G.D.

GOENKA PUBLIC SCHOOL

SECTOR 22 ROHINI

MACROECONOMICS
NOTES AND
ASSIGNMENTS

CLASS XII
 UNIT 1

NATIONAL INCOME ACCOUNTING (THEORY ASSIGNMENT )

1 Mark questions :

1. Define

Final Goods

Final Goods are those goods which are either used by consumers for direct satisfaction of wants or
by firms for investment .

Example: Shoes used by the households, or tractor used by the farmers

Intermediate Goods

Intermediate Goods are those goods which are either completely used up in production of other
goods or meant for resale in one year .

Example: Wood used in the production of chairs.

Consumption Goods :

Consumption Goods are those goods which are directly used for the satisfaction of human wants.

Example: Milk and ice cream used by the households.

Capital Goods :

Capital Goods are fixed assets of the producers and are repeatedly used in the process of
production.

These are durable-use producer goods and a re of high value. Example: Plant and machinery.

Investment :

Investment is a process of adding to the stock of capital.

Components of investment are : (i) Fixed investment, and (ii) Inventory investment.

Fixed Investment :

Fixed investment refers to increase in the stock of fixed assets (like plant and machinery) of the
producers during an accounting year.

Inventory Investment :
Change in inventory stock during the year is called inventory investment of the producers.

Depreciation:

Depreciation (also called consumption af fixed ca pital) refers to loss of value of fixed assets in
use, on account of normal wear and tear.

Stock:

Stock refers to the quantity of a variable which is measured at a point of time. Example: Your
balance in the bank account as on January 1, 2020.

Flow :

Flow refers to the quantity of a variable which is measured over a specified period of time.
Example: Your income per month.

Circular Flow of Income :

Circular Flow of Income refers to the circularity of the flows of production, income and
expenditure across different sectors of the economy.

Real Flows :

Real Flows refer to the flow of goods and services across different sectors of the economy.

Money Flows :

Money Flows refer to the flow of money (in terms of receipts and payments) across different
sectors of the economy.

Factor income:

Factor income refers to the payments made by the producing units (firms) to the factors of
production) for the use of their factor services.

Transfer income :

Transfer income are those incomes which are not earned as rewards for rendering factor services
. They are unilateral payments received by a person as help, donation or charity, etc.

Normal resident :

A normal resident referes to a person or institution (i) who ordinarily resides in the country
concerned, and (ii) whose centre of economic interest lies in that country.

Domestic / Economic territory :

Economic territory is the geographical territory administered by a government within which

persons, goods and capital circulate freely.

Gross Domestic Product at Market Price [GDP MP] :

Gross domestic product at market price is the gross market value of final goods and services
produced within the domestic territory of a country during the period of an accounting year.

Gross Domestic Product at factor cost [GDP fc] :

Gross domestic product at factor cost is the gross money value of final goods and services
produced within the domestic territory of a country during the period of an accounting year.

Net Domestic Product at Market Price [NDPMPl :

Net domestic product at market price is the net market value of the final goods and services
produced within the domestic territory of a country during the period of an accounting year.

Net Domestic Product at factor cost [NDPfcl :

Net domestic product at factor cost is the net money value of the final goods and services
produced within the domestic territory of a country during the period of an accounting year.

Gross National Product at Market Price [GDP MP] :

Gross national product at market price is the gross market value of final goods and services
produced by normal residents of a country during the period of an accounting year.

Gross national Product at factor cost [GDP fc] :

Gross national product at factor cost is the gross money value of final goods and services
produced by normal residents of a country during the period of an accounting year.

Net national Product at Market Price [NDPMPl :

Net national product at market price is the net market value of the final goods and services
produced by normal residents of a country during the period of an accounting year.

Net national Product at factor cost [NDPfcl :

Net national product at factor cost is the net money value of the final goods and services
produced by normal residents of a country during the period of an accounting year.

Nominal GDP :

It refers to GDP at current prices. It is the market value of the final goods and services produced
within the domestic territory of a country during an accounting year, as estimated using the
current year prices.

Real GDP :

It refers to GDP at constant prices. It is the market value of the final goods and services produced
within the domestic territory of a country during an accounting year, as estimated using the base
year prices.

GDP Deflator :

GDP Deflator is the ratio between nominal GDP and real GDP. It shows change in GDP owing to
the change in the price level. It is also called price index.

2.Name the four sectors of the economy.

A. The four sectors of the economy are:

(i) Household sector, (ii) Producer sector, (iii) Government sector, and (iv) The External (Rest
of the world) sector.

3.State the two basic principles of circular flow of income and product.

Ans. The circular flow of income and product works on two basic principles:

(i) Money flows are opposite to the real flows (in terms of goods and services).

(ii) Flow of income across different sectors always implies the identity between payments and
receipts.

4.When will domestic factor income be greater than national income?

A. Domestic factor income is greater than national income when net factor income from abroad is

negative.

3 to 4 MARKS QUESTIONS

1.Distinguish between final goods and intermediate goods .

A.

Basis Final Goods Intermediate goods

Meaning Final Goods are those goods which Intermediate Goods are those goods which are
 are either used by consumers for either completely used up in production of
direct satisfaction of wants or by other goods or meant for resale in one year .
firms for investment .

Example Shoes used by the households, or Wood used in the production of chairs.
tractor used by the farmers

Production These goods remain outside the
Boundary boundary line of production, and
are ready for use by their final
users.
Treatment These goods are included in the
estimation of national product or
national income.
These goods remain within the
boundary line of production, are not ready for
use by their final users.
These goods are not included in
the estimation of national product
or national income.

2.Distinguish between Consumption Goods and Capital Goods .

A.

Basis Consumption Goods Capital goods

Meaning Consumption Goods are those goods which are Capital Goods are fixed assets of
directly used for the satisfaction of human the producers and are repeatedly
wants. used in the process of production.

Example Milk and ice cream used by the households.
Effect Higher production of consumption goods leads
to higher level of welfare of the people. It raises
their quality of life.
Plant and machinery.
Higher production of capital
goods leads to higher production
capacity in the economy. It is the
backbone of GDP growth.

3.Distinguish between stock and flow .

A.

Basis Stock Flow

Meaning Stock refers to the quantity of a Flow refers to the quantity of a variable which
variable which is measured at a is measured over a specified period of time.
point of time.
Example Your balance in the bank account Your income per month.
 as on January 1, 2020.

Effect Stock is not time dimensional. Stock is not time dimensional.

4.Distinguish between GDP at current prices and GDP at constant prices .

A.

Basis GDP at current prices GDP at current prices

Meaning It is the market value of the final goods
and services produced with in the
domestic territory of a country during
an accounting year, as
estimated at current year prices.
Change It can increase if price level rises even
when there is no increase in the flow of
goods and
services in the economy.
It is the market value of the final
goods and services produced within
the domestic territory of a country
during an accounting year, as
estimated at base year prices.
It can increase only when the flow of
goods and
services increase in the economy.

Alternative It is known as nominal G D P. It is known as real G D P.

name
Effectiveness It is not a good measure of welfare of It is a good measure of welfare of
people. people.

5.Explain circular flow of national income in a two sector economy .

A. Meaning : Circular flow of income refers to the unending flow of the activities of production,
income

generation and expenditure involving different sectors of the economy, the producers and the

households in particular.

Assumptions of the Model

Households

The circular flow model is based on the following assumptions:

(i) There are only two sectors in the economy namely, households and producers.

(ii) The households spend their entire income, so that there are no savings.
This can be explained with the help of given diagram :

Inner green loop from household to firms shows that producing sector hires/purchases factors of
production from the households who are the owners of these factors (land, labour, capital and
entrepreneurship). The factor inputs are used along with the non-factor inputs (raw material, etc.)
for the production of goods and services.

Outer purple loop from firms to households shows for rendering their factor services to the
producers, the households get factor payments: rent for land, interest for capital, wages/salaries for
labour and profit for entrepreneurship.

Inner green loop going from the households to the firms, represents the spending the households
undertake to buy goods and services produced by the firms.

Outer purple loop from firms to households is the counterpart of the arrow above. It stands for the
goods and services which are flowing from the firms to the households.

6. Explain different components of Net Factor Income from Abroad.

A. (i) Net Compensation of Employees:

It is the difference between compensation (of employees) received by resident workers,

temporarily employed abroad and a similar payment made to non-resident workers who are
employed temporarily within the domestic territory of a country.

(ii) Net Income from Property and Entrepreneurship (other than Retained Earnings of Resident
Companies Abroad):
It is the difference between the income in the form of rent, interest and profit received by the
residents of a country and similar payments made to the rest of the world.

(iii) Net Retained Earnings of Resident Companies Abroad:

It is the difference between the retained earnings of resident companies located abroad and
retained earnings of foreign companies located within the domestic territory of a country.

7.State precautions in calculating national income by production method.

A.Precautions in calculating national income by production method (or value added method)

1. Avoid double counting. Value of intermediate goods is not included in the estimation of value
added because value of intermediate goods is reflected in the value of final goods. So, avoid
double counting of goods and services as these tend to inflate national income estimates.

2. Do not include sale of second hand goods. Value of second hand goods being sold should not be
included in national income as their value was accounted for at the time of first production.
However, any brokerage or commission paid to sell the second hand goods is a fresh production
activity, so brokerage or commission is included.

3. The imputed value of production for self consumption should be included since output has been
produced during the year, e.g., a farmer consuming a part of his own produce.

4. The imputed value of owner occupied dwellings should be included in national income as these
provide housing services.

8.State precautions in making estimates of national income by income method

A.Precautions in making estimates of national income by income method

1. Avoid transfers. National income includes only factor payments, i.e. payment for the services
rendered to the production units by the owners of factors of production. Any payment for which no
service is rendered is called a transfer, e.g. gifts, donations, charity, etc. Since transfers are not a
production activity it must not be included in NI.

2. Avoid capital gain. Capital gain refers to the income from the sale of second hand goods and
financial assets. So,income from sale of old cars, old house, etc. is not included since these are not
production transactions. Similarly, income from sale of financial assets, e.g., shares, bonds,
debentures, etc. are not included since financial assets are neither goods nor services, hence not a
production activity.

3. Include income from self-consumed output, e.g. when a house owner lives in that house, he does
not pay any rent. But imputed rent should be included in national income since the house provides
housing services.
4. Include imputed value of free services provided by the owners of the production units, e.g.
imputed salary of owners, imputed interest on own capital, imputed rent of own building, etc.

9.State precautions in making estimates of national income by expenditure method

A.Precautions in making estimates of national income by expenditure method

1. Avoid intermediate expenditure. Only final expenditures, i.e. expenditure on consumption and
investment are included in national income. Intermediate expenditure like that on raw materials,
etc. in not included.

2. Do not include expenditure on second hand goods and financial assets because buying second
hand goods is not a fresh production activity and financial assets are neither goods nor services.

3. Avoid transfer expenditures. A transfer payment is a payment against which no services are
rendered, e.g. charities, donations, gifts, scholarships, etc. Since no production takes place,
therefore, not included in national income.

4. Imputed rent of self occupied houses is included in the national income because self-occupied
houses provide housing services similar to those as rented houses.

10. Explain the problem of double counting . State two ways to avoid it .

A.Problem of double counting arises when the value of certain goods and services are counted
more than once while estimating National Income. This happens when the value of intermediate
goods is counted in the estimation of National Income along with the value of final goods and
services. Including intermediate goods separately will lead to overestimation of national income.
There are two methods to avoid the problem of double counting:

(i) To consider only the final value of output produced.

(ii) To consider only the value added of the output produced. (Value added = Value of output
– Cost of intermediate goods used)

11. Explain steps for calculating national income by value added method .

Steps for calculation of national income by product method

Step 1: Estimation of value of output produced by each firm in all the sectors of the economy
during the year.

GVOmp = Value of output = Output produced (in units) × Market price

Step 2: Calculation of Value Added (VA) and Gross Domestic Product at market price (GDPmp)

Value added of a firm is the net contribution made by the firm in the production process.
GVAmp= Value added = Value of output – Intermediate consumption

Step 3: Calculation of Net Domestic Product at factor costs (NDPfc)

NDPfc (domestic factor income) = GDPmp – Depreciation – Indirect taxes + Subsidies

Step 4: Calculation of National Income (NNPfc): National income (NNPfc) = NDPfc + NFIA

12. Explain steps for calculating national income by income method .

Step 1: Estimate the factor payments by each firm in the economy.

Step 2: Take the sum total of NVAfc by all firms to arrive at NDPfc.

NDPfc = Compensation of employees + Operating surplus + Mixed income

Step 3: National income (NNPfc) = NDPfc + NFIA

( NDPfc = Compensation of employees + Operating surplus + Mixed income

1. Compensation of employees: It includes (a) Wages and salaries in cash and in kind, e.g. bonus,
free medical facilities, free meals, house rent allowance, etc. (b) Social security contributions by
the employers, e.g., provident fund or insurance premium paid by employers.

2. Operating surplus: Operating surplus is defined as the sum of rent, royalty, interest and profits.
(Profit = Corporation tax + Dividend + Retained earnings)

3. Mixed income of self-employed: The income of self employed people like doctors etc. has two
or more factor incomes; total income is estimable, but not its different components. So, mixed
income is another factor payment.)

13. Explain steps for calculating national income by expenditure method .

Step 1: We take the sum of final expenditures on consumption and investment in the economy.
This equals GDPmp. Its components are:

GDPmp = Private final consumption expenditure + Government final consumption expenditure +

Gross domestic capital formation + Net exports (or – Net imports)

Step 2: NDPfc = GDPmp – Depreciation – Net indirect taxes

Step 3: National income (NNPfc) = NDPfc + NFIA

Long answer questions

1.What lowers the significance of real per capita GDP as an index of welfare?

There are certain limitations related to GDP as an index of social welfare. These are as under:

(1) Distribution of Income:

If distribution of income turns unequal, GDP growth fails to reflect a rise in social welfare. India
is facing this situation at present. While per capita GDP is rising, starvation deaths are hitting the
headlines more often than ever before as distribution of income is becoming increasingly unequal.

(2) Composition of GDP:

Composition of GDP may not be welfare-oriented. Example: Increase in the production of defence
goods

does not lead to any direct increase in welfare of the people. Similarly more production and
consumption of economic bads like alcohol , cigarettes leads to decrease in welfare.

(3) Non-monetary Exchanges:

Non-monetary Exchanges like mother cooking food , kitchen gardening etc. remain unrecorded
due to unavailability of data . This causes underestimation of GDP. To the extent GDP remains
underestimated, it remains an inappropriate index of welfare.

(4) Externalities:

Externalities refer to harm or benefit caused due to an economic activity which is neither
penalised nor rewarded. There are both positive and negative externalities. Positive externalities
occur when, for example, Mr. X maintains a beautiful garden and Mr. Y (neighbour of Mr. X)
enjoys it. It adds to welfare of Mr. Y but he does not pay for it.

Negative externalities occur when, for example, smoke emitted by factories causes air pollution .
It causes a loss of social welfare. But, factory owners do not pay the penalty.

GDP fails to account for the impact of positive and negative externalities on social welfare. Hence,
it is an inappropriate index of welfare.

( since question is on real per capita GDP , therefore point of population and price is not taken
here)

HOTS

1.All producer goods are not capital goods. Why?

A. Producer goods include:

(i) goods used as raw material, like wood used to make furniture, and

(ii) goods used as fixed assets, like plant and machinery.

Capital goods include only fixed assets of the

producers. These are durable-use producer goods. On the other hand, goods used as raw material
are

single-use producer goods. These are not repeatedly used in the process of production.
Accordingly,

all producer goods are not capital goods.

2. All Machines are not Capital Goods. Explain.

• Capital goods are only those durable goods which are used as producer goods, not as
consumer goods. Whereas, all machines are not capital goods as they include consumer
durables too.
• If the end-user of a durable good is a household consumer, it is durable-use consumer good.
On the other hand, if the end-user of a durable good is a producer, it is a capital good.
• Example:
✓ A sewing machine in a tailoring shop is a fixed asset of the tailor; it is a capital good.
✓ But the same machine with a consumer household is not a capital good. It is simply a
durable- use consumer good.

3. A kind of goods used as intermediary goods can never be final goods. Defend or refute.

A. The given statement is incorrect. The same good may be a final good or an intermediate good. It
all

depends on the end-use of the goods. Example :

✓ Sugar is a final good when used by households.

✓ It is an intermediate good when used by candy-makers.

4. Should purchase of wheat in the wholesale market be treated as the purchase of final
good?

Ans. Purchase of wheat in the wholesale market is often done by the traders. Wheat is a
consumption

good and traders are not the final users of wheat. Therefore, purchase of wheat in the wholesale

market is to be treated as the purchase of intermediate good.

However, sometimes the households buy wheat in bulk from wholesale market. In such situations,

purchase of wheat should be treated as purchase of final good.

REASON BASED QUESTIONS

1. No value is to be added to the final goods.

True. Because these goods have crossed the boundary line of production and are ready for use by

the final users.

2. Intermediate goods are durable-use producer goods.

False. Because intermediate goods are not repeatedly used for several years by the producers and

are not of high value.

3. Final goods must finally be consumed by the households.

False. Final goods can finally be consumed by the households as well as by the producers.

4. Vegetables used by the households are consumption goods.

True. Because, vegetables are directly used for the satisfaction of human wants.

5. Only final goods and services are to be considered in the estimation of GDP, to avoid
double counting.

True. Only final goods and services are to be considered to avoid double counting in the
estimation

of GDP. Because, final goods and services do not require further value addition. These are outside

the boundary line of production.

6. Purchase of a refrigerator by a firm for its own use is included in the estimation of
national income
because it leads to final consumption expenditure.

False. Purchase of a refrigerator by a firm for its own use is included in the estimation of national

income because it leads to final investment expenditure.

7. Capital goods involve loss of value on account of their depreciation.

True. Capital goods are fixed assets of the producers. They depreciate in value as these are
repeatedly

used in the process of production.

8. The same good may be a consumption good or capital good, depending on its end-use.

True. Example: Car purchased by the household is a consumer (or consumption) good, while the
car

purchased by a tourist company is a capital good.

9. Clothes used by the households are durable consumer goods.

False. Clothes used by the households are semi-durable consumer goods. Because (i) clothes are

used for a period of one year or slightly more, and (ii) these are not of very high value.

10. Gross investment may occur even when net investment is zero.

True. Gross investment = Net investment + Depreciation.

Gross investment = Depreciation (= Replacement Investment), when net investment = 0.

11. Gross investment includes the value of expected obsolescence.

True. Gross investment = Net investment + Depreciation. And, expected obsolescence is a part of

depreciation.

12. Net investment always implies an increase in the stock of capital.

True. Net investment always implies increase in the stock of capital. Because, it does not include
replacement investment.

13. Net investment induces employment.

True. Because net investment leads to increase in the stock of capital. And, more labour can be
employed when the stock of capital increases.

