average propensity to save can never be less than zero.

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Ans. (i) False. When MFC = 0, Multiplier 1/ 1-MPC = 1/1/0=1

(ii) False. AFS or S/Y can be negative when S is negative at low level of income. At low level of
income consumption expenditure is more than income.

Q.12. Giving reasons, state whether the following statements are true or false:
(i) If the ratio of marginal propensity to consume and marginal propensity to save is 4:1, the
value of investment multiplier will be 4.
(ii) Sum of average propensity to consume and marginal propensity to consume is always
equal to 1.
Ans. (i) False, When MFC: MPS = 4:1
Then MPS = 1/ 5

Investment multiplier = 1/MPS= 1/0.2 = 5

(ii) False, there can be no such relationship between APC and MPC. APC is the ratio of C and Y
and MPC is the ratio of ∆C and ∆Y.

Numerical Questions

1. Complete the following table:

Income MPC Saving APS

0 -90

100 0.6 __ __

200 0.6 __ __

300 0.6 __ __

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Ans:
Income MPC ∆C (MPC x ∆Y) Saving APS
0 -90

100 0.6 60 (=0.6 x 100) 150 (=90+60) -0.5 (=-50/100)

200 0.6 60 210 -0.05 (=-10/200)

300 0.6 60 270 0.1 (=30/300)

2. Complete the following table:

Income Consumption Expenditure Marginal Propensity to Average Propensity to

Save Save
0 80 __ __

100 140 0.4 __

200 __ __ 0

__ 240 __ 0.20

__ 260 0.8 0.35

3. Complete the following table:

income Saving Marginal Propensity to Average Propensity to Consume

Consume
0 -20 __ __

50 -10 __ __

100 0 __ __

150 30 __ __

200 60 __ __

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4. Complete the following table:

income Consumption MPC MPS

expenditure
1,000 900 __ __

1,200 1,060 __ __

1,400 1,210 __ __

1,600 1,350 __ __

Ans.

income Consumption MPC(∆C/∆Y) MPS(1-MPC)

expenditure
1,000 900 __ __

1,200 1,060 160/200=0.8 0.2

1,400 1,210 150/200=0.75 0.25

1,600 1,350 140/200=0.7 0.3

5.Complete the following table:

income Consumption Marginal Propensity to Average Propensity to

expenditure Save (MPS) Save (APS)
2,000 1,900 __ __

3,000 2,700 __ __

4,000 3,400 __ __

5,000 4,000 __ __

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Ans.

income Consumption Saving (S) MPS = ∆S/∆Y APS =S/Y

expenditure
2,000 1,900 100 __ 1900/2000 = 0.95

3,000 2,700 300 200 (=300-100) = 0.2 2700/3000 = 0.9

1000 (= 3000-2000)
4,000 3,400 600 300/1000 = 0.3 3400/4000 = 0.85

5,000 4,000 1,000 400/1000 = 0.4 4000/5000 = 0.8

6.Complete the following table:

Income Saving MPC APS

0 -12

20 -6 __ __

40 0 __ __

60 6 __ __

Ans.

Income Saving Consumption MPC(∆C/∆Y) APS (S/Y)

0 -12 12

20 -6 26 0.07 (=14/20) -0.30 (=-6/20)

40 0 40 0.07 0.00

60 6 54 0.07 0.10

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7.Complete the following table:

Income Consumption Marginal Propensity to Average Propensity to Consume

Save

0 15 __ __

50 50 __ __

100 85 __ __

150 120 __ __

Ans.

Income Consumption Saving Change Marginal Propensity Average Propensity

(S) = Y - C in Saving to Save ∆S to Consume
(APC) = C/Y
(∆S) (MPS) = ∆Y
0 15 -15 __ __ __

50 50 0 15 15/50=0.3 50/50=1

100 85 15 15 15/50=0.3 85/100=0.85

150 120 30 15 15/50=0.3 120/150=0.8

6. Complete the following table:

Income Marginal Propensity to Saving Average Propensity to

Consume Consume

0 __ -30 __

100 0.75 __ __

200 0.75 __ __

300 0.75 __ __

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Ans.

Income( Y ) Marginal Propensity Saving Consumption Average Propensity to

to Consume (S) = Y - C (C) Consume
(MPC) (APC) =C/Y
0 __ -30 30 __

100 0.75 -5 105 105/100= 1.05

200 0.75 20 180 180/200= 0.9

300 0.75 45 255 255/300=0.85

9.Complete the following table:

Income Average Propensity to Consume Saving Marginal Propensity to

Consume

0 __ -80 __
100 1.6 __ __
200 1 __ __
300 0.8 __ __

Ans.

Income Average Propensity to Consumption Saving Marginal Propensity to

(Y) Consume (C) (S) = Y – C Consume(MPC = ∆S )
(APC) ∆Y

0 __ -80 -80 __

100 1.6 160 -60 80/100 = 0.8

200 1 200 0 40/100 = 0.4

300 0.8 240 60 40/100 = 0.4

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10. Complete the following table:

Income Saving Average Propensity to Marginal Propensity to

Consume Consume

0 -40 __ __

50 -20 __ __

100 0 __ 0.6

150 30 0.8 __

200 50 __ __

11. Complete the following table:

Consumption Saving Income Marginal Propensity to

Expenditure Consume

100 50 150 __

175 75 __ __

250 100 __ __

325 125 __ __

12. Calculate (i) Income (ii) Savings and (iii) Consumption Expenditure from the following

Where, C = 200 + 0.8MPC, Investment = 60 Millions.

13. Calculate (i) Income (ii) Savings and (iii) Consumption Expenditure from the following

Where, C = 600 + 0.5MPC, Investment = 150 Millions.

14. Calculate (i) Income (ii) Savings and (iii) Consumption Expenditure from the following

Where, C = 800 + 0.9MPC, Investment = 180 Millions.

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Value Based Questions

Q.1. How can FDI in retail be used as a measure to reduce inflation in US?

Supply of essential commodities can be brought in to US through FDI, which will bring equilibrium in the
market demand and supply to check inflation.

Effective and efficient distribution of goods can be ensured govt. monitoring and price ceiling.

Value: problem solving.

Q.2. Central bank raises LRR when the country is suffering through inflation. How vital a tool can it be
in this situation?

LRR-it is the rate at which commercial banks maintains their reserve against the deposits. Their lending
capacity is reduced when LRR is raised and credit money in circulation is checked to control the inflation.
Credits become costlier.

Value: critical thinking. 3.70% crude oil in US is imported. Increase in oil price has played cascading
effect on cost of production of all goods and prices have gone up several times.

Q.3. Suggest measures to reduce the import of oil. Explore the possibilities of alternatives and oil
extraction with in USA.

Reduction of oil usage wherever possible. Usage of public transport system. Increasing taxes on oil to
check its imports for essential usage. Rationing of oil distribution-including retail.

Value: critical thinking/problem solving

Q.4. A part of population prefers to work even though suitable work is available to them. What values
are affected under such situation?

This situation is voluntary unemployment. It occurs due to lack of willingness to do the work. The
available human resource remain unutilized and affects the economic growth as they share the
development with others without their contribution.

Value: social responsibility / maximum social welfare.

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Q.5. Nowadays market demand for gold investment is steadily increasing in spite of price rise. Suggest
any two measures to check it.

Sales tax to be raised. Import duty to be raised

Value: social responsibility.

Encouraging individuals to save is a virtue but if the entire economy begins to save then it could be a
vice.

Excess saving results in deficient demand because when everyone saves, the demand in the economy
automatically decreases leading to a deflationary status in the economy.

Value: social responsibility.

Q.6. Should the Govt. concentrate on full employment of resources or bringing about equilibrium in
the economy since achieving both simultaneously is difficult.

Govt. should first try to achieve equilibrium to attain economic stability and economic growth and then
to focus on achievement of full employment.

Value: economic stability/social justice and equality.

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4 Government Budget

Learning Objectives

1. Meaning of government Budget

2. Objectives of Government Budget
3. Impact of Budget
4. Components Budget
5. Revenue Receipts and Capital Receipts
6. Revenue Expenditure and Capital Expenditure
7. Balanced Budget, Surplus Budget and Deficit Budget
8. Budget Deficit

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 Principles of Macroeconomics

A government budget is an annual financial of statement of estimated revenue and

estimated expenditure during a fiscal year.

Government budget
“A government budget is an annual statement of the estimated receipts and
expenditure over a fiscal year.” Just as your household budget is all about what you earn and
spend, similarly the govt. budget is a statement of govt. income and expenditure. The
government first plans expenditure according to its objectives and then tries to raise resources
to meet the proposed expenditure. This, a budget is a statement of anticipated expenditure
under various heads and proposed resources of financing the expenditure for the ensuri9ng
financial year. Government earns money broadly from taxes and fees, interest on loans
given to states and dividend by public sectors enterprises. Government spends (i) on securing
and providing goods and services to citizens, (ii) on law and order, and (iii) internal security,
defence, staff salaries etc. The financial (fiscal) year starts on April 1 and ends on March 31 of
next year.

Objectives of a Government Budget

Briefly put, rapid and balanced economic development with equality and social justice has
been the objective of all our policies. General objectives of a government budget are as under:

(i) Economics growth. To promote rapid and balanced economic growth so as to improve living
standard of the people.
(ii) Reduction of Poverty and Unemployment. To eradicate mass poverty and unemployment
by creating maximum employment opportunities and providing maximum social benefits to the
poor. Social welfare is the single most objective of the government. Every American should be
able to meet his basic needs like food, clothing, and housing along with decent health care and
educational facilities.
(iii) Reallocation of Resources. To reallocate resources in line with social and economic
objectives. Again government has to allocate resources into areas where private sector is not
coming, e.g., sanitation, rural development, education, health etc.
(iv) Reduction of inequalities. To reduce inequalities of income and wealth through levying
taxes and granting subsidies. Govt. uses progressive taxation policy, i.e., high rate of tax on rich
people and low rate on lower income group. Govt. provides subsides and amenities to people
whose income level is low. More, emphasis is laid on equitable distribution of wealth and
income. Economic progress in itself is not a sufficient goal but goal must be equitable progress.

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 Principles of Macroeconomics

(v) Price stability. To maintain price stability and correct business cycles involving depression
characterised by falling output, prices and increasing unemployment.
(vi) Management of public enterprises . To manage public enterprises which are of the nature
of monopolies like railways, electricity etc.

Impact of budget
A budget impacts the society at three levels : (i) It promotes aggregate fiscal discipline through
controlled expenditure, given the quantum of revenues. (ii) Resources of the country are
allocated on the basis of social priorities. (iii) It contains effective and efficient programmes for
delivery of goods and services to achieve its targets and goals. In short, the budget impacts the
economy through aggregate fiscal discipline, resource allocation and provision of programmes
for delivery of services.

Components of the budget

The budget is divided into two parts-

(i) Revenue Budget, and (ii) Capital Budget.
(i) The Revenue Budget comprises current revenue receipts and current expenditure met from
such revenues. The revenue receipts include both tax revenue and non-tax revenue(ii) Capital
Budget consists of capital receipts and capital expenditure of the government. Capital receipts
are receipts of the government which create liabilities or reduce assets. Capital expenditure is
the expenditure of the government which either reduces liability or creates an asset. Thus
capital budget is an account of assets and liabilities of the government which takes into
consideration changes in capital.
Further government budget broadly consists of two parts – Budget Receipts and Budget
Expenditure as shown in the following chart. Let us see their classification.

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 Principles of Macroeconomics

Budget Receipts
Budget receipts refer to estimated receipts of the government from various sources during a
fiscal year. It shows the sources from where the government intends to get money to finance
the expenditure (both revenue and capital expenditure). Budget receipts are of two types –
Revenue Receipts and Capital Receipts – as explained below: Their components are shown in
the following chart.
Budget (Govt.) Receipts

Revenue Receipts Capital Receipts

(Components)

Tax Revenue Non-tax Revenue

(Components) (Components)
(i) Income tax (i)Interest receipts (i) Borrowings
(ii) Corporate tax (ii) Profits and dividends (ii) Recovery of loans
(iii) Custom duty (iii) Fees and fines (iii) Disinvestment
(iv) Excise duty (iv) Special assessment (iv) Small savings and
(v) Expenditure tax (v) External grants-in-aid Provident funds
(vi) Wealth tax
(vii) Interest tax
(viii) Estate Duty

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Difference between Revenue Receipts and Capital

Receipts
Government receipts are divided into two groups – Revenue Receipts and Capital Receipts.
Basis of classification – All government receipts which either create liability or reduce assets
are treated as capital receipts whereas receipts which neither create liability not reduce assets
are called revenue receipts.
(i) Revenue Receipts. Government receipts which neither (i) create liabilities, nor (ii) reduce
assets are called revenue receipts. These are proceeds of taxes, interest and dividends on
government investments, cess and other receipts for services rendered by government. Thus
these are current income receipts of the government from all sources. Government revenue is
the means for government expenditure in the same way as production is means for
consumption. Revenue receipts are further classified into Tax Revenue and Non-tax Revenue as
explained in part (c) of this question.
(ii) Capital Receipts. Government receipts which either (i) create liabilities (of returning loans),
or (ii) reduce assets (on disinvestment) are called capital receipts. Two main examples of capital
receipts which create liability are (A) Borrowing, and (b) Raising of funds from PPF and Small
Saving Deposits. Borrowing is treated capital receipts because it creates liability of returning
loans. Similarly funds raised from Post Office deposits, Public Provident Fund, NSS deposits etc.
are also treated as capital receipts because government has to repay these amounts.
Difference
The main difference between revenue receipts and capital receipts is that in case of revenue
receipts, government is under no future obligation to return the amount, i.e., they are non-
redeemable. But in case of capital receipts which are borrowings, government is under
obligation to return the amount along with interest.
Debt creating and non-debt creating capital receipts. Capital receipts may be debt creating or
non-debt creating. Examples of debt creating receipts are: Net borrowing by government at
home, loans received from foreign governments, borrowing from Central Bank. Examples of
non-debt capital receipts are: Recovery of loans, proceeds from sale of public enterprises (i.e.,
disinvestment etc.). These do not give rise to debt.

