MACRO ECONOMICS 190 Pages Questions and Answers 21.9.23

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CHAPTER 1. INTRODUCTION
Topic 1 : Basic Concepts of Economics
1. Macroeconomics: It studies economic problems at the level of an economy as a whole.It is concerned with the
determination of aggregate output and general price level in which are not concerned with an individual rather the
economy as a whole.
2. Scope of Macroeconomics : Macroeconomics is the study of aggregates of the economy as a whole. Study of
macroeconomics includes:
(i) Aggregate consumption It is the consumption of goods and services by all individuals in the economy during the
period of an accounting year.
(ii) Aggregate investment It refers to the total capital formation in the economy during an accounting year.
(iii) Aggregate Demand (AD) It is the total demand of an economy including all the sectors at a given level of income
during at a given period of time.
(iv) Aggregate Supply (AS) It is the total supply of goods and services by all the sectors of an economy at a given period
of time.
(v) Domestic income It is the income generated with in the domestic boundary of the country during an accounting year.
(vi) General price level It is the index of prices of all goods and services at the end of the specific time period.
3. Importance of Macroeconomics
(i) It helps in government policy formulation.
(ii) It facilitates international comparison.
(iii) It helps in understanding the distribution of income among different groups of people.
(iv) It has special significance in studying monetary problems that affects the economy.
4. Types of Goods Produced in An Economy
(i) Final goods: The goods, which have crossed the boundary line of production and are ready for use by their final users
are known as final goods, e.g. clothes, milk consumed by a consumer. Final goods are often classified as:
(a) Final consumer goods: These are the goods which are consumed by the consumers like milk, bread etc.
(b) Final producer goods: These are the goods which are consumed or used by the producers like machinery equipment
etc.
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(ii) Intermediate goods : The goods purchased by a firm for the use in production of other goods or for the purpose of
reselling, are known as intermediate goods, e.g. steel used in the production of cars and those finished goods which are
meant for resale such as milk purchase by milk seller.
(iii) Consumer goods Goods : which are directly used for satisfaction of human wants and which are not used in
production for other purpose are known as consumer goods, e.g. ice-cream and milk used by the households.
Consumer goods are further classified into:
(a) Durable goods: These are those goods, which can be used several number of times for a considerable period of time.
i.e. these goods has certain life spam like car, A.C. etc.
(b) Semi-durable goods: These are those good which do not have very long life span however do not gets exhausted in a
single use either. For example, crockery, clothing etc.
(c) Non-durable goods: These are the goods which have a very short life span and mostly get exhausted in a single use.
For example, milk, vegetables etc.
(d) Services : It refers to the intangible items which cannot be seen however it can be felt. For example, services of a
doctor, teacher etc.
(iv) Capital goods: The goods which are repeatedly used in the process of production. They are the fixed assets of the
producer, e.g. building, plant and machinery. They help to convert intermediate goods into finished goods.
5. Great Depression : The period from 1929 to 1933 is called the period of great depression. In this period, there was
huge fall in the levels of output and employment in the countries of Europe and North America.
Previous years Examination Questions
1 Mark Questions
1. Give the meaning of capital goods. (Compartment 2014)
or
Define capital goods. (Delhi 2012; All India 2010)
Ans. The goods which are repeatedly used in the process of production. They are the fixed assets of the producer, e.g.
building, plant and machinery. They helps to convert intermediate goods into finished goods.
*
2. Give two examples of intermediate goods. (All India 2013)
Ans. Two examples of intermediate goods are:
(i) Steel used in the car.
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(ii) Mobile sets purchased by a mobile dealer.
3.Define consumption goods. (All India 2012)
Ans. Goods which are directly used for satisfaction of human wants and which are not used in production and for other
purpose are known as consumer goods or consumption goods, e.g. ice-cream and milk used by the households.
4.Define intermediate goods. (Delhi 2011 c)
Ans. The goods purchased by a firm for the use in production of other goods or for the purpose of reselling are known as
intermediate goods, e.g. steel used in the production of cars and those finished goods which are meant for resale, such
as milk purchases by a milk seller.
5.Define final product. (Delhi 2010 c)
Ans. The goods, which have crossed the boundary line of production and are ready for use by their final users, known as
final goods, e.g. clothes, milk consumed by a consumer.
Final goods are often classified as:
(i) Final consumer goods (ii) Final producer goods
4 Marks Questions
6.Giving reasons, classify the following into intermediate products and final products
(i) Furniture purchased by a school.
(ii)Chalks, dusters, etc purchased by school (Delhi 2012)
Ans. (i) Furniture purchased by school — Final product.
Reason: Schools buy furnitures for long-term use and it can be considered an investment.
(ii) Chalks, dusters, etc purchased by school — Intermediate good
Reason: Chalks, dusters, etc; are purchased by a school for use in their day-to-day consumption. This is meant for further
production in the form of services.
7. Give reason and identify whether the following are final expenditures or intermediate expenditure.
(i) Expenditure on maintenance of an office building.
(ii) Expenditure on improvement of machine in a factory. (All India 2012)
Ans. (i) Expenditure on maintenance of an office building — Intermediate expenditure.

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Reason: Expenditure on maintenance of office building is for production purpose.
(2) Expenditure on improvement of machine in a factory — Final expenditure
Reason: Expenditure on improvement of machine in a factory is a kind of capital investment, so it should be considered
as final expenditure.
8. Giving reasons, classify the following into intermediate products and final products.
(i) Computers installed in an office.
(ii)Mobile sets purchased by a mobile dealer. (Delhi 2011)
Ans. (i) Computers installed in an office — Final product
Reason Offices buy computers as long-term durable products and are investment for them.
(ii) Mobile sets purchased by a mobile dealer — Intermediate products
Reason: A mobile dealer purchases mobile sets for reselling purpose. That’s why it is considered as intermediate
products.
9. Giving reasons, classify the following into intermediate and final goods.
(i) Machine purchased by a dealer of machines.
(ii) A car purchased by a household. (All India 2010)
Ans. (i) Machine purchased by a dealer of machines — Intermediate goods
Reason: A dealer purchases machines for reselling purpose, so it is an example of intermediate goods.
(ii) A car purchased by a household — Final goods
Reason: A household purchases a car for consumption purpose, so it is an example of final goods.
10. Distinguish between intermediate and final goods. Give two examples of each.
(All India 2010)
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Investment,Stock,Flows and Circular Flow of Income
1. Investment It is the process of capital formation by a firm or increase in the stock of existing capital stock.
2. Components of Investment
(i) Fixed investment In a specific time period (generally in an accounting year), the increase in the stock of fixed assets of
the producers is termed as fixed investment.
(ii) Inventory investment During a specific time period, (generally an accounting year) the change in inventory stock (i.e.
the sum of unsold goods, semi-finished goods and raw materials) is termed as inventory investment, it is also called as
change in stock and calculated as closing stock – opening stock.
3. Types of Investment
(i) Gross investment: Gross investment of an economy constitutes that part of our final output that comprises of capital
goods, i.e. expenditure on fixed assets or on inventory stock.
Gross Investment = Expenditure on the Purchase of Fixed Assets in an Accounting Year + Expenditure on the Inventory
Stock in an Accounting Year.
(ii) Net investment: It is the increase in stock of capital during an accounting year. It is also termed as new capital
formation.
Net Investment = Gross Investment – Depreciation
4. Concept of Depreciation: It is the loss of value of fixed assets in use on an account of normal wear and tear, normal
rate of accidental damages and expected or foreseen obsolescence. Depreciation is also called consumption of fixed
capital.
5. Depreciation Reserve Fund: It is a fund created by the producers to meet the upcoming depreciation losses in the
process of production.
6. Inventory: It is termed as the stock of unsold finished goods, semi-finished goods (goods which are in the process of
production) and raw materials which a firm carries from one year to the next year.
7. Stock: These are defined as any quantity measured at a particular point of time, e.g. number of machines in a plant,
amount in the bank account on a specific date, etc.
8. Flow: These are defined as any quantity measured per unit at a particular period of time. e.g. income or expenditure
over a time period of one month or one year.
9. Circular Flow of Income: The circular flow means the unending flows of production of goods and services, income and
expenditure in an economy. It shows the redistribution of income in a circular manner between production unit and
households.
10. Phases of Circular Flow Income

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(i) Production of goods and services.
(ii) Generation of income in terms of wages, rent, interest and profit.
(iii) Expenditure in terms of consumption and investment.
11. Types of Circular Flow of Income
(i) Real flow: The flow of factor services from households to business and flow of goods and services from business to
households is known as real flow.
(ii) Money flow The flow of money across different sectors of the economy is temed as money flow. i.e. exchange of
factor services by the household for factor payments from firms.
(iii) Injection: It means introduction of income into the flow when households and firms borrow the savings, they
constitute injections.
(iv) Leakages: It refers to the withdrawal from the flow, when households and firms save part of their incomes, it
constitutes leakage.
12. Different Sectors in Circular Flow of Income in an Open Economy
(i) Production sector (ii) Household sector
(iii) Government sector (iv) Rest of the world sector

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Previous Years Examination Questions
1 Mark Question
1.Define stock variable. (Delhi 2012; All India 2011)
Ans. Stock variables are defined as any quantity measured at a particular point of time. e.g. number of machines in a
plant, amount in the bank account on a specific date, etc.
2. Define flow variable. (All India 2012; Delhi 2011)
Ans. Flow variables are defined as any quantity measured per unit at a particular period of time, e.g. income or
expenditure over a time period of one month or one year.
3. Define depreciation. (All India 2011)
Ans. It is the loss of value of fixed assets in use on an account of normal wear and tear, normal rate of accidental
damages and expected or foreseen obsolescence. Depreciation is also called consumption of fixed capital.
3 Marks Question
4.Explain the circular flow of income. (Compartment 2014; Delhi 2009)
Circular flow of income refers to the unending flows of production of goods and services, income and expenditure in an
economy. It shows the redistribution of income in a circular manner between production units (firms) and households. It
can be better understood with this diagram
4 Marks Questions
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5. Distinguish between stock and flow. Give two examples of each.
(All India 2013)
6.Give reasons and categorise the following into stock and flow
(Delhi 2013)
(i) Capital (ii) Saving
(iii) Gross Domestic Product (iv) Wealth
Ans. (i) Capital : It is a man made means of production. It is a stock because it is measured at given point of time.
(ii) Saving: Give reasons and categorise the following into stock and flow
(iii) Gross Domestic Product: It is a flow as it is the market value of final goods and services produced within the
domestic territory during a period of time.
(iv) Wealth :It is a stock as it is measured at a particular point of time.
7. Explain the circular flow of income. (Delhi 2013)
Ans. Circular Flow of Income: Circular flow of income refers to the unending flows of production of goods and services,
income and expenditure in an economy. It shows the redistribution of income in a circular manner between production
units (firms) and households. It can be better understood with this diagram
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Phases of Circular Flow of Income: There are three different phases (generation, distribution and disposal) in circular
flow of income, as shown in the given diagram
(i) Generation phase :In this phase, firms produce goods and services with the help of factor services.
(ii) Distribution phase This phase involves the flow of factor income (rent, wages, interest and profit) from firms to the
households.
Disposal phase In this phase, the income received by factors of production, is spent on the goods and services produced
by firms.
Income is first generated in production units, then distributed to households, and finally spent on goods and services
produced by these units to make the circular flow complete its course.
8. Give reasons and categories the following into stock and flow
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(i) Profits (ii) Capital
(iii) Savings (iv) Balance in bank account (All India 2011)
Ans. (i) Profits: These are flow variables as it is measured over a period of time.
(ii) Capital : It is a man made means of production. It is a stock because it is measured at given point of time.
(iii) Savings: Give reasons and categorise the following into stock and flow
(iv) Balance in bank account: This is a stock variable which is measure on a specific date, i.e. point of time.
9. Give reasons and categories the following in stock and flow
(i) Losses (ii) Capital
(iii) Production (iv) Wealth (Delhi 2011 c)
Ans. (i) Losses: These are those flows as it is measured over a period of time.
(ii) Capital : It is a man made means of production. It is a stock because it is measured at given point of time.
(iii) Production: It is a flow as it is measured over a period of time.
(iv) Wealth : It is a stock as it is measured at a particular point of time.
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CHAPTER: 2 National Income and its Related Concepts
1. National Income It is defined as the sum total of factor incomes accruing to normal residents of a country with a given
period of time, generally a financial year
2. Normal Residents of a Country These are the residents of a country or are those ‘individuals’ or ‘institutions’ who
normally reside in a country and their economic interest lies in that country. For becoming a normal resident, an
individual or an institution has to reside/operate for more than one year in that country.
3. Persons or Entities Who are Not Normal Residents of a Country International organisations (such as UN, WHO, IMF,
World Bank, etc), foreign tourists and visitors for any purpose, crew members of foreign cargo, ships and airplanes,
officials, diplomats and sport persons visiting on a tour are not considered as normal residents of a country. As their
centre of economic interest does not lie in that country.
4. Domestic Territory of a Country In terms of National Income accounting, domestic territory of a country refers to the
areas of operation generating domestic income. It includes two things:
(i) Territory within the political boundaries of a country.
(ii) All ships, aircraft, vessels owned and operated by the resident of the country and generating income of the country.
5.Domestic Income: The sum total of all factor incomes generated during an accounting year within the domestic
territory of a country is termed as domestic income or domestic product of a country.
6.Difference between Domestic Income and National Income
7. Gross Domestic Product (GDP): It is the total value of all the final goods and services by all the enterprises (both
resident and non-resident) within the domestic territory of a country in a particular year. GDP is considered as one of
the best indicators of judging the economic performance of a country.
8. Gross National Product: It is defined as the total value of all final goods and services produced in a country in a
particular year, plus the income which is earned by its citizens who are located abroad and minus the income of non-
residents located within the country, it includes depreciation.
9. Net National Product at Factor Cost (NNPFC): It is the sum total of factor incomes (rent + interest + profits + wages)
earned by normal residents of a country during the period of an accounting year. It is net of depreciation.
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10.Net National Product at Market Price (NNPMP): It refers to market value of final goods and services produced
during the year inclusive of Net Factor Income from Abroad but exclusive of depreciation
11. Nominal Gross Domestic Product: It refers to market value of the final goods and services produced within the
domestic territory of a country during a financial year, as estimated using the current year prices. It is also called GDP at
current price.
12. Real Gross Domestic Product: It refers to market value of the final goods and services produced within the domestic
territory of a country during a financial year, as estimated using the base year prices. It is also called GDP at constant
price.
13. GNP Deflator It shows the change in GNP with the change in price levels.
14. GDP is not Appropriate Indicator for Welfare GDP may be a good a indicator of economic growth but not economic
welfare or economic development, because of:
(i) Ignorance of distribution of income among the population.
(ii) Welfare is not a component of GDP calculation.
(iii) Non-monetary transactions are ignored.
(iv) Externalities (good and bad impact of personal activities on others).
15. Some Important Terms
Some important terms are described below:
(i) Net Factor Income from Abroad (NFIA): This is the difference between the income earned from abroad for
rendering factor services by the normal residents of the country to the rest of the world and the income
paid for the factor services rendered by non-residents in the domestic territory of a country. .
(ii) Factor income: These are incomes received by the owners of factors of production for rendering their factor
services to the producers i.e. wages to the labour , rent to land, interest to capital and profit to the entrepreneur.
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(iii) Transfer payments :These are all those unilateral payments (one way payments) corresponding to which there is no
value addition in the economy, e.g. gifts, donations, etc.
(iv) Private income : It is the total income from all sources (factor income as well as current transfers) that accrues to
the private sector during the period of one year. Private Income = Factor Income from Net Domestic Product Accruing to
Private Sector + Net Factor Income from Abroad -(-Interest on National Debt + Net Current Transfers from Rest of the
World + Current Transfer from Government.
(v) Personal income: It is the income actually received by the individual households from all sources in the form of
current transfer payment and factor incomes.
Personal Income = Private Income – Corporation Tax – Retained Earnings or Corporate Savings.
(vi) Personal disposable income: It is the amount, which is actually available to the households and the non-corporate
businesses after the deduction of all tax obligations to the government.
Personal Disposable Income = Personal Income – Direct Personal Taxes– Miscellaneous Receipts of the Government
(vii) National Disposable Income (NDI): It is defined as the maximum, the country can afford to spend on consumption
goods or services during an accounting year without having to finance its expenditure by disposing of assets or by
increasing its liabilities.
National disposable income can be ‘gross’ or ‘net’.
Net National Disposable+ Income = NNPFC + Net Indirect Taxes
+ Net Current Transfers from Rest of the World
Gross National Disposable Income = Net National Disposable Income + Depreciation
(viii) Private sector It refers to all those businesses and enterprises which are owned and controlled by the private
individuals.
(ix) Public sector It refers to all those departmental and non-departmental businesses and enterprises which are owned
or controlled by government, e.g.
(а) Departmental Post offices, Railways, Tourism Corporation of India, etc.
(b) Non-departmental Indian Aviation, Indian Oil, etc.
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1 Mark Questions
1. Give one example of ‘externality’ which reduces welfare of the people. (Delhi 2013)
Ans. When the activities of one result in harm to others with no payment made for the harm done, such activities are
called negative externalities, e.g. factories produce goods but at the same time creates water and air pollution.
Production of goods increases welfare but at the same time pollution reduces the welfare
2. What is Nominal Gross Domestic Product? (Delhi 2011)
Ans. Nominal Gross Domestic Product refers to market value of the final goods and services produced within the
domestic territory of a country during a financial year, as estimated using the current year prices. It is also called GDP at
current price.
3. What is meant by Real Gross Domestic Product? (Delhi 2011 c)
Ans. Real Gross Domestic Product refers to market value of the final goods and services produced within the domestic
territory of a country during a financial year, as estimated using the base year prices. It is also called GDP at constant
price.
4. Define domestic product. (All India 2011,2010)
Ans. The value of all factor incomes generated during an accounting year within the domestic territory of a country is
termed as domestic product or domestic income of a country.
5. What is transfer payment? (All India 2011)
Ans. Transfer payments are all those unilateral payments corresponding to which there is no value addition in the
economy, e.g. gifts, donations, etc.
3 Marks Questions
6. Define externalities. Give an example of negative externality. What is its impact on welfare? (Delhi 2014)
Ans. Externalities refer to the benefits or harms a firm or an individual causes to another for which they are not paid.
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Examples of negative externalities are:
(i) River pollution created by an oil refinery has disastrous effects on aquatic life.
(ii) It reduces the overall welfare of the society and creates negative externality.
7. What are externalities? Give an example of a positive externality and its impact on welfare of the people. (All India
2014)
Ans. Externalities refer to the benefits or harms a firm or an individual causes to another for which they are not paid.
These externalities can be positive as well as negative. A positive externality exists when an individual or firm making a
decision does not receive the full benefit of the decision, e.g. Immunisation prevents an individual from getting a disease,
but has the positive effect of the individual not being able to spread the disease to other.
It enhances the overall walfare of the society and creates positive externalities.
8. Explain how ‘non-monetary exchanges’ are a limitation in taking domestic product as an index of welfare?
(Foreign 2014; All India 2011)
Ans. The non-monetary exchanges which take place in the informal sectors are not included in the calculation of GDP
since money is not being used. For example, Service of a housewife, kitchen gardening, etc. This results in an under
estimation of GDP. Hence, GDP calculated in the standard manner may not give us a clear indication of the productive
activity and actual welfare of the country.
9. Explain how ‘distribution of Gross Domestic Product’ is a limitation in taking Gross Domestic Product as an index of
welfare. (Delhi 2011)
Ans. If the Gross Domestic Product of a country is rising sharply, it may not necessarily indicate the welfare. This is
because the rise in GDP may be concentrated in the hands of few individuals or firms leading to increase inequality of
income and wealth, i.e. the gap between the income of rich and poor widens which does not indicate increase in the
welfare.
10. How can externalities be a limitation of using Gross Domestic Product as an index of welfare? (Delhi 2011 c)
Ans. Increase in Gross Domestic Product is due to increased economic activities like industrialisation and urbanisation.
With increase industrialisation certain problems for society also increase like pollution of air, water and soil and
deforestation. Urbanisation also results in housing problems, increase in road accidents, etc. On the whole welfare
decreases and this decrease in welfare is ignored while calculation of GDP. So, we can say that externalities can be a
limitation of using GDP as an index of welfare. .
11.Give the meaning of factor income to abroad and factor income from abroad. Also give an example of each. (All
India 2009)
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Ans. Factor income to abroad It is the income earned by a non-resident factor of production working in domestic market,
e.g. the earnings of a person from Bangladesh who is-working in India is factor income to abroad.
Factor income from abroad It is the income earned by residents of a country from rest of the world, e.g. an Indian citizen
working in US, earns his salary and this is treated as factor income from abroad.
14.Distinguish between domestic product and national product. When can domestic product be more than the
national product? (All India 2009)
Ans. The sum total of all factor incomes generated or produced during an accounting year within the domestic territory
of a country is termed as domestic income or domestic product of a country. On the other hand, the sum total of all
factor incomes earned by the normal residents of a country, irrespective of the fact that in which part of the world this
income is generated, during an accounting year is called National Income or national product of a country.
National Product = Domestic Product + Net Factor Income from Abroad.
If Net Factor Income from Abroad (i.e. income paid to abroad is more than income received) is negative, the domestic
product is more than the national product
15. Distinguish between Real Gross Domestic Product and Nominal Gross Domestic Product.
Which of these is a better index of welfare of the people and why?
(All India 2013)
Or
Distinguish between Real and Nominal Gross Domestic Product. (All India 2010)
Ans. (i) Nominal GDP is the market value of all final goods and services produced in a geographical
region usually a country, on the other hand, Real GDP is a macroeconomic measure of the value of
output, economically adjusted for price changes. The adjustment transforms the Nominal GDP into an
index for quantity of total output.
(ii) Nominal values of GDP from different time periods can differ due to changes in quantities of goods
and services and/or changes in general price levels. Values for Real GDP are adjusted for difference
in price levels while figures for Nominal GDP are not adjusted.
Real GDP is a better index of welfare of the people, when Real GDP rises, flow of goods and services
tends to rise, other things remaining constant. This means greater availability of goods per person,
implying higher level of welfare.
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16. Explain why subsidies are added to and indirect taxes deducted from domestic product at
market price to arrive at domestic product at factor
cost? (Delhi 2010 c)
Ans. Subsidies by government are grants that decrease the price of a commodity, whereas indirect
taxes are paid by a firm and households that increase the final price of a commodity. Hence, to derive
Gross Domestic Product at Factor Cost from Gross Domestic Product at Market Price, we deduct
indirect taxes and add subsidies. Also subsidies are the income received while indirect taxes are paid.
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Methods of Calculating National Income
1. Methods of Calculating National Income
(i) Income method
(ii) Expenditure method
(iii) Product method or value added method or output method
2. Income Method: By this method, the total sum of the factor payments received during a given period is estimated to
obtain the value of Domestic Income. Depending on the way, the income is earned.
It can be classified into following components:
(i) Compensation of employees
(ii) Operating surplus (rent, profit and interest)
(iii) Mixed income of self-employed
3. Computation of National Income (By Income Method)
4. Precautions While Using Income Method
(i) Income from illegal activities like smuggling, theft, gambling, etc, should not be included.
(ii) Corresponding to production for self consumption, the generation of income of economy to be taken into account.
(iii) Brokerage on the sale/purchase of shares and bonds is to be included.
(iv) Income in terms of windfall gains should not be included.
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(v) Transfer earnings like old age pensions, unemployment allowances, scholarships, pocket expenses, etc, should not be
included.
5. Expenditure Method: By this method, the total sum of expenditures on the purchase of final goods and services
produced during an accounting year within an economy is estimated to obtain the value of domestic income.
6. Final Expenditure : It is the expenditure on the purchase of final goods and services during an accounting year. It is
broadly classified into four categories:
(i) Private final consumption expenditure.
(ii) Government final consumption expenditure.
(iii) Investment expenditure or gross domestic capital formation.
(iv) Net exports, i.e. difference between exports and imports during an accounting year.
7. Computation of National Income (By Expenditure Method)
8. Precautions While Using Expenditure Method
(i) Only final expenditure is to be taken into account to avoid error of double counting.
(ii) Expenditure on second hand goods is not to be included.
(iii) Expenditure on transfer payments by the government is not to be included.
(iv) Imputed value of expenditure on goods produced for self consumption should be taken into account.
(v) Expenditure on shares and bonds is not to be included in Total Expenditure.
9. Value Added Method/Product Method/Output Method By this method, the total value of all the final goods and
services produced in an economy during a given time period are estimated to obtain the value of domestic income.
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10. Computation of National Income (By Value Added Method)
11. Precautions While Using Value Added Method
(i) The value of intermediate goods should not be included.
(ii) Purchase and sale of second hand goods should not be included.
(iii) Imputed value of self-consumed goods should be included, but self-consumed services should not be included.
(iv) Own account production should be included.
(v) Commission earned on account of sale and purchase of second hand goods is included.
(vi) If sales are given, then exports are not included separately.
(vii) If intermediate purchases are given, then imports are not included.
3 Marks Questions
1. Calculate sales from the following data (All India 2013)
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2. Calculate sales from the following data (Delhi 2013)
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4. Calculate Gross Value Added at Factor Cost (Delhi 2012)
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5. Calculate Net Value Added at Factor Cost (Delhi 2012)
6. Find Net Value Added at Market Price (Delhi 2012)
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7. Find Net Value Added at Market Price (All India 2012)
8. Find Gross Value Added at Factor Cost (All India 2012)
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9. Find out Net Value Added at Factor Cost (All India 2012)
10. From the following data calculate Net Value Added at Factor Cost
(Delhi 2011)
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Ans. Net Value Added at Factor Cost (NVAFC) = Value of Output (Sales + Change in Stock)-Purchase of
Intermediate Goods – Consumption of Fixed Capital – Indirect Taxes
= 3500 + 50 – 2000 – 500 – 350
= 3550-2850 = Rs. 700 crore
Ans. Net Value Added at Factor Cost (NVAFC) = Sales + Change in Stock (Closing Stock- Opening Stock)- Purchase of
Intermediate Goods – Consumption of Fixed Capital – Indirect Tax
= 500+ (80-60)-350-90-50
= 520-490 = Rs. 30 crore
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Ans. Net Value Added at Factor Cost (NVAFC) = Value of Output (Sales + Change in Stock) – Purchase of Intermediate
Goods – Depreciation – Net Indirect Taxes
= 750+ (-30)-500-60-100
= 750 – 690 = Rs. 60 crore
13. Calculate value of output from the following data (Delhi 2008)
Ans. Value of Output = Net Value Added at Factor Cost (NVAFC) + Depreciation
+ (Excise Duty – Subsidy) + Intermediate Consumption
= 100+10+ (20-5) + 75
= 185+15
= Rs. 200 crore
14. Calculate intermediate consumption from the following data
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Ans. Intermediate Consumption = Value of Output – Net Value Added at Factor Cost (NVAFc)+ Depreciation + (Sales
Tax-Subsidy)
= 200-[80+ 20+ (15 -5)]
= Rs. 90 lakh
Ans. Sales = Net Value Added at Factor Cost (NVAFC)+ Intermediate Consumption – Change in Stock+ Indirect Tax +
Depreciation
= 300+ 200-(-50)+ 20+ 30
= Rs. 600 lakh
16.Calculate Net Value Added at Factor Cost from the following data
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Ans. Net Value Added at Factor Cost (NVAFC) = Value of Output (Sales + Change in Stock) – Intermediate Cost-
Depreciation – Net Indirect Tax
= [140+ (-10)]-90-20-(-5)
= 140-110 + 5
= 30 + 5 = Rs. 35 lakh
17. Calculate Gross Value Added at Factor Cost from the following data
Ans. Gross Value Added at Factor Cost (GVAFC) = Value of Output (Sales + Change in Stock)- Purchase of Raw Materials –
Indirect Tax (Sales Tax + Excise Duty)
= [400+ (-40)]-250-(20+ 30)
= 400 – 340 = Rs. 60 lakh
18.Calculate Net Value Added at Factor Cost from the following data
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Ans. Net Value Added at Factor Cost (NVAFC) = Value of output (Sales + Change in Stock) – Purchase of Raw Materials –
Consumption of Fixed Capital + Subsidies
= [700 + (-30)] – 400 -20 + 50
= 750-450 = Rs. 300 lakh
19. Calculate Net Value Added at Factor Cost from the following data
Ans. Net Value Added at Factor Cost (NVAFC) = Value of Output (Sales + Change in Stock)- (Purchase of Raw Material +
Import of Raw Material) – Consumption of Fixed Capital + Subsidies
= (800 + 50) – (400 +100) – 40 + 30
= 880-540
= Rs. 340 lakh
20. From the following information about firm X, calculate Net Value Added at Factor Cost (Delhi 2008 C)
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Ans. Net Value Added at Factor Cost (NVAFC) = Value of Output [Sales + Change in Stock (Closing Stock – Opening
Stock)] – Purchase of Raw Material – Depreciation (Gross Capital Formation – Net Capital Formation) + Subsidies
= [800 + (40 – 50)] – 500 – [200 -180] + 60
= 790-500-20+60
= 850-520
= Rs. 330 lakh
(Delhi 2008 C)
Ans. Net Value Added at Factor Cost (NVAFC) = Sales + Change in Stock – Purchase of Raw Materials- Consumption of
Fixed Capital + Subsidies
= 500 + (-20) – 250 -40 + 30
= 530-310
= Rs. 220 lakh
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4 Marks Questions
22.Giving reason, explain how should the following be treated in estimating National Income (Delhi 2012)
(i) Expenditure on fertilisers by a farmer.
(ii) Purchase of tractor by a farmer
Ans. (i) Expenditure on fertilisers by a farmer is ‘not included’ in the estimation of National Income as it is an
intermediate consumption as fertilisers are meant for further production.
(ii) Purchase of a tractor by a farmer is included in the estimation of National Income as it is capital formation or
investment expenditure.
23.Giving reason, explain how should the following be treated in the estimation of National Income (Delhi 2012)
(i) Payment of bonus by a firm.
(ii) Payment of interest on loan taken by an employee from the employer.
Ans. (i) Payment of bonus by a firm is not Included in the estimation of National Income as it is not a part of factor
income.
(ii) Payment of interest on loan taken by an employee from the employer will ‘not’ be included in the estimation of
National Income as it will be treated as transfer income, also loan is taken for consumption purpose.
24. Giving reason, explain how should the following be treated in estimation of National Income (Delhi 2012)
(1)Interest paid by banks on deposits by individuals.
(ii) National debt interest.
Ans. (i) Interest paid by banks on deposits by individuals should be included in estimation of National Income as it will be
treated as factor income.
(ii) National debt interest should ‘not’ be included in estimation of National Income as it is assumed that government
borrows for consumption and hence, it is treated as transfer income.
25.Giving reason, explain how should the following be treated while estimating National Income (All India 2012)
(i) Expenditure on free services provided by government.
(ii) Payment of interest by a government firm.
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Ans. (i) Expenditure on free services provided by government should be Included’ in the estimation of National Income,
as it is a final expenditure of the government.
(ii) Payment of interest by a government firm should ‘not’ be included in the estimation of National Income, as it is a
transfer payment.
26.How should the following be treated while estimating National Income? Give reasons. (All India 2012)
(i) Expenditure on education of children by a family.
(ii) Payment of electricity bill by a school.
Ans. (i) Expenditure on education of children by a family is ‘included’ in the estimation of National Income as it is a part
of final consumption expenditure by the household.
(ii) Payment of electricity bill by a school is ‘included’ in the estimation of National Income as it is a part of final
consumption expenditure.
27. Giving reason, explain the treatment assigned to the following while estimating National Income (All India
2011)
(i) Family members working free on the farm owned by the family.
(ii) Payment of interest on borrowings by general government.
Ans. (i) Family members working free on the farm owned by the family should included’ as it is a part of mixed income.
(ii) Payment of interest on borrowings by general government should ‘not’ be included in the estimation of National
Income as it is not mentioned and not clear whether the government has borrowed for consumption or production.
28.Giving reason, explain the treatment assigned to the following while estimating National Income (All India 2011)
(i) Social security contributions by employees.
(ii) Pension paid after retirement.
Ans. (i) Social security contributions by employees is ‘included’ in the estimation of National Income, as it is a part of
compensation of employees and it is an earned income.
(ii) Pension paid after retirement is ‘not’ included in the estimation of National Income as it is a kind of deffered
payment to employees.
29.Giving reason, explain how are the following be treated in estimation of National Income by income method
(All India 2010)
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(i) Interest paid by banks on deposits.
(ii) National debt interest.
Ans. (i) Interest paid by banks on deposits will be ‘included’ while estimating National Income by income method, as it is
an income earned by depositors and bank uses these deposits for commercial purposes.
(ii) National debt interest will ‘not be included’ while estimating National Income by income method, as the government
takes loan for both productive and non-productive activities.
30.Giving reason, explain how are the following treated in estimating National Income method (Delhi 2010 c)
(i)Interest on a car loan paid by an individual.
(ii) Interest on a car loan paid by a government owned company.
Ans. (i) Interest on a car loan paid by an individual should not be ‘included’ while estimating National Income as the loan
is taken for consumption purpose.
(ii) Interest on a car loan paid by a government owned company should included while estimating National Income as it
is a part of government final consumption expenditure.
6 Marks Questions
31. Giving reason explain how should the following be treated in estimating Gross Domestic Product at Market Price ?
(Delhi 2014)
(i) Fees to a mechanic paid by a firm.
(ii) Interest paid by an individual on a car loan taken from a bank.
(iii) Expenditure on purchasing a car for use by a firm
Ans. (i) it is included in the GDPMP, as it is a part of government final consumption expenditure.
(ii) It is not included in the estimation of GDPMP because loans are not used for production purpose.
(iii) It is included in the estimation of GDPMP because it is a part of final expenditure by a firm.
32. How should the following be treated in estimating National Income of a country?
You must give reason for your answer.