14. Inventory investment includes change in stock of consumer goods with the producers.
True. Inventory investment includes stock of all types of goods (including consumer goods) with
the producers.

15. Depreciation may occur even when fixed assets are not in use.

False. Depreciation is the loss of value of fixed assets (capital goods) in use, on account of their
normal wear and tear.

16. Expected obsolescence is a 'capital loss'.

False. Unexpected obsolescence is a 'capital loss'.

17. Obsolescence is a part of depreciation.

True. But only expected obsolescence is to be considered as a part of depreciation.

18. Stocks do not change over time, while flows do.

False. Both stocks as well as flows tend to change over time.

19. Inventory investment refers to change in stock and is, therefore, a stock variable.

False. Inventory investment is a flow concept because it is related to a period of time.

20. Income is a stock concept.

False. It is a flow concept. Because it is related to a period of time.

21. Population of a country is a flow concept .

False. Population of a country is a stock concept because it is related to a point of time.

22. Flow of goods and services across different sectors of the economy is money flow.

False. Flow of goods and services across different sectors of the economy is real flow.

23.Domestic product refers to value addition only by the resident producers.

False. Domestic product/income refers to value addition or income generated in the domestic
territory

of a country by all producers (resident and non-resident) during one year.

24. Net factor income from abroad is treated as a component of income from domestic
product

accruing to the government sector.

False. Net factor income from abroad is a component of national income. It is added to domestic
income to get national income.

25. There is no difference between GDP at market price and GDP at factor cost in a two
sector economy including household sector and producer sector.

True. Difference between GDP at market price and GDP at factor cost is the net indirect taxes.

Net indirect taxes = Indirect taxes - Subsidies

The parameters of tax and subsidies emerge only when we are considering a three sector economy

including households, producers and the government.

26. GDP growth as an index of welfare loses its significance if there is a deep economic divide
in the

economy.

True. Economic divide indicates the increasing gulf between the rich and poor people. If the gulf

increases, GDP growth loses its significance.

27.National income at current prices can increase even when the quantum of goods and
services

produced during the year remains constant.

True. Increase in the price level can cause an increase in national income at current prices without

increase in the quantum of goods and services.

28. National income is always greater than domestic income.

False. National income can be less than domestic income. National income is greater than
domestic

income only when net factor income from abroad is some positive number.

29. Increase in national income always implies increase in domestic income.

False. National income = Domestic income + Net factor income from abroad.

This equation shows that national income can increase when net factor income from abroad

increases even when domestic income is constant.

30. National income at market price is always greater than national income at factor cost.

False. National income at market price = National income at factor cost + Net indirect taxes.
 National income at market price can be less than national income at factor cost in case net indirect

taxes is a negative number.

31. Domestic income as well as national income include only factor incomes.

True. National income is the sum total of factor incomes earned by normal residents of a country
during a given year. Domestic income is the sum total of factor incomes generated within the
domestic territory of a country.

32.Market price includes the impact of indirect taxes, but not of subsidies.

False. Market price includes the impact of both indirect taxes and subsidies. Indirect taxes raise the

market price while subsidies lower it.

33. Net indirect taxes are never equal to zero.

False. Net indirect taxes are equal to zero in case indirect taxes are equal to subsidies.

34. Increase in national income implies increase in the flow of goods and services in the
economy.

True. Provided that, national income (as the market value of final goods and services produced

during the year) is estimated at constant prices, NOT at current prices.

Appendix:

S.No. Items Example Reason

1. Intermediate 1. Purchase of raw material by a firm Value of intermediate

Consumption Examples : consumption is already included in
· Chalk , duster etc . purchased by a school
the final expenditure .We don’t
· Leather purchased by a shoe manufacturing firm
· Milk purchased by a dairy shop include the expenditure on
· Test tubes purchased by a pathological lab intermediate consumption to avoid
· Baker buys flour to bake a cake for her bakery the problem of double counting .
· A professional basketball team buys a
basketball for practice
· Accountant purchases pencils to prepare taxes
for clients
2. Items meant for resale in the same accounting year
.
Examples :
 · Purchase of car by a car dealer
· Purchase of juices by school canteen
· Purchase of furniture by a furniture showroom
· Purchase of machinery by a machinery supplier
· A jeweler buys a diamond for a ring he is
designing for sale
3. Expenditure on repair and maintenance of fixed
asset :
Examples :
· Painting of office building
· Repair of a machinery
· Expenditure by a school on repair of a school bus
· Spare part of a truck

4. Research and development expenditure :

Examples:
· Expenditure on commodities consumed in
research
· Expenditure on commodities consumed in basic
scientific research
· Expenditure on advertisement , market research
and public relations
· Business expenses of employees on tour and
entertainment
5. Goods and services supplied to employees :
Examples :
· Clothing and footwear given to employees
· Transportation and accommodation facilities
while travelling for work
6. Intermediate consumption of General Government
:
Examples :
· Value of non-durable goods and services
· Expenditure on military goods primarily for
military purposes
· Value of goods received in kind from foreign as
gifts or transfers (excluding those meant for
distribution among consumers after alterations)
· Expenditure on maintenance of government
buildings
7. Payment of water/electricity bill by a firm
8. Payment of fees to a lawyer engaged by a firm
2. Transfer 1. From Government to households : Unilateral payments, not
payments Examples : connected with any productive
· Scholarship
activity
· Old age pension
· Unemployment allowance
· Financial help given to natural calamity victims,
 accident victims etc.
2. From Government to enterprise :
Examples :
· Subsidies
· Development grants
· Investment grants
3. Enterprises to Government :
Examples :
· Direct and indirect taxes
· Development cess for a particular area
4. Households to Government :
· Compulsory payments such as direct and indirect
taxes
5. One country to another :
Examples :
· Transfers received from abroad
· Charity or grants
· War damages
· Gifts and donations
· Economic assistance
6. Enterprise to households :
Examples :
· Gift received from employer
· Prizes
7. Other examples :
· Remittance from abroad
· Free meals to beggars
· Pocket money given to a child
· Wedding and birthday gifts
· Donations to NGOs
3. Compulsory 1. Direct taxes : Compulsory transfers to
transfer Examples : government and government
· Wealth tax
payments doesn’t give anything directly in
· Death duty
· Capital gain tax return
· Gift tax
· Income tax
· Corporation tax
· Property tax
· Estate tax
2. Indirect taxes :
Examples :
· Excise duty
· Sales tax
· VAT
· Octroi
· Custom duties
· Stamp duties
 · Service tax
4. Illegal 1. Income earned from illegal activities such as : No estimates are available for
income · Smuggling these incomes
· Gambling
· Theft
2. Black money
5. Sale and 1. Income earned from sale and purchase of second Their value has already been
purchase of hand goods like old house , old vehicle , old machinery included in the national income
, old jewellery etc.
second hand
goods

6. Windfall 1. Gains from winning lottery , horse race , lucky They do not add to production of
gains draw etc goods and services

7. Capital gains 1. Profit due to increase in the price of : They do not add to production of
· Land goods and services
· Building
· Shares
· Sale of second hand goods
· Gold or other precious metal
· Stock lying with a trader
8. Non market 1. Services of housewife such as cleaning of home, No estimates are available for
transactions cooking food etc. these activities
2. Leisure time activities such as painting , kitchen
gardening , making craft items etc.
3. Parents teaching their own child
4. Self repair of breakage in the house
5. Services rendered by family members to each
other
9. Selected 1. National debt interest paid by households to It is interest paid for consumption
interest commercial banks purpose
2. Interest payment on loan taken for consumption
payments
purpose
3. Inter firm interest payment
4. Payment of dividend from one firm to another It is already included in the profits
of the firm which makes the
payment

10. Income Examples : It is income received by non

earned by 1. Salaries received by Russian / Chinese/Japanese residents , so can’t be a part of
etc. from Indian firms
non national income
2. Profits earned by a foreign bank/ company from
residents its branches in India
3. Rent received by foreigners on buildings rented to
Indian Embassy
11. Goods lying Example: Only value of final goods to be
within the 1. Steel lying with a car manufacture included to avoid the problem of
production double counting
boundary

Unit 2
Money and Banking

Very short questions :

1.Define money .
A. Money is defined as an instrument that serves as a generally accepted medium of exchange,
store of value, a measure of value and a standard for deferred payments.

2.Define money supply

A. Money supply refers to total stock (volume )of money held by the people of a country at a
particular point of time.
Some important points regarding money supply :
➢ Money supply is a stock concept as it is measured at a point of time .
➢ Supply of money includes only that stock of money which is held by people, other than
suppliers of money ( banking system and government) themselves.

3.What is fiat money?

A. Fiat money refers to money backed with order (authority) of the government. Eg. notes and
coins.

4.What is fiduciary money?

A. Fiduciary money is the money backed with mutual trust between the payer and the payee.

5.Define full bodied money.

A.Full bodied money refers to money in terms of coins whose commodity value is equal to the
money value as and when these are issued. Eg. gold coins.

6.What is credit money?

A.Credit money is the money for which money value (face value) is more than commodity value
(intrinsic value).

7.Define high powered money.

A.High powered money is the money issued by the RBI and the government. It includes:
(i) currency held by the public, (ii) cash reserves of the commercial banks with the RBI.

Some important points regarding high powered money :

➢ High powered money refers to monetary base or base money in the country as it includes
cash reserves that serve as the actual base for the generation of demand deposits.
➢ Difference between money and high powered money : Money includes demand deposits of
banks , while high powered money includes cash reserves of banks .

8.Define demand deposits.

A. Demand deposits of commercial banks are those deposits which can be withdrawn from the
bank on demand or by writing a cheque any time by the depositor.
*Nowadays there are other mediums too to withdraw demand deposits like UPI , debit card etc.
 9.Define term deposits.
A. Term deposits are those deposits which cannot be withdrawn from the bank as and when needed
or by writing a cheque anytime. These deposits involve a lock-in period.

10.Define bank money .

A. Money created by the commercial banks by way of demand deposits is called Bank Money.

11.State the principal components of money supply.

Ans. The principal components of money supply are:
(i) Currency (notes + coins) held by the public.
(ii) Demand deposits of the people with the commercial banks, and
(iii) Other deposits with RBI.

12.Why are cash deposits of the government and of the commercial banks with the RBI not
treated as a part of money supply?
A.Because government and commercial banks are creators/suppliers of money. And, money held
by the creators/suppliers of money is never treated as a part of money supply.

13.What do you mean by Aggregate Monetary Resources of the Country ?

A.If money supply in the country is measured using M3 measure, it is called 'aggregate
monetary resources of the country.

14.Who are the suppliers of money in India?

Ans. (i) The central bank of the country (RBI in India )
(ii) The commercial banks
(iii) The government of the country

15. In which accounts demand deposits are maintained ?

A. Demand deposits are maintained under :
(a) saving account deposits, and
(b) current account deposits.

Short answer questions: (3 to 4 marks )

1.Explain the concept of M1 measure of money supply.

A.According to M1 measurement, money supply includes the following components:

M1 = C +DD+ OD
Here,
C : Currency with public :
It refers to currency held by the public. It includes coins as well as paper notes. Currency is also
termed as legal tender as it can be legally used to make payments of all debts or other obligations.
DD :Net demand deposits with banks :
It refers to demand deposits of the people with the commercial banks. These are chequeable
deposits which can be withdrawn or transferred on demand.
OD :Other deposits with RBI:
These are demand deposits with RBI of public financial institutions like NABARD ,foreign
central banks and of the foreign governments ,international financial institutions like IMF and
World Bank.

2.Explain functions of money.

A. Money performs following functions :
(i) Medium of exchange :
Money acts as a medium of exchange, which means that it can be used to make payments for all
transactions of goods and services.
(ii) Store of value :
Money serves as a store of value (people save in terms of money). It can be used to transfer
purchasing power from present to future.
(iii) Money measure of value:
Money works as a common denomination , which means market price of goods and services is
expressed in terms of money.
(iv) Standard for deferred payments (future payments)· money acts as a ‘ standard for payment’,
which are to be made in future . For eg. when business contracts are signed on the basis of future
payments, money acts as an instrument for those payments.

3.What is the difference between gross demand deposit and net demand deposits ?
A.Gross demand deposits include inter-banking claims( claims of one bank against the other).
Net demand deposits do not include inter-banking claims. Inter-banking claims are not a part of
demand deposits of public.

4.Distinguish between 'Narrow Money' and 'Broad Money' concepts of Money Supply.
A.The distinction between narrow money and broad money is sometimes drawn with reference to
the measure used for estimating total money supply in the country.
➢ If M 1 or M 2 measures are used, then it is known as 'narrow money' concept of money
supply.
➢ If M 3 or M 4 measures are used, then it is known as 'broad money' concept of money
supply.

5.Who Supplies Money in India ?

A. Suppliers of money include:
(i) Central bank of the country (RBI in India) :
RBI is the principal supplier of money. RBI issues currency notes of denomination above Rs.1 on
the basis of Minimum Reserve System.
(ii) Commercial banks:
Commercial banks are the second significant source of money supply. Money is created by the
commercial banks by way of demand deposits called Bank Money.
(iii) The Government:
 Government is the third source of money supply in the country. In India, the Ministry of Finance
issues one rupee notes and coins of all
denomination .

6.The commercial banks cannot issue notes and coins, yet they are the suppliers of money.
Comment .
A.Unlike the central bank, commercial banks do not have the authority of issuing currency (i.e.
notes and coins ). Yet, they are the suppliers of money as they create money by way of demand
deposits.
➢ These deposits serve as supply of money because these are chequeable deposits.
➢ People can withdraw or transfer money by writing cheques. Money created by the
commercial banks by way of demand deposits is called Bank Money.

7.Explain the concept of M1 , M 2 , M 3 , M 4 measures of Money Supply in India .

A. Concept of M1 , M 2 , M 3 , M 4 measures of Money Supply in India are as follows :
➢ M1 = Currency with public + Net demand deposits with banks + Other deposits with RBI
➢ M 2 = M 1 + Deposits with Post Office Saving Bank Account
➢ M 3 = M 1 + Net Time Deposits with the Commercial Banks
➢ M 4 = M 3 + Total Deposits with Post Offices (other than in the form of National Saving
Certificate)

8. Explain the concept of Term Deposits and Demand Deposits.

A.Term deposits are different from demand deposits:

Basis Term deposits Demand deposits

Meaning Term deposits are those deposits which
cannot be withdrawn from the bank as
and when needed or by writing a cheque
any time. These deposits involve a
lock-in period.
Time period Term deposits are always for a specific
period of time, like fixed deposits for a
period of one year or two years.
Chequable Term deposits are not chequeable
deposits.
Demand deposits of commercial banks
are those deposits which can be
withdrawn from the bank on demand
or by writing a cheque any time by the
depositor.
Demand deposits are not for any
specific period of time.
Demand deposits are chequeable
deposits.

9. Introduction of money has separated the acts of 'sale' and 'purchase'. How?
A. Under the barter system of exchange, acts of sale and purchase of an individual must occur at
the same point of time. To buy a thing, an individual must at the same time sell something needed
by the other person. Also, sale and purchase by an individual must be of equal value.
With the introduction of money (as a medium of exchange), an individual can buy a thing with
money without selling anything at the same time. Likewise, he can sell a thing for money without
buying anything at the same time. Thus, with the introduction of money, acts of sale and purchase
have been separated.
10. Explain the concept of spread .
A.
➢ The interest rate paid by the banks to depositors ( deposit rate ) is lower than the rate
charged from the borrowers (lending rate ).
➢ This difference between these two types of interest rates, called the ‘spread’ is the profit
appropriated by the bank.

BANKING

Very short questions :

1. Define Central bank .

A. The central bank is an apex bank that controls the entire banking system of a country. It is the
sole agency of note issuing and controls the supply of money in the economy. RBI is the central
bank of India .

2. Define Commercial bank .

A. A commercial Bank is that financial institution which accepts deposits from the general public
and offers loans to the people for purpose of consumption and investment.

3. Define primary deposits.

A.Primary deposits are cash deposits with the commercial banks by the people. These indicate
savings of the depositors with the banks.

4. What are secondary deposits?

A. Secondary deposits are those deposits which arise on account of loans by the banks to the
people. These are reflected as a part of demand deposits of the banks. These are also called
derivative deposits.

5. Define CRR.
A. CRR (cash reserve ratio) refers to the legally required minimum percentage of commercial
bank's net demand and time liabilities required to be kept with the RBI as cash reserves.

6.What is SLR?
A. It refers to the minimum percentage of commercial bank's net demand and time liabilities
required to be kept with themselves in the form of liquid assets.

7. Define bank rate.

A. Bank rate refers to the rate of interest at which the RBI lends money to the commercial banks
to meet their long term needs.

8. What is repo rate?

A : Repo rate refers to the rate of interest at which the RBI lends money to the commercial banks to
meet their short term needs.

9. What is reverse repo rate?

A. Reverse repo rate is the rate of interest at which commercial banks can park their surplus funds
with the central bank, for short period of time.

10. What do you mean by open market operations?

A. Open market operations refer to the sale and purchase of government securities in the open
market by the central bank of the country.

11. Define margin requirement.

A. Margin requirement refers to the difference between market value of the security offered for
loans and the amount of loans offered by the commercial banks. Suppose, a person mortgages his
house worth Rs. 1 crore with the bank for a loan of Rs. 80 lakh. The margin requirement in this
case would be Rs. 20 lakh.

12. Define moral suasion.

A. Moral suasion refers to persuasion as well as pressure exercised by the central bank on the
commercial banks to be restricted and selective in lending during inflation, and to be liberal in
lending during
deflation.

13.Commercial banks are required to maintain a fixed percentage of its deposits as SLR in
which form of liquid assets ?
A.The liquid assets include: (i) cash, (ii) gold, and (iii) unencumbered approved securities.

14.What are two types of two types of open market operations ?

A.There are two types of open market operations (i) outright, and (ii) repo

15. Define LRR

A. It refers to the minimum percentage of commercial bank's net demand and time liabilities
required to be kept with themselves and central banks as reserves.
Short Answer questions ( 3 to 4 marks )

1. Explain functions of central bank . (any 1 function will come for 3 to 4 marks )
A.Bank of Issuing Notes:
The central bank has sole monopoly to issue currency notes that are the legal tender
money of the economy. In India one rupee notes and coins are issued by ministry of
finance, government and all other notes are issued by Reserve Bank of India.

The advantages of this are:

• Brings uniformity to note circulation

• Gives distinctive prestige to note issue and develops faith in currency. It enables central
bank to directly control the supply of money.
• Enables central bank to control over credit creation by commercial banks.

Banker to the Government:

Central bank is a banker, agent, and financial advisor to the government.
As Banker:
• Central bank conducts banking functions of government department in the same
manner as commercial banks perform for their customers.
• It receives deposits from the government and collects cheques and drafts
deposited in government account.
• Provides cash for payment of compensation of employees to its employees.
Advances short term loans to the government.

