UNIT-I National Income and related aggregates Chapter1.

- Some basic concepts of national income

National income accounting is a branch of macroeconomics of which estimation of national income
and related aggregates is a part. In a closed economy, without a government or external trade, there
are only two sectors, namely households and firms. A. Classification of Goods:- i. Final goods:- These
are those goods which are ready to be used by their final users to satisfy their wants directly. Final
users can be either consumers (final consumer goods) or producers (final producer goods). Final
goods have direct demand The value of final goods will be included in National Income. ii.
Intermediate goods:- These are the goods which are purchased by one firm from another firm in the
form of raw material and are completely used up within the same year of purchase or are purchased
for reselling purposes within one year. Therefore, Intermediate goods are also called single use
producer goods. Intermediate goods have indirect demand as their demand depends upon demand
of final goods. Value of intermediate goods ultimately becomes part of the value of final goods.

Therefore, it is not included in calculation of National Income. Note 🙂The same goods may be final or
intermediate:- The same goods may be final or intermediate. It depends upon the end-use of the
goods and not on the good itself. If the goods are used by producers as raw material then they are
classified as intermediate goods. If the goods are used by producers as fixed assets they are known
as final goods. 🡺 For eg: - Purchase of car. If cars are purchased by consumers, they are final goods
and if purchased by retailers then they are known as intermediate goods. iii. Consumer goods:- These
goods are directly used by consumers to satisfy human wants. It includes: - Durable goods: - These
goods are used for several years and are of high value which remains with the consumer. For eg: -
Car, scooter etc. Semi-durable goods: - These are those goods which are used for a specific time
period. For eg: - Clothes, shoes etc. Non-durable goods: - The value of such goods will be finished
after single use of goods. For eg: - Milk, etc. Services: - The services that directly satisfy human want.
For eg: - Doctor, Lawyer etc. Besides households, consumer goods are also purchased by the
government and NGOs. iv. Capital goods:- These are the goods which are used as fixed assets by the
producers and help in production of other goods and services for overtime and help in generation of
income. Capital goods are also called producer goods and producer goods are of two types Durable
capital goods:- Which help in production of other goods and services for overtime and help in
generation of income like Building, Machinery etc. Non durable capital goods:-Which help in
production of other goods and services for one year or slightly more and completely used in
production process like raw material, electricity, water, printer etc.Non durable capital good are also

called intermediate goods or single use producer goods Note 🙂 All capital goods are producer goods,
but all producer goods are not capital goods. Goods which are of high value and used for further
production for overtime are known as capital goods. but there are certain products which are used
by producers such as nails, screws etc. These are producer goods but cannot be treated as capital
goods and are called non durable capital goods. A Good can be a producer goods or a consumer
goods at the same time There are certain goods which can be used by producers as well as
consumers.For eg: - Sewing machines with tailor are capital goods whereas sewing machines for
household purpose are consumer goods. Therefore it is the end use of the product and not the
product itself defines a good as a capital good or consumer goods B. Concept and components of
consumption expenditure:- Consumption expenditure refers to the expenditure done for the
consumption purpose by households, government and non-profit organizations. Household: -
Household incurs consumption expenditure to satisfy their needs. Government: - Government incurs
expenditure to purchase the goods which are to be distributed among defense forces, government
schools etc. Non-profit organization: - Goods purchased for the purpose to distribute as charity. 🡺
Sum of all these components will result in consumption expenditure and included in National
Income. C. Concept and components of Investment:- Investment means addition made in the existing
stock of capital goods and inventory. So a change in stock of capital and inventory is called capital
formation. Capital formation is a flow concept and of following two types i. Fixed Investment:- like
purchase of factory, building, machinery ● It is an increase in the stock of existing fixed assets, which
is used in the process of production for many years. It does not include purchase of financial assets
like shares, bonds,debentures, insurance policy etc since these are only paper claims and do not add
to stock of capital goods. ● It raises the capacity of producers. ● Increased capacity of producers will
increase the overall production of the country. ● High level of output implies high GDP. ii. Inventory
& Inventory Investment:- ● Inventory means stock of unsold goods, semi finished goods and raw
material, therefore stock of unsold goods, semi finished goods and raw material which a firm carries
forward from one year to next year is called inventory and changes made in inventory during the
year are called inventory investment. ● Inventory ensures regular supply of inputs to the producers.
And it is only inventory investment which is included in national income. iii. Gross Investment:- ● It
includes expenditure by the producer on the purchase of new assets as well as expenditure on the
replacement of existing assets. ● Replacement of existing assets refers to depreciation. iv. Net
Investment:- ● It includes expenditure by the producers only on the purchase of new assets. ● It
does not include expenditure on existing assets. ● It generates employment opportunities, promotes

efficiency of labour and accelerates GDP growth. Note 👍 It is only net investment expenditure of the
firm and consumption expenditure included in national income. C. Concept of Depreciation:- ●
Depreciation means fall in the value of fixed assets due to normal wear and tear of assets or
expected obsolescence . When any assets after regular use, have some reduction in their value or
their value is reduced when the assets become obsolete, it is known as depreciation. ● Because of
depreciation, fixed assets are replaced. Therefore all capital goods produced ● To complete their cost
of replacement, producers keep some funds with them which is known as depreciation reserve fund.
● Net investment= Gross investment – depreciation 🡺 Depreciation= cost of capital asset-scrap value
Estimated life of capital asset Depreciation is also defined as:- Consumption of fixed capital, Current
replacement cost Replacement cost of fixed capital Part of capital assets used in the production
process. Difference between depreciation and capital loss Expected obsolescence (Depreciation)
Unexpected obsolescence (Capital loss) 🡺 It means change in value of fixed assets due to regular use
of assets. 🡺 It means change in value of fixed assets due to any natural calamities. Or unexpected 🡺
It is a part of depreciation and expected loss. 🡺 It is a part of capital loss and unexpected loss. 🡺 It
can be managed by reserve fund. 🡺 It can be managed through insurance. D. Stocks and Flow:-
Stock: - A stock is a quantity measured at a specific time period. It is an economic variable which is
measured at a given point of time. For eg: - wealth, money supply, population, inventories etc. Stock
impacts the flow of goods and services as larger the stock of wealth larger is the flow of goods and
services. Flow: - A flow is a quantity measured over a specified time period. It is an economic variable
which is measured over a period of time. Flow is time dimensional. For eg: - consumption and
investment. Flow impacts the stock as larger the income generation larger the stock of wealth. Basis
Stock Flow Meaning Any variable measured at a point of time. Any variable measured over a period
of time. Time dimension It has no time dimension. It has a time dimension. Examples Capital, wealth,
inventories. Per capita income, inventories speed. Nature It is a static concept. It is a dynamic
concept. E. Transfer income and factor income Factor income :- It is received in return for rendering
productive services. It is an earned income and hence an earning concept and it is two-sided
payment and it is injective in nature.It is included in national income Transfer income:- Any income
without having production in economy and without employing factors of production is transfer
income. It is an unearned income and hence only receipt concept and it is one sided payment and it
is leakage in nature.It is not included in national income Transfer income is of two types Current
transfer: These are the transfers made out of current income of the payer and are added to current
income of the recipient. These are meant for consumption purposes only. Examples are old age
pension, unemployment allowances, Donations, Gifts etc. Capital transfer: These are transfers made
out of past savings and wealth of the payer and are added to the savings and wealth of the recipient.
These are meant for capital formation. Examples – investment grants, capital gain tax & wealth tax,
compensation for war damages, lump sum payments to households for natural calamities damages
etc Treatment in National income - Both Current transfers and capital transfers are not included in
National income. F. Production of goods for market and self-consumption a) Production of goods for
self-consumption - Goods produced by the household producers and retained for their own use are
called goods for self- consumption. It is also called own account production. Production of goods for
self-consumption are produced by producer household and it does not generate any surplus and
hence does not involve funds for any investment b) Production of goods for Market – Goods which
are sold for a price by their producers are called goods for exchange or market. Production of goods
for market is produced by corporate and quasi corporate enterprises it generates surplus and hence
provides funds for investment Treatment in National income - Production for self- consumption and
for market both are included in estimation of National income because they are a part of current
year’s production G. Production of services for market and self -consumption a) Services produced
for self -consumption are not included in National income as these are non- monetary exchanges. For
example, domestic services like cooking, housekeeping, rearing of children etc., performed by
housewives are not included in national income. b) However, if the same services are performed by
paid servants then they are included. H. Circular flow of Income:- It shows the flow of income or
goods and services across different sectors of Economy. Different sectors:- i. Household sectors: -
They are the consumers of goods and services. These are also known as the owners of factors of
production. ii. Producer sector: - It includes producing units which produce goods and services and
provide it to the household sector. They are also known as hires of factors of production and provide
payment using factor services. iii. Government sector: - Government receives tax from producers and
households whereas the government provides subsidies to the society. iv. External sector: - It
includes the rest of the world, which is export and import of goods and services. Flow of income is
circular in a two sector economy Flow of income is circular in a two sector economy. The income
received by the household sector from firms for their factor services is spent by them on purchase of
goods and services produced by the firms. Thus income goes back from where it had come. This flow
of income is continuous as producers would always require factor services from household and
household would always depend upon producers for supply of goods and services thus consumption
and production are a continuous process. It can be explained with the help of the following diagram.
Circular flow of income is of following two types 1. Real flows - Real flows refers to the flow of factor
services and goods and services among different sectors of the economy. When factor services (land,
labour, capital, enterprise) flow from the household sector to firms which require them for producing
goods and services are called real flows. Similarly when goods and services flow from firms to the
household sector who buy them for satisfying their needs, these are also real flows. Such flows are
continuous and are also called physical flows. Thus real flow consists of factor flow and product flow.
2. Money flow –Money flow refers to exchange of goods and factor services for money. It is also
known as income flow or Nominal flow. When the household provides factor services to the firms
and receives factor payments in terms of money like rent, wages, interest and profits, money flows
from firms to the household sector and when the household sector spends this factor money on the
purchase of goods and services 3. produced by firms, money again flows from household sector to
firms. Thus money first flow from firm to household sector and then flow from household sector to
firm Three phases of circular Flow Phase-I Production:- Production means producing goods from
given raw material. It adds value to the raw material. For eg: - Wood is converted into furniture.
Therefore, it is a process of value addition by the producing sector. The producer hires factors of
production from households and uses these factors of production as factor inputs for manufacturing
goods and services. Phase-II Income Generation:- When consumers render services to the producer
they get income in return which is factor income. This factor income is in the form of rent, wages,
interest, profits etc. Phase-III Expenditure:- By receiving income, consumers will spend this income
on the purchase of goods and services in the form of consumption expenditure. This income is used
for consuming goods and services produced by producing sectors. When expenditure is made by the
consumer then it is known as consumption expenditure. And when expenditure is done by producers
then it is known as Investment expenditure. Assumption of model:- 🡺 Only two sectors prevail in the
country: - Household, producer. 🡺 Households spend their entire income for consumption. 🡺 No
interference of government. 🡺 All the activities are carried out within the boundaries of a country.
