EXAM GAP REVISION

AD- AS
GOVT. BUDGET
FOREIGN EX RATE & BOP

BOARD EXAM 2024

 MEANING

AGGREGATE DEMAND (AD)

It refers to Total demand for all Final goods and

services in an economy during a fiscal year
(1st April to 31st March)
COMPONENTS OF AD
 Schedule
Y C I AD= C + I
So AD = C + I + G + (X – M) 0 20 10 30 = 20 + 10
But in two sector economy. 20 25 10 35 = 25 + 10
AD = C + I 40 30 10 40 = 30 + 10
C = Desired consumption, I = Desired 60 35 10 45 = 35 + 10
Investment
80 40 10 50 = 40 + 10
 AGGREGATE SUPPLY (AS)
It is the total production or supply of all goods and services in the economy
during fiscal year.
(i) Consumption: It is the part of income which is spent on consumption (c).
(ii) Savings: It is the part of income which is not consumed i.e. saved. (S).
(iii) Initially saving is negative but after a stage it is positive.
AS= C + S (Y = C + S)
AS is 45 degree line
AS (Output) = Y (National income)

Y C S AS = C + S
100 70 30 100
200 140 60 200
300 200 100 300
 Break even point
It is a point where income is equal to consumption.
savings are equal to Zero
 Equilibrium level of Output/ Income
I. AD-AS Approach: In this approach,
equilibrium level output (GDP) is
achieved when aggregate demand is
equal to aggregate supply. i.e. [AD = AS]

Schedule
Y C I AD S AS
100 150 50 200 -50 100
200 200 50 250 0 200
300 250 50 300 50 300
400 300 50 350 100 400
500 350 50 400 150 500
What happens if AD > AS ?
• When AD is greater than AS,
flow of goods and services in the
economy tends to be less than
their demand.
• Producers need to produce
more goods and services in the
economy.
• Whole existing stock sold out
producers would suffer the loss of
unfulfilled demand.
What happens if AD < AS ?
• When AS is more than AD,
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 stock, the
producer would plan a cut in
production. Consequently, AS
would reduce to become equal
to AD.
 II. S-I Approach:
In saving investment approach
equilibrium level of output (GDP)
is achieved when planned saving is
equal to planned investment. i.e.
[S = I]
Schedule
Y S I
0 -10 10
100 0 10
Point “e” is equilibrium point where
200 10 10 (S = I) at full employment level of
300 20 10 income ₹200.
 What happens if S > I ?
It implies that when planned savings
(S) is greater than the planned
investments (I) is to the circular flow
of income. Accordingly, overall
expenditure in the economy would
remain lower than what is require to
buy the planned output.
Some output would remain unsold
and producers will have undesired
stock. To clear their stocks, the
producer would now plan lesser
output. The process would continue
till S = I.
What happens if S < I ?
It implies that planned savings (S) is
less than planned investments (I) into
the circular flow of income.
Accordingly, overall expenditure in
the economy would turn out to be
greater than what is required to buy
the planned output. Here the
producers would suffer the losses of
unfulfilled demand. To manage the
situation, the producer would now
plan higher production.
The process would continue till S = I
A. Excess Demand
It refers to the situation when
aggregate demand (AD) is in
excess of aggregate supply (AS)
corresponding to full employment
level of output in the economy.
AD > AS
Inflationary gap is
⇒ AD1 – AD
Causes of Excess Demand and Inflationary Gap
(i) increase in private final consumption expenditure.
(ii) increase in private investment expenditure.
(iii) increase in govt. final consumption expenditure.
(iv) increase in govt. investment expenditure.
(v) Increase in exports, owing to lower domestic prices in relation to
international prices.
(vi) Decrease in imports, owing to higher international prices as compared to
domestic prices.
(vii) A cut in tax rates leads to higher disposable income of people.
B. Deficient Demand
It refers to the situation when
aggregate demand (AD) is less than
aggregate supply (AS)
corresponding to full employment in
the economy.
AD < AS
Deflationary gap is
⇒ AD – AD1
 Causes of Deficient Demand and Deflationary Gap
(i) Decrease in private final consumption expenditure.
(ii) Decrease in private investment expenditure.
(iii) Decrease in government expenditure.
(iv) Decrease in exports and increase in imports.
(v) Increase in tax rate leads to decrease in disposable income of people.
 Full employment and involuntary unemployment
(i) Full employment

