Various concepts of national income

Meaning of National Income. National income reflects the sum total of money value of
goods and services produced during a year in a country. The income derived from the
international trade is also included in the national income. In other words, national income is
the total of all income payments received by the factors of production-land, labour, capital
and entrepreneur-the net cost of producing the national product. In the words of Edward
Shapiro, "National income is the sum of wages, interest, rent and profit for the time period."
In the words of J.L. Hanson. "There are two ways of looking at the national income of a
country. It can be regarded either as the money value of the total volume of production of
goods and services or the total of all incomes derived from economic activity, during a
specific period, generally one year. Thus national income and volume of production are really
alternative terms for the same thing."

We know that national output is the flow of goods and services which becomes available to
the community during a year. In other words, it is the net output of commodities and services
flowing during the year from the country's productive system into the hands of the ultimate
consumers or into net addition to the country's capital goods.

Suppose an individual or a firm produces goods and services in a year. The income earned by
a firm or an individual from the production of goods and services in a particular time period
is called income of an individual or a firm. The incomes received by various individuals and
firms constitute the income of the entire nation. We can also say that national income is a
flow which is the sum total of the incomes of different sectors. In the words of Peterson,
"National income is a flow of output over a period of time. National income means value of
total output

The important concepts of national income are:

1. Gross Domestic Product (GDP)

2. Gross National Product (GNP)

3. Net National Product (NNP) at Market Prices

4. Net National Product (NNP) at Factor Cost or National Income

5. Personal Income

6. Disposable Income

Let us explain these concepts of National Income in detail.

1. Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total market value
of all final goods and services currently produced within the domestic territory of a country in
a year.

Four things must be noted regarding this definition.

First, it measures the market value of annual output of goods and services currently produced.
This implies that GDP is a monetary measure.

Secondly, for calculating GDP accurately, all goods and services produced in any given year
must be counted only once so as to avoid double counting. So, GDP should include the value
of only final goods and services and ignores the transactions involving intermediate goods.

Thirdly, GDP includes only currently produced goods and services in a year. Market
transactions involving goods produced in the previous periods such as old houses, old cars,
factories built earlier are not included in GDP of the current year.

Lastly, GDP refers to the value of goods and services produced within the domestic territory
of a country by nationals or non-nationals.

2. Gross National Product (GNP): Gross National Product is the total market value of all
final goods and services produced in a year. GNP includes net factor income from abroad
whereas GDP does not. Therefore,

GNP = GDP + Net factor income from abroad.

Net factor income from abroad = factor income received by Indian nationals from abroad –
factor income paid to foreign nationals working in India.

3. Net National Product (NNP) at Market Price: NNP is the market value of all final goods
and services after providing for depreciation. That is, when charges for depreciation are
deducted from the GNP we get NNP at market price. Therefore‟

NNP = GNP – Depreciation

Depreciation is the consumption of fixed capital or fall in the value of fixed capital due to
wear and tear.

4. Net National Product (NNP) at Factor Cost (National Income): NNP at factor cost or
National Income is the sum of wages, rent, interest and profits paid to factors for their
contribution to the production of goods and services in a year. It may be noted that:

NNP at Factor Cost = NNP at Market Price – Indirect Taxes + Subsidies.

5. Personal Income: Personal income is the sum of all incomes actually received by all
individuals or households during a given year. In National Income there are some income,
which is earned but not actually received by households such as Social Security
contributions, corporate income taxes and undistributed profits. On the other hand there are
income (transfer payment), which is received but not currently earned such as old age
pensions, unemployment doles, relief payments, etc. Thus, in moving from national income
to personal income we must subtract the incomes earned but not received and add incomes
received but not currently earned. Therefore,

Personal Income = National Income – Social Security contributions – corporate income taxes
– undistributed corporate profits + transfer payments.
Disposable Income: From personal income if we deduct personal taxes like income taxes,
personal property taxes etc. what remains is called disposable income. Thus,

Disposable Income = Personal income – personal taxes.

Disposable Income can either be consumed or saved. Therefore,

Disposable Income = consumption + saving.

CIRCULAR FLOW OF INCOME

The circular flow of income and product is the flow of goods and services among different
sectors of the economy. (Household sector, Producing sector, Government Sector & Foreign
Sector). When we talk about only Household and producing sector, it is called TWO
SECTOR economy Model. Also called Private closed economy model.

Household Sector + Producing Sector = Two Sector economy

Household Sector + Producing Sector + Govt. Sector = Three Sector economy Or closed
Economy

Household Sector + Producing Sector + Govt. Sector + Rest of the World = four Sector
economy Or Open Economy

There is a flow of Income & Expenditure among these, which is called „Circular Flow of
Income‟.

Circular Flow of Income in TWO sector Economy

It is a model of private closed economy. Circular flow of income in a two sector economy
consists following assumption: -

1. There are only two sectors, i.e., household sector and firm sector in the economy.

2. Household sector is the owner of all the factors of production (Land, Labour, Capital &
Entrepreneur).

3. Firm sector hire factor services from household for the production of goods and services.

4. Households sector spends entire income on consumption.

5. Firm sector sell all the products to household sectors.

6. There is no interference of government sector and external sector.

Working of this model

 All factors of production are owned by household sector. Therefore, firm sector hire factor
services from households for the production of goods and services. As a reward of factor
services from household, firm sector makes payment in the form of rent, wages, interest and
profit to household which is called their factor income. This income is used by household on
the purchase of goods and services. In exchange, firm sector sells whatever it produces to
household sector for their consumption.

Households and firms interact in two types of markets.

In the markets for goods and services, households are buyers, and firms are sellers. In
particular, households buy the output of goods and services that firms produce. In the markets
for the factors of production, households are sellers, and firms are buyers. In these markets,
households provide the inputs that firms use to produce goods and services.

Circular Flow of Income in THREE sector Economy

It is the Model of Closed Economy. This model is more close to real life situation. In this
model economic activities of the government have also been accounted for. However, we
continue to assume that the economy is a closed economy. It means the circular flow of
income is influenced by the foreign sector at all.
Working of this model

1) Money flows from firms and households sector to govt. in the form of taxes. Government
receives direct taxes from the households and indirect taxes from the firm sector.

