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Introduction to Macro
Economics 1
Introduction and Structure of Macro Economics:
Macroeconomics is the part of economic theory that studies the economy as a whole, such as national income,
aggregate employment, general price level, aggregate consumption, aggregate investment, etc. Its main
instruments are aggregate demand and aggregate supply. It is also called the ‘Income Theory’ or ‘Employment
Theory’.

Structure of macro economy

As we know, Macroeconomics is concerned with economic problems at the level of an economy as a whole.
Structure of Macroeconomics implies study of different sectors of the economy.
An economy may be divided into different sectors depending on the nature of study.
• Producer sector engaged in the production of goods and services.
• Household sector engaged in the consumption of goods and services.
Note: Households are taken as the owners of factors of production.
• The government sector engaged in activities like taxation and subsidies
• Rest of the world sector engaged in exports and imports.
• Financial sector (or financial system) engaged in the activity of borrowing and lending.

Circular Flow of Income:

It refers to the occupation in which people work for others and get remuneration in the form of wages/ salaries.
Those who are employed by others are called employees and the one who employs is called employer.
There are three phases of circular. flow
• Production.
• Income generation.
• Expenditure

Real flow
• Real flow of income implies the flow of factor
services from the household sector to the
producing sector and corresponding flow of
goods and services from the producing sector to
the household sector.
• Let us consider a simple economy consisting
only of 2 sectors
➢ Producer Sector.
➢ Household Sector.

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These two sectors are dependent on each other in the following ways.
• Producers supply goods and services to the households.
• Household (as the owners of factors of production) supplies factors of production (or factor services) to the
producers.
This interdependence can be explained with the help of the diagram given here.

Money Flow
Money flow refers to the flow of factor income, as rent, interest, profit and wages from the producing sector to the
household sector as monetary rewards for their factor services as shown in the flowchart.
• The households spend their incomes on the goods and services produced by the producing sector.
Accordingly, money flows back to the producing sector as household expenditure as shown in the flowchart.

Circular Flow of Income in Two Sector Model

The following assumptions with regard to a simple economy with only two sector of economics activity are:
• There are only two sectors in the
economy; that is, household and
firms.
• Household supply factor services to
firms.
• Firms hire factor services from
Households.
• Households spend their entire
income on consumption.
• Firms sell all that is produced to the
households.
• There is no government or foreign
trade.
• Such an economy described above
has two types of markets.
• Market for goods and services, that is product market.
• Market for factors of production, factor market.

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As a result we can derive the following, in the case of our simple economy:
• Total production of goods and services by firms = Total consumption of goods and services by Household
Sector.
• Factor Payments by Firms = Factor Incomes of Household Sector.
• Consumption expenditure of Household sector = Income of Firm.
• Hence, Real flows of production and consumption of Firms and households = Money flows of income and
expenditure of Firms and Households.

Phases Of Circular Flow:

There are three types of phases of Circular flow.

Production Phase:
• It deals with the production of goods and services by the producer sector.
• If we study it in term of the quantity of goods and services produced, it is a Real Flow. But, it is a Money flow,
if we study it in terms of the market value of the goods produced.

Disposition Phase:
It means the flow of income in the form of rent, interest, profit and wages, paid by producer sector to the household
sector. It is a Money Flow.
• Disposition means expenditure made. This phase deals with expenditure on the purchase of goods and
services by households and other sectors.
• This is a Money Flow from other sectors to the producer sector. These phases are illustrated in the figure
given here.

Some Basic Concepts of Macro Economics

Factor Income:
• Income earned by factor of production by rendering their productive services in the production process is
known as Factor Income.
• It is a bilateral [Two-Sided] Concept.
• It is included in National Income as it contributes something in the flow of goods and services.
Examples: Rent, interest, wages and profit.

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Transfer Income:
• Income received without rendering any productive services is known as transfer income.
• It is a unilateral [one-sided] concept.
• It is not included in National Income as it does not contribute anything in the flow of goods and services.
Examples: Old Age Pension, Scholarship, Unemployment allowance.
There are two types of transfers:
• Current transfers
• Capital transfers
• Current Transfers

Current transfers:
• Transfers made from the income of the payer and added to the income of the recipient (who receive) for
consumption expenditure are called current transfers.
• It is recurring or regular in nature.
For example, scholarships, gifts, old age pension, etc.

Capital Transfers:
• Capital transfers are defined as transfers in cash and in kind for the purpose of investment to recipients,
made out of the wealth or saving of the donor.
• It is non recurring or irregular in nature.
For example, investment grant, capital gains tax, war damages, etc.

Stock:
• Any economic variable which is calculated at a particular point of time is known as stock.
• It is static in nature, i.e., it do not change.
• There is no time dimension in stock variables.
For example, Distance, Amount of Money, Money Supply, Water in Tank, etc.

Flow:
• Any economic variable which is calculated during a period of time is known as flow.
• It is dynamic in nature, i.e., it can be changed.
• There is time dimension in flow variables.
For example, Speed, Spending of Money, Water in River, Exports, Imports, etc.

Economic territory or Domestic Territory:

• According to the United Nations, economic territory is the geographical territory administered by a
government within which persons, goods and capital circulate freely.
• The above definition is based on the criterion “freedom of circulation of persons, goods and capital”. Clearly,
those parts of the political frontiers (or boundaries) of a country where the government of that country does
not enjoy the above “freedom” are not to be included in economic territory of that country.
• One example is embassies. Government of India does not enjoy the above freedom in the foreign embassies
located within India. So, these are not treated as a part of economic territory of India. They are treated as
part of the economic territories of their respective countries. For example the U.S. embassy in India is a part
of economic territory of the U.S.A. Similarly, the Indian embassy in Washington is a part of economic
territory of India.
• International organizations like UNO, WHO, etc. located within the geographical boundaries of a country.

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• In layman terms, the domestic territory of a nation is understood to be the territory lying within the political
frontiers (or boundaries) of a country. But in national income accounting, the term domestic territory is
used in a wider sense. Based on ‘freedom’ criterion, the scope of economic territory is defined to cover:
• Ships and aircrafts owned and operated by normal residents between two or more countries. For example,
Indian Ships moving between china and India regularly are part of domestic territory of India. Similarly,
planes operated by Air India between Russia and Japan are part of the domestic territory of India. Similarly,
planes operated by Malaysian Airlines between India and Japan are a part of the domestic territory of
Malaysia.
• Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of a country in the
international waters where they have exclusive rights of operation. For example, Fishing boats operated by
Indian fishermen in international waters of Indian Ocean will be considered a part of domestic territory of
India.
• Embassies, consulates and military establishments of a country located abroad. For example, Indian
Embassy in Russia is a part of the domestic territory of India. ‘Consulate’ is an office or building used by
consul (an officer commissioned by the government to reside in a foreign country to promote the interest
of the country to which he belongs).

Citizenship/ Nationalship:
• Citizenship is basically a legal concept based on the place of birth of the person or some legal provisions
allowing a person to become a citizen.
It means, Indian citizenship can arise in two ways:
• When a person is born in India, he acquires automatic citizenship of India.
• A person born outside India applies for citizenship and Indian Law allows him to become Indian Citizen.

Normal Resident/ Resident:

• A Normal resident, whether a person or an institution, is one whose center of economic interest lies in the
economic territory of the country in which he lives.
The center of economic interest implies in two things:
• The resident lives or is located within the economic territory for more than one year and
• The resident carries out the basic economic activities of earnings, spending and accumulation from that
location
• There is a difference between the terms normal resident (resident) and citizen (or national).
• A person becomes a national of a country because he was born in the country or on the basis of some other
legal criterion.
• A person is treated resident of a country on the basis of economic criterion.
• 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 criterion.
• For example, a large number of Indian nationals have settled in U.S.A., England, Australia, etc. as residents
(and not as nationals) of these countries. For India, they are Non-resident Indians (NRI) but continue to
remain Indian nationals.
Following are not included under the category of Normal residents:
• Foreign visitors in the country for such purposes as recreation, holidays, medical treatment, study tours,
conferences, sports events, business etc. (they are supposed to stay in the host country for less than one
year. In case they continue to stay for one year or more in the host country, they will be treated as normal
residents of the host country).
• Crew members of foreign vessels, commercial travelers and seasonal workers in, the country (Foreign
workers who work part of the year in the country in response to the varying seasonal demand for labour

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and return to their households and border workers who regularly cross the frontier each day or somewhat
less regularly, (i.e. each week) to work in the neighbouring country are the normal residents of their own
countries. Example: Nepal.
• Officials, diplomats and members of the armed forces of a foreign country.
• International bodies like World Bank, World Health Organization or International Monetary Fund are not
considered residents of the country in which these organizations operate but are treated as residents of
international territory. However, the staffs of these bodies are treated as normal residents of the country in
which the international body operates. For example, international body like World Health Organization
located in India is not normal resident of India but Americans working in its office for more than a year will
be treated as normal residents of India.
• Foreigners who are the employees of non-resident enterprises and who have come to the country for
purposes of installing machinery or equipment purchased from their employers. (They are supposed to stay
for less than one year. In case they continue to stay for one year or more, they will be treated as normal
residents of the host country).

Final Goods:
• These are the goods that are used for: Personal Consumption (like bread purchased by consumer
household), or (if) Investment or Capital Formation (like building, machinery purchased by a firm)
• In other words, final goods are those, which require no further processing and are available in an economy
for consumption purpose or investment. These give direct satisfaction to a consumer.
• According to production boundary, if a good crosses the imaginary line around the production unit and
reaches to final consumer or investment made by a producer within the imaginary line of production unit
is known as the final good.

Intermediate Goods:
These are the goods that are used for:
• Further processing (like sugar used for making sweets); or
• Resale in the same year (If car purchased by car dealer for resale).
In other words, intermediate goods are the ones, which require further processing and are not available in
an economy for the purpose of consumption. These goods give indirect satisfaction to a consumer.
According to the production boundary, if a good does not cross the imaginary line around the production
unit and reaches to other firm within the production boundary, is known as intermediate good.
Point to Remember for Final Goods and Intermediate Goods:
Basis of Classification: If a good is used for:
• Personal consumption
• Investment
Then it is a final good, whereas, if a good is used for:
• Further processing
• Resale in the same year, then it is known as intermediate good.
Thus, the basis of classification between these two goods is not the commodity itself, but the use made of it.
For example, bread used by a consumer household is a final goods, but the same used by a bakery for making a
sandwich is a intermediate goods.

Production Boundary:
• Production boundary plays a vital role to differentiate between intermediate and final goods. The
production boundary is the imaginary line around the production unit.

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• According to the production

boundary, if a good crosses the
imaginary line around the
production unit and reaches to final
consumer or investment made by a
producer within the imaginary line
of production unit, it is known as
final good.
As against it, if a good does not cross
the imaginary line around the
production unit and reaches to other
firm within the production boundary, it is known as intermediate good.
In the given diagram, there are 3 production units. The thick border drawn around these three units is the
Production Boundary.
Within this limit, wheat and flour are intermediate goods.
Bread is final good as it lies outside the purview of production boundary.

Important Points about:

Intermediate Goods: As far as intermediate consumption of general government is concerned, it’s purchased
goods ranges from ordinary writing paper, pencils and pens to sophisticated fighter aircrafts. The goods and
services purchased include both durable goods and non-durable goods and services.
The intermediate consumption of the general government includes the following items:
• Value of all Non-durable Goods and Services such as petrol, electricity, lubricants, stationery, soaps, towels
etc. including repair and maintenance of capital stock: Non-durable goods and services are those which have
an expected life time of use of less than one year. Repair and maintenance of capital stock mean expenditure
incurred for maintaining fixed assets and keep them in good working order. This includes the expenditure
on new parts of the fixed assets. The life of the new parts may be around one year or slightly more and the
value should be relatively small. For example, replacement of the tyres of a truck is an intermediate
consumption, but not the replacement of its engine.
• Expenditure on Military Equipment missiles, rockets, bombs, warships, submarines, military aircrafts,
tanks, missile carriers and rocket-launchers etc. whose function is to release weapons. Military vehicles and
light weapons.
• Value of goods received from foreign governments in form of gifts or as transfers. Examples of these
transfers in kind are food, clothing, medicines, vegetable oils, butter, toys sent by the government of one
country to the other in times of natural calamities or as a token of goodwill and friendship between two
countries. However, the goods received for distribution to consumer households without renovation or
alternation should not be included in intermediate consumption as these goods go into the final
consumption of consumer households.
• As we know, intermediate goods are purchased by one production unit from another production unit within
the production boundary.
• However, it’s not necessary that all purchases by one production unit from other production units are
intermediate purchases. For example, purchases of building, machinery, etc. are not intermediate purchases
(if they are not meant for resale in the same year). Rather, these purchases are meant for investment and
are termed as final product.

Research and development:

• Commodities consumed. In research and exploratory activities (like oil exploration in different parts of
India by the Oil and Natural Gas Commission) or improving the technology of a particular production
process.

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• Commodities used in basic scientific research.

• Advertisements, market research and public relationship meant for improving the goodwill of the business
enterprises.
• Business expenses of the employees on tours and entertainment.

Final goods can be classified into two groups:

Consumption Goods and Capital Goods.

Consumption Goods:
Meaning: Consumption goods are those which satisfy the wants of the consumers directly. For example, cars,
television sets, bread, furniture, air-conditioners, etc.

Categories of Consumption Goods:

• Durable goods: These goods have an expected life time of several years and of relatively high value. They
are motor cars, refrigerators, television sets, washing machines, air-conditioners, kitchen equipments,
computers, communication equipments etc.
• Semi-durable goods: These goods have an expected life time of use of one year or slightly more. They are
not of relatively great value. Examples are clothing, furniture, electrical appliances like fans, electric irons,
hot plates and crockery.
• Non-durable goods: Goods which cannot be used again and again, i.e., they lose their identity in a single
act of consumption are known as non-durable goods. These are food grains, milk and milk products, edible
oils, beverages, vegetables, tobacco and other food articles.
• Services: Services are non-material goods which satisfy the human wants directly. They cannot be seen or
touched, i.e., they are intangible in nature. These are medical care, transport and communications,
education, domestic services rendered by hired servants, etc.

Capital Goods:
• Capital goods are defined as all goods produced for use in future productive processes. For example, all the
durable goods like cars, trucks, refrigerators, buildings, aircrafts, air-fields and submarines used to produce
goods and are ready for sale in the market are a part of capital goods.
• Stocks of raw materials, semi-finished and finished goods lying with the producers at the end of an
accounting year are also a part of capital goods.
• Some more examples of capital goods are machinery, equipment, roads and bridges.
• These goods require repair or replacement over time as their value depreciate over a period of time.

Words that Matter:

• Circular flow of income: It refers to flow of money income or the flow of goods and services across different
sectors of the economy in a circular form.
• Money flow (nominal flow): Money flow refers to the flow of factor income, as rent, interest, profit and
wages from the producing sector to the household sector as monetary rewards for their factor services.
• Real flow or physical flow: Real flow of income implies the flow of factor services from the household
sector to the producing sector and corresponding flow of goods and services from the producing sector to
the household sector.
• Factor income: Income earned by factor of production by rendering their productive services in the
production process is known as Factor Income.
• Transfer income: Income received without rendering any productive services is known as Transfer
Income.

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• Current transfers: Transfers made from the current income of the payer and added to the current income
of the recipient (who receive) for consumption expenditure are called current transfers.
• Capital transfers: Capital transfers are defined as transfers in cash and in kind for the purpose of
investment to recipient made out of the wealth or saving of a donor.
• Final goods: These are those which are used for:
• Personal consumption (like bread purchased by consumer household), or
• Investment or capital formation (like building, machinery purchased by a firm).
• Intermediate goods: These are those, which are used for:
• Further processing (like sugar used for making sweets)
• Resale in the same year (If car purchased by a car dealer for resale).
• Consumption goods: Consumption goods are those goods which satisfy the wants of consumers directly.
• Capital goods: Capital goods are defined as all goods produced for use in future productive processes.

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Important Questions
Multiple Choice Questions: 7. In which of the following sectors is
manufacturing activity included?
1. At the time of independence, most of the land
was owned by …………….. (a) Primary

(a) farmers (b) Tertiary

(b) zamindars (c) Secondary
(c) labor (d) All of these
(d) all of these 8. Where was the first iron and steel company
2. What was the life expectancy in India during the established?
British rule? (a) Kolkata
(a) 65 (b) Jamshedpur
(b) 38 (c) Patna
(c) 32 (d) Ranchi
(d) 44 9. What is the tax or duty on imports called?
3. During colonial period India’s demographic (a) Tariff
profile showed ……………….
(b) uota
(a) high birth rate
(c) Export
(b) low death rate
(d) None of these
(c) low infant mortality rate
10. Which of the following was the major occupation
(d) high literacy rate
on the eve of independence?
4. Indian economy on the eve of Independence was
(a) Industry
……………..
(b) Services
(a) underdeveloped
(c) Agriculture
(b) developing
(d) None of these
(c) stagnant
11. The Tata Iron and Steel Company was
(d) semi-feudal
incorporated in the year:
5. Suez Canal was opened for transport in
(a) 1907
………………
(b) 1947
(a) 1850
(b) 1853 (c) 1908

(c) 1869 (d) 1950

(d) 1901 12. The road which was built by British in India was
to
6. Who made significant estimates about
calculating national income in India during the (a) Mobilizing the army within India
British period? (b) Drawing out of raw materials from the
(a) V.K.R.V. Rao countryside

(b) Dadabhai Naoroji (c) To overcome the problem of freuent

(c) Findlay Shirras famines in India

(d) William Digby (d) Only A and B

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13. The exports surplus during the British rule was 5. What are the different types of goods produced
used: in an economy?
(a) To make payments for expenses incurred
by an office set up by the colonial
Case Study Based Question-
government in Britain 1. Read the following hypothetical text and answer
(b) To meet expenses on war fought by the the given questions: -
British government 2. Read the following hypothetical text and answer
(c) To import invisible items the given questions: -
(d) All of these Assertion Reason Type Question-
14. During the British rule, high mortality rate was
1. In these questions, a statement of assertion
due to
followed by a statement of reason is given.
(a) Inadeuate public health facilities Choose the correct answer out of the
(b) Occurrence of freuent natural calamities following choices.
(c) Both (a) and (b) a. Both Assertion (A) and Reason (R) are
(d) Neither (a) nor (b) true and Reason (R) is the correct
15. At the time of Independence, the infant mortality explanation of Assertion (A).
rate was: b. Both Assertion (A) and Reason (R) are
(a) 220 per thousand true and Reason (R) is not the correct
explanation of Assertion (A).
(b) 250 per thousand
c. Assertion (A) is true but Reason (R) is
(c) 218 per thousand
False
(d) 280 per thousand
d. Assertion (A) is False but Reason (R) is
Very Short Questions- true.
1. What is export? Assertion: Production Possibility Frontier
2. What is import? (PPF) is a concave-shaped curve.

3. The term Macro is derived from Reason: PPF shows all the maximum possible
combinations of two goods, which can be
4. Who is called the ‘father of modern economics’?
produced with the available resources and
5. What is the name of John Maynard Keynes' technology.
celebrated book?
2. In these questions, a statement of assertion
Short Questions- followed by a statement of reason is given.
Choose the correct answer out of the
1. Distinguish between microeconomics and
following choices.
macroeconomics.
a. Both Assertion (A) and Reason (R) are
2. What is entrepreneurship?
true and Reason (R) is the correct
3. Define great depression.
explanation of Assertion (A).
4. What are the features of capitalist economy?
b. Both Assertion (A) and Reason (R) are
5. What are economic agents? true and Reason (R) is not the correct
explanation of Assertion (A).
Long Questions-
c. Assertion (A) is true but Reason (R) is
1. What is Macroeconomics and microeconomics
False
and what is the connection between the two?
d. Assertion (A) is False but Reason (R) is
2. Define and explain the importance of ‘scarcity’
true.
and ‘opportunity costs’ in economics.
3. What are the different ways in which resources Assertion: Human wants differ in priorities.
can be allocated and what are their respective Reason: For every individual, some wants are
advantages and disadvantages? more important and urgent as compared to
4. Explain the scope of Macroeconomics. others.