As Agent:
• It manages public debt
• Collects taxes and other payments like interest on debt on behalf of government.
• Represents government in international financial institutions and conferences.

As Advisor:
• Gives advice on all financial and economic matters like devaluation, deficit
financing, trade policy , capital market, government loan and foreign exchange
policy.

Bankers' Bank and Supervisory Role:

As a Bankers' Bank, it has almost the same relation with other banks in the country as a commercial
bank has with its customers. It performs following functions as bankers’ bank:
Custodian of CRR of commercial banks: Every commercial bank has to keep a certain percentage ofits
primary deposits as cash reserves with central bank. This ensures a more effective control of central
bank on the banking system, and centralized reserve can be more effectively used.
Lender of last resort: Central bank acts as lender of last resort. In case commercial banks
fail to meet their financial requirements from other sources they can as a last resort
approach to the central bank for loans and advances. The central bank assists through
discounting of approved bills of exchange, treasury bills or government securities.

Supervisor: It supervises, regulates and controls the commercial banks. This is done by
using its vested powers relating to licensing, branch expansion, liquidity of assets and
merger and liquidation of banks.

Controller of Credit:
• The principal function of the central bank is to control the supply of credit in the economy
with the help of quantitative and qualitative monetary tools.
• It implies increase or decrease in the supply of money in the economy by regulating the
'creation of credit' by the commercial banks.
• The central bank needs to control the supply of money to cope with the situations of
inflation and deflation.
• During inflation, the supply of money is reduced and during deflation, it is increased.
• Quantitative Instruments of Monetary Policy:
Bank rate, (b) Repo rate, and (c) Reverse repo rate (d) CRR, and (e) SLR (f) Open market
operations.
• Qualitative Instruments of Monetary Policy:
Margin requirement, (b) Rationing of credit, and (c) Moral suasion.

2. Explain quantitative methods of credit control as used by Central bank. (any 1 measure
will come for 3 to 4 marks )
A.Bank Rate:
Meaning :Bank rate refers to the rate of interest at which the RBI lends money to the commercial
banks to meet their long term needs. Any change in bank rate is often followed by change in the
lending charged by the commercial banks from the general public.
Contractionary monetary policy : To contract the supply of money bank rate is increased, as a
result of which lending rate also increases . This discourages borrowers to take credit and
therefore, the supply of money tends to fall. Accordingly, inflation is corrected.
Expansionary monetary policy : To expand the supply of money bank rate is decreased , as a
result of which lending rate also decreases . This encourages borrowers to take credit and
therefore, the supply of money tends to increase . Accordingly, deflation is corrected.

Repo Rate:
Meaning :Repo rate refers to the rate of interest at which the RBI lends money to the commercial
banks to meet their short term needs. Any change in repo rate is often followed by change in the
lending charged by the commercial banks from the general public.
Contractionary monetary policy : To contract the supply of money repo rate is increased, as a
result of which lending rate also increases . This discourages borrowers to take credit and
therefore, the supply of money tends to fall. Accordingly, inflation is corrected.
Expansionary monetary policy : To expand the supply of repo bank rate is decreased , as a
result of which lending rate also decreases . This encourages borrowers to take credit and
therefore, the supply of money tends to increase . Accordingly, deflation is corrected.

Reverse Repo Rate:

Meaning : Reverse repo rate is the rate of interest at which commercial banks can park their
surplus funds with the central bank, for short period of time.
Contractionary monetary policy : To contract money supply reverse repo rate is raised, banks are
encouraged to park their surplus funds with the RBI. This leads to a decrease in lending
capacity of commercial banks and a consequent decrease in credit supply (money supply) in the
economy Accordingly, inflation is corrected.
Expansionary monetary policy : To expand money supply reverse repo rate is lowered, banks are
discouraged to park their surplus funds with the RBI. This leads to an increase in lending capacity
of commercial banks and a consequent rise in credit supply (money supply) in the economy.
Accordingly, deflation is corrected.

Cash Reserve Ratio (CRR):

Meaning : It refers to the minimum percentage of commercial bank's net demand and time
liabilities required to be kept with the RBI as cash reserves.
Contractionary monetary policy : When the supply of money is to be reduced, CRR is raised. This
leads to rise in cash reserves for a given amount of demand deposits . Eventually , there will be a
decrease in lending capacity of commercial banks and a consequent decrease in credit supply
(money supply) in the economy. Accordingly, inflation is corrected.
Expansionary monetary policy : When the supply of money is to be increased, CRR is lowered,
and This leads to fall in cash reserves for a given amount of demand deposits . Eventually , there
will be rise in lending capacity of commercial banks and a consequent increase in credit
supply (money supply) in the economy.Accordingly, deflation is corrected.

Statutory Liquidity Ratio (SLR):

Meaning : It refers to the minimum percentage of commercial bank's net demand and time
liabilities required to be kept with themselves in the form of liquid assets.
Contractionary monetary policy : When the supply of money is to be reduced, SLR is raised. This
leads to rise in liquid assets to be held by the commercial banks with themselves . Eventually ,
there will be a decrease in lending capacity of commercial banks and a consequent decrease
in credit supply (money supply) in the economy. Accordingly, inflation is corrected.
Expansionary monetary policy : When the supply of money is to be increased, SLR is lowered, and
This leads to fall in liquid assets to be held by the commercial banks with themselves . Eventually
, there will be rise in lending capacity of commercial banks and a consequent increase in
credit supply (money supply) in the economy. Accordingly, deflation is corrected.

Open market operations :

Meaning : Open market operations refer to the sale and purchase of securities to and from public
and commercial banks by the RBI on behalf of the government.
Contractionary monetary policy : To contract money supply securities are sold by the RBI .This
soaks liquidity and leads to a fall in cash reserves of the commercial banks . Eventually , there
will be a decrease in lending capacity of commercial banks and a consequent decrease in
credit supply (money supply) in the economy . Accordingly, inflation is corrected.
Expansionary monetary policy : When the supply of money is to be increased, securities are
purchased by the RBI .This releases liquidity and leads to a rise in cash reserves of the
commercial banks . Eventually , there will be rise in lending capacity of commercial banks
and a consequent increase in credit supply (money supply) in the economy .Accordingly,
deflation is corrected.

3.Explain quantitative methods of credit control as used by Central bank. (any 1 measure
will come for 3 to 4 marks or a combined question can come )
A.Margin requirement :
Meaning : The margin requirement refers to the difference between the current value of the
security offered for loan (called collateral) and the value of loan granted. For eg. if marginal
requirement is 40%. Soagainst a security of Rs 1,00,000 a loan of only Rs.60,000 can be raised.
Contractionary monetary policy : To contract money supply margin Requirement is raised . This
leads to a fall in demand for credit . Hence credit by the commercial banks reduces leading to
fall in money supply . Accordingly, inflation is corrected.
Expansionary monetary policy : To expand money supply margin Requirement is reduced . This
leads to rise in demand for credit . Hence credit by the commercial banks increases leading to
rise in money supply . Accordingly, deflation is corrected.

Moral Suasion: It is like rendering an advice to the commercial banks by the RBI to follow its
directives. The banks are advised to restrict loans during inflation, and be liberal in lending during
deflation.

Selective credit control

It refers to discriminatory policy of the central bank relating to select sectors of the economy.
Flow of credit to certain sectors (priority sectors) may be encouraged with a view to stimulating
production in these sectors. This is a positive application of selective credit controls. On the other
hand, the central bank may decide to restrict the availability of credit to certain (non-priority)
sectors. Generally, during periods of inflation, availability of credit for speculative activities (like
storage of food grains)is discouraged. This is a negative application of the selective credit controls.

3. Distinguish between Bank rate and repo rate .

A.
Basis Bank rate Repo rate
Meaning Bank rate refers to the rate of interest Repo rate refers to the rate of interest at
at which the RBI lends money to the which the RBI lends money to the
commercial banks to meet their long commercial banks to meet their short
term needs. term needs.
Collateral Bank rate relates to the loans offered by Repo rate relates to the loans offered by the
the RBI to the commercial banks RBI to the commercial banks NOT
without any collateral (security for without collateral. The securities are
purpose of loans). pledged as a security for the loans.
Repurchase Bank rate does not allow any facility of Repo rate allows repurchase of securities.
repurchase of securities.
4. Distinguish between SLR and CRR .
A.
Basis CRR Repo rate
Meaning It refers to the minimum percentage It refers to the minimum percentage of
of commercial bank's net demand and commercial bank's net demand and time
time liabilities required to be kept liabilities required to be kept with
with the RBI as cash reserves. themselves in the form of liquid assets.
Form It is kept in form of cash reserves The liquid assets include: (i) cash, (ii) gold,
and (iii) unencumbered approved
securities.
Credit CRR has a direct bearing on credit SLR impacts credit creation only indirectly
creation creation by the commercial banks in by increasing or decreasing the amount of
India. liquid assets of the commercial banks

Long answer questions :

1. Explain the process of credit / money creation with the help of a numerical example .
A. Definition

Money creation is a process in which commercial banks are able to create money/credit in the form
of deposits which is in the multiples of initial deposit made with the bank.

Money created = Initial deposits x money multiplier

Money multiplier

The number by which initial deposit is multiplied to get the final deposit is known as money
multiplier.

Money multiplier= 1 / LRR

Where, LRR is Legal Reserve Ratio

Assumption

This process is based on two assumptions

a. Entire banking system of the country is one unit.

b. All transactions in an economy be routed through bank.
Process:

➢ This process can be explained with the help of given numerical example.
➢ Assume an initial deposit of Rs. 1,000 crores is made in an economy. LRR is assumed to be
10%
➢ Since LRR is 10%, banks will deposit Rs. 100 crores as cash reserve and lend rest Rs. 900
crores. This amount is deposited in the account of the borrower.
➢ Since all the transactions are routed through bank Rs. 900 crores will come to the bank in
the form of deposit from the person who received the payment from borrower.
➢ This Rs. 900 crores will be given as loan of Rs. 810 crores keeping Rs. 90 crores as cash
reserve.
➢ The deposit will keep increasing by 90% in each round and the process will stop when the
total reserve will become equal to initial deposit and money is created in multiples of initial
deposit as calculated below:
Money Multiplier = 1/LRR

= 1/10%

= 10

Monet created = 1000X10=10000

Deposit Loan Reserve

1000 (initial deposits) 900 100
900 810 90
810 729 81
‘’ ‘’ ‘’
‘’ ‘’ ‘’
‘’ ‘’ ‘’
10,000 9000 1000

Therefore, Total deposit = initial deposit x money multiplier

= 1000 x 10= 10,000

i.e. Rs. 10,000 crores

Conclusion:

Thus it can be seen that an initial deposit of Rs. 1000 crores led to creation of total deposits
equivalent to Rs.10,000 crores with money multiplier as 10.

Critical points
There is an inverse relation between money multiplier and LRR

Total deposits= Primary/Initial deposit + secondary deposit (Loan)

HOTS

1.RBI lowers repo rate from 5.40% to 5.15%. [4th October, 2019]

Analyse the economic value of this statement from the viewpoint of (i) the households, (ii)
investors, and (iii) the economy.

A. A cut in repo rate (the rate at which commercial banks can raise loans from RBI) is expected to
be followed by a cut in market rate of interest (the rate at which the commercial banks offer loans
to the

people). It is expected to impact the households, investors, and the economy as under:

(i) Impact on Households: A cut in market rate of interest (followed by a cut in repo rate) is
expected to induce borrowings for the purchase of consumer durables, as well as houses and flats.
Also,

the existing loans (raised against floating interest rate) will now attract lower EMI. Implying a
direct monetary benefit to the households.

(ii) Impact on the Investors: As a result of a cut in the market rate of interest, the cost of
borrowings (implying the cost of capital) will reduce. Accordingly, investment is expected to
increase across all areas of production activity.

(iii) Impact on the Economy: When demand for consumer durables rises, aggregate demand is
expected to rise. Aggregate demand also tends to rise when investment expenditure rises.

Because both consumption expenditure and investment expenditure are significant components of
aggregate demand. Thus, the level of planned output is expected to rise along with the level of
planned purchase in the economy. Accordingly, the equilibrium GDP level is expected to rise.
Implying a rise in the growth rate of GDP.

2. Post office are not commercial banks . Comment .

A. Commercial banks perform the dual function of :

➢ accepting deposits from public

➢ advancing loans
 Post offices accept deposits from public but they don’t advance loans , therefore they are
not commercial banks.
If similar ques is on LIC then write LIC doesn’t accept deposits .

3. Is there a limit to money or credit creation by banks?

A.Yes, there a limit to money or credit creation by banks and this is determined by the Central
bank (RBI). The RBI decides a certain percentage of deposits which every bank must keep as
reserves. This is done to ensure that no bank is ‘over lending’. This is a legal requirement and is
binding on the banks. This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’ or ‘Cash
Reserve Ratio’ (CRR).

4. What are two types of open market operations ?

A. There are two types of open market operations: outright and repo.

➢ Outright open market operations are permanent in nature: when the central bank buys these
securities (thus injecting money into the system), it is without any promise to sell them
later. Similarly, when the central bank sells these securities (thus withdrawing money
from the system), it is without any promise to buy them later. As a result, the
injection/absorption of the money is of permanent nature.
➢ However, there is another type of operation in which when the central bank buys the
security, this agreement of purchase also has specification about date and price of resale of
this security. This type of agreement is called a repurchase agreement or repo.

5. Define repurchase agreement .

A. It is a type of open market operation in which the central bank buys the security, this agreement
of purchase also has specification about date and price of resale of this security. The interest rate at
which the money is lent in this way is called the repo rate.

6. Define reverse repurchase agreement .

A. It is a type of open market operation in which the central bank sell the securities through an
agreement which has a specification about the date and price at which it will be repurchased. The
rate at which the money is withdrawn in this manner is called the reverse repo rate.

CRITICAL POINTS
➢ It needs to be noted that while the commercial banks are a source of money supply in the
economy, they DO NOT have the authority of issuing notes or coins. They are a source of
money supply only as creators of credit or bank money.
➢ Both CRR and SLR are legally determined by the RBI. But, both are independently
determined, as these are differently estimated. Never miss the point that while CRR has a
direct bearing on credit creation by the commercial banks (as it sets the limit up to which
 the commercial banks can legally create credit), SLR impacts credit creation only
indirectly by increasing or decreasing the amount of liquid assets of the commercial banks.
➢ Bank rate is often higher than the repo rate as it (bank rate) relates to instant loan
requirement of the commercial banks.
➢ Total Demand Deposits of the Commercial Banks = Primary Deposits of the
Commercial Banks + Secondary Deposits of the Commercial Banks.
➢ While primary deposits indicate savings of the depositors with the banks, secondary
deposits indicate borrowings of the depositors from the banks.
➢ Alternate names :
Money multiplier ; Deposit multiplier
Legal reserve ratio ; Reserve deposit ratio
➢ India got its central bank in 1935. Its name is the ‘Reserve Bank of India’.
➢ The Reserve Bank of India conducts repo and reverse repo operations at various maturities:
overnight, 7-day, 14- day, etc.
➢ Repo rate and reverse repo rate are the main tools of monetary policy of the Reserve Bank
of India.
 Unit 3 : Determination of Income and Employment

Part A
Aggregate demand and Aggregate supply

Note :
Notes for this chapter are divided in part A and part B for ease. Both parts are important .
a section in part A is added as sure shot questions . They are most important from this
chapter.

Important definitions :

Aggregate demand :
AD is the sum total of value of final goods and services that all sectors of an economy are
planning to buy corresponding to different levels of income during the period of an accounting
year.
Aggregate Supply :
AS refers to total of value of final goods and services that all producers in an economy are
planning to supply during an accounting year.

Autonomous consumption (C):

It refers to the minimum level of consumption for survival even at a zero level of income. It is
called autonomous consumption because this consumption expenditure does not depend upon the
level of income.

Induced consumption (bY):

It refers to the level of consumption directly determined by the level of income.

Break even point:

The point where total consumption is equal to the total income or the point where total saving is
equal to zero is called break-even point.

Propensity to consume :
Propensity to consume refers to the proportion of income used as consumption expenditure. It is
measured as the ratio between C and Y.

Propensity to save:
Propensity to save refers to the proportion of income which is kept as saving. It is measured as the
ratio between S and Y.

Equilibrium level of income:

Equilibrium level of income is that level of income where AS = AD.
Autonomous investment:
Autonomous investment refers to investment which is independent of the rate of interest and the
level of GDP in the economy.

Induced Investment :
Induced investment refers to the investment expenditure which is dependent on the level of
income.

Ex-ante investment :
It refers to desired (or planned) investment corresponding to different income levels in the
economy.

Ex-ante consumption:
It refers to planned consumption expenditure on final goods in the economy.

Ex-ante savings:
It refers to the planned savings at different levels of income in an economy.

Effective demand:
It refers to that level of AD where ex-ante aggregate demand is equal to the ex-ante aggregate
supply, i.e. AD = AS.

Investment Multiplier:
Investment multiplier or output multiplier refers to the number by which change in investment
(ΔI) multiplies to become change in output/income (ΔY). It is measured as the ratio between
change in output/income and change in investment K = ΔY/ ΔI .
Full Employment:
Full employment refers to the situation when all workers who are willing to and able to work at
prevailing wage rates are actually employed and there is no involuntary unemployment.

Voluntary unemployment:
It is a situation when people choose to remain unemployed even when jobs are available. In this
situation, people are not willing to work at the prevailing wage rate.

Involuntary unemployment :
Involuntary unemployment refers to a situation when people are able and willing to work at the
prevailing wage rate and are not getting work. The aggregate demand in the economy is not
sufficient to use the existing resources in the economy.
Some Important concepts :

Variable Ex- ante Ex- post Relation

Consumption It refers to planned
consumption expenditure on
final goods in the economy.
Saving It refers to the planned
savings at different levels of
income in an economy.
Investment It refers to desired (or
planned) investment
corresponding to different
income levels in the
economy.
It refers to 'actual In the context of
consumption ' in the economy equilibrium GDP, we
during the period of one year. should focus only on
It refers to 'actual saving' in ex-ante saving and
the economy during the ex-ante investment.
period of one year. Equilibrium is struck only
It refers to 'actual investment' when:
in the economy during the ex-ante saving (S) =
period of one year. ex-ante investment (I)
Whereas, expost
investment = ex post
savings at all levels of
income.The equality
between two is bought
by changes in income.