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(i) Taking care of aged parents
(ii) Payment of corporate tax
(iii) Expenditure on providing police services by the government
Ans. (i) It is not included in the estimation of National Income as it does not involve any production of goods and services.
(ii) It is included in the estimation of National Income as it is a part of profit.
(iii) It is included in the estimation of National Income as it is a part of government final consumption expenditure.
33. How should the following be treated while estimating National Income? (Foreign 2014)
You must give reason in support of your answer.
(i) Bonus paid to employees.
(ii) Addition to stocks during a year.
(iii) Purchase of taxi by a taxi driver.
Ans. (i) No, it is not included while estimation of National Income as it is not a factor income.
(ii) Yes, it is included while estimation of National Income as it is considered as a change in stock during the year.
(iii) Yes, it is included while estimation of National Income as it is an investment expenditure by the producer.
34. How will you treat the following while estimating National Income of India?
(i) Dividend received by an Indian firm from its investment in shares of a foreign company.
(ii) Money received by a family in India from relatives working abroad.
(iii) Interest received on loans given to a friend for purchasing a car.

(Delhi 2010)
Ans. (i) Dividend received by an Indian firm from its investment in shares of a foreign company will be included in the
estimation of National Income, as dividend is a part of profit and treated as factor income from abroad which is added to
domestic income.
(ii) Money received by a family in India from relatives working abroad will not be included while estimating National
Income, as it is merely remittance from abroad and no flow of goods or services are involved.
(iii) Interest received on loans given to a friend for purchasing a car will not be included in the estimation of National
Income as loan is given for consumption purpose.
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35. How will you treat the following while estimating National Income of India? Give reasons for your answer.
(All India 2010)
(i) Dividend received by a foreigner from investment in share of an Indian company.
(ii) Profits earned by a branch of an Indian bank in Canada.
(iii) Scholarship given to Indian students studying in India by a foreign company.
Ans. (i) Dividend received by a foreigner from investment in shares of an Indian company will be deducted from National
Income as it is factor income to abroad.
(ii) Profits earned by a branch of Indian bank in Canada is factor income received from abroad. It is included in National
Income.
(iii) Scholarship given to Indian students studying in India by a foreign firm will not be included while estimating National
Income, as it is a transfer payment.
36.Explain the problem of double counting in estimating national income, with the help of an example. Also explain,
two alternative ways of avoiding the problem. While estimation of National Income.
Ans. The counting of the value of a commodity more than once while estimation of National Income is called double
counting. This leads to over estimation of the value of goods and services produced. In other words, problem of double
counting arise when the value of intermediate goods is also added in total output, e.g. suppose if we include the price of
wheat, then the price of floor and finally price of bread. It will lead to the problem of double counting. As the price of
wheat is included three time and that of floor two times.
The problem of double counting can be avoided by the following two alternative ways:
(i) Final output or final product method In this method, only final products (goods and services) are added to obtain the
GDP. Intermediate products are ignored. Here, final products are only those products which are ready for end use or
consumption by their final users (consumers or producers).
(ii) Value added method This approach or method is a way to avoid the problem of double counting. The value added by
a firm is the difference between value of output and the value of intermediate products of each firm of the country. The
sum of Value added’ by all the firms gives us the GDP of the country. Hence, the problem of double counting is avoided.
Value Added by a Firm = Value of Output of the Firm – Intermediate Consumption of the Firm.
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37. How will you treat the following while estimating National Income of India? Give reasons to your answer.
(i) Salaries received by Indian residents working in Russian Embassy in India.
(ii) Profits earned by an Indian bank from its abroad branches.
(iii) Entertainment tax received by government. (Delhi 2009)
Ans. (i) Salaries received by Indian residents working in Russian Embassy in India will be included while estimating
National Income in India, as it is a factor income from abroad.
(ii) Profits earned by an Indian bank from its abroad branches is included while estimating National Income of India as it
is a factor income from abroad.
(iii) Entertainment tax received by government is not included while estimating the National Income of India as it is a
indirect tax and not included at factor cost.
38. How will you treat the following while estimating National Income of India? Give reasons for your answer.
(i) Salaries paid to Russians working in Indian Embassy in Russia.
(ii) Profits earned by an Indian company from its branches in Singapore.
(iii) Capital gains to Indian residents from sale of shares of a foreign company.
Ans. (i) Salaries paid to Russians working in Indian Embassy in Russia will not be included in estimation of National
Income of India, as it is a factor income paid to abroad.
(ii) Profits earned by an Indian company from its branches in Singapore will be included while estimating National
Income of India, as it is a factor income from abroad.
(iii) Capital gains to Indian residents from sale of shares of a foreign company will not be included while estimating
National Income in India, as it is a kind of transfer income.
39. While estimating National Income, how will you treat the following? Give reasons for your answer. (All India 2009)
(i) Imputed rent of self occupied houses.
(ii) Interest received on debentures.
(iii) Financial help received by flood victims.
Ans. (i) Imputed rent of self occupied houses are included while estimating National Income, as it is a factor income.
(ii) Interest received on debentures are not included in National Income as it is a transfer income.
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(iii) Financial help received by flood victims are not included while estimating National Income, as it is a kind of transfer
payment.
40. How will you treat the following while estimating National Income? Give reasons for your answer.
(i) Capital gain on sale of a house.
(ii) Prize won in a lottery.
(iii) Interest on public debt.
Ans. (i) Capital gain on sale of a house will not be included while estimating National Income, as it is already included in
the year when it is built.
(ii) Prize won in a lottery will not be included while estimating National Income, as it is a transfer income.
(iii) Interest on public debt will not be included while estimating National Income, as it is the loan taken for consumption
purpose.
41. Giving reasons, explain whether the following are included in National Income.
(i) Profits earned by a branch of foreign bank.
(ii) Interest paid by an individual on a loan taken to buy a car.
(iii) Expenditure on machine for installation in a factory. (Delhi 2009)
Ans. (i) Profits earned by a branch of foreign bank will not be included while estimating National Income, as it is a factor
income paid to abroad.
(ii) Interest paid by an individual on loan taken to buy a car will not be included while estimating Ntional Income, as loan
is taken for consumption purpose.
(iii) Expenditure on machines for installation in a factory will be included while estimating National Income, as it is a final
consumption expenditure by factory management.
42. Giving reason, explain whether the following are included in domestic product of India.
(i) Profits earned by a branch of foreign bank in India.
(ii) Payment of salaries to its staff by an embassy located in New Delhi.
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(iii) Interest received by an Indian resident from its abroad firms.
(All India 2009)
Ans. (i) Profits earned by a branch of foreign bank in India will be included in domestic income of India, as the profits are
earned in domestic territory of India.
(ii) Payment of salaries to its staff by an embassy located in New Delhi will not be included in domestic income of India,
as it is not a part of domestic territory of India.
(iii) Interest received by an Indian resident from its abroad firms will not be included in domestic income of India as it is
factor income from abroad.
43. Giving reasons, explain how the following are treated while estimating National Income?
(i) Payment of fees to a lawyer by a firm.
(ii) Rent free house to an employee by an employer.
(iii) Purchase by foreign tourists. (Delhi 2008)
Ans. (i) Payment of fees to a lawyer engaged by a firm will not be included while estimating National Income, as it is a
kind of intermediate expenditure for the firm.
(ii) Rent free house to an employee by an employer will be included while estimating National Income, as it is a part of
compensation to the employee.
(iii) Purchase by a foreign tourists will be included while estimating National Income as it is considered as exports of
goods and services.
44.Giving reason, explain, how the following are treated in estimating National Income?
(i) Wheat grown by farmer but used entirely for family’s consumption.
(ii) Earning of shareholders from the sales of shares.
(iii) Expenditure by government on providing free education.
Ans. (i) Wheat grown by farmer but used entirely for family’s consumption will be included while estimating National
Income, as the production is done for self-consumption purpose and relate to current production.
(ii)Earning of shareholders from the sale of shares will not be included while National Income, as it will be considered as
transfer payment.
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(iii) Expenditure by government on providing free education will be included while estimating National Income, as it is a
part of government’s final consumption expenditure.
45. Are the following a part of country’s Net Domestic Product at Market Price? Explain.
(i) Net Indirect Taxes
(ii) Net exports
(iii) Net Factor Income from Abroad
(iv) Consumption of fixed capital (All India 2008)
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CHAPTER: 3 MONEY AND BANKING
1. Barter System: It is a system of exchange, where goods are exchange for goods, also known as c-c economy. Where c
stands for commodity.
2.Drawbacks of Barter System of Exchange
(i) Lack of double coincidence of wants
(ii) Lack of common measures of value
(iii) Lack of store of value (iv) Lack of standard for deferred payments
(v) Lack of divisibility
3. Evolution of Money: Money finds its origin to facilitate the need of exchange. Earlier under barter system, people
were dependend on each other to satisty their wants. Barter system had many problems in itself. Money is the most
useful and necessary invention to overcome the drawbacks of barter system.
4. Money It is defined as a thing that is commonly accepted as a medium of exchange. It is an intermediate good which
is acceptable to both the parties i.e. buyer and seller.
5. Definition of Money
(i) Legal definition of money According to this definition, money is anything which has the legal power to act as a
medium of exchange and to discharge debt.
(ii) Functional definition of money According to this definition, money is anything that is generally accepted as a means
of an exchange and at the same time, acts as a measure and as a store of value.
6. Forms of Money
(i) Fiat money: The money issued by the legal authority of an economy, such as coins and currency notes are termed as
fiat money.
(ii) Fiduciary money :The form of money which is backed by the trust between the two parties i.e. payer and payee, is
termed as fiduciary money e.g. cheques issued by one party to another, promissory notes, etc.
(iii) Full bodied money: The money in terms of coins whose commodity value is equal to the monetary value, is termed
as full bodied money.
(iv)Credit money : It refer to that money of which money value is more than commodity value.
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7. Functions of Money
(i) Primary Functions of Money
(a) Medium of exchange
(b) Common unit of account or unit of account
(ii) Secondary Functions of Money
(a) Store of value
(b) Transfer of value
(c) Standard of deferred payments
8. Demand for Money: It is referred to as liquidity preference of an individuals, i.e. the choice of holding the money in
liquid form (cash) or to earn interest rate or for precaution purpose. (People generally holds money for three purposes
(according to keynes)
(i) Transactive purpose
(ii) Speculation purpose (for investment)
(iii) Precautionary purpose (for unforseen circumstances)
9. Aggregate Money Demand: The total demand for money in an economy is composed of transaction demand,
speculative demand and precautionary demand. Transaction ‘ demand is directly proportional to GDP and price level,
whereas the speculative demand is inversely related to the market rate of interest. The Aggregate Money Demand in an
economy is, therefore, written as
10. Concept of Supply of Money: The total stock of money in circulation among the public at a particular point of time is
called money supply.
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11. Indian Monetary System: In India, currency notes and coins are used for monetary transaction. Currency notes are
issued by the Reserve Bank of India (RBI), which is monetary authority in India. However, coins are issued by the
Govermment of India.
12. Components of Money Supply
(i) Currency held by public/people
(ii) Demand deposits of banks
(iii) Time deposits of banks
(iv) Savings account deposits
(v) Time and savings deposits with post offices
(vi) Other deposits of the RBI
(vii) National Savings Certificates (NSCs)
13. Measures of Money Supply in India
1 Mark Questions
1. State the components of money supply. (Delhi 2013,2010)
or
What is included in money supply? (Delhi 2011c)
or
Name the two components of money supply. (All India 2010)
Ans. The following are included in money supply:
(i) Currency notes held by public
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(ii) Demand deposits of commercial banks
2. Define money supply. (Delhi 2011,2010c)
Ans. The total stock of money in circulation among the public at a particular point of time is called money supply.
3. Define money. (All India 2011)
Or
Give the meaning of money. (All India 2010)
Ans. Money is defined as a thing or object that is commonly accepted as a medium of exchange. It is an intermediate
good which is acceptable to both the parties i.e. buyers and sellers.
3 Marks Questions
4. Explain the significance of the unit of account function of money. (All India 2014)
Ans. Money serves as a unit of value or common measure of value in terms of which the value of all goods and services
are measured. This helps in measuring the exchange values of commodities. The prices of all the goods and services can
be fixed in terms of money and the problem of expressing of the value of each commodity in terms of quantities of other
goods can be avoided. This function of money makes it possible to keep business accounts. It would not be possible to
keep business account unless all business transaction are expressed in terms of money.
5. Explain the significance of the store of value function of money.
(Delhi 2014,2012; Compartment 2014)
Ans. Significance of store of value as a function of money are:
(i) The money is an asset that retains value over time provided price remains constant. The public stores their wealth in
the form of money.
(ii) People can hold wealth in the form of money as it has general acceptability.
(iii) It promotes capital formation by the way of new investment.
6. Explain the standard of deferred payment function of money. (All India 2014,2012)
Ans. Money simplifies the mechanism of deferred payments by a great deal. Deferred payments means future payment.
When we take a loan from somebody, we not only pay the principal amount but also the interest amount. Under barter
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system of exchange, it was very difficult to make such transactions. As money maintains a standard value over a period
of time provided price remains constant deferred payments can be easily done.
7. Explain the store of value as function of money. (Foreign 2014; All India 2009)
Ans. Money is an asset that retains its value over time. People store their wealth in the form of money. Money
overcomes the problem of storing perishable item under barter system of exchange. With money, people hold liquidity
and value in a much more convenient manner.
8. Explain the significance of medium of exchange function of money. (Delhi 2014)
or
Explain the medium of exchange function of money. (All India 2013; Delhi 2009c)
Ans. The primary function of money is, acting as a medium of exchange between two parties involved in a transaction. It
avoids the practical problems of wastage of time and resources, involved in the barter system of an exchange and it
improves the transactional efficiency. It also promotes allocational efficiency in the trade and production of goods and
services. Hence, it can be said that money was Seprated the acts of sales and purchases.
9. Explain the problem of double coincidence of wants faced under barter system. How has money solved it? (Delhi
2013)
Ans. Double coincidence of wants :Barter system can only work, when both the persons are ready to exchange each
other’s goods i.e. person A should have the good person B wanted and vice-versa. But Usually this type of double
coincidence is rare, especially in modern times.
Money eliminates double coincidence of wants: In modern times, the buyer exchanges goods for money, the seller
exchanges goods for money due to common measure of value function of money, It facilitates an exchanges of goods
and services and helps in carrying on trade smoothly.
10. Explain the evolution of money. (All India 2008)
Ans. Money find its origin to facilitate the need of exchange. Earlier under barter system people were dependend on
each other to satisfy their wants. Barter system had many problems in itself. Money has over all those problems and
hence, accepted as a medium of exchange. Money has also over come the problem of double coincidence of wants and
lack of common measure of value.
4 Marks Questions
11. Define money supply and explain its components. (Foreign 2014)
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Ans. The total stock of money in circulation among the public at a particular point of time is called money supply. Money
supply, like money demand, is a stock variable.
Where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks.
The word ‘net’ implies that only deposits of the public held by the banks are to be included in money supply. The
interbank deposits, which a commercial banks, are not to be regarded as part of money supply.
12. How does money overcome the problems of barter system? Explain briefly. (All India 2011)
Ans. Money overcomes the problem of barter system by replacing the C-C economy with monetary economy
(i) In a barter system, there was a problem of double coincidence of wants. It is very difficult to match the expectations
of two different individuals. Thus, money was envolved to overcome the problem of coincidence of wants. As it is very
difficult to find two person having goods needed by the other person in the barter system of exchange.
(ii) When there was no money, it was difficult to give common unit of value to measure goods or commodities but when
money is evoluted, it gives a common unit of amount to every goods and commodities.
(iii) Money facilitates the contractual and future payments i.e. deferred payments which, were very difficult at the time
of barter system.
(iv) Money is also a legal tender which has a general acceptance which was not the case under barter system.
13. State four functions of money. Explain any one of them. (Delhi 2009)
Ans. Following are the four functions of money:
(i) It acts as a medium of exchange.
(ii) It is a common unit of account.
(iii) Money acts as a store of value.
(iv) It is a standard of deferred payment.
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Money as a medium of exchange: The primary function of money is, acting as a medium of exchange between two
parties involved in a transaction. It avoids the practical problems of wastage of time and resources, involved in the
barter system of an exchange and it improves the transactional efficiency. It also promotes allocational efficiency in the
trade and production of goods and services. Hence, it can be said that money was Seprated the acts of sales and
purchases.
14. Explain any two functions of money. (Delhi 2009; All India 2008)
Ans. (i) Standard of deferred payment: Money simplifies the mechanism of deferred payments by a great deal. Deferred
payments means future payment. When we take a loan from somebody, we not only pay the principal amount but also
the interest amount. Under barter system of exchange, it was very difficult to make such transactions. As money
maintains a standard value over a period of time provided price remains constant deferred payments can be easily done.
(ii) Store of value: Money is an asset that retains its value over time. People store their wealth in the form of money.
Money overcomes the problem of storing perishable item under barter system of exchange. With money, people hold
liquidity and value in a much more convenient manner.
15. Describe the evolution of money. (All India 2009)
Ans.Evolution of money: Money find its origin to facilitate the need of exchange. Earlier under barter system people
were dependend on each other to satisfy their wants. Barter system had many problems in itself. Money has over all
those problems and hence, accepted as a medium of exchange. Money has also over come the problem of double
coincidence of wants and lack of common measure of value.
There are mainly six stages of evolution of money, that are as follow:
(i) Use of animals such as cow, sheep for exchange.
(ii) Use of commodities such as rice, wheat, cotton for exchange.
(iii) Use of metals such as gold, silver, brass for exchange.
(iv) Use of currency notes and coins.
(v) Use of cheques, drafts, bill of exchange, bonds, etc as money. ‘
(vi) Use of credit and debits cards for exchange.
16. State the functions of money. (Delhi 2008C)
Ans. The following are the functions of money
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(i) Unit of account: Money acts as a common denominator in terms of which the value of all the commodities are
expressed. The price and value of a commodity is quoted in terms of money. This function of money helps to compare
the value of commodities and calculate the rate of exchange between two goods or services.
(ii) Medium of exchange :The primary function of money is, acting as a medium of exchange between two parties
involved in a transaction. It avoids the practical problems of wastage of time and resources, involved in the barter
system of an exchange and it improves the transactional efficiency. It also promotes allocational efficiency in the trade
and production of goods and services. Hence, it can be said that money was Seprated the acts of sales and purchases.
(iii) Standard of deferred payments: Money simplifies the mechanism of deferred payments by a great deal. Deferred
payments means future payment. When we take a loan from somebody, we not only pay the principal amount but also
the interest amount. Under barter system of exchange, it was very difficult to make such transactions. As money
maintains a standard value over a period of time provided price remains constant deferred payments can be easily done.
(iv) Store of value: Money is an asset that retains its value over time. People store their wealth in the form of money.
Money overcomes the problem of storing perishable item under barter system of exchange. With money, people hold
liquidity and value in a much more convenient manner.
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Commercial Banks and Central Bank
1. Bank It is an institution which receives funds from the public and gives loans and ; advances to those who need them.
2. Commercial Banks A profit making financial institution which accepts chequeable and non-chequeable deposits from
the people and offers different kind of loans for the purpose of consumption or investment, is termed as commercial
banks.
3. Definition of Commercial Bank by Indian Banking Companies Act ‘Banking company is one which transacts the
business of banking which means the accepting (for the purpose of lending or investment) of deposits of money from
the public repayable on demand or otherwise withdrawal by cheque, draft order or otherwise.’
4. Functions of Commercial Banks
(i) Acceptance of deposits (chequeable and non-chequeable)
(ii) Advancement of loans
(iii) Credit creation
(iv) Transfer of funds
(v) Overdraft facility
(vi) Discounting bills of exchange
(vii) Agency functions i.e. fund transfer, fund collecton, etc.
5. Chequeable Deposits Deposits against which cheques can be issued for withdrawing money any time on demand, are
termed as chequeable deposits, e.g. saving deposits, current deposits, etc.
6. Non-chequeable Deposits Deposits against which cheques can not be issued for money withdrawal any time on
demand, are termed as non-chequeable deposits. These deposits are fixed for a period of time and also, termed as time
deposits e.g. fixed deposits, recurring deposits etc.
7. Money or Credit Creation by Commercial Banks Commercial banks increases the flow of money in an economy by