(a) Structural unemployment

(b) Frictional unemployment
(c) Voluntary unemployment
(d) Involuntary unemployment
Measures to correct Excess demand & deficient demand
A. Fiscal measures (By the government)
B. Monetary policy (By RBI)
A. Fiscal Policy (Fiscal Measures) It refers to budgetary policy of the
government to correct the situation of excess demand and deficient
demand.
Common instruments are
a) Government spendings
b) Taxation policy
 PROPENSITY TO CONSUME & PROPENSITY TO SAVE

APC (Average Propensity to Consume) It is the part of income

which is consumed. (or) It shows the relationship between
consumption and income.
APS (Average Propensity to Save) It is the part of income which is
saved. It shows the relationship between savings and income.
MPC (Marginal propensity to consume) It shows change in consumption
due to change in income. MPC is always more than zero less than one.
 MUST REMEMBER

# MPC of Poor is More than MPC of Rich.

# MPC falls with successive increase in income.
MPS (Marginal propensity to save) It shows change in savings due to
change in income.
 Consumption Function
The functional relationship between C and Y is called consumption function.
 Saving Function
It is the functional relationship between S and Y (income)
S = – a + (1 – b)Y
Here S = Saving
Note:
• MPC is slope of consumption
function.
• MPC is constant at each level.
• MPS is slope of saving function
• MPS is constant for a straight line
S-function
 INVESTMENT MULTIPLIER
It measures change in income due to change in investment in the economy.
We have noted that increase in income is many times more than the increase
in investment. The number of times by which the increase in income exceeds
the increase in investment is called investment multiplier or output multiplier.
It is denoted by “K”
Working of investment multiplier with a numerical example.

Investment Multiplier Process Assume MPC = 0.8 i.e. 80%

Round Increase in Increase in Increase in
Investment income consumption
1 100 100 80
2 - 80 64
3 - 64 51.20
All other Round - 256 204.80
Total 100 500 400
The above table clearly shows that initial increase in investment of `100
crores has resulted in an increase of additional income of `500 crores.
i.e. the resultant increase in income is 5 times the initial investment.

• Ex – ante saving: It refers to planned saving in an economy in a year.

• Ex – ante investment: It refers to planned investment in an economy in
a year.
• Ex – post investment: It refers to the actual amount of investment in
an economy during a year.
• Ex-post saving : It refers to actual savings in an economy in a year
ALL FORMULAE
GOVERNMENT BUDGET
 Government Budget
It is a statement of expected receipts and expected expenditures of the
government for a fiscal year.
Every government prepares budget whether it is local, state and central
government.

First day of the month of February is well

known in India as a day the Finance
Minister present annual budget of the
government called
Union Budget of India
 OBJECTIVES OF GOVERNMENT BUDGET
Budget is not only a statement but it is a reflection of Government policies and set of objectives
that the government seeks to achieve over time

04
03
Allocation of Resources
02
Redistribution of
01 Economic income and wealth
stability
Managing Public
Sector Enterprise
 Government Budget Components

Budgetary Receipts Budgetary Expenditure

Revenue Receipts Capital Receipts Revenue

Expenditure
Tax Non-Tax Capital
Expenditure
Direct Tax
Fines ,Fees, Escheat, Recovery of loan,
Income tax,
Corporation tax, gift Grants/Donation, Disinvestment,
tax, wealth tax, etc. Income from public Borrowing and other
enterprises, liabilities.
Interest.
Indirect Tax
Goods and services tax, custom duty, etc.
 Difference between Revenue Receipts & Capital Receipts
Basis Revenue Receipts Capital Receipts
Meaning These are those receipts of the These are those receipts of the
government which don’t leads to government which leads to
reduction in any assets nor reduction in any assets or creation
creation of any liabilities of any liabilities
Nature These are recurring in nature. These are non recurring in nature.
Debt Revenue receipts are not debt Some capital receipts like
Creation creating borrowing are debt creating
Examples Tax receipts, fees, fines, interest, Recovery of loans, disinvestments
penalties, etc. (PSU) & borrowings.