2) Govt sector also provides subsidies (like fertilizer subsidies) to the firm and transfer
payment (scholarship, old age pension etc.) to household. Also money flow from govt. to
firm in the form of govt. expenditure on goods and services.

3) A part of income earned by the government is saved and invested into financial (capital
market). Govt also borrow money form capital market in the form of loan to meet current
expenditure (daily expenses) or development expenditure.

4) Household sectors are the owner of all factors of production. Household sector provide
factor services (L, Lb, K, Ent) only to firms and household received factor payment (Rent,
wages, Interest, profit) from firms.

Circular Flow of Income in FOUR sector Economy

Circular flow of income in four sector economy (Open Economy) consists of households,
firms, governments and Rest of the World.

1) The ROW sector receives income from the producing sector in return for the goods and
services imported by the firm. Thus, the money flows from producing sector to the ROW
sector. The ROW sector makes payment to the producing sector for the purchase of goods
and services exported by the firms. Thus, there is a flow of income from ROW sector to the
producing sector.

2) Household also provides services to the ROW sector and get payment in return. Also
ROW sector provides remittances or any transfer payment to the household sector.
3) Money flows from firms and households sector to govt. in the form of taxes. Government
receives direct taxes from the households and indirect taxes from the firm sector.

4) Govt sector also provides subsidies (like fertilizer subsidies) to the firm and transfer
payment (scholarship, old age pension etc.) to household. Also money flow from govt. to
firm in the form of govt. expenditure on goods and services.

5) A part of income earned by the government is saved and invested into financial (capital
market). Govt also borrow money form capital market in the form of loan to meet current
expenditure (daily expenses) or development expenditure.

6) Household sectors are the owner of all factors of production. Household sector provide
factor services (L, Lb, K, Ent.) only to firms and household received factor payment (Rent,
wages, Interest, profit) from firms.

7) Household sector also spent amount on consumption of goods and service. Households do
not spent entire income on consumption; they saved a part of their income into capital
market. On the other hand, firms borrow this amount from capital market for their expansion
and growth. In this way flow of income continues between three sectors of economy.

Real flow
Households render factor services as owners of land, labour, capital and entrepreneurship to
firms. The firms produce good, and services to meet the demand of the households. Such
flow of factor services from households to firms and flow of goods and services from firms to
households is known as real flow.
Money flow
In modern economies, goods and services and factor services are valued is terms of money.
Households receive rent for land, wages for labour, interest for CapitaLand profit for
entrepreneurship- from firms and make payment for goods and services supplies by firms.
This flow of money between firms and households is called money flow:
Circular flow can be shown with the help of a diagram given below: Circular flow of income
in a two sector economy without savings.

Gross domestic product (GDP)

GDP is a macro concept. GDP refers to the market value of all final goods and services
produced by all the producing units located in the domestic territory of a country during a
period of one year.
When we talk about GDP, it is always calculated on Market price (called GDPmp).
It includes depreciation, net indirect tax and value of output produced within the domestic
territory by all the producers (resident and non- resident).
1. It measures the market value of annual output of final goods and services currently
produced. this implied GDP is a monetary measure
2. for calculating gdp accurately all goods and services produced in any given year
(final) goods must be counted only once so as to avoid double counting so it includes
only final goods not intermediate goods
3. It includes only currently produced goods in a year. market transactions involving
goods produced in the previous year such as old houses, old cars, factories earlier
are not included in GDP of the current year
4. It included goods and services produced by both residents and non-residents within
the domestic territory.

Activities that is not included in GDP

1. Net Factor Income from Abroad (NFIA): GDP is limited to Domestic territory of a
country and therefore it does not include Net Factor Income from Abroad (NFIA).
2. Goods produced in the previous year: GDP is a flow concept, i.e., flow of goods and
services produced during a year. It does not include goods produced in the previous year.
3. Value of intermediate consumption: GDP is not value of output because it excluded
value of intermediate consumption. GDP or GVA (Gross Value Added) is sum total of value
added by all the producing units in domestic territory of a country.
Value Added or GDP or GVA = value of output – Intermediate consumption
4. Transfer payments: GDP includes only factor payments, it does not include transfer
payments because these are unilateral transfer i.e., One side transfer.
5. Capital gain: GDP does not include capital gains. Capital gains refer to income from sale
of second hand goods (like old car) and financial assets (share, debenture bonds). Any
income arising from such transactions are not a factor income these are the transfer income
and these does not add to the current flow of goods and services in the economy.
6. Income from illegal activities: Income from illegal activities like smuggling, black
marketing, theft, dacoity, gambling etc. should not be included in national income. Income
earned by way of legal activities is included.
7. Sale of Shares and Bonds: Sale of Shares, Debentures, bonds etc. will not be included in
national income because such transactions do not contribute to current flow of goods and
services. These financial assets are only paper claims.

Components of GDP
1) Consumption Expenditure: It refers to expenditure incurred by households and non –
profit institutions serving goods and service to households.
2) Government Expenditure: It refers to the expenditure incurred by government on various
administrative services like defence, law and order, education etc.
3) Gross Investment: It refers to the sum of Gross fixed investment and Change in stock. It
includes:
a. Gross fixed capital formation: It includes expenditure on capital good and expenditure on
construction of roads, dams and bridges.
b. Change in stock (Inventory Investment): It refer to the change in stock during the year.
It is estimated as the difference between „closing stock‟ and „opening stock‟ of the year.

