MACRO XII Subhash Dey All Chapters PPTs (Teaching Made Easier)

 What is Macroeconomics?
 Basic concepts in macroeconomics: consumption

goods, capital goods, final goods, intermediate
goods; stocks and flows; gross investment and
depreciation.
 Circular flow of income (two sector model);
Methods of calculating National Income - Value
Added or Product method, Expenditure method,
Income method.
 Aggregates related to National Income: Gross
National Product (GNP), Net National Product
(NNP), Gross Domestic Product
 (GDP) and Net Domestic Product (NDP) - at
market price, at factor cost; Real and Nominal
GDP.
 GDP and Welfare
What is Macroeconomics?
In macroeconomics, we study the economic behaviour
of the economy as a whole by focusing our attention on
aggregate measures such as total output, employment
and aggregate price level.
Here, we are interested in finding out how the levels of
these aggregate measures are determined and how the
levels of these aggregate measures change over time.
Some of the important questions that are studied in m-
acroeconomics are as follows:
• What is the level of total output in the economy?
• How is the total output determined?
• How does the total output grow over time?
• Are the resources of the economy (e.g. labour) fully
employed?
• What are the reasons behind the unemployment of
resources?
• Why do prices rise?
Thus, instead of studying the different markets as is d-
one in microeconomics, in macroeconomics, we try to
study the behaviour of aggregate or macro measures of
the performance of the economy.
1.1
Some Basic Concepts of
National Income Accounting
Final Goods and Intermediate Goods
Goods are classified as final goods and intermediate g-
oods on the basis of the end use of the goods.
Final Goods
If goods are purchased for consumption, i.e., for satisfa-
ction of wants, or for investment, these are called final
goods (or final products).
Expenditure on them is called final expenditure.
Examples:
(i) Machine purchased by a firm for installation in
factory is a final good because it is purchased for
investment.
(ii) Milk purchased by households is a final good as
it is purchased for consumption.
(iii) Furniture purchased by a school is a final prod-
uct because it is purchased for investment.
(iv) Computers installed in an office is a final prod-
uct because it is purchased for investment.
(v) Printer purchased by a lawyer for office use is a
final product because it is purchased for investment.
(vi) Blackboard used in a school is a final good beca-
use it is for investment. It is not used up com-
pletely in a year but remains for production of
educational services.
(vii) Second hand car purchased by a house hold is a
final good because it is purchased for consumption.
Intermediate Goods
Goods and services purchased by a production unit fr-
om other production units with the purpose of resel-
ling or with the purpose of using them completely du-
ring the same year are called intermediate goods (or
intermediate products).
 Top Tip
• Raw materials or non-factor inputs purchased for producing
goods are intermediate goods.
• Intermediate goods are also called ‘single use producer goo-
ds’.
• The expenditure on the intermediate goods is called interm-
ediate cost or intermediate consumption.
Examples:
(i) Steel sheets used for making automobiles and co-
pper used for making utensils are intermediate
goods since they are purchased with the purpose
of using them completely during the same year for
production of steel gates/utensils.
(ii) Mobile sets purchased by a mobile dealer are inter-
mediate products because these are purchased for
resale.
(iii) Chalks, dusters, etc. purchased by a school are int-
ermediate products because these are used up
completely during the same year in the production
of educational services.
(iv) Paper purchased by a publisher is an intermediate
product because it is used as raw material for prod-
uction of books in the same year.
(v) Purchase of rice by a grocery shop is an intermed-
iate product because it is purchased for resale.
(vi) Coal used by a manufacturing firm is an inter-
mediate product because it is used as a non-
factor input for production of other commodities
during the same year.
(vii) Fertilisers used by the farmers are intermediate
products because these are used up completely
for producing grains during the same year.
(viii) Cotton used by a spinning mill is an intermediate
product because it is used for further production
of clothes during the same year.
 Top Tip
National income includes the value of final goods only.
The value of intermediate goods is not included in the
national income estimates because it is already included
in the value of the final goods. Including intermediate g-
oods separately will inflate or overestimate the national
income.
Consumption Goods and Capital Goods
Final goods produced in an economy in a given period
of time are either in the form of consumption goods
(both durable and non-durable) or capital goods. As final
goods they do not undergo any further transformation at
the hands of any producer. Thus, of the final goods, we
can distinguish between consumption goods and capital
goods.
Consumption Goods
The final goods which are consumed (or used) for sat-
isfaction of wants by the consumers are called consump-
tion goods* or consumer goods, e.g., food, clothing, tele-
vision sets, etc.
 Those consumer goods like television sets, automo-
biles, home computers, etc. which are of durable
character are called consumer durables.
 Those consumer goods like food, clothing, etc. wh-
ich are extinguished by immediate or short period
consumption are known as consumer non-dura-
ble goods.
*This also includes services like recreation which are consumed but for convenience
we may refer to them as consumer goods.
Capital Goods
The final goods of durable character which are used in
the production of other goods and services are called
capital goods or investment goods, e.g., machines, too-
ls and equipments.
Capital goods are also called durable use producer
goods having a long span of life, say 5 years or 10
years.
 Top Tip
Basis of classification of final goods into consumption
goods and capital goods
The same good can be consumption good and also capital
good. It depends on the economic nature of its use. For
example, a machine purchased by a household is a consu-
mption good whereas, if it is purchased by a firm for use
in the business, then it is a capital good. Similarly, a car
purchased by a household is a consumption good where-
as if it is purchased by a firm for use in business, then it is
a capital good.
Stocks and Flows
Stocks
Stocks are economic variables measured at a given po-
int of time.
For example, Capital, Wealth, Money supply, Population,
Inventories, Foreign debts, Buildings and machines in
a factory, Balance in a bank account, etc. are stock
variables since they are measured at a particular point
of time.
Flows
Flows are economic variables measured over a period
of time.
National income or Gross domestic product (GDP) or
Production or Output, Sales, Savings, Expenditure, Pr-
ofits, Losses, Exports, Imports, Net capital formation
or net investment, Depreciation, Interest, Change in
inventories, Change in money supply, Value added, e-
tc. are flow variables since they are measured over a
period of time.
 Top Tip
An example to understand the difference between stock
variables and flow variables
Suppose a tank is being filled with water coming from a tap.
The amount of water which is flowing into the tank from the
tap per minute is a flow. But how much water there is in the
tank at a particular point of time is a stock concept.
Gross Investment and Depreciation
Investment
In economics, the term ‘investment’* is defined as
addition to the stock of fixed capital (such as machin-
es) and change in inventories during a year.
That part of final output which comprises of capital
goods constitutes gross investment of an economy. For
example, machines, tools and implements, buildings,
office spaces, store houses or infrastructure like roads,
bridges, airports or jetties, etc.
* The term ‘investment’ must not be confused with the commonplace notion of
investment which implies using money to buy physical or financial assets. Thus, use of
the term investment to denote purchase of shares or property or even having an
insurance policy has nothing to do with how economists define investment.
Depreciation
A part of the capital goods produced this year goes for
maintenance or replacement of existing capital goods
because the existing capital stock suffers wear and tear
and needs maintenance and replacement. This portion
of the capital goods produced is not an addition to the
stock of capital goods and its value needs to be subtr-
acted from gross investment to arrive at net investme-
nt. This deletion made from the value of gross invest-
ent in order to accommodate regular wear and tear of
capital, is called depreciation.
Depreciation is an annual allowance for normal wear
and tear and foreseen obsolescence of a fixed capital
asset.
New addition to capital stock in an economy is called
net investment (or net capital formation).
Thus, investment is defined as capital formation, a gross

or net addition to capital stock.
Let us examine the concept of depreciation a little more
in detail:
Example: Suppose a new machine is purchased for

`20 lakh having useful life of service 10 years, after
which it falls into disrepair and needs to be replaced.
Suppose, the scrap value of the machine will be nil
after 10 years.
Therefore, Depreciation on the machine
= lakh per year.
Thus, the machine is gradually used up in each year’s

production process and each year 1/10th of its original
value, i.e. `2 lakh gets depreciated. So, instead of
considering a bulk investment for replacement after 10
years, we consider an annual depreciation cost every
year.
Note that depreciation does not take into account
unexpected/unforeseen obsolescence or sudden
destruction or disuse of capital as can happen with
accidents, natural calamities or other such extraneous
circumstances. This is called ‘capital loss’.
 Top Tip
Depreciation is also defined as:
1. Consumption of fixed capital
2. Value of capital consumption
3. Current annual replacement cost of fixed capital assets
4. Annual replacement investment to keep the value of fixed
capital assets constant
5. Annual allowance for normal wear and tear and foreseen
obsolescence
6. Annual maintenance and replacement cost of existing cap-
ital goods
7. Regular wear and tear of capital
8. Part of capital stock used up in each year’s production pro-
cess
Industrial classification – Primary,
Secondary and Tertiary Sectors
Industrial classification means grouping production
units into distinct industrial groups, or sectors. This is
the first step required to betaken in estimating nation-
al income, irrespective of the method of estimation. It
is statistically more convenient to estimate national
income originating in a group of similar production
units rather than for each production unit separately.
It is now a matter of general practice to group all the
production units of a country into three broad groups
– primary sector, secondary sector and tertiary sectors.
Each of these sector can be further subdivided into
smaller groups depending upon the requirement. Let
us now explain each sector.
Primary Sector
Primary sector includes production units exploiting
natural resources like land, water, subsoil assets, etc.
Growing crops, catching fish, extracting minerals,
animal husbandry, forestry, etc. are some examples.
Primary means of first importance. It is primary beca-
use it is a source of basic raw materials for the second-
ary sector.
Secondary Sector
Secondary sector includes production units which are
engaged in transforming one physical good into another
physical good. Such an activity is called manufacturing
activity. These units convert raw materials into finished
goods. Factories, construction, power generation, water
supply, etc. are some examples.
It is called secondary because it is dependent upon the
primary sector for raw materials.
Tertiary Sector
Tertiary sector includes production units engaged in
producing services. Transport, trade education, hotels
and restaurant, finance, government administration,
etc. are some examples.
This sector finds third place because its growth is mai-
nly dependent on the primary and secondary sectors.
Indirect Tax and Subsidy
Indirect Tax
Indirect tax is a tax imposed by government on pro-
duction and sale of goods and services. It is a tax where
the payer and the bearer of the tax are different people.
Examples: Goods and services tax (GST),* excise tax,
customs duties (export duty and import duty), service
tax, sales tax etc.
Imposition of indirect taxes by the government incr-
eases the market prices of goods and services.
* In India, Goods and Services Tax (GST) has replaced various indirect taxes,
levied by the Central and State/UT Governments. Some of the major taxes that
were levied by Centre were Central Excise Duty, Service Tax, Central Sales Tax,
etc. The major State taxes were VAT/Sales Tax, Entry Tax, Luxury Tax, Octroi,
Entertainment Tax, etc. These have been subsumed in GST.
Subsidy
Subsidy is a from CBSE 2020 assistance given by the
government to the firms and households, with a mot-
ive of general welfare.
Examples: Cash grants, interest-free loan to the firms,
subsidy on price of cooking gas to the households, etc.
Subsidies granted by the government reduce the mark-
et prices of goods and services.
Market Price and Factor Cost
Market Price
Market prices are the prices as paid by the consumers.
Market prices also include indirect taxes.
Factor Cost
Factor cost refer to the prices of products as received
by the producers. In other words, factor cost is what is
actually available to production units for distribution
of income among the owners of factors of production.
Indirect taxes are deducted from and subsidies are
added to market price to calculate what production
units actually receive.
OR, Factor Income and Transfer Income

Factor Income and Transfer Income
Factor Income
The payment for the services rendered to the production
units by the owners of factors of production is called fa-
ctor payment or factor income. Examples: Wages and
salary, rent, interest profit, etc.
Transfer Income
Any payment for which no service is rendered is called
a transfer payment or transfer income. It does not inv-
olve any production of goods and services.
Examples: Gifts, donations, charity, etc.
 Top Tip
National income includes only factor payments which are rec-
eived in return for the factor services provided in production
of goods and services.
On the other hand, transfer payment is not included in na-
tional income. This is because national income is a measure of
the value of production activity of a country, whereas transfer
payment does not involve any production activity.
Inventory and Change in Inventories
Inventory
The stock of unsold finished goods, or semi-finished
goods, or raw materials which a firm carries from one
year to the next is called inventory.
Inventory is measured at a given point of time, e.g. va-
lue of inventory in the beginning of the year or value
of inventory at the end of the year. So, it is a stock var-
iable.
Change in Inventories
Change in inventories equals closing inventory minus
opening inventory.
Change in inventories (or stock) takes place over a

period of time. Therefore, it is a flow variable.
 Top Tip
Inventory is treated as capital. So, it is a stock variable. On the
other hand, change in the inventory of a firm is treated as
investment, i.e., addition to the stock of capital of a firm. So, it
is a flow variable.
Net product taxes and Net production
taxes
Net product taxes
Product taxes and subsidies are paid or received per
unit of product, e.g., excise tax, service tax, export and
import duties, etc.
Net production taxes
Production taxes and subsidies are paid or received in
relation to production and are independent of the
volume of production, e.g. land revenues, stamp and
registration fee.
 Top Tip
• Market prices include both Net Product taxes and Net
Production taxes.
• Basic prices include net production taxes but not net
product taxes.
• Factor cost includes only the payment to factors of
production, it does not include any tax.
Key Terms
Final goods—Goods purchased for final consumption, i.e., for
satisfaction of wants, or final investment.
Intermediate goods—Goods purchased by a production unit from
other production units with the purpose of reselling or with the
purpose of using them completely during the same year.
Consumption goods—The final goods which are consumed (or
used) for satisfaction of wants by the consumers.
Capital goods—The final goods of durable character which are
used in the production of other goods and services.
Stocks—Economic variables measured at a given point of time,
e.g. capital, wealth, etc.
Flows—Economic variables measured over a period of time, e.g.
income, output, etc.
Gross investment—That part of final output which comprises of
capital goods such as machines.
Depreciation—An annual allowance for normal wear and tear and
foreseen obsolescence of a fixed capital asset.
Net investment—New addition to capital stock in an economy is
called net investment or net capital formation.
RECAP
Macroeconomics
In macroeconomics, we study the economic behaviour of the
economy as a whole, e.g. aggregate demand, aggregate supply,
levels of income, employment and price in the economy.
Final Goods and Intermediate Goods
Goods are classified as final goods and intermediate goods on
the basis of the end use.
Final goods are the goods which are used for final
consumption (i.e., for satisfaction of wants) or for
investment.
Examples: (i) Machine purchased by a firm for installation in
factory, (ii) Milk or bread purchased by households, (iii)
Printer purchased by a lawyer for office use, etc.
Intermediate goods (or single use producer goods) are the
goods which are purchased during the year by a firm from
another for the purpose of further production or resale.
Examples: (i) Raw materials such as steel sheets used for
making automobiles and copper used for making utensils,
(ii) Mobile sets purchased by a mobile dealer, (iii) Chalks,
dusters, etc. purchased by a school, (iv) Paper purchased by
a publisher, (v) Purchase of rice by a grocery shop, (vi)
Fertilisers used by the farmers, etc.
Consumption Goods and Capital Goods
Consumption goods (or consumer goods) are that part of
the final goods which are consumed (or used) for
satisfaction of wants by the consumers, e.g., food, clothing,
TV sets, refrigerators, etc.
Capital goods (or investment goods or durable use
producer goods) are that part of the final goods which are
bought not for meeting immediate needs of the consumers
but are for producing other goods, e.g., machines and
equipments. They are of durable character.
Stocks and Flows
Stocks are economic variables which can be measured at a
given point of time, e.g. Capital, Wealth, Money supply,
Inventories, Buildings and machines in a factory, Balance in
a bank account, etc.
Flows are economic variables which can be measured over a
period of time, e.g, National income or GDP or Production
or Output, Sales, Savings, Expenditure, Profits, Losses,
Exports, Imports, Gross/Net capital formation or Gross/Net
Investment, Depreciation, Interest, Change in inventories,
Change in money supply or money creation, Value addition,
etc.
Gross Investment and Depreciation
Gross investment (or gross capital formation) refers to the
addition to capital stock of an economy during an
accounting year.
Depreciation is an annual allowance for normal wear and
tear and foreseen obsolescence of a fixed capital asset.
Depreciation is also defined as value of consumption of fixed
capital or annual maintenance and replacement cost of fixed
capital assets.
Depreciation on fixed capital asset =
Note: Unexpected/unforeseen obsolescence or sudden

destruction of capital assets is not depreciation. It is called
capital loss.
Net investment (or net capital formation) is the new
addition to capital stock in an economy. A part of the capital
goods produced goes for maintenance or replacement of
existing capital goods. Thus, Net Investment = Gross
investment – Depreciation.
Indirect Tax and Subsidy
Indirect tax is a tax imposed by government on production
and sale of goods and services. Examples: Goods and
services tax (GST), excise tax, etc. Indirect taxes increase
market prices of goods and services.
Subsidy is a form of financial/economic assistance given by
the government to the firms and households, with a motive
of general welfare. Examples: Cash grants, interest-free loan
to the firms, subsidy on price of cooking gas to the
households, etc. Subsidies reduce the market prices of goods
and services.
Net indirect tax = Indirect taxes – Subsidies
Market Price and Factor Cost
Market price is what the buyers pay. It includes indirect
taxes but excludes subsidies.
Factor cost is what is actually available to production units.
Factor cost = Market price – Indirect taxes + Subsidies
Factor Income and Transfer Income
The payment for the services rendered to the production
units by the owners of factors of production is called factor
payment or factor income, e.g. wages and salary, rent,
interest profit, etc.
Any payment for which no service is rendered is called a
transfer payment or transfer income. It does not involve
any production of goods and services. Examples: Gifts,
donations, charity, etc.
Inventory and Change in Inventories
The stock of unsold finished goods, or semi-finished goods,
or raw materials which a firm carries from one year to the
next is called inventory.
Net change (or increase) in inventories = Closing inve-
ntory – Opening inventory
NUMERICAL 1
Calculate ‘Depreciation on Capital Asset’ from the

following data:
(CBSE Sample Question Paper 2020) (4 marks)
S. No Particulars Amount (in `crore)
i. Capital value of the asset 1,000
ii. Estimated life of the asset 20 years
iii. Scrap Value Nil
Solution: Depreciation on capital asset

Do it yourself 1
Arrange the following coefficients of price elasticity of
demand in ascending order: (1 mark)
(–) 3·1, (–) 0·2, (–) 1·1
Solution of Do it yourself 1
Good X (units) Good Y (units) MRT

0 16 -
1 12 4Y:1X
2 8 4Y:1X
3 4 4Y:1X
4 0 4Y:1X
PPC will be a straight line since marginal rate of

transformation (MRT) is constant.
Question 1
The good or service purchased by an individual or an
enterprise is for : (Choose the correct alternative)
(a) Final use
(b) Use in further production
(c) Both (a) and (b)
(d) Consumption
Objective Type Questions 1.1

Answer 1

Question 2
A good that is meant for final use and will not pass
through any more stages of production or transformations
at the hands of any producer is called __________ .
(Fill in the blank)

Answer 2
a final good

Question 3
A final good may also undergo transformations.
True/False? Give reason.

Answer 3
True: Final goods may be transformed during their
consumption, e.g. the tea leaves purchased by the
consumers are used to make drinkable tea.

Question 4
It is not in the nature of the good but in the _______
that a good becomes a final good. (Fill in the blank)

Answer 4
economic nature of its use

Question 5
If tea leaves are used in a restaurant for tea brewing ,
and the drinkable tea is sold to the customers, then the
tea leaves will be________________.
(Choose the correct alternative)
(a) Final goods
(b) Intermediate good
(c) Consumption goods
(d) Capital goods

Answer 5

Question 6
Final goods are: (Choose the correct alternative)
(a) Consumption goods
(b) Capital goods
(d) Intermediate goods

Answer 6

Question 7
Goods of durable character which make production of
other commodities feasible but they themselves don’t
get transformed in the production process, are called
__________. (Fill in the blanks)

Answer 7
Consumption goods or consumer goods

Question 8
Goods like food and clothing and services like
recreation that are consumed when purchased by their
ultimate consumers are called ________________.
(Fill in the blank)

Answer 8
Capital goods

Question 9
The durable goods which undergo wear and tear with
gradual use, and thus are repaired or gradually replaced
over time are : (Choose the correct alternative)
(a) Intermediate goods
(b) Capital goods
(c) Consumer durables
(d) Both (b) and (c)

Answer 9

Question 10
All the final goods and services produced in an economy
in a given period of time are either in the form of
________________ or __________ .
(Fill in the blanks)

Answer 10
Consumption goods (both durable and non-durable);
Capital goods

Question 11
Of the total production taking place in the economy, a
large number of products don’t end up in final
consumption and are not capital goods either. These are
________________. (Fill in the blank)

Answer 11
Intermediate goods

Question 12
Raw materials or non-factor inputs used for production
of other commodities are:
(a) Capital goods
(b) Final goods
(c) Intermediate goods
(d) Consumer durables

Answer 12
(c) Intermediate goods

Question 13
Income, or output, or profits are concepts that make
sense only when a time period is specified. These are
called ___________. (Fill in the blank)

Answer 13
flows

Question 14
(i) ______________ (Stock / Flows) are defined over a
period of time, whereas (ii) ______________ (Stock /
Flows) are defined at a particular point of time.
(Choose the correct option)

Answer 14
(i) Flows (ii) Stocks

Question 15
Capital goods (e.g. buildings or machines in a factory) or
consumer durables (e.g. television sets, home computers, etc)
once produced do not wear out or get consumed in a
delineated time period. In fact, capital goods continue to
serve us through different cycles of production. There
can be addition to, or deduction from, these if a new
machine is added or a machine falls in disuse and is not
replaced. These are called ____________ . (Stock /
Flows) (Choose the correct option)

Answer 15
Stocks

Question 16
Change in stocks are _____________. (Stocks /
Flows). (Choose the correct option)

Answer 16
Flows

Question 17
Suppose a tank is being filled with water coming from a
tap. The amount of water which is flowing into the tank
from the tap per minute is a (i) _________________
(Stock concept / Flow concept). But how much water is
in the tank is a (ii) _________________ (Stock
concept / Flow concept). (Choose the correct option)

Answer 17
(i) Flow concept (ii) Stock concept

Question 18
The part of final goods that comprises of capital goods
constitutes ______________ of an economy.
(Fill in the blank)

Answer 18
Gross investment

Question 19
All the capital goods produced in a year do not
constitute net addition to the capital stock already
existing. True/False Give reason

Answer 19
True: Significant part of current output of capital
goods goes in maintaining or replacing part of the
existing stock of capital goods in an economy. This
is because the already existing capital stock suffers
wear and tear and needs maintenance and
replacement.

Question 20
A part of the capital goods produced this year goes for
replacement of existing capital goods and is not an
addition to the stock of capital goods already existing
and its value needs to be subtracted from gross
investment for arriving at the measure of net investment.
This deletion, which is made from the value of gross
investment in order to accommodate regular wear and
tear of capital is called __________ . (Fill in the blank)

Answer 20
Depreciation/Consumption of fixed capital

Question 21
New addition to capital stock in an economy is
________________.

Answer 21
Net investment/Net capital formation

Question 22
Which of the following does not explain the concept of
depreciation? (Choose the correct alternative)
(a) An annual allowance for wear and tear of a capital
good.
(b) Cost of the capital good (minus scrap value) divided
by number of years of its useful life.
(c) Unexpected or sudden destruction or disuse of
capital as can happen with accidents, natural
calamities etc.
(d) Maintenance and replacement cost of existing
capital goods.
Answer 22
(c) Unexpected or sudden destruction or disuse of
capital as can happen with accidents, natural
calamities etc.

Question 23
Depreciation is an accounting concept.

Answer 23
True: No real expenditure may have actually been
incurred each year yet depreciation is annually
provided for.

Question 24
Which of the following define ‘investment’ in Economics
? (Choose the correct alternative)
(a) Purchase of share or property.
(b) Having an insurance policy.
(c) Using money to buy physical or financial assets.
(d) Capital formation ,i.e. a gross or net addition to
capital stock.

Answer 24
(d) Capital formation ,i.e. a gross or net addition to
capital stock.

Question 25
In economics, investment implies using money to buy
physical or financial assets. True/False? Give reason.

Answer 25
False: In economics, ‘investment’ implies capital
formation, i.e. a gross or net addition to capital
stock/goods, e.g. machines, tools and
implements, buildings, office spaces, store
houses, or infrastructure like roads, bridges,
airports or jetties.

Question 26
Total final output produced in an economy in a given
year are used : (Choose the correct alternative)
(a) To substain the consumption of the entire
population of the economy.
(b) For maintenance and replacement of the existing
capital stock.
(c) For new addition to the capital stock.
(d) All of the above

Answer 26

Question 27
More capital goods would always mean more consumer
goods. True/False?

Answer 27
False

Question 28
_________ add to, or maintain, the capital stock of an
economy and thus make production of other
commodities possible. (Fill in the blank)

Answer 28
Capital goods

Question 29
Match the following:
Column I Column II
(i) Fertilisers or pesticides used (a) Intermediate goods
by a farmer to produce wheat
(ii) Bread produced by a baker (b) Final goods

for selling it to consumers or
restaurants

Answer 29
(i) - (a), (ii) - (a)

Question 30
Depreciation is also known as:
(a) Consumption of fixed capital
(b) Annual replacement cost
(c) Value of capital consumption

Answer 30

Question 31
Inventory is a stock variable. True/False? Give reason.

Answer 31
True: Inventory is measured at a particular point of
time. It may have a value at the beginning of the
year or it may have a value at the end of the
year.

Question 32
Change in inventories is a stock variable .

Answer 32
False: Change in inventories is a flow variable. It takes
place over a period of time (say one year).

Question 33
‘Exports’ is a flow variable. True/False? Give reason.

Answer 33
True: as exports are measured on an annual basis, i.e.
over a period of time.

Question 34
Which of the following is a flow concept?
(a) Foreign exchange reserves
(b) Inventory
(c) Capital
(d) Exports

Answer 34
(d) Exports

Question 35
Which of the following is a stock variable?
(a) Money supply
(b) Depreciation
(c) Interest
(d) Output

Answer 35
(a) Money supply

Question 36
Losses are classified as: (Choose the correct alternative)
(a) Stock variable
(b) Flow variable
(c) Either (a) or (b)
(d) Neither (a) nor (b)

Answer 36
(b) Flow variable

Question 37
Which of the following is not a flow?
(a) Capital
(b) Income
(c) Investment
(d) Depreciation

Answer 37
(a) Capital

Question 38
Which of the following is a stock?
(a) Wealth
(b) Saving
(c) Exports
(d) Profits

Answer 38
(a) Wealth

Question 39
Which of the following is a flow?
(a) Deposits in a bank
(b) Capital
(c) Depreciation
(d) Wealth

Answer 39
(c) Depreciation

Question 40
Which one of the following is an intermediate product?
(a) Purchase of pulses by consumers
(b) Machine purchased by a firm
(c) Wheat used by a flour mill
(d) Wheat used by households

Answer 40
(c) Wheat used by a flour mill

Question 41
Which of the following is an example of an intermediate
good? (Choose the correct alternative)
(a) Copper purchased for making utensils
(b) Steel and cement used to construct a flyover
(c) Fertilizers purchased by a farmer
(d) All of these

Answer 41
(d) All of these

Question 42
Depreciation of fixed capital assets refers to:
(a) Normal wear and tear
(b) Foreseen obsolescence
(c) Normal wear and tear and foreseen obsolescence
(d) Unforeseen obsolescence

Answer 42
(c) Normal wear and tear and foreseen obsolescence

Question 43
Unforeseen obsolescence of fixed capital assets during
production is: (Choose the correct alternative)
(a) Consumption of fixed capital
(b) Capital loss
(c) Income loss
(d) None of the above

Answer 43
(b) Capital loss

Question 44
Refrigerator purchased by a confectionery shop is an
example of: (Choose the correct alternative)
(a) Final good
(c) Capital good
(d) Both (a) and (c)

Answer 44
(d) Both (a) and (c)

Question 45
Which of the following is an example of consumer non-
durable good? (Choose the correct alternative)
(a) Milk
(b) Bread
(d) Clothes

Answer 45

Question 46
Addition to the capital stock of an economy is termed
as: (Choose the correct alternative)
(a) Investment
(b) Capital loss
(c) Consumption of fixed capital
(d) All of these

Answer 46
(a) Investment

Question 47
Goods purchased for the following purpose are final
goods : (Choose the correct alternative)
(a) For satisfaction of wants
(b) For investment in firm
(d) None of these

Answer 47

Question 48
(i) Profits (a) Stock variable
(ii) Savings (b) Flow variable
(iii) Balance in a bank account
(iv) Gross Domestic Product (GDP)

Answer 48
(i) – (b), (ii) – (b), (ii) – (a), (iv) – (b)

Question 49
State giving reason whether the following statement is
True or False:
Capital formation is a flow concept.

Answer 49
True: Capital formation is measured over a period of
time.

Question 50
True or False:
Bread is always a consumer good.

Answer 50
False: It depends on the economic use of bread. When
it is purchased by a household, it is a consumer
good. If it is purchased by restaurant, it is a
producer (intermediate) good.

Question 51
True or False:
Savings are a stock.

Answer 51
False: It is a flow variable as it is measured over a
period of time.

Question 52
True or False:
Butter is only a final product.

Answer 52
False: It will be an intermediate product if it is for
resale or used by a restaurant for preparing
meals.

Question 53
True or False:
National income of a country is a stock variable.

Answer 53
False: National income is flow variable since it is
measured over a period of time.

Question 54
True or False:
Capital goods are used up to produce other goods.

Answer 54
False: Capital goods like machines make production of
other goods feasible, but they themselves don’t
get transformed in the production process, i.e.,
they are not used up to produce other goods.

Question 1
'Machine purchased is always a final good.' Do you agree
with the given statement? Give reasons. (3 marks)
HOTs 1.1— Analysing, Evaluating & Creating Type Questions

Answer 1
The given statement is not correct. Whether ‘machine’
is a final good or not depends on how it is being used.
• If the machine is bought by a household, then it is a
final good because it is used for final consumption.
• If the machine is bought by a firm for its own use,
then also it is a final good because it is used for
investment.
• If the machine is bought by a firm for re-sale, then it
is an intermediate good.

Question 2
Which of the following is a stock variable and which is a
flow variable? Give reasons. (3 marks)
(a) Inventory
(b) Change in inventory

Answer 2
(a) Inventory is a stock variable because it is measured
at a particular point of time, i.e., at the beginning or
end of the year.
Inventories are treated as capital and hence it is a
stock variable.
(b) Change in inventory (closing inventory – opening
inventory) is a flow variable because it takes place
over a period of time.
Change in the inventory of a firm is treated as
investment, i.e., addition to the stock of capital of a
firm. So, it is a flow variable.
Question 3
Distinguish between stock and flow. Between net
investment and capital which is a stock and which is a
flow? Compare net investment and capital with flow of
water into a tank. (NCERT) (3 marks)

Answer 3
Stocks are defined at a particular point of time; whereas
flows are defined over a period of time.
Capital is a stock variable as it is measured on a particular
day, i.e., at the beginning of the year or at the end of the
year. On the other hand, net investment, i.e., net addition
to the stock of capital is a flow variable as it takes place
over a period o For example, suppose a tank is being filled
with water coming from a tap. The amount of water
which is flowing into the tank from the tap per minute is a
flow. On the other hand, how much water there is in the
tank at a particular point of time is a stock.
Question 4
Which among the following are final goods and which
are intermediate goods ? Give reasons.
(a) Milk purchased by a tea stall
(b) Bus purchased by a school
(CBSE 2018) (3 marks)

Answer 4
(a) Intermediate good
Reason: Since it is used up completely in the
production process (making tea) in the same year.
(b) Final good
Reason: Since it is for final investment.

Question 5
Which of the following products are intermediate
products and final products? Give reasons. (3 marks)
(i) Wheat and rice purchased by households
(ii) Purchase of ticket for train journey by an individual
(iii) Purchase of a car by an employer for office use by
his employees

Answer 5
(i) Final products; because these are used for
consumption.
(ii) Final product; because it is a final consumption
expenditure.
(iii) Final product; because it is a final investment
expenditure.

1.2
Domestic Territory and
Resident: Implications
Domestic territory (or Economic territory)
The first thing to note is that economic territory of a
country is not simply political frontiers of that country.
The two may have common elements, but still they are
conceptually different. Let us first see how it is defined.
According to the United Nations:
Economic territory (or Domestic territory) is the geographical
territory administered by a government within which pers-
ons, goods and capital circulate freely.
The above definition is based on the criterion "freedom of
circulation of persons, goods and capital."The above
definition is based on the criterion "freedom of circulation
of persons, goods and capital." Clearly, those parts of the
political frontiers 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.
Based on the criterion ‘freedom of circulation of persons,
goods and capital’, the scope of domestic territory is defined
to cover:
1. Political frontiers or geographical boundaries
including territorialwatersand airspace.
For example:
(i) Branch of an American Bank in India is included in
the domestic territory of India because it is located
within the geographical boundaries of India.
(ii) Office of Tata Industries in America is not included in
the domestic territory of India because it is outside the
geographical boundaries of India.
2. Embassies, consulates, military bases, etc.
located abroad.
For example:
(i) Indian embassy in Japan is a part of the domestic
territory of India.
(ii) Russian embassy in India is not a part of the domestic
territory of India. It is a part of domestic territory of
Russia.
3. Ships, aircrafts etc. operated by the residents
between two or more countries.
For example, aircrafts operated by Air India between
Russia and Japan are treated as a part of the domestic
territory of India.
4. Fishing vessels, oil and natural gas rigs, etc.
operated by the residents in the international
waters or other areas over which the country
enjoys the exclusive rights or jurisdiction.
For example, fishing vessels operated by Indian fishermen
in international waters of Indian Ocean are treated as a
part of the domestic territory of India.
Resident
A resident is defined as follows:
A resident, whether a person or an institution, is one
whose centre of economic interest lies in the domestic
territory of the country in which he lives.
The ‘centre of economic interest’ implies two things:
(i) the resident lives or is located within the
domestic territory, and
(ii) the resident carries out the basic economic a-
ctivities of earnings, spending and accumulation
from that location.
Examples:
(i) Indians working in the office of the United Nations
Organisation (UNO) in India are normal residents
of India since they live in India and their centre of
economic interest also lies in India.
(ii) Indians going abroad for medical treatment are
residents of India. Normally, visit for medical
treatment is a short period visit.
(iii) Foreign tourists who visit India for recreation,
holidays, medical treatment, study, sports,
conferences, etc. are not residents of India, e.g.
foreign tourists visiting India to see the Taj Mahal.
Normally, visit to see historical monuments like
Taj Mahal is a short period visit.
(iv) Indian officials working in the Indian Embassy in
USA are not residents of India because although
they are living within the domestic territory of
India but they do not carry out the basic economic
activities of earnings, spending and accumulation in
India. activities of earnings, spending and accumu-
lation in India.
(v) Americans working in Indian embassy in America
are not residents of India, but residents of America
because they live in America.
 Top Tip
Resident versus Citizen
Note that citizen and resident are two different terms. This
does not mean that a citizen is not a resident, and a resident
not a citizen. A person can be a citizen as well as a resident,
but it is not necessary that a citizen of a country is necessarily
the resident of that country. A person can be a citizen of one
country and at the same time a resident of another country.
For example a NRI, Non-resident Indian. A NRI is citizen of
India but a resident of the country in which he lives.
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. On the other hand, residentship is
basically an economic concept based on the basic economic
activities performed by a person.
Implications of the Concepts of Econo-
mic Territory and Resident
National income and related aggregates are basically
measures of production activity. There are two catego-
ries of national income aggregates: domestic income
and national income, or domestic product and nat-
ional product.
Domestic product
Domestic product includes production activity of the
production units located in the economic territory
irrespective of whether carried out by the residents or
non-residents.
Gross Domestic Product (GDP), Net Domestic Product
(NDP) are some examples.
Illustrative example:
How will you treat the following while estimating domestic
product (or domestic factor income) of India?
(i) Rent received by an Indian resident from his
property in Singapore
(ii) Salaries received by Indian residents working in
Russian embassy in India
(iii) Profits earned by a foreign company or a foreign bank in
India
(iv) Salaries paid to Koreans working in Indian embassy in
Korea
(v) Compensation of employees to the resident of Japan
working in Indian embassy in Japan
(vi) Profits earned by a branch of State Bank of India in Japan
Answer:
(i) No, it will not be included in domestic factor income
of India because this income is earned outside the
domestic territory (economic territory) of India. It is
factor income from abroad.
(ii) No, it will not be included in domestic factor income
of India because Russian embassy in India is not a
part of domestic territory of India. So, this income is
not earned within the domestic territory of India. It is
(iii) Yes, it will be included in domestic factor income of
India because the foreign company or the foreign
bank is located within the domestic territory of India.
So, it is an income earned within the domestic
territory of India.
(iv) Yes, it will be included in domestic factor income
of India because this income is earned within the
domestic territory of India. Indian embassy in
Korea is a part of the domestic territory of India.
(v) Yes, it will be included as it is part of Factor
Income earned in domestic territory of India,
though earned by non-resident.
(vi) No, as profits are not earned within the domestic
territory of India. It is factor income from abroad.
National product
National product includes production activities of resi-
dents irrespective of whether performed within the ec-
onomic territory or outside it.
Gross National Product (GNP), Net National Product
(NNP) are some examples.
Illustrative example:
Will the following be included in Gross National
Product (GNP)? Give reasons.
(i) Profits earned by a foreign company or a foreign
bank in India
(ii) Salary paid to Americans working in Indian
Embassy in America
(iii) Salaries received by Indian residents working in
Russian Embassy in India
(iv) Dividend received by an Indian from his investment in
shares of a foreign company
Answers:
(i) No, because it is a factor income earned by a non-
resident (a foreign company or a foreign bank) from its
contribution to production inside the domestic
territory of India, i.e., factor income paid to abroad.
(ii) No, because this factor income is paid to non-
residents, i.e., factor income to abroad.
(iii) Yes, because it is a factor income earned by Indian
residents outside the domestic territory of India i.e.,
(iv) Yes, because it is a factor income earned by a resident
from outside the domestic territory of India, i.e., factor
income from abroad.
 Top Tip
It can be realised that a factor income which is included in
domestic factor income of India may not be included in national
income. For example, profits earned by a branch of a foreign
bank in India will be included in the domestic factor income of
India because these profits are earned within the domestic
territory of India. However, it will not be included in national
income of India as it is a factor income paid to abroad. (Foreign
Bank is not a resident of India.)
Similarly, an income which is included in national income may not be
included in the domestic factor income. For example, salaries received
by Indian residents working in Russian Embassy in India will be included
in the national income as it is residents’ contribution to production,
though outside the domestic territory of India. However, it will not be
included in domestic income since this income is earned outside the
domestic territory of the country i.e. factor income from abroad.
Relation between national product and
domestic product
The concept of domestic product is based on the
production units located within economic territory,
operated both by residents and non-residents.
The concept of national product is based on residents, and
includes their contribution to production both within and
outside the economic territory.
Normally, in practical estimates, domestic product is
estimated first. National product is then derived from the
domestic product by making certain adjustments. Let us
see how?
National product is derived in the following way:
National product = Domestic product
+Residents' contribution to production outside the
economic territory
–Non-residents' contribution to production inside the
economic territory
In practical estimates, the residents' contribution outside
the economic territory is called "factor income received
from abroad" and the non-residents' contribution inside
the economic territory is called "factor income paid
to abroad". Therefore:
National product = Domestic product
+ Factor income received from
abroad
– Factor income paid to abroad
 'Factor income received from abroad' is added to
domestic product because this contribution of resi-
dents is in addition to their contribution to domestic
product.
 'Factor income paid to abroad' is subtracted because
this part of domestic product, does not belong to
the residents.
By subtracting "factor income paid to abroad" from
"factor income received from abroad", we get a net
figure
"Net factor income from abroad" popularly
abbreviated as NFIA.
Net factor income from abroad
It is the excess of factor incomes (rent, wages, interest,
profit) earned from abroad over factor incomes (rent,
wages, interest, profit) paid to abroad.
NFIA can be positive, negative or zero.
1. Positive NFIA: NFIA is positive when factor income
from abroad is more than factor income paid to
abroad.
Note that if NFIA is positive, national product (or
national income) will be greater than domestic product
(or domestic income).
2. Negative NFIA: NFIA is negative when factor income
from abroad is less than factor income paid to abroad.
If NFIA is negative, national income will be less than
domestic income.
3. Zero NFIA: NFIA is zero when factor income from
abroad is equal to factor income paid to abroad.
If NFIA is zero, national product (or national income)
will be equal to domestic product (or domestic
income).
It is important to note that ‘Net factor income paid
to abroad’ is opposite/negative of NFIA. If Net factor
income to abroad = `100 crore, then NFIA = (–) `` 100
crore.
 Top Tip
Calculation of NFIA in different cases: Calculation of NFIA in
different cases:
1. If factor income from abroad = `1000 crore and factor
income to abroad = `800 crore, then
NFIA = 1000 – 800 = `200 crore
2. If factor income from abroad = `700 crore and factor
income to abroad = ` 1100 crore, then
NFIA = 700 – 1100 = (–) ` 400 crore
3. If factor income to abroad = `200 crore and factor income
from abroad is not given, then we assume that factor
income from abroad is zero. Therefore, NFIA = 0 – 200 = (–
) ` 200 crore
4. If factor income to abroad = (–) `300 crore and
from abroad is not given, then we assume that factor
income from abroad is zero. Therefore, NFIA = 0 – (–)300
= `300 crore
5. If factor income from abroad = (–) `50 crore and factor
income to abroad is not given, then we assume that factor
income to abroad is zero. Therefore, NFIA = –50 – 0 = (–) `
50 crore5. If factor income from abroad = (–) `50 crore
and factor income to abroad is not given, then we assume
that factor income to abroad is zero. Therefore, NFIA = –
50 – 0 = (–) ` 50 crore
Key Terms
Domestic territory (or economic territory)—The geographical
territory administered by a government within which persons,
goods and capital circulate freely. Domestic territory (or economic
territory)—The geographical territory administered by a
government within which persons, goods and capital circulate
freely.
Resident—A person or an institution whose centre of economic
interest lies in the domestic territory of the country in which he
lives.
Domestic product—It includes production activity of the
production units located in the economic territory irrespective of
whether carried out by the residents or non-residents.
National product—It includes production activities of residents
irrespective of whether performed within the economic territory
or outside it.
Factor income received from abroad—Resident’s contribution
to production outside the economic territory of the country.
Factor income paid to abroad—Non-resident’s contribution to
production inside the economic territory.
Net factor income from abroad (NFIA)—Difference between
factor income from abroad and factor income to abroad.
RECAP
Domestic territory (or Economic territory)

Domestic territory (or Economic territory) is the geographical
territory administered by a government within which
persons, goods and capital circulate freely. For example, (i)
Branch of an American Bank in India, (ii) Embassies located
abroad, e.g. Indian embassy in America, etc. are included in
the domestic territory of India.
Resident
Resident is a person or an institution whose centre of
economic interest lies in the domestic territory of the country
in which he lives, for example, Indian officials working in the
Indian Embassy in USA, etc. are normal residents of India.
Implications of the Concepts of Domestic territory
and Resident.
Domestic product includes production activity of the
units located in the domestic territory of the country
irrespective of whether carried out by the residents or non-
residents, for example, (i) Profits earned by a foreign
company or a foreign bank in India (ii) Salaries paid to Koreans
working in Indian embassy in Korea (iii) Compensation of
employees to the residents of Japan working in Indian embassy in
Japan are included in domestic product as it is a factor income
earned in domestic territory of the country.
National product includes production activity of residents
only irrespective of whether performed within the domestic
territory of the country or outside it, for example, (i) Salaries
received by Indian residents working in Russian Embassy in
India (ii) Dividend received by an Indian from his
investment in shares of a foreign company are included in
national product as it is a factor income earned by Indian
residents from abroad.
Net factor Income from Abroad (NFIA)
Net Factor Income from Abroad is the difference between
factor income earned from abroad and factor income paid to
abroad. (NFIA = Factor income from abroad – Factor income
to abroad)
In other words, NFIA = Residents’ contribution to
production outside the domestic territory – Non-residents’
contribution to production inside the economic territory.
NFIA is negative when factor income from abroad is less
than factor income paid to abroad (i.e., Net factor income
paid to abroad).
Relation between Domestic Product and National
Product
National product = Domestic Product + Factor income
received from abroad – Factor income paid to abroad
• Factor income received from abroad is added to domestic
product to calculate national product because this contr-
ibution of residents is in addition to their contribution to
domestic product.
• Factor income paid to abroad is subtracted because this
part of domestic product does not belong to the reside-
nts.
Question 1
Which of the following is within the domestic territory of
India? (Choose the correct alternative)
(a) State Bank of India in UK
(b) Google office in India
(c) Office of Tata Motors in USA
(d) Russian Embassy in India

Answer 1
(b) Google office in India

Question 2
Foreign embassies in India are a part of India’s :
(a) Economic territory
(b) Geographical territory

Answer 2
 (b) Geographical territory

Question 3
Out of the following, who are residents of India?
(a) Indians working permanently in the office of the
United Nations Organisation in New York
(b) Indians working in Indian Embassy in America
(c) Indians working in a branch of an American Bank in
India
(d) Americans working in India embassy in America

Answer 3
(c) Indians working in a branch of an American Bank in
India

Question 4
Which of the following will be included in gross national
product of India? (Choose the correct alternative)
(a) Profits earned by a foreign company in India
(b) Salary paid to Americans working in Indian Embassy
in America
(c) Salaries received by Indians working in Russian
Embassy in India
(d) Salaries received by Indians working in Indian
Embassy in Korea

Answer 4
(c) Salaries received by Indians working in Russian
Embassy in India

Question 5
National income is the sum of factor incomes accruing
to: (Choose the correct alternative)
(a) Nationals
(b) Economic territory
(c) Residents
(d) Both residents and non-residents

Answer 5
(c) Residents

Question 6
Which of the following will be included in Gross
Domestic Product (GDP) of India?
(a) Rent received by an Indian resident from his
property in Singapore
(b) Salaries received by Indian residents working in
Russian embassy in India
(c) Profits earned by a branch of State Bank of India in
Japan
(d) Profits earned by standard Chartered Bank in India
Answer 6
(d) Profits earned by standard Chartered Bank in India

Question 7
Factor income earned by the domestic factors of
production employed in the rest of the world – Factor
income earned by the factors of production of the rest
of the world employed in the domestic economy = ?
(a) Net exports
(b) Net factor income from abroad
(c) Net compensation of employers
(d) Net retained earnings

Answer 7
(b) Net factor income from abroad

Question 8
National income is always more than the domestic
income. True/False? Give reason.

Answer 8
False: National income can be less than domestic
income when net factor income from abroad
(NFIA) is negative. National income can also be
equal to domestic income if NFIA is zero.

Question 9
Wages earned by a citizen of India working in Saudi
Arabia will be included in GDP of India.

Answer 9
False: It will be included in Saudi Arabian GDP , not in
GDP of India as it is not earned within the domestic
territory of India.

Question 10
Profits earned by the Korean-owned Hyundai car
factory in India will be included in National income of
India. True/False?

Answer 10
False: It is a factor income paid to abroad. It will be
subtracted from the GDP of India to arrive at
the National income.

Question 11
GDP can be greater than GNP. True/False? Give reason.

Answer 11
True: GDP can be greater than GNP if factor income
paid to abroad is greater than factor income
received from abroad, i.e., when net factor
income from abroad (NFIA) is negative. True:
GDP can be greater than GNP if factor income
paid to abroad is greater than factor income
received from abroad, i.e., when net factor
income from abroad (NFIA) is negative.

Question 1
Will the following factor income be included in domestic
factor income of India? Give reasons.
(i) Compensation of employees to the resident of Japan
working in Indian embassy in Japan.
(ii) Rent received by an Indian resident from Russian
embassy in India.

Answer 1
(i) Yes, it will be included as it is part of factor income
earned in domestic territory of the country.
(ii) No, as rent received by Indian resident from
Russian embassy will be part of Factor Income
received from abroad as Russian Embassy is not
part of domestic territory of the country.

Question 2
How will you treat the following in the calculation of
Gross Domestic Product of India? Give reasons.
(i) Profits earned by a branch of foreign bank in India.
(ii) Salaries of Indian employees working in embassy of
Japan in India.
(iii) Salary of resident of Japan working in Indian
embassy in Japan. (3 marks)

Answer 2
(i) Yes, it will be included because profits are earned
within the domestic territory of India.
(ii) No, it will not be included because the embassy of
Japan is not a part of the domestic territory of
India.
(iii) Yes, it will be included because the Indian Embassy
is a part of the domestic territory of India.

Question 3
Will the following be included in domestic factor income
of India? Give reasons.
(i) Profits earned by a resident of India from his
company in Singapore.
(ii) Profits earned by a company in India which is owned
by a non-resident.
(iii) Profits earned by a branch of State Bank of India in
England. (3 marks)

Answer 3
(i) No, it will not be included as the company is located
outside the domestic territory of India.
(ii) Yes, it will be included as profits are earned within the
domestic territory of India.
(iii) No, it will not be included as State Bank of India is
located outside the domestic territory of India.

Question 4
Domestic Income of India? Give reasons.
(i) Compensation of employees to the residents of
Japan working in Indian embassy in Japan.
(ii) Rent paid by the embassy of Japan in India to a
resident Indian.
(iii) Salaries to Indian residents working in the Russian
embassy in India.
(iv) Profits earned by Indian employees working in the
US embassy in India. (4 marks)
Answer 4
(i) Yes, it will be included as the Indian embassy in Japan
is a part of the domestic territory of India.
(ii) No, it will not be included as the Japanese embassy is
not a part of the domestic territory of India.
(iii) No, it will not be included as the Russian embassy is
not a part of the domestic territory of India.
(iv) No, it will not be included as the US embassy is not a
part of the domestic territory of India.

1.3
Circular Flow of Income
(Two- Sector Model)
Circular flow of income refers to flow of income across
different sectors of an economy in a circular way.
In a closed economy* without a government, external
trade or any savings, there are only two sectors, namely,
households and firms.
Households are owners of factors of production. They
provide factor services (in the form of labour, capital,
land and entrepreneurship) to the firms (producing
units). Income is generated in production units in the
form of value of total final goods and services
produced in the economy.
Firms distribute the entire income generated to make
factor payments (in the form of wages and salaries,
interest, rent and profit). Thus, factor payments flow
from firms to households.
*Closed economy is one that does not trade with other nations in goods and
services, and in financial assets.
•Leakages refer to withdrawal of money from the circular flow of income. It is that
part of income, which does not pass through the circular flow. For example,
savings, taxes and imports are leakages from the circular flow of income.
In this simplified economy, there is only one way in
which the households may dispose off their earnings –
by spending their entire income to buy the goods and
services produced by the firms. Households do not save,
they do not pay taxes to the government – since there is
no government, and neither do they buy imported
goods since there is no external trade in this simple
economy. So, households buy goods and services from
firms for which they make payment to the firms. Thus,
consumption expenditure (i.e., spending on goods and
services) flows from households to the firms, making
the circular flow of income complete. Hence, circular
flow of income in a two sector economy is based on the
axiom that one’s expenditure is other’s income.
The entire income of the economy, therefore, comes
back to the producers in the form of sales revenue.
There is no leakage from the circular flow of income.
Note that the same amount of money is moving in a

circular way. Thus, national income can be calculated
by three methods, which give us the same value.
1. Production method: Product method measures
aggregate value of final goods and services
produced by all the firms in the economy during a
year (Annual flow at A).
2. Income method: Income distribution method
measures aggregate factor payments made in the
economy during a year (Annual flow at B).
3. Expenditure method: Expenditure method
measures the aggregate final expenditure on goods
and services in the economy during a year (Annual
flow at C).
 Top Tip
Nominal Flow and Real Flow
• Nominal Flow/Money Flow is the flow of factor payments
and payments for goods and services between households
and firms.
• Real Flow is the flow of factor services and the flow of
goods and services between households and firms.
RECAP
Circular flow of income in a two sector economy

In a two sector economy, households are owners of factors of
production. They provide factor services (in the form of
labour, capital, land and entrepreneurship) to the firms.
Firms produce goods and services and make factor payments
(in the form of wages and salaries, interest, rent and profit) to
the households. So, factor payments flow from firms to
households.
The factor income earned by the households will be used to
buy the goods and services produced by the firms, for which
they make payment to the firms. So, consumption
expenditure (i.e., spending on goods and services) flows from
households to the firms. Thus, aggregate final consumption
expenditure by the households in the economy is equal to the
aggregate factor income received by the households.
Hence, circular flow of income in a two sector economy is
based on the axiom that one’s expenditure is other’s income.
Question 1
Contribution made by factors of production Remuneration
(i) Human labour (a) Rent
(ii) Capital (b) Wage
(iii) Fixed natural resources (called ‘land’) (c) Interest
(iv) Entrepreneurship (d) Profit

Answer 1
(i) – (b) , (ii) – (c) (iii) – (a) (iv) – (d)

Question 2
In a two sector economy, in which of the following way
the households may dispose off their entire earning or
income? (Choose the correct alternative)
(a) Spending on the goods and services produced by
the domestic firms.
(b) Payment of taxes to the government.
(c) To buy imported goods.
(d) Savings

Answer 2
(a)Spending on the goods and services produced by the
domestic firms.

Question 3
The sum of final expenditure in the economy must be
equal to ___________________. (Fill in the blank)

Answer 3
Aggregate factor payments (i.e. wages and salaries , rent ,
interest and profits).

Question 4
In __________________ method we calculate the
aggregate value of all final goods and services produced
by all the firms within the domestic territory of the
country in a year. (Fill in the blank)

Answer 4
product or value added

Question 5
(a) Sum total of all factor payments (i) Product method
(b) Aggregate value of final goods and (ii) Income method
services produced by all the firms.
(c) Aggregate value of spending that the (iii) Expenditure
firms receive for the final goods and method
services which they produce.

Answer 5
(a) – (ii), (b) – (i), (c) – (iii)

Question 6
Flow of factor payments and payments for goods and
services between households and firms is called
______________ . (Fill in the blank)

Answer 6
Nominal flow/Money flow

Question 7
Looking at the demand side of the final goods and
services to calculate the GDP is referred to as the
__________ .
(Product method / Expenditure method / Income method)
(Choose the correct option)

Answer 7
Expenditure Method.

Question 1
"Circular flow of income in a two sector economy is
based on the axiom that one’s expenditure is other’s
income." Do you agree with the given statement? Support
your answer with valid reasons.

Answer 1
Yes, the given statement is correct. In a two sector
economy, the firms produce goods and services and
make factors payments to the households. The factor
income earned by the households will be used to buy
the goods and services which would be equal to
income of firms. The aggregate consumption
expenditure by the households in the economy is equal
to the aggregate expenditure on goods and services
produced by the firms in the economy (Income of the
producers).

1.4
Production Method of
Calculating National Income
In product method or value added method, we
calculate the aggregate annual value of goods and
services produced during a year. How to go about doing
this? Do we add up the value of all goods and services
produced by all the firms in an economy? The
following example will help us to understand.
Let us suppose that there are only two kinds of
producers in the economy – wheat producers (or the
farmers) and the bread makers (the bakers). The wheat
producers grow wheat and they do not need any input
other than human labour. They sell a part of the wheat
to the bakers. The bakers do not need any other raw
materials besides wheat to produce bread. Let us
suppose that in a year the total value of wheat that the
farmers have produced is `100. Out of this they have
sold `50 worth of wheat to the bakers. The bakers have
used this amount of wheat completely during the year
and have produced `200 worth of bread.
What is the value of total production in the economy?
If we follow the simple way of aggregating the values of
production of the sectors, we would add `200 (value of
production of the bakers) to `100 (value of production
of farmers). The result will be `300.
A little reflection will tell us that the value of aggregate
production is not `300. The farmers had produced `
100 worth of wheat for which it did not need assistance
of any inputs. Therefore, the entire `100 is rightfully
the contribution of the farmers. But the same is not
true for the bakers. The bakers had to buy `50 worth of
wheat to produce their bread. The `200 worth of bread
that they have produced is not entirely their own
contribution. To calculate the net contribution of the
bakers, we need to subtract the value of the wheat that
they have bought from the farmers. If we do not do this
we shall commit the mistake of ‘double counting’.
This is because `50 worth of wheat will be counted
twice. First, it will be counted as part of the output
produced by the farmers. Second time, it will be
counted as the imputed value of wheat in the bread
produced by the bakers.
Therefore, the net contribution made by the bakers is,
`200 – `50 = `150.
Hence, aggregate value of goods produced by this simple
economy is `100 (net contribution by the farmers) + `150
(net contribution by the bakers) = ` 250.
The term that is used to denote the net contribution
made by a firm is called its 'value added'. We know
that the raw materials that a firm buys from another
firm which are completely used up in the process of
production are called ‘intermediate goods’. Therefore:
The value added of a firm is distributed among its four factors

of production, namely, labour, capital, entrepreneurship and
land. Therefore wages, interest, profits and rents paid
out by the firm must add up to the value added of the
firm. Value added is a flow variable.
We can represent the example given above in terms of
the following Table.
Farmer Baker
Value of output 100 200
Intermediate consumption 0 50
Value added 100 200 – 50 =150
Problem of Double Counting
The problem of double counting arises when the value
of same goods and services are counted more than
once while estimating national income.
There are two approaches/methods to avoid the problem
of double counting:
(i) Take the value of final goods and services only
ignoring all intermediate products.
(ii) Take value added at different stages in production
process instead of total output.
Steps for calculation of national income
by product method
Step 1: Estimation of value of output produced by
each firm in all the sectors of the economy during
the year.
Value of output is the market value of goods and
services produced by a firm during an accounting year.
(a) If a firm had no initial unsold stock in the

beginning of the year:
Note: Sales = Output sold (in units) × Market price

Sales = Sale of goods and services to domestic
buyers + Exports of goods and services.
(b) If a firm had some unsold stock in the
beginning of the year:
or, Value of output = Sales + Closing stock – Opening

stock
Example: Suppose that a firm had an unsold stock
worth `100 at the beginning of the year. During the
year it produced ` 1000 worth of goods by using
raw materials and other inputs worth ` 400 and
managed to sell ` 800 worth of goods.
(i) Value of closing stock = Opening stock + Value of
output produced – Sales
= 100 + 1000 – 800 = `300
(ii) Change in stock = Closing stock – Opening
stock = 300 – 100 = `200
Or, change in stock = Value of output produced – Sales
- = 1000 – 800 = `200
(iii) Value of output produced = Sales + Change in
stock = 800 + 200 = `1000
Step 2: Calculation of Value Added/Value Addition
(VA) and Gross Domestic Product at market price
(GDPmp)
Value added/value addition is the difference between
value of output and intermediate consumption.
 Top Tip
Intermediate consumption = Purchase of raw materials etc. +
Imports of raw materials etc.
In our example of farmers and bakers, the Value Added

by farmers and bakers are their Gross Value Added at
market price (GVAmp).
Now, if we sum the GVAmp of all the firms in all the
sectors of the economy, we get Gross Domestic Product
at market price (GDPmp).
GDPmp is the money value of all final goods and

services produced within the domestic territory of a
country during an accounting year. All production done
by the national residents or the non-residents in the
domestic territory of the country gets included, regardless
of whether that production is owned by a local company
or a foreign entity. Everything is valued at market prices.
Why is GDPmp called gross?
GDPmp is final products valued at market price. This is
what buyers pay. But this is not what production units
actually receive. Out of what buyers pay, the production
units have to make provision for depreciation and payment
of indirect tax like excise, sales tax, etc. This explains why
GDPmp is called 'gross'. It is called gross because no
provision has been made for depreciation. However, if
depreciation is deducted from the GDP, it becomes Net
Domestic Product (NDP). Naturally, depreciation does
not become part of anybody’s income.
Why is GDPmp called ‘at market price’ ?
Out of what buyers pay, the production units have to
make payments of indirect taxes, if any. Indirect taxes
accrue to the government, and not to the production
units. Payment of indirect taxes to the government is a
transfer payment as no good or service is provided in
return. Hence, indirect taxes are deducted from
GDPmp to calculate what production units actually
receive.
Sometimes production units receive subsidy on
production. This is in addition to the market price which
production units receive from the buyers. Therefore, what
production units actually receive is not the 'market-price'
but "market price – indirect tax + subsidies".
Step 3: Calculation of Net Domestic Product at
factor cost (NDPfc)
If we make adjustment of depreciation, indirect taxes
and subsidies in GDPmp, we get Net Domestic Product
at Factor Cost (NDPfc).
or, NDPfc = GDPmp – Depreciation – Net indirect taxes

or, NDPfc = GDPmp – Depreciation – Net product taxes
– Net production taxes
NDPfc is the income earned by the factors of production in
the form of wages, profits, rent, interest, etc., within the
domestic territory of a country. This is also called domestic
income because this is the income generated in the
production process within the domestic territory of the
country.
Step 4: Calculation of Net National Product at
factor cost (NNPfc) or National Income (NI)
Net National Product at factor cost (NNPfc) is the net
domestic factor income added with the net factor
income from abroad. In other words:
or, NNPfc = GDPmp – Depreciation – Net indirect

taxes + NFIA
or, NNPfc = GDPmp – Depreciation – Net product
taxes – Net production taxes + NFIA
NNP at factor cost is the sum of income earned by all
factors in the production in the form of wages, profits,
rent and interest, etc., belonging to a country during a
year. It is the National Product and is not bound by
production in the national boundaries.
 Top Tip
Other Basic National Income
Aggregates
1. Net Domestic Product at Market Price
(NDPmp)
This measure allows policy-makers to estimate how

much the country has to spend just to maintain their
current GDP. If the country is not able to replace the
capital stock lost through depreciation, then GDP will
fall.
2. Gross National Product at Market Price
(GNPmp)
GNPmp is the value of all the final goods and services

that are produced by the normal residents of India and
is measured at the market prices, in a year. GNP refers
to all the economic output produced by a nation’s
normal residents, whether they are located within the
national boundary or abroad. Everything is valued at
the market prices.
3. Net National Product at Market Price
(NNPmp)
This is a measure of how much a country can consume

in a given period of time. NNP measures output
regardless of where that production has taken place (in
domestic territory or abroad).
4. Gross Domestic Product at Factor Cost
(GDPfc)
GDP at factor cost is gross domestic product at market
prices less net indirect taxes.
or GDPfc = GDPmp – Net Product Taxes –

Net Production Taxes
GDP at factor cost measures money value of output
produced within the domestic boundaries of a country
in a year, as received by the factors of production.
5.Gross National Product at Factor Cost
(GNPfc)
GNP at factor cost is gross domestic product at market
prices less net indirect taxes plus NFIA.
or GNPfc = GDPmp – Net Product Taxes –

Net Production Taxes + NFIA
GNP at factor cost measures value of output received
by the factors of production belonging to a country in a
year.
Precautions in calculating national
income by value added method
1. Avoid double counting.
Value of intermediate goods is not included in the
estimation of value added because value of intermediate
goods is reflected in the value of final goods. So, avoid
double counting of goods and services as these tend to
inflate national income estimates.
2. Do not include sale of second hand goods.
Value of second hand goods (or used goods) being sold
should not be included in national income as their
value was accounted for at the time of first production.
Sale of the second hand goods is not a production
activity. The second hand good should not be treated
as fresh production, and therefore is not included in
national income.
However, any brokerage or commission paid to
facilitate the sale of second hand goods is a fresh
production activity. It should be included in
production but to the extent of brokerage or
commission only.
3. Self-consumed output must be included.
Output produced but retained for self-consumption,
rather than selling in market, is output and must be
included in estimates. Services of owner-occupied
buildings, farmer consuming its own produce, etc. are
some examples.
Key Terms
Value of output — It is the market value of goods and services
produced by a firm during an accounting year.
Double counting — The problem of double counting arises when the
value of same goods and services are counted more than once while
estimating national income.
Value added/value addition — It is the difference between value of
output and intermediate consumption.
Gross Domestic Product (GDP) — It is the money value of all final goods
and services produced within the domestic territory of a country during
an accounting year.
NDP at factor cost — It is the income earned by the factors in the form
of wages, profits, rent, interest, etc., within the domestic territory of a
country. It is also called net domestic factor income or domestic income.
National Income (NI)/NNP at factor cost — It is the sum of factor
incomes earned by the normal residents in the form of wages,
profits, rent and interest, etc., during an accounting year within
the domestic territory or abroad.
RECAP
Steps for calculation of national income by

product method
Step 1 : Estimation of value of output produced by each
firm in all the sectors of the economy during the year.
Value of output is the market value of goods and services
produced by a firm during an accounting year. Value of
output = Sales + Change in stock
Step 2 : Calculation of Value Added (VA) and Gross
Domestic Product at market price (GDPmp)’
Value added/Value addition is the excess of value of output
over the value of intermediate consumption.
Sum of Value added of all firms in the economy is Gross
Domestic Product (GDP), which refers to the money value
of all final goods and services produced in an economy
during an accounting year.
GDPmp = Value of output of all the sectors – Intermediate
consumption
Step 3 : Calculation of Net Domestic Product at factor
cost (NDPfc)
NDPfc (net domestic factor income) = GDPmp –
Depreciation – Indirect taxes + Subsidies
NDPfc is the income earned by the factors in the form of
wages, profits, rent, interest, etc., within the domestic
territory of a country.
Step 4 : Calculation of Net National Product at factor
cost (NNPfc) or National Income (NI)
National income or NNPfc = NDPfc + NFIA
Precautions in calculating national income by
production method (or value added method)
1. Avoid double counting. Value of intermediate goods is
not included in the estimation of value added because it is
reflected in the value of final goods. So, avoid double
counting of goods and services as these tend to inflate
national income estimates.
2. Do not include sale of second hand goods. Their
value was accounted for at the time of first production.
However, any brokerage or commission paid to sell the
second hand goods is a fresh production activity, so
included.
3. Self-consumed output must be included. Output
produced but retained for self-consumption rather than
selling in the market should be included since output
has been produced during the year. E.g. Farmer
consuming its own produce, services of owner occupied
buildings etc.
NUMERICAL 2
Suppose in an imaginary economy GDP at market

price in a particular fiscal year was `4000 crore,
National Income was ` 2500 crore, Net Factor Income
paid by the economy to Rest of the World was ` 400
crore and the value of Net Indirect Taxes is ` 450
crore. Estimate the value of consumption of fixed
capital for the economy from the given data.
(NCERT) (3 marks)
Solution: National Income (NNPfc)= GDPmp –
Consumption of fixed capital – Net indirect taxes + NFIA
2500 = 4000 – Consumption of fixed capital – 450 + (–)400
Consumption of fixed capital = 4000 – 450 – 400 – 2500 =
`650 crore
Note: Net factor income paid by the economy to rest of
the world = `400 crore. Therefore, NFIA = (–) ` 400 crore
Do it yourself 2
GNPmp of an imaginary economy is ` 120000 crore and its
capital stock is worth `300000 crore. If capital stock
depreciates @ 20% per annum, indirect taxes amount to `
30000 crore and subsidies are put at ` 15000 crore. What is
national income? (3 marks)
[Ans. ` 45000 crore]
National Income (NNPfc)
= GNPmp – Depreciation – Indirect Taxes + Subsidies
= 120000 – 60000 (20% of 300000) – 30000 + 15000
= `45000 crore
NUMERICAL 3
In an economy, the following transactions took place.