credit creation. This process of credit creation is an outcome of its two primary functions, i.e. acceptance of loans and
advancement of deposits. The banks issue loans from their cash reserves with the confidence on their historical
experience that all depositors will not withdraw their funds at the same time. In this way, commercial banks create
credit many more times than their cash reserves and contributes to increase money supply in the economy. It depends
on initial level of deposits and money multiplier.
8. Money Multiplier It refers to the fraction by which commercial banks would be able to multiply money from their
initial level of deposits. It is obtained by the following formula
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9. Difference between a Banking Institution and Financial Institution
A financial institution will not be called a banking institution, until it performs the following two primary functions, i.e.
(i) Acceptance of deposits (chequeable and non-chequeable).
(ii) Providing loans.
Hence, all financial institutions are not banking institutions, but all banking institutions are financial institutions. Other
financial institutions are known as non-banking financial institution, which performs some but not all functions of a bank.
They can accepts deposits but cannot give loans such as LIC, UTI, etc.
10. The Central Bank It is an apex banking institution which controls and regulates the entire banking system and money
supply of a country. Reserve Bank of India is the Central Bank of India.
11. Functions of Central Bank
(i) Authority for issuing of currency notes
(ii) Banker to the government
(iii) Banker’s bank
(iv) Lender of the last resort
(v) Supervision of all commercial banks
(vi) Maintains the custody of nation’s foreign currency reserves
(vii) Clearing house
(viii) Controls the supply of credit
(ix) Collection of statistical information
12. Credit Control Policy/Monetary Policy of Central Bank The central policy to control and regulate the supply of
money or credit within an economy, is termed as monetary policy.
The following instruments are used in monetary policy to control the flow of credit:
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(i) Quantitative Instruments These instruments affect the overall supply of money in an economy. These are
(a) Bank rate policy (b) Open market operations
(c) Cash reserve ratio (d) Statutory liquidity ratio
(e) Repo rate (f) Reverse repo rate.
(i) Qualitative Instruments These instruments affect the flow of money in selected cmp intended sectors. These are
(a) Margin requirement
(b) Rationing of credit or selective credit control
(c) Direct action
(d) Moral suasion
13. Difference between Central Bank and commercial banks
Some important concepts
(i) Repo rate The rate at which the (Central Bank) offers loans to other commercial banks for a period ranging from 1 to
14 days.
(ii) Reverse repo rate The interest rate at which commercial banks can deposit their surplus funds with Central Bank, or
in other words the rate at which Central Bank borrows from commercial banks.
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(iii) Cash Reserve Ratio The percentage of total deposits,which a commercial bank needs to keep as reserve with the
Central Bank, this ratio is termed as Cash Reserve Ratio.
(iv) Statutory Liquidity Ratio (SLR) Every commercial bank is required to maintain a fixed percentage of its assets in the
form of cash or other liquid assets. This is termed as statutory liquidity ratio.
(v) Legal Reserve Ratio (LRR) It refers to that legal minimum fraction of total deposits which the commercial banks are
required to keep. It is sum of CRR and SLR.
(vi) Bank rate The rate at which commercial banks can borrow money from RBI, when they run short of reserves, is
termed as bank rate. This loan is given for a period of more than 90 days.
15. High Powered Money The total liability of the Central Bank is termed as high powered money or monetary base. It
includes the currency notes and coins held by public and commercial banks, deposits held by the government and
commercial banks with the Central Bank.
1 Mark Questions
1. What are demand deposits?
(All India 2014,2011,2010; Delhi 2013,2012)
Ans. Demand deposits are current and savings account deposits with banks or other financial institutions, which are
payable on demand. No interest payments are given on current account deposits whereas, on saving account very low
rate of interest are given.
2. What are time deposits? (All India 2014,2012; Delhi 2010C; Compartment 2014)
Ans. Time deposits are fixed term and recurring deposits having a fixed period of maturity, where the term of deposit
may vary. Cheques cannot be issued aganist them and are not payable on demand and these deposits yield interests for
the depositor.
3. What is a Central Bank? (Foreign 2014; Delhi 2009C, 2008)
Ans. The Central Bank is an apex banking institution which controls the entire banking system and money supply of a
country. Reserve Bank of India is the Central Bank of India.
4. Define Cash Reserve Ratio. (Delhi 2011)
Ans. The percentage of total deposits, which a commercial bank needs to keep as reserve with the Central Bank, this
ratio is termed as Cash Reserve Ratio.
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5. Define Statutory Liquidity Ratio. (All India 2011)
Ans. Every commercial bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid
assets. This is termed as Statutory Liquidity Ratio.
6. Define bank rate. (Delhi 2009,2008C)
Ans. The rate at which commercial banks can barrow funds from Central Bank for a period of more than 90 days is
termed as bank Rate.
7. What is commercial bank? (All India 2008)
Ans. Commercial bank is financial institution which accepts chequeable and non-chequeable deposits from the people
and offers different kind of loans for the purpose of consumption or investment.
3 Marks Questions
8. Explain the currency authority function of Central Bank. (Foreign 2014)
Ans. Central Bank of the country has the sole authority of currency issue in the country, which gives it a monopoly in
issuing currency. As in India RBI issues the currency, while currency notes are printed by the subsidies of RBI and coins
are minted by the Central Government of the country, however both currency notes and coins are circulated by RBI,
which gives RBI the power to control, superwise and enhance the money supply in the economy.
9. Explain lender of the last resort function of the Central Bank.
(Delhi 2014,2010; All India 2013,2010)
When a commercial bank fails to accommodate its financial requirements, the Central Bank acts as the lender of last
resort. The Central Bank issues loans to a commercial bank against specified and approved securities of the bank.
In this way, the Central Bank ensures the smooth functioning of commercial banks and appropriate flow of credit in the
economy.
10. Explain the banker to the government function of the Central Bank.
(Delhi 2013,2010; Ml India 2010)
Central Bank acts as a banker, advisor and agent to the Central and State Governments. As the common public keep
their cash balance, demand deposits and time deposits with commercial banks; the Central Bank manages the cash
reserves and demand deposits of governments in current accounts. It carries out the exchange, remittance and other
banking operations on behalf of the government, i.e. the Central Bank maintains same relation with the government as
commerical banks has with genes.
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11.Explain the meaning of Cash Reserve Ratio and Statutory Liquidity Ratio. (All India 2010)
Cash Reserve Ratio The percentage of total deposits, which a commercial bank needs to keep as reserve with the Central
Bank, this ratio is termed as Cash Reserve Ratio.
Statutory Liquidity Ratio Every commercial bank is required to maintain a fixed percentage of its assets in the form of
cash or other liquid assets. This is termed as Statutory Liquidity Ratio.
12. State any three points of distinction between Central Bank and commercial banks. (Delhi 2009; All India 2008)
13. State three main functions of commercial bank. Explain any one of them. (All India 2009)
Ans.The three main functions of commercial banks are
(i) Accepting deposits
(ii) Advancing loans
(iii) Credit/money creation
Accepting deposits It is one of the primary function of commercial banks. It accepts chequeable and non-chequeable
deposits from public in the form of demand deposits (which can be withdrawn on demand) and time deposits (which
cannot be withdraws on demand).
14. Explain any two functions of a Central Bank. (Delhi 2009; All India 2009)
Ans. The two main functions of a Central Bank are
(i) Bank of Issue Note issue is the main function of a Central Bank. It has the monopoly or we can say, have a sole
authority to issue currency notes.
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(ii) Banker’s bank Central Bank keeps the cash balances of commercial banks and issues loans to them on requirements
in the same manner as the commercial bank does for its customers. A Central Bank has almost the same relation with
the other commercial banks of the country that the commercial banks have with the common public. That is why the
Central Bank is also called as banker’s bank.
15. What is bank rate policy? How does it work as a method of credit control? (Delhi 2008)
Ans. Central bank adopts bank rate policy as a quantitative technique to control credit in an economy. This is the rate at
which commercial banks can barrow funds from Central Bank for a period of more than 90 days.
It works accordingly when the bank rate is increased by RBI, it discourages commercial banks and people from taking
loans. It decreases the credit multiplier and the money/credit flow is controlled. On the other hand, at time of credit
crunch, RBI decreases the bank rate and this encourages commercial banks and people to take more loans due to low
interest payments. This enhances the flow of credit in the economy.
16. What are open market operations? How do these work as a method of credit Control? (Delhi 2008)
Ans. Under open market operations, RBI purchases or sells government securities to commercial banks and general
public for the purpose of increasing or decreasing the stock of money in an economy. The purchase or sale of securities
controls the money in the hands of public as they deposit or withdraw the money from commercial banks. Thus, money
creation by commercial banks get affected. By selling the securities, the Central Bank withdraws cash balances from the
economy and by buying the securities, the Central Bank adds to the balance in the economy, in this way, it works as a
method of credit control. Based on economic conditions, the Central Bank conduct buying and selling of securities in the
open market.
17. State three methods of credit control used by the Central Bank. (All India 2008)
Ans. The three methods of credit control used by the Central Bank are as follows:
(i) Bank rate policy
(ii) Open market operations
(iii) Legal Reserve Ratio
18. Explain any two main functions of commercial banks. (Delhi 2008C)
Ans. Commercial banks perform two primary functions are:
(i) Accepting deposits Bank accepts deposits from the public in the form of chequeable or non-chequeable deposits, e.g.
saving and current account deposits and fixed and recurring deposits.
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(ii) Providing loans Commercial bank provides loans and advances to the public to fulfil their needs of money. Loan may
be granted in the form of cash, credit, ordinary loans, overdraft, discounting of bills, short-term loan, consumer credit
etc.
4 Marks Questions
19.Explain the credit creation role of commercial banks with the help of a numerical. (Compartment 2014; All India
2013)
or
How do commercial banks create deposits? Explain. (Delhi 2013)
Ans. Commercial banks increases the flow of money in an economy by credit creation. This process of credit creation is
an outcome of its two primary functions, i.e. advancement of loans and acceptance of deposits. The banks issue loans
from their cash reserves with the confidence on their historical experience that all depositors will not withdraw their
funds at the same time. In this way, commercial banks create credit many more times than their cash reserves and
contributes to increase money supply in the economy. Demand deposits of the commercial banks are many times more
than their cash reserves.
Money creation is determined by *
(i) The amount of the initial fresh deposits.
(ii) The Legel Reserve Ratio (LRR) is the minimum ratio of deposits legally required to be kept as cash by the banks.
(iii) Money Multiplies = 1/LRR
Total Money Creation = Initial Deposits x 1/LRR
e.g. Let the LRR be 20%
Fresh deposits = Rs. 10000
Amount required by the banks to keep = Rs. 2000 as cash suppose the banks lend the remaining amount of Rs. 8000. The
commercial banks also know by way of their historical experience that all the depositors would not show up in the banks
to withdraw all their deposits at a point of time. Those person who borrow, use this money for making payments, also all
the transactions will be carried out through banks.
Further, it is also assumed that, those who receive fresh deposits of Rs. 8000, the banks again keep Rs. 1,600 as cash and
lend Rs. 6,400, which is also 80% of the last deposit, the money again comes back to the banks leading to a fresh deposit
of Rs.6,400. In this way, the money goes on multiplying and ultimately total money creation is Rs.50,000.
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As, according to the formula
Total money creation =10,000 x 1/20 x 100 = Rs. 50,000
20. Explain the banker’s bank function of Central Bank. (All India 2014; Delhi 2012)
Ans. Banker’s bank Central Bank keeps the cash balances of commercial banks and issues loans to them on requirements
21. Explain the lender of last resort function of the Central Bank. (Compartment 2014; All India 2012)
Ans. In emergency situations, when a commercial bank fails to accommodate its financial requirements from any other
sources, the Central Bank acts as the lender of last resort. The Central Bank issues loans to a commercial bank against
specified and approved securities of the bank.
In this way, the Central Bank ensures the smooth functioning of commercial banks and appropriate flow of credit in the
economy. Due to the above stated reason, the Central Bank is termed as lender of the last resort.
22. Explain government banker function of the Central Bank. (All India 2014; All India 2012)
Ans. Central Bank acts as a banker, advisor and agent to the Central and State Governments. As the common public
keep their cash balance, demand deposits and time deposits with commercia banks; the Central Bank manages the cash
reserves and demand deposits of governments in current accounts. It carries out the exchange, remittance and other
banking operations on behalf of government.
It issues loans and advances to the government and does buying and selling of securities on behalf of government. It also
advises the government to frame fiscal policy of the country. That is why, the Central Bank is called as ‘government’s
banker’.
23. Explain, how do open market operations by the Central Bank affect money creation by commercial banks?
(Compartment 2014; All India 2010)
Ans. Under open market operations, RBI purchases or sells government securities to commercial banks and general
public for the purpose of increasing or decreasing the stock of money in an economy. The purchase or sale of securities
controls the money in the hands of public as they deposit or withdraw the money from commercial banks. Thus, money
creation by commercial banks get affected. By selling the securities, the Central Bank withdraws cash balances from the
economy and by buying the securities, the Central Bank adds to the balance in the economy, in this way, it works as a
method of credit control. Based on economic conditions, the Central Bank conduct buying and selling of securities in the
open market.
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Suppose, the Central Bank purchase securities of Rs. 1,000 from a bond holder by issuing a cheque, The seller of the
bond produces this cheque of Rs. 1,000 to his bank. The bank credits the account of the seller by Rs. 1,000 and the
deposits of the bank goes up by Rs. 1,000, which is a liability to the bank on the other hand, the assets of the commercial,
also go up as the cheque in its possession is a claim on the Central Bank.
Thus, purchase of security, increases the money creation of commercial banks and similarly, sale securities decreases
the credit creation of commercial banks. Thus, the Central Bank controls the process of money creation by commercial
banks by open market operations.
24. Explain any two methods of credit control used by Central Bank. (All India 2013)
Ans. The Central Bank acts as a controller of money supply and credit, using the following methods
(i) Margin requirement It is a qualitative method of credit control. A margin refers to the difference between market
value of the security offered for loan and the amount loan offered by the ‘ commercial banks. During inflation, supply of
credit is reduced by raising the requirement of margin. During deflation supply of credit is increased by lowering the
requirement of ‘margin’. This measure is often used to discourage the flow of credit into speculative business activities.
(ii) Open market operations Under open market operations, RBI purchases or sells government securities to commercial
banks and general public for the purpose of increasing or decreasing the stock of money in an economy. The purchase or
sale of securities controls the money in the hands of public as they deposit or withdraw the money from commercial
banks. Thus, money creation by commercial banks get affected.
By selling the securities, the Central Bank withdraws cash balances from the economy and by buying the securities, the
Central Bank adds to the balance in the economy, in this way, it works as a method of credit control. Based on economic
conditions, the Central Bank conduct buying and selling of securities in the open market
25. Explain the components of Legal Reserve Ratio. (Delhi 2012)
Ans. The minimum percentage of a bank’s total demand and time deposits, that is required to be maintained in the form
of cash or specified liquid assets by the commercial banks with the Central Bank is termed as Legal Reserve Ratio.
The components of Legal Reserve Ratio are as follows
(i) Cash Reserve Ratio The percentage of total deposits, which a commercial bank needs to keep as reserve with the
Central Bank, this ratio is termed as Cash Reserve Ratio.
(ii) Statutory Liquidity Ratio Every commercial bank is required to maintain a fixed percentage of its assets in the form
of cash or other liquid assets. This is termed as Statutory Liquidity Ratio.
26. How do changes in bank rate affect money creation by commercial banks? (Delhi 2010)
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Ans. The rate at which commercial banks can borrow money from RBI, when they run short of reserves, is called bank
rate. When the Central Bank increase the bank rate, it increases the cost of borrowing and hence, discourages the
borrowers from taking a loan. Due to this, the process of credit creation and flow of money also reduces.
On the other hand, when the Central Bank decreases the bank rate, it encourages the borrower to take more and more
loan. A high demand of loan increases the credit multiplier and credit creation process of the commercial banks.
27. Explain banker’s bank and supervisor function of Central Bank. (Delhi 2009c)
Ans. (i) Banker’s bank Central Bank keeps the cash balances of commercial banks and issues loans to them on
requirements in the same manner as the commercial bank does for its customers. A Central Bank has almost the same
relation with the other commercial banks of the country that the commercial banks have with the common public. That
is why the Central Bank is also called as banker’s bank..
(ii) Supervisor A Central Bank supervises the operation of all commercial banks. It supervises in the form of licensing of
the commercial banks, expansion and opening of branches of commercial banks, merger of banks and the liquidation of
the banks. Thus, the Central Bank supervises the smooth functioning of commercial banks.
28. Explain the ‘acceptance of deposits’ function of commercial banks. (Delhi 2008)
Ans. Acceptance of deposits is one of the primary function of commercial banks. Commercial banks accept chequeable
and non-chequeable deposits from its customer in the form of demand deposits, savings deposits and time deposits.
Acceptance of chequeable deposits function discriminates a commercial bank from non-banking financial institutions,
who can accepts deposits but cannot advance loans, e.g. LIC.
29.Give four agency functions of commercial banks. (Delhi 2008)
Ans. The agency functions of commercial banks are as follows
(i) Sale and purchase of securities The commercial banks help their customers to buy and sell government and private
company’s securities.
(ii) Fund transfer Commercial banks transfer the customers’ funds from one place to another through cheques, demand
drafts, NEFT, RTGS, etc.
(iii) Collection of funds Commercial banks collect the funds from cheques, demand drafts, etc for its customers.
(iv) Collection of dividends Commercial banks collect the dividends on shares of its customers.
30. Explain the lending function of commercial banks. (All India 2008)
Ans. Commercial banks give loans to its customers in many forms. The bank advances the following types of loans:
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(i) Cash credit In this type of credit scheme, banks advance loans to its customers on the basis of securities inventories
etc.
(ii) Overdraft Bank advance loans to its customer’s upto a certain amount through overdraft facility, if there are no
deposits in the current account.
(iii) Short-term loan These loans may be given as personal loans, loans to finance working capital or as priority sector
advances. These are made against some security.
(iv) Discounting of bills of exchange Under this system, banks advance loans to the traders and business firms by
discounting their bills, before the maturity of the bill.
6 Marks Questions
31. Explain the process of money creation by commercial banks with the help of a numerical example. (Delhi 2011;
All India 2010,2010c)
Ans. Commercial banks increases the flow of money in an economy by credit creation. This process of credit creation is
an outcome of its two primary functions, i.e. advancement of loans and acceptance of deposits. The banks issue loans
from their cash reserves with the confidence on their historical experience that all depositors will not withdraw their
funds at the same time. In this way, commercial banks create credit many more times than their cash reserves and
contributes to increase money supply in the economy. Demand deposits of the commercial banks are many times more
than their cash reserves.
Money creation is determined by *
(i) The amount of the initial fresh deposits.
(ii) The Legel Reserve Ratio (LRR) is the minimum ratio of deposits legally required to be kept as cash by the banks.
(iii) Money Multiplies = 1/LRR
Total Money Creation = Initial Deposits x 1/LRR
e.g. Let the LRR be 20%
Fresh deposits = Rs. 10000
Amount required by the banks to keep = Rs. 2000 as cash suppose the banks lend the remaining amount of Rs. 8000. The
commercial banks also know by way of their historical experience that all the depositors would not show up in the banks
to withdraw all their deposits at a point of time. Those person who borrow, use this money for making payments, also all
the transactions will be carried out through banks.
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Further, it is also assumed that, those who receive fresh deposits of Rs. 8000, the banks again keep Rs. 1,600 as cash and
lend Rs. 6,400, which is also 80% of the last deposit, the money again comes back to
the banks leading to a fresh deposit of Rs.6,400. In this way, the money goes on multiplying and ultimately total money
creation is Rs.50,000.
As, according to the formula
Total money creation =10,000 x 1/20 x 100 = Rs. 50,000
32. Explain the following functions of the Central Bank (All India 2011)
(i) Bank of issue
(ii) Banker’s bank
Ans. (i) Bank of issue Note issue is the main function of a Central Bank. It has the monopoly or we can say, have a sole
authority to issue currency notes..
(ii) Banker’s bank Central Bank keeps the cash balances of commercial banks and issues loans to them on requirements
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CHAPTER 4. Aggregate Demand and Supply and Their Components
Aggregate Demand (AD) The sum, total of the demand for all the goods and services in an economy during an
accounting year is termed as an Aggregate Demand of an economy. Aggregate Demand of an economy is measured in
terms of the (expected) Total Expenditure on all products (goods and services) in an economy during an accounting year.
Aggregate Demand is directly related with income level arid inversely related with general price level.
2. Components of Aggregate Demand (for a four sector economy)
(i) Household consumption demand or expenditure (C).
(ii) Private investment demand or expenditure (I).
It is affected by:
(a) Rate of interest.
(b) Marginal efficiency of capital.
(iii) Government expenditure or demand for goods and services (G).
It comprises of:
(a) Intermediate consumption of government sector.
(b) Compensation of employees of government sector.
(c) Imports by government sector.
(iv) Net export (X – M).
Thus, Aggregate Demand can, also be written as
Note
It should be remembered that AD is not zero at zero level of income.
AD = C +1+ G + X- M
3. Aggregate Supply (AS) It is the money value of the final goods and services or national product produced in an
economy during one year. It is equal to income generated.
4. Components of Aggregate Supply
(i) Consumption expenditure (C) (ii) Saving (S)