Type of Meaning Equation Slope Intercept

function
Consumption The functional C = a + bY The slope of Intercept of
function relationship (or a in this equation refers to the consumption consumption
the algebraic minimum level of consumption. function is function is a ,
relationship) It is the value of consumption 'marginal autonomous
between when Y = 0. propensity to consumption .
consumption and consume'.
income is called
Consumption The parameter 'b' refers to the ΔC/ΔY
Function. rate at which
consumption increases in
response to an increase in
income . It is also known as
MPC.
Saving The functional S = -a + (1 - b)Y The slope of Intercept of saving
function relationship (or saving function is function is -a ,
the algebraic -a indicates the value of S when 'marginal indicating
relationship) Y = 0. It indicates dis-savings at propensity to dis-savings at zero
between zero level of income saving '. level of income .
saving and
income is called 1 - b = MPS. It indicates the rate ΔS/ΔY
saving Function. at which 'S' changes in response
to a change in 'Y'
Aggregate Meaning Formula Maximum Value Minimum Value
APC It is the ratio of C/Y It can exceed one It is less than one (but
consumption expenditure when consumption positive ) when
to corresponding level exceeds income . consumption is less than
of income at a point of income .
time It is equal to 1 when
consumption is equal
to income.
APS It is the ratio of savings to S/Y It cannot exceed one It is zero when
corresponding level (or equal to 1) as consumption is equal to
of income at a point of saving can never income and savings are
time exceed income. zero.

It is negative when
consumption exceeds
income and savings are
negative.
MPC It is the ratio of change in ΔC/ΔY 1 Zero
consumption to change in When entire When entire increased
income over a period of increased income is income is saved
time . consumed

MPS I t is the ratio of change ΔS/ΔY 1 Zero

in saving to change in When entire When entire increased
income over a period of increased income is income is consumed
time . saved

Sure shot (most important ) Questions: (6 marks )

1.Given a consumption curve, outline the steps required to be taken in deriving a saving
curve from it. Use diagram.
A. We know that
Income (Y) = Consumption ( C ) + Savings ( S)
This implies ,
S=Y-C
Thus , saving curve can be derived with the help of diagram given below comprising Part-A
showing, CC curve representing consumption function corresponding to each level of income
whereas 45° line represents income. Saving curve is derived in part B by taking reference
points from part A as given below :
 Step 1: At zero level of income consumption is equal to OC (Autonomous consumption ) . This
implies that saving curve starts from the point OS1 (in negative quadrant ) as at zero level of
income dissavings is exactly equal to the autonomous consumption (OC) .
Step 2: From the break-even point B in part A (where C=Y) , we draw a perpendicular on
X-axis which cuts the X-axis at B1in part B. At OB1 level of income, savings must be zero and
APS = 0) because at this level of income consumption equals income.
Step 3: Join S1 and B1 and extend it by a straight line to get the savings curve S1S
Saving curve S1S is a straight line, moving upward from left to right with slope as 1-MPS.

2. Explain the theory of determination of equilibrium level of output and income with the
help of aggregate demand and aggregate supply curves.
A. According to Keynesian theory , an economy is in equilibrium when where ex-ante aggregate
demand is equal to the ex-ante aggregate supply, i.e. AD = AS.
This can be explained with the help of given diagram :
 In the given diagram, AD is represented by C+I curve and AS by 45degree line . Equilibrium is
stuck at point K where AD = AS with OY as equilibrium level of income. E is equilibrium
point as at this point , level of desired spending on consumption and investment is exactly
equal to level of total output. In case of any deviation from the equilibrium following changes
will take place in the economy that will bring back economy to equilibrium:

When AD > AS (Y): (corresponding to income level ON )

1. It means consumers and firms are planning to buy more goods and services than
what firms are planning to produce.
2. Thus, planned inventories in hand with the producers would fall below the desired
level..
3. In order to bring back inventory to the desired level, firms will plan to raise the
production. This will increase the level of output and income till AS (Y) = AD.

When AD < AS (Y): (corresponding to income level OT )

1. It means consumers and firms are planning to buy less goods and services than
what firms are planning to produce.
2. Thus, there will be unplanned accumulation of inventories.
3. In order to bring back inventory to the desired level , firms will plan to cut down
production. This reduces output and income till AS (Y) = AD.

Thus, AD-line intersects the 45° AS-line at point K, so that K is the point of equilibrium where
AS = AD. OY is the equilibrium GDP in the economy and AD corresponding to this level of
income is effective demand.

3. What is Effective Demand Principle? Discuss with the help of imaginary numerical
example.
A. Effective demand refers to that level of AD where AS = AD. Thus, Effective Aggregate
demand always corresponds to the equilibrium level of income in the economy. It is called
'effective' as it is this level of AD which actually determines the equilibrium between AS and AD.
Numerical Example: Determination of Equilibrium Income or Output (C = 100, MPC = 0.8
and I = 300)

AD function shows different levels of aggregate demand. But it is only at point Y = 2000, that
AS = AD. Hence, 2000 is aggregate effective demand, which is effective in striking an
equilibrium between AS and AD.
Proof :
At Y = 0, and Y = 1,000; AD > AS. This causes unplanned decrease in inventories inducing
producers to produce more output.
At Y = 3,000 and Y = 4,000; AD < AS. This causes unplanned increase in inventory of unsold
goods inducing producers to produce less.
Therefore , At Y = 2,000; AD = AS. This keeps the inventory level unchanged. Thus, Effective
Demand (AD = AS) is obtained at `2,000 crores level of income/output which is the equilibrium
level of income/output.

4. Explain the determination of equilibrium level of income using 'saving-investment'

approach. Use diagram.
A.We know that in a simple two sector economy the equilibrium is struck when:
AD = AS
Since, AS (Y) = C + S,
and AD = C + I .
Therefore at equilibrium ,
C +S=C+I
or , S=I
Thus, equilibrium level of income/output is that level of income at which planned savings and
planned investment are equal.
This can be further explained with the help of given diagram:
As shown in the diagram below, in the upper panel the equilibrium is represented using the AD and
AS approach while the lower panel represents the equilibrium using S and I approach. Investment
curve (I) is parallel to the X-axis because of the autonomous character of investments. The Saving
curve (S) slopes upwards showing that as income rises; saving also rises.

The economy is in equilibrium at point ‘E’ where saving and investment curves, intersect each
other in lower panel.
If savings (S) > Investment (I) :
If planned saving is more than planned investment, i.e., after point ‘E’ in Fig., it means that
households are not consuming as much as the firms expected them to. As a result, the inventory
rises above the desired level. To clear the unwanted increase in inventory, firms would plan to
reduce the production till saving and investment become equal to each other.
If Saving (S) < Investment (I) :
If planned saving is less than planned investment, i.e. before point ‘E’ in Fig., it means that
households are consuming more and saving less than what the firms expected them to. As a result,
planned inventory would fall below the desired level. To bring the inventory back to the desired
level, firms would plan to increase the production until saving and investment become equal to
each other.
Thus, the equality between S and I is restored through change in the level of Y and OY is the
equilibrium level of output corresponding to point E.

5.Explain the working of investment multiplier with the help of a numerical example.
A.Investment multiplier measures the number of times an increase in investment in the economy
leads to an increase in income. The investment multiplier is based on the principle that “one man’s
expenditure is another man’s income”.

The multiplier can be represented by the following formula.

K = ΔY / ΔI
Where,
ΔY = Increase in GDP or National Income
ΔI = Increase in Investment
Also,
k = 1/ 1- MPC
And, k = 1/ MPS

Assuming that in the economy MPC is 0.5, the mechanism of investment multiplier is explained
with the numerical schedule given below.
Working of multiplier
1. Suppose the initial increase in investment in the economy is ∆I = 100 cr.
This additional investment will generate income of Rs. 100 cr.
2. With MPC as 0.5 , the recipient of this additional income would spend
Rs.50 cr on consumption and remaining Rs.50 cr. Will be saved.
3. In round 2, increase in consumption is converted into increase in income
by Rs.50 cr. This will again split into increase in consumption =Rs.25 crore and
increase in savings = Rs.25 crores.
4. This multiplier process will go on and consumption in each round will be
0.5 times of additional income generated in previous round. Process will come to an
end when initial increase in investment and total savings are equal and income is
generated in multiples of increase in investment.
5. It implies that there will be a two times increase in income in the economy
due to initial increase in investment.
K = ∆Y/∆I,
∆Y= k x ∆Y = 2 x 100 = Rs. 200 crores is the increase in income in the economy
due to an initial increase in income of Rs. 100 crores.

6. What is meant by aggregate demand? Explain its components.

A. AD is the sum total of value of final goods and services that all sectors of an economy are
planning to buy corresponding to different levels of income during the period of an accounting
year.

Private Consumption Expenditure (C):

Private consumption expenditure refers to the total expenditure incurred by all the households
in an economy on different types of final goods and services in order to satisfy their wants.
Consumption depends on the level of the disposable income.
Private Investment Expenditure (I):
Private investment expenditure refers to the planned (ex-ante) total expenditure incurred by all
the private investors on the stock of physical capital and change in inventories of a firm in an
economy.
Government Expenditure (G):
Government expenditure refers to the total planned expenditure incurred by the government
on consumption and investment purposes to enhance the welfare of the society and to achieve
higher economic growth rates.
Net Exports (X – M):
Net exports refers to the difference between the demand for domestically produced goods and
services by the rest of the world (exports) and the demand for goods and services produced
abroad by the residents of a country. In other words, it is the difference between the exports
and imports.

SOME OTHER QUESTIONS

Short Answer Questions

1. List components of aggregate demand .
A. Components of aggregate demand are:
(i) Consumption Expenditure(C) (ii) Investment Expenditure(I ) (iii) Government’s final
expenditure (G) (iv) Net exports.

2.Why cannot the value of marginal propensity to consume be greater than one?
A. It is because change in consumption cannot be greater than change in income.

3. What is the relationship between marginal propensity to save and marginal propensity to
consume?
A. Aggregate of marginal propensity to save and marginal propensity to consume is equal to one or
M PS + M PC = 1.
4. What is the value of marginal propensity to consume when marginal propensity to save is
zero?
A. Value of marginal propensity to consume is 1 when marginal propensity to save is zero.

5.Do you agree that M PS cannot be negative, but APS can be?
A. Given the fact that there is a positive relationship between saving and income, an increase in
income must cause an increase in saving. Implying that M PS must always be positive. However,
APS can be negative when at a very low level of income consumption is greater than income so
that saving is negative .

6.Do you think higher the level of Y, higher should be the level of autonomous consumption
in C-function?
A. This is not correct because autonomous consumption is not related to the level of Y.

7. The exports fall 15% to 1718.07 cr. in first 6 months of FY 15. How will this affect
aggregate demand in the economy?
A. Fall in exports would be reflected as a fall in aggregate demand. Because, exports a re a
component of aggregate demand.

8. In a situation when planned S > planned I, inventory investment of the producers is

expected to be larger than desired . Do you agree?
A. When planned S > planned I, some output would remain unsold and producers will have
undesired stock of goods. Hence, the given statement is correct.

9. Higher saving induces greater investment. Comment.

A. The given statement is incorrect. According to Keynes, saving causes a leakage in the circular
flow of income. Higher saving implies lower consumption which reduces the inducement to
invest.

10. Is actual stock equal to desired stock with the producers only in a state of full
employment?
A. No, equality between desired stock and actual stock with the producers refers to the state of
equilibrium where AS = AD. This may occur with or without the state of full employment.

11. Is it correct that a tax on the households reduces their M PC?

A. No, it is not correct. A tax on the households only reduces their disposable income.

12. Do you agree that by raising the level of investment in the economy, the government
intends to raise the value of output multiplier?
A. No, by raising the level of investment, the government intends to increase the level of AD in the
economy. That has nothing to do with the multiplier which, in turn, depends on marginal
propensity to consume of the consumers. Hence, the given statement is incorrect.
Long Answer Questions: ( 3 to 4 marks )

1.Explain the relationship between Consumption and Income.

A. The functional relationship (or the algebraic relationship) between consumption and
income is called Consumption Function.

1. Consumption can never be zero. Even at zero level of income, there is always a minimum
level of consumption. This is known as autonomous consumption (a). The positive intercept
OB in the Y axis in the fig 1 indicates the autonomous consumption (a). The autonomous
consumption at the level of income zero is Rs. 50 crores.
2. Consumption and income are directly related. A rise in income causes a rise in consumption
and vice versa.
3. When consumption expenditure increases and reaches the level of income, it is called
break-even point. At the level of income Y = Rs. 100 crores, Y = C. This is called breakeven
point. At this level, savings in the economy will be zero and Y=C =Rs.100 crores. Break-even
point is marked as point D in the figure 1.
4. With an increase in income, the entire increase in income is not consumed. A part of the
income is saved as well. Hence with increase in income, the rate of increase in consumption is
less than the increase in income. This is explained by the Keynes psychological law of
consumption. When Y increases each time by Rs.100 crores, C increase by less than 100
crores.

2. Enlist properties of APC .

A.
1. APC decreases with increase in income. Income rises faster than consumption and the rich
are expected to save more from their income than the poor.
2. APC can never be zero, as consumption can never be zero.
3. APC can never be negative, as consumption can never be negative.
4. The value of APC can be equal to 1, at break-even point when Y = C. (When Y = C, C/Y =
1).
5. The value of APC can be more than 1 at lower levels of income. The APC of poor economies
are greater than 1. (when C > Y, C/Y > 1).
6. The value of APC can be less than 1 at higher levels of income. The APC of rich economies
are less than 1. (when C < Y, C/Y < 1).
3. Enlist properties of MPC .
A.

4. Enlist properties of APS .

A.
1. APS can never be 1 or more than 1, because Savings can never be equal to income or more
than income.
2. APS can be negative or less than 1, at lower levels of income.
3. APS can be zero, when savings is zero at break-even point.
4. APS increases with increase in income, as level of income saved increases with income.

5. Enlist properties of MPS.

A.
1. MPS varies between 0 and 1.
2. The minimum value of MPS is zero, when the entire increase in income is consumed and not
saved.
3. The maximum value of MPS is 1, when the entire increase in income is saved and not
consumed.
4. MPS for developed economies are high and for under developed economies are low.
 PART B
EXCESS DEMAND VS DEFICIENT DEMAND

Concept Meaning Diagram with explanation

Excess demand Excess demand is a
situation when AD is
Inflationary more than what is
gap required for full
employment. Excess
demand is defined as a
situation when AD is
greater than AS at full
employment.

Inflationary gap is
measured as the gap
by which actual
aggregate demand
exceeds aggregate
demand required to
attain full employment In the diagram, ADAE is actual aggregate demand curve .
level of income . The equilibrium is attained at point G where the AS and AD
are intersecting with equilibrium income as OP’.
But, full employment income is OP . At OP level of income :
Actual AD = FP
AD required to attain full employment equilibrium= EP

The vertical difference between both is FE is which is

excess demand excess demand or inflationary gap.

Deficient Deficient demand is a

demand situation d when AD is
less than what is
Deflationary required for full
gap employment.
Deficient demand is
defined as a situation
when AD is less than
AS at full
employment.

Inflationary gap is
measured as the gap
by which actual
aggregate demand
 falls short
of aggregate demand
required to attain full In the diagram, ADIU is actual aggregate demand curve .
employment level of The equilibrium is attained at point G where the AS and AD
income . are intersecting with equilibrium income as OP’.
But, full employment income is OP . At OP level of income :
Actual AD = FP
AD required to attain full employment equilibrium= EP

The vertical difference between both is EF is which is

deficient demand or deflationary gap.

1. State reasons behind excess and deficient demand .

A.Deficient demand in the economy arises due to following reasons:
1. A decrease in the private consumption (C)
2. A decrease in the investment expenditure by firms (I)
3. A decrease in the government expenditure (G)
4. Decrease in exports.
5. Increase in imports

Excess demand in the economy arises due to following reasons:

1. An increase in the private consumption (C)
2. An increase in the investment expenditure by firms (I)
3. An increase in the government expenditure (G)
4. Increase in exports.
5. Decrease in imports.

2. What is the effect of deficient demand on output, employment and prices?

A. (i) Effect on Output: Deficient demand leads to low level of output.
(ii) Effect on Employment: Because deficient demand lowers the level of planned output, the level
of employment is also lowered . A situation of unemployment or underemployment prevails in the
economy.
(iii) Effect on Prices: Fall in prices is the immediate consequence of deficient demand. Because,
owing to low sales, stocks tend to pile u p, compel ling the producers to lower the prices.

3. What is the effect of excess demand on output, employment and prices?

A. (i) Effect on Output: In the situation of excess demand, output does not increase. The economy
is already operating at full employment. So that the possibility of increase in output is ruled out.
(ii) Effect on Employment: Employment will not increase because there is no involuntary
unemployment in the economy. The economy has already achieved full employment.
(iii) Effect on Prices: Excess demand only generates pressure of demand on the existing flow
of goods and services in the economy. Accordingly, prices tend to rise.
4. What fiscal measures would you recommend to correct deficient demand?
A. Following fiscal measures are recommended to correct deficient demand:
(i) The government should step up its expenditure on
(a) public works programmes, (b) education and public welfare, (c) subsidies to the producers, and
(d) defence and law & order . Higher government expenditure acts like an injection into the
circular flow of income in the economy.
(ii) The government should reduce tax burden on the households, so that they are left with greater
cash balances. Higher cash balances with the people lead to higher level of AD.
(iii) The government should plan a cut in public borrowing, so that, people are left with greater
liquidity (or cash balances). Greater cash balances implies higher AD. Briefly, deficient demand is
corrected when the government steps up its own expenditure and ensures that cash balances with
the people are raised .

[Note: Students are advised to write just an opposite answer in case the question relates to excess
demand.]

Note : Measures to correct excess and deficient demand to be done from money and banking

HOTS
1.In poor countries like India, people spend a high percentage of their income so that APC
and MPC are high. Yet, value of the multiplier is low. Why?
A.Working of the multiplier process is based on one fundamental assumption: that there exists excess
capacity in the economy, so that whenever consumption expenditure rises (implying increase in demand)
there is a corresponding increase in production (implying increase in income). But poor countries like India,
lack in production capacity. Accordingly, whenever demand increases (in terms of increase in consumption
expenditure), there is increasing pressure of demand on the existing output (implying inflation or rise in
prices) rather than the increase in output or income.

2.Why should rising MPS be a cause of worry when it is a sign of rising GDP in the economy?
A.Rising M PS implies falling M PC, as M PS+ M PC = 1. It indicates that lesser and lesser proportion of
the additional income goes to consumption expenditure. Implying a gradual shrinkage of AD (aggregate
demand) in relation to Y (income). In such a situation, the economy might slip into a state of recession or
economic slowdown.

3.Equilibrium beyond full employment is a better situation (in terms of the level of GDP) than
equilibrium at full employment. Defend or refute.
A. The given statement is incorrect. Output remains constant even beyond full employment equilibrium.
Because, full employment equilibrium output is the maximum output.