4) Net Exports: It refers to the difference between exports and imports of a country during a
period of one year.
GDP = C + G + I + (X-M)

Limitations of Real GDP

In an economy, when the level of GDP increases, it is always considered that the economy is
getting economic welfare. Economic welfare is a situation in which the level of GDP
increases with the growth of living standard of people. But sometimes in spite of increase in
GDP there is no economic welfare in the economy.
GDP are of two types: (1) Nominal GDP (2) Real GDP.
The nominal GDP is influence by change in price and change in quantity. If there is rise in
price the nominal GDP will rise even there is no rise in the level of production. So, we can
say that it is not a good indicator of measuring economic welfare. On the other hand, Real
GDP is influence by change in Quantity only. Real GDP rise when the level of production
rises in the economy. It is considered a good indicator of economic welfare. But there are
some limitations of real GDP as an indicator of economic welfare.
1. Distribution of GDP/Income: A only rise in GDP (or National Income) may not shows
that there is rise in economic welfare. If there is unequal distribution of income with rise in
GDP, means Rich is getting rich and the poor is getting poor, few rich have a large share of
National Income and many poor have a small share of National income i.e., there is wide gap
between poor and rich. Then there will be no effect on economic welfare with rise in GDP.
On the contrary, if there is equal distribution of income with rise in GDP then, we can say
that GDP is the true indicator of economic welfare.
2. Composition of GDP: Composition of GDP means what is the share of different types of
Goods in GDP. If in an economy, there is increase in production of war materials (like, tanks,
guns, bomb etc.), dangerous goods (liquor, cigarette, tobacco etc.), then these goods doesn‟t
have any effect on economic welfare, it will not increase economic welfare. But if there are
more of consumer goods and capital goods which is needed by people, then there will be
economic welfare in the economy. Only then real GDP can be said the good indicator of
economic welfare.
3. Non – Monetary Exchange: In rural economies, barter exchange still prevails to some
extent. When goods are exchanged with goods it‟s called barter exchange or non-monetary
exchange. Examples, payment for farm labour are often made in kind rather than cash. All
such transaction remains unrecorded. These transactions raise the economic welfare but not
to be included in estimation of national income. So, GDP is not a proper index of welfare.
4. Externalities: Externalities refer to good and bad impact of an economic activity without
paying the price or penalty for that. There are both positive and negative externalities. For
example, Mr. Mohan maintains a beautiful garden and Mr. Shyam (neighbour of Mr. Mohan)
enjoys it. It adds to welfare of Mr. Shyam but he does not pay for it, it is the example of
Positive Externalities. Similarly, Environmental pollution caused by industrial plants. It
causes a loss of social welfare. It is the example of Negative externalities. The GDP remains
unaffected by externalities. Hence, it is an inappropriate index of welfare.

Differences between GNP and GDP

Gross National Product (GNP) Gross Domestic Product (GDP)

GNP is the sum of market value of final GDP is the sum of market value of goods and
goods and services produced by the normal services produced by all the producers in the
resident of a country in a domestic territory of a country in a year

It is related to the normal resident of the It is related to the domestic territory of a

country. It includes the income earn inside country in a year. It includes the income earn
and outside the country. by normal resident of a country

It includes the net factor income from abroad. It does not include net factor income from
So it is a broad concept abroad.

It is based on citizenship It does not include net factor income from

abroad.

GNP = GDP – NFIA GDP = Consumption + Investment + Govt.

Spending + Net export

Real GDP vs Nominal GDP

Real Income/GDP
It refers to market value of final goods and services produced by normal residents of country
during an accounting year, measured at price of base year. It is obtained by multiplying the
goods and services produced in the current year with the price fixed in the base year or
constant year. Real income or real national income is also termed as National income at
constant price. Base year or constant year is a stable year. It is carefully selected as one in
which there were no natural calamities like floods, earthquakes, drought or wars. The prices
remain stable throughout the year. For example, to estimates national income or NNP (Net
national product) at constant price in 2021-22. You have to multiply the value of all the final
goods and services produced in the current year (2021-22) with price fixed in 2011-12 (Base
Year). Real National Income is very useful index to measure the real or actual growth of
output. A rise in real income implies rise in GDP and economic growth.
Real Income = Base year price (P0) × Current year Quantity (Q1)
Nominal Income / GDP
It refers to market value of final goods and services produced by normal residents of country
during an accounting year, measured at current year price. It is obtained by multiplying the
goods and services produced in the current year with the price fixed in the current year.
Nominal income or Nominal national income is also termed as National income at current
price or monetary national Income. Each and every country calculates national income at
current prices. For example, to estimate national at current price in 2021-22, You have to
multiply the value of all the final goods and services produced in the current year (2021-22)
with price fixed in 2021-22. Nominal National Income is very poor index to measure the
growth of output/economy. It is not compulsory that a rise in nominal income always implies
rise in GDP and economic growth.
Nominal Income = Current year price (P1) × Current year quantity (Q1)

Difference between National Income at Current Price and National Income at Constant
Price

National Income at Current National Income at Constant

Price Price

Meaning It refers to market value of final It refers to market value of final

goods and services produced by
normal residents of country
during an accounting year,
measured at current year price.
Economic growth It is not a good tool for
measuring the economic
growth of a country.
Causes of changes It is affected by change in both
price and quantity.
Calculation Current year price(P1) ×
Current year quantity (Q1)
Alternative name Nominal GDP or Monetary
GDP
goods and services produced by
normal residents of country
during an accounting year,
measured at price of base year.
It is a better tool for measuring
the economic growth of
country.
It is affected by change in the
quantity only.
Base year price (P0) × Current
year Quantity (Q1)
Real GDP
 GDP Deflator (Implicit Deflator)
When we compute the GDP at current prices is referred to as nominal GDP or Monetary
GDP and when we compute the GDP at base year price or at constant price is called Real
GDP. As we have seen that, Nominal GDP is affected by both changes in price and physical
output. On the other hand, Real GDP is affected by change in physical output only. For
example, if the output of goods and services produced by an economy remain the same
during a year and price rises, then there will be a rise in GDP. However, this is a rise in
Nominal GDP not in Real GDP. On the other hand, if price remained constant, and there is an
increase in production, real GDP will increase. This means that there is economic growth in
the economy.
To eliminate the effect of price changes and to determine the real change in physical output,
we can use Implicit GDP deflator. Implicit GDP Deflator measures the average level of
prices of all the goods and services that make GDP. It is measured by Following Formulae:
Implicit GDP Deflator (Implicit Price Index) = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃/𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 ×100
For Example: If nominal GDP is ₹15,000 crores and Real GDP is ₹12,000 crores, then
Implicit GDP Deflator = 15,000/12,000 ×100
=125
In the above example, we can also convert nominal GDP into real GDP with the help of
Implicit GDP Deflator. The conversion of Nominal GDP into Real GDP is known as
Deflating.
Real GDP = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃/𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 ×100
= 15,000/125 ×100
= ₹12,000.