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Answer Key
MCQ Answers- Short Answers-
1. (b) zamindars 1.
2. (d) 44 Basis Micro Macro
economics economics
3. (a) high birth rate
Focus It investigates It investigates
4. (a) underdeveloped upon the individual the aggregate
5. (c) 1869 economic unit. economic units.
Concerned It is concerned It is concerned
6. (a) V.K.R.V. Rao with with the with the
7. (c) Secondary determination determination of
of prices and the general price
8. (b) Jamshedpur output in level and output
9. (a) Tariff individual in the entire
markets. economy.
10. (c) Agriculture
Challenges The two most The
11. (a) 1907 important fundamental
central issue in this case
12. (d) Only A and B challenges are is determining
13. (d) All of these price the level of
determination income and
14. (c) Both (a) and (b) and resource addressing
15. (c) 218 per thousand allocation. unemployment
in the economy.
Very Short Answers- Approach. Microeconomics Macroeconomics
analyzes the analyzes the
1. Ans: An export is a function of international economy from economy from
trade in which items produced in one country the bottoms- up. the top-down.
are shipped to another for sale or trade in the
2. The ability and willingness to conceive, organize,
future. The sale of such commodities contributes
and manage a business initiative, as well as any
to the gross domestic product of the producing risks associated with it, in order to generate
country. profit is called entrepreneurship. The
establishment of new businesses is the most
2. Ans: Imports are goods or services that are
visible manifestation of entrepreneurship.
brought into one country from another. Because
3. The Great Depression was the worst economic
commodities are frequently delivered by boat to downturn in the history of the industrialized
foreign nations, the term "import" is derived world, lasting from 1929 to 1933. Economic
from the word "port." Imports, together with historians typically ascribe the commencement
of the Great Depression to the abrupt and
exports, are the backbone of international trade.
disastrous drop of US stock market prices on
3. Ans: Latin word ‘Macros’. October 29, 1929, known as Black Tuesday.
Some, however, disagree with this conclusion,
4. Ans: Adam Smith
viewing the stock market crash as a symptom
5. Ans: The title of the book is 'The General Theory rather than a cause of the Great Depression.
of Employment, Interest, and Money,' and it was 4. According to Karl Marx's 'Das Kapital,' the
released in 1936. capitalist takes on average twelve hours of work
from the worker and pays him wages equivalent
to six hours of effort.

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“Capitalism is a free-market form or capitalistic economics that studies the behavior of the
economy that may be regarded as an automatic economy as a whole, rather than just individual
self-regulating system motivated by self-interest businesses.
of individuals and regulated by competitions,” While these two economics subjects appear to be
writes Ferguson. distinct, they are actually interrelated and
The main features are: complement one another due to many
• Private ownership exist, and the property overlapping concerns.
is owned by the private sector or • For example: Higher inflation would raise the
individuals or companies. cost of raw materials for businesses, influencing
the price of the end product charged to the
• No or minimum interference from the
public. According to Professor Ackley, "the link
government takes place.
between macroeconomics and theory of
• There exists the influence of the private individual behavior is a two-way street."
sector in all the decisions.
• Microeconomic theories should serve as the
• The forces of demand and supply, as well foundation for our collective ideas, but
as the behaviour of economic participants macroeconomics can also aid in microeconomic
determines the economy. knowledge. For example, empirically stable
• The main objective is profit maximisation. macroeconomic generalizations that appear to
• USA, and Japan are examples of capitalist contradict microeconomic theories may help us
economies. better understand individual behavior.

• There exists freedom of enterprise, where 2. Scarcity

individuals are free to make their own Scarcity is the condition that exists when there
are insufficient resources to meet all of an
• economic choices.
individual's or society's desires. Any resource
5. Individuals or institutions that make economic with a non-zero cost to use is rare to some
decisions are referred to as economic units or extent, but relative scarcity is what matters in
economic agents. practice.
• They could be consumers who choose • Scarcity is sometimes known as "paucity."
what and how much to consume.
• Economics is the study of how people use
• They could be manufacturers of goods finite resources to meet their boundless
and services who decide what and how desires.
much to produce.
• At the heart of economics is the notion
• They could be institutions such as the that our world is afflicted by scarcity, that
government, corporations, or banks that we do not have access to all of the
make economic decisions such as how resources we desire. As a result, we must
much to spend, what interest rate to make a decision.
charge on credit, how much to tax, and so Importance of Scarcity:
on.
• It influences the level of supply and
Long Answers- demand in the economy.

1. Many books have been written about • The production of goods and services is
macroeconomics and microeconomics, as well as influenced by the scarcity of input
the underlying concepts that underpin them. resources. If the resources are scarce,
Microeconomics is the study of decisions made producers will find it difficult to produce
by individuals and businesses regarding the required level of goods and services.
resource allocation and the pricing of goods and • It affects the price of goods and services,
services. It focuses on supply and demand, as as scarce resources are high in demand
well as other forces that influence price levels in but low in supply, leading to higher price
the economy. Macroeconomics is the branch of charges.

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• No economy would exist if there is no Advantages:

scarcity. As due to scarcity of resources • Higher economic growth and
the problem of choice and problem of development due to social welfare
resource allocation arises. objectives.
Opportunity cost: • Reduced income and social inequalities.
When we make a decision, it is unavoidable that • Reduced duplication of resources
we will have to give up something. The thing we
• Better and optimum utilisation of
give up is referred to as opportunity cost.
resources.
• Economists describe opportunity cost as Disadvantages:
the next best or highest valued alternative
• Lack of individual choice.
to the chosen option. If we choose to make
a product out of a resource, the • Restricts individual rights
opportunity cost of making that good is • As the government makes the decisions,
the highest valued alternative use of that there is no say of individuals.
resource. • Inefficiency is there, as the products are
• Opportunity Costs are the costs incurred as per government decisions, irrespective
when the next highest valued alternative of consumer choice.
is foregone when a decision is taken. • Market Economy: All economic activities
Every resource used in the economy has a in a market economy are organised
limited quantity available. through the market. Free interaction of
individuals who pursue their respective
• This is what leads to the existence of a
economic activities takes place in a
price for all commodities and services. If
market.
there were no scarcity of resources,
everything would be free, and there In other words, a market is a collection of
arrangements in which economic agents freely
would be no opportunity cost of choosing
exchange their endowments or products with
the next best opportunity. Because
one another. Also, no interference of
neither the customer nor the producer
government takes place, and there exists the
has an infinite supply of anything, hence
influence of the private sector. The forces of
opportunity cost is tied to scarcity.
demand and supply, as well as the behaviour of
3. The problem of resource allocation can be economic participants determines the economy.
settled either by free interaction of individuals The main objective is profit maximisation.
or a government controlled economic system. Advantages:
Mainly three market systems exist that decide
• Higher efficiency due to competition
about the allocation of resources.
between firms.
• Centrally Planned Economy: A centrally
• To enable differentiation, and gain
planned economy is one in which the
competitive advantage, firms offer wide
government or a central authority plans
variety of products.
all the economy’s major activities. All
• Innovation in products take place to boost
major decisions regarding the production,
consumer demand.
exchange, and consumption of goods and
services are made by the government. The • Efficient production, and utilisation of
central authority attempts to achieve a resources is there
specific resource allocation and also the Disadvantages:
distribution of the final combination of • Due to profit motive, no/less concern to
goods and services that is deemed society and environment is there.
desirable for the society as a whole. The • Exploitation of people takes place.
primary goal is social welfare.

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• Cut throat competition leads to important in investigating the origins,

competitive disadvantages. impacts, and treatments of general
• The social, economic, and income unemployment.
inequalities take place. 4. National Income: Understanding
macroeconomics is critical for assessing
• Mixed Economy: The economy in which
the overall performance of the economy
both the government and the private
in terms of national income. With the
sector own and operate production
onset of the 1930s Great Depression, it
factors. Profit maximisation in the private
became necessary to investigate the
sector and social welfare in the public
causes of general overproduction and
sector are the primary goals. The central
general unemployment.
planning authority and the price
mechanism solve central problems. 5. Economic Growth: Growth economics is a
branch of macroeconomics. The
Advantages:
resources and capacities of an economy
• Efficient allocation of resources.
are assessed using macroeconomic
• Social welfare principles. Plans for overall increases in
• Private sector is encouraged. national income, output, and employment
are developed and implemented in order
• Reduction in economic differences
to boost the economy's overall level of
Disadvantages:
economic development.
• Delay in decision making. 5. The following are some examples of different
• High possibility of resource wastage. categories of goods:
• More chances of corruption and black 1. Ordinary products: The quantity
marketing. requested of such commodities rises as
• Lack of proper economic planning. the consumer's income rises and falls as
the consumer's income falls. Such items
4. The scope of Macroeconomics is as follows:
are referred to as regular goods.
1. To comprehend the operation of the
2. Free Products: These are goods that have
economy: The study of macroeconomic
an infinite supply and are offered as a free
variables is essential for understanding
gift from nature. These items are referred
how the economy works. Our key
to as 'Free Goods.' For example, air, sea,
economic challenges are related to the
water, sunlight, desert sand, and so on.
behavior of total income, output,
employment, and the economy's overall 3. Economic Goods: Vegetables, cereals,
price level. minerals, fruits, and fish, etc. which are
neither man-made nor limitless in supply
2. Economic Policies: Macroeconomics is
from nature are referred to as ‘Economic
particularly useful in terms of economic
Goods.' All of these items are exclusively
policy. Modern governments, particularly
available for purchase and sale in the
those in developing countries, face a slew
market.
of domestic issues. They are
overcrowding, inflation, balance of 4. Substitute goods: These are items that
payments, general underproduction, and can be consumed or used in lieu of one
so on. another. Also, an increase in the price of
one type of good leads to an increase in
3. Unemployment in General:
the demand for its replacements, and a
Unemployment is thus generated by a
decrease in the price leads to a decrease
lack of effective demand. To eradicate it,
in the demand for its substitutes. For
total investment, total output, total
example, tea and coffee are substitutes.
income, and total consumption should be
increased to increase effective demand. 5. Private Goods Private goods are all goods
As a result, macroeconomics is especially owned by private entities. A car, a house,

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a motorcycle, a mobile phone, books, a Case Study Answer-

television set, and so on are examples of
1. Answer:
private commodities.
1. a) absolute poverty
6. Public Goods: There are many goods that
are jointly owned by society, the public, or 2. Poverty line
the government. These are referred to as 3. Consumption
public or government products. Roads, 4. per capita expenditure
bridges, hospitals, government schools,
and so on are examples of public goods, 2. Answer:
social goods, or government goods. 1. d) All of the above
7. Consumer Goods: Consumer Goods are 2. Casualization
goods that are directly used by the
3. Gini Coefficient
consumer for the purpose of
consumption. Bread, biscuits, butter, jam, 4. d) all the above
rice, fish, eggs, shoes, clothes, fans, books,
pens, cooking gas, and so on are examples
Assertion Reason Answer-
of consumer products. 1. b) Both Assertion (A) and Reason (R) are true
8. Capital Goods: All that are not and Reason (R) is not the correct explanation of
immediately utilized to satisfy Assertion (A).
consumption but are used in subsequent 2. a) Both Assertion (A) and Reason (R) are true
manufacturing are referred to as and Reason (R) is the correct explanation of
‘Producer Goods' or ‘Capital Goods.'
Assertion (A).
Examples include seeds, fertilizers, tools,
machineries, raw materials, and so on.
❖❖

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National Income Accounting 2

Introduction:
To determine private income, personal income, personal disposable income, National disposable income (net and
gross) and their differences.

Basic Concepts of Macroeconomics

Macroeconomics deals with the overall economy of the market and other systems on a large scale.
Macroeconomics studies about the performance, structure, and behavior of the entire economy. It focuses on the
way the economy performs as a whole.
It analyzes how different sectors of the economy relate to one another. This includes unemployment, GDP,
inflation, aggregate consumption, aggregate investment, saving, energy, international trade, international finance,
etc. Its main instruments are demand and supply.
Macroeconomists study topics such as GDP, unemployment rates, national income, price indices, output,
consumption, unemployment, inflation, saving, investment, energy, international trade, and international finance.
There are three main topics for macroeconomic theories which are related to the phenomena of output,
unemployment, and inflation.
Output: It is the total amount of everything a country produces and sold in a given which generates an equal
amount of income. The total output of the economy is measured GDP per person.
Unemployment: It refers to people who are employable but are unable to find a job. It also Includes people in the
workforce who are working but do not have an appropriate job.
Unemployment is measured by the unemployment rate, which is dividing the number of unemployed and
employed people in the workforce, unemployment is one of the indicators of a country’s economic status.
Inflation: When a general price increase across the entire economy is
called inflation and when prices decrease, that is deflation. These changes
in prices are measured with price indexes. Inflation can occur when an
economy grows too quickly. Similarly, a declining economy can lead to
deflation.

Types of Goods:
Consumer Goods:
Consumer goods are products made for consumption by the average
consumer. It is the end result of production and manufacturing. Consumer
goods are purchased to fulfill personal consumption needs
Examples of consumer goods are clothing, food, furniture, jewelry etc.
Basic materials, such as copper, are not considered consumer goods
because they must be transformed into usable products.

Capital Goods:
Capital goods are the goods that can be used to increase production. These goods are fixed, durable or tangible
assets that are purchased by a business in order to produce finished products or consumer goods.
Examples of capital goods are equipment, machinery, buildings, computers, vehicles, and more. The concept of

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capital goods is used in macroeconomic terms where it is used in determining the capital formation and the
production capacity.
For purchasing capital goods, a considerable amount of investment is required. This purchase of a capital good is
referred to as a capital expense in accountancy.

Final Goods:
A final good is a product that are used by the final consumer which does not require any additional processing. It
is for the direct use of the final consumer.
Final goods are also purchased by the firms for investment purposes or for capital formation.

Classification of Final Goods:

• Convenience goods: Convenience goods are those goods that are regularly consumed, e.g., milk, bread,
pulses, and more.
• Specialty goods: Speciality goods that provide luxury and are expensive. These goods are not a necessity.
Examples of such goods are antique cars, jewellery, and more.
• Shopping goods: These goods are durable and, more expensive than the convenience goods. e.g.
refrigerators, televisions, laptops, and more.
• Unsought goods: These types of goods are not purchased often by the consumers, e.g. fire extinguishers,
snow jackets, etc.
• Intermediate Goods: Intermediate goods are partially finished goods that are used for the production of
other goods or services, that become final goods. Intermediate goods are an integral part of the production
process, they are also known as producer goods, because they are used in the production process. These
goods are transformed into another product, which is either another intermediate good or a final good for
end user.
Intermediate goods are of three main categories:
• They are produced and immediately used by the manufacturer to produce final goods
• They are produced and sold in its partially completed form to other companies to produce final goods
• They are sold to another company to produce another intermediate good.

Stocks and Flows

Any quantity that is measured at a particular point in time is known as Stock, and the quantity that can be
measured over a period of time is called Flow
Both stocks and flow are dependent on each other. The concept of stock and flow is very important in Economics,
it helps to understand the development of economic variables.
In a small period of time, flows will be close to zero, whereas stocks could have some value. Stocks are accumulated
over time by flows, whereas flows represent the rate of movement of items in and out of stocks.
Flows can be divided into two parts: inflows (that add to stocks), and outflows (that deplete the stocks). The
difference between these two is called net inflows.
If the inflow is more, than net inflow is positive and the stock will be rising, but if the inflow is less, than net inflow
is negative, and the stock will be falling.
Example of stocks and flow is a bucket. The level of water in the bucket is a stock, the water coming from the tap
is an inflow, and the draining of the water through the drain is an outflow.
If we plug the drain and turn on the tap, the net inflow will be positive, and the stock of water in the bucket will be
rising. If, instead, we close the tap and open the drain, the net inflow of water will be negative, and the stock of
water in the bucket will fall.
Economic development can be well described with the knowledge of which variables represent stock and which
variables represent flows. Most of the macroeconomic variables reported by statistical agencies are flow variables.

Gross Investment and Depreciation:

Gross investment refers to the total expenditure on new capital goods over a specific period of time without
considering depreciation. The investment which considers depreciations is known as Net investment

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Net investment is calculated by subtracting depreciation from gross investment.

Some gross investment is required each year just to replace technologically, obsolete or worn-out plant and
machinery.
Investment is done to obtain a good target return over a specified period of term. The target returns may be of any
forms like an increase in the value of assets or securities.
There are different types of investments like autonomous, financial, real, planned, unplanned, gross and net.
If gross investment is greater than depreciation over any period of time then the net investment is positive and
the capital stock has increased.
This indicates that businesses will have a higher productive capacity and can meet rising demand in the future.
But, if gross investment is less than depreciation, then the net investment tends to be negative and the capital stock
declines.

Circular Flow of Income (two sector model):

It refers to flow of money, income, goods and services
across different sectors of the economy in a circular
form.
This flow shows the redistribution of income in a
circular manner between the production unit and
households
These flows include land (rent), labor (wages), capita
(interest), and entrepreneurship (profit).
There are two types of Circular flow:
✓ Real/ Product/ Physical Flow
✓ Money/ Monetary/ Nominal Flow
• Real flow: This is the flow of factor services from
the household sector to the producing sector and
in return flow of goods and services from the
producing sector to the household sector
• Money Flow: This flow of factor income, as rent,
interest, profit and wages from the producing
sector to the household sector as monetary rewards for their factor services

Circular Flow Of Income In Two Sector Model:

• It is the flow of payments and receipts for goods, services, and factor services between the households and
the firm sectors of the economy.
• Household supply factor services to firms and firms hire factor services from Households. Households
spend their income on consumption and firms sell all its products to the households.

Methods of calculating National Income

There are three known methods by which national income is determined. These are:
✓ Value added method
✓ Expenditure method
✓ Income method

Value Added Method:

• The value added method is also known as the product method. Its main objective is to calculate national
income by taking the value added to a product during the various stages of production into account.
• The formula for calculating the national income by the value added method can be expressed as:
National income (NI) = (NDPfc) + Net factor income from abroad

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Expenditure Method:
• The expenditure method of national income calculation is based on the expenditures taking place in the
economy. This expenditure is done by individuals, households, business enterprises, and the government.
• The formula for calculating the national income by the expenditure method can be expressed as:
National income (NI) = C + G + I + (X – M) Or, National income (NI) = C + G + I + NX

Income Method:
• This method is based on the income generated by the individuals by providing services to the other people
in the country either individually or by using the assets at disposal.
• The income generated from land, capital in the form of rent, interest, wages and profit is taken into
consideration.
• In this method the national income is calculated by adding up the wages, interest earned on capital, profits
earned, rent obtained from land, and income generated by the self-employed people in an economy. It is
known as net domestic product at factor cost or NDPfc.
The formula for income method is:
NNPfc = (NDPfc) + Net factor income from abroad

Aggregate Of National Income:

• In an economy, various types of goods and services are produced by different productive units during a
period of one year. Such goods and services cannot be added together in terms of quantity. Therefore, these
are expressed in terms of money.
• There are many aggregates in national income to measure the value of goods and services in terms of money.
• Gross Domestic Product at Market Price (GDPMP): It is the gross market value of the final goods and
services produced within the domestic territory of a country during an accounting year by all production
units.

GDPMP
• G stands for ‘Gross’ signifies that depreciation is included, i.e., no provision has been made for depreciation.
• D stands for ‘Domestic’ which signifies that it includes all the final goods and services produced by all the
production units located within the economic territory (irrespective of the fact whether produced by
residents or non-residents).
• M stands for ‘Market Price’ ; it signifies that indirect taxes are included and subsidies are excluded, i.e., it
shows that Net Indirect Taxes (NIT) have been included.
• P stands for ‘Product’ it signifies that only final goods and services have to be included and intermediate
goods should not be included to avoid the double counting.
• Gross Domestic Product at Factor Cost (GDPFC): It is the gross factor value of the final goods and services
produced within the domestic territory of a country during an accounting year by all production units
excluding Net Indirect Tax.
GDPFC = GDPMP - Net Indirect Taxes
• Net Domestic Product at Market Price (NDPMP): It is defined as the net market value of all the final goods
and services produced within the domestic territory of a country by its normal residents and non-residents
during an accounting year.
NDPMP = GDPMP - Depreciation
• Net Domestic Product at Factor Cost (NDPFC): It refers to a total factor income earned by the factor of
production within the domestic territory of a country during an accounting year.
NDPFC = GDPMP - Depreciation - Net Indirect Taxes
NDPFC is also known as Domestic Income or Domestic factor income.
• Gross National Product at Market Price (GNPMP): It refers to market value of all the final goods and
services produced by the normal residents of a country during an accounting year.
GNPMP = GDPMP + Net factor income from abroad (NIFA)

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GNPMP is less than GDPMP when NFIA is negative. However, GNPMP will be more than GDPMP when NFIA
is positive.
• Gross National Product at Factor Cost (GDPFC): It refers to gross factor value of all the final goods and
services produced by the normal residents of a country during an accounting year.
GDPFC = GNPMP - Net Indirect Taxes
• Net National Product at Market Price (NNPMP): It refers to net market value of all the final goods and
services produced by the normal residents of a country during an accounting year.
NNPMP = GNPMP - Depreciation
• Net National Product at Factor Cost (NNPFC): It refers to net money value of all the final goods and
services produced by the normal residents of a country during an accounting year.
NNPFC = GNPMP - Depreciation - Net Indirect Taxes
It must be noted that NNPFC is also known as National Income.

Gross National Product (GNP):

• Gross National Product (GNP) is Gross Domestic Product (GDP) plus net factor income from abroad.
• It measures the monetary value of all the finished goods and services, which are produced by the nation’s
economy during a specific period of time irrespective of their location.
• Only the finished goods are considered as factoring intermediate goods used for manufacturing would
amount to double counting. It only includes taxes not including subsidies.
• The GNP is identical to gross domestic product (GDP) only difference is that the latter does not include the
income accruing to a nation’s residents from investments abroad.
• Gross national product is an indicator of the level of a nation’s economic activity.