(i) Firm A sold to firm B goods of `80 crore; to firm C `
50 crore; to households ` 30 crore and goods of
value ` 10 crore remains unsold.
(ii) Firm B sold to firm C goods of ` 70 crore; to firm D `
40 crore; goods of value ` 30 crore were exported
and goods of value ` 5 crore was sold to government.
Calculate: (i) Value of output of Firm A and Firm B.
(ii) Value added by Firm B
Solution: (i) Value of output of Firm
= Total sales + Value of unsold stock
= (Sales to Firm B + Sales to Firm C + Sales to Households)
+ Value of unsold stock
=(80 + 50 + 30) + 10 = `170 crore
Value of output of Firm B = Sales to Firm C + Sales to Firm
D + Exports + Sales to Government
= 70 + 40 + 30 + 5 = `145 crore
(ii) Value added by Firm B= Value of output of Firm B –
Purchases by Firm B from Firm A
= 145 – 80 = `65 crore
Do it yourself 3
From the following data, calculate the value added by firm
A and firm B. (3 marks)
S. No. Items (` in lakh)

(i) Closing stock of firm A 20
(ii) Closing stock of firm B 15
(iii) Opening stock of firm A 5
(iv) Opening stock of firm B 10
(v) Sales by firm A 300
(vi) Purchases by firm A from firm B 100
(vii) Purchases by firm B from firm A 80
(viii) Domestic sales by firm B 250
(ix) Import of raw material by firm A 50
(x) Exports by firm B 30
[Ans. (a) `165 lakh (b) ` 205 lakh ]

(a) Value Added by Firm A
= Value of output of firm A – Intermediate consumption
= [sales + change in stock (closing stock – opening stock)]
– (purchases from firm B + Import of raw materials)
= [300 + (20 – 5)] – (100 + 50) = `165 lakh
NUMERICAL 4
In a single day, Raju, a barber, collects `500 from haircuts.

Over this day, his equipment depreciates in value by `50.
Of the remaining In a single day, Raju, a barber, collects `
500 from haircuts. Over this day, his equipment
depreciates in value by ` 50. Of the remaining ` 450, Raju
pays sales tax ` 30, takes home ` 200 and retains ` 220 for
improvement and buying of new equipment. He further
pays ` 20 as income tax.
Based on this information, calculate Raju's contribution to
GDP, NDP and National Income. (3marks)450, Raju pays
sales tax `30, takes home `200 and retains ` 220 for
improvement and buying of ne
Solution: equipment. He further pays ` 20 as income
tax.
Based on this information, calculate Raju's contribution to
GDP, NDP and National Income. (3 marks)
(i) GDP = Value of haircuts service produced by him =
`500
(ii) NDP = GDP – Depreciation of equipment
= 500 – 50 = `450
(iii) National Income (NNP at factor cost) = NDP –
Sales Tax
= 450 – 30 = ` 420
Do it yourself 4
From the following data about a firm, calculate the firm’s
net value added at factor cost. 3 marks
(i) Subsidy 40
(ii) Sales 800
(iii) Depreciation 30
(iv) Exports 100
(v) Closing stock 20
(vi) Opening stock 50
(vii) Intermediate purchases 500
(viii) Purchase of machinery for own use 200
(ix) Import of raw material 60
[Ans. `280 lakh]

Net value added at factor cost
= Sales + Closing stock – Opening stock – Intermediate
purchases
– Depreciation + Subsidy
= 800 + 20 – 50 – 500 – 30 + 40 = `280 lakh
NUMERICAL 5
Calculate GVA at factor cost of a firm: (3 marks)

S. No. Items (`)
(i) Net production taxes 600
(ii) Product taxes 400
(iii) Price per unit of output 10
(iv) Net change in stocks (–)50
(v) Purchases of raw materials 10,000
(vi) Import of raw materials 3,000
(vii) Import of machines 20,000
(viii) Product subsidies 100
Additional information: Output sold is 2000 units.

Solution:
Particulars (`)
Sales (note 1) 20,000
(+) Net change in stocks (–) 50
Value of output (–) Intermediate consumption 19,950
(Purchases of raw materials) (–)10,000
GVA at market prices 9,950
(–) Net product taxes (note 3) (–) 300
GVA at basic prices 9,650
(–) Net production taxes (–) 600
GVA at factor cost 9,050
Note:
1. Sales = Output sold × Price per unit = 2,000 units × `10 = `
20,000
2. Import of raw materials is already included in
Purchase of raw materials. Import of machines is not
included in intermediate consumption.
3. Net product taxes = Product taxes – Product subsidies
= 400 – 100 = `300
Do it yourself 5
Find net value added at factor cost: 3 marks
(i) Sales 100
(ii) Closing stock 20
(iii) Excise 15
(iv) Opening stock 10
(v) Current replacement cost 12
(vi) Intermediate consumption 50
[Ans. `33 lakh]

consumption
– Current replacement cost – Excise
= 100 + 20 – 10 – 50 – 12 + 15 = `33 lakh
NUMERICAL 6
Find NVA at factor cost of a firm. (3 marks)

S. Items (`)
No.
(i) Durable use producer goods with a life span of 10 years 10
(ii) Single use producer goods 5
(iii) Sales 20
(iv) Unsold output produced during the year 2
(v) Net indirect taxes 1
Solution:
Particulars (` in lakh)
Sales 20
(+) Unsold output 2
Value of output 22
(–) Intermediate consumption (Single use (-)5
producer goods)
GVA at market prices 17
(–) Depreciation (note) (-)1
(–) Net indirect taxes (-)1
GVA at factor cost 15
Do it yourself 6
Find Net Value Added at market price of a firm: 3 marks
S. No. Items (` in
lakh)
(i) Fixed capital good with a life span of 5 years 15
(ii) Raw materials 6
(iii) Sales 25
(iv) Net change in stock (-)2
(v) Taxes on production 1
[Ans. `14 lakh]

Net Value Added at market price = (iii) + (iv) – (ii) –
Depreciation
= 25 + (–2) – 6 – 3 = `14 lakhs
Note: Depreciation = 15/5 = ` 3 lakhs
NUMERICAL 7
Calculate ‘Sales’ from the following: (3 marks)

S. Items (`)
No.
(i) Subsidies 200
(ii) Opening stock 100
(iii) Closing stock 600
(iv) Intermediate consumption 3000
(v) Consumption of fixed capital 700
(vi) Profit 750
(vii) Net value added at factor cost 2000
(viii) Exports 100
Solution:
consumption – Consumption of fixed capital + Subsidies
2,000 = Sales + 600 – 100 – 3,000 – 700 + 200
Sales = 2,000 – 600 + 100 + 3,000 + 700 – 200
Sales = `5,000 lakh
Do it yourself 7
Calculate ‘Value of output’ from the following: 3 marks
(i) Net value added at factor cost 100
(ii) Intermediate costs 75
(iii) Excise duty 20
(iv) Subsidy 5
(v) Depreciation 10
[Ans. `200 lakh]

Net value added at factor cost = Value of output –
Intermediate costs – Depreciation – Excise duty + Subsidy
100 = Value of output – 75 – 10 – 20 + 5
Value of output = 100 + 75 + 10 + 20 – 5
Value of output = `200 lakhs
NUMERICAL 8
Calculate (a) Gross Domestic Product at Market Price

and (b) National Income. (6 marks)
S. No. Items (`in crore)
(i) Value of output 800
(a) Primary sector 200
(b) Secondary sector 300
(c) Tertiary sectorOpening stock
(ii) Cost of intermediate inputs
(a) Primary sector 400
(b) Secondary sector 100
(c) Tertiary sector 50
(iii) Indirect taxes paid by all sectors 50
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(iv) Consumption of fixed capital of all 80
sectors
(v) Factor income received by the residents 10
from rest of the world
(vi) Factor income paid to non-residents 20
(vii) Subsidies received by all sectors 20
Solution:
Particulars (` in crore)
Value of output of all sectors (note 1) 1300
(–) Cost of intermediate inputs purchased by all (–)550
sectors (note 2)
(a) Gross Domestic Product at Market Price 750
(GDPmp)
Adjustments:
(–) Consumption of fixed capital of all sectors (-) 80
(–) Indirect taxes paid by all sectors (–)50
(+) Subsidies received by all sectors 20
(+) Net factor income from abroad (NFIA) (note (–)10
3)
(b) National Income (NNPfc) 630
Note:
1.Value of output of all sectors = Value of output of
primary, secondary and tertiary sectors
= 800 +200 + 300 = `1300 crore
2. Cost of intermediate inputs purchased by all sectors
= 400 +100 + 50 = ` 550 crore
3. NFIA = Factor income received by the residents from
rest of the world – Factor income paid to non-residents
= 10 – 20 = (–) ` 10 crore
Do it yourself 8
From the following data calculate the (a) Gross National

Product at Market Price (b) National Income. 3 marks
(i) Value of output in primary sector 1,000
(ii) Net factor income from abroad (–)20
(iii) Value of output in tertiary sector 700
(iv) Intermediate consumption in secondary sector 400
(v) Value of output in secondary sector 900
(vi) Intermediate consumption in primary sector 500
(vii) Intermediate consumption in tertiary sector 300
(viii) Net Indirect Taxes 300
(ix) Consumption of fixed Capital 100
[Ans. (a) `1,380 crore (b) ` 980 crore]

(a) Gross National product at market price (GNPmp)
= Value of output of all the sectors
– Intermediate consumption of all the
sectors + NFIA
= (1,000 + 900 + 700) – (500 + 400 + 300) +
(–20) = `1,380 crore
(b) National Income (NNPfc)
= GNPmp – Consumption of fixed capital –
Net indirect taxes
= 1,380 – 100 – 300 = `980 crore
Question 1
Though intermediate goods are crucial inputs to any
production process, yet we measure final goods only. This
is because _________________.
(Complete the sentence)

Answer 1
the value of final goods already includes the value of the
intermediate goods also.

Question 2
Column I Column II
(a) Inventories (i) Investment
(b) Change in inventories (ii) Capital

Answer 2
(a) – (ii) , (b) – (i)

Question 3
__________ is what production units actually receive
for distribution of income among the owners of factors
of production. (Choose the correct alternative)
(a) GDPmp
(b) NDPfc
(c) NNPfc
(d) NNPmp

Answer 3
(b) NDPfc

Question 4
The problem of ‘Double counting’ can be avoided by
__________. (Choose the correct alternative)
(a) counting only value added
(b) counting only value of final products
(c) not counting value of intermediate products
(d) All of these

Answer 4
(d) All of these

Question 5
Market price and factor cost will be equal when there is:
(a) No direct tax
(b) No indirect tax
(c) No subsidy
(d) No indirect tax and no subsidy

Answer 5
(d) No indirect tax and no subsidy

Question 6
Market price is always more than factor cost.

Answer 6
False: Market price can be less than factor cost if net
indirect tax (i.e., indirect taxes – subsidy) is
negative, subsidy is more than indirect taxes.
Market price can also be equal to factor cost if
net indirect tax is zero.

Question 7
Goods produced for self-consumption will be included
in national income. True/False? Give reason.

Answer 7
True: Such goods represent the current output and
their imputed value will be included in national
income.

Question 8
Counting intermediate goods separately will lead to the
error of ____________ , which will highly exaggerate
the ____________ . (Fill in the blanks)

Answer 8
Double counting ; National income

Question 9
In a simple economy, suppose there are only two
producers/firms — the farmers who produce wheat and
the bakers, i.e. the bread makers. The total value of
wheat produced by the farmers is `100, for which they
do not need any input other than human labour. Out of
this, the farmers have sold `50 worth of wheat to the
bakers, who have used it completely during the year and
have produced ` 200 worth of bread. The aggregate
value of final goods produced by this simple
economy will be : (Choose the correct alternative)
(a) `300
Question 9
(b) `250
(c) `350
(d) `200

Answer 9
(b) `250

Question 10
Column I Column I
(a) Net contribution made by a (i) Value of output
firm
(b) Raw materials that a firm (ii) Intermediate goods
buys from another which
are completely used up in
the process of production.
(iii) Value added

Answer 10
(a) – (iii), (b) – (ii)

Question 11
Value of production of a firm – value of intermediate
goods used by the firm = ____________.
(Fill in the blank)

Answer 11
Value added of the firm

Question 12
Value added is a flow variable. True/False? Give reason.

Answer 12
True: Since value added (= value of output – intermediate
costs) is the net contribution of a firm during a
period of time (say one year)

Question 13
To calculate the net contribution made by a firm, we
need to deduct (i) ___________ from the value of
production. If we do not do this, we shall commit the
mistake or error of (ii) __________. (Fill in the blanks)

Answer 13
(i) Intermediate costs / Intermediate consumption
(ii) Double counting

Question 14
A firm produces `100 worth of goods per year, `20 is
the value of intermediate goods used by it during the
year and ` 10 is the value of capital consumption. The
net value added will be:(Choose the correct alternative)
(a) ` 100
(b) ` 80
(c) ` 70
(d) ` 130

Answer 14
(c) `70

Question 15
A firm buys raw materials from other firms.
Column I Column II
(a) The part of raw materials (i) Intermediate good.
which gets used up in the
same year.
(b) The part of raw material (ii) Final good
which does not get used up.
(iii) Inventory
(iv) Value added

Answer 15
(a) – (i) , (b) – (iii)

Question 16
In economics, ‘inventory’ includes the stock of unsold
finished goods only. True/False? Give reason.

Answer 16
False: In economics, ‘inventory’ includes the stock of
unsold finished goods, or semi finished goods, or
raw materials which a firm carries from one
year to the next.

Question 17
Column I Column II
(i) If the value of inventories at (a) Inventories have increased (or
the end of the year is higher accumulated)
than that at the beginning of
the year.
(ii) If the value of inventories is Inventories have decreased
less at the end of the year (or decumulated)
compared to the beginning of
the year

Answer 17
(i) – (a) , (ii) – (b)

Question 18
Production of a firm during a year – Sales of the firm
during the year = ___________ ? (Fill in the blank)

Answer 18
Change in inventories of the firm during a year.

Question 19
In case of an unexpected fall in sales, there will be
_________________ of inventories.
(unplanned accumulation / unplanned decumulation)
(Fill in the blank with correct option)

Answer 19
Unplanned accumulation

Question 20
In case, there is unexpected rise in sales, there will be
___________________ of inventories.
(unplanned accumulation / unplanned decumulation)

Answer 20
Unplanned decumulation

Question 21
Suppose a firm produces shirts. It starts the year with an
inventory of 100 shirts. During the coming year it
expects to sell 1,000 shirts. Hence, it produces 1,000
shirts, expecting to keep an inventory of 100 shirts at
the end of the year. However, during the year, the firm
could sell only 600 shirts. The unexpected rise of
inventories by ________ units is an example of
_________ inventories. (Fill in the blank)

Answer 21
400, unplanned accumulation

Question 22
A firm produces computers. It has opening inventory of
100 computers. During the coming year it expects to
sell 1,000 computers. Hence, it produces 1,000
computers expecting to keep an inventory of 100 at the
end of the year. But the sales during the year is 1,050
computers. The reduction in inventory by
____________ computers is called ______________
of inventories. (Fill in the blanks)

Answer 22
50 , unplanned decumulation

Question 23
A firm wants to raise the inventories from 100 to 200
shoes during the year. Expecting sales of 1,000 shoes
during the year, the firm produces 1,100 shoes. The sales
are actually 1,000 shoes and the firm ends up with an
inventory of 200 shoes. This rise in inventories is called
_____________ (Planned accumulation of inventories/
unplanned accumulation of inventories).

Answer 23
Planned accumulation of inventories

Question 24
A firm wants to reduce the inventories from 100 to 25
mobile phones. Expecting sales of 1,000 mobile phones
during the year, the firm produces 925 mobile phones.
The sales turn out to be 1,000 as expected by the firm
and the firm ends up with an inventory of 25 mobile
phones. This reduction in inventories is called
____________________.
(Planned decumulation of inventories / Unplanned
decumulation of inventories).

Answer 24
planned decumulation of inventories

Question 25
The sum total of gross value added of all the firms in the
economy is called ______________. (Fill in the blank)

Answer 25
Gross Domestic Product (GDP).

Question 26
Sales by a firm includes sales to domestic buyers only.

Answer 26
False: Sales by a firm includes sales not only to
domestic buyers but also to buyers abroad (i.e.
exports).

Question 27
To calculate GVA at factor cost from GVA at market
prices, which of the following is deducted :
(a) Net product taxes (product taxes – product
subsidies)
(b) Net production taxes (production taxes –
production subsides)
(d) Net factor income from abroad.

Answer 27

Question 28
Production taxes are paid per unit of production.

Answer 28
False: Production taxes are paid in relation to
production and are independent of the volume
of production, e.g. land revenues, stamp and
registration fee.

Question 29
Excise tax, service tax, export and import duties, etc are
product taxes. True/False? Give reason.

Answer 29
True: There are paid per unit of product.

Question 30
Basic prices include both product taxes (less product
subsidies) and production taxes (less production
subsidies). True/False? Give reason.

Answer 30
False: Basic prices include the production taxes (less
production subsides) but not product taxes
(less product subsidies).

Question 31
__________ measures the aggregate production of
final goods and services taking place within the domestic
territory of the country during a year. (Fill in the blank)

Answer 31
Gross Domestic Product at market price (GDPmp)

Question 32
A part of the capital which gets consumed during the
year due to wear and tear is called _________. If we
deduct it from GNP the measure of aggregate income
we obtain is called __________. (Fill in the blanks)

Answer 32
Depreciation; Net National Product

Question 33
Depreciation is deducted from GDP while calculating
national income because ______________.
(Fill in the blank)

Answer 33
depreciation does not become part of anybody’s income

Question 34
Column I Column II
(a) Subsidies (b) Indirect taxes
(c) Intermediate consumption (d) Depreciation

Answer 34
(b) Indirect taxes

Question 35
_____________ are deducted and ______________
are added from NNP at market prices in order to
calculate that part of NNP which actually accrues to the
factors of production. (Fill in the blanks)

Answer 35
Indirect taxes ; Subsidies

Question 36
Indirect taxes are deducted from NNP at market prices
to calculate national income because _________.
(Complete the sentence)

Answer 36
Indirect taxes accrue to the government. It is a transfer
payment, not a factor payment.

Question 37
That part of NNP which actually accrues to the owners
of factors of production is called ___________ .
(Fill in the blank)

Answer 37
Net National Product at factor cost or National
Income.

Question 38
GDPmp includes market value of all final goods and
services produced by the normal residents or the non-
residents in a country. True/False? Give reason.

Answer 38
True: GDPmp includes the market value of all final
goods and services produced within the
domestic territory of a country in a year,
regardless of whether production unit is owned
by a local company or a foreign entity.

Question 39
The prices of products as received by the owners of
factors of production is called _____________ .
(Fill in the blank)

Answer 39
Factor cost

Question 40
______________ is the value of all the final goods and
services that are produced by the normal residents of
India and is measured at the market prices, in a year,
regardless of whatever they are located within the
economic territory or abroad. (Fill in the blank)

Answer 40
GNP at market prices

Question 41
_______________ measures value of output received
by the factors of production belonging to a country in a
year of (in domestic territory or abroad).
(a) GNP at market price
(b) GNP at factor cost
(c) GDP at market price
(d) GDP at factor cost

Answer 41

Question 42
This is a measure of how much a country can consume
in a given period of time. It measures output regardless
of where that production has taken place (in domestic
territory or abroad). (Choose the correct alternative)
(b) GDP at market price
(c) NNP at market price
(d) NDP at market price

Answer 42

Question 43
It is the net domestic factor income added with the net
(d) NNP at factor cost

Answer 43
(d) NNP at factor cost.

Question 44
______________ is the sum of income earned by all
factors of production in the form of wages, profits, rent
and interest, etc, belonging to a country during a year (in
the domestic territory or abroad). (Fill in the blank)

Answer 44
Net National Product at factor cost (NNPfc) or
National Income (NI).

Question 1
What is the difference between planned and unplanned in-
ventory accumulation? Write down the relation between
change in inventories and value added of a firm.
(NCERT) (4 marks)

Answer 1
In case of an unexpected fall in sales, a firm will have
unsold stock of goods which it had not anticipated.
Hence, there will be unplanned inventory accumulation.
On the other hand, if the firm wants to raise the inventory
during the year and produces goods accordingly; and the
sales also happen to be the same as expected, then there
will be planned accumulation of inventories.
Relation between change in inventories and value added of
a firm:
Value added of a firm = Sales during the year + Change
in inventories – Value of intermediate goods used
Question 2
Explain why subsidy is added to and indirect tax is

deducted from domestic product at market price to
arrive at domestic product at factor cost.
(3 marks)

Answer 2
Domestic product at market price is what buyers pay.
But this is not what production units actually receive.
Out of what buyers pay the production units have to
make payment of indirect tax, e.g., Goods and Services
Tax (GST). Therefore, indirect tax is deducted.
Sometimes, production units get subsidy on production
from the government.Therefore, subsidy is added.
What production units actually receive is not the
‘Market Price’ but ‘Market Price – Indirect tax +
Subsidies’. This is what is actually available to production
units for distribution of income among the owners
of factors of production. Therefore, Market Price (mp) –
Indirect Tax (IT) + Subsidies = Factor Cost (fc) or
factor payments.

Question 3
State, giving reason, whether the following will be included
in the estimation of national income: (3 marks)
(i) Services of owner-occupied building
(ii) Payment of indirect taxes by a firm
(iii) Wheat grown by a farmer but used entirely for his
family’s consumption.

Answer 3
(i) Yes, imputed value of free services provided by the
owners of production units must be included in
national income.
(ii) No, it is not included in national income because
an indirect tax paid to the government is a transfer
payment as no good or service is provided in
return.
(iii) Yes, its imputed value is included in national
income because it adds to the current flow of
goods and services.

1.5
Income Method of
Steps for calculating national income
by income method
Step 1: Estimate the factor payments by each
firm in all the sectors of the economy during
the year.
The sum of factor payments equals Net Value Added at
Factor Cost (NVAfc) of a firm.
Step 2: Take the sum total of NVAfc by all firms
in all the sectors of the economy to arrive at
NDPfc.
The components of NDPfc are compensation of employees,
operating surplus and mixed income.
1. Compensation of employees: It is defined as the
total remuneration in cash or in kind, payable by
the employers to employees in return for work done
by them during an accounting year.
The main components of compensation of employees
are:
(a)Wages and salaries in cash and in kind. For example,
• Payment of bonus by a firm to its employees
•Free medical facilities, free meals and rent-free house
given by the employer
• House rent allowance or leave travel allowance paid
by the employer
• Medical treatment of employee’s family
(b) Social security contributions by the employers.
For example,
• Contribution to provident fund by the employer
• Insurance premium paid by the employer
 Top Tip
Contribution to provident fund or insurance premium paid by
employees is not included in national income because it is
paid out of compensation of employees, which is already
included.
Similarly, compensation given by insurance company to an
injured worker is not included as compensation is given by
insurance company to the employee, and not by employer.
Also, gifts received from employer, e.g. festival gift, gifts on
independence day, etc. is not included in national income as it
is a transfer payment.
2. Operating surplus: Operating surplus is defined as

the sum of rent, royalty, interest and profits. Operating
surplus can also be termed as 'Income from property
and entrepreneurship', i.e. incomes earned by property
owners. It includes rent and royalty, profit and interest.
(a) Rent is defined as the amount receivable by a
landlord from a tenant for the use of land.
(b) Royalty is defined as the amount receivable by the
owner for granting the leasing rights of sub-soil
assets, e.g., royalty income received by an author of
a book from the publisher.
(c) Interest is defined as the amount payable to the
owners of financial assets in the production unit.
The production unit uses these assets for
production and in turn makes interest payment,
imputed or actual.
 Top Tip
Payment of interest by banks to its depositors or Payment of
interest by a firm (government firm or a private firm) to
households or Payment of interest by a firm to a bank is
included in national income because it is factor payment. The
borrowed money is used for carrying out production of goods
and services.
However, payment of interest on a loan taken by an employee
from the employer or payment of interest by an individual to a
bank on a loan to buy a car or interest received on loans given
to a friend for purchasing a car will not be included in national
income because the individual is a consumer, and the loan is
taken to meet consumption expenditure. There is no
contribution to production of goods and services. Therefore, it
is not a factor payment.
(d) Profit is a residual factor payment by the
production unit to the owners of the production
unit. The production unit uses profit for (i) payment
of corporation tax to the government, (ii) dividend
payments to the owners of the production unit, and
(iii) undistributed profits/ retained earnings for
investment in new projects and ventures.
Profits = Corporation tax
+ Dividend
+ Undistributed profits/Retained
earnings/savings of private
corporate sector
or, Profits = Corporate profit tax + After-tax
profit
(Note: After-tax profit = Dividend + Retained earnings)
 Top Tip
Payment of corporate tax by a firm is also not included in
national income as it is a transfer payment. Corporate tax is
already included in profits. Corporate tax accrues to the
government. It is not received by the owners of factors of
production. Hence, it is not a factor income.
3. Mixed income of self-employed: The income of self

employed people like doctors, chartered accountants,
consultants, etc. has two or more factor incomes. For
example, a doctor’s income may consist of salary from a
hospital, fees earned by him from the patients in his
own clinic, rental income from his property, and profits
of a business owned by him. In such cases, total
income is estimable, but not its different components.
So, mixed income of self-employed is another factor
payment, which is added to the national income.
 Top Tip
The main source of factor payments are the accounts of
production units. Since accounts of most production units are
not available to the estimators, and also since the accounting
practices differ, it is not possible for the estimators to clearly
identify the components. Therefore, in cases where total
factors payment is estimable but not its different components,
an additional factor payment item called 'mixed income‘is
added. Since this problem arises mainly in case of self
employed people like doctors, chartered accountants,
consultants, etc, this factor payment is popularly called
"mixed income of the self-employed".
Step 3: Once we estimate NDPfc, we can find
NNPfc (national income) by adding NFIA
to it.
 Top Tip
Components of National Income by Income Method are:
(i) Compensation of employees
(ii) Operating surplus
(iii) Mixed income of self-employed
(iv) Net factor income from abroad (NFIA)
National income (NNPfc) = Compensation of employees +
Operating surplus + Mixed income + NFIA
Precautions in making estimates of na-
tional income by income method
1. Avoid transfers.
National income includes only factor payments, i.e.
payment for the services rendered to the production
units by the owners of factors of production.
Any payment for which no service is rendered is called
a transfer (e.g. gifts, donations, charity, etc.), and not a
production activity. Hence, transfer payment is not
included in national income.
2. Avoid capital gain.
Capital gain refers to the income from the sale of
second hand goods and financial assets.
Income from the sale of old cars, old house, bonds,
debentures, etc are some examples.
These transactions are not production transactions. So,
any income arising to the owners of such things is not a
factor income.
3. Include income from self-consumed output.
When a house owner lives in that house, he does not
pay any rent. But in fact he pays rent to himself. Since
rent is a payment for services rendered,even though
rendered to the owner itself,it must be counted as a
factor payment.
4. Include free services provided by the
owners of the production units.
Owners work in their own unit but do not charge
salary. Owners provide finance but do not charge any
interest. Owners do production in their own buildings
but do not charge rent.
Although they do not charge, yet the services have
been performed. The imputed value of these must be
included in national income
Treatment of Items in the Estimation
of National Income by Income Method
S. No. Items Treatment Reason
1 Value of bonus shares No, it will not be As bonus shares
received by shareholders of included in the are financial assets
a company national income. and do not contribute
to the production of
goods and services.
2 Payment of interest on No, it is not Because the
a loan taken by an included in individual is a
employee from the national income. consumer, and the
employer/Payment of loan is taken to meet
interest by an individual to a consumption
bank on a loan to buy a expenditure. There is
car/Interest received on no contribution to
loans given to a friend for production of goods
purchasing a car. and services.
Therefore, it is not a
factor payment.
3 Paymentof interestby banks Yes, it is included in Because it is a factor
to its depositors/Paymentof national income. income paid by a
interestbyafirm to production unit (bank
households. or firm). Banks borrow
forcarrying out
banking services./The
firms borrow money
forcarrying out
production.
4 Payment of interest by a Yes, it is included in Because it is a factor

firm (government firm national income. payment by the firm.
or a private firm) to a The firm borrows
bank money for carrying
out production of
goods and services.
5 Interest received on loan Yes, it will be As it is a factor

given to a foreign company included in the national income from abroad.
in India. income.
6 Interest received on Yes, it will be Because interest
debentures. included in the received on debentures
national income. is a factor income
because debenture is a
sort of loan taken by a
production unit, which
uses the money in
producing goods and
services.
7 Payment of interest on No, it will not be Because it is a transfer
borrowings by general included in the payment as general
government (National national income. government borrows
debt interest) only for consumption
purpose.
8 Money received by a family in No, it will not be As it is a transfer
India from relatives working included in national payment, which is
abroad, i.e., remittances from income. received without
abroad/Scholarship given to any contribution to
Indian students studying in production of goods
India by a foreign and services. It is
company/Financial help not a factor income.
received by flood
victims/Expenditure on old
age pensions by
government/Gift received
from employer, e.g. festival
gift, gifts on independence
day, etc.
9. Free medical facilities or free Yes, it will be As it is a part of the
meals or house rent included in the compensation of
allowance or leave travel national income. employees.
allowance paid by the
employer/Rent-free house
given to an employee by an
employer/ Expenditure on
medical treatment of
employee’s family/Payment
of bonus by a firm to its
employees/Contribution to
provident fund by employer
10 Payment of corporate No, it is not included As it is a transfer
tax by a firm in national income. payment. Corporate tax
accrues to the
government. It is not
received by the owners
of factors of production.
Hence, it is not a factor
income.
11 Contribution to provident No, it is not included Because it is paid out of
fund or insurance premium in national income. compensation of
paid by employees employees, which is
already included.
12 Compensation given by No, it is not included As compensation is
insurance company to an in national income. given to the employee
injured worker. by insurance company,
not by employer.
13 Salaries paid to Russians It will be included As it is a factor income
working in Indian in domestic income paid to abroad. It is
Embassy in Russia. of India (since the subtracted from
factor income is earned domestic income to get
within the domestic national income.
territory). But it will not
be included in national
income of India.
14 Imputed rent of self Yes, it will be Because self-occupied
occupied houses. included in the houses provide housing
national income. services similar to those
as rented houses.
15 Earnings of shareholders No, it will not be Because financial
from the sale of shares. included in the assets (shares, bonds,
national income. etc.) are neither goods
nor services, and do not
contribute to any
production of goods and
services.
16 Capital gains to Indian No, capital gains As they do not add
residents from sale of shares from sale of shares to the current flow
of a foreign company. will not be included of goods and
in national income. services in the
economy.
17 Money received from sale No, it will not be Because sale of second
of second-hand goods/ included in national hand goods is not a fresh
Money received from sale income. production transaction.
of old house or old car. So any income arising to
the owners of such
goods is not a factor
income, but a capital
gain.
18 Commission received by Yes, it will be included As it is a factor
a dealer from the buyer in national income. income because any
and seller of a house. commission paid to
facilitate the sale of
house is a fresh
production activity.
19 Prize won in a lottery No, it will not be Because it is a windfall
included in national gain, not a factor
income. income.
20 Receipts from sale of land No, it will not be As land is a free gift of
included in national nature and cannot be
income. produced.
21 Profit earned by foreign It will be included in As it is a factor income
banks in India. domestic income of paid to abroad. It is
India (since the factor subtracted from
income is earned domestic factor income
within the domestic to get national income.
territory). But it will not
be included in national
income of India.
22 Profits earned by an Indian Yes, it will be As it is a factor
bank from its branches included in national income from abroad.
abroad. income.
23 Dividend received by a No, it will not be As it is a factor
foreigner from included in national income paid to
investment in shares of income. abroad.
an Indian company.
24 Dividend received by Yes, it will be As it is a part of the
shareholders. included in national
profits of production
income. units, which is
distributed to the
owners. Hence, it is a
factor income.
25 Rent received by Indian Yes, it will be This factor income
residents on their included in national is earned by the
buildings rented out to income. residents.
foreigners in India.
26 Royalty Yes, it will be As royalty is a
included in national productive income.
income.
Key Terms
Compensation of employees — It is defined as the total
remuneration in cash or in kind, payable by the employers to
employees in return for work done by them during an accounting
year. It includes (a) Wages and salaries in cash and in kind and (b)
Employers’ contribution in social security schemes.
Operating surplus — Operating surplus is defined as the sum of
rent, royalty, interest and profits.
Income from property and entrepreneurship — are incomes
earned by property owners. It includes rent and royalty, profit
and interest. It can also be termed as operating surplus.
Mixed Income — Income of self-employed people like doctors,
chartered accountants, consultants, etc. has two or more factor
incomes. Total income is estimable, but not its different
components. So, mixed income is added to national income.
RECAP
National income by income method

In this method, we first estimate factor payments by each
sector. The sum of such factor payments equals Net Value
Added at factor cost (NVAfc) by that sector.
Then we take sum total of NVAfc by all the sectors to arrive at
NDPfc. The components of NDPfc are:
(i) Compensation of employees: It includes:
(a) Wages and salaries in cash and in kind, e.g. bonus, free
medical facilities, free meals, house rent allowance, etc.
(b) Social security contributions by the employers, e.g.,
provident fund or insurance premium paid by
employers.
(ii) Operating surplus: Operating surplus is defined as the
sum of rent, royalty, interest and profits.
Operating surplus can also be termed as 'income from property
and entrepreneurship'.
Note: Profit = Corporation tax + Dividend + Retained
earnings/undistributed profits.
Alternately, Profit = Corporation tax + After tax profit
(iii) Mixed income: The income of self employed people
like doctors etc. has two or more factor incomes; total
income is estimable, but not its different
components. So, mixed income is another factor
payment.
Once we estimate NDPfc, we can find NNPfc or national
income, by adding net factor income from abroad.
National income = Compensation of employees
+ Operating surplus
+ Mixed income of self employed
+ Net factor income from abroad
Precautions in making estimates of national
income by income method
1. Avoid transfers. National income includes only
factor payments, i.e. payment for the services
rendered to the production units by the owners of
factors of production.
Any payment for which no service is rendered is
called a transfer, e.g. gifts, donations, charity, etc.
Since transfers are not a production activity it must
not be included in national income.
2. Avoid capital gain. Capital gain refers to the
income from the sale of second hand goods and
financial assets. Income from the sale of old cars,
old house, bonds, debentures, etc are some
examples.
These transactions are not production transactions.
So, any income arising to the owners of such things
is not a factor income.
3. Include income from self-consumed output.
When a house owner lives in that house, he does not
pay any rent. But in fact he pays rent to himself.
Since rent is a payment for services rendered,even
though rendered to the owner itself,it must be
counted as a factor payment.
4. Include free services provided by the owners of
the production units. Owners work in their own
unit but do not charge salary. Owners provide
finance but do not charge any interest. Owners do
production in their own buildings but do not charge
rent.
Although they do not charge, yet the services have been
performed. The imputed value of these must be
included in national income.
NUMERICAL 9
From the following data relating to a firm:

(a) Estimate the net value added at market prices.
(b) Show that net value added at factor cost is equal
to the sum of factor incomes. (6 marks)
(i) Purchase of raw materials and other 600
inputs from the domestic market
(ii) Increase in stocks 200
(iii) Domestic sales 1800
(iv) Imports of raw materials 100
(v) Exports 200
(vi) Depreciation 75
(vii) Salaries and wages 600
(viii) Interest payments 450
(ix) Rent 75
(x) Dividends 150
(xi) Undistributed profits 80
(xii) Corporate profit tax 20
(xiii) Indirect taxes 50
Solution: (a) Net value added at market prices

= (Domestic sales + Exports + Increase in
stocks)
– (Purchase of raw materials and other inputs
from the domestic market
+ Imports of raw materials) – Depreciation
= (1800 + 200 + 200) – (600 + 100) – 75 = `1425
lakh
(b) Net value added at factor cost
= Net value added at market prices – Indirect
taxes
= 1425 – 50 = `1375 lakh
Factor Incomes
= Salaries and wages + Interest + Rent + Dividends +
Undistributed profits + Corporate tax
= 600 + 450 + 75 + 150 + 80 + 20 = `1375 lakh
Hence, net value added at factor cost is equal to the sum of
factor incomes.
Do it yourself 9
Calculate:
(a) Net value added at factor cost and
(b) Value of output at market price from the following
data. 6 marks
S. No. Items (` in arab)
(i) Subsidies 40
(ii) Intermediate costs 200
(iii) Compensation of employees 400
(iv) Depreciation 50
(v) Royalty 5
(vi) Interest 25
(vii) Indirect taxes 100
(viii) Rent 10
(ix) Profits 60
(x) Net change in stocks 20
(a) Net value added at factor cost (NVAfc)
= Sum of factor incomes
= Compensation of employees + Rent +
Royalty + Interest + Profit
= 400 + 10 + 5 + 25+ 60 = `500 arab
(b) NVAfc = Value of output – Intermediate costs
– Depreciation – Indirect taxes + Subsidies
500 = Value of output – 200 – 50 – 100 + 40
Value of output at market price = 500 + 200 + 50 + 100 –
40 = `810 arab
NUMERICAL 10
Calculate national income: (4 marks)

S. No. Items (` in crore)
(i) Compensation of employees 2,000
(ii) Interest paid by production units 500
(iii) Rent 700
(iv) Profits 800
(v) Employers’ contribution to social security schemes 200
(vi) Dividends 300
(vii) Consumption of fixed capital 100
(viii) Net indirect taxes 250
(ix) Net exports 70
(x) Net factor income to abroad 150
(xi) Mixed income of self-employed 1,500
Solution:
Compensation of employees 2,000
(+) Interest paid by production units 500
(+) Rent 700
(+) Profits 800
(+) Mixed income of self employed 1,500
(–) Net factor income to abroad (–)150
National Income (NNPfc) 5,350
Do it yourself 10
Calculate national income from the following data.4 marks

(i) Rent 80
(ii) Interest 100
(iii) Profits 210
(iv) Tax on profits 30
(v) Employers’ contribution to social security schemes 25
(vi) Mixed income of self-employed 250
(vii) Net indirect taxes 60
(viii) Employees’ contribution to social security schemes 50
(ix) Compensation of employees 500
(x) Net factor income from abroad (–)20
[Ans. `1120 crore]

National Income = Compensation of employees
+ Rent + Interest + Profits + Mixed income of self-employed
= 500 + 80 + 100 + 210 + 250 + (– 20) = `1120 crore
NUMERICAL 11
Calculate Domestic Income: (4 marks)

(i) Dividends 50
(ii) Social security contributions by employers 40
(iii) Corporate profit tax 30
(iv) Consumption of Fixed Capital 60
(v) Retained earnings of private corporate sector 20
(vi) Interest paid by firms 150
(vii) Rent 70
(viii) Royalty 30
(ix) Wages and salaries 600
(x) Interest paid by households 10
Solution:
\Particulars (` in crore)
Compensation of employees 640
(+) Interest paid by production units 150
(+) Rent 70
(+) Royalty 30
(+) Profits 100
Domestic income (NDPfc) 990
Note: (i) Compensation of employees = Wages and salaries

+ Social security contributions by employers
= 600 + 40 = `640 crore
(ii) Profits = Dividends + Corporate profit tax + Retained
earnings of private corporate sector
= 50 + 30 + 20 = `100 crore
Do it yourself 11
Calculate Net national product at market price 4 marks

(i) Net current transfers from abroad (–)10
(ii) Wages and salaries 1,000
(iii) Net factor income to abroad (–)20
(iv) Social security contributions by employers 100
(v) Net indirect tax 80
(vi) Rent 300
(vii) Consumption of fixed capital 120
(viii) Corporation tax 50
(ix) Dividend 200
(x) Undistributed profits 60
(xi) Interest 400
[Ans. `2,210 crore]
Net national product at market price (NNPmp)
= Wages and salaries + Social security contributions
by employers
+ Rent + Interest + Corporation tax + Dividend
+ Undistributed profits – Net factor income to
abroad + Net indirect tax
= 1,000 + 100 + 300 + 400 + 50 + 200 + 60 – (–20) +
80 = `2,210 crore
NUMERICAL 12
Calculate Net Domestic Product at market price:

(4 marks)
(i) Interest received by households 600
(ii) Consumption of fixed capital 800
(iii) Rent and royalty 700
(iv) Net factor income from abroad 100
(v) Net indirect tax 850
(vi) Profit 1,200
(vii) Social security contributions by employees 700
(viii) Mixed income of self-employed 8,000
(ix) Wages and salaries 5,000
(x) Dividend 400
Solution:
\Particulars (` in crore)
Compensation of employees (wages and salaries) 5,000
(+) Interest received by households 600
(+) Rent and royalty 700
(+) Profit 1,200
(+) Mixed income of self-employed 8,000
Domestic factor income (NDPfc) 15,500
(+) Net indirect tax 850
Net Domestic Product at market price (NDPmp) 16,350
Do it yourself 12
From the following data calculate the Gross National

Product at Market Price. 4 mark
(i) Wages and Salaries 700
(ii) Rent 100
(iii) Current replacement cost 50
(iv) Net factor income from abroad (–)10
(v) Mixed income 400
(vi) Subsidies 100
(vii) Profits 400
(viii) Indirect taxes 300
(ix) Employers’ contribution to social security schemes 50
(x) Interest 40
[Ans. `1,930 crore]

Gross National Product at Market Price
= Compensation of Employees (Wages and Salaries +
Employers’ contribution to social security schemes)
+ Operating Surplus (Rent + Profits + Interest) + Mixed
Income
+ Current replacement cost + Indirect taxes – Subsidies +
NFIA
= (700 + 50) + (100 + 400 + 40) + 400 +50 + 300 – 100 +
(–10)
= `1930 crore
NUMERICAL 13
Calculate Gross National Product at market price:

(4 marks)
(ii) Profits after tax 500
(iii) Mixed income of self-employed 7,500
(iv) Net addition to capital stock 400
(v) Rent and royalty 400
(vi) Interest 350
(vii) Factor income from abroad 150
(viii) Goods and Services Tax 200
(ix) Gross investment 470
(x) Net exports 40
(xi) Factor income paid to abroad 100
(xii) Subsidies 50
(xiii) Corporation tax 200
Solution:
Compensation of employees 2,500
(+) Profit 700
(+) Rent and royalty 400
(+) Interest 350
(+) Mixed income of self-employed 7,500
Domestic income (NDPfc) 11,450
Adjustments:
(+) Depreciation (note 1) 70
(+) Goods and Services Tax 200
(–) Subsidies (–)50
(+) Net factor income from abroad (NFIA) (note 2) 50
GNP at market price 11,720
Note: 1. Depreciation = Gross investment – Net investment

(or Net addition to capital stock)
= 470 – 400
= `70 crore
2. Net factor income from abroad (NFIA) = Factor income
from abroad – Factor income paid to abroad
= 150 – 100
= `50 crore
3. Profits = Profits after tax + Corporation Tax
= 500 + 200
= `700 crore
Do it yourself 13
Calculate Gross National Product at Market Price from the

following data. 4 mark
(i) Wages and Salaries 500
(ii) Net Capital formation 100
(iii) Exports 50
(iv) Imports 60
(v) Gross capital formation 120
(vi) Employers’ contribution to social security schemes 20
(vii) Net factor income from abroad (–) 10
(viii) Rent and interest 250
(ix) Profits after tax 300
(x) Goods and Services Tax 50
(xi) Subsidies 10
(xii) Corporate Tax 100
[Ans. `1220 crore]
GNPmp = Compensation of employees (Wages and
Salaries + Employers’ contribution to social security
schemes) + Operating surplus (Rent and interest +
Profits) + Depreciation + Goods and Services Tax –
Subsidies + NFIA
= (500 + 20) + (250 + 400) + 20 + 50 – 10 + (–10) =
`1220 crore
Note: (i) Depreciation = Gross capital formation – Net
capital formation
= 120 – 100 = 20
(ii) Profits = Profits after tax + Corporate Tax = 300 + 100
= 400
NUMERICAL 14
Calculate compensation of employees: (3 marks)

(i) Rent 20
(ii) Interest 35
(iii) Profits 15
(iv) Gross domestic product at factor cost 250
(v) Consumption of fixed capital 60
Solution:
Gross domestic product at factor cost
= Compensation of employees + Rent + Interest + Profits
+ Consumption of fixed capital
250 = Compensation of employees + 20 + 35 + 15 + 60
Compensation of employees = 250– 20 – 35 – 15–60 = `120 crore
Do it yourself 14
Calculate Gross National Product at Market Price from the

following data. 4 mark
(i) Gross value added at market price 15,000
(ii) Wages and salaries 5,000
(iii) Net indirect taxes 750
(iv) Consumption of fixed capital 250
[Ans. `9,000 crore]
Gross value added at market price
= Wages and salaries + Operating surplus + Consumption
of fixed capital
+ Net indirect taxes
15000 = 5000 + Operating surplus + 250 + 750
Operating surplus = 15000 – 5000 – 250 – 750 = `9000
crore
NUMERICAL 15
From the following data, calculate:

(a) Gross domestic product at market price and
(b) Factor income from abroad (6 marks)
(i) Gross national product at factor cost 6,150
(ii) Net exports (–) 50
(iii) Compensation of employees 3,000
(iv) Rent 800
(v) Interest 900
(vi) Profit 1,300
(viii) Net domestic capital formation 800
(ix) Gross fixed capital formation 850
(x) Change in stocks 50
(xi) Dividend 300
(xii) Factor income to abroad 80
Solution:
(a) Gross domestic product at market price (GDPmp)
= Compensation of employees + Rent +
Interest + Profit + Depreciation + Net indirect taxes
= 3,000 + 800 + 900 + 1,300 + 100 + 300
= `6,400 crore
Note: Depreciation = Gross fixed capital formation +
Change in stocks – Net domestic capital formation
= 850 + 50 – 800 = `100 crore
(b) Gross national product at factor cost
= GDPmp + Factor income from abroad –
Factor income to abroad – Net indirect taxes
6,150 = 6,400 + Factor income from abroad – 80 – 300
Factor income from abroad = 6,150 + 80 + 300 – 6,400
= `130 crore
Do it yourself 15
Calculate: (a) Net national product at factor cost and (b)

Gross Domestic product at market prices. 6 marks
(i) Net indirect taxes 38
(ii) Consumption of fixed capital 34
(iii) Net factor income from abroad (–)3
(iv) Rent 10
(v) Profits 25
(vi) Interest 20
(vii) Royalty 5
(viii) Wages and salaries 170
(ix) Employers’ contribution to social security schemes 30
[Ans. (a) `257 crore (b) `332 crore]

(a) Net National Product at Factor Cost (or National income)
= Wages and salaries + Employers’ contribution to social security
schemes
+ Rent + Interest + Profits + Royalty + Net factor income from
abroad
= 170 + 30 + 10 + 20 + 25 + 5 + (–3) = `257 crore
(b) Gross Domestic Product at Market Price = Net national
product at Factor Cost + Consumption of fixed capital + Net
indirect taxes
– Net factor income from abroad
= 257 + 34 + 38 – (–3) = `332 crore
NUMERICAL 16
Calculate the value of “Rent” from the following data:

(i) Gross Domestic Product at market Price 18,000
(ii) Mixed Income of Self-Employed 7,000
(iii) Subsidies 250
(iv) Interest 800
(v) Rent ?
(vi) Profit 975
(vii) Compensation of Employees 6,000
(viii) Consumption of Fixed Capital 1,000
(ix) Indirect Tax 2,000
Solution: GDPmp = NDPfc+ Depreciation + Net indirect tax

(i) = (vii) + (ii)+ [(iv) + (vi) + Rent] + (viii) + [(ix)-(iii)]
18,000 = (6,000 + 7,000 + (800 + 975 + Rent) + 1,000 +
(2,000 – 250)
18000 = 17525 + Rent ⇒ Rent = `475 crore
Do it yourself 16
Calculate the value of “Interest” from the following data

(4 marks)
(i) Indirect tax 1,500
(ii) Subsidies 700
(iii) Profits 1,100
(v) Gross domestic product at market price 17,500
(vi) Compensation of employees 9,300
(vii) Interest ?
(viii) Mixed income of self-employed 3,500
(ix) Rent 800
[Ans. 1,300 crore]

GDPMP = NDPFC+ Depreciation + Net indirect tax
(v) = (vi) + (viii)+ [(iii)+(ix) + interest] + (iv) + [(i) – (ii)]
17,500 = (9,300+3,500+1,100+800+interest) + 700+ (1,500-700)
17,500 = 16,200 + Interest
Interest = 1,300 crore
NUMERICAL 17
Calculate compensation of employees from the following

data: (CBSE Sample Question Paper 2020) (3 marks)
(i) Profits after tax 20
(ii) Interest 45
(iii) Gross Domestic Product at Market Price 200
(iv) Goods and Services Tax 10
(v) Consumption of Fixed Capital 50
(vi) Rent 25
(vii) Corporate Tax 5
Solution: GDPmp = NDPfc + Consumption of Fixed Capital + Goods

and Services Tax
GDPmp = Compensation of employees + Profits (Profits after tax +
Corporate Tax) + Interest + Rent
+ Consumption of Fixed Capital + Goods and Services Tax
200 = Compensation of employees + (20 + 5) + 45 + 25 +
50 + 10
Compensation of employees = 200 – 25 – 45 –25 – 50 – 10 =
`45 crore
Do it yourself 17
Calculate the value of “Mixed Income of Self-Employed”

from the following data: (CBSE 2019) (4 marks)
(i) Compensation of Employees 17,300
(ii) Interest 1,200
(iii) Consumption of Fixed Capital 1,100
(iv) Mixed Income of Self-Employed ?
(v) Subsidies 750
(vi) Gross Domestic Product at Market price 27,500
(vii) Indirect Taxes 2,100
(viii) Profits 1,800
(ix) Rent 2,000
[Ans. `2,750crore]
GDPMP = (i) + [(ix) + (ii) + (viii)]
+ Mixed Income of Self employed + (iii) + (vii- v)
500 = 17,300 + (2000+ 1200 + 1800)
+ Mixed Income of Self employed +1100 +(2100-750)
Mixed Income of Self employed =`2,750crore
Question 1
Which of the following will be included in national
(a) Money receipt from sale of old car
(b) Scholarships received by students
(c) Remittances from abroad
(d) Free services of owner occupied building

Answer 1
(d) Free services of owner occupied building

Question 2
Which of the following transactions is not included in
national income? (Choose the correct alternative)
(a) Payment of interest by a private firm
(b) Payment of interest by banks on deposits
(c) Interest paid by an individual on a car loan taken
from a bank
(d) Interest on finance provided by the owners of the
production units

Answer 2
(c) Interest paid by an individual on a car loan taken
from a bank

Question 3
Which one of the following is not included in
compensation of employees?
(a) Payment of bonus by a firm to its employees
(b) House rent allowance by the employer
(c) Free medical facilities by the employer
(d) Festival gift from an employer

Answer 3
(d) Festival gift from an employer

Question 4
Which of the following is not included in compensation
of employees? (Choose the correct alternative)
(a) Wages and salaries in cash
(b) Wages and salaries in kind
(c) Employees’ contribution to social security schemes
(d) Employers’ contribution to social security schemes

Answer 4
(c) Employees’ contribution to social security schemes

Question 5
Broker’s commission on sale and purchase of second
hand goods is included in national income because:
(a) It is a part of compensation of employees
(b) It is a part of gross domestic capital formation
(c) It is an income earned for rendering productive
services
(d) None of these

Answer 5
(c) It is an income earned for rendering productive
services

Question 6
Which of the following will be included in national
(a) Financial transactions
(b) Sale of old goods
(c) Illegal activities
(d) Production of goods and services

Answer 6
(d) Production of goods and services

Question 7
Which of the following transactions is not included in
national income? (Choose the correct alternative)
(a) Brokerage paid to broker for facilitating sale of
second hand goods
(b) Payment of corporation tax by a firm
(c) Interest on finance provided by the owners of the
production units
(d) Interest paid by banks on deposits by individuals

Answer 7
(b) Payment of corporation tax by a firm

Question 8
Wages, interest, profits and rents paid out by the firm
must add up to _________ of the firm.(Fill in the blank)

Answer 8
Net value added at factor cost (NVAfc)

Question 9
Prizes received by the household from government and
firms are included in National Income.
True/ False? Give reason.

Answer 9
False : It is a transfer payment.

Question 10
Payment of interests by households to the firm and the
government as well, in case they hold borrowed money
from either, will be included in National Income.
True/ False? Give reason.

Answer 10
False: It is not a factor payment because the
borrowings by households are assumed to be on
consumption expenditure.

Question 11
A part of profit which is distributed among the factors
of production is called _____________ .
(Fill in the blank)

Answer 11
dividend

Question 12
_____________ is the income earned by the factors of
production in the form of wages, profits , rent interest,
etc, within the domestic territory of a country.
(Fill in the blank)

Answer 12
Net Domestic Product at factor cost

Question 1
State the various components of the Income Method that
are used to calculate national income.

Answer 1
The various components that are used under the
income method to calculate national income are:
(i) Compensation of employees which includes wages
and salaries in cash and kind and employers’
contribution to social security benefits.
(ii) Operating surplus which includes rent and royalties,
interest and profit earned by a firm.
(iii) Mixed income of self-employed which includes any
income that has two or more factor income, which
cannot be accounted for separately.

(iv) Net factor income from abroad, which is the
difference between factor income from abroad and
factor income to abroad.

Question 2
How will you treat the following in the calculation of Net
Domestic Product (NDP) of India? Give reasons for your
answer.
(a) Factor income from abroad.
(b) Remittances from non-resident Indians to their
families in India. (3 marks)

Answer 2
(a) No, it is not included in NDP of India because the
factor income is earned outside the domestic
territory of India.
(b) No, it is not included in NDP of India because it is a
transfer income from abroad.

Question 3
Are the following items part of compensation of
employees? Give reasons for your answer.
(i) Entertainment allowance to an employee to entertain
business guests.
(ii) Employers’ contribution to gratuity fund of the
employees.
(iii) Employees’ contribution to provident fund.
(iv) Payment of insurance claim by LIC to the injured
worker.

(v) Old age pension to an employee.
(vi) Medical expenses of a firm on treatment of an
employee’s family. (6 marks)

Answer 3
(i) It is not a part of compensation of employees
because it is paid for the benefit of business and
not for the employee. It is an intermediate
expenditure.
(ii) It is a part of compensation of employees because
such contribution is for the benefit of the
employees and is paid for their productive
services.
(iii) It is not a part of compensation of employees
because such contribution is made by an employee
from his wages/salary.
(iv) It is not a part of compensation of employees
because it is not paid by the employer, but by LIC.
(v) It is not a part of compensation of employees
because it is paid to the old employee without any
productive service by him in return. It is a transfer
payment.
(vi) It is a part of compensation of employees because
such expenses are incurred by the firm in return of
productive services of the employee.

Question 4
Giving reason state whether the following will be included
in domestic product (or domestic factor income):
(i) Profits earned by branches of a country’s bank in
other countries
(ii) Profits earned by foreign companies of India
(iii) Salaries of Indian working in the Russian Embassy in
India (3 marks)

Answer 4
(i) No, it is not included in domestic product because
this factor income is not generated in the domestic
territory of the country. It is factor income from
abroad.
(ii) Yes, it is included in domestic factor income of
India because this factor income is earned within
(iii) No, it is not included in domestic factor income of
India because Russian Embassy in India is not a part
of the domestic territory of India. It is factor
income from abroad.
Question 5
Giving reason state how the following are treated in
estimation of national income:
(i) Payment of interest by banks to its depositors.
(ii) Expenditure on old age pensions by government.
(iii) Profits earned by a company partly owned by
residents and party owned by non-residents and
located in India.

Answer 5
(i) Payment of interest by banks is included in national
income because it is factor income paid by a
production unit.
(ii) Expenditure on old age pension is not included
because it is a transfer payment.
(iii) Yes, it will be included in the domestic factor
income of India as profits are earned within the

1.6
Expenditure Method of
In this method, we take the sum of final expenditures
on consumption and investment. This sum equals
GDPmp. These final expenditures are on the final
goods and services (both consumption goods and
capital goods) produced within the domestic territory
of the country.
 Top Tip
Expenditure method includes only final expenditures, i.e.
expenditure on consumption and investment. Intermediate
expenditure like that on raw materials, etc. is not included in
national income.
Final Expenditure refers to the expenditure on final goods and
services produced within the domestic territory of the
country, which are meant for final consumption and
investment. Examples:
(i) Expenditure on purchase of car/furniture/sewing
machine/refrigerator by a household is a final expenditure on
consumption, and thus included in national income.
(ii) Expenditure on purchase of a car/furniture/machine/
refrigerator for use by a firm is a final investment
expenditure, and thus included in national income.
Intermediate Expenditure /Intermediate Consumption/
Intermediate Cost refers to the expenditure incurred by a
production unit on purchasing those goods and services from
other production units, which are meant for resale or for using
up completely during the same year. Examples:
(i) Expenditure on fertilisers by a farmer
(ii) Payment of electricity bill by a school
(iii) Purchase of uniforms for nurses by a hospital
(iv) Expenditure on engine oil by a car service station
(v) Expenditure by a firm on payment of fees to a chartered
accountant or a lawyer (Note that a chartered accountant
or a lawyer is an outsider to the firm. So, payment of fees
to them will not be a factor income, but an intermediate
expenditure)
(vi) Expenditure on maintenance of factory building by a firm
(vii) Fees to a mechanic paid by a firm
(viii) Transport expenses by a firm
(ix) Expenditure on advertisement and scientific research by
a firm
Main components of GDPmp or final
expenditures in the economy
1. Private final consumption expenditure
(PFCE)
It is the consumption expenditure of households on
the final goods and services produced in the economy.
For example, purchase of car by a household,
expenditure on education of children by a family
(school fee or purchase of books), etc.
2. Government final consumption
expenditure (GFCE)
It is the consumption expenditure that the government
makes on the final goods and services produced in the
economy. For example, government expenditure on
free services provided such as education, health, police
service, defense services, etc.
3. Gross domestic capital formation (GDCF)
It is the final investment expenditure incurred by firms
and the government. For example, purchase of tractor
by a farmer, purchase of taxi by a taxi driver, purchase
of a truck to carry goods by a firm, purchase of a
machine or refrigerator installed in a production unit
by a firm.
Note that GDCF is composed of the following:
GDCF = Gross domestic fixed capital
formation + Net change in stocks
or GDCF = (Net fixed capital formation +
Depreciation) + (Closing Stock – Opening
Stock)
4. Net exports (= Exports – Imports) (X–M)
Net export refers to the excess of the value of exports
over the value of imports of a country in an accounting
year.
Exports, though purchased by non-residents, are
produced within our domestic territory, and therefore,
a part of domestic product and thus, included in
GDPmp and hence national income.
Imports, however, are deducted because goods and
services imported are not produced within the
domestic territory of the country.
GDPmp = Private final consumption expenditure
+ Government final consumption
expenditure
+ Gross domestic capital formation
+ Net exports
 Top Tip
Net imports is negative of net exports. For example, if net
imports = `30 crore, it means net exports = (–) `30 crore.
GDPmp = PFCE + GFCE + GDCF – Net Imports
By making the usual adjustments we can arrive at

national income.
Precautions in making estimates of
national income by expenditure
method
1. Avoid intermediate expenditure.
By definition, the expenditure method includes only
final expenditures, i.e. expenditure on consumption
and investment. Like in the value added method,
inclusion of intermediate expenditure like that on raw
materials, etc. will mean double counting.
2. Do not include expenditure on second
hand goods and financial assets.
Buying second hand goods is not a fresh production
activity. Buying financial assets is not a production
activity because financial assets are neither goods nor
services. Therefore, they should not be included in
estimates of national income.
3. Avoid transfer expenditures.
A transfer payment is a payment against which no
services are rendered. Therefore, no production takes
place. Since no production takes place, it has no place in
national income. Charities, donations, gifts, scholarships, etc.
are some examples.
4. Include the self use of own produced final
products.
For example, a house owner using the house for self.
Although explicitly he does not incur any expenditure,
implicitly he is making payment of rent to himself.
Since the house is producing a service, the imputed
value of the housing service must be included in
national income.
Treatment of Items in the Estimation
of National Income by Expenditure
Method
S. No. Items Treatment Reason
1. Expenditure on education Yes, it is included in Because it is a private
of children by a family, e.g. national income. final consumption
purchase of books etc. expenditure.
2. Purchase of car by a Yes, it will be included Because it is a private
household in the national income. final consumption
expenditure.
3. Fees received from Yes, it will be included Because it is a private
students in the national income. final consumption
expenditure.
4. Expenditure on free Yes, it is included in Because it is government
services provided by the national income. final consumption
government, e.g., free expenditure.
educational services, free
treatment of the poor in
government hospitals, etc.
5. Purchase of tractor by a Yes, it is included in Because it is gross
farmer/Purchase of taxi national income. domestic capital
by a taxi driver/Purchase of formation or final
a truck to carry goods by a investment expenditure.
firm.
6. Purchase of a machine Yes, it is included in Because it is gross
or refrigerator installed national income. domestic capital
in a production unit by a formation or final
firm. investment expenditure.
7. Construction of a house by Yes, it is included in Because it is a part of
an individual/Expenditure national income by gross fixed capital
on adding a floor to the expenditure method. formation, i.e. a final
building investment expenditure.
8. Addition to the machinery, Yes, it is included in Because it is a part of
factory buildings and national income by gross fixed capital
equipments by the firms expenditure method. formation, i.e. a final
investment expenditure.
9. Net addition to capital Yes, it is included in Because it is net
stock national income by investment or net capital
expenditure method. formation, which is an
item of final expenditure.
10. Purchase of goods by Yes, it is included in Because these are exports,
foreign tourists national income. i.e. demand for goods
produced in the domestic
territory, an item of final
expenditure.
11. Purchase of second No, it is not included in Because the value of
hand machinery national income. imports are deducted while
from abroad estimating the national
income of a country.
12. Expenditure on No, it is not included in Because it is an
fertilizers by a farmer national income. intermediate expenditure for
the farmer and hence
deducted from value of
output while calculating
national income.
13. Payment of electricity No, it is not included in Because it is an
bill by a school national income. intermediate cost for the
school.
14. Purchase of uniforms No, it is not included in Because it is an
for nurses by a national income. intermediate cost for the
hospital hospital.
15. Expenditure on engine No, it is not included in Because it is an
oil by car service station national income. intermediate cost or
intermediate expenditure for
the car service station.
16. Expenditure by a firm No, it is not included in Because it is intermediate
on payment of fees to a national income. cost or intermediate
chartered accountant or expenditure of the firm.
lawyer (Note that a chartered
accountant or a lawyer is an
outsider to the firm. So,
payment of fees to them will
not be a factor income, but an
intermediate expenditure)
17. Fees to a mechanic No, it is not included in Because it is intermediate
paid by a firm. national income. cost or intermediate
expenditure of the firm.
18. Expenditure on No, it will not be included Because it is an
maintenance of factory in the national income. intermediate expenditure of
building by a firm the firm.
19. Transport expenses No, it will not be Because it is a part of
by a firm included in national intermediate
income. consumption.
20. Expenditure on No, it will not be Because it is an
advertisement and included in national intermediate expenditure.
scientific research income.
by a firm
21. Purchase of bonds No, it will not be Because buying financial
by a domestic firm included in the national assets like bonds, shares,
income. etc. does not contribute to
any production of goods
and services.
Key Terms
Final Expenditure — It refers to the expenditure on final goods
and services produced within the domestic territory of the
country, which are meant for final consumption and investment.
Intermediate Expenditure (or Intermediate Consumption or
Intermediate Cost) — It refers to the expenditure incurred by a
production unit on purchasing those goods and services from
other production units, which are meant for resale or for using up
completely during the same year.
Net Exports — It refers to the excess of the value of exports over
the value of imports of a country in an accounting year.
RECAP
Expenditure Method of Calculating National

Income
In this method, we take the sum of final expenditures on
consumption and investment. This sum equals GDPmp.
These final expenditures are on the final goods produced
within the domestic territory of the country. Main
components of GDPmp or final expenditures in the economy
are:
(i) Private final consumption expenditure (PFCE)
(ii) Government final consumption expenditure (GFCE)
(iii) Gross domestic capital formation (GDCF) (= Gross
domestic fixed capital formation + Net change in stocks)
(iv) Net exports (X–M) refers to the excess of the value of
exports over the value of imports of a country in an
accounting year. Exports, though purchased by non-
residents, are produced within our domestic territory, so
included in GDPmp; whereas Imports are deducted because
imported goods are not produced within our domestic
territory.
GDPmp = PFCE + GFCE + GDCF + Net Exports (or – Net
Imports)
By making the usual adjustments we can arrive at national
income:
National Income (NNPfc) = GDPmp – Depreciation –
Indirect taxes + Subsidies + NFIA
Precautions in making estimates of national income by
expenditure method
1. Avoid intermediate expenditure. National income
includes only final expenditures, i.e. expenditure on
consumption and investment.
2. Do not include expenditure on second hand goods
and financial assets. Buying second hand goods is not
a fresh production activity. Buying financial assets is not
a production activity because financial assets are neither
goods nor services.
3. Avoid transfer expenditures, e.g. Charities, donations,
gifts, scholarships, etc. since no production takes place.
4. Include the self use of own produced final
products. For example, a house owner using the house
for self. Although explicitly he does not incur any
expenditure, implicitly he is making payment of rent to
himself. Since the house is producing a service, the
imputed value of the housing service must be included
in national income.
NUMERICAL 18
Compute National Income. (4 marks)
S. No. Particulars (` in crore)

(i) Private final consumption expenditure 900
(ii) Government final consumption expenditure 400
(iii) Net imports 30
(iv) Gross domestic capital formation 250
(v) Change in stock 50
(vi) Net domestic fixed capital formation 180
(viii) Net factor income from abroad (–)40
(ix) Profits 100
Solution:
Private final consumption expenditure 900
(+) Government final consumption expenditure 400
(+) Gross domestic capital formation 250
(–) Net imports (–)30
Gross Domestic Product at market price (GDPmp) 1520
(–) Depreciation (–)20
(–) Net indirect taxes (–)100
(+) Net factor income from abroad (NFIA) (–)40
Note: Depreciation = Gross domestic capital formation

(iv) – Net domestic capital formation (vi + v)
= 250 – (180 + 50) = 250 – 230 = `20
crore
Do it yourself 18
Calculate National income from the following data.