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Components (Sources) of Revenue Receipts (Tax

Revenue and Non-tax Revenue)
Revenue receipts of the government are divided into two groups, namely, (i) tax revenue, and
(ii) non-tax revenue. Tax revenue consists of proceeds of taxes and other duties levied by the
Union Government such as income tax, corporate tax, excise duty, custom duty etc. Non-tax
revenue consists of all receipts from sources other than taxes. These are shown in the above
chart. Components or sources of revenue receipts are explained below.

Tax revenue
Tax revenues consist of proceeds of taxes and other duties levied by the Union Government. It
is the main source of government revenue. A tax is a legally compulsory payment imposed by
the government on income and profit of persons and companies without reference to any
benefit. Similarly, government levies taxes on sale of goods(sale tax), manufacturing of goods
(excise duty), an export and import of goods (custom duty), wealth , gifts, existing tax rates are
contained in the budget. The money received from taxes is used by the government to meet
the expenditure incurred on providing common benefits to the people. No one can refuse to
pay the tax otherwise the defaulter is prosecuted and penalised. The tax payer cannot demand
in exchange for tax payment. For instance a rich man cannot claim that he would not pay taxes
to supports schools because he has no children. The central government collects revenue in the
form of various taxes such as income tax, corporate tax, custom duty, excise duty, expenditure
tax, wealth tax, interest tax etc. The main objectives of taxation are:
(i) To increase government income,
(ii) To achieve equitable distribution of income,
(iii) To restrain use of harmful commodities,
(iv) To regulate foreign trade, and
(v) To conserve country’s resources.
Taxes are of different kinds such as direct and indirect taxes which are discussed in Q.9.5.

Non-tax revenue
Income from sources other than taxes is called non-tax revenue. It arises on account of
administrative function of of the government. These are incomes which the government gets
in the form of interest, dividend, profit, fees, fines and external grants as explained below.

It comprises the following items.

(i) Interest. It is an important source of government non-tax revenue. Government receives
interest on loans given by it to state governments, union territory governments, local
governments, private enterprises and the people.

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(ii) Profits and dividends. Of late government has developed a new source of income by
starting its own production units called public enterprises which like private enterprises
produce and sell goods and services.
(iii) Fees and fines. Government gets income, though nominal, in the form of different types of
fees charged by it, e.g., tuition fees in schools, OPD card fees , driving licence fees, imports
fees etc. Similarly government gets income by way of fines and penalties imposed by it on
various types of offences committed by the low-breakers. These are called administrative
revenue. Forfeitures of basic surety or bond (imposed by courts for non-compliance with
orders) and escheat (lapsing of property to state for want of legal heir of the deceased) are
other sources of non-tax revenue. Administration revenue is revenue that arises on account
of administrative functions of the government.
(iv) Special Assessment. When government undertakes development activities like construction
of roads, provision of drainage, street lighting in a particular areas, the value of nearby
property or rental value of houses goes up in the vicinity. Clearly the additional income and
profit which the owners of the landed property get is not the result of efforts on their part.
Special assessment is, therefore, like a special tax that government levies in proportion to
the benefit accruing to property owners to defray the cost of development. It is payment
made once-for-all by the owners of properties for increase in the value of their properties
resulting from development activities of the government.
(v) External grants-in-aid. Government receives financial help from foreign governments and
international organisations in the form of grants, donations, gifts and contribution.

Components (Sources) of Capital Receipts.

These are the following:
(i) Borrowing (domestic and external). Funds raised by government from borrowing are
treated as capital receipts. These funds are borrowed from(i) open market (known as
market borrowing), (ii) Federal Reserve Bank, (iii) foreign governments and
international organisations (like World Bank, Asian Development Bank etc.).
Government resorts to borrowing when its expenditure exceeds its revenue (i.e., when
there is fiscal deficit).
(ii) Recovery of loans and advances. Loans offered by government to others are govt.
assets because it owns money that it lends. We know that Central Government grants
loans to (i) states, union territories, (ii)public sector enterprises, other parties and (iii)
foreign governments. Reduction in assets of the government.
(iii) Disinvestment. Government raises funds from disinvestment also Disinvestment
means selling whole or a part of the shares (i.e., equity) of selected public sector
enterprises held by government to private sector. As a result, government assets are
reduced. Sometimes disinvestment is also termed as privatisation because it involves
transfer of ownership of public sector enterprises to private entrepreneurs.

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(iv) Small savings. Government receipts also include small savings like Post Office deposits,
GPF deposits, NSS deposits, Kisan Vikas Patras etc. Answer to Board’s question-(i) It is
capital receipt because it reduces financial assets. (ii)and (iii) are revenue receipts
because these create neither liabilities nor cause any reduction in assets. (Iv) This is
capital receipt because disinvestment reduces government assets.

Budget (Government) Expenditure

Budget (or Government) Expenditure refers to the estimated expenditure to be incurred by the
government under different heads in a year.

Main objectives of government’s expenditure are as under. They show the importance
(significance) of public expenditure.
I. For satisfaction of collective needs of the people.
II. For smooth functioning of government machinery.
III. For economic and social welfare of the people.
IV. For creation/addition of capital goods and infrastructure.
V. For controlling depressionary tendencies in the economy.
VI. For accelerating the speed of economic development.
VII. For reducing regional disparities of growth.
Like two types of budget receipts, i.e., Revenue Receipts and Capital Receipts, budget
expenditure is also of two types, i.e., Revenue Expenditure and Capital Expenditure. But the
point to be noted in case of expenditure is that all government expenditure is first classified
into (i) Plan Expenditure, and (ii) Non-plan Expenditure and thereafter they are further sub-
classified into Revenue Expenditure and Capital Expenditure each of which in turn is subdivided
into development and non-development expenditure as shown in the following chart. Thus
government (public) expenditure is broadly classified in three ways : (i) Revenue and Capital
Expenditure, (ii) Plan and Non-plan Expenditure, and (iii) Development Expenditure.

Budget (Govt.) Expenditure

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Plan Expenditure Non-plan Expenditure

Revenue Capital Revenue Capital

Expenditure Expenditure Expenditure Expenditure
(Components) (Components) (Components) (Components)
(i) Central plans (i) Central plans (i) Interest payment (i) Defence
(ii) Assistance to capital projects (on loans taken by capital
Finance state (ii) Loans to State and Union Govt.) (ii)Other
And U.T. plans. Territories for their capital (ii) payments of salaries than
Projects. (iii) Defence services defence
Expenditure capital
(iv) Subsidies (iii) Loans
(v) Grant to States to states
And Union Territories and
(vi) Economic services Union
(vii) Education and health Territories
Services (iv) Loans
(viii)Family welfare to public
(ix)Flood control (v) Loans
(x)Rural development to
Foreign
Government

Difference between Revenue Expenditure and capital

Expenditure are further subdivided into revenue

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Expenditure and capital expenditure.

(i) Revenue Expenditure. Simply put, an expenditure which neither creates assets nor
reduces liability is called Revenue Expenditure i.e. Salaries of employees, interest
payment on post debt, subsidies, pension etc. These are financed out of revenue
receipts. Broadly any expenditure that does not lead to any creation of assets or
reduction in liability is treated as revenue expenditure. Generally expenditure incurred
on normal running of the government departments and maintenance of services is
treated as revenue expenditure. Examples of revenue expenditure are salaries of
government employees, interest payment on loans taken by the government, pensions,
subsidies, grants, rural development, education and health services etc. It is a short
period expenditure and recurring in nature which is incurred every year (as against
capital expenditure which is long period expenditure and non-recurring in nature). The
purpose of such expenditure is not to build up any capital asset but to ensure normal
functioning of government machinery. Traditionally all grants given to state governments
are treated as revenue expenditure even though some of the grants may be for creation
of assets.
(ii) Capital Expenditure. An expenditure which either creates an asset (e.g. School building)
or reduces a liability (e.g. repayment of loan) is called capital expenditure. (A) Capital
expenditure which leads to creation of assets are (a) expenditure on purchase of assets
like land, buildings, machinery and construction of roads, canals etc. (b) investment in
shares, loans by central government to state govt., foreign governments and government
companies, cash in hand and (c) acquisition of valuables. Such expenditure are incurred
on long period development programmes, real capital assets and financial assets. This
type of expenditure adds to the capital stock of the economy and raises its capacity to
produce more in future. (B) Repayment of loan to World Bank, foreign government etc. is
also capital expenditure because it reduces liability. These expenditures are met out of
capital receipts of the government including capital transfers from rest of the world.

Difference between Plan and Non-plan Expenditure

(i) Plan Expenditure. Plan Expenditure refers to the estimated expenditure which is
provided in the budget to be incurred during the year on implementing various
projects and programmes included in the plan.
Provision of such expenditure in the budget is called Plan Expenditure. Expressed
alternatively “plan expenditure is that public expenditure which represents current
development and investment outlays (expenditure) that arise due to proposals in
the current plan”. Such expenditure is incurred on financing the central plan relating
to expenditure on (i) construction of roads and bridges, (ii) generation of
electricity,(iii) irrigation and rural development, and (iv) science, technology and
environment, etc. It includes both revenue expenditure and capital expenditure.
Again the assistance given by the Central Government for the plans of States and

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Union Territories (U.T.) is also a part of plan expenditure. Plan expenditure is further
sub-classified into Revenue Expenditure and Capital Expenditure which along with
their components are shown in the preceding chart.

(ii) Non-plan Expenditure. This refers to the estimated expenditure provided in the
budget for spending during the year on routine functioning of the government. Non-
plan expenditure is all expenditure other than plan expenditure. Such and
expenditure is a must for every country, planning or no planning. For instance no
government can escape from its basic function of protecting the lives and properties
of the people and protecting the country from foreign invasions. For this,
government has to spend on police, judiciary, military etc. Similarly, government has
to incur expenditure on normal running of government departments and on
providing economic and social services. In short, Expenditure other than plan
expenditure related to current Five Year Plan is treated as non-plan expenditure. Its
components are shown is the preceding chart.

Development and Non-development Expenditure

Developmental expenditure
It refers to expenditure on activities which are directly related to economic and social
development of the country. For instance expenditure incurred on education, health, housing,
agricultural and industrial development, rural development, social welfare, scientific research
etc. are treated as development expenditure. It also includes plan expenditure of Railway, post
and Telecommunications, Non-departmental commercial undertakings.

Non-development expenditure
It refers to government expenditure incurred on essential general services of routine nature like
defence, of view. For instance expenditure on police, judiciary, defence, general administration,
interest payment, tax collection, subsidies on food etc. are treated as non-developmental
expenditure. Agreed non-developmental expenditure does not contribute directly to national
product but it does help indirectly in economic development of a country. That way it is an
essential part of the development process.

Main difference between development and non-development expenditure is that the

development expenditure directly adds to the flow of goods and services wheras non-
development expenditure does not. Again all the different types of expenditure, viz., plan or
non-plan expenditure. Revenue or capital expenditure can also be categorised into
developmental expenditure and non-developmental expenditure as shown above.

Tax

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A tax is a legally compulsory payment imposed by the government on income and property
of persons and companies without any benefit in exchange, e.g., income tax, corporate tax,
wealth tax, sales tax, excise duty etc. Taxes are of two types – direct taxes and indirect taxes.
Broadly taxes whose burden and liability to pay is borne by the same person are called direct
taxes but whose burden and liability to pay is borne by different persons are called indirect
taxes.

Distinction between Direct Tax and Indirect Tax

Basis of Classification
The basis of classifying taxes into direct tax and indirect tax is “whether the burden of the tax is
shift able to other or not.” If it is not shift able, it is a direct tax. If burden is shiftable to others,
it is indirect tax.
(i) Direct tax. When(i) liability to pay a tax, and (ii) the burden of that tax falls on the same
person, the tax is called a direct tax. Thus a direct tax is the tax whose burden is borne
by the same person on whom it has been levied, i.e., its burden cannot be shifted to
others. Direct taxes are levied on the income and property of persons. Income tax and
corporate (profit) tax are most appropriate examples of direct taxes. Income tax is
levied on the profit of a company (business enterprise) is paid by the company itself
which bears its burden also. Wealth tax, gift tax, interest tax, expenditure tax etc. are
other examples of direct taxes. In short, direct taxes are those taxes levied immediately
on the income and property and are paid directly by the consumers to the state.
Direct taxes are generally considered progressive taxes because they are based on the ability to
pay. A progressive tax is one the rate of which increases with rise in income and decreases with
fall in income.