Net National Product (NNP):

• Net national product (NNP) is the monetary value of finished goods and services, which are produced by a
country’s citizens, both overseas and domestically, in a given period of time minus depreciation.
• NNP is generally examined on an annual basis as a way to measure a nation’s success in continuing
minimum production standards.
• It is a very useful method to keep track of an economy as it takes into account all its citizens, regardless of
where they make their money. It acknowledges the fact that capital must be spent to keep production
standards high.
• Gross Domestic Product (GDP) is the most popular method to measure national income and economic
prosperity, although NNP is prominently used in environmental economics.
• Gross Domestic Product (GDP) and Net Domestic Product (NDP) - at market price, at factor cost.

Real and Nominal GDP:

• Real gross domestic product (Real GDP) is an inflation-adjusted measure that reflects the value of all goods
and services produced by an economy in a given year
• It is a macroeconomic measure of the value of the economy’s output adjusted for price changes (inflation or
deflation).
• Real GDP compares GDP from year to year which shows comparisons for both the quantity and value of
goods and services.
• Real GDP is calculated by dividing nominal GDP over a GDP deflator
• Nominal GDP is a macroeconomic measure of the value of the economy’s output that is not adjusted for
inflation.
• Nominal gross domestic evaluated at current market prices. Nominal GDP includes changes in prices due to
inflation, which reflects the rate of price increases in an economy.
• GDP is measured as the monetary value of goods and services produced.
• Since nominal GDP doesn’t remove the pace of rising prices when comparing one period to other.

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GDP Deflator:
• GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services
in an economy in a year.
• The GDP deflator measures the changes in prices for all of the goods and services produced in an economy.
It helps to identify how much prices have inflated over a specific time period.
• GDP deflator helps economists to compare the levels of real economic activity from one year to another.
• It is a more comprehensive inflation measure than the CPI index because it isn’t based on a fixed basket of
goods.
• Formula to calculate the GDP price deflator:
GDP Price Deflator = (Nominal GDP ÷ Real GDP) × 100

Components of Final Expenditure:

1. Final Consumption Expenditure
a. Private Final Consumption Expenditure(C)
b. Government Final Consumption Expenditure(G)
2. Gross Domestic Capital Formation
a. Gross Domestic Fixed Capital Formation
i. Gross business Fixed Investment
ii. Gross Residential Construction Investment
iii. Gross public Investment
b. Change in Stock or Inventory Investment
3. Net Export(X-M)
a. Export(X)
b. Import(M)

Components of Domestic Income :

1. Compensation of Employees
a. Wages and salaries(Cash/or kinds)
b. Employers Contribution of Social security Schemes
2. Operating surplus
a. Rent
b. Interest
c. Profit
i. Corporate Tax
ii. Dividend
iii. Undistributed corporate profit
3. Mixed Income for self-Employed person
Net Factor Income from Abroad NFIA = It is difference between factor income received/earned by normal
residents of a country and factor income paid to non-residents of the country.

Components of NFIA :
1. Net Compensation of Employees
2. Net Income from Property and entrepreneurship
3. Net Retained earning of resident companies abroad
Hints : NFIA : Net Factor Income Earned from Abroad.
NFIA = Factor Income Received from Abroad.
– Factor Income Paid to Abroad.

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OR
NFIA = Net compensation of Employees
Net income from property and entrepreneurship.
+ Net retained earning of resident companies abroad.
Net National Disposable Income (NNDI): It is defined as net national product at Market price plus net
current transfer from rest of the world.
NNDI = NNPMP
+ Net current transfers from rest of the world.
= National income + net indirect tax + net current transfers from the rest of the world.
Gross National Disposable Income (Gross NDI = GNP MP + Net current Transfers from rest of the world.
Net National Disposable Income (Net NDI) = NNPMP + Net current Transfers from rest of the world.
OR
= Gross NDI – Depreciation.

Concept of Value Added of One Sector or One Firm

1. Value output = Sales + Change in Stock. or value of output = price × qty. sold + ΔS.
2. Gross value added at market price (GVAMP) = Value of output – Intermediate consumption.
3. Net value added at market price (NVAMP) = GVAMP – Depreciation.
4. Net value added at factor cost (NVAFC) = NVAMP – Net indirect tax.
Note: By adding up NVAFC of all the sectors, we get NVPFC or Domestic Income.
Personal Disposable Income from National Income (NVPFC)

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Private Income : Private income is estimated income of factor and transfer incomes from all sources to private
sector within and outside the country.
Personal Income : It refers to income received by house hold from all sources. It includes factor income and
transfer income.
Personal Disposable Income : It is that part of Personal income which is available to the households for disposal
as they like.

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:
Real GDP : When the goods and services are produced by all producing units in the domestic territory of a country
during an a/c. year and valued these at base year’s prices or constant price, it is called real GDP or GDP at constant
prices. It changes only by change in physical output not by change price level. It is called a true indicator of
economic development.
Nominal GDP : When the goods and services are produced by all producing units in the domestic territory of a
country during an a/c. year and valued these at current year’s prices or current 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 =  100
Price index
Price index plays the role of deflator deflating current price estimates into constant price estimates. In this way it
may be called GDP deflator.

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Welfare mean material well being of the people. It depends on many economic factors like national income,
consumption level quality of goods etc and non-economic factor like environmental pollution, law and order etc.
the welfare which depends on economic factors is called economic welfare and the welfare which depends on non-
economic factor is called non-economic welfare. The sum total of economic and non-economic welfare is called
social welfare. Conclusion thus GDP and welfare directly related with each other but this relation is incomplete
because of the following reasons.

Limitation of per capita real GDP/GDP as a indicator of Economic welfare :

• Non-monetary exchange
• Externalities not taken into GDP but it affects welfare.
• Distribution of GDP.
• All product may not contribute equally to economic welfare.
• Contribution of some products may be negative.
• Inflation may give falls impression of growth of GDP.

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Important Questions
Multiple Choice Questions: 8. The subject of the Study of Macro Economics is:
1. Macro Economics Studies: (a) The Principle of National Income
(a) Employment opportunities in the (b) The Principle of Consumer
economy (c) The Principle of Producer
(b) Theory of supply of Commodities (d) None of these
(c) Elasticity of demand in Scooter 9. Macro Economics Studies:
(d) Price of wheat in the market (a) Employment opportunities in the
2. Who had made the first attempt at National economy
Income Accounting? (b) Theory of supply of Commodities
(a) Prof. D.R.Gadgill (c) Elasticity of demand in Scooter
(b) Simon Kuznets (d) Price of wheat in the market
(c) J.M.Keynes 10. General Price Level is studied in:
(d) Gregory King (a) Micro Economics
3. When did the great depression occur?
(b) Macro Economics
(a) 1929-30
(c) Both (a) and (b)
(b) 1934-35
(d) None of these
(c) 1938-39
11. Employment Theory is related to :
(d) 1941-42
(a) Static Economics
4. Who is known as the father of modern
(b) Micro Economics
macroeconomics?
(a) Adam Smith (c) Macro Economics

(b) J. M. Keynes (d) None of these

(c) Samuelson 12. Increase in Stock of Capital is known as:
(d) Hicks (a) Capital Loss
5. Mr. Skund Kumar wants to study the national (b) Capital Profit
income. Which branch of economics will he have (c) Capital Formation
to study? (d) None of these
(a) Microeconomics 13. Which one of the following is included in circular
(b) Price theory flow?
(c) Factor price determination (a) Real Flow
(d) Macroeconomics (b) Money Flow
6. Accounting of National Income at constant (c) Both (a) and (b)
prices is known as …………………
(d) None of these
(a) Money income
14. Which one of the following is included in ‘Stock’?
(b) Real income
(a) uantity of Money
(c) Current income
(b) Wealth
(d) Domestic income
(c) uantity of wheat stored in a warehouse
7. Which of the following items are excluded from
GNP measurement? (d) All the above
(a) Purely financial transactions 15. Which one is included inflow ?
(b) Transfer of used goods and non-market (a) Consumption
goods and services (b) Investment
(c) Illegal activities and the value of leisure (c) Income
(d) All of these (d) All of these

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Very Short Questions- 5 Net current transfers from 15

1. What is national disposable income? abroad

2. What is real flow? 6 Private final consumption 600

expenditure
3. Define money flow.
7 Change in stock 10
4. What must be added to domestic factor income
to obtain national income?
8 Net factor income from 05
5. Explain the meaning of non-market activities. abroad
6. Define Real GNP. 9 Gross domestic fixed 125
capital formation
Short Questions-
1. Explain the main steps involved in measuring 3. Calculate NNP at market price by production
national income through the product method. method and income method.
2. What is double counting in the economy? How
S.No Contents Rs. (in
can it be avoided? crores)
3. Do you agree with the statement, ‘Machine
1 Intermediate consumption 500
purchased is always a final good’. Give reason for
Primary sector 400
your answer.
Secondary sector 300
4. What are the precautions to be taken while
Tertiary sector
calculating national income through product
method, specially value-added method? 2 Value of output of Primary 1000
sector 900
Long Questions- Secondary sector 700
1. Calculate net value added at market price of a Tertiary sector
firm: 3 Rent 10
Items Amount 4 Emoluments of employers 400
Sale 300 5 Mixed income 650
Change in stock -10 6 Operating surplus 300

Depreciation 20 7 Net factor income from -20

abroad
Net in direct taxes 30
8 Interest 05
Purchase of machinery 100
9 Consumptive of fixed 40
Purchase of intermediate product 150 capital

10 Net indirect tax 10

2. Calculate national income and gross national
disposable income from the following data: 4. Giving reason, explain whether the following are
S.No Contents Rs. (in included in domestic product of India.
crores) 1. Profits earned by a branch of foreign bank
1 Net indirect tax 05 in India

2 Net domestic fixed capital 100 2. Payment of salaries to its staff by embassy
formation located in New Delhi
3 Net exports (-) 20 3. Interest received by an Indian resident
from its abroad firms
4 Government’s final 200
consumption expenditure

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30 | Step Up Academy

5. Calculate National Income and Private Income b. Both Assertion and Reason are true and
from the following data. Reason (R) is not the correct explanation
S.No Contents Rs. (in of Assertion (A)
crores) c. Assertion (A) is True but Reason (R) is
1 Net current transfers from 10 False
rest of the world
d. Assertion (A) is False but Reason (R) is
2 Private final consumption 600 True
expenditure
Assertion: Value Added Method, Income
3 National debt interest 15 Method, and Expenditure Method are three
4 Net exports (-)20 different methods to measure the National

5 Current transfers from 5 Income.

government Reason: Production, Income, and Expenditure
6 Net domestic product at 25 are three different phases of the circular flow of
factor cost accruing to the Income.
government.
2. In these questions, a statement of assertion
7 Government final 30 followed by a statement of reason is given.
consumption expenditure
Choose the correct answer out of the following
8 Net indirect tax 05 choices.
9 Net domestic capital 40 a. Both Assertion and Reason are true and
formation
Reason (R) is the correct explanation of
10 Net indirect tax 10 Assertion (A)

Case Study Based Question- b. Both Assertion and Reason are true and
Reason (R) is not the correct explanation
1. Read the following hypothetical text and answer
of Assertion (A)
the given questions: -
c. Assertion (A) is True but Reason (R) is
2. Read the following hypothetical text and answer
False
the given questions: -
d. Assertion (A) is False but Reason (R) is
Assertion Reason Type Question- True
1. In these questions, a statement of assertion Assertion: National Income is a national
followed by a statement of reason is given. Concept.
Choose the correct answer out of the following Reason: National Income includes the value of
choices. final goods and services produced in the entire
a. Both Assertion and Reason are true and world by all producers who are normal residents
Reason (R) is the correct explanation of of the country.
Assertion (A)

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Answer Key
MCQ Answers- 6. Ans: In economics, real GNP is defined as GNP
1. (a) Employment opportunities in the economy computed at constant prices, or through a base
year price.
2. (D) Gregory King
3. (a) 1929-30 Short Answers-
4. (b) J. M. Keynes 1. The most important steps in calculating national
5. (d) Macroeconomics income using the product approach:
6. (b) Real income 1. First, divide the manufacturing units into
7. (d) All of these industrial sectors such as primary,
8. (a) The Principle of National Income secondary, and tertiary.
2. Next, calculate the factor cost's net value
9. (a) Employment opportunities in the economy
added.
10. (b) Macro Economics
3. In the third phase, calculate the output
11. (c) Macro Economics
value by adding sales and stock changes.
12. (c) Macro Economics
4. Calculate gross value added by deducting
13. (c) Both (a) and (b) intermediate consumption from output
14. (d) All the above value.
15. (b) Investment 5. Subtract depreciation and net indirect tax
from gross value added at market price to
Very Short Answers- get NDPFC (net value added at factor
1. Ans: The term "national disposable income" cost).
refers to the amount of money available to the 6. Finally, add net factor income from
entire economy for spending or disposition. outside the country to NDPFC to get
The formula for calculating national disposable NNPFC, which is national income once
income is NNPMP + Net Current Transfers from more.
Abroad (NDI). 2. Doubt counting is the process of calculating the
2. Ans: The flow of services and goods between value of goods multiple times at each stage of
various segments is referred to as real flow. Flow production.
sector services, for example, flow from
The following methods can be used to avoid it:
household to firm and then back again.
a) When estimating national income, use the
3. Ans: The flow of money between different
value-added technique.
sectors of the economy, such as firms,
b) Calculating national income only on the
households, and so on, is referred to as money
basis of the final commodity's worth.
flow. For example, consider the flow of income
from firms to households and the flow of 3. Yes, we agree with the assertion made here. It is
consumption expenditure from households to up to the user to decide if a machine is a finished
firms. product or not. When a machine is purchased by
4. Ans: To calculate the national income, net factor a household, it is referred to as a final good. On
income from outside the country must be added the other hand, if a machine is purchased by a
to domestic factor income. business, it is referred to as a final good.
However, if it is purchased by a company for
5. Ans: Non-marketing activities are those that are
resale, it is referred to as an intermediate good.
gained as a result of the purchase of a large
number of finished goods and services. They are 4. The steps will be as follows:
really not bought and sold on the open market. a) Instead of relying on the value added by
Vegetables, for example, cultivated in the house each production unit, avoid using the
kitchen garden. production's doubt counting approach.

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b) Inclusion of output produced for self- = 2600 - 1200

consumption. Hence GDPMP = 1400 crores
c) The cost of intermediary consumption NNPMP = GDPMP - (Consumptive of fixed capital
should never be taken into account. + Net factor income from abroad)
d) The sale and acquisition of used products = 1400 – 40 = (-20)
should never be included.
NNPMP is equal to 1380 crores
g) The value of services rendered must
2. By Income Method:
always be factored into sales.
NNPMP = Emoluments of employers + Mixed
Long Answers- income + Operating surplus + Net indirect tax +
1. Value of output: - Sale + Change in stock (300+ () Net factor income from abroad
10 = 290/-) = 400 + 650 + 300 + 10 + (-20)
Gross Value added at MP= Value of output - NNPMP = 1350 + 10 - 20
Purchase of intermediate product. = 1340 crores
290 - 150 = 140/- 4. 1. Profits earned by a foreign bank branch in
Net Value added at MP = Gross Value added at India are included in India's domestic
MP - Depreciation income because they are earned within
140 - 20 = 120/- the country's borders.

Thus, the final answer is Rs. 120. 2. Since the embassy in New Delhi is not part
of India's domestic territory, salaries paid
2. Putting the equation together
to its employees will not be included in
Net national income (NNPFC) = Net disposable the country's domestic income.
income (NNDPM)
3. Interest received by an Indian resident
= (Government final consumption expenditure + from his or her foreign enterprises is not
private final consumption included in India's domestic income
expenditure + net domestic fixed capital because it is a factor income.
formation + net exports) 5. a) National Income (NNPFC) = (Private final
= 200 + 600 + 100 + 10 + (-) 20 consumption expenditure + Government
= 910 – 20 = 890 final consumption expenditure + Net
domestic capital formation + Net exports
So NDP MP = 890 crores
+ Net factor income from abroad- Net
NNPFC = NNDPM + (Net factor income from
indirect tax)
abroad – Net indirect tax)
= 600 + 100 + 70 + (-20) + 10 - 30
= 890 + 5 – 5
= 780 - 50
So NNPFC = 890 crores
= 730 crores
Depreciation = (Gross domestic fixed capital
b) Private Income = NNPFC - Net domestic
formation - Net domestic fixed
product at factor cost accruing to govt +
capital formation)
Transfer payments + National debt
= 125-100= 25 crores
interest
GNDI = (NNPFC + Net indirect tax + Net current
= 730 – 25 + (10 + 5) + 15
transfers from abroad + Depreciation)
= 760 - 25
= 890 + 05 + 15 + 25
= 735 crores
GDNI = 935 crores
3. 1. By Production Method: Case Study Answer-
Value added at MP = Value of output - 1. Answer:
Intermediate consumption 1. a) absolute poverty
= (1000 + 900 + 700) – (500 + 400 + 300)

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2. Poverty line Assertion Reason Answer-

3. Consumption 1. a) Both Assertion and Reason are true and
4. per capita expenditure Reason (R) is the correct explanation of
2. Answer: Assertion (A).

1. d) All of the above 2. a) Both Assertion and Reason are true and
Reason (R) is the correct explanation of
2. Casualization
Assertion (A).
3. Gini Coefficient
4. d) all the above

❖❖

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34 | Step Up Academy

Money and Banking 3

Money:
Money is a liquid asset used in the settlement of transactions. It is an economic unit that functions as a generally
recognized medium of exchange for transactional purposes in an economy.
Function of money is based on the general acceptance of its value within a governmental economy and
internationally through foreign exchange.
Money is commonly referred to as currency. Each government has its own money system.
It is a normally recognized medium of exchange that people and global economies intend to hold and are willing
to accept as payment for current or future transactions.

Supply of Money:
The overall stock of money circulating in an economy or among the public is the money supply. This circulating
money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.
Valuation and analysis of the money supply help the policy makers to frame the policy or to change the current
policy of increasing or reducing the supply of money. The valuation of money is important as it ultimately affects
the business cycle and thereby affects the economy.
The Reserve Bank of India publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and
M4.
• M1 = CC + DD + OD M2 = M1 + Savings deposits with Post Office savings banks
• M3 = M1 + Net time deposits of commercial banks
• M4 = M3 + Total deposits with Post Office savings organizations (excluding National Savings Certificates)
• CC is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial
banks
Money deposits of the public held by the banks are to be included in the money supply.
The interbank deposits, in which a commercial bank holds in other commercial banks, are not to be regarded as
part of the money supply.
• M1 and M2 are known as narrow money. M3 and M4 are known as broad money.
• These gradations are in decreasing order of liquidity.
• M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.
• M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.

Money Creation by The Commercial Banking System:

Commercial banks create money through credit against deposits through the bank multiplier. Here credit means
granting loans and advances made by banks to the public.
Credit creation by commercial banks refers to the multiplication of original bank deposits,

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As every loan creates a deposit:

Commercial Banks create deposits via lending. Banks don’t give loans in cash, instead they issue cheques against
the name of the borrowers.
Now the borrower is free to draw money by drawing cheques upon the banks. Borrowers deposit the cheque in
another bank. However, the bank knows that the amount of money that the depositors withdraw soon returns to
the bank.
Banks keep a certain minimum fraction of the deposits made by customers as reserves. Rest of the deposits they
lend. This fraction is called the Legal Reserve Ratio (LRR) and is fixed by the central bank.
Banks keep this fraction of deposits as Cash Reserves because all the depositors do not withdraw the entire amount
in one go.
So, to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a fraction of deposits as
cash reserves. It means, if experience of the banks show that withdrawals are generally around 20% of the
deposits, then it needs to keep only 20% of deposits as cash reserves (LRR).
Let’s take an example:
Suppose, initial deposits in banks is Rs 20,000, now banks are required to keep only Rs 4,000 (20%) as cash reserve
and are free to lend Rs 16,000.
Banks do not lend this money in cash. Rather, they open the accounts in the names of borrowers, who are free to
withdraw the amount whenever they like.
Suppose borrowers withdraw the entire amount of 16,000, it will come back into the banks in the form of deposit
accounts of those who have received this payment.
With these new deposits of 16,000, banks keep 20% as cash reserves and lend the balance Rs 12,800. Borrowers
use this amount and deposits back.
In this manner the deposits keep on increasing in each round by 80% of the last round deposits. Simultaneously,
cash reserves also go on increasing, each time by 80% of the last cash reserve.
This deposit creation comes to end when total cash reserves become equal to the initial deposit.