(4 marks)
(ii) Profit 100
(iii) Government final consumption expenditure 400
(iv) Net indirect taxes 100
(v) Gross domestic capital formation 250
(vi) Change in stock 50
(vii) Net factor income from abroad (–)40
(viii) Consumption of fixed capital 20
(ix) Net imports 30
[Ans. ` 1,360 crore]

National income = Private final consumption expenditure
+ Government final consumption expenditure
+ Gross domestic capital formation – Net imports
– Consumption of fixed capital – Net indirect taxes
= 900 + 400 + 250 – 30 – 20 – 100 + (– 40) = `1360 crore
NUMERICAL 19
Find National Income from the following using

expenditure method. (4 marks)
(i) Current transfers from rest of the world 50
(ii) Net indirect taxes 100
(iii) Net exports (–)25
(iv) Rent 90
(v) Private final consumption expenditure 900
(vi) Net domestic capital formation 200
(vii) Compensation of employees 500
(viii) Net factor income from abroad (–)10
(ix) Government final consumption expenditure 400
(x) Profit 220
(xi) Mixed income of self-employed 400
(xii) Interest 230
Solution:
Private final consumption expenditure 900
Government final consumption expenditure 400
Net domestic capital formation 200
Net exports (–)25
Net Domestic Product at market price (NDPmp) 1,475
(–) Net indirect taxes (–)100
(+) Net factor income from abroad (NFIA) (–)10
Do it yourself 19
Calculate Net National Product at factor cost by expendi-

ture method from the data given below. (4 marks)
(i) Private final consumption expenditure 1,020
(ii) Net fixed capital formation 180
(iii) Indirect taxes 180
(iv) Government current transfers to households 25
(v) Government final consumption expenditure 100
(vi) Net factor income from abroad (–)10
(vii) Mixed income of the self-employed 560
(viii) Change in stocks 60
(ix) Current replacement cost 80
(x) Rent, interest and profits 190
(xi) Subsidies 20
(xii) Exports 100
(xiii) Imports 120
[Ans. `1,170 crore]

Net National Product at factor cost
= Private final consumption expenditure
+ Net fixed capital formation + Change in stocks
+ Exports – Imports – Indirect taxes + Subsidies + NFIA
= 1020 + 100 + 180 + 60 + 100 – 120 – 180 + 20 + (–10) =
`1170 crore
NUMERICAL 20
Calculate Net National Product at market price.

(4 marks)
(i) Gross domestic fixed capital formation 350
(ii) Private final consumption expenditure 8,000
(iii) Government final consumption expenditure 3,000
(iv) Value of output produced in the economy 150
(v) Current replacement cost of fixed capital 40
(vi) Net exports (–)60
(vii) Net factor income from abroad 80
(viii) Sales by all firms in the economy 100
Solution:
Private final consumption expenditure 8,000
Government final consumption expenditure 3,000
Gross domestic capital formation (note) 400
Net exports (–)60
Gross Domestic Product at market price 11,340
(–) Depreciation (–)40
(+) Net factor income from abroad (NFIA) 80
Net National Product at market price 11,380
Note: Gross domestic capital formation = Gross domestic

fixed capital formation (i) + Change in stock (iv – viii)
= 350 + (150 – 100) = 350 + 50 = `400 crore
Do it yourself 20
Calculate Gross National Product at factor cost from the

following data. (4 marks)
(i) Net domestic fixed capital formation 310
(ii) Closing stock 100
(iii) Government final consumption expenditure 200
(iv) Net indirect taxes 50
(v) Opening stock 60
(vi) Consumption of fixed capital 50
(vii) Net exports (–)10
(viii) Private final consumption expenditure 1,500
(ix) Imports 20
(x) Net factor income from abroad (–)10
[Ans. `2,030 crore]

Gross National Produce at Factor Cost
+ Government final consumption
expenditure
+ Gross domestic capital formation
+ Net exports – Net indirect taxes + NFIA
= 1500 + 200 + 400 + (–10) – 50 + (–10) =
`2030 crore
Note: Gross domestic capital formation
= Net domestic fixed capital formation
+ Change in stock + Consumption of fixed capital
= 310 + (100 – 60) + 50 = `400 crore
NUMERICAL 21
Calculate Net Domestic Product at factor cost.

(4 marks)
(i) Private final consumption expenditure 8,000
(ii) Government final consumption expenditure 1,000
(iii) Exports 70
(iv) Imports 120
(v) Annual allowance for wear and tear of capital 60
stock
(vi) Fixed business investment 300
(vii) Residential investment 200
(viii) Change in stock 100
(ix) Factor income to abroad 40
(x) Factor income from abroad 90
(xi) Net product taxes 400
(xii) Net production taxes 250
Solution:
Private final consumption expenditure 8,000
Government final consumption expenditure 1,000
Gross investment (note 1) 600
Net exports (note 2) (–)50
Gross Domestic Product at market price 9,550
(–) Depreciation (Annual allowance for wear and (–)60
tear of capital stock)
(–) Net product taxes (–)400
(–) Net production taxes (–)250
Net National Product at market price 8,840
Note: 1. Gross investment = Fixed business investment +

Residential investment + Change in stock
= 300 + 200 + 100 = `600 crore
2. Net exports = Exports – Imports
= 70 – 120 = (–) `50 crore
Do it yourself 21
Calculate Gross National Product at factor cost from the

(i) Consumption of fixed capital 60
(iii) Net factor income received from abroad (–) 10
(iv) Private final consumption expenditure 800
(v) Exports 50
(vi) Opening stock 30
(vii) Imports 60
(viii) Closing stock 20
(ix) Gross domestic fixed capital formation 230
[Ans. `1,200 crore]

Gross National Product at market price
= Government final consumption expenditure
+ Private final consumption expenditure
+ Gross domestic fixed capital formation
+ Net exports (Exports – Imports)
+ Change in stock (closing stock – opening stock)
= 200 + 800 + 230 + (50 – 60) + (20 – 30) + (–10) =
`1200 crore
NUMERICAL 22
Suppose there are only two firms, A and B in an

imaginary economy. Firm A uses no raw material and
produces cotton worth `50 lakh. Firm A gives ` 20
lakh to the workers as wages and keeps the remaining
` 30 lakh as its profits. Firm A sells its cotton to firm
B, who uses it produce cloth. Firm B sells the cloth
produced to consumers for ` 200 lakh and gives ` 60
lakh as wages and keeps the remaining income
generated as profits.
Assuming no depreciation and indirect taxes or
subsidies, calculate GDP by three methods.
(NCERT) (6 marks)
Solution:
(i) GDP by Value Added Method (Production phase)
Value added (VA) = Value of output – Intermediate
consumption
VA by Firm A = 50 – 0 = `50 lakh
VA by Firm B = 200 – 50 (purchases of cotton by Firm B
from Firm A) = `150 lakh
Hence, GDP = VA by Firm A + VA by Firm B
= 50 + 150 = `200 lakh
Particulars Firm A Firm B Total

Wages 20 60 80
Profits 30 90 120
Thus, GDP = Sum total of factor incomes paid by Firms A

and B
+ Total profits of Firms A and B = 80 + 120 = `200 lakh
(iii) GDP by Expenditure Method (Disposition phase)
GDP = Sum of final expenditures, i.e. expenditures on
goods and services for end use
In the given question, the final expenditure is expenditure
by consumers on cloth.
Therefore, GDP = `200 lakh
Thus, all the three methods of estimating GDP give us the
same answer.
 Top Tip
In Numerical 22, we have left out factor payments in the form of rent
and interest. But this will not make any difference to the basic result,
because after paying wages the remainder of value added by a firm
will be distributed between rent, interest and profits (together called
operating surplus).
Do it yourself 22
In an imaginary economy, suppose there are only two kinds

of producers — farmers and bakers (bread makers).
Farmers produced wheat worth `100 crore with no
intermediate costs. They sold `50 crore worth of wheat to
the bakers, who used this amount of wheat completely
during the year and produced `200 crore worth of bread.
Value of capital consumption is `10 crore.
Calculate GDP and NDP by (i) Value Added method, and
(ii) Expenditure method. (4 marks)
[Ans. `240 crore]
(i) Value Added Method
Value Added (VA) =Value of output – Intermediate costs
VA by Farmer = 100 – 0 = `100 crore
VA by Bakers = 200 – 50 = `150 crore
Thus, GDP = VA by Farmers + VA by Bakers = 100 +
150
= `250 crore
NDP = GDP – Depreciation (value of capital
consumption)
= 250 – 10 = `240 crore
(ii) Expenditure Method
GDP = Sum of final expenditures, i.e. expenditures on
Goods and services for end use
= Final consumption expenditures by consumers
= Purchases of wheat by consumers from Farmers +
Purchases of Bread from Bakers = 50 + 200 = `250 crore
NDP = GDP – Depreciation = 250 – 10 = `240 crore
NUMERICAL 23
Calculate Net domestic product at market price by (a)

Income method and (b) expenditure method.
(6 marks)
(i) Net Indirect taxes 40
(ii) Net exports 10
(iii) Social security contribution by employers 50
(iv) Operating surplus 110
(v) Net purchases of goods and services by 30
general government
(vi) Net domestic capital formation 60
(vii) Government final consumption expenditure 130
(viii) Change in stocks 10
(ix) Sales by general government 10
(x) Compensation of employees 500
(xi) Private final consumption expenditure 450
Solution:
(a) Net domestic product at market price (Income
method) = Compensation of employees + Operating
surplus + Net indirect taxes = 500 + 110 + 40
= `650 crore
(b) Net domestic product at market price (Expenditure
method) = Private final consumption expenditure +
Government final consumption expenditure + Net
domestic capital formation + Net exports
= 450 + 130 + 60 + 10 = `650 crore
Do it yourself 23
From the data given below, calculate: (a) Gross National

Product at market price by expenditure method (b) Gross
Domestic Product at market price by income method (6)
S. No. Pariculars (` in crore)
(iii) Gross domestic capital formation 40
(iv) Net exports (–) 5
(v) Wages and salaries 165
(vi) Employers’ contribution to social security schemes 10
(vii) Profits 15
(viii) Interest 20
(ix) Indirect taxes 30
(x) Subsidies 5
(xi) Rent 15
(xii) Net factor income from abroad 5
(xiii) Consumption of fixed capital 5
(a) Gross National Product at market price (Expenditure
method)
+ Gross domestic capital formation + Net exports
= 200 + 20 + 40 + (–5) + 5 = `260 crore
(b) Gross Domestic Product at market price (Income method)
= Wages and salaries + Employers’ contribution to social
security schemes
+ Profits + Interest + Rent + Indirect taxes – Subsidies
= 165 + 10 + 15 + 20 + 15 + 30 – 5 + 5 = `255 crore
NUMERICAL 24
From the data given below, calculate :

(a) National income by income method.
(b) Gross Domestic Product at factor cost by
expenditure method. (6 marks)
(ii) Net domestic fixed capital formation 25
(iii) Consumption of fixed capital 2
(iv) Closing stock 10
(v) Opening stock 5
Government final consumption expenditure
(vi) Net exports 10
(vii) Wages and salaries (–)5
(viii) Contribution of employers towards social 80
(ix) security 10
(x) Operating surplus 20
(xi) Net factor income received from abroad (–)5
(xii) Net indirect taxes 10
(a) National income (Income method) = Wages and

salaries + Contribution of employers towards social
security + Operating surplus + Net factor income
received from abroad
= 80 + 10 + 20 + (–) 5 = `105 crore
(b) Gross Domestic Product at factor cost (Expenditure
method) = Private final consumption expenditure +
Government final consumption expenditure + Net
domestic fixed capital formation + Consumption of
fixed capital + Change in stock (Closing stock –
opening stock) + Net exports – Net indirect taxes
= 85 + 10 + 25 + 2 + (10 – 5) + (– 5) – 10 = `112 crore
Do it yourself 24
Calculate national income by (a) Income method and (b)

Expenditure method. (6 marks)
(i) Rent 50
(ii) Net factor income from abroad 5
(iii) Compensation of employees 500
(iv) Indirect taxes 100
(vi) Subsidies 30
(vii) Royalty 20
(viii) Net exports (–)20
(ix) Interest 40
(x) Corporate tax 20
(xi) Profit after tax 100
(xii) Private final consumption expenditure 630
(xiii) Change in stocks 10
(xiv) Net domestic fixed capital formation 60
[Ans. `735 crore]
(a) National income (Income method)
= Compensation of employees + Rent + Royalty + Interest
+ Profit after tax + Corporate tax + NFIA
= 500 + 50 + 20 + 40 + 100 + 20 + 5 = `735 crore
(b) National income (Expenditure method)
+ Net domestic fixed capital formation
+ Change in stocks + Net exports
– Indirect tax + Subsidies + Net factor income from
abroad
= 630 + 120 + 60 + 10 + (–20) – 100 + 30 + 5 = `735 crore
NUMERICAL 25
Calculate from the following data, net national

product at market price by (a) income method and
(b) expenditure method. (6 marks)
(ii) Mixed income of the self-employed 800
(iii) Gross fixed capital formation 430
(v) Employers’ contribution to social security 100
schemes
(vi) Operating surplus 1,000
(vii) Net capital formation 450
(viii) Exports 10
(ix) Imports 40
(x) Indirect taxes 140
(xi) Subsidies 20
(xii) Private final consumption expenditure 2,100
(xiii) Government final consumption expenditure 600
(xiv) Purchase by non-residential households in the 50
domestic market
(xv) Net factor income to abroad 20
Solution:
(a) Net National Product at market price (Income
method) = Compensation of employees + Operating
surplus + Mixed income of the self-employed – Net
factor income to abroad + Indirect taxes – Subsidies
= 1,200 + 1,000 + 800 – 20 + 140 – 20 = `3,100 crore
(b) Net National Product at market price
(Expenditure method) = Private final consumption
expenditure + Government final consumption
expenditure + Net capital formation + Export –
Imports – Net factor income to abroad
= 2,100 + 600 + 450 + 10 – 40 – 20 = `3,100 crore
Do it yourself 25
Calculate national income by expenditure and income

methods. (6 marks)
(i) Operating surplus 110
(ii) Private final consumption expenditure 300
(iii) Net factor payment made abroad 20
(iv) Social security contribution by employees 20
(v) Compensation of employees 230
(vi) Change in stocks 10
(vii) Government final consumption expenditure 60
(viii) Net exports (–)10
(ix) Net domestic capital formation 40
(x) Consumption of fixed capital 30
(xi) Net indirect taxes 50
[Ans. `320 crore]
National income (Expenditure method)
+ Net domestic capital formation + Net exports
– Net factor payment made abroad – Net indirect
taxes
= 300 + 60 + 40 + (–10) – 20 – 50 = `320 crore
National income (Income method) = Compensation
of employees
+ Operating surplus – Net factor payment made
abroad
= 230 + 110 – 20 = ` 320 crore
NUMERICAL 26
Calculate from the following data, Net National

Product at market price by (a) income method and
(b) expenditure method. (6 marks)
(i) Compensation of employees paid by the 40
Government
(ii) Mixed income of the self-employed 50
(iii) Wages and salaries 400
(iv) Employers’ contribution to social security 80
schemes
(v) Operating surplus 300
(vi) Indirect taxes 30
(vii) Subsidies 10
(viii) Net capital formation 150
(ix) Net factor income to abroad 10
(x) Government final consumption expenditure 230
(xi) Private final consumption expenditure 500
(xii) Exports 15
(xiii) Imports 45
(xiv) Consumption of fixed capital 20
(xv) Profits 130
Solution:
(a) Net National Product at market price (Income
method) = Wages and salaries + Employers’ contribution
to social security schemes + Operating surplus + Mixed
income – Net factor income to abroad + Indirect taxes –
Subsidies
= 400 + 80 + 300 + 50 – 10 + 30 – 10 = `840 crore
(b) Net National Product at market price
(Expenditure Method) = Private final consumption
expenditure + Government final consumption expenditure +
Net capital formation + Exports – Imports – Net factor
incometoabroad = 500 + 230 + 150 + 15 – 45 – 10 = `840crore
Do it yourself 26
Calculate gross national product at market price from the

following data by (a) income method and (b) expenditure
method. (6 marks)
(i) Mixed income of self-employed 800
(ii) Corporation tax 50
(iii) Interest 100
(iv) Rent 80
(v) Undistributed profits 150
(vi) Dividends 70
(vii) Employers’ contribution to social security schemes 120
(viii) Compensation of employees 1,200
(ix) Government final consumption expenditure 730
(x) Private final consumption expenditure 1,580
(xi) Net factor income to abroad 20
(xii) Gross capital formation 300
(xiii) Change in stocks 40
(xiv) Net indirect taxes 100
(xv) Current replacement cost 50
(xvi) Net exports (–)10
[Ans. `2,580 crore]

(a) Gross National Product at Market price (Income Method)
= Compensation of employees+ Mixed income of
self-employed
+ Interest + Rent + Corporation tax + Undistributed
profits
+ Dividends – Net factor income to abroad
+ Current replacement cost + Net indirect taxes
= 1200 + 800 + 100 + 80 + 50 + 150 + 70 – 20 + 50
+ 100
= `2580 crore
(b) Gross National Product at market price (Expenditure
Method)
+ Gross capital formation + Net exports – Net factor
income to abroad
= 1580 + 730 + 300 + (–10) – 20 = `2580 crore
NUMERICAL 27
Calculate gross national product at market price by

income method and expenditure method from the
(i) Rent 40
(iii) Net exports 20
(iv) Interest 60
(v) Profit 120
(vi) Government final consumption expenditure 200
(vii) Net domestic capital formation 100
(viii) Compensation of employees 800
(ix) Consumption of fixed capital 20
(x) Net indirect taxes 100
(xi) Net factor income from abroad (–)20
Solution : GNPmp (Income method) = Compensation
of employees + Rent + Interest + Profit + Consumption of
fixed capital + Net factor income from abroad + Net indirect
taxes
= 800 + 40 + 60 + 120 + 20 + (–20) + 100 = `1,120 crore
GNPmp (Expenditure method) = Private final consumption
expenditure + Government final consumption expenditure +
Net domestic capital formation + Consumption of fixed capital
+ Net exports + Net factor income from abroad = 800 + 200 +
100 + 20 + 20 + (–20) = ` 1,120 crore
Do it yourself 27
Calculate gross national product at factor cost by income

method and expenditure method from th following data.
(6 marks)
(i) Factor income from abroad 10
(ii) Compensation of employees 150
(iii) Net domestic capital formation 50
(iv) Private final consumption expenditure 220
(v) Factor income to abroad 15
(vi) Change in stock 15
(vii) Employers’ contribution to social security schemes 10
(ix) Interest 40
(x) Exports 20
(xi) Imports 25
(xii) Indirect taxes 30
(xiii) Subsidies 10
(xiv) Rent 40
(xv) Government final consumption expenditure 85
(xvi) Net current transfers from abroad (–)80
(xvii) Profit 100
(xviii) Dividend 40
[Ans. `340 crore]

GNPfc (Income method) = Compensation of employees
+ Interest + Rent + Profit + Consumption of fixed
capital
+ Factor income from abroad – Factor income to
abroad
= 150 + 40 + 40 + 100 + 15 + 10 – 15 = `340 crore
GNPfc (Expenditure method) = Private final consumption
expenditure
+ Net domestic capital formation
+ Consumption of fixed capital + Exports
– Imports – Indirect taxes + Subsidies
+ Factor income from abroad – Factor income to
abroad
= 220 + 85 + 50 + 15 + 20 – 25 – 30 + 10 + 10 – 15 =
`340 crore
NUMERICAL 28
Given the following data, find the missing value of

‘Government Final Consumption Expenditure’ and
‘Mixed Income of Self Employed’. (CBSE 2019) (6)
(i) National Income 71,000
(ii) Gross Domestic Capital Formation 10,000
(iii) Government Final consumption Expenditure ?
(iv) Mixed Income of self-Employed ?
(v) Net Factor Income from abroad 1,000
(vi) Net Indirect Taxes 2,000
(vii) Profits 1,200
(viii) Wages and Salaries 15,000
(ix) Net Exports 5,000
(x) Private Final Consumption Expenditure 40,000
(xi) Consumption of fixed Capital 3,000
(xii) Operating Surplus 30,000
Solution :
Mixed income of self-employed = (i)–[(viii)+(xii)+(v)]
= 71,000 – (15,000 + 30,000
+ 1,000)
Mixed income of self-employed = `25,000 crore
Government Final consumption expenditure
= (i)–[(x)+(ii)+(v)+(ix)]+(vi)+(xi)
= 71,000 –(40,000 + 10,000 + 1,000 + 5,000) + 2,000 + 3,000
= `20,000 crore
Do it yourself 28
Calculate gross national product at factor cost by income

method and expenditure method from th following data.(6)
(ii) Net Indirect Taxes 1,000
(iii) Private Final Consumption Expenditure ?
(iv) Gross Domestic Capital Formation 17,000
(v) Profits 1,000
(vi) Government Final Consumption Expenditure 12,500
(vii) Wages & Salaries 20,000
(viii) Consumption of Fixed Capital 700
(ix) Mixed Income of Self Employed 13,000
(x) Operating Surplus ?
(xi) Net Factor Income from Abroad 500
(xii) Net Exports 2,000
[Ans Private final Consumption expenditure ` 19,700 crore;

Operating surplus `16,500 crore]
Operating surplus = (i) – [(vii) + (ix) + (xi)] = 50,000 –
(20,000 + 13,000 + 500) = `16,500 crore
Private final Consumption expenditure = (i)–
[(iv)+(vi)+(xi)+(xii)]+(vii)+(ii)
= 50000 – (17000 + 12500 + 2000 + 500) + 700 + 1000 =
`19,700 crore
NUMERICAL 29
Given the following data, find the missing values of

‘Gross Domestic Capital Formation’ and ‘Wages and
Salaries’. (CBSE 2019) (6 marks)
(i) Mixed Income of Self Employed 3,500
(ii) Net Indirect Taxes 300
(iii) Wages & Salaries ?
(iv) Government Final Consumption Expenditure 14,000
(v) Net Exports 3,000
(vi) Consumption of Fixed Capital 300
(vii) Net Factor Income from Abroad 700
(viii) Operating Surplus 12,000
(ix) National Income 30,000
(x) Profits 500
(xi) Gross Domestic Capital Formation ?
(xii) Private Final Consumption Expenditure 11,000
Solution :
Wages and salaries = ix–[(i)+(viii)+(vii)]
= 30,000 – (3,500 + 12,000 + 700)
= `13,800 crore
Gross domestic Capital formation
= (ix)– [(iv)+(v)+(vii)+(xii)]+(ii)+(vi)
= 30,000 – (14,000 + 3000 + 700 + 11,000) + 300 + 300
= `1,900 crore
Do it yourself 29
Given the following data, find the values of “Gross

Domestic Capital Formation” and “Operating Surplus. (6)
(ii) Wages and Salaries 12,000
(iii) Private Final Consumption Expenditure 7,200
(iv) Net Indirect Taxes 700
(v) Gross Domestic Capital Formation ?
(vi) Depreciation 500
(vii) Government Final Consumption Expenditure 6,100
(viii) Mixed Income of Self-Employed 4,800
(ix) Operating Surplus ?
(x) Net Exports 3,400
(xi) Rent 1,200
(xii) Net Factor Income From Abroad (–) 150
[Ans. Gross Domestic Capital Formation `6,750 crore; Operating

surplus `5,450 crore]
Gross Domestic Capital Formation
= (i) – {iii+vii+x} + vi – xii + iv
GDCF = 22,100 – {7,200 + 6,100 + 3,400} + 500 – (–150) +
700
GDCF = 6,750 crore
Operating surplus = National Income – wages and
salaries
– Mixed Income of Self Employed – Net Factor Income
from Abroad
= (i) – (ii) – (viii) – (xii) = 22,100 – 12,000 – 4,800 – (–
150) = 5,450 crore
NUMERICAL 30
Given the following data, find the missing values of

‘Gross Domestic Capital Formation’ and ‘Wages and
Salaries’. (CBSE 2019) (6 marks)
(i) Mixed Income of Self-Employed 700
(ii) Net Factor Income from Abroad 150
(iii) Private Final Consumption Expenditure 2,200
(iv) Profits 200
(v) Net Indirect Taxes 150
(vi) National Income 5,000
(vii) Gross Domestic Capital Formation 1,100
(viii) Wages and Salaries 2,200
(ix) Net Exports ?
(x) Government Final Consumption Expenditure 1,300
(xi) Consumption of Fixed Capital 200
(xii) Operating Surplus ?
Solution :
National Income (vi) = Wages and Salaries (viii) + Operating
Surplus + Mixed Income (i) + NFIA (ii)
Operating Surplus = (vi) – (viii) – (i) – (ii) = 5,000 – 2200
– 700 – 150 = `1,950 crore
National Income (vi) = PFCE (iii) + GFCE (x) + GDCF (vii)
+ Net Exports (ix) – Consumption of Fixed
Capital (xi) – Net Indirect Taxes (v) + NFIA (ii)
Net exports = (vi) – (iii) – (x) – (vii) + (xi) + (v) – (ii)
= 5,000 – 2,200 – 1,300 – 1,100 + 200 + 150 – 150 = `600
crore
Do it yourself 30
Given the following data, find the values of “Gross

Domestic Capital Formation” and “Operating Surplus. (6)

(i) Wages and Salaries 2,400
(ii) National Income 4,200
(iii) Net Exports ?
(iv) Net Factor Income from Abroad 200
(v) Gross Domestic Capital Formation 1,100
(vi) Mixed Income of Self-Employed 400
(vii) Private Final Consumption Expenditure 2,000
(viii) Net Indirect Taxes 150
(ix) Operating Surplus ?
(x) Government Final Consumption Expenditure 1,000
(xi) Consumption of Fixed Capital 100
(xii) Profits 500
[Ans. Operating surplus `1,200 crore; Net exports `150 crore]

Operating surplus = (ii) – (iv) – (vi) – (i)
= 4200 – 200 – 400 – 2400 = 1200 crore
Net exports = (ii) – (vii) – (x) – (v) + (xi) + (viii) – (iv)
= 4200 – 2000 – 1000 – 1100 + 100 + 150 – 200 = 150
crore
Question 1
Which one of the following is an intermediate expenditure?
(a) Expenditure on purchase of furniture by a firm for its
own use
(b) Expenditure on maintenance by a firm
(c) Expenditure on purchase of tractor by a firm for its
own use
(d) Machine bought by a household
Answer 1
(b) Expenditure on maintenance by a firm

Question 2
Which one of the following is not included in national
(a) Payment of indirect tax by a firm
(b) Bonus paid to employees
(c) Addition to stocks during a year
(d) Purchase of taxi by a taxi driver

Answer 2
(a) Payment of indirect tax by a firm

Question 3
Purchase of car by a household is a part of gross
domestic capital formation. True/False? Give reason.

Answer 3
3. False: It is a private final consumption expenditure.

Question 4
Free services provided by the government will not be
included in national income. True/False? Give reason.

Answer 4
False: It will be included in national income as it is
government final consumption expenditure.

Question 5
Gross domestic capital formation is always greater than
gross fixed capital formation. True/False? Give reason.

Answer 5
False: Gross domestic capital formation can be less
than gross fixed capital formation if change in stock is
negative, i.e., when opening stock exceeds closing
stock.

Question 6
Column I Column II
(i) Addition to the (a) Change in inventories
machinery factory buildings and
equipment employed by
the firms.
(ii) Addition of housing (b) Residential investment
facilities
(iii) Addition to the stock of (c) Fixed business
capital of the firms investment

Answer 6
(i) – (c) , (ii) – (b) , (iii) – (a)

Question 7
It is only the households which undertake the final
consumption expenditure on the goods and services
produced by the firms. True/False? Give reason.

Answer 7
False: Final consumption expenditure is also incurred
by the government. Firms may also buy consumption
goods to treat their guests or for their employees.

Question 8
The expenditure on intermediate goods is not included
in the calculation of GDP, whereas the expenditure on
investment goods is included. True/False? Give reason.

Answer 8
True: The reason is that investment goods remain with
the firm, whereas intermediate goods are consumed in
the process of production.

Question 9
The final expenditure incurred by the government
includes the consumption expenditure only.

Answer 9
False: The expenditure that the government makes on
the final goods and services, includes both final
consumption expenditure and final investment expenditure.

Question 10
Aggregate imports expenditure incurred by the
economy includes expenditure on the imports of
consumption goods by households, expenditure on
imports of foreign investment goods by firms and
_______________. (Fill in the blank)

Answer 10
Government expenditure incurred on imports

Question 11
____________ (Exports / Imports), which denotes
aggregate expenditure incurred by the foreigners on the
final goods and services produced in the domestic
territory of the country is ____________
(included / not included) in national income.
(Fill in the blanks with the correct options)

Answer 11
Exports , included

Question 12
Final expenditure is the spending on (i)
______________; it does not include spending on (ii)
_____________(Intermediate goods / Final goods).
(Fill in the blanks with the correct options)

Answer 12
(i) Final goods (ii) Intermediate goods

Question 13
Which one of the following is not a part of a country’s
Net Domestic Product at market price’?
(a) Depreciation
(b) Indirect tax
(c) Net exports
(d) Net change in stocks

Answer 13
(a) Depreciation

Question 1
Should the following be treated as final expenditure or
intermediate expenditure? Give reason.
(i) Purchase of furniture by a firm
(ii) Expenditure on maintenance by a firm
(3 marks)

Answer 1
(i) It is a final expenditure if it is purchased by the firm
for its own use because it is an investment
expenditure. However, if it is purchased by the firm
for re-sale, then it is an intermediate expenditure.
(ii) It is an intermediate expenditure because it is an
expenditure on single use producer goods.

Question 2
State the various components of the Expenditure Method
that are used to calculate national income.

Answer 2
The components of the Expenditure Method that are
used to calculate national income are:
(a) Private Final Consumption Expenditure: The final
consumption expenditure of households on the
goods and services produced by all the firms in the
economy.
(b) Government Final Consumption Expenditure: The
expenditure that the government makes on the final
goods and services produced by all the firms in the
economy.
(c) Investment Expenditure: The final investment
expenditure incurred by firms on the capital goods
produced by other firms in the economy.
(d) Net Exports: Exports minus imports. (Net exports
= Exports – Imports)

Question 3
Write down the three identities of calculating GDP of a
country by the three methods. Also briefly explain why
each of these give us the same value of GDP.
(NCERT) (6 marks)

Answer 3
GDPmp (by Product Method)
= Value of output produced by all firms in the
economy during the year – Value of intermediate
goods used by all firms in the economy during the
year
GDPmp (by Income method)
= Compensation of employees + Interest + Rent
and royalty + Profits + Mixed income of self-
employed + Depreciation + Net indirect taxes
(Indirect taxes – Subsidies)

GDPmp (by Expenditure Method)
+ Gross domestic capital formation + Net Exports
(Exports – Imports)
All the three methods give equal value of GDP because
the same amount of money, representing the aggregate
value of final goods and services moves in the economy
in a circular way. Income generated in production units
in the form of aggregate value of final goods and
services produced in the economy is distributed among
owners as factors payments, which in turn spent on
consumption and investment expenditure on final foods
and services produced by all the firms in the economy.

Question 4
Why are (a) net exports and (b) net change is stocks
included in national income? Explain. (4 marks)

Answer 4
(a) National income by expenditure method includes
net exports (= exports – imports) because it is an
item of final expenditure. Exports, though
purchased by non-residents, are produced within
our domestic territory, and therefore, a part of
domestic product and hence included in national
income. Imports are deducted because goods and
services imported are not produced within the
domestic territory of the country.

(b) Net change in stocks, i.e., net addition to stocks
during a year is included in national income
because it is a component of final investment
expenditure since Gross investment = Net change
in stocks + Fixed business investment + Residential
investment.

Question 5
Are the following a part of a country’s Net Domestic
Product at market price? Explain giving reasons.
(i) Indirect tax
(ii) Net exports
(iii) Net factor income from abroad
(iv) Consumption of fixed capital (6 marks)

Answer 5
NDPmp (by production method) = Value of output –
Intermediate consumption – Depreciation
NDPmp (by expenditure method) = Private final
consumption expenditure + Government final
consumption expenditure + Gross domestic capital
formation + Net exports – Depreciation
(i) Yes, Indirect tax is a part of NDPmp because
indirect taxes have not been paid yet to the
government.
(ii) Yes, Net exports is a part of NDPmp because it is
an item of final expenditure.
(iii) No, NFIA is not a part of NDPmp because this is
the net income earned outside the domestic
territory of the country.
(iv) No, consumption of fixed capital (or depreciation)
is not a part of NDPmp because provision for
depreciation has been made while arriving at
NDPmp.

1.7
Real and Nominal GDP
Nominal GDP, Real GDP and GDP
Deflator
Nominal GDP
It is the market value of the final goods and services
produced within domestic territory of a country during
an accounting year, as estimated at the current year’s
prices. In other words, Nominal GDP (or GDP at
current prices) is measured as the product of current
year’s output (Q1) of final goods and services and their
current year’s price (P1).
Change in nominal GDP may include both change in
prices and change in flow of goods and services. Thus,
nominal GDP may increase even if there is no increase
in the output of goods and services produced in the
economy, due to rise in general price level during the
current year.
Real GDP
It is the market value of the final goods and services
produced within the domestic territory of a country
during an accounting year, as estimated at the base
year’s* prices/constant prices. In other words, Real
GDP (or GDP at constant prices) is measured as
product of current year output (Q1) and their base
year’s price (P0).
Since base year’s prices remaining constant, real GDP
will increase only if the output of goods and services
produced in the economy is increasing.
* Base year is the year whose prices are used to calculate the real GDP.
 Top Tip
Real GDP is a better indicator of economic growth and welfare
of people of the country than Nominal GDP as it is not
affected by changes in general price level. Secondly, because
increase in real GDP means more goods and services are
available to the society during the year. Thus, welfare
increases.
Numerical Example:
Goo Price of Price of Quantity of Nominal Real GDP
ds Current Year Base Year Current GDP (P0Q1)
(P1) (in `) (P0) (in `) Year (Q1) (in units) (P1Q1)
A 20 10 100 2,000 1,000
B 10 5 200 2,000 1,000
C 30 20 50 1,500 1,000
5,500 3,000
In the above example, Nominal GDP = ΣP1Q1 = ` 5,500
and Real GDP = ΣP0Q1 = `3,000
The difference between Nominal GDP and Real GDP is
5,500 – 3,000 = ` 2,500. This is only the monetary difference
as the quantity sold in the market remains unchanged
and the variation in the value of nominal and real GDP
is merely due to the change in the prices in the
economy between the base year and current year.
GDP Deflator
The ratio of Nominal GDP to Real GDP of current year
is a well known price index, called GDP Deflator.
Sometimes GDP deflator is also denoted in percentage

terms. In such a case,
It gives the change in price level between the base year

and current year. This is because in the calculation of
real and nominal GDP of the current year, the volume
of production is fixed. Therefore, if these measures
differ it is only due to change in the price level between
the base year and the current year.
In our numerical example, Nominal GDP = ΣP1Q1 =
`5,500 and Real GDP = ΣP0Q1 = ` 3,000
Therefore,
This implies that the prices have risen by 83.33%

between the base year and the current year.
Given the Nominal GDP, how to find out
Real GDP?
Given the Nominal GDP, we can find out Real GDP by
eliminating the effect of change in prices between the
base year and the current year.
The effect of change in prices on the nominal GDP can
be eliminated in the following way:
Example: Suppose Nominal GDP = `288 and Price

index = 120, then Real GDP can be calculated as:
 Top Tip
Nominal GNP, Real GNP and GNP Deflator
• Nominal GNP is the value of GNP at the current year’s
prices.
• Real GNP is the value of GNP at the base year’s prices.
• The ratio of nominal GNP to real GNP of the current year is
called GNP Deflator.
Nominal and Real Income
Nominal National Income (or National
Income at current prices)
When national income (product) of the current year is
estimated on the basis of prices prevailing in the
current year, it is called nominal national income (or
national income at current prices).
In other words, nominal national income is measured
as the product of current year’s output (Q1) of final
goods and services and their current year’s price (P1).
Change in nominal national income may include both
change in prices and change in flow of goods and
services. Thus, nominal national income may increase
due to increase in prices of goods and services during
the current year without increase in the flow of goods
and services in the economy, due to rise in general
price level during the current year.
Real National Income (or National Income at
constant prices)
estimated on the basis of prices prevailing in the base
year, it is called real national income (or national
income at constant prices).
In other words, real national income is measured as
product of current year output (Q1) and their base
year’s price (P0).
Since base year’s prices remaining constant, real nat-
ional income will increase only if the output of goods
and services produced in the economy is increasing.
Thus, real national income reflects the real growth of
an economy because it increases only when there is an
increase in real national output over a period of time.
Numerical Example:
Goods Price of Price of Quantity Nominal Real NI
Current Year Base Year of Current NI (P0Q1)
(P1) (in `) (P0) (in `) Year (Q1) (P1Q1)
(in units)
A 20 10 100 2,000 1,000
B 10 5 200 2,000 1,000
C 30 20 50 1,500 1,000
5,500 3,000
Nominal National Income = ΣP1Q1 = `5,500; Real

National Income = ΣP0Q1 = ` 3,000
The difference between Nominal National Income and
Real National Income is 5,500 – 3,000 = `2,500.
This is only the monetary difference as the quantity so-
ld in the market remains unchanged and the variation
in the value of nominal and real national income is
merely due to the change in the prices in the economy
between the base year and current year.
Given the Nominal National Income, how to
find out Real National Income?
Given the Nominal national income, we can find out Real
national income by eliminating the effect of change in
prices between the base year and the current year.
The effect of change in prices on the nominal national
income can be eliminated in the following way:
Example: Suppose Nominal national income = `288

and Price index = 120, then Real national income can
be calculated as:
RECAP
Nominal GDP
Nominal GDP is measured as the product of current year’s output
(Q1) of final goods and services and their current year’s price (P1).
Nominal GDP may increase even if there is no increase in the
output of goods and services produced in the economy, due to
rise in general price level during the current year.
Real GDP
Real GDP is measured as product of current year output (Q1)
and their base year’s price (P0). Real GDP will increase only if
the output of goods and services produced in the economy is
increasing. Thus, Real GDP is a better indicator of economic
growth and welfare of people of the country than Nominal
GDP as it is not affected by changes in general price level.
Given Nominal GDP, we can find Real GDP by eliminating the effect
of change in prices between the base year and the current
year in the following way:
GDP Deflator
The ratio of Nominal GDP to Real GDP of current year is a well
known price index, called GDP Deflator. It gives the change in price
level between the base year and current year.
Nominal and Real National Income

• When national income (product) of the current year is
estimated on the basis of prices prevailing in the current
year, nominal national income (or national income at
current prices) whereas when national product of the
current year is estimated on the basis of prices prevailing
in the base year, it is called real national income (or
national income at constant prices).
• Nominal national income may increase due to increase
in prices of goods and services during the current year
without increase in the flow of goods and services in the
economy. Real national income reflects the real growth
of an economy because it increases only when there is an
increase in real national output over a period of time.
Given Nominal Income, we can find Real Income by
eliminating the effect of change in prices between the
base year and the current year in the following way:
Key Terms
Nominal GDP — It is the market value of the final goods and
services produced within domestic territory of a country during an
accounting year, as estimated at the current year’s prices.
Real GDP — It is the market value of the final goods and services
produced within the domestic territory of a country during an
accounting year, as estimated at the base year’s* prices/constant
prices.
GDP Deflator — The ratio of Nominal GDP to Real GDP of current
year is a well known price index, called GDP Deflator.
Nominal National Income — When national income (product) of
the current year is estimated on the basis of prices prevailing in
the current year, it is called nominal national income.
Real National Income — When national income (product) of the
current year is estimated on the basis of prices prevailing in the
base year, it is called real national income.
NUMERICAL 31
Calculate real national income, nominal national

income and price index. Also, interpret the result.
(6 marks)
Goods Price of Current Price of Base Quantity of Quantity of
Year Year Current Base
(in `) (in `) Year (in units) Year (in units)
A 20 10 10 5
B 30 20 20 10
C 50 40 5 2
Solution:
Goods Price of Price of Quantity Quantity Nominal Real NI
Current Base Year of of Base NI (P0Q1)
Year (P1) (P0) (in `) Current Year (Q0) (P1Q1)
(in `) Year (Q1) (in units)
(in units)
A 20 10 10 5 200 100
B 30 20 20 10 600 400
C 50 40 5 2 250 200
ΣP1Q1 = ΣP0Q1 =
1,050 700
Nominal National Income = `P1Q1 = `1,050; Real National

Income = ` P0Q1 = ` 700
Interpretation: The difference between Nominal

National Income and Real National Income is 1,050 – 700
= `350.
difference between Nominal National Income and Real
National Income is 1,050 – 700 = `350.
This is only the monetary difference as the quantity sold
in the market remains unchanged and the variation in the
value of nominal and real national income is merely due
to the change in the prices in the economy between the
base year and current year.
Price index of 150% signifies that price level has increased
by 50% between the base year and the current year.
Do it yourself 31
Calculate real GNP, nominal GNP and GNP Deflator. Also,
interpret the result. (6 marks)
Goods Price of Current Price of Base Quantity of Current

Year (in `) Year (in `) Year (in units)
A 20 10 100
B 10 5 200
C 30 20 50
Goods Price of Price of Quantity of Nominal Real GNP
Current Year Base Year Current GNP (P0Q1)
(P1) (in `) (P0) (in `) Year (Q1) (P1Q1)
(in units)
A 20 10 100 2,000 1,000
B 10 5 200 2,000 1,000
C 30 20 50 1,500 1,000
ΣP1Q1 = ΣP0Q1 =
5,500 3,000
Nominal GNP= ΣP1Q1 = ` 5,500; Real GNP = ΣP0Q1 =

`3,000
Price index = Nominal GNP/Real GNP × 100 =
5,500/3,000 × 100 = 183.33%
Interpretation: Price index of 183.33% signifies that price
level has increased by 83.33% between the base year and
the current year.
NUMERICAL 32
If the Nominal Gross Domestic Product = `4400 crore

and the Price Index (base = 100) = 110, calculate the
Real Gross Domestic Product. (3 marks)
Solution:
Do it yourself 32
If the Real GNP is `500 crore and Price Index (base = 100) is
125, calculate the Nominal GNP. (3 marks)
[Ans. Nominal GNP= ` 625 crore]
Real GNP = Nominal GNP/Price index × 100
⇒ 500 = Nominal GNP/125 × 100
⇒ Nominal GNP = (500 × 125)/100 = `625 crore
NUMERICAL 33
Suppose only one Product X is produced in the

country. Its output during the year 2019 and 2020 was
100 units and 110 units respectively. The market price
of X during the years 2019 and 2020 were `50 and ` 55
per unit respectively.
(i) Calculate the percentage change in real GDP and
nominal GDP in year 2020 using 2019 as the base
year.
(ii) Calculate GDP deflator for the years 2019 and
2020 (in percentage terms) and comment on the
results.
(6 marks)
Solution: Substituting L = 100 and K = 9 in the given
production function,
Year Output Market Price Real GDP using Nominal GDP using
(units) (`per unit) base year price current year price
2019 100 50 100 × `50 = `5,000 100 × `50 = `5,000
2020 110 55 110 × `50 = `5,500 110 × `55 = `6,050
(i)
(ii)
For the year 2019:
Since real and nominal GDP in 2019 are same, GDP deflator is
100. This is because 2019 is the base year.
For the year 2020:
It means prices have risen by 10% between the two
periods. Which is true because price of product X has
indeed gone up from `50 to `55.
Do it yourself 33
Use the following information of an imaginary country:
Year 2017-2018 2018-2019 2019-2020

Nominal GDP 6.5 8.4 9
GDP deflator 100 140 125
(i) For which year is real GDP and nominal GDP same and
why?
(ii) Calculate real GDP for the given years. Is there any year
for which real GDP falls?
[Ans. (a) 2017-18 because it is the base year (b) GDP
declined in the year 2018-2019]
(i) For the year 2017-2018, real GDP and nominal GDP
are same as it is the base year and thus, GDP deflator is
100.
(ii)
Year 2017-2018 2018-2019 2019-2020
Nominal GDP 6.5 8.4 9

GDP deflator 100 140 125
Real GDP* 6.5 6 7.2
*Real GDP = Nominal GDP/GDP Deflator × 100
The real GDP declined in the year 2018-2019. It is due to
high rate of inflation or price level. (Price level has risen
by 40% between the base year and the year 2018-2019.)
Question 1
If the nominal GDP of the current year is double the
nominal GDP of the base year, the volume of production
of the country must have doubled.
True/False? Given reason.

Answer 1
False: It is possible that only prices of all goods and
services (i.e. price level) have doubled between the
base year and the current year whereas the
production has remained constant.

Question 2
In order to compare the GDP figures of different
countries , we cannot rely on (i) ____________. For
comparison we take help of (ii) ____________. (Real
GDP/ Nominal GDP)
(Fill in the blanks with correct options)

Answer 2
(i) Nominal GDP (ii)Real GDP

Question 3
Nominal GDP can never be less than Real GDP.

Answer 3
False: Nominal GDP can be less than real GDP, if prices
in the current year are less than the prices in the
base year.

Question 4
Real gross domestic product can be equal to nominal
gross domestic product. True/False? Given reason.

Answer 4
True: Real GDP can be equal to nominal GDP if prices
in the current year are equal to the base year’s
prices.

Question 5
National income at current prices is higher than national
income at constant prices during a period of:
(a) Rising prices
(b) Falling prices
(c) Constant prices
(d) Both (a) and (b)

Answer 5
(a) Rising prices

Question 6
Suppose a country produces bread only. In the year
2018 - 19 it had produced 1,000 units of bread, price
was ` 10 per bread . In 2019 - 20, it produced 1,100
units of bread at price of ` 12 per bread. In 2019 - 20,
the nominal and real GDP are:
(a) `10,000 and `10,000
(b) `10,000 and `11,000
(c) `13, 200 and `10,000
(d) `13,200 and `11,000

Answer 6
(d) `13,200 and ` 11,000

Question 7
The ratio of nominal GDP to real GDP is a well-known
index of prices, called ______________.
(Fill in the blank)

Answer 7
GDP deflator

Question 8
Which of the following formula is correct?

Answer 8

Question 9
In the calculation of real and nominal GDP of the
current year, the difference between the two is due to
________________. (Change in volume of production
/ Change in the price level between the base year and
the current year)
(Fill in the blank with correct options)

Answer 9
Change in the price level between the base year and
the current year.

Question 10
Cost of purchase of a given basket of commodities by a
representative consumer in the current year is
expressed as a percentage of the cost of purchase of the
same basket in the base year, this gives us
___________ . (Fill in the blank)

Answer 10
the consumer price index (CPI) of the current year

Question 11
If the GDP deflator is 150 % and real GDP is `1,100 the
nominal GDP will be : (Choose the correct alternative)
(a) `733
(b) `1,650
(c) `1,100
(d) `2,750

Answer 11
(b) `1,650

Question 12
A representative consumer had to spend `1,400 on
purchase of a given basket of commodities in the year
2015-16. Due to inflation, CPI of the year 2019-20
(taking 2015-16 as base year) was 120. How much
amount the consumer had to spend on purchase of the
same basket of commodities in the year 2019-20?
(a) ` 1,167
(b) ` 1,680
(c) ` 1,520
(d) ` 1,280
Answer 12
(b) `1,680

Question 13
Like Consumer Price Index (CPI), the index for wholesale
prices is called _____________.
(Fill in the blank)

Answer 13
Wholesale Price Index (WPI)

Question 14
___________ takes into account all the goods and
services produced in a country.
(a) GDP deflator
(b) Consumer Price Index
(c) Producer Price Index
(d) Wholesale Price Index

Answer 14
(a) GDP deflator

Question 15
CPI includes prices of imported goods also but GDP
deflator does not include price of imported goods.

Answer 15
True: CPI includes prices of goods consumed by the
representative consumer, hence it includes
prices of imported goods. But GDP Deflator
calculated on the basis of nominal and real GDP
includes domestically produced goods only.

Question 16
The weights are constant in (i) _______________ but
they differ according to production level of each good in
(ii) _______________. (GDP deflator/ CPI)
(Fill in the blank with correct options)

Answer 16
(i) CPI (ii) GDP deflator

Question 1
When can Real GDP be greater than Nominal GDP?
(1 mark)

Answer 1
When base year’s prices are higher than the current
year’s prices.

Question 2
Discuss any two differences between GDP at constant
prices and GDP at current Prices.

Answer 2
Two main difference between GDP at current prices
and at constant price are:
(i) GDP at current prices are measured at current
year’s prices whereas GDP at constant prices are
measured at base year’s prices.
(ii) GDP at current prices may increase due to rise in
prices even if there is no flow of goods and services
whereas GDP at constant prices will only increase
when there is an increase in the flow of goods and
services.

1.8
GDP and Welfare
Is GDP a perfect index of economic
welfare?
Generally it is considered that an increase in the Gross
Domestic Product (GDP) of any economy ensures
increase in welfare of the people of the country.
However, this may not always be correct. Following are
some of the limitations of using GDP as an index of
welfare of a country:
1. Distribution of GDP
If the GDP of the country is rising, the welfare of
people may not increase if there is inequalities in the
distribution of GDP. Increase in inequalities means
that rich become richer and poor become poorer. Since
utility of money is higher among poor and lower Amo-
ng the rich, therefore, if the distribution of GDP is not
uniform, inequalities may not lead to increase in
welfare of the entire country people.
2. Non-monetary exchanges (or non-monetary
production)
Non-monetary exchanges are those activities in an
economy which cannot be evaluated in terms of money
due to non-availability of data.
For example, domestic services of a housewife/family
members, hobbies like painting, gardening, etc. are not
paid for. Similarly, barter exchanges take place without
the help of money. But these activities do contribute to
welfare of the people.
Since GDP does not account for such activities, it is a major
cause of underestimation of GDP in the economy. As a
result, welfare of the people is also underestimated.
Thus, GDP may not give us a clear indication of the
production activity and welfare of people of the country.
3. Externalities
Externalities refer to the harms (or benefits) a firm or
an individual causes to another for which they are not
penalised (or not paid).
Examples of negative externalities:
(i) Pollution caused by vehicles and smoke out of
chimneys of factories
(ii) Traffic jams
Such externalities may cause harm to the people.
Hence, their welfare will fall. However, GDP does not
account for such negative externalities. Thus, GDP
overestimates the actual welfare.
Examples of positive externalities:
(i) Introduction of metro rail has saved the time and
money of general public and has provided safe
means of transport.
(ii) Saving of commuting time due to construction of a
fly-over
Positive externalities increase welfare of people or
general public. However, GDP does not account for su-
ch positive externalities. Thus, GDP as an index under-
estimates welfare.
4. Composition of GDP
• If the production of tobacco products, liquor, etc.
increases in the country, GDP will increase since it is
counted in GDP. However, these harmful goods
adversely affect the health of people.
• If the government imposes a ban on consumption of
tobacco products, liquor, etc., it will bring the
production of tobacco products, liqour, etc. Since it
is counted in GDP, GDP will fall. However, the ban
will improve the health in general. It will thus
increase welfare.
Key Terms
Non-monetary exchanges—Those activities in an economy which
cannot be evaluated in terms of money due to non-availability of
data, e.g. domestic services of a housewife/family members.
Externalities—Harms (or benefits) a firm or an individual causes
to another for which they are not penalised (or not paid).
RECAP
Limitations of using GDP as an index of welfare of

a country:
1. Distribution of GDP: If the GDP of the country is rising, the
welfare of people may not increase if there is inequalities in
the distribution of GDP, i.e. rich become richer and poor
become poorer.
2.Non-monetary exchanges: Non-monetary exchanges refer to
the goods and services produced but not exchanged for any
monetary value. For example, value of household chores
(cooking, washing, cleaning etc.) by a millions of home-makers is
not included in the GDP of the economy. It is major cause of
undervaluation of GDP in the economy. As result, welfare of the
people is also underestimated.
3. Externalities: Externalities refer to the harms (or benefits) a
firm or an individual causes to another for which they are not
penalised (or not paid). Negative externalities: (i) Air pollution
caused by vehicles (ii) Traffic jams. Such externalities reduce
welfare. However, GDP does not account for such negative
externalities. Thus, GDP overestimates the actual welfare. Positive
externalities: (i) Introduction of metro rail has saved the time
and money of general public (ii) Saving of commuting time
due to construction of a fly-over. Positive externalities
increase welfare of people. However, GDP does not account
for such positive externalities. Thus, GDP as an index
underestimates welfare.
Question 1
If the real GDP of a country is rising, the welfare of
people always rise. True/False? Given reason.

Answer 1
False: With rise in real GDP, welfare may not rise if there
is inequality in the distribution of GDP, or due to
externalities and non - monetary exchanges.

Question 2
The exchanges which take place in the informal sector
without the help of money are called________. They
are generally not counted in the GDP of a country. This
is a case of _________ of GDP. (Fill in the blanks)

Answer 2
barter exchanges , under-estimation

Question 3
GDP calculated in the standard manner may not give us
a clear indication of the productive activity and well-
being of a country because of :
(a) Unequal distribution of GDP
(b) Non-monetary exchanges
(c) Externalities

Answer 3
(b) Non-monetary exchanges

Question 1
Give one example of ‘externality’ which reduces welfare
of the people. (CBSE 2013) (1 mark)

Answer 1
Smoke of a factory polluting the air or release of
contaminated water into river or traffic jams, etc. (any
one)

Question 2
Define externalities. Give an example of negative exter-
nality.What is its impact on welfare?

Answer 2
Externalities refer to the benefits (or harms) a firm or
an individual causes to another for which it is not paid
(or penalised)
Example of negative externality: Smoke of a factory
polluting the air.
Impact: Reduces welfare through negative effect on
health.

Question 3
‘GDP as an index of welfare may understate or overstate
welfare.’ Explain the statement using examples of a
positive and a negative externality.

Answer 3
GDP doesn’t account for externalities
Positive Externality: e.g. saving commuting time due to
construction of a fly-over, increases welfare. GDP as an
index understates welfare.
Negative Externality: e.g. pollution from factories,
decreases welfare. GDP overstates welfare.

Question 4
How do the negative externalities affect the welfare of the
people ? Explain by taking an example.

Answer 4
Pollution by factories, vehicles, etc is an example of
negative externalities, i.e. harm caused by a firm or a
person to others for which they are not paid for. Gross
domestic product does not take into account such
harms caused.

Question 5
Suppose a ban is imposed on consumption of tobacco.
Examine its likely effects on (a) gross domestic product
and (b) welfare.

Answer 5
(a) Ban on consumption of tobacco will bring down
production of tobacco. Since it is counted in GDP,
GDP will fall.
(b) The ban will improve the health in general. It will
thus increase welfare.

Question 6
How does increase in inequalities in distribution of
income affect welfare of the society ? Explain.

Answer 6
Increase in inequalities means that rich become richer
and poor become poorer. Since utility of money is
higher among poor and lower among the rich, any
increase in inequalities may not lead to increase in
welfare.

Question 7
Government incurs expenditure to popularise yoga
among the masses. Analyse its impact on gross domestic
product and welfare of the people.

Answer 7
Government expenditure on popularising yoga raises
GDP because it is government’s final consumption
expenditure. It also raises welfare of the people because
yogic exercises improve health and thus, raise efficiency
of the people.

Question 8
Sale of petrol and diesel cars is rising particularly in big
cities. Analyse its impact on gross domestic product and
welfare. (CBSE 2016) (3 marks)

Answer 8
Sale of cars raises GDP, because sales are of final
products. Cars provide convenience in transportation
but at the same time, it causes traffic jams, air pollution
and noise pollution, which reduces the welfare of the
people. Pollution has bad effects on the health of the
people.

Question 9
State, giving reasons, whether the following will be
included in national income: (3 marks)
(i) Growing vegetables in a kitchen garden of the
house/Services rendered by family members to each
other.
(ii) Production of tobacco products, liquor, etc.
(iii) Harmful effects of air pollution caused by factories or
vehicles.

Answer 9
(i) No, it will not be included in the national income as
it is difficult to estimate the market value of
production. It is a non-monetary production or
non-monetary exchange.
(ii) Yes, it is included in the national income since
output is produced.
(iii) No, national income does not include negative
e0xternalities though they reduce welfare of people.

Self-Assessment Test 1
National Income and Related Aggregates
Time Allowed: 1 hour Maximum Marks: 25

Question 1
What is Macroeconomics ? (1 mark)
Question 2
Give any two examples of flow concept. (1 mark)
Answer 2
National income, Investment
Question 3
According to a report forwarded by the Reserve Bank of
India, there was a fall in rate of inflation as measured by
Consumer Price Index (CPI) on year-on-year basis to 5%
from 8% in the precious year. Which of the following
statements represents the situation? (1 mark)
(a) CPI has fallen
(b) CPI has risen at a rate lower than the preceding
year
(c) CPI is constant
Answer 3
(b) CPI has risen at a rate lower than the preceding
year
Question 4
Depreciation is also known as: (1 mark)
(a) Capital loss
(b) Unforeseen obsolescence
(c) Capital allowance
Answer 4
(c) Capital allowance
Question 5
Calculate “Intermediate Consumption” from the following
data: (3 marks)

(i) Gross value of output 300
(ii) Net value added at factor cost (NVAfc) 100
(iii) Subsidies 15
(iv) Depreciation 30
Answer 5
Intermediate consumption = (i)- (iv)-(Indirect tax – iii)
– (ii)
= 300 – 30 – (0-15) – 100 = 300 – 30 + 15 – 100
= `185 crore
Question 6
Which of the following items will be included/not
included while estimating Gross Domestic Product? Give
valid reasons in support of your answer.
(a) Wages received by an Indian working in the British
Embassy in India.
(b) Financial aids received from abroad after “Fani
cyclone”.
(c) Purchase of second hand machinery from abroad.
(3 marks)
Answer 6
(a) Wages received by an Indian working in British
embassy in India is not a part of economic
territory of India, as British Embassy is a part of
Economic territory of Britain.
(b) Financial aid is a transfer income as no factor
service is provided in return. Hence, it is not
included while estimating the value of GDP.
(c) Purchase of second hand machinery from abroad
is not included as the value of imports are
deducted while estimation GDP of a country.
Question 7
What is meant by the problem of double counting?
Discuss briefly the two approaches to avoid this problem.
(3 marks)
Question 8
(a)Distinguish between Real Gross Domestic Product
and Nominal Gross Domestic Product. (2 marks)
(b)"Real Gross Domestic Product is a better indicator of
economic growth than Nominal Gross Domestic
Product."
Do you agree with the given statement? Support your
answer with a suitable numerical example. (4 marks)
Answer 8
(b) The given statement is correct. Real Gross Domestic
Product (GDP) is a better indicator of economic growth
than Nominal Gross Domestic Product (GDP) as it is not
affected by changes in general price level.
Numerical Example:
Goods P1 P0 Q1 P1Q1 P0Q1
A 20 10 100 2,000 1,000
B 10 5 200 2,000 1,000
C 30 20 50 1,500 1,000
ΣP1Q1 = ΣP0Q1 =
5,500 3,000
In the above example the difference between Real
GDP (ΣP0Q1) and Nominal GDP (ΣP1Q1) is 5,500 –
3,000 = `2,500. This is only the monetary difference
as the quantity sold in the market remains unchanged
and the variation in the value of GDP is merely due to
the change in the prices in the economy.
Question 9
(a) The value of the nominal GNP of an economy was `
2500 crore in a particular year. The value of GNP
of that country during the same year, evaluated at
the prices of base year, was `3000 crore. Calculate
the value of the GNP deflator of the year in
percentage terms. Has the price level risen between
the base year and the year under consideration?
(3 marks)
(b) Calculate compensation of employees from the
following data: (3 marks)
S. No Particulars Amount (in ` crore)
i. Profits after tax 20
ii. Interest 45
iii. Gross Domestic Product at Market Price 200
iv. Goods and Services Tax 10
v. Consumption of Fixed Capital 50
vi. Rent 25
vii. Corporate Tax 5
Answer 9
(a) GNP Deflator = (Nominal GNP/Real GNP) × 100
= 2500/3000 × 100 = 83.33%
Thus, the price level has fallen by 16.67% between
the base year and the year under consideration.
(b) Compensation of Employees = (iii) – (v) – (iv) – (vi
+ ii + i + vii)
= 200 – 50 -10 – (25 + 45 + 20 + 5) = `45 crore

Question 1
Define an intermediate good. (1 mark)
Question 2
Wages received by an Indian working in the British
Embassy in India will be included in Gross Domestic
Product (GDP) of India. True/False? Give reason.
(1 mark)
Answer 2
False: Not included in GDP of India as it is factor income
from abroad.
Question 3
If the national income is ` 2,800 crore and NDPfc is
`3,000 crore, which of the following option will be
correct? (1 mark)
(a) Factor income from abroad ` 500 and factor
income to abroad is `200
(b) Factor income from abroad ` 400 and factor
income to abroad is ` 600
(c) Factor income from abroad `600 and factor
(d) Factor income from abroad ` 700 and factor
Answer 3
(b) Factor income from abroad `400 and factor income
to abroad is ` 600
Question 4
Which of the following would be the normal resident of
India? (1 mark)
(a) An Indian working in an American embassy in India
(b) An Indian working in Singapore branch of an
Indian bank.
(c) A team of German engineers in India on official
job for six months.
(d) Five Afghan student pursing law in India for the
last four years
Answer 4
(a) An Indian working in an American embassy in India
Question 5
"Circular flow of income in a two sector economy is
based on the axiom that one’s expenditure is other’s
income."
Do you agree with the given statement? Support your
answer with valid reasons. (3 marks)
Answer 5
income earned by the households will be used to buy the
goods and services which would be equal to income of
firms. The aggregate consumption expenditure by the
households in the economy is equal to the aggregate
expenditure on goods and services produced by the
firms in the economy (Income of the producers).
Question 6
“India’s GDP is expected to expand 7.5% in 2019-20:
World Bank” — The Economic Times.
Does the given statement mean that welfare of people
of India increase at the same rate? Comment with
reason. (3 marks)
Answer 6
Generally it is considered that an increase in the Gross
Domestic Product (GDP) of any economy (India in this
case) ensures increase in welfare of the people of the
country. However, this may not always be correct. Some
of the prime reasons for the same are:
(a) unequal distribution and composition of GDP,
(b) non-monetary transactions in the economy which are
not accounted for in GDP, and
(c) occurrence of externalities in the economy (both
positive and negative).
Question 7
Calculate “Depreciation” from the following data:
(3 marks)
(i) Gross value of output 300
(ii) Net value added at factor cost (NVAfc) 100
(iii) Subsidies 15
(iv) Intermediate Consumption 185
Answer 7
Depreciation = (i) – (iv) – ( iii) – (ii) = 300 – 185 – (–15)
– 100
= 200 – 185 + 15 = 215 – 185 = `30
crore.
Question 8
Using numerical example, distinguish between Real
National Income and Nominal National Income.
OR
Explain any three precautions while calculating GDP
by Value Added Method. (6 marks)
Question 9
(a) Distinguish between net factor from abroad and
net exports. (2 marks)
(b) Calculate the value of “Mixed Income of Self-
Employed” from the following data : (4 marks)
(i) Compensation of Employees 17,300
(ii) Interest 1,200
(iii) Consumption of Fixed Capital 1,100
(v) Subsidies 750
(vi) Gross Domestic Product at Market price 27,500
(vii) Indirect Taxes 2,100
(viii) Profits 1,800
(ix) Rent 2,000
Answer 9
(b) GDPMP = (i) + [(ix) + (ii) + (viii)]
+ Mixed Income of Self employed + (iii) + (vii – v)
500 = 17,300 + (2000 + 1200 + 1800) + Mixed
Income +1100 + (2100 – 750)
Mixed Income =`2,750crore

Question 1
What are 'non-monetary exchanges'? (1 mark)
Question 2
Define 'Value Addition'? (1 mark)
Question 3
estimated on the basis of prices prevailing in the
current year, it is called (i)_________ whereas when it
is estimated on the basis of prices prevailing in the
base year, it is called (ii)__________. (real national
income/nominal national income) (Fill in the blanks with
the correct options) (1 mark)
Answer 3
(i) nominal national income (ii) real national income
Question 4
If Real GDP = `240 crore and Price Index = 120,
Nominal GDP = __________? (1 mark)
Answer 4
`288 crore. Explanation : Real GDP = Nominal
GDP/Price index × 100
Nominal GDP = (Real GDP × Price index)/100 × (240
× 120)/100 – 266
Question 5
Calculate “Gross value of output” from the following
data: (3 marks)

(i) Net value added at factor cost (NVAfc) 100
(ii) Depreciation 30
(iii) Subsidies 15
(iv) Intermediate Consumption 185
Answer 5
(i) = GVO – (iv) – (ii) – (IT – iii)
100 = GVO – 185 – 30 – (0 – 15)
GVO = 100 + 200 = `300 crore.
Question 6
If in a locality, a new park is developed by the
municipal corporation, it will have externalities, both
positive and negative. State on example each of both
types of externalities with reason. (3 marks)
Answer 6
The park in neighbourhood can be a source of positive
externality as it helps in reducing pollution and thereby
improving health and efficiency.
The park in neighbourhood can be a source of negative
externality if it is used by anti-social elements. This can
increase crime and lead to insecurity.
Question 7
Define the problem of double counting in the
computation of national income. State any two
approaches to correct the problem of double counting.
(3 marks)
Question 8
Explain any three precautions while calculating
national income by Income Distributed Method. (6)
OR
Will the following be included in domestic factor income
of India? Give reasons in support of your answer. (6)
(i) Compensation of employees paid by a foreign
company located in India.
(ii) Compensation of employees paid by American
embassy in India to resident Indians.
(iii) Expenditure on engine oil by car service station.
Answer 8
II Part:
(i) Yes, it will included in the domestic factor income of
India as foreign company is located within the
(ii) No, it will not be included in the domestic factor
income of India as American embassy is not a part
of the domestic territory of India.
(iii) Expenditure on engine oil by a car service station is
not included because it is an intermediate cost.
Question 9
Given the following data, find the values of
‘Operating Surplus’ and ‘Gross Domestic Capital
Formation’: (6 marks)
(i) Government Final Consumption Expenditure 2,000
(ii) Mixed Income of Self-Employed 1,500
(iii) National Income 12,000
(iv) Net Factor Income from Abroad 200
(v) Operating Surplus ?
(vi) Profits 500
(viii) Net Indirect Taxes 1,800
(ix) Net Exports 2,000
(x) Consumption of Fixed Capital 600
(xi) Gross Domestic Capital Formation ?
(xii) Wages and Salaries 6,000
Answer 9
Operating surplus = iii – xii – ii – iv
= 12000 – 6000 – 1500 – 200 =
4300 Crore.
GDCF = iii+ x + viii – iv – i – vii – ix
= 12000+ 600 + 700– 200 -2000-6000 –
1800 = `3300 crore.