(ii) Indirect tax. When (i) liability to pay a tax is on one person, and(ii)the burden of that tax
falls on some other person, the tax is called an indirect tax. Thus it is a tax whose burden
can be shifted to others. In case of an indirect tax, some person first pays the tax but he
is able to recover it from some other person thereby transferring the burden of the tax
to others. For instance, sale tax is an indirect tax because liability to pay the tax is that of
the shopkeeper who in turn realises the tax amount from the buyer by including it in the
price of the commodity. Simply put all taxes levied on goods and services in different
forms (like on production, sale, transport etc.) are called indirect taxes. Examples of
indirect taxes are sale tax, excise duty, custom duty, entertainment tax, service tax,
octroi (chungi) etc. Taxes imposed when goods are imported from a foreign country are
called custom duties wheras taxes levied when a product leaves factory gate are called
excise duties.

Goods and Services Tax (GST)

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Goods and Services Tax (GST) is an indirect tax (or consumption tax) levied in USA on the
supply of goods and services. GST is levied at every step in the production process, but is
meant to be refunded to all parties in the various stages of production other than the final
consumer.

Wealth tax is a direct tax as liability of its payment and burden fall on the same person.
Entertainment tax is an indirect tax because its burden can be shifted.
Income tax is a direct tax because its liability to pay and its burden fall on the same person

Balanced Budget, Surplus Budget and Deficit Budget

(i) Balanced Budget. A government budget is said to be a balanced budget in which

government estimated receipts (revenue and capital) are shown equal to government
estimated expenditure. Let us suppose for the sake of convenience that the only
source of revenue is a lump sum tax. A balanced budget will then imply that the
amount of tax is equal to the amount of expenditure.

Symbolically:
Balanced Budget
Estimated Govt. Receipts = Estimated Govt. Expenditure

Two main merits of a balanced budget are : (i) It ensures financial stability, and (ii) It
avoids wasteful expenditure. Two main demerits are : (i) Process of economic growth is
hindered, and (ii) Scope of undertaking welfare activities is restricted.
According to Adam Smith, public expenditure should never exceed public revenues, i.e.,
he advocated a balanced budget. But Keynes and modern economists are not agreed
with the policy of a balanced budget. Falls short of the amount necessary to maintain

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full employment. Therefore, government should increase its expenditure to close the
gap between the expenditure essential for full employment and expenditure that
actually takes place. Ideally a balanced budget is a good policy to bring the near full
employment economy to a full employment equilibrium.
When government estimated expenditure is either more or less than government
estimated receipts, the budget is said to be an unbalanced budget.
(ii) Surplus Budget. When government estimated receipts are more than government
estimated expenditure in the budget, the budget is called a surplus budget. In other
words, a surplus budget implies a situation wherein government revenue is in excess
of government expenditure.
Surplus Budget
Estimated Govt. Receipts > Estimated Govt. Expenditure

A surplus budget shows that government is taking away more money than what is is
pumping in the economic system. As a result aggregate demand tends to fall which
helps in reducing price level. Therefore, in times of severe inflation which arises due to
excess demand, a surplus budget is the appropriate budget. But in a situation of
deflation and recession, surplus budget should be avoided.
(iii) Deficit Budget. When government expenditure exceeds government receipts in the
budget, the budget is said to be a deficit budget, In other words, in a deficit budget,
government estimated revenue is less than estimated expenditure. Symbolically:
Deficit Budget
Estimated Govt. Receipts < Estimated Govt. Expenditure

Keynes recommended deficit budget to solve the problem of unemployment and

under-employment. Today deficit budget has become very common. Government
covers the gap either (i) through domestic borrowing or (ii) through sale of assets or (iii)
through borrowing from external sources. Thus a deficit budget implies increase in
government liability and fall in its reserves. When an economy is in a good remedy to
combat recession.
A deficit budget has its own merits especially for developing economy For example :
(i) It accelerates economic growth, and (ii) It enables to undertake welfare programmes
of the people. At the same time, it has demerits also such as (i) It encourages
unnecessary and wasteful expenditure by the government, and (ii) It may lead to
financial and political instability.
We have read in the preceding chapter the situation of excess demand leading to
inflation ( continuous rise in prices) and the situation of deficient demand leading to
depression (fall in prices, rise in unemployment etc.) A surplus budget is recommended
in the situation of inflationary trends in the economy whereas a deficit budget is
suggested in the situation of depression.

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Measures of Govt. Budget deficit

Revenue deficit Fiscal deficit Primary deficit

(Govt. borrowing)
1. Revenue deficit = Total revenue expenditure – Total revenue receipts
2. Fiscal deficit = Total expenditure – total receipts excluding borrowings
3. Primary deficit = Fiscal deficit – interest payments

Revenue deficit
Revenue deficit refers to the excess of total revenue expenditure of the government over its total
revenue receipts. It signifies that government’s own revenue, it incurs revenue deficit. Mind,
revenue deficit includes only such transactions that affect current income and expenditure of
the government.
Symbolically:
Revenue deficit = Total Revenue expenditure – Total Revenue receipts

Fiscal deficit
Fiscal deficit is defined as excess of total expenditure over total receipts excluding borrowings
during a fiscal year. It is extend to which expenditure overshoots the sum of revenue receipts
and capital receipts excluding borrowing. In the form of an equation:
Fiscal deficit = Total budget expenditure – Total budget receipts excluding borrowings

Going deeply we will find that fiscal deficit is in fact equal to borrowing. The point to be noted is
that fiscal deficit does not take into account borrowings which is a part of capital receipts. Total
Receipts means Revenue Receipt + Non-debt Capital Receipts (i.e., capital receipts reduced by
disinvestment proceeds. Thus in terms of components:

Fiscal deficit = Total Expenditure – Revenue Receipts – Capital Receipts excluding

borrowing
Fiscal deficit is the most important measure of deficit budget.

Can there be Fiscal deficit without Revenue deficit?

Fiscal deficit without revenue deficit is possible
(i) When revenue budget is balanced but capital budget shows a deficit or (ii) when there is
surplus in revenue budget but deficit in capital budget is greater than surplus of revenue
budget. The following equations further clarify the distinction between the two.

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Revenue Deficit = Revenue expenditure – Revenue receipts

Fiscal Deficit = Total expenditure (Revenue exp. + capital exp.) – Revenue receipts – capital
receipts excluding borrowing

Importance

Fiscal deficit is the measure of borrowing requirements of the government during the budget
year. The extent of fiscal deficit indicates how far the government is living beyond its own
sources to meet budget expenditure.

Implications
(i) Debt trap. Fiscal deficit, i.e., borrowing creates problems of not only (A) repayment of loans
but also of (b) payment of interest. As the government borrowing increases, its liability in future
to repay loans along with interest thereon also increases. Payment of interest increases
revenue expenditure leading to a higher revenue deficit. Increased revenue deficit may further
lead to more borrowing and more interest payment. Ultimately government may be compelled
to borrow to finance even interest payment leading to emergence of a vicious circle and debt
trap.
(ii)Wasteful expenditure. High fiscal deficit generally leads to wasteful and unnecessary
expenditure by the government. Therefore, fiscal deficit should be kept as low as possible.
(i) Inflationary pressure. A large fiscal deficit means larger amount of borrowing which in
turn creates larger burden of interest and loan repayment in future. This may load to
inflationary pressure in the economy.
(ii) Only a part of borrowing is available, The entire amount of fiscal deficit, i.e., borrowing
is not available for meeting the expenditure because a part of it is used for interest
payment. Only primary deficit (fiscal deficit – interest payment) is available for
financing expenditure.

Formulae of Budget Deficit

Budgetary Deficit

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Revenue Deficit Fiscal Deficit Primary Deficit

Revenue Deficit = Total Revenue Expenditure – Total Revenue Receipts

Fiscal Deficit = Total Expenditure – Total Receipts Excluding borrowings

Or
Fiscal Deficit = Total Expenditure – Revenue Receipts – Capital Receipts Excluding
= Borrowings

Primary Deficit = Fiscal Deficit – Interest Payments

Summary of Budget Estimates for 2008-09

(Rs. in millions)
1. Revenue Receipts (2 + 3) 602,935
2. Tax revenue 507,150
3. Non-tax revenue 95,785
4. Capital Receipts(5 + 6 + 7) 147,949
5. Recoveries of loans 4,497
6. Other receipt 10,165
7. Borrowing and other liabilities 133,287
8. Total receipts (1 + 4) 780,884
9. Non-plan expenditure (10 + 12) 507,498
10. On revenue account 448,352
11. (of which interest payment) 190,807
12. On capital account 59,146
13. Plan expenditure (14 + 15) 243,386
14. On revenue account 209,767
15. On capital account 33,619
16. Total expenditure (9 + 13) 750,884
17. Revenue expenditure (10 + 14) 658,119
18. Capital expenditure (12 + 15) 92,765

Ans. (a) Revenue deficit = (17 – 1) = 658,119 – 602,935 = 55,184 millions

(b) Fiscal deficit =[16 – (1 + 5 + 6)]
= 750,884 – (602,935 + 4,497 + 10,165)
= 133,287 millions
(a) Primary deficit = Fiscal deficit (b) – interest payment(11)
= 133,287 – 190,80-7 = -570,520 millions

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Exercise
Multiple Choice Questions
Q.1. which one is direct tax?

(a) Service Tax (b) Excise Tax

(c) GST (d) Entertainment Tax

Q.2. If budgetary deficit is nil and borrowings and other liabilities are 70 millions,
what is the amount of fiscal deficit?

(a) Nil (b) 30 Millions

(c) Can’t say (d) 70 millions

Q.3. Payment of interest is

(a) Revenue expenditure (b) capital expenditure

(c) Primary deficit (d) Fiscal deficit

Q.4. If in a budget, revenue deficit is Rs. 50,000 and borrowings are Rs. 75,000
millions. How much is the fiscal deficit?

(a) 50,000 millions (b) 75,000 millions

(c) 25,000 millions (d) 1,25,000 millions

Q.5. Capital receipt may come from

(a) Market borrowing (b) Provident fund

(c) Recoveries of loan (d) All the above

Short Questions
Q.1. What is a budget?
Ans. A government budget is an annual statement of estimated receipts and expenditure over a
fiscal year which runs from April 1 to March 31.

Q.2. What are the objectives of a budget?

Ans. (i) To reallocate resources, (ii) To eradicate mass poverty and unemployment, (iii) To
reduce inequalities of income and wealth, (iv) To reduce regional imbalances, (v) To manage
public enterprises, and (iv) To prevent business fluctuations and maintain price stability etc.

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Q.3. What are revenue items?

Ans. Revenue items consists of tax items like income tax, corporate tax, excise duty, wealth tax
etc. and non-tax items like interest receipts, profits, dividend, fees and fines etc.
Define Direct Tax.
Ans. A tax is called a direct tax when its final burden falls on a person who has to pay for it
himself. Income tax and wealth tax are examples of direct taxes.
Q.4. Define indirect tax. Give two examples of indirect taxes.
OR
Give two examples of indirect taxes.
Ans. A tax is called an indirect tax when the final burden of the tax falls on someone other than
the person who is liable to pay the tax or taxes. Sales tax and excise duty are examples of
indirect taxes.
Q.5. Why are the borrowings by the government called capital receipts?
Ans. Borrowings by the government are capital receipts since they create a liability for
government.
Q.6. What is a balanced government budget?
Ans. A balanced budget is one in which estimated revenues are equal to estimated
expenditure.
Q.7. Define a surplus government budget.
Ans. A surplus government budget is one in which estimated revenues are more than the
estimated expenditure.
Q.8. Define a deficit government budget.
Ans. A deficit government budget is one in which estimated government revenues are less than
the estimated government expenditure.
Q.9. What is budgetary deficit?
Ans. The excess of total expenditure over total receipts of a government in an accounting year
is called budgetary deficit.
Q.10. What is deficit financing?
Ans. Printing new currency notes by central bank to meet the budgetary deficit is called deficit
financing.
Q.11. What is fiscal deficit?
Ans. Fiscal deficit is the excess of total expenditure over total receipts excluding borrowings.
Q.12. What is meant by revenue deficit.
Ans. Revenue deficit means excess of revenue expenditure over revenue receipts.
Q.13. What is primary deficit.

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Ans. Primary deficit is equal to the fiscal deficit reduced by the amount of interest payments
paid by the government.
Q.14.Why is repayment of loan a capital expenditure?
Ans. Repayment of loan reduces liability thus, it is a capital expenditure.
Q.15. Why is payment of interest a revenue expenditure?
Ans. Payment of interest does not change the assets and liabilities position of the government,
thus it is treated as revenue expenditure.
Q.16. Why are subsidies treated as revenue expenditure?
Ans. Payment of subsidies neither create any asset nor reduce any liability of the government,
thus it is treated as revenue expenditure.
Q.17. Why is recovery of loan treated as capital receipts?
Ans. Recovery of loan reduces assets of the government to the extent of the amount of loan
recovered, it is thus treated as capital receipt.
Q.18. Why is interest received categorized as revenue receipts?
Ans. Receipt of interest does not cause any reduction in assets nor create any liability, it is thus
categorized as revenue receipt.
Q.19. Why are borrowings a capital Receipt?
Ans. Because it leads to increase in liability.
Q.20. Why are receipts from taxes categorized as revenue receipts?
Ans. Government incurs no liability in receipts of taxes collected by it, therefore these are
categorized as revenue receipts.
Q.21. What are Non-tax revenue receipts?
Ans. The revenue receipts from sources other than tax termed as non-tax revenue receipts.
Q.22. State any two sources of Non-tax revenue receipts.
Ans. (i) Interest, (ii) Dividends, (iii) Profits, (iv) External grants.
Q.23. What is a debt trap?
Ans. It is a vicious circle in which the government takes new loans to repay its earlier
loans/interest.
Q.24. What is a balanced budget multiplier?
Ans. It is the ratio of increase in income to increase in government expenditure financed by
taxes.
Q.25. How is Primary Deficit Calculated?
OR
What is primary deficit?
Ans. Primary deficit = Fiscal deficit – Interest payment
Q.26. What does zero primary deficit mean?