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Thus, Aggregate Supply can also be written as AD = C + S
5. Propensity to Consume It refers to the ratio between consumption (C) and income (Y). It shows level of consumption
(C) with respect to a given level of income (Y).
6. Average Propensity to Consume The ratio between the consumption expenditure and income is called Average
Propensity to Consume.
Average Propensity to Consume (APC) = C/Y
Where, C = Consumption, Y = Income
7. Marginal Propensity to Consume The ratio between the change in consumption expenditure with the change in
income is called Marginal Propensity to Consume.
8. Consumption Function The functional relationship between the consumption expenditure and the income is known
as consumption function.
C = f(Y)
Where, C = Consumption expenditure
Y = Income, or in other words, consumption is a function of income.
9. Algebraic Expression of Consumption Function The algebraic expression of consumption function is given by
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10. Propensity to Save It refers to the ratio between savings (S) and income (Y) with respect to given level of income.
11. Average Propensity to Save The ratio between total savings and the total income in an economy at a given level of
income is termed as Average propensity to Save.
Average Propensity to Save (APS) = S/Y
Where, S = Saving
Y= Income
12. Marginal Propensity to Save The ratio between the change in savings with the change in income is known as
Marginal Propensity to Save.
13. Saving Function The functional relationship between saving and income is known as saving function.
S = f(Y)
Where, S = Saving
Y = Income or we can also say that saving is a function of income.
Saving is the excess income which is left with the consumer after paying for all the consumption expenditure.
S=Y-C
Where, terms have their usual meaning.
14. Algebraic Expression of Saving Function The algebraic expression of saving function is given by
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15. Relationship between APC and APS
APC + APS =1
or APC = 1 – APS
and APS = 1 – APC
16. Relationship between MPC and MPS
MPC + MPS = 1
or MPC = 1 – MPS
and MPS = 1 – MPC
17. Investments There are additions made to the present stock of capital. It leads to an increase in capital assets.
18. Autonomous Investment An investment which is not influenced by expected profitability or level of income is called
autonomous investment.
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19. Induced Investment It is positively related to the level of income in an economy. At higher levels of income,
consumption expenditure tends to increase, thereby motivating the producers to increase their investment to be able to
meet Higher Demand levels.
1 Mark Questions
1. What is excess of exports of goods over the imports of goods called? (Foreign 2014)
Ans. It is referred to as net exports.
2. Define Investment. (Compartment 2014)
Ans. Investments are additions made to the present stock of capital. It leads to an increase in capital assets.
3. Give the meaning of Aggregate Supply. (Foreign 2014)
or
Define Aggregate Supply. (All India 2009,2008)
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Ans. Aggregate Supply is the money value of the final goods and services or national product produced in an economy
during one year. It is equal to income generated.
4. Define Marginal Propensity to Consume. (Delhi 2014; All India 2009)
Ans. The ratio between the change in consumption expenditure with the change in income is called Marginal Propensity
to Consume.
5. Give the meaning of Marginal Propensity to Save. (All India 2010)
or
Define Marginal Propensity to Save. (All India 2009; Delhi 2008C)
Ans. Marginal Propensity to Save is the ratio of change in saving with the change in income.
6. Give the meaning of Aggregate Demand. (Delhi 2010,2009c)
or
Define Aggregate Demand. (Delhi 2009c)
Ans. The sum, total of the demand for all the goods and services in an economy during an accounting year is termed as
Aggregate Demand of the economy. Aggregate Demand of an economy is measured in terms of the (expected) Total
Expenditure on all products (goods and services) in the economy during an accounting year.
7. Give the meaning of autonomous consumption. (Delhi 2009)
Ans. The initial or minimum level of consumption done at zero level of income for sustenance is termed as autonomous
consumption.
8. What is propensity to consume? (Delhi 2009c)
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Ans. It refers to the ratio between consumption (C) and income (Y). It shows level of consumption (C) with respects to a
given level of income (Y).
9. What is consumption function? (Delhi 2008)
Ans. The functional relationship between consumption expenditure and the income is known as consumption function.
C = f(Y)
Y= Income, f = Functional relationship
10. If Marginal Propensity to Save is 3r what is the value of Marginal Propensity to Consume? (All India 2008)
Ans. Here, Marginal Propensity to Save (MPS) =0.3
Hence, Marginal Propensity to Consume (MPC) =1- MPS =1- 0.3 =0.7
MPC = 0.7
11. Define Average Propensity to Consume. (All India 2008)
Ans. The ratio between the consumption expenditure and income is known as Average Propensity to Consume.
Average Propensity to Consume (APC) = C/Y
Y = Income.
12. If the value of Average Propensity to Save is (-) 0.6, what will be the value of Average Propensity to Consume?
(All India 2008)
Ans. Here, Average Propensity to Save (APS) (-) 0.6
Hence, Average Propensity to Consume (APC) = 1 – APS =1 – (- 0.6) =1.6
Average Propensity to Save (APC) =1.6
13. If the value of Average Propensity to Consume is 1.5, what will be the value of Average Propensity to Save?
(Delhi 2008C)
Ans. Here, Average Propensity to Consume (APC) = 1.5
Now, we know that
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Average Propensity to Save (APS) =1- APC
So, Average Propensity to Save (APS) =1- 1.5 = – 0.5
3 Marks Questions
14. Give the meaning of Average Propensity to Save. What is its relation with Average Propensity to Consume?
(Compartment 2014)
Ans. The ratio between total savings and total income in an economy at a given level of income is termed as ‘Average
Propensity to Save’. Symbollically,
Average Propensity to Save (APS) = savings (S)/Income Y)
Relation of Average Propensity to Save with Average Propensity to Consume
APC is the ratio of the total consumption to total income and APS is the ratio of total saving to total income
As we know that, Y=C+S
APC is the ratio of the total consumption to total income and APS is the ratio of total saving to total income
Average Propensity to Save (APS) can have negative value, when the amount of consumption expenditure is more than
the income.
15. Find consumption expenditure from the following
Autonomous Consumption =Rs. 100
Marginal Propensity to Consume =0. 70
National Income = Rs. 1000 (Delhi 2012)
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16. Find consumption expenditure from the following
National Income =Rs. 5000
Autonomous Consumption = Rs. 1000
Marginal Propensity to Consume = 0.8
17. Find National Income from the following
Marginal Propensity to Consume =0.60
Investment = Rs. 200
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18. Find investment from the following
National Income = Rs. 600 Autonomous Consumption = Rs. 150
Marginal Propensity to Consume =0.70
19. Given that National Income is Rs. 80 crore and consumption expenditure is Rs. 64 crore, find out Average
Propensity to Save. When income rises to Rs. 100 crore and consumption expenditure to Rs. 78 crore, what will be the
Average Propensity to Consume and Marginal Propensity to Consume? (Delhi 2011)
Ans. Here, in first condition, Y = Rs. 80 crore
C = Rs. 64 crore
Hence, S=Y–C
= 80 – 64 =Rs. 16 crore
Now, Average Propensity to Save (APS) = S/Y = 16/80 = 0.20
Again, when income and consumption expenditure rises,
Y = Rs. 100 crore
C= Rs. 78 crore
So, Average Propensity to Consume (APC) =C/Y=78/100=0.78
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20. If National Income is Rs. 50 crore and saving is Rs. 5 crore, find out Average Propensity to Consume. When income
rises to Rs. 60 crore and saving to Rs. 9 crore, what will be the Average Propensity to Consume and Marginal
Propensity to Save? (Delhi 2011)
Ans. Here, in first condition,
Y = Rs. 50 crore
S = Rs. 5 crore
Hence, C=Y–S
= (50 – 5) crore
= 45 crore
Average Propensity to Consume (APC) = C/Y = 45/50 =0.90
Again when income and savings rises,
New Y=Rs. 60 crore
New S = Rs.9 crore
Average propensity to consume (APC) =C/Y
Y-S/Y=60-9/60=0.85
21. If National Income is Rs. 90 crore and consumption expenditure Rs.81 crore, find out Average Propensity to Save.
When income rises to Rs. 100 crore and consumption expenditure to Rs. 88 crore, what will be the Marginal
Propensity to Consume and Marginal Propensity to Save? (Delhi 2011)
Ans. Here, in first condition, Y= Rs. 90 crore
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C=Rs. 81 crore
Average Propensity to Save (APS) =S/Y
=Y-C/Y=90-81/90=0.10
Again, when the income and consumption expenditure rises,
Y = Rs. 100 crore
C = Rs. 88 crore
22. In an economy, the Marginal Propensity to Consume is 0.75. Investment expenditure in the economy increases by
Rs. 75 crore. Calculate the total increase in National Income. (All India 2011)
23. Explain the relationship between Average Propensity to Consume and Average Propensity to Save. Which of these
can have a negative value and when? (All India 2011)
Ans. APC is the ratio of the total consumption to total income and APS is the ratio of total saving to total income
As we know that, Y = C +S
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Average Propensity to Save (APS) can have negative value, when the amount of consumption expenditure is more than
the income.
24. Explain the meaning of Marginal Propensity to Consume. What is its relationship with Marginal Propensity to Save?
(Delhi 2011 c)
Ans. The ratio between the change in consumption expenditure with the change in income is called Marginal Propensity
to Consume. Marginal Propensity to Consume tells about the relationship between the change in consumption due to
change in National income.
Relationship between Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS). The excess of
income over consumption is saved, similar is the case for change in income
Hence, MPC + MPS =1
or MPS =1-MPC
and MPS = 1-MPC
25.In an economy, total savings are Rs. 2000 crore and the ratio of Average Propensity to Save and Average
Propensity to Consume is 2 : 7. Calculate the level of income in an economy. (All India 201)
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26. In an economy, the consumption expenditure is Rs. 8750 crore and the ratio of Average Propensity to Consume
and Average Propensity to Save is 7 : 1. Calculate the level of income in the economy. (All India 2010)
27. In an economy, the ratio of Average Propensity to Consume and Average Propensity to Save is 5 : 3. The level of
income is Rs. 6000. How much are the savings? Calculate. (Delhi 2010c)
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28. Complete the following table (Delhi 2009)
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31. Complete the following table (All India 2009)
32. Complete the following table (All India 2009)

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4 Marks Questions
34. Calculate Marginal Propensity to Consume from the following data about an economy which is in equilibrium
National Income = Rs. 2000
Autonomous Consumption Expenditure = Rs. 200
Investment Expenditure = Rs. 100 (All India 2014)
35.Calculate investment expenditure from the following data about an economy which is in equilibrium

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Marginal Propensity to Save = 0.20
Autonomous Consumption Expenditure = Rs. 100 (All India 2014)
36. Calculate autonomous consumption expenditure from the following data about an economy which is in
equilibrium
Investment Expenditure =Rs. 100 (All India 2014)
37. Calculate investment expenditure from the following data about an economy which is in equilibrium (Delhi
2014)
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38. Calculate autonomous consumption expenditure from the following data about an economy which is in
equilibrium. (Delhi 2014)
Investment expenditure = Rs. 100
39. Calculate Marginal Propensity to Consume from the following data about an economy which is in equilibrium
(Delhi 2014)
Investment Expenditure = Rs. 300
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40. Calculate ‘autonomous consumption expenditure’ from the following data about an economy which is in
equilibrium
Investment Expenditure =Rs. 80 (Foreign 2014)
Ans. As we know that, Savings = Investment,
Therefore, Savings = Investment = Rs. 80.
Also, consumption expenditure = Income – Savings Expenditure
= 900 – 80 = Rs. 820
Also, Marginal Propensity to Consume (MPC) = 1 – 0.10
= 0.90
Now,
41. Calculate ‘investment expenditure’ from the which is in equilibrium
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42.Calculate ‘Marginal Propensity to Consume’ from the following data about an economy which is in equilibrium
(Foreign 2014)
Investment Expenditure =Rs.100
Ans. As we know that, Savings = Investment,
Therefore, Savings = Investment = Rs. 100
Also, Consumption Expenditure = Income – Savings
800 -100 = Rs. 700
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43. Outline the steps taken in deriving saving curve from the consumption curve. Use diagram. (Foreign 2014; Delhi
2012)
or
Explain the steps taken in derivation of saving curve from the consumption curve. Use diagram. (Delhi 2014; Delhi
2011C)
Ans. Various steps to be taken for derivation of saving curve from consumption curve are:
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6 Marks Questions
44.Outline the steps taken in deriving consumption curve from the saving curve. Use diagram. (All India 2014; 2012)
or
Explain the steps taken in derivation of consumption curve from savings curve. Use diagram. (All India 2011)
Ans. Various steps to be taken for derivation of consumption curve from saving curve are
45. Explain the consumption function and saving function.(Foreign 2014)
Ans. (i) Consumption functions The functional relationship between the consumption expenditure and the income is
known as consumption function.
C = f(Y), Where C = Consumption expenditure,
y = Income, and f = Functional relationship.
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46. (i) Distinguish between autonomous investment and induced investment.
(ii) On the basis of the following information about an economy, Calculate its equilibrium level of income
(Compartment 2014)
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47. (i) Distinguish between Aggregate Demand and Aggregate Supply.
(ii) From the following data about an economy, calculate its equilibrium level of income.(Compartment 2014)
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50. From the data given below about an economy, calculate
(i) Investment expenditure (ii) Consumption expenditure.
Equilibrium level of income Rs. 5000
Autonomous consumption Rs. 500
Marginal Propensity to Consume 0.4 (All India 2013)
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51. In an economy, S = -100 + 0.6 Y is the saving function, where S is saving and Y is National Income. If investment
expenditure is Rs.1100. Calculate
(i) Equilibrium level of National Income.
(ii) Consumption expenditure at equilibrium level of National Income. (Delhi 2013)
Ans. S = -100 + 0.6 Y
l=*1100
(i) Equilibrium level of National Income
S=l
-100 + 0.6Y = 1100
0.6Y = 1100+100
Y= 1200/0.6=Rs. 2ooo
Y= Rs. 2000
(ii) Consumption expenditure at equilibrium level of National Income
Y= C + l
C= Y- l
C =2000-1100 = Rs. 900
C = Rs. 900
52. C = 100 + 0. AY is the consumption function of an economy, where C is consumption expenditure and Vis National
Income. Investment expenditure is Rs. 1100. Calculate
(ii) Consumption expenditure at equilibrium level of National Income. (Delhi 2013)
Ans. Given, C =100 + 0.4Y
l= Rs. 1100
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Y=C + I
Y= 100 + 0.4Y+1100
Y- 4Y = 100+1100
– 0.6Y = 1200
Y= 1200/ 6
Y= Rs. 200
(ii) Consumption expenditure at equilibrium level of income
C = 100 + o.4y
C =100 + 0 .4 x 2000
C = 100 + 800=900
C = Rs.900
53. C= 50+ 0. 5Y is the consumption function of an economy, where C is consumption expenditure and Y is National
Income and investment expenditure is Rs. 2000 in an economy. Calculate
(ii) Consumption expenditure at equilibrium level of National Income. (Delhi

2013)
Ans. Y = C + l or C+5
Given, C = 50+0.5Y
l=Rs. 2000
Y= C + I
Y= 50 +0.5y + 2000
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0.5 Y= 50 + 2000 =2050/0.5
Y = Rs. 4100 (therefore, National Income =Rs. 4100)
C = 50 + 05y
C = 50 +05×4100
C= 50 + 2050
C= Rs. 2100 (therefore, Consumption expenditure =Rs. 2100)
54. Explain consumption function, with the help of a schedule and diagram. (All India 2011)
Ans. The functional relationship between the consumption expenditure and the income is known as consumption
function.
C = f(Y), Where C = Consumption expenditure,
y = Income, and f = Functional relationship.
Consumption function in terms of an algebraic expression can be written
as
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The point B represents the break even point, where the consumption expenditure equals the income. To the left of point
B, consumption is greater than income and to the right of point B, consumption is less than income
55. Explain saving function with the help of a schedule and diagram.
(All India 2008)
Ans. The functional relationship between the savings and income is known as saving function.
S = f (Y), Where S = Saving, Y = Income and f = Functional relationship.
Saving function as an algebraic expression, can be written as
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Point E represents the break even point where income is equal to consumption hence, saving is equal to zero. To the left
of point E, there is negative savings or dissavings (represents the situation when income is less then consumption), to
the right of E, there is positive savings (represents the situation when income is greater than consumption).
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Short run Equilibrium Output
1.Short-run According to JM Keynes, ‘A period of time during which level of output is determined exclusively by the level
of employment in the economy, is termed as short-run.’
2. Equilibrium Output It refers to the level of output where the Aggregate Demand is equal to the Aggregate Supply (AD
= AS) in an economy. It signifies that whatever the producers intend to produce during the year is exactly equal to what
the buyers intend to buy during the year.
Where, AD = C + I (for a two-sector economy)
and AS = C + S
Where, AD = Aggregate Demand, AS = Aggregate SupplyC = Consumption, I = Investment, Saving
3. Determination of Equilibrium Output
We have two approaches to study the determination of equilibrium output/income.
(i) AD = AS Approach
According to the modern theory, income and employment are determined at the level, where Aggregate Demand is
equal to Aggregate Supply.
It is illustrated with the help of a diagram
This is illustrated with the help of the above diagram.
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4. Ex-ante Saving The planned or desired saving during an accounting year is termed as ex-ante saving. These are
desired savings by the people for one year.
5. Ex-ante Investment The planned or desired investment expenditure which is intended to be made in an economy
during an accounting year, is termed as ex-ante Investment.
6. Ex-post Saving The actual saving in the economy during a period of one year is termed as ex-post saving.
7.Ex-post Investment The actual investment expenditure during a period of one year is termed as ex-post investment.
8. Shifts in Equilibrium In an economy, the flow of income changes due to injections and withdrawals in the circular flow
of income. Injections boosts the flow of income and cause positive multiplier effect. On the other hand, withdrawals
reduces the flow of income and cause a negative multiplier effect. Investment is considered as an injection and savings is
treated as a withdrawal from the circular flow.
9. Investment Multiplier The ratio between change in income and the change in investment is termed as investment
multiplier. It is denoted by K.
It represents the responsiveness of income to change in the investment.
10. Relationship between Multiplier (K) and Marginal Propensity to Consume (MPC) There is a direct relationship
between multiplier and MPC. Higher the value of MPC, higher the multiplier and vice-versa.
Infact, multiplier can also be estimated using the following formula, K=1/1-MPC
11. Relationship between Multiplier (K) and Marginal Propensity to Save (MPS) There is an inverse relationship
between multiplier and MPS. Higher the values of MPS, lower the multiplier and vice-versa.
In fact, multiplier can be estimated using the following formula, K=1/MPS
12. Derivation of Investment Multiplier
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1 Mark Questions
1. Give the meaning of ex-ante savings. (Delhi 2010)
Ans. The planned or desired savings during an accounting year is termed as ex-ante saving. These are desired savings by
the people for one year.
2. What is ex-ante Aggregate Demand? (All India 2010)
Ans. The planned expenditure on the purchase of goods and services in an economy during a period of one year, is
termed as ex-ante Aggregate Demand.
3. When will there be equilibrium level of National Income? (All India 2010)
Ans. When Aggregate Demand is equal to Aggregate Supply (AD = AS) in an economy at full employment level, then it is
termed as the equilibrium level of National Income.
4. What can be the minimum value of investment multiplier? (Delhi 2009)
Ans. The minimum value of investment multiplier is 1.
5. If the investment multiplier is 1, what will be the value of Marginal Propensity to Consume? (Delhi 2009)
Ans. If the investment multiplier is 1, the value of Marginal Propensity to Consume is 0.
Multiplier (K) =1/1-MPC
1=1/1-MPC
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1- MPC =1
1 -1 = MPC = 0
3 Marks Questions
6. Explain the meaning of investment multiplier. What can be its minimum and maximum value? (Compartment 2014)
Ans. Investment multiplier is the ratio between change in income and the corresponding change in investment. It
represents the responsiveness of income to change in investment. It is denoted by K. Symbolically,
MPC is Marginal Propensity to Consume.
The value of Multiplier depends on the value of MPC.
7.Explain the relationship between investment multiplier and Marginal Propensity to Consume. (Delhi 2011)
Ans. There is direct or positive relationship between MPC and multiplier. Higher the MPC, higher will be the value of
multiplier and vice-versa
Multiplier (K) =1/1-MPC
e.g. If MPC =0.5, then K will be, K =1/1-0.5=2
When MPC increase to 0.75, then K will be
K=1/1-0.75=1/0.25=4
8.As a result of increase in investment by Rs. 60 crore, National Income rises to Rs. 240 crore. Calculate Marginal
Propensity to Consume.
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(All India 2011)
9. In an economy, investment is increased by Rs. 2000 crore. Calculate the change in total income, if Marginal
Propensity to Save is 0.25.
10. Find the