Question 1
The problem of _________ arises when the value of
some goods and service are counted more than once
while estimating national income. (1 mark)
Answer 1
Double counting
Question 2
Higher GDP always means greater per capital
availability of goods in the economy.
True/False? (1 mark)
Answer 2
False: GDP does not account for inequalities in
distribution of income. If the rising GDP is
concentrated in a few hands, per capital
availability of goods in the economy might not
increase.
Question 3
Which of the following is used for calculating National
Income by income method? (1 mark)
(a) Income Tax
(b) Corporation Tax
(c) Sales Tax
(d) Net Indirect Tax
Answer 3
(b) Corporation Tax
Question 4
If GDPmp is `5,000 crore, intermediate consumption is
` 2,500 crore and the ratio of sales to change in stock
is 2 : 1, then sales will be: (1 mark)
(a) ` 4,000
(b) ` 5,000
(c) ` 3,000
(d) ` 2,000
Answer 4
(b) `5,000
Question 5
How is Real Gross domestic Product (GDP) different from
Nominal Gross Domestic Product (GDP)? Given the
Nominal GDP, how is Real GDP computed? Explain using
a numerical example. (3 marks)
Question 6
Explain the circular flow of income in a two sector
economy. (3 marks)
Question 7
Distinguish between final goods and intermediate goods.
Give suitable examples. (3 marks)
Question 8
Define the following: (6 marks)
(a) Value addition
(b) Gross Domestic Product
(c) Flow variables
(d) Income from property and entrepreneurship
(e) Net factor income from abroad
(f) Net exports
OR
Explain any four precautions while calculating national
income by expenditure method. (6 marks)
Question 9
Given the following data, find the value of
‘Government Final Consumption Expenditure’ and
‘Mixed Income of Self-Employed’: (6 marks)
(ii) Government Final Consumption Expenditure ?
(iii) Gross Domestic Capital Formation 1,000
(v) Net Indirect Taxes 200
(vi) Net Factor Income from Abroad 100
(viii) Consumption of Fixed Capital Indirect Taxes 300
(ix) Profits 120
(x) Wages and Salaries 1,500
(xi) Net Exports 500
(xii) Operating Surplus 3,000
Answer 9
Government final Consumption Expenditure= i – iii – vii –
xi + v + viii – vi
= 7100 –1000 – 4000 – 500+200+300 – 100 =
`2,000crore
Mixed Income of Self Employed = i – x – xii – vi
= 7100 – 1500 – 3000 – 100 = ` 2500 crore

Question 1
National income and money creation are examples of
stock concept. True/False? (1 mark)
Answer 1
False: National income and money creation are
examples of flow concept as they are measured
during a period of time. False: National income
and money creation are examples of flow concept
as they are measured during a period of time.
Question 2
To avoid double counting , we should: (1 mark)
(a) Take the value of final goods and services only
ignoring all intermediate products.
(b) Take the value added at different stages in
production process instead of total output.
(c) Either (a) or (b)
Answer 2
(c) Either (a) or (b) (c) Either (a) or (b)
Question 3
Goods which are not bought for meeting immediate
needs of the consumers but are producing other goods
are called _____________. (1 mark)
Answer 3
Capital goods
Question 4
Net Domestic Product (NDP) of India? Give reasons for
your answer. (3 marks)
(a) Factor income from abroad.
(b) Remittances from non-resident Indians to their
families in India.
Answer 4
(a) No, it is not included in NDP of India because the
factor income is earned outside the domestic
territory of India.
(b) No, it is not included in NDP of India because it is a
transfer income from abroad.
Question 5
What are ‘non-monetary exchange’? Discuss with suitable
example. (3 marks)
Question 6
State under what conditions in the following statements
may be true: (4 marks)
(a) Domestic Income is equal to National Income.
(b) Value of output is equal to Value Added.
(c) Gross domestic capital formation = Gross domestic
fixed capital formation
(d) Operating surplus = Rent + Royalty + Profit
Answer 6
(a) When Net Factor Income from Abroad is zero.
(b) When intermediate consumption is zero.
(c) When net change in stocks is zero.
(d) When there is no income in the form of interest.
Question 7
Explain the meaning of Real Gross Domestic Product and
Nominal Gross Domestic Product. Which of the two
indicates economic welfare? Explain using a numerical
example. (6 marks)
Question 8
Calculate Gross Domestic Product at market prices and
national income from the following data. (6 marks)
(i) Net imports (–) 30
(iii) Subsidies 5
(iv) Net domestic fixed capital formation 50
(vi) Net factor income from abroad (-)10
(vii) Closing stock 10
(ix) Indirect taxes 55
(x) Opening stock 20
Answer 8
Gross Domestic Product at Market Price
+ Net domestic fixed capital formation
+ Closing stock – Opening stock – Net imports
= 400 + 100 + 50 + 40 + 10 – 20 – (– 30) = `610
crore
National Income (NNPfc) = GDPmp – Consumption of
fixed capital– Indirect taxes + Subsidies + Net factor
income from abroad
= 610 – 40 – 55 + 5 + (–10) = `510 crore
b
 Money – meaning and supply of money –
Currency held by the public and net demand
deposits held by commercial banks
 Money creation by the commercial banking
system
 Central bank and its functions (example of the
Reserve Bank of India) : Bank of issue, Govt.
Bank, Banker’s Bank, Controller of Credit
2.1 Money and Supply of Money
Money — Its Meaning
Anything which is commonly accepted as a medium
of exchange is called money.
It is usable for undertaking transactions, i.e., receipts
and payments. In a modern economy, money comprises
cash and bank deposits. Currency notes and coins can be
used for settlement of any economic transactions. Bank
deposits, e.g. the balance in savings and current account
deposits with commercial banks, are also used to settle
transactions through cheques, debit cards, etc.
Supply of Money
Meaning
Money supply refers to the total quantity of money
in circulation in the economy at a given point of
time.
 Top Tip
Money supply is a stock variable since the total stock of
money in circulation among the public is measured at a
particular point of time.
Components
The basic measure of money supply (M1) has two
components–Currency with public and demand deposits
in commercial banks.
1. Currency held by the public (CU): Money supply
consists of currency notes and coins held by the public
outside the banks. The Reserve Bank of India (RBI) is
the only institution which can issue currency in India.
Currency notes are issued by the RBI. However, coins
are issued by the Government of India.
 The currency issued by the central bank (Reserve
Bank of India in India) can be held by the public or
by the commercial banks, and is called the
high-powered money or 'reserve money' or
'monetary base' as it acts as a basis for credit creation.
 Currency notes and coins are called legal tenders
as they cannot be refused by any citizen of the
country for settlement of any transaction.
 Currency notes and coins are called fiat money
because every currency note bears on its face a
promise from the Governor of RBI that if someone
produces the note to RBI ,or any other commercial
bank, RBI will be responsible for giving the person
purchasing power equal to the value printed on
the note. The same is also true of coins.
2. Net demand deposits held by commercial banks
(DD): Demand deposits are the deposits which can
be withdrawn on demand by the depositors from
banks, example, current account and savings account
deposits.
 Demand deposits are created by the commercial
banks and are called bank money.
 The word 'net' implies that only deposits of the
public held by the banks are to be included in
money supply. The inter-bank deposits, which a
commercial bank holds in other commercial
banks,are not to be regarded as part of money
supply.
 Top Tip
Commercial banks also hold time deposits of the public.
Time deposits are those deposits in banks which have a
fixed period of maturity, e.g., Fixed Deposits (FD).
However, the basic measure of money supply (M1)
includes only demand deposits, not time deposits.
Key Term
Money — Anything which is commonly accepted as a medium
of exchange is called money.
Money supply — Money supply refers to the total quantity of
money in circulation in the economy at a given point of time.
High powered money — The currency issued by the central
bank (Reserve Bank of India in India) can be held by the public
or by the commercial banks, and is called the high-powered
money.
Demand deposits — Demand deposits are the deposits which
can be withdrawn on demand by the depositors from banks, e.g.
current account and savings account deposits.
Time deposits — Those deposits in banks which have a fixed
period of maturity, e.g., Fixed Deposits (FD).
Bank money — Demand deposits are created by the commercial
banks and are called bank money.
RECAP
Money and Supply of Money

Anything which is commonly accepted as a medium of exchange is
called money.
Money supply refers to the total quantity of money in circulation
in the economy at a given point of time. Thus, it is a stock variable.
It has two components:
(i) Currency held by the public (CU): The currency issued by the
central bank (Reserve Bank of India) can be held by the public
or by the commercial banks, and is called the high-powered
money.
(ii) Net demand deposits held by commercial banks (DD): Demand
deposits are the deposits which can be withdrawn on demand
by the depositors from banks, e.g. current account and savings
account deposits. Demand deposits are created by the
commercial banks and are called bank money. The word ‘net’
implies that money supply includes only deposits of the public
held by the banks, not inter-bank deposits).
Question 1
Demand deposits created by the commercial banks are
called _________.
(a) High powered money
(b) Money
(c) Bank money
(d) Time deposits

Answer 1
(c) Bank money

Question 2
_________ are called legal tenders.
(a) Demand deposits
(b) Time deposits
(c) Inter-bank deposits
(d) Currency notes and coins

Answer 2
(d) Currency notes and coins

Question 3
Which of the following is not included in money supply?
(a) High powered money
(b) Bank money
(c) Time deposits
(d) Inter-bank deposits

Answer 3
(d) Inter-bank deposits

Question 4
Supply of money refers to quantity of money ________.
(CBSE 2017) (Choose the correct alternative)
(a) as on 31st March
(b) during any specified period of time
(c) as on any point of time
(d) during a fiscal year

Answer 4
(c) as on any point of time

Question 5
Demand deposits include __________.
(a) Saving account deposits and fixed deposits
(b) Saving account deposits and current account deposits
(c) Current account deposits and fixed deposits
(d) All types of deposits

Answer 5
(b) Saving account deposits and current account deposits

Question 6
_____________ is the main source of money in an
economy.
(a) Central bank of the economy
(b) Commercial banking system
(d) Government

Answer 6

Question 7
Currency issued by the central bank is called:
(a) Fiat money
(b) Legal tenders
(c) High powered money

Answer 7

Question 8
Apart from currency notes and coins, the balance in
(i) ___________, held by the public in commercial banks
is also considered money since the amount in these
accounts can be used to settle transactions. Such deposits
are called demand deposits because (ii) ___________.

Answer 8
(i) savings, or current account deposits
(ii) they are payable by the bank on demand from the
account-holder.

Question 9
Demand deposits created by commercial banks are
called ________.
(Fill in the blank)

Answer 9
bank money

Question 10
Demand deposits are not _______ since cheques drawn
on these accounts can be refused by anyone as a mode of
payment.
(Fill in the blank)

Answer 10
legal tenders

Question 11
Bank deposits which have fixed period to maturity, e.g.
fixed deposits are referred to as _______.
(Fill in the blank)

Answer 11
Time deposits

Question 12
M1 measure of money supply is defined as follows:
M1 = CU +DD
where, CU is Currency (notes plus coins) held by
the public and DD is ‘net’ demand deposits held by
commercial banks. The word ‘net’ here implies that
_____________.
(Fill in the blank)

Answer 12
Only deposits of the public held by the banks are to be
included in money supply. The interbank deposits, which
a commercial bank holds in other commercial banks, are
not to be regarded as part of money supply.

Question 13
In a modern economy, money comprises _______.
(Fill up the blank with correct answer)

Answer 13
Cash and bank deposits

Question 14
The currency issued by the central bank can be held by
the public or by the commercial bank, and is called the
‘___________’ or ‘reserve money’ or ‘monetary base’
as it acts as basis for credit creation.
(Fill up the blank with correct answer)

Answer 14
high powered money

Question 15
Besides central bank, ________ are the other type of
institutions which are a part of the money-creating system
of the economy.

Answer 15
commercial banks

Question 16
__________ accept deposits from the public and lend
out part of these funds to those who want to borrow.

Answer 16
Commercial banks

Question 17
_______ is the only institution which can issue currency
notes. However, coins are issued by the _______.

Answer 17
The Reserve Bank of India (RBI): Government of India.

Question 18
Which of the following is not a function of the Reserve
Bank of India?
(a) It issues the currency of the country.
(b) It acts as a bank to the banking system.
(c) It is the custodian of the foreign exchange reserves
of the economy.

Answer 18

Question 19
Central Bank is a very important institution in a modern
economy. Almost every country has one central bank.
India got its central bank in 1935. Its name is ________.
(Fill up the blanks with correct answer)

Answer 19
The Reserve Bank of India (RBI)

Question 20
Currency notes and coins are called fiat money.

Answer 20
True: RBI is responsible for giving the bearer of the
currency equal purchasing power.

Question 21
Currency notes and coins are called legal tenders.

Answer 21
True: They cannot be refused by any citizen of the
country for settlement of any kind of transaction.

Question 22
Demand deposits are called legal tenders.

Answer 22
False: Cheques drawn on savings or current accounts
can be refused by anyone as a mode of payment. Hence,
demand deposits are not legal tenders.

Question 23
Money supply is a stock variable.

Answer 23
True: Money supply is the total stock of money in
circulation among the public at a particular point of time.

Question 24
Currency created by the Central Bank is called bank
money.

Answer 24
False: The currency created by the Central bank
(Reserve Bank of India in India) is called High Powered
Money.

Question 25
Who regulates money supply in India?
(a) Government of India
(b) Reserve Bank of India
(c) Commercial Banks
(d) Planning Commission

Answer 25
(b) Reserve Bank of India

Question 26
The components of money supply are:
(a) Currency held by the public
(b) demand deposits of the public in commercial banks
(c) other deposits with the RBI
(d) currency held by the public and demand deposit of
the public in commercial banks

Answer 26
(d) currency held by the public and demand deposit of
the public in commercial banks

Question 27
Fixed deposit is also termed as:
(a) Chequeable deposits
(b) Demand deposit
(c) Time deposit
(d) Non-chequeable deposits

Answer 27
(c) Time deposit

Money Creation by Commercial
2.2 Banking System: Working of Money
Multiplier/ Lending Process of Banks
Process of Money Creation by
Commercial Banks
Commercial banks receive deposits from the public.
The depositors are free to withdraw, in part or in
full,their deposit amounts by writing cheques. The
banks use the money in these deposits to give loans.
These functions of the commercial banking system are
the basis of money creation. Note that money creation
is also called 'deposit creation' or 'credit creation‘.
Commercial banks cannot use the total deposits for
giving loans. It is legally compulsory for the banks to
keep a certain minimum fraction of net total demand
and time deposits as legal reserves. The fraction is
called the Legal Reserve Ratio (LRR).
LRR is the minimum reserve that a commercial
bank must maintain as per the instructions of the
central bank.
 Top Tip
Legal Reserve Ratio is also called Reserve Ratio or Required
Reserve Ratio or Reserve Deposit Ratio or Legal Reserve
Deposit Ratio.
The LRR is fixed by the Central Bank. It has two
components:
(i) Cash reserve ratio (CRR): It is the fraction of net
total demand and time deposits that commercial
banks must keep as cash reserves with the Central
Bank.
(ii) Statutory liquidity ratio (SLR): It is the fraction
of net total demand and time deposits that
commercial banks must keep with themselves in
the form of specified liquid assets.
How much are the deposits created is determined by
primary deposits and Legal Reserve Ratio (LRR). Primary
deposits refer to initial deposits with the commercial banks.
Given the amount of primary deposits (or initial deposits)
and the legal reserve ratio (LRR), total deposits creation
(or credit creation or money creation) will be:
Total credit creation (or money creation)
= Initial deposits × 1/Legal Reserve Ratio
Money creation (or deposits creation or credit creation) is
a process by which a commercial bank creates total
deposits number of times the primary deposits.
Process of money creation (or deposits creation or credit
creation) is based on the following assumptions:
(i) There is single banking system in the economy.
(ii) All transactions are routed through banks. One who
makes payment does it by writing cheque. The one who
receives payment deposits the same in his deposit account.
Numerical Example
Suppose customer deposits `10,000 in bank and the
legal reserve ratio (LRR) proposed by the Central Bank
is 20%. Bank has to pay interest on this amount for
which bank should lend this money to someone. A part
of the amount is to be retained with bank to meet its
customers' obligations. Since LRR is 20%,the bank will
keep 20% of deposits as reserves, i.e., `2,000 and will
lend the remaining 80%, i.e. `8,000. Those who borrow
will spend this money and same `8,000 will come back
to bank in the form of deposits. This raises the total
deposits to `18,000 now. Bank again keeps 20% of
`8,000,i.e. `1,600 as reserves and lend `6,400 to those
who needs. This will further raise the deposits with
bank. In this way deposits will go on increasing @ 80%
of the last deposit.
 Top Tip
The deposits creation comes to an end when total reserves
become equal to the initial deposit, i.e. `10,000.
Deposits creation by commercial bank

(with initial deposits `10,000 and LRR 20%)
Rounds Deposits (`) Loans (`) Reserves (`)
I 10,000 8,000 2,000
II 8,000 6,400 1,600
III 6,400 5,120 1,280
   
Total 50,000 40,000 10,000
Total deposits creation (or credit creation or money
creation) = Initial deposits × 1/LRR
= `10,000 × 1/0.2
= `10,000 × 5
= `50,000
How many times the total deposits would be of the
initial deposit is determined by the LRR. The multiple
called the money multiplier (or deposit multiplier or
credit multiplier) is:
Money multiplier = 1/Legal Reserve Ratio
In our example, Legal Reserve Ratio is 20%, therefore,
money multiplier = 1/0.2 = 5
Thus, the total deposit creation is 5 times the initial
deposit.
Money Multiplier – Its role in determining
credit creation power of banks
Meaning
Money Multiplier (or Credit Multiplier or Deposit
Multiplier) is the number by which total deposits
can increase due to a given change in deposits.
Money Multiplier (or Credit Multiplier or Deposit
Multiplier) is inversely related to legal reserve ratio.
Money multiplier = 1/Legal Reserve Ratio
Money multiplier measures the amount of money that
the banks are able to create in the form of total deposits
with every initial deposit.
Role in determining credit creation power
of banks
The credit creation by commercial banks depends on
money multiplier. There is a direct relationship
between money multiplier and total credit creation by
commercial banks.
Lower the money multiplier, lesser will be total
credit creation by the commercial banking system
and vice-versa.
Total credit creation
= Initial deposits × Money Multiplier (1/LRR)
Numerical Example
Suppose the LRR is 20% and initial deposit is `10,000.
Money multiplier = 1/LRR = 1/0.20 = 5; and Total credit created =
`10,000 × 5 = `50,000
Whereas, suppose LRR is increased by the Central Bank to 50%
and initial deposits remain the same, i.e. `10,000.
Then, Money multiplier = 1/0.50 = 2; and Total credit created =
`10,000 × 2 = `20,000.
Direct relationship between money multiplier and credit creation
Legal Reserve Money multiplier Credit creation = Initial
Ratio (= 1/LRR) deposits × 1/LRR
20% 1/0.20 = 5 `10,000 × 5 = `50,000
50% 1/0.50 = 2 `10,000 × 2 = `20,000
Thus, with the same initial deposit total credit creation decreases
with a decrease in the value of money multiplier.
Legal Reserve Ratio – Its influence in
the process of credit creation by banks
Legal Reserve Ratio (LRR) is the minimum reserves
that a commercial bank must maintain as per the
instructions of the Central Bank.
Credit creation is inversely related to the legal
reserve ratio.
Total credit creation (or money creation) = Initial
deposits × 1/Legal Reserve Ratio
Higher the legal reserve ratio, lesser will be the
credit creation by the commercial banking
system and vice-versa.
Numerical Example
Suppose the LRR is 20% and initial deposit is `10,000.
Total credit creation = Initial Deposits × 1/LRR = 10,000 × 1/0.2 =
10,000 × 5 = `50,000
Now suppose, if the LRR is increased by the Central Bank to
50% and initial deposits remain the same.
Total credit creation = Initial Deposits × 1/ LRR = 10,000 × 1/0.5 =
10,000 × 2 = `20,000.
Inverse relationship between LRR and credit creation
Legal Reserve Ratio Credit creation = Initial deposits × 1/LRR
20% 10,000 × 1/0.2 = `10,000 × 5 = `50,000
50% 10,000 × 1/0.5 = `10,000 × 2 = `20,000
Thus, any increase in LRR will decrease the credit creation power of
the commercial banks (banking system).
Key Term
Legal Reserve Ratio (LRR) – It is the minimum reserve that a commercial
bank must maintain as per the instructions of the central bank.
Cash reserve ratio (CRR) – It is the fraction of net total demand
and time deposits that commercial banks must keep as cash
reserves with the Central Bank.
Statutory liquidity ratio (SLR) – It is the fraction of net total
demand and time deposits that commercial banks must keep with
themselves in the form of specified liquid assets.
Money creation (or deposits creation or credit creation) – It is a
process by which a commercial bankcreates total deposits number
of times the primary deposits.
Primary deposits – It refers to the initial deposits with commercial
banks.
Money Multiplier (or Credit Multiplier or Deposit Multiplier) – It
is the number by which total deposits can increase due to a given
change in deposits.
RECAP
Money creation by commercial banks

Money creation (or credit creation or deposit creation) is a
process by which a commercial bankcreates total deposits
number of times the primary deposits. Primary deposits refer
to initial deposits with the commercial banks.
Process of credit creation is based on the following
assumptions:
(i) There is single banking system in the economy.
(ii) All transactions are routed through banks.
Total credit creation = Initial deposits
× 1/Legal Reserve Ratio
LRR is the minimum reserve that a commercial bank must
maintain as per the instructions of the central bank.
Initially, customer deposits `10,000 and LRR is 20%. Bank
keeps `2,000 as reserves to meet customers’ obligations and
give loans of `8,000. Those who borrow will spend this
money and same `8,000 will ultimately come back to bank as
fresh deposits. Out of these `8,000, bank keeps 20%, i.e.
`1,600 as reserves and give loans of `6,400. In this way, in
every round 80% of loans are converted into fresh deposits.
Total deposits creation (or credit creation or money creation)
= Initial deposits × 1/LRR
= 10,000 × 1/0.2 = 10,000 × 5 = `50,000
Credit creation is inversely related to the legal
reserve ratio.
For example, suppose LRR is 0.2 and initial deposits are
`10,000.
Total credit creation = Initial Deposits × 1/LRR = 10,000 ×
1/0.2 = 10,000 × 5 = `50,000
Now suppose, if the LRR is increased by the Central Bank to
0.5 and initial deposits remain the same, i.e. `10,000.
Now, total credit creation = Initial Deposits × 1/ LRR = 10,000 ×
1/0.5 = 10,000 × 2 = `20,000.
Thus, any increase in LRR will decrease the credit creation
power of the commercial banks (banking system).
Credit creation is directly related to money multiplier.
Money Multiplier (or Credit Multiplier or Deposit Multiplier)
is the number by which total deposits can increase due to a
given change in deposits. Lower the money multiplier, lesser
will be the total credit created and vice-versa.
Total credit creation = Initial deposits × Money Multipler
(1/LRR)
For example, suppose the LRR is 0.2 and initial deposit is
`10,000. Money multiplier = 1/LRR = 1/0.2 = 5; and Total credit
created = `10,000 × 5 = `50,000.
Whereas, suppose LRR is increased by the Central Bank to 0.5
and initial deposits remain the same, i.e. `10,000.
Then, Money multiplier = 1/0.5 = 2; and Total credit created =
`10,000 × 2 = `20,000.
Thus, with the same initial deposit total credit creation
decreases with a decrease in the value of money multiplier.
Question 1
There is a limit to money or credit creation by banks,
and this is determined by the central bank (RBI). The RBI
decides a certain percentage of (i)_______ which every
bank must keep as reserves, called (ii)_______. This is
done to ensure that no bank is ‘Over lending’

Answer 1
(i) Net total demand and time deposits
(ii) Legal Reserve Ratio/Reserve Ratio

Question 2
Since banks earn interest from loans they make, any
bank would like to land the maximum possible. But
there is a limit to money or credit creation by banks
and this is determined by ___________.
(Fill in the blank)

Answer 2
the central bank (RBI)

Question 3
Apart from the CRR, banks are also required to keep
some reserves in liquid form in the short term. This
ratio is called __________________.
(Fill in the blank)

Answer 3
Statutory Liquidity Ratio (SLR)

Question 4
Deposit creation by banks comes to an end when
__________________.
(a) fresh deposits with banks become zero
(b) legal reserve ratio becomes zero
(c) money multiplier becomes zero
(d) total reserves equal initial deposits

Answer 4
(d) total reserves equal initial deposits

Question 5
State, giving reason, whether the following
statement is true or false:
Higher the Legal Reserve Ratio (LRR), greater
would be the money creation in the economy.

Answer 5
False: Value of money multiplier is inversely related to
LRR since money multiplier = 1/LRR. Therefore, higher
the LRR, lower would be the value of money multiplier
and hence, money creation will be less in the economy.

Question 6
LRR and money creation has ____________.
(a) positive relation
(b) negative relation
(c) No relation

Answer 6
(b) negative relation

Question 7
The value of credit multiplier will be high when ______.
(a) Legal reserve ratio is high
(b) Legal reserve ratio is low
(c) Legal reserve ratio is zero
(d) Legal reserve ratio is infinity

Answer 7
(b) Legal reserve ratio is low

NUMERICAL 1
Calculate the value of credit multiplier if the legal reserve

deposit ratio is 20%.
(CBSE Sample Question Paper 2019) (1 mark)
Solution: Credit Multiplier = 1/Legal Reserve Deposit
Ratio = 1/0.2 = 5
Do it yourself 1
Calculate the value of money multiplier if Required Reserve
Ratio is 12.5%. (1 mark)
[Ans. 8]
NUMERICAL 2
If the Reserve Ratio is 20% and the primary deposits are

`100, what is the value of deposit multiplier and total
lending by the banking system?
Given the same amount of initial deposits, if the RBI
increased the Reserve Ratio to 25%, what would happen in
the economy? Explain.
(NCERT) (4 marks)
Solution: Deposit multiplier (or Money multiplier or
Credit multiplier) = 1/Reserve ratio = 1/20% = 1/0.2 = 5
Credit creation (or Money creation or Deposit creation) =
Primary Deposits × 1/Reserve ratio = `100 × 5 = `500
Total lending by the banking system = 500 –100 = `400
If the RBI increases the Reserve Ratio to 25%, total money
creation = `100 × 1/0.25 = `100 × 4 = `400
Thus, the banking system would now be able to loan `300
only (`400 – `100). It would have to call back some loans to
meet the increased reserve requirements. Hence, money
supply would fall.
Do it yourself 2
If the Reserve Deposit Ratio is 25% and the initial deposits
of the public are `2,000, what is the value of deposit
multiplier, total deposit creation and total lending by the
banking system? (4 marks)
[Ans. Deposit multiplier = 4; Total deposit creation =
`8,000 and total lending by the banking system `6,000]
NUMERICAL 3
If the total deposits created by commercial banks is `50,000

crore, and CRR is 12% and SLR is 8%, then calculate the
amount of initial deposit with the bank. (3 marks)
Solution: LRR = CRR + SLR = 12 + 8 = 20% = 0.2
Therefore, Money Multiplier = 1/LRR = 1/0.2 = 5
Deposits creation = Initial deposit × 1/LRR
50,000 = Initial deposit × 5
Initial deposit = 50,000/5 = `10,000 crore
Do it yourself 3
Total deposits created by commercial banks is `12,000 crore
and LRR is 25%. Calculate the amount of initial deposits.
[Ans. `3,000 crore] (3 marks)
NUMERICAL 4
Calculate the legal reserve ratio if the initial deposit of

`10,000 crore lead to a creation of total deposits of `1,00,000
crore. (3 marks)
Solution: Deposits creation = Initial deposits × 1/LRR
1,00,000 = 10,000 × 1/LRR
1/LRR = 1,00,000/10,000
1/LRR = 10
LRR = 1/10 = 0.1 or 10%
Do it yourself 4
Calculate the legal reserve ratio if the initial deposit of `25,000
crore lead to a creation of total deposits of `1,25,000 crore.
[Ans. 20%] (3 marks)
2.3 Central Bank and Its Functions
Central Bank – Meaning
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.
India got its Central Bank in 1935. Its name is the
'Reserve Bank of India (RBI)'. It is the apex bank
engaged in regulating commercial banks in India.
Functions of the Central Bank
1. Authority of Currency Issue/Bank of issue
The Central Bank is the sole authority for the issue of
currency in the country. It promotes efficiency in the
financial system. Firstly, because this leads to uniformity
in the issue of currency. Secondly, because it gives
Central Bank direct control over money supply.
2. Banker to the Government/Government's
Bank
The Central Bank acts as a banker to the government
(both Central government as well as State governments).
Banker to the government means that the Central Bank
gives the same banking facilities to the government
which commercial banks give to the general public. The
Central Bank does not give such facilities to the general
public.
 As the banker to the government, the central bank
provides a large number of routine banking
functions to the government like maintaining the
balances, arranging and managing funds of the
government and so on.
 It gives loan to the government.
 It accepts receipts and makes payments for the
government.
 It works as agent of the government in matters of
collection of taxes, etc.
 It manages public debt.
 It also acts as a financial advisor to the government.
3. Bankers' Bank
 As the banker to the commercial banks, the Central
Bank holds surplus cash reserves of commercial banks.
 It also gives loans to the commercial banks when
they are in need of funds.
 The Central Bank also provides a large number of
routine banking functions to the commercial banks,
like cheque clearing, remittance facilities, etc.
 It also acts as a supervisor and a regulator of the
banking system. It makes rules regarding their
licensing, branch expansion, liquidity of assets,
amalgamation (merging of banks) and liquidation
(the winding up of banks), etc. The control is
exercised by periodic inspection of banks and the
returns filed by them.
What role of RBI is known as 'lender of last resort'?
When commercial banks need more funds in order to be
able to create more credit,they may go to market for
such funds or go to the Central Bank. Central bank
provides them funds through various instruments.
‘Lender of Last Resort' refers to the role of the Central
Bank (RBI), of being ready to lend to banks, especially
when a bank is faced with unanticipated severe financial
crises, and due to this central bank is said to be the
‘lender of last resort’.
If the central bank refuses to extend this help, there is
no option for the bank but to shut down.
 Top Tip
Commercial banks are legally required to keep only a
fraction of deposits as cash reserves. This is because not all
depositors approach the banks for withdrawal of money at
the same time, and also that normally they withdraw a
fraction of deposits. Secondly, there is a constant flow of
new deposits into the banks. Therefore, to meet the daily
demand for withdrawal of cash, it is sufficient for banks to
keep only a fraction of deposits as cash reserves. However,
if suppose all the account-holders want to withdraw their
deposits at the same time, the bank will not have enough
funds to satisfy the need of every account holder. This
situation is called 'bank run'. The bank may approach the
Central Bank, which then lends money to meet its emergent
needs.
4. Controller of Credit
'Credit control' is the most crucial function played by
any Central Bank in the modern times. The primary
objective of credit control is to remove causes
responsible for instability in price fluctuations which
in turn are related to the supply of money. By
controlling credit, the Central Bank can exercise an
effective control over economic activity and mobilise it
in the desired direction.
In India, The RBI controls the money supply in the
economy in various ways. The tools used by the Central
bank to control money supply can be quantitative or
qualitative.
 Quantitative tools control the extent of money
supply by changing the Cash Reserve Ratio (CRR)
or Statutory Liquidity Ratio (SLR) or Bank Rate or
Repo Rate or Reverse Repo Rate, or through Open
market operations (OMO).
 Qualitative tools include persuasion by the
Central Bank in order to make commercial banks
discourage or encourage lending which is done
through margin requirement, moral suasion, etc.
 Top Tip
The policy adopted by the Central Bank of a country in the
direction of credit control or money supply is known as Monetary
Policy. Instruments of Monetary Policy are Bank Rate, Cash
Reserve Ratio (CRR), Open Market Operations (OMO), etc.
Key Term
Central Bank – 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.
Bank of issue – The Central Bank is the sole authority for the issue
of currency in the country.
Lender of Last Resort – It refers to the role of the Central Bank
(RBI), of being ready to lend to banks, especially when a bank is
faced with unanticipated severe financial crises.
Monetary Policy – The policy adopted by the Central Bank of a
country in the direction of credit control or money supply is
known as Monetary Policy.
Credit Control – The central bank controls the money supply and
credit in the best interests of the economy by taking recourse to
various quantitative and qualitative tools.
RECAP
Functions of the Central Bank

The Central Bank is the apex institution of a country’s
monetary system. India’s central bank is the ‘Reserve Bank of
India’. It is the apex bank engaged in regulating commercial
banks. Four main functions of Central Bank are:
1. Authority of Currency Issue/Bank of issue: The Central
Bank is the sole authority for the issue of currency in the
country. It promotes efficiency in the financial system.
Firstly, because this leads to uniformity in the issue of
currency. Secondly, because it gives Central Bank direct
control over money supply.
2. Government’s Bank: The Central Bank acts as a banker to
both central as well as state governments. • The Central
Bank keeps accounts of government and accepts deposits
from government.
• The Central Bank accepts receipts and makes payments
for the government. • It carries out exchange, remittance
and other banking operations for the government. • It
advances credit/loan to the government to meet its
requirements in case of crisis. • It also acts as an agent to
buy and sell government securities and advises the
government on various financial matters.
3. Bankers’ Bank: • As the banker to the banks, the Central
Bank holds surplus cash reserves of commercial banks. • It
also lends to commercial banks when they are in need of
funds. • Central Bank also provides a large number of
routine banking functions to the commercial banks. • It also
acts as a supervisor and a regulator of the banking system.
Central Bank acts as the ‘Lender of Last Resort’: It refers
to the role of the Central Bank (RBI), of being ready to lend
to banks, especially when a bank is faced with unanticipated
severe financial crises, and due to this central bank is said to be
the ‘lender of last resort’. If the central bank refuses to extend
this help, there is no option for the bank but to shut down.
4. Controller of Credit: The primary objective of credit control
is to remove causes responsible for instability in price
fluctuations which in turn are related to the supply of money.
By controlling credit, the Central Bank can exercise an
effective control over economic activity and mobilise it in the
desired direction. Central Bank regulates the volume and use
of credit by using quantitative and qualitative tools.
Quantitative tools control the extent of money supply by
changing the Cash Reserve Ratio (CRR) or Statutory
Liquidity Ratio (SLR) or Bank Rate or Repo Rate or Reverse
Repo Rate, or through Open market operations (OMO).
Qualitative tools include persuasion by the Central Bank in order
to make commercial banks discourage or encourage lending
which is done through margin requirement, moral suasion, etc.
Question 1
When commercial banks need more funds in order to
be able to create more credit, they may go to market for
such funds or go to the Central Bank. Central Bank
provides them funds through various instruments. This
role of RBI, that of being ready to lend to banks at all
times is a important function of the central bank, and
due to this central bank is said to be the __________.
(Fill in the blank)

Answer 1
lender of last resort

Question 2
The RBI controls the money supply in the economy in
various ways. The tools used by the central bank to
control money supply can be quantitative or qualitative.
____________ tools include persuasion by the central
bank in order to make commercial banks discourage or
encourage lending. ________ tools control the extent of
money supply. (Quantitative/Qualitative)

Answer 2
Qualitative; Quantitative

Question 3
(a) CRR, Bank rate, open (i) Quantitative credit control
market operations, etc. techniques
(b) Moral suasion, margin (ii) Qualitative credit control
requirements, etc. techniques

Answer 3
(a) — (i), (b) — (ii)

Question 4
Monetary policy is the policy of
(a) Government
(b) Central Bank
(c) Commercial Bank
(d) NABARD

Answer 4
(b) Central Bank

Question 5
The bank that operates without any profit motive in
public interest is
(a) Central Bank
(b) Nationalised Commercial Bank
(c) Canara Bank
(d) Punjab National Bank

Answer 5
(a) Central Bank

Question 6
CRR stands for
(a) Credit Reserve Ratio
(b) Cash Reserve Ratio
(c) Commercial Reserve Ratio
(d) Central Reserve Ratio

Answer 6
(b) Cash Reserve Ratio

Question 7
Which of the following is the function of the Central
Bank?
(a) Accepting deposits from the general public
(b) Giving loans to general public
(c) Bankers’ Bank
(d) Credit Creation

Answer 7
(c) Bankers’ Bank

 Aggregate demand and its components.
 Propensity to consume and propensity to save
(average and marginal).
 Short-run equilibrium output; investment
multiplier and its mechanism.
 Meaning of full employment and involuntary
unemployment.
 Problems of excess demand and deficient
demand; measures to correct them - changes in
government spending, taxes and money supply
through Bank Rate, CRR, SLR, Repo Rate and
Reverse Repo Rate, Open Market Operations,
Margin requirement.
Ex-ante and Ex-post Measures
Ex-ante measures
The planned values of the variables are called their ex-
ante measures. For example, ex-ante consumption, ex-
ante savings and ex-ante investment.
 Ex-ante consumption: It refers to planned
consumption expenditure on final goods in the
economy.
 Ex-ante investment: It refers to planned
investment expenditure on final goods in the
economy.
 Ex-ante savings: It refers to the planned savings at
different levels of income in an economy.
Ex-post measures
The actual (or realised or accounting) values of the
variables is called their ex-post measures. For
example, ex-post savings, ex-post investment, etc.
 Ex-post savings: Ex-post savings are the actual
amount of savings made in the economy during a
period.
 Ex-post investment: Ex-post investments are the
actual amount of investments made in the economy
during a period.
 Top Tip
Ex-ante savings and ex-post savings may or may not be equal
because ex-ante savings are those which all the households
plan to make at different levels of income during a period,
whereas ex-post savings are the actual amount of savings
made in the economy during a period.
The ex-ante variables (e.g. ex-ante consumption,

ex-ante investment, etc.) are the basis of
determination of national income.
3.1
Consumption Function:
Propensity to Consume
Consumption Function:
Propensity to Consume
Consumption Function
The most important determinant of consumption demand
is household income.
A consumption function describes the relation
between consumption and income.
The simplest consumption function assumes that
consumption changes at a constant rate as income
changes. Of course, even if income is zero, some
consumption still takes place. If your income is zero in
a certain period, you use your past savings or borrow
money to buy certain minimum consumption items in
order to survive. Hence, it is not possible to think of a
situation where there is no consumption at all. Since
this level of consumption is independent of income,
it is called autonomous consumption.
We can describe consumption function as:
Here, C = Consumption expenditure by households

Y = Level of income in the economy
= Autonomous consumption (i.e. consumption
expenditure at zero income)
b = Slope of the consumption function (It measures
rate of change in consumption per unit change in
income.)
 Top Tip
Note that the equation of a straight line is y = mx + c, where y
is the dependent variable, x is the independent variable, m is
the slope of the straight line (i.e. Dy/Dx) and c is the intercept,
i.e. value of y when x is zero.
Therefore, C = C + bY is a linear consumption function, i.e. a
straight line consumption function, where:
• Consumption (C) is the dependent variable and income (Y)
is the independent variable. Clearly, consumption
expenditure depends on the level of income.
• b = Slope of the consumption function, i.e. DC/DY (slope
means change in dependent variable due to a given
change in independent variable)
• The intercept C is the level of consumption (C) when
income (Y) is zero, i.e. autonomous consumption
Components of Consumption Function
The consumption function C = + bY consists of the
two components – (i) Autonomous consumption
and (ii) Induced consumption ( bY ).
1. Autonomous consumption: It refers to the
minimum level of consumption for survival even at a
zero level of income. It is called autonomous
consumption because the consumption expenditure
does not depend upon the level of income.
If consumption takes place even when income is zero,
it is because of autonomous consumption. It is denoted
by and shows the consumption which is independent
of income.
2. Induced consumption: Induced consumption is
directly determined by the level of income. Clearly, bY
shows dependence of consumption on income. directly
determined by the level of income. Clearly, bY shows
dependence of consumption on income.
Example: Suppose the consumption function in an
economy is C = `100 crore + 0.8Y and the level of
income is `800 crore. Autonomous Consumption
= ` 100 crore and Induced Consumption (bY) = 0.8Y =
0.8 × `800 crore = `640 crore (since Y = `800 crore)
Marginal Propensity to Consume
In the consumption function equation C = + bY, 'b'
represents the slope of the consumption function. It is
called Marginal Propensity to Consume (MPC).
MPC may be defined as change in consumption
due to a given change in income.
 Top Tip
MPC represents the slope of the consumption function as it
represents change in consumption due to a given change in income
(MPC = ∆C/∆Y). In Keynesian analysis, MPC is assumed to be
constant. Therefore, the consumption function will be a straight line
(linear) consumption curve. However, in reality, MPC has a tendency
to decline.
What can be the value of MPC?

Generally, MPC lies between 0 and 1 (inclusive of both
values).
 As income increases, consumers may choose not to
change consumption at all (i.e. ∆C = 0). In this case
MPC = 0 (since MPC = ∆C/∆Y = 0/ ∆Y = 0)
 On the other hand, as income increases, consumers
may use entire increase in income on consumption,
i.e. ∆C = ∆Y. Thus, MPC = ∆C/∆Y = ∆C/ ∆C = 1.
 Also, as income increases, consumers may use a part of
the increase in income for increasing consumption, i.e.
∆C < ∆Y. Thus, MPC < 1. However, MPC is greater than
0 because consumption cannot be zero even at zero
income. There has to be a minimum or subsistence
level of consumption even at zero income, called
autonomous consumption. Thus, when consumers
use a part of the increase in income for increasing
consumption, 0< MPC < 1.
 Top Tip
When income changes, change in consumption (∆C) can never
exceed the change in income (∆Y). Therefore, value of MPC
cannot exceed 1. In other words, the maximum value of MPC
can be 1.
Average Propensity to Consume
Average Propensity to Consume (APC) is the consumption
per unit of income. In other words, APC is the ratio of
consumption and income at a given level of income.
Consumption Schedule
Imagine a country Imagenia which has a consumption
function described by: C = 100 + 0.8Y
This indicates that even when Imagenia does not have
any income, its citizens still consume `100 crore worth
of goods. Thus, Imagenia’s autonomous consumption
is `100 crore. Its marginal propensity to consume is 0.8.
This means that if income goes up by `100 in Imagenia,
consumption will go up by `80. In other words, people
spend 80% of rise in income on consumption.
Table 3.1: Consumption Schedule
Income DY Consumption DC MPC APC
(Y) (C) (DC/DY) (C/Y)
0 – 100 – – –
100 100 180 80 0.8 1.80
200 100 260 80 0.8 1.30
300 100 340 80 0.8 1.13
400 100 420 80 0.8 1.05
500 100 500 80 0.8 1
600 100 580 80 0.8 0.97
700 100 660 80 0.8 0.94
800 100 740 80 0.8 0.93
900 100 820 80 0.8 0.91
1000 100 900 80 0.8 0.90
 Column (3) shows the consumption expenditure at
various levels of income. The values in column (3)
are obtained from the consumption function
equation C = 100 + 0.8Y. For example:
When income (Y) = `100 crore, consumption (C) =
100 + 0.8 × 100 = 100 + 80 = ` 180 crore.
When Y = ` 200 crore, C = 100 + 0.8 × 200 = 100 +
160 = ` 260 crore.
 Column (5) shows MPC, which is equal to ∆C/∆Y.
For example, as income increases from ` 100 crore
to `200 crore (∆Y=`100 crore), the consumption
increases from ` 180 crore to ` 260 crore
(∆C = ` 80 crore) and thus MPC = 80/100 = 0.8.
Consumption Curve
Figure 3.1 shows the graph of the consumption
function given by the equation: C = 100 + 0.8Y
The consumption curve does not start from origin
because of the assumption that there is some
minimum level of consumption even at zero level of
income, called autonomous consumption.
Thus, the consumption curve starts from the Y-axis at a
distance equal to autonomous consumption from the
origin.
The 45° line from origin has the feature that every
point on it has the same horizontal and vertical
coordinates. Since income is shown on the horizontal
axis (i.e. X-axis) and consumption on the vertical axis
(i.e. Y-axis), therefore at every point on the 45° line,
consumption is equal to income.
Thus, the 45° line tells us whether consumption is
equal to, greater than, or less than income.
 The consumption curve crosses the 45° line at point
B. This point is known as the break-even point
(B.E.P.).
Break-even point is the point at which the level of
consumption is equal to the income.
In Figure 3.1, point B is the B.E.P. because consumption
(C) = income (Y) = `500 crore.
Since C = Y, therefore APC = C/Y = C/C = 1. (Thus, at
break even point APC = 1)
When the consumption curve lies above the 45° line,
consumption is greater than income (C > Y). For example,
at an income level (Y) = `200 crore, the consumption (C) is
` 260 crore. The households must find funds (`60 crore) to
meet this consumption expenditure. They will either
sell the assets acquired in the past, or will borrow. This
act of the households is called dis-saving.
Since C > Y, APC > 1. (Thus, before break even point
APC > 1)
When the consumption curve lies below the 45° line,
consumption is less than income (C < Y). For example,
at an income level (Y) = ` 900 crore, consumption (C)
is `820 crore.
Since C < Y, APC < 1. (Thus, after break even point APC
< 1)
 Top Tip
The value of APC can be greater than one when total
consumption is greater than total income (i.e., C > Y) before
break even point, due to the existence of autonomous
consumption.
RECAP
Ex-ante and Ex-post Measures

The planned values of the variables–consumption, savings,
investment etc.–are called their ex-ante measures whereas
the actual or realised value of the variables is called their ex-
post measures. The ex-ante variables (ex-ante consumption
and ex-ante investment) are the basis of determination of
national income.
•Ex-ante consumption refers to planned consumption
expenditure on final goods in the economy.
•Ex-ante investment refers to planned investment
•Ex-ante savings refers to the planned savings at different
levels of income in an economy.
Consumption Function
Consumption function describes the relation between
consumption and income. Consumption function:
C = C + bY.
Consumption function has two components:
(i) Autonomous consumption (C): It refers to to the
minimum level of consumption for survival even at a zero
level of income. It is called autonomous consumption
because the consumption expenditure does not depend
upon the level of income.
(ii) Induced consumption (bY): It is directly determined
by the level of income. Clearly, bY shows dependence of
consumption on income.
For example, if the consumption function equation is C =
100 + 0.8Y, C = 100 and MPC = 0.8, so when income rises by
`100, induced consumption rises by ` 80 (0.8 × 100).
Marginal propensity to consume (MPC)
MPC is the change in consumption due to a given change in
income. It is denoted by ‘b’ and is equal to ∆C/∆Y.
MPC represents the slope of the consumption function as it
represents change in consumption due to a given change in
income (MPC = ∆C/∆Y).
• When income changes, change in consumption (∆C) can
never exceed the change in income (∆Y). Therefore, the
maximum value of MPC can be 1.
• Generally, MPC lies between 0 and 1 (inclusive of both
values). This means that as income increases either the
consumers do not increase consumption at all (MPC = 0)
or use entire change in income on consumption (MPC =
1) or use part of the change in income for changing
consumption (0< MPC<1).
Average Propensity to consume (APC)
APC is the consumption per unit of income, i.e. C/Y. In
other words, APC is the ratio of consumption and income
at a given level of income.
Key Terms
Ex-ante and ex-post — Ex-ante variable is the planned or
expected value of the variable whereas, ex-post variable is the
actual or realised value of the variable. Ex-ante and ex-post — Ex-
ante variable is the planned or expected value of the variable
whereas, ex-post variable is the actual or realised value of the
variable.
Ex-ante consumption — It refers to planned consumption
Ex-ante investment — It refers to planned investment
Ex-ante savings — It refers to the planned savings at different
levels of income in an economy.
Ex-post investment — Ex-post investments are the actual amount
of investments made in the economy during a period.
Consumption function — It describes the relation between
consumption and income.
Break-even point — The point at which the level of consumption
is equal to the income.
Autonomous consumption — Consumption at zero level of
income i.e., consumption which is independent of income. It is the
subsistence level of consumption.
Induced consumption — The consumption expenditure which is
dependent on the level of income.
Marginal propensity to consume (MPC) — Change in
consumption per unit change in income, i.e. DC/DY.
Average propensity to consume (APC) — APC is the consumption
per unit of income, i.e. C/Y.
NUMERICAL 1
Given the consumption function of an economy:

C = `100 crore + 0.75Y
The equilibrium level of income is `900 crore.
Calculate the values of the two components of the
consumption function when the economy is in
equilibrium. (3 marks)
Solution: The values of the two components of the
consumption function are:
Autonomous Consumption (a) = `100 crore
Induced consumption (bY)= 0.75 × `900 crore = `675
crore
Do it yourself 1
Calculate autonomous consumption and induced consumption
from the following:
National income = `1,000 crore, MPC = 0.75 and
Consumption expenditure = ` 850 crore (3 marks)
[Ans. (i) Autonomous consumption, a = ` 100 crore; (ii)
Induced consumption, bY = ` 750 crore]
C = a + bY, where b = MPC = 0.75
Therefore, 850 = a + 0.75 × 1,000 ⇒ 850 = a + 750 ⇒ a =
100
(i) Autonomous consumption, a = `100 crore
(ii) Induced consumption, bY = `750 crore
NUMERICAL 2
Given the consumption function of an economy C = `100

crore + 0.8Y.
(a) What are the values of autonomous consumption
and the slope of consumption function?
(b) What is the level of income at Break-Even Point?
(3 marks)
Solution: (a) From the consumption function C = 100 +
0.8Y, autonomous consumption = `100 crore
Slope of consumption function = MPC = 0.8
(b) At Break even point, C = Y
100 + 0.8Y = Y
Y – 0.8 Y = 100
0.2Y = 100
Y = 100/0.2 = 500
Therefore, break even level of income = `500 crore
Do it yourself 2
Given the consumption function of an economy C = `100
crore + 0.75Y, calculate:
(a)Values of autonomous consumption and slope of
consumption function.
(b) The level of income corresponding to the Break-Even
Point. (3 marks)
[Ans. Autonomous consumption = `100 crore; Slope of
consumption function = 0.75; Level of income corresponding to
the Break-Even Point = `400 crore]
(a) Autonomous consumption = `100 crore
Slope of consumption function = MPC = 0.75
(b) Break-even point is the level of income at which
consumption and income are equal, i.e., C = Y
C = 100 + 0.75Y ⇒ 100 + 0.75Y = Y ⇒ Y – 0.75Y =
100
0.25Y = 100 ⇒ Y = 100/0.25 = 400
Therefore, the level of income corresponding to the
Break-Even Point = `400 crore
NUMERICAL 3
Given that National Income is ` 80 crore and

consumption expenditure `64 crore, find out average
propensity to consume. When income rises to ` 100 crore
and consumption expenditure to ` 78 crore, what will be
the APC and MPC? (3 marks)
Solution:
Income ∆Y Consumption ∆C APC MPC
(Y) (C) (C/Y) (∆C/∆Y)
80 – 64 – 0.8 –
100 20 78 14 0.78 0.7
Do it yourself 3
If national income is `50 crore and consumption `45 crore,
find out average propensity to consume. When income rises
to `60 crore and consumption by `6 crore, what will be the
APC and MPC? (3 marks)
[Ans. APC 0.9, 0.85 and MPC 0.6]
Income ∆Y Consumption ∆C APC MPC

(Y) (C) (C/Y) (∆C/∆Y)
50 – 45 – 0.9 –
60 10 51 6 0.85 0.6
Question 1
State which of the following statements are true or false.
Give valid reasons. (CBSE 2019) (3 marks)
(a) According to Keynesian theory of employment, Ex-ante
savings and Ex-post savings are always equal.
(b) In a two-sector economy if income is zero, consumption
will also be zero.

Answer 1
(a) The given statement is false, as ex-ante savings are
those which all the households plan to make at
different level of income during a period, whereas
ex-post savings are the actual amount of savings
made in the economy during a period. So, the two
may or may not be equal.
(b) The given statement is false, even at zero level of
income there is still some minimum consumption
(autonomous consumption) in the economy, as it is
essential for survival.

Question 2
Why does consumption curve not start from the origin
? (CBSE 2018) (1 mark)

Answer 2
Consumption curve does not start from origin because of
the assumption that there is some minimum level of
consumption even at zero level of income.

Question 3
Value of which of the following can be greater than one
and why? (1 mark)
(a) Marginal Propensity to Consume (MPC)
(b) Average Propensity to Consume (APC)

Answer 3
(b) The value of Average Propensity to Consume (APC) can
be greater that one. This is because total consumption can
be greater than total income, due to the existence of
autonomous consumption.

Question 4
Giving valid reason, state whether the following
statement is true or false: (1 mark)
Marginal propensity to consume represents the slope of
the consumption function.

Answer 4
The given statement is true, as MPC represents change in
consumption due to a given change in income.
(MPC = ΔC/ΔY)

Question 1
The ratio of change in consumption to change in income
is called _________. (Choose the correct alternative)
(a) Marginal propensity to consume
(b) Marginal propensity to save
(c) Average propensity to consume
(d) Average propensity to save

Answer 1
(a) Marginal propensity to consume

Question 2
Average propensity to consume can never be zero.
(True/False)

Answer 2
True: APC = C/Y and APC will be zero if consumption
(C) is zero which is not possible. Even if income is
zero, there is some consumption expenditure to
survive (called autonomous consumption).

Question 3
Average propensity to consume can be greater than one.
(True/False)

Answer 3
True, average propensity to consume can be greater than
one, when total consumption in an economy is greater than
national income due to the existence of autonomous
consumption. Households will either sell the assets acquired in
the past or will borrow to meet extra consumption
expenditure.

Question 4
The minimum level of consumption for survival even if
income is zero is called ________ because ______ .

Answer 4
Autonomous consumption; this level of consumption is
independent of income.

Question 5
The value of MPC can exceed one.
True/False? Give valid reason.

Answer 5
False: MPC = DC/DY. When income changes, change in
consumption (DC) can never exceed the change
in income (DY).
The maximum value of MPC can be one (MPC =
1) when the consumers use entire change in
income on consumption (i.e. DC = DY).

Question 6
Which of the following is not true for MPC in an
economy? (Choose the correct alternative)
(a) MPC can be zero.
(b) MPC lies between zero and one.
(c) MPC can exceed one
(d) None of these

Answer 6
(c) MPC can exceed one

Question 7
The consumption function of an imaginary country is: C
= ` 80 crore + 0.7Y. Which of the following is true for
his economy? (Choose the correct alternative)
(a) Even if the country does not have any income, its
citizens still consume `80 crore.
(b) People spend 70% of rise in income on consum-
ption
(d) Autonomous consumption is `80 crore and people
spend 70% of income on consumption.
Answer 7

Question 8
When the consumption curve in an economy lies above
the 45° line from origin, the value of APC is :
(a) Greater than one
(b) Zero
(c) One
(d) Less than one

Answer 8
(a) Greater than one

Question 9
APC can be zero at a particular level of income.

Answer 9
False: APC can never be zero because even at zero
income, some consumption still takes place, called

Question 10
The planned values of the variables are their
___________ (ex-ante/ex-post) measures.

Answer 10
ex-ante

Question 11
In order to understand the determination of national
income, we need to know the ________ (ex-ante/ex-
post) values of the components of aggregate demand.

Answer 11
ex-ante

Question 12
___________ describes the relation between
consumption and income. (Fill in the blank)

Answer 12
A consumption function

Question 13
Even if income is zero, some consumption still takes
place. Since this level of consumption is independent of
income, it is called __________ . (Fill in the blank)

Answer 13
autonomous consumption

Question 14
If consumption takes place even when income is zero, it
is because of __________ . (Fill in the blank)

Answer 14
autonomous consumption

Question 15
Given the consumption function of an economy: C = a +
bY
The autonomous consumption and induced
consumption are respectively denoted by _________.
(Fill in the blank)

Answer 15
a ; bY

Question 16
The maximum value of MPC can be _________ when
___________ . (Fill in the blanks) The maximum value
of MPC can be _________ when ___________ .

Answer 16
1 (one); the consumers use entire change in income on
consumption.

Question 17
The minimum value of MPC can be ______ when
_______ . (Fill in the blanks) The minimum value of
MPC can be ______ when _______ .(Fill in the blanks)

Answer 17
0 (zero) ; consumers do not increase consumption as
income increases.

Question 18
The range of MPC is: (Choose the correct alternative)
(a) between 0 and 1
(b) from 0 to 1
(c) between 1 and ∞
(d) from 1 to ∞The range of MPC is:

Answer 18
(b) from 0 to 1

Question 19
When consumers consume part of change in income,
which of the following is true?
(a) MPC > 1
(b) MPC = 1
(c) MPC = 0
(d) 0 < MPC < 1

Answer 19
(d) 0 < MPC < 1

Question 20
At zero level of income, consumption is
(a) zero
(b) positive
(c) negative
(d) zero or negative

Answer 20
(b) positive

Question 21
In consumption function C = a + bY, b represents
(a) autonomous consumption
(b) savings
(c) MPC
(d) MPS

Answer 21
(c) MPC

Question 22
If MPC is 0.5, what will be change in consumption, if
income increases by `100 crore?
(a) ` 60 crore
(b) ` 50 crore
(c) ` 40 crore
(d) ` 70 crore

Answer 22
(b) `50 crore

Question 23
APC can never be equal to 1. True/False? Give reason.

Answer 23
False: APC is equal to 1 when total consumption (C) is
equal to total income (Y) corresponding to the break
even point.

3.2
Savings and Investment
Functions
Savings Function
The relationship between savings and income is called
the savings function. There is a direct (positive) relation
between income and savings. Higher the income, higher is
the level of savings and vice-versa.
Derivation of savings function from
consumption function
Savings is that part of income which is not consumed,
that is
This equation tells us that by definition, saving is equal

to income minus consumption.
Substituting the consumption function equation C =
+ bY into the above equation, we can get the savings
function equation.
S = Y – ( + bY)
S = Y– – bY
S = – + (1 – b)Y
S = – + Sy
This is the savings function, where Y is the level of
income in the economy, i.e. national income and S is
the desired or planned savings at that income level.
 The intercept term is the amount of savings done
when there is zero level of income. It is already
shown that is positive. Therefore, savings is
negative.
Thus, there is negative savings at zero level of
income. Since negative savings is nothing but
dissaving, this means that at zero level of income,
there is a dissaving of amount . Note that the
amount of autonomous consumption is exactly
equal to the amount of dissaving at zero level of
income. This is because of the fact that Y = C + S
(whether S is positive or negative).
 s = (1 – b) is the slope of the savings function. The
slope of the savings function gives the change in
savings due to a given change in income. This is
known as the Marginal Propensity to Save (MPS).
 Top Tip
MPS represents the slope of the savings function as it
represents change in savings due to a given change in income
(MPS = ∆S/∆Y).
Marginal propensity to save (MPS) is
defined as the change in savings per unit
change in income.
or, MPS refers to the change in savings due to a
given change in income, i.e. MPS = ∆S/∆Y.
Relationship between MPC and MPS
MPC + MPS = 1
Explanation:
Since S = Y – C, therefore
⇒
⇒ MPS = 1 – MPC
⇒ MPS + MPC = 1 or MPC + MPS = 1
Numerical Example:
Given the consumption function C = 100 + 0.8Y, we can
derive the corresponding savings function.
Substituting the consumption function equation C =

100 + 0.8Y into the above equation, we can get the
savings function equation.
S = Y – (100 + 0.8Y)
S = Y – 100 – 0.8Y
S = – 100 + 0.2Y
Here, MPS = 0.2, which means that in the economy
20% of total additional income is put into additional
savings by the people; and dissaving at zero income = `100
crore (which is equal to autonomous consumption)
 Top Tip
Derivation of consumption function from savings function
Given the savings function, we can derive the corresponding
consumption function. The two functions are closely related, since
income always equals consumption plus saving (Y = C + S).
C=Y– S
Substituting the savings function equation S = – + sY into the
above equation, we can get the consumption function equation.
C = Y – (– + sY) ⇒ C = Y + – sY ⇒ C = + (1 – s) Y ⇒
C = + bY
Example: Given the savings function S = –100 + 0.2Y, we can
derive the corresponding consumption function. C = Y – S
Substituting the savings function S = –100 + 0.2Y into the
above equation, we can get the consumption function.
C = Y – (–100 + 0.2Y) ⇒ C = Y + 100 – 0.2Y ⇒ C = 100 + 0.8Y
Derivation of savings curve from
consumption curve
Figure 3.2 shows the derivation of savings curve from
consumption curve.
Step 1: Draw a 45° line from origin. Given consumption
curve CC intersects it at B (Break-even point).
Corresponding to the Break-even point is the
level of income at which consumption equals
income (C = Y). Therefore, savings is zero (S =
0).
Step 2: Take OS1 equal to O because at zero income,
negative savings is exactly equal to the
Step 3: From the break-even point B, we draw a
perpendicular on X-axis which cuts the X-axis at
B1. At OB1 level of income, savings must be zero
because at this level of income consumption
equals income.
Step 4: Join S1 and B1 and extend it by a straight line to
get the savings curve S1S.
 Top Tip
Derivation of consumption curve from savings curve
Since income equals consumption plus savings, therefore,
consumption and savings curves can be called complementary
curves. Consumption curve can be derived from savings curve.
Fig. 3.2 shows the derivation of consumption curve from
savings curve.
Step 1: Draw a 45° line from origin.
Step 2: Given the savings curve S1S, take O equal to OS1
because in the economy the autonomous consumption
is exactly equal to negative savings at zero income.
Step 3: At point B1, savings = 0. We draw a perpendicular from
B1 till it intersects the 45° line at B. B is the break-even
point where consumption equals income.
Step 4: Join C and B and extend it by a straight line to get
the consumption curve C.
Average propensity to save (APS)
Average propensity to save (APS) is the savings per unit
of income, i.e. S/Y. In other words, APS is the ratio of
savings and income at a given level of income.
Relationship between APC and APS: The sum of
APC and APS is equal to one.
Explanation: Income is either consumed or saved.
Dividing both sides of the equation by Y, we have
⇒ 1 = APC + APS
Therefore, APS =1 – APC and APC = 1 – APS
Income ∆Y Consumpt ∆C Savings ∆S APC APS MPC MPS
(Y) ion (C) (S = Y– (C/Y (S/Y) (∆C/∆Y) (∆S/∆Y)
C) )
0 — 100 — –100 — — — — —
100 100 180 80 –80 20 1.80 –0.80 0.8 0.2
200 100 260 80 –60 20 1.30 –0.30 0.8 0.2
300 100 340 80 –40 20 1.13 –0.13 0.8 0.2
400 100 420 80 –20 20 1.05 –0.05 0.8 0.2
500 100 500 80 0 20 1 0 0.8 0.2
600 100 580 80 20 20 0.97 0.03 0.8 0.2
700 100 660 80 40 20 0.94 0.06 0.8 0.2
800 100 740 80 60 20 0.93 0.07 0.8 0.2
900 100 820 80 80 20 0.91 0.09 0.8 0.2
1000 100 900 80 100 20 0.90 0.10 0.8 0.2
Important observations from Figure 3.2 and Table
3.2
1. APC is continuously declining as income increases; and
APS is continuously increasing as income increases. This
means that as income increases, the proportion of
income saved increases and the proportion of income
consumed decreases.
2. APC can never be zero because consumption
expenditure in the economy cannot be zero. Even at zero
income, there has to be a minimum or subsistence level
of consumption expenditure, called autonomous
consumption
3. APC (= C/Y) can be greater than one, equal to one or
less than one.
• APC can be greater than one, when total consumption is
greater than national income before Break-even point,
due to the existence of autonomous consumption. (Since
C > Y, therefore, APC > 1)
• APC can be equal to one, when consumption is
equal to income (at Break-even point). (Since C = Y,
therefore, APC = 1)
• APC can be less than one, when consumption is less
than income. (Since C < Y, therefore, APC < 1)
4. APS can be negative, zero or positive.
• APS can be negative because of negative savings at a
low level of income(before break even point) when
total consumption is greater than national income,
due to the existence of autonomous consumption.
(Since C > Y, therefore, S is negative and APS is also
negative.)
• APS can be zero when savings is zero at a level of
income when consumption is equal to income, i.e.
at break even point. (Since C = Y, therefore, S = Y –
C = C –C = 0. So, APS = S/Y = 0/Y = 0)
• APS is positive because of positive savings at a level,
when consumption is less than income. (Since C <
Y, therefore, S is positive and APS is also positive.)
5. Both MPC and MPS range from 0 to 1, i.e. MPC or
MPS can be 0 or 1 or between 0 and 1.
6. MPC represents the slope of the consumption
function as it represents change in consumption
due to a given change in income (MPC = ∆C/∆Y). In
Keynesian analysis, MPC is assumed to be constant.
Therefore, MPC is 0.8 at all levels of income. Similarly,
MPS, i.e. the slope of the savings function is the
same at all levels of income because of a linear curve
with constant slope we used in our example.
7. MPC cannot be negative because as income increases,
consumption cannot decrease. Similarly, MPS cannot be
negative because as income increases, savings cannot
decrease.
8. The sum of MPC and MPS is equal to one. This
means that the part of the increase in income, which
is not consumed, is saved. This is because income is
either consumed or saved.
9. The APC gives the average consumption- income
relationship at different levels of income. Similarly, from
the savings function, we can find out the average savings-
income ratio. The sum of the APC and APS is always
equal to one. This is because income is either consumed
or saved.
Investment Function
Investment expenditure refers to the addition to the
stock of physical capital and change in inventories of a
firm in an economy.
Investment decisions by firms, such as whether to buy
a new machine, depend, to a large extent, on the
market rate of interest. However, for simplicity, we
assume here that firms plan to invest the same amount
every year. We can write the ex-ante investment
demand as:
where, is a positive constant which represents the
autonomous investment (or ex-ante investment)
in the economy in a given year. Autonomous
investment refers to the investment expenditure which
is independent of income. The investment expenditure
is the same, no matter whatever is the level of income.
Since firms plan to invest the same amount I regardless
of the level of income or output, the investment
function/schedule/curve will be a horizontal line (i.e.,
parallel to X-axis). This is because every point on the
investment curve lies at the same height above the X-
axis. That is, the level of investment demand is the
same at every level of income.
 Top Tip
Autonomous investment refers to the investment expenditure
which is independent of income whereas, Induced investment
refers to the investment expenditure which is dependent on
the level of income.
Key Terms
Savings Function — The relationship between savings and income
is called the savings function.
Marginal propensity to save (MPS) — It refers to the change in
savings due to a given change in income, i.e. MPS = ∆S/ ∆Y.
Average propensity to save (APS) — It is the savings per unit of
income, i.e. S/Y.
Investment expenditure — It refers to the addition to the stock of
physical capital and change in inventories of a firm in an economy.
Autonomous investment — It refers to the investment
expenditure which is independent of income.
Induced investment — It refers to the investment expenditure
which is dependent on the level of income.
RECAP
Savings Function
Savings is that part of income which is not consumed. In other
words, S = Y – C.
Substituting C = + bY, we get S = Y – ( + bY) ⇒ S = – + (1 –
b)Y ⇒ S = – + Sy
where – is the dissavings at zero level of income. Since even at
zero level of income, there will be some minimum amount of
consumption (i.e. autonomous consumption) for survival,
therefore at zero level of income, there will be dissavings.
‘s’ is Marginal propensity to save (MPS), which refers to the
change in savings due to a given change in income, i.e. DS/DY. It
is equal to 1 – MPC.
It implies that the sum of MPC and MPS is equal to 1.
Explanation: Since S = Y – C, therefore
MPS = ∆S/∆Y = ∆ (Y – C)/∆Y = ∆Y/∆Y – ∆C/∆Y = 1 – MPC.
MPS represents the slope of the savings function as it
represents change in savings due to a given change in
income (MPS = ∆S/∆Y).
Average propensity to save (APS) is the savings per unit of
income, i.e. S/Y. In other words, APS is the ratio of savings
and income at a given level of income.
The sum of APC and APS is equal to one. Explanation: Y = C
+ S. Dividing both sides of the equation by Y,
Y/Y = C/Y + S/Y ⇒ 1 = APC + APS.
Therefore, APS = 1 – APC and APC = 1 – APS.
• When the consumption and income are equal, the savings
will be zero. Hence, APS = S/Y = 0/Y = zero.
• When total consumption is greater than total income,
Savings will be negative and APS (= S/Y)will also be
negative.
• When consumption is less than income, saving is
positive. Then, APS (= S/Y) is positive.
Investment Function
Investment refers to the addition to the stock of physical
capital and change in inventories of a firm in an economy.
For simplicity, we assume that firms plan to invest the same
amount every year. We can write the ex-ante investment
demand as I = I where I is a positive constant which
represents the autonomous investment in the economy in a
given year. So, investment curve will be a horizontal straight
line parallel to X-axis.
NUMERICAL 4
Given the consumption function of an economy C =

100 + 0.8Y.
(a) Derive the corresponding savings function.
(b) What is the value of slope of the savings function?
(c) Show that in this economy as income increases,
APC declines and APS increases. (6 marks)
Solution:
(a) C = 100 + 0.8Y
Savings is that part of income which is not consumed,
i.e. S = Y – C = Y – (100 + 0.8Y) = –100 + 0.2Y
Thus, S = –100 + 0.2Y is the required savings function.
(b) From the savings function S = – 100 + 0.2Y, the slope
of savings function (i.e. MPS) = 0.2
(c) At Y = 1000, C = 100 + 0.8 (1000) = 100 + 800 = `900
crore
At Y = 2000, C = 100 + 0.8 (2000) = 100 + 1600 = ` 1700
crore
At Y = 3000, C = 100 + 0.8(3000) = 100 + 2400 = ` 2500
crore
Income Consumption Savings APC APS

(Y) (C) (S = Y – C) (C/Y) (S/Y)
1000 900 100 0.9 0.1
2000 1700 300 0.85 0.15
3000 2500 500 0.83 0.17
As income increases from 1000 to 3000, APC declines from

0.9 to 0.83 but APS increases from 0.1 to 0.17.
Do it yourself 4
Given the consumption function of an economy C = 200 +
0.75Y.
(a) Derive the corresponding savings function.
(b) What is the value of slope of the savings function?
(c) Show that in this economy as income increases, APC
declines and APS increases. (6 marks)
[Ans. (a) S = – 200 + 0.25Y (b) 0.25]
(a) C = 200 + 0.75Y
Savings is that part of income which is not
consumed, i.e. S = Y – C
S = Y – (200 + 0.75Y) ⇒ S = –200 + 0.25Y
Thus, S = – 200 + 0.25Y is the required savings function
(b) From the savings function S = – 200 + 0.25Y, the
slope of savings function (i.e. MPS) = 0.25
(c) At Y = 1,000, C = 200 + 0.75 (1,000) = 200 + 750 =
`950 crore At Y = 2,000, C = 200 + 0.75 (2,000) =
200 + 1,500 = ` 1,700 crore
At Y = 3,000, C = 200 + 0.75(3,000) = 200 + 2,250 =
` 2,450 crore
Income Consumption Savings APC APS
(Y) (C) (S = Y – C) (C/Y) (S/Y)
1,000 950 50 0.95 0.05
2,000 1,700 300 0.85 0.15
3,000 2,450 550 0.81 0.19
The table shows that as income increases from 1000 to

3000, APC declines from 0.95 to 0.81 but APS increases
from 0.05 to 0.19. The table shows that as income
increases from 1000 to 3000, APC declines from 0.95 to
0.81 but APS increases from 0.05 to 0.19.
NUMERICAL 5
Complete the following table:
Income Savings MPC APC

0 –20
50 –10 – –
100 0 – –
150 30 – –
200 60 – –
Solution:
(a) C = 100 + 0.8Y
Incom ∆Y Savings C ∆C MPC APC
e (S) (Y – S) (DC/DY) (C/Y)
(Y)
1000 900 100 0.9 – – –
2000 1700 300 0.85 40 0.8 1.2
3000 2500 500 0.83 40 0.8 1
20 0.4 0.8
20 0.4 0.7
As income increases from 1000 to 3000, APC declines from

0.9 to 0.83 but APS increases from 0.1 to 0.17.
Do it yourself 5
Complete the following table: (3 marks)
Income Savings APC MPC

0 –40
50 –20 – –
100 0 – 0.6
150 30 0.8 –
200 50 – –
[Ans. APC 1.4, 1, 0.75 and MPC = 0.6, 0.4, 0.6]
Income ∆Y Savings Consumption ∆C APC = MPC =

(Y) (S) (C = Y – S) C/Y DC/DY
0 – – 40 40 – –
50 50 – 20 70 30 1.4 0.6
100 50 0 100 30 1 0.6
150 50 30 120 20 0.8 0.4
200 50 50 150 30 0.75 0.6
NUMERICAL 6
Complete the following table:
Income Consumption APS MPS

200 120 0.40
400 220 – –
– 250 0.50 –
Solution:
*Note: APC = C/Y. When APC = 0.50, C = 250.