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Ans. Zero primary deficit means the government has to borrow only to make payment of
interest.
Q.27. What does primary deficit indicate?
Ans. Primary deficit indicates borrowing requirement of a government to meet deficit excluding
interest payments.
Q.28. What are the consequences of deficit financing?
Ans. Deficit financing involves printing of more currency which increases the money supply and
leads to inflation.
Q.29. What is developmental expenditure?
Ans. Expenditure on the activities related to economic and social development of the country is
called developmental expenditure.
Q.30. What is non-developmental expenditure?
Ans. Expenditure on non-essential general services of the government is called non
development expenditure.
Q.31. Give an example of non-developmental expenditure.
Ans. Expenditure on defence.
Q.32. Give an example of developmental expenditure.
Ans. Expenditure on health.

Long Questions
Q.1. Government has started spending more or providing free services like education and
health to the poor. Explain the economic value it reflects.
Ans. The economic value reflected by the above act of the government is ‘Promoting Social
Welfare’. The government uses the fiscal instruments of subsidies and taxation to improve the
distribution of income and wealth in the economy. By spending more on provision of free
services like education and health, government is trying to promote social justice. Social justice
is the principal objective of annual budget of a developing country like India. It leads to fair and
equitable distribution of income in an economy.

Q.2. Tax rates on higher income group have been increased. Which economic value does it
reflect? Explain.
Explain the redistribution of income objective of government budget.

Ans. The economic value that is reflected in the rise in tax rate for higher income group is the
‘equality and social welfare’. The main objective of the budgetary policy of the government is to
reduce inequalities of income and wealth in the country.
Even distribution of wealth and social welfare remains the main objective of budgetary policy.
The government uses progressive taxation policy to reduce the inequalities of income and

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wealth in the country. Government imposed high tax rates on higher income group and low tax
rate on lower income group. People with income below a certain level are not levied any direct
tax altogether. On the other hand, the government spent these tax receipts on granting
subsidies and providing other public services such as health and education, to people with
lower income groups, the wealth gets redistributed and reduction in inequalities is achieved.

Q.3. Government raises its expenditure on producing public goods. Which economic value
does it reflect? Explain.
Ans. The economic value that is reflected in the rise in the production of public goods is the
‘social welfare’. The major objective of the budgetary policy of the government is to enhance
the welfare of the society as a whole. For this, it performs the allocative function. The allocative
function is concerned with allocating the resources between private and public sectors. As the
public goods cannot be provided by the private sectors through market mechanism, hence the
need for providing such goods is to be fulfilled by the government.
In addition to this, private goods cannot be afforded by all, that is, only those who can pay for
these goods can avail the benefits of such goods. But, as the public goods as required by all and
are essential from welfare point of view, thus, government provide these goods.

Numerical Questions
1. A government budget shows a primary deficit of Rs. 4,400 millions. The revenue
expenditure on interest payment is Rs. 400 millions. How much is the fiscal deficit?

2. In a government budget revenue deficit is Rs. 50,000 millions and borrowings are Rs. 7500
millions. How much is the fiscal deficit?

3. 13. In a Govt. Budget primary deficit is Rs. 25,000 Cr. and interest payments are Rs. 15,000
Cr. How much is the fiscal deficit?

4. From the following data about a government budget, find out, (i) Revenue deficit, (ii) Fiscal Deficit
and (iii) Primary Deficit

Items (In Millions)

(i) Capital Receipts net of borrowings 95
(ii) Revenue expenditure 100
(iii) Interest Payment 10
(iv) Revenue receipts 80
(v) Capital expenditure 110

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(i) Revenue Deficit = Revenue Expenditure – Revenue Receipts =100 -80 =Rs. 20 Millions
(ii) Fiscal Deficit = [Revenue Expenditure + Capital Expenditure] – [Revenue Receipt
+ Capital Receipt Net of Borrowing]
= [100 + 110]- [80 + 95]
=210-175
= Rs. 35 Millions
(iii) Primary Deficit = Fiscal Deficit – Interest Payments = 35-10 =Rs. 25 Millions

5. From the following data about a government budget, find

(i) Revenue deficit
(ii) Fiscal deficit
(iii) Primary deficit

Items (in(in Millions) Millions)

(i) Tax Revenue 47

(ii) Capital Receipts 34

(iii) Non- Tax Revenue 10

(iv) Borrowings 32

(v) Revenue Expenditures 80

(vi) Interest Payments 20

Ans. (a) Revenue Deficit = Revenue Expenditure – (Tax Revenue + Non-tax Revenue)
= 80-[47+ 10] = 80-57
= Rs. 23 Millions
(i) Fiscal Deficit = Borrowings Borrowings = Rs. 32 Millions
So, Fiscal Deficit = Rs. 32 Millions
(iii) Primary Deficit = Fiscal Deficit – Interest Payments
= 32-20
= Rs. 12 Millions

6. Calculate Fiscal and Primary Deficit from the following.

Estimated Total Expenditure of the Government 1,50,000

Revenue Receipts 1,20,000
Non Debt Capital Receipts 10,000
Interest Payments 75,000

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Value Based Questions

Q.1. Suggest two measures through which the government can regulate the subsidy given to the
farmers for electricity.

Rationing of subsidies-depending upon the land size and land holdings.

Restricted hours of electricity supply for the use of farm lands Alternate source of energy could be
explored.

Collection of minimum charges from the farmers excepting the marginal farmers.

Value: social responsibility/social justice

Q.2. What type of budget is advocated for emerging economies?

Deficit budget is the suitable one for the emerging economies, as they have to achieve maximum social
welfare through lots of developmental projects. Govt. has to borrow and inject more capital to generate
employment. Because, the revenue receipts will be less.

Value: social welfare.

Q.3. What would you suggest to improve the rate of growth of real income of the weaker sections of
the society in an emerging economy like India?

Progressive taxation, grants for the mass employment schemes, development Of infrastructure,
establishment of banks for productive credit creation.

Value: social justice/equality/social responsibility/care &concern.

Q.4. Low income, low investment and low level of production leads to economic depression. How
capital can be mobilized by the govt. to increase the production and capital formation?

Foreign direct investment/ disinvestments to attract investment from abroad/ Borrowings from external
sources.

Value: critical thinking.

Q.5. Black money is detrimental to the economic growth of any economy. Suggest two measures to
curb the same.

Progressive tax system may be effectively introduced. Tax slabs and rates may be reduced at all levels to
make it more reasonable and acceptable.

Incentives may be given for the corporate companies to attract more tax income. Taxation procedures
may be simplified.

Value: social responsibility.

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5 Balance of Payments

Learning Objectives

1. Meaning of balance of Payment

2. Components of Balance of payment
3. Difference between BOP & BOT
4. Components of current account
5. Components of capital account
6. Balance of Payment always balances
7. Autonomous & Accommodating Items in BOP
8. Meaning of foreign exchange
9. Meaning of foreign exchange rate
10. Sources of Demand for foreign exchange
11. Sources of supply of foreign exchange
12. Fixed & Flexible exchange rate system
13. Appreciation & Revaluation of Currency
14. Depreciation & Devaluation of Currency

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A balance of payment is a systematic record of all economic transactions between residents

of a country and the rest of the world carried out in a specific period of time.

A balance of payment account is a systematic record of all economic transactions between

residents of a country and the residents of foreign countries during a given period of time. BOP
Account records a country’s all transactions with the rest of the world involving flow of foreign
exchange. Thus BOP Account is basically a flow of foreign exchange account. How?

International transactions arise on account of the following:

(i) Flow of goods, (ii) Flow of services, and (iii) Flow of capital.

Accordingly BOP records the transactions in goods, services and assets between residents of a
country with the rest of world. Remember, when a country exports goods or renders services, it
receives payment in foreign exchange. Similarly, it makes payment in foreign exchange when it
imports goods or receives services. Again foreign exchange is received when capital flows in
and goes out when capital flows out. BOP Account records all these transactions.

Double entry system of accounting

All international transactions are recorded in BOP Account in double entry system of
bookkeeping. Every international transaction will result in credit entry and debt entry of equal
size. Since balance of payment accounts are prepared on the double entry system of
accounting, sum of all debits equals the sum of all credits and the accounts are always in
balance. Hence in accounting sense, balance of payments account will always be in equilibrium.
A hypothetical simplified example of a country’s Balance of Payment Account is given in the
following table, Its left side shows all the ways a country can acquire foreign currency whereas
right side shows how the foreign currency is spent.

Thus Balance of Payments Account of a country has two sides – credit (receipts) on the left side
and debit (payment) on the right side. All economic transactions that are carried out with the
rest of world are either credited or debited. Note that all receipts of foreign currency are credit
items whereas all payments of foreign currency are debit items as shown in the following table.

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Account of a country’s balance of payments

Credit Debit
(1) Exports of goods 550 (5) Imports of goods 800
(visibles items)
(2) Exports of services 150 (6) Imports of services 50
(Invisibles)
(3) Unilateral transfer (gifts, (7) Unilateral transfers (gifts, indemnities
Remittances, indemnities etc. etc. paid to foreigners) 80
Received from foreigners) 100
(4) Capital receipts (8) Capital payments (lending to, capital
(borrowings from abroad, capital repayments to, or purchase of assets from
repayments by, or sale of assets to foreigners) 70
foreigners) 200
Total Receipts 1000 Total payments 1000

Visible and Invisible items

Export and import of goods (like machinery, tea) are visible items because goods are visible.
As against it, export and import of services (like shipping, banking, and tourism) are
invisible items since services cannot be seen.

1. Export and import of goods: The most straight forward way in which a country can acquire
foreign currency is by exporting goods. These are called visible items because goods can be
seen, touched and measured. This is shown by row (1) which indicated that the country has
exported goods to a value of Rs. 550 millions. In an analogous (similar) way, row (5) shows that
the country has imported goods to a value of Rs. 800 millions. These two rows describe the
country’s visible trade. Movement of goods between countries is known as visible trade
because the movement is open and can be verified by custom officials at custom barriers.

2. Services rendered and received: It includes both (a) non-factor income like income from
shipping, banking, insurance, tourism, software services, and (b) factor income (investment
income) like interest, dividends, profits on assets abroad. It should be noted that interest,
dividends and profits, which citizens of a country earn on investment abroad are investment
income and treated as factor income. Citizens of the country own land, bonds shares etc.
abroad for which the foreigners who enjoy the services of this capital will have to pay for them.
These payments will be registered under row (2) exports of services or invisible exports.

In a completely analogous way, row (6) covers payments which residents of the country in
question make to foreigners for similar services, All these items describe country’s invisible
trade.

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Balance of Invisible

The balance of imports and export of services is called balance of invisibles since services are
not seen to cross national borders. The invisible account includes not only property and
entrepreneurial income (rent and dividends) but also interest payment and receipts.

Unilateral transfers

(Gifts, remittances, donations, indemnities etc. from foreigners). The items in row (3) are
called unrequited receipts because residents of a country receive ‘for free’. Nothing has to be
paid in return at present or future for these receipts. These are like transfer payments. It
includes both private and government transfers. Examples of this head are gifts received by
residents from foreigners, remittances sent by emigrants (like Indians in Gulf Countries) to
relatives, war indemnities paid by a defeated country etc.

Capital receipts and payments

(Borrowings, investment, capital repayments, sale of assets, changes in stock of gold and
reserves of foreign currency). It records international transactions which affect the assets and
liabilities of domestic country with ROW. Items (4) and (8) of the table indicate changes in stock
magnitudes and refer to capital receipts and payments. Government of a country may get loan
from another government; a firm may issue stocks abroad or a bank may float a loan in a
foreign country. In all these instances, the country in question will acquire foreign currency and
these transactions will be entered as items in row (4). Similarly foreigners may acquire assets in
the country with whose balance of payments they are concerned. Assets may be in the form of
land, houses, plants, shares etc. Changes in stock of gold or reserves of foreign currency are
also included in Row (4). Analogously if residents of the country in their turn were to acquire
similar foreign assets, this would give rise to outflow of foreign currency and come as a capital
transfer under row(8).

Balance of Trade
It is the difference between the money value of exports and imports of material goods (called
visible items or merchandise items). Clearly the two transactions which determine BOT are
exports and import of goods (visible items). The difference between the values of exports and
imports of goods is called balance of trade or trade balance.

Alternatively balance of visible items is called balance of trade.

Balance of trade may be in surplus or in deficit or in equilibrium. If value of exports of

visible items is more than the value of imports of visible items, balance of trade shows a
surplus. Then BOT is also called positive or favourable. In case value of exports is less than the
value of imports, the balance of trade is said to be negative or adverse or unfavourable. Thus,

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the balance of trade is called in deficit. In case value of exports equals its imports, the balance
of trade is said to be balanced or in equilibrium. Remember when balance of trade is in deficit,
it is offset with the help of capital account.