4.Exemption limit for the payment of income tax has been raised from Rs. 2 lakh to Rs. 2.5 lakh, for
the financial year 201 7-18. Do you think it would help correct the deficiency of demand even when
M PC remains constant?
A. A rise in exemption limit from Rs. 2 lakh to Rs. 2.5 lakh would lead to a rise in disposable income of a
taxpayer by Rs. 50,000. Let us assume that M PC = 0.5, and it remains constant. It would mean that
aggregate consumption in the economy would increase by 0.5 x Rs. 50,000 = Rs. 25,000 per taxpayer.
Accordingly, deficiency of demand would be corrected . Thus, we conclude that an increase in exemption
limit relating to income tax would help correct deficiency of demand even when M PC remains constant.
 UNIT 4
GOVERNMENT BUDGET AND THE ECONOMY

Short answer questions :

1. Define the following terms :

Government budget:

Government budget is a statement of expected receipts and expected expenditure of the

government for a given fiscal year to achieve the twin objective of growth with stability.

Budget Receipts :

Budget receipts refer to estimated money receipts of the government from all sources during the
fiscal year.

Broadly, the budget receipts are classified as:

( 1) Revenue Receipts, and

(2) Capital Receipts.

Budget Expenditure :

Budget expenditure refers to estimated expenditure of the government during the fiscal year.

Budget expenditure of the government is broadly classified as:

( 1) Revenue Expenditure, and

(2) Capital Expenditure.

Revenue receipts :

Revenue receipts are those receipts of the government which neither create any liability nor lead
to any reduction in assets of government .

Eg . Income tax received from government.

Revenue expenditure:

Revenue expenditure is that expenditure of the government which neither creates assets nor causes
a reduction in liabilities of the government.

Eg. Salaries paid by government .

Tax :

A tax is compulsory unilateral payment made by an individual, household or a firm to the

government without reference to anything in return.

Tax revenue:

Tax revenue refers to sum total of receipts from taxes and other duties imposed by the government
.

Direct tax :

A direct tax is that tax in which liability to pay tax ( impact ) and incidence of tax ( incidence) lies
on the same person . Burden of direct tax can’t be shifted.

Eg. Income tax , corporate tax .

Indirect tax :

Indirect tax is that tax in which liability to pay tax ( impact ) and incidence of tax ( incidence) lies
on different person . Burden of indirect tax can be shifted.

Eg. GST.

Progressive tax :

Progressive tax is a tax that increases with an increase in the level of income of tax payers. It
causes relatively less real burden on the poor and more on the rich.

Eg.

Income Tax rate

5 lakh to 10 lakh 10%
10 lakh to 15 lakh 20%

Regressive tax :

Regressive tax is a tax that decreases with an increase in the level of income of tax payers. It
causes relatively more real burden on the poor and less on the rich.

Eg.

Income Tax rate

5 lakh to 10 lakh 20%
10 lakh to 15 lakh 10%
Capital budget :

Capital budget is the statement of estimated capital receipts and estimated capital expenditure of
government during a fiscal year .

Revenue budget :

Revenue budget is the statement of estimated revenue receipts and estimated revenue
expenditure of government during a fiscal year .

Capital receipts:

Capital receipts are those receipts of government which either create a liability or lead to
reduction in assets of the government .

Eg. Disinvestment of PSU

Capital expenditure:

Capital expenditure is that expenditure which either leads to creation of assets or reduction in
liabilities of the government .

Eg. Loan given to other countries.

Plan expenditure:

Plan revenue expenditure relates to central Plans (the Five-Year Plans) and central assistance for
State and Union Territory Plans.

Non-plan expenditure:

Non-plan expenditure refers to expenditure on general, economic and social services of the
government. The main items of non-plan expenditure are interest payments, defence services,
subsidies, salaries and pensions.

Balanced budget:

Balanced budget is that budget in which government estimated receipts are equal to government
estimated expenditure.

Surplus budget:

Surplus budget is that budget in which government estimated receipts are more than government
estimated expenditure.

Budgetary deficit :
 Budgetary deficit is the excess of total estimated expenditure over total estimated receipts of the
government.

Revenue deficit:

Revenue deficit refers to the excess of total revenue expenditure over the total revenue receipts of
the government.

Revenue deficit = Revenue expenditure - Revenue receipts

Fiscal deficit:

Fiscal deficit is equal to the excess of total expenditure over the sum of revenue receipts and
capital receipts excluding borrowing.

Fiscal deficit = Total Expenditure – Total receipts excluding borrowings

Primary Deficit :

Primary deficit is the difference between fiscal deficit of the current year and interest payments on
the previous borrowings.

Primary deficit = Fiscal deficit - Interest payment

Budgetary policy :

The programmes and policies of the government (as presented in the budget) are known as
'Budgetary Policy' of the government, or 'Fiscal Policy' of the government.

It has two aspects: (i) revenue aspect, and (ii) expenditure aspect.

Disinvestment:

Disinvestment refers to withdrawal of existing investment of government from an existing PSUs.

Example: The Government of India is making disinvestment by selling its shares in Air India .

Paper tax :

Paper taxes refer to the taxes like gift tax in India which carry their significance only on paper.
These taxes are of little or no significance in terms of their revenue yield.

Non-tax receipts :

Non-tax receipts are those receipts which arise from sources other than taxes.

Eg. fees and fine

Fees:

A fee is a payment to the government for the services that it renders to the people.

Examples: Land registration fees.

Fines:

Fines are those payments which are made by the law breakers to the government.

Escheat:

Escheat refers to that income of the state which arises out of the property left by the people without
a legal heir.

Special Assessment:

Special assessment is that payment which is made by the owners of those properties whose value
has appreciated due to developmental activities of the government.

Public goods (such as national defence, roads, government administration), are those goods that
are directly provided by the government . They cannot be provided through the market
mechanism. These goods are non excludable and non rivalrous in nature.

Public provision:

Public provision of goods means that they are financed through the budget and made available free
of any direct payment.

2.What are the three ways of measuring budgetary deficit ?

With reference to the budget of the Government of India, there are three important types of budget
deficit. These are:

( 1) Revenue Deficit,

(2) Fiscal Deficit, and

(3) Primary Deficit.

3.Enlist different sources from which the government borrows money from ?

The government borrows money from:

(a) the general public. [Borrowings from the general public are called market borrowings.]

(b) the Reserve Bank of India.

(C) the rest of the world.

4.Give two examples of non debt creating capital receipts.

A. Two examples of non debt creating capital receipts are :

1. Disinvestment
2. Recovery of loan

Short answer questions

1.Explain given objectives of government budget : ( any 1 objective can come for 3 to 4
marks )

A.

Allocation of Resources:

• The government of a country directs the allocation of resources in a manner such that there
is a balance between the goals of profit aximization and social welfare.
• Production of goods which are injurious to health (like Cigarettes and Whisky) is
discouraged through heavy taxation. On the other hand, production of ‘socially useful
goods’ (like, ‘Khadi’) is encouraged through subsidies.
• Through budgetary allocation of funds public goods are sufficiently provided to the
people by the government . These are those goods which satisfy collective needs of the
people Eg. Law & order and defence. These goods are not provided by the private sector
as they always desire to allocate resources to those areas of production where profits are
high.

Redistribution of Income and Wealth:

The government uses fiscal instruments of taxation and subsidies with a view to improving the
distribution of income and wealth in the economy. Equitable distribution of income and wealth is a
sign of social justice which is the principal objective of any welfare state as in India. Distribution
of income and wealth is improved in two ways:
(A) By imposing taxes on rich which decreases their disposable income and giving subsidies to
the poor, and

(ii) By supplying food grains to BPL population at a low price. Example: Free distribution of LPG
connection to the poor people.

Economic Stability:

The government of a country is always committed to ensure economic stability in the country by
saving the economy from large scale fluctuations in prices. Budget is used as an important policy
instrument to correct the situations of deflation and inflation as follows:

• In case of inflation government adopts the policy of surplus budget. It brings down the
aggregate demand by reducing its own expenditure and imposing higher taxes .
• In case of deflation government adopts the policy of deficit budget. It raises the
aggregate demand by increasing its own expenditure and giving tax concessions and
subsidies .

GDP Growth:

GDP growth is the central objective of government budgetary policy.It implies a sustained rise in
real GDP of an economy. It is achieved in two ways:

a. By making public investment expenditure: Spending on infrastructure enhances the productive

activity in economy which further generates demand for different types of goods and services
inducing growth in private sector too.

b. By inducing private investment expenditure : Government stimulates savings and investment in

the economy by providing tax rebates and other incentives for productive venture.

Balanced Regional Growth:

The budgetary policy places priority on the development of backward regions in the country.
This is achieved through liberal tax laws for the backward regions. Establishment of SEZ (special
economic zones) in the backward regions through liberal tax laws may be cited as an example.

Employment Opportunities:
Budgetary policy focuses on the generation of employment opportunities through investment
in public enterprises. Budgetary provisions are made for schemes like MGNREGA offering
employment to poorer sections of the society.
2.Explain the structure of government budget .

A. Government Budget includes

(i) revenue budget showing revenue receipts and revenue expenditure of the government, and

(ii) Capital budget showing capital receipts and capital expenditure of the government.

Looked at from a different angle, structure of the budget includes: (i) budget receipts (including
revenue receipts and capital receipts), and

(ii) Budget expenditures (including revenue expenditure and capital expenditure).

3.Explain the basis of classifying any receipt of government as revenue receipt .

A. Revenue receipts are those money receipts of the government which show the following two
characteristics:

(i) These receipts do not create any corresponding liability for the government. Example: Tax
receipts. Tax is a revenue receipt because it does not involve any corresponding liability for the
government.

(ii) These receipts do not cause any reduction in assets of the government. Example: Tax receipts
do not lead to any reduction in assets of the government.
 • In contrast, if government receives money by selling its share of some company (say Air
India), it causes reduction in assets of the government. These are therefore, not to be treated
as revenue receipts.

In short, revenue receipts of the government are those money receipts which do not create a
liability for the government and as well do not lead to reduction in assets of the government.

4.Explain the basis of classifying any expenditure of government as revenue expenditure .

A.Revenue expenditure of the government is that expenditure which shows the following two
characteristics:

(i) It does not create any asset for the government. For example, expenditure by the government on
old-age pensions, salaries and scholarships are to be treated as revenue expenditure. Because

this does not lead to any type of asset formation.

(ii) It does not cause any reduction in liability of the government. Expenditure by way of grants to
the state government to cope with natural calamities (like floods and earthquakes) does not reduce
financial liability of the central government in any manner. Accordingly, this is to be treated as
revenue expenditure.

In short, revenue expenditure refers to estimated expenditure of the government in a fiscal year
which does not create assets or causes a reduction in liabilities.

5.Explain the basis of classifying any receipt of government as capital receipt .

A.Capital receipts are those money receipts of the government which show the following two
characteristics:

(i) These receipts create a liability for the government. For example, loans by the government are a
liability. These are to be paid back. These are, therefore, the capital receipts of the government.

(ii) These receipts cause reduction in assets of the government. As stated earlier, money received
by the government by selling its shares (say of Air India) would cause reduction in assets of the
government. These are, therefore, to be treated as capital receipts.

In short, capital receipts are those money receipts of the government which either create a liability
for the government or cause a reduction in its assets.
6.Explain the basis of classifying any expenditure of government as capital expenditure.

A.Capital expenditure of the government is that expenditure which shows the following two
characteristics:

(i) It either creates assets for the government. Equity (or shares) of the domestic or multinational
corporations purchased by the government may be cited as an example.

(ii) It causes reduction in liabilities of the government. Repayment of loans certainly reduces liability of
the government. Accordingly, this is to be treated as capital expenditure.

In short, capital expenditure refers to the estimated expenditure of the government in a fiscal year
which creates assets or causes a reduction in liabilities.

7.Distinguish between revenue receipts and capital receipts .

A.

Basis Revenue Receipts Capital Receipts

Meaning Revenue receipts are those receipts
of the government which neither
create any liability nor lead to any
reduction in assets of government .
Example Tax receipts , fees , fine etc.
Nature Recurring in nature
Significance High revenue receipts (as tax
receipts) point to sound financial
health of the economy.
Capital receipts are those receipts of
government which either create a liability or
lead to reduction in assets of the government .
Receipts from disinvestment , loan taken by
government
Non- recurring inn nature
High capital receipts (borrowings and
disinvestment) point to poor financial health
economy of the economy.

8.Distinguish between revenue expenditure and capital expenditure .

A.

Basis Revenue Expenditure Capital Expenditure

Meaning Revenue expenditure is that
expenditure of the government which
neither creates assets nor causes a
reduction in liabilities of the
government.
Example Eg. Salaries paid by government
Nature Recurring in nature
Significance Revenue expenditure (subsidies and
law & order) focuses on welfare of
Capital expenditure is that expenditure
which either leads to creation of assets or
reduction in liabilities of the government .
Eg. Loan given to other countries.
Non- recurring inn nature
Capital expenditure (public investment)
focuses on growth. It directly
 the people. It does not directly contributes to GDP growth.
contribute to GDP growth.

9.Distinguish between revenue budget and capital budget .

A.

Basis Revenue Budget Capital Budget

Meaning Revenue budget includes revenue
receipts and revenue expenditure
of the government.
Nature Revenue budget does not impact
asset- liability status of the
government .
Significance Revenue budget focuses on
welfare of the people by way of
direct benefit transfers.
Capital budget includes capital receipts and
capital expenditure of the government.
Capital budget impact asset-liability status
of the government.
Capital budget focuses on GDP growth (by
way of public investment).

10.Distinguish between direct tax and indirect tax .

A.

Basis Direct tax Indirect tax

Meaning A direct tax is that tax in which Indirect tax is that tax in which liability to
liability to pay tax ( impact ) and pay tax ( impact ) and incidence of tax (
incidence of tax ( incidence) lies on incidence) lies on different person .
the same person .
Example Income tax , corporate tax GST , VAT
Imposed on It is imposed on people and It is imposed on goods and services.
companies.
Nature Direct taxes are generally Indirect taxes are generally regressive in
progressive in nature. nature.
Shift of Burden of direct tax can’t be Burden of direct tax can be shifted.
burden shifted.
11.Distinguish between Revenue Deficit, Fiscal Deficit and Primary Deficit.

Basis Revenue deficit Fiscal deficit Revenue deficit

Revenue deficit refers Fiscal deficit is equal to the Primary deficit is the
to the excess of total excess of total expenditure difference between
revenue expenditure over the sum of revenue fiscal deficit of the
over the total revenue receipts and capital current year and
receipts of the receipts excluding interest payments on
government. borrowing. the previous
borrowings
Formula Revenue deficit = Fiscal deficit = Total Primary deficit = Fiscal
Revenue expenditure - Expenditure – Total deficit - Interest
Revenue receipts receipts excluding payment
borrowings

Borrowing It means that the It indicates the total It estimate of

requirements government will have borrowing requirements of borrowing on account
to borrow not only to the government from all of current expenditures
finance its investment sources. exceeding revenues
but also its
consumption
requirements.
Significance When the government High fiscal deficit (in terms Primary deficit points
incurs a revenue deficit, of borrowings) points to to the need for
it implies that the the lack of fiscal discipline borrowings even when
government is in the country. It is a hurdle interest payment on the
dissaving and is using in the process of GDP existing loans is
up the savings of the growth. ignored. It reflects
other sectors of the continuous
economy to finance a lack of fiscal discipline
part of its consumption in
expenditure. the country.

12.What are three ways of managing revenue deficit

A.Three Ways of Managing Revenue Deficit

(i) Borrowing from the general public, RBI or rest of the world.

(ii) Disinvestment by way of selling its ownership (shares) of public enterprises.

(iii) Cut in expenditure (subsidies in particular)

13.Discuss implications of revenue deficit .

A. Implications of revenue deficit are discussed as follows:

i. The revenue deficit includes only such transactions that affect the current income and
expenditure of the government. Thus, revenue deficit indicates that government’s own
revenue is insufficient to meet the expenditure on normal functioning of government’s
departments.
ii. The government may have to raise funds through borrowing. This raises liabilities of the
government and lowers its credit-worthiness.
iii. The government may be compelled for disinvestment-selling its ownership of public
enterprises. Consequently, economic control of the foreigners may increase in the
domestic economy.
iv. A high fiscal deficit is a warning signal to the government to either curtail its expenditure
or increases its revenue .

14.Discuss implications of fiscal deficit .

A. Implications of fiscal deficit are discussed as follows:

i. Borrowing : Fiscal deficit is an estimate of borrowings by the government. Greater fiscal

deficit implies greater borrowings by the government.
ii. Debt trap : Fiscal deficit leads to national debt. It hinders GDP growth. Because, a
significant percentage of national income is used up to pay the past debts.
iii. Inflationary Spiral: Fiscal deficit is often linked to inflationary spiral in the economy
when it is met by deficit financing ( printing new currency ) . Deficit financing leads to
increase in money supply that consequently leads to increase in the general price level.
iv. Vicious Circle of High Fiscal Deficit and Low GDP Growth: Constantly high fiscal deficit
leads to a situation where: (a) GDP growth remains low because of high fiscal deficit, and
(b) fiscal
deficit remains high because of low GDP growth.
v. Crowding-out: High fiscal deficit leads to 'Crowding-out Effect'. This is a situation when
high borrowings by the government (owing to high fiscal deficit) reduces the availability of
funds (in the money market) for the private investors. Accordingly, overall investment in
the economy is reduced.
15. What are the two ways of financing fiscal deficit ? Which one is better ?

A. Two ways of financing fiscal deficit are :

i. Borrowings : Fiscal deficit is financed by the borrowings done by the government.

various sources of borrowings are (i) Borrowing from RBI + (ii) Borrowing from abroad
+ (iii) Net borrowing at home
ii. Deficit financing : Government may borrow from RBI against its securities . RBI prints
new currency for this purpose. This is called as deficit financing .

Borrowings are considered as a better source as they do not increase the money supply ,
which is regarded as main source of inflation . Whereas, deficit financing may lead to
inflationary trends in the economy due to more money supply.

16. Discuss implications of primary deficit .

A. Implications of primary deficit are discussed as follows:

i. Primary deficit points to the need for borrowings even when interest payment on the
existing loans is ignored. It reflects continuous lack of fiscal discipline in the country.
ii. Zero primary deficit means the government resorts to borrowing only to clear the backlog
of interest payments.
iii. Primary deficit is the root cause of fiscal deficit . In India high interest payments on past
borrowings have greatly increased the fiscal deficit .

HOTS

1.What does zero primary deficit mean?

A. It means the government resorts to borrowing only to clear the backlog of interest payments.
There are no borrowing because of the excess of current year expenditure over the current year
revenue.

Simply because, current year expenditure happens to be equal to current year revenue. It is a sign
of fiscal discipline or fiscal responsibility on the part of the government.
2.Can there be a fiscal deficit without a revenue deficit?

A. Yes , because fiscal deficit is worked out by accounting for both the revenue and capital
receipts and expenditures of the government. So that, even when revenue receipts and revenue
expenditure are in a state of balance, there could be excess of capital expenditure over capital
receipts, causing fiscal deficit.

