Eco Revision Book

ECONOMICS FOR FINANCE LAST DAY REVISION SUMMARY BOOK BY CA NAMIT ARORA SIR 3
CHAPTER 1 - DETERMINATION OF NATIONAL INCOME

1. Meaning of National Income:
 National Income Accounting, pioneered by the Nobel prize-winning economists Simon Kuznets and
Richard Stone, is one such measure.
 National Income is defined as the net value of all economic goods and services produced within the
domestic territory of a country in an accounting year plus the net factor income from abroad.
2. Usefulness and Significance of National Income Estimates:

 Framework for analyzing and evaluating the short-run performance of an economy
 Pattern of demand for goods and services
 Economic welfare
 Quantitative basis for assessing and choosing economic policies
 Throw light on income distribution
 Assist in determining eligibility for loans etc.
 A guide to make policies for growth and inflation
 Forecasting about the future development trends of the economy
3. Different Concepts of National Income:

Market Price = Factor Cost + Net Indirect Taxes
= Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price - Net Indirect Taxes

= Market Price - Indirect Taxes + Subsidies
Net Indirect Taxes = Indirect Taxes - Subsidies
Gross = Net + Depreciation
Net = Gross – Depreciation
GDPMP = Value of Output in the Domestic Territory – Value of Intermediate

Consumption
Or
GDPMP = Σ Value Added
Factor Cost Net

Name of Item Mixed Dep. Indirect NFIA
Wages Rent Interest Profit
Income Tax
GDPMP Y Y Y Y Y Y Y -
GDPFC Y Y Y Y Y Y - -
NDPMP Y Y Y Y Y - Y -
NDPFC Y Y Y Y Y - - -
GNPMP Y Y Y Y Y Y Y Y
GNPFC Y Y Y Y Y Y - Y
NNPMP Y Y Y Y Y - Y Y
NNPFC (NI) Y Y Y Y Y - - Y
 The basis of distinction between ‘gross’ and ‘net’ is depreciation or consumption of fixed capital.
 If NFIA is positive, then National Income will be greater than domestic factor incomes.
4. Few Important Points While Learning About National Income:

 The value of only final goods and services or only the value added is considered.
 ‘Value Added’ means the difference between value of output and purchase of intermediate goods.
 Consumption of fixed assets is ignored.
 Production of agriculture, forestry and fishing which are used for own consumption of producers is
also included.
 Economic activities, include all human activities which create goods and services that are exchanged
in a market and valued at market price.
 Non-economic activities are not considered e.g. hobbies, housekeeping and child rearing services of
home makers and services of family members that are done out of love and affection.
 National income is a ‘flow’ measure of output per time period (like 1 year).
 The net change in inventories may be positive or negative.
5. Nominal GDP VS Real GDP (GDP at Current and Constant Prices):

 GDP in terms of current market prices, termed ‘nominal GDP’ or ‘GDP at current prices’,
 ‘Real GDP ’or ‘GDP at constant prices’ which is the value of domestic product in terms of constant prices
6. Per Capita Income:

GDPFC per capita = GDPFC ÷ Population
7. Personal Income (PI):

PI = NI + Income received but not earned – Income earned but not received
PI = NI - Undistributed profits – Net interest payments made by households – Corporate Tax +

Transfer Payments to the households from firms and Government
PI = Factor income from net domestic product accruing to the private sector + Net factor
income from abroad + National debt interest + Current transfers from government +
Other net transfers from the rest of the world - Undistributed profits – Corporate Tax
8. Disposable Personal Income (DI):

DI = PI - Personal Income Taxes – Non tax payments
Two more concepts need to be understood, namely:

(a) Net National Disposable Income (NNDI)
NNDI = Net National Income + Other net current transfers from the rest of the world (Receipts
less payments)
= NNI + Net taxes on income and wealth receivable from abroad + Net social
contributions and benefits receivable from abroad.
(b) Gross National Disposable Income (GNDI)

GNDI = NNDI + CFC (Consumption of fixed capital)
= GNI + Other net current transfers from the rest of the world (Receipts less payments)
(Other Current Transfers refer to current transfers other than the primary incomes)
9. Categories of Domestic Income:

 Income from domestic product accruing to the public sector which includes income from property
and entrepreneurship accruing to government administrative departments and savings of non-
departmental enterprises.
 Income from domestic product accruing to private sector = NDPFC – Income from property and
entrepreneurship accruing to government administrative departments - Savings of non-departmental
enterprises.
10. Private Income:

Private Income = Factor income from net domestic product accruing to the private sector + Net
factor income from abroad + National debt interest + Current transfers from
government + Other net transfers from the rest of the world.
Private Income = Personal Income + Undistributed Profit + Corporate tax
11. There are many reasons to dispute the validity of GDP as a perfect measure of wellbeing:
 Income distributions and, therefore, GDP per capita is a completely inadequate measure of welfare.
 Quality improvements in systems and processes are ignored.
 Productions hidden from government authorities.
 Nonmarket production and Non-economic contributors to well-being.
 The disutility of loss of leisure time.
 Economic ’bads’.
 The volunteer work and services rendered without remuneration.
 Many things such as, leisure time, fairness, gender equality, security of community feeling etc.
 Both positive and negative externalities.
 The distinction between production that makes us better off and production that only prevents us
from becoming worse off.
12. The Circular Flow of Income:
Production of goods and services
Disposition Distribution as factor income

consumption/Investment (Rent, Wages, Interest and
Profit)
13. Value Added Method or Product Method or Industrial Origin Method or Net Output Method:
Step 1: All the producing enterprises are broadly classified into three main sectors namely:
(a) Primary sector,
(b) Secondary sector, and
(c) Tertiary sector or service sector
Step 2: Estimating the gross value added (GVAMP) by each producing enterprise:
GDP/GVAMP = Value of output – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption
Step 3: Estimation of National income for each individual unit and then National Income:
NDP/NVAMP = (GVAMP) – Depreciation
NDP/NVAFC = NVAMP – Net Indirect taxes
NI/NNPFC = NVAFC + NFIA
14. Income Method or Factor Payment Method or Distributed Share Method:

National income is calculated by summation of factor incomes paid out by all production units within
the domestic territory of a country as wages and salaries, rent, interest, and profit. By definition, it
includes factor payments to both residents and non- residents.
NDPFC = Sum of factor incomes paid out by all production units within the domestic
territory of a country
NNPFC/NI = Compensation of employees + Operating Surplus (rent + interest + profit)

+ Mixed Income of Self- employed + NFIA
15. Expenditure Method:

Under this method, National income is calculated by summation of following items:
1. Final Consumption Expenditure:

(a) Private Final Consumption Expenditure (PFCE)
(b) Government Final Consumption Expenditure
2. Gross Domestic Capital formation
3. Net Exports
GDPMP = Final consumption expenditure + Gross domestic capital formation + Net Export
GNPMP = GDPMP + NFIA
GNPFC = GNPMP – Net indirect taxes
NNPFC or NI = GNPFC - Depreciation
16. National Income as per Keynes:

A comprehensive theory of National Income was first put forward by the British economist John
Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’ published in 1936.
The Keynesian theory of income determination is presented in three models:

 The two-sector model consisting of the household and the business sectors,
 The three-sector model consisting of household, business and government sectors, and
 The four-sector model consisting of household, business, government and foreign sectors.
17. Circular Flow in a Simple Two-Sector Model:
18. The Simple Two Sector Economy Model Assumes:

 Only two sectors in the economy viz., households and firms,
 Only consumption and investment outlays,
 Households own all factors of production,
 They sell their factor services to earn factor incomes,
 They do not save,
 No corporations, corporate savings or retained earnings,
 Y = Yd
 No government, no taxes, no government expenditure or transfer payments,
 The economy is a closed economy, i.e., foreign trade does not exist.
Factor Payments = Household Income = Household Expenditure = Total Receipts of Firms = Value of Output
19. The Aggregate Demand Function (AD): Two-Sector Model:

Aggregate demand (AD) or aggregate expenditure consists of only two components:
(i) Aggregate demand for consumer goods (C), and
(ii) Aggregate demand for investment goods (I)
AD = C + I̅ (constant investment)
20. The Consumption Function (C):

C = f (Y)
According to Keynes:
C = a + bY
Where,
C = Aggregate consumption expenditure;
Y = Total disposable income;
a = Consumption at zero level of disposable income;
b = The slope of the function, (ΔC/ΔY)
21. Marginal Propensity to Consume (MPC) ‘b’: MPC (b) = Δ𝐂/Δ𝒀
22. Average Propensity to Consume (APC): APC = 𝐂/𝐘
23. The Saving Function (S): S = f(Y)

S = Y–C
24. The Marginal Propensity to Save (MPS): MPS (1 - b) = Δ𝐒/Δ𝐘
 MPC is always less than unity, but greater than zero, i.e., 0 < b < 1
 MPC + MPS = 1
25. Average Propensity to Save (APS): APS = 𝐒/𝐘
26. Relationship Between Income and Consumption:

Income Consumption APC MPC Saving APS MPS
(Y) (C) (C/Y) (ΔC/ΔY) (S) (S/Y) ‘1-b’
0 500 500/0 = ∞ - -500 - 500/0 = ∞ -
1,000 1,250 1,250/1,000 = 1.25 750/1,000 = 0.75 -250 -250/1,000 = - 0.25 0.25
2,000 2,000 2,000/2,000 = 1.00 750/1,000 = 0.75 0 0/2,000 = 0 0.25
3,000 2,750 2,750/3,000 = 0.92 750/1,000 = 0.75 250 250/3,000 = 0.08 0.25
6,000 5,000 5,000/6,000 = 0.83 2250/3000 = 0.75 1,000 1,000/6,000 = 0.17 0.25
27. The Consumption and Saving Function:
Since C + S = Y, the national income equilibrium can be written as:
Y = C+I
C+S = C + I, or S=I
28. Determination of Equilibrium Income Chart: Two Sector Model:
29. Determination of Equilibrium Income: Three Sector Model:

Y = C+I+G
30. Determination of Equilibrium Income: Four Sector Model:

Y = C + I + G + (X - M)
31. Effects on Income when Imports are Greater than Exports: National income will decrease.
32. The Investment Multiplier (k)

 In two sector model:
k = ΔY/ΔI or ΔY = k × ΔI
Δ𝒀/Δ𝑰 = 1/1-MPC = 1/MPS
 In three sector model:

1
k = 1 − 𝑏 (1 − 𝑡)
 In four sector model:

1
k = 1 − b (1 − t) + m
Where m is the propensity to import
APPLICATION ORIENTED QUESTIONS
Question 1
The nominal and real GDP respectively of a country in a particular year are `3,000 Crores and `4,700 Crores
respectively. Calculate GDP deflator and comment on the level of prices of the year in comparison with the
base year.
Answer
Nominal GDP = `3,000 Crores
Real GDP = `4,700 Crores
Nominal GDP 3,000
GDP Deflator = Real GDP
× 100 = 4,700
× 100 = 63.83
The price level has fallen since GDP deflator is less than 100 at 63.83.
Question 2
In a two sector economy, the business sector produces 7,000 units at an average price of `5.
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 80 percent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
Answer
(a) The money value of output equals total output times the average price per unit. The money value of
output is: = 7,000 × 5 = `35,000
(b) In a two sector economy, households receive an amount equal to the money value of output. Therefore,
the money income of households is the same as the money value of output i.e `35,000.
(c) Total spending by households: = `35,000 × 0.8 = `28,000
(d) The total money revenues received by the business sector is equal to aggregate spending by
households ie. `28,000.
(e) The business sector makes payments of `35,000 to produce output, whereas the households purchase
only output worth `28,000 of what is produced. Therefore, the business sector has unsold inventories
valued at `7,000. They should be expected to decrease output.
Question 3
Assume that an economy’s consumption function is specified by the equation C = 500 + 0.80Y.
(a) What will be the consumption when disposable income (Y) is `4,000, `5,000, and `6,000?
(b) Find saving when disposable income is `4,000, `5,000, and `6,000.
(c) What amount of consumption for consumption function C is autonomous?
(d) What amount is induced when disposable income is `4,000? `5,000? `6,000?
Answer
(a) Consumption for each level of disposable income is found by substituting the specified disposable
income level into the consumption equation.
When Y = `4,000
C = `500 + 0.80 (`4,000) = `500 + `3,200 = `3,700
When Y = `5,000
C = `500 + 0.80 (`5,000) = `500 + `4,000 = `4,500
When Y = `6,000
C = `500 + 0.80 (`6,000) = `500 + `4,800 = `5,300
(b) Saving is the difference between disposable income and consumption:
S = Y-C
= 4,000 – 3,700 = `300 (when Y is `4,000)
= 5,000 – 4,500 = `500 (when Y is `5,000)
= 6,000 – 5,300 = `700 (when Y is `6,000)
(c) Autonomous consumption is the amount consumed when disposable income is zero; autonomous
consumption is ` 500, i.e the consumption expenditure when the disposable income is 0. Since
autonomous consumption is unrelated to income, autonomous consumption is `500 for all levels of
income.
(d) Induced consumption is the amount of consumption that depends upon the level of income.
Consumption is `3,700 when disposable income is `4,000. Since `500 is autonomous (i.e. consumed
regardless of the income level), `3,200 out of the `3,700 level of consumption is induced by disposable
income. Similarly, Induced consumption is `4,000 when disposable income is `5,000, and `4,800 when
disposable income is `6,000.
Question 4
Compute the amount of subsidies from the following data:
GDP at market price (` in crores) 7,79,567
Indirect taxes (` in crores) 4,54,367
GDP at factor cost (` in crores) 3,60,815
Answer
GDPMP = GDPFC + Indirect taxes – Subsidies
`7,79,567 crores = `3,60,815 crores + `4,54,367 crores – Subsidies
Subsidies = `35,615 crores
Question 5
Calculate the aggregate value of depreciation when the GDP at market price of a country in a particular year
was `1,100 Crores. Net Factor Income from Abroad was `100 Crores. The value of Indirect taxes – Subsidies
was `150 Crores and National Income was `850 Crores.
Answer
NNPFC = GDPMP – NIT + NFIA - Depreciation
850 = 1,100 – 150 + 100 - Depreciation
Depreciation = 1,050 – 850 = 200 Crores
Question 6
Calculate ‘Sales’ from the following data:
` in Lakhs
Subsidies 200
Opening stock 100
Closing stock 600
Intermediate consumption 3,000
Consumption of fixed capital 700
Profit 750
Net value added at factor cost 2,000
Answer
NVAFC = Sales + Change in stocks – Intermediate consumption - depreciation – NIT
2,000 = Sales + (600 - 100) – 3,000 – 700 – (-200)
Sales = 2,000 - 500 + 3,000 + 700 – 200 = 5,000 Lakhs
Question 7
Compute GNP at factor cost and NDP at market price using expenditure method from the following data:
(` in Crores)
Personal Consumption expenditure 2,900
Imports 300
Gross public Investment 500
Exports 200
Inventory Investment 170
Government purchases of goods & services 1,100
Gross Residential construction Investment 450
Net factor Income from abroad (-) 30
Gross business fixed Investment 410
Subsidies 80
Answer
GDPMP = Personal consumption expenditure + Government purchase of goods and
services + gross public investment + inventory investment + gross residential
construction investment + Gross business fixed investment + [export–import]
= 2,900 + 1,100 + 500 + 170 + 450 + 410 + (200 - 300)
= `5,430 Crores
GNPFC = GDPMP + Net Factor Income from Abroad - Net Indirect Taxes
= 5,430 + (-30) + 80 = `5,480 Crores
NDPMP = GDPMP - Consumption of fixed capital

= 5430 - 60 = 5,370 Crores
Question 8
From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.
` in Crores
Operating surplus 2,000
Mixed income of self-employed 1,100
Rent 550
Profit 800
Net indirect tax 450
Net factor income from abroad -50
Compensation of employees 1,000
Answer
GDPMP = Compensation of employees + mixed income of self-employed + operating
surplus + depreciation + net indirect taxes
GDPMP = 1,000 + 1,100 + 2,000 + 400+ 450 = 4,950 Crores
GNPMP = GDPMP + NFIA

= 4,950 + (50) = 4,900 Crores
NNPMP = GNPMP - Depreciation

= 4,900 - 400 = 4,500 Crores
NNPFC = NNPMP – Net indirect tax

= 4,500 - 450 = 4,050 Crores
Question 9
From the following data, estimate National Income and Personal Income.
` in Crores
Net national product at market price 1,891
Income from property and entrepreneurship accruing
to government administrative departments 45
Indirect taxes 175
Subsidies 30
Saving of non-departmental enterprises 10
Interest on National debt 15
Current transfers from government 35
Current transfers from rest of the world 20
Saving of private corporate sector 25
Corporate profit tax 25
Answer
National Income = Net national product at market price – Indirect taxes + Subsidies
= 1,891 – 175 + 30 = 1,746 Crores
Personal Income = National income – Income from property and entrepreneurship accruing to
government administrative departments – Saving of non-departmental
enterprises + National debt interest + Current transfers from government +
Current transfers from rest of the world – Saving of private corporate sector –
Corporate profit tax
= 1,746 – 45 –10 + 15 + 35 + 20 – 25 – 25 = 1,711 Crores
Question 10
On basis of following information, calculate NNP at market price and Disposable personal income
` in Crores
NDP at factor cost 14,900
Income from domestic product accruing to government 150
Interest on National debt 170
Transfer payment by government 60
Net private donation from abroad 30
Net factor income from abroad 80
Indirect taxes 335
Direct taxes 100
Subsidies 262
Taxes on corporate profits 222
Undistributed profits of corporations 105
Answer
NNPMP = NDPFC + NFIA + NIT
= 14,900 + 80 + 335 – 262 = 15,053 Crores
Disposable personal income (DI):

DI = PI - Personal income tax
= NI + Income received but not earned – Income earned but not received
– Personal Income Tax
= (14,900 + 80) + (170 + 60 + 30) – (150 + 222 + 105) – 100
= 14,663 Crores
Question 11
Calculate National Income by Value Added Method with the help of following data:
` in Crores
Sales 700
Opening stock 500
Intermediate Consumption 350
Closing Stock 400
Net Factor Income from Abroad 30
Depreciation 150
Excise Tax 110
Subsidies 50
Answer
GVAMP = Value of output- Intermediate consumption
= Sales + Change in stock - Intermediate consumption
= 700 + (400 - 500) – 350 = 250 Crores
NVAFC = GVAMP – Depreciation + NFIA - Net Indirect Tax

NI = 250 - 150 + 30 - (110 - 50) = 70 Crores
Question 12
Calculate the Operating Surplus with the help of following data:
` in Crores
Sales 4,000
Compensation of employees 800
Intermediate consumption 600
Rent 400
Interest 300
Net indirect tax 500
Consumption of Fixed Capital 200
Mixed Income 400
Answer
GVAMP = Value Output – Intermediate consumption
= (Sales + Change in stock) – Intermediate consumption
= 4,000 – 600 = 3,400 Crores
NDPMP = GDPMP – Consumption of fixed capital