A Balance of payment account

BOP account of a country is systematic record of all economic transactions between residents
of the domestic country and the residents of foreign countries during a given period of time.
It is a complete statement of a country’s receipts and payments in foreign exchange arising
form international transactions.

 BOP account records a country’s transactions in goods, services and assets with rest of
the world during a given period.
 BOP is the difference between a nation’s total payment to foreign countries and its total
receipts from them.
 The balance of payment is said to be in deficit when autonomous receipts are less than
autonomous payments. On the contrary if autonomous receipts are greater than
autonomous payments, balance of payment is said to be in surplus.

Balance of Payment always balances – How?

We know from our earlier discussion that all transactions are recorded in balance of payment
account in double entry system of bookkeeping. Under this system every transaction creates
two equal eateries, i.e., one credit entry showing where it came from and the other debit entry
showing where the same is put (spent). As a result total amount of credit (receipt) side is
always equal to debit (payment) side. Thus, in accounting sense, balance of payment always
balances. In operating sense also BOP is always in equilibrium because if current account is in
deficit, the same is restored (compensated) with capital account. Hence overall balance of
payment is always balanced.

Comparison between BOT and BOP

Briefly BOP is the difference between money value of imports and exports of material goods
only whereas BOP is the difference between a country’s receipts and payments in foreign
exchange. Balance of payments is a wider concept as compared to balance of trade which is just
one of the four components of the former. The other three components of balance of
payments are export/import of services, unilateral receipts/payments and capital
receipts/payments. BOT does not include any of these components of BOP. Therefore, BOP
represents a better picture of a country’s economic transactions with the rest of the world than
the Balance of Trade. Both are compared below.

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BOT BOP
(i) It records only merchandise (i.e., (i) It records transactions relating to
goods) transactions. both goods and services.
(ii) It does not record transactions of (ii) It records transactions of capital
capital nature. nature.
(iii) It is a narrow concept because it (iii) It is a wider concept because it
is only one part of BOP account. includes balance of trade,
balance of service, balance of
unilateral transfers and balance
of capital transactions.
(iv) It may be favourable, (iv) It always remains in balance in
unfavourable or in equilibrium. accounting sense because receipt
side is always made to be equal
to payment side.

Current Account
The current account is that account which records imports and exports of goods, services and
unilateral transfers. It relates to all activities which do not alter the value of assets and
liabilities of a country. Current account deals with payment for currently produced goods
and services (as against capital account can be estimated as the sum total of balance of
trade, balance of services and balance of unilateral transfers. This is called current account
balance.

Components of current account of BOP

These items are as under :

(i) Export and import of goods (called visible trade).

(ii) Export and import of services – non-factor and factor services (called invisible trade).
(iii) Unilateral transfers (Transfer receipts/payments) and
(iv) Investment income (factor income from land, bonds, shares abroad)

Distinction between BOT and Balance on current

account
Balance of trade is the difference between value of exports and imports of material goods
(visible items). Balance on current account is the difference between receipts and payments of

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foreign exchange on account of goods, services and unilateral transfers. Clearly BOT is a part of
balance of current account and therefore, a narrow concept.

A deficit in current account of BOP indicates that payments are more than receipts reflecting
unfavourable balance of payment in a year. Like an individual who finances his excess
expenditure by selling his assets or by borrowing, similarly a country having deficit in its current
account must finance it by selling assets or by borrowing abroad. Thus a current account deficit
is financed by a capital account surplus (i.e. by net capital inflow from ROW).

Capital Account
The capital account of BOP records all such transactions between residents of a country and
the rest of the world which cause a change in the assets or liability status of residents of a
country or its govt. It represents international flow of loans and investments which bring a
change in country’s foreign assets and liabilities. Capital account flows consist of
investments, loans, commercial borrowings, banking capital etc.

Components of capital account

Main forms of capital account transactions are given below:

(i) Private transactions. These are transaction which affect assets and liabilities by
individuals, businesses and other non-government entities. The bulk of foreign
investment is private.
(ii) Official transactions. These include transactions affecting assets and liabilities by
Government and its agencies.
(iii) Direct investment. It means purchasing an asset and at the same time acquiring
control of it, e.g., acquisition of a firm in one country by a firm in another country or
purchase of a house by individuals abroad.
(iv) Portfolio investment. It is the acquisition of an asset that does not give the
purchaser control over assets. Examples are purchase of shares in a foreign country
or purchase of bonds issued by a foreign government.

Autonomous items in BOP

These refer to international economic transactions that take place due to some economic
motives like profit maximisation. Such transactions are independent of the state of
country’s balance of payments. These items are generally called ‘above the line items’ in
BOP. Again BOP is in deficit if the autonomous receipts are less than autonomous
payments. BOP is in surplus if the autonomous receipts are greater than autonomous
payments. In other words deficit or surplus in BOP occurs due to autonomous items (As
against it, accommodating items are meant to restore equilibrium.)

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Accommodating items in BOP

These refer to transactions that take place because of other activity in BOP like government
financing. These items are also called ‘below the line items’. Because of government
financing, official settlement, are seen as accommodating items to keep the BOP identity.
The official settlement approach is based on the assumption that monetary authority is the
ultimate financier of any deficit in BOP or the ultimate recipient of any surplus.

Foreign exchange rate

The price of one currency in terms of another is known as foreign exchange rate. It is the rate
at which one unit of a foreign currency is exchanged for domestic currency. Since there is
symmetry between two currencies, exchange rate can be quoted in two ways i.e. one unit of
foreign currency expressed terms of so many units of domestic currency or one unit of
domestic currency expressed in terms of so many units of foreign currency.

Nominal exchange rate

It is price of foreign currency in terms of domestic currency. When cost (price) of purchasing
one unit of foreign currency (say, dollar) is quoted in terms of domestic currency (say,
rupees), it is called nominal exchange rate because exchange rate is quoted in money terms
i.e. so many rupees per dollar. For instance if 1 American dollar can be obtained (exchanged)
for 50 Indian rupees i.e. if it costs rupees 50 to buy 1 dollar, it will be called nominal exchange
rate, i.e. so many units of home currency are to be paid to get one unit of foreign currency.

Real exchange Rate

It is relative price of foreign goods in terms of domestic goods. When cost of purchasing one
unit of domestic currency (say, rupees) is quoted in terms of foreign currency (say, dollar),
it is called real exchange rate. For instance in the above case it costs 2 cents (1 dollar = 100
cents) to buy 1 rupee. People who plan to visit America need to know how expensive American
goods relative to goods at home. Real exchange rate is equal to Nominal exchange rate
multiplied by foreign price level and divided by domestic price level. Symbolically:

𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒆𝒙𝒄𝒉𝒂𝒏𝒈𝒆 𝒓𝒂𝒕𝒆 𝑿 𝑭𝒐𝒓𝒆𝒊𝒈𝒏 𝒑𝒓𝒊𝒄𝒆 𝒍𝒆𝒗𝒆𝒍

Real exchange rate = 𝑫𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒑𝒓𝒊𝒄𝒆 𝒍𝒆𝒗𝒆𝒍

Foreign exchange market

The market in which national currencies of various countries are converted, exchanged or
traded for one another is called foreign exchange market. Alternatively it is the market where
national currencies are traded for one another. It is not any physical place but is a network of

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communication system which connects the whole complex of institutions. It includes banks,
specialised foreign exchange dealers, brokers and official government agencies through which
the currency of one country can be exchanged (converted) for that of another. Again foreign
exchange market is of two types – Spot market and forward market. (See Q.10.4).

Functions of Foreign Exchange Market

Foreign exchange market performs three main functions, namely, (i) transfer function, (ii) credit
function, and (iii) hedging function. Transfer function refers to transferring purchasing power
between countries; credit function refers to providing credit channels for foreign trade and
hedging function pertains to protecting against foreign exchange risks. Hedging is an activity
which is designed to minimize risk of lass. When people want to operate in the foreign
exchange market. It implies that they intend to buy or sell foreign exchange depending on their
demand for or supply of foreign exchange. For instance, when we (American residents) buy
foreign goods, say Japanese goods, it shows supply of rupees to foreign exchange market to be
exchanged for Yen because seller of Japanese goods will expect payment in Yen only. Similarly
American exporters of their goods will expect to be paid in rupees for which foreigners will
have to sell their currency in the exchange market to buy rupees in return. It shows demand for
rupees in foreign exchange market. Transactions in foreign exchange market are reflected in
the balance of payment account.

Exchange Rate
There are various concepts of exchange rate systems. Its two important types are Fixed
Exchange Rate and Flexible Exchange Rate as explained below. (In between these two extreme
rates, there are some hybrid systems like Crawling Peg, Managed Floating etc. which
combine merits of both fixed and flexible system of exchange rates. These are briefly
discussed in the following pages.)

Fixed Exchange Rate System

Fixed exchange rate is the rate which is officially fixed by the government/monetary
authority and not determined by market forces. Only a very small adjustment or deviation
from this fixed values is possible. In this system foreign central banks stand ready to buy
and sell their currencies at a fixed price. In case there is disequilibrium in balance of
payment causing excess demand or excess supply of foreign exchange, Central bank of the
country has to buy or sell required quantities of foreign exchange to eliminate the excess
demand or supply. A typical kind of this system was used under Gold Standard System in which
each country committed itself to convert freely its currency into gold at a fixed price. Thus value
of each currency was defined in terms of gold and therefore, exchange rate was fixed. The
advantages of this system are as under:

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Merits
(i) It ensures stability in exchange rate which encourages foreign trade. (ii) It contributes to the
coordination of macro policies of countries in an interdependent world economy (iii) Fixed
exchange rate prevents capital outflow. (iv) It prevents speculation in foreign exchange market.
(v) Fixed exchange rate are more conducive to expansion of world trade because it prevents risk
and uncertainly in transactions.

Demerits
(i) Fear of devaluation. In a situation of excess demand. Central Bank uses its reserves to
maintain fixed exchange rate. But when reserves are exhausted and excess demand still
persists, government is compelled to devalue domestic currency. If speculators believe that
exchange rate cannot be held for long, they buy foreign exchange in massive amount causing
deficit in BOP. This may lead to larger devaluation. This is the main flam of fixed exchange rate
system. (ii) Benefits of free markets are deprived. (iii) There is always possibility of
undervaluation or overvaluation.

Flexible (Floating) Exchange Rate

Flexible exchange rate is the rate which is determined by forces of supply and demand in the
foreign exchange market. There is no official (govt.) intervention. Here the value of a
currency is left completely free to be determined by market forces of demand and supply of
foreign exchange. Under this system, the central banks, without intervention, allow the
exchange rate to adjust so as to equate the supply and demand for foreign currency. The
foreign exchange market is busy at all times by changes in the exchange rate. Advantages
of this system are listed below.

Merits
(i) Deficit or surplus in BOP is automatically corrected. (ii) There is no need for government to
hold any foreign reserve. (iii) It helps in optimum resource allocation. (iv) It frees the
government from problem of balance of payment. (v) Such rates are helpful in removing the
barriers to trade and capital movements. (vi) Flexible exchange rate increases the efficiency in
the economy by achieving best allocation of resources.

Demerits
(I) It encourages speculation leading to fluctuations in exchange rate. (ii) Wide fluctuations in
exchange rate can hamper foreign trade and capital movement between countries. (iii) It

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generates inflationary pressure when prices of imports go up due to depreciation of currency

caused by deficit in BOP. (iv) It discourages investment and international trade.

Difference
Fixed exchange rate is the rate which is officially fixed in terms of gold or any other currency by
the government. It does not change with change in demand and supply of foreign currency. As
against it, flexible exchange rate is the rate which, like price fo a commodity, is determined by
forces of demand and supply in the foreign exchange market. It changes according to changes
in demand and supply of foreign currency. There is no government intervention.

Demand for foreign Exchange (US dollars)

Remember, payment in foreign exchange cause demand for foreign exchange. The following
factors cause demand for foreign exchange, i.e., foreign exchange is demanded by domestic
residents for the following reasons:

Demand by domestic residents for the following reasons:

Sources of demand for foreign exchange

I. To purchase goods and services by domestic residents from foreign countries.

II. To purchase financial assets (I.e. to invest in bonds and equity shares) by domestic
residents in a foreign country.
III. To send gifts and grants abroad.
IV. To invest directly in shops, factories, buildings in foreign countries.
V. To speculate on the value of foreign currencies.
VI. To undertake foreign tours (or for travelling abroad) and
VII. To make payments of international trade.

Supply of Foreign Exchange (US dollars)

Supply of foreign exchange comes from foreigners who make us payment in foreign exchange
(currency) for different purposes. The following factors cause supply of foreign exchange. As a
result foreign currencies flow into domestic economy

Sources of supply of foreign exchange

(i) When foreigners purchase home country’s (say India’s) goods and services through
exports (by India).
(ii) When foreigners invest in bonds and equity shares of the home country (say India).

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(iii) When currency dealers and speculators cause flow of foreign currency in the
domestic economy.
(iv) When Indian workers working abroad send their savings to families in India.
(Remittances)
(v) When foreign tourists come to India.