value of multiplier given
(i) Marginal Propensity to Consume = 1 and
(ii) Marginal Propensity to Save = 1. (All India 2010)
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11. In an economy, asa result of increase in investment by Rs. 100 crore, National Income rises by Rs. 1000 crore. Find
Marginal Propensity to Consume. (Delhi 2010c)
12. If Marginal Propensity to Save is one, what is the value of multiplier? What can you say about the change in
National Income, given change in investment. (Delhi 2010C)
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13. Given Marginal Propensity to Save equal to 0.25, what will be the increase in National Income, if investment
increases by Rs.125 crore? Calculate. (All India 2008)
4 Marks Questions
14. State whether the following statements are true or false. Give reasons for your answer
(i)When Marginal Propensity to Consume is greater than Marginal Propensity to Save, the value of investment
multiplier will be greater than 5.
(ii) The value of Marginal Propensity to Save can never be negative.
(Delhi 2010)
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Ans. (i) No, the statement is false. This can be understood by an example. Suppose, the value of MPC = 0.6,
hence, MPS = 0.4 (as MPS = 1 – MPC)
Here, MPC > MPS
Now, K=1/1-MPC=1/1-0.6
=1/0.4=2.5
So, K < 5 even if MPC > MPS.
(ii) Yes, the statement is true.
As MPS tells about the change in savings due to change in income and change is saving will always be positive even if
savings is negative, as with rise in income, savings rise at a faster rate than consumption, so MPS can never be negative.
15. Giving reasons, state whether the following statements are true or false.
(i) Average Propensity to Save is always greater than 0.
(ii) Value of investment multiplier varies between zero and infinity. (Delhi 2010)
Ans. (i) No, the statement is false.
When Average Propensity to Consume (APC) is greater than one (i.e. when consumption is greater than income),
Average Propensity to Save (APS) will less than or equal to zero.
(ii) No, the statement is false.
We know that, K =1/1-MPC so even if the MPC will have its minimum value, i.e. 0, the investment multiplier will be 1.
Similarly, when MPC = 1, the value of investment multiplier is infinity.
Hence, value of investment multiplier varies between one and infinity.
16. Giving reasons, state whether the following statements are true or false
(i) When Marginal Propensity to Consume is zero, the value of investment multiplier will also be zero.
(ii) Value of Average Propensity to Save can never be less than zero.
(All India 2010)
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When Marginal Propensity to Consume is zero, the value of investment multiplier will be 1 (not zero).
K=1/1-MPC or K=1/1-0=1/1=1
17. Giving reasons state whether the following statements are true or false
(i) If the ratio of Marginal Propensity to Consume and Marginal Propensity to Save is 4 : 1, the value of investment
multiplier will be 4.
(ii) Sum of Average Propensity to Consume and Marginal Propensity to Consume is always equal to 1. (All India 2010)
If the ratio of MPC and MPS is 4 : 1, then the value of investment multiplier is 5.
MPC=4/4+1=4/5=0.8 as (MPC/MPS=4/1)
K=1/1-0.8=1/0.2=5
(ii) No, the statement is false.
APC and MPC can have values other than 1.
18. Investment in an economy rises by Rs. 1000 crore. Suppose Marginal Propensity to Save is 0. What can you say
about the increase in National Income? Calculate. (All India 2009)
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19. Investment in an economy rises by Rs. 400 crore. Marginal Propensity to Consume is zero. Calculate the change in
National Income. (All India 2009
20. There is an increase in investment of Rs. 100 crore in an economy. Marginal Propensity to Consume is 1. What can
you say about total increase in the income? Calculate. (Delhi 2009 c)
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21. There is an increase in investment of Rs. 1000 crore in an economy. Marginal Propensity to Consume is 0. What is
the total increase in income? Calculate. (Delhi 2009C)
22. As a result of increase in investment of Rs. 125 crore, National Income increases by Rs. 500 Calculate Marginal
Propensity to Consume. (Delhi 2008)
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23. As a result of an increase in investment National Income rises by Rs. 600 crore. If Marginal Propensity to Consume
is 0.75, calculate the increase in investment. (Delhi 2008)
24. If Marginal Propensity to Consume is 0.9, what is the value of multiplier? How much investment is needed to
increase National Income by Rs. 5000 crore? Calculate. (Delhi 2008)
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25. In an economy an increase in investment leads to an increase in National Income which is three
times more than the increase in investment. Calculate Marginal Propensity to Consume. (AlIndia2008)
26. If Marginal Propensity to Save is 0.2, how much new investment is required to ational Income rise by RS. 600 crore?
Calculate.
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6 Marks Questions
27. When is an economy in equilibrium? Explain with the help of saving and investment function. Also, explain the
changes that take place in an economy when the economy is not in equilibrium. Use diag
(All India 2014)
Ans. Equilibrium level of income is determined at a point, where ex-ante or planned saving is equal to planned
investment. This is because, in equilibrium.
AS = AD or C+S=C + l or S=l
Saving is that part of income which is not spent on consumption expenditure
We know that, Y=C+S
or Y is the Aggregate Supply of the economy.
Investment refers to expenditure on capital goods and capital stock during one year,
We know that, AD = C + /
Now, at equilibrium situation, AD = AS
or C + S = C + l or S = l
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E is the point where 5 = l , hence the point at which the economy is in equilibrium. OY is the equilibrium level of National
Incomes
When savings is greater than investment in an economy, it refers to AD < AS. There will be a rise in inventory stock and
prices will start to fall. To clear their stocks, the producers would now plan lesser output. This would mean lesser income
in the economy. Lesser income implies lesser saving. The process would continue till S = l.
But if investments are more than savings, it means that AS < AD. Stocks would reduce and prices will start to rise. To
stand benefitted from such a condition, the producers will increase their production, leading to an increase in AS. The
process would continue till S = l.
28. Explain National Income equilibrium through Aggreate Demand and Aggregate Supply. Use diagram. Also explain
the changes that take place in an economy when the economy is not in equilibrium. (Delhi 2014)
Ans. In an economy, equilibrium livel of income and employment is determined when AD (Aggregate Demand) is equal
to AS (Aggregate Supply).
According to Keynes, AS may be assumed to be perfectly elastic in an economy where full employment (of resources) is
yet to be achieved. Accordingly, AD becomes the principal determinant of equilibrium level of income.
In the following figure, AD represents aggregate demand curve and 45° line is the line of reference, where AS – AD.
Equilibrium level of income Y is determined at point E, where AD = AS, Prior to point E, Aggregate Demand exceeds
Aggregate Supply leading to an increase in level of income upto point E, Aggregate Supply exceeds Aggregate Demand
leading to a fall in income back towards point E.
It is only when AS = AD that the equilibrium is struck. Because the equality between AS and AD implies that the desired
level of output in the economy (as indicated by AS) is exactly equal to the desired level of expenditure (indicated by AD)
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in the economy. So that, the entire output as planned by the producers (during and accounting year) is purchased by the
buyers. There are on undesired or unwanted inventories (stock of goods) with the producers.
29. In an economy 75% of the increase in income is spent on consumption. Investment is increased by 11000 Calculate.
(Delhi 2010)
(i) Total increase in income.
(ii) Total increase in consumption expenditure.
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30. In an economy, the equilibrium level of income is Rs. 12000 The ratio of Marginal Propensity to Consume and
Marginal Propensity to Save is 3:1. Calculate the additional investment needed to reach new equilibrium level of
income of Rs. 20000 crore. (All India 2010)
31. How is saving and investment approach derived from the Aggregate Demand and supply approach of income
determination? Explain and use diagram. (Delhi 2010c)
Ans. The equilibrium level of income or output is that level at which the planned savings and planned investments are
equal. It is derived from Aggregate Demand and supply approach in the following way: Aggregate Demand in a two
sector economy is defined as the sum of consumption expenditure(c) and investment expenditure (I) i.e. AD = C + I,
where as Aggregate Supply is defined as the sum of consumption (c) and savings (s) i.e. AS = C + S.
Mathematically, AD = AS
C + l = C+S
Hence, l=S
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or S=l
OP or OP’ is the equilibrium level of income. E is the equilibrium point where Aggregate Demand equals Aggregate
Supply. Equality between AS and AD implies the equality between S and l. When we stretch the line EP vertically
downward, it meets at point E’ with S and l. It is the equilibrium point of saving and investment approach OP or OP’
represents the level of income at which the economy is in equilibrium.
32. Given consumption function C = 100 + 0.75 Y (where, C = Consumption expenditure and Y = National Income) and
investment expenditure Rs. 1000, calculate
(ii) Consumption expenditure at equilibrium level of National Income (Delhi 2009)
Ans. (i) Equilibrium level of National Income
know that, Y = C + I
or Y= 100 + 0.75 Y+1000 (as, l=Rs. 1000)
or y-0.75 y= 1100
or 0.25Y=1100
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or Y=1100/0.25
or National Income (Y) = Rs. 4400
Now, Y=C+l
or 4400= C+1000
or C=4400-1000
or Consumption expenditure (C)= Rs. 3400
33. What changes will take place to bring an economy in equilibrium, if
(i) Planned savings are greater than planned investment
(ii) Planned savings are less than planned investment (Delhi 2009)
Ans. The situation when S > l or when S < l are explained with the help of following figure:
In the diagram, equilibrium is struck at point E when S = I. Equilibrium level of income = OY.
Let us consider a situation when S > l. It happens at point E1,.
In such a situation, the following changes will occur
(i) Stocks of the producers would be in excess of the desired limit.
(ii) Profits will start shrinking.
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(iii) Desired level of output for the subsequent year will face a cut.
(iv) Levels of income and employment will tend to shrink to the point where S =l, corresponding to point E in the
diagram.
Thus, the economy will come back to the state of equilibrium.
Now, consider a situation when S < l. It happens at point E2. It is a situation when AD>AS.
In such a situation, the following changes will occur
(i) Existing stocks of the producers are not enough to cope with the level of AD.
(ii) Profits will not be maximum, because the desired level of stock is not available.
(iii) Producers will plan higher level of output for the subsequent years.
(iv) Level of output and employment will rise to drive the economy to the point of equilibrium at point E.
34. In an economy, S = – 50 + 0.5 Y is the saving function (where, S = Saving and Y = National Income) and investment
expenditure is Rs. 7000. Calculate (All India 2009)
Ans.(i) At equilibrium situation,
S= l
or -50 + 0.5 Y= 7000
or 0.5 Y= 7000 + 50
or Y=7050/0.5
or National Income (Y)=Rs. 1400
(ii) Again, we know that Y=C+l
or 14100= C+7000
or C = 14100-7000
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or Consumption expenditure (C) = Rs. 7100
35. In an economy, C = 200 + 0.9 Y is the consumption function (where, C = Consumption expenditure and Y = National
Income) and investment expenditure is Rs. 3000. Calculate (All India 2009)
Ans. (i) We know that, Y=C+/
or Y = 200 + 0.9 Y+3000 (as l=Rs. 3000)
or Y -0.9 Y= 3200
or 0.1 Y= 3200
or Y= Rs. 3200/0.1
or National Income (Y)=Rs. 32000
(ii) Again, Y= C+ /
or 32000 = C + 3000
or C = 32000-3000
36. Explain the determination of National Income using, Aggregate Demand and Aggregate Supply, approach. Explain
the changes that take place when Aggregate Demand is greater than Aggregate Supply.
(Delhi 2009)
As, we can see from the above diagram that Aggregate Demand curve ‘AD’ cut Aggregate Supply curve ‘AS’ at
Ans. The determination of income and employment in the Keynesian model depends on the level of AD and AS. The
point where AD = AS, i.e. Aggregate Demand meets, the Aggregate Supply is known as equilibrium point.
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When AD is greater than AS, flow of goods and services in the economy tends to be less than their demand. The
exisiting stocks of the producers would be sold out. To rebuild the desired stocks, the producers would plan greater
production. AS would increase to become equal to AD.
Aggregate Demand (AD) is the sum of demand for consumption and investment. In the above figure, C is the
consumption curve which meets AS curve at B. B becomes the break even point where savings is O. Again, E is the point
where AD curve meets the AS curve and it is the equilibrium point. OP is the level of national income where AS = AD and
is known as equilibrium income.
37. Explain the determination of National Income using ‘saving and investment approach, with the help of a diagram.
Explain the changes that take place when saving is greater than investment. (Delhi 2009c)
Ans. Saving is that part of income which is not spent on consumption expenditure.
We know that, Y=C+S
or Y is the Aggregate Supply of the economy.
Investment refers to expenditure on capital goods and capital stock during one year,
We know that, AD = C + l
Now, at equilibrium situation, AD = AS
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or C + S = C + l or S = lTP2-6MQ-37
E is the point where S = l, hence, the point at which the economy is in equilibrium. The point P refers to the equilibrium
level of National Income.
When savings is greater than investment in an economy, it refers to AD < AS. There will be a rise in inventory stock and
prices will start to fall. To clear their stocks, the producers would now plan lesser output. This would mean lesser income
in the economy.
Lesser income implies lesser saving. The process would continue till S = l
38. In an economy, C = 500 + 0.9 Y and I = 1000 (where, C = Consumption expenditure and
Y = National Income and I = Investment). Calculate the following
(i) Equilibrium level of income.
(ii) Consumption expenditure at equilibrium level of income. (Delhi 2008)
Ans. Here, C = 500 + 0.9 Y
l =Rs. 1000
Y= Rs. C+l
or Y=500+0.9 Y+ 1000
or Y-0.9 Y= 1500
or 0.1 Y = 1500
or Income (Y) = 15000
Again, we know that Y = C+l
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or 15000 = C+ 1000
or C = 15000-1000
or Consumption expenditure (C)= Rs. 14000
39. Explain determination of equilibrium level of income using consumption plus investment (C +l) approach. Use
diagram. (Delhi 2008)
Ans. Equilibrium level of income is the point, where Aggregate Demand equals to Aggregate Supply in an economy.
Let us derive the equilibrium with the help of a
schedule
E represents the equilibrium point and OP represents the equilibrium level of National Income, where AD = AS. To the
left of point E, AD > AS, where as to the right of point E, AD < AS.
40. In an economy, C = 300 + 0.8 Y and I = 500 (where, C = Consumption, Y = Income and I = Investment). Calculate the
following
(i) Equilibrium level of income
(ii) Consumption expenditure at equilibrium level of income (All India 2008)
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Ans. (i) Here, l = Rs. 500
C = 300 + 0.8 Y
Now, we know that, Y = C+l
or Y= 300 + 0.8 Y+500
or Y-0.8 Y= 800
or 0.2 Y= 800
or Y=800/0.2
or Income (Y) =Rs. 4000
(ii) We know that,
Y= C+l
or 4000 = C + 500
or C = 4000 – 500
41. In an economy, with every increase in income, 10% of the rise in income is saved. Suppose a fresh investment of Rs.
120 crore take place in the economy. Calculate the following
(i) Change in income (ii) Change in consumption (All India 2008)
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42. In an economy, C = 500 + 0.75 Y and I = 800 (where, C = Consumption, Y = Income, I = Investment). Calculate the
following
(All India 2008)
Ans. (i) Here, l = Rs. 800, C = 500 + 0.75 Y
Now, we know that, Y= C+ /
or Y= 500 + 0.75 Y + 800
Y- 0.75 Y = 1300
or 0.25 Y = 1300
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or Y=1300/0.25
or Income (Y) = 5200
(ii) Again, Y = C+ /
or 5200 = C + 800
or C= 5200-800
or Consumption expenditure(C)=Rs. 4400
43. In an economy, with every increase in income, 70% of the increased income is spent on consumption. Suppose a
fresh investment of Rs. 300 crore takes place in the economy. Calculate
(i) Change in income (ii) Change in saving (Delhi 2008)
44. In an economy, every time income rises, 75% of the rise in income is spent on consumption. Now, suppose in the
same economy, investment rises by Rs. 750 crore. Calculate the following
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(i) Change in income (ii) MPS (Delhi 2008C)
(ii) Now, MPS = 1 – MPC
or MPS = 1-0.75 or
MPS = 0.25
45. In an economy C = 300 + 0.5 Y and I = Rs. 600
(where, C = Consumption, Y = Income, / = Investment). Calculate the following
(Delhi 2008C)
Ans. (i) Here, l = Rs. 600 and C = 300 + 0.5 Y
Now, we know that, Y=C+l
or Y=300+0.5 Y
or Y – 0.5Y = 900
or 0.5 Y = 900
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or Y= 900/0.5
or Income (Y) = Rs. 1800
(ii) Again, Y = C+l
or 1800= C+600
or C = 1800-600
46. In an economy, everytime income rises, 20% of rise in income is saved. Now, suppose in the same economy
investment rises by ? 200 crore. Calculate the following
(i) Change in income (ii) Change in consumption
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Problems of Deficient and Excess Demand
1.Full Employment Equilibrium In an economy, when AS = AD or S = I alongwith fuller utilisation of labour force, the
economy is said to be in full employment equilibrium.
2. Under Employment Equilibrium In an economy, when AS = AD or S = I but without the fuller utilisation of labour force,
the economy is said to be in under employment equilibrium.
3. Full Employment A situation when all those who are willing to or able to work are getting work, is termed as full
employment. Full employment never means zero unemployment in an economy, because there may always exist
voluntary unemployment.
4. Voluntary Unemployment It is a kind of unemployment situation, when some people are not willing to work at all, or
are not willing to work at the existing wage rate.
5. Involuntary Unemployment It is a situation in the economy, when even if people are willing to work at existing wage
rates, they are not getting work.
6. Deficient Demand A situation when the Aggregate Demand is less than the Aggregate Supply in an economy,
corresponding to full employment in the economy, is termed as deficient demand.
Deficient demand —> AS > AD, corresponding to full employment condition.
8. Deflationary Gap When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand
from the level required to maintain a full employment equilibrium. This short fall is termed as deflationary gap.
EF is deflationary gap
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8. Causes of Deflationary Gap
(i) Reduction in private consumption expenditure.
(ii) Reduction in private investment expenditure.
(iii) Reduction in government consumption and investment expenditure.
(iv) Rise in imports.
(v)Reduction in exports.
(vi) Increase in tax burden on people.
9. Problems Due to Deficient Demand In case of deficient demand in an economy, AD < AS. It means all the goods and
services produced in an economy cannot be sold at existing price levels. The inventory of producers start increasing and
profits start shrinking with fall in price levels.
This results in low income or output and under employment in an economy. Thus, deficient demand causes deflation
and under employment. The economy gets trapped in low income equilibrium.
10. Excess Demand The situation of an economy, when Aggregate Demand is more than the Aggregate Supply
corresponding to full employment, it is termed as excess demand situation.
Excess demand —> AD > AS, corresponding to full employment level of output or income.
11. Inflationary Gap
The excess of Aggregate Demand above the level that is required to maintain full employment level of equilibrium is
termed as inflationary gap.
In other words, when AD > AS it causes rise in prices and hence, leads to inflationary gap.
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12. Causes of Inflationary Gap
(i) Increase in private consumption expenditure (C).
(ii) Increase in private investment expenditure (I).
(iii) Increase in government consumption and investment expenditure(G).
(iv) Rise in exports (X).
(v) Reduction in imports (M).
(vi) Decrease in tax burden on people (T).
13. Problems Due to Excess Demand
In case of excess demand in an economy, AD > AS. It means the total demand for goods and services in an economy is
more than that of production in the economy. Producers would start selling from their stocks to meet Aggregate
Demand and hence, the inventory with producers starts decreasing and profits starts increasing with steep increase in
price levels.
This results in high level of output and income. The price levels and wage rates will keep on increasing. Thus, excess
demand causes inflation in an economy.
14. Measures for Correcting Deficient and Excess Demand
(i) Fiscal measures relates to fiscal policy of the government.
(ii) Monetary measures relates to monetary policy of the Central Bank.
15. Fiscal Policy
The revenue and expenditure policy of the government to correct the problem of deficient and excess demand is termed
as fiscal policy.
16. Components of Fiscal Policy