Characteristics or features of money:

a. Durability: Money must be durable and not likely to deteriorate rapidly with frequent handling. Currency
notes and coins are being used repeatedly and shall continue to do so for many years.
b. Medium of exchange: Money is the thing that acts as a medium of exchange for the sale and purchase of
goods and services.
c. Weight: Money must be light in weight. Paper money is better than metal coins because it is light in weight.
d. Measure of value: It not only serves as medium of exchange but also acts as a measure of value. The value
of all the goods and services is expressed in terms of money.
Money has overcome the drawbacks of barter system: Barter system makes the exchange process very difficult
and highly inefficient. Money has overcome the drawbacks of barter system in the following manners:

Medium of exchange
• Under barter system, there is lack of double coincidence of wants.
• With money as a medium exchange individuals can exchange their goods and services for money and then
use this money to buy other goods and services according to their needs and conveniences.
• A buyer can buy goods through money and a seller can sell goods for money.

Measure of value
• Under barter system, there was no common measure of value. Money has also solved this difficulty.
• As Geoffrey Crowther puts it, “Money acts as a standard measure of value to which all other things can be
compared.” Money measures the value of economic goods.

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• Money works as a common denominator into which the values of all goods and services are expressed.
• When we express the values of a commodity in terms of money, it is called price and by knowing prices of
the various commodities, it is easy to calculate exchange ratios between them.

Store of value
• Under barter system it is very difficult to store wealth for future use.
• Most of the goods are perishable and their storage requires huge space and transportation cost.
• Wealth can be conveniently stored in the form of money.
• Money can be stored without loss in value.
• Money can easily be stored for future use.

Standard of deferred payments

• Under barter system, transactions on deferred payments are not possible.
• With money, the debtors make a promise that they will make payments on some future dates. In these
situations money acts as a standard of deferred payments.
• It has become possible because money has general acceptability, its value is stable, it is durable and
homogeneous.

Legal definition of money:

a) Legally, money is anything proclaimed by law as a medium of exchange.
b) Paper notes and coins (together called currency) is money as a matter of law.
c) Nobody can refuse its acceptance as medium of exchange.
d) In other words, it is legal tender. It means people have to accept it legally for different payments. Currency
is also called FIAT money because it commands ‘FIAT’ (order/authority) of the government.

Functional definition of money:

Functional definition of money refers to money as anything that performs four basic functions,
a) It serves as a medium of exchange.
b) It serves as a standard unit of value.
c) It serves as a means for future / contractual payments or standard of deferred payments.
d) It serves as a store of value.
e) According to this, definition of money includes both notes and coins as well as chequeable deposits with the
banks.

Narrow definition of money:

Functional definition of money is a narrow definition of money. It includes only notes, coins and demand deposits
as money. In other words, in its narrow definition, money includes only those things that function as money in
terms of:
a) Medium of exchange.
b) Measure of value.
c) Standard of future/Deferred payments.
d) Store of value.

Broad definition of money:

a) A broad definition of money also includes time deposits/term deposits with the banks or post offices as a
component of money.
b) These deposits can be converted into demand deposits on a short notice, and are “Near money assets”.
Money assets and near money assets together make up a definition of money.

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Money Supply and Measures Of Money Supply

Money supply: The volume of money held by the public at a point of time, in an economy, is referred to as the
money supply. Money supply is a stock concept.
Measures of money supply: On the recommendation of the second working group on money supply, the RBI
presented four measures of money supply in its 1977 issues of RBI Bulletin, namely M1, M2, M3 and M4.

Measures of M1 include:
a) Currency notes and coins with the public (excluding cash in hand of all commercial banks) [C]
b) Demand deposits of all commercial and co-operative banks excluding inter-bank deposits. (DD),
Where demand deposits are those deposits which can be withdrawn by the depositor at any time by means
of cheque. No interest is paid on such deposits.
c) Other deposits with RBI [O.D]
M1 = C + DD + OD
Where, Other deposits are the deposits held by the RBI of all economic units except the government and
banks. OD includes demand deposits of semi¬government public financial institutions (like IDBI, IFCI, etc.),
foreign central banks and governments, the International Monetary Fund, the World Bank, etc.

Measures of M2:
i. M1 [C + DD + OD]
ii. Post office saving deposits

Measures of M3:
i. M1
ii. Time deposits of all commercial and co-operative banks.
Where, Time deposits are the deposits that cannot be withdrawn before the expiry of the stipulated time for which
deposits are made. Fixed deposit is an example of time deposit.

Measures of M4:
i. M3
ii. Total deposits with the post office saving organization (excluding national savings certificates).
High-powered money: High-powered money is money produced by the RBI and the government. It consists of
two things: (a) currency held by the public and (b) Cash reserves with the banks.

Words that Matter

1. Barter system: Barter system of exchange is a system in which goods are exchanged for goods.
2. Double coincidence of wants: It means that goods in possession of two different persons must be useful
and needed by each other.
3. Money: Money is something which is generally acceptable as a medium of exchange and can be converted
into other assets without loosing its time and value.
4. Legal definition of money: Legally, money is anything proclaimed by law as a medium of exchange. Paper
notes and coins (together called currency) is money as a matter of law.
5. FIAT Money: It is defined as a money which is under the ‘FIAT’ (order/authority) of the government to act
as a money.
6. Functional definition of money: Functional definition of money refers to money as anything that performs
four basic functions. (Medium of exchange, standard unit of value, standard of deferred payments, store of
value)
7. Narrow definition of money: Functional definition of money is a narrow definition of money. It includes
only notes, coins and demand deposits as money.

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8. Broad definition of money: A broad definition of money also includes time deposits/ term deposits with
the banks or post offices as a component of money.
9. Money Supply: The stock of money held by the public at a point of time, in an economy, is referred to as the
money supply. Money supply is a stock concept.
10. High-powered money: It is money produced by the RBI and the government. It consists of two things: (i)
currency held by the public and (ii) Cash reserves with the banks.
11. Demand deposits: These are the deposits that can be withdrawn by the depositor at any time by means of
cheque. No interest is paid on such deposits.
12. Time deposits: These are the deposits that cannot be withdrawn before the expiry of the stipulated time
for which deposits are made. Fixed deposit is an example of time deposit.
13. Other deposit measures of M1: Other deposits are the deposits held by the RBI of all economic units except
the government and banks. OD includes demand deposits of semi-government public financial institutions
(like IDBI, IFCI, etc.), foreign central banks and governments, the International Monetary Fund, the World
Bank, etc.

Central Bank and Its Functions

A central bank of any country (e.g., Reserve Bank of India) is an independent national authority that conducts
monetary policy, regulates banks, and provides financial services including economic research.
Central bank’s goals are to stabilize the nation’s currency, keep unemployment low, and prevent inflation.
Most central banks are governed by a board consisting of its member banks. The central bank aligned with the
nation’s long-term policy goals. At the same time, it is free from political influence in its day-to-day operations.

Functions of Central Bank:

There are two kinds of functions of the Central bank.
• Traditional Functions
• Developmental Functions

Traditional Functions:
The traditional functions of the central bank include the following:
• Bank of issue: Possesses an exclusive right to issue notes in every country of the world. The issue of notes
by one bank has led to uniformity in note circulation and balance in money supply.
• Government’s banker, agent: Central bank performs banking functions for the government as commercial
banks performs for the public by accepting the government deposits and granting loans to the government.
As an agent, the central bank manages the public debt.
• Custodian of cash reserves: Central bank takes care of the cash reserves of commercial banks.
• Custodian of international currency: Central bank maintains a minimum reserve of international
currency to meet emergency requirements of foreign exchange and overcome adverse requirements of
deficit in balance of payments.
• Bank of re discount: Serve the cash requirements of individuals and businesses by Re discounting the bills
of exchange through commercial banks.
• Lender of last resort: The central bank provides loans against treasury bills, government securities, and
bills of exchange.
• Bank of settlement and transfer: The central bank helps in settling mutual indebtedness between
commercial banks.
• Controller of Credit: The central bank regulate the credit creation by commercial banks directly or
indirectly.

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Developmental Functions:
Functions that are related to the promotion of banking system and economic development of the country.
• Developing specialized financial institutions: The central bank establishes institutions that serve credit
requirements of the agriculture sector and other rural businesses.
• Influencing money market and capital market: Central bank deals in short term credit and capital
market deals in long term credit. The central bank maintains the country’s economic growth by controlling
the activities of these markets.
• Collecting statistical data: Gathers and analyzes data related to banking, currency, and foreign exchange
position of a country.

Bank of issue:
The central bank is the bank of issue. It issues notes and coins to commercial banks.
In addition to issuing currency to the banks, the central bank also issues currency to the central Government of
the country.
Currency which are manufactured by the Government, they are put into circulation through the central bank.
However, the central bank has its monetary liability, it is obliged to back the currency issued by its asset of equal
value such as gold and bullions.

Government Bank:
Government banks are also called Public Sector Banks (PSBs), where a majority stake is held by the Ministry of
Finance of the Government of India or Ministry of Finance of various State governments of India.
Currently there are 12 Public Sector Banks in India are existing:
• State Bank of India
• Punjab National Bank
• Bank of Baroda
• Bank of India
• Central Bank of India
• Canara Bank
• Union Bank of India
• Indian Overseas Bank
• Punjab and Sind Bank
• Indian Bank
• UCO Bank
• Bank of Maharashtra.

Banker’s Bank:
A bankers’ bank is a specific type of bank that exist for the purpose of servicing the charter banks that founded
them.
Their banking services are not open to the public. These institutions are designed to support community banks.
Bankers’ banks can help community banks to effectively compete with larger banking entities.

Control of Credit Through Bank Rate:

There are two methods of Credit Control through Bank Rate.
Quantitative or general methods, and
Qualitative or selective methods.

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Quantitative or General Methods:

This methods is used by the central bank to influence the total volume of credit in the banking system.
It regulates the lending ability of the financial sector of the whole economy and do not discriminate among the
various sectors of the economy.
The quantitative methods of credit control are:
• Bank rate
• Open market operations
• Cash-reserve ratio.

Qualitative or Selective Methods:

These methods are used by the central bank to regulate the flows of credit into particular directions of the
economy.
The qualitative methods affect the types of credit extended by the commercial banks. They affect the composition
rather than the size of credit in the economy.
The qualitative methods of credit control are:
• Marginal requirements
• Regulation of consumer credit
• Control through directives
• Credit rationing
• Moral suasion and publicity
• Direct action

Bank Rate Policy:

The bank rate or the discount rate is the rate at which a central bank is prepared to discount the first class bills of
exchange.
The bank rate is different from the market interest rate. The bank rate is the rate discount of the central bank,
while the market interest rate is the lending rate charged in the money market by the ordinary financial
institutions.
An increase in the bank rate makes the credit costlier, reduces the volume of credit, discourages economic activity
and brings down the price level in the economy.
A declining in the bank rate makes the credit cheaper, increases the volume of credit, encourages the businessmen
to borrow and invest, and increases the levels of economic activity.

Bank rate policy aims at influencing:

• The cost and availability of credit to the commercial banks
• Interest rates and money supply in the economy
• The level of economic activity of the economy.

Cash Reserve Ratio (CRR):

Cash reserve ratio is a certain percentage or share that all banks have to keep with the RBI as a deposit as reserves
in the form of liquid cash.
This percentage is fixed by the RBI, which changes from time to time. Currently, the CRR is fixed at 3%. That means
for every Rs 100 worth of deposits, the bank has to keep Rs 3 with the RBI.
CRR keep inflation under control. During high inflation in the economy, RBI raises the CRR to sanction loans. It
squeezes the money flow in the economy, reducing investments and bringing down inflation.

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Statutory Liquidity Ratio (SLR):

SLR is the minimum percentage of the aggregate deposits that commercial banks has to maintains in the form of
liquid cash, gold or other securities.
Basically, it is the reserve requirement that banks are expected to keep before offering credit to customers.
SLR is not reserved with the Reserve Bank of India (RBI), but with banks themselves. But the ratio is fixed by RBI.
The SLR was prescribed by Section 24 (2A) of Banking Regulation Act, 1949.
CRR and SLR are the tools of the central bank’s monetary policy to control credit growth, flow of liquidity and
inflation in the economy.

Repo Rate and Reverse:

Repo Rate:
Repo rate refers to the rate at which commercial banks borrow money from Central bank (Reserve Bank of India)
by selling their securities to maintain liquidity, in case of shortage of funds or due to some statutory measures.
As you borrow money from the bank as a loan on interest, similarly, banks also borrow money from RBI during a
cash crunch on which they are required to pay interest to the Central Bank. This interest rate is called the repo
rate.
Repo stands for ‘Repurchasing Option’. It is an agreement in which banks provide eligible securities such as
Treasury Bills to the RBI while availing overnight loans.

Components of a Repo Transaction:

• Control inflation: The Central bank increases or decreases the Repo rate depending on the inflation, to
control the economy by keeping inflation in the limit.
• Hedging & Leveraging: RBI aims to hedge and leverage by buying securities from the banks and provide
cash to them
• Short-Term Borrowing: RBI lends money for a short period of time, maximum being an overnight post
which the banks buy back their securities deposited at a predetermined price.
• Collaterals: RBI accepts collateral in the form of gold, bonds etc.
• Cash Reserve (or) Liquidity: Banks borrow money from RBI to maintain liquidity as a precautionary
measure.

Affect of Repo Rate:

Repo rate is a strong system of the Indian monetary policy that can regulate the country’s money supply, inflation
levels, and liquidity.
The levels of repo have a direct impact on the cost of borrowing for banks. If repo rate is higher then borrowing
will be a costly affair for businesses and industries, which in turn slows down investment and money supply in the
market.
On the other hand lowers the repo rate, industries find it cheaper to borrow money. It also boost the overall supply
of money in the economy.

Reverse Repo Rate:

RBI borrows money from banks when there is excess liquidity in the market is called Reverse Repo Rate. In return
the banks benefit out of it by receiving interest for their holdings with the central bank.
When levels of inflation is high in the economy, the RBI increases the reverse repo. It encourages the banks to keep
more funds with the RBI to earn higher returns on excess funds. Banks are left with lesser funds to extend loans.

Open Market Operations

Open Market operations are purchases and sales of government securities and sometimes commercial paper by
the central bank for the purpose of regulating the money supply and credit conditions on a continuous basis.

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Under this system, when the central bank wants to reduce the money supply in the market, it sells securities in the
market.
Similarly, when the central bank wants to increase the money supply, it purchase securities from the market. This
step is taken to reduce the rate of interest and also to help in the economic growth of the country.

Margin Requirement:
Margin Requirement means the amount of money that you are required to deposit for entering into a Trade and
maintaining an Open Position.
It is the amount of equity, that an investor has in their brokerage account. A margin account is a account in which
the broker lends the investor money to buy more securities than what they could otherwise buy with the balance
in their account.

Words that Matter

1. Commercial Bank: Commercial bank is a financial institution which performs the functions of accepting
deposits from the public and making loans and investments, with the motive of earning profit.
2. Legal Reserve Ratio: It is the minimum ratio of deposits legally required to be kept by the commercial
banks with themselves (Statutory Liquidity Ratio) and with the central bank (Cash reserve Ratio).
3. Money Multiplier or Credit Multiplier: When the primary cash deposit in the banking system leads to
multiple expansion in the total deposits, it is known as money multiplier or credit multiplier.
4. Central Bank: The central bank is the apex institution of a country’s monetary system. The design and the
control of the country’s monetary policy is its main responsibility.
5. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary
policy that affect overall supply of money/credit in the economy.
6. Qualitative Instruments or Selective Tools of Monetary Policy: The instruments which are used to
regulate the direction of credit is known as Qualitative Instruments.
7. Bank rate: It is the rate of interest at which central bank lends to commercial banks without any collateral
(security for purpose of loan).
8. Repo rate: It is the rate at which commercial bank borrow money from the central bank for short period
by selling their financial securities to the central bank.
9. Reverse Repo rate: It is the rate at which the central bank (RBI) borrows money from commercial bank.
10. Open Market Operation: It consists of buying and selling of government securities and bonds in the open
market by central bank.
11. Cash Reserve Ratio: It refers to the minimum percentage of a bank’s total deposits, which it is required to
keep with the central bank.
12. Statutory Liquidity Ratio: It refers to minimum percentage of net total demand and time liabilities, which
commercial banks are required to maintain with themselves.
13. Marginal requirement: Business and traders get credit from commercial bank against the security of their
goods. Bank never gives credit equal to the full value of the security. It always pays less value than the
security. So, the difference between the value of security and value of loan is called marginal requirement.
14. Moral suasion: It implies persuasion, request, informal suggestion, advice and appeal by the central banks
to commercial banks to cooperate with general monetary policy of the central bank.
15. Selective Credit Controls (SCCs): In this method the central bank can give directions to the commercial
banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority
sectors.

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Important Questions
Multiple Choice Questions: 7. …………….. is the main function of Central Bank.

1. In order to encourage investment in the (a) Notes issue

economy, the Central Bank may …………….. (b) Credit creation

(a) Reduce Cash Reserve Ratio (c) Accepting deposits from the public
(d) Advancing loans to public
(b) Increase Cash Reserve Ratio
8. The central bank can increase the availability of
(c) Sell Government securities in the open
credit by:
market
(a) Rasing repo rate
(d) Increase Bank Rate
(b) Raising reverse repo rate
2. Banks are able to create credit many times more
(c) Buying government securities
than initial deposits through
(d) Selling government securities
(a) secondary deposits
9. Giving permission to withdraw money by an
(b) providing overdraft facilities amount more than deposited to is known as
(c) accepting deposits ………………..
(d) advancing loans (a) Advance

3. The creation is called credit creation. (b) Overdraft

(c) Loan
(a) time deposits
(d) None of these
(b) primary deposits
10. What are the alternative measures of money
(c) secondary deposits
supply in India?
(d) None of these (a) M1
4. The ratio of total deposit that a commercial bank (b) M2
has to keep with the Reserve Bank of India is (c) M3 and M4
called
(d) All of these
(a) Statutory Liuidity Ratio 11. Who circulates all mint and one rupee not in
(b) Deposit Ratio India?
(c) Cash Reserve Ratio (a) Ministry of Finance
(d) Legal Reserve Ratio (b) RBI
5. Credit creation by the commercial bank is (c) Ministry of External Affairs
determined by (d) State Government
(a) Cash Reserve Ratio 12. Which of the following is the narrow measure of
the money supply?
(b) Statutory Liuidity Ratio
(a) M2
(c) Initial Deposits
(b) M3
(d) all of the above
(c) M1
6. ……………. is the rate of interest charged by the
(d) M4
central bank on loans given to the commercial
13. When was the minimum reserve system started
bank.
in India?
(a) Bank Rate (a) 1947
(b) Cash Reserve Ratio (b) 1948
(c) Statutory Liuidity Ratio (c) 1951
(d) Reverse Repo Rate (d) 1957

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14. Which is the most liuid measure of the money is to maintain the reserve of foreign exchange.
supply? Also, it intervenes in the foreign exchange
(a) M4 market to stabilise the excessive fluctuations in
the foreign exchange rate. In other words, it is
(b) M3
the central bank’s job to control a country’s
(c) M2
economy through monetary policy.
(d) M1
If the economy is moving slowly or going
15. High Powered Money includes: backward, there are steps that central bank can
(a) C + DD + OD take to boost the economy. These steps, whether
(b) C + R + OD they are asset purchases or printing more
money, all involve injecting more cash into the
(c) C + R + TD
economy. The simple supply and demand
(d) C + DD + TD economic projection occur and currency will
devalue. When the opposite occurs, and the
Short Questions-
economy is growing, the central bank will use
1. Calculate the value money multiplier and the various methods to keep that growth steady and
total deposit created if initial deposit is Rs. 500 in-line with other economic factors such as
crores and LRR is 10%. wages and prices. Whatever the central bank
2. Calculate LRR, if initial deposit of Rs. 200 crores does or in fact don’t do, will affect the currency
lead to creation of total deposits of Rs. 1600 of that country. Sometimes, it is within the
crores. central bank’s interest to purposefully affect the
3. If total deposits created by commercial banks value of a currency. For example, if the economy
are Rs. 12,000, LRR is 25%, calculate initial is heavily reliant on exports and their currency
deposit. value becomes too high, importers of that
4. What do you mean by high powered money? country’s commodities will seek cheaper supply;
hence directly affecting the economy.
5. Bring out the role of Central Bank as the
controller or money supply or credit. Questions:
1. Which of the following tools are used by the
Long Questions- central bank to control the flow of money in
1. Explain the following functions of the Central domestic economy?
Bank of India. a) Fiscal tools
2. Bank of Issue b) Quantitative monetary tools
3. Banker’s bank c) Qualitative monetary tools
4. Explain the leading functions of commercial d) Both (b) and (c)
banks. 2. Money supply is a ------------- concept.
5. State the functions of money. a) Flow
6. How does money overcome the problems of b) Stock
barter system?
c) Ratio of stock and flow
7. Why only a fraction of deposits is kept as Cash
d) None of above
Reserves?
3. Which of the following steps should take by the
Case Study Based Question- central bank if there is excessive rise in the
1. Read the following case study paragraph foreign exchange rate?
carefully and answer the questions based on the a) Supply foreign exchange from its stock
same. b) Demand more of other foreign exchange
The central bank of India (Reserve Bank of India) c) Allow commercial banks to work under
is the apex institution that controls the entire less strict environment
financial market. It’s one of the major functions
d) Both (b) and (c)