Determination of Foreign Exchange Rate

This is determined at a point where demand for and supply of foreign exchange are equal.
Graphically, intersection of demand and supply curves determines the equilibrium exchange
rate of foreign currency. At any particular time, the rate of foreign exchange must be such at
which quantity demanded of foreign currency is equal to quantity supplied of that currency. It is
proved with the help of the following diagram. The price on the vertical axis is stated in terms
of domestic currency (i.e., how many rupees for one US dollar).

The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars).
In this figure, demand curve is downward sloping which shows that less foreign exchange is
demanded when exchange rate increases (i.e., inverse relationship). The reason is that rise in
the price of foreign exchange (dollar) increases the rupee cost of foreign goods which makes
them more expensive. The result is fall in imports and demand for foreign exchange.

The supply curve is upward sloping which implies that supply of foreign exchange increases as
the exchange rate increases (i.e., direct relationship). Home country’s goods (here Indian
goods) become cheaper to foreigners because rupee is depreciating in value.

As a result, demand for Indian goods increases. Thus, our exports should increase as the
exchange rate increases. This will bring greater supply of foreign exchange. Hence, the supply of
foreign exchange increases as the exchange rate increases which proves the slope of supply
curve.

In the below figure, demand curve and supply curve of dollars intersect each other at point E
which implies that at exchange rate of OR (QE), quantity demanded and supplied are equal
(both being equal to OQ). Hence, equilibrium exchange rate is OR and equilibrium quantity is
OQ.

Change in Exchange Rate

Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s demand for US dollars, supply
remaining the same, will cause the demand curve DD shift to D’D’. The resulting intersection

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will be at a higher exchange rate, i.e., exchange rate (price of dollar in terms of rupees) will rise
from OR to OR, (say, 1 dollar = 52 rupees). It shows depreciation of Indian currency (rupees)
because more rupees (say, 52 instead of 50) are required to buy 1 US dollar. Thus, depreciation
of currency means a fall in the price of home currency.

Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’ and as a result
exchange rate will fall from OR to OR2. It indicates appreciation of Indian currency (rupees)
because cost of US dollar in terms of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less
rupees are required to buy 1 US dollar or now Rs 48 instead of Rs 50 can buy 1 dollar. Thus,
appreciation of currency means ‘a rise in the price of home currency’.

Depreciation and Appreciation of currency

Depreciation

Currency Depreciation refers to decrease in the value of domestic currency in terms of foreign currency.

It makes the domestic currency less valuable and more of it is required to buy the foreign currency.

For example:

(i) Rupee is said to be depreciating if price of $1 rises from Rs 45 to Rs 50.

(ii) A change from $3 = £1 to $2= £1 represents that UK pound is appreciating.

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Effect of Depreciation of Domestic Currency on Exports

Depreciation of domestic currency means a fall in the price of domestic currency (say, rupee) in terms of

a foreign currency (say, $). It means, with same amount of dollars, more goods can be purchased from

India, i.e. exports to USA will increase as they will become relatively cheaper.

Appreciation

Currency Appreciation refers to increase in the value of domestic currency in terms of foreign currency.

The domestic currency becomes more valuable and less of it is required to buy the foreign currency. For

example:

(i) Indian rupee appreciates when price of $1 falls from Rs. 50 to Rs 45.

(ii) A change from $3 = £1 to $5 = £1 represents that the UK pound is appreciating.

Effect of Appreciation of Domestic Currency on Imports

Appreciation of domestic currency means a rise in the price of domestic currency (say, rupee) in terms

of a foreign currency (say, $). Now, one rupee can be exchanged for more $, i.e. with same amount of

money, more goods can be purchased from USA. It leads to increase in imports from USA as American

goods will become relatively cheaper.

Devaluation and Evaluation of currency

In modern monetary policy, a devaluation is an official lowering of the value of a
country's currency within a fixed exchange rate system, by which the monetary authority
formally sets a new fixed rate with respect to a foreign reference currency or currency basket.
A central bank maintains a fixed value of its currency by standing ready to buy or sell
foreign currency with its own currency at a stated rate; a devaluation is a change in this
stated rate that renders the foreign currency more expensive in terms of the home currency.

The opposite of devaluation, a change in the fixed rate making the foreign currency less expensive, is called
a revaluation.

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Exercise

Multiple Choice Question

Q.1. Which item is an intangible item in balance of payments statement?
(a) Export of food grains
(b) Import of crude oil
(c) Banking services provide in other countries
(d) Import of steel by steel industries
Q.2. Capital account may be
(a) Private capital (b) Banking capital
(c) Official Capital (d) All the above
Q.3. Current account of BOP records transactions is relating to
(a) Exchange of goods (b) Exchange of services
(b) Unilateral Transfers (d) All the above
Q.4. Buyers and sellers of foreign exchange are
(a) Central Bank (b) Commercial bank
(c) Brokers (d) All the above
Q.5. How exports are affected during appreciations of currency?
(a) Increases (b) Decreases
(c) Remains Constant (d) None of the above

Short Questions
Q.1. State the components of capital account of balance of payments.
Ans. (1) Borrowings and lending’s to and from abroad.
(2) Investments to and from abroad.

(3) Changes in foreign exchange reserves, (or any other way to describe components)

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Q.2. State the components of current account of balance of payments

OR
List the transactions of current account of the Balance of Payment Account
Ans. (1) Exports and imports of goods.
(2) Exports and imports of services.

(3) Income receipts and payments to and from abroad.

(4) Transfers to and from abroad.

Q.3. List the items of the current account of balance of payment account. Also define balance
of ‘trade’.
Ans. Items of current account:
(i) Export and imports of goods.

(ii) Export and import of services.

(iii) Income from and to abroad.

(iv) Transfers from and to abroad.

Balance of Bade is the difference between ‘exports of goods’ and imports of goods

Balance of Current Account:

i. The current account of Balance of Payment comprises of visible exports and imports of goods,
invisible items (services) and unilateral transfers like gifts, remittances and donations etc.

ii. The net value of all these is the balance of current account.

iii. Balance of trade is thus a part of current account of Balance of Payment.

Q.4. What are the sources of supply of foreign exchange?

Ans. Supply of foreign exchange comes from:
(i) Purchase of goods and services by foreigners

(ii) Inflow by the NRIs settled in foreign countries.

(iii) Foreign Direct Investment (FDI) into our country.

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(iv) Speculative purchase of home currency by NRIs/Foreigners.

Q.5. Giving two examples explain the relation between the rise in price of a foreign currency
and its demand.
Ans. When Price of Foreign Currency Rises:
(i) Imports become dearer resulting in less imports and therefore falls demand for foreign
currency.

(ii) Tourism abroad becomes costlier and so demand for foreign currency falls.

Q.6. When price of a foreign currency rises, its demand falls. Explain why.
Ans. When price of foreign currency rises it makes imports costlier. This leads to fall in demand
for imports. As a result demand for foreign exchange falls.
Q.7. When price of foreign currency rises, its supply also rises. Explain why.
Ans. When price of foreign currency rises it makes exports cheaper. This to rise in demand for
exports. As a result supply of foreign currency rises.
Q.8. When price of a foreign currency falls, the demand for that foreign currency rises.
Explain why.
Ans. When price of foreign currency falls it makes imports or investing abroad, etc. cheaper. As
a result, demand for foreign exchange rises.
Q.9. When price of a foreign currency falls, the supply of that foreign currency also falls.
Explain why.
Ans. When price of foreign currency falls it makes exports investments by foreign residents-
costlier. As a result supply of foreign currency falls.
Q.10. Giving two examples, explain why there is a rise in demand for a foreign currency when
its price falls.
Ans. When price of foreign currency falls, imports are cheaper. So more demand for Foreign
Exchange by importers. Tourism abroad is promoted as it becomes cheaper. So demand for
foreign currency rises.
Q.11. What functions are performed by foreign exchange market?
Ans. The foreign Exchange market performs the following functions:
(i) Transfer of foreign currencies between countries:
Foreign Exchange market facilitates in flow of foreign Exchange from one nation to another.

(ii) Provides credit for foreign business:

Foreign exchange market makes available credit for foreign transactions.

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(iii) Hedging risks:

Covering exchange risk is called hedging. By entering into forward contracts to buy or sell
foreign exchange at a future date trough banks, exchange risks can be minimized.

Q.12. Explain the effect of appreciation of domestic currency on imports.

Ans. Appreciation of domestic currency means fall in exchange rate, i.e., price of foreign
currency. It means that the importers have now to pay less domestic currency to buy one unit
worth of foreign currency goods from abroad. Imports become cheaper. This raises demand for
imports.
Q.13. Distinguish between devaluation and depreciation of domestic currency.
Ans. i. Under fixed exchange rate regime reduction in price of domestic currency in terms of all
foreign currencies is called devaluation.
ii. Under flexible exchange rate regime, fall in market price of domestic currency in terms of a
foreign currency is called depreciation.

Long Questions
Q.1. What are the effects of disequilibrium in Balance of Payment?
Ans. Effects of disequilibrium in Balance of Payment are:
(i) Economic credibility of a country obviously goes down.

(ii) It results in reduction of FOREX reserves.

(iii) It has an adverse effect on the economic growth and prosperity of the nation.

(iv) Foreign dependence may lead to political dependence & can hence result in bleeding of
resources and exploitation of the country.

Q.2. What is balance of payment? What are its components?

Ans. Balance of Payment is a systematic record of all economic transactions of a country with
rest of the world in a given period of time which is usually one year.
The Balance of Payment account has two main components
(i) Current Account and

(ii) Capital Account.

(i) Current Account:

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a. The current account of balance of payment records imports and exports of goods, services
and unilateral transfers.

b. It includes record of services like shipping, banking, insurance etc.; interest and dividends
flowing in and out of the country; receipts and payments from foreign travel and tourism;
miscellaneous items like royalties, subscription, consultancy, telephone and telegraph services
and transfer payments like gifts, remittances, donations etc.

c. The final balance of visible trade i.e., exports and imports of goods alone is known as trade
balance. The total of visible and invisible items gives current account balance, which is moved
to capital account.

(ii) Capital Account:

i. The capital account of balance of payment records those capital transfers between one nation
and all other countries which result in change in the assets or liabilities of the citizens of that
country or of its government.

ii. It consists of capital of various kinds e.g., gold. The flows of capital can be in the form of
borrowings or lending’s to abroad by private sector and government or both.

iii. The final balance of capital account shows a country’s final position. It may be surplus or
deficit.

Q.3. What is balance of payment? What are its main features?

Ans. Balance of Payment (BOP) is a systematic record of all economic transactions of a country
with rest of the world during a given period which is usually one year.
The main features of BOP are:
(i) Systematic record:
It is a systematic record of all transactions of the residents of a country with rest of the world.

(ii) Fixed time:

It is a statement of account for a fixed period of time which is usually one year.

(iii) Comprehensive statement:

Balance of payment is a comprehensive statement of accounts which includes all transactions
visible, invisible and capital transfers.

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(iv) Double Entry system:

Balance of payment account is based on double entry system of book keeping. It means there is
a credit for every debit entry. Receipts are recorded on the credit side and payments are
recorded on the debit side.

(v) Balanced system:

In Double entry system debit and credit sides of the account are always equal i.e., total debits
are always equal to total receipts hence it is a balanced system.

Q.4. Explain the meaning of deficit in balance of payments.

Ans. When autonomous foreign exchange payments exceed autonomous foreign exchange
receipts, the difference is called balance of payments deficit.
Autonomous transactions in foreign exchanges are those which are undertaken for their own
sake and independent of the State of balance of payments.

Q.5. What are the various categories of economic transactions which are recorded in Balance
of Payment account?
Ans. Various categories of economic transactions in Balance of Payment are as follows:
(i) Visible items:
All types of physical goods which are exported and imported by a country are called visible
items since such goods are made of some material and thus have physical existence.

(ii) Invisible Items:

Invisible items include different types of services, investment income and unilateral transfers.
Shipping, banking, travel services, etc., are included in services. Interest, profit, dividend,
royalties etc. form part of investment income and gifts, remittances, etc. are included in
unilateral transfers.

(iii) Capital transfers:

Capital receipts and capital payments form part of capital transfers.

Q.6. Distinguish between balance of trade and balance on current account.

Ans. i. Exports of goods less imports of goods refers to balance of trade. Adding excess of
inflows over the outflows on account of invisibles to the balance of trade is called balance on
current account.
ii. Balance of Trade = Exports of Goods – Imports of goods Balance on current Account = Sum of
credit on current account – sum of debits on current account

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Q.7. Which transactions determine the balance of trade ? When is balance of trade in
surplus?
Ans. Exports of goods and imports of goods.
When the value of exports of goods is greater than the value of imports of goods.

Q.8. How are foreign exchange rates determined? Explain.

Ans. i. Foreign exchange rate is determined at the equilibrium point where demand for foreign
exchange and supply of foreign exchange are equal.
ii. The demand curve for foreign exchange is downward sloping since there is an inverse
relationship between price and demand of foreign exchange. At higher prices, demand for
foreign exchange is upward sloping. If price of foreign exchange rises, the value of rupee will
depreciate which will make domestic goods cheaper. Demand for export will rise which means
more supply of foreign currency.

iii. In the diagram Dfe DFe and Sfe Sfe are demand and supply curves for dollars which are
intersecting at I at which point Rs 50 will be the price of a dollar. An increase in demand for
dollars will increase the price of dollar and an increase in supply of dollars will reduce the price
of dollar.
iv. In the short run, there can be difference in demand and supply of foreign exchange.

v. But in the long run, the equilibrium rate of exchanges will prevail as in the situation of excess
demand or excess supply the price will automatically come to the equilibrium level due to
competition in foreign exchange market.