= 3,400 – 200 = 3,200 Crores
NDPFC = NDPMP – NIT

= 3,200 – 500 = 2,700 Crores
NDPFC = Compensation of employees + Operating surplus + Mixed income

2,700 = 800 + Operating Surplus + 400
Operating surplus = 1,500 Crores
Question 13
Calculate national income by value added method
` in Crores
Value of output in primary sector 2,000
Intermediate consumption of primary sector 200
Value of output of secondary sector 2,800
Intermediate consumption of secondary sector 800
Value of output of tertiary sector 1,600
Intermediate consumption of tertiary sector 600
Net factor income from abroad -30
Net indirect taxes 300
Depreciation 470
Answer
GDPMP = (Value of output in primary sector - intermediate consumption of primary
sector) + (value of output in secondary sector – intermediate consumption of
secondary sector) + (value of output in tertiary sector - intermediate
consumption of tertiary sector)
= 2,000 – 200 + 2,800 – 800 + 1,600 – 600 = 4,800 Crores
NNPFC = GDPMP + NFIA – NIT - Depreciation

= 4,800 + (-30) - 300 – 470 = 4,000 Crores
Question 14
Calculate NNPFC by expenditure method with the help of following information:
` in Crores
Private final consumption expenditure 10
Net Import 20
Public final consumption expenditure 05
Gross domestic fixed capital formation 350
Depreciation 30
Subsidy 100
Income paid to abroad 20
Change in stock 30
Net acquisition of valuables 10
Answer
GDPMP = Government final consumption expenditure (Public final consumption
expenditure) + Private final consumption expenditure + Gross domestic
capital formation (Gross domestic fixed capital formation + Change stock +
Net acquisition of valuables) + Net export
= 5 + 10 + [350 + 30 + 10] + (- 20) = 385 Crores
NNPFC = GDPMP – Depreciation + Net factor income from abroad (Income from abroad
– Income paid to abroad) – Net Indirect tax (Indirect tax – subsidies)
= 385 – 30 + [0 – 20] – [0 - 100] = 435 Crores
Question 15
Given the following data, determine the National Income of a country using expenditure method and
income method:
` in Crores
Private Final Consumption Expenditure 1,000
Government Final Consumption Expenditure 550
Compensation of Employees 600
Net Exports -15
Net Indirect Taxes 60
Net Domestic Fixed Investment 385
Consumption of Fixed Capital Formation 65
Net Factor Income from Abroad -10
Interest 310
Rent 200
Mixed Income of Self-Employed 350
Profit 400
Answer
Expenditure Method:
NNPFC = Private Final Consumption Expenditure + Net Domestic Fixed Investment +
Government final consumption expenditure + Net Exports + Net factor
income from abroad – Indirect Taxes
= 1,000 + 385 + 550 -15 – 10 – 60 = 1,850 Crores
Income Method:
NNPFC = Employee compensation + Profits + Rent + Interest + Mixed income + NFIA
= 600 + 400 + 200 + 310 + 350 -10 = 1,850 Crores
Question 16
Suppose in an economy: C = 100 + b (Y – 50 – tY); I = 50; G = 50; X = 10; M = 5 + 0.1Y; MPC (b) = 0.8;
Proportional income tax rate (t) = 0.25
(a) Find the equilibrium national income, foreign trade multiplier, equilibrium value of imports.
(b) If equilibrium national income falls short of full employment income by `50, how much government
should increase its expenditure to attain full – employment?
Answer
(a) Y = C + I + G + (X – M)
= 100 + b (Y – 50 – tY) + 50 + 50 + (10 - 5 - 0.1Y)
= 100 + 0.8 (Y – 50 – 0.25Y) + 105 - 0.1Y
= 100 + 0.8Y – 40 – 0.2Y + 105 – 0.1Y
= 165 + 0.5Y
Y = 165 ÷ 0.5 = 330
1 1
Foreign trade multiplier = 1 − b (1 − t) + m
= 1 − 0.8 (1 − 0.25) + 0.1
= 2
Equilibrium value of imports can be obtained by substituting the equilibrium income in the import function.
Thus,
M = 5 + 0.1Y = 5 + 0.1 × 330 = 38
(b) Required increase in government expenditure to attain `50 increase in income can be obtained as
under:
ΔY = Foreign trade multiplier × ΔG

1
= 1 − b (1 − t) + m
× ΔG
50 = 2 × ΔG
ΔG = 50 ÷ 2 = 25
Question 17
Suppose the consumption function is C = 50 + 0.8Yd, I = 180 crores, G =190 crores, T = 0.20Y
(a) Find the equilibrium level of income.

(b) Find the revenue from taxes at equilibrium. Is the government budget balanced?
(c) Find the equilibrium level of income when investment increases by 120 crores.
Answer
(a) Y = C + I + G + (X – M)
= 50 + 0.8 (Y – 0.2Y) + 180 + 190
= 420 + 0.8Y – 0.16Y
Y = 420 ÷ 0.36 = 1,166.66 Crores
(b) T = 0.2Y
= 0.2 × 1,166.66 = 233.332 Crores
G i.e. 190 < T i.e. 233.332, thus, budget is not in balance. There exists a budget Surplus.
(c) Change in Y = Change in I/(1 – b + bt)

= 120/(1 - 0.8 + 0.16)
= 120/.36 = 333.33 Crores
So new Y equilibrium:
Y new = 1,166.66 + 333.33 = 1,499.99 Crores

CHAPTER 2 - PUBLIC FINANCE
1. Richard Musgrave’s Three Branch Taxonomy on Public Finance:
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the
three branch taxonomy of the role of government in a market economy:
 Resource Allocation (efficiency),
 Income Redistribution (fairness) and
 Macroeconomic Stabilization.
2. The Allocation Function:

Resource allocation refers to the way in which the available factors of production are allocated among
the various uses to which they might be put. One of the most important functions of an economic system is the
optimal or efficient allocation of scarce resources so that the available resources are put to their best use and
no wastages are there.
3. Main Reasons of Need of Efficient Allocation:

 Imperfect competition and presence of monopoly power
 Markets typically fail to provide collective goods
 Externalities
 Factor immobility which causes unemployment and inefficiency
 Imperfect information, and
 Inequalities in the distribution of income and wealth.
4. State/Government and Allocation:

The allocative function in budgeting determines who and what will be taxed as well as how and on
what the government revenue will be spent. It is concerned with the provision of public goods and the process
by which the total resources of the economy are divided among various uses and an optimum mix of various
social goods (both public goods and merit goods).
5. Allocation Instruments:
 Government may directly produce the economic good,
 Government may influence private allocation through incentives and disincentives,
 Government may influence allocation through its competition policies, merger policies etc.,
 Governments’ regulatory activities such as licensing, controls, minimum wages etc.,
 Government sets legal and administrative frameworks, and
 Any of a mixture of intermediate techniques may be adopted by governments.
6. Redistribution Function:
It is concerned with the adjustment of the distribution of income and wealth so as to ensure
distributive justice namely, equity and fairness. The distribution function also relates to the manner in which
the effective demand over the economic goods is divided among the various individual and family spending
units of the society.
7. Aim of Redistribution Function:

 To achieve an equitable distribution of societal output among households,
 Advancing the well-being of all,
 Providing equality in income, wealth and opportunities,
 Providing security for people who have hardships, and
 Ensuring that everyone enjoys a minimal standard of living.
8. Redistribution Function Performed By Government:

 Progressive taxation of the rich and subsidy to the poor households,
 Financing public services, especially those that benefit low-income households,
 Employment reservations and preferences,
 Regulation of the manufacture and sale of certain products to ensure the health and well-being of
consumers, and
 Special schemes for backward regions and for the vulnerable sections.
9. Stabilization Function:
The stabilization function is one of the key functions of fiscal policy and aims at eliminating
macroeconomic fluctuations arising from suboptimal allocation.
10. Concern of Stabilization Function:

 Labour employment and capital utilization,
 Overall output and income,
 General price levels,
 Balance of international payments, and
 The rate of economic growth.
11. The Concept of Market Failure:

Market failure is a situation in which the free market leads to misallocation of society's scarce
resources in the sense that there is either overproduction or underproduction of particular goods and services
leading to a less than optimal outcome. There are four major reasons for market failure. They are:
 Market power,
 Externalities,
 Public goods, and
 Incomplete information
12. Market Power or Monopoly Power

Market power or monopoly power is the ability of a firm to profitably raise the market price of a good
or service over its marginal cost.
13. Externalities:
Sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect
as part of the market price. Such costs or benefits which are not accounted for by the market price are called
externalities because they are “external” to the market. The four possible types of externalities are:
 Negative production externalities
 Positive production externalities
 Negative consumption externalities ,and
 Positive consumption externalities
1. Negative Production Externalities: A negative externality initiated in production which imposes an

external cost on others may be received by another in consumption or in production.
2. Positive production externalities: A positive production externality initiated in production that confers
external benefits on others may be received in production or in consumption.
3. Negative consumption externalities: A negative consumption externalities initiated in consumption

which imposes an external cost on others may be received by another in consumption or in production.
4. Positive consumption externalities: A positive consumption externality initiated in consumption that

confers external benefits on others may be received in consumption or in production.
14. Private Cost and Social Cost:

Private cost includes direct cost of labour, materials, energy and other indirect overheads.
Social Cost = Private Cost + External Cost
15. Negative Externalities and Loss of Social Welfare Chart:

16. Public Goods/Collective Consumption Goods/Social Goods:

Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path-breaking 1954
paper ‘The Pure Theory of Public Expenditure’ is usually recognized as the first economist to develop the theory
of public goods.
A public good (also referred to as collective consumption good or social good) is defined as one which
all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtraction
from any other individuals’ consumption of that good.
17. Classification of Public Goods:

Excludable Non-excludable
A B
Rivalrous Private goods: Common resources:
Food, clothing, cars etc Fish stocks, forest resources, coal etc.
C D
Club goods: Pure public goods:
Non-rivalrous Cinemas, private parks, satellite National defence
television etc
18. Pure Public Goods: Which perfectly satisfy non rivalness and non-excludability.
19. Impure Public Goods:

Hybrid goods that possess some features of both public and private goods. These goods are partially
rivalrous or congestible.
 Club goods; first studied by Buchanan, Examples: Swimming pools, fitness centres etc.
 Variable use public goods; first analyzed by Oakland and Sandmo, Examples: Roads, bridges
etc. They can be excludable or non excludable.
20. Quasi Public Goods (Mixed Goods) or Near Public Goods:

Possess nearly all of the qualities of the private goods and some of the benefits of public good.
Examples: Education, health services etc.
21. Common Access Resources or Common Pool Resources:

Non-excludable and rival in nature. Some important natural resources fall into this category.
22. Global Public Goods:

There are several public goods benefits of which accrue to everyone in the world.
The WHO delineates two categories of global public goods:

 Final public goods which are ‘outcomes’, and
 Intermediate public goods, which contribute to the provision of final public goods.
World Bank identifies five areas of global public goods:

 The environmental commons
 Communicable diseases (including HIV/AIDS, COVID19),
 International trade,
 International financial architecture, and
 Global knowledge for development.
23. Free Rider Problem:

Free riding is ‘benefiting from the actions of others without paying. Due to free-rider problem, the
following two outcomes are possible:
 No public good
 Under production public goods
24. Incomplete Information:

Complete information is an important element of competitive market. Perfect information implies that
both buyers and sellers have complete information about anything that may influence their decision making.
25. Asymmetric Information and Lemons (poor items in market) Problem:

Asymmetric information occurs when there is an imbalance in information between buyer and seller.
26. Adverse selection:

A situation in which asymmetric information about quality eliminates high-quality goods from a
market.
27. Moral Hazard:

An informed person’s taking advantage of a less-informed person through an unobserved action. It
arises from lack of information about someone’s future behavior.
28. Government Intervention to Minimize Market Power:

 By establishing rules and regulations
For example, in India, we have the Competition Act, 2002 (as amended by the Competition
(Amendment) Act, 2007)
 Price regulation in the form of setting maximum prices that firms can charge
 Determines an acceptable price, called as rate-of-return regulation
 Setting price-caps based on the firm’s variable costs, past prices, and possible inflation and
productivity growth
29. Government Intervention to Correct Externalities:
Direct Controls:
 Prohibit specific activities or limited to a certain level,
 Stringent rules are in place in respect of tobacco advertising, packaging and labeling etc.,
 Governments may pass laws to alleviate the effects of negative externalities,
 Government stipulated environmental standards are rules. For example, India has enacted the
Environment (Protection) Act, 1986.
The Market Based Approaches:

 Setting the price directly through a pollution tax (Pigouvian taxes),
 Setting the price indirectly through the establishment of a cap-and-trade system (tradable emissions
permits).
30. In Case of Positive Externalities:

Subsidies involve government paying part of the cost to the firms in order to promote the production
of goods having positive externalities.
31. Government Intervention in the Case of Merit Goods:
 Merit goods are goods which are deemed to be socially desirable.
Examples: Education, health care, welfare services, fire protection, waste management, public
libraries, museum and public parks etc.
 Free of cost direct provision of merit goods by government.
32. Government Intervention in the Case of Demerit Goods:

 At the extreme, government may enforce complete ban,
 Negative advertising campaigns,
 Prohibit the advertising or promotion of demerit goods,
 Strict regulations to limit access to the good,
 Regulatory controls in the form of spatial restrictions e.g. smoking in public places,
 Imposing unusually high taxes,
 Fix a minimum price.
33. Government Intervention in the Case of Public Goods:

 Direct provision of a public good (free of cost),
 Excludable public goods can be provided by government and the same can be financed through entry
fees.
 Grant licenses to private firms to build a public good facility.
34. Price Intervention:

Price controls may take the form of either
 A price floor (a minimum price buyers are required to pay) or
 A price ceiling (a maximum price sellers are allowed to charge for a good or service)
35. Government Intervention for Correcting Information Failure:

 Accurate labeling and content disclosures by producers,
 Public dissemination of information,
 Regulation of advertising and setting of advertising standards.
36. Government Intervention for Equitable Distribution:

 Progressive income tax,
 Targeted budgetary allocations,
 Unemployment compensation,
 Transfer payments,
 Subsidies,
 Social security schemes,
 Job reservations,
 Land reforms,
 Gender sensitive budgeting etc.
37. Government Failure in Intervention:

 Cost of intervention is higher than benefit from intervention,
 Intervention produces fresh and more serious problems.
38. Objectives of Fiscal Policy:

 Achievement and maintenance of full employment,
 Maintenance of price stability,
 Acceleration of the rate of economic development, and
 Equitable distribution of income and wealth,
39. Automatic Stabilizers Versus Discretionary Fiscal Policy:

 In automatic or non-discretionary fiscal policy, the tax policy and expenditure pattern are so framed
that taxes and government expenditure automatically change with the change in national income.
 Discretionary fiscal policy refers to deliberate policy actions on the part of government to change the
levels of expenditure, taxes to influence the level of national output, employment and prices.
40. Instruments of Fiscal Policy:

 Taxes,
 Government expenditure,
 Public debt and
 Budget.
41. Government Expenditure as an Instrument of Fiscal Policy:

Government expenditures include:
 Current expenditures to meet the day to day running of the government,
 Capital expenditures (capital equipments and infrastructure), and
 Transfer payments.
42. Taxes as an Instrument of Fiscal Policy:

 During recession and depression, the tax policy is framed to encourage private consumption and
investment,
 During inflation, new taxes can be levied and the rates of existing taxes are raised to reduce disposable
incomes and to wipe off the surplus purchasing power.
43. Public Debt as an Instrument of Fiscal Policy:

 Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in
the economy,
 Repayments of debt by governments increase the availability of money in the economy and increase
aggregate demand.
44. Budget as an Instrument of Fiscal Policy:

 A balanced budget will have no net effect on aggregate demand
 A budget surplus has a negative net effect on aggregate demand since leakages exceed injections,
 A budget deficit has a positive net effect on aggregate demand since total injections exceed leakages
from the government sector.
45. Types of Fiscal Policy:

 Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a
business cycle or when there is an anticipation of a business cycle contraction,
 Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy
during an inflationary phase or when there is anticipation of a business-cycle expansion which is likely
to induce inflation.
46. Fiscal Policy for Reduction in Inequalities of Income and Wealth:

 A progressive direct tax system
 Indirect taxes can be differential
 A carefully planned policy of public expenditure helps in redistributing income from the rich to the
poorer sections of the society.
47. Crowding Out:

An increase in the size of government spending during recessions will ‘crowd-out’ private spending in
an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also
reduce the economy’s prospects of long-run economic growth.
Question 1
If country X has a marginal propensity to consume of 0, what is the value of fiscal multiplier?
Answer
Given MPC = 0; MPS = (1 - 0) = 1
The spending multiplier = 1

There is no multiplier effect.
Question 2
Average per capita income of country Y rose from 42,300 to 50,000 and the corresponding figures for per
capita consumption rose from 35,400 to 42,500.
Find the spending multiplier for this economy.
Answer
Spending multiplier = 1/(1 - MPC)
MPC = Increase in Consumption/ Increase in Income

= (42,500−35,400)/(50,000 − 42,300) = 0 .922
Multiplier = 1/(1 - 0.922)

= 1/(0.078) = 12.82
Question 3
Assume that the MPC is equal to 0.6.
(a) What is the value of government spending multiplier?
(b) What impact would a 50 billion increase in government spending have on equilibrium GDP?
(c) What about a 50 billion decrease in government spending?
Answer
1 1
(a)
1 − MPC
= 1 − 0.6
= 2.5
1
(b) Change in GDP = Initial Change in Spending ×
1 − MPC
Change in GDP = 50 × 2.5 = 125 billion
1
(c) Change in GDP = Initial Change in Spending × 1 − MPC
Change in GDP = -50 × 2.5 = -125 billion
Question 4
What would be the impact on GDP if both government spending and taxes are increased by 5 billion when the
MPC is 0.9?
Answer
1 1
Spending Multiplier = 1 − MPC
= 1 − 0.9
= 10
Change in GDP = Initial Change in Spending × 10

= 5 × 10 = 50 billion
−b − 0.9
Tax multiplier = 1−b
= 1 − 0.9
= -9
Change in GDP = Initial Change in Tax × -9 = -45 billion
The net result is that output increases by 5 billion.