Proof :

Fiscal Deficit = Revenue deficit + capital expenditure – non debt creating capital receipts

if revenue deficit is zero then fiscal deficit will occur if capital expenditure exceeds non debt
creating capital receipts .

3.How does high fiscal deficit leads to low GDP growth ?

A. High fiscal deficit leads to low GDP growth because of two reasons:

(i) The government lacks funds for investment, and

(ii) Owing to high fiscal deficit, taxes are raised. This reduces disposable income of the people.
Low disposable income leads to low AD and their low inducement to invest in the economy.

Also, low GDP growth leads to high fiscal deficit. Because, low GDP generates low revenue for
the government.

4.Explain through an example, how the burden of an indirect tax is shifted.

A. GST is an indirect tax. A shopkeeper pays GST to the government. But, the shopkeeper
recovers the tax from the customers as a part of price of the commodity sold. So, impact of GST
(an indirect tax) is ultimately shifted to the consumers.

5.Give the relationship between revenue deficit and fiscal deficit.

A: The relationship between revenue deficit and fiscal deficit is:

Fiscal Deficit = Revenue Deficit +Capital expenditure – non debt creating capital receipts

(i) The fiscal deficit is always broader than the revenue deficit as revenue deficit is a part of fiscal
deficit.
(ii) Fiscal deficit is worked out by accounting for both the revenue and capital receipts and
expenditures of the government. So that, even when revenue receipts and revenue expenditure are
in a state of balance, there could be excess of capital expenditure over capital receipts, causing
fiscal deficit.

Numericals :

Numerical 1

Numerical 2
Numerical 3
Appendix

Important examples

Revenue Receipts Revenue Expenditure Capital Receipts Capital Expenditure

Tax revenue : interest payments, Market borrowings, Expenditure on the
Direct tax like defence services, borrowing by the acquisition of land,
Income tax , subsidies, salaries and government from the building, machinery,
Corporation tax , pensions. Interest Reserve Bank and equipment, investment
wealth tax, gift tax payments on loans , commercial banks and in shares, and loans
and estate duty (now Defence expenditure , other financial and advances by the
abolished ) Subsidies institutions through central government to
Indirect taxes like the sale of treasury state and union
excise taxes (duties bills, loans received territory governments,
levied on goods from foreign PSUs and other parties.
produced within the governments and
country), customs international
duties (taxes organisations, and
imposed on goods recoveries of loans
imported into and granted by the central
exported out of government. Other
India) GST (earlier items include small
service tax ,excise savings (Post-Office
taxes . Savings Accounts,
National Savings
Non – tax revenue : Certificates, etc),
Interest receipts , provident funds and
dividends and net receipts obtained
profits, fees , fine , from the sale of shares
escheat, special in Public Sector
assessment , cash Undertakings (PSUs).
grants-in-aid from
foreign countries
and international
organisations

Critical points

• Implicit subsidies are provide through under-pricing of public goods and services like
education and health, the government also extends subsidies explicitly on items such as
exports, interest on loans, food and fertilisers.
• Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from
abroad.
• Public goods, as distinct from private goods, are collectively consumed. Two important
 features of public goods are – they are non-rivalrous in that one person can increase her
satisfaction from the good without reducing that obtained by others and they are
non-excludable, and there is no feasible way of excluding anyone from enjoying the
benefits of the good. These make it difficult to collect fees for their use and private
enterprise will in general not provide these goods. Hence, they must be provided by the
government.
• The three functions of allocation, redistribution and stabilisation operate through the
expenditure and receipts of the government.
• The budget, which gives a statement of the receipts and expenditure of the government, is
divided into the revenue budget and capital budget to distinguish between current financial
needs and investment in the country’s capital stock.
• The growth of revenue deficit as a percentage of fiscal deficit points to a deterioration in
the quality of government expenditure involving lower capital formation.
• When the government incurs a revenue deficit, it implies that the government is dissaving
and is using up the savings of the other sectors of the economy to finance a part of its
consumption expenditure. This situation means that the government will have to borrow
not only to finance its investment but also its consumption requirements.
• To obtain an estimate of borrowing on account of current expenditures exceeding
revenues, we need to calculate what has been called the primary deficit.
• The redistribution objective is sought to be achieved through progressive income taxation,
in which higher the income, higher is the tax rate.
• The main items of capital receipts are loans raised by the government from the public
which are called market borrowings.
• Defence expenditure : Defence services like payment of salaries : Revenue expenditure;
Purchase of defence equipments : Capital expenditure
 UNIT 5

Balance of Payment

1. Define the following :

Foreign exchange :

It refers to the currency of other countries apart from domestic currency.

Eg : Dollar $ is foreign exchange for India .

Exchange Rate :

Exchange Rate refers to the price of one currency in relation to other currencies in the international
money market (or international exchange market).

Example: If Rs. 75 are to be paid to buy one US dollar, exchange rate between the two currencies is
1$ = 75 Rs.

Flexible Exchange Rate :

Flexible Exchange Rate is a floating rate of exchange, determined by the supply of and demand
for different currencies in the international exchange market.

Fixed Exchange Rate System:

Fixed Exchange Rate System is a system under which exchange rate is set and maintained by
the government at a particular level. Market forces of supply and demand have no role to play in
this system.

Managed Floating :

Managed Floating ( also called Dirty Floating ) is a system of floating exchange rate where
exchange rate is determined by the forces of demand and supply of foreign exchange but
managed by the central bank of the country by way of sale and purchase of foreign exchange in the
international money market.

Foreign Exchange Market :

Foreign Exchange Market refers to the market for national currencies of different countries of the
world. It is a centre of trade for different currencies.
Depreciation :

Depreciation of the (domestic) currency occurs when the value of the (domestic) currency reduces
in the international money market in comparison to foreign currency , because of the market forces
of supply and demand.

Eg. Rupee depreciates when price of dollar rises from 1$ = Rs. 70 to 1$ =Rs. 75

Devaluation :

Devaluation of the (domestic) currency occurs when the value of the domestic currency is
deliberately reduced by the government by raising the exchange rate.

Eg. Rupee devalues when price of dollar rises from 1$ = Rs. 70 to 1$ =Rs. 75 by the government.

Appreciation :

Appreciation of the (domestic) currency occurs when the value of the domestic currency rises in
the international money market in comparison to foreign currency, because of the market forces of
supply and demand.

Eg. Rupee appreciates when price of dollar falls from 1$ = Rs. 75 to 1$ =Rs. 70

Revaluation :

Revaluation of the (domestic) currency occurs when the value of the domestic currency is
deliberately raised by the government by lowering the exchange rate. The market forces of supply
and demand play no role whatsoever.

Eg. Rupee revalues when price of dollar falls from 1$ = Rs. 75 to 1$ =Rs. 70 by the
government.

Spot Market :

Spot Market deals with current sale and purchase of foreign exchange. It determines spot rate of
exchange.

Forward Market :

Forward Market deals with such sale and purchase of foreign exchange which are contracted today
but are implemented sometimes in the future. It determines forward rate of exchange.

Spot exchange rate :

Spot exchange rate (also known as current rate of exchange) is that rate of exchange
which prevails in the market at the time when transactions are made. It relates only to spot
transactions in the international money market.
Forward exchange rate :

Forward exchange rate is a sort of 'contracted' exchange rate to be applicable for the
transactions which are signed today but are to be honoured sometimes in the future.

Hedging:

Hedging means avoiding the risk of an adverse change in exchange rate by signing foreign
exchange transactions for future delivery.

2.At what point equilibrium rate of exchange is determined?

A. Equilibrium exchange rate is determined at the point where demand for foreign currency and
supply of foreign currency are equal to each other.

Short answer questions :

1.Distinguish between fixed and flexible exchange rate system.

Basis Fixed Exchange Rate Flexible Exchange Rate

Meaning Exchange rate is said to be fixed when it
Flexible rate of exchange (also called
is set and maintained by the governmentfloating rate of exchange) is that
at a particular level. exchange rate which is determined by
the supply-demand forces in the
foreign exchange market.
Changes Changes in the fixed rate of Changes in the flexible rate of
exchange are planned and introduced by exchange are linked to changes in
the government. the market forces of supply and
demand.
Value As set and maintained by the As determined by the forces of
government, the fixed rate of supply anddemand, flexible rate of
exchange leads to: exchange leads to.
(a) devaluation(when the value of the (a) depreciation of the domestic
domestic currency is lowered by the currency (when the exchange rate
government), or rises), and
(b) revaluation (when the value of the (b) appreciation of the domestic
domestic currency is raised by the currency (when the exchange rate
government). falls).
Stock of To maintain the fixed rate of exchange Flexible exchange rate does not
foreign at a particular level, the government require any large stock of foreign
exchange needs to keep a large stock of foreign exchange, as its level is set by
 exchange.
Speculation Degree of speculation is very low in
the system of fixed exchange rate. It
arises only when people expect some
change in the government policy
the market forces of supply and
demand.
Degree of speculation is very high
in the system of flexible exchange
rate. It is because of the uncertainty
of market forces of supply and
demand.

2. How does the central bank exercises its influence in managed floating market exchange
rate?

A. Government exercises its influence in managed floating market exchange rate through the
sale and purchase of foreign currency in the international money market.

• When the exchange rate (say of US $) needs to be reduced, the central bank increases the
supply of US $ in the foreign exchange market by acting as bulk seller . Other things
remaining constant, higher supply of US $ would lower the price of US $, as desired. This
would lead to appreciation of domestic currency.
• On the other hand, when the exchange rate needs to be raised, the central bank reduces the
supply for US $ in the foreign exchange market by acting as bulk buyer . Other things
remaining constant, low supply of US $ would raise the price of US $, as desired. This
would lead to depreciation of the domestic currency.

3.Briefly explain various sources of demand of foreign exchange .

A. Various sources of demand of foreign exchange are as follows :

Imports:

In order to import goods (like cellphones and TVs) and services (like of banking and insurance)
from rest of the world foreign exchange is required because payments for imports are made in
foreign exchange only.

Repayment of International Loans:

International loans are raised in terms of foreign currency. Accordingly, foreign currency is
required for the repayment of these loans.

Investment in Rest of the World:

Investment in rest of the world is an important business activity for which currency of the country
in which investment is to be made is needed.

Payment of Incomes:
Demand for foreign exchange in the domestic economy also arises for the payment of factor
incomes (rent, interest, profit/dividend and wages) which are sent abroad.

Transfers :

Unilateral payments (Grants and donations etc ) to rest of the world also contribute to the demand
for foreign exchange.

Speculative Trading:

Foreign exchange (particularly in terms of strong currencies like US dollar) is held/demanded by

the people for purpose of speculative trading. Often, more foreign exchange is held when the
exchange rate is low, and vice versa.

4.Briefly explain various sources of supply of foreign exchange .

A. Various sources of supply of foreign exchange are as follows :

Exports:

Export of goods and services is an important source of supply (inflow) of foreign exchange from
rest of the world as domestic country receives foreign exchange in terms of receipts for exports.

Investments from Rest of the World:

Investments from rest of the world (including FIi and FDI) flows from foreign countries to
domestic country in terms of foreign exchange .

Loans from Rest of the World:

It refers to borrowings from rest of the world. For eg. A loan from UK would mean flow of UK £
from UK to India. It contributes to the supply of foreign exchange to India.

Income Receipts:

Foreign exchange also flows from rest of the world to the domestic economy by way of income
receipts.

Transfers :

Unilateral payments (Remittance , grants and donations etc ) from rest of the world also
contribute to the supply for foreign exchange.
5.Distinguish between appreciation and depreciation of domestic currency.

Basis Appreciation Depreciation

Meaning Appreciation of the (domestic)
currency occurs when the value of the
domestic currency rises in the
international money market in
comparison to foreign currency,
because of the market forces of supply
and demand.
Depreciation of the (domestic)
currency occurs when the value of the
(domestic) currency reduces in the
international money market in
comparison to foreign currency ,
because of the market forces of supply
and demand.

Example Eg. Rupee appreciates when price of Eg. Rupee depreciates when price of
dollar falls from 1$ = Rs. 75 to 1$ dollar rises from 1$ = Rs. 70 to 1$ =Rs.
=Rs. 70 75

Effect on Appreciation of the domestic currency Depreciation of the domestic currency

imports implies that less rupees are required
to buy a dollar .
As a result imports will become cheap
and hence consequently imports will
increase.
Effect on Appreciation of the domestic currency
exports implies that more dollars are required
to buy a rupee.
Accordingly, exports will become
expensive and hence exports are
likely to fall.
implies that more rupees are required
to buy a dollar .
As a result imports will become
expensive and hence consequently
imports will fall .
Depreciation of the domestic currency
implies that less dollars are required
to buy a rupee.
Accordingly, exports will become
cheap and hence exports are likely to
increase.

• In case of ques on difference between revaluation and devaluation just change the
definition .

6.Why demand curve of foreign exchange is downward sloping ?

A
 • Other things remaining constant, demand of foreign exchange is inversely related to its
price.
• Therefore, demand curve of foreign exchange rate is downward sloping.
• This can be explained with the help of a diagram.
• DD is downward sloping demand curve of foreign exchange rate.
• At point A, foreign exchange rate is $1 = Rs 70 and quantity demanded is OM.
• If foreign exchange rate falls from $1= Rs 70 to $1 = Rs 50, then imports will become
cheap . As a result demand of imports increases and consequently demand of foreign
exchange will rise from OM to ON.
• Thus as foreign exchange rate falls , its quantity demanded increases and vice versa.

7.Why supply curve of foreign exchange is upward sloping ?

• Other things remaining constant, supply of foreign exchange is directly related to its price.
• Therefore, supply curve of foreign exchange rate is upward sloping.
• This can be explained with the help of diagram given above .
• SS is upward sloping supply curve of foreign exchange .
• At, foreign exchange rate 1$ = Rs 50 and quantity supplied is OM.
• If foreign exchange rate rises to 1$ = Rs 70 , then export will become cheap , as a result,
export will rise leading to increase in supply of foreign exchange rate from OM to ON.
• Thus as foreign exchange rate rises, its quantity supplied also rises and vice versa.
8. Discuss merits and demerits of fixed exchange rate .

A. Merits

(i) Market Stability: Stability of the market is key merit of fixed exchange rate. It promotes
investment across nations.

(ii) Stable Macroeconomic Policies: Given the fixed exchange rate, the central bank can frame its
monetary policy and the government can frame its fiscal policy, independent of the external shocks
relating to fluctuations in exchange rate.

(iii) Devaluation: Fixed exchange rate system allows devaluation of the currency. It is a planned
fall in the value of the domestic currency. It helps expand foreign market for the domestic
producers.

Demerits

(i) Reserves of Forex: To maintain the rate of exchange at the desired level,the government need
to keep a large stock of foreign exchange. This is theprincipal demerit of the fixed exchange rate
system.

(ii) Inefficient Allocation of Resources: Exchange rate fixed by the government often deviates
from the equilibrium exchange rate (in a free market

economy). To that extent, allocation of resources may not be efficient

(iii) Small Size of Forex Market: When the rate of exchange is fixed, foreign exchange does not
emerge as a trading commodity. Accordingly, size of the forex market remains small. This acts as
a hurdle in the global economic growth.

9. Discuss merits and demerits of flexible exchange rate .

A. Merits:

(i) Large Reserves of Forex not required: Flexible system of exchange rate does not require large
reserves of foreign exchange with the government. Market forces of supply and demand
automatically drive the rate of exchange to the point of equilibrium.

(ii) Efficient Allocation of Resources: Efficient allocation of resources is achieved, as the system
is ruled by the free play of the market forces.

(iii) Large Size of the Forex Market: Since foreign exchange itself becomes a trading commodity,
the size of forex market tends to be large. This induces economic growth across all parts of the
world.
(iv) International Mobility of Liquidity: Since large reserves of forex are not required, flexible
exchange rate tends to promote international mobility of liquidity. This is good for the less
developed countries (like India), where foreign investment is a significant determinant of GDP
growth.

Demerits

(5) Marginalisation of Weak Currencies: Flexible exchange rate system leads to

marginalisation of weak currencies in the international money market. Weak
currencies (of small economies) often suffer huge depreciation in relation to strong
currencies (of big economies). Accordingly, gains of international trade accrue
more to the large economies than the small economies.

(ii) Uncertainty of the Market: There is a high degree of uncertainty in the market. Owing to the
frequently changing rate of exchange, it becomes difficult to formulate a stable monetary policy in
the domestic economy.

(6) External Shocks: Flexible exchange rate system exposes the domestic economy to
external shocks.

Long answer questions

1. Explain the process of determination of equilibrium exchange rate .

A. Equilibrium rate of exchange occurs when supply of foreign exchange is equal to demand for
foreign exchange. Diagrammatically, it can be explained as follows:

• In the figure given above , supply and demand of foreign exchange are measured on the
X-axis, and exchange rate on the Y-axis.
• Df is the demand curve and Sf is the supply curve of foreign currency.
 • Both these curves intersect at point E (equilibrium point ) and OR is the equilibrium rate of
exchange.
• If the rate of exchange rises to OR 1 then supply of foreign currency (ON) will exceed its
demand (OM) by an amount equivalent to MN. Due to excess supply , rate of exchange
will start falling till it reaches the equilibrium at OR.
• On the contrary, if the rate of exchange falls to OR 2 then demand for foreign currency
(ON) will be more than its supply (OM) by MN. Due to excess demand , rate of exchange
will again rise to OR.
• Rate of exchange will ultimately be determined at a point where demand for and supply of
foreign currency are equal.

2. Discuss the impact of increase in demand of foreign currency on exchange rate .

A. Increase in Demand of Foreign Currency will lead to an increase in the foreign exchange rate
and hence depreciation of domestic currency . This can be explained as follows :

• In the figure given above , supply and demand of foreign exchange are measured on the
X-axis, and exchange rate on the Y-axis.
• D is the demand curve and S is the supply curve of foreign currency. Both these curves
intersect at point E (equilibrium point ) and OR is the equilibrium rate of exchange.
• When demand of the foreign exchange increases , demand curve shifts right from D to D 1
.
• This causes excess demand of foreign exchange at old equilibrium exchange rate OR . This
leads to rise in the equilibrium exchange rate from OR to OR 1 .
• Now one US $ is available for Rs. 70, instead of Rs. 60 earlier.
• Thus, other things remaining constant, increase in demand for foreign currency leads to a
rise in exchange rate. This is described as a situation of depreciation of the domestic
currency.
3. Discuss the impact of decrease in demand of foreign currency on exchange rate .