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(i) Government expenditure (ii) Taxes
17. Monetary Policy
The policy adopted by the Central Bank by regulating the cost of credit (i.e. rate of interest) and availability of credit (i.e.
money supply) in the economy to control the problem of deficient and excess demand is termed as monetary policy.
18. Components of Monetary Policy
(i) Quantitative instruments or tools
(a) Bank rate
(b) Open market operations
• Open market purchases • Open market sales
(c) Legal reserve requirements
• Cash Reserve Ratio (CRR) • Statutory Liquidity Ratio (SLR)
(d) Repo rate and Reverse repo rate
(ii) Qualitative instruments or tools
(a) Margin requirement (b) Selective credit control or rationing
(c) Moral suasion.
1 Mark Questions
Ans. When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand from the level
required to maintain a full employment equilibrium. This short fall is termed as deflationary gap.
2. Give the meaning of inflationary gap. (All India 2014,2010; Delhi 2008)
Ans. The excess of Aggregate Demand 1. Give the meaning of deflationary gap. (All India 2014; Delhi 2010,2008)
above the level that is required to maintain full employment equilibrium in an economy, is termed as inflationary gap.
3. What is meant by excess demand in macroeconomics?
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(Foreign 2014; Delhi 2009)
or
Give the meaning of excess demand in an economy. (All India 2009)
Ans. The situation of an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full
employment, it is termed as excess demand situation.
4. Define involuntary unemployment. (Delhi 2014,2009; All India 2009)
or
What is involuntary unemployment? (All lndia 2009; Delhi 2008)
Ans. Involuntary unemployment is a situation in the economy when even, if people are willing to work: at existing wage
rates, they are not getting work.
5. Define full employment. (Delhi 2014,2009c, 2008; All India 2014)
Ans. A situation when all those who are willing to or able to work are getting work, is termed as full! employment in an
economy.
6. Give the meaning of deficient demand. (Foreign 2014; All India 2008)
Ans. A situation when the Aggregate Demand is less than the Aggregate Supply in an. economy, corresponding to full
employment, is termed as deficient demand.
7. What is under employment equilibrium? (Delhi 2008)
Ans. In an economy, when AS = AD or 5 = / but without the fuller utilisation of labour force, the economy is said to be in
underemployment equilibrium.
3 Marks Questions
8. Explain the distinction between voluntary and involuntary unemployment. (All India 2011)
or
Distinguish between voluntary unemployment and involuntary unemployment. (Delhi 2011C)
Ans. Voluntary unemployment is a kind of unemployment situation, when some people are not willing; to work at all or
are not willing to work at the existing wage rate.
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Involuntary unemployment is a situation in the economy when even if people are willing to work at: existing wage rates,
they are not getting work.
9. What is the meaning and implications of deflationary gap?
(All India 2011,2008)
or
In an economy, Aggregate Demand is less than Aggregate Supply. Explain the changes that will take place in this
economy. (All India 2011)
Ans. When there is involuntary unemployment in the economy, thereis a short fall in Aggregate Demand from the level
required to maintain a full employment equilibrium.
As a result of this producers will stop producing more and hence, income level will fall in the economy. The fall in
Aggregate Supply will continue till the time, it again becomes equal to Aggregate Demand.
10. In an economy, Aggregate Demand is greater than Aggregate Supply. Explain the changes that will take place in
this economy. (Delhi 2011c)
Ans. When AD > AS in an economy, it will lead to inflationary pressure in the economy when price level and wage rate
tends to rise. This inflationary gap encourages producers to increase their output to meet the excess demand. It will lead
to gradual increase in income and output ultimately, Aggregate Supply will also increase to the point to be equal to
Aggregate Demand.
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11. Explain the problem of deficient demand in an economy. State two measures to solve it. (Delhi 2008C)
Ans. A situation when Aggregate Demand fall short of Aggregate Supply at the full employment level of equilibrium is
known as deficient demand.
(i) To solve this situation, government can reduce the tax rate, which will lead to an increase in the disposable income
and in turn, consumption expenditure and Aggregate Demand will also increase.
(ii) Central Bank can reduce bank rate, which will lead to an increase in the money supply and income and Aggregate
Demand will also increase.
4 Marks Questions
12. Distinguish between inflationary gap and deflationary gap.
(All India 2012)
Ans. The excess of Aggregate Demand above the level that is required to maintain full employment level of equilibrium,
is termed as inflationary gap. Inflationary gap causes inflation and increases wage and price levels in the economy.
When there is involuntary unemployment in the economy, there is a shortage in Aggregate Demand from the level
required to maintain a full employment equilibrium. This short fall is termed as deflationary gap. Deflationary gap causes
reduction in wage and prices in the economy.
13. Explain the concept of excess demand in macroeconomics. Also, explain the role of open market operation in
correcting it. (Delhi 2012)
Ans. The situation in an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full
employment level is termed as excess demand. In other words, the level of Aggregate Demand exceeds the level of
Aggregate Supply even when there is full capacity production in the economy.
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In the above figure, £ is the point where AD = AS, i.e. equilibrium point. But at the present. Aggregate Demand ADae is
more than the Aggregate Supply. Hence, EF represents the excess demand in the economy.
Excess demand leads to reduction in inventories and inflation in the economy. High prices encourage producers to
produce more to reach the desired level of stock. Hence, the AS will also rise and economy will attain a new equilibrium
at point G with National Income of OP.
Role of Open Market Operations to Correct the Problem of Excess Demand
Open market operations refer to sale and purchase of securities by the Central Bank on behalf of government in the
open market. It directly affects the supply of money in the hands of citizens of the country. –
In case of excess demand, the Central Bank sells its securities to common public and financial institutions. It reduces the
supply of money in the economy and reduces the money/credit creation
power of commercial banks. Thus, the Aggregate Demand comes down and the economy attains equilibrium.
6 Marks Questions
14. Explain all the changes that will take place in an economy whenAggregate Demand is not equal to Aggregate
Supply. (All India 2013)
Ans. (i) AD > AS When AD is greater than AS, flow of goods and services in the economy tends to be less than their
demand. The existing stocks of the producers would be sold out. To rebuild the desired stocks the producer would plan
greater production. AS would increase to become equal to AD.
(ii) AD < AS When AD is less than AS, flow of goods and services in the economy tends to exceed their demand. As a
result, some of the goods would remain unsold. To clear unwanted stocks, the producers would plan a cut in production.
Consequently, AS would reduce to become equal to AD. This is how AS adapts itself to AD
15. Explain the meaning of under employment equilibrium. Explain two measures by which full employment
equilibrium can be reached.
(All India 2013)
Ans. In an economy, when AS = AD or S = I but without the fuller utilisation of labour force, the economy is said to be in
under employment equilibrium.
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Under employment equilibrium occurs when AS= AD but without the fuller utilisation of labour force.
Measures to Correct Under Employment Equilibrium
(i) Bank rate Central Bank should decrease the bank rate. A decrease in bank rate lowers the rate of interest and credit
becomes cheap. Accordingly, the demand for credit expands and Aggregate Demand increases.
(ii) Open market operations By buying the government securities, the Central Bank injects additional purchasing power
into the system which results in the expansion of credit. As a result Aggregate Demand increases.
16. Explain the concept of deficient demand in macroeconomics. Also, explain the role of bank rate in correcting it.
(Delhi 2012; All India 2011)
Ans. A situation in an economy, when the Aggregate Demand is less than the Aggregate Supply, corresponding to full
employment level, is termed as deficient demand.
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Deficient demand gives rise to a deflationary gap and leads the economy to an equilibrium level of income/output that is
less than the full employment level of income. This leads to deflationary pressures on economy and increases the
inventory of producers as sales falls. The producers are discouraged to produce more as price level fall. The economy
therefore will attain a new equilibrium at point C with National Income of OP
Role of Bank Rate in Correcting the Problem of Deficient Demand
The rate at which the Central Bank lends money to commercial banks is termed as bank rate. In case of deficient
demand, the Central Bank reduces the bank rate to increase the money supply in the economy. Reduction in bank rate
increases the credit/money creation capacity of commercial banks and also reduces the market rate of interest which
encourages people to borrow more. In this way, the Aggregate Demand increases to the level of Aggregate Supply and
the economy attains equilibrium.
17. Explain the concept of deflationary gap. Also, explain the role of margin requirement in reducing it. (All India
2012,2011,2010)
Ans. When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand from the level
that is required to maintain a full employment equilibrium. This short fall is termed as deflationary gap.
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Role of Margin Requirements to Reduce Deflationary Gap Margin requirement refers to the difference between the
amount of loan granted and the current value of security offered for loans. In case of deflationary gap, the margin
requirements are lowered to increase the flow of credit by encouraging people to borrow. As a result of that, the
Aggregate Demand increases and ultimately the economy attains equilibrium.
18. Explain the role of the following in correcting deficient demand in an economy.
(i) Open market operations
(ii) Bank rate (Delhi 2012,2010)
Ans. (i) Role of open market operations in correcting deficient demand Open market operations refers to sale and
purchase of securities by the Central Bank on behalf of government in the open market. It directly affects the supply of
money in the hands of commercial banks and citizens of the country. In case of deficient demand, the Central Bank
purchase securities from public.
It increases the supply of money in the economy as well as credit/money creation power of commercial banks. Thus, the
Aggregate Demand increases and ultimately the economy attains equilibrium.
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(ii) Role of bank rate In correcting deficient demand The rate at which the Central Banks lends money to commercial
bank is termed as bank rate. In case of deficient demand, the Central Bank reduces the bank rate to increase the money
supply in the economy.
Reduction in bank rate increases the money/credit creation power of commercial banks and also reduces the market
rate of interest which encourages people to borrow more. In this way, the Aggregate Demand increases and ultimately
the economy attains equilibrium.
19. Explain the role of the following in correcting excess demand in an economy
(i) Bank rate
(ii) Open market operations (Delhi 2011; All India 2011)
Ans. (i) Role of bank rate in correcting excess demand The rate at which the Central Bank lends money to commercial
bank is termed as bank rate. In case of excess demand, the Central Bank increases the bank rate to decrease the supply
of money in the economy. Increase in bank rate reduces the money creation power of commercial banks and also
increases the market rate of interest which discourages public to borrow loans. The Aggregate Demand comes down and
the excess demand is corrected.
(ii) Role of open market operations in correcting excess demand Open market operations refer to sale and purchase of
government securities by the Central Bank in open market. In case of excess demand, the Central Bank sells the
securities to public.
It reduces the supply of money and also reduces the credit creation power of commercial banks. In this way, the
Aggregate Demand of economy comes down and the problem of excess demand is corrected.
20. Explain the concept of inflationary gap. Also, explain the role of legal reserves in reducing it. (All India 2011,2010)
or
Define and represent inflationary gap on a diagram. Explain the role of the varying reserves requirement in removing
the gap. (Delhi 2010c)
or
Explain the concept of inflationary gap. Use diagram. Also, explain the role of legal reserve ratio in removing the gap.
(All India 2009)
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Ans. (i) Inflationary gap occurs when AD > AS corresponding to full employment level. This inflationary gap i.e. excess of
Aggregate Demand causes inflation in the economy and price levels tend to rise.
(ii) Role of legal reserves to correct the problem of inflationary gap
Legal reserves like Cash Reserve Ratio and Statutory Liquidity Ratio are the tools to correct the problems of inflationary
gap.
(i) Cash Reserve Ratio (CRR) Every commercial bank has to keep a certain proportion of its total demand and time
deposits in the form of cash and other liquid assets with the Central Bank. This ratio is termed as cash reserve ratio. To
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correct the problem of inflationary gap the Central Bank increases the CRR. It reduces the supply of money and credit
money creation capabilities of commercial banks. Due to lesser supply of money, the Aggregate Demand comes down
and the economy attains equilibrium situation.
(ii) Statutory Liquidity Ratio (SLR) It refers to a fixed percentage of the total assets of a bank in the form of cash or other
liquid assets that is required to be maintained by the bank with themselves. During the situation of inflationary gap, SLR
is increased. This reduces the credit creation capacity of commercial banks and reduces the flow of money in the
economy. As a result of that, the Aggregate Demand comes down and ultimately the economy attains equilibrium again.
21. Explain the meaning of equilibrium level of income. Can there be an unemployment in the economy at an
equilibrium level of income? Explain.(Delhi 2008C)
Ans. Equilibrium level of income is the level at which Aggregate Demand is equal to Aggregate Supply in the. economy i.e.
AD = AS. In other words, when desired output equals desired expenditure , equilibrium output or income is attained.
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CHAPTER 5. Concept and Components of Government Budget
1.Government Budget It is a statement of expected/estimated receipts and expenditure of the government over the
period of a financial year, i.e. 1st April to 31st March.
2. Types of Budget
(i) Balanced budget, i.e. estimated receipts = estimated expenditure
(ii) Surplus budget, i.e. estimated receipts > estimated expenditure
(iii) Deficit budget, i.e. estimated receipts < estimated expenditure
3. Objectives of Government Budget
(i) Re-distribution of income and wealth
(ii) Re-allocation of resources
(iii) Economic growth
(iv) Management of public enterprises
(v) Economic stability
(vi) Generation of employment
(vii) Reducing regional disparities
4. Impacts of Budget
(i) Brings aggregate fiscal discipline level.
(ii) Promotes better allocation of resources.
(iii) Can effectively and efficiently implement programme.
5. Components of Budget
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(i) Revenue budget It is the statement of estimated revenue receipts and estimated revenue expenditure during a fiscal
year.
(ii) Capital budget It is an account of the assets as well as the liabilities of the Central Government, which takes into
consideration changes in capital during a fiscal year.
6. Revenue Receipts The receipts which neither create any corresponding liability for the government nor does it lead to
any reduction in assets is termed as revenue receipts, e.g. tax receipts of the government.
7. Classification of Revenue Receipts
(i) Tax revenue It consists of the proceeds of taxes and other duties levied by the Central Government. It comprises of
(a) Direct tax These are the taxes for which the incidence and impact of tax falls on the same person, i.e. actual burden
of the taxes cannot be shifted, e.g. income tax, corporation tax, etc.
(b) Indirect tax These are the taxes for which the incidence and impact fall on separate persons, i.e. burden of these
taxes can be shifted to others, e.g. service tax, entertainment tax, etc.
(ii) Non-tax revenue It mainly consists of interest receipts on account of loans by the Central Government, dividends and
profits on investment made by the government, fees and other receipts for services rendered by the government.
8. Revenue Expenditures Those expenditures of the government, which neither cause any increase in government
assets nor cause any reduction in government liabilities are termed as revenue expenditures, e.g. expenditure on old
age pensions, salaries, etc.
9. Classification of Revenue Expenditure
(i) Administrative expenses These are incurred on normal running of the government, e.g. salaries and pension of
government employees.
(ii) Social welfare expenses These are incurred to promote social well being of the citizens, e.g. expenditure on rural
development, education and health services, and subsidies.
Note Interest payments by government on loans taken is also an example of revenue expenditure.
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10. Capital Receipts The receipts which create corresponding liability for the government or which lead to reduction in
assets of the government are termed as capital receipts, e.g. loans taken by the government, disinvestment of any PSUs,
etc. Classification of capital receipts are :
(i) Borrowings These are funds raised by the government to meet its expenses. Government may borrow from :
(a)Public
(b) RBI
(c) Foreign Governments
(d) International Financial Institutions like IMF, World Bank Etc.
(ii) Recovery of loans It refers to that inflow of cash which the government has disbursed previously.
(iii) Other receipts It includes
(a) Proceeds from disinvestment.
(b) Mobilisation of savings through NSC, KVP, etc.
11. Capital Expenditures Those expenditures of the government, which lead to increase in government assets or lead to
reduction in government liabilities is termed as capital expenditure, e.g. expenses on the construction of national
highways, payment of loan by the government, etc.
Classification of capital expenditure are :
(i) Loans to states and union territories result in outflow of funds, but also create assets in the form of debtors.
(ii) Expenditure of building infrastructure like roads, metro rail network, etc.
12. Public Expenditure These expenses are incurred by the government for developing infrastructure and promoting
social welfare.
1 Mark Questions
1. Define government budget. (Delhi 2014 c)

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or
What is government budget? (Delhi 2013,2009; All India 2008)
Ans. Government budget is a statement of expected receipts and expenditures of the government over the period of a
financial year, i.e. 1st April to 31st March.
2. Give two examples of indirect taxes.(Compartment 2014)
Ans. Two examples of indirect taxes are :
(i) Entertainment tax
(ii) Value added tax
3. What is a direct tax? (Compartment 2014)
or
Define a direct tax. (All India 2012)
Ans. Direct taxes are those taxes for which the incidence and impact of tax falls on the same person, i.e. actual burden of
these taxes cannot be shifted, e.g. income tax, corporation tax, etc.
4. Give two examples of non-tax revenue receipts. (Compartment 2014)
or
State any two sources of non-tax revenue receipts.
(Delhi 2011 C; All India 2008)
Ans. Two sources of non-tax revenue receipts are :
(i) Fees
(ii) Grants/donations
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5. Define tax (Delhi 2012; All India 2010)
Ans. Tax is a compulsory payment made by an individual, household or a firm to the government without reference to
anything in return.
6. Give two examples of direct tax. (All India 2010)
Two examples of direct tax are :
(i) Income tax (ii) Corporation tax ‘
7. Define revenue receipts in a government budget.
(All India 2010; Delhi 2009)
Ans.The receipts which neither create any corresponding liability for the government nor create any reduction in assets,
are termed as revenue receipts, e.g. tax receipts of government.
8. What is revenue expenditure in government budget? (Delhi 2010c)
Ans.The expenditure of the government which neither cause any increase in the government assets nor cause any
reduction in government liabilities, are termed as revenue expenditures, e.g. expenditure on old age pensions, salaries,
etc.
9. Define capital expenditure. (Delhi 2010c, 2009 c)
Ans.The expenditure by the government which leads to an increase in government assets and reduction in government
liabilities, is termed as capital expenditure, e.g. expenses on the construction of national highways, dams and repayment
of loans, etc.
10. Why is repayment of loan a capital expenditure? (Delhi 2009)
Ans.Repayment of loan causes a decrease in the liabilities of the government. That is why, it is a capital expenditure.
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11. Why are borrowings a capital receipt? (Delhi 2009)
Ans.Borrowings lead to increase in liabilities of the government, hence, it is a capital receipt.
12.Why the taxes received by government are not capital receipts?
(All India 2009)
Ans. Taxes received by government are not capital receipts as taxes do not create any liability for government, nor lead
to decrease in government assets.
13. State any one objective of government budget. (Delhi 2008)
Ans. Re-distribution of income and wealth is an objective of government budget.
3 Marks Questions
14. Is the following a revenue receipt or a capital receipt in the context of government budget and why?
(i) Tax receipts
(ii) Disinvestment (All India 2014)
Ans. (i) Tax receipts are revenue receipts for the government because neither they create a liability nor they lead to
reduction in any assets.
(ii) Disinvestment refers to the withdrawal of existing investment, e.g. the government of India is undertaking
disinvestment by selling its shares in Maruti Udyog Ltd. It is a capital receipt for the governments as it reduces the assets
of the government.
15. Giving reason, state whether the following is a revenue expenditure or a capital expenditure in a government
budget:
(i) Expenditure on scholarships
(ii) Expenditure on building a bridge (Foreign 2014)
Ans. (i) Expenditure on scholarships is a revenue expenditure because neither it lead to decrease in liabilities nor lead to
an increase in assets.
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(ii) Expenditure on building a bridge is a capital expenditure because it increases the assets of the country.
16. State three sources each of revenue receipts and capital receipts in government budget. (All India 2013)
Ans. Sources of revenue receipts are :
(i) Income from public enterprises
(ii) Tax revenue
(iii) Non-tax revenue
Sources of capital receipts are:
(i) Recovery of loans
(ii) Borrowing and other liabilities
(iii) Disinvestment
17. Explain any one objective of government budget. (Delhi 2013)
or
Explain the role of government budget in bringing economic stability.
(All India 2012)
or
Explain the economic stability objective of government budget.
(All India 2011)
Ans. Economic stability an objective of government budget Government tries to establish economic stability by its
budgetary policies. It refers to a situation where there is no fluctuation in price level in an economy. Economic stability
is achieved by saving the economy from harmful effects of various trade cycles and its phases, i.e. boom, recession,
depression and recovery, through various budgetary tools.
18. How can budgetary policy be used to reduce inequalities of income? (All India 2013)
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Ans. Even distribution of wealth and social welfare remains one of the main objective of budgetary policy. The
government uses progressive taxation policy to reduce the inequalities of income and wealth in the country. People with
higher incomes are levied higher rate of tax and people with lower income are levied lower rate of tax. People with
income below a certain level are not levied any direct tax altogether.
On the other hand, the government spent these tax receipts on granting subsidies and providing other public services
such as health and education free of cost, to people with lower income groups. Thus, the wealth gets redistributed and
reduction in inequalities is achieved.
19. Distinguish between revenue expenditure and capital expenditure in a government budget. Give an example.
or
Distinguish between revenve expenditure and capital expenditure.
(All India 2010)
Ans. Difference between revenue expenditure and capital expenditure
20. Distinguish between revenue receipts and capital receipts in a government budget. (All India 2013,2012; Delhi
2010C)
Ans. Difference between revenue receipts and capital receipts
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21. Explain the role of government in allocation of resources.
(HOTS; Delhi 2012,2011)
or
Explain the allocation function of government budget.(Delhi 2010)
Ans. The government does the allocation of resources in such a manner that there is a balance between the goals of
profit maximisation of PSUs and social welfare in an economy. This allocation is done with the help of government
budgetary policy. The government allocates the resources in accordance with the social and economic priorities of the
country.
Government encourages the production of certain commodities by giving tax reliefs and providing necessary
infrastructural requirements. On the other hand, it discourages production of hazardous and harmful goods by imposing
heavy taxes, e.g. government imposes tax on liquors and cigarettes.
22. Distinguish between direct tax and indirect tax.
(All India 2011,2008; Delhi 2009)
Ans. Direct taxes are those taxes for which the incidence and impact of tax falls on the same person, i.e. actual burden of
taxes cannot be shifted, e.g. income tax, corporation tax, etc. Whereas indirect taxes are those taxes for which the
incidence and impact fall on separate persons, i.e. burden of these taxes can be shifted to other, e.g. service tax,
entertainment tax, etc.
23. State three objectives of a government budget. (Delhi 2011c, 2009c)
Ans.Objectives of a government budget are as follows:
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(i) Re-distribution of income and wealth.
(ii) Re-allocation of resources.
(iii) Economic stability.
24. On what basis is government expenditure classified into capital expenditure and revenue expenditure? Give an
example of each.
(Delhi 2011c; All India 2008)
Ans. Government expenditures are aimed at providing benefits to the people and enhancing the development of the
country. On such basis expenditure is classified into :
(i) Capital expenditure The expenditure by the government which leads to an increase in government assets and
reduction in government liabilities, is termed as capital expenditure, e.g. expenses on the construction of national
highways, dams and repayment of loans, etc.
(ii) Revenue expenditure The expenditure of the government which neither cause any increase in the government
assets nor cause any reduction in government liabilities, are termed as revenue expenditures, e.g. expenditure on old
25. How can the government budget be helpful in altering distribution of income in an economy? (Delhi 2010)
or
Explain how the government budget can help in fair distribution of income in the economy. (All India 2010; Delhi
2010C, 2009)
Ans. Government budget shows its comprehensive exercise on the taxation and subsidies. The government uses these
fiscal instruments with a view to improve the distribution of income and wealth in the economy, e.g. in India progressive
tax structure is followed (i.e. tax rate increases with increase in income) to redistribute income from rich to poor.
26.Give meanings of revenue expenditures and capital receipts m a government budget. Give one example of each.
(All India 2009)
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Ans. Revenue expenditures The expenditure of the government which neither cause any increase in the government
assets nor cause any reduction in government liabilities, are termed as revenue expenditures, e.g. expenditure on old
Capital receipts The receipts which create corresponding liability for the government or lead to reduction in assets of
the government are termed as capital receipts, e.g. disinvestment of PSUs. i
27. Give meanings of revenue receipts and capital expenditures with one example for each. (All India
2009) !
Ans. Revenue receipts The receipts of government which neither create any corresponding liability of the government,
nor it create any reduction in assets, are termed as revenue receipts, e.g. tax receipts of the government.
Captial expenditure The expenditure by the government which leads to an increase in government assets and reduction
in government liabilities, is termed as capital expenditure, e.g. expenses on the construction of national highways, dams
and repayment of loans, etc.
28. Give meanings of capital receipts and revenue receipts with an example of each (Delhi 2008)
Ans. Capital receipts The receipts which create corresponding liability for the government or lead to reduction in assets
of the government are termed as capital receipts, e.g. disinvestment of PSUs.
Revenue receipts The receipts of government which neither create any corresponding liability of the government, nor it
create any reduction in assets, are termed as revenue receipts, e.g. tax receipts of the government.
29. Distinguish between balanced budget and surplus budget. (All India 2008)
Ans. When the expected receipts are equal to the expected expenditures in the government budget, the budget is said
to be balanced (Expected receipts = Expected expenditures). Whereas when the expected receipts are more than the
expected expenditures in the government budget, it is termed as surplus budget (Expected receipts > Expected
expenditure).
30. Giving reasons to classify the following into direct tax and indirect tax.
(i) Wealth tax
(ii) Entertainment tax
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(iii) Income tax (Delhi 2008C)
Ans. (i) Wealth tax It is a direct tax, as the burden of this tax cannot be shifted to someone else.
(ii) Entertainment tax It is an indirect tax, as the burden of this tax can be shifted to other’s.
(iii) Income tax It is a direct tax, as the burden of this tax cannot be shifted to someone else.
4 Marks Questions
31. Government has started spending more or providing free services like education and health to the poor. Explain
the economic value it reflects. (VBQ; Foreign 2014)
Ans. The economic value reflected by the above act of the government is ‘Promoting Social Welfare’. The government
uses the fiscal instruments of subsidies and taxation to improve the distribution of income and wealth in the economy.
By spending more on provision of free services like education and health, government is trying to promote social justice.
Social justice is the principal objective of annual budget of a developing country like India. It leads to fair and equitable
distribution of income in an economy.
32. Tax rates on higher income group have been increased. Which economic value does it reflect? Explain. (VBQ; All
India 2014)
Explain the redistribution of income objective of government budget.
Ans. The economic value that is reflected in the rise in tax rate for higher income group is the ‘equality and social
welfare’. The main objective of the budgetary policy of the government is to reduce inequalities of income and wealth in
the country.
Even distribution of wealth and social welfare remains the main objective of budgetary policy. The government uses
progressive taxation policy to reduce the inequalities of income and wealth in the country. Government imposed high
tax rates on higher income group and low tax rate on lower income group. People with income below a certain level are
not levied any direct tax altogether. On the other hand, the government spent these tax receipts on granting subsidies
and providing other public services such as health and education, to people with lower income groups, the wealth gets
redistributed and reduction in inequalities is achieved.
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33.Government raises its expenditure on producing public goods. Which economic value does it reflect? Explain. (VBQ;
Delhi 2014)
Ans. The economic value that is reflected in the rise in the production of public goods is the ‘social welfare’. The major
objective of the budgetary policy of the government is to enhance the welfare of the society as a whole. For this, it
performs the allocative function. The allocative function is concerned with allocating the resources between private and
public sectors. As the public goods cannot be provided by the private sectors through market mechanism, hence the
need for providing such goods is to be fulfilled by the government.
In addition to this, private goods cannot be afforded by all, that is, only those who can pay for these goods can avail the
benefits of such goods. But, as the public goods as required by all and are essential from welfare point of view, thus,
government provide these goods.
34.Distinguish between revenue receipts and capital receipts. Give two examples of each. (All India 2011)
Ans.Difference between revenue receipts and capital receipts
35. Giving reasons, classify the following into direct and indirect tax. (Delhi 2010)
(i) Wealth tax (ii) Value added tax
Ans. (i) Wealth Tax It is a kind of direct tax as it is paid by the same person on which it is levied or imposed, i.e. burden of
this tax is not possible to shift to the other person.
(ii) Value Added Tax It is a kind of indirect tax as it is imposed on one person and its burden shifts to other person.
36. Explain any two objectives of government budget.
(All India 2009,2008)
Ans. (i) Economic stability Economic stability an objective of government budget Government tries to establish
economic stability by its budgetary policies. It refers to a situation where there is no fluctuation in price level in an
economy. Economic stability is achieved by saving the economy from harmful effects of various trade cycles and its
phases, i.e. boom, recession, depression and recovery, through various budgetary tools.
(ii) Redistribution of incomeThe economic value that is reflected in the rise in tax rate for higher income group is the
‘equality and social welfare’. The main objective of the budgetary policy of the government is to reduce inequalities of
income and wealth in the country.
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Even distribution of wealth and social welfare remains the main objective of budgetary policy. The government uses
progressive taxation policy to reduce the inequalities of income and wealth in the country. Government imposed high
tax rates on higher income group and low tax rate on lower income group. People with income below a certain level are
not levied any direct tax altogether. On the other hand, the government spent these tax receipts on granting subsidies
and providing other public services such as health and education, to people with lower income groups, the wealth gets
redistributed and reduction in inequalities is achieved.
37. Classify the following receipts into revenue receipts and capital receipts. Give reasons in support of your answer.
(i) Recovery of loans.
(ii) Interest received on loans.
(iii) Dividend received from public enterprises.
(iv) Grants from foreign government. (All India 2008)
Ans. Recovery of loans is a kind of capital receipt as it will lead to decline in financial assets of government.
On the other hand, interest received on loans, dividend received from public enterprises, and grants from foreign
government are revenue receipts as they neither create liability nor any reduction in assets of the government.
38. Define a government budget. State its main objectives. (Delhi 2008C)
Ans. Government budget is a statement of expected/estimated receipts and expenditures of the government over a
period of a financial year, i.e. 1 st April to 31 st March.
The main objectives of government budget are given below :
(i) Redistribution of income and wealth. .
(ii) Reallocation of resources for maximisation of social welfare.
(iii) Economic stability.
(iv) Management of public enterprises.
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39. Distinguish between the following. Also give an example of each.
(Compartment 2014)
(i) Direct tax and indirect tax
(ii) Revenue expenditure and capital expenditure.
Ans. (i) Direct taxes are those taxes for which the incidence and impact of tax falls on the same person, i.e. actual burden
of taxes cannot be shifted, e.g. income tax, corporation tax, etc. Whereas indirect taxes are those taxes for which the
incidence and impact fall on separate persons, i.e. burden of these taxes can be shifted to other, e.g. service tax,
entertainment tax, etc.
(ii) Difference between revenue expenditure and capital expenditure
40. Explain the objectives of resource allocation and income distribution in a government budget.(Compartment 2014)
Ans. Allocation of resources
The government does the allocation of resources in such a manner that there is a balance between the goals of profit
maximisation of PSUs and social welfare in an economy. This allocation is done with the help of government budgetary
policy. The government allocates the resources in accordance with the social and economic priorities of the country.
Government encourages the production of certain commodities by giving tax reliefs and providing necessary
infrastructural requirements. On the other hand, it discourages production of hazardous and harmful goods by imposing
heavy taxes, e.g. government imposes tax on liquors and cigarettes.
Distribution of income Government budget shows its comprehensive exercise on the taxation and subsidies. The
government uses these fiscal instruments with a view to improve the distribution of income and wealth in the economy,
e.g. in India progressive tax structure is followed (i.e. tax rate increases with increase in income) to redistribute income
from rich to poor.
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Budgetary Deficit and its Measures
1. Budgetary Deficit When a government spends more than it collects by way of revenue, it incurs a budgetary deficit,
i.e. Expected expense > Expected revenue.
2.Measures of Budgetary Deficit It includes revenue deficit, fiscal deficit and primary deficit.
3. Revenue Deficit When the revenue receipts are less than the revenue expenditures in the government budget, this
short fall is known as revenue deficit.
It is calculated as
Revenue Deficit = Revenue Expenditure – Revenue Receipts
4. Implications of Revenue Deficit
(i) Huge expenditure on administration and maintenance.
(ii) Increase in government liability.
(iii) Higher inflation.\
(iv) Higher future burden of loan and interest payments on government.
5. Measures to Reduced Revenue Deficit
(i) Reduction in government’s expenditure.
(ii) Increase in government’s revenue.
6. Sources of Financing Fiscal Deficit The two main sources are :
(i) Borrowings
(ii) Deficit Financing
7. Fiscal Deficit It refers to the excess of total expenditure over the sum of revenue receipts and capital receipts
excluding borrowings. It is calculated as
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Fiscal Deficit = Total Budget Expenditure – Total Budget Receipts (excluding borrowings)
or
Fiscal Deficit = [Revenue Expenditure + Capital Expenditure]
– [Revenue Receipts + Capital Receipts (excluding borrowings)]
or
Fiscal Deficit = Borrowings
8. Implications of Fiscal Deficit
(i) High inflation
(ii) Increased foreign dependence
(iii) Financial burden on citizens
(iv) Increased borrowings by government
(v) Debt trap
(vi) High interest payments by the government
9. Measures to Reduce Fiscal Deficit
(i) Reduction in public expenditure by:
(ii) Reducing subsidies
(iii) Reducing non-plan expenditure.
(iv) Steps to increase revenue by :
(v) Increasing the incidence and burden of tax.
(vi) Increasing the profitability of PSU’s