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4. Dear money policy of central bank, which is used c) By increasing supply of products
to keep the growth steady and in-line with other d) All of above
economic factors, refers to 2. Why does RBI fix the inflation target?
a) Tighten the money supply in the economy a) To make growth process fast
b) Ease the money supply in the economy
b) To make coordination with government
c) Allow commercial banks to work under
c) To manage exchange rate
less strict environment
d) To stabilize economy
d) Both (b) and (c)
3. Why increasing crude oil prices are matter of
2. Read the following case study paragraph
concern:
carefully and answer the questions on the basis
of the same. a) Increasing crude oil prices are increasing
transportation cost.
The Reserve Bank of India raised inflation
forecasts on the back of higher oil and other raw b) Increasing crude oil prices are making
materials while it maintained the growth economy potentially unstable.
forecast at 9.5% for FY22 despite anemic c) Increasing crude oil prices are volatising
investment demand. growth process.
Governor Shaktikanta Das said inflation d) Increasing crude oil prices are adversely
measured by the consumer price index (CPI) affecting demand.
might remain close to the upper tolerance band
of 6% up to September expecting easing of Assertion Reason Type Question-
pressure thereafter on kharif harvest arrivals. 1. In these questions, a statement of assertion
[RBI has fixed inflation rate target in between followed by a statement of reason is given.
2%-6 %.] Choose the correct answer out of the
following choices.
The central bank projected CPI at 5.7% for FY22
compared to its earlier projection of 5.1%. “The a. both (A) & (R) both are true and (R) is
supply-side drivers could be transitory while correct explanation of (A)
demand-pull pressures remain inert, given the b. both (A) & (R) both are true and (R) is not
slack in the economy. A pre-emptive monetary correct explanation of (A)
policy response at this stage may kill the nascent c. (A) is true but (R) is false
and hesitant recovery that is trying to secure a d. (A) is false but (R) is true
foothold in extremely difficult conditions,” Das
Assertion: RBI gives licence to commercial
said.
banks and supervise them.
Crude oil prices are volatile with implications for
Reason: RBI is the largest bank of country.
imported cost pressures on inflation, RBI said.
“The combination of elevated prices of industrial 2. In these questions, a statement of assertion
raw materials, high pump prices of petrol and followed by a statement of reason is given.
diesel with their second-round effects, and Choose the correct answer out of the
logistics costs continue to impinge adversely on following choices.
cost conditions for manufacturing and services, a. both (A) & (R) both are true and (R) is
although weak demand conditions are correct explanation of (A)
tempering the pass-through to output prices and b. both (A) & (R) both are true and (R) is not
core inflation. correct explanation of (A)
Questions: c. (A) is true but (R) is false
1. How does RBI promote growth process of d. (A) is false but (R) is true
country:
Assertion: when CRR is increased, credit
a) By controlling price level in country creation capacity of commercial banks reduces.
b) By changing various interest rates and Reason: with increase in reserve ratios, banks
money supply have less funds available for loans.

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Answer Key
MCQ Answers- 4. It is the money that the RBI and the government
have generated, in which the public holds the
1. (a) Reduce Cash Reserve Ratio
currency and banks keep the cash reserves.
2. (a) secondary deposits
Money varies from cash reserves in that money
3. (c) secondary deposits is made up of demand deposits, whereas cash
4. (c) Cash Reserve Ratio reserves are used to create demand deposits.
5. (d) all of the above The equation is:
6. (a) Bank Rate H=C+R
7. (a) Notes issue Where H = High Powered Money
8. (d) Selling government securities C = Currency with the public (Paper money +
9. (b) Overdraft coins)

10. (d) All of these R = Government and bank deposits with RBI

11. (a) Ministry of Finance Thus, the sum total of money deposited with the
public and the funds of banks are termed as
12. (c) M1
powerful money. It is mainly created by the
13. (d) 1957
central bank.
14. (d) M1
5. The Central Bank will hike the bank rate if it
15. (b) C + R + OD wants to regulate lending. Market rates and
other loan rates on the money market will
Short Answers-
increase as a result of this. Borrowing will be
1. Value of money multiplier = 1/LRR which is frowned upon. The expansion of credit will be
equal to 1/0.1 = 10 hampered by a rise in the bank rate. Likewise, a
Initial deposit was Rs. 500 crores decrease in the bank rate significantly decreases
Hence, money market lending rates, which in turn
stimulates commercial and industrial activity,
Total Deposit will be Initial Deposit × Money
requiring more credit from banks. As a result,
Multiplier
the volume of bank credit will increase.
= 500 ×10
= 5000 Crores Long Answers-
Thus, the total deposit is 5000 crores. 1. 1. Bank of Issue: The central bank of a
2. Money Multiplier = Total Deposits / Initial country, whose tasks include currency
Deposits issuance, monetary policy administration,
open market activities, and engaging in
= 1600 / 200 = 8
transactions that promote healthy
Hence Money Multiplier = 1/LRR
business connections. For example, the
8 = 1/LRR Reserve Bank of India, the Bank of
LRR = 1.25 or 12.5 England, and the Federal Reserve banks
3. Money Multiplier = 1/LRR = 1/025 = 4 of the United States. Simply put, a bank
with the formal right to manufacture
Initial Deposit = Total Deposit / Money
currency, which can include both paper
Multiplier
money and coins. The Reserve Bank of
= 12000 / 4
India is the sole authority in India for
= Rs. 3000 issuing banknotes. The Reserve Bank, like
Thus, the initial deposit is Rs. 3000. other central banks across the world,

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periodically modifies the design of funding. Demand and time

banknotes. Since 1996, the Reserve Bank deposits are the two forms of
has released banknotes of the Mahatma deposits. Demand deposits are
Gandhi Series, which include those that can be easily withdrawn
denominations of Rs. 5, Rs. 10, Rs. 20, Rs. by individuals without giving the
50, Rs. 100, Rs. 200, and Rs. 500. bank prior notice. Deposits made
for a specific length of time are
2. Banker’s bank: A bankers' bank is a type
known as time deposits. On these
of bank formed by a collection of larger,
deposits, banks pay a greater rate
more well-established banks. Bankers'
of interest.
banks exist to provide services to the
charter banks that established them. ii. Advancing Loans refers to the
These institutions are created to help utilisation of public deposits by
community banks, even though their commercial banks to make loans to
financial services are not normally open individuals and enterprises.
to the public in any way. Commercial Overdrafts, cash credit, and
banks have a current account with the discounting bills of exchange are
central bank and are able to borrow all examples of commercial bank
money in the short term. As a result, loans.
banks that need to provide banknotes to b. Secondary Functions: The term
their customers either over the counter or "secondary functions" usually refers to
through automated teller machines get critical activities performed by
them from the central bank, which has a commercial banks. Agency functions,
monopoly on issuing banknotes. In India, general utility functions, and other
the Reserve Bank of India (RBI) serves as functions are the three types of secondary
the banker's bank. This bank requires all functions that can be classified.
commercial banks in India to maintain a i. Agency Function - Commercial
cash reserve ratio. Credit is created by banks act as agents for their
commercial banks. The RBI's role is to customers by collecting checks,
regulate credit via the CRR, bank rate, and collecting income, and paying
open market activities. expenses, among other things.
2. The most essential components of the banking ii. Providing Locker Facilities, Issuing
system are commercial banks. A commercial Traveller’s Checks, Dealing in
bank is a profit-driven financial organisation Foreign Exchange, and
that provides loans, accepts deposits, and Transferring Funds are examples
provides other financial services like overdrafts of general utility functions.
and electronic fund transfers. According to
iii. Other tasks include lending money
Culbertson, “Commercial Banks are the entities
to individuals and opening demand
that establish short-term bans on business and
deposits, as well as electronic
create money in the process.”
banking, which encompasses
Commercial banks have divided their services such as debit cards, credit
functionality into two sections, as seen in the cards, and Internet banking, among
diagram above: primary and secondary others.
functions.
3. Money is typically described in terms of the
a. Primary Functions: The term "primary three functions or services it provides. Money
functions" refers to the basic functions of functions as a means of exchange, a store of
commercial banks, which include: value, and a monetary unit. It is a current means
i. Accepting Deposits suggests that of trade in the form of coins and banknotes
commercial banks rely on public (together, coins and banknotes). In the words of
deposits for the majority of their Prof. Walker, "Money is as money does."

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The following are the primary purposes of iii. Money as a store of value solves the
money: challenge of storing wealth that plagues
i. Money as a Medium of Exchange: The barter. It broadened people's purchasing
basic or primary function of money is to power.
serve as a medium of exchange. The iv. Using money as a deferred payment
medium of money is used to exchange standard helps to alleviate the barter
commodities and services. Money serves problem of a lack of deferred payment
as both a medium of commerce and a standards. It also aids in the formation of
means of payment. Money has no value on contracts involving future payments.
its own. It's only a stepping stone.
v. The use of money allowed people to sell
ii. Money as a Unit of Account or Measure of
their excess commodities in exchange for
Value: Money is used to represent a unit
cash and utilise the cash to purchase their
of account or a measure of value. Money
necessities. Currency was invented
serves as the yardstick by which the value
during ancient wars because it was too
of other goods and services is measured
difficult for warriors to carry chickens
and expressed in monetary terms.
and beans around to exchange for what
iii. Money as a Deferred Payments Standard:
they needed.
Deferred payments are payments that are
made at a later date. Debts are typically vi. The indivisibility of goods was a
expressed in terms of account money. significant issue. A severe problem of
Loans are taken out and repaid in indivisibility of certain items arose under
monetary terms. barter. Some articles were tough to break
iv. Money as a Store of Value: Money can be down into manageable chunks. As a
used to store wealth for the future. It is result, one of the trade parties was forced
used to store the worth of liquid items. We to give up his entire indivisible thing in
can receive any commodity in the future return for the other's goods.
by spending it. This is a function of money vii. A major issue at the time was the difficulty
that Keynes emphasises a lot. Because in transferring wealth. The problem of
money can be quickly transformed into transferring a person's wealth under
other things, it is akin to having a reserve barter emerges. When he wants to move
of liquid assets. his money, such as his house, property, or
v. Money's Liquidity: Money is entirely car from one location to another, it's
liquid. Liquidity refers to a currency's nearly impossible to find someone in
ability to be converted into cash. Liquidity another location who can trade his
of asset refers to the ability to turn an property or wealth.
asset into money rapidly and without
5. Deposits are accepted by banks, while loans are
losing value. Modern economics places a
disbursed to lenders. As a result, banks can lend
premium on money availability.
some of their depositors' money while having
4. i. By separating the acts of sale and enough on hand to cover daily withdrawals. The
purchase, money, as a medium of
fractional-reserve banking system is what it's
exchange, resolves the problem of
called. Cash Reserves are a portion of deposits
bartering's lack of double coincidence of
held by banks. Any seasoned banker knows two
wants.
things based on his or her experience. For
ii. The absence of a common measure of starters, depositors do not all go to the bank at
value is solved by using money as a
the same time to withdraw money, nor do they
measure or unit of value or a unit of
withdraw the entire amount at once. Second,
account. Money serves as a unit of account
new deposits will continue to flow into banks on
and a yardstick for determining the
a daily basis.
exchange value of all goods.

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Case Study Answer- 2. d) To stabilize economy.

1. Answer: 3. b) Increasing crude oil prices are making

economy potentially unstable.
1. d) Both (b) and (c).
2. b) Stock. Assertion Reason Answer-
3. a) Supply foreign exchange from its stock. 1. c) (A) is true but (R) is false
4. a) Tighten the money supply in the 2. b) both (A) & (R) both are true and (R) is correct
economy. explanation of (A)
2. Answer:
1. b) By changing various interest rates and
money supply.

❖❖

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Determination of Income
and Employment 4
Aggregate Demand and Its Components:
Aggregate demand is an economic measurement of the total amount of demand for all finished goods and services
at a specific price produced in an economy.
It is the number of goods and services people buy. It’s usually reported for a specific time period, such as month,
quarter, or year.
Demand changes as the price increases. That’s called the law of demand. It says people will want more goods and
services when prices fall. They will buy less as prices increase.
The aggregate demand formula is AD = C + I + G + (X - M).
Aggregate demand has four components: consumption, investment, government spending, and net exports.
Consumption of goods and services can change for a number of reasons, including movements in income, taxes,
expectations about future income, and changes in wealth levels.
Investment can change based on expected profitability, which in turn is shaped by expectations about future
economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment.
Investment also changes when interest rates rise or fall.
Government spending and taxes are determined by political considerations.
Exports and imports of goods change according to relative growth rates and prices between two economies.
An inflationary gap exists when equilibrium is at a level of output above potential GDP.
Propensity to consume and propensity to save (average and marginal).
the balance in their account.

Marginal Propensity to Consume (MPC)

The marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a
consumer spends on the consumption of goods and services, instead of saving it.
Marginal propensity to consume is a component of Keynesian macroeconomic theory which is calculated as the
change in consumption divided by the change in income.
MPC varies by income level. It is typically lower at higher incomes.
The marginal propensity to consume is equal to Change in income/ change of consumption If consumption
increases by 80 cents for each additional Rupees of income, then MPC is equal to 0.8 / 1 = 0.8.
Suppose you receive a Rupees 50000 bonus on Diwali on top of your normal annual earnings. You suddenly have
50000 more in income.
If you decide to spend 40000 of this marginal increase in income on a new suit and save the remaining 10000, your
marginal propensity to consume will be 0.8 (40000 divided by 50000).
On the other hand your saving of 0.2 (10000/50000) will be your MPS (Marginal Propensity to Save).
If you decide to save the entire 50000, your marginal propensity to consume will be 0 (0 divided by 50000), and
your marginal propensity to save will be 1 (50000 divided by 50000).

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Marginal Propensity to Save (MPS):

The marginal propensity to save (MPS) refers to the proportion of an aggregate raise in income that a consumer
saves rather than spends on the consumption of goods and services.
This save is the proportion of each added dollar of income that is saved rather than spent.
MPS is a component of Keynesian macroeconomic theory which is calculated as the change in savings divided by
the change in income, or as the complement of the marginal propensity to consume (MPC).
This savings is the proportion of an increase in income that gets saved instead of spent on consumption.
MPS varies by income level. It is higher at higher incomes.

Short Run Equilibrium Output:

Short run is a period of time during which the level of output is determined by the level of employment in the
economy.
In short run the firm can try varying its output by bringing about a change in the variable factors of production,
which can lead to maximum profit or losses.
In this short period, the prices and wages are slow to adjust to equilibrium level thereby creating sustained periods
of shortage or surplus and thus prevents the economy from operating, as per its full potential
An economy is in short run equilibrium when the level of aggregate output demanded is equal to the level of
aggregate output supplied.
Equilibrium Output refers to the level of output where the Aggregate Demand is equal to the Aggregate Supply (AD
= AS) in an economy.
It signifies that whatever the producers produce during the year is exactly equal to what the buyers intend to buy
during the year.
Therefore, AD = C + I (for a two-sector economy) and AS = C + S
(AD = Aggregate Demand, AS = Aggregate Supply, C = Consumption, I = Investment, S = Saving)

Investment multiplier and its mechanism

Investment Multiplier refers to increase in national income as a multiple of a given increase in Investment.
It 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.
It is multiplying investment spending beyond those immediately measurable. The larger an investment’s
multiplier, the more efficient it is in creating and distributing wealth throughout the economy.
Investment Multiplier is rooted in the economic theories of John Maynard Keynes.
The range of the investment multiplier depends on two factors: the marginal propensity to consume (MPC) and
the marginal propensity to save (MPS).
The investment multiplier tries to determine the economic impact of public or private investment. For instance,
extra government spending on roads can increase the income of construction workers and materials suppliers.
These workers may spend the extra income in the retail, consumer goods, or service industries, boosting the
income of the workers in those sectors which boost the economy.
Suppose increase in investment is Rs 1000 and MPC = 0.8.

The increase in national income is in the following sequence:

• Increase in investment on goods raises income of those who supply investment goods by Rs 1000. This is
the first round increase
• Since MPC = 0.8, the income earners spend Rs 800 on consumption, which raises the income of the suppliers
of consumption goods by Rs 800. This is a second round increase.
• In the similar way, the third round increase is Rs 640 = 800 × 0.8. In this way, national income goes on
increasing round after round.
• The total increase in income is Rs 5000.

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Full employment and involuntary unemployment

Full Employment:
Full employment refers to the people, who are willing and able to work at the existing wage rate, get work without
any difficulty.
Generally, the term ‘full employment’ means that there is no unemployment that means everyone gets work. And
the demand for labor is equal to its supply.
However, in macroeconomics, there can be some types of unemployment even during full employment.
Under full employment, there can be two types of unemployment:

Frictional Unemployment:
It is temporary unemployment, which exists during the period wherein workers leave one job and join some other.
It happens due to labor market imperfections such as lack of market information about availability of jobs and lack
of perfect mobility on the part of workers.
Introduction of new machines, nationalization in the production process or breakdown of plants may also lead to
frictional unemployment.

Structural Unemployment:
In this type of unemployment, people remain unemployed due to a mismatch between unemployed persons and
the demand for specific types of workers. It is associated with structural changes in the economy.
For example, due to computerization, workers who do not have enough knowledge of computers will be
unemployed until they do some computer courses or training.
These two types of unemployment are referred as ‘Natural rate of Unemployment’. It must be noted that the
concept of Full Employment is explained only in the context of ‘labor force’.
Labor force refers to that part of the population which is physically and mentally able and willing to work. Children
and old persons will not be considered as they are not supposed to be employed even during full employment.

Involuntary Unemployment:
Involuntary unemployment refers to all those people, who are willing and able to work at the existing wage rate,
do not get work.
Under involuntary unemployment, people are unemployed against their wishes or under compulsion. It must be
noted that only involuntary unemployment is considered while estimating the total unemployment in an economy.

Problems of Excess Demand and Deficient Demand

Problem of Excess Demand:
Excess demand is the excess of aggregate demand over and above its level required to maintain full employment
equilibrium in the economy.
When in an economy, aggregate demand exceeds aggregate supply, the demand is said to be an excess demand.
Suppose by employing all its available resources a company can produce 10,000 quintal of rice. But aggregate
demand of rice is 12,000 quintal, this extra demand of 2000 will be called an excess demand,

Causes of Excess Demand:

The main reasons for excess demand are apparently the increase in the following components of aggregate
demand:

Reason of Excess Demand:

• Increase in household consumption demand due to rise in propensity to consume.
• Increase in private investment demand because of rise in credit facilities.
• Increase in public (government) expenditure. Increase in export demand.
• Increase in money supply or increase in disposable income.

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Effects of excess demand on price, output, employment:

• Increase in General Price Level: Excess demand rise general price level, it arises when aggregate demand
is more than aggregate supply at a full employment level.
• Output: Excess demand has no effect on the level of output, because the economy is at full employment
level and there is no idle capacity in the economy.
• Employment: There will be no change in the level of employment also.
• The economy is already operating at full employment equilibrium, and hence, there is no unemployment.

Measures to control the excess demand:

We can control the excess demand with the help of the following policy:
Fiscal Policy
Monetary Policy

Fiscal Policy:
Fiscal policy is the expenditure and taxation policy of the
government to accomplish the desired objectives. The
objective of fiscal policy is to reduce aggregate demand.

The main tools of fiscal policy are:

• Reduce Expenditure policy: In case of excess
demand, government should reduce 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 can reduce the budget deficit
which shows excess of expenditure over revenue.
• Increase Tax Revenue policy: Revenue policy is
expressed in 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.
• Increase Public borrowing: Government should resort to large scale public borrowing to mop up excess
money with the public.
• Reduce Deficit financing: Deficit financing (printing of currency/ notes) should be reduce drastically
because it leads to increase in demand. To keep deficit financing low, government may raise small savings
such as PPF, NSC, etc. by offering incentives.

Monetary Policy:
It is the policy of the central bank of a country to control money supply and credit in the economy.

Measures of monetary policy:

• Quantitative (which influence the total volume of credit)
• Qualitative (which regulates flow of credit for specific uses) as explained below:

Quantitative Measures:
• Bank rate or Repo rate (Increase bank rate): Bank rate (Repo rate) is the rate of interest charged by
central bank on loans given to all commercial banks.

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Increase in bank rate forces commercial banks to increase their own lending rate of interest which makes
loan costlier. As a result, the demand for credits falls.
High rate of interest slows down the demand for goods and services and encourage people to increase their
savings.
• Open Market Operation (Sell securities): It refers to buying and selling of government securities and
bonds in the open market by the central bank to influence the cash reserves with commercial banks. This
brings flow of money. Thereby restricting their lending capacity.
• Cash-Reserve Ratio (Raise CRR): When there is an inflationary situation, the central bank raises the rate
of minimum cash-reserve ratio thereby. As a result banks keep more cash reserve with RBI which in turn
curtails the lending capacity of commercial banks.
• Statutory Liquidity Ratio (Raise SLR): In addition to CRR, there is another measure called SLR. When RBI
wants to contract credit by banks, it increases SLR and thereby reduces credit availability.