A. Decrease in Demand of Foreign Currency will lead to an fall in the foreign exchange rate and
hence appreciation of domestic currency . This can be explained as follows :

• In the figure given above , supply and demand of foreign exchange are measured on the
X-axis, and exchange rate on the Y-axis.
• D is the demand curve and S is the supply curve of foreign currency. Both these curves
intersect at point E (equilibrium point ) and OR is the equilibrium rate of exchange.
• When demand of the foreign exchange decreases , demand curve shifts left from D to D 1 .
• This causes excess supply of foreign exchange at old equilibrium exchange rate OR . This
leads to fall in the equilibrium exchange rate from OR to OR 1 .
• Now one US $ is available for Rs. 50, instead of Rs. 60 earlier.
• Thus, other things remaining constant, decrease in demand for foreign currency leads to a
fall in exchange rate. This is described as a situation of appreciation of the domestic
currency.

4. Discuss the impact of increase in supply of foreign currency on exchange rate .

A. Increase in supply of Foreign Currency will lead to a decrease in the foreign exchange rate and
hence appreciation of domestic currency . This can be explained as follows :
 • In the figure given above , supply and demand of foreign exchange are measured on the
X-axis, and exchange rate on the Y-axis.
• D is the demand curve and S is the supply curve of foreign currency. Both these curves
intersect at point E (equilibrium point ) and OR is the equilibrium rate of exchange.
• Due to increase in supply of foreign exchange , supply curve shifts right from S to S1 .
• This causes excess supply of foreign exchange at old equilibrium exchange rate OR . This
leads to fall in the equilibrium exchange rate from OR to OR 1 .
• Now one US $ is available for Rs. 50, instead of Rs. 60 earlier.
• Thus, other things remaining constant, increase in supply of foreign currency leads to a
fall in exchange rate. This is described as a situation of appreciation of the domestic
currency.

5. Discuss the impact of increase in supply for a foreign currency on exchange rate .

A. Decrease in supply of Foreign Currency will lead to an increase in the foreign exchange
rate and hence depreciation of domestic currency . This can be explained as follows :

• In the figure given above , supply and demand of foreign exchange are measured on the
X-axis, and exchange rate on the Y-axis.
• D is the demand curve and S is the supply curve of foreign currency. Both these curves
intersect at point E (equilibrium point ) and OR is the equilibrium rate of exchange.
• Due to decrease in supply of foreign exchange , supply curve shifts left from S to S1 .
• This causes excess demand of foreign exchange at old equilibrium exchange rate OR . This
causes a rise in the equilibrium exchange rate from OR to OR 1 .
• Now, one US $ is available for Rs. 70, instead of Rs. 60 earlier. This is a situation of
depreciation of the domestic currency.
HOTS:

1.The market price of US dollar has increased considerably leading to rise in rupee value of
imports of essential goods. What can the RBI do to correct the situation?

A. The central bank can sell its reserves of US dollars in the money market to reduce the pressure
of demand for dollars. In case supply aligns with demand, the price of dollar will fall in terms of
the Indian rupee.

2.Why managed floating is known as a hybrid exchange rate system ?

A. Managed floating is known as a hybrid exchange rate system as it is a mixture of both flexible
and fixed exchange rate systems.

• It comprises the element of flexible exchange rate system as the exchange rate is
primarily determined by the forces of supply and demand.
• Likewise, it comprises the element of fixed exchange rate system as the exchange rate
is moderated (or managed) by way of intervention by the RBI.

3.When foreign exchange rate in a country is on the rise, what impact is it likely to have on
exports and imports and how?

A. A unit of the domestic currency will now buy less goods from rest of the world while a unit of
foreign currency can now buy more goods in the domestic economy. Goods produced in the
domestic

economy become cheaper to the buyers abroad while foreign goods become relatively expensive
to the domestic buyers. As a result, exports are expected to rise and imports are expected to fall.

4.How is depreciation of Indian rupee likely to affect Indian exports? Explain.

A. Depreciation of the domestic currency implies that the domestic currency (rupee) loses its value
in relation to a foreign currency (say US dollar). Now, more rupees are required to buy a dollar, or
a dollar can now buy more goods in the domestic economy. Accordingly, exports are expected to
rise.
5.Explain briefly functions of foreign exchange market .

A.Foreign exchange market performs the following functions:

(1) Transfer Function: It implies transfer of purchasing power in terms of foreign exchange across
different countries of the world.

(2) Credit Function: It implies provision of credit in terms of foreign exchange for the export and
import of goods and services across different countries of world.

(3) Hedging Function: It implies protection against risk related to variations in foreign exchange
rate. Exchange rate is locked for future supplies of foreign exchange.

6.Are the concepts of demand for domestic goods and domestic demand for goods the same?

A. 'Demand for domestic goods' and 'domestic demand for goods' are different concepts.

• Demand for domestic goods includes demand for goods by the domestic consumers and by
the foreigners.
• Domestic demand for goods includes (i) demand for goods produced domestically, and (ii)
demand for goods produced abroad.

Demand for domestic goods = C + I + G + X - M.

Domestic demand for goods = C + I + G.

So that, Demand for domestic goods = Domestic demand for goods + (X - M).]

Appendix :

Gold Standard According to this system {prevalent in most countries prior to 1920s),gold was
taken as the common unit of parity between currencies of different countries.
Each country was to define value of its currency in terms of gold.
Illustration
If UK £ (Pound) = 4 g of gold and US $ (Dollar) = 2 g of gold, then 1 UK £
= 2 US $. Exchange rate or exchange ratio between UK £ and US $ = 1 : 2.
Two US dollars would exchange for 1 UK pound.
Bretton wood According to this system,
(i) Different currencies were pegged ( or related) to one currency, that is US
dollar.
(ii) US dollar was assigned gold value at a fixed price.
BALANCE OF PAYMENTS

1.Define

Balance of Payments :

Balance of payments (BoP) is a statement of accounts showing all monetary transactions (or
economic transactions) of residents of a country with the rest of the world during an accounting
year .

Current Account of BOP:

Current account of BOP records receipt and payment of foreign exchange on account of such
transactions which do not impact asset liability status of a country in relation to rest of the world .

Capital account of BOP:

Capital account records receipts and payments of foreign exchange on account of such transactions
which cause an impact on asset-liability status of a country in relation to rest of the world.

Trade deficit :

It refers to the excess of payment for imports of visible items over the value of receipts of exports
of visible items.

Trade surplus :

It refers to the excess of value of receipts of exports of visible items over the value of payment for
imports of visible items.

Balance of trade :

Balance of trade is defined as the difference between the value of imports and exports of only
physical goods or visible items.

Deficit in Balance :

Deficit of balance in payments arise when total inflows on account of autonomous transaction are
less than total outflows on account of such transactions .

Surplus in Balance :

If total inflows on account of autonomous transactions exceed total outflows on account of such
transaction ,then there is surplus in balance of payments accounts
Current account surplus:

Current account surplus (cas) arise when credit items of credit account are more than debit items of
credit account . it indicates net inflow of foreign exchange. Cas arise when the value of exports of
goods and services is more than the value of imports of goods and services .Cas signifies that the
nation is a lender to the rest of the world.

Current account deficit :

Current account deficit (cad) arises when debit items of credit account are more than credit items
of credit account that is when foreign exchange receipts in the current account for short of foreign
exchange payments, it leads to current account deficit. It indicates net outflow of foreign
exchange . Cad arises when the value of exports of goods and services is less than the value of
imports of goods and services . Cad signifies that the nation is a borrower from the rest of the
world.

2.Which two transactions determine balance of trade?

A.
i. Export of goods ( or visible items ) .
ii. Import of goods (or visible items ) .

3.What is meant by visible items of balance of payments?

A. All such items of exports and imports which are material in nature are called visibles. These
items can be seen crossing the borders . These are also called merchandise.

4.Name three invisible items of balance of payments .

A.
i. Export and import of services such as of shipping, insurance and banking.
ii. Interest and dividend payments between the countries.
iii. Expenditure by the tourists.

5. List three such items which are not included in balance of trade .
A. Three items which are not included in balance of trade are:
(i) Export and import of services such as of shipping, ice and banking.
(ii) Interest and dividend payments between the countries.
(iii) Expenditure by the tourists.

6.What is the difference between balance of trade and current account balance?
Ans. Balance of trade refers to the balance occurring on account of export and import of visible
items (goods only ) .Current account balance includes the balance of trade as well as balance on
invisibles.
7.Distinguish between autonomous and accommodating transactions .

Basis Autonomous transactions Accomodating transactions

Meaning Autonomous items refer to such
BoP transactions which are
undertaken with a view to earn
profits.
Surplus / Deficit When BoP deficit/surplus is
estimated, it is with reference to
only the autonomous items or
autonomous transactions of BoP.
Movement of Autonomous items may involve
goods the movement of goods across
the borders (like export and
import of consumer goods or
capital goods).
Classification Autonomous items are classified
as 'above the line' items of BoP
Accommodating items, on the other
hand, refer to such transactions which
are undertaken by the central bank of a
country with a view to correct BoP
imbalance (surplus or deficit ) and
restoring BoP equilibrium.
Accommodating items are meant to
restore BoP balance.
Accommodating items do not involve
the movement of goods across the
borders. These items only involve the
movement of official reserves
with the RBI.
Accommodating items are classified as
'below the line' items of BoP

8.Distinguish between balance of trade and balance of current account .

Basis Balance of trade Balance of current account

Meaning Balance of trade is that part of
current account which records the
difference exports and imports
of goods only.
Current account balance of payments
refers to the difference between receipts
(credit ) and payments (debit )in current
account of BOP. Basically its sum total of
difference between :
(a) export and import of goods,
(b) export and import of services,
(c) current transfers made and received
and
(d) Income received and paid

Scope It involves international It involves international transactions

transactions relating to physical relating to physical goods (which can be
goods which can be seen crossing seen crossing the borders) as well as
the borders. transactions relating to services which
cannot be seen crossing the borders.
Type of concept Balance of trade is a narrow Balance of current account is a broader
concept as it is a part of balance of concept as compared to Balance of trade .
current account
9.Distinguish between Balance of Payments and Balance of Trade.

Basis Balance of trade Balance of payment

Meaning Balance of trade is the difference Balance of payments is a summary
between visible exports (X) and statement of all economic transactions of a
visible imports ( M ) . country with rest of the world .

Scope It records transactions related to It records transactions related to goods

goods as well as services. only

Type of concept It records both current account as
well as capital account
transactions.
Balance BoP always balances, provided
movement of RBI reserves
(official reserves) is reflected in it
It does not record capital account
transactions.
It is either positive (X > M ) or negative (X
< M).It balances only when X = M.

10.How overall balance is calculated in Indian BoP accounting system.

A. In the Indian BoP accounting system , overall balance is estimated as the sum total of
( i ) current account balance ,
( i i ) capital account balance, and
( i i i ) errors and omissions (accounting for statistical discrepancies) .
Overall Balance = Current account balance+ Capital account balance+ Errors and omissions

11. What are official reserve transactions explain their importance in the balance of
payments?
A.Transactions that are carried out by the monetary authority of a country which makes changes in
official reserves is known as official reserve transaction or ORT.
Official reserve transactions are very important as they help to bring a balance in the country's overall
balance of payments. So, such transactions act as accommodating Item in BOP.

By selling foreign currencies in the exchange market during the period of deficit and purchasing
them during the surplus period. The increase and decrease in the official reserve are called as the
balance of payments surplus and deficit respectively.
Importance of Official reserve transaction in the balance of payments are:
1. Helps in adjusting deficit or surplus in the balance of payments
2. Purchasing of own currency is regarded credit item in the balance of payments where selling is
regarded as a debit.
HOTS

Long answer questions :

1.Explain components of current account of BOP .

A. Principal components of current account of BOP are as under:

Export and Import of Goods:

Export and import of goods is treated as ' merchandise' or 'visible trade' . Payment for import of
goods leads to outflow of foreign exchange and therefore it is recorded in the debit side . Whereas,
export of goods leads to inflow of foreign exchange and therefore it is recorded in the credit side.

Export and Import of Services

Export and import of goods is treated as non factor service . Services are generally of 3 kinds :
shipping , banking and insurance .Payment for import of services leads to outflow of foreign
exchange and therefore it is recorded in the debit side . Whereas, export of services leads to
inflow of foreign exchange and therefore it is recorded in the credit side.

Factor Income:
Factor services consists of income received and paid abroad on account of :
i) investment income, and
(ii) compensation of employees. Income paid abroad leads to outflow of foreign exchange and
therefore it is recorded in the debit side . Whereas, income received from abroad leads to inflow
of foreign exchange and therefore it is recorded in the credit side.

Unilateral transfers to and from abroad :

Unilateral transfers made by way of gifts, grants and remittances ( to and from abroad). Transfers
sent abroad leads to outflow of foreign exchange and therefore it is recorded in the debit side .
Whereas, transfers received from abroad leads to inflow of foreign exchange and therefore it is
recorded in the credit side.

2.Explain components of capital account of BOP .

A.Principal components of current account of BOP are as under:

Borrowing and lending to and from abroad:

Borrowing from rest of the world raises our liability to rest of the world and therefore it is
recorded as a 'credit item' in the capital account of BoP.
Lending to rest of the world is recorded as 'debit item' in the capital account, as it causes flow of
foreign exchange from our country to rest of the world.
Foreign Investment:
Foreign investment is split as:
(i) Portfolio Investment, and
(ii) Foreign Direct Investment (FDI)
Investment made by rest of the world in domestic country is recorded on the credit side as it brings
in the foreign exchange.
Investment made by normal residents abroad is recorded on the debit side as it leads to outflow
of the foreign exchange.

Change in foreign exchange reserves :

A change in foreign exchange reserves held by government in the Central Bank serves as a
financing item in BOP. Any withdrawal from reserves is recorded in the credit side , whereas ,
addition to reserves is recorded in the debit side.

HOTS

1. Balance of payment always balances.

A.

• Balance of payment is always balanced but only in accounting sense

• Balance of payment can have either surplus or deficit balance on account of autonomus
transaction
• But since its an account based on the double entry book keeping system so it is balanced
with the help of accommodating transactions.
• Surplus in BOP is offset by a corresponding debt accommodating transactions (
increase in forex reserves)
• Whereas , deficit in BOP is offset by a corresponding credit accommodating
transactions ( decrease in forex reserves)

2."Slump in oil prices."

How will this affect India's CAD?
A. India is a big importer of oil . A fall in oil prices means that India will be able to save foreign
exchange even when the quantum of import is not reduced . Accordingly, CAD will be managed .
This will help in improving India's current account deficit.

3.Indian Rupee has been depreciating in the recent times.

What effect will it have on the CAD?
A. As a result of depreciation of the rupee, foreign goods become expensive while domestic goods
become cheaper. This should lead to a rise in exports and fall in imports . Accordingly, CAD
should improve . But, if we are importing certain essential raw materials ( t he imports of which
cannot be cut ) our import bill may swell with the increase in exchange rate . Accordingly, CAD
may not improve . In fact, it may deteriorate further.

4."A country with traded eficit cannot have current account surplus in its Balance of
Payments ." Do you agree with the given statement? Discuss with reason .
A. No . Surplus in current account can a rise when the deficit on trade account is less than the
surplus on account of invisibles . In other words, when the surplus a rising out of the excess of
export of invisibles over the import of invisibles is greater than the deficit a rising out of the excess
of imports over exports, we will have current account surplus.

Some Numericals
Critical points

1 . (i)All current transfers between a country and rest of the world are recorded as invisibles in the
current account BoP, and
(ii) all direct purchases by
non-resident tourists in the domestic economy and all direct purchases by the resident tourists in
rest of the world are recorded as invisibles in the current account BoP Thus, charity (grants) to rest
of the world (or from rest of the world) is to be recorded as a component of invisibles in the current
account of BoP.

2. All receipts of foreign exchange (by way of incomes, revenue, transfers or borrowings) are
recorded as positive (+) items, while all payments of foreign exchange are recorded as negative
(-) items. The balance is estimated as the difference between receipts (+ items) and payments (-
items).
3. Export and import of goods includes all types of goods, whether these are consumer goods ( like
bread and butter) or capital goods ( like plant and machinery) . Balance on account of export and
import of goods is called Trade Balance. It is an element of current account BoP Never consider
the export and import of capital goods (like plant and machinery) as an element of capital account
BoP.

4. Monetary transactions relating to capital account BoP do not involve the movement of goods
and services from one country to the other.

Borrowing is split as:

(i) External commercial borrowing, and
(ii) External assistance.
The principal difference between the two is that while external
commercial borrowing is available at the market rate of interest
(in the international money market), external assistance is
available at the concessional rate of interest.
 NATIONAL INCOME NUMERICALS

VALUE ADDED METHOD

TYPE 1

NORMAL QUESTION

Q1) From the following date about a firm X, calculate gross value added at factor cost by it.

S.No. Items Amount (in Rs. Crore )

1) Sales 350
2) Opening stock 30
3) Closing stock 20
4) Purchase of machinery 150
5) Purchase of intermediate products 170
6) Subsidy 40
7) Depreciation 35
Answer: GVA FC = 210 THOUSANDS

Solution :

TYPE 2

WHEN DOMESTIC SALES ARE GIVEN

Q2) From the following data about a firm, estimate the net value added at factor cost by the firm.

S.No. Items Amount (in thousands)

1) Domestic sales 2000
2) Subsidies 40
3) Purchase of raw materials 560
4) Exports 500
5) Depreciation 100
6) Import of raw materials 60
7) Change in stock 200
8) Net indirect taxes 60
Answer: NVA FC = 1980 THOUSANDS

Solution :
TYPE 3

WHEN DOMESTIC SALES AND DOMESTIC PURCHASES ARE GIVEN

Q3) From the following data about the firm, estimate the net value added at factor cost by the firm.

S.No. Items Amount (in thousands )

1) Domestic sales 2500
2) Subsidies 40
3) Purchase of raw materials in the domestic market 500
4) Exports 200
5) Depreciation 100
6) Import of raw materials 60
Answer: NVA FC = 2080 THOUSANDS

Solution :

TYPE 4

TREATMENT OF MACHINERY

Q4) Calculate the net value added by firm X from the following data:

S.no. Items Amount (in lakhs )

1) Sales 600
2) Purchase of raw material 200
3) Import of raw materials 100
4) Closing stock 40
5) Opening stock 10
Answer : VALUE ADDED = 430 LAKHS

Solution :
TYPE 5

MULTIPLE POINTS

Q5) From the following data, calculate gross value added at factor cost:

S.no. Items Amount (in crore)

1) Sales 1200
2) Decrease in stock 80
3) Production for self consumption 100
4) Single use producer goods 300
5) Exports 150
6) Electricity charges 50
7) Excise duty 70
8) Subsidy 40
Answer: GVA FC = 890 CRORE

Solution :

TYPE 6

DEPRECIATION TO BE CALCULATED

Q6) Find net value added at market price:

S.no. Items Amount (in lakhs)

1) Fixed capital with good life span of 5 years 15
2) Raw materials 6
3) Sales 25
4) Net change in stock (-)2
5) Taxes on production 1
Answer: VALUE ADDED AT MP = 14 LAKHS

Solution :
TYPE 7

SALES FORMULA TO BE APPLIED

Q7) Find out net value added at market price.