Formula: Total Receipts = Revenue receipts + Capital receipts

 Difference between Revenue Expenditure & Capital Expenditure
Basis Revenue Expenditure Capital Expenditure
Meaning These are those expenditure of These are those expenditures of
the government which don’t the government which leads to
leads to creation of any assets creation of any assets or reduction
nor reduction of any liabilities. of any liabilities.
Nature These are recurring in nature. These are non recurring in nature.
Purpose These are incurred on normal These are incurred on acquisition
functioning of the government. of assets and granting loans
Examples Interest, subsidies, expense on Acquisition of machinery,
collection of taxes, donation, construction of school, hospital,
pensions, etc building, repaid loans, etc.
Formula: Total expenditure = Revenue expenditure + Capital expenditure
Formulae:
Total receipts = Revenue receipts + Capital receipts
Revenue receipts = Tax revenue + Non tax revenue
Tax revenue = Direct tax + Indirect tax
Capital receipts = Recovery of loans + Disinvestment + Borrowings
Situation in Government Budget

(i) Balanced budget / Equilibrium Budget: It is a situation when budgetary

expenditure is equal to budgetary receipts.
TR = TE
(ii) Surplus Budget: It is a situation when budgetary receipts are greater than
budgetary expenditure. In situation of inflation, surplus budget is prepared by
the government.
TR > TE
(iii) Deficit Budget: It is a situation when budgetary expenditures are greater
than budgetary receipt. In situation of deflation, deficit budget is prepared by
the government.
TE > TR
 Budgetary Deficit are Three types

Revenue Deficit Fiscal Deficit Primary Deficit

Budgetary Deficit = Total expenditure – Total receipts

(i) Revenue deficit: It is the excess of revenue expenditures over revenue receipts.
RD = RE – RR, Here (RE > RR)
IMPLICATIONS OF REVENUE DEFICIT
Since revenue receipts and revenue expenditures are related largely to recurring
expenses of the Government (as on administration & maintenance) High revenue
deficit gives a warning signal to the government either to cut its expenditure or
increase its tax/non tax receipts. In less developed countries like India, it is difficult to
force the poor people to pay high tax. In such situation, the Government is compelled
to cope with high revenue deficit through borrowings or disinvestment. Borrowings
creates liability of the Government whereas disinvestment cause reduction in assets
of the Government
(ii) Fiscal deficit: It is the excess of Total expenditure over Total receipts other
than borrowings.
i.e. Fiscal deficit is equal to borrowings of the Government Fiscal deficit =
TE – TR (excluding borrowings)
⇒ Fiscal deficit = Total expenditure – Revenue Receipts – Capital receipts
excluding Borrowings
⇒ Fiscal deficit = (RE + CE) – RR – Recovery of loan – Disinvestment
⇒ Fiscal deficit = Budgetary deficit + Borrowing & Other liabilities
IMPLICATIONS OF FISCAL DEFICIT
Greater fiscal deficit implies greater borrowings by the Government.
(a) It causes Inflation: Government borrowings includes borrowing from RBI.
It increases circulation of money in economy and cause inflation.
(b) Increase foreign dependence: Government also borrows from rest of the
world. It increases our dependence on other countries.
(c) It accumulates financial burden for future generation to repay the loan with
interest.
(d) Increase in fiscal deficit implies increase in borrowings i.e. ultimately leads
to increase in interest expenditure i.e. increase in revenue deficit also. It is also
called Debt Trap.
(iii) Primary Deficit: It is the difference between fiscal deficit and interest
payment
Primary Deficit = Fiscal deficit – Interest payment
While fiscal deficit shows borrowings requirement of the Government including
of interest payment on the accumulated national debt. Primary deficit shows
borrowing requirement of the Government exclusive of interest payment.
Tax Receipt = Direct Tax + Indirect Tax
Q.1) Given the following data estimate the value of: (i) Revenue deficit; (ii) Fiscal
deficit:

Particulars Amount
Tax revenue 1,000
Non-tax revenue 150
Net borrowings by government 780
Disinvestment proceeds 50
Revenue expenditure 1,500
Capital expenditure 480
FOREIGN EXCHANGE
RATE
 Foreign exchange rate refers to the rate at
which one unit of foreign currency can be
exchanged for number of units in domestic
currency.
OR
It is the price paid in domestic currency in order
to get one unit of foreign currency.