Therefore, 0.50 = 250/Y
⇒ Y = 250/0.50 = 500
Do it yourself 6
Complete the following table: (3 marks)
Income Savings APS MPC

400 240 0.4
800 440 – –
– 520 0.48 –
[Ans. Income = 1,000

APS = 0.45
MPS = 0.5 and 0.6]
Income ∆Y Consum ∆C Savings ∆S APS APC MPS

(Y) ption (S = Y – C) (S/Y) (1–APS) (DS/DY)
(C)
400 – 240 – 160 – 0.4 0.6 –
800 400 440 200 360 200 0.45 0.55 0.5
1,000* 200 520 80 480 120 0.48 0.52 0.6
*Note: APC = C/Y. When APC = 0.52, C = 520. Therefore, 0.52

= 520/Y
⇒ Y = 520/0.52 = 1000
NUMERICAL 7
In an economy, the ratio of average propensity to

consume and average propensity to save is 5 : 3. The
level of income is `6000. How much is the savings?
Calculate. (3 marks)
Solution:
Thus, savings in the economy are `2,250 crore.

Do it yourself 7
In an economy, total savings are `2000 crore and the ratio

of average propensity to save and average propensity to
consume is 2 : 7. Calculate the level of income in the
economy. (3 marks)
APS/APC = 2/7 ⇒ (S/Y)/(C/Y) = 2/7 ⇒ S/C = 2/7
2,000/C = 2/7 ⇒ C = 7,000
Therefore, level of income in the economy Y = C + S =
7,000 + 2,000
= `9,000 crore
Question 1
If APC = 0.6,APS = ___________
(a) 0.4
(b) 1
(c) 2.4
(d) None of these

Answer 1
(a) 0.4

Question 2
Average propensity to save is always greater than zero.
(True/False)

Answer 2
False: APS = S/Y. At low levels of income, consumption
(C) exceeds income (Y). So, saving (S) is negative.
Therefore, APS is negative. Also, when C = Y, S =
0. Then APS = 0. Thus, APS can be zero or
negative.

Question 3
The value of marginal propensity to save can never be
negative. (True/False)

Answer 3
True: MPS = ∆S/∆Y. When income increases (∆Y is
positive), savings also increases (∆S is positive); so
MPS is positive. Also, when income decreases (∆Y
is negative), savings also decreases (∆S is negative);
so MPS is positive.

Question 4
Average propensity to save cannot be negative.
(True/False)

Answer 4
False: Average propensity to save can be negative at a
level when there is dissavings, i.e. when total
consumption is greater than national income, due to
the existence of autonomous consumption.

Question 5
_____________ refers to actual or realised savings in
an economy during a year.
(a) Ex-ante savings
(b) APS
(c) MPS
(d) Ex-post savings

Answer 5
(d) Ex-post savings

Question 6
Which of the following can have a negative value?
(a) APC
(b) MPC
(c) MPS
(d) APS

Answer 6
(d) APS

Question 7
If C = 100 + 0.75 Y, then the corresponding Savings
Function will be expressed as:
(a) S = 100 + 0.25 Y
(b) S = –100 + 0.75 Y
(c) S = –100 + 0.25 Y
(d) S = 75 + 0.25 Y

Answer 7
(c) S = –100 + 0.25 Y

Question 8
If the savings function of an economy is given as: S = –
100 + 0.40Y, then MPC is:
(a) 1
(b) 0.40
(c) 0.60
(d) None of these

Answer 8
(c) 0.60

Question 9
Sum of average propensity to consume and marginal
propensity to consume is always equal to 1. (True/False)

Answer 9
False: Sum of APC and APS is equal to 1 and Sum of
MPC and MPS is equal to 1.

Question 10
If APC = 1.2, APS will be zero. (True/False)

Answer 10
False: Since APC + APS = 1, therefore, APS = 1 – APC
= 1 – 1.2 = –0.2.Thus,APS will be negative.

Question 11
When the consumption function lies below the 45° line,
APS will be positive. (True/False)

Answer 11
True: When the consumption function lies below the
45° lines, the level of consumption is less than
the level of income. This means that there is
positive savings. Since APS = S/Y and S is positive,
therefore,APS will be positive.

Question 12
The value of average propensity to save can never be
greater than 1. (True/False)

Answer 12
True: Average propensity to save (APS = S/Y) can never
be greater than 1 as savings (S) can never be
more than income (Y).

Question 13
The point at which consumption curve intersects the 45
degree line,APS is zero. (True/False)

Answer 13
True: Because at this point (called Break-even point),
consumption is equal to income and hence,
saving is zero.Therefore,APS = S/Y = 0/Y = 0

Question 14
Out of the following, which can have a value more than
one? (Choose the correct alternative)
(a) MPC
(b) APC
(c) APS
(d) MPS

Answer 14
(b) APC

Question 15
The value of MPS ranges from ________ .
(Fill in the blank)

Answer 15
0 to 1

Question 16
(i)________is the rate of change in savings per unit
change in income, and is equal to (ii)________ .

Answer 16
(i) MPS (ii) 1 – MPC or DS/DY

Question 17
As income increases, APS ______. (increases/decreases)

Answer 17
increases

Question 18
As income increases, APC ______.
(increases/decreases)

Answer 18
decreases

Question 19
__________ is the savings per unit of income.
(Fill in the blank)

Answer 19
Average Propensity to Save (APS)

Question 20
Investment decisions by producers, such as whether to
buy a machine, depend, to a large extent on
_________. (Fill in the blank)

Answer 20
the market rate of interest

Question 21
In the Keynesian analysis, we assume that firms plan to
invest the same amount every year. We can write the ex-
ante investment demand as: I = I, where I is a positive
constant which represents the ___________ in the
economy in a given year. (Fill in the blank)

Answer 21
Autonomous (or exogenous) investment (which
means, it is the same no matter whatever is the level of
income)

Question 22
In the consumption function, C = 200 + 0.6Y, the value
of dis-saving will be (Choose the correct alternative)
(a) 200
(b) –200
(c) 0.6
(d) 0.4

Answer 22
(b)–200

Question 23
When consumption function starts from Y-axis, it
indicates that: (Choose the correct alternative)
(a) consumption is zero when income is zero
(b) saving is negative when income is positive
(c) consumption is positive when income is zero
(d) saving is positive when income is zero

Answer 23

Question 24
Break even point occurs when
(a) Y = S
(b) S = 0
(c) C > Y
(d) Y > C

Answer 24
(b) S=0

Question 25
When consumption function starts from Y-axis, it
indicates that: (Choose the correct alternative)
(a) consumption is zero when income is zero
(b) saving is negative when income is positive
(d) saving is positive when income is zero

Answer 25
(a) a horizontal straight line.

Question 26
If the MPS is 1, how much will be MPC?
(a) 1
(b) 0.5
(c) 0
(d) 0.4

Answer 26
(c) 0

Question 27
How are both APC and APS associated with National
Income? (Choose the correct alternative)
(a) both APC and APS fall with increase in National
Income
(b) both APC and APS rise with increase in National
Income
(c) APC falls APS rises with increase in national income
(d) APC rises APS falls with increase in national income

Answer 27
(c) APC falls APS rises with increase in national
income

Question 28
If MPC = 0.4 and change in income is `1,000 crore, what
will be change in savings?
(a) `400 crore
(b) `500 crore
(c) `600 crore
(d) `250 crore

Answer 28
(c) `600 crore

Question 29
Ex-post investment means fixed capital with production
units during a particular period of time.

Answer 29
False: As ex-post investment includes both fixed as well as
inventory investment with the production units
during a period of time.

3.3
Aggregate Demand and
Aggregate Supply
Aggregate Demand
Aggregate Demand (AD) means the total demand for
final goods in an economy during an accounting year.
It also means the aggregate expenditure on final goods
in the economy.
Components of aggregate demand
The components of aggregate demand are:
(i) Consumption Expenditure (C)
(ii) Investment Expenditure(I)
(iii) Government’s final expenditure (G)
(iv) Net exports.
1. Consumption Expenditure(C)– It is that portion
of income which is spent on purchase of goods and
services by the consumers in an economy during the
accounting period.
2. Investment Expenditure (I)– It refers to the
addition to the stock of physical capital and change
in inventories of a firm in an economy.
Thus, in a two sector economy without a government
and external trade, ex-ante aggregate demand is sum
total of ex-ante consumption expenditure and ex-ante
investment expenditure, viz.
Substituting the values of C = + bY and I = , ex-ante

aggregate demand for final goods can be written as:
AD = + bY +
⇒ AD = ( + ) + bY +
Or, AD = + bY
Where is the total autonomous expenditure.
 Top Tip
Note that the slope of aggregate demand function AD = A +
bY is given by ‘b’, i.e. MPC.
There are two components of autonomous expenditure :

(i) Autonomous consumption
(ii) Autonomous investment
In reality, these two components of autonomous
expenditure behave in different way s. representing
subsistence consumption level of an economy, remains
more or less stable over time. However, has been
observed to undergo periodic fluctuations. We have
assumed that investment is autonomous. However, it
just means that it does not depend on income. There
are a number of factors other than income which can
affect investment. One such factor is availability of
credit, for example, easy availability of credit encourages
investment. Another factor is market rate of interest, for
example, interest rate is the cost of investible funds, and at
higher interest rates, firms tend to lower investment.
 Top Tip
AD can change if there is change in consumption or/and
change in investment.
1.Change in consumption: This can happen due to (i) change in
autonomous consumption (C) or/and (ii) change in MPC.
2. Change in investment: Easy availability of credit encourages
investment. Similarly, at lower market rate of interest, firms
tend to increase investment.
Diagrammatic Presentation
The ex-ante aggregate demand curve shows the total
demand (ex-ante consumption + ex-ante investment )
at each level of income. Graphically, it means the
aggregate demand curve can be obtained by vertically
adding the consumption and investment curves.
The aggregate demand curve is parallel to the
consumption curve since they have the same slope, i.e.
MPC. This is because AD = C + I, where I remains
constant irrespective of the level of income. So, AD rises
only with the rise in consumption, C. So, the slope of
the aggregate demand curve remains the same as that
of the consumption curve.
Aggregate Supply
Aggregate Supply (AS) is the value of total quantity of
final goods and services produced in the economic
teritory of a country.
In Keynesian analysis, aggregate supply refers to the
ex-ante, i.e. In a two sector economy, in the absence of
indirect taxes or subsidies, the value of total final goods
and services is distributed among the factors of
production (wages to labour, interest to capital and
rent to land). Whatever is left over is appropriated by
the entrepreneur and is called profit. Thus, the sum
total of aggregate factor payments in the economy, i.e.
National Income, is equal to the aggregate value of the
output of final goods, i.e. Aggregate Supply.
Therefore, aggregate supply curve is represented by a
45° line from the origin because the 45° line from the
origin establishes the relation of Y = C + S.
Also, since the 45° line from the origin has the feature
that every point on it has the same horizontal and
vertical coordinates, therefore, corresponding to every
point on the 45° line, AS = Y.
Key Terms
Aggregate Demand (AD) – It means the total demand for final
goods in an economy during an accounting year.
Autonomous expenditure (A �) – It is the sum of autonomous
consumption (C� ) and Autonomous investment (I)̅
Aggregate Supply (AS) – It is the value of total quantity of final
goods and services produced in the economic teritory of a
country.
RECAP
Aggregate Demand (AD)

It means total expenditure planned to be incurred on final goods
and services. Its components are:
(i) Consumption Expenditure(C)
(ii) Investment Expenditure(I)
(iii) Government’s final expenditure (G)
(iv) Net exports.
In a two sector economy, there are only two components of
aggregate demand, viz.
(i) Consumption Expenditure (C)
(ii) Investment Expenditure (I).
Consumption Expenditure(C)– It is that portion of income
which is spent on purchase of goods and services by the
consumers in an economy during the accounting period.
Investment Expenditure (I)– It refers to the addition to
the stock of physical capital and change in inventories of a
firm in an economy.
Thus, in a two sector economy, AD = C + I ⇒ AD = C� + bY +
�I ⇒ AD = ( C + �I ) + bY ⇒ AD = A � + bY
where A � = C� + �I = Autonomous expenditure.
Note that the slope of aggregate demand function is given by
‘b’, i.e. MPC. Thus, the aggregate demand curve is parallel to
the consumption curve since they have the same slope.
Aggregate Supply (AS)
It is the value of total quantity of final goods and services
produced in the economic teritory of a country. It refers to
the ex-ante, i.e. planned aggregate output in the economy. It
is equal to the National Income and is represented by a 45
degree line from origin because at every point on it, AS = Y.
NUMERICAL 8
Estimate the value of Aggregate Demand in an

economy if:
(a) Autonomous Investment = `100 crore
(b) Marginal Propensity to Save = 0.2
(c) Level of Income = `4,000 crore
(d) Autonomous Consumption Expenditure = `50
crore (3 marks)
Solution: MPC = b = 1 – MPS = 1 – 0.2 = 0.8, C� = 50, Y =
4,000 and I̅ = 100
Aggregate demand, AD = C + I
AD = C� + bY + I̅
AD = 50 + 0.8 × 4,000 + 100
AD = 50 + 3,200 + 100 = `3,350 crore
Do it yourself 8
Estimate the value of ex-ante AD, when autonomous

investment and consumption expenditure (A) is ` 50
crore, and MPS is 0.2 and level of income is ` 300
crore. (3 marks)
[Ans. `290 crore]
Since MPS = 0.2, therefore, MPC = b = 1 – MPS = 1 – 0.2 = 0.8
Autonomous investment and consumption expenditure (A) = C + I
= `50 crore
Level of income (Y) = `300 crore.
The value of ex-ante AD = C + I = C + bY + I = (C + I) + bY= A + bY
= 50 + 0.8 × 300 = `290 crore
Question 1
Why is aggregate demand curve parallel to the
consumption curve? (3 marks)

Answer 1
The aggregate demand curve is parallel to the
consumption curve since they have the same slope, i.e.
MPC. This is because AD = C + I, where I remains
constant irrespective of the level of income. So, AD
rises only with the rise in consumption, C. So, the slope
of the aggregate demand curve remains the same as
that of the consumption curve.

Question 2
State the two components of autonomous expenditure.
How do they behave in general? (3 marks)

Answer 2
Consumption curve does not start from origin because of
the assumption that there is some minimum level of
consumption even at zero level of income.
There are two components of autonomous expenditure (A �):
(i) Autonomous consumption (C �)
(ii) Autonomous investment (I)̅
In reality, the two components of autonomous expenditure
� remains more or less stable over
behave in different ways. C
time. However, I̅ undergoes periodic fluctuations. We have
assumed that investment is autonomous, which means
that it does not depend on
income. But, investment may increase at lower interest
rates.

Question 1
Which of the following is not a component of aggregate
demand in a two-sector economy?
(a) Net Exports
(b) Government Expenditure
(c) Consumption expenditure

Answer 1

Question 2
In a two sector economy and without any indirect tax
and subsidy, aggregate supply and ______ are always
equal. (Choose the correct alternative)
(a) National Income
(b) Aggregate Demand
(c) Marginal Propensity to save
(d) Average Propensity to Consume

Answer 2
(a) National Income

Question 3
What causes the Aggregate Demand Curve swing
downwards from AD1 to AD2?

Answer 3
Decline in MPC, i.e. slope of the AD curves decreases.

Question 4
Aggregate demand curve is parallel to ________ because
they have the same _________ . (Fill in the blanks)

Answer 4
consumption curve; slope, i.e. MPC consumption curve;
slope, i.e. MPC

Question 5
In a two sector economy, the aggregate demand curve
shifts in parallel upwards. In which of the following case
the above situation is possible?
(a) Change in autonomous consumption, MPC and
autonomous investment.
(b) Change in autonomous investment only, while
autonomous consumption and MPC remain the
same.
(c) Change in both the autonomous consumption and
autonomous investment; but MPC remains the same.

Answer 5

3.4
Short-Run Equilibrium
Level of Income/Output
We shall confine our analysis of the determination of
the equilibrium level of income or output in an
economy with only two sectors, households and firms.
Hence, the only components of aggregate demand will
be consumption and investment.
 Top Tip
The level of output, income and employment in an economy
move together in the same direction till full employment is
reached. In other words, increase in output means increase in
level of employment and increase in level of income. Decrease
in output means less employment and lower level of income.
Consumption plus investment
approach (or AD-AS approach)
Meaning of equilibrium level of
income/output
Equilibrium level of income or output is that level
of income or output at which ex-ante aggregate
demand becomes equal to ex-ante aggregate
supply.
It is also called ‘effective demand principle’.

Since AS = Y, therefore the economy is in equilibrium if
Y = AD
or, Y=C+I
The Adjustment Mechanism
When ex-ante aggregate demand (i.e. planned demand
or planned expenditure) is not equal to ex-ante
aggregate supply (i.e. planned output) of final goods
and services, then output will tend to adjust up or
down until the two are equal again.
 If planned demand falls short of planned
output (AD < Y)
It means buyers are planning to buy less goods and
services than producers are planning to produce.
Thus, inventories of unsold goods will be piling up in
the warehouses (i.e. unplanned accumulation of
inventories). As a result, producers will plan to cut
down production. This will decrease planned output
and income. The process continues till the planned
output produced in the economy becomes equal to
planned demand, i.e. Y = AD.
 If planned demand exceeds planned output (AD >
Y)
It means buyers are planning to buy more goods and
services than producers are planning to produce.
Thus, the inventories in hand with the producers
will start falling (i.e. unplanned decumulation of
inventories). As a result, producers will plan to raise
the production. This will increase planned output
and income. The process continues till planned
the planned demand, i.e. Y = AD.
Thus, Y = AD is a necessary condition for equilibrium
level of income or output.
Equilibrium is shown graphically by putting ex-ante
aggregate demand and supply together in a diagram.
The point where ex-ante aggregate demand is equal to
ex-ante aggregate supply will be equilibrium. Thus,
equilibrium point is E and equilibrium level of income
is OM.
Savings and Investment Approach
Derivation of S-I approach from C + I
approach
Under C + I approach, the equilibrium level of income
or output is determined at that level of income or
output at which planned aggregate demand is equal to
ex-ante aggregate supply, i.e. AD = Y or Y = C + I
Planned output or income is either consumed or saved,
i.e. Y = C + S
Substituting Y = C + S in the equilibrium condition
equation, we have
C+S=C+I
⇒
Equilibrium level of income or output is that level of
income or output at which ex-ante savings and ex-ante
investment are equal.
The Adjustment Mechanism
When planned savings and planned investment are not
equal, output will tend to adjust up or down till they
are equal again.
 If planned saving is greater than planned inves-
tment (S > I)
It implies buyers are planning to buy less goods
than producers are planning to produce. In other
words, planned demand is less than planned output
(i.e. AD < Y). Thus, inventories of unsold goods will
be piling up in the warehouses (i.e. unplanned
accumulation of inventories). accumulation of
inventories). As a result, producers will plan to cut
down production. This will decrease planned output
and income. The process continues till the planned
planned demand, i.e. planned investment becomes
equal to planned savings and the economy achieves
the equilibrium level of national income.
 If planned saving is less than planned
investment (S < I)
It implies buyers are planning to buy more goods than
producers are planning to produce (i.e. AD > Y). Thus,
the inventories in hand with the producers will start
falling (i.e. unplanned decumulation of inventories).
As a result, producers will plan to raise the production.
This will increase planned output and income. The
process continues till planned output produced in the
economy becomes equal to the planned demand, i.e.
planned investment becomes equal to planned savings
and the economy achieves the equilibrium level of
national income.
Thus, S = I is a necessary condition for equilibrium
level of income or output.
Fig. 3.7 shows that the economy is in equilibrium at
point E, where OM is equilibrium level of income or
output.
At this level of income or output, planned savings of
households is equal to the planned investment of firms.
'Effective Demand' Principle
Table 3.3: Determination of Equilibrium Income
or Output (𝐂𝐂� = 100, MPC = 0.8 and I = 300)
 At Y = 0, and Y = 1,000; AD > AS. This causes unplanned

decrease in inventories inducing producers to
produce more output.
 At Y = 2,000; AD = AS. This keeps the inventory level
unchanged. Thus, Effective Demand (AD = AS) is
obtained at `2,000 crore level of income/output
which is the equilibrium level of income/output. is
the equilibrium level of income/output.
 At Y = 3,000 and Y = 4,000; AD < AS. This causes
unplanned increase in inventory of unsold goods
inducing producers to produce less.
Key Terms
Equilibrium level of income or output – It is that level of income or
output at which ex-ante aggregate demand becomes equal to ex-ante
aggregate supply or ex-ante savings and ex-ante investment are equal.
Effective Demand – It refers to that level of income/output where
ex-ante aggregate demand is equal to the ex-ante aggregate
supply, i.e. AD = AS.
RECAP
C + I approach or AD-AS approach

Equilibrium income/output (or effective demand) refers to that
level of income/output where ex-ante aggregate demand is equal
to the ex-ante aggregate supply, i.e. AD = AS.
Since AS = Y, therefore the economy is in equilibrium if Y = AD ⇒
Y = C + I (the equilibrium condition in a two sector economy)
• When AD < Y, it means buyers are planning to buy less goods
and services than producers are planning to produce. Thus,
there will be unplanned accumulation of inventories. As a
result, producers will plan to cut down production. This
reduces output and income till Y = AD.
• When AD > Y, it means buyers are planning to buy more
goods and services than producers are planning to produce.
Thus, inventories in hand with the producers will start falling.
As a result, producers will plan to raise the production. This
Savings-Investment Approach: Derivation from
C+I Approach
Under C + I approach that equilibrium level of income is
determined where AD = Y, or Y = C + I ...(i)
Also,
From (i) and (ii), we have C + S = C + I ⇒ S = I
Thus, equilibrium level of income/output is that level of
income at which planned savings and planned investment
are equal.
• When S > I, it implies AD < Y. There is unplanned
accumulation of inventories. Producers plan to cut down
production. This reduces output and income till Y = AD and
hence, S = I.
• When S < I, it implies AD > Y. Inventories start falling.
Producers plan to raise the production. This raises output
and income till Y = AD and hence, S = I.
NUMERICAL 9
If in an economy consumption function is given by C

= 100 + 0.75 Y, and autonomous investment is `150
crore. Estimate (i) Equilibrium level of income by C +
I approach and (ii) Consumption and Savings at the
equilibrium level of income. (6 marks)
Solution: C = 100 + 0.75Y; I = `150 crore
(i) At equilibrium level of income:
Y=C+I
Y = 100 + 0.75Y + 150
Y – 0.75Y = 250
0.25Y = 250
Y = 250/0.25 = 1,000
The equilibrium level of income in the economy Y = `1,000
crore
(ii) Consumption at the equilibrium level of income:
C= 100 + 0.75Y
Do it yourself 9
Find equilibrium level of national income from the

following: 3 marks
[Ans. `750 crore]
S. No. Items (`crore)

(i) Autonomous consumption 100
(ii) Marginal propensity to consume 0.8
(iii) Investment 50
Autonomous consumption C = 100, MPC = b = 0.8,
Investment I = 50
Consumption function equation
C = C + bY = 100 + 0.8Y\Equilibrium level
of national income Y = C + I
Y = 100 + 0.8Y + 50 ⇒ Y – 0.8Y = 150 ⇒
0.2Y = 150
Y = 150/0.2 = `750
NUMERICAL 10
In an economy, C = 100 + 0.4Y is the consumption

function, where C is consumption and Y is National
Income. If investment expenditure is `1,100 crore,
calculate:
(i) Equilibrium level of National Income using savings
and investment approach.
(ii) Consumption expenditure at equilibrium level of
National Income. (6 marks)
Solution: Consumption function C = 100 + 0.4Y.
Therefore, savings function
S=Y–C
S = Y – (100 + 0.4Y)
S = –100 + 0.6Y
Investment expenditure I = `1,100 crore
At equilibrium level of national income, S = I
–100 + 0.6Y = 1,100
0.6Y = 1,100 + 100 = 1,200
Y = 1,200/0.6 = 2,000
(i) Equilibrium level of national income = ` 2,000 crore
(ii) At equilibrium level of national income, Savings (S) =
Investment (I) = `1,100 crore
Consumption expenditure at equilibrium level of national
income, C = Y – S = 2,000 – 1,100 = `900 crore
Do it yourself 10
In an economy, S = –100 + 0.6Y is the saving function,

where S is Saving and Y is National Income. If
investment expenditure is 1,100, calculate:
(i) Equilibrium level of National Income
National Income. (6 marks)
[Ans. (i) 2,000 (ii) 900]
Savings function S = –100 + 0.6Y
Investment expenditure I = 1100
At equilibrium level of national income S = I
–100 + 0.6Y = 1100 ⇒ 0.6Y = 1100 + 100 = 1200
Y = 1200/0.6 = 2000
(i) Equilibrium level of national income = 2000
(ii) Savings at equilibrium level of national income
S = Investment expenditure = 1100
Consumption expenditure at equilibrium level of
national income
C = Y – S = 2000 – 1100 = 900
NUMERICAL 11
The savings function of an economy is S = –200 + 0.25Y.

The economy is in equilibrium when income is equal to
`2,000 crore. Calculate: (i) Investment expenditure at
equilibrium level of income and (ii) Autonomous
consumption. (6 marks)
Solution: (i) Equilibrium level of income Y = `2,000
crore, Savings function S = –200 + 0.25Y
Savings at equilibrium level of income S = –200 + 0.25(2,000)
S = –200 + 500 = `300 crore
At equilibrium, planned savings and planned investment
expenditure are equal. Therefore, investment expenditure
at equilibrium level of income I = `300 crore
(ii) From the Savings function S = –200 + 0.25Y, we
get dissavings at zero income = `200 crore, which is equal
to autonomous consumption.
Therefore, autonomous consumption = `200 crore
Do it yourself 11
If in an economy Consumption function is given by C =

100 + 0.75 Y, and Autonomous investment is `150 crore.
Estimate (i) Equilibrium level of income and (ii)
Consumption and Savings at the equilibrium level of
income. (3 marks)
[Ans. (i) `1,000 crore (ii) `150 crore]
C = 100 + 0.75Y ⇒ I = 150
(i) At equilibrium level of income: Y = C+I ⇒ Y = 100 +
0.75Y + 150
Y – 0.75Y = 250 ⇒ Y = 250/0.25 = `1000 crore
(ii)C = 100 + 0.75Y = 100 + 0.75(1000) = 100 + 750 =
`850 crore
Y = C + S or S = Y – C = 1000 – 850 = `150 crore
NUMERICAL 12
Measure the level of ex-ante aggregate demand when

autonomous investment and consumption expenditure
� ) is `50 crore, and MPC is 0.8 and level of income (Y) is
(A
`4000 crore. State whether the economy is in equilibrium
or not (cite reasons). (3 marks)
Solution: Sum of autonomous investment (I)̅ and
autonomous consumption (C) � =A� = `50 crore, MPC = b =
0.8 and national income (Y) = `4,000 crore
Ex-ante aggregate demand, AD = C + I
AD = C� + bY + I̅
AD = (C� + I)̅ + bY = A� + bY
AD = 50 + 0.8 × 4,000 = `3,250 crore
Since AD (`3,250 crore) is less than National Income (Y =
`4,000 crore), therefore, the economy is not equilibrium.
The economy is in equilibrium when AD = Y.
Do it yourself 12
In an economy the autonomous investment is ` 100 crore

and the consumption is C = 80 + 0.4Y. Is the economy in
equilibrium at an income level ` 400 crore ? Justify your
answer.
[Ans. No, equilibrium level of income = `300 crore]
At equilibrium, Y = C + I (since at equilibrium AD = Y
C + I = Y) ⇒ Y = 80 + 0.4Y + 100 ⇒ Y – 0.4Y = 80 + 100
0.6Y = 180 ⇒ Y = 180/0.6 = 300
Thus, equilibrium level of income = `300 crore.
Since the given income of ` 400 crore is greater than
equilibrium level of income, the economy is not at
equilibrium at the income level ` 400 crore.
NUMERICAL 13
In an economy the autonomous investment is ` 60 crore

and the marginal propensity to consume is 0.8. If the
equilibrium level of income is `400 crore, then the
autonomous consumption is ` 30 crore. True or False?
Justify your answer. (3 marks)
Solution: At equilibrium, Y = C + I (since at equilibrium
AD = Y ⇒ C + I = Y)
Y = C� + bY + I̅
400 = C� + 0.8 × 400 + 60 (since Y = 400, MPC = b= 0.8 and I̅
= 60)
400 = C � + 320 + 60
� = 400 – 320 – 60 = 20
C
Autonomous consumption C � = `20 crore
The given value of autonomous consumption (`30 crore)
is incorrect.
Do it yourself 13
In an economy, C = 50 + 0.5Y is the consumption function,

where C is consumption expenditure and Y is National
Income. If investment expenditure is 2,000, calculate:
(i) Equilibrium level of National Income
National Income.
(iii) Savings at equilibrium level of income (6 marks)
[Ans. (i) 4,100 (ii) 2,100 (iii) 2,000]
Consumption function C = 50 + 0.5Y
Investment expenditure I = 2000
At equilibrium level of national income
Y = C + I ⇒ Y = 50 + 0.5Y + 2000 ⇒ Y – 0.5Y = 2050
0.5Y = 2050 ⇒ Y = 2050/0.5 = 4100
(i) Equilibrium level of national income = 4100
national income C
= 50 + 0.5(4100) = 50 + 2050 = 2100
(iii) Savings at equilibrium level of income = Investment
expenditure = 2000
Alternately, Savings at equilibrium level of income S = Y – C
= 4100 – 2100 = 2000
NUMERICAL 14
From the data given below about an economy, calculate

investment expenditure and consumption expenditure:
Equilibrium level of income = `5,000 crore
Autonomous consumption = ` 500 crore
Marginal propensity to consume = 0.4 (3 marks)
Solution: Equilibrium income Y = `5,000 crore,
Autonomous consumption C � = `500 crore, MPC = b = 0.4
Consumption expenditure C � = C + By
C = 500 + 0.4(5,000)
C = 500 + 2,000
C = `2,500 crore
At equilibrium income Y=C+I
(since at equilibrium AD = Y ⇒ C + I = Y)
5000 = 2,500 + I
I = 5,000 – 2,500
I = 2,500
∴ Investment expenditure I = `2,500
Do it yourself 14
Calculate Investment expenditure from the following data

about an economy which is in equilibrium:
National income = `1,000 crore
Marginal propensity to save = 0.25
Autonomous consumption expenditure = ` 200 crore
(3 marks)
[Ans. ` 50 crore]
Autonomous consumption expenditure C = 200.
MPC = b = 1 – MPS = 1 – 0.25 = 0.75
At equilibrium level of national income
Y = C + I ⇒ Y = C + bY + I ⇒ Y = 200 + 0.75Y + I
1000 = 200 + 0.75 (1000) + I ⇒ 1000 = 200 + 750 + I
1000 = 950 + I ⇒ I = 1000 – 950 = 50
Therefore, investment expenditure = `50 crore
NUMERICAL 15
An economy is in equilibrium. Calculate Marginal

Propensity to Save from the following:
National Income = `1,000
Autonomous Consumption = ` 100
Investment Expenditure = ` 200 (4 marks)
Solution : At equilibrium, Y = C + I
Y=C � + by + I̅
1,000 = 100 + b(1,000) + 200
b (1,000) = 1,000 – 100 – 200 = 700
b = 700/1,000 = 0.7 = MPC
Therefore, MPS = 1 – MPC = 1 – 0.7 = 0.3
Do it yourself 15
An economy is in equilibrium. From the following data,

calculate the marginal propensity to save:
(a) Income = 10,000
(b) Autonomous consumption = 500
(c) Consumption expenditure = 8,000 (4 marks)
[Ans. 0.25]
C = C + mpc(Y)
8000 = 500 + mpc(10,000)
mpc = 7,500/10,000 = 0.75
So, mps = 1 – 0.75 = 0.25
NUMERICAL 16
Calculate Autonomous consumption expenditure from the

following data about an economy which is in equilibrium:
National income = `1,200 crore
Marginal propensity to save = 0.20
Investment expenditure = ` 100 crore (3 marks)
Solution: Since MPS = 0.20, therefore, MPC = b = 1 – MPS
= 1 – 0.20 = 0.80
Consumption function equation C = C � + bY = C� + 0.80Y
At equilibrium level of national income Y = C + I (since at
equilibrium AD = Y ⇒ C + I = Y)
Y= C � + 0.80Y + I
1,200 = C� + 0.80 × 1,200 + 100 (since Y = 1200, I = 100)
1,200 = C� + 960 + 100
� = 1,200 – 960 – 100 = 140
C
Autonomous consumption expenditure = `140 crore
Do it yourself 16
Calculate Marginal Propensity to Consume from the

following:
Equilibrium income = `350 crore
Consumption expenditure at zero income = `20 crore
Investment = ` 50 crore (3 marks)
[Ans. 0.8]
Consumption expenditure at zero income
(Autonomous consumption) C = 20,
Equilibrium income Y = 350, Investment I = 50
Consumption function equation C = C + bY = 20 + 350b
At equilibrium level of national income Y = C + I
350 = 20 + 350b + 50 ⇒ 350 = 70 + 350b
350b = 350 – 70 = 280
b = 280/350 = 4/5 = 0.8
Marginal propensity to consume = 0.8
NUMERICAL 17
If in an economy savings function is given by S = (–) 50 +

0.2 Y and Y = `2,000 crore; consumption expenditure for
the economy would be ` 1650 crore and the autonomous
investment is ` 350 crore and the marginal propensity to
consume is 0.8. True or False? Justify your answer with
proper calculations. (3 marks)
Solution: Level of income Y = `2,000 crore
Savings S = –50 + 0.2Y
S = –50 + 0.2(2,000) = –50 + 400 = `350 crore
Consumption expenditure C = Y – S = 2,000 – 350 = `1,650
crore (Which is true.)
From the savings function equation S = (–) 50 + 0.2 Y, we
have MPS = 0.2
Since MPC + MPS = 1, therefore, MPC = 1 – MPS = 1 – 0.2
= 0.8 (Which is true.)
At equilibrium level of income, Savings = Investment =
`350 crore (Which is also
true.)
Thus, all the given values are correct.
Do it yourself 17
In an economy C = 200 + 0.5 Y is the consumption function

where C is the consumption expenditure and Y is the
national income. Investment expenditure is `400 crore. Is
the economy in equilibrium at an income level ` 1,500
crore? Justify your answer. (3 marks)
[Ans. No, the equilibrium level of income is ` 1,200 crore]
No, the Economy is not in a state of equilibrium at
`1500 crore
Given Consumption function, C = 200 + 0.5Y
Investment expenditure (I) = `400 crore
At the equilibrium level, Y = C + I
Substituting the values from the question:
Y = 200 + 0.5Y + 400 ⇒ Y – 0.5Y = 600
0.5Y = 600 ⇒ Y = 600/0.5 = 1200
The equilibrium level of income is ` 1200 crore. The
given income ` 1500 crore is greater than equilibrium
level of income.
Therefore, the economy is not in equilibrium.
NUMERICAL 18
The saving function of an economy is given as: S = – 250 +

0.25Y
If the planned investment is `2,000 crore, calculate the
following:
(a) Equilibrium level of income in the economy.
(b) Aggregate demand at income of ` 5,000 crore.
Solution: S = –250+ 0.25Y (Given)
(a) Equilibrium level of income in the economy exist when
S=I
Substitute the values of saving and investment, we get
–250 + 0.25Y = 2,000
0.25Y = 2,000 + 250
0.25Y = 2,250
Y = 2,250/0.25
Equilibrium level of income Y = `9,000 crore
(b) C = Y – S = Y – (– 250 + 0.25Y)
C = 250 + 0.75Y
Given that Y = 5,000
C = 250 + 0.75 (5,000) = 250 + 3,750 = 4,000
AD = C + I = 4,000 + 2,000 = 6,000
Aggregate demand at income of `5,000 crore = `6,000
crore
Do it yourself 18
The saving function of an economy is given as: S = – 10 +

0.20Y
If the planned investment is ` 100 crore, calculate the
following:
(b) Aggregate demand at income of ` 300 crore.
[Ans. (a) `550 crore (b) ` 350 crore]
S = –10 + 0.20Y
(a) Equilibrium level of income in the economy exist
when S = I
Substitute the values of saving and investment, we get
– 10 + 0.20Y = 100
0.20Y = 100 + 10 = 110 ⇒ Y = 110/0.20
Equilibrium level of income Y = `550 crore
(b) C = Y – S = Y – (– 10 + 0.20Y)
C = 10 + 0.80Y
Given that Y = 300
C = 10 + 0.80 (300) = 10 + 240 = 250
Aggregate demand AD = C + I = 250 + 100 = `350
crore
Question 1
Ex-post value of total output is always equal to the ex-
post aggregate expenditure in the economy.
(3 marks)

Answer 1
True; ex-post value of total output (Y) must always be
equal to the sum total of ex-post consumption
expenditure (C) and ex-post investment expenditure (I) in
the economy.
However, ex-ante aggregate supply is equal to ex-ante
aggregate demand only when the final goods market and
hence the economy, is in equilibrium.
Thus, even though planned Y is greater than planned C + I,
actual Y will be equal to actual C + I, with the extra output
showing up as unplanned accumulation of inventories in the
ex-post I on the right hand side of the accounting identity.
Question 2
“Inventories accumulate when planned investment is less
than planned saving.” Is the statement true or false? Give
reason in support of your answer. (3 marks)

Answer 2
True: When planned investment is less than planned saving,
AD < Y. It implies that consumers are not planning
to buy as much goods and services as the firms are
planning to produce. This will lead to an unplanned
accumulation of inventories.

Question 3
Explain how the level of effective demand is attained in
an economy if, Aggregate Demand is more than the
Aggregate Supply.

Answer 3
Effective demand refers to that level of output where
Aggregate demand is equal to the Aggregate supply. If
Aggregate Demand exceeds Aggregate Supply, it means
buyers are planning to buy more goods and services than
producers are planning to produce. Thus, the inventories
in hand with the producers will start falling. As a result,
producers will plan to raise the production. This will
increase the level of income upto the level Aggregate
Demand is equal to Aggregate Supply.

Question 4
How is ‘saving and investment’ approach derived from
the ‘aggregate demand and supply’ approach of income
determination? Explain using diagram. (6 marks)

Answer 4
Equilibrium level of income/output is that level at which
aggregate planned expenditure is equal to aggregate
planned output, i.e.AD = AS. In other words, C + I = Y
We know that planned income/output is either consumed
or saved, viz.Y = C + S
Therefore, equality of aggregate planned expenditure and
aggregate planned output at equilibrium implies that
C+I=C+S
⇒ S=I
Equilibrium level of income/output is that level at which
planned savings and planned investment are equal.
Thus, the two alternative approaches of national income
determination are:
(i) AD = Y which is on E in the upper part of diagram
when AD curve intersects the 45˚ line with
equilibrium income OM.
(ii) S = I which is on E1 in the lower part of the diagram
when saving curve intersects the investment curve at
E1 with OM as the equilibrium income level.

Question 5
Discuss the significance of 45-degree line in Keynesian
Economics. (3 marks)

Answer 5
• The straight line obtained which will originate from
point of origin O forming a 45° angle establishes the
relation of: Income = Consumption + Savings (Y = C
+ S). Therefore, the 45° line from origin represents the
aggregate supply curve.
• At any point on the 45° line, consumption expenditure
is exactly equal to income. Thus, the 45° line from
origin tells us whether consumption is equal to,
greater than, or less than income.
• The 45° line also helps to identify the equilibrium level
of income/output in the economy. At all points
on the 45° line, the aggregate demand equals the level
of income/output in the economy. Thus, the point
where the aggregate demand curve (C + I curve) will
intersect the 45° line must be the equilibrium point
because at that point on the 45° line aggregate
demand must be equal to the income/output in the
economy.

Question 1
AD curve starts: (Choose the correct alternative)
(a) From the origin
(b) Point below to the origin
(c) Point above the origin
(d) None of these

Answer 1
(c) Point above the origin

Question 2
In determination of equilibrium level of income by AD–
AS approach, AD is represented by:
(a) C + S
(b) C + I
(c) S + I
(d) C +Y

Answer 2
(b) C + I

Question 3
Which of the following is the equilibrium condition in a
two sector economy? (Choose the correct alternative)

Answer 3

Question 4
When Aggregate Demand is more than Aggregate
Supply, this will lead to _________.
(a) a planned inventories accumulation
(b) a planned inventories decumulation
(c) an unplanned inventories accumulation
(d) an unplanned inventories decumulation

Answer 4
(d) an unplanned inventories decumulation

Question 5
When Planned Savings is more than Planned Investment,
then _________. (Choose the correct alternative)
(a) National income is likely to fall
(b) There will be no change in national income
(c) National income is likely to rise
(d) None of these

Answer 5
(a) National income is likely to fall

Question 6
When aggregate demand is greater than aggregate
supply, inventories _________.
(a) fall
(b) rise
(c) do not change
(d) first fall, then rise

Answer 6
(a) fall

Question 7
The equilibrium level of income changes if there is
_________. (Choose the correct alternative)
(a) change in autonomous consumption
(b) change in MPC
(c) change in autonomous investment

Answer 7

Question 8
In the Keynesian analysis of determination of equilibrium
income in the short run, the justification for taking the
price level as fixed is: (Choose the correct alternative)
(a) We are assuming an economy with unused
resources: machineries, buildings and labours.
(b) In such a situation, the law of diminishing returns
will not apply.
(c) Additional output can be produced without
increasing marginal cost.
Answer 8

3.5
Investment Multiplier and
its Mechanism
Meaning of Investment Multiplier
A change in the investment spending will affect output
and therefore employment. It is logical that an increase
in fixed business investment will increase the level of
equilibrium income,output and employment through
increase in productive capacity. Conversely, a decrease
in investment will decrease the level of income,output
and employment. The operation of the multiplier
ensures that a change in investment causes a change in
income/output by an amplified amount, which is a
multiple of the change in investment.
The multiplier is the number by which the change in
investment must be multiplied in order to determine
the resulting change income/output.
For example, Suppose the consumption function of the
economy is C = 100 + 0.8Y and autonomous investment
is `300 crore. Then, the equilibrium level of income/ouput
is:
Y=C+I
Y = 100 + 0.8Y + 300
Y – 0.8Y = 100 + 300
0.2Y = 400
Y = 400/0.2 = `2,000 crore
Suppose, autonomous investment increases by `100 crore,
i.e. new investment I = `400 crore. Then, the equilibrium
level of income/output will be:
Y=C+I
Y = 100 + 0.8Y + 400
Y – 0.8Y = 100 + 400
0.2Y = 500
Y = 500/0.2 = `2,500 crore
Thus, the increase in equilibrium level of
income/output (i.e. `500 crore) exceeds the initial
increase in autonomous investment of ` 100 crore.
Here, the value of multiplier is 5 (i.e. `500 crore/`100
crore).
Investment Multiplier (k) is the ratio of the change in
final income/output (∆Y) due to a given change in
initial investment (∆I).
 Top Tip
We know that there are two components of autonomous
expenditure— Autonomous consumption and Autonomous
investment. A � = C� + I̅
Autonomous consumption C� remains more or less stable over
time. Therefore, ∆C� = 0
Autonomous investment I,̅ on the other hand, may increase
due to factors other than income. For example, at low market
rate of interest, firms tend to increase investment. Note that
we have assumed that investment is autonomous. However, it
just means that it does not depend on income. Autonomous
investment may increase due to other factors such as market
rate of interest, availability of credit, etc.
Since � = C� + I,̅ therefore ∆ A
A � = ∆C� + ∆ I̅
∆A� = 0 + ∆ I̅ (since DC = 0)
∆A� =∆ I̅
Hence, change in autonomous investment is equal to change
in autonomous expenditure.
Therefore,
Thus, investment multiplier may also be defined as the ratio of

the total increment in equilibrium level of income/output to
the initial increment in autonomous expenditure.
Investment Multiplier Mechanism—
We know that equilibrium level of income/output is
determined at that level where planned aggregate
demand/expenditure (C + I) becomes equal to the
planned aggregate output/income (Y). In Figure 3.11,
this happens when the AD (C + I) curve intersects the
45° line from origin (i.e., AS curve) at point E1. The
equilibrium level of income/output is OY1. Here, we
assume that investment expenditure is autonomous,
i.e., firms plan to investment a fixed amount I.
Now suppose there is an increase in autonomous
investment, i.e., firms to plan to invest a higher amount
I + DI. As a result, aggregate demand in the economy
increases and thus, the AD curve shifts in parallel upwards
and assumes the position AD2. Now at output/income OY1,
AD > Y by an amount ∆I. Thus, E1 no longer represents the
equilibrium. Since AD > Y, there will be unplanned
decrease in inventories inducing producers to produce
more output to meet this extra demand. This raises income.
This will happen till Y = AD at new equilibrium point E2
where the new aggregate demand curve AD2 intersects 45°
line. The new equilibrium level of income/output is OY2.
Observe that increase in income/output (∆Y) is greater
than the initial increase autonomous investment (∆I).
That is, a change in investment causes a multiple change in
income.
Relationship between MPC and
investment multiplier
The value of investment multiplier depends on the
value of marginal propensity to consume.
There exits a direct (or positive) relation between MPC

and investment multiplier. If MPC rises, value of
multiplier increases and vice-versa.
Example: Suppose the MPC of an economy increases
from 0.6 to 0.8, the value of multiplier will be calculated as
follows:
MPC
0.6
0.8
Thus, if the MPC of an economy increases from 0.6 to

0.8, the value of multiplier increases from 2.5 to 5, i.e.,
direct/positive relation. Therefore, national income will
increase more number of times the initial increase in
investment. Thus, coefficient of investment multiplier
carries direct relation with rate of growth in an economy,
i.e. higher the MPC more chance of growth exists in an
economy.
Note that investment multiplier is a two sided sword.
Hence, if investment falls in an economy the income
may also fall by a multiple times.
 Top Tip
Derivation of Investment Multiplier (for reference only)
At equilibrium, Y= C+I
Substituting C = C� + bY, we get Y = C� + bY + I
Y – bY = C� + I
Y (1 – b) = C� + I
Y=
Since 'b' is nothing but the MPC, we have
Y=
In the above equation, MPC and C� are constant. To find out

the effect of a change in investment on income, we
differentiate the above equation to obtain:
Derivation of Investment Multiplier (for reference only)
differentiate the above equation to obtain:
Relation between MPS and investment
multiplier
Since and 1 – MPC = MPS, therefore, value of
investment multiplier is:
There exists a negative/inverse relation relation between

MPS and investment multiplier.
Example: Suppose the MPS of an economy increases from
0.2 to 0.5, the value of multiplier will be calculated as
follows:
MPS
0.2
0.5
Thus, if the MPS of an economy rises from 0.2 to 0.5,

the value of multiplier decreases from 5 to 2. National
income increases less number of times the increase in
investment. Thus, rising MPS hampers the rate of
growth in the economy. So, the economists are always
concerned with the rising MPS.
Why does a change in investment cause a
multiple change in income?
A change in investment causes a multiple change in
income, i.e. change in income is greater than the
change in investment, ∆Y > ∆I because value of
investment multiplier is always greater than one (i.e., k
> 1).
Explanation: Value of multiplier depends on the value

of MPC since
Minimum value of investment multiplier can be 1 when
MPC = 0.
Maximum value of investment multiplier can be ∞
(infinity) when MPC = 1.
However, in an economy generally 0 < MPC < 1,

therefore, 1 < k < ∞ (i.e. value of multiplier ranges
between one and infinity.)
1 < k < ∞ implies that k > 1, i.e.
⇒ ∆Y > ∆I (i.e. change in income is greater than the
change in investment)
Hence, a change in investment will always cause a
multiple change in income.
Working/Process of Investment
Multiplier – Numerical Example
Suppose in an imaginary country, MPC is 0.8 and an
additional investment of `1000 crore (DI) is made by
government for a bullet train project in the country.
 This extra investment will generate an additional income
of `1000 crore in the country in first round, as expenditure
of one is income for another.
 Since MPC of this country is 0.8, the nationals who are
receiving this additional income will spend 80% portion
of this additional income, i.e. `800 crore, which in return
becomes additional income during second round.
 Similarly, in third round `640 crore of income is
generated.
 Consumption expenditure in every round will be 0.8
times of additional income received from previous round.
 This process will go on infinitely and comes to an end
when increase in savings (i.e., total leakages) become
equal to the increase in investment, i.e. `1000 crore.
Table 3.4: Working of Investment Multiplier (with
increase in investment `1000 crore and MPC 0.8)
Roun Increase in Increase in Induced Additional
ds Income (∆Y) Consumption (∆C) Savings/Leakages
(∆S)
I `1,000 crore `800 crore `200 crore
II `800 crore `640 crore `160 crore
III `640 crore `512 crore `128 crore
… … … …
Total 5,000 4,000 1,000
Total increase in income will be:
As a result, value of Investment Multiplier,
 Top Tip
Why did DI of `1,000 crore cause DY `5,000 crore? (for
reference only)
An endless chain of secondary consumption spending is set in
motion by the primary investment of `1,000. However. not
only is the chain of secondary consumption spending endless,
it is also ever-diminishing. Eventually, the sum of the
secondary consumption expenditures will be a finite amount.
We can calculate the total increase in income as follows:
∆Y = `1,000 crore + [0.8 × `1,000 crore] + [0.8 × (0.8 × `1,000
crore)] + ... ∞
∆Y = `1,000 crore + [0.8 × `1,000 crore] + [(0.8)2 × ` 1,000
crore] + ... ∞
This is of the form of the sum of an infinite geometric
progression series [a + ar + ar2 + ... ∞], whose first term (a)
is 1,000 and common ratio (r) is 0.8. The formula for the
sum of such an infinite geometric progression is
Thus,
RECAP
Investment Multiplier
Investment Multiplier (k) is a measure of the effect of an
initial increase in investment on increase in final income
based on MPC since k = 1/(1 – MPC).
Investment multiplier is the ratio of the change in income
due to a given change in initial investment, i.e. k = ∆Y/∆I.
Relationship between MPC and investment multiplier
Direct/Positive relation between MPC and investment
multiplier since k = 1/(1 – MPC). If MPC rises, value of multiplier
increases. For example, if MPC of an economy increases from 0.6
to 0.8, value of multiplier increases from k = 1/(1–0.6) = 1/0.4 = 2.5
to k = 1/(1–0.8) = 1/0.2 = 5. Thus, investment multiplier carries
direct relation with rate of growth in an economy.
Relationship between MPS and investment multiplier
Inverse/Negative relation between MPS and investment multiplier
since k = 1/MPS. If MPS rises, value of multiplier decreases.
For example, if MPS of an economy increases from 0.2 to 0.5,
value of multiplier decreases from k = 1/0.2 = 5 to k = 1/0.5 =
Thus, rising MPS hampers the rate of growth in the
economy. That is why, economists are concerned with rising
MPS.
Minimum value of investment multiplier is 1 when MPC
= 0 since k = 1/(1 – MPC) = 1/(1–0) = 1/1 = 1.
Maximum value of multiplier can be infinity when MPC
= 1 since k = 1/(1 – MPC) = 1/(1–1) = 1/0 = ∞.
However, in reality 0 < MPC < 1, therefore, 1 < k < ∞
(Investment multiplier ranges between one and infinity.)
⇒ k > 1 ⇒ ∆Y/∆I > 1 ⇒ ∆Y > ∆I.
Thus, change in final income is greater than initial change in
investment since k >1.
Working of Investment Multiplier – Numerical Example
Suppose increase in investment by government for a bullet
train project, DI = `1000 crore and MPC = 0.8. In Ist round,
this additional investment will generate an extra income of
`1000 crore. Since MPC is 0.8, people will spend `800 crore
(0.8 × 1000), which in return becomes additional income of
other people during second round (as one man’s expenditure is
another man’s income). Similarly, in third round `640 crore of
additional income is generated. This process will go on
infinitely till the total increase in income is equal to multiplier
times the initial investment.
Total increase in income,
Value of multiplier, k = ∆Y/∆I = 5000/1000 = 5

NUMERICAL 19
In an economy 75% of the increase in income is spent on

consumption. Investment is increased by `1,000 crore.
Calculate:
(i) Total increase in income
(ii) Total increase in consumption expenditure
(iii) Change in savings (3 marks)
Solution: In the economy 75% of the increase in income
is spent on consumption, i.e., MPC = 75% = 0.75
Increase in investment ∆I = `1,000 crore
k= 1/(1–MPC) = 1/(1–0.75) = 1/0.25 = 4
k= ∆Y/∆I ⇒ 4 = DY/1,000 ⇒ ∆Y = 4,000
MPC =∆C/∆Y ⇒ 0.75 = ∆C/4,000 ⇒ ∆C = 0.75 × 4,000 =
3,000
∆S = ∆Y – ∆C = 4,000 – 3,000 = 1,000
(i) Total increase in income = `4,000 crore
(ii) Total increase in consumption expenditure =
`3,000 crore
(iii) Change in savings = ` 1,000 crore
Do it yourself 19
In an economy, with every increase in income 10% of the

rise in income is saved. Suppose a fresh investment of `120
crore takes place in the economy. Calculate:
(i) Change in consumption
(ii) Change in savings
[Ans. (i) Total increase in consumption expenditure =
`1,080 crore (ii) Increase in savings = ` 120 crore]
In the economy, with every increase in income 10% of
the rise in income is saved, i.e., MPS = 10% = 0.10
Increase in investment DI = ` 120 crore
k= 1/MPS = 1/0.10 = 10
k = DY/DI ⇒ 10 (DY/120) ⇒ DY = 1,200
MPS = DS/DY ⇒ 0.10 = DS/1,200 ⇒ DS =
0.10× 1,200 = 120
DC = DY – DS = 1,200 – 20 = 1,080
(i) Total increase in consumption
expenditure = ` 1,080 crore
(ii) Increase in savings = `120 crore
NUMERICAL 20
An increase of `250 crore in investment in an economy

results in income increasing by three times more than the
increase in investment. Calculate:
(i) Marginal propensity to consume
(ii) Change in savings
(iii) Change in consumption expenditure
(iv) Value of multiplier (4 marks)
Solution: Increase in investment ∆I = 250, Increase in
income ∆Y = 250 + 3 × 250 = 1,000
Therefore, investment multiplier k = ∆Y/∆I = 1,000/250 = 4
k = 1/(1–MPC) ⇒ 4 = 1/(1–MPC)
1–MPC = 1/4 ⇒ MPC = 1 – (1/4) = 3/4
MPC =∆C/∆Y ⇒ 3/4 = ∆C/1,000 ⇒ 3/4 × 1,000 = 750
∆S = ∆Y – ∆C = 1,000 – 750 = 250
(i) Marginal propensity to consume = 3/4 = 0.75
(ii) Change in savings = `250 crore
(iii) Change in consumption expenditure = `750 crore
(iv) Value of multiplier = 4
Do it yourself 20
In an economy an increase in investment leads to increase

in national income which is three times more than the
increase in investment. Calculate marginal propensity to
consume. (3 marks)
[Ans. MPC = 0.75]
Suppose increase in investment be DI. Therefore,
increase in income DY= DI + 3DI = 4DI
Value of multiplier, k = DY/DI = 4DI/DI = 4
k = 1/(1 – MPC) ⇒ 4 = 1/(1 – MPC)
1 – MPC = 1/4 ⇒ MPC = 1 – 1/4 = 3/4 = 0.75
NUMERICAL 21
In an economy, the marginal propensity to save is 0.4.

National income in the economy decreases by `200 crore
as a result of change in investment. Calculate the change
in investment (? marks)
Solution: MPS = 0.4, therefore, value of multiplier, k =
1/MPS = 1/0.4 = 10/4 = 5/2
National income decreases by `200 crore, i.e., ∆Y = –200
k = ∆Y/∆I ⇒ 5/2 = –200/∆I
⇒ ∆I = (–200 × 2)/5 = –80
The investment decreases by `80 crore.
Do it yourself 21
Investment in an economy decreases by `400 crore.