Leakage and Injection:- Leakages Injections They have a negative impact on the process of
production. They cause an increase in the process of production. It is a withdrawal of money from
the flow. It is an addition to the circular flow of income. It is that part of income which is not spent
on consumption but it is saved in the capital market and is termed as savings. The money that is
borrowed from the capital market and is re-injected or reinvested into the production process. For
eg:- savings, imports and taxes For eg:- investment, export government purchases Ch-3 National
Income and Related Aggregates 1. Concept of National Income:- It is the sum total of all factor
income earned by normal residents of a country during a financial year. It includes: - Factor income
and income earned by normal residents of the country. a. Factor Income:- Factor income is the
income received by households for rendering their services to producers. It includes: - compensation
of employees (salaries/wages), Rent (Land used by producer), Interest (Capital used by producer),
Profit (for managing and using skills) etc. b. Normal residents:- Normal residents are the ones who
reside in the country for more than one year and who carry all their economic activities in that
country. The person may or may not have citizenship of that country. Normal residents include both
individuals and institutions. 🡺 The person‘s economic interest (production, consumption,
Investment, etc.) should lie in that country. 🡺 For eg: - Indians working in the office of UNO in India
are normal residents of India since they live in India. 🡺 Indians going abroad for medical treatment
are residents of India as they go abroad for short time period. 🡺 Indian officials working in the Indian
embassy in USA are normal residents of India as they their economic interest is always in India
whereas Indian resident working in the Indian embassy in USA are normal residents of the USA if
their period of stay is more than one year in the USA. Non-residents:- Foreigners working in WHO,
IMF, MNCs, Airlines, Ships located in India and Similarly any foreign citizen working in India for less
than one year as seasonal workers like overseas IPL players, commercial travelers, cross border
workers are the normal residents of their home country. Domestic territory:- It is also called an
economic territory governed by a government within which persons, goods and capital circulate
freely. It will include the factor income which is part of the domestic territory of country. 🡺 It covers:
- (a) Political frontiers or geographical frontiers. For eg: - Branch of an American Bank in India is
included in domestic territory of India. Office of Tata industries in the USA is not included in the
domestic territory of India. (b) Embassies, consulates, military bases etc. located abroad. For eg: -
Indian embassy in Japan is a part of the domestic territory of India. The Russian embassy in India is
not a part of the domestic territory of India. (c) Ships, aircrafts etc. operated by the residents
between two or more countries. For eg: - aircrafts operated by Air India between Russia and Japan
are treated as a part of the domestic territory of India. 2. Domestic and National concepts of
Income:- Domestic Income National Income It is the sum total of factor income (Compensation of
employees+ rent+ interest+ profit) generated within the country either by residents or non-residents
of the country during a financial year. It is the sum total of factor income(Compensation of
employees+ rent+ interest+ profit) generated by normal residents in any part of the world during a
financial year.. Relationship between National income and Domestic income National Income=
Domestic income + Net factor Income from Abroad Where:- Net factor income from abroad(NFIA) is
the excess of factor incomes earned from abroad(FIFA) over factor incomes paid abroad(FITA) NFA =
FIFA - FITA Positive NFIA:- when factor income from abroad is more than factor income to abroad
Negative NFIA: - when factor income to abroad is more than factor income from abroad. Zero NFIA: -
when factor income to abroad is equal to factor income from abroad Components of NFIA: - There
are three main components of FFIA: 1. Net Compensation to Employees: It refers to the difference
between income from work received by resident workers living or employed abroad for less than one
year and similar payments made to non-resident workers staying or employed within the domestic
territory of the country for less than one year. 2. Net Income from property and entrepreneurship: It
refers to the difference between income from property and entrepreneurship (in the form of rent,
interest and dividend) received by residents of the country and similar payments made to the non-
residents. 3. Net Retained Earnings: It refers to the difference between retained earnings of resident
companies located abroad and retained earnings of non-resident companies located within the
domestic territory of the country. Gross and Net concepts of domestic product Domestic product can
be measured with the help of gross domestic product and net domestic product. We know that a
part of capital goods is used up or consumed in the process of production of goods and services in
the economy. This is called depreciation of fixed capital. GDP is inclusive of depreciation whereas
NDP is exclusive of depreciation. Net Product= Gross product- Depreciation Domestic product at
market price and at factor cost:- Market price is the price paid by the buyer of a commodity in the
market. Factor cost is the cost paid by the producer to the factors of production for their contribution
in the production of the commodity. Market price includes indirect taxes but does not include
subsidies granted by the government. 🡺 Market price= Factor cost –Net indirect taxes Where; Net
Indirect taxes = Indirect taxes-Subsidy Indirect taxes are the taxes which are imposed by the
government on the goods and services and in case of indirect taxes imposition and incidence of tax
fall on different persons. Subsidies are economic grants given by the government to producers to
encourage the production of certain types of goods or to promote exports or to households to
ensure essential goods are made available to them at least possible prie as possible. For eg: -
Suppose, the price of a packet of Tata salt is Rs 45 In this case market price is Rs 45. ∙ Let us suppose
that sales tax on this Tata salt packet is Rs 5, which is included in the price of a packet of Tata salt that
is Rs 45. ∙ Therefore factors of production will receive only Rs 40 (45 -5) because the balance goes to
the government in the form of tax. For eg: - if the market price of khadi is Rs 100, but the producer is
giving 120 to factors of production to produce it. The difference between Market price and Factor
cost is subsidies (120-100 =20) which are paid by the government to producers, in order to promote
sale of khadi. Treatment in National income of indirect taxes and subsidies ⮚ Subsidies reduce
market value of goods and services and hence added back to calculate national income at market
value of goods and services. However, being transfer payment it is not included in national income ⮚
Indirect taxes are also not included in national since these are transfer payment and subtracted while
finding national income at factor cost. Aggregates of Domestic and National Income 1. Gross
domestic product at market price (GDPmp) - GDPmp refers to gross market value of all final goods
and services produced by both residents and non-residents in the domestic territory of a country
during a year. The word gross means it includes depreciation and the word market price means it is
inclusive of net indirect taxes. 2. Gross domestic product at factor cost (GDPfc) - GDP fc refers to the
sum total of all factor income (rent, wages, interest, profit) generated by both resident and non-
resident within the domestic territory of a country during an accounting year. The word gross means
it includes depreciation and the word factor cost implies it is exclusive of NIT. 3. Net domestic
product at market price (NDPmp) - NDP mp refers to the net market value of all final goods and
services produced by both residents and non-residents within the domestic territory of a country in a
year. The word ‘net’ implies it is exclusive of depreciation and the word MP implies it is inclusive of
net indirect taxes. 4. Net domestic product at factor cost - NDP fc refers to the sum total of all factor
income (rent, wages, interest, profit) generated by both resident and non-resident within the
domestic territory of a country during an accounting year. The word net means it is exclusive of
depreciation and factor cost implies it is exclusive of NIT. NDPfc also called Domestic income.
“National income is the sum total of all factor income generated by residents of a country in any part
of the world during an accounting year.” National income is a flow concept. National income
aggregates include the following 1. Gross national product at market price (GNP mp) - It refers to
gross market value of all final goods and services produced by a normal resident of a country in any
part of the world during an accounting year. The word national implies it is inclusive of net factor
income from abroad and the word market price implies it is inclusive of NIT 2. Gross national product
at factor cost (GNP fc) - It refers to the sum total of all factor income generated by residents of a
country in any part of the world during an accounting year. The word gross implies it is inclusive of
deprecation and factor cost implies it is exclusive of NIT. 3. Net national product at market price (NNP
mp) - NNP mp refers to net market value of all final goods and services produced by a normal
resident of a country in any part of the world during an accounting year. The word national implies it
is inclusive of net factor income from abroad and the word market price implies it is inclusive of NIT.
4. Net national product at factor cost (NNP fc) - NNPfc refers to the sum total of all factor income
generated by residents of a country in any part of the world during an accounting year. The word net
implies it is exclusive of depreciation and factor cost implies it is exclusive of NIT Nominal and real
GDP: i. Nominal GDP:- The total monetary value of all the goods and services produced in the
domestic territory of a country during a year, counted on the basis of current market price of that
particular year, is known as nominal GDP or GDP at current prices. Current year prices are the prices
prevailing during the year of estimation. Nominal → GDP=Q x P Nominal GDP can increase when
there is either increase in quantity or increase in price. When Q increases then flow of goods and
services also increases in a country and as a result nominal GDP also increases. When P increases
nominal GDP also increases which creates an money illusion in the country. ii. Real GDP:- The total
monetary value of all the goods and services produced in the domestic territory of a country during a
year, counted on the basis of market price of base year, is known as real GDP or GDP at constant
prices. 🡺 Real GDP=Q x P * whereas P *=Prices of base year. In this, real GDP always increases with
increase in quantity which shows increase in flow of goods and services in the country. Real GDP is
more useful in making comparisons of economic development among various other countries. 🡺
Real GDP always changes with change in goods and services. So, it will reveal the true picture about
economic growth. iii. Conversion of nominal GDP into real GDP:- Real GDP can be converted into
nominal GDP with the help of price index. We assume the price index of the base year to be 100.
Nominal GDP = Real GDP × 𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝑌𝐸𝐴𝑅 𝑃𝑅𝐼𝐶𝐸 𝐼𝑁𝐷𝐸𝑋 𝐵𝐴𝑆𝐸 𝑌𝐸𝐴𝑅 𝑃𝑅𝐼𝐶𝐸 𝐼𝑁𝐷𝐸𝑋 Q1.
Suppose, GDP for the year 2014 was Rs 1000 Cr, and in 2015 it is Rs 1210 Cr at current prices. If price
index rises from 100 to 110 during the same period, then find Real GDP (Ans. Rs 1100) Q2. If Real
GDP is Rs 200 and price index (with base = 100) is Rs 110, calculate Nominal GDP (Ans. 220) GDP and
welfare:- Real GDP is regarded as a good index of the welfare of the people. Welfare of the people is
measured in terms of goods and services. GDP measures the value of goods and services and this
value of goods and services will be considered as factor income. Income provides satisfaction and
hence becomes the basis of social well-being. Therefore, greater the magnitude of GDP, greater the
level of welfare. But, the benefit of increased GDP will be considered as a benefit for society if this
benefit reaches everyone in the society. Limitations:- i. Distribution of income:- 🡺 It is possible that a
rise in GDP may not contribute to the well-being of the people of a country if it is not distributed
equally. 🡺 If with increase in GDP, rich are getting richer and poor are getting poorer, then this
growth in GDP cannot promote welfare. 🡺 Rather, it may lower down welfare of the people.
Therefore, mere increase in GDP cannot be regarded as a good index of welfare unless it is
accompanied by equitable distribution of income. ii. Composition of GDP:- 🡺 The components of
GDP may or may not be welfare oriented. 🡺 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 and
production of tobacco then GDP will reduce but it will provide welfare to society. iii. Non-monetary
exchanges:- 🡺 The non-monetary exchanges are not included in the estimation of GDP. 🡺 For eg: -
Services rendered by the housewives to the family members greatly add to their welfare but they are
not counted in GDP. 🡺 This causes underestimation of GDP. iv. Externalities:- 🡺 It refers to harmful
effects or beneficial effects that the production enterprises have on the members of the society for
which they are not penalized or paid. 🡺 For eg:-A steel plant produces steel, value added by steel
plant will be included in GDP but the pollution caused by steel plant is ignored. 🡺 Therefore in such
cases, if we are taking GDP as the measure of welfare, we are overestimating the actual welfare. 🡺
Apart from negative externalities, there can be positive externalities, which have beneficial effects
also. For eg: - construction of dams, colleges etc. 🡺 In this case GDP may underestimate actual
welfare. Ch-4 Methods of calculating National Income Value added method : - It is that method of
calculating national income in which value addition (GVAmp) done by All productive sectors to
domestic product are added up to arrive at GDP mp and then by adding net factor income from
abroad and subtracting depreciation and net indirect taxes, we get net national income at factor cost
(NNP fc). Note – Value added method is also called product method, inventory method, net output
method, commodity services method, industries services method Steps involved in estimating
national income by Value added method (Production method). (i) Identify all the producing units in
the domestic economy and classify them into three industrial sectors such as primary sector,
secondary sector and tertiary sectors on the basis of similarity of their activities. (ii) Estimate net
value added at FC (NVAfc) by each producing unit by deducting the value of intermediate
consumption, depreciation and net indirect taxes from the value of output. (iii) Compute Domestic
Income (NDP at FC) by adding up NVA at FC of all industrial sectors calculated in step (ii). (iv) Estimate
net factor income from abroad and add it to Domestic Income (NDP at FC) for deriving National
Income (NNP at FC). So, Gross value added=Value of Gross output-Intermediate consumption
where :- 1. Intermediate consumption: - One firm purchases goods from another firm. 2. Value of
gross output: - It includes market value of all goods and services. If entire goods and services are sold
then it is also equal to sales. So, value of gross output=output x price Or Value of gross output=sales+
change in stock Change in stock: - closing stock-opening stock Hence, GDPMP=Value of output –
Intermediate consumption NNPFC GDPMP (-) Depreciation(-) Net Indirect Taxes(+) Net factor income
from abroad Precautions:- 🡺 Value of second hand goods either purchased or sold will not be
included as it leads to double counting because it is already included earlier when it was produced.
🡺 Commission earned from sale of second hand goods will be included as it is the reward of services
rendered. 🡺 Own account production of fixed assets by all producers will be included. 🡺 Production
for self-consumption will be included in estimating national income. 🡺 Value of intermediate goods
will not be included in estimating national income. 2. Income method :- It is a method of calculating
National income in which the sum total of all the factor income paid by production units to all factors
of production (household sector) within domestic territory within one year is calculated to get
NDPfc. Income method is also known as Factor payment or distributive share method. The steps
involved in the estimation of National income by using income method Step 1. All producing units
which employ factors of production are identified and classified broadly into three categories –
primary, secondary and tertiary sector. Step 2. Sum up all the factor payments made by all
production units to factor inputs within domestic territory and classify it into various categories like
(a) Compensation of employees (b) Operating surplus (c) Mixed income of self employed Step 3.
Estimate net factor income from abroad which is the difference between FIFA and FITA step 4. Add
NFIFA to Domestic Income (NDPfc) calculated at step 3 to derive National Income at factor cost.