Meaning and Types of Unemployment

The population of any country consists of two components (i) Labour Force (ii) Non-Labour
Force. Labour force means all persons who are working (i.e. being engaged in the economic
activity) as well as those who are not working but are seeking or available for work at the
current wage rate. It means the labour force consists of both employed and unemployed
people. The component of population which is not a part of the labour force is Non-Labour
Force. It includes all those who are not working and are neither seeking nor available for
work.
Unemployment can be defined as a state of workless ness for a person who is fit and willing
to work at the current wage rate. It is a condition of involuntary and not voluntary idleness.
Simply stated an unemployed person is the one who is an active member of the labour force
and is seeking work, but is unable to find the same. In case of voluntary unemployment a
person is out of job on his own accord or choice, doesn‟t work on the prevalent or prescribed
wages. Either he wants higher wages or doesn‟t want to work at all. The involuntary
unemployment on the other hand is the situation when a person is separated from
remunerative work and devoid of wages although he is capable of earning his wages and is
also anxious to earn them. It is the involuntary idleness that constitutes unemployment.
Involuntary unemployment can be further divided into cyclical unemployment, seasonal
unemployment, structural unemployment, frictional unemployment, disguised unemployment
and under employment.

So Unemployment may be defined as “a situation in which the person is capable of working

both physically and mentally at the existing wage rate, but does not get a job to work”.

In other words unemployment means only involuntary unemployment wherein a person who
is willing to work at the existing wage rate does not get a job.

Types of Unemployment

Cyclical Unemployment Cyclical or demand deficient unemployment occurs when the

economy is in need of low workforce. When there is an economy-wide decline in aggregate
demand for goods and services, employment declines and unemployment correspondingly
increases. Cyclical unemployment mainly occurs during recession or depression. This form
of unemployment is most commonly known as cyclical unemployment since unemployment
moves with the trade cycle. For instance, during the recent global slowdown in late 2008,
many workers around the globe lost their jobs.
Seasonal Unemployment This type of unemployment occurs in a particular time of the year
or season and thus is known as seasonal unemployment. Seasonal unemployment is most
common in industries like agriculture, tourism, hotel, catering etc.
Structural Unemployment Structural unemployment arises when the qualification of a
person is not sufficient to meet his job responsibilities. It arises due to long term change in
the pattern of demand that changes the basic structure of the economy. The person is not able
to learn new technologies used in the new expanding economic sectors and they thus may be
rendered permanently unemployed. For instance, when computers were introduced, many
workers were dislodged because of a mismatch between the existing skills of the workers and
the requirement of the job. Although jobs were available, there was a demand for a new kind
of skill and qualification. So, persons with old skills did not get employment in the changed
economic regime, and remain unemployed.
Frictional Unemployment Frictional unemployment occurs when a person is out of one job
and is searching for another for different reasons such as seeking a better job, being fired
from a current job, or having voluntarily quit a current job. It generally requires some time
before a person can get the next job. During this time he is frictionally unemployed.
Disguised Unemployment The unemployment which is not visible is said to be disguised
unemployment. It occurs when a person doesn‟t contribute anything to the output even when
visibly working. This happens amongst family labour especially in agriculture who are
engaged on land but are not contributing to the given level of output. Thus their marginal
productivity is zero.
Underemployment When a person is engaged in the economic activity but that fail to
provide him fully in accordance to his qualification and efforts. Thus it is a situation in which
a person is employed but not in the desired capacity whether in terms of compensation, hours,
or level of skill and experience. While not technically unemployed the underemployed often
compete for available jobs.
Technological Unemployment:
It is the result of certain changes in the techniques of production which may not warrant
much labour. Modern technology being capital intensive requires fewer labourers and
contributes to this kind of unemployment.
Chronic Unemployment:
If unemployment continues to be a long term feature of a country, it is called chronic
unemployment. Rapid growth of population and inadequate level of economic development
on account of vicious circle of poverty are the main causes for chronic unemployment.

Unemployment rate is the percent of the labour force that is without work. It is
calculated as below:

Unemployment rate = (Unemployed Workers/Total labour force) × 100

CAUSES OF UNEMPLOYMENT IN INDIA

Slow Economic Growth: During the planning period the trend rate of growth was
considerably lower than the targeted rate. Therefore, jobs in adequate number were not
created. Further, economic growth by itself does not solve the problem of unemployment. In
the recent past there has been deceleration in the growth of employment in spite of the
accelerated economic growth. This can be explained in terms of steady decline in the degree
of response of employment to change in output in all the major sectors of economic activity
except in construction. According to T.S. Papola, over a period of time, the output growth in
agriculture and manufacturing sector has become more input and technology-intensive and
less labour-intensive. Besides, the sectoral composition of growth is also an important
determinant of unemployment. Excessive dependence on agriculture and slow growth of non-
farm activities limit employment generation.

Increase in Labour force; there are two important factors that have caused an increase in the
labour force which are as follows:

(i) Rapid Population Growth: Rising population has led to the growth in the labour supply
and without corresponding increase in the employment opportunities for the increasing labour
force has aggravated the unemployment problem.

(ii) Social Factors: Since Independence, education among women has changed their attitude
toward employment. Many of them now compete with men for jobs in the labour market. The
economy has however failed to respond to these challenges and the net result is a continuous
increase in unemployment backlogs.

Rural-Urban Migration; the unemployment in urban area is mainly the result of substantial
rural migration to urban areas. Rural areas have failed to provide subsistence living in
agriculture and allied activities and so large scale migration is taking place to cities.
However, economic development in cities has failed to create enough additional jobs for the
new urban entrants to the labour market. Thus only some of the migrants are absorbed in
productive activities and the rest join the reserve army of unemployed workers.

Inappropriate Technology; In India, though capital is a scarce factor, labour is available in

abundant quantity; yet producers are increasingly substituting capital for labour. This policy
results in larger unemployment. Despite the abundance of labour, capital intensive
technology is adopted in India mainly because of rigid labour laws. It is quite difficult to
follow easy hire and fire policy and so right sizing of manpower is difficult for the
enterprises. It is difficult to reduce the number of labour-Force. Further, the factors like
labour-unrest and lack of work-culture leads to the increased inefficiency of labour and thus
provide incentives to follow labour-saving technology by organizations.