Qualitative Measures:
• Moral Suasion (Restrict credit): This means written or oral advice given by the central bank to
commercial banks to restrict or expand credit. During inflation, the central bank persuades its member
banks not to advance credit for speculation or prohibit banks from entering into certain transactions. This
advice is generally followed by member banks.
• Increase Margin Requirements: Margin requirement refers to the amount of security that banks demand
from borrower of loan. This discourages borrowing, it makes traders get less credit against their securities.
In case of deficient demand, margin requirements are lowered to encourage borrowing.
• Miscellaneous: There are certain other measures which can be: import promotion, wage freeze, control
and blocking of liquid assets, compulsory savings scheme for households, increase in production by utilizing
idle capacities, etc.

Deficiency Of Demand
Deficient demand (deflationary gap) is an excess of available aggregate output over anticipated aggregate
expenditure, at full employment level.
The situation of deficient demand builds deflationary pressures leading to a fall in the general price level in the
economy. When AD is less than AS (at full employment condition), the producers are forced to reduce their output
as prices and profits are hit adversely.
This may result in unemployment of resources and reduced income in the economy which further reduces the
demand for goods and services,

Causes of Deficient Demand:

• Fall in Consumption: Any decrease in the consumption demand of the households may lead to a fall in AD
• Fall in Investments: Any decrease in the investment expenditure incurred by the households and firms
may lead to a fall in AD and result in deficient demand-like situation.
• Fall in Government Expenditure: Government decreases its consumption or investment expenditure, it
may result in a fall in money supply in the economy.
• Decrease in Net Exports: When the export of goods and services from an economy is less and import is
more, this may result in lesser money at the disposal of the people in the economy leading to deficient
demand.
• Budget Surplus: If an economy is facing budgetary surplus, it may result in deflationary gap.
• Higher Taxes: When the tax structure in the economy is stringent and doesn’t leave money at the disposal
of the general public in the economy, this could prove to be deflationary in nature.

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Measures to Correct Deficient Demand:

The problem of deficient demand in an economy can be tackled either by increasing budget deficits (using the
fiscal policy measures) or by encouraging the availability of credit (using the monetary policy measures)

Fiscal Policy Measures:

These are the steps taken by the government which affect either revenue or expenditure of the government.
Two fiscal policy measures are as follows:
• Taxation Policy: The government can use taxation policy (both direct and indirect taxes) to regulate the
money in the pockets of the public.
• Government Expenditure Policy: Any increase in the public expenditure by government will directly
affect the demand of goods and services and as a result AD may be equal to AS.
• Monetary Policy Measures: Central bank concentrating on the money supply and availability of credit in
the economy using various qualitative and quantitative tools of controlling funds in the hands of the general
public.

Quantitative Methods:
• Bank Rate/ Discount Policy: A lower Bank Rate aims to reduce the cost of funds that are made available
by the central bank to these commercial banks which, in turn, reduce their own lending rates to the
borrowers.
• Open Market Operations: If there is lower money supply in the market, the central bank may start
purchasing the treasury bills and other securities in the open market with an aim of creating a gap in the
funds in the market from banks and other financial institutions.

Legal Reserve Ratio:

There are two major reserve ratios in this regard:
• Cash Reserve Ratio (CRR): If the central bank feels that the credit availability in the economy is in
deficiency, it may reduce the Cash Reserve Ratio, leaving more cash with the commercial banks to create
lending.
• Statutory Liquidity Ratio (SLR): In order to push money, the central bank will reduce SLR, which will give
more money to the commercial banks to lend and increase money supply to reduce deflation as per the
requirements of the economy.
• Repo Rate/Reverse Repo Rate: A fall in repo rate may promote borrowings due to cheaper fund
availability. Reverse Repo Rate when falls it ensures liquidity in the market.

Qualitative Methods:
• Margin Requirements: Lower margin requirements promote credit-creating power of the banks, as a
result the money supply in the economy enhanced.
• Regulation of Consumer Credit: During adverse conditions, the central bank may ask the commercial
banks to grant more loans and advances to the consumers.

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Important Questions
Multiple Choice Questions: 8. On the basis of government law, the compulsory
1. Supply creates its own Demand. Who gave this payment made by the public is known as
law? ………………..
(a) J.B.Say (a) Expenditure
(b) J.S.Mill (b) Investment
(c) Keynes (c) Tax
(d) Ricardo (d) Subsidy
2. If MPC is eual to 1, the value of the multiplier is 9. According to classical economists, there always
(a) 0 exists ……………… euilibrium in the economy.
(b) 1 (a) Full employment
(c) Between 0 and 1 (b) Underemployment
(d) Infinity (c) Over full employment
3. If the marginal propensity to consume is greater (d) None of these
than the marginal propensity to save, the value 10. What will be APC when APS = 0?
of the multiplier will be:
(a) One
(a) greater than 2
(b) Zero
(b) less than 2
(c) Two
(c) two eual to 2
(d) Infinite
(d) eual to 5
11. If MPC = 1, the value of the multiplier is:
4. If MPC is zero, the value of the multiplier is
(a) 0
(a) 0
(b) 1
(b) 1
(c) Between 0 and 1
(c) between 0 and 1
(d) Infinity
(d) infinity
12. Which is the measure of correcting excess
5. Average Propensity to Consume can never be
demand?
………………
(a) Deficit financing
(a) positive
(b) Reduction in taxes
(b) zero
(c) more than one (c) Increase in public expenditure

(d) less than one (d) Increase in public debt

6. According to classical economists, there always 13. If the marginal propensity to consume is greater
exists an euilibrium in the economy. than the marginal propensity to save, the value
of the multiplier will be
(a) Full employment
(a) greater than 2
(b) Underemployment
(c) Over full employment (b) less than 2

(d) None of these (c) eual to 2

7. According to classical economists, real wage rate (d) eual to 5

is ……………… to the Marginal Productivity of 14. Supply creates its own Demand. Who gave this
Labour. law?
(a) Eual (a) J.B.Say
(b) More (b) J.S.Mill
(c) Less (c) Keynes
(d) None of these (d) Ricardo

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15. Aggregate demand can be increased by: Case Study Based Question-
(a) increasing bank rate 1. Read the following hypothetical text and answer
(b) selling govt, securities by RBI the given questions: -
(c) increasing cash reserve ratio a. Both Assertion and Reason are true and
(d) none of these Reason (R) is the correct explanation of
Assertion (A)
Very Short Questions- b. Both Assertion and Reason are true and
1. What is the relation between APC and APS? Reason (R) is not the correct explanation
2. State the important factor influencing the of Assertion (A)
propensity to consume in an economy. c. Assertion (A) is True but Reason (R) is
3. Give the formula of investment multiplier in False
terms of MPC. d. Assertion (A) is False but Reason (R) is
4. Write down the equation of saving function. True
5. What is equilibrium income? Assertion: At the Break-Even point,
consumption is equal to National Income.
Short Questions -
Reason: APC falls continuously with an increase
1. Explain the components of S = -a + (1-b)Y in income as the proportion of income spent on
2. Can the average propensity to consume be consumption keeps on decreasing.
greater than one? Give the reason for your 2. Read the following hypothetical text and answer
answer. the given questions: -
3. Differentiate between ex ante and ex post a. Both Assertion and Reason are true and
investment.
Reason (R) is the correct explanation of
4. Explain the working of a multiplier with an Assertion (A)
example.
b. Both Assertion and Reason are true and
5. Can the value of APS be negative? If yes, then Reason (R) is not the correct explanation
when? of Assertion (A)

Long Questions- c. Assertion (A) is True but Reason (R) is

False
1. Define and represent the inflationary gap on a
diagram. Explain the role of the varying reserves d. Assertion (A) is False but Reason (R) is
requirement in removing the gap. True

2. In an economy C = 300 + 0.5Y and I = Rs. 600 Assertion: There is a positive relationship
(where C is consumption, Y is income or between saving and income.
investment). Calculate the following: Reason: Savings are positive even at zero level
a. Equilibrium level of income of National Income.
b. Consumption expenditure at equilibrium Assertion Reason Type Question-
level of income.
1. In these questions, a statement of assertion
3. If in an economy investment increases by Rs.
followed by a statement of reason is given.
1000 lakhs to Rs. 1200 lakhs and as a result, total
Choose the correct answer out of the following
income raises by 800 lakhs, calculate MPS.
choices.
4. Explain the role of the following in correcting
2. In these questions, a statement of assertion
deficient demand in an economy.
followed by a statement of reason is given.
a. Open market operations Choose the correct answer out of the following
b. Bank rate choices.
5. Draw a hypothetical propensity to consume
curve and from it draw a propensity to save
curve.

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Answer Key
MCQ Answers- Short Answers -
1. (a) J.B.Say 1. The equation of saving function is
2. (d) Infinity S = -a + (1-b)Y
3. (a) greater than 2 In this equation, -a indicates the intercept term
4. (b) 1 and the amount of savings made while there is
no income. Savings are negative at zero since
5. (b) zero
income consumption ‘a’ is positive. Negative
6. (a) Full employment saving is also known as dissaving, which means
7. (a) Equal that at the 0 level, there is dissaving of the
8. (c) Tax amount represented by -a

9. (a) Full employment The slope of the saving function is measured by

the coefficient 1-b. The slope of the saving
10. (a) One
function indicates the amount of money saved
11. (d) Infinity for every unit increase in income. This is
12. (d) Increase in public debt referred to as the Marginal Propensity to Save.
13. (a) greater than 2 Since b,' or Marginal Propensity to Consume, is
smaller than one, 1-b i.e. MPS, is positive. And Y
14. (a) J.B.Say
refers to income here.
15. (d) none of these
2. When consumption surpasses income, the
Very Short Answers- average propensity to consume can be greater
than one. Also, APS is negative at this level, so
1. The relation between Average Propensity to
APC will be more than one.
Consume (APC) and Average Propensity to Save
(APS) is always equal to 1 (unity), that is, For example, if income is Rs. 1000, consumption
is Rs. 1200, then,
APC + APS = 1
1200
This is because the money income can either be APC = =1.20
1000
spent on consumption or saved.
3. The difference between ex ante and ex post
2. It is always the level of income (Y) that impacts
investment.
an economy's propensity to consume (C).
3. The formula of investment multiplier in terms of Basis Ex-ante Ex-post
MPC is shown below. Investment Investment

1 Meaning It refers to what It refers to

K= is planned or the actual
1- MPC
intended to level of
4. The equation of saving function is given below. happen during a investment
S = −a + (1 − b) y specific time over a
Here, period. specific time
period.
1-b = MPS
Type of It is a fictitious It is true or
Y= Income
situation (intended) unique that
-a = Savings, when Y is 0 situation in which represents
5. The amount of income at which aggregate a company the existing
demand equals aggregate supply is referred to as assumes the level investment
the equilibrium income. That is when AD=AS, of investment on of a specific
there is equilibrium income. its own. time.

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Based It is planned It is the 5. Yes, when the value of spending/ consumption

on based on future actual exceeds the value of income, the average
expectations. outcome of propensity to save might be negative. Though
variables. APS can never be greater than one, as a person
cannot save more than his income.
4. The multiplier shows us what the eventual
For example: Assume that the income is Rs. 1000
change in income will be as a result of a change
and its consumption expenditure is Rs. 1200.
in investment. Changes in investment lead to
changes in income. It is represented Y= C-S
symbolically by: S= C-Y

I →Y →C →Y S= 1000-1200

S= -200
The operation of a multiplier can be illustrated
using the table below, which is based on S
APS =
4 Y
K = 1000 and MPC =
consumption, that is, 5. −200
APS =
1000
The process of income generation is shown
APS = -0.2
below.

Rounds I Y C Long Answers-

1 1000 1000 4 1. Meaning: Inflationary Gap
 1000 = 800
5 • An inflationary gap is a macroeconomic
2 – 800 4 concept that defines the difference
 800 = 640 between the current level of real GDP and
5
the expected GDP that would be
3 – 640 4
 640 = 512 experienced if an economy is at full
5
employment, also known as the potential
4 – 512 4
 512 = 409.6 GDP.
5
• An inflationary gap is always associated
    with a business-cycle expansion and
Total 5000 occurs when an economy's equilibrium
4
level of aggregate output exceeds the
According to the above table, as MPC = , the output that could be produced at full
5
initial increase in investment of Rs 1000 results employment.
in a total increase in income of Rs 5000. From the
• It also depicts the excess of aggregate
whole increase in income, Rs. 4000 will be spent
demand over aggregate supply even when
and Rs. 5000 will be saved.
there is full utilization of the factors.
The derivation of the sum of total increase in
Formula
income is shown below.
AD= C + I + G + (X-M)
4  4 2  4 3
= 1000 +  1000   1000   1000 + ............... 
5 5 5 That is, Consumption spending (C), investment
 4  4 2  4 3  expenditure (I), government expenditure (G),
= 1000 1 + +   +   + ...................   and the trade balance, or the value of exports
 5 5 5 
minus the value of imports (X – M), comprise
1 4 
= 1000  −  aggregate demand. Thus, the inflationary gap is
1 5  the product of excess demand.
5
= 1000 Diagram
1
(Image will be Uploaded Soon)
= Rs. 5000 crores.

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Explanation: 2. (a) Given:

In the diagram: C = 300 + 0.5Y
• AD curve represents the Aggregate I = Rs. 600.
demand at full employment. The equilibrium level of income is calculated as
• AD’ curve represents the Aggregate
demand beyond the full employment.
• Point A is the equilibrium, where AD=AS
(the 45° line is the AS or Y curve).
• Vertical area AB depicts inflationary gap,
as here at point E, the aggregate demand
BY1 is greater than Aggregate Supply AY1.
• OY1 is the full employment level of
output. Y= Rs 1800

• As the output could not be increased (b) The consumption expenditure at equilibrium
beyond the full employment level, prices level of income is calculated as
will rise, and there will be a situation of Y = C+I
inflation in the economy. 1800 = C +600
The following things can be useful in order to 1800-600 = C
remove the gaps given below. 1200 = C
• Cash Reserve Ratio: The Cash Reserve 3. In this case, MPS would be
Ratio (CRR) is the specified minimum
fraction of total customer deposits that
commercial banks must retain as reserves
in cash or as deposits with the central
bank.
To curb inflationary gap, RBI decides to raise the
Cash Reserve Ratio, due to which the quantity of
money accessible to banks decreases, and the
commercial bank’s capacity to provide credit
also falls. Hence the aggregate demand falls
down with a low credit creation and supply of
money in the economy.
• Statutory Liquidity Ratio: Statutory
liquidity ratio (SLR) is the term used by
the Indian government to describe the
reserve requirement that commercial
banks in India are required to hold in the Therefore, the value of MPS is 0.25
form of cash, gold reserves, and 4. (a) The sale and purchase of government and
government-approved securities before other sanctioned securities by the central bank
extending credit to consumers. to commercial banks and other financial
institutions is referred to as open market
To curb inflationary gap, RBI decides to raise the
operation. When the economy's cash balance
SLR, due to which the quantity of money
needs to be increased, especially when demand
accessible to banks decreases, and the
is low, the central bank purchases a number of
commercial bank’s capacity to provide credit
securities. This improves commercial banks'
also falls. Hence the aggregate demand falls cash holdings, allowing them to make more
down with a low credit creation and supply of loans and advances. As a result, aggregate
money in the economy. demand rises.

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(b) The bank rate is the interest rate at which the Part A is the vertical distance between the
central bank loans to commercial banks. To CC curve and the 45° line.
control the situation of insufficient demand, the • We can derive a saving curve by plotting
central bank reduces the bank rate. As a result of vertical distances from Part A in Part B of
the central bank's drop in the bank rate, the Figure and connecting them.
commercial banks lower the market rate of
For example,
interest. This will result in cheaper borrowing
costs from commercial banks for consumers and • In Part A, at 0 (zero) level of income,
investors. This raises credit demand, resulting in vertical distance OC (representing
additional liquidity in the hands of the people. dissaving) is plotted as OS1 in Part B.
Hence in this case the consumption and • Similarly, at the OR level of income in Part
investment spending increases, and aggregate A, the vertical distance between the CC
demand (AD) also rises. curve and the 45° line at point B is nil
5. The sum of consumption and saving is always (indicating zero saving) and is depicted as
equal to income because income is either point Bj at the same level of income in Part
consumed or saved. It implies that consumption B.
and saving curves, which represent • LM vertical distance of part A is shown as
consumption and saving functions, are mutually L1M1 in Part B at the OS level of income.
exclusive. Thus, given the income, we can We get the saving curve by connecting the
directly derive the saving function from the points St, Bt, and Lv. Thus, in the form of a
consumption function, as shown in Fig, which saving curve, the saving function is
consists of Part A displaying the consumption diagrammatically derived from the
function and Part B displaying the saving consumption function. (Similarly, the
function. consumption curve can be derived from
(Image will be Uploaded Soon) the saving curve.)

• In Part A of the accompanying Figure, the Case Study Answer-

CC curve represents the consumption
1. Answer:
function for each level of income, whereas
the 45° line OL represents income. 1. a) absolute poverty

• Because the 45° line divides the graph 2. Poverty line

into two equal parts, each point on this 3. Consumption
line is equidistant from the X and Y axes. 4. per capita expenditure
• The CC curve intersects the 45° line OL at 2. Answer:
point B, where BR is equal to OR, i.e., 1. d) All of the above
consumption equals income.
2. Casualization
• As a result, point B is known as the
3. Gini Coefficient
breakeven point. There is no saving at
point B, but to its left, the consumption 4. d) all the above
function is above the 45° line, indicating
Assertion Reason Answer-
negative saving (dissaving), and to its
right, the consumption function is above 1. b) Both Assertion and Reason are true and
the 45° line, indicating positive saving. Reason (R) is not the correct explanation of
Assertion (A)
• Part B now deduces the saving function in
2. c) Assertion (A) is True but Reason (R) is False
the form of a saving curve. Remember
that the amount of saving (or dissaving) in
❖❖

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The Government Budget

Function and Scope 5
Government Budget
Meaning, Objectives and Components:
Meaning
A government budget is an annual financial statement showing item wise estimates of expected revenue and
anticipated expenditure during a fiscal year.
Just like your household budget, the government also has a budget of its income and expenditure. In the beginning
of every year, the government presents before the Lok Sabha an estimate of its receipts and expenditure for the
coming financial year.
The government plans a budget according to its expenditure and then tries to raise funds to meet the proposed
expenditure.
Government earns money broadly from taxes, fees and fines, interest on loans given to states and dividends by
public sector enterprises.
Government spends mainly on: Securing and providing goods and services to citizens, On law and order and
Internal security, defense, staff salaries, etc.
In India there is a constitutional requirement to present a budget before Parliament for the ensuing financial year.
The financial (fiscal) year starts on April 1 and ends on March 31 of next year.

Objectives:
General objectives of a government budget are as under:
• To promote rapid and balanced economic growth to improve the living standard of the people.
• To eradicate poverty and unemployment by creating employment opportunities and providing maximum
social benefits to the poor
• To reduce inequalities of income and wealth, the government can influence distribution of income through
levying taxes and granting subsidies.
• To reallocate resources so as to achieve social and economic objectives. e.g., public sanitation, rural
electrification, education, health, etc.
• To bring economic and price stability, by controlling fluctuations in general price level through taxes,
subsidies and expenditure.
• To finance and manage public enterprises like railways, power generation and water lines etc.

Components And Classification:

There are two main components of the Government Budget

Revenue Receipts:
Incomes which are received by the government from all sources in its ordinary course of governance are revenue
receipts.

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Revenue receipts are further classified as tax revenue and non-tax revenue.
• Tax Revenue: Tax revenue is the income received from different taxes and other duties levied by the
government. It is a major source of public revenue.
Taxes are of two types of tax], viz., Direct Taxes and indirect taxes
• Direct taxes: Direct taxes are taxes that an individual pays directly to the government, such as income tax,
land tax, and personal property tax. Such direct taxes are based on the ability of the taxpayer to pay, higher
their capability of paying is, the higher their taxes are.
• Indirect taxes: Indirect taxes are those taxes which are levied on goods and services and affect the income
of a person through their consumption expenditure. E.g. Custom duties, sales tax, services tax, excise duties,
etc.

Non-Tax Revenue:
Apart from taxes, governments also receive revenue from other non-tax sources.
• Fees: Fees paid for registration of property, births, deaths, etc.
• Fines and penalties: Fines and penalties for not following (violating) the rules and regulations.
• Profits from public sector enterprises: Many enterprises are owned and managed by the government. It
is an important source of non-tax revenue. For example in India, the Indian Railways, Oil and Natural Gas
Commission, Air India, etc.
• Gifts and grants: Gifts and grants are received by the government. Citizens of the country, foreign
governments and international organizations like the UNICEF, UNESCO, etc. donate during times of natural
calamities.
• Special assessment duty: It is a type of levy imposed on the people for getting some special benefit. For
example, in a particular locality, if roads are improved, property prices will rise.