CHAPTER 3 - MONEY MARKET
1. Functions of Money:
 Money is a convenient medium of exchange,
 Money is an explicitly defined unit of value or ‘common measure of value’ or ‘common denominator of
value’,
 Money serves as a unit or standard of deferred payment.
2. General Characteristics of Money:

 Generally acceptable,
 Durable or long-lasting,
 Effortlessly recognizable,
 Difficult to counterfeit i.e. not easily reproducible by people,
 Relatively scarce, but has elasticity of supply,
 Portable or easily transported,
 Possessing uniformity; and
 Divisible into smaller parts.
3. The Demand for Money:

If people desire to hold money, we say there is demand for money. Demand for money is actually
demand for liquidity and demand to store value.
4. Classical Approach: The Quantity Theory of Money (QTM):

The quantity theory of money, one of the oldest theories in Economics, was first propounded by Irving
Fisher of Yale University in his book ‘The Purchasing Power of Money’ published in 1911 and later by the
neoclassical economists. Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is
formally stated as follows:
MV = PT
Where,
M = the total amount of money in circulation
V = transactions velocity of circulation
P = average price level (P = MV/T)
T = the total number of transactions.
Fisher’s extended the equation:
MV + M'V' = PT
Where,
M' = the total quantity of credit money
V' = velocity of circulation of credit money
5. The Neo Classical Approach Or The Cambridge Approach:

In the early 1900’s Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard
Keynes put forward a fundamentally different approach to quantity theory, known as neoclassical theory or
cash balance approach. The Cambridge version holds that money increases utility in the following two ways:
 Enabling the possibility of split-up of sale and purchase to two different points, and
 Being a hedge against uncertainty.
The Cambridge equation:
Md = k PY
Where,
Md = demand for money
Y = real national income
P = average price level
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances
6. The Keynesian Theory of Demand for Money:

Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. According to Keynes,
people hold money (M) in cash for three motives:
 Transactions motive,
 Precautionary motive, and
 Speculative motive.
7. Inventory Approach to Transaction Balances:

Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for money,
known as Inventory Theoretic Approach, in which money or ‘real cash balance’ was essentially viewed as an
inventory held for transaction purposes. Inventory models assume that there are two media for storing value:
 Money and
 An interest-bearing alternative financial asset.
There is a fixed cost of making transfers between money and the alternative assets and Liquid financial
assets other than money offer a positive return.
Therefore, people hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost.
8. Friedman's Restatement of The Quantity Theory:

Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset
price theory.
 The demand for money as nothing more than theory of demand for capital assets
 Demand for money is affected by the same factors as demand for any other asset, namely:
 Permanent income
 Relative returns on assets (which incorporate risk).
Friedman identifies the following four determinants of the demand for money:
 is a function of total wealth,
 is positively related to the price level, P,
 rises if the opportunity costs of money holdings decline,
 is influenced by inflation.
9. The Demand For Money as Behavior Toward Risk (Tobin’s Risk-Aversion Approach):
In his classic article, ‘Liquidity Preference as Behavior towards Risk’ (1958), Tobin established that the
theory of risk-avoiding behavior of individuals provided the foundation for:
 The liquidity preference and
 For a negative relationship between the demand for money and the interest rate.
According to Tobin, the optimal portfolio structure is determined by:

 The risk/reward characteristics of different assets,
 The taste of the individual in maximizing his utility consistent with the existing opportunities
Demand for money as a store of wealth will decline with an increase in the interest rate.
10. Measurement of Money Supply:

From April 1977, the RBI has been publishing data on four alternative measures of money supply
denoted by M1, M2, M3 and M4 besides the reserve money:
M1 = Currency notes and coins with the people + demand deposits of banks (Current and Saving
deposit accounts) + other deposits with the RBI
M2 = M1 + savings deposits with post office savings banks
M3 = M1 + net time deposits with the banking system
M4 = M3 + total deposits with the Post Office Savings Organization (excluding National Savings
Certificates)
Following the recommendations of the Working Group on Money (1998), the RBI has started publishing a set
of four new monetary aggregates:
Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with
the RBI
= Net RBI credit to the Government + RBI credit to the Commercial sector +
RBI’s Claims on banks + RBI’s net Foreign assets + Government’s Currency
liabilities to the public – RBI’s net non monetary Liabilities
NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’
deposits with the RBI
NM2 = NM1 + Short-term time deposits of residents (including and up to contractual

maturity of one year)
NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial
institutions
‘Liquidity’ aggregates in addition to the monetary aggregates:

L1 = NM3 + All deposits with the post office savings banks (excluding National
Savings Certificates)
L2 = L1 +Term deposits with term lending institutions and refinancing institutions

(FIs) + Term borrowing by FIs + Certificates of deposit issued by FIs
L3 = L2+ Public deposits of non-banking financial companies
11. Money Multiplier:

Money Multiplier (m) = Money supply ÷ Monetary base
12. The Money Multiplier Approach to Supply of Money:

The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz,
(1963) considers three factors as immediate determinants of money supply, namely:
 The stock of high-powered money (H)
 The ratio of reserves to deposites, e = (ER/D) and
 The ratio of currency to depoists, c = (C/D)
To summarise the money multiplier approach, the size of the money multiplier is determined by the
required reserve ratio (r) at the central bank, the excess reserve ratio (e) of commercial banks and the currency
ratio (c) of the public. The lower these ratios are, the larger the money multiplier is.
13. The Credit Multiplier: Credit Multiplier = 1 ÷ Required Reserve Ratio
14. Monetary Policy Defined:

Monetary policy is essentially a programme of action undertaken by the monetary authorities,
normally the central bank, to control and regulate the demand for and supply of money with the public and
the flow of credit with a view to achieving predetermined macroeconomic goals.
15. The Monetary Policy Framework:
 The objectives of monetary policy,
 The analytics of monetary policy, and
 The operating procedure.
16. The Objectives Of Monetary Policy:

The objectives of monetary policy generally coincide with the overall objectives of economic policy. In
developing countries:
 Maintenance the economic growth,
 Ensuring an adequate flow of credit,
 Sustaining - a moderate structure of interest, and
 Creation of an efficient market for government securities.
17. Analytics of Monetary Policy:

The process or channels through which the change of monetary aggregates affects the level of
production and prices etc. There are mainly four different mechanisms:
 The interest rate channel,
 The exchange rate channel,
 The quantum channel (relating to money supply and credit), and
 The asset price channel i.e. via equity and real estate prices.
18. Operating Procedures and Instruments:

The operating framework relates to all aspects of implementation of monetary policy. It primarily
involves three major aspects, namely,
 Choosing the operating target,
 Choosing the intermediate target, and
 Choosing the policy instruments.
The operating target refers to the variable (for e.g. inflation) that monetary policy can influence with its
actions.
The intermediate target (e.g. economic stability) is a variable which the central bank can hope to influence to
a reasonable degree through the operating target and which displays a predictable and stable relationship
with the goal variables.
The monetary policy instruments are the various tools that a central bank can use to influence money market
and credit conditions and pursue its monetary policy objectives.
19. Cash Reserve Ratio (CRR):

Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time liabilities (NDTL) of
a scheduled commercial bank in India which it should maintain as cash deposit with the Reserve Bank.
20. Statutory Liquidity Ratio (SLR):

As per the Banking Regulations Act 1949, all scheduled commercial banks in India are required to
maintain a stipulated percentage of their total Demand and Time Liabilities (DTL)/Net DTL (NDTL) in one of
the following forms:
 Cash
 Gold, or
 Investments in un-encumbered Instruments
21. Liquidity Adjustment Facility (LAF):

LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding
RRBs) and primary dealers to avail of liquidity in case of requirement on an overnight basis against the
collateral of government securities including state government securities.
22. Marginal Standing Facility (MSF):

The Marginal Standing Facility (MSF) announced by the Reserve Bank of India (RBI) in its Monetary
Policy, 2011-12 refers to the facility under which scheduled commercial banks can borrow additional amount
of overnight money from the central bank over and above what is available to them through the LAF window
by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
23. Market Stabilisation Scheme (MSS):

This instrument for monetary management was introduced in 2004 following a MoU between the
Reserve Bank of India (RBI) and the Government of India (GOI) with the primary aim of aiding the sterilization
operations of the RBI. Under this scheme, the Government of India borrows from the RBI and issues treasury-
bills/dated securities for absorbing excess liquidity from the market arising from large capital inflows.
24. The Monetary Policy Framework Agreement:

Agreement reached between the Government of India and the RBI on the maximum tolerable inflation
rate that the RBI should target to achieve price stability. The amended RBI Act (2016) provides for a statutory
basis.
 The inflation target is to be set, once in every five years
 4 per cent CPI inflation as the target for August 5, 2016 to March 31, 2021
 Upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent
 Publish a Monetary Policy Report every six months,
 The following factors are notified by the CG:
 The average inflation is more than the upper tolerance level for any three consecutive
quarters; or
 The average inflation is less than the lower tolerance level for any three consecutive quarters.
25. The Monetary Policy Committee (MPC):