Defective Educational System; the present educational system has theoretical bias and has
limited utility for productive purposes. It lacks the emphasis on the development of aptitude
and technical qualifications required for various types of work among job seekers. This has
created a mismatch between the need and availability of relevant skills and training, which
results in unemployment, especially of youth and educated while shortage of technical and
specialized personnel continues.
 Lack of Infrastructure Development; Lack of investment and infrastructure development
limits the growth and productive capacity of different sectors which leads to inadequate
generation of employment opportunities in the economy.

Lack of employability; India faces poor health and nutrition situation among masses which
reduces the capacity of person to be employable and it causes unemployment.

Concept of money

Economists define money as anything that is generally accepted by the society for payment
for goods or services or in the repayment of debts

Coins and Notes clearly fit this definition and is one type of money. When most people talk
about money, they are talking about currency (paper money and coins). If, for example,
someone comes up to you and says. Your money or your life, you should quickly hand over
all your currency rather than ask. What exactly do you mean by money! To define money
only as currency (coins & Notes) is much too narrow for economists. Because cheques are
also accepted as payment for purchases, it is also considered as money. As you can see, there
is no single, precise definition of money for comments

Money is Different from Wealth & Income

Wealth - The total collection of property which has store value is called wealth. Wealth
includes not only money but also other assets such as bonds, stock, art, land, furniture, cars,
and houses etc.

• Income - Income is a flow of earnings per unit of time like your income per day, per week,
per month, per annum etc. Money, by contrast, in a stock it is a certain amount at a given
point in time.

• If someone tells you that he has an income of Rs1000, you cannot tell whether he earned a
lot or little without knowing whether this 1000 is earned per year, per month, or even per day.
Thu if someone tells you that she has 1000 in her pocket, you know exactly how much this is

Definitions of Money:

(1) "Anything which is widely accepted in payments for goods or in discharge of other kinds
of business obligations". Robertson

(2) "Money constitutes all those things which are at any time and place, generally accepted
without doubt or special enquiry as a means of purchasing commodities and services, and of
defraying expense." - Prof Marshall
(3) In the words of Crowther, "Money may be defined as anything which is generally
acceptable as a medium of exchange and at the same time acts as a measure and store of
value"

Functions of money

(1) Primary Functions of Money;

a) Medium of Exchange: Medium of exchange is an important function of money. Money
as medium of exchange means that it can be used to make payments for all transactions of
good and services because it has the quality of general acceptability. Now a person can buy
and sell goods at any time and place with the help of money. Money has separated the
function of sale and purchase. This function has removed the major difficulty of lack of
double coincidence of wants. Now, exchanges of goods become convenient and simple.
Money saves a lot of time and labour Money works as medium of exchange because it is
generally acceptable and approved & authorised by Government

b) Measure of Value (Unit of Value/Account): Money as a measure of value means that

each goods and service expressed in a common unit. For example In India the common unit
for measure of value is INR (Indian Rupee), In America the common unit for measure in
USD (US Dollar) In barter system, the value of one goods was expressed in terms of other
good. Now, this function of money has removed this difficulty. This motion provides
maintenance of business accounts, which would be otherwise impossible in barter exchange.
When all values are expressed in terms of money, it becomes easier for anyone to compare
the values of any two goods. Money works as a unit of account and it express the value of
each good in monetary unit

(2) Secondary Functions of Money

c) Store of value: It is a subsidiary or Secondary function of Money. Money as a store of

value means that money is an asset and can be stored for use in future. This function is also
known as Asset function of Money In barter system it was very difficult to store the value in
terms of goods because goods are perishable in nature and needed much space. But now
money has removed this difficulty.

Money as a store of value in the following benefits

a. money is available in fractional denomination, ranging from Rs. 1 to Rs. 2000

B. Value of money remains relatively stable to other goods.

c. It is the most liquid assets.

(d) Standard of Differed payments: It is a subsidiary function of money differed payments

refer to these payments which are made in the future. Money has made deferred payments
much easier than before. In the absence of money, deferred payments were difficult it was
difficult to arrange the goods of exactly the same quality at the time of repayment. It was
impossible to determine the amount of principle and interest in terms of goods. But now,
money has removed this difficulty, due to general acceptability of money, future payments
are expressed in terms of money. Money has simplified the borrowing and lending activities
it has led to the creation of financial institutions Money is unit in term of which debts and
future transactions can be settled. Thus loans are made and future transactions are settled in
term of money.

e) Transfer of Value: Money also serves as a convenient mode of transfer of value. Goods
and property etc. can be transfer from one place to other with the help of money. Due to this
function, Money has promoted both consumption expenditure and investment expenditure
across all parts of the world. Concept of Global economy has come into existence Markets
have expanded across international borders.

POVERTY IN INDIA

In general, poverty can be defined as a situation when people are unable to satisfy the basic
needs of life. The definition and methods of measuring poverty differs from country to
country. The extent of poverty in India is measured by the number of people living below the
Poverty Line.

Poverty Line: The Poverty Line defines a threshold income. Households earning below this
threshold are considered poor. Different countries have different methods of defining the
threshold income depending on local socio-economic needs. The Planning Commission
releases the poverty estimates in India. Poverty is measured based on consumer expenditure
surveys of the National Sample Survey Organisation (NSSO). A poor household is defined as
the one with an expenditure level below a specific poverty line.

Earlier, India used to define the poverty line based on a method defined by a task force in
1979. It was based on expenditure for buying food worth 2,400 calories in rural areas and
2,100 calories in urban areas. In 2009, the Suresh Tendulkar Committee defined the poverty
line on the basis of monthly spending on food, education, health, electricity and transport.

The Planning Commission has updated the poverty lines and poverty ratios for the year 2009-
10 as per the recommendations of the Tendulkar Committee. It has estimated the poverty
lines at all India level as an MPCE (monthly per capita consumption expenditure) of `. 673
for rural areas and `. 860 for urban areas in 2009-10. So a person who spends ` 673 in rural
areas and `. 860 in urban area per month is defined as living below the poverty line.