Precautions:- 🡺 Transfer payments like gift, scholarship, old-age pension, taxes, donations etc. will be
included. 🡺 Income through illegal activities will not be included. 🡺 Corporation tax and income tax
will not be included separately as they are already included in corporation tax and compensation of
employees. 🡺 Income from lotteries will not be included. 🡺 Commission earned from sale of second
hand goods will be included as it is the reward of services rendered. 🡺 Payment of interest on loan
taken by an employee from the employer will not be included in national income. 🡺 Imputed rent of
self - occupied house will be included in national income. 🡺 Receipts from sale of land will not be
included in national income as land is free gift of nature. 🡺 Earnings of shareholders from the sale of
shares will not be included in national income. 🡺 Value of bonus shares received by shareholders of
the company will not be included in national income. Factor income:- i. Compensation of employees:
- It is the payment made by producers, to their employees in the form of cash, kind and social
security benefits. It includes:- Wages and salaries:- Compensation in kind:- Employers’ contributions
to social security schemes of Employees – These are monetary benefits like basic salary and wages,
commission paid to sales staff, bonus and overtime allowances, Dearness allowances, House rent
allowances, medical allowances, LTAs. These are non-monetary benefits which includes interest free
loan, exemption on interest on loan given to employees, free or subsidized food, free cloth
(unstiched), rent free accommodation, free education, free water and electricity, free conveyance,
vehicles for personal use, Creche facilities for children, entertainment facilities, free goods and
services produced by employer to It refers to the contributions made by employers for the welfare of
the employee and his family members. It includes the following 1. Employers’ contributions to
employee’s provident fund their employees for example free rail travel to railways employees etc 2.
Gratuity and retirement pension 3. Insurance schemes, labour welfare schemes. 4. Any contribution
towards the family of employees like expenses of their medical treatments etc. ii. Operating surplus:
- It includes income from property and entrepreneurship in the form of rent, interest and profits.
Profits include (Corporate tax/Profit tax, Dividend also called distributed profit , Undistributed profits
also called savings of private sector or retained earnings) iii. Mixed income: - It is the income of the
self -employed also called factor income can not be separated into different heads Hence, NDPFC
compensation of employees+ operating surplus+ mixed income. NNPFC NDPFC + Net factor income

from abroad. Note 🙂 Profit = Profit before tax + Profit after tax ( which is sum of dividend + retained
earnings) 3. Expenditure method:- 🡺 It is that method of calculating National income in which final
expenditure (consumption expenditure and investment expenditure) by all sectors (firms, household
and govt.) of economy is added up to arrive at GDP mp and then by adding FIFA and subtracting
depreciation and net indirect taxes, we get National income at factor cost (NNPfc). Note: 🡺
Expenditure method is also known as income disposal method as we measure national income by
looking at the demand side of the final goods and services 🡺 Since final expenditure consists of
consumption expenditure and investment expenditure, it is also called consumption and investment
method. Steps involved in estimating GDPmp by expenditure method. 1. Identification of economic
units incurring final expenditure and classifying them into household sector, businesssector,
government sector and rest of the world. (ii) Classification of final expenditure of all the above
mentioned economic units into: a) Private final consumption expenditure b) Government final
consumption expenditure. c) Gross domestic capital formation. d) Net exports. (iii) Sum total of the
above (1-4) items gives us the value of GDP at MP and by deducting depreciation and net
indirecttaxes from GDP at MP we get NDP at FC. (iv) Now estimate net factor income from abroad
which is added to NDP at FC calculated in step (iii) to obtain NNP atFC (National Income). So, GDPMP
Private final expenditure+ government expenditure + investment expenditure + net exports. NNPFC
GDPMP -Depreciation +NFIA-Net Indirect taxes Precautions:- 🡺 Purchased of second hand machinery
from abroad will not be included in national income. 🡺 Payment of electricity bill by a school will not
be included in national income. 🡺 Expenditure on engine oil by car service station will not be
included in national income. 🡺 Purchase of goods by foreign tourist will be included in national
income. 🡺 Expenditure on advertisement and scientific research by a firm will not be included in
national income. 🡺 Purchase of bonds by a domestic firm will not be included in national income.
UNIT-II Money and Banking Barter system: - It is a system of exchange in which goods are exchanged
with other goods. For eg: - Exchanging wheat with milk or whatever is available. Meaning and
Evolution of Money:- Money: - Money is anything that is generally acceptable as a means of
exchange and at the same time, acts as measure and as a store of value. Functions of money:- a)
Primary functions:- i. Medium of exchange: - It shows the purchasing power of an individual. It is
readily acceptable everywhere. Anything can be exchanged with money at any time. Money has
solved the problem of double coincidence of wants. ii. Measure of value: - It acts as a standard value.
All the goods and services are measured in terms of money. The value of each goods and services are
expressed as its price. b) Secondary functions:- i. Store of value: - Money can be stored in bank
accounts as well as in lockers. It enables us to save money for future use. Money occupies less space
for storage in comparison with goods. ii. Transfer of value: - Money can be transferred from one
place to another through cheques or drafts. It helps to transfer the purchasing power from present
use to future use. iii. Standard of deferred payments: - It means ―Buy now, Pay later. With the help
of money one can opt for future payments. Money makes credit transactions happen when
payments are not to be made immediately. Supply of money:- Money supply refers to the total stock
of money in circulation in an economy at a given point of time. Money supply is, therefore, a flow
concept. Money supply has two components. A. Currency with the public (C) – It includes currency
notes and coins held by the public outside the bank. It is also known as standard money or fiat
money or legal money or high-powered money. It is the most liquid of all assets. B. Net demand
deposits (DD) – Demand deposits are the deposits of the public held at banks and these are called
demand deposits because the amount in these accounts can be withdrawn by the public from banks
on demand by writing cheques, drafts and using debit cards. These deposits can also be transferred
from one person to the other for making payments. The word net demand deposits implies that it
includes Saving account deposits, Current account deposits of the public but does not include inter-
bank deposits, which a commercial bank holds in other commercial banks. Inter bank deposits do not
form a part of the money supply as they do not belong to the public. Demand deposits are also

called Bank money. Thus Money supply = Currency held by public outside banks (C) + Net DD Note 🙂
Saving account deposits and current account deposits are also known as ‘Transaction money’ as they
can be directly used for carrying out transactions at will. What are not included in components of
money supply? Money supply does not include money held by the government and held by the
banking system of India. Because they are suppliers of money. Suppliers of Money: - Government,
Central Bank, Commercial bank because cash balances held by them do not come into actual
circulation in the economy and they do not belong to the public. Thus, following are not included in
money supply A. Cash reserves of commercial banks. B. Inter- bank deposits. C. The stock of gold is
held with the central bank. D. Cash held by the government in the treasury and with the central
bank. Measurement of Money supply:- M1 approach: - It includes following components:- M1=
C+DD+OD C- Currency held by public, DD- Demand deposits, OD- Other deposits with RBI M2= M1+
Deposits with post office savings M1 is popularly known as narrow approach. Bank Banking and bank
are generally considered synonyms, however they are two different terms ▪ Banking is an industry
that handles cash, credit and other financial transactions whereas banks provide safer places to keep
cash and credit. Thus ▪ Bank is a financial institution that accepts deposits from the general public
and provides loans. Therefore, any financial institution to be called bank must satisfy the following
conditions 1. Acceptance of demand deposits that have cheque facilities. 2. Provide short term and
long-term loans Therefore, post offices are not called banks as they do not provide loans even
though they accept chequable deposits from public and similarly mutual fund companies like IDBI,
UTI, LIC etc., are also not called banks because they do not accept deposits even though they give
loans. THE SOURCES OF MONEY SUPPLY Generally, there are two types of banks: Central bank and
Commercial bank that operate in an economy and are the two main sources of money supply. The
money supplied by the central bank is called ‘High powered money’ whereas the money supplied by
banks is called ordinary money/credit money. Commercial bank and credit money Commercial banks
are the second most important source of money supply. The money supplied by commercial banks is
called ‘credit money/ordinary money’. The credit money that commercial banks create is an outcome
of their monetary transactions, mainly borrowing and lending money. ● Borrowing rate: The rate at
which they borrow money from public is called the borrowing rate and ● Lending rate: The rate at
which they lend money to private investors, banks, investment in government securities and other
approved bonds. is called lending rate. Lending by commercial banks mainly consists of cash credit,
demand and short-term loans ● And the difference between borrowing rate and lending rate is called
spread or profit of banks. But commercial banks can’t use their entire deposits to give loans or
investment credit. This credit creation power of commercial banks is controlled by central bank with
the help of following ratios 1. The reserve deposit ratio (rdr): Banks hold a part of the money people
keep with them as reserve money and loan out the rest to various investment projects. This reserve
money consists of two things: a) Cash reserve ratio (CRR) – Every commercial bank is required to
keep a fixed percentage of public deposits (Demand deposits and time deposits) in the form of cash
reserves with the central bank at zero interest rate and which can’t be used by commercial banks to
provide loans to the public. These cash reserves of banks are used by the Central bank to meet the
individual demand of commercial banks. b) Statutory liquid ratio (SLR) – Every commercial bank is
required to keep a fixed percentage of public deposits (Demand deposits and time deposits) in the
form of cash reserves with itself to meet the demand of depositors. SLR is the rate at which the
government borrows from commercial banks. Credit creation/ Money Multiplier:- 🡺 The capacity of
commercial banks to create credit depends on two factors: - Primary deposits and LRR. 🡺 The
deposits of households and firms held by a bank are called Primary deposits. 🡺 LRR- Legal Reserve
Ratio. It is the fraction of deposits of commercial banks which is legally compulsory for the
commercial bank to keep in the form of cash (CRR) and liquid assets (SLR) as reserves. 🡺 Money
multiplier= 1/Legal reserve ratio Process of Credit Creation:- 🡺 Let us assume primary deposit is
equal to 1000. 🡺 Banks know from their experience that all depositors do not demand all the money
at the same time, only some portion of it may be demanded at any time. 🡺 Suppose bank decides to
keep 10% as cash reserves of their deposits. Then remaining can be given as a loan. 🡺 So, now bank
can give remaining 900 as a loan to the public. Banks never offer loans in cash, rather banks open the
account of the borrower and this loan money is deposited in their account. The amount which is
given as a loan is known as secondary deposit. 🡺 Further again bank will keep 10% of 900 with them
and excess can be given as loan and this process will go on. 🡺 Total Money/Deposit creation=
Primary deposit x 1/LRR = 1000 x 10 = 10,000 And total credit creation will be 10,000 - 1000 = 9000
Rs The Central Bank:- The Reserve Bank of India is the central bank of India. Before the RBI, Imperial
Bank of India used to perform the function of the central bank of India in 1921. Later on, the Hilton
young commission recommended that there should be a separate central bank. Then RBI came into
existence in 1935 and was owned by private stakeholders. Earlier its headquarter was in Kolkata .In
1949, RBI was nationalized and transferred its ownership to central government. Functions of central
bank:- 1. Bank of Issue:- 🡺 RBI has the legal and sole right to issue currency. It is the primary and
very important function of RBI. Money issued by central bank is called High powered money which
shows total liability of monetary system, therefore 🡺 RBI whole issuing currency keeps a minimum
reserves of Rs 200 cores out of which 115 crore is gold and 85 crore is foreign securities. 🡺 It leads to
uniformity in note circulation and builds up faith in the currency system. 2. Banker to the
government:- 🡺 The central bank makes and receives payment on behalf of the government and
carries out all banking businesses of government. 🡺 The central bank acts as an agent of government
as they conduct sale and purchase of government securities and also manage the national debt and
foreign debt. 🡺 The central bank also acts as advisor to the government especially on matters of
finance. 3. Banker’s Bank and supervisory role:- 🡺 The central bank holds a part of the cash reserves
of banks because commercial banks are supposed to deposit CRR with central bank. 🡺 Central bank
holds excess reserves of banks to meet any clearing drains due to settlement with other banks. The
claims of one bank against another are conveniently settled by simple transfers from and to their
accounts from these cash reserves. 🡺 The central bank supervises, regulates and controls the
commercial banks. 4. Lender of last resort:- 🡺 As commercial banks lend money to individuals,
similarly central banks lend to commercial bank during the time of crisis. 🡺 When commercial bank
runs out of its cash reserves then central bank makes short term credit available to them against
approved securities. 6. Controller of credit:- It includes quantitative measures and qualitative
measures:- a. Quantitative measures:- 1. Repo rate: - It is the rate of interest at which RBI lends
money to commercial banks for short term against some security. Repo rate affects credit creation of
commercial banks as well as it controls money supply in the market. 🡺 A rise in Repo Rate will
discourage commercial banks to take loan from central bank and forces them to increase their
lending rates which discourages people to take loan from commercial banks and it reduces the credit
creation capacity of commercial banks. It reduces the money supply and as a result inflation can be
curbed. 🡺 A fall in repo rate will allow commercial banks to take loan which increases the credit
creation capacity of commercial banks. It reduces money supply and as a result deflation can be
curbed. 2. Reverse repo rate: - This is the rate at which commercial banks deposit their extra /
surplus funds with RBI to earn interest income. As RBI gives a certain percentage of rate of interest
on this deposit. 🡺If reverse repo rate is less, then commercial bank will deposit less amount of
money which will increase their credit creation capacity and hence deflation is curbed. 🡺If reverse
repo rate is more, then commercial bank will deposit more amount of money which will decrease
their credit creation capacity and hence inflation is controlled. 3. Bank rate: - It is the rate at which
RBI lends money to commercial banks for the long term. 🡺 A rise in Bank Rate will discourage
commercial banks to take loan from central bank and forces them to increase their lending rates
which discourages people to take loan from commercial banks and it reduces the credit creation
capacity of commercial banks. It reduces the money supply and as a result inflation can be curbed. 🡺
A fall in Bank rate will allow commercial banks to take loan which increases the credit creation
capacity of commercial banks. It reduces money supply and as a result deflation can be curbed. 4.