An important landmark in India’s monetary history is the constitution of an empowered six-member
Monetary Policy Committee (MPC) in September, 2016 consisting of the RBI Governor (Chairperson), the RBI
Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining
three central government nominees representing the Government of India who are persons of ability, integrity
and standing, having knowledge and experience in the field of Economics or banking or finance or monetary
policy.
26. Repurchase Options or in short ‘Repo’: is defined as ‘an instrument for borrowing funds by selling
securities with an agreement to repurchase the securities on a mutually agreed future date at an
agreed price which includes interest for the funds borrowed’.
27. Reverse Repo: is defined as an instrument for lending funds by purchasing securities with an
agreement to resell the securities on a mutually agreed future date at an agreed price which includes
interest for the funds lent.
28. Bank Rate: Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined
as ‘the standard rate at which the Reserve Bank is prepared to buy or rediscount bills of exchange or
other commercial paper eligible for purchase under the Act’. The bank rate once used to be the policy
rate in India i.e. the key interest rate based on which all other short term interest rates moved.
29. Open Market Operations: Open Market Operations (OMO) is a general term used for market
operations conducted by the Reserve Bank of India by way of sale/purchase of Government securities
to/from the market with an objective to adjust the rupee liquidity conditions in the market on a
durable basis.
Question 1
(a) Calculate M if Velocity 19, Price 108.5 and Volume of transactions 120 billion.
(b) What will be the effect on money supply if velocity is 25?
Answer
(a) MV = PT,
M × 19 = 108.5 × 120
M = 685.26 billion
(b) MV = PT,
M × 25 = 108.5 × 120
M = 520.8 billion
Effect: Money supply will decrease by 164.46 (685.26 – 520.8) billion.
Question 2
(a) Calculate velocity of money, Money Supply 5,000 billion, Price 110 and Volume of transaction 200.
(b) What will be the outcome if volume of transaction increases to225?
Answer
(a) MV = PT,
5,000 × V = 110 × 200
V = 4.4
(b) MV = PT,
5,000 × V = 110 × 225
V = 4.95
Question 3
Calculate Narrow Money (M1) from the following data:
Currency with public `90,000 Crores
Demand Deposits with Banking System `2,00,000 Crores
Time Deposits with Banking System `2,20,000 Crores
Other Deposits with RBI `2,80,000 Crores
Saving Deposits of Post office saving banks `60,000 Crores
Answer
M1 = Currency with public + Demand Deposits with Banking System + Other
Deposits with the RBI
= 90,000 + 2,00,000 + 2,80,000 = 5,70,000 Crores
Question 4
Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every `1,00,000 deposited in
the banking system. What will be the total credit money created by the banking system in each case?
Answer
1
(a) Credit Multiplier = Required Reserved Ratio
1
For RRR 10% = Required Reserved Ratio
= 1/10% = 10
1
For RRR 12.5% = Required Reserved Ratio
= 1/12.5% = 8
(b) Credit creation = Initial deposits × Credit Multiplier

For RRR 10% = 1,00,000 × 10 = 10, 00,000
For RRR 12.5% = 1,00,000 × 8 = 8, 00,000
Question 5
Calculate currency with the Public from the following data (` Crores)
Notes in Circulation 24,96,611
Circulation of Rupee Coin 25,572
Circulation of Small Coins 743
Cash on Hand with Banks 98,305
Answer
Currency with the Public = 24,96,611 + 25,572 + 743 – 98,305 = 24,24,621
Question 6
Calculate M2 from the following data: (` Crores)
Notes in Circulation 24,20,964
Circulation of Rupee Coin 25,572
Circulation of Small Coins 743
Post Office Saving Bank Deposits 1,41,786
Cash on Hand with Banks 97,563
Deposit Money of the Public 17,76,199
Demand Deposits with Banks 17,37,692
‘Other’ Deposits with Reserve Bank 38,507
Total Post Office Deposits 14,896
Time Deposits with Banks 1,78,694
Answer
M2 = M1+ Post Office Saving Bank Deposits
M1 = (Notes in Circulation + Circulation of Rupee Coin + Circulation of Small Coins –

Cash on Hand with Banks) + Deposit Money of the Public
= (24,20,964 + 25,572 + 743 – 97,563) + 17,76,199 = 41,25,915 Crores
M2 = M1+ Post Office Saving Bank Deposits

= 41,25,915 + 1,41,786 = 42,67,701 Crores
Question 7
If the required reserve ratio is 10 percent, currency in circulation is `400 billion, demand deposits are `1,000
billion, and excess reserves total `1 billion, find the value of money multiplier.
Answer
r = 10% or 0.10
Currency = 400 billion
Deposits = 1,000 billion
Excess Reserves = 1 billion
Money Supply is M = Currency + Deposits = 1,400 billion
c = C/D
= 400 billion/1,000 billion
= 0.4 or depositors hold 40% of their money as currency
e = 1 billion /1,000 billion

= 0.001 or banks hold 0.1% of their deposits as excess reserves
1+c 1 + 0.4
Multiplier ‘m’ = = = 2.79
r+e+c 0.1 + 0.001 + 0.4
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.

CHAPTER 4 - INTERNATIONAL TRADE
1. The Mercantilists’ View of International Trade:
 Increase exports and collect precious metals in return
 More gold and silver a country accumulates, the richer it becomes
 Mercantilism advocated maximizing exports in order to bring in more “specie” (precious metals) and
minimizing imports through the state imposing very high tariffs on foreign goods
 Trade is a ‘zero-sum game’
 Who win does so only at the expense of losers
 One country’s gain is equal to another country’s loss
2. The Theory of Absolute Advantage:

 Adam Smith was the first to put across the possibility that international trade is not a zero-sum game
 Absolute cost advantage is the determinant of mutually beneficial international trade.
 In other words, exchange of goods between two countries will take place only if each of the two
countries can produce one commodity at an absolutely lower production cost than the other country.
Output per Hour of Labour

Commodity Country A Country B
Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 5
 Country A is more efficient than country B, or has an absolute advantage over country B in production
of wheat.
 Similarly, country B is more efficient than country A, or has an absolute advantage over country A in
the production of cloth.
3. The Theory of Comparative Advantage:

 David Ricardo developed the classical theory of comparative advantage in his book ‘Principles of
Political Economy and Taxation’ published in 1817.
 Even if one nation is less efficient than the other nation in the production of all commodities, there is
still scope for mutually beneficial trade.
 The first nation should specialize in the production and export of the commodity in which its absolute
disadvantage is smaller and import the commodity in which its absolute disadvantage is greater
Output per Hour of Labour

Commodity Country A Country B
Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 2
 Country A’s absolute advantage is greater in wheat

 Country B’s absolute disadvantage is smaller in cloth, so its comparative advantage lies in cloth
production.
4. The Heckscher -Ohlin Theory of Trade or Factor-Endowment Theory of Trade or Modern Theory
of Trade or Heckscher-Ohlin-Samuelson theorem:
 Different regions have different factor endowments (Labour, Capital).
 If a country is a capital abundant one, it will produce and export capital intensive goods.
 A labour-abundant country will produce and export labour intensive goods
5. New Trade Theory – An Introduction:

 New Trade Theory (NTT) is an economic theory that was developed in the 1970’s as a way to
understand international trade patterns.
 According to NTT, two key concepts give advantages to countries that import goods to compete with
products from the home country:
 Economies of Scale: If the firm serves domestic as well as foreign market instead of just one, it
can reap the benefit of large scale of production consequently the profits are likely to be higher
 Network effects: The value of the product or service is enhanced as the number of individuals
using it increases. This is also referred to as the ‘bandwagon effect’.
6. Forms of Import Tariffs:

 Specific Tariff fixed monetary tax per physical unit of the good imported
 Ad valorem tariff constant percentage of the monetary value of one unit of the imported good
 Mixed Tariffs 5 per cent ad valorem or `3,000 per tonne, whichever is higher
 Compound Tariff or a Compound Duty is a combination of an ad valorem and a specific tariff
 Technical/Other Tariff the duties are payable by its components or related items
 Tariff Rate Quotas imports above the quota face a much higher tariff
 Most-Favored Nation Tariffs MFN rates are the highest (most restrictive) that WTO members charge
one another
 Variable Tariff a duty typically fixed to bring the price up to the domestic support price
 Preferential Tariff a lower tariff is charged from goods imported from a country which is given
preferential treatment
 Bound Tariff tariff which a WTO member binds itself with a legal commitment not to raise it above a
certain level
 Applied Tariffs duty that is actually charged on imports
 Escalated Tariff nominal tariff rates on imports of manufactured goods are higher than tariff rates on
intermediate inputs and raw materials
 Prohibitive tariff so high that no imports will enter
 Import subsidies
7. Tariffs as Response to Trade Distortions:

 Anti-dumping Duties: Dumping occurs when manufacturers sell goods in a foreign country below the
sales prices in their domestic market or below their full average cost of the product. Anti-dumping
duty is additional import duty so as to offset the foreign firm's unfair price advantage.
 Countervailing Duties: Countervailing duties are tariffs that aim to offset the artificially low prices
charged by exporters who enjoy export subsidies and tax concessions offered by the governments in
their home country.
8. Effects of Tariffs:
 Tariff barriers create obstacles to trade, decrease the international trade
 Tariffs discourage import
 Protect domestic industries
 The price increase in the domestic market
 An increase in the output of the existing firm
 An increase in employment in the industry
 Prevent countries from enjoying gains from trade arising from comparative advantage.
 Tariffs increase government revenues
9. Non - Tariff Measures (NTMs):

Non-tariff measures comprise all types of measures which alter the conditions of international trade,
including policies and regulations that restrict trade and those that facilitate it:
 Technical Measures
 Non-technical Measures
10. Technical Measures:

 Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied to protect human, animal or
plant life from risks arising from additives, pests, contaminants, toxins or disease-causing organisms
and to protect biodiversity
 Technical Barriers To Trade (TBT): Mandatory ‘Standards and Technical Regulations’ that define the
specific characteristics that a product should have, such as its size, shape, design, labelling / marking
/ packaging, functionality or performance and production methods, excluding measures covered by
the SPS Agreement
11. Non - Technical Measures:

 Import Quotas
 Price Control Measures/Para Tariff Measures
 Non-automatic Licensing and Prohibitions
 Financial Measures
 Measures Affecting Competition
 Government Procurement Policies
 Trade-Related Investment Measures
 Distribution Restrictions
 Restriction on Post-sales Services
 Administrative Procedures
 Rules of origin
 Safeguard Measures
 Embargos/Total Ban
12. Export - Related Measures:

 Ban on exports
 Export Taxes
 Export Subsidies and Incentives
 Voluntary Export Restraints
13. Taxonomy of Regional Trade Agreements (RTAS):

 Unilateral trade agreements
 Bilateral Agreements
 Regional Preferential Trade Agreements
 Trading Bloc: group of countries that have a free trade agreement between themselves
 Free-trade area: group of countries that eliminate all tariff barriers independence in determining their
tariffs with nonmembers
 A customs union: group of countries that eliminate all tariffs on trade among themselves but maintain
a common external tariff on trade with countries
 Common Market: free flow of factors of production labour and capital
 Economic and Monetary Union: common currency and macroeconomic policies
14. The General Agreement on Tariffs and Trade (GATT):

 GATT provided the rules for much of world trade for 47 years, from 1948 to 1994,
 It was only a multilateral instrument governing international trade or a provisional agreement
 The original intention to create an International Trade Organization (ITO) did not succeed
 The Kennedy Round in the mid-sixties, and the Tokyo Round in the 1970s led to massive reductions
in bilateral tariffs, establishment of negotiation rules and procedures on dispute resolution, dumping
and licensing
 The eighth, the Uruguay Round of 1986-94, was the last and most consequential of all rounds and
culminated in the birth of WTO and a new set of agreements.
15. The GATT lost its relevance by 1980s because:

 It was obsolete
 International investments had expanded substantially
 Intellectual property rights and trade in services were not covered
 Liberalizing agricultural trade were not successful
 Inadequacies in institutional structure and dispute settlement system
16. The Uruguay Round and the Establishment of WTO:

 The need for a formal international organization which is more powerful and comprehensive was felt
by late 1980s
 Members established 15 groups to work
 The Round started in Uruguay in September 1986
 Finally, in December 1993, the Uruguay Round was completed after seven years
 The agreement was signed by most countries on April 15, 1994, and took effect on July 1, 1995.
 It also marked the birth of the World Trade Organization (WTO)
17. The World Trade Organization (WTO):

 The most important outcome of the Uruguay Round agreement was the replacement of the GATT
secretariat with the WTO in Geneva with authority not only in trade in industrial products but also in
agricultural products and services.
 The objectives of the WTO Agreements include “raising standards of living, ensuring full employment
and a large and steadily growing volume of real income and effective demand, and expanding the
production of and trade in goods and services”
 The principal objective of the WTO is to facilitate the flow of international trade smoothly, freely, fairly
and predictably
18. The Structure of The WTO:

 Secretariat located in Geneva, headed by a Director General
 It has a three-tier system of decision making
 The WTO’s top level decision-making body is the Ministerial Conference
 The next level is the General Council
 At the next level, the Goods Council, Services Council and Intellectual Property (TRIPS) Council
19. The Guiding Principles of World Trade Organization (WTO):

 Trade without discrimination
 The National Treatment Principle (NTP)
 Freer trade/“progressive liberalization”
 Predictability
 Principle of general prohibition of quantitative restrictions
 Greater competitiveness
 Tariffs as legitimate measures for the protection of domestic industries
 Transparency in Decision Making
 Market Access
 Special privileges to less developed countries
 Protection of Health & Environment
 A transparent, effective and verifiable dispute settlement mechanism
20. The Doha Round:

 The Doha Round, which is the ninth round, in November 2001
 Seeks to accomplish major modifications through lower trade barriers and revised trade rules
 The negotiations include 20 areas of trade
 The most controversial topic in the yet to conclude Doha Agenda has been agriculture trade
21. The Exchange Rate:

Exchange rate is the rate at which the currency of one country exchanges for the currency of another
country.
 A direct quote is the number of units of a local currency exchangeable for one unit of a foreign
currency. Example: `66 is needed to buy one US dollar
 An indirect quote is the number of units of a foreign currency exchangeable for one unit of
local currency. Example: $ 0.0151 per rupee
22. The Exchange Rate Regimes:

It refers to the method by which the value of the domestic currency in terms of foreign currencies is
determined. There are two types of exchange rate regimes:
 Floating exchange rate regime (also called a flexible exchange rate):
The equilibrium value of the exchange rate of a country’s currency is market determined, and
 Fixed exchange rate regime/pegged exchanged rate:
Central Bank and/or government announces what its currency will be worth in terms of either another
country’s currency or a basket of currencies or another measure of value, such as gold
23. The Main Advantages of a Fixed Rate Regime are:

 Eliminates exchange rate risks
 Enhance international trade
 Lower levels of inflation
 Stability encourages investment
 Enhance the credibility of the country’s monetary policy
 Adequate amount of foreign exchange reserves
24. The Main Advantages of a Floating Rate Regime are:

 Independent monetary policy
 Exchange rate can be used as a policy tool
 The central bank is not required to maintain a huge foreign exchange reserves
25. Nominal Versus Real Exchange Rates:

 Nominal exchange rate: how much of one currency can be traded for a unit of another
currency when prices are constant.
 The ‘Real exchange rate': describes ‘how many’ of a good or service in one country can be
traded for ‘one’ of that good or service in a foreign country. It is calculated as:
𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥

Real exchange rate = Nominal exchange rate ×
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥
26. The Foreign Exchange Market:

The wide-reaching collection of markets and institutions that handle the exchange of foreign
currencies is known as the foreign exchange market.
In the foreign exchange market, there are two types of transactions:

 Current transactions which are carried out in the spot market and the exchange involves immediate
delivery, and
 Contracts to buy or sell currencies for future delivery which are carried out in forward and/or futures
markets
27. Determination of Nominal Exchange Rate:

The supply of and demand for foreign exchange in the domestic foreign exchange market determine
the country’s exchange rate.
Determination of Nominal Exchange Rate
28. Devaluation (Revaluation) VS Depreciation (Appreciation):

 Devaluation is a deliberate downward adjustment in the value of a country's currency relative to
another currency, group of currencies or standard and depreciation is a decrease in a currency's value
due to market forces.
 Revaluation is the opposite of devaluation and the term refers to a discrete raising of the otherwise
fixed par value of a nation’s currency and appreciation is an increase in a currency's value due to
market forces.
29. Impacts of Exchange Rate Fluctuations on Domestic Economy:

 Changes in import spending and export revenue
 Changing the relative prices of domestically-produced and foreign-produced goods and services
 Affect economic activity in the domestic economy
 Currency depreciation helps in increases the volume of exports and promotes trade balance.
 Increased import prices will increase firms’ cost of production, push domestic prices up and decrease
real output
 For an economy where exports are significantly high, a depreciated currency would mean a lot of gain
 Make financial forecasting more difficult for firms
 Depreciating currency hits investor sentiments
30. Types of Foreign Capital:

 Foreign aid or assistance which may be:
 Bilateral or direct inter government grants
 Multilateral aid
 Tied aid
 Foreign grants which are voluntary transfer
 Borrowings which may take different forms such as:
 Direct inter government loans
 Loans from international institutions (e.g. world bank, IMF, ADB)
 Soft loans for e.g. from affiliates of World Bank such as IDA
 External commercial borrowing, and
 Trade credit facilities
 Deposits from non-resident Indians (NRI)
 Investments in the form of:
 Foreign portfolio investment (FPI) in bonds, stocks and securities, and
 Foreign direct investment(FDI) in industrial, commercial and similar other enterprises
31. Foreign Direct Investment (FDI):

Foreign direct investment is defined as a process whereby the resident of one country (i.e. home
country) acquires ownership of an asset in another country (i.e. the host country) and such movement of
capital involves ownership, control as well as management of the asset in the host country.
FDI may be categorized as horizontal, vertical or conglomerate:
 A horizontal direct investment: same type of business
 A vertical investment: different from main business activity yet in some way supplements its
major activity
 A conglomerate: unrelated to its existing business in its home country
32. Modes of Foreign Direct Investment (FDI):

 Opening of a subsidiary in a foreign country,
 Equity injection into an overseas company,
 Acquiring a controlling interest in an existing foreign company,
 Mergers and acquisitions (M&A),
 Joint venture with a foreign company,
 Green field investment
33. Foreign Portfolio Investment (FPI):
Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than ‘real
capital’ and does not involve ownership or control on the part of the investor.
34. Foreign Direct Investment (FDI) VS Foreign Portfolio Investment (FPI):

Foreign direct investment (FDI) Foreign portfolio investment (FPI)
Investment involves creation of physical assets Investment is only in financial assets
Has a long term interest and therefore remain Only short term interest and generally remain
invested for long invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology transfer Not accompanied by technology transfer
Direct impact on employment of labour and wages No direct impact on employment of labour and
wages
Enduring interest in management and control No abiding interest in management and control
Securities are held with significant degree of Securities are held purely as a financial investment
influence by the investor on the management of the and no significant degree of influence on the
enterprise management of the enterprise
35. Reasons for Foreign Direct Investment:

 The chief motive for shifting of capital between different regions or between different industries is the
expectation of higher rate of return than what is possible in the home country
 Investment in a host country may be found profitable by foreign firms because of some firm-specific
knowledge or assets
36. Benefits of Foreign Direct Investment:

 Competitive environment in the host country
 Enhance the total output
 FDI can accelerate growth and foster economic development
 Political reforms, including legal systems and macroeconomic policies
 It generates direct and indirect employment in the recipient country
 Promote relatively higher wages for skilled jobs
 Source of new tax revenue
 Better work culture and higher productivity standards
37. Foreign Direct Investment In India (FDI):