Marginal propensity to consume is zero. Calculate the
change in national income. 3 marks
[Ans. ` 400 crore]
Decrease in investment DI = –400, MPC = 0
Value of multiplier, k = 1/(1 – MPC) = 1/(1 – 0) = 1/1 = 1
k = ∆Y/∆I ⇒ 1 = ∆Y/(–)400 ⇒ ∆Y = – 400
Therefore, national income decreases by `400 crore.
NUMERICAL 22
In an economy, 60% of the additional income is spent on

consumption. Assuming that the investment increases by
`900 crore, explain the working of multiplier.
Solution: Working of multiplier (with increase in
investment `900 crore and MPC = 0.6)
• Increase in investment will generate an extra income of

`1000 crore in first round, as expenditure of one is
income for another.
• Since MPC is 0.6, the nationals who are receiving this
additional income will spend `540 crore (0.6 × 900),
which in return becomes additional income during
second round.
• Similarly, in third round `324 crore of income is
generated.
• This process will go on infinitely and total increase in
income will be:
∆Y = ∆I. 1/(1–MPC)
= 900 × 1/(1 – 0.6)
= 900 × 1/0.4 = 900 × 2.5
= `2,250 crore
As a result, value of Investment Multiplier, k = ∆Y/∆I =
2,250/900 = 2.5
Do it yourself 22
In an economy, 75% of the additional income is spent on

consumption. Assuming that the investment increases by `
800 crore, explain the working of multiplier.
[Ans. ∆Y = `3,200 crore]
Working of multiplier (with increase in investment
`800 crore and MPC = 0.75)
• Increase in investment will generate an extra

income of `800 crore in first round, as expenditure
of one is income for another.
•Since MPC is 0.75, the nationals who are receiving this
additional income will spend `600 crore (0.75 × 800),
which in return becomes additional income during
second round.
• Similarly, in third round `450 crore of income is
generated.
• This process will go on infinitely and total
increase in income will be:
∆Y = ∆I. 1/(1–MPC) = 800 × 1/(1 – 0.75) = 800 ×
1/0.25 = 800 × 4
= `3,200 crore
As a result, value of Investment Multiplier, k = ∆Y/∆I =
3,200/800 = 4
NUMERICAL 23
In an economy, C = 100 + 0.75Y is the consumption

function, where C is consumption expenditure and Y is
National Income. If investment expenditure is 1,000.
(i) Derive the savings function
(ii) Calculate equilibrium level of National Income
(iii) Calculate additional investment needed to reach the
new equilibrium level of income 6,000. (6 marks)
Solution: Consumption function C = 100 + 0.75Y,
Investment expenditure I = 1,000
(i) Savings function S = Y – C
S = Y – (100 + 0.75Y)
S = Y – 100 – 0.75Y
S =– 100 + 0.25Y
(ii) At equilibrium level of income Y = C + I
Y = 100 + 0.75Y + 1000
Y – 0.75Y = 1100
0.25Y = 1100
Y = 1,100/0.25
∴ Equilibrium level of national income = 4,400
(iii) From the consumption function C = 100 + 0.75Y,
we get MPC = 0.75
Value of multiplier k = 1/(1–MPC) = 1/(1–0.75) =
1/0.25 = 4
To reach the new equilibrium level of income 6000,
required increase in income, DY = 6000 – 4400 =
1600
k = ∆Y/∆I ⇒ 4 = 1,600/∆I ⇒ ∆I = 1,600/4 = 400
∴ Additional investment needed = 400
Do it yourself 23
If in an economy C = 500 + 0.9Y and I = `1000 crore. (Where C =

Consumption expenditure, Y = National income, I =
Investment)
Calculate the following: (i) equilibrium level of income (ii)
value of investment multiplier (3 marks)
[Ans. (i) `15000 crore (ii) 10]
(i) Equilibrium level of income will be determined
when
Y = C + I ⇒ Y = 500 + 0.9Y + 1000
Y – 0.9Y = 1500 ⇒ Y = 1500/0.10 = `15000 crore.
(ii) Value of Investment Multiplier = 1/(1 – MPC) =
1/(1 – 0.9) = 1/0.1 = 10
NUMERICAL 24
There is increase in investment of `100 crore in an

economy. Marginal propensity to consume is 1. What can
you say about total increase in income? Calculate.
(3 marks)
Solution: Increase in investment ∆I = 100, MPC = 1

Value of multiplier, k = 1/(1 – MPC) = 1/(1 –
1) = 1/0 = ∞
Therefore, there will be an infinite increase in income in
the economy due to an increase in investment of `100
crore.
Do it yourself 24
There is increase in investment of `1,000 crore in an
economy. Marginal propensity to consume is zero. What is
the total increase in income? Calculate. (3 marks)
Increase in investment DI = 1,000, MPC = 0
Value of multiplier, k = 1/(1 – MPC) = 1/(1 – 0) = 1/1 = 1
k = ∆Y/∆I ⇒ 1 = ∆Y/∆I
∆Y = ∆I = 1,000
Therefore, total increase in income = `1,000 crore,
which is exactly equal to the increase in investment.
NUMERICAL 25
In an economy the equilibrium level of income is ` 12,000

crore. The ratio of marginal propensity to consume and
marginal propensity to save is 3 : 1. Calculate the additional
investment needed to reach a new equilibrium level of income
of `20,000 crore. (3 marks)
Solution: Required increase in income ∆Y = 20,000 –
12000 = 8,000
MPC : MPS = 3 : 1. Therefore, MPC = 3MPS
Since MPC + MPS = 1, therefore, 3MPS + MPS = 1 ⇒
4MPS = 1 ⇒ MPS = 1/4
Value of multiplier k = 1/MPS = 4
k = ∆Y/∆I ⇒ 4 = 8,000/DI ⇒ DI = 8,000/4 = 2,000
Therefore, additional investment needed = `2,000 crore
Do it yourself 25
Investment in an economy increases by `1000 crore.
Suppose marginal propensity to save is zero. What can you
say about increase in national income? Calculate. (3 marks)
Increase in investment ∆I = 1000, MPS = 0
Value of multiplier, k = 1/MPS = 1/0 = ∞
k = ∆Y/∆I ⇒ ∞ = ∆Y/∆I ⇒ ∆Y = ∆I × ∞
Therefore, an increase in investment by `1000 crore
causes infinite increase in national income.
NUMERICAL 26
In an economy investment increases from 300 to 500. As a

result of this equilibrium level of income increases by
2,000. Calculate the marginal propensity to consume.
Solution: Increase in investment ∆I = 500 – 300 = 200
Increase in income ∆Y = 2,000
Therefore, value of investment multiplier k =
∆Y/∆I = 2,000/200 = 10
Since k = 1/MPS, therefore, 10 = 1/MPS ⇒ MPS
= 1/10
Hence, MPC = 1 – MPS = 9/10 = 0.9
Do it yourself 26
In an economy, a 20% increase in investment results in a
100% increase in income. Calculate the marginal propensity
to consume. (3 marks)
[Ans. MPC = 0.8]
Increase in investment ∆I = 20%
Increase in income ∆Y= 100%
Value of multiplier, k = ∆Y/∆I = 100%/20% = 5
k = 1/(1 – MPC) ⇒ 5 = 1/(1 – MPC)
1 – MPC = 1/5
MPC = 1 – 1/5 = 4/5 = 0.8
NUMERICAL 27
Calculate Multiplier when MPC is 4/5 and 1/2. From the

calculations establish the relation between size of
Multiplier and size of MPC. (4 marks)
Solution: Multiplier k = 1/(1–MPC)
MPC Value of Multiplier, k
4/5 = 0.8 k = 1/(1–0.8) = 1/0.2 = 5
1/2 = 0.5 k = 1/(1–0.5) = 1/0.5 = 2
Observing the same we may conclude that there exists
positive or direct relation between MPC and Investment
Multiplier. Investment multiplier coefficient measures the
change in final income with respect to given change in the
initial investment in the economy. It carries direct relation
With rate of growth in an economy, i.e., higher the MPC
more chance of growth exists in an economy. But, it is a
two sided sword hence if investment falls in an economy
the income may also fall.
Do it yourself 27
In an economy, investment increased by `1,100 crore and as
a result of it income increased by ` 5,500 crore. Calculate
the value of multiplier and MPS.
Had the marginal propensity to save been 25 percent, what
would have been the increase in income? (4 marks)
[Ans. 5, 0.2, ` 4,400 crore]
[Ans. MPC = 0.8]
Increase in Investment (∆I) = 1,100
Increase in Income (∆Y) = 5,500
Value of multiplier, k = ∆Y/∆I = 5,500/1,100 = 5
k = 1/MPS, i.e. 5 = 1/MPS
MPS = 1/5 = 0.2
Now, if MPS = 0.25, then k = 1/MPS = 0.25 = 4
Therefore, increase in income (∆Y) = k × ∆I = 4 ×
1,100 = 4,400
NUMERICAL 28
If in an economy, income increases from `5,000 crore to `

8,000 crore as a result of 20% increase in investment,
calculate the value of investment multiplier. (3 marks)
Solution: Increase in income ∆Y = (8,000 – 5,000)/5,000 × 100
= 3,000/5,000 × 100
= 60%
Increase in investment ∆I = 20%
Therefore, value of investment multiplier k
= ∆Y/∆I
= 60%/20%
= 0.6/0.2
=3
Do it yourself 28
If in an economy C = 500 + 0.9 Y and I = ` 1,000 crore.
(where C = Consumption expenditure, Y = National
income, I = Investment)
Calculate the following:
(i) Equilibrium level of income
(ii) Value of investment multiplier (CBSE 2018) (4 marks)
[Ans. (i) `15000 crore (ii) 10]
(i) Equilibrium level of income will be determined when
Y=C+I
Y = 500 + 0.9Y + 1,000 ⇒ Y – 0.9Y = 1,500
Y = 1,500/0.10 = `15000 crore.
(ii) From the consumption function C = 500 + 0.9Y,
MPC = 0.9
Therefore, value of Investment Multiplier = 1/(1–MPC)
- 1/(1–0.9) = 10
NUMERICAL 29
The consumption function of an economy is given by C = `100

crore + 0.8Y.
As a result of increase in autonomous expenditure in this
economy, national income increases by `500 crore. Calculate the
increase in autonomous expenditure in the economy. (3 marks)
Solution : From the consumption function C = `100 crore +
0.8Y, we have MPC = 0.8
Value of investment multiplier, k = 1/(1–MPC) = 1/ (1–0.8) = 1/0.2
=5
Now, Investment multiplier, k = ∆Y/∆I
∆Y = `500 crore (given) and k = 5
Therefore, 5 = 500/∆I ⇒ ∆I = 100
Since ∆A = ∆I, therefore increase in autonomous expenditure
∆A = `100 crore
Do it yourself 29
Suppose in a hypothetical economy, the savings increase by
`20 crore when national income increases by `100 crore.
Compute the increment in autonomous expenditure in this
economy to attain an increase in national income by `
6,000 crore. (3 marks)
[Ans. `1,200 crore]
MPS = ∆S/∆Y = 20/100 = 0.2
Value of investment multiplier, k = 1/MPS =
1/0.2 = 5
Now, Investment multiplier, k = ∆Y/∆I
∆Y = `6,000 crore (given) and k = 5
Therefore, 5 = 6,000/∆I ⇒ ∆I = 1,200
Since ∆A = ∆I, therefore increase in autonomous
expenditure ∆A = `1,200 crore
NUMERICAL 30
The consumption function of an economy is given by C = `100

crore + 0.8Y.
As a result of increase in autonomous expenditure in this
economy, national income increases by `500 crore. Calculate the
increase in autonomous expenditure in the economy. (3 marks)
Solution : (i) We know that the equilibrium level of
income in an economy is determined when: S = I
Substituting S = (–) 10 + 0.20Y and I = 240, we have
–10 + 0.20Y =240
0.20Y =250
Y = 250/0.20 = 1,250
Equilibrium level of income in the economy = `1,250crore
(ii) From the savings function S = (–) 10 + 0.20Y, MPS = 0.20
Value of investment multiplier, k = 1/MPS = 1/0.20 = 5
To double of the existing income level (∆Y = 1,250 crore),
suppose additional investments needed = ∆I
k=∆Y/∆I
=1250/∆I
∆I=1,250/5 = 250
Additional investments needed = `250 crore
Do it yourself 30
The saving function of an economy is given as: S = (–) 50 +
0.10 Y
If the ex-ante Investments are `450 crore, calculate the
following:
(i) Equilibrium level of income in the economy.
(ii) Additional investments which will be needed to gain an
additional income level of ` 3,000
crore.

[Ans. (i) ` 5,000 crore (ii) `300 crore]
(i) We know that the equilibrium level of income in an
economy is determined when: S = I
– 50+0.10Y=450 ⇒ 0.10Y=500
Y= `5,000 crore
(ii) MPS = 0.10, k = 1/MPS = 1/0.10 = 10
To gain additional income level (∆Y = 3,000
crore), ∆I = ?
k = ∆Y/∆I ⇒ 10 = 3,000/∆I
∆I = `300 crore
NUMERICAL 31
If Marginal Propensity to Consume (MPC) is 0.8 and

increase in autonomous investment is `1,000 crore,
calculate the increase in induced consumption and the
leakages in the economy. (6 marks)
Solution : Investment Multiplier k = 1/(1 – MPC)
= 1/(1 – 0.8) = 1/0.2 = 5
Also, k = ∆Y/∆I
5 = ∆Y/1,000
⇒ ∆Y = 5,000
Thus, increase in final income (∆Y) = `5,000 crore
MPC = 0.8
⇒ ∆C/∆Y = 0.8
⇒ ∆C/5,000 = 0.8
⇒ ∆C = 0.8 × 5,000 = 4,000
Thus, increase in induced consumption (∆C) = `4,000
crore
Leakages in the economy means the additional savings of
the economy i.e. ∆S = ∆Y – ∆C = 5,000 – 4,000 = `1,000
crore
Do it yourself 31
If Marginal Propensity to Consume (MPC) is 0.75 and
change in initial investment is `2,000 crore, calculate the
increase in induced consumption and the leakages in the
economy. (6 marks)
[Ans. ` 6,000 crore; ` 2,000 crore]
Investment Multiplier k = 1/(1 – MPC) = 1/(1 – 0.75)
= 1/0.25 = 4
Also, k = ∆Y/∆I ⇒ 4 = ∆Y/2,000 ⇒ ∆Y = 8,000
Thus, increase in final income (∆Y) = `8,000 crore
MPC = 0.75 ⇒ ∆C/∆Y = 0.75 ⇒ ∆C/8,000 = 0.75
∆C = 0.75 × 8,000 = 6,000
Thus, increase in induced consumption (∆C) = `6,000
crore
Leakages in the economy = Additional savings, ∆S = ∆Y
– ∆C
= 8,000 – 6,000 = `2,000 crore
Question 1
When an economy decides to save the whole of its
additional income, what will be the value of investment
multiplier? (1 mark)

Answer 1
When an economy decides to save the whole of its
additional income, i.e. MPS = 1, the value of investment
multiplier will be:
k = 1/MPS = 1/1 = 1

Question 2
State giving reasons whether the following statements
are true or false: (4 marks)
(a) When marginal propensity to consume is greater
than marginal propensity to save, the value of
investment multiplier will be greater than 5.
(b) If the ratio of marginal propensity to consume and
marginal propensity to save is 4 : 1, the value of
investment multiplier will be 4.

Answer 2
(a) False
Reason: Value of investment multiplier will be greater
than 2.
Explanation: MPC >MPS
1 – MPS <MPS
1 > 2 MPS
1/MPS >2
k >2
(b) False
Reason:Value of investment multiplier will be 5.
Explanation: MPC/ MPS = 4 : 1
MPC = 4 MPS
We know that MPC + MPS = 1
Therefore, 4 MPS + MPS = 1
⇒ 5 MPS = 1
⇒MPS = 1/5
Therefore, value of multiplier, k = 1/MPS = 5

Question 3
If in an economy, the consumption and savings curves
are parallel to each other, what will be the value of
investment multiplier? Explain. (3 marks)

Answer 3
Value of investment multiplier = 2
Explanation: When two straight lines are parallel, their
slopes must be equal.
Since consumption and savings curves are parallel to each
other, therefore they have the equal slopes.
We know that the slope of the consumption curve is
MPC and the slope of the savings curve is MPS.
Thus, MPC = MPS
Since MPC + MPS = 1, therefore we have
MPS + MPS = 1
2 MPS = 1
MPS = 1/2 = 0.5
Therefore,Value of investment multiplier, k = 1/MPS
= 1/0.5 = 2

Question 4
Why does a change in investment cause a multiple
change in income? Explain. (3 marks)

Answer 4
Since value of investment multiplier is always greater than 1.
Explanation
Value of investment multiplier k = 1/(1 – MPC)
Minimum value of investment multiplier is 1 when MPC =
0 since = 1/(1–0) = 1/1 = 1.
Maximum value of multiplier can be infinity when MPC =
1 since k = 1/(1 – MPC) = 1/(1–1) = 1/0 = ∞.
However, in reality 0 < MPC < 1, therefore, 1 < k < ∞
⇒ k>1
⇒ ∆Y/∆I > 1
⇒ ∆Y > ∆I
Thus, change in final income is greater than initial change
in investment.

Question 5
How is this money creation by commercial banks likely
to affect the national income? Explain. (3 marks)

Answer 5
Commercial banks create money through the lending of
deposits of the public after keeping legal reserves.
Commercial banks lend money mainly to investors. Thus,
more lending by banks means more investment in the
country.
The rise in investment in the economy leads to rise in
national income through the investment multiplier
mechanism.

Question 6
Government of India launched ‘Jan-Dhan Yojna' which
aimed at every household in the country to have at least
one bank account. Explain how deposits made under the
plan affect national income of the country.

Answer 6
Opening more bank accounts means more bank deposits.
More deposits means increase in the lending capacity of
the commercial banks. Commercial banks lend money
mainly to investors. Thus, more lending by banks means
more investment in the country. The rise in investment in the
economy leads to rise in national income through the
investment multiplier mechanism.

Question 1
If MPC = 1, the value of multiplier is:
(a) 0
(b) 1
(c) Between 0 and 1
(d) Infinity

Answer 1
(d) Infinity

Question 2
If MPC = 0, the value of multiplier is:
(a) 0
(b) 1
(c) Between 0 and 1
(d) Infinity

Answer 2
(b) 1

Question 3
The maximum value of investment multiplier can be
__________ when the MPC is assumed to
__________. (Choose the correct alternative)
(a) Infinity, zero
(b) Infinity, one
(c) One, infinity
(d) None of these

Answer 3
(b) Infinity, one

Question 4
National income will rise with the rise in investment.

Answer 4
True: Since production capacity will increase with rise
investment, therefore national income will rise
multiplier times the initial rise in investment.

Question 5
If the value of MPC is 0.75, the value of multiplier is
__________. (Fill in the blank)

Answer 5
4

Question 6
Value of investment multiplier varies between zero and
infinity. (True/False)

Answer 6
False: Investment multiplier, k = 1/(1–MPC)
Since 0 < MPC < 1, therefore, value of multiplier
ranges between 1 and ∞.

Question 7
When marginal propensity to consume is zero, the value
of investment multiplier will also be zero. (True/False)

Answer 7
False:Value of investment multiplier, k = 1/(1–MPC)
When MPC = 0, k = 1/(1 – 0) = 1/1 = 1

Question 8
The ratio of the total increment in equilibrium value of
final goods output to the initial increment in
autonomous expenditure is called __________ of the
economy. (Fill in the blank)

Answer 8
Investment multiplier

Question 9
What is the value of multiplier, when S = –100 + 0.4Y?
(a) 1.5
(b) 1.05
(c) 2.5
(d) 2.05

Answer 9
(c) 2.5

Question 10
In an economy, when investment decreases national
income decreases at least by an amount equal to
decrease in investment. (True/False)

Answer 10
True: Investment multiplier, k = 1/(1 – MPC) Since 0 <
MPC < 1, the value of multiplier will be greater
than 1 (k > 1). Therefore, a change in investment
will cause a multiple change in income. Hence, a
decrease in investment will cause national
income to decrease at least by an amount equal
to decrease in investment.

Question 11
If MPS = 1, change in national income will be exactly
equal to change in investment. (True/False)

Answer11
True: When MPS = 1, k = 1/MPS = 1/1 = 1
k = DY/DI = 1
DY = DI
Thus, change in national income will be exactly
equal to change in investment.

Question 12
If MPC is double the MPS, value of investment multiplier
will be 2. (True/False)

Answer 12
False: MPC = 2MPS ;
MPC + MPS = 1 ⇒ 2MPS + MPS =1
⇒ 3MPS = 1 ⇒ MPS = 1/3
Value of investment multiplier, k = 1/MPS = 3

Question 13
When MPC is equal to MPS, increase in national income
will be twice the initial increase in investment.(True/False)

Answer 13
True: Equality between MPC and MPS signifies that
both of them are equal to 0.5 (as MPC + MPS =
1). Therefore, value of investment multiplier (k) =
1/MPS = 1/0.5 = 2. It means that increase in
income in the economy will be twice the initial
increase in investment.

Question 14
When investment multiplier is 1, the value of marginal
propensity to consume is zero. (True/False)

Answer 14
True: k = 1/(1 – MPC)
Since k = 1, therefore, 1 = 1/(1 – MPC)
1 – MPC = 1
MPC = 0

Question 15
A change in initial investment causes a change in final
income by an amplified amount, which is a multiple of
the change in initial investment and depends upon the
value of ____________. (Fill in the blank)

Answer 15
MPC; since k = 1/(1 – MPC)

Question 16
As MPC rises, value of multiplier increases.

Answer 16
True: Because the size of the multiplier (k) depends on
the value of MPC as k = 1/(1 – MPC).
There is a direct/positive relation between MPC
and value of multiplier. Thus, as MPC rises, the
value of multiplier increases.

3.6
Problems of Deficient
Demand and Excess
Demand
Full Employment Equilibrium
Full employment refers to a situation of no involuntary
unemployment.
Involuntary unemployment refers to a situation
when a person who is willing and able to work at the
prevailing wage rate, does not get work.
Thus, full employment is a situation in which all those
who are able and willing to work at the prevailing wage
rate find work.
 Top Tip
Involuntary unemployment is distinguished from voluntary
unemployment which refers to that part of population which
are able to work but voluntarily prefer not to work. Such
people are not included in the labour force of the country
because labour force comprises of people who are able to
work and willing to work.
Full employment level of income is that level of
income where all the factors of production are fully
employed in the production process.
Figure 3.9 shows that the economy is in equilibrium at
point E where the aggregate demand (AD) curve
intersects the 45° line from origin. The corresponding
level of income is OQ, which is full employment level
of income. It must be noted that equilibrium level of
output determined by the equality, Y = AD does not
necessarily mean the full employment level of output.
The equilibrium level of output may be more or less
than the full employment level of output.
 If it is less than the full employment of output, it is
due to the fact that demand is not enough to
employ all factors of production. This situation is
called the situation of deficient demand.
 On the other hand, if the equilibrium level of
output is more than the full employment level, it is
due to the fact that the demand is more than the
level of output produced at full employment level.
This situation is called the situation of excess
demand.
Deficient demand and Deflationary
gap
If equilibrium level of income/output is less than the
full employment level of income/output, it is due to
the fact that aggregate demand is not enough to
employ all the factors of production. This situation is
called the situation of deficient demand.
When aggregate demand is less than aggregate supply
at full employment, it is a situation of deficient demand.
Deficient demand gives rise to a deflationary gap,
which causes the economy’s income, output and
employment to decline, thus pushing the economy
into an underemployment equilibrium.
Deflationary gap is the amount by which the aggregate
demand falls short of aggregate supply at full employment.
The deflationary gap is called deflationary because it
sets in motion forces that cause deflation i.e. a fall in
general price level.
When aggregate demand and aggregate supply are
equal at below full employment level, it is called
under-employment equilibrium.
Figure 3.10 depicts the situation of deficient demand
and deflationary gap. OQ is the full employment level
of income/output. For the economy to be at full
employment equilibrium, the aggregate demand should be
equal to the full employment level of income/output, i.e.
FQ (which is equal to OQ since point F lies on the 45°
line from the origin).
However, the actual aggregate demand is GQ, which is
less than FQ. This results in a situation of deficient
demand. The resulting deflationary gap created due to
deficient demand is represented by FG in figure 3.10.
The deflationary gap is the amount by which the
actual aggregate demand falls short of the level of
aggregate demand required to established the full
employment equilibrium.
To correct the situation of deficient demand, the
aggregate demand must be increased by an amount
equal to the deflationary gap FG. This will move the
economy to the full employment equilibrium at point
F.
Note that since we are considering only two-sector
economy, aggregate demand can be increased through
increase in investment, as shown by DI in figure 3.10.
(In a two-sector economy, there is no role of the
government.)
Remedy for deficient demand and
deflationary gap
In order to remedy the problem of deficient demand,
the aggregate demand has to be increased by an
amount equal to the deflationary gap.This will move
the economy to the full employment equilibrium.
The aggregate demand may be increased by taking
recourse to fiscal policy, monetary policy or both.
Fiscal policy measures
Fiscal policy is the expenditure and taxation policy of
the government.
(i) Increase in government expenditure: Government
should increase its own expenditure to leave more
personal disposable income. Then, aggregate demand
will increase to correct the deflationary situation. (ii)
Decrease in taxes: The government under its fiscal
policy may decrease the rate of taxes (both direct and
indirect taxes). This will ensure greater purchasing
power in the hands of general public. This will help to
increase aggregate demand and remove the
deflationary gap.
Monetary policy measures – Increase
in money supply
Central bank through its expansionary monetary
policy can increase the money supply in the economy.
Central bank can use tools like bank rate, cash reserve
ratio, repo and reverse repo rates etc. to ensure greater
money in the hands of general public which would in
turn increase the aggregate demand in the economy
and be helpful in reducing/removing the deflationary
gap.
Central bank should:
• Reduce bank rate
• Reduce statutory liquidity ratio
• Reduce reverse repo rate
• Purchase government securities in the open
market.
• Reduce cash reserve ratio
• Reduce repo rate
• Reduce margin requirement on loan
(These were explained under functions of Central Bank
in the Unit 2, Section 2.4. The students are expected to
revise these monetary policy instruments from Unit 2.)
Excess Demand and Inflationary gap
If the equilibrium level of income/output is more than
the full employment level of income/output, it is due
to the fact that the aggregate demand is more than the
level of output produced at full employment level. This
situation is called the situation of excess demand.
When aggregate demand is more than the aggregate
supply at full employment, it is a situation of excess
demand.
Excess demand gives rise to an inflationary gap,
which causes a rise in the general price level or
inflation.
The Inflationary gap is the amount by which the
aggregate demand exceeds aggregate supply at full
employment. Inflationary gap is called inflationary
because it sets in motion forces that will cause
inflation or a rise in general price level. (It is called
demand pull inflation, i.e., an aggregate demand
induced rise in the general price level.) Figure 3.11
depicts the situation of excess demand and
inflationary gap. OQ is the full employment level of
income/output. For the economy to be at full
employment equilibrium, the aggregate demand
should be equal to the full employment level of
income/output, i.e. FQ (which is equal to OQ since
point F lies on the 45° line from the origin).
However, the actual aggregate demand is GQ, which is
greater than FQ. This results in a situation of excess
demand.
The resulting inflationary gap created due to excess
demand is represented by GF in figure 3.11.
The Inflationary gap is the amount by which the
actual aggregate demand exceeds the level of
aggregate demand required to established the full
employment equilibrium.
To correct the situation of excess demand, the
aggregate demand must be decreased by an amount
equal to the deflationary gap GF. This will move the
economy to the full employment equilibrium at point
F.
Note that since we are considering only two-sector
economy, aggregate demand can be decreased through
decrease in investment, as shown by ∆I in figure 3.11.
(In a two-sector economy, there is no role of the
government.)
Impact of excess demand in the economy
(i) On employment – There will be no change in the
employment as the economy is already working at
the full employment. Thus, there is no further
scope of creation of employment.
(ii) On output – Output cannot increase because full
employment level of output is the largest output
that the economy is capable of producing since all
resources are fully employed.
(iii)On general price level – Production cannot be
increased beyond the full employment level.
Increase in aggregate demand here onwards, will
only increase the general price level.
(iv) On income – Excess demand will cause increase
in nominal income only due to rise in the general price
level. However, real income (i.e. output) remains the
same. It cannot increase because full employment level
of output is the largest output that the economy is
capable of producing when all resources are fully
employed.
Remedy to correct the situation of excess
demand and inflationary gap
In order to remedy the problem of excess demand, the
aggregate demand has to be reduced by an amount
equal to the inflationary gap. This will keep the
economy at full employment equilibrium but will lower
the price level and thus combat the inflation.
The aggregate demand may be reduced by taking
recourse to fiscal policy or to monetary policy.
(i) Decrease in government expenditure: Decrease
in government expenditure will reduce aggregate
demand and remove the inflationary gap. The fall
in government expenditure should be equal to the
inflationary gap.
(ii) Increase in taxes: The government may increase
the rate of taxes (both direct and indirect taxes).
This will reduce purchasing power in the hands of
general public. This will help to decrease aggregate
demand and reduce the inflationary gap.
Monetary policy measures: Decrease in
money supply:
Central Bank can decrease the money supply in the
economy. Central bank can use tools like bank rate,
cash reserve ratio, repo and reverse repo rates etc. to
ensure lesser money in the hands of general public
which would in turn decrease the aggregate demand in
the economy and be helpful in reducing/removing the
inflationary gap.
• Increase bank rate
• Increase cash reserve ratio
• Increase statutory liquidity ratio
• Increase repo rate
• Increase margin requirement on loan
• Sell government securities in the open market.
(These were explained under functions of Central Bank
in the Unit 2, Section 2.4. The students are expected to
revise these monetary policy instruments from Unit 2.)
Key Terms
Full employment – It refers to a situation of no involuntary
unemployment.
Involuntary unemployment – It refers to a situation when a
person who is willing and able to work at the prevailing wage rate,
does not get work.
Full employment level of income – It is that level of income
where all the factors of production are fully employed in the
production process.
Deficient Demand – When aggregate demand is less than
aggregate supply at full employment, it is a situation of deficient
demand.
Deflationary gap – It is the amount by which the aggregate
demand falls short of aggregate supply at full employment.
Under-employment equilibrium – When aggregate demand and
aggregate supply are equal at below full employment level, it is
called under-employment equilibrium.
Excess Demand – When aggregate demand is more than the
aggregate supply at full employment, it is a situation of excess
demand.
Inflationary gap – It is the amount by which the aggregate
demand exceeds aggregate supply at full employment.
Demand pull inflation – An aggregate demand induced rise in the
RECAP
Full employment refers to a situation of no involuntary

unemployment.
Involuntary unemployment refers to a situation when a
person who is willing and able to work at the prevailing wage
rate, does not get work.
Deficient demand and deflationary gap
When aggregate demand is less than the full employment
level of aggregate supply, it is a situation of deficient
demand. Deficient demand gives rise to deflationary gap.
Deflationary gap is the amount by which the aggregate
demand falls short of full employment level of aggregate
supply. It is called deflationary because it leads to decline in
prices in the long run.
The economy will be operating at under employment
equilibrium level.
Remedy to correct the situation of deficient demand
and deflationary gap
To tackle the situation of deficient demand, the aggregate
demand must be increased by an amount equal to the
deflationary gap.
(i) Increase in government expenditure: Government
should increase its own expenditure to leave more
personal disposable income. Then, aggregate demand
will increase to correct the deflationary situation.
(ii) Decrease in taxes: The government under its fiscal
policy may decrease the rate of taxes (both direct and
indirect taxes). This will ensure greater purchasing
power in the hands of general public. This will help to
increase aggregate demand and remove the deflationary
gap.
Monetary policy measures – Increase in money supply
Central bank through its expansionary monetary policy can
increase the money supply in the economy.
Central bank can use tools like bank rate, cash reserve ratio,
repo and reverse repo rates etc. to ensure greater money in
the hands of general public which would in turn increase the
aggregate demand in the economy and be helpful in
reducing/removing the deflationary gap.
Excess demand and inflationary gap
When aggregate demand is more than the full employment
level of aggregate supply, it is a situation of excess demand.
Excess demand gives rise to inflationary gap.
Inflationary gap is the amount by which the aggregate
demand exceeds the full employment level of aggregate
supply. It is called inflationary because it leads to rise in
prices in the long run.
Impact of excess demand in the economy:
(i) On employment, output and income – There will be no
change in the employment as the economy is already
working at the full employment. Thus, there is no
further scope of creation of employment.
Output cannot increase because full employment level
of output is the largest output that the economy is
capable of producing since all resources are fully
employed.
Only nominal income will increase due to rise in general
price level.
(ii) On general price level – Production cannot be increased
beyond the full employment level. Increase in aggregate
demand here onwards, will only increase the general
price level.
Remedy to correct the situation of excess demand and
inflationary gap
In order to remedy the problem of excess demand, the
aggregate demand has to be reduced by an amount equal to
the inflationary gap.
(i) Decrease in government expenditure: Decrease in
government expenditure will reduce aggregate demand
and remove the inflationary gap. The fall in government
expenditure should be equal to the inflationary gap.
(ii) Increase in taxes: The government may increase the rate
of taxes (both direct and indirect taxes).
This will reduce purchasing power in the hands of
general public.
This will help to decrease aggregate demand and reduce
the inflationary gap.
Monetary policy measures – Decrease in money supply
Central Bank can decrease the money supply in the
economy.
Central bank can use tools like bank rate, cash reserve ratio,
repo and reverse repo rates etc. to ensure lesser money in the
hands of general public which would in turn decrease the
aggregate demand in the economy and be helpful in
reducing/removing the inflationary gap.
NUMERICAL 32
In an economy, autonomous consumption is `100

crore and autonomous investment is `60 crore. In
this economy, with every increase in income, 80% of
it is spent on consumption. The full employment
level of income is `1000 crore.
(a) Calculate the equilibrium level of income.
(b)State whether the economy is facing a situation of
excess demand or deficient demand. Give reasons in
support of your answer. Calculate the required
increase/decrease in investment to reach the full
employment equilibrium. (6 marks)
Solution: (a) Autonomous consumption C = 100, MPC = b
= 80% = 0.8, Autonomous investment I = 60
Consumption function equation C = C + bY = 100 +
0.8Y
At equilibrium level of income, Y = C + I
Y= 100 + 0.8Y + 60
⇒ Y – 0.8Y = 160 ⇒ 0.2Y = 160 ⇒ Y = 160/0.2
= 800
Therefore, equilibrium level of income = `800 crore
(b) Full employment level of income = `1000 crore
Since equilibrium level of income is less than full
employment level of income, it is a situation of
deficient demand, which gives rise to a deflationary
gap. The economy is operating at under-employment
equilibrium.
Required increase in income to combat deflationary
gap or to reach the full employment equilibrium, DY =
1000 – 800 = `200 crore
Value of multiplier, k= 1/(1–MPC) = 1/(1–0.8) = 1/0.2 = 5
k = ∆Y/∆I ⇒ 5 = 200/∆I ⇒ ∆I = 40
Hence, increase in investment required to reach the full
employment of level of income = `40 crore
Do it yourself 32
The consumption function of an economy is given as: C = 10

+ 0.8Y
If the planned investment is `100 crore, calculate the
following:
(b)Deflationary gap at the full employment level of income
`1,000 crore. (6 marks)
[Ans. (a) ` 550 crore (b) ` 90 crore]
C = 10 + 0.8Y and I = 100
when Y = C + I
Substitute the values of consumption and
investment, we get
Y = 10 + 0.8Y + 100
Y – 0.8Y = 10 + 100 ⇒ 0.2Y = 110
Equilibrium level of income Y = 110/0.2 = `550
crore
(b) At full employment level of income (Y = 1,000)
Aggregate demand will be: AD = C + I = 10 + 0.8
(1,000) + 100 = 10 + 800 + 100 = `910 crore
Thus, AD < Y at full employment level of income,
i.e. a situation of deficient demand in the economy.
Deflationary gap = Full employment level of income –
AD at full employment level = 1,000 – 910 = `90 crore
NUMERICAL 33
In an economy the equilibrium level of income is

`500 crore whereas the full employment level of
income is ` 800 crore. The marginal propensity to
consume is 0.75. Calculate the decrease in investment
required to combat the inflationary gap. (3 marks)
Solution: Since equilibrium level of income is less than
full employment level of income, it is a situation of excess
demand in the economy. Inflationary gap = 800 – 500 =
`300 crore. Thus, required decrease in income ∆Y = (–) `
300 crore
Investment multiplier, k = 1/(1–MPC) = 1/(1–0.75) = 1/0.25 = 4
k = ∆Y/∆I ⇒ 4 = –300/∆I ⇒ ∆I = –75
Thus, required decrease in investment required to combat
the inflationary gap = `75 crore
Do it yourself 33
The consumption function of an economy is given as: C =

250 + 0.75Y
If the planned investment is ` 2,000 crore, calculate the
following:
(b)Inflationary gap at the full employment level of income
`5,000 crore. (6 marks)
[Ans. ` 9,000 crore; ` 1,000 crore]
Given C = 250 + 0.75Y, I = 2,000
when Y = C + I
Substitute the values of consumption and investment,
we get
Y = 250 + 0.75Y + 2,000
Y – 0.75Y = 2,250 ⇒ 0.25Y = 2,250
Y = 2,250/0.25
Equilibrium level of income Y = `9,000 crore
(b) At full employment level of income (Y = 5,000)
Aggregate demand will be:
AD = C + I ⇒ AD = 250 + 0.75 (5,000) + 2,000
AD = 250 + 3,750 + 2,000
AD = 6,000
Thus, AD > Y at full employment level of income, i.e. a
situation of excess demand in the economy.
Inflationary gap = AD at full employment level – Full
employment level of income = 6,000 – 5,000 = `1,000
crore
Question 1
Giving valid reasons, state whether the following
statements are true or false: (4 marks)
(a) An excess of aggregate demand over full employment
level of aggregate supply represents a situation of
inflationary gap.
(b) An economy facing unintended accumulation of
inventories would try to reduce aggregate demand.

Answer 1
(a) The given statement is true; an excess of aggregate
demand over full employment level of aggregate
supply represents a situation of inflationary gap,
production cannot be increased beyond this level.
Increase in AD here onwards, will increase only the
(b) The given statement is not correct. The situation of
unintended accumulation of inventories arises when
ex-ante aggregate demand is lesser than the ex-ante
aggregate supply. This would pile up the stock with
the producers, thus to tackle this situation the
economy must increase AD.
Question 2
‘An economy is operating at under-employment level of
income’. What is meant by the given statement? Discuss
one fiscal measure and one monetary measure to tackle
the situation.

Answer 2
An economy is said to be operating at under employment
equilibrium level, if the planned aggregate expenditure (i.e.
aggregate demand) falls short of available output in the
economy, corresponding to the full employment level. It
refers to a situation of deficient demand, which gives rise
to a deflationary gap.
To tackle such a situation the aggregate demand has to be
increased by an amount equal to the deflationary gap.
Following measures may be taken for the same.

(i) One fiscal measure – Decrease in taxes
The government under its fiscal policy may decrease
the rate of taxes (both direct and indirect taxes). This
will ensure greater purchasing power in the hands of
general public. This will help to increase aggregate
demand and remove the deflationary gap.
(ii) One monetary measure – Increase in money
supply Central bank through its expansionary
monetary policy can increase the money supply in
the economy. Central bank can use tools like bank
rate, cash reserve ratio, repo and reverse repo rates
etc. to ensure greater money in the hands of general
public which would in turn increase the aggregate demand
in the economy and be helpful in reducing/removing the
deflationary gap.

Question 3
State which of the following statements are true or false.
Give valid reasons. (CBSE 2019) (3 marks)
(a) According to Keynesian theory of employment, the
state of full employment is obtained only when the
economy is in equilibrium.
(b) According to Keynesian theory of employment, a
state of under-employment can never exist in an
economy.

Answer 3
(a) The given statement is false – as per Keynesian
theory of Employment the economy can be in
equilibrium at less than or more than full employment
level also.
(b) The given statement is false, according to Keynesian
theory of employment the state of under
employment can exist. This may occur at that level of
income where equilibrium between AD and AS
happens at less than full employment level.

Question 4
State the impact of ‘Excess Demand’ under the
Keynesian theory on employment, in an economy.

Answer 4
In case of ‘Excess Demand’ under the Keynesian Theory,
there will be no change in the employment as the
economy is already working at the full employment. Thus,
there is no further scope of creation of employment.

Question 5
What does the deflationary gap measure? (1 mark)

Answer 5
The deflationary gap is a measure of the amount of
deficiency of aggregate demand.

Question 6
What is meant by demand pull inflation? (1 mark)

Answer 6
Demand pull inflation is an aggregate demand induced rise
in the price level.

Question 7
Why is the inflationary gap so called? (1 mark)

Answer 7
The inflationary gap is so called because it sets in motion
forces that will cause inflation or a rise in the price level.

Question 8
What is the effect of a decrease in bank rate on
aggregate demand? (1 mark)

Answer 8
It will increase the level of aggregate demand in the
economy.

Question 9
What is the effect of a rise in cash reserve ratio on

Answer 9
It will decrease the level of aggregate demand in the
economy.

Question 10
What is the effect of increase in Reverse repo rate on

Answer 10
It will decrease the level of aggregate demand in the
economy.

Question 11
Give two measures taken by the government to remove
deflationary gap. (1 mark)

Answer 11
(i) Increase in government expenditure
(ii) Reduction in the amount of taxes

Question 12
Give two measures taken by the Central bank to
combat excess demand. (CBSE 2009) (1 mark)

Answer 12
(i) Increase in Legal reserves (CRR, SLR)
(ii) Increase in Bank rate

Question 13
In the situation of inflation, more credit creation by
commercial banks has negative impact on the economy.
How?

Answer 13
Credit creation by commercial banks in inflationary
situation in the economy increases the money supply and
hence aggregate demand. It creates the situation of excess
demand and inflationary gap if aggregate demand exceeds
the full employment level of output/income.

Question 14
Is equilibrium level of income and output always
associated with full-employment? Explain. (3 marks)

Answer 14
The economy will be in full-employment equilibrium if
aggregate demand is equal to aggregate supply at full
employment. However, the equilibrium level of income/output
is not always associated with full employment.
• If aggregate demand is less than aggregate supply at full
employment, then it is a situation of deficient demand
in the economy which gives rise to deflationary gap.
• On the other hand, if aggregate demand is more than
aggregate supply at full employment, then a situation of
excess demand exists in the economy which gives rise
to inflationary gap.
Question 15
What changes will take place in the economy if
(4 marks)
(i) aggregate demand exceeds aggregate supply?
(ii) aggregate demand exceeds aggregate supply at full
employment?

Answer 15
(i) If aggregate demand exceeds aggregate supply (AD
> AS), this means that consumers would be buying
more goods than firms were producing. This would
lead to an unplanned decrease in inventories. Firms
would then increase output and thus income would
increase. This process of increase in income will
continue until the economy is in equilibrium where
AD = AS.
(ii) If aggregate demand exceeds the full employment
level aggregate supply, then a situation of excess
demand exists in the economy. Excess demand gives
rise to an inflationary gap; which causes a rise in the
general price level or inflation.

Question 1
Aggregate demand can be increased by:
(a) increasing bank rate
(b) selling government securities by Reserve Bank of India
(c) increasing cash reserve ratio
(d) none of the above

Answer 1
(d) none of the above

Question 2
The remedy to combat deficient demand is .................... .
(a) Decrease in bank rate
(b) Increase in cash reserve ratio
(c) Increase in tax rate
(d) All of these

Answer 2
(a) Decrease in bank rate

Question 3
A fiscal policy measure to combat deflationary gap is
.................... . (Choose the correct alternative)
(a) Increase in tax rates
(b) Increase in government expenditure
(c) Increase in price level
(d) Decrease in government expenditure

Answer 3
(b) Increase in government expenditure

Question 4
Increase in cash reserve ratio will lead to:
(a) Fall in Aggregate Demand
(b) Rise in Aggregate Demand
(c) No change in Aggregate Demand
(d) None of these

Answer 4
(a) Fall in Aggregate Demand

Question 5
The gap by which actual aggregate demand exceeds the
aggregate demand required to establish full employment
equilibrium is known as ............... .
(a) Deficient Demand
(b) Deflationary gap
(c) Inflationary Gap
(d) Excess Demand

Answer 5
(c) Inflationary gap

Question 6
............ refers to the situation when aggregate demand is
less than aggregate supply corresponding to full
employment level of output in the economy.
(b) Excess Demand
(c) Inflationary Gap
(d) Deflationary gap

Answer 6

Question 7
A situation of excess demand in the economy will lead
to ............. (Choose the correct alternative)
(a) Increase in the level of employment
(b) Decrease in the level of employment
(c) No change in the level of employment
(d) None of these

Answer 7
(c) No change in the level of employment

Question 8
Deficient Demand indicates:
(a) Under employment equilibrium
(b) Deflationary gap
(c) Full employments equilibrium

Answer 8

Question 9
Monetary Policy is the policy of the ................. to control
money supply and credit creation in the economy.
(a) Central Government
(b) Central Bank
(d) None of these

Answer 9
(b) Central Bank

Question 10
In situation of excess demand, the central bank ................
the margin requirement
(a) Decreases
(b) Increases
(c) Removes
(d) Does not change

Answer 10
(b) Increases

Question 11
An increase in the bank rate is effective to combat
inflation. (True/False)

Answer11
True: The bank rate is the rate of interest at which the
Central Bank lends money to the commercial
banks. During inflation, the Central bank
increases the bank rate, which increases the cost
of borrowings from the Central bank. Therefore,
commercial banks also increase their lending
rates. This will discourage people to take loans.
This will reduce the money supply and the level
of aggregate demand in the economy to combat
inflation.

Question 12
In situation of deficient demand, the central bank raises
cash reserve ratio. (True/False)

Answer 12
False: In situation of deficient demand, the Central
bank decreases the cash reserve ratio (CRR). As
a result,banks are required to hold smaller
fraction of their deposits as cash reserves with
the central bank. Therefore, the lending capacity
of the banks increases. It leads to an increase in
money supply. This will raise the level of
aggregate demand and correct the situation of
deficient demand.

Question 13
The effects of deficient demand in an economy are:
(a) Increase in output, income, employment and price
level.
(b) Decrease in output, income, employment and price
level.
(c) Increase in output, income and employment, but no
change in the price level.
(d) Decrease in output, income and employment, but no
Answer 13
(b) Decrease in output, income, employment and
price level.

Question 14
If the equilibrium level of output is more than the full
employment level, this situation is called the situation of
__________. (Fill in the blank)

Answer 14
excess demand

Question 15
The level of output determined by the equality of Y and
AD necessarily mean the level of output at which
everyone is employed. True/False? Give reason.

Answer 15
False: The equilibrium level of output determined by
the equality of Y and AD does not necessarily
signify the full employment level of output. The
equilibrium level of output may be greater than
the full employment level of output (the situation
of excess demand) or less than the full
employment level of output (the situation of
deficient demand).

Question 16
The impact of ‘Excess Demand’ under the Keynesian
theory of income and employment, in an economy are:
(a) Decrease in output, income, employment and price
level.
(b) Increase in output, income employment and price
level.
(c) Rise in the price level and the nominal income but
no change in the output and employment.
(d) Increase in output, income and employment; but no
Answer 16
(c) Rise in the price level and the nominal income but
no change in the output and employment.
Reason: Since the economy is already working at the
full employment, there is no further scope of creation
of employment. So there is no change in the
employment and hence, the output (real income).
However, excess demand gives rise to an
inflationary gap; which causes a rise in the price
level or inflation (demand pull inflation—an aggregate
demand induced rise in the price level).
Nominal income increases due to rise in the price level.
Question 17
_________ is that level of income where all the factors
of production are fully employed in the production
process. (Fill in the blank)

Answer 17
Full employment level of income

Question 18
Full employment means absence of _________ .
(Fill in the blank)

Answer 18
involuntary unemployment

Question 19
If the equilibrium level of output is less than the full
employment level of output, this situation is called the
situation of ___________ . (Fill in the blank)

Answer 19
deficient demand

Question 20
In situation of excess demand, taxes must be ________
(increased/decreased).

Answer 20
decreased

Determination and Income and Employment

Question 1
Average Propensity to Consume can never be
………………………...
(choose the correct alternative) (1 mark)
(a) positive
(b) zero
(c) more than one
(d) less than one
Answer 1
(b) Zero
Question 2
The monetary policy generally targets to
ensure………….……
(Choose the correct alternative) (1 mark)
(a) price stability in the economy
(b) employment generation in the country.
(c) stable foreign relations.
(d) greater tax collections for the government.
Answer 2
(a) price stability in the economy.
Question 3
In an economy, break-even point and equilibrium
point may lie at the same level of income, if ex-ante
investments are …………………
(Fill up the blank with correct answer) (1 mark)
Answer 3
Zero
Question 4
In an economy, MPC = 0.75. As a result of multiplier
mechanism, national income increased by `300 crore
caused by an additional investment of ..............
(1 mark)
(a) `400 crore
(b) ` 225 crore
(c) ` 1200 crore
(d) ` 75 crore
Answer 4
(d) `75 crore
Question 5
Calculate the value of Marginal Propensity to Consume
(MPC), if in an economy, autonomous consumption is `500
crore, ex-ante investments are ` 4000crore and equilibrium
level of Income of the economy is ` 8,000 crore. (3 marks)
Answer 5
We know that consumption function is: C = C +MPC. Y

At equilibrium level of Income in the economy Y = C + I
Given, Autonomous Consumption (C) = `500 crore
and Ex-ante Investments (I) = `4000 crore
18,000 = 500 + MPC(18,000) + 4,000
MPC (18,000) = 18000 – 4500 ⇒ MPC =
13,500/18,000
MPC = 0.75
Question 6
Suppose in a hypothetical economy, the savings increase
by ` 20 crore when national income increases by `100
crore. Compute the additional investments needed to
attain an increase in national income by `6,000 crore?
(3 marks)
Answer 6
MPS = (Change in Saving/Change in Income) =
(ΔS/ΔY) ) = 20/100 = 0.20
Investment Multiplier (K) = 1/MPC = 1/0.20 = 5
Investment Multiplier (K) = Change in Income /Change
in Investment
= (ΔY/ΔI)
5 = `6,000/Change in Investment (ΔI)
Change in Investment (ΔI) = `1,200 crore
Increase in investment by `1,200 crore is required to
attain additional income of ` 6,000 crore.
Question 7
(a) Ex-post investment means fixed capital with
production units during a particular period of time.
(b) Marginal propensity to consume represents the slope
of the consumption function.
Answer 7
(a) The given statement is false, as ex-post investment
includes both fixed as well as inventory investment
with the production unit during a period of time
(b) The given statement is true, as it represents change
in consumption due to a given change in income.
MPC = (ΔC/ΔY)
Question 8
Define inflationary gap. Show inflationary gap using a
well-labelled diagram. Explain any one fiscal measure
and one monetary measure to correct the situation of
inflationary gap. (6 marks)
Question 9
What is Effective Demand Principle? Discuss with the help
of an imaginary numerical example. (6 marks)
Determination of Income and Employment

Question 1
According to Keynesian Theory of employment, ex-ante
savings and ex-post savings are always equal.
True/False? Give reason. (1 mark)
Answer 1
False: as ex-ante savings are those which all the
households plan to make at different levels of
income during a period, whereas, ex-post savings
are the actual amount of savings made in the
economy during a period. So, the two may or may
not be equal.
Question 2
In the Keynesian theory of employment, it is assumed that
consumption changes at a constant rate as income
changes. It implies: (1 mark)
(a) Both MPC and MPS are constant
(b) Both the consumption and savings curves have
constant slopes, and are linear curves.
(c) Aggregate demand curve is parallel to the
consumption curve, i.e. they have the same slope (i.e.,
MPC).
Answer 2
Question 3
If change in investment is ` 1,000 crore and MPC is 0.8
then national income will change by (1 mark)
(a) `1,250 crore
(b) ` 2,500 crore
(c) ` 5,000 crore
(d) ` 10,000 crore
Answer 3
(c) `5,000 crore
Question 4
An excess of aggregate demand over full employment
level of aggregate supply represents a situation of
inflationary gap. (True/False) (1 mark)
Answer 4
True: An excess of aggregate demand over full
employment level of aggregate supply represents
a situation of inflationary gap; production cannot
be increased beyond this level. Increase in
aggregate demand here onwards, will increase
only the general price level.
Question 5
“An economy facing unintended accumulation of
inventories would try to reduce aggregate demand.” Do
you agree with the given statement? Support your
answer with valid reasons. (3 marks)
Answer 5
income earned by the households will be used to buy the
goods and services which would be equal to income of
firms. The aggregate consumption expenditure by the
households in the economy is equal to the aggregate
expenditure on goods and services produced by the
firms in the economy (Income of the producers).
Question 6
Estimate the change in final income, if Marginal
Propensity to Consume (MPC) is 0.75 and change in
initial investment is `2,000 crore. (3 marks)
Answer 6
Multiplier K = 1/(1 – MPC)
When MPC = 0.75, K = 1/(1 – 0.75) = 1/0.25 = 4
Also, K = ∆Y/∆I, 4 = ∆Y/2,000, ∆Y =4 × 2,000 =
8,000.
Change in final income = `8,000 crore
Question 7
(a) An excess of aggregate demand over full
employment level of aggregate supply represents a
situation of inflationary gap.
(b) If the ratio of Marginal Propensity to Consume
(MPC) and Marginal Propensity to Save (MPS) is 4 :
1, the value of investment multiplier will be 4.
Answer 7
(a) The given statement is true; an excess of aggregate
demand over full employment level of aggregate
supply represents a situation of inflationary gap,
production cannot be increased beyond this level.
Increase in AD here onwards, will increase only the
(b) The given statement is false.
Let the value of MPS = x
Therefore, MPC = 4x
We know that; MPC + MPS = 1 ⇒ x + 4x = 1 ⇒
5x = 1
MPS (x) = 1/5 = 0.20
Substituting the value of MPS in k = 1/MPS = 1/0.20 = 5
Thus, the value of multiplier is 5 and not 4.
Question 8
Discuss the working of the adjustment mechanism in the
following situation : (6 marks)
(a) Ex-Ante Aggregate demand is greater than Ex-
Ante Aggregate supply.
(b) Ex-Ante/Planned Investments are lesser than Ex-
Ante/Planned Savings.
Answer 8
8. (a) When Aggregate Demand is greater than
Aggregate Supply (AD>AS), buyers are planning to,
buy more goods and services than what producers
are planning to produce. It will lead to fall in planned
inventories below the desired level. The producers in
turn will produce more, which will raise the income
level i.e. AS, till AD becomes equal to AS.
Question 9
Draw a straight line consumption curve. From it derive
a savings curve explaining the process. Show on this
diagram:
(a) the level of income at which average propensity
to consume is equal to one.
(b) a level of income at which average propensity to
save is negative.
Determination of Income and Employment

Question 1
If MPS = 0.20 and investment is increased by `100
crore, then total increase in income will be: (1 mark)
(a) `80 crore
(b) ` 1000 crore
(c) ` 500 crore
(d) ` 800 crore
Answer 1
(c) `500 crore
Question 2
An economy is at full employment and AD is greater
than AS, what will be the impact on price level in such
an economy? (1 mark)
(a) Rise
(b) Fall
(c) no change
(d) both rise and fall
Answer 2
(a) Rise
Question 3
Which of the following is not true? (1 mark)
(a) APC can be more than 1
(b) APC can be equal to 1
(c) APC rises with increase in income
(d) APC can never be 0
Answer 3
(c) APC rises with increase in income
Question 4
Ex-post investment means fixed capital with production
units during a particular period of time. True/False?
Give reason. (1 mark)
Answer 4
False: As ex-post investment includes both
fixed as well as inventory investment
with the production units during a
period of time.
Question 5
Value of which of the following can be greater than one
and why? (3 marks)
(a) Marginal Propensity to Consume (MPC)
(b) Average Propensity to Consume (APC)
Answer 5
(b) The value of Average Propensity to Consume (APC)
can be greater than 1.
This is because total consumption can be greater than
total income, due to the existence of autonomous
consumption.
Question 6
The consumption function of an economy is : C = 40 +
0.8Y (amount in `crore). Determine that level of income
where average propensity to consume will be one.
(3 marks)
Answer 6
Given, APC=1, which means that income (Y) is equal to
the consumption (C), i.e. Y = C.
C = 40+0.8Y ⇒ Y = 40+0.8Y (since Y = C)
Y – 0.8Y = 40 ⇒ 0.2Y = 40 ⇒ Y = `200 crore
Question 7
State and discuss the components of Aggregate Demand
in a two sector economy. (3 marks)
Answer 7
Components of Aggregate Demand are:
(i) Consumption Expenditure
(C) (ii) Investment Expenditure(I)
• Consumption Expenditure (C) – It is that portion of
income which is spent on purchase of goods and
services by the consumers in an economy during the
accounting period.
• Investment Expenditure (I)– The addition to the stock
of physical capital and change in inventories of a
firm in an economy.
Question 8
The saving function of an economy is given as:
S = (–) 10 + 0.20Y
If the ex-ante investments are `240 crore, calculate the
following:
(i) Equilibrium level of income in the economy.
(ii) Additional investments which will be needed to
double the present level of equilibrium income.
(6 marks)
Answer 8
We know that the equilibrium level of income in an
economy is determined when: S = I ⇒ –10 + 0.20Y =
240 ⇒ 0.20Y = 250
Y= `1,250 crore
To double of the existing income level (DY = 1,250
crore), k =DY/DI = 1/MPS, 1250/DI = 1/0.2, DI =
`250crore
 Government budget – meaning, objectives and
components.
 Classification of receipts - revenue receipts and
capital receipts; classification of expenditure –
revenue expenditure and capital expenditure.
 Measures of government deficit–revenue deficit,
fiscal deficit, primary deficit their meaning.
4.1
Meaning and Objectives of
Government Budget
Government Budget is a financial statement of budgetary
receipts and budgetary expenditure of the government
during a fiscal year.
Objectives of Government Budget
1. Reallocation of resources
Reallocation of resources refers to re - distribution of
resources from one use to another. Government through
its budgetary policies tries to reallocate resources to
ensure fulfillment of various socio-economic objectives.
The government may influence the allocation of resources
through:
(a) Taxation policy
 Imposition of heavy taxes: Heavy taxes can be
imposed on production units engaged in producing
harmful products like liquor, cigarettes, tobacco,
etc. Thus, it discourages those occupations which
are not beneficial to the society by imposing taxes
at higher rates.
 Subsidies and Tax concessions: Subsides and
tax concessions can be given to the private sector
industries to encourage production of those
products which are beneficial to people. For
example, government can give subsidies and tax
concessions to the enterprises who are willing to
undertake electricity generation, especially in
backward areas. In this way, budgetary incentives
(tax concessions, subsidies, etc.) can be used to
influence allocation of resources in the country.
(b) Expenditure policy (Direct participation in production)
There are many non-profitable economic activities
which are not undertaken by the private sector
either due to lack of enough profits or due to huge
investment expenditure involved, e.g. water supply,
sanitation, street lighting, maintaining law and
order, national defence, government administration,
measures to reduce air pollution, etc. These are
called public goods. Therefore, government can
directly produce these goods and services in public
interest in order to create social welfare. For
example, more expenditure by the government on
maintaining law and order raises the sense of
security among the people. Any such expenditure
raises welfare of the people.
2. Reduction in income inequalities or
Redistribution of income
Inequalities of income and wealth reflect a section of
society being deprived of even basic necessities. Thus
arises the need for reducing income inequalities in the
society, i.e. reducing the gap between rich and poor.
Every government tries to reduce inequality of income
among masses so as to ensure progress of the people
with lesser monetary resources. Inequalities of income
can be reduced either by rationalisation of taxation policy
or regulating the expenditure policy of the government
or both.
(a) Taxation policy (progressive income taxation)
The redistribution objective is sought to be achieved
through progressive income taxation, in which higher
the income, higher is the tax rate. The government
puts a higher rate of taxation on incomes of the rich
people and lower rates of taxation on lower income
groups. This will reduce the inequalities of income
as the difference between personal disposable incomes*
of higher income and lower income groups will fall.
*The national income of the country goes to either the private sector, that is, firms and
households (known as private income) or the government (known as public income).
Out of private income, what finally reaches the households is known as personal
income and the amount that can be spent is the personal disposable income (PDI). PDI
= Personal income – Personal income tax.
(b) Expenditure policy (transfer payments and subsidies)
The amount collected through taxes can be used by
the government for spending on welfare of the poor
people. It can provide them transfer payments and
subsidies. For example:
(i) Providing free services like education and health
to the poor people.
(ii) Providing essential items of food grains almost
free to the families living below the poverty line.
(iii) Free LPG kitchen gas connections and subsidised
LPG gas to the families living below the poverty
line.
Increased expenditure by the government on such transfer
payments and subsidies will have twin effects:
First, it will increase their disposable income and thus
will reduce the income inequalities, i.e., the gap between
rich and poor.
Secondly, spending on free services to the poor raises
their standard of living and thus increases their welfare.
3. Economic stability or Price stability
Economic stability (or price stability) means absence of
large-scale fluctuations in general price level in the
economy. Too much fluctuations in prices is not good
for the economy as they create uncertainties in the economy.
Stability in price level in the country is necessary to
create business environment.
Government can exercise control over price fluctuations
through its taxation policy and expenditure policy.
(a) Under inflationary situations
Inflationary tendencies emerge due to aggregate
demand being higher than aggregate supply under
conditions of high employment. Therefore, during
periods of inflation government may discourage
spending by increasing taxes and reducing its own
expenditure. This will decrease aggregate demand
to correct inflationary situation. To raise aggregate
supply, tax concessions and subsidies for private
sector enterprises can also be used by the government.
(b) Under deflationary situations
During periods of recession (or high rate of
unemployment), government can reduce taxes to
encourage demand as well as increase its own
expenditure. Government can also use subsidies to
encourage spending by people. It will increase the
personal disposable income of people and thus, will
raise the level of aggregate demand. It will combat
deflationary situation in the economy.
4. Economic growth
Economic growth implies a sustainable increase in real
GDP of an economy, i.e., an increase in volume of goods
and services produced in an economy. Government
budget can be an effective tool to ensure the economic
growth in a country.
(a) Taxation policy and subsidies
If the government provides tax rebates and other
budgetary incentives for productive ventures and
projects, it will stimulate savings and investments
in the economy and thus, economic growth. For
example, suppose the government decides to give
tax concessions (or tax rebates) and subsidies to
investors for making investments in backward
regions. Tax concessions aim at reducing cost and
thus, making profits. Similarly, subsidies aim at
reducing prices of products to encourage sales and
earning more profits. Thus, tax concessions and
subsidies both aim at raising profits. When profits
increase, savings and investment will also increase.
It will lead to economic growth.
(b) Expenditure policy
Spending on infrastructure in the economy promotes
the production activities across different sectors.
Government expenditure is a major factor that
generates demand for different types of goods and
services, which induces economic growth in the
country.
However, before planning such expenditure, tax
rebates and subsidies, the government should check
the rate of inflation and tax rates. Also, there may
be the risk of debt trap if loans are too high to
finance the expenditure.
Key Terms
Government Budget–Government Budget is a financial statement
of budgetary receipts and budgetary expenditure of the government
Reallocation of resources– It refers to re-distribution of resources
from one use to another.
Public goods – Non-profitable economic activities which are not
undertaken by the private sector either due to lack of enough profits
or huge investment expenditure, e.g. water supply, sanitation,
maintaining law and order, etc. are called public goods.
Inequalities of income and wealth – It reflects a section of society
being deprived of even basic necessities.
Economic stability (or price stability) –It means absence of large-
scale fluctuations in general price level in the economy.
Economic growth – It implies a sustainable increase in real GDP of
an economy, i.e., an increase in volume of goods and services
produced in an economy.
RECAP
Government Budget is a financial statement of budgetary

receipts and budgetary expenditure of the government
Objectives of Government Budget
1. Reallocation of resources: The government may
influence the allocation of resources through:
(a) Taxation policy: Heavy taxes may be imposed on
harmful products, e.g. liquor, cigarettes, tobacco,
etc.to discourage their production. On the other
hand, tax concessions/subsidies may be provided
on the production of socially useful products to
encourage their production.
(b) Expenditure policy: Government may directly
undertake production of certain goods and services
in the areas where private sector may not be
willing to participate in production activities due
to lack of enough profits and huge investment
expenditure involved, e.g. water supply, sanitation,
law and order, national defence, etc.
2. Reduction in income inequalities or Redistribution
of income: Inequalities of income can be reduced
by government either by rationalisation of taxation
policy or regulating the expenditure policy of the
government or both.
(a) Taxation policy: The government puts a higher
rates of taxation on incomes of the rich people
and lower rates of taxation on lower income groups.
This will reduce the inequalities of income as
the difference between disposable incomes of
higher income and lower income groups will
fall.
(b) Expenditure policy: The amount collected through
taxes can be used by the government for spending
on welfare of the poor people. It can provide
them transfer payments and subsidies. For
example, providing free education and health,
providing essential food grains almost free, free
LPG kitchen gas connections and subsidised
LPG gas, etc. It will reduce the income inequalities
and raise their standard of living.
3. Economic stability or Price stability: Government
uses taxation policy and expenditure policy in controlling
the prices.
(a) Under inflationary situations:
Inflationary tendencies emerge due to aggregate
demand being higher than aggregate supply.
Therefore, government can increase taxes and
decrease its own expenditure. To raise aggregate
supply, tax concessions and subsidies can also
be used.
(b) Under deflationary situations:
During deflationary situation, government can
reduce taxes and increase its own expenditure
to leave more disposable income in the hands of
people, thereby increasing aggregate demand to
combat deflationary situation.
Question 1
Goods and services provided by the market mechanism,
i.e. by exchange between individual consumers and producers
are called ______________ .
Government provides certain goods and services which
cannot be provided by the market mechanism such as
national defence, roads, government administration etc,
which are referred to as ___________.

Answer 1
(i) Private goods
(ii) Public goods

Question 2
Which of the following is not a characteristic of public
goods?
(a) Public goods are non-excludable.
(b) It is difficult and sometimes impossible to collect
fees for the public goods.
(c) The consumption of public goods by several
individuals is rivalrous.
(d) None of the above.

Answer 2
(c) The consumption of public goods by several individuals
is rivalrous.

Question 3
_______ means that public goods are financed through
the budget and can be used without any direct payment.
Public goods may be produced by the government or the
private sector. When public goods are produced directly
by the government it is called ___________. (Public
provision/Public production)
(Fill in the blanks with correct option)

Answer 3
(i) Public provision
(ii) Public production

Question 4
The government affects the (i) ________ of households
by making transfers and collecting taxes. It is through
this that the government can change the distribution of
income and bring about a distribution that is considered
‘fair’ by society. This is the (ii) ___________ function of
government Budget. (Choose the correct alternative)
(a) (i) Private income, (ii) allocation
(b) (i) Personal income, (ii) Stabilisation
(c) (i) Personal disposable income, (ii) redistribution
(d) (i) Public income, (ii) redistribution
Answer 4
(c) (i) Personal disposable income, (ii) redistribution

Question 5
The intervention of the government whether to raise the
level of aggregate demand or reduce it constitutes the
_____________ of government budget.
(a) Allocation function
(b) Redistribution function
(c) Stabilisation function
(d) None of these.

Answer 5
(c) Stabilisation function

Question 6
Law and order, national defence, sanitation, etc. are
__________.
(a) final goods
(b) intermediate goods
(c) public goods
(d) private goods

Answer 6
(c) public goods

Question 7
State giving reason whether the following statement
is true or false:
Provision of public goods is the same as public production.

Answer 7
False: Provision of public goods means that the
public goods like law and order, defence, parks,
roads, etc. are financed through the budget. These
goods may be produced directly by the government or
it can encourage the private sector by giving them tax
concessions and subsides.

Question 8
State giving reason whether the following
Through changes in its expenditure and taxes, the
government brings economic stability.

Answer 8
True: In case of deflation (or unemployment), the
government can give tax concession or increase
expenditure to leave more disposable income in the
hands of people. In case of inflation, government
can reduce its own expenditure or increase tax.

Question 9
The government has increased the rate of income tax.
The objective of government is to:
(a) maintain balanced regional development
(b) redistribute income & wealth
(c) reallocate resources
(d) ensure economic stability

Answer 9
(b) redistribute income & wealth

Question 10
Column I Column II
1. Government increases taxes on (a) Reallocation of
very rich people resources
2. Government increases its own (b) Economic stability
expenditure during deflation to
increase aggregate demand
(c) Reducing in equalities
in income and wealth

Answer 10
1 — (c), 2 — (b)

Question 1
“Through its budgetary policy government allocates
resources in accordance with the requirements of the
country.” Do you agree with the given statement?
Support your answer with valid reasons.
HOTs 4.1 — Analysing, Evaluating & Creating Type Questions

Answer 1
The given statement is true.
Reallocation of resources refers to re-distribution of
resources from one use to another. The government
reallocates resources with a view to balance the goals of
profit maximisation (by firms) and social welfare (by
government). Production of goods which are injurious to
health is discouraged through taxation. On the contrary,
production of socially useful goods is encouraged through
subsidies. If the private sector does not take initiative in
certain activities, government directly controls them like
water supply, sanitation etc.
Question 2
What is the role of Government Budget in allocation of
resources?
(1 mark)

Answer 2
Government can directly undertake the production of
public goods and services. Alternately, it can encourage
private sector by giving tax concessions and subsidies.

Question 3
How does the government reduce inequalities of income
and wealth?
(1 mark)

Answer 3
Government can reduce inequalities through taxes and
expenditure. It can tax the rich or the goods consumed
by the rich. It can spend the amount so collected on
providing free services to the poor.

Question 4
State one fiscal measure that can be used to reduce the
gap between rich and poor.

Answer 4
(a) Increasing government expenditure which will directly
benefit the poor.
(b) Increasing the taxes on rich and using the same amount to
benefit the poor. (any one)

Question 5
Name any one step that the government can take through
its budget to check inflation that is causing hardships to
the people.
(CBSE 2013) (1 mark)

Answer 5
Government can reduce its own expenditure to leave
less disposable income in the hands of people.

Question 6
Government raises its expenditure on producing public
goods. Which economic value does it reflect? Explain
with an example.

Answer 6
Increased expenditure by government on public goods
like defence, maintaining law and order etc. increases
their availability to the people of the country. For
example, more expenditure on maintaining law and
order raises the sense of security among the people.
Any such expenditure raises welfare of the people.

Question 7
Tax rates on higher income group have been increased.
Which economic value does it reflect? Explain.

Answer 7
This will reduce the inequalities of income as the
difference between disposable incomes of higher income
and lower income groups will fall. This will also provide
more resource to the government for spending on welfare
of the poor, e.g. free services like education and health to
the poor people.

Question 8
Government has started spending more on providing
free services like education and health to the poor.
Explain the economic value it reflects.
(3 marks)

Answer 8
Spending on free services to the poor raises their
standard of living and at the same time helps in reduction
in income inequalities. It also helps in raising production
potential of the country by raising the efficiency level of
the working class among the poor.

Question 9
The government decides to give budgetary incentives to
investors for making investments in backward regions.
Explain these possible incentives and the reasons for the
same.

Answer 9
Possible Budgetary Incentives: Budgetary incentives refer
to concession in taxation and granting subsidies to those
production units which set up their units in economically
backward areas.
• Tax concessions aim at reducing cost and thus raising
profits.
• Subsidies aim at reducing prices of products to
encourage sales and earning more profits.
Clearly, tax concessions and subsidies both aim at raising
profits. Reasons for giving tax concession and subsidies
by the government:
(i) Economic Growth: The aim of giving tax rebates
and subsidies for productive ventures and projects is
that it can stimulate savings and investments in the
economy leading to economic growth.
(ii) Allocation of resources: Government can influence
allocation of resources by encouraging industries to
produce selected goods by giving tax concessions
and subsidies.

Question 10
The Government, under Ujjwala Yojana, is providing
free LPG kitchen gas connections to the families ‘below
the poverty line’. What objective the government is
trying to fulfill through the government budget and how?
Explain.
(6 marks)

Answer 10
By providing free LPG kitchen gas connections to the
families ‘below the poverty line’, the objective which the
government is trying to fulfill is ‘Reduction in
inequalities of income and wealth.’
Inequalities of income and wealth reflect a section of the
society being deprived of even basic necessities of life
like food, clothing and housing. Thus arises the need for
reducing inequalities of incomes in the society, i.e.,
reducing the gap between rich and poor. The government
can impose higher taxes on the rich reducing their disp-
osable income. The amount so collected through taxes
can be used by the government for spending on welfare
of the poor people. It can provide them transfer paym-
ents and subsidies.
Increased expenditure by the government on such tran-
sfer payments and subsidies will have twin effects: First,
it will increase their disposable income and thus will red-
uce the income inequalities, i.e., the gap between rich and
poor. Secondly, spending on free services to the poor
raises their standard of living and thus increases their
welfare.