Capital Receipts:
Receipts which create a liability or result in a reduction in assets are called capital receipts. They are obtained by
the government by raising funds through borrowings, recovery of loans and disposing of assets.
Some more examples:
• Loans raised by the government from the public through the sale of bonds and securities. They are called
market loans.
• Borrowings by government from RBI and other financial institutions through the sale of Treasury bills.
• Loans and aids received from foreign countries and other international Organizations like International
Monetary Fund (IMF), World Bank, etc.
• Receipts from small saving schemes like the National saving scheme, Provident fund, etc.
• Recoveries of loans granted to state and union territory governments and other parties.

Classification Of Capital Expenditure and Revenue Expenditure

Capital Expenditure:
Any projected expenditure which is incurred for creating asset for a long life is capital expenditure.
Therefore, expenditure on land, machines, equipment, irrigation projects, oil exploration and expenditure by way
of investment in long term physical or financial assets are capital expenditure.
The following are the examples of capital expenditure:
Expenditure incurred for:
• Acquisition of fixed tangible assets such as land, building, machinery, furniture, motor vehicle etc.
Improvement or extension of fixed assets such as increasing the seating capacity of a theatre.

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• Bring the fixed assets to the place of their use and expenditure incurred on their installation or erection
such as freight on fixed assets, wages paid for purchase of intangible assets such as goodwill, patent rights,
and trademarks, copyright, etc.
• Reconditioning of old fixed assets such as expenditure incurred on repairing or over healing of secondhand
machinery.
• Major repairs and replacement of plants which increase the efficiency of the plant.

Rules for Determining Capital Expenditure:

An expenditure is capital expenditure:
• When it is incurred for acquiring a long term asset (having a useful life of more than one year) for use in the
business to earn revenue and not meant for sale.
• When it is incurred to put an asset into working condition. For example, the transportation and installation
charges are added to the cost of machine, the legal charges like registration and stamp duty is added to the
cost of land and building, etc.
• When it incurred for putting an old asset into working condition is treated as capital expenditure and added
to the cost of the asset.
• When it is incurred to increase the earning capacity of a business is treated as capital expenditure. For
example, expenditure incurred for shifting the factory to convenient site is a capital expenditure.

Revenue Expenditure:
When an expenditure is made for running the business with a view to produce the profits is revenue expenditure.
Such expenditure benefits the current period only.
It is incurred to maintain the existing earning capacity of the business. Administrative expenses and selling and
distribution expenses are examples of revenue expenditure.

Rules for Determining Revenue Expenditure:

An expenditure incurred:
• For the purpose of acquiring goods purchased for resale, consumable items, etc. Other direct expenses like
production and purchase of goods such as wages, power, freight etc. are revenue expenditure.
• For maintaining fixed assets in working order e.g. amount spent on repairs and renewals
• Depreciation on fixed assets
• On office and administrative and selling and distribution departments in the normal course of business.
These include salaries, rent, telephone expenses, electricity, postage, advertisement, travelling expenses,
commission to salesmen.
• On non-operating expenses and losses are revenue expenditures. For example, interest on loan taken after
commencement of commercial production, loss on sale of a long term asset, loss by theft, loss by fire are
revenue expenditures.
• By an enterprise to discharge itself from recurring liability is of revenue nature. For example, a lump sum
amount paid to a pensioner by the employer is revenue expenditure.
• For protecting the business is a revenue expenditure. For example, the amount spent on propaganda
campaign to oppose the threatened nationalization of industry is of revenue nature.
• To maintain the existing efficiency or the earning capacity is of revenue type.

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Distinction Between Capital Expenditure and Revenue Expenditure:

Capital Expenditure Revenue Expenditure

Enduring for more than one accounting period. Enduring for one accounting period only.

Relates to the acquisition of fixed asset Relates to the acquisition of stock-in-trade.

Usually of non-recurring nature Usually of recurring nature.

Helps to increase the earning capacity of the Is incurred to maintain the existing earning
business or to reduce the operating cost. capacity of the business.

Not matched against capital receipts. Matched against revenue receipts for income
determination

May be incurred even before the commencement Incurred only after the commencement of
of business. business

Measures Of Government Deficit

A Deficit is the budgetary situation where expenditure is higher than the revenue. When in a set budget
government expenditure exceeds the income amount it is government deficit.
This deficit indicates the financial health of the economy. To reduce this deficit between expenditures and income,
the government cut back certain expenditures and also increased revenue-generating activities.
This expenditure revenue gap may be financed by either printing of currency or through borrowing.
Nowadays most governments in the world are having deficit budgets and these deficits are often financed through
borrowing.

Types Of Government Deficits:

✓ Revenue Deficit
✓ Fiscal Deficit
✓ Primary Deficit

Revenue Deficit:
It is the surplus of the government’s revenue expenditure over the revenue receipts.
It is the shortfall between the total revenue received to the total revenue expenditure.
Revenue deficit = Revenue expenditure - Revenue receipts
Revenue deficit only incorporates current income and current expenses. A high degree of deficit symbolizes that
the government should reduce its expenses.
The government may raise its revenue receipts by raising income tax. Disinvestment and selling off assets is
another corrective measure to minimize a revenue deficit.

Fiscal deficit:
It is the distinction between the government’s total expenditure and its total receipts, which excludes borrowing.
Gross fiscal deficit = Total expenditure - (Revenue receipts
+ Non-debt creating capital receipts)
A fiscal deficit has to be financed by borrowing. Thus, it includes the total borrowing necessities of the government
from all the possible sources. From the financing part.
A greater deficit implies more borrowing by the government and the extent of the deficit indicates the amount of
expense for which the money is borrowed.

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Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad
Fiscal deficit indicates the amount of money that the government will need to borrow during the financial year.
A disadvantage or implication of fiscal deficit is it may lead to a debt trap or it may lead to unnecessary and wasteful
expenditure by the government which may lead to uncontrolled inflation.

Primary deficit:
It is the amount of money that the government requires to borrow from the interest payments on the formerly
borrowed loans.
The aim of quantifying the primary deficit is to concentrate on current fiscal imbalances.
Gross primary deficit = Gross fiscal deficit - Net interest liabilities
Net interest liabilities comprise interest payments - interest receipts by the government on the net domestic
lending.

Difference between Fiscal Deficit and Revenue Deficit:

Measures to Reduce Government Deficit:
• Increased emphasis on tax-based revenues and appropriate measures to reduce tax evasion.
• Disinvestment should be done where assets are not being used effectively
• Reduction in subsidies by the government will also help reduce the deficit.
• Try to avoid unplanned expenditures.
• Borrowing from domestic sources.
• Borrowing from external sources.
• A broadened tax base
An uncontrolled government deficit may lead to decline in the financial health of the economy. The agenda of the
government should be to plan the revenues and expenditures in such a way that the economy moves towards a
balanced budget situation.

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Important Questions
Multiple Choice Questions: 7. The amount collected by the government in the
form of interest, fees, and dividends is known as
1. Which one of the following is a combination of
……………..
direct taxes?
(a) Tax-revenue receipts
(a) Excise duty and wealth tax
(b) Capital receipts
(b) Service tax and income tax (c) Non-tax revenue receipts
(c) Excise duty and service tax (d) None of these
(d) Wealth tax and income tax 8. Borrowing in the government budget is:
2. Which of the following statement is true? (a) Revenue deficit
(a) Loan from IMF is a revenue receipt. (b) Fiscal deficit
(b) Higher revenue deficit necessarily leads (c) Primary deficit
to higher fiscal deficit. (d) Deficit in taxes
(c) Borrowings by the government represent 9. The non-tax revenue in the following is:
a situation of fiscal deficit. (a) Export duty
(d) Revenue deficit is the excess of capital (b) Import duty
received over the revenue receipts. (c) Dividends
3. Which of the following is not a revenue receipt? (d) Excise

(a) Recovery of loans 10. The primary deficit in a government budget will
be zero, when ……………..
(b) Foreign grants
(a) Revenue deficit is zero
(c) Profit of public enterprises
(b) Net interest payments are zero
(d) Wealth tax
(c) Fiscal deficit is zero
4. Primary deficit is borrowing requirements of the (d) Fiscal deficit is eual to interest payment
government for payment(s)
11. Direct tax is called direct because it is collected
(a) of interest directly from:
(b) other than interest (a) The producers on goods produced
(c) of all types (b) The sellers on goods sold

(d) that are specific (c) The buyers of goods

(d) The income earners
5. Which of the following sources of receipts in the
government budget increases its liabilities? 12. Financial Year in India is:
(a) April I to March 31
(a) Direct taxes
(b) January 1 to December 31
(b) Recovery of loans
(c) October 1 to September 30
(c) Borrowings
(d) None of the above
(d) Dividend from PSUs
13. Which objectives government attempts to obtain
6. Which of the following is an indirect tax? by Budget
(a) Profit tax (a) To Promote Economic Development
(b) Wealth tax (b) Balanced Regional Development
(c) Custom duty (c) Redistribution of Income and Wealth

(d) Gift tax (d) All the above

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14. Which is a component of Budget? ii) Non-tax Revenue 68,714

(a) Budget Receipts B) Capital receipts 1,43,478
(b) Budget Expenditure i) Recoveries of loans 15,164
(c) Both (a) and (b) ii) Other receipts 12,000
(d) None of the above iii) Borrowings and other
1,16,314
liabilities
15. Which is a component of the Budget Receipt?
C) Revenue expenditure 3,10,566
(a) Revenue Receipt
i) Interest payments 1,12, 300
(b) Capital Receipt
ii) Major subsidies 27,845
(c) Both (a) and (b)
iii) Defence Expenditure 1,70,421
(d) None of the above
D) Capital Expenditure 64,657
Very Short Questions- E) Total Expenditure 3,75,223
1. Define a Budget. i) Plan expenditure 1,00,100
2. What are the two types of taxes? ii) Non-plan expenditure 2,75,123

3. What are the main items of Capital Receipt?

2. What is a balanced government budget? Explain
4. What are the four different concepts of Deficits? the multiplier effect of a balanced budget.
5. Give two examples of Developmental 3. Explain the objectives of resource allocation and
Expenditure. income distribution in a government budget.
6. Define Surplus Budget. 4. How is tax revenue different from
7. Give two examples of Non – Developmental administrative revenue?
expenditures. 5. Explain the concept of fiscal deficit in a
8. What are the two types of Revenue Receipts? government budget. What does it indicate?

Short Questions- Case Study Based Question-

1. Define Direct taxes and Indirect taxes. Also give 1. Read the following hypothetical text and answer
two examples of each. the given questions: -
2. What are the three major ways of Public Public expenditure accelerates the pace of GDP
Expenditure? growth. Higher rate of GDP growth is achieved
3. Explain the four different concepts of Budget through (a) investment expenditure in public
deficit. sector enterprises, (b) capital grants by the
government for the purchase of capital
4. Explain the objectives of the Government
equipment, (c) subsidies for the purchase of
Budget.
inputs, and (d) purchase of farm output at the
5. What are the Non-Tax Revenue receipts?
minimum support price. Public expenditure
Long Questions- promotes equality in the distribution of income
and wealth. This is achieved by offering old-age
1. The following figures are based on budget
pensions, as well as by providing free food,
estimates of Govt. of India for the year 2016-17.
education, and health services to the Below
Calculate:
Poverty Line Population.
1. Fiscal deficit
Public expenditure plays a significant role in
2. Revenue deficit restoring economic stability. Particularly, when
3. Primary deficit the economy is battling economic recession. The
government expenditure (consumption
ITEMS Amount (Rs)
expenditure as well as investment expenditure)
A) Revenue receipts 2,31,745
raises the level of AD. Only when AD is raised
i) Tax Revenue 1,63,031 that the vicious circle of economic recession is
broken. Public expenditure generates

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investment- friendly environment in the Questions:

economy. The government spends money on 1. Public enterprises will always desire to allocate
infrastructural development. It constructs roads, resources to those areas of production, where:
dams, bridges. It introduces faster and a. Profits are high
convenient means of transportation. Such b. Cost is low
facilities promote inducement to investment.
c. Social welfare is high
Briefly, public expenditure is indispensable in
d. Revenue is high
any welfare state like India. It not only promotes
2. GDP growth is the central objective of
GDP growth, but also promotes social welfare.
government budgetary policy.
Questions:
a. True
1. The construction of roads, dams, bridges
b. False
is called.
3. Suitable title for the passage:
a. Social development
a. GDP
b. Infrastructure development
b. Private enterprises
c. Industrial development
c. Subsidies
d. Agrarian development
d. Government Budget
2. The government expenditure does not
raise the level of AD: Assertion Reason Type Question-
a. True 1. In these questions, a statement of assertion
b. False followed by a statement of reason is given.
Choose the correct answer out of the
3. Which is included in the non- transfer
following choices.
income:
a. Both Assertion (A) and Reason (R) are
a. Old age pension
true,
b. Subsidies
b. Both Assertion (A) and Reason (R) are
c. Retirement pension false.
d. Scholarship c. Assertion (A) is true and Reason (R) is
2. Read the following hypothetical text and answer false.
the given questions: - d. Assertion (A) is false and Reason (R) is
GDP growth is the central objective of true.
government budgetary policy. It is achieved in Assertion: Cigarettes and Whisky are
two ways: (i) by making public investment discouraged through heavy taxation.
expenditure, and (ii) by inducing private Reason: These are ‘socially useful goods'
investment expenditure (through tax rebates
2. In these questions, a statement of assertion
and subsidies).
followed by a statement of reason is given.
Allocation of Resources: Private enterprises will Choose the correct answer out of the
always desire to allocate resources to those following choices.
areas of production where profits are high.
a. Both Assertion (A) and Reason (R) are
However, it is possible that such areas of
true, (R) is correct explanation of (A).
production (like production of alcohol) may not
b. Both Assertion (A) and Reason (R) are
promote social welfare. Through its budgetary
true but (R) is not correct explanation of
policy, the government of a country directs the
(A).
allocation of resources in a manner such that
there is a balance between the goals of profit c. Assertion (A) is true and Reason (R) is
maximization and social welfare. Production of false.
goods which are injurious to health (like d. Assertion (A) is false and Reason (R) is
Cigarettes and Whisky) is discouraged through true.
heavy taxation. On the other hand, production of Assertion (A): GST is an indirect tax.
'socially useful goods' (like, 'Khadi') is Reason (R): because it is imposed on goods and
encouraged through subsidies. services.

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Answer Key
MCQ Answers- 6. When expected revenues exceed estimated
expenditures in a given year, the result is a
1. (d) Wealth tax and income tax
surplus budget.
2. (c) Borrowings by the government represent a
7. Defense expenditure and interest on payments
situation of fiscal deficit.
are two examples of such expenditures.
3. (a) Recovery of loans
8. Tax revenue and non-tax revenue are the two
4. (b) other than interest
types of revenue received.
5. (c) Borrowings
6. (c) Custom duty Short Answers-
7. (c) Non-tax revenue receipts 1. Direct taxes are those that are imposed
8. (b) Fiscal deficit immediately on a person's property or income.
The public pays these taxes directly to the
9. (c) Dividends
government. Income tax, wealth tax, corporate
10. (d) Fiscal deficit is equal to interest payment tax, and other taxes are examples.
11. (d) The income earners Indirect taxes are levied on people's income and
12. (a) April I to March 31 assets as a result of their consumer spending.
13. (d) All the above These taxes are imposed on one individual, but
14. (c) Both (a) and (b) they are paid by another. Customs duties, excise
duties, sales tax, service tax, and other taxes are
15. (c) Both (a) and (b)
examples.
Very Short Answers- 2. The following are the three major methods in
1. The budget is a statement of the government's which the government spends money:
expected receipts and expenditures for the fiscal 1. Revenue and capital expenditures are the
year. A fiscal year in a country (most notably first two items on the list.
India) goes from April 1 to March 31. 2. Planned and unplanned expenses
2. Direct and indirect taxes are the two most 3. Expenditures for development and non-
common types of taxes. developmental purposes.
1. Income tax, interest tax, and wealth tax 3. The following are the four different types of
are all examples of direct taxes.
budget deficits:
2. Indirect taxes include items like customs
1. Budget deficit: The difference between
duties, excise duties, and sales taxes,
the state's total expenditure, current
among others.
revenue, and net internal and foreign
3. The primary items are: capital receipts is known as the budget
1. Market Loans raised by the government deficit. B.D = B.E. >B.R. is the formula for
from the general population. calculating it.
2. Government Borrowings. Where B.D = Budget deficit,
3. Loans from foreign governments and B.E = Budget expenditure, and
international financial institutions. B.R = Budget revenue.
4. Budget deficit, revenue deficit, primary deficit, 2. Fiscal deficit: The difference between the
and fiscal deficit are the four main types of government's total expenditure, revenue
deficits. revenues, and accrued capital receipts is
5. Economic services provided by railways and known as the fiscal deficit.
postal services, as well as grants to states and
F.D = B.E – B.R (B.E > B.R except for
union territories, are two examples.
borrowings) is the formula.

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Where F.D. stands for fiscal deficit, B.E. Long Answers-

stands for budget expenditure, and B.R. is 1. 1. Fiscal deficit = Total expenditure –
for budget receipts. Revenue receipts – Non debt receipts
3. Revenue deficit: The difference between = 3, 75,223 - 2,31,745-(15,164+12,000)
government revenue expenditures and = Rs. 1, 16,314 billion
revenue revenues is known as the 2. Revenue deficit = Revenue expenditure –
revenue deficit. Revenue receipts
R.D = R.E – R.R. = 3, 10,566-2, 31,745
Where R.D denotes revenue deficit, R.E = Rs. 78,821 billion
denotes revenue expenditure, and R.R 3. Primary deficit = Fiscal deficit – Interest
denotes revenue receipts. payments
4. Primary deficit: The fiscal deficit that is = 1, 16, 314-1, 12, 300
removed from interest payments is = Rs. 4014 billion
known as the primary deficit. 2. The overall difference between government
P.D = F.D. – I.P. is the formula receipts and spending is known as the
government budget balance, also known as
Where P.D = Primary deficit, general government balance, public budget
F.D = Fiscal deficit, and balance, or public fiscal balance. Simply said, a
I.P = Interest payment. balanced budget is one in which spending does
not exceed earnings. This term can be applied to
4. The key goals of the government budget are any budget, including that of a company, a non-
listed below. profit organisation, or even a family. The term is,
1. Activities to ensure resource however, most commonly linked with a
reallocation - The government must government budget. An effectively balanced
budget displays fiscal health by demonstrating
reallocate resources while taking social
that expenditure remains in line with costs.
and economic factors into account.
The following are the multiplier effects of a
2. Redistribution activities - To eliminate balanced budget:
inequities, the government redistributes
1. The balanced-budget multiplier is a
income and wealth. metric that estimates the change in
3. Stabilizing actions - The government aggregate production caused by a change
seeks to keep the economy stable by in government taxation on its own.
preventing business swings. 2. This multiplier comes in handy for
4. Management of public enterprises - analysing fiscal policy changes that
include both government purchases and
Through its public enterprises, the
taxes.
government engages in commercial
3. The multiplier for a balanced budget is
activities such as natural monopolies,
one. The "good" impact of a change in
heavy manufacturing, and so on.
government purchases on aggregate
5. The following are non-tax revenue receipts: production is large, although not entirely,
1. Postage payments, tolls, interest on funds countered by the "negative" impact of a
change in taxes.
borrowed from the government, credit
corporations, railways, and postal 4. The first injection's purchase of aggregate
production is the only element of the
department, as well as electrical services,
impact of the change in government
are all examples of commercial revenue.
purchases that is not compensated by the
2. Dividends and interest rise in taxes. As a result, the initial change
3. Fees, penalties, fines, and other in government purchases is equal to the
administrative revenue change in aggregate production.