CRR: - Cash reserve ratio. It is the minimum percentage of deposits of commercial banks which is
kept in cash form with RBI. 🡺 In order to control inflation, RBI will increase CRR rate, as a result bank
will have less reserves to give loans and hence create less credit and money supply will be less. 🡺 In
order to correct deflationary situation, RBI will decrease CRR rate, as a result bank will have more
reserves to give loans and hence create more credit and money supply will increase. 5. SLR: -
Statutory liquidity ratio. It is the percentage of deposits of commercial banks which every bank is
required to maintain with themselves in the form of liquid assets. 🡺 In order to control inflation, RBI
will increase SLR rate, as a result bank will have less reserves to give loans and hence create less
credit and money supply will be less. 🡺 In order to correct deflationary situation, RBI will decrease
SLR rate, as a result bank will have more reserves to give loans and hence create more credit and
money supply will increase. 6. Open market operations: - It refers to the policy of sale and purchase
of securities in the open market by the central bank of the country. 🡺 When central bank starts
selling securities in the market, the RBI soaks liquidity in the market which helps in controlling the
inflation situation of country. 🡺 When central bank starts buying the securities in the market, it
means RBI is releasing the liquidity, which will increase money supply and hence deflation is
corrected. UNIT-III DETERMINATION OF INCOME AND EMPLOYMENT Chapter -6:- Aggregate Demand
and its components 1. Consumption function or propensity to consume Consumption function
means a functional relationship between total consumption and total disposable income. Thus,
C=f(Y); C= consumption; Y= disposable income ● It is also called a linear consumption function
because it is based on the assumption that consumption changes at a constant rate as and when

income changes in the short run. Note 🙂 Keynes gave his famous law of consumption called
“Psychological law of consumption” which states that as income increases, consumption also
increases, but at a lesser rate than increase in income.” Components of consumption function There
are two components of consumption function 1. Autonomous consumption (c): Autonomous
consumption refers to minimum consumption needed for survival even when income is zero which is
financed by past savings or borrowings. Autonomous consumption is also called Independent
consumption 2. Induced consumption (b): Response of consumption to change in income is called
induced consumption and it is also known as marginal propensity to consume Relationship between
consumption function and income level The relationship between Income and consumption function
of an individual can be explained with the help of the following schedule in which consumption
function is assumed as C = 100 +0.8Y. And by assuming values of income as Rs 100, 200 and so on we
get the following table. Income(Y) Rs Consumption (C) Rs 0 100 100 180 200 260 300 340 400 420
500 500 600 580 700 660 Properties of consumption function 1. Consumption function curve always
begins above the origin because of autonomous consumption, which implies that consumption can
never be zero, even when the level of income is zero. 2. As and when income increases, consumption
also increases but by a constant amount and less than increase in income, this happens because a
part of increased income is also saved. It implies that the relationship between income and
consumption is linear and non-proportional 3. When consumption is exactly equal to income, this
situation is called break- even point, C =Y, 4. At any level of income before break-even point,
consumption is greater than income.and at any level of income above break-even point,
consumption is less than income 5. Consumption function is a psychological concept as it is
influenced by subjective factors such as taste, preferences and habits of the consumer Types of
Consumption function - Propensity to consume:- APC -Average propensity to consume. MPC-
Marginal propensity to consume It is the ratio of total consumption to total income. APC= C/Y It is
the ratio of change in consumption to the change in income. MPC= change in consumption/ change
in income What can be the value of APC? A) Value of APC can be equal to 1 if C = Y, it is called break-
even point B) Value of APC can be greater than 1, if C > Y, as in case of autonomous consumption,
before break- even point C) Value of APC can’t be zero since C ≠ 0 because of autonomous
consumption D) Value of APC can be less than 1 when C < Y, beyond the break- even point. What can
be the value of MPC? 🡺 The value of MPC lies between 0 and 1. 🡺 As income increases, consumers
may choose not to change consumption at all. In this case MPC=0. 🡺 On the other hand, as income
increases consumer may use entire increase in income on consumption. So, MPC=1. 🡺 Also, as
income increases, consumers may use a part of the increase in income for increasing consumption.
So, MPC< 0 D) Region beyond Break- even point R, S > 0, which shows increase in savings with rise in
income Saving function- Propensity to save:- APS MPS -Average propensity to save -It means the ratio
of total savings to total income. - -Marginal propensity to save -It is the ratio of change in savings to
the change in income. - Properties of APS a) APS can be zero, when savings are zero (C =Y) b) APS can
never be 1. It is because savings can never be equal to income as people spend a part of income on
consumption. c) APS can never be more than 1. It is because savings can’t be more than income. d)
APS can be negative. When C > Y as in case of autonomous consumption Properties of MPS 1. Value
of MPS lies between 0 and 1(0 < MPS < 1) ● Value of MPS can be equal to 1. If the entire increase in
income is saved ● Value of MPS can be 0. If the entire increase in income is consumed 2. Value of
MPS can’t be more than 1. Because all increases in savings can’t be more than an increase in income.
3. Value of MPS can’t be negative. This is because a part of increased income is always saved and as
and when income increases the level of savings also increases. Also, MPS measures the slope of the
saving curve, which is always positive. 3. Derivations of savings curve from consumption curve:- 🡺
Draw a 45 degree 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. 🡺 Take OS1 equal to OC because at zero income, negative savings is
exactly equal to the autonomous consumption. 🡺 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. 🡺 Join S1 and B1 and extend it by a
straight line to get the savings curve S1S. AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS) 1.
Concept of Aggregate Demand(AD):- Aggregate demand refers to the total demand for final goods
and services in an accounting year. AD is always measured in terms of total expenditure on goods
and services. AD, is, therefore also known as planned or aggregate expenditure of the economy
Components of Aggregate demand (AD):- i. Consumption expenditure:- 🡺 It is total expenditure
made by all households of a country on their personal consumption. 🡺 It depends upon level of
income and their ability to consume. ii. Investment expenditure:- 🡺 It refers to the demand for
capital goods. 🡺 In other words, it is the addition to the stock of real capital goods. 🡺 It depends
upon two factors: - rate of interest and efficiency of investment. iii. Government final expenditure:-
🡺 Government purchase of goods and services indicates demand of government. 🡺 It is done for the
satisfaction of collective wants. Eg: - roads, railways, education etc. iv. Net exports: - Net exports are
exports less imports. Assumptions:- Two sector models prevail in the country. It includes
consumption expenditure and investment expenditure. All Ex-ante variables will be taken. Algebraic
expression of aggregate demand AD: In a two-sector closed economy without government and
foreign trade, AD is sum total of consumption expenditure and investment expenditure AD = C + I
Behavior of Aggregate demand:- 🡺 AD schedule refers to the table showing the behavior of AD with
respect to income. AD curve is a diagrammatic presentation of AD schedule, showing Aggregate
demand corresponding to different levels of income. Amount in crores Table A (Y) (C) (I) AD (C + I) 0
40 20 60 100 120 20 140 200 200 20 220 300 280 20 300 400 360 20 380 500 440 20 460 600 520 20
540 1. AD curve begins above the origin because of autonomous consumption and autonomous
investment 2. The AD curve slopes upward because it bears a direct and positive relation with
income. 3. AD curve is parallel to the consumption curve since they have the slope, i.e. MPC. This is
because AD = C + I, where ‘I’remains constant irrespective of income level, so AD rises only with rise
in consumption, so slope of AD curve remains same as that of consumption curve. 4. The vertical
distance between AD curve and Consumption curve is constant which represents autonomous
investment as shown by TS in the above figure C. Aggregate supply:- 🡺 AGGREGATE SUPPLY:- In the
Keynesian analysis, Aggregate supply (AS) refers to the money value of all final goods and services
that all the producers are planning to produce in an economy in a given time period. Therefore,
aggregate supply is also called planned aggregate output of the economy. 🡺 Here, aggregate supply
refers to the ex-ante supply produced in the economy in a given year. 🡺 Because of two sector
economy, indirect taxes and subsidies are not present and the total value of goods and services are
distributed among the factors of production. 🡺 Aggregate supply is always equal to national income.
Components of Aggregate supply The major portion of national income is spent on consumption of
goods and services and the balance is saved. It means,Income (Y) is either consumed or saved. So,
National Income (Y) = Consumption (C) + Saving (S) AS(Y) = C + S Diagrammatic Representation of AS
The aggregate supply curve and national income curve coincide with each other. The aggregate
supply curve can be obtained by adding consumption expenditure to savings of households at
different levels of income, by taking C = 40 +0.8Y, and Y as 0, 100, 200 and so on. In Fig 7.2. income is
represented on the X-axis and consumption and savings are measured on the Y-axis. A 45° line, which
represents the aggregate supply, has been drawn from the origin. The line is drawn by taking the
same scale on both the axes. At every point on this 45° Line, Y = C + S. Income (Y) (C) (S) AS (C + S) 0
40 -40 0 100 120 -20 100 200 200 0 200 300 280 20 300 400 360 40 400 500 440 60 500 600 520 80
600 Chapter -7 Short Run Equilibrium Output 1. AccordingTo Keynes: - Equilibrium level of output
implies the equilibrium level of employment. The level of output, income and employment in an
economy move together in the same direction till full employment is reached. In other words, an
increase in output means an increase in the level of employment and increase in level of income.
Decrease in output means less employment and lower level of income. 2. Determination of
equilibrium level of output/ employment/income:- To determine equilibrium output there are two
approaches:- a. AD=AS approach and b. S=I approach A. AD=AS approach:-( Consumption plus
investment approach) 🡺 Equilibrium level of income or output is that level of income or output at
which ex-ante (planned) aggregate demand becomes equal to ex-ante (planned) aggregate supply. 🡺
Aggregate demand must be equal to aggregate supply. It is also called the ' effective demand
principle‘. 🡺 Keynes assumed that there is unutilized capacity in an economy. 🡺 To use the
production capacity, there is a need to increase aggregate demand. 🡺 When aggregate demand
rises, then aggregate supply will also rise and this process continues till excess capacity is fully
utilized and economy reaches the state of full employment or equilibrium level. Fig in Crore Y C S I
AD AS 0 40 -40 20 60 0 100 120 -20 20 140 100 200 200 0 20 220 200 300 280 20 20 300 300 400 360
40 20 380 400 🡺 In order to go for equilibrium GDP, Keynes considers only Autonomous investment.
(Autonomous investment is that investment which is independent of level of income. There is no
change in investment with respect to change in income.) 🡺 Relating AD to Y, E is an equilibrium point
where AD=Y=AS. Before that AD>Y—It is a situation of deficit supply. When ADAS:- 🡺It means buyers
are planning to buy more goods and services than what producers are planning to produce. 🡺Thus,
the inventories in the hand with the producers will start falling, which is called ‘Unplanned
decumulation of inventories’ 🡺Producers will suffer from loss due to unfulfilled demand. 🡺So,
producer will start producing more production. 🡺By this way Aggregate demand=Aggregate supply.
B. S=I approach:- 🡺The equilibrium level of output can also be explained with the help of saving-
investment approach. 🡺Savings change with change in income whereas investment remains constant
because of autonomous investment. 🡺Equilibrium level of output is determined at a point where ex-
ante savings are equal to ex-ante investment or where saving curve intersects investment curve.