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(vii) Controlling tax evasion.
10. Primary Deficit The difference between fiscal deficit and interest payment is termed as primary deficit. It is
calculated as
Primary Deficit – Fiscal Deficit – Interest Payments
11. Implications of Primary Deficit
(i) Indicates how much government borrowing is going to meet expenses other than interest payments.
(ii) Reflects the extent to which current government policy is adding to future burdens.
(iii)Used as a measure of fiscal irresponsibility.
12. Measures to Reduce Primary Deficit
(i) Efforts should be made to reduce fiscal deficit.
(ii) Early repayment of loans should be encouraged.
1 Mark Questions
1. Define fiscal deficit. (All India 2014)
Ans. Fiscal deficit is the difference between the government’s total expenditure and total receipts excluding borrowings.
Fiscal Deficit = Total Budget Expenditure – Total Budget Receipts (Excluding borrowings) or
Fiscal Deficit = Borrorings
2. What is’primary deficit’. (Foreign2014)
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or
How is primary deficit calculated? (Delhi 2010,2008C)
Ans. The difference between fiscal deficit and interest payment is known as primary deficit.
Primary Deficit = Fiscal Deficit – Interest Payments
3. What is’revenue deficit? (All India 2013)
or
What is the meaning of revenue deficit? (All India 2010)
Ans. When the revenue receipts are less than the revenue expenditures in a government budget, this shortfall is termed
as revenue deficit.
3 Marks Questions
4. Distinguish between fiscal deficit and revenue deficit. (Delhi 2013)
Ans. Difference between fiscal deficit and revenue deficit
5. Explain the meaning and implications of revenue deficit.
(All India 2011)
Ans. When the revenue receipts are less than the revenue expenditures in the government budget, this shortfall of
receipts is known as revenue deficit.
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Implications of revenue deficit are as follows:
(i) High revenue deficit shows accumulated and recurring expenses of government such as expenses on defence,
payment of interest, etc.
(ii) The revenue deficit is managed by borrowing or disinvestment. Hence, high revenue deficit either increases
government liability or reduction of government assets.
(iii) High revenue deficit leads to inflationary situation in the economy, as high government expenditure increases the
aggregate demand of the economy.
(iv) High revenue deficit implies high future burden of loan and interest payments on the government.
6. Distinguish between fiscal deficit and primary deficit.
Ans. Difference between fiscal deficit and primary deficit
7. Give the meaning of revenue deficit, fiscal deficit and primary deficit.
(All India 2009; Delhi 2009C)
Ans. (i) Revenue deficit When the revenue receipts are less than the revenue expenditures in the government budget,
this short fall is known as revenue deficit. It is calculated as
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(ii) Fiscal deficit It refers to the excess of total expenditure over the sum of revenue receipts and capital receipts
excluding borrowings. It is calculated as
Fiscal Deficit = Total Budget Expenditure – Total Budget Receipts (excluding borrowing)
or
(iii) Primary deficit The difference between fiscal deficit and interest payments is termed as primary deficit. It is
calculated as
Primary Deficit = Fiscal Deficit – Interest Payments
4 Marks Questions
8. Explain revenue deficit in a government budget. What does it indicate?
(Delhi 2012; All India 2009C)
or
What is revenue deficit? Explain its implications. (Delhi 2012; All India 2008)
Ans.When the revenue receipts are less than the revenue expenditures in the government budget, this shortfall of
receipts is known as revenue deficit.
9. Explain the concept of fiscal deficit in a government budget. What does it indicate? (All India 2012)
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or
What is fiscal deficit? What are its implications? (Delhi 2008; All India 2008)
Ans. It refers to the excess of total expenditure over the sum of revenue receipts and capital receipts excluding
borrowings. It is calculated as :
Fiscal Deficit = Total Budget Expenditure – Total Budget Receipts (excluding borrowing)
or
Implications of fiscal deficit are :
(i) Borrowings requirements of government.
(ii) High interest payments by government.
(iii) High level of inflation due to high government expenditure.
(iv) Increased foreign dependence of the economy.
10. From the following data about a government budget, find out the following:
(i) Revenue deficit
(ii) Fiscal deficit
(iii) Primary deficit
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(i) Revenue Deficit = Revenue Expenditure – Revenue Receipts =100 -80 =Rs. 20 Arab
(ii) Fiscal Deficit = [Revenue Expenditure + Capital Expenditure] – [Revenue Receipt
+ Capital Receipt Net of Borrowing]
= [100 + 110]- [80 + 95]
=210-175
= Rs. 35 Arab
(iii) Primary Deficit = Fiscal Deficit – Interest Payments = 35-10 =Rs. 25 Arab
11. From the following data about a government budget, find
(i) Revenue deficit
(ii) Fiscal deficit
(iii) Primary deficit
Ans. (a) Revenue Deficit = Revenue Expenditure – (Tax Revenue + Non-tax Revenue)
= 80-[47+ 10] = 80-57
= Rs. 23 Arab
(i) Fiscal Deficit = Borrowings Borrowings = Rs. 32 Arab
So, Fiscal Deficit = Rs. 32 Arab
(iii) Primary Deficit = Fiscal Deficit – Interest Payments
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= 32-20
= Rs. 12 Arab
12. Define a government budget. Give meanings of revenue deficit, fiscal deficit and primary deficit. (Delhi 2011)
or
What is a government budget. Explain the meanings of fiscal deficit and primary deficit. (All India 2010C)
Ans. Government budget is a statement of expected/estimated receipts and expenditure of the government over a
period of one financial year, i.e. 1 st April to 31 st March.
Revenue deficit, fiscal deficit, primary deficit
When the revenue receipts are less than the revenue expenditures in the government budget, this shortfall of receipts is
known as revenue deficit.
6 Marks Question
13. Distinguish between the following
(i) Revenue receipts and capital receipts
(ii) Revenue deficit and fiscal deficit. (Compartment 2014)
Ans. (i) Difference between revenue receipts and capital receipts
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(ii) Difference between revenue deficit and fiscal deficit
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CHAPTER 6. Foreign Exchange Rate
1. Foreign Exchange It refers to the reserve of foreign currencies.
e.g. INR is Indian currency except that all other currency will be foreign exchange for India.
2. Foreign Exchange Rate It is the rate at which one currency can be exchanged for the other currency in foreign
exchange market, e.g. ? 58 are to be paid to buy one dollar, then the t/ $ (Rupees per dollar) exchange rate is 58 i.e. ?58
per $ .
3.Exchange Rate System
(i) Fixed exchange rate system It is a system in which the central authority or government maintains their exchange rate
fixed either against gold or some other currency. Fixed exchange rate has two important types:
(a) Gold standard Under gold standard, a country’s Central Bank fixes its currency against certain quantity of gold.
(b) Bretton woods system Under this system, Central Bank ties its currency with USD, as the official reserve asset.
(ii) Flexible Exchange Rate System The rate of exchange which is determined by the market forces of demand and
supply of foreign currencies in the foreign exchange market, is termed as flexible exchange rate system. Flexible
exchange rate system has two main types:
(a)Clean floating system Under this system, exchange rate is freely determined by the market forces of demand and
supply of foreign exchange with no interference by the central authority.
(b) Managed floating system Under this system, exchange rate is determined by the market forces of demand and
supply of foreign exchange and the excessive fluctuation is checked by the central authority, it is also termed as dirty
floating.
4. Merits of Fixed Exchange Rate System
(i) Minimise exchange rate fluctuations
(ii) Reduces volatility and fluctuations in prices
(iii)Imposes discipline on the monetary authority
(iv) Encourages international trade and investment flows
(v) Less speculation in the currency market
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5. Demerits of Fixed Exchange Rate System
(i) Central Bank needs to hold huge stocks of either Gold or USD.
(ii) Do not allow for automatic stabilisation of exchange rate.
(iii) Diverts Central Banks focus from economic problems to exchange rate
(iv) It discourages venture capital.
(v) These exist the possibility of policy delay.
6. Merits of Flexible Exchange Rate System
(i) Independent monetary policy
(ii) Encourages international mobility of capital and trade
(iii) Encourages venture capital
(iv) No need to maintain huge stock of gold or other currency
7. Demerits of Flexible Exchange Rate System
(i) Creates the condition of instability in the international trade
(ii) Adverse effect on economic structure
(iii) Unnecessary capital movements
(iv) Inflationary problems
(v) Difficulty in policy formation
8. Different Concepts of Foreign Exchange Rate
(i) Nominal exchange rate It refers to the number of units of domestic currency, one must give up to get an unit of
foreign currency. In simple term, it refers to the price of foreign currency in terms of domestic currency.
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(ii) Real exchange rate The real exchange rate is the ratio of foreign to domestic prices, measured in the same currency.
It is defined as
(iii) Nominal Effective Exchange Rate (NEER) It is that type of effective exchange rate which does not account for
change in price level while measuring average strength of one currency in relation to the other.
(iv) Real Effective Exchange Rate (REER) It is that type of effective exchange rate which accounts for changes in the price
level across different countries of the world.
9. Sources of Demand for Foreign Exchange
(i) Payment of loans and interest to international organisations
(ii) Gifts and grants to rest of the world
(iii) Foreign investment across the world
(iv)Foreign trade i.e. Imports
(v) Foreign exchange trade for speculation
(vi) Foreign tourism
10. Sources of the Supply of Foreign Exchange
(i) Exports of goods and services from domestic country
(ii) Foreign investment
(a) Foreign direct investment
(b) Portfolio
(iii)Foreign tourism from abroad.
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(iv)Purchases by non-residents in the domestic country.
(v) Remittances from abroad
Determination of Exchange Rate Exchange rate is determined by the demand and supply forces of foreign exchange in
foreign exchange market.
Determination of Equilibrium Rate of Exchange The equilibrium exchange rate is obtained at the point where supply of
foreign exchange equakb,.tp the demand for foreign exchange.
Some Important Terms Related to Foreign Exchange Market
(i) Foreign exchange market It is that market where exchange of foreign currencies took place. The major participants in
this market are commercial banks, brokers, other authorised dealers, etc.
(ii) Functions of foreign exchange market
(a) Transfer function
(b) Credit function
(c) Hedging function
(iii) Forward market It refers to that market which covers sale and purchase of foreign exchange for future delivery, at a
rate decided today.
(iv) Spot market The market which handles only spot transactions or current transactions of foreign exchange are
termed as spot market or current market.
Some Important Terms Related to Foreign Exchange Rate
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(i) Appreciation of currency When the value of domestic currency increases in relation to a foreign currency due to
demand and supply forces in the free market, it is termed as appreciation of the domestic currency, (under flexible
exchange rate system.)
(ii)Depreciation of currency Depreciation of domestic currency occurs when the value of domestic currency decreases
in relation to the value of foreign currency (under flexible exchange rate system) .
(iii) Revaluation of currency Revaluation is the rise in the value of domestic currency in relation to foreign currency as
planned by Central Bank in a situation when exchange rate is not determined by market forces of demand and supply
(under fixed exchange rate system.)
(iv) Devaluation of currency Devaluation is the fall in the value of domestic currency in relation to foreign currency as
planned by the Central Bank in a situation when exchange rate is not determined by forces of demand and supply under
fixed exchange rate system.
(v) Spot exchange rate It refers to that situation where exchange rate is determined on spot. However, actual
transaction may take 1 day or 2 to get settled.
(vi) Forward exchange rate Under this system, exchange rate is determined on some specified future date at a rate
decided at present.
1 Mark Questions
1. Give the meaning of managed floating exchange rate. (All India 2014; Delhi 2012)
Ans. The system of adjusting the exchange rates as per the rules and regulations of foreign exchange market is termed
as managed floating.
2. Define foreign exchange rate. (All India 2014:1 Delhi 2011)
Ans. Foreign exchange rate refers to the rate at which one currency can be exchanged for the other currency in foreign
exchange market, e.g. if Rs. 58 is paid to buy one US dollar, then Rs./$ exchange rate will be 58 i.e. Rs.58 per dollar.
3. What is floating exchange rate? (All India 2014)
or
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Define flexible exchange rate system. (Delhi 2008)
Ans. The rate of exchange which is determined by the market forces of demand and supply of foreign currencies in the
foreign exchange market, is termed as flexible exchange rate system.
4. What is a fixed exchange rate? (Ail India 2013)
or
Give the meaning of fixed foreign exchange rate.(All India 2012,2009,2008; Delhi 2009)
Ans. Fixed exchange rate is the system under which the central authority or government maintains their exchange rate
fixed either against gold or some other foreign currency, (say USD)
5. What is foreign exchange? (All India 2011; Delhi 2009c)
or
Give meaning of foreign exchange. (Delhi 2009c)
Ans.Foreign exchange refers to the reserve of foreign currency with a country, e.g. currency of US and UK are the foreign
exchanges for India.
6. State two sources of supply of foreign exchange. (Delhi 2010)
Ans. Two sources of supply of foreign exchange are:
(i) Export of goods and services from domestic country to foreign country.
(ii) Foreign direct investment.
7. State two sources of demand for foreign exchange. (All India 2010)
Ans. Two sources of demand for foreign exchange are
(i) Payment of loans and interest to international organisations.
(ii) Gifts and grants to rest of the world.