Example: $1 = ₹83 or ₹1 = $ 1/83

 Types of Exchange rate

01 Fixed exchange rate system

02 Flexible (or) floating exchange rate system

03 Managed Floating Rate system

(Hybrid)
 1. Fixed exchange rate system
Fixed exchange rate system is a rate of exchange which is fixed by the
government. Historically, it has two important variables:
Gold standard system of exchange: Bretton woods system of exchange
According to this system before 1920’s gold According to this system US $ was taken
was taken as common unit of exchange as common unit of exchange between
between the currencies of different the currency of different countries.
countries. Each country was to define value Different currencies are related to one
of its currency in terms of gold. Accordingly currency i.e. US $ (dollar). Each country
value of one currency in terms of the other was to define value of its currency in
currency was fixed considering gold value of terms of US Dollar.
each currency. e.g. 1 UK £ = 4 gm gold, 1 US It is also called Adjustable peg system of
$ = 2 gm gold then 1 UK £ = 2 US $ exchange.
(exchange ratio between UK and US)
This system is also known as mint par value
of exchange or mint parity.

SUNIL PANDA COMMERCE CLASSES

 Merits and Demerits of fixed exchange rate system
Merits Demerits
a) Stability in the exchange rate a) Huge Gold reserve required
b) Promotes international Trade b) Difficulty in fixing the exchange
and investment rate
c) Prevent speculative activities c) Problem of undervaluation and
d) Free Market overvaluation
2. Flexible (or) floating exchange rate system
It is the rate which is determined by the demand for and supply of different
currencies in the foreign exchange market. In other words, flexible exchange
rate is determined by the market forces. The exchange rate at which demand
for foreign currency is equal to supply of foreign currency is called equilibrium
rate or normal rate or par rate of exchange. It is a flexible rate because it tends
to change in accordance with changes in the demand and supply for different
currencies in the foreign exchange market
 Merits and Demerits of flexible exchange rate system
Merits Demerits
a) Equilibrium level is determined a) Instability in the exchange
b) No need of huge Gold reserves rate
c) Free Market, No Unwanted b) Speculative activities
Control of Government c) Creates inflationary situation
d) No problem of undervaluation d) Risk of Foreign Trade and
& Overvaluation Foreign investment
3. Managed floating rate system
It is a system in which exchange rate is determined by the market forces of
demand and supply in international money market, but when domestic
currency is heavily depreciating then Reserve Bank of India Intervenes to
place some influence on the exchange rate so that it remains with in the
desired limits. It is also known as ‘Dirty floating’. Here RBI sells foreign
exchange in international money market. So that supply of foreign
exchange increases managed floating is a hybrid of a fixed exchange rate
and a flexible exchange rate system.
DEMAND FOR FOREIGN EXCHANGE
(OR)
Why foreign exchange is Demanded
(OR)
What are the sources of demand for foreign exchange?
• To purchase goods and services from other countries.
• To purchase assets (like land, shares, bond, etc.)
in other countries.
• Payment of international loans.
• Gift and grants sent to rest of the world.
• Foreign exchange is needed to undertake foreign tours.

There is an inverse relationship between Demand for foreign exchange and foreign
exchange rate.
Increase in foreign exchange rate leads to decrease in demand for foreign exchange
and vice-versa
 SUPPLY FOR FOREIGN EXCHANGE
(OR)
Why foreign exchange is Supplied?
(OR)
What are the sources of supply of foreign exchange?
• Export of the country to rest of the world.
• Foreign direct investment (FDI).
• Gift / donation / Remittance received from foreign countries.
• Supply of foreign exchange also comes when foreign tourists come in to Home
Country
There is a Direct relationship between supply of foreign exchange and foreign exchange
rate.
Increase in foreign exchange rate leads to increase in supply of foreign exchange and
vice-versa
Equilibrium Rate of Exchange