S.no. Items Amount (in rupees)

1) Intermediate cost 10000
2) Change in stock 1000
3) Output sold (units) 750
4) Price per unit of output 40
5) Import duty 2000
6) Consumption of fixed capital 3000
Answer : NVA FC = 18000

Solution :

TYPE 8

MISSING VALUE

Q8) From the following data, calculate the gross value added at factor cost.

S.no. Items Amount (in crores)

1) Sales 180
2) Rent 5
3) Subsidies 10
4) Change in stock 15
5) Purchase of raw materials 100
6) Profits 25
ANSWER : GVA FC = 105 CRORE

Solution :
TYPE 9

MISSING VALUE

Q9) Calculate intermediate consumption from the following data:

S.no Items Amount (in lakhs)

1) Value of output 200
2) Net value added at factor cost 80
3) Sales tax 15
4) Subsidy 5
5) Depreciation 20
ANSWER : INTERMEDIATE CONSUMPTION = 90 LAKHS

Solution :

TYPE 10

MISSING VALUE (DIFFICULT)

Q10) Calculate ‘sales’ from the given data about of a firm:

S.no Items Amount (in lakhs)

1) Factor payments 40
2) Payments for non-factor inputs 60
3) Depreciation 5
4) Goods and service tax 16
5) Subsidy 4
6) Decrease in stock 8
7) Purchase of machinery 30
ANSWER : SALES = 125 LAKHS

Solution :
TYPE 11

WORD PROBLEMS

Q11) A firm had an inventory of rupees 18 lakhs at the beginning of the year. During the year, the firm has
produced goods of worth rupees 500 lakh and sold goods of worth rupees 400 Lakhs. Calculate the change in
inventories for the year.

ANSWER : 100 LAKHS

Solution :

TYPE 12

WORD PROBLEMS

Q12) A firm had an inventory of rupees 800 lakhs at the beginning of the year. During the year, the firm had
produced goods worth rupees 5000 lakhs and sold goods of worth rupees 4000 lakhs. Calculate the closing stock as
well as the change in inventions for the year.

ANSWER : CLOSING STOCK = 1800 LAKHS

Solution :
TYPE 13

WORD PROBLEMS

Q13) A firm produces goods of worth rupees 500 lakhs during a year and intermediate goods used by the firm is of
worth rupees 250 lakhs. The cost of capital consumption is rupees 20 lakhs per year. Calculate gross value added
and net value added by the firm.

ANSWER : 250 LAKHS

Solution :

TYPE 14

MORE THAN 1 FIRM

Q14) From the following data, calculate the value added by firm A And firm B

S.no Items Amount (in lakhs)

1) Closing stock by firm A 20
2) Closing stock by firm B 15
3) Opening stock by firm A 5
4) Opening stock by firm B 10
5) Sales by firm A 300
6) Purchases by firm A from firm B 100
7) Purchases from firm B by firm A 80
8) Sales by firm B 250
9) Import of raw materials by firm A 50
10) Exports by firm B 30
ANSWER : VALUE ADDED BY A = 165 LAKHS

VALUE ADDED BY B = 175 LAKHS

Solution :
TYPE 15

MORE THAN 1 FIRM

Q15) Calculate value added by firm A and B from the following data:

S.no Items Amount (in lakhs)

1) Sales by B to general government 100
2) Sales by firm A 500
3) Purchases by household from firm B 300
4) Exports by firm B 50
5) Change in stock of firm A 20
6) Change in stock of firm B 10
7) Imports by firm A 70
8) Sales by firm C to A 250
9) Purchases by firm B from firm A 200
ANSWER : VALUE ADDED BY A = 200 LAKH

VALUE ADDED BY B = 260 LAKH

Solution :

TYPE 16

MORE THAN 1 FIRM

Q16) Calculate the value added by firm A and firm B from the following data:

S.no Items Amount (in lakhs)

1) Purchases by firm A from the rest of the world
2) Sales by firm A
3) Purchases by firm A from firm B
4) Sales by firm A
5) Opening stock of firm A
6) Closing stock of firm A
7) Opening stock of firm B
8) Closing stock of firm B
9) Purchases by firm B from firm A
ANSWER : VALUE ADDED BY A = 5 LAKH

VALUE ADDED BY B = 30 LAKH

Solution :
TYPE 17

RELATED TO INCOME METHOD (HOTS)

Q17) From the following data relating to a firm, calculate (a) NVAFC and (b) Opening stock

S.no Items Amount (in lakhs)

1) Factor payments 130
2) Purchase of raw materials 290
3) Sales 430
4) Replacement cost of fixed capital 25
5) Net indirect taxes 35
6) Closing stock 80
ANSWER : NVA FC = 130

OPENING STOCK = 30 LAKHS

Solution :

TYPE 18

MIXED NUMERICAL

Q18) Calculate net value added at factor cost from the following data:

S.no Items Amount (in crores)

1) Sales 2200
2) Used for self-consumption by owners 300
3) Opening stock 350
4) Purchase of raw materials 1050
5) Electricity charges 80
6) Consumption of fixed capital 130
7) Excise duty 60
8) Income tax 30
9) Closing stock 100
ANSWER : 930 LAKHS

Solution :
TYPE 19

MIXED NUMERICAL

Q19) In an economy described below

(A,B and C are three firms)

. A import goods worth rupees 100 crores and exports goods worth rupees 60 crores and sells for rupees
20 crores to B

. B sells goods for rupees 80 crores to C and for rupees 60 crores to consumers

. C exports goods worth rupees 120 crores and sells goods for rupees 50 crores to Government

Find the value added by all the three firms.

ANSWER : VALUE ADDED BY INDUSTRY OF ORIGIN = 190 CRORES

Solution :

INCOME METHOD

TYPE1

CALCULATION OF COE

Q1) From the following data, estimate compensation of employees:

S. no. Items Amount(in thousands)

1) Wages and salaries received by workers in cash 560
2) Value of free medical facilities 70
3) Compensation received by an injured worker from the 20
insurance company
4) Commission received by workers in sales departments 40
5) Employer’s contribution to social security scheme 60
ANSWER : COE = 730 THOUSAND

Solution :
TYPE 2

CALCULATION OF COE

Q2) Estimate compensation of employees from the following data:

S. no. Items Amount (in thousand)

1) Wages and salaries received by the staff 1000
2) Value of free medical facilities 105
3) Travelling allowance paid to staff 70
4) Employer’s contribution to state insurance fund 40
5) Commission received by workers in sales departments 30
6) Interest on free loans given to staff 201
7) Value of subsidized food 52
ANSWER : COE = 1428 THOUSAND

Solution :

TYPE 3

CALCULATION OF COE

Q3) From the following data, estimate compensation of employees:

S.no. Items Amount (in thousand)

1) Wages and salaries received by workers in cash 720
2) Employer’s contribution to social security 80
3) Compensation received by an injured worker from insurance 25
company
4) Value of medical facilities 120
5) Commission received by workers of sales department 80
ANSWER : COE=1000 THOUSAND

Solution :
TYPE 4

CALCULATION OF OS

Q4)

Calculate (a) operating surplus and (b) compensation of employees from the following data:

S.no. Items Amount (in crore)

1) Indirect taxes 250
2) Depreciation 200
3) Royalty 20
4) Profit 250
5) Subsidies 50
6) Gross domestic product at MP 2000
7) Interest 40
8) Rent 90
9) Net factor income from abroad (-)40
ANSWER (A) OPERATING SURPLUS = 400 CRORE

(B) COMPENSATION OF EMPLOYEES = 1200 THOUSAND

Solution :

TYPE 5

CALCULATION OF OS

Q5) Calculate (a) NDP FC (b) Compensation of employees and (c) Operating surplus from the following data:

S.no. Items Amount (in crore)

1) Rent 1400
2) Royalty 200
3) Interest 1500
4) Wages and salaries 800
5) Profit 500
6) Mixed income 1000
7) Depreciation 70
8) Employer’s contribution to social security schemes 200
ANSWER : (a) NDP FC = 5600 CRORE

(b) Compensation of employees = 1000 thousand

( c ) Operating surplus = 3600 crore

Solution :

TYPE 6

CALCULATION OF OS

Q6) Calculate the operating surplus

S.no Items Amount (in crores)

1) Compensation of employees 200
2) Indirect taxes 200
3) Consumption of fixed capital 100
4) subsidies 50
5) Gross domestic product at MP 600
ANSWER : OS = 150 CRORE

Solution :

TYPE 7

NORMAL QUESTION

Q7) Calculate (i) Gross domestic product at market price and (ii) Net national product at factor cost from the
following data:

S.no. Items Amount (in crores)

1) Consumption of fixed capital 34
2) Employer’s contribution to social security schemes 30
3) Rent 10
4) Interest 20
5) Profits 25
6) Royalty 5
7) Wages and salaries 170
8) Net indirect taxes 38
9) Net factor income from abroad (-)3
ANSWER : (i) GDP MP = 332 CRORES

(ii) NNP FC = 257 CRORES

Solution :

TYPE 8

NORMAL QUESTION

Q8) From the following data, calculate GNP MP by income method:

S.no. Items Amount (in crore)

1) Wages and salaries 700
2) Rent 100
3) Cost of capital consumption 50
4) Net factor income from abroad (-)10
5) Mixed income 400
6) Subsidies 100
7) Profits 400
8) Indirect taxes 300
9) Employer’s contribution to schemes 50
10) Interest 40
ANSWER : GNP MP = 1930 CRORES

Solution :

TYPE 9

NORMAL QUESTION (IGNORE SUB PARTS)

Q9) Find out national income from the following data:

S.no. Items Amount (in crore)

1) Operating surplus 200
2) Wages and salaries 700
3) Net factor income from abroad (-)10
4) Contribution to social security schemes by employees 100
5) Rent and royalty 50
ANSWER : NATIONAL INCOME = 890 CRORE
Solution :

TYPE 10

MIXED QUESTIONS

Q10) Calculate (a) NDP FC (b) Operating surplus and (c) Compensation of employees from the following data :

S. no. Items Amount (in crore )

1) Rent 1400
2) Royalty 200
3) Interest 1500
4) Wages and salaries 500
5) Mixed income 1000
6) Depreciation 70
7) Employer’s contribution to social security schemes 200
ANSWER : (a) 5600 crore (b) 3600 crores ( c ) 1000 crore

Solution :

TYPE 11

MIXED QUESTIONS

Q11) Calculate (a) Operating surplus and (b) Domestic income

S. no. Items Amount (in crore)

1) Compensation of employees 2000
2) Rent and interest 800
3) Indirect taxes 120
4) Corporation tax 460
5) Consumption of fixed capital 100
6) Subsidies 200
7) Dividend 940
8) Undistributed profit 300
9) Net factor income to abroad 150
10) Mixed income 200
ANSWER : (a) 2500 crore (b) 4700 crore
Solution :

TYPE 12

MISSING VALUE

Q12) Calculate compensation of employees from the following data:

S.no. Items Amount (in lakhs)

1) Rent 40
2) Interest 70
3) Profit 30
4) Consumption of fixed capital 100
5) Gross domestic product at factor cost 500
6) Mixed income of self employed 100
ANSWER : 160 LAKHS

Solution :

TYPE 13

MISSING VALUE

Q13) Calculate operating surplus from the following data :

S.no. Items Amount (in crore)

1) Value of output 800
2) Intermediate consumption 200
3) Indirect tax 30
4) Compensation of employees 200
5) Depreciation 20
6) Subsidies 50
7) Mixed income 100
ANSWER : 300 CRORE

Solution :
EXPENDITURE METHOD
TYPE 1
Q1) Calculate (a) GNP MP and (b) NNP FC from the following data:
S.no. Items Amount (in crore)
1) Government final consumption expenditure 24
2) Net indirect taxes 23
3) Consumption of fixed capital 22
4) Gross domestic capital formation 24
5) Net exports (-)4
6) Private final consumption expenditure 161
7) Net factor income from abroad (-)1
8) Net changes in stocks 3
ANSWER : (a) 204 CRORE (b)159 CRORE
Solution :
TYPE 2
GROSS DOMESTIC CAPITAL FORMATION NOT GIVEN
Q2) Calculate net domestic product at factor cost:
S.no. Items Amount (in crore)
1) Private final consumption expenditure 8000
2) Government final consumption expenditure 1000
3) Exports 70
4) Imports 120
5) Consumption of fixed capital 60
6) Gross domestic fixed capital formation 500
7) Change in stock 100
8) Factor income to abroad 40
9) Factor income from abroad 90
10) Indirect taxes 700
11) Subsidies 50
12) Net current transfers to abroad (-)30
ANSWER : 8840 CRORES
Solution :
TYPE 3
NET DOMESTIC CAPITAL FORMATION IS GIVEN
Q3)Calculate national income :
S.no. Items Amount (in crores)
1) Net current transfers from rest of the world 30
2) Private final consumption expenditure 400
3) Net domestic capital formation 100
4) Change in stock 50
5) Depreciation 20
6) Government final consumption expenditure 200
7) Net exports 40
8) Net indirect taxes 80
9) Net factor income paid to abroad 10
ANSWER : NATIONAL INCOME = 650 CRORE
Solution :
TYPE 4
NET FIXED CAPITAL FORMATION IS GIVEN
Q4) Calculate domestic factor income from the following data:
S.no. Items Amount (in crore)
1) Consumption of fixed capital 100
2) Personal consumption expenditure 5000
3) Net fixed capital formation 1000
4) Inventory investment 500
5) Exports 200
6) Imports 250
7) Net indirect taxes 50
8) Government purchases of goods and services 2200
9) Net factor income from abroad (-)10

ANSWER : DOMESTIC FACTOR INCOME = 8600 CRORE

Solution :
TYPE 5
HIDDEN DEPRECIATION
Q5) Calculate (a) NNP MP and (b) consumption of fixed capital from the following data:
S.no. Items Amount (in crores)
1) Government final consumption expenditure 24
2) Net indirect taxes 23
3) NNP FC 159
4) Gross domestic capital formation 24
5) Net exports (-)24
6) Private final consumption expenditure 161
7) Net factor income from abroad (-)1
8) Change in stock 3
ANSWERS : (a) 182 crore
(b) Consumption of fixed capital= 22 crore
Solution :
TYPE 6
HIDDEN DEPRECIATION
Q6) Calculate the value of depreciation from the following data:
S.no. Items Amount (in crore)
1) Net fixed capital formation 790
2) Closing stock 30
3) Opening stock 20
4) Gross domestic capital formation 840
ANSWER : 40 CRORE
Solution :

TYPE 7
HIDDEN DEPRECIATION
Q7) Determine GNP at market price from the following:
S. no. Items Amount (in crore)
1) Mixed income of self employed 2500
2) Net capital formation 1600
3) Net indirect taxes 700
4) Compensation of employees 3000
5) Net factor income from abroad (-)200
6) Change in stock 300
7) Gross fixed capital formation 1500
8) Operating surplus 5000
9) Exports 700
10) Imports 1000
ANSWERS: GNP MP = 11200 CRORE
Solution :
TYPE 8
COMPOSITION OF CONSUMPTION EXPENDITURE ARE GIVEN
Q18) Calculate National income from the following data:
S. no. Items Amount (in crore)
1) Final consumption expenditure 1200
2) Gross domestic fixed investment 600
3) Government fixed investment 200
4) Closing stock 300
5) Opening stock 100
6) Exports 800
7) Imports 300
8) Depreciation 200
9) Net factor income from abroad 130
10) Net indirect taxes 80
ANSWER : NATIONAL INCOME = 2350 CRORE
Solution :
TYPE 9
COMPONENTS OF FIXED 1 ARE GIVEN
Q9) From the following data, estimate the national income using expenditure method.
S. no. Items Amount (in crore)
1) Government purchases of goods 250
2) Inventory investment 20
3) Consumption of fixed capital 50
4) Exports 30
5) Net factor income from abroad (-)10
6) Personal consumption expenditure 700
7) Gross residential consumption expenditure 150
8) Gross public investment 80
9) Imports 10
10) Net indirect taxes 30
11) Gross business fixed investment 20
ANSWER : NATIONAL INCOME = 1150 CRORE
Solution :
TYPE 10
COMPOSITION OF PRIVATE FINAL CONSUMPTION EXPENDITURE ARE GIVEN
Q10) Compute gross national product at market price from the following data:
S. no. Items Amount (in crore)
1) Household final consumption expenditure 800
2) Consumption of fixed capital 100
3) Closing stock 20
4) Government final consumption expenditure 300
5) Final consumption expenditure of private non-profit institutions 200
serving household
6) Net indirect taxes 50
7) Opening stock 20
8) Net domestic fixed capital formation 110
9) Net imports (-)15
10) Net factor income to abroad (-)10
ANSWER : GNP MP = 1535 CRORE
Solution :
MIXED QUESTIONS

Q1) Calculate national income by (i) Income method and (ii) Output method from the following data:
S. no. Items Amount (in crores)
1) Value of output of primary sector 1500
2) Value of output of other sectors 600
3) Raw materials etc. purchased by the primary sector 700
4) Raw materials etc. purchased by other sectors 360
5) Factor income from the rest of the world 20
6) Factor income paid to the rest to the world 20
7) Depreciation 25
8) Indirect taxes 25
9) Subsidies 30
10) Mixed income of self-employed 430
11) Compensation of employees 280
12) Rent 80
13) Interest 60
14) Profit 35
ANSWER : NATIONAL INCOME = 880 CRORE
Solution :
Q2) From the following data calculate NDP MP by income method and NNP FC by expenditure methods.
S. no. Items Amount (in crore)
1) Personal consumption expenditure 610
2) Wages and salaries 230
3) Employers’ contribution to social security schemes 200
4) Gross business fixed investment 180
5) Profits 50
6) Gross residential construction investment 120
7) Government purchases of goods and services 95
8) Gross public investment 60
9) Rent 70
10) Inventory investment 55
11) Exports 50
12) Interests 60
13) Imports 60
14) Net factor income from abroad (-)5
15) Mixed income 380
16) Depreciation 40
17) Subsidies 10
18) Indirect taxes 90
ANSWER : NDP MP = 1070 CRORE NNP FC = 985 CRORE
Solution :
Q3) From the following data, calculate National Income by Income and Expenditure method:
S. no. Items Amount (in crore)
1) Government final consumption expenditure 100
2) Subsidies 10
3) Rent 200
4) Wages and salaries 600
5) Indirect taxes 60
6) Private final consumption expenditure 800
7) Gross domestic capital formation 120
8) Social security contribution by employers 55
9) Royalty 25
10) Net factor income paid to abroad 30
11) Interest 20
12) Consumption fixed capital 10
13) Profit 130
14) Net exports 70
15) Change in stock 50
ANSWER : NI BY INCOME METHOD = 1000 CRORES
NI BY EXPENDITURE METHOD = 1000 CRORES
Solution :