 The most important shift in investment policy occurred when India embarked upon economic
liberalisation and reforms programme in 1991 to raise its growth potential and to integrate it with the
world economy.
 According to United Nations Conference on Trade and Development (UNCTAD)’s World Investment
Report 2016, India ranks as the tenth highest recipient of foreign direct investment globally in 2015
receiving $44 billion of investment that year compared to $35 billion in 2014. India has also moved up
by one rank to become the sixth most preferred investment destination.
 India received the maximum FDI equity inflows from Mauritius (US$ 5.85 billion) followed by
Singapore, Netherlands, Japan and the USA.
38. In India, Foreign Investment is Prohibited in the Following Sectors:

 Lottery business including Government / private lottery, online lotteries, etc.
 Gambling and betting including casinos etc.
 Chit funds
 Nidhi company
 Trading in Transferable Development Rights (TDRs)
 Real Estate Business or Construction of Farm Houses
 Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes.
 Atomic energy and railway operations
39. Overseas Direct Investment by Indian Companies:
 Outward Foreign Direct Investment (OFDI) from India stood at US$ 1.86 billion in the month of June,
2016
 The overseas investments have been primarily driven by resource seeking, market seeking or
technology seeking motives
 Many Indian IT firms like Tata Consultancy Services, Infosys, WIPRO, and Satyam acquired global
contracts and established overseas offices in developed economies to be close to their key clients
 Overseas investments by Indian companies, especially to acquire energy resources in Australia,
Indonesia and Africa
 Indian entrepreneurs are also choosing investment destinations in countries such as Mauritius,
Singapore, British Virgin Islands, and the Netherlands on account of higher tax benefits they provide
Question 1
Countries Rose Land and Daisy land have a total of 4,000 hours each of labour available each day to produce
shirts and trousers. Both countries use equal number of hours on each good each day. Rose Land produces
800 shirts and 500 trousers per day. Daisy land produces 500 shirts and 250 trousers per day.
In the absence of trade:
1. Which country has absolute advantage in producing (a) Shirts, (b) Trousers.
2. Which country has comparative advantage in producing (a) Shirts, (b) Trousers.
Answer
1. Calculation of absolute advantage:
Goods produced by each country:
Country Shirts Trousers
Rose Land 800 500
Daisy Land 500 250
Each country has 4,000 hours of labour and uses 2,000 hours each for both the goods. Therefore, the number
of hours spent per unit on each good:
Country Shirts Trousers
Rose Land 2.5 4
Daisy Land 4 8
Since Rose Land produces both goods in less time, it has absolute advantage in both shirts and trousers.
2. Calculation of comparative advantage:

Rose Land:
Opportunity cost of Shirts = 2.5/4 = 0.625 trousers
Opportunity cost of Trousers = 4/2.5 = 1.6 shirts
Daisy Land:
Opportunity cost of Shirts = 4/8 = 0.5 trousers
Opportunity cost of Trousers = 8/4 = 2 shirts
For producing shirts Daisy Land has comparative advantage and for producing Trousers Rose Land has
comparative advantage
Question 2
The table given below shows the number of labour hours required to produce Sugar and Rice in two countries
X and Y:
Commodity Country X Country Y
1 Unit of Sugar 2.0 5.0
1 unit of Rice 4.0 2.5
(a) Compute the Productivity of labour in both countries in respect of both commodities.
(b) Which country has absolute advantage in production of Sugar?
(c) Which country has absolute advantage in production of Rice?
Answer
(a) Productivity of labour (output per labour hour = the volume of output produced per unit of labour
input) = output / input of labour hours
Output of commodity Units in Country X Units in Country Y
Sugar 0.5 0.20
Rice 0.25 0.40
(b) A country has an absolute advantage in producing a good over another country if it requires fewer
resources to produce that good. Since one hour of labour time produces 0.5 units of sugar in country
X against 0.20 units in country Y, Country X has absolute advantage in production of sugar.
(c) Since one hour of labour time produces 0.40 units of rice in country Y against 0.25 units in country X,
Country Y has absolute advantage in production of rice.
Question 3
The Nominal Exchange rate of India is `56/1$, Price Index in India is 116 and Price Index in USA is 112. What
will be the Real Exchange Rate of India?
Answer
The ‘real exchange rate' describes ‘how many’ of a good or service in one country can be traded for ‘one’ of
that good or service in a foreign country. Thus it incorporates changes in prices
Real Exchange rate = Nominal exchange rate* (Domestic price index/Foreign price index)
116
= 56 × 112 = 58
Question 4
(a) Labour group in your country oppose the flow of FDI into the country on grounds of perceived
inequities consequent on FDI. What are their arguments?
(b) Beth & Sushil are members of the committee for resolution of the issue cited above. What arguments
would they put forth to convince the labour groups with respect to welfare implications for labour that
may arise from FDI?
Answer
(a) Foreign corporates concentrate on capital-intensive methods of production - so they need to hire only
relatively few workers, technology inappropriate for a labour-abundant country - does not support
generation of jobs or address poverty and unemployment help accentuate the already existing income
inequalities- jobs that require expertise and entrepreneurial skills for creative decision making may
generally be retained in the home country and therefore the host country is left with routine
management jobs that demand only lower levels of skills and ability. The argument of possible human
resource development and acquisition of new innovative skills through FDI may not be realized in
reality- may resort to anti-ethical, and anticompetitive practices- ‘off –shoring’, or shifting jobs –
negative effects on employment potential of home country- continuance of lower labour or
environmental standards and ruthless labour and natural resources exploitation.
(b) FDI will - accelerate growth and foster economic development – bring in technological know-how,
management skills and marketing methods- generate direct employment in the recipient country-
Subsequent FDI as well as domestic investments propelled in the downstream and upstream projects
that come up in multitude of other services generate multiplier effects on employment and income -
generate indirect employment opportunities - promote relatively higher wages for skilled jobs- more
indirect employment will be generated to persons in the lower-end services sector occupations
thereby catering to an extent even to the less educated and unskilled engaged in those units- Better
work culture and higher productivity standards- induce productivity related awareness and may also
contribute to overall human resources development.

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ECONOMICS FOR FINANCE LAST DAY REVISION SUMMARY BOOK BY CA NAMIT ARORA SIR 3

CHAPTER 1 - DETERMINATION OF NATIONAL INCOME

2. Usefulness and Significance of National Income Estimates:

3. Different Concepts of National Income:

Factor Cost = Market Price - Net Indirect Taxes

Net Indirect Taxes = Indirect Taxes - Subsidies

Gross = Net + Depreciation

Net = Gross – Depreciation

GDPMP = Value of Output in the Domestic Territory – Value of Intermediate

Factor Cost Net

4. Few Important Points While Learning About National Income:

5. Nominal GDP VS Real GDP (GDP at Current and Constant Prices):

6. Per Capita Income:

7. Personal Income (PI):

PI = NI - Undistributed profits – Net interest payments made by households – Corporate Tax +

8. Disposable Personal Income (DI):

Two more concepts need to be understood, namely:

(b) Gross National Disposable Income (GNDI)

9. Categories of Domestic Income:

10. Private Income:

12. The Circular Flow of Income:

Production of goods and services

Disposition Distribution as factor income

NDP/NVAFC = NVAMP – Net Indirect taxes

NI/NNPFC = NVAFC + NFIA

14. Income Method or Factor Payment Method or Distributed Share Method:

NNPFC/NI = Compensation of employees + Operating Surplus (rent + interest + profit)

15. Expenditure Method:

1. Final Consumption Expenditure:

GNPMP = GDPMP + NFIA

GNPFC = GNPMP – Net indirect taxes

NNPFC or NI = GNPFC - Depreciation

16. National Income as per Keynes:

The Keynesian theory of income determination is presented in three models:

17. Circular Flow in a Simple Two-Sector Model:

18. The Simple Two Sector Economy Model Assumes:

19. The Aggregate Demand Function (AD): Two-Sector Model:

20. The Consumption Function (C):

21. Marginal Propensity to Consume (MPC) ‘b’: MPC (b) = Δ𝐂/Δ𝒀

22. Average Propensity to Consume (APC): APC = 𝐂/𝐘

23. The Saving Function (S): S = f(Y)

24. The Marginal Propensity to Save (MPS): MPS (1 - b) = Δ𝐒/Δ𝐘

25. Average Propensity to Save (APS): APS = 𝐒/𝐘

26. Relationship Between Income and Consumption:

28. Determination of Equilibrium Income Chart: Two Sector Model:

29. Determination of Equilibrium Income: Three Sector Model:

30. Determination of Equilibrium Income: Four Sector Model:

32. The Investment Multiplier (k)

Δ𝒀/Δ𝑰 = 1/1-MPC = 1/MPS

 In three sector model:

 In four sector model:

(c) Total spending by households: = `35,000 × 0.8 = `28,000

= 5,000 – 4,500 = `500 (when Y is `5,000)

= 6,000 – 5,300 = `700 (when Y is `6,000)

NDPMP = GDPMP - Consumption of fixed capital

GDPMP = 1,000 + 1,100 + 2,000 + 400+ 450 = 4,950 Crores

GNPMP = GDPMP + NFIA

NNPMP = GNPMP - Depreciation

NNPFC = NNPMP – Net indirect tax

Disposable personal income (DI):

NVAFC = GVAMP – Depreciation + NFIA - Net Indirect Tax

NDPMP = GDPMP – Consumption of fixed capital

NDPFC = NDPMP – NIT

NDPFC = Compensation of employees + Operating surplus + Mixed income