SUNIL PANDA COMMERCE CLASSES

 Depreciation of Domestic Currency
(Or) Appreciation of Foreign Currency
There are two reasons behind depreciation of domestic
currency.
(i) Increase in demand for foreign currency. An increase in
demand for foreign exchange leads to raise in foreign
exchange rate. In the given diagram as Demand increases
from DD to D′D′ then exchange rate increases from OR to
OR′.
(ii) Decrease in supply of foreign currency.
A decrease in supply of foreign exchange leads to raise
in foreign exchange rate. In the given diagram as supply
decreases from SS to S′S′ then exchange rate increases
from OR to OR′.
Increase in Export and Decrease in Imports
SUNIL PANDA COMMERCE CLASSES
 Appreciation of Domestic Currency
(OR) Depreciation of Foreign Currency

There are two reasons behind appreciation of domestic

currency.
(i) Increase in supply of foreign currency. An increase in
supply of foreign exchange leads to fall in foreign exchange
rate. In the given diagram as supply increases from SS to
S′S′ then exchange rate decreases from OR to OR′

(ii) Decrease in Demand for foreign currency

A decrease in demand of foreign exchange leads to fall
in foreign exchange rate. In the given diagram as
Demand decrease from DD to D′D′ then exchange rate
decreases from OR to OR′.
Increase in Imports and Decrease in Exports
SUNIL PANDA COMMERCE CLASSES
Difference between Devaluation and Depreciation of domestic currency.
Basis Devaluation Depreciation
Meaning It refers to fall in price of It refers to fall in price of
domestic currency under domestic currency under
fixed exchange rate system flexible exchange rate
system.
Control It is under the control of It is under the control of
Government. market forces of demand
and supply
Exchange rate It was in fixed exchange It is in flexible exchange rate
system rate system. system

SUNIL PANDA COMMERCE CLASSES

BALANCE OF
PAYMENTS
 BALANCE OF TRADE
Balance of Trade:
It is the difference between the value of
goods exported and value of goods
imported.
BOT = Export value – Import value
[Only Tangible/ Visible goods]
It is a Narrow concept as Compared to
Balance of payments.

Types of Balance of Trade can be:

Favorable Balance Unfavorable Equilibrium

of Trade Balance of Trade Balance of Trade
 BALANCE OF PAYMENTS
It is a statement that records all economic
transactions of a country with rest of the
world.

Balance of payments includes the following

04
03
Capital transfers
02
Unilateral
01 transfers
Invisible items
Visible items
 Export and import
of goods
Current Account Export & import
in BOP of services
Balance of Payment
have two Accounts
Unilateral
transfers
Foreign direct investment
Foreign (FDI)
Investments Portfolio investment (foreign
institutional investment)
Capital Account in Commercial Borrowings
BOP
Borrowings /
Loans Borrowing from international
Change in foreign monetary fund (IMF)
exchange reserves
Equilibrium in BOP: Current account balance + Capital account balance = 0
There is no movement of official reserves of the Central Bank.
i.e. inflow of foreign exchange = outflow of foreign exchange.
Disequilibrium in BOP: When current account Balance + Capital account
Balance is not equal to zero. (It may be Positive and Negative).
(i) Surplus BOP: Here autonomous receipts are more than the autonomous
payments.
(ii) Deficit BOP: Here autonomous receipts are less than the autonomous
payments.
BOP is always balances, in case there is imbalance, it is corrected through
accommodating transactions.
 Difference Between Autonomous and Accommodating Transactions
AUTONOMOUS TRANSACTION ACCOMMODATING TRANSACTIONS
Autonomous items refers to those Accommodating items refer to those
international Transactions which occur due transaction which take place to cover
to some economics motive such as profit deficit or surplus in autonomous
maximization eg. Import of machinery transactions. e.g. withdrawal from foreign
from Japan, FDI, etc. exchange reserve, loan from IMF, etc. to
maintain BOP
These items are independent in nature These items are dependent in nature
These item take place on both current and These item take place only on capital
capital account account
These items are also known as above the These items are also known as below the
line items as they are recorded as first item line items, as they are recorded as
before calculating deficit or surplus in BOP secondary item after calculating deficit or
surplus in BOP
 THANK YOU
MUST LEARN THIS BEFORE NEXT CLASS
WRITE ALL IMP POINTS IN YOUR NOTE BOOK
SO THAT YOU CAN REVISE ALL THESE IN SHORT SPAN OF TIME ONE DAY
BEFORE EXAM

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