Behavior of S and I approach:- Y C I S AD AS 0 20 10 -20 30 0 20 30 10 -10 40 20 40 40 10 0 50 40 60
50 10 10 60 60 80 60 10 20 70 80 100 70 10 30 80 100 120 80 10 40 90 120 🡺This table shows
constant investment. 🡺In order to see equilibrium GDP, Keynes considers only autonomous
investment. 🡺Relating S and I , E is an equilibrium point where S=I which is at income of 60. The
process of Adjustment:- i. What happens if SI? 🡺 It means buyers are consuming less and saving
more or they are planning to buy less than what sellers are planning to sell. 🡺 This will lead to
accumulation of inventories, producers will reduce production. 🡺 This reduces the level of
employment, level of output and in turn income level. 🡺 Low level of income implies less savings and
it will go on till S=I. 3. Investment Multiplier- Its Mechanism:- Investment multiplier is defined as the
ratio of increase in National income to the increase in initial autonomous investment and it is
denoted by the letter K Mathematically Relationship between Multiplier and Marginal propensity to
consume (MPC):- K=1/1-MPC 🡺There is direct relationship between Multiplier and MPC. 🡺Higher the
value of MPC, higher the multiplier and vice-versa. • In case of higher MPC, people will spend a large
proportion of their increased income on consumption. In In such cases, the value of the multiplier will
be more. • In case of low MPC, people will spend a lesser proportion of their increased income on
consumption. In such a case, the value of the multiplier will be comparatively less. Thus, the value of
multiplier K, depends upon the MPC, since value of MPC lies between 0 and 1 a) If MPC = 0, K =1
which means change in income has no effect on consumption expenditure, in this case consumption
function is parallel to X- axis. b) If MPC = 1, K = ∞, which implies that change in income brings equal
change in consumption expenditure and in this situation consumption function is linear and begins
from origin Therefore, minimum value of K is one and maximum value is infinity Investment
multiplier is inversely related with the value of MPS. Higher the value of MPS lowest is the value of K
and vice versa. Mathematically In case of higher MPS, people will spend lesser proportion of their
increased income on consumption and will save more. In such case, value of multiplier will be
comparatively less. In case of low MPS, people will spend a larger proportion of their increased
income on consumption and will save less. In such case, value of multiplier will be comparatively
large. Multiplier Mechanism:- (working of investment multiplier) Here, MPC plays a major role.
Higher the MPC, higher the multiplier. 🡺Change in investment causes change in Income. 🡺Change in
income leads to change in consumption. 🡺Consumption expenditure of one person is income of other
person. 🡺This process will continue till change in consumption reduces to zero. Suppose An
additional investment (∆I) of Rs 100 Cr. is made to construct a rural road. This extra investment will
generate an additional income (∆Y) of Rs 100 Cr in the first round. But this is not the end of working
of Multiplier. ● If MPC is assumed to be 0.90, then recipients of this additional income will spend 90%
of Rs 100 crores, i.e., Rs 90 crores as consumption expenditure and the remaining amount will be
saved. It will increase the income by Rs 90 crores in the second round. ● In the next round, 90% of the
additional income of 90 crores, i.e., Rs 81 crores will be spent on consumption and the remaining
amount will be saved. ● This process will go on and the consumption expenditure in every round will
be 0.90 times of the additional income received from the previous round. This process of increase in
income would continue till total increase in income becomes Rs 1000 Cr. ∆Y =K x ∆I = 10 x 100 = Rs
1000 Since MPC = 0.9. K = 1 Chapter 9:- Problem of Deficient Demand and Excess Demand A.
Concept:- i. Full employment equilibrium and under employment equilibrium:- 🡺 Full employment
refers to the situation when all workers who are able and prepared to work at current wage rate get
employment. 🡺 It is struck when planned AS=planned AD along with fuller utilization of resources. 🡺
Underemployment refers to the situation when some of the workers who are able and prepared to
work at current wage rate are not getting employment. 🡺 It is a situation when planned AS=planned
AD but resources are not fully utilized. ii. Voluntary and Involuntary unemployment:- 🡺 Voluntary
unemployment refers to the situation when people willingly do not want to work or they are not
ready to work at existing wage rate. 🡺 Involuntary unemployment refers to the situation where
people are not getting the work. 🡺 Problem of unemployment is due to involuntary unemployment
where jobs are not available. iii. Full employment and natural unemployment:- 🡺 Full employment
refers to a situation when everybody who wants employment is getting employment at existing wage
rate. 🡺 Natural unemployment means when some minimum rate of unemployment prevails in the
economy due to change in demand and supply pattern. 🡺 Natural unemployment arises due to:-
Frictional and Structural unemployment. 🡺 Frictional unemployment arises due to change of job
whereas Structural unemployment arises due to change in technology Full employment equilibrium
Full employment equilibrium refers to the situation when AD of economy is equal to AS of economy
corresponding to full employment of resources. Full employment does not mean 100% employment
since it is measured in the context of the working population only. At full employment level there can
be a natural rate of unemployment in the form of seasonal, frictional, structural and voluntary
unemployment. Diagrammatic explanation As in figure 8.3, let us suppose that for the given
resources, OQf is the level of output associated with full employment of resources, shown by point E
on AS curve and planned AD curve meets 450 curve at point E and determines full employment
equilibrium with natural rate of unemployment in the form of structural, seasonal and voluntary
unemployment. However, it is not necessary that equality between AD and AS is always at full
employment of resources, the equilibrium level of output may be more than or less than full
employment level of output a) If the AD of economy is equal to AS of economy at less than full
employment output level, it is called under full employment equilibrium and it shows involuntary
unemployment in the economy, it occurs before full employment of resources. b) If the AD of
economy is equal to AS of economy, beyond than full employment output level, it is called over full
employment equilibrium. Problem of Deficient Demand:- 🡺 Deficient demand arises when aggregate
demand is less than aggregate supply at full employment. 🡺 Aggregate demand falls short of what is
required for fuller utilization of resources. Deficient demand can also be explained with the help of
the following diagram in which lets us suppose that for given resources, OM is the level of output
associated with full employment of resources, which is shown as point E on AS curve. And AD is the
desired level of Aggregate demand needed to achieve this full employment of resources which cuts
the AS curve at point E associated with full employment. Now let us also suppose that AD’ is the
actual level of aggregate demand in economy, which cuts AS curve at point E1 and determines OM1
level of output clearly OM – OM1 = M1M or BE, shows deficient demand or under full employment
equilibrium. What are the possible causes of deficit demand? The possible causes of deficit demand
are 1. Fall in consumption expenditure of household sector due to fall in propensity to consume or
rise in propensity to save 2. Increases in taxes which reduces disposable income of consumers and
hence consumption expenditure 3. Fall in investment expenditure of manufacturing sector due to rise
in rate of interest or fall in expected rate of return 4. When govt. reduces its demand for goods and
services due to fall in public expenditure Explain the effect of deficit demand on employment level,
output level and general price level. Impact of Deficit demand on 1. Output – Due to lack of sufficient
aggregate demand there will be an increase in unsold stock of goods with firms which forces firms to
plan for lesser output in subsequent years and hence level of output falls in the economy and it raises
idle capacity in economy. 2. Employment – Due to fall in investment and output level and
employment level will also fall and it increases involuntary unemployment in the economy. 3. Price
level - As there is deficient aggregate demand in the economy, price tends to fall which leads to
deflation in the economy. Meaning of Excess demand It refers to the situation where level of actual
aggregate demand (AD) exceeds the desired level of aggregate demand (AD) required to achieve full
employment of resources. It is also known as over full employment equilibrium. Diagrammatic
presentation Excess demand can also be explained with the help of following diagram in which lets us
suppose that for the given resources, OM is the level of output associated with full employment of
resources and shown as point E on AS curve and ADf is the desired level of Aggregate demand
needed to achieve this full employment of resources and it cuts AS curve at point E and determines
OM full employment of resources Let us also suppose that AD’ is the actual level of aggregate
demand. Clearly EM is the desired level of AD needed to achieve full employment equilibrium but
actual level of AD is BM. Therefore, the vertical difference between MB – ME = BE, shows excess
demand or over full employment equilibrium. What are the possible Causes of excess demand? The
possible Causes of excess demand are 1. Rise in consumption expenditure of household sector due to
rise in propensity to consume or fall in propensity to save 2. Decreases in taxes which increases
disposable income of consumers and hence consumption expenditure 3. Rise in investment
expenditure of manufacturing sector due to fall in rate of interest or rise in expected rate of return 4.
When govt. raises its demand for goods and services due to rise in public expenditure Explain the
effect of excess demand on employment level, output level and general price level. Impact of Excess
demand on 1. Output – As the economy is already operating at full employment of resources output
remains constant as there is no idle capacity in the economy. 2. Employment – Since economy is
already operating at full employment of resources There will be no change in employment level in the
economy as there is no involuntary unemployment. 3. Price level - As there is no possibility of
increase in output. AS falls short of AD and hence price tends to rise which leads to inflation in the
economy Does price level rise only after full employment? Explain According to Keynes, price level
does not rise in response to rise in aggregate demand (AD) before full employment. It is because AS is
assumed to be perfectly elastic at fixed price in the short run. Before full employment, AS tends to rise
proportionate to any rise in AD. Accordingly, the price level remains constant. But after full
employment is reached, AS stops rising in response to rise in AD. Accordingly, price level tends to rise
with rise in AD Concept of Inflationary gap and Deflationary gap Deflationary Gap Inflationary Gap
Meaning: It refers to the situation where level of actual aggregate demand falls short of desired level
of aggregate demand required for achieving full employment of resources. It is obtained before the
full employment of resources Meaning: It refers to the situation where level of actual aggregate
demand exceeds the desired level of aggregate demand required to achieve full employment of
resources It is the amount by which desired level of aggregate demand (AD) fall short of actual level
of aggregate demand. It is obtained after the full employment of Resources Causes a) Fall in
consumption expenditure of household sector due to fall in propensity to consume or rise in
propensity to save b) Increases in taxes which reduces disposable income of consumers and hence
consumption expenditure c) Fall in investment expenditure of manufacturing sector due to rise in rate
of interest or fall in expected rate of return Causes a) Rise in consumption expenditure of household
sector due to rise in propensity to consume or fall in propensity to save b) Decreases in taxes which
increases disposable income of consumers and hence consumption expenditure c) Rise in investment
expenditure of manufacturing sector due to fall in rate of interest or rise in expected rate of return d)
When govt. reduces its demand for goods and services due to fall in public expenditure d) When govt.
raises its demand for goods and services due to rise in public expenditure Solution Solution Deflation
can by removed by fiscal and monetary policy like a) Increase in public expenditure b) Fall in tax rate
c) By lowering CRR, SLR, Bank rate etc Inflation can by removed by fiscal and monetary policy like a)
Decrease in public expenditure b) Rise in tax rate c) By increasing CRR, SLR, Bank rate etc Fiscal
measures and Monetary measure to correct deficit demand and excess demand Fiscal measures to
correct deficit demand 1. Reduction in taxes and increase in subsidies - Government should decrease
Its existing direct tax rates on both income and profit and indirect taxes on goods and services and
should try not to impose any new taxes and increase amount of subsidized programme. 2. Increase in
public expenditure – the government should increase its expenditure on development and productive
works. 3. Govt. should use deficit financing- In which govt. takes loan from RBI against its securities
Fiscal measures to correct excess demand 1. Increase in taxes and decrease in subsidies- Government
should increase its existing direct tax rates on both income and profit and indirect taxes on goods and
services specially purchased by the rich section of the society and try to impose new taxes on rich
people and decrease the amount of subsidized programmes. 2. Decrease in public expenditure – the
government should decrease its expenditure on nondevelopment and unproductive works. Monetary
measures by Central bank 1. Bank rate: Bank rate is the rate at which the central bank provides long
term loans to commercial bank. When the Central Bank has to increase the money supply (during
recession/deflation/Deficient demand), it lowers Bank Rate. When the Central Bank lowers bank rate,
commercial banks also lower their lending rates. Since borrowing becomes cheaper, people may
borrow more. This leads to increase in credit creation by banks and thus, rise in money supply in the
hands of the general public. Consequently, consumption expenditure and investment expenditure
may increase, implying increase in Aggregate Demand. Thus, the situation of deficient demand will
be corrected. 2. Repo Rate: Repo Rate is the rate of interest at which central bank lends to
commercial banks for their short- term requirements. When the Central Bank has to increase the
money supply (during recession/deflation/Deficient demand), it lowers Repo Rate. A decrease in repo
rate will induce commercial banks to decrease their lending rates. It will make borrowings cheaper to
general public. People may borrow more. Thus, credit creation by banks increases and money supply
increases in the economy. Consequently, consumption expenditure and investment expenditure may
increase, implying increase in Aggregate Demand. Thus, the situation of deficient demand will be
corrected. 3. Reverse Repo Rate: Reverse Repo Rate is the rate of interest at which commercial banks
can deposit their surplus funds with the central bank, for a relatively shorter period of time. When
the Central Bank has to increase the money supply (during recession/deflation/Deficient demand), it
Reverse Repo Rate. It may discourage the commercial bank to deposit their surplus funds with
Central Bank. As a result, the availability of creating credit with the commercial bank will increase.