Based on these cut-offs, the percentage of people living below the poverty line in the country
has declined from 37.2 per cent in 2004-5 to 29.8 per cent in 2009-10. Even in absolute
terms, the number of poor people has fallen by 52.4 million during this period. Of this, 48.1
million are rural poor and 4.3 million are urban poor. Thus poverty has declined on an
average by 1.5 percentage points per year between 2004- 5 and 2009-10. The annual average
rate of decline during the period 2004-5 to 2009- 10 is twice the rate of decline during the
period 1993-4 to 2004-5 (Table).

CAUSES OF POVERTY IN INDIA

Vicious Circle of Poverty: It is said that “a country is poor because it is poor.” This idea has
come down from Ragnar Nurkse who pinpointed the problem of the vicious circle of poverty.
Low level of saving reduces the scope for investment; low level of investment yields low
income and thus the circle of poverty goes on indefinitely.

Low Resources Endowment: A household is poor if the sum total of income earning assets
which it commands, including land, capital and labour of various levels of skills, cannot
provide an income above the poverty line. The poor mainly consists of unskilled labour,
which typically does not command a high enough level of wage income.

Inequality in the Distribution of Income and Assets: The distribution of income and assets
also determine the level of income. The economic inequalities are the major cause of poverty
in India. It means the benefits of the growth have been concentrated and have not “trickled
down” sufficiently to ensure improved consumption among the lower income groups.

Lack of Access to Social Services: The lack of access to social services such as health and
education compound the problems arising from inequality in the ownership of physical and
human assets. These services directly affect household welfare. The poor typically get much
less than a fair share of such services. This is partly because governments do not invest
enough to ensure an adequate supply of these services and the limited supply is mainly
availed by non-poor households. Further, the poor may not have adequate access for a variety
of other reasons like lack access to information about the existence of such services, lack of
knowledge and corruption.

Lack of access to Institutional Credit: The banks and other financial institutions are biased
in the provision of loans to the poor for the fear of default in the repayment of loans. Further,
the rules regarding collateral security, documentary evidences etc. present constraints for the
poor to avail loan facility from banks. The inaccessibility to institutional credit may force
poor to take credit from the landlord or other informal sources at a very high interest rate and
which in turn may weaken their position in other areas, leading, for example, to the payment
of abnormally high rental shares for land, or acceptance of abnormally low wages in various
types of “bonded labour” arrangements or selling their crop at a very low price. In some cases
poor people cannot make themselves free from the clutches of moneylenders. Their poverty is
further accentuated because of indebtedness. Such indebted families continue to remain under
the poverty line for generations because of this debt-trap.

Price Rise: The rising prices have reduced the purchasing power of money and thus have
reduced the real value of money income. The people belonging to low income group are
compelled to reduce their consumption and thus move below the poverty line.
 Lack of Productive Employment: The magnitude of poverty is directly linked to
unemployment situation. The present employment conditions don‟t permit a reasonable level
of living causing poverty. The lack of productive employment is mainly due to problems of
infrastructure, inputs, credit, technology and marketing support. The gainful employment
opportunities are lacking in the system.

Rapid Population Growth: The faster population growth obviously means a slower growth
in per capita incomes for any given rate of growth of gross domestic product (GDP), and
therefore a slower rate of improvement in average living standards. Further the increased
population growth increase consumption and reduces national savings and adversely affects
the capital formation thereby limiting the growth in the national income.

Low Productivity in Agriculture: The level of productivity in agriculture is low due to

subdivided and fragmented holdings, lack of capital, use of traditional methods of cultivation,
illiteracy etc. This is the main cause of poverty in the rural India.

Social Causes

(i) Education: Education is an agent of social change. Poverty is also said to be closely
related to the levels of schooling and these two have a circular relationship. The earning
power is affected by investment in individual‟s education and training. However, poor people
do not have the funds for human capital investment and thus it limits their income.

(ii) Caste system: Caste system in India has always been responsible for rural poverty. The
subordination of the low caste people by the high caste people caused the poverty of the
former. Due to rigid caste system, the low caste people could not participate in various
economic activities and so remain poor.

Social customs: The rural people generally spend a large percentage of annual earnings on
social ceremonies like marriage, death feast etc. and borrow largely to meet these
requirements. As a result, they remain in debt and poverty.

Measures of money supply

Money supply refers to total volume of money held by public at a particular point of time in
an economy.

 It is a stock concept
 It includes the money held by the public only (consumers of money)
 It does not include the money held by the govt. and banking system of a
country(producers of money)

Features of Money Supply

a. It includes Money held by public only. It does not include stock of money held by
Government and banking system of a country

b. It is a 'stock' Concept.
Components of Money supply

There are mainly two principle components of Money supply:

(1) Currency: It consists of coins and paper.

Coins: coins are made up of metal. The metallic coins are issued by the monetary authority
of the country. The metal used in coins has no significance and these coins are token coins
since their face value is much higher than their intrinsic value. In India, today coins of Rs.1,
Rs. 2, Rs.5 and Rs. 10 are in use.

Paper currency: Paper currency or currency notes are the most important part of the money
supply. The central bank in every country has monopoly right of issuing currency notes. In
India, one rupee note is issued by the Ministry of Finance while the remaining notes of higher
denominations are issued by central bank i.e., Reserve Bank of India. The central bank is
permitted to issue notes to any extent provided a minimum reserve kept in the form of gold
and foreign securities. In our country, RBI has to keep a minimum reserve of Rs. 200 crores
in which there is gold bullion of Rs. 115 crores and foreign securities of Rs. 85 crores.

(2) Demand Deposits: Demand deposits are the most important component of money supply.

These are the money deposit made by the depositor to the bank. Bank agrees to pay money on
demand at any time and to whomsoever the owner of the deposit may wish. For this purpose
people use cheques to meet financial obligations.

In India, Up to 1967-68 a single measure M was used by the RBI. M is the sum of currency
and demand deposits held by the public. Traditionally, M is known as the narrow measures of
money supply. Form 1967-68 to 1977 a broad measure of money supply known as AMR
(Aggregate money resources) was followed. AMR includes currency, demand deposit and
time deposit. In 1977, RBI introduces four measures of monetary aggregates. These are M1,
M2, M3 and M4.