Q.9. Explain the meaning and two merits of fixed foreign exchange rate?
Ans. Fixed exchange rate is the rate fixed by government.

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Merits:
(i) It ensures stability in exchange rate. The exporters and importers have not to operate under
uncertainty about the exchange rate. Thus it promotes foreign trade.

(ii) It promotes capital movements. Fixed exchange rate system attracts foreign capital because
a stable currency does not involve any uncertainties about exchange rate that may cause
capital loss.

Q.10. Explain two sources each of demand and supply of foreign exchange rate.
Ans. Sources of demand for a foreign currency:
(i) For imports payment is to be made in foreign currency. So it is a source of its demand.

(ii) For transfer payments to other country in the form of gifts or remittance etc., foreign
currency is needed.

(iii) For making investments in other countries foreign currency is needed Sources of supply of a
foreign currency.

(i) Payment for exports are received in foreign currency. So exports are a source of its supply.

(ii) Factor income earned from abroad is a source of supply of foreign currency as it is received
in foreign currency.

(iii) Remittances from abroad are also in foreign currency. So it is also a source of supply of
foreign currency.

Q.11. Distinguish between fixed and flexible foreign exchange rate.

Ans. Fixed Exchange Rate:
i. Fixed exchange rate is the rate of exchange which is officially declared and fixed by the central
bank government.

ii. The rate of exchange is fixed by legislation or intervention in currency market.

iii. Government buys and sells currencies according to the needs of the country Flexible or
Floating Exchange Rate

iv. Flexible exchange rate is that rate which is determined by the market forces of demand and
supply of a foreign currency.

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v. The rate of exchange is allowed to adjust freely according to changes in forces of demand
and supply of that currency.

Q.12. What are the merits of a flexible exchange rate?

Ans. The merits of a flexible exchange rate are:
(i) Problem of over-valuation or undervaluation of currencies, deficit or surplus of balance of
payment is automatically solved.

(ii) Therefore Government gets rid of problem of disequilibrium of BOP.

(iii) The government is not required to keep reserves of foreign currencies.

(iv) Efficiency in the economy increases since optimum resource allocation is achieved.

Q.13. Differentiate between devaluation and depreciation.

Ans. Devaluation:
(i) Devaluation refers to the reduction in the external value of the currency of a country. It is a
deliberate measure adopted by the government. In other words, currency of a country is made
cheaper, in terms of foreign currency, by the government.

(ii) Devaluation occurs in a fixed exchange rate system.

(iii) Government may resort to devaluation of its currency to encourage exports and restrict
imports whenever the country suffers from continued deficit m BOP.

Depreciation:
(i) Depredation of a currency means drop in the value of domestic currency in relation to
foreign currency For example if value of rupee falls in terms of say dollars from Rs 40 to Rs 65, it
will be called depreciation of the Indian rupee since more rupees will now be required to buy
same one dollar.

(ii) Depreciation takes place in flexible exchange rate regime.

Q.14. Explain the distinction between autonomous and accommodating transactions in

balance of payments. Also explain the concept of balance of payments ‘deficit’ in this
context.
Ans. Autonomous Transactions:

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Are independent of all other transactions in the BOP. These transactions are not influenced by
the foreign exchange position of the country. Exports, imports etc. are some examples.

Accommodating Transactions:
Are undertaken to cover deficit or surplus in the autonomous transactions. Therefore, their
magnitude is determined by the autonomous transactions. Deficit in BOP is determined only by
the autonomous transactions. When autonomous foreign exchange payments exceed
autonomous foreign receipts, the excess is called BOP deficit.

Q.15. Give the meaning of ‘foreign exchange’ and ‘foreign exchange rate’. Giving reason,
explain the relation between foreign exchange rate and demand for foreign exchange.
Ans. Foreign exchange refers to any currency other than the domestic currency. Foreign
exchange rate is the rate at which one currency can be converted into another currency.
Suppose foreign exchange rate falls, it means that imports etc. have become cheaper because
people now have to pay less for imports.
As a result demand for imports etc. rises. This leads to increase in demand for foreign
exchange. Similarly if exchange rate rises, the demand for foreign exchange falls.

Value Based Questions

Q.1. Do you think visiting foreign countries is wise, when the domestic currency value depreciate?

It is not advisable to carry foreign tours during depreciation of local currency, as we have to pay more
for the foreign currency.

Value: Analytical thinking.

Q.2. promotion of tourism in US would attract more foreign exchange- do you agree?

Yes, it will attract more foreigners to visit US and brings in more exchange. Moreover, it will help to
promote cultural exchange and values and international Understanding.

Value: universal brother hood/ international understanding

Q.3. political instability leads to disequilibrium in balance of payments. How?

Political instability may lead to large capital outflows and reduce the inflow of foreign funds, thus leads
to disequilibrium in the BOP.

Value: critical thinking

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Important Questions
Principles of Macroeconomics
Module I
Q.1. The ratio of total deposits that a commercial bank has to keep with Federal Reserve Bank
is called: (Choose the correct alternative) 1
(a) Statutory liquidity ratio
(b) Deposit ratio
(c) Cash reserve ratio
(d) Legal reserve ratio
Q.2. Aggregate demand can be increased by: 1
(a) Increasing bank rate
(b) Selling government securities by Federal Reserve bank
(c) Increasing cash reserve ratio
(d) None of the above
Q.3. Give the meaning of involuntary unemployment. 1
Q.4. What is primary deficit? 1
Q.5. Give the meaning of balance of payments. 1
Q.6. Distinguish between final goods and intermediate goods. Give an example of each. 3
Q.7. Explain the store of value function of money. 3
Or
State the meaning and components of money supply.
Q.8. Explain the basis of classifying taxes into direct and indirect tax.
Give examples. 3
Q.9. Explain ‘banker to the government’ function of the central bank. 4
Or
Explain the role of reverse repo rate controlling money supply. 4
Q.10. Explain how government budget can be used to Influence distribution of income? 4

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Q.11. An economy is in equilibrium. From the following data about an economy calculate
autonomous consumption. 4
(i) Income = 5000
(ii) Marginal propensity to save = 0.2
(Iii) Investment expenditure = 800
Q.12. Why does the demand for foreign currency fall and supply rises when its price rises?
Explain. 6
Q.13. Explain ‘non-monetary exchanges’ as a limitation of using gross domestic product as an
index of welfare of a country. 6
Or
How will you treat the following while estimating domestic product of a country? Give reasons
for your answer:
(a) Profits earns by branches of country’s bank in other countries.
(b) Gifts given by an employer to his employees in Independence Day.
(c) Purchase of goods by foreign tourists.
Q.14. Calculate net domestic product at factor cost
6

$ In millions
(i) Private final consumption expenditure 8000
(ii) Government final consumption expenditure 1000
(iii) Exports 70
(iv) Imports 120
(v) Consumption of fixed capital 60
(vi) Gross domestic fixed capital formation 500
(vii) Change in stock 100
(viii) Factor income to abroad 40
(ix) Factor income from abroad 90
(x) Indirect taxes 700
(xi) Subsidies 50
(xii) Net current transfers to abroad (-) 30

Q.15. Assuming that increase in investment is $ 1000 millions and marginal propensity to
consume is 0.9, explain the working of multiplier. 6

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Module II
1. Write the two components of money supply.
2. Which one of the following is a transfer income:
(a) Rent
(b) Interest
(c) Unemployment
(d) Profit
3. Define depreciation.
4. Explain the ‘banker’s bank’ function of the central bank.
5. Distinguish between the following.
(a) Final good and capital good.
(b) Stock variable and flow variable.
6. If the legal ratio is 20 percent and initial deposits $10,000, explain the process of credit creation
by commercial bank.
7. Calculate the Gross National Product at market price (GNPmp) by income method and
expenditure method:
($ in millions)
(i) Net Exports 10
(ii) Rent 20
(iii) Private final composition expenditure 400
(iv) Interest 30
(v) Dividends 45
(vi) Undistributed profits 5
(vii) Corporate tax 10
(viii) Government final composition expenditure 100
(ix) Net domestic capital formation 50
(x) Compensation of employees 400
(xi) Consumption of fixed capital 10
(xii) Net indirect tax 50
(xiii) Net factor income from abroad (-)10

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Module III

1. Which one of the following affects national income? (choose the correct alternative )
(a) Goods and service tax
(b) Corporation tax
(c) Subsidies
(d) None of the above
2. Define money supply.
3. The central bank can increase availability of credit by : (choose the correct alternative)
(a) Raising repo rate
(b) Raising reverse repo rate
(c) Buying government securities
(d) Selling government securities
4. Why does consumption curve not start from the origin?
5. Which among the following are final goods and which are intermediate goods? Give reasons.
(a) Milk purchased
(b) Bus purchased by a school
(c) Juice purchased by a student from the school canteen.
Or
Given nominal income, how can we find real income? Explain.
6. Define multiplier. What is the relation between marginal propensity to consume and multiplier?
Calculate the marginal propensity to consume if the value of multiplier is 4.
7. Explain the role of the Federal Reserve Bank as the “lender of last resort”
8. What is meant by inflationary gap? State three measure to reduce this gap.
Or
What is meant by aggregate demand? State its components.
9. The value of marginal propensity to consume is 0.6 and initial income in the economy is $ 100
millions. Prepare a schedule showing income, consumption and saving. Also show the
equilibrium level of income by assuming autonomous investment of $ 80 millions.
10. Explain the meaning of the following:
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit
Or
Explain the following objectives of government budget:
(a) Allocation of resources.
(b) Reducing income inequalities.

11. (i) Explain the impact of rise in exchange rate on national income.

(ii)Explain the concept of deficit in balance of payments.

12. Calculate (a) net- national product at market price, and (b) gross domestic product at factor
cost:

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($ in millions)
(i) Rent and interest 6,000
(ii) Wages and salaries 1,800
(iii) Undisturbed profit 400
(iv) Net indirect tax 100
(v) Subsidies 20
(vi) Corporation tax 120
(vii) Net factor income from abroad 70
(viii) Dividends 80
(ix) Consumption of fixed capital. 50
(x) Social security contribution by employers 200
(xi) Mixed income 1,000

Module IV
1. Calculate the value of money multiple if the legal reserve requirement are 20%
1 1
Ans. Money Multiplier = = =5
𝐿𝑅𝑅 20%

2. What is money supply?

Ans. It refers to the total quantity of money in circulation in the economy at a given point of time.

OR

What is meant by reverse repo rate?

Ans. Reverse repo Rate is the rate is the rate at which central bank of a country (RBI in India) borrows
funds from commercial bank within the country.

3. ………………… (Choose the correct alternative) is a revenue receipt of the government

A) Funds raised by the government by issuing national saving certificates

B) Sale of 40% shares of public sectors undertaking to a private enterprises
C) Profits of LIC, a public enterprises amount borrowed from japan for construction of bullet train.

Ans. (C) Profits of LIC, a public enterprise

4. Identify which of the following statement is true?

A) Fiscal deficit is difference between planned revenue expenditure and total planned revenue
receipts
B) Fiscal deficit is difference between total planned expenditure and total planned revenue
C) Primary deficit is the difference between total planned receipt and interest payment.
D) Fiscal deficit is the sum of primary deficit and interest payment.

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Ans. (D) Fiscal deficit is the sum of primary deficit and interest payment.

5. Estimate the value of aggregate demand in an economy if:

(A) Autonomous investment (I) = $ 100 millions

(B) Marginal propensity to save = 0.2

(C) Level of income (Y) = $ 4,000 millions

(D) Autonomous Consumption Expenditure = $ 50 millions

Ans. The Aggregate Demand (AD) function is given as:

AD=C+I

AD={c+b(Y)} + 1

C= 50 (Given)

B or MPC = 1-MPS=1-0.2 = 0.8

Substituting the values of c and b in AD function, we get:

AD = {50+0.8(4000)} + 100 = $ 3,350 millions.

Aggregate Demand is $ 3,350 millions

Or

In an economy C=200+ 0.5 Y is the consumption function where C is the consumption expenditure and Y
is the national income. Investment expenditure is $ 400 millions. Is the economy in equilibrium at an
income level $ 1500 millions? Justify your answer.

ANS. No, the economy y is not in a state of equilibrium at $ 1500 millions

Given consumption function, C= 200+0.5Y

Investment expenditure (I) = $ 400 millions

At the equilibrium level

Y=C+I

Substituting the values from the question.

Y= {200+0.5Y} + 400

Y – 0.5Y= 600

0.5Y = 600
600
Y= = 1200
0.5

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The equilibrium level of income is $ 1200 millions. The given income $ 1500 millions is greater than
equilibrium level of income. Therefore, the economy is not in equilibrium.

6. Explain how the level of effective demand is attained in an economy if, Aggregate Demand is more
than the Aggregate supply.

Ans. Effective demand refers to that level of output where Aggregate demand is equal to the aggregate
supply.

If Aggregate Demand exceeds Aggregate supply, it means buyers are planning to buy more goods and
services that producers are planning to produce. Thus the inventories in hand with the producers will
start falling. As a result producers will plan to raise the production this will increase the level of income
up to the level of aggregate demand is equal to aggregate supply.