Consequently, consumption expenditure and investment expenditure may increase, implying increase
in Aggregate Demand. Thus, the situation of deficient demand will be corrected. 4. Legal Reserve
Requirements CRR and SLR When the Central Bank reduces CRR or SLR or both, more money is left
with commercial banks for lending. As lending increases, the money creation increases and money
supply in the economy increases. Consequently, consumption expenditure and investment
expenditure may increase, implying increase in Aggregate Demand. Thus, the situation of deficient
demand will be corrected. 5. Open Market Operations (0M0) to combat the situation of deficient
demand and deflationary gap Open Market Operations refers to buying and selling of government
securities (bonds) by the Central Bank from/ to the general public. It is an important step which may
be undertaken to control money supply in the economy. By purchasing government securities, Central
Bank releases liquidity in the economy since it pays for it by giving a cheque. This cheque increases
cash reserves with banks and thus increases bank’s ability to create credit and hence increases the
money supply in the hands of general public. As a result, aggregate demand will increase, which
helps in correcting the situation of deficient demand UNIT-IV GOVERNMENT BUDGET Chapter:- 9
Government Budget and the Economy There is a constitutional requirement in India (Article 112) to
present before the Parliament a statement of estimated receipts and expenditures of the government
in respect of every financial year which runs from 1 April to 31 March. This ‘Annual Financial
Statement’ constitutes the main budget document of the government. A. Government Budget:- A
government budget is an annual statement showing item wise estimates of expected receipts and
expected expenditure during a fiscal year. Objectives of Government Budget 1. ECONOMIC GROWTH:-
The main objective of government is to focus on gross domestic product. So, budgetary policies are
made in such a way that there should be growth of GDP. It can happen in two ways:- (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. 🡺 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. 2. RE-ALLOCATION 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:- Subsidies and tax concessions can be given to the private sector industries to
encourage production of those products which are beneficial to people. For example, the 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 can be used to influence
allocation of resources in the country. (b) Expenditure policy:- 🡺 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, eg. Water supply, sanitation, street lighting,
maintaining law and order etc. These are called public goods. 🡺 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 the welfare of the people. 3. REDISTRIBUTION OF INCOME AND
WEALTH:- The distribution of income and wealth is unequal in India. There is a huge gap between
rich and poor people. With the help of budgetary policy the government can provide benefits to poor
people. This can be done with the help of taxes and subsidies. Tax can be charged from rich people
whereas subsidies can be given to poor people. Inequalities of income can be reduced either by
rationalization of taxation policy or regulating the expenditure policy of the government or both. (a)
Taxation policy:- 🡺 The redistribution objective is sought to be achieved through progressive
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. (b) Expenditure policy:- 🡺 The amount collected
through taxes can be used by the government for spending on the welfare of the poor people. 🡺 It
can provide them transfer payments and subsidies. For eg:- providing free services like education and
health to the poor people. 🡺 Increased expenditure by the government on such transfer payments
and subsidies will have twin effects:- Firstly, 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. 4. ECONOMIC
STABILITY:- Economic stability is ensured by correcting inflationary and deflationary gaps in the
country. Inflationary gap is corrected by reducing government expenditure and generating revenue.
The deflationary gap is reduced by increasing government expenditure and reducing income.
Government can exercise control over price fluctuations through its taxation policy and expenditure
policy. (a) Under inflationary situation:- 🡺 Inflationary tendencies emerge due to aggregate demand
being higher than aggregate supply under conditions of high employment. 🡺 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 situation:- 🡺 During periods of recession, 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. B.
Components of Budget I. Budget Receipts:- It includes Revenue receipt and capital receipts. 1.
Revenue Receipts:- The money receipts of the government are called revenue receipts:- 🡪 Which do
not create liability for the government. For eg:- Tax 🡪Which do not cause any reduction in assets of
the government. It is classified as:- Tax receipts and Non-tax receipts i. TAX RECEIPTS:- A tax is a
compulsory payment to the government without expectation of direct benefits in return to taxpayer.
Types of tax a) Progressive and regressive taxes:- The taxes in which the rate of tax increases as the
tax base increases are called progressive taxes. When the rate of tax decreases as the tax base
increases, the taxes are called regressive taxes. b) Value added and specific taxes:- Value added is an
indirect tax which is imposed on the value of output. Specific tax is levied on a commodity on the
basis of size, weight etc. c) Direct and Indirect taxes:- Direct taxes(VIMP):- When the impact of tax
(liability to pay tax) and incidence of tax (final burden of tax) fall on the same person is called a direct
tax.. In case of direct tax, the incidence of tax (final burden) can’t be shifted on the other person.
Direct taxes are imposed on income and property of people and generally progressive in nature as
their burden is more on rich people. These taxes do not affect the market price of the product since
they are imposed on income and profit of people. For eg: Income tax, profit/corporate tax, wealth
tax, estate duty, gift tax, capital gain tax. Indirect taxes – When the impact of tax (liability to pay tax)
and incidence of tax (final burden of tax) fall on different persons these are called indirect taxes . In
case of indirect taxes, incidence of tax can be easily shifted on others. Indirect taxes are imposed on
sales, transportation and production of goods and services like excise duties, custom duties,
entertainment tax, service tax, Octroi, etc. Indirect taxes affect all income group people and are
generally regressive in nature as their burden is more on poor group people as compared to rich
people since they all pay the same rate of tax on commodities and as a result low-income people face
more burden of taxes. ii. NON-TAX RECEIPTS:- The receipts which arise from sources other than tax. It
is as follows:- a) Govt. fees:- The fees paid by people to the government. For eg:- passport fees etc. b)
Fines:- Fines and penalties paid by people to the government when they break laws. c) Escheat:-
When people leave the property without any legal heir and the government generates revenue out of
that property is known as Escheat. d) Income from public enterprise:- Various companies are owned
by the government. So the government earns revenue from these companies. For eg:- Railways,
Indian oil etc. e) Grants and Donations:- When there are certain natural calamities such as flood,
drought etc., people provide grants or donations which are used as government revenue. 2. CAPITAL
RECEIPTS:- These receipts are long term receipts for the government :- 🡪 It creates liability. For eg:-
Loans 🡺 It reduce assets. For eg:- selling its shares. It is classified as:- a) Non debt capital receipts
which do not generate any liabilities for the government but reduce only assets of The government
likes recovery of loans and advances, disinvestment etc. for eg: Recovery of loans and advances - The
central government grants loans and advances to state governments, Union Territory governments,
foreign governments, PSU etc. They become financial assets (debtors) of the government and when
the government recovers these loans from its debtors, it is treated as capital receipt as it leads to the
decline in the financial assets of the government. ● Disinvestment– It means selling whole or part of
the shares (equity) of selected public sector enterprises held by the government to the private sector.
As a result, the government's assets are reduced. b) Debt creating capital receipts which create
liabilities on the government but do not affect assets debt creating capital receipts are also known as
borrowing and other liabilities. II. Budget Expenditure:- Budget expenditure refers to the government
expenditure in a year. It is of two types:- Revenue Expenditure and Capital expenditure. Revenue
expenditure:- Revenue expenditure - Expenditure which neither reduces liabilities for the govt. nor
generates assets for the government. are called revenue expenditure. Revenue expenditures are
short term expenditure and recurring in nature. Revenue expenditures are generally meant for
consumption purposes. It is incurred for the normal running of the government departments and
maintenance of law and order. Examples of revenue expenditure are A) Payment of interest on past
borrowings. B) Payment of wages & salaries and pension of govt. employees Capital expenditure -
Expenditure which either creates assets for the government or reduces liabilities of the government.
Capital expenditures are long term expenditures and non-recurring in nature. Capital expenditures
are generally meant for acquisition of assets or reduction of liabilities. Examples of capital
expenditure A) Repayment of borrowed loans B) Construction of bridges, dams, roads, buildings,
schools, colleges etc.. A. Budget Deficit:- Budget deficit means a situation when budget expenditure is
more than budget revenue. Types:- i. Revenue Deficit:- It refers to the situation when revenue
expenditure is greater than revenue receipts. Methods of financing revenue deficit 1. Borrowings – It
refers to borrowings from domestic sources like commercial banks, open market or external sources
like foreign governments, international organizations etc. 2. Deficit financing- the government may
borrow from RBI against its securities to meet fiscal deficit. RBI issues new currency for this purpose.
This process is known as deficit financing 3. Disinvestment - Under this govt. sells a part of or the
whole of equity shares of selected public sector to private sector and the revenue received is used to
pay a part or the whole of the borrowed money. However, borrowings and deficit financing are
considered two main sources of financing revenue deficit. Revenue deficit and inflation Revenue
deficit is financed through borrowings or deficit financing and may or may not result in inflation
depends upon the use of borrowings or deficit financing a) When increased borrowings or increased
money supply are spent on consumption expenditure rather on investment and development
activities, it increases AD in the economy over supply and it results in increase in prices of goods and
services, therefore revenue deficit may result in inflation. b) However, increased borrowings or
increased money supply are spent on development activities and increasing supply of goods. Then,
revenue deficit may generate economic growth and not inflation in the economy. Therefore, revenue
deficit may not always be inflationary in nature. IMPLICATIONS OF REVENUE DEFICIT 1. Revenue
deficit indicates the inability of the government to meet its regular and recurring expenditure. 2.
Revenue deficit implies that the government is dis-saving and government. is using up savings of
other sectors of the economy to finance a part of its current consumption expenditure. This situation
implies that the government will have to borrow not only to finance its consumption expenditure but
also its investment expenditure. 3. This will increase borrowing requirements of the government and
the burden of interest liabilities in future and eventually force the government to cut expenditure. 4.
Since a major part of revenue expenditure is committed expenditure (interest payments and defense
expenditure) and hence can’t be reduced, therefore govt. reduces either investment expenditure
(acquisition of lands, building, machinery etc.,) or welfare expenditure (education and health
expenditure) which in turn reduces either economic growth of the country or social welfare of the
people. 5. Revenue deficit is financed either through borrowings or disinvestment. a. When it is
financed through borrowings, it has two implications: first higher borrowings would increase the
burden on future generations to repay loan amount and interest on accumulated loan second,
increased borrowing further increases revenue deficit.. b. If the Revenue deficit is financed through
disinvestment then it reduces the assets of the government. Therefore, revenue deficit results either
in reduction of assets or in generation of liabilities, that is revenue deficitresults in capital receipts of
the government. 2. FISCAL DEFICIT Fiscal deficit refers to excess of total expenditure over total
receipts of the government excluding borrowing during afinancial year. Formula: Fiscal deficit = Total
expenditure (-) Total receipts excluding borrowing OR (Revenue expenditure+Capital expenditure) -
(Revenue receipts+non debt capital receipts/capital receipts net of borrowings) Where capital
receipts net of borrowing/non debt capital receipts refer to disinvestment and recovery of loans and
advances. Methods of financing Fiscal deficit a) Borrowings –fiscal deficit can be met by borrowings
from the domestic sources like commercial banks or external sources like foreign governments,
international organizations etc. b) Disinvestment – Under this govt. sells a part of or the whole of
equity shares of selected public sector to private sector and the revenue received is used to pay a part
or whole of the borrowed money. Is fiscal deficit always inflationary in nature or does Fiscal deficit
lead to inflation in the economy? ● No, the fiscal deficit is not always inflationary. Fiscal deficit can
prove inflationary, a) When the fiscal deficit is financed by using either borrowing or deficit financing
which increases money supply and purchasing power in the economy and if this increase in money
supply is spent on consumption only. b) However, if increased money supply leads to more production
of goods and services in economy or new money is used for the development of infrastructure or
other capital projects then fiscal deficit helps in increasing employment and hence welfare of the
economy. ● Similarly, if borrowing is spent on development activities, then it can generate economic
growth. Significance of Fiscal deficit 1. Fiscal deficit shows total borrowing requirement of the
government. This is because, Fiscal deficit = Total expenditure –Total revenue receipts plus non debt
capital receipts. Therefore, Fiscal deficit indicates the total amount the government is required to
borrow when its total receipts excluding borrowing are not enough to meet its total expenditure. In
other words, the fiscal deficit of the government budget is met by debt creating capital receipts i.e.,
through total borrowing. This total borrowing requirement also includes the interest commitment on
accumulated debt. Therefore, Fiscal deficit is inclusive of interest payment. Therefore, Fiscal deficit
will be zero, if there is no provision of borrowings in the government budget. 2. Fiscal deficit is a key
variable in judging the financial health of the public sector and the stability of the economy. This is
because if performance of PSUs was good, then non debt capital receipts (profits and dividends from
running PSUs) would result in much higher revenue for the government and the government did not
require to borrow or even government was required to borrow then proceeds received from
disinvestment from PSUs would also be large. Relationship Budget deficit and Fiscal deficit : Are
Budget deficit and Fiscal deficit one and the same thing? No, budget deficit and fiscal deficit are not
the same thing. Fiscal deficit is a wider term than budget deficit since fiscal deficit indicates ‘total
borrowing requirements’ of the government which also includes budget deficit in it. It can be
explained as follows, since budget deficit occurs when budget expenditure exceeds budget receipts.