4.2
Components of Government
Budget
Although the Government Budget relates to the budg-
etary receipts and budgetary expenditure of the gover-
nment for a particular financial year, the impact of it
will be there in subsequent years. Therefore, there is a
need to have two accounts — the revenue account (also
called revenue budget) and the capital account (also
called capital budget).
Revenue Budget: Those receipts and expenditure that
relate to the current financial year only are included in
the revenue budget. Therefore, revenue budget includes
both revenue receipts and revenue expenditure.
Capital Budget: Those receipts and expenditure that
concern the assets and liabilities of the government are
included in the capital budget. Therefore, capital bud-
get includes both capital receipts and capital expendit-
ure.
Thus, major components of Government Budget are:
(i) Revenue Receipts (ii) Capital Receipts
(iii) Revenue Expenditures (iv) Capital Expenditures
Capital Receipts
Capital receipts are those receipts of the government
which either create a liability (e.g. borrowings) or lead
to reduction in assets (e.g. recovery of loans, sale of
shares in Public Sector Undertakings, etc.).
Components of capital receipts are:
1. Debt creating capital receipts
Debt creating capital receipts are borrowings made by
the government. When government takes fresh loans,
these loans will have to be returned and interest will
have to be paid on these loans. So, borrowings are debt
creating capital receipts of the government. For exam-
ple,
(i) loans raised by the government from the public
(called market borrowings),
(ii) borrowing by the government from the Reserve
Bank of India (RBI) and commercial banks and o-
ther financial institutions through the sale of tr-
easury bills,
(iii) loans received from foreign monetary authorities
and international organisations like IMF, etc.
2. Non-debt creating capital receipts
Non-debt creating capital receipts are those capital re-
ceipts which are not borrowings and therefore, do not
give rise to debt. For example,
(i) Proceeds from sale of shares in Public Sector Und-
ertakings (PSUs) (This is referred to as PSU disinv-
estment.)
(ii) Recovery of loans
 Top Tip
Other sources of capital receipts are:
(i) Small savings (Post Office Savings Accounts, National Savings
Certificates, etc.)
(ii) Provident funds
Revenue Receipts
Revenue receipts are those receipts of the government
that neither create a liability nor lead to reduction in a-
ssets. For example: income tax, profit of PSU, dividends,
fees and fines etc.
Components of revenue receipts: Revenue receipts are
divided into tax and non-tax revenues
1. Tax revenue
Tax revenue/tax receipt is the revenue earned by the
government from taxes levied on income, wealth and
commodities. For example, corporation tax, personal
income tax, excise tax, customs duties, etc.
Tax revenues are classified into direct and indirect taxes:
(i) Direct taxes: Direct taxes are those taxes which
cannot be shifted to the other person/entity. The-
ir monetary burden is borne by those on whom
they are levied. A direct tax is collected directly
from the income earners. For example, personal
income tax falls directly on individuals and corp-
oration tax falls directly on firms. The payer and
bearer of a direct tax is the same person.
Other direct taxes include Interest tax, Wealth tax,
Gift tax, Estate duty (now abolished), etc.
 Top Tips
• Asset ↓ or Liability ↑ ⇒ Capital receipts. If NOT, then Revenue
rec-eipts.
• A tax is legally compulsory transfer payment made by the people to
the government.
• Wealth tax, gift tax are the direct taxes which have insignificant
contribution to tax revenues; so called ‘paper taxes’.
(ii) Indirect taxes: Indirect taxes are those taxes

which can be shifted to another person/entity.
Their monetary burden is ultimately borne by
final users of goods and services, rather than the
person on whom the tax is levied. For example,
Goods and services tax (GST), Entertainment tax,
Sales tax, Excise tax, Customs duties, Service tax,
etc.
2. Non-tax revenues
Non-tax revenues/Non-tax receipts are the revenue ea-
rned by the government from sources other than taxes.
Examples:
(i) Interest receipts on loans advanced by the Central
Government
(ii) Dividends and profits on investments made by the
Central Government
(iii) Fees and other receipts for services rendered by the
government
(iv) Cash grants in aid from foreign countries and inte-
rnational organisations
Capital Expenditure
Capital expenditure is an expenditure of the Governm-
ent which either leads to creation of assets (e.g. constr-
uction of school buildings, hospitals, etc.) or reduces
its liabilities (e.g. repayment of loans). Examples:
(i) Expenditure on the acquisition of land, building,
machinery, equipment, etc.
(ii) Investment in shares
(iii) Loans and advances by the central government to
state and union territory governments, PSUs and
other parties
(iv) Construction of school buildings, hospitals, etc.
(v) Repayment of loans
Revenue Expenditure
Revenue expenditure is that expenditure of the govern-
ent that neither creates any asset nor reduces any liabi-
lity. Examples:
(i) Interest payments on loans
(ii) Grants given to state governments and other parti-
es (even though some of the grants may be meant
for creation of assets).
(iii) Defence services expenditure
(iv) Salaries and pensions
(v) Expenditure on education and health
(vi) Subsidies
 Top Tips
• Asset ↓ or Liability ↑ ⇒ Capital expenditure. If NOT, then
Revenue expenditure.
• Revenue expenditure relates to the expenses incurred for the
normal functioning of the government departments and var-
ious services.
Key Terms
Revenue Budget – Those receipts and expenditure that relate to
the current financial year only are included in the revenue budget.
It includes both revenue receipts and revenue expenditure.
Capital Budget – Those receipts and expenditure that concern the
assets and liabilities of the government are included in the capital
budget. It includes both capital receipts and capital expenditure.
Capital receipts – Those receipts of the government which either
create a liability (e.g. borrowings) or lead to reduction in assets (e.g.
recovery of loans, sale of shares in Public Sector Undertakings, et-
c.).
Debt creating capital receipts – Borrowings made by the govern-
ent.
Non-debt creating capital receipts – Those capital receipts whic-
h are not borrowings and therefore, do not give rise to debt. For
example, PSU disinvestment, recovery of loans.
Revenue receipts – Those receipts of the government that neither
create a liability nor lead to reduction in assets, e.g. income tax,
profit of PSU, dividends, fees and fines etc.
Tax revenue/tax receipt – Revenue earned by the government
from taxes levied on income, wealth and commodities, e.g.
corporation tax, personal income tax, GST, etc.
Tax – Legally compulsory transfer payment made by the people to
the government.
Direct taxes – Those taxes which cannot be shifted to the other
person/entity, e.g. income tax, corporation tax, etc.
Indirect taxes – Those taxes which can be shifted to another per-
son/entity, e.g. Goods and services tax (GST)
Non-tax revenues/Non-tax receipts – Revenue earned by the gov-
ernment from sources other than taxes, e.g. interest receipts, div-
idends and profits on investments, fees and fines, cash grants in
aid.
Capital expenditure – An expenditure of the Government which
either leads to creation of assets (e.g. construction of school buil-
dings, hospitals, etc.) or reduces its liabilities (e.g. repayment of
loans).
Revenue expenditure – That expenditure of the government that
neither creates any asset nor reduces any liability, e.g. interest pa-
yments, subsidies, etc.
RECAP
Revenue Budget (or Revenue Account): It includes tho-

se receipts and expenditure that relate to the current finan-
cial year only (i.e., revenue receipts and revenue expendit-
ure).
Capital Budget (or Capital Account): It includes those
receipts and expenditure that concern the assets and liabil-
ities of the government (i.e., capital receipts and capital
expenditure).
Major components of Government Budget:
(i) Revenue Receipts (ii) Capital Receipts
(iii) Revenue Expenditures (iv) Capital Expenditures.
Capital Receipts
Capital Receipts are those receipts of government which
assets. For Example: borrowings, receipts from recovery of
loans, receipts from disinvestment.
Components of capital receipts are:
1. Debt creating capital receipts — When govern-ment
takes fresh loans, e.g. market borrowings, borrowing
from RBI and borrowing from abroad, these loans will
have to be returned and interest will have to be paid
on these loans. So, borrowings are debt creating capital
receipts of the govern-ment.
2. Non-debt creating capital receipts — Those receipts
which are not borrowings and therefore, do not give
rise to debt. For example, proceeds from sale of shares
in Public Sector Undertakings (PSUs) which is referred
to as PSU disinvestment and Recovery of loans reduce
the assets of the government.
Revenue Receipts
Revenue receipts are those receipts of government which
neither lead to increase in its liabilities nor reduction in its
assets. For example: income tax, profit of PSU, dividends,
assets. For example: income tax, profit of PSU, dividends,
fees and fines etc. It has two components:
1. Tax revenues: Tax is a compulsory payment made by
the individuals and the firms to the government. Tax
revenue/tax receipt is the revenue earned by the govern-
ent from taxes levied on income, wealth and commod-
ities. Tax revenues are classified into direct and indirect
taxes:
(a) Direct taxes: Direct taxes are those taxes which
cannot be shifted to the other person/entity. Their
monetary burden is borne by those on whom they
are levied. A direct tax is collected directly from the
income earners, e.g., Personal income tax, Corpora-
tion tax, Interest tax, Wealth tax, Gift tax.
(b) Indirect taxes: Indirect taxes are those taxes which
can be shifted to another person/entity. Their mon-
etary burden is ultimately borne by final users of
goods and services, rather than the person on whom
the tax is levied, e.g. GST, Entertainment tax, Sales
tax, Excise tax, Customs duties, Service tax, etc.
2. Non-tax revenues: Non- tax revenues/Non-tax receipts
are the revenue earned by the government from sources
other than taxes. Examples: Interest receipts on loans
advanced by the Central Government, Dividends and
profits on investments made by the Central Governme-
nt, Fees and other receipts for services rendered by the
government, Cash grants in aid from foreign countries
and international organisations, etc.
Capital Expenditure
Capital Expenditure is that expenditure of the government
which either creates assets or reduces its liabilities, e.g.,
construction of school buildings, hospitals, flyovers etc., r-
epayment of loans, investment in shares, loans and adva-
nces given to state and UT governments, etc.
Revenue Expenditure
Revenue expenditure is that expenditure of the governm-
ent that neither creates any asset nor reduces any liability,
e.g. Interest payments, Grants given to state governments
and other parties (even though some of the grants may be
meant for creation of assets), Defence services expendit-
ure, Salaries and pensions, Expenditure on education and
health, Subsidies, etc.
Question 1
Column I Column II
(i) Revenue (a) neither create any asset nor reduces any
receipts liability
(ii) Capital (b) either creates a liability or reduces an
receipts asset
(c) either creates asset or reduces liability
(d) neither creates a liability nor reduces any
asset

Answer 1
(i) — d, (ii) — b

Question 2
Although the budget document relates to the planned
receipts and planned expenditure of the government
for a particular financial year, the impact of it will be
there in subsequent years. So there is a need to have
two accounts.
Those planned receipts and planned expenditures of
the government that relate to the current financial year
only are included in the ____ of the government
budget and those that concern the assets and liabilities
of the government into the ____.
Answer 2
(i) Revenue Account (also called Revenue Budget)
(ii) Capital Account (also called Capital Budget)

Question 3
________ (Revenue receipts/Capital receipts) are those
receipts that do not lead to a claim on the government.
They are non-redeemable.

Answer 3
Revenue receipts

Question 4
Match the columns and choose the correct alternative:
Column I Column II
(i) Tax on the incomes of firms (A) Paper tax
(ii) Duties levied on goods (B) Corporation tax
produced within the country
(iii) Tax imposed on goods (C) Excise taxes imported
into and exported out of
India.
(iv) Wealth tax and gift tax (D) Customs duties

(a) (i) — (A), (ii) — (D), (iii) — (C), (iv) — (B)
(b) (i) — (B), (ii) — (C), (iii) — (D), (iv) — (A)
(c) (i) — (B), (ii) — (D), (iii) — (C), (iv) — (A)
(d) (i) — (A), (ii) — (B), (iii) — (C), (iv) — (D)

Answer 4
(b) (i) — (B), (ii) — (C), (iii) — (D), (iv) — (A)

Question 5
Which of the following is a capital receipt in a governm-
ent budget?
(a) Interest receipts on account of loans by the central
government
(b) Dividends and profits on investments made by the
government
(c) Cash grants-in-aid from foreign countries and inter-
national organisations
Answer 5

Question 6
When the government receives money by way of loans
or from the sale of its assets, such receipts are called
____________ in a government budget.
(Fill in the blank)

Answer 6
Capital receipts

Question 7
Sale of shares in public sector undertakings (PSUs),
which is referred to as _______ is a _______ .

Answer 7
(i) PSU disinvestment
(ii) non-debt creating capital receipt.

Question 8
_______ Revenue expenditure/Capital expenditure) is
expenditure incurred for purposes other than creation of
physical or financial assets of the central governme-nt.
(Fill in the blank)

Answer 8
Revenue expenditure

Question 9
Which of the following is a revenue expenditure in a go-
vernment budget?
(a) Expenses incurred for the normal functioning of the
government departments and various services.
(b) Interest payments on debt incurred by the govern-
ment
(c) Grants given to a state government for creation of
assets
Answer 9

Question 10
Interest payments, defence-services expenditure, subsidies,
salaries and pensions are main items of ________ of the
government. (plan expenditure/non-plan expenditure)
(Fill in the blank)

Answer 10
non-plan expenditure

Question 11
Match the columns and choose the correct alternative:
Column I Column II
(i) Interest payments on market (A) Committed expenditure
loans, external loans and from
various reserve funds
(ii) Defence Expenditure (B) Under-pricing of public goods
and services like education and
health
(iii) Implicit subsidies (C) Single largest component of
non-plan revenue expenditure
(iv) Explicit subsidies (D) Subsidies on items such as
exports, interest on loans, food
and fertilisers
(a) (i) — (A), (ii) — (C), (iii) — (D), (iv) — (B)
(b) (i) — (A), (ii) — (C), (iii) — (B), (iv) — (D)
(c) (i) — (C), (ii) — (A), (iii) — (D), (iv) — (B)
(d) (i) — (C), (ii) — (A), (iii) — (B), (iv) — (D)

Answer 11
(d) (i) — (C), (ii) — (A), (iii) — (B), (iv) — (D)

Question 12
Which of the following is an example of capital
expendi-ture of the government?
(a) Expenditure on the acquisition of land, building,
ma-chinery and equipment.
(b) Investment in shares
(c) Loans and advances by the central government to
state and union territory governments, PSUs and
other parties
Answer 12

Question 13
Loans to State Governments and Union Territory Gove-
rnments are a part of __________.
(a) Revenue receipts
(b) Capital receipts
(c) Capital expenditure
(d) Plan revenue expenditure

Answer 13
(c) Capital expenditure

Question 14
Which of the following is a capital receipt in the conte-
xt of government budget?
(a) Interest receipts
(b) External grants
(c) Provident funds
(d) Personal Income tax

Answer 14
(c) Provident funds

Question 15
The non-tax revenue in the following is:
(a) Export duty
(b) Import duty
(c) Dividends
(d) Excise

Answer 15
(c) Dividends

Question 16
Which one of the following is a combination of direct
taxes?
(a) Excise duty and Wealth tax
(b) Service tax and Income tax
(c) Excise duty and Service tax
(d) Corporation tax and Personal income tax

Answer 16
(d) Corporation tax and Personal income tax

Question 17
Which of the following is not a revenue receipt?
(a) Recovery of loans
(b) Foreign grants
(c) Profits of public enterprises
(d) Wealth tax

Answer 17
(a) Recovery of loans

Question 18
Direct tax is called direct because it is collected directly
from:
(a) The producers on goods produced
(b) The sellers on goods sold
(c) The buyers of goods
(d) The income earners

Answer 18
(d) The income earners

Question 19
Which one of these is a revenue expenditure?
(a) Purchase of shares
(b) Loans advanced
(c) Subsidies
(d) Expenditure on acquisition of land

Answer 19
(c) Subsidies

Question 20
Construction of flyovers is a revenue expenditure
of the government.

Answer 20
False: It is a capital expenditure since it leads to creation
of physical assets of the government.

Question 21
Defence services expenditure is a capital expenditure.

Answer 21
False: Defence services expenditure is a revenue expen-
diture because it neither creates any asset nor reduces any
liability of the government.

Question 22
Receipts of Post-office Savings Accounts, National
Savings Certificates, etc. are capital receipts.

Answer 22
True: Small savings of people (Post-office Savings
Accounts, National Savings Certificates, etc.) are capital
receipts for the government because these receipts create a
liability of repayment on government.

Question 23
Personal income tax and corporation tax are indirect
taxes.

Answer 23
False: These are direct taxes which fall directly on
individuals (personal income tax) and firms (corporation
tax). The liability to pay and burden of the tax lie on the
same person, i.e., burden cannot be shifted.

Question 24
PSU disinvestment is an example of non-debt creating
capital receipts.

Answer 24
True: PSU disinvestment, i.e., net proceeds from sale of
shares in PSUs is a capital receipt that reduces the fina-
ncial assets of the government. However, it does not give
rise to debt. So, it is a non-debt creating capital receipt.

Question 25
Loans to state government are a part of:
(a) revenue receipts
(b) capital receipts
(c) capital expenditure
(d) plan revenue expenditure

Answer 25
(c) capital expenditure

Question 26
Which one of these is revenue expenditure?
(a) purchase of shares
(b) loan advanced
(c) subsidies
(d) expenditure on acquisition of land

Answer 26
(c) subsidies

Question 27
Identify the tax whose burden can’t be shifted.
(a) GST
(b) Income Tax
(c) Sales tax
(d) VAT

Answer 27
(b) Income Tax

Question 28
Which of the following is a direct tax?
(a) Income Tax
(b) GST
(c) excise duty
(d) custom Duty

Answer 28
(a) Income Tax

Question 29
Which of the following is a source of capital receipt?
(a) foreign donations
(b) dividends
(c) disinvestment
(d) indirect taxes

Answer 29
(c) disinvestment

Question 30
Gift tax is a paper tax because ____________.
(a) it is an indirect tax
(b) it is a direct tax
(c) it does not have significant revenue yield
(d) it does not have significant capital yield

Answer 30
(c) it does not have significant revenue yield

Question 31
Which one of the following statement is incorrect?
(a) Revenue receipts are regular in nature
(b) There is no future obligation to return the amount in
case of revenue receipts.
(c) Capital receipts either create an asset or cause a
reduction in the liabilities of the government.
(d) Borrowings are treated as capital receipts as they
lead to an increase in liability.

Answer 31
(c) Capital receipts either create an asset or cause a
reduction in the liabilities of the government.

Question 32
Fees of the government college is a revenue receipt
because:
(a) it creates liability of the government
(b) it neither creates any liability nor reduces any asset
of the government.
(c) it neither creates any asset nor reduces any liability
of the government.
(d) it increases assets of the government.

Answer 32
(b) it neither creates any liability nor reduces any asset
of the government.

Question 33
Which one of the following is a combination of capital
expenditure?
(a) Grants and interest payments
(b) Subsidies and construction of roads
(c) Construction of roads and repayment of loans
(d) Defense services expenditure and construction of
school building

Answer 33
(c) Construction of roads and repayment of loans

Question 34
Column I Column II
(i) Purchase of metro coaches from (a) revenue expenditure
Japan
(ii) Dividend received by (b) capital receipts
government from a company
(iii) Sale of 40% shares of a PSU to a (c) capital expenditure
private company
(iv) Pension paid to retired (d) revenue receipts
government employees

Answer 34
(i) – c, (ii) – d, (iii) – b, (iv) – a

Question 1
Why are borrowings a capital receipt?

Answer 1
Because it leads to increase in liability of repayment on
government.

Question 2
Why are taxes received by the government not capital
receipts?

Answer 2
Because taxes neither create any liability nor reduce any
asset of the government.

Question 3
Giving reasons classify the following into direct and
indirect tax:
(i) Personal income tax
(ii) Goods and services tax
(iii) Corporation tax

Answer 3
(i) It is a direct tax because it falls directly on individu-
als. Its impact (liability to pay) and incidence (actual
burden) falls on the same person, i.e., its burden ca-
nnot be shifted.
(ii) It is an indirect tax because its impact (liability to
pay) and incidence (actual burden) lie on different
persons, i.e., payer and bearer of the tax are differe-
nt people.
(iii) It is a direct tax because it falls directly on firms. Its
impact (liability to pay) and incidence (actual burden)
falls on the same person, i.e., its burden cannot be
shifted.
Question 4
Categorise the following into revenue expenditure and
capital expenditure. Give reasons.
(i) Grants to state governments
(ii) Payment of salaries to staff of government hospitals
(iii) Purchase of cranes for the construction of flyovers
(iv) Repayment of loan from IMF
(4 marks)

Answer 4
(i) It is a revenue expenditure because it neither creates
any asset nor reduces liability of the government.
(ii) It is a revenue expenditure because it neither creates
any asset nor reduces any liability of the government.
(iii) It is a capital expenditure because it increases asset of
the government.
(iv) It is a capital expenditure because it reduces the liab-
ility of the government.

Question 5
Categorise the following into revenue expenditure and
capital expenditure. Give reasons.
(i) Investment in shares
(ii) Subsidies
(iii) Construction of school building
(iv) Defence services expenditure
(v) Repayment of loan with interest
(vi) Grants to state governments for creation of assets
(6 marks)

Answer 5
(i) It is a capital expenditure because it creates asset of
the government.
(ii) It is a revenue expenditure because it neither creates
(iii) It is a capital expenditure because it creates asset of
the government.
(iv) It is a revenue expenditure because it neither creates
(v) Repayment of the principal amount of loan is a capi-
tal expenditure because it reduces liability of the go-
vernment. But interest amount will be a revenue exp-
enditure because it neither creates any asset nor re-
duces any liability of the government.
(vi) It is a revenue expenditure because it neither creates
any asset nor reduces liability of the Central Govern-
ment (since grants are given for creation of assets of
state governments).

Question 6
In the Government of India’s budget, the Finance Minist-
er proposed to raise the excise duty on cigarettes. He also
proposed to increase income tax on individual earn-ing
more than `one crore per annum. Identify and expla-in
the types of taxes proposed by the Finance Minister. Was
the objective only to earn revenue for the govern-ment?
What possible welfare objectives could the Gover-nment
be considering?
(6 marks)

Answer 6
Excise duty — Indirect tax
Indirect tax is a tax where the payer and the bearer of the
tax are different people.
Income tax — Direct tax
Direct tax is a tax where the payer and bearer of the tax is
the same person.
Besides the objective of raising more revenue, the propos-
als also serve some welfare objectives:
(i) Allocation of resources: Raising excise duty on
cigarett-es will make them more expensive. The
price rise is
expected to discourage cigarette smoking, which will
positively impact the health of people and raise their
welfare.
(ii) Redistribution of income: Raising income tax on
inco-me above `1 crore will reduce the gap between
the rich and poor people. In other words, income
inequ-alities will reduce.
The revenue raised from these proposals could be
spent on health, education, etc. to improve the wel-
fare of the poor.

Question 7
Classify the following statements as revenue receipts or
capital receipts. Give valid reasons in support of your
answer.
(a) Financial help from a multinational corporation for
victims in a flood affected area.
(b) Sale of share of a Public Sector Undertaking (PSU)
to a private company, Y Ltd.
(c) Dividends paid to the Government by the State
Bank of India.
(d) Borrowings form International Monetary Fund (IMF).
Answer 7
(a) Revenue receipt of the government, as it is neither
creating any liability nor reducing any assets for the
government.
(b) Capital receipt of the government, as it is reducing
the assets of the government.
(c) Revenue receipt of the government, as it is neither
creating any liability nor reducing any assets for the
government.
(d) Capital receipt, as it is increasing the liability of the
Government.

Question 8
Do ‘disinvestment’ and ‘loan proceeds from abroad’
constitute revenue receipts of the government? Give
reason.

Answer 8
(i) No, Disinvestment are capital receipts of the gover-
nment as it leads to reduction in assets.
(ii) No “loan proceeds from abroad” are capital recei-pts
of the government as it increases the liabilities of the
Government.

4.3
Measures of Government
Deficit – Revenue Deficit,
Fiscal Deficit and Primary
Deficit
The government may spend an amount equal to the
revenue it collects. This is known as a balanced budget.
If it needs to incur higher expenditure, it will have to
raise the amount through taxes in order to keep the b-
udget balanced.
When tax collection exceeds the required expenditure,
it is called a surplus budget.
The most common feature of government budget is the
situation when expenditure exceeds revenue. This is
known as a deficit budget.
When a government spends more than it collects by
way of revenues, it incurs a budget deficit. More for-
mally, it refers to the excess of total expenditure (both
revenue and capital) over total receipts (both revenue
and capital).
There are various measures that capture government
deficit and they have their own implications for the
economy.
Table 4.1: The government budget of a
hypothetical economy (2020-21)
Items (` in lakh crore)
1. Revenue Receipts (a + b) 70
(a) Tax revenue (net of states’ share) 60
(b) Non-tax revenue 10
2. Revenue Expenditure 100
(a) Interest payments 50
(b) Defence expenditure 20
(c) Other expenditures (salary, subsidies,
etc.) 30
3. Revenue Deficit (2 – 1) 30
4. Capital Receipts (a + b + c) 165
(a) Borrowings 120
(b) Recovery of loans 40
(c) Other receipts (mainly PSU
disinvestment) 5
5. Capital Expenditure 135
6. Total Expenditure (2 + 5) 235
7. Fiscal Deficit [4(a) = 6 – {1 + 4(b) + 4(c)}] 120
8. Primary Deficit [7 – 2(a)] 70
Revenue Deficit
Meaning
Revenue deficit refers to excess of government’s reven-
ue expenditure over its revenue receipts.
Revenue deficit = Revenue expenditure – Revenue receipts
The revenue deficit indicates that the government will

not be able to meet its revenue expenditure from its cu-
rrent income (i.e., revenue receipts).
Implications
When the government incurs a revenue deficit, it imp-
lies that the government is dissaving and is using up
the savings of the other sectors of the economy to fina-
nce a part of its consumption expenditure. This situa-
tion means that the government will have to borrow
not only to finance its investment but also its consum-
ption requirements. This will increase borrowings of
the government and the burden of interest liabilities,
and eventually force the government to cut expenditu-
re. Since a major part of revenue expenditure is comm-
itted expenditure (mainly interest payments and defe-
nce expenditure), it cannot be reduced.
Often the government reduces productive capital expe-
nditure, (e.g., expenditure on the acquisition of land,
building, machinery, equipment, etc.) or welfare expe-
nditure (e.g. subsidies though under-pricing of essen-
tial goods, and services like education and health).
This would mean lower growth and adverse welfare im-
plications.
Fiscal Deficit
Meaning
Fiscal deficit is the difference between the Governm-
ent’s budgetary expenditure and its budgetary receipts
excluding borrowings.
Fiscal deficit = Total expenditure – Total receipts net of borrowings
Since total expenditure includes both revenue expen-

diture and capital expenditure, and total receipts net of
borrowings is the sum total of revenue receipts and
non-debt creating capital receipts, therefore:
Fiscal deficit = (Revenue expenditure + Capital expenditure)
–(Revenue receipts+Non-debt creating capital receipts)
Fiscal deficit indicates the total borrowing
requirements of the government from all
sources.
The fiscal deficit will have to be financed through borr-
owings. Therefore, Fiscal Deficit = Borrowings
From the financing side:
Fiscal Deficit = Net borrowing at home* + Borrowing
from RBI + Borrowing from abroad
Thus, it indicates the total borrowing requirements of
the government from all sources.
*Net borrowing at home includes that directly borrowed from the public through debt
instruments (for example, the various small savings schemes) and indirectly from
commercial banks through Statutory Liquidity Ratio (SLR).
Relationship between the revenue deficit
and the fiscal deficit
Revenue deficit is a part of fiscal deficit.
Explanation:
Fiscal deficit = Total expenditure – Total receipts
excluding borrowings
= (Revenue expenditure + Capital
expenditure) – (Revenue receipts +
Non-debt creating capital receipts)
= (Revenue expenditure – Revenue
receipts) + Capital expenditure – Non-
debt creating capital receipts
= Revenue deficit + Capital expenditure –
Non-debt creating capital receipts
Clearly, revenue deficit is a part of fiscal deficit. Thus, a
large share of revenue deficit in fiscal deficit indicates
that a large part of borrowings is being used to meet
the government’s consumption expenditure needs rat-
her than investment.
Implications of Fiscal Deficit
1. A large fiscal deficit means large amount of borro-
wings. This creates a large burden of interest paym-
ent and repayment of loans in the future.
2. Fiscal deficit equals borrowings of the government.
Such borrowings are generally financed by issuing
new currency which may lead to inflation. However,
if the borrowings are for infrastructural developm-
ent this may lead to capacity building and may not
be inflationary.
Thus, fiscal deficit is a key variable in judging the
financial health of the public sector and the stability
of the economy.
Primary Deficit
Meaning
Primary deficit is the difference between fiscal deficit
and the interest payments made by the government.
Primary deficit = Fiscal deficit – Interest payments
Implications
 Primary deficit indicates borrowing requirements
of the government other than to make interest pay-
ments on past debts.
Explanation: Fiscal deficit is nothing but total
borrowings of the government during the current
year. Total borrowings also includes borrowing on
account of interest payments. Therefore, out of to-
tal borrowings requirement (i.e. fiscal deficit) if we
deduct borrowing on account of interest payments,
we get the primary deficit, which indicates borrowi-
ng requirements of the government other than to
make interest payments.
Thus, Fiscal Deficit = Primary Deficit + Interest
Payments
 If primary deficit in a government budget is zero, it
means fiscal deficit is equal to interest payment.
Explanation: Primary deficit = Fiscal deficit – Interest
payments
If primary deficit is zero, then
0 = Fiscal deficit – Interest payments
⇒ Fiscal deficit = Interest payments
It implies that the government has to borrow only
on account of interest payments.
 Top Tips
• To obtain an estimate of borrowing on account of current
expenditures exceeding revenues, we need to calculate the
primary deficit.
• The goal of measuring primary deficit is to focus on present
fiscal imbalances.
• Gross primary deficit = Gross fiscal deficit – Net interest
liabilities
where net interest liabilities consist of interest payments
minus interest receipts by the government on net domestic
lending.
Key Terms
Balanced Budget – When the government's budgetary expendit-
ure is equal to the revenue it collects, this is known as a balanced
budget.
Surplus Budget – When tax collection exceeds the required
expenditure, it is called a surplus budget.
Deficit Budget – When the government's budgetary expenditure
is more than budgetary receipts, this is known as a deficit budget.
Budget Deficit – When a government spends more than it collects
by way of revenues, it incurs a budget deficit.
Revenue deficit – It refers to excess of government’s revenue
expenditure over its revenue receipts.
Fiscal deficit – It is the difference between the Government’s
budgetary expenditure and its budgetary receipts excluding
borrowings.
Primary deficit – It is the difference between fiscal deficit and the
interest payments made by the government.
RECAP
Revenue Deficit
Revenue deficit refers to excess of government’s revenue
expenditure over its revenue receipts.
Revenue deficit = Revenue expenditure –
Revenue receipts
It indicates that government will not be able to meet its
revenue expenditure from its revenue receipts. It implies
that government is dissaving and borrowing to meet cons-
umption expenditure. The government may have to cut
productive capital expenditure or welfare expenditure, whi-
ch could have lower growth and adverse welfare implicate-
ons.
Fiscal Deficit
Fiscal deficit is the difference between the Government’s
budgetary expenditure and its budgetary receipts exclude-
ng borrowings.
Fiscal deficit = Total expenditure – Total receipts net
of borrowings
= (Revenue expenditure + Capital expend-
iture) – (Revenue receipts + Non-debt cr-
eating capital receipts)
= Revenue deficit + Capital expenditure –
Non debt creating capital receipts
Clearly, revenue deficit is a part of fiscal deficit. So, a large
share of revenue deficit in fiscal deficit indicates that a
large part of borrowings is being used to meet the govern-
ment’s consumption expenditure needs rather than investment.
Fiscal deficit indicates total borrowing requirements of the
government from all sources. From the financing side:
Fiscal Deficit = Net borrowing at home + Borrowing from
RBI + Borrowing from abroad.
Primary Deficit
Primary deficit is the difference between fiscal deficit and
the interest payments made by the government.
Primary deficit = Fiscal deficit – Interest payments
Since fiscal deficit is nothing but total borrowings of the
government, therefore, primary deficit indicates borrowi-
ngs other than to make interest payments.
Question 1
Column I Column II
1. Fiscal deficit (a) Total expenditure – Total receipts
2. Primary deficit (b) Revenue expenditure – Revenue
receipts
3. Revenue deficit (c) Total expenditure – Total receipts
(d) Fiscal deficit – Interest payment

Answer 1
(i) – c, (ii) – d, (iii) – b

Question 2
Column I Column II
(i) When government expenditure (A) Deficit Budget
equals the revenue it collects.
(ii) Tax collection exceeds the (B) Surplus Budget
required expenditure.
(iii) When government expenditure (C) Balanced Budget
exceeds the revenue.

Answer 2
(i) – (C), (ii) – (B), (iii) – (A)

Question 3
If the government needs to incur higher expenditure, it
will have to _______ taxes in order to keep the budget
balanced. (increase/decrease)

Answer 3
increase

Question 4
The ______ includes only such transactions that affect
the current income and expenditure of the government.
(a) Budget deficit
(b) Revenue deficit
(c) Fiscal deficit
(d) Primary deficit

Answer 4
(b) Revenue deficit

Question 5
Which of the following is not true for revenue deficit?
A revenue deficit:
(a) implies that the government is dissaving and is
using up the savings of the other sectors of the
economy.
(b) means that the government will have to borrow n-ot
only to finance its investment but also its consu-
mption expenditure requirements.
(c) focuses on present fiscal imbalances.
(d) leads to build up of stock of debtObjective
and Type
interest lia-
Questions 4.3
bilities; and forces the government, eventually, to
cut productive capital expenditure or welfare
expendit-ure. This would mean lower growth and
adverse welfare implications.

Answer 5
(c) focuses on present fiscal imbalances.

Question 6
Which of the following is not true for fiscal deficit?
(a) Fiscal deficit= Total expenditure – Revenue
receipts –Non debt creating capital receipts
(b) Fiscal deficit= Net borrowing at home+ Borrowing
(c) Fiscal deficit = Primary deficit + Interest payments
on accumulated debt

Answer 6

Question 7
Fiscal deficit = Total expenditure – (Revenue receipts +
_______________________)
(Fill in the blank)

Answer 7
Non debt creating capital receipts.
(Those capital receipts which are not borrowings and
therefore, do not give rise to debts, e.g. proceeds from sale
of PSUs, and recovery of loans i.e. PSU disinvestment)

Question 8
Fiscal deficit will have to be financed through _______.
(a) Primary deficit
(b) Revenue deficit
(c) Borrowing
(d) Taxes

Answer 8
(c) Borrowing

Question 9
Fiscal deficit indicates the total borrowing requirements
of the government from all sources.

Answer 9
True: Fiscal deficit is financed through borrowings.
Fiscal deficit = Net borrowing at home + Borrowing from
RBI + Borrowing from abroad

Question 10
_______ is a key variable in judging the financial health
of the public sector and the stability of the economy.
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit

Answer 10
(b) Fiscal deficit

Question 11

Answer 11
True: Revenue deficit is a part of fiscal deficit
Fiscal deficit = Total expenditure – Total receipts
= Revenue expenditure + Capital expenditure
– (Revenue receipts + Non debt creating capital receipts)
= Revenue expenditure – Revenue receipts
+ Capital expenditure – Non debt creating capital receipts
= Revenue deficit + capital expenditure
– Non debt creating capital receipts

Question 12
A large share of __________ in fiscal deficit indicates
that a large part of borrowing is being used to meet the
government’s consumption expenditure needs rather
than investment.
(Fill in the blank)

Answer 12
revenue deficit

Question 13
The goal of measuring ________ is to focus on present
fiscal imbalances.
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit

Answer 13
(c) Primary deficit

Question 14
To obtain an estimate of borrowing on account of
current expenditure exceeding revenues, we need
to calculate __________.
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit

Answer 14
(c) Primary deficit

Question 15
Primary deficit = Fiscal deficit – Net interest liabilities.

Answer 15
True: Primary deficit = Fiscal deficit – Net interest
liabilities
Net interest liabilities consist of interest payments
minus interest receipts by the government on net
domestic lending.

Question 16
Fiscal deficits are always inflationary.

Answer 16
False: Fiscal deficit equals borrowings of the
government. Such borrowings are generally financed by
issuing new currency which may lead to inflation.
However, if the borrowings are for infrastructure
development, this may lead to capacity building and may
not be inflationary.

Question 17
Primary deficit in a government budget will be zero, when
__________.
(a) Revenue deficit is zero
(b) Fiscal deficit is zero
(c) Total borrowing is equal to interest payments
(d) Net interest payments is zero.

Answer 17
(c) Total borrowing is equal to interest payments

Question 18
Which of the following is a revenue receipt?
(a) Sale of shares of a public sector undertaking (PSU)
to a private company, Y Ltd.
(b) Financial help from a multinational corporation for
victims in a flood affected area.
(c) Dividends paid to the government by the State Bank
of India.

Answer 18
Fiscal deficit = Total expenditure – (Revenue
receipts + Non debt creating capital receipts)
= [(iv)+(v)]-[(i)+(ii)]-(iii)
= (1500 + 480)-(1,000 + 150)-50
= 1,980 –1,150 -50 = ` 780 crore

Question 19
Fiscal Deficit – Interest payments = __________.
(a) Revenue Deficit
(b) Budget Deficit
(c) Primary Deficit
(d) None of these

Answer 19
(c) Primary Deficit

Question 20
_________ indicates that the government will have to
borrow not only to finance its investments but also its
consumption expenditure.
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit
(d) Budget deficit

Answer 20
(a) Revenue deficit

Question 21
Fiscal deficit is financed through __________.
(a) market borrowings
(b) borrowings from the Central Bank
(c) borrowings from foreign governments
(d) All of these

Answer 21
(d) All of these

Question 22
Which of the following statement is not true for fiscal
deficit?
A fiscal deficit:
(CBSE SQP 2015) (Choose the correct alternative)
(a) represents the borrowing of the government.
(b) is the difference between total expenditure and total
receipts of the government
(c) is the difference between total expenditure and total
receipts other than borrowing
(d) increases the future liability of the government
Answer 22
(b) is the difference between total expenditure and
total receipts of the government

Question 23
Borrowing in government budget is:
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit
(d) Deficit in taxes

Answer 23
(b) Fiscal deficit

Question 24
Which of the following statements is true?
(a) Fiscal deficit is the difference between total expen-
diture and total receipts.
(b) Primary deficit is the difference between total rece-
ipt and interest payments.
(c) Fiscal deficit is the sum of primary deficit and inter-
est payment.

Answer 24
(c) Fiscal deficit is the sum of primary deficit and inter-
est payment.

Question 25
Which of the following statement is true?
(a) Loans from IMF is a Revenue Receipt.
(b) Higher revenue deficit necessarily leads to higher fi-
scal deficit.
(c) Borrowing by a government represents a situation of
fiscal deficit.
(d) Revenue deficit is the excess of capital receipts over
the revenue receipts.

Answer 25
(c) Borrowing by a government represents a situation of
fiscal deficit.

Question 26
Primary deficit in a government budget equals:
(a) Interest payments
(b) Interest payments less borrowings
(c) Borrowings less interest payments
(d) None of these

Answer 26
(c) Borrowings less interest payments

Question 27
is true or false:
Increase in revenue deficit will always lead to higher
fiscal deficit.

Answer 27
False: Fiscal deficit = Revenue deficit + Capital expenditure
– Non-debt creating capital receipts. Therefore, increase in
revenue deficit may not lead to higher fiscal deficit because
fiscal deficit is also influenced by non-debt creating capital
receipts and capital expenditure of the government in
addition to revenue deficit.

Question 28
is true or false:
Primary deficit equals revenue deficit less interest payme-
nts.

Answer 28
False: Primary deficit equals fiscal deficit less interest
payments.

Question 29
Primary deficit is borrowing requirement of government
for making
(a) interest payment
(b) other than interest payment
(c) payments off public debts
(d) payment off borrowing from RBI

Answer 29
(b) other than interest payment

Question 30
Zero primary deficit means:
(a) no liabilities with government
(b) the government has to resort to borrowing only to
meet interest payments
(c) no interest payments
(d) no current liabilities

Answer 30
(b) the government has to resort to borrowing only to
meet interest payments

Question 31
In a situation of Inflation, the government should adopt:
(a) Balanced Budget
(b) Deficit budget
(c) Surplus Budget
(d) None of these

Answer 31
(c) Surplus Budget

Question 1
Suppose you are a member of the “Advisory Committee
to the Finance Minister of India”. The finance Minister is
concerned about the rising Revenue Deficit in the bud-
get.
Suggest any one measure to control the rising Revenue
deficit of the government.

Answer 1
Measure to Control Revenue deficit: (any one)
(a) To reduce government administrative expenses.
(b) To reduce the burden of subsidy.
(c) To increase taxation.

Question 2
State whether the following statement is true or
false. Support your answer with reason.
Revenue deficit increase when government fails to reco-
ver loans forwarded to different nations.

Answer 2
The given statement is false, because recovery of loans is
a capital receipt. It does not affect the revenue receipts.

Question 3
"Fiscal deficit indicates the total borrowing requirements
of the government from all sources." Elucidate.
(4 marks)

Answer 3
Fiscal deficit is the difference between the Government’s
budgetary expenditure and its budgetary receipts exclu-
ding borrowings.
The fiscal deficit will have to be financed through borro-
wings. Therefore, Fiscal Deficit = Borrowings
Fiscal Deficit = Net borrowing at home + Borrowing
Thus, it indicates the total borrowing requirements of the
government from all sources.

Question 4
‘‘A large fiscal deficit leads to a higher revenue deficit in
future. ’’Do you agree with the statement? Give reasons
in support of your answer.
(3 marks)

Answer 4
Yes, a large fiscal deficit leads to a higher revenue deficit
in future.
Reason: A large fiscal deficit means large amount of bo-
rrowings. This creates a large burden of repayment of loa-
ns in future and interest payments. More interest paymen-
ts will increase revenue expenditure. Hence, revenue defi-
cit in future will increase.

Question 5
“Governments across nations are too much worried a-
bout the term fiscal deficit”. Do you think that fiscal de-
ficit is necessarily inflationary in nature? Support your
answer with valid reasons.

Answer 5
The term fiscal deficit is the difference between the gover-
nment’s total expenditure and its total receipts (excluding
borrowing). Such borrowings are generally financed by
issuing new currency which may lead to inflation.
However, if the borrowings are for the infrastructural
development-al purposes this may lead to capacity
building and may not be inflationary.

Question 6
Explain the relationship between revenue deficit and
fiscal deficit.
(4 marks)

Answer 6
Explanation: Fiscal deficit = Total expenditure – Total
receipts excluding borrowings
= (Revenue expenditure + Capital expenditure) – (Reve-
nue receipts + Non-debt creating capital receipts)
= (Revenue expenditure – Revenue receipts) + Capital
expenditure – Non-debt creating capital receipts
= Revenue deficit + Capital expenditure – Non-debt cre-
ating capital receipts
Clearly, revenue deficit is a part of fiscal deficit.
Thus, a large share of revenue deficit in fiscal deficit
indic-ates that a large part of borrowings is being used to
meet the government’s consumption expenditure needs
rather than investment.

Question 7
Can there be a fiscal deficit without revenue deficit?
Explain.
(4 marks)

Answer 7
Fiscal deficit = Total expenditure – Total receipts exclu-
ding borrowings
= (Revenue expenditure + Capital expenditure) – (Re-
venue receipts + Non-debt capital receipts)
= (Revenue expenditure – Revenue receipts) – (Capital
expenditure – Non-debt capital receipts)
Yes, there can be a fiscal deficit in a government budget
without a revenue deficit in the following situations:
(i) When revenue budget is balanced (i.e., revenue expe-
nditure = revenue receipts) and capital budget shows

a deficit (i.e., capital expenditure > non-debt capital
receipts).
(ii) When there is a surplus in the revenue budget (i.e.,
revenue receipts > revenue expenditure) but the de-
ficit in capital budget is greater than this surplus.

Question 8
What will be the effect of a deficit budget on the level
of aggregate demand?
(3 marks)

Answer 8
When the government’s total expenditure (both revenue
and capital) exceeds its total receipts (both revenue and
capital), it incurs a budget deficit. Increased government
expenditure will raise the level of aggregate demand in e-
conomy since government expenditure is a component of
aggregate demand.
A budget deficit is financed through borrowings, mainly
Central Bank Borrowing, which issues new currency to
the government. The government then pays for its exp-
enses with this money. The money thus ultimately comes
into the hands of the general public and becomes a part
of money supply. That is, money supply in the economy
increases. As a result, aggregate demand in the economy
increases.

NUMERICAL 1
From the following data calculate Fiscal Deficit.

Items (` in billion)
(i) Capital receipts net of borrowings 95
(ii) Capital Receipt 68
(iii) Revenue Expenditure 160
(iv) Interest Payment 20
(v) Borrowings 32
(vi) Tax Revenue 50
(vii) Non-tax Revenue 10
Solution: Fiscal deficit = Borrowings = `32 billion

Do it yourself 1
In a government budget, revenue deficit is`50000 crore and
borrowings are `75000 crore. How much is the fiscal deficit?
(1 mark)
[Ans. `75000 crore]
Fiscal deficit = Borrowings = ` 75000 crore
NUMERICAL 2
A government budget shows a primary deficit of `400

crore. The revenue expenditure on interest payment is `
400 crore. How much is the fiscal deficit?
(1 mark)
Solution:
Primary deficit = Fiscal deficit – Interest payment
Therefore, Fiscal deficit
= Primary deficit+ Interest payment
= 4400 + 400 = `4800 crore
Do it yourself 2
A government budget shows a primary deficit of `3,500 cr-
ore. The interest payment is `500 crore. How much is the
fiscal deficit?
(1 mark)
[Ans. `4,000 crore]
Fiscal deficit = Primary deficit + Interest payment
= 3,500 + 500 = `4,000 crore
NUMERICAL 3
In a government budget, if revenue receipts are `100 crore,

capital receipts are ` 50 crore and revenue deficit is ` 25
crore, how much is the revenue expenditure?
(1 mark)
Solution:
Revenue deficit = Revenue expenditure – Revenue receipts
25 = Revenue expenditure – 100
Revenue expenditure = 25 + 100 = `125 crore
Do it yourself 3
In a government budget, if tax revenue receipts are `80
crore, non-tax revenues are ` 20 crore and revenue deficit is
` 50 crore, how much is the revenue expenditure?
(1 mark)
[Ans. `150 crore]
Revenue deficit = Revenue expenditure – Revenue
receipts (tax and non-tax revenues)
50 = Revenue expenditure – (80 + 20)
Revenue expenditure = 50 + 100 = `150 crore
NUMERICAL 4
From the following data about a government budget find

(a) Revenue deficit, (b)Fiscal deficit and(c) Primary deficit:
Items (` in billion)
(i) Tax revenue 47
(ii) Capital receipts 34
(iii) Non-tax revenue 10
(iv) Borrowings 32
(v) Revenue expenditure 80
(vi) Interest payments 20
Solution: (a) Revenue deficit = Revenue expenditure –
Revenue receipts (Tax revenue + Non-tax revenue)
= 80 – (47 + 10) = 80 – 57 = ` 23 arab
(b) Fiscal deficit = Borrowings = ` 32 arab
(c) Primary deficit = Fiscal deficit – Interest payments =
32 – 20 = ` 12 arab
Do it yourself 4
From the following data about a government budget find (a)

Fiscal deficit and (b) Primary deficit : (4 marks)
Items (` in arab)
(i) Revenue expenditure 70000
(ii) Borrowings 15000
(iii) Revenue receipts 50000
(iv) Interest payments 25% of revenue deficit
[Ans. (a) ` 15000 crore (b) ` 10,000 crore]

(a) Fiscal deficit = Borrowings = ` 15000 crore
(b) Primary deficit = Fiscal deficit – Interest payments
= 15000 – 5000 = ` 10000 crore
Note: Revenue deficit = Revenue expenditure –
Revenue receipts = 70000 – 50000 = ` 20000 crore.
Therefore, interest payments = 25% of 20000
= ` 5000 crore
NUMERICAL 5
From the following data about a government budget find:

(a) Revenue deficit (b) Fiscal deficit (c) Primary deficit
(6 marks)
S. No. Items (` in billion)
(i) Tax revenue 1037
(ii) Revenue expenditure 2811
(iii) Interest receipts by the government on 400
net domestic lending
(iv) Dividends and profits on investments 600
(v) Recovery of loans 135
(vi) Capital expenditure 574
(vii) Proceeds from sale of shares in PSUs 100
(viii) Interest payments on accumulated debts 1013
Solution:
(a) Revenue deficit = Revenue expenditure – Revenue
receipts = 2811 – 2037 = ` 774 crore
Note: Revenue receipts = Tax revenue + Non- tax
revenues (Interest receipts + Dividends and profits)
= 1037 + (400 + 600) = ` 2037 crore
(b) Fiscal deficit = Total expenditure – Total receipts
= (Revenue expenditure + Capital expenditure) –
(Revenue receipts + Non-debt capital receipts)
= (2811 + 574) – (2037 + 235) = 3385 – 2272 = ` 1113 crore
Note: Non-debt creating capital receipts = (vii) + (v) =
100 + 135 = ` 235 crore
(c) Primary deficit = Fiscal deficit – Net interest payments
(viii – iii) = 1113 – (1,013 – 400) = ` 500 crore
Do it yourself 5
Find out (a) Revenue deficit, (b) Fiscal deficit and

(c) Primary deficit : (CBSE 2011) (4 marks)
(iii) Interest payments 10
(iv) Revenue receipts 80
(v) Capital expenditure 110
[Ans. (a) ` 20 arab (b) ` 35 arab (c) ` 25 arab]

(a) Revenue deficit = Revenue expenditure
– Revenue receipts = 100 – 80
= ` 20 arab
(b) Fiscal deficit = Total Expenditure – Total receipts
= (Revenue expenditure + Capital expenditure) –
(Revenue receipts
+ Capital receipts net of borrowings)
= (100 + 110) – (80 + 95) = 210 – 175 = ` 35 arab
(c) Primary deficit = Fiscal deficit – Interest payments
= 35 – 10 = ` 25 arab
NUMERICAL 6
From the following data about a government budget calcu-

late Primary deficit:
(i) Revenue deficit 40
(ii) Non-debt creating capital receipts 190
(iii) Tax revenue 125
(iv) Capital expenditure 220
(v) Interest payments 20
Solution: Fiscal deficit = Revenue deficit + Capital

expenditure – Non-debt creating capital receipts = 40 +
220 – 190 = ` 70 arab. Therefore, Primary deficit = Fiscal
deficit – Interest payments = 70 – 20 = ` 50 arab
Government Budget and the Economy
Time Allowed: 1 hr. Maximum Marks: 25

Question 1
The formula to calculate Primary deficit is _____.
Self Assessment Test-1

Answer 1
Primary Deficit = Fiscal Deficit – Interest
Payments

Question 2
Government expenditure on Mid-Day Meal sche-
me running in government (state run) schools is a
type of _____ expenditure in government budget.

Answer 2
Revenue

Question 3
Which of the following is not a Capital expenditu-
re?
(a) Loan advanced by World Bank
(b) Construction of school buildings
(c) Repayment of loans
(d) Tax Receipts

Answer 3
(d) Tax Receipts
OR
(a) Loan advanced by World Bank

Question 4
State the meaning of Revenue Deficit.
(1 mark)

Answer 4
Revenue deficit refers to excess of government’s
revenue expenditure over its revenue receipts.

Question 5
If an economy, the Estimated Receipts of the gov-
ernment during a year are lesser than the Estimated
Expenditure, the budget would be called ________
budget.

Answer 5
deficit

Question 6
How a capital expenditure different from revenue
expenditure? Discuss briefly.
(4 marks)

Answer 6
(d) All of the above are methods of data collection

Question 7
Classify the following statements as revenue recei-
pts or capital receipts. Give valid reasons in sup-
ort of your answer. (4 marks)
(a) Financial help from a multinational corpora-
tion for victims in a flood affected area.
(b) Sale of share of a Public Sector Undertaking
(PSU) to a private company, Y Ltd.
(c) Dividends paid to the Government by the Sta-
te Bank of India.
(d) Borrowings form International Monetary F-
und (IMF).

Answer 7
(a) Revenue receipt of the government, as it is ne-
ither creating any liability nor reducing any
as-sets for the government.
(b) Capital receipt of the government, as it is re-
ducing the assets of the government.
(c) Revenue receipt of the government, as it is
nei-ther creating any liability nor reducing any
as-sets for the government.
(d) Capital receipt, as it is increasing the liability
of the Government. Self Assessment Test-1
Question 8
Given the following data estimate the values of (i)
Revenue Deficit, and (ii) Fiscal Deficit: (4 marks)
(i) Tax Revenue 1,000
(ii) Non-Tax Revenue 150
(iii) Net Borrowings by Government 780
(iv) Disinvestments Proceeds 50
(v) Revenue Expenditure 1,500
(vi) Capital Expenditure 480
Answer 8
(i) Revenue Deficit = Total Revenue expenditure -
Total revenue Receipt
= Revenue Expenditure - (Tax revenue + Non Tax
revenue)
= 1500 – (1000 + 150 ) = `350 crore
(ii) Fiscal deficit = Total expenditure – (Revenue Rece-
ipt + Disinvestment proceeds)
= (1500+480)–(1000+150+50) = 780 crore
Alternately, fiscal deficit = Net Borrowings by
Gov-ernment = `780 crore
Question 9
“Through its budgetary policy government alloca-
tes resources in accordance with the requirements
of the country.” Do you agree with the given stat-
ement? Support your answer with valid reasons.
(4 marks)

Question 10
Elaborate the objective of ‘reallocation of resources’
in the government budget.
(4 marks)


Question 1
Primary deficit in a government budget will be zero,
when _____________.
(a) Revenue deficit is zero.
(b) Net interest payments are zero.
(c) Fiscal deficit is zero.
(d) Fiscal deficit is equal to interest payment.

Answer 1
(d) Fiscal Deficit is equal to interest payment

Question 2
What is meant by revenue deficit?

Question 3
Which the following is a capital receipt in the Go-
vernment Budget?
(a) Income tax
(b) Interest receipt
(c) Sale of shares of a Public Sector Undertaking
(PSU) to X Limited (Private Company)
(d) Dividends from a Public Sector Undertaking
(PSU)
Answer 3
(c) sale of shares of a Public sector undertaking
(PSU) to X Limited (Private Company)

Question 4
Dividends received from public sector Underta-
kings (PSUs) are a part of the government’s ____.
(a) Non-tax Revenue Receipts
(b) Tax receipts
(c) Capital receipts
(d) Capital expenditure

Answer 4
(a) Non-tax Revenue Receipts

Question 5
State any two items of revenue expenditure in a
Government budget.
(1 mark)

Answer 5
Expenditure of the government on salaries, pens-
ions, subsidies, grants etc.

Question 6
Explain how the government can use the budget-
ary policy in reducing inequality of income in the
econ-omy.
(4 marks)

Question 7
How are capital receipts different from revenue
receipts? Discuss briefly.
(4 marks)

Question 8
Is the following revenue expenditure or capital
exp-enditure in the context of government budget?
Give reason.
(4 marks)
(i) Expenditure on collection of taxes
(ii) Expenditure on purchasing computers
(iii) Expenditure on scholarships
(iv) Expenditure on building a bridge

Answer 8
(i) Expenditure on collection of taxes is revenue
expenditure because it neither creates any as-
set nor reduces any liability of the governme-
nt.
(ii) Expenditure on purchasing computers is capit-
al expenditure because it creates assets of the
government.
(iii) Expenditure on scholarships is revenue expen-
diture because it neither creates any asset nor
reduces any liability of the government.
(iv) Expenditure on building a bridge is capital
expenditure because it leads to creation of
assets of the government.

Question 9
From the following data about a Government bud-
get, find out (a) Revenue deficit, (b) Fiscal deficit
and (c) Primary deficit: (4 marks)
(iii) Interest payments 10
(iv) Revenue receipts 80
(v) Capital expenditure 110
Answer 9
(a) Revenue deficit = Revenue expenditure – Re-
venue receipts = 100 – 80 = ` 20 arab
(b) Fiscal deficit = Total Expenditure – Total re-
ceipts excluding borrowings
= (Revenue expenditure+ Capital expenditure)
– (Revenue receipts + Capital receipts net of
borrowings)
= (100 + 110) – (80 + 95) = 210 – 175
= ` 35 arab
(c) Primary deficit = Fiscal deficit – Interest pa-
yments = 35 – 10 = `25 arab

Question 10
"Fiscal deficit indicates the total borrowing require-
ments of the government from all sources." Eluc-
idate.
(4 marks)


Question 1
State any two examples of non-tax revenue receipts
of the government.
(1 mark)

Answer 1
Fees, Fines, Penalties, Escheat etc.

Question 2
State whether the following statement is true
or false. Support your answer with reason.
Taxation is an effective tool to reduce the inequa-
lities of income.
(1 mark)

Answer 2
The given statement is true. Generally, the gove-
rnments collect higher taxes from the rich people
and spend it on the welfare of the poor. Thereby,
reducing the inequalities of income.

Question 3
Which of the alternatives best describes the follo-
wing?
The receipts of the government which creates bur-
den of repayment of loans and interest thereon in
future. (Choose the correct alternative) (1 mark)
(a) Non-debt creating capital receipts
(b) Debt creating capital receipts
(c) Fiscal deficit
Answer 3

Question 4
Which of the following is/are capital receipt(s) in
a government budget?
(a) Financial help from a multinational corporat-
ion for victims in a flood affected area.
(b) Sale of share of a public sector undertaking
(PSU) to a private company.
(c) Dividends paid to the Government by the Sta-
te Bank of India.
(d) Borrowings from International Monetary Fu-
nd (IMF).

Answer 4
(b) and (d)

Question 5
_______ is the difference between the Government
budgetary expenditure and its budgetary receipts
excluding borrowings.

Answer 5
Fiscal deficit

Question 6
From the following data about a government bud-
get find (a) Revenue deficit, (b) Fiscal deficit and
(c) Primary deficit: (4 marks)
(i) Tax revenue 47
(ii) Capital receipts 34
(iii) Non-tax revenue 10
(iv) Borrowings 32
(v) Revenue expenditure 80
(vi) Interest payments 20
Answer 6
(a) Revenue deficit
= Revenue expenditure – Revenue receipts
(Tax revenue + Non-tax revenue)
= 80 – (47 + 10) = 80 – 57 = ` 23 arab
(b) Fiscal deficit = Borrowings = ` 32 arab
(c) Primary deficit = Fiscal deficit – Interest pa-
yments = 32 – 20 = ` 12 arab

Question 7
Categorise the following government receipts into
revenue and capital receipts. (4 marks)
(i) Profits and dividend received from public se-
ctor undertakings
(iii) Tax receipts
(iii) Recovery of loans granted by the Central go-
vernment
(iv) Cash grants-in-aid from foreign countries and
international organisations
Answer 7
(i) It is a revenue receipt as it neither creates a li-
ability nor reduces any asset of the government.
(ii) It is a revenue receipt as it neither creates a
liability nor reduces any asset of the govern-
ment.
(iii) It is a capital receipt as it reduces assets of the
Central Government.
(i) It is a revenue receipt as it neither creates a li-
ability nor reduces any asset of the government.
Question 8
Discuss briefly the role of the government budget
in influencing “allocation of resources” in the eco-
nomy.
(4 marks)

Question 9
Distinguish between revenue receipts and capital
receipts of the government.
(4 marks)

Question 10
Define 'revenue receipts' in a government budget.
Do ‘disinvestment’ and ‘loan proceeds from abroad’
constitute revenue receipts of the government? Give
reason.
(4 marks)

Answer 10
(i) No, Disinvestment are capital receipts of the
government as it leads to reduction in assets.
(ii) No “loan proceeds from abroad” are capital
receipts of the government as it increases the
liabilities of the Government.

 Balance of payments account – meaning
and components
 Foreign exchange rate – meaning of fixed
and flexible rates and managed floating
Balance of Payments: Meaning and
5.1
Components
Meaning of Balance of Payments
Balance of Payments (BoP) is defined as the statement
of accounts of a country’s inflows and outflows of
foreign exchange in a fiscal year. (Foreign exchange or
foreign currency refers to any currency other than the
domestic currency.)
There are two main accounts in the BoP – the current
account and the capital account. Current account is
the record of trade in goods and services and transfer
payments, whereas capital account records all
international transactions of assets, e.g. money, stocks,
bonds, government debt, etc.
Since it is difficult to record all international economic
transactions accurately, therefore we have a third
element of BoP (apart from the current and capital
accounts) called errors and omissions which reflects
this.
Debit Side
Any international transaction which results in outflow
of foreign exchange is recorded on the debit side in the
balance of payments accounts (the current account and
or capital account). It is given a negative sign.
For example, payments for imports of goods and services,
purchase of financial assets (e.g. shares, debentures,
bonds, etc.) in a foreign country, etc.
Buying
Top Tip
foreign goods (i.e. import) is expenditure from our country
and it becomes the income of that foreign country. Hence, it is a
debit item of the current account of balance of payments.
Note that imports decrease the domestic demand for goods and
services in our country.
Credit Side
Any international transaction which leads to inflow of
foreign exchange is recorded on the credit side in the
balance of payments accounts (the current account or
the capital account). It is given a positive sign.
For example, receipts on account of exports of goods
and services, foreign investments, factor income earned
from abroad, loans and grants from abroad, etc.
 Top Tips
 Selling of domestic goods to foreign nationals, i.e. export,
brings income to our country. Hence, it is a credit item of
the current account of balance of payments. Note that
exports add to the aggregate domestic demand for goods
and services in our country.
 Foreign investments lead to inflow of foreign exchange.
Hence, it is recorded on the credit side of the capital
account since it is an international transactions of assets.
Note that foreign investments are divided into Foreign
Direct Investment (FDI) and Portfolio investment. While FDI
involves foreign investors taking a controlling and lasting
stake in productive enterprises, portfolio investments
represent holdings of minor equity (without management
control) or debt through the stock markets by foreign
investors for the purpose of earning return on investment.
Current Account of BoP
Current Account is the record of trade in goods and
services and transfer payments.
Components of the Current Account
1. Trade in goods: It includes (i) exports of goods
and (ii) imports of goods.
For example, export or import of machinery.
2. Trade in services: Services trade includes both
net factor income and net non-factor income
transactions.
(i) Net factor income: Net factor income
includes net international earnings of factors
of production (like labour, land and capital).
Examples:
• Net income from compensation of employees
• Net investment income, i.e., interest, profits and
dividends on our assets abroad minus the income
foreigners earn on assets they own in India.
(ii) Net non-factor income: Net non-factor income is
net sale of service products like shipping, banking,
tourism, software services, etc.
3. Transfer payments: Foreign transfers are the
receipts which the residents of a country get for
‘free’, without having to provide any goods or
services in return. They consist of gifts, remittances
and grants. They could be given by the government
or by private citizens living abroad.
Balance on Current Account
Balance on Current Account has two components: (i)
Balance of Trade or Trade Balance and (ii) Balance on
Invisibles.
1. Balance of Trade (BoT)/Trade Balance: It is the
difference between the value of exports and imports
of goods of a country during a year.
Balance of Trade (BoT) = Value of exports of goods –
Value of imports of goods
 Top Tips
Exports and imports of goods is also called visible trade.
Export of goods is entered as a credit item in BoT as it
leads to inflows of foreign exchange whereas import
of goods is entered as a debit item in BoT as it results
in outflow of foreign exchange.
 BoT is said to be in balance when exports of goods
are equal to the imports of goods.
 Surplus BoT or Trade surplus will arise if the total
value of country’s exports of merchandise (goods)
is more than value of its imports of the
merchandise during a year.
 Deficit BoT or Trade deficit will arise if the total
value of country’s imports of merchandise (goods)
is more than value of its exports of the merchandise
during a year.
2. Balance on Invisibles: Net invisibles is difference
between the value of exports and imports of
invisibles of a country in a given period of time.
Invisibles include services, transfers and flows of
income.
 Current account is in balance when receipts on
current account are equal to the payments on the
current account.
 Current Account Surplus (CAS) refers to excess
of receipts from value of export of visible items,
invisible items and unilateral transfers over
payments for value of import of visible items,
invisible items and unilateral transfers.
CAS is relatively broader concept as compared to
trade surplus.
CAS signifies that the nation is a lender to the
rest of the world.
 Current Account Deficit (CAD) arises when the
value of exports of visible items, invisible items
and unilateral transfers is less than the value of
imports of visible items, invisible items and
unilateral transfers.
CAD is relatively broader concept as compared
to trade deficit.
CAD signifies that the nation is a borrower from
the rest of the world.
 Top Tip
Difference between Balance on Trade Account and
• 'Balance on Trade Account' is the difference between
value of exports of goods and imports of goods. In other
words, it is the difference between visible inflows and
visible outflows of foreign exchange.
• 'Balance on Current Account' is the sum total of balance
of trade and balance on invisibles. In other words, it is the
difference between the sum of both visibles and invisibles
inflows and outflows of foreign exchange.
Capital Account of BoP
Capital account records all international transactions of
assets. An asset is any one of the forms in which wealth
can be held, for example, money, stocks, bonds,
government debt, etc.
 Capital inflows such as receipt of loans from
abroad, sale of assets or shares in foreign
companies, etc. are recorded on the credit side of
the capital account as there is inflow of foreign
exchange in India.
 Capital outflows such as repayment of loans,
purchase of assets or shares in foreign countries,
etc. are recorded on the debit side of the capital
account as it results in outflow of foreign exchange.
Components of Capital Account
There are three components of the capital account —
Foreign Investments, External Borrowings and External
Assistance.
1. Foreign Investments: Foreign investments may be
of two kinds:
(a) Direct Investment, e.g. Foreign Direct
Investments (FDIs), Equity Capital, Reinvested
Earnings and other Direct Capital Flows.
(b) Portfolio Investment, e.g. Foreign Institutional
Investments (FIIs), Offshore Funds, etc.
2. External Borrowings: Examples: External Commercial
Borrowings, Short-term Debt, etc.
3. External Assistance: Examples: Government Aid,
Inter-governmental, Multilateral and Bilateral Loans.
Balance on Capital Account
Balance on Capital Account is the sum total of net
foreign investments, net external borrowings and net
external assistance.
 Capital account is in balance when capital inflows
(like receipt of loans from abroad, sale of assets or
shares in foreign companies) are equal to capital
outflows (like repayment of loans, purchase of
assets or shares in foreign countries).
 Surplus in capital account arises when capital
inflows are greater than capital outflows.
 Deficit in capital account arises when capital
inflows are lesser than capital outflows.
Key Term
Foreign exchange — Any currency other than the domestic
currency.
Balance of Payments (BoP) — The statement of accounts of a
country’s inflows and outflows of foreign exchange in a fiscal year.
Debit — Any international transaction which results in outflow of
foreign exchange is entered as a debit in BoP accounts.
Credit — Any international transaction which results in inflow of
foreign exchange is entered as a credit in BoP accounts.
Current Account — The record of trade in goods and services and
transfer payments.
Capital Account — The record of all international transactions of
assets, e.g. money, stocks, bonds, government debt, etc.
Factor income — Net international earnings on factors of
production (like labour, land and capital).
Non-factor income — Net sale of service products like shipping,
banking, tourism, software services, etc.
Balance of Trade (BoT) — The difference between the value of
exports and imports of goods of a country in a given period of time.
Invisibles — Services, transfers and flows of income that take
place between different countries.
Current Account Surplus (CAS) — A situation that arises when
the receipts on current account are more than the payments on
current account.
Current Account Deficit (CAD) — A situation that arises when the
receipts on current account are less than the payments on
current account.
Balance on Current Account — Sum total of balance of trade and
balance on invisibles.
Balance on Capital Account — Sum total of net foreign investments,
net external borrowings and net external assistance.
Foreign Investments—Foreign Direct Investments (FDIs), Portfolio
Investment, e.g. Foreign Institutional Investments (FIIs).
External Borrowings — External Commercial Borrowings, Short-
term Debt.
External Assistance — Government Aid, Inter-governmental,
Multilateral and Bilateral Loans.
Surplus in capital account — Capital inflows (like receipt of loans
from abroad, sale of assets or shares in foreign companies) are
greater than capital outflows (like repayment of loans, purchase
of assets or shares in foreign countries).
RECAP
Balance of Payments
Balance of Payments is defined as the statement of
accounts of a country’s inflows and outflows of foreign
exchange in a fiscal year. Foreign exchange refers to any
currency other than the domestic currency.
There are two main accounts in the BoP – the current
account and the capital account. Current Account is the
record of trade in goods and services and transfer
payments. Capital Account records all international
transactions of assets, e.g. money, stocks, bonds,
government debt, etc.
 Any transaction which results in outflow of foreign
exchange is recorded on the debit side in the balance of
payments accounts (the current account and the capital
account), e.g. imports.
 Any transaction which leads to inflow of foreign exchange
is recorded on the credit side in the balance of payments
accounts, e.g. exports.
Components of Current Account
1. Trade in goods: It includes:
(i) exports of goods and (ii) imports of goods.
2. Trade in services: Services trade includes both factor
income and non-factor income transactions.
 Factor income includes net international earnings on
factors of production (like labour, land and capital).
For example, net income from compensation of
employees and net investment income, e.g., profits
from investments made abroad.
 Non-factor income is net sale of service products like
shipping, banking, tourism, software services, etc.
3. Transfers payments: The receipts which the residents of
a country get for ‘free’, e.g. gifts, remittances and grants.
Components of Balance on Current Account
1. Balance of Trade/Trade Balance: The difference between
the value of exports and imports of goods of a country
during a year.
 Trade surplus will arise if the total value of country’s
exports of merchandise (goods) is more than value of
its imports of the merchandise during a year.
 Trade deficit will arise if the total value of country’s
imports of merchandise (goods) is more than value of
its exports of the merchandise during a year.
2. Balance on Invisibles: The difference between the value
of exports and imports of invisibles of a country in a given
period of time. Invisibles include services, transfers and
flows of income.
Current Account Surplus (CAS) refers to excess of receipts
from value of export of visible items, invisible items and
unilateral transfers over payments for value of import of visible
items, invisible items and unilateral transfers. It is relatively
broader concept as compared to trade surplus. CAS signifies
that the nation is a lender to the rest of the world.
Current Account Deficit (CAD) arises when the value of
exports of visible items, invisible items and unilateral transfers
is less than the value of imports of visible items, invisible items
and unilateral transfers. It is relatively broader concept as
compared to trade deficit. CAD signifies that the nation is a
borrower from the rest of the world.
Capital Account
Capital Account records all international transactions of
assets, e.g. money, stocks, bonds, government debt, etc.
It has three components:
1. Foreign Investments: (i) Direct Investment, e.g. Foreign
Direct Investments (FDIs) (ii) Portfolio Investment, e.g.
Foreign Institutional Investments (FIIs).
2. External Borrowings, e.g. External Commercial
Borrowings, Short-term Debt.
External Assistance, e.g. Government Aid, Inter-
governmental, Multilateral and Bilateral Loans.
Balance on Capital Account
Surplus in capital account arises when capital inflows (like
receipt of loans from abroad, sale of assets or shares in
foreign companies) are greater than capital outflows (like
repayment of loans, purchase of assets or shares in foreign
countries).
Deficit in capital account arises when capital inflows are
lesser than capital outflows.
Question 1
What does the Balance of payments (BoP) accounts record?
(a) Transactions in goods, services and assets between
residents of a country with the rest of the world
(b) Transactions in foreign exchange assets and liabilities
(c) Inflows and outflows of foreign exchange during a
fiscal year.
(d) None of these
Answer 1
(c) Inflows and outflows of foreign exchange during a
fiscal year.