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3. The budget is prepared by the government to provided indirect service to the entire
achieve specific objectives. The government's population. In today's public finance, taxes
economic, social, and political policies are account for a major portion of revenue. Taxation
directly responsible for these objectives. has a macroeconomic impact. The amount and
1. Resource reallocation: The style of consumption, the pattern of production,
government's budgetary policy attempts and the distribution of income and wealth can all
to reallocate resources in accordance be influenced by taxes.
with the country's economic i.e., profit Administrative Revenue: Public authorities
maximisation and social interests i.e., can raise funds through fees, fines and penalties,
public welfare. To stimulate investment, and specific assessments under public
the government might provide tax breaks, administration. Fees are levied by the
subsidies, and other incentives to government or public bodies in exchange for
producers. providing a service to the public. This includes
2. Reducing income and wealth court fees, passport fees, and so on. Similarly,
disparities: The government's fiscal license fees are levied by the regulating
policy strives to reduce income and authorities to confer authorization for anything,
wealth disparities. The government seeks such as a driving license price, an import license
to impact income distribution by fee, a liquor permit fee, and so on. As a form of
imposing taxes on the wealthy and punishment, lawbreakers are subjected to fines
spending more on the poor's welfare. and penalties, which are assessed and collected.
The major goal of these levies is to prevent the
3. Economic Growth: A country's growth
commission of crimes and violations of the
rate is determined by its savings and
country's laws, rather than to generate revenue.
investment rates. Budgetary policy tries
to achieve this by mobilising adequate 5. When a government's entire expenditures
resources for public sector investment. exceed its total revenue, excluding money
borrowed, it has a fiscal deficit. The deficit is
4. Reducing regional disparities: The
distinct from debt, which is the result of a series
government budget attempts to eliminate
of annual deficits. The fiscal deficit is said to be
regional inequalities by supporting the
the difference between the total revenue and
establishment of manufacturing units in
total spending of the government. It's a figure
economically underdeveloped regions
that sums up the government's total borrowing
through its taxes and expenditure
requirements. Borrowings are not taken into
policies.
account when calculating total revenue. The
5. Public Enterprise Management: There budget deficit in India for the fiscal year ended
are a big number of public sector March 2018 was 3.53 percent of GDP. In
industries that are developed and February, India raised its fiscal deficit target for
managed for the public's social welfare. the 2017-18 fiscal year from 3.2 percent to 3.5
The budget is created with the goal of percent of GDP. The government of the country
establishing various provisions for expects to reduce the deficit to 3.3% of GDP this
operating such businesses and giving fiscal year.
financial assistance.
The following are the consequences of a fiscal
4. The term "public income" or "public revenue" deficit:
refers to the government's total income from all
1. It denotes the government's borrowing
sources.
needs.
Tax Revenue: Taxes are mandatory
2. It also denotes the government's high
contributions placed on citizens by the
interest payments.
government to cover its general expenses for the
common good, with no commensurate benefits 3. It denotes a high level of inflation due to
to the taxpayer. A tax is levied to cover the high government spending.
government's public spending in the national 4. It suggests that the economy is becoming
interest. It is remuneration for a government- more reliant on overseas markets.

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Case Study Answer- 2. a) True

1. Answer: 3. c) Subsidies

1. b) Infrastructure development Assertion Reason Answer-

2. b) False 1. c) Assertion (A) is true and Reason (R) is false.
3. c) Retirement pension 1. a) Both Assertion (A) and Reason (R) are true,
2. Answer: (R) is correct explanation of (A).
1. c) Social welfare is high

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Balance of Payment 6
Open Economy
It is one that conducts business with other countries in a range of methods. The majority of modern economies are
open.
Balance of Payment (BOP): It is a record of all transactions that occurred between firms in a particular country
and the rest of the world over a certain time period, such as a quarter or a year.
Accounts of Balance of Payment:
Current Account: It is the record of goods and services traded as well as transfer payments. It encompasses a
country's most important activities, such as capital markets and services.
Two Components of the Current Account:
• Balance of Trade (BOT): It is the difference between the value of a country’s exports and imports of goods
over a specified timeframe. The export of products is recorded as a credit in the BOT, whereas the import
of goods is recorded as a debit. It is also referred to as the Trade Balance.
• Balance of Invisibles: The difference between a country’s exports and imports of invisible over a certain
time frame is known as the balance of invisible. Services, transfers, and income movements between
countries are all examples of invisible.

Capital Account:
All overseas asset transactions are recorded in the Capital Account. An asset is any type of wealth that may be held,
such as money, stocks, bonds, government debt, and so on. The purchase of assets is recorded as a debit item on
the capital account.

Components of Capital Account:

Investments:
• Direct Investment: Equity Capital, FDI, Reinvested Earning, and other Direct Capital Flows.
• Portfolio Investment: Offshore Funds, FII.
• External Borrowings: Includes Short-term Debt, External Commercial Borrowings.
• External Assistance: Multilateral and Bilateral Loans, Government Aid, Inter-governmental Aid.

Deficit of Balance of Payment Account:

• When a country has a balance of payments deficit, it imports more goods, capital, and services than it
exports. It must take from other countries in order to pay for its imports.
• A deficit in the balance of payment happens when total payment surpasses total receipts; ergo BOP = Credit
< Debit.
• A deficit of the balance of payment can be amended through an official reserve deal which signifies the sale
of foreign exchange by the Reserve Bank.

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Autonomous Transactions:
• When international economic transactions are made for reasons other than bridging the balance of
payments gap, they are referred to as autonomous transactions.
• One reason might be to make money. In the balance of payment, these items are referred to as “above the
line” items.
• This type of transactions are free of the condition of the balance of payment account.
• Autonomous items allude to those international economic exchanges, which happen because of some
economic intention, for example, profit maximization.

Accommodating Transactions:
• The gap in the balance of payments, or whether there is a deficit or surplus in the balance of payments,
determines accommodating transactions, also known as
• “Below the line” items. In other words, the net consequences of autonomous transactions determine them.
• Accommodating transactions are repaying capital exchanges that are intended to address the
disequilibrium in the balance of payments, i.e., the autonomous items.
• If the balance of payment has a surplus or deficit, accommodating transactions are carried out on purpose
to balance the balance of payment's surplus or deficit.

Errors and Omissions:

• It is difficult to keep accurate records of all international transactions. As a result, in addition to the current
and capital accounts, there is a third element of the balance of payment called errors and omissions, which
reflects this.
• The entries made under this head relate for the most part to leads and lags in the detailing of exchange
• It is a balancing entry that is expected to counterbalance the exaggerated or underestimated components.

Foreign Exchange Market:

• The foreign exchange market is the market where national currencies are exchanged for one another.
• Commercial banks, foreign exchange brokers, other authorized dealers, and monetary authorities are the
main participants in the foreign exchange market.
• The foreign exchange markets are the first and most established financial markets and remain the premise
whereupon the remainder of the financial edifice is built. It provides global liquidity, ideally with reasonable
stability.

Foreign Exchange Rate:

An exchange rate is the worth of a country's currency versus that of another nation or an economic zone, also
termed as Forex rate. Most of the trade rates are free-floating and will rise or fall based on market interest on the
lookout. A few monetary forms are not free-floating and have limitations. It connects different countries'
currencies and allows for cost and price comparisons across territorial boundaries.
• Demand for Foreign Exchange: People require foreign exchange because they want to buy goods and
services from other countries, send gifts abroad, and buy financial assets from a specific country. The
demand for foreign exchange falls as the flexible exchange rate rises and vice versa.
• Supply of Foreign Exchange: Foreign currency flows into the home country for the following reasons - a
country's exports lead to foreigners purchasing its domestic goods and services; foreigners send gifts or
make transfers, and foreigners purchase a home country’s assets. The foreign exchange supply has a
positive relationship with the foreign exchange rate. When the foreign exchange rate rises, so does the
supply of foreign exchange, and vice versa.

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Flexible Exchange Rate:

The market forces of demand and supply determine this exchange rate. It is also referred to as a floating exchange
rate.
• An increase in the exchange rate indicates that the price of foreign currency (dollar) in terms of domestic
currency (rupees) has risen. This is referred to as depreciation of the domestic currency (rupees) in terms
of foreign currency (dollars).
• Appreciation of the domestic currency (rupees) in terms of foreign currency (dollars) occurs when the price
of domestic currency (rupees) increases in relation to foreign currency (dollars) (dollars).

Merits of Flexible Exchange Rate:

• There is no need to keep foreign exchange reserves.
• As a result, the ‘balances of payments’ are automatically adjusted.
• To remove impediments to capital and trade transfers.
• Improves resource allocation efficiency.
• It eliminates the issue of currency undervaluation or overvaluation.
• It encourages foreign exchange-based venture capital.

Demerits of Flexible Exchange Rate:

• Future exchange rate fluctuations.
• Is a deterrent to international trade and investment.
• Promotes speculation.
• It contributes to market uncertainty.

Fixed Exchange Rate:

The government fixes the exchange rate at a specific level in this exchange rate system. The goal of a fixed exchange
rate system is to maintain the value of a currency within a narrow spectrum.
• Devaluation occurs in a fixed exchange rate system when a government action raises the exchange rate,
causing the domestic currency to become cheaper.
• In a fixed exchange rate system, a revaluation occurs when the government lowers the exchange rate,
making the domestic currency more expensive.

Merits of Fixed Exchange Rate:

• Exchange rate stability.
• There is no room for speculation.
• Encourages capital mobility and international trade.
• Attracts foreign investment.
• It forces the government to keep inflation under control.

Demerits of Fixed Exchange Rate:

• In relation to the balance of payments, there are no automatic adjustments i.e., it forestalls changes for
monetary standards that become under-or over-esteemed.
• Requiring a huge pool of reserves to help the currency of a country in the event that it goes under pressure.
• It could lead to currency undervaluation or overvaluation.
• It undercuts the goal of free markets.

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Determination of Equilibrium Foreign Exchange Rate:

The equilibrium foreign exchange rate is the rate at which demand and supply of foreign exchange are equitable.
It is determined by market forces, i.e., demand for and supply of foreign exchange, in a free market situation. The
demand for foreign exchange and the exchange rate has an inverse relationship. There is a direct relationship
between foreign exchange supply and exchange rate. Because of the aforementioned reasons, the demand curve is
sloped downward, and the supply curve is sloped upward. The equilibrium foreign exchange rate is determined
graphically by the intersection of the demand and supply curves.

Managed Floating:
It is a hybrid of a flexible exchange rate system, known as the float, and a fixed rate system, known as the managed
part. This exchange rate system enables a country's central bank to intervene on a regular basis in foreign
exchange markets to moderate exchange rate movements whenever such actions are deemed appropriate.

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Important Questions
Multiple Choice Questions: 7. When there is a favourable balance of trade?
1. Foreign exchange transactions which are (a) X>M
independent of other transactions in the Balance (b) X=M
of Payments Account are called: (c) X<M
(a) Current transactions
(d) None of these
(b) Capital transactions
8. The trade of visible and invisible items is known
(c) Autonomous transactions as ………………..
(d) Accommodating transactions (a) Balance of Payments
2. What is the cause of the devaluation of any (b) Balance of Trade
country’s currency?
(c) Deficit of interest
(a) Increase in the domestic inflation rate
(d) Profit
(b) Domestic real interest rates are less than
9. Other things remaining unchanged, when in a
foreign interest rates
country the price of foreign currency rises,
(c) Much increase in the income
national income is:
(d) All of these
(a) Likely to rise
3. The operation of daily nature in the foreign
(b) Likely to fall
exchange market is known as
(c) Likely to rise and fall both
(a) Spot market
(d) Not affected
(b) Forward market
10. Other things remaining the same, when in a
(c) Domestic market
country the market price of foreign currency
(d) International market falls, national income is likely:
4. The operation of future delivery in the foreign
(a) To rise
exchange market is known as
(b) To fall
(a) Spot market
(c) To rise or to fall
(b) Current market
(d) To remain affected
(c) Forward market
11. Which one is the king of the exchange rate?
(d) Domestic market
(a) Fixed Exchange Rate
5. Trade of visible items between the countries is
known as (b) Flexible Exchange Rate

(a) Balance of Payment (c) Both (a) and (b)

(b) Balance of Trade (d) None of the above

(c) Deficit Balance 12. Which of the following is true?

(d) All of these (a) Fixed exchange rate is determined by the

government
6. When the import and export of visible items are
eual, the situation is known as (b) Flexible exchange rate is determined by
market forces (demand and supply of
(a) Balance of Trade
foreign exchange)
(b) Balance of Payment
(c) Both (a) and (b)
(c) Trade Surplus
(d) None of the above
(d) Trade Deficit

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13. Which one is a kind of fixed exchange rate? Short Questions-

(a) Gold Standard System of Exchange Rate 1. Why does demand for foreign exchange rise
(b) Bretton Woods System of Exchange Rate when price falls?
(c) Both (a) and (b) 2. Give two examples and explain why there is a
(d) None of the above rise in demand for a foreign currency when its
price falls.
14. Which one is a merit of the fixed exchange rate?
3. Distinguish between fixed and flexible exchange
(a) Promotes Foreign Trade
rate.
(b) Induces Foreign Capital
4. Distinguish between autonomous and
(c) Increases Capital Formation accommodating transaction of balance of
(d) All the above payment account.
15. Which one is a demerit of the fixed exchange 5. What determines the flow of foreign exchange
rate? into the country?
(a) Ignores National Interests
Long Questions-
(b) Restricted Movement of Capital
1. Give the meaning of foreign exchange and
(c) Sudden Fluctuations in Exchange Rates
foreign exchange rate. Giving reason, explain the
(d) All the above relation between foreign exchange rate and
demand for foreign exchange.
Very Short Questions-
2. Explain the distinction between autonomous
1. What do you mean by Foreign exchange market?
and accommodating transactions in balance of
2. Define a flexible exchange rate. payments. Also explain the concept of balance of
3. What is meant by appreciation of currencies? payments deficit in this context.
4. What is the balance of visible items in the 3. Distinguish between balance of trade account
balance of payments account called? and current account balance of BOP account.
5. What is meant by managed floating?
6. When does a situation of deficit in BOP arise?

Answer Key

MCQ Answers- 13. (c) Both (a) and (b)

1. (c) Autonomous transactions 14. (d) All the above
2. (d) All of these 15. (d) All the above

3. (a) Spot market Very Short Answers-

4. (c) Forward market
1. The foreign exchange market is the marketplace
5. (b) Balance of Trade where international currencies are exchanged
6. (a) Balance of Trade for one another.
7. (a) X > M 2. The flexible exchange rate, also known as free
8. (a) Balance of Payments exchange rate is a rate which is governed by the
free play of demand and supply forces in a
9. (a) Likely to rise
foreign exchange market.
10. (b) To fall
3. Currency appreciation refers to an increase in
11. (b) Flexible Exchange Rate the exchange value of a currency as compared to
12. (c) Both (a) and (b)

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84 | Step Up Academy

the currency of another country. For example, if 3. The differences between between fixed and
earlier 1 was equal to Rs75, but later, the value flexible exchange rate are as follows:
of 1 moves from Rs 75 to Rs 72, In such a
Basis Fixed Flexible
situation, we can say that the value of rupee is Exchange Exchange
appreciating. Rate Rate
4. Balance of trade Meaning A fixed A market-
5. It is a system that allows exchange rate exchange rate determined
is one that is exchange rate
modifications based on a set of rules and
set and is referred to
regulations that are publicly published in the maintained by as a flexible
foreign exchange market. It is an effort to keep the central exchange rate.
the exchange rate within a specific limit. government.

6. When the payments in respect to the economic Controlled An apex bank The demand
by or monetary and supply
transactions of a country with the rest of the
authority forces govern
world surpasses its receipts, it is called a BOP controls a a flexible
deficit. fixed exchange rate.
exchange rate.
Hence, a BOP shortfall occurs when autonomous
receipts are fewer than autonomous payments. How it A fixed A flexible
affects exchange rate exchange rate
Short Answers- currency devalues and allows a
evaluates a currency's
1. When the price of foreign exchange falls, the currency. value to
exchange value of domestic currency rises while depreciate
the value of foreign currency declines. This and
appreciate.
indicates that foreign goods become less
expensive and domestic demand increases. Hedging If the country Hedging is
uses a fixed used to
Rising domestic demand for international goods
exchange rate, reduce
indicates increased need for foreign currency. As there is no currency risks
a result, there is a link between foreign exchange need for in a flexible
pricing and demand. hedging. exchange rate
environment.
For example, When the price of 1 US Dollar falls
from Rs 75 to Rs 70, It means that the imports 4. The difference between autonomous and
will rise, and domestic demand for US goods will accommodating transaction of balance of
increase as the US products will be cheaper to payment account is as follows:
purchase. Hence, a demand for the US dollar will
Basis Auto- Accommoda-
also rise.
nomous ting Items
2. The two examples are: Items
1. When the price of foreign exchange falls, Meaning Autonomou Transactions
the exchange value of domestic currency s items are that are done to
internationa cover a deficit
rises while the value of foreign currency
l economic or surplus in
falls, and foreign goods become cheaper transactions autonomous
in comparison to domestic goods. Rising that take transactions
domestic demand for foreign goods place for are referred to
some as
implies increased demand for foreign
economic accommodating
currency. reason, such items.
2. As the value of the foreign currency falls, as profit
maximizatio
tourists from the home country find it less
n.
expensive to travel abroad. As a result,
demand for foreign currency rises.

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Effects on Autonomou To keep the There are two approaches for determining
BOP s balance in the foreign exchange rates- one technique is based
account transactions BOP account, on the conventional gold standard mechanism,
are accommodating while the other is based on the classical paper
unaffected transactions
currency system. Because no standard monetary
by the state are carried out.
of the unit is currently exchanged for gold, the gold
payment standard mechanism no longer operates.
account's Foreign exchange demand is created when
balance. Indians and commercial firms desire to make
Current/c Autonomou Only capital payments to US nationals for purchasing US
apital s accounts are goods and services, make gifts to US individuals,
account transactions subject to or buy assets in the US. The greater the amount
occur on accommodating
of imports, the greater the demand for foreign
both the transactions.
current and currency.
capital Relation between foreign exchange rate and
accounts. demand for foreign exchange:
Alternate These are These are also • An inverse relationship exists between
Name also called called "below
the foreign exchange rate and the demand
"above the the line items,"
line items". for foreign exchange.
• The foreign currency demand curve is
5. The following variables contribute to the flow of always downward sloping, indicating an
foreign exchange into the country: inverse relationship between demand
• Foreigners purchasing domestic goods, in and exchange rate.
terms of exports. • When the exchange rate rises, more units
• Foreigners buying the assets of the home of domestic currency are required to be
country. paid for the same unit of foreign money.
• In-country foreign direct investment and This raises the cost of import. As a result,
portfolio investment. imports reduce, causing a drop in demand
for foreign exchange.
• Foreign exchange speculative buying, that
will lead to inflow of the foreign exchange. • In the figure given below, the demand for
foreign currency is represented by the DD
• Foreign tourists visiting various locations
curve. When the exchange rate reaches
in India.
R1, the demand for foreign money
Long Answers- decreases to Q1. And, when the exchange
1. Foreign Exchange: It refers to the amount of rate falls to R2, the demand for foreign
foreign currency held in relation to the amount currency rises to Q2
of domestic currency. Foreign exchange is (Image will be uploaded soon)
important in international transactions. All 2. The distinction between autonomous and
currencies other than the Indian rupee are accommodating transactions in balance of
considered as foreign exchange in India. payments are as follows:
Foreign Exchange Rate: The rate at which one
Basis Auto-nomous Accommoda-
currency is exchanged for another is referred to
Transac-tions ting Transac-
as the foreign exchange rate. As a result, an tions
exchange rate can be defined as the cost of one
Meaning Autonomous Accommodatin
currency in terms of another. The exchange rate
items are g Items refers
is often expressed in terms of rupees per unit of international to transactions
foreign currency. As a result, an exchange rate economic which are
represents the external purchasing power of transactions those that are
money. that take place undertaken to

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for some cover a deficit country's economic growth. It's

economic or surplus in analogous to taking out a student loan to
reason, such as autonomous pay for college, as ultimately college will
profit transactions.
help in shaping the future of the student.
maximization.
3. The following are the differences between the
Effects Autonomous To keep the
on BOP transactions balance in the trade balance and the current account balance:
account are unaffected BOP account, Basis of Balance of Balance on
by the state of accommodatin differences Trade current
the payment g transactions amount
account's are carried
balance. out. Meaning It only covers It is the
objects that difference
Current Autonomous Only capital are visible. It between the
/capital transactions accounts are is the gap sum of
account occur on both subject to between the credit and
the current and accommodatin country's debit items
capital g transactions. exports and on the
accounts. imports. current
Alternat These are also These are also account.
e Name called "above called "below Coverage It does not It contains
the line items." the line items." keep track of the balance
any of visible
BOP deficit: transactions objects, the
• When a country's payments for involving balance of
invisible invisible
autonomous transactions exceed its items or items, and
receipts, the gap is referred to as the BOP transfers. the balance
deficit. It can be calculated as follows: of unilateral
transfer.
• Deficits in BOP occur when the receipts on
account of autonomous transactions are Concept It is a limited It is a broad
fewer than payments on account of concept that idea. The
accounts for current
autonomous transactions.
only a account
• If the home country's receipts are Rs. 500 portion of the balance
crore and payments are Rs. 600 crore, the payment includes the
account trade
BOP deficit will be calculated 600-500=
balance. balance.
100 Crore.
Financing of A trade Current-
• When a country has a balance of deficit deficit can be account
payments deficit, it imports more compensated deficits
products, services, and capital than it for by a cannot be
exports. current offset by
account balance-of-
• The country has to borrow from other surplus. trade
countries in order to pay for its imports.. surpluses.
• In the short run, this contributes to the

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