Budget deficit = Budget expenditure (RE +CE) –Budget receipts (RR + CR excluding borrowing). As per
the above formula budget deficit occurs when government receipts (excluding borrowing) are less
thangovernment expenditure and borrowing refers to the fiscal deficit. Therefore, when we add
borrowing requirements tothe budget deficit we get a fiscal deficit. Fiscal deficit = Budget deficit +
Borrowings and other liabilities Relationship between Revenue deficit and Fiscal deficit Revenue
deficit is a part of fiscal deficit and therefore fiscal deficit is always greater than revenue deficit since
the fiscal deficit is the sum total of both revenue deficit and capital deficit. Fiscal deficit = (Revenue
deficit) + (Capital deficit) Therefore, there can be fiscal deficit without any revenue deficit, in the
following situations 1) When revenue expenditure = revenue receipts but capital expenditure exceeds
capital receipts 2) When revenue expenditure is less than revenue receipts that is there is revenue
surplus but deficit in capital budget is more than this revenue surplus. Therefore, an increase in the
revenue deficit will not always lead to an increase in the fiscal deficit, because fiscal deficit is also
influenced by non-debt creating capital receipts and capital expenditure of the govt. in addition to

revenue deficit. Note 👍When the share of revenue deficit is considerably high in the fiscal deficit of a
country, it indicates a large part of total borrowing is being used for consumption expenditure rather
than investment expenditure. Such a situation in the fiscal deficit shows fiscal indiscipline of the
government and adversely affects future growth. Primary deficit iii. Primary Deficit:- It is defined as
fiscal deficit less interest payments. Primary deficit = Fiscal deficit of current year – interest payments
on previous borrowings 🡪Primary deficit indicates borrowing requirements of the government to
meet fiscal deficit net of interest payments. Explanation:- Fiscal deficit is nothing but total
borrowings of the government during the current year. Total borrowings also include borrowing on
account of interest payments. Therefore, out of total borrowing requirement if we deduct borrowing
on account of interest payments, we get the primary deficit, which indicates borrowing requirements
of the government other than to make 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 So,
Fiscal deficit=Interest payments. Significance of Primary deficit ▪ Primary deficit is calculated to
estimate borrowing on account of current expenditure (RE + CE) exceeding current revenues (RR +
CR). ▪ Primary deficit indicates how much of government borrowing in the current year is going to
meet expenses other than interest payments on past borrowings. Therefore, the goal of measuring
primary deficit is to focus on present fiscal imbalances and to know the current financial health
status of the country. ▪ The total borrowing requirement of the government includes interest
commitments on accumulated debts. Primary deficit indicates the extent to which such interest
commitments have compelled the government to borrow in the current period. Difference between
Primary deficit and Fiscal deficit 1. Fiscal deficit indicates total borrowing (Borrowing and other
liabilities) requirements of the government, whereas the primary deficit shows how much of total
borrowing is going to meet expenses other than interest payments. 2. Primary deficit is exclusive of
interest payments whereas fiscal deficit is inclusive of interest payments. 3. Primary deficit will be
zero when total borrowing of current year is equal to interest payment on past borrowings, whereas
Fiscal deficit will be zero if borrowing requirements of the govt. is zero UNIT-V BALANCE OF
PAYMENTS An open economy is said to be one that trades with other nations in goods and services
and most often, also in financial assets. Indians, for instance , can consume products which are
produced around the world and some of the products from India are exported to other countries. A.
Meaning:- The balance of payment of a country is a systematic record of all economic transactions
between the residents of a country and the rest of the world during a year. These transactions can be
made by individuals, firms and the government of a country. Structure of BOP Since BOP is an
accounting statement therefore it uses a ‘Double entry system’ for recording the transactions with
the rest of the world. Like a typical business account, it has two sides namely debit side and credit
side. And it is the direction of flow of foreign exchange which determines the nature of international
transactions: (i) Credit side: If the direction of flow of foreign exchange is into the country it is
recorded on the credit side of BOP and treated as a positive item. Similarly (ii) Debit side: If the
direction of flow of income (foreign exchange) is outside the country it is treated as a negative item
and recorded on the debit side of the BOP. B. Components of Balance of Payment:- 1. Current
account:- It records all the flow items between residents of one country and the rest of the world
which do not cause any change in the liabilities or assets of the resident of a country in the foreign
soil. Current account of BOP records all the actual transactions of goods and services which affect the
income, output and employment of the country. So, it shows the net income generated in the foreign
sector/soil. Components of current account of BOP:- a) Export and import of goods also called
merchandise account or balance of trade (BOT) ● Exports of goods are recorded as positive items on
the credit side since the direction of foreign exchange is into the country and there is no effect on
either assets or liabilities in the foreign soil. ● Import of goods are recorded as negative items on
debit side since direction of foreign exchange is outside the country and there is no effect on either
assets or liabilities in the foreign soil. b) EXPORT AND IMPORT OF SERVICES:- Trade in services is
called invisible trade because they can not be seen while crossing borders. It is further classified as:-
● Factor income:- These include interest and service payments on foreign loans and credits. In short,
investment income consists of interest, profit, dividend and rental income. ● Non-factor income:- It
includes all services. It mainly covers transportation services, financial services such as insurance,
banking, software etc. c) CURRENT TRANSFERS:-Transfer payments refer to those receipts and
payments which take place without getting anything in return. These refer to the gift, donations etc.
d) Interest payment on past borrowing or lending – All interest payment received on loans and
advances is recorded on the credit side of BOP and interest paid on borrowings are treated on the
debit side of BOP under current account. Balance on Current Account:- 🡺 It has two components:-
Balance of trades and balance of invisibles. 🡺 Balance of Trade:- it is the difference between the
value of exports and imports of a country during year. ■ Export of goods is entered as a credit side
whereas import of goods is entered in debit side. ■ Balance of trade is said to be in balance when
exports of goods are equal to the import of goods. ■ Balance of trade is to be in surplus when exports
are greater than imports. ■ Balance of trade is said to be in deficit when imports are greater than
exports. 🡺 Balance of invisible trade refers to the difference between the value of export and import
of invisible items only. Balance of invisible trade = Export of services - Imports of services a)
Favourable invisible trade - It is favorable when the value of exports of services is more than value of
imports of services. b) Unfavourable invisible trade - It is unfavorable when the value of exports of
services is less than value of imports of services. c) Balanced invisible trade – Invisible trade is said to
be in balance when the value of exports of services is equal to value of imports of services. Capital
account of BOP - It records all flow international economic transactions between residents of one
country and the rest of the world which cause a change either in assets or in liabilities of the resident
of the country in foreign soil. It is related to claims and liabilities of financial nature. Capital account
is concerned with financial transfers, so it does not have a direct effect on income, output and
employment of the country. The items recorded in capital account of BOP are as follows: Components
:- a) BORROWING:- Borrowing and lending of funds is an important component of India‘s capital
account. It takes two forms:- 🡺 External assistance:- It means borrowing of funds from foreign
country under concessional rate of interest. 🡺 Commercial borrowings:- It means funds borrowed
from rest of the world at higher rate of interest. b) FOREIGN INVESTMENTS:- It includes foreign direct
investment and portfolio investment. 🡺 Foreign direct investment:- It refers to the purchase of fixed
capital assets or ownership of enterprises, for eg:- Walmart in India. If an Indian firm purchases the
capital assets in another country, it is an outflow of foreign exchange and vice-versa. 🡺 Portfolio
investment:- It refers to purchase of financial assets such as shares, bonds etc. it is investment by rest
of the world in shares and bonds of domestic company. c) BANKING CAPITAL:- It refers to foreign
assets held by commercial banks. Foreign assets if converted into liquidity, inflow of foreign exchange
in domestic country will rise. 3. Official Reserves:- RBI is the custodian of foreign exchange reserves.
So, official reserves are those reserves which are reflected in the account of the RBI. If overall balance
is positive, it causes increase in official reserves. If overall balance is negative, it causes decrease in
official reserves. Current account deficit (CAD) and current account surplus (CAS) Current account
deficit: When the inflow of foreign exchange on account of visible trade, invisible trade and interest
receipts on loans and advances is less than outflow of foreign exchange on account of visible trade,
invisible trade and interest payments on borrowings, it is known as current account deficit. Current

account deficit = Sum total of debit side – Sum total of credit side Note 🙂Current account deficit
indicates that a nation is borrower from the rest of the world. Current account surplus (CAS): When
the inflow of foreign on account of visible trade, invisible trade and interest receipts on loans and
advances is more than outflow of foreign exchange on account of visible trade, invisible trade and
interest payments on borrowings, it is known as current account surplus. Current account surplus =

Sum total of credit side – Sum total of debit side Note 🙂Current account surplus indicates that a
nation is a lender to the rest of the world. ❖ Difference between Balance of Trade and Balance of
Payment:- Balance of payments Balance of trade 🡪 Balance of payments includes both visible and
invisible trade. 🡪It includes only visible trade. 🡪 It is a systematic record of all economic
transactions. 🡪 It is a systematic record of visible imports and exports in a given year. 🡪It records
transaction of both goods as well as services. 🡪It records transaction of only goods. 🡪It records
transaction of both current account as well as capital account. 🡪It records transaction of only current
account. C. Autonomous and Accommodating transactions:- 1. Autonomous transactions:- These are
the balance of payment transactions which are undertaken for some economic motives such as profit
maximization. These items are also called ‘above the line‘ items in balance of payments because they
are recorded as first items of BOP without knowing BOP status. Significance:- 🡺 These transaction
cause imbalance in balance of payments. A deficit or surplus in balance of payments equals deficit or
surplus in autonomous transactions only. 🡺 The balance of payments is in deficit if autonomous
foreign exchange receipts are less than autonomous foreign exchange payments and it causes
decrease in official reserves held with RBI. 🡺 The balance of payments is in surplus if autonomous
foreign exchange receipts are greater than autonomous foreign exchange payments and it causes
increase in official reserves held with RBI. Thus, autonomous transactions are international economic
transactions made due to some reason other than to bridge the gap in the balance of payments. 2.
Accommodating transactions:- These are the balance of payment transactions which are determined
by the gap in the balance of payments. These items are termed as ‘below the line‘ items in the
Balance of payments as they are recorded as last items in BOP after knowing the status of BOP
Significance:- 🡺 It is influenced by the state of country‘s Balance of payments. 🡺 They are undertaken
to cover the deficit in balance of payments and hence they are the solution of BOP disequilibrium 🡺 It
helps to restore the balance in balance of payments. 3. The transactions carried out by the central
bank which cause change in official reserves held with the central bank and are used to finance
surplus or deficit in BOP are called official reserve transactions and are treated as accommodating
transactions Significance of Official reserve transactions /accommodating transactions: a) When
there is a deficit in BOP, it implies demand for foreign exchange is more than its supply, this deficit is
financed from the country's foreign exchange reserves held with the central bank. To meet this excess
demand for foreign exchange, the central bank sells foreign exchange in the foreign exchange
market. This is recorded as a credit item of a capital account, because there is inflow of foreign
exchange from the central bank into the BOP account and reduction in financial assets of the country.