Question 2
________ of Balance of payments (BoP) is the record
of trade in goods and services and transfer payments.
(Current Account/Capital Account)

Answer 2
Current Account

Question 3
Which of the following is true for Transfer Payments in
the Current Account of Balance of Payments?
(a) Transfer payments are the receipts which the
residents of the country get for free, without having
to provide any goods and services in return.
(b) They consist of gifts, remittances and grants.
(c) They could be given by the government or by
private citizen living abroad.
(d) All of these
Answer 3
(d) All of these

Question 4
“Domestic demand for goods and demand for domestic
goods are one and the same thing.”

Answer 4
False: In an open economy, aggregate demand for
domestic goods equals domestic demand for goods
(consumption investment and government spending)
plus exports and minus imports.
Purchase of foreign goods (i.e. imports) decreases the
domestic demand for goods of our country; whereas
exports adds to the demand for domestic goods.

Question 5
Which of the following is not a component of the current
account of Balance of Payments?
(a) Exports and imports of goods and services
(b) Remittances given by private citizens living abroad
(c) Net international income from compensation of
employees

Answer 5

Question 6
Current Account Deficit (CAD) means:
(a) The value of exports of goods and services is less
than the value of imports of goods and services.
(b) The nation is a borrower from other countries.
(d) The nation is a lender to other countries.

Answer 6

Question 7
Current Account Surplus (CAS) means:
(a) The value of exports of goods is more than the
value of imports of goods.
(b) The nation is a lender to the rest of the world
(d) The nation is a borrower from other countries.

Answer 7
(b) The nation is a lender to the rest of the world

Question 8
_____________ is the difference between the value of
exports and value of imports of goods of a country in a
given period of time.
(Fill in the blank)

Answer 8
Balance of Trade (BoT) or Trade Balance

Question 9
Exports of goods is entered as a _____ item in Balance
of Trade (BoT), whereas import of goods is entered as a
______ item in BoT. (debit/credit)

Answer 9
(i) credit
(ii) debit

Question 10
__________ will arise if a country imports more goods
than what it exports. Whereas, ___________ will arise if
the country exports more goods than what it imports.

Answer 10
(i) Deficit BoT or Trade Deficit
(ii) Surplus BoT or Trade Surplus

Question 11
__________ is the difference between the value of
exports and value of imports of services, transfers and
flows of income of a country in a given period of time.
(a) Balance of Trade
(b) Net invisibles
(c) Trade Surplus
(d) Current Account Surplus

Answer 11
(b) Net invisibles

Question 12
_______________ of Balance of Payments records all
international transactions of assets.
(Fill in the blank)

Answer 12
Capital Account

Question 13
Capital Account of BoP records all international
transactions of assets. Which of the following is
not included in assets?
(a) Money
(b) Stocks and bonds
(c) Machinery
(d) Government debt

Answer 13
(c) Machinery

Question 14
If an Indian buys a UK Car Company, it enters ________
(Current Account/Capital Account) of Balance of
Payments as a _________ (debit/credit) item.
(Fill up the blanks with correct option)

Answer 14
(i) Capital Account (since it is an international
transaction of assets)
(ii) Debit (as foreign exchange is flowing out of India)

Question 15
Sale of share, of an Indian Company to a Chinese
customer is a ___________ (debit/credit) item on
the _______________ (Current Account/Capital
Account) of Balance of Payments.

Answer 15
(i) credit (as it leads to inflow of foreign exchange into
the country)
(ii) Capital account (since it is an international transaction
of assets)

Question 16
Which of the following is not included in the capital
account of the Balance of Payments?
(a) Foreign Direct Investments (FDIs)
(b) Foreign Institutional Investments (FIIs)
(c) External assistance

Answer 16

Question 17
Foreign Investments include:
(a) Direct Investment, e.g. FDI, Equity Capital, Reinvestment
earnings and other Direct Capital Flows:
(b) Portfolio Investment, e.g. FII, off share Funds

Answer 17

Question 18
___________ in capital account arises when capital
inflows (like receipt of loans from abroad, sale of assets
or share in foreign companies) are greater than capital
outflows (like repayment or loans, purchase of assets or
shares in foreign countries), whereas, __________ in
capital account arises when capital inflows are lesser than
capital outflows. (Deficit/Surplus)

Answer 18
(i) Surplus
(ii) deficit

Question 19
Receipts of loans from abroad is recorded as a ________
(debit/credit) item in the _____ (Current account/capital
account) of Balance of Payments.

Answer 19
(i) Credit
(ii) Capital account

Question 20
Which of the following is not recorded in the Capital
Account of Balance of Payments?
(a) Equity capitals
(b) Gifts, Remittances and Grants
(c) Government Aid
(d) Offshore Funds

Answer 20
(b) Gifts, Remittances and Grants

Question 21
Which of the following is recorded in the capital account
of Balance of Payments?
(a) Reinvested Earnings
(b) Inter-governmental multilateral and bilateral loans
(c) Short term debt
(d) All of these

Answer 21
(d) All of these

Question 22
It is difficult to record all international transactions
accurately. Thus, a third element of BoP (apart from the
current and capital accounts), called ______________
reflects this.
(Fill in the blank)

Answer 22
Errors and omissions

Question 23
An increase in foreign income improves the trade balance.

Answer 23
True: An increase in foreign income leads to increased
exports.
Thus, trade balance (= exports of goods – imports of
goods) increases.

Question 24
_________ is the sum of the balance of merchandise
trade, services and net transfers received from the rest
of the world.

Answer 24
Current Account balance

Question 25
If inflation is higher in country A than in country B, and the
exchange rate between the two countries is fixed what is
likely to happen to the trade balance between two
countries? (Choose the correct alternative)
(a) Trade balance of country A will share a deficit whereas
trade balance of country B will show a surplus.
(b) Trade balance of country A will show a surplus
whereas trade balance of country B will show a deficit.
(c) Balance of trade of both the countries will be in
balance
Answer 25
(a) Trade balance of country A will share a deficit whereas
trade balance of country B will show a surplus.
Hint: Effect on trade balance of country A
Since prices of goods in country A are more than that
in country B, it exports will decrease an imports will
increase. Thus, trade balance (= exports of goods –
imports of goods) will show a deficit.
Effect on trade balance of country B
Its exports of goods will increase and imports of
goods will decrease. Thus, trade deficit will show a
surplus.
Question 26
Interest on loan received from Nepal is recorded on
the _____________ (debit side/credit side) of the
__________ (current account/capital account) of the
Balance of Payments.

Answer 26
(i) Credit side
(ii) Current account
Hint:
Credit side; as brings foreign exchange into the country
Current account; as it is a part of net factor income
(net investment income).

Question 27
Import of mobile phones from China is recorded on
the ____________ (debit side/credit side) of the
__________ (current account/capital account) of the
Balance of Payments.

Answer 27
(i) Debit side
(ii) Current account
Hint:
Debit side; as it represents outflow of the foreign
exchange from the country
Current account; as it is an import of goods/visibles.

Question 28
A company located in India receives a loan from a company
located abroad. How is this transaction recorded in India’s
balance of payments account?
(a) Credit side of current account
(b) Debit side of current account
(c) Credit side of capital account
(d) Debit side of capital account

Answer 28
(c) Credit side of capital account

Question 29
An Indian company located in India invests in a company
located abroad. This transaction is entered in India’s
balance of payments account on:
(a) credit side of current account
(b) debit side of current account
(c) credit side of capital account
(d) debit side of capital account

Answer 29
(d) debit side of capital account

Question 30
Which of the following will be entered as a Credit item
in the Balance of Payments of a country?
(a) Imports of goods and services
(b) Portfolio investments
(c) Purchase of foreign securities
(d) Transfer payments

Answer 30
(b) Portfolio investments

Question 31
Which of the following items is not included in the current
account of the Balance of Payments of a country?
(a) Interest, profits and dividends on assets abroad
(b) Income from software services
(c) Remittances from abroad
(d) Foreign direct investment

Answer 31
(d) Foreign direct investment

Question 32
Difference between value of exports and imports of
goods and services is called trade balance.

Answer 32
False: Trade balance is the difference between value of
exports of goods and imports of goods only. It does not
include exports and imports of services.

Question 33
External assistance is recorded in the current account of
the Balance of Payments.

Answer 33
False: External assistance (e.g. Government aid, Inter-
governmental, Multi-lateral and Bilateral Loans) is recorded
in the capital account of the Balance of Payments.

Question 34
Export and import of machines are recorded in capital
account of the balance of payments account.

Answer 34
False: Export and import of machines is the export and
import of goods. Therefore, it is recorded in the Current
account of the Balance of Payments account.

Question 35
Foreign investments are recorded in the capital account of
balance of payments.

Answer 35
True: Foreign investments, e.g., foreign direct investment
are the international transactions of assets during a fiscal
year. Therefore, foreign investments are recorded in the
capital account of balance of payments.

Question 36
In balance of payments, repayment of loans by Indian
government to US Government will be recorded on
the credit side of current account.

Answer 36
False: It will be recorded in the capital account since
loan from US Government is an international liability.
The repayment of loans results in outflow of foreign
exchange. Therefore, it will be recorded on the debit
side.

Question 37
In the context of balance of payments of a country,
state whether the following statement is true or
false. Give reason for your answer.
Profits received from investments abroad is recorded in
capital account.

Answer 37
False: Profits received from investments abroad is
recorded in the current account since it is an investment
income (factor income). Factor income includes net
international earning of factors of production.
It will be recorded on the credit side of the current
account since it leads to inflow of foreign exchange.

Question 38
In the context of balance of payments of a country,
state whether the following statement is true or
false. Give reason for your answer.
Import of machines is recorded in current account.

Answer 38
True: All imports and exports of goods are recorded in
the current account. Import of machines is simply import
of a good.

Question 39
The current account of BoP includes transactions related
to:
(a) Financial assets
(b) Borrowing from foreign countries
(c) Export and import of invisible items
(d) Foreign investment

Answer 39
(c) Export and import of invisible items

Question 40
Which one is the component of current account of BoP?
(a) Invisibles
(b) Foreign Direct Investment
(c) Banking Capital
(d) Loans

Answer 40
(a) Invisibles

Question 41
Which of the following items are included in current
account BoP?
(a) Foreign Investment
(b) External Borrowings
(c) External Assistance
(d) Non-factor income

Answer 41
(d) Non-factor income

Question 42
Borrowing and lending money in international money
market is a part of current account in BoP.

Answer 42
False: Borrowing and lending money in international
money market is a part of capital account in BoP.

Question 43
Purchase of shares of a foreign company are included
in credit side of Capital account.

Answer 43
False: It is recorded on the debit side of capital account
of BoP as there will be outflow of foreign exchange.

Question 1
“A country with trade deficit cannot have current account
surplus in its Balance of Payments”. Do you agree with
given statement? Discuss with reason.
HOTS — Analysing, Evaluating & Creating Type Questions

Answer 1
No, trade deficit occurs when value of goods/visibles
imported is more than the value of goods/visibles
exported.
Trade deficit = Value of imports(Vm) < Value of
exports (Vx)
Trade Surplus in this situation will arise when the
deficit on trade account is less than the surplus on
account of invisibles.

Question 2
State on which side of capital account/current account
will the following transactions be recorded and why:
(i) Interest on loan received from Nepal
(ii) Import of mobile phones from China

Answer 2
(i) Interest on Loan received from Nepal - It will be
recorded on the credit side of the current account
as it brings in funds to the country.
(ii) Import of mobile phones from China - It will be
recorded in the debit/payment side of the current
account as it is represents outflow of the foreign
currency through visible imports.

Question 3
Distinguish between Balance of Trade and Balance of
Payments.
(3 marks)

Answer 3
Balance of Trade (or trade balance) is the difference
between value of exports and imports of goods. Its
scope is narrower since it records transactions in
goods only.
Balance of payments is an account which records the
transactions in goods, services, incomes, transfers and
assets between residents of a country with the rest of
the world. It reveals the true picture of a country’s
international transactions.

Question 4
Where will sale of machinery to abroad be recorded in
the Balance of Payments Accounts? Give reasons.

Answer 4
Sale of machinery to abroad is export of goods and thus
recorded in the Current Account. Sale of machinery to
abroad brings in foreign exchange and thus recorded on
the credit side.

Question 5
In which sub-account and on which side of balance of
payments account, will foreign investments in India be
recorded? Given reasons.
(3 marks)

Answer 5
Foreign investment will be recorded in the capital account
of the balance of payments account because these give
rise to foreign exchange liabilities.
Foreign investment will be recorded on the credit side
because these bring in foreign exchange to the economy.

Question 6
In which sub-account and on which side of balance of
payments account, will Profits received from investments
abroad be recorded? Given reasons.
(3 marks)

Answer 6
Profits received from investments abroad is recorded in
the current account since it is an investment income
(factor income).Factor income includes net international
earning of factors of production.

Question 7
Where will (a) import of machinery and (b) charity to
foreign countries be recorded in the Balance of Payments?
Give reasons.
(4 marks)

Answer 7
(a) Imports of Machinery is recorded as visible items in
the current account, because it is simply import of a
good. It is recorded as a debit item because it leads to
outflow of foreign exchange.
(b) Charity to foreign countries is recorded in the current
account of BoP because it is a transfer payment. It is
recorded on the debit side because it leads to outflow
of foreign exchange.

Question 8
Where will (a) Remittances from family members from
abroad and (b) Borrowings from abroad be recorded in
the Balance of Payments? Give reasons.
(4 marks)

Answer 8
(a) Remittances from family members from abroad is
accounted for under unilateral transfers of the current
account. It is recorded on the credit side because it
brings in foreign exchange into the country.
(b) ‘Borrowings from abroad’ is recorded in the ‘capital
account’ of BoP because it increases international
liability of the country. It is recorded on the credit side
because it brings in foreign exchange into the country.

Question 9
Are the following entered (i) on the credit side or the
debit side and (ii) in the current account or capital
account in the Balance of Payments? You must give
reason for your answer.
(a) Transfer of funds to relatives abroad.
(b) Imports of Petroleum, Oil and Lubricants (POL)
(4 marks)

Answer 9
(a) It is a transfer payment which results into outflow of
foreign exchange from the country, so it is recorded
on the debit side of the Current account of Balance
of Payments (BoP).
(b) Imports of Petroleum, Oil and Lubricants (POL) is
the imports of goods, which involve outflow of
foreign exchange from the country, so it is recorded
on the debit side of the Current account of BoP.

Question 10
In the context of balance of payments account, state
whether the following statements are true or false. Give
reasons for your answer.
(a) Profits received from investments abroad is recorded
in capital account.
(b) Import of machines is recorded in current account.

Answer 10
(a) False: Profits received from investments abroad is
recorded in the current account since it is an
investment income (factor income). Factor income
includes net international earning of factors of
production.
(b) True: All imports and exports of goods are recorded
in the current account, because it is simply import/
export of a good.

Question 11
Giving reason explain how the following will be entered
in (i) current account or capital account and (ii) on
credit side or debit side of balance of payments:
(a) Imports of machinery
(b) Investments from abroad

Answer 11
(a) Imports of Machinery
(i) Recorded as visible items in the current account,
because it is simply an import of a good.
(ii) Recorded on debit side because it leads to
outflow of foreign exchange.
(b) Investments from abroad
(i) Recorded in capital account because it is a
transaction in assets.
(ii) Recorded on credit side because it leads to inflow
of foreign exchange.
Question 12
Given the exchange rate, what is the effect of fall in
domestic prices on aggregate demand?
(3 marks)

Answer 12
If prices of domestic goods fall, exports become cheaper.
So, domestic exports will increase. Since exchange rate
remains constant, imports remain unchanged. As a result,
net exports (i.e., exports – imports) will increase. Since
net exports is a component of aggregate demand,
therefore, aggregate demand will increase.

Question 13
If inflation is higher in country A than in country B, and
the exchange rate between the two countries is fixed,
what is likely to happen to the trade balance between
the two countries? Explain.
(3 marks)

Answer 13
Effect on trade balance of country A: Since prices of
goods in country A are more than that in country B, its
exports to country B will decrease and imports from
country B will increase.
Thus, trade balance (i.e., value of exports of goods –
value of imports of goods) will show a deficit.
Effect on trade balance of country B: Since price of goods
in country B are relatively less than that in country A, its
exports to country A will increase and imports from
country A will decrease. Thus, trade balance will show a
surplus.
Question 14
What will be the effect of the following on the Balance
of Payments of India?
(a) ‘Make in India’ Programme
(b) Import of Pulses
(3 marks)

Answer 14
(a) ‘Make in India’ will increase supply (inflow) of
foreign exchange in India, causing improvement in
the balance of payments position.
(b) Import of pulses will lead to outflow of foreign
exchange from the country, causing adverse effect
on balance of payment position.

NUMERICAL 1
If the value of exports of goods of a country is `1,000 crore

and the value of imports of goods is `1,650 crore, calculate
the trade balance of the country. (1 mark)
Solution: Trade balance or Balance of trade
= Value of exports of goods – Value of imports of goods
= 1,000 – 1,650 = (–)`650 crore
Thus, there is a trade deficit of `650 crore.
Do it yourself 1
If the value of exports of merchandise of a country is `800
crore and the value of imports of merchandise is `650 crore,
calculate the trade balance of the country. (1 mark)
[Ans. Trade surplus of `150 crore]
NUMERICAL 2
If the balance of trade of a country is showing a deficit of `400

crore and the value of imports of goods is `1,100 crore, then
what is the value of exports of goods? (1 mark)
Solution: Trade balance or Balance of trade = Value of exports
of goods – Value of imports of goods
Since there is trade deficit of `400 crore, trade balance = (–)
`400 crore and value of imports of goods = `1,100 crore,
therefore, (–) `400 crore = Value of exports of goods – `1,100
crore Value of exports of goods = – 400 + 1,100 = `700 crore
Do it yourself 2
If a country has trade surplus of `200 crore and the value of
exports of goods is `700 crore, then what is the value of
imports of goods? [Ans. `500 crore] (1 mark)
Foreign Exchange Rate – Fixed and
5.2
Flexible Rates and Managed Floating
Foreign exchange or foreign currency refers to any
currency other than the domestic currency.
The market in which national currencies are traded for
one another is known as the foreign exchange market.
The major participants in the foreign exchange market
are commercial banks, foreign exchange brokers and
other authorised dealers and monetary authorities.
It is important to note that although participants
themselves may have their own trading centres , the
market itself is world-wide. There is a close and
continuous contact between the trading centres and
the participants deal in more than one market.
Foreign Exchange Rate
Foreign Exchange Rate (also called 'Forex Rate') is the
price of one currency in terms of another. It links the
currencies of different countries and enables comparison
of international costs and prices. For example, if we have
to pay 70 rupees for one dollar, then the exchange rate is
`70/$.
Foreign exchange rate is the rate at which one currency
can be converted into another currency.
Different countries have different methods of determining
their currency’s exchange rate. It can be determined through
Flexible Exchange Rate, Fixed Exchange Rate or Managed
Floating Exchange Rate.
Flexible (or Floating) Exchange Rates
An exchange rate determined by the forces of demand
and supply in the foreign exchange market is flexible or
floating exchange rate.
In a completely flexible exchange rate system (i.e. clean
floating), the central banks do not intervene in the
foreign exchange market.
A central bank does not maintain any reserves of foreign
currency as the market automatically adjusts to determine
the market driven exchange rate. Therefore, there are no
official reserve transactions.
Demand for Foreign Exchange in the foreign
exchange market
People demand foreign exchange because of the following
reasons. These are sources of demand because these lead
to outflow of foreign exchange.
(i) Imports: Importers need foreign exchange for
making payments for buying goods and services
from abroad.
(ii) Foreign transfer payments: For transfer payments
to any other country in the form of gifts, grants or
remittances, etc. foreign currency is needed.
(iii) Investments abroad: For investment in other
countries, e.g. purchase of financial assets like shares,
bonds, etc. abroad, foreign currency is needed.
(iv) Tourism abroad: Foreign currency is needed for
foreign travel, for example, Indian people visiting
abroad on a vacation say, for sight-seeing etc.
(v) Foreign exchange speculation: Another reason for
the demand for foreign exchange is for speculative
purposes. Foreign exchange is demanded for the
possible gains from appreciation of the foreign
currency. If speculators believe that the British
pound is going to increase in value relative to the
rupee, they will want to hold pounds. For instance,
if the current exchange rate is `90/£ and investors
believe that the pound is going to appreciate by
the end of the month and will be worth `95 (i.e.,
exchange rate will rise to `95/£), investors think if
they took `90000 and bought 1000 pounds, at the
end of the month, they would be able to exchange
the pounds for `95000, thus making a profit of
`5000. This expectation would increase the demand
for pounds in the foreign exchange market.
Inverse/Negative Relationship between
Foreign exchange rate and demand for
Foreign exchange
A rise in price of foreign exchange causes decrease in
demand for foreign exchange and vice-versa.
Explanation: A rise in price of foreign exchange will
increase the cost (in terms of rupees) of purchasing a
foreign good. For example, if rupee-dollar exchange rate
rises from `70/$ to `75/$, Indians have to pay more
rupees to import US goods. This reduces demand for
imports of foreign goods (US goods). This results in less
outflow of foreign exchange from India. Therefore,
demand for foreign exchange (Dollars) decreases, other
things remaining constant.
Sources of supply of foreign exchange in the
foreign exchange market
Foreign currency flows into the home country due to the
following reasons. These are sources of supply because these
lead to inflow of foreign exchange.
(i) Exports: All exports of goods and services by domestic
residents bring foreign exchange into the country.
(ii) Foreign Investments: Foreign Direct Investment
(FDI), Portfolio Investments, e.g. Foreign Institutional
Investment (FII) add to the supply of foreign exchange
as these bring in foreign exchange into the country.
(iii) Foreign tourism: Foreign tourists coming to India,
say to visit Vrindavan bring foreign currency into the
country.
(iv) Other sources of supply of foreign exchange:
Factor income earned from abroad, Remittances
from abroad, e.g. NRIs send gifts or make
transfers, Loans and grants from abroad, Interest
received on loans to abroad, etc. are also received
in foreign currency.
Direct/Positive Relationship between
Foreign exchange rate and demand for
Foreign exchange
A rise in price of foreign exchange causes increase in
supply of foreign exchange and vice-versa.
Explanation: A rise in price of foreign exchange will
reduce the foreigners’ cost (in terms of foreign
currency) while purchasing goods from India, other
things remaining constant. For example, if rupee-dollar
exchange rate rises from `70/$ to `75/$, US dollars can
now buy more of domestic goods. That is, exported
goods become cheaper in the international market
giving a competitive edge for the goods of domestic
country (India). As exported goods become cheaper,
this increases exports of India. This results in more
inflow of foreign exchange. Therefore, supply of foreign
exchange (Dollars) increases, other things remaining
constant.
 Top Tip
Link between the balance of payments accounts and the
transactions in the foreign exchange market:
Outflow of foreign exchange on account of imports of goods
and services, investments made abroad, etc. (total debits in
the BoP accounts) represent the demand for foreign
exchange in the foreign exchange market.
Conversely, total credits in the BoP accounts, e.g., inflow of
foreign exchange for all exports of goods and services,
external borrowings, foreign investments, etc. represent the
supply of foreign exchange in the foreign exchange market.
Fixed Exchange Rates
Under fixed exchange rate system, the Government fixes
the exchange rate at a particular level. The Central Bank
actively uses its foreign exchange reserves to maintain the
officially determined exchange rate.
An exchange rate between the two currencies fixed at
government level is called fixed exchange rate.
The market determined exchange rate is `70/$. However,
let us suppose that for some reason the Indian
Government wants to encourage exports for which it
needs to make rupee cheaper for foreigners it would do so
by fixing a higher exchange rate, say `75 per dollar from
the current exchange rate of `70 per dollar. At this
exchange rate, the supply of dollars exceeds the demand
for dollars. The RBI intervenes to purchase the dollars
for rupees in the foreign exchange market in order to
absorb this excess supply which has been marked as
AB in the figure. Thus, through intervention, the
Government can maintain any exchange rate in the
economy. But it will be accumulating more and more
foreign exchange so long as this intervention goes on.
On the other hand, if the government was to set an
exchange rate at a lower level, there would be an excess
demand for dollars in the foreign exchange market. To
meet this excess demand for dollars, the government
would have to withdraw dollars from its past holdings
of dollars. If it fails to do so, a black market for dollars
may come up.
 Top Tips
Official reserve transactions are more relevant under a
regime of fixed exchange rates than when exchange rates
are floating.
Devaluation of domestic currency

In a fixed exchange rate system, when the government
increases the exchange rate (thereby, making domestic
currency cheaper in terms of a foreign currency) is called
Devaluation of domestic currency. In other words,
devaluation of domestic currency is reduction in the
value of domestic currency by the government with
respect to a given foreign currency.
Revaluation of domestic currency
In a fixed exchange rate system, when the government
decreases the exchange rate (thereby, making domestic
currency costlier in terms of a foreign currency) is called
Revaluation of domestic currency.
Managed Floating Exchange Rates
Without any formal international agreement, the world
has moved on to what can be best described as a managed
floating exchange rate system.
In a system of managed floating exchange rates, the
exchange rate is determined by the combined forces of
demand and supply of foreign exchange, but the Central
Bank may intervene to buy or sell foreign currencies in
order to control the exchange rate fluctuations. Official
reserve transactions are, therefore, not equal to zero.
Managed floating exchange rate is the floating (or flexible)
exchange rate which can be influenced by the intervention
of the Central Bank in the foreign exchange market.
Thus, managed floating exchange rate system is the
amalgamation of the flexible exchange rate system and
the fixed exchange rate system because managed
floating exchange rate is decided by market forces (the
float part) but remains within a specific range as
decided by central bank (the managed part).
 Top Tips
Managed floating exchange rate system is also called 'dirty floating'
as the clean floating rate is influenced by the intervention of the
Central Bank in the foreign exchange market.
Key Terms
Foreign exchange market – The market in which national
currencies are traded for one another is known as the foreign
exchange market.
Foreign exchange rate – Foreign Exchange Rate (also called
'Forex Rate') is the rate at which one currency can be
converted into another currency.
Flexible (or Floating) Exchange Rates – An exchange rate
determined by the forces of demand and supply in the
foreign exchange market is flexible or floating exchange rate.
Equilibrium exchange rate – Equilibrium exchange rate is
the rate at which market demand and supply of foreign
exchange are equal.
Fixed exchange rate – An exchange rate between the two
currencies fixed at government level is called fixed exchange
rate.
Devaluation of domestic currency – In a fixed exchange rate
system, when some government action increases the exchange
rate (thereby, making domestic currency cheaper) is called
Devaluation of domestic currency.
Revaluation of domestic currency – In a fixed exchange rate
system, when some government action decreases the
exchange rate (thereby, making domestic currency costlier) is
called Revaluation of domestic currency.
Managed floating exchange rate (also called 'dirty floating') –
Managed floating exchange rate is the floating (or flexible)
exchange rate which can be influenced by the intervention of
the Central Bank in the foreign exchange market.
Question 1
___________ links the currencies of different countries
and enables comparison of international costs and prices.
(Fill in the blank)

Answer 1
Foreign Exchange Rate (also called Forex Rate)

Question 2
The market in which national currencies are traded for
one another is known as the ____________.
(Fill in the blank)

Answer 2
Foreign exchange market

Question 3
Which of the following is a major participant in the foreign
exchange market?
(a) Commercial banks
(b) Foreign exchange brokers and other authorised dealers
(c) Monetary authorities

Answer 3

Question 4
People demand foreign exchange because:
(a) They want to import goods and services.
(b) They want to purchase financial assets from abroad
(c) They want to send gifts abroad

Answer 4

Question 5
Which of the following is not a source of supply of foreign
exchange?
(a) Exports
(b) Speculation
(c) Transfer receipts
(d) Foreign Direct Investment (FDI)

Answer 5
(b) Speculation

Question 6
Match the columns:
Column I Column II
(i) This exchange rate is determined (a) Fixed exchange rate
by the market forces of demand
and supply
(ii) This exchange rate is determined (b) Flexible exchange rate
by the market forces of demand
and supply, with central bank
intervention to buy and sell
foreign currencies in an attempt
to moderate exchange rate
movements.
(iii) This exchange rate is fixed by the (c) Managed floating exchange rate
Government at a particular level.
Answer 6
(i) – (b), (ii) – (c), (iii) – (a)

Question 7
Under managed floating official reserve transactions are
equal to zero.

Answer 7
False: In case of managed floating, central banks intervene
to reduce fluctuations in the exchange rate.
Official reserve transactions are, therefore not equal to
zero. However, under clean floating, the exchange rate is
market determined without any central bank intervention.
So, official reserve transactions are equal to zero.

Question 8
Without any formal international agreement the world
had moved on to what can be best described as a
_______________ exchange rate system. (flexible/fixed
/managed floating).

Answer 8
managed floating

Question 9
Why does the central bank need to intervene in a
managed floating system?
(a) To reduce fluctuations in the exchange rate.
(b) To maintain the exchange rate at the specified level.
(c) To cover the surplus and deficits in the BoP.

Answer 9
(a) To reduce fluctuations in the exchange rate.

Question 10
Managed floating exchange rate system is a mixture of a
flexible exchange rate system and a fixed rate system.

Answer 10
True: Under managed floating exchange rate system, the
exchange rate is determined by the market forces of
demand and supply of foreign exchange (the float part)
but the central banks need to intervene to buy and sell
foreign currencies in an attempt to moderate exchange
rate movements whenever they feel that such actions are
appropriate (the managed part).

Question 11
If there is a deficit in the BoP, governments will have to
intervene to take care of the gap by use of its official
reserves. Which of the following exchange rate system
has been described above?
(a) Flexible exchange rate system
(b) Fixed exchange rate system
(c) Managed floating exchange rate system

Answer 11

Question 12
_____________ (Fixed/Floating) exchange rates system
automatically takes care of the surplus and deficits in the
BoP.

Answer 12
Floating

Question 13
In a ____________ the central banks do not intervene
in the foreign exchange market.
(a) Completely flexible exchange rate system, i.e. clean
floating
(b) Fixed exchange rate system
(d) Managed floating exchange

Answer 13
(a) Completely flexible exchange rate system, i.e. clean
floating

Question 14
In a fixed exchange rate system, when some government
action increases the exchange rate, it is called _________.
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) Revaluation

Answer 14
(c) Devaluation

Question 15
__________ is said to occur, when the Government
decreases the exchange rate in a fixed exchange rate
system.
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) Revaluation

Answer 15
(d) Revaluation

Question 16
Suppose the market determined exchange rate is `70/$.
However, the Indian Government fixes a higher exchange
rate of `75/$ for some reason. The is called ________ of
Rupee. The purpose of the Indian Government may be
___________.

Answer 16
Devaluation, to encourage domestic exports to US for
which it needs to make rupee cheaper for foreigners.

Question 17
The market determined exchange rate is `65/$. However,
to encourage exports the RBI devalued rupee by fixing a
higher exchange rate `75/$. How will the RBI intervene
to maintain the fixed exchange rate of `75/$?
(a) The RBI will withdraw dollars from its past holdings
of dollars to meet the excess demand for dollars in
the foreign exchange market.
(b) The RBI will purchase the dollars for rupees in the
foreign exchange market in order to absorb the
excess supply of dollars
(c) The RBI will follow the managed floating exchanges
rate system
Answer 17
(b) The RBI will purchase the dollars for rupees in the
foreign exchange market in order to absorb the
excess supply of dollars

Question 18
When the market determined exchange rate is higher
than the exchange rate fixed by the government there
will be ___________ (excess demand/ excess supply) of
foreign exchange in market. The government will ______
(buy/sell) foreign exchange from its resources. If it fails to
do so, a black market for foreign exchange may come up.
When people know that the amount of reserves is
inadequate, they would begin to doubt the ability of the
government to maintain the fixed exchange rate. This may
give rise to _____________. When this belief translates
into aggressive buying of one currency thereby forcing
the government to devalue, it is said to constitute a
speculative attack on a currency.
Answer 18
(i) excess demand
(ii) sell
(iii) Speculation of devaluation

Question 19
Excess demand of foreign exchange implies there is ____
in the BOP. Thus, the Central Bank will have to intervene
to take care of the gap by ______________.

Answer 19
(i) deficit
(ii) use of its official reserves of foreign exchange

Question 20
__________ (Fixed/Flexible) exchange rate system gives
the government more flexibility and they do not need to
maintain large stock of foreign exchange reserves.

Answer 20
Flexible

Question 21
The flexible exchange rate system is also called ________
because exchange rate movements automatically take care
of the surpluses and deficits in the BOP. The Central Banks
do not have to intervene to maintain exchange rate which
are automatically taken care of by the market.
On the other hand, the managed floating exchange rate
system is also called ____________ as central banks
intervene to buy and sell foreign currencies to moderate
exchange rate movements in the foreign exchange market.

Answer 21
(i) Clean floating
(ii) Dirty Floating

Question 22
Which of the following is a source of supply of foreign
currency?
(a) Investments made abroad
(b) Loans and grants from abroad
(c) Imports of goods and services
(d) Tourists going abroad

Answer 22
(b) Loans and grants from abroad

Question 23
State giving reason, whether the following
The official reserve transactions are relevant under
fixed exchange rate system.

Answer 23
True: Under fixed/pegged exchange rate system, the
Central Bank actively uses its foreign exchange reserves
to maintain the officially determined exchange rate. Thus,
the official reserve transactions are relevant under a
regime of pegged or fixed exchange rates.

Question 24
Price of one currency in relation to foreign currencies is
determined by forces of demand and supply is known as:
(a) Equilibrium Rate
(b) Fixed exchange Rate
(c) Exchange Rate
(d) Flexible exchange Rate

Answer 24
(d) Flexible exchange Rate

Question 25
Occasional intervention by the central bank to influence
the exchange rate is known as:
(a) Managed floating
(b) Hedging
(c) Appreciation
(d) Depreciation

Answer 25
(a) Managed floating

Question 26
Which of the following is a source of supply of foreign
exchange?
(a) Current transfers to abroad
(b) Speculation
(c) Portfolio investment
(d) None of these

Answer 26
(c) Portfolio investment

Question 27
The component of demand for foreign exchange are:
(a) Repayment of international debts
(b) Imports
(c) Exports
(d) Remittances from abroad

Answer 27
(b) Imports

Exchange Rate in a Free Market:
5.3 Effects of Change in Demand and
Supply
Effects of Increase in Demand for Foreign
Exchange
Increase in demand for foreign exchange may be due
to the following reasons:
(i) Rise in imports of foreign goods and services, for
example, due to increased international travelling
by Indians,
(ii) Purchasing more financial assets abroad,
(iii) Increase in demand for foreign exchange for
speculative purposes,
(iv) Increase in transfer payments to foreign countries,
etc.
Effect on the exchange rate
 Due to increase in demand for foreign exchange, the
demand curve shirts upward and right to the original
demand curve.
 Supply of foreign exchange remaining same, increase
in demand will cause excess demand of foreign
currency at the prevailing foreign exchange rate.
 As a result, a new equilibrium rate of foreign exchange
rate will be determined which will be higher than the
prevailing foreign exchange rate.
 Thus, there will be a rise in the foreign exchange rate
(say from `70/$ to `75/$), other things remaining
unchanged.
 Rise in the price of foreign exchange, say `70/$ to
`75/$ implies ‘depreciation’ of domestic currency
(rupees).
Depreciation is the fall in the value of domestic currency
in relation to a foreign currency caused by rise in foreign
exchange rate in the foreign exchange market under the
flexible exchange rate system.
Depreciation of rupee indicates that the value of rupees
in terms of dollars has fallen. Clearly, a rise in exchange
rate from `70/$ to `75/$ means that we need to pay more
rupees for a dollar now.
Effect of depreciation of domestic currency
on exports and imports
Depreciation of domestic currency (rupees) normally
increases exports from a country, as exports become
cheaper for the foreign nationals and foreign currency
can now buy more of domestic goods, i.e., the international
competitiveness of the goods and services of the nation
gets better.
On the other hand, Depreciation of domestic currency
(rupees) will increase the cost (in terms of rupees) of
purchasing a foreign good. Indians will have to pay more
rupees to import foreign goods. This reduces demand for
imports of foreign goods. Thus, imports fall.
Effect on national income
Since exports rise and imports fall, therefore, Net Exports
(= Exports – Imports) will increase. An increase in Net
Exports will increase the national income, other things
remaining unchanged.
 Top Tips
1. Effects of decrease in demand for foreign exchange
Due to decrease in demand for foreign exchange, the demand curve
shifts leftwards to the original demand curve. Supply of foreign
exchange remaining same, decrease in demand will cause excess supply
of foreign currency at the prevailing foreign exchange rate. As a result, a
new equilibrium rate of foreign exchange rate will be determined which
will be lower than the prevailing foreign exchange rate. Thus, foreign
exchange rate is likely to fall, leading to appreciation of domestic
currency. (Appreciation will be discussed next.)
2. Depreciation of domestic currency implies appreciation of the foreign
currency.
Effects of Increase in Supply for Foreign
Exchange
Increase in supply for foreign exchange may be due to
the following reasons:
(i) Rise in exports of goods and services,
(ii) Increase in foreign investments(e.g. Foreign Direct
Investment, Portfolio Investments, etc.),
(iii) More foreign tourists coming to India, etc
Effect on the exchange rate
 Due to increase in supply of foreign exchange, the supply
curve shifts rightwards to the original supply curve.
 Demand for foreign exchange remaining same,
increase in supply will cause excess supply of foreign
currency at the prevailing foreign exchange rate.
 As a result, a new equilibrium rate of foreign exchange
rate will be determined which will be lower than the
 Thus, there will be a fall in the foreign exchange rate
(say from `70/$ to `68/$), other things remaining
unchanged.
 Fall in the price of foreign exchange, say `70/$ to `68/$
implies ‘appreciation’ of domestic currency (rupees).
In a flexible exchange rate system, when the price of
foreign currency (say, dollars) in terms of domestic
currency (rupees) falls, the value of domestic currency
in terms of foreign currency increases, it is called
appreciation of domestic currency.
Appreciation of domestic currency means that we need
to pay fewer rupees in exchange for one dollar.
For example, a fall in the exchange rate (say, from `70/$
to `68/$) indicates that the value of rupee relative to
dollar has increased since we need to pay only 68
rupees in exchange for one dollar.
Effect of appreciation of domestic currency
on exports and imports
Appreciation of domestic currency decreases exports
since domestic goods become costlier for the foreign
nationals. This is so because one unit of foreign currency
can now buy less of domestic goods, i.e. the international
competitiveness of the goods and services of the nation
gets worse.
On the other hand, due to appreciation of domestic
currency, the importers have now to pay less domestic
currency to import one unit worth of foreign currency
goods. Imports thus become cheaper. This raises demand
for imports.
Effect on national income
Since exports decrease and imports increase, therefore, Net
Exports (= Exports – Imports) will decrease. A decrease in
Net Exports will decrease the national income, other things
remaining unchanged.
 Top Tips
1. Effects of decrease in supply of foreign exchange
Due to decrease in supply of foreign exchange, the supply curve
shifts leftwards to the original supply curve. Demand for foreign
exchange remaining same, decrease in supply will cause excess
demand of foreign currency at the prevailing foreign exchange rate.
As a result, a new equilibrium rate of foreign exchange rate will be
determined which will be higher than the prevailing foreign exchange
rate. Thus, foreign exchange rate is likely to rise, leading to depreciation
of domestic currency.
2. Appreciation of domestic currency implies depreciation of foreign
currency.
Key Terms
Depreciation of domestic currency – Depreciation is the fall in

the value of domestic currency in relation to a foreign currency
caused by rise in foreign exchange rate in the foreign exchange
market under the flexible exchange rate system.
Appreciation of domestic currency – In a flexible exchange
rate system, when the price of foreign currency (say, dollars) in
terms of domestic currency (rupees) falls, the value of
domestic currency in terms of foreign currency increases, it is
called appreciation of domestic currency.
RECAP
Depreciation of domestic currency

It means fall in the value of domestic currency in terms of a foreign
currency caused by a rise in the exchange rate under the flexible
exchange rate system.
 Depreciation of home currency implies fall in the purchasing
power of domestic currency in terms of foreign currency.
 Depreciation of home currency implies fall in the price of
domestic goods for the foreign buyers.
Depreciation encourages exports as domestic goods become
cheaper for the foreign nationals, i.e., the international competitiveness
of the goods of the nation gets better.
However, depreciation will make imports of foreign goods costlier.
So, imports fall.
Since exports rise and imports fall, therefore, Net Exports (Exports
– Imports) will increase.
Therefore, national income is likely to rise.
Appreciation of domestic currency
It means a rise in the value of domestic currency in terms of a
foreign currency caused by a fall in the exchange rate under the
flexible exchange rate system.
 Appreciation of home currency implies that purchasing
power of home currency in terms of a foreign currency has
gone up.
 Appreciation makes foreign goods cheaper for the domestic
buyer.
Appreciation decreases exports since domestic goods become
costlier for the foreign nationals.
However, it will make imports cheaper for the Indian residents
since they have to pay less domestic currency to buy imported
goods. So, imports rise.
Since exports fall and imports rise, therefore, Net Exports
(Exports – Imports) will decrease.
Therefore, national income is likely to fall.
Question 1
A rise in price of foreign exchange will increase demand
for imports.

Answer 1
False: A rise in price of foreign exchange will increase
the cost (in terms of rupees) of purchasing a foreign
good. This reduces demand for imports,; other things
remaining constant.

Question 2
A rise in price of foreign exchange increases India’s
exports.

Answer 2
True: A rise in price of foreign exchange will reduce
the foreigner’s cost (in terms of USD) while purchasing
products from India other things remaining constant
this increase India’s exports.

Question 3
What will be the likely effects of increased international
travelling by Indians?
(a) Depreciation of Rupee
(b) Increase in exports
(d) Increase in imports

Answer 3

Question 4
In a flexible exchange rate regime, when the price of
domestic currency (rupees) in terms of foreign currency
(Dollars) decrease, it is called _____________ of the
domestic currency (rupees) in terms of foreign currency
(dollars).
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) Revaluation
Answer 4
(b) Appreciation

Question 5
Suppose the Rupee-Dollar exchange rate is `70/$. Indian
investors believe that USD is going to appreciate by the
end of the month and will be worth `75. The investors
think if they gave the dealer `70,000 and bought 1,000
dollars, at the end of the month, they would be able to
exchange the dollars for `75,000, thus making a profit of
`5,000.
What will be the likely effect of this speculation or
expectation on the exchange rate in the present?

(a) The exchange rate will increase.
(b) The exchange rate will decrease.
(c) The exchange rate will remain unchanged.

Answer 5
(a) The exchange rate will increase.

Question 6
A rise in the interest rates at home leads to ________
of the domestic currency. (depreciation/appreciation)

Answer 6
appreciation

Question 7
It government bonds in country A pay 8 per cent of
interest whereas equally safe bonds in country B yield
10 percent, what will be the likely effect on country A’s
currency?
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) No effect

Answer 7
(a) Depreciation
Hint: Due to interest rate differential of 2 per cent,
investors from country A will be attracted by the high
interest rates in country B and will buy the currency
of country B selling their own currency to make
investment in country B. So, demand for currency of
country B increases, causing depreciation of currency
of country A.

Question 8
If there is increase in income in the home country, the
domestic currency will be ___________. (depreciating
/appreciating)

Answer 8
Depreciating
Hint: When income increases, consumers spending
increases. Spending on imported goods is also likely to
increase. When imports increase, the demand for foreign
exchange increases. The exchange rate thus, is likely to
rise.There is a depreciation of the domestic currency.

Question 9
If there is an increase in income abroad the domestic
currency will be ________________. (depreciating/
appreciating)

Answer 9
appreciating
Hint: Due to an increases in income abroad, domestic
exports will rise and hence the supply of foreign
currency will increase. The exchange rate is likely to fall.
There is appreciation of domestic currency.

Question 10
If income increases in the home country as well as
abroad, what is the likely effect on the value of domestic
currency.
(a) Domestic currency will be depreciating
(b) Domestic currency will be appreciating
(c) Domestic currency may be depreciating or
appreciating

Answer 10
(c) Domestic currency may be depreciating or appreciating
Hint: with increase in income, demand for imported
goods and hence demand for foreign exchange increases.
With increase in income abroad as well, domestic exports
and hence supply of foreign exchange also increase.
On balance, the domestic currency may be depreciating
or appreciating
– If imports are growing faster than exports, domestic
currency will be depreciating
– If exports are growing faster than imports, domestic
currency will be appreciating
Question 11
Suppose a shirt costs $20 in the US and `1000 in India,
What will be the effect on exports of India if the
rupee-dollar exchange rate is `70/$?
(a) Exports will increase
(b) Exports will decrease
(c) Exports will remain unchanged

Answer 11
(a) Exports will increase
Hint: At the exchange rate `70/$, it costs `1,400 (=
`20) in the US but only `1,000 in India. Being cheaper,
exports of shirts from India will increase.

Question 12
Other things remaining unchanged when in a country
the price of domestic currency rises, national income
is:
(a) Likely to rise
(b) Likely to fall
(c) Not affected
(d) Likely to rise and fall both

Answer 12
(b) Likely to fall
Reason: When the price of domestic currency rises, it
denotes appreciation of domestic currency. So, imports
will rise and exports will fall, i.e. net exports will fall. So,
aggregate demand and hence national income will fall,
other things remaining unchanged.

Question 13
Suppose the present foreign exchange rate is of `70/$. It
rises to `75/$ leading to rise in prices of imports of
essential goods. How can the RBI help in bringing down
the foreign exchange rate which is very high?
(a) The RBI should withdraw dollars to sell them in the
(b) The RBI should purchase the dollars for rupees in
the foreign exchange market.
(c) The RBI should fix the exchange rate at lower level.
Answer 13
(a) The RBI should withdraw dollars to sell them in the
Hint: Selling dollars will cause increase in supply of
dollars in the foreign exchange market. It will lead
to a fall in the exchange rate.

Question 14
A fall in the external value of a currency as notified by the
government of the country is called _______________,
whereas a fall in the external value of a currency due to
the change in demand and supply of the currency in the
foreign exchange market is called _______________.

Answer 14
(i) Devaluation of currency
(ii) Depreciation of currency

Question 15
“Indian rupee (`) plunged to all time low of `74.48 against
the US Dollar ($).” What will be effect on National
Income of India, other things remaining the same?
(i) National Income will rise.
(ii) National Income will fall.
(ii) National Income may or may not fall.
(iv) National Income may or may not rise.

Answer 15
(i) National Income will rise.
Hint: Depreciation of Rupee will encourage exports
while discourage imports. Net exports (= Exports -
Imports) will increase. Hence, national income will rise,
other things remaining the same.

Question 16
“USA has accused China of currency devaluation to
promote its exports.” Is it true that by devaluating its
currency, China can promote its exports?

Answer 16
True: Devaluation of currency makes Chinese goods
cheaper in the international market. Thus, it promotes
exports of Chinese goods and may adversely impact the
production and sale of importing country.(USA)

Question 17
What is the likely impact of foreign exchange speculation
on the exchange rate?
(a) Exchange rate is likely to fall
(b) Exchange rate is likely to rise
(c) Exchange rate remains unchanged
(d) None of these

Answer 17
(b) Exchange rate is likely to rise

Question 18
Which of the following is likely to raise the foreign
exchange rate?
(a) Government gives incentives for exports.
(b) Government doubled the import duty on gold.
(c) Government promotes foreign direct investment.
(d) Visits to foreign countries by people increase.

Answer 18
(d) Visits to foreign countries by people increase.

Question 19
A rise in the interest rates at home leads to ________.
(a) Depreciation of foreign currency
(b) Depreciation of domestic currency
(c) Rise in exchange rate
(d) None of these

Answer 19
(a) Depreciation of foreign currency

Question 20
Other things remaining the same, when in a country
the price of foreign currency rises, national income is
likely:
(a) to rise
(b) to fall
(c) to rise or to fall
(d) to remain unaffected

Answer 20
(a) to rise

Question 21
An increase in demand for imported goods raises the
foreign exchange rate.
(True/False)

Answer 21
True: Demand for foreign exchange will increase in
order to make the payment for imported goods. Supply
of foreign exchange remaining unchanged, increase in
demand will cause the exchange rate to rise.

Question 22
How can increase in foreign direct investment, other
things remaining the same affect the foreign exchange
rate:
(a) Exchange rate will fall
(b) Exchange rate will rise
(c) No change in exchange rate
(d) None of these

Answer 22
(a) Exchange rate will fall

Question 23
When the exchange rate rises under managed floating,
it is called ______________ of domestic currency.
(a) Devaluation
(b) Appreciation
(c) Depreciation
(d) Revaluation

Answer 23
(c) Depreciation

Question 24
When there is depreciation of foreign currency, the supply
of foreign currency in domestic economy will:
(a) Increase
(b) Not change
(c) Either increase or decrease
(d) Decrease

Answer 24
(d) Decrease

Question 1
What is the role of a Central Bank in the following
exchange rate?
(a) Fixed exchange
(b) Floating exchange
(c) Managed floating

Answer 1
The role of the Central Bank in maintaining the foreign
exchange rates under different regimes is:
(a) Fixed exchange rate system: A Central Bank
actively uses its foreign currency reserves to
maintain the officially determined exchange rate
(b) Floating exchange rate system: A Central
Bank does not maintain any reserves of foreign
currency as the market automatically adjusts to
determine the market driven exchange rate

(c) Managed Floating: A Central Bank enters the
foreign exchange market to buy/sell foreign currency
in order to control fluctuations and volatility in the
market.

Question 2
‘Devaluation and Depreciation of currency are one and
the same thing’. Do you agree? How do they affect the
exports of a country?

Answer 2
Depreciation and Devaluation both imply a fall in external
value of a currency; however the term depreciation is used
under the floating exchange rate system that is when the
exchange rate system is determined by the combined
market forces of demand and supply. A currency loses or
gains value because of fluctuations in demand and supply.
The term devaluation is used in system of fixed exchange
rates. In this system, the exchange value of a currency is
decided by the government. Devaluation of currency is the
deliberate value of currency decided by the government.
Devaluation of currency is the deliberate action of the
government.
Depreciation and devaluation of a currency normally
encourages exports from a country, as exports become
cheaper for the foreign nationals and foreign currency can
now buy more of domestic goods, i.e., the international
competitiveness of the goods and services of such a
nation gets better.

Question 3
“Foreign Institutional Investors (FIIs) remained net seller
in the Indian capital markets over the last few weeks.”
– The Economic Times
State and discuss the likely effects of the given statement
on foreign exchange rate with reference to the Indian
Economy.

Answer 3
Selling of securities by Foreign Institutional Investors
(FII’s) in Indian capital market will lead to fall in the
supply of foreign currency in the economy. This situation
might lead to excess demand of foreign currency at the
As a result, a new equilibrium rate of foreign exchange
will be determined which will be higher than the
prevailing foreign exchange rate, leading to depreciation

Question 4
"Many large Multinational Corporations (MNCs) have
recently shifted their investments from China and have
started their production in India, thereby boosting the
Make in India plans of the Government." Presuming
other factors being constant, discuss the effects of the
given statement on Foreign Exchange rates with
reference to the Indian Economy.

Answer 4
Investments by large multinational corporations (MNCs)
in India will ensure greater inflow of foreign exchange,
leading to an increase in the supply of foreign currency.
This situation may result into excess supply of foreign
currency in the economy at the prevailing foreign
exchange rate.
As a result, a new equilibrium rate of foreign exchange
will be determined which will be lower than the
prevailing foreign exchange rate, leading to appreciation

Question 5
‘‘Indian rupee (`) plunged to all time low of `74.48
against the US Dollar ($)’’. –The Economic Times
In the light of the above report, discuss the impact of the
situation on Indian Imports, Exports and BoP position of
India.
(4 marks)

Answer 5
Indian rupee plunged to all time low of `74.48 against US
dollar. It is called depreciation in the value of Indian Rupees.
It may lead to fall in imports as foreign goods will become
costlier for the domestic consumers. Fall in imports less
outflow of foreign exchange from the country.
Also, depreciation of rupee causes increase in exports of
India since international competitiveness of Indian goods
gets better. So, there will be more inflow of foreign
exchange into the country. Thus, net inflow of foreign
exchange increases which has favourable effect on the
Balance of Payments position.
Question 6
“Government of India doubled the import duty on gold.”
Economy.
(4 marks)

Answer 6
Increasing import duty on gold will make imports of gold
costly. It will reduce demand for import of gold and
consequently of foreign exchange. This situation may result
into excess supply of foreign currency in the economy at
the prevailing foreign exchange rate.
As a result, a new equilibrium rate of foreign exchange will
be determined which will be lower than the prevailing
foreign exchange rate, leading to appreciation of domestic
currency.
Thus, foreign exchange rate is likely to fall.

Question 7
“Visits to foreign countries for sightseeing etc. by the
people of India is on the rise.”
Presuming other factors being constant, discuss the effects
of the given statement on Foreign Exchange rates with
reference to the Indian Economy.
(4 marks)

Answer 7
It will raise demand for foreign exchange for spending the
same in foreign countries. This situation might lead to
excess demand of foreign currency at the prevailing
foreign exchange rate. As a result, a new equilibrium rate
of foreign exchange will be determined which will be
higher than the prevailing foreign exchange rate, leading to
depreciation of domestic currency. Thus, foreign exchange
rate likely to rise.

Question 8
“Government of India is giving incentives for exports.”
Economy.
(4 marks)

Answer 8
Incentives for exports are aimed at increasing exports.
Increase in exports will bring more foreign exchange into
the country (i.e. increase in supply of foreign exchange).
This situation may result into excess supply of foreign
currency in the economy at the prevailing foreign exchange
rate.
As a result, a new equilibrium rate of foreign exchange will
be determined which will be lower than the prevailing
foreign exchange rate, leading to appreciation of domestic
currency.
Thus, foreign exchange rate is likely to fall.
Question 9
Suppose the present foreign exchange rate is 1 $= `70. It
rises to 1 $ = `74 leading to rise in prices of imports of
essential goods. How can Reserve Bank of India help in
bringing down the foreign exchange rate which is very
high?

Answer 9
Rise in exchange rate from 1 $ = `70 to 1 $ = `74 means
depreciation of Indian currency. Foreign goods become
costlier. Prices of imports of essential goods rise. So,
imports decrease. The Reserve Bank of India should sell
US Dollars from its foreign exchange reserves. As a result,
supply of foreign exchange (dollars) in the foreign
exchange market increases. It will lead to fall in the foreign
exchange rate.

Question 10
How can increase in foreign direct investment affect the
price of foreign exchange and exports? (4 marks)

Answer 10
Foreign direct investment (FDI) is a source of supply of
foreign exchange as it brings in foreign exchange into the
country. Supply of foreign exchange will increase in the
market. This situation may result into excess supply of
foreign currency in the economy at the prevailing foreign
exchange rate. As a result, a new equilibrium rate of
foreign exchange will be determined which will be lower
than the prevailing foreign exchange rate, leading to
appreciation of domestic currency. Thus, foreign exchange
rate is likely to fall.
Fall in exchange rate means that exports become costlier
for the foreign buyers because they will now get less
goods and services for each unit of foreign currency. This
will reduce exports from India.

Question 11
According to recent media reports: ‘USA has accused
China of currency devaluation to promote its exports’.
In the light of the given media report comment, how
exports can be promoted through the Currency
devaluation?
(CBSE SQP 2019) (3 marks)

Answer 11
USA has a valid point of argument as devaluation of a
currency encourages exports of a country. As exported
goods become cheaper in the international market
giving a competitive edge for the goods of domestic
country (China).
Devaluation of the value of domestic currency
promotes the exports of the country and may
adversely impact the production and sale of importing
country (USA).

Question 12
Indian investors lend abroad. Answer the following
questions:
(a) In which sub-account and on which side of the
Balance of Payments such lending is recorded?
Give reasons.
(b) Explain the impact of this lending on foreign
exchange rate.
(4 marks)

Answer 12
(a) Indians lending abroad is recorded in capital account
of the Balance of Payments because it is an
international transaction of assets. It is recorded on
the debit side because it leads to outflow of foreign
exchange.
(b) Lending abroad increases demand for foreign exchange.
Supply of foreign exchange remaining unchanged, the
exchange rate may rise.

Question 13
If USA has higher rate of inflation than in India, US
dollar will be depreciating. Do you agree with the given
statement? Support your answer with an example.
(3 marks)

Answer 13
Yes, the given statement is true.
Example: Suppose a shirt costs $10 in the US and ` 700
in India, the rupee-dollar exchange rate should be ` 70/$.
Suppose prices in India rise by 20 per cent while prices in
the US rise by 50 per cent. Indian shirts would now cost
`840 per shirt while American shirts cost $15 per shirt.
For these two prices to be equivalent, $15 must be
worth `840, or one dollar must be worth ` 56 (840/15).
The dollar, therefore, has depreciated since USA has
higher rate of inflation.

Question 14
Explain the effect of rise in income at home on the
foreign exchange rate.
(4 marks)

Answer 14
When income of people of India increases, consumer
spending increases. Spending on imported goods is also
likely to increase. When imports increase, the demand for
foreign exchange rises. This situation might lead to
excess demand of foreign currency at the prevailing
foreign exchange rate. As a result, a new equilibrium rate
of foreign exchange will be determined which will be
higher than the prevailing foreign exchange rate, leading
to depreciation of domestic currency. Thus, foreign
exchange rate likely to rise.

Question 15
Explain the impact of rise in exchange rate on national
income.

Answer 15
A rise in exchange rate, say rupee-dollar exchange rate
rises from `70/$ to `75/$, denotes depreciation of Indian
Currency (rupee). Indian goods will become cheaper to
foreigners because they can now buy more goods with
one unit of foreign currency (dollars). Exports become
cheaper. So, exports will increase.
On the contrary, our imports become costlier because
importers have to pay more rupees to buy one unit of
foreign currency worth goods. So, imports will decrease.
As a result, net exports (i.e., exports – imports) will
increase. Since net exports is a component of aggregate
demand, therefore, aggregate demand will increase [AD =
C + I + G + (X – M)]. Increase in aggregate demand will
increase the national income.

Question 16
How does foreign exchange speculation affect the
exchange rate? Explain with an example.
(3 marks)

Answer 16
Foreign exchange rate is affected by foreign exchange
speculation where foreign exchange is demanded for the
possible gains from appreciation of foreign currency.
Suppose the investors believe that the Rupee-Dollar
exchange rate is going to rise from `70/$ to `75/$ by the
end of the month. They think if they took `70000 and
bought 1000 dollars, at the end of the month they would
be able to exchange the dollars for `75000, thus making a
profit of `5000. This expectation would increase the
demand for dollars. Supply of foreign exchange remaining
unchanged, increase in demand will cause the exchange
rate to rise in the present.
Question 17
What is the effect of rise in interest rates at home on the
foreign exchange rate? Explain.
(3 marks)

Answer 17
A rise in interest rates at home will attract foreign
investors to invest in the home country. This will lead to
inflow of more foreign currency (i.e. increase in supply
of foreign exchange).
Demand of the foreign exchange remaining unchanged,
the exchange rate is likely to fall causing appreciation of
the domestic currency and depreciation of the foreign
currency.

Question 18
Suppose a shirt costs $10 in the US and `600 in India,
what will be the effect on exports of India if the rupee-
dollar exchange rate is `70/$?
(3 marks)

Answer 18
At the exchange rate `70/$, it costs `700 per shirt in
the US but only `600 in India. That is, international
competitiveness of shirts reduced in India gets better. In
that case, all foreign customers would buy shirts from
India.Thus, exports of shirts from India will increase.

Question 19
Explain the effect of rise in income on the exchange rate.
(6 marks)

Answer 19
When income of people of India increases, consumer
spending increases. Spending on imported goods is also
likely to increase. When imports increase, the demand for
foreign exchange rises. Supply of foreign exchange
remaining unchanged, the exchange rate is likely to rise.
There is a depreciation of the domestic currency.
If there is an increase in income abroad as well, domestic
exports will rise, i.e. more inflow of foreign exchange.
Therefore, supply of foreign exchange also increases. On
balance, the domestic currency may or may not
depreciate. What happens will depend on whether exports
are growing faster than imports. If exports are growing
faster than imports, domestic currency will appreciate.
On the other hand, if imports are growing faster, than
domestic currency will be depreciating.

Question 20
Explain the effect of difference in interest rates between
countries on the exchange rate with an example.
(6 marks)

Answer 20
In the short run, the interest rate differential i.e. the
difference between interest rates between countries is
an important factor in determining exchange rate
movements. For example, if government bonds in
country A pay 8 per cent rate of interest whereas
equally safe bonds in county B yield 10 per cent, the
interest rate differential is 2 per cent. Investors from
country A will be attracted by the higher interest rates
in country B and will buy the currency of country B
selling their own currency. At the same time investors
in country B will also find investing in their own country
more attractive and will therefore demand less of country
A’s currency. This means that the demand for country A’s
currency will decrease and the supply will increase causing
a depreciation of country A’s currency and an appreciation
of country B’s currency. Thus, a rise in the interest rates at
home often leads to an appreciation of the domestic
currency, other things remaining the same, e.g. no
restrictions exist in buying bonds issued by foreign
governments.

MACRO XII Subhash Dey All Chapters PPTs (Teaching Made Easier)

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 What is Macroeconomics?

 Basic concepts in macroeconomics: consumption

Thus, investment is defined as capital formation, a gross

Example: Suppose a new machine is purchased for

Thus, the machine is gradually used up in each year’s

OR, Factor Income and Transfer Income

Change in inventories (or stock) takes place over a

Note: Unexpected/unforeseen obsolescence or sudden

Calculate ‘Depreciation on Capital Asset’ from the

Solution: Depreciation on capital asset

Good X (units) Good Y (units) MRT

PPC will be a straight line since marginal rate of

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