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3 Mark Questions
8. How does giving incentives for exports influence foreign exchange rate? Explain (Delhi 2014)
Ans. The incentives for exports boosts exports for the country. As a result of increase in exports the supply of foreign
currency in the country increases. With demand remaining the same, this results in a fall in the exchange rate implying
currency appreciation.
9. Recently Government of India has doubled the import duty on gold. What impact is it likely to have on foreign
exchange rate and how? (Delhi 2014)
Ans.When government increase the import duty of gold, the import of gold will fall. This reduces the demand for foreign
currency. With the supply of foreign currency remaining same, the foreign exchange rate would fall.
This implies appreciation of rupees.
10. Visits of foreign countries for sightseeing etc. by the people of India is on the rise. What will be its likely impact on
foreign exchange rate and how? (Delhi 2014)
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Ans. When there is a rise in the visit of foreign countries by the people in India, the demand for foreign currency
increases. With the supply of foreign currency remaining same, the foreign exchange rises, implying a depreciation of
rupee.
11. Foreign exchange rate in India is on the rise recently. What impact is it likely to have on exports and how? (All
India 2014)
Ans. With the rise in foreign exchange rate in India, the demand for foreign currency increases. This rise in exchange rate
implies depreciation in domestic currency. It encourages exports from a country.
12. When foreign exchange rate in a country is on the rise, what impact is it likely to have on imports and how? (All
India 2014)
Ans. With the rise in foreign exchange rate in India, the demand for foreign currency increases. This rise in exchange rate
implies depreciation in domestic currency. It encourages exports from a country and discourages imports from rest of
the world.
13. What is ‘appreciation’ of domestic currency? What is its likely effects an exports and how? (Foreign 2014)
or
Explain the effect of appreciation of domestic currency on imports. (Delhi 2013)
Ans. Domestic currency appreciates when there is a fall in foreign exchange rate, the domestic economy can now buy
more quantity of goods and services from foreign countries with the same amount of domestic currency. As a result
imports rise.
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e.g. When Rs. / $ exchange rate falls from 55 to 50, it leads to currency appreciation and this will help in buying more
and more units of foreign goods as a result demand for foreign goods will rise. i.e. imports will rise.
14.Explain the effect of depreciation of domestic currency on exports. (All India 2013)
Ans. Domestic currency depreciates when there is a rise in foreign exchange rate. Depreciation has an expansionary
effect on Aggregate Demand and output. Depreciation increases the demand for domestically produced goods by
reducing their relative price. This will lead to increase in exports and hence fall in imports, as now foreign country can
buy greater units in the domestic country with same amount of their currency.
15. How is exchange rate determined in the foreign exchange market? (All India 2013)
Ans. Foreign exchange rate is determined by the market forces of demand and supply in foreign exchange market. The
point where demand and supply of foreign exchange meet, gives the equilibrium rate of exchange as shown in figure
and quantity of foreign exchange.
16. How can Reserve Bank of India help in bringing down the foreign exchange rate which is very high? (All India 2013)
Ans. Central Bank starts selling foreign exchange from its reserve to bring down the foreign exchange rate, as the
demand for foreign exchange is very high.
17. How can increase in foreiqn direct investment affect the price of foreign exchange? (Delhi 2013)
Ans. Increase in foreign direct investment will result in more supply of foreign exchange therefore, due to excess supply,
price of foreign exchange will fall. i.e. exchange rate falls which leads to appreciation of domestic currency.
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18. When price of a foreign currency rises, its demand falls. Explain why? (Delhi 2011)
or
Explain, why there is a fall in demand of foreign exchange, when its price rises. (All India 2011)
or
There is an inverse relationship between foreign exchange rate and demand for foreign exchange. Explain why? (Delhi
2009c)
Ans. Exchange rate of foreign currency is inversely related to the demand. When price of a foreign currency rises, it
results into costlier imports for the country. As imports become costlier, the demand for foreign products also reduce.
This leads to reduction in demand for that foreign currency and vice-versa.
19. When price of a foreign currency rises, its supply also rises. Explain why? (Delhi 2011)
or
There is a direct relationship between price of foreign exchange and supply of foreign exchange. Explain why?(All
India 2009; Delhi 2008)
or
When the rate of a foreign currency rises, its supply iises. How?(Delhi 2008)
Ans. Rise in exchange rate of foreign currency refers to appreciation of foreign currency in relation to domestic currency.
When there is rise in foreign exchange rate (Say from Rs. 55 per$ to Rs. 60 per $), it leads to depreciation of domestic
currency and rise in exports leading to rise in supply of foreign exchange supply.
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20. When the price of a foreign currency falls, the demand for that foreign currency rises. Explain why? (All India 2011)
or
Explain why there is a rise in demand for foreign exchange, when its price falls? (All India 2011)
or
When the rate of exchange of foreign currency falls, its demand rises. Explain how? (All India 2008)
Ans. Foreign exchange rate shares an inverse relationship with the demand for that currency, with a fall in the price of
foreign exchange, value of domestic currency increases (i.e. appreciation of domestic currency) and that means foreign
goods become cheaper and their domestic demand (i.e. imports) increases. The rising domestic demand for foreign
goods implies higher demand for foreign exchange which increased from OC1 to OQ2 as shown in the figure.
21. When the price of a foreign currency falls, the supply of that foreign currency also falls. Explain why? (All India
2011,2008)
Ans. The supply of foreign currency is directly proportional to the price of foreign exchange. When the price of a foreign
currency falls, it leads to cheaper imports and costlier exports as it leads to appre ciation of domestic currency. The
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exporters are discouraged due to costlier exports. This results lesser inflow or supply of foreign currency in the economy.
As a result supply of foreign exchange decreases from OQ2 to OQ1.
22. Give the meaning of foreign exchange rate. How it is determined under flexible exchange rate system? (All India
2011)
Ans. Foreign exchange rate Foreign exchange rate refers to the rate at which one currency can be exchanged for the
other currency in foreign exchange market, e.g. if Rs. 58 is paid to buy one US dollar, then Rs./$ exchange rate will be 58
i.e. Rs.58 per dollar.
Flexible rate of exchange is also called free rate of exchange, as it is freely determined by the market forces of supply
and demand of foreign exchange in the international market. If the demand for foreign exchange rises, its value will also
rise and if demand for foreign exchange falls, its value will also fall.
Similarly, supply of foreign exchange also influences the exchange rate. Greater the supply, lower the rate of exchange.
The point at which demand for foreign exchange and supply of foreign exchange meets, gives the equilibrium rate of
exchange at OR. Any rate above equilibrium would lead to excess supply and any exchange rate below equilibrium
would lead to excess demand.
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23. Giving two examples, explain the relation between the rise in price of a foreign currency and its demand. (Delhi
2011)
Ans. (i) when the price of a foreign currency rises, the imports become costlier and exports become cheaper so the value
of imports will fall with time, hence the demand for foreign exchange will fall.
(ii) When domestic companies want to buy foreign assets and with the rise in price of foreign currency the price of the
assets also increases. Hence, the demand for foreign exchange falls.
24. Distinguish between devaluation and depreciation of domestic currency. (Delhi 2010)
Difference between devaluation and depreciation
Basis Devaluation Depreciation
Meaning Devaluation is the fall in the value of domestic currency in relation to foreign currency
It is planned by the Central Bank in situation, when exchange rate is not determined by the forces of demand and
supply. It occurs when the value of domestic currency decreases in relation to the value of foreign currency in the
foreign exchange market.
Example A government has set 10 units of its currency is equal to one dollar. If US $ exchanges ? 45 instead
of ? 40 earlier the domestic currency (Indian rupee) has shown depreciation of domestic currency.
25. Giving two examples, explain why there is a rise in demand for a foreign currency when its price falls? (All India
2010)
Ans. (i) when there is a fall in the price of foreign currency, the import gets cheaper. It encourages the importers to
import more and consequently, the demand for that foreign currency increases.
(ii) When the price of a foreign currency falls, the price of foreign assets also falls. It encourages domestic people and
companies to buy foreign assets and consequently, the demand for that foreign currency increases.
26. Distinguish between fixed and flexible foreign exchange rate. (All India 2010)
Ans. Fixed exchange rate is the system, under which the central authority or government maintains their exchange rate
fixed either against gold or some other foreign currency. Whereas the rate of exchange which is determined by the
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market forces of demand and supply of foreign currencies in the foreign exchange market, is termed as flexible
exchange rate.
27. Give meanings of fixed, flexible and managed floating exchange rates.
Ans. Fixed and flexible exchange rate
The rate of exchange which is determined by the market forces of demand and supply of foreign currencies in the
foreign exchange market, is termed as flexible exchange rate system.
Managed floating exchange rate The system of adjusting the exchange rates as per the rules and regulations of foreign
exchange market is termed as managed floating.
28. What is meant by appreciation and depreciation of domestic currency? Explain. (All India 2010)
Ans. When the value of domestic currency increases in relation to a foreign currency due to demand and supply forces in
a free market, it is termed as appreciation of the domestic currency.
Depreciation of the domestic currency occurs when the value of domestic country’s currency decreases in relation to the
foreign currency.
For example, Increase in exchange rate is currency depreciation and decrease in exchange rate is currency appreciation.
(i) When Rs./$ exchange rate falls from 55 to 50 , it is termed as appreciation of domestic currency (i.e. Indian rupee) –
(ii) When Rs./$ exchange rate rises from 50 to 55, it is termed as depreciation of domestic currency .
29. Explain the meaning and two merits of fixed foreign exchange rate. (Delhi 2010,2009)
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Ans.Fixed foreign exchange rate
Two merits of fixed foreign exchange rate are:
(i) Less speculation in the currency market.
(ii) Encourages international trade and investment flows.
30. State two sources each of demand and supply of foreign exchange.
Ans. Two sources of demand for foreign exchange are:
(i) Imports from rest of the world.
(ii) Foreign investment across the world.
Two sources of supply of foreign currency are:
(i) Exports of goods and services from domestic country to foreign country .
(ii) Remittances from abroad.
4 Mark Questions
31. Explain two merits each of fixed exchange rate and flexible exchange rate. (Delhi 2009; All India 2009)
Ans. Merits of fixed exchange rate are as follows:
(i) Minimises exchange rate fluctuations.
(ii) Encourages international trade and investment flows.

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Merits of flexible exchange rate are as follows:
(i) Independent monetary policy.
(ii) No need to maintain huge stock of gold or other currency.
32. How is foreign exchange rate is determined in the market?(All India 2009)
Foreign exchange rate is determined by the market forces of demand and supply in foreign exchange market. The point
where demand and supply of foreign exchange meet, gives the equilibrium rate of exchange
, D stands for the demand for foreign exchange and 5 curve represents the supply of foreign exchange for different
values of R i.e. rate of exchange. Point E is the equilibrium point, where D =5, so R will be the rate of exchange. If the
rate of exchange is arbitrarily fixed other than R, there wi 11 be a situation of either excess demand or excess supply of
foreign exchange, so R is the rate of exchange which is obtained from the equilibrium point E. Any disequilibrium will be
adjusted automatically by the forces of demand and supply of foreign exchange to attain equilibrium.
6 Mark Question
33. Give the meaning of foreign exchange and foreign exchange rate. Giving reason, explain the relation between
foreign exchange rate and demand for foreign exchange. (All India 2012)
Ans. Foreign exchange Foreign exchange rate is determined by the market forces of demand and supply in foreign
exchange market. The point where demand and supply of foreign exchange meet, gives the equilibrium rate of exchange
as shown in figure and quantity of foreign exchange.
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Foreign exchange rate Foreign exchange rate refers to the rate at which one currency can be exchanged for the other
currency in foreign exchange market, e.g. if Rs. 58 is paid to buy one US dollar, then Rs./$ exchange rate will be 58 i.e.
Rs.58 per dollar.
Relation between foreign exchange rate and demand for foreign exchange There is an inverse relationship between the
foreign exchange rate and demand for foreign exchange, with the rise in foreign exchange rate, demand for foreign
exchange falls and vice-versa.
In the above figure, D curve represent the demand for foreign currency. When exchange rate is high (R1), demand for
the foreign currency falls (Q1,). On the other hand, when exchange rate is low (R2), demand for the foreign currency
rises Q2. The demand curve for the foreign currency is always downward sloped and signifies an inverse relationship
between demand and exchange rate i.e. price of foreign exchange.
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CHAPTER 7. Balance of Payments
1. Balance of Payments The Balance of Payment (BoP) of a country is a systematic record of all economic transactions
between its residents and residents of foreign countries.
2. Classification of Economic Transactions in BoP
(i) Visible items (physical goods)
(ii) Invisible items (services)
(iii) Capital transfers (capital receipts and payments)
(iv) Uni-lateral transactions
3. Balance of Trade The difference between export and import of goods, i.e. only the visible items of economic
transactions is termed as Balance of Trade.
Balance of Trade = Export of Goods – Import of Goods
Balance of Trade does not include the export and import of invisible items (services) or capital transfers.
4. Components of BoP Account
(i)Current account
(ii) Capital account
(iii) Official international reserve account
5. Current Account of BoP Current account is that account of BoP, which records exports and imports of visible and
invisible items and unilateral transfers.
6. Components of Current Account
(i) Export and import of visible items
(ii) Exports and imports of invisible items
(iii) Unilateral transfer to and from rest of the world.
7. Capital Account of BoP It records capital transfer such as loans and investments between one country and the rest of
the world, which causes a change in the assets or liability status of the residents of the domestic country or its
government.
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8. Components of Capital Account
(i)Investment to and from rest of the world which includes FDI and FII.
(ii) Borrowing and lendings to and from rest of the world.
(iii) Foreign exchange reserves.
9. Official International Reserve Account Official international reserve account includes the foreign exchange reserves,
gold reserves and Special Depository Receipts (SDRs).
10. Autonomous Items in BoP :Autonomous items, also termed as ‘above the line items’, are those items, these
transactions are done by consideration of profit (economic motive). Hence, these transactions have nothing to do with
the state of BoP.
11. Accommodating Items of BoP: Accommodating items, also termed as ‘below the line items’, are those items of BoP
that are not determined by considerations of profit but to restore identity of BoP i.e. to balance the BoP.
12. Balance of Payments Identity
Current Account + Capital Account + Official Reserve = 0
Current Account + Capital Account = – (Official Reserve)
13. BoP Surplus: When the receipts of the country on account of autonomous transactions exceed the payments
of a country on account of autonomous transactions, this difference is termed as BoP surplus.
BoP Surplus = R > P, where R = Receipts of the country, P = Payment of the country.
14. BoP Deficit When the payments of a country on account of autonomous transactions exceed the receipts of a
country on account of autonomous transactions, this difference is termed as BoP deficit.
BoP Deficit = Receipts on account of autonomous transactions < Payments on account of autonomous transactions or
Bop Deficit = R<P
Where, R = Receipts
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P = Payments .
Disequlibrium in BoP
BoP is said to be in state of disequilibrium when there is either surplus or deficit in BoP.
Causes of Disequilibrium in BoP
(i) Economic factors
(ii) Social factors
(iii) Political factors
1 Mark Questions
1. What is the meaning of deficit in Balance of Payments? (Delhi 2014,2010)
or
How is Balance of Payment ‘deficit’ measured? Explain(Foreign 2014)
Ans. When the payments of a country on account of autonomous transactions exceed the receipts of the country on
account of autonomous transactions, this difference is termed as BoP deficit.
Deficit in BoP = Receipts on account of autonomous transactions < Payments on account of autonomous transactions
Suppose, the receipts of the domestic country is r 200 crore. Where as payments are r 220 crore. Then BoP deficit will be
= 220 – 200 crore = Rs. 20 crore
2. Distinguish between current account and capital account of the Balance of Payments account on the basis of its
components.(Compartment 2014)
Ans. Current account of BoP measures the transaction of export and import natures which do not affects the assets and
liabilities positions of a country whereas, capital of BoP includes of Investment and borrowing nature which has direct
import on assets and liabilities of a country.
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Current account includes export and imports of visible and invisible items and unilateral transactions to and from
abroad, while capital account includes:
(a)Investment to and from abroad,
(b) Borrowings and landings to and from abroad
(c) Official reserves which contains foreign currency, SDRs and gold.
3. Give meaning of Balance of Trade (Delhi 2014)
or
What is trade balance? (All India 2010,2008)
Ans. The difference between export and import of goods, i.e. only the visible items of economic transactions is termed
as Balance of Trade.
4. Name two invisible items of the Balance of Payments account. (Delhi 2010c)
Ans. Two invisibles of the Balance of Payments account are:
(i) Banking services (ii) Insurance services
5. What does a deficit in Balance of Trade indicate? (All India 2009)
Ans. A deficit in Balance of Trade indicates that the value of exports of goods are less than the imports of goods for a
country.
3 Mark Questions
6. Distinguish between autonomous and accommodating transactions of Balance of Payments account. (All India
2014,2010; Delhi 2010c)
Ans. Autonomous items, also termed as ‘above the line items’, are those items, which are related to transactions which
are determined by considerations of profit (economic motive) and hence, was no concern with the state of BoP.
Autonomous transactions are present in both current and capital account of BoP, While accommodating transactions
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are present only in capital account of BoP. Accommodating items, also termed as ‘below the line items’, are those items
of BoP that are not determined by considerations of profit but to restore identity of BoP.
The difference between autonomous and accommodating transacting is mat while deficit or surplus in BoP due to
autonomous items, the accommodating items, are meant to restore the BoP identity.
7. Distinguish between Balance of Trade and balance on current account. (Delhi 2013)
or
Distinguish between Balance of Trade and balance on current account of Balance of Payments. (All India 2013)
Ans. Difference between Balance of Trade and balance on current account
Basis Balance of Trade Balance on current account
Meaning Balance of Trade includes only visible items. It is the difference between exports and imports
of goods of a country. Balance of current account is the difference between sum of credit items and sum of debit items
on current account.
Coverage Balance of Trade does not record any transactions of invisible items and transfers Balance of
current account includes balance of visible items, balance of invisible items and balance of unilateral transfer.
Concept Balance of Trade is a narrow concept and it is only a part of the Balance of Payment account. Balance
of current account includes the Balance of Trade hence, it is a broader concept.
8. State the components of capital account of Balance of Payments. (Delhi 2011)
Ans. Components of capital account of Balance of Payments:
(i) Investments It includes investments to and from abroad in the form of FDI and Fll. Investment from abroad is a
‘credit’ item, whereas investment to abroad is a ‘debit’ item.
(ii) Borrowing and lending It includes the borrowings by residents from the residents of abroad (credit item), and sending
to the resident of foreign country (debit item).
(iii) Foreign exchange It includes the reserve of foreign currency gold and Special Drawing Rights (SDRs) with the
domestic country.
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9. What does a Balance of Payments account show? Name the two parts of the Balance of Payments account. (Delhi
2011)
Ans. The Balance of Payment (BoP) of a country is a systematic record of all economic transactions between its residents
and residents of foreign countries. It summarises the exports and imports and other international transaction of a
country with other countries.
Two parts of Balance of Payments account are as follows:
(i) Current account (ii) Capital account
10. Which transactions determine the Balance of Trade? When is Balance of Trade in surplus? (All India 2011)
Ans. The transactions involving export and import of goods, i.e. only the visible items of economic transactions,
determine the Balance of Trade. Balance of Trade is in surplus, when the value of export of goods are more than the
value of import of goods.
11. List the transactions of current account of the Balance of Payments.
(All India 2011; Delhi 2008C)
Ans. The transactions included in the current account of the Balance of Payments are:
(i) Export and import of visible items (ii) Export and import of services (invisible items)
(iii) Unilateral transfers
12. Explain the concept of surplus in the Balance of Payments account. (All India 2010)
Ans. Balance of surplus When the receipts of the country on account of autonomous transactions exceed the payments
of a country on account of autonomous transactions, this difference is termed as BoP surplus.
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BoP Surplus = R>P, where R = Receipts of the country, P = Payment of the country, e.g., if the receipts of the country is
Rs. 200 crore and the payments are Rs. 190 crore, then BoP surplus will be (200 -190) = Rs. 10 crore.
4 Mark Questions
13. What is Balance of Payments account? Where are borrowings from abroad recorded in it and why? (Delhi
2011,2009c)
Ans. Balance of Payment The Balance of Payment (BoP) of a country is a systematic record of all economic transactions
Balance of Payments account are classified into current account and capital account. Borrowing from abroad are
recorded in the capital account (credit side) of Balance of Payments as it is a foreign liability on the country and it is to
be repaid with interest.
14. What is Balance of Payments? Give meanings of trade balance and current account balance. (Delhi 2011; All India
2011,2009)
Ans. Balance of Payment
Balance of Payment The Balance of Payment (BoP) of a country is a systematic record of all economic transactions
Trade Balance The difference between export and import of goods, i.e. only the visible items of economic transactions is
termed as Balance of Trade.
Balance of Trade = Export Goods – Import of Goods
Current account balance Current account is that account of BoP, which records exports and imports of visible and
15. Giving reasons, state whether the following statements are true or false
(i) Current account of Balance of Payment account records only export and import of goods and services.
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(ii) Foreign investments are recorded in the capital account of Balance of Payments. (All India 2011)
Ans. (i) False, as current account of Balance of Payments account also records unilateral transfers.
(ii) True, as all kind of foreign investments (foreign direct investments and portfolio investments) are included in the
capital account of Balance of Payments as they affect the assets positions of the country.
16. Giving reasons, state whether the following statements are true or false.
(i) Excess of foreign exchange receipts over foreign exchange payments on account of accommodating transactions
equals deficit in the Balance of Payments.
(ii) Export and import of machines are recorded in capital account of Balance of Payments account. (Delhi 2011C)
Ans. (i) False, as accommodating transactions removes both surplus and deficit of Balance of Payments account.
(ii) False, export and import of machine, it will be recorded in current account as it is a producer good exported.
17. State whether the following statements are true or false. Give reasons for your answer.
(i) Difference between value of exports and imports of goods and services are called Balance of Trade.
(ii) External assistance is not recorded in Balance of Payments account. (Delhi 2011C)
Ans. (i) False, because Balance of Trade only records the export and import of visible items, i.e. goods.
(ii) False, because external assistance are included in the current account of Balance of Payments as unilateral receipts..
19. List the items of the current account of Balance of Payments account. Also define Balance of Trade. (Delhi
2009,2008)
Ans. Components of current account are as follows:
(i) Export and import of goods (visible items).
(ii) Export and import of services (invisible items).
(iii) Unilateral transfers to and from abroad.
Balance of Trade
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Balance of Payment The Balance of Payment (BoP) of a country is a systematic record of all economic transactions
Trade Balance The difference between export and import of goods, i.e. only the visible items of economic transactions is
termed as Balance of Trade.
Balance of Trade = Export Goods – Import of Goods
Current account balance Current account is that account of BoP, which records exports and imports of visible and
19. Distinguish between Balance of Trade account and current account balance of BoP account.(All India 2009,2008)
Ans. Difference between Balance of Trade and current account balance of BoP account
Basis Balance of Trade Balance on current account
Meaning Balance of Trade includes only visible items. It is the difference between exports and imports of goods of
a country. . Balance of current account is the difference between sum of credit items and sum of
debit items on current account.
Coverage Balance of Trade does not record any transactions of invisible items and transfers Balance of
current account includes balance of visible items, balance of invisible items and balance of unilateral transfer.
Concept Balance of Trade is a narrow concept and it is only a part of the Balance of Payment account. Balance
of current account includes the Balance of Trade.
Financing of deficit A deficit in Balance of Trade can be meet out by surplus of current account. Deficit in
current account cannot be meet out by using surplus of BoT.
20. Distinguish between current account and capital account of Balance of Payments. (All India 2008)
Ans. Current account is that account of BoP, which records exports and imports of visible and invisible items and
unilateral transfers. Current account shows the trade position of the country. Whereas capital account shows the assets
and liabilities position of the country.
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It records capital transfer such as loans and investments between one country and the rest of the world, which causes a
change in the assets or liability status of the residents of a country or its government.
6 Mark Question
21. Explain the distinction between autonomous and accommodating transactions in Balance of Payments. Also
explain the concept of Balance of Payments deficit in this context. (Delhi 2012)
Ans. Autonomous items, also termed as ‘above the line items’, are those items, which are related to transactions which
are determined by considerations of profit (economic motive). Autonomous transactions are that transaction between
the residents of two countries which take place due to the considerations of profit. Autonomous items are not
conditioned by the BoP status of the country, i.e. these are independent. Autonomous transactions are not done to
establish identity of BoP. i.e. current account and capital account.
Accommodating items, also termed as ‘below the line items’, are those items of BoP that are not determined by
considerations of profit but to restore identity of BoP. These are undertaken to maintain balance in the BoP account.
These transactions correct the disequilibrium in autonomous items of BoP account. Accommodating transactions are
also known as ‘below the line items’ and include foreign exchange reserve and borrowings to meet BoP deficit.
BoP Deficit
When the payments of a country on account of autonomous transactions exceed the receipts of the country on account
of autonomous transactions, this difference is termed as BoP deficit.
Deficit in BoP = Receipts on account of autonomous transactions < Payments on account of autonomous transactions
Suppose, the receipts of the domestic country is r 200 crore. Where as payments are r 220 crore. Then BoP deficit will be
= 220 – 200 crore = Rs. 20 crore
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KNOWLEDGE CLASSES

Topic 1 : Basic Concepts of Economics

(i) It helps in government policy formulation.

(ii) It facilitates international comparison.

4. Types of Goods Produced in An Economy

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Consumer goods are further classified into:

Previous years Examination Questions

1. Give the meaning of capital goods. (Compartment 2014)

Define capital goods. (Delhi 2012; All India 2010)

2. Give two examples of intermediate goods. (All India 2013)

Ans. Two examples of intermediate goods are:

(i) Steel used in the car.

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3.Define consumption goods. (All India 2012)

4.Define intermediate goods. (Delhi 2011 c)

5.Define final product. (Delhi 2010 c)

Final goods are often classified as:

(i) Final consumer goods (ii) Final producer goods

(i) Furniture purchased by a school.

(ii)Chalks, dusters, etc purchased by school (Delhi 2012)

Ans. (i) Furniture purchased by school — Final product.

(ii) Chalks, dusters, etc purchased by school — Intermediate good

(i) Expenditure on maintenance of an office building.

(ii) Expenditure on improvement of machine in a factory. (All India 2012)

Ans. (i) Expenditure on maintenance of an office building — Intermediate expenditure.

(2) Expenditure on improvement of machine in a factory — Final expenditure

(i) Computers installed in an office.

(ii)Mobile sets purchased by a mobile dealer. (Delhi 2011)

Ans. (i) Computers installed in an office — Final product

(ii) Mobile sets purchased by a mobile dealer — Intermediate products

(i) Machine purchased by a dealer of machines.

(ii) A car purchased by a household. (All India 2010)

Ans. (i) Machine purchased by a dealer of machines — Intermediate goods

(ii) A car purchased by a household — Final goods

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Net Investment = Gross Investment – Depreciation

10. Phases of Circular Flow Income

(ii) Generation of income in terms of wages, rent, interest and profit.

(iii) Expenditure in terms of consumption and investment.

11. Types of Circular Flow of Income

12. Different Sectors in Circular Flow of Income in an Open Economy

(i) Production sector (ii) Household sector

(iii) Government sector (iv) Rest of the world sector

Previous Years Examination Questions

1.Define stock variable. (Delhi 2012; All India 2011)

2. Define flow variable. (All India 2012; Delhi 2011)

3. Define depreciation. (All India 2011)

4.Explain the circular flow of income. (Compartment 2014; Delhi 2009)

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(i) Capital (ii) Saving

(iii) Gross Domestic Product (iv) Wealth

(iv) Wealth :It is a stock as it is measured at a particular point of time.

7. Explain the circular flow of income. (Delhi 2013)

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(iii) Savings (iv) Balance in bank account (All India 2011)

9. Give reasons and categories the following in stock and flow

(i) Losses (ii) Capital

(iii) Production (iv) Wealth (Delhi 2011 c)

(iii) Production: It is a flow as it is measured over a period of time.