Measures of Money supply

a. M1 Currency (notes and coins) + Demand Deposits + Other deposits with RBI

b. M2 Currency (notes and coins) + Demand Deposits + Other deposits with RBI + Deposits
with post office saving bank account.

c. M3 Currency (notes and coins) + Demand Deposits + Other deposits with RBI + Net Time
(Term/Fixed) deposits with commercial banks

d. M4 Currency (notes and coins) + Demand Deposits + Other deposits with RBI + Net Time
(Term/Fixed) deposits with commercial banks + Total Deposits with post offices
Note: Other deposits with RBI include:

 Demand deposits with RBI of Public Financial Institutions

 Demand Deposits with RBI of foreign central banks and of foreign governments
 Demand deposits of World Bank, IMF etc.

It does not include Deposits of the govt. of the country with RBI and Deposits of country's
banking system with RBI.

There are two approaches regarding Money supply. They are:

a. Traditional or Narrow Approach: It is a narrow definition of money. Money supply

according to this approach includes coins, currency notes and demand deposits. It includes
M1 and M2 measures of money supply. MI is the most liquid and easiest for the transactions.
It measured on a specific day. Beside all the components of M1, M2 also includes savings of
the people with post office.

b. Modern or Broader Approach: Money supply according to this approach includes coins,
currency notes, demand deposits, post office savings, Net term deposits etc. It includes M3
and M4 measures of money supply. M3 include all the components of M1 and in addition to
that it also includes net (time/fixed) deposit. And Beside all the components of M3, M4 also
include savings with the post offices.

These approaches are in decreasing order of liquidity. M1 is most liquid and easiest for
transactions, whereas, M4 is least liquid of all.

The New Monetary Aggregates.

RBI third working group for measuring money supply in India was formed in 1998. The
working group recommended that the proposed monetary aggregates should be applied from
fiscal year 1999-20 However; the old monetary aggregates would need to be continued for
some time for the purpose of comparability. There are two basic changes in new monetary
aggregates.

A. Since the post office is not a part of banking sector, postal deposits are not treated as
money, as it was treated in M2 and M4

B.The new series clearly distinguish b/w monetary aggregates and liquidity aggregates"

New monetary aggregates are = NM0, NM1, NM₂, NM3

Liquidity Aggregates= L1, L2, L3

Weekly Compilation

NM0 = Monetary Base/High Powered Money

= Currency in circulation + Banker deposit with RBI + other deposit with RBI.
Fortnightly Compilation (15 days).

NM1, = Currency with Public + Demand Deposit with Bank + other deposit with RBI

NM2, = NM1, + Time liabilities portion of Saving deposit with bank + certificate of deposit
+ Term Deport of maturity within a year (excluding. FCNR Bank deposit).

Certificate of Deposit;- Certificate of Deposit is a Certificate offered by a bank that

guaranteed payment of a specified interest until a maturity date. Larger the amount of
certificate deposit, longer the term, greater the interest. Certificate of Deposit is same as fixed
deport in Terms of interest, time, amount etc. But there are some Differences b/w FD and
CD, CD is negotiable, FD is not. You cannot loan against on CD, but you can take loan
against FD. Minimum investment in CD is rupees 100,000. But there is no such requirement
an FD.

Time liabilities portion of saving deposit with bank; - when we deposit an amount in
banks we sometimes, with draw some amount and sometimes we deposit some amount. The
banks are giving interest on that amount which will remain as basic amount in our deposit.

FCNR (Foreign Currency Non Resident bank deposit: _ it is a type of Bank account only
for NRI. They can deposit foreign Currency in Indian bank for saving purpose. This type of
bank account is called FCNR account. The person does not need to convert its currency into
Indian rupee. It is a type of FD account for NRI."

NM3 = NM2, + Time deposits with maturity over one Year (Excluding FCNR Bank Deposit)
+ Call / term Borrowing by banking system.

Call Borrowing or call Money; call money is a short-tum loan which is due to be paid
immediately in full as and when demanded by the lender. Call money loan doesn‟t have a
defined schedule of payment and maturity. Furthermore, the lender of the call money need
not provide prior notice to the borrower about the repayment.

[Term money refers to borrowing / lending of funds for period exceeding 14 days.

Liquidity aggregates: L1, L2, and L3

The working group under the chairmanship of Dr. Y. V. Reddy (1998), then deputy governor
of RBI had suggested four new monetary measures, NMO, NM1, NM2, NM3 and three
liquidity aggregates

Monthly Compilation

L1= NM3 + postal deposits (excluding national saving certificate)

L2= L1 + term money borrowings, certificate of deposit and term deposits of financial
institutions like IDBI, SIDBI, NABARD Etc.

Quarterly Compilation

L3 = L₂ + Deposits of public with NBFI (Non-Banking financial institution) Like Muthoot

finance Corporation Ltd, Bajaj Finance Limited etc

Monetary Policy

Ans: Monetary policy refers to those policy measures which are taken by the central bank of
a country to control and regulate the money supply. In advanced countries, monetary policy
mainly plays a regulatory role. But in a developing country, like India, monetary policy has to
play the twin role: promotional and regulatory. That is, monetary policy has to develop and
promote banks, money market, capital market, sock exchange etc. and at the same time,
control and regulate the growth of capital by quantitative and qualitative methods. In other
words, monetary policy of refers to that policy through which the central bank of the
country (Reserve Bank in India) controls the supply of money, availability of money,
cost of money or the rate of interest in order to achieve the objective of growth and
stability in the economy.

Objectives of Monetary Policy

a) Price Stability

The main objective of government policy is attaining price stability in the country. Price
stability means control of wide fluctuations in the general price level in the economy.
Consistently upward tends of prices is called inflation. This is the main worry of less
developed countries like India. If prices are gone up to a great extent then they may lead to
fall in the level of production and employment. This may give birth to depression in the
economy.