7. What is meant by the problem of double counting? How this problem can be avoided?

Or.

Discuss briefly, the circular flow of income in a two sector economy with the help of a diagram.

Ans. The problem of double counting arises when the value of certain goods and services and counted
more than once while estimating the national income by value added Method. This happens when the
value of intermediate goods is counted in the estimation of National Income along with the final value of
goods and services.

Two methods to avoid the problem of double counting:

i. To consider only the final value of output produced.

ii. To consider only the value added of the output produced.

Or

Circular flow of income in a two sector economy – Households are owners of factors of production, they
provide factor services to the firms (producing units) Firms provide factor payments in exchange of their
factor services. So, factor payments flow from firms (producing units) to households.

Households purchase goods and services from firms (producing units) for which they make payment to
them. So, consumption expenditure (spending on goods and services) follows from households to the
firms.

8. Elaborate ‘economic growth’ as objective of government budget.

Ans. Economic Growth implies a sustainable increase in real GDP of an economy, i.e. an increase in
volume of goods and services produced in an economy. Budget can be an effective tool to ensure the
economic growth in a country.

(i) If the government provides tax rebates and other incentives for productive activities, it can
stimulate savings and investments in the economy.

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(ii) Spending on infrastructure in the economy promotes the production activities across
different sectors. Government expenditure is a major factor that generates demand for
different types of goods and services, which induces economic growth in the economy.

9. How the following tools can be used for credit control by the central bank is an economy:

A) Open market operations

B) Margin requirement.

Ans. A. Open Market Operations (OMO) refers to the sale and purchase of government securities in the
open market by the Central Bank. By selling such securities the Central Bank soaks liquidity from the
economy and by purchasing the government securities, Central Bank releases liquidity. This is an
important method of regulating the money supply (liquidity) in the market.

B. the Margin Requirement of loan refers to the difference between the current value of the security
offered and amount of loan granted.

When margin requirement is lowered by the Central Bank, the borrowers are able to secure larger
amount of funds from the banks which will increase the money supply in the economy. Conversely, a
rise in the margin requirements will contract the supply of credit in the economy.

10. How initial increase in investment affects the level of final income of the economy? Show its
working with a suitable numerical example.

Ans. Initial increase in investment increase the final income of the economy. Investment multiplier
explains this effect:

Multiplier (k) is the ratio of the increase in National Income (∆Y) due to a given increase in investments.
(∆l).
∆𝑦
K= ∆𝑙

For eg. If an additional investment of 1000 millions is made by government for a bullet train project in a
country; this extra investment will generate an extra income of 1000 millions; as expenditure of one is
income for another. Also, it is assumed that Marginal Propensity to Consume of the country is 0.8.

An additional investment of 1000 millions (∆l) made by government will generate an extra income of
1000 millions in first round. If MPC of this country is 0.8, the nationals who are receiving this additional
income will spend 80% portion of this additional income, i.e. 800 millions which in return becomes
additional income during third round. Similarly, in third round 640 millions of income is generated.

Consumption expenditure in every round will be 0.8 times of additional income received from previous
round.

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 Principles of Macroeconomics

Round Increase in Increase in Increase in Increase in

Investment(∆𝐈) Income(∆𝐘) Consumption(∆𝐂) Savings
(∆S = ∆𝐘 − ∆𝐂)
Ist 1000 1000 800(1000X0.8) 200
2nd -- 800 640(640X0.8) 160
3rd -- 640 512(640X0.80) 128
4th -- 512 409.6(512X0.8) 102.4
-- -- -- -- --
-- -- -- --
Total Total 5000 4000 1000

1
Thus additional investment of 1000 millions leads to total increase of 5000 millions (1000x ) in
1−0.8
income.
∆𝑦 5000
As a result Multiplier (k) is = = 5.
∆𝑙 1000

11. (a) According to recent media exports:

‘USA has accused china of currency devaluation to promote its exports’.

In the light of the given media report comment, how exports can be promoted through the
currency

Devaluation?

(b) What is meant by current account deficit (CAD) and current account surplus (CAS)? State their
significance.

Ans.

A) USA has a valid point of argument as devaluation of a currency encourages exports of a country.
As exported goods become cheaper in the international market giving a competitive edge for
the goods of domestic country (China). Devaluation of the value of domestic currency promotes
the exports of the country and may adversely impact the production and sale of importing
country (USA).
B) Current Account Deficit (CAD) is a situation that arises when the receipts on current account are
less than the payments on current account. In simple words, Current Account Deficit (CAD)
arises when the value of exports of goods and services is less than the value of imports of goods
and services.

Current Account Surplus (CAS) is a situation that arises when the receipts on current account is
more than the payments on current account. In simple words, Current Account Surplus (CAS)
arises when the value of exports of goods and services is more than the value of imports of
goods and services.

CAD signifies that the national is borrower from rest of the world, whereas, CAS signifies that
the nation is a lender the rest of the world.

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Guidelines for Project Work in Economics (Class XII)

 Students are supposed to pick any ONE of the two suggested projects.

 Teachers should help the students to select the topic after detailed discussions and
deliberations. Teacher should play the role of a facilitator and should supervise and monitor the
project work of the student. The teacher must periodically discuss and review the progress of
the project.

 The teacher must play a vital role of a guide in the research work for the relevant data,
material and information regarding the project work. Also, the students must be guided to
quote the source (in the Bibliography/References section) of the information to ensure
authenticity.

 The teacher must ensure that the students actually learn the concepts related to the project
as he/she would be required to face questions related to the project in viva-voce stage of the
final presentation of the project.

 The teacher may arrange a presentation in the classroom of each and every student so that
students may learn from each other’s project work.

 The teacher must ensure that the students learn various aspects of the concept related to the
topic of the project work.

I. Project (Option One) : What’s Going Around Us

The purpose of this project is to –

 Enable the student to understand the scope and repercussions of various Economic events
and happenings taking place around the country and the world. (eg. The Dynamics of the Goods
& Services Tax and likely impacts on the Indian Economy or the Economics behind the
Demonetisation of 500 and 1000 Rupee Notes and the Short Run and Long Run impact on the
Indian Economy or The impact of BREXIT from the European Union etc.)

 Provide an opportunity to the learner to develop economic reasoning and acquire analytical
skills to observe and understand the economic events.

 Make students aware about the different economic developments taking place in the country
and across the world.

 Develop the understanding that there can be more than one view on any economic issue and
to develop the skill to argue logically with reasoning.

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 Compare the efficacy of economic policies and their respective implementations in real world
situations and analyse the impact of Economic Policies on the lives of common people.

 Provide an opportunity to the learner to explore various economic issues both from his/her
day to day life and also issues which are of broader perspective.

Scope of the project: Student may work upon the following lines:

 Introduction

 Details of the topic

 Pros and Cons of the economic event/happening

 Major criticism related to the topic (if any)

 Students’ own views/perception/ opinion and learning from the work

 Any other valid idea as per the perceived notion of the student who is actually working and
presenting the Project-Work.

Mode of presentation and submission of the Project: At the end of the stipulated term, each
student will present the work in the Project File (with viva voce) to the external examiner.

Marking Scheme: Marks are suggested to be given as –

The external examiner should value the efforts of the students on the criteria suggested.
Suggestive List
1. Micro and small scale industries
2. Food supply channel in USA
3. Contemporary employment situation in USA

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4. Disinvestment policy
5. Health expenditure (of any state)
6. Goods and Services Tax Act
7. Inclusive growth strategy
8. Human Development Index
9. Self-help groups
10. Any other topic

II. Project (Option Two): Analyse any concept from the syllabus the
purpose of this project is to –

 Develop interest of the students in the concepts of Economic theory and application of the
concept to the real life situations.

 Provide opportunity to the learners to develop economic reasoning vis-a-vis to the given
concept from the syllabus.

 Enable the students to understand abstract ideas, exercise the power of thinking and to
develop his/her own perception

 To develop the understanding that there can be more than one view on any economic issue
and to develop the skill to argue logically with reasoning

 Compare the efficacy of economic policies in real world situations

 To expose the student to the rigor of the discipline of economics in a systematic way

 Impact of Economic Theory/ Principles and concepts on the lives of common people

Scope of the project:

Following essentials are required to be fulfilled in the project.
Explanation of the concept: -
Meaning and Definition –
Application of the concept –
Diagrammatic Explanation (if any) –
Numerical Explanation related to the concept etc. (if any) –
Students’ own views/perception/ opinion and learning from the topic..
Mode of presentation and submission of the Project:

Guidelines for Project

183
 Principles of Macroeconomics

At the end of the stipulated term, each student(s) will present their work in the Project File
(with viva voce) to the external examiner.
Marking Scheme:
Marks are suggested to be given as –

The external examiner should value the efforts of the students on the criteria suggested.
Suggested List  Price Determination

 Price Discrimination

 Opportunity Cost

 Production Possibility Curve

 Demand and its determinants

 Supply and its determinants

 Production – Returns to a Factor

 Cost function and Cost Curves

 Monopoly

 Oligopoly

 Monopolistic Competition

 Credit Creation

 Money Multiplier

 Central Bank and its functions

 Government Budget & its Components

 Budget deficit

Guidelines for Project

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 Principles of Macroeconomics

 Exchange Rate Systems

 Foreign Exchange Markets

 Balance of payments

 Any other topic

Guidelines for Project

185
 Principles of Macroeconomics

Formulae

National Income (NNPFC)

Conversion

Gross = Net + Dep. MP = FC + NIT

Net = Gross – Dep. FC = MP – NIT
Dep. = Gross – Net NIT = IT – Subsidies
Dep. = Gross Capital Formation – Net capital Formation
Dep. / Consumption of Fixed Capital

National = Domestic + NFIA

Domestic = National – NFIA

NFIA = Factor Income from Abroad – Factor Income to Abroad

Abbreviations
Dep. = Depreciation
MP = Market Price
FC = Factor Cost
NIT = Net Indirect Taxes
IT = Indirect Taxes
NFIA = Net Factor Income from abroad
NNPFC = Net National Product at Factor Cost

Formulae

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 Principles of Macroeconomics

Value Added or Production Method (GVAMP)

(GVAMP) = Sales + Change in Stock – Intermediate Consumption

Value of Output = Sales + Change in Stock (Closing Stock –

Opening Stock)

(GVAMP) = Value of Output – Intermediate Consumption/Cost

Value of Output = Production of Three Sectors

(Primary + Secondary + Tertiary)

Intermediate Consumption = Intermediate Consumption of

Three Sectors (Primary + Secondary + Tertiary)

Formulae

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 Principles of Macroeconomics

Domestic Income or Income Method (NDPFC)

(A) Compensation of Employees

Wages & Salaries Social Securities Schemes by Employers

(B) Operating Surplus

Rent Interest Profit Royalty

Dividend Corporate Tax Undistributed Profit

(C) Mixed Income

NDPFC = (A) + (B) + (C)

NDPFC = Net Domestic Product at Factor Cost

Formulae

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 Principles of Macroeconomics

Expenditure Method (GDPMP)

(A) Government Final Consumption Expenditure

(B) Private Final Consumption Expenditure

(C) Gross Domestic Fixed Capital Formation

(Gross Fixed Capital Formation +Change in Stock)

(D) Net Export (Export – Import)

Note: Change in Stock = Closing Stock – Opening Stock

GDPMP = (A) + (B) + (C) + (D)

GDPMP = Gross Domestic Product at Market Price

Relationship between MPC & MPS, APS & APS

MPC + MPS = 1 APC + APS = 1

∆𝐂 ∆𝐒 𝐂 𝐒
+ =1 + =1
∆𝐘 ∆𝐘 𝐘 𝐘
∆𝐂+ ∆𝐒 𝐂+𝐒
=1 =1
∆𝐘 𝐘
∆𝒀 𝒀
=1 =1
∆𝒀 𝒀

1 =1 1 =1

Formulae

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 Principles of Macroeconomics

Formulae of MPC, APC, MPS, APS, Multiplier(K), Autonomous

Consumption

MPC, APC, MPS, APS

Y=C+S Y=C+I ∆𝐘 = ∆𝐂 + ∆𝐒
S=Y–C (S = I) I=Y–C ∆𝐒 = ∆𝐘 − ∆𝐂
C=Y–S C=Y–I ∆C = ∆Y − ∆S

∆C C
MPC = APC =
∆Y Y
∆S S
MPS = APS =
∆Y Y

MPC + MPS = 1 APC + APS = 1

MPC = 1 – MPS APC = 1 APS
MPS = 1 – MPC APS = 1 APC

Autonomous Consumption(C)
Y=C+S
C = C + MPC . Y
Y = C + MPC . Y + S
or
Y = C + MPC . Y + I

Formulae

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 Principles of Macroeconomics

Multiplier
∆Y
K=
∆I
1
K=
MPS
1
K=
1−MPC

Formulae of Budget Deficit

Budgetary Deficit

Revenue Deficit Fiscal Deficit Primary Deficit

Revenue Deficit = Total Revenue Expenditure – Total Revenue Receipts

Fiscal Deficit = Total Expenditure – Total Receipts Excluding borrowings

Or
Fiscal Deficit = Total Expenditure – Revenue Receipts – Capital Receipts Excluding
= Borrowings

Primary Deficit = Fiscal Deficit – Interest Payments

Formulae

191