Therefore, any decrease in foreign exchange reserve of a country is recorded on the positive side of
the capital account and is equal to the deficit in BOP. b) When there is a surplus in BOP, it implies
supply of foreign exchange is more than its demand, this surplus is withdrawn or purchased by the
central bank to keep BOP identity. It is recorded as a debit item of capital account, because there is
outflow of foreign exchange from BOP to central bank and it increases the financial assets of the
country. Therefore, any addition to foreign exchange reserves with the central bank is recorded in the
negative side of the capital account and is equal to surplus in BOP. c) Surplus in capital account is also
used to purchase foreign securities, foreign currency, gold etc. for speculation purpose Thus, the
decrease or increase in official reserves is equal to overall deficit or surplus in BOP. And deficit in BOP
means sell of foreign exchange and surplus in BOP implies purchase of foreign exchange in the
foreign exchange market. Foreign exchange Rate A. Foreign exchange and foreign exchange rate:-
Foreign exchange refers to all currencies other than domestic currency. For eg:- US dollar, euro, yen
etc. Foreign exchange rate is the rate at which one currency is exchanged for the other. For eg:-
1$=50 rupees B. Systems of exchange rate:- 1. Fixed exchange rate:- It is that rate of exchange which
is fixed by the government of a country. It has two methods:- a) Gold standard system:- Under this
method of exchange rate, gold is taken as a common unit. Each currency has to be valued in terms of
gold. For eg:- 1$=4g of gold where as 1=2g of gold. Then, exchange rate will be measured as:-
1$=2 .This system is also known as Mint par value means gold value of currency. b) Bretton woods
system:- It is a fixed system of exchange rate but still some adjustments are allowed. So. It is also
known as the Adjustable peg system. Advantages of fixed exchange rate:- (not in syllabus ) 🡺
International trade:- stability in exchange rate encourages international trade. International trade
flows more quickly and easily when there is confidence all around that existing rates would continue
in future also. 🡺 International investment:- investment is promoted through a system of stable
exchange rates. Unless the exchange rate is stable, the lender and investor will not lend for longer
term period. 🡺 Economic policies:- fixed exchange rate system remove the disturbance which can
weaken the economic policy. It forces the government to keep a check on inflation. Disadvantages of
fixed exchange rate system:- (not in syllabus) 🡺 Gold reserves:- Fixed exchange rate is measured with
the help of gold. So, the country has to keep gold reserves which may hamper money supply. It will
reduce international liquidity. 🡺 FOREX trade:- There is trade in foreign exchange rate in the market.
In case of fixed exchange rate the trade will not be possible as there is neither increase nor decrease
in the value. 🡺 BoP deficit:- Central bank or the government has to intervene to finance balance of
payment deficit to maintain fixed exchange rate. 2. Flexible exchange rate system:- This is the rate
which is determined by demand and supply forces in the free market. C. Determination of exchange
rate:- Free market is determined by demand and supply forces. Equilibrium rate of foreign exchange
is determined by the equality between demand and supply of foreign currency. According to this
diagram:- ✔ OX- axis shows supply and Demand of foreign currency, whereas OY-axis shows rate of
exchange. ✔ E is equilibrium point where demand is equal to supply. ✔ At point E, OR is equilibrium
exchange rate, OQ is equilibrium demand and supply. ✔ If the prevailing exchange rate increases
from OR to OR1 then supply will increase from OQ to ON, whereas demand will reduce from OQ to
OM. ✔ When demand < supply, it is a situation of excess supply. This will lead to a fall in the
exchange rate. Ultimately the rate will restore back to its equilibrium level, where quantity
demanded is equal to quantity supplied. ✔ If the prevailing exchange rate decreases from OR to OR2
then demand will increase from OQ to ON, whereas supply will reduce from OQ to OM. ✔ When
supply< demand, it is a situation of excess demand. This will lead to a rise in the rate of exchange.
Ultimately the rate will restore back to its equilibrium level, where quantity demanded is equal to
quantity supplied. Conclusion:- If the rate of exchange is not in equilibrium then there is a situation of
either excess demand or excess supply. Free play of forces such as supply and demand work in such a
manner that the equilibrium rate of exchange is automatically restored. Advantages and
disadvantage of Flexible exchange rate (Not in syllabus) 🡺 Gold reserves not required:- This exchange
system does not require gold reserves. So, the cost of keeping and acquiring reserves can be avoided.
🡺 Optimum utilization of resources:- flexible exchange rate provides opportunity for the optimum
utilization of resources and thus raise the level of efficiency in the economy. 🡺 Trading:- Flexible
exchange rate provides a way to trader to trade in international currencies. This will lead to
expansion in business activity and growth of the international money market. D. Demand and Supply
of Foreign Currency:- i. Demand of foreign currency:- Foreign currency is demanded to make
payments to the rest of the world. 🡺 Repayment of international loans:- International loans are in
the form of foreign currency. So, to repay these loans foreign currency is demanded. 🡺 Foreign
investments:- Foreign investment is an important business activity. In order to make an investment in
another country, currency of that particular country is demanded. 🡺 Imports:- Goods and services
are imported from another country. For making payment to that particular country, foreign exchange
is demanded. For eg:- laptop is imported from U.S. so U.S dollar is demanded to make payment. 🡺
Direct purchases:- Direct purchase means when people go to another country as a tourist, for
purchases they have to make payments in their currency which arises demand of foreign currency. 🡺
Grants and donations:- Grants and donations to the rest of the world always made in currency of
that country. 🡺 Speculative trading:- Speculative trading means trading in international money
market. For trade purposes foreign currency is required and more of such currency will be held if the
rate is low. Why is there an inverse relationship between exchange rate and demand for foreign
exchange? ▪ Why is there an inverse relationship between demand of foreign exchange and exchange
rate? ▪ Why for a rise in demand for foreign exchange when its price in terms of domestic currency
falls? ▪ Why is the demand curve of foreign exchange downward sloping? Ans. A rise in the price of
foreign exchange causes a decrease in demand for foreign exchange and vice-versa. Reason : a) A rise
in the price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign
good. For example, if the rupee-dollar exchange rate rises from `80/$ to `85/$, 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. b) A rise in the value of the US dollar also
reduces demand for FDI, portfolio investment, and tourism in the US by Indians. The relationship
between foreign exchange rate and demand for foreign exchange can be explained with the help of
the following diagram in which the downward sloping demand curve for foreign exchange DD,
showing inverse relationship between the demand for foreign exchange and exchange rate. When
the exchange rate rises from OR to OR1, the demand for US dollars falls from OQ to OQ1 because of
fall in demand for US commodities, FDI, tourism demand in the US etc. ii. Supply of foreign currency:-
🡺 Exports:- Export of goods and services to foreign country is the important component of supply of
foreign currency. 🡺 Investment from rest of the world:- Investment such as FDI etc. made by foreign
country to domestic country will also lead to supply of foreign currency. 🡺 Direct purchases:- Direct
purchases by rest of the world also contribute to increase in supply of foreign currency. 🡺
International loans:- Loans taken from rest of the world by domestic country will be in the form of
foreign currency. This way foreign currency is supplied in the country. 🡺 Grants and donations:-
Grants and donations from rest of the world will also become the source of supply of foreign
currency. 🡺 Gifts:- Receiving gifts from the rest of the world is also considered as supply of foreign
currency. Direct relationship between foreign exchange rate and supply of foreign currency:- A rise in
the price of foreign exchange causes an increase in supply of foreign exchange and vice-versa. Reason
: a) A rise in the 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 the
rupee-dollar exchange rate rises from `80/$ to `85/$, US dollars can now buy more domestic goods.
That is, exported goods become cheaper in the international market giving a competitive edge for the
goods of domestic countries (India). b) A rise in foreign exchange rate increases FDI, portfolio
investment, tourism in India which increases supply of foreign exchange. The relationship between
supply of foreign exchange and exchange rate can be illustrated with the help of the above graph in
which’ SS’ is an upward sloping supply curve of foreign exchange showing positive relation between
supply of foreign exchange and exchange rate. When the exchange rate rises to OR1 from OR, supply
of foreign exchange rises from OQ to OQ1 because of an increase in imports from India by USA,
increase in FDI, portfolio investment by USA in India. E. Effects of change in demand and supply on
exchange rate:- There is a direct and positive relationship between demand for foreign exchange and
exchange rate 1. If there is increase in demand for foreign currency and there will be increase in rate
of foreign exchange Acc. To diagram:- ✔ OX-axis shows demand and supply of foreign currency. OY-
axis shows rate of exchange. ✔ Due to certain conditions, demand of foreign currency rises from OQ
to OQ1 and demand shifts from D to D1 . ✔ Supply of foreign currency will remain the same, increase
in demand will cause excess demand of foreign currency. ✔ New equilibrium rate will be higher than
the prevailing exchange rate. Rate of exchange rises from OR to OR1 which results in Depreciation of
currency. The above question can also be asked as follows:- Q1. Explain the effect of rise in demand
for foreign exchange on equilibrium exchange rate? Or Explain the effect of the rightward shift in
demand curve for foreign exchange. Or Explain the effect of rise in demand for imports, portfolio, FDI,
Tourism, education and higher studies, remittances etc in foreign countries in India on equilibrium
exchange rate for India. Concept of Depreciation and Devaluation:- Depreciation:- Depreciation of
domestic currency occurs when the value of domestic currency reduces in the international money
market, because of demand and supply forces. There is no intervention from the government in this
case. Devaluation:- It occurs when the value of domestic currency is deliberately reduced by the
government by raising exchange rate. Effect of Depreciation and Devaluation:- --It increases exports
from a country as exports become cheaper for the foreign nationals and foreign currency can buy
more domestic goods. --It reduces imports as it will increase the cost of purchasing foreign goods. --
Since, exports increase and import falls therefore, Net exports will increase which will ultimately
increase national income. 2. Increase in supply of foreign currency Acc. To Diagram:- ✔ OX- axis
shows demand and supply of foreign currency. OY- axis shows rate of exchange. ✔ Due to increase in
supply of foreign currency, the supply curve shifts rightwards to the original curve. ✔ Demand of
foreign exchange remains same, increase in supply will cause excess supply. ✔ If supply of foreign
currency rises from OQ to OQ1 , then supply curve will shift from S to S1 . New equilibrium price will
be lower than prevailing price. ✔ Equilibrium rate of exchange will fall from OR to OR1 . This is the
situation of currency appreciation. The same question can also be asked in the following manner Q1.
Explain the effect of rise in supply of foreign exchange on equilibrium exchange rate? Or Explain the
effect of the rightward shift in supply curve for foreign exchange. Or Explain the effect of rise in
portfolio demand, FDI, Tourism and education demand in India on equilibrium exchange rate. Or
Explain the effect on equilibrium exchange rate when there is deflation in India. OR Explain the effect
on equilibrium exchange rate when there is fall in domestic interest rate in India. Concept of
Appreciation and Revaluation:- Appreciation:- It occurs when the value of the domestic currency rises
in the international money market, because of the market forces of supply and demand. There is no
intervention from the government. Revaluation:- It occurs when the value of the domestic currency is
deliberately raised by the government by lowering the exchange rate. Effect of Appreciation and
Revaluation:- --It decreases exports; since domestic goods become costlier for foreign nationals,
therefore they will purchase less of domestic goods. --It increases imports; the importers now have to
pay less domestic currency to buy foreign goods. --Since exports decrease and imports increase, Net
exports will reduce and as a result national income will fall. Interest rate and exchange rate There are
huge funds owned by banks, multinational corporations, and wealthy individuals which move around
the world in search of higher interest rates. If we assume that government bonds in India pay a 10%
rate of interest whereas equally safe bonds in the USA pay 8% rate of interest. Therefore, investors in
the USA find it more profitable to invest in India which will increase the supply of foreign exchange
(USA dollars) in India which will shift the supply curve to the right and the exchange rate will fall. On
the other hand, investors in India will also find it profitable to invest in India as a result demand for
US dollars will fall in India which shifts demand curve leftward and exchange rate will fall. Therefore,
the exchange rate will fall for the home country and there is appreciation of the Indian rupee. 2.
Increase in Income and exchange rate Ans. When income increases in the home country consumer
spending also increases. Spending on imported goods is also likely to increase. When imports
increase demand for foreign exchange increases which shifts demand curve for foreign exchange
rightward and exchange rate for home country increases which leads to depreciation of rupees. On
the other hand, if income increases abroad exports of countries also increase which shifts supply
curve rightward and exchange rate falls. Therefore, whether the exchange rate will increase or
decrease depends upon whether exports grow faster than imports or imports grow faster than
exports. Generally, the country whose aggregate demand i.e., imports increase faster than exports
find its currency depreciating Speculation activity and the exchange rate Under speculation activities
foreign exchange is demanded for the possible gain from appreciation of foreign currency. How does
it affect: Suppose the investors speculate the rupee –dollar exchange rate is going to rise from 1 Us
dollar = 60 Rs to 1 us dollar = 66 Rs by the end of this month. This means they can gain 6 Rs in each
transaction at the end of the month when they will sell one dollar in exchange of rupee. This
exception would increase the demand of US dollar and cause exchange rate to rise in the present F.
Managed floating exchange rates:- 🡺 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. 🡺 Therefore, it is the combination of the flexible exchange rate system and the fixed
exchange rate system because managed floating exchange rate is decided by market forces but
remains within a specific range as decided by the central bank. NOTE: Therefore, official reserves are
applicable in the case of fixed exchange and managed floating exchange rate systems Demand for
domestic goods and domestic demand for goods the same No, demand for domestic goods and
domestic demand for goods do not mean the same thing a) Demand for domestic goods is the total
demand for goods from the domestic consumers and from foreign consumers, thus it is inclusive of
exports and results in inflow of foreign exchange whereas b) Domestic demand for goods is the
demand for the domestic goods as well as of foreign goods and thus it is inclusive of imports and
results in outflow of foreign exchange