To ensure price stability, strong monetary policy is required. The monetary policy does not
depend upon central bank alone but rather on a large number of commercial bank.

b) Exchange stability

The main objective of monetary policy is to preserve gold reserve of a country. For this, it is
necessary that our exports are boosted and imports reduced. Normally exchange stability is
not possible without price stability because increase in price will make our exports costlier
which leads to devaluation of rupee. Thus, price stability is a must to make exchange rate
stable.

c) Full employment

This is the objective of full employment, particularly in less developed countries. Full
employment refers to the situation wherein all person who are able to work and willing to
work, get work. Under cheap monetary policy, loans are made available to the public at cheap
rate of interest; they will go for heavy investment. This will help in creating more
employment opportunities. Hence, the level of full employment gets achieve.

d) Economic Growth

Economic growth refers to process of sustained rise in per capita income, national income
and standard of living. In underdeveloped countries there is low production capacity.
Production capacity is low mainly because of low rate of capital formation. On account of
low rate of capital formation economies fail to utilize fully their natural resources and human
resources. Accordingly, the government should adopt such a monetary policy which may
accelerate the rate of capital formation in the country.
e) Economic Equality

It is another objective of monetary policy. In capitalist and mixed economies there are
widespread inequalities in the distribution of wealth and income. As a result, the society is
divided into two class- rich and poor. Rich class exploits the poor. Monetary policy serves as
an instrument of achieving equal distribution income and wealth through faster delivery of
credit to weaker sections of the society at lower rate of interest.

Explain the instruments of Monetary Policy used by the central bank to control credit.
Ans: Monetary policy refers to those policy measures which are taken by the central bank of
a country to control and regulate the money supply. In other words, monetary policy of refers
to that policy through which the central bank of the country (Reserve Bank in India) controls
the supply of money, availability of money, cost of money or the rate of interest in order to
achieve the objective of growth and stability in the economy.
Various monetary instruments used by the central bank of country divided into two parts.

A. Quantitative Instruments
Quantitative instruments are those instruments which affect the amount of credit in the
economy. Qualitative instruments are those selective instruments which affect the amount of
credit in specific areas.
1. Bank Rate
2. Repo Rate
3. Open Market operation
4. Cash reserve ratio (CRR)
5. Statutory liquidity ratio (SLR)

B. Qualitative Instruments
1. Margin Requirements
2. Moral suasion

A. Quantitative Instruments
1. Bank Rate
Bank rate is the rate at which the central bank of a country offers loan to the commercial
bank .Central bank has the authority to change in Bank rate. Central bank has been actively
used Bank rate to control credit. Increase in bank rate increases the cost of borrowing from
the central bank. Also, increase in bank rate cause in increase in market interest rate (rate of
interest charged by the commercial bank form general public). It discourages borrowers from
taking loans, which reduces credit creation capacity of the commercial bank. Thus, there
would be less credit in the market which results fall in aggregate demand and hence fall in
price. On the other hand, Decrease in bank rate lowers the rate of interest and credit becomes
cheap. Thus, there would be more credit creation in the market. The aggregate demand
increases and prices tend to rise.

2. Repo Rate

The Repo Rate (or Policy Interest rate) is the rate at which the central bank of a country
lends money to commercial banks for short term period (1 to 14 days). Central bank has the
authority to change repo rate. Repo rate is directly related with rate of Interest. The increase
in Repo rate increases the rate of interest, and it will increase the cost of borrowing. Credit
becomes dear or expensive. It reduces the ability of commercial banks to create credit. Thus,
there would be less credit in the market which results fall in aggregate demand and hence fall
in price. On the other hand, decrease in Repo rate lowers the rate of Interest and credit
becomes cheap. Thus, there would be more credit creation in the market. The aggregate
demand increases and prices tend to rise.

3. Open Market Operations

Open market operations refer to sale and purchase of government securities in the open
market by central bank. When the central bank sells these securities to the commercial banks,
cash moves from commercial banks to central bank. It will reduce the cash reserves of
commercial banks. And the ability to create credit by commercial banks also gets reduced.
Thus, there would be less credit in the market which results fall in aggregate demand and
hence fall in price. On the contrary, when central banks purchase these securities from
commercial bank, the cash reserves of commercial banks will increase. It increases the ability
to create credit by commercial bank. Thus, there would be more credit in the market. The
aggregate demand increases and prices tend to rise. Hence, The central banks controls the
process of money creation by commercial bank by open market operations.

4. Cash Reserve Ratio

CRR (Cash Reserve Ratio) refers to the minimum percentage of Bank’s total deposit required
to kept with Central Bank. Commercial banks have to keep with the Central Bank, a certain
portion of their deposit as a matter of law. A change in Cash Reserve Ratio affects the ability
of bank of Credit creation. For instance, an increase in CRR reduces the reserves of
commercial bank. It will reduce the credit creation ability of Bank which results fall in
aggregate demand and hence fall in price. On the other hand, When the CRR is decreased;
credit creation ability of the commercial bank is enhanced. The aggregate demand increases
and prices tend to rise.

5. Statutory Liquidity Ratio

SLR (Statutory Liquidity Ratio) refers to the minimum percentage of Bank’s total deposit
required to maintain in cash or other liquid assets with themselves. A change in Statutory
Liquidity Ratio affects the ability of bank of Credit creation. For instance, an increase in SLR
reduces the reserves of commercial bank. It will reduce the credit creation ability of Bank
which results fall in aggregate demand and hence fall in price. On the other hand, When the
SLR is decreased; credit creation ability of the commercial bank is enhanced. The aggregate
demand increases and prices tend to rise.

B. Qualitative Instruments

1. Margin requirement

Margin is the difference between the amount of Loan and the market value of the security
offered by the borrower against the loan. If margin requirement is fixed by the Central Bank
is 20%, then commercial banks are allowed to give loan only up to 80%. By changing the
margin requirement, the Central bank affects the amount of loan made against securities. An
increase in margin requirement reduces the borrowers‟ capacity. Thus, there would be less
credit creation in the market which results fall in aggregate demand and hence fall in price.
On the other hand. A fall in margin requirements encourages the people to borrow more.
Thus, there would be less credit creation in the market. The aggregate demand increases and
prices tend to rise.

2. Moral suasion

The word “suasion” literally means persuasion on moral ground, with no implied force. In
this technique, the RBI issues letter to the banks encouraging them to exercise their control
over credit and grant loans for essential purposes only and not for speculative purposes. It is
very useful method of restricting availability of credit in a situation of excess demand in
India. During deflation, the RBI issues instruction to member banks to increase the
availability of credit to borrowers for non – essential purpose also.